A substantial boost of US $15 bn to Sri Lanka's GDP t hrough digital economy, by 2030  
 
The Chairman of the Federation of Information Technology Sri Lanka (FITIS), Mr. Indika De 
Soysa, has projected a substantial boost of 15 billion US dollars to Sri Lanka' s gross domestic 
product (GDP) through the expansion of the digital economy, by the year 2030.  
 
Presently, the digital economy contributes 3.7 billion US dollars to the GDP.  
 
Mr. Indika De Soy sa made these remarks during a press conference today (20), at the Presidential 
Media Centre (PMC), where he discussed the "DIGIECON Sri Lanka 2030" program, aligning 
with President Ranil Wickremesinghe's vision.  
 
The upcoming 41st National Information Technology Conference, themed 'Towards a Sustainable 
Digital Society,' is scheduled to take place from October 11 to 13 at the Sh angri La Hotel in 
Colombo. Organized by the Sri Lanka Computer Association, this event ai ms to leverage 
technology for accelerating Sri Lanka's economic growth through the DIGIECON 2030 program, 
aligning with the government's vision of "Towards a Sustainable Digital Society" under the 
guidance of State Minister of Technology, Mr. Kanaka Herath . 
 
Mr. Indika De Soy sa emphasized the global trend of developed countries contributing 
approximately 40% of their GDP from the digital economy, while Sri Lanka currently stands at 
5%. The goal is to elevate this contribution to 20% and increase the current  3.7 billion US dollars 
in GDP to 15 billion US dollars by 2030.  
 
Additionally, a comprehensive set of guidelines for the next seven years is being developed in 
collaboration with the DIGIECON 2030 government program to enhance technological knowledge 
among Sri Lankans.  
 
Furthermore, the conference will introduce a digital economy master plan and regulatory policy 
framework by 2030, aiming to accelerate the country's digital economy. The event will feature 
over thirty expert speakers, both local and intern ational, addressing key areas such as financial 
technology, education technology, tourism technology, information security, agricultural 
technology and electronic health services.  
 
Notably, the conference will include a digital investment component, seekin g to attract potential 
investors for established IT companies in Sri Lanka and achieve a target of 3 billion US dollars in 
IT exports. The support extended by the Sri Lanka Information and Communication Technology 
Agency for this endeavour  is acknowledged.  
 
The conference enjoys the patronage of President Ranil Wickremesinghe and is supported by the 
State Minister of Technology, Mr. Kanaka Herath, the Ministry of Technology and the Information 
and Communication Technology Agency of Sri Lanka.

Key figures i n attendance included Sri Lanka Computer Association President Dr. Ajantha 
Athukorala, National Information Technology Conference Co -Chairman Dr. Nirosha Vedasinghe, 
Sri Lanka Computer Association Secretary Heshan Karunaratne, DIGIECON 2023 -2030 Project 
Director Prasad Samarawickrama and Sri Lanka Computer Association Member Dr. Amal 
Ilesingha, among others.  
 
President's Media Division ( PMD)  
20.09.2023

CIMA 
 
Subject E1 
 
Managing Finance in a 
Digital World 
 
Study Text

P.2   
 
           Published by: Kaplan Publishing UK Unit 2 The Business Centre, Molly Millars Lane, Wokingham, Berkshire RG41 2QZ Copyright © 2019 Kaplan Financial  Limited. All rights reserved. 
No part of this publication may be reproduced, stor ed in a retrieval system or transmitted in any 
form or by any means electronic, mechanical, photocopying, recording or otherwise without the 
prior written permission of the publisher. 
Acknowledgements 
We are grateful to the CIMA for permission to  reproduce past examination questions. The 
answers to CIMA Exams have been prepared by Ka plan Publishing, except in the case of the 
CIMA November 2010 and subsequent CIMA Exam  answers where the official CIMA answers 
have been reproduced. Questions from past live assessments have been included by kind 
permission of CIMA, 
Notice 
The text in this material and any others made available by any Kaplan Group company does not 
amount to advice on a particular matter and should not be taken as such. No reliance should be 
placed on the content as the basis for any invest ment or other decision or in connection with 
any advice given to third parties. Please consult your appropriate professional adviser as necessary. 
Kaplan Publishing Limited and all other Kaplan gro up companies expressly disclaim all liability 
to any person in respect of any losses or other  claims, whether direct, indirect, incidental, 
consequential or otherwise arising in relation to the use of such materials. 
Kaplan is not responsible for the content of external websites. The inclusion of a link to a third 
party website in this text should not be taken as an endorsement. 
British Library Cataloguing in Publication Data 
A catalogue record for this book is available from the British Library. 
ISBN: 978-1-78740-193-8 Printed and bound in Great Britain

P.3 
Contents 
  Page 
Chapter 1 The roles of the finance fu nction in organisations 1 
Chapter 2 The activities performed by finance 
professionals to fulfil the roles 29 
Chapter 3 The structure and shape of the finance function 43 
Chapter 4 What each level of the finance function does 85 
Chapter 5 Technology affecting busi ness and finance 127 
Chapter 6 How the finance func tion uses digital 
technologies 151 
Chapter 7 Data and the finance function 179 
Chapter 8 Data to create and preserve value for organisations 195 
Chapter 9 How the finance function interacts with operations 209 
Chapter 10 How the finance function interacts with sales 
and marketing 269 
Chapter 11 How the finance function interacts with human 
resources 305 
Chapter 12 How the finance function interacts with IT 339 
Index  I.1

P.6  
 
How to use the Materials 
These official CIMA learning material s have been carefully designed to make 
your learning experience as easy as po ssible and to give you the best chances 
of success in your objective tests. 
The product range contains a number of features to help you in the study 
process. They include: 
• a detailed explanation of all syllabus areas 
• extensive ‘practical’ materials 
• generous question practice, together with full solutions. 
This Study Text has been designed wit h the needs of home study and distance 
learning candidates in mind. Such st udents require very full coverage of the 
syllabus topics, and also the facility to undertake extensive question practice. 
However, the Study Text is also  ideal for fully taught courses. 
The main body of the text is divided into a number of chapters, each of which is organised on the following pattern: 
• Detailed learning outcomes.  These describe the knowledge expected 
after your studies of the chapter are complete. You should assimilate 
these before beginning detailed work on the chapter, so that you can 
appreciate where your studies are leading. 
• Step-by-step topic coverage. This is the heart of each chapter, 
containing detailed expl anatory text supported wh ere appropriate by 
worked examples and exercises. You should work carefully through this 
section, ensuring that you understand the material being explained and 
can tackle the examples and exercise s successfully. Remember that in 
many cases knowledge is cumulative: if  you fail to digest earlier material 
thoroughly, you may struggle to understand later chapters. 
• Activities.  Some chapters are illustrated by  more practical elements, such 
as comments and questions designed to stimulate discussion. 
• Question practice.  The text contains three styles of question: 
– Exam-style objective test questions (OTQs). 
– ‘Integration’ questions – these test your ability to understand topics 
within a wider context. This is parti cularly important with calculations 
where OTQs may focus on just one element but an integration 
question tackles the full calculation, just as you would be expected to 
do in the workplace.

P.7 
– ‘Case’ style questions – these test your ability to analyse and discuss 
issues in greater depth, particula rly focusing on scenarios that are 
less clear cut than in the objective tests, and thus provide excellent 
practice for developing the skills needed for success in the 
Management Level Case Study Examination. 
• Solutions.  Avoid the temptation merely to ‘audit’ the solutions provided. It 
is an illusion to think that this pr ovides the same benefits as you would 
gain from a serious attempt of your own. However, if you are struggling to get started on a question you shoul d read the introductory guidance 
provided at the beginning of the solution, where provided, and then make your own attempt before referr ing back to the full solution. 
If you work conscientiously through this Of ficial CIMA Study Text according to 
the guidelines above you will be giving your self an excellent chance of success 
in your objective tests. Good luck with your studies! 
Quality and accuracy are of the utmost importance to us  so if you spot an error 
in any of our products, please send an em ail to mykaplanreporting@kaplan.com 
with full details, or follow the link to the feedback form in MyKaplan. 
Our Quality Co-ordinator will work with our technical team to ve rify the error and 
take action to ensure it is corrected in future editions. 
Icon explanations 
 Definition  – These sections explain impor tant areas of knowledge which 
must be understood and reproduced in  an assessment environment. 
 
 Key point  – Identifies topics which are key to success and are often 
examined. 
 
 Supplementary reading  – These sections will help to provide a deeper 
understanding of core areas. T he supplementary reading is NOT  optional 
reading. It is vital to provide you with the breadth of knowledge you will 
need to address the wide range of topics within your syllabus that could 
feature in an assessment question. Reference to this t ext is vital when 
self-studying.  
 
 Test your understanding  – Following key points and definitions are 
exercises which give the opportunity  to assess the understanding of these 
core areas. 
 
 Illustration  – To help develop an understanding of particular topics. The 
illustrative examples are useful in preparing for the Test your 
understanding exercises.

P.8  
 Exclamation mark – This symbol signifies a topic which can be more 
difficult to understand. When reviewing these areas, care should be taken. 
 
 New – Identifies topics that  are brand new in subjects that build on, and 
therefore also contain, learning  covered in earlier subjects. 
 
 Tutorial note  – Included to explain some of the technical points in more 
detail. 
Study technique 
Passing exams is partly a matter of  intellectual ability, but however 
accomplished you are in that resp ect you can improve your chances 
significantly by the use of appropriate study and revision techniques. In this 
section we briefly outline some tips for effective study during the earlier stages 
of your approach to the objective tests. We also mention some techniques that 
you will find useful at  the revision stage. 
Planning 
To begin with, formal planning is essential to get the bes t return from the time 
you spend studying. Estimate how much time in total you are going to need for 
each subject you are studying. Remember that you need to allow time for revision as well as for initial study of the material. 
With your study material before you, decide which chapters you are going to 
study in each week, and which weeks you will devote to revision and final question practice. 
Prepare a written schedule summarising the above and stick to it! It is essential to know your syllabus. As your studies progress you will become 
more familiar with how long it takes to cover topics in sufficient depth. Your 
timetable may need to be adapted to a llocate enough time for the whole 
syllabus. 
Students are advised to refer to the exam ination blueprints (see page P.13 for 
further information) and the CIMA webs ite, www.cimaglobal.com, to ensure they 
are up-to-date. The amount of space allocated to a topic in the Study Text is not a very good 
guide as to how long it will take you. The syllabus weighting is the better guide as to how long you should spend on a syllabus topic.

P.9 
Tips for effective studying 
(1) Aim to find a quiet and undisturbed location for your study, and plan as far 
as possible to use the same period of time each day. Getting into a routine 
helps to avoid wasting ti me. Make sure that you have all the materials you 
need before you begin so as to  minimise interruptions. 
(2) Store all your materials in one place, so that you do not waste time 
searching for items every time you want  to begin studying. If you have to 
pack everything away after each study period, keep your study materials 
in a box, or even a suitcase, which wil l not be disturbed until the next time. 
(3) Limit distractions. To make the most  effective use of your study periods 
you should be able to apply total concentration, so turn off all 
entertainment equipment, set your phones to message mode, and put up your ‘do not disturb’ sign. 
(4) Your timetable will tell you which t opic to study. However, before diving in 
and becoming engrossed in the finer points, make sure you have an 
overall picture of all the areas that need to be covered by the end of that 
session. After an hour, allow yourself a short break and move away from your Study Text. With experience, you will learn to assess the pace you need to work at. Each study sessi on should focus on component learning 
outcomes – the basis for all questions. 
(5) Work carefully through a chapter , making notes as you go. When you 
have covered a suitable amount of material, vary the pattern by attempting a practice question. When you have finished your attempt, make notes of any mistakes you made, or any areas that you failed to cover or covered 
more briefly. Be aware that all component learning outcomes will be tested 
in each examination. 
(6) Make notes as you study, and discove r the techniques that work best for 
you. Your notes may be in the form  of lists, bullet points, diagrams, 
summaries, ‘mind maps’, or the writt en word, but remember that you will 
need to refer back to them at a later date,  so they must be intelligible. If 
you are on a taught course, make sure you highlight any issues you would like to follow up with your lecturer. 
(7) Organise your notes. Make sure that all your notes, calculations etc. can 
be effectively filed and easily retrieved later.

P.10   
Progression  
There are two elements of progression that we can measure: how quickly 
students move through individual topics within a subject; and how quickly they 
move from one course to the next. We k now that there is an optimum for both, 
but it can vary from subject to subj ect and from student to student. However, 
using data and our experience of student per formance over many years, we can 
make some generalisations.  
A fixed period of study set out at the start of a cour se with key milestones is 
important. This can be within a subject, for example ‘I will finish this topic by 30 
June’, or for overall achievement, such as  ‘I want to be qualified by the end of 
next year’.  
Your qualification is cumulative, as earlier papers provide a foundation for your 
subsequent studies, so do not allow there to be too big a gap between one 
subject and another. For example, E1 Managing finance in a digital world  builds 
on your knowledge of the finance function from certificate level and lays the foundations for E2 Managing performance and all strategic papers particularly 
E3 Strategic management  and P3 Risk management . 
We know that exams encourage techniques  that lead to some degree of short 
term retention, the result being that you will simply forget much of what you 
have already learned unless it is refreshed (look up Ebbinghaus Forgetting Curve for more details on this). This make s it more difficult as you move from 
one subject to another: not only will you have to learn the new subject, you will also have to relearn all the underpinni ng knowledge as well. This is very 
inefficient and slows down your overa ll progression which makes it more likely 
you may not succeed at all.  
In addition, delaying your studies slows your path to qualification which can 
have negative impacts on your career, pos tponing the opportunity to apply for 
higher level positions a nd therefore higher pay.

P.11 
You can use the following diagram sho wing the whole structure of your 
qualification to help you keep track of your progress. Make sure you carefully 
review the 2019 CIMA syllabus transition rules and seek appropriate advice if 
you are unsure about your progre ssion through the qualification.

P.12   
Objective test 
Objective test questions require you to  choose or provide a response to a 
question whose correct answer is predetermined. 
The most common types of objecti ve test question you will see are: 
• Multiple choice, where you have to  choose the correct answer(s) from a 
list of possible answers. This could either be numbers or text. 
• Multiple choice with more choices and answers, for example, choosing two 
correct answers from a list of eight po ssible answers. This could either be 
numbers or text. 
• Single numeric entry, where you give  your numeric answer, for example, 
profit is $10,000. 
• Multiple entry, where you give several numeric answers. 
• True/false questions, where you state whet her a statement is true or false. 
• Matching pairs of text, for example, matching a technical term with the 
correct definition. 
• Other types could be matching text with graphs and labelling 
graphs/diagrams. 
In every chapter of this Study Te xt we have introduced these types of 
questions, but obviously we have had to labe l answers A, B, C etc. rather than 
using click boxes. For convenience, we  have retained quite a few questions 
where an initial scenario leads to a number of sub-questions. There will be no 
questions of this type in the objective tests. 
Guidance re CIMA on-screen calculator 
As part of the CIMA objective test soft ware, candidates are now provided with a 
calculator. This calculator is on-screen and is availabl e for the duration of the 
assessment. The calculator is available in each of the objective tests and is 
accessed by clicking the calculator butt on in the top left hand corner of the 
screen at any time during the assessment. Candidates are permitted to utilise 
personal calculators as long as they  are an approved CIMA model. Authorised 
CIMA models are listed here: https:// www.cimaglobal.com/Studying/study-and-
resources/. 
All candidates must complete a 15-minut e exam tutorial before the assessment 
begins and will have the opportunity to famili arise themselves with the calculator 
and practise using it. The exam tutorial is also available online via the CIMA 
website. 
Candidates may practise using the ca lculator by accessing the online exam 
tutorial. 
Fundamentals of objective tests 
The objective tests are 90-minute assessments comprising 60 compulsory 
questions, with one or more parts. There will be no choice and all questions should be attempted. All el ements of a question must be answered correctly for 
the question to be marked correctly. All questions are equally weighted.

P.13 
CIMA syllabus 2019 – Structure of  subjects and learning outcomes 
Details regarding the content of the new CIMA syllabus can be located within 
the CIMA 2019 professi onal syllabus document. 
Each subject within the syllabus is divided into a number of broad syllabus 
topics. The topics contain one or more lead learning outcomes, related component learning outcomes and indicative knowledge content. 
A learning outcome has two main purposes: (a) To define the skill or ability that a well prepared candidate should be able 
to exhibit in the examination. 
(b) To demonstrate the approach likely to be taken in examination questions. The learning outcomes are part of a hier archy of learning objectives. The verbs 
used at the beginning of eac h learning outcome relate to a specific learning 
objective, e.g. Calculate  the break-even point, profit target, margin of safety and profit/volume 
ratio for a single product or service. The verb ‘ calculate ’ indicates a level three l earning objective. The following 
tables list the verbs that appear in the syllabus learning outcomes and 
examination questions. 
The examination blueprints and re presentative task statements 
CIMA have also published examination blueprints giving learners clear 
expectations regarding what is expected of them. The blueprint is structured as follows: 
• Exam content sections (reflecting the syllabus document)  
• Lead and component outcomes (refle cting the syllabus document) 
• Representative task statements. 
A representative task statem ent is a plain English description of what a CIMA 
finance professional should know and be able to do. 
The content and skill level determine the language and verbs used in the 
representative task. 
CIMA will test up to the level of the ta sk statement in the objective tests (an 
objective test question on a particular topic could be set at a lower level than the 
task statement in the blueprint). 
The format of the objective test blueprints  follows that of the published syllabus 
for the 2019 CIMA Profe ssional Qualification. 
Weightings for content sections are al so included in the individual subject 
blueprints.

P.14   
CIMA VERB HIERARCHY 
CIMA place great importance on the definition of verbs in structuring objective 
tests. It is therefore crucial that y ou understand the verbs in order to appreciate 
the depth and breadth of a topi c and the level of skill required. The objective 
tests will focus on levels one, two and thr ee of the CIMA hierarchy of verbs. 
However, they will also test levels four and five, especially at the management 
and strategic levels. 
 
Skill level Verbs used  Definition 
Level 5  
Evaluation 
How you are expected to use 
your learning to evaluate, 
make decisions or 
recommendations Advise Counsel, inform or notify 
Assess Evaluate or estimate the nature, ability or 
quality of 
Evaluate Appraise or assess the value of 
Recommend Propose a course of action 
Review Assess and evaluate in order, to change if 
necessary 
Level 4  
Analysis 
How you are expected to 
analyse the detail of what you 
have learned Align Arrange in an orderly way 
Analyse Examine in detail the structure of 
Communicate Share or exchange information 
Compare and contrast Show the similarities  and/or differences 
between 
Develop Grow and expand a concept 
Discuss Examine in detail by argument 
Examine Inspect thoroughly 
Interpret Translate into intelligib le or familiar terms 
Monitor Observe and check the progress of 
Prioritise Place in order of priority or sequence for 
action 
Produce Create or bring into existence 
Level 3  
Application 
apply your knowledge Apply Put to practical use 
Calculate Ascertain or reckon mathematically 
Conduct Organise and carry out 
Demonstrate Prove with certainty or exhibit by practical 
means 
Prepare Make or get ready for use 
Reconcile Make or prove consistent/compatible

P.15 
Level 2 
Comprehension 
What you are expected to 
understand Describe Communicate the key features of 
Distinguish Highlight the differences between 
Explain Make clear or intelligible/state the meaning or 
purpose of 
Identify Recognise, establish or select after 
consideration 
Illustrate Use an example to describe or explain 
something 
Level 1 
Knowledge 
know List Make a list of 
State Express, fully or clearl y, the details/facts of 
Define Give the exact meaning of 
Outline Give a summary of 
 
Information concerning formulae and tables will be provided via the CIMA 
website, www.cimaglobal.com.

P.16   
SYLLABUS GRIDS 
E1: Managing Finance in a Digital World 
How the finance function is organised 
Content weighting 
Content area Weighting 
A Role of the finance function 20% 
B Technology in a digital world 20% 
C Data and Information in a digital world 20% 
D Shape and structure of the finance function 20% 
E Finance Interacting with the organisation 20% 
  100%

P.17 
E1A: Role of the finance function 
This section examines the roles that finance plays in organisations and why. It describes in detail the 
activities that finance professionals perform to fulfil these roles. Consequently, it is the foundation of the 
whole qualification and answers the question: what do finance professionals do and why? It provides links with other topics within the subject and what is covered in other areas of the Operational Level. 
 
Lead outcome Component outcome Topics to be covered Explanatory notes 
1. Explain the roles of 
the finance function 
in organisations. Explain how the finance 
function: 
a. Enables organisations to 
create and preserve value 
b. Shapes how organisations 
c. Narrates how 
organisations create and 
preserve value • The fast-changing and 
unpredictable contexts in 
which organisations 
operate 
• Enabling value creation 
through planning, 
forecasting and resource 
allocation 
• Shaping value creation 
through performance 
management and control 
• Narrating the value 
creation story through 
corporate reporting 
• The role of ethics in the 
role of the finance function Describe the increasingly 
disruptive contexts in which 
organisations and their 
finance teams operate and 
how these contexts shape the 
role of finance. Take each 
role and show how finance 
performs it in a typical 
organisational setting. The 
coverage should be 
introductory and brief. It is 
meant to set the scene for 
subsequent sections and 
draw a link between the roles 
and the topics that will be 
covered in other areas of the 
Operational Level. 
2. Describe the 
activities that 
finance 
professionals 
perform to fulfil the 
roles. Describe how the finance 
function: 
a. Collates data to prepare 
information about 
organisations 
b. Provides insight to users 
by analysing information 
c. Communicates insight to 
influence users 
d. Supports the 
implementation of 
decisions to achieve the 
desired impact 
e. Connects the different 
activities connect to each 
other • How data is collected, 
cleaned and connected by 
finance 
• Types of analysis to 
produce insights 
• How finance 
communicates to influence 
key stakeholders 
(audiences, frequency, 
format, etc.) 
• How finance uses 
resource allocation and 
performance management 
to enable organisations to 
achieve their objectives 
• Potential impact of 
technology Use ‘information to impact’ 
framework to describe the 
primary activities finance 
professionals perform. Relate 
it to how data is generated, 
transformed and used. Link it 
to how technology could be 
used to improve the 
productivity of finance 
professionals in these areas 
and the threat of automation.

P.18   
E1B: Technology in a digital world 
This section focuses on the technologies that define and drive the digital world in which finance operates. 
It provides awareness of the technologies used in organisations and deepens understanding of the impact 
of the technologies on what finance does. It draws on the issues raised in the previous section about the 
role of finance and the activities finance performs to fulfil these roles. Given that the digital world is 
underpinned by technology and the use of data, this section provides a foundation to the next section on data. 
 
1. Outline and explain 
the technologies 
that affect business 
and finance. a. Outline the key features of 
the fourth industrial 
revolution. 
b. Outline and explain the 
key technologies that 
define and drive the digital 
world. • Characteristics and 
dynamics of the fourth 
industrial revolution 
• Cloud computing 
• Big data analytics 
• Process automation 
• Artificial intelligence 
• Data visualisation 
• Blockchain 
• Internet of things 
• Mobile 
• 3-D printing The aim is to create 
awareness of the 
technologies that drive the 
digital world and how they 
interact with each other. The 
technologies outlined by the 
major advisory firms and the 
World Economic Forum digital 
transformation initiative 
provide the material on which 
learning and related activities 
can be based. 
2. Examine how the 
finance function 
uses digital 
technologies to 
fulfil its roles. Examine how finance uses 
the following to guide how it 
performs its roles: 
a. Digital technology 
b. Digital mindsets 
c. Automation and the future 
of work 
d. Ethics of technology 
usage • How finance uses 
technologies listed above 
• Areas of finance 
susceptible to automation 
and why 
• New areas for finance to 
focus on 
• Digital mindsets for 
finance 
• Ethics of the use of 
technology Examine how finance 
professionals use the relevant 
technologies to fulfil their 
roles. Explain how the 
technologies affect various 
activities finance 
professionals perform in the 
‘information to impact’ 
framework. The intention is to 
move from creating 
awareness to generating 
understanding of how finance 
can use these technologies to 
increase its value and 
relevance to organisations.

P.19 
E1C: Data and information in a digital world 
This section draws out one of the major implications of using technology in organisations and the finance 
function – namely the collection and processing of information can be done more effectively by machines 
rather than by people. It asserts that the role of finance professionals should be to use data to create and 
preserve value for organisations. Five ways of using data are examined. The key competencies required 
to use data in these ways are also highlighted. The primary objective is to help finance professionals understand what they can do with data and how to build the skills needed to use data. 
 
1. Describe the ways 
in which data is 
used by the finance 
function. Identify the ways in which the 
finance function uses data: 
a. In a general sense 
b. Specifically in each of the 
primary activities of 
finance Using data for: 
• Decision-making 
• Understanding the 
customer 
• Developing customer 
value proposition 
• Enhancing operational 
efficiency 
• Monetising data 
• Ethics of data usage Build on the previous section 
on technology to explain why, 
in the digital world, finance 
professionals must place 
more focus on using 
information than on collecting 
and/or processing 
information. Outline and 
describe the various uses of 
information. Link them to the 
primary activities that the 
finance function performs and 
to the topics to be covered in 
other modules of the 
2. Explain the 
competencies 
required to use 
data to create and 
preserve value for 
organisations. Explain the competencies that 
finance professionals need in: 
a. Data strategy and 
planning 
b. Data engineering, 
extraction and mining 
c. Data modelling, 
manipulation and analysis 
d. Data and insight 
communication • Assessment of data needs 
• Extraction, transformation  
and loading (ETL) systems 
• Business Intelligence (BI) 
systems 
• Data visualisation Highlight and explain the data 
competencies required in the 
digital world. Locate where 
finance has a competitive 
advantage and where finance 
will need to work with data 
scientists.

P.20   
E1D: Shape and structure of the finance function 
This section brings together the implications of the previous sections. It reveals how the finance function is 
structured and shaped. This structure and shape enables finance to perform its role in the organisation 
and with other internal and external stakeholders. In this sense, it prepares candidates for the next 
section, which looks at how finance interacts with key internal stakeholders in operations, marketing and 
human resources. 
 
1. Describe the 
structure and 
shape of the 
finance function. Describe the: 
a. Evolution of the shape of 
b. Shape of the finance 
function in the digital era • Structure of the finance 
function from the roles that 
generate information to 
the roles that turn 
information into insight 
and communicate insight 
to decision-makers 
• Hierarchical shape of 
• Shared services and 
outsourcing of finance 
operations 
• Retained finance 
• Automation and diamond 
shape of finance function Introduce candidates to the 
structure of the finance 
function and outline the broad 
areas of finance such as 
finance operations, external 
reporting, financial planning 
and analysis (FP&A), decision 
support etc. Describe the 
evolving shape of the finance 
function from the triangle to 
the diamond shape. Link the 
description to the impact of 
digital technology and 
automation on the finance 
function. 
2. Explain what each 
level of the finance 
function does. Explain the activities of: 
a. Finance operations 
b. Specialist areas including 
financial reporting and 
financial planning and 
analysis (FP&A) 
c. Strategic partnering for 
value 
d. Strategic leadership of the 
finance team • Finance operations to 
generate information and 
preliminary insight 
• FP&A, taxation, corporate 
reporting, decision support 
to produce insight 
• Business partnering to 
influence organisation to 
make appropriate 
decisions 
• Leading the finance team 
to create the required 
impact for the organisation The focus is the diamond 
shape and the four levels 
within this shape. Explain 
what each level does, the 
relationship between the 
levels, and the link between 
the levels and the basic 
finance activities covered 
under the role of finance.

P.21 
E1E: Finance interacting with the organisation 
The finance function is not the only area of activity in organisations. Finance joins with others to create 
and preserve value for their organisations. This section brings together what has been learned in the 
previous section to describe how finance can interact with other parts of the organisation to achieve the 
objectives of finance, those other areas and crucially the objectives of the whole organisation. The aim is 
to show how finance can work collaboratively in a connected (and joined-up) organisation and not in isolation. 
 
1. Describe how the 
interacts with 
operations. Describe: 
a. Main role of operations 
b. Areas of interface with 
finance 
c. Key performance 
indicators • Process management 
• Product and service 
management 
• Supply chain management Describe how finance plays 
its role by interacting with the 
rest of the organisation. Bring 
together the issues raised in 
the previous sections and link 
them to what the other areas 
of the organisations do. For 
example, address how 
finance and marketing interact 
using data and collaborative 
technology to achieve 
organisational goals and the 
individual functional goals of 
both finance and marketing. 
Describe how the use of KPIs 
influence these interactions 
and how the KPIs of finance 
and these areas can be 
aligned to ensure they work 
together effectively. 2. Describe how the 
interacts with sales 
and marketing. Describe: 
a. Main role of sales and 
marketing 
finance 
indicators • Market segmentation 
• Big data analytics in 
marketing 
• Channel management 
• Sales forecasting and 
3. Describe how the 
human resources. Describe: 
a. Main role of human 
resources 
finance 
indicators • Staff acquisition 
• Staff development 
• Performance management 
• Motivation and reward 
systems 
4. Describe how the 
interacts with IT. Describe: 
a. Main role of IT 
finance 
indicators • IT infrastructure 
• IT systems support 
• Costs and benefits of IT 
systems

1 
The roles of the finance 
function in organisations 
Chapter learning objectives 
Lead Component 
A1: The roles of the finance 
function in organisations. (a) Enables organisations to 
create and preserve value. 
(b) Shapes how 
organisations create and preserve value. 
(c) Narrates how 
 
  Chapter 
1

The roles of the finance function in organisations 
2 
 
1 Introduction  
Before we look at the roles of the finance function in organisations, it is useful to 
understand the overall purpose of E1 and how it fits within CIMA’s Professional 
Qualification. 
1.1 The CIMA Professional Qualification 
The CIMA Professional Qualification will give you the skills that you need to 
work as a confident and competent management accountant in an age where change is the new norm so that you c an guide and lead your organisation’s 
success. 
We live in an age of technological advancements and innovation and these 
factors are transforming the way in which we work and live. The World 
Economic Forum calls it the 4
th Industrial Revolution  and this revolution is 
having a huge impact on the finance function and, as a result, the skillset of a 
management accountant. 
1.2 The Operational Level 
‘Finance’ runs through the Operational Level: 
• P1 – focuses on ‘ what ’ the finance function does 
• F1 – focuses on ‘ what ’ the finance function does and its  implications  
• E1 – focuses on ‘ how’ the finance function is organised 
At the Operational Level the emphasis will be on remembering and 
understanding  but some insight  regarding specific probl ems or situations may 
also be required.

Chapter 1 
 3 
1.3 Paper E1: Managing Finance in a Digital World 
There are five connected areas to the syllabus: 
 
1.4 The roles of the finan ce function in organisations 
This chapter covers syllabus area A1 , ‘explain  the roles of the finance 
function in organisations ’. By the end of this c hapter you should understand 
how the finance function enables, shapes and narrates value creation through 
its roles  of: 
• planning 
• forecasting • resource allocation • performance managem ent and control and 
• financial (corporate) reporting. 
These roles are changing due to the continuous change  that is impacting all 
organisations and so before introducing the roles of the finance function we will 
begin our discussion of this syllabus area by briefly looking at change.

4 
The chapter concludes with a discussion of ethics, corporate social 
responsibility  and corporate governance  since these areas will be 
fundamental underpinning factors in an organisation’s sustained value and are 
therefore related to the finance func tion’s role in value creation and 
preservation. 
2 Change: The new norm 
Change is the new norm in many organisati ons due to seismic shifts in the level 
of competition , customers’ expectations and the global political outlook 
combined with a fast pace of technological change  (with machines 
increasingly taking over routine tasks and new technologies emerging across 
the global economy this is considered to be the key driver of change). 
This rapid  and often unpredictable  evolution has resulted: 
• in organisations having to plan for a different way of doing business and 
• has resulted in an evolution of the roles of the finance function. 
These changes present both risks and opportunities and will be explored in 
greater depth in subsequent chapters but before we explore what the changes are and how they will impact the organisati on and the finance function within it, 
we need to firstly understand what the overall roles of the finance function are within an organisation. 
 
Illustration 1 – Change and impact on organisations 
 Extraordinary economic changes ar e happening at such a fast pace 
driven by technology innovations and advances. The digital world created 
has been cited as the main reason ju st over half of companies on the 
Fortune 500 have disappeared since the year 2000. Those companies that have disappeared, such as Blo ckbusters in 2010 and Kodak in 2012, 
may well have been using outdated 20
th century business thinking and 
concepts trying to build sustainable organisations in the 21st century 
digital world.  
3 Introduction to the finance function  
Before focusing on the finance function it is useful to remind ourselves of the different types of organisations that exist and also of the diffe rent functions that 
exist within an organisation.  
3.1 Different types of organisation 
As we know from our earlier studies there are many different types of 
organisation: 
• Profit seeking organisations, i.e. businesses  include companies, 
partnerships and sole traders. Their main objective is the maximisation of 
the wealth of their owners.

Chapter 1 
 5 
• Not-for-profit organisations (NFPOs)  include public sector organisations 
(such as schools and hospitals) and priv ate sector organisations (such as 
charities and clubs). These organisations do not see profit as their main 
objective. 
Throughout the text the concepts that are introduced are done so mainly in 
relation to businesses. However, it is worth noting that much of the discussion is 
just as relevant to NFPOs. 
 
 Profit versus not-for-profit organisations 
 
 Test your understanding 1 
 Which of the following are not-for- profit organisations? Choose all 
that apply.  
A private school 
B medical research charity C local hospital D sole trader who is making a loss E private limited company F local government agency

6 
3.2 The functions of an organisation 
The main functions of a business are: 
• operations 
• sales and marketing • human resources (HR)  • IT and • finance . 
This reflects the model of the business as  taking three basic types of resource – 
material, labour and money – to produce goods and services which generate 
profit. 
It is a major part of the finance function’ s work to look after the business’s 
money. The finance function’s role in m anaging the financial resources of the 
organisation and providing information to help economic decision making will be 
integral to the effectiveness of the finance function. 
3.3 The roles of the finan ce function in organisations 
The finance function plays three key roles. A finance function: 
• ENABLES  an organisation to create and preserve value though planning, 
forecasting and resource allocation: 
– Planning:  the finance function will hav e an important role in 
preparing plans to assist the organi sation in achieving its objectives 
and formulating relevant strategies . One of the main types of 
planning carried out at  the operational level will be budgeting. 
– Forecasting:  the preparation of forecast s, for example of future 
sales or material prices, will be an important role of the finance 
function at the operational level. 
– Resource allocation:  an important role of t he finance function will 
be in working out which resources (for example, labour, material, 
machinery, finance) the organisation will require to achieve its 
objectives. 
In the CIMA Professional Qualif ication, the ‘enables’ element is 
encompassed in the Enterprise pillar. 
• SHAPES HOW  an organisation creates and preserves value through 
performance managem ent and control: 
– Performance management:  the finance function has an important 
role in the management of performance and the achievement of the organisation’s plans and budgets.

Chapter 1 
 7 
For example, it will help to prepare information for internal 
management such as performance m easures. These measures will 
assist in monitoring the perfo rmance of the organisation. The 
performance measures may be quantitat ive, i.e. numerical (such as 
sales, profit or units produced) or may be qualitative, i.e. non-
numerical (such as customer satisfaction or levels of innovation).  
– Control: this will be an important par t of effective performance 
management; actual performanc e will be compared to planned 
performance to identify any differe nces. Variance analysis may be 
carried out as part of this role. The identification of these differences 
may result in a reassessment or amendment of the original plans, 
strategies or budgets. 
In the CIMA Professional Qualific ation, the ‘shapes how’ element is 
encompassed in the Performance pillar. 
• NARRATES HOW  an organisation creates a nd preserves value through 
financial (corporate) reporting: 
– Financial reporting (also called cor porate reporting): an important role 
of the finance function is in  preparing comprehensive reports 
intended to give information to shar eholders and/or other interested 
people about the organisation’s  activities and performance 
throughout the year. 
In the CIMA Professional Qualification, the ‘narrates how’ element is 
encompassed in the ‘Financial’ pillar. 
If it plays these roles effectively, t hen finance professionals are valuable to 
organisations.  
Important note: This is a brief introduction to t he roles of the finance function. 
However, this area is highly examinabl e and will be returned to and built upon in 
subsequent chapters. It will underpin much of the discussion in these later 
chapters. 
4 The role of ethics in the role of the finance function  
4.1 The ethical responsibilities of the organisation and individuals 
As mentioned previously (in section 1.4), ethics will be a fundamental underpinning factor in the organisa tion’s sustained value creation. 
The roles that the finance function performs  should be carried out in an ethical 
way, with integrity and professionalism. 
The professional accountant has a special role in promoting ethical behaviour 
throughout the business.

8 
 Ethics, business ethics and ethical dilemmas 
 Ethics is the system of moral principles  that examines the concept of 
right and wrong. 
Business ethics  is the application of ethical values to business 
behaviour. An ethical dilemma involves a situation where a decision-maker has to 
decide what is the ‘right’ or ‘wrong’ thing to do. Examples of ethical 
dilemmas can be found throughout all aspects of business operations: 
Accounting issues 
• Creative accounting to boost or  suppress reported profits. 
• Directors’ pay arrangements – should directors continue to receive 
large pay packets even if the company is performing poorly? 
• Should bribes be paid to facilitate contracts, especially in countries 
where such payments are commonplace? 
• Insider trading, where for exampl e directors may be tempted to buy 
shares in their company knowing that a favourable announcement 
about to be made should boost the share price. 
Production issues 
• Should the company produce certai n products at all, for example 
guns, pornography, tobacco, alcoholic drinks aimed at teenagers? 
• Should the company be conc erned about the effects on the 
environment of its production processes? 
• Should the company test its products on animals? 
Sales and marketing issues 
• Price fixing and anti-competitive behaviour may be overt and illegal 
or may be more subtle. 
• Is it ethical to target advertising at children, for example for fast food 
or for expensive toys at Christmas? 
• Should products be advertised by  junk mail or spam email? 
Personnel (HRM) issues • Employees should not be favoured or discriminated against on the 
basis of gender, race, religion, age, disability, etc. 
• The contract of employment must offer a fair balance of power 
between employee and employer. 
• The workplace must be a safe and healthy place to operate in.

Chapter 1 
 9 
4.2 CIMA's ethical guidelines 
Management accountants have a duty to observe the highest standards of 
conduct and integrity, and to uphold the good standing and reputation of their 
profession. 
The Code of Ethics for Professi onal Accountants, published by The 
International Federation of Accountants (I FAC), forms the basis for the ethical 
codes of many accountancy bodies, including CIMA. CIMA’s Code of Ethics , based on IFAC's five ethical principles, seeks to help 
management accountants in their day to  day role. It helps management 
accountants to identify areas where ethica l pressures may exist and provides a 
recommended course of action for their resolution. In order to achieve the objectives of the accounting profession, professional 
accountants have to observe five fundamental principles: 
Fundamental Principle Interpretation 
Integrity Integrity means being straightforward, honest and 
truthful in all professional and business 
relationships. 
Objectivity Objectivity means not allowing bias , conflict of 
interest, or the influence of  other people to override 
your professi onal judgement. 
Professional competence and due care This is an ongoing commitment to maintain your level of professional knowledge and skill so that your client or employer  receives a competent 
professional service. Work should be completed carefully, thoroughly and diligently, in accordance with relevant technical and professional standards. 
Confidentiality This means respec ting the confidential nature of 
information you acquire through professional relationships such as past or current employment. You should not disclose such information unless you have specific permission or a legal or professional duty to do so. You should also never use confidential information for your or another person’s advantage. 
Professional behaviour This requires y ou to comply with relevant laws and 
regulations. You must also avoid any action that could negatively affect the reputation of the profession.

10 
 Test your understanding 2 
 John is a CIMA Member in Practice, and advises a range of individual 
clients and organisations. John has been asked, by his brother, to prepare 
the accounts for his brot her’s company. John’s brother says that he wants 
the reported profit to be  as high as possible, as  he will soon be applying to 
the bank for loan finance.  
To do this would be in breach of wh ich fundamental ethical principle 
(according to CIMA’s Code of Ethics)?  
A integrity 
B objectivity C professional competence and due care D confidentiality E professional behaviour 
4.3 Why business ethics are important 
In addition to the professional accountant having a role in promoting ethical 
behaviour within an organisation, the organi sation as a whole, and all of the 
individuals within it, are expected to act in an ethical way. 
Businesses are part of society. Soci ety expects its individuals to behave 
properly, and similarly expects companies  to operate to certain standards. 
Acceptable business ethics may comprise as a minimum: 
• paying staff decent wages  and pensions 
• providing good working conditions  for staff 
• paying suppliers  in line with agreed terms 
• sourcing supplies  carefully 
• using sustainable or renewable sources  
• being open and honest  with customers. 
However, apart from any moral duty to  be ethical, the prime purpose of a 
company is to maximise shareholder wealth and the chance of this happening is 
increased by the adoption of ethical behaviour since: 
• Ethical behaviour is likely to be favoured by: 
– customers: resulting in higher sales volumes and/or prices. 
– employees:  resulting in the attraction/re tention of the best employees 
and increased employee productivity. 
– business collaborators:  resulting in increased opportunities for 
profitable projects.

Chapter 1 
 11 
• Ethical behaviour reduces risk and gives access to cheaper funds which, 
in turn, increase project profitability. 
• Unethical behaviour wi ll, at some point be discovered resulting in a 
damage to reputation and potential legal charges. 
 
 Illustration 2 – Why business ethics are important 
 The Fairtrade mark is a label on cons umer products that guarantees that 
disadvantaged producers in the develo ping world are getting a fair deal. 
For example, the majori ty of coffee around the wo rld is grown by small 
farmers who sell their produce through a local co-operative. Fairtrade 
coffee guarantees to pay a price to pr oducers that covers the cost of 
sustainable production and also an extra premium that is invested in local 
development projects. 
Consumers in the developed world ma y be willing to pay a premium price 
for Fairtrade products, knowing that the products are grown in an ethical 
and sustainable fashion. 
 
 Test your understanding 3 
 Which of the following would potenti ally be ethical concerns for a 
cosmetics manufacturer? Choose all that apply. 
A The amount of chemicals included in their products. 
B The quality of the cosmetics. 
C How much it pays its staff. D How much its supplier pays its staff. E The way the cosmetics are advertised. 
4.4 Corporate codes of ethics 
Most companies (especially if they ar e large) have approached the concept of 
business ethics by creating a written code of  ethics (a set of internal policies) 
and instructing employees to follow them. These policies can either be broad  
generalisations ( a corporate ethics statement ) or can contain specific  rules 
(a corporate ethics code). 
There is no standard list of contents – it will vary between different 
organisations. Typically, however, it ma y contain guidelines on issues such as 
honesty, integrity and customer focus. 
Many organisations appoint Ethics Of ficers (also known as Compliance 
Officers) to monitor the application of t he policies and to be available to discuss 
ethical dilemmas with em ployees where needed.

12 
4.5 Corporate social responsibility 
This follows on from our discussion of ethics but before we review ‘corporate 
social responsibility’, we need to define the term ‘stakeholder’. 
 A stakeholder is a group or individual, who has an interest in what the 
organisation does, or an expect ation of the organisation. 
 
The needs/expectations of different st akeholder groups may conflict. In the 
event of conflict, an organisation will need to decide which stakeholders’ needs 
are more important. This will commonly be the most dominant stakeholder. If 
the organisation is having difficulty deciding who the dominant stakeholder is, 
they can use Mendelow’s power-interest matrix . 
 
By plotting each stakeholder according to  the power that they have over an 
organisation and the interest they have in a particular decision, the dominant 
stakeholder(s), i.e. the key player(s) can be identified. The needs of the key 
players must be considered during the formulation and evaluation of new strategies. 
 
 Illustration 3 – Stakeholders' influence 
 The airline, Ryanair, has regular l abour relations problems with pilots, 
cabin attendants and check-in staff. For ex ample, in recent years pilots at 
Ryanair threatened a mass strike (and possible desertion to a competitor 
airline) if there were not significant improvements in pay and conditions. 
Ryanair cannot operate without thes e staff so these employees have 
great power and have shown that they are happy to exercise that power.

Chapter 1 
 13 
 Types of stakeholder 
 Stakeholders can be broadly categorised into three categories; internal, 
connected and external. 
Internal stakeholders 
Internal stakeholders are intimately connected to the organisation, and 
their objectives are likely to have a strong influence on how it is run. Internal stakeholders include: 
Stakeholder Need/expectation 
employees pay, working conditions and job security 
managers/directors status, pay, bonus, job security 
Connected stakeholders 
Connected stakeholders either invest in or have dealings with the firm. 
They include: 
shareholders dividends and capital growth and the continuation 
of the business 
customers value-for-money  products and services 
suppliers paid promptly 
finance providers repayment of finance 
External stakeholders These stakeholders tend to not have a direct link to the organisation but 
can influence or be influenced by its activities. They include: 
community at large will not want their lives to be negatively impacted 
by business decisions 
environmental 
pressure groups the organisation does not harm the external environment 
government provision of taxes and jobs and compliance with 
legislation 
trade unions to take an active part in the decision-making 
process

14 
 Example of stakeholder management  
 R is a high-class hotel situated in a thriving city. It is part of a worldwide 
hotel group owned by a lar ge number of shareholders.  Individuals hold the 
majority of shares, each holding a sm all number, and financ ial institutions 
hold the rest. The hotel provides full amenities, in cluding a heated 
swimming pool, as well as the normal facilities of bars, restaurants and 
good quality accommodation. There are many other hotels in the city, all 
of which compete with R. The city in which R is situated is old and 
attracts many foreign visitors , especially in the summer season 
The main stakeholders with whom relationships need to be established and maintained by management and the im portance of maintaining these 
relationships is as follows. 
The employees and the manage rs of the hotel are t he main link with the 
guests and the service they provide is vital to the quality of the hotel as 
guests’ experience at the hotel will be determined by their attitude and 
approach. 
Managers should ensure that employees  deliver the highest level of 
service and are well trained and committed. 
The shareholders of the hotel will be concerned with a steady flow of 
income, possible capital growth and continuation of the business. Relationships should be developed and maintained with the shareholders, especially those oper ating on behalf of institutions. 
Management must try to achieve im provements in their returns by 
ensuring that customers are sati sfied and are willing to return. 
Each guest will seek good service and satisfaction. Different types of guests, for example business versus tourist, will have different needs and 
managers should regularly analyse the customer database to ensure that these needs are met. 
Suppliers should be selected very care fully to ensure that services and 
goods provided (for example, food and laundry) continue to add to the 
quality of the hotel and to custom er satisfaction. Suppliers will be 
concerned with being paid promptly  for goods. Maintaining a good 
relationship with suppliers will ensure t heir continued support of the hotel. 
External stakeholders 
The management of t he hotel must maintain close relationships with the 
authorities to ensure they comply with legislation. Examples of external 
stakeholders include fire and safety authorities and food hygiene authorities. Failure to do so could re sult in the hotel being closed down.

Chapter 1 
 15 
 Stakeholder conflict  
 The needs/expectations of the differ ent stakeholder groups may conflict. 
Some of the typical conflicts are shown below: 
Stakeholders Conflict 
Employees versus managers Jobs/wages versus bonus 
Customers versus shareholders Product quality/service levels 
versus profits/dividends 
General public versus sharehol ders Effect on the environment 
versus profit/dividends 
Managers versus shareholders Independence versus growth 
by merger/takeover 
It is important that an organisation meets the needs of the most dominant 
stakeholders, but the needs of the other stakeholders should also be 
considered – nearly every decision becomes a compromise. For example, the firm will have to earn a satisfactory return for its 
shareholders whilst paying reasonable wages. 
 
Now that we understand what we mean by ‘stakeholders’ we can introduce the 
concept of ‘corporate social responsibility’. 
 Corporate social responsibility  (CSR) refers to t he idea that a company 
should be sensitive to the needs and w ants of all the stakeholders in its 
business operations, not just the shareholders.  
As such, business ethics are just one dimension of CSR. 
A socially responsible company may consider: 
• the environmental impact of produc tion or consumption, for example due 
to the use of non-renewable res ources or non-recyclable inputs 
• the health impact for consumers of ce rtain products, for example tobacco 
and alcohol 
• the fair treatment of employees 
• whether it is right to experiment on animals • the safety of products  and production processes. 
Traditionalists  argue that companies should oper ate solely to make money for 
shareholders and that it is not a com pany’s role to worry about social 
responsibilities.

16 
The modern view  is that by aligning the company’s core values with the values 
of society, the company can improve its reputation and ensure it has a long-
term future due to the following: 
• Differentiation  – the firm's CSR strategy (for example with regards to the 
environment, experimentation on animals or to product safety) can act as 
a method of differentiation. 
• High calibre staff  will be attracted and retained due to the firm's CSR 
policies. 
• Brand strengthening  – due to the firm's honest approach. 
• Lower costs  – can be achieved in a number of ways, for example due to 
the use of less packaging or energy. 
• The identification of new market opportunities  and of changing social 
expectations . 
An overall increase in profitability  should be achieved as a result of the above 
– good CSR should hopefully contribut e to an increase in revenue and a 
reduction in costs in the long-term. 
 
 Illustration 4 – Responsibilities of businesses to stakeholders 
 888.com is an internet gambling si te that is listed on the London Stock 
Exchange. Its headquarters are in Gi braltar and it operates under a 
licence granted by the Govern ment of Gibraltar.  
It has responsibilities to t he following stakeholders: 
• Shareholders – since it is listed on the London Stock Exchange it 
must comply with the rules of that  exchange, including adopting the 
Corporate Governance Code (the code is discussed later in this 
chapter). 
• Employees  – to be a good employer to all its members of staff. 
• Customers – to offer a fair, regulat ed and secure environment in 
which to gamble. 
• Government  – to comply with the terms of its licence granted in 
Gibraltar. 
• The public  – the company chooses to sponsor several sports 
teams as part of strengthening its brand. The company also tries to 
address public concerns about the negative aspects of gambling, for 
example by identifying compulsive gamblers on their site and taking 
appropriate action.

Chapter 1 
 17 
 Test your understanding 4 
 Voluntarily turning away business 
Why should a gambling company like 888.com voluntarily choose to 
turn away certain business, for example known compulsive gamblers, gamblers who may be under-age, gamblers in certain countries etc? 
 
 Test your understanding 5 
 Humes plc adopts a socially  responsible approach.  
This means that the company seeks to: 
A Meet the minimum obligations it owes to its shareholders 
B Exceed the minimum obligations it owes to its shareholders 
C Meet the minimum obligations it owes to its stakeholders 
D Exceed the minimum obligations it owes to its stakeholders  
5 Corporate governance 
The discussion of corporate governanc e touches upon and builds upon aspects 
of business ethics and CSR. 
5.1 Why corporate governance? 
Corporate governance has become a ma jor business issue driven by a 
succession of public ‘scandals’. 
In the early nineties, the collapse of London Stock Exchange listed company 
Polly Peck International, the Mirror Gr oup collapse (and the associated Maxwell 
pension scandal) and the liqui dation of BCCI (The Bank of Credit and 
Commerce International) led to the formati on of the  UK Corporate 
Governance Code .

18 
 Illustration 5 – Why corporate governance? 
 Polly Peck International 
Asil Nadir, the owner of Polly Peck International (PPI) built the company 
from very little but by the end of the 1980s it was worth over £2bn. However, the company collapsed in 1991 following the discovery of huge 
theft by Nadir from his own company, totalling £29m. 
The Mirror Group 
In 1991 the Mirror Group collapsed amid allegations that £440m had 
been defrauded from the company’s pens ion scheme by its owner, the 
late Robert Maxwell. An enquiry conc luded that Robert Maxwell and his 
son Kevin had a heavy responsibility for the collapse of the company but 
that City Institutions were also to blame. 
BCCI In 1991 BCCI was forced to shut its doors by the Bank of England amid 
identification of huge fraud. Hard hit were 35 local UK councils who lost 
approximately £90m in  investments. 
More recently, the 2008 financial cris is, which claimed Lehman Brothers, 
Northern Rock, Bradford & Bingley and m any others, saw the code revised and 
radical changes to how risks are asse ssed within financial institutions. 
The need for corporate governance  arises because, in a ll but the smallest of 
organisations, there is a separat ion of ownership and control. 
 The separation of ownership and control  refers to the situation in a 
company where the people who own t he company (the shareholders) may 
not be the same people as those who run the company (the board of directors). 
This separation can bring benefits (for example, specialist managers can often 
run the company more efficiently than those who own the company). However, 
there is a risk that the directors may run the company in their own interests, 
rather than those of th e shareholders and the other stakeholders. This is 
referred to as the ‘ agency problem ’. 
 
 Illustration 6 – The agency problem in a company 
 The directors of a large quoted company may hold a board meeting and 
vote themselves huge bonuses and sala ries even if only modest profit 
targets are achieved and may also put contractual terms in place granting 
them huge compensation payments if t hey are sacked. Those votes are 
in the selfish best interests of the directors, and not in the best interests 
of the shareholders who own the company and whose interests the directors are meant to be looking after.

Chapter 1 
 19 
5.2 The meaning of corporate governance 
 Corporate governance is the set of processes and policies by which a 
company is directed, administered  and controlled. It includes the 
appropriate role of the board of directors and the auditors of the company. 
Corporate governance is concerned with the overall cont rol and direction of a 
business so that the business’s objec tives are achieved in an acceptable 
manner by ALL stakeholders. 
The following symptoms  can indicate that there is  poor corporate governance: 
• Domination of the board  by a single individual or group 
• No involvement by the board, for example  meeting irregularly, failing to 
consider systematically the organisati on’s activities and risks, or basing 
decisions on inadequate information 
• An inadequate control function , for instance no internal audit, or a lack 
of adequate technical knowledge in key roles, or a rapid tu rnover of staff 
involved in accounting and control 
• Lack of supervision  of employees 
• Lack of independent scrutiny by external or internal auditors  
• Lack of contact with shareholders  
• Emphasis on short-term profitability , leading to concealment of 
problems or errors, or manipulation of financial statements to achieve 
desired results 
• Misleading financial statements and information 
5.3 The principles of corporate governance 
One of the main debates surrounding corporate governance regulation is 
whether it should be: 
• A set of best practice  guidelines – as in the UK with its principles based 
approach requiring companies to adhere to the spirit rather than the letter 
of the law. 
• A  legal requirement – as in the US  with appropriate penalties for 
transgression.

20 
 The US Sarbanes-Oxley Act 2002 (SOX) 
 In 2002, following a number of co rporate governance scandals such as 
Enron and WorldCom, tough new corpor ate governance regulations were 
introduced in the US by SOX. 
SOX is only applicable in the US and for subsidiaries of US-based 
companies. 
 
5.4 Features of the UK corporate governance code 
In the UK, company law sets out a gr eat many of the rules on corporate 
governance, especially with regards to the following: 
• The board of directors 
• Directors’ powers and duties  
• The relationship of the co mpany with directors , such as loans to 
directors and the interests of di rectors in company contracts 
• Accountability for stewardshi p and financial reporting via the financial  
statements  
• Rules on meetings and resolutions 
The Financial Reporting Council (FRC) is the body responsible for promoting 
high standards of corporat e governance in the UK. All companies listed on the 
London Stock Exchange are required to  apply the principles of the UK 
Corporate Governance Code (last revised in 2018) and must produce a disclosure statement confirming comp liance with the code and explaining any 
departures from it.

Chapter 1 
 21 
Smaller listed companies, i.e. those not in the FTSE 350 can take a more 
flexible approach to applying the code. ( Note:  The FTSE 350 is an index of the 
top 350 companies by capitalisation and includes the more commonly used 
FTSE 100 index, which contains the top 100 companies and the smaller FTSE 
250 combined.) 
The following guidance exists: 
Use of the AGM 
The board should use the annual general meeting (AGM) to construct a 
dialogue with shareholders. 
Board 
The company should have an effective board (with a balance of skills, 
experience, independence and knowledge) that meets regul arly. The annual 
report should identify the Chairman, Deputy Chairman, Chief Executive Officer (CEO), senior independent directors and the members and chairs of the board 
committees. It should also disclose the number of meetings held and the 
directors’ attendance. 
The revised 2018 Code emphasises the im portance of positive relationships 
between the company, its shareholders and its stakeholders. For example, the 
board is now responsible for workforce policies and practices that reinforce a 
healthy culture. 
Chairman and Chief Executive Officer (CEO) 
The positions of the Chairman (pers on responsible for leadership and board 
effectiveness) and the CEO (the person in charge of running the company) 
should be separated. This is to ensure that no one individual has too much 
power within the company. The C hairman should be independent on 
appointment. 
Non-executive directors (NEDs) 
Directors who are involved in the execution of day-to-day management 
decisions are called executive directors (EDs) . Those who primarily only 
attend board meetings (and the meetings  of board committees) are known as 
NEDs.  
Current guidance is that NEDs should as  far as possible be ‘independent’ so 
that their oversight role can be effectively and responsibly carried out. NEDs must not: 
• have been an employee of the com pany in the last five years 
• have had a material business interest in the company for the last three 
years either directly or indirectly (for example, as an employee of an 
organisation that has a relationship with the business) 
• participate in the company’s share options, performance-related pay 
scheme or pension schemes 
• have close family ties with company directors or senior employees

22 
• serve as a NED for more than nine years with the same company 
• hold cross directorship (i .e. two or more directors sit on the board of the 
same third party company) or have si gnificant links with other directors 
through involvement in other organisations. 
If any of these apply to a NED, their independence will be seriously 
compromised. 
Typical recommendations include: 
• At least half of the board (excludi ng the chairman) should comprise 
independent NEDs. A smaller company should have at least two 
independent NEDs. 
• One of the NEDs shou ld be appointed the ‘senior  independent director’. 
Shareholders can contact them if t hey wish to raise matters outside the 
normal executive channels of communication. 
 
 Test your understanding 6 
 Independent NED 
Mr X retires from the post of finance director at AB plc. The company is 
keen to retain his experience, so invite him to become a NED of the 
company.  
Can he qualify as an independent non-executive? 
Nomination committees 
Appointments to the board should be made via a nominat ions committee. Over 
50% of this committee should be made up of NEDs. This is to provide some 
independence from the cu rrent board members and to ensure that all 
appointments are based on merit and suitability and that t he composition of the 
board is balanced. 
The revised 2018 Code states that the co mmittee is responsible for effective 
succession planning when developing a more diverse board and that the 
gender balance of senior management and their direct reports should be 
reported. 
Remuneration committees 
It is an important principle of corporat e governance that no director should be 
involved in setting the level of their own remuneration. 
 A remuneration committee is a committ ee made up of NEDs (at least three 
for FTSE 350 companies and at least two for smaller listed companies) 
which is responsible for deciding on the pay and incentives offered to executive directors (including pension rights and compensation payments). The Chairman can be a member but cannot chair the 
committee. The chair must have been a committee member for at least 12 
months.

Chapter 1 
 23 
Remuneration should be sufficient to at tract, retain and motivate quality 
directors but shouldn’t be more than nec essary. A significant proportion of 
director’s pay should be performance related. 
The revised 2018 Code states that there should be clear reporting on 
remuneration and how its hel ps the organisation to achieve its strategy and 
long-term success and its alignment to workforce remuneration. 
 
 Remuneration committee 
 Advantages of having a remuneration committee: 
• It avoids the agency problem of directors determining their own 
levels of remuneration. 
• It leaves the board free to make strategic decision about the future. 
Disadvantages of having a remuneration committee: 
• There is a danger that NEDs may recommend high remuneration for 
the executive directors in the hope that the ex ecutives will 
recommend high remuneration for the NEDs. 
• There will be a cost involved in preparing for and holding the 
meetings 
 
 Test your understanding 7 
 Remuneration of NEDs 
On what basis should NEDs be rem unerated for their service to the 
company?  
 
 Test your understanding 8  
 Which one of the following can non-executive directors accept as 
remuneration from the company? 
A A fixed daily rate for their time 
B Shares C Pension payments D Equity options

24 
Audit committees 
 An audit committee consists solely of  independent NEDs (at least three for 
FTSE 350 companies and at least two fo r smaller listed companies) who 
are responsible for monitoring and reviewing the company’s financial 
controls and the integrity of  the financial statements. 
The board should review the effectiv eness of risk management and internal 
controls at least annually and report to shareholders covering all material 
controls. 
The audit committee acts as an interfac e between the board of directors on one 
side and the internal and external auditors on the other side. They: 
• review the work and effectiveness of the internal audit function 
• monitor the external audito r’s independence and objectivity 
• short-list external audit firms when a change is needed. 
An audit committee should be the first point of contact for auditors, improving 
the independence and the overall quality of the audit functions. 
 
 The role of the audit committee 
 Responsibilities include the following: 
• Reviewing accounting policies an d financial statements as a whole 
to ensure that they are appropriate and balanced. 
• Review systems of internal c ontrols and risk management within the 
organisation. (Note that risk ma nagement may be dealt with by a 
separate committee – the risk committee.) 
• Agreement of the work agenda for the internal audit department, as 
well as reviewing the result s of internal audit work.  
• Liaising with the external audit ors, including dealing with problems 
in the audit as they arise as we ll as the appointment and removal of 
external auditors. 
 
 Test your understanding 9 
 Composition of audit committee 
Why are the members of an audit committee required to be NEDs 
rather than executive directors?

26 
Test your understanding answers 
 The correct answers are: 
B – Medical research charity 
C – Local hospital 
F – Local government agency 
 
 The correct answer is  B 
By virtue of his family relationshi p John’s objectivity is potentially 
compromised. There is also an argument that answer A (integrity) and 
answer E (professional behaviour) are also correct. Do note that this question is in the Study Text to get you to start thinking about these 
principles. Any questions given in t he exam will have a definitive right or 
wrong answer. 
 
Test your understanding 3 
 The correct answers are A, B, C, D and E 
All of the issues would be of ethical concern. 
 
 Either you could argue that such action was ethically correct (with the 
company wanting to ‘do the right thing’), or you could argue that a concentration on short-term profits is  likely to store up problems in the 
longer term. If under-age gamblers are seen to be gambling on a particular website, then the public reput ation of that site will be damaged 
and its long term profitability coul d be in jeopardy if governments or 
customers turn against it. 
 
 The correct answer is D 
A socially responsible organisation s eeks to exceed their obligations they 
owe to all stakeholders not  just the shareholders.

Chapter 1 
 27 
 It is very unlikely that Mr X can be independent since he has been an 
employee of the company within the last  five years. If the board believes 
that Mr X is independent despite his recent employment then they must 
state the reasons for this determination. 
 
 NEDs should be paid fees that reflect the time commitment and the 
responsibilities of the role, for exampl e a fixed daily rate for when they 
work for the company. Share options should not be granted to the NEDs 
since this could detract fr om their indep endent judgement. 
 
 Test your understanding 8 – OTQ 
 The correct answer is A 
NEDs should be paid fees that reflect the time commitment and the 
work for the company. Share options  should not be granted to NEDs 
since this would detract from the detached judgem ent that they should 
bring, and it would also prevent them from being identified as 
‘independent’ NEDs. 
 
 NEDs have no day-to-day operating res ponsibilities, so they are able to 
view the company’s affairs in a detached and independent  way and liaise 
effectively between the main board and both sets of auditors.

29 
The activities performed 
by finance professionals 
to fulfil the roles  
A2: The activities that finance 
professionals perform to 
fulfil the roles. (a) Collates data to prepare 
information for organisations. 
(b) Provides insight to users 
by analysing information. 
(c) Communicates insight to 
influence users. 
(d) Supports the 
implementation of decisions to achieve the 
desired impact. 
(e) Connects the different 
activities to each other. 
 Chapter 
2

The activities performed by finance professionals to fulfil the roles 
30 
 
In the previous chapter we discussed the roles of the finance function in 
organisations – understanding how the finance function enables , shapes and 
narrates value creation and preservation through planning, forecasting, 
resource allocation, performanc e management and control, and financial 
(corporate) reporting. 
In Chapter 2 we will focus on the activities  that finance professionals perform 
to fulfil these roles. 
2 Finance activities from information to impact 
2.1 The information to impact framework 
The structure of the finance function and the activities that finance professionals 
perform can be best understood in the context of the basic finance activities that 
form the backbone of all the work  of finance professionals. 
These basic activities can be summarised using the ‘information to impact 
framework ’.

Chapter 2 
 31 
The finance professionals’ basic activities are the 5 A’s – assemble, a nalyse, 
advise , apply, acumen:  
Finance activity Explanation 
Assembling 
information Collates data to prepare information about the 
organisation 
Finance professionals collect and assemble data from a 
range of internal and external sources (see section 2.2). Data is defined as facts or fi gures in a raw, unprocessed 
form. 
To become useful in the organisation this data needs to be 
turned into information. Info rmation is data that has been 
processed in such a way that is has a meaning and use to the person who receives it. This processing may involve: 
• cleaning the data, i.e. identifying incomplete, 
inaccurate or irrelevant data and then replacing, 
modifying or deleting it 
• connecting different sources of data. 
Examples of assembled information would be: 
• management information in an accessible format for 
managers 
• accounts and returns prepar ed in a prescribed format 
for external reporting. 
(See section 2.3 for more detail on ‘information’). 
This activity can also be viewed as the broad role of 
REPORTING . 
Analysing for 
insights Provides insight to users by analysing information 
Finance professionals analyse bo th financial (for example, 
sales information) and non-financial  (for example, customer 
satisfaction information) info rmation to draw out patterns 
and relevant insights for those who use the information. 
This could take the form of a comparison of the information 
with budgeted or historical figures. 
(See section 2.4 for more detail on the ‘types of 
information’). 
QUESTIONING .

32 
Advising to 
influence Communicates insight to influence users 
Finance professionals then: 
• communicate these insights and 
• contribute an objective and responsible perspective 
to influence the organisation’s decision making. 
DEVELOPING SOLUTIONS . 
Applying for 
impact (also called ‘execute’ ) Supports the implementation of decisions to achieve the desired impact 
Finance professionals apply the information to harness 
value for the organisation th rough their impact on, for 
example: 
• strategic plans 
• budgeting and resource allocation • performance measures • performance reviews. 
DEPLOYING SOLUTIONS. 
Acumen Connects the different activities to each other 
Finance professionals prepare valuable information (such 
as reports and analysis) on the outcomes achieved from different initiatives to help inform future proposals. 
(Note:  The information to impact framework may not always 
show ‘acumen’ but it will alwa ys be an important activity of 
the finance function.) 
Note:  These activities will be explored in more detail in Chapter 4.

Chapter 2 
 33 
 Using the ‘Information to Impact ’ framework, match the following 
descriptions to the activities they are describing and put them into 
the correct order. 
Activity Description 
Advising to influence  Providing insi ghts that will be useful for future 
decisions. 
Assembling information Using information to create value for the 
organisation. 
Applying for impact Interpreting information to find patterns and 
trends that may not have been previously 
known. 
Acumen Processing data in to meaningful, useful 
information. 
Analysing for insights Developi ng solutions to influence the 
decisions made by the organisation. 
  
The information to  impact framework can be expanded  as follows: 
 
Moving from left to right there is a shift in emphasis between: 
• accounting and governance  (for example, financia l (corporate) reporting, 
management accounting, regulator y compliance, risk management and 
corporate governance) and 
• guidance and management  (for example, helping the organisation to 
forecast and analyse trends to reac h profitable growth goals).

34 
2.2 Sources of data 
As discussed, finance professionals assemb le data from a range of internal and 
external sources. 
Internal sources 
Internal sources of data may be tak en from a variety of areas such as: 
• accounting records including sales l edger data (such as the volume of 
sales), purchase ledger data (such as the value of purchases for each 
supplier) and fixed asset data (such as  the depreciation method and rate) 
• payroll data such as the number of employees and the hours worked and 
paid 
• production data such as t he number of rejected units 
• sales and marketing data such as market research results. 
 
 Examples of internal sources of data 
 Examples of internal data: 
Source Data 
Sales ledger system • Number and value of invoices  
 • Volume of sales  
 • Value of sales, analysed by customer  
 • Value of sales, analysed by product  
Purchase ledger 
system • Number and value of invoices  
 • Value of purchases, analysed by supplier  
Payroll system • Number of employees  
 • Hours worked  
 • Output achieved  
 • Wages earned  
 • Tax deducted  
Fixed asset system • Date of purchase  
 • Initial cost  
 • Location  
 • Depreciation method and rate  
 • Service history  
 • Production capacity

Chapter 2 
 35 
  
Production • Machine breakdown times  
 • Number of rejected units  
Sales and marketing • Types of customer  
 • Market research results  
  
External sources 
In addition to internal data sources, t here is much data to be obtained from 
external sources such as: 
• suppliers (for example, product prices) 
• customers (for example, product requirement and price sensitivity) 
• newspapers, journals and t he internet (for example,  data on competitors, 
technological development s, discussion groups) 
• the government (for example, inflation rate). 
External data may be limited in its us efulness to finance professionals. The 
limitations of using externally generated data  are as follows: 
• External data may not be accurate. 
• External data may be out of date. • The company publishing the data may not be reputable. 
• External data may not meet the exact needs of the business. 
• It may be difficult to gather external data, for example, from customers or 
competitors. 
 
Examples of external sources of information 
  
External source Information 
Suppliers • Product prices 
 • Product specifications 
Newspapers, 
journals • Share price 
• Information on competitors 
 • Technological developments 
 • National and market surveys

36 
  
Government • Industry statistics 
 • Taxation policy 
 • Inflation rates 
 • Demographic statistics 
 • Forecasts for economic growth 
Customers • Product requirements 
 • Price sensitivity 
Employees • Wage demands 
 • Working conditions 
Banks • Information on potential customers 
 • Information on national markets 
Business enquiry 
agents • Information on competitors 
• Information on customers 
Internet • Almost everything via databases (public and 
private), discussion groups and mailing lists 
  
2.3 Information 
As discussed in section 2.1, to become useful in the organisation, the data 
needs to be turned into information. 
The organisation needs ‘good’ information for planning and decision making 
and in order to manage and control the organisation effectively.  
‘Good’ information should be: 
• accurate  
• timely  
• relevant (i.e. fit for purpose) • concise (information overload can be a problem) but with sufficient detail 
to enable effective management 
• cost effective (cost < benefit).

Chapter 2 
 37 
Another way of looking at the qualities of good information is to use the 
acronym ‘ accurate ’. This is explained using the illustration below. 
 
 Illustration 1 – Qualities of management reports ACCURATE 
 The ‘accurate’ acronym is explained in the context of the management 
reports produced by an information system. 
The management reports from an information system should allow the 
organisation to run the business effe ctively both today and in the future. 
Management reports should have t he following characteristics: 
Characteristic Explanation 
Accurate For example, figures should add up and there should 
be no typos. 
Complete The reports should includ e all the information that is 
needed by the r eaders of the report and should be 
aligned to the overall objectiv es of the report or of the 
Cost < benefit The benefit of having the information must be greater 
than the cost of providing it. 
Understandable The readers of the report must be able to understand 
the contents and use the contents to fulfil their needs. 
Presentation should be cl ear and in line with best 
practice. 
Relevant Information that is not needed by the r eader(s) of the 
report should be omitted. Information overload can be a huge problem and c an detract from the 
usefulness of the report. T he problem of information 
overload may be overcome using, for example, drill-down reports (provide users with the capability to look at increasingly detailed information about a particular item) and excepti on reports (which are only 
triggered when a situation is unusual or requires management action). 
Adaptable The output reports should  have the capability of being 
adapted to meet the needs of the user or the organisation. 
Timely The information should be provided when needed 
and should not be provided too frequently (this can result in information ov erload and the cost of 
providing the information  exceeding the benefit). 
Easy to use Information should be presented in a form 
recommended by the industry or organisation’s best practice. It should not be too long (to prevent 
information overload) and it should be sent using the most appropriate communication channel to ensure user needs are met.

38 
Technology  will play a key role in captur ing this information. Machines and 
automation can now do the collection of data much more effectively and much 
more efficiently than humans.  
Information can now be produced at a press of a button, in real time and in a 
format the suits the needs  of the organisation. 
 
 Illustration 2 – Visualisation 
 Visualisation is becoming a mainstr eam feature of m any organisations’ 
finance functions. Visualisation is about using technology to turn 
increasing amounts of raw data in to useful information for the 
organisation. Traditional spreadsheet content is turned into pictures and infographics, making important organi sational stories much easier to 
understand for the laymen who sit outside of the finance function.
 
Technology should not be viewed by the finance function as a threat but rather 
as an opportunity. For the finance profe ssional, the automation of repetitive 
tasks will free up their time to concentrate on creating and preserving organisational value. 
Important note:  This is only a brief introduction as to how technology is 
impacting business and finance. This area will be explored and built upon in 
subsequent chapters. 
2.4 Types of information 
As discussed in section 2.1,  finance professionals will analyse  a range of 
information to draw out patterns and rele vant insights for those who use the 
information. Information may include the following: 
 
Quantitative and qualitative information will be discussed in a little more detail 
below.

Chapter 2 
 39 
Quantitative information 
 Quantitative information is information that can normally be expressed in 
numerical terms  
Financial information will be qua ntitative (for example total sales information). 
Non-financial information will be partly quant itative (for example, number of 
complaints). 
There are a number of common mistakes that finance professionals could make 
when analysing quantitative information for insights. For example: 
• Presentation of information  – the choice of, say, graph or chart may be 
inappropriate. For example, a graph may indicate dramatic changes but 
only because of the scale chosen. 
• Failure to evaluate the figures us ing a suitable comparator or 
benchmark – finance professionals may report an increase in sales of 
20% on the last year but this may i ndicate poor performance if the market 
grew by 30% over the same period. 
• Collection of data  – an organisation often uses sampling to collect data 
and establish statistics. However, it is difficult to collect a random sample and a sample that is big enough to be representativ e of the whole 
population. This will result in poor  information being produced and then 
analysed by finance professionals. 
Qualitative information 
 Qualitative information is information that cannot normally be expressed 
in numerical terms  
Qualitative information is often in the form of opinions, for example: 
• employees  – who will be affected by cert ain decisions which may threaten 
their continued employment, or cause them to need re-training 
• customers – who will be interested to know about new products, but will 
want to be assured that service arrangements, etc. will continue for 
existing products 
• suppliers  – who will want to be aware of the entity’s plans, for example, a 
move to a just-in-time (JIT) env ironment (i.e. holding no or minimal 
inventory). 
The fact that qualitative information is o ften in the form of  opinions presents a 
problem since the information is subjective  in nature. For example, in 
assessing quality of service, custom ers have different expectations and 
priorities and so are unlikely to be consistent in their judgements. One way to 
reduce the effect of subjectivity is for finance professionals to look at trends in 
performance since the biases  will be present in each individual time period but 
the trend will show relative changes in quality.

40 
It is difficult to record and process data of a qualitative nature but qualitative 
factors still need to be considered when making a decision. These include: 
• The effects on the environment: certain decisions may affect emissions 
and pollution of the environment. The green issue and the entity’s 
responsibility towards the environment  may seriously affect its public 
image. 
• Legal effects:  there may be legal implications of a course of action, or a 
change in law may have been the caus e of the decision requirement. 
• Political effects:  government policies, in bot h taxation and other matters, 
may impinge on the decision. 
• Timing of decision: the timing of a new product launch may be crucial to 
its success. 
These factors must be considered before ma king a final decision. Each of these 
factors is likely to be measured by opini on. Such opinions must be collected and 
coordinated into meaningful informati on. Qualitative data will often be 
transformed into quantitative  information (for example,  by applying a 1 to 5 
scale when assessing customer satisfaction). However, it will never escape from the problem of being j udgemental and subjective. 
3 How finance connects the different  activities in the organisation 
The finance function does not work in is olation. Rather the contemporary 
finance function works with and alongside the other functions of the business and helps to connect the different activities that they perform. 
• It provides information and insight to other functions enabling  them to 
• It works with other functions to shape how the function creates and 
preserves value. 
• It works with other functions to achieve the desired organisational impact 
for this function, narrating how the finance function creates and 
The finance function will communicate insi ght to influence stakeholders, getting 
value from financial and non- financial data in order to  help the organisation to, 
for example: • make better future decisions 
• enhance future operational efficiency • better understand its customers. 
The focus will be very much on what the organisation will need to do in the 
future to preserve and to create value.  
Important note:  This is a brief introduction only . Chapters 9 to 12 will discuss in 
greater detail how finance in teracts with the organisation.

42 
1 Assembling information Processing  data into meaningful, useful 
2 Analysing for insights Interpre ting information to find patterns 
and trends that may not have been 
previously known. 
3 Advising to influence  Devel oping solutions to influence the 
4 Applying for impact Using information to create value for the 
5 Acumen Providing insights that will be useful for 
future decisions.

43 
The structure and shape 
of the finance function  
D1: The structure and shape 
of the finance function. (a) Evolution of the shape of 
the finance function. 
(b) Shape of the finance 
function in the digital era. 
 
  Chapter 
3

The structure and shape of the finance function 
44 
 
In the previous chapters we looked at t he different roles of the finance function 
and the activities that finance professionals perform to fulfil these roles. We also 
discussed the importance of ethics, CSR and corporate governance for an 
organisation and its people and, more s pecifically, for the finance function. 
In this chapter we are going to conti nue to learn about the finance function, with 
a focus on the structure and shape of t he finance function and how this enables 
finance to perform its role in the organisa tion. We will learn about the traditional 
shape and structure of the finance func tion and we will then look at the 
contemporary transformation of this shape and structure and the reasons for 
this transformation. 
Before we learn about these areas it is useful to begin by understanding the 
different structures that the organisation as a whole may adopt. 
2 Organisational structure 
 Organisational structure is formed by the grouping of people into 
departments or sections and the allocation of responsibility and authority.  
2.1 Mintzberg’s effective organisation 
Mintzberg suggested that an org anisation can be analysed into six building 
blocks and that effective co-ordination  will be needed to integrate the building 
blocks into one cohesive unit.

Chapter 3 
 45 
 
Operating core – this is the basic work of the organisation, i.e. the individuals 
who perform the task of pr oducing the product or providing the service. In a 
small organisation this will represent nearly all the organisation, but larger 
organisations will require more complex arrangements.  
Strategic apex – higher levels of management responsible for formulating the 
strategy and long-term plans. 
Middle line  – this links the strategic apex to the operating core and includes 
middle and lower level management.  Technostructure  – this is responsible for designing procedures and standards. 
The technostructure includes accountants, computer specialists and engineers. Support staff – provide services to the organisation which support 
operations/production. 
Ideology  – this is the organisation’s values and beliefs (culture). 
 
Test your understanding 1 
 The technostructure : 
A is dedicated to the technical side of product and process 
development 
B is the board of directors who decide on the financial structure and 
technicalities of a business 
C are departments such as accounting and personnel which provide 
support for technical structures by co-ordinating and standardising 
work 
D are functions to purchase materials and process them for 
distribution

46 
 Mintzberg’s effective organisation 
 As mentioned, co-ordinating mechanisms  integrate the building blocks 
into a cohesive unit: 
Co-ordinating 
mechanism Explanation 
1 Mutual adjustment Co-ordination through informal contact 
2 Direct supervision Co-ordinat ion through a formal hierarchy 
3 Standardisation of work 
processes Standardisation of work processes and specified operating procedures 
4 Standardisation of 
outputs Product and service specifications 
5 Standardisation of skills 
and knowledge Identifies training needs and the necessary skills base to do the work 
6 Standardisation of 
norms Cultural norms and expectations 
The building blocks and the co-ordinat ing mechanisms vary significantly 
from business to business. Mintzberg combined the building blocks 
and co-ordinating mechanisms in different ways and identified five 
main structural configurations . 
Environment  Internal  
factors  Key 
building 
block  Key  
coordinating  
mechanism  
Simple structure (newsagent) Entrepreneurial  
structure (below)  Simple/ 
dynamic Small, young, simple tasks Strategic apex Direct supervision 
Machine bureaucracy 
(heavily unionised 
Company) 
Functional/  
bureaucratic 
structure  (below)  Complex/ 
static Large, old 
regulated 
tasks Techno structure Standardisation of work 
Professional bureaucracy  (hospital, Kaplan) Complex/ static Professional, simple systems Operating core Standardisation of skills 
Divisionalised 
(conglomerate) 
Divisional structure  
(below)  Simple/ 
Static diverse Very large, old, divisible tasks Middle line Standardisation of outputs 
Adhocracy/Innovative (advertising agency) 
Matrix structure  
(below)  Complex/ 
dynamic Young, complex tasks Operating core/ Support 
staff Mutual 
adjustment

Chapter 3 
 47 
 According to Mintzberg’s structur al configurations model, which 
one of the following structures occur when the middle line is the key 
building block? 
A Machine bureaucracy 
B Simple C Divisionalised D Professional bureaucracy Note:  This test your understanding is  on the content in the expandable 
text. The expandable text content is  a useful aid for understanding a 
subject area but is less likely to get  examined than the content in the 
main body of the Study Text. 
2.2 Types of structure 
Different categories of st ructure exist and will be appropriate to businesses at 
the various phases of their lives. A typica l pattern of structural change would be 
as follows: 
• entrepreneurial structure 
• functional structure • divisional structure • matrix structure.  
Entrepreneurial structure 
• The structure is built around t he owner-manager – typical of small 
companies (early st ages of development). 
• The structure is totally centralised wit h all key decisions being made by the 
strategic leader (often the owner /entrepreneur in an owner-managed 
business). 
 
Advantages Disadvantages 
• Fast decision making 
• More responsive to market 
• Good control 
• Close bond to workforce • Lack of career structure • Dependent on the capabilities of the 
managers/owners 
• Cannot cope with diversification/growth

48 
 Advantages and disadvantages of entrepreneurial structures 
 Advantages 
• There is only one person or a few key people making decisions – 
this should lead to decisions being made quickly. 
• As soon as an element of the market alters, the entrepreneur(s) 
should recognise it and act quickly. 
• A lack of a chain of command and t he small size of the organisation 
should mean that the ent repreneur(s) has or have control over the 
workforce and all decisions within t he organisation, leading to better 
goal congruence. 
Disadvantages 
• This type of structure is usually suited to small companies where 
due to the size there is no career path for the employees. 
• Its success relies heavily on t he capabilities of the owner-manager. 
• If the organisation grows, one per son or a few people will not be 
able to cope with the increased volume of decisions etc. 
Functional structure 
• Common in organisations that have outgrown the entrepreneurial 
structure, therefore need to group t ogether employees that undertake 
similar tasks into departments. 
• Most appropriate to smaller companies with few products and locations 
and which exist in a relatively stable environment. 
 
• Economies of scale 
• Standardisation/efficiency • Specialists more comfortable 
• Career opportunities • Empire building 
• Slow to adapt to market changes • Conflicts between functions 
• Cannot cope with diversification

Chapter 3 
 49 
 Advantages and disadvantages of functional structures 
• Rather than duplicating roles in different parts of the company, 
similar activities are grouped together, leading to:  
– lower costs – standardisation of output/systems, etc. – people with similar skills being grouped together and so not 
feeling isolated. 
• Due to the larger size of the organisation and the grouping into 
functions, there is a career path for employees – they can work their 
way up through the function. 
 Disadvantages 
• Managers of the functions may try to make decisions to increase 
their own power or are just in t he best interests of their function, 
rather that working in the best inte rest of the company overall. This 
leads to empire building and conflicts between the functions. 
• Due to the longer chain of co mmand, decisions will be made more 
slowly. 
• This style of structure is not suited to an organisation which is 
rapidly growing and dive rsifying. For example, the specialists in one 
organisation’s production function may not be able to cope with 
making a new product. 
Divisional structure 
• This structure occurs where an or ganisation is split into several divisions 
(strategic business units) – eac h one autonomously overseeing a product 
line/brand or geographical location. 
• Headed by general managers who take responsibility for their own 
resources.

50 
 Illustration 1 – Divisional structure 
 AB is a company that manufactures two different products – toasters and 
televisions. The products require  different components and require 
different advertising and sales and staffing. 
AB therefore operates a divi sional structure,  with a toasters division and a 
television division. Each division ha s its own sales, purchasing, HR and 
advertising divisions. The finance department, however, is still operated centrally. 
 
• Enables product or geographical 
growth 
• Clear responsibility for divisions 
• Training of general managers 
• Easily adapted for further 
diversification 
• Top management free to 
concentrate on strategic matters • Duplication • Lack of goal congruence 
• Potential loss of control 
• Allocation of central costs can be 
a problem 
• Specialists may feel isolated 
 
 Advantages and disadvantages of divisional structures 
• If an organisation wants to grow and diversify, the functional 
structure cannot cope, so instead t he divisional structure should be 
adopted. Should the company want to diversify further, it is easy to 
‘bolt on’ another division. 
• It encourages growth and diversity of products, e.g. by adding 
additional flavours etc to  capture other segments of the market. This 
in turn promotes the use of s pecialised equipment and facilities. 
• Due to the breakdown of the company’s  activities into the divisions, 
it should mean that the divisional  managers can clearly see where 
their area of responsibility lie s and it should leave the top 
management free to concentrate on stra tegic matters, rather than to 
get involved in the day to day op erations of each division – although 
this can lead to a lack of control ov er the activities of the division 
and possible lack of goal congruence. 
• The focus of attention is on product performance and profitability. By 
placing responsibility for product prof itability at the division level, 
they are able to react and make decisions quickly on a day to day 
basis. 
• The role of the general manager has less concentration upon 
specialisation. This promotes a wider view of the company’s 
operations.

Chapter 3 
 51 
• Duplication of business functions – each division must have its own 
finance, human resources and sales manager. This results in more 
managers than if the com pany were centralised. 
• Potential for sub optimisation as the divisions take decisions to 
benefit themselves, possibly to the detriment of  the overall 
company. 
• Increased cost arising from  extra administration and the 
development and maintenance of the control system. 
• The design of the control syst em poses serious problems with 
regard to creating goal congruence between investment decisions 
made by managers and decisions which may be made to improve 
their own personal reward package – the risk of short-termist action or suboptimal behaviour. 
• Loss of operational and tactical control requires increasing elements 
of formality which can stifle t he operation of the divisionalised 
concept. 
• Designing a transfer prici ng system where divisions are 
interdependent. 
• Specialists may feel isolated. 
Matrix structure 
• This structure aims to combine the benefits of a divisional structure and a 
functional structure. 
• Usually found in multi-product and mu lti-functional organisations with 
significant interrelationships and interdependencies.

52 
• Advantages of both functional 
and divisional structures 
• Flexibility to fo cus on customers, 
projects etc. 
• Encourages teamwork and the 
exchange of opinions and 
expertise • Dual command  
• Dilution of f unctional authority 
• Time-consuming meetings 
 
 Illustration 2 – Starbucks’ matrix structure 
 Starbucks Coffee Company has a matrix  structure with the following four 
features: 
1 Functional groups  – the company is split into a number of 
functions including human resour ces (HR), finance and marketing. 
The functions are hierarchical so , for example, the company’s HR 
function implements policies applicable to all of the company’s cafes 
and these are then monitored and controlled by senior 
management. 
2 Geographical divisions  – these are based on the physical location 
of operations, with each division head being given the flexibility to 
adjust strategies and policies to re flect the local market. Starbucks 
has three geographical divisions: (1) Americas, (2) China and Asia-Pacific and (3) Europe, Middle East and Africa. 
3 Product-based divisions  – this feature enables Starbucks to focus 
on product development. There are a number of product divisions including (1) coffee and related products, (2) baked goods and (3) 
merchandise such as mugs. 
4 Teams – team working is an important part of how Starbucks is 
structured. This team working is most visible in the cafes where 
teams are organised to deliver the goods and service to the 
customer in the optimum way.

Chapter 3 
 53 
 Advantages and disadvantages of matrix structures 
• In today's rapidly changing envir onment, there is a need for effective 
coordination in very complex situat ions. If a car manufacturer wants 
to design, produce and market a new model, the process involves 
most parts of the organisation an d a flexible system is needed to 
achieve the objectives. The more rigid structure experienced in a 
divisional company would not have the flexibility to be able to 
coordinate the tasks and the people, whereas the matrix structure 
can cope. 
• The production managers coul d be replaced with customer 
managers, in which case the whole team will be focussed on 
meeting the needs of the customer. 
• Where the matrix stru cture can cause difficult y is in the lines of 
control. These may become ambiguo us and conflict with each other. 
A team member may be answe rable to the product manager and to 
a functional head, and this may ca use confusion and stress. Time 
consuming meetings may be requir ed to resolve the conflict, so 
resulting in higher administration costs. 
 
 Consider the fo llowing statements: 
(i) Under the functional structur e, each department operates as a 
strategic business unit. 
(ii) The matrix structure will enable  rapid decision-making within the 
Which of the statements is/are correct? 
A (i) only 
B (ii) only C Both D Neither

54 
 M is a large company that operates in count ry G. It manufactures several 
different products, each of which is highly complex and extremely 
specialised. Its sales have grown signifi cantly over the last several years, 
with each of its products producing a r oughly equal amount of M's overall 
revenue. 
Which organisational structure is mo st likely to be appropriate for 
M? 
A Geographic 
B Divisional C Functional D Entrepreneurial 
2.3 Centralisation an d decentralisation  
Another method of analysing structures  is by reference to the degree of 
autonomy or the level at wh ich decisions are made. 
 In a centralised structure,  the upper levels of an organisation’s hierarchy 
retain the authority to make decisions. 
 In a decentralised structure,  the authority to make decisions is passed 
down to units and people at lower levels. 
 
 Factors affecting the amount  of (de)centralisation 
 The following factors will affect the amount of (de)centralisation: 
• Management style – for example, managers who want to retain 
control may operate a c entralised structure. 
• The ability of management/employees  – for example, the more 
able the employees, the more decisions they can be entrusted with 
and the greater the level of decentralisation.  
• Geographical spread  – this may make central control more difficult 
resulting in a decentralised structure. 
• The size  of the organisation  – small organisations can retain a 
level of central control relatively easily. 
In reality most organisations will operate a degree of both centralised and decentralised decision making; the extent of each will be influenced by the factors above.

Chapter 3 
 55 
 Illustration 3 – A centralised organisation 
 A good example of a centralised busine ss would be a multinational fast 
food chain such as McDonalds or Bu rger King. The majority of the 
locations of these international fa st-food chains are privately owned 
franchises (a franchise is the purchas e of the right to exploit a business 
brand in return for a capital sum and a s hare of the profit or turnover).  
A centralised structure enables control and consistency to be maintained 
across thousands of outlets thus protecting its brand and reputation, 
while saving on overheads such as local payroll and accounting functions, through economies of scale. 
The advantages and disadvantages  of decentralisation are: 
Advantages of decentralisation Di sadvantages of decentralisation 
• Senior management free to 
concentrate on strategy 
• Better local decisions due to local 
expertise 
• Better motivation due to 
increased empowerment of employees and a more defined career path 
• Quicker responses/flexibility due 
to reduced bureaucracy and increased autonomy 
 • Loss of control by senior 
management and lack of standardisation 
• Dysfunctional decisions due to a 
lack of goal congruence 
• Poor decisions made by 
inexperienced managers 
• Training costs 
• Duplication of roles within 
• Extra costs in obtaining 
information since it is stored in 
several locations 
 
 Which one of the following is NOT a likely additional cost to an 
organisation caused by  decentralisation? 
A Additional training costs are often required in a decentralised 
B Duplication of roles, leading to higher costs 
C Extra costs of gathering informa tion from various sources and 
locations 
D Lost sales due to a lack of local knowledge and expertise

56 
2.4 Tall and flat organisations  
Organisations can also be classed as ta ll or flat depending on the length of the 
scalar chain and the breadth of the span of control. 
 The scalar chain  is the line of authority which can be traced up or down 
the chain of command, from  the most senior member of staff to the most 
junior. It therefore relate s to the number of levels of management within an 
 
 Illustration 4 – British Army chain of command 
 The British Army is a good example of an organisation with a long chain 
of command. There are two main groups of staff with a ranking system 
existing within each group: 
1 Commissioned officers  are ranked from top to bottom as follows – 
Field Marshal, General, Lieuten ant General, Major General, 
Brigadier General, Colonel, Lieut enant Colonel, Major, Captain, 
Lieutenant, Second Lieutenant. 
2 Other ranks and non-commissioned officers are ranked from top 
to bottom as follows – Regimental Sergeant Major, Company 
Quarter Master Sergeant, Company Sergeant Major, Staff Sergeant, 
Sergeant, Corporal, Lance Corpor al, Private, Volunteer. 
 
 The span of control  considers how many people report to one superior. 
 
 Factors that influence the span of control 
 The factors that influence t he span of control include the: 
• Nature of the work  – the more repetitive or  simple the work, the 
wider the span of control can be. 
• Type of personnel  – the more skilled and motivated the managers 
and other staff members are, the wider the s pan of control can be. 
• Location of personnel  – if personnel are all located locally, it takes 
relatively little time and effort to  supervise them. This allows the 
span of control to become wider.

Chapter 3 
 57 
(i) The scalar chain relates to t he number of people over whom a 
manager has authority. 
(ii) A business with highly skilled, motivated members of staff will tend 
to have a wider span of control than a business with demotivated 
employees. 
Which of these statements is/are correct? 
A (i) only 
B (ii) only C Both D Neither 
 
 A ‘tall’ organisation has many levels of  management (a long scalar chain) 
and a narrow span of control.  
 A ‘flat ’ organisation has few levels of  management (a short scalar chain) 
and a wide span of control. 
 
 Illustration 5 – A move by organisations to a flatter structure 
 Many organisations are adopting (and seeing the benefits of) a flatter 
structure . For example, Google’s core val ues from the beginning were to 
have a flat organisation, a lack of  hierarchy and a collaborative 
environment . This flatter organisation enc ourages employees to take 
initiative without needing approval from multiple managers. They  
empower employees to take charge,  help make decisions and feel 
responsible for the company’s success.

58 
 
It is worth noting that tall organisations tend to be more bureaucratic  and take 
longer to make decisions , due to the large number of  levels of management 
that need to be involved. 
However, flat organisations are not without thei r problems. These organisations 
tend to have weaker control and fewer chances for employees to progress  
or be promoted withi n the organisation. 
 
 If a managerial structure has many levels of management, is it likely 
to have a narrow or wide span of control at each level of 
management? 
2.5 Contemporary transformation of organisations  
• It is worth noting that the discussion above has focused on the 
historical organisationa l configurations and structural dimensions  
that an organisation may adopt. 
• Although much of this is still relevant, the changing expectations of 
customers, competitive pressure s, a changing political and economic 
landscape and huge technological innovat ions have changed many of the 
traditional organisational  forms and boundaries. 
• Organisations have adopted new forms, for example outsourcing many 
aspects of the organisation’s work to specialist providers, and have focused on factors such as flexibility rather than having a more rigid set of 
organisational boundaries in place.

Chapter 3 
 59 
 Illustration 6 – Nike 
 The sports good manufact urer, Nike, outsources production activities but 
retains total control over des ign and quality specifications. 
• This contemporary transformation will be reviewed in the remainder of this 
chapter, with a specific focus on the contemporary transformation of the 
finance function.  
 
 Illustration 7 – General Electric 
 The term ‘boundaryless’ organisation or iginated from Jack Welch in the 
early 1990s when he was Chairman of General Electric. He recognised 
that the modern environ ment was subject to continuous innovation and 
change, thus requiring management to develop more flexible organisations. He aimed to achieve competitive advantage by replacing vertical hierarchies with horizontal networks; linking t ogether traditional 
functions into inter-functional team s and forming strategic alliances with 
suppliers, customers a nd even competitors. 
3 Contemporary transformation  of the finance function  
3.1 Introduction 
In Chapter 2 we discussed the finance acti vities from informa tion to impact. The 
basic activities of the finance function are still relevant in today’s organisations but there has been a shift in emphasis r egarding the importance of each of the 
activities. 
Historically, the overall mandate of the finance function was to focus on 
organisational efficiencies and to reduc e operational costs. This focus has 
resulted in organisations achievin g optimum operati onal efficiency. 
Technology has, to a large extent, replaced the historical mandate of the 
finance function, with machines being c apable of monitoring operational costs 
and patterns of organisational efficiency. 
If we relate this back to the information to impact framework this has resulted in 
automation of much of the  ‘assembly ’ and ‘ analysis ’.

60 
 Illustration 8 – Automation of th e finance function’s activities 
 Advances in technology are providin g opportunities to automate many of 
the activities of the finance functi on. For example, robotic process 
automation (RPA) is providing opport unities to automate many routine, 
clerical ‘assembly’ activities. 
RPA is a software-based approach that replicates user actions to reduce 
or eliminate human intervention in  mundane, repetitive and manually 
intensive processes. 
RPA started off in manufacturing (f or example, with robotic vehicle 
assembly lines) but is now used acro ss other functions such as finance. 
Rapid strides in the development of this technology mean machines are 
now encroaching on activities prev iously assumed to require human 
judgement and expense, such as data entry, automated formatting, 
reconciliations and foreign exchange transactions. 
This allows finance staff to re-foc us on higher value, customer-focused 
Finance professionals should not view th is automation as a threat but as an 
opportunity. The core accounting role will still be an essential foundation of the 
finance function but enabled by new tec hnologies, the function can now be a 
more influential player in the organisation. Technology allows the contemporary finance function to refocus its energy on 
revenue and value creation.  
The finance function will no longer work la rgely in isolation but will work with 
others from across the organisation to  drive business transformation that 
creates shareholder value. To do this the  finance function will need to reallocate its resources to the  
‘advising’  and ‘applying/executing ’ activities in the information to impact 
framework. Note:  The use of technology by the finance function is explored in more detail in 
Chapter 6. 
 
Test your understanding 8 
 Are the following statements true or false? 
A Because of advancements in technology the basic activities of the 
finance function are no longer relevant 
B Technology allows the contemporary finance function to refocus its 
energy on value creation 
C Technology has meant that a large amount of the assembly and 
analysis activities can be automated 
D Technology has meant that a la rge amount of the advising and 
applying activities can be automated

Chapter 3 
 61 
3.2 Can the finance function cope with this shift? 
The finance function will need to build new competencies but it is well 
positioned to meet this  changing mandate since: 
• it has a unique end-to-end view of the organisation, understanding that 
every activity has a financial consequence 
• its accounting information is trusted and credible 
• it already provides a framewor k for performance management, for 
example through management accounting 
• it brings professional, evidence based objectivity to decision making. 
3.3 The information to imp act framework revisited 
 
The information to impact framework clearly shows that: 
• Technology and automation  will play an important role in all of the 
activities of the finance function but  will have the largest impact on the 
‘assembly ’ and ‘analysis’ activities. 
• This will ‘free up’ the resource of the finance function professionals  who 
can now place greater focus on the ‘ advising ’ and ‘applying/executing ’ 
• The finance function will need to develop its competencies : 
– firstly, so that  they are able to use the up to date technology  and 
– secondly, so that they have the necessary skills to provide the 
influence and impact required .

62 
 Illustration 9 – New competencies required by finance function 
 The World Economic Forum published a ‘Future of Jobs’ report in 2018. 
This report concluded that by 2022 each individual within the finance 
function will require an ex tra 101 days of learning.  
Competencies will not only be around technology but will also focus on 
business skills, leadership skills, people skills and more traditional technical skills (all of which will be underpinned by ethics, integrity and 
professionalism). 
The survey identified ten key competencies: 1 Analytical thinking and innovation 2 Active learning and learning strategies 3 Creativity, originality and initiative 4 Technology design and programming 5 Critical thinking and analysis 6 Complex problem-solving 7 Leadership and social influence 8 Emotional intelligence 9 Reasoning, problem solving and ideation 10 Systems analysis and evaluation 
 
 Which of the following activities are likely to be the most impacted 
by technology and automation? Choo se all the answers that apply. 
A Processing data into information B Producing monthly variance reports 
C Developing solutions to influence the decisions of an organisation 
D Analysing non-financial information for insights E Using information to create value for the organisation

Chapter 3 
 63 
4 Shape of the finance function  
4.1 Introduction 
In this section we are going to look at the shape of the finance function and how 
this shape is evolving as a result of  advances in technology, the changing 
mandate of the finance function and the c hanging capabilities of the finance 
function. 
The evolution of the shape of the finance function is as follows: 
 
The shape is migrating from: 
• a hierarchical triangle (traditional shape) – containing a broad base of 
finance workers reporting upwards to a series of ever narrower 
management levels 
• to a segregated triangle (last 20 years)  – globalisation a nd technological 
advances meant that much of the routine processing of the finance 
function could be carried out by a shared service centre (i.e. the centralisation of this routine pr ocessing into one place). The bottom 
section of the segregated triangle repr esents the finance function activity 
carried out by these shar ed service centres. ( Note:  This change is 
discussed in section 5) 
• and finally to the diamond shape (today’s digital age)  – the traditional 
triangular base is being eroded due to automation of many  of the basic 
activities of the finance function. 
We will begin by briefly looking at the traditional hierarchical shape of the 
finance function before looking at how this shape could/has evolve(d) to a 
diamond shape.

64 
 Test your understanding 10 
 Pick from the following options to complete the sentences below: 
Options: 
Traditional hierarchy 
Legislation Diamond shape Globalisation Boundaryless structure Technology Governance 
Sentences: 
The shape of the finance func tion has evolved from a  
_________________ to a ____________ _____ in today’s digital age.  
 
This has primarily been driven by _________________  
and _________________ 
4.2 Traditional hierarchical triangle 
In Chapter 1 we learned that the roles of th e finance function can be 
summarised as enabling , shaping how  and narrating how  the organisation 
creates and preserves value.  We can understand the traditional hierarchic al triangle shape in the context of 
these roles. In the traditional triangle: 
• at the bottom of the triangle, t here is a broad base of finance workers 
carrying out the operational ‘enabling’  roles of planning, forecasting and 
resource allocation. 
• in the middle of the tr iangle, there is a narrower set of management level 
finance workers who are reported to from the level below and who carry 
out the ‘shaping how’ roles of per formance management and control. 
• at the top of the triangl e sit a narrower group of senior finance staff. These 
staff are reported to from below and they concentrate on the ‘narrating 
how’ role of financial (corporate) reporting.

Chapter 3 
 65 
4.3 Diamond shape 
Evolution into a diamond shape 
The traditional hierarchical triangle is evolving into a diamond shape as follows: 
 
The evolution can be summarised as follows: 
1 Technological automation has eroded the traditional triangular shape  
with much of the lower level assembly and processing tasks now being 
carried out by technology rather  than finance professionals. 
2 The central bulge  in the diamond shape is due to many of the higher-
value services now being offered by  centres of excellence (or shared 
service centres) where finance professi onals will work as part of a multi-
disciplinary team, assembled in sk ills combinations that support the 
business. 
3 The flat top of the structure shows a mo ve to a collaborative finance 
leadership approach – with the chief finance officer (CFO) and other senior finance staff working with and alongside the chief executive officer 
(CEO).

66 
 Illustration 10 – The diamond shape of the finance function 
 Industry experts have considered the need to design a finance function 
that is fit for the future. Some usef ul quotes highlight the importance of 
the following: 
1 Tackling technology 
‘Finance is actually no different from any other department in our 
business. The problem facing it can be encapsulated in one word: technology. Automation and all the efficiencies that come with improved technology are removing many of the function’s traditional tasks. I think that’s a good thing, because they are mundane and no one really wants to do them.’ 
(Daniel O’Toole, CEO of Retail Merchandising Services, a 
development company that supports many of the UK’s biggest high-
street names.) 
2 A focus on strategic decision m aking and growth rather than 
historical data 
‘Finance is no longer simply a back-office concern. It is a leading 
function in the business. It’s up front, collating the intelligence and presenting it in a way that is eas ily understood. In t he past it was 
just about reporting fin ancial performance in the preceding year or 
quarter, but now things are so di fferent. Today it’s about combining 
financial data with non-financial intelligence to get a much wider perspective on how the business has performed and to predict how it will perform – and it’s about using all of this to make sound business decisions.’ 
(Hari Punchihewa, deputy chief execut ive and finance director at the 
University of Derby (UK).) 
3 Finance as a business partner 
‘Management accountants don’t really exist now as they once did. 
They are being replaced with what I would call finance business 
partners. Accounting was always  seen as the boring part of 
the business, but the new position of finance business partner is 
much more exciting and creative.’ 
(Jim Jordan, finance director at the IoD (Institute of Directors – UK).)

Chapter 3 
 67 
The four levels of the diamond shape 
This evolution has resulted in a diamond shape. The diamond can be split into 
four levels. Level 1 is at the top  and level 4 is at the bottom  of the diamond. 
 
Note:  This is an important diagram to  learn and to understand for the exam. 
Why the shape of the finance function is changing 
There are three main reasons why the shape of the finance function is 
changing: 
Reason Explanation 
The changing mandate 
for finance The contemporary transf ormation of the finance 
function was discussed in section 3. The changes discussed better enable the finance function to focus on level 2 ‘strategic business partnering’ and explain why the diamond shape bulges outwards at this level. 
Technology Technology has impacted the finance function in two 
main ways: 
Firstly, it has supported t he automation of many of 
the management information processes and much of 
the reporting performed at level 4. 
Secondly, It has increased the need for skills at levels 
2 and 3 (as discussed below). 
Finance function capability The changing mandate for finance combined with advancements in technology have changed the competencies required of the finance function. 
Level 2 is the focal point  of these changes and is 
another reason for the bulge in the finance function 
shape at this point.

68 
Will the shape of the finance function continue to evolve? 
The shape of the finance function will continue to evolve and finance will no 
longer just be for pure accountants.  
• There will be an increasing emphasis on professional level roles requiring 
support and management skills. 
• There will be a continued emphasis on specialist knowledge (for example, 
in different areas of aut omation and technology) leading  to the formation of 
multi-disciplinary teams who will become members of the finance team. 
Important note: The activities that the finance  professionals perform to fulfil 
their roles at each of the four levels of the diamond shape will be explored in 
more detail in Chapter 4.  
5 Shared services and outsourci ng of finance operations  
5.1 Introduction 
Contemporary developments in the role and activities of the finance function 
have for some organisations meant a struct ural reconfiguration, with solutions 
based on greater or less centralisation, o ffshoring, shared service provision (as 
discussed in section 4.1 when we explai ned the migration of the shape of the 
finance function from a hierarchical tr iangle to a segregated triangle), business 
partnerships, out sourcing etc.  
The local variations are endless but the aim is the same – to make the finance function a valued and worthwhile ess ential of organisational functioning. 
Two of these options, outsourcing and s hared service provision, are discussed 
below. 
 Outsourcing  means contracting out aspec ts of the work of the 
organisation previously done in-house, to specialist providers. 
 A shared service centre may be established for a particular activity of the 
organisation. The term describes a situation whereby, a usually large, multinational organisation with processing centres in all or several of the 
countries in which it operates chooses to consolidate these activities at 
one site, or shared service centre. Th is is sometimes referred to as 
‘internal outsourcing ’. 
5.2 Introduction to outsourcing 
The outsourcing of many aspects of busines s activity is one strategy that has 
been suggested as a source of adding value and streamlining activities to 
maintain competitiveness. 
It has become increasingly common over the past two decades.  
In theory, any of the operations that  a business performs can be outsourced. 
However, an organisation will often outsource its non-core services  to a third 
party, allowing them to focus on their co re competencies which are integral to 
the organisation’s ability to  create and to add value.

Chapter 3 
 69 
Non-core activities may include: 
• facilities management 
• human resource management • cleaning services • catering services and • legal services. 
The organisation’s core competencies are something that they are able to do 
that drives competitive advantage and is very difficu lt for a competitor to 
emulate. It may be unwise for an organisati on to outsource activities in 
which they have a core competence  as this could erode competitive 
advantage. 
 
Illustration 11 – Outsourcing in a clothing retailer 
 In clothing retail, it may be the case that most firms have outsourced 
production to Asian manufacturers in  order to gain low costs. This 
outsourcing may be essential just to be a feasible player in the market. 
However, the clothing retailers may still retain aspects of the work in 
which they have a core competence in-house. For example, a particular clothing retailer may have core competencies relating to design and brand management and may retain these activities within the organisation. 
 
 Test your understanding 11 
 Canterell is a bank based in country Z. It is considering outsourcing its IT 
function. Its current IT systems ar e considered excellent, which is 
important, as the banking industry in country Z is highly competitive and 
innovative.  
Which of the following statements  regarding this proposal is 
correct? 
A Canterell will be definitely be abl e to improve its in house IT 
expertise as a result 
B Outsourcing could cause Canterell a loss of competitive advantage 
C It will be easy for Canterell to bring IT back in-house if they are not 
satisfied with the outsource supplier 
D It is not possible to outsource IT

70 
Outsourcing has become increasingly common in organisations. The 
advantages and disadvantages include: 
Advantages of outsourcing 
The main reason for outsourcing is that it is cheaper. Cost advantages  can 
come from a number of sources: 
• A large supplier may benefit from economies of scale in production. 
• The firm concerned will benefit fr om reduced capital expenditure. 
• Reduced headcount.  
• Research and development expenditure may also be saved. 
There can also be quality advantages : 
• The supplier may have superior skills and expertise. For example, Apple’s 
main reason for outsourcing to China is superior manufacturing capability 
rather than cost savings. 
• Outsourcing may solve the problem  of the company having a skills 
shortage in certain areas. 
Other advantages  include the following: 
• The supplier may have greater production expertise and efficiencies, 
leading to faster and more fl exible supply of components. 
• The management of the cu stomer are no longer distracted by fringe areas 
and so can focus on core business activities. 
• The organisation can exercise buye r power over suppliers ensuring 
favourable terms and conditions. 
• The organisation has greater flexibility to switch suppliers based on 
changing cost/quality considerations. 
• Cost issues – the supplier will want to  make a profit margin, suggesting it 
may be cheaper to do the work in hous e. In addition, if dealing with a 
major supplier the organisation may be vulnerable to future price rises. 
• Loss of core competence – the servic e may represent (or contribute to) a 
core competence for the organisation and therefore outsourcing may lead 
to a loss of competitive advantage. 
• Transaction costs – arise from the effort put into specifying what is 
required, co-ordinating deliv ery and monito ring quality. ( Note:  Transaction 
costs are discussed in more detail later on in the chapter). 
• Finality of decision – once a servic e has been contracted out it may be 
difficult to take back in-house at a la ter date, for example due to a loss of 
in-house expertise. 
• Risk of loss of confidential information.

Chapter 3 
 71 
• Risk of continuity of supply if the supplier has problems. 
• Difficulty agreeing/enforcing contract terms. 
• Damage to employee morale if re dundancies occur or if organisational 
culture is eroded. 
 
 Illustration 12 – Outsourcing advantages 
 Organisations can outsource a wide r ange of activities and processes.  
Robotic process automation (RPA) wa s discussed earlier on in this 
chapter. Organisations may want to harness this new technology but do 
not have the resources or expertise to do so effectively. Therefore, the organisation may outsource this business process to an  expert in this field. 
This outsourcing will a llow the organisation to harness the potential to 
automate business processes and to enj oy the benefits of RPA including:  
• faster processing and improved productivity 
• lower costs • improvements accuracy and compliance • a focus on higher value, cu stomer focused activities. 
 
 Test your understanding 12 
 Q Co is considering outsourcing its IT  function to a third party IT company 
on a fixed fee basis. Q does not consider  IT to be core function. A junior 
accountant has produced a list of possible advantages of this to the 
company.  
Which FOUR of the following fact ors are likely advantages of Q 
outsourcing its IT function? 
A It will reduce the probability of other organisations gaining access to 
Q’s information 
B It will reduce uncertainty relating to  how much the IT function will 
cost Q each year 
C The third party company may have access to IT skills that Q lacks 
D If the third party fails to perform  well, Q can easily bring the IT 
function back in-house 
E The third party company may have access to more economies of 
scale for IT, allowing Q to sa ve money on its IT function 
F It will reduce Q’s dependence on its suppliers G Q is likely to gain competitive advantage over rivals with its IT 
systems 
H It is likely to allow Q to focus it s management time on core activities

72 
Service level agreements 
At least some of the potential disadv antages can be controlled though the use 
of effective service level agreements. 
 A service level agreement  (SLA) is a negotiated agreement between the 
supplier and the customer and is a legal agreement regarding the level of 
service to be provided. 
 
 Service level agreements 
 Service level agreements shoul d include the following factors: 
• A detailed explanation of exactly w hat service the supplier is offering 
to provide. 
• The targets/benchmarks to be us ed and the consequences of failing 
to meet them. 
• Expected response time to technical queries. 
• The expected time to recover the operations in the event of a 
disaster such as a systems crash, terrorist attack, etc. 
• The procedure for dealing with complaints. • The information and reporting procedures to be adopted. • The procedures for cancelling the contract. 
Transaction cost theory 
 Transaction costs are the indirect costs (i.e. non-production costs) 
incurred in performing a particular ac tivity, for example the expenses 
incurred through outsourcing. 
When outsourcing, transaction costs arise from the effort  that must be put into 
specifying what is required and subs equently co-ordinating delivery and 
monitoring quality. 
There are three main types  of transaction costs: 
• Search and information costs  – for example, the cost of determining 
which supplier is cheapest. 
• Bargaining costs  – the cost of agreeing on an acceptable SLA. 
• Policing and enforcement costs  – are the costs of making sure the other 
party sticks to the terms of the contract, and taking appropriate action 
(often through the legal system) if th is turns out not to be the case. 
High transaction costs for outsourci ng may suggest an in-house solution 
whereas low transaction costs for outsourcing would support the argument to outsource.

Chapter 3 
 73 
 Test your understanding 13 
 Which of the following statements is/are true? 
 True? 
High transaction costs will usually  lead to a company deciding 
to outsource  
A robust SLA will prevent the risk of a loss of confidential data  
Transaction costs include bargaining costs  
Transaction costs are incurred when outsourcing is used  
Transaction costs include the cost of production  
  
 Transaction cost theory (Wiliamson and Coase) 
 Organisations choose between two met hods of obtaining control over 
resources: 
• the ownership of assets (hierarchy solutions – decisions over 
production, supply, and the purchases of inputs are made by 
managers and imposed through hierarchies) and 
• buying-in the use of assets (the market solution – individuals and 
firms make independent decisions that are guided and co-ordinated by market prices). 
The decision is based on a comparison of  the transaction costs of the two 
approaches. 
Transactions have three dimensions that determine the costs associated 
with them: 
• uncertainty – the more uncertain t he environment the harder it is to 
write effective long-term contracts and the more likely the 
acquisition of a supplier is 
• the frequency with which the transactions recur; and 
• asset specificity – the extent to wh ich the transacting firms invest in 
assets whose value depen ds on the business relationships remaining 
intact. The greater the sp ecificity of the assets  involved, the greater 
the likelihood that a transaction will take place within the firm. 
These factors translate into ‘make-o r-buy’ decisions: whether it is better 
to provide a service from within the organisation, with hierarchical co-
ordination, or from out side the organisation, with market co-ordination. 
Williamson and Coase argue t hat it is the third di mension, the degree of 
asset specificity, which is the most  important determinan t of transaction. 
The more specific the assets are to  a transaction then, all other things 
being equal, the greater will be the associated transaction costs and the more likely that the tran saction will be internalised into a hierarchy.

74 
Conversely, when the productive assets  are non-specific the process of 
market contracting is the more effi cient because transaction costs will be 
low. 
Asset specificity 
An asset is said to be transaction- specific if its value to a given 
transaction is greater than its value in its best alternative use. The greater 
the gap between these two values, the gr eater the degree of specificity of 
the asset. Williamson and Coase sugges ted six main types of asset 
specificity: 
• Site specificity – suggests that once sited the assets may be very 
immobile. 
For example, a car components manufacturer locating a 
components factory near to a large customer’s manufacturing plant. 
• Physical asset specificity – when parties make investments in 
machinery or equipment that are s pecific to a certain task these will 
have lower values in alternative uses. 
For example, a supplier of wet cement to building sites may invest in 
wet cement delivery trucks (a ‘hierarchy’ solution) since these trucks are so specific to this task t hat they cannot be sourced via a 
network. 
• Human asset specificity – occurs when workers may have to 
acquire relationship-specific skills, know-how and information that is 
more valuable inside a particular transaction than outside it. 
For example, a consultant may ha ve to acquire detailed knowledge 
of a client’s in-house develop ed systems but this knowledge may 
not be useful on other clients. 
• Brand name capital specificity refe rs to becoming affiliated with a 
well-known 'brand name' and thus becoming less free to pursue 
other opportunities. 
For example, an actor may become ‘typec ast’ in a particular role or show. 
• Dedicated asset specificity entai ls investments in general-purpose 
plant that are made at the behest of a par ticular customer. 
For example, the car components manufacturer above invests in 
dedicated machinery to make be spoke components for just one 
manufacturer. Should the contract be lost, these components may have to be adapted for sale elsewhere. 
• Temporal specificity – arises wh en the timing of performance is 
critical, such as with perishable agricultural commodities where a 
farmer may struggle to find alternat ive processors at short notice.

Chapter 3 
 75 
5.3 Outsourcing the activiti es of the finance function 
Introduction 
Outsourcing of the finance function’s activities has become increasingly 
common in organisations in recent times. The emphasis has been on 
reducing costs but outsourcing has also enabled the retained finance 
function to focus on strategic change  by working more closely with the 
business to provide business partneri ng to help improve decision making. 
Which finance function activities should be outsourced? 
A key consideration is which finance activities should be outsourced.  
• Transactional processes (such as a ccounts payable/receivable, travel and 
entertainment and cash management) tended to be very popular to 
outsource. 
• However, improvements in provider capabilities have also resulted in 
outsourcing of services such as statutory and regulatory accounting, 
financial reporting and tax, management accounting, budgeting and 
forecasting. 
Relating this back to the ‘ information to impact framework’ (discussed in 
Chapter 2 and section 3 of this chapter) thes e activities relate largely to the left 
hand side of the framework and the ‘ assembly ’ and ‘ analysis ’ activities within. 
Benefits and drawbacks of outsourci ng the finance function’s activities 
Benefits Drawbacks 
• Cost reduction  – outsourcing 
can deliver significant economies of scale through the use of standardised processes and leading-edge technology. 
• Radical transformation  – 
outsourcing can enable broad structural change. Low value, non-core activities can be moved to the external provider allowing the organisation to shift internal resources from operations to innovation, i.e. the ‘advisory’ and ‘application’ parts of the ‘information to impact framework’. 
Note:  A radical transformation and 
fundamental rethinking of business processes is called business process re-engineering (BPR). • Loss of control – the external 
provider is relied upon for 
providing the right level of resource and skill. 
• The organisation will need to 
develop expertise and invest time and money in managing the 
outsourced services . 
• Outsourcing will cause 
disruption  and may result in 
significant resistance to change. 
• Risk of intellectual property 
theft and data breaches. 
• Erosion of internal knowledge 
and skills.

76 
• Access to superi or capabilities, 
expertise and resources  of the 
specialist provider. 
• Business partnering  – the 
retained finance function can 
concentrate on their role as business partners, working more closely with the business in decision making.  
5.4 Establishing a shared service centre for the finance function 
Shared service centres have become a well- established model for organisations 
to drive efficiencies, improve compli ance and controls and enable insight into 
the business. 
The scope of services t hat are provided include finance , HR, IT, procurement, 
and other business support activities. As discussed in section 4, the traditional shape of the finance function was a 
hierarchical triangle , with a broad base a nd few roles at senior levels. Over the 
past two decades this shape evolved to  a segregated tria ngle with routine 
processes  being migrated to and carried out by shared  service centres.  
This change was driven by two main factors : 
• Globalisation  – many organisations grew in size and became 
multinational organisations with operat ions and processing centres in 
several countries. The establishment  of a shared service centre enabled 
the consolidation of these activities at one site. 
• Advances in information technology  – enabling automat ion of many of 
the lower level tasks carried out by the finance function (as discussed 
earlier in this chapter). 
The benefits  of establishing a shared service centre for the finance function are 
• Cost reduction – a shared service centre may reduce costs by up to 50% 
due to factors such as: 
– a reduction in premises and associated costs 
– potentially favourable labour rates, for example if the shared service 
centre is based in a country with lower wage rates 
– headcount reductions, for example due to the more routine activities 
benefiting from economies of scale and a reduction in repetition of 
tasks 
– systems consolidation 
– potential tax savings.

Chapter 3 
 77 
• Opportunity to standardise processes: 
– resulting in a lower potential for errors 
– making the design and update of t he control environment easier 
– allowing for consistent reporting. 
• An improved level of service – t he shared service centre will view the 
business to be the customer. The mo re professional supplier/customer 
relationship should result in marked improvements in the quality of the 
service provided. 
• A better opportunity to compar e trends across the organisation. 
• Consolidation of systems, to say one type of accountancy software, makes 
add-ons such as robotics and great er use of automation easier. 
However, there are risks associated with the establis hment of a shared service 
centre: 
• Has the organisation got the resources required to spread the major set up 
costs? 
• Employee issues – these include the potential cost of making staff 
redundant plus the impact on the morale of the remaining staff due to the 
changes made. 
• Lack of systems integration across the organisation may make migration 
of diverse systems complicated, costly and time consuming. 
• A shared service centre is often estab lished in a multinational organisation 
which has operations in several count ries. The complexities of these 
countries including different laws, ta xes, languages, cultures and reporting 
requirements may make  this difficult. 
 
 Tips on establishing a successful shared service centre 
 • A clear vision of how the shared serv ice centre fits into the overall 
business model. 
• Senior management commitment – senior management need a 
clear vision and strategy and to support the process. 
• Integration with other  change initiatives. 
• Clear scope with delineation of responsibilities. 
• Buy-in of operating unit s impacted by the change. 
• Ensuring that the organisation that remains after service transfer is 
robust. 
• Support from those who have im plementation experience to help 
navigate through the challenges faced. 
• A strong customer -focused culture. 
• A commitment to continuous improvement.

78 
 
 Test your understanding 14 
 Which of the following are draw backs of outsourcing the non-core 
activities of the finance func tion? Choose all that apply. 
A Loss of control 
B Risk of data breaches C Erosion of internal knowledge D Increased costs E Loss of competitive advantage F Major set up costs 
Alternatives to establishing a shar ed service centre for the finance 
function 
The benefits must be weighed up against the risks before a decision is taken to 
establish the shared service centre. It ma y be that a decision is taken to keep 
the finance function’s activities in several sites  across the business. 
An alternative would be to establish a shared service centre but rather than the services being provided in-house a decision is taken to outsource the 
provision of the shared services to a third party  who specialises in the 
provision of such services. 
 
 Illustration 13 – Outsourcing of finance shared services 
 PwC (UK) is a one of the larger providers of finance shared services. The 
following is taken from their website and illustrates nicely the future of the 
finance function and how an outsourcing pr ovider could assist with this 
future: 
‘It’s 2020 and you’re the CFO sat in a finance shared service centre. 
There’s a wall of screens showing the latest profit forecasts for each of 
your divisions – changing every few minutes. In the co rner, there’s a 
Robotic Process Automation (RPA) hub with a few people studiously monitoring the 50 bots deployed across your finance processes. In the general accounting team it’s month end – but there’s an air of calm as 
with your cloud based Enterprise Resource planning (ERP) you can close whenever you want within a few minut es. The brightest monitor in the 
room is at the back, showing the daily Shared Service Centre’s (SSC) 
huddle board with lots of st ars and names up in lights. 
At PwC we are helping clients ta ke advantage of new digital tools and 
ways of thinking to move towards this so rt of reality. Whether you’re just 
thinking about shared services or outsourcing or have been established for years and are looking to evolve your SSC further to take advantage of 
the digital revolution, we can help.’

Chapter 3 
 79 
Shared services and the diamond shape of the finance function 
The discussion above has focused on the past two decades over which time the 
shape of the finance function has evolved from a traditional hierarchical triangle to a segregated triangle with routine pr ocesses being migrated to and carried 
out by shared service centres. The scope of the shared service centre’s work 
was very much on the lower level tasks (level 4 tasks) of ‘assembling and extracting data and provid ing limited insight’. 
However, as discussed earlier on in th is chapter, the shape of the finance 
function is now evolving to a diamond s hape. In the diamond shape the level 3 
tasks present within ‘specialists generating further insights in their areas of specialism’ are now offered by shared service centres. Opportunities for 
business partnering will also be expanded. 
In summary , shared service centres whether in-house or operated by a 
service provider (outsourced) have indus trialised the provision of routine 
management and accounting services but now offer scope to expand 
vertically to offer higher value services.

80 
6 Chapter summary

Chapter 3 
 81 
 The correct answer is C – by definition . 
 
 The correct answer i s C 
A divisionalised form is characterised by a powerful middle line in which a 
there are a large numbe r of middle managers who each takes charge of a 
more or less autonomous division.  
 
 The correct answer is  D 
The separate parts of the organisati on operate as SBUs in a divisional 
structure – not a func tional structure.  
The matrix structure tends to requi re time-consuming meetings and has 
significant overlap of authority between managers. This tends to slow the 
decision-making process down. 
 
As M has several complex products, a structure t hat creates a separate 
division to look after each one seems the most logical. Functional and 
geographical structures w ould struggle to cope with the differing needs of 
the products. The level of work needed to run a large, complex 
organisation would also probably be beyond the capabilities of an 
entrepreneurial structure.  
 
Decentralisation should result in better local decisions being made since autonomy is devolved to local managers.

82 
The scalar chain relates to the num ber of levels of management within 
the organisation. 
 
 Narrow 
 
 Test your understanding 8 
 Answer A: Because of advancements in technology the basic activities of 
the finance function are no longer relev ant – FALSE they are still relevant 
but there has been a shift in emphasis  on the importance of each of the 
Answer B: Technology allows the contemporary finance function to 
refocus its energy on va lue creation – TRUE. 
Answer C: Technology has meant that a large amount of the assembly 
and analysis activities can be automated – TRUE. 
Answer D: Technology has meant that a large amount of the advising 
and applying activities can be autom ated – FALSE, although some of 
these activities can be automated the  finance function  will need to 
reallocate its resources to these activities. 
 
 A, B, D  – these are all assembly and analysis activities, which are more 
heavily impacted by technology and automation.  
C and D are advising and applying activities. 
 
 The shape of the finance function has evolved from a traditional hierarchy  
to a diamond shape  in today’s digital age.  
This has primarily been driven by globalisation  and technology .

Chapter 3 
 83 
 Answer B is the correct answer – outsourcing is likely to cause a loss of 
competitive advantage as IT is a core competence within this highly competitive and innovative industry. In  addition, Canterell will have no 
way to create its own unique systems. 
Outsourcing IT would be likely to m ean the closure of their own IT 
department, which will mean the loss of skilled staff. This will make it 
difficult to bring IT back in ‐house in the future (answer C) and will result in 
a loss of IT expertise (answer A). It is possible to outsource the IT 
function (answer D) although this decision may not be in the best interest of the company.  
 
 The correct answers are B,C, E and H  
As it is a fixed fee, Q will know ho w much the IT function will cost each 
year (answer B). Outsourcers oft en have a level of expertise that 
organisations can benefit from if they have skills lacking in-house (answer C). As outsourcers are providing serv ices for many customers they are 
able to generate economies of scale,  often making outsourcing a cheaper 
option (answer E). Not having to focus on non-core activities mean that 
management can focus on core activities which often are the source of 
competitive advantage (answer H). 
 
 True? 
High transaction costs will us ually lead to a company 
deciding to outsource No – 
opposite 
A robust SLA will prevent the risk of a loss of confidential data Reduce not 
prevent 
Transaction costs include bargaining costs  
Transaction costs are incurred when outsourcing is used  
Transaction costs include the cost of production No

84 
 The correct answers are  A, B and C – The organisation will become 
reliant on the external provider and wil l not have as much control over the 
function being outsourced (answer A). This leads  to the erosion of 
internal knowledge (answer C) and could increase the risk of data 
breaches (answer B). 
Outsourcing should be a c heaper option thereby reducing costs (answer D). 
Outsourcing the non-core activities m eans the remaining ac tivities retained 
within finance can focu s on business partnerin g enhancing competitive 
advantage (answer E) . Major set up costs are a drawback of setting up a 
shared service centre not a draw back of outsourcing (answer F).

85 
What each level of the 
finance function does  
D2: What each level of the 
finance function does. (a) Finance operations. 
(b) Specialist areas including 
financial planning and analysis (FP&A). 
(c) Strategic partnering for 
value. 
(d) Strategic leadership of 
the finance team. 
  Chapter 
4

What each level of the finance function does 
86 
 
 1 Introduction  
In Chapter 2 we discussed the basic acti vities that the fi nance function performs 
using the ‘information to impact framework’. 
 
We also linked these basic activities to th e diamond shape of the finance 
function  (see diagram below). 
In this chapter we are going to review eac h of these activities in more detail, 
understanding what the role of the fi nance function is within each of these 
We will also briefly discuss how an organisation could use technology to 
improve the productivity of finance pr ofessionals within these areas and we will 
discuss the threat of automation.

Chapter 4 
 87 
 
2 Finance operations (level 4) 
2.1 Introduction 
In this section we are going to look  at the basic components of finance 
operations (i.e. accounting operations) and how these finance operations 
generate information and pr eliminary insight. The information and extracted 
data provided at this level becomes the foundations of the work of finance professionals. 
Finance operations consist of the followi ng, often inter-related, components: 
  
Each of these components will be explored in turn below.

88 
2.2 Financial reporting 
 Financial (or corporate) reporting is concerned with the production of 
financial information for external users in accordance with relevant 
accounting standards and legislation. 
The financial information may include: 
• financial statements 
• tax reporting (to HM Revenue and Cu stoms in the United Kingdom) and 
• regulatory reporting. 
The information provided about the business to external users will be useful to 
them in their decision making and fo r assessing the stewardship of the 
business’s management. 
Financial statements produced 
There are three main financial statem ents produced by most businesses each 
year: 
• The statement of profit or loss (SOPL)  for the year, which details the 
income as well as the costs incurr ed in the period. This allows the 
business to calculate whether it has  made a profit (if income exceeds 
costs) or a loss (if costs exceed income). 
• The statement of financial position (SOFP)  as at the year end, which 
shows the assets (business resources such as motor vehicles, buildings 
and cash) and liabilities (money owed to  third parties such as banks and 
suppliers) of the business. This stat ement also shows the stake that the 
owners of the business have in the organisation (or their ‘capital’). In a 
company, this is often referred to as ‘shareholder’s equity’. 
• The statement of cash flows  for the year, which summarises the cash 
receipts and payments for the year. This helps to show whether the 
company is solvent (has sufficient  cash) and where the cash has been 
spent in the year. 
In summary, the normal sequence of steps in the accounting function is:

Chapter 4 
 89 
 Test your understanding 1  
 J has been asked to find four pieces of information about FGH Ltd for his 
manager from the company’s statement of profit or loss (SOPL) and 
statement of financial position (SOFP). He has been asked to find: 
(1) The ratio of current assets to current liabilities 
(2) Total shareholders’ equity (3) Gross profit as a percentage of turnover 
(4) Total rent paid for the year 
Which of the following (A, B, C or D) correctly match the information 
needed with the financial statement each would be found in? 
 (1) (2) (3) (4) 
A SOFP SOFP SOPL SOPL B SOPL SOPL SOFP SOFP C SOFP SOPL SOFP SOPL 
D SOPL SOFP SOPL SOFP 
 
Why do businesses need to prepare financial statements? 
The preparation of financia l statements is a time-c onsuming and expensive 
process. So why do most organisati ons have a financial reporting component? 
The main reason is to satisfy groups of people who have an interest in the 
financial performance of the business. These could include: 
• Owners – interested in how profitable the business is and how well it is 
being run. 
 
 Illustration 1 – Investor ratios 
 A number of ratios will be of interest  to the investor. These include: 
Earnings per share (EPS) 
EPS is a measure of the pr ofit attributable to each ordinary shareholder. 
EPS =	Profit after tax (less preference dividends)
Weighted average 	number of ordinary shares in issue 
 Price/ earnings  (P/E) ratio 
P/E ratio 	=	Share price
EPS 
A high P/E ratio means that invest ors are paying more for today’s 
earnings in anticipatio n of future growth. 
Dividend yield 	
Dividend yield 	=	Dividend per share
Current	share price × 100

90 
• Managers  – interested in the company’s financial situation so that they 
can plan effectively for the future. 
• Banks  – may wish to see whether the bus iness can afford the repayments 
on loans and overdrafts. 
• Employees  – interested in the financial pos ition of the company and the 
impact this will have on their jobs and wages. 
• Suppliers and customers  – may wish to check the financial stability of 
the business to ensure it will be able to make payments/supply goods as 
needed. 
• Government – may wish to check that the business is obeying relevant 
laws on reporting and taxation. 
Companies must send a copy of thei r financial statements to each of their 
shareholders at the end of the year. Large and public ly-quoted companies are 
also required to appoint external audito rs each year to give an independent 
opinion on whether the financial statements have been  drawn up properly and 
whether they give a true and fair view. 
2.3 Management accounting 
 Management accounting is the provision of information to help managers 
and other internal users in their decision making, performance measurement, planning and control activities. 
Management accountants will use financial a ccounting records as a source of 
data for their work but they will also use other sources of internal and external 
data. 
While there are no legally required formats for management accounts, there are 
several key management reports that ar e common to many businesses. Three 
of the most common are cost schedules, budgets  and variance reports. 
Cost schedules 
A cost schedule  lists the various expenses involved in manufacturing units of a 
product. This is often shown as a list of  the costs incurred when making a unit of 
each type of product. This may be called a standard cost card.

Chapter 4 
 91 
 Illustration 2 – Standard cost card 
 ABC Ltd manufactures toys. One of its products is a wooden train set, 
which has the following standard costs per unit: 
 $ 
Direct materials (wood and paint) 5.50 Direct labour (time spent  cutting and painting) 6.50 
 ––––– Prime cost 12.00 Variable overheads (heat and light) 4.00 
Marginal cost 16.00  ––––– Fixed overheads (factory rent) 5.00 
 ––––– 
Total (absorption) cost 21.00  ––––– 
 
There are several key business decisions that this report can help a business to 
make: 
• Pricing decisions – How much should the business sell the products for 
in order to ensure it makes a profit? 
• Break-even analysis – Which products are profitable or loss-making? Is a new product worth producing? Can the business se ll enough units to cover 
the costs of making the product? 
• Key factor analysis  – should products be made in-house or should their 
manufacture be outsourced to somewhere cheaper? 
• Investment appraisal  – should a new machine be bought to replace an 
old machine? Should the business begin a new project, such as launching 
a new product? 
Budgets 
In addition, once the costs per unit have been identified, it should be possible to 
produce a budget. This shows the tota l planned revenues and costs for the 
business for the coming period. It is based on the cost schedules mentioned 
earlier. 
Budgets are useful for several reasons. A useful memory aid is the acronym 
CRUMPET  
• Co-ordination – the budget  provides guidance for managers and ensures 
they are all working together  for the good of the company. 
• Responsibility – the budget authorises managers to make expenditure, 
hire staff and generally follow the plans laid out in the budget. 
• Utilisation – budgets (especially cash budgets) help managers to get the 
best out of their business res ources in the coming period.

92 
• Motivation – the budget can be a useful device for influencing the 
behaviour of managers and motivating t hem to perform in line with 
business objectives. 
• Planning – budgets force managers to l ook ahead. This may help them to 
identify opportunities for, or threat s to, the business and take effective 
action in advance. 
• Evaluation – budgets are often us ed as the basis for management 
appraisal. The manager has  performed well if he has met his budgets in 
the period. 
• Telling – also called ‘communication’ , budgets ensure that all members of 
the business understand what is expected from them during the coming 
period. 
One major drawback of budgets is that they are only estimates of what will happen in the coming period. In reality, most businesses will not perfectly achieve the targets set out for them in their budgets. 
This means that they  will have to prepare a variance report  at the end of each 
period, comparing the budget to the actual results and identifying any 
differences (i.e. variances) between the two. 
 
The differences between financial reporting and management 
accounting 
  
 Management 
accounting Financial reporting 
Why information 
is mainly produced For internal use, such 
as managers and employees. For external use, such as shareholders, creditors, banks, government. 
Purpose of 
information To aid planning, controlling and 
decision making. To record the financial 
performance in a 
period and the financial position at the end of the period. 
Legal requirements None. Limited companies 
must produce financial accounts. 
Formats Management decide on the information that they require and the most useful way of presenting it. Format and content of financial accounts must follow accounting standards and company law. 
Nature of 
information Financial and non-financial. Mostly financial. 
Time period Historical and 
forward-looking. Mainly a historical record.

Chapter 4 
 93 
 Test your understanding 2  
 Consider the following two st atements regarding the management 
accounting function. 
(i) Variance analysis enables a busi ness to identify why the actual 
financial results were different to those predicted by the budget. 
(ii) Management accounts follow a set, pre-determined format as laid 
out in relevant accounting standards. 
A (i) only 
Variance reports 
 A variance report compares the budget to the actual results achieved for 
the budget period and identifies any signifi cant differences, or variances, 
between the two. 
For control purposes, management may nee d to establish why a particular 
variance has occurred. Once the reas on has been established, a decision can 
be taken as to what, if any, contro l measures might be appropriate to: 
• prevent adverse variances from occurring again in the future, or 
• repeat a favourable variance in the future, or 
• bring actual results back on course to achieve the budgeted targets. 
The management accountant will assist and interact with other functions in 
providing solutions to variances. 
2.4 Treasury management 
 Treasury management is the management of the funds of the business, 
namely cash and other working capital it ems, plus long-term investments, 
short-term and long-term debt, and equity finance.

94 
The key roles of the treasury function include: 
Working capital 
management The treasury section will monitor the organisation’s cash balance and working capital to ensure that it never runs 
out of money. 
Cash management Preparation of cash b udgets and arrangement of 
overdrafts where necessary. 
Financing The treasury section will monitor the organisation’s investments and borrowings to ensure they gain as much investment income as possible and incur as little interest expense as possible. 
Foreign currency The treasury section will monitor foreign exchange rates and try to manage the organisation ’s affairs so that it 
minimises losses due to changes in foreign exchange rates. 
Tax The treasury section will try to manage the organisation’s affairs to legally avoid as much tax as possible. 
Working capital management 
 Working capital is the capital available for conducting the day-to-day operations of an organisation, calculat ed as the excess of current assets 
over current liabilities. Thus: 
 
Inventory X 
Trade receivables X Cash X 
 –––– 
Total current assets X Less: Trade payables (X) 
 –––– 
Working capital balance X  –––– 
The treasury function is responsible for deciding on an appropriate level of 
investment in working capital for the business. 
There are advantages in hol ding either large or small balances of each 
component of working capital, as shown below.

Chapter 4 
 95 
 Advantage of large 
balance Advantage of small 
balance 
Inventory Customers are happy since 
they can be immediately provided with goods. Low holding costs. Less risk of obsolescence costs. 
Trade receivables Customers are happy since 
they like credit. Less risk of irrecoverable debts. Good for cash flow. 
Cash Creditors are happy since 
bills can be paid promptly.. More can be invested elsewhere to earn profits. 
Trade payables Preserves your own cash. Suppliers are happy and 
may offer discounts. 
Management must decide on the appropriate balance to be struck for each 
component. 
 
 Test your understanding 3  
 Conservative managers will have a policy of holding a large working 
capital balance, while aggressive  management will hold a low working 
capital balance.  
Which one of the following is a consequence of an aggressive 
management policy? 
A Increased bad and doubtful debts 
B Increased credit periods attract more customers 
C Increased inventory obsolescence D Increased risk of inventory outages 
Financing 
The organisation may need additional funding to  allow it to grow and invest in 
new projects. It may therefore need to raise finance from external sources. 
There are two main types of external finance: 
• Debt  involves borrowing cash from a third party and promising to repay 
them at a later date. Normally, the company will also have to pay interest on the amount borrowed. 
There are various sources of debt t hat an organisation can raise funds 
from, including bank loans and overdrafts, venture capitalists and through 
selling bonds or debentures. 
The main advantages of raising cash through debt finance are: – Interest payments are allowable against tax. Note that dividend 
payments made to shareholders, by contrast, are not an allowable 
deduction. 
– Raising debt financ e does not change th e ownership of the 
organisation.

96 
– Debt tends to be cheaper to service than equity, as it is often secured 
against the assets of the company and takes priority over equity in 
the event of the business being liquidated. 
• Equity involves selling a stake in the business in order to raise cash. For 
companies, this involves selling s hares to either new or existing 
shareholders. 
Raising equity finance has the following advantages: – There is no minimum level of dividend that must be paid to 
shareholders. This means that divi dends can be suspended if profits 
are low and the company cannot a fford them. Interest payments on 
debt finance must  be paid each year. 
– A bank will normally require security on the company’s assets before 
it will offer a loan. Some companies may lack quality assets to offer, 
making equity more attractive as  it does not require security. 
The treasury and finance function will wei gh up which source of finance best 
suits the circumstances  of the business. 
 
Illustration 3 – Financial gearing 
 
Financial gearing 	=	Long-term debt 
Shareholders'funds × 100 
A high gearing ratio indicates a high level of risk since debt obligations (such as interest payments) mu st be met, whereas returns to 
shareholders (such as dividends) are voluntary. 
 
 Test your understanding 4  
 AHG needs to raise $50m to launch a new product. AHG hopes the new 
product will be a success, but the returns are highly uncertain, with a 30% chance that the launch will be a failure. The product is expected to sell for around 5 years. 
AHG is currently trying to decide whether the launch should be financed 
using a 5 year bank loan, or through raising equity. 
Which one of the following statements is correct? 
A Equity will be cheaper, as divi dends are allowable against tax 
B AHG should choose equity due to the risky nature of the project 
C Equity should be chosen as AHG needs a permanent increase in its 
finance 
D Debt usually does not require secu rity, meaning it may be easier for 
AHG to raise

Chapter 4 
 97 
Foreign currency 
Companies may have borrowings in foreign currencies, or may have 
customers/suppliers who will pay/expect payment in a foreign currency. The treasury department will try to manage a ffairs to minimise the company’s 
exposure to foreign exchange lo sses, i.e. minimise losses. 
 
 Illustration 4 – Managing foreign currency risk 
 Background 
Assume a UK company buys goods costing US$1m from a US company 
on 1 January 20X1. 
The goods are due to be paid for on 31 March 20X1. The exchange rate at 1 January is £1:US$1.5, so the goods will cost 
£666,667 ($1m/1.5). However if the exchange rate changes to, say, £1:US$1.3, then the 
payment to be made will be £769,231 ($1m/1.3). 
 Managing the risk 
The company can manage this risk by entering into a ‘forward exchange 
contract’ at 1 January to fix the rate  of exchange at which it can buy $1m 
at 31 March. 
The rate in the forward exchange c ontract will depend on what the market 
thinks will happen to exchange rates. Let us say, for example, that the company can ent er into a contract to 
purchase $1m at the rate of £1:S1.48. The company’s cost, in sterling, is 
then fixed at £675,676 ($1m/1.48). 
Tax 
One of the roles of the finance and treasur y function is to calculate the business 
tax liability for the organisati on and mitigate, or reduce, that liability as far as 
possible within the law.

98 
 Tax avoidance, tax evasion and tax mitigation 
 Tax avoidance  is the legal use of the rule s of the tax regime to one’s 
own advantage, in order to reduce t he amount of tax payable by means 
that are within the law. 
Tax evasion  is the use of illegal means to reduce one’s tax liability, for 
example by deliberately misrepresenting the true state of your affairs to 
the tax authorities. The directors of a company have a duty to their shareholders to maximise 
the post-tax profits that are available for distribution as dividends to the 
shareholders, thus they have a duty to  arrange the company’s affairs to 
avoid taxes as far as possible. However, dishonest reporting to the tax 
authorities (for example, declaring less income than actually earned) 
would be tax evasion and a criminal offence. 
While the traditional distinction be tween tax avoidance and tax evasion is 
fairly clear, recently authorities have introduced the idea of tax mitigation  to mean conduct that reduces tax liabilities without frustrating 
the intentions of Parliament, while tax avoidance  is used to describe 
schemes which, while they are legal, are designed to defeat the 
intentions of Parliament. Thus, in the United Kingdom, once a tax 
avoidance scheme becomes public k nowledge, Parliament will nearly 
always step in to change the law in  order to stop the scheme from 
working. 
2.5 Internal audit 
What is internal audit? 
 Internal audit  is an independent activity, established by management to 
examine and evaluate the organisati on’s risk management processes and 
systems of control, and to make reco mmendations for the achievement of 
company objectives. 
The purpose of internal audit 
Company directors have a legal requirement to produce true and fair annual 
financial statements. To hel p ensure this is done, co mpanies are required to 
have their published financial statements audited by an exte rnal team of experts 
(external auditors).  
Directors also need assurance on other financial matters. This assurance is primarily for their own internal use, alt hough in recent years pressure has grown 
for increasingly more of such wo rk to be made publicly available. 
This additional work is carried out by  internal auditors, who may be company 
employees or outside experts fr om a firm of accountants. 
Internal audit is part of the organisational co ntrol of a business; it is one of the 
methods used by management to ensure the efficient and orderly running of the 
business as a whole, and is part of  the overall control environment.

Chapter 4 
 99 
Internal auditors’ work has expanded in rece nt years, and the role of internal 
audit often now includes: 
• helping to set corporate objectives 
• helping to design and monitor perform ance measures for these objectives. 
 
 Internal audit as part of good corporate governance 
 A properly functioning internal audit department is part of good corporate 
governance, as recognised by all national and international corporate 
governance codes. 
Internal audit enables management to  perform proper risk assessments 
(another central theme of corporate governance codes) by means of 
properly understanding the strengths and weaknesses of all parts of the 
control systems in the business. The UK Corporate Governance Code st ates that companies without an 
internal audit function should annually review the need for one . 
Where there is an internal audi t function, the board should annually 
review its scope of work , authority and resources. 
Ideally, the internal audit function should be staffed with qualified, 
experienced staff , whose work is closely monitored by an audit 
committee. 
 
 The function of internal audit in  the context of corporate risk 
 Internal audit has a particular intere st in evaluating the company’s risk 
management structures. Internal audit can: 
• manage the basic data used by management to identify risks 
• identify techniques for prioritising and managing risks 
• report on the effectiveness of risk management solutions (for 
example, internal controls). 
Scope of internal audit 
Internal audit staff are typically expec ted to carry out a variety of tasks: 
• reviewing internal controls and financial reports 
• reviewing risk management systems • carrying out special assignment s (e.g. fraud investigations) 
• conducting operational reviews (e.g. into efficiency of parts of the 
business).

100  
The purpose of internal audit can be summarised  in the table below: 
Role To advise management on whether the organisation has 
sound systems of internal contro ls to protect the organisation 
against loss. 
Legal basis Generally not a legal requirement. However the UK Corporate Governance Code recommends that if a listed company does not have an internal audit depar tment it should annually 
assess the need for one. 
Scope of work Determined by management. Covers all areas of the organisation, operational as well as financial. 
Approach Increasingly risk-based. Assess risks. Evaluate systems of controls. Test operations of systems. Make recommendations for improvements. 
Responsibility To advise and make recommendati ons on internal control and 
corporate governance. 
 
 The internal audit is simply a necessa ry cost that must be incurred by a 
company and offers few tangibl e benefits for the organisation. 
Is this statement: 
A True 
B False 
 
 Internal audit may be carried out by  employees of the company being 
audited, or may be carried out by ex ternal accountants who are paid for 
delivering this service. 
A True 
B False

Chapter 4 
 101 
 Test your understanding 7  
 In a large company, to who do intern al auditors normally report their 
conclusions? 
A Executive directors 
B Board of directors C Shareholders D Non-executive directors 
 
 The role of internal audit in  preventing and detecting fraud 
 Fraud  is an intentional act involving the use of deception to obtain an 
unjust or illegal advantage – essentially ‘theft by deception’. Fraud is a 
criminal offence, punishable by a fine or imprisonment. 
As far as the financia l statements are concer ned, fraud comprises both 
the use of deception to obtain an unjust or illegal financial advantage and 
intentional misrepresentat ions affecting the financial statements. It is 
ultimately up to the courts to dec ide in each instance whether fraud has 
occurred, for example: 
• deliberate falsificati on of documents/records 
• deliberate ignoring of e rrors requiring correction 
• deliberate suppression of relevant information. 
There are three prerequisites that are required for fraud to occur: 
• dishonesty – relates to a lack of integrity or honesty. An honest 
employee will be unlikely to commit a fraud. 
• opportunity – the individual must have the opportunity or opening 
for a fraud to be committed. T hese opportunities will often be 
created due to weak internal controls. 
• motivation  – the individual must feel that the rewards that can be 
earned by the fraud will outweigh t he potential costs if they are 
caught. 
 All three  are usually required – for example an honest employee is 
unlikely to commit fraud even if gi ven the opportunity and motive  
Factors that might indicate an in creased risk of fraud and error include 
(amongst others): 
• management domination by one person, or a small group of 
people  – dominant individuals often find it easy to circumvent 
controls and procedures. 
• unnecessarily complex corporate structure  – this makes it 
harder to trace transactions, meaning it is easier for employees to 
hide fraud.

102  
 • poor staff morale  – if staff dislike the company they work for, it may 
give them additional moti vation to perpetrate frauds. 
• personnel who do not take leave/holidays  – this may indicate 
that staff members are unwilling to pass their duties over to other 
members of staff in case they  identify fraudulent activities. 
• lavish lifestyles of employees  – if an employee is clearly living 
beyond their means, it may indicate  they are committing fraud in 
order to fund it. 
• inadequate segregation of duties  – if tasks are not shared 
between employees, the risk of fraud rises 
• lack of monitoring of control systems  – for controls to be 
effective, they need to be m onitored on a regular basis 
• unusual transactions  – in cash, or direct to numbered bank 
accounts 
• payments for services disproportionate to effort  may also be an 
indication of fraudulent activity. 
If management has establishe d a strong system of internal control then 
the potential for fraud is greatly reduced. 
It is up to the directors to decide what internal audit should do, but 
normally, where there is an effective internal audit department, the 
internal auditors will be given the respons ibility to test the internal control 
system and to recommend improvements.  The better the control system, 
the less likely it is that fraud will be attempted, or will succeed if it is 
attempted. 
The directors may also ask the internal auditors to carry out a specific 
investigation into situations wher e fraud has been discovered, to learn 
lessons for the future and ensure t hat such a fraud cannot be repeated. 
There is a spectrum of implications of fraud , from the immaterial to the 
critical. These include: 
• Loss of shareholder confidence 
• Loss of assets • Financial difficulties • Collapse of the company • Fines by tax and other authorities 
Once a fraud has been identified, inte rnal audit should be sent to the 
department to investigate the circumstances and to make 
recommendations to improve the controls in the area to deter future fraud. Internal audit should report t heir findings to the audit committee 
who can monitor whether the recomm endations are swiftly implemented 
by management.

Chapter 4 
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Limitations of internal audit 
• Internal auditors have an unavoidable independence problem. They are 
employed by the management of t he company and yet are expected to 
give an objective opinion on matt ers for which management are 
responsible. 
• There is an argument that in order to  overcome some of the problems of 
independence (or lack thereof ), that internal audit should be completely 
separate to the finance function. Howe ver, although this may be feasible 
in, say, a large multinational organisa tion, resource constraints tend to 
prevent this in smaller organisations. In these organisations, internal audit 
and the finance function are still inextricably linked. 
• Internal audit will only succeed if it  is properly staffed and resourced. 
• If internal auditors iden tify fraud, they may be unw illing to disclose it for 
fear of the repercussions (which could involve the collapse of the company 
and the loss of their jobs). 
These limitations can be reduced if an audit committee:  
• sets the work agenda for internal audit 
• receives internal audit reports • is able to ensure the internal  audit is properly resourced 
• has a ‘voice’ at main board level. 
2.6 Recent changes in finance operations 
As was touched upon in Chapter 3: 
• Over the last two decades shared service centres (SSCs), whether in-
house or outsourced, have taken contro l of the management  of many of 
the rules-based finance operations of an organisation. 
• More recently the scope of the SSCs work has expanded to handle all of 
the processes of finance operations from end to end. 
• In addition, the quality of service or level of expertise, and the value they 
can contribute has become more important than being low cost. 
Technology  (such as robotic process automation, cognitive computing and 
blockchain) has also had/will have a big impact on finance operations. It has 
resulted in the creation of ‘ smart finance factories ’ at this level (i.e. level 4) of 
the diamond shape of the finance functi on. This will be discussed further in 
section 6.

104  
 Which of the following statements about changes in finance 
operations is/are true? 
A A shared service centre is also referred to as outsourcing 
B The quality of work produced by an SSC is lower than if it were 
outsourced 
C Establishing an SSC enables a business’ processes to be 
standardised 
D Shared service centres can only pr oduce work at the lowest level 
(level 4) of the finance function 
3 Specialist areas (level 3)  
In this section we are going to look at  the specialist areas that exist within an 
organisation. The specialists are experts who provide insight derived from the 
information that has been handed over to t hem (at level 4) in their specialist 
areas. Their insights create the building blocks of the organisation’s value 
creation. The specialist areas include: 
 
We will briefly introduce each of these spec ialist areas and will look at how the 
finance function works with these specialist areas to provide further insight to decision makers about value creation/pr eservation in areas of specialism. 
3.2 Financial planning and analysis (FP&A) 
Careful financial planning and cash flow  management is an important tool in 
ensuring an organisation is consistent ly profitable and continues to grow. 
FP&A specialists play a crucial role in organisations by performing budgeting, 
forecasting and data analysis that supports  the major organisational decisions 
of the board. 
The specialists utilise both quantitativ e and qualitative analys is of all the 
operational aspects of the organisation in order to evaluate its progress towards 
its goals and to map out future goals and plans.

Chapter 4 
 105 
The specialists consider economic  and business trends, review past 
organisational performance, and attempt to anticipate obst acles and potential 
problems, all with an eye to forecasti ng the organisation’s future results. 
 
 Illustration 5 – Examples of responsibilities of FP&A specialists 
 • Looking at the effectiveness of  the organisation’s current 
investments and comparison to other ways it may utilise its cash 
flow (for example, other invest ments or an increased dividend 
payment). 
• Gauging the organisation’s overal l financial health using key 
financial ratios (for exam ple, current ratios). 
• Identifying which products or pr oduct lines are most profitable. 
• Working with independent departments to prepare budgets and 
consolidate them into an overall budget. 
3.3 Taxation 
Taxation specialists play an impo rtant role in an organisation in minimising 
risk and creating value. They do this by focusing on two main areas: 
• Tax compliance – following current legislation, regulation and procedures 
to minimise risk . For example, they will comp lete and file timely tax 
returns and produce and required supplementary reports or calculations. 
• Tax planning  – this focuses on ensuring the organisation is working in the 
most tax efficient manner to reduce the total tax paid and create value . 
Taxation specialists will help the organi sation to achieve its goals, playing 
an important role in: 
– lowering the amount of taxable income – reducing the tax rate – allowing greater control of when taxes get paid 
– maximising tax relief/tax credits available. 
3.4 Project management 
 Project management is the integration of  all aspects of a project, ensuring 
that the proper knowledge and resources are available when and where 
needed, and above all to ensure the ex pected outcome is produced in a 
timely, cost effective manner. 
Project teams will be put together for the sole purpose of achieving the project 
goals and objectives. 
Projects may run for anything from a few weeks to many years depending on 
their size and complexity.

106  
 Illustration 6 – Project management stages 
 There are five stages  to the project management process: 
 Stage Explanation 
1 Initiation A project is initiated when a need or organisational 
objective is identified. The project identified is 
appraised to ensure it is feasible. 
2 Planning The drawing up of detailed plans. For example, 
communication of what has to be done, when and by 
whom, identifying the resources needed and establishing measures of success for the project. 
3 Executing  The proj ect team members will pe rform the tasks they 
are responsible for and the project manager will provide leadership and co-ordination. 
4 Controlling Projects progre ss, costs and performance will be 
tracked against the project plan and any corrective action necessary will be taken.  
5 Review 
and close Once the project work is fi nished, the pr oject will be 
signed off and the team disbanded. A project review meeting will be held. 
  
3.5 Project appraisal 
 Project appraisal will take place prio r to the project management process 
commencing and will involve an assessm ent and evaluation of the many 
decisions and potential outcome s of a particular project. 
One of the most important project decisions that will need to be appraised is the 
capital investment decision, since t he organisation may commit a substantial 
proportion of its resources here and this commitment may be long-term or 
irreversible. 
Many different capital investment proj ects exist including: replacement of 
assets, cost reduction schemes, new  product/service developments and 
product/service expansions.  
To appraise a potential capital project: 
• Estimate the costs and benefits from the investment 
• Select an appraisal method and use it  to assess if the investment is 
financially worthwhile 
• Decide whether or not to go ahead with the project.

Chapter 4 
 107 
There are a number of appraisal met hods which are used to assess how 
financially worthwhile invest ments are. These include: 
• payback 
• net present value (NPV) • internal rate of return (IRR). 
Based on the decision rule of the met hod used, a decision can be made as to 
whether the investment is financially worthwhile, although there will be other, 
non-financial considerations which must also be taken into account. 
 
Illustration 7 – An example of an appraisal method: payback 
 JKL is considering purchasing a new machine. The machine will cost 
$550,000. The management accountant  of JKL has estimated the 
following additional cash flows will be re ceived over the next 6 years if the 
new machine is purchased: 
Year 1: $40,000 
Year 2: $65,000 
Year 3: $140,000 Year 4: $175,000 
Year 5: $160,000 
Year 6: $70,000 
JKL has a target payback period of 4 years. 
Calculate the payback period for the new machine and advise JKL 
whether or not to proceed with the investment. 
 Solution 
Note: The investment is shown in year 0. Work out the cumulative cash flow  for each year until the cash flow 
becomes positive. This will highlight  when payback has been achieved. 
Year Cash flow Cumulative cash flow 
 $000 $000 
0 (550) (550) 
1 40 (510) 
2 65 (445) 
3 140 (305) 
4 175 (130) 
5 160 30 
6 70 100 
You can see that payback is achieved between years 4 and 5. JKL have 
a target payback period of 4 years. The payback is after this target, so 
the advice to JKL would be to  not undertake the investment .

108  
 Kazim, Paul, Belinda and Saira all work in a business partnering role, 
supporting the specialist areas  of their organisation.  
Match the type of work they do to  the specialist area that they 
support. 
• Part of Kazim’s role is to m anage and minimise the tax risk that the 
organisation is exposed to. Amongs t other things this involves 
compliance and planning 
• Paul is heavily involved in using techniques such as calculating net 
present values and payback 
• Belinda performs budgets and forecasts and data analysis, as well 
as using key financial ratios 
• Saira is in charge of managing re sources to achieve a specific 
objective 
A Financial planning and analysis 
B Taxation C Project management D Project appraisal 
 
 A finance member who is working in the area of project 
management would typically u ndertake which of the following 
activities? 
A Feasibility study B Tax mitigation C Resource identification D Leadership and co-ordination E Net present value analysis 
F Cost control 
G Liquidity ratio calculations and analysis

Chapter 4 
 109 
3.6 How the finance function works with these specialists 
The finance function offers expertise in accounting and financial matters. 
Their subject matter expertise can be harnessed and developed by different 
specialist areas. However, rather than work ing separately, the finance function works alongside 
these specialists providing expert suppor t for decisions and projects and helps 
to formulate strategies so that the business is able to adapt to the ever 
changing environment. The finance function is able to question and investigate, to constantly improve 
the shared understanding of how the business generates value . 
 
Illustration 8 – How the finance function works with FP&A 
 As was discussed in section 3.2,  FP&A specialists have a number of 
responsibilities, such as the calculation of key financial ratios for 
presentation to decision makers to gauge the organisation’s overall 
financial health. These responsibilities will only be fulfilled by the provision of accurate information  from the finance function (at level 4 
of the diamond shape). 
The FP&A specialists will own and be held accountable for the process 
that generates that data. The finance f unction can act as an ‘expert’ from 
outside of this specialist area ensur ing the process is subject to the 
necessary rigour required. The finance function can assemble and 
validate  the analysis presented to decision -makers and is able to provide 
further insight. 
3.7 Recent changes to specialist areas 
As was discussed in Chapter 3, the shape of the finance function is now 
evolving to a diamond shape: 
• This has expanded the opportunities for business partnering between the 
finance function and specialist areas. 
• It has also increased the number of tasks present within these specialist 
areas that are offered by shared service centres. This has enabled experts 
from different disciplines to work together on the same team to better 
support the business. 
• Technology has been used by the specialist areas, and by the finance 
function to improve their productivity in working alongside these specialists. ( Note:  Technology will be discussed in greater detail in section 
6). 
• The use of advanced technology and the creation of shared service 
centres have resulted in ‘ digital centres of excellence ’ at this level (i.e. 
level 3) of the diamond shape.

110  
 Illustration 9 – Technology developments and FP&A 
 Technology has had a significant impact on the work carried out by the 
FP&A specialists and the finance function staff who work alongside them. 
For example: 
• The production of routine m anagement information is being 
automated. 
• Managers across the organisation ma y have access to user friendly, 
self-service, dashboards on their de sks so they can monitor current 
performance.  
• These self-service tools allo w interrogation, so managers are 
empowered to identify the root  cause of problems and address 
these problems promptly. 
• Advanced data visualisation and analytics can provide improved 
However, rather than posing a threat  to the work carried out by the FP&A 
specialists, and the finance function employees who work alongside 
them, these developm ents can be seen as an opportunity .  
Finance professionals can harness the value of the data generated and 
increase their focus on supporting bigger decisions and projects. 
 
 Harry, a finance professional, is concerned that due to advancements in 
technology his job will be under threat. Mo ira, Harry’s boss, is doing her 
best to reassure him that there are many advantages of the modern 
finance function that have been enabl ed due to the increased use of 
technology. 
Which of the following could Moira use to explain the benefits to 
Harry? 
A Technology can improve the produc tivity of the finance team 
B There are more opportunities for partnering with specialists in the 
business 
C Technology means the finance team have less work to do and 
therefore, will have more time to pursue their own interests 
D Automation of routine tasks m eans the finance team can focus on 
more value adding analysis for the benefit of the organisation 
E Technology used to support data analytics can provide improved 
forecasting enabling employees to make better business decisions 
F Advances in technology mean Harry will have no new skills to learn, 
making his life easier

Chapter 4 
 111 
4 Strategic partnering for value (level 2)  
Level 2 involves: 
• communicating insight to influence users (section 4.1) 
• business partnering (section 4.2) 
4.1 Communicating insight  to influence users 
As discussed previously: 
• Finance operations will generate information  and preliminary insight  
(level 4) 
• The finance function will work with specialists to provide further insight  to 
decision makers (level 3) 
At the next level (of the diamond shape), t he insights that leve l 3 provide will be 
passed on to finance professionals work ing as strategic partners. These 
strategic partners will: 
• interpret and use financial statements along with other data to 
communicate this insight 
• in an appropriate format • and required frequency • to internal and external stakeholder s such as senior managers, colleagues 
in other functions (for example, ma rketing or operations), shareholders 
and regulators 
to influence  users of this information in their decision making and 
implementation and control activities. 
The evolving shape of the finance f unction means that more people will be 
needed here and the finance function will need to develop the competencies  
required to adequately carry out this activity. 
 
 Illustration 10 – Communicating in sight to influence users: 
Budgeting 
 The finance function’s value adding role  is often underpla yed but they have 
an important role in  communicating insi ght to influenc e the effectiveness of 
the decisions made by the users of the information. 
For example, an organisation’ s budget is often out of da te before it is even 
complete, takes significant time to  produce and the nu mbers can be of 
questionable value. 
However, the process of budgeting sets aside time from day-to-day 
activities for managers to  think about risks  to their plans, strategies to 
develop growth and to reduce costs. 
Importantly, the process can add value even if the output does not . 
The finance function could therefore consider an al ternative output that 
would be more valuable itself, whilst st ill capturing the value of the process.

112  
 Level 2 of the contemporary shape of the finance function involves 
Strategic Business Partnering. Which of the following st atements are true 
and which are false? 
Statement True/False? 
The finance function will communicate their insights 
once a month  
The finance function communicates their insights only to internal stakeholders  
Fewer people are required at this level of the finance function than previously  
Insight means the capacity to gain an accurate and 
deep understanding of someone or something  
New competencies need to be developed by the finance function to be able to effectively generate and communicate insight  
  
4.2 Business partnering 
Strategic business partnering will be an incr easingly important activity of the 
finance function. 
The finance function will ac t as a business partner influencing  the 
organisation’s decisions to achieve the desired organisational impact . 
The focus of the finance function’s work  is shifting from reporting historic 
performance to challenging management thinking and driving decision making 
to influence future performance. The chief financial officer (CFO, i.e. the head of the finance function) works 
closely with the CEO to support him or her in the running of the organisation. 
Organisations develop and use finance f unction professionals as business 
partners to cascade the CFO’s in fluence throughout the business. 
Business partnering services may be provided by: 
• individual finance function employees deployed to work alongside 
departmental mangers 
• a multi-disciplinary team in a centre of excellence 
• a mix of both with some local suppor t but also an expert team tackling a 
particular problem or guiding a major initiative. 
The expectation for finance to add greater value to the business is growing. 
Successful finance business partners are se en as leaders that can influence the 
decisions that a business makes to maximise value. 
Success in this role requires a mix of commercial acumen, analytical skills, an 
ability to build relationships, to communicate effectively and persuade.

Chapter 4 
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 Illustration 11 – The finance business partner: skills needed 
 Amongst the many skills needed, people sk ills are critical. The effective 
finance business partner is adaptable and can deliver information in a 
digestible way to thei r particular audience. 
This is particularly important when the message is one that the audience 
may not wish to hear, for example info rming the sales function that they 
have overstated their margin. 
Finance business partners must also be able to identify and win over key 
stakeholders, to build relationships and to persuade stakeholders in order 
to achieve the organisation’s objectives. 
 
 Which of the following would be useful as a definition of business 
partnership? Choose all that apply. 
A Involvement in strategy fo rmulation, implementation and 
communication 
B Involvement in commercial decision making and negotiations 
C Leading on business analysis D Being a sounding board, trusted advis er, critical friend and facilitator 
of productive business discussions 
5 Strategic leadership of th e finance team (level 1)  
The final activity is strategic leadership of the finance team. The head of the finance function is the CFO and it is their responsibility to lead 
the finance team to achieve the desired organisational impact : 
• leading key initiatives that  support the organisation’s goals 
• executing and funding strategies set by the CEO 
• liaising effectively with inter nal and external stakeholders. 
To do this they will need to put a t eam in place that has the appropriate 
knowledge, skills and experience to effe ctively execute all of the finance 
function activities already discussed in this chapter. 
CFOs are increasingly taking a more acti ve leadership role working alongside 
and with the CEO as a ‘co-pilot’ in the success of the business.

114  
 Illustration 12 – The CFO’s changing role: from navigator to co-pilot 
 CIMA have illustrated well the c hanging role of the CFO using the 
analogy of traditional versus modern aviation. 
If we think about the cockpit of a large passenger plane (such as the 
Boeing 707) that flew in the 1950s: 
• we would have had a pilot (le ft), a co-pilot (right) and a small 
instrument cluster 
• plus a wooden chair for the navi gator who was an essential part of 
the crew and who had access to  a lot more instruments. 
The CFO would have traditionally viewed their role as  navigator  to the 
business. 
If we fast forward to a m odern large passenger plane: 
• we still have a pilot (left) and co-pilot (right) and they now have a 
large instrument cluster 
• there is no longer a seat (or a need) for the navigator. 
The navigator’s role has become redundant meaning that the CFO has 
had to learn to ‘fly the plane’, usin g the large cluster of instruments 
available to them, to act as the co-pilot  to the CEO. 
Today’s CFO needs a wider skill set: 
• possessing strong analytical and communication skills • and mastering areas outside of finance such as regulation, risk 
management, business transformation, supply chain management and IT. 
The CFO is increasingly relying on aut omation of key business processes and 
is relying more on technology to transform data into actionable insights that can 
influence and impact the organisation’s achievement of its goals. 
 
Test your understanding 14 
 Which of the options can be best u sed to correctly fill the blanks in 
the following sentence? 
‘It is the responsibility of the CFO to lead the finance team to achieve the 
desired organisational. This involves  leading key initiatives to support 
organisational, as well as liaising effectively with internal and external.’ 
 Gap 1 Gap 2 Gap 3 
A profit efficiencies stakeholders 
B impact goals shareholders 
C mission norms reporters 
D impact goals stakeholders

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 115 
6 The impact of technology on the activities of finance 
professionals  
6.1 Introduction 
The finance function can view technology as both: 
• an opportunity  and 
• a threat . 
It can be viewed as an opportunity  and used to improve the efficiency and 
productivity of the finance pr ofessionals in the areas discussed in the previous 
section of this chapter. It can also free up the finance professionals time to work 
on more interesting, challenging, value-adding work. This may require the 
finance function to build new capabilities. 
However, automation and new technology can also be viewed as a threat  to 
finance professionals since it can be used to reduce or replace many of their 
traditional roles and activities. 
 
 Illustration 13 – Technology and automation of jobs 
 In 2016, a UK newspaper, the Da ily Mail reported a speech by the 
Governor of the Bank of England under  the headline ‘Robots to steal 15 
million of your jobs says bank chief’. The article said that the bank 
‘…..predicted that entire professions, such as accountancy, could be pushed to the brink of extinction as developments in computers make roles redundant’. 
The World Economic Forum Future of  Jobs report (2018) concluded that 
the top 10 declining role s by 2022 would be: 
1 Data entry clerks 2 Accounting, bookkeeping and payroll clerks 3 Administrative and executive secretaries 4 Assembly and factory workers 5 Client information and customer service workers 6 Business services and administration managers 7 Accountants and auditors 
8 Material-recording and stock-keeping clerks 
9 General and operations managers 10 Postal service clerks 
Just as with any other opportunity or  threat, the organisation and its finance 
function must embrace the opportunities t hat the new technology offers and find 
a way of eliminating the threat or, even better, turning it into an opportunity.

116  
6.2 Technology and the information to impact framework 
Firstly, let’s remind ourselves of our discussion from Chapter 2: 
 
influence and impact required . 
Expanding on our discussion from Chapt er 2, organisations are using 
technology to support the automation of management information processes 
and to provide reporting to the rest of  the business on a self-service basis: 
• This is resulting in a narrowing of t he level 4 activities (diamond shape) of 
finance operations to generate information and preliminary insight. 
• It has also increased the need for skills and talent at level 2 (working with 
specialists to provide further insight) and level 3 (communicating insight to 
influence users and business partnering to influence and impact the 
organisation). 
Technology and its impact on the finance f unction will be explored in depth in 
the next few chapters. However, it is worth noting briefly that there have been 
two main technological changes that have impacted the finance function: 
• New data sources and analysis methods (section 6.3). 
• Automation and cognitive computing (section 6.4).

Chapter 4 
 117 
 Illustration 14 – Opportunities offered by technology 
 Finance professionals might anticipate the technological advancements 
of the 4th Industrial Revolution with fear. Ho wever, the use of machines to 
take over repetitive, time-consum ing and redundant tasks, will free the 
finance professionals to do higher level, value-adding work. 
The opportunities offered to the financ e function by technology will be 
explored in later chapters.  Here will take a look at just a few of  the opportunities that are available to 
an organisation as a whole thanks to this digital transformation: Accounts payable/receivable – artificial intelligence (AI) powered 
invoice management systems make invoice processing much more streamlined. They can learn accounti ng codes that are more appropriate 
for each invoice. 
Supplier management  – machines can vet new suppliers by checking 
their credit scores or tax informa tion and set them up in the system 
without human involvement. Procurement  – the procurement process for many organisations is filled 
with paperwork and uses different systems and files that are not 
compatible with one anot her. As machines are able to be integrated and 
the unstructured data is process ed, the procurement system will 
eventually become paperless.  Robots are ideally suit ed to tracking price 
changes among a number of suppliers. Expense management  – reviewing and approving expenses to ensure 
they are compliant with the organisati on’s policies is time consuming. 
Machines can read receipts, audit expenses and alert humans when a 
possible infraction has occurred. 
AI chatbots  – these can be used to efficiently solve common questions 
or queries from customer s including the latest account balances, when 
certain bills are due, the status on accounts and more. 
6.3 New data sources and analysis methods 
New data sources and advanced methods fo r analysing this data are providing 
opportunities for better informed decision making. For example, predictive analysis has improved forecasting and reduced the 
need to rely on the personal judgment  of the finance professional. 
Analytics has/will extend to areas such as FP&A pulling demand for talent from 
level 4 of the diamond to level 3.

118  
6.4 Automation and cognitive computing 
A 2016 McKinsey report studied which functions could be automated by 
advancing technology:  
 
Work activities at risk of automation include data collection and data processing. 
Less automatable activities include applyi ng expertise, stakeholder interactions 
and managing others. 
The McKinsey illustration can be overlaid across the diamond shape of the 
finance function:

Chapter 4 
 119 
New technology being used includes: 
• Robotic process automation (RPA) pr oviding opportunities to automate 
many routine, clerical activities. 
• Cognitive computing, such as artifi cial intelligence (AI), machine learning 
and natural language progra mming, providing opportunities to automate, 
say, advanced data analytics and report writing. 
• Higher up the diamond, new technology will change what finance 
professionals can do and support roles t hat require personal interactions 
and the ability to manage ot hers. These are less likely to be automated. 
 
 Test your understanding 15 
 Which four of the following may be  considered to be advantages of 
automating much of the traditiona l work of the finance function? 
A Reduced human input, and therefore human error 
B Reduced paperwork, for a more sustainable organisation C Faster processing, meaning more r eal time information is available 
D Improved data integrity E Fewer finance staff requir ed, reducing headcount costs 
F Less training required for finance staff, reducing training costs

120  
 Test your understanding 16 
 Stanley, a CIMA student, has been asked by his manager to summarise 
the various viewpoints of the contemporary finance function.  
Complete the table below from the options overleaf. 
Level in 
diamond Impact to 
influence 
framework Activity Position in 
finance 
function McKinsey’s 
automated 
functions 
Level 1  
    
Level 2  
    
Level 3  
    
Level 4  
    
 • Impact 
• Smart finance factory • Apply • Data collection • Advise • Strategic business partner • Information • Stakeholder interactions/ applying expertise • Influence • Analyse • Data processing • Digital centre of excellence • Managing others/ stakeholder interactions • Insight • Assemble 
• Senior finance team

122  
 
Statement (i) is correct. However, st atement (ii) descri bes a feature of 
financial accounting, rather  than management accounting. 
 
Keeping a low level of receivables  means that money is collected 
promptly, decreasing the chance of  bad debts. Low receivables would 
also mean we are offering less credit to customers, which they may find 
unattractive. Low levels of invent ory mean that the company is less 
exposed to inventory obsolescence, but it does mean the company may 
run out of inventory if demand is unexpectedly high. 
 
 The correct answer is B 
A is incorrect, as dividends are not tax allowable – interest is. 
B is correct as, in the event of th e product being a failure, AHG would not 
need to make unaffordable repayments to investors if it raises finance 
from equity. C is incorrect as AHG only needs the money for 5 years. It could be 
argued that a 5 year loan would ma tch the term of the project and 
therefore be more appropriate than equity finance, on which the company 
will have to pay dividends forever. D is also incorrect as debt does no rmally require security from the 
company. Equity does not.

Chapter 4 
 123 
 The correct answer is B – False  
The benefits of internal audit should ex ceed the costs. The IIA definition 
stresses that internal audit is a value-adding activity by helping an 
organisation to manage its risks and achieve its objectives. If an 
organisation believes that the costs of internal audit would exceed the 
benefits, then it shouldn’t operate that internal audit function. This is a 
choice to be made by the directors of  a company; there is no requirement 
to operate an internal audit department. 
 
 The correct answer is A – True  
Internal auditors can either be empl oyees of the company being audited, 
or may be external experts brought in. Compare this with external 
auditors who have to be external to  the company; employees of the 
company are not allowed to carry out  an external audit of that company. 
 
Test your understanding 7  
Internal audit reports to the management  of the company. In a smaller 
company, internal audit is likely to r eport directly to t he board of directors 
of the company being audited. In a larger company where there is an 
audit committee, internal audit is likel y to report to the audit committee, 
which will be made up of non-executive directors. 
 
 Answer A is false  – a shared service centre may be outsourced (internal 
outsourcing) but the two terms do not  strictly mean the same thing.  
Answer B is false  – the shared service centre will view the business to 
be the customer. The more professi onal supplier/customer relationship 
should result in marked improvements in the quality of the service provided. 
Answer C is true – establishing an SSC enables a business’ processes 
to be standardised. Answer D is false  – in the diamond shape the level 3 tasks present 
within ‘specialists generating further insights in their areas of specialism’ 
are now offered by shar ed service centres.

124  
 Kazim – taxation 
Pail – project appraisal 
Belinda – financial pl anning and analysis 
Saira – project management  
 
 The correct answers are A, C, D & F  
Tax mitigation (answer B) would be carried out within the specialist area 
of taxation. 
Net present value analysis (answer E) is typically performed by project 
analysts.  FP&A may use liquidity ratios to gauge the financial health of the 
organisation (answer G). 
 
Test your understanding 11 
 The correct answers are A, B, D & E 
Answer C – the finance team do not have less to do because of changes in technology, but the work they  do is of a different nature. 
Answer F – there are new skills to learn due to changes in technology and it is important that  members within finance are up to date with these 
changes and have the necessary skills required to adapt.

Chapter 4 
 125 
  
The finance function will 
communicate their insights once a month False – the insights will be communicated as frequently as required. 
The finance function communicates their insights only to internal stakeholders False – the finance function will communicate to both internal and external stakeholders. 
Fewer people are required at this level of the finance function than previously False – the evolving shape of the finance function will mean more people will be required at this level. 
Insight means the capacity to gain 
an accurate and deep understanding of someone or something  True – by definition. 
New competencies need to be developed by the finance function to be able to effectively generate and communicate insight True – new competencies and skills will be required. 
  
 The answer is all of them . There is no single definition of business 
partnership. Finance will support the organisation in all of the ways described 
 
 The best answer is D 
“It is the responsibility of the CFO to lead the fi nance team to achieve the 
desired organisational impact.  This involves leading key initiatives to 
support organisational goals,  as well as liaising effectively with internal 
and external stakeholders .”

126  
 The four advantages are A, B, C & D  
Whilst E and F appear to be advantages, it is not necessarily true that 
fewer staff will be requir ed, merely that the ty pe of work they are 
performing will be at a differ ent level. Additionally, the transition to the 
contemporary finance function will require  additional training to develop 
the new competencies required. 
 
Level in 
influence 
finance 
automated 
functions 
Level 1 Impact Apply Senior 
finance team Managing others/ stakeholder interactions 
Level 2 Influence Advise Strategic 
business partner Stakeholder interactions/ applying expertise 
Level 3 Insight Analyse Digital centre 
of excellence Data processing 
Level 4 information Assemble Smart 
finance factory Data collection

127 
Technology affecting 
business and finance 
B1: Outline and explain the 
technologies that affect business and finance. (a) Outline the key features 
of the fourth industrial revolution. 
(b) Outline and explain the 
key technologies that define and drive the digital world. 
 
 Chapter 
5

Technology affecting business and finance 
128  
 
In this chapter we will look at the tec hnology driven changes facing the business 
world today. Considering key technologie s fuelling what is increasingly being 
viewed as a new industrial revolution. 
2 The 4th Industrial Revolution  
2.1 What is an industrial revolution? 
An industrial revolution can be generalised as ‘‘a rapid and major change in 
an economy, driven by a shift in  the methods and types of work 
undertaken’’ . 
 
 Illustration 1 – Industrial revolutions 
 The 1st Industrial Revolution  in the 18th and 19th centuries saw a shift 
from rural, agricultural lif e to urban, industrialised societies. The growth in 
steam power and advancements in  machinery transformed both 
agriculture and craft industries, and fundamentally changed the basis of 
the economy of the time. 
The period from 1870-1914 has been labelled the 2nd Industrial 
Revolution  by historians. Already industria lised societies driven by coal, 
steam power, iron and textiles were transformed by advancements in the 
electricity, petroleum and steel industr ies. This saw the growth of vast 
corporations and a wave of globalisation. The 3
rd Industrial Revolution  is popularly held as originating in the 
1980s. It is known as the Digital Revolution  and saw a move from 
mechanical and analogy technology to the digital technology of today. 
Developments and improvements in communications, computers and the 
introduction of the internet were some of the key drivers of this period of 
rapid change.  
Technologies such as cloud computing , big data, data analytics, process 
automation, artificial intelligence , data visualisation , blockchain , internet 
of things, mobile technologies and 3-D printing  are some of the more 
commonly known developments predicted to drive the 4th Indus trial Revolution.

Chapter 5 
 129 
2.2 Features of the 4th Industrial revolution 
Each industrial revolution has impacted upon society in their own specific way 
driven by the nature of the advances exper ienced. The characteristics predicted 
to define the 4th Industrial revolution  include: 
• Fusion – cyber and physical systems will continue to fuse becoming 
increasingly autonomous 
• Employment – robotics, automation and digiti zation are predicted to make 
many jobs redundant or fundament ally different to today 
• Artificial intelligence and machine learning – improved computing 
speed and optimized supply chains, enabl es products to be customised 
more easily and more cheaply 
• Machine led manufacturing – the shift from machines helping workers 
manufacture, to workers helping machines will accelerate 
• Improved asset management – Benefits to the natural world through 
more efficient use of natural assets, a shift to renewables, innovations in 
recycling, coupled with digitization ar e anticipated to benefit the natural 
world. 
 
 Illustration 2 – A hypothetical vision of the future 
 An article from the BBC (October 2018 – Justin Rowlatt) discusses the 
impact of some of these emerging technologies and predicts how they may revolutionise our lives in the non-to-distant future. 
The article titled ‘why you have ( probably ) already bought your last 
car’ is written to provoke debate and is formed from the ideas of a 
number of tech analysts who predict wit hin 20 years (so by 2038) we will 
have stopped owning cars altogether. This idea is built upon the emergence of  self-driving electric vehicles, 
enabled by tech including AI, inter net of things and data analytics 
amongst others. The article claims that  these vehicles will be operated in 
an ‘Uber ’ (the ride hailing technology com pany) style network that will be 
so cheap the idea of owning a car will become obsolete within a decade.  The idea of this sounds almost unbelievable when viewed through the 
norms of today, however the rapid em ergence of the motor car just over 
100 years ago is cited as evidence of how quickly things can change. Once mass production began, city st reets changed from almost entirely 
horse and carriage to cars in the space of a decade.

130  
 So how will it all take hold? 
The article walks through an example us ing an Uber style company as its 
backbone. Uber and their rivals have already transformed the face of 
urban transport, a driver can be haile d immediately using a smart phone 
and arrive within minutes, then for a m odest fee, say $10, take us from A 
to B. These services have grown at a rapid pace and despite concerns and media criticism continue unabated. 
Now, of the $10 cost, at least 50% is  paying the driver a wage. Therefore 
once driverless tech  is available and licensed, which many believe could 
be within 5 years, the cost  of your journey has immediately halved to $5. 
(This timescale is evidenced by ev ery major motor and tech company 
fighting to take the lead of what will become a vast market worth billions 
of dollars annually)  
The next thing to consider is the development and improvement of 
electric powered vehicles. The cost of purchasing electric cars is 
currently significantly higher than t heir fossil-fuelled counterparts. The 
emergence and growth of companies like Tesla, along with the threat of 
climate change and dwindling oil re serves, has seen major car 
companies shift their att entions to electric powered vehicles; they are 
ploughing billions of dollars in to refining and improving the technology. 
This level of investment will soon make electric vehicles accessible to the 
mass
 market and will ultimately bring the cost down to less than the cost 
of their fossil fuel led equivalents. 
Further to this we must consider t he running costs; fuel is one of the 
biggest costs for any fleet of taxis, a move to electric powered vehicles 
would see another significant co st removed. Additionally,  electric motors 
are much simpler than a conventional en gine, with only around 20 
moving parts compared to 2,000 or so in the traditional engine. Therefore 
electric cars are expected to last for at least 500,000 miles delivering a 
huge increase in the useful life of the asset. 
Battery technology continues to advance  and investments such as 
Tesla’s ‘gigafactory’ are anticipated to  see the efficiency and reliability of 
batteries improve, the cost and speed of charging will also continue to 
fall. Statistics show that the average driver in England drives less than 10,000 
miles annually meaning 95% of the time their cars are parked , which 
makes for an expensive and somewhat  inefficient lump of metal. 
Especially when compared with an autonomous and intelligently 
controlled taxi which could be utilised at near full capacity. Then on top of 
all of these factors, as adoption of th is new service takes hold, it will fuel 
its own growth becoming cheaper and mo re efficient as more vehicles 
would be added to the network achieving significant economies of 
scale.

Chapter 5 
 131 
 Influential analysts predict with all of these factors combined, the cost of 
your $10 Uber journey of today coul d be cut by as much as 90%, so 
down to just $1! This would be a h uge saving on the cost of buying and 
running your own car. 
Additional considerations include time saved  leading to increased 
productivity i.e. that 1 hour commute becoming part of your productive 
working day for instance. Additiona lly once self-driving technology is 
perfected the flow of traffic will become much smoother and safer  as the 
most unreliable and unpredictable el ement, the human behind the wheel, 
is removed. In fact the article goes on to suggest that ultimately humans 
will be banned from driving altogether due to the th reat they pose to the 
efficient and safe running of the ‘s elf-diving robo-network’ of taxis. 
If the potential upheaval of all t hese changes isn’t enough, when you 
consider the array of industries and businesses built around private car ownership and how these could disappe ar or be radically changed, it 
makes you realise how far reaching such developments will be to the 
world of today in terms of industrial and social upheaval . 
The fact that this sounds like science-fiction, is much like the idea of the light bulb and the motor car would have sounded to people only a handful of generations ago, prior to prev ious industrial revolutions.  
Much of the technology discussed above is well on its way so this could well become science fact sooner than we may imagine, and the 4
th 
industrial revolution will be in full swing.  
3 Key technologies drivin g the digital world 
In this section will we introduce some of the key developments and technologies 
driving the new wave of innovation and increasingly changing the world around 
us. 
How these technologies are beginning to  impact the world of finance and the 
role of the finance professional will be considered in more detail in later 
chapters.  
3.1 Cloud computing 
 Cloud computing  is defined as the deliver y of on-demand computing 
resources – everything from applicat ions to data centres – over the 
internet. (IBM) 
The basic idea and application of cloud co mputing sees users log in to an 
account in order access, manage and pr ocess files and software via remote 
servers hosted on the internet. This replac es the traditional method of owning 
and running software locally on a computer or networked server.

132  
There are two main types of cloud setups: 
• Public cloud hosted by a third-party company. Specialist companies sell 
their cloud computing services to anyone over the public internet who 
wishes to purchase them 
• Private cloud sees IT services provided over a private infrastructure, 
typically for the use of a single or ganisation. They are usually managed 
internally also 
 
 Illustration 3 – Amazon, cloud computing services 
 Amazon’s market value briefly brok e the $1 trillion mark in 2018. A large 
contributor to this was the conti nued growth of Amazon Web Services 
(AWS). They are the market leader in  cloud computing, controlling a third 
of the market in an industry expec ted to be worth $145bn by 2020. Their 
customers range from individua ls to government agencies.  
Significantly their AWS business supports  operations of other core areas 
of Amazon’s business including e-commerce, Amazon prime video & 
music and the Amazon home assistant. Th is is a gateway to the ‘internet 
of things’ another marketplace projected to grow significantly in the coming years. 
Features of cloud computing  
Flexibility and scalability  – Cloud 
computing allows simple and 
frequent upgrades allowing access to the latest systems developments. A company doesn’t become laden with expensive hardware and software that quickly becomes obsolete. This allows organisations to evolve and change, to adapt to new opportunities and working practices Organisational change  – Working 
methods and roles need to be modified to incorporate a move to cloud computing. It may also lead to job losses, primarily in IT support and maintenance roles 
Cost efficient – Limited IT maintenance costs and reduced costs of IT hardwar e, sees capital 
expenses and fixed costs become operating expenses. Cloud technology also allows pay as you go computing, with charges based on what a company actually needs Contract management  –The cloud 
provider will immediately become a very significant supplier. Managing this relationship, monitoring performance and ensuring contractual obligations will introduce new challenges and costs

Chapter 5 
 133 
Security  – Cloud services like any 
outsource provider are specialists. 
The security and integrity of their systems is fundamental to their business model and will be a strategic priority. Disaster recovery and backups are built in Security, privacy & compliance – Whilst cloud providers will be specialists, they are bigger targets for malicious agents. This can threaten the security of sensitive information. Additionally compliance with data regulations is put largely in the hands of a third party. 
Flexible working  – The increase in 
remote and home working is supported by cloud computing and the ability to access your ‘desktop’ from any location  Reliance  – More so than with a 
standard outsource arrangement, the reliability of the cloud service provider is essential. Often the entire provision of 
information systems fundamental to the operation of a business is passed to this third party. 
Environment  – Less waste from 
disposal of obsolete technology. More efficient use of scarce resources.   
 
 Which ONE of the following describes a cloud service that can only be accessed by a limited number of authorised people? 
A Management Information System 
B Private Cloud C Public Cloud D Big Data

134  
3.2 Big data 
 Big Data describes data sets so large and varied they are beyond the 
capability of traditional  data-processing  
The key features of Big Data are described as the 4Vs: 
 
Sources of big data 
Big data comes in two main  forms; structured data is deliberately produced and 
collected for a specific purpose and therefore exhibits a clear, deliberate 
structure. For instance feedback data when people have been asked to rate a 
service or product. Unstructur ed data, this is captured passively without a clear 
purpose, social media posts and ‘likes’ ar e an example of this. Its format is 
highly variable and non-standard. 
The principal sources of these two forms of data are classified as follows: 
• Human-sourced data – billions of data points are produced every day 
from social media, text mess ages, web browsing, emails etc. 
• Machine-generated data – smart technologies and the internet of things 
is a growing source of data. Sensors built in to all aspects of modern 
technology, log and upload data const antly. Home assistants, smart 
meters, TV boxes and cars are a small selection of items producing 
machine-generated data. 
• Processed data –Traditional data, held on databases of businesses and 
organisations recording customers, transactions and company assets 
• Open data – Publically available data stemming from sources such as 
governments, the public sector and national statistics agencies

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 135 
 Illustration 4 – Big data in everyday life 
 The sheer volume of data we produce on a daily basis is vast and 
increasing all the time. It largely goes  unnoticed as much of it we produce 
incidentally as we live our lives. Ye t companies are desperate to collect 
this data as they hope to gain unique insights and information that could 
deliver a crucial advantage over their rivals. 
If you consider a hypothetical morni ng routine for instance; woken up by 
your smartphone alarm, you pick it up to  silence it before having a look at 
emails or messages received overnight.  Realising its a little cold you ask your  smart home assistant to turn the 
heating up a few degrees and maybe even tu rn the lights on. As it’s the 
weekend you decide to turn the TV on, digital of course, constantly firing 
data back to the service provider. What programme are you watching, 
how long do you watch for? Which adverts do you watch? 
Next up you decide to have a quick browse on social media, a few likes 
and shares, time spent watching vi deos and clicking on an interesting 
advert or two, all adds a little more  to this ‘gold mine’ of data.  
So without even leaving bed we have al ready generated multiple types of 
data. Not to mention the smart meter that is monitoring the power usage 
of all this technology and continually harvesting this data. 
A quick drive to the shops will see the computer used to control all 
modern cars collect a wide arra y of data about the performance and 
condition of the car, both the cars sat-nav and your smart phone will be communicating data about your location and what the driving conditions 
are like on the roads you travel down. M onitors in traffic lights and in the 
roads themselves as well as cameras along the way will also track vehicles passing with data being used for traffic monitoring and 
surveillance.  
You then pull up and park, the car par k records your number plate and 
updates its information on the num ber of available spaces.  
As you enter the shop your footfall is logged, the way we navigate the 
store, what causes us to stop and pick up certain items, a ll of this is of 
huge value to retailers so increasing attention is devoted to trying to 
capture this data to gain valuable insight. Our card payment is logged by the provider as we pay for the basket of 
shopping, the contents of which is recorded and matched to our loyalty 
card profile which contains all of our shopping history as well as our profile info. This can be used to be tter understand customer s, their habits 
and how they may be changing, what people want and when they buy it, 
what was the weather like when these purchases were made? And did this influence your choices?

136  
 Data on stock movements will also be generated, which is vital to the 
supply chain and inventory management  systems of stores; these are 
often almost entirely automated. 
So from this simple example, without  any deliberate actions or specific 
intent a surprisingly large amount of  different data has been generated by 
one individual. If you multiply this across billions of different people doing 
their own morning routine, the result  is a truly vast amount of data. 
 
 A private educational college is look ing at ways they can utilise data in 
their organisation. The managing direct or has suggested using the current 
system that has names of students, their student ident ity number, and the 
company they work for.  
What kind of data would this be using? 
A Public data 
B Unstructured data C Volume of data D Structured data 
3.3 Data analytics 
 Data analytics is the process of co llecting, organising and analysing large 
sets of data ( big data ) to discover patterns and other information which an 
organisation can use to inform future decisions.

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Uses of data analytics and big data  – Understanding the potential value of 
data and its significance to an organisati on presents a real opportunity to gain 
unique insight. This can be used to improve competitive posit ion and potentially 
gain competitive advantage over rivals. 
Business consultants Mckinsey, summarised the following benefits an 
organisation can realise from effective data analytics: 
• Fresh insight and understanding – Seeing underlying patterns through 
the intelligent use of data can re veal patterns and insight into how a 
business operates, revealing issues that they may not have known existed 
• Performance improvement – Data, processed and sorted into relevant 
management information in real time, can lead to significant operational 
gains and improved decision maki ng and resource utilisation 
• Market segmentation and customisation – Refining customer groups 
into ever more specific segm ents and understanding the want and needs 
of those groups can lead to increas ed personalisation and customisation 
of products and services 
• Decision making – Real time information that is relevant can lead to 
faster decisions and decisive advantage over competitors 
• Innovation – Existing products can be im proved from under standing the 
features and elements that customers enjoy and use. This can also lead to 
the development of whole new products 
• Risk management – Risk management and control are vital in the 
effective running of any organisation. The use of data can enhances all 
stages of the risk management process. 
3.4 Process automation 
 Para The technology enabled automation of complex business processes. 
This can be entire processes or el ements therein, ai med at improving 
consistency, quality and speed whilst delivering cost savings.  
Traditional process automation  – The traditional idea of process automation 
is that of a machine carrying out a simp le repetitive task, replacing a job that 
would have been done by hand or in a semi -automated fashion. This type of 
automation is everywhere and has driven indu strialisation, through the ability to 
produce ever higher volumes of products, with fewer problems and at less cost. 
Modern process automation  – Increasingly automation and process 
automation are focusing upon complex busi ness areas, which were previously 
thought to be beyond the lim its of technology.  
Big data  and the internet of things  generate huge amounts of data; data 
analytics transforms this into useful information that supports artificial 
intelligence (see next section) and machine learning . Essentially process 
automation is becoming smarter and can make decisions using reasoning, language and lear ned behaviour.

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 Illustration 5 – Process automation 
 Customer contact centres are an area that many businesses are keen to 
automate. It is a business function deemed to be relatively low skilled in 
comparison to other business processes, but is an ar ea that customers 
value so must be handled with care. 
This was evidenced by the wave of contact centres being moved 
overseas to countries with lower labour costs in the 1990s/2000s driven by the aim of achieving cost savi ngs. Customers were however, often 
dissatisfied with the level of service received resulting in a large number 
of companies ultimately bringing t heir contact centres back to the home 
country. 
Companies were still keen to realise cost savings in this area but required 
a new approach to doing so. Developments in technology have led to significant improvements in process automation, contact centres are now 
typically heavily automated using t he technology in conjunction with 
humans. The use of automation has been designed to use workers time 
more efficiently, through redesigni ng and streamlining processes as well 
as fully automating simple tasks and processes. 
Developments in voice recognition te chnology and the ability of artificial 
intelligence allows contact centre ca lls to be answered robotically, they 
will typically ask the nature of the call,  then place this on the right track. 
Many calls can be handled fully autonomously for instance making 
payments or tracing orders. Callers  who do require a contact centre 
operative will then begin the security  process, this will then interrogate 
the system to bring t he customer and case information up on the 
operatives screen before they even speak.  
Data capture and analytics are also  used to monitor and understand call 
types, monitoring for new or emerging trends and suspicious or 
potentially fraudulent activity. This will enable workers to be more prepared and trained specifically to  deal with high risk call types. 
All of these improvements have led to both cost savings and service 
improvements through more targeted and efficient use of contact centre workers time, seeing them specifically  used on activities where value can 
be added. 
3.5 Artificial intelligence 
 Artificial Intelligence is an area of computer science that emphasises the 
creation of intelligent machines that work and react like human beings.  
A common definition from  Kaplan and Haenlein describes AI as a “system’s 
ability to correctly interpret external da ta, to learn from such data, and to 
use those learnings to achieve speci fic goals and tasks through flexible 
adaptation”.  This is often considered in the context of human-t ype robotics but 
reaches much further than this, and is set to transform the way we live and 
work.

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Some of the more advanced activities and skills artificial intelligence can now 
master, and therefor e present huge opportunity for developers and companies 
alike, include: 
• Voice recognition 
• Planning • Learning  • Problem solving 
 
 Illustration 6 – Artificial intelligence 
 Companies such as Apple  and Amazon  have developed and marketed 
voice recognition systems, either to be built into an existing product (such 
as Apple with its Siri  system) or developed new products whose main 
function is voice recognition (such as Amazon and ‘ Alexa ’). 
A further simple example is that of Facebook, and its process of 
recommending new friends for users to connect with. 
There are many, more complex examples  of Artificial Intelligence, but a 
common factor to both the simple and the more involved is machine 
learning.  
Machine learning 
Machine learning is a subset of AI where ef fectively AI computer code is built to 
mimic how the human brain works. It e ssentially uses probability based on past 
experiences through data, events and connections between events. The 
computer then applies this learning to a given situation to give a fact driven 
plausible outcome. If the conclusion the computer reaches turns out to be 
incorrect this will act to add more experience and enhance its understanding further, so in future the sa me mistake will not be repeated. 
Essentially machine learning algorithms detect patterns and learn how to make 
predictions and recommendations rather than following explicit programming 
instruction. The algorithms themselves  then adapt to new data and experiences 
to improve their function over time.

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 Illustration 7 – Artificial Intelligence: ‘Move 37’ 
 Go is a highly complex strategy game, believed to originate in China over 
2,500 years ago. It is considered to be more complicated and advanced 
than Chess, with a larger board, mo re elements meaning each move has 
many more alternatives to consider. 
In 2016 Google DeepMind (GDM) , an AI technology played a challenge 
match against Go world champion Lee Sedol . The match was won by 
GDM in what many considered to be a significant milestone in AI 
research and development. 
Essentially the program had been bu ilt from uploading thousands of 
previous Go games, which allowed t he software to learn moves, patterns 
and responses to moves, to become a Go expert. One moment in the match, referred to as Move 37, is considered to be a 
particularly seminal moment in AI development. GDM played its 37
th 
move which to all commentators and indeed Lee Sedol himself, appeared 
to be completely abstract and in effect a ‘bad’ move. It turned out to be an 
innovative new move never seen befor e. The significance of the move 
wasn’t felt until much later in the gam e but it turned out to be the pivotal 
moment, which enabled GDM to win the match. The fact the computer software, who’s ‘knowledge’ was built upon past 
games of Go and the moves and pe rmutations encountered, was then 
able to take this learning and build  upon it, doing something completely 
new was a demonstration of the power of AI and Machine learning. 
Interestingly Lee Sedol the human world champion was later able to beat GDM by effectively identifying limitations in its coding. He then made moves that were outside of GDM’s understanding and the system 
therefore struggled to respond appropriately. This is a useful illustration of 
why AI and human thinking will need to be used in a mutual and 
collaborative way to help achieve innovations. 
 
 Dollar Co is a chain of banks. It co llects data from customers who visit the 
banks in person, and also from online transactions. For the online banking 
system, customers need to log in via the website using their login and 
password. Recently Dollar Co invest ed in a system that  promoted certain 
products to customers when they were online, based on past transactions and banking history.  
What is this is an example of? 
A Traditional process automation 
B Data visualisation C Artificial intelligence D Virtual reality

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3.6 Data visualisation 
 Data visualisation allows large volume s of complex data to be displayed in 
a visually appealing and accessible wa y that facilitates the understanding 
and use of the underlying data.  
The growing significance of data has seen a rise in the import ance of being able 
to access and understand the data in clear, concise way. This is where data 
visualisation fits in. The tools of today’s market leaders Tableau and Qlik, go 
far beyond the simple charts and graphs of Mi crosoft Excel. Data is displayed in 
customisable, interactive 3D formats t hat allow uses to manipulate and drill 
down as required. Central to data visualisation is understanding and ease of 
use, the leading companies in the fiel d look to make data easier and more 
accessible for everyone.  
Essentially it aims to remove t he need for complex extraction, analysis and 
presentation of data by finance, IT and data scientists. It puts the ability to find 
data in to the hands of the end user, thr ough intuitive, user friendly interfaces. 
The most common use of data visualisation  is in creating a dashboard to 
display the key performance indicators of a business in a live format, thus 
allowing immediate under standing of current performance and potentially 
prompting action to correct or amend performance accordingly. An effective data visualisation tool should display these five features: 
• Decision making ability  – Results focused, it should aid decision making 
• Effective infrastructure – The output is reliant upon sufficient quantity 
and quality of data 
• Integration capability  – With existing systems and the business overall 
• Prompt discovery of rules and insights  – Live data is vital and delay 
can render any insight useless 
• Real time collaboration – Users must interact with each other and the data 
3.7 Blockchain 
 
 A blockchain has been described as a decentralised, distributed and 
public digital ledger that is used to record transactions across many 
computers. This means the record cannot be altered retroactively without 
the alteration of all subsequent blocks and the consensus of the network.  
Alternatively, it has  been defined by the Bank of England  as a technology that 
allows people who do not k now each other to trust a shared record of events. 
Benefits of a blockchain 
The main benefit of blockchain is security. In the digital era, cyber security is a 
key risk associated with the use of IT sys tems and the internet. This is because 
traditional systems have been ‘closed’, and so modifications to data have been 
carried out by just one party. If the system is hacked, there is little control over 
such modification to prevent it from happening.

142  
 Illustration 8 – A blockchain 
 A simple illustration is the relationship that individuals have with their 
banks or credit card companies. If a transaction is carried out with 
either (for example, you use your  credit card to pay for goods or 
services) there is only one party that records the transaction, your credit card company. How is that co mpany to know that the transaction 
is valid? If the details appear r easonable, the transactions will be 
authorised. This allows those who ca rry out credit card fraud to make 
their (illegal) gains.
 
A blockchain provides an effective c ontrol mechanism aimed at addressing 
such cyber security risks. It is a reco rd keeping mechanism that is ‘open’ or 
public, as it utilises a distributed ledger; it has been described as a form of collective bookkeeping. 
Key features of a blockchain 
• In a blockchain system, transactions are recorded by a number of 
participants using a network which oper ates via the internet. The same 
records are maintained by a number of different parties; as a transaction is 
entered, it is recorded by not just two parties, but instead by all of the 
parties that make up the overall chain. This can happen because all of the records in the blockchain are publica lly available and distributed across 
everyone that is part of that network. 
• When a transaction takes place (f or example, between a buyer and a 
seller) the details of that deal are re corded by everyone – the value, the 
time, the date and the details of those parties involved. All  of the ledgers 
that make up the blockchain are updated in the same way, and it takes the 
agreement of all participants in the c hain to update their ledgers for the 
transaction to be accepted. 
• The process of verifying the transacti on is carried out by computers; it is 
effectively the computers making up the network that audit the transaction. If all of the computers review the transaction and verify the details are 
correct, the systems of all particip ants in the blockchain have updated 
records. The computers work together to ensure that each transaction is 
valid before it is added to the blockc hain. This decentralised network of 
computers ensures that a single syst em cannot add new blocks to the 
chain. 
• When a new block is added to a blockchain, it is linked to the previous 
block using a cryptographic hash gener ated from the co ntents of the 
previous block. This ensures that the chain is never broken and that each 
block is permanently recorded. It is in tentionally difficult to alter past 
transactions in the blockchain because all of the subsequent blocks must be altered first.

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It is this control aspect of blockchai n technology which addresses the main 
concern of cyber security. If anyone should attempt to interfere with a 
transaction, it will be rejected by t hose network parties making up the 
blockchain whose role it is to verify t he transaction. If just one party disagrees, 
the transaction will not be recorded. 
Typical stages in a blockchain transaction 
 
 Illustration 9 – Cryptocurrency 
 Bitcoin  is a digital currency that was introduced in 2009. Other 
cryptocurrencies exist, such as Ethereum  and Litecoin . 
There is no physical version of Bitcoin; all Bitcoin transactions take place 
over the internet. Unlike traditional currencies, Bitcoin is decentralised, meaning it is not controlled by a single bank or government. Instead, Bitcoin uses a peer-to-peer (P2P) pay ment network made up of users 
with Bitcoin accounts. 
Bitcoins can be acquired in two di fferent ways: 1) exchanging other 
currencies for bitcoins; and 2) bitcoin mining. 
The first method is by far the mo st common, and can be done using a 
Bitcoin exchange such as Mt.Gox  or CampBX . These exchanges allow 
users to exchange sterling, dollars etc. for bitcoins.

144  
 Bitcoin mining involves setting up a computer system to solve maths 
problems generated by the Bitcoin netwo rk. As a bitcoin miner solves 
these complex problems, bitcoins ar e credited to the miner. The network 
is designed to generate increasingly complex math problems which 
ensure that new bitcoins are generated at a consistent rate. 
When a user obtains bitcoins, the bal ance is stored in a secure ‘wallet’ 
that is encrypted using password prot ection. When a bitcoin transaction 
takes place, the ownership of the bitc oins is updated in the network on all 
ledgers, and the balance in the re levant wallets updated accordingly. 
There is no need for a central bank to  authorise transactions, since they 
are verified by those computers that make up the system. This therefore 
has the advantages of speed, reduced co st (transaction fees are small, 
typically $0.01 per transaction), and increased security. 
Additionally, there are no pre-requisites for creating a Bitcoin account, 
and no transaction limits. Bitcoins c an be used around the world, but the 
currency is only good for purchasing items from vendors that accept 
Bitcoin . 
 
 Which TWO of the fo llowing are advantages of blockchain 
technology? 
A Anything of value can be transferred 
B Everybody understands it C Easy for management to override D No need for an intermediary 
3.8 Internet of things 
 The internet of things describes the network of smart devices with inbuilt 
software and connectivity to the inter net allowing them to constantly 
monitor and exchange data. 
What devices are connected to th e internet of things (IoT)?  Essentially 
anything with an on off switch can becom e a ‘smart’ device and be connected 
over the internet. This allo ws them to talk to us, applications and each other, 
which is at the core of their functionality. 
Common devices currently connected as part of the internet of things include: 
• Smart meters  and home control devices whic h allow control of heating, 
electricity and hot water. 
• Doorbells and security ; these talk to your smart device. A live connection 
is established if the doorbell is pre ssed or the motion sensors activated, 
allowing immediate interaction

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• Wearable tech such as smart watches and fitness trackers capture and 
record an array of data to m onitor and record your fitness 
• Home appliances such as  smart lights, fridges, washing machines, ovens 
etc… the connectivity built in allows remote access and control of these 
devices, for instance turnings your lights on if you’re out at night can be 
done using a smart phone. 
• Cars; the computer systems used to control cars are increasingly 
sophisticated. They track and monito r thousands of parameters on every 
journey. This capability is central in  the continued pursuit of autonomous 
vehicles. 
• Transport and infrastructure; smart motorways are a common feature in 
many countries with traffic sensors monitoring the flow and build-up of 
traffic and responding to provide extra lanes or activate temporary speed 
limits 
• Manufacturing equipment and plant; monitoring of business assets 
facilitates efficient utilisation, it allows continual live feedback to track 
performance and flag maintenan ce requirements earlier. 
The growth in the internet of things often termed ‘smart technology ’ is fuelled 
by improvements in broadband connecti vity and the development of 4G 
communication networks. As governments look to roll out the next generation 
5G networks, improving connectivity furt her. Coupled with t he fact the people 
and businesses are increasingl y comfortable with the i dea and operation of this 
smart technology , it is anticipated that the internet of things will continue 
grow, becoming increasingly central to how we live and work as new and 
innovative applications for the te chnology emerge all the time.  
 
 Illustration 10 – Farming 
 Connected devices are becoming increas ingly prevalent in the world of 
farming. It is an industry that is particularly vulnerable to adversity, through climate and weather  effects, disease and pests. Therefore the 
ability to monitor data on climatic conditions and the health of animals allows farmers to be forewarned of potential problems at  an earlier stage. 
This allows farmers to take preventat ive action to fix problems or switch 
to alternative strategies, resulting in increased yields and importantly 
saving costs, wastage and loss. 
A company called Allflex use smart sens ors, built into collars which are 
worn by each animal in the herd. T hese sensors monitor temperature, 
health, breathing, activity and nutriti on of individual animals and the herd 
overall. Early warning signs can al ert the farmer to potential problems 
and early preventative action can be ta ken such as veterinary care or 
isolating an animal showing markers of infection.

146  
 X Co has created a brand of electroni c toothbrushes that can sync with a 
mobile phone to let the user know t he appropriate length of time they 
should be spending brushi ng their teeth.  
This is an example of what? 
A Big data 
B Internet of things C 3D printing D Mobile technologies 
3.9 Mobile technologies 
 Code-division multiple access (CDMA) is the technology that underpins 
mobile technology. It has developed rapidly over the last decade and 
increased the capability of mobile technology. 
Developments  in mobile technology have s een mobile phones progress from 
basic call and message devices in the late 1980s and 1990s to the smart 
phones  and tablets  we see today. These devices are more like computers than 
telephones and this is reflected in the prices of t he latest models. 
The rapid development in the capability  of mobile technology has emerged at 
the same time as huge advances in inte rnet technology an d together the two 
technologies have been perfect partners. All aspects of modern life are impac ted by mobile technology, with major 
industries being completely transformed or new ones emerging, including: 
• Newspapers – Physical sales of newspapers are in terminal decline. 
News is now consumed via mobile devic es and is live rather than being a 
record of yesterday’s news. News paper companies have attempted to 
evolve to maintain a presence in this mobile online world. 
• Advertising – Closely linked with newspapers and other media, 
advertising is being transformed. Lar ge scale mass advertising is in 
decline with a growth in sm arter, targeted adverts.  
• Music – CD’s were replaced by MP3’s which were seen as the future but 
have in turn have been replaced by  music streaming services like Spotify 
• Banking – Increasingly people bank via m obile apps, designed for ease 
and convenience, the traditional high street branch continues to decline 
• Socialising – Social media has transfo rmed how people socialise and 
communicate with friends using smartphones to post and tag and 
photograph their every move. 
• TV/Film  – Video streaming services such as Netflix  and Amazon Prime 
as well as OnDemand TV and video sites like YouTube  are designed for 
mobile internet technology and are transforming how we watch TV and films.

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3.10 3-D Printing 
 3-D printing  is part of a process known as additive manufacturing  
where an object is created layer by layer. It allows complex parts and 
components to be produced much cheaper, faster and in an entirely 
customisable manner. 
How does it work? First a blueprint needs to be made; modelling software is widely available and catering for domes tic and industrial scale operations. 
Alternatively objects created by others can be accessed on specialist communities. 
Once a design is finalised it is ready to be printed. Printers can range from small 
desktop to industrial arrays. Most 3D pr inters use thermoplastic composite type 
material. The printer follows the precis e coordinates laid out by the design, 
building up the item layer by layer to produce a fully formed single piece 3D 
object. Applications range from producing prototype parts  for manufacturing to 
printing human organs and bone using bio-printing . 
What are the advantages? 
• Speed – compared with conventional manufacturing such as injection 
moulds, 3D printing gives significant time savings from prototype to 
finished article. Prototypes can be printed and tested in the same day, 
amendments made and r eprinted immediately  
• Cost effectiveness – linked to the speed of the process, the labour cost 
of a conventional prototype process is high as designs need to be made 
into moulds which will then be tooled for manufacture, before a prototype 
can be made. Any changes need to follow the same lengthy and costly process 
• Customisation – the ability to easily amend designs and tailor them to 
individual wants is a big draw for 3D printing over traditional manufacture 
which is more focused on large volumes of identical products. This is a big selling point that can differentia te a business from its rivals 
• Less waste – 3D printing sees the exact design printed and nothing else 
so uses raw materials much more efficiently than traditional manufacturing methods which see a lot of offcuts extracting the finished product 
• Confidentiality – 3D printing allows cont inuous prototyping and 
manufacturing in-house, thus pr otecting intellectual property

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4 Chapter summary

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Private clouds are on a private in frastructure and managed internally. 
MIS may be limited in access but is not a cloud service. Public clouds are 
hosted by 3rd party. Big Data is the term for data sets so large that 
necessitates cloud computing to allow more storage.  
 
Structured data is usually presented in some order and for particular 
uses. Public data is open data from  governments. Unstructured data 
comes from a variety of sources, co llected passively. Volume of data is a 
characteristic of big data. 
 
 The correct answer is C 
Artificial intelligence has algorithms t hat processes data and can use it to 
make recommendations. Traditional process automation is carrying out a 
simple repetitive task, which this is not. Data visualisation allows complex data to be viewed in a visually appeali ng way. Virtual reality is a computer 
generated experience in a simulated environment. 
 
 The correct answer is A and D  
Anything of value can be transferred, and it removes the need for an intermediary. Not everybody underst ands blockchain, and there may be 
some resistance to it. Bl ockchain technology makes it more difficult to 
interfere with transactions. 
 
Internet of things allows everyday obj ects to be connected to the internet 
and interact with us. Big data gets generated from products like this. 
There is no mention that this is done via 3D printing (though toothbrushes 
could be!). Mobile tech nologies involve using them for the transactions, 
which is not the case here.

151 
How the finance function 
uses digital technologies 
B2: Outline how the finance 
function uses digital technologies to fulfil its roles. (a) Digital technology. 
(b) Digital mindsets. (c) Automation and the 
future of work. 
(d) Ethics of technology use. 
 
 Chapter 
6

How the finance function uses digital technologies 
152  
 
1 Digital technologies and the finance function 
1.1 Introduction 
In Chapter 5 we considered the idea of the 4th industrial revolution , 
considering some of the key technology developments driving the changes that 
will increasingly impact all aspects of modern life. 
In this chapter we will look more spec ifically at how these emerging and 
developing technologies will affect the fi nance function of organisations and will 
shape future finance professionals. 
We will consider the innovation and progress this technology can offer as well 
as investigating some of the ethical, legal and soci al considerations, through 
data protection and the idea of overall corporate digital responsibility. 
Some of the technologies are anticipated to effectively update existing systems and improve capability; these have been termed core modernisation tools  
and are considered mainstream. Whilst others will deliver new capabilities, pushing the finance function forward, these are referred to as exponentials  and 
are still at the early-adopter stage. 
Core modernisation tools  include: 
• Cloud technology 
Exponentials  include: 
• Advanced analytics 
 
Illustration 1 – The changing face of the finance function 
 Essentially the finance function looks after an organisation's money. They 
ensure that a company’s records ar e kept up to date, in order to 
understand, plan and ultimately contro l the money avai lable within the 
business. 
The finance function must estab lish sound systems which enable all 
financial transactions to be recorded. They must also be able to 
interrogate this data to provide meani ngful information that is accurate, 
complete and timely.

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 Modern technologies introduced in C hapter 5 are impacting all areas of 
the finance function including: 
• The hardware and software businesses use are being revolutionised 
with cloud computing  transforming the way that accounting 
systems are owned, maintained and operated, leading to time and 
cost savings and more effi cient ways of working.  
• The variety and volume  of data that is available to the modern 
finance professional has grown ex ponentially and br ought about the 
concepts of big data  and data analytics  enabling greater insights 
into all areas of a business’ operations. 
• The information generated by the finance function, vital in managing 
all aspects of business c an be brought to life through huge 
improvements in data  visualisation. 
2 New technologies and their use in the finance function 
2.1 Cloud computing 
Cloud computing as di scussed introduced in Chapter 5, involves the provision of 
shared computing services over t he internet. Cloud systems can be public 
(shared) or private (closed) depending upon the ne ed and requirement s of users. 
Cloud computing and the finance function: 
Cloud technology is impacting the provision of computing services within 
organisations including the finance func tion. This has wide ranging impacts on 
the way people and organisations work. The classic idea of office based 9 to 5 working within a physical team is becoming increasingly obsolete and the advent of cloud computing  is one of the main drivers of this. 
Cloud computing has driven the following changes in the structure and working 
of the finance function: 
• Collaboration  – File sharing and version control issues are minimised. 
Services such a Google drive for instance allow multiple collaborators to 
update documents in real time 
• Flexible working  – Full access to all files and documents anywhere with 
an internet connection has facilitated increased flexibility to work pattern and arrangements 
• Increased security – Cloud service providers understand and 
acknowledge the security of data, es pecially financial data is critical to 
their success.  
• Up to date – Continually up to date softw are, helping to ensure 
compliance with regulations such as GDPR 
• Easier integration – Cloud based accounting software can easily link with 
other cloud based software such as  customer relationship management 
(CRM) allowing an integrated approach to business in a cost effective way 
when compared with traditional software solutions

154  
Cloud computing, digital t ech and financial reporting – The provision of 
services via cloud networks has revolutionised many industries. Physical 
products and the ownership of traditional  physical assets like property, plant 
and equipment are becoming less important in the modern digital world. This has led to a growth in the significance of intangibles which often aren’t recorded 
on the statement of financial position . As a result it is more difficult to 
determine the underlying value of digita l businesses and to identify their 
sources of value creation us ing traditional route of financial statement analysis. 
Using financial statements alone may signi ficantly undervalue such entities as 
many intangible assets are internally generated and thus can’t be recognised. This includes things like in tellectual property and staff skills. 
 
Illustration 2 – Cloud services impact on physical goods 
 Music streaming through services such as Spotify, Deezer, Apple 
music amongst others now dominate the music industry. While the 
buying of a physical product like a CD fr om a physical record store like 
HMV or Virgin is increasingly a thing of the past. 
Other industries like hotels have seen the emergence of new players and business models. AirBnB for instance who act as an online broker, 
facilitating the short term lets  of private accommodation between 
individuals is one of the largest ‘hote l’ companies in the world valued at 
around $30 billion (2019) yet t hey own no hotels or property. 
Similarly companies like Uber, Lyft and Didi, who offer ride hailing 
services don’t own a single vehicle yet dominate the transport industry and have estimated values beyond that of AirBnb. 
All these businesses utilise cloud com puting technology in the provision 
of their services and operate in a way that has revolutionised their 
industries.  
They all have in common an absence of physical assets such as stock, 
property, plant, vehicles and equipment. Therefore, the financial reporting 
of these entities is a fundamentally  different proposition compared to 
traditional bricks and mortar businesses.  
2.2 Big data and data analytics 
Computerisation  has seen the role of finance professionals evolve over a 
number of decades from t he traditional idea of ‘bean counters’ to a more 
strategic value adding position.  
Technology has facilitated the ability to sort and analyse data to produce 
meaningful information far quicker than before, largely through the use of 
spreadsheet  and database  software.  
The development and use of ever more s ophisticated digital technology means 
the role of the finance professional c ontinues to evolve. Elements such as big 
data and data analytics, artificial intelligence and data visualisation present 
significant opportunities as well as  challenges to both businesses and 
individuals.

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Business partnering – Management accountants are embedded within 
functional departments of t he organisation rather than operating from a central 
accounts department. The object is to prov ide real-time support and analysis to 
improve the operational performanc e of the functional department.  
Big data and  data analytics  will increase the significance of the business 
partnering role, with the potential for new insights to be gained. It is anticipated 
accountants will act as the interface between data specialists such as data 
scientists ( who have a background in statistics and computer science) and the 
business, essentially making the data generated commercially relevant thus 
transforming it into valuable information. 
Other impacts of big data on el ements of the finance function: 
Management accounting  In management accounting, big data will contribute 
to the development of more efficient and insightful 
management control systems and budgeting 
processes.   
Financial accounting 
 In financial accounting, big data will improve the 
quality and relevance of accounting information. 
This can enhance transparency and stakeholder 
decision making.   
Reporting 
 In reporting, big data can assist with the creation 
and improvement of accounting standards. This 
will help to ensure that t he accounting profession 
continues to provide useful information as the 
dynamic global economy evolves.  
Internal audit and big data  
Big data and data analytics are expected to enhance the quality and relevance 
of internal audit  assignments. Technology advancements in big data and 
analytics are fundamentally changing how the review of internal controls and 
systems are carried out.  
New technology is driving an expansion beyond sample-based testing to 
include analysis of entire populations of audit-relevant data, using intelligent 
analytics to deliver a higher quality of audit evidence and more relevant 
business insights. Big data and analytics are enabling internal audit to better 
identify anomalies, fraud and operati onal business risks and tailor their 
approach to target more business critical areas.

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 The impact of big data in organisati ons will affect which elements of 
the finance function? 
A Business partnering 
B Management accounting C Financial accounting D Internal audit E All of the above 
2.3 Process automation 
As discussed in Chapter 5 , process automation involv es the use of technology 
to automate processes previously carried out by human workers. Developments in technology are enabl ing more complex activities to be 
automated and process automation  is therefore becoming increasingly 
significant to the finance function of an organisation. Repetitive, low skilled manual tasks su ch as data entry, duplication and 
processes that add minimal value to t he end users of financial information are 
most likely to be automated by new developments in process automation 
software. This will free up time and re source for higher level value adding 
activities. An organisation consi dering investing in process automation technology within 
the finance function would we igh up the following adv antages and disadvantages: 
Advantages
 Disadvantages  
Cost savings  – reduction in 
headcount as routine aspects of 
finance work automated  Uncertainty – process automation 
changes the way the finance function works and can lead to uncertainty around job security and future prospects
 
Value adding – staff and management time is freed up to focus on higher level value adding activity Relationship management – for process automation software to be successful, time and resource is required for relationship management with IT support and software providers
 
Improved accuracy – automated 
processes will benefit  from improved 
accuracy and efficiency with the removal of human error and working patterns. Competence – the automated 
process is built by IT staff who must also understand in detail the existing process as the automated process is only as effective as the coding that drives it.

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Advantages  Disadvantages  
Positive return – well managed and 
implemented process automation 
software will provide positive returns on investment Training – costs of training staff to 
understand how the new software works and interfaces with their roles can be significant 
Adaptability – process automation 
can be used for existing processes or can form part of an overarching process improvement exercise Change management – as with any 
significant changes made by organisation the process must be managed carefully and led effectively for it to be successful 
 
 Illustration 3 – Process automation in the finance function 
 Process automation when considered in the co ntext of a large scale 
conglomerate organisation such as Johnson & Johnson  can generate 
time, cost and resource savings as  well as genera ting significant 
efficiencies. 
Compatibility issues between the multiple systems across Johnson & 
Johnson’s many operating locations led the company to investigate the 
potential benefits process automation could deliver. 
An initial project, focused on simpli fying their intercompany requests, 
recharges and postings process to test the capability of process 
automation and its potential for wider use in the business. The automated process worked as follows: 
• Requests for intercompany transactions are forwarded to an 
automated inbox instead of  going to a member of the finance team. 
• They are submitted following a standard and consistent template. 
This allows the software to open the email and process the details 
of the transaction.  
• The details should be complete due to the standard template used 
enabling the system to verify the divisions involved, the general 
ledger codes, authorisation and narrative.. 
• Any omissions cause the request to be automatically rejected and 
an email is generated to notify the sender of the reasons. 
• Complete requests, are then accepted and the details uploaded into 
the purchase order sy stem automatically. 
• The purchase order then needs to be approved. 
• This approval triggers the next st age of the system and an invoice is 
automatically raised by the system in the division that initiated the 
process.  
• All relevant postings are then autom atically made in both divisions 
with sales and receivables on one side and expenses and payables 
in the other division.

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 The automation process has improved the consistency, accuracy and 
timeliness of the intercompany recharge process. Due to the fact that all 
postings are controlled by the single process there are no longer issues 
with intercompany balances not agreeing. It also allows for simpler 
reporting and increased detail wit h regard to workflows. 
The work has freed up finance staff time  to focus on more value adding 
activities and improved the understandi ng of the core process that has 
been redeveloped.  
 
 Value Co, a chain of supermarkets, is taking action to increase process 
automation in the finance functi on for repetitive tasks such as 
intercompany transactions and reconciliations.  
Which ONE of the followi ng is a disadvantage of taking such action? 
A Free up management time 
B Increased risk of human error C Less training costs D Resistance to change 
2.4 Artificial Intelligence (AI)  
AI and machine learning  are anticipated to lead to significant impacts on the 
future of accountancy. Process automation  as discussed above, will be 
enhanced by AI enabling automated reasoni ng making automation more flexible 
and capable of dealing with complexity. AI enables computers and machines to  exhibit higher level, human style 
learning. A system can interpret data correctly and over a period of time 
continually learn to interpret data better by understanding the differences 
between its interpretations and the actual outcomes. 
 
Illustration 4 – Artificial Intelligence and forecasting – Salesforce 
 Saleforce.com  a cloud based provider of CRM systems, has embraced 
the capability AI to aid their revenue fore casts. The process of 
forecasting is built on data but wit h a very significant human input. 
Research has shown this human input is clouded by emotion and 
confirmation bias and often amounts to  little more than hunches and gut 
feeling. 
By investing in AI the data becomes the key dr iver of forecasting and 
treats the process of forecasting in  a more scientific manner. Using a 
data driven approach allows for a solid rationale to be visible behind the 
forecasts that are produced.

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 For it to be successful t he Chief Information Officer of Salesforce  asserts 
that data needs to be seen in the day  to day operations of a business. 
This will act to aid understandi ng and buy-in to the process. 
For instance in a sales driven business forecasting often involves the 
assessment of leads and the likelihood these will be realised. Each salesperson’s view and assessment of  these leads will be impacted by 
their own opinion and disposition. In troducing a data driven approach to 
assessing sales leads, will be consistent  and fact led, it will smooth the 
human inconsistency, enhance the forecasting and perhaps most significantly, improve the AI learning that can be achieved. This is done 
by the system interrogating and attempting to understand the differences between the forecasts and actuals. The data driving these differences is 
then ‘learned’ by the system  and will not be replicated in future forecasts. 
So over time the process of fo recasting will become increasingly 
accurate. 
The process of running this change at Salesforce , especially the human 
element wasn’t smooth and took time  but the CIO insi sts the improved 
forecasting it has resulted in has been more than worth any hardship.  
Artificial intelligence and accountancy 
Although artificial intelligence techniques such as machine learning are not new, 
and the pace of change is fast, wi despread adoption in business and 
accounting is still in the relatively early stages.  Increasingly, we are seeing systems that are producing outputs that far exceed 
the accuracy and consistency of those produced by humans. In the short to 
medium term,  AI brings many opportunities for accountants to improve their 
efficiency, provide more insight and deliv er more value to businesses. In the 
longer term, AI brings opportunities fo r much more radical change, as systems 
increasingly carry out decision-ma king tasks currently done by humans. 
AI, no doubt, will contribute to substantia l improvements across all areas of 
accounting, equipping acc ountants with powerful new c apabilities, as well as 
leading to the automation of many tasks and decisions. 
Examples include:  
• Using machine learning to code a ccounting entries and  improve on the 
accuracy of rules-based approaches, enabling greater automation  of 
processes 
• Improving fraud detection through more sophisticated, machine learning 
models of ‘normal’ activities and better prediction of fraudulent activities 
• Using machine learning based predictive models  to forecast revenues 
• Improved analysis of unstructured data, including contracts and emails. 
Despite the opportunities that AI  brings, it does not replicate human 
intelligence . The strengths and limits of this different form of intelligence must 
be recognised, and users need to build an understanding of the best ways for 
humans and computers to work together.

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 Illustration 5 – AI and the Serious Fraud Office (SFO) 
 In the UK, the Serious Fraud Office (SFO) has invested in an AI system 
called OpenText Axcelerate . One of the main oper ations of the system 
in the SFO’s investigations involves interrogating huge volumes of 
documents. Connections between indi viduals and groups as well as key 
words and phrases can be identified and mapped in a way far beyond the capabilities of human workers. 
This has not only saved countless man hours spent trawling through and 
cross referencing documents, it has been proven to actually improve the 
process, identifying more connecti ons than the average human worker 
and crucially more complex and opaque connections that would typically 
not be spotted by the human eye.  This has therefore enhanced the 
investigative power and effe ctiveness of the fraud agency. 
2.5 Data Visualisation 
This area of technology is of particular si gnificance to the finance function of an 
organisation. The provision of informati on to help support the efficient and 
effective running of all functions within a business and the business overall is the fundamental purpose of the finance function . 
Big data and data analytics are now mainst ream in business. This growth in 
data and the need to communicate the information and insights to be found within the data makes data visualisation  critically important to the finance 
function. The ability to make data relevant, accessible and easy for all end users is vital. 
Key benefits of data visualisation 
• Accessible – traditional spreadsheets and financial reports can be both 
difficult to understand and unappeali ng to look at. Modern data 
visualisation graphics and dashboards are designed to be user friendly 
and intuitive 
• Real time  – synchronising real time data wit h data visualisation tools gives 
live up to date numbers in a clear, informative style. This allows quicker 
response to business changes rather t han waiting for weekly or monthly 
reports 
• Performance optimisation  – the immediacy and clarity of the information 
being displayed supports better decis ion making and proactive, efficient 
utilisation of resources as pr oblems are identified promptly 
• Insight and understanding  – combining data and visualising it in a new 
way can lead to improved understandi ng and fresh insights about the 
cause and effect relationships  that underpin performance.

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 Illustration 6 – Visualisation,  key performance indicators 
 Key performance indicators  are a set of metrics used by a business to 
monitor performance in areas where thi ngs must go according to plan for 
the business to be successful. These critical areas must first be identified, 
and then suitable metrics established to monitor performance, before 
finally setting targets to outline the level of desired performance. 
The ability to receive real time information about critical areas and feed 
this back to staff allowing them to understand current performance and 
respond accordingly can be the difference between success and failure. The collection and analysis of the data are underpi nned by the ideas of 
big data  however bringing this data to life in an easy to understand and 
intuitive fashion is the purpose of data visualisation.  
Companies are increasingly using  dashboards  (a collection of key 
infographics displayed together) to disp lay key performance indicators to 
staff in real time and to flag areas requiring improvement in order to hit 
the pre-determined targets and drive success. This instant feedback 
allows for action to be taken quick ly to highlight and fix potential 
problems. 
For instance an IT service desk within a business will use key 
performance indicator dashboards to m onitor and display performance for 
all staff and the departm ent as a whole. 
Metrics such as the number of suppor t tickets logged, time taken to open 
support tickets, time ta ken to resolve support tickets and customer 
satisfaction would all be displayed clearly using graphics. If performance in any of the areas is  falling below target levels the 
graphics will clearly display this, prom pting action to resolve the poor 
performance. 
 
 Which TWO of the following  are benefits of data  visualisation for the 
finance function? 
A User friendly and intuitive 
B Regular monthly reporting C Create fresh insights into the data D Wider use of performance metrics

162  
2.6 Blockchain 
Blockchain is most widely understood in the context of cryptocurrencies such 
as Bitcoin  as illustrated in Chapter 5. The illustration below compares a 
traditional payment to a payment using cryptocurrency, demonstrating the key 
differences of the blockchain transaction. 
 
 Illustration 7 – Cryptocurrency, how do they work? 
 First, consider a transaction usin g a standard currency like pounds or 
dollars for instance. 
• Making a purchase, you present your  payment card to the retailer, 
they then process the payment.  
• In doing so the card payment machine essentially asks your bank 
do you have sufficient funds to make the purchase. 
• The bank then checks its ledgers to verify whether you do in fact 
have the money to make the purchase. 
• If so, the bank gives authorisatio n to the retailer, processes the 
payment and updates its ledgers. They  also charge a small fee for 
doing so. 
• If other intermediaries such as cr edit card companies or PayPal are 
added to this process they also take  a slice to pay for their input. 
Cryptocurrencies such as Bitcoin  essentially act to remove the bank 
from the process, they use  blockchain  technology to both authorise the 
transaction and then also record it, in what is known as a distributed 
ledger. This replaces the single ledger that is held by a bank, with many separate or distributed ledgers which are all individually held by different people (or essentially computer servers)  they all independently verify the 
transaction and record the movement of  cryptocurrency at the same time. 
The fact that multiple different l edgers all support the same information 
acts to verify the legitimacy of t he transaction. If one of these ledgers 
tried to record something different, or effectively cheat, this would not 
agree with the other ledger s and would be refused. 
So the process for the transaction using a cryptocurrency would be: 
• I would present my payment deta ils to the retailer, detailing my 
cryptocurrency account 
• They would then present this to the distributed ledgers, so 
effectively would ask all of these different independent ledger holders whether I had sufficient cryptocurrency to make the 
payment 
• If they all agreed that I did, t he transaction and the payment would 
then be authorised and all of the distributed ledgers would update 
their records to re flect the movement

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 • Note:  It is here where an inaccurate  entry would be rejected, if 
someone attempted to change their l edger it would be flagged up as 
different to all of the other ledgers and would not be processed 
• The reward for the l edger holders is that one randomly selected 
ledger would be given some newly created cryptocurrency for each 
transaction. 
This distributed ledger approach remove s the central inte rmediary i.e. the 
bank and distributes it in essence to everyone. 
Blockchain and the finance function 
Blockchain is the most notable example of  distributed ledger technology. Its use 
will impact upon the current operations of the finance function of an 
organisation. Digital assets recorded and secured by blockchain technology 
such as cryptocurrencies, present  both opportunities and challenges. 
Financial reporting  – Accounting for cryptocurrency is currently a grey area for 
standard setters and exactly how they shoul d be classified is subject to ongoing 
debate. Accounting standards were not designed with such technological 
developments in mind and therefore do not have an applic able standard. 
Whether cryptocurrencies should be considered as cash, an intangible asset, a financial instrument or even inventory have all been discussed with elements of 
each standard working and fa iling in equal measure. 
Cross border payments  – these remain complex, expensive and slow. The 
actions of intermediaries, the fees charged and the exact timescale is often 
opaque. Blockchain driven solutions such as RippleNet  are growing in number 
and use. They aim to make the transfer of  money like the transfer of data, easy 
and seamless by circumventing the traditi onal centralised intermediaries i.e. 
banks and payment providers. 
Smart contracts  – self executing contracts us e blockchain technology built 
upon cryptography, digital signatures and secure computation. Theoretically 
money, property or any assets can be exchanged in a transparent manner. The 
document is created and agreed upon and then verified by the distributed 
ledger. The performance obligations, if me t, execute at an agr eed time and date 
and cannot be tampered with, without validation.  
Security & traceability  – the distributed ledger means all network participants 
involved in a blockchain hold a copy of t he full ledger. Any attempts to amend a 
single block will become invalid and the peer to peer network will be 
immediately aware. All blocks ar e time stamped and secured through 
cryptography. This may fundamentally im pact how finance functions record 
transactions with third parties.

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Examples of how blockchain can enhance the accounting prof ession include: 
• Reducing the costs of mainta ining and reconciling ledgers  
• Providing absolute certainty over the ownership and history of assets 
• Helping accountants gain clarit y over available resources  
• Freeing up resource to concentrate on value adding activities rather than 
record-keeping. 
 
 Lyric Co is a record company that uses music artists to record songs and 
produces the music itself. Revenues from sales of music come from 
physical sales in music stores , downloads from websites, and 
commissions from radio stations. Ly ric Co wants the revenues to be 
distributed in pre-determined measures (i.e. a certain percentage) to the artist and the record company as long as agreed performance requirements are met.  
Which ONE of the followi ng areas of technology should they look to 
use? 
A Artificial intelligence 
B Cryptocurrency C Blockchain D Digital Mind-sets 
2.7 Internet of things 
The internet of things  considers a network of smart devices with inbuilt 
sensors and internet connectivity. They collect and transmit data constantly and 
are an increasingly significant element of big data .  
The ability to make virtually any asse t a business owns and operates a ‘smart’ 
asset by building in some relevant sens ors and internet connectivity can lead to 
some very useful data. It should facili tate better business planning, resource 
allocation and will help to optimise processes, minimise expenditure and give 
advanced warning of potential issues. 
It is thought the finance prof essionals will work increasin gly closely with the IT 
function of a business as the two func tions overlap and require each other’s 
mutual knowledge.

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 Illustration 8 – Internet of things. Rolls Royce 
 Rolls-Royce , manufacturer of aircraft engines, has embraced the 
capabilities of the internet of things  and big data  and this has 
fundamentally changed their business model. 
Rolls-Royce engines are manufactured with hundreds of sensors built in 
throughout the engine unit. These sens ors produce constant live data 
which is fed back to systems engineer s at centres across the globe. Any 
anomalies are immediately flagged and the engineers can make an 
assessment from the vast array of data available as to the best course of 
action. Preventative maintenance can be scheduled much earlier than would ordinarily be possible and can be planned for the most convenient 
and cost effective time and location. 
AI is anticipated to replace the hum an intervention over time as its 
capability and reliability improves, the st akes are very high when it comes 
to aircraft engines so t here is no room for error. 
This new way of monitoring the performance of their engines has 
facilitated design improvements for new models and has led to an entirely 
new business model in how Rolls-Royce  ‘sell’ their engines. Customers 
are now charged per hour of use of  an engine and have a package called 
total care that covers all maintenance and upkeep of the engines. 
2.8 Mobile technologies 
Mobile technologies are a fundamental aspect of modern life, most notably 
smartphones  and tablet computers . Their use continues to drive changes in 
how we live and work, creating both opportunities and threats as new ways of operating and entirely new business models emerge. 
The impact of mobile technologies on t he finance function remains modest. The 
focus of this technology and the bulk of  investment has been on changing the 
way we communicate and interact with customers and ensuring we are in tune 
with customer expectations. 
From the finance function perspective t he use of mobile technologies has 
centred on efficient communication within teams. There remains little practical 
day to day application of smart phones and tablets in the actual functioning of 
the accountancy operations. Some areas and efficiencies delivered or facilitated by mobile technologies 
include: 
• Communication and flexibility  – smart phones and t ablets help deliver 
flexible working and facilitate im proved communication between staff 
• Scalability  – mobile tech and cloud tech co mbined, overcome some of the 
obstacles traditionally associated with starting and growing a business, 
most notably the capital co sts of setting up systems and IT

166  
• Less paperwork  – use of mobile technology has reduced duplication and 
data entry. For instance new app so ftware for logging and recording 
expenses has reduced manual processi ng, whilst delivering significant 
efficiencies and better quality management information 
• Instant data visibility  – accessing and communicating key data through 
data visualisation tools such as dashboards. Key metrics can be viewed 
live by all 
2.9 3-D printing 
3-D printing  as discussed in Chapter 5 , is a process driven by CAD and CAM 
technology that allows almost anything to  be printed to exact specifications as 
defined by the system. It has transform ed the way products are prototyped and 
is anticipated to continue to increase in significance as technology develops and 
associated costs reduce.  
The impact on the finance function is largely from a costing perspective, 
practically dealing with the changes in operations this technology allows: 
• Less waste as the material is printed direct ly so no offcuts or by products 
• No overproduction as products are made to exact specification as 
ordered rather than being produced in volu me to a forecast demand level. 
• An increase in  direct costs as the time spent setting up the systems, the 
materials used and the parts handling are all distinct to a specific job. 
• Minimal tooling and set-up costs make small production runs and 
bespoke products cost effective. 
• Inventory holding of finished goods should be zero and with effective 
supply chain management raw materi als should be delivered following the 
‘just-in-time’ principle meaning practically no holding of raw materials 
 
 3D printing is classed as wh at type of manufacturing? 
A Just-in-time 
B Subtractive C Lean D Additive

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3 Digital mindsets 
3.1 Digital mindsets 
 A digital mindset is the concept of seeing beyond the individual elements 
of digital change, to understand the deeper all-pervading ways in which 
digital technology will ultimately tr ansform every aspect of society and 
therefore impact an organisation. 
A ‘helicopter view’ is a feature associat ed with strong visionary leaders. It is the 
ability to take a step back from an or ganisation and achieve a clear overview. 
It’s about seeing the bigger picture, not getting stuck in the smaller detail and 
appreciating how all of the elements of the organisation interconnect.  
A digital mindset is an extension of this idea and requires leaders and staff to 
see beyond the smaller incremental consid erations of digita l adaptation, instead 
thinking about the longer term vision fo r the organisation and how it will appear 
in a digital world.  
The five following qualities, practi ces and approaches we re identified by Forbes 
as being important dimensions of the digital mindset : 
• Provide vision yet empower others – clear vision of how a business 
should evolve and transform in this digital age, whilst supporting the 
initiatives of employees in translating this vision into tangible action 
• Give up control yet ‘’architect’’ the choices – empowering employees to 
adapt the organisation but maintainin g sufficient oversight to shape and 
direct the process 
• Sustain yet disrupt – existing business practice s must be sustained and 
enhanced where possible to ensure pr ofitability. New ideas and concepts 
will disrupt and challenge the status quo, but must be protected and 
nurtured for their future prospects 
• Rely on data yet trust your intuition – data is a powerful tool in decision 
making but the digital mind-set is forward looking and change focused so 
looking beyond the numbers and using vi sion and intuition are important 
skills 
• Be sceptical yet open minded – there are many new technologies and 
approaches that emerge and could potentially be the ‘next big thing’ or simply disappear. It is important to ma intain a degree of caution yet to also 
consider and try things to l earn lessons and see what fits.

168  
3.2 Implications of a digital mindset on th e finance professional 
Acknowledging and accepting that technology will increasingly change and 
disrupt the ways in which society, organisations and therefore the finance 
function operates will be an impo rtant part of a finance professionals skill set. 
Change adept organisations have the capability, capacity and readiness to 
deal with change, through flexible st ructures, lean processes and forward 
thinking. A key element of being change adept is having staff who share these 
attributes, so finance professionals must focus on having what Dr Carol Dweck described as a growth mindset . This is an appetite to continuously develop 
and learn. Feedback will be openly given a nd received and viewed as a tool for 
growth rather than criticism and confrontation, change wil l be embraced as a 
challenge and opportunity not seen as threat. 
 
 Illustration 9 – Change as opportunity OR threat 
 A digital mindset  talks about seeing the bigger picture and 
understanding the potential of new technology and the limitations of existing processes and ways of working. 
An early illustration of this is the company Kodak.  
Kodak developed the first digital camera in 1975 but didn’t pursue the 
innovation at the time as they viewed it as a threat to their core business 
of selling single use phot ographic film. Eventually digital photography was 
developed by Kodak’s competitors and became mainstream leading to 
the decline of the traditional film business.  
Therefore Kodak lost both their core business of photographic film and 
didn’t benefit from being t he pioneer of digital photography by seizing the 
opportunity they discovered and being first to market. They did eventually enter the digital ca mera market but were just another 
name among many. As digital came ras became commodity items and 
cheap to purchase Kodak floundered before fili ng for Chapter 11 
bankruptcy in the US in 2012. A proactive digital mindset , seeing the bigger picture of technology 
beyond the here and now, would have enabled Kodak to embrace the 
opportunity of this new technology and may have seen a very different 
story for the business.

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4 The finance function and process automation 
4.1 Impacts on the finance func tion of increased automation 
Technology and software developments ar e driving an increase in process 
automation across the finance function. Routine and transactional areas such 
as balancing ledger accounts and extracting trial balances and accounting summaries have been automated since computerised accounting packages came on to the market many years ago. 
As technology continues to develop more areas of finance are becoming 
automated or are likely to become automated. 
 
Illustration 10 – New technology impacting finance. Expenses. 
 The process of dealing with staff ex penses has long been inefficient and 
unnecessarily complicated, new technology businesses like Certify or 
Rydoo  allow staff to photograph receipts instantly on their mobile device, 
this uploads the receipt which is  synchronised with their software 
account. The details are extracted,  categorised and where required can 
be submitted for approval immediat ely. Exceptions can be flagged and 
reports can be generated showing line by  line detail along with supporting 
receipts and mileage maps. A pproved expenses can then be 
automatically reimbursed to the em ployee. The information from all 
employees is available in instant reports, allowing improved analysis and 
control.  
The process still involves hum an input but the software enabled 
automation of the compilati on and submission of expenses as well as the 
removal of manual receipts and the need for physical verification saves 
staff time and improves the effi ciency of the process whilst also 
significantly improving the m anagement information available. 
4.2 Skills required by the future finance professional 
Accountants and finance professionals in the future will see basic routine, 
transactional work reduced with a shift to higher level skills. The following skills 
are anticipated to be fundamental  to future accountants: 
• Analytical skills – much of the data produc ed will come from automated 
processes and data specialists. Accountants will add value through 
analysing this data in the business context for meaning and insight 
• Business acumen – having a wide understanding of all aspects of a 
business and the environment they are in  is crucial to effective decision 
making and the ability to provide insight to other functions 
• Judgement – making decisions, evaluating data sources and applying 
knowledge to make sound judgement s will be a key higher level skill

170  
• People skills – interpersonal skills including the ability to communicate, 
empathise and understand people will be increasingly important as 
accountant occupy more central busine ss partnering roles, rather than just 
producing accounts and reports for others 
• Leadership –  accountants have a unique centra l position in organisations. 
This is necessary to be able to understand and question the numbers and 
information they are given. This provides them a wider understanding of the entire business and sees account ants increasingly occupying senior 
executive positions in companies.  
 
Illustration 11 – Automation. Wh ere machines will replace humans. 
 A 2017 McKinsey  report, investigated occupational activities where 
machines would be most likely to replace humans. 
The report summarised that roles involving routine repetitive 
programmable tasks such as  data collection, data processing and 
repetitive physical activities are most at risk.   
The following is a summary of the extent to which various role types were 
believed to be automatable: 
Data collection – 64%  Data processing – 69% Applying expertise – 18% Stakeholder interactions – 20% Managing others – 9% As these numbers illustrate some relatively basic areas associated with 
today’s finance professional are likely to disappear, at least partially. Other areas with higher level skill s are likely to become much more 
significant. 
4.3 The automation paradox 
Increased automation of routine tasks takes them out of human control. This 
can result in the loss of these skills on a practical level, as the automated 
process takes over and is relied upon.  
However atypical events can undermine an automated process as they are built 
by humans using code and algorithms that cannot accommodate all possible 
permutations. In this situation, where m anual control is required, the deskilling 
of humans can see organisations unable to cope and therefore slow to respond. 
Retaining expertise  and ensuring knowledge and understanding of the basic 
functions of accounting systems and how they operate will be a challenge for 
the modern finance professional.

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For example the basic process of m anually maintaining ledger accounts and 
balancing them off is fundamental to ever y bookkeeping course yet it is a task 
seldom undertaken by accountants t oday. Modern accounting systems perform 
multiple checks and balances automatica lly. Yet this underpinning knowledge is 
essential to ensure a full understanding of how the system functions and means 
an accountant can step in  should the system fail. 
5 Ethics of technology usage 
5.1 Legal considerations of technology use 
Technology  – as discussed in Chapter 5, da ta is a central aspect of the 
technology developments driving t he 4th industrial revolution. 
The amount of personal data available to  and used by organisations means that 
the privacy, sensitivity and security of this data are very significant 
considerations in modern business.  
A business must ensure it is compliant with all legislation but there are also 
considerations from an ethical and social responsibility point of view in terms of 
what is right and wrong in the eyes of the public. 
Data protection  – General Data Protection Regulation (GDPR) was introduced 
throughout the EU in 2018. It is legislati on which details the following principles 
about data: 
• Used fairly, lawfully and transparently 
• Used for specified, explicit purposes • Used in a way that is adequate, rele vant and limited to only what is 
necessary 
• Accurate and, where required, kept up to date • Kept for no longer than is necessary • Handled in a way that ensures appropriate security. Including protection 
against unlawful or unauthorised processi ng, access, loss, destruction or 
damage. 
Data controllers  within organisations have to ensure adequate safeguards and 
controls to implement these data principles. 
Background to GDPR  
This new legislation was designed to ov erhaul the previous data protection act 
from 1995. This was written at a time when the internet was in its infancy, 
smartphones didn’t exist and some of the largest and most influential 
companies in the world such as Fa cebook, Google and Amazon were barely 
even conceived.  
The way data is used in 2018 and beyond r equired new laws that were fit for 
purpose and designed with the modern landscape in mind and are therefore 
able to safeguard the privacy and  rights of individuals today.

172  
 Illustration 12 – Facebook and Cambridge Analytica scandal 
 Facebook received a £500,000 fine for its role in the Cambridge 
Analytica scandal. The fine was the maximum available under the data 
protection legislation in place at the time (prior to the introduction of 
GDPR legislation). 
Facebook was found to have breached data protection legislation by 
allowing third party app developer s access to users data without 
sufficiently clear and informed consent. They also failed to make suitable 
checks on apps and developers using the platform. 
What was the Cambridge Analytica scandal? 
A third party app designed as a persona lity quiz collected the data of 87 
million Facebook users without their kno wledge or explicit content. This 
data was then sold on to third par ties, one of whom was Cambridge 
Analytica.  
They then used this data to profile voters in the US election based on 
personality and psychology before ta rgeting advertising which took 
advantage of this information. Around 1 million UK users’ data was obtained in the scandal. 
 
 GDPR legislation in the EU attemp ts to ensure that organisations follow 
the principles about data.  
Which of the following are contained in those principles? Select all 
A Data is kept up to date 
B Data is kept for longer than is necessary C Data is used for implicit purposes D Data is protected against unlawful access 
E Data should always be in hard copy format 
5.2 Ethical and social consid erations of technology use 
 Ethics is a system of moral principles that affect how people and 
organisations make decisions. It involves acting in a way deemed 
acceptable by society. 
Ethical and social considerations  – Compliance with legislation such as the 
GDPR laws noted above is something that all companies should achieve. However the question of whether th is is sufficient opens up ethical 
considerations as to what companies  should  do and how they should act.

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Why are ethical and social considerations important? 
• Ethically sound companies give investors’ confidence 
• Customer confidence in data security is vital in the digital age and is an 
important element of brand confidence 
• Consumers feel safer dealing with companies that are proactive and 
responsible in their use of data 
• Employees are attracted to companies that exhibit a strong ethical stance 
• Helps ensure long term sustainabi lity of an organisation through 
stakeholder confidence and trust 
• Demonstrates a proactive and an aw areness of risks associated with data 
 
 Illustration 13 – Microsoft AI ethical principles 
 Microsoft  is one of a number of high prof ile technology companies to lay 
down a voluntary set of ethical principles surrounding its use of artificial 
intelligence (AI). AI is an area of technology  that presents some of the 
most challenging ethical questions. 
Microsoft’s AI principles: 
Fairness – AI systems should treat all people fairly  
Reliability & safety – AI systems should perform reliably and safely  
Privacy & security – AI systems should be secure and respect privacy  
Inclusiveness – AI systems should empow er everyone and engage 
people 
Transparency – AI systems should be understandable  
Accountability – AI systems should have algor ithmic accountability 
5.3 Corporate digital responsibility 
Corporate digital responsibility or CDR  is a relatively new concept which 
extends the idea and ethos of corporate social responsibility (CSR) to the 
digital world. It is a voluntary commitment by organisations to go beyond mere compliance 
with legislation, when it comes to how they handle technology and data. It 
considers the broader ethical values of organisations driving forward the advancement of technology to do so in a manner that is fundamentally leading 
toward a positive future. 
CDR involves a commitment to protec ting both customers and employees and 
ensuring that new technologies and data are used both productive ly and wisely.

174  
The development of a CDR strategy is increasingly common in modern 
business and would include the following 5 key areas: 
• Digital stewardship , using data in a responsible and secure way that is in 
line with customers and employees ex pectations of what is reasonable 
• Customer expectations  around data use and the need for transparency 
are increasing. The ability to opt in and be rewarded for sharing data 
empowers the consumer 
• Giving back  a bank with knowledge of financial information could help to 
inform a customer's choices to im prove their financial management, even 
if it meant a loss of ov erdraft or credit card fees. Additionally companies 
can share data in a benevolent way to help society: for instance a 
pharmaceutical company sharing clinical trial data with university researchers for no gain. 
• Data value is becoming increasingly apparen t to customers as well as 
businesses, so the need to reward and in centivise customers to give more 
data will become the norm 
• Digital inclusion  is about ensuring all member s of society have the skill, 
tools and ability to access the online digital world, and are not left behind through lack of education or opportunity. Businesses need to be proactive to help and support users and reduce barriers and obstacles. 
 
Test your understanding 7 
 X Co is a traffic data management company, involved in town planning 
and transport logistics. They heavily invest  in software to l ook at real time 
data on the impact of cycle lanes, new r oads, types of cars etc on traffic 
times in city centres. This wealth  of knowledge has been built up for 
years, and recently X Co has looked at the possibility of sharing this 
information with hospitals and the em ergency services, free of charge. 
This is to help the emergency services get to incidents quicker.  
What is this project a specific example of? 
A Corporate digital responsibility 
B Corporate social responsibly C Lobbying D Artificial intelligence

176  
 The correct answer is all options . They will all be impacted in some way 
by big data. 
 
Process automation brings uncer tainty and change, which means 
employees, may resist change. Proc ess automation brings advantages 
such as freeing up time for value added activities and improving accuracy 
by removing human error. It may involve more training costs to 
understand how the software may work. 
 
 The correct answer is A and C  
Data visualisation uses graphics and dashboard to be user friendly and intuitive. It also allows better und erstanding and fresh views on the data. 
Data visualisation can use real time data, to avoid mont hly reporting. It 
does not necessarily involve a wider use of performance metrics, data visualisation just shows t hem in different ways.  
 
Blockchain would allow smart contra cts to be used, which are self-
executing and can’t be ta mpered with. Artificial intelligence wouldn’t be 
needed to make decisions. Cryptocurrency uses blockchain to underpin the digital transactions. Digital mind- sets look at how technology may 
impact society.  
 
Additive manufacturing is creati ng additional layers to build up a 
structure, like 3D printing. Subtract ive manufacturing removes layers e.g. 
cutting sections. Just in Time generates  raw material orders to coordinate 
with demand to reduce production cycles. Lean manufacturing concentrates on waste reduction.

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GDPR wants data to be kept up to dat e and protected. It also requires 
data to only be kept for as long as necessary and that it is used for 
explicit, specified purposes. Data can be stored in a variety of formats.  
 
Corporate digital responsibility (CDR) goes beyond legislation when 
handling technology and data. Corporate social responsibility looks at maximising positive impacts on society and minimising negative, and may incorporate CDR. Lobbying tries to in fluence the policies of government 
officials. Artificial intelligence is t he creation of intelligent machines that 
work and react like humans.

179 
Data and the finance 
function 
C1: Data and the finance 
function. (a) General usage of data in 
finance 
(b) Specific usage of data in 
finance 
 Chapter 
7

Data and the finance function 
180  
 
We have introduced some of the key developments in technology which are 
transforming the world in which we work and live.  
In this chapter we will look more closel y at the growing im portance of data and 
how this is both a key driver of new tec hnologies, whilst also being a product of 
these same technologies. We will also look at how data is us ed by businesses across their various 
functions to help increase sales, gener ate new and innovative products, control 
costs and drive operational efficiencies. 
2 Technology, data and improved information 
2.1 The importance of information to decision makers 
Decision making is a vital task in any business and takes place at 3 different 
levels in an organisation; stra tegic, tactical and operational. 
Strategic – Long term, complex decisions made by directors and senior 
management. Decisions at this level impact the overall strategic direction of an 
organisation.  
Tactical – Decisions are medium term and invo lve putting the strategic plan into 
action. This may involve selecting what products to stock in the current season 
or whether to open new branches. Operational – Day to day decisions at junior  levels of management concerned 
with the practical running of the business in line with plans set higher up the 
Information  
 Information is data, processed in su ch a way that it has meaning to the 
person who receives it; this can t hen be used to improve the quality of 
decision making. 
Accountants and the finance function are tasked with providing high quality 
information to support the successful operation of a business. The more insight 
this information can provide the more valuable it is to an organisation.  
Some of the technological developments discussed in the previous chapters, are providing and utilising data on a new le vel, which if harnessed correctly can 
provide high value information, facilitating enhanced decision making across 
all levels of an organisation.

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Some of the benefits of enhanced information include: 
• Greater customer insights  
• Potential for new source s of competitive advantage 
• New business models and revenue streams   • Operational efficiencies offering significant cost savings as well as 
improved products and service for customers 
• Quicker more reacti ve decision making   
• Early warning of potential problems  • Customised products specific to a customer needs 
 
 Which of the following is th e definition of information? 
A A large store of data obtained from a wide variety of sources that can 
be used for decision making. 
B Raw and unprocessed numbers, fact s or symbols that may contain 
valuable information if analysed effectively  
C A structured set of data held in a computer 
D Data processed in a way that it has a meaning to the person who 
receives it 
2.2 Technology and data  
 Data is raw and unprocessed numbers, facts or symbols that may contain 
potentially valuable informati on if analysed effectively. 
Big data, data analytics and insight 
Big data  and data analytics are providing new insi ghts and understanding of 
all aspects of the world around us. Acce ssing these insights is an opportunity 
for businesses but also a sizeable challenge and a potentia l threat should a 
business fall behind its rivals. 
The main sources of big data are the technologies seen in previous two 
chapters, the most significant being the internet, mobile technologies and the 
internet of things. These technologies facilitate software, applications (apps) 
and websites which generate vast amounts of data every second of every day.

182  
 Illustration 1 – The scale of big data 
 Internet  – There are 5 billion internet  searches every day and in 2019 
almost 2 billion people made online purchases, with each individual 
search and transaction providing multiple data points 
Mobile technologies – Smartphones have sound sensors, image 
sensors, touch sensors, an accelero meter, a light sensor, a proximity 
sensor and positional sensors for GPS. These are all used in the 
functioning of the smar tphone but also produce enormous amounts of 
data continuously Internet of things – there are expected to be 200 billion ‘connected’ 
devices by 2020, all with multiple sensors generating co nstant data about 
how devices are used and performing Applications, software and websites – Facebook has over 2.3 billion 
users, with 1.1 billion active mobile users daily on the site. Users of the 
site generate 4 million likes every minute. 
2.3 Improving information for decision makers 
Decision makers at all levels of an organi sation rely on good quality 
information to help inform and guide them. Whether it is an aged receivables 
report used by a credit controller or an in vestment proposal being considered at 
board level, the information us ed will be built from data.  
In order to improve the information for decision makers, an organisation needs 
to improve the data being used to generate the information. 
Internet of things,  social media  and the internet  itself are three significant 
sources of data for organisations. Co llecting this data and using it in a 
deliberate manner is hugely beneficial to decision makers for the following 
reasons. 
• Enhanced data transparency – Improved systems for handling data 
allows new meaning to be found in data which may have previously been 
unviable to process. Technological developments allow data to be more easily integrated with other data sour ces across the business, generating 
greater insight.  
• Enhanced performance – Real time monitoring of data, summarised into 
key metrics can enable corrective ac tion to be taken immediately to 
improve controllable c hanges in performance. 
• Market segmentation and customisation – Data can enable new market 
segments to be identified, which may previously have been lost within a 
broader market segment. Once identif ied, this segment can be more 
actively targeted with a customised message.

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• Improved decision-making – Better understanding and insight into 
consumer behaviour through detailed dat a analysis can facilitate improved 
decision making. For instance choosing which products to stock not just 
based on sales volumes but due to related purchases they encourage and the type of customer they  attract are insights dr iven by deeper data driven 
understanding. 
• New products and services – Understanding the va rious drivers that 
prompt customers to purchase a spec ific product or service over another 
can provide valuable insight into t he development of new products or 
service offerings. 
• Operational gains – Detailed insight into a business’s operations can 
highlight potential efficiencies, cost savings and service improvements that 
can give a company an advant age over their rivals.  
3 Data and technology u ses in sales & marketing 
3.1 Sales and marketing 
 Marketing is defined as the mana gement process that identifies, 
anticipates and supplies customer needs efficiently and profitably. 
Marketing is considered in detail in Chapter 10 . In this section we are 
considering how the use of technology and data  can help both the marketing 
and sales functions within a business. 
Data use in marketing and sales – Big data and the use of smart technology, 
which collects relevant data,  summarises it and pres ents the key findings, are 
driving real changes in the way businesse s choose what to sell, the price to 
charge, when to sell it and when to discount. The use of data is providing real, fa ct based insight into customers and 
competitors actions and thereby acting to remove a lot of the ‘guesswork’ from 
the business critical decisions made in the marketing and sales departments. 
Pricing – Is a critical decision. Price too low and a business misses out on 
potential revenue, price to high and sale s volumes will be low, followed by 
heavy discounting which can reflect badly on brand image. Live market data 
allows a company to compare and benchmar k prices across an entire industry, 
as well as seeing the rate of sales. This  data indicates the right price point for a 
given product so the first price of a product can be set optimally. 
Products – The days of retailers buying huge quantities of products in advance of 
distinct seasons are a thing of the past. Re tailers test the mark et and constantly 
monitor what products and trends are selling both for themselves and their 
competitors. Short lead times allow produc ts to be sourced al most immediately. 
Segmentation – Analysis of buying patterns and social media trends and 
interactions can refine and identify new market segments by grouping similar data-points. This can be an opportunity enabling more target ed marketing; it 
may also provide data to show a segment isn’t as significant as first thought and 
may not be viable.

184  
Promotions – Data from past product launches and company promotions for 
an entire industry combined with the s ubsequent sales performance of those 
products provides huge insight into what  promotions work best and when. This 
can reduce the guesswork by supporti ng companies with real data. 
Customer relationship management (CRM) – Data on customers provides a 
profile which, together wit h their past buying trends, can make advertising and 
communications more personalised and tailo red to meet their specific ‘wants’. 
For instance knowing a customer likes a bargain means offering them a 
discount on specific items may lead to a sale. 
Targeting – By analysing market trends and seeing products, colours and 
designs that are on-trend and selling out  elsewhere, a business can then push 
specific items to the front page of their website or a pr iority position in store and 
incorporate it in their advertising,  targeted at spec ific consumers. 
 
 Illustration 2 – Data use in marketing and sales. Edited  
 Edited is a technology company that provides real-time data analytics  
software for retailers  and fashion brands. 
The software utilises AI and SpiderBots or web crawlers (these are 
automated programs which browse the web methodically extracting 
target data, such as pricing, styles, colours etc.) The Edited software pulls together key i ndustry wide metrics for the 
types of products being sold, thos e selling fast, the key colours and 
fashion trends and crucially pricing data. This information is available 
instantly and provides retailers wit h data on what products they should be 
designing or ordering, the pricing ar chitecture of products and what 
products should be discounted and by how much. 
All of this information is publically av ailable but the process of searching 
for and sorting this data would tradi tionally be a laborious and time 
consuming task and by the time the dat a was available or use it would be 
old. Edited cuts out the leg work and provides live data in a visually 
appealing and accessible way using data visualisations to highlight the 
key data points required.  The software is used by retailers such as John Lewis, Topshop, Ted 
Baker, Boohoo to name just a few.

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 Trolley Co is a supermarket. It analyses weather patterns and forecasts 
for the upcoming weeks, and links it to its product portfolio.  
In terms of marketing, which ON E area would this help the most? 
A Price 
B Place  C Segmentation D Promotion 
 
 Illustration 3 – Data use and CRM 
 By harnessing technology and building a profile on customers, even small 
independent restaurants are incorporating data driven  customer 
relationship management (CRM)  in driving repeat custom. 
Rather than taking a booking and it bei ng a one-time only transaction, a 
restaurant will collect data such  as an email address and/or phone 
number when taking this booking. This will then be used to create a new 
customer profile. 
In addition they will look at what the type of booking it is i.e. couple, 
group, family as well as the time and date of the booking. They may even 
try to find out if it is a special occasi on which could also be used for future 
marketing. The data collection continues as once the pr ofile is established what food 
you order and the drinks you have will also be added to the profile giving 
them an insight into what you like and what in future may prompt you to 
return. Then with all this data collected if t he restaurant notices that you are a 
fairly regular customer and you haven’t visited for some time. A marketing 
email can be generated; this can be tailored to hit the specific data held in 
your profile. For instance if every time  you visit you order the same starter 
the email may contain a pi cture of this dish to whet your appetite as well 
as offering a complimentary  starter on your next visit. This may well be 
enough to convince you to make that next booking.  
4 Data and technology uses in operations 
4.1 Using data to enhance operations 
Data and technology provide insights, and opportunity for businesses to drive sales growth and identify new revenue stream s, but it is also playing a major 
role for businesses in changing and im proving their internal operations and 
processes.

186  
This can lead to multiple benefits for a business, these include: 
• Cost saving – As with any efficiency gains, insights gained from the use 
of technology can generate significant  cost savings through alleviating 
bottlenecks, reducing waste and reducing downtime.  
• Improved service – Operational improv ements and live data in 
operational processes can lead to si gnificant service improvement and 
information availability for customer s. Modern logisti cs companies allow 
live tracking of all deliveries through the use of data and connectivity. 
• Supply chain – Big data is enabling increasingly complex supply chain 
networks through knowledge sharing and collaboration. Data sharing 
enables suppliers and customers to collaborate in order to modify either components or end products in the most cost effective manner 
• Preventative maintenance – Using an internet of things based 
approach, embedding sensors and connectivity in machines and assets facilitates continual monitoring of per formance. Deviations from expected 
performance give early warning of potential problems and preventative maintenance can be scheduled at a convenient time and before an asset breaks down. 
• Forecasting – Companies can use big data analytics to map the 
behaviour of customers, using sophi sticated forecasting and predictive 
modelling techniques in order to schedule production processes for efficient utilisation and order fulfilment 
 
Illustration 4 – Data use in manufacturing 
 A case study from consulting firm McKinsey looked at the manufacturing 
processes of a leading pharmaceutical company. 
The company manufactured vaccines  and blood components, in which 
the need for purity is critical. Over 200 variables were monitored to inform 
on the level of purity, these would vary between batches impacting the ultimate yield of saleable vaccine or blood products achieved each time. 
By analysing the huge amounts of dat a generated in the manufacturing 
process, 9 key parameter s were identified. Thes e were found to have a 
direct causal impact on the yield achi eved in the process. The company 
was able to then target improvements and consistency in these 9 specific 
areas to achieve increased standardisation and optimise these 
parameters, ultimately in creasing the saleable yiel d. Output data from the 
process is now tracked and monitored against target levels. 
The yield from the vaccine producti on process increased by 50% which 
led to savings for the business of over $7.5 million dollars per annum

Chapter 7 
 
 187 
 Illustration 5 – Data use in operations. DHL 
 DHL have invested heavily in an internet of things  based tracking and 
monitoring system using embedded sens ors in their various machinery 
and assets. This allows the business to track a huge range of metrics 
including vehicle behaviour and perfo rmance, the actual packages they 
are processing and environmental per formance through sensors in their 
warehouses and vehicles. All of this data is collected and harnessed to generate real time monitoring and process improvement as well as providing a huge array of data the busi ness can mine to identify further 
insight that may drive future performance improvement. 
This system at DHL is still in its infancy but is already generating 
efficiencies, cost savings and serv ice improvements. The long term 
picture promises vast improvements in the scale and capability of such 
systems to companies like DHL and by adopting this technology DHL 
hope to be ahead of the curve in realising the benefits the internet of 
things  and the big data it generates, can offer. 
 
 Core Co is a mining company. It ex tracts minerals from the ground using 
drills. Core buys drills that have software contained within them that 
records when each drill became oper ational; the hours used each day and 
the drill performance.  
Which ONE of the following  would be the main benefit to Core Co of 
this software? 
A Immediate cost savings 
B Improved customer retention C Preventative maintenance D Reduction of accidents 
5 Creating value from digital assets  
5.1 Digital assets 
 Assets held by a business in digita l form that do not have physical 
substance. This typically inclu des images, animations, audio, video and 
PDF files. 
The volume of digital assets  is rising rapidly in line with the increase in 
internet  usage, connectivity  and mobile technologies . These are the media 
upon which digital asset content is cons umed and are now central to everyday 
life. Digital assets have become a significant part of modern businesses and 
must be managed in a deliberate and coor dinated manner in order to leverage 
them to their maximum.

188  
5.2 Digital asset management systems 
A digital asset management system (DAM) is  designed to coordinate the digital 
assets of a business, ensuring they are held centrally in an accessible, secure 
and logically designed repository. This s upports the efficient  running of the 
business, by facilitating availability and use of these increasingly important 
assets. 
The finance function of a business would be involved in the process of 
building a business case for investing in a  digital asset management system , 
coordinating the search for a suitable provider of a DAM system and managing 
the change in working practices to inco rporate the system. This would need to 
be managed as a standalone project, out side of day to day activities. 
Features of DAM system include: 
• DAM systems are essentially a database specifically designed to manage 
digital assets 
• Single central location for digital asset storage and access 
• Often facilitated by cloud based softwar e, supporting security and allowing 
access from any location 
• Access levels built into the system, allow access only to those with 
authorisation  
• Assets categorised by format with associated metadata describing the 
content to facilitate search functionality 
 
 Illustration 6 – DAM system. American Kennel Club 
 The American Kennel Club (AKC) invested in a DAM system from the 
specialist provider Canto . 
The organisation is the authority on purebred dogs in the US, they 
maintain a registry of pedigrees and organise numerous dog shows. AKC 
hold a vast catalogue of digital assets, including photos, videos and 
certified documentation wh ich is all held electronically. Organising these 
assets for efficient use was a signifi cant challenge and countless hours of 
staff time was being spent scouring th rough a variety of locations on the 
network and hard drives trying to locate images or documents needed for promotional material, newsletters , their website and social media 
accounts. 
The organisation recognised the need for a solution to this problem and 
looked into DAM systems. Canto was the provider they ultimately opted 
for; they provided a cloud-based cent ralised library of digital assets 
tailored to their exact requirement s. Assets are logged in the DAM 
system with numerous tags or met adata, which provides detailed 
information about the asset to facilitat e easy searches, built on a user 
friendly platform with intuitive desi gn. This had made the use of these 
assets more efficient and saved hundreds  of staff hours searching for or 
duplicating content.

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Benefits of a digital asset management systems include: 
• Strengthen relationships across teams by  facilitating the sharing of assets 
and content 
• Improve service to customers and partners through easy asset sharing 
using web portals 
• A standardised approach to metadat a as prescribed by a DAM system 
eliminates wasted time spent search ing for files and digital assets and 
prevents duplication and re -creation of content.  
• Cost and space saving through use of cloud technology designed 
specifically for the purpose of managing digital assets 
• Version control, watermarking and em bargo dates allow increase security 
and protect assets from improper or untimely use 
• Provides valuable data on the usage and access of digital assets that can 
provide insight and direct the producti on and type of digital assets that 
generate value 
• Copyrighting and contact information can automatically be attached to 
every digital asset held. This prov ides consistency in publication and 
clarity to external users. 
 
 Y Ltd is a newspaper and magazine publisher, established over 100 years 
ago. In that time, they have collec ted millions of photos to accompany 
their news stories. The Board have decided they need to make more 
efficient use of the photo bank.  
Which ONE of the following would be needed to utilise the photo 
bank? 
A Augmented reality 
B 3D printing C Non-market strategy D Digital asset management system

190  
6 Data protection and privacy , practical considerations 
6.1 Data protection and privacy 
In Chapter 6 we introduced the ethical consi derations of technology use, 
looking at legal elements such as GDPR and the ethical and social side of 
things through corporate digital responsibility (CDR) . Here we will consider 
some the practical considerations of data protection for a business. 
 Data protection  can be defined as the process of safeguarding important 
information from corruption,  compromise or loss. 
Businesses as a minimum must ensure t hey are compliant with data protection 
legislation such as GDPR in order to avoid potential fines and legal recourse. 
Ideally a business should go abo ve and beyond the requirements of GDPR by 
having a strong moral and ethical st ance on how and why they handle data. 
This is covered by the concept of CDR covered in Chapter 6. 
As a starting point to assess the adequacy of a business’s data security, the  UK 
information commissioner’s office (ICO)  outlined the following key questions 
a business must address. Any questions t hat a business fails to answer should 
be immediately flagged as a critical weak ness, with immediate action taken to 
correct the issues identified. 
Key questions to assess data  security capabilities 
• Do you have a record of what personal data you hold? Do you know what 
you use it for? 
• Do people know you have their personal data and do they know how you 
use it? 
• Do you only collect t he personal data you need? 
• Do you only keep personal data for as long as it is needed? 
• Do you keep personal data accurate and up to date? • Do you keep personal data secure? • Do you have a way for people to ex ercise their rights regarding the 
personal data you hold about them? 
• Do you and your staff know your  data protection responsibilities? 
 
Test your understanding 5 
 Which of the following is not one of  the 5 key areas of an effective 
approach to corporate digital responsibility? 
A Digital stewardship 
B Digital inclusion C Digital sustainability D Data value

Chapter 7 
 
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6.2 Features of sound data management 
Traditionally data in organisations was not  viewed with strategic significance 
both from a risk perspective i.e. GDPR and legislation, and as an opportunity 
i.e. Big data . It would often be found under t he umbrella of IT due to the 
obvious crossovers. 
However as data has grown in signific ance organisations are changing their 
approach to how data and data managemen t fits within their overall 
organisation. The following are some of the features of m odern organisational 
structures and their approach to data: 
• Chief Data Officer (CDO) – This is an increasingly common executive 
role in larger organisations. The CDO  holds overall responsibility for 
governance and protection of data as well as strategies to optimize the 
use of data as an asset 
• Data strategy – Is now a deliberate and in tegrated part of overall 
corporate strategy. The SAS institute a specialist in data analytics 
identified the five following key building blocks of data strategy: 
– Identify – What data does a business hav e and require? What is its 
structure, origin and location? 
– Store – What structure and storage approach will enable easy 
sharing and access to data whilst ensuring it is adequately protected? 
– Provision – An overarching data strategy should ensure data is 
packaged to allow easy use throu ghout the organisation. Rules, 
guidelines and access leve ls will be essential. 
– Process – Current and existing data should be designed for easy 
clear and consistent processing. Un ifying separate data stores to 
maximise the processing potential. 
– Govern – Establish clear, consistent user friendly policies on the use 
and storage of data to ensure correc t use and minimise risk of data 
breaches. 
• Culture – Promoting the significance of  data at all levels of the 
organisation is essential. This must be led from the top of the business to 
show intent and commitment.  
• Training – Additional to the areas such  as health and safety and cyber 
security, data awareness training is increasingly mandatory to ensure compliance with legislation.

Chapter 7 
 
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Information can be used by people fo r decision making, therefore must 
have some meaning. A large store of  data is called a data warehouse. 
Raw and unprocessed numbers and facts is the definition of data itself. A 
structured set of data in a computer is a database. 
 
Weather patterns can dictate what pr oducts sell well at certain times and 
temperatures. This information can be used to promote specific goods, 
with in-store promotions such as end of  aisle displays.  Price is what the 
ultimately the products get sold for and how you set it. Pl ace looks at the 
length and breadth of dist ribution channels. Segm entation is dividing 
populations up into homogenous groups so  you can treat them the same 
for marketing purposes 
 
Software/sensors can give ideas of  when assets have reached their 
useful lives, or need to be replaced or improved. This may cost more 
initially, but leads to savings further  down the line. Customers would not 
necessarily see the impact of this. Accidents may still occur due to the nature of the work. 
 
Digital asset management looks at all assets held in a digital format. Augmented reality is an interactiv e experience where a real world 
scenario is augmented by computer  generated perceptual information.  
3D printing is an additive manufacturi ng process. Non-Market strategy 
looks at stakeholders outside of the no rmal commercial interests, such as 
governments.

194  
The other two areas of effectiv e CDR not listed are Giving back and 
Customer expectations. Dig ital sustainability is not a real concept and is a 
blend of elements of CDR and CSR.

195 
Data to create and 
C2: Data to create and 
organisations. (a) Data strategy and 
planning. 
(b) Data engineering, 
extraction and mining. 
(c) Data modelling, 
manipulation and analysis. 
(d) Data insight and 
 Chapter 
8

Data to create and preserve value for organisations 
196  
 
Having considered data and how it plays an increasingly significant role in 
modern business this chapter looks at more technical elements of data 
management and how these impact the finance function. 
We will consider the main stakeholders of the finance function, considering 
some of their data needs. Before taking a closer look at the data strategy of a business as introduced in Chapter 7 . 
2 Data strategy and planning 
2.1 Data requirements and stakeholders 
A stakeholder  can be defined in many ways but is often summarised as being 
anybody who can affect or be affected by an organisations actions. In this section we are more specifically inte rested in the stakeholders of the finance 
function of an organisation. So who would this typically include? 
• Other departments and managers – The finance function of an 
organisation conducts the budgeting process and provides important 
management information and performance data to all functions of an organisation 
• External stakeholders – Users of  the financial st atements include 
shareholders, lenders and investors.  Auditors, customers and suppliers w ould be other significant external 
stakeholders of t he finance department 
• Employees – Staff in the financ e department will clearly be a very 
significant stakeholder in the departm ent and will need to be considered in 
all future strategies 
• Directors – Key metrics and perfo rmance reports for the board are an 
important component of the finance department’s work 
Having considered the finance functi ons main stakeholders, the next 
consideration is what type of feedback we might receive from them and how 
could this impact the future data needs of the organisation. This would be an 
important element of informi ng an overall data strategy.

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Stakeholder Feedback Data needs 
Sales Selling prices, 
sales volumes, customer feedback Live data on competitors pricing and market trends. Metrics on key customer feedback about products and services received. 
Production Order levels, lead times, approved suppliers and unit cost information Data collection and recording could be designed to support the collecting of cost data to enable more accurate understanding of costs and drivers of cost. Live systems such as smart shelves can automatically reorder stock. 
HR Staff performance and development, the level of training planned and achieved. Appraisal process. Data system requirements would need to incorporate appraisal systems, productivity analysis as well as collecting data on internal progressions and training days. An integrated office management system could be considered. 
Shareholders Requirement for more information about impacts and future prospects of a business, over the standard annual report A move to integrated reporting could see a shift in data needs and reporting. For instance data about carbon footprint and water usage could be collected to report under the natural capital section of an integrated report.  
Employees Hands on users of systems and processes within finance. Unique position to flag inefficiencies in the system and potentially suggest improvements and test solutions.  
Directors Seek insight and clarity from information provided by finance. Investment in improved systems to facilitate the use of data in an organisation incorporating effective data visualisations to summarise key metrics.

198  
3  Data engineering, extraction and mining  
3.1 Extraction, transformation and loading (ETL) 
 Extraction, transformation and loading ( ETL) are the three stages in 
transferring data. They are combined in to a single tool to automatically 
bring data from various source s into a destination system.  
• Extraction  – This is the process of harve sting data from source databases 
and locations. There will typically be multiple data sources used in the 
extraction process. Data profiling in t he extraction stage is vital to validate 
the source data is consistent and manageable and will allow successful 
transformation. 
• Transformation – The source data will be transformed into a format 
suitable for the destination database and its ultimate intended use. This is 
done using code and rules, designed to in terrogate the source data before 
converting it to a new format as per the code instructions. 
• Loading – This is the process of the newly cleaned and prepared data 
being uploaded into the destination databas e ready for use. This will often 
be a data warehouse . 
• Data profiling – Is an important element in  an ETL process. Prior to 
extraction the data needs to be anal ysed to understand its content, 
formats and structure. This then informs  the data conditions  built into the 
rules and code used in the extraction and transformation process.  
• Data warehouse – A data warehouse is a store for data that has been 
loaded in the ETL process. The dat a will be held in a systematic and 
logical way ready for further interrogation and analysis by the business 
intelligence function 
ETL systems are a vital component of the business intelligence ( BI) process. 
BI and ETL developers coordinate to pull t ogether relevant data from multiple 
sources into one place. This can then be used by the BI function for further 
interrogation. 
c  
 
Data source 1 
Data source 2 
Data source 3 Data Warehouse 
 Single logical data 
array ETL 
System

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3.2 Business intelligence (BI) 
 Business intelligence is the technology driven process of analysing 
business data to create insightful and actionable information to help 
improve the operations or products of a business. 
As discussed ETL systems are an important element of business intelligence , 
providing the data in clean and ready-t o-use format. Business intelligence 
systems are built to access and analyse this data further and present the findings using data visualisation  techniques as well as traditional summaries 
and reports. Business intelligence software has evolved to become more user 
friendly and intuitive allowing users throughout an organisation to access data 
that may be of value without IT or  finance assistance being required.  
Big data, ETL and BI  
Traditional ETL systems are not a new devel opment and have been around 
since the 1970s. The modern digital world means these ETL or data integration 
systems are faced with fresh challe nges the main trends include: 
• Rate of growth – data volumes are growin g at unprecedented levels 
• Types and sources – traditional database integration is a thing of the 
past. Data for the modern business comes in all shapes and sizes and 
from an array of sources both inte rnal and external. Social media, 
connected devices, live streaming etc.  
• New technologies  – ETL  software is still a fundamental element of 
business intelligence but new solutions such as Hadoop  and 
GoogleBigQuery  are designed for the modern landscape of big data. 
They use innovative techniques in  order to handle the challenges 
presented by the volume, variety and velocity of big data. 
 
 Illustration 1 – Hadoop and modern data requirements 
 Hadoop is a name synonymous with big data  and is an example of 
business intelligence software in the digital age. 
Hadoop – provides a framework, using ope n source software, to facilitate 
distributed processing wh ich enables companies to tackle big data and 
maximise the potential gains. 
How it works 
Put simply, Hadoop essentially breaks tasks down and then shares them 
between ‘nodes’ which are basically a se ries of servers. By breaking a 
task down it allows the processing to be run in parallel, making a task 
much faster, it also has inbuilt fa ilsafe’s so if one node fails, its work will 
be picked up and processed elsewhere. 
For instance if I had a task that was going to take me 20 days to 
complete but it needed to be done quicker,  the obvious route would be to 
break the work down into blocks and get others to help. I would then 
reassemble the blocks of work a nd present the finished task.

200  
 Another advantage is that should one of the workers get ill (or fail from a 
computing perspective) their block of  work could be shared between the 
other workers without any significant  impact on the ultimate outcome. 
Components of Hadoop 
HDFS (Hadoop Distribute File System)  – This is the part of the system 
responsible for breaking down a task into chunks of work and distributing 
them. HDFS operates following a simila r logic to that on your personal 
computer, but scales this up to operate and arrange files across many 
machines.  
MapReduce framework  – Having broken the data into chunks, the 
MapReduce element of Hadoop then coor dinates the actual distributed 
processing of this data to achieve an outcome.  So for instance if we were trying to interrogate a large data set looking for 
key words. The HDFS would take the large volume of data, break it into 
manageable chunks and spread this across multiple nodes. The MapReduce element would then find the instances of these key words in each chunk (mapping) and then summarise the outcome (reduce) to say how many instances we had overall.  
 
 Which of the following are reasons why traditional ETL systems may no longer be valid for an organisati on today? Select all that apply. 
A Increased rate of data growth 
B Wider sources of data C More balanced composition of the Board D Increased use of Corporat e Social Responsibility 
E Introduction of new big data technologies F Restrictions in employee skillset 
4 Data modelling, manipu lation and analysis  
4.1 Data modelling and the finance function 
 A data model considers the data of an organisati on in a systematic way 
that allows it to be stored and retrieved in an efficient and effective 
manner. 
The process of data modelling involv es laying out an organisation’s data 
requirements in a way that can be easily and deliberately conver ted to computer 
code. The modelling process requires a clear and systematic plan of the key 
data being stored and how this should be org anised to allow it to be retrieved, 
interrogated, linked and grouped.

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The advantages of data modelling include: 
• Foundation for handling data, it facilitates th e effective use of that data 
throughout the organisation  
• Enforces business rules and helps achieve regulatory compliance by 
ensuring data is complete and secure 
• Consistency of naming conventions and va lues ultimately underpin a 
systematic and reliable database 
• The quality  of data is enhanced. Data modelling provides an organisation 
with a well-planned approach to it s data, ensuring completeness and 
facilitating high quality data warehouses. 
Three levels of a data modelling process 
Conceptual – Business oriented and practical,  considering the business data 
and its requirements 
Logical –  This level begins to develop a technical map of rules and data 
structures, defin ing how data will be held and used 
Physical  – This considers how the def ined system requirements will be 
implemented using a specific dat abase management system (DBMS) 
4.2 Data manipulation 
 Data manipulation is the process of changing data to make it easier to 
read. It involves adding, deleting,  querying and modifying data in a data-
store using a data manipulation language  or DML. 
Data held in a database is held acco rding to the parameters of the data model 
used to design it. This data can then be searched and interrogated using data 
manipulation language (DML ) which essentially gives instructions to a 
database in a consistent and structured fashion.  
From a finance perspective, the query function of DML  is the most relevant 
feature, allowing users to  ask the database questions a bout the data held. This 
is done in order to gather information required by management for things like 
analysis, reporting and decision making. 
 
 What are the THREE levels of  the data modelling process? 
A Rational, Time variant, Logical 
B Conceptual, Irrational, Variety C Conceptual, Logical, Physical D Extraction, Transformation, Loading

202  
5 Data insight and communication 
5.1 Managing big data – the finance function 
The role of providing management information in business has long been the 
remit of the finance function. Big data  has seen the pool of available data 
available to compile this management in formation increase exponentially. The 
finance function still plays an integral role in understanding and managing the data and information of a business. 
Data strategy  – the use of data is of fundament al importance to most modern 
businesses. In line with the concept of developing a digital mindset; digital 
technology and data must be considered at a strategic level within a business. 
Data is central to the overall stra tegic thinking of business and must be 
incorporated in strategic planning. An overall data strategy  is a common 
element of overall corpor ate strategy and is defined by the Harvard Business 
Review as follows: 
 Data strategy  is a coherent approach for or ganising, governing, analysing 
and deploying an organisations information assets.  
As introduced in Chapter 7  developing a data strategy is a key part of the 
modern business landscape and an effective data strategy should consist of the 
5 elements, identify, store, provision, process  and govern as covered 
earlier. The strategy should provi de a coherent, organisation wide approach, 
moving away from isolated data pr ojects being conducted throughout the 
business in a haphazard fashion. 
A key element  of any data strategy from a va lue adding perspective is how to 
effectively capture and utilise big data.  
To maximise the benefits it can deliver  a system must be designed that can 
cope with the attributes of big data as outlined by the 4 V’s in Chapter 5:  
• Volume – As discussed the volume of data available from modern 
technologies is vast, the capabilit y to handle and process the sheer 
quantity of data, which will continue to grow, must be a key consideration 
in any data strategy.   
• Velocity  – The stream of data coming in  to organisations is constant, 
transactions, web clicks, ‘likes’ on soci al media etc… occur in their millions 
every minute of every day. Data systems must have the capability to 
process this live data, providing up to date information as well as storing it 
for further use. 
• Variety – Data comes from a range of sour ces both internal and external 
and in an array of formats. Traditional data use was largely internal and 
structured, but the growth in external  sources such as social media and 
web cookies sees data in a range of unstructured formats. Systems must have the capability to handle this increasingly rich source of data

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• Veracity – This considers how trustworthy data is and is crucial to 
effective use of data. Systems mu st ensure data can be validated to 
reduce uncertainty to tolerable levels . Combining data with other sources 
can act as a check of dat a authenticity. For instance GPS location data in 
cities suffers high levels of interf erence, this data could be validated by 
comparison to other data such as purchase data, accelerometer data or 
social media updates. 
Overall  an effective data strategy must address the challenges of big data 
considering how data is collected, held and incorporated across the business to 
maximise its value adding potential 
5.2 Data visualisations and the finance function 
As introduced in Chapter 5, data visualisation  is an enabling technology that 
complements data analytics by facili tating user friendly and accessible 
presentation of key data through the following: 
• Information  – Providing information for stakeholders in and outside the 
business is core to the finance functi ons responsibilitie s, therefore data 
visualisation is a very important concept for the finance professional  
• Users  – Many users of the data financ e departments produce do not have 
a finance background so it is important  to avoid data heavy presentations 
and technical jargon. Instead the focus is  on highlighting the key pieces of 
data the audience need and presenting these in an engaging and 
informative way 
• Simplicity  – Effective visualisations should be intuitive and involve 
practically no training for the end user 
Prior to producing a data visualisation it  is useful to consider some simple 
questions in order to improve its effectiveness: 
• Who are the audience?  Who are we producing the data for and what 
level of detail they require are key c onsiderations. It is also useful to 
consider the technical abi lity of the audience too. 
• How do they wa nt the data?  Is it for our sales force? If so the data 
should be mobile friendly, summ arised and quick to read, with the 
potential to drill down wher e required. Generally t he level of detail, the 
interface, medium and interactiv ity should all be considered 
• What outcome do we want?  Ultimately what do they  want to take from 
the data and how should it  help enhance performance.

204  
 Illustration 2 – Data visualisation. Edited. 
 This is an example of a data visualisation from Edited the retail data 
analytics technology company discussed in Chapter 7 . It demonstrates a 
summary of the stock movements, replenishment rates and price 
discounting across a range of retailers in  the same sector of the market. 
The visualised data summarises a vast amount of data into a visually appealing and useful infographi c that highlights just  the key information 
needed by users. 
 Sellout Replenished Currently 
discounted Avg. 
Discount 
Debenhams  
22.4%  
19.1%   
63.4%   
46.3% 
House of 
Fraser  
8.7%   
17.8%   
44.2%   
41.5% 
John Lewis  
42.1%   
22.6%   
28.1%   
32.1% 
Marks & 
Spencer  
18.2%  
9.0%   
52.2%   
50.1% 
     
 Illustration 3 – Data visualisation. Accounts receivable 
 The visualisation below is an extract from an accounts receivable report; 
this simple pie chart gives the user a clear indication of the ageing of the 
receivables balances in a clear and concise way. The heavy detail of 
multiple pages of individual credit cu stomers along with the breakdown of 
their balances is not needed by most uses and this infographic directs 
users to the key headline information. 
Here the figures of AR turnover and the AR turnover ratio are displayed 
clearly at the top and can be easil y compared against budget to get an 
indication of performance. 
A visualisation like this would typically  allow users to drilldown into the 
detail behind the numbers, for inst ance by selecting the 90+ days 
segment of the pie chart the user  would access the customers and 
balances that make up this figur e and further questions could then be 
asked upon these. This is the idea of layering data and making 
visualisations intuitive and simple to navigate.

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 Which of the following are charact eristics of effective data 
visualisation? Tick all that apply. 
A Use of jargon 
B Intuitive visuals C Audience specific D Extensive training used at same time E High level only F Paper format only 
5.3 Business focused data 
 Data scientists  are individuals with the ability to extract meaning from and 
interpret data, which requires both tools and methods from statistics and 
machine learning.  
Data science is a very new field. It is an amalgam of data experts with a 
background in mathematics, statisti cs, programming and computer science. 
Organisations looking to capitalise on big data using data analytics  are 
increasingly employing s pecialist data scientists. 
In this data driven world it is import ant to maintain a coherent commercial, 
business focus to the work being undertake n by data scientists, this is where 
management accountants  are ideally situated to take  the lead. Partnering with 
data scientists to ensure the work they undertake is deliberate and targeted with 
clear objectives to ultimately suppor t or enhance the business. Management 
accountants should also act to translate insights gained back to the wider business in a practical and commercial way.

206  
Essentially management accountants will act as an interface between the 
business functions and the data specialis ts; they are uniquely positioned to do 
so for the following reasons: 
• All activities have a financial consequence so the finance function is 
central to an organisation with a un ique understanding of the overall 
business picture. 
• The information produced is alread y trusted, typically audited and 
grounded in factual accounting reality. 
• The management accounting function and the information produced 
provides the basis of perform ance management across the business 
• Finance is based on rational and measurable information. Finance 
professionals have credibility and ethi cal guidelines which underpin their 
objectivity and rigour in decision making.

208  
 The correct answer is A, B, E 
Growth of data, sources of data and new data technologies all mean 
traditional ETL programs may not be as  valid today. The composition of 
the Board should not influence th is, as the board have a duty to 
safeguard assets and manage risk, whatever era they are in. Employee 
skillsets will change, but won’t be the reason the systems are no longer valid.  
 
The three levels are Conceptual, Logical, and Physical. Extraction, 
transformation and Loading (ETL) are st ages in transferring data into a 
single destination. 
 
 The correct answer is B, C 
Data visualisation should allow the audience to intuitively see results, and be focused at the right level for the audience. It should not use excessive 
jargon, need much training to understand.  It can drill down into further 
depth if required, and be across several mediums, including paper copies.

209 
interacts with operations 
E1: Describe how the finance 
function interacts with operations. (a) Main role of operations. 
(b) Areas of interface with 
finance. 
(c) Key performance 
indicators. 
 Chapter 
9

How the finance function interacts with operations 
210  
 
Chapters 9 to 12 will cover syllabus area E ‘Finance Interacting with the 
Organisation ’. We will bring toget her previous sections and link them to other 
areas of the organisation, describing how the finance function plays its role by 
interacting with the rest of the organisation. 
The functions that need to be perfo rmed in a business depend on many 
variables, such as what industry it is in, how geographically spread it is, and 
what its plans are for the future . Most commonly, however, these functions  are 
identified generically as follows: 
• Operations 
• Sales and marketing 
• Human resources (HR) • Information technology (IT)  • Finance 
In today’s connected and joined up organisations, finance will work 
collaboratively with these ot her functions to achieve the objectives of finance, 
those other areas and crucially the obj ectives of the whole organisation. 
In syllabus area E we will look at the main  role of the first four of these five 
functions before understanding the areas of  each function that interface with 
finance and, finally, understanding how t he finance function helps to manage 
these functions. 
Operations  will be covered in this chapter.

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2 How the finance function re lates to the other functions 
This area will be explored in more detail in each of Chapters 9 to 12 but a short 
introduction is useful at this point. 
The finance function’s role in managi ng the financial resources of the 
integral to the effectiveness of the other function (in this case the operations function). 
The finance function will: 
• Assemble and extract data to provide information  to the other function 
and insight  about value creation/preservation. 
• Work with the other function ( an internal stakeholder) and other 
stakeholders to influence  and shape how this function creates and 
• The CFO will work with the head of each function (for example, the chief 
operating officer (COO)) to ac hieve the desired organisational impact  for 
this function. 
3 Main role of operations 
3.1 Definitions 
 Operations  are those activities concerned with the acquisition of raw 
materials, their conversion into fini shed products and the supply of that 
finished product to the customer. 
Contemporary thinking has broadened the definition to ‘what the company 
does’ to include service operations as well as manufacturing operations.  
 
 Illustration 1 – Examples of operations 
  
Organisation Operations function Operation 
McDonalds Kitchen and serving staff Selling fast food 
Vauxhall Production line Making cars 
Dell Production line, internet Making and selling 
computers 
Real Madrid Football coaches, 
training facilities Playing football

212  
 Operations management is the activities involved in designing, producing 
and delivering products and services that satisfy the customer’s 
requirements. 
 
 Illustration 2 – Operations management in IKEA 
 IKEA is the most successful furniture retailer ever. With over 400 stores 
in 25 countries, it has managed to devel op its own special way of selling 
furniture. Innovations in its operations  dramatically reduced its selling 
costs. These included the idea of sell ing furniture as self-assembly flat 
packs (resulting in reduced production and transport costs) and its 
‘showroom-warehouse’ concept which required customers to pick the furniture up themselves from the warehouse (which reduced retailing 
costs). Both of these operating prin ciples are still the basis of IKEA’s 
retail operations process today. 
IKEA’s operations managers  are involved in a number of activities. 
These include: 
• Process design  – arranging the store’s layout to give smooth and 
effective flow of customers. 
• Product design  – designing stylish products that can be flat-packed 
efficiently. 
• Job design  – making sure that all staff can contribute to the 
company’s success. 
• Supply network design  – locating stores of an appropriate size in 
the most effective place. 
• Supply chain management  – arranging for the delivery of products 
to stores. 
• Capacity management  – coping with fluctuations in demand. 
• Failure prevention  – maintain cleanliness and safety of storage 
area. 
• Inventory management  – avoiding running out of products for sale. 
• Quality management  – monitoring and enhancing quality of service 
to customers. 
• Operations improvement  – continually examining and improving 
operations practice. 
These activities are only a small part of IKEA’s total operations 
management effort but they do give an indication of how operations management can contribute to business success.

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 Processes – All operations consist of a colle ction of processes. These are 
the building blocks of operations and connect with one another to form a 
network. The processes transform t he input resources into output 
products/services. 
 
 Illustration 3 – Some operations described in terms of their 
processes 
  
Operation Inputs Pr ocesses Outputs 
Airline Aircraft 
Pilots and air 
crew 
Ground crew 
Passengers and 
freight Check passengers in 
Board 
passengers 
Fly passengers 
and freight 
around the 
world 
Care for 
passengers Transported 
passengers and 
freight 
Department store Goods for sale 
Sales staff Information 
systems 
Customers Source and 
store goods 
Display goods 
Give sales 
advice 
Sell goods Customers and 
goods ‘assembled’ 
together 
Police Police officers 
Information 
systems 
Public (law-
abiding and 
criminals) Crime prevention 
Crime detection 
gathering 
Detaining 
suspects Lawful society, 
public with a feeling of 
security 
Frozen food manufacturer Fresh food 
Operators Process 
technology 
Cold storage 
facilities Source raw 
materials 
Prepare foods Pack and freeze 
food Frozen food

214  
3.2 The different characteris tics of operations processes 
Although all operations processes are sim ilar in that they all transform inputs 
into outputs, they do differ in a number of ways, four of which, known as the 
four Vs , are particularly important. Each of  these effect the way in which an 
operation will be or ganised and managed. 
Volume  of inputs and outputs 
Operations differ in the volume of input s they process. High-volume operations 
are likely to be more capital-intensive than low-volume operations, and there is 
likely to be a greater spec ialisation of labour skills. 
 
 Illustration 4 – The volume dimensions at McDonalds 
 McDonald’s serves millions of burgers around the world every day. 
Volume has important implications for the way McDonald’s operations are 
organised. The first thing you notice if the repeatability  of the tasks 
people are doing and the systemisation of the work where standard 
procedures are set down specifying how each part of the job should be 
carried out. Also, because tasks ar e systemised and repeated, it is 
worthwhile developing specialised frye rs and ovens. All this gives low unit 
costs. 
Variety  of inputs and outputs 
Some operations handle a wide range of different inputs, or produce a wide 
range of output products or services. Ot hers are much more restricted in the 
range of inputs they handle or outputs they produce. 
Variation  in demand 
With some operations demand might vary significantly from one season of the year to another or from one time of the day to anot her, with some periods of 
peak demand and some periods of low demand. Other operati ons might handle 
a fairly constant volume of demand at all times. 
Visibility  to customers 
Visibility refers to the ex tent to which an organisation is  visible to its customers. 
When an operation is highly visible, the employees will have to show good 
communication skills and interpersonal skills in dealing with customers. 
All four dimensions have implications for the cost of creat ing the products or 
services. Put simply, high volume, low va riety, low variation and low customer 
contact (visibility) all help keep processing costs down.

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 Company A is an online retailer spec ialising in basic household cleaning 
products, it has a limited product r ange and sells many of its goods in 
bulk to cleaning companies. 
Company B sells seasonal organic food st uffs from its local retail outlet. 
Its staff are expected to provide cooking and recipe guidance to its 
customers. 
Using the 4 Vs, which company would be expected to have the 
lower processing costs? 
3.3 Porter's value chain 
The value chain model is based around activities  rather than traditional 
functional departments (such as  operations or finance).  
It considers the organisation’s activities  that create value and drive costs and 
therefore the organisation should fo cus on improving those activities. Many of 
the activities relate to the operations function . 
The activities are split into primary ones (the customer interacts with these and 
can ‘see’ the value being created) and secondary  (or support) activities which 
are necessary to support the primary activiti es. Each activity is looked at to see 
if they give a cost adv antage or a quality advantage. 
Margin, i.e. profit will be ac hieved if the customer is willing to pay more for the 
product/service than the sum of the costs of all the activities in the value chain.

216  
 Value chain activities 
 Primary activities  – directly concerned with the creation or delivery of a 
product/service. 
Activity Description Example 
Inbound logistics Receiving, storing and 
handling raw material 
inputs A just-in-time stock 
system could give a 
cost advantage. 
Operations Transformation of raw materials into finished goods and services. Using skilled employees could give a quality advantage. 
Outbound logistics Storing, distributing and delivering finished goods and services. Outsourcing activities could give a cost advantage. 
Marketing and sales The mechanism by 
which the customer is 
made aware of the product or service. Sponsorship of a 
sports celebrity could 
enhance the image of a product. 
After sales service All activities that occur after the point of sale, such as customer enquiries, returns and repairs/maintenance. A friendly approach to returns gives it a perceived quality advantage. 
Operations management is concerned with all of thes e primary activities 
apart from marketing and sales. 
Support activities  – help improve the efficiency and effectiveness of the 
primary activities. 
Infrastructure How the firm is 
organised. A firm could have a very 'lean' structure at 
head office in contrast to competitors with more staff and more bureaucracy. 
Human resource management How people contribute to competitive advantage. Includes activities such as recruitment, selection, training and development and reward policies. Employing expert buyers could enable a supermarket to purchase better wines than competitors.

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Technology How the firm uses 
technology The latest computer-controlled machinery gives greater flexibility to tailor products to customer specifications. 
Procurement Purchasing, but not 
just limited to 
materials. Buying a building out 
of town could give a 
cost advantage over High Street competitors. 
Operations management is directly  concerned with procurement and 
some elements of firm infrastr ucture and technology development. 
 
 Illustration 5 – Value chain 
 One particular clothes manufactu rer may spend large amounts on: 
• Buying good quality raw materials (inbound logistics) 
• Hand-finishing garments (operations) • Building a successful brand image (marketing) • Running its own fleet of delivery trucks in order to deliver finished 
clothes quickly to customers (outbound logistics). 
All of these should add value to the product, allowing the company to 
charge a premium for its clothes. 
 Another clothes manufacturer may: 
• Reduce the cost of its raw materials by buying in cheaper supplies 
from abroad (inbound logistics) 
• Making all its clothes by machinery running 24 hours a day 
(operations) 
• Delaying distribution until delivery trucks can be filled with garments 
for a particular request (outbound logistics). 
All of these should allow the com pany to be able to gain economies of 
scale and be able to sell clothes at a cheaper price than its rivals. 
Linkages connect the interdependent elements of the value chain together. For 
example, better quality production could re duce the need for after-sales service.

218  
 Which one of the following is  a value-added activity? 
A Painting a car, if the or ganisation manufactures cars 
B The board of directors who decid e on the financial structure and 
C Purchasing of materials 
D A staff development programme 
 
 BB makes and sells freshly baked bread. It has recently developed an 
automated inventory control system for its finished loaves, which 
significantly reduces wastage. 
Which ONE of the following val ue chain activities will BB’s 
automated inventory system directly improve? 
A Inbound logistics 
B Operations C Outbound logistics D Marketing E Procurement 
3.4 Process design 
 Process design  is the method by which individual specialists seek to 
understand business processes and ens ure that these processes are 
designed to be as efficient and effe ctive as possible. The design of 
processes will go hand in hand with the design of new products and 
services. 
Before any changes in processes are under taken it is necessary to understand 
the organisation’s mission, goals and customer needs and to carry out a 
detailed analysis of existing processes. Process maps can assist in such an 
examination. 
 A process map  provides a visual repr esentation of the steps and 
decisions by which a product or transaction is processed. 
 
 Illustration 6 – Simple process map for hiring process

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Advantages of process maps 
• Management understanding  – allows a better understanding of the basic 
processes that are undertaken, so providing management with a 
convenient overview demonstrating re sponsibilities and key stages in the 
operations. 
• Role understanding  – allows workers to understand what their job is and 
how their work fits into the whole pr ocess (and therefore the importance of 
undertaking their role effectively) . Process mapping also allows 
consideration of role reallocation. 
• Standardisation – highlights where opportuniti es exist to standardise 
processes. 
• Highlights inefficiencies – visually highlights ar eas where inefficiencies 
are present through analysis of queues, value and location, so pinpointing 
areas of waste. This provides an agenda to tackle duplication of effort, the 
requirement to complete unnecessary paperwork, and misdirected queries that hold up production, etc. 
• Supports corporate initiatives  – mapping can be used as a tool as part 
of a corporate initiative such as  customer satisfaction improvement 
programmes. 
 
Example of a process map 
 Supply process map

220  
3.5 Product and service development 
Companies need to continually look for new or improved produc ts or services, 
to achieve or maintain compet itive advantage in their market. 
The stages of product/service development are as follows: 
 
 Illustration 7 – Considering customers' needs 
 The design of a new product/servi ce should begin by understanding the 
needs of the customer. There are a number of ways to do this, for 
example: 
• Customer relationship managemen t (CRM) systems will allow this 
either directly via customer su rveys or more softly via prudent 
logging of cust omer sentiment. 
• More radical solutions, e.g. Lego created Lego Ideas – a customer 
portal for idea crowdsourcing and validation. 
 
 Product and service development 
 Stage 1: Consider customers' needs 
The product/service should satisfy the needs of the customer, for 
example value for money, high quality, cutting edge design. 
Stage 2: Concept screening 
The new product/service concept should be vetted. It will only pass 
through to the design and development proc ess if it meets certain criteria. 
For example, does the company thin k that the new product/ service will 
be profitable? 
Stage 3: The design process 
This may include procedures such as: 
• Building a physical prototype or a virtual prototype (using computer 
aided design). 
• Value engineering, i.e. ensuring that all components/features add 
value.

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 Stage 4: Time-to-market 
A short time-to-market is desirable since: 
• New product/service may be re leased ahead of competitors. 
• Developments costs may be lower. 
Stage 5: Product testing 
The new product should be tested before it is released to the market: 
• Does it work properly? 
• Do customers like it?  
4 Areas of interface between  operations and finance 
Operations management will be an important contribut or to effective and 
efficient purchasing, production and delivery of customer specific goods and 
services. 
The operations function and the finance func tion should work in partnership to 
ensure this efficiency and effectiveness is optimised. In this section we will examine ho w specific parts of an organisation’s 
operations (i.e. purchasing,  production and service prov ision) interact with the 
organisation’s finance function. The focus here will be on the operational 
level  tasks performed by t he finance function.  
Section 5  will explain how relationships in the supply chain can be managed 
and the interface with the finance f unction will be examined at a more strategic 
level  here. 
4.2 Purchasing (procurement) 
Purchasing is an important part of the operations function. It is responsible for 
placing and following up or ders. It co-ordinates wit h the finance function as 
follows: 
Establishing 
credit terms The finance function will work with  the purchasing to liaise with 
suppliers to obtain a credit a ccount and to negotiate credit 
terms which are acceptable. 
Prices The finance function can advise purchasing on the maximum price that should be paid to maintain margins. 
Payment Payments may be approved by purchasing but are made by the finance function. 
Data capture, for example, orders Order details will be input by purchasing and details passed to the finance function.

222  
Inventory Purchasing will consult with the in ventory section of the finance 
function to determine the quantity of items already in stock and 
therefore the quantity required. 
Budgeting The finance function will consul t with purchasing on the likely 
costs in preparing budgets. 
 
 Illustration 8 – Purchasing 
 
 XYZ Limited is a company manufacturing handbags. 
Describe how purchasing liaises wit h the finance function when buying 
some leather to make handbags from  DEF Limited, a new supplier. 
credit terms Purchasing will advise the fi nance function that the 
preferred supplier is DEF. The finance function 
contacts the credit controlle r at DEF and provides the 
information required to set up a credit account. 
Prices The finance function obtains the cost estimate for the 
handbag being produced. It di scusses with purchasing 
how much can be paid for the leather in order to 
maintain margins. 
Payment The payment for the leather is approved by 
purchasing and then made by the finance function. 
Data capture, 
for example, 
orders Order details for the leather will be input by 
purchasing and details passed to the finance function 
to check that the price on the invoice is correct. 
Inventory Before placing the order, purchasing will consult with 
the inventory section to determine how much suitable 
leather is already in stock. 
  
 Which of the following is an e xample of co-ordination between 
purchasing and the finance function? 
A  Establishing credit terms 
B  Determining sales prices 
C  Allocating costs 
D  Calculating pay rises

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4.3 Production 
Production is a core part of the operati ons function. It plans and oversees the 
production of goods. It liaises with  the finance function as follows: 
Cost 
measurement, allocation, absorption Production measures quantities of  materials and time used; 
the management accountant gives a monetary value to them. 
Costs are then allocated and absorbed to calculate production costs based on advice given by production. 
Budgeting Production will decide how many it ems of what type are to be 
produced. The cost of produci ng these will be determined by 
the finance function and producti on together, and incorporated 
into the overall budget. 
Cost v quality Production and the finance function  will discuss the features 
that can be included in products  and the raw materials that 
should be used. They should agree which better quality materials and features justify t he extra cost, and discuss how 
to maximise quality and profit. 
Inventory Production will liaise with the in ventory section of the finance 
function to ensure that there ar e sufficient raw materials in 
inventory for the production that is planned. 
 
 Illustration 9 – Production 
 XYZ Limited is a company manufacturing handbags. The company has 
commissioned a designer to design a new style of handbag and 
discussions are taking place about the materials to be used and the 
quantity to be produced. 
Describe how the finance function and production would liaise over this. 
Cost 
measurement, 
allocation, 
absorption Production would estimate  the quantity of raw 
materials required and (in conjunction with 
purchasing) estimate thei r cost. Together with the 
finance function overheads will be allocated to 
determine the full cost of the handbag. 
Budgeting Production, the finance function and marketing will 
discuss how many bags are likely to be sold at what 
price and determine how many should be produced. A 
budget can then be produced. 
Cost v quality Production, the finance function (and marketing) will 
discuss the various grades of leather and the material 
that could be used, their co sts, and the extra price 
that could be charged for better quality material. They 
will decide on the bes t combination of 
cost/quality/profit.

224  
  
Inventory Production will discuss with t he inventory section of 
the finance function the ma terials required. Some 
existing materials may be us able for the new product 
or entirely new materials may need to be purchased. 
  
4.4 Service provision 
Characteristics of services 
Services are said to have four main characteristics.  
• Intangibility  – services are activities undertaken by the organisation on 
behalf of its customers and therefore cannot be packaged for the customer 
to take away with them. They often hav e few, if any, physical aspects.  
• Inseparability  – services are often created by the organisation at the 
same time as they are consumed by  the customer. The service cannot 
therefore be easily distinguished from  the person or organisation providing 
the service. 
• Perishability  – services cannot be stored for later.  
• Variability  – each service is unique and cannot usually be repeated in 
exactly the same way, making o ffering a standardised service to 
customers very difficult. 
These characteristics must be considered when seeking to manage the 
performance of the service. 
The relationship between service provision and the finance function 
A business very often provides services to customers, at t he same time as a 
sale or afterwards. For ex ample, a computer retailer may charge an extra fee to 
help customers set up their system, or a car dealer may provide car servicing. 
This service provision will form an impor tant part of the oper ations function. 
There are several issues about whic h the service departments may need the 
input of the finance function. 
Charge-out 
rates This is the hourly rate which t he company charges clients. It 
should be higher than the salary, as  it should include a share of 
overheads, for example training,  and any profit the company 
wishes to make. However if the charge-out rate is too high customers will not us e the service.  
Estimating costs Problems arise in determining the amount of overhead to be included in the charge-out rate. Al so, if the service takes longer 
to provide than expected, the company may not be able to pass on the extra cost.

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Problems 
measuring 
benefits Market conditions may mean that  the charge-out rate contains 
a very low profit element. The company may question whether it is worth carrying out these se rvices. The problem is that the 
benefits are intangible and not easy no measure, but nevertheless real. A company wit h effective service provision 
has happier customers, and happy cu stomers are more likely to 
buy from the company in futu re, therefore leading to lower 
selling costs. But it is very di fficult to measur e these benefits. 
 
 Which of the following is a likel y advantage of providing a good 
service? 
A  Greater customer satisfaction 
B  Higher payroll costs 
C  Higher inventory turnover 
D  Economies of scale 
 
 ‘Most services provided by an organisation will be created at the same 
time as they are consumed.’ 
Which feature of services is being described? 
A Intangibility 
B  Inseparability 
C  Perishability 
D  Variability 
5 Supply chain management  
 A supply chain  consists of a network of organisations. Together they 
provide and process the necessary ra w materials firstly into work in 
progress and then into finished goods for distribution and sale to the end customer.

226  
The transformation of the product along t he supply chain includes activities 
such as: 
• production planning 
• purchasing • materials management • distribution • customer service • forecasting. 
 
More complex supply chains 
 The situation is usually more comp lex than is shown in the diagram 
above. Most businesses have several suppliers and several customers. 
Some businesses may compete for customers and have common 
suppliers. There may be several s upply chains serving one group of 
customers and they may form complex webs.  
 
 Supply chain management (SCM)  involves the co-ordination of activities 
from the supplier(s) of ra w materials at one end of the supply chain to the 
customer at the other end. 
The idea behind supply chain management is that co-ordinating the activities of the different businesses in the supply c hain can save costs while also adding 
value.  
Technology  can play a key part in effective SCM.

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 Illustration 10 – Use of blockchain in supply chain transparency  
  
Start-up tech firm Provenance has developed technology which tracks 
the journey of organic food from farm to shop shelf. It is hoped that 
shoppers will be able to tap their sm artphones on food, such as organic 
bacon, and instantly retrieve the pr oduct’s complete supply chain journey. 
The pilot uses blockchain technology . This means the information of a 
product’s journey and exactly what it m eans to be certified organic is now 
instantaneously accessible to shoppers with their smart phones, no app 
required. The technology will be avai lable both on product packaging and 
on the shop shelf. 
 
Traditionally, businesses within the supply chain operated independently. 
However, organisations are recognising that there are benef its associated with 
establishing links between different businesses in the supply chain. The 
objective of SCM is to achieve synergies that benefit every player along the chain. 
In this section we will understand: 
• how the relationships within the supply chain can be managed and 
• the interface between SCM and the finance function. 
5.2 The strategic supply wheel – Cousins 
Traditionally , supply was viewed as an  operational issue . Purchasing was 
seen as an administrative task with the em phasis being on price negotiations 
with suppliers. There was little awareness that supply could affect the firm’s 
strategic goals or that it should be view ed as a key part of strategic planning. 
Successful organisations in today’s competit ive environment  have 
recognised that supply should be viewed as a strategic issue . The 
organisation’s supply strategy should be aligned with the overall corporate goals 
and strategy and is integral to the organisation’s competitive strategy. 
Cousin’s model emphasises the importanc e of viewing supply as central to the 
organisation and its effectiveness.  
Cousins’ thinking is based on the noti on that an organisation’s supply strategy 
should involve a number of key areas described as ‘spokes’ in the wheel. As 
such, the model can help an organisation concentrate on key areas for attention 
and action. 
The wheel depicts the corporate supply strategy at the hub of the wheel and 
underlines the need for an integrated approac h to supply strategy involving 
balancing all five ‘spokes’.

228  
 
Spoke of wheel Explanation 
Organisation structure The choice of structure (centralised, decentralised or 
a mix of these) impacts control and interaction. It 
should enhance rather than hinder supply strategy. 
Relationships with 
suppliers Relationships can be: 
• competitive (contract ual) – based on price 
deals, or 
• collaborative (relationa l) – a more positive 
relationship based on a joint quest to reduce 
costs and a sharing of technology and innovations to improve quality. 
Cost/benefit Supply decisions should be based on benefits as well 
as costs. Cost/benefit analys is should be at the heart 
of any strategic decision. 
Competences Do the skills exist to achieve the chosen strategy? 
For example, the developm ent of long term supplier 
relations may lead to a need to retrain key personnel. 
Performance measures Necessary for monitoring and controlling the strategy 
chosen. Measures should extend beyond price and be aligned with the strategy.

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 Which of the following statements  about supply chain management 
are true and which are false? 
The co-ordination of activities  from the supplier(s) of raw 
materials at one end of the supply chain to the customer 
at the other end is known as supply chain management  
Cost savings are the only advantage of supply chain 
management  
The objective of SCM is to achieve synergies that 
benefit the customers at t he end of the supply chain.  
Cousins’ supply wheel is a model used to look at the 
traditional supply function  
Cousins’ supply wheel has five spokes  
  
5.3 Relationship with suppliers 
As mentioned above, Cousins identifi ed two broad approaches to supplier 
relationships: 
• competitive (also known as contractual) and  
• collaborative (also known as relational). 
Competitive (contractual) 
In the past the supply chain was typicall y defined by competitive relationships. 
• The purchasing function sought out the lowest-price suppliers, often 
through a process of tendering, the use of 'power' and the constant 
switching of supply sources to prevent getting too close to any individual source. 
• Supplier contracts feat ured heavy penalty clauses and were drawn up in a 
spirit of general mistrust of  all external providers. 
• The knowledge and skills of the supplier could not be exploited effectively. 
Information was deliberately withheld in case the supplier used it to gain power during price negotiations. 
Hence, no single supplier ever knew enough about the ultima te customer to 
suggest ways of improving the cost-e ffectiveness and quality of the trading 
relationship. 
Collaborative (relational) 
Over the last 15-20 year s there has been an increased recognition that 
successful management of suppliers is  based upon collaboration and offers 
benefits to an organisation's suppliers as well as to the organisation itself. By 
working together and forming relationships organisations can make a much

230  
better job of satisfying t he requirements of their end market, and thus both can 
increase their market share. 
• Organisations seek to enter into partnerships with key customers and 
suppliers so as to better understand how to provide value and customer 
service. 
• Organisations' product design processes include discussions that involve 
both customers and suppliers. By opening up design departments and 
supply problems to selected suppliers , a synergy results, generating new 
ideas, solutions, and new innovative products. 
• To enhance the nature of collaborati on, the organisation may reward 
suppliers with long-term sole sourcing agreements in return for a greater 
level of support to the busine ss and a commitment to on-going 
improvements of materials, deliveries and relationships. 
• The nature of the collaboration needs to shift to refl ect the constant 
change in the environment (see illustration below). 
 
 Illustration 11 – Recent changes in UK supply chain relationships 
  
Partnerships within the supply chain must  continue to adapt to reflect the 
unprecedented level of change in the external environment.  
For example, a number of recent changes are impacting supply chain 
collaboration in the United Kingdom (UK). These changes include: 
• a volatile political and economic climate 
• increased urbanisation in the UK 
• a dramatic change in consumer  behaviour, for example with a 
preference for convenience, onlin e shopping and smaller but more 
frequent shopping 
• the growth in automation 
• a shift towards digitisation. 
The supply chain needs to address these changes, viewing them as an 
opportunity to reinvent itself and improve the effectiveness of 
collaboration across the supply chain: 
• Changing technology combined with mo re accurate data is allowing 
for greater collaboration.  For example, distribution is planned more 
effectively to minimise empty miles and waste. 
• Today’s consumers, driven by urbanisation, have moved away from 
the traditional large weekly shop in out-of-town retail parks and are 
seeking smaller urban stores and online shopping. The supply chain 
has collaborated to introduce new distribution models and retailing 
formats (such as meal delivery subscriptions and ‘click and collect’) 
in a cost effective manner.

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5.4 Material requirement planning 
One important aspect of supply chain m anagement is to ensure that materials 
are ready when they are needed. A number of systems can be used to assist 
with this requirement. 
 MRP  is a computerised system for planning the requirements for raw 
materials, work-in-progr ess and finished items. 
MRP is designed to answer three questions: 
• What  is needed? 
• How  much is needed? 
• When is it needed? 
Functions include: • Identifying firm orders and forecasti ng future orders with confidence. 
• Using orders to determine quant ities of material required. 
• Determining the timing of the material requirement. 
• Calculating purchase orders based on stock levels. 
• Automatically placing purchase orders. • Scheduling materials for future production. 
 
Benefits of MRP 
 • Improved forecasting. 
• Improved ability to meet order s leading to increased customer 
satisfaction. 
• Reduced stock holding. • The MRP schedule can be amended quickly if demand estimates 
change since the system is computerised. 
• System can warn of purchasi ng or production problems due to 
bottlenecks or delays in the supply chain. 
• A close relationship tends to be built  with suppliers (it is consistent 
with just-in-time – see discussion in section 5.6). 
However, MRP will not be su itable if it is not possible to predict sales in 
advance.

232  
The following technology has  been developed from MRP: 
• Manufacturing resource planning (MRPII)  – goes several steps beyond 
MRP and includes: 
– production planning – machine capacity scheduling – demand forecasting and analysis – quality tracking tools – employee attendance and – productivity tracking. 
• Enterprise resource planning (ERP)  – the next evolution of an MRP 
system. It integrates information from  many aspects of operations (for 
example, manufacturing, inventory management, invoicing and 
management accounting) and support functions (such as human resource management and marketing) into one single system.  
 
Benefits of ERP 
 Benefits of ERP to the organisation include: 
• identification and planning of t he use of resources across the 
organisation to ensure customers’ needs are fulfilled 
• the free flow of information across all functions and improved 
communication between departments 
• aids management decision making due to decision support features 
• can be extended to incorporate supply chain management (SCM) 
and customer relationship management (CRM) software, thus 
helping to manage connections outside the organisation. 
 
 Which of the following are possibl e advantages of a collaborative 
relationship with suppliers? Select  all the options that apply. 
A Increased market share 
B Development of innovative products C Better understanding of how to  satisfy customer needs 
D Improved qualit y is guaranteed 
E The relationships will be harder to manage F Relationship management will be more time consuming

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5.5 Quality management  
Introduction to quality 
In today's competitive global business environment, quality is one of the key 
ways in which a business can differentia te its product or service, improve 
performance and gain competit ive advantage. Quality can form a key part of a 
strategic supply chain management. 
 Quality can be defined in a number of ways: 
• Is the product/service free from errors and does it adhere to design 
specifications? 
• Is the product/service fit for use? 
• Does the product/service meet customers' needs? 
 
 What is quality? 
 In order to control and  improve quality, it must first be defined. Most 
dictionaries define quality as ‘the degree of excellence’ but this leaves 
one having to define what is meant by ‘excellence’. Who defines what is 
excellent and by what standards is it  measured? In response to this 
problem, a number of diffe rent definitions of quality have been developed. 
In an industrial context, quality is defined in a functional way. Here, 
quality means that a product is made free from errors and according to its 
design specifications, within an acceptable production tolerance level. 
Such an approach also emphasises  that every unit produced should meet 
the design specifications, so the i dea of consistency becomes important. 
Note that consistency is a key as pect of quality standards such as the 
ISO 9000 series. 
This still leaves a problem, however. How should standards and 
specifications be set? Who decides what an ‘acceptable’ tolerance level 
should be? 
An alternative approach to defining qua lity is thus to focus on the user. 
• Japanese companies found the definiti on of quality as ‘the degree of 
conformance to a standard’ too na rrow and consequently started to 
use a new definition of quality as ‘user satisfaction’. 
• Juran defines quality as ‘fitness for use’ (1988). 
 In these definitions, cu stomer requirements and cu stomer satisfaction are 
the main factors. If an organisation can meet the requirements of its 
customers, customers will presumably be satisfied. The ability to define 
accurately the needs related to design, performance, price, safety, 
delivery, and other business activities and processes will place an 
organisation ahead of its com petitors in the market.

234  
 Taking these definitions together , Ken Holmes (Total Quality 
Management) has defined quality as ‘the totality of features and 
characteristics of a product or service which bears on its ability to meet 
stated or implied needs’. 
Quality is also normally seen in rela tion to price, and customers judge the 
quality of a product in relation to t he price they have to pay. Customers 
will accept a product of lower design quality provided that the price is 
lower than the price of a better quality alternative. 
 
 Illustration 12 – Pret A Manger’s focus on quality 
  
Described by the press as having ‘rev olutionised the concept of sandwich 
making and eating’, Pret A Manger (P ret) opened their first store in the 
mid-1980s, in London. Now they have over 500 shops in the UK and 
other locations such as New York, Hong Kong and Tokyo. 
They say that their secret is to c ontinually focus on qual ity – not just of 
their food but in every aspect of t heir operations practice. They go to 
extraordinary lengths to avoid the chemicals and preservatives common 
in many other ‘fast’ foods which are often used by retailers to extend the 
shelf life of their products. Pret hopes to maintain the edge by selling food 
that simply can’t be beaten for fres hness. At the end of each day, they 
give whatever they haven’t sold to  charity to help feed those who might 
otherwise go hungry. 
Pret rejected the idea of a huge cent ralised sandwich factory even though 
it could significantly reduce costs. Instead, each shop has its own kitchen 
where fresh ingredients are delivered fi rst thing every morning, and food 
is prepared throughout the day. 
Pret have also worked hard to build great teams – taking reward 
schemes and career opportunities very seriously.  
Customer feedback is also  regarded as being particularly important at 
Pret. Examining customers’ comments for feedback is a key part of 
weekly management meetings, and of the daily team briefs in each shop. 
 
 Explain the reasons why quality may be important to an 

Chapter 9 
 235 
The growth of global companies has resu lted in dramatic improvements in the 
quality of products and services. Much of this impetus can be attributed to the 
efforts of Japanese manufacturing companies. 
 
 Key writers on quality 
 There are a number of key writers on quality. 
Writer Main contribution 
W. Edward Deming 
 Believed: 
• managers should set up and then 
continuously improve  the systems in 
which people work 
• managers should work with employees to 
gain feedback from those who do the job 
• workers should be trained in quality to 
identify what needs changing and how. 
Deming was credited with t he creation of TQM in 
Japan and developed 14 points for quality 
improvement. 
Joseph M. Juran 
 • Drew on Pareto principle and stated that 
85% of quality problems are due to the 
systems that employ ees work within 
rather than the employees themselves . 
• Therefore, need to develop key projects for 
dealing with quality problems rather than 
concentrating on employee motivation. 
• He argued that qualit y should focus on the 
role of the customer . He believed that 
anyone affected by the product is 
considered a customer, so introduced the 
idea of internal as well as external 
Phillip P. Crosby 
 • Introduced the concept of ‘ zero defects’ . 
• Believed that prevention is key and that the 
importance of quality is measured by the 
cost of not having quality. 
• He argued for worker participation and the 
need to motivate individuals to do something 
about quality.

236  
Methods of quality measurement 
• There are four main types of quality -related costs. The organisation needs 
to identify these costs. 
• Monitoring the costs of quality is c entral to the operation of any quality 
improvement programme. 
• Targets should be set for each of the quality-related costs. 
 
 Illustration 13 – Examples of quality-related costs 
  
Category  Examples 
Prevention costs • Cost of designing products and services with 
built in quality 
• Cost of training employees in the best way to 
do their job 
• Cost of equipment testing to ensure it 
conforms to quality standards required 
Appraisal costs Inspection and testing, for example of purchased 
material or a service 
Internal failure 
costs • Cost of scrapped material due to poor quality 
• Cost of re-working parts 
• Re-inspection costs 
• Lower selling prices for sub-quality products 
External failure 
costs • Cost of recalling and correcting products 
• Cost of lost goodwill

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 237 
 Which TWO of the fo llowing are examples of prevention costs of 
quality? 
A Inspection of raw materials 
B Routine repairs and maintenance of machinery C Returns of faulty products D Machine breakdown repairs E Training costs of operational staff 
5.6 Operational improvements  
Introduction  
There are a number of techniques that an organisation may use to improve the 
effectiveness of the supply chain and t he management of relationships within 
the supply chain. These include: 
• statistical process control 
• total quality management (TQM) • Kaizen • Six Sigma • lean thinking • just-in-time and • reverse logistics. 
It is worth noting these techniques all have a quality  focus and that the 
techniques may often be used alongside one another. 
Each of the techniques will be briefly introduced below. 
Statistical process control 
 Statistical process control (SPC) is a method for measuring and controlling 
quality during a process.  
Quality data is obtained in real -time and plotted on a graph with a 
pre-determined target and control limits.  
Data that falls within the control limits  indicates that everything is operating as 
expected – any variation within the control limits is due to natural variation that 
is expected as part of a process. If data falls outside of the control limits, the variation should be investigated and 
corrective action taken before a defect occurs.

238  
 Illustration 14 – Statistical process control and Mars Bars 
  
Statistical process control may be us ed when a large number of similar 
items, such as Mars Bars, are being produced. Every process is subject 
to variability, for example it is not  possible to put exactly the same 
amount of ingredients in each Mars Bar.  
A target weight is set for a Mars Ba r (51g) and control limits assigned (1g 
above and below the target). The weight  of the Mars Bars produced will 
be plotted on a chart and any points out side of the control limits (i.e. 
below 50g and above 52g) should be inve stigated and corrective action 
taken. 
 
Total quality management 
Total quality management (TQM) is a ph ilosophy of quality management that 
originated in Japan in the 1950s. 
 TQM is the continuous improvement in quality, productivity and 
effectiveness obtained by establis hing management responsibility for 
processes as well as outputs. In th is, every process has an identified 
process owner and every person in an entity operates within a process 
and contributes to its improvement. 
Fundamental features  of TQM include: 
• Prevention of errors before they occur  – the aim of TQM is to ‘get 
things right first time'. TQM will result in an increase in prevention costs 
but internal and external failure costs will fall. 
• Continual improvement – quality management is not a one-off process, 
but is the continuous examination and improvem ent of processes.

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• Real participation by all  – the ‘total’ in TQM me ans that everyone in the 
value chain is involved in the process, including: 
Employees – they are expected to s eek out, identify and correct quality 
problems. Teamwork will be vital. Employees should be empowered to 
decide how best to do their work and should be responsible for achieving 
targets. Suppliers – quality and reliability of suppliers will play a vital role. 
Customers – the goal is to identify and meet the needs of the customer. 
• Commitment of senior management  – management must be fully 
committed and encourage everyone else to become quality conscious. 
 
Illustration 15 – TQM success and failure 
 A TQM success story 
Corning Inc is the world leader in s peciality glass and ceramics. This is 
partly due to the implementation of a TQM approach. In 1983 the CEO 
announced a $1.6 billion investment in  TQM. After several years of 
intensive training and a decade of appl ying the TQM approach, all of 
Corning's employees had bought into the quality concept. They knew the lingo – continuous improvement, empowerment, customer focus, management by prevention and they wit nessed the impact of the firm's 
techniques as profits soared. 
An example of TQM failure 
British Telecom launched a total qualit y program in the late 1980s. This 
resulted in the company getting bogged down in its quality processes and 
bureaucracy. The company failed to focus on its customers and later 
decided to dismantle its TQM program.  This was at great cost to the 
company and they have failed to make a full recovery.

240  
 Implementation of a TQM approach 
 The implementation of a TQM approac h may involve the following steps 
 
 Discuss some of the common reasons for the failure of TQM 
programmes.

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Kaizen 
What is Kaizen? 
Kaizen  is a Japanese term for the philosophy  of continuous improvement in 
performance via small, incremental steps. 
Characteristics 
• Kaizen involves setting standards and then continually improving these 
standards to achieve long-term sustainable improvements. 
• The focus is on eliminating waste,  improving processes and systems and 
improving productivity. 
• Kaizen involves all areas of the business. 
• Employees often work in teams and are empowered to make changes. 
Rather than viewing employees as the source of high costs, Kaizen views 
the employees as a source of ideas on how to reduce costs. A change of 
culture will be required, encouraging employees to suggest ideas to 
reduce costs. 
• Kaizen allows the organisation to respond quickly to changes in the 
competitive environment. 
 
 Illustration 16 – Kaizen 
 Many Japanese companies have introduced a Kaizen approach: 
• In companies such as Toyota and Canon, a total of 60–70 
suggestions per employee are wri tten down and shared every year. 
• It is not unusual for over 90% of those suggestions to be 
implemented.  
  
 Illustration 17 – British cycling 
 British cycling’s revolution through small, incremental 
improvements 
When Sir David Brailsford became perfo rmance director of British cycling, 
he believed that if it we re possible to make a 1 % improvement in a whole 
host of areas, the cumulative gains would end up being hugely 
significant. He was on the look-out fo r all the weaknesses in the team’s 
assumptions and saw these as opportuni ties to adapt and make marginal 
gains. For example: 
• By experimenting in a wind tunne l he noted that the bike was not 
sufficiently aerodynamic. Then by analysing the mechanics area in 
the team truck, he discovered t hat dust was accumulating on the 
floor, undermining bike maintenance. So he had the floor painted 
pristine white, in order to spot any impurities.

242  
 • The team started using antibacterial hand gel to cut down on any 
infections. 
• The team bus was redesigned to improve comfort an d recuperation. 
Many critiqued the approach and saw David Brailsford as a laughing 
stock. However, the last two Ol ympics have seen the team win an 
unprecedented host of gold medals and, never having previously secured 
a win in over 100 years, British riders have won the Tour de France a 
number of times since 2012.  
  
 Continuous improvement explained 
 Continuous improvement is the c ontinual examinati on and improvement 
of existing processes and is very different from approaches such as 
business process re-engineering (BPR ), which seeks to make radical 
one-off changes to improve an organisa tion's operations and processes. 
The concepts underlying cont inuous improvement are: 
• The organisation should always seek  perfection. Since perfection is 
never achieved, there must a lways be scope for improving on the 
current methods. 
• The search for perfection should be ingrained into the culture and 
mind-set of all employees. Impr ovements should be sought all the 
time. 
• Individual improvements identified by the work force will be small 
rather than far-reaching. 
Six Sigma 
• Six Sigma is a quality management programme  that was pioneered in 
the 1980s by Motorola. 
• The aim of the approach is to achieve a reduction in the number of faults 
that go beyond an accepted tolerance lim it through the use of statistical 
techniques. 
• The sigma stands for standard devia tion. For reasons that need not be 
explained here, it can be demonstrated that, if the error rate lies beyond 
the sixth sigma of probability, there will be fewer than 3.4 defects in 
every one million. 
• This is the tolerance level set. It is almost perfection since customers will 
have a reason to complain fewer than four times in a million.

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 Illustration 18 – The Six Sigma approach 
 A hospital is using the Six Sigma process to improve patient waiting 
times. An investigation of the vi ews of patients has revealed that: 
• patients do not want to be called before their appointment time as 
they do not want to feel  that they have to be at the hospital early to 
avoid missing an appointment 
• the maximum length of time they  are prepared to wait after the 
appointment time is 30 minutes. 
 
The aim of the Six Sigma programme will be to ensure that no more than 
3.4 waits in every million occurrences exceed 30 minutes or are less than 
0 minutes. 
 
 Further aspects of Six Sigma 
 Key requirements for successful  Six Sigma implementation 
There are a number of key requirem ents for the implem entation of Six 
Sigma. 
• Six Sigma should be focused on the customer and based on the 
level of performance acceptable to the customer. 
• Six Sigma targets for a proce ss should be related to the main 
drivers of performance. 
• To maximise savings, Six Sigma needs to be part of a wider 
performance management programme  which is linked to the 
strategy of the organisation. It s hould not be just about doing things 
better but about doing things differently.

244  
 • Senior managers within the organisation have a key role in driving 
the process. 
• Training and education about  the process throughout the 
organisation are essential for success. 
• Six Sigma sets a tight target, but accepts some failure – the target is 
not zero defects. 
Some criticisms and limitations of Six Sigma 
Literature on Six Sigma contains some criticisms of the process and 
identifies a number of limitations as follows 
• Six Sigma has been criticised for it s focus on current processes and 
reliance on data. It is suggested that  this could become too rigid and 
limit process innovation. 
• Six Sigma is based on the use of models which are by their nature 
simplifications of real  life. Judgement needs to  be used in applying 
the models in the context of business objectives. 
• The approach can be very time  consuming and expensive. 
Organisations need to be prepared to put time and effort into its 
implementation. 
• The culture of the organisati on must be supportive – not all 
organisations are ready for su ch a scientific process. 
• The process is heavily data-driven.  This can be a strength but can 
become over-bureaucratic. 
• Six Sigma can give all parts of  the organisation a common language 
for process improvement, but it is important to ensur e that this does 
not become jargon but is express ed in terms specific to the 
organisation and its business. 
• There is an underlying assumption in  Six Sigma that the existing 
business processes meet customers' expectations. It does not ask whether it is the right process 
Lean thinking 
 As the name suggests, lean is a philosophy that aims to systematically 
eliminate waste  through the identification and elimination of all non-value 
adding activities). 
 
 Illustration 19 – lean production at Toyota 
 60 years ago, the cars that Toyota  was making were uncompetitive in 
both cost and quality terms. In a bid to catch up with its American 
competitors, it developed lean production. Lean production helped Toyota to become what it is now – the bi ggest car manufacturer in the world.

Chapter 9 
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Wastes to be eliminated include: 
• Inventory  – holding or purchasing unnecessa ry raw materials, work-in- 
progress and finished goods. 
• Waiting  – time delays/idle time when va lue is not added to the product. 
• Defective units  – production of a part that is scrapped or requires rework. 
• Effort or motion  – actions of people/equipment that do not add value. 
• Transportation – delays in transportation or unnecessary handling due to 
poor planning or factory layout. 
• Over-processing  – unnecessary steps that do not add value. 
• Over-production  – produce more than customers have ordered. 
 
 Characteristics of lean 
 Characteristics of lean include: 
• Improved production scheduling  – production is initiated by 
customer demand rather than ability  and capacity to produce, i.e. 
production is demand-pull,  not supply-push. 
• Small batch production or continuous production – production 
is based on customer demand, re sulting in highly flexible and 
responsive processes. 
• Economies of scope  – lean production is only achieved where 
‘economies of scope’ make it economical to produce small batches 
of a variety of products with the sa me machines. This is in stark 
contrast with traditional manuf acturing and its emphasis on 
economies of scale. 
• Continuous improvement  – the company continually finds ways to 
reduce process times: 
– A multi-skilled, trained workforce provides flexibility. 
Employees should be involved in and engaged with the lean 
philosophy. 
– The machines, tools and people used to make an item are 
located close together. 
– Quality at source reduces re-working. 
– A clean and orderly workplace. 
• Zero inventory  – just-in-time purchasing (this is discussed below) 
eliminates waste. 
• Zero waiting time – JIT production (this is discussed below) means 
that the work performed at each stage of the process is dictated 
solely by the demand for materials for the next stage, thus reducing 
lead time.

246  
 Illustration 20 – Lean management in the NHS 
 Toyota pioneered the concept of a ‘lean’ operating system and it has now 
been implemented in countless manufacturing companies. Lean 
techniques can also be applie d to service organisations. 
With service operations, a lean approach often focuses on improving the customer experience. 
Within the NHS (National Health Serv ice) in England, lean thinking is 
being used to improve performance. It s use is based on a number of core 
principles: 
Patient perspective 
Under lean, value is defined solely from the customer’s (normally the 
patient) perspective. Anything that helps treat the patient is value-adding, 
anything else is waste. 
Pull 
To create value, the NHS aims to pr ovide services in line with demand. 
 
The lean supply chain 
 The main objective of a lean supply chain is to completely remove waste 
in order to achieve competitive advantage through a reduction in costs 
and an improvement in qualit y. Other benefits are: 
• reduced inventories (and thus increased cash flows and profits) 
• shorter lead times, and thus faster deliveries to customers 
• few bottlenecks, so better utilisation of resources, and further 
improvements in profit 
• few quality problems, so less re-wor k, lower costs of quality failures, 
and happier customers. 
However, disadvantages include the potential for large, powerful 
customers to dominate the supply c hain and an over-emphasis on cost 
reduction rather than quality improvement.

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 Criticisms and limitations of lean manufacturing 
 • High initial outlay  – It might involve a large amount of initial 
expenditure to switch from ‘traditional’ pr oduction systems to a 
system based on cellular manufacturing. All the tools and equipment 
needed to manufacture a product need to be re-located to the same area of the factory fl oor. Employees need to be trained in multiple 
skills. 
• Requires a change in culture  – Lean manufacturing, like TQM, is 
a philosophy or culture of worki ng, and it might be difficult for 
management and employees to acquire this culture. Employees might not be prepared to give the necessary commitment. 
• Part adoption  – It might be tempting for companies to select some 
elements of lean manufacturing (such as production based on cellular manufacturing), but not to adopt others (such as 
empowering employees to make on-the-spot decisions). 
• Cost may exceed benefit  – In practice, the expected benefits of 
lean manufacturing (lower costs a nd shorter cycle times) have not 
always materialised, or might not have been as large as expected. 
 
Illustration 21 
 Comparison of Toyota to a non-lean car manufacturer 
 Non-lean manufacturer Lean pioneer – Toyota 
Production Mass production requiring: 
• time to set up 
machinery and 
• skilled engineers Produce smaller batches 
leading to: 
• quick set up 
• flexibility • production line staff 
trained to do set 
ups 
• job for life 
• defined career path • empowered staff 
Human 
resources Cyclical nature of industry resulting in: 
• staff layoffs 
• unmotivated staff • Job for life • Defined career path • Empowered staff

248  
  
Employee roles • Assembly worker 
• Foreman • Housekeeper • Engineer Eliminates non-value 
adding activities so all workers trained on all aspects hence no indirect wages 
Production problems • Couldn't stop the 
production line 
• 20–25% defects • Stops the 
production line and then the team works to solve issues quickly 
• Zero defects 
Suppliers Chosen on cost • Use supplier 
expertise 
• Fair price 
• JIT 
Sales • Sell through 
dealers 
• Narrow product 
range • Sell direct to 
customers 
• Customer feedback 
valued 
• Flexibility resulting 
in wide product 
range 
   
 Lean synchronisation  aims to meet demand in stantaneously with perfect 
quality and no waste.  
Lean synchronisation overlaps to a la rge degree with the gener al concept of 
lean (elimination of waste) and just-in-ti me (which emphasises the idea of 
producing items only w hen they are needed). 
Just-in-time 
Most inventory management systems assume that it is necessary to hold some inventory. An alternative view is that inventory is wasteful and adds no value to 
 Just-in-time (JIT) is a system whose objective it is to produce or procure 
products or components as they are r equired by the custom er or for use, 
rather than for inventory. This means t hat inventory levels of raw materials, 
work-in-progress and finished goods  can be kept to a minimum.

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 JIT purchasing and JIT production 
 JIT applies to both production withi n an organisation and to purchasing 
from external suppliers: 
• JIT purchasing is a method of purchasing that involves ordering 
materials only when customers place an order. When the goods are 
received, they go straight into production. 
• JIT production  is a production system that is driven by demand for 
the finished products (a ‘pull’ system), whereby each component on 
a production line is produced only when needed for the next stage. 
 
 Illustration 22 – JIT at Toyota 
 Toyota pioneered the JIT manufacturing system, in which suppliers send 
parts daily – or several times a day – and are notified electronically when 
the assembly line is running out. 
More than 400 trucks a day come in  and out of Toyota’s Georgetown 
plant in the USA, with a separat e logistics company organising the 
shipment from Toyota’s 300 suppliers – most located in neighbouring 
states within half a day’s  drive of the plant. 
Toyota aims to build long-term relati onships with its suppliers, many of 
whom it has a stake in, and says it now produces 80% of its parts within 
North America. 
Requirements for successful ope ration of a JIT system 
• High quality and reliability  – disruptions create hold ups in the entire 
system and must be avoided. The emphasis is on getting the work 'right first time': 
– Highly skilled and well trained staff should be used. – Machinery must be fully maintained. – Long-term links should be established with suppliers in order to 
ensure a reliable and high quality service. 
• Elimination of non-value added activities  – value is only being added 
whilst a product is being process ed. For example, value is not added 
whilst storing the products and therefore inventory levels should be 
minimised. 
• Speed of throughput  – the speed of production should match the rate at 
which customers demand the product. Production runs should be shorter with smaller stocks of finished goods.

250  
• Flexibility – a flexible production system is needed in order to be able to 
respond immediately to customer orders: 
– The system should be capable of switching from making one product 
to making another. 
– The workforce should be dedicated and have the appropriate skills 
JIT is an organisational culture and the concept should be adopted 
by everyone. 
– Management should allow the work t eams to use their initiative and 
to deal with problems as they arise. 
• Lower costs  – another objective of JI T is to reduce costs by: 
– Raising quality and eliminating waste. – Achieving faster throughput. – Minimising inventory levels. 
 
Test your understanding 12 
 Explain the advantages and disadvan tages to an organisation of 
operating a JIT system. 
 
 JIT and supplier relations 
 As mentioned previously, many of t he steps taken to improve the supply 
chain (and hence prof itability) involve improving the relationship 
between the manufacturer and its suppliers. This will be of particular importance in a company operating a JIT system. 
The advantages to a JIT company of developing close supplier 
relationships are as follows: 
• No rejects/returns  – a strong relationship should help to improve 
the quality of supplies. This shoul d minimise production delays since 
there will be less inspection, fewer returns and less reworking of 
goods. 
• On-time deliveries  – the development of close working 
relationships should help to guarantee on-time deliveries of supplies. 
• Low inventory  – suppliers can be relied upon for frequent 
deliveries of small quantities of ma terial to the company, ensuring 
that each delivery is just enough to  meet the immediate production 
schedule. 
• Close proximity  – the supplier/portfolio of suppliers will be located 
close to the manufacturing plant. This will reduce delivery times and costs.

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Reverse logistics 
 Reverse logistics is the return of unwanted or surplus goods, materials or 
equipment back to the organisation fo r reuse, recycling or disposal. 
The emergence of internet selling (some in ternet retailers estimate returns of 
50%) and shorter product life cycles has led to many organisations focusing on 
their reverse logistics capability. 
The main reasons for returns are as follows: 
• The customer is not satisfied with the product and takes advantage of 
the organisation’s return policy. 
• Installation or usage problems  – a common problem if installation or 
usage is complicated, for example with IT equipment. 
• Warranty claims for defective products or parts. 
• Some manufacturers allow the return of unsold stock  by retailers, for 
example this is common practice in the book industry. 
• Manufacturer recall  program due to faults. 
Attacking the returns challenge  is a critical area of supply chain 
management. Steps should be taken to: • minimise returns, for example through the pr oduction of good quality 
products or parts, which meet cust omer requirement s and have clear 
guidelines for installation and usage. 
• ensure the possible reuse or recycling of material . This is closely 
linked to corporate social responsibility but should contribute to increased 
profitability. 
Techniques  include: 
• Root cause analysis to understand the reasons for returns. 
• Creation of profit centres around the returns process to focus 
organisations on maximising the price t hat they will get for any returns. 
• Separation of the supply chain into separate forward and reverse logistics. 
• Centralising the returns centre to  improve the speed and efficiency of 
handling returns. 
• Outsourcing the returns process to  a competent and dedicated provider. 
• The use of technology such as enter prise resource planning (ERP) which 
supports reverse logistics processes. 
The use of these techniques should r educe costs, improve customer service 
and increase revenue.

252  
 Match the following technique s to their explanation. 
Technique Explanation 
Statistical Process 
Control The philosophy of continuous improvement via small, incremental steps 
Just in Time The return of unwanted or surplus goods, 
materials or equipment ba ck to the organisation 
Total Quality Management An approach to achieve a reduction in the number of faults that go beyond an accepted tolerance limit 
Six sigma A method for measuring and controlling quality 
during a process.  
Lean thinking A system whose objective it is to produce or 
procure products or co mponents as they are 
required by the customer or  for use, rather than 
for inventory. 
Reverse logistics A philosophy that aims to systematically eliminate 
waste 
Kaizen The continuous im provement in quality, 
productivity and effectiveness obtained by establishing management responsibility for processes as well as outputs 
  
 Lean thinking identifies seven wastes to be eliminated. These include 
which of the following? Select all that apply. 
A Over-processing 
B Over-production C Over-thinking D Over-selling E Transportation F Effort or motion G Human resources H Inventory

Chapter 9 
 253 
 Illustration 23 – Reverse logistics at Estee Lauder 
 A good example of a complete reverse logistics program is a project by 
cosmetics manufacturer Estee Lauder. The firm used to dump $60 million 
of its products into landfills each year, destroying more than a third of the 
name brand cosmetics returned by retailers. 
Estee Lauder made a small in vestment of $1.3 million to build its reverse 
logistics system and apparently recover ed its investment in the first year. 
Estee Lauder has reduced its production and inventory levels through its 
increased ability to put retur ned goods back on the market and the 
availability of better data on the reasons for returns. In the first year Estee Lauder was able to evaluate 24 per cent more returned products, 
redistribute 150 per cent more of its returns, reduce the destroyed 
products from 37 per cent to 27 per  cent and save about $0.5 million on 
labour costs. 
5.7 SCM interface with finance 
• Organisations with strong links between their finance function and supply 
chain teams are more likely to hav e effective supply chain management. 
• A collaborative relationship between the CFO and the leader of the 
supply chain (either directly or thr ough their teams) is advantageous for 
organisational growth and competitive advantage: 
– The role of the leader of the supply chain has become more 
prominent in recent years. As discu ssed earlier in this chapter, the 
focus of SCM has moved away from  cost reductions to creating a 
supply chain strategy that is align ed to the broader corporate goals of 
the organisation and is efficient in enabling the organisation to 
respond to new opportunities. 
– Meanwhile, the role of the financ e function has been transformed (as 
discussed in Chapter 2). The finance function now collaborates more 
closely with other internal functi ons; not just fr om a monitoring, 
reporting and risk management perspecti ve, but also as supporters 
and enablers of performance. 
– The result is that CFOs and supply chain leaders are working 
increasingly together to under stand, analyse and address supply 
chain issues. CFOs are drawing on their skills and unique view of the organisation to provide insight to  deliver more informed decision 
making.

254  
Opportunities for business partnering 
The finance function has a unique end to end view of the organisation and is 
considered a trusted advisor. As a resu lt, there are a number of areas where 
the CFO (and their team) has an opport unity to enhance performance through 
business partnering with the s upply chain. These include: 
• Stronger alignment between the supply chain and the broader strategy 
and consistency of strategy within the various parts of the supply chain. 
• CFOs help to set the right growth priorities and pace of growth; they 
support and challenge the rationale for new investment, apply data 
analytics to support and challenge business decisions and ensure that tax is considered as part of operational decisions. 
• Monitoring and enhancing performance through the establishment of 
appropriate KPIs that are aligned to  the broader organisa tion (this will be 
discussed in more detail in section 6). 
• Managing risk and business continuity; the CFO has the opportunity to 
work with procurement and treasury to determine the extent to which risk 
is owned and managed by the company, and to what extent it is pushed further down the supply chain. 
 
Illustration 24 – Technology and business partnering 
 Data and analytics present CFOs with a significant opportunity to drive a 
more collaborative, business partner ing relationship with the supply 
chain. Robust information and insight are central to any business partnering relationship. The CFO’s access to financial information from across the business allows them to cr eate a credible single version of the 
truth to drive decisions and performance measurement.  
6 Key performance indicators  
 Critical success factors  (CSFs) are the vital areas ‘where things must go 
right’ for the business in order for them to achieve their strategic 
 Key performance indicators  (KPIs) are the measures which indicate 
whether or not the CS Fs are being achieved. 
For example, if quality is an important CSF, the busi ness needs to ascertain the 
quality expected by customers and then set appropriate targets which might 
include the percentage of products re turned, the amount spent on warranties 
etc.  
The achievement of the KPIs s hould be measured and any necessary 
corrective action taken.

Chapter 9 
 255 
Characteristics  of good KPIs include: 
• KPIs should cascade from strategy to  tactics, and to operational level. 
• KPIs should cover all perspectives in  supply chain management such as 
cost information and financial performanc e, quality of the supply chain, 
flexibility, resource utilisation, innovation, sustainability and 
competitiveness. This coverage will give a complete and well balanced view of  
– internal/external performance – short and long term performance and  – financial and non-finan cial performance. 
• KPIs should be challenging but achi evable and should enable employees 
to understand the performance measures they have control over and 
should motivate them to achieve KPIs through the establishment of 
appropriate rewards. 
• KPIs should be SMART, i.e. specific, m easurable, achievable, relevant 
and time-bound. 
• KPIs should be extended to include supply chain partners, because the 
objective of SCM is to create a supply chain that is much more competitive 
than the alternative supply chain prov iders of that product or service. 
6.2 Examples of KPIs for operations 
Appropriate KPIs may include: 
• Supply chain costs per unit sold 
• Time taken to deliver a customer order • Percentage on-time delivery to a customer • Percentage of custom er orders fulfilled 
• Percentage defect rate (supp lies and customer orders) 
• Percentage wastage rate • Quality costs (individual KPIs for prev ention, detection, internal failure and 
external failure costs) 
• Labour utilisation rate • Asset utilisation rate • Warehousing costs • Transport costs • Queues and waiting times

256  
• Working capital ratios such as inventory days, payable days and 
receivable days and the length of  the cash operating cycle: 
– Inventory days = Inventory ÷ Cost of sales × 365 
– Receivables days = Receivables ÷ Sales × 365 – Payables days = Payables ÷ Purchases × 365 – Cash operating cycle = Inventory days + Payables days – 
Receivables days 
 
Test your understanding 15 
 Ali is constructing some KPIs to measure whether or not the firm’s CSFs 
are being met. He has been told that  these KPIs should be SMART. 
Which of the SMART criteria is not  being met in the following KPI? 
KPI: Reduce the time taken to deliver a customer’s order by three days. 
(the current lead time for deliveries is two weeks). A Specific B Measurable C Achievable D Relevant E Time-bound 
 
 Calculate the cash operating cycl e using the extracts from the 
financial statements below: 
Statement of Profit or Loss 
$000 
Sales 400 
Cost of Sales 
opening inventory 12 
purchases 245 
closing inventory 15 
242 
Gross Profit 158

Chapter 9 
 257 
  
Statement of Financia l Position (extract) 
$000 
Inventory 15 
Trade receivables 45 Cash 78 
Payables 35 
    
6.3 How the finance function ma nages operations using KPIs 
The finance function plays an important ro le in the performance management of 
the operations function, implement ing a performance management approach 
that gives a complete and well balanced view of all supply chain activities. 
Information to impact framework revisited 
We can understand how the finance function helps manage operations through 
the use of KPIs by looking the information to impact framework (as 
discussed in Chapter 2): 
 
Finance function activity Explanation of how the fina nce function helps manage 
operations through the use of KPIs 
Assembling information The finance function works with oper ations to establish a set 
of appropriate KPIs (as per the characteristics in section 
6.1). It then assembles  data from a range of internal and 
external sources and processes this data to turn it into 
useful KPI information. 
This information is then reported to those people who need 
it within the organisation and across the supply chain. 
insights The finance function analyses the KPI information to draw out patterns and relevant insights  for those who use the 
This questioning  may require individual KPIs to be broken 
down into several different performance measures so that 
the root cause of any deviati ons between the actual KPI and 
the target KPI c an be established.

258  
Finance 
function activity Explanation of how the fina nce function helps manage 
influence The finance function then: 
• communicates these insights and 
• contributes an objective and responsible perspective 
helping to develop solutions  to any operational 
problems or areas for improvement identified 
to influence  decision making in the operations function. 
impact (also called ‘execute’ ) The finance function applies the information to harness value for the operations function through its impact . 
Solutions are deployed  such as changes to the 
operational strategy and future KPIs. 
Impact of technology  
In Chapter 2 we discussed the impact of technology and automation on the 
information to impact framework. 
 
If we now consider this in relati on to how the finance function manages 
operations through the use of  KPIs we can see that: 
‘assembly’ and ‘analysis’ activities. 
– Successful companies operate an enterprise data warehouse that 
acts as a single source to assemble ‘clean’ data (in-house data is 
seamlessly integrated with data fr om supply chain partners) and 
reports this in the form of a suppl y chain dashboard that is accessible 
and adaptable for relevant users across the supply chain and the 
– This integrated technology can draw out patterns and relevant 
insights for those who use the information, reducing the analysis  role 
of the finance function.

Chapter 9 
 259 
• This will ‘free up’ the resource of the finance function professionals who 
activities. However, even in these activities, technology will take on a role. 
For example, predictive algorithm s may be used for advanced business 
intelligence and to determine timely corrective actions along the end-to-
end supply chain. 
 
 Illustration 25 – Technological developments  
 Advances in technology offered by the 4th Industrial Revolution are giving 
organisations an opportunity to e nhance performance management in the 
operations function. For example: 
• Easier linking  of internal supply chain data with external 
sources  such as financial information about suppliers to improve 
supply chain risk management. 
• Ongoing digitisation of supply chains  and resulting exponential 
growth in data from connected devi ces (such as delivery vehicles). 
• Use of web mining  to report only the most  relevant data and to 
quickly react to new events. 
• A shift to real-time data enabled  by sensors covering different 
locations. 
• The most common use of data visualisation  is in creating a 
dashboard to display the key performance indicators of a business 
in a live format, thus allowing im mediate understanding of current 
performance and potentially prompting action to correct or amend 
performance accordingly. 
• Increasing use of predictive measures  to (for example) forecast 
sales, detect product quality i ssues, evaluate maintenance 
requirements and produce sound ‘what-if’ scenarios. 
• Improved analytics capabilities  (for example, using cloud 
technology) allowing for fast pr ocessing and analysis of large 
amounts of data.

260  
 Test your understanding 17 
 The finance function helps manage oper ations through the use of KPIs. 
Match the following KPI activities to the relevant stage in the 
‘information to impact framework’. 
Assembling information Deploying solutions such as developing 
future KPIs 
Analysing for insights Helping to  develop solutions to any 
operational problems 
Advising to influence Establishing the cause of any deviations 
between actual and target KPIs 
Applying for impact  Establishing a set of appropriate KPIs 
  
 Test your understanding 18 
 Which of the following stat ements is/are correct? 
I Technology will have the largest impact on the assemble and 
analysis activities of the finance function 
II Technology facilitates easier int egration of internal supply chain 
data with external sources 
III By analysing KPIs, the finance function can guarantee that CSFs 
are met 
IV A primary feature of the intera ction between finance and operations 
is performance management 
A All of them 
B I and IV C I only D I, II and IV

262  
 The answer is company A 
High volume (selling in bulk), low variety (basic products), low variation 
and low customer contact (visibility) all help keep processing costs down. 
 
 The correct answer is C – outbound logistics  
The new system helps manage the fini shed loaves, indicating that it 
refers to outbound logistics. It doe s not manage the raw materials (or 
ingredients), indicating t hat it will not help inbound logistics. It also is used 
after BB bakes the loaves of bread, so it cannot be part of operations. 
The system does not affect marketi ng or procurement of the bread. 
 
B relates to marketing, C relates to  production and D relates to human 
resource management. 
 
Note that provision of services woul d be unlikely to affect the sale of 
physical units, so inventory turnover would be unaffected. 
 
By definition.

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The co-ordination of activities from the 
supplier(s) of raw materials at one end 
of the supply chain to the customer at 
the other end is known as supply chain 
management True 
Cost savings are the only advantage of 
supply chain management False. Supply chain 
management can also add 
value to an organisation, for 
example in improved 
customer services. 
The objective of SCM is to achieve 
synergies that benefit the customers at 
the end of the supply chain False. The objective of SCM 
is to achieve synergies that 
benefit every player along the 
chain. 
Cousins’ supply wheel is a model used 
to look at the traditional supply function False. Cousins’ model 
examines supply in a 
strategic way. Successful 
organisations in today’s 
competitive environment 
have recognised that supply 
should be viewed as a 
strategic issue.  
Cousins’ supply wheel has five spokes True. The spokes are: 
Organisation structure, 
Performance Measures, 
Relationships with suppliers, 
Cost Benefit, and 
Competences 
  
 The correct answers is A, B and C 
Answer D – improved quality is not guaranteed and therefore this is not 
an advantage. 
Answers E and F – these are disadvantages.

264  
 Higher quality can help to increase revenue and reduce costs: 
• Higher quality improves the perceiv ed image of a product or service. 
As a result, more customers will be willing to buy the product/service 
and may also be willing to pay mo re for the product/ service. 
• A higher volume of sales may result in lower unit costs due to 
• Higher quality in manufacturing should result in lower waste and 
defective rates, which will reduce production costs. 
• The need for inspection and testing should be reduced, also 
reducing costs. 
• The volume of customer complaints should fall and warranty claims 
should be lower. This will reduce costs. 
• Better quality in production should l ead to shorter processing times. 
This will reduce costs. 
 
Test your understanding 10 
 The correct answer is B and E 
Prevention costs are those incurred in order to prevent poor quality. 
Answer A – inspection of raw materials is an appraisal cost. 
Answer C – returns from customer s are an external failure cost. 
Answer D – machine breakdown repairs  are internal failure costs. 
 
 Tail off  – after an initial burst of ent husiasm, top management fails to 
maintain interest and support. 
Deflection – other initiatives or problems deflect attention from TQM. 
Lack of buy-in  – managers pay only ‘lip service’ to the principles of 
worker involvement and communication. Rejection  – TQM does not fit in with t he organisational culture and is 
therefore rejected.

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 Advantages of JIT 
• Lower stock holding costs means a reduction in storage space 
which saves rent and insurance costs. 
• As stock is only obtained when it  is needed, less working capital is 
tied up in stock. 
• There is less likelihood of stock perishing, becoming obsolete or out 
of date. 
• Avoids the build-up of unsold fi nished products that can occur with 
sudden changes in demand. 
• Less time is spent checking and re-working the products as the 
emphasis is on getting the work right first time. 
The result is that costs should fall and quality should increase. This 
should improve the company ’s competitive advantage. 
Disadvantages of JIT 
• There is little room for mistakes as  little stock is kept for re-working 
a faulty product. 
• Production is very reliant on suppliers and if stock is not delivered 
on time or is not of a high enough quality, the whole production 
schedule can be delayed. 
• There is no spare finished product available to meet unexpected 
orders, because all products are made to meet actual orders. 
• It may be difficult for managers to  empower employees to embrace 
the concept and culture. 
• It won’t be suitable for all compan ies. For example, supermarkets 
must have a supply of inventory. 
• It can be difficult to apply to the service industry. However, in the 
service industry a JIT approach may focus on eliminating queues, which are wasteful of  customers' time.

266  
  
Control A method for measuring and controlling quality during a process.  
Just in Time A system whose objective it is to produce or 
procure products or components as they are required by the customer or  for use, rather than 
Total Quality Management The continuous improv ement in quality, 
Six sigma An approach to achieve a reduction in the 
number of faults that go beyond an accepted tolerance limit 
Lean thinking A philosophy that aims to systematically eliminate 
waste 
Reverse logistics The return of unwanted or surplus goods, 
Kaizen The philosophy of c ontinuous improvement via 
small incremental steps. 
  
 The correct answers are A, B, E, F & H 
The other two wastes to be eliminated under lean thinking are waiting and defective units. 
 
 The correct answer is  E time-bound. There is no mention of by when the 
KPI needs to be achieved. Just becaus e it mentions a number of days, 
does not make it time-bound.  
The KPI is straight forward and, hence,  specific, the time to deliver can 
be easily measured. Three days reducti on seems achievable. The KPI is 
relevant to the CSF as delivery wa iting times will be important to the 
customer.

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Receivables Days 45
400 × 365 =  41 days 
    
Inventory Days 15
242 × 365 = 23 days 
    
Payables Days 35
245 × 365 = 52 days 
    
Cash operating cycle 41 + 23 – 52 = 12 days 
    
Assembling information Establishing a set of appropriate KPIs 
Analysing for insights Establishing the cause of any deviations 
Advising to influence Helping to develop solutions to any 
Applying for impact  Deploying so lutions such as developing 
  
 The correct answer is D  
Option III is not correct as there is no guarantee that the CSFs will be 
met.

269 
interacts with sales and 
marketing  
E2: Describe how the finance 
function interacts with 
sales and marketing. (a) Main role of sales and 
marketing. 
finance. 
 Chapter 
10

How the finance function interacts with sales and marketing 
270  
 
In Chapter 9 we described the finance func tion’s relationship with operations. In 
this chapter we will continue to describe how the finance function plays its role 
by interacting with the rest of the organi sation and, more specifically here, the 
organisation’s sales and marketing function. 
We will begin by discussing the main role of the sales and marketing function; 
understanding the marketing environment, the marketing mix and the main 
techniques of sales and marketing.  
We will then discuss the areas of inte rface with finance; understanding how the 
finance function interacts with sales and marketing and the role of big data 
analytics. The final part of this chapter will di scuss how the finance function helps to 
manage the sales and marketing function through the use of key performance 
indicators (KPIs). 
2 Main role of sales and marketing 
 Marketing is defined by the Chartered In stitute of Marketi ng (CIM) as ‘the 
management process that identifies, anticipates and supplies customer 
needs efficiently and profitably.’ 
The key emphasis of the sales and marketing function is thus on customer 
needs.

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 Benefits of a marketing orientation 
 As CIM point out: 
"It is all about getting the right product or service to the customer at the 
right price, in the right place, at the right time. Business history and 
current practice both remind us that  without proper marketing, companies 
cannot get close to customers and sa tisfy their needs. And if they don’t, a 
competitor surely will." 
 
 Marketing is mainly concerne d with which of the following? 
A  Increasing sales revenue 
B  Streamlining production 
C  Anticipating and meeting customer needs 
D  Maximising profit 
The market planning process 
A marketing action plan will be needed to ensure the effectiveness of the sales 
and marketing processes. 
The following is an example of the diffe rent components that  could be included 
in this plan: 
Step 1: Situation analysis 
A number of techniques can be used. These include: 
SWOT analysis – the organisation needs to understand its own strengths (S) 
and weaknesses (W) together with an apprec iation of the wider environment in 
which it operates, i. e. the opportunities (O ) and threats (T). 
PESTEL analysis – The organisation should re view the external environment for 
opportunities that may allow it to furt her meet their customers' needs. This 
analysis divides the business environment into six related sub-systems – 
Political, Economic, Social, Technological , Environmental/Ecological factors and 
Legal. Each of these factors can be applied to the market ing function.  
Note:  PESTEL will be discussed in section 2.2 below. 
Step 2: Review mission and objectives 
The organisation will already have a mi ssion statement and a set of objectives 
in place. These will underpi n the marketing objectives. 
Step 3: Set marketing objectives 
Marketing objectives should be consist ent with the organisation’s overall 
mission and objectives.

272  
Marketing objectives should be SMART – specific, measurable, achievable, 
relevant and time bound. For example, acquire 50,000 new online customers 
this financial year at an average cost  per acquisition of $30 with an average 
profitability of $5. 
Step 4: Devise an appropr iate marketing strategy 
There may be a gap between the current  performance and the performance 
required to achieve the marketing obj ectives set. The organisation needs to 
consider how to close the gap. The following techniques can be used: 
• Market research  will be required to under stand the organisation’s 
activities and to provide a basis for effective marketing decisions to be 
made. 
• Segmentation – the market should be segm ented, for example by age, 
social class or income. The needs of each segment should be established 
using market research. 
• Targeting  – the most attractive segments in terms of profitability and 
growth should be targeted using an appropriate marketing mix. 
• Positioning  – an appropriate positioning strategy, for example 
differentiation or cost leadership should be chosen for each market segment. 
• Marketing mix – the organisation should use the marketing mix to 
determine the correct marketing strategy. 
Note:  Each of these ideas will be explored in more detail in sections 2.3 and 2.4 
below. 
Step 5: Implementation 
The marketing action plan should t hen be implemented and appropriate KPIs 
established (section 4). Step 6: Review 
The plan should be monitored to gauge its success (or otherwise) and to 
identify any necessary changes required to  achieve the marketing objectives 
set. 
2.2 Understanding the marketing environment 
The marketing environment is the content  in which the organisation exists. The 
environment can have a considerabl e impact on the organisation. 
The macro environment  includes all the factors t hat influence an organisation 
but are outside of their control. Organisations will need flexible marketing 
practices to respond to this dynamic environment.

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One popular technique for analysing the macro  environment is PESTEL  
analysis: 
PESTEL factor Explanation 
Political Political factors can have a direct effect on the way an 
organisation operates. Decisions made by government affect 
our everyday lives. For example, the instability of many 
governments in less developed countries has led a number 
of companies to question the wis dom of marketing in those 
countries. 
Economic All businesses are affected by  economic factors nationally 
and globally. For example, within the UK, the climate of the economy can dictate consumer ex penditure on luxury goods. 
Social Forces within society such as family, friends and the media affect our attitude, interests and opinions and, in turn, will influence our purchases. 
For example, within the UK peop le’s attitudes are changing 
towards their diet and health. Ov er the last 5 years, the UK 
has seen a massive increase in demand for vegan food. 
Technological This is an area in which change takes place very rapidly and 
the organisation needs to be constantly aware of what is going on. For example, new technology has resulted in the production of new products, such as hybrid cars. These cars have improved fuel economy and reduced emissions. 
Environmental/ Ecological These have become increasingly important in recent years 
and influence a marketing orientated organisation in a number of ways. For example, using the example above, demand for vegan food has increased not only for health reasons but also due to the negat ive environmental impact of 
meat and dairy farming and fishing. 
Legal Laws and regulations governing businesses are widespread. 
These include laws on health  and safety, information 
disclosure, the dismissal of employees, vehicle emissions, 
the use of pesticides and many more. For example, the UK 
smoking ban in public places has resulted in UK tobacco 
companies exploring new produc ts, such as the legal, 
electronic cigarette (although these may also be banned in public in the near future), and ne w markets outside of the UK. 
 
 Describe the changes that may be made to the marketing approach of a supermarket if the country goes into recession.

274  
 Social factors 
 According to Johnson and Scholes the following social influences should 
be monitored: 
• Population demographics  – a term used to describe the 
composition of the population in any given area, whether a region, a 
country or an area within a country. 
• Income distribution  – will provide the marketer with some 
indication of the size of the target markets. Most developed 
countries, like the UK, have a rela tively even distribution spread. 
However, this is not the case in other nations. 
• Social mobility  – the marketer should be aware of social classes 
and the distribution among them. The marketer can use this 
knowledge to promote products to di stinct social classes within the 
market. 
• Lifestyle changes – refer to our attitudes a nd opinions to things like 
social values, credit, health and women. Our attitudes have 
changed in recent years and this information is vital for the marketer. 
• Consumerism – one of the social trends in recent years has been 
the rise of consumerism. This tre nd has increased to such an extent 
that governments have been pressured to design laws that protect the rights of the consumer. 
• Levels of education  – the level of education has increased 
dramatically over the last few years. There is now a larger 
proportion of the population in hig her education than ever before. 
2.3 Understanding the marketing mix 
 The marketing mix is the set of controlla ble variables that a firm blends to 
produce desired results from its chosen target market. 
The 7 Ps 
The traditional 
marketing mix (4 Ps): Elements 
Product This includes product f eatures, durability, design, 
brand name, packaging, range, after-sales service, warranties and guarantees. 
Place Distribution channels and intermediaries, transportation and storage.  
Promotion Advertising, personal selling, public relations, sales 
promotion, sponsorship, direct  marketing, e.g. direct 
mail and telephone marketing. 
Price Price level, discounts, credit policy, payment methods.

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 275 
Additional 3 Ps for 
the service industry: Elements 
People The role of employees in the service industry is 
particularly important becaus e of the inseparability of 
the service from the servic e provider. Staff must be 
selected, trained and motivated to meet the needs of 
the target customer. 
Processes These are the systems through which the service is 
delivered. For example, t he teaching methods used in 
a university or the speed and friendliness of service in a restaurant. 
Physical evidence Required to make the intangible service more tangible. 
For example, brochures , testimonials and the 
appearance of staff and of the environment. 
The extension of the traditional marketing mix to include the three additional Ps 
acknowledges that there are fundam ental differences between products and 
services and therefore services market ing assumes a different emphasis to 
product marketing. 
 
Features of service organisations  
 Service organisations have certain distinguishing features that should be 
considered: 
• Services are intangible  and it is more difficult to measure their 
quality than it is for a physical product. Customers may be more 
reluctant to make a purchase due to  uncertainty regarding what they 
will receive. Tools such as testimonials and brochures may help to address this problem. 
• Services are consumed immediately and cannot be stored . Meeting 
customer needs depends on staff being available. Therefore, 
anticipating and responding to levels of demand is a priority. 
• Heterogeneity  – maintaining consistent, standard output can be 
difficult, for exampl e due to the high level of staff and human 
intervention. The marketing policy could address this, e.g. through 
effective staff selection and standards  for customer service and care. 
• Inseparability  of the service from the provider will again reinforce 
the need for high quality employee selection and training. 
• Services do not result in the transfer of propert y and so it will be 
necessary to convince the customer of the benefits of what they are paying for. A tangible symbol of owner ship, such as a certificate, may 
be used.

276  
Each element of the traditional mark eting mix will be reviewed in turn: 
Product 
There are two main product issues to consider: 
• Product definition – The main issue regarding product is to define exactly 
what the product should be. This can be done on three levels: 
 
• Product positioning – With all of t hese factors the question of product 
positioning is critical – how does our product compare with the offerings of 
competitors? Is our product better? If so, in what way? 
 
 Illustration 1 – Product definition 
 A new car could be specified as follows: 
• Core/generic product – personal transportation. 
• Actual product – range of engine sizes, different body shapes offered, etc. 
• Augmented product – manufacturer’s warranty or dealer’s discounted 
service contract. 
 
 Product – further considerations 
 The core product  – what is the buyer really buying? The core product 
refers to the use, benefit or problem-s olving service that the consumer is 
really buying when purchasing the pr oduct, i.e. the need that is being 
fulfilled. 
The actual product is the tangible product or intangible service that 
serves as the medium for receiving core product benefits. 
The augmented product  consists of the measures taken to help the 
consumer put the actual product to su stained use, including installation, 
delivery and credit, warranties, and after-sales service.

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 277 
 A product, therefore, is more than a simple set of tangible features. 
Consumers tend to see products as complex bundles of benefits that 
satisfy their needs. Most important is  how the customer perceives the 
product. They are looking at factor s such as aesthetics and styling, 
durability, brand image, packaging, se rvice and warranty, any of which 
might be enough to set the product apart from its competitors. 
Pricing 
There are four key considerations (the ‘4 Cs’) when deciding the price of a 
product: 
• Cost – the price must be high enough to make a profit. 
• Customers – what are they willing to pay? 
• Competition  – is our price highe r than competitors? 
• Corporate objectives  – for example, the price could be set low to gain 
market share. 
These issues can be blended to give a range of pricing tactics, including the 
following: 
• Cost plus pricing  – the cost per unit is calculated and then a mark-up 
added. 
• Penetration pricing – a low price is set to gain market share. 
• Perceived quality pricing  – a high price is set to reflect/create an image 
of high quality. 
• Price discrimination  – different prices are se t for the same product in 
different markets, for exam ple, peak/off-peak rail fares. 
• Going rate pricing  – prices are set to  match competitors. 
• Dynamic pricing  – prices are altered in line with demand, for example 
this is used widely in the hotel and airline industries. 
• Price skimming  – high prices are set when a new product is launched. 
Later the price is dropped to increase demand once t he customers who 
are willing to pay more have been ‘skimmed’ off. 
• Loss leaders – one product may be sold at a loss with the expectation 
that customers will then go on and buy other more profitable products. 
• Captive product pricing  – this is used where customers must buy two 
products. The first is cheap to attr act customers but the second is 
expensive, once they are captive.

278  
 Companies with high costs will fi nd it difficult to compete on the 
basis of price and would be well advised to: 
A compete on the Internet 
B develop brand loyalty amongst customers C employ high pressure sales techniques D develop new products 
Promotion 
Promotion is essentially about market communication. The primary aim is to 
encourage customers to buy the pr oducts by moving them along the AIDA 
sequence: 
 
Towards this organisations will use a co mbination of different promotional 
techniques as part of their ‘p romotional mix’, including: 
• Advertising – for example, placin g adverts on the Internet, TV, in 
newspapers, on billboards, etc. 
• Sales promotion techniques – fo r example, ‘buy one get one free’. 
• Personal selling – for example, telesales. 
• Public relations (PR) – building good relationships and a good corporate 
image, for example, by s ponsoring sports events. 
 
 Identify the advantages and disadvantages of following methods of 
promotion: 
(a) Advertising 
(b) Sales promotion (c) Personal selling (d) Public relations

Chapter 10 
 279 
 Advertising  
 There are two polar opposite views on advertising: 
• Advertising is ineffective and a waste of money, only adding to 
company (and hence customer) costs.  Brands such as Rolls Royce 
and Zara do not see a need to use advertising in their promotional 
campaigns relying instead on other sources of information in order to form positive attitudes towards their products. In any case some 
might think that advertising dem eans a particular product or 
company. In some cases, advertising may seem unethical. Lancaster and Withey (2005) conclude that some brands may be strong enough to sell on their own merits only if they are long established and have strong brand-loyal users. 
• Advertising is so powerful and effective as to be essential. 
Consumers, it could be argued, wil l rarely purchase unadvertised 
brands so by not advertising, a company will be at serious disadvantage compared to its compet itors. The results of advertising 
campaigns have been undeniably succe ssful including those for 
brands such as Walkers Crisps and John Lewis. 
Some new forms  of marketing communication include: 
Type of marketing communication Explanation 
Viral Encourages individuals to pass on a marketing 
message to others, so creating exponential growth in the message’s exposure in the same way computer viruses grow. 
Guerrilla Relies on well thought out, highly focused and often 
unconventional attacks on key targets. 
Experiential An interactive marketing experience aimed at 
stimulating all the senses, for example road shows, street theatre, product trials. The next time the consumer sees the product, it should trigger a range of positive memories making it the first choice. 
Digital The promotion of products or brands via one or more 
forms of electronic media, for example using email, social media, the organisa tion's website or Google 
search. 
Search engine marketing A form of digital marketing that involves the promotion of an organisation’s website by increasing its visibility 
in search engine results pages, such as Google. 
Social media marketing A form of digital marketing, social media marketing refers to the process of ga ining traffic or attention 
through social media sites.

280  
Type of marketing 
communication Explanation 
Postmodern marketing A philosophical approach to marketing which focuses 
on giving the customer an experience that is 
customised to them and in ensuring they receive marketing messages in a form they prefer. 
 
 New forms of marketing communication 
 Viral marketing 
A good example of viral marketing is  Dove's ‘choose beautiful’ campaign 
which involved a video where wom en had to choose which door to use 
when entering a building – one was l abelled ‘beautiful’ and the other 
‘average’. The campaign conclude s with all women wishing they had 
chosen beautiful like some of their peers,  reinforcing Dove’s idea of real 
beauty and what that means. 
Guerrilla marketing 
A good example of guerrilla marketing is when a leading men’s magazine 
projected the image of the model Gail Porter on the Houses of Parliament 
in London. It was a stunt that wa s talked about by a huge number of 
people. It was an attempt to get people to vote fo r the magazine’s ‘world’s 
sexiest women’ poll and t he results were outstanding. 
Experiential marketing 
Carlsberg unveiled a billboard in  Brick Lane, London, named ‘Probably 
the best poster in the world’ that had an actual working tap attached to 
the centre where peopl e could pour themselves a pint of beer. 
Place 
A key decision under ‘place’ is between: 
• Selling direct – here the manufacturer sells directly to the ultimate 
consumer without using any middlemen (intermediaries). For example, 
rather than booking a hol iday through a travel agent, the internet has 
enabled customers to go direct ly to hotel websites or airline websites and 
book their accommodation and flights themselves. 
• Selling indirect  – here the channel strategy could comprise a mixture of 
retailer, distributors, wholesalers and shipping agents. For example, food 
distribution will often invo lve distributors and retailers to get the product 
from farmer to consumer. Using the example above, customers could use 
online travel websites (such as Expe dia) to book their holidays from a 
range of options that t he website has sourced fr om flight and hotel 
reservation systems.

Chapter 10 
 281 
 Variations in marketing mix settings 
 Different companies put different  emphasis on each of the four 
components of the marketing mix. 
For example, some companies plac e all the focus on making a good 
quality product; other com panies place the emphasis  on making it at a 
cheap price or emphasise the promoti on and advertising to sell it. A 
manufacturer of desks might wish to sell to both the consumer market 
and the industrial market for office fu rniture. The marketing mix selected 
for the consumer market might be low prices with attractive dealer 
discounts, sales largely through discount warehouses, modern design but 
fairly low quality and sales promoti on relying on advertising by the retail 
outlets, together with personal selling by the manufacturing firm to the 
reseller. For the industrial market, the firm might develop a durable, 
robust product that sells at a higher price; selling may be by means of 
direct mail-shots, backed by personal visits from salespeople. 
An interesting comparison can be made between different firms in the 
same industry; for example, Avon and Elizabeth Arden both sell 
cosmetics but, whereas Avon relies on personal selling in the consumer’s 
own home, Elizabeth Arden relies on an extensive dealer network and 
heavy advertising expenditure. 
2.4 The main techniques of marketing 
The marketing strategy discussed in  section 2.1 touched upon the following 
marketing techniques: 
• market research (this includes da ta gathering techniques and methods of 
analysis) 
• market segmentation 
• market targeting and • market positioning. 
These will be explored in turn below. 
Market research     
 Market research is the systematic gathering , recording and analysing of 
information about problems relating to the marketing of goods and 
services. These problems will all rela te to what customers and potential 
customers want, need and care about.

282  
Data gathering  techniques can be divided into two main types: 
 
Data gathering technique Examples 
Secondary (desk) research  – this is 
data that is already  available and is 
therefore usually quicker and cheaper 
than carrying out primary research. However, the data may not be accurate and may not meet the exact needs of the organisation. • Internal sources – accounts 
information, production records, order information, organisational website information, loyalty card information etc. Often sourced using an organisation’s database. 
• External sources – such as the 
internet, trade and technical journals, published statutory reports, market research agency data etc. 
Primary (field) research – this involves the collection of new (primary) information direct from respondents. As such, it is usually more expensive than desk research and is only performed if desk research fails to answer the questions asked. The sample chosen should be representative of the population in question. 
 • Questionnaires – can be done 
online, face to face, over the 
telephone or by self-completion. 
• Interviews – focus on a small 
group of individuals. 
• Focus groups – a trained 
moderator leads group discussion, such as feedback on a new product. Can be online or face to face. 
• Trial testing – for example, out of 
three chocolate bars which would you choose? 
• Observation – for example, use 
cameras to determine on average how long it takes to serve customers in a restaurant.

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The data gathering techniques  discussed above will be used to collect two main 
types of data: 
• Quantitative (i.e. numerical) data – such as the total market size, market 
share percentage, segment informat ion such as age and gender, location 
of existing/potentia l customers etc. 
• Qualitative (i.e. non-numerical) data – such as the values and beliefs of existing/potential customers, trends in consumer preferences, growth 
opportunities for products sold etc. 
 
 Illustration 2 – Technology used in market research 
 Technology has had a significant impac t on market research in both 
positive and, potentially, not so positive ways.  
The positive  includes: 
• The ability to access a wide range of secondary research (research 
conducted by others) online. 
• The ability to conduct qualitative research activities such as 
sentiment analysis and consumer perception analysis through social 
media monitoring.  
• Organisations can now also conduct focus groups online through 
technology allowing us to interact with people across wide 
geographic boundaries. 
• Business insight can be gained faster and more comprehensively 
than before. 
However, the use of technology for market research is not without its 
disadvantages. For example, online research can give the false 
impression that it is as  statistically reliable as  traditional research. It 
certainly can be, but much of what passes as statistically reliable, 
quantitative research, these days rea lly isn't. Organisations need to 
understand how to tell what is, and isn't, reliable or valid. That's not to say 
that qualitative research can't be hel pful. It can. Organisations just need 
to know what they are dealing with. 
The data gathered will be recorded and then analysed to provide insights that 
will help to achieve the goals of the research. Large quantities of data must be 
summarised and presented in such a way that clearly communicates the most 
important features and conclusions. (Note:  The role of big data analytics and its 
use in the marketing process wil l be discussed in section 3.3). 
The organisation may use an automated platfo rm tailored to the specific needs 
of the organisation to do this. This technology will enable the organisation to filter, sort, highlight  and present visually  (for example, usi ng pie charts or bar 
charts) the data.

284  
 Illustration 3 – Market research and analysis techniques for 
websites and apps 
 Market research and data analysis technology can be used to improve 
the performance of an organisation’s website or app helping to track the 
behaviour of individual users, gather insights, test new ideas and tie the 
activities back to revenue. 
Some examples of tools used include: 
• Click analysis – tracks the actions  of individual users within the 
website or app. For example, an e-commerce site may monitor 
items added to a shopping cart by visitors or a new app that relies 
on advertising revenue may monitor view time and clicks. 
• Visual behaviour tools – reveal w here users spend time looking at a 
screen (for example, through the use of number of taps and swipes on a mobile). Data may be presented as a heat map that highlights 
the most heavily trafficked or clicked areas. 
• Search engine optimisation (SEO) tools – help the organisation 
understand how likely their site and content are to show up in online search results. 
• Dashboard tools – consolidate mark et research into one interface so 
that the data can be quickly manipulated to gain insight. 
Market segmentation 
 Market segmentation is the sub-di viding of the market into homogenous 
groups to whom a separate ma rketing mix can be focused. 
A market segment is a group of consumers with distinct, shared needs. 
Why segment the market? 
• The key objective is to say that peopl e falling into a particular segment are 
more likely to purchase the product than most. 
• The company will choose a particular segment or segments to target. The 
total marketing budget can be split based on the likely return from each 
segment. 
• The organisation may be able to identif y new market opportunities or can 
try to dominate a particular s egment because it will have a better 
understanding of customers’ needs in each segment.  
Kotler suggested that segments must be meet three criteria . They should be: 
• Measurable – it must be possible to identif y the number of buyers in each 
market segment so that their potential profitability can be assessed. For example, the size of the segm ent of people aged 30–4 0, or who are 
married with children, can be accurate ly calculated but information about 
the number of people who are environm entally conscious is not readily 
available.

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• Accessible – it must be possible to reac h potential customers via the 
organisation’s promotion and distribut ion channels. For example, some 
potential customers ma y be inaccessible if they ar e tied to other suppliers 
by long-term supply contracts. 
• Substantial  – small market segments may prove unprofitable to target. 
There are a number of different bases for segmentation . Possible bases 
include: 
 
 Bases for segmentation 
 Demographic 
Market segments are frequently ba sed on age, gender, geographical 
location or family life cycle. 
This can be highly relevant with so me products, for example, certain 
brands of breakfast cereal have r egular sales to families with young 
children (for example, Coco Pops), whereas other brands  (for example, 
Bran Flakes) sell almost entirely to adults. 
In other areas, demographic influences  seem to have little effect. For 
instance, own-label products are belie ved to sell equally to high and low 
income families and single people and across all age groups.

286  
 Family life cycle segmentation divides customers by thei r position in the 
family life cycle: 
Life cycle stage Characteristics Examples of 
products purchased 
Bachelor Financially well off. 
Fashion opinion 
leaders. Recreation 
orientated. Cars, holidays, basic 
furniture, kitchen 
equipment. 
Newly married couple Still financially well off. 
Very high purchase 
rate, especially of 
durables. Cars, furniture, 
houses, holidays, 
refrigerators. 
Full nest (i) Liquid assets low. 
Home purchasing at a 
peak. Little money 
saving. Kitchen appliances, 
baby foods, toys, 
medicines. 
Full nest (ii) Better off. Some 
partners work. Some 
children work part 
time. Less influenced 
by advertising. Larger size grocery 
packs, foods, cleaning 
materials, bicycles. 
Full nest (iii) Better off still. 
Purchasing durables. New furniture, luxury 
appliances, 
recreational goods. 
Empty nest (i) Satisfied with financial 
position. Travel, luxuries, home 
improvements. 
Empty nest (ii) Drastic cut in income. 
Stay at home. Medicines, health 
aids. 
Geo-demographic segmentation combines demographic and 
geographic variables. This is a recent, but powerful, development in 
which geographical segment ation is undertaken at a much more localised 
level and linked to ot her demographic factors.

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 Socio-economic 
One of the most widely used forms of segmentation in the UK is socio-
economic. 
Class Social status Job descriptions 
A Upper middle class Higher managerial, administrative and 
professional 
B Middle class Middle management, administrative and 
C1 Lower middle class Supervisory, clerical, junior management, 
administrative staff 
C2 Lower middle class Semi and unskilled manual jobs 
D Subsistence Pensioners, widows, lowest grade 
workers 
While such class-based systems may seem out of date, the model is still 
widely used, especially in advertising. Socio-economic class is closely 
correlated with press readership and viewing habits, and media planners 
use this fact to advertise in the most effective way to communicate with 
their target audience. 
Psychological 
Lifestyle segmentation may be used because people of similar age and 
socio-economic status may lead quite different lifestyles. Marketers have 
segmented the market using terms such as ‘Dinkies’ (double income, no 
kids). 
Attitudes and values can be harder to  measure but can prove to be a 
useful basis for segmentation. For ex ample, individuals may have a value 
based on caution and ther efore purchase a safe, reliable car. 
Situational (or behavioural) 
Occasion of use – a product may be bought at different times for different 
uses. For example, workers may expect a lunchtime meal in a restaurant 
to be fast and good value for money, whereas those same individuals 
may be willing to pay more in the evening for a more relaxed dining 
experience. 
Frequency of purchase – frequent buyer s may be more demanding with 
regards to product features and may be more sensitive to price changes. 
 
 Explain five variables that you thin k would be useful as a basis for 
segmenting the market for cars.

288  
Targeting 
 Targeting is the process of selecting the most lucrative market segment(s) 
for marketing the product. 
Having segmented the market, the organi sation can now decide how to respond 
to the differences in customer needs i dentified and will reach a conclusion as to 
which segments are worth targeting. 
The organisation may choose a number of  different approaches. For example, 
the market for package holidays can be split  into a variety of different segments 
– the family market, the elderly marke t, the young singles market, the activity 
holiday market, the budget holiday market, etc. 
It would be virtually impossible to provi de one single holiday package that would 
satisfy all people in the above markets.  Because the people in the different 
segments will have different needs and want s, a holiday company has a choice 
in terms of its marketin g approach. It can go for: 
• Concentrated marketing  (sometimes referred to as niche or target 
marketing) specialises in one of t he identified markets only, where a 
company knows it can compete succe ssfully. For example, Saga holidays 
offer a variety of holidays for the older market niche only. 
• Differentiated marketing  (sometimes called segmented marketing) – the 
company makes several products each aimed at a separate target 
segment. For example, Virgin Holidays o ffers a variety of family holidays, 
honeymoon packages and city breaks, each of which is targeted at a different group. Many retailers have developed different brand formats to target different groups. 
• Undifferentiated marketing  (sometimes called mass marketing) – this is 
the delivery of a single product to the entire market. There is little concern for segmentation. The hope is that as many customers as  possible will buy 
the product. When Henry Ford began manufacturing cars he offered any colour ‘as long as it’s black’. 
Positioning 
 Positioning involves the formulation of a definitive marketing strategy 
around which the product would be ma rketed to the target audience. 
After the target market has been chosen,  marketers will want to position their 
products in relation to the competitors fo r that segment. A variety of techniques 
are available.

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For example, Porter identified four positioning strategies: 
 
Test your understanding 6 
 Undifferentiated marketing involves an organisation in offering: 
A products based on market research 
B a single product to the market as a whole C multiple products to the market as a whole D single products to segmented markets 
 
 Segmentation involves identifying target markets that must be: 
A measurable, accessible and substantial B acceptable, feasible and suitable C undeveloped, undiscover ed and undifferentiated 
D aligned to core competences

290  
 Which one of the following phrases explains concentrated 
marketing? 
A The company produces one product for a number of different 
market segments 
B The company introduces several versions of the product aimed at 
several market segments 
C The company produces one product for a mass market 
D The company produces one produc t for a one segment of the 
marketplace 
3 Areas of interface between sales and marketing and finance 
The way in which finance interacts wit h sales and marketing will be explored in 
greater depth below. However, it is useful  to begin by thinking about some basic 
ways in which the two areas interact: 
Budgeting Finance will discuss the likely sales volume of each product 
with the sales and marketing, in  order to produce the sales 
budget. 
Advertising Finance will help sales and marketing in setting a budget, and in monitoring whether it is cost  effective. For example, they 
could help in measuring new bus iness generated as a result of 
different advertising campaigns. 
Pricing Finance will have input into the price that is charged. Often products are priced at cost pl us a percentage. Even if sales 
and marketing determine the price based on market forces they need to consult with finance to ensure that costs are covered. 
Market share Finance can provide marketing with information on sales volumes for each product, to help the marketing department in determining market share. 
KPIs Finance will establish and monito r the KPIs for the sales and 
marketing function.

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3.2 How the finance function inte racts with sales and marketing 
• Finance and sales and marketing should interact to achieve organisational 
goals and their own individ ual functional goals.  
• Traditionally, there may have been antagonism between the two functions 
over issues such as pr icing and cost control.  
• The modern approach is for the two functi ons to collaborate and to work in 
partnership. 
• Effective interaction will be based on close working teams which possess 
a shared vision for the organisation and an appreciation of each other’s 
specialisms. 
• Technology is assisting this collaborat ion through the use of tools such as 
cloud computing, data anal ytics and blockchain. 
business partnering with the sales and ma rketing. Two of these areas will be 
explored below: 
• product/service development • product/service life-cycles and costing 
Product/service development 
Organisations need to continually look  for new or improved products or 
services, to achieve or maintain competitive advantage in their market. 
 
Test your understanding 9 
 M Ltd are in the process of designing a new product to fit with the rapidly 
changing environment.  
Which THREE of the following ar e activities that M may undertake 
during the first three stages of product development? 
A Interviewing customers to determine what they want 
B Analysing social media to gain an insight into customer tastes 
C Testing the product to ensure it is durable 
D Using computer aided design (CAD) to build a prototype E Ensuring the product is rel eased ahead of the competition

292  
Given the rapidly changing nature of t he modern consumer’s  preferences and 
expectations, this initial process of development can make or break an 
organisation. The finance function will wo rk collaboratively with the sales and 
marketing function to evaluate new produc t/service lines or innovations. They 
have a sharp eye for the economic upside (or otherwise!) of a product/service.  
Product/service life-cycles and costing 
After product/service development most  products/services go through a number 
of stages in their existence: 
 
• Stage 1: Introduction  – A small number of indi viduals will be prepared to 
pay a high price for a new, innovative product/service, for example, the 
latest mobile phone model. Revenues will be low and expenditure 
(including marketing costs) high. 
• Stage 2: Growth  – Revenue and profit grow as production and interest in 
the product/service increases. The firm will seek to differentiate its product/service and brand. Purchase costs and prices may fall due to economies of scale and increased compet itive pressure. Investment costs 
will still be high.  
• Stage 3: Maturity  – This is the longest and most successful stage of the 
life cycle. Costs settle down into a patte rn of repeat or replacement costs. 
Growth slows or halts due to high leve ls of competition. The price may be 
cut in order to attract a new group of customers. 
• Stage 4: Decline  – Few people will purchase t he product/service at the 
end of the life cycle as superior alter natives replace it and promotional 
activity will drop. The firm will look to exit the market and  find profitable 
alternatives.

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The finance function will interact with the sales and marketing function in two 
main ways: 
• Life-cycle costing  – this considers the costs and revenues of a 
product/service over its whole life (i ncluding product/service development) 
rather than one accounting per iod. Therefore, the full cost incurred prior to, 
during and after production will be consi dered to ensure that the costs can 
be covered and/or any possible steps are taken to reduce the costs. 
• Balanced portfolio  – products/services at different stages in the lifecycle 
have different implications for res ource requirements,  risk and strategy. 
This would emphasise the importa nce of the finance function’s 
involvement in portfolio management and suggest that a balanced portfolio 
of products/services is required.  
For example, having too many products /services in the development stage 
will put a strain on finances as they will all require significant investment in 
marketing. On the other hand, if all products/services are at the maturity 
stage, then there may be a question mark  over the organisation's long 
term future – how long will it be befor e they move into the decline phase? 
 
 Are the following statements about the product life-cycle true or 
false? 
Economies of scale will be greatest during the introduction stage  
The growth stage is the longest stage   
Prices tend to increase during the maturity stage as this 
is when demand is highest and therefore, revenue can 
be maximised  
Product costs tend to be lowest  during the later stages 
of the lifecycle  
All businesses will have a product at each stage of the lifecycle

294  
 Illustration 4  – The use of technology in the life-cycle 
 Blockchain offers the prospect of desi gning a data struct ure from the 
perspective of the produc t; meaning that in a single chain all vital data 
about that product over it s whole life-cycle can be captured. An accurate 
record of say, inventory levels, costs and revenue is available by 
examining the current state of the block. 
The internet of things (IoT) connects devices over the internet. Its 
applications can be used in the life-cycle in several ways: 
• Maintenance and service – sensor s can provide data on products 
for servicing purposes. This should help optimise future service 
schedules and reduce maintenance costs. 
• Requirements management – providing visibility into how customers 
are using products. Knowing that so me product functions are not in 
use and injecting this information in  product modifications and future 
requirement analysis is of huge advantage. 
• Product performance monitoring – pr oviding real performance data 
from, say, the engine and other parts of a car, airplane, computer or 
even a toothbrush. This data helps inform future decisions. 
3.3 Big data analytics in marketing 
Big data and data analytics have been discu ssed in detail in Chapters 5-8.  
 
 Illustration 5  – Big data analytics 
 An organisation and its sales and mark eting function face a number of 
challenges when in using its big data. For example, a lack of insight for 
targeted campaigns or an inabi lity to support data growth. 
Value is extracted from  big data by the proce ss of data analytics. 
For example, Google Analytics tracks many features of website traffic. 
Hadoop software allows the processing of large data sets by utilising 
multiple servers simultaneously. It enables instant analysis of social 
sentiment and customer feedback acro ss digital, face-to-face and phone 
interactions. 
The result should be a reduced time to  obtain customer insight, an ability 
to make changes to campaigns or adjust product roll outs based on real-
time customer reactions and an ability to offer incentives and new 
services to retail and grow its customer base.

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Unlocking the potential value of big dat a using real-time dat a analytics and its 
significance to an organisation’s sale s and marketing function presents a huge 
opportunity to gain unique insight which can be used to improve competitive 
position and potentially gain competitive advantage over rivals. The finance 
function will work collaboratively with the sales and marketing function to 
provide this insight.  
Examples of big data analytics in marketing 
• Market segmentation and customisation – the volume and variety 
within big data enables organisations to  create highly specific segments 
within its markets in and to tailor its products and services precisely to 
meet those needs in real-time. 
 
 Illustration 6 
 Biscuit manufacturer, Oreo 
Many marketers consider Oreo’s fa mous ‘You can still dunk in the 
dark’ marketing campaign during S uper Bowl in New Orleans to be a 
landmark event in real-time marketi ng. During the third quarter of the 
game, the Superdome experienced a parti al power outage, darkening the 
stadium and suspending play for 34 mi nutes. During this time, Oreo 
cleverly took advantage of the sit uation and tweeted its message out to 
thousands of loyal followers, rece iving over 10,000 re-tweets and 20,000 
likes on Facebook. 
• Product/service development  – organisations can use data on customer 
behaviour and social trends to creat e new products/services to meet 
customers’ needs or to enhance existing products/services so that they 
meet these needs more exactly.  
 
 Illustration 7 
 Motor insurance  
The availability of real-time loca tion data, from satellite sensors and 
satellite navigation systems, can enabl e motor insurance companies to 
refine the pricing of their insurance policies according to where, and how, 
people drive their cars. 
Health and life insurance 
Health and life insurance company, Vita lity, is offering its customers the 
opportunity to link their activity tr acking device or app to their online 
Vitality profile. Points are earned for comp leting eligible activities such as 
a target number of steps, a gym visi t or a park run. Customers can then 
redeem their points for treats such as  Starbucks coffee or cinema visits.

296  
• Decision making – the sophisticated analytics tools can also be used to 
improve decision making. For example,  a retailer may use algorithms to 
optimise decisions about inventory levels  and pricing (i.e. dynamic pricing) 
in response to current and predicted sales. Real-time data visualisation 
technologies (for exampl e, dashboards) allow managers to adjust tactics 
based on, for example, live sales or inventory data. 
 
 Illustration 8 
 Dynamic pricing in action 
The chances are that you’ve already seen dynamic pricing in action, even 
if you haven’t realised you’re being s pecifically targeted in this way. 
Perhaps you’ve viewed a flight or a holiday several times on a website 
but when you finally return to book it the price has jumped. Or maybe 
you’ve added an item to your baske t on Amazon but a week later when 
you go to actually click ‘buy’ the price has changed. 
This kind of dynamic pricing is the re sult of ever increasing quantities of 
data giving retailers and service provi ders more insights into their own 
supply and customer desires than ever  before. They can increase the 
price when demand rises or supply falls, or they can fill those last seats 
and sell out a service by dropping the pr ice as the deadline comes closer. 
Some retailers can even work out how likely you are to make a purchase 
and either drop the price to give you an extra incentive to buy or hike it 
because they know you’re ready to pay. 
• Obtaining customer feedback  – organisations now have access to huge 
amounts of customer feedback in real or almost r eal time. For example, 
identifying what customers are saying in social media about an 
organisation’s products or its customer  service could help the organisation 
identify potential changes  that may be needed. 
 
 Using the options below, comple te the following statements 
concerning big data analytics in marketing: 
Tailoring products and services precisely to meet customers’ needs in 
real-time is know n as___________________ 
Using algorithms to optimise decisions such as those about pricing is known as pric ing___________________ 
What a consumer is saying about t he product on social media can be a 
useful way of obt aining_____ ______________

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 Options to choose from 
• Hadoop 
• Criticism 
• Feedback 
• Dynamic 
• Static 
• Customisation 
• Analytics  
4 Key performance indicators (KPIs) 
In section 6 of Chapter 9 we: 
• defined KPIs 
• discussed their use in managing the operations function • identified relevant KPIs for operations • discussed how the finance function manages operations using KPIs and • discussed the impact of technology in this area.  
Much of this discussion can also be appl ied to the sales and marketing function 
and can therefore be referred back to. 
In this section we will briefly discu ss how the finance function helps to manage 
the sales and marketing function thr ough the use of KPIs before identifying 
some relevant KPIs for sales and marketing. 
4.2 How finance helps to manage  sales and marketing using KPIs 
• The sales and marketing function will i dentify its relevant CSFs (i.e. the 
vital areas where things must go right for the function in order for them to 
achieve their strategic objectives). 
• The KPIs are the measures that i ndicate whether or not the sales and 
marketing function is achieving these CSFs. KPIs are essential to the 
achievement of these objectives si nce ‘what gets measured gets done’, 
i.e. the things that ar e measured get done more often than the things that 
are not measured. 
• The finance function works with the sales and marketing function to: 
– identify  appropriate KPIs 
– assemble  KPI data and information  
– analyse this for insight

298  
– give advice to the sales and marketing function based on this insight 
and 
– apply  what has been learned to impac t the achievement of the 
objectives of the sales and marketi ng function and the organisation 
as a whole. 
• Technology  will act as a key enabler in th is, particularly in the ‘assembly’ 
and ‘analysis’ tasks. 
 
 Illustration 9  – KPI dashboards 
 One of the most comm on technologies used in this area is performance 
dashboards. The dashboard displays the KPIs of the sales and marketing 
function in a live format, thus allowing immediate understanding of 
current performance and pot entially prompting acti on to correct or amend 
The dashboards assist with data visual isation. The simple and visually 
appealing layout can be understood by non -technical users. With just a 
few clicks interactive and versatile vi ews can be built, providing, at a 
glance, relevant information and insights for different users. 
This will ‘free up’ the resource of the finance function who can now spend 
more time on the ‘advising’ and ‘applyi ng’ activities – a shift that makes 
better use of their skills and expertise. 
Note:  It would be useful to spend a few minutes looking at examples of 
sales and marketing dashboard images on the internet. 
4.3 Examples of KPIs for sales and marketing 
Example activity Possible KPI 
Overall sales and 
marketing activity Growth is sales volume/revenue 
Market share Gross margins 
Customer retention rate 
Cost of customer acquisition 
Marketing spend per customer 
Customer lifetime value 
Promotion Promotion cost 
Awareness levels 
Website traffic to conversion % 
Social media reach (for ex ample, Twitter followers) 
Email marketing performance (f or example, unsubscribe 
rate) 
Sales team response times

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Product/service  Product development time/cost 
Product life-cycle costs 
Repurchase rate 
Brand value 
Warranty claims 
Pricing Price relative to industry average Price elasticity of demand 
Place Transport costs 
Storage costs 
 
 Match the following KPIs to the element of the marketing mix that it 
could measure. 
A Brand value 
B Packaging cost C Lead times D Price elasticity of demand E Social media activity F Number of ‘clicks to buy’ Choose from the following options: 1 Product 2 Price  3 Place  4 Promotion

300  
5 Chapter summary

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The key focus of marketing is customer needs. 
 
 The changing needs of the population must be reflected in the product 
offerings. For example: 
• The supermarket may reduce its range of luxury items in favour of 
lower priced, basic products. 
• Special offers may be made on products, for example, discounts, 
buy one get one free offers, additional loyalty points on products. 
• The supermarket may introduce more  'restaurant style' meals to 
reflect the trend that fewer people are eating out. 
 
The key focus of successful market ing is customer needs and therefore 
developing brand loyalty amongst cust omers would assist in this.  
 
Method Advantages Disadvantages 
(a) Advertising • Reach a large 
number of potential 
• Low cost for each 
potential customer. • Total cost can be 
very high. 
• Difficult to evaluate 
effectiveness. 
(b) Sales 
promotion • Can help gain new 
users. 
• Counteract 
competition. 
• Clear out surplus 
stock. • Can be costly. 
• May not win 
customer loyalty.

302  
    
(c) Personal 
selling • Can focus on 
needs of individual 
customer. 
• A talented 
salesperson can be very persuasive. • Can be seen as 
pushy. 
• High cost per 
potential customer. 
(d) Public 
relations • Low or no cost. 
• Can be targeted. • Unbiased opinion. • Negative review 
may damage 
reputation. 
   
 Gender 
It would be useful to segment the market based on gender. Females may 
prefer a car that is smaller, is avai lable in bright colours and comes with 
fashionable accessories. Males, on the other hand, may prefer a more 
masculine looking and powerful car. 
Age 
The age of the consumer will be of upmost importance. Teenage drivers 
may prefer a cheaper model, whereas drivers in their 20s, with more 
disposable income, may prefer a more expensive and stylish model. 
Lifestyle 
There may be a number of different lifestyles that could be targeted. Each 
group will have quite different needs. For example, a leisure user may be 
more interested in the style and design of the car where as a commuter may want a safe, reliable car. 
Income 
The level of income will impact the make and the model that the user can 
afford and any optional extr as that may be purchased. 
Family life cycle 
The life cycle stage will be important. Fo r example, bachelors may prefer 
a higher priced, sporty, stylish mo del where as those with a young and 
growing family may prefer a safe, re liable and family orientated people 
carrier. 
 
 The correct answer is B

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 303 
 
 The correct answers are A, B and D 
The first three stages are:  
1 Consider customer’s needs, 2 Concept screening, and 3 Design process Interviewing customers and analysi ng social media will help to 
understand the customer’s needs. Building a prototype is part of the 
design process. 
The final two stages are: 1 Time to market and 2 Product testing 
 
Economies of scale will be greatest during 
the introduction stage False, economies of scale are greatest when higher volumes of the product are sold.  
The growth stage is the longest stage  False, each stage can 
vary in length. However, it is the maturity stage that tends to be the longest 
Prices tend to increase during the maturity stage as this is when demand is highest and therefore, revenue can be maximised False, prices tend to decrease during the maturity stage, partially in order to attract new customers to prolong the maturity phase.

304  
   
Product costs tend to be lowest during the 
later stages of the lifecycle True 
All businesses will have a product at each 
stage of the life-cycle False, whilst a business may aim to have balanced portfolio, there is no guarantee that they will have products at each stage 
  
 Tailoring products and services precisely to meet customers’ needs in 
real-time is known as customisation 
Using algorithms to optimise decisions such as those about pricing is known as dynamic  pricing. 
useful way of obtaining feedback.  
 
 A Brand value – product  
B Packaging cost – product  
C Lead times – place 
D Price elasticity of demand – price  
E Social media activity –  promotion  
F Number of ‘clicks to buy’ – promotion

305 
interacts with human 
resources  
E3: Describe how the finance 
human resources. (a) Main role of human 
resources. 
finance. 
 Chapter 
11

How the finance function interacts with human resources 
306  
 
In this chapter we will continue to describe how the finance function plays its 
role by interacting with the rest of t he organisation (syllabus area E) and, more 
specifically here, t he organisation’s human res ources (HR) function. 
We will begin by discussing the main role of the HR function; understanding the different HR activities that exist. An e ffective HR function will view employees as 
a hugely valuable resource within the organisation and as a potential source of competitive advantage.  
We will then discuss the areas of interf ace with finance before moving on to the 
final part of the chapter which will di scuss how the finance function helps to 
manage the HR function through the use of key performance indicators (KPIs). 
2 Main role of HR  
 The HR function is responsible for human resource management within 
the organisation. Human resource m anagement (HRM) is the creation, 
development and maintenance of an effective workforce, matching the requirements of the organisation and responding to the environment. 
Note:  That although many aspects of HRM are likely to be the responsibility of 
the HR function, there will also be some responsibility of line managers in charge of employees’ day-to-day work. 
The HR plan 
 The HR plan is a strategy developed in the context of the organisation’s 
overall strategic plan.  
A typical plan will look forward 3-5 y ears and aims to identify and close the gap 
between the demand for labour and the supply of labour within the organisation.

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 Stages of HR planning 
 
 The economic situation in a country (o r specific area of a country) may 
have a marked effect on the ability of an organisation to attract suitable 
candidates. 
A  True 
B  False 
 
 How can an organisation plan rationally in an unstable 
environment?

308  
The HR cycle 
A common approach to viewing the differ ent HR activities is as a cycle: 
 
The first six of these acti vities will be discussed below. 
2.2 Recruitment 
 Recruitment  involves attracting a field of suitable candidates  for the job. 
 
The best recruitment campaign will attrac t a small number of highly suitable 
applicants, be cost effective, be speedy and show courtesy to all candidates. 
 
 Illustration 1 – Recruitment in a downturn 
 In periods of economic recession, recruitment would appear to be less 
important, as large num bers of people will be looking for employment, 
meaning a field of candidates should be easy to attract. 
However, even in times of high unemployment, organisations must 
ensure they only hire the correct peopl e with the skills and abilities that 
they need. This can become more diffi cult when there are larger numbers 
of applicants.

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 309 
 Assessing the need to recruit 
 When considering recruitment, th ere are two questions that managers 
must address. The first is whether ther e is really a job, and the second is 
whether there is someone suitable who is already employed by the 
organisation. There are many alternat ives to recruitment, for example: 
• promotion of existing staf f (upwards or laterally) 
• secondment (temporary transfers  to another department, office, 
plant or country) of existing sta ff, which may or may not become 
permanent 
• closing the job down, by shar ing out duties and responsibilities 
among existing staff 
• rotating jobs among staff, so that  the vacant job is covered by 
different staff, on a systematic basis over several months 
• putting the job out to tender, using external contractors. 
Agree vacancy – A vacancy may arise due to growth in the organisation, a 
change of direction or because an employee leaves the organisation. 
Job analysis – This is the detailed study and description of the tasks that make 
up the job. Job description – After a full job analysis has been carried out, a job 
description can be drawn up. 
 A job description is a broad statem ent of the purpos e, scope duties and 
responsibilities of the job. 
A typical job description will tend to include: 
 
 Prepare a job description for a London based role as a Finance 
Director in an internet media co mpany which is about to become a 
public company.

310  
Person specification – Once management have a job description, they can 
attempt to define the key attributes  and qualities that the jobholder should 
ideally have. Prospective candidates can then be compared to this specification 
as part of the selection process. 
Alec Rodgers devised a seven-point plan which suggests the content of a 
person specification. You can remem ber this using the acronym BADPIGS. 
Category Example 
B – Background/ 
circumstances Details of previous work experience and circumstances – for example, criminal record or flexible working requirements. 
A – Attainments Details of qualifications and any relevant experience. 
D – Disposition The individual's natur e (for example, can work calmly 
under pressure) and goals (for example, future ambitions). 
P – Physical make-up Personal appearance and level of health. 
I – Interests General interests and hobbies will be important. For 
example, being a member of a football team demonstrates teamwork skills. 
G – General intelligence Not necessarily  academic qualifications but may refer 
to practical intelligence such as problem solving ability or whether the c andidate is of average 
intelligence (or otherwise). 
S – Special attributes Skills such as the ability to speak another language 
or IT skills. 
 
 Illustration 2 – Person specification for an accountant 
 An example of a person specificat ion for an accountant could include: 
Requirement Essential or desirable? 
Qualifications 
Professional qualification  
Degree level  
Essential  
Desirable 
Experience 
Experience of working in a similar role 
Experience of dealing with clients  
Essential  
Desirable

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Skills and competencies 
Excellent communication skills 
Ability to present complex information  
Excellent numerical skills 
Team player 
Ability to work flexibly  
Essential  
Essential  
Essential  
Desirable  
Desirable 
Personal attributes 
Self-motivated 
Able to use own initiative  
Attention to detail 
Prepared to learn new skills  
Essential  
Essential  
Essential  
Desirable 
Other 
Ability to use Microsoft Word and Sage 
Willing to participate in client meetings  
Essential 
Essential 
  
 The purpose of a person specification is to provide details of: 
A organisational size and diversity of activity 
B the types of responsibilities and duties to be undertaken by the post 
holder. 
C personal characteristics, experience and qualifications expected of a 
candidate 
D individual terms of engagement  and period of contract 
 
 Are there any circumstances when discrimination on the basis of 
physical make-up is acceptable? 
Source candidates  – this stage involves persuading relevant candidates to 
apply for the role the organisation wishes to fill. The following methods may be used to make contact with and to secure the 
application of appropriate candidates: 
• internal sourcing 
• internet and social media • recruitment consultants

312  
• newspaper and specialis t journal advertising 
• radio and television advertising 
• job centres • job fairs. 
 
Illustration 3 
 Care must be taken not to transgr ess one of the laws relating to 
discrimination, as in the case of a job advertisement seeking ‘a female 
Scottish cook and housekeeper’, which was barred both on the grounds 
of race and sex discrimination. 
2.3 Selection 
 Selection is aimed at c hoosing the best person for the job from the field of 
candidates sourced via recruitment. 
 
Application form 
Application forms are used to obtain re levant information about the applicant 
and allow for comparison with the pers on specification of the job.  
They should also give the applicants some ability to express themselves 
beyond the limited factual remit of the form. 
A Curriculum Vitae (CV) may be request ed alongside the application form. This 
details the individual’s uni que skills, character, ex perience and achievements. 
Selection interviews 
Once the least appropriate candidates have been rejected using their 
application forms, the remaining applicants can be interviewed. 
The purpose of an interview is to: 
• find the best person for the job 
• ensure that the candidate understands w hat the job involves and what the 
career prospects are 
• make the candidate feel that they have been treated fairly  in the selection 
process.

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There are various types of interview t hat an organisation may use, including: 
 
 What are the key advantages and disadvantages of interviews as a 
way of selecting candidates? 
 
 A has been asked to attend a job interview. He has been told that he will 
be interviewed by the Finance Direct or first, followed by the Human 
Resources Director. 
What type of interview is A going to experience? 
A  Group 
B  Panel 
C  Stress 
D  Succession 
Selection testing 
Testing can be undertaken either before or after the interview has taken place. 
The two basic types of test are: 
• Proficiency and attainment – these are used to examine the applicant’s 
competences, skills and abilities in ar eas that will be required in the job 
they have applied for. 
• Psychometric  – these are more general and test psychological factors, 
such as aptitude, inte lligence and personality.

314  
 Psychometric testing 
 In the following extracts from an ar ticle by Bryan Appleyard the growth 
and usefulness of psychometric testing is reviewed: 
Welcome to the weird world of psychom etrics. If you want to work for a 
big company there’s at least a 70% chance that before being given a job 
you will be subjected to a personality test by one of the big four – MBTI 
(Myers-Briggs Type Indicator), 16 PF (16 personality factors), OPQ 
(occupational personality questionnaire) or Hogan – and an ability exam measuring verbal reasoning and numeracy. 
These are basically IQ tests by another name...according to the 
Association of Graduate Recruiters, it’s because nobody trusts university 
degrees any more. It has just i ssued a report saying degree standards 
are inconsistent and, as a resu lt, companies are turning to 
psychometrics. But Ceri Roderick at occupation psychologists Pearn Kandola adds two other reasons. ‘Com panies want to know things like 
the motivational characteristics of recruits and the technology is now 
available to do these things.’ There’ s also a fourth reason: the need to 
compete for quality recruits. ‘There’s a war for talent,’ says Professor 
David Bartram of the British Psycholog ical Society (BPS), ‘companies are 
fighting to get the best people.’ All of  which means there is now a rapid 
proliferation of psychom etrics consultancies, most of them offering 
candidates the chance to do all the tests online.... 
 Sceptics think the whole enterprise is misguided. In America a book –The 
Cult of Personality by Annie Mur phy Paul – has cast doubt on the 
intellectual credibilit y of psychometrics... 
In support of Paul’s book the author  Malcolm Gladwell questions the very 
idea of measuring personality: ‘We hav e a personality in the sense that 
we have a consistent pattern of behav iour. But that pattern is complex 
and that personality is contingent: it represents an interaction between 
our internal disposition and tendencies and the situations that we find 
ourselves in.’... 
But are Gladwell and Paul right to  question the whole theory on which 
they are based? The history of ps ychometrics marches hand in hand with 
the history of IQ test ing. Alfred Binet, the French psychologist, produced 
the first modern IQ test in 1905 and Walter Dill Scott subjected 15 
engineering graduates to t he first psychometric test in 1915. Both ideas 
were inspired by the conviction that  there could be no reason why the 
human mind should be impervious to scientific investigation. . 
Psychometrics works, but only if the tests are properly applied, rigorously 
interpreted and accompanied by traditi onal interviews. This means that 
they do not necessarily speed up the recruitment process. They might, 
however, help weed out unsuitables in advance, a huge benefit at a time 
when all companies are swamped wit h applicants for attractive jobs. 
Source: Appleyard, B. (2007) Want  a job? Let’s play mind games.

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Assessment centres 
Assessment centres involve candidates being observed and evaluated by 
trained assessors as they are given a se lection of pre-progr ammed exercises or 
trials. These exercises may include: 
 
Assessors will be looking for evidence that  candidates have certain abilities that 
are important in the job they have appl ied for. These criteria will change from 
job to job, but may include leadership or communication skills, for example. 
 
 Assessment centres 
 The assessment centre is really a combination of many forms of 
selection. Groups of around six to t en candidates are brought together for 
one to three days of intensive assessment. As well as being multi-
method, other characteristics of a ssessment centres ar e that they use 
several assessors and they assess several dimensions of performance 
required in the higher-level positions. 
The advantages of assessment centres include: 
• A high degree of acceptability and user confidence. 
• Avoidance of a single-assessor bias. 
• Reliability in predicting potentia l success (if the system is well 
conducted). 
• The development of skills in the assessors, which may be useful in 
their own managerial responsibilities. 
• Benefits to the assessed individu als, including experience of 
managerial/supervisory situations , opportunity for self-assessment 
and job-relevant feedback and opportunities to discuss career 
prospects openly with senior management.

316  
References 
The purpose of references is to conf irm facts about the employee and increase 
the degree of confidence felt about informa tion given during the other selection 
 
 References 
 References should contain two types of information: 
• Straightforward, factual informa tion, confirming the nature of the 
applicant’s previous job, per iod of employment, pay and 
circumstances of leaving. 
• Opinions about the applicant’s personality and other attributes, 
though these are open to bias and should therefore be treated with 
caution. 
Many organisations ask for a minimum of two references – including references from past employers as well as personal references (which 
are likely to be more biased in favour of the candidate). 
References, while useful, have to be viewed with caution. Allowances 
must be made for: 
• prejudice (favourable or unfavourable) 
• charity (withholding detrimental remarks) • fear of being actionable for libel (although references are privileged, 
as long as they are factually correct and devoid of malice). 
What happens next? 
Once a suitable candidate has been found, a job offer can be made. It may be 
necessary to negotiate  over some aspects of the employment contract, such as 
pay or hours of work. 
On starting work with the organisation,  the employee should be effectively 
assimilated into the organisation through a process of induction . 
 
 Illustration 4 
 The average UK employee turnover ra te is 15% and the average cost of 
employee turnover is £6,300 for eac h employee. A major reason why 
employees leave within the first six months to a year is a poorly planned 
induction process. Theref ore, there are signific ant savings to be made 
from implementing an effe ctive induction process.

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2.4 Staff development and training 
Often the terms 'training' and 'dev elopment' are used inter-changeably. 
However, there are differences between the two: 
 Training  is the planned and systematic modification of behaviour 
through learning events, programmes and instruction which enable 
individuals to achieve the level of  knowledge, skills and competence to 
carry out their work effectively. 
 Development  is the growth or realisat ion of a person’s ability and 
potential through conscious or unconscious learning and educational experiences.  
It is often argued that development is t herefore more general, more future-
oriented and more individua lly-oriented than training. 
Organisations should view training and dev elopment of staff as an investment. 
 
 What are the benefits, for both the learner and the organisation, of training and development? 
The training and development process 
Due to the obvious importance of tr aining and development, a systematic 
approach should be taken in order to maxi mise its effectiveness. To help with 
this, organisations may find it helpful to  view training and development as a 
step-by-step process.

318  
 Stages in training and development 
 • Identifying training (or development) needs  – this could include 
an investigation into the organisa tion’s current performance as well 
as mapping the corporate skills base. It should drill down to the level 
of the individual to target specific needs. 
• Setting training (or development) objectives – as with all 
objectives these should have clear, specific, measurable targets in 
relation to the standard of behaviour required in order to achieve a 
given level of performance. 
• Planning the training (or development)  – this covers who 
provides the training, where the tr aining takes place and divisions of 
responsibilities between trainers, line managers or t eam leaders and 
the individual personally. 
• Delivering/implementing the training (or development)  – a 
combination of formal  and on-the-job training  programmes will be 
used. 
• Evaluating training (or development)  – assessment of cost 
versus benefit using feedback forms, end of course tests, assessment of improved performance in the work place and impact on corporate goals. 
Evaluating the training (or development) 
To ensure training and development are effective, learning processes need to 
be evaluated (stage 5). 
Donald Kirkpatrick suggested a four  level model of evaluation. 
Level Evaluation Description Examples 
1 Reaction • How the delegates felt 
about the training or 
learning experience • Feedback forms 
• Interviews 
2 Learning 
 • The measurement of 
the increase in 
knowledge –before and after • Assessment tests 
before and after 
• Observation 
3 Behaviour • The extent of applied 
learning back on the 
job -implementation. • Observation and 
interview over time 
4 Results • The effect on the 
business or environment by the trainee. • Impact on existing 
KPIs

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2.5 Performance management 
 Performance management is used to assess and ensure that the 
employee is carrying out their duties which they are employed to do in 
an effective and satisfactory manner, wh ich is contributing to the overall 
objectives of the organisation. 
Organisations follow four main st eps when managing the performance of 
employees: 
• Set targets  – at the start of the period, the manager  and employee should 
agree on which SMART goals and targets the employee is going to work 
towards.  
 
 Setting targets 
 The targets usually include: 
• areas that the employee needs to improve (perhaps where the 
employee is currently making mistakes) 
• targets that link in to the overall business goals (such as increasing 
activity by five percent) 
• development and training targets that will benefit the employee (and 
the business) and therefore increase motivation. 
It is important that employees un derstand and agree to these targets. If 
they do not ‘buy into’ them, they will not put any effort in to accomplishing 
the goals set – especially if they do not feel that the targets are 
achievable. This can lead to demotivation. 
• Monitor – during the period,  the manager should monitor employee 
performance and provide regular f eedback. Managers can offer rewards 
for good performance and support and help w here it looks as though the 
employee is failing to meet their targets. 
• Review – at the end of the period, the manager and employee will usually 
have a formal appraisal where they discuss the employee’s performance 
and investigate how successful the employee has been at meeting the 
pre-agreed targets (apprai sal is discussed in more detail below). 
• Action plan – the manager and employee then agree on new targets that 
will be set for the coming period.

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Appraisal 
 Appraisal is the systematic revi ew and assessment of an employee's 
performance, potential and training needs. 
 
 Illustration 5 – Appraisal 
 Karl works for a call centre and is set targets for the number of calls he 
takes in the year, the number of cust omers who say they were satisfied 
with his performance and the number of  complaints he receives in the 
year. 
At the end of the year, the appraisal will allow both Karl and his manager 
to compare his actual performance against these targets. Any areas 
where he deviates from the targets (i n either a positive or negative way) 
can be discussed and are likely to form the basis of Karl’s annual bonus 
and pay rise for next year. 
Any areas that Karl is struggling with,  or would like to gain additional skills 
and knowledge in, can be used to identify training and development 
opportunities for the coming year. 
Finally, the appraisal can then be used to agree what Kar l’s targets will 
be for next year. 
 
 Which of the following is an object ive of the appraisal process to an 
employer? 
A  It enables them to identify underperforming employees for 
punishment 
B  It helps the business to recruit the best possible employees 
C  It helps to identify employees’ skills gaps 
D  It reinforces management authority over employees 
If not handled carefully, appraisals can cause demotivation for employees. 
Various studies have indicated that crit icism of employees can have a negative 
effect on their goal achiev ement and self-confidence.

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Lockett  suggested that there are six main barriers to effective appraisals. 
Barrier Example 
Confrontation • Feedback is badly delivered. 
• Differing views regarding performance. 
Judgement • Appraisal is seen as a one-sided process – the 
manager is judge, jury and counsel for the 
prosecution. 
Chat • Lack of will from either party. 
• No outcomes set. 
Bureaucracy • Purely a ‘form filling exercise’. 
• No purpose or worth. 
Annual event • A traditional ceremony carried out once or twice a 
year. 
Unfinished 
business • No follow up. 
• Points agreed not actioned. 
2.6 The role of incentives and practices relating to motivation 
 In an organisation, motivation  refers to the willingness of individuals to 
perform certain tasks or actions. It is the incentive or reason for them 
behaving in a particular way. 
In practice, motivation is taken as meaning how hard an employee is willing to work in their job. It goes beyond empl oyees merely following rules and orders 
and looks at how dedicated they are. 
 
 What are the benefits for: 
• the organisation 
• the individual employee and  
• the teams they work in 
of having motivated staff members? 
As there are so many advantages to havi ng motivated workers, motivation is a 
key issue for most organisations. 
Unfortunately, motivation is difficult to measure directly, meaning that managers 
have to look at other factors that may i ndicate the level of motivation within the 
organisation, often including staff tu rnover or productivity levels.

322  
However, remember that these factors could also be caused by issues other 
than employee motivation. For instance, low productivity could be caused by 
poor working practices within the or ganisation, rather than unhappy staff. 
 
 Illustration 6 – Maslow's hierarchy of needs 
 A well know theory of motivation is Maslow's hierarchy of needs. 
 
Maslow stated that people’s wants and needs follow a hierarchy. As employees become progressively more highly paid, monetary rewards become less important as other needs such as recognition and an ability to achieve one’s potential become more important. 
There are a number of different incentiv es and practices that can be used to 
assist in the motivation of employees. The role of the psychological contract , 
employee involvement and the use of workforce flexibility  will be discussed 
below. The use of an appropriate reward system will be discussed separately 
in section 2.7.  
The psychological contract 
 The psychological contract outlines the perceptions of the employee and 
the employer regarding what their mu tual obligations are towards each 
other. 
Unlike the employment contract, the psyc hological contract is highly subjective, 
not written down and not legally binding.

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Key elements include the following: 
 Employee Employer 
What do they want? Want their needs to be 
satisfied Want employee to work hard. Will have a set of expectations for each employee 
What are they willing to give? Will offer their energies and talents Payment, benefits and other outcomes, e.g. a promotion 
In order for managers to motivate and retain employees, they must understand 
the importance of the psychological contra ct and fulfil their side of the bargain. 
 
 Kate has worked as a trainee account ant with the same company for the 
past two years. She is ambitious and enjoys her work. Her manager asks 
her to produce a report that is outside of her normal role. 
The report turns out to be difficult and time consuming and she has to put 
in long hours to complete the report  on time as well as carrying out her 
normal work. 
She meets the deadline and sends the report to her manager. However, 
she receives no acknowledgement. T he next day she finds out that her 
manager has successfully presented the findings of the report to his boss 
and has taken the credit for the report. Kate is angry and has decided that she will never do any extra work for 
her boss again and has even started looking for another job due to the breach of her psychological contract. 
Employee involvement 
Employees should be empowered to contri bute to the organisation. Relying on 
all employees for their ideas, inte lligence and commitment to make the 
organisation successful should increase employee motivation and have positive 
financial benefits for the business.

324  
 Illustration 8 – Talent management at Apple 
 Apple’s amazing product success is, in part, due to their (sometimes 
unusual) approach to talent management. 
• Apple has an ability to move in to and dominate completely unrelated 
industries. This is only possible be cause of extraordi nary talent, the 
way it manages it and the creation of a culture that after succeeding 
in one task, employees will immediately move onto something different. 
• A lean talent management approac h enables Apple to achieve 
exceptional levels of employ ee productivity. Tight deadlines and 
lean schedules force everyone to wo rk together and solve problems 
early on. 
• The rewards and recognition progra mme is extremely attractive 
creating a performance culture and an element of internal 
• Rather than a work/life balance, A pple makes it clear that it is 
looking for extremely hard-worki ng and committed individuals; the 
idea being that the satisfacti on and reward achieved by the 
employee for their hard work is huge. 
 
 Illustration 9 – Employee empowerment and quality 
 Quality in operations management was discussed in Chapter 9. Many of 
the quality practices rely on the empowerment of employees. For 
example: 
• In TQM,  employees are expected to seek out, identify and correct 
quality problems and are responsib le for achieving targets. 
• With Kaizen,  employees are encouraged to come up with small 
improvement suggestions on a regular basis. 
• A lean culture will require a multi-skilled and flexible workforce. 
• Highly skilled and well trained staff will be required for effective 
operation of a JIT  system.

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Workforce flexibility 
• Flexible working arrangements  – these can be used to increase 
employee motivation. Flexibility in wo rk patterns can be achieved in many 
ways: 
Type of flexible 
working arrangement Explanation 
Remote working/teleworking Technology has enabled employees to work away from the office, usually at home 
Flexitime The need to work a standard set of hours but less 
restriction on when these hours are worked 
Shift system Working outside of normal working day patterns 
Compressed week Standard hours within fewer days in a shift rotation 
Job sharing Two employees share a standard hour week 
Part-time Fewer hours than the standard weekly number 
Flexible working arrangements encom pass one type of flexibility within 
organisations but can include a range of  flexibility options such as: 
• Task or functional flexibility  – employees have the ability to move 
between tasks as and when is required. This will allow an organisation to 
react to changes in production requi rements and levels of demand and 
should result in better skilled and motivated employees. 
• Financial flexibility  – this is achieved through variable systems of rewards, 
for example bonus sch emes or profit sharing.  By linking rewards to 
performance, a number of im provements in performa nce should be realised. 
2.7 Reward systems 
 A reward system refers to a ll the monetary, non-monetary and 
psychological payments that an organisation provides for its employees in exchange for the work they perform. 
The aims of a reward system 
Reward is not simply a benefit for t he employee and a cost for the employer. 
Rather it is a fundam ental aspect of HRM: 
• It should support the overall strategy. 
• It is a vital part of the psychol ogical contract being adhered to. 
• It influences the success of recruitment and retention policies. • It must conform to rele vant laws and regulations. 
• It must be affordable. • It affects motivation and per formance management and should be 
managed accordingly. 
• It must be administered efficiently and correctly.

326  
Methods of reward 
Rewards can be divided into three categories: 
• Basic pay  – this is the minimum amount that the employee receives for 
working in the organisation. It c an be determined in a number of ways, 
such as an hourly rate or an annual salary. 
• Performance-related pay  – pay is based on the level of performance. 
Rewards may be based on individual, group or organisational 
performance, all of which aim to mo tivate employees to work harder. 
SMART objectives should be set for employees so that it is clear the level of performance they are trying to achieve. 
 
 Illustration 10 – Types of performance related pay 
 There are a number of different types of performance-related pay: 
• Individual performance-related pay  – a pay rise or bonus is given 
to an employee on achievement of pre-agreed objectives or based on the assessment by a manager (as part of their appraisal). 
Advantages include the ability to align individual objectives with 
organisational goals and the controllability of rewards by the employee. However, such schemes may result in a lack of teamwork and in tunnel vision (sole concentration on areas which are measured and rewarded). 
 • Group performance-related pay  – rewards are based on the 
achievement of group targets. En courages teamwork but may not 
be seen as fair by employees. 
• Knowledge contingent pay  – for example, an accountant may 
receive a bonus or pay rise on passing their CIMA exams. 
• Profit-related pay  – part of the employee’s remuneration is linked 
to organisational profit. Can motivate employees to increase company profit and increase loyalt y but may lead to short termism 
and lack of motivation if employees feel they have no control over 
organisational profit. 
• Share options – they are often given to  senior managers and should 
motivate them to increase shar e price. However, there is an 
argument that many of the factors that influenc e share price will be 
outside of the manager’s control or that (previously risk averse) managers could be tempted to take  risks in the hope of increasing 
the share price. 
• Commission – normally used for sales staff and is based on a 
percentage of their sales. Can moti vate staff but may lead to short 
termism and manipulat ion of results. 
• Piecework schemes  – a price is paid for each unit of output.

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• Benefits  – a wide range of rewards other  than wages or pensions, such 
as company cars or health insurance. These can provide additional 
incentives at a lower cost and can be des igned in a flexible way to suit the 
individual employee. 
3 Areas of interface between HR and finance 
In Chapters 9 and 10 we discussed the interaction between the operations 
function/sales and marketing function and finance. Much of the discussion 
below overlaps with what has already been said in that finance, as a trusted advisor, should collaborate with the other  function to achieve organisational 
goals and their own individual functional goals. 
3.2 Interaction between HR and finance 
• Traditionally , the HR function and the finance function worked 
independently:  
– Finance very much viewed people as a cost whereas HR viewed 
people as an asset. 
– Collaboration between the functions  was limited to , for example, 
establishing a budget for a reward programme. 
• The modern  approach is to view people as one of the greatest assets an 
organisation has. Finance and HR need to  work more closely with the 
‘people as assets’ as their focus. 
 
 Illustration 11 – AI to replace doctors? 
 In the past, doctors were viewed as  one of the greatest assets in the 
medical world, with highly prized trai ning, skills and experience. However, 
there is a view that even in organi sations that have previously viewed 
their employees as their key asset, technology will be able to replace 
many of the roles they previously carried out. 
One example of this technology is t he use of artificial intelligence (AI) 
systems in medicine. AI systems stimulate human intelligence by 
learning, reasoning and self-correction. Already this technology shows 
potential to be more accurate than doctors at making diagnoses in specialist areas such as radiology and intensive care and at performing 
surgery. 
Having said that, it is still widely t hought that machines will never be able 
to replicate the inter-relational qualit y of the therapeutic  nature of the 
doctor-patient relationship and that doctors will still be viewed as the 
greatest asset in the tr eatment of patients.

328  
• Technology is freeing both functions from day-to-day duties in their 
respective fields. This combined with the increasingly competitive and fast 
changing global environment is leading to the functions having an 
increased role in the strategic direction of the organisation and an 
opportunity to work in a more joined-up way. 
• Both functions will have overlapping responsibilities. For example, they 
must consider: 
– the cost and benefit of recrui ting and selecting new employees. 
– the impact of HR policies, such as reward policies, on the profitability 
of the business. 
• This requires data analysis and financ ial projections from the finance 
function. For example, an increase in salary, bonus payments or benefits 
will result in an increased cost for the organisation but this cost needs to 
be considered in the context of the increased benefit to the organisation 
due to, say, increased motivation and productivity and reduced staff 
turnover. The finance function can pr ovide this ‘information’ and can then 
use it for ‘insight’, ‘influence’ and ‘impact’.  
 
 Which of the following is an exam ple of co-ordination between HR 
and the finance function? 
D  Calculating reward packages 
3.3 How technology is helping this interaction 
• New technology has resulted in be tter joined up systems creating better 
• Some examples of this technology usage are illustrated below. 
 
 Illustration 12 – How the cloud is  fuelling this collaboration  
 Sharing a finance and HR cloud system, integrating enterprise resource 
planning and human capita l management systems will: 
• make it quicker and easier to track and to forecast key HR 
information and 
• to collaborate to make effective decisions that will help achieve the 
functional and organisational objectives.

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 Illustration 13 – Analytics technol ogy fuelling better collaboration 
 Advances in analytics technology have helped in quantifying different HR 
activities or to measure the impact of a HR programme.  
By demonstrating the value of investi ng in different HR activities, through 
measures such as employee satisfaction scores, HR and finance can 
work together to ensure they have t he right information for responsible 
Much of this discussion can also be applied to the HR function and can 
therefore be referred back to. 
the HR function through the use of KPIs before identifying some relevant KPIs 
for HR. 
4.2 How finance helps to manage HR using KPIs 
Let’s begin by recapping our discussion from  Chapter 10 but this time in the 
context of the HR function. 
• The HR function will identify its relevant CSFs. 
• The KPIs are the measures that indica te whether or not the HR function is 
achieving these CSFs.  
• The finance function works with the HR function to: 
– analyse this for insight  
– give advice to the HR function based on this insight and 
objectives of the HR function and the organisation as a whole. 
and ‘analysis’ tasks.

330  
 Illustration 14 – KPI dashboards 
 As discussed in Chapter 10, one of  the most common technologies used 
in this area is performance dashboards. The dashboard displays the KPIs 
of the HR function in a live format, thus allowing immediate, visual 
understanding of current performance and potentially prompting action to 
correct or amend performance accordingly. 
Separate dashboards may be used for areas such as: 
• the recruitment and selection process – identifying bottlenecks and 
opportunities in the hiring process; in order to improve efficiency, 
reduce lost revenue and minimise costs 
• rewards – ensuring the system is fair (for example, females are not 
at a disadvantage compared to males) and competitive (for 
example, by benchmarking against competitor salaries) 
• employee turnover rate – to help prevent valued employees leaving 
the business and to minimise hiring and training costs. 
HR dashboard images on the internet. 
4.3 Examples of KPIs for HR 
Example activity Possible KPIs 
Recruitment and selection Cost per employee hired 
Selection method conversion rate Time to fill a position Female to male ratio 
Training and development Training and development costs 
Impact of training on existing KPIs Training feedback 
Performance management Appr aisals completed on time 
Appraisal action plan agree and followed up 
Motivation Turnover rate 
Employee absenteeism Employee productivity Employee satisfaction scores Flexible working arrangements offered 
Reward systems Cost of rewards 
Competitiveness of reward system Adherence to laws and regulations

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 Match the following CSFs of the HR function to the most appropriate 
KPI. 
CSF KPI 
Diversity of workforce Employee turnover 
Motivated workforce Training and development costs 
Fair remuneration Female to male ratio 
Efficient recruitment process Co mpetitiveness of reward system 
Suitably skilled workforce Time to fill a position 
  
 Fernando is constructing some KPIs to  measure whether or not the firm’s 
HR CSFs are being met. He has been told that these KPIs should be 
SMART.  
KPI: 90% of all staff appraisals to be completed by the end of January 
each year (last year 50% of appraisals were completed by the end of 
January).  
A  Specific 
B  Measurable 
C  Achievable D Relevant E Time bound 
 
 Test your understanding 14 – KPI Case Study Question 
 Pop Up Limited  
Pop Up Limited (PUL) is a business that provides a platform for pop up 
shops to run themselves a little more efficiently. Many pop-up shops have 
virtually no management experience and so ‘fly by the seat of their pants 
a little’, making mistakes along the way. 
PUL provides an accounting system linked to a point-of-sale (POS) 
system along with the necessary equipment to record transactions. It also 
provides a performance management system to ensure that the staff 
have a clearer idea what is expec ted of them fr om the start.

332  
 PUL ask owners to complete an on line form and questionnaire and from 
that, the basic understanding of the business is gleaned. Key 
performance targets are then generated and allocated to all staff 
members taking into account their indivi dual roles. It is common that each 
staff member be allocated one KPI  and the system will measure against 
this KPI every day, reporting to the owner accordingly. 
Required: 
Identify and explain three errors of the KPI setti ng process outlined 
above.    
(15 marks)

334  
 The correct answer is A – True 
Economic uncertainty may cause people to remain in their present job 
and discourage them from moving elsewh ere, particularly if finance from, 
say, building societies and banks is difficult to obtain. People with 
dependent children with children ma y be less disposed to move and 
movement will mainly be among younger persons. Growth industries may 
therefore find it difficult to obtai n people with the required experience. 
 
 • By staying flexible. 
• By taking greater account of external factors. • By more sophisticated moni toring and control mechanisms. 
• By planning in shorter time frames. 
Problems in achieving plans might to a degree be predictable and in the 
past have also centred on: 
• retention, especially when empl oyees are well trained or have 
specialist skills 
• slow promotion leading to staff turnover 
• unexpected vacancies arising in senior positions or vital skills areas. 
 
 • Finance Director required (job title). 
• At least five years post qualified experience (special 
requirements) . 
• Experience of a dynamic industry (special requirements) . 
• Understanding of investor relati ons and pre-floatation requirements 
(special requirements) . 
• Ability to manage change and form own department (special 
requirements) .

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 • Role includes (brief description of role):  
– Planning, monitoring and contro l of business and financial 
strategy. 
– Reporting and accounting as per the legal requirements. 
– Management of strategy for and liaison with stock market 
business press and the business analyst community. 
• Excellent package including competitive salary and share options 
(remuneration) . 
• Responsible for a growing team of 18 people (number of staff 
directly supervised). 
• Report directly to the Managing Director (responsible to) . 
• Located in London with approximately 20% travel to other European 
locations (location and special attr ibutes, for example, shift 
systems, willingness to travel) . 
 
 Discrimination may be acceptable in certain circumstances, for example: 
• Army soldiers must be fit, heal thy and be able to carry heavy kit. 
• Firemen must be a certain height so that they can reach the 
• An Italian restaurant can choose to recruit only Italian waiters and 
waitresses. 
 
Advantages of the interview 
technique Disadvantages of the interview technique 
• Places candidate at ease. 
• Highly interactive, allowing 
flexible question and 
answers. 
• Opportunities to use non-
verbal communication. • Too brief to ‘get to know’ 
• Interview is an artificial 
situation. 
• Halo effect from initial 
impression.

336  
   
• Opportunities to assess 
appearance, interpersonal and communication skills. 
• Opportunities to evaluate 
rapport between the candidate and the potential colleagues/bosses. • Qualitative factors such as 
motivation, honesty or integrity are difficult to assess. 
• Prejudice – stereotyping 
groups of people. 
• Lack of interviewer 
preparation, skill, training and practice. 
• Subjectivity and bias. 
  
 The benefits for the learner and the organisation include: 
For the individual: 
• improved skills and (dependent on the type of training)  qualifications 
• increased confidence and job satisfaction. 
For the organisation: 
• increased motivation of employees , leading to higher productivity 
• increased competence and confi dence, meaning higher quality and 
fewer mistakes 
• low staff turnover, saving the organisation time and money 
• skilled workforce, leading to more innovation and a better customer 
  
The appraisal process is certainly not designed to find employees that 
need to be punished and only applies to existing employees, meaning 
that it will not help the organisation wit h its recruitment. It is also designed 
to improve communication between  managers and employees, not 
reinforce the differences between them.

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 Having motivated staff members has a range of benefits – from the 
perspectives of both the organisa tion and the individuals or teams 
themselves. These include: 
Organisation 
perspective Individual 
perspective Team perspective 
Harder working 
employees Greater job 
satisfaction Increased cooperation 
Fewer mistakes and 
errors Improved health, due 
to less stress More commitment to 
team needs 
Less waste of time 
and resources Improved career 
prospects Better ideas 
generation and 
evaluation 
More suggestions and 
ideas generated Finding the job more 
interesting and 
enjoyable  
Increased job 
satisfaction and 
therefore lower staff 
turnover   
More customer 
satisfaction due to 
better service from 
staff   
   
 The answer is D, calculating the rewards package  
 
 The CSFs should be matched to the KPIs as follows: 
CSF KPI 
Diversity of workforce Female to male ratio 
Motivated workforce Employee turnover 
Fair remuneration Competit iveness of reward system 
Efficient recruitment process Time to fill a position 
Suitably skilled workforce Trai ning and development costs

338  
 The answer is Achievable . It will be very difficult to increase this 
completion rate by 40%. 
 
 The PUL system has a number of flaws and only three are required: 
Lack of discussion 
It is sensible that KPIs are discuss ed with staff members in advance, but 
this is not the case here. This discussion would flush out practical 
problems that might exist and wo uld ensure the employee fully 
understood what was expected of t hem. It is generally accepted that 
discussion and agreement prevent dictated standards. Employees will 
often buy in to targets more readily if they feel that they have had an input 
to them. This is clearly not the case here. 
Incorrect level of difficulty 
Equally, without due discussion, the level of difficulty set for the KPI could 
be wildly wrong. Setting a target that is too difficult can demotivated an 
employee meaning that they resent t he target (and the employer who set 
it) and underperform. There is plenty of evidence to suggest that the level 
of output achieved is sub-opt imal in this situation. 
Equally the level of target could be too easy. Whilst this is then easily 
achieved an employee will often have a lack of respect for the setter as 
they will think of them a fool to se t such an easy target. They may even 
feel patronised. As above, the output actually achieved will be suboptimal 
in most cases as the employee stops pushing once the target is reached. 
Single KPI Setting only one KPI keeps things simple and this may well have been 
the intention. However, single KPIs are notoriously easy to manipulate. Suppose a target is simply to make more sales volume . A staff member 
could quickly realise that this is achievable by deep discounting prices. 
This will destroy margin. Without a second KPI, perhaps on price level or 
margin achieved the consequences of a volume only target could be dire. 
Unfairness between differe nt members of staff 
There is no evidence that the targets set are compared in terms of level 
of difficulty from one staff member  to another. Resentment can quickly 
fester in a staff memb er feels unfairly treated.

339 
interacts with IT 
E4: Describe how the finance 
function interacts with IT. (a) Main role of IT. 
finance. 
indicators. Chapter 
12

How the finance function interacts with IT 
340  
 
In this chapter we will complete our discussion of how the finance function plays 
its role by interacting with the rest of  the organisation (syllabus area E) and, 
more specifically here, the organisation’ s information technology (IT) function. 
We will begin by discussing the main role of the IT function; understanding how IT systems can be used to support the re st of the organisation, how these 
systems can be best organised and m anaged and the costs and benefits of 
information systems. 
manage the IT function through the use of  key performance indicators (KPIs). 
2 Main role of IT  
2.1 IT systems support 
The role of information systems in organisations   
Organisations need information systems to enable them to capture and 
generate the information that managers need for planning, control  and 
The hunger for information has nev er been greater than for today’s 
organisations, likewise the value of information systems that deliver this 
information has never been so keenly felt. It follows that information technology (IT) and information systems (IS) assu me increasing managerial importance 
within the modern organisation. 
As has been discussed in earlier chapters,  IT is becoming a strategic weapon 
which many organisations are using to improve their competitive position. This 
can come in many forms. For example, using IT can improve efficiency and reduce costs in order to compete better, it can help t he organisation react more 
quickly to the changing environment or it can create new opportunities etc. 
Before discussing the role of IT in more  detail, it is useful to understand a few 
key definitions .

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 Information systems (IS)  refer to the provision and management of 
information to support the r unning of the organisation. 
 Information technology (IT)  is the supporting equipm ent (hardware) that 
provides the infrastructure to run the information systems. 
 The IT function  is responsible for planning,  evaluating, installing, 
operating and maintaining the hardware, software, networks and data 
centres required by the organisation. 
 A management information system  (MIS) converts internal and external 
data into useful information which is then communicated to managers at all levels and across all functions to enable them to make timely and 
effective decisions for planning, di recting and controlling activities. 
There are a number of key types of MIS: 
Type of MIS Explanation 
Executive information system (EIS) An EIS gives senior management access to internal and external in formation. Information is 
presented in a flexible, user-friendly, summarised form with the option to ‘drill down’ to a greater level of detail. 
Decision support system (DSS) A DSS aids managers in making decisions. The system predicts the consequences of a number of possible scenarios and the manager then uses their judgement to make  the final decision. 
Transaction processing system (TPS) A TPS is mainly used by operational managers to make decisions. It records all the daily transactions (for example, payroll or purchases) of an organisation and summarises them so they can be reported on a routine basis. 
Expert system Expert systems hold specialist knowledge, for 
example on law and taxation, and allow non-experts to interrogate them for information, advice and recommended decisions. Can be used at all levels of management.

342  
 Illustration 1 – EIS 
 A typical report from an EIS would combine many types of data on the 
same screen and make it easier for senior management to understand 
the performance of the business. 
 
Illustration 2 – DSS  
 A supermarket chain is planning to start selling its goods online, but is 
uncertain of whether it is appropriate for the organisation. 
A DSS would gather information about t he company itself – does it have 
the resources to st art selling online? 
It will also provide information about the online groceries market, such as 
the size of the market and who the competitors are. 
The DSS will then present this information in a way that is easy to understand, helping the management  to make the decision 
 
 Illustration 3 – Expert systems 
 An accountant could use an ES to calculate a client’s personal tax 
liability. 
The accountant will input the releva nt information about the client’s 
circumstances. The ES will then acce ss its database of rules and r egulations 
about personal tax, decide which rule s apply to the client and then use 
them to calculate a tax liability.

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How IT enables knowledge manage ment between the functions  
In Chapter 7 we discussed how: 
• the finance function can use data and information to assist sales and 
marketing to better understand custom ers and to develop customer value 
proposition. 
• the finance function can use data and information to assist operations in 
enhancing operational efficiency. 
• the finance function can partner with other areas of the organisation to 
create value from digital assets. 
As part of this discussion we covered some really good and relevant examples 
of how IT enables knowled ge management between functions. 
Here we will look more specifical ly at knowledge management systems and 
how these enable knowledge m anagement between the functions. 
Knowledge is an important organisational  resource. There is a difference 
between: 
 • data – raw facts 
• information  – processed, organised data 
• knowledge  – an application of a cognitive process to the information 
so that it becomes useful. 
There are two broad types of knowledge: • Explicit knowledge  – is knowledge that the company knows it has, for 
example customer information. 
• Tacit knowledge  – is personal knowledge and expertise held by people 
within the organisation that has not been formally documented, for 
example knowledge gained through the experiences of employees within 
 Knowledge management is the process for the acquisition, sharing, 
retention and utilisation of knowledge. 
In what is increasingly referred to as a knowledge-based economy, it is evident 
that sufficient management attention should be given to this valuable organisational asset. 
Organisations hold a huge volume and vari ety of information in different 
systems and people and therefore a k nowledge management strategy is 
needed to unlock the value of this asset and improve organisational 
performance. An important part of this  strategy will involve a technology-based solution (a 
knowledge management system).

344  
 Knowledge management systems refer to any type of IT that helps to 
capture, store, retrieve and us e knowledge to enhance the knowledge 
management process. 
Examples include: 
• Groupware – refers to technology designed to help people collaborate. 
Examples include email, file sharing technology and video/audio 
conferencing. 
• Intranets – a private network within the organisation allowing the sharing 
of information and resources with employees. 
• Extranets – an extension of an intranet  to include suppliers, customers 
and other business partners. 
• Data warehouses and data mining. 
• Decision support systems (DSS). • Content management system s – these make it eas ier to create content 
(for example, using templates), to edit content, to track changes allowing 
for version control and allow for collaborative and parallel work on content. 
• Document management systems – o ften part of a content management 
system. They assist with, for exampl e, the indexing and retrieval of 
documents. 
It is important to note that although technology is an important part of 
knowledge management, it may simply increase the volume and management 
of unfocused data and analysed information if appropriate people skills and 
organisational processes focused on the conversion of this 
data/information into knowledge are not established . 
 
Test your understanding 1  
 The best working definition of in formation from the options below 
would be: 
A facts you can work with 
B facts C facts useful to the operations manager 
D facts useful to the decision maker

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2.2 IT infrastructure 
 IT infrastructure consists of the core networks, databases, software, 
hardware and procedures m anaged by the IT function. 
The modernisation of IT infrastructure is necessary to take advantage of innovations such as data visualisation, AI and blockchain, which will all require 
the analysis of huge amounts of data. 
In this section we will discuss the wa ys of organising and managing IS in the 
context of the wider organisation including: 
• the emergence of new technology  
• enabling transformation • geographically dispersed teams • enhancing internal and external relationships • ethical and social issues with IS and data. 
Each of these will be explored in turn. 
The emergence of new technology 
Advancements in technology (as discussed in Chapter 5) are allowing 
organisations to do much more than they have in the past. However, many organisations are struggling with the pace of change, cons tantly having to react 
rather than lead with technological innovation.  
There are a number of fa ctors that influence the extent and the pace of 
technology adoption by organisations. These include: 
• technical feasibility 
• the cost of developing, implement ing and maintaining the new technology 
• the economic benefits of  the new technology 
• the availability of labour skills to implement and use the new technology 
• regulatory and social acceptance. 
By implementing an up to date and flexible  IT infrastructure, the organisation 
can manage many of these factors – enabling technical feasibility, minimising 
costs and maximising the economic benefit  and having the appropriate labour 
skills present – thus allowing them to embrace new technology and the 
opportunities it presents. 
Enabling transformation 
Technology is no longer viewed mainly as  a vehicle for improved productivity 
but is seen as a key component of business transformation.

346  
 Illustration 4 – Cloud technology 
 The cloud is one transformational te chnology of IT infrastructure. 
Previously, organisations that want ed to increase their capability would 
have had to invest in new equipm ent which was time consuming and 
expensive. 
Organisations are at different stages of their digital transformation but having a 
good IT infrastructure in place can enabl e organisational transformation in a 
huge variety of ways, such as: 
• the adoption of new ways of working across the business  and the 
industry . 
 
 Illustration 5 – BPR  
 BPR enabling new ways of working across the business 
A company manufactures high quality wo men’s clothing in its factory. The 
company is organised into traditional  functional departments most of 
which have their own unreliable spreadsheet-based systems for planning 
and reporting. As a result, the company  often fails to produce accurate, 
timely and consistent data to mo nitor its own performance, which 
contributes to failures in achievin g the performance targets set by its 
retail customers. 
The market is highly competitive. Retailers, who are the company’s 
customers, have two key demands: they  want lower prices to pass on to 
consumers and they also require suppliers to meet performance targets 
relating to lead times and quality. 
To help them comply with the retailers’ demands, the company have 
decided to use BPR to re-engineer t he production process. It will close 
down all of their own manufacturing facilities and outsource all production to overseas suppliers, who have much larger factories and lower costs. 
IT will act as a key enabler in this re-engineering. To mitigate the cost of 
shipping goods over long distances, the company have invested in sophisticated software to consolidat e orders so that each shipping 
container is completely full before despatch from their suppliers. Purchase invoice processing will also be automated by the integration of 
information systems into the suppliers’ bespoke systems. 
The changes will mean t hat staff from the co mpany’s functional 
departments will reorganise into multi- disciplinary teams, each serving 
major customer accounts. Each team  will perform all aspects of account 
management from taking sales orders and procurement through to 
arranging shipping and after sales service.

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 347 
 Illustration 6 – Disruptive technology 
 Disruptive technology and new wa ys of working across the 
hospitality industry 
AirBnB, which was founded in 2008, is an online website. It allows hosts 
to post their homes on t he site for short-term r ent. AirBnB do not own the 
homes, it just acts as a broker and takes commission on every property 
that is rented. Innovative technology  has been used, such as the use of 
cloud-based platforms to collect pay ments and the incorporation of the 
latest technology to allow hosts to  set the optimum price for their 
accommodation.  
Earlier, it was only focusing on low-va lue customers, but eventually, it 
started focusing on high value custom ers as well. Renters can select 
homes or apartments on t he basis of location and the money they want to 
pay. AirBnB is tough competition to  the hotels and other accommodation 
providers in the hospitality industry who are not able to match AirBnB on 
price, household comforts and the local experience offered. 
• productivity improvements  
 
 Illustration 7 – Technology improving farming productivity 
 In the United Kingdom, farm subsidies keep farmers’ incomes from 
sagging but there is a real need for di rect application of  digital and other 
technologies to increase farm productivity and address increasingly 
visible climate change impacts. Some examples of how technology can 
be used to improve farm productivity include: 
• Geographic information systems for agricultural mapping enabling 
better management of soil and irrigation.  
• Digital technology can guide crop and input selection, provide 
weather, disease and pest-relat ed advice, and real-time data on 
domestic and export markets.  
• multi-source data capture and analysis 
 
 Illustration 8 – Big data analytics use by supermarkets 
 In Chapter 5, we discuss ed big data and data analytics: 
• Big data describes data sets so large and varied they are beyond the 
capability of traditi onal data-processing.   
• Data analytics is the process of collecting, organising and analysing 
large sets of data to discover pa tterns and other information which an 
organisation can use for future decisions.

348  
 A supermarket can analyse this multi-source big data to improve its 
targeting of customers: 
For example, a supermarket is able to take data from your past buying 
patterns, its internal inventory in formation, your mobile phone location 
data, social media as well as weat her information to send you a voucher 
for barbeque food; but only if you own a barbeque, the weather is nice, 
you are within 3 miles of one of thei r stores and the barbeque food is in 
stock. 
• the creation of shared service capabi lity – shared service centres were 
discussed in Chapter 3. Globalisation and technological advances have 
meant that much of the routine processing of the organisation’s functions 
(for example, the finance functi on) could be carried out by a shared 
service centre (i.e. the centralisati on of this routine processing into one 
place).  
• digitisation of information 
 
 Illustration 9 – Digitisation within the NHS 
 The National Health Service (NHS) provides healthcare for all citizens in 
the United Kingdom. It is the fifth la rgest employer in the world. The 
government has committed billions of pounds to creating a ‘paperless’ 
NHS, recognising that making the best use of IT will deliver huge benefits 
and improved outcomes for patients. 
Digitisation is planned across t he whole NHS, for example: 
• the creation of electronic record s for all patients (so patients will no 
longer have to repeat t heir medical history) 
• the creation of online booking an d prescription ordering services 
• access to healthcare apps for patients (for example, allowing 
patients to send real-time data to their healthcare providers on long-
term conditions such as high blood pressure or diabetes) 
• options for patients to choose to  speak to a doctor online or via 
video link. 
However, digitisation is a huge chal lenge due to anti quated systems, the 
vast scale of the task and insuffici ent funding. However, although the 
modernisation is fraught with difficulty, it continues to make progress in 
an attempt to move the NHS forward. 
• flexible working practices (see discussion below) 
• virtual organisations (see discussion below)

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 349 
Geographically dispersed teams 
Technology developments have enabled the cr eation of new ways of working. 
Two significant changes include an increase in remote  working and the 
formation of virtual teams : 
• an increase in remote working  – IT developments (such as email and the 
internet), have enabled employees to work away from the office (for 
example, at home). The advant ages and disadvantages for the 
organisation may include: 
• Lower infrastructure costs. 
• Increased employee 
motivation and productivity. 
• Increased commitment to the 
• Attracting individuals because 
of the availability of such 
conditions. 
• Reduced absenteeism and 
staff turnover. • Difficulties in co-ordinating 
staff. 
• Loss of control of staff. 
• Dilution of organisational 
culture. 
• Less commitment to the 
• Extra labour costs, for 
example providing employees 
with equipment. 
 
 Consider your own employment. Would you like or dislike working from home? Discuss the reason for your opinion on this issue. 
• the emergence of virtual organisations and virtual teams  
 A virtual organisation  outsources most or all of its functions to other 
organisations and simply exists as a netwo rk of contracts, with very few, if 
any, functions being kept in-house. 
 
 Illustration 10 – Amazon, a virtual company 
 Many internet companies are ex amples of networks – Amazon being 
perhaps one of the best known on-line retailers. 
• Amazon operates its website but relies on external suppliers, book 
publishers, warehouses, couriers and credit card companies to deliver the rest of t he customer experience. 
• These partners are also expected to provide Amazon with 
information on, for example, stock availability, delivery times and promotional material. 
• The customer feels that they ar e dealing with one organisation, not 
many.

350  
 A virtual team is a group of people who interact through independent 
tasks guided by a common purpose and work across space, time and 
organisational boundaries wit h links strengthened by IT. 
They are essentially teams of people who are not present in the same office or 
organisation and are a key component  of a virtual organisation. 
The following challenges  face virtual teams: 
Challenge Explanation 
Forming a team It may be difficult to  establish a cohesive and trusting 
team. 
Knowledge sharing It may pr ove more difficult due to the absence of face to 
face contact. 
Processes and goals It may be more difficu lt to establish clear decision 
making processes and goals. 
Leadership This may be more diffi cult since individuals will be 
working at different times, in different locations and in different ways. 
Cultural differences Team members will be from different backgrounds and 
cultural differences may ma ke working together more 
difficult. 
Morale Some team members may find this way of working 
isolating. 
 
 Identify the ways in which the ch allenges faced by virtual teams can 
be overcome. 
 
 Which one of the following statements regarding virtual organisations is incorrect? 
A Virtual organisations occur w hen some or all elements of the 
organisation’s functions are outsour ced to third party organisations 
B Information technology is usually  a vital requirement for virtual 
C Virtual organisations usually face higher overhead costs 
D Virtual organisations have more flexibility than traditionally 
structured organisations

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Enhancing internal and external relationships 
Information systems provide an opportunity to build stronger relationships with 
stakeholders and to improve internal efficiency by providing convenient, easy to 
use, communication channels. For exam ple, intranets and ex tranets, shared 
databases (these may utilise the cloud) , email and live chat features. 
 
 Illustration 11 – Enhancing relationships with customers 
 One example of a system that ca n be used to enhance relationships with 
stakeholders (in this case, customers) is a customer relationship 
management (CRM)) system . 
CRM  is the process the organisation uses to: 
• identify, attract and win new customers 
• retain existing customers • entice past customers back. 
CRM systems refer to the technology that is used to gather the 
information needed to achieve the above (i.e. CRM). CRM systems range from simple spreadsheets and databases containing information about the customer to more complex on line applications which are fully 
integrated with the or ganisation’s other system s. A CRM system may 
include the following features: 
Feature Benefits 
A central database that is accessible by all employees to view and update customer data. Improved customer service, loyalty and retention. 
Analysis of customer data 
including customer segmentation 
(existing and potent ial customers). Improved marketing campaigns 
through customised targeting. 
Customer web-based or dering. Reduced order cost and customer 
service cost. 
Identifying and tracking potential 
customers. A wider customer base and more focused prospect tracking. 
Reports generated with up-to-date information including revenue forecasting and trend analysis. Better and more timely decision making.

352  
Ethical and social issu es with IS and data 
In Chapter 6 we discussed how the increased use of technology impacts ethical 
and social considerations. In the context of IT infrastructure, the organisation must manage its information systems and data with these ethical and social 
issues in mind, including: 
• data protection and data privacy – the amount of personal data 
available to and used by organisations m eans that the priv acy, sensitivity 
and security of this data is a very significant consideration in modern 
business. A business must ensure it is  compliant with a ll legislation but 
there are also considerations from an ethical and social responsibility point 
of view in terms of what is right  and wrong in the eyes of the public. 
 
 Illustration 12 – IT infrastructure a nd legal, ethical and social issues 
 An organisation must manage its info rmation systems in the context of 
the legal, ethical and social issu es that exist with IS and data: 
Example of an issue Possible intervention 
Legal issue  – data may be used 
or handled in an unlawful way, for example resulting in unauthorised access of data. In the UK, the organisation’s IS must be set up to comply with GDPR principles. This will ensure that the organisation’s data is used lawfully. Data controllers within the organisation may be used to ensure that these adequate GDPR safeguards are in place. 
Ethical issue  – goes beyond legal 
requirements and considers what is right or wrong for the organisation to do. For example, just because an organisation’s IS will allow the collection and analysis of an employee’s social media presence, it may not be considered ethical to do so. Organisations may create a written code of ethics and instruct employees to follow them. In the context of the example given here, it may contain a broad or more specific statement regarding the use of the organisation’s IS to monitor an employee’s social media presence. 
Social issue  – an organisation 
should make choices that are for the best of the society in which it operates (see illustration below). The IT infrastructure within the organisation should be set up to collect, analyse and share data in an appropriate way. So, for 
example, a pharmaceutical 
company may align its systems so that it can easily share data and analysis with university research teams.

Chapter 12 
 353 
 Illustration 13 – Social issues 
 In Chapter 6, we said that pha rmaceutical companies may hold huge 
amounts of data and analysis from clinical  trials. It may not make financial 
sense but from a societal point of  view the company should consider 
donating this data and analysis to, say, uni versities for research purposes 
that could benefit society. 
For example, in 2014, Johnson and Johnson agreed to give all of its 
clinical trial data to Yale University to help advance science and medicine.  
• corporate digital responsibility (CDR)  – as discussed in Chapter 6, CDR 
is a voluntary commitment by organisations to go beyond mere compliance with legislation, when it comes to how they handle technology 
and data. The social and ethical issues discussed above will be relevant here. The organisation’s IT infrastructure should be aligned to it CDR strategy. 
2.3 The costs and benefits of IS 
When an organisation sees a possibility for introducing a new IS, an evaluation 
of the new system should be made to decide whether the potential benefits are 
sufficient to justify the costs. 
 Cost-benefit analysis  (CBA) can be used to assess the expected costs 
and benefits  of the IS. 
The costs  of a new IS are: 
Initial costs Running costs 
• Costs to design and develop 
system if software is bespoke. 
• Purchase price of software if it is 
not bespoke. 
• Purchase cost of new hardware. 
• Cost of testing and 
implementation of the new 
system. 
• Training costs. • Cost of labour time to run the 
system. 
• Cost of materials, for example 
replacement parts. 
• Cost of service support, for 
example IT helpdesk. 
• Other ongoing costs such as the 
cost of quality or security adherence/failure.

354  
The benefits  of a new IS include: 
• Speed – for example, in dealing with repetitive tasks such as data 
collection and payroll processing. 
• Accuracy – the IS should reduce the incidence of human error and better 
information should be produced. 
• Volume – the IS should be able to handle much larger volumes of data, 24 
hours per day. 
• Complexity – Once systems are co mputerised and integrated, they can 
generally handle a greater level of complexity than humans. 
• Collaboration – the IS can enable co llaboration across the organisation 
due to better access and sharing of real-time information. 
• Presentation – the IS ma y display information in as ‘user-friendly’ way as 
possible. 
• Lower costs – all of the above benef its mean that IS have become highly 
cost-effective providers of ‘good’ information. 
We will now look more specifically at the different costs and benefits of 
information systems including: 
• privacy and security 
• systems architecture • data flows • big data information management. 
Privacy and security 
As discussed already, IS are exposed to privacy and security issues. The 
organisation must safeguard the privacy and  security of data (considering legal, 
ethical and social factors and a wider sense of CDR) as well as ensuring 
complete and accurate processing of data. 
There are different privacy and security risks that exist, together with solutions 
as to how the organisation can tackle each risk. Each of the solutions will have 
an associated cost (i.e. to implement the solution) and benefit (i.e. mitigation of 
the risk). 
Potential threat Solution 
• Natural disasters – for example, 
fire or flood. • Fire procedures – fire alarms, 
extinguishers, fi re doors, staff 
training and insurance cover. 
• Location, for example, not in a 
basement area liable to flooding. 
• Physical environment – for 
example, air conditioning and 
dust controls.

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• Back up procedures – data 
should be backed up on a regular 
basis (ideally in real-time) to allow recovery. 
• Business continuity planning – to 
decide which systems are critical to the organisation continuing its activities. 
• Malfunction – of computer 
hardware or software. • Network design – to cope with 
periods of high volumes. 
• Back up procedures and 
business continuity planning (as above). 
• Unauthorised access, usage, 
damage or theft  • Personnel controls – includes 
segregation of duties, policy on usage and compliance with regulations such as GDPR, hierarchy of access. 
• Access controls – such as 
passwords and time lock-outs. 
• Computer equipment controls – 
to protect equipment from theft or destruction. 
• Viruses – a small program that 
once introduced into the system spreads extensively. Can affect the whole computer system. • Anti-virus software – should be 
run and updated regularly to prevent corruption of the system by viruses. 
• Formal security policy and 
procedures, for example, employees should only download files or open attachments from reputed sources. 
• Regular audits to check for 
unauthorised software. 
• Hackers – deliberate access to 
systems by unauthorised persons. • Firewall software – should 
provide protection from unauthorised access to the system from the Internet. 
• Passwords and user names – 
limit unauthorised access to the system.

356  
• User awareness training and a 
formal security policy so that 
employees are aware of the risks that exist and how best to mitigate them. 
• Data encryption – data is 
scrambled prior to transmission and is recovered in a readable format once transmission is complete. 
• Human errors – unintentional 
errors from using IS. • Training – adequate staff training 
and operating procedures. 
• Controls ensuring only valid data 
is input/processed and that all data is processed. 
• Human resource risk – for 
example, repetitive strain injury (RSI), headaches and eye strain from computer screens, tripping over loose wires. • Ergonomic design of 
workstations should reduce problems such as RSI. 
• Anti-glare screens reduce eye 
strain. 
• Cables should be in ducts. 
 
 Illustration 14 – WikiLeaks 
 WikiLeaks is a not-for-profit organisation created to protect 
whistleblowers and journalists who have sensitive information to communicate to the public. WikiLe aks has dominated the news because 
of its steady drip feed of secr et documents. For example: 
• In 2010, the site released almost 400,000 secret US military logs 
detailing its operations in Iraq, 90,000 classified military records 
giving an insight into military st rategy in Afghanistan and posted a 
video on its website showing a US A pache helicopter killing at least 
12 people during an attack in Baghdad in 2007. 
• In 2016, during the US presidential election, Hilary Clinton was 
exposed by WikiLeaks due to the unprecedented levels of 
corruption throughout her history.

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 Illustration 15 – Virus infection in the NHS 
 The NHS (National Health Service) faced a week of chaos after hackers 
demanding a ransom infiltrated the health service’s computer system. 
Operations and appointments were c ancelled and ambulances diverted 
as up to 40 hospital trusts became infected by a ransomware (malicious 
software) attack demanding payments to  regain access to vital medical 
records. 
The attack was part of the biggest r ansomware attack in history with 
57,000 infections in 99 countries being observed. 
Systems architecture 
 The systems architecture  is the way the systems infrastructure is 
organised together to support the organi sation’s functions and its overall 
goals. 
The development of network  technology has facilitated the transfer of 
information between different parts of t he business. Organisations connect their 
computers together in local area networks  (LANs), enabling them to share 
data (for example, via email) and devices (such as printers). Wide area 
networks  (WANs) are used to connect LANs together, so that computer users 
in one location can communicate with computers users in another location.  There are two broad approaches to systems architecture  – a centralised 
architecture or a decentralised architecture: 
 A centralised  systems architecture is when the whole IT function or the 
entire IS is based out of a single, central location. 
 A decentralised systems architecture is when t he IT function or the IS is 
spread out throughout the organisation’s location. 
The costs and benefits of a decentr alised approach are as follows: 
Costs of decentralised architecture Benefits of decentralised 
architecture 
• Higher costs due to duplication of 
equipment and effort: 
– analysis, design and 
implementation of IS 
– data gathering and 
administration 
– operation, support and 
maintenance of IS. 
• Barriers to sharing data between 
different parts of the organisation, 
for example, due to unaligned IS. • Better ability to meet local needs. 
• Fewer staff relying on a single 
system. 
• Less reliance on a few key staff 
who plan, develop and run the 
systems. 
• Technology tends to be less 
complex making problems easier to diagnose. 
• Security breaches will have less 
of an impact.

358  
• Inconsistent data, for example, 
one version of the data may be 
more reliable or up to date. 
• Loss of control at a central level 
may result in common goals not being worked towards. • Efficiencies since time is saved 
not having to collect information locally, process it and collate it centrally and then feedback down to a local level. 
The costs and benefits of centralised system s architecture are the opposite of 
those above. 
It is worth noting that an organisation may decide to outsource IS  – the scope 
ranging from outsourcing of the devel opment of a single system to total 
outsourcing when the vast majority of the organisation’s IS and IT services and 
capabilities are outsourced. 
Data flows 
 Data flow is the movement of data through a process or system. It 
includes: 
• data inputs (raw data) 
• data processing (turning the raw data into meaningful information) 
• data outputs (‘good’ information, i. e. accurate, ti mely, relevant, 
concise and cost effective, is produced for the user) 
• data storage. 
There will be costs  associated with data flows, i. e. the cost of collecting the 
data, processing the data, dat a output costs and the cost  of the storage of data 
(much of this will rely on effective net work technology). There will also be an 
upfront cost for the production of a data flow diagram – this is a model used to 
map out the entire proc ess of data movement. 
However, there are benefits  of having good data flows in place. As discussed 
in Chapter 5, understanding the potential value of data and its significance to an 
organisation presents a real opportunity  to gain unique insight which can be 
used to improve competitive position and potentially gain competitive advantage 
over rivals.

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Big data information management 
Big data and data analytics was discussed in Chapter 5. Effective big data 
information management will unlock the potential value of big data but this will 
also come at a cost to the organisation: 
The benefits , as discussed in Chapter 5, are: 
• enhanced transparency 
• performance improvement • market segmentation and customisation • improved decision making • possible product innovation • effective risk management and control. 
 
 Illustration 16 – Big data information management at Netflix 
 Netflix  has over 100 million users worldwide. The company uses 
information gathered from analysis of viewing habits to inform decisions 
on which shows to invest in. Analysing past viewing figures and 
understanding viewer populations and the shows they are likely to watch 
allows the analysts to predict likely viewing figures before a show has 
even aired. This can help to determine if  the show is a viable investment. 
However, there are costs associated with big data information management: 
• The cost of establishing the hardware and software needed. In addition, 
there will be a need to constantly update  or maintain  it in order to achieve 
competitive advantage. 
• There may be technical difficulties, and therefore associated costs, with 
integrating existing data warehousing and, for example, Hadoop systems. 
• Incorrect data (poor veracity) may result in  incorrect conclusions being 
made. For example, data collected  from social media may not be 
accurate. This wastes times and can result in poor and costly decisions. 
• It is important to recognise t hat just because something CAN be 
measured, this does not necessarily m ean it should be. There is a risk that 
valuable time is spent measuri ng relationships that have no 
organisational value . 
• The security of data is a major concern in the majority of organisations 
and if the organisation lacks the res ources to manage data then there is 
likely to be a greater risk of leaks and losses. There can be a risk to the 
data protection of organisations as they  collect a greater range of data 
from increasingly personal sources (for  example, Facebook). Current laws 
and regulations on the st orage of personal informa tion must be complied 
with to avoid legal action and/or reputat ional damage. This will all come at 
a cost.

360  
• The nature of much of the data means  that there is a risk that it will 
become outdated and irrelevant very quickly  resulting in the need to 
constantly monitor databases. 
• The availability of skills  to use big data systems, which is compounded 
by the fact that many of the systems are rapidl y developing and support is 
not always easily and readily availabl e. There is also an increasing need 
to combine data analysis skills with a deep understanding of the industry 
being analysed and this need is not always recognised. Recruitment and 
training of the right staff and provisi on of competitive remuneration to 
these staff can prove costly. 
3 Areas of interface between IT and finance 
3.2 Interaction between IT and finance 
• Traditionally , the IT function and the finance function worked 
– Finance very much viewed IT as a cost whereas the IT function 
viewed it as an asset. 
establishing a budget for a new IT system. 
• The modern  approach is to view IT as one of the greatest assets an 
organisation has. Given the central role that technology plays in 
supporting modern business and their finance functions, the finance 
function and the IT function need to form a productive partnership. 
Examples of why the two functions need to interact include: 
– Smarter investment in IT  – whether the business needs to 
implement a company-wide system or a solution that’s for the finance 
function alone, the expert guidanc e of the IT function on which 
technology will help the company achieve its strategic goals and 
increase competitiveness will be of huge benefit to the finance 
function. 
– Information security and compliance  – when it comes to data 
privacy and security, the finance function can work with the IT 
function on many fronts, including creating access policies and minimising the threat of data theft and loss.

Chapter 12 
 361 
– Data analytics  – organisations of all sizes are working to find ways 
to turn their data into actionable business intelligence. The finance 
function wants to make sure that only the most relevant and accurate 
data is used for decision making. This requires the business to apply the right combination of technologi es, processes and strategies. The 
IT function is well equipped to lead and shape these activities. 
Much of this discussion can also be appli ed to the IT function and can therefore 
be referred back to. 
the IT function through the use of KPIs before identifying some relevant KPIs for 
IT. 
4.2 How finance helps to manage IT using KPIs 
context of the IT function. 
• The IT function will identify its relevant CSFs. 
• The KPIs are the measures that indicate  whether or not the IT function is 
• The finance function works with the IT function to: 
– assemble KPI data and information  
– analyse  this for insight  
– give advice to the IT function based on this insight and 
objectives of the IT function and the organisation as a whole. 

362  
4.3 Examples of KPIs for IT 
Type of activity Possible KPIs 
Operational  activities – KPIs 
are used to monitor the day to 
day activity and effectiveness of the IT function. • Ticket response rates for IT issues sent 
to IT support. 
• Resolution rates. 
• System/technology downtime. • Customer feedback/experience. 
Transformational  activities – 
KPIs are used to measure the 
impact of IT initiatives in terms of better and more informed decision making. • Cost of new technology. 
• Time saved using new technology. • IT spend per employee. • IT utilisation. • Security adherence/breaches. 
Strategic  activities – KPIs are 
used to monitor the progress of 
the IT function towards long-term strategic goals.  • New/improved business opportunities 
using technology. 
• Revenue generated by using new 
• Technology leading to competitive 
• IT function as a leader in the market 
place. 
 
 Lamp Limited is introducing a new information system and given it is a 
large project the project manager has decided to set some key performance indicators for the te am after discussion with them. 
The project manager is concerned t hat the benefits fr om the project 
exceed the costs of it and that the project is co mpleted on time with all 
the deliverables (outputs) of suitable quality. 
Three KPIs have been selected for scrutiny and you have been asked to 
comment.

Chapter 12 
 363 
  
KPI Background 
Volume of transactions 
Capable of processing up to 6,000 
transactions per hour This is an increase of 80% over the previous system 
Labour 
Total labour spend on the project 
must not exceed $100,000  This is based on the original specification and scope of the project 
Deliverables 
All originally specified deliverables 
(outputs) must be 100% delivered  This is based on the original specification and scope of the project 
Required: 
For each KPI listed above comment on the positives and the negatives 
you can identify in the measure suggested and comment on whether and 
how this measure could be manipulated.  
(15 marks)

364  

Chapter 12 
 365 
 The best answer here is D 
 
• Reduced travel time and hence cost savings. • Reduction is stress due to the re moval of the daily commute and the 
removal of the distractions of a busy office. 
• Better work/life balance due to th e removal of the daily commute 
and potential opportunities to work more flexible hours than the 
traditional ‘9 to 5’. 
• Control – employees may feel an improved sense of control if they 
have more flexibility to decide their working patterns and hours. 
• Employment opportunities for disadvantaged individuals, for 
example disabled people may now fi nd it possible to work due to the 
removal of travel and the office environment. 
• May not suit those with poor personal  motivation or who are not self-
starters. 
• May be distracted at home, for example by family members. 
• Loss of learning/sharing of ideas  from face to face contact. 
• Loss of social interaction and stimulation. • Difficultly in separating home and work life – an inability to ‘switch 
off’ from work may lead to ‘burn out’ or damaged personal 
relationships.

366  
 The challenges faced by virtual teams can be overcome by: 
• training in technology and teamwork 
• spending time getting to know each other, for example, team 
identity, jokes, occasional face to  face meetings, team trips out 
• clear roles and responsibilities • detailed and timely feedback between the leader and team 
members 
• regular and predictable communica tion matters. The benefits should 
be maximised, for example, the use of email, video conferencing, 
social networking sites and blogs could all assist in overcoming some of the challenges. Time zone differences may mean that 
managers and employees may have to accept that response times may not be immediate 
• paying attention to cultural differences. This may require training in 
cross-cultural appreciation 
• choosing dependable and self-reli ant employees but managers 
should still be on hand to offer support 
• valued staff should be made to feel wanted and a sense of loyalty to 
the firm instilled 
• managers may need to view their role differently, the emphasis 
being on co-ordination ra ther than leadership 
• clear communication from manager s of information coming from 
higher up in the organisation to ens ure that employees are fully 
informed and share the organisation’s vision. 
 
 The correct answer is C – virtual organisations usually have lower 
overhead costs.

Chapter 12 
 367 
 Volume of transactions 
Positive aspects 
This measure is clearly very specif ic and should be measurable. It could 
be that the capacity of the system may never be fu lly utilised and so the 
6,000 could never be reached and which case the actual data may show 
a number less than this tar get, without there being any 
underperformance. 
Negative aspects 
It is unclear whether an 80% increas e is achievable, although system 
upgrades do tend to result in big increases in potential speeds in the 
modern IT world. 
There is no quality aspect and speed alone may not be what is needed or 
preferred. 
Manipulation 
The number of transactions processed in a given time space is a very 
factual matter and without any element of  judgement it is mo re difficult to 
manipulate. 
A determined employee could duplicate tr ansactions I order to get this 
figure higher but that would result  in the need for reversal and the 
likelihood of being caught. 
Total labour spend 
Providing a financial constraint is cl early relevant and this measure is 
clear and measurable. However, this is set based on the agreed 
specification and scope of the project and if these change at all during the 
project then this limit mi ght have to be revisited. 
Setting cash limits can constrain decis ions during the project. “We can’t 
do (sensible thing) because we will spend more than was allowed”. This 
can have very damaging effect s on the project outcomes. 
If the scope changes and the target is not  adjusted it will become either 
too lenient, or more likely too harsh. 
Costs incurred could be wrongly ca tegorised to either another cost 
heading or another project t hus under recording the cost in this project

368  
 Deliverables 
This is a clear target that is  incapable of being misunderstood. 
It is relevant as the quality of work was a concern of the project manager. 
One questions the achievability of 100%  perfection, if a target is too 
difficult it can be ignored or become a demotivating factor. 
You could also question its desirabili ty. If delivering perfection gets 
expensive the costs might exceed the benefits here. 
Other than just lying it  is harder to see how this measure could be 
manipulated. Either the system delivers, or it doesn’t. However, if some of 
the deliverables have elements of subj ectivity (the “good” appearance of 
a document) then it is possible to “str etch” the definition a little and say it 
delivers when some might believe it does not.

Index 
 I.1 
3-D printing..... 128, 147, 166 
Advantages.....147 
Finance function.....166 
4 Cs.....277 
4 Vs.....134, 202 4th Industrial Revolution .....2, 128, 129, 152, 171 
5 As 
Acumen.....32 
Advising to influence.....32 
Analysing for insights.....31 
Applying for impact.....32 
Assembling information.....31 
A 
Additive manufacturing.....147 
Agency problem.....18 Annual general m eeting (AGM).....21 
Application form.....312 
Appraisal.....320 
Lockett – Barriers to effective appraisal.....321 
Artificial intelligence..... 128, 137, 138, 139, 154, 
158, 159, 160, 165, 173, 345 
Finance function.....159 
Assessment centres.....315 
Asset specificity.....73 
Audit committees.....24, 103 
Augmented product.....276 Automation paradox.....170 
B 
Balanced portfolio.....293 
Big data.....128, 134, 136, 137, 149, 153, 154, 
155, 156, 160, 161, 164,  165, 176, 181, 182, 
183, 186, 187, 191, 199,  200, 202, 203, 205, 
294, 347, 359 
4Vs.....134, 202 
Big data and marketing.....294 
Finance function.....155, 202 
  Hadoop.....199 
Human sourced data.....134 
Machine generated data.....134 
Open data.....134 
Processed data.....134 
Sources of big data.....134 
Blockchain.....103, 128, 141,  142, 143, 144, 149, 
152, 162, 163, 164, 176, 291, 294, 345 
Benefits of a blockchain.....141 
Cryptocurrenc y.....162 
Distributed ledger.....162, 163 
Finance function.....163 
Key features of a blockchain.....142 
Smart contracts.....163 Typical stages in a blockchain 
transaction.....143 
Budgets.....91 
Business intelligence (BI).....198, 199 Business partnering.....66,  67, 109, 112, 155, 
156, 254 
Business process re-engineering (BPR).....242, 
346 
C 
Captive product pricing.....277 
Centralisation.....54, 68 Change.....4 
Adept.....168 
Chief Data Officer (CDO).....191 
Chief Financial Officer.....112, 113, 114, 125, 
211, 253, 254 
Chief Informati on Officer.....159 
CIMA’s Code of Ethics.....9, 10 Cloud computing.....128, 131, 132, 133, 149, 152, 
153, 154, 291, 328 
Features of clo ud computing.....132 
Financial reporting.....154 
Private cloud.....132, 153 
Public cloud.....132, 153 
Code-division multiple  access (CDMA).....146 
Cognitive computing.....119 
Concentrated ma rketing.....288 
Contemporary transformation of 
Organisations.....58 
Finance function.....59 
Content management systems.....344 
Continuous impr ovement.....242, 245 
Core competencies.....68, 69 
Core modernisation tools.....152 
Corporate codes of ethics.....11 
Corporate digital resp onsibility (CDR).....152, 
190, 353 
Corporate governance.....4, 17, 18, 19, 20, 22, 99 
AGM.....21 
Audit committees.....24 
Board structure.....21 
Chairman.....21 
Chief executive officer.....21 
Nomination committees.....22 Non-executive directors.....21 
Principles based approach.....19 
Remuneration committee.....22 
Sarbanes-Oxley (SOX).....20 
UK corporate governance code.....17 
Corporate social resp onsibility.....4, 12, 15 
Modern view.....16 Traditionalists.....15 
Cost plus pricing.....277 
Cost schedules.....90 Critical success fa ctors (CSFs).....254 
Customer relationship management 
(CRM).....153, 158, 184, 185, 351 
Customisation.....295

Index 
I.2  
D 
Dashboards.....258, 298, 330 
Data.....343 
Analytics.....128, 129, 13 6, 137, 153, 154, 
155, 160m 181, 184, 186, 191, 205, 270, 283, 
291, 294, 295, 296,  347, 359, 361 
Controllers.....171 
Engineering, extracti on and mining.....195, 
198 
External sources.....35 
Flow.....358 
Internal sources.....34 
Management.....191, 196 
Manipulation.....201 
Mining.....344 
Modelling.....195, 200, 201 
 Three levels of data modelling.....201 
New data sources.....117 
Profiling.....198 
Protection and dat a privacy.....352 
Protection and privacy.....190 
Requirements.....196 
Scientists.....155, 205 Security.....190 
Sources of data.....34 
Strategy.....191, 195, 196, 202 
Technology and data.....181 
Visualisation.....128, 14 1, 152, 153, 154, 160, 
161, 166, 176, 184, 199,  203, 204, 205, 345 
 Dashboard.....141, 161 
 Finance function.....160, 203 
Warehouse(s).....198, 258, 344 
Debt.....95 
Decentralisat ion.....54, 55 
Decision support syst ems (DSS).....341, 344 
Development.....317 
Diamond shape.....63, 64, 65,  66, 67, 68, 79, 82, 
86, 103, 109, 111, 116, 118, 123 Four levels.....67 
Differentiated marketing.....288 Digital asset management systems (DAM).....188 
Benefits.....189 
Digital assets.....163, 187, 188, 189 
Creating value.....187 
Digital marketing.....279 
Digital mindsets.....151, 167, 168, 202 
Finance function.....168 
Disruptive tech nology.....347 
Dividend yield.....89 
Divisional structure.....46,  47, 49, 50, 51, 81 
Geographical.....49 Product.....49 
Document management systems.....344 
Dynamic pricing.....277 
E 
Earnings per share.....89 
Enabling transformation.....345 Enterprise resource  planning (ERP).....232 
Entrepreneurial structure.....47, 48, 81 Equity.....96 Ethical and social cons iderations of IT.....352 
Ethics.....4, 7, 8, 10, 11, 12, 15, 17 
Business ethics.....7, 10 CIMA code.....9 
Corporate code of ethics.....11 
Ethical behaviour.....10 
Individual ethics.....7 
Ethics of technology usage.....171 
Ethical and social considerations.....172 
GDPR.....171 
Legal consider ations.....171 
Evaluating the training.....318 
Donald Kirkpatrick – Four level model.....318 
Executive information system (EIS).....341 
Experiential ma rketing.....279 
Expert system.....341 Explicit knowledge.....343 Exponentials.....152 External audit.....98 
Extraction, transformation and loading 
(ETL).....198, 199, 200, 208 
Extranets.....344 
F 
Features of servic e organisations.....275 
Features of UK cor porate governance.....20 
Finance activities 
Information to impact.....30 
Finance function.....6, 169, 210 
3-D printing.....166 
Artificial intelligence.....159 
Big data.....155, 202 
Blockchain.....163 
Changing face of finance.....152 
Cloud computing.....153 
Contemporary transformation.....59 
Data visualisation.....160, 203 
Diamond shape.....63 
Digital mindsets.....168 
Digital technologies.....152 
Drivers for change.....67 
Ethics.....7 
Future skills.....116 
Hierarchical triangle.....63 
Information to impact framework.....61 
Interface with HR.....327 
Interface with IT.....360 
Interface with operations.....221 
Interface with sales and marketing.....290 
Interface with supply chain 
management.....253 
Key roles 
 Enables.....6, 40, 64 
 Narrates how.....7, 40, 64 
 Shapes how.....6, 40, 64 
New technologies.....153

Index 
 I.3 
Outsourcing functions.....75 
Process automation.....59, 67, 156, 169 
Relationship to other  functions.....211 
Roles of the finance function.....3, 6 
Segregated triangle.....63 
Shape.....63 
Shared service centre.....76 
Structure and shape.....44 
Working with specialist functions.....109 
Finance interacting with the organisation.....210 
Finance operations..... 87, 103, 104, 116 
Finance professional.....153, 154, 169, 170 
5 As.....31 Future skills.....61 
Impact of automation.....38 
Impact of technology.....115 
Process automation.....60 
Skills.....169 
Financial gearing.....96 
Financial planning and a nalysis.....104, 108, 110 
Financial reporting.....88, 92 Financial Reporting Council (FRC).....20 Financial statements.....88,  89, 90, 98, 101, 111 
Financing.....95 
Debt.....95 Equity.....96 
Flat organisational st ructure.....56, 57, 58 
Foreign currency.....94, 97 Fraud.....101 Functional structure..... 47, 48, 50, 51, 53, 81 
Functions of an organisation.....6, 210 
G 
General Data Protection Regulation 
(GDPR).....171, 190, 191 
Going rate pricing.....277 
Groupware.....344 
Guerrilla mark eting.....279 
H 
Hadoop software.....294 
Hierarchical triangle.....63,  64, 65, 68, 76, 79 
HR cycle.....308 HR plan.....306 Human resource management (HRM).....306 
Human resources.....6, 210,  305, 306, 327, 329, 
330, 331 Interface with finance.....327 
Technology.....328 
I 
Information.....36, 180, 343 
'Good' information.....36 Information and decision makers.....182 
Levels of information.....180 Qualitative in formation.....39 
Quantitative information.....39 
Technology to capture information.....38 
Types of information.....38 
Information systems (IS).....341 
Stakeholder rela tionships.....351 
Information technology (IT).....341 
Information to impact framework.....30, 32, 33, 
59, 60, 61, 75, 86, 116, 257 
Technology impacts.....116, 258 
Internal audit.....98, 99, 100, 102, 103, 123 
Fraud.....101 Limitations.....103 
Scope of work.....99 
Internet of things.....128,  129, 132, 134, 137, 144, 
145, 164, 165, 181, 182, 186, 187, 294 
Smart technology.....145 
Intranets.....344 
IT.....6, 210, 340 
Enabling knowledg e management.....343 
Function.....341 
Infrastructure.....345 
Interface with finance.....360 
Modern organisation.....340 
Systems support.....340 
IT/IS  
Cost versus benefits.....353 
Emergence of new technology.....345 
J 
Job analysis.....309 
Job description.....309 Just-in-time.....216, 231,  237, 245, 248, 324 
JIT production.....249 
JIT purchasing.....249 
K 
Kaizen.....237, 241, 252, 266, 324 
Key performance indicators (KPIs).....161, 329, 
254, 297, 361 Finance KPIs to monitor HR.....329 
For operations.....255 
HR.....330 
IT.....362 
Sales and marketing.....297 
Used by finance to manage IT.....361 
Used by finance to manage oper ations.....257 
Knowledge manag ement.....343, 344 
Systems.....344 
Kotler – Market segmentation.....284 
L 
Lean.....237, 244, 246, 247,  248, 252, 266, 324 
Types of waste.....245 
Life-cycle costing.....293 
Lockett.....321 Loss leaders.....277

Index 
I.4  
M 
Machine learning..... 137, 139, 158, 159 
Management acc ounting.....90, 92 
Management information system (MIS).....341 
Manufacturing resource planning (MRPII).....232 Market planning process.....271 Market positioning.....281 
Market research.....272, 281, 284 
Primary (field) research.....282 Secondary (desk) research.....282 
Market segmentation.....281, 284, 295 
Bases for segmentation.....285 
Market targeting.....281 
Marketing.....183, 270 
New forms.....279 Pricing.....183 
Product.....183 
Promotion.....184 
Segmentation.....183 
Service organisations.....275 
Marketing mix.....270, 272, 274, 275, 276, 281, 
284, 299 
4 Ps.....274 
7 Ps.....274 
Place.....280 Price.....277 
Product.....276 
Promotion.....278 
Maslow's hierarchy of needs.....322 
Material requirement planning (MRP).....231 
Matrix structure.....46,  47, 51, 52, 53, 81 
Mendelow’s power-interest matrix.....12 Mintzberg.....44, 46, 47 
Mobile technologies.....128,  146, 165, 181, 182, 
187 
Motivation.....319, 321, 322,  323, 325, 326, 328, 
336 
N 
Nomination committees.....22 
Non-executive directors.....21 
Not-for-profit organisations.....5 
Private sector.....5 Public sector.....5 
O 
Offshoring.....68 
Operational impr ovements.....237 
Operations.....6, 185, 210, 211 
Data and technology.....185 Production.....223 
Purchasing.....221 
Service provision.....224 Operations ma nagement.....212 
Four Vs.....214 
Interface with finance.....221 
Processes.....213 
Variation.....214 
Variety.....214 
Visibility.....214 
Volume.....214 
Organisational structure.....44 
Centralisation and de centralisation.....54 
Divisional structure.....49 
Entrepreneurial structure.....47 
Functional structure.....48 
Matrix structure.....51 
Mintzberg.....44 
Scalar chain.....56 
Span of control.....56 
Tall and flat structures.....56 
Organisational types.....4 
Outsourcing.....58, 68, 69, 70, 71, 72, 73, 75, 78, 
83, 84 Advantages of outsourcing.....70 
Disadvantages of outsourcing.....70 
Service level agreements.....72 
Transaction cost theory.....72 
P 
Pareto principle.....235 
Penetration pricing.....277 
Perceived quality pricing.....277 Performance m anagement.....319 
Performance-rela ted pay.....326 
Person specific ation.....310 
Alec Rodgers.....310 
PESTEL.....271, 273 
Porter's four positi oning strategies.....289 
Porter's generic strategies.....289 Porter's value chain.....215, 217 
Positioning .....272, 288 
Postmodern marketing.....280 Price discrimin ation.....277 
Price skimming.....277 Price earnings (P/E) ratio.....89 Pricing 
Privacy and security.....354 
Process automation.....118, 128, 137, 138, 140, 
149, 156, 157, 158, 169, 176 Advantages and disa dvantages.....156 
Modern process aut omation.....137 
Traditional process automation.....137 
Process design.....212, 218 
Process map.....218, 219 
Product and service dev elopment.....220, 291 
5 stage process.....220 
Stages.....291 
Product/service life-cycle.....292

Index 
 I.5 
Production.....211, 223, 224,  247, 248, 249, 265 
Profit seeking organisations.....4 
Companies.....4 
Partnerships.....4 
Sole traders.....4 
Project appraisal.....106, 108 
Capital investment decision.....106 Internal rate of return.....107 
Net present value.....107 
Payback.....107 
Project management.....105, 106, 108 
Process.....106 
Psychological contract.....322, 323, 325 Purchasing.....217, 218, 221, 222, 227 
Q 
Qualitative in formation.....39 
Quality.....212, 233, 234, 237, 245, 252,  255, 266 
Quality management.....212, 233 
Joseph M. Juran.....235 Key writers on quality.....235 
Phillip P. Crosby.....235 
W.Edward Deming.....235 
Quality-related costs.....236 
Appraisal costs.....236 
External failure costs.....236 Internal failure costs.....236 
Prevention costs.....236 
R 
Recruitment.....308, 330 References.....316 
Remote working.....349 Remuneration committees.....22 
Reverse logistics..... 237, 251, 252, 253, 266 
Techniques.....251 
Reward systems.....325, 330 
Methods of reward.....326 
Robotic process automation.....60, 71, 103, 119 
S 
Sales and marketing.....6 , 183, 210, 269, 270, 
271, 290, 291, 292, 293,  294, 295, 297, 298 
Data and technology.....183 
Interface with finance.....290 
Scalar chain.....56, 57, 82 
Search engine marketing.....279 Segmentation.....272, 289 Segregated triangle.....63, 76 
Selection.....312, 313, 330 
Interviews.....312 Testing.....313 
Separation of owners hip and control.....18 
Service level agreements.....72 Service provision.....224 
Shape of the financ e function.....43, 63 
Shared service centre(s).....63, 68, 76, 77, 78, 79, 
84, 103, 109, 348 
Benefits and risks.....76 
Six sigma.....237, 242, 243, 244 
Social media.....182, 183, 188 
Marketing.....279 
Span of control .....56, 57, 58 
Staff development and training.....317 
Stakeholders.....12 
Connected stak eholders.....13 
Data needs.....197 
External stakeholders.....13 
Internal stakeholders.....13 
Mendelow's matrix.....12 
Stakeholder conflict.....15 
UK Corporate Governance Code.....17 
Statement of cash flows.....88 
Statement of financial position.....88 Statement of profit or loss.....88 
Statistical proce ss control.....237 
Strategic leadership of  the finance team.....85, 
113 
Strategic partnering.....85, 111 
Strategic supply wheel – Cousins.....227 
Supply chain.....221, 225,  226, 227, 229, 230, 
231, 232, 233, 237, 246,  250, 251, 253, 254, 
255, 257, 258, 259, 260, 263 
Supply chain managemen t.....212, 225, 226, 263 
Collaborative.....229 
Competitive.....229 
Interface with finance.....253 
Technology.....226 
Systems architecture.....357 
Centralised.....357 Decentralised.....357 
T 
Tacit knowledge.....343 
Tall organisational stru cture.....56, 57, 58 
Targeting.....272, 288 
Tax.....94, 97, 98, 105, 108, 124 
Tax avoidance.....98 Tax compliance.....105 
Tax evasion.....98 
Tax mitigation.....98 
Tax planning.....105 
Total quality management (TQM).....235, 237, 
238, 239, 240, 247, 264, 324 
Step by step approach.....240 
Training.....317, 330, 331, 337 Training and development process.....317 
Transaction cost theory.....72, 73 
Transaction costs.....70, 72, 73, 83

Index 
I.6  
Transaction processing system (TPS).....341 
Treasury management.....93 
U 
Undifferentiated marketing.....288 
V 
Variance reports.....93 
Viral marketing.....279 Virtual organis ation.....349 
Virtual teams.....349, 350, 366 
W 
Workforce flexibility.....325 Working capital management.....94 
Z 
Zero defects.....235

P.2   
 
Published by: Kaplan Publishing UK 
Unit 2 The Business Centre, Molly Millars Lane, Wokingham, Berkshire RG41 2QZ  
Copyright © 2019 Kaplan Financial Limited. All rights reserved. 
No part of this publication may be reproduced, stored in a retrieval system or transmitted in any 
We are grateful to the CIMA for permission to reproduce past examination questions. The 
answers to CIMA Exams have been prepared by Kaplan Publishing, except in the case of the 
CIMA November 2010 and subsequent CIMA Exam answers where the official CIMA answers 
have been reproduced. 
Notice 
placed on the content as the basis for any investment or other decision or in connection with any advice given to third parties. Please consult your appropriate professional adviser as 
necessary. Kaplan Publishing Limited and all other Kaplan group companies expressly disclaim 
all liability to any person in respect of any losses or other claims, whether direct, indirect, 
incidental, consequential or otherwise arising in relation to the use of such materials. 
A catalogue record for this book is available from the British Library.  
ISBN: 978-1-78740-194-5 
Printed and bound in Great Britain.

P.3 
Contents 
  Page 
Chapter 1 The concept of business ecosystems 1 
Chapter 2 Alternative approaches to business models 37 
Chapter 3 Business models in digital ecosystems 59 
Chapter 4 Leadership and management 97 
Chapter 5 Controlling performance – part 1 157 
Chapter 6 Controlling performance – part 2 199 
Chapter 7 Building, leading and managing teams 233 
Chapter 8 Managing organisational relationships  263 
Chapter 9 The concept of project management 305 
Chapter 10 Project management – tools and techniques 343 
Chapter 11 Project leadership 395 
Index  I.1

P.6  
 
These official CIMA learning materials have been carefully designed to make 
your learning experience as easy as possible and to give you the best chances of success in your objective tests. 
• a detailed explanation of all syllabus areas • extensive ‘practical’ materials 
This Study Text has been designed with the needs of home study and distance 
learning candidates in mind. Such students require very full coverage of the syllabus topics, and also the facility to  undertake extensiv e question practice. 
However, the Study Text is also ideal for fully taught courses. 
The main body of the text is divided into a number of chapters, each of which is 
organised on the following pattern: 
after your studies of the chapter ar e complete. You should assimilate 
• Step-by-step topic coverage.  This is the heart of each chapter, 
containing detailed explanatory text supported where appropriate by worked examples and exercises. You should work carefully through this section, ensuring that you understand the material being explained and can tackle the examples and exercises successfully. Remember that in many cases knowledge is cumulative: if you fail to digest earlier material thoroughly, you may struggle to understand later chapters. 
• Activities.  Some chapters are illustrated by more practical elements, such 
within a wider context. This is particularly important with calculations 
where OTQs may focus on just one element but an integration question tackles the full calculation, just as you would be expected to do in the workplace.

P.7 
issues in greater depth, particularly focusing on scenarios that are 
less clear cut than in the objective tests, and thus provide excellent practice for developing the skills needed for success in the Management Level Case Study Examination. 
• Solutions. Avoid the temptation merely to ‘audit’ the solutions provided. It is an illusion to think that this provides the same benefits as you would gain from a serious attempt of your own. However, if you are struggling to get started on a question you should read the introductory guidance provided at the beginning of the solution, where provided, and then make your own attempt before referring back to the full solution. 
If you work conscientiously through this Official CIMA Study Text according to the guidelines above you will be giving yourself an excellent chance of success in your objective tests. Good luck with your studies! 
Quality and accuracy are of the utmost importance to us so if you spot an error 
in any of our products, please send an email to mykaplanreporting@kaplan.com with full details, or follow the link to the feedback form in MyKaplan. 
Our Quality Co-ordinator will work with our technical team to verify the error and 
 Definition  – These sections explain important areas of knowledge which 
must be understood and reproduced in an assessment environment. 
 
examined. 
 
understanding of core areas. The supplementary reading is NOT  optional 
reading. It is vital to provide you with the breadth of knowledge you will need to address the wide range of topics within your syllabus that could feature in an assessment question. Reference to this text is vital when 
self-studying.

P.8  
exercises which give the opportunity to assess the understanding of these 
 
illustrative examples are useful in preparing for the Test your understanding exercises. 
Passing exams is partly a matter of intellectual ability, but however accomplished you are in that respect you can improve your chances significantly by the use of appropriate study and revision techniques. In this section we briefly outline some tips for effective study during the earlier stages of your approach to the objective tests. We also mention some techniques that you will find useful at the revision stage. 
Planning 
To begin with, formal planning is essential to get the best return from the time 
you spend studying. Estimate how much time in total you are going to need for each subject you are studying. Remember that you need to allow time for revision as well as for initial study of the material. 
Prepare a written schedule summarising the above and stick to it! It is essential to know your syllabus. As your studies pr ogress you will become 
timetable may need to be adapted to allocate enough time for the whole syllabus. 
Students are advised to refer to the examination blueprints (see page P.13 for 
further information) and the CIMA website, www.cimaglobal.com, to ensure they 
are up-to-date. 
The amount of space allocated to a topic in the Study Text is not a very good 

P.9 
helps to avoid wasting time. Make sure that you have all the materials you need before you begin so as to minimise interruptions. 
searching for items every time you want to begin studying. If you have to pack everything away after each study period, keep your study materials in a box, or even a suitcase, which will not be disturbed until the next time. 
(3) Limit distractions. To make the most effective use of your study periods 
you should be able to apply total concentration, so turn off all entertainment equipment, set your phones to message mode, and put up your ‘do not disturb’ sign. 
(4) Your timetable will tell you which topic to study. However, before diving in 
and becoming engrossed in the finer points, make sure you have an overall picture of all the areas that need to be covered by the end of that session. After an hour, allow yourself a short break and move away from your Study Text. With experience, you will learn to assess the pace you need to work at. Each study session should focus on component learning outcomes – the basis for all questions. 
(5) Work carefully through a chapter, making notes as you go. When you 
have covered a suitable amount of material, vary the pattern by attempting a practice question. When you have finished your attempt, make notes of any mistakes you made, or any areas that you failed to cover or covered more briefly. Be aware that all component learning outcomes will be tested in each examination. 
(6) Make notes as you study, and discover the techniques that work best for 
you. Your notes may be in the form of lists, bullet points, diagrams, summaries, ‘mind maps’, or the written word, but remember that you will need to refer back to them at a later date, so they must be intelligible. If you are on a taught course, make sure you highlight any issues you would like to follow up with your lecturer. 

P.10   
students move through individual topics within a subject; and how quickly they move from one course to the next. We know that there is an optimum for both, but it can vary from subject to subject and from student to student. However, using data and our experience of student performance over many years, we can make some generalisations.  
A fixed period of study set out at the start of a course with key milestones is important. This can be within a subject, for example ‘I will finish this topic by 30 June’, or for overall achievement, such as ‘I want to be qualified by the end of next year’.  
Your qualification is cumulative, as earlier papers provide a foundation for your subsequent studies, so do not allow there to be too big a gap between one 
subject and another. For example, E2 Managing performance  builds on your 
knowledge of data use from E1 Managing finance in a digital world  and lays the 
foundations for E3 Strategic management . 
We know that exams encourage techniques that lead to some degree of short term retention, the result being that you will simply forget much of what you 
have already learned unless it is refreshed (look up Ebbinghaus Forgetting Curve for more details on this). This makes it more difficult as you move from one subject to another: not only will you have to learn the new subject, you will 
also have to relearn all the underpinning knowledge as well. This is very inefficient and slows down your overall progression which makes it more likely you may not succeed at all.  
have negative impacts on your career, postponing the opportunity to apply for higher level positions and therefore higher pay.

P.11 
You can use the following diagram showing the whole structure of your 
qualification to help you keep track of your progress. Make sure you carefully review the 2019 CIMA syllabus transition rules and seek appropriate advice if you are unsure about your progression through the qualification.

P.12   
Objective test questions require you to choose or provide a response to a 
The most common types of objective test question you will see are: 
• Multiple choice, where you have to choose the correct answer(s) from a 
correct answers from a list of eight possible answers. This could either be 
• Single numeric entry, where you give your numeric answer, for example, 
• True/false questions, where you state whether a statement is true or false. • Matching pairs of text, for example, matching a technical term with the 
In every chapter of this Study Text we have introduced these types of 
questions, but obviously we have had to label answers A, B, C etc. rather than using click boxes. For convenience, we have retained quite a few questions where an initial scenario leads to a number of sub-questions. There will be no questions of this type in the objective test. 
Guidance re CIMA on-screen calculator As part of the CIMA objective test software, candidates are now provided with a 
calculator. This calculator is on-screen and is available for the duration of the assessment. The calculator is available in each of the objective tests and is accessed by clicking the calculator button in the top left hand corner of the screen at any time during the assessment. Candidates are permitted to utilise personal calculators as long as they are an approved CIMA model. Authorised CIMA models are listed here: https://www.cimaglobal.com/Studying/study-and-
All candidates must complete a 15-minute exam tutorial before the assessment begins and will have the opportunity to familiarise themselves with the calculator and practise using it. The exam tutorial is also available online via the CIMA website. 
Candidates may practise using the calculator by accessing the online exam 
tutorial. 
questions, with one or more parts. Ther e will be no choice and all questions 
should be attempted. All elements of a question must be answered correctly for the question to be marked correctly. All questions are equally weighted.

P.13 
CIMA syllabus 2019 – Structure of subjects and learning outcomes 
the CIMA 2019 professional syllabus document. 
(b) To demonstrate the approach likely to be taken in examination questions. The learning outcomes are part of a hierarchy of learning objectives. The verbs 
used at the beginning of each learning outcome relate to a specific learning objective, e.g. 
Calculate  the break-even point, profit target, margin of safety and profit/volume 
ratio for a single product or service. The verb ‘ calculate’ indicates a level three learning objective. The following 
The examination blueprints and representative task statements 
expectations regarding what is expected of them. 
The blueprint is structured as follows: 
• Lead and component outcomes (reflecting the syllabus document) 
A representative task statement is a plain English description of what a CIMA 
representative task. CIMA will test up to the level of the task statement in the objective tests (an 
objective test question on a particular topic could be set at a lower level than the task statement in the blueprint). 
The format of the objective test blueprints follows that of the published syllabus 
for the 2019 CIMA Professional Qualification. 
Weightings for content sections are also included in the individual subject 

P.14   
tests. It is therefore crucial that you understand the verbs in order to appreciate the depth and breadth of a topic and the level of skill required. The objective tests will focus on levels one, two and three of the CIMA hierarchy of verbs. However, they will also test levels four and five, especially at the management and strategic levels. 
 
Level 5  
quality of 
necessary 
Level 4  
Analysis 
Compare and contrast Show the similarities and/or differences 
between 
Interpret Translate into intelligible or familiar terms 
action 
Level 3  
means 

P.15 
Level 2 
purpose of 
something 
Level 1 
Knowledge 
State Express, fully or clearly, the details/facts of 
 
P.16   
E2: Managing Performance 
Mechanisms to implement decisions and manage people 
performance 
A Business models and value creation 30% 
B Managing people performance 40% 
C Managing projects 30% 
  100%

P.17 
E2A: Business models and value creation 
The digital world is characterised by disruptions to business models by new entrants and incumbents who 
seek superior performance and competitive advantage. This section covers the fundamentals of business 
models and how new business and operating models can be developed to improve the performance of 
organisations. 
 
1. Explain the 
ecosystems of 
organisations. Explain: 
a. Markets and competition 
b. Society and regulation • Definition of ecosystems 
• Participants and roles 
• Interactions and dynamics 
• Rules and governance 
• Technology 
• Risks and opportunities What is the nature of the 
ecosystem? What are its 
critical elements and how do 
they interact with each other? 
How do they impact the 
organisation? 
elements of 
business models. Explain the following 
a. Concept of value and the 
business model 
b. Defining value 
c. Creating value 
d. Delivering value 
e. Capturing and sharing 
value • Stakeholders and relevant 
value 
• Stakeholder analysis 
• Resources, process, 
activities and people in 
creating value 
• Products, services, 
customer segments, 
channels and platforms to 
deliver value 
• Distribution of value to key 
stakeholders This section covers the 
concept of value from 
different stakeholder 
perspectives. It examines the 
various elements of the 
business model, their 
interaction with each other 
and their implication for costs 
and revenue. The section also 
covers the connectivity and 
alignment between the 
ecosystem and the elements 
of the business model. 
3. Analyse new 
business models in 
digital ecosystems. a. Analyse digital business 
models and their related 
operating models • Disruption 
• Ways to build disruptive 
and resilient business 
models 
• Creating digital operating 
models 
• Types of digital operating 
models New business models have 
evolved to disrupt industries 
and their ecosystems. What 
are they? How have they 
redefined their industries?

P.18   
E2B: Managing people performance 
Human capital is one of the key intangible assets of organisations in an age where intangible assets are 
the dominant means by which organisations create and preserve value. Leadership is a crucial means for 
managing individual performance and the relationships between people. This section examines how different styles of leadership can be used to improve the performance of individuals so they can achieve 
organisational goals. 
 
1. Compare and 
contrast different 
types of leadership 
and management 
styles. Compare and contrast: 
a. Different leadership 
concepts 
b. Types of leadership 
c. Leadership in different 
contexts • Power, authority, 
delegation and 
empowerment 
• Contingent and situational 
leadership 
• Transactional and 
transformational 
• Leadership of virtual 
teams 
• Leadership and ethics Leadership is key to 
performance management. In 
a digital world it is an area 
that is least susceptible to 
automation. What constitutes 
leadership? What are the 
different types of leadership? 
How does one choose a style 
of leadership that is 
appropriate for the particular 
context? 
2. Analyse individual 
and team 
performance. Analyse the following: 
a. Employee performance 
objective setting 
b. Employee appraisals 
c. Coaching and mentoring 
d. Managing workplace 
environment • Target setting and 
employee alignment 
• Employee empowerment 
and engagement 
• Performance reporting and 
review 
• Rewards and sanctions in 
managing performance 
• Different approaches to 
coaching and mentoring to 
improve performance 
• Diversity and equity 
practices 
• Health and safety 
• Organisational culture Individual performance is 
achieved through structured 
processes and approaches. 
These include objective 
setting and regular review of 
performance against 
objectives. How should these 
processes be developed to 
ensure employee 
engagement, empowerment 
and alignment? How should 
the work environment be 
configured to enhance 
performance? What is the role 
of the leader in coaching and 
mentoring for high 
performance? 
3. Explain how to 
manage 
relationships. Explain the following in the 
context of managing 
a. Building and leading 
teams 
b. Communications 
c. Negotiations 
d. Managing conflicts • Characteristics of high-
performing teams 
• Motivating team members 
• Communication process 
• Digital tools for 
• Negotiation process 
• Strategies for negotiation 
• Sources and types of 
conflicts 
• Strategies for managing 
conflicts 
• Leadership and ethics Individuals work in teams and 
their performance contributes 
to the team performance. 
How should teams be built 
and led to improve 
performance? How is 
collaboration enhanced using 
technology? How can 
conflicts be managed?

P.19 
E2C: Managing projects 
Projects have become pervasive means by which organ isations execute their strategies. This section 
shows candidates how to use project management concepts and techniques to implement strategies 
effectively and efficiently. It is linked to capital investment decision-making that is covered in other areas of 
the Management Level. 
 
concepts and 
phases of projects. Describe the following: 
a. Project objectives 
b. Key stages of the project 
life cycle 
c. Project control • Overall project objectives 
• Objectives relating to time, 
cost and quality 
• Purpose and activities 
associated with key stages 
of the project life cycle Projects are the primary 
means by which many 
organisations implement 
strategic decisions. It is also 
how organisations ensure 
cross-functional collaboration. 
This section covers the key 
elements of project 
management. It seeks to 
provide both awareness and 
understanding of the project 
management process and the 
ability to apply tools and 
techniques to participate in 
projects and to identify, 
evaluate and manage project 
risks. The objective is not to 
train project managers but to 
equip finance people to work 
within projects and to lead 
some parts of projects. 2. Apply tools and 
techniques to 
manage projects. Apply the following to manage 
projects: 
a. Project management tools 
and techniques 
b. Project risk management 
tools • Workstreams 
• Work breakdown 
schedule, Gantt charts, 
network analysis 
• PERT charts 
project risks 
• Scenario planning 
• Managing project risks 
• Project management 
software 
3. Explain the 
concepts of project 
leadership. Explain 
a. Project structure 
b. Roles of key project 
personnel 
c. How to manage project 
stakeholders • Project structures and 
their impact on project 
• Role of project manager 
• Role of key members of 
project team 
• Life cycle of project teams 
• Managing key 
stakeholders of projects 
• Leading and motivating 
project team

1 
The concept of business 
ecosystems 
A1: Explain the ecosystems 
of organisations (a) Markets and competition 
(b) Society and regulation 
Topics to be covered 
• Definition of ecosystems 
• Risks and opportunities. 
 
  Chapter 
1

The concept of business ecosystems 
2 
1  Session content diagram 
 
2  Introduction and background 
2.1 The traditional approach to understanding markets 
A “market” is a place where two parties can gather to facilitate the exchange of 
goods and services. The parties involved are usually buyers and sellers.  
The market may be physical e.g. a retail outlet, where people meet face-to-face, or virtual e.g. online, where there is no direct physical contact between buyers and sellers.  
Markets are therefore comprised of individuals or organisations who exchange products or services within an environment governed by the laws of supply and demand.  
Business is however changing and the growth of technologies, such as social, mobile, analytics, cloud, 3D printing, bio- and nanotechnology are rapidly altering the competitive landscape.  
Traditional methods of analysing these markets and competitive landscape may still apply but will need to be updated to re flect the disruption that these rapidly 
advancing technologies provide.  
The changing business environments associated with these developments provide organisations with new and uncharted opportunities and threats. If they do not adapt and reflect these changes in their chosen strategies, organisations will miss what threatens to be a seismic shift in the way business is conducted. This will provide competitors who adapt quicker with the opportunity to leave the more traditional market players behind by creating new experiences for the consumer.  
To create these experiences, businesses must embrace the concept, mechanics and implications of ecosystems and revise and review the methods used to analyse the competitive landscape.

Chapter 1 
 3 
 More detail on the analysis of traditional markets 
 Traditionally the business environment has been analysed by the use of, 
for example, business models and tools such as PESTLE, Porter’s Five 
Forces and Porter’s Generic Strategies . 
NB – These models are not explicitly mentioned in the E2 syllabus 
but the language and terms used are widely referred to in the 
literature on ecosystems and new business models. They are thus included for reference purposes. 
PESTLE  is an acronym used to help organise the analysis of the 
business environment into broad categories. PESTLE analysis divides 
the business environment into political, economic, social (and cultural), 
technical, legal and ecological/environmental factors. Analysing these factors can help organisations understand the opportunities and threats within their environment and this understanding is crucial in shaping the organisation’s current and future strategic decisions, for example: 
• political influences and events  – legislation, government policies, 
changes to competition policy or import duties, etc. 
• economic influences  – a multinational company will be concerned 
about the international situation, while an organisation trading 
exclusively in one country might be more concerned with the level and timing of domestic development. Items of information relevant to marketing plans might include changes in the gross domestic product, changes in consumers’ income and expenditure, and population growth. 
• social influences  – includes social, cultural or demographic factors 
(i.e. population shifts, age profiles, etc.) and refers to attitudes, value and beliefs held by people; also changes in lifestyles, education and health and so on. 
• technological influences  – changes in material supply, processing 
methods and new product development. 
• legal influences  – changes in laws and regulations affecting, for 
example, competition, patents, sale of goods, pollution, working regulations and industrial standards. 
• ecological/environmental influences – includes the impact the 
organisation has on its external environment in terms of pollution etc. 
Porter's five forces analysis 
Just because a market is growing, it does not follow that it is possible to 
make money in it. Porter's five forces approach looks in detail at the company's competitive environment by analysing five forces. Companies must identify these forces and assess the strength of each force. The relative strength of each of these forces (high, moderate or low) will determine the profit potential of the industry .

4 
1 New entrants  – new entrants into a market will bring extra capacity 
and intensify competition and any barriers to entry which may exist. 
2 Rivalry amongst competitors  – existing competition and its 
intensity. 
3 Substitutes  – this threat is across industries (e.g. rail travel or bus 
travel or private car). 
4 Power of buyers – powerful buyers can force price cuts and/or 
quality improvements. 
5 Power of suppliers  – powerful suppliers can charge higher prices, 
forcing down profit margins. 
Porter’s three generic strategies 
According to Porter, there are three generic strategies' through which an 
organisation can generate superior competitive performance (known as generic because they are widely applicable to firms of all sizes and in all industries): 
1 Cost leadership  – offering products and services of the same 
quality as competitors but at lower prices. 
2 Differentiation – changing higher prices by offering more innovative 
products, or products with a higher perceived quality. 
3 Focus  – concentrating only on a small part of the market. 
The adoption of one or other of these strategies by a business unit is 
made on the basis of: 
• an analysis of the threats and opportunities posed by forces 
operating in the specific industry of which the business is a part 
• the general environment in which the business operates • an assessment of the organisation’s strengths and weaknesses 
relative to competitors. 
The general idea is that the strategy to be adopted by the organisation is 
one which best positions the company relative to its rivals and other threats from suppliers, buyers, new entrants, substitutes and the macro environment, and to take opportunities offered by the market and general  environment. 
Decisions on the above questions will determine the generic strategy 
options for achieving competitive advantage.

Chapter 1 
 5 
 Charlton Inc. is a major manufacturer of ground-source heat-pumps. 
These devices allow users to extract geothermal energy from the earth, 
and to use that energy to heat their premises. In order to develop new products and services, Charlton has already developed mutually-beneficial relationships with its supply chain.  
Charlton Inc. is currently analysing its business environment, and has realised that there might be competitive advantage to be gained by treating its environment as an ‘ecosystem’. This is not something that has ever been done in Charlton’s industry.  
Align each of the following ‘competitive forces’ to match the likely effect of Charlton’s new approach. You may use each effect more than once. 
 
Force Effect  
Bargaining power of suppliers Increase 
Bargaining power of customers Decrease 
Rivalry Remain stable 
Threat of new entrants  
  
2.2 The impact and effect of t echnology on traditional markets 
Organisations will always have to evolve to keep up with changing environments e.g. expectations of customers, advances in technology, environmental change etc. 
Technology impacts markets through its effect on productivity, efficiency and 
the production and delivery of new types of goods and services. As a result it has been the source of competitive advantage for organisations and strongly influences how value is created and delivered. 
Advances in technology and increasing globalisation have changed ideas about 
the best ways to do business. The idea of a business ecosystem is thought to help companies understand how to thrive in this rapidly changing environment.  
In recent years, the rapid increase in the development of new technologies, 
greater openness and escalating customer expectations are converging into a fundamental business change.  
Customers have begun to experience individualised and integrated experiences 
in areas such as telephony and are now expecting similar experiences across all their interactions, regardless of whether they are in a business-to-consumer, business-to-business or consumer-to-government context.  
Most organisations are not set up to deliver these types of experiences and, as 
a result, are often faced with customer frustration and, at times, anger. At the same time, customers know that technology is already available to make such experiences possible—cloud, analytics, mobile and social media.

6 
Organisations therefore face increased risk for the future success if they do 
respond and increased costs (at least in the short term) to ensure that they understand the changes within key stakeholder groups and respond appropriately.  
 
Illustration 1 – The music industry 
 In the music industry the accepted offering for listening to music was, for 
many years, vinyl and cassette format. This then changed in the 1980s to 
CD, before the advent of the internet enabled consumers to purchase online and download to mobile devices such as MP3 players. This then 
progressed further to streaming instead of outright purchase. Each 
successive development lead to a decline in demand for the previous format (although interestingly there has been a recent resurgence in demand for how it all started, as sales of vinyl have started to grow again!). 
However, since the start of the new millennium, the rate of change has 
grown considerably, driven by 2 principal factors: organisations are adopting technologies that enable them to transform the experience that customers can enjoy; and the expectations of the customers themselves are changing at a much faster rate. This latter point is only likely to continue, as present and future consumers, who have been born and raised in such a digital world, embrace new technologies more quickly and expect that they will be able to benefit from improvements to their lives as a result, meaning that organisations will find it much more difficult to surprise them. 
Organisations will therefore need to constantly reinvent what they offer to 
customers if they are to satisfy their rapidly changing expectations. 
Drivers of the digital revolution 
If organisations are to meet these ever-changing needs, it is important that they 
understand the key drivers behind such change. The following are identified as key factors: 
• Mobile and internet penetration  – the increasing rate of mobile phone 
ownership, combined with access to the internet (with mobile beginning to 
exceed broadband). It is estimated that by 2025 the number of smartphone subscriptions will reach 4 billion, with much of the growth coming from emerging economies. 
• Connected devices  – the number of connected devices are expected to 
grow from 2.5 billion in 2009 to 30  billion by 2020. This will help enable 
real-time customisation of products and services. 
• Data analytics and the cloud  – the increasing use of e-commerce 
platforms, social networks, apps et c will result in increased need for 
automated data analytics.

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• User interfaces  – advances in how human beings interact with machines 
(e.g. through voice recognition or motion-tracking systems) means that 
carrying out tasks becomes quicker and more efficient for humans. 
• Global accessibility  – rising living standards in developing economies 
means that more and more people are gaining access to the internet and so increased connectivity. 
• Increasing urbanisation – the growing percentage of people who live in 
urban as opposed to rural areas. The United Nations estimates that, from approximately 54% of the global population in 2014, this will grow to almost 60% by 2050. 
In essence, more and more people are becoming connected to technology, enjoying the benefits that it delivers, and demanding that such benefits increase, not just within 1 industry but across industries – there is no reason to believe that advances in 1 area of business cannot be transferred to other areas. 
 
Illustration 2 – Pager 
 Based in New York, Pager is a company that provides on-demand health 
care from local medical professionals via mobile-based services. Users 
can request services such as check-ups, arranging prescriptions and diagnosis of illnesses from the doctor of their choice within their local area. House calls are made within 2 hours of the service being requested. 
In many respects, this is an example of how benefits can be transferred 
from 1 industry (such as Uber and transport requirements) to another (healthcare). It is therefore little surprise that Pager was founded by Oscar Salazar, a former Uber engineer. 
3 The emergence of “business ecosystems”  
As noted earlier, technologies mature and grow e.g. social, mobile, analytics, cloud, 3D printing, bio- and nanotechnology. The external competitive environment for industry and business is similarly changing rapidly as these emerging technologies create an environment that is connected and open, simple and intelligent, fast and scalable:  
• Connected and open  – the proliferation of mobile devices and Internet 
access, necessitating new levels of trust and accountability with partners 
and consumers. 
• Simple and intelligent  – advances in technology continue to reduce and 
mask complexity and organisations gain more information and use data analytics and insights to drive decision-making. 
• Fast and scalable – transactions increase both in number and frequency but the cost of collaboration inside and outside the organisation continues to decline.

8 
The conundrum that market players face is that despite the technology driving 
this transparency by becoming more sophisticated, intelligent and predictive, it is also becoming easier to use by focussing on ease and “usability”. This allows organisations to tap into structured and unstructured data, motivating intelligent and predictive decision-making. 
This rapid development of new technologies, greater openness and escalating 
customer expectations are converging to create a fundamental business change from traditional markets to the new concept of “business ecosystems”. 
It is these experiences with these new technologies and resulting change to 
traditional business models (see Chapter 2) that is increasing the expectations and the empowerment of the consumer stakeholder group.  
Organisations must react to these changes and adapt their business models or 
risk being left in the wilderness. The increasing technological sophistication is leading to: 
• More information to consumers, allowing more choices and enabling 
greater opportunity to influence organisations  
• Higher expectations of integrated and sophisticated experiences that are 
simple to use and access 
• Decreasing brand loyalty, as consumers have less patience and are more 
willing to switch interchangeably among brands. 
In response, organisations face increasing pressure to play catch-up and meet 
the next generation of consumer demands by providing integrated, customised, consumer centric experiences.  
Consumers expect personalisation across all of their business dealings 
experiences. Whether it be buying cars or purchasing airline tickets, they expect integration across channels and touch points, and they are quick to change loyalties to organisations that can better meet their needs.  
For example, in a recent survey by IBM in which one of the questions was “To 
want extent should organisations change to meet customer expectations”: 
• 81 percent of millennial consumers demand improved response time • 76 percent expect organisations to understand individual needs 
• 68 percent anticipate organisations to harmonise consumer experiences. 
 
Illustration 3 – Xiaomi 
 Chinese smartphone manufacturer Xiaomi is seeking to engage 
connected consumers. Xiaomi uses customer segmentation as a brand 
differentiator. It sells high-end phones for prices close to cost, less than half the price of some rivals. The company leverages consumer feedback captured via Weibo (i.e. Twitter-like social media application) to release new versions of its operating system, which it does on a weekly schedule.

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The Xiaomi illustration demonstrates that, to create an opportunity to provide a 
differentiated experience in line with consumer expectations, organisations must embrace data and analytics to underpin experience and pursue social media to promote collaboration.  
Conclusion 
As the business world rapidly develops beyond traditional markets, 
organisations will need to rethink how t heir business environm ent operates, how 
they partner and how they interact with customers.  
They must embrace the concept of mutuality (see later discussion)  a level of 
formal or informal collaboration among organisations around shared ideals, 
standards, or goals. 
 
More detail on ecosystems 
 Ecosystems exist in the natural world 
The word “ecosystem” was coined in the 1930s by British botanist Arthur 
Tansley to refer to a localised community of living organisms interacting with each other and their particular environment of air, water, mineral soil, and other elements. These organisms influence each other, and their terrain; they compete and collaborate, share and create resources, and coevolve; and they are inevitably subject to external disruptions, to which they adapt together to be able to grow and thrive in ever changing conditions.  
In the 1993 Harvard Business Review article “Predators and Prey: A New 
Ecology of Competition” business strategist James Moore adopted this biological concept to the world of commerce. 
He suggested that a company be viewed not as a single firm in an 
industry, but as a member of a business ecosystem with participants spanning across multiple industries.  
From a business perspective therefore an ecosystem can be thought of 
as a complex web of interdependent enterprises and relationships that creates and allocates business value.

10 
 In the 1993 Harvard Business Review, business strategist James 
Moore adapted the concept to the business world –  
“Successful businesses are those that evolve rapidly and effectively. Yet 
innovative businesses can’t evolve in a vacuum.  
They must attract resources of all sorts, drawing in capital, partners, 
suppliers, and customers to create cooperative networks. I suggest that a company be viewed not as a member of a single industry but as part of a business ecosystem that crosses a variety of industries.  
In a business ecosystem, companies co-evolve capabilities around a new 
innovation: They work cooperatively and competitively to support new products, satisfy customer needs, and eventually incorporate the next round of innovations” 
 
 Illustration 4 – Digital Marketing Ecosystem

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 Consider online marketing to be an ecosystem – a system of 
interconnecting and interacting parts – formed by three distinct areas of 
content creation: search engine optimisation, social media, and target marketing. 
Sustainable success in digital marketing is achieved using strategies that 
leverage the interrelationship of these ecosystem elements. 
The specific strategies and individual tools included in a marketing 
ecosystem (and used to execute digital marketing campaigns) are dependent on many factors including the goals for the campaign as well as the company’s industry and their customer’s buying habits. 
It is therefore key for organisations to maintain a keen eye on new 
developments, monitor trends, and test new tools as they emerge. 
4 What are Business Ecosystems? 
A business ecosystem can be defined as a network of organisations (suppliers, distributors, customers, competitors, government agencies, etc.), who are involved in the delivery of a specific product or service through both competition and cooperation. This network of org anisations and indivi duals will collaborate 
and evolve roles and capabilities to build value and increase efficiency. 
The idea is that each entity in the ecosystem affects and is affected by the 
others, creating a constantly evolving relationship in which each entity must be flexible and adaptable in order to survive, as is the case in a biological ecosystem. 
In this context, an ecosystem is a number of interdependent enterprises drawn 
together in complex relationships aimed at creating and allocating business value. There is a mutual and multiplicative interaction about business ecosystems whereby the whole is greater than the sum of the individual part, thus providing the incentive for the participants to be part of the system.  
Business ecosystems are broad by nature, potentially spanning multiple 
geographies and industries, including public and private institutions, and consumers. Organisations will therefore come together to create value.  
In a less-competitive ecosystem, groups such as a government, charity and a 
community group might collaborate on health or public policy because each entity has a shared interest and goal. 
 
Illustration 5 – Business Ecosystems 
 When BMW and Toyota need to develop key technologies, such as 
batteries, they may join together and then later go on to compete in the 
marketplace.  Similarly, Apple, Fitbit and Garmin created an ecosystem focused on fitness and apps.

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Ecosystems and traditional markets are not unlike however being composed of 
participants and interactions. These are:  
• Participants  – the individual players or organisations within the 
environment defined by: 
– Participants function (or part played in a given environment) – Participants ability to extend acti vity or interactions through the 
environment 
– Range of activities that participants are able to pursue or undertake 
within the environment (key value proposition). 
• Interactions – the products or services exchanged among participants 
defined by: – Set of explicit or implicit principles governing conduct within the 
– Linkages across the environment connecting elements such as data, 
knowledge, or products 
– Speed and direction at which content or value is exchanged among 
participants. 
4.1 Fundamental characteristi cs of a business ecosystem  
As we noted earlier, within a market individuals or organisations who exchange 
products or services within an environment which is governed by the laws of supply and demand. 
A business ecosystem comprises individual and organisations that operate out 
of mutual self-interest and who formally or informally operate together to produce something of greater value for the mutual benefit of the organisation and the ecosystem as a whole. Organisations may therefore 
• Be a part of one or many ecosystems 
• Play different roles in different ecosystems 
• Evolve their roles in the ecosystem, as ecosystems evolve. 
Ecosystems exist because participants can deliver more value within the 
ecosystem acting together and have two defining characteristics.  
These are orchestration and mutuality and are based on the premise that 
ecosystems exist because participants acting together can deliver more value.  
• Orchestration refers to the formal or informal coordination of interactions 
or collaborations among participants within the ecosystem i.e. the 
coordination, arrangement and management of these complex environments.

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Orchestration can be informal, for example via the culture of an organisation, or 
it may be formal through explicit rules or the presence of an actual “orchestrator” – i.e. an explicit entity that  facilitates orchestration processes.  
For example, according to PwC, firms need to orchestrate the interactions of both the different players in their operating environment and the customers to maximise the value delivered, make money out of that for all players and give the firms a fair share of that value. 
 
Illustration 6 – Orchestration (Kaiser Permanente 
 Kaiser Permanente is a U.S.-based integrated managed care consortium 
that orchestrates insurance, hospitals, and physicians to provide 
integrated healthcare services. The company coordinates and orchestrates a membership base of 9 million members, along with physicians, doctors and medical centres. Kaiser Permanente’s “My Health Manager” program facilitates the delivery of preventative care by connecting care providers, pharmacies and physicians. 
 
• Mutuality  reflects an enhanced level of coordination with formally or 
informally shared ideals, standards, or goals. 
 
 Illustration 7 – Mutuality (Doorman) 
 Doorman, a San Francisco-based logistics service, orchestrates storage 
and delivery to solve the “last mile” problem of package delivery. The service facilitates carriers such as FedEx and UPS by receiving packages and delivering them at the customer’s convenience after traditional carrier delivery hours, up until midnight. This enables consumers to control logistics in a manner previously unavailable. 
4.2 The goals of business ecosystems 
As we have established already, a business ecosystem consists of a network of interlinked companies that dynamically interact with each other through competition and cooperation to grow sales and survive. It includes many different stakeholder groups e.g. suppliers, distributors, consumers, government, processes, products and competitors.  
When an ecosys tem thrives, it means that the participants have developed 
patterns of behaviour that streamline the flow of ideas, talent and capital 
throughout the system. 
Ecosystems will also create strong barriers to entry for new competition, as 
potential entrants not only have to duplicate or better the core product, but they also must compete against the entire system of independent complementing businesses and suppliers that form the network. 
Being a part of a business ecosystem provides mechanisms to leverage 
technology achieve excellence in research and business competence and compete effectively against other companies.

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Some other goals of a business ecosystem may include: 
• driving new collaborations to address rising social and environmental 
challenges 
• harnessing creativity and innovation to lower the cost of production or 
allow members to reach new customers 
• accelerating the learning process to effectively collaborate and share 
insights, skills, expertise and knowledge 
• creating new ways to address fundamental human needs and desires. 
 
 Dragon Breath is a consultancy firm, specialising in the provision of 
advice on the use of disruptive technologies in FMCG production, 
logistics and retail. It has previously used traditional ‘environment analysis’ to identify opportunities and threats in its environment. 
Jane Li, the Chief Strategy Officer of Dragon Breath, is considering 
changing the approach taken to environment analysis. She feels that the environment of Dragon Breath resembles an ‘ecosystem’, rather than a traditional linear supply chain. 
Required: 
Identify which TWO of the following characteristics distinguish an 
ecosystem from a traditional supply chain. 
• Interaction • Orchestration 
• Mutuality 
• Communication 
• Conflict 
5 Value creation and value capture in a business ecosystem 
The way organisations create and capture value in an ecosystem differs from 
traditional markets.  
Two fundamental questions need to be addressed. 
• Firstly, what can organisations do to create value in ecosystems? • Secondly, how do organisations capture the value they help to create 
within an ecosystem?

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How is value created? 
Value creation refers to the act of bringing something of value into existence. 
Participants can therefore create value by products enhancements, product development, and the creation of new services or customer experience.  
In an ecosystem partners must collaborate to create and deliver something of a 
mutually beneficial value to all of the participants.  
How is value captured? 
Value capture is the act or process of appropriating or allocating value. 
Participants can capture value directly through transactions or indirectly from an orchestrator.  
Ecosystem complexity and the extent or intensity of orchestration impact the 
potential and govern the nature of value capture. 
As a result, ecosystems can produce more value as a whole than the sum of 
the individual participants acting independently.  
5.1 The difference between traditional markets and ecosystems 
Value creation in traditional markets tends to be linear; value creation in 
ecosystems tends to be networked and mutual. 
To create value, organisations need to identify opportunities, develop 
competencies and leverage synergies. Organisations must understand how 
value is created in the ecosystem and, as a result, identify and exploit opportunities for value creation. To facilitate this, organisations must maintain flexibility in the role they adopt within the ecosystem and interactions they may have with other ecosystem participants. 
Organisations must also leverage common synergies and complementary 
strengths within ecosystems to drive value creation. To do so, they will need to apply their capabilities across the ecosystem, identifying and pursuing compatibility gaps and needs, and develop contracting and connectivity arrangement to insinuate themselves to fill gaps and exploit other opportunities. The more essential and unique the activity organisations can fulfil within an ecosystem, the more sustainable will be their position and role. 
In identifying opportunities, organisations must understand how value is created 
in the ecosystem. They will need to identify and exploit pockets of potential value creation. However given the extent and speed of the change, they must maintain flexibility in the role they adopt within the ecosystem, as well as the type of interactions they have with other ecosystem participants.

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 Illustration 8 – Value Creation (Google) 
 Recently, Google initiated and coordinated the Open Automotive Alliance 
to innovate in-car operating systems with GM, Honda, Audi, Hyundai, 
along with organizations such as Nvidia. Google aims to become the centre of personal operating systems through partnerships. Google seeks to capitalize on the 80 million new cars and light trucks sold each year – a major opportunity for Internet-based services. 
 
 Illustration 9 – Partnerships (Amazon) 
 One opportunity being pursued by Amazon, for example, is to use 
existing partnerships to target the next frontier of online sales. The online retailer has established a physical presence in the warehouses and distribution centres of existing suppliers (e.g. Procter & Gamble) through its “Vendor Flex” initiative. As a result, Amazon is expanding its selling efforts into new and different markets through partnering arrangements. It reduces fulfilment costs and delivery time and allows Amazon to compete even more aggressively with other retailers. 
The participants in an ecosystem can capture value directly through transactions or indirectly from the orchestrator.  
Direct value capture  
Organisations can capture value directly through transactions that occur within 
the ecosystem. Participants facilitate an exchange of value for goods or services rendered, for example, when they buy a ticket on public transport. Value capture is instantaneous and corresponds with the transaction.  
Indirect value capture 
Alternatively, organisations may capture value indirectly by transfer from an 
orchestrator (which captures value directly from consumers) for goods or services.  
Consumers will pay an orchestrator for goods and services (pay to play), and 
the orchestrator will then allocate payment to participants within the ecosystem thereby incentivising them to continue participating in the ecosystem e.g. buying a pass for all public transport in a city for unlimited trips on trains, trams, buses or subways within a defined time.  
A third option is a combination of direct and indirect, with some pay-to-play 
component and some direct component. For example, in the transportation ecosystem of the future, organisations will most likely capture value both directly and indirectly.

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 Illustration 10 – Direct and indirect value capture 
 The mobility (transportation) ecosystem of the future in which consumers 
pay to have access to services that transport them from one location to 
another, irrespective where they are, when they want to travel and where they want to travel to.  
Organisations will most likely capture value both directly and indirectly. 
Mobility providers will oper ate in an orchestrated environment, but with 
specific usage-based transactions co-existing with overall pay-to-play.  Orchestrators will facilitate overarching ecosystems that are composed of 
numerous implicit services and will allocate value to participants based 
on the role they play in the ecosystem.  
Consumers may be able to choose to pay directly for specific distance-
related or transportation type-related services. Direct transactions for usage-based services and infrastructure access could therefore co-exist with an orchestrated, indirect-payment pay-to-play environment. 
5.2 Strategies to capture value 
Each organisation will need to pursue different actions to capture value, 
depending on the underlying nature of the ecosystems in which they operate.  
Each organisation will face differences within their own ecosystem and 
therefore a strategy developed and pursued in one environment may differ 
drastically from strategies pursued in other environments.  
Key drivers of these differences are firstly the level of complexity in the activities 
undertaken, and secondly the extent and formality of the orchestration in and around the ecosystem. 
Complexity: 
Complexity is a function of the number and diversity of participants, the 
sophistication of activities within the ecosystem and the range and nature of relationships that exist within that ecosystem.  
• High complexity – an environment in which barriers to entry are high and 
the threat of new entrants is low. It suggests that a participant’s role in the 
ecosystem is relatively secure as their particular capabilities are typically difficult to replicate e.g. nuclear power, or oil exploration. 
• Low complexity – an environment in which barriers to entry are low and 
the threat of new entrants is high. In this environment, a participant’s position in the ecosystem is vulnerable, as their capabilities are typically easy to copy e.g. production of consumables (bakeries), retailing (individual boutiques), fitness instruction etc. 
Orchestration 
Orchestration depicts the extent of an organisation’s influence over others 
within an ecosystem, the formality of ecosystem interactions and the degree of enforceability and compliance.

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• Tight orchestration reflects an environment in which orchestrators have an 
ability to influence behaviour or actions across the entire ecosystem. For 
example, financial services, in which transactions are governed by stringent and regulated rules of privacy, security and compliance. Interactions will by necessity be rules-based, with orchestrators able to enforce their will over others.  
• Loose orchestration refers to an environment in which no individual 
participant has significant influence across the ecosystem. There is often an absence of strong regulation with limited ability for any particular participant to enforce its will over others. For example the Internet in regimes that have freedom of speech laws. While some content and behaviour is specifically outlawed on criminal grounds in the most part, individuals and organizations are free to express themselves and behave any way they want. 
Based on this premise that Ecosystems are not all alike and as they differ in specific fundamental ways there will be a number of approaches necessary to depict appropriate strategies to deal with these differences. 
Complexity and orchestration characterize a spectrum of ecosystem 
archetypes.  
In the IBM Report “The new age of ecosystems: Redefining partnership in an 
ecosystem environment” The following matrix depicts how some of these different combinations may be characterised in a “spectrum of ecosystem archetypes” 
Ecosystem Archetypes 
 
 Orchestration 
Complexity  Loose Tight 
High Hornet’s Nest  
Where high 
complexity and loose orchestration promotes fragmented competition Lion’s Pride  
Where high 
complexity and tight orchestration motivate a winner-take-all mentality 
Low Shark Tank  
Where low complexity and loose orchestration creates a turbulent environment Wolf Pack  
Low complexity 
and tight orchestration promotes collaboration

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These are referred to as the Shark Tank, the Hornet’s Nest, the Wolf Pack and 
the Lion’s Pride 
• Shark Tank – low orchestration and low complexity. Each participant will 
fend for themselves, identifying opportunities, aligning capabilities and 
making connections. An example of Shark Tank is the retail ecosystem of the future where new technologies will make entry costs into retail ever lower and competition will become even more intense. Consumers will have low switching costs, changing between products at will, while the potential competitive threat will increase as new entrants or existing players watch on ready to take advantage of opportunities. Search costs will become ever lower, with multiple organisations seeking to attract and 
connect with consumers. 
• Lion’s Pride – threats of new entrants are low due to the relative 
complexity of the activities in which participants are engaged. In the Lion’s 
Pride orchestration tends to be formal. The orchestrator will enable and monitor activities within the ecosystem and remunerate individuals or organisations for their participation. An  example of Lions Pride will be the 
future healthcare  industry where an orchestrator will facilitate and manage 
the interaction between patients, providers and physicians into a fully integrated health, wellness and medical experience.  
• Hornet’s Nest – complexity is high, but orchestration is low. Ecosystems 
of this type tend to be simpler, with most of the value being transferred directly by means of payment for specific activities. An example will be the future of Media and Entertainment business where will likely become the 
Hornet’s Nest ecosystem where consumers will likely be unwilling to be tied to a single system to view content. They will demand whatever content they want, on whatever platform or device they want, whenever they want it, anywhere in the world. 
• Wolf Pack – low complexity and high levels of orchestration. Barriers to 
entry are low, indicating that entry in to the ecosystem is relatively easy. 
Orchestration is however high, suggesting that while individual activities within the ecosystem are simple, the overall environment created is potentially highly sophisticated. An example of Wolf Pack maybe the future Energy and Utilities industry. In the futu re, every home, building, facility or 
appliance may be both a consumer and producer of energy. The presence of a strong orchestrator will ensure that energy flows are measured, reserve energy is stored and networks remain in good working order.

20 
 Geronimo is a consumer electronics manufacturer. It produces hardware 
communications devices (tablets, laptops, PCs and phones) and also 
supplies a range of software to operate on those devices (operating systems, tools and apps).  
Geronimo has developed a close working relationship, for mutual benefit, 
with a network of other organisations and individuals. These include software developers, suppliers, retailers and consumers. As a result of these arrangements, Geronimo and its partners create and capture value added, which is shared between the partners. 
Required: 
Identify which of the following approaches is being taken by Geronimo 
• Franchising • Ecosystem development 
• Upstream supply chain management 
• Customer relationship management 
6 Participants and their roles 
We have seen above that the business ecosystem is “an economic community 
supported by a foundation of interacting organisations and individuals – the organisms of the business world.” 
The interacting organisations and individuals are the participants. For example, 
the economic community produces goods and services of value to customers, who are themselves members of the ecosystem.  
Other participants include suppliers, lead producers, competitors and 
other stakeholders. These participants will, over time, co-evolve their capabilities and roles and tend to align themselves with the directions set by 
one or more central companies. 
 
Illustration 11 – The Apple ecosystem 
 Apple exists in a highly complex business ecosystem, made up of many 
participants. Examples would include: 
Software developers  – both those employed by the company and those 
who are not e.g. developers of apps which are then marketed via the App 
Store. 
Suppliers – of components, organisations that assemble the product, of 
accessories (e.g. Belkin is an approved manufacturer of Apple accessories). 
Retailers – not just employees in Apple Stores, but also approved 3rd 
party retailers.

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Competitors – organisations such as Microsoft and Samsung, which are 
constantly innovating and therefore forcing Apple to do the same. 
Customers  – both individuals and also corporate customers. 
Learning institutions – such as universities, that develop potential 
employees with the necessary skills. Governments  – e.g. much of Apple’s product is sourced from China. Any 
trade wars between the US and Chi na will inevitably impact Apple. 
Legislators  – those who formulate the law, which impacts not just on 
Apple but also other organisations e.g. privacy laws and Facebook. NB This list is not exhaustive; there are many other elements of Apple’s 
ecosystem! 
An ecosystem therefore reflects interaction and collaboration between participants to create an opportunity to provide a differentiated experience in line with consumer expectations.  
It is important for organisations to embrace data and analytics to underpin these 
customer experiences and pursue social media to promote collaboration. They will also need to reduce or minimise any barriers to engagement and partnering with other participants. 
3 key questions need to be asked with regards to each participant that makes 
up the ecosystem, and thus how it might impact on any one organisation’s strategy: 
• The precise role of the participant within the environment  – what is 
that participant bringing to the party? It may be cloud computing capacity, 
distribution capability, unique software skills or access to certain markets due to owning a particular licence to operate. It makes sense that, for the ecosystem to create the value that is possible, all necessary participants are present.  
• Each participant’s reach through the environment  – this relates to the 
participant’s ability to ex tend activity or interactions through the 
environment. For example, can the participant operate on a global or just a local level and deal with both consumer (B2C) and industrial (B2B) markets?  
• The capability or key value proposition  – this is the range of activities 
that participants are able to pursue or undertake in the environment. What is the key value that each participant is able to deliver?

22 
 Illustration 12 – Nest 
 Nest is a US-based provider of home automation products, from 
thermostats that control the central heating system to surveillance 
cameras and smoke alarms. It has created a new technology platform that offers homeowners a unique experience because it has correctly brought in other companies such as Mercedes Benz and LG to bring capabilities that Nest itself does not possess. 
 
 Illustration 13 – Burberry 
 Luxury fashion house Burberry, a traditionally conservative brand, 
digitized its organization to create a seamless consumer experience.  
Burberry removed organizational boundaries between digital and 
physical; for example, it equipped employees with iPads to enable online access to leverage consumer data to improve the in-store experience.  
Through digital-physical integration, Burberry has transformed into a 
modern, relevant, and hip luxury brand. 
Ecosystems provide a new frame and mind-set that captures a profound shift in the economy and the business landscape.  
The importance of relationships, partnerships, networks, alliances, and collaborations is not new but it is of increased significance in the ecosystem discussion. It is becoming increasingly possible for firms to deploy and activate assets they neither own nor control, to engage and mobilise larger and larger 
numbers of participants.  
• ecosystems enable and encourage the participation of a diverse range of 
organisations, and often individuals, who together can create, scale, and serve markets beyond the capabilities of any single organisation.  
• participants interact and co-create in increasingly sophisticated ways that 
would historically have been hard to formally coordinate in a “top-down” manner, by deploying a proliferation of technologies, tools of connectivity and collaboration. There is dynamism and substantial potential for increasingly productive ecosystem development in the years ahead.  
• participants including customers—are bonded by some combination of 
shared interests, purpose, and values which incentivises them to collectively nurture, sustain, and protect the ecosystem as a shared common ground. Everyone contributes, everyone benefits enhancing the longevity and durability of ecosystems.  
The rise of business ecosystems is fundamentally altering the key success factors for organisations, forcing them to think and act very differently regarding their strategies, business models, leadership, core capabilities, value creation and capture systems, and organizational models.

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7  Regulating ecosystems 
As was noted above, the economy is fast becoming characterised by 
ecosystems—dynamic and co-evolving communities of diverse participants who create and capture new value through both collaboration and competition. 
In that context, these new markets will need to be regulated. Regulation is 
always contentious to some degree but in relatively slow-moving industries the historical intent and enforcement of the rules can be understood well enough by all involved. This understanding become less clear however when the boundaries of traditional industries becomes less defined, when products blend with services to create customer-centric solutions, and when knowledge assets take on as much importance as physical assets in the creation of value. Constant, high-impact innovation is a prominent new feature in businesses that used to advance only incrementally.  
 
Examples of reasons for regulation 
 Some of today’s most popular products, like the smartphone and tablet, 
didn’t even exist eight years ago. Apple Inc. estimated in 2011 that over 
60 percent of its revenue came from products that were less than three years old. Business models are being reinvented to take advantage of technological change, for example enabling peer-to peer transactions, asset sharing, and social collaboration.  
The nature of work itself is in flux. Sites like Task Rabbit allow anyone to 
outsource small jobs to people with extra time, and the “creative economy” continues to expand. By one reckoning, half of today’s jobs are in occupations that didn’t exist 25 years ago. 
In a recent study researchers at Oxford University estimate that up to 45 
percent of American jobs are at a high risk of disappearing within the next two decades. In fast-changing environments like this, as the US Office of Management and Budget has observed, regulations “have enormous potential for both good and harm.”  
The challenge is to exercise due caution on behalf of the public while 
minimizing any “adverse effects on flexibility and innovation.” 
The case of Uber shows how tricky this balance is to achieve. As of 
January 2015, the company was engaged in no fewer than 40 concurrent regulatory conflicts around the world. Ordinary citizens may love having an alternative to taxis, but their governments aren’t giving the service a free ride. 
Regulatory frameworks are being challenged on several fronts – for example  
• Speed of change – effective regulation depends upon the regulators’ 
understanding of the solutions being offered by businesses, their efficacy, and their possible unintended consequences. Constant innovation makes that very difficult e.g. regulators are confronted with the exponential expansion of digital information assets “big data”. This flood of data combined with ever-sharper analytics allows the discovery of previously

24 
unseen patterns and behaviours. Businesses can personalise marketing to 
better engage consumers, challenging privacy. Traditional means of protecting privacy were not designed for an automated, digital world where much is seen and monitored without explicit consent. 
• Innovators find “back doors”  e.g. Uber has attempted to find legitimate 
ways around regulatory hurdles which have governed taxis and liveries for ages, including stringent controls over taxi medallions and the licensing fees dictating their ownership and transfer. Uber is a system that helps people access transportation, affordably, fast, and reliably. It is about making life easier for potentially millions of people, and regulation has to be rethought to ensure that it is consumer-safe and socially beneficial, 
rather than stifle innovation. 
• Ecosystems evolve  and new and clever business models proliferate, the 
sheer diversity of competitors and competitive modes is yet another 
complicating factor for regulators. In a market-based economy, a major objective of regulation is preserving an even playing field for competitive businesses. Regulators must set the terms of engagement that will keep these non-comparable entities working in ways that benefit society. 
• Innovations cross lines of jurisdiction  and in business ecosystems, 
product definitions, market boundaries, the traditional distinction between digital and physical goods blur. These blurring lines complicate the decision as to which agency or authority has jurisdiction?  
 
Test your understanding 4 
 The Competition and Markets Regulator (CMR) of Newlandia is tasked 
with regulating the activities of firms within that country. The regulators are finding it increasingly difficult to regulate the activities of organisations who choose to participate in a ‘business ecosystem’.  
Required: 
Identify which THREE of the following are major challenges to the CMR 
as a result of firms taking an ecosystem approach. 
• New legislation is expensive to develop 
• Speed of change 
• Date protection is a major issue 
• Ecosystems evolve 
• Innovations cross lines of jurisdiction

Chapter 1 
 25 
8  What does the digital customer want? 
According to the World Economic Forum/Accenture analysis, there are a 
number of factors that drive customer demands in the digital era. These include the following: 
• Contextualised interactions  – this is a rather complicated way of saying 
that customers expect a product or service that is tailored to their own 
specific needs. The video streaming service Netflix helps meets this demand by making recommendations on programmes that are likely to be of interest to the viewer based on historic patterns. 
• Seamless experience across channels  – from being made aware that a 
product or service exists, to doing the research about the product or service, to then taking the decision to purchase, customers expect a seamless service throughout the process. This can also be extended to how the customer pays and takes delivery of the goods. 
• Anytime, anywhere  – there is an expectation of being able to access real 
time information about a product or service. This does not just mean characteristics of the product; it also relates to inventory levels, how soon delivery will occur, the ability to track progress etc. 
• Great service  (it doesn’t matter who provides it) – there is less instance 
these days of customers remaining loyal to a provider following an example of poor service. Customers are prepared to shop around for products or services if they have had a bad experience. 
• Self-service  – customers are prepared to invest more time and energy 
into getting exactly what they want. This doesn’t simply mean customising the features of an existing product; it may mean developing new models that correspond exactly to their needs. Innovations such as 3D printing are an example of just how this is becoming possible. 
• Transparency  – the digital customer expects to have full transparency of 
information about a product or service before they commit to a purchase. 
This includes details such as precise features of the product, but also 
extends to how personal information is to be collected and used. Customers are protective of their personal data and want choice in deciding whether or not it is shared.

26 
• Peer review and advocacy  – there is greater instance these days of 
customers attaching more importance to independent reviews of products 
or services than to marketing information provided by the business or reviews from other organisations (such as trade journals). The purchase decision will be influenced by what fellow customers have said, meaning that a poor review can have a disastrous effect on future sales potential. 
For example, many customers on Amazon place great store by the 
reviews and star ratings attached to products that have been bought by other people. Similarly, the decision on which hotel to stay at or restaurant to eat at could well be determined by comments on sites such as Booking.com or TripAdvisor. 
It is also estimated that bad reviews are seen by twice as many people as 
good reviews. 
8.1 Keeping ahead of customer expectations 
The question must therefore be asked: given that customer demands are evolving at such a rapid pace, how can organisations adapt so that they keep up with, or preferably ahead of, those expectations? A seemingly successful offering today could rapidly fall out of favour and lead to a reversal of the organisation’s competitive advantage. 
This can be avoided via the following: 
• Design thinking  – instead of designing a single product or service that 
can be marketed to many customers, there should be a shift in mind-set to 
designing many experiences for one customer. This must be mixed with the ability to constantly learn and adapt as customer needs change. 
• Experiential pilots  – this refers to the need to monitor how customers 
behave and to gain an appreciation of their reaction to new experiences. Questions should be asked such as “How are the customers responding to a new technology in the way they engage with it? How are customers being influenced by others? What reactions, emotional and behavioural, are we seeing through the new customer experience?” 
 The organisation should be prepared to continuously take products to a 
new level, through innovation and developing prototypes, to be able to gauge such reactions. 
• Prototyping  – instead of waiting until a new product has been perfected 
before bringing it to market, an organisation should recognise that speed to market is vital. So, the first generation of a product may be only about 80% ready, but it provides vital feedback in terms of customer reactions and what needs to be done with the second version. 
• Brand atomisation  – organisations will need to design their offerings so 
that they can be more widely distributed and be part of the platform that is offered by other providers.

Chapter 1 
 27 
 The ‘digital revolution’ (sometimes known as Web 3.0) is a response to 
the changing expectations of customers, very often driven by advances in 
Required: 
Identify which THREE of the following are technological advances driving 
change in this way.  
• Increased demand for fast service provision • Data analytics and the cloud 
• Reduction in hardware cost 
• Global Internet access 
• Increased numbers of connected devices 
 
 Discussion question 
X is a retailer of clothes in country A. Using PESTLE analysis, categorise the following issues identified by the 
Board of A as sources of risk facing X in the light of the increasing volatility and rate of change in the global market.  
A Unemployment levels in country A B Change of government C Education levels D Changing fashions E Changing tax regimes F Increased use of automation in production G Shift in customer attitudes towards ethical consumerism H Requirement for faster service provision I Data, storage and analytics facilities increased J Reduction in cost of IT hardware K Increased Internet access L Proliferation of connected devices

Chapter 1 
 29 
End of chapter questions 
 Question 1 
 Which three  of the following are normally associated with the concept of 
a business ecosystem? 
A  Network of organisations B  Large scale business C  Relationships between organisations D  Interdependency E  Brand loyalty
 
 Question 2 
 In the context of business ecosystems, which of the following statements 
are true? (1) Customers expect a similar experience from all aspects of their lives 
including the products that they buy; fast, convenient and tailored to 
themselves. 
(2) Regulators whilst trying to control large players can inhibit emerging 
players. 
A (1) only 
B (2) only C Both are true D Neither are true 
 
 Question 3 
 In the context of value creation in an ecosystem, which of the following 
statements are true? (1) Although the value created as a whole maybe greater with 
collaboration, an individual player will often be worse off. 
(2) End to end solutions, where different elements of the supply chain 
cooperate is likely to create more value for all players. 
A (1) only B (2) only C Both are true D Neither are true

30 
 Question 4 
 When buying a train ticket through an orchestrator (such as Trainline), 
which is usable through any train operator, as far as the train operator is 
concerned, this is known as: 
A Direct value capture B Indirect value capture 
 
 Question 5 
 The future retail environment is expected to feature ever decreasing 
barriers to entry and, within the confines of what is safe and legal, players 
are free to introduce or trade with any product that they wish.   
In this situation, which is the recommended strategy? A Fly with the hornets B Jump with the sharks C Roar with the lions D Dance with the wolves

Chapter 1 
 31 
  
Matching 
items – correct 
matches Force Effect  
A Bargaining power of suppliers Remain stable 3 
B Bargaining power of 
customers Remain stable 3 
C Rivalry Decrease 2 
D Threat of new entrants Decrease 2 
As Charlton already has mutually-beneficial relationships with customers and suppliers, the adoption of an ecosystem approach is unlikely to have any significant effect on those forces. The most likely impact, if successful, would be to gain Charlton advantage over rivals, as none of them currently take this approach, thus decreasing rivalry. Due to the cost and time involved in establishing an ecosystem approach, a barrier to entry would be created, thus decreasing the threat of new entrants. 
 
 Test your understanding  2 
  
Option 1 Interaction  
Option 2 Orchestration X 
Option 3 Mutuality X 
Option 4 Communication  
Option 5 Conflict  
Orchestration and Mutuality are characteristics of an ecosystem. 
Interaction and Communication would exist in either an ecosystem or a 
traditional linear supply chain. Conflict would only be a characteristic of a traditional supply chain.

32 
  
Option 1 Franchising  
Option 2 Ecosystem development X 
Option 3 Upstream supply chain management  
Option 4 Customer relationship management  
A business ecosystem is “an economic community supported by a 
foundation of interacting organisations and individuals — the organisms 
of the business world.” 
 
 Test your understanding  4 
  
Option 1 New legislation is expensive to develop  
Option 2 Speed of change X 
Option 3 Data protection is a major issue  
Option 4 Ecosystems evolve X 
Option 5 Innovations cross lines of jurisdiction X 
Regulatory frameworks are being challenged by ecosystems on several fronts – these include 
• Speed of change – effective regulation depends upon the 
regulators’ understanding of the solutions being offered by 
businesses, their efficacy, and their possible unintended consequences.  
• Ecosystems evolve and new and clever business models proliferate, 
the sheer diversity of competitors and competitive modes is yet another complicating factor for regulators.  
• Innovations cross lines of jurisdiction and in business ecosystems, 
product definitions, market boundaries, the traditional distinction between digital and physical goods blur.  
The high cost of new legislation and the need for data protection are both general challenges that are not specific to regulating ecosystems.

Chapter 1 
 33 
  
Option 1 Increased demand for fast service provision  
Option 2 Data analytics and the cloud X 
Option 3 Reduction in hardware cost  
Option 4 Global Internet access X 
Option 5 Increased numbers of connected devices X 
The following are identified as key factors: 
Mobile and internet penetration – the increasing rate of mobile phone 
ownership, combined with access to the internet (with mobile beginning to exceed broadband).  
Connected devices – the number of connected devices are expected to 
grow from 2.5 billion in 2009 to 30 billion by 2020. This will help enable real-time customisation of products and services. 
Data analytics and the cloud – the increasing use of e-commerce 
automated data analytics. 
User interfaces – advances in how human beings interact with machines 
(e.g. through voice recognition or motion-tracking systems) means that carrying out tasks becomes quicker and more efficient for humans. 
Global accessibility – rising living  standards in developing economies 
means that more and more people are gaining access to the internet and 
so increased connectivity. 
Increasing urbanisation – the growing percentage of people who live in 
urban as opposed to rural areas.  
The increase in demand for fast service provision is social, NOT 
technological. Reducing hardware costs are financial, NOT technological.

34 
 Risks could be categorised as: 
A is economic B is political C is social D is social E is political F is technological G is social H is social 
I is technological 
J is financial K is technological L is technological 
 
 Question 1 
 A, C and D The terms network, relationships and interdependency are all normally 
associated with business ecosystems. 
 
 Question 2 
 C  
Customer expectations are cross fertilising and what they get in one aspect of their lives is becoming a requirement in others.  If we can put a man on the moon then surely we can……..  Regulations tends to react to abuse by large players and any new rules can become too onerous on the smaller emerging businesses . 
 
 Question 3 
 B 
Most studies and past experience show that cooperation leads to more 
value for all.

Chapter 1 
 35 
 Question 4 
 B 
The value is captured by a third party and is therefore indirect as far as 
the train operator is concerned. 
 
 Question 5 
 B 
This is a turbulent environment which tends to encourage a highly competitive stance being taken by the players.  It has loose orchestration and low complexity.

37 
Alternative approaches 
to business models 
A1: Explain the elements of 
business models (a) Concept of value and the 
(b) Defining value 
(c) Creating value (d) Delivering value (e) Capturing and sharing 
value 
• Stakeholders and relevant value 
• Resources, process, activities and people in creating value 
• Products, services, customer segments, channels and 
platforms to deliver value 
• Distribution of value to key stakeholders. 
  Chapter 
2

Alternative approaches to business models 
38 
 
2  Introduction 
As we have seen in the earlier chapter, the traditional business model is being 
challenged by changes in the way business enterprises operate depicted by the business ecosystem. 
What is a business model? 
According to KPMG any description of the business model must include how 
the firm is structured, the markets in which it operates, how it engages with those markets, its main products and services, its main categories of customers, and its main distribution methods. 
In more common terminology – “Business models are also stories that explain 
how firms work, including how they make money and how they deliver value to customers at an appropriate cost” (Magretta, 2002).  
If this is accepted then the business model depicts not only how a business 
creates value but also how it delivers value. 
The traditional business model therefore has four key aspects: 
• define value  – firms look at who they create value for and what counts as 
value for them 
• create value  – firms look at how resources are sourced and turned into 
outputs that customers and others desire 
• deliver value  – firms find ways to get value to those it was created for 
• capture residual value  for themselves and others to share between the 
firms, their shareholders and others (i.e. stakeholders). 
It is important to recognise that each part of the business model is aimed at a 
wide range of stakeholders.

Chapter 2 
 39 
Stakeholders can be defined in many ways e.g. Freeman defines 
stakeholders as “any person or group that can affect or be affected by the 
policies or activities of an organisation ” and are all in view when firms define 
value. 
It will depend on the industry, business and circumstances as to which 
stakeholder(s) take priority, although the customer is often prioritised as the most important e.g. in retail.  
Those who provide resources and help turn them into outputs (e.g. suppliers 
and employees) are key when creating value. They also receive value from the firm at the same time. Customers are the ones to whom value is delivered.  
The firm captures residual value to share among the providers of financial 
capital, government, senior executives and for reinvestment. The parts of the business model are linked and aligned to each other. 
Value is therefore at the heart of business models and can be: 
• Financial or non-financial  and must be differentiated from price, cost, 
profit or cash flow. These are related concepts but they are not the same 
as value but they are important because they act as measures or stores of value. 
• Tangible and intangible e.g. the move from an industrial economy to a 
knowledge- and information-based economy increased the importance of intangible value to firms.  
• Value affects the past present and the future . Past value is often used in 
reporting, present value in operational management and future value in investment appraisal.  
• Short term and the long term  the short term is important because firms 
must survive for them to have any long-term prospects. However, short-term value must not undermine long-term value. 
High level depiction of a business model.

40 
 Illustration 1 – Tesco 
 Tesco’s business model has four parts that correspond to the four parts 
of the business model above: 
1 Customers: “Tesco exists to serve customers and our business 
model has customers as our number one priority. Our scale and 
reach mean we have the expertise to really understand our customers; allowing us to focus on the delivery of an offer with real value in all areas of price, quality, range and service. This focus means that we will champion our customers at every level and earn their loyalty.” (Define value) 
2 Product: “The product we create for customers is developed by our 
product team. They work with our suppliers to source the best possible range of quality products that meet and anticipate our customers’ needs. Our relationships with suppliers are crucial to meeting our customer offer.”(Create value). 
3 Channels: “To bring the best products to customers easily, we work through a range of channels … As part of improving our offer we will invest in making our channels even more efficient and convenient for our customers.” (Deliver value). 
4 Reinvest: “Our clear priority is to improve Tesco for customers. As 
we do this, we have committed to reinvest any savings or outperformance into further improvements in our shopping trip.” (Capture value). 
In summary: 
The concept of the “business model” has been used over many decades for 
three main reasons.  
• Legal and regulatory requirements in certain jurisdictions require some 
firms to describe their business models when reporting to shareholders. 
For example, UK Corporate Governance Code, which requires directors to “state that the annual report and accounts … provides the information necessary for shareholders to assess the company’s position and performance, business model and strategy”. 
• Business models can be the means by which the firms create long-term 
value and success to identify and exploit business opportunities in the external environment.  
• By the use of these models and frameworks firms can respond to 
disruptions in their operating environments, particularly from firms who have new or better business models.

Chapter 2 
 41 
Required: 
change in this way. 
• Increased demand for fast service provision • The Cloud and data analytics  
• Increased numbers of connected devices world wide 
3 Defining value 
Before creating value firms have to decide who they are creating value for, with 
and why. Firms therefore create value with providers of resources and services for the benefit of their customers in order to earn returns for their investors while acting within the law.  
To do this firms identify their stakeholders, specify their roles and prioritise them 
in terms of the firms response to the “stakeholder claim” i.e. the demands that the stakeholder makes of an organisation. They essentially ‘want something’ from an organisation (see section 3). 
3.1 Stakeholder Analysis 
The traditional approach to stakeholder analysis is depicted by the use of 
Mendelow’s Matrix:  
Stakeholder mapping: The Mendelow model 
 
Interest 
Power  Low High 
Low Minimal Effort Keep informed 
High Keep Satisfied Key Players 
Stakeholder identification is necessary to gain an understanding of the sources 
of risks and disruption. It is  important in terms of assessing the sources of 
influence over the objectives and outcomes for the business decisions or 
projects (such as identified in the Mendelow model).

42 
In strategic analysis, stakeholder influence is assessed in terms of each 
stakeholder’s power and interest, with higher power and higher interest combining to generate the highest influence. 
There is similarly a moral case for knowledge of how decisions affect 
stakeholders both internal and external to the organisation. 
 
 Mendelow model 
 The matrix was designed to track interested parties and evaluate their 
viewpoint in the context of some change in business strategy. 
Power  relates to the amount of influence (or power) that the stakeholder 
group can have over the organisation. However, the fact that a group has 
power does not necessarily mean that their power will be used. 
The level of interest  indicates whether the stakeholder is actively 
interested in the performance of the organisation. The amount of 
influence the group has depends on their level of power. 
Low interest – low power 
These stakeholders typically include small shareholders and the general 
public. They have low interest in the organisation primarily due to lack of power to change strategy or influence corporate governance. 
High interest – low power 
These stakeholders would like to affect the strategy or influence 
corporate governance of the organisation but do not have the power to do this. Stakeholders include staff, customers and suppliers, particularly where the organisation provides a significant percentage of sales or purchases for those organisations. Environmental pressure groups would also be placed in this category as they will seek to influence company strategy, normally by attempting to persuade high power groups to take action. 
Low interest – high power 
These stakeholders normally have a low interest in the organisation, but 
they do have the ability to affect strategy and/or influence corporate governance should they choose to do so. Stakeholders in this group include the national government and in some situations institutional shareholders. The latter may well be happy to let the organisation operate as it wants to, but will exercise their power if they see their stake being threatened. 
High interest – high power 
These stakeholders have a high interest in the organisation and have the 
ability to affect strategy and/or influence corporate governance. Stakeholders include directors, major shareholders and trade unions.

Chapter 2 
 43 
Applying the concept of value to stakeholder analysis however engenders a 
slightly different approach. 
Critical to the decision and action to create value, it is vital that organisations 
decide who they are creating value for, with whom and why they are so doing.  
To do this a firm may apply a four step to this process: 
• Identify  the stakeholders for and with whom they seek to create value. For 
example customers, suppliers, shareholders etc. 
• Prioritise and rank the stakeholders. (NB for most firms, the customer is 
given the highest priority).  
• Establish and identify the needs of the high priority stakeholders.  
• Formulate value propositions  that meet the needs of the high priority 
stakeholders.  
 
Each stakeholder is ranked on the following attributes: • Power – ability to impose their will • Legitimacy – according to the norms and values of the firm and society 
• Urgency – the need for immediate action in the light of a stakeholder 
claim. 
Once they have been identified and ranked, the needs of the stakeholders, their 
contribution and benefit to the firm can be established.  
• Customers – need good services and experiences, they contribute loyalty 
and the benefit to the firm is financial (higher revenue) and non-financial 
(enhanced brand value). 
• Suppliers – need custom, loyalty and cash flow, they contribute resources 
and the benefit to the firm is resource availability and lower cost of sales.

44 
 
NB – Numbers indicate prioritisation 
 
 Test your understanding 2 – Discussion question 
 The LKJ company is a distributor of electricity in a large country. In effect, 
LKJ purchases electricity from companies making electricity and then 
distributes this through a network of cables to companies and private individuals throughout the country. Electricity is generated from a variety of sources including burning coal and natural gas, nuclear power and a small amount from renewal resources such as wind and wave power. 
LKJ’s shares are owned by three other companies, who take an active 
interest in the profitability of LKJ. There are three other electricity distribution companies in the country LKJ operates in. 
The board of LKJ are currently considering the proposal to purchase 
electricity from another country. This source of supply is quoted as being cheaper from those within LKJ’s home country, although the electricity is generated by burning coal. If this supply is taken, LKJ will stop purchasing electricity from an old nuclear power station and some of the expensive wind power plants. The Clean-Earth environmental group has 
learnt of the proposal and is currently participating in a media campaign 
in an attempt to block the change by giving LKJ bad publicity. 
The board, managers and employees in LKJ appear indifferent, although 
changing the source of supply will provide a price advantage over LKJ’s competitors, effectively guaranteeing their jobs for the next few years. 
Required: 
Identify the stakeholder groups who will be interested and/or affected by 
the decision of the LKJ company to change electricity suppliers, evaluating the impact of that decision on the group. 
Discuss the actions the board can take with respect to each stakeholder 
group. 
(15 minutes)

Chapter 2 
 45 
4 Value creation  
The creation of value is a common theme in the description of the purpose of 
business models.  
For example – the FRC definition supports this assumption by defining business 
models as “how the entity generates or preserves value over the longer term”. 
In this context as we have noted in section 1 value is: 
• financial or non-financial 
• tangible and intangible 
• not limited to the past  
• covers both the short term and the long term. 
Value however is also about people. It is about how their needs are met. It is 
created by people, with people and for people. Value goes beyond shareholder 
value to creating shared value .  
For example, organisations such as Nestlé now produce shared value reports annually indicating that value is co-created by different stakeholders and not just the domain of shareholders.  
Creating value 
Within the boundaries of cost control, there are five key elements that must 
connect and align to create value at an appropriate cost. By way of comparison this can be referred to as the operating model of the firm. 
• Partners  – these include suppliers, employees, contractors and other 
partners (high priority stakeholders) who provide access to resources, 
markets and technologies. Firms must build relationships, earn their trust and reward them appropriately for their contribution to value creation.  
• Resources  – firms use their relationships with their suppliers to source 
and secure the right resources to make products or services that satisfy their customers. These are both tangible and intangible inputs. For critical resources long-term availability is also a primary objective. (for example: SABMiller identified water as a critical resource). 
• Processes – firms need to design, develop and deploy processes that provide the infrastructure to convert resources (inputs) into goods and services (outputs).   
• Activities  – firms and their partners engage in activities that use the 
processes to convert resources into goods and services. 
• Outputs  – firms  outputs are in the form of products, services and 
experience, which aim to meet the customer value proposition.

46 
5 Delivering value 
Firms deliver value to customers and earn revenue from customers only when 
customers receive and/or use the goods and services. It is therefore imperative that firms understand their different customer segments and the channels by which to reach each of these segments.  
Customer segments  can be based on any aspect of demographics 
e.g. gender, geography or social behaviour e.g. income, lifestyle etc.  For example: Traditional segmentation focuses on identifying customer groups based on a 
number of variables that include: 
• Geographic variables, such as region of the world or country, country size, 
or climate 
• Demographic variables, such as age, gender, sexual orientation, family 
size, income, occupation, education, socioeconomic status, religion, 
nationality/race, and others 
• Psychographic variables, such as personality, life-style, values and 
attitudes 
• Behavioural variables, such as benefit sought (quality, low price, 
convenience), product usage rates, brand loyalty, product end use, readiness-to-buy stage, decision-making unit, and others. 
Value-based segmentation looks at groups of customers in terms of the revenue they generate and the costs of establishing and maintaining relationships with them. 
Whatever method is chosen, the segment must be: 
• Measurable 
• Meaningful 
• Mutually exclusive 
• Stable 
• Substantial 
• Easy to understand.

Chapter 2 
 47 
 Illustration 2 – Bain and Co 
 Research by consultants Bain and Co suggests that to achieve the 
greatest benefit from segmentation firms must: 
• Divide the market into meaningful and measurable segments 
according to customers’ needs, their past behaviour or their 
demographic profiles. 
• Determine the profit potential of each segment by analysing the 
revenue and cost impacts of serving each segment. 
• Target segments according to their profit potential and the 
company’s ability to serve them in a proprietary way. 
• Invest resources to tailor product, service, marketing and distribution 
programmes to match the need of each target segment. 
• Measure performance of each segment and adjust the 
segmentation approach over time as market conditions change decision-making throughout the organisation. 
Channels  firms deliver value to customers through communication, distribution 
and sales channels. In this context the advent and growth of technology has opened up many channels for firms to connect with their customers, for example phones, tablets and social media. 
 
Illustration 3 – Oracle Report 
 An Oracle report on cross-channel customer experience indicated that 
customers “might start the buying process based on the recommendation 
of a friend, online product research, or an email or text message offer.  
They might then touch and feel the product in a retail store but ultimately 
buy it from the comfort of their home via a tablet or other device in the small hours of the night.” 
They expect the buying journey to be relevant and personalised, to reveal 
consistent features, offers and experiences based on where they’ve been, what they want and how they choose to get it. On average, Oracle’s consumer research shows that more than three-quarters of consumers use two or more channels to browse for, research and purchase products.  
More importantly, 85 per cent of shoppers expect a consistent and 
personalised shopping experience. 
In that respect therefore organisations must develop need a multi-channel integrative customer model that delivers customer value and significant return on investment.

48 
According to Oracle firms must adopt the following key actions to data on 
customers 
• Collect • Clean   
• Connect  
• Transform. 
This will hopefully facilitate seamless perso nalisation of customer needs across 
the different channels. These channels must be integrated despite their variety 
and customer expectations.  
Failure to connect across all channels w ill eventually erode the firm’s brand 
reputation, ability to completely satisfy its customers and hence loss of 
competitive advantage.  
 
 Anji is considering buying a new laptop. She is doing some Internet 
research, and has found a site called ‘techchoice.com’, which contains 
descriptions of various laptops together with their technical specifications and expert reviews. Anji has been asked to enter details about where she 
lives, and why she wishes to buy a laptop. As a result, Anji has identified 
the make and model of laptop she thinks she wishes to purchase, because it precisely meets her needs and is available in her area. The webpage has a link to another site, which provides independent user reviews of that model. There are also links to the relevant pages on the websites of the three retailers in Anji’s country currently offering the lowest prices for that model. 
number of factors that drive customer demands in the digital era. 
Required 
Examine the above statement and select which TWO of the following  
‘drivers of customer demands in the digital era’ are being described. 
• Contextualised interaction • Self-service 
• Peer review 
• Seamless experience 
• Transparency.

Chapter 2 
 49 
6 Capturing residual value 
Value is captured when revenue earned from delivering value exceeds the 
costs of creating value.  
The difference between the two creates a surplus, the size of the surplus will 
depend on market conditions but will also  reflects the decisions made when 
defining value and the success with which firms execute those decisions.  
Firms will share this surplus with stakeholders who contributed to and have 
been part of the value creation process but have not yet received any value themselves. 
There are three main issues to consider when capturing value.   
Cost model – this is established when defining value. It is influenced by the 
value proposition to customers and the partnerships that firms use to create and 
deliver value.  
The total cost will be established by four key factors: 
• Efficiency of the processes. 
• Levels of activity. 
• Resources consumed during activities. 
• Price paid for resources. 
Revenue model – revenue is earned when goods and services are delivered to 
customers and any prices charged should accurately reflect the customer 
segments that the firm addresses, the market conditions in which it trades and any regulatory control in place.  
In addition the firm will also need to establish a collection policy which dictates 
the speed which revenue is converted to cash. Both pricing and collection policy (i.e. terms of trade) are affected by these factors. 
Sharing residual value – is based on the principle of creating shared value, 
which comprises shareholder value and the value delivered to other 
stakeholders. The priority  of these stakeholders will depend on the environment 
on which they operate. For example: 
• government (taxes) • shareholders (dividends) 
• incentives for executives (performance-related pay) 
• the firm (retained income for reinvestments). 
The sharing has to be sensitive to the interactions in the operating environment 
so that it does not avoiding any harm to the harm the firm’s reputation, the creation and delivery of further value and will be dependent on the strategy of the firm in terms of for example its bonus schemes, dividend policy and investment opportunities.

50 
The traditional business model has been significantly affected by changes in 
technology, the operating environment of the firm and, as result the strategy that the firm should adopt. 
The key aspect is that different parts should connect to and align, both with 
each other and to the operating environment. Significant misalignment will affect the performance of the organisation.  
This new approach is depicted the CIMA business model. 
The CIMA Business Model

52 
 Question 1 
 An insurance company is regulated by the Financial Conduct Authority, it 
has many rules that must be obeyed if penalties are to follow.   
How should this stakeholder be dealt with within Mendelow’s matrix? A Keep informed B Obeyed as a key player C Keep satisfied D With minimal effort 
 
 Question 2 
 In the diagram below, where, under normal circumstances, should a 
business focus its value effort?           A  B  C  D  
 
POWER
URGENCY LEGITIMACYDC BA

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 53 
 Question 3 
 In relation to value propositions, which of the following statements are 
true? 
(1) Value propositions for principal stakeholders should remain 
unchanged for long periods to ensure trust is gained 
(2) A good value proposition doesn’t have to meet the needs of a 
stakeholder as long as it is measurable 
A (1) only B (2) only C Both are true 
D Neither are true 
 
 Question 4 
 In relation to the concept of value, which of the following statements are 
true? 
(1) A short-term reduction in training expenditure will increase profit and 
so will enhance long term present value of expected future returns 
where perfect knowledge exists of the reason for the profit improvement. 
(2) Businesses report past values  but assess future values in 
investment appraisal.   
A (1) only 
B (2) only C Both are true D Neither are true

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 Question 5 
 Match the contribution that each stakeholder would be most likely to 
make to a successful business: 
 
Stakeholder Contribution 
Customer Advocacy 
Know how 
Capital 
Investors Advocacy 
Know how Capital 
Employees Advocacy 
Know how Capital

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 55 
  
platforms, social networks, apps et c. will result in increased need for 

56 
 Large institutional investors 
The main strategy of the board regarding a large institutional investor is 
communication with the need for change followed by participation in strategy determination. Most codes of corporate governance indicate the bi-lateral approach to be taken. The large investor is interested in the success of the organisation while at the same time having the ability to adversely affect the organisation if their shareholding is sold. The organisation must therefore keep the stakeholder informed regarding important strategic decisions. Similarly, there is a responsibility on the part of the stakeholder to take an interest in the activities of the organisation and to use their influence responsibly. 
The three investors in LKJ are likely to be keen for the electricity to be 
purchased from the different country as this will increase the return on their investment. 
A dialogue should be established between the chairman and large 
shareholders, as a minimum by discussion at the annual general meeting. However, more frequent meetings throughout the year are also expected. The chairman needs to ensure that the expectations of return from LKJ are congruent with the investing companies. 
Environmental pressure group 
The pressure group will attempt to influence other groups with high power 
to change the strategy of the organisation. The board of LKJ therefore need to communicate with the group with the aim of explaining and educating them in respect of the actions being taken by LKJ. 
Currently Clean-Earth are attempting to influence the strategy of LKJ by 
the media campaign. The basis of this campaign is likely to be the fact that obtaining electricity from coal is more harmful to the environment than renewable sources and possibly nuclear generation. Explanation of the reason for change in terms of increased profit may not, however, be acceptable. 
However, the board must be prepared to learn from the pressure. Many 
pressure groups do have responsible and knowledgeable people within the group. Not to listen may mean that valuable advice and assistance is rejected on grounds of prejudice against this type of stakeholder. While it is likely that advice from the gr oup will be biased towards renewable 
resources, they may have ideas regarding cost efficiency that LKJ can use.

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 Directors/managers/employees of LKJ 
The directors of LKJ are stakeholders in the organisation. In terms of 
corporate governance, they have the responsibility to act in the best interests of the company and its shareholders. In this sense, there is no conflict in the decision to source electricity supplies from another country; LKJ profits are forecast to increase while there is job security for the directors. While the directors have high power and interest in LKJ, this power appears to be being used correctly. 
Similarly, the actions of the directors appears to meet the requirements of 
the managers and employees of LKJ in that their jobs are protected. 
However, the environmental impact of their action may be a cause for 
concern. If LKJ, and therefore the directors, are considered not to be acting ethically then customers may choose alternative suppliers. This action will mean that the profit forecasts are incorrect and the directors may need to consider alternative courses of action. 
 
Option 1 Contextualised interaction X 
Option 2 Self-service  
Option 3 Peer review  
Option 4 Seamless experience X 
Option 5 Transparency  
According to the World Economic Forum/Accenture analysis: 
From being made aware that a product or service exists, to doing the 
research about the product or service, to then taking the decision to purchase, customers expect a seamless service throughout the process. This can also be extended to how the customer pays and takes delivery of the goods. This is known as ‘ seamless experience across 
channels’. 
Contextualised interaction  means that customers expect a product or 
service that is tailored to their own specific needs. The video streaming 
service Netflix helps meets this demand by making recommendations on programmes that are likely to be of interest to the viewer based on historic patterns.

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 Question 1 
 C 
Although the rules must be obeyed Mendelow defined a regulator as 
having low levels of interest (unless provoked) and high levels of power and should therefore be kept satisfied. 
 
 Question 2 
 D 
Under normal circumstances the correct answer is D.  Clearly there are 
situations where an urgent situation arises and might take precedence for example. 
 
 Question 3 
 D 
We live in a VUCA environment with change part of our almost daily lives 
and whilst consistency is important the focus might have to change regularly.  Meeting the needs of a stakeholder is paramount, making something measurable is a “nice to have”. 
 
 Question 4 
 B 
A short term profit improvement in a perfect knowledge environment is 
likely to damage expected long-term future returns. 
 
 Question 5 
 The correct match ups are: 
Customer – Advocacy Investors – Capital Employees – Know how

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Business models in 
digital ecosystems 
A3: Analyse new business 
models in digital ecosystems (a) Analyse digital business 
models and their related operating models 
• Disruption 
• Ways to build disruptive and resilient business models 
• Creating digital operating models 
• Types of digital operating models. 
  Chapter 
3

Business models in digital ecosystems 
60 
1 Session content diagram 
 
2 Introduction 
Throughout the preceding chapters, reference has been made to ‘the digital 
economy’ and to a number of digital technologies. It therefore stands to reason that students need to be aware of modern digital technologies and how they can represent both an opportunity and a threat to business ecosystems. 
3 Disruptive technology 
Disruptive technology relates to instances where technology is used to fundamentally change and ‘disrupt’ the existing business model in an industry. 
 
 An example of a disruptor 
 An example of a disruptor is the passenger service Uber which created a 
business model using technology which avoided the need for licensed 
drivers, a vehicle fleet, local booking services etc. Instead, customers use their internet connected device to hail a ride and all payments are handled by a smartphone app. 
Uber has disrupted the existing business model for traditional passenger 
services. Uber was set up in San Francisco in the United States and its initial key competitor was the Yellow Cab Co-operative, but whilst Uber has grown to a business worth over $60bn, the Yellow Cab Co-operative has since filed for bankruptcy. 
The key reason for the growth of new disruptive businesses is from 
technology. Not only from the technology that they employ in order to cut costs and improve efficiency, but also in the access that consumers now have to technology in the modern on-demand economy. For example, many disruptive businesses rely on smartphone applications or have internet-only based transactions.

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The two largest growth sectors for disruptive technology are in health services 
and financial services. Financial technology (commonly known as Fintech) is, for example, completely disrupting the traditional banking sector – long seen as a highly technical, highly regulated industry dominated by giant banks. 
Fintech businesses exist which can provide investment advice, offer banking 
services, transfer money internationally, provide mortgages and loans, exchange currency etc. These are typically big earners for traditional financial institutions. Goldman Sachs estimates that upstarts could steal up to $4.7 trillion in annual revenue, and $470 billion in prof it, from established financial services 
 
Fintech examples 
 Zopa is a peer-to-peer (or person-to-person) loan company. What this 
means is that Zopa has technology which allows a person who wants to 
borrow money to be matched with a person who wants to lend money. This completely removes the role of traditional banks from the transaction. Lenders receive higher returns than they would from depositing in a bank but it is still cheap er for borrowers to  borrow directly 
from lenders rather than pay bank margins. Zopa has a low margin fee for setting up the transaction. Zopa has no physical branches and therefore avoids many of the overheads and operating costs of traditional lenders. 
The loans are unsecured but credit scores are available to lenders so that 
they can match lending rates to different credit scores. Lenders can also sell their loan if they want to cash in early (for a 1% fee). 
Some borrowers and lenders who use peer-to-peer markets suggest that 
they do this for ethical reasons. They argue that traditional banks often have unethical practices and a peer-to-peer system avoids giving big banks more profits. 
New entrants into the market such as Funding Circle are now offering a 
similar service for business customers with larger loans and longer periods. 
Another example of a Fintech is a company called Betterment. 
Betterment aims to become a financial portfolio management platform – taking business away from the typically person-to-person financial advisers. Users can use a smartphone app to get investment advice and manage their investment portfolio.

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 Here is an extract from Betterment’s mobile app description: 
 
Why we're here 
Betterment is an online financial advisor with one purpose: to help you 
make the most of your money. We’re taking investment strategies that have worked for decades and using technology to make them more efficient. Our goal: to increase your long-term returns. 
What we do for you 
We make tailored recommendations, from how much to invest to how 
much risk to take on in your portfolio. Then, we invest your money in a globally diversified portfolio of low-cost ETFs and help lower taxes in ways many traditional investment services can’t match. 
Seek higher returns: 
• Automated portfolio management 
• Globally diversified portfolio of ETFs 
• Tax efficient investing features, like tax loss harvesting and asset 
location. 
Get a better investing experience: • Sync your external investments • Customer support 7 days per week 
• Access to CFP® professionals and licensed financial experts. 
Invest and save with transparency: 
• Low-cost, straightforward pricing plans • Low fund fees 
• No trading or rebalancing fees. 
 
The advantages that Fintechs have are: 
• better use of data – providing better understanding of their customer and 
giving customers a wider choice 
• a frictionless customer experience using elements such as smartphone 
apps to provide a broad and efficient range of services 
• more personalisation of products/services to individual customers 
• the lack of a physical presence (with associated overheads and operating 
costs) 
• access to cheap capital to fund growth – much like when internet based 
businesses first came to prominence in the 1990’s, investors want to get in 
on the growth potential that Fintechs offer. This gives Fintechs a wide scope for raising cheap finance in order to fund their future expansion.

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 What potential defences might be employed by traditional financial 
services businesses to defend themselves against Fintech? 
 
 Further examples of disruptive technology 
 Cryptocurrencies 
These aim to be a digital form of money, meeting the attributes of a store 
of value, unit of account and medium of exchange. That is not to say that all cryptocurrencies irrefutably meet these criteria, but their main purpose is to achieve this status.  
Hundreds of cryptocurrencies now exist, originating with bitcoin, each 
providing different attributes – “zcash”, for example, offers privacy guarantees. 
Blockchain 
Blockchain is a distributed database existing on multiple computers at the 
same time. It is constantly growing as  new sets of recordings, or ‘blocks’, 
are added to it. Each block contains a timestamp and a link to the previous block, so they actually form a chain.  
The database is not managed by any particular body; instead, everyone 
in the network gets a copy of the whole database. Old blocks are preserved forever and new blocks are added to the ledger irreversibly, 
making it virtually impossible to manipulate by faking documents, transactions and other information.  
All blocks are encrypted in a special way, so everyone can have access 
to all the information but only a user who owns a special cryptographic key is able to add a new record to a particular chain. As long as you remain the only person who knows the key, no one can manipulate your transactions. In addition, cryptography is used to guarantee synchronisation of copies of the blockchain on each computer (or node) in the network.  
For example, think of blockchain as a digital medical record. Every record 
is a block which has a label stating the date and time when the record was entered. The medical history is extremely important for diagnosis and treatment purposes, so neither the doctor nor the patient should be able to modify the records already made. Nevertheless, the doctor owns a private key that allows him to make new records, and the patient owns a public key that allows him to access the records anytime. This method makes the data both accessible and secure. So, blockchain is by definition independent, transparent, and secure. The advantages of such a distributed ledger are obvious: being cost and risk reduction, data security, and/or transactions transparency; companies from most industries can benefit from this new technology.

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We are all pretty much used to sharing information through a 
decentralised interactive platform – the Internet, but when it comes to sending money or other valuables we usually have to use the same old services provided by centralised financial institutions (i.e. banks). There are methods of making payments via the Internet (the most obvious example is PayPal), but they usually require integration with a bank account or credit card; otherwise they cannot really be used. Blockchain technology offers an attractive opportunity to get rid of this "extra link". It’s perfectly designed to take on all three most important roles of the traditional financial services: registration of transactions, identity verification and contracting.  
The financial services industry is the world’s largest market in terms of 
capitalisation. If some part of those services will switch to using blockchain, this will certainly disrupt the industry, but at the same time it will significantly improve the efficiency of those services.  
As transactions are completed directly between the parties with no 
intermediary and in digital form, settling a deal can be faster than ever.  
The benefits noted below of perfect transparency, traceability and 
security provide further reasons to understand its potential. Moreover, blockchain can be used not only for sending digital money but as well for tracking physical goods in a supply chain, helping companies to monitor their suppliers in real time. 
 
 Missfits is a fashion retailer, specialising in the online sale of clothing for 
females aged 14–28. Missfits has a large warehouse in its home country, Homelandia, from where it dispatches ordered goods to customers worldwide. As a result, Missfits holds a significant level of finished goods inventory, which incurs high storage costs and restricts cashflow for expansion of the business. 
During a recent competitor analysis exercise, Ali Dan (an accountant 
working for Missfits) was performing ratio analysis on competitors’ accounts. He noticed that one major competitor, Girlwear, seems to have very low inventory levels.  
Reading elsewhere in Girlwear’s annual report, Ali found reference to the 
fact that Girlwear shares order details with suppliers by means of an extranet, enabling them to manufacture to order and dispatch direct to Girlwear’s customers. Each item of clothing is tracked through the production and delivery processes by means of a Radio Frequency Identification (RFID) tag. This allows the exact location of the garment to be determined automatically.

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 Required: 
Examine the above scenario and identify which of the following is being 
used by Girlwear. 
• Fintech 
• Disaggregation 
• Competence sharing 
• Disruptive technology 
4 Surviving digital disruption 
So how might management ensure that their organisations survive digital 
disruption and rethink their business models so that they can thrive in a digital age?  
The consultancy group Accenture wrote a report in 2015 called Accenture 
Technology Vision, which highlighted five emerging trends that were shaping the digital landscape for organisations and which business leaders should focus on in developing digital strategies: 
1 The Internet of Me – users are being placed at the centre of digital 
experiences through apps and services being personalised. 
2 Outcome economy  – organisations have an increased ability to measure 
the outcomes of the services that they deliver; customers are more attracted to outcomes than just simply to products, and this is what organisations should focus on. 
3 The Platform (r)evolution – global platforms are becoming easier to 
establish and cheaper to run. Developments such as cloud computing and mobile technology offer huge potential for innovation and quicker delivery of next-generation services. The rate of evolution is only going to increase. 
4 The intelligent enterprise  – using data in a smart way enables 
organisations to become more innovative and achieve higher degrees of operating efficiency.  
5 Workforce reimagined  – whilst greater use is made of smart machines, 
the role of human beings is not being removed altogether; they are simply being used in a different way. Ways need to be identified in which man and machines can work effectively together to create better outcomes.  
There are also a number of myths about digital transformation that are common. This is perhaps understandable given the rate of change that has been seen in many industries over the last few years, but such impressions need to be shown as misleading if management are to see digital transformation as an opportunity as opposed to a threat.

66 
Myth 1 – those organisations that are not digital already have missed their 
chance 
It is true that a number of recently-formed businesses have achieved huge 
valuations in a very short space of time, and successfully attacked traditional markets (Uber, AirBnB, Amazon etc.). This is because they have successfully exploited new technologies and understood the changing tastes of consumers. 
However, existing businesses that have been around for a long time have 
substantial assets – know-how, customer relationships, brands, distribution channels, data – and should look to leverage these to their advantage. The business model simply needs to adapt. 
Myth 2 – becoming a digital business is an administrative exercise that 
focusses on achieving operational efficiencies 
The reality is that successful organisations today are not just looking to cut 
costs through using technology; they are looking to increase the revenue sources available to them. Using technology is an important way to achieve this. 
Myth 3 – digital transformation can be successfully achieved just by 
creating a digital business unit headed up by a Chief Digital Officer 
Whilst such business units and roles may be created, the process of digitisation 
will impact on all employees in the business. Digital transformation needs to be driven at the very top of the organisation, with the CEO taking responsibility for it and achieving buy-in from everybody else. 
The lesson from the above myths is that organisations need to recognise how 
technological development requires them to question their business model, to enquire how adopting such technologies can bring benefits, and to understand how employees and their roles are also evolving and how to get the best out of them. 
 
Option 1 The Internet of Things  
Option 2 The Internet of Me  
Option 3 The learning organisation  
Option 4 The intelligent enterprise  
Option 5 The outcome economy  
Technology Vision, which highlighted five emerging trends that were shaping the digital landscape for organisations and which business leaders should focus on in developing digital strategies.

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 Required: 
Identify which THREE of the following, according to Accenture, are 
among those trends 
• The Internet of Things 
• The Internet of Me 
• The learning organisation 
• The intelligent enterprise 
• The outcome economy 
5 The roles and responsibilities of the board and senior 
In order for an organisation to properly take advantage of a move to digital, or to 
survive digital disruption within its indus try, the executive leadership team will 
need to demonstrate a number of abilities: 
1 Inspirational leadership  – digitisation will be an exercise in change 
management, but probably on a bigger and quicker scale than the 
organisation will typically be used to. The leadership team will need to 
energise the workforce and inspire confidence that digitisation is the right way forwards and is being carried out in the right way. 
The move to digital will only succeed if those at the top of the organisation 
take ownership and persuade others to commit to the change. 
2 Competitive edge – not only will the leadership need to motivate others within the organisation to see the digital transformation as the right strategy; they will also have to persuade people to potentially change their mindset. The need to adopt an inquisitive attitude, to be prepared to innovate and think outside the box, to experiment and to learn from failures may not be second nature to some, but is likely to be critical in transforming successfully to digital. 
3 Establishing a strategic direction  – this is probably something that the 
business has done for a long time, but a digital strategy may require it to be done in a different way. For example, the planning horizon may need to be shortened, or greater flexibility in troduced – perhaps a move away from 
the rational model discussed in chapter 1 to a more emergent approach, which would enable the business to adapt as time passes. 
4 Influence external parties  – for example, providers of finance. Raising 
capital is likely to be necessary, but showing how that capital may be applied and the value that will result might be more problematic. Will investing in cloud technology deliver increased shareholder wealth? If so, how much? And when? There will be greater uncertainty over outcomes, and the leaders of the business will need to be persuasive and articulate a compelling value proposition.

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5 Collaboration  – as has already been mentioned earlier in this text, the 
organisation will need to see itself as part  of a wider ecosystem if it is to 
deliver the requisite value. This will require careful thought on who to 
collaborate with and how each part of  the ecosystem will contribute. 
6 Business judgement  – what sort of business model will the organisation 
need to put in place? It is probable that an altogether different model to what has worked in the past will be required. 
7 Execution – having determined what technologies can help to drive the business forwards, thought must then be given to how these can be used most effectively by the people within the business. People and technology need to work in harmony to produce the desired outcomes. 
Careful thought must also be given to how the execution of the digital 
strategy and transformation is to be managed. For example, what sort of metrics (or KPIs) need to be put in place? What benchmarks should be adopted as a successful outcome? 
8 Building talent  – it will be critical to identify the skills that staff will need to 
demonstrate and to manage training/recruitment to ensure that the business has those skills. New roles are likely to be required, including at the most senior level – for example, perhaps a new board position of Chief Digital Officer. 
 
 Mac is CEO of Keel Her, a large manufacturer of smartphones and 
tablets. Mac has recently attended an ‘all staff’ meeting, at which he passionately outlined his personal vision for the future of Keel Her, and launched two new products which will be taken to market within the next two weeks. 
In order for an organisation to properly take advantage of a move to 
digital, or to survive digital disruption within its industry, the executive leadership team will need to demons trate a number of abilities.  
Required: 
Examine the description above, and identify which of those abilities is 
being demonstrated by Mac from the list below. 
• Establishing a strategic direction 
• Building talent 
• Collaboration 
• Inspirational leadership

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6 Strategies to build disruptive business models  
Firms looking to become digital enterprises face two main challenges.  
• The business model that served them well for decades has been disrupted 
by digital innovation and no longer works as desired. 
• All attempts to create a new, viable business model for the digital age will 
flounder unless a company is willing to disrupt itself. 
This conundrum has been termed “the innovator’s dilemma”. 
 
 Illustration 1 – iPods, iTunes – th e innovators dilemma in action 
 For firms, the dilemma can be particularly testing as the disruptive 
technology may directly compete with their profitable existing business. 
This could be reduced to one sentence: “In the years before the launch of the iPod and iTunes in 2001, both Nokia and Sony had similar products under development but chose not to proceed with them, for fear of disrupting their existing business. “In fact, an IMD/Cisco report published in 2015 found that only a quarter of the companies surveyed said that they would be willing to disrupt themselves in order to compete. 
So the key message is not to be afraid of change and disruption .  
 
 Illustration 2 – Michelin 
 Michelin has adapted its business model, from being a manufacturer 
and seller of tangible goods (tyres) to selling outcomes (a promise of 
performance that is backed by a guaranteed refund if not satisfied). 
Michelin offers a package that is has branded EFFIFUEL, which 
includes sophisticated telematics, training in how to drive efficiently, and a tyre management system. It claims that purchasing such a service can save significant costs in operating trucks (fuel and replacing tyres) and also in terms of carbon dioxide emissions.  
Companies need to fundamentally change the way they identify, develop and launch new business ventures.  
They have to enhance their strategic toolkit. Research at the World Economic 
Forum on “Digital Transformation of Industries” suggests that they need to adopt one of five approaches or a combination of  build, buy, partner, invest 
and incubate/accelerate.  
• Build  
Building new business models might be the best route when an opportunity is related to the company’s core business. The benefits are that it typically maximises control and minimises costs in markets that a company must own because of their strategic importance. If companies decide to go for the build route, they can benefit by creating and 
developing new products and services
.

70 
 Illustration 3 – GE 
 GE historically made most of its revenues by selling industrial hardware 
and repair services, but with the pace of advances in digital technology, 
GE was at risk of losing out to competitors. In 2011, GE launched its Industrial Internet initiative to move toward an outcome-based business model focused on optimizing asset performance and operations with the help of big data and analytics. Digitally enabled and outcomes based approaches helped GE generate more than $800 million in incremental income in 2013.  
In 2015, GE made the next step, with dramatic changes to its strategy 
and operations, to emphasize and capitalize on its digital capabilities 
with the creation of GE Digital.  
This move has helped GE bring together all the digital capabilities from 
across the company into one organization with a bold ambition to create a digital show site and grow software and analytics enterprise from $6 billion in 2015 to become a top 10 software company by 2020. 
 
• Buy 
Buying another company is usually the most appropriate path when there is a strategic imperative to ‘own’ a market and may be the only viable option if a significant change market is imminent, hiring the right talent is not possible and the new opportunity bears little relation to the firm’s current business model may provide reasons to buy. Similarly engaging early with a digital disruptor is important to wrong-foot the competition and minimise the investment needed.
 
 Illustration 4 – UPS 
 UPS recently acquired Coyote Logistics, a logistics start-up founded in 
2006, and a highly innovative, technology driven, non-asset based truckload freight brokerage. 10 Other business model-related acquisitions include  
Facebook acquiring Oculus Rift and WhatsApp, or BMW, Audi and 
Daimler buying Nokia’s digital mapping service HERE, with the aim to better position themselves in the battle for self-driving and connected cars. 
 
• Partner  
A firm can use partnering with a digitally disruptor to learn more about the market and its partner’s model. A partnering approach is sensible when it makes sense to learn about emergent opportunities, with an eye toward deeper partnerships or acquisitions in the future. Companies need to develop a more flexible and open mind-set toward partnerships; which are expected to play an important role in the digital transformation of market players.

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 Illustrations 5 – Novartis and Google 
 Novartis and Google have joined forces to work on a smart contact lens 
that monitors blood sugar levels and corrects vision in a new way. This 
helps open up new revenue streams for Novartis, moving away from selling pills to a more holistic offering for patients by enabling them to better monitor their own health and reduce the cost of managing chronic diseases.  
Adidas has partnered with Spotify to launch Adidas Go, the first running 
app that uses iPhone's accelerometer to instantly match a runner's favourite music to their workout. 
 
• Invest   
Investing in interesting start-ups is often a valid option, allowing an 
established company to connect with the right skills and capabilities. It will 
also avoid hindering entrepreneurial forces with a setup focused on internal governance and reporting. 
• Incubate/accelerate  Investment and incubation/acceleration might seem 
similar endeavours. The latter however represents a closer relationship to the funding company, deploying co rporate internal capabilities, 
infrastructure and resources to the start-ups. Having said that, incubators and accelerators need to precisely outline both internal benefits and incentives for start-ups and entrepreneurs, and a clear strategy and vision.
 
 Ben’s Bits was founded in 1982 by Ben Bentley. Mr Bentley had been a 
car mechanic, specialising in classic and vintage Italian car restoration. He had become increasingly frustrated by how much time and effort he was spending to track down spare parts for car models that were no longer in production. Ben took a long lease on a large warehouse and began to visit dealers and vintage car events. 
Having managed to obtain about half  a million spare parts for classic 
Italian car brands, Mr Bentley offered them for sale to enthusiasts and 
mechanics by mail order. In 1998, Mr Bentley’s son, Ben junior, computerised the inventory system. This made it easier to identify what parts were held. 
Between 2000 and 2015, the company acquired over two hundred small 
independent car parts retail businesses, as their owners retired. Ben’s Bits now has over twenty million stock items, for more than thirty classic car marques from around the World, and sells globally through its website. The business is still owned by Ben and his son. 
Research at the World Economic Forum on “Digital Transformation of 
Industries” suggests that companies need to adopt one of (or a combination of) build, buy, partner, invest and incubate/accelerate if they wish to identify, develop and launch new business ventures.

72 
Required: 
Identify which of these was pursued by Ben’s Bits between 2000 and 
2015 from the list below 
• Build 
• Invest 
• Buy 
• Partner 
7 Digital operating models  
To compete, companies will also have to change their business models and 
how they deliver that business model by re-examining every aspect of their operations.  
Many businesses are already making these changes, with 90% of organizations 
saying that they have significantly adjusted their operations.  
This could involve introducing a digital operating model. The World Economic Forum on the Digital Transformation of Industries, 
identified five successful digital operating models. They replace rigid approaches to technology, data and processes with flexibility, while also encouraging a culture that is open to innovation and interaction with customers and partners.  
• Customer-centric . This model focuses on making customers’ lives easier 
and emphasizes front-office processes. Leading exponents include the UK 
retailer Argos, but it can be applied across industries. It works best with a culture that puts the client first and a decentralized structure that empowers frontline staff. 
• Extra-frugal . This model thrives on a culture of ‘less is more’ and a 
standardized organizational structure. By optimizing manufacturing, supply and support processes, it can provide a high-quality service at a low cost. A prime example of this model is tire manufacturer Michelin.  
• Data-powered.  This model is built around prowess in analytics and 
software intelligence. Epitomized by Google and Netflix, data-powered companies have an agile culture focused on innovation through empirical experimentation.

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• Skynet.  Named after the conscious, artifi cial general intelligence of the 
Terminator films, this model makes intensive use of machines to increase 
productivity and flexibility in production. Pioneered by enterprises such as Amazon and Rio Tinto, Skynet organizations are characterized by an engineer-led culture dedicated to automation.  
• Open and liquid.  This model looks outward with a view to creating an 
ecosystem that can enrich the customer proposition. Built around a sharing customer, all processes in organizations of this kind are characterized by a constant flow of dialog with the outside world. Examples include Facebook and PayPal.
  
 Test your understanding  6 
 Simple Minds is a high-street toy and game retailer. It has developed a 
business model based around putting the customer first and making their 
life easier. Simple Minds has a very simple organisation structure, which 
allows staff in the shops to do pretty much anything they choose to ensure that the customer is delighted. This includes giving discounts, demonstrating toys, playing games with customers and dressing up as characters from popular games. 
The World Economic Forum project on the Digital Transformation of 
Industries (DTI) identified five successful digital operating models. They replace rigid approaches to technology, data and processes with flexibility, while also encouraging a culture that is open to innovation and interaction with customers and partners. 
Required: 
Examine the above description, and identify which of the DTI operating 
models is being used by Simple Minds from the list below 
• Skynet • Data-powered 
• Customer-centric 
• Open and liquid 
8 Leadership and culture 
The business will need to ensure that it ha s staff with the right skills, that it can 
attract new recruits as necessary, that the appropriate leadership style is 
adopted, and that a digital culture is properly fostered. 
These will now be looked at in turn. 
8.1 Attracting and retaining talent in the digital age 
With increasing levels of digitisation in the workplace, 2 features have become 
apparent with regards to employing staff.

74 
1 There is much greater transparency about employment opportunities for 
those seeking a new challenge, with applicants becoming more and more 
informed thanks to increased levels of “inside information”. This has come 
about because of the presence of agencies and peer reviews . 
 
 Illustration 6 – Glassdoor 
 One of the fastest growing jobs and recruiting sites in the world, 
Glassdoor keeps over 8 million reviews on more than 423,000 companies. Information such as CEO approval ratings, interview reviews and questions, office photos, benefits and salary reports etc. can be accessed. This is all provided by employees through a peer-to-peer network. 
 
Businesses are realising that transparency needs to be encouraged, and that a mindset of “we have nothing to hide” needs to be adopted. Research shows that fostering such a business culture actually results in a more productive workforce and lower levels of staff turnover. 
2 The competition for digital talent is  increasing; there is a global skills 
shortage in this area to cope with the increasing demand. 
So what do organisations need to do to attract and retain the necessary talent? Firstly, they need to take great notice of what their staff are saying about their organisation, which can be done by monitoring social platforms such as Glassdoor, LinkedIn, and Twitter.  
Secondly, they should look to introduce a referral programme. This means 
incentivising current staff to use such online networks to refer potential new employees; if employees are incentivised in the right sort of way to champion their employer’s digital referral programme, attracting the right calibre staff becomes much easier. 
8.2 Becoming an employer of choice  
It stands to reason that the latest generation of employees, the so-called 
“millenials”, should be the main target for organisations looking to embrace a digital strategy; after all, these are the people who have grown up in the digital era – they see digital as the norm, they have the necessary skills with digital technology, and they also understand what younger customers are looking for in products and services. 
Millenials represent a generation that feels empowered to choose where and 
how they work, and employers must recognise this if they are to offer an attractive working proposition. Technology will be an important part of that proposition; the provision and use of technology is considered one of the most important factors in determining job satisfaction. However, it is not the only factor.

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 Illustration 7 – Zappos 
 Zappos is an online clothing retailer. It has a reputation for a strong 
corporate culture that employees identify with that makes them want to work for the company. This includes having a management structure that is task-orientated, rather than a more formal structure. Employees are encouraged to deal with customers in whatever way is felt appropriate, to use the Zappos Twitter account to air their thoughts, and to work wherever will let them be most creative, such as coffee bars and co-working spaces. 
So how does an organisation become an employer of choice in the digital era? 
The World Economic Forum proposes the following: 
• Formulate a long-term working strategy for millenials  – identify the 
relevant positions that employees will occupy during their career with the 
company and then create suitable promotional opportunities. 
• Work with staff to formulate company values together  – this means 
listening to, and taking note of, the aspirations of those working for the business. Senior management should do this in person, not just as a communication sent company-wide. 
• Empower the workforce – and give them incentives to perform e.g. via long term company share plans, project leadership responsibilities or training opportunities. 
• Build workspaces that attract digital talent  – this relates to the physical 
layout and appearance of the working environment. Flexibility and a dynamic appearance in the workplace inspires creativity and collaboration. Thought should also be given to allowing staff to work from home on occasions and flexible working hours.  
• Create policies that support colla boration and knowledge-sharing 
tools – this can include encouraging staff to use platforms such as 
Facebook@work, Yammer or Sprinklr, or hardware preferences such as being to use your own laptop in the workplace. 
8.3 Creating a workforce with digital skills 
In a recent survey conducted by PwC, almost three quarters of CEOs cited skills shortages as a threat to their bus inesses, and 81% claimed to be looking 
for a broader range of skills  when recruiting. Digitisati on is leading to new roles 
being created in companies, which demand different skills sets.

76 
The table below shows roles that might now be relevant for certain aspects of 
an organisation: 
 
Commercial Technology Web Marketing Facilitation HR 
E-business 
manager Scrum master Web project manager Digital marketing 
professional Service 
design 
thinker Design 
learning 
manager 
Digital account manager Data scientist Web designer Digital copywriters Content curator Digital work experience 
officer 
Digital product 
manager Chief Data 
Officer 
(CDO) Webmaster Media 
acquisition manager Editorial 
manager Employer brand 
director 
Fraud manager Data protection 
officer Developer User 
experience designer Chief 
Listening 
Officer  
In order to create a workforce with the right digital skills, organisations need to 
collaborate with educational establishments – universities, colleges, schools – with a long term view to giving students the right skills and confidence to be the employees of the future. 
 
 Illustration 8 – Lockheed Martin 
 The American aerospace and defence company Lockheed Martin has a 
programme whereby its engineers, scientists and IT professionals volunteer to meet with schoolchildren between the ages of 9 to 12 with a view to building their interest and confidence in science and technology. This is then sustained throughout school and college. 
Organisations also need to focus on making in-house training a critical activity 
within their talent management prog ramme. This will included the following : 
• Develop required competencies within the workforce  – this can be 
done by considering the skills that  are currently needed and creating 
training strategies that are adapted to these. The organisation should look 
ahead and question where the high value work is likely to be in, say, 3 years’ time compared to today, and train accordingly.  
• Mine your own organisation for hidden talent  – this will incorporate 
assessing employees’ abilities and matching these to skills required.  
• Bring new skills into the organisation – this can be done by either 
hiring new, digitally-competent staff, or running exchange programmes with other digital companies and sharing insights. Rotating staff internally to give them exposure to other aspects of the organisation is also common practice within tech giants such as Google and Amazon.

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8.4 Bringing leadership to the digital age 
In order for digitisation to work, leaders need to adapt. This may mean a 
different approach to establishing a corporate structure and also fostering an alternative culture in the workplace. Leaders need to show that they are forward-thinking and progressive, and not just rely on business practices that worked in years gone by. 
A traditional approach to structure might be hierarchical and autocratic – roles 
and responsibilities are clearly defined and work on a top-down basis. In the 
digital age leaders need to accept that  this traditional appr oach will not attract 
people of the right skills and will certainly not get the best out of them. 
As Steve Jobs once commented: “We run Apple like a startup. We always let 
ideas win arguments, not hierarchies. Otherwise, your best employees won’t stay. Collaboration, discipline and trust are vital”. 
It would therefore appear that flatter organisational structures are key to making 
digital work. 
Furthermore, a culture of being more risk-tolerant is to be encouraged. Instead 
of focussing on the mistakes of employees, the organisation should be encouraged to accept failures and to persuade staff to take higher amounts of risk. This will necessarily mean changin g the focus on how the organisation 
performs – it cannot restrict itself to just short term goals, with failure to hit annual targets being seen as career-threatening. Management need to take a longer view of performance, and instil a culture that promotes this. 
According to the World Economic Forum, CEOs should fulfil six key roles in the 
digital age: 
• Creator of vision and mission  – the company’s mission statement 
should be expanded to encompass a transformation purpose.  
• Strategic planner  – this is nothing new, but the focus will change. There 
should be a move from 5 year to 1 year planning cycles, driven by data 
and analysis. Greater focus should be on experimentation rather than long-term planning.  
• Driver of information-based business models – find and develop new 
products that are (fully) data- and information-based for scalability.  
• Enabler of the shift to  on-demand operating models  – the CEO should 
champion the benefit that can be gained from communities in the workplace, crowdsourcing and staff on demand.  
• I nnovation promoter.   
• Operational excellence driver – identify ways in which automation can 
be introduced into processes in all departments of the organisation.

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8.5 Fostering a digital culture 
Culture can be defined as the shared set of beliefs, values and mindsets that 
guide a group’s behaviours. Having the right sort of culture in place can give the organisation a sustainable competitive advantage, as competitors will find it very difficult to replicate. Mention has already been made in previous sections of this chapter about the need for a different sort of culture in the digital era, but how can this be created and adopted? 
To answer this question, leaders must first recognise what factors distinguish a 
digital culture from others. These include: 
• Having a strong mission statement and a clear sense of purpose  
• Lean business structures, with small, cross-functional teams as opposed 
to individual divisions working as separate siloes 
• A diverse workforce with good digital skills. 
Leaders can then focus on four key areas in order to move towards a digital 
culture: 
• Communication – communication by digital means needs to be 
encouraged. This should certainly not replace face to face conversations 
completely, but staff should be encouraged to communicate with each other in an honest and open style using all available digital channels – social media, blogs, forums, webcasts and videos, shared mailboxes etc.  
• Journey management  – the leadership team needs to be at the forefront 
of the cultural change. In order for this to take effect at the operational level, middle management need to be encouraged to think in different ways. Creativity needs to be released, and training should be provided so that middle managers recognise how to achieve this. Further support can come from implementing the right HR policies, rules etc.  
• Make changes visible  – visual aids such as diagrams and charts on 
office walls, highlighting the “journey” that the business is undertaking. 
• Continuous change monitoring – using tools such as feedback surveys 
and performance monitoring to highlight gains made. 
8.6 Create environments where human  and robots can work successfully 
together 
In the event that jobs are threatened by automation, employers will have to assess whether it is possible to reskill workers, either to work alongside robots or in new roles.

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8.7 Integrate your on-demand workforce 
Integrate your on-demand workforce. The most effective way to recruit on-
demand workers is through online talent platforms. The extended workforce can help improve the overall quality of the talent pool. 
All of this can be accelerated through appointing to a senior position someone 
who is already well-versed in digital culture. 
 
 Obongjayar is a bank but has chosen a disruptive approach which allows 
it operate without branches and with a significant number of ‘bots’ 
(automated process applications, using artificial intelligence). In order to stop this being a barrier to recruitment, Obongjayar has established a ‘fast-track’ development programme for its graduate recruits. The bank also offers prizes to employees if they propose a radically-different way of performing any standard banking process. 
The World Economic Forum Digital Transformation of Industries project 
(DTI) proposed a 7-step process to build a ‘digital workforce’.  
Required: 
Examine the above description and identify which TWO of the steps 
proposed by the DTI are being described from the list below 
• Attract and retain talent 
• Foster a digital culture in the enterprise 
• Create a workforce with digital skills • Become an employer of choice for millennials 
• Bring leadership into the digital age

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 Question 1 
 Sonny and the Bear (SatB) is a leading children’s fashion brand. 
Although SatB has high-street stores, it also has a vibrant and diverse e-
commerce platform which it launched in 2015. SatB also pursued organic backward vertical integration, opening a design studio and fabric manufacturing factory.  
None of those extensions to its business model was an acquisition, as 
SatB is cash-rich and chooses to pursue organic growth. It has, however, taken minority stakes in a number of small children’s fashion brands, which are given access to the SatB online platform. Other than providing a cash injection, and allowing partners to sell through its e-commerce system, SatB provides no further support. 
Industries” suggests that companies need to adopt one of (or a combination of) build, buy, partner, invest and incubate/accelerate if they wish to identify, develop and launch new business ventures. 
Examine the information above, and identify which TWO of these are 
being pursued by SatB. 
 
Option 1 Build  
Option 2 Buy  
Option 3 Partner  
Option 4 Invest  
Option 5 Incubate/accelerate

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 Question 2 
 Arlo Search (AS) began in 2001 as a search engine. Following its rapid 
growth, in this developing market sector, AS diversified into travel 
planning, cloud services and big data analytics. These moves were made by a combination of acquisition and organic growth. 
In 2011, AS opened its ‘Media Lab’ to encourage its employees to be 
‘intrapreneurs’. Any AS employee with a good idea is encouraged to submit a detailed Business Case to the innovation committee of AS. If successful, the employee is provided with resources and finance, and can spend up to 2 years developing their idea. If it is successful, the 
intrapreneur is appointed CEO of a new AS business unit to take the idea 
to market. If AS does not see a future for the innovation, the employee is permitted to buy it from AS and run it as a stand-alone business. If AS sees an external start-up with high potential, its founder(s) are offered cheap finance and the opportunity to join the Media Lab. In return, AS obtains the right to acquire all or part of the business, should that business prove successful. 
In 2018, AS formed a joint venture (AS-SD) with SearchDog Inc, another 
leading search engine provider. The joint venture aims to provide a completely safe search and email platform for users under the age of 16, free from any unsuitable content and secure from SPAM and phishing. 
Examine the information above, and identify which  of these is/are being 
pursued by AS. Select ALL that apply.  
 
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 Question 3 
 The World Economic Forum project on the Digital Transformation of 
Industries (DTI) proposed a 7-step process to build a ‘digital workforce’.  
Prioritise the following steps into the sequence proposed by the DTI. 
 
Step 1 Create a workforce with digital skills  
Step 2 Foster a digital culture in the enterprise  
Step 3 Integrate your on-demand workforce  
Step 4 Attract and retain talent  
Step 5 Create environments where humans and robots 
can work successfully together  
Step 6 Bring leadership into the digital age  
Step 7 Become an employer of choice for millennials  
   
 Question 4 
 Aldous Harding is an online provider of fitness information services. 
Named after its founder, a successful athlete who won a gold medals at 
three successive Paralympics, Aldous Harding sells its services through a subscription-only smartphone application. 
Since its foundation, Aldous Harding has widened its service offering 
considerably. Originally only tracking ‘steps’, and mapping users’ walking and running, the app now integrates with most commercially-available smart watches and fitness trackers, as well as the modern equipment used in up-market gyms. The app is also able to track users playing sports as diverse as football and golf, analysing their performance and recommending a tailored fitness regime. Gym users particularly like the way that the Aldous Harding app sets them daily challenges and helps them to achieve their fitness goals. 
The Aldous Harding app, in common with others available, gathers a 
huge volume of data from other systems. However, the Aldous Harding app is characterised by the way it encourages feedback and suggestions from subscribers. In return for suggesting changes and improvements, Aldous Harding subscribers are rewarded with discounts on their app subscription and on fitness-related goods. ‘Power users’ (those who make a lot of suggestions) also receive Aldous Harding branded sportswear. An Aldous Harding cap is widely regarded as a prestige possession, as it cannot be purchased. 
Industries (DTI) identified five successful digital operating models. They replace rigid approaches to technology, data and processes with flexibility, while also encouraging a culture that is open to innovation and interaction with customers and partners.

84 
models is being used by Aldous Harding. 
 
Option 1 Customer-centric  
Option 2 Extra-frugal  
Option 3 Data-powered  
Option 4 Skynet  
Option 5 Open and liquid  
   
 Question 5 
 Cate is a Non-Executive Director of King Tubby, and Chair of its Risk 
Committee. The Board is currently discussing a major proposed investment in ‘cloud and mobile’ technologies.  
Cate has strongly made the case for the investment, stressing the 
argument that King Tubby needs a radical change to its business model if it is to deter the foreign competition currently threatening entry into King Tubby’s market. 
Examine the description above, and identify which of those abilities is being demonstrated by Cate. 
 
Option 1 Inspirational leadership  
Option 2 Business judgement  
Option 3 Influence external parties  
Option 4 Collaboration

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 Traditional financial services providers need to meet the threat from 
Fintech head on. There are a number of defences that they are 
employing to fight back against this emerging threat such as: 
• Improving their own services in order to, for example, promote a 
more personal service that differentiates from the impersonal 
Fintech products. 
• Offering more flexible products that are tailored to individual needs. 
• Offer additional services not av ailable via Fintech (such as the 
ability to use a physical location for cashing services). 
• Seek out legislative help – the financial services industry is heavily 
regulated but many Fintech businesses fall outside the scope of 
current legislation. Traditional banks want to have more and tougher legislation of Fintechs, arguing that this will level the playing field for everyone. 
• Relying on technophobia and hoping that a few bad actors in the 
Fintech market will destroy consumer confidence and bring consumers back to the relative safety of traditional lenders (though there is no evidence yet that this will happen). 
• Better environmental analysis so that Fintech opportunities and 
threats are recognised and acted upon much earlier. 
• Launching their own Fintech divisions or acquiring growing Fintech 
businesses. 
 
Option 1 Fintech  
Option 2 Disaggregation  
Option 3 Competence sharing  
Option 4 Disruptive technology X 
Explanation Disruptive technology relates to instances where 
technology is used to fundamentally change and ‘disrupt’ the existing business model in an industry.

86 
  
Option 2 The Internet of Me X 
Option 4 The intelligent enterprise X 
Option 5 The outcome economy X 
 2 Outcome economy – organisations have an increased ability to 
measure the outcomes of the services that they deliver; customers 
are more attracted to outcomes than just simply to products, and this is what organisations should focus on. 
4 The intelligent enterprise – using data in a smart way enables 
5 Workforce reimagined – whilst greater use is made of smart 
machines, the role of human beings is not being removed altogether; they are simply being used in a different way. Ways need to be identified in which man and machines can work effectively together to create better outcomes. 
The IoT is the connected network of consumer and industrial non-IT hardware. It includes, but is not limited to, vehicles, factory machinery, domestic appliances and buildings. 
The learning organisation was a concept proposed by Senge, in the 
1990s.

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Option 1 Establishing a strategic direction  
Option 2 Building talent  
Option 3 Collaboration  
Option 4 Inspirational leadership  X 
digital, or to survive digital disruption within its industry, the executive 
leadership team will need to demons trate a number of abilities: 
management, but probably on a bigger and quicker scale than the organisation will typically be used to . The leadership team will need 
to energise the workforce and inspire confidence that digitisation is the right way forwards and is being carried out in the right way. The move to digital will only succeed if those at the top of the organisation take ownership and persuade others to commit to the change. 
3 Establishing a strategic direction – this is probably something that the business has done for a long time, but a digital strategy may require it to be done in a different way. For example, the planning horizon may need to be shortened, or greater flexibility introduced – 
perhaps a move away from the rational model to a more emergent approach, which would enable the business to adapt as time passes. 
4 Influence external parties  – for example, providers of finance. 
Raising capital is likely to be necessary, but showing how that capital may be applied and the value that will result might be more problematic. Will investing in cloud technology deliver increased shareholder wealth? If so, how much? And when? There will be greater uncertainty over outcomes, and the leaders of the business will need to be persuasive and articulate a compelling value proposition.

88 
 5 Collaboration  – as has already been mentioned earlier in this text, 
the organisation will need to see itse lf as part of a wider ecosystem 
if it is to deliver the requisite value. This will require careful thought 
on who to collaborate with and how each part of the ecosystem will contribute. 
6 Business judgement  – what sort of business model will the 
organisation need to put in place? It is probable that an altogether different model to what has worked in the past will be required. 
7 Execution – having determined what technologies can help to drive the business forwards, thought must then be given to how these can be used most effectively by the people within the business. People and technology need to work in harmony to produce the desired outcomes. Careful thought must also be given to how the execution of the digital strategy and transformation is to be managed. For example, what sort of metrics (or KPIs) need to be put in place? What benchmarks should be adopted as a successful outcome? 
Building talent  – it will be critical to identify the skills that staff will need 
to demonstrate and to manage training/recruitment to ensure that the business has those skills. New roles are likely to be required, including at the most senior level – for example, perhaps a new board position of Chief Digital Officer. 
 
Option 2 Invest  
Option 3 Buy X 
Option 4 Partner  
Buy 
Buying another company is usually the most appropriate path when there 
is a strategic imperative to ‘own’ a market and may be the only viable option if a significant change market is imminent, hiring the right talent is not possible or the new opportunity bears little relation to the firm’s current business. Similarly engaging early with a digital disruptor is important to wrong-foot the competition and minimise the investment needed.

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Option 1 Skynet  
Option 2 Data-powered  
Option 3 Customer-centric X 
Option 4 Open and liquid  
The five DTI business models are: 
• Customer-centric . This model focuses on making customers’ lives 
easier and emphasizes front-office processes. Leading exponents 
include the UK retailer Argos, but it can be applied across industries. It works best with a culture that puts the client first and a decentralized structure that empowers frontline staff. 
• Data-powered . This model is built around prowess in analytics and 
software intelligence. Epitomized by Google and Netflix, data-powered companies have an agile culture focused on innovation through empirical experimentation.  
 • Skynet . Named after the conscious, artificial general intelligence of 
the Terminator films, this model makes intensive use of machines to increase productivity and flexibilit y in production. Pioneered by 
enterprises such as Amazon and Rio Tinto, Skynet organizations are characterized by an engineer-led culture dedicated to automation.  
Open and liquid. This model looks outward with a view to creating an ecosystem that can enrich the customer proposition. Built around a sharing customer, all processes in organizations of this kind are characterized by a constant flow of dialog with the outside world.  
Examples include Facebook and PayPal.

90 
  
Option 1 Attract and retain talent  
Option 2 Foster a digital culture in the enterprise X 
Option 3 Create a workforce with digital skills  
Option 4 Become an employer of choice for millennials X 
Option 5 Bring leadership into the digital age  
 
2 Become an employer of choice for millennials. Initiatives to boost 
the recruitment of millennials include identifying where their digital 
skills will best fit in the organization, offering career development 
programmes  and building workspaces designed to attract digital 
talent. 
5 Foster a digital culture in the enterprise. Factors that set a digital 
company’s culture apart include a strong sense of purpose and a diverse high-quotient digital workforce. Leadership needs to 
release people’s creativity  and apply lean start-up methodologies 
such as hackathons and design thinking
. 
 
 Question 1 
  
Option 1 Build X 
Option 4 Invest X 
Option 5 Incubate/accelerate  
 
 Build  
Building new business models might be the best route when an 
opportunity is related to the company’s core business. The benefits are that it typically maximises control and minimises costs in markets that a company must own because of their strategic importance. If companies decide to go for the build route, they can benefit by creating and developing new products and services. 
Invest  
established company to connect with the right skills and capabilities. It will also avoid hindering entrepreneurial forces with a setup focused on internal governance and reporting.

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 Question 2 
  
Option 2 Buy X 
Option 3 Partner X 
Option 5 Incubate/accelerate X 
Build  
opportunity is related to the company’s core business. The benefits are that it typically maximises control and minimises costs in markets that a 
company must own because of their strategic importance. If companies 
decide to go for the build route, they can benefit by creating and developing new products and services. 
Buy 
is a strategic imperative to ‘own’ a market and may be the only viable option if a significant change market is imminent, hiring the right talent is not possible and the new opportunity bears little relation to the firm’s current business model may provide reasons to buy. Similarly engaging early with a digital disruptor is important to wrong-foot the competition and minimise the investment needed. 
Partner 
A firm can use partnering with a digital disruptor to learn more about the 
market and its partner’s model. A partnering approach is sensible when it makes sense to learn about emergent opportunities, with an eye toward deeper partnerships or acquisitions in the future. Companies need to develop a more flexible and open mind-set toward partnerships; which are expected to play an important role in the digital transformation of market players. 
Invest  

92 
 Incubate/accelerate  
Investment and incubation/acceleration might seem similar endeavours. 
The latter however represents a closer relationship to the funding company, deploying corporate internal capabilities, infrastructure and resources to the start-ups. Having said that, incubators and accelerators need to precisely outline both internal benefits and incentives for start-ups and entrepreneurs, and a clear strategy and vision. 
 
 Question 3 
  
Step 1 Create a workforce with digital skills 3 
Step 2 Foster a digital culture in the enterprise 5 
Step 3 Integrate your on-demand workforce 7 
Step 4 Attract and retain talent 1 
Step 5 Create environments where humans and 
robots can work successfully together 6 
Step 6 Bring leadership into the digital age 4 
Step 7 Become an employer of choice for millennials 2 
 
1 Attract and retain talent. Attracting and retaining talent starts by 
listening to what employees are saying about a firm, both externally and internally. Referred employees perform better, so enterprises should incentivize their employees to use online networks to refer potential employees. 
the recruitment of millennials include identifying where their digital skills will best fit in the organizati on, offering career development 
programmes and building workspaces designed to attract digital talent. 
3 Create a workforce with digital skills. Organizations need to actively 
develop the skills they need in-house by making training a critical component of their talent management strategy. Bring new skills into the organization by hiring digital leaders and digital natives. 
4 Bring leadership into the digital age. Leaders need to hire people 
with digital mindsets and a willingness to challenge the status quo. A possible way for organizations to facilitate change at the top is by 
creating technology immersion workshops or advisory committees for boards.

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 5 Foster a digital culture in the enterprise. Factors that set a digital 
company’s culture apart include a strong sense of purpose and a 
diverse high-quotient digital workforce. Leadership needs to release people’s creativity and apply lean start-up methodologies such as hackathons and design thinking. 
6 Create environments where humans and robots can work 
successfully together. In the event that jobs are threatened by automation, employers will have to assess whether it is possible to reskill workers, either to work alongside robots or in new roles. 
7 Integrate your on-demand workforce. The most effective way to 
recruit on-demand workers is through online talent platforms. The extended workforce can help improve the overall quality of the talent pool. 
 
 Question 4 
  
Option 5 Open and liquid X 
• Extra-fruga l. This model thrives on a culture of ‘less is more’ and a 

94 
 • Skynet . Named after the conscious, arti ficial general intelligence of 
the Terminator films, this model makes intensive use of machines to 
increase productivity and flexibilit y in production. Pioneered by 
• Open and liquid . This model looks outward with a view to creating 
an ecosystem that can enrich the customer proposition. Built around a sharing customer, all processes in organizations of this kind are characterized by a constant flow of dialog with the outside world. Examples include Facebook and PayPal. 
 
 Question 5 
  
Option 2 Business judgement X 
Option 4 Collaboration  
In order for an organisation to properly take advantage of a move to digital, or to survive digital disruption within its industry, the executive leadership team will need to demons trate a number of abilities: 
2 Competitive edge – not only will the leadership need to motivate others within the organisation to see the digital transformation as the right strategy; they will also have to persuade people to potentially 
change their mindset. The need to adopt an inquisitive attitude, to 
be prepared to innovate and think outside the box, to experiment and to learn from failures may not be second nature to some, but is likely to be critical in transforming successfully to digital. 
3 Establishing a strategic direction  – this is probably something 
that the business has done for a long time, but a digital strategy may require it to be done in a different way. For example, the planning horizon may need to be shortened, or greater flexibility introduced – 
perhaps a move away from the rational model to a more emergent approach, which would enable the business to adapt as time passes.

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Raising capital is likely to be necessary, but showing how that 
capital may be applied and the value that will result might be more problematic. Will investing in cloud technology deliver increased shareholder wealth? If so, how much? And when? There will be greater uncertainty over outcomes, and the leaders of the business will need to be persuasive and articulate a compelling value proposition. 
5 Collaboration  – as has already been mentioned earlier in this text, 
if it is to deliver the requisite value. This will require careful thought on who to collaborate with and how each part of the ecosystem will contribute. 
7 Execution – having determined what technologies can help to drive the business forwards, thought must then be given to how these can be used most effectively by the people within the business. People and technology need to work in harmony to produce the desired outcomes. Careful thought must also be given to how the execution of the digital strategy and transformation is to be managed. For example, what sort of metrics (or KPIs) need to be put in place? What benchmarks should be adopted as a successful outcome?  
Building talent – it will be critical to identify the skills that staff will need to demonstrate and to manage training/recruitment to ensure that the business has those skills. New roles are likely to be required, including at the most senior level – for example, perhaps a new board position of Chief Digital Officer.

97 
Leadership and 
B1: Compare and contrast 
different types of leadership and management styles (a) Different leadership 
concepts 
(b) Types of leadership 
(c) Leadership in different 
contexts 
• Power, authority, delegation and empowerment 
• Contingent and situational leadership 
• Transactional and transformational leadership 
•  Leadership of virtual teams 
• Leadership and ethics. 
 
  Chapter 
4

Leadership and management 
98 
 
2  The difference between leadership and management 
Sometimes the terms management and leadership are used interchangeably. 
There is, however, a difference between the two and it does not follow that every leader is a manager, or that every manager is a leader. 
Leadership 
Leadership can be viewed as providing direction, creating a vision, and then 
influencing others to share that vision and work towards the achievement of organisational goals. Leadership can be seen as 'getting other people to do things willingly' and can occur at all different levels within the organisation. 
We will look at leadership in mo re detail later in  the chapter. 
Management 
Management is the process of getting things done through the efforts of other 
people. It focuses on procedures and results. Managers tend to react to specific situations and be more concerned with solving short-term problems. Management suggests more formality and the term 'manager' refers to a position within a structured organisation with prescribed roles. 
A century ago, in 1916, Fayol  identified the common features of management. 
These are still relevant to management today.

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He identified the common features as: 
• Planning  
• Organising  
• Co-ordinating 
• Commanding 
• Controlling . 
More recently, in 1989, Mintzberg  identified the ten roles which managers fulfil 
in the course of their job. These are divided into three groups: 
• Interpersonal 
• Informational 
• Decisional. 
 
Interpersonal 
Figurehead Symbolic role in which the manager is obliged to carry out 
social, inspirational, legal and ceremonial duties. 
Leader This relates to the manager’s relationship with subordinates, 
especially in allocating tasks, hi ring, training and motivating 
staff. 
Liaison The manager must develop a network of contacts outside the 
chain of command through which information and favours can 
be traded for mutual benefit. 
Informational 
Monitor The manager collects and sorts out information which is used 
to build up a general understanding of the organisation and its environment as a basis for decision making. 
Disseminator The manager is responsible for distributing information to 
those who need it. 
Spokesperson The manager is responsible for transmitting information to 
various external groups by acting in a PR capacity, lobbying for the organisation, informing the public about the organisation’s performance, plans and policies. 
Decisional 
Entrepreneur The manager should be looking continually for problems and 
opportunities when situations requiring improvement are discovered. 
Disturbance handler The manager has to respond to pressures over which the department has no control.

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Resource 
allocator The manager must choose from among competing demands for money, equipment, personnel and management time. 
Negotiator The manager must take charge when their organisation 
engages in negotiations with others. In these negotiations, the manager acts as a figurehead, spokesperson and resource allocator. 
3  Important concepts in management 
Individuals within the workplace have different relationships with each other. To be able to analyse the nature of management relationships it is necessary to understand a number of important concepts. 
• Power 
• Authority 
• Responsibility 
• Accountability 
• Empowerment 
• Delegation. 
Power 
Power is the capacity to exert influence, to make someone act according to 
your own preferences. 
Types of power 
French and Raven  identified five possible bases of a leader's power: 
• Reward power . A person has power over another because they can give 
rewards, such as promotions or financial rewards. 
• Coercive power . This power enables a person to give punishments to 
others: for example, to dismiss, suspend, reprimand them, or make them 
carry out unpleasant tasks. 
Reward power and coercive power are similar but limited in application 
because they are limited to the size of the reward or punishment that can be given. For example, there isn't much a manager could get a subordinate to do for a $5 reward, but there are many, many things they might do for a $50,000 reward.

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• Referent power. This is based upon the identification with the person 
who has charisma, or the desire to be like that person. It could be regarded as 'imitative' power which is often seen in the way children imitate their parents. Think of the best boss you've ever had and consider what you liked about them and if it encouraged you to act in a similar way. 
Psychologists believe that referent power is perhaps the most extensive 
since it can be exercised when the holder is not present or has no intention of exercising influence. 
• Expert power . This is based upon doing what the expert says since they 
are the expert. You will have a measure of expert power when you join CIMA. People will do as you suggest because you have studied and have qualified. However expert power only extends to the expert's field of expertise. 
• Legitimate power. This is based on agreement and commonly-held values which allow one person to have power over another person. For 
example, an older person, or one who has longer service in a company. In 
some societies it is customary for a man to be the 'head of the family', or in other societies elders make decisions due to their age and experience. 
 
Case study style question 1 
 G, the senior partner of LMN, a medium sized accountancy firm, has 
worked for LMN for over twenty years and has a sound knowledge and understanding of the different activities of the company’s business. Over the years, G has become known for his fairness in how he manages staff. He is also well liked and respected for his enthusiastic approach. He always has time to encourage and mentor younger members of staff. 
The company has recently invested in new technology which will improve 
the effectiveness of its office systems, but will mean the roles and responsibilities of the support staff will change. G has taken on the unenviable role of leading the project to introduce the technology and new working practices. He knows that the project will be met with resistance from some members of staff and he will need to draw on various sources of power to ensure the changes are successfully implemented. 
Required: 
Write an email to G explaining the different sources of power that he has 
which will help him in introducing the changes. 

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Authority 
Authority is the right to exercise power  such as hiring and firing or buying and 
selling on behalf of the organisation; the right that an individual has to require 
certain actions of others; the right to do or act. 
Max Weber  proposed that authority legitimises the exercise of power within the 
structure and rules of the organisation. Hence, it allows individuals within an 
organisation to issue instructions for others to follow. Weber defined three bases for such authority as follows: 
Charismatic authority . Here the individual has some special quality of 
personality which sets them apart. Because the charismatic power in the 
organisation is so dependent on the individual, difficulties arise when he or she has to be replaced. Unless someone else is available, who also possesses the necessary charisma, the organisation could start to fail or may have to change to another form. 
Traditional authority . This authority is based upon custom and practice. The 
personality of the individual is irrelevant as he or she inherits their authority 
because of the long-standing belief in the natural right to ‘rule’ which is sometimes handed down. 
Rational-legal authority . Here the authority comes from the individual's 
position in the organisation chart. The ability to perform particular functions and 
their operations is based on following a set of written rules. This authority is not personal but is vested, impersonally, in the position held. This is Weber's classic bureaucracy which will be considered later in the chapter. 
 
The link between authority and power bases  
 Weber’s three types of authority (charismatic, traditional and rational-
legal) can be linked to the French and Raven power bases as follows: 
Power base Authority base 
Coercive and Legitimate Traditional Reward and Referent Charismatic Expert Rational-legal 
  
Responsibility 
Responsibility involves the obligation of an individual who occupies a 
particular position in the organisation to perform certain duties, tasks or 
make certain decisions.  
Responsibility means the right to hold subordinates accountable for personal performance and achievement of the targets specified by the organisation's plans. It is the obligation to use authority to see duties are performed. 
 
 The scope of responsibility mu st correspond to the scope of 
authority given

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All managers should have both responsi bility and authority appropriate to their 
role. If these are not in balance, it can cause serious problems. 
Responsibility without authority. This may occur when a manager is held 
responsible for, say, timekeeping, but does not have the authority to discipline subordinates who are regularly late. The manager is likely to become frustrated and demotivated as they lack the power and authority needed to meet the targets they have been made responsible for. 
Authority without responsibility.  This may occur where an HR department 
has the authority to employ new members of staff, but are not held responsible 
for the quality of the employees that they have selected. Managers who are not made accountable for their decisions and actions may act irresponsibly, as they do not expect to suffer any negative consequences. 
Accountability 
Accountability describes the need for individuals to explain and justify any 
failure to fulfil their respons ibilities to their superiors  in the hierarchy. It 
refers to being called to account for one's actions and results. Empowerment 
Employee empowerment is where employees are given autonomy and 
responsibility to undertake tasks without  being directed at each step by 
management . To be able to empower staff, management has to have trust in 
their capabilities and be willing to allow employees to make decisions, within set 
limits. 
Companies can benefit from empowering staff as the managers will not feel the 
need to micro-manage every aspect of the employees behaviour, which should free up management time. From the point of view of the employees, they will feel valued and motivated. 
To promote empowerment, managers should: 
• Set clear boundaries and ensure employees know what is expected from 
them 
• Actively encourage employee development • Communicate openly with employees and adopt and open-door policy 
• Allow employees to contribute and listen to their views 
• Offer regular feedback 
• Lead by example.

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Delegation 
Delegation is one of the main functions of effective management. It is the 
process whereby managers assign part of their authority to a subordinate to fulfil their duties. However, delegation can only occur if the manager initially possesses the authority to delegate. 
 
 Responsibility can never be delegated. 
A superior is always responsible for the actions of his subordinates and cannot evade this responsibility by delegation. 
Benefits of delegation 
There are many practical reasons why managers should delegate: 
• Without it the chief executive would be responsible for everything and 
individuals have physical and mental limitations. 
• Allows for career planning and development, aids continuity and cover for 
absence. 
• Allows for better decision making; those closer to the problem make the 
decision, allowing higher-level managers to spend more time on strategic 
issues. 
• Allowing the individual with the ap propriate skills to make the decision 
improves time management. 
• Gives people more interesting work, increases job satisfaction for 
subordinates; increased motivation encourages better work. 
Reluctance to delegate 
Despite the benefits many managers are reluctant to delegate, preferring to 
deal with routine matters themselves in addition to the more major aspects of their duties. There are several reasons for this: 
• Managers often believe that their subordinates are not able or experienced 
enough to perform the tasks. 
• Managers believe that doing routine tasks enables them to keep in touch 
with what is happening in the other areas of their department. 
• Where a manager feels insecure they will invariably be reluctant to pass 
any authority to a subordinate. They may fear that the subordinate will do 
a better job than they can. 
• Some managers do not know how or what to delegate. 
• Managers fear losing control. 
• Initially delegation can take a lot of a manager's time and a common 
reason for not delegating is that the managers feel they could complete 
the job quicker if they did it themselves.

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Effective delegation 
Koontz and O'Donnell  state that to delegate effectively a manager must: 
• define the limits of authority delegated to their subordinate. 
• satisfy themselves that the subordinate is competent to exercise that 
authority. 
• discipline themselves to permit the subordinate the full use of that 
authority without constant checks and interference. 
In planning delegation therefore, a manager must ensure that: • Too much is not delegated to totally overload a subordinate. 
• The subordinate has reasonable skill and experience in the area 
concerned. 
• Appropriate authority is delegated. • Monitoring and control are possible. 
• There is not a feeling of 'passing the buck' or 'opting out'. 
• All concerned know that the task has been delegated. 
• Time is set aside for coaching and guiding. 
 
Methods of delegation  
 There are different methods of delegation, which vary in effectiveness: 
• Abdication . This leave issues without any formal delegation, which 
is very crude and usually an ineffective method. 
• Custom and practice . This is an age-old system, the most junior 
member of staff opens the mail, gets the coffee and so on. 
• Explanation . The managers brief subordinates along the lines of 
how the task should be done. (not too little and not too much – a 
fine balance that requires judgement). 
• Consultation . Prior consultation is considered to be important and 
very effective. People, if organised, are immensely powerful; by contributing or withholding their cooperation they make the task a success or failure. Managers admit that sometimes good ideas come from below. In fact the point of view of the person nearest the scene of action is more likely to be relevant.

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 Case study style question 2 
 H has for some time been in charge of a department which was 
producing satisfactory results before he took over. However, recently, 
several of his staff have asked whether similar jobs in other departments are available. There have also been a number of unexpected mistakes, and information has not been transmitted properly. 
You are H’s manager. As a result of your concern you have been keeping 
an eye on the situation. You have found that H comes in early every day, stays late, takes large amounts of work home with him, and is showing definite signs of strain. In the meantime, his staff appear bored and 
disinterested. You have arranged a meeting with H to discuss these 
issues. 
Required: 
Write briefing notes for the meeting covering the following:
  
(a)  Describing the possible causes of this situation. 
(10 minutes) 
(b) Explaining the principles for effective delegation. 
(c) Commenting on the advantages to both manager and subordinate 
of effective delegation. 
(10 minutes)

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4  Classical and contemporary theories of management 
The study of management theory and development of ideas on effective 
management practice helps in providing an understanding of the principles underlying the process of management and which in turn influences management behaviour in organisations. The main schools of management thinking can be grouped according to their broad approaches as shown below: 
 
Classical theories 
The classical approach to management emphasises the technical and 
economic aspects of organisations. It assumes that behaviour in organisations is rational and logical. There are different approaches within the Classical School which can be identified as Scientific Management ( Taylor ) and 
Bureaucracy ( Weber ). 
The foundation on which the various theories developed was that management could be learnt and codified. These ideas were developed in an era when mass production and economies of scale were viewed as central to business success. Although some of these theories were developed over a century ago they do continue to inform management practice today.

108  
There are some common interests that all these different perspectives focus on: 
• The purpose and structure of organisations and planning of work. • The technical requirements of each job. 
• The principles of management. 
Scientific management (Taylor) 
The objective of management is to secure the maximum prosperity for both 
employer and employee: 
• One best approach to the job, using work study methods 
• Once employees were trained in the best approach then payment should 
be based on piece-rate (believed money to be a motivator) 
• Well-trained employees delivered high productivity 
• Win:win for both employee and organisation. 
Taylor recognised that if specialised knowledge and skills were concentrated in 
the hands of well-trained and able employees, there would be an improvement in productivity. He therefore broke jobs down into separate functions and then 
gave each function to an individual. Taylor believed that it was only through the 
effective use of control by specialists that best use would be made of the resources available. 
 
Relevance today 
Scientific management provided the basis for time and motion studies and work 
study that still seek to define the 'best' way of performing a task. However, 
many firms now recognise that for some tasks there may not be a single best 
way and that a more flexible approach is needed. 
Furthermore, most modern theories would see money as just one factor in a 
more complex understanding of motivation. 
Bureaucratic management (Weber)  
Max Weber developed his model of the ‘ideal type’ of bureaucracy, in which he explored the characteristics of a rational form of organisation. Today, the term bureaucracy tends to have many negative connotations, but Weber used it to describe what he believed to be potentially the most efficient form of organisation. 
Weber's bureaucracy is based on formalisation and standardisation. 
• Based on hierarchy of authority 
• Strict rules and regulations govern decision making 
• Specialisation in duties, segregated 'offices' and levels.

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Nowadays, most large organisations will have some levels of bureaucracy, 
particularly where repetitive administrative tasks are performed. Because of the 
formal nature of this type of organisation, the main disadvantages are: 
• slow response to change, as many rules have to be followed 
• lack of speedy communication owing to the segregated ‘offices’ and levels 
• little need for involving staff in decision-making 
• rules stifle initiative and innovative ideas, preventing development 
• no recognition of very important informal relationships. 
This type of organisational culture is not suitable if the firm operates in a 
dynamic changing environment . 
 
 The main characteristics of bureaucracy   
 Weber listed the main characteristics of bureaucracy: 
• Specialisation . Clear division of labour, so that each member has 
well-defined roles and responsibilities. 
• Hierarchy . A hierarchy of authority, in which offices are linked 
through a clear chain of command. 
• Rules . Strict rules and procedures govern decision-making and 
conduct. 
• Impersonality . Objective and rational decisions rather than 
personal preferences. 
• Appointed officials . Managers are selected by their qualifications, 
education or training. 
• Career officials . Managers pursue their career within the 
bureaucracy and work within a defined salary structure. 
• Full-time officials . Professionalism requires commitment. 
• Public/private division . Money is used in a limited liability 
framework to prevent family money being used, as this creates 
conservatism because of personal risk.

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5  The human relations school 
In the 1930s researchers started studying the behaviour of people in groups. 
While the classical theories viewed workers as components in the system, and focused on processes and procedures, these researchers started looking at the effects of social interaction on motivation and productivity. This was the beginning of Human Relations School. 
Herzberg 
Frederick Herzberg looked at the identification of the motivational needs of 
individuals. His two factor theory describes motivational and hygiene factors. 
• Hygiene factors  are based on a need to avoid unpleasantness. They do 
not provide any long-term motivating power. A lack of satisfaction of 
hygiene factors will demotivate staff. 
• Motivational factors (motivators) satisfy a need for personal growth. 
Satisfaction of motivator factors can encourage staff to work harder. 
Herzberg believed that only motivators can move employees to action, the 
hygiene factors cannot. They can only prevent dissatisfaction. 
In order to motivate the workforce management must avoid dissatisfaction and 
put in place motivators to encourage the staff. 
Hygiene factors 
To avoid dissatisfaction there should be: 
• Policies and procedures for staff treatment. • Suitable level and quality of supervision. 
• Pleasant physical and working conditions. 
• Appropriate level of salary and status for the job. 
• Team working. 
Motivational factors 
In order to motivate staff managers should provide: 
• Sense of accomplishment (achievement) through setting targets. • Recognition of good work. 
• Increasing levels of responsibility. 
• Career advancement. 
• Attraction of the job. 
Herzberg felt that 'you can't motivate dissatisfied people' . Satisfiers or 
motivators will only generate job satisfac tion if the hygiene factors are present.

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 Herzberg’s theory of motivation illustration  
 CDE Local Authority employs around 8,000 members of staff. It operates 
as a traditional, formal governmental type of organisation. Over the last 
few years it has recognised a problem regarding its junior management level in that many of them are failing to meet the expected level of performance. 
A team has been set up to investigate the problem and they have 
decided to hold a series of meetings with all levels of management. Initially they found that the junior managers were reluctant to participate in the meetings, saying that they could see no real value in them. ‘We 
have seen it all before’ was a typical response. After the meetings, the 
team produced a report which identified three main problem areas. 
Firstly, it became apparent that the level of morale for all staff was low. 
Lack of facilities and pressure of work appeared to be the main grievance. There appeared however to be a deeper problem, that of mistrust between the staff as a whole and senior management. The reason for this was unclear. 
The second problem appeared to be that junior managers were regarded 
by staff as poor at managing their sections. In response, the junior managers said that their positions in general were unclear; there were no clear lines of authority, command or responsibility which allowed them to make decisions for their departments. In addition many quoted their roles as being menial and highlighted funding shortages, unrealistic targets, little recognition of their position, no job descriptions and lack of training as problems. 
Job security was the third issue. Financial cutbacks and changes in 
service levels had led to rumours of substantial cutbacks in staff. Rumours were especially strong amongst the junior management. It was felt that new, younger staff would be better trained and would be likely to replace them. 
In all, the problems had shown themselves in high labour turnover, which 
in addition to the problems already outlined, were blamed on low salaries, little opportunity for personal advancement and poor working conditions. 
Using Herzberg’s theory of motiva tion, the attitude of the junior 
managers can be explained as follows: The case illustrates Herzberg’s motivation theory, which attempts to 
explain those factors which motivate the individual by identifying and satisfying the individual’s needs, desires and the goals pursued to satisfy these desires. 
This theory is based upon the idea that motivation factors can be 
separated into hygiene factors and motivation factors and is therefore often referred to as a ‘two need system.’ These two separate ‘needs’ are the need to avoid unpleasantness and discomfort and, at the other end of the motivational scale, the need for personal development.

112  
 A shortage of those factors which positively encourage employees 
(motivating factors) will cause those employees to focus on other, non-job 
related factors, the so called ‘hygiene’  factors. These are illustrated in the 
case with the attitude of the junior management to senior management and their concerns for example with shortages, targets, recognition and training and ‘we’ve seen it all before’. 
The most important part of this theory of motivation is that the main 
motivating factors are not in the environment but in the intrinsic value and satisfaction gained from the job itself. It follows therefore that the job itself must have challenge, scope for enrichment and be of interest to the job holder. This is not the case in the scenario; there appears to be little or no intrinsic satisfaction from the junior manager’s work, illustrated by them regarding themselves and their role as menial and their lack of responsibility and decision making power s within their own departments. 
Motivators (or ‘satisfiers’) are those factors directly concerned with the satisfaction gained from the job itself, the sense of achievement, level of recognition, the intrinsic value felt of the job itself, level of responsibility, opportunities for advancement and the status provided by the job. Motivators lead to satisfaction because of the need for growth and a sense of self achievement. Clearly, none of this applies to the junior managers of CDE Local Authority. 
A lack of motivators leads to over concentration on hygiene factors; that 
is those negative factors which can be seen and therefore form the basis of complaint and concern. 
Hygiene (or maintenance) factors lead to job dissatisfaction because of 
the need to avoid unpleasantness. They are so called because they can in turn be avoided by the use of ‘hygienic’ methods i.e. they can be prevented. Attention to these hygiene factors prevents dissatisfaction but does not on its own provide motivation. Hygiene factors (or ‘dissatisfiers’) are concerned with those factors associated with, but not directly a part of, the job itself. These can be detected in the scenario; salary and the perceived differences with others, job security, working conditions, the quality of management, organisational policy and administration and interpersonal relations. 
Understanding Herzberg’s theory identifies the nature of intrinsic 
satisfaction that can be obtained from the work itself, draws attention to job design and makes managers aware that problems of motivation may not necessarily be directly associated with the work.

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 Maslow’s hierarchy of needs 
 Maslow developed a hierarchy of needs, shown below. 
 
According to the model, each individual has a set of needs which can be 
arranged in a hierarchy. The above diagram has shown the hierarchy in a business context. The largest and most fundamental needs, such as basic pay and safe working conditions are shown at the bottom, and the need for self-actualisation/self-fulfilment is at the top, moving through aspects such as job security, friendships at work and status. 
The lowest needs must be satisfied first, only then can an individual move 
to the next level. This can be used as a motivational tool, if the 
management can determine where individuals are on the hierarchy, they 
will know that the next level can be used in motivating staff. 
6  Systems theory 
Systems theory is an approach to organisational work design which takes account of social aspects and technical aspects. It looks at the interaction between people and technology within the organisation. 
Trist and Bamforth 
Trist and Bamforth developed a socio-technical systems theory. While he was 
working at the Tavistock Institute, Tris t’s most famous research was into the 
structure and operation of the 'longwall’ method of mining in County Durham in the 1940s as it highlighted the interaction between social needs and technological activities. The 'longwall' method introduced new cutting equipment which widened the narrow coal ‘face’ into a ‘longwall’. But very soon the low morale, high absenteeism and deteriorating relationships were so serious that the Tavistock Institute was invited to investigate causes and possible solutions to the problems.

114  
Trist and Bamforth diagnosed that although the new methods had been 
introduced ‘scientifically’: 
• close-knit groups had been broken up • communication was difficult because of the geographical spread of 
workers 
• new payment schemes caused jealousy among the workforce • too much specialisation and individuality was built into the jobs. 
The mine owners had not considered the effects on the workforce, showing an 
ignorance of individual and group needs at work, especially in such a traditionally close-linked occupation as mining. The social and technological factors are interlinked and cannot be treated in isolation. Managers should note that this interaction between the technical and social aspects of work, if ignored, will inevitably bring problems. 
7  Contingency theory 
Managers, researchers and consultants often found that the methods suggested by the classical management schools did not always work. The idea of one approach being right, whether it be the school of scientific management, classical, human relations or systems, is rejected in favour of contingency. The contingency view suggests that the effectiveness of various managerial practices, styles and techniques will vary according to the particular 
circumstances of the situation . 
Mechanistic versus Organic Orga nisations (Burns and Stalker)  
Burns and Stalker (1961) distinguished between mechanistic and organic organisations. Burns is quoted as saying: ‘The beginning of administrative wisdom is the awareness that there is no one best way of designing a management system.’ Burns and Stalker studied the way in which high-technology industries were being introduced into Scotland. The difficulties experienced by low-technology companies in the conversion process to high technology highlighted many organisation structural problems. 
Burns and Stalker’s studies led them to distinguish between two major types of 
organisations (mechanistic and organic). However, they considered these two systems to be located at opposite ends of a continuum, with various combinations in between. 
Features of a mechanistic organisation: 
• High degree of task specialisation. 
• Responsibilities and authority clearly defined. 
• Coordination and communi cation – a responsibility of each management 
level. 
• Selectivity in the release of top-level information to subordinates.

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• Great emphasis on the organisational hier archy’s ability to develop loyalty 
and obedience. 
• Employees are often locally recruited. 
• The mechanistic system was seen to be appropriate in fairly stable 
conditions where the management of change was not seen to be an 
important factor. The relationship with Weber’s bureaucracy is obvious. 
Features of an organic organisation 
• Skills, experience and specialist knowledge recognised as valuable 
• Integration of efforts via lateral, vertical and diagonal communication 
channels. 
• Leadership based on consultation and involvement in problem-solving. 
• Commitment to task achievement, survival and growth more important 
than loyalty and obedience. 
• Employees are recruited from a variety of sources. • The organic system is seen to be more responsive to change, and is 
therefore recommended for organisations moving into periods of rapid 
changes in technology, market orientation, or tasks. 
The appropriateness of organisational structure to its environment is a cornerstone of contingency theory. 
 
Contemporary perspectives  
 Gareth Morgan has argued that we can view organisations in different 
ways as we try to understand them. We are rarely aware of the image of 
organisations we take for granted but, just like the photographs of the Parthenon from different perspectives, they fundamentally influence what we see and the explanations we put forward to make sense of it. However, the Parthenon can be approached from different directions, though not all are equally easy. Different angles will give different perspectives, and by arriving very early in the morning you could get a photograph with unusual lighting and fewer people in it. 
The same is true of the way we look at organisations and the process of 
From one perspective it is helpful to think of organisations as machines, 
in which the various jobs and departments are carefully designed to work smoothly together to perform certain functions effectively. This is certainly the view implicit in the early classical theories such as scientific management.

116  
 The view of organisations as machines provides some useful insights, but 
also imposes limitations, which in some circumstances can be severe. 
For example, the use of basic costing techniques in large multi-product firms may result in misleading information for decision-making. In this type of situation, more sophisticated models which recognise the more complicated nature of the organisation, may be more appropriate. 
The limitations of mechanistic perspectives on organisations are as 
follows: 
• They can create organisational forms that have great difficulty 
adapting to changed circumstances. 
• They can result in mindless and unquestioning bureaucracy. 
• They can have unanticipated and undesirable consequences as the 
interests of those working in the organisation take precedence over 
the goals the organisation was designed to achieve. 
• They can have dehumanising effects upon employees, especially 
those at the lower levels of the organisational hierarchy (Morgan, 1986). 
Morgan goes on to argue that there are other ways of viewing organisations that lead to different insights. It is not possible to go into all of those here, but two other perspectives he identifies are the view of organisations as organisms and organisations as cultures. It is important for managers to be able to examine organisational problems from more than one perspective in their search for effectiveness. 
8  Leadership 
Leadership is influencing others to do what he or she wants them to do; it 
involves human interaction and is often associated with the willing and 
enthusiastic behaviour of followers. The ability to influence needs the permission of those to be influenced. Leadership is related to motivation, interpersonal behaviour and the process of communication. 
Leadership is a dynamic process  and is very important at all levels within the 
organisation, from the board room to the shop floor. It does not necessarily take 
place within the hierarchical structure of the organisation. A leader may have no formal title at all and may rely on personal traits and style to influence followers. 
Leadership comes about in a number of different ways: 
• Some leaders are elected  such as in politics and trade unions. 
• Other leaders emerge  by popular choice and through their personal drive 
and qualities. 
• Within an organisation a manager is appointed  to a position of authority. 
Leadership is a function of the position.

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Types of leaders 
• Charismatic . The influence springs mainly from personality. 
• Traditional. The influence stems from accepted social order, such as a 
director runs a company. 
• Situational. The influence can only be effective by being in the right place 
at the right time. 
• Appointed . The influence arises directly from a position/status, e.g. most 
managers and supervisors. This is the bureaucratic type of leadership, where legitimate power springs from the nature and scope of the position within the hierarchy. 
• Functional . The influence comes from the individual securing the position 
by doing what he or she does well. 
The benefits of leadership 
There are many benefits from good leadership, including the following: 
• Reducing employee dissatisfaction. • Encouraging effective delegation. 
• Creating team spirit. 
• Helping to develop skills and confidence in the group. 
• Helping to enlist support and co-operation from people outside the group 
or organisation. 
The skills of a leader 
The skill of leadership seems to be a compound of at least four major 
ingredients: 
• The ability to use power effectively and in a responsible manner. • The ability to comprehend that human beings have different motivation 
forces at different times and situations. 
• The ability to inspire. • The ability to act in a manner that will develop a climate conducive to 
responding to and arousing motivations.

118  
 Differences in attitudes between managers and leaders 
 There are differences in attitudes towards goals, conceptions of work, 
relations with others, self-perception and development between 
leadership and management. 
• Managers tend to adopt impersonal or passive attitudes towards 
goals. Leaders adopt a more personal and active attitude towards 
them. 
• In their relationships with other people, managers maintain a low 
level of emotional involvement. Leaders have empathy with other people and give attention to what events and actions mean. 
• Managers perceive themselves as regulators of the existing order of 
affairs within the organisation. A leader's sense of identity does not depend upon membership or work roles. Leaders tend to search out opportunities for change. 
• Management may be seen more in terms of planning, organising, 
directing and controlling the activi ties of subordinates. Leadership, 
however, is concerned more with attention to communicating with, motivating, encouraging and involving people. 
• Management reacts. Leadership transforms – making a difference.

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Theories of leadership 
In the search to explain why some leaders are more effective than others, the 
following approaches can be identified: 
 
9  Personality, trait or qualities theories 
Early studies focused on the qualities required by effective leaders. Lists were compiled of required leadership qualities including: 
• physical traits, such as drive, energy, appearance and height • personality traits, such as adaptability, enthusiasm and self-confidence; 
and 
• social traits, such as co-operation, tact, courtesy  and administrative ability. 
Certain other writers selected other personal qualities which were thought to be 
desirable in leaders, who are ‘ born and not  made ’ Many great leaders were 
considered to have: 
• above-average intelligence

120  
• initiative – independence and inventiveness and the capacity to perceive a 
need for action 
• motivation 
• self-assurance and self-confidence 
• the ‘helicopter factor’ – the ability to rise above the particulars of a 
situation and perceive it in relation to the surrounding context 
• Other ‘essential’ qualities included enthusiasm, sociability, integrity, 
courage, imagination, determination, energy, faith, even virility. 
The problem with personality or trait theories is that there are always counter-
examples that can be given, for instance, when one theorist suggested a good leader must be tall, a short yet effective leader was identified; when one theorist suggested a leader must be tactful and courteous, a rude yet effective leader was found. Clearly good leadership is more than simply possession of particular physical or psychological attributes. 
10  Style theories 
The essence of leadership style theories is that a successful leader will exhibit a pattern of behaviour (i.e. 'style') in gaining the confidence of those they wish to lead. Style is a difficult factor to measure or define. The style of a manager is essentially how he or she operates, but it is a function of many different factors. 
It is useful to start by looking at the three main styles of leadership: Autocratic or authoritarian style . ‘Do this’ 
With this style the leader takes complete control, imposes all decisions on the 
group and neither asks for or listens to the opinions of others. Autocratic leaders tend to distrust the members of the group and as a result closely supervise and control the actions of the group. 
While in many circumstances this style can cause resentment, in other 
situations it can be necessary. For exampl e, in the military, or where safety and 
security is paramount. 
Democratic or participative style.  ‘Let’s work together to solve this’ 
With this style there is open discussion between the leader and the group. Ideas 
from the group are encouraged and while t he leader will still ultimately make the 
decisions, the reasons for the decisions will be explained to the group. 
This style is more likely to encourage innovation and creativity and group 
members are normally more motivated under a democratic leader.

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Free rein or delegative style.  ‘You go and sort out the problem’ 
With this style, the leader provides little or no leadership and expects the group 
to make decisions and solve problems on their own. 
Like the autocratic style, this style of leadership can also lead to resentment 
within the group. 
There are a number of theories dealing with style approaches to leadership. It is 
important that students have knowledge of a wide variety of theories. 
• McGregor – Theory X and Theory Y • Lewin 
• Blake and Mouton – the managerial grid. 
As you go through these models, it can be useful to consider the similarities in 
each and identify if the positions in each model fit under the three main styles of leadership discussed above. 
 
Model Autocratic 
style Democratic 
style Free rein 
style 
McGregor    
Lewin    
Blake and Mouton    
 
Douglas McGregor – Theory X and Theory Y 
Independently of any leadership ability, managers have been studied and 
differing styles emerge. The style chosen by a manager will depend very much 
upon the assumptions the manager makes about their subordinates, what they think they want and what they consider their attitude towards their work to be. McGregor came up with two contrasting theories: 
• Theory X  managers believe: 
–  employees are basically lazy, have an inherent dislike of work and 
will avoid it if possible 
–  employees prefer to be directed  and wish to avoid responsibility  
–  employees need constant supervision and direction 
–  employees have relatively little ambition and wants security above 
everything else 
–  employees are indifferent to organisational needs. 
Because of this, most people must be coerced, controlled, directed and 
threatened with punishment to get them to put in adequate effort towards the achievement of organisational objectives. This results in a leadership style which is authoritarian . This is indicted by a tough, uncompromising style which 
includes tight controls with punishment/reward systems.

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• Theory Y  managers believe: 
–  employees enjoy their work; they are self-motivated and willing to 
work hard to meet both personal and organisational goals 
–  employees will exercise self-direction and self-control 
–  commitment to objectives is a function of rewards and the 
satisfaction of ego 
–  personal achievement needs are perhaps the most significant of 
these rewards, and can direct effort towards organisational objectives 
–  the average employee learns, under proper conditions, not only to 
accept, but to seek responsibility 
–  employees have the capacity to exercise a relatively high degree of 
imagination, ingenuity and creativity in the solution of organisational 
problems. 
This theory results in a leadership style which is democratic. This will be 
indicated by a manager who is benevolent, participative and a believer of self-controls. 
Of course, reality is somewhere in between these two extremes. Most managers do not give much conscious thought to these things, but tend to 
act upon a set of assumptions that are largely implicit. 
Kurt Lewin 
The first significant studies into leadership style were carried out in the 1930s by 
psychologist Kurt Lewin. His studies focused attention on the different effects created by three different leadership styles. 
• Authoritarian . A style where the leader just tells the group what to do. 
• Democratic . A participative style where all the decisions are made by the 
leader in consultation and participation with the group. 
• Laissez-faire . A style where the leader does not really do anything but 
leaves the group alone and lets them get on with it. 
Lewin and his researchers were using experimental groups in these studies and 
the criteria they used were measures of productivity and task satisfaction. 
• In terms of productivity and satisfaction, it was the democratic  style that 
was the most productive and satisfying. 
• The laissez-faire  style was next in productivity but not in satisfaction – 
group members were not at all satisfied with it. 
• The authoritarian  style was the least productive of all and carried with it 
lots of frustration and instances of aggression among group members.

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While Lewin’s leadership models could be viewed as being simplistic, his work 
emphasises how critical the quality of leadership is for teams and organisations 
and that leadership can be taught, learned, and adapted. 
Furthermore, the terminology and ideas are still useful, although some of the 
conclusions need to be seen in context. 
For example, you could argue that Warren Buffett (an extremely successful and 
high profile investor) has a hands-off, laissez-faire management style that is 
highly successful because he focuses on hiring very capable people, and the 
autonomy of these executives is key to the success. 
On the other hand, Steve Jobs (Apple) was well known for his authoritarian 
approach and reluctance to delegate, so could be described as having an 
autocratic approach. Lewin's work indicated that this style was the least 
effective, but according to Forbes, Apple was the world’s most valuable brand in 
2019, and was also the 6th largest company in the world. 
Blake and Mouton – The Managerial Grid 
Effective leaders will have concern bot h for the goals ('tasks') of their 
department and for the individual ('people'). Blake and Mouton designed the managerial grid, which charts people-orientated 
versus task-oriented styles. The two extremes can be described as follows: 
• Task-centred leadership – where the main concern of the leader is 
getting the job done, achieving objectives and seeing the group they lead 
as simply a means to the end of achieving that task. 
• Group-centred leadership  – where the prime interest of the leader is to 
maintain the group, stressing factors such as mutual trust, friendship, support, respect and warmth of relationships.

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The grid derived its origin from the assumption that management is concerned 
with both task and people. Individual managers can be given a score from 1 to 9 for each orientation and then plotted on the grid. 
 
• The task-orientated  style (9,1) is in the best Taylor tradition. Staff are 
treated as a commodity, like machines. The manager will be responsible for planning, directing, and controlling th e work of their subordinates. It is a 
Theory X approach, and subordinates of this manager can become indifferent and apathetic, or even rebellious. 
• The country-club  style (1,9) emphasises people. People are encouraged 
and supported and any inadequacies overlooked, on the basis that people are doing their best and coercion may not improve things substantially. The 'country club' has certain drawbacks. It is an easy option for the manager but many problems can arise from this style of management in the longer term.

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• The impoverished style (1,1) is almost impossible to imagine occurring 
on an organisational scale but can happen to individuals e.g. the 
supervisor who abdicates responsibility and leaves others to work as they 
see fit. A failure, for whatever reason, is always blamed down the line. Typically, the (1,1) supervisor or manager is a frustrated individual, passed over for promotion, shunted sideways, or has been in a routine job for years, possibly because of a lack of personal maturity. 
• The middle road  (5,5) is a happy medium. This viewpoint pushes for 
productivity and considers people, but does not go 'over the top' either way. It is a style of 'give and take', neither too lenient nor too coercive, arising probably from a feeling that any improvement is idealistic and unachievable. 
• The team  style (9,9) may be idealistic; it advocates a high degree of 
concern for production which generates wealth, and for people who in turn generate production. It recognises the fact that happy workers often are 
motivated to do their best in achieving organisational goals. 
Style theories – is there one best style?  
The difficulty with style theories, even when they attempt to reflect the 
multidimensional nature of leadership, is that they ignore the important influence of the context  in which the leader is operating. From the discussions on the 
leadership styles theories, it should be apparent that there is no one best style of leadership that is equally effective for all circumstances. The best leadership style is the one that fulfils the needs of the group the most, while at the same time satisfying the needs of the organisation.

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 Case study style question 3 
 Management development 
You are running a management development course for six supervisors 
from a finance department. One of them, A, has reported his proposals about a case, which they have been studying. The other five have rated A by placing crosses on Blake and Mouton's managerial grid. The results are as shown. 
 
Required: 
As part of the course discussion on this topic, what should you tell the 
group about the significance of the result and what suggestions could you make to A as to how he could improve his management style. 

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11  Contingency or situational theories 
Contingency theory suggests that here is that there is no one best approach to 
leadership, either in terms of  trait or style. A good l eader will change their style 
to suit the situation. The best leadership style is the one that fulfils the needs of the individual, the group, and the organisation. 
A more advanced version of simple trait theories is situational leadership . The 
theory here is that leaders are products of particular situations. Where a given 
set of factors exists e.g. economic depression, weak government, high unemployment and a disenchantment with traditional politics the theory suggests the emergence of a leader, who recognises the problems and has characteristics or traits that fit the needs of the situation. This can be seen where a company is in financial difficulties and its going concern is in danger, a new, more experienced CEO may be brought it to make the hard decisions required to ensure the survival of the company. 
Theories dealing with contingency or situational approaches to leadership: 
• Adair – action centred leadership 
• Fielder – contingency model. 
Adair – Action-centred leadership 
Adair's action-centred leadership takes Blake and Mouton's ideas one step 
further, by suggesting that effective leadership regards not only task and group 
needs as important, but also those of the individuals making up the group: 
 
Adair’s model stresses that effective leadership lies in what the leader does to meet the needs of task, group and individuals. 
• Task achievement is obviously important for efficiency and effectiveness, 
but it also can be valuable for motivating people by creating a sense of 
achievement.

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• Teams, almost by definition generate  synergy out of the different skills and 
knowledge of individuals. 
• Where individuals feel they have opportunities to satisfy their needs and 
develop, they are more likely to contribute to creativity and effectiveness. 
The key task for the action-centred leader is to understand these processes and 
bond them together because otherwise there will be a tendency for the organisation to remain static. 
However, the three elements can conflict with each other, for example, pressure 
on time and resources often increases pressure on a group to concentrate on the task, to the possible detriment of the people involved. But if group and individual needs are forgotten, much of the effort spent may be misdirected. In another example, taking time creating a good team spirit without applying effort to the task is likely to mean that the team will lose its focus through lack of achievement. 
It is important that the manager balance all three requirements. 
Adair's ideas still form a key element of many management and leadership 
training programmes. However, the model does not stand alone but it must be 
part of an integrated approach to managing and leading. 
 
 Case study style question 4 
 As part of your training, you have been sent on a leadership development 
course. Your manager P has worked for BCD for over twenty years as 
the Accounts partner. He has a sound knowledge and understanding of the different activities of the company’s business. 
Over the years he has demonstrated fairness in how he manages staff 
and is well liked for his enthusiastic approach. P has decided that he needs to dedicate more time and energy managing the business and asked you to take over some of hi s leadership responsi bility especially 
encouraging and leading the younger members of staff. 
He has asked you to think about the different types of leader at BCD 
whilst on the course. 
During your time so far you have noted the following leadership styles 
from three of the partners: 
L treats his staff like computerised machines and doesn’t consider his 
employees views, feelings or ambitions. 
J barely vacates his office and leaves his employees to get on with the 
workloads themselves. 
R gives and takes. She is neither lenient nor too coercive.  Upon your return, P has asked for a report on certain matters.

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 Required: 
Write a report to P, covering the following: (a) Providing a definition of leadership. 
(5 minutes) 
(b) Describing the managerial grid and the five extreme scores 
identified by Blake and Mouton. Relating what you have learnt to the 
BCD leadership styles. 
(15 minutes) 
(c) Briefly explaining Adair’s action centred leadership theory. 
(d) Explaining whether you feel one style of leadership is effective in all 
circumstances. 
(10 minutes)  
 
 Fiedler – contingency model  
 The development of the contingency approach marked the bringing 
together of the personality and situational approaches. Fiedler’s contingency model is the best example of an attempt to integrate individual characteristics with the structural and task properties of the situation. 
First, he identified two distinct styles of leadership: 
Psychologically distant managers (PDMs) 
• seek to keep their distance from subordinates by formalising roles 
and relationships within the team 
• are withdrawn and reserved in their interpersonal relationships 
• prefer formal communication and consultation methods rather than 
seeking informal opinions 
• are primarily task oriented. 
Psychologically close managers (PCMs) 
• do not seek to formalise roles and relationships 
• prefer informal contacts to regular staff meetings 
• are primarily person oriented rather than task oriented.

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 Fiedler suggested that the most effective style of leadership would be 
determined by the situation, which would be influenced by three factors: 
• Leader/member relations  – the nature of the relationship between 
the leader and the group 
• Task structure  – the extent to which the task is structured 
• Leader position power  – the degree of formal 
authority/responsibility allocated to the position. 
In terms of leadership style, Fiedler intimates that the leader can be high 
on only one aspect at a time – either people oriented or task oriented, but not both. 
Fiedler suggested that a PDM approach works best when the situation is 
either very favourable or very unfavourable to the leader and the PCM approach works best when the situation is only moderately favourable for the leader. 
12  Recent thinking on leadership   
Transformational/transactional leadership 
Bennis  proposed that there were two types of leaders: 
• Transactional leaders  see the relationship with their followers in terms of 
a trade: they give followers the rewards they want in exchange for service, loyalty and compliance. 
• Transformational leaders  see their role as inspiring and motivating 
others to work at levels beyond mere compliance. Only transformational leadership is said to be able to change team/organisational cultures and move them in a new direction. 
Transactional leaders tend to be more passive and transformational leaders more proactive. While a transactional leader would work within the confines of the organisational culture, the transactional leader would seek to change and improve the culture. Transformational leadership enhances the motivation, morale, and job performance of followers. They act as a role model and inspire others to develop and innovate. They would advocate empowerment, encouraging followers to take greater ownership for their work. 
Transformational leadership has become more important in recent years. The 
dynamic nature of the environment facing many organisations today means that there is a constant need to innovate and change. It is suggested that to cope with this type of environment, leaders need to have vision and creativity, be innovative and capable of inspiring others. The distinguishing feature of transformational leadership is the ability to bring about significant change. 
Also bear in mind that leadership styles are not only relevant within business. 
Nelson Mandela was a prime example of a transformational leader who spearheaded change on a very large scale by inspiring others.

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Skills required by transformational leaders 
The new kind of transformati onal leader needs a different range of skills from 
those suggested by traditional management theories. These new skills according to Boyd  encompass: 
• anticipatory  skills providing foresight in a constantly changing 
• visioning  skills whereby persuasion and example can be used to induce 
the group to act in accordance with the leader’s purpose or the shared 
purpose of a larger group 
• value-congruence  skills which enable the leader to be in touch with 
• individuals’ economic, psychological, physical and other important needs, 
in order to be able to engage them on the basis of shared understanding 
• empowerment  skills involving the willingness to share power and to do so 
effectively 
• self-understanding so that the leader understands his or her own needs and goals as well as those of the followers. 
Boyd believes that there is a need to develop such skills in organisations and to 
create the conditions in which this type of leadership can emerge. 
Distributed leadership 
Another more modern perspective on leadership is distributed leadership. While 
traditional leadership has been viewed as the role of one person in charge of others, a distributed, or shared, leadership perspective recognises that there are multiple leaders. 
 
Case study question 5 
 Before taking up her position as Head of the Finance department of QRS, 
T had enjoyed a career in the Army where she had attained the rank of 
major. The military style of command had suited T's personality. She is by nature an assertive kind of individual, so giving orders is something that comes naturally to her. 
The start of her new post as Head of Finance has not been easy. She 
has found that her previous style of management has not been well received by her new staff. Her enthusiasm for improving the way things are done in the department is not matched by that of her staff. In fact, if anything, an air of resentment seems to exist in the department. More generally, T is finding it difficult to adjust to the whole way of operating in QRS. In her view, so much time seems to be spent in meetings and in consultation generally that she wonders how the organisation manages to compete in the market place as successfully as it does.

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 Required: 
Using any appropriate theory of management style, write an email to T 
explaining why she is experiencing the difficulties described in her new post, and recommend the kind of management style that might be more appropriate. 
(15 minutes)  
13  Leadership in virtual teams 
As organisations become more global and cost-conscious, virtual teams have become more widely used.  
 
 A virtual team is a team made of members with complementary skills 
working towards a common purpose, but which is separated physically and must interact electronically. The teams do, however, meet up in person from time to time.  
Virtual teams can eliminate the expenses of  travelling, relocating and acquiring 
property allowing companies to bring employees at different locations together to work on the same projects. Virtual teams help increase productivity and maximise profit while reducing cost.  
There are many operational reasons why businesses are now increasingly 
reliant on virtual teams to achieve their project and business aims. Virtual teams are now an established and increasingly important part of the global business environment. Virtual teams can potentially offer a range of benefits such as greater flexibility, higher  productivity and increas ed job satisfaction for 
employees.  
This will inevitably present challenges to the leadership and management of 
these teams. It is vital to overcome these challenges and work effectively and successfully in virtual environments. As a result managers of virtual teams need to adapt or change their approach and develop new and existing behaviours and skills in order to generate optimum leve ls of individual and organisational 
Virtual teams are likely to become a more common feature of working life, so it's 
increasingly important that managers are as adept at leading in the virtual world as they are in the physical one. The growth of virtual teams has been possible because of significant achievements in communication technologies.  
However they also produce unique challenges for both managers and their 
team members, such as communication challenges, cultural sensitivities and performance management. 
It would incorrect to assume that the characteristics that make a good leader 
are the same no matter where that leader is located. However, managing virtual teams effectively requires a set of skills that is different from managing teams located under the same roof. In addition to excelling at the execution-oriented practices that define any good leader, virtual leaders must also juggle the interpersonal, communication and cultural factors that define virtual teams.

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Leaders of virtual teams must see themselves as leaders as well as managers. 
Managers’ roles involve ensuring the business aspects of the team’s work are undertaken correctly, that timesheets and documentation are delivered correctly and on time and to ensure the right skills are made available to the project at 
the right times. All of these activities  still need to be undertaken, and often are 
done or overseen by the leader, but to be an effective leader you also need to see yourself as a leader and take responsibility for setting the culture, tone and pace of the team. The team will look to the leader for guidance and leadership more than for management. This is critical to ensure that the motivation needed to succeed in this environment is not subdued; resulting in the achievement of goals and objectives being challenged.  
Virtual team leadership skills are therefore more complex. The leader of a 
virtual team must be able to inspire and lead their team without meeting them, without seeing them each and every day and without being able to model appropriate and desirable behaviour in a physically visible way. 
Leadership skills in virtual teams are different to leadership skills needed in a 
co-located team. Leaders of co-located teams need to be able to inspire and direct a team they see around them every day; they can lead by example and by modelling in ways that all of their team members can see visually each day. They develop their communication skills to  be effective in face to face 
environments and in casual discussions around the office, their external communication skills are typically honed around dealing with suppliers, subcontractors and clients. 
The effective leader of a virtual team must also be able to deal with higher 
levels of ambiguity, understand and lead across cultural boundaries and lead a distributed team of personnel who, themselves, may never meet and rely on communicating using electronic media. In short, the skills required to effectively lead a virtual team are all those of a leader of co-located personnel with many additional skills added on. 
 
Illustration 1 – SAP 
 SAP holds the title of the world’s largest inter-enterprise software 
company. With more than 30,000 employees in 60 countries, virtual team 
collaboration is critical to the company’s success. The company has structured itself in a strategic way, with global headquarters in Germany and large R&D centres in India, China, Israel and the United States. Each centre has a specific area of expertise it shares with the entire company, which reduces costs. Managers can assemble virtual teams that include employees from each of these specialty groups, making each team more well-rounded. 
SAP has also enhanced its virtual team performance by creating an 
ongoing team building initiative with the help of an organisational development consulting company. This initiative began with a training program in which teams worked together to build a community through a blend of online learning, conference calls, briefings, and coaching sessions.

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14  Leadership and ethics  
 Business ethics is defined as the set of moral rules that govern how 
businesses operate, how business decisions are made and how people are treated.  
In business, there are many different stakeholders to answer to e.g. customers, shareholders and clients. Law often guides business ethics, while other times business ethics provide a basic framework that businesses may follow to gain public acceptance.  
To facilitate this acceptance, leaders need to create a healthy culture that 
influences employee actions, decision-making and behaviour. This takes time 
and requires awareness, sensitivity, patience and resources. One of the key dangers in this context is that unethical behaviour may be ingrained into a company’s culture or industry to be considered as ‘the way business is done around here’, and so may not be considered unethical at all.  
 
Illustration 2 –  Examples of poor business ethics: 
 For example, in a company that sells cereals with all-natural ingredients, 
the marketing department must temper enthusiasm for the product versus 
the laws that govern labelling practices in the pursuit of market share. Some competitors' advertisements advertise high-fibre cereals that have the potential to reduce the risk of some types of cancer. The marketing department cannot make dubious health claims on cereal boxes without the risk of litigation and fines. Even though competitors with larger market shares of the cereal industry may use shady labelling practices, that 
doesn't mean every manufacturer should engage in unethical behaviour. 
Nestle The World Health Organization found children in developing countries 
who fed on Nestle’s infant-formula had mortality rates five to ten times greater than that of breast-fed children. The problem was Nestle’s sinister campaign of appointing uniformed nurses to distribute the baby formula to poor mothers for free, long enough for lactating mother’s milk to dry up. The mother and child now became entirely dependent on Nestle’s infant formula, and since most of them could not afford the formula, they gave their children an insufficient quantity of the formula. The formula also required clean water, which most mothers could not access. 
ASDA (owned by US company WalMart) is a retail colossus. It has 
monumentally failed to embed corporate responsibility into its operations 
and supply chains around the globe. This has led to workers' rights abuses at supplier factories, accusations of discrimination by staff, and a host of other charges.

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Excellence in leadership means having the ability to influence others and 
directing them down a particular course of action. A good leader will have a strong following and a strong sense of ethics. There is a direct link between leadership and ethics. A leader must display an ethical approach to everything that they do if they want others to follow their actions.  
So how does an organisation ensure that it is developing its business 
leaders to become ethical activists? 
• To create and maintain a strong ethical culture, core ethical values need 
to be identified and integrated into everything the organisation does – from external processes such as buying and selling to internal ones such as governance and accounting. From the first interview to their last day of 
work, employees should feel that the company’s core values form the 
basis of every decision it makes.   
• The role of managers  at all levels is critical to the process of embedding 
ethics throughout any organisation. Line managers have an essential role in communicating ethics messages and acting as role models. Ethical acumen is a key competence for 21st-century business leadership. 
• The quality and style  of the leadership will influence the tone of the entire 
organisation. While the collective ‘tone from the top’ of the organisation is of utmost importance, there are also ‘leaders’ at every level, who others will naturally try to emulate.  
• ‘Tone from the middle’  is as important as ‘tone from the top’. Research 
into embedding ethics in the workplace indicates that employees consider their line manager as the biggest enabler and teacher of ethics in their organisation. Data from the Ethics at Work survey shows that, in Britain, 71% agree that their line manager ‘sets a good example of ethical business behaviour’ and 69% feel supported by their line manager in ‘following [the] organisation’s standards of ethical behaviour’. 
The challenge lies with not only enforcing ethical behaviour amongst leaders and followers but instilling it. In many cases when instances of fraud and illegal practices are uncovered the board of directors were unaware that these activities were taking place. Although directors can create a set of values and principles that they think define the business, they are useless if they are not being implemented by employees. In order for these guidelines to be effective an organisation must rely on its business leaders to set the example.  
Ethical leadership is all about the CEO and board leading by example; only then 
can you truly have an ethical culture in an organisation.

136  
15  Leadership in context  
Summary of thoughts on leadership  
Throughout this chapter we have viewed a range of theories and models 
discussing how to be a good leader. Some theories, especially 'classical' ones, suggested that there was one best approach but many others support a more modern view of leadership that suggests that there is no single best approach. Instead a situational/contingency approach is taken that argues that leadership approaches need to be adapted to the context within which it operates. 
Summarising some of the models already covered: 
 
Theory/model Contextual va riable Recommendation 
Fiedler • How favourable 
the situation is to 
the leader, based on leader/member relations, task structure and leader position power Fiedler suggested that a PDM (Psychologically distant manager) approach works best when the situation is either very favourable or very unfavourable to the leader and the PCM (Psychologically close manager) approach works best when the situation is only moderately favourable for the leader. 
Bennis • Business 
environment In a dynamic business environment, a transformational leadership approach is more likely to facilitate the change required. 
Daniel Goleman 
Another useful model in this context is the work of psychologist Daniel Goleman. He identified six key types of leadership styles and argued that effective leaders move across these styles in a situational manner and use the style that works best for the specific context. 
 
Leadership style Descrip tion When suitable 
Visionary • Leader has good 
communication skills, see the big-picture and has a forward-looking focus. 
• Can inspire teams to 
shared goals by outlining where the organisation is going, but not necessarily how it will get there. 
• Example: Steve Jobs 
(Apple). • The company or 
team needs to shift in a new direction.

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Coaching • Objective is to develop 
people for the future. 
• Style is one-on-one and 
instructional, guiding the 
employee on how they can improve. • You have an 
employee with strong initiative who wants to develop professionally. 
Affiliative • Designed to create 
strong bonds and connections between people. 
• Gives positive feedback 
and promotes team building. • When there is a 
need to improve harmony, morale, communication and repair trust. 
Democratic • (See also Lewin's 
concept of democratic leadership). 
• Builds consensus by 
encouraging participation, encouraging ideas from others and communal decision making. • Most effective when 
direction is weak and the organisation can benefit from tapping into the skills, 
talents, and 
opinions of staff. 
• Inappropriate for a 
crisis. 
Pacesetting • Leads by example and 
sets high standards. 
• Expect team members 
to be self-directed and follow their lead. • Can help motivate 
staff to achieve strict deadlines and tight schedules. 
• However, should be 
used sparingly given its potential to "poison the climate" – i.e. affect morale and team members’ sense of achievement. 
Commanding • Military style where the 
leader demands compliance. 
• Rarely offers praise but 
focusses on criticism, coercion, and prescription. • Should be used 
only in crises requiring rapid redirection and change.

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 Question 1 
 Identify the correct definition for each of the following management 
concepts. 
 
Accountability  Getting others to do things willingly 
Delegation  Being called to account for one’s actions 
and results 
Responsibility  The right to exercise power 
Power  The obligation to perform certain duties, 
tasks or make certain decisions 
  The assignment of tasks or duties to 
another member of staff 
  The ability to exert influence 
   
 Question 2 
 Insert the correct word into the sentences. 
• Referent 
• Coercive 
• Reward 
• Legitimate 
• Expert 
Where a member of staff undertakes a task because they believe their 
manager has knowledge about the subject, the manager is said to have ________________  power. 
A manager who uses threats to get compliance from staff is using 
________________  power. 
Where a member of staff undertakes a task for their manager because 
they have respect for them, this would indicate _______________ power. 
 
 Question 3 
 Authority which is based on custom and practice is known as? 
A  Charismatic authority 
B  Traditional authority C  Expert authority D  Rational-legal authority

140  
 Question 4 
 Which of the following statements are correct? Select all that apply. 
A  Authority can never be delegated 
B  The scope of responsibility mu st correspond to the scope of 
authority given 
C  Accountability is the ability to exercise influence D  Responsibility is the right to exercise power E  Responsibility can never be delegated F  Authority is the right to exercise power 
 
 Question 5 
 Which three of the following are common features of management as 
identified by Fayol? A  Contracting B  Commanding C  Communicating D  Co-ordinating E  Controlling F  Coercing 
 
 Question 6 
 Complete the sentences using the phrases provided. 
• Psychologically distant managers 
• Psychologically close managers 
• Transformational leaders 
• Transactional leaders 
• Bureaucratic management 
• Scientific management 
The idea of there being one best approach to doing a job, arrived at from 
work study methods, comes from ____________________ theory. 
Leaders who keep their distance from subordinates by formalising roles 
and relationships with their team are known as ____________________. 
__________________ see their role as inspiring and motivating others. _________________ is based on a hierarchy of authority with strict rules and procedures.

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 Question 7 
 Using Herzberg’s theory of motivation, match the items to whether they 
are hygiene or motivating factors. 
• Team working 
• Career advancement 
• Increasing levels of responsibility 
• Pleasant physical working conditions 
• Suitable level and quality of supervision 
 
Hygiene factor Motivating factor 
  
 Question 8 
 With reference to Burns and Stalker’s theory, match the following 
features to whether they relate to a mechanistic or an organic 
A  High degree of task specialisation B  Most suitable under stable conditions C  Employees recruited from a variety of sources D  Emphasis on loyalty and obedience E  Emphasis on task achievement F  More responsive to change 
 
 Question 9 
 Which of the following statements would relate to a Theory X manager? 
Select all that apply. A  Employees dislike work and will avoid it if possible B  Employees will exercise self-direction and self-control C  Employees accept and seek responsibility D  Employees need constant supervision E  Employees are indifferent to organisational goals F  Employees can exercise creativity to solve organisational problems

142  
 Question 10 
 In the Blake and Mouton managerial grid, shown below, match the styles 
to the correct place on the grid. 
 
• Task orientated 
• Country-club 
• Impoverished 
• Team style 
• Middle road.

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 Case study style question 1 
 EMAIL 
To: G From: Management accountant  Date: today 
Subject: Sources of power 
A useful framework that can be used to discuss the different sources of 
power is that proposed by French and Raven and includes referent, reward, coercive, expert and legitimate power. 
Referent power is sometimes termed charismatic power and is derived 
from one’s admiration or respect for an individual that can inspire followers. This is gained by the personal qualities of the individual and when followers believe that the leader has desirable characteristics that should be copied, or has inspiration charisma. You are known for your fairness and are well liked and respected for your enthusiastic approach. It is therefore likely that you will have referent power which will help you in implementing the changes to working practices. 
Reward power  is where the leader is able to directly influence the 
intrinsic or extrinsic rewards available to followers. For example, the 
ability to provide incentives for individuals to behave in a particular manner and has control over the organisation’s resources such as salary, bonuses or promotion. This type of power is usually used in a positive manner, although it can be used in a negative way through the threat of removal of rewards. As senior partner, you will have reward power that you could use to encourage people to adopt the new working practices. As well as financial rewards, you could use intrinsic rewards such as verbal praise and recommendation for promotion. 
Coercive power , as the term implies, is the ability to punish or deprive 
people of things that they value and where the leader uses penalties or 
sometimes physical punishments to enforce compliance. It is based on fears and the use of the ‘stick’ or sanction, making life unpleasant for people. The receiver is unlikely to respond to this type of power. Whilst the immediate response might be compliance, it is unlikely to result in long term commitment. It is doubtful that you would want to resort to using this type of power, unless there is strong resistance to the changes, in which case you may have no choice.

144  
 Expert power  is based on the followers’ belief that the leader has certain 
expertise and knowledge relevant to a particular problem or issue. It will 
only work if others acknowledge that expertise. You will probably have this power given the time you have worked for the organisation and your sound knowledge and understanding of the firm’s different business activities. This experience will be of great help in the drive to introduce new technology and working practices into the organisation and should encourage respect from staff. 
Legitimate power, sometimes referred to as position power, is the power 
which is associated with a particular job. It is when followers accept that the leader has the right to influence them in certain areas or aspects of behaviour. This is often based on the individual’s formal position in the organisation. Since you are a senior partner and leader of the project you will be deemed to have legitimate power in managing the changes and hence the right to issue instructions to staff. 
I hope you have found the above helpful. Please do not hesitate to get in 
touch if you require any further information.  
 
 BRIEFING NOTES FOR MEETING WITH H 
(a)  Causes of the situation  
–  The main reason for the situation in H’s department is his 
inability or unwillingness to delegate work. 
–  What should he delegate?  – the day-to-day operational 
activities to his staff, instead of doing it himself. 
–  Explain why . This leaves his time free for organising and 
planning the medium-term activities of the department – putting the strategic decisions made by his superiors into place. 
–  Why does H not delegate ? Whether he does not delegate 
because he does not trust his staff  to do the work properly or 
he does not know how to , is a matter only H can clarify. As 
staff are trying to leave, H may even feel more pressure to carry most of the work load instead of having to pass it on to inexperienced staff in the future. There may have been changes or reorganisations in the department resulting in a higher workload for H, and thus inadequate time for managing his subordinates. 
–  Any external factors? The problems seem to have started recently, therefore, it must be established whether or not H is experiencing any external problems, domestic for instance, that are affecting his performance at work.

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 (b)  Principles of delegation  
–  Explain what delegation should be . Delegation is the 
passing on to someone else of the freedom and authority to 
carry out a job for which the delegator is accountable. 
–  Go through the process . Ideally, the process should include 
a careful and thorough briefing of the subordinate by the senior covering the following points: 
(i) the required performance levels (ii) agreement of the actual tasks assigned (iii) agreement of the resources allocated (iv) delegation of authority to do the job (v) recognition of the responsibility by the senior. 
Although there is no single approach to delegation, it should be well 
planned and ensure that the content is appropriate and understood. 
• Explain the main principles . The following principles are 
essential for delegation to be effective: 
–  The range of the authority delegated must be clearly 
understood by both parties and must be within the scope 
of the delegator’s authority. 
–  It is the manager’s responsibility to ensure that the 
subordinate has sufficient ability and experience to carry out the task. If necessary, training and an initial period of close supervision must be given. 
–  The manager must have the authority to delegate before 
he or she does so and must delegate sufficient resources to complete the task. 
–  The subordinate should have only one immediate 
superior, so that there is no confusion concerning his or 
her (space) accountability and responsibility. 
(c)  Advantages of effective delegation 
In any large complex organisation, management must delegate 
some authority and tasks simply because of the limitation (physical and mental) of the workload on any individual and the need for specialisation of certain tasks. 
• Explain the Benefits:  
(i) Workloads of managers and supervisors are relieved with 
the subsequent reduction in stress. 
(ii) Managers are left free to  carry out non-routine tasks 
while passing on more routine activities to subordinates. 
(iii) Specialists are able to develop their specialisms.

146  
 (iv) Training of subordinates is assisted by the delegation of 
tasks. The right opportunity to do a job is a very effective 
method of training. 
(v) Management succession is aided, as subordinates are 
able to gain experience and become accustomed to working at the higher level of management. 
(vi) Decisions can be made sooner by managers with 
delegated authority on the spot that can respond to changing events. 
(vii) The subordinate’s work experience is enriched with 
subsequent increase in job satisfaction leading on to better work. 
(viii) The opportunity exists to evaluate the performance of a 
subordinate before being permanently promoted. 
• Explain the problems/disadvantages:   
(i) Decisions taken at a lower level may not be to overall 
advantage of the organisation. 
(ii) The organisation must be able to meet the aspirations 
through eventual promotion of subordinates who accept delegated duties. 
(iii) There may be an increase in costs due to additional 
payments to the extra member of staff with delegated authority. 
 
 You should tell the group the following: 
• That supervisor A is perceived to have a high 'concern for 
production'. In this context that could refer to the case they have been studying. It could also refer to insights others have gained into how A does their job. Either way this high concern for the job would be seen as a positive attribute of A. 
• However, A is perceived to have a low 'concern for people'. Again 
this could refer to how the other supervisors felt they were treated on the course or how they feel A supervises his staff at work. 
• This would be viewed as a potential problem with A being too task-
orientated. 
• These findings are reinforced by the fact that that everybody saw 
supervisor A in a similar light.

Chapter 4 
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 In terms of how A could improve his management style, you could 
suggest any of the following: 
• Attending a further training course. • Delegating more work to subordinates. 
• Within this, using more trust rather than explicit control. 
• Involving staff in more discussions. 
• Asking staff for more feedback concerning his management 
approach. 
• Treating staff more as adults. • Using more group discussions to make decisions. 
• Adopting an 'open door' policy. 
• Adopting more 'management by walkabout'. 
• Give staff more feedback on the quality of work done. 
 
 REPORT 
To: P From: Management accountant  Date: today 
Subject: Management styles  
This report will cover the definition of leadership and look at two 
management models, namely the Blake and Mouton managerial grid and 
Adair’s action centred leadership. It will also cover whether one style of leadership will be effective in all circumstances. 
(a)  Definition of leadership
 
Leadership is a conscious activity and in business is about setting 
goals and inspiring people to give a commitment to achieve the organisation’s goals. It is a relationship through which one person influences the behaviour or actions of others. 
Leadership is seen as ‘a social process in which one individual 
influences the behaviour of others without the use or threat of violence’.

148  
 Leadership can be viewed from three standpoints: 
–  an attribute of a position e.g. your role at BCD as Finance 
Director 
–  a characteristic of a person e.g. you are a natural leader, well-
liked by all 
–  a category of behaviour e.g. your enthusiastic approach to 
everything. 
From the position of leadership at work, the latter standpoint is most 
applicable and can be considered as something one person does to influence the behaviour of others. It is all about moving people and things on, getting them from ‘a’ to ‘b’ by improving performance, changing the way things are done, making a new product or creating a new or better service. 
There are different levels of leadership from the top down to small 
team leaders, but they will still share the same function – to get people to do the job. How they do that will depend on their attitudes, their perceptions of what motivates people and the prevailing culture of the organisation. If the designated leader cannot communicate the why, how and when of moving from ‘a’ to ‘b’ then he or she will neither behave like a leader, nor succeed in the task. 
(b)  Blake and Mouton’s Managerial Grid 
Blake and Mouton, observed two basic ingredients of managerial 
behaviour, namely: concern for production and concern for people. Concern for production includes the manager’s attitude towards procedures, processes, work efficiency, and volume of output. Concern for people includes personal commitment, sustaining the esteem and trust of the group, maintaining interpersonal relationships and ensuring good working conditions.

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 They recognised that it was possible for concern for production to 
be independent of concern for people. It was therefore possible for a 
leader to be strong on one and weak on the other, strong on both, weak on both or any variation in between. They devised a series of questions, the answers to which enabled them to plot these two basic leadership dimensions as the axes on the following grid structure: 
 
A high concern for production will score 9 and a high concern for people will also score 9, the two co-ordinates on the grid indicating the proportion of each concern present. Blake and Mouton picked out these two elements of a manager’s job as characterising the leadership role. The implication is that managers should aim for the 9.9 combination; a goal-centred team approach that seeks to gain optimum results through participation, involvement, commitment and conflict solving where everyone can contribute. According to Blake and Mouton, individuals can adapt their style to become more effective personally and, working in a team, can build the synergy needed to raise output above the level that could be achieved individually. 
Although there are 81 points of reference in the managerial grid, 
only five positions are precisely identified and described.

150  
 The task-orientated style (9,1) is almost totally concerned with 
production and has a low concern for people. Subordinates are 
treated as a commodity, like machines. Their needs are virtually ignored and conditions of work are arranged so that people cannot interfere to any significant extent. This is very similar to L who treats his staff like computerised machines and fails to consider their views. 
The country club style (1,9) emphasises people and pays little 
attention to achieving results. The manager is attentive to staff needs and has developed satisfying relationships. People are encouraged and supported, and any inadequacies are overlooked, on the basis that people are doing their best and coercion may not improve things substantially. 
The impoverished style (1,1) is almost impossible to imagine, with a 
lazy manager showing little concern for production and low concern for staff or work targets. This type of manager only makes the minimum effort in either area and will make the smallest possible effort required to get the job done. J who very rarely leaves his office and makes no effort with his team is an example of this style of leader. 
The middle road (5,5) is a happy medium. This viewpoint pushes for 
productivity and considers people, but does not go ‘over the top’ either way. It is a style of ‘give and take’, neither too lenient nor too coercive, arising probably from a feeling that any improvement is idealistic and unachievable. This manager is able to balance the task in hand and motivate the people to achieve these tasks. R is a good example of this type of leader. She gives and takes and likes to be neither lenient nor coercive to her staff. 
The team style (9,9) may be idealistic as it advocates a high degree 
of concern for production and for people. This manager integrates the two areas to foster working together and high production to produce true team leadership. You are the only manager that matches this description. You are the one to follow. 
(c)  John Adair (1983) 
Adair put forward a model of action centred leadership, which is 
based on the premise that effective leadership requires a bringing together of task, team and individual needs. Adair’s action-centred leadership takes Blake and Mouton’s ideas one step further, by suggesting that effective leadership regards not only task and group needs as important, but also those of the individual subordinates making up the group.

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Adair’s model stresses that effective leadership lies in what the 
leader does to meet the needs of task, group and individuals. 
Task achievement is obviously important for efficiency and 
effectiveness, but it can also be valuable for motivating people by creating a sense of achievement. Effective teams generate synergy out of the different skills and knowledge of individuals. Where 
individuals feel that they have opportunities to satisfy their needs and develop, they are more likely to contribute to efficiency and effectiveness. 
The key is for us to understand these processes and bond them 
together because otherwise there will be a tendency for the organisation to remain static. 
(d)  One best style 
From discussions of leadership it is clear that there is no one style 
that is equally effective in all circumstances and no one style has proved to be universally superior to the others. The best leadership style is the one that fulfils the needs of the group the most, whilst at the same time satisfying the needs of the organisation. 
The variables that define the successful style include:  –  The personality of the leader –  The situation of the group – calm or crisis –  The situation within the group – cooperative or militant –  The people within the group – intelligence and interest. 
Conclusion This report has shown that there are many ways to look at leadership and 
a number of models available to help explain the different approaches. Styles of leadership should be adaptable to the situation to ensure that the leadership is always effective.

152  
 Case study style question 5  
 EMAIL 
To: T 
From: Management accountant  Date: today 
Subject: Management style 
Management style is concerned with how a manager deals with 
subordinates. There are a number of different models but one that is commonly used is that of Lewin. 
Using Lewin's model, you could be described as adopting an autocratic 
style of management. This means that you are telling the subordinates what to do. This style of management probably comes naturally to you since it is the style adopted in the armed forces where subordinates are trained to not question their orders. Since you have spent a long time in this environment it is, understandably, the style you are used to. 
The workers that you are supervising in the Finance department however 
may well be professionally qualified people used to carrying out tasks in their own way without a great deal of supervision. 
With this kind of worker an autocratic style is unlikely to be successful, 
since the workers will resent the reduction in the amount of decision-making they are allowed. You may find it more useful to adopt a more democratic management style in which decisions are discussed with the employees rather than being imposed. This should lead to greater worker contentment with resulting gains in productivity and morale. 
There will probably be a number of di fficulties in changing your 
management style. You are used to doing things in ‘the army way’ (which 
you clearly did successfully having risen to the rank of major) and you are a naturally assertive person to whom an autocratic style of management is probably most comfortable. 
Another factor that could cause problems is the potential for you to feel 
that you are ‘losing face’ by changing to suit your subordinates. You might question the effect  this will have on your authority both now and in 
the future, for example, what happens if they dislike something else, will you be expected to adapt to them again?

Chapter 4 
 153 
 Although there are many practical difficulties surrounding this change in 
style they are not insurmountable. You may have to gradually change 
your style over time, perhaps by getting key subordinates more involved now and gradually extending this. 
An alternative solution would be to involve another senior manager from 
a different department to help mentor you. This would involve working with a mentor who could help you discuss practical ways in which your style can evolve. 
The above measures are likely to be unsuccessful unless you recognise 
that it is in your interests as well as that of your sub-ordinates and the company to change your style. 
touch if you require any further information. 
 
 Question 1  
    
Power  The ability to exert influence 
Accountability   Being called to account for one’s actions and results 
Delegation   The assignment of tasks or duties to another member of staff 
Responsibility   The obligation to perform certain duties, tasks or make certain decisions 
The right to exercise power is authority . 
Getting others to do things willingly is leadership .

154  
 Question 2  
 Where a member of staff undertakes a task because they believe their 
manager has knowledge about the subject, the manager is said to have 
expert  power. 
A manager who uses threats to get compliance from staff is using coercive  power. 
Where a member of staff undertakes a task for their manager because they have respect for them, this would indicate referent  power. 
French and Raven suggested five sources of power: 
• Expert power where the holder has specialist knowledge 
• Coercive power where the holder has the ability to punish 
• Reward power where the holder has the ability to reward 
• Legitimate power where the holder has power due to the position 
held 
• Referent power where the holder has charisma and makes others 
desire to like them. 
 
 Question 3  
 B 
According to Weber there are three bases for authority: 
• Authority based on custom and practice is known as traditional 
• Charismatic authority is based on the individual’s personality. • Rational-legal authority comes from the individual’s position in the 
hierarchy. 
 
 Question 4  
 B, E and F 
When delegating, authority must always be delegated but responsibility 
can never be delegated. 
Accountability is being called to account for one’s actions and results. 
The ability to exercise influence is power. 
Responsibility is the obligation of an individual to perform certain duties, 
tasks or take certain decisions.

Chapter 4 
 155 
 Question 5  
 B, D and E 
Fayol suggested five principles of management, the other two are 
Planning and Organising. 
 
 Question 6  
 The idea of there being one best approach to doing a job, arrived at from 
work study methods, comes from scientific management  theory. 
Leaders who keep their distance from subordinates by formalising roles and relationships with their team are known as psychologically distant 
managers . 
Transformational leaders  see their role as inspiring and motivating 
others. 
Bureaucratic management is based on a hierarchy of authority with 
strict rules and procedures. 
 
 Question 7 
  
Hygiene factor 
Team working 
Pleasant physical working 
conditions 
Suitable level and quality of 
supervision Motivating factor 
Career advancement 
Increasing levels of 
responsibility 
According to Herzberg, hygiene factors can avoid dissatisfaction and these factors must be in place before motivating factors will take effect.

156  
 Question 8  
 A  High degree of task specialisation – mechanistic  
B  Most suitable under stable conditions – mechanistic  
C  Employees recruited from a variety of sources – organic  
D  Emphasis on loyalty and obedience – mechanistic  
E  Emphasis on task achievement – organic  
F  More responsive to change – organic  
Burns and Stalker identified two major types of organisation which they 
felt were at the opposite ends of a continuum. 
Mechanistic organisations show many of the features of Weber’s 
bureaucracy and are seen as being more suitable under fairly stable 
Organic organisations are more responsive to change and more suitable 
for organisations moving through periods of rapid change. 
 
 Question 9 
 A, D and E 
Theory X managers believe that people need to be coerced, controlled 
and directed. This results in an authoritarian approach to leadership. Theory Y managers would adopt a more democratic style of leadership. 
 
 Task orientated – (9,1) 
Country-club – (1,9)  
Impoverished – (1,1)   
Team style – (9,9)  
Middle road – (5,5)

157 
Controlling performance 
– part 1 
B2: Analyse individual and 
team performance (a) Employee performance 
(b) Employee appraisals 
(c) Coaching and mentoring (d) Managing workplace 
• Target setting and employee alignment 
• Employee empowerment and engagement 
• Performance reporting and review 
• Rewards and sanctions in managing performance 
• Different approaches to coaching and mentoring to improve 
• Diversity and equity practices • Health and safety 
• Organisational culture. Chapter 
5

Controlling performance – part 1 
158  
 
2  The purpose of Organisational Control  
Fundamental to the achievement of organisational strategy is the contribution of 
the human element of the organisation. In this respect human resources are seen as valuable assets for the organisation however benefits obtained from these assets come at a cost. The recruitment, retention and training of employees is costly, especially where their knowledge, skills and experience are expected to generate competitive advantage. 
Hence, the effective management of human resources is a vital part of 
organisational success. In many organisations, particularly service organisation, the investment in human resources is significant. CMAs will be involved in ensuring that the investment being made in human resources is worthwhile and is generating value and advantage for the organisation. 
Human resource management in its broadest sense is concerned with 
management decisions and practices associated with people. The management accountant needs to understand the importance of good managerial practices and how to make the best use of people. This encompasses recruiting and selecting staff, development and reward, and performance management as well as ensuring that all legal requirements relating to human resources are adhered to.

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 159 
Human resource management involves ensuring that the right people are 
recruited for the organisation and that they develop their knowledge, skills and 
experience so that they perform to th e best of their abilities to help the 
organisation achieve its strategy. At the same time, they must control the behaviour of the people within the organisation to ensure that they are doing the right things in the right way within the rules of the organisation and any statutory rules imposed upon the organisation. 
3  Management control 
An underlying feature of the relationship between managers and their subordinates is management control. Most definitions of management include control as a function, it is essentially a means of ensuring that the objectives of the organisations are met. One definition of control is: 
Control is a primary task and is the process of ensuring the operations 
proceed according to plan. 
This chapter looks at the human resource management approaches to control. 
Behavioural aspects of control w ill be covered in the next chapter. 
Within the context of human resources management, control will require to be exercised over the recruitment of staff, their performance and legal requirements connected with employment. 
Note: all legal requirements referred to in this chapter are based on UK 
legislation. 
Control systems in practice 
Internal control systems exist to enhance the achievement of organisational 
objectives. They promote the orderly and efficient conduct of business, help keep the business on course, and help it change safely. 
In CIMA’s framework of control, the control system is seen as consisting of: 
• The control environment. This includes management philosophy, 
operating style and management policies 
• Control procedures . This includes control mechanisms such as 
segregation of duties, authorisation, reconciliation and so on. 
In today's organisations, one of the most important systems of control is the human resources system. The quality of an organisation’s employees is fundamental to its success. It is essential for the organisation to get its people system right.

160  
Human Resources are largely responsible for ensuring a number of 
employment practices are in place in the organisation. These should all contribute to the effectiveness of the organisation. 
• Appraisal system • Health and Safety 
• Discipline and Grievance 
• Dismissal and Redundancy 
• Fairness in the workplace – Diversity and Equal Opportunities. 
Some of these, such as appraisal systems, are management controls, while 
others are legal requirements. Appraisal systems will be covered in the next chapter, while the rest of these control systems will be discussed in this chapter. 
Policies, procedures and best practice 
For many organisations the main mechanisms of control and influence relate to 
setting up HR policies and procedures. 
For example, legislation on equality and diversity is translated into a set of 
policies and procedures that make it much easier for managers to follow, thus ensuring that legislation is adhered to. 
Similarly clear procedures for grievance and disciplinary action are established 
to ensure that managers do not unwittingly break the law, leaving the organisation exposed to the risk of legal action, but also to ensure that employees' rights are protected. 
Most organisations will insist that employees undergo training to ensure that 
they are aware of the policies and procedures, have a system where this is acknowledged and link this to disciplinary policies. 
For example, suppose a company has clear policies on appropriate use of 
company laptops and an employee then breaks those rules. It would be very difficult for the employee to make a defence against resulting disciplinary procedures if they have already signed something stating that (1) they were aware of the policies and (2) they accepted and understood that breaking them was a disciplinary offence. 
4  Management by Objectives 
One of the economic points of leadership is to leverage the more 'drone-like' resources of staff with lesser skills by giving them guiding frameworks of what they are setting out to achieve. Poor delegation means the job is done twice – and by a more expensive resource. 
MBO supports delegation by setting a more global sense of direction while 
leaving it up to staff to sort out the minutiae of how they actually do the work. It is linked with the idea of empowerment, with decisions being taken lower down the organisation.

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 161 
MBO could be defined as 'setting a clear direction and aims without necessarily 
predetermining how that will be achi eved and delegating much of the 
responsibility for making the 'how' decision'. 
Empowerment is about encouraging staff wherever possible to be proactive and 
creative and solve problems with support and coaching from above, rather than just waiting to be told what to do. 
MBO was popularised by management expert Peter Drucker decades ago. His 
idea has the virtues of relevance and simplicity, and helps combat micromanagement. Its relevance can be observed frequently in everyday management situations. 
One of the key jobs of an MBO leader is thus to set objectives and to coach 
staff to achieve them, like a football manager, rather than dictating exactly how the ball should be kicked. 
NB MBO will be covered in more detail in Chapter 6. 
5  Health and Safety 
A legal requirement which management must adhere to is health and safety 
legislation. Management have a responsibility to manage the health and safety risks in their workplace. They must think about what, in their organisation, might cause harm to people and ensure that they are doing enough to prevent that harm. 
Management must identify the health and safety risks within their organisations 
and decide how to control them and put the appropriate measures in place. 
Benefits of health and safety controls 
• Employers' legal obligations for health and safety are being met. 
• Cost savings. Accidents and illness cost the employer money in legal 
damages and operating costs. 
• Company image. The company does not want to be associated with a 
poor health and safety record. 
• To preserve the well-being of employees and others, improves employee 
morale, trust and motivation.

162  
 The Health and Safety at Work Act (HASAWA)  
 In the UK, the Health and Safety at Work Act 1974 (HASAWA) requires 
every organisation employing five or more persons to prepare and 
regularly revise a health and safety policy statement of: 
• their policy for health and safety 
• the organisation to enforce it 
• the arrangements to implement it 
and bring it to the attention of the employees. 
The following are key areas: 
• Provision and maintenance of risk-free plant and systems of work. • Ensuring the safety in use, handling, storage and transport of 
articles and substances. 
• Provision of information, training, instruction and supervision. • Maintenance of a safe workplace. 
• Provision of means of entry and exit. 
• Provision of a safe working environment. 
• Adequate facilities. 
A senior member of the organisation should be responsible for 
implementing the policy and may be supported by safety officers. Employees also have basic responsibilities in this regard. Most companies have a safety committee and representatives  who 
have some experience, are entitled to training and are consulted about 
arrangements to ensure the effectiveness of the health and safety policy implementation. 
The Health & Safety Executive (HSE)  
The Health & Safety Executive is an independent regulator with the duty 
to make adequate provision for the enforcement of the HASAWA. The main function of the HSE is providing workplace inspections to ensure compliance with the law and enforce the legal requirements, if necessary. The HSE also provides an advisory service to employers and unions. 
Safety committee and meetings 
One rule requires organisations to have a method of communicating and 
evaluating safety and health issues brought up by management or employees in their workplace. Larger employers must establish a safety committee. Smaller employers have the choice of either establishing a safety committee or holding safety meetings with a management representative present.

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 163 
 There is a difference between a safety committee and a safety 
meeting: 
• A safety committee is an organisational structure where members 
represent a group. This gives everyone a voice but keeps the 
meeting size to an effective number of participants. 
• A safety meeting includes all employees and a management person 
is there to ensure that issues are addressed. Typically, the safety committee is an effective safety management tool for a larger employer and safety meetings are more effective for a smaller employer. 
Health and safety training 
The Health and Safety at Work Act imposes a duty on employers to provide training to ensure a healthy and safe workplace. As well as being a way to obtain compliance with health and safety regulations, safety training enhances employees' knowledge, understanding and commitment. 
Organisations implement safety training because it improves job 
knowledge and skills and ensures optimum employee performance at a specified level. In health and safety training, specified performance standards include attention to safety rules and regulations regarding safe work behaviour. 
• First, problems or training needs are identified by inspection, by 
accident reports and through discussion at the health and safety 
• Next, the planning, execution and evaluation of the training takes 
place. 
• Because training programmes only have a short-term effect on 
employee's behaviour, regular refresher courses should be organised. 
• Top management support is a key ingredient in the availability and 
success of health and safety courses. 
All new staff under induction  must receive training that ensures their 
safety both in normal working conditions and in cases of emergency.

164  
 Monitoring policy 
Safety specialists argue that the safety policy should reflect the 
employer's commitment to develop safe systems of work and to pursue a healthy work environment. 
There is a growing awareness that, in practice, many employers are 
turning a blind eye to health and safety requirements. 
Furthermore, many safety policies are not that helpful in practice because 
of the failure to monitor their relevance to workplace arrangements, inadequate training, and supervisors and safety officers lacking authority to make decisions. 
A proactive approach would involve Human Resources regularly 
checking to ensure that safety policies, management procedures and arrangements are working and are changed to suit new developments or work structures in the workplace. 
 
 PQR has recently been taken over by RST. RST has always been very 
concerned about health and safety however this is not an area that PQR has paid much attention to. The previous managing director of PQR has always said that as they are not a manufacturing company, then they don’t really have to comply with health and safety. The management team of RST have arranged a presentation about health and safety for the managers and staff of PQR. You have been asked to present part of the presentation. 
Required: 
Write briefing notes for your presentation. These notes should cover: 
(a) An outline of the main features of health and safety legislation. 
(8 minutes) 
(b) An identification of those responsible for ensuring that the 
organisation is a safe place in which to work. 
6  Discipline 
The word discipline is used and understood in several different ways. It brings 
to mind the use of authority or force. To many, it primarily carries the disagreeable meaning of punishment. However, there is another way of thinking about discipline, based on the meaning of the original Latin distipulus meaning a learner or pupil.

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Discipline means learning 
Maintaining discipline (learning) among employees is an integral function of 
management. Discipline is present when the members of the enterprise follow goals or objectives sensibly without overt conflict and conduct themselves according to the standards of acceptable behaviour. 
Discipline therefore can be considered as positive when employees willingly 
follow or go beyond the rules of the enterprise. Discipline is negative when employees follow the rules over-strictly, or disobey regulations and violate standards of acceptable behaviour. 
The main purpose of taking disciplinary action is to achieve a change in 
behaviour of employees so that future action is unnecessary. 
The stages involved in a disciplinary process  
Employees need to be aware that certain actions will lead to disciplinary action. 
There are several situations where work norms might not be adhered to and 
which would cause problems if there were no remedial action: 
• leaving work early, lateness, absenteeism • defective and/or inadequate work performance 
• breaking safety or other rules, regulations and procedures • refusing to carry out a legitimate work assignment 
• poor attitudes which influence the work of others or which reflect on the 
public image of the firm, such as improper personal appearance.
 
Rules will normally cover issues such as absence, timekeeping and holiday 
arrangements, health and safety, use of the organisation's equipment and 
facilities, misconduct, sub-standard performance, discrimination, bullying and harassment. 
Rules and procedures should be clear, and should preferably be put in writing. 
They should be known and understood by all employees. 
Process for handling disciplinary procedures: 
• The informal talk. 
• The oral warning. 
• The written or official warning – first and second. 
• Suspension. 
• Demotion. • Dismissal.  
Standards need to be set for the right to appeal against these procedures. 
In a well-managed organisation disciplinary procedures may not be needed very 
often. But if a problem does arise then they are vital. Good procedures can help organisations to resolve problems internally – and avoid employment tribunal claims.

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 The statutory procedures a nd the Code of Practice 
 Although organisations can be flexible about how formal or extensive 
their procedures need to be, there is a statutory procedure they must 
follow as a minimum if they are contemplating dismissing an employee – or imposing certain kinds of penal ty short of dismissal such as 
suspension without pay or demotion. Unless employers follow the statutory procedure, em ployment tribunals will automatically find 
dismissals unfair. 
The statutory procedure involves the following three steps: 
• A statement in writing of what it is the employee is alleged to have 
done. 
• A meeting to discuss the situation. • The right of appeal. 
The statutory procedure is the minimum standard. Employment tribunals 
expect employers to behave fairly and reasonably. 
Disciplinary procedures are an aid to the effective management of 
people, and should not be viewed primarily as a means of imposing sanctions or as leading to dismissal. Where dismissal does occur, employees may make a complaint to an employment tribunal if they believe they have been unfairly dismissed, although ordinarily the employee must have one year's service. 
It is for the employer to show the reason for the dismissal and that it was 
a fair reason. 
The tribunal will determine whether the dismissal was fair or unfair and 
will take into account the size and administrative resources of the employer in deciding whether they acted reasonably or unreasonably. The tribunal consider how far the statutory procedures have been followed. Employment Tribunals expect employers to behave fairly and reasonably. 
 
 ACAS code of practice  
 In the United Kingdom, there exists a set of advisory booklets about 
various employment practices published by the Advisory Conciliation and Arbitration Service (AC AS). These are often used as yardsticks against 
which internal disciplinary procedures are judged to be fair or reasonable. The disciplinary code of practice states that disciplinary procedures should: 
• be in writing 
• specify to whom they apply 
• provide for matters to be dealt with quickly 
• indicate the disciplinary actions which may be taken

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• specify the levels of management which have the authority to take 
the various forms of disciplinary action 
• provide for individuals to be informed of the complaints against them 
and to be given an opportunity to reply 
• give individuals the right to be accompanied by a trade union 
representative or by a fellow employee 
• ensure that, except for gross misconduct, no employees are 
dismissed for a first breach of discipline 
• ensure that disciplinary action is not taken until the case has been 
carefully investigated 
• ensure that individuals are given an explanation for any penalty 
imposed 
• provide a right of appeal and specify the procedure to be followed. 
 
 Handling discipline  
 Encourage improvement 
The main purpose of operating a disciplinary procedure is to encourage 
improvement in an employee whose conduct or performance is below acceptable standards. 
Act promptly 
Problems dealt with early enough can be 'nipped in the bud', whereas 
delay can make things worse as the employee may not realise that they are below standard unless they are told. The manager should arrange to speak to the employee as soon as possible – the matter may then be able to be dealt with in an informal manner and not as part of the disciplinary process. 
Gather the facts 
Whilst maintaining satisfactory standards and dealing with disciplinary 
issues requires firmness on the part of the manager, it also requires fairness. The manager must be as objective as possible, keep an open mind, and do not prejudge the issues. 
Having gathered all the facts, the manager or supervisor should decide 
whether to: 
• drop the matter – there may be no case to answer or the matter may 
be regarded as trivial.

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 • arrange counselling/take informal  action – this is an attempt to 
correct a situation and prevent it from getting worse without using 
the disciplinary procedure. 
• arrange a disciplinary meeting – this will be necessary when the 
matter is considered serious enough to require disciplinary action. 
Stay calm 
All enquiries, investigations and proceedings must be conducted with 
thought and care. 
Be consistent 
The attitude and conduct of employees may be seriously affected if 
management fails to apply the same rules and considerations to each case. 
Consider each case on its merits 
While consistency is important, it is also essential to take account of the 
circumstances and people involved. 
Follow the disciplinary procedure 
The disciplinary procedure must be followed and the supervisor or 
manager should never exceed the limits of his or her authority. 
If the employee is dismissed or suffers a disciplinary penalty short of 
dismissal – such as suspension without pay – the statutory minimum procedures must have been followed. 
Suspension with pay 
Where there appears to be serious misconduct, or risk to property or 
other people, a period of suspension with pay should be considered while the case is being investigated. 
Self-discipline 
Self-discipline is based upon socialisation, producing norms which follow 
reasonable standards of acceptable behaviour. Positive self-discipline is based upon the premise that most employees want to do the right thing. Most people accept the idea that following instructions and fair rules of conduct is part of the work ethic. 
Once employees know what is expected of them and feel that the rules 
are reasonable, self-disciplined behaviour becomes a part of collective attitudes and group norms (i.e. the way in which employees behave as a work group), enabling ‘responsible autonomy’. When new rules are introduced, the manager must try to convince employees of their purpose and reasonableness. If the work group as a whole accepts change, a strong sense of group cohesiveness on the employees’ part will usually exert group pressure on possible dissenters, thus reducing the need for corrective action.

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 Douglas McGregor’s ‘hot stove rule’ 
 This rule draws a comparison between touching a hot stove and 
experiencing discipline. When one touches a hot stove, the reaction is 
immediate, consistent, impersonal and with warning. The burn is immediate, with no questions of cause and effect. There is a warning, because everyone knows what happens if one touches a stove when the stove is hot. The result is consistent; every time a person touches a hot stove, they are burned. The result is impersonal; whoever touches a hot stove is burned. One is burned because of what they do, because the stove is touched, not because of who the person is. The comparison between the ‘hot stove rule’ and disciplinary action is that discipline should be directed against the act and not against the person. 
Immediacy  means that after noticing the offence, the supervisor 
proceeds to take disciplinary action as speedily as possible, normally the 
preliminary informal investigation. 
For example, emotional incidents such as arguments in public or 
insubordination often require immediate response. 
 
 EFG was established three years ago. Since then, the company, which 
provides online financial advice, has experienced rapid growth, and the management has not really had the time to get all management systems and procedures into place. 
The chief executive officer has recruited you to look at the way in which 
the company deals with its disciplinary problems and procedures. 
Required: 
Write a report to the CEO covering the following: (a) Explaining why EFG should have a formal disciplinary procedure. 
(b) Recommending guidelines for drawing up a disciplinary procedure. 
7  Grievance procedures 
Grievance procedures are not the same as disciplinary procedures. A grievance 
occurs when an employee feels superiors or colleagues are wrongly treating him or her; e.g. unfair appraisal, discrimination, prevented from advancing, being picked on, etc. 
The grievance procedure often follows this sequence: 
• The employee discusses the grievance with a colleague, staff or union 
representative.

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• If the grievance is warranted, it is taken to the employee's immediate 
superior. 
• If that superior cannot help, then it is referred to the superior's manager, 
at which stage the HR or Personnel department should be informed. 
• Distinction should be made between an individual and a collective 
grievance. 
• The colleague, staff or union representative should be permitted to be 
involved. 
• Time-frames and deadlines should be stated to resolve the issue or submit 
an appeal. 
Tribunals 
A company may find that an employee is not happy with the outcome of a 
grievance procedure and that the individual wants to make a claim to an employment tribunal. 
Employment tribunals are independent judicial bodies, less formal than a court, 
established to hear and determine claims to do with employment matters. Their aim is to resolve disputes between employers and employees over employment rights. 
• unfair dismissal • breach of contract 
• discrimination 
• equal pay. 
 
Resolving disputes without a tribunal  
 In some cases it is possible to resolve disputes without the need for a 
tribunal. The following techniques may be used: 
Arbitration 
With arbitration, an independent arbitrator hears the case and delivers a 
legally binding decision in favour of one party. It is used to decide cases of alleged unfair dismissal or claims under flexible working legislation. 
Benefits include: 
• Speedy private informal hearing. 
• No cross-examination. 
• Limited grounds for review of the arbitrator’s decision.

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 Mediation 
With mediation an impartial third party facilitates discussion between the 
parties and encourages them to reach a mutually satisfactory conclusion. 
• Speedy resolution 
• Avoids the stress of a formal hearing 
• Parties can express their views directly to each other. 
Conciliation 
This can be used to settle a dispute before it gets to a tribunal hearing. It 
involves trying to build a positive relationship between the disputing parties. 
• Confidentiality. • Avoid time, stress and cost of attending a tribunal. 
• Lessening damage to the employment relationship. 
• Reaching an agreement that satisfies both parties. 
Benefits of discipline and grievance procedure 
• Employer's legal obligations are being met. • Cost savings. Fewer costs for legal damages and lower operating costs. 
discipline and grievance record. 
morale, trust and motivation. 
 
Case study style question 3 
 P has worked in the customer services department of LMN company for 
two years. Last week he was sent to meet with M, a senior Human 
Resources manager. 
At the meeting, which lasted less than ten minutes, P was told that the 
company were very unhappy with his performance and that his attitude was ‘not as it should be’. He was informed that, in accordance with the company’s discipline code, he was being demoted to a lower graded role in the credit control department and that this was with immediate effect.

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 P was shocked by this as he had never been informed of the company’s 
unhappiness with him before and he was confused about the comment 
about his attitude. He had always enjoyed his job, and thought he got on well with his colleagues . He had also never heard of the company’s 
discipline code. 
Required: 
Write an email to P discussing what LMN have done wrong in the 
handling of his case and explain the actions which are available to him regarding this decision. 
(20 minutes)  
 
 S, who was recently appointed as Head of Human Resources (HR) in a 
small but growing business, reviewed the company HR policies and decided that they need updating. The company has existing documents covering Equal Opportunities, a Company Code of Conduct, Disciplinary Procedures and Grievance Procedures. Several members of staff did not know the difference between grievance and disciplinary procedures and were unaware that the company had policies on these matters. 
Required: 
Write an email to be sent to all members of staff explaining the difference 
between ‘grievance’ and ‘discipline’ and briefly describing the disciplinary process. 
(20 minutes) 
8  Dismissal and redundancy   
Dismissal 
Under UK law, dismissal is described as termination of employment  with or 
without notice by the employer, or in the case of constructive dismissal, resignation by the employee because the conduct of the employer was sufficient to be deemed to have terminated the contract by the employer’s actions. Dismissal without notice is usually wrongful dismissal, that is breach of the contract of employment; it may or may not also be unfair dismissal. 
Dismissal is normally fair only if the employer can show that it is for one of the 
following reasons: 
• a reason related to the employee's conduct . 
• a reason related to the employee's capability  or qualifications for the job.

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• because a statutory duty  or restriction prohibited the employment being 
continued. 
• some other substantial reason  of a kind which justifies the dismissal and 
that the employer acted reasonably in treating that reason as sufficient for 
dismissal. 
• because the role was redundant . 
 
 Types of dismissal  
 • Constructive dismissal is resignation by the employee because the 
conduct of the employer was sufficient to be deemed to have terminated the contract by the employer’s actions. 
• Wrongful (unfair) dismissal is dism issal without notice, a breach of 
the contract of employment. 
For a dismissal to be fair, the employer must show that the reason for the dismissal is of a type acceptable under statute. 
Redundancy 
Redundancy is a type of dismissal. The grounds of redundancy may be justified on any of the following grounds: 
• cessation of business • cessation of business in the place where the employee was employed 
• cessation of the type of work for which he or she was employed. 
 
The law relating to redundancy  
 For the purposes of the right to be consulted, which applies when an 
employer proposes to make 20 or more employees redundant over 
90 days or less, the law defines redundancy as: 'dismissal for a reason not related to the individual concerned or for a number of reasons all of which are not so related'. This definition might include, for example, a situation where dismissals are not re lated to the conduct or capability of 
the individuals but are part of a reorganisation.

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 Case study style question 5 
 DEF, a national airline carrier, has made a net loss for the last five years. 
While its major competitors have pursued programmes of modernisation, 
DEF has been left behind and is reported to have administrative costs and average salary costs that are, respectively, 35% and 25% higher than those of its competitors. The use of outdated and fuel-inefficient aircraft, as well as a reluctance to make use of modern Internet systems for online reservation, have been among the factors that have contributed to DEF’s decline. 
The board of DEF has produced a restructuring plan that includes 5,000 
job cuts out of a workforce of 50,000; new, more demanding employment 
conditions; the sale of non-core assets; the establishment of twelve profit centres; a reduction in routes flown; replacement of its ageing fleet with fewer but more fuel-efficient aircraft and a complete overhaul of its reservation system. 
Fierce confrontation is expected with the fourteen airline unions, but the 
board of DEF is committed to the implementation of the restructuring plan. 
Required: 
Your manager, the Finance Director, has asked you to prepare some 
notes for her on this matter for the next board meeting. Your notes should identify the key problems associated with making large-scale redundancies and discuss the ways in which redundancies can be managed to minimise these problems for DEF. 
9  Equality and diversity 
Globalisation has changed the nature of companies in many ways. In terms of staff, it has meant: 
• The end of the “job for life” ideal. • A move from employee’s effort due to loyalty to the company towards 
effort expecting appropriate rewards. 
• Employees willing to look outside of the company for advancement 
opportunities. 
Obtaining employee commitment is often seen as the key to competitive 
performance, but due to the above factors, commitment from employees is becoming more difficult for companies to obtain.

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Rosseau and Greller's psychological contract  
Rosseau and Greller  looked into the relationship between what the employees 
believed was expected of them and what they expected in return from the 
employer. They called this the psychological contract . They defined three 
types of psychological contract: 
• Coercive  where employees feel forced to contribute and view rewards as 
inadequate. 
• Calculative where employee acts voluntarily and works in exchange for 
an identifiable set of rewards. 
• Cooperative  where employees contribute more than would normally be 
expected from them. They actively seek to contribute further to the achievement of company goals. 
In coercive contracts, motivation and commitment would be low, or even negative. In calculative contracts, motivation and commitment could be increased if the rewards were increased. In cooperative contracts motivation and commitment would be linked to achievement. Motivation was found to be highest when the contract was viewed in the same way by the organisation and the individual, that is where the employee perceived the practices of the company towards them to be fair. 
 
Salomon  
 Salomon looked at the difficulty in achieving equity in relation to pay, 
there are many considerations: 
• A living wage (compare employee needs and their income) 
• Rate for the job (compare employees carrying out the same role) 
• Output reward (compare the output of employees working in the 
same area) 
• Responsibility (compare the responsibilities of employees at 
different levels of the organisation) 
• Differentials (compare employees carrying out different roles within 
the organisation) 
• Comparability (compare employees carrying out the same roles in 
different organisations) 
• Status (compare employees carrying out different roles in different 
organisations) 
• Contribution (compare the employee’s pay to the profitability of the 
organisation) 
• Supply and demand (compare the organisation’s ability to pay and 
its need for labour).

176  
Equality and diversity are important concepts in human resources management. 
They cover the legal obligation of organisations to protect against discrimination and to ensure that all individuals are treated fairly and equally. 
Equality 
In the UK, The Equality Act  (2012) is the most significant piece of equality 
legislation to be introduced for many years. It is there to strengthen protection, 
advance equality and simplify the law. The Equality Act brings together, and significantly adds to and strengthens, a number of previous existing pieces of legislation, including race and disability. One of the key changes is that it extends the protected characteristics to encompass: 
• age 
• disability 
• gender reassignment 
• marriage and civil partnership 
• pregnancy and maternity 
• race 
• religion or belief 
• sex 
• sexual orientation. 
Diversity 
Every business wants the best person for the job. Unequal treatment, prejudice 
or harassment discredits businesses and can be very costly. The owner or manager of a business may also be held responsible for discriminatory action by its employees. 
Under the Equality Act (2012) it is unlawful to discriminate on the grounds of 
someone's sex, sexual orientation, status as a married person or a civil partner, race, colour, nationality, ethnic origin, relig ion, beliefs or because of a disability, 
pregnancy or childbirth, or subsequent maternity leave or because they are a member or non-member of a Trade Union. It is also unlawful to discriminate against part-time workers. 
Equal opportunities 
The object of providing equal opportunities on the workplace is to: 
• ensure fair and non-discriminatory treatment is given by management to 
all job applicants and existing employees.

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A positive approach to equal opportunities should: 
• secure the best recruits from the widest available range of candidates. • ensure the best use is made of the skills and abilities of all employees. 
• reinforce the professionalism and image of the organisation itself. 
The implementation of equal opportunities policies is important to all 
organisations. Unfair or unlawful discriminatory practices not only lead to resentment on the part of those who suffer from them; they also adversely affect public perceptions of the organisation. A genuine belief in equal opportunities, coupled with the knowledge that unfair or unlawful discriminatory practices will 
not be tolerated, should yield benefits within the organisation itself and lead to a more positive public belief in its fairness and professionalism and an improved relationship with its stakeholders. 
 
Equal Opportunities Policy  
 The main points of a typical Equal Opportunities Policy should be as 
follows: 
• Equal opportunities shall mean fairness for all; the recognition, 
development and use of everyone's talents. 
• This fairness will run through re cruitment, selection, training, 
promotion, specialisation and career development generally. It 
should also govern the relationship of all employees with each other. 
• Equal opportunity does not just relate to sex or marital status, but 
the fact that people can be particularly disadvantaged for those reasons is reflected in legislation. 
• No job applicant or employee shall receive unfavourable treatment 
directly or indirectly on the grounds of gender, sexual orientation, marital status, race, nationality, ethnic origin, religious beliefs and, where applicable, trade union membership, age or disability. 
• Selection criteria and procedures will be frequently reviewed to 
ensure that individuals are selected, promoted and dealt with on the basis of merit, fitness and competence, subject only to the restrictions imposed by law. 
• Training is an important part of the implementation of the Equal 
Opportunities Policy. Training programmes will be arranged to ensure that staff are fully aware of their roles and responsibilities and have the opportunity to develop and progress within the organisation.

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The differences between equa l opportunities and diversity: 
 
Equal opportunities Diversity 
Removing discrimination Maximising potential 
Issue for disadvantaged groups Relevant to all employees 
A Human Resources role A managerial role 
Relies on proactive action Does not rely on proactive action 
10  Organisational culture 
What is culture? 
Organisational culture is an important concept since it has a widespread 
influence on the behaviours and actions of employees. It represents a powerful force on an organisation’s strategies, structures and systems, the way it responds to change and ultimately, how well the organisation performs. 
Handy described culture as: 
'the way we do things around here' 
By this Handy means the sum total of the belief, knowledge, attitudes, norms  
and customs that prevail in an organisation. 
Levels of culture According to Edgar Schein (1992)  Culture exists at three different levels: 1 Artefacts . These are the things that can be seen, heard and observed. 
This is largely the view of the organisation that the public experience. It 
can include items such as: 
–  Dress codes. Is the dress code formal or informal, for example are 
uniforms worn? 
–  Patterns of behaviour. This is the way people within the organisation 
are seen as acting. 
–  Physical symbols. This could include logos and branding.  –  Office layout. This includes the facilities and furnishings.
 
2 Espoused Values . These can be identified from stories and the opinions 
of those within the organisation. It can include items such as: –  Language. This is the way people communicate both within and 
outside the organisation.

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–  Behaviour. This shows what the people in the organisation feel is 
important. 
–  How people justify what they do. These values can be deep rooted, 
many will take for granted that their behaviour is acceptable without 
questioning it. 
3  Basic assumptions . These beliefs are so deeply embedded in a culture 
that members are no longer consciously aware of them. It can include: 
–  Beliefs on environmental issues. If this is important, it will be part of 
every aspect of the work done. 
–  How people should be treated. This will include human relations 
policies, customer relationships etc. 
As you go through the levels, the elements become less visible and more 
ingrained. At the third level, those within the organisation may not even be aware of their beliefs, they have become so fundamentally part of their way of being. 
For an organisation, understanding this helps them to anticipate problems with 
their culture and allows them to see how difficult it may be to change. Changing level one items, such as dress codes or office layouts, is relatively easy, but changing values and beliefs can be very difficult. This may also lead to differences between the levels, for example what the organisation says and does may be different to how it is perceived by the outside world. The public may view certain acts as superficial and often do not believe that the underlying beliefs of the organisation have really changed. 
 
The organisational iceberg  
 The idea of hidden elements in culture is often referred to as the 
organisational iceberg. 
The iceberg describes two levels at which culture operates: 
• Formal aspects (visible) above the water • Behavioural aspects (hidden) below the water.  
The elements of culture above the surface would include: 
• goals • technology 
• procedures 
• structure 
• skills.

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 The hidden elements represent the larger part of the iceberg which is 
below the water, and that would include: 
• attitudes • style 
• communication patterns 
• values 
• feelings 
• beliefs. 
 
The diagram shows that what the public, customers, suppliers and others 
outside of an organisation see is only a small part of the picture. Much of what makes the organisation what it is, is intangible or hidden from view. It suggests that it is really only possible to fully understand the workings and culture of an organisation from within. 
Why is culture important? 
Culture is that invisible bond, which ties the people of a community together. It refers to the pattern of human activity. The importance of culture lies in its close association with the way of living of the people. The different cultures of the world have brought in diversity in the ways of life of the people inhabiting different parts of the world. 
Culture is related to the development of one’s attitude. The cultural values of an 
individual have a deep impact on his/her attitude towards life. They shape an individual’s thinking and influence his/her mindset. 
• It gives an individual a unique identity. • The culture of a community gives its people a character of their own. 
• Culture shapes the personality of a community. This includes the language 
that a community speaks, the art forms it hosts, its staple food, its 
customs, traditions and festivities comprise the community’s culture.

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Advantages of having a strong culture 
An organisation's culture has a significant bearing on the way it relates to its 
stakeholders (especially customers and staff), the development of its strategy and its structure. A strong culture will: 
• facilitate good communication and co-ordination within the organisation. • provide a framework of social identity and a sense of belonging. 
• reduce differences amongst the members of the organisation. 
• strengthen the dominant values and attitudes. 
• regulate behaviour and norms among members of the organisation. 
• minimise some of the perceptual differences among people within the 
• reflect the philosophy and values of the organisation’s founder or dominant 
group. 
• affect the organisation’s strategy and ability to respond to change. 
Disadvantages of havi ng a strong culture 
A strong culture that does not have positive attributes in relation to stakeholders 
and change is a hindrance to effectiveness. Other disadvantages of a strong culture are: 
• Strong cultures are difficult to change, beliefs which underpin culture can 
be deep rooted. 
• Strong cultures may have a blinkered view which could affect the 
organisation's ability or desire to learn new skills. 
• Strong cultures may stress inappropriate values. A strong culture which is 
positive can enhance the performance of the organisation, but a strong 
culture which is negative can have the opposite effect. 
• Where two strong cultures come into contact e.g., in a merger, then 
conflicts can arise. 
• A strong culture may not be attuned to the environment e.g., a strong 
innovative culture is only appropriate in a dynamic, shifting environment. 
 
Influences on culture 
The structure and culture of an organisation will develop over time and will be 
determined by a complex set of variables, including: 
Size How large is the organisation in terms of turnover, physical size 
and employee numbers? 
Technology  How technologically advanced is the organisation either in terms 
of its product, or its productive processes? 
Diversity  How diverse is the company either in terms of product range, 
geographical spread or cultural make-up of its stakeholders?

182  
Age How old is the business or the managers of the business? Do its 
strategic level decision makers have experience to draw upon? 
History  What worked in the past? Do decision makers have past 
successes to draw upon; are they willing to learn from their 
mistakes? 
Ownership   Is the organisation owned by a sole trader? Are there a small 
number of institutional shareholders or are there large numbers of small shareholders? 
When analysing an organisation, look for clues given as to the culture of the organisation using these main areas, although there are many other influences, including the leadership style adopted. 
 
Other influences on culture  
 As well as the main influences on culture listed above, there are other, 
more subtle influences: 
• The degree of individual initiative – is it encouraged or are decisions 
always referred upwards? 
• The degree of risk tolerance – are managers only allowed to follow 
low-risk strategies? 
• Clarity of direction – is there a clear focus; are these clear objectives 
and performance expectations? 
• The degree of integration between groups – are different units 
encouraged to work together? Are management aloof or 
approachable; is communication clear to lower level staff? 
• The reward system – are individuals rewarded for succeeding, 
i.e. are rewards based on performance criteria? 
• Conflict tolerance – are employees encouraged to air grievances? 
• Communication patterns – is there a formal hierarchy or an informal 
network? 
• Formalisation of clothing and office layout – are there strict rules 
over this? 
• The kind of people employed – are they graduates, young, old, etc.?

184  
 Question 1 
 Match the techniques for resolving employment disputes with the correct 
definition: 
Tribunal Arbitration C onciliation Mediation 
• An independent party hears the case and delivers a legally binding 
decision 
• An independent party facilitates  discussion between the parties and 
encourages them to reach a mutually satisfactory conclusion 
• An independent judicial body hears the claims and passes a legally 
binding judgement 
attempts to build more positive relations between the parties 
 
 Question 2 
 Human Resources are largely responsible for ensuring a number of 
employment practices are in place in the organisation. One of these is 
health and safety. Health and safety legislation is a legal requirement in the UK. 
Which of the following statements are true in relation to health and 
safety? Select all that apply. 
A  Health and safety is solely the responsibility of management B  The Health and Safety at Work Act 1974 applies to all organisations 
in the UK 
C  Organisations can save costs through health and safety compliance D  Health and safety issues should be covered during the induction of 
new members of staff 
E Adhering to health and safety legislation can improve a company’s 
reputation 
F All large organisations in the UK must have an up to date health and 
safety policy statement

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 Question 3 
 Insert the correct words in the sentences below (words can be used more 
than once). 
• Discipline 
• Grievance 
• Dismissal 
• Tribunal 
• Redundancy 
A __________ occurs when a member of staff feels they are being 
treated unfairly. The objective of _____________ is to change behaviour. Where an employee has been subject to _________ they may wish to take their case to a___________________. Unfair ____________ would be grounds to take a case to a ___________. _____________ is a form of ____________ which would be allowed if the 
business ceased trading. 
 
 Question 4 
 Which of the following statements about discipline are true? Select all 
that apply. 
A  There are no legal requirements regarding disciplinary procedures; 
organisations can be flexible about how formal their disciplinary 
procedures are. 
B  Where a member of staff feels that they are being unfairly treated by 
colleagues or managers, they may initiate disciplinary action. 
C  Douglas McGregors’s ‘hot stove rule’ suggests that disciplinary 
action should be taken immediately after the offence is noticed. 
D  Persistent lateness or absenteeism would be unfair grounds for 
disciplinary action. 
E  Disciplinary action will normally follow a process including verbal 
and written warnings before dismissal would be considered. 
F  The purpose of a disciplinary procedure is to change behaviour.

186  
 Question 5 
 Using Rosseau and Greller’s model of psychological contract, match the 
words to the definitions. 
 
Calculative Cooperative Coercive 
 
• Employees feel forced to contribute and view rewards as 
inadequate 
• Employees contribute more than would normally be expected from 
them 
• Employee acts voluntarily and works in exchange for an identifiable 
set of rewards 
 
 Question 6 
 Which of the following is NOT covered by the Equality Act 2012? 
A  Pregnancy and maternity 
B  Sexual orientation C  Physical appearance D  Religion or belief 
 
 Question 7 
 Which of the following would be seen as fair grounds for dismissal? 
Select all that apply. A  The member of staff was known as a troublemaker B  Company restructuring C  The role had become redundant D  Gross misconduct, such as theft or violence E  Long term absenteeism due to ill health F  Statutory restriction prohibiting continued employment

Chapter 5 
 187 
 Question 8 
 Match the statements to whether they relate to equal opportunities or 
diversity. 
  Equal 
opportunities Diversity 
A Human Relations role    
Objective of maximising potential    
Objective of removing discrimination    
Relevant to all employees    
A management role    
    
 Question 9 
 Which three  of the following statements regarding equality are correct? 
A  It is unlawful to discriminate against part-time workers 
B  Equal Opportunities is a managerial role C  Diversity is about removing discrimination D  Equal opportunities is an issue for disadvantaged groups E  The UK Equality Act 2012 makes it illegal to discriminate on the 
grounds of age

188  
 BRIEFING NOTES 
Presentation on Health and Safety for PQR 
(a) The Health & Safety at Work Act (HASAWA)  was designed to 
have far-reaching consequences upon employers’ premises and 
methods of work. The main provisions of the Act require an employer to provide a safe and healthy working environment in which to work. This includes the duty to provide training and appoint individuals responsible for maintaining safety at work, for example, safety representatives and trained safety officers. 
The Health & Safety Executive (HSE). The Commission, together 
with the Secretary of State makes appointments to the Health & 
Safety Executive whose duty it is to make adequate provision for the enforcement of the HASAWA. The main function of the HSE is providing workplace inspections to ensure compliance with the law and enforce the legal requirements, if necessary. The HSE also provides an advisory service to employers and unions. 
(b) Managerial responsibilities. Health and safety at work is the 
responsibility of both employers and employees. Legislation can only 
provide the underpinning to safe working practices, ultimately, it is how the legislation is translated in practice that determines whether a workplace is safe, or not. There are a number of ways in which managerial responsibility can be discharged to make work safe. The management of an organisation carry the prime responsibility for implementing a policy they have laid down, and they also have responsibility under the Act for oper ating the plant and equipment in 
the premises safely and meeting all the Act’s requirements whether these are specified in the policy statement, or not. Management has a duty to provide a safe and healthy working environment, which is hazard free, and to train others so that they are able to operate and maintain a safe and healthy working environment for themselves. 
Employee responsibilities . For the first time in health and safety 
legislation a duty is placed on employees while that are at work to 
take reasonable care for the safety of themselves and others. The employee is, therefore, legally bound to comply with the safety rules and instructions that the employer requires. Employers are also fully empowered to dismiss employees who refuse to obey safety rules on the grounds of misconduct, especially if the possibility of such a dismissal is explicit in the disciplinary procedure. Employees need to be enabled by management to carry out their duties and responsibilities. This might take the form of communicating policies 
and procedures about health and safety issues, appointing safety representatives, setting up committees and providing training.

Chapter 5 
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 Safety representatives. To reinforce the employees’ role in the 
care of their own health and safety, provision has been made for the appointment of safety representatives by trade unions. Safety representatives have a legal duty of consultation with employers and are entitled to paid time off for training to enable them to carry out their function. Under the HASAWA employers’ are expected to set up safety committees and consult with safety representatives about the membership of that committee. 
Safety committees . Although the Act does not specifically instruct 
employers to set up safety committees, it comes very close. Safety 
representatives and training officers have to be consulted about the membership of the committee, and detailed advice on the function and conduct of safety committees is provided by the Health and Safety Commission. Since the Act there has been a great increase in the number of Safety Committees in operation. It has also been noted that the effectiveness of committees has been very much dependent on the employment of trained safety officers. 
 
 REPORT 
To: CEO From: Consultant  Date: today 
Report on the need for a formal disciplinary procedure for EFG.  
In this report, the need for EFG to introduce a formal disciplinary 
procedure will be explained and guideli ne for drawing up this procedure 
will be recommended. 
Need for a formal disciplinary procedure (a)  At its most fundamental level, the existence of a written disciplinary 
procedure is designed to protect both the employer and the 
employee. 
Employer perspective The employer should be protected from facing future actions 
(e.g. for unfair dismissal). If the company has clearly set out what it views as unacceptable behaviour and the actions that will be taken if this behaviour is undertaken, then it becomes very hard for the employee to claim they have been mistreated. 
If an employee does undertake some action that is deemed  
unacceptable, the sliding scale of various different punishments should mean that the employee is less likely to repeat the action.

190  
Looking at the big picture, the point of a disciplinary scheme is to 
deter employees from breaking the rules; in other words, to make sure that the scheme never has to be used. 
Employee perspective The employee of an organisation benefits from having a formal 
disciplinary proc edure since it reduces the risk that they will be 
arbitrarily accused and punished for their actions. 
This is becoming more important as more individuals are left to their 
own devices at work, rather than being given detailed rules and procedures (as organisations move from a mechanistic to an organic approach). This is likely to be particularly important in a company, such as EFG which is growing and changing rapidly. 
Guidelines for drawing up a disciplinary procedure 
(b)  Any disciplinary procedure must take account of local legislation. In 
the case of EFG, there are a number of steps that should be 
followed. 
The company should write down the procedures to avoid 
misunderstandings, and provide all members of staff with a copy. 
It should be very clear which sections apply to which staff 
(e.g. some parts may only be relevant to senior executives). 
The procedures should state very clearly the forms of disciplinary 
action which can occur, e.g. verbal warnings, written warnings, etc. 
The procedures should also state which levels of management are 
able to use certain kinds of action (e.g. only senior executives being able to issue written warnings). 
Detail the steps that will be taken to investigate co mplaints that 
might lead to action being taken. Detail the procedures of how the employee will be notified of any 
complaint and of any action being taken against them. 
Detail the appeal procedures for workers who feel that the action 
taken is unmerited. 
The establishing of a disciplinary procedure is important for EFG as it 
would protect the company and the employees of the company.

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 EMAIL 
Subject: Grievance 
Dear P, 
I feel that LMN have acted against the statutory procedures laid down for 
companies in the way they have treated you. 
Companies are expected to follow the ACAS code of practice in all 
disciplinary and grievance procedures. 
The purpose of disciplinary procedures should be to improve the 
behaviour of the individual before action such as suspension, demotion or dismissal takes place. These actions sh ould only occur in  cases of gross 
misconduct or after a number of other courses of action have been taken first. This is clearly not the case here. 
The stages which would normally be undertaken in this sort of case 
before a demotion would be: 
• Informal chat • Oral warning 
• Written warning – first then second 
It would appear that none of these stages had been undertaken as the 
meeting notifying you of the demotion was the first you knew of the company’s unhappiness with your performance. You also do not appear to have been given any details, or shown any evidence about the source of their unhappiness and it would appear that you have been given no opportunity to respond to their claims.

192  
 It is also significant that you were not aware of the company’s discipline 
code. All employees should be made aware of this code when they join 
the company. The code should be clear about the expectations of the company and about actions which would be taken as a result of these expectations not being met. 
You have obviously never had any sort of appraisal since joining the 
company or these matters would have been raised, and hopefully resolved, sooner. 
In this case, you would have the right to appeal the decision at tribunal. 
As the company have not followed the statutory rules, it is likely that you would win your case. 
I hope you have found the above useful. Please do not hesitate to get in 
touch if you would like any more information or would like to discuss any of these issues further. 
 
 EMAIL 
To: all staff 
Subject: Grievance and discipline 
It has come to the attention of Human Resources management that staff 
may be unclear about the difference between grievance and discipline and may not be aware of the disciplinary process within the company. The purpose of this email is to clarify the differences between grievance and discipline and to outline the disciplinary process within the company. 
Grievance procedures are used for considering problems or concerns 
that employees wish to raise with their employers. Discipline is not about punishment, but about correcting inappropriate 
behaviour. When an employee breaks the company code of conduct, a disciplinary process starts so that the employee becomes aware of their mistakes and can take the opportunity to improve their behaviour. Disciplinary offences may include, but are not limited to, persistent lateness, refusal to carry out reasonable work, poor work performance, harassment of colleagues and/or misuse of company assets. 
A code of conduct should be established and documented. Staff should 
have access to the document and be made aware of its importance and the consequences of a breach. 
The disciplinary process is progressive in nature. A disciplinary offence 
does not automatically lead to dismissal.

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 The stages of the disciplinary process are: 
• informal talk 
• formal talk 
• verbal warning 
• written warning 
• decision – suspension, demotion, dismissal. 
At each stage of the process, the employee must be made aware of the 
• the section of the code that has been breached 
• how the behaviour can be rectified 
• what will happen if there is no improvement. 
In many instances an informal talk can rectify problems without the need 
to progress through the formal stages. It is also important to establish if there are any mitigating circumstances that might be causing problems at work. Additionally all staff should be treated in the same manner with regard to discipline in accordance with the Equal Opportunities Policy. 
 
 NOTES 
To: Finance Director 
From: Management Accountant  Date: today 
Subject: Problems associated with large-scale redundancies 
The key problems in any redundancy situation include that of deciding 
which personnel shall be made redundant, carrying out the redundancy process in a way that is fair and within the law, deciding what the redundancy package will consist of, and how to maintain the morale and motivation of the remaining workforce. 
Selection for redundancy must be fair, carried out according to an agreed 
procedure laid down beforehand and consistently applied. This procedure does not have to be the last in first out’ principle, although this is a popular method because of its ease of application.

194  
 In the United Kingdom, the ACAS Code of Practice provides a useful 
checklist that helps ensure that companies operate within the law and 
that individuals are treated fairly in the redundancy process. Other countries have similar codes of practice and these should be followed where available. 
The ACAS code suggests that mana gement should stop recruitment, 
reduce overtime, consider retraining or transfer of people to other jobs, 
retire those over normal retirement age and introduce short-time working. Where the redundancy is inevitable, as in the case of DEF, employers should give as much warning as possible, use voluntary redundancy and early retirement, and offer help in finding other work. Employers must also ensure that individuals are informed before any news leaks out, and should try to run down establishments slowly. 
The redundancy package offered needs to be considered for a number of 
reasons. First, a basic legal minimum sum based on the number of years of employment can result in a substantial sum, and this has to be budgeted for. Second, DEF might consider paying over the legal minimum as a way of indicating to the remaining employees and the world more generally that it is a ‘good’ employer. 
The needs of the remaining staff should also be considered. Their morale 
and confidence in the organisation will need to be boosted. In the case of a partial redundancy, those remaining at work may well have to change their work patterns by operating new machinery, coping with bigger jobs or changing their job location. This  will need to be discussed with the 
trade union(s), the employees concerned and their supervisors. 
The term ‘outplacement’ has come to be used to describe the efforts of 
management to place redundant employees in other economically active positions. Some consultants have become expert in revising curriculum vitae (CVs) of staff and ‘selling’ them to a network of contacts. 
Please do not hesitate to get in touch if you would like me to prepare any 
additional notes on this topic. 
 
 Question 1 
 The correct definitions are: 
decision – Arbitration  
encourages them to reach a mutually satisfactory conclusion – Mediation  
binding judgement – Tribunal  
attempts to build more positive relations between the parties – Conciliation

Chapter 5 
 195 
 
 Question 2 
 C, D, E and F 
All employees have responsibility for health and safety, not just 
The HASAWA applies to all organisations which employ five or more 
people. 
 
 Question 3 
 A grievance  occurs when a member of staff feels they are being treated 
unfairly. 
The objective of discipline  is to change behaviour. 
Where an employee has been subject to dismissal they may wish to take 
their case to a tribunal . 
Unfair dismissal  would be grounds to take a case to a tribunal . 
Redundancy  is a form of dismissal  which would be allowed if the 
 
 Question 4 
 C, E and F 
There are no legal requirements regarding disciplinary procedures; 
organisations can be flexible about how formal their disciplinary procedures are. This is incorrect as disciplinary procedures are set by law. 
Where a member of staff feels that they are being unfairly treated by 
colleagues or mangers, they may initiate disciplinary action. This is incorrect as in this case they would initiate grievance procedures. 
Persistent lateness or absenteeism would be unfair grounds for 
disciplinary action. This is incorrect as this would be grounds for disciplinary action. 
 
 Question 5 
Coercive – Employees feel forced to contribute and view rewards as 
Cooperative – Employees contribute more than would normally be 
expected from them  
Calculative – Employee acts voluntarily and works in exchange for 
an identifiable set of rewards

196  
 
 Question 6 
 C 
The Equality Act 2012 covers: 
• Pregnancy and maternity 
• Sexual orientation 
• Religion of belief 
• Age 
• Disability 
• Gender reassignment 
• Marriage and civil partnership 
• Race 
• Sex 
But it does not cover physical appearance. 
 
 Question 7 
 C, D and F 
A member of staff being known as a troublemaker is not grounds for 
dismissal but should be dealt with through the disciplinary process if there is evidence of troublemaking. 
Company restructuring may result in redundancy but is not in itself 
grounds for dismissal. 
Employees cannot legally be dismissed on the grounds of ill health. 
 
 Question 8 
 The correct matching is: 
 
A Human Relations role 
Objective of removing 
discrimination Diversity 
A management role 
Objective of maximising potential 
Relevant to all employees

Chapter 5 
 197 
 Question 9 
 A, D and E 
Equal opportunities is a Human Resources role. Equal opportunities is about removing discrimination, diversity is about 
maximising potential.

199 
– part 2 
• Organisational culture. 
 
  Chapter 
6

Controlling performance – part 2 
200  
 
2  The wider context of control 
In the previous chapter a number of control techniques were looked at. These 
were the responsibility of HR and were all legal requirements under UK law. 
Note that legal requirements in relation to employment practices may differ in other countries. 
In addition to these legal requirements, organisations need to consider what 
other controls are necessary to manage and control the behaviour of their employees and to ensure that the organisation performs effectively. 
What do we mean by 'behavioural' control? 
Organisations want to influence employees' behaviour to benefit the 
organisation. This can involve a mixture of the following: 
• Encouraging employees to adopt best practice to do 'the right thing the 
right way' 
• Motivating employees to improve productivity 
• Motivating employees to improve quality 
• Preventing employees making mistakes and ensuring that mistakes are 
detected quickly if made 
• Trying to limit the likelihood and impact of employee malfeasance, such as 
theft or fraud 
• Encouraging employees to act ethically 
• Motivating managers to make decisions that are in the best interests of the 

Chapter 6 
 201 
The role of management includes trying to get the best performance from their 
employees as possible. This includes using control to modify the behaviour of employees. The leadership and management chapter covered a number of concepts which are used by management to control the behaviour of employees. The use of power and authority, the style of management adopted, the use of delegation and the empowerment of staff all contribute to behavioural control. 
The following sections consider different ways of classifying and analysing 
approaches to control. 
Control mechanisms 
There are a wide number of ways that control can be used within an 
organisation, including the following: 
• Organisational structure  – breaking the organisation down into smaller 
units, such as having a dedicated accounts department, with clearly 
defined roles, responsibilities and authority. This can be reflected in many ways, such as insisting that all capital expenditure over $1,000 must be authorised by the Finance Director, for example. 
• Target  setting and budgeting – so staff know what is expected of them. 
• Direct supervision  of staff by managers. 
• The culture  of the organisation – for example, where mistakes are not 
tolerated. 
• Self-control  where employees are encouraged to work independently and 
take responsibility for their own results. 
• Control systems  – for example where actual results are compared to the 
budget each month and variances produced. These allow managers to identify, and focus on, areas where performance is not as expected and take corrective action, facilitating 'management by exception'. 
• Specific control processes  – for example, Creditors Ledger Control 
Account reconciliations may identify errors in processing purchase invoices. 
• Policies  and guidelines – for example having an ethical code to help 
employees recognise and deal with ethical conflicts.

202  
 Jersey Ltd is a small business that manufactures high quality portable 
loudspeakers. The business is small and has only twenty members of staff, 
with one supervisor. The work is highly skilled and complex, with staff divided into four teams – each with very different sets of required skills. 
Currently there are no control procedures or any work guidance for 
employees, meaning that each member of staff often works in the way they individually feel is best. The twenty employees are moderately well paid, though there are few, if any, real promotion prospects and several employees have expressed their dissatisfaction with the working 
conditions within Jersey. 
Jersey is owned and run by one person, H. She is concerned that the 
level of quality of production has fallen in recent months, as evidenced by an increase in wastage and a decrease in output. H is concerned about the effect this is having on the profitability of the company. As such, H is examining the possibility of introducing control processes to ensure that all units made are of adequate quality. 
Task 
Discuss the appropriateness of each of the following possible controls for 
Jersey: 
(a) Direct supervision of manufacturing staff (b) Setting performance targets for employees based on quality of 
output 
(c) Relying on individual employees to control their own work. 
Types of organisational control The type of control used within organisations is largely dependent on the nature 
of the organisation, and will be influenc ed by the size and structure of the 
organisation, the number and types of employees and the work carried out within the organisation. 
As well as the list of possible controls given above, there are a number of 
different ways of discussing or classifying controls and control systems, depending on the context or perspective being taken. Another angle considers the following four main types of organisational control. 
• Personal centralised control . This approach is likely to be found in small 
owner-managed organisations where there is centralised decision-making 
by the owner. Control is carried out by the owner through personal supervision. 
However, as the organisation grows in size and complexity, owners may 
find increasing external demands on  their time and will need to employ 
others to undertake supervision of da y-to-day tasks. In this phase of 
growth, control moves away from personal centralised control to more bureaucratic control or output control.

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 203 
• Bureaucratic control. Controls will be based on formalised rules, 
procedures, standardisation and hierarchy. This is achieved through specifications of how employees should behave and carry out their work using formal job descriptions and specification of standard methods for performance of tasks. Reward and punishment systems can be used to reinforce this control strategy. 
• Output control . This approach is a form of control that is based on the 
measurement of outputs and the results achieved. It is most appropriate where there is a need for quantifiable and simple measures of organisational performance since it requires a specification of output standards and targets to be achieved. This approach facilitates delegation without the need for bureaucratic controls, because once output standards have been agreed, employees can work semi-autonomously to carry out tasks. 
• Clan or Cultural control . This form of control requires the development of 
employees’ strong identification with management goals, for example through professional identification and acceptance of the values and beliefs of the organisation. If employees have the necessary skills, experience and ability, they can be given freedom in deciding how to undertake their tasks. This leads to semi-autonomous working with few formal controls. This approach depends on the common agreement of objectives and shared cultural values. It will require careful selection, socialisation and development of employees. 
Trust and control 
Trust is the belief that someone is reliable and honest. In an organisational context this suggests that management believe that 
employees can be depended upon to act ethically, with integrity and in the best interests of the organisation. 
Where there is a high level of trust, management may reduce the level of formal 
control as they will have conf idence that employees will always take the correct 
action. In essence, management have to find the right balance between trust and control within their organisation. 
In the past, control systems within organisations were formal in nature. The 
system would rely on the required behaviour being specified in detail, with predictable outcomes expected. This type of approach could be seen in the classical theories of management where there was a high degree of specialisation, a hierarchical structure of authority and each employee was tasked with very specific roles.

204  
A key feature of the scientific management school is the use of job, process 
analysis and time study to establish the optimum production methods and targets as to how long each task should take. The worker is not left with any discretion. The principles of scientific management make the workplace much simpler for managers to control. It is easier to measure inputs and outputs and compare the performance of workers. This approach can also be seen in McGregor’s theory X model where the view held by the manager is that the employee is basically lazy and cannot be trusted. This opinion leads to an authoritarian approach to leadership. 
The problem with this type of approach to management control, like the problem 
with the classical management theories, is that it fails to take account of the human element. A focus on this type of control could lead to: 
• Motivation problems . Lack of morale; little worker commitment; no 
interchangeable skills (people are only trained to do one small part of the 
job); high staff turnover. 
• Quality problems . No overall responsibility; no intrinsic satisfaction from 
work. 
• Little understandi ng of people . People at work are not necessarily 
rational, for example they do not always work harder to earn more money and they are sometimes less inclined to work well if closely supervised; budgets sometimes cause problems, for example people might be inclined to purchase poor quality raw materials to stay within budget, thus causing production problems. 
Today’s business climate requires a far greater degree of flexibility and 
employees need to be more empowered to accommodate this flexibility. This suggests that an approach closer to McGregor’s Theory Y approach, which was covered in the leadership and management chapter, should be adopted and managers should recognise that employees want to work and can be trusted. 
The human relations approach emphasises the social organisation and the 
importance of informal relationships. Elton Mayo’s studies on how to improve productivity revealed that work groups impose their own controls on members, such as the rate of work, working conditions and the members’ interaction with managers. This control was imposed through a series of ‘punishments’, for example ostracising members who were persuaded to comply with the objectives of management rather than the norms set by the group. 
Control is, therefore, a feature of interpersonal influences rather than close and 
constant supervision, recognising that people do not behave as unfeeling robots. This has an impact on control sy stems. There still needs to be control 
over the work being carried out and the manger must put in place regular reviews so that they have confidence that the objective will be met as required. Any possibility that the objective will not be met must be highlighted as soon as possible so that corrective action can be taken. 
Allowing trust in controls works well for both the company and the employee. 
The employee is allowed to work on their own initiative and feels valued, this leads to increased motivation and increased productivity which benefits the company.

Chapter 6 
 205 
In order for control based on trust to work a number of factors must be in place. 
• The manager must be confident that the employee has the knowledge and 
the skills to undertake the task. 
• The objective must be clear and agreed by both parties. 
• The employee must be motivated to work hard and use initiative to 
achieve the objective. 
 
 STU develops accountancy software for small-to medium-sized 
businesses. STU was established 15 years ago by a graduate in 
accounting. Despite an increasingly competitive environment, it has grown and diversified to become a global provider of specialised accountancy software. 
In order to cope with the increasing size and diversity of the business, 
additional levels of management and control systems have been introduced, including additional policies, rules and procedures. Unfortunately, the increase in bureaucracy is having the effect of slowing down decision-making processes and limiting ideas for new software development. 
The Chief Executive Officer is aware of the conflict between the structural 
changes and the need for continuous creativity and innovation that are critical to new software development and the future success of the business, but is not sure how to overcome the problem. 
Required: 
Write an email to the CEO explaining why formal control systems are 
increasingly necessary as an organisation grows and diversifies and why the use of bureaucratic forms of control in STU might limit creativity and innovation. 
3  Employee performance appraisal 
An important management control system used in most organisations is the employee performance appraisal system. 
A performance appraisal system involves the regular and systematic review of 
performance and assessment of potential, with the aim of producing action programmes to develop both work and individuals. It aims to improve the efficiency of the organisation by ensuring that the individual employees are performing to the best of their abilities and by developing their potential for improvement.

206  
There are different views on the purpose of performance appraisal. The 
purpose can be viewed as developmental or control but we will focus on the control aspect. 
A performance appraisal system can bring many benefits to both the 
individual and the organisation. Benefits to individuals 
• Feedback about performance at work and an assessment of competence 
through comparison of performance against established standards and 
agreed targets 
• Identifies work of particular merit done during the review period 
• Provides a basis for remuneration 
• May be used as an opportunity to discuss future prospects and ambitions 
• Identifies training and development needs. 
Benefits to organisation 
• Provides a system for assessing competence of employees and identifies 
areas for improvement 
• Provides a fair process for reward decisions • Helps identify and formulate training needs 
• Improves communication between managers and subordinates 
• Provides clear targets linked to corporate objectives 
• Provides a basis for HR planning 
• Monitors recruitment and induction process against results. 
The formal process of performance appraisal (TARA) 
Targets . Targets must be set which employees understand and agree to. If they 
do not ‘buy into’ them, they will not put any effort in to accomplishing them, 
especially if they do not feel that the targets are achievable. This can lead to demotivation. 
Actual results monitored . During the period, the manager should monitor the 
actual employee performance and provide regular feedback. Managers can 
offer rewards for good performance and support and help where it looks as though the employee is failing to meet their targets. 
Review . At the end of the period, the manager and employee will usually have 
a formal appraisal interview where they discuss the employee’s performance 
and investigate how successful the employee has been at meeting the pre-agreed targets. 
Action plan.  The manager and employee then agree on new targets that will be 
set for the coming period.

Chapter 6 
 207 
Approaches to performance appraisal 
There are a number of approaches to performance appraisal, including: The Ranking System . This is a formal structured approach which consists of 
the individual being assessed and anal ysed in terms of objectives, tasks, 
workflows and results achieved. These are then compared with previously 
agreed statements of required results and performance levels. For each of the set targets, the manager will provide a ranking as to the individual’s performance. The rankings are usually based on an agreed scale, for example 1–5, with 1 being unsatisfactory and 5 being excellent. 
The Unstructured Format . The unstructured format is another common 
approach where evaluators use an essay or short answer to grade employees. 
The benefit here is that any and all variables are used, from the most quantitative to the most informal. This approach tries to capture all aspects of employee performance rather than being restricted to the pre-agreed targets used in the more structured approach. Unstructured appraisals are meant to be open ended and all encompassing. 
Self Rating . This approach is where the individual rates themselves on certain 
agreed criteria. This is then fed back to the manager who can review the 
individual’s assessment and make their own assessment. The advantage of this approach is that that the individuals get the opportunity to consider their performance and in some cases remind management of what they have achieved in the period. It also forms the basis for the appraisal interview where both parties get the opportunity to discuss the ratings they have given and try to reach a consensus. 
360 approach . In most appraisal approaches the manager appraises the 
individual. The individual may get some say in the appraisal, but ultimately the 
outcome will be decided by the manager. The 360 approach allows more participation by the indivi dual. While the manager will appraise the individual, 
the individual is also given the opportunity to appraise the manager. In some systems, individuals will also appraise their colleagues. Every member of staff can be asked to give confidential and anonymous assessments on their colleagues and their manager. Thes e assessments will help senior 
management to build up a more accurate pictures of the performance of departments. It also encourages individuals to work together for the good of the department. 
Effective performance appraisal 
To be effective, the system must: 
• Be applied fairly and consistently • Have the commitment and support from senior managers 
• Be carried out with serious intent 
• Relate to the main objectives of organisation 
• Be clearly understood by all parties 
• Be cost effective to operate.

208  
 
 Barriers to effective performance appraisal  
 One aspect of the typical performance appraisal system that can reduce 
its effectiveness is the appraisal interview. Poor performance appraisal 
interviews can be confrontational, judgemental, just a chat, a paper exercise, a substitute for the management process that should be undertaken during the year and/or out of date and irrelevant because it is only held annually. 
Barriers to effective appraisal may be overcome if: 
• There is commitment from all parties involved. 
• There is a system of follow up and feedback. 
• Recorded agreement between manager and employee about future 
training and development. Training should be arranged within an 
agreed time period. 
• Alternative methods of appraisal, such as self rating or 360 
approach could be used. 
 
 H joined the finance department of MNO a year ago. He is surprised that 
in that time, he has never been given any clear targets or objectives and he has had no opportunity to discuss his performance with his line manager, G. Other members of the department feel the same so they have discussed this with G. G was surprised and stated that if something was wrong with their work, he would have told them about it by now. G has confided in you that he has never undertaken performance appraisal in the department because he felt that it would take up a lot of his time and he was not really sure what it would achieve. 
Required: 
Write an email to G, explaining the benefits that MNO and the individual 
members of staff would obtain from having a formal staff appraisal system. 
Reward systems 
Linked to behavioural control is the reward system used within the organisation. 
In developing a reward system, organisations hope to support the goals of the organisation by aligning the goals of employees with these. Reward systems can be used to motivate employees to work in the best interest of the 

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 209 
A reward is something given, to an individual or group, in recognition of their 
services, efforts or achievements. The rewards that an organisation offers to its employees can either be intrinsic or extrinsic. Note that extrinsic rewards are closely linked to Herzberg’s hygiene factors, while intrinsic factors tie in to Herzberg’s motivators. 
• Intrinsic rewards  – these arise from the performance of the job itself. 
Intrinsic rewards include the feeling of satisfaction that comes from doing a 
job well, being allowed to make higher level decisions or being interested in your job. 
• Extrinsic rewards – these are separate from (or external to) the job itself 
and are dependent on the decisions of others (i.e. the workers have no 
control over these rewards). Pay, working conditions and benefits are all examples of extrinsic rewards. 
The offering of positive rewards to employees is a key motivational issue for most organisations. However, rewards systems should be carefully designed in order to ensure that they: 
• are fair and consistent for all employees, even for those workers with 
different job sizes or required levels of skill 
• are sufficient to attract and retain staff • maintain and improve levels of employee performance 
• reward progression and promotion 
• comply with legislation and regulation (i.e. minimum wage laws) • control salary costs. 
Employees can be rewarded in a number of ways, including through ongoing 
development and training (which will boost their future career prospects). This links back to Maslow’s hierarchy of ne eds, as continuous development will help 
to meet self fulfilment and ego needs. However, most employees will be particularly interested in their remuneration. One way that businesses tie the performance of their employees to their pay is through the use of incentive schemes. There are a number of incentive schemes: 
• Performance related pay (PRP)  – part of the payments received by the 
individuals relates to the performance of the company. 
• Piecework  – reward related to the pace of work or amount of effort. The 
faster the employee works, the higher the output and the greater the 
reward. 
• Points system  – a range of rewards is available based on a point system 
derived from the scale of improvement made, such as the amount of cost reduction achieved. 
• Commission – paid on the performance of an individual and typically paid to salaried staff in sales functions, where the commission earned is a proportion of total sales made.

210  
• Bonus schemes  – usually a one off as opposed to PRP schemes which 
are usually a continual management policy. Bonuses may also be 
awarded to teams or groups that have met or beaten certain targets. Group bonuses can help the team to pull together and work as a cohesive unit, but may lead to conflict if some members of the team are seen to be doing less work than others. 
• Profit sharing  – usually available to a wide group of employees (often 
company wide) where payments are made in the light of the overall profitability of the company. Share issues may be part of the scheme. 
4  Performance management and measurement systems 
While a staff performance appraisal system can offer many benefits to an organisation, one of its main objectives is to manage and measure performance. Within organisations, performance can be measured at divisional, departmental and individual level, as well as at the overall organisation level. 
Target setting 
In order to measure performance, a target must be set to measure performance 
against. To be acceptable a target must be viewed as fair, measurable, achievable and controllable by the person or people being measured. 
A well set target can influence behaviour in a positive way and can lead to 
increased level of commitment and motivation, which in turn can lead to increased productivity. It is therefore important for organisations to carefully consider the targets they set to ensure that they obtain the behaviour they desire. 
Setting targets for individuals is made more complex because most jobs have 
many dimensions, meaning that the targets must look at a number of different criteria in order to accurately reflect the employee’s performance. Targets may include the following: 
• Volume of work produced 
• Knowledge of work 
• Quality of work 
• Management skills 
• Personal skills. 
Drucker's Management by objectives 
A model which can expand on the setting of targets within the appraisal system 
is Drucker's Management by objectives. Management by objectives can be defined as a type of control strategy which focuses on controlling outputs. Within this model Drucker emphasised that if corporate objectives are to be effective, they must be stated in behavioural or measurable terms, so that any deviation can be highlighted at an early enough stage to permit corrections to be made.

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This is a process whereby individual goals are integrated with the corporate 
plan, as part of an ongoing programme of goal setting and performance review involving all levels of management. 
Many people have responsibility in an organisation, but managers are held 
accountable for the work of others as well as their own. Managers, when setting objectives, have a responsibility to: 
• agree their own departmental targets with their superiors • discuss and agree targets for their staff that are achievable 
• ensure that all targets set are measurable and possible, and that 
resources are made available together with some setting of priorities 
• ensure that there is a balance between the goals and needs of 
departments and individuals 
• apply the control system and discuss progress with staff at regular 
intervals. Where staff jointly set objec tives with their manager they achieve 
valuable feedback on performance, a motivating factor acknowledged by 
Herzberg 
• ensure continual review and appraisal of results. 
 
Drucker's key objectives 
Drucker argues that the nature of the business organisation requires multiple 
objectives to cover every area where performance and results affect the business. 
Drucker suggested the following eight key objectives: 1 Profitability . This could be measured by growth in earnings per share. At 
some stage in the planning procedure, probably at the time of developing 
the strategic plan, this objective will need to be translated into targets for control linking sales, profit and capital employed. 
2 Innovation . The board must determine whether it intends to lead in 
developing technology and products, to follow other companies or to design to meet customer needs. 
3 Market standing . Overall marketing policies and objectives such as which 
products to sell and in which markets. 
4 Productivity . Productivity targets will be set in terms of output in relation 
to manpower, plant, material yields and costs. 
5 Financial and physical resources . Financing both working and long-term 
capital requirements through debt and shares. Physical resource objectives will include the location and acquisition of physical resources 
over the planning period, whether to lease or buy the assets, etc.

212  
6 Managerial performance and development . Policies and objectives will 
cover matters such as organisation and development; measures of 
performance; training and development; reward systems and organisational culture. 
7 Worker performance and attitude . Policies and objectives will cover the 
development of management and worker relationships. 
8 Public responsibility . There may well be objectives relating to social 
responsibility and business ethics. 
Not all of these will apply to all organisations, and emphasis could change in response to environmental changes. The need for balancing objectives is obvious. There has to be a balance between profit and the demands of the future (short-, medium-, and long-term). 
The Balanced Scorecard 
Another commonly used performance management tool is Kaplan and 
Norton’s  Balanced Scorecard. In developing the balanced scorecard. 
The balanced scorecard provides a framework which can be utilised to develop 
a multidimensional set of performance measures for strategic control of the overall organisation. These measures should be in line with the overall strategic objectives and vision of the organisation. 
Kaplan and Norton recognised that when measuring performance, 
organisations tended to focus almost exclusively on short-term financial measures. They recognised that this did not reflect the complexity and diversity of business circumstances and that organisations should use a variety of measurements, many of them non-financial to give managers a broader perspective of their business performance. Measures used should attempt to address all relevant issues of performance in an objective and unbiased fashion 
and should cover areas such as profitabilit y, customer satisfaction, internal 
efficiency and innovation. 
Kaplan likened running a business to flying a plane in that airspeed, altitude, 
heading and fuel level are just a few of the pieces of information needed. Yet, in many businesses, managers have to rely on a narrow set of financial indicators to support their decision making and this in an environment with many more complexities than a plane.

Chapter 6 
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This is a powerful tool that assists in the running of an organisation. Gains in 
one area need to be considered with the losses that may arise in other areas and vice versa. Thus the manager's view is broadened and the tendency to concentrate on one measure is reduced, hopefully removed. 
Once the balanced scorecard has been set at an organisational level, it can be 
cascaded down to departmental and individual levels setting appropriate targets for each depending on their role. In this way individuals can see that their efforts are contributing to the overall goals of the organisation. The scorecard approach can help management to identify any areas of weakness within the organisation. Any failure in meeting a target at an individual or department level scorecard will be cascaded up to the top le vel organisational scorecard. In this 
way, the source of any failure can be quickly identified and action can be taken to remedy it. 
The main benefits are: 
• It avoids management reliance on short-termist or incomplete financial 
measures. 
• By identifying the non-financial measures, managers may be able to 
identify problems earlier. For example, managers may be measuring 
customer satisfaction directly as part of the balanced scorecard. If this changes, steps can be taken to improve it again before customers leave and it starts to impact on the company's finances. 
• It can ensure that divisions develop success measures for their division 
that are related to the overall corporate goals of the organisation. 
• It can assist stakeholders in evaluating the firm if measures are 
communicated externally.

214  
The drawbacks are: 
• It does not provide a single overall view of performance. Measures like 
ROCE are popular because they conveniently summarise ‘how things are 
going’ into one convenient measure. 
• There is no clear relation between the balanced scorecard and 
shareholder analysis. 
• Measures may give conflicting signals and confuse management. For 
instance, if customer satisfaction is  falling along with one of the financial 
indicators, which should management sacrifice? 
• It often involves a substantial shift in corporate culture in order to 
implement it. 
5  Other techniques to enhance performance 
Mentoring 
Mentoring is quite simply a relationship where one person helps another to 
improve their knowledge, work or thinking. It is a very valuable development tool for both the person seeking support (the mentee) and the person giving the support (the mentor). 
The benefits of mentoring include: 
• Faster career progress. 
• Excellent value for money for the organisation as the financial cost is 
relatively small. 
• Enhances company image. The company does not want to be associated 
with a poor turnover record and encouraging learning helps staff to 
achieve their full potential and not look for new employment. 
• Improved motivation. Employees often feel that real improvements in 
competences are delivered from the mentoring process. This can preserve the well-being of employees and others, improves employee morale, trust and motivation. 
Who is a mentor? 
A mentor should be someone who: 
• Can give practical support and advice. 
• Can give technical, ethical and general business guidance. • Can help with development of interpersonal and work skills. 
• Is an impartial sounding board – a mentor would generally have no direct 
reporting responsibility. 
• Is a good guide, counsellor. 
• Is a role model who can help improve career goals.

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Quite often a mentor is from the same function (i.e. finance), it is unusual for 
them to be a direct line manager. The mentor is normally a role model, having already achieved a status (and possibly qualification) to which the subordinate aspires. 
For a mentoring system to be successful, relationships should not be based on 
authority but rather a genuine wish by the mentors to share knowledge, advice and experience and should be one of mutual trust. 
Mentoring works alongside more formal control mechanisms, such as appraisal, 
and is intended to provide the employee with a forum to discuss development issues which is relaxed and supportive. Mentors often discuss such issues as training, the choice of qualification, interpersonal problems and career goals. 
The role of a mentor is to encourage and assist junior members of staff to 
analyse their performance in order to identify their strengths and weaknesses. The mentor should give honest but supportive feedback and guidance on how weaknesses can be eliminated or neutralised. The mentor could also act as a sounding board for ideas. The process should help junior staff to question and reflect on their experiences.  
A mentoring system has both career-enhancing and psychological functions. The career function is concerned primarily with enhancing career advancement through exposure, visibility and sponsorship. The psycholog ical function is more 
concerned with aspects of the relationship that primarily enhance competence and effectiveness in management roles. A mentoring system should help junior staff in expanding their network of contacts and gain greater exposure in the organisation. 
 
Examples of the benefits of mentoring  
 Mentoring has many benefits for those involved: 
Mentees will find a safe environment where they can admit gaps in 
knowledge and skills, raise queries and consider their strengths. Below 
you can see how some of our mentees felt they have gained from their mentoring relationships. 
'I gained a better vision of what I want to do in the future, and what steps I 
must take in order to achieve my goals.' 
'I gained a great deal. It was good to talk with someone who was 
independent of my work, college and home circumstances. I gained an alternative and dispassionate view and I have been able to make a more rational assessment of my priorities.' 
'I learned about self belief, having respect for others, becoming more 
assertive, when to listen and w hen to ask questi ons, planning and 
decision making.' 
'I gained a great insight into the practice of running your own business, 
which is what I would like to achieve myself.'

216  
 'My mentor gave a good sounding board and plenty of encouragement 
towards my impending exams.' 
Mentors get a unique opportunity to put something back into their 
profession while enjoying a fresh challenge and personal and professional development of their own. Richard Garnett MAAT explains why he volunteered as a mentor: 
'I felt it was time to give something back to the AAT. I think I have 
experience I can usefully share with those newer to the AAT. I really hope I helped my mentee to develop. I also think the scheme had some great learning for me too.' 
Article by the AAT (Association of Accounting Technicians) 
 
 P is a senior manager in the finance department of PQR. He has worked 
for PQR for 25 years and is well respected throughout the company. PQR 
have decided to implement a mentoring scheme to help new recruits to the company fit in more quickly and P has been asked to be a mentor to K, who is a ne w managem ent accounting trainee. K has just left 
university and his first placement is in the production department, but he will be moved to different areas of the company on a six monthly basis. 
P has never mentored anyone before and is unsure about what would be 
expected of him, he is also concerned about spending time on this task as he is unsure of the benefits of mentoring. 
Required: 
Write an email to P, explaining what would be expected of P as a mentor 
and how a mentoring scheme would benefit K in his new role. 
Coaching 
Coaching is another method which can be used to enhance performance. 
Unlike mentoring, coaching focuses on achieving specific objectives, usually within a defined time period. It is more about improving the performance of someone that is already competent, rather than establishing competency in the first place. 
• It is usually on a one to one basis and is set in the everyday working 
• It involves gently encouraging people to improve their performance, to 
develop their skills and increase their self confidence in order to develop 
their career prospects. 
• Most coaching is carried out by a more senior person or manager, however 
the key issue is that whoever carries out the coaching must have sufficient expertise, experience and judgement to help the person being coached.

218  
 Question 1 
 There are a number of approaches to performance appraisal, such as: 
 
Ranking system 
360 approach 
Self rating 
Unstructured format 
Match the approach to performance appraisal to the correct description. 
• This approach tries to capture all aspects of employee performance 
rather than being restricted to pre-agreed targets. 
• This approach is where the individual rates themselves on certain 
agreed criteria. 
• A structured approach where the performance is compared to 
previously agreed targets. 
• The manager will appraise the indi vidual and the individual is also 
given the opportunity to appraise the manager.  
 
 Question 2 
 Complete the following sentences regarding rewards: 
 
Intrinsic Extrinsic 
 
• Rewards which arise from the performance of the job itself are 
known as ________________ rewards. 
• Herzberg’s hygiene factors are closely linked to ________ rewards. 
• Recognition or higher levels of responsibility would be classed as 
____________ rewards. 
• ____________ rewards would include pay and working conditions.

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 219 
 Question 3 
 There are a number of financial incentive schemes available for 
employers to motivate their staff, such as: 
 
Piecework 
Commission 
Profit sharing 
Bonus schemes 
Performance related pay 
Match the incentive scheme to the correct description. 
• Reward related to the pace of work or amount of effort. The faster 
the employee works, the higher the output and the greater the 
reward. 
• Payments are made in the light of the overall profitability of the 
company. 
• Paid on the performance of an individual and typically paid to 
salaried staff in sales functions. 
• Key results are identified for which rewards will be paid on top of 
salary. 
• One off rewards which can be paid to individuals or groups if they 
meet certain targets. 
• Part of the payment received by individuals relates to the overall 
performance of the company.  
 
 Question 4 
 Which THREE of the following are key objectives as suggested by 
Drucker? 
A  Customer satisfaction B  Innovation C  Productivity D  Public responsibility E  Employee satisfaction F  Ethical behaviour

220  
 Question 5 
 In the balanced scorecard, one of the perspectives is the financial 
perspective. What are the other three perspectives? 
A Customer B Training and development C Product D Internal Business Process E Employee F Learning and growth
 
 Question 6 
 Which of the following statements relating to mentoring are true? Select 
all that apply. A  Mentoring can lead to faster career progress. B  A mentor will generally be the mentee’s line manager. C  A mentor can give technical, ethical and general business guidance. D  A mentor is a role model who can help improve career goals. E  Mentoring is used as a means of measuring performance. F  Mentoring focuses on achieving specific objectives, usually within a 
defined time period.
 
 Question 7 
 Complete the sentences to suggest the most appropriate type of control 
for each organisation. 
• Personal centralised 
• Bureaucratic 
• Clan or Cultural 
• Output 
Small, owner managed organisations which rely on key individuals are 
likely to use _____________ control. 
Large manufacturing companies would be most likely to use 
__________________ control. 
A professional firm of lawyers would most likely use _______________ 
control. 
A large hierarchical organisation would be likely to use _____________ 
control.

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 221 
 
 Question 8 
 The balanced scorecard model provides a framework which can be 
utilised to develop a multidimensional set of performance measures for 
strategic control of the overall organisation. The model is shown below: 
 
Within each perspective of the model, key metrics are used to measure the performance of the organisation. 
Drag the following metrics to the most appropriate perspective on the 
balanced scorecard model. 
• Number of complaints 
• ROCE 
• New products launched 
• Operational efficiency 
• Repeat purchases

222  
 Question 9 
 To achieve our vision, how will we sustain our ability to change and 
improve? 
The above statement relates to which of the perspectives of Kaplan and 
Norton’s balanced scorecard? 
A  Financial perspective B  Customer perspective C  Internal business process D  Learning and growth
 
 Question 10  
 Which of the following statements regarding target setting are correct? 
Select all that apply. A  A well set target can improve motivation. B  Targets can only be set using financial measure. C  Volume of work would be a suitable target. D  To be accepted, target should be viewed as controllable and 
achievable. 
E  Ideally, each individual will be set just one main target.

Chapter 6 
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 (a) Direct supervision of staff 
Jersey could opt to directly monitor the activities of its staff in order to 
ensure their work is of appropriate quality. This could be effective at stopping the production of poor quality speakers and the associated waste that would be involved in this. The fact that Jersey only has a small number of staff would also tend to make this approach work well. 
However, there would be several problems associated with this 
control. Firstly, each group of wo rkers has highly specialised skills. 
This may make it difficult for Jersey’s supervisor to understand what each group does and monitor their activities effectively. In addition, the fact that each worker may undertake the same job as their colleagues but using a different technique, will increase the complexity of the monitoring role. 
While the workforce is small, there is only one supervisor. They may 
have insufficient time available to supervise all staff. Hiring of additional supervisors would have cost implications for Jersey. 
Finally, additional supervision may have a negative impact on the 
motivation of employees, who are used to having autonomy over the way they perform their jobs. A sudden change to being closely monitored could cause further job dissatisfaction. 
(b) Performance targets 
Setting performance targets could be of great use to Jersey. This 
would likely involve offering incentives for staff (such as pay rises and bonuses) depending on how well they perform their jobs. For Jersey, the number of defective units produced by each employee could be measured and a bonus could be offered if this was below a pre-agreed level. 
This could be a very practical approach for Jersey, as it links 
employee rewards with the objectives of the company itself. It should be easy to implement and would prevent the production of units that were defective, reducing waste. The offer of an additional bonus or extra pay may also help to improve general motivation as workers are currently only adequately paid and have few other 
benefits or prospects. 
Note that this may not improve the output of each worker, which is 
another issue for Jersey. Workers may spend longer on each unit in order to ensure the quality and thus receive their bonus, leading to a further fall in productivity.

224  
 (c)  Reliance on self-control of workers 
Relying on individual staff to monitor their own activities may be 
problematic. It has the advantage of being cheap for Jersey, as it does not require any further staff to be hired. In addition, the staff are clearly skilled at their jobs, making it easier for them to understand the best way to approach individual tasks. 
However, staff seem to be relatively de-motivated. This means that 
they are less likely to be concerned about the quality of their output. Unless they are offered an incentive by Jersey, there is no reason why they would focus on higher quality production. 
In addition, there is no agreed ‘best practice’ for each of the four 
teams. Each worker is likely to see their method as superior to those of their colleagues, whether this is in fact correct or not. This means that they are unlikely to change their working practices to ones that would improve output and quality. 
 
 EMAIL 
To: CEO of STU 
Subject: The necessity of formal control systems 
For any organisation like STU, the growth and diversification of the 
business poses an increasing problem of control. As the number of levels in the organisation is increased and th e number of different kinds of tasks 
to be carried out multiplies, the division of labour becomes more complex. In this changing situation, it becomes increasingly difficult to ensure that members of an organisation are doing what they are supposed to be doing. 
Without some attempt to control what people do in organisations, there is 
a danger of staff beginning, intentionally or unintentionally, to do ‘their own thing’ by working towards their own personal goals and perceived self-interests. 
To counteract the tendencies created by the processes of differentiation, 
and to ensure goal congruence, there is a need to create a ‘common focus’ in an organisation, which will control and integrate members’ diverse activities. This is why organisations introduce a variety of formal controls.

Chapter 6 
 225 
 In small, simple organisations it is possible for the owner manager or 
senior management to supervise subordinates’ activities personally and 
systematically. Often, in such organisations, it is possible to achieve control in an informal way by setting  employees tasks and then checking 
that they have been carried out. Any deviations from the accepted standard of performance can be communicated directly by the owner manager to particular employees and the necessary corrective action taken. In larger organisations, however, with a complex division of labour, and a taller hierarchy of responsibility,  it is not physically possible to 
control people in such a simple manner. In such situations, formal policies, rules and procedures have to be put into place together with a system of rewards and punishments to ensure that the policies, rules and procedures are observed. 
In such hierarchical organisations, policies and objectives are typically 
set, or at least confirmed, by occupants of higher-level positions and are then communicated to lower-level staff, who are then charged with the responsibility to carry out the necessary actions. It is up to the higher-level managers to determine whether or not the objectives have been met and, if not, to take the appropriate steps. This is the process of control. 
It is important to note, however, that there are a number of different ways 
of exercising control in organisations and that the effectiveness of a particular type of control system depends on a number of factors including the organisation’s strategy, culture, structure, environment and the type of goods or services produced. 
In the case of STU, it chose to use bureaucratic (administrative) forms of 
control, but as the CEO realised, such a form of control is not conducive to creativity and innovation. 
Creativity, which can be defined as ‘the generation of new ideas, and 
innovation, which is the transformation of creative ideas into tangible products or processes’ varies considerably between one organisation and another. Some organisations have a reputation for creativity and innovation while other organisations hardly ever seem to generate new products or new ways of doing things. 
The generation of new ideas and their translation into commercial use is 
a particularly important issue for an organisation like S because its future depends on a continuous supply of innovative software products. There are many factors influencing the rate of innovation in organisations, but research suggests that one reason has to do with how an organisation is structured and controlled. 
Studies have found that excessive bureaucracy with its allegiance to 
central control and to rules and procedures discourages creativity and innovation. The focus on rules and procedures and the accompanying sanctions designed to ensure compliance means that employees ‘play safe’ by sticking to the rules rather than risk trying out new ideas. Rules can become ‘ends in themselves’.

226  
 The division of labour that often accompanies the growth of an 
organisation also affects creativity and innovation because it restricts the 
sharing of ideas between individuals and between different units, departments or divisions. The case of STU illustrates well the problems facing all large organisations at some time in their development – that of balancing the need to ensure adequate direction and control of staff and yet allowing sufficient freedom and discretion of middle managers and other employees to contribute their particular knowledge and expertise to the organisation. Too little direction and control can result in wasted effort and inefficiencies as the departments and divisions into which an organisation is subdivided pursue their own particular goals. Too much central control and lower level staff become frustrated by rules and procedures forced upon them from on high by those who are too far from the action to make informed decisions. 
 
 EMAIL 
To: G 
Subject: Performance appraisal system 
You are right in saying that a performance appraisal system can be time 
consuming, but the time spent on this can bring many benefits to both the company and to the individuals within your department. Performance appraisal can help to improve efficiency and effectiveness of a company. It should be used to review, change, inform, examine and evaluate employees. 
From the company point of view, a formal appraisal system can: 
• Provide a means for assessing employees and identifying areas for 
improvement. The system would encourage you to review the work 
of the individuals within your department, which would benefit you in allowing you to get to know their capabilities. 
• Provide a fair basis for reward decisions. 
• Aid in succession planning by identifying candidates for promotion. 
• Help to plan for training needs. 
• Link targets to company’s strategic plans. 
• Aid in human resource planning.

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 227 
 From the employee’s point of view it can: 
• Provide a fair and understandable basis for remuneration. 
• Provide feedback about performance and allow an opportunity to 
discuss future prospects. H, and others within the department are 
unhappy with the lack of feedback from you. A formal appraisal system would give both you and H the opportunity to discuss his work. 
• Identify training and development needs. 
• Help to highlight work of high quality carried out in the period. 
I hope you have found the above useful. A performance appraisal system 
can be very beneficial to both you as a manager, the individual members of your team and the company as a whole. Please do not hesitate to get in touch if you want to discuss any of these aspects more fully. 
 
 EMAIL 
To: P From: Management Accountant  
Date: today 
Subject: Mentoring 
A mentor is a person who helps another person to develop. A mentor is 
usually a more experienced person within the organisation and they are appointed to mentor a more junior member of staff who will usually come from another part of the organisation. If the mentor is from the same department, they would not usually be a direct line manager. In this case, you are an experienced, well respected manager in the finance department, and have been asked to mentor K who is a management accounting trainee in the production department. This is a fairly typical mentoring arrangement whereby the mentor is from the same function, but not the same department. 
As a mentor, you would be expected to arrange regular meetings with K, 
or allow K to contact you as required. When you meet, you should make it clear to K that he can discuss any issues of concern he has. Topics discussed could include study support and advice, technical or business guidance, training advice, interpersonal problems or career advice. K may also wish to use you as a sounding board for decisions he has to make. You should be able to give K impartial and independent advice. 
Discussions between you and K should be confidential so that K feels 
that he can discuss any areas of concern he has in a safe environment.

228  
 There are many benefits from mentoring. There are career-enhancing 
benefits and personal developmental benefits. From a career-enhancing 
perspective, you can provide technical help and study support. K would be able to discuss openly areas of weakness within their role and you may be able to provide practical advice as to how to overcome these weaknesses. Going forward you could also advise K on routes for career development. 
You may also be able to help K get to know other members of staff within 
the organisation. You have been with PQR for 25 years, so you are very likely to know many of the other managers that K will be dealing with. This is especially helpful to K as he will be moving round the organisation 
every six months. You may be able to give K information about the managers and staff he will be dealing with in each of the departments. As he moves around the organisation, K may come across new situations which he finds difficult to deal with. You may be able to give him general advice to help build his confidence in dealing with new situations, or may be able to help identify suitable training courses which would help him. 
In addition, K would also gain from a personal point of view. He is just out 
of university and is not used to this working environment. You will be able to help K understand the culture of LPM which would help him to settle in more quickly. A better understanding of PQR will improve K’s confidence which would help him to perform better in his role. 
Over time, as he develops in his role, K may contact you less about how 
to handle situations and more for advice on career development. 
touch if you want to discuss any of these aspects more fully. 
 
 Question 1 
 
Ranking system A structured approach where the performance is compared to previously agreed targets 
360 approach The manager will appraise the individual and the individual is also given the opportunity to appraise the manager 
Self rating This approach is where the individual rates themselves on certain agreed criteria 
Unstructured format This approach tries to capture all aspects of employee performance rather than being restricted to pre-agreed targets

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 229 
 Question 2 
 • Rewards which arise from the performance of the job itself are 
known as intrinsic rewards. 
• Herzberg’s hygiene factors are closely linked to extrinsic rewards. 
intrinsic  rewards. 
• Extrinsic rewards would include pay and working conditions. 
Intrinsic rewards arise from the performance of the job itself while 
extrinsic rewards are external to the job and rely on the decisions of others. 
 
 Question 3 
 
Piecework reward related to the pace of work or amount of effort. The faster the employee works, the higher the output and the greater the reward 
Commission paid on the performance of an individual and typically paid to salaried staff in sales functions 
Profit sharing payments are made in the light of the overall profitability of the company 
Bonus schemes one off rewards which can be paid to individuals or groups if they meet certain targets 
Performance related pay part of the payment received by individuals relates to the overall performance of the company 
  
 Question 4 
 B, C and D 
The others are:  
• Profitability 
• Market standing 
• Financial and physical resources 
• Management performance and development 
• Worker performance and attitude

230  
 Question 5 
 A, D and F 
The complete diagram is shown below: 
 
 Question 6 
 A, C and D A mentor will generally be the mentee’s  line manager is incorrect. It is 
generally accepted that it is better for the mentor to come from a different 
department. 
Mentoring is used as a means of measuring performance is incorrect. 
Mentoring is used to enhance performance. 
Mentoring focuses on achieving specific objectives, usually within a 
defined time period is incorrect. Mentoring an ongoing activity.

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 231 
 Question 7 
 Small, owner managed organisations which rely on key individuals are 
likely to use personal centralised  control. 
Large manufacturing companies would be most likely to use output  
control. 
A professional firm of lawyers would most likely use clan or cultural 
control. A large hierarchical organisation would be likely to use bureaucratic  
control. Personal centralised control is used where there is centralised decision 
making by a key individual. This is usually found in small, owner run 
Bureaucratic control is usually found in large hierarchical organisations 
with formalised rules and procedures and detailed job descriptions. 
Clan or Cultural control is found where employees have a strong 
identification with management goals. 
Output control is based on the measurement of outputs and results 
achieved and is often used in manufacturing organisations. 
 
 Question 8 
 The completed model is shown below:

232  
 Question 9 
 D 
The learning and growth perspective looks at how an organisation 
manages change through development and innovation. 
 
 A, C and D 
Targets can only be set using financial measure is incorrect. Targets can 
also use non-financial measures. In fact, in many cases, these are better measures than financial measures. 
Ideally, each individual will be set just one main target is incorrect. Most 
jobs have a number of dimensions meaning that multiple targets are normally required to actually assess an employee’s performance.

233 
Building, leading and 
managing teams 
B3: Explain how to manage 
relationships (a) Building and leading 
teams 
Topic to be covered 
• Characteristics of high-performing teams 
• Strategies for managing conflict. 
 Chapter 
7

Building, leading and managing teams 
234  
 
2  Group and teams 
Note that throughout this chapter, the terms groups and teams are used 
interchangeably. 
People rarely work in isolation at work, since most activities need some 
coordination through groups of people. Groups provide security and social satisfaction for their members. They support individual needs and promote communication, formally or informally. 
There are many different definitions available to explain what constitutes a 
group. Schein  suggests that a group is any number of people who: 
• interact with one another 
• are psychologically aware of one another; and 
• perceive themselves to be a group. 
Groups have power structures, leadership structures, role structures, 
communication structures and sociometric structures. They develop norms, ideologies, characteristic atmospheres, degrees of cohesiveness and morale. 
Types of groups 
• Formal groups . Used by organisations to carry out tasks, communicate 
and solve problems. Membership is normally formal, often determined or 
constrained by the organisation into departments or divisions. 
• Informal groups . Individuals join groups to meet their social and security 
or safety needs. Membership is normally voluntary and informal. Individual members are dependent on each other, influence each other's behaviour and contribute to each other's needs.

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• Reference groups . These are groups the individual does not currently 
belong to but wants to join, for example a particular work group or 
• Self directed and autonomous groups . The ideas of these evolved from 
the work of Trist and Bamforth and through experiments carried out in the 70s by Swedish car manufacturers Volvo and Saab. A self directed or autonomous group is one which is encouraged to manage its own work and working practices. 
 
Informal groups  
 Managers need to pay attention to the formation of, and support for, 
formal groups and also realise that they cannot ignore or suppress informal groups. In relation to informal groups, it is important: 
• to let employees know that managers understand and accept them 
while discouraging dysfunctional behaviour in such groups 
• to try to anticipate how decisions will influence informal groups; and • to keep formal decisions from unnecessarily threatening informal 
groups. 
Work teams 
A work team is a formal group . It has a leader and a distinctive culture and is 
geared towards a final result. 
An effective team can be described as 'any group of people who must 
significantly relate with each other in order to accomplish shared objectives'. 
In order to ensure that the team is truly effective, team members must have a 
reason for working together. They must need each other's skills, talent and experience in order to achieve their mutual goals. 
Multiskilled teams  bring together individuals who can perform any of the 
group's tasks. These can be shared out in a flexible way according to 
availability and inclination. 
Multidisciplinary teams  bring together individuals with different specialisms so 
that their skills, knowledge and experience can be pooled or exchanged.

236  
Benefits and problems with groups  
Benefits of groups 
Within organisations there has been an implicit belief that people working as 
members of a group or team perform more effectively than if they are organised as individuals. There are a number of benefits from team working: 
• Increased productivity  – working as part of a group can result in a better 
overall result than could be achieved if each person worked 
independently. By breaking a task up into its component parts, different members of the group, with different skills, can be working on different aspects of the task at the same time. 
• Synergy  – One person cannot do everything, but a team can combine all 
the main areas of skill and knowledge that are needed for a particular job. Synergy describes the phenomenon in which the combined activity of separate entities has a greater effect than the sum of the activities of each entity working alone – often described as a way of making 2 + 2 = 5 . 
• Improved focus and responsibility  – each member can be given the 
responsibility for specific tasks, avoidi ng overloading o ne person with too 
much responsibility which may result in a loss of focus. 
• Improved problem solving  – having a group made up of members with 
different abilities will mean a higher lik elihood of having the appropriate 
knowledge and skills to solve problems. 
• Greater creativity  – the idea that two (or more) heads are better than 
one. Group discussions can generate and evaluate ideas better that individuals working alone. 
• Increased satisfaction  – working as part of a group can bring social 
benefits and a sense of belonging to its members. In addition the group will offer support to its members and pr ovide a facility for individual training 
and development needs. 
• Increased motivation  – members will work hard for the other members of 
the group. They will feel a collective responsibility and will not want to let the other members down. 
• Improved information flows  – there will be more effective 
communication through participation in group discussions. 
Problems with groups 
Unfortunately groups can also have negative as well as positive effects. 
Subsequent research has identified a number of these negative effects, some of which are discussed below: 
• Conformity  – individuals can be persuaded by group pressures to agree 
with decisions which are obviously wrong, and which the person must 
know to be wrong.

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• The Abilene paradox  – this is a famous case, which demonstrates that 
the group can end up with an outcome that none of the members wanted. 
The story was written up as a case by a sociologist whose family all ended up in Abilene, Texas, driving 100 miles through desert heat, though none of them actually wanted to go. They all thought each other wanted to go, and no one wanted to disturb the ‘consensus’. 
• ‘ Risky shift’ or group polarisation  – this is the tendency for groups to 
take decisions which are riskier than any that the individual members would take on their own. It now appears that there is also a tendency, under certain circumstances, for groups to take excessively cautious decisions. 
• Groupthink  – this occurs within deeply cohesive groups where the 
members try to minimise conflict and reach consensus without critically testing, analysing, and evaluating ideas. 
In a group, there is a high level of mutual interaction and awareness which are 
responsible for powerful forces, which cause the individual to behave, 
sometimes, rather differently from the way they would behave on their own. It is important to the organisation that these forces work for the organisation and not against it. 
Clearly, managers must attempt to minimise these potential problems while 
harnessing the many benefits of groups and teams. 
 
Groupthink  
 Some symptoms of groupthink are: 
• the raising of protective barriers and the illusion of impregnability. 
• a negative attitude towards competing projects. 
• an unwavering belief in the group and its decisions. 
• a sectarian emphasis on agreement. 
 Groupthink can lead to disastrous results. After the initial ‘Bay of Pigs’ 
disaster, when the United States encouraged an abortive ‘invasion’ of 
Cuba via the Bay of Pigs, John F Kennedy saw clearly how to try to avoid ‘groupthink’ and planned his leadership accordingly by insisting on: 
• critical evaluation of alternatives 
• independent sub-groups to work on solutions 
• external testing of proposed solutions 
• the leader avoiding domination of the group (which can be 
unconscious) 
• the avoidance of stereotypes of the opposition.

238  
 Group cohesiveness  
 There are a number of factors which affect the integration of 
organisational and individual objectives in groups, and hence the 
cohesiveness of the group. They include: 
Membership factors 
• Homogeneity . Similarity of members is preferred for simple tasks; it 
leads to easier working but less creative problem-solving. A variety 
of skills and knowledge is more effective for complex tasks. Homogeneity of status, both internally and externally, leads to a more cohesive group. 
• Alternatives. If the individual has alternatives, that is he or she can 
leave the group easily, his or her dependence on the group is 
reduced. Similarly, if turnover of  membership is high, the group will 
tend to lack cohesion. Management may, of course, deliberately keep changing the membership of awkward groups. 
• Size of group.  The importance of this factor depends on the nature 
of the particular task. Groups solve problems more quickly and effectively than individuals, but one should also consider cost-effectiveness. As the size of the group goes up, the average productivity of the members goes down; there is less opportunity to participate; individuals’ contributions are less obvious; cliques or factions may form; less work is done; and ‘social loafing’ or ‘social noise’ may increase. 
• Membership in other groups . This may detract from the cohesion 
and effectiveness of the original group. 
 Environmental factors 
• Task:  the nature of the task and its organisation must be 
compatible. 
• Isolation of the group:  external threats and incentives are lower 
the more isolated the group is. 
• The climate of management and leadership:  the leadership style 
adopted should be appropriate to the task. For example in 
organisations where management adopt McGregor's Theory X approach, this can lead to anti-management groups forming, even if only informally. 
Dynamic factors 
• Groups are continually changing.  It should be recoginsed that 
groups are changing all the time, not just in membership but also in 
understanding each other and of the task. 
• Success and failure.  There can be a tendency for groups to persist 
in failure.

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3  Team development 
The level of group performance is affected by the manner in which teams come 
together. According to Tuckman , teams typically pass through four stages of 
development: The stages are: 
• Forming  
• Storming  
• Norming 
• Performing. 
This is shown in the following diagram: 
 
• Forming . At this initial stage, the team members are no more than a 
collection of individuals who are unsur e of their roles and responsibilities 
until the manager clearly defines the initial processes and procedures for 
team activities. 
• Storming . Most teams go through this conflict stage. As tasks get 
underway, team members may try to test the manager’s authority and team preconceptions are challenged. Conflict and tension may become evident. The conflict resolution skills  and the leadership skills of the 
manager are vital at this stage and he or she needs to be more flexible to allow team members to question and test their roles and responsibilities 
and to get involved in decision-making. 
• Norming. This stage establishes the norms under which the team will operate and team relationships become settled. Team procedures are refined and the manager will begin to pass control and decision-making authority to the team members. They will be operating as a cohesive team, with each person recognising and appreciating the roles of the other team members.

240  
• Performing. Once this final stage has been reached the team is capable 
of operating to full potential. Progress is made towards the set objectives and the team feels confident and empowered. 
Not all teams automatically follow these four stages in this sequence and not all teams pass through all the stages. Some get stuck in the middle and remain inefficient and ineffective. 
Tuckman added a fifth stage: 
• Adjourning . If a team remains for a long time in the performing phase, 
there is a danger that it will be operating on automatic pilot. 'Groupthink' 
occurs to the extent that the group may be unaware of changing circumstances. Instead, maintaining the team becomes one of its prime objectives. In this situation it may be necessary for the group to 'adjourn' or be suspended. 
These development stages can be seen clearly in project management where teams are put together to undertake a specific project. This model will be considered again in the people and projects chapter. 
4  Belbin's team roles 
Belbin suggests that the success of a group can depend significantly upon the balance of individual skills and pers onality types within the group. 
Belbin devised a personality test which highlighted key character traits. He recognised that different personality types would prefer certain types of role. For example some individuals like interaction, while others prefer to work on their own. Some individuals come up with original ideas but may not be able to take these forward, while others may not be good at generating new ideas but may be very good at progressing existing ideas. The theory suggests that if individuals characteristics are known then each individual can adopt an appropriate role for their personality type. Where individuals are working in roles which suit them, they are more likely to engage fully with the role, be more motivated and perform better. 
From a group point of view, a balance of personality types is needed. A team 
full of shy, ideas people may be able to generate great ideas but is unlikely to be successful as it would lack the ability to take the ideas forward and communicate these ideas outside the team.

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According to Belbin, a well-balanced group should contain the following nine 
main character types: 
 
Character types Role 
Co-ordinator Mature and confident. Ensures team focuses on objectives. Delegates well. 
Shaper Challenging and dynamic. Provides the drive to keep the team moving. Promotes activity. 
Plant Thoughtful and creative. Generates original ideas. 
Monitor Evaluator Logical and analytical. Evaluates options in an impartial manner. 
Resource Investigator Enthusiastic and inquisitive. Find ideas from outside to bring to the team. 
Implementer Practical and reliable. Deals with planning and scheduling. Drives efficiency. 
Teamworker Co-operative and diplomatic. Concerned with relationships within the team . Diffuses conflict. 
Completer Finisher Anxious and conscientious. Scrutinises the work of the team for errors. Quality control. 
Specialist Single-minded and dedicated. Brings in-depth specialist knowledge to solve technical problems. 
The description of Belbin's basic nine roles does not mean that a team cannot be effective with fewer than nine members. Members can adopt two or more roles if necessary. However, the absence of one of these functions can mean a reduction in the effectiveness of the team. 
 
 N is in charge of a group of twelve people involved in complex work. The 
group has been working together amicably and successfully for a 
considerable time. Its members value N's leadership and the back-up given him by O. She often elaborates on N's instructions and deals on his behalf with group members' queries, especially when he is absent on the group's business. 
Much of the success of the group has been due to P, who is very creative 
at problem solving, and R who has an encyclopaedic knowledge of sources of supply and information. Q is an expert on all aspects of product development, and S is invaluable at sorting out disagreements and keeping everyone cheerful. The remaining members of the group also have roles which are acceptable to themselves and to the others.

242  
 Recently O resigned for family reasons. Because the workload has been 
increasing, N recruited four new people to the group. N now finds that 
various members of the group complain to him about what they are expected to do, and about other people's failings. P and R have been unusually helpful to N but have had several serious arguments between themselves and with others. 
N recently attended a presentation about effective work groups and 
would like to understand the issues his group is experiencing better. The presentation covered models by Tuckman and Belbin and N thinks that if he understood these models better, he could improve the performance of his team. 
Required: 
Write an email to N explaining the causes of these changes in the group 
and recommending how he can ensure that the group reverts to its former cohesiveness. The email should refer to the theories of Belbin and Tuckman. 
 
 Role theory  
 Role theory is concerned with the roles that individuals adopt. Developing 
a group means identifying distinct roles for each of its members. Any individual can have several roles, varying between different groups and activities. The role adopted will affect the individual's attitude towards other people. 
Role theory assists in the understanding of how productive teams are 
formed and operated. 
There are several terms associated with role theory. 
• Role ambiguity  arises when individuals are unsure what role they 
are to play, or others are unclear of that person's role and so hold 
back co-operation. For example this can arise when a new member joins an established group. 
• Role conflict  arises when individuals find a clash between differing 
roles that they have adopted. A company finance officer who uncovers fraud by senior management may feel a conflict between the roles of professional confidentiality and honest citizenship. 
• Role incompatibility  occurs when individuals experience 
expectations from outside groups about their role that are different from their own role expectations.

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 • Role signs  are visible indications of the role. Style of dress and 
uniform are clear examples of role signs. These may be voluntary 
(a male accountant wearing a grey or blue suit and a tie) or mandatory (in military, polic e and hospital occupations). 
• Role set  describes the people who support a lead person in a major 
role, e.g. the clerk and junior barristers would form part of a senior barrister's role set. 
• Role behaviour where certain types of behaviour can be associated with a role in an office or works. For instance, the 'crown prince' behaving as if they are heir apparent to a senior position. 
5  High performing teams  
Vaill – high-performance teams 
Vaill said that high-performing teams may be defined as human systems that 
are doing dramatically better than other systems. He claimed that they have a number of common characteristics: 
• Clarification of broad purposes and near-term objectives. • Commitment to purposes. 
• Teamwork focused on the task at hand. 
• Strong and clear leadership. 
• Generation of inventions and new methods. 
Peters and Waterman – successful teams 
Peters and Waterman  identified five key aspects of successful teams as: 
• The numbers should be small; inevitably each member will then represent 
the interest of their section/department. Larger teams would be slower and 
harder to manage. 
• The team should be of limited duration , and exist only to achieve a 
particular task. 
• Membership should be voluntary. Where members do not want to be part 
of the group, they are unlikely to participate fully. 
• Communication should be informal and unstructured , with little 
documentation and no status barriers. 
• It should be action-oriented . The team should create a plan for action not 
'just a form of words'.

244  
Building the team and improving effectiveness  
Teams are not always able to achieve their goals without some outside 
intervention or support from management. As such, managers may attempt to create ‘teambuilding’ exercises for workers. Team building exercises are tasks designed to develop group members and t heir ability to work together. Team 
building exercises tend to be based around developing the team in several areas, including: 
• improved communication , such as through the use of problem solving 
exercises which force all team members to discuss a problem the group is 
facing. 
• building trust  between team members, which will help the individual 
members work as a group. 
• social interaction  between the individuals in the team can help to reduce 
conflict and increase the cohesion of the group. 
In addition to formal teambuilding exercises, managers can attempt to reinforce the individual identity of the team, strengthening team members’ sense of belonging and improving the efficiency of the group. This can be accomplished in a number of ways, including giving the team its own name, its own office/space or its own uniforms. 
Measuring team effectiveness 
There are many possible ways of measuring team effectiveness, including: 
• the degree to which the team achieved its stated objectives and the quality 
of its output. 
• team member satisfaction. 
• the efficiency of the team which can be measured by the resources used 
to achieve team objectives. 
Management could measure these by using labour turnover or absenteeism 
rates or through the use of questionnaires for team members, interviews, or direct observation of the team. Team rewards could then be designed to not only motivate the individuals within the group, but also encourage cooperation and responsibility sharing between the team as a whole. 
6  Distributive leadership 
A distributed leadership perspective recognises that there are multiple leaders. From the leadership and management chapter it can be seen that traditionally leadership has been viewed as the role of one person in charge of others, but this view is changing. 
Distributive leadership is also known as shared , or collective leadership and 
involves the sharing of the power base between a number of individuals. With 
distributed leadership, leadership is shared so that team members effectively interact with and lead each other. This form of leadership is more horizontal in

Chapter 7 
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nature, compared to traditional leadership which tends to be more vertical or 
hierarchical. This can be seen in the self directed and autonomous groups mentioned earlier in the chapter. With these groups, individuals are encouraged to manage their own work and working practices. 
Carson et al proposed that s hared leadership is facilitated by an overall team 
environment that consists of three dimensions: 
• Shared purpose . When team members have similar understandings of 
their team's main objectives and take steps to ensure a focus on collective 
goals. 
• Social support . The extent to which team members actively provide 
emotional and psychological strength to one another. 
• Voice . The degree to which a team's members have input into how the 
team carries out its purpose. 
The three dimensions are highly inter-related. If team members are encouraged to voice their opinions and get involved, they are more likely to start 
demonstrating leadership traits. If all members do this, there will be a greater 
focus on collective goals. This in turn leads to increased motivation within the team which encourages members to voice their opinions and get involved. 
This suggests that a consequence of distributive or shared leadership is 
improved team performance and many studies have found a positive relationship between shared leadership and team effectiveness. 
7  Inter-group and intra-group conflict 
Inter-group conflict within organisations can be defined as the behaviour that occurs between organisational groups when participants identify with one group and perceive that other groups may block their group's goal achievement. While intra-group conflict occurs when there are disagreements or misunderstandings between members of a team. Conflict between team members can lead to a reduction in team productivity. 
Inter-group conflict requires three ingredients. 1 Group identification . Employees have to perceive themselves as part of 
an identifiable group or department. 
2 There has to be an observable group difference  of some form. The 
ability to identify oneself as a part of one group and to observe differences 
in comparison with other groups is necessary for conflict. 
3 Frustration . This means that if one group achieves its goal the other will 
not; it will be blocked. Frustration need not be severe and only needs to be anticipated to set off intergroup conflict. Intergroup conflict will appear when one group tries to advance its po sition in relation to other groups.

246  
Managing inter-group conflict 
Faced with inter-group conflict, the purpose of any managerial strategy will be to 
turn the conflict into fruitful competition or, if this is not possible, to control the conflict. 
There are a number of approaches which can be used to manage intergroup 
conflict including: 
• Confrontation . Occurs when parties in conflict directly engage one 
another and try to work out their differences. Negotiation is the bargaining 
process that often occurs during confrontation and that enables the parties to systematically reach a solution. Confrontation is not always successful as there is no guarantee that discussions will focus on a conflict or that emotions will not get out of hand. 
• Third-party consultants . When conflict is intense and enduring, and 
department members are suspicious and uncooperative, an expert third-party consultant can be brought in from outside the organisation to meet with representatives from both departments. 
• Inter-group training. A strong intervention to reduce conflict is intergroup 
training. This technique has been developed by psychologists such as 
Robert Blake, Jane Mouton and Richard Walton. When other techniques fail to reduce conflict to an appropriate level, or when other techniques do not fit the organisation in question, special training of group members may be required. 
• Member rotation . It means that individuals from one department can be 
asked to work in another department on a temporary or permanent basis. The advantage is that individuals become submerged in the values, attitudes, problems and goals of the other department. In addition, individuals can explain the problems and goals of their original departments to their new colleagues. This enables a frank, accurate exchange of views and information. 
• Superordinate goals. Another strategy is for top management to 
establish superordinate goals that require cooperation between 
departments. Conflicting departments then share the same goal and must depend upon one another to achieve it. 
Confrontation, third-party consultants and some training methods could also be used to manage intra-group conflict.

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 Illustration 1 – Rivalry generate d by inter-group competition 
 The intensity of rivalry generated by inter-group competition can be seen 
in the well-known case documented below. 
Sherif and Sherif divided boys at a summer school camp into two teams 
and established clear identities for each with a rivalry between the two. The immediate result was that inter-group competition increased group cohesion. Each group regarded the other as the enemy, and fraternisation and communication between the groups ceased. 
Within each group it was found that: 
• conformity was demanded, and group requirements outweighed 
individual needs 
• group members encouraged a move from informal to formal and 
from a leadership approach of participation to an autocratic one the 
group became better organised. 
At the end of the exercise a winning team and losing team resulted. The friction existing between the teams resisted concentrated efforts to remove it. Attempts to run joint teams and act against an outside team were of limited success. It was noted that the winning team retained its spirit and cohesion but became complacent and sought to satisfy the needs of individuals. On the other hand, the losing team sought to allocate blame both inside and outside the group. Its cohesion fell and it ignored the needs of individual members. 
In summary, some degree of competition may prove beneficial but the 
long-term result of excessive competition is likely to result in conflict and a reduction in efficiency. 
 
 Managing inter-group conflict – training  
 Training is a method for managing inter-group conflict. 
This training requires that department members attend an outside workshop away from day-to-day work problems. The training workshop may last several days, and various activities take place. This technique is expensive, but it has the potential for developing a company-wide cooperative attitude. The steps typically associated with an intergroup training session are as follows: 
• The conflicting groups are both brought into a training setting with 
the stated goal of exploring mutual perceptions and relationships. 
• The conflicting groups are then separated and each group is invited 
to discuss and make a list of its perceptions of itself and the other 
group.

248  
 • In the presence of both groups, group representatives publicly share 
the perceptions of self and other that the groups have generated, 
while the groups are obligated to remain silent. The objective is simply to report to the other group as accurately as possible the images that each group has developed in private. 
• Before any exchange takes place, the groups return to private 
sessions to digest and analyse what they have heard; there is great likelihood that the representatives’ reports have revealed to each group discrepancies between its self-image and the image the other group holds of it. 
• In public session, again working through representatives, each 
group shares with the other what discrepancies it has uncovered and the possible reasons for them, focusing on actual, observable behaviour. 
• Following this mutual exposure, a more open exploration is 
permitted between the two groups on the now-shared goal of identifying further reasons for perceptual distortions. 
• A joint exploration is then conducted of how to manage future 
relations in such a way as to encourage cooperation between groups. 
After this training experience, department employees understand each other much better. The improved attitudes lead to better working relationships for a long time. 
 
 LMN is a company which undertakes road reconstruction and 
maintenance. The work is carried out by teams which operate independently of each other. The team members have worked together for years and are well integrated. Each team includes a salesman who is responsible for getting additional work, ideally in the area where the team is already working. The teams draw their materials and road-surfacing and other machinery from the company pool, and obtain information on potential customers from a central sales office. 
Although the company's performance has been satisfactory, the 
operations manager has decided to try to improve productivity by introducing competition between the teams. This will be done by drawing half of the wages of each team member from a single bonus pool for which all the teams compete.

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 The finance manager is concerned about these proposals as she feels 
that while this could improve team performance, it could also adversely 
affect the behaviour of the teams. She has requested a meeting with the operations manager to discuss the proposals. She has asked you to prepare some discussion points for her to use in the meeting. 
Required: 
Prepare a paper containing discussion points for the finance manager. 
The points should cover how such a policy is likely to affect the behaviour of these teams. 

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 251 
 Question 1 
 When members of a group try to minimise conflict and reach consensus 
without critically testing, analysing and evaluation ideas, this is known as: 
A  Conformity B  Risky shift C  Groupthink D  The Abilene paradox
 
 Question 2 
 Using Tuckman’s model, match the descriptions to the stage of team 
development. 
 
Storming  Members start to operate as a team and 
appreciate the roles of others 
Performing  Team members test the manager’s authority, 
and conflict can arise 
Forming  The team is capable of operating to full potential 
Norming  Team members are a collection of individuals 
unsure of their roles

252  
 Question 3 
 Using Belbin’s team roles, insert  the correct character type in the 
sentences below. 
• Shaper 
• Teamworker 
• Monitor Evaluator 
• Resource Investigator 
• Plant 
• Co-ordinator 
• Implementor 
• Completer Finisher 
The _____________ is concerned with the relationships within the group. The ______________ will promote activity within the group. The ______________ analyses others’ ideas and brings the group down 
to earth. 
The ______________ chases progress and ensures timetables are met. 
 
 Question 4 
 Consider the following types of group behaviour: 
According to Peters and Waterman, which of these would be 
characteristics of a successful group? Select all that apply. 
• Avoidance of conflict 
• Small number of members 
• Informal and unstructured communication 
• Strong pressure for group members to conform 
• Voluntary membership 
• Dominant individual members

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 253 
 Question 5 
 Which of the following are the three requirements for intergroup conflict? 
• The groups have to have superordinate goals. 
• Employees have to perceive themselves as part of an identifiable 
group or department. 
• There has to be dominant personalities within the groups. • There has to be weak leadership within the groups. 
• There has to be an observable group difference of some form. 
• There has to be a degree of frustration between the groups.
 
 Question 6 
 Which THREE of the following statements about distributed leadership 
are true? 
• Distributed leadership is facilitated by the team members having a 
shared purpose, social support and a voice. 
• Distributed leadership is also known as transformational leadership. 
• Distributed leadership tends to be more vertical in nature while more 
traditional leadership tends to be more horizontal. 
• Distributed leadership has been found to improve motivation and 
team performance. 
• Distributed leadership involves the power base for a team being 
shared between a number of team members.  
 
 Question 7 
 Team X is successfully run by A and has six members including A. A has 
been in the team for over 20 years and is very good at analysing new 
ideas and at keeping the group focused. 
D has been in the industry for 20 years but only joined the team two 
years ago. She has a lot of contacts with suppliers and customers and is very good at networking. 
E is very good at sorting out disputes and conflicts between team 
members. The main disputes happen between B, who can be aggressive and pushes people to get the job done, and F who is stable and deals with the administration and the scheduling for the team.

254  
 C tends to generate the ideas for the team and is very creative at 
problem solving. 
Match the team members to the Belbin’s tam role which they would be 
most suited to. A team member can have more than one role. 
• co-ordinator • shaper 
• plant 
• monitor evaluator 
• resource investigator 
• implementer 
• teamworker 
• completer finisher 
• specialist
 
 Question 8 
 Match the approach for managing inter-group conflict to its description. 
 
Superordinate goals 
Member rotation 
Third-party consultants 
Confrontation 
 
• Parties directly engage with each other to attempt to work out their 
differences 
• An expert is brought in from outside to meet with both parties 
• Conflicting parties are set the same goal and must depend on each 
other to achieve it 
• Individuals from one department can be asked to work in another 
department

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 Question 9 
 Which of the following statements about types of groups are true? 
• Organisations should try to discourage informal groups. 
• A group that an individual does not belong to but would like to join is 
known as a reference group. 
• Organisations use informal groups to carry out tasks, communicate 
and solve problems. 
• When making bu siness decisions managers should al ways consider 
how these decisions will impact on informal groups. 
• Individuals join informal groups to meet social and security needs.  
 
 According to Vaill, which THREE of the following are key characteristics 
of high-performance teams? 
• Commitment to purpose 
• Functional specialism 
• Eight main character types 
• Strong and clear leadership 
• Super-ordinate goals 
• Teamwork focused on the task at hand

256  
 Case study style question 1  
 EMAIL 
To: N 
Subject: Team performance 
N, Your group of twelve people is a long established and successful group. 
It would therefore be operating in Tuckman's fourth and final stage, which he terms 'performing'. In this stage the group is mature and individuals have evolved the roles that each will discharge and the norms of behaviour for group sessions. Such a settled group will be comfortable 
and familiar with each other, encouragin g each individual to fulfil his/her 
role. 
Belbin has devised a series of questionnaires whereby a person's natural 
role within a group can be defined. His theory further explains that a successful group has a balance of types. 
Prior to the recent changes in the team, you were fulfilling the 'Co-
ordinator' role; P was the 'Plant', capable of innovative solutions but may be low on practical follow through. R would have been the 'Resource Investigator', Q was an 'implementor', but may also have functioned as a 'Monitor Evaluator', providing an organising, dutiful, unemotional aspect to the group's work. S was the 'Teamworker', defined by Belbin as important in promoting team spirit. O seems to have been the 'Completer Finisher', ensuring that matters are followed through; also during your absence she may have acted as 'Shaper' in providing the drive and momentum for completion of the work. This analysis suggests that this group was well balanced in having all major team roles present. 
The resignation of O could cause an imbalance within the group unless 
another individual develops into the 'Completer Finisher' and 'Shaper' roles. Belbin explains that people can adopt different roles in different groups and amend their behaviour to fill a vacant role. However, there will be a temporary imbalance. Furthermore, the resignation of O and her replacement by four new people means that the group reverts to the earlier stages of Tuckman's group formation i.e., forming, storming and norming. 
As the group seeks to absorb new unknown people and strange roles are 
adopted it is inevitable that some people conflict will emerge. This could be aggravated by the increased size of the group. When the group had twelve members, a degree of  cohesiveness is possibl e; however, this is 
less likely in a group of fifteen, especially when four members are new.

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 Since P and R have been unusually helpful, they are probably aware of 
this difficulty and are trying to cover O's role gap. However, the friction 
between them and with others highlights the need for you to take action. 
To recapture group cohesiveness and efficiency you could: 
• let the group evolve over time through the four stages until the 
performing stage is reached when group cohesiveness would be 
restored. This would incur the intermediate stages when the group members get to know each other, when roles develop and are accepted by others, when disagreements arise. This may feel like a safe option since eleven of the fifteen members are long standing and extra support is coming from P and R. However, you need to remember that the personality of the new group will be different from the old team – there are new people and roles involved. Also, the size of the group is significantly larger and could not operate in the same way. 
• break the group into smaller teams, which may progress through the 
four stages of formation more quickly. A smaller team can be managed in a more personal manner and this may suit you. 
• become directly involved in structuring the progression of the group 
through each stage of formation. You could, for example, influence the development of roles and behaviour norms through your own behaviour in recognising a particular person as the 'Shaper' in the team. 
• change the group structure through delegation, assigning individual 
responsibilities, making some tasks team based instead of personal based. Since the tasks are complex, this may be a current practice. 
• emphasise the change and need for a new approach by altering the 
physical layout of the office. A revised desk seating plan could create its own team influences and separate potential conflict staff. 
 • introduce a series of team building training sessions in which the 
group could analyse its own behaviour. This could involve understanding the value that each person brings to the team as well as ensuring that ever yone understands the group tasks that must be 
completed. In the final resort this could lead to the payment of team bonuses based on team, rather than individual, performance. 
• you may also have to consider whether there is a need to change 
your management style. Likert emphasises that the effective manager can adapt his/her management style in response to changes in staff, tasks and situation. For example, you may find it necessary to be less participative in the early stages of group formation. Or even adopt two different styles if you chooses to split the group into two smaller teams. 
touch if you would like any more information or would like to discuss any 
of these issues further.

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 Discussion points for meeting re team bonus structure 
Prepared by Management Accountant  
Road reconstruction and maintenance work will consist of contracts 
where each contract is different in nature, size and location. The techniques and materials used may be common but the application will be variable. Under this pattern of work there is considerable initiative available to the work team while central control cannot be detailed. 
The present teams are cohesive, successful and operate independently 
of each other. The introduction of competition between groups will heighten the cohesive aspect and reduce the co-operation overall, this can be concluded from the boys camp experiments of Sherif and Sherif. This will be accentuated in this example because the change in wage system means that teams are competing for a share of a single bonus pool. The operations manager's introduction of  competition will change 
the attitude and behaviour of the teams. Some of these changes will be beneficial while others will be negative. 
 The positive changes in behaviour are likely to be: 
• An improvement in productivity within the teams. Each team will 
endeavour to safeguard or increase its share of the bonus pool. The 
team will concentrate its attention on improving its own productivity 
through streamlining working practices, ignoring trade demarcation boundaries and working outside normal hours to complete the job. 
• The bonus element of the wages can be calculated on a basis of 
contract profitability as contract ti me targets. If profitability is the 
measure then the team will be cost conscious and material wastage, equipment abuse etc will be minimised. However, if the measure is time targets then wastage and machinery abuse will be irrelevant to the team's bonus and management will need a central system to check team behaviour and operations. 
• An improvement in timekeeping and attendance should occur. 
Mayo, in the Hawthorne Experiment, was the first researcher to point out the strong pressure of group colleagues upon the behaviour of any individual within a group. The more cohesive the group, the stronger its peer pre ssure. Group names will be clearly 
evident covering areas of attendance, timekeeping, 'breaktimes' and individuals will be pressurised to fulfil their role within the team. As Mayo discovered, if the behaviour of an individual usurps a team name then team members exact a penalty and the offender is subjected to ostracisation, sneering comments and similar social pressure.

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 • Local sales effort is likely to be increased. If potential customers are 
logged with a central sales office then once a team has commenced 
work with a customer, they are likely to 'sell' extra services and develop sales to a maximum. There could be a situation where this is damaging to the organisation. For instance a major customer operating several sites could employ more than one team from the road reconstruction company. If one team disparages the work of another team or causes it to miss a deadline, in order to gain the next slice of work, then the overall company reputation is damaged. This is the potential danger in all situations of local rivalry. 
• There will be a change in internal working relationships as group 
members become less social in behaviour and more task centred. This will increase pressure on new comers or poor-performers, as 
time spent in coaching or supporting by other team members becomes resented. 
The negative changes in behaviour are likely to be: 
• Competition will breed selfishness and the bonus share out will 
create winners and losers encouraging envy and recriminations 
between teams and their members. 
• Teams will be selective in the jobs that they undertake. A difficult or 
potentially low bonus job is likely to be avoided. An additional temptation would arise when a team developed a major customer and was unable to handle all the work generated in the timescale required by the customers. The team may seek to postpone the work and so safeguard future bonuses but would damage customer services in doing so. 
• Fluctuating wages and internal group pressure to perform could 
have harmful consequences for individuals and reduce loyalty. 
• There will be severe pressure on the sales person to put the 
interests of his team first and the company second. Sub-optimising of performance is likely as each team seeks to direct its sales 
person's efforts for the team's benefit. This selfishness of behaviour could extend to other areas such as machines being drawn from the company pool and not returned promptly for other teams to use. A further example could arise where one team learns of a contract which is in the immediate vicinity of a rival team's current working. The overall benefit of the company dictates that disruption and travelling costs would be minimised by the team in  that locality 
fulfilling that work. But selfish team behaviour may block this. 
In summary competition between teams will deeply affect the behaviour of individuals within groups and inter group behaviour.

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 Question 1 
 C  Groupthink 
Conformity is where individuals are persuaded by team pressure to agree 
with decisions which are obviously wrong. 
Risky shift is the tendency for groups to take riskier, or more cautious, 
decisions than the individuals would take. 
The Abilene Paradox refers to the situation where the outcome achieved 
was not what any of the members wanted but they all thoughts the others did. 
 
 Question 2 
 The correct match is: 
 
Norming  Members start to operate as a team and 
Storming  Team members test the manager’s authority, 
Performing  The team is capable of operating to full potential 
 
Forming  Team members are a collection of individuals 
unsure of their roles 
   
 Question 3 
 The teamworker  is concerned with the relationships within the group.  
The shaper  will promote activity within the group. 
The monitor evaluator  analyses others’ ideas and brings the group 
down to earth. 
The completer finisher chases progress and ensures timetables are 
met. 
 
 Question 4 
 • Small number of members 
• Clear objectives 
Paters and Waterman also suggested that successful teams should be of 
a limited duration and be action orientated.

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 Question 5 
 • Employees have to perceive themselves as part of an identifiable 
• There has to be an observable group difference of some form – 
individuals must identify themselves as part of one group. 
• There has to be a degree of frustration between the groups – 
frustration means that one group achieving its goals will block 
another group from meeting its goals. Frustration only has to be anticipated to cause conflict. 
 
 Question 6 
 • Distributed leadership is facilitated by the team members having a 
shared between a number of team members. 
Distributed leadership is also known as transformational leadership. This is false, it is also known as collective leadership. 
Distributed leadership tends to be more vertical in nature while more 
traditional leadership tends to be more horizontal. This is false as distributed leadership tends to be more horizontal.  
 
 Question 7 
 A  is coordinator and monitor-evaluator 
B  is completer/finisher 
C  is plant D  is resource-investigator E  is team worker F  is implementer

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 Question 8 
differences – Confrontation  
• An expert is brought in from outside to meet with both parties –
Third-party consultants  
other to achieve it – Superordinate goals  
department – Member rotation  
 
 Question 9 
 • A group that an individual does not belong to but would like to join is 
• Individuals join informal groups to meet social and security needs. 
Organisations should try to discourage informal groups. This is false, they 
have to be aware of them and understand the need for them. 
Organisations use informal groups to carry out tasks, communicate and 
solve problems. This is incorrect. While informal groups may contribute to these outcomes, they would generally use formal groups for these purposes.
 
 • Commitment to purpose 
In addition Vaill suggested that high performing teams would also exhibit: 
• Clarification of broad purpose and near term objectives 
• Generation of inventions and new methods.

263 
Managing organisational 
relationships 
relationships (b)  Communication 
(c) Negotiations 
(d)  Managing conflicts 
• Digital tools for communication 
• Sources and types of conflicts 
• Strategies for managing conflict 
• Leadership and ethics.   Chapter 
8

Managing organisational relationships 
264  
 
Why are these communication skills important? 
In any organisation there will frequently be conflicting demands on time, or 
differences of opinion or attitude for which these skills are key in trying to reach agreements where all parties are happy and can work together towards the organisational goals. In certain job roles they will be more important than others, for example in any role with responsibilit y for customer or supplier relationships, 
or for managing others, these communication skills are essential. 
The importance of effective communi cation for Chartered Management 
Accountants 
For Chartered Management Accountants (CMAs) who are required to deal with 
a variety of parties, both internal and external, these skills are fundamental. 
CMAs are an integral part of any business and hold a variety of positions within 
organisations, often senior management positions. Their roles are varied and can include (amongst others): 
• formulation of policy and setting of corporate objectives 
• acquisition and use of finance 
• generation, communication and interpretation of financial and operating 
information for management and other stakeholders 
• derivation of performance measures 
• improvement of business systems. 
To undertake these roles, they often work as part of multi-skilled management 
teams. They will be required to deal with other employees throughout the organisation, at all different levels, and external parties such as customers, suppliers, contractors and advisors. Effect ive communication skills are therefore 
vital for the CMA as they will be required to  deal with a variety of people in order 
to carry out a variety of roles. Influencing, persuasion and negotiation skills will be particularly important.

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2  Communication 
An important aspect in all relationships within an organisation is communication. 
Most organisations will depend to some extent on the speed and accuracy of communication to maintain their competitive edge, and the management function relies on effective communication. Good communication skills are often included as an essential management competence, since people with good communication skills have been found to make better decisions and tend to be promoted more frequently. 
Effective and regular personal communication is vital to ensure coordination 
and to identify problems quickly. 
Types of communication 
Most communication within an organisation can be classified as either formal or 
informal. 
Formal communication 
Formal communication is planned and intentional and tends to have a more 
professional tone. This is generally used within a work context. 
Informal communication 
Informal communication is more casual in nature and is generally unplanned. 
Informal communication is less structured with a more relaxed tone. This type of communication is generally used between family and friends. 
The process of communication 
The communication process can be defined as a process that is used to 
transmit a message from a sender to a receiver. A message can be words, numbers, gestures or non-verbal cues such as body language. 
 
The message goes through several stages when it is sent by the sender to the receiver. These stages are as follows: 
1 Sender . The sender is the entity that conveys or sends the message. 
2 Encoding . Encoding is a process through which the message is 
symbolised. 
3 Channel . Channel is the medium through which message is being sent. 
(email, face-to-face conversations, meetings, telephone calls etc).

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4 Receiver . The receiver is the entity that receives the message. 
5 Decoding . Decoding is the process in which the message is translated 
and meaning is generated out of it. (problems can occur here due to 
interpretation). 
6 Feedback . Is the process through which receiver sends their response. 
The importance of feedback 
When a message is sen t, it is important that the sender receives feedback from 
the receiver to let them know that the message was succe ssfully received. 
Feedback can be verbal, for example acknowledgements, questions or 
comments or it can be non-verbal such as a smile (or a frown). Feedback can also be written, for example in replying to a text or email. 
Feedback is a very important part of the communication process as it gives the 
sender the knowledge that the message has been received as intended, or can allow the sender to clarify the message where it appears that the receiver is confused or doesn’t understand the message. 
It is important that the sender asks for feedback. Assuming a message has 
been received and understood can be a dangerous assumption to make. 
Noise 
Another feature of the communication process is noise. Noise is anything which 
interferes with the communication process and stops the message being received and understood by the receiver as it was intended. There are many types of noise, including: 
Environmental/physical noise:  This noise physically disrupts communication 
and prevents the receiver from hearing or seeing the message clearly. For 
example, loud music, phones ringing, people chatting loudly or difficult-to-read fonts or colours. 
Physiological noise: This kind of noise refers to actual physical barriers within 
the sender or the receiver that cause messages to have trouble getting through. For example, hearing loss, poor eyesight or the sender having a speech impairment. 
Semantic noise:  This noise occurs when the sender and receiver have a 
different understanding of words. This could include different dialects or 
languages, using jargon, or words with several possible meanings. 
Psychological noise:  The attitude of the sender and receiver can also make 
communication difficult. For example anger or sadness may cause someone to 
lose focus, being preoccupied with a problem or feelings of prejudice can all affect the communication process.

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 Barriers to communication  
 Sender: 
• not being clear as to what has to be communicated 
• omitting information 
• choosing words in coding the message that do not accurately reflect 
the idea/concept, and or choosing words that the intended receiver 
cannot understand 
• choosing words that provoke an emotional response 
• using technical jargon 
• choosing an inappropriate medium 
• sending too much information 
• sending mixed messages. 
Receiver: 
• not in an appropriate state to receive the message 
• not wishing to receive the message 
• filtering out elements that he or she does not wish to deal with 
• information overload 
• mindset that does not admit the substance of the message. 
 Ways to overcome the barriers:  
the sender  should: 
• have a definite, clear objective 
• plan the communication 
• think about the receiver and their situation 
• anticipate reactions to the message and cater for these 
• practise using the channels of communication 
• seek and work with the feedback. 
the receiver  should: 
• consider their contribution 
• listen attentively 
• check out anything that is vague 
• give feedback.

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Non-verbal communication 
According to Druker: "The most important thing in communication is 
hearing what isn’t said.” 
Studies by Mehrabian  suggested that only around 7% of a message is 
transmitted through the actual words said, with the other 93% being conveyed 
through the way the words are said and other non-verbal elements. 
A great deal of communication can take place without any words at all. The 
raised eyebrow, the smile, the frown and the glare all say a great deal; so can more obvious physical gestures such as the hand shake, pat on the back or an arm around the shoulders. 
Body language is about: 
• appearance 
• eye contact 
• facial expression • posture and distance 
• tone. 
Non verbal actions can vary across countries and cultures. For example in most 
western countries eye contact is seen as a way of indicating interest in what the other person is saying while eye contact is avoided in Japan. Pointing and other 
hand gestures can also be interpreted differently in different countries, with 
some gestures viewed as positive in some countries and offensive and rude in others. 
2.1 Digital tools for communication  
The traditional workplace was composed of a physical office space with 
employees working face-to-face, communicating via paper and meetings which were usually held on-site. 
The introduction of email (first configured in the 1970’s by Ray Tomlinson) and 
other forms communication such as video conferencing changed this format. In 1995 when the restrictions on carrying commercial traffic over the Internet ended it became the norm for employees to be working across multiple locations, hours and devices.  
The workforce became more flexible and was no longer confined to a single 
office environment. As these diversified workplaces emerged, the need for team-based, collaborative and digitally connected work environments became critical to business efficiency and future growth.

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Some examples of such digital communication tools are: 
Intranet 
A private hub that can be accessed by any authorised users within a business 
organisation. It is mainly used for effective internal communication and collaboration among coll eagues, producing a more educated, skilled and 
engaged workforce.  
With the advent of bring-your-own-device (BYOD) and telecommuting, an 
intranet solution will result  in a more flexible workforce and ensure all 
employees are working towards the same goals.  
Intranets enable organisations to easily share company news and build an 
information-rich environment, for example, news feeds can be personalised for each staff member based on their team, department and/or location to ensure the most relevant news is provided for their needs. Clearly this would need to be linked to security permissions to ensure sensitive or confidential information is protected.  
Intranets can be further developed by facilitating communication among staff 
working in different locations or in a particular location or area of specialty facilitating interaction with the content and offering feedback in real-time. 
Chat and private messaging 
Collaborative spaces which provide private/group messaging and “chat 
functions” are often viewed as one of the best business communication tools to keep teams working together…an effective form of communication for busy employees and managers.  
For example, instant messaging makes updates on projects and general team 
discussion much easier, which works well when employees or team members are spread across different geographical locations or different time zones. Similarly they enable files to be shared and conversations can be accessed if needed.  
Discussion forums 
A discussion forum can bring together management and employees and allows 
for an open discussion on any topic (usually set up and monitored/moderated). It can also help in knowledge dissemination and bring the workforce together.  
Forums are also effective in archiving organisational knowledge to be used by 
anyone as a reference. Employee morale can also be boosted by participating in regular discussion forums which will also facilitate knowledge sharing. This will enable information to be discovered by people who need it, when they need it.

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Tracking and case software 
An online help desk with a case tracking system enables employees and 
customers to submit a case or support ticket. This allows it to be assigned to the right employee and have it checked and resolved in time, helps centralise customer support queries and keep track of any open issues. 
Tracking team productivity can be monitored and it enables the business to 
prioritise the most relevant and important queries and collect valuable customer feedback which in turn can help in improving future products, services and customer relationships. 
This can also be extended to an issue tracking system which is generally used 
in an organisation’s customer support/call centre to create, update and resolve reported customer issues or internal issues reported by employees within the company. 
Internal blogs 
The internal blog is a place where employees can share ideas and experiences 
fast and in an informal fashion.  
Internal blog advantages can include: 
• Broadcasting and highlighting an employee’s knowledge about a certain 
topic or area of the organisation. 
• Creating a searchable and permanent archive of articles, knowledge and 
expertise.  
• Promotes open discussion and collaboration among the workforce. (NB 
there are instances where some employees will be more likely to speak up 
in a virtual environment than face-to-face). 
• It connects employees across departments and locations. 
• It keeps the staff up-to-date on important information and company 
updates. 
2.2 Data visualisation 
 Data visualisation allows large volumes of complex data to be displayed in 
a visually appealing and accessible way that facilitates the understanding and use of the underlying data. 
The growing significance of data has seen a rise in the importance of being able to access and understand the data in clear, concise way. This is where data visualisation fits in. The tools of today’s market leaders Tableau and Qlik, go far beyond the simple charts and graphs of Microsoft Excel. Data is displayed in customisable, interactive 3D formats that allow uses to manipulate and drill down as required. Central to data visualisation is understanding and ease of use, the leading companies in the field look to make data easier and more accessible for everyone.

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Essentially it aims to remove the need for complex extraction, analysis and 
presentation of data by finance, IT and data scientists. It puts the ability to find data in to the hands of the end user, through intuitive, user friendly interfaces. 
The most common use of data visualisation is in creating a dashboard to 
display the key performance indicators of a business in a live format, thus allowing immediate understanding of current performance and potentially prompting action to correct or amend performance accordingly. 
3  Meetings 
Meetings can be an effective communication method for the manager. In order to ensure that meetings are effective and useful it is important to adopt the following steps: 
• determine the purpose of the meeting • establish who needs to attend 
• determine the agenda in advance 
• make suitable arrangements for location and time 
• facilitate discussion 
• manage the plan of action 
• summarise 
• publish results/minutes. 
 
A rule of thumb of facilitation is that successful meetings are: 
80% preparation  and 20% execution . 
Roles of team members in meetings: 
• The meeting requires a chairperson/facilitator  to setting the agenda and 
ensuring the meeting achieves its objectives. During the meeting this 
person will ensure the agenda is followed. 
• The meeting will require a secretary or administrator  to take minutes. 
• Team members will play various roles: 
–  protagonists are positive supporters. 
–  antagonists are challenging and disruptive. 
All meeting members must be listened to with respect, but it is the responsibility 
of the facilitator to make the whole team  aware of the overall objectives, and the 
role that each team member plays in their achievement.

272  
If the meeting is designed to solve problems, individual team members will be 
called upon to offer their own expertise and advice on the situation. Other team members will take a more passive role, but will be important in providing an objective perspective on the solutions generated. It is important that a variety of skills are represented at a meeting so that those present can provide varying expert opinions upon the same problem. 
 
Problems with meetings and their solution  
  
Problems with meetings Actions to avoid problem 
Inappropriate chairperson. Selection should be based on someone 
with the requisite range of 
communication skills. 
The objectives of the meeting are undefined and unclear. Ensure that an agenda is produced and circulated prior to the meeting. During the meeting, the chairperson should state the objective and must return the focus of the meeting to the points on the agenda. 
Lack of enthusiasm or interest in the meeting. For future meetings, ensure that only those with an interest in the meeting, or whose view is required, are actually invited to the meeting. For the current meeting, suggest a short break or stress the need to reach a conclusion. 
Attendees talk too much without regard to the chairperson’s requests. The chairperson must impose some order on the meeting. Possible solutions include asking the participants 
to speak in accordance with meeting 
protocols such as a time constraint if necessary, or (worst case) asking them to leave the meeting altogether. 
Attendees cannot reach an agreement concerning issues on the agenda. The chairperson will need to exercise negotiation skills to try to bring the meeting to some agreement. If this is not possible, then attendees may have to agree to differ. However, some action points may be required to ensure that more information is obtained so agreement can be achieved at the next meeting.

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Action points from previous 
meetings have not been carried out. Assuming that minutes were issued correctly, in the current meeting, the chairperson should obtain reasons for actions not being completed. For future action points, ensure that each has a person identified as responsible for completing it. Check the minutes of the meeting to ensure that all action points are included. 
Minutes are either too long (information overload) or too brief (do not include appropriate points). Ensure that the minutes are either minutes of resolution (which contain agreed outcomes) or, if minutes of narration, that they are sufficiently edited to provide the flavour of the discussions, but not small detail. 
  
 PQR has experienced significant success over the last year and is 
expanding rapidly. B, the founder and managing director, feels that changes to the way the company is being run will have to be made in order to ensure future success. One area he has identified which needs improving is the communication between managers. 
The main means of communication between mangers is via a monthly 
managers’ meeting, however these meetings are generally unproductive. B feels this is due to the following reasons: 
• Lack of participation. During the meetings, some managers do not 
contribute, many feel they have better things to do with their time, so 
keep quiet to speed the meeting up. 
• Non-attendance. Not all managers turn up for the monthly meetings, 
and on some occasions the operations manager has sent a junior member of staff on his behalf. 
• Decisions are rarely made at the meeting as the managers don’t 
usually know what will be discussed at the meeting so rarely bring any documentation. Discussions can be held at the meeting, but managers can leave the meeting unclear as to what will happen next.

274  
 • The manager of the sales department is a formidable character and 
the other managers are usually reluctant to disagree with him. He 
usually takes over the discussions within the meeting. 
B has employed you as a consultant for advice as to how to improve these areas. 
Required: 
Write a report for B discussing the problems which have been 
experienced in the monthly meetings and s uggesting what should be 
done to make future meetings more productive. 
4  Influence, persuasion and negotiation skills 
Influence, persuasion and negotiation are all aspects of communication. They are linked and can often be used together, but they are different. 
• Influence  is the ability to change others' attitudes, opinions or behaviour. 
• Persuasion  is the attempt to deliberately get others to change an attitude, 
opinion, or behaviour. 
• Negotiation  is the ability to discuss an issue with one or more other 
people in the attempt to establish ways to reach agreement. 
Influence 
Influence can be direct or indirect. Direct influence is when the person 
attempting to change the attitude of another speaks directly to the other person. This type of influence would be used within sales or customer services roles. Indirect influence is where the message attempts to reach its target via a third party. For example organisations may pass messages to public relations firms or analysts, in the hope that these parties will in turn influence potential customers. 
Influencing techniques are used frequently by sales people to encourage us to 
purchase goods and services. There w ill also be many situations within 
organisational relati onships where it will be important  to influence other people, 
for example, attempting to gain support for a new product or process. When attempting to influence others it is important to consider the objective and the reasons why influencing the other party is necessary as forceful influence may be seen as manipulative.

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Cialdini  came up with six principles of Influence (or the six weapons of 
influence). These can be used whenever there is a need to influence others. 
1 Reciprocity . Human nature can lead us to feel obliged to return favours. 
Therefore we may be influenced to support someone who has supported 
us in some way in the past. 
2 Commitment . As humans, we desire consistency and don’t like to be 
seen to be changing our minds. Therefore we may be influenced to follow through with our support for something if we had shown some initial interest in it. 
3 Social  Proof . This principle relies on the fact that humans tend to be 
influenced by peer pressure. If we see others acting in a certain way, it is likely to influence us to act in the same way. 
4 Liking . This principle is based on the fact that as humans we are more 
likely to be influenced by people we like, people who are nice and friendly towards us or people who are similar to us. 
5 Authority . Another principle of influence is based on the premise that we 
are more likely to be influenced by people in positions of authority. This comes from a sense of trust and respect for the position held. 
6 Scarcity . This principle suggests that we are more likely to want 
something if its availability is limited. We are more likely to support something if we fear losing out if we don’t. 
 
Using the six principles of influence  
 Reciprocity : Identify what you want to achieve and what you need from 
the other person. You can then identify what you may be able to offer them, or remind them of what you have done for them in the past. 
Commitment : Try to get some commitment from others at an early stage 
on the process. This makes it more difficult for them to withdraw their 
support later on. 
Social Proof : Use the opinions of those already supporting you to 
influence others to join that support. If others are talking about your 
project, new people will want to be part of it. 
Liking : Build relationships with those you want to influence so that they 
trust you. This can be difficult and can take some time, also different 
approaches may be required for different people. 
 Authority : Use your own authority and the authority of others, as 
influencers. Getting the backing of se nior, powerful people will encourage 
others to back you. 
Scarcity : People need to know that they could miss out if they don't act 
quickly. Imposing deadlines to enhance urgency can encourage people to 
give their support. 
It is worth recognising these principles so that you can be aware when 
others are trying to use them to influence you.

276  
Persuasion 
Persuasion is a stronger form of influence. While influence can be direct or 
indirect, intentional or unintentional, persuasion is always direct and intentional. The aim of influence could be to inspire someone to buy in to an idea or make a particular decision, while the aim of persuasion is to change a person, or group’s attitude or behaviour towards something or someone. The person using persuasion has a clear objective and is set on achieving it by getting others to support them. Persuasion falls short of telling or ordering someone to do something, but may use coercion as it attempts to get the other person to agree, albeit perhaps under duress. 
The six principles of influence can be used  in persuasion, but they may be used 
in a stronger form. 
Negotiation 
Negotiation is another important communication skill required within 
organisations. Negotiation can be used by managers in their relationships with not only subordinates but with other stakeholders such as suppliers and customers. 
The aim of negotiation is to settle differences between people or groups, and to 
allow them to come to an agreement which both parties accept. 
Negotiation is defined by three characteristics: 1 Conflict of interest between two or more parties. What one wants is not 
necessarily what the others want. 
2 No established set of rules for resolving conflict, or the parties prefer to 
work outside of an established set of rules to develop their own solution. 
3 Parties prefer to search for an agreement rather than to fight openly, to 
have one side capitulate, to break off contact permanently, or to take their 
dispute to a higher authority. 
Examples of negotiations manage rs might need to undertake: 
• on his/her own behalf  when securing a pay rise, for instance, or an 
improvement in the terms and conditions of employment. 
• on behalf of a departme nt or functional area , e.g. securing an 
acceptable departmental budget. 
• with the external environment  on behalf of the organisation, 
e.g. obtaining planning permission for an extension to the warehouse.

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The skills required by a negotiator can be summarised under three main 
headings: 
• Interpersonal skills . The negotiator requires good communicating 
techniques such as influence, and persuasion. 
• Analytical skills . The negotiator requires the ability to analyse 
information, diagnose problems, to plan and set objectives, and the 
exercise of good judgement in interpreting results. 
• Technical skills . The negotiator requires attention to detail and thorough 
case preparation. 
The process of negotiation 
The negotiation process can be divided into four distinct stages: 
 
• Preparation . This stage involves information gathering. It is important to 
know the background to the problem, and the likely constraints acting on 
each participant. 
• Opening . During this stage both sides present their starting positions. This 
is a good opportunity to influence the other party. 
• Bargaining. The purpose of this stage is to narrow the gap between the two initial positions and to persuade other party of the strength of your case. In order to do this, you should use clearly thought out, planned and logical debate. 
• Closing . At this stage agreement is reached and hopefully a mutually 
beneficial outcome has been found.

278  
Guidance for successful negotiation 
• Focus initially on each side’s primary objective. Trivial negotiating points 
can become a distraction in the early stages (bikeshedding). 
• Be prepared to settle for what is fair. If an agreement is not seen to be fair 
it is unlikely to be stable. Maintain flexibility in your own position, this 
makes it easier for the other side to be flexible as well. 
• Listen to what the other side wants and make efforts to compromise on 
the main issues, so that both sides can begin to attain their goals. 
• Seek to trade-off wins and losses, so each side gets something in return 
for everything they give up. 
 
 Types of negotiation  
 Negotiation processes can differ fundamentally in their approach and in 
their relative prospects for the stability of the agreement that is reached. 
The first is called the ‘win-win’  approach. In these negotiations, the 
prospects for both sides’ gains are encouraging. Both sides attempt to 
reconcile their positions so that the end result is an agreement under which both will benefit. 
The second is called the ‘win-lose’  approach. In these negotiations, each 
of the parties seeks maximum gains and therefore usually seeks to 
impose maximum losses on the other side. 
A third potential outcome of negotiation is the 'lose-lose'  approach. In 
this scenario either both parties concede more than they initially intend, 
or no agreement is actually reached. Both parties can end up in worse positions than they were in before the negotiation. 
It is clear that a win-win solution is more likely to lead to a stable solution 
and a successful business relationship in the long run.

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 BCD is a manufacturer of building materials, supplying the house building 
industry. As a result of the downturn in the demand for its products and in 
response to difficult operating conditions in its existing market, the company is currently going through a major restructuring. It is anticipated that the restructuring plan will involve the consolidation of some business activities which will result in a number of staff having to move to different areas of the company. This could mean re-location to different sites, and other staff being made redundant. 
While employee relations have in the past been good, the management 
of the company is aware that employees and the trade unions which 
represent their interests will be resistant to the changes that need to be made. The first stages of change will require skilful negotiation between the management and unions on a range of issues relating to the movement of staff jobs, the proposed job losses and, specifically, the criteria for redundancy and the redundancy package. 
K, the operations director has been asked to lead the negotiations on 
behalf of BCD. He is not confident about this as he has never been involved in negotiations of this kind before. He has asked you for some advice. 
Required: 
Write an email to K, explaining the role of negotiation in the management 
of change in BCD, making reference to the different stages involved in the negotiation process. 
(15 minutes ) 
5  Conflict 
Conflict is a disagreement, and is when one party is perceived as preventing or interfering with the goals or actions of another. Conflict can occur in a variety of forms and at different levels, for example organisational, group or individual level. 
Inter-group conflict was looked at in the previous chapter. Conflict can arise for many different reasons, these are known as the causes of 
conflict . When conflict occurs certain behaviours can develop, these are known 
as the symptoms of conflict . There are also two main types of conflict . It is 
important that that you can distinguish between these different elements of 
conflict.

280  
Causes of conflict 
Mainwaring suggested that the causes of conflict generally include: 
• History . Conflicts have a tendency for being self-perpetuating. 
• Differences . Mainly of interests, objectives, priorities and ideologies. 
• Limited resources . Where there are limited resources, there may be a 
battle for what is available. 
• Win/lose situations. Success for one group often involves failure for 
others. 
• Interdependencies . Where relationships, responsibilities or boundaries 
are not clearly defined, and/or where they are perceived to be unfair. 
• Misunderstandings . These include communication failures and are 
common where there already exists some sort of conflict or threat. 
• Conviction beliefs . If one group is convinced of their essential rightness 
or goodness, then there may be tendencies to 'enlighten' others, causing 
resistance. 
• Stress and failure . If an individual, a group, or an organisation feels 
unable to cope with pressures and problems, then this is likely to generate fault finding, reality denial and seemingly irrational acts. 
• Change . Individual, group, organisational and societal change creates 
new relationships, objectives, perceptions, problems and possibilities. 
Symptoms of conflict 
Certain behaviours and attitudes can manifest themselves when conflict exists. Sometimes these behaviours are overt, as when it emerges in the form of a strike, or individuals refusing to communicate with each other at all. However, the management of conflict is likely to be easier and more effective if these symptoms of conflict can be recognised and dealt with at an earlier stage. Such symptoms would probably include some of the following: 
• Problems, even trivial ones, being passed up the hierarchy because no 
one wants to take responsibility for them. 
• Hostility and jealousy between groups. 
• Poor communications up and down the hierarchy, and between 
departments. 
• Widespread frustration and dissatisfaction because it is difficult to get even 
simple things done efficiently. 
• Problems constantly being polarised around people, usually in different 
groups, and personalities rather than issues.

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 Consequences of conflict  
 Daft noted that several negative consequences for organisations that 
may arise from conflict are as follows: 
• Diversion of energy resulting in time and effort wasted. 
• Altered judgement. Judgement becomes less accurate as focus is 
lost. 
• Loser effects. The loser may deny or distort the reality and may 
seek scapegoats. 
• Poor co-ordination. Under intense conflict co-ordination does not 
happen. Co-operation across groups decreases and groups may 
actively attempt to jeopardise the goals of other groups. 
Types of conflict  
Horizontal conflict 
The first type of conflict is horizontal. Horizontal conflict occurs between groups 
and departments at the same level  in the hierarchy. The main sources of 
horizontal conflict are: 
• Environment . Each department or group becomes tailored to ‘fit’ its 
environmental domain and, thus, is differentiated from other groups or 
• Size. As organisations grow, members of departments begin to think of 
themselves as separate, and they erect walls between themselves and other departments. 
• Technology . Interdependency creates opportunity for conflict as 
technology determines task allocation. 
• Structure . Divisionalisation and departmentalisation create competition 
which can lead to conflict. 
• Goal incompatibility . Each department's operative goals interfere with 
each other or the achievement of goals by one department may block achievement of the goals of other departments. 
• Task interdependence. Dependence on each other for materials, 
resources and information. Generally, as interdependence increases, the 
potential for conflict increases. 
• Reward systems . If departments are rewarded only for departmental 
performance, managers are motivated to excel at the expense of the rest of the organisation. 
• Differentiation. Functional specialisation causes differences in cognitive 
and emotional orientations.

282  
 More on horizontal conflict  
 The potential for horizontal conflict exists in any situation in which 
separate departments are created, members have an opportunity to 
compare themselves with other groups, and the goals and values of respective groups appear mutually exclusive. The main sources of horizontal conflict are: 
• Environment . Each department is geared to fit its external dynamic 
environment. As the uncertainty and complexity of the environment 
increase, greater differences in skills, attitudes, power, and operative goals develop among departments. Moreover, increased competition, both domestically and internationally, have led to demands for lower prices, improved quality, and better service. These demands exert more intense goal pressures within an organisation and, hence, greater conflict among departments. 
• Size. As organisations increase in size, subdivision into a larger 
number of departments takes place. Employees feel isolated from other people in the organisation. The lengthening hierarchy also heightens power and resource differences among departments. 
• Technology . Groups that have interdependent tasks interact more 
often and must share resources. Interdependence creates frequent situations that lead to conflict. 
• Structure . Pay incentives may be based on competition among 
divisions. Organisation structure defines departmental groupings and, hence, employee loyalty to the defined groups. 
• Goal incompatibility . Goal incompatibility is probably the greatest 
cause of intergroup conflict in organisations. A typical example of goal conflict may arise between marketing and manufacturing departments. Marketing strives to increase the breadth of the product line to meet customer tastes for variety. A broad product line means short production runs, so manufacturing has to bear higher costs. 
• Uncertainty . When departments do not know where they stand 
because activities are unpredictable. When factors in the environment are rapidly changing, or when problems arise that are poorly understood, departments may have to renegotiate their respective tasks. Managers have to sort out how new problems should be handled. The boundaries of a department’s territory or jurisdiction become indistinct.

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 • Reward system  — the reward system governs the degree to which 
subgroups cooperate or conflict with one another. When 
departmental managers are rewarded for achieving overall organisation goals rather than departmental goals, cooperation among departments is greater. 
• Differentiation – functional specialisation requires people with 
specific education, skills, attitudes, and time horizons. The 
underlying values and traits of personnel differ across departments, and these differences lead to horizontal conflicts. 
Vertical conflict 
A second type of conflict is vertical. Vertical conflict occurs among individuals 
and groups at different levels in the hierarchy. Individual employees may have conflicts with their bosses. Managers of international divisions often experience conflict with senior executives located at domestic headquarters. Many of the sources of horizontal conflict above may apply here as well. The other primary sources of vertical conflict are often about power and powerlessness and differences in status and power. Some example are: 
• Power and status . At the bottom of the hierarchy, workers often feel 
alienated. 
• Ideology . Different values held by individuals can cause conflict, e.g. free 
enterprise versus the right to industrial action. 
• Psychological distance . Workers can feel isolated from the organisation. 
• Scarce resources . Financial resources affecting remuneration and 
working conditions, and costs. 
 
Destructive and constructive conflict  
 Management thinking and writing has generally viewed conflict as 
negative, unhelpful and undesirable. However it is accepted that not all 
conflict is harmful and a certain degree of conflict can be positive, beneficial, desirable and often inevitable. The terms destructive and constructive conflict are used to differentiate between negative or positive outcomes. 
Constructive conflict 
Constructive conflict is considered useful, positive and beneficial to the 
organisation as it does not revolve around personality and: 
• creates an environment of innovation and change • facilitates bringing problems to the surface so that they can be dealt 
with 
• settles and defines boundaries of authority and responsibility.

284  
 Destructive conflict 
Destructive conflict tends to be ad hoc and personal: 
• harmful for the organisation and its involved members • causes alienation between groups, within groups and between 
individuals 
• can be demoralising for those involved. 
Some companies have sought to promote team spirit by creating 
competition between work teams. In some instances this has been successful in reducing absenteeism and bad timekeeping but, when extended to include poor productivity, working relationships have tended to deteriorate. It was found that work teams concentrate on rivalry instead of the tasks to be achieved. A group would take greater interest in impeding the progress of the competing group than in achieving a better result. 
6  Managing conflict – the Thomas-Kilmann Conflict Mode 
Instrument 
A useful framework for classifying different ways of handling conflict is the Thomas-Kilmann Conflict Mode Instrument (TKI).  It is based on two conflict-
management dimensions. These are the degree of assertiveness in pursuit of one’s interests and the level of co-operation in attempting to satisfy others’ interests. The strength of each of these in a particular situation can suggest the ways the conflict may be resolved, as shown: 
 
This results in five conflict-handling strategies: 
• Competing : High assertiveness and low co-operativeness – the goal is to 
'win' . All or both parties seek to maximise their own interest and goals. 
They do not co-operate, creating winners and losers as well as causing 
damage to the organisation and one of the parties.

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• Avoiding : Low assertiveness and low co-operativeness – the goal is to 
'delay'. One or more of the parties seeks to ignore or suppress the 
conflict. 
• Collaborating : High assertiveness and high co-operativeness – the goal 
is to 'find a win-win solution' . A 'win-win' situation is achieved through 
joint confrontation of the problem and using problem-solving techniques with creative solutions. 
• Accommodating: Low assertiveness and high co-operativeness – the goal is to 'yield' . One party puts the other party's interests first. 
• Compromising : Moderate assertiveness and moderate co-operativeness 
– the goal is to 'find a middle ground' . Negotiation results in each party 
giving up something and 'meeting half way'. The problem is each party may lose something when there may be a better alternative. 
 
Mainwaring – Strategies for managing conflict  
 Mainwaring suggested four broad strategies for managing conflict in organisations: 
• Conflict stimulation and orchestration . This approach actively 
encourages conflict  as a means of generating new ideas and new 
approaches or of stimulating change. There are obvious dangers in 
generating conflict, not least that they will escalate in a destructive 
way. However some conflict is necessary to prevent organisations becoming fixed and unwilling to change. This approach involves the maintenance and management of constructive conflict as a means of continuous renewal. 
• Conflict suppression . This involves the use or threatened use of 
authority or force, or the avoidance of recognition that a conflict 
situation exists , or smoothing over the conflict by de-emphasising 
the seriousness of the situation. Such strategies are essentially short-term, and are likely to be perceived as such by those involved. 
• Conflict reduction . This involves building on areas of agreement  
and on common objectives, and changing attitudes and perceptions of the parties involved. Techniques that can be used include compromises and concessions. These can be facilitated by independent third party interventi ons, such as conciliation and 
arbitration. 
• Conflict resolution . This seeks to eliminate the root causes of 
conflict  by establishing a consensus. Attitude change is a key 
element, particularly regarding the possibility of 'win-win' situations where the parties involved are aware of the mutual gains to be derived from co-operation and collaboration. 
The mix of strategies used will depend not only on the situation, but also on the assumptions that managers make about conflict.

286  
 Important methods to apply when dealing with organisational conflict are 
altering: 
• the context, e.g. new procedures, reducing interdependency, 
changing work allocation. 
• the issue in dispute by separating into smaller issues, separating 
people- and task- related issues. 
• the proximity, i.e. physically separating the persons or groups 
involved. 
• the individuals involved including relocation and dismissal, or 
changing behaviour through training or organisational development 
techniques.  
 
 Dealing with industrial  relations conflict  
 Although vertical conflict can take place without the presence of trade 
unions, Unions highlight vertical conflict as they try to equalise power differences between workers and management where the ground rules for conflict are formalised by laws and regulations. The sources of vertical conflict reflect the reasons why workers join unions. 
The first priority for representatives is loyalty to their group. These can 
create strategies for avoidance or individualistic approaches: 
• Union avoidance strategies  including 'double-breasting' (setting 
up new plants in areas of high unemployment, or low union activity), 
devolving collective bargaining to factory level, removing unions from annual pay rounds whilst giving the right of the union members to be consulted and represented. 
• Individualistic approaches  away from third party involvement 
using appraisal systems, training and development schemes, performance-related pay systems, share schemes and the same pension and health schemes for all. 
• Collective bargaining  using procedural methods (a prescribed 
format) ultimately leading to the substantive agreement (defining each party's rewards and responsibilities for the next two to three years) in collective negotiations between workers and management. 
 New approaches tend to be more co-operative including: 
• Partnership agreements . 
• Gain sharing  based on bonuses and profit rather than fixed-rate 
increases. 
• Labour-management teams  based on Japanese quality circles at 
shop-floor levels, middle management and union leader teams, and at top management, long-term policies to avoid layoffs. 
• Employment security  rather than job security where workers are 
reassigned to different positions and jobs are dependent on the firm's success.

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 Textile company, TUV, is in a troubled state. The weavers have just been 
awarded a pay increase, and this has led to a claim by the mechanics, 
who maintain the machinery, for a similar percentage pay increase. TUV is seeking to resist the mechanics’ claim on the grounds that the weavers’ extra payment can be justified by increases in productivity, while the maintenance work carried out by the mechanics has not changed. The response of the mechanics has been to threaten industrial action. 
The problems for TUV have been made worse by a dispute between the 
Weaving Department and the Cloth Inspection Department. All members of the Weaving Department receive a bonus based on the productivity of the whole department. Employees in the Cloth Inspection Department are paid a fixed salary based on proven competence and experience. 
The conflict between the departments has heightened recently by the 
decision of the new manager of the Cloth Inspection Department to tighten up of the inspection standards. He insists that the quality of output has to improve if the company is to remain competitive. This has resulted in weaving machines standing idle more frequently than in the past while faults detected during cloth inspection are investigated. 
The sight of idle machines has resulted in intense frustration among 
management and employees in the Weaving Department as every idle machine means a reduction in their bonus payments. The weavers’ frustration is now being taken out on the Cloth Inspection Department by adopting a policy of not cooperating. 
The CEO has become aware of these issues and is concerned about the 
effect they are having on productivity. 
Required: 
The CEO has asked you to write a report for him: 
(a) Explaining the causes of the conflicts within TUV. 
(b) Discussing how each type of conflict within TUV might be resolved. 

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 289 
 Question 1 
 The element in the communication process which makes it a cycle rather 
than a series of send-receive events is called _____________. 
The process through which the message is symbolised is known as 
___________________. 
____________ is anything which stops the message being received and understood as intended. Supply the term that most accurately fills the gaps. 
• Message 
• Encoding 
• Noise 
• Feedback 
 
 Question 2 
 Which of the following is most likely to cause vertical conflict within an 
A  Psychological distance B  Goal incompatibility C  Task interdependence D  Functional specialisation

290  
 Question 3 
 Mainwaring suggested four strategies for managing conflict.  
Match the strategy to the correct description. 
 
Stimulation and orchestration 
Suppression 
Reduction 
Resolution 
 
• This approach actively encourages conflict as a means of 
generating new ideas and stimulating change. 
• The approach seeks to eliminate the root cause of the conflict by 
establishing consensus. 
• The approach involved building of areas of agreement and on 
common objectives. 
• The approach involves the use, or threatened use of authority or 
force. 
 
 Question 4 
 X is trying to communicate with all the staff within his department. He has 
placed the information on the business intranet, but after a week very few 
staff members have seen the information. X has been told by several of his colleagues that they ‘never really look on the intranet’ and so they had failed to see X’s message. 
Which aspect of the communication process has caused this problem? A  X has chosen the wrong channel B  X has encoded the message poorly C  X’s communication has suffered from too much noise D  X’s communication has not been accurately decoded

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 291 
 Question 5 
 Match the description to the stage in the negotiation process. 
 
Bargaining 
Preparing 
Closing 
Opening 
 
• Getting to know the background to the problem and the likely 
constraints 
• Attempting to narrow the gap between the two initial positions 
• Reaching agreement which is mutually beneficial 
• Presenting starting positions and attempting to influence the other 
party 
 
 Question 6 
 Two key roles in a meeting are that of the chairperson and the secretary. 
Match the responsibilities shown to the correct role. 
 
Chairperson Secretary 
 
• Ensuring all agenda items are discussed • Preparing minutes of the meeting 
• Summing up the issues discussed at the meeting 
• Preparing and issuing the agenda before the meeting

292  
 Question 7 
 According to Cialdini, which of the following are principles of Influence. 
Select all that apply. 
A  Reciprocity B  Accountability C  Commitment D  Trust E  Assertiveness F  Authority 
 
 Question 8 
 Three important concepts in communication are Negotiation, Influence 
and Persuasion. Match each of these to their correct definition. 
• The ability to deliberately manipulate others to change an attitude, 
• The ability to change others' attitudes, opinions or behaviour and 
can be direct or indirect. 
• The ability to discuss an issue with one or more other people to 
determine ways to reach agreement and mutual satisfaction. 
 
 Question 9 
 The conflict management strategy recommended as a means to benefit 
all parties in a dispute is: 
A  compromising B  competing C  collaborating D  accommodating

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 293 
 Place the conflict resolution strategies on the Thomas-Kilmann conflict 
managing grid. 
• Avoiding 
• Competing 
• Collaborating 
• Compromising 
• Accommodating

294  
 REPORT 
To: B 
From: Consultant  Date: today 
Subject: Management communication within PQR  Introduction 
There is a need for good communicat ion between the mangers in PQR, 
especially as the company is growing. To this end, a monthly meeting is 
held with the departmental managers however the meetings are not effective. This report will look at the issues affecting the effective communication at the management meetings and will suggest improvements. 
Lack of participation 
The first problem with the meetings is that the managers do not seem to 
appreciate the importance of them. Some deliberately do not contribute so as to finish the meeting early. These meetings are an opportunity for the department managers to discuss what is happening in their departments and learn what is happening in the other departments. Without coordination between the departments, PQR will struggle as it grows in size. The importance of these meetings must be stresses to all managers. Maybe if they become more effective, managers will start to see their value and participate more. 
Non-attendance 
For a meeting to be effective, the right people must attend. Every 
manager must attend these meetings where possible. The meetings should be scheduled at a regular time and place and managers should give priority to attending these meetings. Where a manager cannot attend, they could send a representative if this is appropriate and acceptable to the other managers, but this person should be of a senior enough level to participate in the meeting. Sending a junior member of staff is unacceptable as it would be difficult for the more junior members to talk out at the meeting. Sending a junior member shows that the operations manager does not view the meeting as important.

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 295 
 No agenda 
Managers do not know what is going to be discussed at the meeting 
which suggests that there is no agenda. For a meeting to be successful, all participants must prepare for the meeting and bring along any relevant documentation. This is only possible if an agenda is drawn up and circulated in advance of the meeting. This also gives managers the opportunity to add items to the agenda which they would like discussed. 
Action points not recorded 
Decisions must be made at the meetings. Attendees should leave the 
meeting with a clear understanding of what has been agreed and any 
action points which they have to take away with them. It appears that there is no secretary at the meetings as nothing appears to be being recorded. A secretary should attend the meeting taking notes of proceedings and documenting decisions made. The minutes of the meeting should be sent to all attendees soon after the meeting to ensure that everyone is aware of the decisions made. 
No Chairperson 
There appears to be no one chairing the meetings. The sales manager is 
domineering and others are not contributing. A chairman should be selected to chair each meeting. The chairman must be a strong character and must be able to keep all attendees in line, they must ensure that all attendees are given the opportunity to speak at the meeting. The chair should ensure that an agenda is available for the meeting and that it is followed. This would avoid the meeting becoming unproductive and going off topic. 
The monthly management meetings held at PQR are important in terms 
of communication between the managers, however a number of improvements are required in order to make this form of communication more effective.

296  
 EMAIL 
To: K 
Subject: Negotiation 
Negotiation is an activity that seeks to reach agreement between two or 
more conflicting starting positions. The aim in any negotiation is to achieve a settlement that is acceptable to the other parties concerned but which also comes as close as possible to one’s own desired outcome. 
In the case of BCD the two parties involved and their objectives are as 
follows: 
• Management is seeking to restructure the organisation to ensure 
business survival and long-term profit ability. This will involve cutting 
costs through redundancies and staff relocations. 
• Trade unions will represent employees’ interests and will thus be 
acting to minimise job losses, and to enhance relocation and 
redundancy packages. 
There is thus a clear conflict over job cuts and how much the company will pay to the employees affected. Negotiation is essential in this situation as the alternative is likely to be a strike, which would benefit neither party in the short term. Such a scenario could precipitate a collapse of the company, ultimately affecting all employees’ jobs. 
Most writers on negotiation argue that the aim is to achieve a ‘win-win’ 
situation where both parties feel that they have gained from the negotiation process. 
Most negotiation processes go through four stages: preparation, opening, 
bargaining and closing. These can be applied to BCD as follows: 
Preparation:  The preparation stage involves each side gathering 
information to gain insights into the conflict. This could include trying to 
understand the other party’s key concerns and finding out who will be 
involved in the negotiating process. In the case of BCD, the union will seek to understand the business case for redundancies, explore possible alternative strategies that the company could undertake and will ensure it is fully up to date on employment law. This will help it see how strong its bargaining position is.

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 297 
 Similarly management will try to obtain details of how many employees 
will be affected, their ages and likelihood of getting other jobs. For 
example, the option of early retirement sounds better than redundancy, even though it is still a job cut. The time for negotiation will also be agreed. 
Opening:  During this stage each party presents its position to the other, 
hoping to gain influence early on. Management will presumably want to 
emphasise that redundancies are inevitable to save the company. It will try to move the negotiation onto what support is given rather than whether job cuts are needed. Similarly the union may present the case that it wants to prevent any job cuts and will initially reject all management proposals in this respect. 
Bargaining:  During the bargaining phase both parties will try to narrow 
the gap between the two positions and to seek a win-win solution. Usually 
this will involve a degree of compromise by each party. The main focus during this phase is the ability to argue and persuade the other side that your arguments are stronger than theirs to ensure that they compromise more than you. Given the circumstances involved, it is likely that the negotiations for BCD will end up with a reduction in the overall number of planned redundancies and detailed discussion focusing on the size of redundancy payouts and the level of support for employees to gain new jobs. 
Closing:  The closing phase gives the opportunity to capitalise on the 
work done during the previous stages. During the closing phase 
agreement is reached and the results are publicised and implemented. 
I hope you have found the above useful, please do not hesitate to contact 
me if you require any additional information.

298  
 REPORT 
To: CEO 
Report on the conflict within TUV  Introduction 
In this report, the causes of the current conflict within TUV will be 
explained and recommendations will be made for how each type of conflict could be resolved. The report will also cover the factors which 
might influence the likelihood of a successful outcome for each type of 
conflict. 
(a)  The causes of conflict The conflict in TUV encompasses both vertical and horizontal 
conflict. 
Horizontal conflict happens between groups of staff or between departments at the same level in the hierarchy. The conflict between the Weaving Department and the Cloth Inspection Department could be classified as horizontal conflict. The cause of the conflict is due to the fact that the tightening of standards in the inspection process has had the knock-on effect of machines standing idle. This has affected the productivity of weavers and reduced their bonus payments. At a more fundamental level, there is a conflict in the goals of the Departments, the weavers are focused on producing cloth to maximise output and hence receive bonuses. On the other hand, the key objective of the Cloth Inspection Department is the quality standard of the material. The two groups are rewarded in different ways. 
Vertical conflict occurs between individuals or groups who are at different levels in the hierarchy, and often arises because of status and power differences amongst groups. In the case of T, conflict has arisen between mechanics and management over status and pay. Mechanics want the same percentage pay increase as weavers but management argues that weavers can justify the increase by increasing productivity, whereas the work carried out by mechanics has not changed. This has led to industrial unrest.

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 (b)  Managing conflict 
A useful framework for classifying different ways of handling conflict 
is known as the TKI. It is based on two conflict-management dimensions. These consist of the degree of assertiveness in pursuit of one’s interests and the level of cooperation in attempting to satisfy others’ interests. The relative strength of each of these produces five conflict-handling strategies. 
It is difficult to determine the degree of assertiveness and the level 
of cooperation that exist in the case of TUV, so we cannot come to a conclusion here and now but the framework does provide a useful means of considering alternatives if we can gather the necessary information. 
The five conflict-handling strategies are: Avoidance  – one or more parties in conflict may seek to avoid, to 
suppress or to ignore the conflict. This is not recommended as it 
does not resolve the conflict and may break out again when the parties meet in the future. 
Accommodation – this involves one party putting the other’s 
interests first and suppressing their own interest in order to preserve some form of stability and to suppress the conflict. Again, if the causes of conflict are endemic or lasting, the accommodation strategy may not resolve the differences. Also, the accommodating party may well lose out as a result. 
Compromise – often seen as the optimum solution. Each party 
gives something up, and a deal somewhere between the two is accepted after negotiation and debate. However, in compromise, both parties lose something and there may be a better alternative. This approach could be used to resolve the conflict between mechanics and management. 
Competition  – this is a state where both or all parties do not 
cooperate, instead they seek to maximise their own interests and 
goals. It creates winners and losers. The resultant conflict can prove damaging to the organisation as well as to at least one of the parties. So it is not recommended. 
Collaboration  – from the perspective of all parties, this is likely to 
be the optimum solution. Differences are confronted and jointly 
resolved, novel solutions are sought, and a win/win outcome is achieved. This is the proposed strategy to deal with the conflict between weavers and the cloth inspection staff.

300  
 Managing horizontal conflict 
The best approach to managing horizontal conflict in TUV would be 
collaboration where differences are confronted and jointly resolved. The desired outcome is a win:win for both groups. This could be achieved by holding meetings between the two Departments, including the managers, weavers and inspection staff. Solutions to how quality standards could be maintained while minimising the down time of machines could be discussed. Communications between the different Departments, sharing an understanding of each other’s goals and objectives should assist the process. Perhaps, the organisation could look at some of the techniques associated with total quality management in resolving the problems. 
Managing vertical conflict 
The vertical conflict in TUV is an example of industrial relations conflict over pay claims. This type of conflict may be resolved through negotiation between management and representatives of the mechanics through collective bargaining. The representatives of the mechanics could present a proposal for consideration by management, followed by counter-proposals and concessions. 
The outcome will depend on the relative power held by the mechanics (for example, withdraw labour, gain support from other workers and willingness to take industrial action) and the power of management (ability to replace mechanics, ability to switch production to other factories). A win/win situation is desirable but often industrial relations conflict is resolved through compromise. 
 
 Question 1 
 The complete sentences are: 
The element in the communication process which makes it a cycle rather than a series of send-receive events is called feedback . 
The process through which the message is symbolised is known as encoding . 
Noise  is anything which stops the message being received and 
understood as intended.

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 Question 2 
 A 
Psychological distance refers to the situation where workers feel isolated 
from the organisation. 
Goal incompatibility, task interdependence and functional specialisation 
are all examples of horizontal conflict. 
 
 Question 3 
Stimulation and orchestration  – This approach actively encourages 
conflict as a means of generating new ideas and stimulating change. 
Resolution – The approach seeks to eliminate the root cause of the 
conflict by establishing consensus. 
Reduction  – The approach involved building of areas of agreement and 
on common objectives. Suppression  – The approach involves the use, or threatened use of 
authority or force. 
 
 Question 4 
 A The channel is the medium through which the message is sent. It is 
important for the sender to select the correct channel to ensure the message gets through to the receiver as expected. 
 
 Question 5 
Bargaining – Attempting to narrow the gap between the two initial positions 
Preparing  – Getting to know the background to the problem and the 
likely constraints Closing  – Reaching agreement which is mutually beneficial 
Opening  – Presenting starting positions and attempting to influence the 
other party

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 Question 6 
 
Chairperson 
Ensuring all agenda items are 
discussed 
Summing up the issues discussed 
at the meeting Secretary 
Preparing minutes of the meeting 
Preparing and issuing the agenda 
before the meeting 
  
 Question 7 
 A, C and F 
The other principles of influence are: 
• Social proof • Liking 
• Scarcity 
 
 Question 8 
Negotiation  – The ability to discuss an issue with one or more other 
people to determine ways to reach agreement and mutual satisfaction. 
Influence  – The ability to change others' attitudes, opinions  or behaviour 
and can be direct or indirect. Persuasion  – The ability to deliberately manipulate others to change an 
attitude, opinion, or behaviour. 
 
 Question 9 
 C The approaches of competing, collaborating, compromising, 
accommodating and avoiding come from the Thomas-Kilmann conflict mode instrument. The collaborating approach attempts to find a win-win solution.

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 The complete diagram is shown below:

305 
The concept of project 
C1: Describe the concepts 
and phases of projects (a) Project objectives 
(b) Key stages of the project 
life cycle 
(c) Project control 
• Overall project objectives 
• Objectives relating to time, cost and quality 
• Purpose and activities associated with key stages of the 
project life cycle. 
 
  Chapter 
9

The concept of project management  
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2  The importance of project management in delivering change 
From the previous chapter it is clear that change is an inevitable part of today’s 
organisations. Effectively managing this change is therefore critical to the ongoing success of the organisation. 
Change will be delivered thr ough projects, therefore understanding project 
management and being able to successfully complete projects is essential for 
This and the following chapters cover the project management process in detail. 
3   A project and project management   
Project A project has a number of key attributes which differentiates it from business as 
usual: 
A project is a unique  undertaking to achieve a specific objective .  
A project has a defined beginning and end. A project has resources , like staff and funding allocated specifically for the 
length of the project. The project will also have stakeholders, i.e. all those who are interested in the 
progress and final outcome of the project. A project will inevitably have some degree of uncertainty  as the uniqueness of 
it will lead to some degree of risk in the deliverables and the activities to achieve 
the deliverables. 
Once completed, it should then become integrated into the normal day-to-day 
activities of the business.

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 The Association of Project Managers defines a project as: ‘A human 
activity that achieves a clear objective against a time scale.’  
Project management  
Project management is the managing of the work of a team or teams to achieve 
specific goals and objectives. The teams will be put together for the sole purpose of achieving the project goal s and objectives and will be disbanded 
after the completion of the project. The teams will be managed by the project manager who will make all of the day to day decisions in relation to the project and who is ultimately responsible for the successful completion of the project. The project manager will report to the proj ect sponsor, who initiates the project, 
makes all of the high level decisions regarding the project and who provides the funding for the project. 
The roles of these project stakeholders will be looked at in detail in the project 
leadership chapter. 
their size and complexity. The process of project management however is very similar in all projects regardless of size or duration and it differs greatly from the process of business as usual management which generally consists of a long line of repetitive or similar functions stretching ahead indefinitely. 
 
 CIMA Official Term inology defines project management as ‘the 
integration of all aspects of a project, ensuring that the proper knowledge and resources are available when and where needed, and above all to ensure that the expected outcome is produced in a timely, cost-effective manner. ' 
4  Project constraints 
Every project has constraints. Constraints are anything which restricts, limits, prevents or regulates activities being carried out. When running a project it is critical that the constraints are known, so they can be taken account of throughout the project. 
The primary constraints are time, cost  and quality . These are often referred to 
as the 'project triangle'. 
 
It is worth thinking about the conflicting nature of these constraints.

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Time and cost tend to be positively correlated in projects (i.e. when time 
increases, so does cost), as taking longer to complete a project generally means that human resources are needed for longer. However, this is not always the case. If there is a degree of urgency in a project, it may be possible to reduce the timescale to completion by allocating additional resources, or by scheduling expensive overtime working. Both of these situations will increase cost while reducing time. 
Project quality tends to be positively correlated with both cost and time, in that 
increasing the quality of the project will normally lead to an increase in both the cost of the project and its overall duration. 
In additional to these three main constraints, there are a number of other 
constraints which will affect the project’s delivery, such as legal, technological, political, environmental and ethical. 
5  The project life cycle 
Large-scale projects usually follow a life cycle made up of separate phases, which occur in sequence. There are a number of models which detail these phases. Regardless of which model is used, it is important to highlight the separate stages which the project goes through from beginning to end, and to understand what happens during each stage. A project life cycle is shown below: 
 
Stages in the project life cycle 
Gido and Clements  identified four phases of large projects 
Phase 1 – Identification of a need 
The first phase of the project life cycle involves identification of a need, 
opportunity or problem. Initially, a feasibility study will be conducted to check the size of potential benefits and evaluate in broad outline potential alternative solutions and their lifetime costs. At t he end of this phase, the company will 
decide whether to proceed with the project. If it does, then a project team is formed and a project initiation document  (PID) is raised. This will include a 
vision and a business case for the project. The business case is an important guide to decision-making throughout the project, and the vision encourages motivation and congruent goals in the project team.

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Phase 2 – Development of a proposed solution 
The second stage of the project life cycle is the development of a proposed 
solution. All proposals for the solution will be submitted and evaluated and the most appropriate solution to satisfy the need will be selected. 
Phase 3 – Implementation 
The third stage of the project life cycle is the implementation of the proposed 
solution. This phase is the actual performance of the project and will involve doing the detailed planning, and then implementing that plan to accomplish the project objective. 
The overall solution is subdivided into separate deliverables to be achieved at 
fixed points (milestones) throughout this stage of the project. Achievement of these deliverables may be linked to stage payments. The project’s objectives of functionality, quality, cost and time are monitored regularly against each deliverable to ensure they are being met. Timely appropriate action can then be taken if any slippage has occurred. 
Phase 4 – Completion 
The fourth stage of the project life cycle is the completion or closure of the 
project. When a project closes, important tasks need to be carried out, such as confirmation that all deliverables have been provided and accepted, and all payments have been made and received. Project performance is evaluated and appraised in order to learn from the project for future reference. Obtaining customer feedback is important in improving the quality of future project provision. The original business case is also revisited to check whether any subsequent actions are needed to ensure achievement of the anticipated benefits. 
6  Five project management process areas 
An alternative five stage project life cycle based on the Project Management Institute's 5 Project Management Process Areas identifies the stages as: 
• Initiating • Planning 
• Executing (implementating) 
• Controlling 
• Closing.

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This model is very similar to the Gido and Clements  project life cycle above. 
However, it places greater emphasis on the ‘planning’ and ‘con trolling’ activities, 
as is to be expected from a professional project management institute. 
It is important to understand the purpose of each stage of the project life cycle 
and the activities which are carried out at  each stage. Each of the stages will 
now be looked at in detail. 
7  Initiating 
Projects are initiated when a need or objective is defined. 
Objectives are those things that the organisation wants to achieve. Typically, 
top-level objectives are profit-oriented, or in not-for-profit organisations objectives will be to improve the standard of living or education, and so on of 
members. It is usually a function of the board of directors to determine the high-level organisational objectives. 
There are a number of reasons why a project would be initiated: • To help meet the company’s long term goals and objectives. 
• Process/service enhancement. • Solve problems identified internally or externally. • To take advantage of new opportunities. 
• Statutory/legal requirement. 
Companies may have a number of potential projects they would like, or need to 
undertake, but they may not have the resources to carry them all out. They often have to go through a selection process to establish the most worthwhile projects. The purpose of the initiation stage is to identify the most worthwhile projects to undertake. Only these projects will be taken forward to the planning stage. 
One of the main ways companies select the most worthwhile projects is by 
considering the feasibility  of the proposed projects and the risk and 
uncertainty  relating to the project.

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Feasibility 
The development of any new project requires careful consideration and 
planning. It will consume large volumes of resources, both financial and non-financial, and is likely to have a major effect on the way in which the organisation will operate. 
Feasibility studies may be carried out on a number of potential strategies and 
the aim of the study is to decide on which proposal to choose. Sometimes the potential project manager is involved in the feasibility study 
stage of a project, but not always. However, it is important for project managers to understand the process of feasibility assessment. 
Types of feasibility 
There are a number of types of feasibility which could be considered, including 
• Technical feasibility 
• Social (operational) feasibility 
• Ecological (environmental) feasibility 
• Economic (financial) feasibility. 
Technical feasibility – can it be done? 
There are a number of key aspects regarding technology which must be 
considered, for example: 
• Is the technology available? • Is the technology tried and tested? 
• What performance do we require of the technology? 
• Is the technology suitable to satisfy the objective of the project effectively? 
Social (operational) feasibility – does it fit with current operations? 
It is becoming increasingly necessary to assess operational/social factors 
affecting feasibility. These may include awareness of the social issues within a group or office (e.g. introducing a computerised system), or larger social awareness regarding the effect of projects or products on workers, employment or the environment. It is also important to ensure that the projects fits with business goals.

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Social considerations include: 
• Number of people required (during the project and after implementation). • Skills required – identify re cruitment, traini ng, redundancy. 
Some of these issues can be directly costed (such as training costs). Others 
have less tangible effects that must be documented in the feasibility report. 
Ecological (environmental) feasibility – how does it affect the 
environment? 
Ecological considerations may be driven by the understanding that customers 
would prefer to purchase alternative products or services as they are more ecologically sound and less harmful to the environment. 
Ecological considerations include: 
• Effects on local community and what that might do to company image. 
• What pollution could be caused by the project. 
Economic (financial) feasibility – is it worth it? 
The project (proposed system) must provide a benefit to the organisation. 
Economic feasibility will be assessed through a cost-benefit analysis. Cost-benefit analysis helps to identify and evaluate the costs of the proposal over its anticipated life. The other side to cost-benefit is the identification and evaluation of the benefits of the project over its life. 
 
Cost-benefit analysis  
 When considering economic feasibility, the benefits and the costs of the 
project must be considered in detail. 
Financial costs and benefits can be evaluated using investment appraisal 
techniques such as payback and discounted cash flow approaches like NPV or IRR. 
You would not rely on a single measure to determine the financial 
feasibility of a project. 
The types of costs and benefits involved in a project will depend upon the 
precise nature and scope of that project and can vary greatly. 
Benefits 
• Tangible – those benefits that can be evaluated financially 
(reduction of staff costs when processes are automated). 
• Intangible – those benefits that are not easy to evaluate financially 
(a new computer system may provide better information to 
managers for decision making and control). 
Remember that any intangible benefits will have been excluded in the financial evaluation process.

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Costs 
• Capital Costs – costs incurred in the acquisition of assets plus any 
additional costs of installation and maintenance. 
• Revenue Costs – any costs other than for the purchase of assets. 
These costs are incurred on a regular basis and include repairs and 
consumables. 
• Finance Costs – finance costs are usually incurred as interest 
charges. Sources of finance include banks, shareholders, retained profit from the business and grants or subsidies from the government. 
 
 Illustration 1 – Feasibility 
 We will use the following example to explain the types of feasibility: 
RST, a manufacturer of car components, operates from a large industrial site in V town where it is the largest local employer. RST is well respected in the town, and have always stated their commitment to the town and their employees. The current site is too small for the company’s current needs and is in need of some upgrading. As such the board have been considering alternative courses of action to expand the current site. 
Last week the board of RST was approached with an offer to buy their 
current site for a substantial sum of money from a neighbouring mining company who have plans to develop the site as an open cast mine. As part of the deal, the mining company have offered to build RST a new factory on land they own in H town, about 150 miles from RST’s current site. The board of RST are considering the offer. 
For RST, this may involve considerations such as the ability to set up a 
fully functioning factory in H town. Given the nature of RST’s business, this may involve the moving and installation of large pieces of equipment. It will also have to be considered if all utilities required will be available at the new site, the ability to get planni ng permissions and so on. It seems 
likely that the project will be technically feasible. 
For RST, they may have difficulty with the social and operational 
feasibility of the project. It will mean moving from V town where they are a respected employer (and the largest local employer) and the move will result in many people losing their jobs. It is unclear how many jobs the mining operation would bring to the area, but it unlikely that the mining company would be able to take on all of those affected by the move. It would seem that the project would not be socially feasible.

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 Ecological (environmental) feasibility – how does it affect the 
For RST, there are some environmental implications of the proposal. 
Firstly for V Town, they would be losing a factory but gaining an open cast mine. This could have large adverse implications for the local environment. On the other hand, the new factory operated by RST is likely to be more efficient and have less impact on the environment than the old factory, but the overall impact on the environment is likely to be adverse. How RST’s board feel about this will depend on their view of social responsibility. They have always stated their commitment to V town, but if the plan goes ahead they will cause unemployment and environmental damage to the area. 
For SMK, the cost of the project w ill include the cost of planning and 
building the new factory. The costs will also include kitting out the new 
factory and they will have to consider the employment costs. A number of current employees will not be able to move to work at the new site, therefore SMK may face redundancy costs and they will also incur costs in hiring and training a new workforce for the new factory. The costs will be high but a substantial sum of money will be received from the sale of their existing site. 
Benefits should derive from the business case that identified the need to 
expand the current factory in the first place (e.g. capital growth, increased equity, increased capacity and income, profits). It seems likely that the project would be economically feasible. 
Project initiation document (PID) 
The main output of the initiation stage of the project is the project initiation document (PID). There are two primary reasons for having a PID: 
1 To secure authorisation of the project. 2 To act as a base document against which project progress and changes 
can be assessed. 
The PID can be used to ensure that the project team and project stakeholders 
are in general agreement about the nature of the project and exactly what it is trying to achieve. 
This document therefore: 
• Defines the project and its scope. • Justifies the project.

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• Secures funding for the project, if necessary. 
• Defines the roles and responsibilities of project participants. 
• Gives people the information they need to be productive and effective right 
from the start. 
Contents of a project in itiation document (PID)  
There is no set format required for a PID but it would generally contain the 
following sections: 
• Purpose statement  – explains why the project is being undertaken. 
• Scope statement  – puts boundaries to the project by outlining the major 
activities. This section is important in preventing ‘scope creep’, where 
additional activities are added making achievement of the cost and time 
objectives totally impossible. 
• Deliverables  – tend to be tangible elements of the project, such as 
reports, assets and other outputs. 
• Cost and time  estimates  – it is a good idea to start with some feel for the 
organisation’s expectations in terms of the project budget. These 
estimates will be modified later in the project, but are necessary to give a starting point for planning. 
• Objectives  – a clear statement of the mission, CSFs and key milestones 
of the project. 
• Stakeholders  – a list of the major stakeholders in the project and their 
interest in the project. 
• Chain of command  – a statement (and diagram) of the project 
organisation structure. 
8  Planning 
After the initiation stage comes the detailed planning stage.  
The planning stage of a project is essential as it helps to: 
• Communicate what has to be done, when and by whom. • Encourage forward thinking. 
• Provide the measures of success for the project. 
• Make clear the commitment of time, resources (people and equipment), 
and money required for the project. 
• Determine if targets are achievable. • Identify the activities the resources need to undertake.

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During the planning stage, a number of separate detailed plans will be drawn 
up. For example, separate plans for: 
• Time . The time plan lists all the activities and how long each is planned to 
take. This includes the finish dates of each stage of the project life cycle, 
and the estimated completion date of the whole project. 
• Quality . The quality plan includes identification of the project's customers, 
the key outcomes each expects and the acceptance criteria that have been agreed with them. This may include safety and security planning. It will also include an audit plan for the project management process. 
• Resources . The resource plan checks peaks and troughs of workload to 
ensure the human resources plan is feasible. It also lists all purchases required for the project. 
• Contingency . Contingency planning was mentioned earlier and includes 
deciding on what additional activities, costs and time need to be added to the plan to ensure a reliable budget and completion date. A risk register will identify contingency plans for each of the key risks and allocates 
responsibility for monitoring each. 
• Cost . The cost plan uses a rate per hour for each activity in the time plan, 
plus cost of purchases from the resource plan, plus contingency costs to 
create a budget for the project. This will be phased over the project to 
provide a detailed cash flow forecast. 
• Communication . The communication plan identifies the key people in the 
project, their likely concerns, messages needed, planned method of communication and who will be responsible. 
• Deliverables . The deliverables plan will detail exactly what has been 
agreed as the deliverables of the project. This must be agreed by the users and sponsors at the outset of the project. 
The project manage r and planning  
It is important to understand the responsibilities of the project manager within the planning stage. Their primary responsibility is to define the project 
objective  clearly with the customer, then to communicate  this objective to the 
rest of the project team, making it clear what constitutes a successful project 
outcome . 
The project manager should involve the team members in the planning process, as this will encourage involvement, commitment and ownership of the project. 
A project reporting information system should be set up to record and monitor 
the progress of the project against the plan. The comparisons between actual and plan should be communicated to team members on a regular basis. Responsibility structures may be used (i.e. ensuring that team members receive information on their own area of influence), but this must be carefully weighed against ensuring that project team members do not forget that their particular area of control is likely to affect other areas and will ultimately affect the overall achievement of the whole project objective.

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 Examples of project planning  
 A project is to be undertaken to upgrade the computer system of EFG, a 
company which deals with examination results. The deadline for 
completion is 30 September 20X7. Key personnel in the project are the project manager, H and J (EFG's IT manager). As the system will deal with examination results, security of the system will be critical. 
The plan below would be issued to stakeholders such as corporate 
management, customers and the project team. There may be ‘commercial-in-confidence’ elements in it that would only be shown to the senior management. There are no set layouts or contents of 
management plans.  Some illustrative examples have been used. 
 
Section title Contents 
Overview or summary Project objectives; organisation of the project team; schedule of work; resources required including the budget and an assessment of significant risks. 
Project name For example, project for the upgrade of a computer 
system for EFG. 
Project players and responsibility The project authorisation document will identify roles and responsibilities such as the project board, the project manager, and the project team. For example: H, Project Manager. 
Responsible for: initiating the project; selecting the 
project team; preparing and implementing plans; managing the successful delivery of the project to time, cost and quality applications. 
Project objectives For example, to design and implement an upgraded examination system for EFG, the customer, 
maintaining pre-existent standards but catering for 
an increase in candidate applications. 
Project scope and contract This is identified in the project authorisation document. Reasons for undertaking this project, what is to be achieved in terms of the deliverables (e.g. the completion of the contract with all user training by 30 September 20X7 at a cost of $x). 
Methodology The project team will use project management 
techniques consistent with accepted UK standards. 
Assumptions These may refer to site access, costs of supplies, 
the cost of borrowing money, inflation, the availability of particular staff and so on. A major assumption for the project is that the system is accessible in the quiet period between major application periods or examination dates.

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Technical plan The technical features of the project are identified. 
They will include requirements, specifications, 
system diagrams, site plans, tools, techniques, support functions, standards and any relevant document relating to the provision of the new exam administration system. In-house or subcontracted provision of modules will be specified. 
Quality and management The quality plan identifies our customer, EFG, the key outcomes it expects, acceptance criteria agreed, a test plan of how each outcome is to be tested, and responsibility for each test. Safety and security planning will be essential, as this system must be 100% secure. An audit plan will be included. 
Communication plan This will identify the key st akeholders in the project, 
what their interest in the project is and their concerns that will need to be addressed, what communication is planned and the responsible person. In our project, H will be responsible for communicating with J on a weekly basis to update her on the progress and to tackle any concerns she has. Monthly status projects, monthly resource reports (financial – critical to this project – and human resource reports) will be issued and any milestones will be reported on in writing. Should any critical status reports be needed, they will be made outside the weekly meeting. 
Organisation and personnel The organisation plan describes the structure of the project team and each person’s responsibilities. Included will be any sub-contra ct staff and staff from 
EFG with any input to the project. Organisation charts will be drafted by position if staff need to be recruited. If so, recruitment methods, sources and training required will be identified with start times. In our project, we need to recruit one extra software engineer to bespoke the application. 
Project schedule This will describe the main phases of the project and highlight all key milestones. It is usually illustrated by 
a Gantt chart or with a network diagram. (these will be covered in the next chapter).

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Resources and 
facilities including budget breakdown This includes checks on peaks and troughs of workload to ensure the plan is feasible and to ensure procurement is achieved by the provision of lists. The cost plan will give a rate per hour for all work and the costs of purchases. Contingency costs are included to give the project budget. Time phasing will give a cash flow forecast. EFG has made it clear that no extra project money will be available, so H must ensure as much as possible that his costings and time/resources management are accurately assessed. The contracting company will be bearing the risk of overrun and any other contingencies. 
Risk assessment and risk management The risks are identified and contingency plans made, including extra activities and cost and time buffers to be added to ensure reliable budget and completion date. The risk register identifies each contingency plan for each key risk and allocates responsibility for monitoring. In the project, unauthorised access to candidate details or results is the greatest outcome risk. Security must be 100%. This may mean that the best encryption software will be needed for online applications. There will be cost implications which H has taken account of. He must also make contingency costing in line with his contingency plans. 
Acceptance The project manager will submit the final system for 
acceptance to the customer, in our example EFG. It may sign off the project or return it with a specific statement of requirements that will make it acceptable. Acceptance will be in writing. The managing director of EFG will sign off the project with J. 
Change management Details of how changes will be handled throughout the project will be specified, for example requests for change may be initiated by H or J. These will be reviewed and approved by the project board with decisions in writing. 
  
Project constraints – time, cost and quality 
Project constraints were discussed earlier in the chapter. It was highlighted that the successful accomplishment of the project objective is usually constrained by three main factors: time, cost and quality. Recognising these, and the other constraints the project faces, is critical at the detailed planning stage as these constraints, and their inter-relationshi ps, will have to be taken into account 
within each part of the project plan.

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Project time 
The schedule is the timetable for activities involved in achieving the project 
objective. The project will have a finite date for completion, either set by the customer or negotiated and agreed upon with the customer. For example, planning a wedding will require organisation of all activities to occur at a specific time and on a specific date. 
Project cost 
The cost is the amount the customer agrees to pay for the final project or 
product. The project cost is based on the budget, which includes a cost estimate of the resources that will be used in the project. This will include salaries of the people working on the project, project materials, equipment purchase or hire, subcontractors’ or c onsultants’ costs and facilities costs. 
Quality (customer satisfaction) 
The objective of any project is to complete the project within the budget and by 
the agreed date to the customers’ satisfaction and quality requirements. It is important to ensure that prior to the project planning the project team has a clear understanding of the customer specifications and requirements, that the customer is kept informed of project progress throughout the project life, and that the plan includes progressive testing to ensure that quality requirements are fully met. Quality in computer systems can be measured in the number and type of errors (‘bugs’) it still contains, response times, fitness for purpose (i.e. matches the business process it is intended to support) and so on. 
Another important constraint is scope/functionality . 
The scope of the project is all of the work that must be carried out to satisfy the 
project’s objective. The customer will expect the work to be carried out to completion and that there is nothing expected which is missing. For example, when building a house the project scope w ill include clearing the land, building 
the house and landscaping, all within the agreed quality standards expected by the customer. Leaving windows or walls unfinished, a hole in the roof, or a garden full of rubble, will be unlikely to satisfy the customer! In computer systems, the scope is often defined by all the functions that the system is expected to fulfil. 
Project scope tends to be positively correlated with both cost and time, in that 
increasing the number of tasks to be performed within the project will normally lead to an increase in both the cost of the project and its overall duration. Managing variations to scope is one of the most complex aspects of project management. The manager must ensure that every time the customer asks for a change or addition to the scope of the project, the customer is informed of (and ‘signs off’) the cost and time consequences of that change. Such changes should also be fully recorded and documented to avoid arguments about what changes were required and authorised.

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9  Executing and controlling 
Once the project plan has been developed and agreed by the customer and 
project team, the project can commence. At this stage, the project manager must provide leadership and co-ordination to the project team members and other stakeholders with the aim of successfully delivering the project objectives. This is the stage where stakeholders n eed to be focused upon the project tasks 
and the project team will perform the ta sks they are responsible for, as and 
when scheduled in the plan. 
This stage can be weeks, months or years long. The executing stage is closely linked with the controlling stage. 
Configuration management  and change control 
Change is an inevitable part of any project and it must be managed carefully 
during the execution stage. 
Change control 
Change may arise from internal or external factors, and can often change the 
outcome of the project. It is therefore important to have an agreed change 
management process  in place so that everyone involved in the project is 
aware of how change will be managed. 
Change can be required at all stages of the project, very often during the 
execution phase as new factors emerge. It is important that the initial project documents, such as the PID and the detailed project plan, remain as 'baselines' so that all changes can be carefully monitored and controlled. 
A change control process is not to stop change happening, but to ensure that 
the changes, which will inevitably be required during the project, are agreed and communicated to all parties before they are implemented. 
Problems if change is not managed: 
• Team members may be working to the old plans which do not incorporate 
the changes. This can mean wasted time on aspects which may no longer 
be relevant. 
• The project is unlikely to deliver the set objectives if change is not well 
managed. 
• End users will be unhappy at the final product if their expectations have 
not been managed throughout the project and they have not been advised of changes. 
• The project may end up costing more as costs may continue to be 
incurred on aspects of the project which are no longer required, but that team members were unaware of. 
• It can cause confusion and conflict for the project stakeholders.

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Change process 
At the outset of the project a change management process must be agreed. It 
should include the following: 
• Method for prioritising changes requested . Changes requested will 
range from: 
–  Must be done . Without these changes the project cannot succeed, 
to 
–  Nice to have. These are changes requests suggesting 
enhancements to the current project plan. Not all changes of this nature are able to be incorporated into the final project. 
• Authorisation for changes . It must be agreed who has the authority to 
agree to changes. This may be set as a sliding scale whereby the project manager is able to authorise small, low cost changes, but larger changes must be authorised at the highest level, for example the project committee or the project sponsor. 
• Agreement of a change budget . It is likely that changes will result in 
additional cost to the project. A change budget may be set up for this purpose to avoid the project sponsor having to authorise every dollar of additional spend. 
• Recording of changes . A set procedure should be agreed for how all 
changes are to be recorded and w ho will manage this procedure. 
• Communication of changes . The change management process must 
specify how changes to the project w ill be communicated to all interested 
parties. 
Configuration management 
Configuration management is an important element within projects. It involves tracking and controlling all aspects of the project and all documentation and 
deliverables from the project. The configuration management system for a project will specify how all aspects of the project are to be managed. 
Included in configuration management will be: 
• Version control for documentation • Ownership and responsibility for documentation 
• Authorisation and tracking procedures for any changes required to 
documentation 
• Monitoring and control procedure to ensure only authorised documents 
and records are held 
• Access control over project records.

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The change control process discussed ab ove will be part of the configuration 
management system. 
Without configuration management, several versions of documents or product 
may be being used and no one will be aware of which is the correct version. It also helps to ensure that the project runs smoothly, even when key personnel are unavailable. 
Throughout the execution stage of the project the project manager is 
responsible for monitoring and contro lling its progress towards successful 
completion. The most important aspect of project control is ensuring that monitoring progress is carried out and reported on a regular basis. 
Effective project control will involve a system to regularly gather data on actual 
project progress, costs and performance, and compare these against the project plan. If a deviation is discovered (such as overspending or taking longer than anticipated), and the project manager considers that corrective action needs to be taken, the project manager must: 
• report the deviation 
• obtain authorisation if necessary 
• take corrective action to get the project back on track. 
A regular project reporting period should be set up (e.g. daily, weekly or 
monthly), depending on the complexity or duration of the project. More complex projects are likely to require more frequent progress assessment and reporting. 
What are the main purposes of a control system?  
• Prevention of deviations. 
• Correction of deviations. 
• Prevention of any future deviations, by revising plans, target, measures 
etc. 
• Implementation of recommendations from monitoring, reviewing and 
evaluating the project.

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A project control system (Gido and Clements) is shown below: 
 
How elaborate a control system is depends on the size and scope of the task to 
be managed, as well as the size and distribution of the team working on it. 
 
 Performance and conformance management  
 Performance management 
Performance management is required throughout the project in order to 
assess the progress of each aspect of the project. 
Measurement to assess performance can include: 
• Scope performance measures. • Functional quality measures 
• Technical quality performance measures 
• Client satisfaction measures.

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The main project constraints of time, cost and quality are especially 
important to control throughout the project. 
Controlling time can be done using milestones which should be built into 
the project schedule. Progress can then be measured against these milestones. 
Controlling quality can be done using the project quality plan (PQP) which 
sets out the standards required in the project and how these standards are to be tested throughout the project. 
Milestones and the PQP will be covered in more detail later. Controlling cost can be done by comparing actual spend against the 
project budget and by calculating variances on a regular basis. 
Conformance management systems focus on: 
• inspection • quality control 
• quality assurance. 
Conformance quality depends upon compliance with technical 
specifications and relates to the use of superior operations management to reduce waste and costs, and increase uniformity. 
For each element, control limits should be set at outset which can be 
used to assess the seriousness of any deviation from plan. Where non-conformance with the set standards are detected, any deviation larger than a specified limit should automatically trigger corrective action. 
Reports and meetings 
The two most important elements used in the control of projects are reports and 
meetings. 
Project reports 
To enhance and facilitate the communicati on of control and progress throughout 
the life of the project, the following main reports are produced: 
Exception reports 
This is when everything is in accordance with the plan. Only exceptions are 
reported. 
Progress reports 
Both formal and regular, these note what has happened in the report period and 
the project status to date. It normally includes: 
• Status against plan in terms of cost, timetable, and scope. 
• Status and progress of resolving issues identified to date. 
• New issues.

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• Corrective action plan. (Corrective action requires consideration of 
alternatives before implementation. For instance, adding extra resources 
in order to get a project back on time will incur extra costs and may therefore overrun the project budget. The project manager needs to consider very carefully the implications of any corrective action upon the project scope, budget and schedule). 
• Expected achievement of milestones before next report. 
• Next report date. 
Reports from the project manager to the project board should be made on a 
regular and frequent basis. In most projects, written reports are made monthly, with a major summary report quarterly (or on completion of a life cycle stage). These reports should have a standard format, both within and between projects, so the recipients become familiar with their content. Areas covered by the report would obviously focus on progress in terms of cost, scope, and time, with any anticipated variances from plan highlighted. 
Project meetings 
Regular meetings are an essential part of control within a project. As well as 
communicating the progress of the project, they can also enhance relationships with the project team and with other stakeholders. 
The main meetings which should be held throughout the project are: 
Team meetings 
The project manager should hold regular meetings with the members of the 
project team. These may be formal or informal and may be held periodically or when a specific issue needs to be resolved. 
Team meetings can foster good working relationships with the project manager 
and the members of the project team and also between the team members. 
Regular team meetings ensure that all team members are aware of the 
progress of the project and any issues which have arisen. 
Project progress review meetings 
These are regular, formal meetings involving the project manager, team 
members, and the customer or steering committee. 
In many projects, such a meeting might take place quarterly, and the project 
manager would present their summary report. This will allow those involved with 
the project to ask questions that are not covered by the written report. The purpose of the meeting is to provide an update on the project status, identify any issues and establish action plans from that point.

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Other meetings 
A number of other meetings may be held by the project manager throughout the 
project, such as: 
Project problem solving meetings  – these would be held on an ad hoc basis 
as required to deal with problems which have arisen. Meetings with external parties  – the project manager will also have to arrange 
meetings with external resource providers such as suppliers and sub 
contractors. 
Remember: meetings were covered in an earlier chapter. All of the material 
covered earlier is equally applicable to project meetings. 
 
 G is about to undertake his second project in the role of project manager. 
In his last project he was criticised by the project sponsor for the lack of 
reporting throughout the project. G has commented that he does not see the need for reporting as long as the project is delivered as it would just take his time away from managing the project. 
Required: 
The new project has the same sponsor and he has asked you to email G 
to explain to him the benefits of a well-defined project reporting system. 
10  Closing 
The final stage of the project life cycle is the closure of the project once the project work is finished. A number of activities must be undertaken at this stage: 
• Project is delivered to users • End of project meeting 
• Formal sign off of project 
• Project review meetings 
• Final report issued 
• Project team disbanded. 
An end of project meeting confirms closure of the project by a formal sign-off. At 
this meeting or another shortly afterwards, a review evaluates how well the project was managed: if deadlines were met, quality standards maintained and budgets adhered to. Lessons learned from the review are used in future projects. 
Project review meetings should be carried out both internally with project team 
members and externally with the customer.

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 End of project review meetings  
 The internal review (team) 
This is: 
• an opportunity to review the planning, management, reporting and 
control 
• an opportunity to discuss the success and failures of the project 
process 
• to establish what can be learned in future for the benefit of other 
projects 
• an opportunity for the project manager to discuss with individual 
team members their role in the project and the means by which they 
could improve their own performance on future projects. 
The external review (customer) 
This is: 
• a crucial aspect of project closure 
• an important part of establishing whether the project has satisfied 
the customer's requirements 
• to obtain feedback to help improve future projects • when customers can voice any concerns regarding how the project 
was carried out. 
 
 The final report  
 The contents of the final project report will include: 
• Brief overview of project. • Customer original requirements and original project deliverables. 
• List of deliverables which the customer received. 
• Actual achievements re costs, schedules and scope. 
• Degree to which the original objective was achieved. 
• Future considerations. 
To produce this report reference will be made to the following 
documentation: 
• feasibility study and report 
• PID 
• project planning reports 
• milestones and gates.

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The purpose of the closing stage of the process is: 
• To ensure that the project is finally completed and conforms to the latest 
definition of what was to be achieved. 
• Formal comparison between PID and project outcomes. 
• To evaluate performance of project against agreed levels of performance. 
• Cost of the system in comparison with budgeted cost with an explanation 
of variances. 
• Comparison of time taken with the budgeted time anticipated. • Effectiveness of the management process. 
• Significance of any problems encountered. 
• To complete the project termination activities, such as: 
–  Organising and filing all project documentation.  
–  Receiving and making final payments to suppliers of resources. 
–  Agreeing formally with the customer that all agreed deliverables have 
been provided successfully. 
–  Meeting with project team and customers to report on project 
successes and failures. 
–  Disbanding the project team. 
• To provide continuous improvement and feedback. Any improvement, 
even a small one, is important. 
• To learn from the experience. 
Post Completion Audit (PCA) 
A few months after the end of the project a meeting of managers, users and 
developers is held. This is designed to review the success of the project as a whole as well as to receive the users' feedback on it now that they have had time to judge it. It may also highlight specific issues with the project and the review meeting may organise a set of actions to deal with these issues. In addition it should also establish whether the project has helped the business to deliver the benefits defined in the original business case. 
The primary benefit derived from the post-completion audit is to augment the 
organisation's experience and knowledge. This may be difficult to quantify, it may be necessary to justify the cost of the post-completion audit by carrying out a cost benefit analysis. In this case, the expected savings to future projects should be offset against the cost of the audit. 
Other benefits of PCAs include more rea listic forecasting of a project's costs 
and revenues, enhanced understanding of project failures, and improved future 
decision making and project management performance.

330  
 Post completion audit – key areas  
 Key areas to consider in the post completion audit: 
• Technical performance review (was the scope of project achieved?). 
• Extent to which the quality has been achieved. 
• Whether benefits have been achieved. 
• Cost/budget performance. 
• Schedule performance. 
• The effectiveness of project planning and control. 
• Team relationships. 
• Problem identification process. 
• Customer relationships. 
• Communication. 
• Risk evaluation and assessment of risk management policies. 
• Outstanding issues. 
• Recommendations for future management of projects. 
Continuous improvement 
Many organisations view project management as a strategic competence, from 
which they can gain a competitive advantage. This is particularly true of organisations in project-based industries, such as engineering and consultancy. 
Such organisations have begun to see that without continuing to improve their 
project management approach they will continue to make the same mistakes and poor practices will be carried forward. Excellence in project management requires the development of a strong approach (methodology), a culture that believes in the approach and an effort by all to continuously improve this approach. 
Elements of continuous improvement can be seen in the activities carried out 
during the completion and post-completion stages of the project. As part of the internal review at the end of the project and the post completion audit, an aspect of learning takes place whereby the project team review how well the project was carried out and considers lessons learned which could be taken forward to benefit future projects.

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 T is about to complete his first project as project manager. Prior to this 
project he spent six months as a member of a project team working on 
the development of an educational visitors centre for the company. 
Reflecting on his experiences whilst working on the previous project, he 
feels that the final stages of the project were not dealt with effectively, with the project members going back to their functional jobs without any discussion or feedback on the project performance and outcomes. 
He is determined that he will improve the experience for his project team, 
however most of the project team in his current project were members of 
the team in the last project so T feels that he will have to convince them 
of the need to undertake certain activities as the project draws to a close. 
Required: 
T has asked you to write a report for him to circulate to the team 
members explaining the importance of the activities to be carried out at the closure and post-completion stages of the project. 

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 Question 1 
 There are four main types of feas ibility which should be considered when 
deciding to initiate a project, namely: 
• Technical 
• Social 
• Ecological 
• Economic 
Match the descriptions to the types of feasibility. 
• Does it fit with current operations? 
• How will it affect the environment? 
• Can it be done? 
• Is it worth it? 
 
 Question 2 
 According to Gido and Clements, during which phase of the project 
lifecycle would ideas be submitted and evaluated? 
A  Identification of a need 
B  Development of a proposed solution 
C  Implementation D  Completion 
 
 Question 3 
 Which of the following are purposes of a project initiation document? 
Select all that apply. A  Acts as a base document against which progress can be assessed B  Assesses whether the project is technically feasible C  Justifies the project D  Defines the project and its scope E  Provides a method for prioritising change requests F  Considers alternative actions should uncertain events occur

334  
 Question 4 
 Complete the following sentences relating to project constraints, using 
the following words: 
• reduce 
• increase 
Part way through a project to install a new IT system, one of the finance 
providers announced that it could no longer support the project. It is likely that the quality of the project will _____________ or the timescale of the project will ___________________. 
It has now been made clear by the project customer that the system must 
be in place by the agreed date, or the company will lose a very valuable contract. 
To get the project installed on time, it is likely that the quality of the 
project will _______________________. 
 
 Question 5 
 All projects have a number of constraints that which restrict their 
progress. The three main constraints are known as the project triangle. Which of the following constraints make up the project triangle? 
A  Legal B  Resources C  Quality D  Communication E  Time F  Cost

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 Question 6 
 Insert the correct word from the list to complete the sentences below: 
• Completion 
• Implementation 
• Need 
• Solution 
The project stage where customer feedback would be obtained during an 
external review meeting is known as ______________________. 
At the ________________ stage, a project initiation document would be 
completed. 
The phase when the actual performance of the project is undertaken is 
known as ______________________. 
At the _________________stage, proposals are evaluated and the most 
appropriate is selected. 
 
 Question 7 
 Configuration management is designed to: 
A  track deviation from proposed deliverables 
B  track deviation from schedule C  track product changes and versions D  track co-ordination between different project teams 
 
 Question 8 
 Which of the following statements regarding project control are correct? 
Select all that apply. A  A project control system will ensure that the project meets its 
deadlines. 
B  Performance management is only required at the end of the project. C  Reports and meetings are important elements of control within 
projects. 
D  Project progress review meetings are regular, formal meetings 
involving the project manager, team members, and the customer or 
steering committee. 
E  The main purposes of a control system are to prevent and correct 
deviations.

336  
 Question 9 
 A number of activities are undertaken at the completion stage of a 
project. Further activities are undertaken a few months after the 
completion of the project, this is known as the post completion review. 
Match the statements below to whether they relate to the completion or the post completion stages. 
 
Completion Post completion 
 
• The purpose of this stage is to establish whether the project helped 
the business to deliver the benefits defined in the original business case. 
• The project team will be disbanded. 
• The purpose of this stage is to ensure that the project conforms to 
the latest definition of what was to be achieved. 
• At this stage the final report is produced. 
 
 An important element in projects that is used to track and control all 
aspects of the project and includes version control and access over 
project records is known as: 
A  Change control B  Risk management C  Configuration management D  Project initiation document

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 EMAIL 
To: G 
Subject: The benefits of a well-d efined project reporting system 
I have been asked by the sponsor of your latest project to write this 
email to explain to you the benefits of a well-defined project reporting system. I appreciate that your last project was a success and that you therefore see little point in spending time on reporting, but a well defined project reporting system will have the following benefits: 
• It will enhance the communication throughout the project. • It ensures that all team members are aware of the importance of 
regular monitoring and control. Everyone involved in the project 
will know that their progress will be monitored and reported on 
which will encourage hard work within the team. 
• It ensures that all stakeholders can be kept informed of the 
progress of the project, which means that issues affecting the project are advised to the relevant parties on a timely basis. 
• Corrective action can then be undertaken sooner to ensure that 
the project stays on track. 
• It is necessary to compare with planned performance, although it 
must be done regularly to ensure progress is maintained. Reporting can be daily, weekly or monthly, depending on the complexity and timescales involved. 
• Standard reports will make it easier for all parties to follow the 
progress of the project, and to compare the progress of projects against each other. 
I hope that you have found the above useful and that you will see the 
benefit of implementing a project reporting system for this and all of your future projects. Please do not hesitate to get in touch if you want to discuss this further.

338  
 REPORT 
To: Members of the project team  
From: T Date: Today 
Subject: The importance of the activities at the closing and post-
completion stages of the project. 
In this report, the importance of the activities at the completion and post-
completion stages of the project will be considered. 
Project closing 
Project closing is the final stage of the project life cycle and occurs once 
the project work has finished. The purpose is to ensure benefits are gained in the final stages. It is important that all members of the team maintain commitment until all the work is completed since people tend to be more motivated to move on to new projects rather than tying up the loose ends. It is also important to evaluate the conduct of the project in order to learn from experiences which will help the company improve on its performance in future projects. The questions that could be asked include: 
• Was the project completed to quality, on time and within budget? • Did the project deliver according to the objectives set? 
• Are there lessons to be learnt? 
• Are there any follow up action on this project needed? 
Project closing acti vities would involve practica l tasks such as organising 
and filing all project documentation and ensuring that members of the 
project team have jobs to return to. It should also involve formally agreeing with the ‘client’ that all the agreed deliverables have been achieved. The business case should be reviewed to check that intended benefits are likely to be realised. In other words, examining project performance by comparing achievement with the original project plan to show that the project has delivered the outputs. 
Post completion review and audit. In addition, there should be a review of the project organisation and 
methods to recommend future improvements. This can be achieved through the post completion review and audit. The main purpose of the post completion review is to evaluate the overall project and to learn from the experiences gained before the project team is disbanded. This might involve debriefing meetings which enable all parties involved in the project to assess their own performance.

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 It provides a forum to discuss with individual team members their role in 
the project and how they could improve their own performance for the 
future. An evaluation from the client’s perspective will establish if the project was successful in satisfying their requirements and has given them the opportunity to voice any concerns. 
The review will provide an opportunity to discuss the successes and 
failures of the project process. The feedback should provide reinforcement of good skills and behaviours and the identification of areas for improvement or change in practice for the smooth running of future projects. 
The post completion audit is the final stage and involves conducting a 
formal audit of the enti re project against a checklist. This will include an 
assessment of: 
• whether the required quality of the project has been achieved; the 
efficiency of the solution compared with the agreed performance 
standards 
• the actual cost of the project compared with budgets and reasons 
for over/under expenditure 
• the time taken to develop the solution compared with target dates 
and reasons for any variances 
• the effectiveness of project management methodologies. 
Together, the review and audit can provide a case history of the project, 
providing a repository for the knowledge captured. The project manager should issue a report summarising project performance and advising on how it could be improved in the future. The reason that post project activities are not always undertaken is that it is often difficult to quantify in a tangible way the benefits derived, given the associated costs of review and audit. 
The activities carried out at the closing of the project are important as 
they help to ensure that the project is completed successfully, they help to review not only what was delivered by the project but how it was delivered. This allows all parties to the project learn lessons which will help them improve the management of future projects. 
 
 Question 1 
Technical  – Can it be done? 
Social  – Does it fit with current operations?  
Ecological – How will it affect the environment?  
Economic  – Is it worth it?

340  
 Question 2  
 The second stage of the project lifecycle is the development of a 
proposed solution.  All proposals for the solution will be submitted and 
evaluated and the most appropriate solution to satisfy the need will be 
selected. 
 
 Question 3 
 A, C and D 
Assessing if the project is technically feasible would be done as part of 
the feasibility study. 
A change process provides a method for prioritising change requests. Contingency planning considers alternative actions should uncertain 
events occur. 
 
 Question 4 
Part way through a project to install a new IT system, one of the finance provides announced that it could no longer support the project. It is likely that the quality of the project will reduce  or the timescale of the project 
will increase . 
It has now been made clear by the project customer that the system must be in place by the agreed date, or the company will lose a very valuable contract. 
project will reduce . 
 
 Question 5 
 C, E and F 
The 3 main constraints which make up the project triangle are: 
• Quality • Time 
• Cost

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 341 
 Question 6 
external review meeting is known as completion. 
At the need  stage, a project initiation document would be completed.  
The phase when the actual performance of the project is undertaken is known as implementation . 
At the solution  stage, proposals are evaluated and the most appropriate 
is selected. 
 
 Question 7 
 C 
Configuration management involves tracking and controlling all aspects 
of a project and all documentation and deliverables from the project. 
It includes version control for documentation and all aspects of change 
 
 Question 8 
 C, D and E 
A project control system will aim to reduce the risk within a project but 
cannot ensure that a project will meet its deadlines. 
Performance management is required throughout a project to assess the 
progress of each aspect of the project. 
 
 Question 9 
 
The project team will be disbanded. 
The purpose of this stage is to 
ensure that the project conforms to the latest definition of what was to be achieved. 
At this stage the final report is 
produced. The purpose of this stage is to establish whether the project helped the business to deliver the benefits defined in the original business case.

342  
 C 
Change control is used to ensure that all changes to the project are 
agreed and communicated before they are implemented. 
Risk management considers how the risks associated with a proposed 
project can be managed. 
A project initiation document is used to authorise the project and to act as 
a base document against which the project deliverables can be assessed.

343 
Project management – 
tools and techniques 
C2: Apply tools and 
techniques to manage projects (a) Project management 
(b) Project risk management 
tools 
• Workstreams 
• Work breakdown schedule, Gantt charts, network analysis 
• Sources and types of project risks 
• Project management software. 
 
  Chapter 
10

Project management – tools and techniques 
344  
1  Session content diagram

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 345 
2  Tools and techniques 
There are a number of tools, techniques and documents which are used 
throughout a project, particularly at the planning stage. These can be summarised as follows:

346  
3 Planning for activities and costs   
Breakdown structures: 
1 Work Breakdown Structure (WBS)  
The WBS is an important starting point for planning. It contributes to 
planning in the following ways: 
–  Breaks complex tasks into manageable pieces. –  Sets out the logical sequence of project events.  –  Provides a logical framework for making decisions. –  Provides an input into subsequent project processes, such as 
estimating time and resources. 
–  Provides a framework for continuous assessment of the project 
progression. 
–  Provides a communication tool. An extract from a possible WBS for planning the Olympic Games is shown 
below. 
 
2 Work Packages (WPs) and Statements Of Work (SOWs)  
–  The work package specifies the work to be done for each 
package described in the work breakdown structure. 
–  The statement of work describes the deliverables against which the 
project can be measured. 
–  Both types of document identify in detail work to be done and may 
state the standard to which the work is to be done. 
–  The statement of work also indicates who is responsible and when 
the work needs to be delivered.

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3 Product Breakdown Structure (PBS) 
–  The products required for each activity would then be listed, for 
example the Long Jump would require:  Sand pit 
 White board 
 Measuring equipment. 
–  A description of the machinery and equipment required for the project 
would be made. 
–  This allows different suppliers to be compared. 
4 Cost Breakdown Structure (CBS) This will include information gathered from: –  The WBS, WP, SOW and PBS. –  Capital and revenue costs identified in the cost-benefit analysis and 
feasibility study documents. 
It describes the categories that require costing to ensure nothing is left out 
of the budget process. 
Numbers and costs would be allocated to each product. This creates the detailed financial plan (budget)  for the project.  
The benefits of using breakdown structures include: 
• Summarising all the activities comprising the project, including support and 
other tasks 
• Displaying the interrelationships of the various jobs (work packages) to 
each other and the total project 
• Establishing the authority and respon sibility for each part of the project 
• Estimating project cost • Performing risk analysis 
• Scheduling jobs (work in progress) 
• Providing a basis for controlling the application of resources to the project.

348  
4  Planning for quality  
Project Quality Plan (PQP) 
This major document details the standards that must be adhered to in order to 
ensure a successful development process. It will provide a clear indication of 
procedures and policies that must be followed to maintain quality within the work carried out. It generally includes: 
• Risk assessment  – of the possible internal and external risks that are 
likely to affect the project and the alternative actions which are required to 
reduce the risks. 
• Project overview  – outline of the main activities to be carried out. 
• Project requirements  – details a description of the work to be carried out, 
timescales and deliverables and is cross referenced to the requirements specification. 
• Project organisation  – stating management roles and responsibilities, 
this will help to determine the allocation of resources to each of the project activities. 
• Monitoring and reporting procedures  – cross referenced to the project 
standards, this section identifies how  the project will be monitored and 
what to do if slippage occurs. It also states the frequency and content of reports as well as key control processes, such as end of stage meetings, for example, when the steering meetings will take place and procedures for evaluating the final installed system. 
• Key development stages and processes  – the activities that will need to 
be completed during the life cycle. 
• Key standards to be used in the project (quality assurance)  – this will 
help to ensure quality outputs, standards that need to be evaluated and will include hardware, software and development standards such as notation of modelling techniques. 
• Testing strategy  – this will identify the stages of development where 
testing is to be carried out, by whom and of what. 
• Procurement policy  – the procedures and standards for procurement will 
be stated and any variation from the normal procedure noted, with reasons. 
• Configuration management  – how this will be dealt with should be set 
out so that each version of the deliverables is identified.

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5  Planning for time  
Network analysis  
Network analysis is a general term, referring to various techniques adopted to 
plan and control projects. It is used to analyse the inter-relationships between the tasks identified by the work breakdown structure and to define the dependencies of each task. Whilst laying out a network it is often possible to see that assumptions for the order of work are not logical or could be achieved more cost effectively by re-ordering them. This is particularly true whilst allocating resources; it may become self evident that two tasks cannot be 
completed at the same time by the same person due to lack of working hours 
or, conversely, that by addi ng an extra person to the project team, several tasks 
can be done in parallel thus shortening the length of the project. 
Critical Path Analysis (CPA) 
One of the component parts of network analysis is critical path analysis or CPA 
(this is often called network analysis). It is the most commonly used technique for managing projects. 
The process of CPA. 1 Analyse the project . The project is broken down into its constituent tasks 
or activities. The way in which these activities relate to each other is 
examined, for example which activities cannot be undertaken until some previous activity or activities are complete? 
2 Draw the network . The sequence of activities is shown in a diagrammatic 
form called the ‘network diagram’. 
3 Estimate the time and costs of each activity . The amount of time that 
each activity will take is estimated, and where appropriate the associated 
costs are estimated. 
4 Locate the critical path . This is the chain of events that determines how 
long the overall project will take. Any delay to an activity on the critical path will delay the project as a whole; delays to other activities may not affect the overall timetable for completion. That is the distinction between critical and non-critical activities. 
5 Schedule the project . Determine the chain of events that leads to the 
most efficient and cost effective schedule. 
6 Monitor and control the progress of the project . This implies careful 
attention to the schedule and any other progress charts that have been drawn up, to monitor actual progress in the light of planned achievement. 
7 Revise the plan . The plan may need to be modified to take account of 
problems that occur during the progress of the project.

350  
The network diagram: 
The diagram is made up of two parts: activity lines and nodes. The diagram is 
drawn and read from left to right. 
A complete network diagram (CPA) would look like this: 
 
• Each activity is represented by an arrow  
• The activity letter or description (or both) is written on the arrow. 
• The activity duration is written below the arrow. 
• The activities on the critical path are identified with // 
• Activities start and finish in circles known as nodes (O). 
• Nodes are numbered so that each node has a unique identifier. 
• The nodes also contain information on two times:  
–  The earliest event time (EET) 
–  The latest event time (LET).

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Drawing the diagram 
• First draw a dot-to-dot diagram – this can be completed quickly and allows 
the logic of the diagram to be tested before you begin to draw the final 
version. 
• Once the network has been drawn, calculate the EET and LET for each 
node. 
• To calculate the EET, work left to right. Take the EET from the previous 
node and add this to the duration of the activity. Where you have a 
choice of EETs, always select the highest. 
• To calculate the LET, work right to left. Take the LET from the previous 
node and deduct the duration of the activity. Where you have a choice of 
LETs, always select the lowest.  
Reading the diagram 
• The EET and LET of the final node will always be the same and this will 
equal the overall duration  of the project. 
• We can also identify the critical path , i.e. the activities where any delay 
will lead to a delay in the overall project. These are the activities for which 
EET = LET. 
• Some activities could increase in duration and yet the project could still be 
completed by the required target date. Such activities are said to exhibit 'float' . Float can generally be calculated as the difference between the 
LET and the EET. 
Rules for drawing the diagram 
• If two activities occur in parallel, dummy activity lines  are inserted to 
allow only one activity arrow to join nodes together. Dummy activities do not consume any time or resources and are drawn in the diagram to make it clearer.

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• Loops are not allowed because the network essentially shows a series of 
activities progressing through time. It focuses on the passage of time, not 
on the successful completion of activities. In other words, you cannot have a series of activities leading from one event that lead back to the same event. For example, the following diagram is not allowed. 
 
It would be redrawn including a new activity. 
 
• An activity can only occur once, so there cannot be two lines with the 
same activity. For example, this diagram is not allowed: 
 
The diagram may need to be redrawn and/or a dummy activity used.

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 Illustration 1 – CPA worked example 
 Consider the follow details about a project. You are given the list of 
activities, their durations and the preceding activities. This last column 
tells you which order the activities must be drawn in. 
 
Activity Duration 
(weeks) Preceding 
activity 
A 8 – 
B 10 A 
C 6 – 
D 4 C 
E 8 B, D 
Required: 
Draw the network diagram, and identify the critical path, the estimated 
project duration and any float on any activity. 
Solution: 
Step 1 : draw the basic network diagram, showing the order of the 
activities. Remember the rules above when you are drawing it. You are 
aiming to move across your page from left to right. 
Each activity must start and end with a node, so the first thing to do is to 
identify the activities which can start straight away – these are the ones with no preceding activity. In this case A and C can start straight away.

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 Now you can draw in the other activities. B follows A, and D follows C: 
 
Activity E is a bit harder, because it follows B and D. This can be drawn 
using a dummy line. Connect the nodes at the end of B and D with a dummy line, and show E following that combined node: 
 
You could have drawn the diagram without the dummy line, as shown 
below. Both of the diagrams are acceptable and both show the correct flow 
of activities.

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 Step 2:  Now the basic network diagram has been drawn, we can start to 
add in the details of the durations of each activity. These are shown on 
the activity lines. You can now draw in the node lines, ready for the calculations of EET and LET. 
 
Step 3:  Calculate the Earliest Event Time (EET) working left to right. 
Start at the first node: the EET of the first node must always be zero. You then look at each activity in turn. 
Take the EET from the node at the beginning of the activity line, and add 
it to the duration of the activity, the answer gives you the EET for the node at the end of the activity line. 
So for A, EET at the start is 0, add the duration of A, which is 8, so the 
EET for the node at the end of the activity line is 8. For C, we get 0 + 6 = 6. 
You have to be careful when looking at B and D as they lead to the same 
node – this is a choice: 
For B: 8 + 10 = 18, or for D: 6 + 4 = 10. Remember for the EET, when 
you have a choice, you select the highest, so we use 18. 
E is straightforward: 18 + 8 = 26.

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 Step 4:  Calculate the Latest Event Time (LET) working right to left. Start 
at the last node: the LET of the last node must equal the EET of the last 
node, so in this case the LET of the last node is 26. You then look at each activity in turn. 
Take the LET from the node at the end of the activity line, and deduct the 
duration of the activity. The answer gives you the LET for the node at the beginning of the activity line. 
So for E, the LET of the node at the end is 26, deduct the duration of E, 
which is 8, so the LET for the node at the beginning of E's activity line is 18. For D, we get 18 – 4 = 14, and for B we get 18 – 10 = 8. 
For A and C you have a choice. Using A we get 8 – 8 = 0, or using C we 
get 14 – 6 = 8. When you have a choice for the LET, you always use the lowest, so we use 0. 
 
Our CPA is complete. We can now put in the reference numbers in each node (there are no rules here, just work left to right and number each node, it is just used for identification purposes). 
We can now work out the critical path: Look at your diagram. Where the nodes at the beginning and the end of 
an activity line have the same EET and LET, this tells you that the activity is critical. In our diagram we can see that activities A. B and E are critical. We note these on the diagram with double lines on the activity line. Always check that your critical path is a continuous path through the diagram from the first to the final node.

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From our diagram, we can also see the overall duration of the project. 
This is the same as the EET and LET of the final node, so in this project, 
the overall duration is 26 weeks. 
We can also work out of there is any slack/float on any activity. This can 
be seen from those activities which are not on the critical path. The amount of float can be calculated as the difference between the EET and the LET. In our diagram, activities C or D have a float of 8 weeks. 
 
 The details of activities and duration for Project YT you are managing are 
shown below. 
 
Activity  Duration 
activity 
A Problem definition 2 – 
B Prepare feasibility report 3 A 
C Studying existing system 2 A 
D Logical and physical 4 C 
E Software and hardware 
developmen t 4 B 
F Systems development 
report 8 D, E 
G Testing 4 F 
H File conversion 3 D, E 
I Changeover 6 G, H

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 Required: 
Construct a network diagram of the project's activities as detailed within 
the above table. 
Write an email to the project sponsor explaining the activities which are 
on the critical path, the overall project duration and any activities that have a float. 
Note:  you will not be asked to produce a network diagram as part of the 
E2 assessment, or the management level case study but network diagrams are examinable therefore it is important to be able to draw the network so that you can understand the diagram and be able to answer questions about them. 
Limitations of CPA 
• It may be time consuming to produce and monitor for large projects. 
• Difficult to use for less routine projects with lots of uncertainty. 
• Overly complex for some smaller short-term projects. 
Benefits of CPA 
• Assists in identifying all activities required for completing the project. 
• It will assist in identifying those activi ties that need to be completed before 
the next activity can start (dependent activities), and those that can 
happen at the same time (parallel activities). 
• The network diagram will identify those activities that lie on the critical 
path. These activities cannot overrun, otherwise there would be delays in the overall project. 
• The network diagram will identify those activities that are non-critical and 
exhibit float or buffer. This allows management to rank each activity in relation to how much flexibility is available. 
• The network diagram will show the minimum completion time for the 
project, and will allow for sensitivity analysis to be introduced into the 
project.

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6  Planning for resources 
Resource histogram  
This is a graphical aid for determining the total requirement for a specific 
resource during the project. The histogram identifies, in block graph form, the fluctuating need for finance, staff, technology resources or vendor services at any stage in the project. This can assist  in planning. Reallocation of key tasks 
can reduce the excessive requirement at certain periods, providing a smooth flow of resources throughout the project. 
This smooth flow is easier and cheaper to plan for. The histogram may also 
assist in control activities. 
A resource histogram shows the amount and timing of the requirement for a 
resource or a range of resources using a stacked bar chart. 
 
Illustration 2 – Resource histogram example 
 It is very common for a project budget to be constructed as shown below. 
Variance analysis and financial control are much easier when a 
spreadsheet package is used for project budgeting. 
 
Month 1 2 3 4 5 6 7 8 9 10 11 Total 
 $ $ $ $ $ $ $ $ $ $ $ $ 
Salaries 420  285  662  850  122  453  411  502  850  421  409  5385  
Materials 0  125  0 0 1000  250  400  325  100  125  800  3125  
Overheads 180  55  320  123  249  402  111  122  451  123  201  2337  
Sub-con. 0  200  200  200  200  0 0 560  560  250  0 2170 
Total 600  665  1182  1173  1571  1105  922  1509  1961  919  1410  13017  
Such a budget can be shown as a histogram for immediate visual impact, as shown below: 
 
Resource histograms can be used for all resources, such as equipment 
or human resources.

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Benefits of resource histograms: 
• It helps with capacity planning, resource scheduling and management • Resource availability and allocations can be shown on a histogram, to 
highlight overloads and under-utilisation 
• Easy visualisation of resource requirements • It is drawn in real time. 
7  Project management software 
Most project management today will involve the use of project management 
software. 
Project management software can assist considerably at the planning stage of 
the project in the production of network diagrams, Gantt charts and resource histograms. It is also useful at the other stages of the project. 
There are a number of different software packages available on the market. The 
type of output produced by the package will vary depending upon the package being used. 
Project management software may be used in a variety of ways throughout the 
project and can provide the following: 
Planning: 
• The ability to create multiple network diagrams. 
• The ability to create multiple Gantt charts. 
• The ability to create Project Initiation Document (PID), Project Quality Plan 
(PQP) and Work Breakdown Structure (WBS). 
Estimating: • The ability to consider alternative resource allocation. • The ability to create and allocate project budgets. 
• The ability to allocate time across multiple tasks. 
Monitoring: 
• Network links to all project team members. 
• A central store for all project results and documentation. 
• Automatic comparison to the plan, and plan revision. 
Reporting: 
• Access to team members. 
• Ability to create technical documents. 
• Ability to create end of stage reports.

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Advantages of using project management software 
• Improved planning and control . Software includes various tools which 
can aid planning. All project data ca n be held centrally and this facilitates 
comparison between planned and actual data. 
• Improved communication . Calendars, report generation and scheduling 
of activities can all aid communication during the project. 
• Improved quality of systems developed. 
• Accuracy . Particularly in large projects, manually drawing network 
diagrams can be prone to error. 
• Ability to handle complexity . For large, complex projects, PM software is 
indispensable in ma naging and controlling large volumes of activities. 
• What if analysis. The software allows the user to see the effect of 
different scenarios by altering elements of the project data. This enables 
the project manager to plan for contingencies and to assess consequences. 
• Timesheet recording . In order to ease the project manager’s burden of 
recording the actual effort and revised estimates to complete a task, a number of PM software packages allow this data to be captured from individual team member. 
Project management software recognises that there is a sequence in which activities need to be performed. The use of software can help to ensure that all necessary tasks are carried out as required. 
When choosing project management software, or indeed any software package, 
it is important to: 
• determine requirements of organisation including its current and future 
needs. 
• document requirements including the essential functions/important/wish 
list. 
• review all available packages to identify three/four products which meet 
the essential functions and fall within budget. 
• have a demonstration of the packages on a trial basis if possible. 
• select a package including 'roll out' strategy with installation, training, etc.

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 Project management software functions 
 The following is a list of functions that would commonly be found within a 
standard project management software package, such as Microsoft 
Project: 
• Budgeting and cost control . At any time during the project, actual 
costs can be compared with budgeted costs for individual resources 
or activities, or for the whole project. 
• Calendars . Calendars can be used for reporting purposes and to 
define working periods. 
• Graphics . The ability to create and modify graphics, such as Gantt 
charts, is a useful feature of PM software. It will allow the tasks in Gantt charts to be linked so that preceding activities can be shown. 
• Multiple project handling . Large projects often have to be broken 
down into smaller projects to make them more manageable. Alternatively, project managers may be responsible for more than one project at a time. Most PM software packages will store numerous projects quite easily. 
• Planning . All PM software allows the user to define the activities 
that need to be performed. It will maintain detailed task lists and create critical path analyses. It will allow the project manager to plan several thousand activities, by allocating resources, setting start and completion dates and calculating expected time to complete. 
• Scheduling . Most systems will build Gantt charts and network 
diagrams based on the task and resource list and all of their associated information. Any changes to those lists will automatically create a new schedule for the project. It is also possible to schedule recurring tasks, to set priorities fo r tasks, to schedule tasks to start 
as late as possible, and to specify ‘must end by’ and ‘no later than’ dates. 
• Resource planning . A critical issue in project planning is resource 
management, that is ensuring the project has the correct level of manpower, equipment and material at the right place at the right time and in right quantities.

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 • Resource histograms . These provide the project manager with a 
visual display showing the usage and availability of resources over 
the project’s life. This allows the project manager to see quickly and easily where there are either too few resources or where there are surplus resources to carry out a particular activity. The project manager then has the ability to reallocate resources or to obtain additional resources to ensure that critical activities are achieved on time and therefore the critical path is achieved. An example of a resource histogram is shown on top of next page. 
• Reporting. The project manager has to report on the progress of 
the project to the stakeholders. PM software provides the facility to 
generate standard reports, such as progress to date, budget reports, allocation of resources reports, individual task or WBS reports and financial reports. 
 
 You are a trainee management accountant working for management 
consultants XYZ who have been contracted to assist in the management and control of a large international sporting event due to take place in four years' time. 
A significant part of the project will be the provision of new buildings and 
facilities. Major new works associated with the project include the construction of a 30,000-seat indoor athletics stadium and a world press and media centre. A further consideration is the upgrade of the current transport network, with major development work required on the local rail system between the main stadium and the city centre, and an airport bus link. 
Success will be measured in terms of trouble-free performance of the 
events, level of customer enthusiasm and satisfaction, and sustained economic activity generated in the region. Completion of the project on time is critical, even if cost or quality are adversely affected. 
The main software development aspect of the project is the development 
of the communications software in the form of an information database. This will require development of a dedicated website to give public access to event information. The database will contain information about competitors and their events, time and location and availability of tickets.

364  
 The database will be designed to allow the general public to monitor the 
events, order tickets from the website for any event, and purchase 
merchandise. The website will also contain links to local hotels and restaurant facilities. The whole package of communications software and the telecommunications and IT hardware has been called the 'Communications Infrastructure'. 
A work breakdown structure has been produced and the project has been 
broken down into over 20 activities, all with varying durations. Each of the activities will be carried out by individual specialist project teams, and led 
by a project team manager. It is critical that these events are co-ordinated and planned effectively, as timing is critical to the success of this project. 
One of the key tasks to undertake imme diately is the determination of the 
critical path. 
Required: 
You have been asked by your management to prepare a report which 
includes an explanation of the importance of undertaking critical path analysis for a project such as this and an explanation of how using project management software may assist during this project. 
8  Project management methodologies 
A project management methodology is a set of guidelines which defines methods and processes to be followed which should help the project be delivered successfully. It can be seen as a systematic and disciplined approach to project management. The development of standard processes is obviously helpful as these, together with standard templates for the documents used, help many project issues to be anticipated and worked around. 
Since every organisation is unique, and undertakes unique projects, there is no 
‘one-size fits all’ answer to which proj ect management methodology to use. 
A popular choice – PRINCE2 or PMBOK 
PMBOK provides a knowledge base and roadmap for effective project 
management while PRINCE2 provides a more pragmatic ‘How To’ approach. Both approaches are customisable which is beneficial as it allows for better integration into the level of project management maturity the organisation is currently at and aspires to be at in the future.

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 Benefits and limitation s of a single methodology 
 Benefits of a single methodology: 
• Provides a structured step-by-step approach to managing projects. 
• Stages in the methodology become familiar which speed up the 
completion of the project. 
• Helps to keep the project on track and to identify any deviations at 
an early stage. 
• Users become familiar with the tools and reports used, so can 
compare different projects. 
• Team members and project managers become familiar with the 
approach used and this improves the overall management of 
projects. 
• The methodology can be developed over time and can result in a 
best practice approach. 
Limitations of a single methodology: 
• If the methodology selected is unsuitable , it may make managing 
projects more difficult. 
• No one methodology can be suitable for all projects. • All projects are different, so the methodology may need modifying 
for each project, but this may be difficult. 
• Some methodologies will be too detailed for smaller projects. • Strictly adopting a methodology may become too bureaucratic. 
• All features of the methodology may not be required for all projects. 
9  PRINCE2 methodology 
PRINCE2 is a project management methodology, capable of supporting 
complex projects. The UK Government as an open standard method for managing Information Technology projects originally launched PRINCE in 1989. Since then it has been adopted by many organisations both within government and in outside industry for all types of projects. 
PRINCE2 (PRojects IN Controlled Environments, version 2) is a process-based 
approach for project management providing an easily tailored and scaleable method for the management of all types of projects. Each process is defined with its key inputs and outputs in addition to the specific objectives to be achieved and activities to be undertaken.

366  
The main purpose of PRINCE2 is to deliver a successful project, which is 
defined as: 
• delivery of the agreed outcomes • on time 
• within budget 
• conforming to the required quality standards. 
To do this it contains a large number of control elements which can be applied 
to all sorts of projects, small and large. 
The main control features are: 
• It enforces a clear structure of authority and responsibility. • It ensures the production of key products – PID, project budget, plan & 
progress reports. 
• It gives a clear understanding of the tasks to be completed. • It contains several quality controls, such as clearly defined procedures. 
PRINCE2 structure 
The major component parts of the PRINCE2 methodology address the issues 
of: 
• Organisation  – PRINCE2 suggests using an organisation chart for the 
project so that there is  a clear structure of authority and responsibility. 
Everyone on the project should understand their role and responsibility for 
the delivery of objectives. 
Within PRINCE2, responsibilities are defi ned in terms of roles, rather than 
individuals. The basic PRINCE2 project organisational structure is 
illustrated below (arrows indicate accountability):

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• Plans  – successful control includes setting plans/standards for everything 
that needs to be delivered (time, quality, responsibility, communication). 
• Controls  – regular and formal monitoring of actual progress against plan 
is essential to ensure the timeliness, cost control and quality of the project. 
• Products  – includes a number of tools associated with the control of 
projects (initiation document, budget, progress reports). 
• Quality  – quality should be defined and controlled on the project. The aim 
should be zero defects. Quality plans (PQPs) should set the standards 
required. 
• Risk  management  – identifying different types of risk will allow us to plan 
to reduce them or avoid them. 
• Control of change management and configuration management  – any 
change to the project should only be after the appropriate approval has been authorised. The management of these changes means knowing which versions are the current ones. 
PRINCE2 process areas 
• Starting up a project  – a pre-project process, this stage involves 
designing and appointing the project management team, creating the initial stage plan and ensuring that information required by the project team is available. 
• Initiation  – similar to a feasibility study, this stage establishes whether or 
not there is the justification to proceed with the project. The Project Board take ownership of the project at this stage. 
• Managing stage boundaries  – the primary objective at this stage is to 
ensure that all planned deliverables are completed as required. The Project Board is provided with information to approve completion of the current stage and authorise the start of the next. Lessons learned in the earlier stages can be applied at later stages. 
• Controlling a stage  – monitoring and control activities are carried out by 
the project manager at each stage of the project. This process incorporates the day-to-day management of the project. 
• Managing product delivery  – this includes effective allocation of Work 
Packages and ensuring that the work is carried out to the required quality standard. 
• Project closure  – bringing the project to a formal and controlled close 
approved by the Project Board, it establishes the extent to which the objectives have been met, the extent of formal acceptance obtained of deliverables by the Project Customer, and identifies lessons learned for the future. An End Project Report is completed and the project team disbanded.

368  
Whilst these could all be considered to be elements of any good project 
management, the difference with PRINCE2 is the level of structure and documentation that is required. This helps in providing controls on the planning and execution of projects and forces the identification of potential problems. 
Note:  students are advised to read the article on PRINCE2 from the Cimaglobal 
website. It can be found using the following link: 
http://www.cimaglobal.com/Documents/ImportedDocuments/ PRINCE2_P5_article.pdf 
10 The Project Management Body of Knowledge (PMBOK) 
While not strictly a methodology, the US-based Project Management Institute (PMI) has defined best-practice project management principles and processes. The Project Management Body of Knowledge (PMBOK) describes nine key areas in terms of inputs, outputs, tools, techniques and how they fit together. 
The PMBOK describes nine Project Management Knowledge Areas: 1 Integration  Management – processes for ensuring that the various 
elements of the project are properly co-ordinated. 
2 Scope  Management – processes for ensuring that the project includes all 
the work required and only the work required to complete the project 
successfully. 
3 Time  Management – processes for ensuring timely completion of the 
project. All projects are finite, and time ranks as one of the main limits. 
4 Cost  Management – processes for ensuring that the project is completed 
within the approved budget. All projects must have a budget. 
5 Quality  Management – processes for ensurin g that the project will satisfy 
the needs for which it was undertaken. 
6 Human  Resource  Management – processes required to make the most 
effective use of the people involved in the project. 
7 Communications  Management – processes required to ensure timely 
and appropriate generation, collection, dissemination, storage, and ultimate distribution of project information. 
8 Risk  Management – processes concerned with identifying, analysing and 
responding to project risk. 
9 Procurement  Management – processes for acquiring goods and services 
from outside the performing organisation. 
PMBOK is not intended as an alternative to the project life cycle, but rather as a view of the knowledge and skills required in order to carry out each of the stages of the life cycle. It can be viewed as a toolbox. So, for example, at the ‘initiating’ stage, the project manager would need to consider integration management activities, scope management activities, and so on.

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 RST, a manufacturer and retailer of fashion clothes, has invested in a 
new technology system to improve the logistics of the movement of 
clothes between its warehouses and chain of 250 retail outlets. Ensuring that the outlets have the right supply of clothes is a critical success factor for the company. 
However, the warehousing stock control and logistics project set up to 
develop and deliver the new system has experienced numerous problems. The project ended up being well over budget and was also late in delivering the system. Now, only three months after the new system 
has been installed, it is apparent that the project has not delivered its 
objective. Instead, the company is facing a crisis with many store managers complaining that they are not receiving the correct stock. Even worse, some stores are out of stock of key ranges, whereas the warehouses are full of clothing. 
RST’s CEO (J) held a meeting with the project manager and some of the 
project team. It ended up with everyone blaming each other, saying it was not their responsibility. It is clear that they did not use a project management methodology and did not have adequate control systems in place so that the problems that have now transpired could have been identified and rectified earlier in the project life cycle. 
Required: 
You have been asked for help by J. Write an email to J recommending a 
project management methodology/approach, explaining how it could have helped to prevent the failures of the warehousing, stock control and logistics project. 
 
Why do some projects fail? 
Despite the use of a strong project methodology, extensive use of project 
management software and detailed project planning, projects can still go spectacularly wrong, over schedule and/or budget. 
Here are some common reasons why projects can still fail: 
• Poor leadership . One of the most important elements for a successful 
project is a good project manager. A project manager who does not 
demonstrate all of the required skills may not be able to effectively manage the project team and in turn may struggle to deliver the project successfully. 
• Emphasis on maintaining the plan rather than managing the project . 
In a large project, maintaining the plan can be a full-time task. This can leave little time for dealing with important project issues. It is often better for project managers to delegate the input/maintenance responsibility to a project administrator and receive regular reports as a basis for managing the project.

370  
• Resources may not be managed realistically . This especially applies 
when tasks are over-budget. Adding new people into a project at a late 
stage can make it later since the new team members will be slower at 
grasping what is required and actually divert the attention of other team members. 
• Poor estimates . For planning purposes, the accuracy of estimates is vital 
to the identification of the critical path and the key milestones of the project. However, estimates are subjective and can vary wildly. Also, estimates have been made at a fixed point in time with a particular set of assumptions. 
• Inadequate skills . Projects require project teams made up of individuals 
with the right skill sets. Project plan tend to talk about resources when actually they are referring to human beings with all the uncertainty that it brings. Where one individual may find a task within his/her skillset, another 
person may struggle. It matters which person does which task and this is 
not always well planned. 
• Work breakdown . Some projects fail because the work breakdown into 
tasks does not match with how peopl e work. Work breakdown assumes 
discrete units of work that someone will spend a fixed amount of time on a 
task before moving to the next task and not all projects will work in this 
way. 
11  Planning for risk and uncertainty 
Risk and uncertainty 
Another important activity which is carried out at the initiation stage is to undertake a risk assessment to consider the risks associated with the proposed 
project and to consider how  these risks can be managed. 
Risk management process

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• Identify risk – produce a list of risk items. 
• Analyse risk – assess the risk in terms of the probability of it materialising 
and its potential impact if it was to materialise. 
• Prioritise – produce a ranked ordering of risk items. • Management – plan how to address each risk item, perhaps by avoiding, 
transferring or reducing the risk. (see below) 
• Resolution – produce a situation in which risk items are avoided or 
reduced. 
• Monitoring – continually monitor the progress towards resolving risk, and 
identification of new risks. 
Managing risk 
Once the risks have been identified they can be analysed depending on their 
relative likelihood and impact. They can then be plotted on the following grid which helps determine the best way to manage each risk. 
 
A useful way to remember the risk management approaches is TARA  
(Transfer, Avoid, Reduce, Accept): 
 
Transfer Risks with low likelihood and high impact can be transferred, for example by subcontracting the risk to those more able to handle it, such as a specialist supplier or by insuring against the risk. 
Accept Low likelihood and low impact risks can be accepted. Some risks are an inevitable part of doi ng business. It is important 
to continue to monitor these risks to ensure that their potential impact or likelihood do not increase.

372  
Reduce Risks with high likelihood and low impact should be 
reduced. An alternative course of action with a lower risk exposure could be taken or investment could be made in additional capital equipment or security devices to reduce risk or limit its consequences. Another way of reducing risk is to implement more internal controls. 
Avoid If any risks are defined as high likelihood and high impact, the project should be abandoned as the risk is too great. 
Uncertainty 
Unlike risk, uncertainty is impossible to evaluate because it is impossible to assign probability to an uncertain event. If the event is uncertain we cannot put in place management control to reduce the probability of its occurrence, simply 
because we do not know that probability. Instead we must use contingency planning. 
Contingency planning 
Contingency planning involves considering alternative actions which could be 
taken if uncertain events occur. 
Contingency plans may include: 
• contacting lenders to discuss possible additional finance. 
• re-planning the remaining project with a longer duration. • identifying if required materials are available from other possible suppliers. 
The purpose of contingency planning is to avoid unnecessary delays in the 
project. The contingency plans may never be used, but we can do our contingency planning when it suits us. If we wait for the uncertain event before doing any planning, this may further delay the project. 
 
Case study style question 4 
 It is often claimed that all project management is risk management since 
risk is an inherent and inevitable characteristic of most projects. The aim 
of the project manager is to combat the various hazards to which a project may be exposed. 
L is a new project manager and is about to undertake her first project. 
She is concerned about risk management as she knows it is an important part of her role as project manager. She has come to you for advice. 
Required: 
Write an email to L explaining the concept of risk and the ways in which 
risk can be managed in a project. 

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Dealing with risk and uncertainty when planning for time 
Risk and uncertainty at the initiation stage of the project has been covered 
above. At the detailed planning stage, risk and uncertainty must be considered again when the project manager is planning the time aspect of the project. There are a number of techniques which can assist with this: 
• Project evaluation and review technique (PERT) • Scenario planning 
• Buffering. 
Project evaluation and review technique (PERT)  
This can be used to overcome uncertainties over times taken for individual 
activities in a network diagram. 
Each task is assigned a time. 
• An optimistic (best) time (o) • A probable time (m) 
• A pessimistic (worst) time (p) 
It then uses a formula to calculate an expected time, and by calculating 
variances for each activity, estimates the likelihood that a set of activities will be completed within a certain time. 
The expected time for each activity is then calculated as: 
= o	+	4m	+	p
6
 
These estimates are used to determine the average completion time. 
Advantages: 
• It gives an expected completion time. 
• It gives a probability of completion before the specified date. 
• It gives a Critical Path. 
• It gives slack through earliest and latest start times. 
• It allows calculation of contingency to be added to the plan. 
Limitations: 
• The activity times are very subjective. 
• Assumes probability distribution of project completion time as the critical 
path.

374  
Scenario planning 
Although the use of PERT is one way to cope with risk in time planning there 
are ways of planning in a contingency for risk that are less complex. Wherever risk is identified as taking the form of alternative outcomes, a series of contingency or scenario plans may be constructed for each alternative. 
Scenario planning involves considering one or more sets of circumstances that 
might occur, other than the ‘most likely’ or ‘expected’ set of circumstances used 
to prepare the budget or plan for a project. Each set of assumptions is then tested to establish what the outcome would be if those circumstances were actually to occur. 
This would allow the project manager to switch to the appropriate plan for 
whichever contingency arose. 
Buffering 
A more simplistic way to incorporate risk by adding artificial slack into risky 
activities. It adds padding to the original estimates and allows for the fact that it can be very difficult to ensure that all stages and activities are carried out exactly as planned. This is known as 'buffering', but should not be encouraged because it leads to a build-up of slack in the programme and may lead to complacency. 
Gantt Chart 
This is an alternative or complementary approach to network analysis. It also 
provides a graphical representation of project activities and can be used in both project planning and control. 
A Gantt chart is a horizontal bar chart where the length of the bar represents the 
duration of the activity. 
When a Gantt chart is used to help control a project it is usual to use two bars, 
one showing the planned duration and the second showing the actual duration. 
To create a Gantt chart: 
• Display a schedule of activities using bars. 
• List the activities down the side of the page. 
• Using a horizontal timescale, draw a bar for each activity to represent the 
period over which it is to be performed. 
• Both budgeted and actual timescales can be shown on the same chart.

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 Illustration 3 – Gantt chart example 
 An example of a project undertaken to examine the current procedures in 
the accounts payable department. 
The project manager's first step is to break down the project into phases: 
 
  Estimated time 
to complete 
Phase 1 Document current procedures 4 days 
Phase 2 Produce flowcharts 3 days 
Phase 3 Summarise paper flow and methods for 
receiving, processing and sending information 5 days 
Phase 4 List problem areas and develop initial recommendations 6 days 
Phase 5 Develop improved processing procedures 3 days 
Phase 6 Track sample transactions for one 
week under existing procedures 5 days 
Phase 7 Track sample transactions for two weeks under proposed new procedures 10 days 
Phase 8 Prepare and deliver a final report to the 
treasurer, including recommended changes in procedures and an estimate of savings 2 days 
   
This could then be expressed in a Gantt chart using the most common method, the bar chart, the start of which is shown below. The budgets for the activities are shown, together with the actual durations underneath:

376  
Benefits of Gantt charts: 
The Gantt chart shares some advantages with network analysis: 
• Assists in identifying all activities required for completing the project • It will assist in identifying those activi ties that need to be completed before 
happen at the same time (parallel activities) 
• The Gantt chart will show the minimum completion time for the project, 
and will allow for sensitivity analysis to be introduced into the project. 
In addition, the Gantt chart has further advantages over network analysis: 
• Easier visualisation of relationships 
• Unlike CPA, activities are drawn to scale so the most significant activities 
can be highlighted 
• It is drawn in real time • Actual durations can be shown alongside budget 
• Aids resource allocation. 
Limitations of Gantt charts: 
The Gantt chart is a useful tool for tracking your project and anticipating delay 
problems before the final deadline is compro mised. However, it will be of limited 
use when you have to deal with a relatively large project team. The more complex the team structure the higher the likelihood of schedule delays. 
Remember, charting phases and monitoring progress is only a tool, not the 
solution itself. 
For the more complex projects the Gantt chart has the following limitations: 
• It does not identify potential weak links between phases. 
• The chart does not reveal team problems due to unexpected delays. 
• The chart does not coordinate resources and networking requirements 
needed at critical phases of the schedule. 
• It does not show the degrees of completion for each phase.

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 A new on-line order entry system is currently being developed in your 
organisation. As part of the implementation procedures, users of the new 
system will require a number of training activities. 
K has just taken over as project manager from H who left the project due 
to ill health. K has found the following network diagram for the project but is not sure what it tells him. 
 
Required: 
Write an email to K, explaining the information he should be able to 
establish from the network diagram. You should also explain how a Gantt 
chart might be of more use in this context. 
Milestones and control gates 
One of the main reasons for constructing a network diagram is to improve the 
control of the project duration. 
In order to facilitate this, a number of milestones can be identified in the 
network. They are not specifically shown on the diagram (except of course for the end activities), but they are shown on a Gantt chart as a small triangle or other symbol. 
A milestone , as the name implies, is an event that is clearly identifiable as a 
measure of how far the project has progressed, and how far it has to run. This 
involves partitioning the project into identifiable and manageable phases that are well defined key events and unambiguous targets of what needs to be done and by when, and should be established during the project planning phase. 
Milestones are important in assessing the status of the project and quality of the 
work. Monitoring the milestones enables the project manager to keep control over the projects progress, and allows any delays to be identified immediately.

378  
Some milestones are key points in the project life cycle which give the project 
sponsor or steering committee an opportunity to review project progress, and make a decision whether to proceed further or to terminate the project. These milestones are called control gates  and represent the significant completion of 
milestones. A gate can only be ‘passed’ if the progress meets pre-defined performance standards. This could take the form of technical reviews or completion of documents. 
Control gates should be identified in the project plan and a review will be 
required to formally pass each gate. If at the gate review the criteria have not been met, the project should not continue. This may mean changes are needed to the overall project plan.

380  
 Question 1 
 There are a number of tools and techniques used when managing 
projects, including: 
• Work breakdown structures 
• Network analysis 
• Milestones 
• Resource histograms 
• Product breakdown structures 
• Project quality plan 
Match the tool or technique to its purpose. 
• To identify the product purchases required for each activity 
• To graphically represent the logical order of activities 
• To determine the resource requirements for the project 
 
 Question 2 
 Which THREE of the following are PRINCE2 process areas? 
A  Controlling a stage 
B  Identification of a need C  Managing product delivery D  Planning E  Post completion audit F  Project closure

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 Question 3 
 The following shows a network diagram for a project. The durations are 
shown in weeks. 
 
Using this diagram, which of the following statements are true? Select all 
A  The overall duration of the project is 13 weeks B  The critical path is ADGH C  Activities B and E have slack of 3 weeks D  Activities D and G have slack of 7 weeks E  Activity E is on the critical path 
F  The critical path is ACFH 
 
 Question 4 
 Which of the following statements regarding critical path analysis is 
FALSE? 
A  Each activity line must begin and end with a node B Latest event times are calculated working left to right C  When there is a choice in calculating the earliest event time, select 
the highest 
D  Activities that are not on the critical path will have float

382  
 Question 5 
 When pl anning a project, th ere are a number of te chniques that are used 
to take account of risk and uncertainty: 
• PERT 
• Buffering 
Match the descriptions to the technique. 
• This technique involves considering and testing one or more set of 
circumstances which may occur. 
• In this technique artificial sl ack is added to risky activities. 
• This technique involves using a formula to calculate an expected 
time for each activity. 
 
 Question 6 
 Which of the following are project management knowledge areas as 
defined by the Project Management Institute? Select all that apply. 
A  Communications B  Legal C  Leadership D  Procurement E  Integration F  Scope 
 
 Question 7 
 The following diagram shows a critical path diagram for a network. The 
durations are shown in weeks. 
 
Which of the following statements regarding activity B is true? A  There is no slack in activity B. B  Activity B is on the critical path. C  Activity B can overrun by 2 weeks. D  Activity B can only start after the completion of activity A.

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 Question 8 
 Which of the following statements regarding project management 
software are true? Select all that apply. 
A  Software can only be used at the planning stage of the project B  Software improves the accuracy of drawing network diagrams C  Using project management software will ensure the success of the 
project 
D  Software can be used to undertake 'what if' analysis E  Using software can improve communication during a project 
 
 Question 9 
 Which of the following statements regarding milestones and gates is 
incorrect ? 
A  A milestone is used to measure the progress of a project B  If a milestone is not met, the project should not continue C  Milestones can be shown on gantt charts D  A control gate can only be passed if progress meets pre-defined 
performance standards 
 
 Which TWO of the following statements regarding the PRINCE2 structure 
are correct? A  In the PRINCE2 organisation chart, the project manager reports to 
the project sponsor. 
B  The project committee is made up of senior user, senior supplier 
and project support. 
C  The PRINCE2 structure includes organisation, plans, controls, 
products, quality, risk management and control of change 
D Initiation documents, budgets and progress reports are part of the 
PRINCE2 products. 
E The project assurance team is made up of business assurance co-
ordinator, customer assurance co-ordinator and supplier assurance co-ordinator.

384  
 EMAIL 
To: Project sponsor  
From: Project manager  Date: today 
Subject: Project YT – Network diagram 
I have completed the network diagram for project YT. This is shown 
below: 
 
The diagram gives us a number of pieces of information which will be helpful to us in running the project. 
From the diagram, the overall duration of the project is 27 weeks. A number of the activities are deemed to be ‘critical’. Critical activities are 
those activities which must be done on time, or the overall duration of the project will be extended to beyond 27 w eeks. In project YT, the critical 
activities are A, B, E, F, G and I. Extra care must be taken to ensure that these activities run to plan. 
The diagram also highlights those activities which have float, or slack. 
Activities with float or slack in this project are C and D which have one week of float, and H which has nine weeks. 
I hope this information is useful to you. Please get in touch if you have 
any questions or want to discuss any aspects further.

Chapter 10 
 385 
 EMAIL 
To: K 
From: Management Accountant   Date: today 
Subject: Network diagram 
I have reviewed the network diagram for the on-line entry system project. 
The diagram gives us a number of pieces of information which will be helpful to you in running the project. 
From the diagram, the overall duration of the project is 14 weeks. A number of the activities are deemed to be ‘critical’. Critical activities are 
those activities which must be done on time, or the overall duration of the project will be extended to beyond 14 weeks. In this project, the critical activities are B, D and E. Extra care must be taken to ensure that these activities run to plan. 
Activities with float or slack in this project are A and C which have one week of float. 
The network diagram is useful in giving the above information, but it can 
be difficult to understand. Another tool which could be used to show much the same information is the Gantt chart. This is a straightforward method of scheduling tasks; it is essentially a chart on which bars represent each task or activity. The length of each bar represents the relative length of the task. Its advantages lie in its simplicity, the ready acceptance of it by users, and the fact that the bars are drawn to scale. 
It also has the advantage over the network diagram in that the actual 
activities can be added alongside the scheduled activities which is useful in monitoring progress once the project is underway. 

386  
 REPORT 
To: Management of XYZ 
Subject: Critical path analysis and use of project management 
software Introduction 
In this report the importance of undertaking critical path analysis will be 
explained and the useful of using project management software will also 
be explained. 
The importance of critical path analysis 
Critical path analysis is an important technique to assist with project 
management, when a project has to be completed within a given amount of time, or before a final target date. A CPA chart shows all the activities that must be carried out in order to complete the project, the sequence in which they must take place, the budgeted time for each activity, the minimum overall completion time for the project and the earliest times that each activity can start and must be finished to make sure that the target project completion date is achieved. The analysis therefore enables management to: 
• decide whether the target date for completion is achievable • if the target date is achievable, what is the latest time the project 
can begin 
• identify which activities are critical to completion on time and must 
be started at the earliest possible time 
• identify those activities that are non-critical, and how much 'slack' 
they have, so that they can be started late or might take longer than 
planned without affecting the overall project completion time 
• identify which activities cannot start until another activity (or other 
activities) have finished, and which activities can be undertaken in parallel with each other. 
Regular monitoring of actual progress against the CPA chart will provide management with valuable information to assist with efforts to ensure completion of the project on time. 
Project management software 
Project management software can be used throughout the project in a 
number of ways. It is especially useful in planning, estimating, monitoring and reporting.

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 Planning 
Project management software can be used to enter activities, estimates, 
precedents and resources to automatically produce a network diagram (showing the critical path) and a Gantt chart (showing resource use). These diagrams can be difficult to produce. 
Estimating 
Project management software allows the entry of actual data – the hours 
or days actually taken to complete a particular task. Many of these tasks are the same in systems development across different projects and so a 
considerable amount of information can be collected about the time taken 
to complete common tasks. 
Monitoring 
Project management software allows the entry of actual data, which can 
be used to monitor the progress of the project and to re-plan the rest of the work. 
Reporting 
Most project management software packages have comprehensive 
reporting requirements, which allow managers to print out the progress and status of the project. This means that standard progress reports can be produced automatically. 
This report has looked at two important project management tools, 
namely critical path analysis and project management software. Both of these assist in the management of the project. 
 
 EMAIL 
To: L From: Management Accountant  Date: today 
Subject: Risk management 
Risk can be defined as the probability of an adverse or undesirable event 
occurring. Undertaking any project carries an element of risk and project management will be concerned with understanding what is risky about a particular project or activity within the project. Essentially this will involve identifying the different risks withi n the project and then deciding how 
best to manage them.

388  
 Risk management can be seen as a process which follows a number of 
key stages. 
The first stage is to identify the risks. A list of all risks within the project 
should be produced and a risk register produced. 
Each risk should them be analysed with the intention of prioritising them 
so that your efforts are directed towards the most important risks first. Different levels of risk require different management strategies. This analysis will help you to decide on t he best way to manage each risk. 
Risks can be analysed by considering the probability of the risk occurring 
and the likely impact on the project should they occur. The likelihood and impact of each risk should be assessed as either high or low allowing the outcomes of the assessment to be plotted on a matrix as shown below. 
 
The matrix is used to suggest the appropriate strategy to be used to manage each category of risk. 
• Avoidance of risk. The only way to completely remove risk is to 
avoid the activity giving rise to it. If you analyse any risk to be high 
impact and high likelihood, the best course of action would be to abandon the project. 
• Reduction of risk. Where the risk cannot be fully removed, its 
likelihood should be reduced. This can be done by improving internal controls or bringing in new processes.

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 389 
 • Transference of risk. The risk is unlikely but the impact would be 
significant. In this case it is best to try to pass the risk on to 
someone else, for example through insurance or sharing the risk with another party such as a supplier or sub-contractor. 
• Acceptance of risk. This is when the potential risk is accepted in the 
hope or the expectation that the incidence and consequences can be coped with if necessary, perhaps having contingency plans should the risk occur. Risk exists in all business and a certain level of risk must be accepted. 
It is important to remember that risk management is a continuous process throughout the life of the project. It is therefore important not to view risk management as a one off exercise carried out at the start of the project, rather an ongoing activity throughout the project. Regular review and monitoring must be carried out to ensure that the risks identified are 
being properly managed and that new risks have not appeared. 
The above steps will enable you to monitor risk factors and take 
appropriate action throughout the project. 
I hope you have found the above useful, please get in touch if you need 
any more information about this. 
 
 EMAIL 
To: J 
Subject: Project management methodology 
A project management methodology that could have been used by RST 
is PRINCE2. This is an acronym for PRojects IN Controlled Environments and is a structured approach to project management, used by the UK government and private sector organisations. It includes bureaucratic controls on the planning and execution of projects, identifies some of the potential problems that may arise and early resolution. Whilst it could be argued that aspects of PRINCE2 could be considered to be just good project management, the difference is in the level of structure and documentation required. 
The key processes of PRINCE2 methodology offer a number of features 
that would have benefited RST including: 
• A defined management structure

390  
 • A system of plans 
• A set of control procedures 
• A focus on product based planning. 
The main purpose is to deliver a successful project, which can be defined 
as: 
• Delivery of agreed outcomes 
• On time 
• Within budget 
• Conforming to the required quality standards. 
PRINCE2 has a set of progressive documents for a project and control is 
achieved through the authorisation of work packages. These include controls on quality, time and costs and identify reports and handover requirements, all of which are problems that have led to the failure of the project in RST. The methodology includes a series of ‘management products’, for example project initiation documents, project budget, quality plan and various checkpoint and progress reports, which would have improved controls for RST’s project. 
The key processes and documentation of PRINCE2 would have enforced 
the project team in RST to have a clear structure of authority and responsibility between members in the project team, so that each party has clear objectives. As part of this, the control responsibilities of the various members of the project team would have been determined. This should mean that the different participants in the warehousing stock control and logistics project would have had a clearer understanding of the various tasks and the relationships between them and should have prevented the problems RST is now facing. 
The exception plan concept in PRINCE2 would mean that if RST’s project 
was going to exceed its tolerance, for example variances in time, cost or quality, this would have been reported to the project board. The implications on the whole project deliverables should have been discussed and plans amended to reflect any changes needed to ensure the project delivered its objectives. 
any more information about this.

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 391 
 Question 1 
Product breakdown structures  – To identify the product purchases 
required for each activity. 
Network analysis  – To graphically represent the logical order of 
activities. Resource histograms  – To determine the resource requirements. 
Work breakdown structures are us ed to break complex tasks into 
manageable pieces. Milestones are used to assess the status of the project and how far the 
project has progressed. 
Project quality plans are used to detail the standards required in the 
project. 
 
 Question 2 
 A, C and F 
The other PRINCE2 process areas are: 
• Starting up a project • Initiation 
• Managing stage boundaries 
 
 Question 3 
 A, C and F 
The true statements are: 
• The overall duration of the project is 13 weeks • Activities B and E have slack of 3 weeks 
• The critical path is ACFH 
 
 Question 4 
 B 
This is false as latest event times are calculated working right to left.

392  
 Question 5 
PERT  – This technique involves using a formula to calculate an expected 
Scenario  planning  – This technique involves considering and testing 
one or more set of circumstances which may occur. Buffering  – In this technique artificial slack is added to risky activities. 
 
 Question 6 
 A, D, E and F The project management institute's nine process areas are 
communications, procurement, integration, scope and: 
• time • cost 
• quality 
• human resources 
• risk 
 
 Question 7 
 C 
Activity B has slack of 2 weeks. It is therefore able to overrun by 2 weeks 
without affecting the overall duration of the project. 
Given that the activity has slack, it cannot be on the critical path as 
activities on the critical path must start and end as scheduled. 
From the diagram it can be seen that activity B can start right at the 
beginning of the project and has no preceding activities. 
 
 Question 8 
 B, D and E 
Project management software can be used throughout the project. Using 
software will contribute to the success of the project but cannot guarantee it.

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 393 
 Question 9 
 B 
This is incorrect as a milestone is simply a measure of progress in the 
project. If a control gate is not met, the project should not continue. 
 
 C and D 
In the PRINCE2 organisation chart, the project manager reports to the 
project committee and the project assurance team. 
The project committee is made up of senior user, senior supplier and 
executive. 
The project assurance team is made up of business assurance co-
ordinator, user assurance co-ordinator and specialist assurance co-ordinator.

395 
Project leadership 
C3: Explain the concepts of 
project leadership (a) Project structure 
(b) Roles of key project 
personnel 
(c) How to manage project 
stakeholders 
• Project structures and their impact on project performance 
• Role of key members of project team 
• Managing key stakeholders of projects 
• Leading and motivating project team. 
 
  Chapter 
11

396  
 
2  Who is involved in the project? 
A lot of the material in this chapter will be familiar from the earlier chapters on 
relationship management. Much of the material in the relationship management part of the syllabus will be equally applicable in the context of a project. 
A key aspect in ensuring the success of a project is having the right people 
involved in the project. Decisions need to be made about the people involved in the project after the need for the project has been identified and the methodology has been selected. 
Having the right people, with the right knowledge and skills, involved in the 
project will significantly enhance its chance of success. 
There are various interested parties who are involved in or may be affected by 
the project activities. They are known as its ‘ stakeholders’, as they have a 
‘stake’ or interest in the effective completion of the project. Obviously, the number of people involved will depend on the size of the project. 
A project is much like an organisation in that it has a hierarchical set of 
relationships. This hierarchy is put in place for two main reasons: 
• to create a structure of authority so everyone knows who can make 
decisions, and 
• to create a series of superior-subordinate relationships so each individual 
or group has only one ‘boss’. 
Project stakeholders should all be committed to achieving a common goal – the 
successful completion of the project.

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Stakeholder hierarchy 
Based on the principles of 'one person – one boss' and a decision-making 
authority, the hierarchy shown below is adapted from the one shown in 
Successful Project Management , Gido and Clements  (1999). 
 
The roles of the various stakeholders: 
Project sponsor: 
The project sponsor makes yes/no decisions about the project.  
The role of the sponsor: 
• Initiates the project. They must be satisfied that a business case exists to 
justify the project. 
• Appoints the project manager. 
• Makes yes/no decision regarding the project. The sponsor is responsible 
for approving the project plan. 
• Provides the resources for the project and are responsible for its budget. • Monitors the progress of the project from the information provided by the 
project manager. 
• Provides support and senior management commitment to the project.

398  
Project owner: 
The project owner is the person for whom the project is being carried out. They 
are interested in the end result being achieved and their needs being met. They are more concerned with scope and functionality than in budget. The project owner may be the head of the department for which the project is being carried out. The owner may represent the users (the members of the department). The project owner is a senior stakeholder and would usually sit on the steering committee, and may chair this committee instead of the project sponsor. 
Project customers/users: 
The customer/user is the person or group of people whose needs the project 
should satisfy. The fact that this stakeholder is a ‘group’ leads to its own problems. It may be difficult to get agreement from the customers as to what their needs are; indeed there may be conflicts within the customer group. Conventional logic dictates that users should be, if possible, invited to participate in the project. This may simply mean representation on the steering committee, or may involve being part of the project team. Users, like the project owner, are primarily interested in the scope of a project. However, they may try to ‘hijack’ the project to satisfy their own personal objectives, rather than those of the organisation. This may bring them into conflict with the project owner, despite theoretically being ‘on the same side’. In the case of the new finance system, the users would come from the different parts of the finance function. 
In small projects, the sponsor, owner and customer may be the same 
person. 
Project manager:  
The project manager is responsible for the successful delivery of project 
objectives to the satisfaction of the final customer. As projects are interdisciplinary and cross organisational reporting lines, the project manager has a complex task in managing, coordinating, controlling and communicating project tasks. 
The role of project manager involves: 
• Ensuring project objectives are achieved. 
• Making decisions relating to system resources. 
• Planning, monitoring a nd controlling the project. 
• Selecting, building and motivating the project team. • Serving as a point of contact with management hierarchy. 
• Communicating with the chain of command. 
• Selecting and managing subcontractors. 
• Recommending termination where necessary.

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In essence, the project manager takes re sponsibility for providing leadership to 
the project team who carry out the project tasks in order to achieve the project 
objectives. The project manag er will lead and coordinate  the activities of the 
project team to ensure that activities are performed on time, within cost and to the quality standards set by the customer. An important aspect of project management is to ensure that the team members are organised, coordinated and working together. 
Project team: 
The members of the project team will be given individual responsibility for parts 
of the project. As projects are often interdisciplinary and cross organisational 
reporting lines, the project team is likely to be made up of members drawn from a variety of different functions or divisions: each individual then has a dual role, as he or she maintains functional/d ivisional responsibilities as well as 
membership of the project team. 
Project steering committee/project board 
Overseeing the project and making all high level decision regarding the project 
will be a steering committee or project board. In smalle r projects there will be 
either a steering committee or a project board, but larger scale projects will have both. Where a project has both, the project board sits above the steering committee in the hierarchy and is in charge of the overall management of the project. All high level decisions regarding the project will be made by the board. 
While the steering committee may meet monthly, the board will meet less 
frequently, maybe only several times a year. They will require progress reports 
about the project, but these will be high level reports, focusing on the main 
aspects of the project. A strong project board can make the difference between success and failure of a large, complex project. 
The steering committee/board will normally be chaired by the project sponsor 
and the members should represent all major areas of interest in the project, for example the project owner would sit on the committee/board. The representatives of each area should be at a sufficient level of seniority so that they have the authority to take decisions on behalf of their areas. The project manager will report all progress to t he steering committee/project board. 
Project Champion 
Some high profile projects may have a project champion, or supporter. This is 
an informal role within the project, with no decision making or reporting responsibility. The role of the project ch ampion is simply that, to campaign on 
behalf of the project at the highest levels of the organisation. They will show their support of the project by marketing it at every opportunity, even though they have no formal role in the project.

400  
Other stakeholders 
In addition to the above, suppliers, subcontractors and specialists are also 
important stakeholders. The project will often require input from other parties, 
such as material suppliers or possibly specialist labour, such as consultants. Each of them will have their own objectives, some of which conflict with those of the project. For example, suppliers will seek to maximise the price of the supply, and reduce its scope and quality, in order to reduce cost. This conflicts directly with the objectives of the sponsor and customers. In the case of the new finance system, suppliers may provide hardware and software, and specialists might include members of the organisation’s IT, purchasing or internal audit departments. 
The role of Certified Management Accountants (CMAs) in projects 
Management accountants can undertake a variety of roles within projects, 
including: 
Project manager  – many accountants undertake the role of project manager. 
The range of skills possessed by the management accountant, such as 
leadership, communication and analytical skills are th e skills required by the 
Project sponsor  – the project sponsor, who supplies the funding for the project 
is often a senior member of the finance function. Project customer/user  – all areas within organisations can be affected by 
projects and many projects will have an effect on the financial systems and 
procedures, therefore the management accountants will often be involved in terms of assessing the impact the changes will have on the accounting function. 
Member of project team  – management accountants are often required to be 
part of project teams. They bring financial knowledge and are able to analyse 
and advise on the financial impact of the project on the organisation. 
Providing financial information for the project  – the finance department is 
often involved in supplying financial information to the project manager. At the 
outset of the project when the economic  feasibility is being considered, the 
management accountant would be involved in undertaking the cost-benefit analysis. Throughout the project, the project spend should be monitored and compared to the original budget and this information is usually produced by the management accountant. 
3  Managing stakeholder relationships 
At the beginning of a project potential stakeholders need to be identified and their interest and power in the project assessed. This is a vital project management activity to enable the relationships within the groups to be managed. A plan can be drawn up to secure and maintain their support and to foresee and react to any problems. The project manager can concentrate on the critical stakeholder rela tionships, assess the risks associated with certain 
groups, indicate where attention needs to be focused and thus reduce the vulnerability of the project.

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The project manager has to balance a number of values, beliefs and 
assumptions in attempting to navigate a project to a successful conclusion. These values, beliefs and assumptions relate to the stakeholders in the project, who may be defined as any party with a vested interest. The ability to be able to discern stakeholder values, beliefs, assumptions and expectations is a positive tool in the project manager’s ‘competence toolbox’, not least because they often conflict and may not always be benevolent to the project. 
Once stakeholders are identified they can be mapped in relation to: 
• The likelihood of each stakeholder group attempting to impress their 
expectations on others. 
• The power and means available for them to do so. 
• The impact of stakeholder expectations on the project. 
Mendelow's matrix, which was covered in the concept of business ecosystems 
chapter and the alternative approaches to business models chapter, could be used to aid the project manager in managing the project stakeholders. 
Stakeholder conflict 
Most conflict within projects arises from the interaction of individuals, and a 
good project manager must have the inte rpersonal skills to  be able to manage 
conflict. 
Within a project, there will be a number of stakeholders and they may not share 
the same objectives, which may cause conflict. Among the most common reasons for conflict within projects are the following: 
• Unclear objectives for the project. • Role ambiguity within the project team. 
• Unclear schedules and performance targets. 
• A low level of authority given to the project manager. 
• Remote functional groups within the project, working almost 
independently. 
• Interference from local or functional management. • Personality clashes, or differing styles of working. 
The project manager should establish a framework to predict the potential for 
disputes. 
This involves: 
• risk management – since an unforeseen event (a risk) has the potential to 
create conflict; and 
• dispute management – matching dispute procedures with minimum impact 
on costs, progress and goodwill.

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The techniques used for dispute management are: 
• Negotiation  – involving the parties discussing the problem. This may or 
may not resolve the problem. 
• Mediation or ‘assisted negotiation’ – involves a neutral third party (the 
mediator) intervening to reach a mutually agreeable solution. In practice, 
disputes are often resolved by accepting the view of the stakeholder that has financial responsibility for the projec t. In such a situation, mediation 
and negotiation may only deliver an outcome that is a reflection of the original power imbalance. 
• Partnering – focuses on creating communication links between project participants with the intention of directing them towards a common goal – ahead of their own self-interest. 
• Compromise – is the most obvious approach to conflict management, 
although it does imply that both parties in the conflict must sacrifice 
something. 
 
 A project is being undertaken by the ABC Regional Health Authority to 
connect all medical centres and hospitals within the region to a national information network, called the ‘Healthweb’. 
You are a senior management accountant working for one of the regional 
hospitals, and, as part of the projec t team, it is your responsibility to 
communicate with all the medical centres and hospitals on the progress of the project. 
ABC is one of four regional government-controlled authorities, 
responsible to the central government. Each regional health authority manages and controls the provision of medical care to the public within its local area. ABC is responsible for fifty medical centres and ten 
hospitals within the region, all of which are publicly funded. The project has been initiated by the central government and T has been appointed as the project manager. 
ABC has been set a target by the central government to have 80% of all 
medical centers and 90% of all hospitals within the region connected to the Healthweb by July 20X7. Prior to the project commencement, most information within the hospitals and medical centres was kept by a manual, paper-based system, and all data exchange was done by means of telephone or by post. The senior management team of ABC set up a project board to oversee the progress of the project and to specify the project objectives.

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 Required: 
You have been asked by the executives of your own hospital to prepare a 
report to the other senior managers in the hospital which should discuss the relationship of T, the project manager to: 
• the project sponsor (i.e., the central government) 
• the project board 
• the medical and administrative users (in medical centres and 
hospitals). 
Your report should also Include a discussion of the potential conflicting 
project objectives of the above stakeholders. 
4  Project manager 
The skills required by a project manager 
The skills that the project manager brings to the project are critical to its 
success. A project manager requires a number of varied skills:

404  
 Main project management skills  
 Leadership 
Leadership is the ability to obtain results from others through personal 
direction and influence. Leadership in projects involves influencing others through the personality or actions of the project manager. The project manager cannot achieve the project objectives alone; results are achieved by the whole project team. The project manager must have the ability to motivate the project team in order to create a team objective that 
they want to be part of. 
Communication 
Project managers must be effective communicators. They must 
communicate regularly with a variety of people, including the customer, suppliers, subcontractors, project team and senior management. Communication is vital for the progression of the project, identification of potential problems, generation of solutions and keeping up to date with the customer’s requirements and the perceptions of the team. 
Project managers should communicate by using a variety of methods: 
• regular team meetings 
• regular meetings face-to- face with the customer 
• informal meetings with individual team members • written reports to senior management and the customer 
• listening to all the stakeholders involved in the project. 
Project managers will have to negotiate on a variety of project issues, 
such as availability and level of resources, schedules, priorities, 
standards, procedures, costs, quality and people issues. The project manager may have to negotiate with someone over whom he or she has no direct authority (e.g. consultants), or who has no direct authority over him or her (e.g. the customer). 
A further key skill required for a project manager is that of delegation. 
A project manager will communicate and clarify the overall project 
objective to the team members, and will then further clarify the individual 
team member’s role in achieving that objective by a process of delegation. Delegation is about empowering the project team and each team member to accomplish the ex pected tasks for his or her area of 
responsibility. The project manager has neither the time nor the skills to 
carry out all the project tasks, so he or she must delegate  responsibility to 
those who do have the skills.

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 Problem solving 
Project managers will inevitably face numerous problems throughout the 
project’s life. It is important that the project manager gathers information about the problem in order to understand the issues as clearly as possible. The project manager should encourage team members to identify problems within their own tasks and try to solve them on their own, initially. However, where tasks ar e large or critical to the overall 
achievement of the project, it is important that team members communicate with the project manager as soon as possible so that they can lead the problem-solving effort. 
Change-management skills 
One thing is certain in projects, and that is change. Changes may be: 
• requested by the customer • requested by the project team 
• caused by unexpected events during the project performance 
• required by the users of the final project outcome. 
Therefore, it is important that the project manager has the skills to 
manage and control change. The impact that change has on 
accomplishing the project objective must be kept to a minimum and may be affected by the time in the project’s life cycle when the change is identified. Generally, the later the change is identified in the project life cycle, the greater its likely impact on achieving the overall project objective successfully. Most likely to be affected by change is the project budget and its timescale. 
 
 The project manage r and negotiation  
 A key skill required by the project manager is negotiation. While running a 
complex project, the project manager may get involved in a number of negotiations. 
The following table gives examples of the types of issues for which the 
project manager may get involved in negotiation.

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Negotiation point Possible issues Negotiate with 
Resources Funding 
Staff 
Equipment Time scale Senior management Line managers Purchasing Customer/senior management 
Schedules Order of activities 
Duration of activities Timing of activities Deadlines Customer/teams 
Line managers/team members 
Line managers/team members Customer/line managers 
Priorities Over other projects or work 
Between cost, quality and 
time 
Of team members’ activities Senior management 
Customer/team members Team members 
Procedures Methods 
Roles and responsibilities Reporting Relationships Team members Team members/customer Senior management/customer Team members 
Quality Assurance checks 
Performance measures Fitness for purpose Customer/teams 
Customer/teams 
Customer/team members 
Costs Estimates 
Budgets Expenditure Accountants/team members Customer/senior management Customer/accountants 
People Getting team to work 
together Getting required skills Work allocations Effort needed Team members Team members/line managers Team members/line managers Team members/line managers 
   
5  Project team management 
The basic project team consists of the project manager (and possible team 
leaders), and a group of specialists assigned or recruited for the project. 
The project team should include everyone who will significantly contribute to the 
project, both managerial and non-managerial people, whether they are full-time 
or part-time.

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The project team will obviously include a ll of the technical people responsible 
for the project's efforts toward research, design, development, procurement, 
production and testing. Team members are expected to attend all project meetings, and to participate in project decision-making. Therefore, care should be taken in making sure that the team does not have any non-performing members. The project team is likely to be made up of a range of staff with different skills and experience. Effective team working is essential for the success of a project and it is important to foster this through regular meetings to establish team cohesion, helping to develop a team which is integrated, has common objectives and positive group dynamics. 
The ideal project team will achieve project completion on time, within budget 
and to the required specifications. They will do all this with the minimum amount of direct supervision from the project manager. 
The project manager must get the individual team members to view the project 
from the ‘big-picture’ perspective, and to concentrate on overall project goals. 
Lifecycle of project teams 
Tuckman’s model of team development can be used to show the lifecycle of the 
project team. 
The stages are: 
• Forming  – a collection of individuals ar e brough t together, often from 
different areas of the organisation. The project manager has an important 
role at this stage to provide clear direction to the team and ensuring they understand the project objectives. 
• Storming  – As the individuals start to operate as a team, most teams go 
through this conflict stage. Team members may try to test the project manager’s authority and may challenge the role they have been given. The project manager must demonstrate strong conflict resolution leadership skills at this stage. 
• Norming – The individuals settle in to their roles and the team starts to 
perform. The project manager will begin to pass control and decision-
making authority to the team members. 
• Performing – The team is capable of operating at full potential at this stage. The project manager will concentrate on the performance of the project. 
• Adjourning  (dorming) – Once the objectives of the project have been 
achieved, the team can be disbanded and the individuals can go back to their previous roles, or move on to work on a new project.

408  
These stages can be considered alongside the project lifecycle as shown 
below: 
 
Likewise the other models of team building, such as Belbin, can also be applied to project teams. These models should be reviewed at this stage and consideration given as to how they could be applied in a project scenario. 
Managing project teams 
In the management of project teams we must pay attention to two particular 
characteristics of each team: 
• Each project is a complete entity, and unique in terms of experiences, 
problems, constraints and objectives. 
• The members of the team concerned may well have not worked together 
as a group on any previous occasion. 
The style of management  for the team must be the relevant approach aimed 
at the creation of the appropriate internal team environment or, in other words, 
team climate. Some large organisations provide the team with initial status by providing it with all the necessary support and resources, such as office accommodation, a budget, support secretarial staff, and so on. Other organisations simply appoint a leader, authorised by the board to appoint team members and acquire resources at his or her own discretion. 
The planning and controlling of the team  activities are vital aspects of 
management in that a major project cost lies in the fact that team members are 
not undertaking their own tasks but have been taken from these temporarily. It is essential that there should be an unambiguous statement of: 
• the project objective(s) – what is to be achieved? • the project approach, methods – how is it to be achieved? 
• the location of activities – where is it to be achieved? 
• the allocation of responsibilities – what is to be done by whom? 
• the project budget – at what cost?

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Leading and motivating project teams 
All aspects of leadership and motivation which were covered in the leadership 
and management chapter are equally applicable in the context of a project team as they are to business as usual. The models covered in the leadership and management chapter should be reviewed at this stage and consideration given as to how they could be applied in a project scenario. 
The project manager does not and cannot complete a project on his or her own. 
It requires effective teamwork and team motivation. To foster a motivated project team environment, the project manager needs to understand his or her team members first in order to understand what motivates them. The project manager should attempt to create a project environment that is supportive and where team members feel enthusiastic and want to work towards the overall project goal. 
The project manager can create such an environment by: 
• Ensuring that the team is made up of the correct people. The project 
manager should be aware of Belbin’s model and ensure that all required 
roles in the team are met. This will avoid conflict and foster good working relationships. 
• Adequate knowledge and experience in team. The project manager must 
ensure that all team members are able to participate fully in their role and that they possess the required knowledge and skills. 
• Adopting a participative style of management. 
• By encouraging participation in project decision-making. 
• By delegating decisions to the team members, thus encouraging 
involvement and ownership. 
• Holding regular project meetings whereby team members can participate 
and air their views and put forward their opinions. 
• Holding regular one-to one meetings with individual team members, 
encouraging them to put forward their own ideas and suggestions for 
project improvement. 
• Ensuring that conflict is minimised by ensuring that all team members are 
clear about their role and what is required of them. 
The project manager needs to demonstrate that he/she values the contribution made by team members and that their contribution is important to the overall project.

410  
 EFG is a large construction company that has just won a major contract 
for a road-widening scheme through an area of countryside that has been 
officially designated as an ‘area of outstanding natural beauty’. The work will be carried out to some extent by direct employees of EFG, but most of the work will be undertaken by sub-contractors. 
The scheme has already attracted a considerable amount of publicity and 
the Preserve the Countryside Movement, a large national pressure group, has already announced its intention to organise demonstrations and protests against the construction work. More extreme and radical protest 
groups have threatened disruptive action. 
The project is being financed by the transport department of the central 
government, and the managers of EFG who are responsible for the project have already spoken to the police authorities about the preservation of public order. A security firm will be employed to provide physical protection to employees and assets. 
A traffic survey conducted for the central government has suggested that, 
during the time that the road widening is taking place, there will be severe 
disruption to normal road traffic and severe delays for drivers on their journeys will be inevitable. 
P has been appointed as project manager, but this is the largest and 
most complex project he has managed. He knows that in this project he must give strong leadership to get the best possible performance out of the project team, but he is concerned about how he is going to manage this aspect of the project. 
Required: 
Write an email to P suggesting what leadership style is most likely to be 
successful for a project such as this road-widening scheme. Give your reasons and make reference to any theories of leadership style with which you are familiar. 
6  Project structure 
Establishing an effective project management structure is crucial for its success. Every project has a need for direction, management, control and communication, using a structure that differs from line management. As a project is normally cross functional and involves partnership, its structure needs to be more flexible, and is likely to require a broad base of skills for a specific period of time. The project manager needs a clear structure, consisting of roles and responsibilities that bring together the various interests and skills involved 
in, and required by, the project.

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In conventional (functional or divisional) structures, there is often a lack of clarity 
as to how authority is divided between line managers and project managers. If a project is relatively small or short term, for example an information system redevelopment, this may not be a major issue. However, if the project forms a major part of the business of the organisation, such as in a construction company, this may necessitate an organisation structure such as a matrix, where lines of authority are clearer. 
Matrix and project structure 
A matrix structure aims to combine the benefits of decentralisation (motivation 
of identifiable management teams, closeness to the market, speedy decision making) with those of co-ordination (achieving economies and synergies across all business units, territories and products). 
The matrix structure seeks to add flexib ility and lateral coordination. One way is 
to create project teams made up of members drawn from a variety of different 
functions or divisions. Each individual has a dual role as he/she maintains their functional/divisional responsibilities as we ll as membership of the project team. 
Both vertical and horizontal relationships are emphasised, and employees have dual reporting to managers. The following diagram shows a mix of project and functional structures. 
 
The matrix organisation structure has been widely criticised, but is still used by many project-based organisations in industries such as engineering, construction, consultancy, audit and even education.

412  
The matrix structure is most suitable where: 
• The business of the organisation consists of a series of projects, each 
requiring staff and resources from a number of technical functions. 
• The projects have different start and end dates, so the organisation is 
continually reassigning resources from project to project. 
• The projects are complex, so staff benefit from also being assigned to a 
technical function (such as finance of logistics) where they can share 
knowledge with colleagues. 
• The projects are expensive, so having resources controlled by functional 
heads should lead to improved utilisation and reduced duplication across projects. 
• The projects are customer-facing, so the customer requires a single point 
of contact (the project manager) to deal with their needs and problems. 
Impact on project achievement 
The matrix structure can impact on the achievement of the project as follows: 
• improved decision-making by bringing a wide range of expertise to 
problems that cut across departmental or divisional boundaries 
• replacement of formal control by direct contact 
• assists in the development of managers by exposing them to company-
wide problems and decisions 
• improves lateral communication and cooperation between specialists.  
There are, however, disadvantages with a matrix structure: 
• a lack of clear responsibility • clashes of priority between product and function 
• functions lose control of the psychological contract 
• career development can often be stymied • difficult for one specialist to appraise performance of another discipline in 
multi-skilled teams 
• project managers are reluctant to impose authority as they may be 
subordinates in a later project 
• employees may be confused by reporting to two bosses 
• managers will need to be able to resolve interpersonal frictions and may 
need training in human relations skills 
• managers spend a great deal of time  in meetings to prioritise tasks.

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 HIJ designs and manufactures sports equipment and is currently 
positioned as the market leader in the industry. However, whilst operating 
in a growth market, there are new competitors entering the market with innovative new product offerings. The marketing director is aware that to retain market leader position, the company must improve its practices involved with new product development (NPD), and the time taken to get from the product idea to launch needs to be much quicker. 
The company has a functional structure with the marketing director 
heading up the marketing function, and the R&D director heading up the 
function responsible for research and product development; in addition, 
there are separate functions for production, human resources, finance, sales and IT. 
The marketing director feels that the functional structure is impeding the 
NPD process. Having recently read an article on organising for NPD, he is proposing that the best way to manage the process would be through introducing a matrix structure and the use of cross functional teams. However, at a recent meeting of the functional heads, the R&D director said that, in his experience, the potential difficulties in using a matrix structure offset the benefits. 
The managing director is unsure as to whether HIJ should adopt a matrix 
structure and has asked for your advice. 
Required: 
Write a report for the managing director describing the advantages and 
disadvantages of HIJ using a matrix structure in project management work for NPD. 

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 Question 1 
 There are a number of people involved in a project. Match the people to 
the correct description. 
 
Project sponsor  Responsible for the successful delivery of 
the project 
Project owner  The person for whom the project is being 
carried out 
Project manager  Responsible for making all high level 
decisions about the project 
Project board  Provides resources for the project 
   
 Question 2 
 The person responsible for approving the project plan is which of the 
following? 
A  Project manager B  Project owner C  Project sponsor D  Project user 
 
 Question 3 
 Organisations that run a number of projects often adopt the matrix 
structure. Which three of the following characteristics lead to the matrix 
structure being the most suitable? 
A  The projects have different start and end dates. B  The projects are all of short duration. C  The organisation runs projects occasionally. D  The projects are expensive. E  The organisation has a dedicated project team which works on all 
projects. 
F  The projects are customer facing.

416  
 Question 4 
 H is a project manager. He has just been appointed to manage a project 
on behalf of XYZ, a property development company, to build 300 low-cost 
family homes in R Town. XYZ has recently acquired an area of land on the outskirts of R Town and have just received planning permission from R Town Council for the building project. 
R town council see this as a way of addressing the problem of lack of 
affordable housing in R Town. 
R Town university however are opposing the development. They say that 
the building will spoil the view of the university. They claim that the 
picturesque setting of the university is one of the main attractions for 
students and staff and that this development will detract from their reputation. 
As project manager, H must manage the project stakeholders. Using the 
Mendelow matrix, match the two stakeholders to the correct management strategy. 
 
R Town Council  Key player 
R Town University  Keep satisfied 
  Keep informed 
  Minimal effort 
   
 Question 5 
 Which three of the following statements are true regarding the matrix 
structure? 
A  Requires centralised decision making B  Employees have dual reporting to managers C  The structure seeks to add flexibility and coordination D  Reduces the time spent in meetings E  Clear lines of responsibility F  Replaces formal control with direct contact

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 Question 6 
 Which of the following would be the role of the project manager? Select 
all that apply. 
A  Selecting, building and motivating the project team B  Providing resources for the project C  Making all high level decision regarding the project D  Recommending termination of the project if necessary E  Main point of contact with the management hierarchy F  Communicating with the chain of command 
 
 Question 7 
 Project managers require a number of skills including: 
• Delegation 
• Negotiation 
• Problem solving 
• Planning and control 
• Leadership  
Match the following activities to the required project manager skill. 
• The project manager may have to deal with disputes between 
various stakeholders. 
• The project manager must ensure that all stakeholders are kept up 
to date about the progress of the project. 
• The project manager must clarify each team member's role and 
must empower them to achieve their objectives. 
• The project manager must motivate the project team so that the 
team works hard to achieve the project objective.

418  
 Question 8 
 Which three of the following statements regarding the project manager 
are true? 
A  They must be effective communicators B  They must have all the technical skills required in the project C  They may have to negotiate on a variety of issues D  They must adopt the democratic style of leadership E  They are responsible for the project budget F  They must have change-management skills 
 
 Question 9 
 A key role of any project manager is to build and lead the project team. 
When putting together a project team, Belbin’s model of team roles can 
be used. 
Which of the following statements relating to Belbin’s model of team roles 
is true? Select all that apply. 
A  The team worker is concerned about the relationships within the 
team. 
B  A successful team requires at least eight members. C  The plant promotes activity in others. D  All of Belbin’s roles should be filled for an effective team. E  The implementer is practical and efficient. F  The completer/finisher is thoughtful and thought provoking. 
 
 Tuckman's model of team development can be used throughout a project. 
Match the project stage to the most suitable stage in Tuckman's model. 
 
Need  Norming 
Solution  Performing 
Implementation  Adjourning 
Completion  Storming 
  Forming

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 REPORT 
To: Hospital senior managers  
From: Management Accountant  Date: Today 
Subject: Project relationships  
This report will consider the various relationships which exist within the 
Healthweb project. In any project the project manager will have relationships with the project sponsor, the project board and the project users. This report will cover each of these relationships and will also consider the potential conflicting project objectives of these stakeholders. 
Project manager and project sponsor 
T, as the project manager is responsible for delivering the project. 
The project sponsor is usually the party responsible for payment of 
projects, but in this case the amount of funding from the central government is not clear, neither in the initial funding nor the on-going running costs. Therefore, the proj ect manager will need to work with the 
sponsor to resolve potential conflict over project costs. The role of the central government in this project as a fund provider may cause conflict 
between central government and ABC. 
The project manager may have little direct reporting/communication with 
the central government, as responsibility for the project progress is 
mainly to the project board. 
However, central government, as th e project sponsor, will be evaluating 
strategic level objectives and who will be concerned with ensuring that 
the whole project is not seen to waste public resources. 
Project manager and the project board 
The project manager is responsible for achieving the objectives set by the 
project board. The project board is responsible for the overall running of the project, and their objectives are to delegate the achievement of the sponsors’ targets without disrupting the achievement of their own business objectives. 
Direct communication between the project manager and the project board 
is necessary, with on-going regular reporting of project milestone review meetings. 
The project board will be concerned with the achievement of 
management/business level objectives, in particular that the project improves business efficiency and effectiveness.

420  
 Project manager to medical and administrative users 
The project manager is responsible for the overall delivery of the final 
working system to the end users. The objectives of the users are to care for their patients, while minimising their workload. The first role of the project manager is to ‘sell’ the benefits of the new system to the users, as without their backing the project is unlikely to succeed. Good communication between the project manager and the end users is essential to the implementation of a successful project. The project manager is responsible for reviewing the needs of each group of users to ensure that systems design meets the needs of the users as far as possible within the project constraints, and ensuring that training is effective. In addition, the project manager will need to manage both medical and administrative staff expectations of the system as the project progresses. 
The administrative and medical staff will be evaluating the operational 
day-to-day objectives of the project. 
Possibility of conflicting objectives 
The sponsor’s objectives are the achievement of improved service to 
patients. This may conflict with the objectives of the staff, who will seek to minimise their workload while providing good care for their patients. Staff are likely to have concerns about the implementation workload, the on-going costs and workloads and the patient record security. 
There is also likely to be conflict between the sponsor and the project 
board over funding. 
In addition, the central government and project board may be concerned 
with funding and cost minimisation, whereas the end users may see this as cost-cutting, thus reducing the value of the end product. 
As a public sector project, financial objectives should not be primary 
ones. Quality and customer perspective should be of more importance to all of the stakeholders. However, public funds must not be seen to be wasted. 
There are many stakeholders in any project and they often have different 
objectives which can lead to conflict within the project. It is important to recognise potential conflict in a project to ensure that it is managed so that it does not affect the successful delivery of the project.

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 EMAIL 
To: P 
From: Management Accountant  
Subject: Project management leadership style 
The most effective leadership style within an organisation will depend on 
the circumstances, and might well differ for different types of employee and different types of task. 
According to Adair, the most appropriate leadership style depends on the 
relative significance of three factors – task needs, group needs and individual needs. Task needs refer to the tasks that the leader must carry out, such as setting objectives, planning tasks, allocating responsibilities, setting performance standards and giving instructions for work to be done. Group needs refer to the management responsibilities for communication, team-building, motivation and discipline. Individual needs relate to the manager’s responsib ilities for coaching, counselling and 
motivating individual employees. The relative significance of task needs, group needs and individual needs will vary from one situation to another, and the most appropriate leadership style will depend on the relative significance of each of these three factors in the given circumstances. 
In managing a road widening project, it seems likely that the task needs 
will be the most significant and individual needs the least. If this is the case, a task-orientated leadership style – in other words an authoritarian style of leadership – might be most appropriate. 
Fiedler, another contingency theorist, argued that the most appropriate 
leadership style in a given situation depended on the extent to which the task is highly structured, the leader’s position power and the nature of the leader’s existing relationship with the work group. If the task is highly structured and the leader’s position power is high, and if the relationship between the leader and the work group is already good, Fiedler suggested that the most appropriate leadership style would be a task-orientated leader. These circumstances probably apply to the management of construction projects such as a road-widening scheme. 
A similar conclusion might also be made if Hersey and Blanchard’s 
situational theory is considered. They argued that the most appropriate leadership style in a given situation depends on the maturity of the individuals who are being led. The greater the maturity of the employees, the more a leader should rely on relationship behaviour rather than task behaviour. With construction work, the maturity of many employees might be considered fairly low, however, and a task-orientated leadership style would therefore be more appropriate. 

422  
 
 REPORT 
To: Managing Director 
Subject: Structure  Introduction 
The structure adopted by a company when undertaking projects can have 
an effect on the success of the project. There are a number of possible structures which could be adopted by HIJ. This report will consider the 
advantages and disadvantages of the matrix structure. 
Matrix structure As the marketing director in HIJ has noted, the ability to develop new 
products and get them to market quickly requires the cooperation of a range of individuals from various functions. HIJ could fundamentally reorganise to form a matrix structure. This type of structure is based on a dual chain of command and is often used as a structure in project management. In the case of HIJ it would involve establishing a cross functional team to design and develop new sports equipment products. Each individual would have a dual role in terms of their functional responsibility as well as membership of a project team. For instance, an individual could belong both to the marketing function and to the NPD project. Employees would report both to a functional manager and a project manager. 
Benefits of a matrix structure 
As the marketing director suggests, this structure does bring a number of 
benefits to NPD project work. The matrix structure is particularly suited to a rapidly changing environment, such as that facing HIJ, creating flexibility across the project, with the aim of speedy implementation. It can improve the decision-making process by bringing together a wide range of expertise to the new product development process, cutting across boundaries which can be stifled by normal hierarchical structures. Lateral communication and cooperation should be improved. From an employee’s perspective it can facilitate the development of new skills and adaptation to unexpected problems, broadening a specialist’s outlook.

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 Disadvantages of a matrix structure 
Whilst there are benefits, the R&D director is also correct in his view that 
there are downsides to the matrix structure. One of the main problems is associated with the lack of clear responsibilities and potential clashes and tensions between the different priorities of the project tasks and the specialist function. Employees may end up being confused by having to report to two bosses and deciding whose work should take precedence. There is also the question of who should do the appraisal of their performance? 
The complexity of the matrix structure can often make it difficult to 
implement. Inevitably, conflicts will arise due to the differences in the 
backgrounds and interests of staff from different functional areas. 
The matrix structure is fairly complex and can cause issues with lack of 
clarity in reporting lines, however it also offers a number of benefits for project work. 
HIJ will have to consider both the advantages and disadvantages 
carefully in deciding whether or not to implement the matrix structure. 
 
 Question 1 
 
Project sponsor  Provides resources for the project 
Project owner  The person for whom the project is being carried out 
Project manager  Responsible for the successful delivery of the project 
Project board  Responsible for making all high level decisions about the project 
   
 Question 2 
 C 
The role of the project sponsor is to make all the yes/no decisions for the 
project, including approving the project plan. Note: in larger scale projects, there may be a project board. In addition the project sponsor also supplies the funds for the project.

424  
 Question 3 
 A, D and F 
In addition, the matrix structure is most suitable when the organisation 
carries out a number of projects which all require teams made up of individuals from different technical backgrounds. 
 
 Question 4 
 The correct matching area is: 
R Town Council – Key player  
R Town University – Keep informed  
The council have high power as they are able to give permission for the development. They also have high interest as they want the development to bring much needed housing to the area. This puts them in the category of key players. 
The university have high interest as they do not want their view spoiled, 
but they have limited power to stop the development. This puts them in the keep informed category. 
 
 Question 5 
 B, C and F 
A drawback of the matrix structure is that there can be an increase in 
time spent in meetings. In addition the lines of responsibility can be confusing as members of staff have two reporting lines. The matrix structure requires decentralised decision making. 
 
 Question 6 
 A, D, E and F 
Providing resources for the project and making the high level decisions 
for the project will be the responsibility of the project sponsor.

Chapter 11 
 425 
 Question 7 
Negotiation  – The project manager may have to deal with disputes 
between various stakeholders. 
Communication  – The project manager must ensure that all 
stakeholders are kept up to date about the progress of the project. Delegation – The project manager must clarify each team member's role 
and must empower them to achieve their objectives. 
Leadership  – The project manager must motivate the project team so 
that the team works hard to achieve the project objective. 
 
 Question 8 
 A, C and F Project managers do not require all the technical skills to run a project as 
long as someone in the project team has the required skills. 
In terms of the leadership style they adopt, the democratic style has been 
shown to be effective. However the manager will have to make all the decisions regarding the project and they may not be able to allow team members to contribute to that decision making. They must adopt the most suitable leadership style depending on the situation. 
The responsibility for the project budget rests with the project sponsor. 
 
 Question 9 
 A, D and E According to Belbin, all of the team roles should be covered, but 
members can hold more than one role, therefore a team does not need to have exactly eight members. 
The plant is the creative, ideas person in the team. The shaper promotes 
activity. 
The completer/finisher is the person who chases the progress of the 
project, ensuring all documentation is complete and deadlines are met.

426  
Need – Forming  
Solution – Storming  
Implementation – Norming/Performing   
Completion – Adjourning

Index 
 I.1 
A 
Adair…..127 
B 
Balanced Scorecard…..212 
Behavioural control…..200 Belbin…..240 
Bennis…..130 
Blake and Mouton…..123 Blockchain…..63 Boyd…..131 
Buffering…..374 
Burns and Stalker…..114 Business Ecosystems…..11 
Characteristics of a business 
ecosystem…..12 Goals of business ecosystems…..13 
Participants and their roles…..20 
Regulating ecosystems…..23 
Value creation and value capture…..14 
C 
Capturing residual value…..49 
Cialdini…..275 
Coaching…..216 
Communication…..265 
Barriers to communication…..267 
Conflict…..279 
Contingency theory…..114 
Control gates…..378 Critical Path Analysis…..349 Cryptocurrencies…..63 
D 
Data visualisation…..270, 271 
Dashboard…..271 
Delegation…..104 
Delivering value…..46 
Digital operating models…..72 Discipline…..164 Dismissal…..172 
Disruptive technology…..60 
Distributive leadership…..244 Drivers of the digital revolution…..6 Drucker…..210 
Druker…..268 
E 
Employee performance appraisal…..205 
 
 F 
Fiedler…..129 Freeman…..39 
French and Raven…..100 
G 
Gantt Chart…..374 
Gido and Clements…..308, 397 
Goleman…..136 Grievance procedures…..169 Groups…..234 
Benefits and problems with groups…..236 
Types of groups…..234 Work teams…..235 
H 
Health and Safety…..161 
Herzberg…..110 
I 
Initiating…..310 
K 
Koontz and O'Donnell…..105 
L 
Leadership…..98, 116 
and culture…..73 
and ethics…..134 
in virtual teams…..132 
Lewin…..122 
M 
Mainwaring…..280 
Management…..98 
by Objectives…..160 
Maslow…..113 McGregor…..121, 169 Meetings…..271 
Mehrabian…..268 
Mendelow’s Matrix…..41 Mentoring…..214 Milestone…..377 
Mintzberg…..99 
N 
Negotiation…..276

Index 
I.2  
O 
Organisational 
control…..202 
culture…..178 
P 
PERT…..373 
Peters and Waterman…..243 
PMBOK…..364 Porter’s generic strategies…..3 Porter's five forces…..3 
Post Completion Audit…..329 
PRINCE2…..364 Project 
constraints…..307 
initiation document…..314 life cycle…..308 
management software…..360 
management…..307 
manager…..403 
R 
Redundancy…..173 
Resource histogram…..359 
Role theory…..242 
Rosseau and Greller…..175 
S 
Salomon…..175 
Scenario planning…..374 
Strategies to build disruptive business 
models…..69 
Style theories…..120 
Surviving digital disruption…..65 
Systems theory…..113 T 
TARA…..371 
Taylor…..107 
Team development…..239 Thomas-Kilmann…..284 Trist and Bamforth…..113 
Tuckman…..239 
V 
Vaill…..243 
Value creation…..45 
W 
Weber…..102, 107

P.2   
 
Unit 2 The Business Centre, Molly Millars Lane, Wokingham, Berkshire RG41 2QZ 
CIMA November 2010 and subsequent CIMA Exam answers where the official CIMA answers have been reproduced. Questions from past live assessments have been included by kind 
Notice 
necessary. 
Kaplan Publishing Limited and all other Kaplan group companies expressly disclaim all liability 
to any person in respect of any losses or other claims, whether direct, indirect, incidental, 
ISBN: 978-1-78740-195-2 
Printed and bound in Great Britain

P.3 
Contents 
  Page 
Chapter 1 The strategy process 1 
Chapter 2 Generating strategic options: Mission, vision, 
values and stakeholders  
31 
Chapter 3 The role of governance and ethics in the strategy process  
69 
Chapter 4 The organisational ecosystem: External 
environmental analysis  
113 
Chapter 5 Strategic networks and platforms 151 
Chapter 6 Resources and value creation within the 
organisational ecosystem  
191 
Chapter 7 Framework for generating strategic options 231 
Chapter 8 Strategic options and choice 269 
Chapter 9 Developing strategic performance management 
systems  
331 
Chapter 10 Understanding the impact and context of change 385 
Chapter 11 Change management – the role of the leader in 
managing change  
411 
Chapter 12 Digital strategy – digital technologies 463 
Chapter 13 Digital strategy – governance and elements of 
digital strategies  
507 
Index  I.1

P.7 
 
examined. 
 
exercises which give the opportunity to assess the understanding of these core areas. 
 
illustrative examples are useful in preparing for the Test your understanding exercises.

P.8  
Passing exams is partly a matter of intellectual ability, but however 
accomplished you are in that respect you can improve your chances significantly by the use of appropriate study and revision techniques. In this section we briefly outline some tips for effective study during the earlier stages of your approach to the objective tests. We also mention some techniques that you will find useful at the revision stage. 
Planning 

P.10   
A fixed period of study set out at the start of a course with key milestones is 
important. This can be within a subject, for example ‘I will finish this topic by 30 June’, or for overall achievement, such as ‘I want to be qualified by the end of next year’. 
subject and another. For example, E3 Strategic management  builds on your 
knowledge of digital ecosystems and management of performance and projects from E2 Managing performance . 

P.12   
questions, but obviously we have had to label answers A, B, C etc. rather than using click boxes. For convenience, we have retained quite a few questions where an initial scenario leads to a number of sub-questions. There will be no questions of this type in the objective tests. 
tutorial. 
The objective tests are 90-minute asse ssments comprising 60 compulsory 
should be attempted. All elements of a question must be answered correctly for 

P.16   
E3: Strategic Management 
Formulate strategy and create conditions for successful 
implementation 
A The strategy process 15% 
B Analysing the organisational ecosystem 20% 
C Generating strategic options 15% 
D Making strategic choices 15% 
E Strategic control 20% 
F Digital strategy 15% 
  100%

P.17 
E3A: The strategy process 
Strategy is at the heart of what organisations do. This section provides the foundation of strategic 
management for the organisation. It introduces the strategy process that is elaborated on in the rest of the 
subject. 
 
purpose of 
strategy. a. Define strategy. 
b. Explain the purpose of 
strategy. • Different definitions of 
strategy 
• Essential features and 
characteristics of strategy This section introduces the 
rest of E3. It provides the 
various definitions of strategy 
and outlines its essential 
features and characteristics. It 
discusses the different types 
and levels of strategy and the 
leaders who have 
responsibility for them. 
Finally, it looks at the strategy 
process from both the rational 
and emergent perspectives. 2. Discuss the types 
and levels strategy. Discuss 
a. Types of strategy 
b. Levels of strategy • Intended and emergent 
strategy 
• Corporate, business and 
functional strategies 
3. Outline the strategy 
process. a. Outline the rational and 
emergent processes of 
arriving at strategy. • Analysis of organisational 
ecosystem 
• Generating options 
• Strategic choice 
• Strategic control

P.18   
E3B: Analysing the organisational ecosystem 
Every organisation inhabits an ecosystem within which it adapts and evolves. This ecosystem comprises 
markets and society, has its players and its own system of governance. Organisations can also join with 
others to form a smaller ecosystem within the broader one to reflect their strategic preferences. This section provides candidates with an understanding of the dynamics of the ecosystem (both the wider and the smaller more deliberate ones formed by organisations) and how it affects the strategy of the 
 
1. Analyse the 
elements of the 
ecosystem. Analyse 
b. Society and regulation • SWOT analysis 
• PESTEL analysis 
• Competitor analysis 
• Customer analysis 
• Wider ecosystems 
• Industry ecosystems What types of markets do 
organisations operate in? 
What are the ‘rules of the 
game’ in these markets? 
What are the sources and 
opportunities for disruption in 
the market? How does society 
regulate the markets and 
provide ‘permission to play’ 
for organisations? 
2. Discuss drivers of 
change in the 
ecosystem. Discuss the following drivers 
of change: 
a. Institutional and systemic 
b. Social 
c. Market 
d. Technology 
e. Sustainability • Globalisation 
• Geopolitics 
• Demography 
• Customer empowerment 
• Digital technology 
• Automation What are the drivers of 
change in the ecosystem? 
How are the individual drivers 
linked? What type of 
outcomes do they bring 
individually and collectively? 
What risks and opportunities 
do they bring organisations? 
3. Discuss the impact 
of the ecosystem 
on organisational 
strategy. a. Discuss the impact of 
strategic networks and 
platforms on 
organisational strategy 
b. Conduct stakeholder 
analysis in networks • Value creation in 
• Participants and 
interactions in networks 
and platforms 
• Technology enablers in 
networks 
• Process of creating 
networks and platforms 
• Stakeholder analysis in 
networks 
• Corporate social 
responsibility In a digital world what is the 
importance of networks and 
platforms? What are the roles, 
interactions, and governance 
systems in the ecosystems? 
Who are the key players? 
How does this affect the 
business model of 
organisations?

P.19 
E3C: Generating strategic options 
Strategy is about choice of options. These options must be generated and developed based on the 
dynamics of the ecosystem in which the organisation operates and the foundational contexts of the 
organisation (e.g. its purpose, values etc). This section covers how options are generated and links them to the purpose, values and vision of the organisation. In addition, it looks at the role of various parts and 
levels of the organisation in the strategy process. 
 
1. Discuss the context 
of generating 
options. Discuss: 
a. The role of governance 
and ethics in the strategy 
process 
b. The purpose, vision and 
values of the organisation 
and their impact on 
strategy • Roles and responsibility of 
leaders of organisations 
for strategy 
• Definition of purpose, 
vision and values of 
• Linkage between purpose, 
vision and values to each 
other and to strategy Who is responsible for various 
aspects of the strategy 
formulation process? How are 
those roles determined and 
governed? How does the 
organisation derive its 
purpose, vision and values? 
What processes exist to 
ensure that strategy is based 
on and/or are aligned to 
these? 
2. Discuss how to 
generate and 
develop options. Discuss how to: 
a. Frame key strategic 
questions 
b. Diagnose organisation’s 
starting position 
c. Forecast potential 
organisational operating 
ecosystem 
d. Use various frameworks to 
generate options • Product/market matrix 
• Generic strategies 
• Trend analysis 
• System modelling 
• Tangible and intangible 
value drivers and data to 
measure them 
• Game theory perspectives 
• Real option perspectives What are the core strategic 
questions to ask and what are 
the criteria and constraints for 
asking them? What is the 
organisation’s starting point? 
Where and how does it make 
money? What potential 
futures might it inhabit and 
what are the forces potentially 
driving these futures? What 
are the potential pathways to 
this future? What new 
business models are in play?

P.20   
E3D: Making strategic choices 
Once options have been generated in various areas of the organisation’s operations the organisation has 
to choose between the alternatives. The choice is based on predefined criteria and an evaluation of the 
options against these criteria. The various options chosen must then be integrated into a coherent whole to form the organisation’s strategy. This section covers how the options are evaluated, chosen and 
integrated coherently to form the strategy of the organisation. 
 
1. Evaluate options. a. Develop criteria for 
evaluation. 
b. Evaluate options against 
criteria. 
c. Recommend appropriate 
options. • Suitability, acceptability 
and feasibility framework What are the different criteria 
to guide the choice of options, 
one how are they prioritised 
and why? 
2. Produce strategy 
by the integration 
of choices into 
coherent strategy. Conduct: 
a. Value analysis 
b. Portfolio analysis • Value chain analysis 
• Managing product portfolio What are the criteria to 
ensure effective integration 
and why? What are the trade-
offs to be made when putting 
the individual choices 
together? How does one 
ensure integrated thinking?

P.21 
E3E: Strategic control 
Once strategy has been formulated, it has to be implemented. This involves developing and 
communicating action plans, allocating resources and monitoring the implementation of the plans. In 
addition, implementing strategy involves significant change. The nature of these changes should be 
evaluated and appropriate ways of managing change have to be developed and implemented. This 
section examines how these implementation objectives are achieved and how change is managed. 
 
1. Develop strategic 
system. a. Develop detailed action 
plans 
b. Communicate action plans 
c. Monitor implementation 
d. Align incentives to 
performance • Action plans 
• Target setting 
• Critical success factors 
(CSFs) 
• Key performance 
indicators (KPIs) How does the organisation 
prepare the grounds for 
executing strategy? How does 
it create and communicate 
action plans for 
implementation? How is the 
whole organisation mobilised, 
motivated and incentivised to 
implement the plans? What 
role can integrated reporting 
play? 
2. Advise on resource 
allocation to 
support strategy 
implementation. a. Advise on resource 
availability 
b. Align resource allocation 
to strategic choices • Audit of key resources and 
capabilities required to 
implement strategy 
• Matching resources to 
strategy What are the resources 
needed to implement 
strategy? Where are the 
resources needed? How does 
the organisation re-align 
resource allocation from 
existing units or projects to 
new ones that match the 
strategic choices made? 
3. Recommend 
change 
techniques and 
methodologies. a. Assess impact of strategy 
on organisation 
b. Recommend change 
management strategies 
c. Discuss the role of the 
leader in managing 
change • Types of change 
• Impact of change on 
organisational culture 
• Resistance to change 
• Approaches and styles of 
change management 
• Role of change leader in 
communication What is the impact of the new 
strategy on the whole 
organisation, parts of the 
organisation and partners of 
the organisation? What 
transformation is required and 
how does the organisation 
drive these changes?

P.22   
E3F: Digital strategy 
Strategy takes place within specific organisational contexts and ecosystems. The primary characteristics 
of the current context is digital transformation. Organisations need to think through their approach to 
strategy within this perspective. This section covers how to introduce thinking about digital transformation 
in the strategy of organisations. 
 
governance of 
digital 
transformation. a. Describe the roles and 
responsibilities of the 
board and executive 
leadership in digital 
strategy. • Role of board and senior 
strategy Who is responsible for leading 
the process of digital 
transformation? What is their 
role in the process and why? 
2. Analyse digital 
transformation. Analyse 
a. Digital technologies 
b. Digital enterprise • Cloud computing 
• Mobile 
• 3-D printing What are the technologies 
that underpin digital 
transformation? How are they 
evolving and what impact do 
they have on the organisation 
and its immediate and wider 
operating environment? What 
type of organisation do such 
technologies create? What 
are the elements of the 
business and operating 
models of such digital 
enterprises. 
3. Discuss the various 
elements of digital 
strategies. Discuss: 
a. Economics of digitisation 
b. Digital ecosystems 
c. Digital consumption 
d. Data and metrics 
e. Leadership and culture • Business case for digital 
transformation 
• Participants, interactions 
and dynamics of 
ecosystem and impact on 
strategy 
• Trends in consumption 
(e.g., hyper 
personalisation, move 
from products and 
services to experience) 
• New metrics (scale, active 
usage and engagement 
metrics) 
• Leadership in digital 
transformation What is the economic and 
business case for digitisation? 
How does the organisation 
create partnerships in the 
ecosystem to ensure strategic 
success? What are key trends 
underlying the consumption of 
the organisation’s products 
and services by customers 
and consumers? What data 
and metrics should 
organisations use to evaluate 
success of digital enterprises? 
How should leaders and their 
organisations think, act and 
react differently because of 
digital transformation?

1 
The strategy process  
A1: The purpose of strategy. (a) Define strategy. 
(b) The purpose of strategy. 
A2: Discuss the types and 
levels of strategy. (a)  Types of strategy. 
(b) The levels of strategy. 
A3: Outline the strategy 
process. (a)  Outline the rational and 
arriving at strategy. 
 
  Chapter 
1

The strategy process 
2 
 
 1 Introduction – the organisational ecosystem 
 
The E3 syllabus, as its title suggests, looks at how organisations are managed 
from a strategic perspective. Much of this paper is therefore about understanding what is meant by the term strategy and the different processes that a management team might go through to formulate and implement an appropriate strategy. 
It should be accepted from the outset that there is no ‘one size fits all’ strategy 
that is appropriate for all organisations; what will work for, say, a global oil company is likely to be very different for a manufacturer of consumer electronics. 
Fundamental to recognising what will wo rk for a particular organisation is 
understanding the ecosystem in which it exists. 
What is meant by the term ‘ecosystem’? 
An organisation’s ecosystem is made up of a network of organisations – 
including customers, suppliers, distributors, competitors, government agencies etc. – involved in the delivery of a product or service. This can be via either cooperation (e.g. customers and suppliers) or competition. 
The idea is that all components of an ecosystem impact on each other, creating 
a relationship that is constantly evolving and within which each organisation must be flexible and adaptable to survive. The term ecosystem was first used in the 1930s in a botanic context; a community of organisms (for example, plants and insects) interact with each other and their environments (such as air, water, sunshine, the earth). In order to survive and thrive, these organisms compete and collaborate with each other on available resources, evolve together, and adapt jointly to external disruptions.

Chapter 1 
 3 
The same concept was then used in the 1990s to look at the business world. In 
his article “Predators and Prey: A New Ecology of Competition”, the strategist James Moore identified similarities between the commercial and botanical worlds. He argued that organisations operating in the increasingly connected world of commerce should not be viewed as single companies in an industry; instead they should be seen as members of a business ecosystem with participants spanning across multiple industries. 
Advances in technology and the increasing degree of globalisation have made 
people question the best ways in which to do business. The concept of a business ecosystem is thought to help organisations consider how to succeed in an environment which is changing constantly and at great speed. 
 
Illustration 1 – The Apple ecosystem 
participants. Examples would include: Software developers  – both those employed by the company and those 
Store. 
party retailers. Competitors – organisations such as Microsoft and Samsung, which are 
constantly innovating and therefore forcing Apple to do the same. Customers  – both individuals and also corporate customers. 
Apple but also other organisations e.g. privacy laws and Facebook. This list is not exhaustive; there are many other elements of Apple’s 
In this chapter we look at the process of strategy formulation. This is fundamental to your understanding of the E3 syllabus as a whole. However, before we look at how strategies are created, we will first look at what we mean by the word ‘strategy’.

4 
2 The purpose of strategy 
Strategy can be defined in a number of different ways, including: 
 
 ‘A course of action, including the specification of resources required, to 
achieve a specific objective.’  
CIMA official terminology 
‘Strategy is the direction and scope of an organisation over the long term: which achieves advantage for the organisation through its configuration of resources within a changing environment, to meet the needs of markets and to fulfil stakeholder expectations.’ 
Johnson, Scholes and Whittington (E xploring corporate strategy) 
Essentially strategy involves setting the future plans of the organisation, but it requires a comprehensive understanding of the organisation’s: 
• resources (such as cash, assets and employees) 
• ecosystem i.e. its environmental factors (such as markets, political and 
economic issues, customers and competitors) 
• stakeholders (anyone with an interest in the business, such as 
shareholders, staff, customers, government, etc) and what they expect of 
This will allow organisations to decide how they are going to achieve a sustainable competitive advantage in the market(s) they operate within. 
 
The characteristics of strategic decisions 
 In their book 'Exploring Corporate Strategy', Johnson, Scholes and 
Whittington outline the characteristics of strategic decisions. They discuss 
the following areas: 
• Strategic decisions are likely to be affected by the scope of an 
organisation’s activities, because the scope concerns the way the 
management conceives the organisation’s boundaries. It is to do with what they want the organisation to be like and be about. 
• Strategy involves the matching of the activities of an organisation to 
its ecosystem. 
• Strategy must also match the activities of an organisation to its 
resource capability. It is not just about being aware of the environmental threats and opportunities but about matching the organisational resources to these threats and opportunities. 
• Strategies need to be considered in terms of the extent to which 
resources can be obtained, allocated and controlled to develop a strategy for the future. 
• Operational decisions will be affected by strategic decisions 
because they will set off waves of lesser decisions.

Chapter 1 
 5 
• As well as the environmental forces and the resource availability, 
the strategy of an organisation will be affected by the expectations 
and values of those who have power within and around the organisation. 
• Strategic decisions are apt to affect the long-term direction of the 
In his book 'Competitive Strategy', Michael Porter put it this way: 
‘The essence of formulating competitive strategy is relating a company to 
its environment.’ 
 
 Advantages and disadvantages of deliberate long-term planning 
 Advantages of adopting a long-term planning approach (such as the 
rational model discussed above) include: 
• Forces managers to look ahead  – formal planning methodologies 
require managers to identify changes in the organisation’s 
circumstances and look at ways to deal with them. This will help to ensure that the organisation stays relevant in its market and survives in the long term. 
• Improved control – the organisation is forced to identify a mission and objectives. This will be communicated to management, meaning that they know what targets they are working towards/being assessed against. This will also improve goal congruence. 
• Identifies key risks  – by undertaking detailed analysis, 
management can identify key exter nal and internal risks and create 
contingency plans to deal with these. 
• Encourages creativity  – management will have to generate ideas 
for the organisation, meaning that it can benefit from their experience and ability to innovate. 
Disadvantages of formal, long-term planning include: 
• Setting corporate objectives – it may be difficult for the 
organisation to create an overall mission and objectives. This is 
often due to the contradictory needs of key stakeholders. For example, maximising profit for shareholders may require restructuring to the organisation that causes employee redundancy. Dealing with stakeholder conflict w ill be dealt with in chapter 2. 
• Short-term pressures  – The pressures on management are often 
for short-term results. It can therefore be difficult to motivate managers by setting long-term strategies when short-term problems can consume their entire working day.

6 
 • Difficulties in forecasting accurately  – it may be hard to identify 
long-term trends in the market - especially in fast-moving industries 
such as computing. This may make it difficult to create a strategy that is effective for the organisation over several years. 
• Bounded rationality  – the internal and external analysis 
undertaken as part of long-term strategic planning is often incomplete. This means that any strategies developed by the organisation based on this incomplete analysis may be ineffective. 
• Rigidity  – Once a long-term plan is created, managers often believe 
it should be followed at all costs – even if it is clearly no longer in the best interests of the organisation. This can also lead to the long-term strategy stifling initiative as managers refuse to act ‘outside the plan’. 
• Cost – the strategic planning process can be costly, involving the 
use of specialists, sometimes a specialist department, and taking up management time. 
• Management distrust  – the strategic planning process involves the 
use of management accounting techniques, including forecasting, modelling, cost analysis and operational research. This may be unfamiliar to some managers, leading to resistance. It is worth noting that many academics mistrust these models – not just managers! 
3 Levels of strategy 
Strategy can be broken down into three different levels.

Chapter 1 
 7 
Corporate (or strategic) level 
This is the highest level of strategy within the organisation and examines the 
strategies for the organisation as a whole . In particular it focuses on which 
businesses and markets the organisation should operate within. 
Corporate strategy is therefore often concerned with issues such as: 
• acquisitions, disposals and diversification 
• entering new industries 
• leaving existing industries. 
Business (or management) level 
Having selected a market, the organisation must develop a plan to be 
successful in that market. Business strategy therefore looks at how the 
organisation can compete successf ully in the individual markets  that it 
chooses to operate within. 
Business strategy is concerned with issues such as: 
• achieve advantage over competitors • meet the needs of key customers 
• avoid competitive disadvantage. 
Corporate strategy affects the organisation as a whole, but business strategy 
will focus upon strategic business units (SBUs).  An SBU is a unit within an 
organisation for which there is an external market for products distinct from other units. 
Functional (or operational) level 
This level of strategy is concerned with how the component parts of the 
organisation in terms of resources, people and processes are pulled together to form a strategic architecture which will effectively deliver the overall strategic direction. It looks at the day to day management  strategies of the 
organisation . 
Operational strategy is concerned with: 
• human resource strategy 
• marketing strategy 
• information systems and technology strategy 
• operations strategy. 
These could be unique to the SBU and benefit from being individually focused 
or the corporate unit may seek to centralise them and so benefit from synergy.

8 
 
Remember that all three levels are linked. A corporate or business level 
strategy is only going to succeed if it is supported by appropriate operational strategies. 
For instance, a hotel chain may have a high level strategy of ‘excellence in 
customer care’, but the success or failure of this will depend on the staff who clean the rooms and cook the meals, etc. Therefore the day to day activities must  be focused on achieving the corporate level strategy. 
It is worth mentioning that formulating the strategy is the easy part. Actually implementing it is the difficult part. Premiership football clubs in the UK will all have strategies in place to win their league. Only one will actually do so! 
 
Illustration 2 – Levels of planning 
 Gap is an international clothing retailer. Classification of different levels of 
planning could be as follows. 
Strategic 
• Should another range of shops be established to target a different 
segment of the market? (Gap opened Banana Republic, a more up-
market chain to do just that.) 
• Should the company raise more share capital to enable the 
expansion? 
Business 
• Which geographical markets should the new range of shops open 
in? 
• How often should inventories be changed to ensure the business 
keeps up with changing fashions? 
• What prices should be charged in the new stores relative to rivals?

Chapter 1 
 9 
Operational 
• How will suitable premises be found and fitted out for the new range 
of shops? 
• Which staff should be hired for the new stores? • Which IT systems need to be installed in the stores? 
Gap’s strategic decision to create the Banana Republic chain had to be 
supported by new business and operational level strategies. For example, poor business strategies for Banana Republic (such as pricing goods too high relative to rivals) would have led to the failure of the new stores. Likewise, poor operational strategies (such as poor training for employees in the new stores) would have damaged Banana Republic's brand and ruined Gap’s overall strategic level strategy. 
Whichever approach is chosen, remember that many different types of 
organisation will need a strategy. This w ill include companies (large and small), 
unincorporated businesses, multinational organisations, not-for-profit 
organisations such as charities, schools and hospitals, etc. 
Anywhere that is likely to have a management accountant is likely to need a 
strategy. Remember that the exam itself will be based on any of these types of organisation. Be prepared for a wide range of scenarios! 
4 Types of strategy 
Having an appropriate strategy is seen as vital to the future success of most organisations. So how does an organisation create a strategy? 
There are a number of different models that can be adopted. None can be 
considered to be the ‘best’ approach – it simply depends on which one each organisation feels is the most appropriate for their needs. 
4.1 The rational model 
The rational model is a logical, step-by-step approach. It requires the 
organisation to analyse its existing circumstances, generate possible strategies, select the best one(s) and then implement them.

10 
The rational model follows a series of set stages as shown in the diagram 
below: 
 
Johnson, Scholes and Whittington took the stages from the rational model and grouped them into three main stages:

Chapter 1 
 11 
 Illustration 3 – The rational model 
 H plc is a company with a chain of high-street stores selling CDs and 
DVDs across country V. It has posted significant losses in the last three 
financial years and wishes to create a strategy using the rational model. 
Mission and objectives 
In this stage, H will decide on what it needs to accomplish. For this 
business, it may consider its mission to be a ‘turnaround’ of the organisation’s fortunes. 
While this gives an overall direction to the organisation, it will also need to 
convert this into specific objectives, or targets. These may include (for example) a return to profitability, a reduction of costs by fifteen percent and a rise in sales by three percent over the next five years. 
H can use these objectives to assess when it has achieved its mission of 
turning the business around. 
Position and appraisal 
This stage will require H to undertake a detailed analysis of its situation. It 
needs to understand its operations and external environment before it 
can suggest how to achieve its mission. 
H will examine its internal environment – for example the quality and 
number of its stores, the ability and moti vation of its staff and its cash 
balances. It will also examine its external environment – noting the shift in the market towards online downloading of music and films, rather than the purchase of DVDs and CDs. 
H will also examine its stakeholders at this point to try and understand 
what they expect from the company. For example, what do H’s shareholders want? Are they willing to invest more money into the company? What do H’s customers expect from H and how powerful are they in determining H’s overall strategic direction? 
Strategic options 
Once H has gained an understanding of its position (and why it is making 
significant losses), it can suggest possible strategic options that would help it achieve its mission. 
For example, it could consider offering online downloads to customers as 
well as selling through its traditional stores. Alternatively it could continue selling via its stores, but dispose of any that are unprofitable. There are likely to be a number of different options that H could consider. 
Evaluation and choice 
Based on H's position analysis, H will pick the strategic option that best 
fits its circumstances. For example, it may lack the cash and skills to create a new online download site, meaning that it simply chooses to dispose of any unprofitable stores.

12 
 Implementation 
H undertakes the chosen strategy. This involves choosing and closing 
any stores identified as underperforming as well as dealing with any unexpected problems (such as the reaction of staff unions). 
Review and control 
Once H’s new strategy has been implemented it can go back to its initial 
mission and objectives. Has the store closure led to a return to profits, a reduction in costs by fifteen percent and a rise in sales by three percent? If not, H will need to decide on a new strategy to accomplish these goals. 
 
 Illustration 4 – The JSW approach 
 A full-price airline in considering setting up a ‘no-frills’, low-fare 
subsidiary. The strategic planning process, according to JSW, would include the following elements: 
Strategic analysis:  Competitor action, oil price forecasts, passenger 
volume forecasts, availability of cheap landing rights, public concern for 
environmental damage, effect on the main brand. 
Strategic choices:  Which routes to launch? Set up a subsidiary from 
scratch or buy an existing low-cost airline? Which planes to use? Which 
on-board services to offer? 
Strategic implementation:  Setup of new subsidiary. Staff recruitment 
and training. Acquisition of aircraft and obtaining of landing slots. 
 
 Which THREE of the following are stages in the rational model of 
strategic development? A Implementation B Strategic analysis C Mission and objectives D Review and control E Strategic planning F Operational strategy

Chapter 1 
 13 
4.2 The emergent approach – Mintzberg 
 Strategies are not always formally planned. In reality, strategies may 
evolve in response to unexpected events that impact on the organisation. Mintzberg referred to these as emergent strategies.  
Mintzberg argued that in a changing environment, the rational model is often too slow and quickly becomes outdated. As an alternative, Mintzberg suggested that in reality, an emergent approach to strategy development occurs, whereby strategy tends to evolve rather than result from a logical, formal process. An emergent approach is evolving, continuous and incremental. 
A strategy may be tried and developed as it is implemented. If it fails a different 
approach will be taken. It is likely to be more short term than the traditional 
process. To attempt to rely on emergent strategies in the longer term requires a culture of innovation where new ideas are readily forthcoming. 
In effect the timing, order and distinctions between analysis, choice and 
implementation become blurred in emergent approaches. For this reason the analysis/choice/implementation identified earlier approach is sometimes shown as a triangle rather than a straight line in the emergent approach. 
Note that the emergent approach does not necessarily mean that the 
organisation does not have a formal plan for the future. However to be 
successful it will need to be able to amend this strategy for unexpected events. 
 
Illustration 5 – The emergent model 
 The emergent model Pfizer, a multinational pharmaceutical company, developed a drug known 
as Sildenafil in an attempt to deal with high blood pressure in patients. 
The drug was ultimately unsuccessful, but patients in the test groups 
reported an interesting side-effect. Pfizer sold the drug as Viagra and started a new multi-billion dollar market. 
4.3 Logical incrementalism 
This approach suggests that strategy tends to be a small-scale extension of past policy, rather than radical change. 
Incrementalism (initially developed by Lindblom ) does not believe that the 
rational model of decision-making is sensible and suggests that, in the real 
world, it is rarely used. This is because: 
• Strategy is not usually decided by autonomous strategic planning teams 
that have time to impartially sift all the information and possible options 
before deciding on the optimal solution.

14 
• Instead, managers have to sift through the options themselves. Due to 
time and knowledge constraints (also known as bounded rationality ), this 
means that they usually only choose between relatively few options. 
• This typically leads to strategy being small scale extensions of past policy 
– in other words, managers try to make small changes to what they know 
has worked well in the past. 
This approach to strategy has a number of advantages over the rational model. 
In particular it is often more acceptable to stakeholders as consultation, compromise and accommodation are built into the process. In addition, it is less of a cultural shift for the organisation to adopt an incremental approach to strategy as the organisation will not be trying to implement major shifts in its activities. 
However, incrementalism may mean that the organisation has no overall long-
term plan, causing it to suffer from strategic drift, eventually leading to it being unable to meet the needs of its customers. In addition, it could mean that the organisation fails to make major changes if needed. 
 
Test your understanding 2 
 Which ONE of the following statements are consistent with 
incrementalism? A Strategy tends to be small-scale extensions of past policies B No formal planning should be undertaken – the business should 
simply react to events as they occur 
C Strategy development should follow a series of logical stages D Detailed internal and external analysis should be undertaken before 
deciding on the future strategy of the organisation 
4.4 Freewheeling opportunism 
 Freewheeling opportunism suggests that organisations should avoid 
formal planning and instead simply take advantage of opportunities as they arise. 
The main justification for this is that formal planning takes too long and is too constraining – especially for organisations in fast-changing industries, such as pharmaceuticals and technology development. It may also suit any experienced managers who happen to dislike planning.

Chapter 1 
 15 
 Problems with a lack of formal planning 
 Freewheeling opportunists dislike formal planning. However, there are a 
number of practical risks invo lved with this approach. 
• Failure to identify risks  – the business is not being forced to look 
ahead. This means that it may fail to identify key risks, which means 
that it will not have contingency plans in place to deal with these, should they arise. 
• Strategic drift  – the organisation does not have an overall plan for 
the future, meaning that it may be difficult for it to effectively compete in its market in the long term. 
• Difficulty in raising finance  – investors typically like to know what 
plans the organisation has for the future. If the company does not have a formal plan, it may be difficult to convince shareholders and banks (amongst others) that the company is a worthwhile investment. 
• Management skill  – freewheeling opportunists require managers 
that are highly skilled at understanding and reacting to the changing market. Less able or experienced managers will find this a difficult 
approach to use. 
 
 T plc is an electronics manufacturer, which has recently created a 
detailed strategic review of its operations, as well as its external 
environment. T identified that it had significant skills with regards to the manufacture of electronic displays and launched a range of flat screen televisions. Unfortunately, its new product range, while praised by reviewers, failed to sell well to the public. T therefore abandoned its original strategy and took advantage of an offer by HHH, another electronics manufacturer, to make  screens for HHH’s popular mobile 
smartphones. 
Which ONE approach to strategy is closest to that adopted by T when 
accepting HHH’s offer? 
A Emergent B Rational C Incrementalist D Opportunism

16 
4.5 Which approach to strategy should we adopt? 
We have identified four different approaches to developing a strategy. While we 
have already mentioned that there is no ‘correct’ approach, it is important that you can justify which one would be the most appropriate for a particular organisation to adopt. 
We can consider the four approaches as a spectrum: 
 
More formal planning approaches, such as the rational model (and to a degree 
the emergent model) tend to suit organisations which: 
• exist in relatively stable industries, meaning there is sufficient time to 
undertake detailed strategic analysis 
• have relatively inexperienced managers, as the formal planning approach 
helps to ensure they are familiar with the organisation as well as providing 
a series of guidelines they can follow to help them develop a strategy. 
More informal approaches, such as freewheeling opportunism (and to a degree incrementalism) tend to suit organisations which: 
• are in dynamic, fast changing industries where there is little time to 
undertake formal strategic analysis 
• have experienced, innovative managers who are able to quickly identify 
and react to changes in the organisation and its environment 
• do not need to raise significant external finance (external investors 
typically prefer a formal planning approach). 
Note that incrementalism is unlikely to be suitable for new organisations as they 
have no past strategies upon which they can base their future policy.

Chapter 1 
 17 
 K is a small organisation which makes plastic toys. The company was 
very recently formed by Mr V. Mr V is a skilled entrepreneur with many 
years of experience in the industry. 
The toy industry is incredibly fast-changing, with new innovations being 
developed regularly. In addition, tastes and trends change regularly, meaning that sales of toys can drop quickly as they fall out of fashion. 
Mr V is aware that K will often require radically new strategies in order to 
keep up with these changes. 
Which ONE of the following approaches to strategic development would 
be most appropriate for K to adopt? 
A Incrementalism B Rational 
C Emergent 
D Freewheeling 
 
 Test your understanding 5 – HAA – (Case Style) 
 You are Ali, a management accountant working for HAA plc – a computer 
games company that operates in country F. You have just found the 
following note from your manager on your desk: 
NOTE Hi Ali, As I'm sure you're aware, HAA is planning to expand abroad, into the 
European market. To support this, we have undertaken a detailed review of our existing operations and the European market. This has been used to produce a three-year budget and operational plan for our proposed European operations. 
The European electronics market has always been seen as a difficult 
market for new entrants. This is due to the fast-moving, innovative nature of the companies currently operating there. HAA has a high spend on research and development and our directors feel that the company is well placed to compete with European games manufacturers. 
I’m meeting with the directors in fifteen minutes so I need you to make 
some brief notes for me evaluating our current approach to strategic planning. Can you suggest any more appropriate approaches we should consider? 
Thanks 
Required: Draft a response to your manager, as requested. 

18 
 Strategic planning for not-for-profit organisations (NFPs) 
 Strategic planning 
Many of the organisations in exam questions will be profit-seeking 
businesses. However, some may involve charities, councils, schools, hospitals and other organisations where profit is not the main objective. With such a 'NFP' a discussion of objectives is likely to be problematic for the following reasons: 
• It is more likely to have multiple objectives. A large teaching hospital 
may want to give the best quality care and treat as many patients as 
possible and train new doctors and research new techniques. Conflict is inevitable. 
This is not just an issue for NFPs, profit-seeking organisations also 
have multiple stakeholders with conflicting demands. 
• It will be more difficult to measure objectives. How can one measure 
whether a school is educating pupils well? Performance in exams? Percentage going on to university? Percentage getting jobs? Percentage staying out of prison once they leave? 
• There may be a more equal balance of power between 
stakeholders. In a company, the shareholders hold ultimate power. If they do not use it, the directors generally get their way. In a school, the balance of power may be more even (or even undefined) between parents, governors, the headmaster and the local education authority. 
• The people receiving the service are not necessarily those paying 
for it. The Government and local NHS trusts determine a hospital's funding, not the patients. Consequently there may be pressure to perform well in national league tables at the expense of other objectives. 
In spite of these problems, NFPs are still likely to need strategies. In the UK, for example, many public sector organisations have to produce strategic plans for between one and five years ahead as this is a Government requirement. 
One of the reasons for this is that the public sector is required to hit 
certain targets and key performance indicators (KPIs), which are set by central government. In a company these targets and KPIs are used to ensure that the business is competitive. For a public sector organisation, they are used by the government to exert control over the activities of the organisation and to ensure that the government’s funding is being used appropriately.

Chapter 1 
 19 
 The 3Es 
Public sector organisations and charities often have difficulty in using 
traditional private-sector-based approaches to objective setting since they do not make a profit by which their success or failure can be measured. One way to address this problem is to use the following approach. 
The 'three Es approach' of the Audit Commission: 
• Economy  looks solely at the level of inputs, e.g. did the hospital 
spend more or less on drugs this year? Or on nurses’ wages? 
• Efficiency  looks at the link between outputs and inputs (the internal 
processes approach). The 'internal processes approach' looks at 
how well inputs have been used to achieve outputs – it is a measure of efficiency. For example, what was the average cost per patient treated? What was the average spend per bed over the period? What was the bed occupancy rate that this achieved? 
• Effectiveness  looks at the outputs (the goal approach). The 'goal 
approach' looks at the ultimate objectives of the organisation, i.e. it looks at output measures. For example, for an NHS hospital, have the waiting lists been reduced? Have mortality rates gone down? How many patients have been treated? 
The best picture of the success of an organisation is obtained by using all of the above approaches and by examining both financial and non-financial issues. Think about effectiveness meaning ‘doing the right things’ and efficiency ‘about doing things right’. 
 
 Illustration 6 – The 3Es 
 Consider O – a large teaching hospital based in a major city which is 
funded by the Central Government. O may want to analyse its value for money using the 3Es in the following ways: 
Economy: O is given an annual budget by the Central Government. Economy is 
likely to look at whether this budget has been met. Has O spent more overall than expected? Has more or less been spent on drugs or wages than predicted? These would help O measure if it has been economical with the use of its funds.

20 
 Efficiency: 
How well have O’s inputs been used to generate its desired outputs? This 
looks at O’s internal processes and could include measures such as the average cost per patient, average spend per hospital bed, or the spend per student in the period. 
Effectiveness: This looks solely at the outputs of O’s operations. For example, has O 
had a higher or lower mortality rate than expected? What percentage of students have qualified or passed exams? How long is the patient waiting list at O? 
 
 H College is a government funded provider of education to several 
thousand students in country G. It aims to ensure that at least 75% of all exams sat by its students are passed. 
In the last year, it achieved a pass rate of 75% on its exams (the same as 
the previous year). The head of the college claimed that this was in spite of the government limiting H College’s budget rise to 3%, which meant that H College was unable to provide the level of service it had in previous years. Inflation in the economy of country G is 2%. 
The government’s official auditor has discovered that the cost per student 
has risen by 5% in H College over the last year, due to internal problems in operations. 
H College is expected to offer value for money (VFM). Which ONE aspect 
of VFM has H College managed to achieve over the last year? 
A Efficiency B Economy C Effectiveness D Ethical behaviour 
5 Perspectives to strategic planning 
While each aspect of strategic planning is important, firms may prioritise the 
perspectives in different ways: 
5.1 A traditional approach – stakeholders 
The traditional approach starts by looking at stakeholders and their objectives 
(e.g. increase EPS by 5% per annum). The emphasis is then on formulating plans to achieve these objectives.

Chapter 1 
 21 
Objectives are very important but this approach is often flawed in so far as 
objectives are often set in isolation from market considerations and are thus unrealistic. 
However, this approach can be particularly useful for not-for-profit organisations 
where a discussion of mission and objectives is often key. 
5.2 A ‘market-led’ or ‘positioning’ approach 
The more modern ‘positioning’ approach starts with an analysis of markets and 
competitors’ actions before objectives are set and strategies developed. 
The essence of strategic planning is then to ensure that the firm has a good ‘fit’ 
with its environment. If markets are expected to change, then the firm needs to change too. The idea is to be able to predict changes sufficiently far in advance to control change rather than always having to react to it. 
The main problem with the positioning approach lies in predicting the future. 
Some markets are so volatile that it is impossible to estimate further ahead than the immediate short term. 
5.3 A ‘resource-based’ or ‘competence-led’ approach 
Many firms who have found anticipating the environment to be difficult have 
switched to a competence or resource-based approach, where the emphasis of strategy is to look at what the firm is good at – its core competences. 
Ideally these correlate to the areas that the firm has to be good at in order to 
succeed in its chosen markets (critical success factors or CSFs – see chapter 5 
for more detail on this area) and are also difficult for competitors to copy. 
 
 J Ltd is a company which offers home television repairs to customers. It 
has an excellent reputation for customer service and good quality 
workmanship. J feels that this has given it a competitive advantage in the market. 
J is considering launching a car maintenance and repair service. It feels 
that its excellent reputation is likely to make such a move successful. 
Which ONE of the following approaches to strategic planning is J 
adopting? 
A A positioning approach B A traditional stakeholder approach C A resource-led approach D A corporate approach

22 
 Test your understanding 8 – GYU – (Case Style) 
 You have just received an email from your manager. 
To: A 
From: A. B Jones Date: 17/05/XX Subject: GYU Hi A, You may not have heard of GYU – they are a new client of ours. GYU is 
a large company which manufactures mobile phone handsets. This is an extremely competitive market and GYU has recently been struggling to 
keep up with other companies in its sector. This is due to the fast-paced 
nature of the market. New handsets with increasingly complex features are constantly being launched by competitors and the directors of GYU are concerned that the range of handsets manufactured by the company are beginning to look dated. 
This has caused a sharp fall in GYU’s cash balances and in response, for 
the first time in its history, GYU has had to cut its dividend. The fall, which was around 10%, was met with an angry response by shareholders and GYU’s share price has fallen significantly since the announcement. 
 While GYU's position appears weak, it is still seen as a market leader in 
the production of mobile handset software. While the reviews of its handsets are no longer entirely favourable, most customers agree that the software on the mobile phones is significantly superior to that produced by any of GYU’s competitors. 
I’m about to have a meeting with GYU’s directors for the first time and 
I think they will ask me to advise them about the three different approaches to strategy that GYU could use and which is the most appropriate for their business. I’d like you to email me back in the next fifteen minutes and tell me your thoughts on these matters. 
Required: 
Reply to the manager as requested. 

Chapter 1 
 23 
6 The role of the management accountant 
It is important to appreciate the role of management accountants within the 
process of developing strategy. Normally this will involve providing information to aid in strategic planning and decision-making. 
Strategic management accounting 
Strategic management accounting is a ‘form of management accounting in 
which emphasis is placed on information which relates to factors external to the entity, as well as non-financial information and internally generated information’. 
CIMA Official Terminology 
This indicates some key differences between strategic and traditional 
management accountants. 
External focus 
Traditional management accountants tend to focus on internal company issues. 
This is because their role is, amongst other things, to: 
• aid in the creation of operational strategies for the business • safeguard company assets – both tangible and intangible 
• measure and report both financial and non–financial performance to 
managers 
• ensure efficient use of assets and resources. 
Strategic management accountants must provide information to help managers 
make key strategic decisions. This requires a stronger external focus – especially regarding the behaviour of competitors, customers and suppliers. Indeed, the strategic management accountant will need to consider all aspects of the ecosystem in which their organisation operates; the activities of business partners will also need to be carefully monitored. 
This information will be vital to allow the business to understand the market it is 
operating in, which is a fundamental part of strategic planning. 
Forward-looking 
A large part of a traditional management accountant’s role is to do with the 
measurement of historic performance of a business and its divisions. 
Strategic management accountants need to be more forward-looking. This is 
because they will be analysing strategies that the business will employ in the future, rather than looking back at past performance.

24 
Information provided by stra tegic management accountants 
The information provided by strategic management accountants (SMAs) will 
include: 
• competitor analysis  – identification of competitors and detailed analysis 
of their activities 
• customer profitability  – which customers are the most important? 
• pricing decision  – forecasting of customer behaviour as well as 
competitor responses may help the business to decide on product pricing 
• portfolio analysis  – identification of key products and the strategies that 
should be adopted for each 
• corporate decision support  – this could include helping managers to 
decide whether or not to launch new products or enter/leave new markets 
• customer profitability analysis  – the SMA can help the business to 
identify which of its customers are most profitable and which may be 
costing the business money. 
• evaluation of brand value – SMAs can help assess the value of an 
organisation’s brand name, which may be useful when considering 
acquisitions and disposals of businesses or strategic business units 
• strategic informati on for acquisitions , disposals and mergers – the 
SMA can help to assess what value such actions could have for an organisation 
• investment in strategic management systems – SMAs can help 
management assess the need for and value of investment in new 
information technology and systems. For example, establishing and managing use of technology such as cloud computing or blockchain as part of the organisational ecosystem. 
A comparison of the information produced by strategic and traditional management accountants may be useful: 
 
Traditional management accountants: 
Cost structure Product costs Market share Profitability Price margins Strategic management  
accountants: 
Competitor cost structure Competitor product costs Relative market share Relative profitability Competitor price margins

Chapter 1 
 25 
Value of strategic ma nagement information 
The information produced by strategic management accountants will help the 
business in a number of ways, including: 
• more effective strategic planning 
• increased awareness of the business and its environment 
• increased control over business performance • better decision-making. 
 
 Which ONE of the following statements is consistent with the role of a 
typical strategic management accountant? 
A They focus primarily on the provision of information about internal 
company issues to management. 
B The information they provide to management is typically forward- 
looking. 
C Their primary focus is on the provision of financial information to 
D They typically focus on the production of the organisation’s financial 
statements.

26 
7 Summary 
By the end of this chapter, you should be able to discuss:

Chapter 1 
 27 
 The correct answers are A, C and D. 
 
B relates to freewheeling opportunism. C and D relate to the rational model. 
 
T has created a formal strategy after extensive analysis of its position. 
While this is consistent with the rational model, T has subsequently abandoned this and reacted to unforeseen events – i.e. the failure of its product to sell well. 
This willingness to adapt to events as they occur is consistent with the 
emergent approach. Note that incrementalism would involve small scale extensions to past 
strategies. HHH’s proposal is significantly different to its original strategy, so this does not appear to be the case. 
HHH is still basing its actions, at least in part, on a formally designed 
original strategy. This would indicate that it is not following an opportunistic approach. 
 
The pace of change in the market would tend to indicate that formal 
planning is not viable. This would suggest that the rational and emergent models are less useful. Incrementalism suggests that future strategies are small scale extensions of what has worked in the past. Again, this is clearly not appropriate given the need for radically new strategies highlighted in the scenario.

28 
 Meeting notes 
Current approach to strategy 
HAA is currently using the rational model to develop its strategies. This 
involves taking a logical, step-by-step approach. HAA has clearly done this by undertaking such detailed planning, including strategic analysis of the market and the production of detailed operating plans. 
The key advantage of such an approach to HAA is the level of 
understanding it will give them in the new market. They are currently not used to operating in the European market, so the initial strategic analysis they have performed will be invaluable. It will give them a picture of the their own capabilities as well as the European market they will be entering. 
However, the European market is fast-moving, both due to its nature 
(high-tech) and the level of innovation by competitors. HAA will have to be prepared to quickly change its approach to deal with unexpected developments in the market. If the company produces a detailed operational plan, this may stifle the innovation that is required. 
In addition, given the lack of experience that HAA has in the European 
market, any detailed forecasts it produces may prove to be unreliable. This may cause it to make inaccurate decisions based on flawed market predictions. 
 Alternative approaches to strategy for HAA 
HAA could adopt the emergent model. While this would still involve 
some initial formal planning, these plans would merely be a starting point for the European operations. They will be continuously reviewed and updated as the games market changes, improving HAA's chances of success in the fast-moving market. 
Alternatively HAA could choose the freewheeling opportunism  
approach to strategy. This would involve not producing a formal strategy 
– instead merely taking advantage of opportunities as they arise. The more rapidly the market evolves, the more applicable this approach may be, although it is considered too high risk for many managers.

Chapter 1 
 29 
Effectiveness looks at the outputs of the organisation. As H has achieved 
its goal of a 75% pass rate, it has been effective. 
Economy looks at the level of inputs – in this case, inputs have risen by 
3% in the year (above inflation), but the efficiency with which H has used these inputs has fallen significantly. These factors would indicate a lack of efficiency and economy. 
 
J has identified a key resource or capability – its strong reputation. It is 
now looking for new ways to capitalise on this. 
 
 There are three main approaches to strategic planning that GYU could 
take. 
Traditional 
This would involve GYU examining its key stakeholders and developing 
objectives that will meet their needs. The two key stakeholders in the scenario are GYU’s customers and shareholders. The shareholders are clearly upset with the reduction in their dividend and will expect GYU to 
reverse this in coming years. The customers will be looking for handsets with more features and that are less ‘dated’. 
Unfortunately, while these are important objectives, they may be difficult 
for GYU to accomplish in the short term. Given the poor level of its finances, it may struggle to either increase dividends or invest enough in research and development to update its product line. 
Market-led 
This will involve the examination of GYU’s competitors and market. Doing 
so should help GYU to ensure that it is competitive in what is a very fast-paced market. 
While this appears to have been a weakness of GYU’s to date (given the 
fact that it seems to have fallen so far behind many of its competitors), it may be inherently difficult in the mobile phone handset market. As the market is changing so rapidly, it may be difficult for GYU to accurately predict future trends and create appropriate strategies.

30 
 Resource-based 
This involves GYU focusing its business strategies on areas that it is 
good at. For GYU its key area of skill is in the production of mobile handset software. It is acknowledged to be the market leader in this area and it appears to be very important to customers. Any future strategies should therefore be based around le veraging this area of skill. 
For example, if it feels unable to produce handsets that are competitive, GYU could consider focusing on producing software which could then be licensed on other manufacturer’s handsets. If this is a big enough market, this could help GYU to turn its business around. 
Based on the information provided, the resource–based approach is likely 
to be best for GYU. 
 
Strategic management accountants tend to focus on information that is 
both internal and external, financial and non-financial information, and forward-looking. This will help management to make the best strategic decisions possible by having all relevant information to hand. Note that strategic management accountants would not usually focus on the production of the financial statements of the organisation – this role would usually be filled by financial accountants.

31 
Generating strategic 
options: Mission, vision, 
values and stakeholders 
A1: Explain the purpose of 
strategy (b) Explain the purpose of 
strategy 
B1: Analyse the elements of 
the ecosystem (a) Markets and competition 
C1: Discuss the context of 
generating options (b) Purpose, vision and 
values of organisation 
and their impact on strategy 
 
 Chapter 
2

Generating strategic options: Mission, vision, values and stakeholders 
32 
 
1 Mission 
Missions 
A mission is: 
The ‘fundamental objective(s) of an entity expressed in general terms’. 
(CIMA Official Terminology) 
The mission therefore is the basic purpose of the organisation  and tries to 
identify the reason it exists. Ultimately the strategies of the organisation should 
be designed to support the accomplishment of this mission. 
It is important that the organisation is able to communicate its mission both 
internally and externally, which requires the creation of a mission statement. 
‘The mission says why you do what you do, not the means by which you do it.’ 
Peter Drucker 
Mission statements 
A mission statement is: A ‘published statement, apparently of the entity’s fundamental objective(s). This 
may or may not summarise the true mission of the entity’. 
(CIMA Official Terminology)

Chapter 2 
 33 
Essentially, the mission statement is a statement in writing that outlines the 
organisation’s mission and summarise s the reasoning and values that 
underpin its operations . 
There is no ‘correct’ format for the mission statement and it will vary in style and 
length for each organisation. However, typically it is a short, punchy (and hopefully memorable) explanation of the reason the organisation exists. 
 
 Illustration 1 – Examples of missions 
 We are a global family with a proud heritage passionately committed to 
providing personal mobility for people all around the world. 
(Ford Motor Company) 
Our Mission is: 
• To refresh the world in mind, body and spirit. 
• To inspire moments of optimism through our brands and actions. 
• To create value and make a difference everywhere we engage. 
(Coca Cola) 
To create lasting solutions to poverty, hunger and social injustice. 
(Oxfam) 
Google’s mission is to organise the world’s information and make it 
universally accessible and useful. 
(Google) 
 
 Characteristics of mission statements 
 There are a number of fundamental questions that an organisation will 
need to address in its search for its purpose and mission. According to Drucker, these are:

34 
Mission statements will therefore typically have some or all of the 
following characteristics: 
• usually a brief statement of no more than a page in length (often 
much shorter) 
• very general statement of entity culture 
• states the aims (or purposes) of the organisation 
• states the business areas in which the organisation intends to 
operate 
• open-ended (not stated in quantifiable terms) • does not include commercial terms, such as profit 
• not time-assigned 
• forms a basis of communication to the people inside the 
organisation and to people outside the organisation 
• used to formulate goal statements, objectives and short-term targets • guides the direction of the entity’s strategy and as such is part of 
management information. 
Mission statements fulfil a number of purposes: • to communicate to all the stakeholder groups  – everyone involved in 
the organisation will be made aware of its mission and should therefore 
know what to expect from the organisation. 
• to help develop a desired corporate culture  – by communicating core 
values, policies and expected standards of behaviour to key groups, such as employees. 
• to assist in strategic planning  – the organisation should ensure that its 
strategies are consistent with its overall mission and therefore its corporate values. The mission statement can also be used as a way of screening out potentially unsuitable strategies. 
However there are a number of criticisms of mission statements, including: 
• they may not represent the actual values of the organisation  – as 
evidenced by the official CIMA definition of a mission statement. 
• they are often vague  – mission statements tend to be stated in very 
general terms, using phrases that are difficult to measure (such as Coca-
Cola’s desire to ‘refresh the world’). 
• they are often ignored  – mission statements are often seen as a public 
relations exercise and are not used by employees or managers when developing strategies. 
• they may become quickly outdated  – especially in fast-moving 
industries.

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 The process of creating a mission statement 
 The process of writing a mission statement 
Mission statements are normally drafted by the senior managers or 
directors of the organisation, as they are uniquely positioned to understand the needs and aims of the business at a high level. 
Usually the first step in creating a mission statement is to analyse the 
stakeholders of the organisation – customers, shareholders and employees (amongst others). More detail on this stage can be found later in this chapter. 
The directors of the company should identify the needs and aims of these 
stakeholders. They can then attempt to create a mission statement that reflects these aims and that shows how the organisation wants to relate to the stakeholders. 
 A draft mission statement can then be written and distributed to key 
stakeholders for review. Any feedback can be built into the final mission statement, which can then be published and widely distributed to as many interested parties as possible. 
The life span of a mission statement 
There are no set rules on how long a mission statement will be 
appropriate for an organisation. It should be reviewed periodically to ensure it still reflects the company’s environment. 
If the market or key stakeholders have changed since the mission 
statement was written, then it may no longer be appropriate. 
 
 Illustration 2 – Yahoo 
 Yahoo – an internet search based company – had a mission statement in 
the early 2000s which identified that it wanted to be ‘the most essential global internet service for consumers and businesses’. 
However, by 2007 Yahoo was beginning to struggle due to the rise of 
major competitors such as Google, whose mission statement was ‘to organise the world’s information and make it universally accessible and useful.’ Yahoo felt that its existing mission statement did not show stakeholders how it was different to these rivals. 
It therefore made its mission statement more specific, changing it to 
reflect that it wanted to ‘connect people to their passions, their communities and the world’s knowledge’. 
This attempted to show the difference between the two companies. 
Yahoo wished to position itself in the entertainment market, rather than merely providing information like Google.

36 
 As time moved on, Yahoo identified more about its target markets and 
the need to connect not only with users and their desire for more 
personalised service, but also their advertisers and key sources of revenue. By 2012, their mission statement had developed further into: 
‘Yahoo! is the premier digital media company. Yahoo! creates deeply 
personal digital experiences that keep more than half a billion people connected to what matters most to them, across devices and around the globe. That’s how we deliver your world, your way. And Yahoo!’s unique combination of Science + Art + Scale connects advertisers to the consumers who build their businesses. 
 
 JJJ Ltd’s mission statement is ‘to offer fantastic service to all customers’. 
The mission statement has recently been created by senior management but has not been widely circulated to anyone else. The CEO of JJJ has stated that all of the high-level strategies created by the organisation need to be measured against this mission. 
Which ONE of the following benefits is JJJ most likely to see from its new 
mission statement in the short term? 
A Rapid change in JJJ’s corporate culture to a focus on quality 
B Improved awareness amongst st akeholders of JJJ’s goals 
C Improved strategic decision-making D Improved image to customers 
 
 Test your understanding 2 – (Integration question) 
 The mission statement of C plc is "to provide our customers with a top 
quality product at a fair price". 
Required: 
Evaluate the usefulness of this mission statement. 
2 Vision statements 
Vision statements are often confused with mission statements, but the two are 
subtly different. 
 
 While a mission statement defines the present purpose and state of an organisation, the vision statement identifies the ideal position that the company wants to reach within the medium to long-term. It is, essentially, the longer term aspirations of the organisation.

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 Illustration 3 – Examples of vision statements 
 A just world without poverty. 
(Oxfam) 
Our vision is a world without Alzheimer’s. 
(Alzheimer’s Association) 
To make people happy. 
(Disney) 
To become the world’s leading consumer company for automotive 
products and services. 
Vision statements help give a longer term direction to the organisation’s 
strategies and are designed to help staff make decisions and behave in a way 
that helps move the company towards its ideal long-term position. 
Unfortunately, they have many of the same drawbacks as mission statements.  
 
Illustration 4 – mission or vision? 
 The main difference between vision and mission is illustrated by the 
statements produced by Microsoft: Mission statement: To help people and businesses throughout the world realise their full 
potential. 
Vision statement: A personal computer in every home running Microsoft software. This shows that the mission statement focuses on the company’s present 
operations. The vision shows the ideal state that the company wishes to achieve in the future.  
3 Values  
The values of the organisation describe the core ethics or principles which the organisation will abide by, no matter what circumstances it might find itself in. The values will help drive the behaviour of the business, and guide the actions of management, employees and other stakeholders, such as suppliers. 
Appropriate values that are clearly stated and adhered to serve a number of 
purposes for the organisation: 
• to guide staff behaviour  – everyone involved in the organisation will be 
expected to share and exhibit its values, resulting in suitable strategic and 
operational decisions being made.

38 
• to demonstrate integrity and accountability to external stakeholders  
– by stating a commitment to set levels of behaviour, failing to adhere will 
naturally result in steps being taken against the business. 
• set the organisation apart from its competitors  – a proven adherence 
to stated values can be a source of competitive advantage should competitors fail to display the same expected standards of behaviour. 
• Reduce the risk of inappropriate behaviour from staff  – particularly if 
the consequences of failing to act in  an expected manner are made widely 
known. 
• Set the culture of the organisation. 
The values set out by the organisation will depend on its industry and circumstances. For example, an academic institution such as a university (and therefore not a business driven by profit) may well place great value on freedom of thought, the value of research, or intellectual rigour. On the other hand, a listed telecoms company may adopt values such as network reliability, customer service, and returns to shareholders.  
 
Illustration 5 – adidas Group values 
 The adidas Group publishes the following extracts under the governance 
section on its website: For the adidas Group, corporate responsibility is rooted in its values: Performance. Passion. Integrity. Diversity. These values come from sport and sport is the soul of the adidas Group. 
It is what links our past and our present. It is what orients us towards the future.  
Our values help us to create brands that our customers believe in, and a company our stakeholders can trust. Corporate responsibility has many facets and permeates all parts and operations of the company. For the adidas Group, operating responsibly means: 
• Improving working conditions in our suppliers’ factories • Reducing the environmental impacts of our operations and in our 
supply chain 
• Caring for the welfare and development of our employees • Making a positive difference to people in the communities where we 
operate.

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4 Objectives 
A mission is an open-ended statement of the firm's purpose and strategy. 
Objectives are more specific and seek to translate the mission into a series of mileposts for the organisation to follow. 
To be useful for motivation, evaluation and control purposes, objectives should 
be SMART: 
• Specific – clear statement, easy to understand 
• Measurable – to enable control and communication down the organisation 
• Attainable – it is pointless setting unachievable objectives 
• Relevant – appropriate to the mission and stakeholders 
• Timed – have a time period for achievement. 
Key issues 
In the same way that an organisation's overall strategic plans need to be 
translated into a hierarchy of lower level tactical and operational plans, there will be a hierarchy of objectives where the mission statement is translated into detailed strategic, tactical and operational objectives and targets. 
Typical issues this gives rise to are as follows: 
• Objectives drive action, so it is important that goal congruence is achieved 
and the agreed objectives do drive the desired strategy. 
• It can be difficult (although necessary) to prioritise multiple, often 
conflicting objectives. 
• This is made more complex when some objectives are hard to quantify 
(e.g. environmental impact). 
• There will be a mixture of financ ial and non-financial objectives. 
• There is always the danger of short-termism. 
• Objectives will vary across stakeholder groups and a strategy may satisfy 
some groups but not others.

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Primary and secondary objectives 
Organisations will typically set themselves different types of objective, with 
some being more important than others. 
 
 Primary objectives  (also known as corporate objectives) are the major, 
overriding objectives of the organisation. They can be financial or non-financial but relate to the organisation as a whole and, typically, the needs of its stakeholders.  
 
 Secondary objectives  directly relate to the various strategies that the 
organisation needs to adopt in order to meet its primary objective. 
For instance, a company may set itself a primary objective of growing returns for its shareholders. It will then need to implement a number of strategies to help it achieve this – each strategy having its own ‘secondary’ objective. These secondary objectives could (for example) be an increase in customer satisfaction, increased sales growth, reduced wastage, or the launch of a number of innovative new products. 
If the company can achieve these secondar y objectives then it will be closer to 
meeting its primary objective of growing shareholder returns. 
Long and short-term objectives 
Objectives can either be long or short-term in nature. Short-term objectives 
typically focus on what the organisation wishes to accomplish over the coming year or so. Short-term objectives should be designed to help the organisation work towards achieving its longer term goals. 
For example, a small retailer may have a long-term objective to grow its 
turnover by 25% within five years’ time. This will need to be supported by a number of short-term objectives, such as a need to grow sales by 5% over the next financial year, or move to larger premises within the next six months. 
If resources are scarce (or simply badly planned by management), then short-
term and long-term objectives may be in conflict. For example, an organisation may set aggressive short-term profit targets for the coming year for its managers. This could lead to managers making decisions that meet the short term profit objectives but which compromise the long-term success of the organisation, such as: 
• Reduced research and development investment, thereby reducing the 
organisation’s ability to i nnovate and continue to meet its customer needs 
in the future. 
• Reducing investment in the organisation’s brand (such as cutting 
advertising costs), which may lead to loss of customers in the longer term.

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• Delaying or cancelling capital investment (such as new production facilities 
or retail space) which may reduce the ability of the organisation to grow in 
the future. 
• Reducing expenditure on staff motivation and training which may lead to 
higher staff turnover in future, as well as reduction in service quality offered to customers causing a fall in goodwill. 
Management therefore must be careful when setting short-term and long-term objectives. In reality, there may have to be a trade-off between the two, but they should not be in direct conflict with each other. 
 
 Which ONE of the following is NOT  a required feature of an objective? 
A Measurable B Strategic 
C Timed 
D Attainable 
 
 Q Ltd is owned by three shareholders. They have stated their desire to 
improve the profitability of the co mpany and thereby  increase their 
dividends. Q Ltd has created a number of objectives to respond to its shareholders 
needs. One of these is to ‘delight its customers and the world at large with our products by the end of the next financial year’. 
One of Q's managers has suggested that this does not meet all of the 
criteria for an objective. 
Which ONE of the following criteria IS being met by Q’s objective? A Measurable B Relevant C Attainable D Timed

42 
 Test your understanding 5 – JAA – (Case style) 
 JAA plc is a publisher of both fiction and non–fiction books, a market in 
which it faces significant competition. 
It has recently published a new mission statement: ‘JAA will continue to grow and innovate  as an organisation, while acting 
in a socially responsible way.’ For a future meeting of the Board of Directors, the Marketing Director has 
been asked to prepare a presentation to discuss this in more detail. She has asked you to help her by suggesting objectives that could be used to help the company achieve its missions of ‘growth’ and ‘innovation’. 
The Marketing Director has suggested that the only objective for ‘social 
responsibility’ will be the happiness of the workforce. 
 Required: 
Recommend, with reasons, TWO possible objectives each for BOTH 
growth and innovation for JAA, as requested by the Marketing Director. 
Comment on her propos ed objective for social responsibility and 
recommend, with reasons, an alternative. 
 
 Not-for-profit organisation (NFP) objectives 
 While we often look at organisations that seek to make a profit, there are 
many organisations for whom this is not the primary objective. These 
include: 
• government departments and agencies 
• trade unions 
• schools 
• charities (e.g. Oxfam, Red Cross) 
• mutual associations (e.g. building societies). 
Rather than seeking to make a profit, these organisations will try to 
satisfy particular needs of their members or the sections of society they have been set up to benefit. 
Illustration – the Chartered Instit ute of Management Accountants 
The objectives of the Institute are (amongst other things): 
• To promote and develop the science of Management Accountancy 
and to foster and maintain investigations into and research into the 
best means and methods of developing and applying such science...’

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 •  ‘...by means of examination and other methods of assessment to 
test the skill and knowledge of persons desiring to enter the 
profession.’ 
The services provided by many NFPs are limited only by the funds they have available. This means they normally aim to: 
• raise as much money as possible 
• spend this money as effectively as possible on the target group 
(with the minimum of administration costs). 
Setting formal objectives can be difficul t for NFPs. This is often due to the 
wide range of possible stakeholders as well as the fact the stakeholders 
who provide the funds may be different to the stakeholders who benefit from the NFP’s activities (e.g. a charity). This gives much more power to the providers of finance and their objectives may not be the same as the NFP’s. 
5 Stakeholders 
Mission and objectives need to be developed with two sets of interests in mind: 
(1) the interests of those who have to carry them out – typically managers and 
staff 
(2) the interests of those who focus on the outcome – such as shareholders, 
customers, suppliers, etc. 
Together these groups are known as stakeholders , ‘those persons and 
organisations that have an interest in the strategy of the organisation.’ 
Given the range of differing interests that these stakeholders will have in the 
organisation, it is not surprising to find that the mission may take several 
months of negotiation before it is finalised. The key aspect is that the organisation must take its stakeholders into account when formulating its mission and objectives. 
The mission-setting process can be a useful basis for getting the stakeholder 
groups to communicate their ideas and then be able to appreciate other viewpoints. 
Stakeholder groups and their differing needs 
It is worth noting that stakeholders are not only interested in the organisation’s 
mission statement. In fact, they are far more interested in the strategies which the organisation is undertaking as it is these strategies that are likely to impact upon the different stakeholder groups. It is this influence and interest which organisations need to carefully manage. 
In order to consider its stakeholders when developing strategies, the 
organisation must first identify who its stakeholders are and what they want or expect.

44 
A large company, for example, could have a wide range of stakeholders, 
Stakeholder: Objectives: 
Internal stakeholders  
Managers and employees Career development, pay, 
job security, enjoyable 
jobs. 
External stakeholders  
Government and regulatory agencies Compliance with relevant 
laws and regulations, collection of taxation. 
Civil society (including Non-Government Organisations (charities, pressure groups), civic clubs, trade unions, public groups, social and sports clubs, co-operatives, environmental groups, professional associations, consumer organisations and media) Varied – could include: 
Pollution controls, health 
of public, human or member rights. 
Industry associations Member rights, 
compliance with industry rules and practises. 
 
Connected 
stakeholders  
Shareholders Profit, share price and dividends. 
Customers Low prices, good quality products, good service. 
Financiers Interest payments, security, meeting loan agreement 
terms. 
Suppliers Assured demand, fair prices paid, payments made on 
time. 
As you can identify from the table above, some stakeholder objectives are likely to directly conflict with one another. Examples of conflict include: 
• shareholders want higher profits, employees want better pay and working 
• customers want may want 24/7 service, while employees want working 
arrangements which fit into their personal lifestyles and home and family 
arrangements 
• customers want high quality and low prices, shareholders want high profits 
• suppliers want prompt payment, lenders want overdraft limits adhered to.

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This means that it may be impossible for an organisation to satisfy the needs of 
all of its stakeholders. It must therefore find a way to prioritise its stakeholders, which is normally done by analysing their level of power and interest in the organisation. 
 
 The more power and interest, the greater the involvement in setting the mission and strategy. 
 
 Actors (Braithwaite and Drahos) 
 It is worth mentioning Braithwaite and Drahos to consider the full range of 
'actors' who may have an influence on the way an organisation conducts its business. 
• Organisations of states:  Organisations formed by groups of states 
that meet and employ staff to explore common agendas (e.g. the 
WTO, the EU). 
• States : Organised political communities with governments and 
geographical boundaries recognised by international law (e.g. Sweden). 
• Organisations formed by firms  and/or business organisations with 
common agendas, such as Chambers of Commerce. 
• Corporations : Organisations formed by actors who invest in them 
as commercial vehicles (e.g. Ford, British Telecom). 
• Non-Governmental Organisations (NGOs):  Organisations 
(excluding business organisations) that explore common agendas. They can be international (e.g. Consumers International) or national (e.g. British Standards Institute). 
• Mass publics: Large audiences of citizens who express together a common concern about an issue. 
• Knowledge based (epistemic) communities:  These consist of 
state, business and NGO representatives who meet sporadically and share a common discourse based on shared knowledge –sometimes technical knowledge requiring professional training; CIMA is an example. 
The last three groups may be collectively termed civil society. Civil society includes, among others, nongovernment organisations; people’s organisations; civic clubs; trade unions; gender, cultural, and religious groups; charities; social and sports clubs; cooperatives; environmental groups; professional associations; academic and policy institutions; consumers/consumer organisations and the media.

46 
6 Mendelow's power/interest matrix 
Mendelow’s matrix is a model which can be used to prioritise stakeholders and 
decide how to deal with each of them. It does this by examining their level of power (how much control they have over the organisation) with their level of interest (how likely the stakeholder is to try and exercise their power over the organisation). 
 
 Sources of stakeholder power 
 Typically, stakeholder power can come from a number of sources: 
• Positional power:  This arises because of an individual's position in 
the organisational hierarchy and is reflected in their formal authority and reputation. Directors, for example, will usually be powerful because of their rank in the organisation. 
• Resource power:  This arises because an individual can control, 
obtain or create resources or other items of value. For instance, a unionised workforce will be powerful as they control the key labour resource in the business. 
• System power:  This arises because a stakeholder has high 
visibility or political access and relevance to a particular situation. A director who is closely connected to a major shareholder is likely to have significant power within the organisation. 
• Expert power:  This arises where an individual has information, 
knowledge or expertise that is im portant to the organisation. Skilled 
employees, for example, will normally have more power than unskilled employees as they have skills that are important to the business and they are harder to replace. 
• Personal power:  This arises because an individual has good 
communication skills and r eputation and (usually) is well liked within 
the organisation. A popular director is likely to have more power in an organisation, as staff will be willing to follow his or her instructions.

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Applying Mendelow’s matrix 
• Minimal effort  
Their low level of interest and power makes these stakeholders open to 
influence. They are more likely than others to accept what they are told 
and follow instructions. 
• Keep informed  
These stakeholders are likely to have high levels of interest in the strategy but lack sufficient power to influence it. Management needs to convince opponents to the strategy that the plans are justified; otherwise these stakeholders will try to gain power by joining with parties with high power but low interest. 
• Keep satisfied  
The key here is to keep these stakeholders satisfied to avoid them gaining interest and moving to the "key players" box. This could involve reassuring them of the outcomes of the strategy well in advance. 
• Key players  
These stakeholders are potentially the most influential stakeholders in the strategic planning process. Their participation in the planning process is vital. Management, therefore, needs to communicate plans to them and then discuss implementation issues. 
Managing the relationship with stakeholder groups 
Powerful stakeholder groups must have confidence in the management team of the organisation. The organisation should ensure therefore that adequate management systems are in place. Some suggestions: 
• Allocate organisational responsibility for the process of stakeholder 
management along with a budget. 
• Use a team to manage stakeholders and decide on appropriate 
management techniques – ensuring a broad range of opinion and 
expertise. 
• Establish and order the objectives of the organisation. Identify the areas 
for potential conflict and target resources into those areas. 
• Frequent face-to-face meetings with the key player and keep satisfied 
groups.

48 
• Communication processes for the keep informed and minimal effort 
groups – possibly via public Q&A sessions. 
• Periodic formal reporting to stakeholders including, for example, the use of 
a website for ‘frequently asked questions’. 
It is worth remembering that this is complicated by the fact that individuals may 
be part of more than one stakeholder group at any point in time. For example, factory workers can also be members of the local community or even elected local government officials. This can mean that there are conflicts between their interests and objectives regarding a particular decision that the company is about to make. 
 
 According to Mendelow, which ONE of the following methods should be 
adopted to manage a stakeholder with high power and low interest? 
A Keep informed 
B Key players C Keep satisfied D Minimal effort 
 
 Country N is split into a number of regions, each with their own local 
government. The local government (LG) is given funding by the central 
government of country N, though LG officials are elected by local residents every four years. Resident turnout at local elections is high and local elections often result in a nu mber of changes to LG officials. 
LG budget is spent on a large number of local issues, such as transport and education for the region – issues that have a significant effect on the lives of local residents. The central government of country N has ultimate control over the amount of money that LG receives. However, central government rarely intervenes in LG affairs unless there is evidence of mismanagement of funds. 
One LG has recently undertaken stakeholder analysis using Mendelow's 
matrix and identified local residents and central government as two of these stakeholder groups. 
Which ONE of the following methods would be appropriate for each of 
these stakeholders? 
 Local residents Central government 
A Keep satisfied Key players 
B Key players Keep satisfied 
C Keep informed Key players D Key players Keep informed

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 Test your understanding 8 – AYL – (Case style) 
 You are Joe, a strategic management account at AYL, which operates 
the only public hospital within a small city in country U. All of its income is 
provided by the central government. However, due to a recent economic downturn, the central government is urgently looking for ways to save money. It has therefore decided to significantly cut AYL’s budget for the coming period. 
The management of AYL have therefore been looking at ways of 
reducing their expenditure while attempting to minimise the impact on the services provided to the public. They are planning to freeze pay for the 
semi-skilled nurses working at the hospital. 
 Your manager has left you the following note: 
Note 
Hi Joe, Our proposed pay freeze has prompted significant opposition from 
nurses. Nurses are not heavily unionised, but the remaining staff members in the hospital, such as doctors, are all members of the same union. There are no plans to cut the number of remaining staff jobs in the hospital, or to freeze the wages of anyone other than the nurses. 
Can you please write me some briefing notes identify the key 
stakeholders that the managers will need to consider. Using Mendelow’s 
matrix, recommend what approach the managers of AYL should take in relation to each one. I know what Mendelow’s matrix looks like, so please don’t draw it in your briefing note. 
Required: 
Draft the briefing notes as requested by the manager. 
 
 Resolving competing stakeholder objectives 
 Cyert and March suggest four ways to resolve conflicting stakeholder 
• Satisficing  involves negotiations between key stakeholders to 
arrive at an acceptable compromise. 
• Sequential attention  is when management focus on stakeholder 
needs in turn. For example, staff may receive a pay rise with the 
clear implication that it will not be their ‘turn’ again for a few years and so they should not expect any further increases.

50 
 • Side payments  are where a stakeholder’s primary objectives 
cannot be met so they are compensated in some other way. For 
example, a local community may object to a new factory being built on a site that will cause pollution, noise and extra traffic. The firm concerned may continue to build the factory but try to appease the community by also building local sports facilities. 
• Exercise of power  is when a deadlock is resolved by a senior 
figure forcing through a decision simply based on the power they possess. 
 
 L runs a small business which sells second hand motor vehicles. She did 
not offer a pay rise to her staff last year, stating that she had not earned sufficient profits to be able to do so. However, she promised that she would offer a pay rise this year – regardless of whether a significant profit was made or not. 
Which ONE of Cyert and March’s stakeholder conflict resolution 
strategies is L adopting? 
A Sequential attention B Satisficing C Exercise of power D Side payments 
 
 Stakeholder alliances 
 As outlined above, organisations do not exist in isolation and can be 
affected by a wide variety of stakeholders. Some of these stakeholders 
can become important allies, helping the organisation to achieve its goals. 
Stakeholder analysis 
Not all stakeholders will make useful  allies for the organisation. Using 
Mendelow’s matrix will help the organisation determine the most 
important stakeholders and the ones that would be sensible to consider as potential allies. 
For example, a company may wish to focus on major shareholders, as 
well as significant customers and suppliers, as these groups are likely to have a high degree of interest and power – making them more useful as allies.

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 Matching needs 
A strategic alliance will only work if it benefits both parties. Once the 
organisation has located potential partners, it needs to research what their aims are, as well as considering how they could link with its own and support its own aims. 
For example, if a manufacturing company knows that a government 
wishes to attract more jobs to a given region, it may suggest opening a factory in the region in exchange for subsidies. 
Creation of the alliance 
Once the organisation has identified the benefits of an alliance, it will be 
in a position to negotiate the terms with the desired partner. The alliance will need to be monitored on an ongoing basis to ensure that both parties are achieving the benefits they wanted. 
 
 Illustration 6 – Stakeholder alliances 
 Alliances can form between any organisations with matching interests. 
Microsoft and Dell are an example of this. Dell is one of the world’s largest manufacturers of personal computers and Microsoft writes the operating system used by the majority of these computers. 
The two companies work together to ensure that the technological 
development of Dell’s computers (i .e. memory and processor speed) 
keeps pace with Microsoft’s software. 
This arrangement benefits both organisations as it maximises the 
functionality of their products and provides their mutual customers with the best possible experience.

52 
 Test your understanding 10 – WRL – (Case style) 
 You are an accountant working in HHH – an accounts consultancy firm. 
You have received the following email from one of HHH’s senior partners: 
To: M. Williams From: A. Scott Date: 10/05/20XX Subject: WRL meeting this afternoon As you are probably aware, we are meeting with the managers of WRL 
later this afternoon to discuss several key issues, and I need you to do some research for me. I need a report in 45 minutes that covers the 
 (i) Categorise, according to Mendelow’s matrix, any three of the 
stakeholder groups of WRL with respect to the decision about the 
disposal of the polluted water. You should explain what the power and interests of the three stakeholder groups you have categorised are likely to be. 
Note:  I don’t want you to draw the Mendelow matrix. 
(ii) Advise the Board of WRL of the actions it should take to resolve the 
problem of its stakeholders’ competing objectives. 
(iii) Discuss the extent to which WRL’s mission statement is consistent 
with its plan to put the polluted water in the lake. 
To help you with this, I’ve attached a copy of our background analysis of WRL and its current situation. Please read it carefully and email me back within the next 45 minutes so I have time to prepare before the meeting. 
Thanks A. Scott Attachment 1 – Background to WRL WRL is a multi-national gold mining company. Its mission statement 
explains that ‘WRL exists to make the maximum possible profit for its shareholders whilst causing the least damage to the environment. WRL will, at all times, be a good corporate citizen’. 
In 2017 WRL was granted a licence to mine for gold by the national 
government of Stravia, a small country whose economy is mainly based on agriculture. The national government of Stravia was very keen to develop its economy and saw gold mining as an important aspect of this. The area where WRL was granted the licence is very remote and has no towns or cities nearby. There are small villages near the site of the gold 
mine. One of the conditions of the licence is that WRL would employ local people wherever possible, which it has done. WRL is entitled under the terms of the licence to dispose of the waste from the gold mining wherever is convenient for it.

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 The terms of the licence granted a payment by WRL to the national 
government of Stravia, payable in US dollars, which in 2019 totalled 
$50 million. This is a significant amount of foreign exchange for Stravia’s economy. Similar levels of payment by WRL to the national government are likely to continue annually for the foreseeable future. The mine has operated profitably since it began. 
WRL’s mine is in an area controlled by the Eastern state government. 
The Eastern state government was not involved in the negotiations to bring WRL to Stravia and is not entitled to any payment from WRL. However, Stravia’s national government granted the Eastern state government $1 million in 2019 from the payments which it received from WRL. 
The Eastern state government discovered that WRL’s proposed mining 
techniques use a great deal of water which becomes polluted. The cheapest way for WRL to dispose of this polluted water is to dispose of it in a lake near the mine and it intends to do this. 
The Eastern state government feared that if the polluted water was 
disposed of in the lake this would kill all the aquatic life in the lake and have a long-lasting adverse effect on the lake and the surrounding area. Therefore, the Eastern state government took legal action against WRL in the Eastern state courts to prevent the disposal of the polluted water in the lake. 
During the court action, WRL argued that if it was not allowed to dispose 
of the polluted water in the lake its mining operations in Stravia would become uneconomic and the mine would have to close. A small number of WRL’s shareholders argued that it was better to close the mine than to pollute the lake. 
The state courts granted the Eastern state government’s request to 
prevent WRL disposing of the polluted water in the lake. However, upon appeal to the National Supreme Court, WRL has been granted permission to pump the polluted water into the lake as its licence imposes no restrictions. 
Required: 
Send the email as requested by the partner. 
(45 minutes)

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7 Non-market stakeholders 
When businesses consider their stakeholders, they typically focus on the needs 
of those groups that help them directly gain competitive advantage, such as customers, suppliers and competitors – who collectively form the organisation’s ‘market environment’. In reality, however, competitive advantage can be built or lost outside of this market environment. 
 
 Non-market strategy  refers to an organisation’s relationship and 
interactions with its ‘non-market’ environment – such as: 
• governments 
• regulators 
• charities 
• pressure groups 
• the media 
• the public at large. 
Essentially non-market strategy sees the organisation as having social and 
political considerations, rather than simply economic concerns. 
For example, governments can have a major impact on an organisation through 
their policies, such as through the setting or removal of subsidies or licenses to operate, employee legislation, environmental regulation and taxation policies. 
Energy utility companies are under intense pressure from many governments 
(and the regulators that they have set up to monitor the energy industry) to not only provide affordable energy for their customers, but also to offer acceptable customer service levels and improve their environmental footprint. Failure on the behalf of the energy companies to meet these targets could lead to fines, other penalties, or even closure in extreme circumstances. 
It is therefore vital that an organisation constantly scans its environment to 
identify these non-market issues in advance and hopefully create appropriate strategies to deal with them. Models such as PEST analysis (which we will examine in more detail in chapter 4) are vital tools to help with this. 
However, it is easy for an organisation to feel that they must simply accept and 
try to manage non-market issues as they arise. In reality, organisations may wish to try and actually influence non-market issues. For instance, rather than simply waiting for governments to pass new laws, organisations may wish to influence political decision making – a process referred to as corporate 
political activity .

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 Porter's view on the influence of government 
 The influence of government on an industry 
Porter  identifies seven ways in which a government can affect the 
structure of an industry. 
• Capacity expansion. The government can take actions to encourage 
firms or an industry as a whole to increase or cut capacity. 
Examples include capital allowances to encourage investment in equipment; regional incentives to encourage firms to locate new capacity in a particular area, and incentives to attract investment from overseas firms. The government is also (directly or indirectly) a supplier of infrastructure such as roads and railways, and this may influence expansion in a particular area. 
• Demand. The government is a major customer of business in all 
areas of life and can influence demand by buying more or less. It 
can also influence demand by legislative measures. The tax system 
for cars is a good example: a change in the tax relief available for different engine sizes has a direct effect on the car manufacturers’ product and the relative numbers of each type produced. Regulations and controls in an industry will affect the growth and profits of the industry, for example minimum product quality standards. 
• Divestment and exit. A firm may wish to sell off a business to a 
foreign competitor or close it down, but the government might prevent this action because it is not in the public interest (there could be examples in health, defence, transport, education, agriculture and so on). 
• Emerging industries may be controlled by the government. For 
instance, governments may control numbers of licences to create networks for next-generation mobile phones. 
• Entry barriers. Government policy may restrict investment or 
competition or make it harder by use of quotas and tariffs for overseas firms. This kind of protectionism is generally frowned upon by the World Trade Organisation, but there may be political and economic circumstances in which it becomes necessary. 
• Competition policy. Governments might devise policies which are 
deliberately intended to keep an industry fragmented, preventing one or two producers from having too much market share. 
• New product adoption. Governments regulate the adoption of new 
products (e.g. new drugs) in some industries. They may go so far as to ban the use of a new product if it is not considered safe (a new form of transport, say). Policies may influence the rate of adoption of new products, e.g. the UK Government ‘switched off’ the analogue television networks in 2012, effectively forcing users to buy digital, cable or satellite services.

56 
 Illustration 7 – non market strategy in action 
 Toyota Prius 
Toyota is the market leader in the production and sale of hybrid cars. In 
the US it successfully lobbied the California state government to allow drivers of its flagship Prius hybrid model use car lanes which were reserved for vehicles with two or more passengers – even if the Prius contained no passengers. It also convinced the state government to allow Prius owners to park for free in public owned car parks. 
This lobbying required little investment from Toyota, but significantly 
boosted their green credentials, as well as giving their cars a competitive 
advantage in the market place. However, this was accomplished through 
their interactions with the government, meaning that this is an example of a non-market strategy. 
Novartis Non-market strategies do not have to only relate to political issues. Non-
market strategy also looks at an organisation’s interactions with wider society. 
Novartis is a leading pharmaceutical company which tried for a number of 
years to gain a patent for one of its anti-cancer drugs (Glivec) in India. India denied a patent, stating that the drug was not a sufficient improvement over existing anti-cancer drugs to warrant a patent. As well as engaging in a high profile court case over the issue, Novartis also offered its new drug to needy Indian patients at a drastically reduced price, as part of its ‘corporate citizenship’ programmes. This helped to build its brand, improve its image with the wider public and thereby undermine its critics. As such, this is another example of a non-market strategy. 
Corporate political activity 
 
 Corporate political activity (CPA) is the involvement by an organisation in the political process, with the aim of obtaining certain policy preferences. 
CPA can take many forms, including: 
• Lobbying  – this can involve members of the organisation (or hired 
professional lobbyists) putting their case to government officials such as 
ministers, MPs or civil servants, in an attempt to win their support. 
• Directorships  – the business may give MPs or retired senior civil servants 
non-executive directorships, in the hope that they will take an interest in legislation that affects the busine ss and will exercise their influence.

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• Influencing public opinion  – the business may attempt to change public 
perception on a key issue through advertising, media or even gathering 
petitions. The business will hope that public feeling will affect the legislative agenda. 
• Donations  – the business may fund individual candidates or whole 
political parties as a way of influencing future legislation. 
• Associations – an organisation may try to act upon the government 
collectively through the creation of an association with other interested parties. In theory this collective action should have more influence on governmental policy than each company acting alone. In the UK examples of this within the business world include: 
– the Confederation of British Industry (CBI), representing the private 
business sector 
– the Institute of Directors (IOD) – the Federation of Small Businesses (FSB). 
• Legal action  – if an organisation believes that a proposed or enacted law 
is unfair, they may take direct action through the courts for its repeal. 
 
Corporate political activity and ethics 
 Several of the methods that organisations can use as part of their 
corporate political activities (CPA) may raise ethical concerns. For 
example: 
• donations to candidates or political parties could be seen as bribery, 
which would be highly unethical 
• offering directorships to MPs or retired civil servants in order to gain 
favourable votes on relevant legislation could equally be seen as a 
form of bribery 
 • advertising campaigns, petitions or legal action could be seen as a 
way of large, well-resourced organisations bringing unfair pressure on the public or government on certain issues, simply for their own profit. 
It is therefore very important that organisations consider what actions to take as part of their CPA. Organisations therefore need to carefully consider: 
• relevant law (i.e. anti-bribery legislation) AND 
• professional ethics (such as the CIMA code of ethics discussed in 
chapter 3) 
when deciding on a strategy.

58 
 K is a large, multinational manufacturer of food and drink products. It has 
manufacturing facilities in five countries, but it sells in almost ninety 
countries around the world – typically through local supermarkets. 
Which of the following options are examples of non-market strategy for 
K? Select ALL that apply. 
A K participates in an annual charity fund-raising day in country H to 
help meet its corporate social responsibility duties 
B K has centralised its purchasing function, allowing it to improve its 
ability to get quantity discounts from suppliers 
C K has recently started an online petition in country G against 
proposed new restrictive health and safety laws 
D K's stores in country B have joined a trade association to help 
improve planning restrictions for retail stores 
E K has cut the prices of its goods by fifteen percent in country K in 
order to attract new shoppers

60 
Mission statements will be of limited use if they are not widely publicised. 
If the Board fails to advertise the mission, it will have little immediate effect on other stakeholders, such as staff and customers. 
However, it will give the Board a yardstick to measure their strategies 
against going forward. This should mean that their decisions are more consistent. 
 
 This can be criticised as a mission statement for a number of reasons. 
• It does not state the business areas in which the company intends 
to operate. As such it would not be useful to assess a strategy of market development, for example. 
• It does not give a reason for the company's existence. In particular, 
the statement fails to give any indication why the company will be better than its competitors in what it does. 
• It appears to focus on customer requirements only, and has nothing 
to say about other stakeholder groups, particularly employees and shareholders. It does not actually define who its customers are or who it wants its customers to be. 
• It is dull. Short mission statements should be inspiring. 
• It communicates nothing about the firm's values to employees. 
• The terms 'top quality' and 'fair price' are unclear in their meaning. It 
is not clear what is meant by 'quality', nor what 'fair' is in terms of 
price. Assuming that it will be expensive to achieve top quality, how high might a fair price be? Does it mean fair to the customer or fair to the shareholders? Taken at face value there is a danger the company could make a loss! 
In defence of the statement it does highlight the need to meet customer expectations in order to be successful. 
On balance, however, the mission statement will fail to inspire 
employees, determine culture or assist strategic planning.

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Objectives should be SMART – specific, measurable, attainable, relevant 
and timed. 
 
The objective asks for the company to 'delight' customers – which is not 
easy to measure. The chances of the company delighting its customers and the rest of the world seem low – especially by the end of the next financial year – suggesting that it is not attainable. It is also not directly 
relevant to the shareholders needs of raising profits and dividends. 
The only aspect of an objective that is present is that there is a time limit 
built in. 
 
 Possible objectives for JAA could include: 
Growth 
JAA could set itself an objective to increase its sales volume  – either in 
terms of the additional number of books it wishes to sell, or in terms of 
the percentage increase it wishes to see compared to its current sales volume. 
The company could also consider setting itself an objective relating to its 
market share. As it operates in a highly competitive market, JAA may wish to set itself an objective to achieve a set percentage share of the total market for fiction and non-fiction books. 
Innovation 
To achieve this objective, JAA could set itself objectives relating to the 
number of new books launched  each year. By bringing more new 
books to market than its competitors, it may be able to increase its market share and put pressure on other publishers. 
JAA could also set objectives relating to the number of new ways of 
selling its products  that it utilises. This could involve selling its books 
online, as electronic downloads or through tablet computers and 
electronic readers.

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 Marketing director's suggestion 
The marketing director has suggested that the happiness of employees 
could be used as the sole objective for social responsibility. While it is correct that an employer who has good social responsibility should see 
an increase in staff happiness, this will not make a good objective on its own. 
Firstly, social responsibility ext ends beyond how the company treats its 
employees. To get a full picture, the company needs to examine how its 
actions are impacting on other stakeholders and the wider environment. 
In addition, employee happiness in itself is not directly measurable, 
meaning it cannot be a good objective. The marketing director needs to be more specific. For example, she could measure the staff turnover to get an indication of how staff feel about the company. 
 
By definition. 
 
 The correct answer is B Local residents are highly affected by the LG’s decisions and are willing 
to exert significant power (as evidenced by the high turnout at elections). This would indicate high power and high interest, making them key players. 
Central government also seems to have high power as they control the 
funding to the LG. However, they rarely get involved in LG operations unless there is evidence of mismanagement. This would suggest they should be kept satisfied.

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 Nurses 
Given the proposals to cut or freeze their pay in the coming period, 
nurses will have high interest  in the proposals. 
However, they are not unionised. This would tend to indicate a lower level of power  as they lack a clear ability to co-ordinate strike action and 
could be relatively easy to replace due to their relatively low level of skill. 
Under Mendelow's matrix, nurses should therefore be kept informed . 
The management of AYL need to try and convince them of the need for 
the pay freeze in order for the hospital to continue to function. This may, 
however, be difficult to do. This may lead to the nurses attempting to gain 
power by unionising and joining with the other workers in AYL, or alternatively lobbying the government. 
Patients If the proposed pay cuts are implemented, patients are unlikely to see a 
significant change in their level of care. This will give them a low level of 
interest . 
In addition, while patients may collectively have an influence on the elected national government, there is no indication that patients have any kind of organisation, indicating a low level of power . 
Mendelow's matrix would therefore suggest that the managers of AYL should adopt a minimal effort  approach with regards to patients in this 
area. They are likely to accept what the management tell them as long as it does not affect their level of care. Should it do so, they may become more interested. 
Other members of hospital staff As it stands, there is no evidence that  any other types of hospital staff will 
be affected by the pay cuts. Given the fact that the nurses are not part of 
the main union that represents the other members of staff, it is likely that they will have low interest . 
However, should they choose to take an interest, the remaining members of staff will probably have high power . They are unionised and include 
key members of staff (skilled doctors). This means that any strike action could be extremely damaging to the hospital. 
As such, the managers of AYL should adopt an approach of keeping 
them satisfied . By reassuring other workers that their circumstances are 
not affected by the cuts, AYL may be able to prevent them taking an 
active interest in the proposals.

64 
 Central government 
The government ultimately controls the budget for the hospital. This gives 
it high power . 
In addition, it is currently looking for ways to reduce its expenditure, so it has high interest  in the success of AYL’s proposals. 
AYL have no choice but to adopt a key players  approach. They need to 
fully communicate their plans to the central government and ensure they are happy with the proposals. If the central government recommends changes to the proposed cuts, AYL's managers would be wise to accept them. 
 
Last year, L focused on giving herself a sufficient return. This year, she is 
making other stakeholders (her staff) a priority. 
 
 To: A. Scott  
From: M. Williams Date: 10/05/20XX Subject: Re: WRL Meeting this afternoon Please find below my analysis of the points you wished me to examine 
for WRL. Please let me know if you wish to discuss any of these points in more detail. 
Kind regards A. Scott (i) Categorisation of three stakeholder groups in WRL 
Eastern State Government/Local residents – High Interest, Low 
power (keep informed) 
The Eastern state government, representing the local population of 
the area around the mine has proven it has high levels of interest in the project. 
On a positive note, the mine will provide local employment as well 
as a payment from the central government of $1m. However, it will also have a significant adverse effect on the local environment, which has caused the state government to take legal action against WRL.

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 The Eastern state government seems to have low levels of power. It 
was not part of the negotiations and it appears that after its 
unsuccessful legal action against WRL it has no further power to prevent the mine from going ahead. 
Central Stravian government – Low Interest, High Power (keep 
satisfied) 
The central government seems to have been unconcerned with 
possible effects on the environment as they have not built any controls into the licence with WRL. After the initial negotiations were concluded, the central government seems to have taken relatively little interest in the problems that have arisen with the project. 
Should they decide to take an active interest in the future, however, 
they would undoubtedly have significant power over the project and could ultimately decide to close it down. 
The Central government’s interest may increase if the impact on the 
environment is a concern for local residents – meaning that it is possible they may become key players in the future. 
WRL Shareholders – Low Interest, High Power (keep satisfied) 
RL’s shareholders ultimately own the company and therefore they 
have significant control over its actions. Should a significant number of shareholders become unhappy with the operations in Stravia, it would put pressure on the company to withdraw. 
In addition, as the investors in the company, they will also have a 
great deal of interest in WRL providing them with sufficient return on their investment. However, only a small number of shareholders have indicated any concern over the potential pollution of the lake in Stravia. The majority seem uninterested in the pollution, as long as their returns are sufficient. 
(ii) Advice on the actions needed to resolve competing stakeholder objectives  
The key conflict here is between the needs of the bulk of WRL’s shareholders to make a profit and the concerns of the Eastern state government and a small minority of shareholders over pollution in the surrounding area. Unfortunately, this conflict is not easily resolved. 
Reduction of environmental impact  – One possible method is to 
investigate ways of treating the polluted water before it is pumped 
into the lake. While this may be more expensive, it may allow a compromise position to be found whereby the damage to the lake is minimised but the project is still economically viable for WRL.

66 
 Publicity – Failing this, WRL may need to attempt a damage- 
limitation exercise. This could involve the publicising of the positive 
effects of the mine on the local economy and residents. The Eastern state government presumably represents the needs of the residents, so highlighting the benefits of the new mine may go a long way towards calming their fears. 
Withdrawal  – Alternatively, given WRL’s insistence on being a good 
corporate citizen, it could opt to pull out of Stravia completely and 
look for alternative investments that will not pollute the environment to such a degree. 
It is unclear whether many alternatives are available for WRL to 
pursue. If not, this may not be acceptable to shareholders, who for the most part seem to support the Stravian mine. There may also be financial penalties for WRL withdrawing from its agreement with the central government. 
WRL could use the model proposed by Cyert & March, who 
examined possible ways to deal with stakeholder conflict. These include: 
– Satisficing – this would involve keeping the most powerful 
stakeholders happy – presumably in WRL’s case, this would 
be its shareholders. 
– Sequential attention – this involves WRL taking turns 
prioritising stakeholders needs. This would be unlikely to be useful in this scenario due to the conflicting nature of the stakeholders needs. 
– Side payments – if WRL is unable to deal with the Eastern 
State Government’s needs, it could look at other ways of compensating them. Perhaps offering additional payments would appease the local government. 
– Exercise of power – ultimately if, as in this case, no agreement 
can be reached, the most powerful stakeholders can exercise their influence and force a settlement. 
Conclusion  – It should be noted that ultimately there may be no 
way to completely resolve this stakeholder conflict. In these cases, stakeholder analysis would indicate the need to side with the most powerful groups – the ‘key players’ – who in this case would be the shareholders.

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 (iii) Discussion of the extent to which WRL’s mission statement is 
consistent with its plan to pollute the lake.  
WRL’s mission statement breaks down into three key statements. The proposed strategy in Stravia should be analysed to see whether it conforms to these. 
To make the maximum possible profit for its shareholders 
WRL obviously feels that this project is profitable for investors. After 
negotiations with the local government it has decided to proceed and feels it will only become uneconomic if the waste water has to be disposed of in an environmentally friendly way. 
Causing the least damage to the environment 
WRL would appear to not be meeting this requirement due to the 
damage about to be done to the lake and local environment. However, given the vague nature of the mission statement, WRL may argue this is the least possible damage to the environment, given the nature of their business. The damage to the lake could be seen as the least damage they can do whilst still meeting their other goal of maximising investor returns. 
Be a good corporate citizen 
Again , the answer to whether WRL is meeting this part of its mission 
statement is more complex than it might initially appear. Certainly the effect on the local environment of the polluted water 
would not be consistent with good corporate citizenship. 
However, it could be argued that WRL is also providing significant 
investment in the local area – with jobs for local workers as well as the $1m payout that the Eastern state government received. 
Contributing to the local economy could be seen as meeting the 
requirement for good corporate citizenship. 
 
 The correct answers are A, C and D 
Remember that non-market activities will not relate to stakeholders such 
as suppliers (option B) and customers (option E). A, C and D all relate to activities that relate to society (option A) or political issues (options C and D), which would form part of a non-market strategy.

68

69 
The role of governance 
and ethics in the 
strategy process 
B3: Discuss the impact of the 
ecosystem on 
organisational strategy (b) Conduct stakeholder 
analysis in networks. 
generating options (a) The role of governance 
and ethics in the strategy process. 
 
  Chapter 
3

The role of governance and ethics in the strategy process 
70 
 
1 What is corporate governance? 
The Cadbury Report 1992  provides a useful definition: 
• 'the system by which companies are directed and controlled'. 
An expansion might include: 
• 'in the interests of shareholders' highlighting the agency issue involved • 'and in relation to those beyond the company boundaries' or 
• and stakeholders' suggesting a much broader definition that brings in 
concerns over social responsibility. 
To include these final elements is to recognise the need for organisations to be 
accountable to someone or something. 
 
 Governance could therefore be described as: 
 
• 'the system by which companies are directed and controlled in the interests of shareholders  and other stakeholders'.

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 Coverage of governance 
 Companies are directed and controlled from inside and outside the 
company. Good governance requires the following to be considered: 
Direction from within: 
• the nature and structure of those who set direction, the board of 
directors 
• the need to monitor major forces through risk analysis • the need to control operations: internal control. 
Control from outside: 
• the need to be knowledgeable about the regulatory framework that 
defines codes of best practice, compliance and legal statute 
• the wider view of corporate position in the world through social 
responsibility and ethical decisions. 
 
 2  The business case for governance 
Providing a business case for governance is important in order to enlist 
management support. Corporate governance is claimed to bring the following 
benefits: 
• It is suggested that strengthening the control structure of a business 
increases accountability of management and maximises sustainable 
wealth creation. 
• Institutional investors believe that better financial performance is achieved 
through better management, and better managers pay attention to governance, hence the company is more attractive to such investors. 
• The above points may cause the share price to rise – which can be 
referred to as the “governance dividend” (i.e. the benefit that shareholders receive from good corporate governance). 
• Additionally, a socially responsible company may be more attractive to 
customers and investors hence revenues and share price may rise (a "social responsibility dividend"). 
The hard point to prove is how far this business case extends and what the returns actually are.

72 
3  Purpose and objectives of corporate governance 
Corporate governance has both purposes and objectives. 
For the private sector: 
• The basic purpose of corporate governance is to monitor those parties 
within a company which control the resources owned by investors. 
• The primary objective of sound corporate governance is to contribute to 
improved corporate performance and accountability in creating long term 
shareholder value. 
For the public and not for profit sectors: 
Often objectives within these organisations are more complex and conflicting. Organisations are often appraised according to the "value for money" (VFM) 
that they generate. 
Value for money may be defined as performance of an activity to 
simultaneously achieve economy, efficiency and effectiveness. 
This means maximising benefits for the lowest cost and has three constituent 
elements: 
• Economy – a measure of inputs to achieve a certain service or level of 
service. 
• Effectiveness – a measure of outputs, i.e. services/facilities. • Efficiency – the optimum of economy and effectiveness, i.e. the measure 
of outputs over inputs.

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 73 
 
 4  Key concepts of governance 
The foundation to governance is the action of the individual. These actions are 
guided by a person’s moral stance. 
Characteristics which are important in the development of an appropriate moral 
stance include the following: 
Fairness 
• A sense of equality in dealing with internal stakeholders. • A sense of even-handedness in dealing with external stakeholders. 
• An ability to reach an equitable judgement in a given ethical situation. 
Openness/transparency 
• One of the underlying principles of corporate governance, it is one of the 
‘building blocks’ that underpin a sound system of governance.

74 
• In particular, transparency is required in the agency relationship that exists 
between directors and investors. In terms of definition, transparency 
means openness (say, of discussions), clarity, lack of withholding of relevant information unless necessary. 
• It has a default position of information provision rather than concealment. 
• Innovation occurs when a firm “transforms knowledge and ideas into new 
products, processes and systems for the benefit of the firm and its 
stakeholders.” 
• In the context of corporate governance, this covers innovation and 
experimentation in reporting, allowing the business to move away from rigid compliance, and towards the better communication of its individual value creation story for its providers of financial capital. 
• Ultimately, innovation improves a firm’s reporting performance to the 
benefit of investors and consumers. 
• Much of the knowledge from which innovation stems is tacit and "local," 
meaning that such knowledge is unique to the company and the environment in which the knowledge arises. 
• In addition, the capacity of a firm to integrate external knowledge is crucial 
for successful innovation. 
Scepticism 
• Scepticism (often referred to as professional scepticism) is an attitude 
which includes a questioning mind, being alert to conditions which may 
indicate possible misstatement due to error or fraud. This is to provide a critical assessment of evidence. 
• For example, The UK Corporate Governance Code provisions advocate 
for non-executives to apply scepticism in order to challenge and scrutinise management effectively. 
Independence 
• Independence from personal influence of senior management for non-
executive directors (NEDs). 
• Independence of the board from operational involvement. • Independence of directorships from overt personal motivation since the 
organisation should be run for the benefit of its owners. 
• A quality possessed by individuals and refers to the avoidance of being 
unduly influenced by a vested interest. 
• This freedom enables a more objective position to be taken on issues 
compared to those who consider vested interests or other loyalties.

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Probity/honesty 
• Honesty in financial/positional reporting. • Perception of honesty of the finance team from internal and external 
stakeholders. 
• A foundation ethical stance in both principles – and rules-based systems. 
 
 In 2014 a whistle blower in the finance team at Tesco alerted 
management to a possible overstatement of profits. This has been 
produced through recognising transactions with suppliers in the wrong accounting period, and was a response to pressure to show improved performance following increased competitive threats from discount retailers such as Aldi and Lidl. 
Tesco lost approximately 50% of its market value that year. In response, the new Tesco CEO wrote a letter to all suppliers, stating: “I expect Tesco to act with integrity and transparency at all times. Our values are what we stand for and we will live those values in all that 
we do for Tesco. It is in times of challenge that our values are tested, and I want to reassure you that we will live our values fully at this challenging time. 
Our relationships with suppliers are critical. They form the bedrock of the 
service we provide to our customers.” 
• Willingness to accept liability for the outcome of governance decisions. 
• Clarity in the definition of roles and responsibilities for action. • Conscientious business and personal behaviour. 
• The obligation of an individual or organisation to account for its actions 
and activities. 
• Accounting for business position as a result of acceptance of 
responsibility. 
• Providing clarity in communication channels with internal and external 
• Development and maintenance of risk management and control systems.

76 
Reputation 
• Developing and sustaining personal reputation through other moral 
virtues. 
• Developing and sustaining the moral stance of the organisation and the 
industry in which it operates. 
 
 Illustration 2 – BP Chief Executive 
 Lord Browne resigned from his position as CEO of oil giant BP in May 
2007 due to media stories regarding his private life. 
His resignation was to save BP from embarrassment after a newspaper 
had won a court battle to print details of his private life. Lord Browne apologised for statements made in court regarding a four year relationship with Jeff Chevalier that he described as being ‘untruthful’ (he had actually lied, this relationship had existed). 
Due to this ‘untruthfulness’ Lord Browne gave up a formidable 
distinguished 41 year career with BP, and did the honourable thing by resigning as the damage to his reputation would have impacted adversely on BP. 
Judgement 
• The ability to reach and communicate meaningful conclusions. 
• The ability to weigh up numerous issues and give each due consideration. 
• The development of a balanced and evaluated approach to making 
business decisions and personal relationships covering intellectual and 
moral aspects. 
• To make decisions in the best interests of the organisation. 
Integrity 
• A steadfast adherence to strict ethical standards despite any other 
pressures to act otherwise. 
• Integrity describes the personal ethical position of the highest standards of 
professionalism and probity. 
• It is an underlying and underpinning principle of corporate governance and 
it is required that all those representing shareholder interests in agency 
relationships both possess and exercise absolute integrity at all times.

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5  How does corporate governance impact organisational 
strategy? 
Corporate governance is very important to help maximise the effectiveness of 
an organisation’s strategy. This is for a number of reasons. 
• Corporate governance works to ensure that no individual can dominate the 
board of directors (by ensuring the CEO and Chairman roles are 
separated as well as the presence of independent non-executive directors). This helps to ensure that no-one is powerful enough to force through inappropriate or ineffective strategy. The non-executive directors should be able to impartially assess whether a proposed strategy is in the best interests of the organisation. 
• Corporate governance should help to improve the diversity of the board of 
directors. This allows the board to identify a wide range of possible strategies, as well as analyse them from a variety of different viewpoints. 
• Adequate internal audit and control systems should ensure that the board 
has accurate information about the current operations of the company. This will enable them to develop more effective strategies for the organisation. In addition, strong internal control increases the chance that the organisation will be able to implement its strategies successfully. 
• Having good corporate governance is attractive to investors. This will 
make it easier for the organisation to raise the funding necessary to invest in the new strategies that they have identified. 
It is therefore extremely important that companies consider corporate governance principles if they wish to develop and implement successful strategies. The increasing emphasis on corporate governance has naturally lead to more scrutiny of the sense of business ethics which is displayed by an organisation (this is examined in more detail later in this chapter). 
It has also lead people to question the overall impact an organisation has on the 
world, and a subsequent increasing demand that this should be as positive as possible. This leads us to examine the s ubject of corporate so cial responsibility. 
 
 Which ONE of the following is NOT a strategic aim of corporate 
governance? 
A To reduce costs within the organisation 
B To increase the organisation’s transparency to stakeholders 
C To improve investor confidence in the organisation D To ensure that the organisation abides by relevant laws and acts 
ethically

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 Test your understanding 2 – ADF – (Case Study) 
 You are the Finance Director of ADF – a large national firm that retails 
clothes direct to the public through a chain of 250 high-street stores in 
country F. You have just received the following email from the Managing Director (MD), Carlos Smith: 
To: Anne Accountant From: Carlos Smith Date: 1/5/20XX Subject: Review of corporate governance arrangements Hi Anne, 
As you may be aware, we are currently reviewing our corporate 
governance arrangements within the company after some of our investors expressed concerns. I felt that you would be the right person to ask about this as I’m aware you’ve studied this topic. 
You’re probably aware that ADF’s executive directors are all employees 
who have worked their way up through the company. Half of the board is made up of non–executive directors. 
If you remember, the Chairman of the board is a retired director of a 
major electrical retailer. All of the other non–executive directors are personal friends of his and were appointed on his recommendation. 
As you know, only one member of the board is female. All the directors 
are from country F and between the ages of 45 and 55. 
 The company does have a small internal audit department but this is 
understaffed. The Head of Internal Audit has stated several times that the work undertaken on ADF’s stores is minimal and that a number of stores have never been visited by internal audit. 
As we discussed at the Board meeting last week, the company is 
concerned that its current market is saturated and is looking to expand abroad into neighbouring countries, though the Chairman has expressed concern over this as he feels it is too risky. 
I’d be grateful if you could identify any weaknesses in our corporate 
governance. Please could you explain how each weakness will affect the company strategically. I’m meeting a few other Board members to discuss this in 20 minutes, so I be grateful if you could give this some urgent attention. 
Thanks Carlos Required: Draft a reply to Carlos, as requested. 
(20 minutes)

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6  What is corporate social responsibility? 
In the modern world, it is seen as being increasingly important to consider how 
organisations manage their business processes to have an overall positive impact on society. 
It is worth noting that corporate social responsibility (CSR) is distinct from 
ethics. Business ethics comprise principles and standards that govern behaviour in the world of business. 
It should also be appreciated that CSR is now more and more integrated into 
corporate governance practices. Both focus on ethics in business practices and responsiveness to stakeholders. Both result in improved image of the business and affect performance. There is therefore a very clear link between CSR and corporate governance. 
 
 CSR, however, refers to a firm’s obligation to maximise its positive 
impacts upon stakeholders while minimising the negative effects . 
The extent to which the organisation fulfils the economic, legal, ethical and charitable responsibilities placed on it by its stakeholders will determine to what extent it is seen as having good CSR. 
The problem is that there is no one definition or theory of CSR. 
Consider the following points. Is it socially responsible to: 
• Experiment on animals? • Use ‘fracking’ to access natural gas reserves? 
• Build a new high speed rail network such as HS2 through countryside? 
• Pay high salaries to senior executives? 
Different individuals will have different views on each of these issues. 
As far as possible, managers have to take account of a range of differing 
viewpoints when deciding on their strategies. In addition, there is always the 
need to balance a company’s responsibility to society with its responsibility to 
earn financial returns for its investors.

80 
 Illustration 3 – corporate so cial responsibility issues 
 Nikon is a well-known multinational company that specialises in the 
manufacture of cameras and other photographic and visual equipment. 
The company’s corporate social responsibility (CSR) statement (extracts of which are shown below) highlights a number of key examples of issues that companies need to consider when thinking about CSR. 
Nikon CSR charter (extracts) 
Sound corporate activities 
The Nikon Group endeavours to comply with international regulations, 
related laws, and internal rules, exercise sound and fair corporate practices, earn the trust of stakeholders such as customers, shareholders, empl oyees, business partners, and society. The Group will 
maintain constructive relationships with administrative bodies, remaining politically neutral and complying with laws, and will not engage in relationships with individuals or groups that threaten social order or safety. 
Provision of valuable goods and services for society 
The Nikon Group will provide valuabl e products and services with 
superior quality and safety to society, endeavouring to increase the 
satisfaction and trust of our customers and contributing to the healthy development of society. 
Respect for human beings 
The Nikon Group will respect divers ity and individual human rights and 
provide a healthy and safe working environment in which all persons 
receive fair treatment without discr imination. It will also oppose enforced 
labour and child labour and respect fundamental human rights as well as workers' rights. 
Protection of the natural environment 
The Nikon Group will proactively engage in environmental efforts and 
work to protect the natural environment, as these are common issues for all of mankind. 
Responsibility to society as a corporate citizen The Nikon Group will carry out corporate activities that take into account 
the cultures and practices of each country and region and proactively engage in activities that contribute to society as a good corporate citizen.

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 Socially responsible behaviour within the supply chain 
The Nikon Group will encourage socially  responsible behaviour within its 
supply chain. Transparent operating activities The Nikon Group will communicate extensively with customers, 
shareholders, employees, business partners, and society and disclose business information in a timely and fair manner. It will also conduct 
reliable financial reporting through accurate accounting processes. 
Responsibility of top management Top management and employees in managerial positions within each 
department must understand that they play an essential role in fulfilling the spirit of this Charter and thus, in addition to leading by example, they must ensure that this information is disseminated to everyone in the Group and all related parties.  
Arguments against CSR 
It can be argued that companies should not pursue corporate social responsibility. Milton Fr iedman argues that: 
‘The business of business is business.’ 
This means that the primary purpose of a business is to try and earn a profit. In 
a company, for instance, the managers have been employed in order to earn the owners of the business a return on their investment. 
As such, it is a manager’s duty to act in a way that maximises shareholder 
wealth, while conforming to all relevant laws and customs. If a manager does anything that is not directly related to wealth maximisation, he is failing in his responsibilities to the owners and therefore acting unethically. 
For example, it can be argued that it is not right for a manager to donate any company funds to charity. The manager should instead work to maximise the return to the owner. If the owner wishes to make donations to charity, he can do so out of his earnings from the business. 
In addition, it can be argued that maximising the wealth of business owners is, 
in itself, socially responsible. This is because: 
• Increased returns will lead to increased tax payments made to the state. 
These can then be passed on to ‘worthy causes’. 
• A high proportion of company shares are owned by pension funds. This 
means that any gains will go to help provide pensions to individuals who 
may well be disadvantaged.

82 
Don't forget that there may also be practical reasons why a business chooses 
not to pursue CSR. These can include: 
• Increased cost of sourcing materials from ethical sources (e.g. Fairtrade 
products or free-range eggs). 
• Having to turn away business from customers considered to be unethical 
(e.g. an ‘ethical’ bank may choose not to invest in a company that 
manufactures weapons). 
• The management time that can be taken up by CSR planning and 
Arguments for CSR 
Not everyone agrees with Friedman's statements. There are a number of reasons why many businesses feel that CSR is a vital part of their strategy. These include: 
• A key part of running a successful business is the ability to offer customers 
and consumers what they need. One of those needs is often a 
requirement for socially responsible behaviour from the organisation. 
Basically, having good CSR can attract customers!  This can be 
because good CSR tends to enhance a company’s reputation and 
therefore its brand. It can also be used a basis for differentiation in the market place – given the choice, many customers will prefer to trade with a company they feel is ethical. 
• Good CSR is likely to involve good working conditions for employees, 
allowing the business to attract a higher calibre of staff . 
• Avoiding discrimination against workers is likely to give the company 
access to a wider human resource base . 
• Avoiding pollution will tend to save companies in the long run – many 
governments are now fining or increasing taxes of more polluting 
businesses . 
• Sponsorship and charitable donations are tax deductible, improve staff 
morale and can be seen as a form of advertising . 
Ultimately, having good CSR can increase the financial value of the 
business . Remember that the value of the business will be the present value of 
its perceived future cash flows discounted at its risk-adjusted cost of capital. 
• Good CSR will reduce the risk of adverse environmental reactions against 
the company. Anything that reduces risk should lower the risk adjusted 
cost of capital, increasing the value of the company. 
• A socially responsible business will be allowed to operate for longer in 
society. This will mean that there will be more years of cash flows in the future. This would also increase the value of the company.

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7 Approaches to corporate social responsibility 
If an organisation wishes to consider how it should approach corporate social 
responsibility, there are a number of models that it can use to help it. 
Carroll’s corporate social responsibility model 
Carroll (The Pyramid of Corporate Social Responsibility: Toward the Moral Management of Organizational Stakeholders), devised a four-part model of CSR: 
 
True CSR requires satisfying all four parts consecutively. 
Economic responsibility – be profitable 
• This is the fundamental level – all other levels rest on this. 
• Shareholders demand a reasonable return. 
• Employees want safe and fairly paid jobs. 
• Customers demand quality at a fair price. 
Legal responsibility – obey the law 
• The law is a baseline for operating within society. • It is an accepted rule book for company operations. 
Ethical responsibility – do what is right and fair 
• This relates to doing what is right, just and fair. 
• Actions taken in this area provide a reaffirmation of social legitimacy. 
• This is naturally beyond the previous two levels.

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Philanthropic responsibility – be a good corporate citizen 
• Relates to discretionary behaviour to improve the lives of others. • Charitable donations and recreational facilities. 
• Sponsoring the arts and sports events. 
The different parts will help the management of an organisation to understand 
the various obligations that society expects from them. 
Carroll suggests four possible strategies (or philosophies) that the organisation 
can adopt with regard to corporate social responsibility. 
Reaction 
The corporation denies any responsibility for social issues, arguing that it is not 
to blame or required to act. 
Defence 
The corporation admits responsibility but fights it, doing the very least that 
seems to be required. Typically this is only done as an attempt to defend the organisation’s current position. 
Accommodation 
The corporation accepts responsibility and does what is demanded of it by 
relevant groups. 
Proaction 
The corporation seeks to go beyond industry norms and anticipates future 
expectations by doing more than is currently expected. The organisation attempts to improve society. 
 
Illustration 4 – Carroll's philosophies in action 
 Q is a large, multinational company which manufactures a popular 
carbonated soft drink – Yu. Yu is one of the leading soft drinks in country 
H and accounts for around 75% of Q’s profits. In recent months it has been reported in the international press that one of the flavourings in Yu has been linked to an increased risk of cancer, though at much higher levels than those found in Yu. This has led to Yu being criticised by pressure groups, who have already complained about Yu’s high sugar content which they claim is not healthy for Q’s customers (though Yu’s sales continue to rise). The Government of country H has not stated that 
they will ban the ingredient, though it has indicated concern over rising 
levels of obesity in the local population. 
Q’s management could consider adopting any of Carroll’s four corporate 
social responsibilit y philosophies with regards to Yu.

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 Reaction 
Q denies that there is any problem with Yu whatsoever. Its managers 
release a statement arguing that there is clearly no health risk associated with consumption of Yu by customers as the government has not made the product illegal. Q then ignores the issue and makes no changes to Yu’s recipe. 
Defence 
Q’s management accepts that there is a potential risk from the high sugar 
content and the flavouring identified by the international press. It 
therefore places additional health information on the bottle about the 
calorie content of the drink, along with a ‘suggested amount’ that should be consumed each day. It argues that this suggested consumption level would also reduce any risk to the consumer of the flavouring identified in the international press. 
The pressure groups claim this is insufficient as most consumers do not 
read the label on soft drinks they consume. 
Q’s managers form a focus group made up of consumers, government 
health officials and pressure group representatives to discuss their concerns. After lengthy discussions to ensure it fully understands their needs, Q lowers the sugar content of Yu and replaces it with natural low-calorie sweeteners to reduce the calorie content but without altering the taste of the product. It also changes the recipe to eliminate the need for the flavouring in question to ensure the government and consumer confidence is maintained. 
Proaction 
Q undertakes detailed analysis of its product and the impact of all the 
ingredients it uses on consumer health. Unlike its competitors, Q significantly reduces the level of sugar in Yu, as well as eliminating all artificial additives in an attempt to reduce any negative health impact of consuming Yu.

86 
 L operates a popular chain of gyms. As well as standard exercise 
equipment, L’s gyms also have personal trainers that work with clients for 
an extra monthly fee (the personal trainer earns 25% of this, with L keeping the remainder). L also has cafes in each of its gyms, which serve food and drink to gym members. 
L is aware that some customers feel that they are not seeing any benefit 
from attending its gyms or seeing a personal trainer. One customer recently complained that ‘L’s cafes offer food that is high in fat and salt, meaning customers that eat there will get little benefit from their earlier 
workout. L’s personal trainers also have an incentive to ensure that 
clients make slow process so that they can continue to earn revenue from the client for as long as possible.’ 
L has decided to use Carroll’s corporate social philosophies model to 
decide how to react to these issues. 
 Which of the following approaches are most consistent with an 
accommodation strategy? Select all that apply. 
A If the service offered to customers does not breach any local laws, 
no further action needs to be taken by L 
B Admit that the service being offered to customers is not appropriate 
or socially responsible 
C Add nutritional information to the menu in the cafe to provide more 
information to customers 
D Redesign personal trainer pay in order to remove any incentive to 
ensure clients make slow progress 
E Introduce a healthier menu for customers in the cafe 
8 Sustainability 
One aspect of CSR that is also becoming increasingly important is 
sustainability. 
 
 Sustainability is the use of resources in such a way that they do not compromise the needs of future generations. It also involves not polluting the environment at a rate faster than they can be absorbed. 
There are many examples of this. For example, some logging companies plant a tree for every one they fell. 
Other companies try to make their products easy to recycle, helping to ensure 
that materials are reused rather than wasted. The computer manufacturer Apple has used this as part of its marketing approach for some years. (http://www.apple.com/recycling/)

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The reason that sustainability is so important for many businesses is that acting 
in a sustainable manner not only helps look after the environment and the wider community, but it strengthens the business and helps ensure its long-term survival. 
It is worth noting that sustainability is increasingly being seen as important 
within the public sector. Ensuring that goods and services procured by the public sector are sustainable can help meet environmental goals across government, save considerable amounts of public money; and help support innovation and economic growth. This will involve taking account of a wide range of costs, such as pollution impacts, carbon emissions and waste disposal. 
The difficulty for many businesses is that many companies focus on short term 
gains, rather than the long-term sustainability of the business and its environment. This is often evident in businesses that offer senior managers bonuses based on short-term or annual performance. 
However, it should be noted that sustainability can lead to cost savings for an 
organisation in the short term. For example, an organisation that reduces packaging on its products may have a positive impact on the environment by generating less waste, but it will also reduc e its costs, thereby improving profits. 
9 Incorporating sustainability and CSR into strategy 
CIMA itself has been heavily involved in identifying and discussing the implications of sustainability for the business. To this end, in 2010 they published a research article discussing this. 
The article came to six key conclusions: 
• Strong ethical principles that go beyond upholding the law can add great 
value to a brand, whereas failure to do the right thing can cause social, 
economic and environmental damage, undermining a company’s long–term prospects in the process. 
• Once they have adopted an ethical approach, companies will often find 
there are bottom-line benefits from demonstrating high ethical standards. 
• The ethical tone comes from the top. 
• High-quality management information on social, environmental and ethical 
performance is vital for monitoring the environmental and social impacts of 
a company and for compiling connected reports showing how effective its governance arrangements are. 
• Corporate communications and repor ting on sustainability need to do 
more than just pay lip service to the green agenda. They need to provide hard evidence of the positive impact on society, the environment and the strategic returns for the business, and how any negative effects are being addressed. 
• Management accountants have a part icular ethical responsibility to 
promote an ethics-based culture that doesn’t permit practises such as bribery.

88 
 Illustration 5 – Corporate social responsibility in action 
 Corporate social responsibility is seen as vital for many organisations. 
One company that is often hailed as a leader in this area is Ben & Jerry’s 
– a US based manufacturer of ice-cream , frozen yoghurt and sorbet. The company has stated that ‘business has a responsibility to the community and the environment’. 
Ben & Jerry’s CSR has included the following: 
• Fair Trade ingredients – this ensures that suppliers of many of the 
company’s raw materials enjoy safe working conditions, reasonable 
work hours and are paid fairly. 
• Ethically sourced supplies – as well as a commitment to Fair Trade, 
the company also ensures, where possible, that it sources ingredients from suppliers who share its values. For example, Ben & Jerry’s has historically sourced free-range eggs and sustainably 
produced dairy for its products. 
• Community work – the company has engaged with communities to 
improve sustainability. Ben & Jerry’s Vermont Dairy Farm 
Sustainability Project was launched in 1999 and sought to develop 
practical methods for dairy farms to reduce nitrogen and phosphorous run-off in order to prove water quality and overall sustainability. 
• Corporate philanthropy – the company donates a portion of its pre-
tax profits to corporate philanthropy via, in part, the Ben & Jerry’s Foundation. 
 
 Further CIMA information on sustainability 
 In December 2010, CIMA collaborated with the AICPA and CICA in a 
report entitled ‘Evolution of co rporate sustainab ility practices’. 
Some key issues that this report raised include: 
General 
Business sustainability is about ensuring that organisations implement 
strategies that contribute to long–term success. Organisations that act in a sustainable manner not only help to maintain the well–being of the planet and people, they also create businesses that will survive and thrive in the long run. 
The accounting profession can play an important role in this. Accountants 
can serve as leading agents for change by applying their skills and competencies to develop sustainability strategies, facilitate effective implementation, accurate measurement and credible business reporting.

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 Why do businesses have sustainability plans? 
According to research conducted by CIMA, the key reasons include: 
• Compliance  – the need to comply with laws and regulations. 
• Reputational risk  – companies are concerned with how 
stakeholders will view them if they fail to act in a sustainable 
manner. 
• Cost-cutting and efficiency – acting in a sustainable manner (for example becoming more energy-efficient) can help to reduce business expenditure. This is especially valuable for smaller companies. 
Ten elements of organisational sustainability 
The following areas are considered crucial to the successful embedding of sustainability within an organisation. It is worth noting that the accounting function will be useful in a number of these areas. 
Strategy and oversight 
• Board and senior management commitment. 
• Understanding and analysing the key sustainability drivers for the 
• Integrating the key sustainability drivers into the organisation’s 
strategy. 
Execution and alignment 
• Ensuring that sustainability is t he responsibility of everyone within 
the organisation (not just a specific department). 
• Breaking down the sustainability targets and objectives for the 
organisation as a whole into targets and objectives which are 
meaningful for individual subsidiaries, divisions and departments. 
• Processes that enable sustainability issues to be taken into account 
clearly and consistently in day-to-day decision-making. 
• Extensive and effective sustainability training. 
Performance and reporting 
• Including sustainability targets and objectives in performance 
appraisal. 
• Champions to prom ote sustainability and celebrate success. 
• Monitoring and reporting sustainability performance.

90 
 Test your understanding 4 – Router – (Case style) 
 You are A. North – and you have recently been provided with the 
following letter from one of your company’s major clients, Router plc (a 
major mining company). 
Letter from Router plc 
H.West 
21 Epp Way Helway Helland HDH 67TY Dear Mr North, Router plc has an opportunity to mine for gold in a remote and sparsely 
populated area. The mining process proposed in this instance would remove all vegetation from the land concerned. After mining has finished, there will remain substantial lakes of poisonous water which will remain toxic for a hundred years. 
The mining process is profitable, given the current high world value of 
gold. However, if the company were to reinstate the mined land, the process would be extremely unprofitable. The company has received permission from the government to carry out the mining. The few local residents are opposed to the mining. 
As you know, our mission statement says that we will ‘endeavour to make 
the maximum possible profit for our shareholders while recognising our wider responsibility to society’. 
 Several investors have raised concerns regarding our mission statement, 
suggesting that it is ‘contradictory’. I would appreciate your thoughts on this. 
We are aware that our decision relating to the above gold mining 
opportunity could potentially cause a conflict between our objectives. We would be grateful for your advice on how we can deal with strategies that cause such a conflict. 
Finally, could you please outline the ethical issues surrounding the 
proposed gold mining operations for our consideration. 
Thank you for your help and we look forward to your urgent response. Kind regards H. West Required: Draft a response to the above letter. 

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10 The impact of technologies on CSR 
The rapid development in technologies has had a significant impact on CSR in 
a number of ways, from how stakeholders get access to information to the level of detail that they can see. Impacts have been witnessed in the following areas: 
• Quicker scrutiny – stakeholders are updated in real-time on the actions 
of organisations, leading to quicker scrutiny of those actions. Connected 
networks and the widespread use of mobile devices mean that that users expect to receive information more quickly, and thus respond more quickly as information is released. Public scrutiny has therefore been accelerated.  
• Greater stakeholder engagement – whereas the annual CSR report 
used to be the main medium by which organisations engaged with stakeholders, there is now much more diversity in communications channels – social media, interactive infographics, virtual reality etc. This has led to increased stakeholder engagement.  
• More integrated CSR practices  – organisations are better placed to 
provide data on the whole of their supply chains, meaning that stakeholders get a bigger picture of the ecosystem as a whole, rather than just one individual component of that ecosystem.  
• Improved measurement  – the use of technologies such as Big Data 
analytics, blockchain and ar tificial intelligence means that more meaningful 
data can be gathered and interpreted about an organisation’s CSR practices. This in turn leads to greater accuracy in assessing CSR impact and performance against metrics.  
• Increased openness in the ecosystem – the result of all the above is 
that there is a greater expectation of openness and transparency from all who make up an organisational ecosystem, which should (in theory) result in more acceptable CSR behaviour being displayed.  
11 Corporate code of ethics 
Corporate ethics relates to the application of ethical values to business 
behaviour. 
• It encompasses many areas ranging from board strategies to how 
companies negotiate with their suppliers. 
• It goes beyond legal requirements and is to some extent therefore 
discretionary. 
• Many companies provide details of their ethical approach in a corporate 
and social responsibility report.

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• Key areas included in a code of corporate ethics: 
 
 Areas covered by Corporate Ethics 
  
Key area  Explanation 
The purpose 
and values of the business This provides the reason for the organisation’s existence. Key areas in the purpose or mission statement of the company will include: the products or services to be provided, the financial objectives of the company, and the role of the business in society as seen by the company itself. 
Employees There must be information on how the business relates to its employees. Employees have rights and they must not be seen simply as a means of producing goods/services. The company will therefore have policies on: 
• working conditions 
• recruitment 
• development and training • rewards • health, safety and security • equal opportunities • retirement 
• redundancy 
• discrimination • use of company assets by employees, and • any other areas required by statute or thought 
appropriate by the company.

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Customer 
relations The company has a responsibility to produce quality goods/services for customers at a reasonable price (taking into account the fact that the company needs to make some profit). Customer faith in the company and its products must be established and built up over time. Key areas for the company to invest in include:  
• product quality 
• fair pricing 
• after sales service. 
Shareholders 
or other providers of money Shareholders are investors in the company – they therefore expect an appropriate and proper return on the money they have invested. The company therefore must commit to: 
• providing a proper return on shareholder 
investment 
• providing timely and accurate information to 
shareholders on the company’s historical 
achievements and future prospects. 
Shareholders will normally be involved to a greater or lesser extent with the decision making in the company under the principles of good corporate governance. 
Suppliers Suppliers provide goods and services for a company. They will usually attempt to provide those goods and services to an appropriate quality in a timely fashion. The company will therefore normally: 
• attempt to settle invoices promptly • co-operate with suppliers to maintain and 
improve the quality of inputs 
• not use or accept bribery or excess hospitality 
as a means of securing contracts with 
suppliers 
• attempt to select suppliers based on some 
ethical criteria such as support of 'fair trade' principles or not using child labour in manufacture.

94 
  
Society or the 
wider community The company is located within society, which implies some social and corporate responsibility to that society. Many companies produce a CSR report as a means of communicating this relationship to third parties. Explained in the CSR report will be features of the company’s activities 
• how it complies with the law 
• obligations to protect, preserve and improve 
the environment 
• involvement in local affairs, including specific 
staff involvement 
• policy on donations to educational and 
charitable institutions. 
 
Ethical stances (Johnson, Scholes and Whittington) 
Johnson, Scholes and Whittington (Exploring corporate strategy) define an 
ethical stance as: 
 
 ‘The extent to which an organisation will exceed its minimum obligations to stakeholders.’ 
There are four possible ethical stances: 
 
Short-term shareholder interest (STSI) 
This ethical stance has a short-term focus in that it aims to maximise profits in 
the financial year. Organisations with this ethical stance believe that it is the role of governments to set the legal minimum standard, and anything delivered above this would be to the detriment of their taxpayers. 
Longer-term shareholder interest (LTSI) This ethical stance takes broadly the same approach as the short-term 
shareholder interest except that it takes a longer-term view. Hence it may be appropriate to incur additional cost now so as to achieve higher returns in the future. An example could be a public service donating some funds to a charity in the belief that it will save the taxpayer the costs associated with providing the entire service should the charity cease to work. Hence this ethical stance is aware of other stakeholders and their impact on long-term profit or cost.

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Multiple stakeholder obligation (MSO) 
This ethical stance accepts that the organisation exists for more than simply 
making a profit, or providing services at a minimal cost to taxpayers. It takes the view that all organisations have a role to play in society and so they must take account of all the stakeholders’ interests. Hence they explicitly involve other stakeholders, and believe that they have a purpose beyond the financial. 
Shaper of society This ethical stance is ideologically driven and sees its vision as being the focus 
for all its actions. Financial and other stakeholders’ interests are secondary to the overriding purpose of the organisation. 
 
 J runs a business which sells flowers from a small shop. He ensures that 
all of his flowers are sourced from ethically responsible suppliers, even 
though this is not legally required. While these flowers are more expensive to purchase, he feels that his ethical approach differentiates him from his rivals and allows him to charge a premium price. 
Which ONE of Johnson, Scholes and Whittington’s ethical stances is J 
adopting? 
A Shaper of society B Multiple stakeholder obligation C Longer-term shareholder interest D Short-term shareholder interest 
12 Fundamental ethical principles 
Professionals need to follow the following fundamental ethical principles: 
• Integrity 
• Objectivity 
• Professional competence and due care 
• Confidentiality 
• Professional behaviour.

96 
 Fundamental ethical principles 
 Integrity 
Integrity implies fair dealing and truthfulness. 
Members are also required not to be associated with any form of 
communication or report where the information is considered to be: 
• materially false or to contain misleading statements • provided recklessly 
• incomplete such that the report or communication becomes 
misleading by this omission. 
Objectivity 
Accountants need to ensure that their business/professional judgement is 
not compromised because of bias or conflict of interest. 
However, there are many situations where objectivity can be 
compromised, so a full list cannot be provided. Accountants are warned to always ensure that their objectivity is intact in any business/ professional relationship. 
Professional competence and due care 
There are two main considerations under this heading: (1) Accountants are required to have the necessary professional 
knowledge and skill to carry out work for clients. 
(2) Accountants must follow applicable technical and professional 
standards when providing professional services. 
Appropriate levels of professional competence must first be attained and 
then maintained. Maintenance implies keeping up to date with business and professional developments, and in many institutes completion of an annual return confirming that continued professional development (CPD) requirements have been met. 
Where provision of a professional service has inherent limitations 
(e.g. reliance on client information) then the client must be made aware of this. 
Confidentiality The principle of confidentiality implies two key considerations for 
(1) Information obtained in a business relationship is not disclosed 
outside the firm unless there is a proper and specific authority or 
unless there is a professional right or duty to disclose. 
(2) Confidential information acquired during the provision of 
professional services is not used to personal advantage.

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 The need to maintain confidentiality is normally extended to cover the 
accountants' social environment, information about prospective clients 
and employers, and where business relationships have terminated. Basically there must always be a reason for disclosure before confidential information is provided to a third party. 
The main reasons for disclosure are when: (1) it is permitted by law and authorised by the client (2) it is required by law, e.g. during legal proceedings or disclosing 
information regarding infringements of law 
(3) there is professional duty or right to disclose (when not barred by 
law), e.g. provision of information to the professional institute or 
compliance with ethical requirements. 
Ethical considerations on disclosure 
The accountant needs to consider the extent to which third parties may 
be adversely affected by any disclosure. 
The amount of uncertainty inherent in the situation may affect the extent 
of disclosure – more uncertainty may mean disclosure is limited or not made at all. 
The accountant needs to ensure that disclosure is made to the correct 
person or persons. 
Professional behaviour  
Accountants must comply with all relevant laws and regulations. 
There is also a test whereby actions suggested by a third party which 
would bring discredit to the profession should also be avoided. 
An accountant is required to treat all people contacted in a professional 
capacity with courtesy and consideration. Similarly, any marketing activities should not bring the profession into disrepute. 
 
 Under the CIMA Code of Ethics, members are not allowed to be 
associated with any ‘materially false or misleading statements’. 
Which ONE of the fundamental ethical principles does this statement 
relate to? 
A Integrity B Professional competence C Objectivity D Professional behaviour

98 
 Test your understanding 7 – (Integration question) 
 Explain why each of the following actions appears to be in conflict 
with fundamental ethical principles. 
(1) An advertisement for a firm of accountants states that their audit 
services are cheaper and more comprehensive than a rival firm. 
(2) An accountant prepares a set of accounts prior to undertaking the 
audit of those accounts. 
(3) A director discusses an impending share issue with colleagues at a 
golf club dinner. 
(4) The finance director attempts to complete the company’s taxation 
computation following the acquisition of some foreign subsidiaries. 
(5) A financial accountant confirms that a report on his company is 
correct, even though the report omits to mention some important 
liabilities. 
(6) You believe your colleague has asked you to include what you 
believe to be misleading information in your forecast. 
(7) Your analysis of a strategic proposal suggests that profitability will 
be improved by making 30 people redundant. 
(8) You can outsource your manufacturing to a country where labour 
costs are much lower. 
(9) Your country is allowed, legally, to dump its waste into a river. This 
will kill all aquatic life along a 50-mile stretch. 
Resolving ethical conflicts 
The code is clear that the professional accountant should respond to an ethical 
conflict. Inaction or silence may well be a further breach of the code. 
Ethical conflicts can be resolved as follows: (1) Gather all relevant facts. (2) Establish ethical issues involved. (3) Refer to relevant fundamental principles. (4) Follow established internal procedures. (5) Investigate alternative courses of action. (6) Consult with appropriate persons within the firm. (7) Obtain advice from professional institutes. (8) If the matter is still unresolved, consider withdrawing from the engagement 
team/assignment/role.

Chapter 3 
 99 
Additional resources 
For more examples of real-life ethical dilemmas and their recommended 
solutions, see the CIMA website. 
http://www.cimaglobal.com/Professional-ethics/Ethics/Responsible-
business/Ethical-dilemma/Case-studies/ 
 
 Test your understanding 8 – (Integration question) 
 Explain your response to the following ethical threats. 
(1) Your employer asks you to suggest to a junior manager that they 
will receive a large bonus for working overtime on a project to hide 
liabilities from the financial statements. 
(2) In selecting employees for a new division, you are advised to 
unfairly discriminate against one section of the workforce. 
(3) You have been asked to prepare the management accounts for a 
subsidiary located in South America in accordance with specific requirements of that jurisdiction. In response to your comment that you do not understand the accounting requirements of that jurisdiction, your supervisor states  ‘no problem, no one will notice a 
few thousand dollars’ error anyway’. 
 
 Test your understanding 9 – ABC – (Case style) 
 One of your colleagues, a junior accountant at ABC Ltd has sent you the 
following email: 
Email To: J. Bank F From: A. Halifax  Date: 15/06/XX Subject: Professional ethics Hi J, I was hoping you could give me some advice! The IT Director of ABC Ltd asked me undertake a cost-benefit analysis of 
a proposed new IT system. The IT Dir ector will use this analysis to try 
and convince the Board of Directors of ABC that they should invest in the new system. 
As part of my analysis, I found that the new system will not run properly 
on ABC’s existing computers. This means that ABC would have to 
replace the majority of their desktop computers and servers, leading to an excess of costs over benefits.

100  
 The IT Director has suggested that I downplay the costs of replacing the 
IT infrastructure as he was sure that he ‘could find a work-around’ that 
would allow the existing computers to use the new software, though he was currently uncertain how this would be accomplished. 
The IT Director has told me that he ‘expects’ the cost-benefit analysis to 
show a favourable result for the new system and has indicated that my future promotion prospects may depend on this being the case. 
Could you email me back right away and explain the CIMA fundamental 
ethical principles that I would be breaching if I agree to the IT Director’s request. I need to know before I decide on the appropriate course of action. 
Thanks for your help! A Required: Reply to the email as requested. 
 
 Ethical threats and safeguards  
  
Ethical threat Safeguard 
Conflict between requirements 
of the employer and the fundamental principles 
For example, acting contrary to 
laws or regulations or against professional or technical standards. Obtaining advice from the employer, professional organisation or professional advisor. 
• The employer providing a 
formal dispute resolution 
process. 
• Legal advice. 
Preparation and reporting on information 
Accountants need to 
prepare/report on information 
fairly, objectively and honestly. 
However, the accountant may be 
pressurised to provide misleading information.  • Consultation with superiors 
in the employing company. 
• Consultation with those 
charged with governance. 
• Consultation with the 
relevant professional body.

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 101 
 Having sufficient expertise 
Accountants need to be honest in 
stating their level of expertise –and not mislead employers by implying they have more expertise than they actually possess. 
Threats that may result in lack of 
expertise include time pressure to carry out duties, being provided with inadequate information or having insufficient experience. • Obtaining additional 
advice/training. 
• Negotiating more time for 
duties. 
• Obtaining assistance from 
someone with relevant expertise. 
Financial interests 
Situations where an accountant or 
close family member has financial interests in the employing company. 
Examples include the accountant 
being paid a bonus based on the financial statement results which he/she is preparing, or holding share options in the company. • Remuneration being 
determined by other members of management. 
• Disclosure of relevant 
interests to those charged with governance. 
• Consultation with superiors 
or relevant professional body. 
Inducements – receiving offers 
Refers to incentives being offered 
to encourage unethical behaviour. Inducements may include gifts, hospitality, preferential treatment 
or inappropriate appeals to loyalty. 
Objectivity and/or confidentiality 
may be threatened by such inducements. • Do not accept the 
inducement! 
• Inform relevant third parties 
such as senior management and professional association (normally after taking legal advice). 
Inducements – giving offers 
Refers to accountants being 
pressurised to provide inducements to junior members of staff to influence a decision or obtain confidential information. • Do not offer the inducement! 
If necessary, follow the conflict resolution process.

102  
   
Confidential information 
Accountants should keep 
information about their employing company confidential unless there is a right or obligation to disclose, or they have received authorisation from the client. 
under pressure to disclose this information as a result of compliance with legal processes such as anti-money laundering/ terrorism – in this situation there is a conflict between confidentiality and the need for disclosure. • Disclose information in 
compliance with relevant statutory requirements, e.g. money laundering regulations. 
 
Whistleblowing 
Situations where the accountant 
needs to consider disclosing information, where ethical rules have been broken by the client. Follow the disclosure provisions of the employer, e.g. report to those responsible for governance. Otherwise disclosure should be based on assessment of: legal obligations, whether members of the public will be adversely affected, gravity of the matter, likelihood of repetition, reliability of the information, reasons why employer does not want to disclose. 
  
 The management accountant of L plc has recently discovered that the 
company is about to launch a major new product which is expected to cause a huge increase in company profits. He has therefore purchased a number of shares in L plc, as he expects the share price to rise significantly when the new product is launched. 
Which TWO of the CIMA fundamental ethical principles is the 
management accountant likely to be in breach of? 
A Objectivity B Integrity C Professional behaviour D Confidentiality E Professional competence F Honesty

Chapter 3 
 103 
 The CEO of G Ltd has stated at a recent board meeting that ‘the 
company has a responsibility to consider the needs of a wide range of 
stakeholders and ensure that we minimise any negative impacts that G Ltd has upon them.’ 
Which ONE of the following best describes the concept referred to by the 
CEO of G Ltd? 
A Ethics B Stakeholder management C  Non-market strategy 
D Corporate social responsibility

104  
13 Summary

Chapter 3 
 105 
Corporate governance is not designed to reduce organisational costs. It 
may, in fact, have the opposite effect due to the management time and additional staff required by corporate governance codes. 
 
 To: Carlos Smith 
From: Anne Accountant Date: 1/5/20XX Subject: Review of corporate governance arrangements Dear Mr Smith, Thank you for your email. I have looked through the information you 
provided and have identified the following weaknesses: 
Lack of diversity of the board of directors 
Most of the directors in ADF are older men from country F. There is only 
one woman on the board. 
Having a diverse board can ensure that the company has a wide range of 
experience to draw on when making decisions. 
For example, ADF wants to expand abroad. By having directors from 
other countries or with experience of these foreign markets, the company would be far better placed to achieve this growth. 
Lack of independence of non–executive directors 
All the non–executive directors are linked to the Chairman. This makes it 
unlikely that they will act impartially. They are likely to vote along with the Chairman. 
This could lead them to reject acceptable projects, such as the proposed 
foreign expansion, merely because the Chairman disapproves. 
Weak internal audit The fact that the directors allow ADF to have such an inadequate internal 
audit function indicates an alarming lack of control. If they are unable to rely fully on the accounts produced, they may find it difficult to implement sensible strategies in the future.

106  
 Overall 
The ultimate goal of corporate governance is to provide investors with 
increased confidence in the company and increase the transparency of the board’s decisions. 
Should investors feel that ADF has poor corporate governance, it can 
damage ADF's reputation with investors. This may harm its share price and make it harder for the company to raise much needed finance in the future – which is likely to be important if it is planning overseas expansion. 
I hope this helps. If you need any further information, please let me know. Kind regards Anne  
 
 The correct answers are B, D and E 
A would match a ‘reaction’ strategy where L denies any wrongdoing and 
does nothing to deal with customer concerns. C most closely matches a defence strategy, where the gym chain does as little as possible to deal with customer concerns. There is no solution to the problem, simply a small effort towards keeping customers quiet. 
An accommodation strategy occurs when the corporation accepts 
responsibility for the identified problems (as in option B) and then does what is demanded by its stakeholders (i.e. prevent personal trainers from behaving unethically, as well as improving the menu in the restaurant). 
 
 A. North 
Business Advice Ltd 
122 Left Way Helland HYY GT65 Dear Mr West, Thank you for your recent letter. I have pleasure in enclosing our 
thoughts on each of your queries below. 
Conflicting mission statement The mission statement that Router plc has published states that the firm 
aims to make the ‘maximum possible profit’. It is quite common for objectives of this kind to be included in mission statements.

Chapter 3 
 107 
In addition, the ‘wider responsibilities to society’ are recognised. This 
company objective is difficult to measure and there will be instances where this conflicts with the maximisation of profit. The gold-mining project provides a perfect example of this. It is expected to be profitable, but also result in the loss of vegetation and the creation of poisonous lakes for the one hundred years. 
While the business could attempt to repair the local environment, doing 
so would make the mine unprofitable, leading to a loss of value to Router’s shareholders. 
However, it could be argued that in the long run, being socially 
responsible could increase the wealth of Router’s shareholders. Router needs the government to grant it licences in order to mine for gold and shareholders to continue investing in it. If it develops a reputation as a ‘dirty’ firm, both stakeholders may change their minds. This would cause a loss of profits and a drop in the share price. This would of course mean a fall in shareholder wealth. 
Dealing with conflicting objectives 
As identified above, Router’s objectives may conflict with each other. 
Methods of dealing with this include: 
(1) Establish a hierarchy of objectives:  Prioritise objectives and 
score alternative projects against them. For Router, it may need to 
decide which is more important – it s wider social responsibilities or 
its desire to maximise profits. 
(2) Satisficing:  Router could try to give each stakeholder group 
something of what it wants. In this case, it could proceed with the mine and then provide some small amount of environmental restitution so that some of the damage is repaired. 
(3) Sequential attention:  This involves giving each stakeholder 
group's interests consideration over time, though not necessarily for every project. The effect is to keep them on board. In this case the mine could be abandoned because the environmental costs are too great. However, the next project, with less environmental damage, will be adopted. Shareholders and environmentalists will both feel that something has been achieved. 
(4) Side payments:  These are compensatory payments to keep 
stakeholders content. Perhaps good quality housing could be provided for the labour force which could be left after the works had finished. This could be pointed to as some compensation for the environmental damage and population displacement.

108  
 The principal ethical issues in mining are: 
(1) The use of non-renewable resources: The mining operation 
results in non-replaceable resources being extracted from the mine. 
This deprives both the present owners and future generations of the resources. Adequate compensation should be provided to the current owners and the resources extracted should not be wasted out of consideration for future generations. 
(2) The use of power in negotiations:  In the negotiations it is 
important that the profit motive does not lead to Router acting improperly and exploiting the present owner of the mining rights. Where the country is poor this is a particular concern. 
(3) The environmental damage:  Poisoning the land for a hundred 
years is clearly not a socially acceptable outcome. Router has an ethical duty to minimise the effect of this pollution by developing a plan to deal with the problem. This should be seen as the minimum the company should do. 
(4) Impacts on the life of local residents:  While they may benefit 
from the economic boost the mine provides to the region, it is likely that the pollution will also affect them. While there may only be a small number of local residents, this does not give Router the right to ignore their needs. They should explain the steps the company is going to take to minimise the effect on their local environment. 
(5) Safety of procedures:  Mining is an industry noted for its poor 
safety record. Router must ensure that strict safety guidelines are in place and that they are followed by the workforce. It should ensure these conform to best practises in its industry – even if this is more than the legal requirements in the country of operation. 
I hope this answers your queries. If you wish to discuss these issues further, please do not hesitate to contact us. 
Kind regards A. North 
 
 The correct answer is C This approach is also known as ‘enlightened self-interest’. J is going 
beyond regulations in an attempt to win customers in the longer term and stand out in his market. 
J is showing no signs of considering the role he plays in society or his 
responsibility to wider stakeholders, su ggesting that he is not operating 
as a shaper of society or under the multiple stakeholder objectives level.

Chapter 3 
 109 
 
 (1) Potential conflict with professional behaviour – audit services 
observe the same standards, therefore implying that a rival has 
lower standards suggests that a firm is not complying with professional standards. 
(2) The accountant is likely to lose objectivity because errors in the 
accounts made during preparation may not be identified when those accounts are reviewed. 
(3) As the information is likely to be confidential, discussing it in a public 
place is inappropriate. 
(4) The accountant needs to ensure that knowledge of the foreign 
country’s taxation regime is understood prior to completing the return, otherwise there is the possibility that the appropriate professional skill will not be available. 
(5) There is an issue of integrity. The accountant should not allow the 
report to be released because it is known that the report is incorrect. 
(6) This is an issue of integrity. Accountants must not be associated 
with any form of communication or report that they know to be either materially false or misleading. 
(7) The reduction of the number of staff in an organisation in order to 
increase profit is not necessarily unethical. For example, if the business has an unnecessarily high number of employees, reducing this number may be appropriate. However, the accountant would need to ensure that the analysis was accurate, as it will impact on individual’s livelihoods. If there is any uncertainty in the results, they may need to consider whether it should be disclosed. In addition, the accountant will need to be aware of the implications and should ensure that the decision-makers are made aware of the potential ethical considerations. 
(8) Again, this is an operational decision. There are ethical concerns 
over the loss of current staff which the accountant should make the decision-maker aware of along with the potential adverse impact on the reputation of the company. 
(9) Ethics involves avoiding negative impacts on the environment that 
the company operates in. Even though legal, the decision to dump pollution into a river is unethical due to the impact on marine life. Should an accountant be complicit in such an action, it is likely to bring the profession into disrepute.

110  
 Threat 1 
• Do not offer the inducement! 
• If necessary, follow the conflict resolution process of the employer. 
• Consider the impact of the financial statements being 
misrepresented. 
Threat 2 • Obtaining advice from the employer, professional organisation or 
professional advisor. 
• The employer providing a formal dispute resolution process. • Legal advice. 
Threat 3 
• Obtaining additional advice/training. 
• Negotiating more time for duties. 
• Obtaining assistance from someone with relevant expertise. 
 
 Email 
To: A. Halifax  From: J. Bank  Date: 15/06/XX Subject: Re: Professional ethics Hi A, If you agree to the IT Director’s demands, you will be in breach of several 
parts of the CIMA Code of Ethics. 
Integrity 
This requires members not to be associated with any form of 
communication or report where the information is materially false, provided recklessly or incomplete. 
You have identified a potential problem with the proposed new system 
that would involve a large outflow of cash to upgrade ABC’s infrastructure.

Chapter 3 
 111 
 Following the IT Director’s suggestion would involve you ignoring the 
issue without a firm idea of how it will be resolved (the IT Director is 
simply suggesting a vague ‘work-around’). This means that the report will be incomplete and misleading to its users. 
This requires accountants to ensure that their judgement is not 
compromised because of bias or conflict of interest. 
You are only likely to agree to the IT Director’s demands because failing 
to do so could jeopardise your career. This would clearly be acting in your own self-interest. 
This requires accountants to follow all applicable technical and 
professional standards when providing services. 
You are aware that the cost-benefit analysis, when undertaken properly, 
shows an unfavourable result for the new IT system. Failing to use the correctly obtained result could be seen as a failure to meet professional and technical standards. 
Professional behaviour 
This principle requires accountants to avoid any activities that might bring 
the profession into disrepute. 
If you are found to have knowingly misled the Board of Directors into 
buying a system that is not cost effective, it would clearly damage confidence in the accountancy profession as a whole. 
I hope that helps! Let me know if you need any more information and I'll 
try to help. 
A 
 
 The correct answers are C and D 
The accountant is in breach of confidentiality as he is using information 
for his own personal gain (regardless of whether he communicates this information to others). He also risks br inging the profession into disrepute 
(and could be in breach of insider dealing laws), which breaches professional behaviour. 
There is no evidence that he is producing any reports or providing 
information relating to the new product, which would tend to suggest that integrity, objectivity and professional competence are not being breached. 
Note that honesty (while being preferable!) is not a fundamental ethical 
principle.

112  
Note that sustainability is part of CSR – however the CEO appears to be 
referring to the wider concept of how the organisation looks after its social responsibility.

113 
The organisational 
ecosystem: External 
environmental analysis 
process (a) Outline the rational and 
arriving at strategy 
B2: Discuss the drivers of 
change in the ecosystem (a-e) Institutional/systemic, 
social, market, 
technology and sustainability 
 
 Chapter 
4

The organisational ecosystem: External environmental analysis 
114  
 
1 Introduction 
As we have already seen in chapter 1, in order to formulate a suitable strategy, 
the organisation must first undertake a detailed appraisal of its ecosystem. Assuming that a rational approach is to be adopted part of such an appraisal will be to consider the ecosystem from both an external and internal point of view. This chapter looks at the external perspective; the organisation must understand what is happening in the outside world (it’s business environment) that could impact on its future strategies. 
Chapter 6 will then take a look at the internal perspective. 
There are a number of different models that can be used to help organisations 
undertake this analysis, each of which focus on a different part of its environment. 
Purpose of environmental analysis 
Why should an organisation bother to spend the time (and money) needed to 
undertake a complete environmental analysis? There are several key purposes, including: 
• Identification of threats and opportunities  
Analysing its environment can help an organisation to identify potential 
problems it may have to face within its ecosystem (such as future changes in legislation that will affect its oper ations) as well as possible areas for 
growth and development that it may wish to take advantage of.

Chapter 4 
 115 
• Assessment of competition  
Environmental analysis involves, in part, the examination of the 
organisation’s competitors. Understanding how rivals are acting in the ecosystem may help the organisation stay more competitive in the market. 
• Identification of strengths and weaknesses 
Understanding its strengths and weaknesses will help the organisation to 
decide on appropriate strategies. These strategies may be to deal with its weaknesses or build on its strengths. 
• Meeting stakeholder needs 
Environmental analysis will help the organisation gain a clear 
understanding of what its key stakeholders require from it. While shareholders are likely to want a high return on their investment, other stakeholders may have different demands on the organisation. These were explored in more detail in chapter 2. 
2 Environmental analysis – the drivers of change 
Before we look at models that help management to identify relevant issues when conducting an environmental analysis of the organisation’s ecosystem, it is important to recognise that it is becoming increasing difficult to undertake. The reason for this is the increasing volatility and rate of change in the global market. 
The business environment has become more volatile for a number of reasons, 
• Changing technology  is leading to the development of new products and 
services and/or altering how existing ones are delivered. For instance, the 
rise of online gaming has had a serious impact on companies such as Game and HMV in the UK, who both sell computer games on physical discs. Indeed, HMV went into administration for the second time in late 2018 because its business model of sellin g through fixed premises was no 
longer viable. 
• Continuing weakness in the global economy has led to unpredictable 
demand in the market and made it more difficult for many organisations to access credit. 
• Increasing globalisation of many markets means that organisations may 
be affected by issues in many different countries. A company like Ford, which trades globally, may be affected by issues in any of the countries it operates within. For example, continued uncertainty over Brexit in the UK led Ford to announce that it was reviewing its UK operations in January 2019.

116  
• The development of high-growth, emerging economies  – such as the 
‘BRIC’ economies (Brazil, Russia, India and China) – means that 
organisations looking to expand may need to consider ways of tapping into these new markets. Investment in such economies can provide high returns if done in the right way and at the right time. However, there is no guarantee that a rate of growth in a particular economy can be maintained indefinitely. 
 For example, between 2000 and 2012 Brazil’s economy was officially one 
of the fastest growing in the world, with an average annual rate of growth in GDP of 5%. Then, between 2013 and 2017, the country officially slipped into recession. 
• Geopolitical impact, such as the relations between countries brought 
about by political policy. For example, the protectionist stance adopted by President Trump in the early years of his administration lead to tariffs being imposed on foreign steel imported into the United States and a threatened trade war with China. A change of ruling party and/or leader might lead to a reversal of such policies. 
• Changing demographics can naturally impact an ecosystem. This refers 
to the make-up of populations, both within particular countries and also globally. 
 
Illustration 1 – world population growth  
 It is reckoned that the global population has grown from 3 billion people 
50 years ago to around 7 billion today, caused (not surprisingly!) by birth rates far exceeding death rates, as medical science and standards of living improve to result in the average life-span increasing. It has also been projected that there will be as many as 9 or 10 billion people on the planet by 2050. 
This has all sorts of consequences, from demand for food and water to 
energy and housing, education, healthcare and so on. 
  
• Increasing levels of customer empowerment . Customers in many 
industries have become accustomed to having greater input into the product offering they receive, and the purchasing experience they enjoy. This has been due in large part to the use of digital technology, giving greater awareness of choice and also an expectation of instant fulfilment. 
 
Illustration 2 – Amazon Prime Air  
 Amazon has announced that it should be able to deliver goods in urban 
areas to customers within 30 minutes of an order being placed via its future delivery system known as Amazon Prime Air. Delivery will be via drone. In theory, a customer could place an order whilst on the move, via their smartphone, and be home in time to take delivery just half an hour later.

Chapter 4 
 117 
• Rapid developments in digital technology . Traditional business models 
are being challenged and redeveloped as the opportunities of new digital 
technologies are recognised and are being introduced into organisations and their ecosystems. 
 More details on this and examples can be found later in chapter 12. 
• Increasing levels of automation are redefining the way in which 
businesses operate. Perhaps the classic example is to look at the motor 
vehicle industry, where modern production lines consist of a series of sophisticated robots carrying out the work that was once performed by people. However, manufacturing is not the only industry sector that is experiencing automation; it can occur just as much in the service and other sectors. 
 
Illustration 3 – Café X  
 Based in San Francisco, Café X has adapted the traditional coffee bar 
model employed by other operators such as Starbucks and Costa by introducing robot baristas. 
Instead of being welcomed by a member of staff when they walk into the 
coffee bar, customers place their order either via an app on their smartphone or at an on-site kiosk. The order is then processed by a robotic arm which brews and prepares the coffee for pick up. 
The entrepreneurs behind Café X claim a number of benefits, in addition 
to reduced costs: 
• Reduced waiting time for the cust omer (so-called ‘m illenials’ are not 
prepared to wait in queues for long) – it is reckoned a robot is 
capable of making 120 cups of coffee per hour. 
• Greater order accuracy i.e. customers get exactly what they have 
ordered. 
• Product consistency i.e. each medium sized skinny latte made by 
the robot is exactly the same as the last. 
• Data is captured about customer preferences which can then be 
used for marketing purposes. 
 
• Increasing awareness of sustainability issues and demands from 
customers that organisations address those concerns. 
Sustainability was considered in detail in chapter 3; as was examined 
there, sustainability isn’t merely about issues such as recycling and looking after the environment, it is more wide-reaching than that.

118  
 Illustration 4 – Aldi  
 In the UK Aldi has committed to paying staff more than the minimum 
living wage that is required by law. This is because the company believes 
the legal pay level set by the government is not sufficient to enjoy a reasonable standard of living and risks keeping people trapped in 
poverty. 
All of these drivers of change mean that  an organisation’s environment will be 
changing all the time. This may lead to environmental analysis quickly becoming outdated. 
It is therefore important that companies consider undertaking environmental 
analysis on a regular basis. 
 
 Illustration 5 – Jaguar Land Rover (JLR)  
 In September 2014 JLR flew a helicopter over Tower Bridge in London 
with a car slung beneath it. This was to publicise the company’s 
ambitions for the future (the plan was to build 1m cars a year by 2020) and to show that the company was in very good health. 
In January 2019, the company announced plans to make over 4,500 job 
cuts in the UK (around 10% of its workforce) in response to changes in its markets. 3 particular factors were identified as causing the change in strategy: 
• The clampdown on diesel-powered cars 
• The slowing rate of growth in one of its core markets, China 
• The continuing uncertainty over the UK’s future relationships with 
the European Union caused by its pending departure from that trade 
bloc (or “Brexit”)’. 
3 PESTEL analysis 
Exam focus 
• PESTEL analyses the general macro-environment , identifying key 
drivers of change and hence sources of risk. 
• Particularly good at identifying whether a market is growing/declining and 
why. 
• Can also be used to generate ideas for a position analysis (SWOT) – 
identifying opportunities and threats.

Chapter 4 
 119 
Model 
P Political  
E Economic 
S Social 
T Technological 
E Environmental 
L Legal 
Look for factors on local, industry, national and global levels, both now and in 
Generic examples of ideas that are relevant under each heading are: 
 
Political 
• Change of government • New political initiatives 
• Political union 
• War • Tax 
• Global political moves Social 
• Demography • Culture & lifestyle 
• Education 
• Income • Consumerism 
Economic • Interest rates 
• Exchange rates 
• Inflation 
• Unemployment 
• Balance of payments 
• Business cycle Technological 
• Rate of development & transfer 
• Innovation 
• Obsolescence 
• Changing cost base 
Legal 
• Health and safety legislation 
• Consumer laws 
• Data protection laws 
• Accounting regulations 
• New laws Environmental • Pollution 
• Wastage 
• Climate and climate change

120  
 Criticisms of PESTEL analysis  
 PESTEL analysis is an excellent way of gaining an understanding of the 
main environmental issues that may affect the organisation, but it does 
have a number of drawbacks, including: 
• The issues identified by a formal PESTEL analysis may quickly 
become irrelevant. This is particularly a problem in fast-moving 
industries, such as computing or mobile phones. 
• The PESTEL analysis process is prone to bias. Different managers 
may have different ideas on what the important issues are that need to be included in the analysis. 
• The PESTEL may be incomplete. It can be difficult (or impossible) 
for managers to correctly identify and understand every environmental issue that might affect the organisation in the future. This problem is sometimes referred to as ‘bounded rationality’. 
 
 Y is a retailer of clothes in country H. 
Which THREE of the following issues would most likely be identified under the ‘social’ heading of PESTEL analysis carried out for Y? 
A Unemployment levels in country H B Change of government C Education levels D Changing fashions E Changing tax regimes F Increased use of automation in production G Shift in customer attitudes towards ethical consumerism

Chapter 4 
 121 
 H is a company that manufactures toys. Its core business has stayed 
constant for many years, allowing H to make reasonable profits. H’s 
managers have an excellent knowledge of the market and wider industry, having worked in H for many years, though the company has not undertaken formal external analysis for many years. One of H’s managers has been asked to undertake a PESTEL analysis for the business. Before he started, he has stated that he feels that the only possible threat to the organisation is changes to the national and international economy. 
Which ONE of the following problems with PESTEL analysis is most likely 
to arise for H? 
A Issues becoming outdated before the analysis can used B Bounded rationality C Bias in the issues chosen to be included in the analysis D Failure to identify all environmental issues for the organisation 
4 Porter’s Five Forces analysis 
Exam focus 
• Five forces examines an organisation’s industry . 
• Just because an industry is large and/or growing, high profits do not 
necessarily follow. The five forces determine profit potential, both for the 
industry as a whole and for individual firms/SBUs. 
• Strong collective forces give low profitability overall. 
• An individual firm can earn better margins than competitors if it can deal 
more effectively with key forces. 
• The model can also be useful to generate ideas for a position analysis – 
especially threats.

122  
Model 
 
 Explanation of Porter's 5 Forces 
 (1) Threat of new entrants 
This will depend upon the extent to which there are barriers to 
entry . 
Establish: 
– which barriers exist – the extent to which they are likely to prevent entry – the organisation's position – is it trying to prevent or attempt 
entry?

Chapter 4 
 123 
 Barriers may include: 
Economies of scale 
The scale of operation allows economies of scale to be reaped 
which new entrants may not be able to match, e.g. UK supermarkets with bulk purchasing, the computer industry and the steel industry. 
Capital requirement for entry This could be high for capital intensive industries such as chemicals, 
power and mining but low for high-street retailers who would be able to lease premises. Pharmaceutical industry has large R&D costs and long lead times. 
Access to distribution channels For decades brewing firms have invested in bars and pubs which 
has guaranteed distribution of their product and made it difficult for competitors to break into the marketplace. Effectively the new entrant is prevented from reaching the customer. 
Cost advantages independent of size Access to cheaper labour or raw materials. Well-established 
companies know the market well and have the confidence of the major buyers along with the established architecture which serves the market. 
Expected retaliation If you expect a competitor to retaliate on your entry then this may 
act as a deterrent to enter the market – they may enter a price war and drive down margins in response to your entry. 
Legislation Legal conditions may exist for entry, e.g. licences and personal 
guarantees, telecommunications and financial services. 
Differentiation Branding and/or high quality may create customer loyalty and 
inelastic demand for their product, which may take longer to break down for the new entrant. 
Switching costs Customers may have to invest in the trading relationship via 
contractual arrangements or an investment in IT. To switch supplier would entail substantial costs and therefore the new entrant would have a challenge on their hands.

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 (2) Bargaining power of buyers 
This is likely to be high when there is a concentration of buyers, 
particularly if the volume purchases of the buyers are high, e.g. grocery retailing. 
This is likely to be further a ccentuated when the selling industry 
comprises a large number of small firms and the product is standard 
with little or no switching costs involved. 
(3) Bargaining power of suppliers 
Close linkages to the preceding section. Supplier power is likely to 
be high when: 
– the input is important to the buying company – the supplier industry is dominated by a few suppliers who have 
secure market positions and are not subject to competitive 
pressure 
– supplier products are branded or involve switching costs 
– supplier customers are highly fragmented with little buying 
power. 
(4) Threat of substitutes  
Substitutes can render products obsolete and can be direct or 
indirect. They can be based on ac tual products or uses, e.g. a 
Ferrari or a Fiat Punto; a car or a bicycle. 
There can also be substitution based on income or even doing 
without, e.g. new furniture or a holiday; giving up smoking. 
The availability of substitutes can place a limit on price and change 
the basis of the product. Consideration must be given to the ease with which consumers can switch to substitutes along with the perceived value that consumer groups would place on the products. At the same time, evaluation of potential actions to build customer loyalty should be undertaken. For example, advertising to build brand image. 
(5) Competitive rivalry  
Some markets are more competitive than others. In highly competitive markets companies regu larly monitor competitors. It can 
be intense or remote and tends to depend upon historical development. 
Factors affecting level of rivalry: – The extent to which competitors are in balance – roughly 
equal-sized firms in terms of market share or finances – often 
leads to highly competitive marketplaces.

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 – Stage of the life cycle. During market growth stages all 
companies grow naturally, whilst in mature markets growth can 
only be obtained at the expense of someone else. 
– High storage costs may lead to cost-cutting to improve 
turnover which in turn increases the rivalry. 
– Extra capacity comes in large increments which means price 
cutting may follow to fill capacity. 
– Difficulty in differentiating products leaves the basis for 
competition on price or augmented product. 
– High exit barriers mean that some companies must stay in the 
market. 
A desirable circumstance would be a situation where there are weak 
suppliers and buyers, few substitutes with high barriers to entry and little rivalry. 
 
 Criticisms of Porter's 5 Forces model 
 Over the last three decades business has focused on one fundamental 
idea – the pursuit of sustainable competitive advantage. While the idea of competition is not new, Michael Porter expanded the concept from competing with rivals to incorporating the struggle for power between the firm and five competitive forces. Porter argued that each of these forces can reduce overall industry profitability and the individual firm’s share of that profit – their ‘profit potential’ – because they can influence prices, costs and the level of investment required. 
Not everyone agrees with Porter – some would argue that the idea of 
satisfying customer needs should not be abandoned in favour of a view that sees customers either as direct competitors or as means to the firm's end. Customers are not objects whose reason for being is to be fought over by competitors seeking ‘sustainable competitive advantage’. Porter’s model might thus distract managers from seeing customers as potential partners.

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 Other limitations include the following: 
 
 WWW Ltd is a large company that sells paint and wallpaper through 
homeware retailers in Country X. WWW has several major competitors, 
each of whom is a similar size to WWW and offers a similar range of products. Due to the generic nature of the products they produce, WWW is unable to secure patents on any of their products. 
WWW sells its goods via several retailers, including BBB, which has a 
52% share of the paint and wallpaper retail market in Country X. WWW has a one-year rolling contract with BBB to stock their products, though BBB is considering launching its own brand range of paint and wallpaper in the near future. WWW is uncertain of how this will affect their sales agreement with BBB. 
Which ONE of the following statements relating to Porter’s Five Forces 
model is correct in relation to WWW’s industry? 
A It has high barriers to entry B It has high supplier bargaining power C It has high buyer bargaining power D It has a high threat of substitutes

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 Under Porter’s five forces model, which ONE of the following would be 
evidence of HIGH supplier power? 
A Customers are relatively small compared to the supplier B Low probability of forward integration by suppliers C Large numbers of suppliers D Supplier’s product is not differentiated 
 
 Test your understanding 5 – Hawk – (Case style) 
 Hawk Leathers Ltd ("Hawk") is a company based in the UK that employs 
around 60 people in the manufacture and sale of leather jackets, jeans, 
one- and two-piece suits and gloves. These are aimed primarily at motorcyclists, although a few items are sold as fashion garments. 
Hawk sells 65% of its output to large retail chains such as Motorcycle City 
and Carnells, exports 25% to the USA and Japan, and sells the remaining 10% to individuals who contact the company directly. The latter group of customers specify their requirements for a made-to-measure suit (they are often professional racers whose suits must be approved by the authorities, such as the Auto Cycle Union). The large retailers insist on low margins and are very slow to settle their debts. 
There are around a dozen companies in the UK who make similar 
products to Hawk, plus very many other companies who compete with much lower prices and inferior quality. Hawk’s typical selling price for a one-piece suit is £1,000, whereas the low quality rivals’ suits retail at around £400. As Hawk say in their literature "if you hit the tarmac, there's no substitute for a second skin from Hawk". Synthetic materials are waterproof, unlike leather, but do not currently offer sufficient protection in an accident. 
Sales of leathers in the UK are growing rapidly, mainly due to a 
resurgence of biking from more mature riders of large, powerful machines. Such riders are often wealthy and have family and financial commitments. Currently Hawk, and its rivals for quality leathers are finding it hard to keep up with demand. However, government policy and EU emissions controls are likely to limit motorcycle performance, and some experts predict that these regulations will cause sales of large motorcycles to level off. 
Whilst supplies of leather from Asia, Scandinavia and the UK are 
plentiful, a key problem is recruiting and training machinists to stitch and line the garments. Hawk has been able to invest in modern machinery to help production but the process is still labour intensive. Hawk has found that the expertise, reputation and skilled labour needed to succeed in the industry takes years to build up.

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 Although the industry is fairly traditional, there are some new 
developments such as a website for individual customers to browse and 
specify requirements, and new colours such as metallics for leathers, and 
a small but growing demand from non-bikers who are interested in 'recreational' and 'club wear' items. 
The Managing Director of Hawk has sent you the following note: Note Hi N, I’m currently heading up an internal strategy group who are looking into 
Hawk’s external position. Could you please analyse the issues facing Hawk’s industry using a PESTEL analysis for me. I also need you to evaluate the strength of each competitive pressure facing Hawk, using Porter’s five forces model. 
If you could draw on your knowledge of the company and its situation, 
that would be great. I only need a couple of points under each heading. 
If you could send me a copy of your analysis in about forty-five minutes 
that would be fantastic. 
Thanks MD 
Required: 
Undertake the analysis requested by the MD. 
(45 minutes)  
5 Industry life cycle analysis 
The life-cycle model suggests that both indivi dual products  and services, as well 
as entire industries, move through a number of different stages in their lives. 
Understanding this for our organisation can be a useful analysis tool and can help to suggest which strategies the organisation needs to adopt in order to compete successfully. 
This model can therefore be used to look at the industry as a whole  that the 
organisation operates in, or can be used to assess individual products or 
divisions  within the organisation.

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Industry/Product life cycle 
 
The model can be used to predict competitive conditions and identify key issues 
for management in corporate appraisals and strategic choices. 
Introduction stage 
The product is new to the market at this stage. Key points are: 
• it will be purchased by 'innovators' 
• high launch and marketing costs are likely 
• production volumes will be low and product cost will be high 
• buyers are unsophisticated 
• competition is little if any. 
Price elasticity of demand will influence the pricing strategy. 
• Price skimming  is appropriate when the product is known to have a price-
inelastic demand. 
• Penetration pricing  is appropriate where the demand is thought to be 
price-elastic and when gaining market share is seen as more important 
than fast recovery of development costs. 
'Pioneer companies', who are the first to the market with a particular product, are usually forced to sell the concept. These early promotions will help competitor companies who enter later with 'me too' versions of the product concept. 
Early entry is risky as heavy requirement for cash and product idea may fail 
BUT early entry allows the prospect of establishing market share and developing first mover advantage.

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Growth stage 
During this stage the market grows rapidly. Key points are: 
• sales for the market as a whole increase • new competitors, attracted by the prospects, enter to challenge the 
'pioneer' 
• new segments may be developed • demand becomes more sophisticated 
• competition levels increase. 
The market becomes profitable and cash flows increase to recover the initial 
investment in development and launch costs. 
There are many new consumers with no preference who they buy from. It will become more difficult in later stages to persuade people to switch from 
their existing brand. It is important to build a brand during this stage if possible to ease the traumas at the later stages via defensive strategy. 
Prices often fall due to economies of scale and increasing competitive pressure, 
and evidence of differentiation will become apparent, e.g. branding develops. 
Maturity stage 
During this stage market growth slows or even halts. Key points are: 
• fully sophisticated demand • high levels of competition 
• price becomes more sensitive 
• demand reaches saturation. The only way to increase market share is to 
gain business from competitors or from 'late adopters' or 'laggards' 
• it would be desirable to have a high market share at this stage or to have 
successfully developed a niche 
• large market share changes can be difficult to achieve at this stage and 
most companies would concentrate on defensive strategies to protect their 
current position and compete hard for the new customers coming into the marketplace 
• over time the company must be vigilant to detect and anticipate changes 
in the market and be ready to undertake product or market modifications with a view to lengthening the life. 
Decline 
During this stage the number of customers falls. Key points are: 
• competition reduces as players leave • price falls to attract business as sophisticated customers expect cheap 
prices

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• slow 'harvesting' must be balanced with straight divestment 
• investment kept to a minimum to take up any market share that may be 
left by departing competitors 
• there may be profitable niches remaining after industrial death. 
Considerations 
• Offer a range of products at various stages of the life cycle – mature 
products will fund the development of new products 
• competencies need to change – at the early stages, creativity and 
innovation are key whilst at later stages efficiencies and low costs become 
important 
• life cycles are difficult to predict, can change quickly and will vary from one 
product to another. Turning points are very hard to predict 
• management anticipation of decline can cause decline! Reduction in 
investment and advertising can cause the appropriate market response 
• SWOT varies across the life cycle 
• strategies will need to change as the organisation progresses through the 
life cycle. 
For example, the market for calculators started with scientists and engineers and 
then moved to business before moving to higher education students. Finally the market moved to include schoolchildren, which proved to be the largest segment of all. A pioneer wishing to stay the course would experience radical change as they move from the organisational markets to the mass consumer version. 
Summary of industry life cycle 
 Intro Growth Maturity Decline 
Sales Low Rapidly rising Peak Declining 
Costs per 
customer High cost Average Low Low 
Profits Negative Rising High Falling 
Customers Innovators Early 
adopters Middle majority Laggards 
Competitors Few Growing 
number Stable number beginning to decline Declining number 
Objectives Create product awareness & trial Maximise market share Maximise profit whilst defending market share Reduce expenditure & 'milk the brand'

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Marketing strategies 
Product Offer basic 
product Offer product 
extensions, service & warranty Diversify brands & models Phase out weak items 
Price Cost plus Price 
penetration Price matching Price cutting 
Promotion Build product 
awareness amongst early adopters & dealers Build awareness & interest in mass market Stress brand differences & benefits Reduce to level to maintain hard core loyalty 
Place Limited Growing Maximum Limited 
Usefulness of the life cycle model 
Management within the organisation can benefit from the use of the life cycle 
model in a number of ways, including: 
• Improved strategic planning  
Using the product life cycle helps organisations with their strategic 
planning. For example, the organisation will realise that the demand for a 
product typically does not last forever. It can therefore put in place contingency plans to deal with this – for example ensuring the development and launch of new products on a periodic basis. Knowing that it will need to replace even successful products at some point in the future can therefore lead to a more innovative organisational focus. 
• Improved budgeting  
The life cycle model indicates when products should generate or use cash throughout their lives. Understanding which stage each product in the organisation’s portfolio has reached (and will reach in the future) can help the organisation to estimate its future cash flow needs. 
• Proactive approach  
Rather than sitting waiting for the decline of a product to begin, the life cycle model allows companies to take a more proactive approach to boosting sales and profits during each stage. For example, if the organisation identifies that a product is moving into decline, it can look at ways of maximising returns by, for example, cutting prices or redesigning the product.

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 F plc sells a product known as the YYU500. The YYU500 has seen sales 
growth of around 1% for the last two years, after strong growth in the 
previous five years. This is due to new products entering the market in competition with the YYU500. 
F is therefore considering cutting its prices to be in line with its major 
rivals. It hopes that this will help it to maintain its market share. Market research indicates that this will now cause a significant increase in the level of sales, even though in previous years price cuts have had little effect on demand. 
F is also planning to launch a promotional campaign to highlight the 
benefits of the YYU500 against its rival products. 
Which stage of the product life cycle does the YYU500 appear to have 
reached? 
A Growth B Decline C Maturity D Introduction 
 
 AJJ Ltd has identified that all three of its main products are at the maturity 
phase of the product life cycle. Which ONE of the following is AJJ likely to 
be experiencing due to this? 
A High, but declining sales B Growing numbers of competitors C Product diversification and differentiation strategies D Adoption of price skimming strategies 
 
 Test your understanding 8 – (Case style) 
 You have recently been appointed to the European strategy steering 
group at PTP Electronics, the holding company for a number of 
subsidiary companies making household name consumer electronic products. Four products were discussed at the recent meeting. All appear to be profitable, and some large retail outlets sell the whole range of PTP products in their stores. 
• High Definition Digital recorders – the market has been expanding 
very quickly since its launch four years ago and PTP has a very 
small share compared to Sony and Panasonic.

134  
 • Home cinema systems – sales are levelling off as people switch to 
soundbars and playbars. PTP's brands have been a market leader 
since the early 2000s. 
• Conventional plasma and LED colour television monitors – demand 
for plasma/LED TVs is declining as customers and manufacturers turn to newer technologies. PTP has recently built a new factory in Holland to produce high definition televisions (HDTV) in both 4K and 8k format. Consequently it has not pushed sales of conventional TVs. 
• 4K and 8K televisions – although expensive, PTP sees these as a 
huge future market with the increase in digital broadcasting. It is the market leader in this field although sales in volume terms are not rising as fast as had been hoped. Launch was two years ago. 
You have been asked by the Chairman of the steering group to make a presentation to the rest of the steering group. She has asked that you use the product lifecycle model to identify and comment on the lifecycle position of each product type, with reasons. She also wishes you to evaluate the balance of PTP's product portfolio as a whole. The presentation should advise PTP’s directors of one idea that you feel may help improve the portfolio balance. 
Required: 
Draft notes that you will use to help you make your presentation to the 
rest of the group as outlined by the Chairman. 
(30 minutes)  
6 Competitor analysis (competitor intelligence) 
This can be defined as a set of activities which examines the comparative position of competing enterprises within a given strategic sector. It seeks to: 
• provide an understanding of the company's competitive 
advantage/disadvantage relative to its competitor's positions 
• help generate insights into competitors strategies – past, present and 
potential 
• give an informed basis for developing future strategies to sustain/establish 
advantages over competitors. 
Grant highlights three purposes: • to forecast competitors' future strategies and decisions • to predict competitors' likely reactions to a firm's strategic initiatives 
• to determine how competitor behaviour  can be influenced to make it more 
favourable for the organisation.

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A framework for competitor analysis 
Step 1: identify competitors 
• Brand competitors sell similar products to the same customers we serve, 
e.g. Coke and Pepsi. 
• Industry competitors  sell similar products but in different segments, 
e.g. BA and Easyjet. 
• Form competitors  sell products that satisfy the same need as ours 
though technically very different, e.g. speedboat and sports car. 
• Generic competitors  compete for the same income, e.g. home 
improvements and golf clubs. 
Step 2: analyse competitors 
 
Step 3: develop competitor response profiles 
• Laid back:  Does not respond 
• Selective:  Reacts to attack in only selected markets 
• Tiger:  Always responds aggressively 
• Stochastic:  No predictable pattern exists.

136  
7 The nature of global competition 
It was identified in section 2 of this chapter that increasing globalisation is one 
of the drivers of change in the organisational ecosystem; this section looks at some of the details as to why there is increased international trade. 
Why enter foreign markets 
• pressure  from shareholders to increase their return on capital employed 
• saturated domestic markets making home expansion difficult 
• opportunities as emerging markets arise with increases in economic 
income and spending power. Advances in technology, such as the internet 
and cloud computing, means recognising and exploiting such opportunities becomes more viable 
• trade barriers coming down  enabling competitors to compete in our 
domestic markets as well as increasing the opportunities for our company overseas. 
Risks arising from entering global markets 
• Marketing mix adaptations  are needed and questions must be 
addressed as to how these modifications should be made and when. Consideration must be given to the cultural implications and the potential costs involved. 
• Cultures vary  more dramatically when national boundaries are traversed 
and cultural environment needs full evaluation. 
• Varying cost structures  will exist from one country to another as will the 
quality of production factors – there may not be sufficient skilled labour and management to enable a global strategy. 
• Different competitive levels  will exist in different markets and the level of 
competition will need to be determined. 
• Exchange rate volatility  requires the deployment of control systems to 
protect the company. 
• Different economic situations will alter the demand for the product and 
the availability of factors of production. 
• Political involvement  as governments will seek to be involved in 
decisions. Careful planning will be needed to ensure that no conflict arises 
or, if likely, the allocation of respons ibility to a suitably qualified individual. 
• Political situation  should be considered with regard to war, terrorism and 
government stability. What are the risks to our personnel and our organisation? 
• Entry requirements? What do we have to do to get in? Is it legal and ethical?

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Benefits of ente ring global markets 
• Economies of scale are possible as research and development can now 
be spread over wider production volumes. Bulk-buying discounts may be 
available as the volume of our purchases and our reputation increases. 
• Management opportunity  is increased and this may prove motivational to 
certain types of managers whilst at the same time allowing those 
managers to experience a wider range of cultural situations. 
• This in turn allows the challenge to the traditional home cultural  
perspective. Items can be viewed from a different perspective with cultural benchmarks being developed. 
• Cheaper sources of raw materials  and labour may allow the 
development of a competitive advantage which could be sustainable for a period of time. 
• Market development  as the emerging markets bring a whole new range 
of consumers who will be embarking on their 'first buy' and so may not be as 'fussy' as consumers in a saturated market. 
• Risk reduction  via portfolio spread will aris e when different markets are 
combined into a portfolio. 
• Political sponsorship  will be possible as national governments, keen to 
boost or maintain home employment, offer attractive packages to global companies to invest in that country. 
• Political power becomes possible as the company grows in size and is seen to be contributing to wealth creation as opposed to exploitation of the nation concerned. 
8 Competitive advantage of nations – Porter’s Diamond 
This model suggests reasons why some nations are more competitive than others and why some industries within nations are more competitive than others. This can be used in a number of different ways: 
• The organisation can understand what, if any, factors have caused it to be 
successful in its current country or countries of operation. 
• The model can be used by the organisation to assess whether a particular 
country is suitable for expansion into. 
• Governments can identify how to adjust their policies in order to attract or 
strengthen certain industries. 
Porter identified four key factors (or dimensions) that determine the relative 
attractiveness of different countries to a particular industry.

138  
 
Factor conditions – supply side 
A supply of production factors that convey advantage. They provide initial 
advantage which is then subsequently built upon to develop more advanced factors. Basic factors are unsustainable as they are easily copied (unskilled labour) whilst advanced factors can convey the advantage as they are less easy to emulate (scientific expertise). 
They include human, physical, knowledge, capital and infrastructure, for 
example: 
• linguistic ability of the Swiss has provided advantage in the banking 
industry 
• financial expertise within the UK. 
You can use the national identity as the basis for a brand, e.g. New Zealand 
lamb. 
Demand conditions – demand side 
Sophisticated home demand can lead to the company developing significant 
advantages in the global marketplace. Demanding consumers set high standards for products whilst past experience of the product's progress through the life cycle in the home market can provide valuable input to new strategic initiatives. 
• Japanese customers have high expectations of their electrical products, 
which forces producers to provide a technically superior product for the 
global marketplace. They are so used to dealing with sophisticated customers that when they come across unsophisticated markets, they excel way beyond the competition.

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Related and supporting industry – the value chain and system 
Advantage conveyed by the availability of superior supplier industries, e.g. Italy 
has a substantial leatherwear industry which is supported by leather-working 
plants and top fashion and design companies. 
Strategy, structure and rivalry – the competition element 
Different nations have different approaches to business in terms of structure 
and the intensity of rivalry that can take place. If a company is used to dealing with strong competition then it will have experience of rivals' attacks and so will be better able to fight them off. 
Domestic rivalry can keep the organisations 'lean and mean' so that when they 
go out into the global marketplace they can compete more successfully with the less capable foreign competition, e.g. Nokia and Finland's approach to the regulation of telecoms. 
Governments can promote this rivalry via policy. 
Other events 
Porter points out that countries can produce world-class firms due to two further 
factors: 
• The role of government  – subsidies, legislation and education can all 
impact on the other four elements of the diamond to the benefit of the 
industrial base of the country. 
• The role of chance events  – wars, civil unrest, chance discoveries and 
others can also change the four elements of the diamond unpredictably. 
A business will initially choose to enter markets in those countries where the above conditions are most favourable. This involves considering the attractiveness of the markets and the barriers to entry that may exist. Strong position audit is needed to assess our company's strategic capability in these 
new segments. 
Research is critical before entering a foreign market. Then on a regular basis, 
more research is needed as well as the setting up of systems to ensure that it is continually updated and monitored.

140  
 Criticisms of Porter's Diamond model 
 The following criticisms are made of Porter’s Diamond model: 
• Porter developed the model by looking at ten developed countries. 
The model thus only really applies to developed economies. 
• Porter argues that inbound foreign direct investment does not 
increase domestic competition significantly because domestic firms 
lack the capability to defend their own markets and face a process of market-share erosion and decline. However, there seems to be little empirical evidence to support that claim. 
• The Porter model does not adequately address the role of multi- 
national corporations. There seems to be ample evidence that the diamond is influenced by factors outside the home country. 
• Porter’s analysis focused on manufacturers, banks and 
management consultancy firms. Some have questioned its relevance to service-based companies such as McDonalds. 
 • Porter’s focus is on the domestic country rather than which foreign 
markets have been targeted. A careful choice of target is essential to ensure that the firm has the competences required for success. 
• Not all firms from a given country are successful, suggesting that 
corporate management is more important than geographical location. 
 
 B is an airline, which operates in a number of different countries around 
the world. It is currently considering entry into country G, but is concerned that there are not enough skilled workers in country G for their needs. 
Insert the missing TWO words into the sentence below: According to Porter ’s Diamond model, country G lacks a key 
________________ and therefore may not be an appropriate expansion 
target for B.

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 141 
 AHH is a supermarket chain which is considering expansion into country 
L. It has decided to analyse the decision using Porter’s Diamond. 
Consider the following lis ts of issues relating to the AHH’s expansion as 
well as the dimensions of Porter’s Diamond. 
 Issue  Dimension 
A Lack of farmers required for 
fresh produce 1 Demand conditions 
B A range of existing 
supermarkets serving a 
large number of customers 2 Strategy, structure and 
rivalry 
C Lack of available land to build 
supermarkets 3 Factor conditions 
D AHH currently operates in highly competitive markets 4 Related and supporting 
industry 
Show which issue relates to each dimension by pairing the appropriate 
letter and number (e.g. A1, B4, etc). 
 
 Test your understanding 11 – (Integration question) 
 Australia has a long-established wine industry, but in the 1970s it decided 
to expand exports to Europe and the USA, since growth was becoming limited in domestic markets. 
Australian producers had benefitted from strong domestic demand, and 
had produced excellent results by cultivating grape varieties imported from Europe, combined with innovative techniques such as cool fermentation in stainless steel containers. Producers had achieved success in a wide range of wines including red, white, sparkling, dry and sweet. 
Although many producers started out as independent small businesses, 
major listed groups such as Penfolds had consolidated many of these small producers into well-known labels. 
Required: 
(a) Discuss two reasons why Australian wine producers decided to 
enter foreign markets, and two risks arising. 
(b) By giving one example of each element, use Porter’s Diamond to 
evaluate the degree of competitive advantage achieved by the 
Australian wine industry.

142  
9 Summary

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 143 
 The correct answers are C, D and G 
A is economic, B and E are political, while F is technological. 
 
The company seems to be in a stable, fairly slow-moving industry, so A is 
less likely to be an issue. B and D are the same issue (just stated differently) – the scenario mentioned that management had a deep knowledge of the market, reducing the risk of bounded rationality. 
However, as can be seen from the scenario, the manager in charge of 
undertaking the PESTEL analysis already has definite ideas about what is important, which could lead to bias creeping into his work. 
 
Barriers to entry appear to be low. Given the lack of patents and its 
distributor’s plans to enter the market, WWW should be worried about the threat of new entrants. 
Supplier power is unknown. No information is provided about WWW’s 
suppliers – it’s retail partner is a customer. 
Customer power seems to be high – BBB has alternative wallpaper and 
paint suppliers it could choose to stock and seems keen to, potentially, replace WWW’s products with its own in the short to mid-term. 
Substitutes are not mentioned in the scenario. BBB will turn into a rival to 
WWW if it enters the market. 
 
If the customer is relatively small,  the supplier is likely to have more 
power in their relationship as it does not rely on the customer for a large 
proportion of its sales. 
The other three options would all suggest low supplier power – if 
suppliers are unlikely to take over the business (low chance of forward integration), there are many of them for the business to choose from, or it easy to switch to other suppliers due to a lack of differentiation in their products, the customer enjoy higher power over the supplier.

144  
 PEST analysis 
Political factors 
Government/EU regulation that could damage motorcycle sales is an 
issue for the whole industry. If there is a clamp down it might seriously threaten sales. Hawk might consider setting up a lobby group with other manufacturers. 
Economic factors 
The recession in the UK economy (and foreign markets) is likely to result 
in lower disposable incomes for what is often a luxury purchase. Hawk may well find a major dip in sales as the recession continues. 
The weakening pound is making exports to the USA and Europe easier, 
but is increasing the import costs of leather. There is little Hawk can do about that, so it is likely to seek new global markets such as the BRIC economies (Brazil, Russia, India and China). 
Social factors 
There has been a growth in demand from mature riders ("born-again 
bikers"). Have companies such as Hawk done any research to assess the life of this trend? How effective is Hawk's marketing at reaching this potentially important market segment? 
More emphasis on safety of riders who often have family; this is a boost 
for the industry and Hawk’s customers are likely to be responsible bikers. 
Technological factors 
Relevant issues include website ordering and metallic paints but neither 
of these is especially important. However, Hawk and others should be aware of new ideas that could help with their processes. 
Environmental factors  
Care will need to be taken with how dyes etc are dealt with as part of the 
manufacturing process, as the level of scrutiny on how manufacturing companies impact on the environment increases. 
Legal  
Approval from the ACU is vital for Hawk’s racing suits. Whilst this will 
require regular inspections, it is important for credibility amongst customers. It may be seen as an endorsement of quality for the entire range (the so-called “halo effect”).

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 Porter’s five forces 
Threat of new entrants 
The threat of new entrants is reasonably high from overseas rivals but is 
limited by existing entry barriers. These include recruiting skilled staff, close associations with racing teams, established relationships with major retailers and brand reputation. 
Bargaining power of customers 
The power of customers depends on which customers are being 
considered. For individual customers it is low because they will be loyal to the brand and are not buying in bulk. 
However, for the large retailers there is higher power that arises from the 
volumes purchased. Retail chains will exercise this power in terms of designs, lead times, prices paid and credit period taken. Hawk need to meet these needs or risk losing major customers to existing/new competition. 
It will also be high for the professional racing teams. Having Hawk’s 
products associated with top class racing teams is imperative to maintain the quality of its brand in the marketplace. Suits must be made to a high quality and exactly to customer specification/compliance with the Auto Cycle Union’s requirements. 
Bargaining power of suppliers 
The power of suppliers is generally low, because leather and machinery 
are readily available. (Note: It may be that supply of leather of the required quality for professional suits is limited, in which case the power would be higher.) 
However, supplies of skilled labour are limited and Hawk may find it has 
to pay high wages. 
Threat of substitutes 
Hawk believes that the threat from substitutes is low and states that only 
leather can offer the required degree of abrasion resistance. Clearly this must be kept under review as newer fabrics and technologies may change this perception. 
The threat of substitute products/fabrics may be higher in the fashion 
lines, although this does not yet constitute a major proportion of Hawk's turnover.

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 Competitive rivalry 
Rivalry is considered to be low. Those “rivals” that offer cheap leathers 
are not really rivals at all, because serious bikers will not contemplate such offerings. 
Furthermore, sales are rising so quickly that all players are working at 
near capacity without the need to take customers from one another. 
Summary 
The key risk areas for Hawk do not come from within the industry as, with 
the exception of the power of larger retailers, competitive forces are low. However, there are major issues that impact the industry as a whole in respect of the current economic climate and government policy. 
(Tutorial note:  each point within the models has been explained and 
assessed for its importance. Finally key points must be highlighted in 
order to then formulate or appraise strategy.) 
 
The seeming saturation of the market and the increase in competition 
would suggest the product is at the maturity stage. This stage typically sees the volume of product sales become more sensitive to selling price changes. 
 
A would indicate products that are in decline. B would tend to occur 
during growth, while D would usually be part of the introduction/growth phase of the product life cycle.

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 Presentation notes: 
(Tutorial note:  it is relatively straightforward to classify the individual 
products/SBUs but make sure you just ify your choice. The higher skills 
element is in looking at the bigger picture to evaluate the overall portfolio 
balance.) 
The market for high definition digi tal recorders is still expanding and 
hence is in the growth phase. PTP really must try to boost its presence in 
this crucial market area (see below), or risk being left behind by rivals. 
Sales of home cinema systems are static, indicating a market that is 
mature and possibly saturated. This is a problem given PTP’s historical dependence on this product stream. T he risk is that profits will soon 
decline or disappear if retailers lose interest in this product group. 
The market for conventional plasma and LED televisions is in decline, 
suggesting that PTP should focus instead on 4K and 8K televisions – the growth area.  
 Despite being a market leader, PTP's sales of 4K and 8K televisions are 
only rising modestly suggesting that the industry (or at least PTP's products) are still in late introduction or early growth stages. PTP believes 
that this segment is going to be huge, so will need to invest heavily in marketing and product development to ensure it can capitalise on the high growth when it arises. 
Overall portfolio evaluation 
The balance of a portfolio can be assessed against a range of criteria 
including cash flow, growth, risk and investment required. This can be achieved to some extent by having products at different stages throughout the lifecycle. While PTP has products at different stages within the lifecycle, the main problems with its portfolio are: 
• Conventional plasma and LED TVs are facing decline but PTP does 
not have any new products in the development stage to replace 
them. 
• The overall portfolio may require a net investment of cash in the 
future. Home cinema systems may be strong cash generators but both high definition digital recorders and HDTVs require investment to benefit from future growth. 
Suggestions for re-balancing the portfolio include: 
• Invest to develop soundbars and playbars. PTP might offer a 
guaranteed trade-in value for old units if customers purchase a new 
soundbar. 
• Switch production away from the old factory to the new one in 
Holland, perhaps selling the old si te and using the proceeds for an 
acquisition of a home entertainment-focused business.

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 The correct answer is FACTOR CONDITIONS 
The business is missing a key factor that would enable it to operate in the 
target country. 
 
 The correct answers are: A4, B1, C3, D2 
A4 – Lack of farming indicates a missing related industry for a 
supermarket. 
B1 – Large numbers of existing supermarkets could indicate that there is 
insufficient spare demand for AHH to win if it wishes to expand into country L. 
C3 – The lack of land is a specific missing factor that AHH also needs in 
order to successfully expand into country L. 
D2 – AHH’s success in other competitiv e markets may indicate that it has 
the necessary strategy and structure to deal with the competition in 
country L. 
 
 Why enter export markets? 
Australian producers would have been under pressure to increase profits 
since some are effectively listed companies. Furthermore, it is likely that domestic markets had become saturated. There must be a limited consumption in Australia, therefore producers’ attention would turn to export volumes. They would have spotted an opportunity to target growth markets in the UK and Europe. 
Likely risks 
One risk would have been culture and tradition. For example, wine 
drinking in the UK was far less common than it is today, and the risk would have been non-acceptance by a UK market. 
Equally, the French are very protective of their own wines and reluctant to 
stock those from other countries. National bias would be a major barrier to overcome in some wine-drinking countries. 
Another risk would be financial – namely exchange rate fluctuations and 
costs involved in transporting a product that is over 85% water for thousands of miles.

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 Porter’s Diamond 
Factor conditions would include the availability of land, the favourable 
climate, and the skill of Australian winemakers (so impressive that they have exported their talents back to European producers – the so-called “flying winemakers”). These would combine to give a strong advantage to Australia, because few rival countries possess such a favourable mix. 
Demand conditions are also strong; Australia has an alcohol tolerant 
culture, and domestic consumers would have set high standards. However, this would also apply to coun tries such as France, so this factor 
may have given Australia a medium-level advantage overall. 
Related and supporting industries will be strong since Australia is a 
modern, developed industrial nation. This will confer a medium-level 
advantage compared to Western-European countries and the USA, but a strong one compared to, say, Chile. Australian firms may also have had an advantage as they could have invested in newer technologies while rivals in France would have been committed to traditional methods. 
Strategy structure and rivalry would be favourable, since there is a 
properly developed stock market, and reasonably intense local rivalry. This would give a strong advantage compared to developing economies such as Argentina and Bulgaria. It would also give a strong advantage compared to countries with old-fashioned rules about wine, such as France (these rules often prevent true competition).

150

151 
Strategic networks and 
platforms 
ecosystem on organisational strategy (a) Discuss the impact of 
platforms on organisational strategy  
(b) Conduct stakeholder 
analysis in networks 
 
  Chapter 
5

Strategic networks and platforms 
152  
 
Customers and suppliers are often key stakeholder groups in an organisational 
ecosystem. One framework that we have already met – Mendelow's power/interest matrix –  and another that you have probably seen before in earlier studies, and which was revisited in chapter 4 – Porter's five forces model – are useful for assessing the power of customers and suppliers and suggesting suitable strategies for dealing with them. 
In this chapter the practicalities of managing the relationships with suppliers and 
customers within the organisational ecosystem is considered. In particular the role of technologies in supply chain management is analysed in detail. 
2 What is a supply chain? 
 A supply chain encompasses all activities and information flows necessary 
for the transformation of goods from the origin of the raw material to when the product is finally consumed or discarded. 
This typically involves distribution of the product from the supplier to the manufacturer to the retailer and then on to the final consumer. Each link in the supply chain (i.e. the supplier, or the consumer) is known as a node. 
Transactions between the business and its suppliers are referred to as its 
‘upstream’ supply chain. Transactions between the business and its customers are referred to as ‘downstream supply chain’. 
 
 Businesses are no longer able to just consider their immediate customers and immediate suppliers. This is because problems anywhere in the organisation’s ecosystem can have a significant impact on the business.

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 Illustration 1 – The supply chain 
 Imagine a (simplified) supply chain for a large, national baker who makes 
and sells bread through a chain of supermarkets. 
 
The baker makes bread with wheat. This means that the supply chain 
starts with the farmers who grow the wheat – the original creator of the resource. The farmers then sell this wheat to mills, who convert the wheat 
into flour. The flour is then purchased by wholesalers who sell the flour in bulk to larger companies, such as our baker. The baker makes the loaves of bread and sells it onto the supermarkets, who sell the bread onto the end consumers (customers). 
Management of the supply chain means that the baker needs to be 
aware of the activities and needs of each part (or node) of the supply chain – from the farmer to the end consumer. 
The baker’s upstream supply chai n includes farmers, mills and 
wholesalers, while its downstream supply chain is made up of 
supermarkets and consumers. 
So the network that forms the organisational ecosystem of the baker is 
comprised of many components in both the upstream and downstream supply chains. 
Note that problems in any part of the supply chain can affect the baker. 
For example, if farmers switch from growing wheat to other, more profitable crops then it will lead to a scarcity of flour on the market, pushing the baker’s costs up. If the end consumers start to dislike the types of bread that the baker is selling (for example if the market shifts away from white bread to brown or granary breads) then this will affect 
how many of the baker’s products will be stocked by the supermarkets. 
As such, even though the baker may not directly transact with the 
consumer and the farmers, it is still af fected by them as they are part of 
its supply chain. 
It is worth noting that managing the supply chain and moving materials and 
products from node to node includes activities such as: 
• production planning • purchasing 
• materials management

154  
• distribution 
• customer service 
• forecasting. 
While each firm can be competitive through improvements to its internal 
practices, ultimately the ability to do business effectively depends on the efficient functioning of the entire supply chain. This requires the business to seriously consider how to most effectively monitor and control its entire supply network. 
 
Illustration 2 – Supply ch ain management (SCM) 
 A wholesaler’s inability to adequately maintain inventory control or 
respond to sudden changes in demand for stock may mean that a retailer 
cannot meet final consumer demand. Conversely, poor sales data from retailers may result in inadequate forecasting of manufacturing requirements. 
Types of supply chain – push and pull 
In the traditional supply chain model, the raw material suppliers are at one end of the supply chain. 
• They are connected to manufacturers and distributors, who are in turn 
connected to a retailer and the end-customer. 
• Although customers are the source of the profits, they are at the end of the 
chain in the ‘push’ model. 
Driven by e-commerce’s capabilities to empower clients, m any companies are 
moving from the traditional ‘push’ business model, where manufacturers, 
suppliers, distributors and marketers have most of the power, to a customer-driven ‘pull’ model. 
This new business model is less product-centric and more directly focused on 
the individual consumer – a more marketing-oriented approach. 
• In the pull model, customers use electronic connections to pull whatever 
they need out of the system. For example, using a platform such as cloud 
computing allows customers to liaise with suppliers in real time. 
• Electronic connectivity in the supply chain network gives end customers 
the opportunity to give direction to suppliers, for example about the precise specifications of the products they want. 
• Ultimately, customers have a direct voice in the functioning of the supply 
chain. 
E-commerce creates a much more efficient supply chain that benefits both customers and manufacturers. Companies can better serve customer needs, carry fewer inventories, and send products to market more quickly.

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 Illustration 3 – Supply ch ain management (SCM) 
 Several personal computer manufacturers allow users to order over the 
internet and to customise their machines (for example Lenovo and Dell). 
PCs are then made to customers’ orders. 
This is an example of a pull supply chain, where the product is not 
produced until the customer requests it. It is then created to fit their 
specific needs. 
 
 V retails toy cars. He manufactures the product in batches of one 
thousand and then visits various independent toy shops, trying to convince them to stock them on their shelves. 
This is an example of a _______ supply chain. 
Required: 
Insert the word missing in the above sentence.  
 
 When managing a supply chain, a business may wish to ensure that 
every part of the chain has sufficient cash and/or profits. Which ONE of the following reasons would best explain this? A To ensure ongoing supply and demand for the business’s products B To ensure that the business has sufficient information on all parts of 
its supply chain 
C To ensure quality throughout the overall supply chain D To ensure maximum collaboration throughout the chain 
3 Upstream supply chain management 
As mentioned above, it is crucial for an organisation to monitor and control its 
entire supply chain. In this section, we will examine some of the methods a company could use to look after its upstream supply chain – i.e. its chain of suppliers. 
3.1 Managing supplier relationships 
There are a number of general issues that an organisation needs to consider in 
relation to its suppliers.

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Overall supplier strategy 
A supply strategy is likely to take acco unt of matters such as the following. 
• Sources 
What sources are available and where are they located? Are suppliers' 
businesses larger or smaller than the buying organisation (this affects bargaining power). Will different suppliers need to be used in different parts of the world? 
• Number of suppliers 
If there is only a single source of supply this may bring the advantage of bulk purchase discounts, but the organisation may prefer to have several or multiple suppliers to avoid the risk of failed deliveries and to prevent a single supplier from getting either too powerful or/and complacent. 
• Cost, quality and speed of delivery 
These factors are closely interrelated and the strategy will probably need to make compromises to achieve the right balance. 
• Make or buy and outsourcing 
The outsourcing decision is effectively the same as the strategy of vertical integration discussed in chapter 7 "Strategic analysis and choice". The decision will depend on the above factor s and whether or not the firm has 
the required competences and resources to bring the supply in-house. 
 
Factors to consider when choosing suppliers 
 • What does the company charge? 
• Does it offer discounts or other incentives? 
• Can it deliver the required quality of product or service (for example 
is it ISO 9001 certified)? 
• Is the supplier willing to customise orders or handle other special 
needs? 
• How will it ship its products, and how much will that cost? • How quickly will orders be delivered? • Will delivery quantities be accurate? 
• How will the supplier handle returns or other problems? 
• Is technical support available, if required? • How will the supplier manage the account? • Do they have adequate technology? • Are they financially secure? Credit reports can help here. 
• Are they reliable? Can references be obtained? 
• What credit period is offered?

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Antagonism or partnership? 
In the past the supply chain was typically defined by antagonistic  relationships. 
• Supplier contracts featured heavy penalty clauses and were drawn up in a 
spirit of general mistrust of all external providers. 
• The knowledge and skills of the supplier could not be exploited effectively: 
information was deliberately withheld in case the supplier used it to gain power during price negotiations. 
Hence no single supplier ever knew enough about the ultimate customer to suggest ways of improving the cost-effectiveness of the trading relationship, for instance buying additional manufacturing capacity or investing in quality improvement activities. 
It is now recognised that management of supplier networks is based upon 
partnership  – collaboration and offers benefits to an organisation's suppliers as 
well as to the organisation itself. By working together organisations can make a much better job of satisfying the requirements of their end market, and thus both can increase their market share. 
service. 
both customers and suppliers. By opening up design departments and supply problems to selected suppliers a synergy results, generating new ideas, solutions, and new innovative products. 
• To enhance the nature of collaboration the organisation may reward 
suppliers with long-term sole sourcing agreements in return for a greater level of support to the business and a commitment to ongoing improvements of materials, deliveries and relationships.

158  
 Service level agreements should include the following factors: 
• A detailed explanation of exactly what service the supplier is offering 
• The targets/benchmarks to be used and the consequences of failing 
• The procedure for dealing with complaints. • The information and reporting procedures to be adopted. 
• The procedures for cancelling the contract. 
3.2 The use of technologies in managing the upstream supply chain 
network 
The key activities of upstream SCM are procurement and upstream logistics. 
Much of the modern approach to managing such areas of the organisational ecosystem will be via technologies. 
What is e-procurement? 
The term ‘procurement’ covers all the activities needed to obtain items from a 
supplier: the whole purchases cycle. 
E-procurement is therefore used to describe the electronic methods used in 
every stage of the procurement process, from the identification of the organisation’s requirements through to payment. 
 
E-sourcing, e-purchasing and e-payment 
 E-procurement is the term used to describe the electronic methods used 
in every stage of the procurement process, from identification of 
requirement through to payment. It can be broken down into the stages of e-sourcing, e-purchasing and e-payment. 
E-sourcing covers electronic methods for finding new suppliers and 
establishing contracts. 
Not only can e-sourcing save administrative time and money, it can 
enable companies to discover new suppliers and to source more easily from other countries.

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 Issuing electronic invitations to tender and requests for quotations reduces: 
• administration overheads 
• potentially costly errors, as the re-keying of information is minimised 
• the time to respond. 
E-purchasing  covers product selection and ordering. 
Buying and selling online streamlines procurement and reduces 
overheads through spending less on administration time and cutting down on bureaucracy. E-purchasing transfers effort from a central ordering department to those who need the products. Features of an e-purchasing system include: 
• electronic catalogues for core/standard items 
• recurring requisitions/shopping lists for regularly purchased items. 
The standard shopping lists form the basis of regular orders and the lists 
can have items added or deleted for each specific order 
• electronic purchase orders despatched automatically through an 
extranet to suppliers 
• detailed management information reporting capabilities. 
Improvements in customer service can result from being able to place and 
track orders at any time of day. An e-catalogue is an electronic version of a supplier’s paper catalogue including product name, description, an illustration, balance in hand and so on.  User expectations  have increased 
dramatically in recent years as a result of their personal experiences of shopping on the internet. Well-designed websites and web interfaces are essential to offer good functionality so as to maintain user satisfaction. 
E-payment  includes tools such as electronic invoicing and electronic 
funds transfers. Again, e-payment can make the payment processes 
more efficient for both the purchaser and supplier, reducing costs and errors that can occur as a result of information being transferred manually from and into their respective accounting systems. These efficiency savings can result in cost reductions to be shared by both parties. 
E-procurement gives rise to a number of specific applications that the 
organisation can use to manage its upstream supply chain. These include: 
• EDI (electronic data interchange) – this involves the organisation linking its 
systems to those of its suppliers, allowing for faster and more efficient 
paperless ordering. This can improve the speed and accuracy in the fulfilment of orders. 
• Use of the Internet – the organisation can use the Internet to shop around 
to ensure that they are using the most reliable, cost effective suppliers. 
• Disintermediation – the organisation may be able to buy its supplies online 
directly from an earlier stage in the supply chain (e.g. from a wholesaler rather than a retailer), which could help the business to save money.

160  
 
 Benefits and drawbacks of e-procurement 
 The benefits of e-procurement 
The more of the procurement process that can be automated, the better, 
as there will be considerable financial benefits. 
• Labour costs will be greatly reduced. 
• Inventory holding costs will be reduced. Not only should 
overstocking be less likely, but if orders are cheap to place and 
process, they can be placed much more frequently, so average inventories can be lower. 
• Production and sales should be higher  as there will be fewer stock- 
outs because of more accurate monitoring of demand and greater ordering accuracy. 
• The firm may benefit from a much wider choice of suppliers rather 
than relying on local ones. 
• Greater financial transpar ency and accountability. 
• Greater control over inventories. 
 • Quicker ordering, making it easier to operate lean or JIT 
manufacturing systems. 
• There are also considerable benefits to the suppliers concerned, 
such as reduced ordering costs, reduced paperwork and improved cash flow, that should strengthen the relationship between the firm and its suppliers. 
Potential risks of e-procurement 
There are some risks associated with e-procurement. These are: 
• technology risks. There is a risk that the system (whether software 
or hardware) will not function correctly. There are risks that it might 
not interface properly with the organisation’s system. There are very high risks that it will not communicate  properly with a wide range of 
supplier systems 
• organisational risks. Staff might be reluctant to accept the new 
procurement methods 
• no cost savings realised. As with all IS/IT projects, it is very difficult 
to predict all the benefits that can arise. Tangible benefits (such as might arise if fewer staff have to be employed) are relatively easy to forecast. However, intangible benefits (such as better customer service giving rise to an improved reputation) are very difficult to estimate with any accuracy.

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Other uses of technologies within the upstream supply chain 
• Communication – email and other IT-based communication allow for more 
rapid communication with all parts of the upstream supply chain. 
• Information gathering – gathering and processing information on the 
upstream supply chain that may impact on the organisation is easier 
thanks to the Internet. 
• Extranets – this allows the organisation to grant suppliers access to 
information that can help enable aid collaboration (such as co-ordination of production and inventory levels) as well as joint development of products. 
• Big data – collecting and interrogating data on those involved in the 
upstream supply chain network can help organisations to manage better the product offering and thereby differentiate themselves in the market. 
 
Illustration 4 – Tesco and Big Data 
 Tesco makes use of Big Data to monitor weather forecasts and feed 
information back to suppliers of likely requirements for the immediate future. 
By using historical buying patterns from customers and expected weather 
trends, Tesco expects to be reasonably accurate in what it predicts 
consumers in specific locations will be looking to purchase. It then feeds this information back to suppliers so that they can ensure that the right products are in the right locations at the right time. 
For example, if a particularly cold spell of weather is soon to be followed 
by warmer temperatures, Tesco suppliers will ensure that this location is properly supplied with foodstuffs such as meat for a barbecue. This means not only increased trade for suppliers, but will also help ensure that Tesco customers have a better chance of seeing what they are looking for in a Tesco store compared to other food retailers. 
 
• Blockchain – the use of  blockchain technology can create much greater 
confidence over the entire supply chain, as the data relating to transactions is more secure and cannot be altered by just one party in isolation.

162  
 Illustration 5 – Soil Association 
 The Soil Association has looked to introduce a process whereby 
customers are able to identify how food has gone from the original 
producer to the shelf in a shop with complete confidence over the accuracy of data provided. 
The foodstuffs that have received organic certification can be traced back 
through the supply chain; shoppers will be able to see information including the certification validity documentation, the criteria that have been met by the product to earn the organic certification, a map of the food’s journey, and even pictures of the farm from which it was originally 
sourced. 
The blockchain technology, having greater security, means consumers 
can be confident over the accuracy of food labelling, country of origin, ‘food miles’ etc., as such information cannot have been tampered with at any point in the overall supply. 
 
• Cloud computing – liaising with upstream suppliers via the use of cloud 
computing has the benefits of greater speed in information flow and also added security. For example, adding new suppliers to the network, or new inventory lines to different locations, becomes an easier administrative exercise, thereby saving time and money. 
 
Test your understanding 3 – (Integration question) 
 XL Travel are a tour operator based in the capital city of country S. They 
run weekly trips to the seaside resort of Black Rock (around 140km away) for four–day visits (typically from Friday to Monday). 
The tours are very popular, especially with people aged over 65 (who 
make up over 90% of XL’s customers). The company has traded profitably for many years on the back of premium pricing. However, recently profits have started to fall, coinciding with a minority of complaints from regular users. Some users feel that the quality of the trips have fallen and are not up to previous high standards. Other users feel that, whilst XL itself has invested (with attractive new offices, better marketing, more staff and easier booking systems) this investment has gone on the wrong areas. 
XL has built up a large cash surplus for further investment. One of the 
ways it is considering using this cash is to invest in and improve its supply chain. 
Required: 
What are likely to be the elements of XL's upstream supply chain? Give 
some examples of what areas XL could aim to change? 

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4 Downstream supply chain management 
As mentioned earlier in this chapter, downstream supply chain management 
refers to the need for the organisation to manage its transactions and relationships with its customer network and consumers of its products and services. 
This can be undertaken in a number of different ways. 
4.1 Analysis of customers and their behaviour 
In order to be able to effectively manage the organisation’s customers, it is vital 
that their needs and behaviour are anal ysed and understood. This will help the 
organisation to improve its service levels (and the product range it offers) in order to better meet customer needs. 
 
 Customer analysis and behaviour – industrial markets 
 Customer behaviour 
Here are the main features of industrial buyers: 
Motivation 
An industrial buyer is motivated to satisfy the needs of the organisation 
rather than his or her individual needs. Often, purchases are repeat 
orders when the stock of items has fallen below a certain level and thus 
the buying motive is clear, i.e. avoiding nil stocks. With significant one-off 
purchases, the motivation will be the achievement of the organisation’s goals or targets. Thus a profit target may mean the buyer placing an emphasis on cost minimisation. A growth target expressed in terms of sales motivates a purchase that will promote that goal. 
The influence of the individual or group 
An industrial purchase may be made by an individual or group. The 
individual or group is buying on behalf of the organisation but the buying decision may be influenced by the behavioural complexion of the individual or group responsible. The behavioural complexion will be influenced by the same influences on consumer buyers already discussed. 
General organisational influences 
Each organisation will have its own procedures and decision-making 
processes when purchases are made. Large centrally controlled organisations will often have centralised purchasing through a purchasing department. The pur chase decisions will tend to be formal with 
established purchasing procedures. In small organisations there will not be a purchasing department. Purchasin g decisions will tend to be made 
on a personal basis by persons who have other functions as well in the organisation. Personal relationships between the supplier and the buyer will often be very important.

164  
 Reciprocal buying 
A feature in many industrial markets is the purchase of goods by 
organisation A from organisation B only on condition that organisation B purchases from organisation A.  
Purchasing procedures 
An industrial buyer appraises a potential purchase in a more formal way 
than a consumer buyer. Written quotations, written tenders and legal contracts with performance specifications may be involved. The form of payment may be more involved and may include negotiations on credit 
terms, leasing or barter arrangements. 
Size of purchases 
Purchases by an industrial buyer will tend to be on a much larger scale. 
Derived demand 
Demand for industrial products is generally derived from consumer 
demands. For example, when consumers demand more motor cars, the demand for steel, glass, components and so on will increase in the industrial sector. Industrial strategists have to know what markets the demand for their products is derived from, and monitor this market as well as their own. This may sound obvious, but when the firm is selling through intermediaries, or in overseas markets, there may be very little contact with users and end-users. 
When industrialists predict a downturn in consumer markets, they will 
often cut back on production in the short run. This, of course, has the effect of lowering demand in the consumer markets through its effect on employment and wages, and is part of the trade cycle process discussed earlier. 
Customer analysis – Industrial segmentation 
• Geographic:  The basis for sales-force organisation. 
• Purchasing characteristics:  The classification of customer 
companies by their average order size, the frequency with which 
they order, etc. 
• Benefit: Industrial  purchasers have different benefit expectations 
from consumers. They may be oriented towards reliability, durability, versatility, safety, serviceability, or ease of operation. They are always concerned with value for money.

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 • Company type:  Industrial customers can be segmented according 
to the type of business they are, i.e. what they offer for sale. The 
range of products and services used in an industry will not vary too much from one company to another. A manufacturer considering marketing to a particular type of company would be well advised to list all potential customers in that area of business. 
• Company size:  It is frequently useful to analyse marketing 
opportunities in terms of company size. A company supplying canteen foods would investigate size in terms of numbers of employees. Processed parts suppliers are interested in production rate, and cutting lubricants suppliers would segment by numbers of machine tools. 
 
 Customer analysis and behaviour – consumer markets 
It is critical in consumer markets to understand why buyers purchase an 
organisation's goods or services. This will enable an organisation to identify critical success factors (CSFs) in markets. 
Critical success factors refer to things that the company needs to do well 
in order to compete in its market and attract customers. For example, a supermarket may need to be cheaper, or stock a better range of products than its rivals in order to successfully compete. 
Customer behaviour analysis will also see if they organisation has the 
required core competences to meet those CSFs and, hence, to determine an appropriate strategy. 
Traditional views of marketing tend to assume that people purchase 
according to the value-for-money that they obtain. The customer considers the functional efficiency of the alternative products, and arrives at a decision by comparing this with the price. This set of beliefs is demonstrably inadequate in explaining consumer behaviour. 
Cognitive dissonance 
Dissonance is said to exist when an individual’s attitudes and behaviour 
are inconsistent. One kind of dissonance is the regret that may be felt when a purchaser has bought a product, but subsequently feels that an alternative would have been preferable. In these circumstances, that customer will not repurchase immediatel y, but will switch brands. It is the 
job of the marketing team to persuade the potential customer that the product will satisfy his or her needs, and to ensure that the product itself 
will not induce dissonant attitudes.

166  
 Personality and product choice 
Products, and their brand names, tend to acquire attributes in the mind of 
the potential customer; indeed, this is one of the primary functions of branding. When considering goods or services for a purchase, customers will invariably select those that have an image consistent with their own personality and aspirations. 
Influence of other people 
When people make purchase deci sions, they reflect th e values of their 
social and cultural environment. Often the form of products and services 
for sale has been determined by that environment. Among the more 
obvious influences are those of family and of reference groups. 
The family is often important in engendering brand purchasing habits in 
grocery lines, although it also has a far broader influence in forming tastes in its younger members. 
Customer analysis – consumer segmentation 
Consumers can be divided into groups sharing common psychological 
characteristics. One group may be described as security-oriented, another as ego-centred and so on. These categories are useful in the creation of advertising messages. 
A recent trend is to combine psychological and socio-demographic 
characteristics to give a more complete profile of customer groups. Appropriately called lifestyle segmentation by one of the companies originating the method, this kind of segmentation uses individuals to represent groups that form a significant proportion of the consumer market. These individuals are defined in terms of sex, age, income, job, product preferences, social attitudes and political views. 
Purchasing characteristics 
Customers may be segmented by the volume they buy (heavy user, 
medium user, light user, non user). They may be segmented by the outlet type they use, or by the pack size bought. These variables, and many others, are useful in planning production and distribution and in developing promotion policy. 
Demographic 
Customers are defined in terms of age, sex, socio-economic class, 
country of origin, or family status. The most widely used forms of demographic segmentation in the UK are the socio-economic classification based on class (A, B, C1, C2 , D and E) and the life cycle model (Bachelor, Newly married couple, Full nest 1, Full nest 2, Full nest 3, Empty nest 1, Empty nest 2).

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 Geographic 
Markets are frequently split into regions for sales and distribution 
purposes. Many consumer goods manufacturers break down sales by television advertising regions. 
Benefit 
Customers have different expectations of a product. Some people buy 
detergents for whiteness, others want economy, and yet others stain removal. 
It can be seen that, within the same product class, different brands offer 
different perceiv ed benefit s. An understanding of customers’ benefits 
sought enables the manufacturer to create a range of products each 
aimed precisely at a particular benefit. 
Customer analysis – use of technologies 
In the digital era, technologies offer organisations greater scope for 
understanding the possible opportunities for marketing to customers in the downstream supply chain network. Examples include: 
Use of social media 
The extent to which content is disseminated to other users across social 
platforms can be assessed by the organisation. This can be assessed by means of variables such as the number of retweets on Twitter, or the shared likes on Facebook. Products or marketing campaigns which do not achieve high results in such variables can be changed or removed from the business portfolio. 
Big Data 
Just as with the upstream supply chain network, data can be collected 
and interrogated on those in the downstream supply chain network to result in a product or service offering that matches greater the demands of customers and consumers. 
 
 Illustration 6 – Time Warner and Big Data 
 Time Warner is using Big Data to track which types of media customers 
are watching and when. This can help to manage bandwidth and therefore optimise the customer experience. The company also uses sophisticated systems to integrate public data such as voter registration and property records with local viewing figures. This enables targeted marketing campaigns by Time Warner’s advertising clients.

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4.2 Marketing 
A key aspect of managing the downstream supply chain is to ensure effective 
marketing. This will help to attract customers and improve the image of the 
organisation with consumers. 
There are a number of possible approaches that can be used to help the 
organisation accomplish this. 
The six markets model (Payne) 
This model helps the organisation understand who it needs to market to . The 
six markets model advocates that an organisation has six key markets, not just 
the traditional customer market. Marketing activity should be extended to build and manage relationships in all these areas. 
• Customer markets 
The final destination for the product. This ability to reach the customer in a 
highly competitive environment depends on other parties or relationships. 
• Referral markets 
This is the institution or person who refers the customer to the supplier. A bank refers customers to providers of insurance services. The Automobile Association (AA) refers members to a bank or hire purchase company. 
• Supplier markets 
Partnerships with suppliers have replaced old adversarial relationships. A supermarket sets up a JIT arrangement with a supplier for short-life articles, such as ready-made salads, in order to retain customer interest in an instant healthy food product. 
• Recruitment markets 
A service provider such as PriceWaterhouseCoopers depends on quality 
staff to deliver quality service. Such an organisation will build up a 
relationship with careers advisers, professional bodies and others to supply the necessary human resources. 
• Influence markets 
Influence marketing used to be called public relations – a new low fat spread depends upon the sponsorship of a body that promotes healthy eating (Weightwatchers). 
• Internal markets 
This concept is not dissimilar to the concept of internal quality management. Every department has a customer provider relationship with others. The UK corporate lending market recognises that the supplier of banking services (transaction processing) supports the manager of the client account (the relationship manager).

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Relationship marketing 
This examines the overall approach to marketing that the organisation can 
adopt. Should it focus on maximising one-off sales, or focus on long-term customer retention? This is a critical issue for many businesses. 
Customers can be lost by a number of factors: 
• unhelpful staff • poor quality of service 
• inappropriate prices 
• lack of customer care. 
The concept of relationship marketing has been defined as the technique of 
maintaining and exploiting the firm’s customer base as a means of developing new business opportunities. 
 
Traditional marketing Relationship marketing 
• concentrates on products • concentrates on retention and 
loyalty 
• little knowledge of customer • considerable customer 
commitment 
• product quality a key issue • considerable customer contact 
• little effort on customer retention • emphasis on quality service 
• focus on single sale • focus on building long-term 
• focus on product features • importance of customer benefits 
4.3 Customer acquisition 
Methods of acquiring customers can be split between traditional off-line 
techniques (e.g. advertising, direct mail, sponsorship, etc) and rapidly-evolving on-line techniques (e-marketing). Examples of e-marketing are: 
Search engine marketing 
• Search engine optimisation – improving the position of a company in 
search engine listings for key terms or phrases. For example, increasing 
the number of inbound links to a page through ‘link building’ can improve the ranking with Google. 
• Pay per click (PPC) – an advert is displayed by search engines as a 
‘sponsored link’ when particular phrases are entered. The advertiser typically pays a fee to the search engine each time the advert is clicked.

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• Trusted feed – database-driven sites such as travel, shopping and 
auctions are very difficult to optimise for search engines and consequently 
haven’t enjoyed much visibility in the free listings. Trusted Feed works by allowing a ‘trusted’ third party, usually a search engine marketing company, to ‘feed’ a website’s entire online inventory directly into the search engine’s own database, bypassing the usual submission process. 
Online PR 
• Media alerting services – using online media and journalists for press 
releases. 
• Portal representation – portals are websites that act as gateways to 
information and services. They typically contain search engines and 
directories. 
• Businesses blogs (effectively online journals) can be used to showcase 
the expertise of its employees. 
• Community C2C portals (effectively the e-equivalent of a village notice 
board) – e.g. an oil company could set up a discussion forum on its website to facilitate discussion on issues including pollution. 
• Social media – platforms such as Facebook and Twitter are often used to 
get news about the organisation into the public domain and to respond to stories in which it features. 
Online partnerships 
• Link-building – reciprocal links can be created by having quality content 
and linking to other sites with quality content. The objective is that they will 
then link to your site. 
• Affiliate marketing – a commission-based arrangement where an e- 
retailer pays sites that link to it for sales. For example, hundreds of thousands of sites direct customers to Amazon to buy the books or CDs that they have mentioned on their pages. 
• Sponsorship – web surfers are more likely to trust the integrity of a firm 
sponsoring a website than those who use straight advertising. 
• Co-branding – a lower cost form of sponsorship where products are 
labelled with two brand names. For example, as well as including details about their cars, the website Subaru.com also includes immediate co-branded insurance quotes with Liberty Mutual Insurance and pages devoted to outdoor lifestyles developed with LL Bean. 
• Aggregators – these are comparison sites allowing customers to compare 
different product features and prices. For example, moneysupermarket.com allows analysis of financial services products. Clearly a mortgage lender would want their products included in such comparisons.

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Interactive adverts 
• Banners – banners are simply advertisements on websites with a click 
through facility so customers can surf to the advertiser’s website. 
• Rich-media – many web users have become immune to conventional 
banner ads so firms have tried increasingly to make their ads more 
noticeable through the use of animation, larger formats, overlays, etc. For example, an animated ad for Barclays banking services will appear on some business start-up sites. 
• Some ads are more interactive and will change depending on user mouse 
movements, for example generating a slide show. 
Opt-in e-mail 
It is estimated that 80% of all e-mails are spam or viruses. Despite this, e-mail 
marketing can still deliver good response rates. One survey found only 10% of e-mails were not delivered (e.g. due to spam filters), 30% were opened and 8% resulted in ‘clickthroughs’. Options for e-mail include the following. 
• Cold, rented lists – here the retailer buys an e-mail list from a provider 
such as Experian. 
• Co-branded e-mail – for example, your bank sends you an e-mail 
advertising a mobile phone. 
• 3rd party newsletters – the retailer advertises itself in a 3rd party’s 
newsletter. 
• House list e-mails – lists built up in-house from previous customers, for 
example. 
Viral marketing • Viral marketing is where e-mail or social media platforms such as 
Facebook or Twitter are used to transmit a promotional message from one 
person to another. 
• Ideally the viral ad should be a clever idea, a game or a shocking idea that 
is compulsive viewing so people send it to their friends. 
 
 Which ONE of the following statements are consistent with the concept of 
transaction marketing? 
A Focus on product quality B Emphasis on quality of service C Focus on retention and loyalty D Investment in customer management

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 WOT is an organisation based in country F that reviews and recommends 
electrical and other products to consumers. WOT has around 4 million 
subscribers in country F, who will typically only buy the products that WOT has highly rated. 
JJH is an electronics manufacturer based in country F. According to 
Payne’s six markets model, which ONE of JJH’s key markets is WOT classified within? 
A Referral B Customer 
C Supplier 
D Influence 
 
 Which THREE of the following are methods of acquiring customers? 
A Electronic data interchange B Social media marketing C Search engine optimisation D Personalisation and customisation E Extranet access F Interactive advertisements 
4.4 Managing the ongoing relationship with customers 
Management of the downstream supply chain for many businesses involves the 
need to identify their major customers and look for ways to keep them satisfied – ensuring that they do not switch to rival suppliers – as well as trying to identify if more sales can be made to the customer (customer extension). 
Customer relationship management (CRM) consists of the processes a 
company uses to track and organise its contacts with its current and prospective customers, with particular emphasis on software-based approaches. 
 
 CRM is defined as a culture, possibly supported by appropriate information systems, where emphasis is placed on the interfaces between the entity and its customers. Knowledge is shared within the entity to ensure that the customer receives a consistently high service level. 
CIMA official terminology

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This ‘customer focused’ approach, which will involve building a strong 
relationship with the customer as well as gathering, storing and sharing information across the organisation, will likely improve customer loyalty. This has historically been achieved through the use of databases and other specific CRM software, but in the digital era much greater use is being made of technologies such as cloud computing and big data. 
It is usually argued that retaining existing customers is cheaper that trying to win 
new customers, so CRM systems may well help the organisation to achieve higher profits. 
 
Marketing audits  
 The marketing audit is a particular form of position audit which focuses on 
the products of the firm and the relationship it has with customers. It helps to not only give the company a deeper understanding of the wider 
organisational ecosystem market it operates in, but also the strategies it will need to implement in order to gain competitive advantage. Its position within that ecosystem and its unique selling points will help to decide the appropriate marketing strategy to adopt. 
The normal stages in a marketing audit include: (1) Define the market.  This involves the firm describing the products or 
services it wishes to offer in the market, as well as the key 
characteristics of the market itself. These could include size, growth rate and the strategies most likely to succeed in it. 
(2) Determine performa nce differentials.  The purpose here is to look 
for segments of the market that are currently not being fulfilled and which may provide an entry-point for the business (or a rival). For example, Subway exploited a niche in the fast-food market by attracting health conscious consumers who were not having their needs met by existing suppliers. 
(3) Profile the strategies of competitors.  This involves ‘getting to 
know your enemy’. Major competitors should be identified, along with a profile of their products, services and style of competitive strategy. The firm’s own strategy can then be compared against those of its competitors. 
(4) Determine the strategi c planning structure.  This involves 
deciding how the strategic marketing effort is to be organised, including the assignment of staff and the goals and objectives of the marketing department.

174  
 Customer satisfaction and retention  
 Key to retention is understanding and delivering the drivers of customer 
satisfaction as satisfac tion drives loyalty and loyalty drives profitability. 
The ‘SERVQUAL’ approach to service quality developed by 
Parasuraman et al focuses on the following factors. 
Tangibles 
• The ‘tangibles’ heading considers the appearance of physical 
facilities, equipment, personnel and communications. 
• For online quality, the appearance and appeal of websites, and the 
social media presence  and usage, will determine to what extent 
customers will consider their interaction with the organisation useful 
and engaging. Customers will revisit websites that they find appealing and interact with the organisation more if its social media presence serves a purpose for them. 
• This can include factors such as structural and graphic design, 
quality of content, ease of use, speed to upload and frequency of update. For example, in the newspaper industry the speed of delivery and ease of use of their social media feeds and instant updates are critical. Multi-media content, such as graphics and videos, will also be an important element of the customer experience. 
Reliability 
• Reliability is the ability to prov ide a promised service dependably 
and accurately and is usually the most important of the different 
aspects being discussed here. 
• For online service quality, reliability is mainly concerned with how 
easy it is to connect to the website and social media platforms. Specially developed apps for smartphones that are free of glitches can enhance the consumer experience, as well as being an increased source of information about the organisation. 
• Reliability will also be assessed on the basis of the content and how 
accurate it is – the phrase ‘fake news’ has become an everyday part of the English language! 
• If websites are inaccessible some of the time and/or e-mails are 
bounced back, then customers will lose confidence in the retailer. 
• Equally, given the increasing usage of many customers (particularly 
those who have grown up during the digital era, the so-called ‘millenials’) to interact with organisations using Facebook, Instagram, Twitter or the like, it is vital that these channels be available and updated at all times.

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 Responsiveness 
• Responsiveness looks at the willingne ss of a firm to help customers 
and provide prompt service. 
• In the context of e-business, excessive delays can cause customers 
to ‘bail-out’ of websites and/or transactions and go elsewhere. 
• This could relate to how long it takes for e-mails to be answered or 
even how long it takes for information to be downloaded to a user’s 
browser. 
• Equally, a failure to respond to a tweet could be interpreted as lack 
of concern at a customer issue. Twitter feeds will need to be monitored around the clock. 
Assurance 
• Assurance is the knowledge and courtesy of employees and their 
ability to inspire trust and confidence. 
• For an online retailer, assurance looks at two issues – the quality of 
responses and the privacy/security of customer information. 
• Quality of response includes competence, credibility and courtesy 
and could involve looking at whether replies to e-mails are 
automatic or personalised and whether questions have been answered satisfactorily. 
• Again, the issue of fake news on social media could be seen as an 
assurance issue. 
Empathy 
• Empathy considers the caring, individualised attention a firm gives 
its customers. 
• Most people would assume that empathy can only occur through 
personal human contact but it can be achieved to some degree 
through personalising websites and e-mail. 
• Key here is whether customers feel understood. For example, being 
recommended products that they would never dream of buying can erode empathy. 
Techniques for retaining customers 
Given the above consideration of service quality, firms use the following 
e-techniques to try to retain customers. 
• Personalisation – delivering individualised content through web- 
pages or e-mail. For example, portals such as Yahoo! enable users 
to configure their home pages to give them the information they are most interested in.

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 • Mass customisation – delivering customised content to groups of 
users through web-pages or e-mail. For example, Amazon may 
recommend a particular book based on what other customers in a particular segment have been buying. 
• Extranets – for example, Dell Computers uses an extranet to 
provide additional services to its ‘Dell Premier’ customers. 
• Opt-in e-mail – asking customers whether they wish to receive 
further offers. 
• Online communities – firms can set up communities where 
customers create the content. These could be focussed on purpose (e.g. Autotrader is for people buying/ selling cars), positions (e.g. the 
social media site Pinterest), intere st (e.g. Football365) or profession. 
Despite the potential for criticism of a company’s products on a community, firms will understand where service quality can be improved, gain a better understanding of customer needs and be in a position to answer criticism. 
• Customisation of social media content that feeds through to your 
profile. For example, if you look at a website with a view to, say, buy clothes, you suddenly find that that same retailer’s details now appear when you next look at Facebook. Or, in a wider context, you look online at a ski holiday and then start to see adverts for ski accessories, such as goggles or gloves, without having actively searched for such products. 
 
 Illustration 7 – North Face 
 Faced with the problem of correctly satisfying customer demand for 
outdoor clothing, North Face have inve sted in artificial intelligence to try 
to deliver a better and more personalised customer experience. This is particularly important for an online transaction, given that the customer does not have an assistant to ask – w ill this clothing be appropriate for 
certain hiking conditions or locations, for example. 
The customer is asked where they are going, what time of year and what 
sort of activities they will be doing. A personalised response is then given that takes into account likely weather conditions and the characteristics of the landscape in that particular part of the world; the customer is directed to products that are most suited to their needs.

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 Customer extension  
 Customer extension has the objective of increasing the lifetime value of a 
customer and typically involves the following. 
• ‘Re-sell’ similar products to previous sales. • ‘Cross sell’ closely related products. 
• ‘Up sell’ more expensive products. 
• For example, having bought a book from Amazon you could be 
contacted with offers of other books, DVDs or DVD players. 
• Reactivate customers who have not bought anything for some time. 
Key to these is propensity modelling. 
Propensity modelling 
Propensity modelling involves evalua ting customer be haviour and then 
making recommendations to them for future products. For example, if you 
have bought products from Amazon, then each time you log on there will be a recommendation of other products you may be interested in. 
This can involve the following. 
• Create automatic product relationships – e.g. through monitoring 
which products are typically bought together. 
• Using trigger words or phrases – e.g. ‘customers who bought …also 
bought…’. 
• Offering related products at checkout – e.g. batteries for electronic 
goods. 
Once again, technologies such as artificial intelligence and big data 
analytics can make propensity modelling much more effective and produce a speedier outcome. 
4.5 The use of technologies in do wnstream supply chain management 
Technologies can be used in a number of ways within the downstream supply chain, including:
 
• Electronic Data In terchange (EDI) – the business can link its sales 
system to the purchasing system of its major customers, increasing the 
speed and efficiency of placing orders. This can act as a tie-in/switching cost as it is likely to make it harder for the customer to leave and move to a rival supplier, as this would lead to expense and disruption. 
• Cloud computing  – the business may be able to keep customers updated 
in real time on important matters such as inventory levels and the fulfilment status of orders. 
• E-commerce  – the business may be able to sell online to customers, 
allowing it to expand its customer base and brand awareness.

178  
• Intelligence gathering  – online customer transactions can be monitored, 
helping the business to understand their needs and work to meet them. 
Online surveys and questionnaires will allow the business to quickly and 
efficiently ask for customer opinions and feedback. This can all be used to improve the quality of the business’s marketing using Big Data analytics. 
• Communication  – email and other IT systems have been used for many 
years in ways that allow the organisation to keep in touch with its customers, keeping them informed about order progress, or new products and services they may be interested in. In the digital era these technologies are still relevant, and ar e being supplemented or replaced by 
use of social media, blogs, and web communities. 
• User communities – the users of some complex products, such as software, set up user communities where members help each other and where pressure on the product supplier can be organised. Strong user communities are valued by their members and the organisation would be 
wise to look at the comments and queries on the bulletin boards. For 
example, adverse comments on a review site such as Tripadvisor can have disastrous effects on future revenues, as many customers will be swayed in their choice of restaurant or hotel by what people who have visited before have posted. 
The use of intranets and extranets 
One key way that an organisation can use IT to improve its downstream supply 
chain management is through the use of intranets and extranets. 
An intranet is a private network within a single company using Internet 
standards to enable employees to share information using e-mail and web publishing. 
An extranet is formed by extending an intranet beyond a company to 
customers, suppliers and other collaborators. 
 
The benefits of using an extranet are as follows: 
• Information sharing in a secure environment 
For example, the advertising agency Saatchi allows customers to view 
draft advertising material during a project. 
• Cost reduction  
Savings can arise from need fewer people in the ordering process and the elimination of the need to re-key information from paper documents.

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• Order processing and distribution  
For example, a customer's point of sales terminals can be linked to a 
supplier's delivery system, ensuring prompt replenishment of goods sold. this results in fewer lost sales due to stock-outs and lower inventory holding. 
• Improved customer service  
Customer service can be improved through easier/quicker access to information, increased accuracy and consistency of information and quicker response times. Together these build customer confidence and may result in increased revenue. 
The effects of technologies on the st ructure of the downstream supply 
chain 
There are three main ways in which technologies can affect an organisation’s 
relationship with its customers: 
Disintermediation – in this process intermediate organisations (middlemen) 
can be taken out of the supply chain. Intermediaries include distributors, wholesalers and agents. The business can therefore sell its product or service direct to the end consumer, rather than selling via a middleman who takes a share of the profits. 
For example, musicians can sell their music directly through their own websites 
rather than being produced and sold through a record company. Games console manufacturers have started selling games that can be downloaded straight to the console, cutting out games retailers and allowing the manufacturer to earn a higher share of the profits from the sale. 
The process of reintermediation is also found, where the business creates a 
new intermediary into the downstream supply chain. In the UK, Confused.com was set up by Admiral (a group of companies that 
offer various types of insurance) to help users pick between insurance providers for their car and home insurance policies. Admiral therefore introduced a new intermediary into the supply chain as customers now went through the 
comparison site before purchasing a policy from an insurance company. 
Countermediation  is where established firms create their own new 
intermediaries to compete with established intermediaries. The launch of Confused.com was followed by the creation of several rival 
comparison sites, including Comparethemarket.com, which was set up by BGL – another UK insurance group.

180  
 Illustration 8 – Downstream SCM 
 An example of disintermediation is seen in the travel industry where 
travel agents have been cut out of many transactions as the public can 
book directly with hotels, airlines and rail companies. 
The travel industry also gives an example of reintermediation. Companies 
like lastminute.com and expedia.com are like new travel agents, presenting a wide choice of products and services. 
An example of countermediation is Opodo.com, set up by a collaboration 
of European airlines to encourage customers to book flights directly with them rather than using cost-comparison intermediaries such as 
lastminute.com. 
 
 Z plc offers car insurance to its customers. The car insurance industry is 
large and made up of hundreds of different rivals, all offering similar 
insurance products. 
One of Z’s rivals, M, has recently created a new website that allows 
consumers to compare quotes quickly and easily from the majority of the car insurance companies in the market. 
While not every customer chooses M from the list of quotes they are 
given, M receives commission from every policy sold through its site. 
Z wishes to respond to this change in the market by creating its own 
comparison website. 
Z’s planned strategy is an example of which ONE of the following? A Intermediation B Disintermediation C Reintermediation D Countermediation

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 Test your understanding 8 – DRB – (Case style) 
 DRB Electronic Services operates in a high labour cost environment in 
Western Europe and imports electronic products from the Republic of 
Korea. It re-brands and re-packages them as DRB products and then sells them to business and domestic customers in the local geographical region. Its only current source of supply is ISAS electronics based in a factory on the outskirts of Seoul, the capital of the Republic of Korea. DRB regularly places orders for ISAS products through the ISAS web-site and pays for them by credit card. As soon as the payment is confirmed ISAS automatically e-mails DRB a confirmation of order, an order 
reference number and likely shipping date. When the order is actually 
despatched, ISAS send DRB a notice of despatch e-mail and a container reference number. ISAS currently organises all the shipping of the products. The products are sent in containers and then trans-shipped to EIF, the logistics company used by ISAS to distribute its products. EIF then delivers the products to the DRB factory. Once they arrive, they are quality inspected and products that pass the inspection are re-branded as 
DRB products (by adding appropriate logos) and packaged in specially fabricated DRB boxes. These products are then stored ready for sale. All customer sales are from stock. Products that fail the inspection are returned to ISAS. 
Currently 60% of sales are made to domestic customers and 40% to 
business customers. Most domestic customers pick up their products from DRB and set them up themselves. In contrast, most business customers ask DRB to set up the electronic equipment at their offices, for which DRB makes a small charge. DRB currently advertises its products in local and regional newspapers. DRB also has a web site which provides product details. Potential customers can enquire about the specification and availability of products through an e-mail facility in the web site. DRB then e-mails an appropriate response directly to the person making the enquiry. Payment for products cannot currently be made through the web site. 
Feedback from existing customers suggests that they particularly value 
the installation and support offered by the company. The company employs specialist technicians who (for a fee) will install equipment in both homes and offices. They will also come out and troubleshoot problems with equipment that is still under warranty. DRB also offer a helpline and a back to base facility for customers whose products are out of warranty. Feedback from current customers suggests that this support is highly valued. One commented that 'it contrasts favourably with your large customers who offer support through impersonal off-shore call centres and a time-consuming returns policy'. Customers can also pay for technicians to come on-site to sort out problems with out-of-warranty equipment.

182  
 Dilip Masood, the owner of DRB, has sent you the following email: 
To: J. Kooper 
From: D. Masood Date: 17/06/XX Subject: Supply chain management Hi J, I’m sure you're aware that DRB is planning to increase our product range 
and market share. We plan to grow from our current turnover of £5m per annum to £12m per annum in two years time. I believe that DRB must change its business model if it is to achieve this growth. I believe that these changes will also have to tackle problems associated with: 
• Missing, or potentially missing shipments. Shipments can only be 
tracked through contacting the shipment account holder, ISAS, and 
on occasions they have been reluctant or unable to help. The trans-shipment to EIF has also caused problems and this has usually been identified as the point where goods have been lost. ISAS does not appear to be able to reliably track the relationship between the container shipment and the Waybills used in the EIF system. 
• The likely delivery dates of orders, the progress of orders and the 
progress of shipments is poorly specified and monitored. Hence deliveries are relatively unpredictable and this can cause congestion problems in the delivery bay. 
I also recognise that growth will mean that the company has to sell more products outside its region and the technical installation and support so valued by local customers will be difficult to maintain. I am determined that DRB will continue to import onl y fully configured products. I am not 
interested in importing components and assembling them. DRB will also not build or invest in assembly plants overseas or commit to a long-term contract with one supplier. 
Bearing this in mind, I would be grateful for your thoughts on a number of 
key issues. 
Firstly, I need you to draw the primary activities of DRB on a value chain. 
Please comment on the significance of each of these activities and the value that they offer to customers. 
Explain how DRB might re-structure its upstream supply chain to achieve 
the growth required by DRB and to tackle the problems that I have identified.

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 Also, please explain how DRB might re-structure its downstream supply 
chain to achieve the growth required. 
I need some briefing notes on this in the next 45 minutes as I am about to 
go into a meeting with our business advisors. 
I look forward to your reply. Kind regards Dilip 
Required: 
Draft the briefing notes as requested by Dilip. 

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 The correct answer is PUSH 
V makes his products without reference to customers and then attempts 
to ‘push’ them onto his clients. 
 
Customers and consumers need to have sufficient cash to buy the 
product, while suppliers need to have enough cash/profit to want to make the components the business uses to make its products. 
Ensuring every link in the supply chain has sufficient cash is therefore an 
important part of ensuring supply and demand for the business’s products. 
 
 Test your understanding 3 – (Integration question) 
 The key elements of XL’s upstream supply chain are likely to include: 
• travel providers (such as bus, train or airline companies) 
• accommodation providers 
• local food producers and restaurants 
• attractions, activity and excursion providers. 
While it could also be widened to consider other suppliers, such as local 
bars and local infrastructure providers (amongst others), supply chain management is likely to focus on the key elements of the supply chain outlined above. 
A key function of the supply chain is to ensure that the chain contains the 
correct value system to support XL’s competitive advantage. As some customers are beginning to complain, there is growing evidence that it may no longer be doing so. 
As such, XL should begin by communicating with a selection of 
customers (not just those who are complaining) to determine what they would like from their tour and how they feel things could be improved. 
XL can then use this information to provide suppliers with areas that they 
will need to focus on to improve the customer experience.

186  
 For example, XL could examine the accommodation it offers. It could 
consider issues such as location, ease of access, appearance, staffing 
and facilities. 
For travel providers, XL may wish to examine the safety measures, the 
ease of check-in, luggage facilities and in-journey refreshments and facilities. 
Should there be any problem areas for customers that a supplier is either 
unwilling or unable to c hange, XL could consider attempting to switch to 
an alternative supplier. 
 
Transaction marketing focuses on the product, rather than the customer 
or service provided. 
 
A referral market occurs when someone refers a consumer to an 
organisation’s products. An insurance broker would be an example of this – the broker is actively referring consumers to certain insurance company products and therefore is part of the insurance company’s referral market. 
WOT is simply rating and recommending products. This would suggest 
an influence market, as they are simply endorsing certain products. 
 
 The correct answers are B, C and F 
The others are methods of retaining or extending existing customers. 
 
M’s website is an example of reintermediation. By setting up an 
equivalent comparison site of its own, Z is countermediating.

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 Briefing notes 
(a) A simple value chain of the primary activities of DRB is shown 
below. 
Handling 
and 
storing 
inbound 
fully 
configured 
equipment 
Quality 
inspection Rebranding Of products 
Repackaging 
Of products Customer collection 
Technician delivery 
and 
installation Local advertising 
Web-based enquiries Onsite 
technical 
support Back to 
base 
support 
Inbound 
logistics Operations Outbound 
logistics Marketing and sales Service 
 
Comments about value might include: 
Inbound logistics: Excellent quality assurance is required in inbound 
logistics. This is essential for pre-configured equipment where customers have high expectations of reliability. As well as contributing to customer satisfaction, high quality also reduces service costs. 
Operations: This is a relatively small component in the DRB value 
chain and actually adds little value to the customer. It is also being undertaken in a relatively high cost country. DRB might wish to re-visit the current arrangement. 
Outbound logistics: Customer feedback shows that this is greatly 
valued. Products can be picked up from stock and delivery and installation is provided if required. Most of the company's larger competitors cannot offer this service. However, it is unlikely that this value can be retained when DRB begins to increasingly supply outside the geographical region it is in. 
Marketing and sales: This is very low-key at DRB and will have to 
be developed if the company is to deliver the proposed growth. The limited functionality of the website offers little value to customers. 
Service: Customer feedback shows that this is greatly valued. Most 
of the company's competitors cannot offer this level of service. They offer support from off-shore call centres and a returns policy that is both time consuming to undertake and slow in rectification. However, it is unlikely that this value can be retained when DRB begins to increasingly supply outside the geographical region it is in.

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 (b) DRB has already gained efficiencies by procuring products through 
the supplier's website. However, the website has restricted 
functionality. When DRB places the order it is not informed of the expected delivery date until it receives the confirmation e-mail from ISAS. It is also unable to track the status of their order and so it is only when it receives a despatch email from ISAS that it knows that it is on its way. Because DRB is not the owner of the shipment, it is unable to track the delivery and so the physical arrival of the goods cannot be easily predicted. On occasions where shipments have appeared to have been lost, DRB has had to ask ISAS to track the shipment and report on its status. This has not been very satisfactory and the problem has been exacerbated by having two shippers involved. ISAS has not been able to reliably track the transhipment of goods from their shipper to EIF, the logistics company used to distribute their products in the country. Some shipments have been lost and it is time-consuming to track and follow-up shipments which are causing concern. Finally, because DRB has no long term contract with ISAS, it has to pay when it places the order through a credit card transaction on the ISAS website. 
DRB has stated that it wishes to continue importing fully configured 
products. It is not interested in importing components and assembling them. It also does not wish to build or invest in assembly plants in other countries. However, it may wish to consider the following changes to its upstream supply chain: 
– Seek to identify a wider range of suppliers and so trade 
through other sell-side websites. Clearly there are costs 
associated with this. Suppliers have to be identified and evaluated and financial and trading arrangements have to be established. However, it removes the risk of single-sourcing and other suppliers may have better systems in place to support order and delivery tracking. 
– Seek to identify suppliers who are willing and able to re-brand 
and package their products with DRB material at the production plant. This should reduce DRB costs as this is currently undertaken in a country where wage rates are high. 
– Re-consider the decision not to negotiate long-term contracts 
with suppliers (including ISAS) an d so explore the possibility of 
more favourable payment terms. DRB has avoided long-term contracts up to now. It may also not be possible to enter into such contracts if DRB begins to trade with a number of suppliers. 
– Seek to identify suppliers (including ISAS) who are able to 
provide information about delivery dates prior to purchase and who are able to provide internet-based order tracking systems to their customers. This should allow much better planning.

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 – Consider replacing the two supplier shippers with a contracted 
logistics company which will collect the goods from the 
supplier and transport the goods directly to DRB. This should reduce physical transhipment problems and allow seamless monitoring of the progress of the order from despatch to arrival. It will also allow DRB to  plan for the arrival of goods 
and to schedule its re-packaging. 
DRB might also wish to consider two other procurement models; buy-side and the independent marketplace. 
In the buy-side model DRB would use its website to invite potential 
suppliers to bid for contract requirements posted on the site. This places the onus on suppliers to spend time completing details and making commitments. It should also attract a much wider range of suppliers than would have been possible through DRB searching sell-side sites for potential suppliers. Unfortunately, it is unlikely that DRB is large enough to host such a model. However, it may wish to prototype it to see if it is viable and whether it uncovers potential suppliers who have not been found in sell-side websites searches. 
In the independent marketplace model, DRB places its requirements 
on an intermediary website. These are essentially B2B electronic marketplaces which allow, on the one hand, potential customers to search products being offered by suppliers and, on the other hand, customers to place their requirements and be contacted by potential suppliers. Such marketplaces promise greater supplier choice with reduced costs. They also provide an opportunity for aggregation where smaller organisations (such as DRB) can get together with companies that have the same requirement to place larger orders to gain cheaper prices and better purchasing terms. It is also likely that such marketplaces will increasingly offer algorithms that automatically match customers and suppliers, so reducing the search costs associated with the sell-side model. The independent marketplace model may be a useful approach for DRB. Many of the suppliers participating in these marketplaces are electronics companies. 
(c) DRB's downstream supply chain is also very simple at the moment 
It has a website that shows information about DRB products. Customers can make enquiries about the specification and availability of these products thr ough an e-mail facility. Conventional 
marketing is undertaken through local advertising and buyers either collect their products or they are delivered and installed by a specialist group of technicians. DRB could tune its downstream supply chain by using many of the approaches mentioned in the previous section.

190  
 For example: 
– Developing the website so that it not only shows products but 
also product availability. Customers would be able to place 
orders and pay for them securely over the website. The site could be integrated with a logistics system so that orders and deliveries can be tracked by the customer. DRB must recognise that most of its competitors already have such systems. However, DRB will have to put a similar system in place to be able to support its growth plans. 
– Participating in independent marketplace websites as a 
supplier. DRB may also be able to exploit aggregation by combining with other suppliers in consortia to bid for large contracts. 
– DRB may also consider participating in B2C marketplaces 
such as eBay. Many organisations use this as their route to market for commodity products. 
DRB may also wish to consider replacing its sales from stock 
approach with sales from order. In the current approach, DRB purchases products in advance and re-packages and stores these products before selling them to customers. This leads to very quick order fulfilment but high storage and financing costs. These costs will become greater if the planned growth occurs. DRB may wish to consider offering products on its website at a discount but with specified delivery terms. This would allow the company to supply to order rather than supply from stock.

191 
Resources and value 
creation within the 
organisational 
ecosystem 
E2: Advise on resource 
allocation to support strategy implementation (a) Advise on resource 
D2: Produce strategy by the 
integration of choices into coherent strategy (a) Value analysis 
 
 Chapter 
6

Resources and value creation within the organisational ecosystem 
192  
 
The last two chapters identified the key external issues that an organisation 
would need to consider in its ecosystem when deciding upon an appropriate strategy. 
In this chapter we will look at how an organisation examines itself – the 
resources it has, the skills, and how it can create value – which will be fundamental to its overall strategic analysis. There is little to be gained in identifying a strategy that might address the external issues facing the organisational ecosystem if the business does not have the resources or capabilities to make that strategy work.

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The process of internal analysis typically involves the following stages: 
 
We will now look at these stages in more detail. 
 
 Internal analysis is a crucial part of developing a strategy. It helps the 
organisation to identify what it is capable of – what skills and assets it possesses. Understanding this will help the organisation identify which strategies it is capable of implementing.  
2 Resource audit 
 The resources audit identifies the resources that are available to an organisation and seeks to start the process of identifying competencies. 
It attempts to assess the relative strength of the resource base – the quantity of 
resources available, the nature of those resources and the extent to which 
those resources are unique and difficult to imitate. 
One model in particular may help managers undertaking a resource audit locate 
these key factors.

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M's model 
This model suggests that the items in a position audit can be categorised into 
factors beginning with ‘M’: 
• Manpower (human resources):  The human assets of the firm, their skills 
and morale. 
• Money:  The company's cash position, gearing, investment plans, short 
and long term finance, etc. 
• Management:  The quality, expertise and experience of the top team. Is 
the firm well managed and does is have the skills and vision needed to 
progress? 
• Machinery:  The physical assets of the business, their flexibility, relative 
costs and the quality of what they produce. 
• Markets:  The products and the markets the company currently operates 
in. The quality and position of the products. 
• Materials:  The relationship between the company and its suppliers. Cost, 
quality and future availability of materials. 
• Methods:  The processes adopted by the business – outsourcing, JIT, AI, 
use of Big Data, cloud computing etc. 
• Management information:  Quality and timeliness of information provided 
to managers. Can include Big Data. Will impact on quality of decisions made. 
• Make-up:  The culture and structure of the organisation. Also, branding 
and other intangibles. 
This is not an exhaustive list to memorise. Instead it is a memory aid to help the resource auditor to identify all the key resources that are central to a business' success. 
Resources can alternatively be grouped under four headings: 
• physical or operational resources  
• human resources  
• financial resources  
• intangibles.  
The key is to know what you have available to you and how this will help you in 
any strategic initiative. At the same time the organisation needs to know what it is lacking and how things may change in the future. Shortage of resources will 
often constrain strategic initiative.

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Note that the audit should also include resources that can be accessed by the 
organisation, not just legally owned. Some strategically important resources may exist, such as a network of contacts or customers or maybe via a strategic alliance or joint venture i.e. to consider the resources available in the wider organisational ecosystem. 
Resources are needed to undertake a strategy. They will not ensure its ultimate 
success. For that, the resources will need to be combined together into competencies. 
 
 H Ltd has a strong brand name. Which ONE of the following resource 
classifications would this be included within? 
A Markets B Make-up C Methods D MIS 
3 Competences 
Resources are combined together to achieve a competence. 
 
 A competence is a group of abilities, resources or skills that enable the 
organisation to act effectively. 
 
There are two key types of competence that you need to be aware of: 
• Core competences – these are things that you are able to do that are 
difficult for your competitors to emulate. They form the basis of competitive advantage and are referred to by Johnson and Scholes as ‘the order 
winners’ . 
• Threshold competences  – these are things that you do well that simply 
enable you to compete in the market. They do not give competitive advantage – if they are not satisfied, you will not even be considered by the customer. They are referred to as ‘the order qualifiers’ . 
 
Illustration 1 – Coca–Cola 
 The Coca-Cola Corporation has, for many years, maintained a very 
strong position in the soft drinks market. Consider its flagship product, Coca-Cola. This has largely survived competition from supermarkets' own-brand colas. There is no great secret in how to make a reasonable imitation (though purists would argue that the imitations are not as good) and the resources needed are not demanding. The own-label colas sell at much lower prices, so how has Coca-Cola managed to keep its dominant position? 
It has been argued that physical resources are often less important.

196  
These are likely to form the threshold competences . Coca-Cola has 
bottling plants, access to suitable water, and a formulation for its drink. 
However, its competitors also have these things. They do not give Coca-Cola a competitive edge. 
The reason Coca-Cola has managed to maintain its dominant position 
mainly lies in the non-physical or intangible resources, such as a very powerful brand. The core competences  lie in managing the brand by 
producing memorable global advertising, global recognition, careful sponsorship and responding to customer requirements (diet/caffeine-free products). 
Over time the core competence will become threshold as: 
• cultures adjust and expectations develop 
• customers and consumers become more sophisticated in terms of their 
needs and expectations 
• competitors imitate our core competences. 
Organisations need to ensure that they are continually monitoring their 
ecosystem to ensure that their core competences are still valid and that all 
thresholds are duly satisfied. 
Remember, what is good today is not necessarily good tomorrow! 
 
 Illustration 2 – Changing competences 
 When Apple l aunched its iPhone in 20 07, it had a number of features that 
gave it competitive advantage, including: 
• full colour touch-screen interface 
• use of premium materials 
• aesthetically pleasing design 
• user-friendly software interface 
• linked to the strong Apple brand. 
Today, rival mobile phone manufacturers have made many of these 
features standard in their products, meaning that they would no longer be considered ‘order winners’. For example, most modern smartphones include touch-screen interfaces, strong design standards and premium materials. These ‘core’ features have thus become ‘threshold’ over time.

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Competence audit 
As well as the resource audit mentioned earlier in the chapter, the organisation 
may well undertake a competence audit . This will typically involve: 
• analysis of what competences the organisation has, as well as how well 
resources are being deployed to create them. 
• categorisation of competences as core or threshold. This will be done by 
looking at historic data, industry norms and benchmarking exercises (which will usually be undertaken by specialist teams). 
 
 Insert the missing word into the following statement: 
_______ competences are those that help an organisation to achieve competitive advantage over its rivals. 
4 Critical success factors 
 Critical success factors (CSFs) are the limited number of areas in which results, if they are satisfactory, will ensure successful competitive performance for the business.  
They are the vital areas where ‘things must go right’ and where the business 
must outperform its competitors. 
It is important, therefore, that any assessment of resources, competences, 
strengths and weaknesses is done by reference to what we have to be good at. 
For example, having the highest quality in the industry may be admirable but it 
misses the point if the market is driven by price wars and customers are only willing to pay low prices. 
Examples of CSFs for major industries include: 
• in the automobile industry – styling, an efficient dealer network, vehicle 
performance and fuel efficiency 
• in the food manufacturing industry – new product development, good 
distribution channels, health aspects (e.g. low fat) 
• in the supermarket industry – having the right product mix, competitive 
pricing. 
The organisation’s critical success factors should tie into their corporate 
objectives. For example, if a supermarket’s objective is to grow its market share, it will need to ensure that understands what it must do in order to successfully implement this strategy (i.e. what its CSFs will be).

198  
The problem with CSFs is that they are often vague. As mentioned above, a 
supermarket may have a CSF of having ‘competitive pricing’, but how would the company know whether its pricing is ‘competitive’ or not? 
In order to deal with this, organisations will need to create ways of measuring 
whether their CSFs are being met. These measures are known as key 
performance indicators, or KPIs. 
 
 What might a parcel delivery service such as DHL identify as two of its 
main critical success factors? 
 
 Illustration 3 – Mission, CSF and KPI 
 A, a major supermarket chain in the country O, has a corporate mission 
to be ‘the best valu e retailer in country O.’ 
One of A’s critical success factors (CSFs) is that it needs to sell its 
goods for a lower price than its major rivals . This will attract 
customers in the fiercely competit ive country O supermarket industry, 
where many customers choose their supermarket based on price. 
In order to measure this CSF, A has set itself a key performance 
indicator (KPI) to keep its average selling price ten percent below 
that of its rivals. It monitors its rivals’  selling prices and amends its 
own prices on a daily basis to ensure that it achieves this KPI. 
A can therefore be confident that if it meets its KPI, its major CSF will 
have been achieved. This will help it meet its overall mission. 
 
 Illustration 4 – Critical success factors 
 The following is an example of CSFs developed for a shipping terminal. 
Critical success factor Indicator Mechanism for 
measurement 
Customer satisfaction 
 • Complaints 
• Insurance claims • Losses of stock • Complaints 
register 
• Correspondence • Internal audit 
Maintenance of 
premises • Repair costs • Inspection 
Efficient use of staff 
 • Time standards 
for loading and 
unloading • Training 
schedules 
• Direct inspection

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 Test your understanding 4 – (Integration question) 
 Using the CSFs previously identified for a parcel delivery company such 
as DHL, explain how the company might measure their performance . 
 
 Sources of CSFs 
 Rockart claims that there are four sources for CSFs: 
(1) The industry that the business is in – each has CSFs that are 
relevant to any company within it. 
For example, the car industry must have as one of its CSFs 
‘compliance with pollution requirements regarding exhaust gases’. 
(2) The company itself and its situation within the industry – e.g. its 
competitive strategy and its geographic location. 
For example, a firm that has decided to compete on the basis of 
quality could have CSFs relating to identifying and delivering key product features that are valued by customers. 
(3) The wider environment – e.g. the economy, the political factors and 
consumer trends in the country or countries that the organisation operates in. 
For example, in a time of oil sh ortages ‘energy supply availability’ 
could be a critical success factor. 
(4) Temporal organisational factors – these are areas of company 
activity that are unusually causing concern because they are 
unacceptable and need attention. 
For example, a company with liquidity problems may place "short 
term cash management" as a CSF to ensure survival. 
 
 H is a retailer of garden furniture. It has recently been told by its major 
shareholders that they wish to see a one-off increase in dividends from the company next year, meaning that H needs to improve its cash flow quickly. 
According to Rockart, which ONE of the following sources of critical 
success factors (CSFs) is being described above? 
A The industry that H is in B Temporal organisational factors C The wider environment D The company and its position in the industry

200  
 Test your understanding 6 – GGG – (Case style) 
 You have recently been provided with the following document giving you 
some background to GGG – a company that you have applied to work for 
as a strategic management accountant. 
Background document – GGG Trains 
GGG operates trains across Country H. The train infrastructure (stations 
and tracks) are owned by the Government of Country H. GGG has a fifteen year franchising agreement with the Government which allows it to exclusively operate the trains across the entire national railway network. GGG is now seven years through its current franchise agreement. 
While the franchise agreement is for fifteen years, it is reviewed annually 
by the Government. The Government wishes to maximise the number of residents of Country H that use the trains (as opposed to motor vehicles), as this will help Country H meet its international environmental targets for carbon emission reductions. 
The road network in Country H is old and is often significantly congested. 
However, train passenger numbers are only growing slowly. A recent Government survey has suggested that this is because passengers still feel that GGG tickets are too expensive and that the services offered are usually overcrowded and often late. GGG's staff are felt to lack knowledge and are ‘unhelpful’ to customers. 
 The Government of Country H is threatening to strip GGG of its franchise 
unless it shows substantial improvement. GGG’s managers have several initiatives planned to improve the issues highlighted by the survey, and are currently considering how they can measure whether these initiatives are being successful. 
Required: 
As part of your job application, you have been asked to suggest FOUR of 
the critical success factors that GGG’s management might identify. For each critical success factor identify ONE key performance indicator that GGG could use to see if its initiatives are being effective. Justify your choices. 

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 The link between CSFs and competences 
Note that CSFs and competences are slightly different concepts. 
• CSFs are what the organisation needs  to be good at in order to compete 
in the market. 
• Competences are what the organisation is good at. 
It should, however, be clear that in order for an organisation to be successful, its 
competences and CSFs should be as closely aligned as possible – which is why regular analysis of both is so important. The organisation’s strategy must look at ways of maximising the correlation between the two. 
 
 HHH has stated that it wishes to ensure that it delivers 95% of goods to 
customers within 15 days of them placing an order. 
Which ONE of the following is this an example of: A A mission B A key performance indicator C A critical success factor D A vision 
 
 B Ltd has identified a critical success factor (CSF): 
Have the best complaints handling department in the industry. 
Which ONE of the following would be the most suitable key performance 
indicator for this CSF? 
A Increase customer happiness by 15% B Reduce the number of complaints received by 20% C Improve the effectiveness of training for complaints staff D Reduce the average time taken to deal with complaints by 15%

202  
 Test your understanding 9 – RCH – (Case style) 
 RCH, an international hotel group with a very strong brand image has 
recently taken over TDM, an educational institution based in Western 
Europe. RCH has a very good reputation for improving the profitability of its business units and prides itself on its customer focus. The CEO of RCH was recently quoted as saying ‘Our success is built on happy customers: we give them what they want’. RCH continually conducts market and customer research and uses the results of these researches to inform both its operational and longer term strategies. 
TDM is well-established and has always traded profitably. It offers a 
variety of courses including degrees both at Bachelor and Masters levels 
and courses aimed at professional qualifications. TDM has always concentrated on the quality of its courses and learning materials. TDM has never seen the need for market and customer research as it has always achieved its sales targets. Its students consistently achieve passes on a par with the national average. TDM has always had the largest market share in its sector even though new entrants continually enter the market. TDM has a good reputation and has not felt the need to invest significantly in marketing activities. In recent years, TDM has experienced an increasing rate of employee turnover. 
RCH has developed a sophisticated set of  Critical Success Factors which 
is integrated into its real-time info rmation system. RCH’s rationale for the 
take-over of TDM was the belief that it could export its customer focus 
and control system, based on Critical Success Factors, to TDM. RCH believed that this would transform TDM’s performance and increase the wealth of RCH’s shareholders. 
 Required: 
(i) Identify four Critical Success Factors which would be appropriate to 
use for TDM. 
(ii) Recommend, with reasons, two Key Performance Indicators to 
support each of the four Critical Success Factors you have 
identified. 
(30 minutes)

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5 Value drivers 
 Value drivers are activities or features that enhance the perceived value of 
a product or service by customers and which therefore create value for the producer. Value drivers can be tangible or intangible.  
For example, a high-street electronics retailer could have several value drivers, 
• Product mix • Convenient store locations 
• Knowledgeable, friendly staff. 
If these value drivers are present, it will attract customers to the retailer’s stores 
and may help it achieve a competitive advantage over rivals. 
Value drivers will be looked at in more de tail in chapter 8 when we start to look 
at the concept of the organisational performance management system. For 
now, we need to consider how value drivers can be identified. 
One of the main models that can be used to identify the value drivers of an 
organisation is Porter’s Value Chain. 
6 Porter’s Value Chain 
 
This is a means by which the activities within and around the organisation are identified and then related to the assessment of competitive strength. 
Resources are of no value unless they are deployed into activities that are 
organised into routines and systems. These should then ensure that products are produced which are valued by customers and consumers. Porter argued that an understanding of strategic capability must start with an identification of the separate value-adding activities.

204  
Primary activities 
These activities are involved in the physical creation of the product, its transfer 
to the buyer and any after-sales service. Porter divided them into five categories: 
(1) Inbound logistics  are activities concerned with receiving, storing and 
distributing the inputs to the product. They include materials handling, 
stock control and transport. 
(2) Operations  transform these various inputs into the final product – 
machining, packing, assembling, testing and control equipment. 
(3) Outbound logistics  relate to collecting, storing and distributing the 
product to buyers. 
(4) Marketing and sales  provide the means whereby consumers and 
customers are made aware of the product and transfer is facilitated. This would include sales administration,  advertising, selling and so on. 
(5) Service  relates to those activities which enhance or maintain the value of 
a product such as installation, repair, training and after-sales service. 
Support activities 
Each of the primary activities are linked to support activities and these can be divided into four areas: 
(1) Infrastructure  refers to the systems of planning, finance, quality control, 
information management, etc. All are crucially important to an 
organisation's performance in primary activities. It also consists of the structures and routines that sustain the culture of the organisation. 
(2) Human resource management,  which involves all areas of the business 
and is involved in recruiting, managing, training, developing and rewarding people within the organisation. 
(3) Technology development  – all value activities have a technological 
content, even if it is just 'know how'. IT can affect product design or process and the way that materials and labour are dealt with. Big Data analytics can help identify how to sell more successfully to customers. 
(4) Procurement refers to the processes for acquiring the various resource 
inputs to the primary activities – not the resources themselves. As such it occurs throughout the organisation. 
Generally 
The primary and secondary activities are designed to help create the 
organisation’s margin by taking inputs and using them to produce outputs with 
greater value. 
The value chain can be used to: 
• give managers a deeper understanding of precisely what their 
organisation does

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• identify the key processes within the business that add value to the end 
customer – strategies can then be created to enhance and protect these; 
and 
• identify the processes that do not add value to the customer. These could 
then be eliminated, saving the organisation time and money. 
The value system 
Looks at linking the value chains of those in the wider organisational ecosystem – suppliers and customers – to that of the organisation. 
Can add value by: 
• Enhancing the supply – e.g. organic food for ready meals. 
• Controlling of the retail process – e.g. car dealerships. 
• Linking it all together to give advantage. 
 
 Illustration 5 – The Value Chain 
 Marks and Spencer plc compete in, amongst other areas, the food and 
grocery market. They have configured their value chain in order to offer 
customers a differentiated service.

206  
 Lidl also operates in the food and grocery market, but their value chain 
supports a cost–leadership approach. 
 
 Which THREE of the following are primary  activities in Porter’s value 
chain? 
A Service B Infrastructure C Procurement D Marketing and sales E Technology development F Procurement G Operations

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 A manager at HG plc (which manufactures plasma televisions) has 
developed a new computerised system which will help the inventory 
control of finished units at HG’s warehouse. She believes that this will reduce the time taken to ship these goods by around 25%. 
Which ONE of the following primary activities with HG’s value chain will 
the new system be directly improving? 
A Inbound logistics B Operations C Outbound logistics 
D Infrastructure 
 
 H is an accountancy firm. It gathers data from its clients’ systems and 
uses this to create a set of year end accounts. A recent internal analysis exercise has allowed H to create a list of its key internal activities. It now wishes to classify these activities using Porter’s value chain. 
 H’s internal activities  Value chain activity 
A Creation of clients’ year end accounts 1 Inbound logistics 
B Meeting with client to deliver and discuss year end accounts 2 Infrastructure 
C Central quality control systems to ensure accuracy of accounts 3 Outbound logistics 
 
D Receiving and storing data 
from client systems 4 Operations 
 
Show which of H's internal activities relates to each value chain activity 
by pairing the appropriate letter and number (e.g. A1, B4, etc).

208  
 Test your understanding 13 – Reggs – (Case style) 
Reggs is a long established bakers, based in country G. It specialises in 
selling pastries, cakes, sandwiches and basic tea and coffee, through a chain of high-street stores. It has grown rapidly over the last ten years and now operates more than 1,500 stores across the country. 
Reggs marketing strategy is to focus on the low prices of its food, with 
heavy advertising in the free press and tabloids. It sells the majority of its products for less than its competitors – a strategy which has paid dividends as country G is suffering an extended period of poor economic growth. 
To achieve these low prices, Reggs uses its purchasing power to source 
large amounts of good quality raw materials at low prices. These goods are transferred to a central warehouse. Reggs uses a sophisticated stock management system to track all materials and ensure that they are used before they perish. 
The raw materials are then sent (using Reggs own fleet of delivery vans) 
to several regional bakeries, where G’s products are part-baked. The part-baked products are then sent to the individual high-street stores, where they are completed. Much of this process is automated, enabling Reggs’ to hire low-skilled workers. This automation has meant that Reggs feel that quality control is no longer necessary. The company does not keep track of customer complaints as these are normally dealt with by the in-store staff. No formal policies have been produced to guide employees when dealing with complaints. 
The high-street stores are of a very basic design, with a large counter 
and racks of produce. There is no seating and, due to Reggs’ popularity, there are often long queues filling the stores. Reggs’ management is 
concerned that this may be putting off some potential customers from patronising the company. However, Reggs has not undertaken any significant customer research in some years as its managers have felt that its rapid growth indicates that there are no significant problems. 
Reggs management are keen to expand the business further and are 
looking at their strategic options. One suggestion is to alter Reggs’ traditional product range. Some lower priced items would be removed to make way for more expensive, luxury foods which will have a higher margin attached to them. These items would not travel well and would therefore need to be produced in the high-street stores. This would require moderately skilled workers.

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 Reggs feels that this may help to attract customers away from its 
competitors – such as coffee shops. These are significantly more 
expensive than Reggs, but have a much higher perceived quality of food and drink. Typically these competitors have well-designed, comfortable seating areas, enabling them to charge higher prices. 
You are a management accountant working for Reggs. You report to the 
Operations Director, who has sent you the following email: 
To: L. Ray From: O. Flow  Date: 12/05/XX Subject: Value chain Hi L, As you are aware, we have been considering making some changes to 
our operations (as we discussed the other day). I need you to undertake some analysis for me. Specifically, I would like you to analyse our primary activities of the value chain, identifying any weaknesses. Please identify how each activity enables our business to sell its goods at low prices. (I don’t need a diagram of the value chain). 
Could you also discuss the drawbacks of the strategy we are currently 
considering – relating to more expensive, luxury products. How far would 
the proposals impact on the existing value chain? 
I am attending a meeting about this in forty-five minutes, so please email 
back by then with your thoughts. 
Kind regards O. Flow 
Required: 
Email the Operations Director as requested. 
 
 Benefits and criticisms of Porter's Value Chain 
 Proponents suggest that the value chain model has many benefits, 
• It provides a generic framework to analyse both the behaviour of 
costs as well as the existing and potential sources of differentiation. 
• Activities that are not adding value can be identified and addressed 
– for example, improved so they do add value or outsourced if this is 
not possible. 
• It emphasises the importance of (re)grouping functions into activities 
to produce, market, deliver and support products, to think about relationships between activities and to link the value chain to the understanding of an organisation's competitive position.

210  
• It makes it clear that an organisation is multifaceted and that its 
underlying activities need to be analysed to understand its overall 
competitive position. 
• It is an attempt to overcome the limitations of portfolio planning in 
multidivisional organisations. Rather than assuming that SBUs should act independently, Porter used his Value Chain analysis to identify synergies or shared activities between them and to provide a tool to focus on the whole rather than on the parts. 
The main criticisms of Porter's Value Chain model are as follows: 
• It is more suited to a manufacturing environment and can be difficult 
to apply to a service provider. 
• The Value Chain model was intended as a quantitative analysis. 
However, this is time consuming since it often requires recalibrating 
the accounting system to allocate costs to individual activities. 
 
 The value shop 
 The value shop is an alternative representation of a value chain for a 
professional services firm which was developed in 1998 by Stabell and Fjelstad. 
A value shop is considered to be a workshop which mobilises resources 
to solve specific problems. This may involve repeating a generic set of activities until a satisfactory solution is reached. The shop model applies to many organisations, particularly those whose main purpose is to identify and exploit specific opportunities like designing a bespoke product. 
The model has the same support activities as Porter’s Value Chain but 
the primary activities are described differently. In the value shop they are: 
• problem finding and acquisition 
• problem solving 
• choosing among solutions 
• execution and control/evaluation. 
The management in the value shop organisation therefore focuses on 
areas such as the assessment of problems and opportunities, the mobilisation of resources, project management, the delivery of solutions, the measurement of outcomes and also learning. 
The value shop primary activities are arranged in a circle showing that 
they are cyclical, with an organisation often moving back and forth to develop or reject theories before reaching a conclusion.

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 211 
 J wishes to link her inbound logistics activities to the outbound logistics 
operations of her suppliers in order to maximise efficiency. 
Which of the following concepts is this referring to? A Value Shop B Value Driver C Value System D Value Linkage 
 
 Test your understanding 15 – Bowland – (Case style) 
 Bowland Carpets Ltd is a major producer of carpets within the UK. The 
company was taken over by its present parent company, Universal 
Carpet Inc., in 20X3. Universal Carpet is a giant, vertically-integrated carpet manufacturing and retailing business, based within the USA but with interests all over the world. 
Bowland Carpets operates within the UK in various market segments, 
including the high-value contract and industrial carpeting area – hotels and office blocks, etc. – and in the domestic (household) market. Within the latter the choice is reasonably wide, ranging from luxury carpets down to the cheaper products. Industrial and contract carpets contribute 25% of Bowland Carpets' total annual turnover, which is currently $80 million. Up 
until 15 years ago the turnover of the company was growing at 8% per annum, but since 20X2 sales revenue has dropped by 5% per annum in real terms. 
Bowland Carpets has traditionally been known as a producer of high-
quality carpets, but at competitive prices. It has a powerful brand name, and it has been able to protect this by producing the cheaper, lower-quality products under a secondary brand name. It has also maintained a good relationship with the many carpet distributors throughout the UK, particularly the mainstream retail organisations.

212  
 The recent decline in carpet sales revenue, partly recession induced, has 
worried the US parent company. It has recognised that the increasing 
concentration within the European carpet manufacturing sector has led to aggressive competition within a low-growth industry. It does not believe that overseas sales growth by Bowland Carpets is an attractive proposition as this would compete with other Universal Carpet companies. It does, however, consider that vertical integration into retailing (as already practised within the USA) is a serious option. This 
would give the UK company increased control over its sales and reduce its exposure to competition. The president of the parent company has asked Jeremy Smiles, managing director of Bowland Carpets, to address this issue and provide guidance to the US board of directors. Funding does not appear to be a major issue at this time as the parent company has large cash reserves on its balance sheet. 
You have been contacted by Jeremy Smiles, who has asked for briefing 
notes covering the following key issues: 
(a) To what extent do the distinctive competences of Bowland Carpets 
conform with the key success factors required for the proposed 
strategy change? 
(b) In an external environmental analysis concerning the proposed 
strategy shift what are likely to be the key external influences which could impact upon the Bowland Carpets decision? 
Required: 
Draft the briefing notes as requested. 
(45 minutes) 
 
 Test your understanding 16 – (Integration question) 
 A university which derives most of its funds from the government 
provides undergraduate courses (leading to bachelor's degrees) and 
post-graduate courses (leading to master's degrees). Some of its funds come from contributions from student fees, consultancy work and research. In recent years the university has placed emphasis on recruiting lecturers who have achieved success in delivering good academic research. This has led to the university improving its reputation within its national academic community, and applications from prospective students for its courses have increased. 
The university has good student support facilities in respect of a library 
which is well stocked with books and journals and up-to-date IT equipment. It also has a gymnasium and comprehensive sports facilities. Courses at the university are administered by well-qualified and trained non-teaching staff who provide non-academic (that is, not learning-related) support to the lecturers and students.

Chapter 6 
 213 
 The university has had no difficulty in filling its courses to the level 
permitted by the government, but has experienced an increase in the 
number of students who have withdrawn from the first year of their courses after only a few months. An increasing number of students are also transferring from their three-year undergraduate courses to other courses within the university but many have left and gone to different universities. This increasing trend of student withdrawal is having a detrimental effect on the university's income as the government pays only for students who complete a full year of study. 
You are the university's management accountant and have been asked 
by the Vice-Chancellor (who is the Chief Executive of the university) to review the withdrawal rate of students from the university's courses. 
Required: Apply Value Chain analysis to the university's activities, and advise the 
Vice-Chancellor how this analysis will help to determine why the rate of student withdrawal is increasing. 

214  
7 Summary

Chapter 6 
 215 
Make-up refers to the intangible resources of the organisation. Brand 
strength would be included here. 
 
 The correct answer is CORE 
Threshold competences are those that simply allow an organisation to 
compete with its rivals, but which do not give competitive advantage. 
 
 The two main critical success factors would probably be: 
• speedy collection from customers after their request for a parcel to 
be delivered 
• rapid and reliable delivery. 
 
 Their performance can be measured by establishing key performance 
indicators for each CSF and measuring actual achievements against them. For example: 
• Collection from customers within three hours of receiving the order 
for orders received before 2.30 p.m. on a working day. 
• Next-day delivery for 100% of parcels to destinations within the UK. 
• Delivery within two days for 100% of parcels to destinations within 
Europe. 
 
There is a short-term need for the organisation to improve cash flow, 
indicating a temporal organisational issue.

216  
 There are a number of issues that the Government’s survey has 
highlighted as areas of concern, which GGG should view as its critical 
success factors/objectives. 
Growth in use of the railways 
The Government wishes to maximise the use of the railways in 
Country H . 
This would appear to be a key objective as it will help them to meet their 
international environm ental targets and will reduce pressure on the road 
network. 
A key performance measure here could be the annual percentage growth 
in passenger numbers. This will be a simple thing for GGG to measure and an area they can agree targets on with the Government. 
Note that dealing with the other objectives (below) is likely to improve this 
area as well. 
Value for money 
The Government survey has indicate d that the public views GGG’s ticket 
prices as too high, which is putting them off travelling by train. GGG therefore needs to find a way of improving its perceived value for 
money if it wishes to grow passenger numbers . 
A key performance measure could be to ensure that the average ticket 
price is no more that the equivalent cost of travel by car or bus. This is likely to ensure that passengers see the train as a viable financial option. 
Reduce overcrowding The frequent overcrowding of the trains is a serious issue which causes 
discomfort for passengers and is limiting uptake of train travel. 
GGG needs to increase its capacity and reduce overcrowding if it 
wishes to attract customers. A key performance measure could be the average number of passengers 
having to stand per km of track. If GGG is able to put on more services (especially at peak times) this should fall, indicating reduced overcrowding. 
Improve punctuality Delays to the trains mean that passengers do not wish to travel as they 
cannot reliably guarantee that they will arrive at their destination on time. 
Again, in order to attract customers, GGG will need to improve the 
punctuality of its trains .

Chapter 6 
 217 
 The performance here could be measured by setting targets for the 
percentage of trains that arrive more than, say, five minutes after their 
stated arrival time. If this figure falls, GGG will be accomplishing its objective in this area. 
Unhelpful staff This is another area in which the Government survey has indicated 
problems – GGG needs to improve on the level of service provided 
by its staff . 
Again this seems to be putting off potential customers (or at least reducing the likelihood of repeat business) and needs to be dealt with. 
To measure whether this is being improved, GGG could set itself targets 
in areas such as a reduction in the number of complaints received about staff each year. 
Alternatively, it could set targets on the average number of days of staff 
training per year, as improvements in this area are likely to improve the problem of unhelpful staff with po or knowledge of GGG’s operations. 
Note:  The requirement only asks for FO UR critical success factors and 
ONE performance measure for each. Additional points have been added to this answer for completeness. 
 
This is an example of a measured target set by the organisation, 
suggesting that it is a KPI. 
A mission, vision or CSF would be at a higher, more general level and 
would likely lack the specific measures set out in option B. 
 
A and C cannot easily be measured and therefore would not make 
suitable KPIs. B is not linked to the handling of complaints and therefore is not relevant to B’s CSF. 
D is measurable and, if achieved, would indicate that the CSF is being 
accomplished successfully.

218  
 (i) Identification of four CS Fs appropriate for TDM  
Critical success factors for TDM may include: 
– Employee satisfaction  – given that TDM is in a service 
industry, staff are likely to be key to its products and high 
levels of staff turnover are a concern. 
– Course quality  – given the competitive nature of the market, it 
is vital that TDM continues to o ffer appropriate courses that will 
attract students. 
– Student satisfaction – in order to be successful, TDM must 
ensure students are pleased with their courses. If not, they 
may move to alternative suppliers and may dissuade other students from using TDM. 
– Strong financial results  – after the takeover, TDM will need 
to make sufficient profits to maximise the wealth of RCH shareholders. 
(ii) Recommended key performance indicators 
TDM’s performance can be measured by establishing key 
performance indicators for each CSF and measuring actual achievements against them. 
Employee satisfaction Number of staff leaving each period This is the most direct measure of whether staff members are 
satisfied with their roles within the business. TDM is experiencing increasingly high staff turnover, which may mean they are losing valuable, skilled members of staff. 
Sickness/absence per staff member per month De-motivated or unhappy staff can tend to take more time off work 
due to sickness. TDM should monitor this as an indirect measure of staff satisfaction, especially as it is likely to cause disruption to courses. 
Course quality Pass rates compared to national average TDM currently achieve exam pass rates that are comparable to the 
national average. Given the competitive nature of the market they operate in, this is likely to be something prospective students use as a way of choosing a tuition provider.

Chapter 6 
 219 
 Number of students choosing not to complete the course 
compared to average 
If a course is of poor quality (either poor materials or tuition), 
students may choose not to complete the course – either ceasing to study with TDM or moving onto an alternative course. If the number of students doing this is above average, it should be investigated and targets put in place to bring it down to average. 
Student satisfaction Percentage student approval rating TDM could give students a questionnaire at the end of each course. 
This could ask them about how they rate the course, the tutor and the course material. This could be invaluable for identifying problem areas that the business needs to resolve. This would be likely to please RCH given their focus on customer research. 
Percentage of students going on to further studies with TDM 
TDM offers a range of courses, including degrees at both Bachelor 
and Masters level. If students feel that TDM have provided a good service, they will be more likely to take their studies further with the organisation. 
Strong financial results Market share While TDM currently has the largest market share in its segment, 
large numbers of competitors are continually entering the market. If market share begins to fall, it will have a damaging effect on the profitability of the business. 
Profit targets Given that RCH has purchased TDM with the specific intention of 
increasing profitability, it is likely that they will have specific targets 
in mind for the business that TDM will need to work to achieve. For example, TDM may need to measure profit margins to ensure they meet the targets set by RCH. 
 
 The correct answers are A, D and G 
The other options are all secondary.

220  
Outbound logistics looks at management of finished goods as well as 
delivery to the customer. 
 
 The correct answers are A4, B3, C2, D1 
Remember that the value chain can be applied to service industries as 
well. In this case, the chain may show the acquisition and handling of data/information rather than raw materials. 
In this case, the firm will receive information from its clients relating to 
their financial statements. This is inbound logistics (D1). 
The firm will then use this information to create the clients’ financial 
statements – the main operation of H. This gives us A4. 
The prepared accounts will centrally quality checked prior to a client 
meeting. This is relates to the way the firm is organised and its systems, giving C2. 
Finally, the accounts will be given to th e client and discussed with them, 
forming H’s outbound logistics – B3. 
 
 Email To: O.Flow From: L. Ray 
Date: 12/05/XX 
Subject: Re: Value Chain Dear O, 
Porter’s value chain helps to identify the activities within and around the 
organisation. These can then be used to help assess the organisation’s competitive strength. 
Inbound logistics 
This relates to the receiving, storing and distributing the inputs to the 
product. 
For Reggs, this involves the storage of raw materials in its central 
warehouse, followed by the transfer of these materials to the regional bakeries. This is particularly impor tant for Reggs due to the perishable 
nature of its goods.

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 221 
 Reggs source “good quality” raw materials that are satisfying customer 
demand. 
It is vital that materials are used promptly to ensure wastage is minimised 
in order to keep costs low and a sophisticated IT system helps to ensure this. 
Operations 
This examines the transformation of raw materials into the final product. In Reggs, this occurs in two stages – firstly when the product is initially 
part-baked in the regional bakeries and secondly (after transport) when the baking is completed in the high-street stores. In both cases, the company automates as much as possible to keep costs low. This also ensures that employees do not need any specialised skills, keeping wage costs low. 
A weakness here seems to be a lack of quality control. The assumption 
that automation means that there will not be any mistakes made seems worrying and there is a risk that problems may not be picked up, potentially damaging Reggs’ reputation and overall brand. 
Outbound logistics 
This relates to the storing and distributing of products to customers. For 
Reggs, customers visit their 1,500 stores to buy food, meaning that outbound logistics is minimal. This stage of the value chain simply relates to making sales to customers in store. 
This appears to be a major weakness for Reggs, who appear to be 
overwhelmed by the numbers of customers demanding their products, leading to long queues. While the level of demand is encouraging, long queues may be losing custom for Reggs, who may wish to look at ways of improving the efficiency with which customers are dealt with –although some research should be undertaken first to see whether this is a sufficient problem to warrant investment. 
Marketing and sales 
Reggs appears to be targeting the lower-end of the market by sourcing 
advertising in the free press and tabloids. This is consistent with its approach of stressing the low-cost aspect of its food. Given the economic conditions in country G, this appears to be a sensible approach. 
The basic store design also reinforces the image that Reggs is a low-cost 
business, strengthening its market image.

222  
 Service 
This looks at after-sales care for customers. At present, this does not appear to be a significant area of concern for 
Reggs. Complaints are not monitored by the company, instead being left to low-skilled employees in store. 
Again, this is consistent with the low-cost approach of the business, but 
does risk damaging Reggs’ reputation in the event of any serious problems occurring and does not enable Reggs to use customer feedback in an effective way. 
Overall 
Reggs has a well-designed supply chain that allows for minimal wastage 
and maximum efficiency. It allows the business to gain competitive advantage by operating as a cost leader within its market. However, it lacks a positive approach to customer feedback. 
Proposed strategy 
If Reggs begins offering luxury items, it will have a significant impact on 
the value chain of the organisation. 
• Reggs will need to procure higher quality materials – potentially 
requiring new suppliers. The luxury items will replace existing 
products, meaning that Reggs will be ordering less of its existing raw materials, which may undermine its economies of scale. 
• Materials will have to be transported directly from the warehouse to 
the stores, where the luxury items will be made. This will increase the complexity and cost of Reggs’ internal transport system. 
• The manufacturing of the luxury goods will require moderately 
skilled workers. Reggs currently employs workers who have low levels of skills, as this keeps wages low. It will incur significant additional costs to hire new workers. 
• The new luxury items do not match the current brand image of the 
company. Reggs has basic stores, little service and advertising that focuses on the low cost of the items. Offering luxury, high priced items does not match this cost leadership strategy. It may fail to attract customers and lead to Reggs becoming “stuck in the middle”. 
• Should the new luxury goods take off and allow Reggs to grow its 
customer base, it may cause additional pressure on the queuing systems of the stores. The staff already seem unable to cope with the volume of custom they have at peak periods. Reggs may wish to deal with this problem first, before trying to capture more customers.

Chapter 6 
 223 
 There are also a number of other reasons why the Reggs proposals may 
not be a success. 
• Reggs has failed to carry out any significant market research into 
either proposal. This means that the company risks proceeding with 
investments that may not be what customers want. At best this 
could waste money – at worst, Reggs could alienate its customer base. 
• Reggs is also eliminating existing, presumably profitable, products 
to make way for the new luxury items. If these are unsuccessful, it may fail to increase its profits overall. Higher priced items may struggle due to the weaker economy in the country. 
• It should also be noted that Reggs is assuming that they can 
compete with coffee shop chains by simply offering higher quality goods. In reality, there are likely to be other factors, such as the comfortable surroundings and atmosphere, as well as the coffee shop brand names, which may make it hard for Reggs to successfully attract their customers. 
Overall, the business needs to undertake significant additional research in order to ensure that the proposal is worth both the disruption to the value chain and the potential brand image confusion that it may cause. 
I hope this helps – if you need any further information, please let me 
know. 
Kind regards L.Ray 
 
 The correct answer is C By definition.

224  
  
Key answer tips 
Part (a) of the question can be split into three parts – what are 
Bowland's existing competencies, what are the key success factors needed in retailing, and do these two things match up. So a good approach would be to split your time evenly between all three elements. 
For part (b) an external analysis is normally a combination of both the 
PESTEL and 5 Forces models, but with only 15 marks available (and working on the basis of two marks per well-explained point) you do not have to cover every element. So if, for example, you can't determine any relevant 'Technical' issues then just leave this factor out. 
Briefing notes 
Bowland’s competences 
An organisation’s distinctive competences  are those things which an 
organisation does particularly well. They include the organisation’s 
unique resources and capabilities as well as its strengths and its ability to overcome weaknesses. These competenc es can include aspects such as 
budgetary control, a strong technology base, a culture conducive to change and marketing skills. 
Key success factors are those requirements which it is essential to 
have if one is to survive and prosper in a chosen industry/environment. These can include areas such as good service networks, up-to-date marketing intelligence and tight cost controls where margins are small. 
It is not guaranteed that the distinctive competences and the key success 
factors are always in alignment. A company moving into the retail sector may have an excellent product resear ch and development capability, but 
this alone will not help if it has no conc ept of service, or poorly sited retail 
outlets. It is critical to ensure that what the company excels at is what is needed to be successful in that particular area. 
The strengths of Bowland Carpets  include strong brand names  which 
maintain integrity within the different market segments where the 
company operates. The company has a balanced portfolio of customers  and the range of products is equally balanced , ensuring 
that any sectoral decline can be compensated for by growth in other markets. Other strengths which the company currently has include a good relationship with distribut ors and strong support from a 
powerful parent company . Some of its distinctive competences, such 
as a strong brand and a reasonable range of products, are critical in the proposed new environment, as will be the financial support of the parent 
company. However, there are some aspects which are cause for concern in the proposed new business environment.

Chapter 6 
 225 
 The strength in the contract and industrial carpet segment will not be 
affected by the proposed vertical integration – sales tend to be through a 
direct sales force. The strong relationship with distributors will 
however be jeopardised by the opening up of retail outlets . Other 
retail chains will be unwilling to permit a rival to operate so freely, and therefore there will be a reluctance to stock Bowland's carpets. Unless 
Bowland Carpets can obtain wide retail market coverage to compensate for this potential problem, sales re venue will be adversely affected. 
The cost of developing extensive market coverage will be enormous 
and whether it is in high-street outlets or specialist out-of-town centres the investment may be greater than the parent company has budgeted for. The company also has no expertise in site appraisal and 
selection. Although the newly structur ed value chain will generate 
greater control there is an associated lack of flexibility  along with an 
increase in the fixed cost base  of the business. 
Another key success factor is the need for expertise in retailing . It may 
be that the UK company can import this from the USA but the culture of marketing household durables may not be transferable internationally. Bowland Carpets as the domestic company has no experience in this field. 
A critical factor in successful retailing is the ability to provide a 
comprehensive range of products. Does Bowland Carpets have one? It is unlikely that the competitive carpet manufacturers will provide such a supply to one of their rivals. 
It would, therefore, appear that there is no close conformity between the 
distinctive competences of Bowland Carpets and the key success factors required in the carpet retailing sector. 
External environment 
The external environment  scan is an essential prerequisite prior to 
selecting a strategic option. It enables the company to identify and 
understand the key external and uncon trollable influences which will have 
an impact upon the company's strategy. The environment is increasingly turbulent and often hostile. Without this knowledge and appreciation the strategist will be operating in a minefiel d. The acquisition of the external 
information is obtained by scanning the environment continuously and monitoring key indicators, which should enable the company to position itself appropriately with respect to the external environment and the competition. The external scan should be structured around a PESTEL framework covering the following environments – social, legal, economic, political and technological. In addition it is also important to assess potential competitive reactions as part of the scanning process.

226  
 The environmental scan will influence the decision as to whether 
Bowland Carpets should concentrate on the UK or seek diversification 
elsewhere, either in products or markets. Possible factors are as follows: 
• Social issues:  Trends towards increasing car-centred shopping 
(superstores and out-of-town sites) or movements back to city-
centre shopping: trends in fashion and furnishing – will carpets become a fashion item and result in greater replacement sales? Other factors of importance to Bowland include the rate of growth or decline in populations and changes in the age distribution of the population. In the UK there will be an increasing pr oportion of the 
national population over retirement age. In developing countries there are very large numbers of young people. Rising standards of living lead to increased demand for certain types of goods. This is why developing countries are attractive to markets. 
• Legal issues:  Laws in the UK differ from the US. They come from 
common law, parliamentary legislation and government regulations derived from it, and obligations under EU membership and other treaties. Legal factors that can influence decisions include aspects of employment law, e.g. minimum wage, laws to protect consumers and tax legislation. The monopoly/competition issues in this case are likely to be insignificant. 
• Economic issues:  An increased concentration for Bowland Carpets 
within the UK economy will depend upon future economic prospects, taxation policy (sales tax) and interest rates, income distribution and unemployment (influencing site location), trade barriers (cheap imports from Third World suppliers, or even low-cost tufted carpets from countries such as Belgium). 
• Political issues:  Government policy affects the whole economy and 
governments are responsible for enforcing and creating a stable framework in which business can be done. The quality of government policy is important in providing physical infrastructure, (e.g. transport), social infrastruc ture, (e.g. education) and market 
infrastructure, (e.g. planning and site development – town centre or out-of-town developments).

Chapter 6 
 227 
 • Technological issues : Is retailing technology evolutionary or 
revolutionary? Will it be costly or labour saving? Will inventory 
control be facilitated – so saving costs? Technology contributes to 
overall economic growth. It can increase total output with gains in productivity, reduced costs and new types of product. It influences the way in which markets are identified – database systems make it much easier to analyse the marketplace. Information technology encourages de-layering of organisational hierarchies and better communications. 
• Competitive issues:  It will be necessary to assess the likely 
responses of both carpet distributors and carpet manufacturers to the proposed incursion by Bowland Carpets. Will the reactions be benign or will they be aggressive? 
 
 Application of the value ch ain to university process 
Tutorial note 
A specialist value chain question that would warrant a brief introduction and possibly a diagram. Don't go mad with the diagrams that do not 'add value' that much. Value chain analysis (VCA) is a method of reviewing all the activities of an organisation and how they interact with each other. Key linkages are identified and areas that create value are focused upon. VCA is not restricted to just the organisation but also the suppliers and customers. 
In this question we will have to address the issue of university suppliers 
of resources: 
• students • staff 
• premises 
• facilities. 
And customers/consumers: 
• degree holders • employers 
• society.

228  
 The starting point is to identify the objectives for the university in this 
context. There appear to be three particular issues. 
• Students dropping out in the first year. • Students transferring to another university or just leaving. 
• Students swapping courses within the university. 
The idea is to look at the primary and support activities to establish why 
these problems may be arising. 
 
Inbound 
logistics Marketing & sales Service 
• Student 
supply 
• Staff 
supply 
• Facilities 
supply 
• Course 
selections 
 • Course 
• Lecturing 
• Research 
• Library 
• IT access 
• Premises 
 • Skills 
base 
• Employer 
view 
• Graduate 
view 
 • Marketing 
mix 
structure 
• USP/CA? 
• Promotions 
• Research? 
• Price 
elasticity 
 • Support 
functions 
• Admin. 
functions 
• Social 
aspects 
• Post- 
qualification 
career 
assistance 
Secondary activities 
 
Procurement Technology HRM Infrastructure 
• Food & drink 
• Accommodation 
• Building work 
• Support staff 
• Books 
• Students & staff • Availability 
• Content 
• Training 
• Change • Staff 
selection processes 
• Staff turnover 
rates 
• Appraisal 
processes 
• Admin. Staff 
processes • Culture 
• Layout 
• Org. Structure 
• Faculties 
• Planning 
systems 
• Control 
systems (FFWD & FBK) 
These are some of the things that should be looked at within this context. 
Processes need to be viewed at first hand and discussed to see how the 'chain' links up. All that needs to happen for the chain to fail is for one link to break.

Chapter 6 
 229 
 How will it help? 
This model is twenty years' old and designed for application in the private 
sector but it does have its uses here. The model acts as a simple 
starting point  to focus management attention onto the issues. It is not 
designed to provide an answer, rather to get the 'ball rolling' for management in trying to identify where the problems lie. Managers will have seen it before and be vaguely familiar with it so there will be less resistance. Solutions to these kinds of problems come from reasoned debate from informed people. 
VCA will start management thinking wher e they can add value. They will 
consider how they differ from the competition and on what basis they will 
attract staff and students in the future. It will force them to identify the order winners or 'core competences' . 
At the same time, the process will identify the threshold competences , 
or order qualifiers, that are needed. Failure to satisfy threshold competences will lead to consumer dissa tisfaction. This would lead to the 
student problems evident in this case so it looks like VCA would be useful here in spotting those threshold competences that are not being satisfied. Universities are age-old organisations and are not well known for embracing change. It is possible that this university may be suffering from competence slip – that is the situation that arises when a past core competence becomes threshold as a result of increasing consumer sophistication. That means, as the consumer gains more experience of the product, they become more expectant of the service offered. The VCA will force management to consider the issues of competitive 
advantage and disadvantage . 
The analysis will see research into student, employer and staff perceptions whilst at the same time may see the application of benchmarking techniques. This would compare a similar institution with ours to see where any issues may exist. So VCA: 
• Is the starting point for discussion. 
• Gets people from all areas of the business talking – team 
perspective so a range of opinion and expertise. 
• Starts or improves communication, and feedback and forward are 
encouraged. 
• Step-by-step analysis allows the competences to be analysed.

230

231 
Framework for 
generating strategic 
options 
C2: Discuss how to generate 
and develop options (c) Forecast potential 
ecosystem 
(d) Use various frameworks 
to generate options 
 
  Chapter 
7

Framework for generating strategic options 
232  
 
1 Position auditing  
In the previous five chapters we have examined the methods that can be used 
to analyse the current situation of an organisation and its ecosystem – internally, externally and with specific reference to its stakeholders, mission and objectives. 
This analysis can be summarised in a formal corporate appraisal, which is 
typically referred to as a SWOT analysis (strengths, weaknesses, opportunities and threats). 
 
Internal environmental anal ysis will look for the strengths and weaknesses of 
the organisation and the role it can play in its ecosystem. 
External environmental analysis will look for the opportunities and threats that 
the organisation needs to be aware of, both for itself and other components of 
its ecosystem.

Chapter 7 
 233 
 
This is an essential part of the strategic management process as it helps the 
organisation answer the question – 'Where are we now?'  
If an organisation is unsure of its current position then it will be very difficult to plot a successful strategy, one that fully appreciates the organisation’s relationship with its wider ecosystem. The ecosystem collectively will be looking to create value; the organisation must question how it is able to contribute to such value creation. Therefore a full analysis of the current position establishes the starting point for the process of strategic choice to help create value successfully. 
Key points 
• SWOT analysis is a tool to assist the position audit process. It is not the 
only tool: e.g. the competitor analysis framework works well in this context 
and can provide a useful framework to analyse a company. 
• Position auditing asks t he question 'Where are we now?' and is viewed by 
many as being the starting point for the process of strategic choice. 
• The audit will usually be undertaken by a team with a pre-set budget, 
objectives listing and support functions. 
• The management accountant will be involved with delivering and 
monitoring the information flows into the process.

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The position audit would seek to identify: 
• Threats focusing on weakness:  This would usually have top priority and 
the company should seek to identify and consider possible solutions. This 
requires a defensive response of some kind and may well necessitate rapid change. 
• Threats focusing on strength:  this requires a review of the supposed 
strength to ensure that it is still as strong as previously thought. 
Remember what is good today, may not be so tomorrow. 
• Opportunity focusing on strength:  this gives the organisation the 
chance to develop strategic advantage in the marketplace. Check the research and assess the strengths again. 
• Opportunity focusing on weakness:  this will require management to 
make a decision as to whether to change and pursue the opportunity or, alternatively, ignore the prospect and ensure resources are not wasted in this area in future. Usually substantial change will be required if the company is going to pursue the opportunity. Check that the company's internal competencies will allow them to exploit the opportunity. 
The review should initially seek to identify what would happen if the organisation chose to do nothing. Remember this is always a strategic option! 
The exercise is designed to allow the following: 
• identification of the current issues relating to the organisation concerned 
• analysis and identification of the relevant problems  facing the 
• consideration of the strategic capability  of the company and its history. 
 
 C Ltd is a large company and is a market leader in a highly competitive 
industry. It has recently undertaken a corporate appraisal and identified 
that it has a significant amount of cash available for future investment. It is considering using this to purchase one of its smaller rivals. 
Within the corporate analysis, which ONE of the following categories 
would C’s cash surplus be included within? 
A Weakness B Strength C Opportunity D Threat

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 VVV plc is an organisation that manufactures stationery. It has used 
various analysis tools in order to identify key issues surrounding the 
business . It has identified four major issues – one from each of the four 
major analysis tools that it used. 
 VVV’s issues  Analysis tool 
A Increased government 
subsidies for recycled paper 1 SWOT  
B Low levels of staff morale 
within VVV 2 Five forces 
C Customers do not see VVV’s 
after sales care as important 3 PEST  
D Customers have relatively low 
levels of influence over VVV’s 
strategy 4 Value chain 
Identify which analysis tool was used to identify each of VVV’s issues by 
pairing the appropriate letter and number (e.g. A1, B4, etc). 
 
 Qualispecs has a reputation for quality, traditional products. It has a 
group of optician shops, both rented and owned, from which it sells its spectacles. Recently it has suffered intense competition and eroding customer loyalty, but a new chief executive has joined from one of its major rivals, Fastglass. 
Fastglass is capturing Qualispecs’ market through a partnership with a 
high-street shopping group. These shops install mini-labs in which prescriptions for spectacles are dispensed within an hour. Some competitors have successfully experimented with designer frames and sunglasses. Others have reduced costs through new computer-aided production methods. 
Qualispecs has continued to operate as it always has, letting the product 
‘speak for itself’ and failing to utilise advances in technology. Although production costs remain high, Qualispecs is financially secure and has large cash reserves. Fortunately the country’s most popular sports star recently received a prestigious international award wearing a pair of Qualispecs’ spectacles. 
The new Chief Executive has established as a priority the need for 
improved financial performance. Following a review she discovers that: 
(a) targets are set centrally and shops report monthly. Site profitability 
varies enormously, and fixed costs are high in shopping malls

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 (b) shops exercise no control over job roles, working conditions, and 
pay rates 
(c) individual staff pay is increased annually according to a 
predetermined pay scale. Everyone also receives a small one-off 
payment based on group financial performance. 
Market analysts predict a slowdown in the national economy but feel that consumer spending will continue to increase, particularly among 18- to 30-year-olds. 
Required: 
Produce a corporate appraisal of Qualispecs, taking account of internal 
and external factors, and discuss the key strategic challenges facing the company. 
(30 minutes) 
2 Value drivers 
Part of the process of conducting a corporate appraisal is to consider the value drivers of the organisation. 
Value drivers are anything that can be used to create additional value to a 
consumer in respect of the product or service that the organisation deals in. Such additional value helps to differentiate that product or service compared to those of competitors, and so gives greater appeal to the consumer. 
The more value drivers that the organisa tion can create or use, the greater will 
be its competitive advantage. Value drivers can be tangible or intangible. 
Examples of tangible value drivers: 
• State of the art production facilities,  including automated processes that 
increase quality and reduce costs. For example, the car manufacturer 
Nissan has enjoyed the reputation of being the most efficient car manufacturer in Europe, measured as cars made per employee, due to continued investment at its plant near Sunderland in the North East of 
England. 
• Distribution facilities that are stra tegically placed to enable rapid and 
efficient delivery to customers. For example, supermarkets may locate 
warehouses close to major road systems such as motorways so that delivery of fresh goods into stores can occur more quickly. 
• Raw materials that are either better quality or cheaper than those used by 
rivals.

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However, in the modern business environment it is felt that tangible drivers of 
value can be copied, over time, by rivals, and theref ore will not necessarily lead 
to sustainable  competitive advantage. Greater strategic importance needs to be 
placed on the intangible drivers of value; organisations are recognising that, if they want to survive and succeed in the long term they need to strategically manage their intangible assets and create value from them. Sustainable competitive advantage is gained from intangible value drivers. 
Examples of intangible value drivers: 
• Brands 
• Intellectual property and patents 
• Relationships with customers 
• Relationships with suppliers 
• Employees 
• Reputation 
• Know-how. 
 
 Illustration 1 – Tesla 
 For a period of time, Tesla was valued at more than the Ford Motor 
Company, despite not having reported a profit and having much lower 
revenues. The value attributed to the company was derived from its technological know-how, its ability to  produce an electric car that had a 
battery power much greater than any rivals could produce, and therefore which could travel much greater distances before needing to be recharged. 
It might also be argued that value was attributed to Tesla’s charismatic 
founder Elon Musk, an entrepreneur with a vision for changing business models, as evidenced through his success with the online payment platform PayPal.

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In the English football Premier League, Manchester City have enjoyed 
gr
eat success since being taken over by Sheikh Mansour of Abu Dhabi in 
2009. 
Which THREE of the following would be classified as intangible drivers of 
value behind that success?  
A Attracting Pep Guardiola to become manager 
B Having Etihad stadium, with a capacity of just over 55,000 people, 
as the home ground 
C The network of football clubs owned by the same group, in 
Melbourne, New York and Yokohama 
D The players that make up the first team squad 
The data needed to des cribe and measure value drivers will be considered in 
more detail in chapter 9. 
3 Gap
 analysis 
Once an organisation has undertake n a detail ed corporate appraisal, it may 
wish to check whether it is on course to mee t its longer ter m str ategic 
For example, a large company may hav e announced that i t aims to double its 
pr
ofits within the nex t five y ears. The question i s, given the current st ate of t he 
organisation, i s this really l ikely to happen? 
To answ er tha t question , many or ganisation s undertake gap a nal ysis. This 
involves fo recasting the o r ganisation ’s future position (if it co ntinue s with its 
current stra t egies) and e xamining whether t his future position w ill meet t he 
organisation’s goals. 
Gap analysis is the comparison between an entity's ultimate objective and 
the expected performance from projects, both planned and under way, identifying means by which any identified difference or gap might be filled. 

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(1) The firm sets its key strategic objective for some time in the future (T), 
such as achieving a certain level of sales in five years time. 
(2) The firm then forecasts its likely performance from current operations (F 0), 
after efficiency savings have been made (F 1) and after new strategic 
initiatives (F 2). (Note: These are often separated out as there is a greater 
degree of uncertainty associated with new initiatives.) 
(3) Identify any remaining 'gap'. New strategies will be needed to close this 
gap. This gap is referred to as the ‘diversification’ gap. 
Closing the gap 
There are a number of possible ways of closing the gaps identified by the 
company: 
Closing an efficiency gap  – this typically involves undertaking an ‘efficiency 
drive’. The organisation looks to make cost savings and any other actions that 
will improve the output for a given set of inputs. This is usually the easiest way of closing a gap and is therefore normally undertaken first. 
It can also involve looking at market penetration strategies, which involve 
considering how to sell more of the organisation’s current products in their current markets (such as through price cuts, advertising or new packaging, for example). 
Closing an expansion gap  – this involves looking at ways that the organisation 
can expand its sales. It could either adopt a market development approach, 
where it looks to sell its existing products to new markets, or alternatively it could choose a product development strategy where it tries to sell new products to its existing customer base.

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Closing a diversification gap  – this involves the organisation taking a riskier 
strategy where it looks to sell new products to new markets (e.g. a 
pharmaceutical company starting to sell beauty products). Due to the higher risk of failure, this is typically the last strategy that the organisation would adopt in order to close its gap. 
Note that the strategies mentioned here (market penetration, market and 
product development and diversification) are all closely linked to Ansoff’s product/market growth framework, which is discussed in more detail in chapter 7. 
 
Illustration 2 – gap analysis 
 KOB is a large company which operates a mobile phone network in 
country C. KOB’s strategic goal is to have annual earnings of $85m in ten 
years’ time. 
KOB’s strategic management accountant has undertaken detailed 
forecasts of KOB’s expected performance over the next ten years and discovered that, if the company continues with its current strategies, it will only have earnings of $78m in ten years’ time, giving an overall strategic gap of $7m. 
KOB’s managers have therefore identified a number of strategies to close 
this gap. 
• Closing the efficiency gap  – KOB have identified a number of 
telephone masts that are currently not required. By 
decommissioning these, as well as outsourcing customer service to overseas call centres, KOB estimates that earnings will rise by $4m after ten years. 
• Closing the expansion gap  – the mobile phone market is highly 
competitive within country C. However, KOB is considering rolling out its mobile phone services into nearby country G. The market here is less developed and KOB estimates that it will be earning around $1m of earning each year from country G in ten years’ time. 
The previous strategies should close $5m of the overall strategic gap. As they have not covered the entire gap, KOB may consider undertaking a riskier diversification strategy in order to close the remaining gap. 
• Closing the diversification gap  – KOB is considering selling fixed 
line internet access to customers in country C. KOB has no 
experience of this product and believes that it will be mainly selling to consumers who are not its current customers. However, KOB predicts that, due to its well-kn own brand name, it will be able to 
earn over $1m each year within ten years. 
The various strategies adopted by KOB have therefore closed the strategic gap and KOB should be able to meet (or exceed) its target of $85m in annual earnings within the ten year window.

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It is worth noting that a plan is what you want to happen whilst a forecast is 
what you predict will happen given the current context and assumptions. The whole approach of gap analysis is based upon the feed forward control concept, i.e. the comparison of plan with forecast. 
The aim is to identify deviance before the problems of missed targets arise so 
enabling corrective action to take place in advance. The strategy is too important to leave to reactive control systems. A proactive approach is needed and this will see the need for a significant spend on the forecasting systems. Spending will normally include: 
• the team • IT 
• data sourcing and audit 
• scenario planning 
• time to facilitate the action 
• uncertainty evaluation techniques such as 'what if' analysis, high-low 
forecasting and simulation exercises. 
The problems with gap analysis 
The whole concept revolves around dealing with uncertainty in the environment. 
Recent times have seen the business environment becoming increasingly uncertain. This increasing amount of uncertainty makes the predictive capabilities of systems less effective. The predictive process works to an extent if the environmental context can be identified. The uncertainty that exists brings with it new unexpected parameters that can render the whole process a costly waste of time. This has been held as a reason for the abandonment of gap analysis. 
The other issue is that in recent years there has been an increasing number of 
powerful stakeholder groups emerging with the knock-on effect being that there 
is a greater range of often conflicting objectives. Gap analysis does not entertain the multiplicity of objectives with conflict and compromise running 
through the whole system. 
The benefits of gap analysis 
(1) The approach acts as a simple starting point to initiate further debate and 
consideration. 
(2) It is easy to understand and as such acts as an effective communication 
device. 
(3) It highlights the need to keep an eye on the long-term time horizon and 
draws attention away from the short-term focus. 
(4) It provides some basic options that may be considered for closing the gap. 
(5) If it is held as a tool to assist and not as the solution provider, the 
approach still has a place in most plan ning systems within organisations.

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(6) It allows the questioning of the realism of the objective – if there is a gap, it 
may be that the objective is unrealistic given the strategic capability of the 
organisation. This may lead to a reappraisal of the objectives and the generation of more realistic versions. 
(7) Stable environments will still provide a basis for effective gap analysis. 
 
 F’s strategic management accountants have recently undertaken gap 
analysis. They have forecasted the likely position of the company after 
taking account of planned efficiency savings as well as after all planned 
strategic initiatives. They have identified that there is still a gap between 
F’s forecast position and it’s ideal position. 
This remaining gap is referred to as the _______________ gap. 
Required: 
Insert the missing word in the above sentence. 
4 Forecasting 
A key part of gap analysis is forecasting. 
 
 A forecast is a prediction of future events and their quantification for 
planning purposes. 
Clearly gap analysis relies on accurate forecasts of future performance. The 
strategies developed as a result of gap analysis are only as good as the quality of the forecast that they rely on. So how do we forecast company or market performance – in some cases looking ahead over a number of years? 
Statistical models 
An organisation could adopt one of several statistical models to try and quantify 
key forecast figures. 
Regression analysis 
This looks at how a particular variable correlates (or varies) with another 
variable. 
For example, an airline may wish to investigate the link between passenger 
numbers and average ticket prices (usually the number of passengers falls as the ticket price rises). Regression will allow the airline to calculate an estimate of the relationship between the two factors, based on past results. This can then be used in its forecasts for coming years. For example, if it intends to raise ticket prices to increase earnings, it can predict what effect this will have on passenger numbers, giving it an accurate forecast of expected earnings.

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Time series analysis 
Time series analysis involves the identification of short- and long-term trends in 
previous data and the application of these patterns for projections. In other words, it looks at how a particular factor varies over time. 
For example, a jewellery firm may find that its results are strongly affected by 
the price of gold. Time series analysis will help the firm look at the past gold price movements and use them to predict what the future price of gold will be. This can then be used in forecasting to help the firm estimate its cost of goods sold, or to decide on a pricing strategy (amongst other things). 
Trend analysis is a particularly useful tool for companies who have to forecast 
demand that is influenced by seasonal fluctuations, or where demand is strongly influenced by the business cycle. 
Drawbacks of statistical models 
While the above models can be useful in helping quantify key forecast figures, 
they have a number of inherent limitations, including: 
• they assume that past results are a good indication of the future. For 
instance, our jewellery firm may find that the price of gold has risen sharply 
in past years. This is not conclusive proof that it will continue to do so. 
• regression analysis assumes that the two factors are strongly correlated 
(i.e. linked to each other). The airline firm mentioned above could plot passenger numbers in past years against the average cost of a newspaper on its flights. Regression analysis would calculate the relationship – but there is not likely to be a causal link between the two, giving rise to misleading forecasts. 
• regression analysis is only likely to be accurate within the range of the 
past data collected. 
• it can be very difficult to accurately build in seasonal and other fluctuations 
into time series analysis, meaning that forecast results using this method can be inaccurate. 
Other forecasting models  
System modelling 
Many large firms seek to develop sophisticated programmes to model economic 
systems, market competition and so on. 
The difficulty lies in identifying all the variables and defining how they relate to 
each other. 
A number of software products are available to help with this. Most large 
accounting packages will include forecastin g facilities, and En terprise Resource 
Management (ERM) software generally includes facilities to model business 

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Intuitive forecasting methods 
What distinguishes intuitive techniques is the relative emphasis they place on 
judgement, and the value of such techniques lies not in their statistical sophistication but in the method of systematising expert knowledge. 
Intuitive forecasting techniques include the use of think tanks, Delphi methods, 
scenario planning, brainstorming and derived demand analysis. 
 
 Intuitive forecasting methods 
 Think tank 
A think tank comprises a group of experts who are encouraged, in a 
relatively unstructured atmosphere, to speculate about future developments in particular areas and to identify possible courses of action. The essential features of a think tank are: 
• the relative independence of its members, enabling unpopular, 
unacceptable or novel ideas to be broached 
• the relative absence of positional authority in the group, which 
enables free discussion and argument to take place 
• the group nature of the activity that not only makes possible the 
sharing of knowledge and views, but also encourages a consensus 
view or preferred scenario. 
Think tanks are used by large organisations, including government, and may cross the line between forecasting and planning. However, the organisations that directly employ, or fund, them, are careful to emphasise that their think-tank proposals do not necessarily constitute company or government policy. 
Think tanks are useful for generating ideas and assessing their feasibility, 
as well as providing an opportunity to test out reactions to ideas prior to organisational commitment. 
The Delphi technique 
Delphi seeks to avoid the group pressures to conformity that are inherent 
in the think tank method. It does this by individually, systematically and sequentially interrogating a panel of experts. 
• Members do not meet, and questioning is conducted by formal 
questionnaires. 
• Where the experts are speculating about the future, they are asked 
for subjective probabilities about their predictions. 
• A central authority evaluates the responses and feeds these back to 
the experts who are then interrogated in a new round of questions. 
The system is based on the premise that knowledge and ideas 
possessed by some but not all of the experts can be identified and shared and this forms the basis for subsequent interrogations.

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 Brainstorming  
This is a method of generating ideas. There are different approaches but 
a popular one is for a number of people (no fewer than six, no more than fifteen) drawn from all levels of management and expertise to meet and propose answers to an initial single question posed by the session leader. 
• Each person proposes something, no matter how absurd. 
• No one is allowed to criticise or ridicule another person's idea. 
• One idea provokes another, and so on. 
• All ideas are listed and none rejected at this initial stage. 
• Rationality is not particularly important, but what is essential is that a 
wide range of ideas emerges and in the ensuing discussion that 
these ideas are picked up, developed, combined and reshaped. 
• Only after the session are ideas evaluated and screened against 
rational criteria for practicality. 
Brainstorming provides a forum for the interchange of ideas without erecting the normal cultural, behavioural and psychological barriers that so often inhibit the expression of ideas. 
Derived demand exists for a commodity, component or good because of 
its contribution to the manufacture of another product. 
For example, the demands for the chromium, copper and rubber used in 
the manufacture of many different products, including cars, are derived demands. 
The forecasting technique involves analysing some aspects of economic 
activity so that the level of other aspects can be deduced and projected. The principle is simple, but the practice is complex and costly. 
Take the example of chrome matched with car manufacture. In order to 
forecast the demand for cars (thus chrome) the forecaster will be faced with the mammoth task of analysing an enormous number of influences and correlated factors. 
Due to its cost and complexity the technique has a very restricted use.

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5 Foresight 
 Foresight goes beyond simple forecasting and tries to identify possible 
ways that the future of the organisation could develop. 
The value of strong brands, loyal customers, etc has diminished over time as the 
business environment has become more dynamic. Whereas once a company 
could rely on these things to bring them future success, they are increasingly unable to do so. Organisations must therefore develop vision and foresight. 
For organisations, foresight means not only predicting the future but developing 
an understanding of all the potential changes, which if managed properly could produce many new opportunities. 
By carrying out techniques to develop foresight, management try to shape the 
future, rather than ‘wait’ for it to happen and become a victim of changes they are unable to adapt to. The concept is crucial in the global commercial environment, where technological changes for example, or non-traditional competition can erode a company’s dominant position overnight. 
 
Advantages of foresight 
 In their book ‘Research Foresight: Creating the future’, John Irvine and 
Ben Martin give the characteristics of foresight as the 5Cs: 
• Communication  – bringing together groups of people and providing 
a structure in which they can communicate. 
• Concentration  – on the longer term. 
• Coordination – enabling different groups to harmonise their future 
R&D activities. 
• Consensus – creating a measure of agreement on future directions 
and research priorities. 
• Commitment  – to the results among those who will be responsible 
for translating them into research advances, technological 
developments and innovations for the benefit of society. 
Techniques to improve an organisation’s foresight include: 
• Scenario planning  – see below. 
• Visioning  – involves management developing a ‘mental image’ of the 
organisation in the future. This should be realistic, attractive and better 
than the company’s current state. Management can then devise ways to reach this future ideal. 
• The Delphi method  – see above. 
• Morphological analysis  – the systematic investigation of all the 
components of large-scale problems. A matrix is used to identify new, reasonable combinations of these components that could result in plausible new outcomes.

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• Relevance trees  – start with a clear goal, which is traced back through 
the trends and events on which it depends so that the organisation can 
determine what needs to change or be developed for the desired outcome to be achieved. 
• Issues analysis  – issues arise through the convergence of trends and 
events. Potentially significant issues should be analysed in terms of probability and impact (i.e. risk). 
• Opportunity mapping  – identifying gaps in the current environment in 
order to reveal new business opportunities. 
• Cross impact analysis  – involves recording events on a matrix and at 
each matrix intersection analysing how the event in the row could affect the likelihood of occurrence of the event in the column. 
• Role-playing  – a group of people are given a description of a hypothetical 
future situation and are told to behave as they believe they would if that situation were true. 
 
 Y plc is attempting to forecast future events in its market. It has therefore 
hired a number of industry experts to identify possible developments over the next ten years. Y plc wishes to avoid any risk of the experts it has hired simply conforming with each other’s opinions, so it has decided to interrogate them by questionnaire, meaning that they will never meet in person. 
Which ONE of the following approaches to forecasting is Y adopting? A Think tank B Brainstorming C Derived demand D Delphi method 
6 Scenario planning 
Competence slip and organisational failure have been linked to the notion that 
management have failed to grasp the way that society is moving and have not conceptualised a possible future ecosystem. It has been suggested that managers need a picture or scenario of where the world may be in a few years' time. 
For example, how would an accountancy training college meet its objectives 
under the following circumstances: 
(1) a merger between three accountancy bodies (2) wide demand for computer-based training (3) changes to immigration laws leading to a reduction in the number of 
overseas students.

248  
The steps involved in scenario planning 
Scenario planning involves the following steps: (1) Identify high-impact, high-uncertainty factors in the environment. 
Relevant factors and driving forces could be identified through a strategic 
analysis framework such as a PESTEL analysis. Once identified, factors need to be ranked according to importance and uncertainty. 
For example, in the oil industry there may be a need to form a view of the 
business environment up to twenty-five years ahead and issues such as crude oil availability, price and ec onomic conditions are critical. 
(2) For each factor, identify different possible futures. 
For example, oil companies would consider possible political uncertainty in oil-producing countries and the attitudes of future governments to climate change, pollution and energy policy. 
Precision is not possible but developing a view of the future against which 
to evaluate and evolve strategies is important. 
At 3M, for example, the general manager of each business unit is required 
annually to describe what his or her industry will look like in fifteen years. 
(3) Cluster together different factors to identify various consistent future 
scenarios. 
For example, two key factors may have been identified as: (a) the threat of new entrants (b) new legislation that may reduce the potential for profit. Clearly, if new legislation is passed that reduces industry profit potential, 
then the likelihood of new entrants will fall. 
This process usually results in between seven and nine mini-scenarios. 
(4) ‘Writing the scenario’ – for the most important scenarios (usually limited to 
three), build a detailed analysis to identify and assess future implications. As part of this, planners typically develop a set of optimistic, pessimistic 
and most likely assumptions about the impact of key variables on the company’s future strategy. 
The result of this detailed scenario construction should include: – financial implications – anticipated net profits, cash flow and net 
working capital for each of three versions of the future 
– strategic implications – possible opportunities and risks – the probability of occurrence, usually based on past experience.

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(5) For each scenario, identify and assess possible courses of action for the 
firm. 
For example, Shell was the only major oil company to have prepared for 
the shock of the 1970s oil crisis through scenario planning and was able to respond faster than its competitors. 
Some strategies make sense whatever the outcome, usually because they 
capitalise on or develop key strengths of the firm. For example, the firm concerned may have a global brand name and could seek to strengthen it by increasing its advertising spend in the short term. 
However, in many cases, new resources and competences may be 
required for existing strategies to succeed. Alternatively, entirely new strategies may be required. 
(6) Monitor reality to see which scenario is unfolding. 
(7) Revise ("redeploy") scenarios and strategic options as appropriate. 
Construction of scenarios 
These need to be well thought out if they are to be effective. Hence the 
following should be considered: 
• use a team for a range of opinions and expertise 
• identify time-frame, markets, products and budget 
• stakeholder analysis – who will be the most influential in the future? 
• trend analysis and uncertainty identification 
• building of initial scenarios 
• consider organisational learning implications 
• identify research needs and develop quantitative models. 
As mentioned above, Shell makes use of scenario planning extensively in order 
to predict future changes in the energy industry so that it can attempt to prepare for them. 
 
How useful is scenario planning? 
 The downside 
• Costly and inaccurate – uses up substantial resources and time 
• tendency for cultural distortion and for people to get carried away 
• the risk of the self-fulfilling prophecy, i.e. thinking about the scenario 
may be the cause of it 
• many scenarios considered will not actually occur.

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 The upside 
• Focuses management attention on the future and possibilities 
• encourages creative thinking 
• can be used to justify a decision 
• encourages communication via the participation process 
• can identify the sources of uncertainty 
• encourages companies to consider fundamental changes in the 
external environment. 
 
 Which THREE of the following are disadvantages of scenario planning? 
A Bounded rationality 
B Reduced communication within the organisation C High cost D Risk of self-fulfilling prophecy E Wastes management time F Discourages creative thinking 
 
 Test your understanding 8 – UHJ – (Case style) 
 UHJ is a multinational company, based in Europe, which manufactures 
aircraft components. This is a fast–moving, dynamic market with a large 
number of innovative competitors attempting to take UHJ’s market share. 
UHJ recently expanded into the North American market and set up a new 
division with two factories on the west coast. Since this expansion, however, the North American market has been hit by a significant economic downturn. This downturn has continued for the last year and analysts are uncertain of how far and when it will recover. 
This has led to a large reduction in orders for aircraft components and 
has meant that the North American division of UHJ is now barely breaking even. Its future profitability for the next few years depends on a large order from a North American airline, VTH. VTH will announce a 
decision on this order next month.

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 UHJ has recently been approached with an offer by one of its rivals to 
buy the factories for what UHJ considers to be a fair price. UHJ wishes to 
avoid closing the factories as it feels that the closure costs and redundancy payouts that would be required would be extremely high. 
Your manager has recently attended a seminar on scenario planning, but 
is concerned that he did not fully understand what is involved. 
He has asked you to prepare him some briefing notes, explaining what 
scenario planning is and how it would benefit UHJ.  
Required: 
Prepare the briefing notes as requested by your manager. 
 
 Test your understanding 9 – NSF – (Case style) 
 The National Sports Foundation (NSF) for Country Z is a public body 
which operates within the central government department for Sport and 
Culture. NSF’s role is to support and develop a sporting environment across all communities in Country Z and to increase the number of people participating in sport. 
NSF is mainly funded by the Government of Country Z. Up until 2010, it 
employed several hundred staff and also relied upon thousands of volunteers throughout Country Z to run the various sporting clubs and associations, such as amateur football clubs and children’s out of school sports activities. Following cuts in  Government funding in 2010, NSF’s 
level of staffing was considerably reduced. This resulted in NSF relying more on private sector partnerships and volunteers. 
Until three years ago, the economic, social and technological 
environment in Country Z had been relatively stable, with NSF receiving guaranteed funding from the Government and the numbers of sports participants and volunteers being reasonably predictable. Therefore, the Board of NSF has not considered frequent and regular environmental analysis to be necessary. 
NSF’s Board has been taken by surprise by the changes that have 
occurred in the environment in the last three years. In addition to Government funding cuts, local administrative government bodies have been forced to sell off local community sports grounds and facilities to raise finance. Furthermore, the level of financial and operational support provided by private sector organisations has also declined due to similar economic challenges. Increasingly stricter regulations and rules have resulted in fewer volunteers throughout the country. The rapid growth in technology-based entertainment products has been blamed for the reduction in the number of young people participating in sports. In addition, NSF has failed to consider the changing demographics and ageing population of Country Z and the impact that this will have on sports participation in future years.

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 The Chairman of the Board of NSF has recently attended several 
conferences where the value of undertaking thorough ‘environmental 
analysis’ has been discussed. The Chairman now realises that there is a serious gap in NSF’s knowledge about the environment in which it operates. He considers that if NSF is to continue successfully in the future then it must improve its foresight to actively plan for the future. 
The Chairman has therefore contacted you and asked you to produce 
some briefing notes to help him apply this knowledge to NSF. His email is shown below: 
To: A. Waterman From: C. H. Airman Date: 15/08/XX Subject: Scenario planning for NSF Hi A, Hope you are well. As you know I have recently attended a number of 
conferences on foresight and scenario planning and I want to try and decide how they could be applied to NSF. I know this is a topic you have studied recently and I would like you to outline a few things to me. 
To start, please explain the concept of foresight and TWO techniques 
(other than scenario planning) which could be used by NSF in the development of foresight. 
I also need you to analyse each of the key stages that would be included 
in a scenario planning process which could be used by NSF. 
I’m going into a meeting with the other board members about this in 
about thirty minutes, so please email back by then. 
Kind regards C.H. 
Required: 
Draft the email requested by the Chairman. 

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7 Game theoretic approaches to strategic planning 
A key aspect of strategic planning is anticipating the actions of competitors and 
acting accordingly. Game theory has been used to great effect in this matter. 
 
 Game theoretic approaches to strategic planning 
 Game theory 
In many markets it is important to anticipate the actions of competitors as 
there is a high interdependency between firms – i.e. the results of my choice depend to some extent on your choices as well. 
Game theory is concerned with the interrelationships between the 
competitive moves of a set of competitors and, as such, can be a useful tool to analyse and understand different scenarios. 
Game theory has two key principles: (1) Strategists can take a rational, informed view of what competitors 
are likely to do and formulate a suitable response. 
(2) If a strategy exists that allows a competitor to dominate us, then the 
priority is to eliminate that strategy. 
Despite the simplicity of these principles, game theory has become very 
complex. 
Many of the bidders for third-generation mobile phone licences in the 
early 2000s and the governments auctioning those licences used game theory principles. In the UK this resulted in over a hundred rounds of bidding and revenue raised of £22 billion. 
Example 
The most famous example of game theory is the "Prisoner's dilemma" 
game. This can be applied to companies as follows: 
Suppose there are two companies, A and B, who between them 
dominate a market. Both are considering whether to increase their marketing spend from its current low level. 
• If just one firm decides to increase their spend, then it will see their 
returns increase. 
• However, if both increase the spend then both end up with lower 
returns than at present.

254  
 These could be shown by the following pay-off table (figures = net profit). 
  Competitor A 
  High spend Low spend 
Competitor B High spend A = 5 
B = 5 A = 3 
B = 10 
 Low Spend A = 10 
B = 3 A = 7 B = 7 
Viewed individually the dominant strategy for both firms is to invest 
heavily. Taking A's perspective: 
• If B does not increase spending, then the best plan of action for A 
would have been to invest heavily. 
• If B does increase spending, then the best plan of action for A would 
have been to invest heavily. 
However, the end result ("equilibrium") is likely to be that both firms 
increase spending and thus end up worse off than if they had both kept their marketing spend at its current low level. Some degree of collusion to keep the spend low would benefit both parties. 
Note:  The original version of the prisoners' dilemma. 
Suppose two men perpetrate a crime together and are later arrested by 
the police. 
Unfortunately the police have insufficient evidence for a conviction, and, 
having separated both suspects, visit each of them to offer the chance of betraying their accomplice. Suppose the possible outcomes are as follows: 
• If one testifies (defects from the other) for the prosecution against 
the other and the other remains silent (cooperates with the other), 
the betrayer goes free and the silent accomplice receives the full 10-year sentence. 
• If both remain silent, both prisoners are sentenced to only six 
months in jail for a minor charge. 
• If each betrays the other, each receives a five-year sentence. 
Each prisoner must choose to betray the other or to remain silent. Each 
one is assured that the other would not know about the betrayal before the end of the investigation.

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 How should the prisoners act? 
The unique equilibrium for this game is  that rational choice leads the two 
players to both play defect, even though each player's individual reward 
would be greater if they both played cooperatively. 
A common application of this is to price wars. Price wars between two 
evenly matched competitors usually results in lower profits for all concerned and no change in market share. No one wins, except the customer. 
 
 TRT is a large company that manufactures light bulbs. The light bulb 
market has been mature for many years, with little innovation and TRT has only three other rivals in the market – all of roughly equal size to TRT. The markets that TRT operate in have strict legislation restricting collusion between competing companies. 
A new type of lightbulb has recently been developed by an entrepreneur, 
Mr B, which provides the same light as a current lightbulb, but which uses a fraction of the electricity of traditional bulbs and which (in theory) will never need to be replaced. Mr B has stated that he is absolutely unwilling to sell this patented new product exclusively to just one supplier. Instead, he wishes to license the technology to any company w ho is willing to pay 
a fixed annual fee for a pre-set 15 year period. 
TRT’s strategic management accountant has calculated that if TRT is the 
only company that decides to license the new lightbulb, it will earn around $5m each year for the foreseeable future. It will make a loss of around $2m each year if one of its rivals also licenses the product and this loss will widen the more of its rivals decide to enter the market. 
Which ONE of the following options is the most appropriate for TRT to 
take in order to deal with this situation? 
A Attempt to copy the technology behind the new lightbulbs, avoiding 
having to pay a license fee to Mr B 
B Negotiate with rival companies and agree a mutually beneficial 
strategy when negotiating with Mr B 
C Attempt to negotiate an exclusive deal with Mr B D Invest in the new lightbulbs as quickly as possible in the hope that 
rival companies will avoid investing

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8 Real options 
When deciding on a strategic project, there are three possible ‘real options’ that 
a manager may wish to take into account. 
• Option to follow on  
When choosing a project, many managers will make their choice on the 
basis of Net Present Value (NPV). Projects with a positive NPV will be accepted as they increase shareholder wealth. Negative NPV projects will be rejected. 
However, under options theory this may not always be the case. This is 
because a project with a negative NPV could provide the business with the opportunity to invest in other, more profitable projects in the future. 
For example, an electronics company may find that designing, 
manufacturing and selling printers has a negative NPV due to the low prices that can be charged in this market. However, the investment will allow the company to sell a range of ink cartridges that have much higher profit margins and a larger positive NPV. 
• Option to abandon  
If a project requires a large capital investment and has an uncertain outcome, the option to abandon may be valuable. 
For example, if a civil engineering company enters a fixed price contract to 
build a stadium, having an option to abandon the project will significantly 
reduce its risk. Should the costs spiral above the value of the contract, the 
company will be able to abandon the project and limit its losses. 
• Option to delay  
The option to delay the beginning of a project can also be valuable to a business. 
A UK house-building company, for example, may have an option to build 
on a plot of land at any point over the next several years. Unfortunately, due to the current economic downturn, house prices have fallen sharply. The company can therefore delay the building of the homes until the market has recovered and house prices rise to a more acceptable level. 
Generally these options will become more valuable as their duration 
increases and as the level of uncertainty in the project rises. Remember that you will not be asked for complex calculations in this area of the syllabus.

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 UPP is an organisation that sells custom-made accountancy software to 
large or complex organisations. It has recently been approached by the 
government of country L, which wishes to employ UPP to create an accountancy software solution for country L’s national health service, which runs the hospitals and doctors surgeries throughout the country. 
UPP is concerned that the government demands a fixed fee contract. It is 
aware that costs on software development are often hard to accurately estimate and this could lead to UPP making significant losses if the contract becomes more complex than originally anticipated. It is therefore 
negotiating with the government a clause in the contract that will allow 
UPP to exit the contract if costs rise above a certain level. 
Under real option theory, the clause UPP is negotiating is referred to an 
option to _______________. 
Required: 
 
 Which ONE of the following changes would BOTH lead to a rise in the 
value of a real option? 
 Option duration Project uncertainty 
A Increases Increases B Increases Decreases 
C Decreases Increases D Decreases Decreases

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Strengths are internal to the organisation. Note that the opportunity to 
purchase C’s rival would likely be classified as an opportunity. 
 
 The correct answers are: A3, B1, C4, D2 
Increased government subsidies is likely to be identified within a PEST 
analysis, under the ‘economic’ heading. 
Low levels of staff morale is an internal weakness within VVV and would 
be identified within a SWOT analysis. 
Note that it could be argued that increased subsidies could also be 
identified by a SWOT analysis as an opportunity/threat. However, as staff morale would only be identified within a SWOT, these subsidies must have been found by VVV’s PEST analysis (as we must pair each point to one analysis tool). 
After sales care (or service) is part of Porter’s value chain, while 
customer power and its influence over strategy is a key part of the five forces model. 
 
 Corporate appraisal 
A corporate appraisal is an overview of an organisation’s current position. 
It leads on from the internal and external analysis undertaken as part of the business planning process. 
As the company works towards achieving its objectives, the corporate 
appraisal is a summary of the company’s: 
• strengths within the organisation relative to competitors 
• weaknesses within the organisation relative to competitors 
• opportunities available from the external environment 
• threats from the external environment.

260  
 The company must develop a strategy which: 
• capitalises on the strengths 
• overcomes or mitigates the impact of weaknesses 
• takes suitable opportunities 
• overcomes or mitigates the threats. 
In the case of Qualispecs: 
Strengths 
• Reputation for quality. 
Quality is a major reason why people buy products, and continuing 
to build on this reputation will ensure customers continue to buy Qualispecs's products. 
• Financially secure/large cash reserves. 
Qualispecs does not need to rush into the implementation of new strategies. It can take its time to ensure strategies chosen are appropriate for the business and implemented effectively. They also have funds to invest in new ventures without having to raise external funds. 
• Backing of a famous sports star. 
This helps to improve the image of Qualispecs's products which in turn should result in higher sales, particularly amongst the younger market that might be influenced by the sports star. 
• New chief executive. 
The group has a new chief executive who has joined from a rival, Fastglass. Fastglass has been a successful and innovative company and the chief executive may be able to bring new ideas and provide a fresh approach. 
• Established group with many stores. 
The group has a good basic infrastructure including many stores and experienced staff. This allows them to implement new strategies quickly and easily. 
Weaknesses 
• Slower dispensing of spectacles. 
Customer service is worse than competitors in this respect and may 
be a reason for the reducing customer loyalty.

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 • Less trendy products than competitors. 
Some competitors have successfully sold designer frames. These 
are likely to be stylish and trendy compared to Qualispecs' traditional products. Qualispecs may need to update products more often with the latest designs. 
• Smaller product range than competitors. 
Some competitors have a wider product range than Qualispecs. This provides more choice, which may attract customers, and also gives competitors the opportunity to on-sell products, i.e. selling prescription sunglasses at the same time as standard spectacles. 
• Older production methods causing higher costs. 
This will either cause prices to be higher than competitors or margins to be less. In either case competitors have a distinct advantage. 
• Varying performance around the group. 
Little action is being taken to improve performance of poorly performing stores causing varying performance around the group. This indicates a weakness in internal control systems and perhaps also in development and training programmes. 
• Little autonomy for shops. 
Without autonomy there is little a shop manager can do to improve local operations. In London, for instance, pay may need to be higher to attract the right staff. With no local control over pay levels, shop managers may find it hard to employ good staff and hence improve their business. 
This lack of autonomy may also be demotivating to managers. 
Responsibility was one of the major factors outlined by Hertzberg in his motivation theory as a way to motivate staff. 
• No incentive to improve for staff. 
The use of group-based bonuses means that people cannot be rewarded for good individual performance. Individuals have little incentive to improve therefore. 
Opportunities 
Note:  Opportunities should be in relation to the market as a whole. They 
therefore need to be available to all competitors in the market. 
• To adopt new technologies to reduce costs (see earlier) 
• to stock a wide range of up-to-date products (see earlier) 
• consumer spending will continue to increase.

262  
 Despite a slowdown in the economy, consumer spending is likely to 
increase, suggesting an increasing market size in the future. There is 
therefore further opportunity for all competitors to increase sales. 
• Targeting 18- to 30-year-olds. 
The 18- to 30-year-old age group offers a particular opportunity 
since its spending is likely to increase especially quickly. There is therefore an opportunity to understand this group's needs and to target it specifically. 
• Develop a partnership with a high-street shopping group. 
Fastglass has already done this successfully and Qualispecs could follow suit. There are likely to be limited suitable partners so Qualispecs must act quickly before other firms make arrangements with the best partners. 
Threats 
• Intense competition/eroding customer loyalty. 
Existing competitors are adopting new strategies with great success 
(e.g. Fastglass developed joint ventures). This has resulted in Qualispecs' customers moving to competitors, thus reducing profits. This is likely to be a continued threat to Qualispecs, who needs to respond. 
 
 The correct answer is A, C, D 
The manager brings skills in selectin g teams and identifying strategies for 
each game, and is an employee of the organisation. The same can be 
said of the players that make up th e first team squad; their skills are 
unique and cannot be copied. 
The network of clubs within the same group enables Manchester City to 
exploit marketing opportunities in areas of the world where demand to watch Premier League football is growing, as well as to identify players that it might wish to bring into the club. 
The stadium is a tangible asset. 
 
 The correct answer is DIVERSIFICATION By definition.

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 The correct answers are: A, C and D 
 
 UHJ is faced with a dynamic and rapidly changing environment in the 
North American market. Scenario planning is the detailed and credible 
analysis of how the business environment might develop in the future, based on various environmental influences and drivers for change. The target for this analysis should be areas where the organisation considers there to be a high degree of uncertainty or opportunity. 
Scenario planning would therefore enable UHJ to calculate and examine 
various possible strategic outcomes. 
For example, UHJ would be able to examine the possible impact of the 
economic downturn lasting for several years, or alternatively beginning to reverse immediately. It could also compare combinations of events, such as: 
• the sale of the division, followed by an economic recovery, but the 
loss of the VTH order 
• the retention of the division, followed by a continuation of the 
economic downturn, along with the acquisition of the VTH order  
and so on. 
This approach will have two key benefits: (1) It will help the directors of UHJ to see ‘worst-case’ scenarios. 
Should the North American economy suffer a prolonged downturn 
and the division lose the VTH order, there could be a significant impact on the division, along with the rest of the company. This may help the directors to decide how much of a risk maintaining the North American division is and whether it would be best to sell immediately. 
(2) Scenario planning will also help the directors to anticipate potential 
problems with, or opportunities from, the North American division. For example, if UHJ wants to sell the division and the VTH order is lost, the price it achieves from the sale may well be much lower than is currently on offer. Alternatively, the market may recover in the near future and the sale of the division now may compromise UHJ’s future growth prospects.

264  
 To: C.H. Airman 
From: A. Waterman  Date: 15/08/XX  Subject: Re: Foresight Dear C.H. Thank you for your email. I’ve outlined the issues below as requested. Foresight has been described as the ‘art and science of anticipating the 
future’. For organisations such as NSF, foresight not only means predicting the future, but also developing an understanding of all potential 
changes which, if managed properly, could produce many new 
opportunities. There are a number of techniques which can be used to improve the foresight of an organisation. These include: 
Visioning 
A possible or desirable future state of the organisation is developed as a 
mental image by the management of the organisation. This vision may start off vaguely as a dream but should be firmed up into a concrete statement of where the organisation wants to be. The critical point is that the vision articulates a view of a realistic, credible and attractive future for the organisation, which is viewed as being an improvement on the current state of affairs. 
Issues analysis 
Issues arise through the convergence of trends and events. A trend is a 
trajectory that an issue takes because of the attention it receives and the socio-political forces that affect it. This convergence usually manifests itself because there are unfavourable events, which are sudden and unanticipated, public interest develops and becomes more important or there is increased political pressure. The issues should be analysed in terms of their impact on the or ganisation and their probability of 
occurrence. 
Role Playing 
This is where a group of people are given a description of a hypothetical 
future situation and are asked to consider what their role would be. 
Delphi Technique 
This seeks to avoid the group pressures of conformity that are inherent in 
other group based forecasting methods. It does this by interrogating a panel of experts individually and sequentially and is based on the premise that knowledge and ideas possessed by some, but not all, of the experts can be identified and shared and this forms the basis of future interrogations.

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 Others which could be discussed are: 
• Opportunity mapping 
• Cross impact analysis 
• Relevance trees. 
Note:  Your answer only needs to explain two of the above techniques. 
Scenario planning, as a to ol, will provide NSF with  a better understanding 
of what could happen in the environment in which it operates and help to 
minimise surprises. 
The stages could be as follows: (1) Define the scope of the scenario  
NSF will need to decide what knowledge is most important to it. 
Consideration of its most important market segments and customers and the time frame it wishes to consider (i.e. how far into the future) should be paramount. It will need to decide whether the scenario is to be focussed on a specific issue e.g. the impact of the technology on the participation of children or a more blue sky approach where it asks a question such as; ‘what is the future of community participation in sport in Country Z?’ 
(2) Identify and map the major stakeholders  
A consideration of who the main stakeholders are in the sporting environment should be undertaken and how they are likely to drive change over the period under consideration. For NSF this would most probably include the Government of Country Z (as the main funder), its volunteers and its customers. All of these stakeholders would need to be evaluated in terms of their impact and power to influence the future activities of NSF. 
(3) Identify the basic trends and uncertainties affecting the business  
In assessing the trends and factors that would be identified in an environmental analysis and considering how they may change in the future, NSF would most probably want to focus upon the technological advances and the increasing use of the internet by 
children and young adults and its effect upon sport participation. 
Since it is very dependent upon the Government for its revenue it would also consider the trends in the economy which would affect its income. Also the changing demographics would be a major consideration for NSF.

266  
 (4) Identify the key trends and uncertainties  
Of the basic trends that have been identified NSF would need to 
decide which are the key uncertainties. These trends and uncertainties will be the ‘drivers for change’ which will require contingency planning activities and will shape the future of the 
industry. In the case of NSF this would certainly include the declining Government funding and societal and demographic changes. These will be the main drivers forcing change in NSF. 
(5) Construct initial scenario themes, or skeleton outlines  
Possible future scenarios should then be created by forming the key trends and uncertainties into coherent themes. Usually two alternative scenarios are produced but more can be identified if necessary. NSF might develop one scenario where the economy continues to be depressed and funding continues to decline with sport becoming less important to society. This would be the ‘negative’ scenario. The alternative ‘positive’ scenario might feature a booming economy with many members of society both volunteering and actively participating in sport activities. 
(6) Check for plausibility and internal consistency  
Effective scenarios are both internally consistent and plausible. This means that different directions that the trends have taken in the scenario could logically happen together and the events described could happen within the timescale chosen. 
(7) Develop learning scenarios 
The next stage would be to ‘flesh out’ the scenarios so that they 
become full descriptions of the sector and conditions that are expected to prevail in the future timeframe. This is often done by writing a detailed piece of narrative. The managers of NSF would need to consider the detailed aspects of each scenario in terms of impact upon NSF’s staff, possible plans for re-training, more 
detailed financial analysis and an overall view of the sporting environment in Country Z. 
Note:  There is no one perfect method of producing scenario plans and 
the following answer is one of a number of ways in which scenarios can be developed. Candidates will be rewarded for appropriate stages which are applied to the NSF. 
I hope this helps you for your meeting – if you need any more 
information, please let me know. 
Kind regards A.

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The technology is patented, meaning that it cannot be copied. This 
means that A cannot be the correct option. 
B would involve TRT colluding with its rivals, which would likely breach 
the strict anti-trust regulation in its markets. 
C is unlikely to be a success as Mr B has stated that he will not offer an 
exclusive contract to any one company. 
D may be the best approach. If TRT can gain a license from Mr B first, it 
may reduce the chances of a rival company attempting to also obtain a license as doing so would incur significant losses. 
 
 The correct answer is ABANDON 
 
The value of a real option will rise as the project becomes more uncertain 
and as the duration of the option rises.

269 
Strategic options and 
choice 
and develop options (a-b) Discuss how to frame 
key strategic questions and diagnose an organisation’s starting position 
D1: Evaluate options (a) Develop criteria for 
(b) Evaluate options against 
criteria 
(c) Recommend appropriate 
options 
integration of choices into coherent strategy (b) Portfolio analysis 
allocation to support strategy implementation (b) Align resource allocation 
to support strategic choices 
 
  Chapter 
8

Strategic options and choice 
270  
 
1 Strategic evaluation and choice 
Once the position has been identified, the organisation will be aware of the 
environment within which its ecosystem functions, and the current strategic capability of the organisation within that  ecosystem. So the question is "What 
should we do now to enable us to have the best chance of achieving our objectives?" In other words, which strategy should we follow? 
There are many ways to achieve the end result! There is no one strategy that 
should be deployed in any given circumstance, rather a range of possible strategies that could be used singly or jointly. 
2 Key strategic questions 
As part of strategic choice there are three key levels of strategy to consider: 
(1) Where to compete?  
Which markets/products/SBUs should be part of our portfolio? 
(2) How to compete?  
For each SBU, what should be the basis of our competitive advantage? 
(3) Which investment vehicle to use?  
Suppose an attractive new market has been identified. Should the 
organisation enter the market via organic growth, acquisition or some form of joint expansion method, such as franchising? 
3 Strategic options – the strategic models 
There are several models that you must be familiar with. 
• Porter – generic strategies – looks at competitive strategy • Ansoff – product/market matrix – directions for growth 
• Boston Consulting Group (BCG) – growth/share matrix.

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Each of these models suggests several possible strategies that the organisation 
could adopt. The organisation can then pick the one that best fits its circumstances, which it will have identif ied from the internal and external 
analysis that it has undertaken. 
You need to understand the basics of each model. However, the key to 
examination success will be to successfully demonstrate your ability to apply them in a scenario. 
Benefits 
• These models provide a useful starting point for the discursive process as 
they initiate discussion amongst the management teams. 
• They are well-known and as such have credibility. This results in their 
easy application with minimal resistance. 
• They generate options that can be used in the debate and allow 
comparison. 
• They can in some instances be linked to each other to enhance the 
analysis. 
• They can be used simply or be developed into more complicated 
applications. 
Limitations 
• They are simplistic – most are two-by-two models. 
• Given their prominence in management education, undue emphasis tends 
to be placed upon them and there is a tendency at times to think that the 
models will provide a solution. 
• They are dated and were produced when environments were very different. 
They tend to suggest that strategic choice is a straightforward process. 
• They serve as a good basis for analysis, but are not perfect and do not 
apply to every situation. 
4 Porter’s Generic Strategies 
Porter suggests that competitive advantage arises from the selection of a generic strategy which best fits the organisation's environment and then organising value-adding activities to support the chosen strategy. 
 
  Competitive stance 
Strategic 
scope  Broad scope. 
Targets whole 
market. Cost leadership Differentiation 
Narrow scope. 
Targets one 
segment. Focus

272  
Cost leadership  – being the lowest-cost producer. 
Differentiation – creating a customer perception that the product is superior to 
that of competitors so that a premium can be charged, i.e. that it is different and that customers are willing to pay more for this difference. 
Focus  – utilising either of the above in a narrow profile of market segments, 
sometimes called niching. Porter argues that organisations need to address two key questions: 
• Should the strategy be one of differentiation or cost leadership? • Should the scope be wide or narrow? 
He argues that organisations can run the risk of trying to satisfy all three and 
end up being 'stuck in the middle'. This seems to suggest that Porter was advocating that organisations need to make a basic competitive decision early on in the strategic determination process. 
Cost leadership strategy 
This approach is based upon a business organising itself to be the lowest-cost 
producer. 
Note that this does not mean producing an inferior product – cost leadership 
means that the organisation’s product is comparable to those of its rivals, but is made more efficiently. 
Potential benefits are: 
• business can earn higher profits by charging the same price as 
competitors or even moving to undercut where demand is elastic 
• lets a company build defence against price wars • allows price penetration entry strategy into new markets 
• enhances barriers to entry 
• develops new market segments. 
Care needs to be taken when deciding on a pricing strategy as a cost leader. 
Cutting prices to below those of rivals can trigger a damaging price war, as well as potentially suggesting to customers that the product is inferior to those produced by more expensive competitors. Cost leaders may therefore choose to sell their products at a comparable price to those charged by rivals, but earn more profit which can be reinvested (such as in advertising, expansion or research and development) to gain competitive advantage. 
Value chain analysis (see chapter 5) is central to identifying where cost savings 
can be made at various stages in the value chain. Attainment depends upon arranging value chain activities so as to: 
• reduce costs by copying rather than originating designs, using cheaper 
materials and other cheaper  resources, producing pr oducts with 'no frills', 
reducing labour costs and increasing labour productivity

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• achieving economies of scale by high-volume sales allowing fixed costs to 
be spread over a wider production base 
• use high-volume purchasing to obtain discounts for bulk purchase 
• locating in areas where cost advantage exists or government aid is 
possible 
• obtaining learning and experience curve benefits. 
Differentiation strategy 
This strategy is based upon the idea of persuading customers that a product is 
superior to that offered by the competition. Differentiation can be based on product features or creating/altering consumer perception (i.e. through superior brand development to rivals). Differentiation can also be based upon process 
as well as product . It is usually used to justify a higher price. 
Benefits: 
• Products command a premium price so higher margins. 
• Demand becomes less price elastic and so avoids costly competitor price 
wars.  
• Life cycle extends as branding becomes possible – hence strengthening 
the barriers to entry. 
Value chain analysis can identify the points at which these can be achieved by: 
• creating products which are superior to competitors by virtue of design, 
technology, performance, etc. Marketing spend becomes important 
• offering superior after-sales service by superior distribution, perhaps in 
prime locations 
• creating brand strength 
• augmenting the product, i.e. adding to it. 
• packaging the product • ensuring an innovative culture exists within the company. 
Focus strategy 
This strategy is aimed at a segment of the market rather than the whole market. 
A particular group of consumers are identified with similar needs, possibly based upon age, sex, lifestyle, income or geography and then the company will either differentiate or cost focus in that area. 
Benefits: 
• smaller segment and so smaller investment in marketing operations • allows specialisation 
• less competition 
• entry is cheaper and easier.

274  
Requires: 
• reliable segment identification 
• consumer/customer needs to be reliably identified – research becomes 
even more crucial 
• segment to be sufficiently large to enable a return to be earned in the long 
run 
• competition analysis – given the small market, the competition, if any, 
needs to be fully understood 
• direct focus of product to consumer needs. Niching can be done via specialisation by: 
• location 
• type of end user 
• product or product line 
• quality • price • size of customer • product feature. 
If done properly it can avoid confrontation and competition yet still be profitable. 
The attractiveness of the market niche is influenced by the following: 
• the niche must be large enough in terms of potential buyers 
• the niche must have growth potential and predictability • the niche must be of negligible interest to major competitors • the firm must have strategic capability to enable effective service of the 
niche. 
 
Illustration 1 – Cost leadership 
 Casio Electronics Co. Ltd – Casio has sold over 1 billion pocket calculators. 
It follows an industry-wide cost leadership approach. Its calculators are 
certainly not inferior products, being able to perform over two hundred basic scientific functions. How does it do it? Consider its value chain: 
• Operations – mass manufactured in China, which has cheaper 
labour and economies of scale. 
• Operations – ‘buttons’, display and instructions manuals are multi– 
lingual – reducing the need to make calculators specific to one 
• Procurement – mass purchase/production of components. 
• Outbound logistics – packaging is robust, yet allows a considerable 
number of calculators to be shipped at any time.

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 Illustration 2 – Differentiation 
 British Airways (BA) is a multinational passenger airline. It ha s adopted a 
differentiation approach by offering passengers a higher-quality 
experience than many of its rivals. This allows it to charge a premium for its flights compared to many other airlines. Again – examination of its value chain may help to explain how it achieves this: 
• Procurement – prime landing slots are obtained at major airports 
around the world. 
• Procurement – high-quality food and drink is sourced from suppliers. • Operations – well-maintained, clean and comfortable aircraft are 
sourced. 
• Operations – high numbers of attendants on each flight. • Marketing – advertising based on quality of service provided. 
• Human resources – training in customer care and the recruitment of 
high-quality staff. 
 
 Illustration 3 – Focus 
 Ferrari is an example of a company that focuses on a niche market in the 
automobile industry. It produces extremely high quality cars which 
command a high premium price. However, this means that Ferrari only has a very small percentage of the global car market, as the majority of consumers will be unable to afford its high sales prices. 
This is a risk of the focus approach. The niche targeted may be small and 
fail to justify the company's attention. In addition the niche may shrink or disappear altogether over time as consumer tastes and fashions change. 
 
 Limitations of Porter’s generic strategies 
 In spite of its popularity, there are a number of problems with Porter’s 
generic strategies model, including: 
• Porter argues that any business that attempts to adopt more than 
one of the generic strategies will become ‘stuck in the middle’. He 
suggested that this is because a business will be unable to successfully implement more than one at the same time, leading to strategic drift. In reality this may be too simplistic. 
A number of companies do not fit into one of the classic generic 
strategies and adopt a ‘hybrid’ approach. Successful UK supermarket chain Sainsbury’s uses a slogan ‘Live well for less’, suggesting to its potential customer s that its products are both lower 
price than rivals and good quality – both differentiation and cost leadership.

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• Cost leadership in itself may not give competitive advantage. 
Failure to pass on cost savings to customers through lower prices 
may mean that the business fails to gain an edge over rivals. Passing on the cost savings may trigger a price war with rivals, meaning that the company fails to benefit from the strategy. 
• Differentiation may not always lead to a business being able to 
command a high price for its goods. It may be used to generate increased sales volume – which Porter argued was typically the purpose of a cost leadership approach. 
 
 Company W makes motor vehicles. Several years ago, W restructured its 
value chain to significantly reduce production costs and improve quality. This was in response to similar activities by its W’s major rivals. 
Because of this, W has been able to maintain its prices at a similar level 
to those of its competitors, while continuing to produce a wide range of cars that are tailored to a variety of market segments. 
W has recently decided to undertake a significant investment in 
advertising, as it feels that its brand is one of the most recognised in the market. W wishes to further increase the desirability of its brand, which it feels could allow it to raise its prices slightly in the coming year, while still 
maintaining its overall sales volume. 
According to Porter’s generic strategies model, W’s current approach to 
its market is an example of which ONE of the following? 
A Cost leadership B Focus C Stuck in the middle D Differentiation 
 
 Y is a small business that sells furniture in country H. It is considering its 
future corporate strategy. The furniture market is dominated by large manufacturers, who have 
large factories as well as close relationships with key suppliers of raw materials. Y is currently the twentieth largest manufacturer of furniture in country H. 
Y’s market analysis has identified that there are a moderate number of 
self-employed individuals in country H who work from home and who desire standard office furniture that is also fashionable. However, there are several companies who have built up established brand names in this sector of the market.

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Y currently makes furniture for small to medium sized businesses (such 
as desks and office chairs). Products in this segment of the market are fairly generic as businesses typically choose a furniture supplier based on price. There are a large number of other suppliers of this style of furniture in country H – including several of the larger manufacturers. 
Y is concerned that it lacks the appropr iate skills to make other types of 
furniture. Which ONE of the following strategies is the most appropriate for Y to 
adopt? 
A Focus B Differentiation C Cost leadership D Y is stuck in the middle 
 
 Test your understanding 3 – AVA – (Case style) 
 You work as a strategic management accountant for AVA, an airline 
company that offers regular passenger flights from several countries in 
country L to destinations all over the world. 
AVA is a long-established company which has historically offered a low-
cost service with few passenger comforts or luxuries. Customers have to book seats online, with no chance for interaction with an AVA staff member. Seats (which are renowned by customers for their lack of leg room) cannot be pre-booked and AVA has a poor record for delays and cancellations. 
In spite of this, AVA has managed to achieve reasonable profits by being 
able to offer its flights at extremely low prices. In recent years, however, the company’s profits have fallen as the economy of country L has started to recover from a long recession. This has led the company to start looking at ways of improving profitability. 
You have been contacted by the Finance Director (FD) of AVA. His email 
is shown below: 
To: H. Pimm From: FD  Date: 16/09/XX Subject: AVA Strategic direction Hi H, As you know, last year the directors felt that the company was missing 
out on the lucrative first class service market – currently dominated by several major international airlines which are significantly larger than AVA. While first class travellers require more services and better facilities, we would be able to charge them a relatively high ticket price.

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The company therefore converted the front section of several of its 
aircraft into ‘first class’ with fewer seats and more leg room. Passengers book these seats through a separate system which enables them to speak to an adviser if they had any problems. AVA also offers free food and drink on the flight to first class passengers. This service is not be available to standard class customers. 
The airplanes AVA upgraded were all based on one of its major routes. 
Unfortunately, uptake was disappointing and AVA wishes to try and understand why. 
The directors would like you to evaluate our first class offering. They feel 
that examining our existing and first class strategies using Porter’s generic strategies would be a good place to start. 
Please have the report on my desk in thirty minutes, so I have time to 
consider it before speaking to the other directors. 
Thanks FD 
Required: 
Draft the report as requested in the FD’s email. 
5 Ansoff 
The product/market growth framework A commonly used model for analysing the possible strategic directions that an 
organisation can follow. Hence useful in areas of strategic choice:

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Market penetration 
The main aim is to increase market share using existing products within existing 
markets. 
Approach 
First attempt to stimulate usage by existing customers:  
• new uses of advertising 
• promotions, sponsorships 
• quantity discounts. 
Then attempt to attract non-users  and competitor customers  via: 
• pricing 
• promotion and advertising 
• process redesign, e.g. Internet/e-commerce. 
Key notes: 
Considered when: 
• overall market is growing • market not saturated 
• competitors leaving or weak 
• strong brand presence by your company with established reputation 
• strong marketing capabilities exist within your company. 
Market development 
Aims to increase sales by taking the present product to new markets (or new 
segments). Entering new markets or segments may require the development of new competences which serve the particular needs of customers in those segments, e.g. cultural awareness/linguistic skills. 
Movement into overseas markets is often quoted as a good example as the 
organisation will need to build new com petences when entering international 
markets. 
Approach 
• Add geographical  areas – regional and national 
• add demographic areas – age and sex 
• new distribution  channels.

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Key notes 
• Slight product modifications may be needed 
• advertising in different media and in different ways 
• research – primary research at this point given significance of the 
• company is structured to produce one product and high switching costs 
exist for transfer to other product types 
• strong marketing ability is needed, us ually coupled with established brand 
backing, e.g. CocaCola. 
Product development 
Focuses on the development of new products for existing markets. 
Offers the advantage of dealing with known customer/consumer bases. 
Approach: 
• develop product features of a significant nature • create different quality versions. 
Key notes: 
Company needs to be innovative and strong in the area of R&D and have an 
established, reliable marketing database. 
Constant innovation allows for the developing sophistication of consumers and 
customers and ensures that any product-related competitive advantage is maintained. 
Diversification 
The risky option? 
Approach: 
New products to new markets. 
Key notes: 
Appropriate when existing markets are saturated or when products are reaching 
the end of their life cycle. It can spread risk by broadening the portfolio and lead to ‘synergy-based benefits’, allegedly. 
This goes through periods of being in and out of favour and the debate is 
always continuing as to whether this is a good strategic option. Critics argue that it is madness to take resources away from known markets and products only to allocate them to businesses that the company essentially knows nothing about. This risk has to be compensated for by higher rewards, which may or may not exist.

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Brand stretching ability is often seen as being the critical success factor for 
successful diversification – this is a possible discussion point. The new 
business and its strategy may well have 'teething problems' with its implementation and this may damage brand reputation. 
Reasons suggested: 
• Objectives can no longer be met in known markets – possibly due to a 
change in the external environment. 
• Company has excess cash and powerful shareholders. 
• Possible to 'brand stretch' and benefit from past advertising and promotion 
in other SBUs. 
• Diversification promises greater returns and can spread risk by removing 
the dependency on one product. 
• Greater use of distribution systems and corporate resources such as 
research and development, market research, finance and HR leading to 
synergies. 
Overall 
It is worth noting that, unlike Porter’s generic strategies model, Ansoff does not argue that a business should only adopt one of the four possible strategies. It is 
possible for an organisation to adopt multiple strategies simultaneously. For example, UK retailer Marks and Spencer has launched a number of new advertising campaigns designed to boost sales of its products (market penetration), while also offering its existing food ranges in motorway service stations (market development). 
 
Illustration 4 – Ansoff 
 • Kellogg’s have repositioned their products through various 
advertising campaigns ( market penetration ). For example, the 
‘have you forgotten how good they taste?’ campaign was to remind 
adults, who buy cereals for their children, of the virtues of their product. 
• Kwik Fit, a motor repair company, took the opportunity to cross sell 
insurance to customers on their database who had visited their outlets to have equipment fitted ( product development –
‘piggybacking’ ). 
• Kaplan now sell their ACCA courses in Eastern Europe and Asia, 
amongst other countries, rather than just their traditional UK markets ( market development ). 
• Virgin, a multinational conglomerate, has expanded into a wide 
range of different activities, including airlines, trains, cosmetics, wedding wear and so on ( diversification ).

282  
 Limitations of Ansoff’s matrix 
 Limitations of Ansoff’s matrix include: 
• The matrix is seen as being too simplistic as it fails to take account 
of the external environment, such as competitor strategies. For a 
complete picture it is essential that the organisation undertakes detailed external analysis with, for example, SWOT, PESTEL and Five Forces. 
• The matrix focuses on ways that the organisation can grow. In reality, 
not all companies want to grow their business. They may wish to simply defend their current position or may be focused on survival. 
• Any decision made by management using Ansoff’s matrix is 
subjective – the model does not show the company which strategy is optimal. As such, ineffective strategies can still easily be selected. 
 
 Consider the following diagram of Ansoff’s matrix: 
  Market 
  New Existing 
Product New A C 
Existing B D 
Which ONE of the following strategies is located in quadrant B on the above diagram? 
A Market penetration B Product development C Diversification D Market development 
 
 HUF is a business that retails wine, beer and other alcoholic beverages 
through a large number of stores. It has recently launched a new radio 
advertising campaign (HUF’s normal advertising medium) offering discounts to all customers if they spend more than a certain amount of money in one of HUF’s stores. 
According to Ansoff, which type of strategy is HUF adopting in the above 
scenario
? 
A Diversification 
B Market development C Market penetration D Product development

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 Test your understanding 6 – (Integration question) 
 Esso is a successful oil company. It has run a ‘pricewatch’ campaign to 
ensure its fuels are priced at a similar level to supermarkets and other 
competitors. It has expanded its range of products available at Esso minimarkets to include groceries and household goods. It has signed agreements with China to sell fuels there and is contemplating acquisitions of engineering and textiles companies. 
Required: 
Categorise these actions using Ansoff’s matrix. Explain your choices. 
 
 As outlined in Ansoff’s model (see previous section), diversification refers 
to a business entering a new market or industry which it is not currently, 
while also developing new a new product or products for this new market. 
Diversification is usually seen as the riskiest of the growth strategies suggested 
by Ansoff as the business has no experience of the market or the product that it 
is planning to sell. 
6 Diversification 
Diversification can take two  main forms: 
6.1 Related diversification (concentric diversification) 
• Growth into similar industries. • Growth forward into the customer marketplace. 
• Growth backward into the existing supply chain: 
– Vertical backwar d – a company seeks to operate in markets in 
which it currently obtains its resources, e.g. a supermarket producing 
some of the products it buys – the benefit would arise from greater control over resource supply. 
– Vertical forward  – a company seeks to move into its customer base, 
e.g. a brewery establishing its own chain of pubs and off-licences. 
– Horizontal – involves a company entering into complementary or 
competing markets, e.g. Honda motorcycles and cars.

284  
Vertical integration 
Taking over a supplier (backwards vertical integration) or customer (forwards 
vertical integration). Key issues relate to 
• Cost. 
Is it cheaper to make a product in-house and avoid paying towards a 
supplier's profit margin or might the supplier have sufficient economies of scale for them to sell it cheaper than you can make it? 
• Quality. 
Making a component in-house means you can tailor it to your own needs and use proprietary expertise... if you have the necessary resources and competences. 
• Risk/flexibility. 
Outsourcing gives a firm the flexibility to switch suppliers and so exercise buyer power to drive down prices. 
 
 Backward integration refers to developments into activities which are 
concerned with inputs to the company’s present business, for example a company becoming a supplier of its own raw materials. Sometimes this form of integration is called “upstream” integration. 
Forward integration refers to development into activities which are 
concerned with the company’s outputs. For example, a company could set up its own distribution channels rather than relying on outside retailers. Sometimes this form of integration is called “downstream” integration. 
Vertical integration can have important benefits and costs which need to 
be considered in any decision. 
Benefits of integration 
• Economies of combined operations, e.g. proximity, reduced 
handling. 
• Economies of internal control and coordination, e.g. scheduling and 
coordinating operations should be better. Information about the 
market can be fed back to the production companies. 
• Economies of avoiding the market, e.g. negotiation, packing, 
advertising costs are avoided.

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 • Tap into technology. Close knowledge of the upstream or 
downstream operations can give a company valuable strategic 
advantages. For example, computer manufacturers have instituted backwards integration into semi-conductor design and manufacturing to gain a better understanding of the technology and its potential. 
• Safeguarding proprietary knowledge. If a firm makes components 
itself, it does not have to supply specifications to its suppliers; this information therefore stays confidential. 
• Assured supply and demand. The firm will have first call on supplies 
in scarce periods and the greatest chance of having an outlet in periods of low demand. Fluctuations in supply and demand are not eliminated but can, perhaps, be better planned. 
• Reduction in bargaining power of suppliers and customers. Two of 
Porter’s forces on a firm are customer and supplier bargaining power. So if your suppliers are giving you a rough time, take them over or set up your own supply company. Similarly with distribution channels. 
• Enhanced ability to differentiate. More of the product comes under 
your control so you have a greater ability to differentiate it. For example, a specialist chain of shops could be established with a distinctive brand image. 
• Defend against “lock out”. It may be necessary to defend against 
being cut off from access to suppliers or distributors. For example, if a competitor were buying up your suppliers you would have to acquire your own supplier to ensure continued supply of components. 
Costs of integration 
• Increased operating gearing. Vertical integration increases the 
proportion of the firm’s costs which are fixed. For example, if the 
firm were to purchase from an outside source, all those costs would be variable. If the input is produced internally the firm has to bear all the fixed costs of production. Vertical integration increases business risk from this source. 
• Reduced flexibility to change partners. If the in-house supplier or 
customer does not do well, then it is not easy to switch to outsiders. You will probably have to get rid of the in-house company first. 
• Capital investment needs. Vertical integration will consume capital 
resources and must yield a return greater than, or equal to, the firm’s opportunity cost of capital, adjusting for strategic considerations, for integration to be a good choice.

286  
 • Cut off from suppliers and customers. By integrating a firm may cut 
itself off from the flow of technology from its suppliers or market 
research information from its customers. For example, a firm will have to take responsibility for dev eloping its own technology. Other 
potential suppliers may be reluctant to share their technology as they would be supplying it not only to a customer, but a customer who is also a competitor. 
• Dulled incentives. The captive relationship between buyer and seller 
can quickly lead to inefficiencies. These can quickly spread through the group as too high cost products are passed through. 
• Differing managerial requirements. Different businesses need 
different management skills. Because a company is a successful manufacturer, this does not mean that it can turn its hand to retailing with a reasonable chance of success. Many companies have found that they do best doing what they do best. 
Horizontal diversification 
Horizontal diversification refers to development into activities that are 
competitive with, or directly complementary to, a company’s present activities. There are three cases. 
 (a) Competitive products. Taking over a competitor can have obvious 
benefits, leading eventually towards achieving a monopoly. Apart from 
active competition, a competitor may offer advantages such as completing geographical coverage. 
(b) Complementary products. For example, a manufacturer of household 
vacuum cleaners could make commercial cleaners. A full product range can be presented to the market and there may well be benefits to be reaped from having many of the components common between the different ranges. 
(c) By-products. For example, a butter manufacturer discovering increased 
demand for skimmed milk. Generally, income from by-products is a windfall: any you get is counted, at least initially, as a bonus. 
6.2 Unrelated diversification (conglomerate diversification) 
This type of diversification occurs when a business expands into completely new markets or industries with which the business currently shares no common ground. 
Advantages 
Conglomerate diversification tends to occur when there are limited opportunities 
for expansion in the organisation’s current markets. The only way for such a business to grow may be through unrelated diversification. It provides an opportunity for return if there is nothing else to do with the resources. The company may need to be seen as an 'aggressive' organisation and may embark on this course of action in order to appease powerful stakeholder groups.

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The fact that the organisation is operating in a range of different markets 
reduces the organisation’s overall risk. It is unlikely that all of the markets that the organisation operates within will enter decline at the same time, reducing variability of returns. 
Even unrelated markets may have some synergies with each other, which could 
reduce the overall costs of the organisation. 
There is significantly more risk for the organisation if they adopt this strategy as 
they are launching a new, unproven product into a market that they have little experience or knowledge of. This significantly increases the chances of failure. This can be eliminated to a degree by acquiring an existing business in the new target market (thereby acquiring the industry knowledge required). 
For many larger organisations, there will be little gain to shareholders. 
Shareholders are already likely to hold a diverse portfolio of investments, 
meaning that they have already diversified away much of their risk. Diversification by one of the companies that they own shares in will therefore do little to help them. 
Attempting to operate in new industries may mean that management lose focus 
on the core markets that the company currently operates within. This could lead to reduced returns for the organisation as a whole. 
 
 Which THREE of the following would be likely reasons for an organisation 
to adopt an unrelated diversification strategy? 
A Reduced risk for diversified institutional shareholders B Increased synergies C Reduced variability in returns for the organisation D Possibility of ‘brand stretch’ E Increased management focus on core activities F Existing markets are saturated G Improved employee morale

288  
 Test your understanding 8 – C – (Case style) 
 C operates several hundred coffee shops across country U. Its stores 
offer a wide variety of coffee and tea-based drinks that customers can 
either drink on the premises or take away. In addition to drinks, C also offers a range of sandwiches and cakes. 
C has a large number of rivals in the intensely competitive coffee shop 
market in country U, all of which offer a similar range of products to C and at a slightly lower price. 
C has built a reputation for high quality service and is currently the market 
leader, allowing it to achieve high margins on its products – even in the 
current economic downturn in country U. 
This has allowed C to build a significant cash surplus and it is considering 
how to further grow its business. At the most recent meeting of the Board of Directors, three directors made suggestions for how to expand the business. 
The Finance Director (FD) suggested that C should consider offering a 
range of other products in its shops. These would include wine and soft drinks as well as hot food. The cash surplus could be used to re-fit the kitchens of C’s shops and launch a large advertising campaign across the country. The FD suggested that the margins on these items were even higher than those currently achieved on coffee, leading to higher profits for C in the future. 
The Marketing Director (MD) disagreed as she felt that C’s coffee shops 
were currently successful and should not be changed. She recommended investing the cash into opening up branches in neighbouring countries. She stated that C’s current branding and product range would be suitable for neighbouring countries with few, if any changes. Many of C’s competitors have already entered the countries surrounding country U. 
The Operations Director (OD), however, stated that he felt that the coffee 
and food market in the region was simply too saturated to make further investment worthwhile. Instead, he feels that C should look to invest in a totally new area. 
A successful online music store has rece ntly posted significant growth in 
profits in country U. The OD has identified this as a high-growth market 
and feels the cash surplus should be used to purchase this business.

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 Required: 
(i) Explain and justify where each of the director’s proposals would be 
placed on Ansoff’s matrix. (Note:  A diagram is NOT required) 
(ii) Identify the strategy suggested by Ansoff that the directors have 
failed to consider and suggest how this could be applied to C. 
(iii) Discuss the advantages and disadvantages of the CEO’s proposal 
to purchase the online music store. 
7 Product Portfolio Theory – Boston Consulting Group (BCG) 
 
Developed originally to assist managers in identifying cash flow requirements of 
different businesses or products within their organisation’s portfolio and to help to decide whether change in the mix of businesses is required. A broad portfolio indicates that a business has a presence in a wide range of products and market sectors – this may or may not be a good thing! 
Using the BCG matrix typically requires four main steps: (1) divide the company into SBUs (2) allocate into the matrix (3) assess the prospects of each SBU and compare against others in the 
matrix 
(4) develop strategic objectives for each SBU.

290  
Relative market share  – the ratio of SBU market share to that of largest rival in 
the market sector. BCG suggests that market share gives a company cost 
advantages from economies of scale and learning effects. The dividing line is set at 1 – i.e. a high market share suggests that the product is a market leader. A figure of 4 suggests that SBU share is four times greater than the nearest rival. A figure of 0.1 suggests that the SBU is 10% of the sector leader. 
Market growth rate  – represents the growth rate of the market sector 
concerned. High-growth industries offer a more favourable competitive 
environment and better long-term prospects than slow-growth industries. The dividing line is set at 10%. 
SBUs are entered onto the matrix as dots with circles around the dots denoting 
the revenue relative to total corporate turnover. The bigger the circle, the more significant the unit. 
Using the matrix 
The model suggests that appropriate strategies would be: 
• hold – adopt strategies to keep the product in its current quadrant – 
i.e. invest heavily in advertising or promotion for a star product in order to 
maintain its current high market share. 
• build  – increase investment in the product in an attempt to boost its 
• harvest  – reduce investment in the product in order to maximise the net 
cash return from the product to the business. 
• divest – disposal/closure of the product in order to release any cash 
currently tied up within it. 
Cash cows – hold or harvest 
These products or SBUs have a high market share in a low-growth market. 
They have usually reached the ‘maturity’ stage of their life cycle (see chapter 4 
for more information on the product/industry life cycle). 
Cash cows, as the name suggests, are usually strongly profit and cash 
generating. This is because they are market leaders with relatively high sales and this has often allowed them to create significant economies of scale. 
The fact that the market is low growth indicates that it is no longer attractive for 
new entrants, or for heavy investment by any participating company. This means that capital requirements are low for the cash cow and that the cost of defensive strategies (such as advertising) are also likely to be fairly low. 
A company will often adopt a harvesting strategy towards its cash cows, 
maximising cash flows by keeping investment to a minimum where possible, while trying to maintain the product and prevent it from entering decline for as long as possible. 
Note that profits from cash cows can be used to support other products in their 
development stage. Therefore for a company to have a balanced portfolio, it needs some of these cash cow products.

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Stars – hold or build 
Stars have high market share in an attractive, high-growth market. They are 
most likely in the ‘growth’ stage of their life cycle. 
As they are likely to be the market leader, they offer attractive long-term 
prospects and, if maintained could one day become a cash cow when the rate of market growth finally slows. 
Stars rarely generate significant amount of cash or profits for the company. 
While they generate high levels of sales, they operate in an attractive, high-growth market meaning that they are likely to be facing significant levels of competition. This requires the company to spend large amounts of money to beat off competitor attack strategies, through marketing and research and development (amongst other things), as well as having to aggressively try and win new customers in the expanding market. 
In addition, in order to sustain the level of growth in the market, stars require 
high levels of capital investment. 
The company therefore usually adopts a ‘build’ strategy, involving heavy 
investment to keep attracting new customers (as well as defending those it already has). 
Question marks (also known as probl em children) – build or divest 
Questions marks have low market share in an attractive, rapidly growing 
market. They may be at the ‘growth’ or ‘introduction’ stage of their life cycle. 
Given the rapid growth in the market, there is opportunity for significant 
development of question marks. However, given the currently low market share, there is high risk of failure – the product may fail to grow its market share and will not therefore become a star. 
As such, management typically adopts a ‘double or quits’ approach to question 
marks. If they feel that the product stands a good chance of success, they will 
adopt a build strategy and try to grow market share through heavy investment in expansion, marketing and promotion. If they are not confident in the future success of the product, they may choose to divest, exiting the market. 
Ultimately, question marks are risky – they will usually absorb substantial 
management time and cash and may not be successfully developed. 
Dogs – harvest or divest 
Dogs have a low market share of a slow growing (or even contracting) market. It 
may be a product which has entered the ‘decline’ stage of its life cycle, or could even be a question mark that never successfully grew. It is likely to be making small profits or losses and will be fairly cash neutral. 
There is usually seen as being little point for the business to try and grow 
market share. The market is no longer attractive and it is dominated by other, rival products. To invest in the dog would require significant cost and risk, with relatively little chance of a reasonable return. This most commonly leads to the BCG matrix suggesting that the product is divested.

292  
However, it is important not to divest the product without further analysis. Some 
dog products support other, more valuable products sold by the business. For example, a computer printer manufacturer may accept a ‘dog’ printer model as it allows them to sell more valuable ink cartridges, which enjoy very high profit margins. Alternatively a ‘dog’ product may be used as a retailer as a loss leader to attract customers. 
The dog may also still be profitable. Th ere is little point divesting a product 
which is still making acceptable returns and may still be helping to earn 
shareholders money. 
Be aware that sometimes dogs cannot be divested – particularly in the public 
sector where failing schools for example will need to be reinvested in and possibly restructured but certainly not divested. 
Whatever the reason for keeping the dog, a harvest strategy would be adopted, 
keeping costs low and maximising what little profit or cash flow can be made from the product. 
BCG recommendations 
Once the company has completed its portfolio analysis, it can identify a number 
of overall portfolio issues: 
• Is the portfolio in balance? While the business does not necessarily need 
any dog products, it would expect to have products in the other three 
quadrants of the grid. It needs cash cows to support stars and develop question marks, but if it only has cash cows it may find that they all enter decline at the same time – stars and question marks may be the successful products of the future. 
• Some less attractive parts of the portfolio may be divested – in particular 
dog products (if not profitable or support for other products) and question marks that the management lacks confidence in. 
 
Limitations of the BCG 
 Limitations 
• Simplistic – only considers two variables 
• connection between market share and cost savings is not strong – 
low-market share companies use low-share technology and can 
have lower production costs 
• cash cows do not always generate cash – cash cows may still 
require substantial cash investment just to remain competitive and defend their market share.

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 • fail to consider value creation – the management of a diverse 
portfolio can create value by sharing competencies across SBUs, 
sharing resources to reap economies of scale or by achieving superior governance. BCG would divert investment away from the cash cows and dogs and fails to consider the benefit of offering the full range and the concept of 'loss leaders'. 
• over-emphasis on being the market leader – many companies have 
products that are not market leaders, but which are highly profitable. 
 
 You have been given the following data regarding four products currently 
sold by company YX: 
Product Revenue –
total 
market 
($m) Revenue 
– YX 
($m) Market 
share of 
largest 
competitor Market 
growth 
rate 
Whizz 400 40 45% 1% 
Bang   60 20 10% 4% 
Wallop 100 5   1% 15% 
Pop   96 4.8 30% –5% 
Show where each product would be categorised using the BCG matrix below. You can place more than one product in each category. 
 
Stars 
  
 Question marks   
 
Cash cows 
 
 Dogs

294  
 O sells four products. 
Product H1 is a type of protective shoe. It has recently lost its market 
leader position as the market for protective clothing continues to shrink. Financially, H1 is breaking even. 
Product E2 is a vented umbrella. It has only recently been launched and 
has yet to see strong sales growth in the market. O feels that the umbrella market is likely to grow strongly over the next few years due to global warming. 
Product Y4 is a waterproof coat. It is the top selling coat in O’s market 
and, as with product E2, O expects ongoing growth due to the changing 
climate. 
Finally, product B3 is a waterproof boot. B3 is far superior to the market 
leaders, but is struggling to gain acceptance in the popular, rapidly growing footwear market. 
According to the BCG matrix model, which ONE of the above four 
products would O be most likely to adopt a holding strategy for? 
A H1 B E2 C Y4 D B3

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 Test your understanding 11 – GC – (Case style) 
 GC is a conglomerate that comprises five strategic business units 
(SBUs), all operating as subsidiary companies. Your manager has sent 
you an email attachment which gives information relating to each SBU (and the market leader or nearest competitor): 
Current market share 
 GC 
% Market 
leader 
% Nearest 
competitor 
% Market 
growth 
expected 
by GC  
Building brick 
manufacturer 
(Declining profitability) 3 25  Small 
Parcel carriage service 
(Long established, 
faces strong 
competition. Turnover and profitability over last three years have been stable but are expected to decline as competition 
strengthens) 1 6  Nil 
Food manufacturer 
producing exclusively 
for household 
consumption 
(Long established with 
little new investment. 
High levels of turnover and profitability, which 
are being sustained) 25  5 Slowly 
declining 
Painting and 
decorating 
contracting company 
(Established three 
years ago. Continuous capital injections from group over that period. Currently not making 
any profit) 0.025 0.5  Historically 
high but 
now 
forecast to 
slow down

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Software development 
and supply company 
(Acquired two years 
ago. Market share expected to increase over next two years. Sustained investment from the group but 
profitability so far low) 10  8 Rapid 
Your manager has left a note on your desk asking you to prepare briefing 
notes for him covering the following issues: 
(a) Comment on GC's overall competitive position by applying the 
Boston Consulting Group growth/share matrix analysis to its 
portfolio of SBUs. 
(b) Discuss how GC should pursue the strategic development of its 
SBUs in order to add value to the overall conglomerate group. 
Required: 
8 Methods of growth 
Businesses may choose to grow in one of several main ways, including 
acquisitions, mergers or organic growth. 
8.1 Acquisition 
 
 Acquisition refers to a corporate action in which a company buys most, if 
not all, of the target company's ownership stakes in order to assume control 
of the target firm.  
 
 Illustration 5 – Facebook 
 Facebook has grown its presence in the social media industry through 
the acquisitions of Whatsapp in February 2014 for an estimated $22 billion and Instagram (2012 – $1 b illion). It also repor tedly tried to 
acquire Snapchat in 2013 for $3 billion, but the Snapchat CEO Evan Spiegel refused to agree to a sale.

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8.2 Merger 
 
 Mergers are business combinations that result from the creation of a new 
reporting entity formed from the combining parties. 
 
 Illustration 6 – Sainsburys and Asda 
 In April 2018, UK supermarket giants Sainsburys and Asda announced 
that they were to merge. This was in response, in part, to the growing threat from discount food retailers Aldi and Lidl. However, there is considerable doubt as to whether the deal will be allowed to proceed due to concerns on the part of the Competition Authority over whether the deal is in the public interest (the merged entity would have too great a market share and therefore restrict choice for the consumer). 
Note that, for our purposes in the E3 examination, there is little or no strategic difference between an acquisition and a merger. 
8.3 Organic growth 
 
 Organic growth is growth through internally generated projects, such as 
increased output, customer base expansion, or new product development. 
 
 Illustration 7 – Sainsburys and organic growth 
 As well as looking to grow by acquisition or merger, Sainsburys has also 
adopted strategies of organic growth in the UK. It increased the number of edge of town supermarkets it operated by identifying suitable locations, applying for planning permission, building premises and then opening for trade.  
It increased the range of products in-store, adding items such as books, 
dvds, clothes etc. to the more traditional foodstuffs. 
It also branched out into convenience stores, opening a chain of 
Sainsburys Local stores in high street locations. 
The above growth strategies were largely by organic means. 
Acquisition may be more expensive than organic growth because the owners of 
the acquired company will need to be paid for the risks they have already taken. On the other hand, if the company goes for organic growth it must take the risks itself so there is a trade-off between cost and risk. 
A company can gain synergy by bringing together complementary resources in 
their own business and that being acquired. Synergy is defined as 'the 
advantage to a firm gained by having existing resources which are compatible with new products or  markets that the company is 
developing' .

298  
For example, sales synergy may be obtained through the use of common 
marketing facilities such as distribution channels. Investment synergy may result from the joint use of plant and machinery or raw materials. 
An acquisition must add value in a way the shareholder cannot replicate in 
order to avoid the risks a ssociated with diversified companies (see Ansoff). 
 
 Acquisition v organic growth 
 Advantages of acquisitions over organic growth 
Acquisition has some significant advantages over internal growth. 
• High-speed access to resources – this is particularly true of brands; 
an acquisition can provide a powerful brand name that could take 
years to establish through internal growth. 
• Avoids barriers to entry – acquisition may be the only way to enter a 
market where the competitive structure would not admit a new member or the barriers to entry were too high. 
• Less reaction from competitors – there is less likelihood of 
retaliation because an acquisition does not alter the capacity of the competitive arena. 
• It can block a competitor – if Kingfisher’s bid for Asda had been 
successful it would have denied Walmart its easy access to the UK. 
• It can help restructure the operating environment – some mergers of 
car companies were used to reduce overcapacity. 
• Relative price/earnings ratio – if the P/E ratio is significantly higher 
in the new industry than the present one, acquisition may not be possible because it would cause a dilution in earnings per share to the existing shareholders. But if the present company has a high P/E ratio it can boost earnings per share by issuing its own equity in settlement of the purchase price. 
• Asset valuation – if the acquiring company believes the potential 
acquisition’s assets are undervalued, it might undertake an asset-stripping operation. 
Disadvantages of acquisitions growth 
There are some disadvantages associated with this method of growth . 
• Acquisition may be more costly than internal growth because the 
owners of the acquired company will have to be paid for the risk already taken. On the other hand, if the company decides on internal growth, it will have to bear the costs of the risk itself. 
• There is bound to be a cultural mismatch between the organisations 
– a lack of ‘fit’ can be significant in knowledge-based companies, where the value of the business resides in individuals.

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 • Differences in managers’ salaries – another example of cultural 
mismatch that illustrates how managers are valued in different 
• Disposal of assets – companies may be forced to dispose of assets 
they had before the acquisition. The alliance between British Airways and American Airlines was called off because the pair would have had to free up around 224 take-off and landing slots to other operators. 
• Risk – of not knowing all there is to know about the business it 
seeks to buy. 
• Reduction in return on capital employed – quite often an acquisition 
adds to sales and profit volume without adding to value creation. 
9 Joint methods of expansion 
Mention has already been made of the importance of networks within an organisational ecosystem. In some situations it might lead to greater value being created if an organisation adopts a collaborative approach to strategy i.e. it works in partnership in some way with another organisation or organisations. For example, sales synergy may be obtained through the use of common marketing facilities such as distribution channels. Investment synergy may result from the joint use of plant and machinery or raw materials. 
There are a number of joint development methods that you should be aware of. 
Joint development methods 
• Joint venture • strategic alliances 
• franchising 
• licenses 
• outsourcing. 
In any joint arrangement key considerations are 
• sharing of costs 
• sharing of benefits 
• sharing of risks • ownership of resources 
• control/decision making.

300  
 Joint development methods 
 Joint venture 
A separate business entity whose shares are owned by two or more 
business entities. Assets are formally integrated and jointly owned. 
A very useful approach for: 
• sharing cost • sharing risk 
• sharing expertise. 
In the UK, an example of a joint venture is Virgin Trains – a company 
whose share capital is 51% owned by the Virgin Group and 49% owned by Stagecoach. The joint venture allowed the two companies to work together to take advantage of the privatisation of the nationalised British Rail. 
A further example is that of Sainsburys Bank, which was originally a joint 
venture between Sainsburys and Bank of Scotland. The joint venture started in 1997, with Sainsburys then taking full control in 2014.  
Strategic alliance 
A strategic alliance can be defined as a cooperative business activity, 
formed by two or more separate organisations for strategic purposes, that allocates ownership, operational re sponsibilities, financial risks, and 
rewards to each member, while preserving their separate identity/ autonomy. 
Alliances can allow participants to achieve critical mass, benefit from 
other participants’ skills and can allow skill transfer between participants. 
The technical difference between a st rategic alliance and a joint venture 
is whether or not a new, independent business entity is formed. A strategic alliance is often a preliminary step to a joint venture or an 
acquisition. A strategic alliance can take many forms, from a loose informal agreement to a formal joint venture. 
Alliances include partnerships, joint ventures and contracting out services 
to outside suppliers. 
Seven characteristics of a well-structured alliance have been identified. 
• Strategic synergy  – more strength when combined than they have 
• Positioning opportunity  – at least one of the companies should be 
able to gain a leadership position (i.e. to sell a new product or 
service; to secure access to raw materials or technology).

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 • Limited resource availability  – a potentially good partner will have 
strengths that complement weaknesses of the other partner. One of 
the partners could not do this alone. 
• Less risk  – forming the alliance reduces the risk of the venture. 
• Co-operative spirit  – both companies must want to do this and be 
willing to co-operate fully. 
• Clarity of purpose  – results, milestones, methods and resource 
commitments must be clearly understood. 
• Win-win  – the structure, risks, operations and rewards must be 
fairly apportioned among members. 
Some organisations are trying to retain some of the innovation and flexibility that is characteristic of small companies by forming strategic alliances (closer working relationships) with other organisations. They also play an important role in global strategies, where the organisation lacks a key success factor for some markets. 
An example of a strategic alliance is that announced by Uber and Volvo 
in August 2016 with a view to developing self-driving (or autonomous) vehicles. Volvo agreed to develop and share base vehicle technology and Uber would develop and add its own self-driving technology. Both companies committed a combined US$300m to the alliance, and this was then taken further when Uber agreed to buy 24,000 vehicles from Volvo in late 2017, Volvo’s biggest corporate sale to date.  
Franchising The purchase of the right to exploit a business brand in return for a 
capital sum and a share of profits or turnover. 
• The franchisee pays the franchisor an initial capital sum and 
thereafter the franchisee pays the franchisor a share of profits or 
royalties. 
• The franchisor provides marketing, research and development, 
advice and support. 
• The franchisor normally provides the goods for resale. 
• The franchisor imposes strict rules and control to protect its brand 
and reputation. 
• The franchisee buys into a successful formula, so risk is much 
lower. 
• The franchisor gains capital as the number of franchisees grows. 
• The franchisor’s head office can stay small as there is considerable 
delegation/decentralisation to the franchisees. 
A classic example of franchising is McDonalds. Within the UK, for 
example, around half of all McDonalds restaurants are franchises.

302  
 Licensing 
The right to exploit an invention or resource in return for a share of 
proceeds. Licensing differs from a franchise because there will be little central support. 
In the UK, many beers such as Heineken and Fosters were ‘brewed 
under licence’ in the UK for many years, with the original companies that developed the beers simply taking a share of the proceeds from the local brewers. 
Outsourcing 
Outsourcing means contracting out aspects of the work of the 
organisation, previously done in-house, to specialist providers. Almost any activity can be outsourced – examples include information technology or payroll. 
Mobile telecommunications company O2 has recently announced plans 
to outsource its customer contact centres in the UK. 
The public sector may also undertake outsourcing. For example, in 2013 
Barnet Council in London announced plans to outsource much of its corporate procurement, IT and HR services to Capita – a private sector company.
 
 H Ltd wishes to rapidly expand its popular chain of retail stores, but does 
not have the capital needed to do so. It has decided to consider joint development methods in order to aid its growth, but H Ltd’s owner T is uncertain about which method to use. 
T is unwilling to allow any other i ndividual or organisation to have 
significant influence over H’s strategic operations as he is used to having 
the final say over all major decisions within the company. 
T wishes to avoid any damage to H’s brand name. As such, he wants 
staff to continue to be trained centrally, as well as all fixtures, fittings and inventory to be purchased from authorised suppliers only. 
Which ONE of the following methods of joint development would be most 
appropriate for H Ltd? 
A Licensing B Franchising C Joint venture D Strategic alliance

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 Test your understanding 13 – (integration question) 
 Which of licensing, joint venture, strategic alliance and franchising might 
be the most suitable for the following circumstances? 
(1) A company has invented a uniquely good ice cream and wants to 
set up an international chain of strongly branded outlets. 
(2) Oil companies are under political pressure to develop alternative, 
renewable energy sources. 
(3) A beer manufacturer wants to move from their existing domestic 
market into international sales. 
10 Divestment 
May occur because: 
• The SBU no longer fits with the existing group. The company may wish to 
focus on core competences. 
• The SBU may be too small and not warrant the management attention 
given to it. 
• Selling the SBU as a going concern may be a cheaper alternative to 
putting it into liquidation if redundancy and wind-up costs are considered. 
• The parent company may need to improve its liquidity position. • There may be a belief that the individual parts of the business are worth 
more than the whole when shares are selling at less than their potential 
value, e.g. ICI's demerger of its bio-sciences business, later called 
Zeneca. 
• An MBO (management buy out) is one way a divestment can occur. 
11 International growth 
When deciding whether to expand abroad, a business has several possible strategies that it can adopt: 
• Exporting strategy  – the firm sells products made in its home country to 
buyers abroad. This often starts with the receipt of a chance order or 
perhaps poor sales at home force the business to export or collapse. 
• Overseas manufacture  – the firm may either manufacture its products in 
a foreign country and then either import them back to its home country or sell them abroad. Either way, the firm is involved in direct foreign investment because it is purchasing capital assets in another country. For example, Nissan Motors is a Japanese company, but operates plants to build its motor vehicles across the world, including North-East England.

304  
• Multinational  – these firms co-ordinate their value-adding activities across 
national boundaries. For example, a multinational car manufacturer will 
have engine plants in one country, car body plants in another and electrics in a third. Production capacity is often duplicated around the world. 
• Transnational  – these are ‘nation-less’ firms that have no ‘home’ country. 
Employees and facilities are treated identically, regardless of where they are in the world. The company may be listed on several national stock exchanges. This is often considered to be (currently) largely theoretical. 
When deciding betw een which approach to take  if expandi ng abroad, 
consideration should be given to the following points: 
• Exposure to risk  – both foreign exchange risk and political risk. 
• Need for capital investment  – this will be lower if an exporting strategy is 
used. 
• Customer relationships  – given the distance between the manufacturer 
and its foreign consumers, this can be hard to maintain in an exporting 
strategy. 
• Transportation costs  – manufacturing at a distance from your target 
market will increase the cost of getting the units to them. 
• Ethical issues  – if operating in countries with less developed labour laws, 
should the company take advantage of this to keep costs low? 
• Cultural issues – managing operations in foreign countries can be difficult 
due to differences in language and customs. This can also make 
advertising and operational control difficult. 
 
 YH operates a large number of food production facilities, based in country 
N. In particular, YH’s operations focus on the growing and harvesting of soft fruit. YH then sorts and grades the fruit, before shipping it to retailers, such as large supermarkets. 
YH has struggled to find the amount of farmland it needs in order to 
expand its production in its home country. In recent years, therefore, YH has been buying farmland and facilities in several new countries around the world. This has allowed it to expand its sales into a number of new geographical markets and grow its business.

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 This business model has been so successful that a significant majority of 
YH’s fruit is now grown abroad, with some of it even being brought back 
into country N to meet demand from YH’s customers. 
Which ONE of the following options is the best match to the international 
growth strategy being adopted by YH? 
A Transnational B Exporting C Multinational D Overseas manufacture  
12 Evaluating strategies – making a strategic choice 
So far in this chapter we have looked at a number of models which provide the 
company with different options for strategies. Management can then select the strategy that they believe is most appropriate for the organisation – for example if following Porter’s generic strategies, managers may decide that a cost leadership approach would be the best strategy to adopt. 
This raises a very important question – how do managers know whether a 
particular strategy should be  adopted by the organisation?  
Strategies need to have 'strategic fit' with their environment if they are to be 
effective. This 'fit' will be with both their internal and external environments and so the ability to assess viability relies very much on the reliability of the position audit. 
Strategic options will be generated by va rious stakeholder groups (and by use 
of the various models discussed earlier in this chapter) and debate/discussion 
will need to follow to assess the viability of each option and make a final selection. 
The final selection will be a function of the following: (1) Relative stakeholder power and their personal characteristics (2) information available and perceived reliability (3) historical experience (4) presentation of options – manner (5) other corporate experiences (6) expectations for the future (7) objectives ordering and perceived ordering – there will be a significant 
political involvement at this stage.

306  
Viability – a basic approach 
According to Johnson and Scholes, potential strategies can be evaluated 
against the following three criteria: 
• Suitability is concerned with whether the strategy addresses the 
circumstances in which an organisation is operating – its strategic position. 
• Feasibility  is concerned with whether the strategy could be made to work 
in practice and as such looks at more detailed practicalities of strategic 
capability. 
• Acceptability is concerned with the expected performance outcomes 
(such as return or risk) of a strategy and the extent to which these would 
be in line with the expectations of stakeholders. 
 
 For a strategy to be accepted, it must meet all three of these criteria. 
Suitability 
Is the proposed strategy a suitable response to environmental events and trends. Do we have strategic fit ? You should consider whether the proposed 
course of action fits with the existing position. Will it cause any problems elsewhere in the company? 
(1) Will it take advantage of opportunities?   
(2) Will it build on our strengths?  
(3) Will it help us meet our mission and objectives?  
(4) How will new products fit with existing ones? Is the new portfolio 
balanced? 
Use within Ansoff's matrix A market development strategy would 'fit' where: 
• Channels of distribution are available 
• a business has a strong marketing presence 
• products are superior to competitors 
• an unsaturated markets exist 
• spare production capacity exists 
• economies of scale are possible. 
A product development strategy would 'fit' where: 
• brand reputation is high 
• the brand is transportable 
• strong research capabilities exist.

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A market penetration strategy would 'fit' where: 
• current markets are not saturated • present customers will rebuy 
• competitors are weak 
• spare production capacity exists. 
A consolidation strategy would 'fit' where: 
• there is a lack of funding • owners do not want to grow 
• human resources not available 
• any kind of restraining factor exists. 
A diversification strategy would 'fit' where: 
• there is a strong brand presence • significant resources are available to enable the development of new 
• market research base is reliable and competent. 
Example 
Gucci sought growth in sales and so expanded into lower-priced goods and 
stretched its brand. It also pushed its products in department stores and duty-free channels. It let its name appear on many licensed products such as watches and perfumes. 
Sales soared – the company was very happy! But it soon found that sales in its traditional high-priced, high-margin segment 
were plummeting as its traditional buyers became disillusioned by the fact that Gucci was now worn by many people thus removing the exclusivity of the product. 
Gucci’s strategy was not suitable. 
Can the necessary resources and competencies be obtained and the required 
changes be implemented? Any new strategy will require change of some kind and this is likely to meet resistance from some quarters. We will need to question whether the company concerned has the strategic capability to pursue the course of action concerned.

308  
So the key questions revolve around: 
(1) Resources – basic and unique. (2) Competences – threshold and core. (3) Implementation issues with regard to dealing with strategic change. Considerations should cover: 
• Cultural change required and realism of change • timescales 
• potential resistance 
• raw materials availability 
• human resources availability 
• distribution channel access 
• marketing requirements 
• IT requirements and skills 
• finance: 
– How much is needed? 
– Where will it come from? – What options exist? – What will the impact be on our financial position and performance? 
Don't forget the basic analysis relating to identifying the threshold and core 
competencies. Are there any sources of competitive advantage or disadvantage? 
Acceptability 
Any proposed strategy will need to be acceptable to the stakeholders of the 
organisation, both in terms of "returns" and risk. 
All stakeholders will need to be considered  relative to their power – the more 
powerful the stakeholder group, the greater the influence they will have and the 
more the strategist will have to consider their views. 
Some areas for consideration: 
• A new strategy usually involves some internal changes and due 
consideration will need to be given to the staff  who may have to confront 
different work practices. Resistance is likely. 
• Financiers often have required rates of return and liquidity positions.

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• Owners  may well have non-financial requirements of their investment. 
They may prefer to have less risk and accept a lower reward as the 
inevitable cost. They could require that all actions conform to their cultural expectations, e.g. Anita Roddick at the Body Shop. 
• Customers, consumers and suppliers  may also have required 
standards that must be met by the company. 
• Local and national governments  may have some concerns about any 
strategic proposals with regard to legality and political implications. 
• Don't forget the public and their ability to form into 'pressure groups'. 
Ethical considerations may need to be included in the evaluation. 
Evaluating "acceptability" will often involve quantitative analysis such as NPV calculations. However, it must be noted that conventional NPV analysis tends to undervalue projects with significant future flexibility. Real option theory, covered in more detail in the F3 paper, is an attempt to incorporate such flexibility into a "strategic NPV". 
Tests of a winning strategy 
The SAF (suitability, acceptability, feasibility) approach is very useful but other 
considerations have been added which are worthy of note. 
The first is referred to as the competitive advantage  test and raises the 
questions: 
• What is it 
• How long can it last? 
The second question highlights that competitive advantage may not be 
sustainable, in other words does the performance measurement  system show 
predicted improvement? 
Thompson  poses this strategic management principle: 
'The more a strategy fits the enterprise's external and internal situation, 
builds sustainable competitive advantage and improves company 
performance, the more it qualifies as a winner.'

310  
 Strategy evaluation – the role of the management accountant 
 Making strategic decisions 
Strategic options can be evaluated using the suitability, feasibility, 
acceptability framework. 
The strategic management accountant will contribute to the acceptability 
and feasibility aspects in particular: 
Aspect Key concerns Typical financial analysis 
Acceptability Returns to 
 • Cash flow forecasts to ensure 
dividend growth requirements 
can be met dividend growth requirements can be met 
• NPV analysis 
• ROCE 
• Valuation of real options 
• Shareholder value analysis 
• Economic value added 
• Cost/benefit analysis 
• Ratio analysis (e.g. dividend 
yield, growth) 
 Risk • Sensitivity • Break-even 
• Ratio analysis (e.g. gearing, 
dividend cover) 
• Expected values 
Feasibility Resources • Cash flow forecast to identify 
funding needs 
• Budgeting resource 
requirements 
• Ability to raise finance needed 
• Working capital implications 
• Foreign exchange implications

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 LL is a company that makes and sells clothing made out of wool. It has 
been having problems manufacturing sufficient garments for its 
customers for several years as demand has increased significantly. LL’s current wool spinning process has been identified as a bottleneck process. 
It is considering the purchase of an automated spinning machine that it 
believes will significantly improve the speed of its manufacturing process. In addition it will allow LL to lay off around fifty members of staff (who are heavily unionised). 
The machine will cost around $5m. LL does not have this cash available, 
but believes that it will be able to raise these funds from its investors. 
LL will only purchase the machine if it is: (i) suitable (ii) acceptable; AND (iii) feasible From the information given above, which ONE of these three criteria does 
the acquisition of the machine meet? 
A Suitable and acceptable only B Suitable only C Acceptable and feasible only D Suitable and feasible only 
 
 When evaluating the acceptability of a new strategy, which ONE of the 
following analysis tools would be the most useful? A BCG matrix B Porter’s five forces C Mendelow’s matrix D Porter’s value chain

312  
 Test your understanding 17 – (Integration question) 
 You work for Blueberry – a quoted resort hotel chain based in Europe. 
The industry 
The hotel industry is a truly global business characterised by the 
• Increasing competition. • An increasing emphasis on customer service with higher standards 
being demanded. 
• In particular the range of facilities, especially spas, is becoming 
more important as a differentiating factor. 
Performance 
• Blueberry offers services at the luxury end of the market only, based 
on a strong brand and prestigious hotels – although its reputation 
has become tarnished over the last five years due to variable customer satisfaction levels. 
• Despite a reputation for having the most prestigious coastal resort 
hotels along the Mediterranean in 20X0, Blueberry was loss-making in the financial years 20X4/5 and 20X5/6. 
• To some extent this situation has been turned around in 20X6/7 with 
an operating profit of €11 million. However, shareholders are putting the board under pressure to increase profits and dividends further. 
• Management have responded to this by setting out an ambitious 
plan to upgrade hotel facilities throughout the company and move more upmarket. The bulk of the finance is planned to come from retained profits as Blueberry has historically kept its financial gearing low. 
Acquisition opportunity 
Your manager has arrived in the office and has said the following: ‘I've just been told that the Board of Blueberry have been approached by 
the owner of ‘The Villa d’Oeste’, a luxury hotel on the shores of Lake Como in Italy, who is considering se lling it. The hotel has an international 
reputation with world-class spa facilities and generates revenue 
throughout most of the year due to Lake Como’s mild micro-climate. The asking price will be approximately €50m. Please spend the next 15 minutes writing some brief notes of issues we should take into account when evaluating the purchase.’ 
Required: 
Draft the notes for your manager. 

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 Test your understanding 18 – GGG – (Case style) 
 You are L. Carter, a strategic management account working for HF&H –a 
large accountancy practise. One of HF&H’s clients is GGG. A partner in 
HF&H has left the following note on your desk: 
Note Hi L, I’m going to be meeting several key managers from GGG shortly and I 
need you to prepare some briefing notes for me. I’ve left you a briefing document giving you some background information about the company. 
Once you've familiarised yourself with the briefing document, please 
prepare some notes, which need to include the following: 
• Analyse the opportunities available to GGG, using Ansoff's strategic 
directional growth vector matrix. 
• Evaluate the opportunities available to GGG in each of the four 
areas of the Ansoff strategic directional growth vector matrix using 
Johnson, Scholes and Whittington's Suitability, Acceptability and Feasibility framework. 
• Recommend, with your justifications, which strategic directions, as 
set out in Ansoff's strategic directional growth vector matrix, would be most appropriate for GGG to follow. 
I'm meeting the clients in 45 minutes, so please have the notes ready by then. 
Thanks P. 
Briefing document – GGG 
GGG is a privately owned unlisted company which runs 20 residential 
care homes for the elderly. A residential care home for the elderly is a building where a number of older people live and receive care (that is, their physical needs are provided for), normally on a full-time basis. The elderly residents may pay the care home fees themselves or they may be paid by their relatives or by the local government authority. 
The elderly residents of GGG’s care homes are all capable of making 
decisions for themselves. All of GGG’s care homes are located in and 
around two cities both located in the south of country X. GGG employs 
around 400 staff in the care homes, some of whom work part-time, and a small team of highly experienced administrators. GGG’s care homes all have modern facilities and their staff are highly trained and dedicated. 
GGG has always been a profitable business, even though its care homes normally have a small amount of spare capacity. GGG has approximately 25% market share in the south of country X. The remainder of the market is shared by a small number of local government funded and operated care homes and some other small private businesses.

314  
 Due to the rising costs of operating care homes as a result of increased 
regulation and the general economic environment, a number of small 
privately owned care homes in the region have recently closed. The owners of some other privately owned care homes are considering closing or selling them. GGG is also aw are that this trend is occurring 
nationally across country X. 
A national shift in the demographics of the population in the last 30 years 
has resulted in a significant rise in the proportion of elderly members of society. Added to this, the increased social movement of families has resulted in an increasing demand for care home places for the elderly. GGG undertakes limited advertising, relying more on word-of-mouth recommendations and referrals from local hospitals and doctors to obtain its customers. 
The prices charged to care home residents by the local government 
authority run care homes are lower than those charged by GGG, due to central government subsidies. However, the Managing Director of GGG is confident that the services and facilities provided by GGG are superior to those offered by the local government funded care homes. 
Although GGG currently offers only full-time care for its elderly residents, 
there is a growing need for the market to offer ‘relief care’ packages. This is where elderly people, who do not normally live in residential care homes, could use any of the 20 care homes’ facilities for short periods of time (normally 1 week), in order to enable their normal carers (usually family members) to take holidays or rest periods. 
A number of GGG’s elderly residents are often referred to local hospitals 
by their doctors for treatments and therapies. Many of GGG’s staff are fully qualified nurses and these treatments and therapies could be undertaken by the staff of GGG in each of its care homes. These hospital visits for treatments and therapies can be disruptive and upsetting for residents who often prefer to remain in GGG’s care homes and be cared for by staff with whom they are familiar. However, if GGG were to offer these additional facilities within its care homes it will need investment in 
training and new facilities. 
Required: 
Prepare the notes as requested in the note from P.

316  
W is currently trying to gain competitive advantage by using its brand 
name to differentiate it from its rivals. 
 
Y appears to be stuck in the middle. Its size prevents it from achieving the economies of scale of its larger 
rivals, meaning that cost-leadership appears unlikely. 
The product that Y currently produces seems to be fairly generic and Y 
seems to lack the skills to do anythi ng different. Note that Y’s current 
customers seem to mainly be interested in price, so a differentiation strategy would be difficult to undertake here. 
Finally, there seems to only be one niche market that Y has identified –
that of home workers. However this is a relatively small part of the market and it appears to be well served by the several existing companies. 
Overall, this is a very difficult market for Y as it will find it difficult to find a 
way to out-compete its rivals. 
 
 Report 
To: FD From: H. Pimm Date: 16/09/XX Title: Evaluation of AVA first class offering Introduction Porter argued that organisations could adopt one of three main strategies 
in order to gain competitive advantage – focus, differentiation and cost leadership. This report will use Porter’s model to analyse the first class strategy at AVA. 
Current strategy in AVA AVA has adopted a classic cost leadership approach. It has removed a 
number of ‘extras’ from the service it provides to customers – such as excess leg room, direct customer service and seat reservations.

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 AVA has done this in order to keep its costs low. These savings can then 
be passed onto the customer in the form of low ticket prices, driving 
demand and enabling AVA to outcompete its rivals. 
Cost leadership requires the price elasticity of the market to be high – in 
other words if AVA offers a low price for its product it needs to be able to generate a high volume of sales. This will allow it to cover its high fixed 
costs in spite of the relatively low contribution made by each ticket sale. 
As the economy in country L has returned to growth, it is likely that 
customers will have more disposable income and therefore be willing to spend more money on flights with additional features – such as increased leg room. AVA has started to see the effect of this as its passenger numbers start to fall. 
First class strategy in AVA AVA’s new approach is to offer a section of ‘first class’ seats to 
customers at the front of each airplane which provide more leg room and free food and drink, as well as better customer service. 
This seems to be an attempt to move into a differentiation approach, 
where AVA will be starting to charge a premium for some of its flights due to additional features that wealthier clients may value. 
For this to work, AVA must be able to offer a real alternative to the 
existing first class airline services – either through the actual services offered to its customers or through its brand name and image. 
Evaluation of the proposal 
Expansion into the first class market could provide a limited amount of 
diversification for AVA. Its low cost approach would seem to be struggling as customers are able to afford better quality flights and this problem is likely to continue as the economy grows. 
In addition, the move into first class flights would help to improve AVA’s 
profitability as first class tickets command higher margins than AVA’s standard tickets. 
However, there are a number of practical problems with the proposals. Firstly, AVA may be struggling to attract more affluent customers as the 
new first class model is inconsistent with its brand image. AVA has a poor reputation in the market for comfort and reliability – things that are likely to strongly appeal to first class customers. 
In addition, the first class market is already dominated by several major 
airlines that have experience of catering to the needs of this market segment. Unless AVA is able to find some way of truly differentiating its product from these rivals, it is unlikel y that it will ever outperform them in 
the market.

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 It is worth noting that attempting to operate both differentiated and cost 
leadership approaches is likely to cause the organisation considerable 
cultural problems – staff may find it difficult to offer an excellent service to some customers but not others. 
Overall by proceeding with its fi rst class strategy, AVA risks becoming 
‘stuck in the middle’ and failing to compete effectively within the market. 
It may therefore wish to consider an alternative plan which is more in keeping with its current strategy. 
 
 The correct answer is C HUF is trying to sell more of its existing product lines (and is therefore not 
adopting a product development strategy) to its existing customers. Note that HUF is continuing to use radio advertising, indicating that it is not trying to attract new market segments (and is therefore not adopting a market development strategy). 
If HUF was diversifying, it would be offering new products to new 
markets, which is clearly not happening in the scenario. 
 
 • Pricewatch – market penetration – building sales from existing 
customer base via lower prices (cost leadership). 
• Esso minimarkets  – product development – addressing customer 
bases who already use Esso outlets. Could also be categorised as market development if minimarkets are effectively acting as local (‘corner’) shops. 
• Distribution to China – market development – taking existing products/technologies and selling them to a new market. 
• Acquisitions – diversification – this involves Esso moving into 
completely new markets/industries.

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 The correct answers are C, D and F 
Operating in several unrelated markets diversifies the risk of the 
organisation, reducing the variability in its returns. Note that this is unlikely to be of benefit to institutional investors, who will likely already hold a diversified portfolio of shares. 
If the company believes that its existing brand name will also be 
recognised in its new venture (or it can ‘stretch’ its brand), this may increase the likelihood of a diversification strategy being adopted. 
Finally, a diversification strategy is useful if the organisation’s existing 
markets are saturated. Diversification may be the only way for the organisation to continue to grow. 
 
 (i) Ansoff’s matrix  
Ansoff identified four main growth strategies in his matrix, depending on whether new or existing products were being offered to new or existing markets. 
New products in C’s coffee shops 
While the products that the FD is suggesting, such as wine and ice-
cream, are food and drink – like C’s current products – they represent a significant departure from C’s current image of a ‘coffee-shop’. They should therefore be classed as new products. 
The FD seems to feel that C will manage to grow its profits due to 
the higher margins achieved on these new items, rather than due to any significant increase in volume. This would seem to indicate that C will be relying on its existing customers. 
C would therefore be attempting to sell new products to our existing 
customers. In Ansoff’s matrix, this would be called product development. 
Expansion into new countries 
Expansion abroad will clear ly help C to break into new markets and 
attract a whole new set off customers. Given the success of the 
current product range, the MD is suggesting that no changes are made when opening up foreign stores. 
Overall, C would be attempting to sell its existing products to a new 
market – an approach that Ansoff called market development.

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 Online music 
This is a completely new business area for C. It would involve 
selling music – a completely different  range of products to its current 
offering. 
In addition, it is likely to appeal to a totally new range of customers –
especially as it will involve trading online, which does not appear to be something that C currently does. 
C will therefore be selling new products to new markets – which 
Ansoff termed diversification. In this case, it would appear to be unrelated or conglomerate diversification. 
(ii) Alternative strategy  
The only strategy suggested by Ansoff that has not been suggested by the directors would involve C attempting to sell more of its existing products to its current market. 
This is referred to by Ansoff as market penetration. 
Application to C 
C will need to look for ways to increase its market share. This may 
be difficult given the competitive nature of the market it operates in and the fact that its rivals offer similar products to it at a similar price. 
C does achieve high margins on its products. This could give it 
scope to consider lowering its prices – especially as it is currently more expensive than its competitors. This may be attractive to customers in the current economic downturn and could encourage customers to ‘defect’ from rival coffee chains. 
It should be noted that if C does lower its prices, this could have a 
detrimental effect on the perceived quality of its products and services by customers. 
Alternatively, C could attempt to make use of its unique selling point 
– good quality service. This has made it a market leader in country U and stressing this in its advertising could also grow its market share further. 
(iii) Proposed acquisition of online music store  
As mentioned earlier, this is an example of unrelated or conglomerate diversification. This could have several advantages and disadvantages for C. 
Saturated current market  – the coffee market appears to be 
saturated in country U. In addition, many of U’s competitors have 
already expanded into the countries around country U, indicating they may also be highly competitive already. C may find it difficult to achieve future growth if it stays within its current market.

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 Spreading of risk – by operating in two unrelated markets, C will 
be spreading its risk. Online music sales have performed well over the last year in country U – in spite of the poor economic climate which has seen a fall in the amount spent on coffee. By operating in both markets, C may be able to enjoy more stable returns.  
Surplus cash  – the acquisition of the music store would allow C to 
get a return on the surplus cash it currently holds. This may be seen favourably by investors. 
Disadvantages: 
Increased risk 
C is planning to enter a new market that is has no experience of. It 
currently does not appear to have an online presence, meaning that it may well not know how to best run the online music store once it has been purchased. 
No economies of scale By expanding into the online music industry, C is unlikely to enjoy 
significant synergies. 
In fact, the opposite may well be true. C’s managers may find that 
operating such an unfamiliar business takes up a significant proportion of their time. This may have a negative effect on C’s core coffee shop business. 
Brand Damage An unsuccessful venture into the online music industry could affect 
the brand of “C” which in should a highly competitive industry could have severe consequences. 
Lack of a clear generic strategy Using Porters understanding of strategic thinking C is clearly a 
differentiator – Entering into new industries such as online music could negatively affect this clear generic strategy. 
Shareholder reaction Shareholders often dislike unrelated diversification as it often has 
few benefits to them. If C’s shareholders had wished to spread their risk, they could simply invest some of their money in the shares of a company in a different industry to C.

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Stars 
Wallop    Question marks 
Cash cows Bang Dogs Whizz Pop   
  
 The correct answer is C H1 appears to be a dog, suggesting a divestment strategy would be 
appropriate. 
E2 and B3 are question marks. These need to be divested or built on. 
Given the attractive nature of the market for these products, O may wish to consider investing heavily to try and increase its market share. 
Y4 is a star. It is a market leader in a growing market. O needs to adopt a 
holding strategy, defending its market share and maintaining its position as a star until the market slows and Y4 becomes a cash cow. 
 
 Part (a) 
• Brick manufacturer  – dog 
• Parcel service  – dog 
• Food manufacturer  – cash cow, maybe dropping from star. Largely 
depends upon the current growth rate 
• Painting and decorating  – problem child. High growth at present 
but forecast to decline. Opportunity to turn this into a star 
• Software development company  – star 
(May consider a diagram with SBUs located on the matrix.)

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 Representations in all sectors of the matrix with two dogs present. May 
need to question what to do with the problem child and the dogs. Dogs 
may need to be divested or harvested. Problem child needs management attention to stop it becoming a dog. 
Food manufacturer (cash cow) will generate cash flows that can be used 
to fund the development of the star software company. Little need for strategic investment will see the cash surpluses rising. 
Star will need investing in and penetration strategies will be appropriate. 
Branding strategies may be initiated with a view to future defence when star becomes the cash cow. Current cash cow will need defending. 
SBUs will each need different business strategies as positions vary. 
Levels of competition and demand sophistication will vary across the SBU marketplaces and the research and information systems will become ever more important. 
Part (b) 
Divest dogs  – gets rid of the poor products quickly. But may not be poor 
performers! May be better to Harvest instead – slow decline leads to less 
damage elsewhere within the group in terms of bad publicity. 
Niche dogs  – a deliberate strategy to take the SBU into a specialist 
marketplace by aiming at a specific market segment and seek to earn 
high return from this focused approach. 
Market development  for dogs and problem children – aiming to expand 
market share and improve value via improved profitability. Product development for the cash cow as a form of defensive strategy 
to extend the life cycle and the subsequent cash flows – but will the cash cow really be cash generative? Will it not need to reinvest to maintain threshold competence in the market place? 
Market penetration  for the star – the market is expanding with many 
new users and strategies should be aimed at building market share. Aim to develop synergy * within the group: 
• Possible brand stretching  – taking the good reputation and respect 
from one brand name and attach it to other products in the form of 
either aggressive or defensive strategy, e.g. use a link from the food manufacturing to painting and decorating and/or software development. 
• Possible sharing of distribution channels  – there seems to be little 
scope for this given the diverse nature of the product portfolio. 
• Possible use of central resources  – scope here for central 
marketing function if a common linkage could be found (such as a brand). HR and IT functions offer scope for value added via cost savings on the functions.

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 McKinsey approach 
• Manage investor relations 
• turnaround strategies at SBU level 
• outsourcing 
• benchmarking 
• cost reduction programmes 
• manage structure of portfolio via acquisition, divestment and 
demerger 
• consider and deploy value adding "group" activities such as brand 
stretching. 
* The idea that combining certain operations/functions will produce a 
benefit in numerical terms that will be greater than the sum of the individual parts. The creation of 'excess value' from combination – what some refer to as '2 + 2 = 5' 
 
T has two major requirements – consistency with the existing H stores 
and the need to retain control of H and its operations. 
Licensing another organisation to trade as H would not allow T to 
maintain control over the day to day operations of the new stores. 
Strategic alliances and joint ventures, by their nature, would require T to 
form partnerships with third party organisations who would work together (or set up a jointly owned company) to operate the new H stores. Again, this would lead to H losing control and being forced to compromise with the other organisation(s) he had entered an alliance with. 
Franchising would allow H to control many of the day to day operations of 
the new stores and would also enable him to still make the key strategic decisions for the organisation. The franchisee would have to work within the pre-set guidelines in the franchise agreement, which may include central training of staff and supplier selection.

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 (1) A franchise arrangement would work well here. There is more than 
just manufacturing involved – there is the whole retail offering, and 
entering into franchise agreements would be a quick, effective way of expanding. 
(2) Unless the oil companies felt that, because of their size, there was 
no need for joint research, development, marketing and lobbying, a strategic alliance of some sort could be useful. Research costs and findings could be shared. Together they could bring powerful pressure to bear on governments to, for example, allow more 
generous time scales for implementation of the new technology. 
Alternatively, the new energy technology could be developed within a joint venture organisation. 
(3) Almost certainly, this company would expand by licensing local 
brewing companies to make and distribute its product. 
 
YH is currently manufacturing (or growing) the bulk of its products 
overseas to meet demand, with some of this produce even finding its way back to country N. This would suggest an overseas manufacture strategy. 
YH does grow some of its fruit in its home country, but given that this is a 
minority of its goods, it cannot be convincingly matched to an exporting strategy. 
As YH does not obviously co-ordinate value adding activities between its 
overseas facilities (they are all simila r growing and processing facilities in 
each country) it is not a multinational. The fact that it still has a home country in which it is based would indicate that it is not a transnational. 
 
The purchase appears to be suitable as it will help the company deal with 
the problems it is facing with supplying its customers by removing a major bottleneck. 
It will also be feasible as the company has the ability to raise the cash 
needed to complete the purchase. 
However, it is unlikely to be acceptable to employees due to the reduction 
in staff numbers it will cause. This is likely to be a problem for LL as employees are heavily unionised and could act collectively to resist the layoffs.

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Acceptability looks at the reaction of  key stakeholders to the proposed 
strategy. Mendelow’s matrix would be the most appropriate way of 
identifying these stakeholders as well as their relative interest and power. 
 
 Suitability 
• The hotel market is becoming increasingly more competitive, so it 
might make more sense for Blueberry to try to diversify its activities 
more. 
• Furthermore, the acquisition does not address Blueberry's 
underlying problems of inconsistent customer service levels. 
• On the other hand, the Villa d’Oeste already has a world class spa 
facility and would fit well into Bluebe rry’s current strategy of moving 
more ‘upscale’. 
• Also the goodwill attached to the Villa’s reputation could enhance 
Blueberry’s image, depending on branding decisions. 
• Financing the acquisition could prove problematic: 
• Debt finance: Historically the Board have chosen to keep 
Blueberry’s financial gearing level relatively low. Blueberry’s existing 
clientele of shareholders may thus resist any major increase in gearing. 
• Equity finance: Given losses in two out of the last three years, 
Blueberry may struggle to raise the purchase price via a rights issue. 
• Growth by acquisition is generally quicker than organic growth, thus 
satisfying institutional shareholders’ desire to see growth in 
revenues and dividends. 
• Further work is needed to assess whether the €50m asking price is 
acceptable.

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 • Buying another hotel should enable Blueberry to gain additional 
economies of scale with respect to insurance, staff costs such as 
pensions and purchasing economies on drinks. This should boost margins and profitability further. 
• The new hotel would fit well into Blueberry’s existing portfolio of 
hotels, for example, by having significant cash inflows throughout the year in contrast to Blueberry’s highly seasonal business, thus reducing the overall level of risk. 
Preliminary recommendations 
• The opportunity to acquire the V illa d’Oeste should be rejected on 
the grounds that financing the acquisition would be problematic at 
present. 
• Blueberry should instead focus on im proving facilities and quality in 
existing hotels before looking to expand through acquisition. 
 
Ansoff 
GGG could utilise the Ansoff growth vect or matrix to anal yse the possible 
future strategic directions it could follow. 
GGG could attempt to increase its market share with its existing services 
to its current market or region. The market is a growing one; with the change in demographics, therefore, market penetration is a real option for GGG. As it currently has 25% of its region's market with the rest fragmented between local government run and privately owned care homes, there is potential for GGG to undertake promotional activities in order to obtain business from these competitors. In particular, the sale and closure of a number of the privately run care homes could be an opportunity to obtain a greater share of the market through targeting these care homes customers. GGG may have to consider its pricing strategies however, as its prices may well be higher than its competitors. It may need to consider a reduction of prices or some form of discounted offer to attract customers who are currently paying less than they would be charged in GGG’s care homes. 
Product Development 
GGG could attempt to offer new services to its existing market or region. 
Within the scenario, there is mention of a new ‘relief package’ facility that 
is becoming popular with customers. GGG could consider offering its facilities for customers within its region for this new service. This would have to be investigated further to ensure that GGG has the capacity and

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facilities to offer such a service. If there is clearly a growing need for this 
type of package, then GGG could try to gain early market entry in order to 
gain early mover advantage. The issue for GGG is likely to be capacity constraints and the need to weigh up the benefits and costs of the option against those of offering continued longer term care to its residents. 
In addition, the additional services that could be offered by the qualified 
staff and nurses of GGG to its patients as an alternative to referral to hospitals could be a form of product development. However, this is likely to involve investment in re-training and facilities. 
Market Development 
GGG could attempt to increase its revenues by offering its current 
services to new customers or at a different geographical location. One option would be to consider moving into another geographical region in its own country to offer its services to the elderly. This is a possibility as the national geographic trend suggests increasing demand nationally for elderly care. However, this is a riskier strategy as GGG currently has no experience of its competitive environment outside its own region and the competitive market may be very different. In addition, GGG would require heavy investment in facilities outside of the region. However, the market 
conditions are likely to be the same as in its own region and, therefore, it could consider buying or merging with another private care home outside of its current region. However, GGG must consider the rising costs of running care homes and the consequent need for it to price its services accordingly. 
GGG could consider offering new services to new customers. For 
example, the trained staff and nurses could be used to offer other nursing and rehabilitation services to individual customers, other care homes or to GP surgeries. These could be offered within the facilities of GGG or could be offered on site in customers’ homes. 
GGG’s administrators are also highly experienced and GGG could 
consider utilising their experience to  offer consultancy and management 
services to other care homes which might consider outsourcing their management and administration function to GGG. 
Evaluation of opportunities 
According to the Johnson, Scholes and Whittington approach, an 
organisation's potential strategies can be evaluated against the following criteria: 
• Suitability: whether a strategy fits with the organisation's operations 
and its strategic position.

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 • Acceptability: whether a strategy fits with the expectations of the 
• Feasibility: whether the strategy can be implemented, taking into 
consideration practical considerations such as time, cost and 
capabilities. 
GGG must consider if the proposed strategy is suitable to respond to environmental events and opportunities and whether it fits with the current strategic position. It would need to consider whether it had the right level of resources and competences. It would also have to consider its key stakeholders in terms of both risk and return. It is important to note that GGG must also consider ‘who’ their customers are, as customers will include not only the actual residents of the care home but also their families or their current carers. Reviewing each of the strategies identified in the Ansoff matrix, GGG should consider: 
Suitability: This strategy would appear suitable as GGG has spare 
capacity and also this option builds upon GGG’s current expertise so there is clear strategic fit. 
Acceptability: The key stakeholders such as staff and management are 
unlikely to be opposed to this strategy as it is a mere development of the current activities of GGG. Existing customers should find it acceptable as long as current standards of operation are not affected if the care homes now take on more customers. 
Feasibility: GGG has the resources in terms of capacity and 
competences to undertake this strategy. However, further growth could mean the need to invest in more facilities if spare capacity limits are exceeded. GGG would also need to consider the costs of advertising. 
Suitability: This strategy continues to  fit with GGG’s strategic position and 
would certainly exploit an obvious market opportunity. It will complement 
the existing long term care facilities and should help to balance GGG’s portfolio. Therefore it is suitable. 
Acceptability: Staff may find this strategy unacceptable if it requires 
additional training or detracts them from the care of GGG’s existing long term care customers. Existing customers should be neutral in the decision as long as it does not affect the standard of their care and potential customers are likely to be positive towards the proposal. 
Feasibility: Investment in facilities and training may make this option 
unfeasible but GGG would have to weigh up the long term benefits of 
building market share through subsequent conversion from short-term care residents into long-term residents and by improving quality of care by providing services in-house rather than necessitating referral to hospital.

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 Market Development 
Suitability: There is certainly a potential for opportunities outside of its 
current geographical region. The national trend suggests increasing demand nationally for elderly residential care. However, GGG has no experience of its competitive environment outside its own region and the competitive market may be very different. GGG does not know whether its own service would be superior from that offered by competitors. 
Acceptability: Staff and managers may not find this strategy acceptable 
as it might affect their own workloads, location and roles. However, current customers are likely to be neutral to the proposal. 
Feasibility: Can GGG find the right facilit ies or a suitable partner to merge 
with or acquire? Costs of relocation of some staff or recruitment and 
training would need to be carefully considered. There might be some resistance from staff and competitors. Also, GGG needs to consider timescales and possible local Government resistance. Therefore, market development may not be feasible. 
Suitability: GGG has the necessary sk ills to undertake diversification 
although additional training may be required. In the present climate it would 
appear that the opportunities for this development may be limited. It would fit with the current activities of GGG and therefore has strategic fit. 
Acceptability: The staff may find this acceptable as it would develop their 
skills and enhance their job roles. Existing customers ar e also likely to 
find this acceptable as it would not mean disruption to them assuming the new services do not detract from their own care. However, GPs and hospitals may not find this acceptable as they may not agree that the same level of care can be offered by GGG’s staff. 
Feasibility: GGG will have to invest heavily in training and facilities which 
may make this unfeasible. There may also be resistance to this from local GPs and hospitals. Therefore, GGG may find this strategy unfeasible. 
Recommendation 
In the current market and competitive environment, where GGG is 
managing to remain profitable despite other similarly businesses failing, the recommended options for GGG would be to follow a market penetration strategy with product development. 
The current geographical market clearly has potential for GGG so there is 
no need for a market development strategy. A market penetration strategy would allow GGG to exploit the current trends and build upon its own strength and reputation. It is also the least risky option in a time when costs are clearly rising. Product development with the care relief packages should also be considered as it has clear potential for GGG to exploit its current spare capacity and to use its expertise to develop a clearly growing market need.

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Developing strategic 
management systems 
and develop options (d) Use various frameworks 
E1: Develop strategic 
management system (a) Develop detailed action 
plans 
(b) Communicate action 
plans  
(c) Monitor implementation 
(d) Align incentives to 
 
  Chapter 
9

Developing strategic performance management systems 
332  
 
1 Performance management 
So far we have looked at how an organisation decides on an appropriate 
strategy to undertake. The next step is to introduce a process by which the strategy can be properly controlled so that it delivers the benefits to its organisational ecosystem that had been anticipated. Such a control process involves the careful selection and introduction of appropriate performance 
measures .  
 
 Performance measurement is the process of assessing the proficiency with which a reporting entity succeeds, by the economic acquisition of resources and their efficient and effective deployment, in achieving its objectives. Performance measures may be based on non-financial as well as on financial information. 
Selecting appropriate performance measures is important for two reasons: 
• management must be able to identify whether the strategy is having the 
desired effect on the organisation’s output 
• setting performance measures is a way of communicating targets to staff 
and other key stakeholders, indicating the organisation’s priorities. 
Rewards can be linked to the achievement of these measures.

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For example, an organisation may have decided to implement a new strategy to 
improve the quality of its output. It will want to create a range of performance measures that support this – such as monitoring the number of defective products produced, or  the number of customer complaints. This will allow the 
organisation to see whether its strategy is having the desired effect and is actually improving quality. Management will also be able to set targets for staff in each of these areas, focusing the attention of workers on the need to improve quality. 
Setting performance measures is often more difficult than would first be 
imagined. 
For example, is the measure of ‘waiting times for patients’ a good measure of a 
hospital’s performance?  There is much discussion in the media about resources made available to the NHS in the UK and its impact on healthcare services. A shortage of hospital beds might lead to patients waiting a long period of time for a necessary procedure, such as a hip replacement operation. And so much focus is placed on hospital waiting times. 
Surely the answer then is to shorten the length of time to perform a procedure 
(so that more procedures can be carried out each day), and then send the patient home immediately to recuperate in their own bed (so that fewer hospital beds are taken up). This would seem appropriate in one sense, in that one measure of performance is now improved.  
However, this would surely have potential negative effects on another means by 
which the NHS is assessed, the quality of healthcare provided. Procedures being performed more quickly might result in patients not being properly cured. Recovering at home, perhaps without the necessary supervision from healthcare experts, might lead to patients having to move about before they are ready and so injuring themselves again. 
Action taken to improve one objective (improve waiting times) has had a 
negative effect on another, equally important objective (quality of healthcare provided). 
The challenge is therefore to be able to design a performance measurement 
system that can be used in the control process and not prove to be a burden and/or misleading.

334  
 How do performance measures control what people do? 
 In Measuring Business Performance: Why, What, How (1998), Neely 
suggested that there were four ways in which performance measures 
could act to control the behaviour of people within the organisation. He referred to these reasons as the ‘four CPs’. 
Imagine that the managers of a manufacturing business have just 
informed staff that they will be assessed on the quality of the goods that they produce. 
• Confirm priorities  – the fact that management have chosen to 
measure and report on quality indicates to workers that this is an 
area that is important and that needs to be prioritised.  
• Compel progress  – workers will want to ensure that they meet 
quality targets as failure to do so may adversely affect their pay or career prospects. Remember that measures can be the basis for 
bonus payments (giving rise to an additional CP not identified by 
Neely – cash prizes!) 
• Check position  – the management of the business (as well as 
individual staff members) will be able to monitor progress relating to quality and see whether they are on course to meet their targets or not. If not, action can be taken to improve performance. 
• Communicate position  – measures of production quality can be  
used by management (and other interested parties, such as quality control organisations, trade associations or even investors) to assess and understand how the organisation is performing. 
2 Critical success factors and their link to performance 
It is clear that the organisation needs to ensure that its performance measurement system ties into its overall strategy. How can this be accomplished? If our overall strategy is to, for example, become a cost leader in our market in order to outperform our rivals, what do we measure to help us ensure that we are doing this successfully? 
One useful way of generating a performance measurement system for the 
organisation is to identify the critical su ccess factors (CSFs) that are determined 
by our strategy. CSFs were discussed in detail in chapter 5. 
 
 Critical success factors are the limited number of areas in which results, if they are satisfactory, will ensure successful competitive performance for the organisation. 
CSFs tie in to the organisation’s overall strategy. For example, if our strategy is 
cost leadership, our CSFs could include: 
• lower labour costs than rivals • efficient production.

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These CSFs would then be translated into key performance indicators (KPIs) – 
which are specific, measured targets that can be used to assess whether the CSF has been achieved. 
For example, KPIs for ‘efficient production’ could include: 
• maximum kg of materials wasted • average time taken to produce one unit of the product, etc. 
A strong performance measurement system is likely to reflect the CSFs and 
KPIs identified by the organisation, as these are areas that the organisation needs to do well at in order to outperform its rivals – a key issue for most businesses. 
Remember that whatever the organisation chooses as its performance 
measurement system will need to be monitored going forward. Management will need to ensure that information systems are put in place to collect data to allow performance in these areas to be measured on an ongoing basis. 
If our cost leader (above) wishes to target its staff performance based on the 
average time they take to produce units, it will need to create systems to keep track of how long each employee works for and how many units they individually produce. 
Note that, as with the organisation’s KPIs, the performance measurement 
system is likely to cover a wide range of criteria – both financial and non-financial. 
Changes to the performance measurement system 
The changing environment presents new risks and opportunities and these 
must be monitored and identified as early as possible. It is therefore likely that 
new measures will be added to the system over time. However, consideration must also be given to keeping the system as uncomplicated as possible and as such old unnecessary measures should be dropped. 
When changing the perform ance measurement system , management need to 
be aware of the following points: 
• too many changes may lead to ‘indicator overload’, confusing employees 
about what the company wants them to do. 
• if something is included as part of the performance measurement system, 
the importance of this item is being highlighted to staff. If you change the 
system, what are you telling people? 
• if a measure is dropped from the measurement system, you are telling 
your staff that this item is no longer important. Is this what you want to achieve?

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3 Financial and non-financial measures 
Financial performance measures 
These indicators concentrate on the revenue, profits, cash and capital position 
Typical indicators may include (but are not limited to): 
Sales margin (gross profit margin): 
 
Revenue – cost of sales
Revenue ×100% 
 
• this indicator focuses on the profitability of the business’ trading account. Net profit margin: 
 
Profit (before interest and tax)
 
• this indicator focuses on the profitability of the business in both its trading 
and its net operating expenses. 
Return on capital employed: 
 
Capital employed 	×100% 
 
• ROCE measures the profitability of a business or division against the 
assets utilised in that business. (Capital employed is normally measured 
as shareholders funds + long–term debt). 
Remember the principle of controllability  when using these measures to 
assess divisional performance. The costs used in both cases should only be those that the division can directly control. Expenses such as head office costs would normally be excluded as it would be unfair to assess divisional managers on spending that they cannot alter. 
Advantages of financial measures of performance 
• Culturally expected 
• focus on financial objectives 
• comparable across companies 
• cheap 
• established framework for preparation in many cases 
• tend to focus onto resource generation and so survival in the long term.

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Disadvantages of financial measures of performance 
• Inflation distortion • leads to suboptimal and short-termist behaviour 
• lack of comparability 
• understood by the 'select few' – i.e. trained accountants and managers 
• subjectivity can exist in calculation, e.g. depreciation. 
Non-financial performance measures 
Non-financial performance indicators are measures of performance based on 
non-financial information that may originate in and be used by operating departments to monitor and control their activities without any accounting input. 
Put simply, businesses also need to focus on factors that actually cause profits to be earned – the non-financial measures. 
For instance in an accountancy training business, sales and market share 
(financial issues) are caused by student pass rates, student satisfaction, class sizes, tutor quality, etc (non-financial issues). These non-financial issues will also need to be measured. If performance in these areas begins to fall, it will not be long before the financial measures deteriorate as well. 
Advantages of non-financial measures 
• Wider view • easier to calculate 
• easy to understand (sometimes) 
• not distorted by inflation 
• can emphasise broad spectrum of management 
• positive motivational implications. 
Disadvantages of non-financial measures 
• Some can be difficult to calculate 
• subjectivity exists in design , interpretation and calculation 
• can lead to indicator overload • costly 
• culture clash implications 
• constant change requires constant monitoring.

338  
 Which THREE of the following are advantages to an organisation of using 
non-financial performance measures, rather than traditional financial 
measures? 
A Culturally expected B Gives a wider view of business performance C Less subjective measurement D Allows earlier problem identification E Not distorted by inflation F Cheaper to measure 
 
 Y plc has noticed that its return on capital employed (ROCE) has fallen 
significantly over the last twelve months. One of the junior management 
accountants has made the following statements regarding this: 
(i) Y’s gearing must have risen in the year. (ii) Y may find it hard to raise additional finance in the coming year. (iii) The ROCE may have fallen due to reductions in Y’s gross profit 
margins. 
(iv) The ROCE may have fallen due to large dividends paid out during 
the last year. 
Which of the above statements is/are correct? A (i) and (ii) only B (i) and (iii) only C (ii) and (iii) only D (ii) and (v) only 
4 The balanced scorecard 
Presented by Kaplan & Norton  in 1992 – 'Kaplan's cockpit' 
'An approach to the provision of information to management to assist strategic 
policy formulation and achievement. It emphasises the need to provide the user with a set of information which addresses all relevant issues of performance in an objective and unbiased fashion. The information provided may include both financial and non-financial elements and cover areas such as profitability, customer satisfaction, internal efficiency and innovation'. 
Its aim is to provide a broad range of both financial and non-financial measures 
designed to reflect the complexity and diversity of business circumstance.

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It was a response to traditional performance measurement which had tended to 
focus on a narrow range of performance measures and caused management to adopt a short-term focus. 
Kaplan likened running a business to flying a plane – airspeed, altitude, 
direction and fuel level are just a few of the pieces of information needed. Yet, in many businesses, managers have to rely on a narrow set of financial indicators to support their decision making – and this in an environment with many more complexities than a plane. 
The balanced scorecard approach brings together a wide range of measures to 
give managers a broader perspective of their business performance. 
 
This is a powerful tool that assists in the running of an organisation. Gains in one area need to be considered with the losses that may arise in other areas and vice versa. Thus the manager's view is broadened and the tendency to concentrate on one measure is reduced, hopefully removed.

340  
 Possible measures for the balanced scorecard 
 The measures used within the balanced scorecard will vary between 
organisations, but some typical examples are shown below for each of 
the four perspectives: 
Financial perspective 
• increased revenue 
• improvements to key ratios, such as gross margin, net margin or 
ROCE 
• rising market share • increased cash flow 
• reduction or increase in gearing. 
Internal business perspective 
• reduction in production time 
• reduction in number of errors/defects 
• reduced wastage • reduction in time taken to supply customers/deal with customer 
queries. 
Customer perspective 
• increase in number of new customers attracted 
• increase in number of customers returning (repeat business) • reduction in number of customer complaints • rise in positive feedback from customers • reduction in returns from customers 
• number of orders delivered on time to customers. 
Innovation and learning (learning and growth) 
• number of days of staff training 
• number of new products or services launched 
• increase in number of sales made through new channels – such as 
online 
• increase in proportion of sales of new products 
• reduction in staff turnover (increased staff satisfaction) 
• number of new business ideas generated by staff. 
Remember that this list is not exhaustive. In your exam you will need to 
select the performance measures that best fit the organisation in question.

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 Illustration 1 – The balanced scorecard 
 For a train company, a balanced scorecard could include indicators such 
as: 
• Percentage of trains running on time/cancelled 
• percentage of trains running per hour between destinations 
• cleanliness levels 
• seat availability. 
Internal business process 
• Staff attendance rates 
• average time taken to process ticket enquiries 
• percentage of trains in full working order. 
Learning and growth 
• Investment in new rolling inventory • number of training days per annum per staff member 
• investment in new passenger facilities (e.g. internet access on– 
board). 
Financial perspective • Profit levels 
• revenue growth 
• revenue by activity 
• cost control versus budget.

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 Strategy mapping 
 Strategy mapping – implementing the balanced scorecard more 
Strategy mapping was developed by Kaplan and Norton as an extension 
to the balanced scorecard and to make implementations of the scorecard more successful. 
The steps involved are: 
 
• At the head of the strategy map is the overriding objective of the 
organisation which describes how it creates value. This is then 
connected to the organisation’s other objectives, categorised in terms of the four perspectives of the balanced scorecard, showing the cause-and-effect relationships between them. 
• The strategy map helps organisations to clarify, describe and 
communicate the strategy and objectives, both within the organisation and to external stakeholders, by presenting the key relationships between the overall objective and the supporting strategy and objectives in one diagram. 
Problems: 
• Organisations have often found it difficult to translate the corporate 
vision into behaviour and actions which achieve the key corporate 
• In practice many employees do not understand the organisation’s 
strategy, and systems such as performance management and budgeting are not linked to the strategy.

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 A bus company uses Kaplan and Norton’s balanced scorecard as a way 
of developing its performance measurement mix. 
One of the measures it has chosen to use is the number of days of driver 
training each year. The company feels that this will reduce the number of accidents and casualties due to more skilled and motivated drivers. 
Which ONE of the balanced scorecard perspectives would this measure 
relate to? 
A Learning and growth B Internal business processes 
C Customer perspective 
D Financial perspective 
 
 Suggest some critical success factors (CSFs) and key performance 
indicators (KPIs) for each perspective of the balanced scorecard for an 
electronics manufacturer. 
Benefits and drawbacks of the balanced scorecard 
measures. 
communicated externally. 
shareholder analysis.

344  
 
 Test your understanding 5 – CCC – (Case style) 
 T is the Chief Executive Officer of a motor car insurance company, CCC. 
T, together with the Board of Directors, developed a mission statement in 
20X3 following a detailed analysis of the company's operations and market place. The mission statement states that ‘CCC wants to continually grow through its commitment to quality and delivering value to its customers’. CCC has developed a complementary vision statement which aspires to: 
• Provide superior returns to our shareholders • Continually improve our business processes 
• Delight our customers 
• Learn from our mistakes and work smarter in the future. 
CCC’s overriding objective, also developed in 20X3, is to double the size 
of its revenue by the end of 20X7. 
T has identified the following areas of concern: 
• Poor customer service has led to CCC losing 15% of its customers 
in 20X3/20X4. The customer sales manager had sponsored an 
initiative to reward customers with a discount if they renewed their motor insurance. However, most of the sales executives were not familiar with the details of this scheme and did not mention it to customers considering renewing their insurance. The discount scheme had not affected the rate of loss of customers. 
• The average age of CCC’s pers onal computers (PCs) was five 
years. There have been many complaints from CCC’s staff that their PC’s are not adequate for the demands of 2014. The last time an initiative had been undertaken to bring PCs up to date was in 20X1. 
• CCC’s internal auditors had conducted performance reviews in 
three departments during 20X3. They found a common pattern in all three departments: many of the staff had only minimal educational qualifications which were inadequate for the jobs they were doing. This resulted in an unacceptable level of errors being made. No initiatives had been undertaken to address this problem. 
• Investors have been critical of the low dividend yield on their CCC 
shares. 
T is worried because, despite the time and effort put into the development of the mission and vision statements and the overriding objective, CCC is not making sufficient progress towards achieving its revenue target. Its revenue growth rate in 20X3 was 10%.

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 CCC’s shortfall against its revenue target was discussed at a recent 
Board meeting. The Corporate Affairs Director stated that "the Board is 
100% behind our strategy and vision but it’s just not happening. I have experience in my previous company of working with an integrated model, the Balanced Scorecard. Could the Balanced Scorecard help CCC?" 
T has asked you, a strategic management accountant working in CCC, 
for a report covering the following areas: 
(i) Advice on how a Balanced Scorecard could assist in delivering 
CCC's vision and strategy. 
(ii) Assume that CCC has adopted a Balanced Scorecard approach to 
help it achieve its vision. Recommend FOUR perspectives and for 
each perspective show: 
– An objective – A measure – A target – An initiative. 
(iii) Discuss briefly TWO drawba cks of the Balanced Scorecard. 
Required: Draft the report as requested by T. 
5 The performance pyramid

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The performance pyramid framework 
The performance pyramid was developed by Lynch and Cross as a model to 
understand and define the links between objectives and performance measures at different levels  in the organisation. 
The performance pyramid is designed to ensure that the activities of every department, system and business unit support the overall vision of the organisation. 
At the top of the pyramid is the vision through which the organisation describes 
how it will achieve long-term success and competitive advantage. 
The second level, the business unit , includes the critical success factors 
(CFSs) in terms of market-related measures and financial measures that need 
to be achieved to meet the organisation’s overall vision. 
The third level, the business operating systems , includes measures which 
relate to the internal systems and processes which are needed to meet the 
needs of customers. For example, measures of flexibility which relate to how responsive the system is to customer demands. They will link to the market and financial measures identified at level two. 
The lowest level of the pyramid, departments and work centres , contains the 
day-to-day operational measures that can be used to monitor the status of the 
level three measures. 
The left-hand side of the pyramid contains measures which have an external 
focus and which are predominantly non-financial. Those on the right are focused on the internal efficiency of the organisation and are predominantly financial. 
Objectives cascade down through the organisation, while measures and 
information flow from the bottom up. 
The performance pyramid does tend to concentrate on two groups of 
stakeholders – shareholders and customers. It is necessary to ensure that measures are included which relate to other stakeholders as well. 
Value drivers 
In chapters 6 & 7 we introduced the concept of value drivers within an 
organisational ecosystem, and how such drivers might be either tangible or intangible. We identified that, over time, tangible drivers of value do not necessarily lead to sustainable competitive advantage as they can be copied by competitors. Intangible drivers of value, such as the organisation’s brand, its reputation, or its know-how, are much more difficult for another business to replicate. 
The performance pyramid framework is a useful means to assess the drivers of 
value in an organisation and to adopt suitable measures of performance within the management system. This is because many elements of the pyramid can be classified as tangible or intangible.

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For example, the measure of ‘quality’ could be said to have a tangible nature, 
perhaps measured by the % of units sold that are returned because they are defective. 
Alternatively, the measure of quality might be seen as an intangible driver of 
value; the product may function as intended, but does it really meet the expectations of the customer/user? Is it, in their eyes, fit for purpose and 
meeting their needs? 
Similarly, ‘waste’ might be seen in a tangible context (such as a restaurant 
measuring the amount of food that gets thrown away), or an intangible context (perhaps taking too long to prepare meals and irritating the customer, a waste 
of the time in the kitchen due to inefficient cooking methods). 
Note that the Lynch and Cross model is not the only framework that could be 
used to assess value drivers; the same thought processes could equally be applied to other models such as the Balanced Scorecard. 
 
 Which ONE of the following would be classified as an internal efficiency 
measure within the performance pyramid? A Customer satisfaction B Cycle time C Delivery D Quality 
 
 G plc has set its staff targets relating to improvements in the number of 
customer complaints received. Which level of the performance pyramid is G measuring? A Corporate vision B Departments and work centres C Business units D Business operating systems

348  
 Test your understanding 8 – Ochil – (Case style) 
 Ochil is an engineering manufacturing company specialising in the 
production of mobile machinery for the construction industry. The 
company has identified and defined a market in which it wishes to operate. This will provide a new focus for an existing product range. Ochil 
has identified a number of key competitors and intends to focus on close co-operation with its customers in providing products to meet their specific design and quality requirements. Efforts will be made to improve the effectiveness of all aspects of the cycle, from product design to after-sales service to customers. This will require inputs from a number of 
departments in the achievement of the specific goals of the new proposal. 
Efforts will be made to improve productivity in conjunction with increased flexibility of methods. 
An analysis of forecast financial and non-financial data relating to the new 
proposal is shown in Schedule 1 below. 
Schedule 1 
 20X4 20X5 20X6 
Total market size ($m)  120 125 130 
Ochil sales ($m)  15 18 20 
Ochil total costs ($m)  14.1 12.72 12.55 
Ochil sundry statistics     
Production achieving design quality standards  95% 97% 98% 
Returns from customers (% of deliveries)  3.0% 1.5% 0.5% 
Cost of after-sales service ($m)  1.5 1.25 1.0 
Sales meeting planned delivery dates  90% 95% 99% 
Average cycle time (customer enquiry to 
delivery) (weeks)  
6  
5.5  
5 
Components scrapped in production (%)  7.5% 50% 2.5% 
Idle machine capacity (%)  10% 6% 2% 
The company is considering the implementation of a new performance measurement system in an attempt to make a clear link between performance and strategy and to be flexible and adapt to an ever changing business environment. The directors are therefore considering implementing the performance pyramid. 
The managing director of Ochil has asked you to prepare an analysis of 
the new proposal for the period 20X4 to 20X6. The analysis should use the information provided in the question, together with the data in Schedule 1.

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 The analysis should contain the following: 
(i) Discussion of the external effectiveness of the proposal in the 
context of ways in which (1) Quality and (2) Delivery are expected to 
affect customer satisfaction and hence the marketing of the product. 
(ii) Discussion of the internal efficiency of the proposal in the context of 
ways in which the management of (1) Cycle time and (2) Waste are expected to affect productivity and hence the financial aspects of the proposal. 
(iii) Discussion of the potential benefits to Ochil of implementing the 
performance pyramid. 
Required: 
Prepare an analysis as requested by the managing director. 
 
 Fitzgerald and Moon 
 The building block model 
 
Fitzgerald and Moon  adopted a framework for the design and analysis 
of performance management systems. The model was first devised as a 
solution to performance measurement problems in service industries. But it can be applied successfully to other manufacturing and retail businesses to evaluate business performance.

350  
 Fitzgerald and Moon based their analysis on three building blocks: 
• Dimensions  
Dimensions are the goals for the business and suitable measures 
must be developed to measure each performance dimension. Below are six dimensions in the building block model, along with examples of measures that could be used under each. 
– Profit  
Measures: successful financial performance and growth, 
increased sales or margins. 
– Competitiveness  
Measure: number of new customers, repeat business, market share. 
– Resource utilisation  
Measure: optimum use of scarce resources, wastage, idle time. 
– Quality issues  
Measure: minimising defects and errors, reliability of service/ delivery to the customer, response times. 
– Innovation  
Measure: product/service development – including time taken to develop new products and services, as well as the number of new products or services launched. 
– Flexibility  
Measure: the ability to respon d to changing needs, customer 
waiting times, overtime worked by staff. 
• Standards  
These are the measures used. To ensure success it is vital that employees view standards as achievable and fair and take ownership of them. 
• Rewards  
To ensure that employees are motivated to meet standards, targets need to be clear and linked to controllable factors. 
Financial performance and competitiveness were seen as the "results" 
and the others as "determinants" of success. 
Fiztgerald and Moon suggested that these six dimensions could be used 
to generate the key performance measures that the business would need to monitor. 
Again, applying this framework whilst thinking about the value drivers of 
the organisational ecos ystem (both tangible and intangible) will be of 
benefit.

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 JKJ is a small company that sells office stationery, such as paper and 
pens. It has set targets in the following areas as performance measures 
for its employees: 
• number of new product lines offered to customers 
• increased revenue and margins 
• number of defective products returned by customers. 
Which of the following dimensions from the Fitzgerald and Moon building 
block model have not been considered by JKJ as part of the above 
measures? Select all that apply. 
A Resource utilisation B Innovation C Flexibility D Profit E Quality issues 
6 Benchmarking schemes 
Benchmarking is ‘the establishment, through data gathering, of targets and 
comparators, through whose use relative levels of performance (and particularly areas of underperformance) can be identified. By the adoption of identified best practices it is hoped that performance will improve.’ 
Most organisations have systems in place to help management monitor key factors such as profits and sales. However, if the financial results or market share of the firm start to deteriorate, management needs to know the reasons why. 
The purpose of benchmarking is to help management understand how well the 
firm is carrying out its key activities and how its performance compares with other, successful, organisations who carry out similar operations (often those considered best in class). 
A famous example of this is the Rank Xerox company. In the 1970s, such was the dominance of the firm that the word ‘Xerox’ meant ‘photocopier’. A decade later and they had serious competition, most notably from Canon. Something had gone wrong...but what? 
Rank Xerox found that clients were switching to other providers because Rank 
Xerox machines were perceived to always be out of order. It used benchmarking to restore its fortunes.

352  
Types of benchmarking 
Seber identifies  three  basic types: 
Internal 
• This is where another branch or department of the organisation is used as 
the benchmark 
• used where conformity of service is the critical issue – either threshold or 
core competence 
• easily arranged, cheaper and culturally relevant 
• but, culturally distorted and unlikely to provide innovative solutions. 
Competitor 
• Uses a direct competitor with the same or similar process 
• essentially aims to render the competition core competence as threshold • relevant for the industry and market 
• but, will the competitor really be keen to hand over their basis for success? 
Process or activity 
• Focus upon a similar process in another company which is not a direct 
competitor, e.g. an airline and a health service 
• looks for new, innovative ways to create advantage as well as solving 
threshold problems 
• takes time and is expensive 
• but, resistance likely to be less and can provide the new basis for 
Implementing a benchmarking scheme 
This will involve: 
(1) identifying what is wrong within the current organisation 
(2) identifying best practice elsewhere (3) contacting, preparing for a site visit 
(4) gathering, evaluating and communicating the results. 
It will need: 
• key executive commitment from the outset 
• establishment of teams for those ranges of opinions and expertise • a team to manage the project • a team for the site visit 
• budget allocations and training to be given 
• a formalised process.

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Problems 
• Best practice companies  unwilling to share data 
• what is 'best practice'? 
• costly in terms of time and money – opportunity cost 
• provides a retrospective view in a turbulent environment – what is best 
today may not be so tomorrow. As one writer put it: ‘Benchmarking is the 
refuge of the manager who’s afraid of the future.’ 
• successful benchmarking firms can find themselves inundated with 
requests for information from much less able firms from whom they can learn little 
• managers may become demotivated if they are compared against a 
better-resourced rival. 
 
 J plc is a medium-sized training organisation based in country V. It 
operates fifteen centres in major towns and cities across V. Each centre offers IT training accredited by the ITTO (International Technology Training Organisation). Staff are required to follow centrally produced teaching plans which have been approved by J’s head office and the ITTO when delivering these courses. J believes that ITTO accreditation is a vital part of its operations. 
J has one major competitor, IHG Ltd, within country V. IHG Ltd also offers 
IT training, but their courses are not ITTO accredited and course content and style varies significantly between IHG centres. 
J is aware that a number of universities offer ITTO accredited courses 
within country V. However J does not see these as competitors as they typically attract school-leavers, rather than the corporations that are J’s main customers. The average university pass rate for ITTO courses is currently higher than J’s. 
J wishes to undertake a benchmarking exercise. Which ONE of the 
following types of benchmarking would be most appropriate to J? 
A Competitor B Process C Internal D Strategic

354  
 Test your understanding 11 – K and L – (Case style) 
 A company which manufactures and distributes industrial oils employs a 
team of salespeople who work directly from home and travel around 
different regions in the country. Each member of the sales team has his or her own geographical area to cover and they visit clients on a regular basis. 
The sales team staff are each paid a basic monthly salary. Each member 
of the team is set an identical target for sales to be achieved in the month. A bonus payment, in addition to the basic salary, is made to any member of the team who exceeds his or her monthly sales target. 
Generally, experience has been that the members of the sales team 
succeed in improving on their sales targets each month sufficiently to earn a small bonus. However, the managers are unclear whether all the team members are achieving their maximum potential level of sales. 
Consequently they are considering introducing a system of benchmarking 
to measure the performance of the sales team as a whole and its individual members. 
The Human Resources Director (HRD) is uncertain how best to 
accomplish this and has sent you the following text: 
Hi K, could you please send me a quick email setting out how a system of 
benchmarking could be introduced in the company to measure the performance of the sales team, both as a team and as individuals who will be compared with each other. I'm going into a meeting about this in fifteen minutes, so please make this a priority. Thanks. L. 
Required: 
Prepare the email as requested by the HRD. 
7 Divisional performance 
While the Balanced Scorecard and performance pyramid both identify the need 
for a wide range of performance me asures, financial performance is still 
extremely important – especially when monitoring the performance of divisions or other strategic business units (SBUs) within the organisation. 
There are a wide number of measures that can be used to examine divisional 
performance, including: 
• Economic value added (EVA) • Shareholder value analysis (SVA) 
• Triple bottom line.

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8 EVA and SVA 
EVA™ (Economic Value Added) 
EVA (developed by Stern Stewart & Co) is an estimate of true economic profit 
after making corrective adjustments to GAAP accounting. 
EVA refers to the profit less a charge for capital employed in the period. 
Accounting profit may be adjusted, for example, for the treatment of goodwill and research and development expenditure, before economic value is calculated. 
 
• Adjustments are made to avoid the immediate write-off of value-building 
expenditure such as research and development expenditure, advertising expenditure or the purchase of goodwill. 
• Adjustments are intended to produce a figure for capital employed which is 
a more accurate reflection of the base upon which shareholders expect their returns to accrue, and to provide a profit after tax figure which is a more realistic measure of the actual cash yield generated for shareholders from recurring business activities. 
SVA (Shareholder Value Analysis) 
A variation along the same theme as EVA. The main aim of the organisation is to add value to shareholder wealth. This can be defined in a variety of ways and usually results in a form of balanced scorecard being used. 
Shareholder value is the total return to the shareholders in terms of both 
dividends and share price growth, calculated as the present value of the future free cash flows of the business discounted at the weighted average cost of the capital of the business less the market value of its debt. 
Essentially this means that management need to ensure that their strategies maximise the wealth of the shareholders of the company, by ensuring that they increase the present value of the returns that they will receive from their shares. 
Rappaport  has a model that is frequently mentioned. He suggested that future 
cash flows should be discounted at a suitable cost of capital and that 
shareholder value would be increased if this measure were to increase.

356  
In order to maximise future cash flows and reduce the cost of capital, he 
identified seven value drivers: 
• Sales growth rate – assuming sales are profitable, this should increase 
cash flow. 
• Life of the project – if the firm can forecast growth over a longer period, 
there will be more cash flows to discount. 
• Operating profit margin – if this is increased, the amount of cash 
generated from each sale should rise. 
• Working capital – this should be minimised to reduce the amount of cash 
tied up in inventory and receivables. 
• Cost of capital – this should be minimised as this is the rate that will be 
used to discount the future cash flows. The lower the discount rate, the 
higher the present value. 
• Asset investment – if growth demands high levels of capital investment, 
this will represent a large outflow of cash. 
• Taxation – clearly, any reduction in this rate will reduce cash outflow. 
An easy way of remembering these drivers is using the mnemonic SLOW CAT . 
Managers should set targets in each of these seven areas in order to ensure they are maximising shareholder wealth. 
It is important to remember that value is not just a financial concept. 
Shareholders can attach non-financial value, e.g. social responsibility of the company – not testing on animals, positive human rights record or even football club membership. 
Later work has developed to include other stakeholders and also non-financial 
perspectives such as social responsibility. Remember, look after the environment in which you operate and you will get a longer life – the implications for increasing future cash flows as a result are substantial. 
Advantages of EVA/SVA approaches 
• Adjustments made to profit effectively mean we are looking at cash-flow 
based measures 
• consistent with NPV so should ensure better goal congruence between 
divisional performance and maximising shareholder value. (Note: You can 
show that the present value of future EVA figures equates to the increase in shareholder value measured by discounted cashflows) 
• cost of financing emphasised.

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Drawbacks of the EVA/SVA Systems 
• Uses accounting data which has been prepared for other purposes and 
involves subjective provisions and estimates 
• it ignores items that don't appear on balance sheets such as brands, staff 
and inherent goodwill 
• confuses management as they are seldom trained fully in its operation and 
it varies from one company to another 
• costly to maintain and resistance is usually high when first deployed 
• assumes value can be measured in money terms • judgement involved by users in evaluation and selection of cost of capital 
rate to be used. 
 
 YU Ltd is a multinational company that makes and sells one major 
product, the TRT. The company is aware that the TRT is starting to show 
signs of decline. YU wishes to undertake one or more of the following strategies to deal with this: 
(i) Rebranding TRT. YU believes that this will extend the life of the TRT 
by five years. 
(ii) Replacing the current computerised inventory management system 
which is coming to the end of its useful life. 
(iii) Altering YU’s internal transfer pricing to reduce its overall tax 
(iv) Adjusting YU’s reported profit figures to remove the effect of GAAP 
Which of the above strategies will be consistent with a shareholder value 
analysis (SVA) approach? 
A (ii) and (iv) B (i) and (iii) C (ii) and (iii) D (i) and (iv) 
9 Triple Bottom Line 
As outlined in chapter 3, many organisations are concerned about their impact 
on the environment and wish to monitor whether they are sustainable. 
Triple Bottom Line (TBL) expands traditional accountancy reporting systems, 
looking at social and environmental performance, rather than simply financial performance. This can be used to help encourage each division and manager within the organisation to act in a socially responsible manner.

358  
The model suggests measuring three areas: 
• profit  (or economic prosperity) – the economic value created by the 
company, or the economic benefit to the surrounding community and 
society 
• people (social justice) – the fair and favourable business practices 
regarding labour and the wider community in which the company conducts its business 
• planet (environmental quality) – the use of sustainable environmental 
practices and the reduction of the environmental impact of the organisation. 
TBL has a number of advantages, most of which relate to its improvement of the organisation’s corporate social responsibility position: 
• attracting ethically aware customers 
• attracting better quality staff 
• cost reductions (i.e. savings in energy, reduced pollution clean-up costs) 
• reduced chance of government legislation. 
However, there are a number of drawbacks, including: 
• Difficult to quantify  
It is often difficult to quantify appropriate social and environmental 
measures. When a business makes a commitment to protecting the environment by recycling, for example, its impact is not always easily discernible. 
• Management conflict  
The organisation’s management usually aims to maximise shareholder return. TBL reporting might create conflict as the benefits of any social and environmental actions that a business engages in are likely to emerge over the long term. However, they could have a short-term negative 
impact on profits, leading to conflict with shareholders. 
 
Test your understanding 13 
 Which ONE of the following benefits is consistent with the use of triple 
bottom line (TBL) reporting? 
A Cost savings through reduced wastage B Measures are all based on objective cash-flows, rather than 
subjective accounting profits 
C Decisions made ensure shareholder wealth is maximised D Cheap and easy measurement of targets

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10 Communication 
Whatever an organisation’s chosen performance measurement system, it is 
essential that the targets set for employees and divisions are appropriately communicated by senior management. 
• communicating the targets being set and how they will be measured 
• identification of why the targets have been selected – why they are 
important and how they feed into the organisation’s overall strategy 
• explaining to employees how they will personally be affected by achieving 
(or failing to achieve) the targets set 
• getting feedback from employees about the appropriateness of the targets 
being set. 
Why is effective communication of the performance measures important? 
• if employees understand the reason for the performance targets that they 
are being set, they are more likely to ‘buy in’ to the performance 
measurement system and see it as important 
• an explanation of how the employee’s performance is going to be 
measured will increase the likelihood that they will understand how to meet the targets they are being set 
• explaining the impact of hitting or missing their targets (i.e. impact on pay 
rises or bonuses) will ensure that the employee is aware of the advantages to them personally of conforming to the performance measurement system, improving their motivation to meet the targets set 
• getting feedback from employees can ensure that targets set are 
achievable. If employees feel that ta rgets are unattainable, they will not be 
motivated to work to achieve them. 
Stretch target 
Communication with employees is particularly important if an organisation sets stretch targets. 
Stretch targets are where the organisation sets goals for its employees that are 
possible, but very difficult for them to meet. The employee is ‘stretched’ in that they have to perform extremely well in order to achieve the target. 
For example, many accountancy firms pay for their junior employees to sit 
professional accountancy exams. Instead of simply requiring these students to pass their exams, a firm may require a mark of, say, 75% or higher. 
In theory, this requirement will stretch the student, making them work hard to 
achieve the target.

360  
While stretch goals can work well to motivate staff to work hard, care has to be 
taken when setting them: 
• if employees see the stretch target as unachievable it will be demotivating. • a stretch target may encourage unethical or risk-taking behaviour – a 
student may be more likely to cheat on their exam in order to achieve the 
required grade! 
As such, setting the right goal is crucial to avoiding behavioural problems. 
It is also worth noting that if the employee has performed exceptionally well and 
met their stretch targets, the organisati on will need to offe r them sufficient 
rewards to maintain their motivation. These could include: 
• pay rises • bonuses 
• promotions 
• more responsibility. 
Excellent performance by an employee should be communicated throughout the 
organisation as this can motivate other employees to work harder, as well as proving that the stretch targets are achievable. 
The high-achieving employee could also be asked to share their approach to 
meeting their targets, so that others are able to imitate their example throughout the organisation. 
11 Problems with performance measurement 
Problems in performance measurement and control in complex business 
structures 
A main feature in modern business management is the practice of splitting an 
enterprise into semi-autonom ous units with devolved authority and responsibility. 
Such units could be described as ‘divisions’, subsidiaries or SBUs, but the principles are the same. 
This raises the following potential problems. 
• How to co-ordinate different business units to achieve overall corporate 
• Goal congruence – managers will be motivated to improve the 
performance of their local business unit, possibly at the expense of the 
larger organisation. 
• The performance of one unit may depend to some extent on others, 
making it difficult to implement responsibility accounting effectively. 
• Whether/how head office costs should be reapportioned. 
• How transfer prices should be set as these effectively move profit from 
one division to another.

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Controllability 
Managers should be made accountable for those factors that they can control. 
This would see a focus onto divisional contribution. This  issue of controllability 
and design poses a few problems: 
• What exactly is controllable? Consider shared assets. 
• Does controllability change when the long run is considered? 
• Transfer pricing issues – should the sales and purchases be included? 
• Managerial performance and divisional economic performance are not 
necessarily the same thing – uncontrollable factors would need to be 
included when considering economic performance. 
• Where does the data originate from? The financial accounting system may 
not be suitable for performance evaluation of SBUs and may need to be adapted by the management accountant. Reporting or accuracy –which is most important? The faster you go the less reliable the information may become. 
• The cultural situation and factors that are likely to motivate the divisional 
management team. 
 
 H runs a small manufacturing company. She is concerned that production 
levels and production quality have been declining in the last several months. H is therefore planning to set stretch targets for her staff relating to the number of units they produce. Typical production levels require staff to make 25 units per hour. After careful analysis and discussion with staff, H feels that this can be increased to 28 per hour, though this will be difficult for staff to achieve. Any employees who manage to hit the new target will be given a significant bonus at the end of the month. 
Which ONE of the following problems is H most likely to face with the 
stretch targets she has set? 
A Staff will see the target as unachievable and are demotivated B The stretch target may lead to staff producing poor quality work C Staff will feel no motivation to work towards the stretch target D The stretch target will be ignored by staff due to lack of 
communication

362  
 Cost centres, profit centres and investment centres  
 Key considerations 
When assessing divisi onal performance it is vital that the meas ures used 
match the degree of decentralisation in the division: 
Type of division Description Typical measures 
Cost centre • Division incurs 
costs but has no 
revenue stream Total cost 
• Cost variances • Cost per unit 
and other cost 
ratios 
• NFPIs 
(nonfinancial  performance indicators) related to quality, productivity, efficiency, etc. 
Profit centre • Division has 
both costs and revenue 
• Manager does 
not have the authority to alter the level of investment in the division All of the above PLUS 
• Sales 
• Profit 
• Sales variances 
• Margins 
• Market share 
• Working capital 
ratios 
(depending on the division concerned) 
• NFPIs related to 
customer satisfaction.

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Investment centre • Division has 
both costs and 
revenue 
have the authority to invest in new assets or dispose of existing ones All of the above PLUS 
• Return on 
Investment 
(ROI) 
• Residual Income 
(RI) 
• SVA/EVA 
These are discussed 
in more detail above. ROI and RI should be familiar to you from your earlier studies. 
In most exam questions you will meet SBUs that are investment centres. 
Sub-optimisation 
Sub-optimisation refers to actions taken to improve the divisional situation at the expense of the company as a whole. This can arise for a number of reasons: 
• Short-termism  
Short-termism refers to actions taken to improve the short-run 
performance at the expense of the long run. For example, cutting discretionary costs such as advertising and training budgets to hit a profit target. 
• Problems intrinsic to the targets used  
Most measures are linked to profit, which does not have a high correlation with shareholder value. 
• Wrong signals  
Excessive pressure to hit targets may result in a culture where it is felt to be acceptable to use 'creative accounting' to achieve results.

364  
 Wrong signals and inappropriate action 
 There are many ways in which poorly designed performance 
management systems can send managers the wrong signals, resulting in 
dysfunctional behaviour. Berry, Broadbent and Otley identified the following problem areas: 
• Misrepresentation – 'creative' reporting to suggest that a result is 
acceptable. 
• Gaming – deliberate distortion of a measure to secure some 
strategic advantage. 
• Misinterpretation – failure to recognise the complexity of the 
environment in which the organisation operates. 
• Short-termism – leading to the neglect of longer-term objectives. • Measure fixation – measures and behaviour in order to achieve 
specific performance indicators which may not be effective. 
• Tunnel vision – undue focus on stated performance measures to the 
detriment of other areas. 
• Sub-optimisation – focus on some objectives so that others are not 
achieved. 
• Ossification – an unwillingness to change the performance measure 
scheme once it has been set up. 
 
 Test your understanding 15 – (Integration question) 
 HIH is a large, multinational chain of high-quality hotels. Recently they 
have expanded rapidly, with growth of over a hundred hotels in the last 
two years. 
Each new hotel is fitted to a high standard by HIH. The head office of HIH 
is responsible for all advertising and special offers, the setting of prices and any branding changes. 
The local hotel managers are responsible for operational decisions, such 
as which staff to hire and employee training. 
HIH sets targets for local managers based on total sales and customer 
satisfaction feedback. The customer feedback is collected by hotel staff from customer questionnaires. 
Required: 
Comment on the suitability of the targets set for local hotel managers. 
(15 minutes
)

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 The role of the management  accountant in performance 
 The Chartered Management Accountant has a crucial role to play within 
the organisation when considering the performance measurement mix. 
They will help management to decide on the performance measurement 
mix itself. Management accountants can help managers analyse the organisation’s strategy and suggest what measures will ensure this strategy is achieved. 
Management acco untants will also help manage rs to decide what targets 
to set staff in each area of the performance measurement mix. This could 
include work studies to identify what employee roles involve, followed by 
calculation of what they can reasonably be expected to achieve. 
Management accountants will also hel p the organisation to design 
systems to capture relevant information relating to the measurement mix. 
They will then communicate this to management, enabling them to identify whether the organisation’s strategy is being successfully implemented. 
12  Integrated Reporting  
12.1 Introduction 
With IR, instead of having environmental and social issues reported in a separate section of the ann ual report, or a standalone ‘sustainability’ report, the 
idea is that one report should capture the strategic and operational actions of management in its holistic approach to business and stakeholder ‘wellbeing’. 
12.2 The management accountant's role in providing key performance 
information for IR 
The management accountant must now be able to collaborate with top 
management in the integration of financial wellbeing with community and stakeholder wellbeing.  This is a more strategic view considering factors that drive long-term performance. 
IR will bring statutory r eporting closer to the mana gement accountant and will 
make management accountants even more important in bridging the gap 
between stakeholders and the company’s reports. 
The management accountant will be expected to produce information that: 
• is a balance between quantitative and qualitative information.  The 
information system must be able to capture both financial and non-
financial measures 
• links past, present and future performance.  The forward looking nature 
will require more forecasted information

366  
• considers the regulatory impacts on performance 
• provides an analysis of opportunities and risks that could impact in the 
future 
• considers how resources should be best allocated • is tailored to the specific business situation but remains concise. 
There is clearly a need for the profession to accept the challenge for being 
the mechanism for a new type of transparency and accountability; one that incorporates social and environmental impacts as well as economic ones. 
The role of the management accountant in sustainability is as yet not well 
established. However, it is anticipated that over time, IR will become the corporate reporting norm. This will offer a productive and rewarding future, not only for the management accountant but for society as a whole. 
12.3 The International Integrat ed Reporting Council (IIRC) 
The IIRC was formed in August 2010 and aims to create a globally accepted 
framework for a process that results in communication by an organisation about value creation over time. 
The IIRC seeks to secure the adoption of an Integrated Reporting Framework (an 
alternative to the recommendations by the Global Reporting Initiative) by report preparers. The Framework sets out several guiding principles and content 
elements  that have to be considered when preparing an integrated report. 
 
Illustration 2 – Guiding principles 
 There are seven  guiding principles, as follows: 
Strategic focus and future orientation  – the report should provide and 
insight into the organisation’s strategy and how it relates to the 
organisation’s ability to create value in the short, medium and long term. 
Connectivity of information  – the report should show a holistic picture 
of the combination, inter-relate dness and dependencies between the 
factors that affect the organisation’s ability to create value over time. 
Stakeholder relationships  – the report should provide an insight into the 
nature and quality of the organisation’s relationships with its stakeholders. 
Materiality  – the report should disclose information about matters that 
substantively affect the organisation’s ability to create value. 
Conciseness  – the report should be concise and include relevant 
information only. 
Reliability and completeness  – the report should include all material 
matters, both positive and negative, in a balanced way and without 
material error. 
Consistency and comparability  – the report should be consistent and 
comparable over time.

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 Illustration 3 – Content elements 
 There are eight content elements.  
Organisational overview and external environment  – what does the 
organisation do and what are the circumstances under which it operates? 
The organisation's mission and objectives, stakeholder analysis and 
PESTEL analysis would be relevant in this section. 
Risks and opportunities  – what are the risks and  opportunities, both 
internal and external, that affect th e organisation’s ability to create value 
over the short, medium and long term and how is the organisation dealing 
with them? 
Strategy and resource allocation  – where does the organisation want 
to go and how does it intend to get there? This section may make use of 
Porter's 5 Forces, the BCG matrix and the value chain. 
Business model  – what is the organisation’s business model, i.e. what 
activities will it carry out to create value? The Value Chai n is likely to be 
highly relevant here. 
Future outlook  – what challenges and uncertainties is the organisation 
likely to encounter in pursuing its strategy and what are the implications 
for future performance? PESTEL and Porter's 5 Forces are likely to be 
particularly relevant here. 
Performance  – to what extent has the organisation achieved its strategic 
objectives for the period? The most appropriate performance indicators 
should be chosen here. 
Governance – how does the organisation’s governance structure support 
its ability to create value in the short, medium and long term? 
Basis of preparation and presentation – how does the organisation 
determine what matters to include in the integrated report and are such 
matters quantified or evaluated? 
12.4 IR and capital 
The IR Framework recognises the importance of looking at financial and 
sustainability performance in an integr ated way – one that emphasises the 
relationships between what it identifies as the “six capitals”: 
• Financial capital 
This is what we traditionally think of as ‘capital’ – e.g. shares, bonds or 
banknotes. It enables the other types of Capital described below to be owned and traded. 
• Manufactured capital 
This form of capital can be described as comprising of material goods, or fixed assets which contribute to the production process rather than being the output itself – e.g. tools, machines and buildings.

368  
• Intellectual capital 
This form of capital can be described as the value of a company or 
organisation's employee knowledge, business training and any proprietary information that may provide the company with a competitive advantage. 
• Human capital 
This can be described as consisting of people's health, knowledge, skills 
and motivation. All these things are needed for productive work. 
• Social and relationship capital 
This can be described as being concerned with the institutions that help maintain and develop human capital in partnership with others; e.g. Families, communities, businesses, trade unions, schools, and voluntary organisations. 
• Natural capital 
This can be described as any stock or flow of energy and material within the environment that produces goods and services. It includes resources of a renewable and non-renewable materials e.g. land, water, energy and those factors that absorb, neutralise or recycle wastes and processes – e.g. climate regulation, climate change, CO
2 emissions. 
The fundamental assumption of the IR Framework is that each of these types of capital – whether internal or external to the business, tangible or intangible – represents a potential source of value that must be managed for the long run in order to deliver sustainable value creation. 
As well as external reporting to a range of stakeholders, the principles of IR can 
be extended to performance management systems. This is sometimes referred to as ‘internal IR'. 
An emphasis on these types of capital could result in more focussed 
performance management in the following ways: 
• KPIs can be set up for each of the six capitals, ensuring that each of the 
drivers of sustainable value creation are monitored, controlled and 
developed. 
• These can be developed further to show how the KPIs connect with 
different capitals, interact with, and impact each other. 
• The interaction and inter-connectedness of these indicators should then 
be reflected in greater integration and cooperation between different functions and operations within the firm. 
• This should result in greater transparency of internal communications 
allowing departments to appreciate better the wider implications of their activities. 
• Together this should result in better decision making and value creation 
over the longer term.

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 369 
 For each of the six capitals outlined in the Integrated Reporting 
Framework, suggest appropriate KPIs. 
12.5 The Global Reporting Initiative (GRI) 
The most accepted framework for r eporting sustainability is the GRI’s 
Sustainability Reporting Guide lines, the latest of which ‘G4’ – the fourth of the 
guidelines – was issued in May 2013. The G4 Guidelines consist of principles 
and disclosure items. 
• The principles help to define report content, quality of the report and give 
guidance on how to set the report boundary. 
• The disclosure items include disclosures on management of issues as well 
as performance indicators themselves. 
 
 Reporting principles and disclosures 
 Reporting principles 
Reporting principles are essentially the required characteristics of the 
Report Content and the Report Quality. The Principles for Defining 
Report Content are given as: 
• Stakeholder Inclusiveness 
• Sustainability Context 
• Materiality 
• Completeness. 
The Principles for Defining Report Quality are given as: 
• Balance 
• Comparability 
• Accuracy 
• Timeliness 
• Clarity 
• Reliability. 
Standard disclosures 
Two types of disclosure are required: General standard disclosures: 
• Strategy and Analysis 
• Organisational Profile 
• Identified Material Aspects and Boundaries

370  
 • Stakeholder Engagement 
• Report profile 
• Governance 
• Ethics and Integrity. 
Specific Standard Disclosures 
• Disclosures on Management's Approach 
• Indicators. 
The G4 guidelines encourage disclosure of various 'aspects' in the three 
categories: Economic, Environmental and Social. 
 
 Illustration 4 – Categories and aspects in the G4 guidelines 
 Examples of the aspects grouped by category are: 
Economic 
• Economic Performance 
• Market Presence. 
Environmental 
• Materials, energy and water 
• Biodiversity 
• Emissions 
• Effluents and Waste. 
Social  – this category is split into four sub-categories, each with several 
aspects associated with it as follows: 
Labour Practices and Decent Work 
• Labour/Management Relations 
• Occupational Health and Safety 
• Training and Education 
• Diversity and Equal Opportunity.

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 371 
 Human rights 
• Non-discrimination 
• Child Labour 
• Human Rights Grievance Mechanisms. 
Society 
• Local Communities 
• Anti-corruption. 
Product responsibility 
• Customer Health and Safety 
• Product and Service Labelling.

372  
13 Summary

Chapter 9 
 373 
A, C and F are advantages of using financial measures. 
 
The return on capital employed (ROCE) is calculated by taking the profit 
before interest and tax and dividing this by capital employed (shareholders funds plus long-term debt). 
Note that the proportions of debt to equity do not matter in this 
calculation, meaning that a shift in gearing will not necessarily affect the ROCE. 
In addition, large dividends would tend to reduce the shareholders funds, 
which could actually cause an increase in the ROCE, rather than a reduction. 
 
Learning and growth relates to both innovation and training for staff 
though this could also have a positive effect on both customers and service quality.

374  
  
Perspective Goals/CSFs Measures/KPIs 
Customer New products 
 % of sales from new 
products 
 Responsive service % ontime delivery 
 Preferred supplier Customer ranking 
 Partnership ventures Number of cooperative 
Internal business Manufacturing excellence Production cycle time, unit cost 
 Design productivity Material efficiency 
 New product development Introduction times, actual versus plan 
Learning and growth Time to market Introduction times v 
competition 
 Product focus % of products giving 80% 
of sales 
 Manufacturing Process time to maturity 
 Learning technology Time to develop next 
generation products 
Financial Survival Cash flow 
 Success Quarterly sales growth 
 Prosperity Increase in market share 
and return on equity (ROE)

Chapter 9 
 375 
 Report 
To: T 
From: A. N. Accountant 
Date: 15/01/XX Subject: Balanced scorecard analysis for CCC 
The Balanced Scorecard (BS) helps an organisation, like CCC, to identify 
key issues that it needs to consider in order to maximise the efficiency of its performance measurement mix. 
How the Balanced Scorecard could assist CCC 
In a widely published model, Johnson and Scholes characterise the 
strategic management process as consisting of three inter-related elements: 
• strategic analysis 
• strategic choice 
• strategic implementation. 
CCC has developed both mission and visi on statements and an overriding 
objective so they have dealt with the first two elements. However, the 
comments of the Corporate Affairs Director that ‘our strategy and vision ..(are)..not happening’ indi cate that CCC has been unsuccessful in 
strategic implementation. This is not an unusual situation as firms often experience a disjunction between the three elements. This is one of the reasons that the Balanced Scorecard (BS) was developed by Kaplan and Norton ‘to assist strategic policy formation and achievement’. 
The BS (See example below) comprises four perspectives surrounding 
the organisation’s vision and strategy. Each of these perspectives can be associated with an aspect of CCC’s vision statement. 
Vision and Strategy 
Our vision aspires to: 
• provide superior returns to our shareholders 
• continually improve our trading methods 
• delight our customers 
• learn from our mistakes, work smarter in the future. 
Our strategy is to double the size of our revenue by 20X7. Customer 
perspective. 
To achieve our vision how should we appear to our customers? Delight our customers.

376  
 Financial perspective 
To succeed financially how should we appear to our shareholders? Provide superior returns to our shareholders. 
To achieve our vision, how will we sustain our ability to change and 
improve? 
Learn from our mistakes and work smarter in future. 
To satisfy our shareholders and customers, what business processes 
must we excel at? 
Continually improve our business processes. 
Example application of the Balanced Scorecard to CCC 
The Balanced Scorecard can be made operational by using: 
• Objectives: what CCC wants to achieve 
• Measures: these will express the progress made towards an 
objective 
• Targets: these give specific values and timescales for the 
achievement of the measures 
• Initiatives: these are the actions taken to achieve a target. 
Examples of these four aspects are given below: 
• Objective: Provide increasing dividend returns 
• Measure: Dividend yield 
• Target: 6% dividend yield by end 20X4 
• Initiative: Cost cutting exercise to increase profits. 
• Objective: Increase customer satisfaction • Measure: Customer complaints 
• Target: Reduce customer complaints to 1% of transactions by mid 
20X5 
• Initiative: Increased training for sales executives.

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 377 
 Learning and Growth 
• Objective: Raise the educational level of staff 
• Measure: Number of graduates 
• Target: 50% of staff to be graduates by 20X6 
• Initiative: Sponsor staff on degree courses. 
Internal processes 
• Objective: Be at the forefront of the use of Information technology 
• Measure: Replacement rate for PCs 
• Target: All PCs to be no older than 2 yrs by the end of 20X4 
• Initiative: Seek new PC suppliers. 
Tutorial note:  the examples given above are not exhaustive: candidates 
were given credit for other appropriate examples. 
Potential drawbacks of the Balanced Scorecard 
It is possible that the pursuit of one perspective may adversely affect 
another one. For example, if customer satisfaction was to be increased by increased investment in inventory, the financial perspective could be damaged. In this case, CCC would have to prioritise one of the perspectives even though both of them were helping to deliver the vision and strategy. 
As CCC has not used the BS before there may have to be a cultural 
change for it to work successfully: cultural change can be hard to achieve. 
The BS may require substantial investment in dedicated software and 
training costs. 
The BS does not provide a single overall view of performance. Managers 
and analysts often favour measures which capture overall performance. 
The BS could be used to great effect within CCC. However, before the 
organisation decides to adopt this approach, it needs to ensure that they have fully understood the drawbacks and prepared strategies to handle these. 
Tutorial note: any other appropriate drawbacks identified by candidates 
would be given credit.

378  
The others are all measures of external effectiveness. 
 
 (i) The marketing success of the proposal is linked to the achievement 
of customer satisfaction. The success will require an efficient 
business operating system for all aspects of the cycle from product design to after-sales service to customers. Improved quality and delivery should lead to improved customer satisfaction. Schedule 1 shows a number of quantitative measures of the expected measurement of these factors: 
Quality is expected to improve. The percentage of production 
achieving design quality standards is expected to rise from 95% to 98% between 20X4 and 20X6. In the same period, returns from customers for replacement or rectification should fall from 3% to 0.5% and the cost of after-sales service should fall from $1.5m to $1.0m. 
Delivery efficiency improvement that is expected may be measured 
in terms of the increase in the percentage of goods achieving the planned delivery date. This percentage rises from 90% in 20X4 to 99% in 20X6. 
(ii) The financial success of the proposal is linked to the achievement of 
high productivity. This should be helped through reduced cycle time and decreased levels of waste. Once again Schedule 1 shows a number of quantitative measures of these factors: 
The average total cycle time from customer enquiry to delivery 
should fall from 6 weeks in 20X4 to 5 weeks in 20X6. This indicates both internal efficiency and external effectiveness. 
Waste in the form of idle machine capacity is expected to fall from 
10% to 2% between 20X4 and 20X6. Also, component production scrap is expected to fall from 7.5% in 20X4 to 2.5% in 20X6. These are both examples of ways in which improved productivity may be measured.

Chapter 9 
 379 
 (iii) Performance pyramid 
The performance pyramid should ensure that Ochil’s performance 
measurement system remains dynamic and relevant in a changing business environment. The pyramid measures performance across nine dimensions from corporate vision to individual objectives. The pyramid links the business strategy with the day to day operations ensuring that the different levels support each other. 
The measures go far beyond traditional financial measures such as 
profitability and cash flow. The measures relate to business operating systems and address the driving forces that guide the strategic objectives of Ochil. 
Customer satisfaction, flexibility and productivity are the driving 
forces upon which company objectives are based. The status of 
these can be monitored using the lower level indicators of waste, delivery, quality and cycle time. 
The pyramid views a range of objectives for both external 
effectiveness and internal efficiency. It makes clear the difference between measures that are of interest to external parties, e.g. customer satisfaction and quality, and measures that are of interest to the business, e.g. productivity and cycle time. 
The measures are seen to interact both horizontally at each level 
and vertically across the levels.  
 
 The correct answers are: A and C 
The number of new product lines relates to the innovation dimension. 
Increased revenue and margins is linked to the profit dimension, while the number of defective products is most closely linked to quality issues. The remaining dimensions have not been well covered by the measures set up by JKJ.

380  
Competitor benchmarking is not appropriate here as J’s rival is not ITTO 
accredited and is highly inconsistent with its approach to tuition. Neither of these things is likely to make it a suitable candidate for benchmarking. 
While J does operate a number of centres, their operations are strictly 
controlled by central teaching programmes and ITTO requirements. This means it is unlikely that internal benchmarking will identify any major improvements that can be made. 
The only group likely to be useful for a benchmarking exercise is 
universities. These are not rivals to J, so it is likely that this would be a process, or activity, benchmarking exercise. Universities are currently achieving a higher pass rate than J, so benchmarking could be useful for J. 
 
 Email 
To: L From: K Date: 19/09/XX Subject: Re: Benchmarking Hi L, As per your text, I’ve outlined the impact of benchmarking on the 
department and individuals below. 
The areas of the sales department as a whole which will be affected by 
the introduction of a system of benchmarking are: 
Planning:  It is important that the company's current practises are 
reviewed and assessed. If comparisons are made with similar 
organisations, it is essential that the present processes are understood to allow an objective view to be taken of the firm’s current sales management function. An effort will need to be made to identify a firm which is prepared to share information that may be regarded as confidential by many firms. 
Research:  It will be necessary to identify the activities which can be 
compared. In a sales department this could include, for example, the 
number of calls per week, the distances covered by each salesperson, etc. These might be useful starting points for the benchmarking process.

Chapter 9 
 381 
 Analysis:  The method used and the specification of the variables should 
be established before comparisons are made with another organisation. It 
is likely that operating costs, past sales levels and new business generated could all be performance indicators that can be analysed to provide the basis on which benchmarking can be undertaken. 
Implementation:  The information obtained in the benchmarking exercise 
will be invaluable in the future in order  to monitor the selling activities of 
the company. In addition it will assist in making better decisions regarding 
sales in the future. 
The impact of benchmarking on individual salespeople would be in the 
following areas: 
Planning:  As the activities of each salesperson need to be monitored, it 
is essential to get their co–operation if the benchmarking process is to be 
successful. Staff may need to be rea ssured that it will not affect them 
adversely. 
Research:  It is necessary to establish performance measures in a 
flexible manner as it may be difficult to make direct comparisons. For 
example, travelling times and the size of purchases by customers are likely to be major performance measures. These targets are currently the same for each sales area, but this may need to be flexed in order to be fair to each salesperson. 
Analysis:  It will become possible to compare performance within the firm 
and with other firms operating in the same areas. This could make 
comparisons more realistic and more effective for determining bonuses. 
Implementation:  Benchmarking will provide a better appreciation of the 
factors involved in setting sales targets. By helping to improve the 
performance of individual salespeople, the performance of the company as a whole can be improved. 
I hope that helps – if you need any more information, please let me know. Kind regards K 
 
(i) will increase the life of the pr oject, while (iii) will reduce the tax 
liability. Both will specifically improve YU’s SVA. 
(ii) will not necessarily add to SVA as it will require additional asset 
investment and there is no evidence that it will reduce YU’s overall 
working capital levels. (iv) relates to EVA, not SVA.

382  
Triple bottom line requires measuring the 3Ps – profits, people and 
planet. This can encourage staff to save money by reducing wastage as they are targeted on their environmental impact. Reducing wastage will help them achieve this and save the company money. 
However, measuring the 3Ps can be time consuming and complex. Note 
that options B and C are benefits of EVA/SVA. 
 
H is worried about production levels AND quality. The targets she is 
proposing are likely to encourage staff to work quickly – not with more care. This could see H suffering from further declines in quality. 
The stretch targets set have been created after discussion with staff -this 
suggests that they are achievable and that have been fully communicated by H. This means that A and D are incorrect. 
The sizeable bonus would i ndicate that staff will feel motivated to work 
towards the stretch target, meaning that C is also incorrect. 
 
 Suitability of targets Remember that targets set for managers need to be based around areas 
that they can directly control. 
Managers do make the operational decisions in the hotel, meaning that 
they should have a large degree of control over the customer experience and therefore customer satisfaction. 
However, as pricing and special offers are set by head office, they do not 
have total control over the sales made by the hotel. Should head office set an inappropriate price per room, sales will suffer. It would be unfair to blame the manager for this.

Chapter 9 
 383 
 Obviously (!) KPIs need to be matched to CSFs, which will depend on the 
precise circumstances of an organisation and the environment within 
which it operates. However, some generic KPIs could include the 
Financial capital 
• Conventional performance measures may be relevant here 
including revenue growth, margins, ROCE, interest cover, key costs 
as a % of revenue, etc. 
• EVATM . 
Manufactured capital 
• Inventory days, inventory turnover, size of forward order book 
compared to annual production, etc. 
• Investment in different classes of NCAs. These could also include 
intangible assets, such as measuring annual investment in R+D as 
a % of revenue. 
Intellectual capital 
• Staff turnover of skilled staff 
• Utilisation of skilled staff 
• Percentage of patented products 
• A measurement of brand strength such as elasticity of demand 
(i.e. the change in demand as a result of a change in price) 
• R+D expenditure. 
Human capital 
• Number of staff, staff turnover 
• Productivity/efficiency measures such as sales per employee for a 
sales team 
• Sickness rates.  
Social and relationship capital 
• Staff satisfaction surveys, looking in particular at staff confidence in 
leadership, opinions about growth and wellbeing. 
Natural capital 
• Any environmental KPIs could be used here such as energy 
consumption and efficiency, output of greenhouse gasses and 
carbon footprint, water usage, % of  waste recycled verses landfill, % 
of products produced that can be recycled, etc.

385 
Understanding the 
impact and context of 
change 
E3: Recommend change 
management techniques 
and methodologies (a) Assess impact of strategy 
(b) Recommend change 
 
  Chapter 
10

Understanding the impact and context of change 
386  
 
Internal and external pressures make change inevitable. 'Adapt or die' is the 
motto of almost every organisation. Some strive to meet the challenge by leading those in the marketplace whilst others hide in niches, snapping at the heels of the major players. 
The key questions for all companies are not whether to change or not but 
rather: 
• What to change?  
• What to change to?  
• How to change successfully?  
2 Triggers for change 
External triggers 
Environmental pressure for change can be divided into two groups. 
• General (indirect action) environmental factors – these can be identified 
using the familiar PESTEL framework and 
• Task (direct action) factors – these can be assessed using Porter's five 
forces model.

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 Examples of external triggers  
 Indirect triggers (PESTEL) 
Political Changes in government 
New environmental protection policies Private/public partnerships 
Economic Growth or recession Changes in currency and interest rates Local labour costs 
Regional prosperity/opportunities 
Disposable income 
Social Attitudes to work and leisure 
Environmentalism 
Attitudes to health/education Fashion trends 
Changing national/regional culture 
Technological 
 
 Environmental 
 
Legal Growth in Internet Public use of IT 
Global sourcing/call centres 
Innovations Visible impact (e.g. plastic in oceans) 
Demands from customers 
New labour laws European directives 
Direct triggers (Porter's five forces) 
Competitive rivalry Powerful rivals may force the firm to have to 
adapt to survive, either through innovation, if a differentiator, or cost cutting if a cost-leader. 
Power of customers Powerful customers could trigger a firm to consider forwards vertical integration. 
Power of suppliers Supplier power could encourage a firm to 
redesign products in order to reduce the 
reliance on specialist components and thus facilitate multi-sourcing. 
Threat of new entrants New entrants may force incumbent firms to improve quality to maintain market share. 
Threat of substitutes New technologies may result in substitutes that render existing products obsolete. This could lead to factory closure and reorganisation.

388  
Internal triggers 
The reasons for change within the organisation could span any functional area 
of operation or level of control from strategic to operational. 
Philosophy New ownership 
 New CEO 
 New initiative/management style 
Reorganisation Takeover/merger 
 Divisional restructuring 
 Rationalisation/cost reduction 
Personnel Promotions/transfers 
 Rules/procedures 
 Training/development 
Conditions Location change 
 Outsourcing 
 Rosters/flexible working 
Technology New procedures/systems 
 Changing information demands 
 Integration of roles 
Problem identification as a precursor to change 
The above triggers can be reasons why change is considered or even necessary. 
However, further strategic analysis is needed to determine  what  needs changing. 
 
 Illustration 1 – Problem identification as a precursor to change 
 For example, TGH Textiles is a UK-based clothing manufacturer that has 
seen falling profits, declining margins and a loss of market share over the 
last two years. The main reason for this decline is increasing competition from manufacturers in China and India. 
The external trigger for change is increased competitive rivalry, but what 
needs changing? 
The first step would involve analysing the firm's cost base and 
determining customer perceptions regarding relative quality. This should help TGH to see how it's competitive advantage is being eroded. Suppose poor quality is identified as the underlying problem. 
Even then, it is not obvious what needs changing. "Poor quality" could be 
an underlying problem of customer perception related to brand or design flaws, the quality of raw materials, production problems or an underlying culture where quality is not valued highly enough. Determining the main cause(s) could involve discussions with customers, competitor analysis, Porter's value chain analysis, SWOT and/or benchmarking. 
Only then will the directors have a clear idea of what needs changing.

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3 Classifying change 
Types of organisational change 
Change can be classified by the extent (or scope) of the change required, and 
the speed with which the change is to be achieved: 
Types of change 
 
(Exploring strategic change  – Balogun, Hope Hailey) 
Note that incremental change is also known as "continuous" change while 
"discontinuous change" refers to the big bang above. 
• Transformation entails changing an organisation’s culture. It is a 
fundamental change that cannot be handled within the existing 
organisational paradigm. This is likely to be a top down process and is normally driven by major external events. 
• Realignment does not involve a fundamental reappraisal of the central 
assumptions and beliefs. 
• Evolution can take a long period of time, but results in a fundamentally 
different organisation once completed. It is normally taken in anticipation of a need for change. 
• Revolution is likely to be a forc ed, reactive transformation using 
simultaneous initiatives on many fronts, and often in a relatively short space of time. It is rapid and likely to affect most, if not all, aspects of what the business does and how it operates – in other words it represents a fundamental change to the organisation’s paradigm. It is therefore critical that this type of change is managed effectively.

390  
 Illustration 2 – Strategic change 
 Strategic change is by definition far-reaching. We speak of strategic 
change when fundamental alterations are made to the business system or 
the organisational system. Adding a lemon-flavoured Coke to the product portfolio is interesting, maybe important, but not a strategic change, while branching out into bottled water was a major departure from Coca-Cola’s traditional business system. 
 
 Evolution or revolution? 
 Another way that evolution can be explained is by conceiving of the 
organisation as a learning system. However, within incremental change there may be a danger of strategic drift, because change is based on the existing paradigm and routines of the organisation, even when environmental or competitive pressure might suggest the need for more fundamental change. 
In selecting an approach to strategic change, most managers struggle 
with the question of how bold they should be. On the one hand, they usually realise that to fundamentally transform the organisation, a break with the past is needed. To achieve strategic renewal it is essential to turn away from the firm’s heritage and to start with a clean slate. On the other hand, they also recognise the value of continuity, building on past experiences, investments and loyalties. To achieve lasting strategic renewal, people in the or ganisation will need time to learn, adapt and 
grow into a new organisational reality. 
The ‘window of opportunity’ for achieving a revolutionary strategic change 
can be small for a number of reasons. Some of the most common triggers are: 
• competitive pressure – when a firm is under intense competitive 
pressure and its market position starts to erode quickly, a rapid and 
dramatic response might be the only approach possible. Especially 
when the organisation threatens to slip into a downward spiral 
towards insolvency, a bold turnaround can be the only option left to the firm. 
• regulatory pressure – firms can also be put under pressure by the 
government or regulatory agencies to push through major changes within a short period of time. Such externally imposed revolutions can be witnessed among public sector organisations (e.g. hospitals and schools) and highly regulat ed industries (e.g. utilities and 
telecommunications), but in other sectors of the economy as well (e.g. public health regulations). Some larger organisations will, however, seek to influence and control regulation. 
• first mover advantage – a more proactive reason for instigating 
revolutionary change, is to be the first firm to introduce a new product, service or technology and to build up barriers to entry for late movers.

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 Strategic change can be classified as evolution, adaptation, 
reconstruction or revolution. The classification depends on both the 
scope and speed of the change. 
Which ONE of the following combinations of extent and speed of change 
would be classified as an evolutionary change? 
 Extent Speed 
A Transformation Big bang  
B Realignment Big bang  C Transformation Incremental  
D Realignment Incremental  
 
 H makes and sells a patented chemical, known as LKL, widely used in 
cosmetics. LKL has recently been found to increase the risk of cancer of 
users. This has led to a ban on all cosmetics containing LKL. 
H has therefore started urgently looking for alternative uses for LKL. It 
has identified that LKL can be an effective pesticide and, due to its lack of contact with humans the increased risk of cancer will not be an issue. H has therefore started looking for pesticide manufacturers to sell to. 
Which ONE of the following types of organisational change is occurring 
at H? 
A Reconstruction B Evolution C Revolution D Adaptation

392  
 Historically the directors of Zed Bank have resisted change, seeking to 
offer a traditional approach to its customers. However, recent problems 
within the banking industry and an increasingly competitive market has forced the Board to consider a number of important initiatives, including: 
• enhancing its current services to customers by providing them with 
on-line internet and telephone banking services; and 
• reducing costs by closing many of its rural and smaller branches 
(outlets). 
In an attempt to pacify the employee representatives (the Banking Trade 
Union) and to reduce expected protests by the communities affected by branch closure, a senior bank spokesperson has announced that the changes will be ‘incremental’ in nature. In particular, she has stressed that:
 
• the change will be implemented over a lengthy time period 
• there will be no compulsory redundancies 
• banking staff ready to take on new roles and opportunities in the 
online operations will be retrained and offered generous relocation 
expenses. 
H For customers, the bank has promised that automatic cash dispensing machines will be available in all the localities where branches (outlets) close. Customers will also be provi ded with the software needed for 
Internet banking and other assistance necessary to give them quick and easy access to banking services. 
The leader of the Banking Trade Union is ‘appalled’ at the initiatives 
announced. He has argued that the so-called ‘incremental’ change is in fact the start of a ‘transformational’ change that will have serious repercussions, not only for the Union's members but also for many of the bank's customers. 
Required: 
Distinguish incremental change from transformational change. Explain 
why the bank spokesperson and the trade union leader disagree over their description of the change. 

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4 Organisational culture 
Definition 
 
 Culture is the set of values, guiding beliefs, understandings and ways of 
thinking that are shared by the members of an organisation and is taught to new members as correct. It represents the unwritten, feeling part of the organisation. 
Culture is ‘the way we do things around here’ (Charles Handy). 
Culture is a set of ‘taken-for-granted’ assumptions, views of the environment, 
behaviours and routines (Schein). 
Cultural processes of change 
The inherent culture of the organisation is important for two reasons: 
Firstly the existing culture can become "embedded" and hence resistant to 
change. Overcoming this resistance can be a major challenge. 
Secondly the existing culture can limit the types of strategy development and 
change that are considered. 
• Faced with forces for change, managers will seek to minimise the extent to 
which they are faced with ambiguity and uncertainty by defining the 
situation in terms of that which is familiar. 
• This can explain why some firms adopt incremental strategies and, worse, 
why some fail to address the impact of environmental triggers, resulting in strategic drift (that is, having no sense of strategy). 
 
 Illustration 3 – Cultural process of change 
 Faced with a change trigger such as declining performance, management 
are likely to react as follows: 
(1) First managers will try to improve the effectiveness and efficiency of 
the existing strategy e.g. through tighter controls. 
(2) If this is not effective, then a change in strategy may occur but in 
line with existing strategies e.g. through market development, selling existing products into 
markets that are similar to existing ones and managing the process 
in the same way as they are used to. 
(3) Even when managers know intellectually that more radical change 
is needed, they find themselves constrained by existing routines, assumptions and political processes.

394  
The cultural web 
 
The cultural web was devised by Gerry Johnson as part of his work to attempt to 
explain why firms often failed to adjust to environmental change as quickly as 
they needed to. He concluded that firms developed a way of understanding their organisation – called a paradigm – and found it difficult to think and act outside this paradigm if it was particularly strong. 
 
Using the cultural web to map change  
 The concept of the cultural web is a useful device for mapping out 
change but its real worth is in the fact that we can identify which elements 
of culture need to change. 
Key questions to ask include: 
Stories  • What stories do people relate within the 
organisation and what do they say about the 
organisation’s values? 
• How pervasive are these beliefs (through the 
levels of the organisation)? 
• What do current staff tell new staff when they 
join? 
• Do stories relate to: strengths or weaknesses, 
successes or failures, co nformity or mavericks? 
Who are the heroes and villains? 
• What norms do the mavericks deviate from?

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Routines and 
rituals 
 • What behaviour do routines encourage? Which 
would look odd if changed? 
• What are the key rituals that staff undertake 
regularly? What core beliefs do they reflect? 
• What do training programmes emphasise? 
• How easy are the rituals/routines to change? 
• What do employees expect when they come to 
work? 
 • Is there a very formal organisational structure? 
Are there any informal reporting mechanisms? 
• How flat/hierarchical are the structures? How 
formal/informal are they? 
• Do structures encourage collaboration or 
competition? 
• What type of power structure does the overall 
organisational structure support? 
Control 
systems 
 • What is most closely monitored/controlled in my 
• Is emphasis on reward or punishment? Are 
there many/few controls? 
• Are all employees aware of the control 
mechanisms in place? 
• Is the organisation well controlled? 
Power 
 • What are the core beliefs of the leadership in my 
• Who has the power to make decisions? 
• Is power used effectively and appropriately? 
• How is power distributed in the organisation? 
• What are the main blockages to change?

396  
   
Symbols 
 • What language and jargon are used in the 
• How internal or accessible are they? 
• What aspects of strategy are highlighted in 
publicity? 
• What status symbols are there? • Are there particular symbols that denote the 
organisation to the outside world/customers? 
Overall 
 • What are the key underlying assumptions that 
are the paradigm? 
• What is the dominant culture? 
• How easy is this to change? 
  
 Illustration 4 – The cultural web 
 Suppose you are acting as a consultant to the technical services 
department of a local government authority. You have found that 
departments are not very responsive to the needs of users and that service is inconsistent from one branch to another. 
A strategic change workshop with managers resulted in the following 
cultural web:

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 What is notable about the paradigm is that staff believe they are providing 
a "good service", that they have a high professional standing and see 
themselves as problem solvers. Unfortunately their problem solving and professional standards do not appear to be customer focused. The fact that stories and myths focus on how things "used to be" indicate staff are out of touch with user needs. 
Furthermore, given the degree of local autonomy, an emphasis on status 
symbols such as parking spaces and a blame culture, it is hardly surprising that co-operation and standardisation across branches is poor. 
These are the cultural challenges that must be met if effective change is 
to be implemented. 
 
 D has recently been hired by B Brothers Ltd, a large department store 
which is owned and run by the Bond family. The family has owned and run the store for 75 years and little has changed in the management approach. 
D has been hired in order to make suggestions relating to strategic 
changes needed within B Brothers, which has seen falling profitability for the last five years. 
His first suggestion was to eliminate the private dining room that was set 
aside for senior managers. D suggested that this room was too expensive to run and damaged management’s ability to interact with more junior members of staff. 
D’s suggestion was met with significant opposition, with senior 
management suggesting that he had ‘failed to understand the culture of B Brothers’. 
Which ONE aspect of B Brothers’ corporate culture would D’s suggestion 
have directly impacted upon? 
A Power structure B Control systems C Symbols D Stories and myths

398  
 G Ltd is a training organisation based in country S. G’s mission 
statement, which is regularly promoted by management is ‘to enable 
students to achieve their long-term goals in the workplace’. 
Employees, however, believe that the company’s main aim is to simply 
make a profit and this has caused problems with customer service and student satisfaction at G Ltd. 
According to the cultural web model, there appears to be confusion 
between managers and students over the organisation’s ________. 
Which ONE of the following words correctly fills the gap in the sentence 
above? 
A Mission B Paradigm C Objectives D Vision 
 
 Test your understanding 6 – HBY – (Case style) 
 HBY is a manufacturer of children’s toys based in country U. It makes 
scale models of motor vehicles and trains using traditional methods. This 
means there is a heavy reliance on manual labour with a focus on quality. HBY’s sales have declined since their peak around twenty years ago, although they have been static for many years. The company is owned by the founding family (who also occupy most of the senior positions on HBY’s Board of Directors) and has always returned acceptable profits, with the family regularly consulting their workers regarding the strategic decisions made by the board – in spite of the organisation’s rigid, bureaucratic structure. The many levels of management create a defined career path for staff, and the directors place a strong emphasis on individual growth and development. 
Recently, the family have decided to sell the company to a large, 
multinational toy-maker, WDG, who wishes to add HBY’s well-known brand name to its portfolio. WDG is a listed company and is under pressure from its shareholders to increase dividends and profits. 
HBY’s employees have been informed of many of WDG’s plans for the 
company, including a move to cheaper, more automated production processes. WDG has not spoken with any staff representatives of HBY to date and redundancies have not been confirmed, though staff expect them to be significant.

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 WDG has announced that it will be replacing several levels of HBY’s 
managers with a single tier of their own senior staff, who will have 
oversight over all of HBY’s employees and remaining managers. Whereas staff at HBY have historically been left to get on with their work, unless there were specific problems, WDG’s Board have stated that they will be more hands-on, helping train staff on the ‘new, improved manufacturing processes being introduced by WDG’. 
WDG has also suggested that the company’s pay structure will be 
altered. Previously, staff were awarded a bonus based on a range of indicators, including sales and customer complaints. WDG wishes to pay staff on a piecework basis and is planning to cut back on the regular social gatherings that HBY has historically provided for its workers. 
Finally, WDG has indicated that it no longer wishes to pursue the quality 
accreditation that HBY has attained for the last ten years, as the ‘costs outweigh the benefits’. 
The staff of HBY have expressed their concern to the current owners. 
Staff are unionised and they have stated their intention to strike over the proposals. A number of HBY’s senior managers have stated that WDG ‘clearly fails to understand the culture of HBY and should not be allowed to destroy the organisation that HBY’s staff have worked so hard to build.’ 
Required: 
Draft a report to the management of WDG, which identifies the various 
aspects of the existing culture of HBY, using an appropriate model to structure your report. 
You should also use your report to explain the reasons for HBY’s staff 
resisting the proposed takeover by WDG. 
(25 minutes)

400  
5 McKinsey 7S Model 
Like the cultural web, McKinsey’s 7S model looks at corporate culture and the 
various components that it is made up of. McKinsey saw culture as seven interconnected elements, each beginning with the letter S. 
 
Three of these factors are referred to as ‘hard’ (tangible and easy to quantify): 
• Structure  – this looks at the way the organisation is structured and who 
reports to whom. 
• Strategy – relates to the ways in which the organisation plans to gain a 
competitive advantage or achieve other objectives. 
• Systems  – these are the daily activities and procedures followed by staff. 
The remaining four factors are ‘soft’ (less easily quantified and more subjective): 
• Skills  – the skills, abilities and competences of the organisation’s 
• Style  – the style of leadership adopted within the organisation. 
• Staff  – the people that make up the organisation. 
• Shared values – the core values of the organisation (i.e. the paradigm). 
The model suggests that all seven elements have to be aligned with each in 
order for the organisation to operate effectively.

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In the context of change, McKinsey’s 7S model can be used to look at the 
factors that could be affected by the change process, as well helping improve the organisation’s understanding of the wider effect of change. If one of the S factors changes, it will have a knock-on effect on other S factors. 
For instance, if the organisation introduces a new automated assembly process, 
this would be a change to the company’s systems. However, this would also likely impact elsewhere in the organisation. Staff may find they lack appropriate skills , leading to uncertainty and resistance. It may lead to a reduction in the 
number of workers, affecting the staff  and structure  of the organisation. If staff 
require fewer skills to undertake their roles, the style  of management within the 
business may be affected. Even a small change can therefore have wide-ranging impacts on the organisation. 
 
 Which THREE of the following are elements within McKinsey’s 7S model 
of corporate culture? 
A Symbols B Stories and myths C Structure D Support E Skills F Styles 
 
 Which ONE of the following factors of the McKinsey 7S model is classified 
as a ‘soft’ element? A Structure B Strategy C Staff D Systems

402  
6 Resistance to change 
Resistance to change is the action taken by individuals and groups when they 
perceive that a change that is occurring is a threat to them. 
 
 Resistance is ‘any attitude or behaviour that reflects a person’s unwillingness to make or support a desired change’ 
 
Resistance may take many forms, including active or passive, overt or covert, individual or organised, aggressive or timid. For each source of resistance, management need to provide an appropriate response, e.g.: 
 
Source of resistance Possible response 
• The need for security and the 
familiar 
• Having the opinion that no 
change is needed 
• Trying to protect vested interests • Provide information and 
encouragement, invite involvement 
• Clarify the purpose of the change 
and how it will be made 
• Demonstrate the problem or the 
opportunity that makes changes desirable

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 Reasons for resisting change  (Kotter and Schlesinger) 
 According to Kotter and Schlesinger (1979) there are four reasons that 
explain why certain people resist change. 
• Parochial self-interest (some people are concerned with the 
implication of the change for themselves and how it may affect their 
own interests, rather than considering the effects for the success of the business). 
• Misunderstanding (communication problems; inadequate 
information). 
• Low tolerance to  change (c ertain people are very  keen on security 
and stability in their work). 
• Different assessments of the situation (some employees may 
disagree on the reasons for the change and on the advantages and disadvantages of the change process). 
 
 Which THREE of the following would usually be classed as social factors 
leading to resi stance to change? 
A Fear of unemployment 
B Dislike of person leading change C Lack of consultation regarding the change D Changes to current social environment E Implied criticism of current methods F Fear of demotion or reduced pay G Work becoming less interesting

404  
 J runs a small business manufacturing personalised stationery (such as 
envelopes and paper). She has recently decided to automate parts of this 
process, meaning that all four of her current staff members will see their overtime pay reduced (though there will be no effect on their basic pay). The main activities of each staff member will not change significantly as a result of the introduction of automation. 
J feels that the current overtime payments are unsupportable and that the 
business will be unable to grow unless the new system is introduced. 
Local competitors are already currently using this automated process. 
Although J has communicated the situation to the staff and they are all 
fully aware of the problems faced by the business, they have complained bitterly to J about the proposal and have suggested that they will refuse to use the new automated system. 
According to Kotter and Schlesinger, which ONE of the following is the 
primary reason for resistance among J’s employees? 
A Differing assessments of the situation B Parochial self-interest C Misunderstanding D Low tolerance to change

406  
 
Change is classified with reference to two factors – extent and speed of 
the change. 
The change in H is clearly rapid, as all the traditional products used for its 
chemical have been banned. It is urgently looking for alternatives to prevent a total collapse of the company. 
The scope of change seems small (a realignment). H will still be 
producing LKL – it will simply be selling it to a different type of organisation. While this may require some changes (such as marketing and customer management), H is still fundamentally producing and 
selling LKL. 
 
 Incremental change means step-by-step changes over time, in small 
steps. When incremental change occurs within an organisation, it is possible for the organisation to adapt to the change without having to alter its culture or structures significantly. Employees are able to adapt to the gradual changes, and are not unsettled by them. 
In contrast, transformational change is a sweeping change that has 
immediate and widespread effects. The effect of transformational change is usually to alter the structure and culture of the organisation, often with major staff redundancies and the recruitment of new staff with new skills. 
The spokesperson for the bank has argued that the change will be 
incremental. Since the change will take place over a long  period of time, 
staff will have time to adapt to the new structure. There will be no compulsory redundancies and staff will be re-trained in new skills. Although some branches will close, others will remain open, and customers will be offered additional facilities through on-line banking.

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 The trade union leader believes that the change will be much more 
dramatic. He might believe that many employees will leave the bank 
because they are unable to adapt to the new service, or because they are unwilling to re-locate from the branches that are closed down. The bank might push through the branch closure programme more quickly than it has currently proposed, and staff redundancies could be made compulsory if there are not enough individuals willing to take voluntary redundancy. 
Essentially, the two individuals take differing viewpoints because they are 
looking at change differently. The spokesperson for the bank wants to persuade employees to accept the change, and even welcome it. The trade union representative wants to warn employees about the potential consequences, and has ther efore stressed the risks. 
 
The private dining room is a symbol of the authority and position of the 
senior managers. Trying to remove th is is likely to cause resistance as 
senior managers will see D’s suggestion as a way of reducing their status within the organisation. 
The proposed change does not directly affect the senior manger’s 
authority or position within the business, suggesting that it will not affect the power structure of B Brothers. 
The removal of the private dining room is also unlikely to impact the way 
that the organisation controls its staff (there is no change to the way that staff are rewarded or punished) and ther e is no evidence that it will alter 
the stories and myths – i.e. what staff members believe and say about the organisation. 
 
The paradigm is the overall aim and purpose of the organisation. This is 
clearly confused at G Ltd, leading to problems with customer management. 
There is no confusion over the mission itself. This has been published, 
meaning that staff are aware of the current mission statement. They simply do not agree that it represents the actual purpose of the organisation.

408  
 Report 
To: The Board of Directors, WDG From: A. Consultant Date: 18/08/XX Subject: Cultural issues and resistance at HBY 
This report will examine the impact of  WDG’s proposals relating to the 
takeover of HBY. Specifically, it will look at how these proposals will 
affect the culture of HBY post-acquisition. 
According to Handy, culture is defined as ‘the way we do things round 
here’. 
When analysing an organisation’s corporate culture, the most logical 
model to use is the Cultural Web. This suggests that the culture of an organisation can be broken down into six different aspects. Any attempt to significantly change the culture of the organisation, as WDG is attempting to do with HBY, is likely to lead to significant resistance. 
Symbols This looks at the symbols or symbolic actions that typify the organisation. Within HBY, the symbols include the regular social gatherings supplied 
by the company. This indicates that staff wellbeing and happiness is valued by the company. Cutbacks to this area are likely to cause 
resistance as staff will feel that WDG is indicating that they are no longer as valued as they once were. 
Power structure 
This examines who is in charge (or who has the power) within the 
HBY currently appears to have several levels of management, with the 
original founding family having ultimate control over the organisation. WDG intends to replace many of these managers with a single layer of their own management. 
This is likely to upset many of HBY’ s employees as it will not only lead to 
redundancies, but it will also change the reporting system that they are 
currently used to. 
Organisational structure 
The current management structure of HBY appears to be bureaucratic, 
with a number of levels of management. WDG is planning to replace this with a single level of its own management, flattening the structure.

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 This may lead to resistance as it may reduce the chances for internal 
promotion for HBY’s existing staff. There will be fewer management 
positions, many of which will be fill ed by WDG’s staff for the foreseeable 
future. 
Control systems 
Controls appear to be few and far between under the traditional approach 
taken by HBY. Staff were largely expected to get on with their own jobs, with management only getting involved if there was a problem. 
The new management systems proposed by WDG involve a much more 
hands-on approach, with employees being trained in the new systems by WDG managers. This is likely to cause resistance as staff will feel that they are no longer trusted by their management to get on with their work in an effective manner. 
The shift from a bonus based on a range of indicators, which focused on 
quality, to pay which is piecework, and therefore only based on the level of productivity, also indicates a shift in what the business expects from its employees. This is likely to cause confusion amongst workers who are used to a quality focus. 
Routines and rituals 
Linked to control systems, WDG are suggesting that the existing methods 
used by HBY’s workers for many years are inferior to the ‘new, improved’ WDG methods. 
Employees may therefore feel that there is an implied criticism of their 
existing working methods by WDG, increasing resistance. 
The fact that WDG has no interest in pursuing the quality accreditation 
that HBY have historically obtained also indicates that it places little value on the work currently being done by HBY and this, in turn, will increase resistance. 
Stories and myths 
The staff of HBY feels that, due to the participative style of the existing 
management, they have ‘helped to build’ the company and that they are a major reason for its historic success. 
Whether this is the case or not, WDG’s desire to implement the changes 
without any staff consultation is a departure from the management style that staff of HBY are used to and is likely to upset them. 
Paradigm 
Overall, HBY’s approach has been a participative one, with defined roles 
and a strong focus on quality. WDG seems to want to shift this towards a focus on output and profitability. This fundamental move in culture is, understandably, a difficult one for the staff of HBY to accept.

410  
 The correct answers are: C, E and F 
Note that A and B are factors from the cultural web model. 
 
Soft factors are those that are less easy to analyse and evaluate. 
 
 The correct answers are B, C and D A and F are job factors, E and G are personal factors. 
 
 The correct answer is B J’s employees are motivated by their own self-interest, rather than the 
ongoing success of the business. 
J’s staff are fully aware of the situation that the business is in – including 
the fact that J’s rivals have adopted similar automated systems. There is no evidence that they have failed to understand how much of a threat this may be to J’s operations. This suggests that options A and C are incorrect. 
It is unclear whether J’s staff have faced changes in their working 
practices in the past, so there is no evidence to support a low tolerance of change. It is therefore unlikely to be the primary reason for resistance.

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Change management –
the role of the leader in 
managing change 
and methodologies (c) Discuss the role of the 
leader in managing change 
 
  Chapter 
11

Change management – the role of the leader in managing change 
412  
 
As can be seen from the previous chapter, understanding the factors that impact 
on change management can be complex. However, even when a manager has a good understanding of the context of change within their organisation, they still need to be able to successfully implement the change itself. 
Given the conflicting views of different stakeholders – such as shareholders, 
employees and customers – achieving change within an organisation is often difficult and prone to failure. Due to this, a number of different theorists have examined the issue and identified possible approaches to managing the change process within the organisation. 
2 The role of the leadership 
In order to successfully implement change, most organisations will require someone to take overall control of the change process. This person is referred to as the change leader . 
Who is the change leader? 
The change leader is a key figure within the organisation who takes overall 
responsibility and control for the proposed change within the organisation. 
For a major, organisation-wide change this role may well be best filled by the 
CEO, but it can be taken on by anyone with the appropriate power and leadership skills within  the organisation. 
What does the change leader do? 
The change leader is responsible for articulating what change is needed and 
why, acting as a figurehead for the change process, as well as helping to deal with any problems or conflicts that arise during the change process. 
Kotter (Leading Change, 1996) suggested that leading change is an 8-step 
process.

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8-step process of change leadership 
• Establish a sense of urgency  – the change leader needs to help others 
see the need for change and convince them that it must be implemented 
promptly. 
Failure to create a sense of urgency leads to a lack of motivation from staff 
– the people who will ultimately be implementing the change you wish to create. Without motivation, they will not see the need to get involved, leading to failure. This sense of urgency is therefore vital and means that change leaders may take drastic action to create it. One company manager commissioned his organisation’s first ever customer satisfaction surveys, knowing the results would be adverse and then made them 
public. This created a strong driving force for change within the 
• Creating the guiding coalition  – the change leader is unlikely to be able 
to control the entire change process by themselves. They must therefore assemble a group with enough power to lead the change process and ensure that they are able to act as a team. 
The coalition may not simply be formed from senior management, as it 
can include anyone with skills or knowl edge which could be useful in the 
change process. However, they will need sufficient power – whether through job titles or reputation, to accomplish the change and (where necessary) force it through against opposition. 
• Developing a change vision  – the change leader needs to create an 
overall vision of the future, illustrating what the change is designed to accomplish as well as its benefits. Strategies will be developed to achieve the proposed changes. 
Failure to develop a clear, concise vision that can be communicated to 
stakeholders means that the project can lack focus and goal congruence. The change management process may simply collapse into a series of conflicting projects that do not move the organisation in the desired direction. 
• Communicating the vision  – the leader needs to communicate the vision 
and strategies identified in the previous stage to as many stakeholders as possible. This will maximise buy-in. 
Implementing major change in an organisation requires the involvement of 
(potentially) a large number of people at all levels. Without plenty of communication, these people will never see the importance of change and will be unwilling to make any effort towards accomplishing it. 
• Empowering broad-based action  – the change leader needs to remove 
obstacles to change (restraining forces) and encourage staff to get involved in generating ideas. 
Using Lewin’s forcefield analysis (as discussed later in this chapter) can 
be a useful exercise here. It helps management identify what will cause resistance, so that plans can be created to deal with these issues.

414  
• Generating short-term wins  – plan for interim achievements that can 
easily be made visible, then publicise and reward staff members involved. 
Change processes can take a long time to implement – in some cases 
years. Most people will become demotivated if they do not see any changes within the short to mid-term. Without some short term wins, they will therefore become demotivated and cynical about the success of the change management process. 
• Never letting up – maintain the change process, hiring, promoting and 
developing employees who support and implement the required changes. 
The use of specific change agents may be of use here (the role of change agents are explored later in this chapter). 
It is easy for an organisation to believe that its change process is complete 
when it has completed all relevant major projects. Unfortunately, as Lewin’s three-stage model indicates later in the chapter, it is easy for staff to slip back into old habits and ways  of working. Management will need to 
monitor the change process for a significant amount of time after ‘completion’ to ensure that the change has indeed become permanent. 
• Incorporating changes into the culture – continually reinforce the 
change and communicate and reward achievement. This stage looks at ways of ensuring that the new change a standard part of everyday work and to prevent staff slipping back into their old habits. 
Management need to ensure that they show staff how the changes have 
improved performance and how they have benefitted. It is also important to ensure that existing and future managers are supportive of the new processes. Choosing new managers who disagree with the changes that have been made could lead to staff slipping back into old habits and practises. 
 
 X plc has been performing well for many years, with staff enjoying 
significant bonuses. However, recent strategic analysis by the Board of X plc has identified that there are a number of rival organisations starting to gain a share in X’s traditional markets. They feel that, unless X significantly updates its working practises, it will lose its market position within three years. B was recently hired as CEO of X plc. She was selected as the company felt that she was the best candidate to lead X plc through a period of major change. 
After a thorough review of X’s operations, B created a powerful group of 
managers and directors across the organisation to help her implement her proposed, wide-ranging changes. She spent a significant amount of time explaining the process of change that was to be implemented, with a series of staff meetings under the slogan ‘changing X for the new markets’. At these meeting she involved staff and tried to build their ideas into the final change strategy. The Board refused to allow B to explain the new entrants to the market, as they felt that the company would see a drop in its share price if this information was leaked to the markets.

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 B backed up her proposed changes with a series of interim goals. When 
the organisation reached these targets, she planned to widely publicise 
them within the organisation in order to improve motivation amongst the staff. 
Unfortunately B struggled to motivate the staff and, in spite of her staff 
meetings, little change occurred. After six months, B had failed to reach any of her interim goals. She decided to step aside and left the company.
 
Kotter suggested that there were eight steps required to successfully lead change. B’s failure to achieve which ONE of these eight steps led to the ultimate failure of the change process at X plc? 
A Creation of a guiding coalition B Communicating the vision C Establishing a sense of urgency D Generating short-term wins 
Group and team formation 
One key aspect of change leadership is the ability to form a group of individuals 
within the organisation who can help to control and implement any proposed 
changes (Kotter’s ‘guiding coalition’ mentioned above). This group, as well as the other groups and teams that they form within the organisation, will actually implement change throughout the organisation. The change leader therefore must  be able to manage them effectively. 
A ‘group’ is simply a collection of individuals. The group the change leader selects may well come from various parts of the organisation, such as finance, human resources and sales – any part of the organisation that may be affected by the proposed change or have useful input into it. 
There is no guarantee that this group of  individuals will work well together. It is 
therefore very important that the change leader turns this group into a team. 
 
 A team is more than a group. It is a set of individuals who must work 
together in order to accomplish shared objectives. 
Teams usually: 
• share a common goal • enjoy working together 
• are committed to achieving certain goals. 
A team will have its own culture, leader and should be geared towards 
achieving a certain goal – in this case, implementing the desired changes within 
A change leader needs to ensure that his change team works well together to 
ensure that they will effectively assist in the implementation of the change process.

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Team building 
intervention. As such, change leaders may need to create ‘team-building’ exercises. These are tasks that are designed to develop team members and their ability to work together. 
Team building exercises tend to be based around developing the team in 
several areas, including: 
exercises which force team members to discuss problems the team is 
facing. 
• building trust  between team members, which will help them work 
together effectively. 
• social interaction  between the individuals within the team can help to 
reduce conflict and increase their ability to work effectively. 
Benefits and drawbacks of teams 
The change leader needs to be aware of the potential advantages and 
drawbacks of using a team to help impl ement change within the organisation. 
• a mixture of skills and abilities within the team. Each member may be from 
a different part of the organisation and may therefore have unique skills 
and knowledge that can be used to help the change process 
• better control, with opportunities for individual performance to be reviewed 
and controlled by other team members 
• improved communication – this can also lead to increased buy-in by the 
rest of the organisation. For example, employees within the HR department are more likely to accept change if an HR staff member is part of the change team. 
However, there are problems with the use of a team, including: 
• slower decision-making, as discussion is needed to come to any 
agreement – also potentially leading to increased conflict 
• decisions may be compromises, rather than decisions that are beneficial 
to the business and change process as a whole 
• group pressure to conform can lead to team members agreeing to 
decisions that they know are wrong because other team members 
support it 
• teams may have a lack of individual responsibility, as responsibility is 
shared between all members. They may therefore be more willing to take riskier courses of action than individuals.

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Leadership styles – Kotter and Schlesinger 
Kotter and Schlesinger set out the following change approaches to deal with 
resistance: 
 
Key considerations when deciding upon a leadership style 
• The speed at which change must be introduced 
• The strength of the pressure for change 
• The level of resistance expected 
• The amount of power you hold 
• How much information you need before you can implement the change 
and how long it will take to get that information. 
 
 Explanation of the Kotter and Schlesinger styles 
 • Participation – aims to involve employees, usually by allowing some 
input into decision making. This could easily result in employees 
enjoying raised levels of autonomy, by allowing them to design their own jobs, pay structures, etc. 
• Education and communication – used as a background factor to 
reinforce another approach. This strategy relies upon the hopeful belief that communication about the benefits of change to employees will result in their accept ance of the need to exercise the 
changes necessary. 
• Power/coercion – involves the compulsory approach by 
management to implement change. This method finds its roots from the formal authority that management possesses, together with legislative support. This approach is often required where the speed of change needs to be rapid and where possible crises occur.

418  
 • Facilitation and support – employees may need to be counselled to 
help them overcome their fears and anxieties about change. 
Management may find it necessary to develop individual awareness of the need for change. 
• Manipulation and co-optation – involves covert attempts to sidestep 
potential resistance. The information that is disseminated is selective and distorted to only emphasise the benefits of the change. Co-optation involves giving key people access to the decision-making process. 
• Negotiation – is often practised in unionised companies. Simply, the 
process of negotiation is exercised, enabling several parties with opposing interests to bargain. This bargaining leads to a situation of compromise and agreement. 
 
 Illustration 1 – Kotter and Schlesinger in practice 
 P is an organisation which wants to undertake a significant restructuring 
and is concerned about staff resistance. Kotter and Schlesinger’s six styles could be a useful way for the business to deal with this resistance. 
Education and communication 
The management of P could look at ways of helping staff see the need 
for (and logic of) the proposed reorganisation. This could involve, amongst other things: 
• meetings with employees 
• presentations 
• emails. 
This is useful if P’s managers believe that the resistance from staff will be 
based on inaccurate information. For example, employees may believe that the restructuring will lead to job losses. If this is not the case, then an education programme will help put staff fears to rest. Explaining the reasoning behind the restructuring (i.e. the need to deal with new, efficient competitors) can also help improve staff support. 
However, the process of communicating with all employees can be time 
consuming, especially in larger organisations – meaning that if P’s proposed changes are urgent, this may not be the best approach. In addition, employees may simply not believe the information that P’s managers are providing, meaning that the communication process will fail to be effective. 
It is also worth noting that if employees do not have inaccurate 
information, this approach is unlikely to work. If P’s plans will involve significant redundancies, then communicating this to employees will clearly not reduce resistance.

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 Participation and involvement 
This approach requires P’s managers to involve employees in the 
development and implementation of the reorganisation of the business. This means listening to the employees affected by the proposed changes and making use of their advice. 
This approach will work well if P’s employees are highly skilled and/or 
experienced, as they may have va luable ideas that will benefit the 
proposed restructuring. In addition, involving staff members in the 
restructuring decision-making process will significantly reduce resistance, 
as it increases employee buy-in. 
However, if employees are less skilled or experienced, they may fail to 
come up with valuable input into the change process. If employees are cautious, they may fail to make the major changes that are required. For instance, if P needs to make significant job cuts in order to compete in its market, it is unlikely that staff members will make that suggestion! 
Involving a large number of employees in the design and implementation 
of a new strategy is likely to be time consuming (as per education and communication) and is likely to therefore be inappropriate if rapid change is needed. 
Facilitation and support 
This involves management looking at ways of being supportive of 
employees who may be worried about the changes being proposed. For P this could include: 
• training staff in the use of any new systems which are being 
introduced 
• giving employees time off after the reorganisation has taken effect 
• giving time off/support for any employees who are being made 
redundant to find another job 
• listening and providing emotional support. 
This is a particularly effective approach to managing a situation where 
resistance is caused by fear and anxiety of the proposals, such as the fear of unemployment, or the fear of not being able to do a new role adequately. 
The main drawback of facilitation and su pport is that it, again, takes time 
and money – and can still ultimately be unsuccessful.

420  
 Negotiation and agreement 
This would involve P negotiating with employees to find a restructuring 
approach which is satisfactory to both P and its staff. This could involve: 
• reducing the extent of the restructuring to keep staff happy 
• offering alternativ e benefits to em ployees if th ey support the 
restructuring, such as increased pay or better working conditions. 
Employees who are made redundant could be offered more attractive redundancy packages. 
Negotiation is particularly useful when one party is clearly going to lose out under the proposed change, but still has the power to significantly resist the change process. Within P, this situation could occur if employees are heavily unionised. P may have to offer some compromises to avoid damaging strike action. 
Ultimately, however, negotiation can be time consuming for the company. 
In addition the agreement demanded by powerful other parties may be expensive. 
Manipulation and co-optation 
This would occur if P’s managers try to use covert attempts to influence 
the staff. It typically involves selective use of information. 
P could consider releasing information which makes it look as if the 
company is in financial difficulties (even if it is not) as a way of convincing staff that the restructuring is necessary for the survival of the business. Staff may simply be scared into thinking there is a crisis coming that only the proposed restructuring can avoid. 
Co-optation involves selectively promoting key staff members (or offering 
them incentives) if they decide to support the proposed change. This is not participation, as P’s managers are not interested in these staff member’s opinions – they simply want their endorsement, which may reduce resistance elsewhere in the business. 
Both of these approaches have possi ble drawbacks. Mani pulation is likely 
to lead to P’s employees feeling that they have been lied to (if the truth 
ever comes out) and can therefore destroy future working relations between employees and management. Producing misleading information is also a breach of an accountant’s professional code of ethics (in particular integrity and professional behaviour) and should therefore not be recommended by P’s strategic management accountant. 
Co-optation may lead to employees feeling that their managers are trying 
to ‘buy their silence’ and this can lead to more bad feeling and increased resistance. 
However, both manipulation and co-optation are relatively cheap to 
undertake and can be implemented quickly. This may therefore be a consideration for P if the proposed restructuring is required urgently.

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 Explicit and implicit coercion 
This involves P’s management attempt to force the restructuring through 
by threatening staff (for example with the loss of their jobs, demotions, or pay cuts) or by actually dismissing them or transferring them. 
Like manipulation, this is likely to cause significant bad feeling from 
employees and this may lead to a breakdown of future working relations. 
However, it is fast, cheap and may be the most effective route to take if 
change is required urgently – especia lly if it will be unpopular, regardless 
of how it is introduced. 
If P intends to fire a large proportion of its workforce as part of the 
restructuring process, none of the other methods discussed above are likely to lead to reduced resistance. As such, coercion may be the only possibility for the company. 
 
 H has recently announced a series of compulsory redundancies amongst 
staff. It plans to offer counselling to staff members affected by this process and has offered them time off (at full pay) to allow them to look for alternative jobs. 
Which ONE of Kotter and Schlesinger’s leadership styles has H adopted? A Education and communication B Facilitation and support C Coercion D Participation 
 
 U is an organisation which is currently experiencing a crisis. Due to the 
loss of a major customer, U feels that it has to cut a minimum of 30% of 
its workforce within the next month or it faces bankruptcy. U’s 10,000 employees are not heavily unionised, but U expects significant resistance from staff when it announces the job losses. 
Which ONE of Kotter and Schlesinger’s leadership styles would be most 
appropriate for U to adopt when dealing with its employees in this situation? 
A Education and communication B Negotiation C Manipulation and co-optation D Coercion

422  
 Test your understanding 4 – Grey – (Case style) 
 Grey Limited is a conglomerate organisation with two major divisions: 
A and B. The two divisions are run as autonomous business units as they 
operate in completely different markets. Both are entering a period of organisational change and the directors of Grey are considering what style of management would be the most effective for each division. 
The CEO of Grey has asked you to produce a set of notes for her, 
suggesting which leadership style(s) would be most appropriate in each division and why. She has sent you the following background information document. 
Briefing document – Divisions A and B 
Division A is currently highly profitable. However, it is looking at ways of 
increasing its efficiency. The managers of A have decided to centralise the accounting function within the business, which will reduce overheads 
and allow for a reduction in the number of employees. Division A has always had an excellent relationship with its relatively small number of highly skilled staff and is concerned about how these plans may affect that. 
Division B is currently loss-making. It is also planning on reducing the 
number of staff it employs, but wishes to do so across all departments. B has a large number of workers and initial estimates are that 18% of all staff members will be made redundant. B has undertaken similar exercises in previous years, leading to significant conflict between the relatively unskilled staff and managers. The directors of Grey have informed the managers of B that if the division does not move back into profit in the near future, the division will be closed. 
Required: 
Produce the notes as requested by the CEO. 

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 Test your understanding 5 – (Integration question) 
 You are a manager who is in charge of a team that has been given the 
task of introducing a new management reporting system into regional 
offices. There is considerable resistance to the changes from the office managers, and comments that you have heard include the following. 
• I have more important work priorities to take up my time. 
• I’m used to the old system. 
• The new system is too complicated. 
• The new system will create more paperwork. 
• The new system will make me more accountable. 
• My job in the new system is not clear. 
How would you try to deal with this resistance to change? 
3 Stage models of the change process 
Lewin's three-stage (“ice cube”) model 
The three-stage model of change was proposed by Kurt Lewin in the 1950’s. He 
argued that, in order for change to occur successfully, organisations need to progress through three stages. 
This process, shown in the following diagram, includes unfreezing habits or 
standard operating procedures, changing to new patterns and refreezing to ensure lasting effects. 
 
The process of change comprises three stages.

424  
Unfreezing 
In this stage, managers need to make the need for change so obvious that most 
people can easily understand and accept it. Unfreezing also involves creating the initial motivation to change by convincing staff of the undesirability of the present situation. Ways of destabilis ing the present stability could include: 
• Identifying and exploiting existing areas of stress or dissatisfaction. 
• Creating or introducing additional forces for change, such as tighter 
budgets and targets or new personnel in favour of the change. 
• Increasing employee knowledge about markets, competitors and the need 
for change. 
Essentially, effective communication and explaining the need for change is vital 
within the unfreeze stage. 
Change 
The change process itself is mainly concerned with identifying what the new 
behaviour or norm should be. This stage will often involve: 
• Establishing new patterns of behaviour • Setting up new reporting relationships 
• Creating new reward/incentive schemes 
• Introducing a new style of management. 
It is vital that new information is communicated concerning the new attitudes, 
culture and concepts that the organisation wants to be adopted, so that these are internalised by employees. 
In the ‘change’ stage participation and involvement is often necessary so that 
individuals feel ownership of change. 
Refreezing 
Refreezing or stabilising the change involves ensuring that people do not slip 
back into old ways. As such it involves reinforcement of the new pattern of work or behaviour by: 
• Larger rewards (salary, bonuses, promotion) for those employees who 
have fully embraced the new culture 
• Publicity of success stories and new "heroes" – e.g. through employee of 
the month. 
The key to this stage is therefore to ensure that change is embedded within the 
organisation and its culture.

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 Bank automation 
 During the economic crisis of 2008, many companies were faced with the 
need to restructure their organisations in order to cut costs and improve 
efficiency – with many banks being particularly hard-hit. 
A number of banks increased the amount of automation in their branches. 
This involved the purchase of cash machines that are able to process deposits of cash and cheques as well as performing other basic account management functions. Many other traditional branch functions now require customers to telephone central call centres rather than going into a branch. These changes allowed the bank to reduce the number of staff 
in their branches, saving money. 
However, such an approach was likel y to create significant resistance 
from staff – especially employees who work within the branches 
themselves. The bank may have wished to use Lewin's three-stage model as a way of managing the change process. 
Unfreezing This involves convincing employees of the initial need for the increased 
automation in the branches. While this may be difficult to do, especially if employees are heavily unionised, it is a crucial step in the change management process. 
The bank may choose to explain to employees about its current position 
in the market and the effect that the economic downturn has had on profits. If reducing costs will help to secure the long-term survival of the entire bank, many employees may be convinced of the need to proceed with the change. 
The directors of the bank may also stress any potential benefits of the 
proposals for the remaining branch employees. For example, a reduction in the number of basic account queries from customers may free up time for more interesting work, such as helping customers review their finances. 
Change 
This is the stage where the proposed change actually occurs. It will 
involve the reduction in the number of branch employees and the installation of new machinery into the branches. 
This will require training for employ ees. They will need to be able to deal 
with customer queries and complaints about the new branch procedures 
as well as how to maintain the new cash machines. 
Communication is vital at this stage. Employees must know what is 
expected of them during and after the change management process.

426  
 Refreezing 
This stage tries to ensure that bank staff do not return to the old systems. 
In this case managers need to prevent staff from processing basic customer transactions themselves ra ther than convincing customers to 
use the new automated systems. 
This may involve the creation of new reward schemes to encourage staff 
to adopt the new procedures. For instance, branch staff could receive an increased bonus if a high proportion of their customers start maintaining their accounts using the automated system. They may be penalised if they continue using the old systems. 
Managers can also reinforce the new approach by publicising success 
stories of branches that have embraced the change and by promoting key members of staff who supported the automation process. 
 
 Criticisms of Lewin's three-stage model 
 Kanter et al suggest that Lewin's ice cube model is too simplistic. 
They argue that the model is based on the assumptions that organisations are stable and static so change results only from concentrated effort and only in one direction. 
Kanter et al argue that change is 'multi-directional and ubiquitous', that it 
happens in all directions simultaneously and is often a continuous process. 
 
 According to Lewin’s three-stage model, which ONE of the following 
activities would be part of the ‘unfreezing’ stage? 
A Explaining the need for change B Creation of new reward schemes C Publicity of success stories D Training of staff in new ways of working

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 Test your understanding 7 – WW – (Case style) 
 WW is a company specialising in industrial paint manufacturing. It has 
recently experienced significant growth in turnover and has opened two 
new factories to help it cope with the additional demand. 
The managers of WW have become concerned that their current 
accounting software is no longer adequate for their needs. The current system is a basic one, which is mainly designed to record transactions and produce financial statements at the end of each period. Given the growth in the business, the managers of WW now need additional information, such as the production of monthly management reports and 
the ability to accurately cost each unit of their products. 
The current accounting system does not support these functions, 
meaning the accounting department is required to produce the information manually, which is both complex and time-consuming. WW’s managers are concerned that this delay in obtaining management information may be putting the firm at a disadvantage in the marketplace. 
The managers are therefore currently considering the purchase of a new, 
more complex, accounting package that will easily allow the production of the management accounting information that they need. 
WW has a small accounting department with six members of staff. All of 
these staff members have been employees of the company for many years. The current accounting package has been in use within WW for the last seven years. 
Required: 
Using Lewin's three-stage model, explain how WW could manage the 
changeover to the new accounting package. 
Force field analysis 
Lewin also emphasised the importance of force field analysis. He argued that managers should consider any change situation in terms of: 
• the factors encouraging and facilitatin g the change (the driving forces) 
• the factors that hinder change (the restraining forces). 
Change will only be successful if the dr iving forces are larger than the 
restraining forces. 
If we want to bring about change we must change the equilibrium by: 
• strengthening the driving forces • weakening the restraining forces 
• or both.

428  
The model encourages us to identify the various forces impinging on the target 
of change, to consider the relative strengths of these forces and to explore alternative strategies for modifying the force field. 
 
 N is the manager of a small division of NNB Ltd, which makes solar cells. 
N wishes to introduce a new shift system for his staff. A large number of N’s staff have stated that they will not accept the new shift pattern. 
N was initially uncertain of the reason for this resistance. After 
investigating, it was discovered that several staff members have 
misunderstood the proposals and spread the rumour within the division that the new shift pattern would lead to redundancies. 
N plans to communicate this error to his employees and explain to them 
that, while the new shift pattern will improve efficiency, it will not lead to redundancies. 
According to Lewin’s forcefield model, N’s plan to communicate with staff 
an example of _________ . 
Which ONE of the following phrases best fits the gap in the above 
sentence? 
A Reducing the restraining forces B Increasing the restraining forces C Reducing the driving forces D Increasing the driving forces

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 Test your understanding 9 – GVF – (Case style) 
 Great Value Foods (GVF) is one of Bigland’s leading supermarket chains, 
having traded for over fifty years. Though fierce competitive activity had 
reduced the major players in the industry to six large chains in the last twenty years, the competitive pressures and large-scale capital investment required had not prevented all new entrants to the market. A high proportion of all workers in the supermarket industry are unionised. 
A few foreign competitors seeking new markets had managed to secure a 
market share by offering unbranded goods at extremely low prices. This development increased the pressure on GVF as these new entrants were 
attracting consumers that had been part of GVF’s traditional customer 
base. 
In the midst of these difficulties, GVF was presented with a major 
opportunity. One of its competitors was experiencing difficulties and offered GVF the chance to purchase 60 of their stores in the south of the country. GVF borrowed $800m and made the purchase, doubling its number of outlets. 
As GVF took over management of the new stores, however, it realised 
that considerable time and funds would be required to convert them to its own distinctive format and to the modern standards now expected by customers. This not only delayed the expected revenue stream, but also required additional borrowing, raising GVF’s gearing to uncomfortably high levels. The government of Bigland subsequently raised interest rates, increasing the financial pressure on GVF. 
During all this, GVF had been seeking to catch up with its competitors in 
a number of ways. This had included increasing the number of own-brand products it offered, along with the development of a new central distribution system that experts agreed was one of the best in the country. However, there were delays in distribution of supplies to some stores during the run up to the country's most important festive period. This resulted in a considerable loss for the company and three of the directors considered responsible for the problems were sacked. 
These problems, together with an accompanying decline in profits, 
resulted in a fall in GVF's share price. Investors were concerned that GVF had paid too much for its 60 southern stores and that a rights issue would be needed to reduce the company’s debt burden. 
GVF has recently appointed a new CEO and she has spent her first few 
weeks reviewing the company and its problems, She has found that the company has too many layers of management, narrow functional attitudes and a controlling, bureaucratic head office culture. She feels that the business is no longer effective or responding to customer needs.

430  
 You are currently working as a strategic management accountant for the 
new CEO of GVF. She has told you that she wishes to involve you in the 
strategic decision-making process within the company and you have just opened up the following email from her: 
To: Anne Sma From: Rebecca Smith (CEO) Date: 12/4/20XX Subject: Strategic change issues within GVF Hi Anne, As you know, I’ve been trying to analyse the problems within GVF and 
come to some sensible conclusions about our way forward as a company and I would like your help. 
I know that when I was employed by GVF, several key shareholder 
representatives told me that they were looking forward to seeing how well I could ‘turn the business around’. I have some of my own ideas about how this could be accomplished, but could you please give me a summary of the measures you think are required to turn GVF around. 
I am also concerned that any proposals I make will be met with 
resistance by key stakeholders. Could you describe the most likely sources of resistance to change for me, please? I know several managers have mentioned a model by Lewin called ‘forcefield analysis’, but this isn't a model I have heard of before. I need you to explain the basics of the model to me and explain how it might be used to implement change in GVF. 
I've got a meeting in an hour with the board and I need this information in 
time to have a look at it. If you could get it to me in 35 minutes that would be great. 
Thanks Rebecca 
Required: 
Reply to the email. 
(35 minutes) 
Beer and Nohria – Theory E & Theory O 
Beer and Nohria (2000) identified that a large proportion of all business change 
initiatives fail. They believed that this was caused by managers becoming overwhelmed by the detail of the change management process and failing to focus on the overall goals of the change itself.

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Beer and Nohria identified that every organisational change conforms to a 
variant of either: 
• Theory E strategies  – these are based on measures where shareholder 
value is the main concern. Change usually involves incentives, layoffs, 
downsizing and restructuring. 
• Theory O strategies  – these are 'softer' approaches to change, often 
involving cultural adjustment or en hancing employee capabilities through 
individual and organisational learning. This involves changing, obtaining feedback, reflecting and then making further changes. This requires involving employees in the change process. 
Both approaches have drawbacks. A Th eory E approach will tend to ignore the 
feelings and attitudes of their employees, which will often lead to a loss of motivation and commitment from staff members. This can damage the competitive advantage of the organisation. 
Theory O organisations, on the other hand , will often fail to take the 'tough' 
decisions that may be needed. To solve these problems, Beer and Nohria recommended that organisations 
should implement both Theory E and Theory O approaches simultaneously and try to balance the associated tensions. 
 
Illustration 2 – Beer and Nohria 
 Due to the recent economic slowdown, many high-street retailers have 
seen a significant reduction in their profits, forcing them to consider a 
number of strategies to improve their results. 
A Theory E approach means that the retailer is only concerned with the 
effect that falling profits has on shareholders – such as reduced dividends 
and share prices. The managers of the company will usually try to improve this quickly by laying off staff, reducing employee pay or closing stores that are seen as underperforming. 
While this can have a positive impact on profits in the short-term, it fails to 
consider the needs of other stakeholders, such as employees. This can cause problems with employee motivation and commitment as staff members will not feel that the company is acting in their best interests. As such, the company may suffer from poor performance in the long-term. 
A Theory O  approach would see the retailer attempt to improve their 
profits by developing the organisation's capabilities and culture. For 
instance, a high-street retailer may train its staff to provide better customer service for shoppers. This will improve the customer experience and therefore, in the longer-term, sh ould improve the profitability of the 
business. The retailer may well choose to involve staff in the decision-making process, asking for suggestions as to how customer service could be improved.

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 All of this is likely to make the employees feel more valued and should 
improve the commitment and motivation of the workforce. However, it 
may be insufficient in the short–term to deal with the fall in profitability and shareholders may expect more drastic, Theory E action in order to quickly improve their returns. 
Beer and Nohria suggested that companies needed to be prepared to 
take both approaches simultaneously. This could, for example, involve some restructuring as well as a development of remaining employees. This would still need careful management as it would be easy to get the ‘worst of all worlds’ where staff are demotivated by the job losses while investors feel the cost cuts have not gone far enough. 
Balance is needed! 
 
 F is a clothes retailer which is struggling in the current economic downturn 
and is looking for ways to improve performance. According to Beer and Nohria, which ONE of the following strategies 
would be consistent with a Theory O approach to change management? 
A Reduction in staff numbers B Store closure C Improved staff training D Reduction in product quality 
 
 In what circumstances would Theory E be a successful approach? 
4 Change agents 
Many organisations seek to identify and reward change agents to encourage 
and facilitate change. They can play a major role in helping deal with resistance 
to change. Usually change agents are figures who are familiar and non-threatening to other people. 
The quality of the relationship between the change agent and key decision 
makers is very important, so the choice of change agent is critical. 
Whether internal or external, the change agent is central to the process, and is 
useful in helping the organisation to: 
• Define the problem and its cause  – the change agent should be able to 
identify restraining forces or potential resistance and help management to 
understand the root causes behind them.

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• Diagnose solutions and select a ppropriate courses of action  – the 
change agent will be responsible for proposing ways in which these 
problems can be overcome and then helping management to select the most appropriate course of action. 
• Implement change  – once management have made their decision about 
which course of action to take, it will need to be implemented. Given that the change agent will be well informed about the proposed change and the reasons behind it, they are likely to be the best person to take the lead in implementing the change. 
• Transmit the learning process to others and the organisation overall  
– the change agent should document the learning process and discussions which the company has undergone during the change process. They can then take the lead in spreading this information throughout the company. 
 
Skills and attributes of change agents 
 The skills and attributes of t he change agent would include: 
Goals • Clarity in defining the achievable 
• Sensitive to the impact of change on all 
• Flexibility to adapt to internal and external 
triggers 
Roles • Team-building skills to establish work groups 
• Networking skills inside and outside the 
company 
• Tolerance of ambiguity and uncertainty 
Communication • Skills with colleagues and subordinates • Personal enthusiasm, stimulating 
• Meeting management 
Negotiation • Creating vision and selling plans 
• Resolving conflict 
• Contract negotiation 
Managing up • Political awareness and influencing skills • Balancing goals and perceptions 
• Helicopter perspective

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 "Power skills" of change agents (Kanter) 
 Kanter identified seven ‘power skills’ that change agents require to enable 
them to overcome apathy or resistance to change, and enable them to 
introduce new ideas: 
• ability to work independently, without the power and sanction of the 
senior management hierarchy behind them, providing visible 
support 
• ability to collaborate effectively 
• ability to develop relationships based on trust, with high ethical 
standards 
• self-confidence, tempered with humility • being respectful of the process of change, as well as the substance 
of the change 
• ability to work across different business functions and units • a willingness to stake personal rewards on results, and gain 
satisfaction from success. 
 
 Using external consultants as change agents 
 Advantages of using external c onsultants as change agents are as 
follows:  
• They can bring a fresh perspective to the problem. • May have state-of-the-art knowledge of the required change – 
e.g. introducing TQM. 
• Being a dedicated resource they may be able to give it more time 
and energy. 
• They may have more experience and hence be better able to avoid 
traps and pitfalls. 
• Greater objectivity as they have no personal stake in the outcomes 
of the change.

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 M Ltd is currently considering who to choose to act as a change agent 
during the implementation of a new JIT system, which M currently has no 
experience of. M has a strong corporate culture, with excellent working relationships between managers and other employees throughout the organisation. 
Which THREE of the following are advantages to M Ltd of using external 
consultants as change agents, rather than internal managers? 
A They can bring a new perspective to the change process B Improved objectivity in decision-making 
C Improved relationship and trust with employees 
D Improved ability to collaborate effectively across different functions E Reduced cost of the change management process F May have specialist knowledge of the change to be implemented 
 
 Test your understanding 13 – (Integration question) 
 MMM is a small company based in country A. It is currently considering 
the acquisition of a rival company, POR, which is based in country D. 
Unfortunately, the employees in country D speak a different language to staff members in country A. The di rectors of MMM are concerned about 
the effect that this could have on the viability of the acquisition. 
They have decided to appoint a change agent to help control the process. 
Required: 
Explain how a change agent could aid in the acquisition of POR. 
5 Executive mentoring and coaching 
Part of managing ch ange is helping employees to perf orm well after the change 
process is complete. For example, a manufacturing organisation that introduces 
a new set of targets based around production quality needs to ensure that its staff are comfortable with how best to achieve these goals. 
While formal training is useful here, management may also consider initiating a 
process of mentoring and coaching to support staff. 
Mentoring 
This refers to a process where a manager (or any other member of staff) offers 
help, guidance, advice and support to fac ilitate the learning and development of 
another.

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A mentor is typically a skilled, senior member of staff who: 
• offers practical advice and support • can give technical and general guidance 
• can help with the development of key work skills 
• can act as a role model. 
A manager could act as an ongoing mentor, giving guidance to staff about how 
to deal with the changes in the organi sation and helping them develop the skills 
and abilities they need on an ongoing basis in order to be successful. 
Key features of mentoring include: 
• it has no specific period – mentoring is indefinite and may be ongoing until 
it is no longer considered necessary 
• it does not have to be a formal process – mentoring does not have to have 
a rigid structure and can be flexible to adapt to the needs of both parties 
(the mentor and the mentee). The agenda is open and will change as necessary over time. 
• it seeks to build wisdom – it is supposed to help the mentee apply key 
skills and experience to new situations. 
Coaching 
The CIPD defines coaching as ‘developing a person’s skills and knowledge so 
that their job performance improves, hopefully leading to the achievement of organisational objectives. It targets high performance and improvement at work. It usually lasts for a short period and focuses on specific skills and goals.’ 
For example, a coach may help staff improve their IT skills over a one month 
period, so that they are able to deal with a new computer system being installed. 
Most coaching is carried out by a senior person or manager, but the most 
important requirement is that the coach has sufficient expertise and experience. 
Key features of coaching include: 
• it tends to take place on a one-to-one basis • it has a very specific purpose and therefore tends to have a planned 
‘programme’ that is followed over a set time period to help the individual 
being coached meet pre-set objectives. 
Similarities between coaching and mentoring 
While the approach may be different, there are similarities between coaching 
and mentoring. 
• Neither is about teaching, instruct ion or telling someone what to do.  
Mentors and coaches both attempt to help members of staff to find their 
own solutions to problems or issues, rather than simply telling them what the best approach is.

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• Both are flexible and evolutionary approaches.  While coaching may 
have more pre-set objectives, these may still change over time as the 
needs of the member of staff being coached change. 
• They require similar skills from the individual acting as the coach or 
mentor.  In both cases, the coach or mentor is likely to act as a ‘critical 
friend’ who helps the staff member in their care to improve their skills and 
abilities. 
Generally 
Note that in either case, the coach or mentor must be someone that supports 
the change process within the organisation. If an individual is selected that disapproves of the changes being made, their negative attitude may transfer to the employees they are trying to help, leading to increased resistance. 
Mentoring and coaching are also important for all levels within the business. As 
well as workers affected by change, it  will also often be useful for senior 
managers. They may need help to ensure they have the relevant leadership 
and management skills required to lead th e change within the organisation. 
Ultimately, coaching and mentoring is a key part of the change management process – it can help keep the change management process moving forward and help reduce the amount of resistance that the organisation faces. 
 
Illustration 3 – Mentoring and coaching in action 
 Mentoring 
J works within the human resources department of a large multinational 
organisation. He has expressed an interest to his line manager about learning more about the organisation’s advertising function, with a possible long-term goal of moving departments. J’s line manager arranges a secondment to the advertising department and approaches M, an advertising department manager, to act as a mentor for J during his secondment. 
M’s main roles as part of this mentoring process would include: 
• agreeing the objectives for J’s secondment – discussing what he 
wishes to get from the experience 
• helping J understand the skills that he will need in the advertising 
department 
• arranging relevant work experience for J during his secondment, 
such as attending marketing meetings and presentations 
• providing relevant information to J about how the marketing 
department is structured and the various roles within the department 
• being available to discuss questions or problems that J has during 
his secondment.

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 Coaching 
P works in a bank as a cashier. He needs to improve his customer 
management skills, as this is an area that he currently feels uncomfortable with. P’s manager arranges for him to be coached by F, an experienced colleague. 
F’s role as coach would include: 
• discuss with P what the coaching needs to achieve – what does P 
need/expect to get from the process? What standard of customer 
service should he be able to reach by the end of the coaching process? 
• decide with P on the length of the coaching period and what it will 
entail – P may, for example, get to shadow F at work and see how she interacts with customers. 
• be available for P so that he can discuss any queries or issues as 
they arise and help him to work towards practical solutions that he can use in his own role. 
• regularly review P’s progress and evaluate the overall success of 
the coaching process. 
 
 Which ONE of the following statements is consistent with the concept of 
coaching? 
A It is typically only useful for senior management B It is undertaken on an on-going, long-term basis C It can only be carried out by senior managers D It is designed to help the person being coached achieve specific 
objectives 
6 Managing decline 
In reality, businesses are not always successful at expanding their business. 
Many managers may therefore find themselves having to manage decline rather than growth. The changes required during a period of decline pose particular dilemmas for managers as decisions often affect the organisation's workforce – its pay, conditions and job security.

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When attempting to help a business recover from a period of decline, a 
manager's strategic priorities are likely to be: 
• reducing costs to improve efficiency, and • improving competitiveness in order to increase revenue. 
Initially, when facing a downturn, the typical management response is to cut 
costs. While these can be cut from anywhere in the supply chain, the most obvious starting point is to reduce labour costs. At first, this may simply involve altering working patterns, such as the elimination of paid overtime or the replacement of full-time with part-time jobs. If this does not produce a sufficient cost reduction, management may move on to a program of voluntary or compulsory redundancies. 
There is, however, a danger that if staf f cuts are too severe then there will be 
reductions in the quality of the product and services provided to customers. 
There is also likely to be a serious impact on staff morale, potentially leading to a loss of commitment, a loss of skilled staff and an increase in conflict within the 
 
Illustration 4 – UK public sector 
 It is not just businesses that have been affected by the global economic 
slow-down in recent years. Many governments have had to reduce their 
level of spending – leading to many public departments having to lay off staff. 
In the UK, local and central government departments have shed 
hundreds of thousands of posts in an effort to cope with the tight budget restrictions that have been imposed upon them, while attempting to continue to maintain their level of service provision. 
This has led to angry reactions from the heavily unionised public sector 
employees, with a number of strikes and protests across the country. The long-term effects of this are unknown, but the government may find it harder to attract good quality staff members in the future as public sector jobs may no longer be seen as secure. 
It should be noted that many of the changes that a business may wish to make during a period of decline, such as compulsory redundancies or improving factory layout, may require some initial expenditure. The business may be unable to afford this if it is experiencing falling revenues. 
In this case, managers may have to consider a fundamental change to the 
business strategy. This may involve: 
• Retrenchment  – this involves doing the same as before, but drastically 
cutting costs. 
• Turnaround  – the organisation repositions itself within the market for 
competitive advantage.

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• Divestment  – this involves the external sale of part of the organisation, or 
the internal closure of units as part of a rationalisation programme. 
• Liquidation  – the organisation is sold to one or more buyers. This is an 
admission of failure by the senior managers and is normally a last resort. 
All four of these strategies require managers to make difficult decisions, which 
may have adverse effects on the organisation's stakeholders –especially employees. Whichever approach is taken, it is important that the business acts ethically towards its stakeholders when making tough decisions. 
 
 O Ltd is experiencing a period of declining demand for its products. It has 
decided to look at ways of sourcing cheaper materials and reduce the 
number of skilled employees to enable it to maintain its profits as sales volume falls. 
What ONE approach to decline is O adopting? 
A Retrenchment B Turnaround 
C Liquidation 
D Divestment 
 
 A business has found itself entering a period of decline. What measures 
could it consider as alternatives to reducing its labour costs? 
 
 AV Ltd is a high-quality board game manufacturer. It is part of a larger 
group of companies that manufacture toys and computer games. While 
these other businesses have prospered over the last few years, this has been at the expense of the traditional board games that AV manufactures and AV’s sales have declined each year for the last several years. In addition, AV has seen increased competition from cheaper board game manufacturers, further reducing demand. 
The directors of AV’s parent company have met to discuss their approach 
to AV’s problems. They have all agreed that a fundamental change is needed to their strategy with regards to the company, but they are not sure what that change should be. 
Required: 
Discuss four possible strategies that the directors may consider, given 
AV’s continuing decline. 

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7 Ethics and change management 
Most ethical issues focus on how one stakeholder group is benefited at the 
expense of another, so within any chang e process there will be a number of 
potential ethical dilemmas that need managing: 
• Whether the change is justified – for example, boosting shareholder profits 
at the expense of widespread job cuts. If the change involves re-
engineering and/or downsizing, then there will usually be redundancies. Ethical issues include: 
– Deciding on who to make redundant (e.g. preference to keep 
younger employees). 
– Fair treatment of all employees (e.g. discrimination by race, sex or 
age). 
– What severance package and assistance to offer. – Skills obsolescence. – Do remember that making employees redundant is not always 
unjustified. If it is necessary to safeguard the business in the long-
term, it cannot be classed as being unethical. 
• Management approach used – e.g. manipulation v participation. 
• Some managers may seek to exploit change to ensure they benefit 
personally from new power structures and reward schemes. 
• Similarly some may resist change to protect their own interests. • The extent to which plans are made available or if a "need to know" culture 
is adopted. 
• Whether "misinformation" is used to drive certain phases of the change 
process – e.g. to unfreeze the existing culture. 
• Accountants may be asked to manipulate figures to exaggerate the case 
This list is not exhaustive. The CIMA E3 syllabus requires you to apply the 
Code of Ethics in the context of business change. This means that whenever you read through a scenario, you need to consider whether there are any business ethical issues or  challenges occurring in the change process which will 
impact upon the ethical position of the organisation.

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 Illustration 5 – Chrysler 
 Even when tough decisions need to be made, the actions of a business 
do not have to be uncaring or disrespectful to the individual employees 
affected. As part of a US government plan to save the struggling Chrysler motor company, Chrysler's CEO was faced with having to close a number of plants. 
The CEO decided to soften the blow through a series of associated plans 
designed to get the employees into self-employment or into other forms of work. Some employees reskilled and moved to jobs in other parts of the Chrysler group, but the majority found employment elsewhere locally. 
8 The importance of adaptation and continuous change 
Many authors have argued that firms need to look beyond change as an event and develop a culture where change is embraced as an ongoing process. These include: 
• change-adept organisations (Kanter) 
• excellent firms that seek to create a climate of change (thrive on chaos) 
(Peters). 
Change-adept organi sations – Kanter 
Kanter’s model focuses on two main issues. Firstly, it identifies the three 
attributes of companies that manage change successfully . 
• The imagination to innovate. • The professionalism to perform. 
• The openness to collaborate.

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The model goes on to examine the seven key skills for leaders in these 
change-adept  organisations. 
 
 Change adept organisations 
 Rosabeth Moss Kanter looked at the characteristics of organisations that 
managed change successfully (‘change-adept organisations’), and the 
qualities of their leaders and managers. 
Attributes of change-a dept organisations 
She suggested that change-adept organisations share three key attributes: 
• The imagination to innovate. 
Effective leaders help to develop new concepts, which are a 
requirement for successful change. 
• The professionalism to perform. 
Leaders provide both personal competence and competence in the 
organisation as a whole, which is supported by workforce training 
and development. This enables the organisation to perform strongly and deliver value to ever-more-demanding customers. 
• The openness to collaborate. 
Leaders in change-adept organisations make connections with ‘partners’ outside the organisation, who can extend the organisation’s reach, enhance its products and services, and ‘energise its practices’. ‘Partners’ will include suppliers working in close collaboration, joint venture partners, and so on.

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 Kanter argued that change should be accepted naturally by 
organisations, as a natural part of their existence. Change that is 
compelled by a crisis is usually seen as a threat, rather than as an opportunity for successful development. Mastering change means being the first with the best service or products, anticipating and then meeting customer requirements (which continually change) and applying new technology. This requires organisations to be ‘fast, agile, intuitive and innovative’. 
Skills for leaders in change-adept organisations 
• Tuning in to the environment. 
A leader can actively gather information that might suggest new 
approaches, by tuning in to what is happening in the environment. Leaders can create a network of ‘listening posts’, such as satellite offices and joint ventures. 
• Challenging the prevailin g organisational wisdom. 
Leaders should be able to look at matters from a different perspective, and should not necessarily accept the current view of what is right or appropriate. 
• Communicating a compelling aspiration. 
Leaders should have a clear vision of what they want to achieve, and should communicate it with conviction to the people they deal with. A manager cannot ‘sell’ change to other people without genuine conviction, because there is usually too much resistance to overcome. Without the conviction, a manager will not have the strength of leadership to persuade others. 
• Building coalitions. 
Change leaders need the support and involvement of other individuals who have the resources, knowledge or ‘political clout’ to make things happen. There are usually individuals within the organisation who have the ability to influence others – ‘opinion shapers’, ‘values leaders’ and experts in the field. Getting the support of these individuals calls for an understanding of the politics of change in organisations. 
• Transferring ownership to the work team. 
Leaders cannot introduce change on their own. At some stage, the responsibility for introducing change will be handed to others. Kanter suggested that a successful leader, having created a coalition in favour of the change, should enlist a team of other people to introduce the change.

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 • Learning to persevere. 
Something will probably go wrong, and there will be setbacks. 
Change leaders should not give up too quickly, but should persevere with the change. 
• Making everyone a hero. 
A successful leader recognises, rewards and celebrates the accomplishments of others who have helped to introduce a change successfully. Making others feel appreciated for their contribution helps to sustain their motivation, and their willingness to attempt further changes in the future. 
 
 Thriving on Chaos (Tom Peters) 
 Tom Peters has written extensively on management theory. One of his 
ideas relates to ‘excellent’ companies that have succeeded by seeking to create a climate of continual and radical change. Peters called this ‘thriving on chaos’. He suggested that: 
• Incremental change is the enemy of true innovation, because it 
makes an organisation less willing to be truly innovative. 
• Excellent firms don’t believe in excellence, only in constant 
improvement and constant change. 
• A constantly changing environment does not necessarily mean 
chaos: instead, it may mean that companies can handle the 
introduction of change successfully. 
Peters suggested that the advantages of having a climate of change are as follows: 
• Innovation and the introduction of new products and new methods 
are actively sought and welcomed. 
• People who are used to change tend to accept it without resistance. 
• Employees develop an external viewpoint, and are less insular and 
defensive in their outlook. 
However, there are possible disadvantages: 
• With a climate of change morale might be damaged 
• Staff might become involved in office politics because of their 
concerns about the possible changes that might occur in the 

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 According to Kanter, which of the following is a required skill for leaders 
within change-adept organisations? 
A Tuning in to the environment B The imagination to innovate C The professionalism to perform D The openness to collaborate 
9 Conclusion 
The management of change is never an easy process and it is rare that the final 
outcome exactly matches the original plans. Remember that there is no recipe for success – it simply does not exist. 
However, change is more likely to succeed if there is/are: 
• clearly understandable goals, 
• realistic time frames, rather than merely looking for a ‘quick fix’ 
• clear guidance as to how each individual's behaviour needs to change 
• clear, unified leadership with no conflict between managers 
• management support for training and other necessary investment. 
 
 Test your understanding 19 – C Co – (Case style) 
 C is a large multinational confectionary manufacturer which was 
purchased in a hostile takeover bid one year ago. The new owners, R Co, 
have been surprised at the number of key staff who have left over the last year. A total of 120 out of 170 managers and executives have resigned since R Co took control of the two-hundred-year-old company. The acquisition of C completed R Co’s ten year geographical expansion strategy. 
In particular, there have been departures among creative, design and 
marketing specialists. While some resignations are normal after such a bitterly fought takeover battle, industry specialists are shocked at the extent of the staff losses. 
A group of remaining managers have been questioned by the board of R 
Co on why they think so many employees have left. The managers explained that the rate of change in C was historically slow, with a great deal of pride taken in making confectionary the old-fashioned way. C’s products are considered part of the national identity of its home country and the company even has a royal license to make chocolate for the queen.

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 Since R Co took over, the company  has changed suppliers for many of 
the key ingredients used in C’s products, and despite pre-takeover 
promises to the contrary, begun devising strategies to move production overseas. Many of the managers who have left made it clear they were resisting these changes before their resignation. 
R Co is a cost leader in the global confectionary market and wishes to 
bring C in line with the rest of the group. The board of R Co have also announced plans to remove the C name altogether and bring the newly acquired company into its own functional structure, rather than allowing it to operate as a stand-alone division. 
The managers stated that in their view, the rate of change has been a 
problem for many employees together with what they perceive to be a ‘selling out’ of the C name and values. 
Required: 
Prepare a report for the Board of R Co, which covers the following key 
issues: 
(a) Explain what is meant by the phrase ‘resistance to change’ and 
discuss the resistance to change at C which led to so many 
managers leaving. 
(b) Evaluate the change management process which has been 
undertaken at C over the last year. 
(c) Advise the board of R Co on an alternative strategy for C, which 
may avoid further loss of staff. 

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10 Summary 
By the end of this chapter you should be able to discuss the following:

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B assembled a large group of powerful stakeholders. This suggests that a 
guiding coalition was indeed formed. Her regular meetings with the staff suggested that she had no problems communicating her change vision – and her request for involvement by staff suggests that she had indeed empowered broad-based action. 
However, due to the refusal of the Board to allow her to discuss the new 
entrants to the market, she was unable to establish a sense of urgency. This is likely compounded by the fact that staff have historically enjoyed high bonuses and that the company is seen to be doing well. 
Note that B was unable to generate short term wins, but this was largely 
due to a lack of staff motivation. Failure was therefore caused by a lack of urgency.  
 
This is a classic example of facilitation and support. Education and communication involve convincing staff of the benefits of 
the change process being undertaken. Coercion relies on the use of threats, while participation involves employees having input into the change management decision-making process. None of these other options fits this scenario. 
 
A is likely to take too long, given the need for rapid change and the large 
number of employees. B is also likely to be inappropriate due to the lack of a central union to negotiate with and the fact that it needs to lay off many of its staff in order to survive, giving little room for negotiation. 
C relates to distortion of the true facts in order to convince staff of the 
need for change. Not only is this unethical, but it is unnecessary given the dire state of U’s actual position. Untruths are not needed. 
Coercion involves the use of managerial power to force change. While 
this is unlikely to be popular with employees, it is rapid and may be U’s best option at managing the change process.

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 Division A 
Division A appears to be making a relatively small change to its business. 
It is currently highly profitable – indicating that it is not currently experiencing a crisis. 
As such, education and communication may be the best approach. This 
involves explaining the reasons behind the proposed centralisation of the accounting function and attempts to persuade the employees that this is a beneficial idea. While this is often time-consuming, A has a relatively small number of staff, which makes this approach more realistic. In addition, as the company currently has a good relationship with its workers (and likely needs to maintain this given that its staff are highly skilled and therefore very important to the company), this approach is most likely to keep the majority of staff happy. 
It is possible that staff may not be convinced by the need to cut costs 
given that the division is highly profitable. In this case, A could choose facilitation and support – perhaps helping the staff who will be made redundant to find new jobs, such as by giving them time off for job interviews. 
Finally, A could consider participation and involvement. This would see A 
getting its employees involved in the change process. Perhaps job losses can be avoided if employees are able to think of alternative ways of improving efficiency. This may be very time consuming, although there is no evidence of time-pressure in the scenario. 
Division B 
Division B is clearly in a crisis, with poor industrial relations and the 
potential threat of closure. 
Given the serious nature of its situation, B could also adopt an education 
and communication style. If the alternative to job losses is a total closure of the division, this may be enough to convince employees of the need for the change. However, given the poor relations between staff and managers, as well as the tight time-constraints that B is under, this may not be realistic. 
As an alternative, B could choose a manipulation and co-optation style. 
This involves undermining resistance in a more covert manner, perhaps by stressing the potential for the division to be closed, or down-playing the number of job losses that would be involved. It is a faster way of dealing with resistance than education and communication, but if employees feel that they are being manipulated, it may damage industrial relations further.

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 Change introduced through the use of power or manipulation is likely to 
add to anxiety. Education and communication will rarely succeed on their 
own when introducing major change. However, they are useful as a support for a negotiation or participation approach. The negotiation approach requires the existence of organised representatives and a formal procedure that is suitable for some items such as change in employment terms but would be inadvisable for other items of changing procedures, organisational changes, decentralisation, etc. In these cases, participation offers the best opportunity of allaying staff anxieties by 
involving them early in the change process and continuing that 
involvement through to completion. 
 
A is part of unfreezing, B and C are part of refreezing, while D is an 
element of change itself. 
 
 Lewin’s model suggests that, in order to be successful, WW will need to 
follow three stages in the change-over to a new accounting package. 
Unfreeze 
Staff need to be convinced of the need for the new accounting package. 
This could be difficult within WW for several reasons. 
WW’s six employees have used the current accounting system for many 
years. This may mean that they are ‘stuck in their ways’ and unwilling to learn the new skills requi red for the new system. 
In addition, currently management accounting information can only be produced after a time-consuming and complex process. If a new system improves the efficiency of this process, employees may fear that they will become redundant. 
To help with this, WW need to convince them of the superiority of the new 
system. For instance, it appears that it will make the production of management reports much faster, easing the workload for the employees.

452  
 WW also needs to communicate well with its employees. Resistance is 
often caused by a fear of the unknown. Managers could discuss with staff 
about the level of training that they will be given on the new system and attempt to allay any fears they may have about potential redundancies. 
Finally, WW’s managers could also stress to staff members that it will 
benefit the business as a whole. The current system may cause WW to be less competitive in the marketplace, which could threaten the business as a whole. 
Change 
This involves actually moving staff onto the new accounting system. This stage will involve training all members of the accounting department 
on how to use the new system. Enough time must be allowed for employees to be reasonably comfortable with the new system before the change-over is made. 
Communication is also vital here – employees must know when the new 
system will be installed and what will be expected from them. For example, what new reports will the managers expect from the system and 
when they will need to be prepared. 
Refreeze 
Finally, WW’s managers must ensure that employees do not slip back 
into old habits and start using the old systems again. 
Clearly, if the old accounting system is entirely replaced by the new one, 
it should be easy to ensure that staff members do not continue to use the original accounting system. However, employees may still continue preparing the management reports manually. 
To avoid this, managers could refuse to accept reports in the old, manual 
format – instead requiring that they be produced from the new system. Staff could be rewarded for using the new system and penalised if the old methods are still used. 
 
The current misunderstanding is an example of a restraining force, which 
is holding the division back from implementing change. N’s planned communication will rectify this misu nderstanding, reducing the force.

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 To: Rebecca Smith 
From: Anne Sma  Date: 12/4/20XX Subject: Re: Strategic change issues within GVF Dear Rebecca, Thank you for your email. I have outlined the points that you requested 
below. 
(a) Summary of measures needed to turn around GVF  
The inefficiency of GVF management seems to be related to the 
structure of the company. According to the CEO, there is a need to 
reduce the number of layers of management, to reduce head office controls and to change attitudes from a narrow concern with departmental objectives to a broader concern for the needs of GVF as a whole. 
The reduction in the layers of management will help to reduce costs 
and to improve communications within the business. Store managers and others may well welcome reduced interference from head office and the increased autonomy may help to motivate them. 
The CEO's comment that the company was ‘no longer effective or 
responding to customer needs’ is clear from the scenario. Given its loss of customers to new entrants to the market, GVF needs to determine precisely what the needs of its customers are. This may need further investigation – although by increasing the number of own–brand products, it appears to be at least part way through this process already. 
(b) (i) Likely sources of resistance  
Resistance to change in organisations can be considered according to whether the resistance comes from individuals, groups or the organisations themselves. 
Individual level At the individual level, resistance is often caused by fear of the 
unknown, long-held existing habits and possible threats to position or livelihood. 
In GVF, all of the above are likely to be factors. Given the 
present circumstances of GVF, employees are likely to fear for their job security and whether or not they will be able to continue in their current role or will have to learn a new one.

454  
 Managers will be particularly fearful, given the CEO’s 
statement regarding the need to reduce the number of layers 
of management within GVF. Given that many of these managers may have much to lose and little to gain from such a restructuring, GVF could expect to see significant resistance from them. 
Group level At a group level, there will be collections of individuals who see 
their positions as threatened and who will join forces to resist and make mutual threats. This will particularly be the case in GVF as many of its employees are unionised, increasing the amount of co-ordinated resistance they are capable of. 
Even where trade unions do not exist, it is possible for groups 
of employees, including managers, to collude informally to resist changes. This may be achieved by withholding information or refusing to co-operate with those seeking to implement change. 
For GVF, managers and employees are unlikely to co-operate 
unless they can see some long-term benefits for themselves. 
(ii) Models of organisational change  
The new CEO of GVF might use the force-field theory of change proposed by Lewin. Lewin's theory suggests that there are two forces present in a change management scenario. One set he refers to as driving forces because they are forces attempting to bring about change; the other set are referred to as restraining forces as they act in the opposite direction and seek to maintain the status quo. 
For GVF, the driving forces are likely to include the need for 
the business to be competitive. Unless GVF can improve its efficiency, its competitors will continue to take its market share. Unless GVF becomes flatter, leaner and more responsive to the market, it may ultimately collapse – especially given its high level of financial gearing. 
Organisational level At the level of the organisation, a number of factors will 
combine to make the change process difficult. These include the existing culture and structure of the organisation, as well as any past agreements with stakeholders. 
Given that the company has traded for over fifty years, the 
company may be ‘set in its ways’, with staff unwilling to see significant changes made to longstanding arrangements or ways of working.

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 The proposed de-layering in GVF will threaten the jobs and 
status of some layers of management. This will again increase resistance. 
The restraining forces will include the reasons for employee 
resistance mentioned above, such as loss of job security and management levels within GVF. 
To be successful, the CEO will need to increase the driving 
forces – perhaps by improved communication with all employees, laying out the benefits of her proposed changes and the potentially dire consequences to the whole of GVF if they are not implemented. 
Alternatively, the CEO may look at reducing the restraining 
forces. This could involve looking at ways of avoiding voluntary redundancies among managers or by supporting employees who are to be made redundant as they try to find alternative employment. 
I hope this helps. If you need any more information, please don't hesitate to get in touch. 
Kind regards Anne Sma 
 
Theory O looks at improving the organisation’s culture and skill-set for 
instance through training staff. 
Theory E looks at predominantly economic changes that can be made to 
 
 Theory E is often the approach taken in a crisis. If a business needed to 
make drastic or rapid cuts to its business, or undertake a major restructuring, management may have to make tough decisions in order to secure the long–term survival of the business. 
In these circumstances, there may be insufficient time to involve staff in 
the decision–making process and doing so would likely make it harder to make the difficult choices, such as the number of job losses in the organisation.

456  
 The correct answers are A, B and F 
The fact that M already has a strong corporate culture with employees 
that work well together would suggest that C and D are all likely to be advantages of using internal change agents. There is no guarantee that the use of external consultants will be cheaper than using internal 
managers – in fact, the reverse may well be true. 
 
 A change agent is a person, or group of people, who help an organisation 
to achieve its strategic change. If MMM appoints a change agent, he or she would carry out a number of useful functions, including: 
Identify any problems and their causes 
This is likely to be relatively straightforward for MMM. The biggest 
problem with their proposed purchase of POR is the language barrier between their staff. MMM and POR will find it almost impossible to work together as they do not understand each other's language. 
This could cause the acquisition to fail. 
Diagnose solutions and select appropriate courses of action 
The change agent is responsible for proposing ways in which the 
problems that they have identified could be overcome. 
For MMM, it could consider: 
• sending key members of staff in both companies on external 
language courses, or 
• hiring some additional staff members in both companies who are 
bilingual. 
In many cases there will be a number of possible solutions. The change 
agent will be responsible for presenting these to management and helping them to decide which option is most appropriate for MMM. 
Implement change 
Once the management have selected an appropriate strategy, they will 
need someone to implement it. As the change agent has been part of the decision-making process, they will be the most logical choice to actually carry out the plan. In MMM, the change agent may, for example, investigate and book language courses for appropriate members of staff.

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 Transmit the learning process to others and the organisation overall 
There may be some resistance to the proposed changes. A change agent 
can champion the proposals, explaining to employees why it is necessary and what the advantages will be. 
The change agent will also document the decision-making process and 
communicate to all members of staff in both MMM and POR. This is a vital step, as employees in both businesses will need to be kept informed about the developments in the company. 
 
A is incorrect as coaching can be useful for all levels within the 
organisation. B relates to mentoring. C is inconsistent with mentoring or coaching as either can be done by any individual with the relevant skills/experience. 
 
 The business could attempt to: 
• generate additional revenue through more effective marketing 
• improve purchasing policies and procedures 
• redesign the product or service offered in order to reduce production 
costs 
• contract out services that are not considered essential to the core 
business (although this may result in job losses) 
• consider changes to reduce duplication and improve financial 
control systems.

458  
 There are four major approaches that the directors could consider with 
regards to AV: 
Retrenchment 
This would involve AV continuing to make board games, but looking at 
ways to significantly cut costs. This would help increase profits and offset the decline in results that the business is experiencing. 
Given that the company currently produces high-quality board games, 
there may be scope for the business to save money by reducing the quality of materials. This may also allow it to cut its prices and compete with the new, lower-cost market entrants. 
Turnaround 
For AV this would probably involve much the same approach as 
retrenchment. AV could attempt to reposition itself within the board games market as a low-cost manufacturer. 
Liquidation 
The directors could choose to sell AV to one or more investors. Given the 
current level of decline, they may not realise a high price for the business. This would normally be a last resort for the directors. 
Divestment 
As an alternative to selling the business, the directors could decide to 
close the business unit down. The assets could then be sold or transferred to other parts of the organisation. 
 
The other three are attributes of change-adept organisations themselves.

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 Report 
To: The Board of R Co 
From: A. Strategy Date: 18/09/XX Subject: Change management at C Introduction This report will examine a number of issues surrounding the change 
management process and the resistance that has been seen at C, a 
business recently acquired by R Co. 
(a) Resistance to change  
Resistance to change is the action taken by individuals and groups 
when they perceive that a change that is occurring is a threat to them. 
Resistance is any attitude or behaviour that reflects an individual’s 
unwillingness to make or support a desired change. 
Reasons for resisting change can stem from three factors. These are discussed below with reference to the situation at C: Job factors Employees may resist change because they fear changes to their 
working conditions, demotion or reduced pay. The managers in question at C took pride in the traditional ways of making confectionary and obviously saw these methods were under threat from R Co. In particular, the creative managers may have foreseen cuts to design and marketing budgets, since these costs are often viewed as discretionary by cost leader organisations like R. 
Reduced pay, demotion and certainly inferior working conditions 
would all be suggested by R’s aggressive strategy over the first few months of ownership. 
Personal factors Managers may have resisted changes as they saw them as a 
perceived criticism of their performance in C. Changing suppliers of raw materials as well as beginning to move production overseas suggests that R Co sees C as inefficient and its cost base as too high. Altering the supply chain and sourcing overseas partners are typical strategies to reduce variable costs. It is likely that the managers felt less valued under the new management than the old. 
The development of C into a cost leader would also signal more 
monotonous roles for many of its staff, with the emphasis on reducing costs rather than being creative with products.

460  
C was a well established part of the national culture in its home 
nation. The staff’s social environment at work would have reflected this, with a great deal of pride being taken in working methods pre-takeover. For new owners to come in and disregard this heritage would lead to personal dislike of R’s staff on the part of the C employees. The lack of consultation carried out by R’s executives is also likely to have led to rejection of change. 
(b) Evaluation of change management process carried out at C  
There are some positives to the way change management has been carried out at C. Employees are in no doubt as to the intentions of R Co, and although acceptance of that may be difficult in some cases, it could be argued that, the sooner processes of change are begun, the sooner staff can get used to new methods of working. 
R Co clearly has a track record of cost leadership, and to maintain a 
subsidiary which has a different strategy would detract from their corporate image and possibly confuse investors and customers. The sooner this mismatch is dealt with the better. 
There is also a clear reason for R Co’s rapid changes, in that it is 
possible for them to save money through moving production abroad and changing suppliers. Such rapid change will in fact increase profit margins and, arguably, benefit stakeholders in C. 
C has given a clear message that it is in charge of C and again, this 
strategic clarity is equivalent to a ‘short, sharp shock’. Once the message is communicated, there can be no doubt or confusion as to the company’s intentions. 
However, the results of such rapid change show that there are 
significant disadvantages to altering strategy upon acquisition in such a fashion. Firstly, C is a highly valued national institution, with a royal endorsement. R’s actions may be seen as disrespectful and result in a consumer backlash. 
Rapid transformational change only works if employees believe it is 
necessary to benefit the company and safeguard their jobs. In the case of C, the opposite is true, with managers feeling so strongly that the change is a mistake and that they would rather resign than see it through. The loss of so many staff, particularly in creative areas, means that new strategies will be harder to implement.

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 R Co is taking significant risks by adopting a cost leadership 
strategy for C. If in fact, it is impossible to complete the transfer of C 
from a differentiator to a cost leader, there will be no return to the previous strategy. C’s brand names are, at best, likely to be devalued once it becomes part of the functional structure of R and at worst, completely lost. 
In conclusion, the unpopularity of R’s actions means they will find it 
harder to push continued change through and high staff turnover together with resistance to change will both remain as key obstacles to their aims. 
(c) Alternative strategy for C  
Since R Co has purchased C as part of a geographical expansion programme, the simplest alternative is to allow C to continue to operate as a division of R but to use its distribution channels to introduce some of R’s products into its markets. 
This parallel strategy could work well for some time and R could 
slowly introduce cost-cutting measures, trying to keep any promises, such as not moving production overseas for the foreseeable future. 
It is likely with a slower approach that many managers could be 
brought on-side. The board of R Co are clearly not averse to consulting with C’s staff, since they have asked for their views on the staff turnover issue. If these consultations could be extended to strategic aims and intent, the ‘old’ C workforce would be much happier to work under R’s board, particularly if they saw the attributes of C protected rather than dismantled. 
Of course, if R Co is determined to make C part of their empire and 
remove its identity completely, any kind of change management is likely to meet fierce resistance.

462

463 
Digital strategy – digital 
technologies 
F2: Analyse digital 
transformation (a) Analyse digital 
(b) Analyse digital enterprise 
 
  Chapter 
12

Digital strategy – digital technologies 
464  
 
economy’ and to a number of digital technologies. The syllabus now contains a section entitled ‘Digital Strategy’, and it makes up 15% of the overall paper. 
It therefore stands to reason that students need to be aware of modern digital 
technologies and how they can represent both an opportunity and a threat to the organisational ecosystem. 
In this chapter we will look at the concept of digital disruption and how 
management need to perhaps rethink their traditional business models. We will also examine what is meant by a number of technological developments, namely: 
• Artificial intelligence • Cloud and mobile computing 
• Internet of Things 
• Big Data 
• 3D Printing 
• Process Automation. 
In chapter 13 we will examine the gover nance of digital transformation and the 
elements of digital strategies.

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2 Digital disruption 
In today’s business environment many industries are experiencing change at an 
increasingly rapid rate, and one of the fundamental drivers of such change is digital transformation. Traditional business models are being re-examined as use of technological advances enables organisations to challenge the status quo and create value in new ways. 
 
Illustration 1 – the changing nature of business 
 A recent article on TechCrunch,  a digital economy news site, made the 
following observation: 
“Uber, the world’s largest taxi company, owns no vehicles. Facebook, the 
world’s most popular media owner, creates no content. Alibaba, the most valuable retailer, has no inventory. And Airbnb, the world’s largest accommodation provider, owns no real estate… Something interesting is happening.”  
Two features are common across all the above-mentioned companies – they have become incredibly valuable in terms of market capitalisation in an astonishingly short space of time; and they have had a profound impact on the businesses that were already present in their industries.  
What is it about these businesses which has allowed them to change 
enormously how their industries work and the ways in which they deliver value? How might organisations in other industries learn lessons from the disruptors mentioned above and other similarly successful companies? And how might that impact on those in senior finance roles? 
Much of the answers to these questions lie in the use of disruptive technology. 
Disruptive technology 
Disruptive technology relates to instances where technology is used to 
fundamentally change and ‘disrupt’ the existing business model in an industry.

466  
technology. Not only from the technology that they employ in order to cut costs and improve efficiency, but also in the access that consumers now have to technology in the modern on-demand economy. For example, many disruptive businesses rely on smartphone applications or have internet-only based transactions. 
The two largest growth sectors for disruptive technology are in health services and financial services. Financial technology (commonly known as Fintech) is, for example, completely disrupting the traditional banking sector – long seen as a highly technical, highly regulated industry dominated by giant banks. 
 
they can match lending rates to different credit scores. Lenders can also sell their loan if they want to cash in early (for a 1% fee).

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 Some borrowers and lenders who use peer-to-peer markets suggest that 
they do this for ethical reasons. They argue that traditional banks often 
have unethical practices and a peer-to-peer system avoids giving big banks more profits. 
Betterment aims to become a financial portfolio management platform – taking business away from the typically person-to-person financial advisers. Users can use a smartphone app to get investment advice and manage their investment portfolio. 
Here is an extract from Betterment’s mobile app description: 
 
much risk to take on in your portfolio. Then, we invest your money in a globally diversified portfolio of low-cost Exchange Traded Funds (ETFs) and help lower taxes in ways many traditional investment services can’t match. 
location. 
• Access to Certified Financial Planner (CFP®) professionals and 
licensed financial experts. 
• Low-cost, straightforward pricing plans 
• Low fund fees 
• No trading or rebalancing fees.

468  
• more personalisation of products/services to individual customers • the lack of a physical presence (with associated overheads and operating 
costs) 
on the growth potential that Fintechs offer. This gives Fintechs a wide scope for raising cheap finance in order to fund their future expansion. 
Of course, Fintech is just one example of how an industry has been disrupted in recent times; there are many others, as was demonstrated at the start of this chapter (AirBnB – the hospitality industry). There are also many examples of industries that are about to be disrupted or are in the early stages of disruption. 
For example, autonomous vehicles are forecast to change the way in which 
people use cars, and detailed testing has been underway in some countries for a while. How soon before they become the ‘norm’? And what sort of impact 
might it have on who is successful in the industry? Will traditional names such 
as Ford, Mercedes, Renault etc. come up against significant competition from organisations such as Apple, Dyson, and Alphabet (the parent company of Google). All of these latter names have been investing major sums in vehicle research and development. 
Surviving digital disruption 
establish and cheaper to run. Developments such as cloud computing and mobile technology offer huge potential for innovation and quicker delivery of next-generation services. The rate of evolution is only going to increase.

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organisations to become more innovative and achieve higher degrees of 
operating efficiency.  
There are also a number of myths about digital transformation that are common. This is perhaps understandable given the rate of change that has been seen in many industries over the last few years, but such impressions need to be shown as misleading if management are to see digital transformation as an opportunity as opposed to a threat. 
chance 
technological development requires them to question their business model, to enquire how adopting such technologies can bring benefits, and to understand how employees and their roles are also evolving and how to get the best out of them.

470  
 JKP company manufactures handmade chocolates which it markets and 
sells in the local area. It was established many decades ago and until 
recently its board was still dominated by the founding family.  However recent changes have brought in some new board members who wish to encourage a fresh approach. 
The newly constructed board is now meeting to discuss the future. One 
area for discussion is the need for the company to develop a digital strategy and become a digital business – something heavily resisted by many of the original board members. 
Which of the following statements made by members of JKP’s board 
during the discussion on digitisation are correct? 
Select ALL that apply. A Digitisation of the company will mean replacing all current 
equipment with internet enabled versions.   
B The main aim of digitisation is the achievement of operational 
C If JKP digitises all its data will be stored in the cloud. D JKP can successfully implement a digitisation programme by setting 
up a digital business unit headed up by a specially appointed Chief 
Digital Officer. 
E Digitisation can be adapted to suit any business model. 
The rest of this chapter will examine what technologies should be considered. 
3 Artificial Intelligence (AI) 
 Definition 
Artificial Intelligence is an area of computer science that emphasises the creation of intelligent machines that wo rk and react like human beings. Some of 
the activities that computers with artificial intelligence are designed for include: 
• Planning 
• Learning • Problem solving.

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 Illustration 2 – Artificial intelligence 
 Companies such as Apple and Amazon have developed and marketed 
as Apple with its Siri system) or  developed new products whose main 
function is voice recognition (such as Amazon and Alexa). 
There are many, more complex examples of Artificial Intelligence, but a 
common factor to both the simple and the more involved is machine learning . 
Most recent advances in AI have been achieved by applying machine learning 
to very large data sets. Machine learning algorithms detect patterns and learn how to make predictions and recommendations by processing data and experiences, rather than by explicit programming instruction. The algorithms themselves then adapt to new data and experiences to improve their function over time. 
There are three major types of machine learning: 
• Supervised learning • Unsupervised learning 
• Reinforcement learning. 
Supervised learning 
In this instance an algorithm uses training data and feedback from humans to 
learn the relationships of given inputs to given outputs. For example, if the objective is to predict future house prices, the inputs might be “time of year” and “interest rates”. 
This sort of approach can be used when the user knows how to classify the 
input data and the type of behaviour that they want to predict, but the algorithm is needed to calculate it on new data. 
There are three steps to how supervised learning works: 1 A human labels every element of the input data (e.g. “time of year”, 
“interest rates” etc) and defines the output variable (e.g. “house prices”). 
2 The algorithm is trained on the data to find the connection between the 
input variables and the output. 
3 Once training is complete – typically when the algorithm is sufficiently 
accurate in providing output data from input – then the algorithm is applied 
to new data.

472  
Unsupervised learning 
With unsupervised learning, an algorithm interrogates input data without being 
given any explicit output variable. For example, the input data might be “customer demographic data” and the algorithm is then used to explore and identify patterns. 
This can be used when there is no known classification of the data, and the 
user wants the algorithm to find patterns and classify the data for them. 
The three steps for using unsupervised learning are: 1 The algorithm receives unlabelled data; for example, a set of data 
describing customer journeys on a website. 
2 The algorithm then infers some sort of structure on the data. 3 The algorithm identifies groups of data that exhibit similar behaviour; for 
example, clusters of customers of similar age that exhibit similar buying 
patterns, such as choice of destination, length of trip, amounts spent etc. 
Reinforcement learning 
This is when an algorithm learns to perform a task by trying to maximise the rewards it receives for the actions it takes. For example, in managing an investment fund, the rewards would be gains in value of the fund based on which investments it has decided to put capital into. 
Reinforcement learning can be used when there isn’t a lot of training data 
available, the ideal end state cannot be clearly defined, or the only way to learn about the environment is to interact with it. 
The three steps for reinforcement learning are: 1 The algorithm takes an action on the environment; for example, it makes a 
trade in a financial portfolio. 
2 It receives a reward if the action taken brings the machine a step closer to 
its objective. For example, it makes a return on the investment chosen. 
3 The algorithm optimises for the best series of actions by correcting itself 
over time. For example, if it makes losses, or could have made better 
returns through investing elsewhere, it will do better at the next time of investing. 
Rewards for reinforcement learning will depend on the application to which the AI is put. 
For example, a courier company that decides to adopt AI in this way might see 
reductions in fuel consumption, or an increase in the number of deliveries made to customers on time, as a gain.  
Reinforcement learning has famously been used in training computers how to 
play games.

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 Illustration 3 – AlphaGo 
 In May 2017, reinforcement learning helped the AI system AlphaGo to 
defeat the world champion Ke Jie in the ancient Chinese board game of 
Go. 
A particular advantage of reinforcement learning compared to supervised 
and unsupervised learning is that it is not based on the limitations that can result from human labelling. Even experienced operators can introduce natural and social bias into labels, which will limit the learning 
process for the machine. 
In a recent development, the AI system AlphaGo Zero defeated its 
predecessor AlphaGo at the board game Go, even though it had not 
been “trained” to play by human beings; instead, it learnt to play Go from scratch, rather than training on Go games played by and with human beings.  
 
 Illustration 4 – ‘intelligent’ vehicles 
 Jaguar LandRover has introduced self-learning vehicles into its range of 
vehicles. The system within the vehicle integrates with different passengers'’ mobile phones, and learns to recognise their individual behaviours and preferences. It can then apply such understanding to adapt issues such as comfort controls within the vehicle, and the entertainment choices that are offered. 
For example, the car can link up with the fitness and activity tracker worn 
by the driver to detect a visit to the gym, and start the air conditioning to create a cooler interior as the driver returns to the vehicle once the gym session is over. 
 
 RTY company sells a wide range of products via its website.  
Management believe that in order to maximise sales the company needs to understand the way customers navigate around its website and the interaction between customer purchasing patterns and a range of other factors such as competitor behaviour, economic indicators, and local weather conditions. 
RTY plans to use an Artificial Intelligence Application to interrogate the 
data.  First staff will label the relevant input data and then an algorithm will be used to find the relevant connections.

474  
 Which ONE of the following forms of machine learning is RTY planning to 
adopt? 
A Supervised learning B Unsupervised learning C Reinforcement learning D Feature learning 
Artificial Intelligence and finance 
and the pace of change is fast, widespread adoption in business and 
accounting is still in relatively early stages.  Increasingly, we are seeing systems that are producing outputs that far exceed 
the accuracy and consistency of those produced by humans. In the short to medium term, AI brings many opportunities for finance professionals to improve their efficiency, provide more insight and deliver more value to businesses. In the longer term, AI brings opportunities for much more radical change, as systems increasingly carry out decision-making tasks currently done by humans. 
AI, no doubt, will contribute to substantial improvements across all areas of 
accounting, equipping those in finance wi th powerful new capabilities, as well as 
leading to the automation of  many tasks and decisions. 
• using machine learning to code accounting entries and improve on the 
accuracy of rules-based approaches, enabling greater automation of 
processes 
• improving fraud detection through more sophisticated, machine learning 
• using machine learning-based predictive models to forecast revenues 
• improving access to, and analysis of, unstructured data, such as contracts 
and emails. 
Despite the opportunities that AI brings, it must remembered that it does not 
replicate human intelligence. The strengths and limits of this different form of 
intelligence must be recognised, and we need to build an understanding of the 
best ways for humans and computers to work together.

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4 Cloud and mobile computing 
Cloud and mobile computing is computing based on the internet. It avoids the 
needs for software, applications, servers and services stored on physical computers. Instead it stores these with cloud service providers who store these things on the internet and grant access to authorised users. 
Benefits of cloud and mobile computing 
• Store and share data  – cloud services can often store more data than 
traditional, local physical drives, and the data can be shared more easily 
(regardless of physical location). 
• On-demand self-service – customers and users can gain access to technology on demand. For example, every time you download an app from iTunes or the Play store you are downloading it from a cloud service where it is stored. 
• Flexibility  – work can be done more flexibly as employees no longer need 
to be ‘plugged into’ work networks or fa cilities to access the data they need. 
• Collaboration  – the cloud facilitates better workforce collaboration – 
documents, plans etc. can be worked on by many different users 
simultaneously. 
• More competitive – smaller firms can get access to technology and 
services that, without significant financial investment, may otherwise only be available to the largest organisations. This can allow small organisations to compete better with larger rivals. 
• Easier scaling – cloud services provide high levels of flexibility in terms of 
size, number of authorised users etc. This means that the service can 
grow as the business grows, and allows businesses to scale up much more easily. 
• Reduced maintenance  – there is no longer need on the part of the 
organization for regular maintenance and (security or software) updates of IT services; the cloud provider will take care of this. 
• Back-ups – it can be used to back up data. This adds an extra layer of 
security and removes the need for physical devices to store backed-up data. 
• Disaster recovery  – this means that it can also aid disaster recovery. 
Using cloud technology makes this faster and cheaper. 
• Better security  – the cloud can increase security of data. For example, if 
in the past an employee were to lose a laptop with sensitive data on it, this would be a high risk security event for the organisation. Keeping data stored in the cloud should reduce su ch risks associated with hardware.

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Risks of cloud and mobile computing 
• Reliance on the service provider  – as with any outsourcing decision, 
relying on the cloud service provider means that any failings at the service 
provider could be more problematic without back-up plans for bringing 
services back in-house. There is not only issues with the trust and security required with the service provider: it also needs to be considered whether the providers services are suitable for the tasks required; whether the technology is advanced enough to give adequate competitiveness; whether the service provider will conti nue as a going concern; whether the 
service provider can ensure continuity in the light of external events such as system failure; whether initial prices will be maintained, etc. 
• Regulatory risks – data security is often highly regulated in terms of what 
can be stored, who can access it, how long it can be stored for, how it can be used etc. Organisations will be reli ant on cloud service providers for 
this compliance. This may become a problem if the service provider is based in a different jurisdiction with different regulations and rules. 
• Unauthorised access of business and customer data  – this can come 
in two forms. Firstly, the cloud service provider is more likely to be a target of hacking than the individual small businesses that use it. If the service provider is targeted all users suffer, even if they were not individual targets themselves. Secondly, providing business and customer data to an outsourced service provider means that the data can be accessed by that service provider’s staff. It will also be important that the service provider does not share this data with unauthorised users such as other users of that service provider’s services. 
 
 TRY company provides financial advice to business clients in P-Land. 
The P-Land financial regulator requires financial advisors to keep all client data confidential.  TRY has a large workforce operating in offices across the country.  At present all its systems are held within the company offices and connected via a company network.  Advisors visit clients at their business premises to discuss options and existing financial plans but currently no changes may be ma de to client accounts until the 
advisors return to the TRY offices. 
The board of TRY company is now considering updating its digital 
strategy by adopting cloud computing and allowing advisors access to mobile computing.

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 Which of the following statements about the use of mobile and cloud 
computing by TRY company are correct? Select ALL that apply. 
A TRY cannot hold client’s financial data using cloud storage as this 
would breach their obligation to keep it confidential. 
B Using cloud computing would reduce the risk of losing sensitive data 
in the event that a mobile device was mislaid or stolen. 
C Providing advisors with mobile computing would provide them with 
additional flexibility to work remotely. 
D Using cloud computing will reduce the risk that hackers will attempt 
to access the company’s data. 
E The use of mobile computing will expand TRY’s network and 
therefore increase the importance of endpoint security. 
Application to finance 
A simple example of how cloud and mobile computing might be of use to 
finance professionals can be seen in the budgeting process. Any organisation which has a number of different locations (such as a multinational company) has historically experienced difficulties and time delays in constructing budgets which require input from people in different places. Cloud computing means that budget templates can be worked on simultaneously by many people without them having to be in the same location. 
5 Internet of Things (IoT) 
The Internet of Things can be described as the inter connection via the internet of computing devices embedded in everyday objects, enabling them to send and receive data. 
This data can then be used for practical applications to the potential benefit of 
both individuals and businesses. 
 
Illustration 5 – intelligent refridgerators 
 The concept of “smart” devices has been around for many years. The 
much-quoted example is of the refridgerator in the home which can tell 
the owner about the contents at any point in time and then turn such knowledge to some use. For example, an alert as to the sell-by date of particular goods might make the owner plan to use those ingredients in the next meal, so as to reduce food waste. Or perhaps the fridge can identify when the house is about to run out of milk, and thereby prompting the householder to buy some more on the way home from work. The truly smart fridge might even be able to add milk to the next online order from a supermarket automatically.

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It is reckoned that, at the start of 2017, there were 8 billion devices globally that 
were connected to the internet – laptops, smartphones, wearables etc. That figure is forecast to grow to 1 trilli on by 2030 (source: Digital Transformation 
Initiative), and this therefore represents potential opportunity for businesses. 
This is already a reality in everyday lives. 
 
 Illustration 6 – Motor insurance 
 Many young drivers now have “black boxes” installed in their cars as a 
requirement of their motor insurance policy. These black boxes record 
data about how the car is driven – speed, acceleration, braking distance, 
how corners are taken etc. – and the agreement to provide such data to 
the insurance company should result in less chances of an accident and therefore lower insurance premiums. 
The cost saving to the motorist, and the reduced chances of a claim to 
the insurance company, are not the only benefits. The fact that the motorist knows that their driving habits are being recorded should lead to more careful driving, and therefore result in fewer injuries and fatalities among a group statistically more at risk of suffering such incidents. 
 
 Illustration 7 – Smart meters 
 In the UK the government has an initiative to encourage energy 
companies to persuade homeowners to have smart meters installed (at no cost to the homeowner) which will enable that owner to control what happens in the home remotely. 
For example, you could turn on the heating just as you are about to leave 
the office so that the home is warm as you arrive. Or set the meter to turn down the temperature if it’s a sunny day, or even turn the heating off altogether if there is nobody home and the house is likely to be empty for a while. It would even be possible to turn your heating on whilst you are abroad on holiday, for example if there is unexpectedly cold weather and you are concerned about pipes bursting in your absence. 
The truly smart meter might simply be able to tell that the smartphone – 
and therefore the owner – has left the building and therefore the heating should be turned down or off. 
The government is keen for homeowners to adopt a smart meter so that 
overall energy consumption can be reduced, thereby helping the UK to hit environmental targets.

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Commercial applications 
It stands to reason that, in a business context, there must be a commercial logic 
to exploiting technology and the IoT. Just because use can be made of 
technology does not mean that it will be. 
For example, a factory owner may well be able to understand the temperature 
of different parts of their factory via smart technology but, unless this can then be used to improve productivity and therefore profit, it is unlikely that such technology will be taken up. 
There needs to be some strategic justification for exploiting the potential of the 
IoT. 
 
Illustration 8 – Dairy farming 
 A dairy farm in Essex was used to trial smart collars attached to a herd of 
cows. A sensor was inserted into each collar which then fed back 
information to the farmer’s computer about the cow’s behaviour. 
Two principle issues affect the profitability of each cow. The first is illness 
(such as mastitis and going lame); this is reckoned to cost the UK dairy industry around £100 milli on per year. The second is a cow’s ability to 
conceive. 
The cows’ behaviour was monitored, and then classified as either 
“normal” or “abnormal”. Abnormal behaviour could then in turn lead to action being taken by the farmer. 
For example, if a cow starts showing initial signs of sore feet, treatment 
could be applied immediately which prevents the bigger problem of it going lame, thereby improving productivity of milk from the cow and saving vets’ bills.  
The typical cost per cow going lame was estimated at £300; the farm 
therefore has to decide if implementing such technology is justified on a cost/benefit basis. 
 
 Illustration 9 – UPS 
 The courier company UPS fitted its fleet of vehicles in the US with smart 
devices that tracked fuel consumption. It identified that making left turns at traffic lights lead to increased amounts of idle time and therefore longer journey durations and fuel consumption. 
It therefore re-routed deliveries so as to avoid unnecessary left turns. 
This resulted in 9 million gallons of fuel (and $31 million of costs) being saved.

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 Illustration 10 – Vitality 
 The insurance company introduced a scheme whereby policyholders who 
took out health insurance with the company were given an Apple watch. 
A condition of the deal was that the member had to download the Vitality Members app on their iPhone. 
The watch was “free” provided that the wearer met the target with regards 
to exercise taken in a specified time. For example, if the wearer walked 12,500 steps per day for 5 days in a week, the amount payable in respect of buying the watch was £NIL. 
If, however, the target was not achieved, a contribution would be paid via 
direct debit to the insurance company; the greater the amount by which 
the target was missed, the more was paid. 
This had a number of benefits. It gave Vitality a marketing edge in the 
insurance market and increased the number of members. 
It also made policyholders think about taking exercise, thereby staying 
healthier and reducing the amount of health insurance claims. 
 
 BGH company is a supplier of vintage wines and uses many types of 
technology in its business.  
The temperature and humidity in its chain of atmosphere-controlled 
warehouses is recorded by sensors and automatically transmitted to head office so that any problems can be identified and dealt with as soon as they arise. Wine barrels are fitted with barcodes which are scanned by despatch staff as the barrels pass through the warehouse to record the movement of inventory.  The data from the barcodes is recorded on BGH’s system, updated overnight and can then be accessed by staff via the company network. 
BGH’s sales teams visit potential customers at their homes or places of 
business and use their work laptops to make sales and record transaction details remotely.  Many of the sales staff also wear wrist mounted health monitors which relay real time information about their heart rate, physical activity etc. to the company.  T hose willing to  wear the devices are 
provided with an upgraded health care insurance package. The company has also ensured that the sales team’s cars are fitted with satellite navigation systems. Staff complain that the systems cannot provide real time traffic information but they are updated for new road networks every time the cars are serviced.

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 The board of BGH has been warned by the company’s IT director that the 
Internet of Things has extended their network and will require a fresh 
assessment of their security risks.   
Based on the information provided, which of the following devices used 
by BGH would be categorised as being included in the Internet of Things? 
Select ALL that apply. A Warehouse atmosphere sensors. B Barcode readers in the warehouse. C Sales team’s laptops. D Wrist mounted health monitors. E In-car satellite navigation systems. 
6 Big Data 
 
 Big Data is a term for a collection of data which is so large that it becomes 
difficult to store and process using traditional databases and data processing applications. 
Big Data often also includes more than simply financial information and can 
involve other organisational data (both internal and external) which is often 
unstructured. 
Examples of data that inputs into Big Data systems can include: 
• social network traffic • web server logs 
• traffic flow information 
• satellite imagery • streamed audio content 
• banking transactions 
• web page histories and content 
• government documentation 
• GPS tracking 
• telemetry from vehicles 
• financial market data.

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The shift to Big Data 
Traditionally, businesses gathered structured information on relevant issues 
from a variety of sources and placed them into a database, or data warehouse. 
As the world has increasingly moved towards digitisation (and especially 
through the growth of the internet), almost all information relating to the organisation and its environment can be stored electronically. The amount of unstructured data generated by electronic interactions increased significantly – through emails, online shopping, text messages, social media sites as well as various electronic devices (such as smartphones) which gather and transmit data. In fact, it is estimated that around 90% of the information in the world today has been created in the last few years. 
The amount of data which businesses have to store and interrogate has 
therefore increased at an exponential rate, requiring new tools and techniques to make the most of them. 
 
Illustration 11 – Big Data 
 Ford’s modern Hybrid Fusion model of car (which has a hybrid 
petrol/electric engine) generates up to 25 GB of data per hour and the 
company is experimenting with vehicles that produce ten times that amount. This data can be used for many purposes, including: 
• A computer model has been developed that projects CO2 emissions 
generated by the fleet of vehicles on roads worldwide for the next 
50 years. This helps Ford to balance fuel economy requirements and environmental considerations. 
• Mathematical models have analys ed millions of possible vehicle 
combinations to assist in the construction of a technology roadmap which has resulted in the development of new features such as Ford Auto Start-Stop. 
• Ford researchers have developed specific tools such as the Ford 
Fleet Purchase Planner, which analyses fleet customers’ needs and identifies their optimal vehicle choice. 
The features of Big Data 
According to Gartner, Big Data can be described using the ‘3Vs’: 
• Volume  – this refers to the significant amount of data that the organisation 
needs to store and process. Match.com (an online dating company) 
estimates that it has 70 terabytes of data about its customers. 
• Variety  – Big Data can come from numerous sources. For example, 
Match.com (with user permission) also gathers data on users’ browser and search histories, viewing habits and purchase histories to build an accurate view of the sort of person the customer might like to date.

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• Velocity – data is likely to change on a regular basis and needs to be 
continually updated. For Match.com, new customers will join the service, 
or existing customers will find their needs and wants from a partner may change. Match.com needs to continually gather data to ensure that they are able to deal with this. 
Another V which is sometimes added by organisations to the above list is: 
• Veracity (truthfulness)  – it is vital that the organisation gathers data that 
is accurate. Failure to do so will make analysis meaningless. Match.com 
has found that when gathering customer data, customers may lie to present themselves in the most positive light possible to prospective partners. This will lead to inaccura te matches. Using non-biased sources 
of information (such as purchasing or web browser histories) rather than relying on customer feedback is therefore important. 
 
 U has recently started looking at ways of gathering Big Data for her 
business. She is concerned that some of the sources of data she has chosen are unreliable and may therefore lead her to inaccurate conclusions. 
Which of Gartner’s features may be missing from U’s Big Data? A Variety B Velocity C Veracity D Volume 
 
 Illustration 12 – Big Data 
 Netflix has over 120 million users wo rldwide who watch billions of hours 
of programmes a month. The company uses information gathered from 
the analysis of viewing habits to inform decisions on which shows to invest in. Analysing past viewing figures and understanding viewer populations and the shows they are likely to watch allows the analysts to predict likely viewing figures before a show has even aired. This can help determine if the show is viable.

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 Illustration 13 – Big Data 
 Big Data analysis is being used by some organisations to help increase 
crop yields by providing information to farmers about when to plant, 
manage and harvest their crops. 
The Climate Corporation, a company acquired by agricultural 
conglomerate Monsanto in 2013, operates an information system that keeps track of weather measurements  from 2.5 million locations every 
day, along with 150 billion soil observat ions. It processes this data to 
generate 10 trillion weather simulation data points. 
With this information, the company claims it can provide US farmers with 
temperature, rain and wind forecasts for areas of 200 acres and above 
for the next 7 day period. 
This allows the farmers to decide optimal times to sow, spray and harvest 
crops to maximise their yields and reduce wastage. 
Benefits of Big Data 
Big Data has several stated benefits to the organisation, including: 
• Driving innovation by reducing the time taken to answer key business 
questions and therefore make decisions. 
• Gaining competitive advantage  by identifying trends or information that 
has not been identified by rivals. 
• Improving productivity  by identifying waste and inefficiency, or 
identifying improvements to working procedures. 
A recent study by Bain & Co suggested that, of 400 large companies, those that 
had adopted Big Data analytics have gained a significant market advantage. 
 
 Illustration 14 – Big Data benefits 
 Delivery company UPS equips its delivery vehicles with sensors which 
monitor data on speed, direction, braking performance and other 
mechanical aspects of the vehicle. 
Using this data to optimise performance and routes has led to significant 
improvements, including: 
• Over 15 million minutes of idling time were eliminated in one year, 
saving 103,000 gallons of fuel. 
• 1.7 million miles of driving were also eliminated in the same year, 
saving a further 183,000 gallons of fuel.

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Big Data problems 
As mentioned before, one of the difficulties  with Big Data is the ability to convert 
it to useful information. To help with this, a number of new open-source 
platforms have emerged to help organisations make sense of Big Data, such as Hadoop and Cassandra, though these may be difficult to integrate with existing data warehouses. 
New roles are also emerging in business – such as ‘data scientists’ whose role 
is to help the organisation get meaning from the data it stores. However, due to the rapidly changing nature of Big Data analysis, there is a shortage of skills 
and support for these systems. 
It is important to realise that just because something CAN be measured, this 
does not mean it should be. There is a risk that valuable time and money will be spent measuring relationships and information that has no value for the organisation. 
The organisation needs to consider how to keep its data secure from viruses 
and hackers. 
Does the organisation actually own the data it has collected on individuals? 
There may be legal (Data Protection) and privacy issues if it holds large amounts of data on potential customers. 
 
Illustration 15 – Risks of Big Data 
 It is widely reported that Walmart tracks data on ov er 60% of adults in the 
US, including online and in-store purchasing patterns, Twitter interactions 
and trends, weather reports and major events. The company argues that this gives them the ability to provide a highly personalised customer experience. 
Walmart detractors criticise the company’s data collection as a breach of 
human rights and believe the company uses the data to make judgements on personal information such as political view, sexual orientation and even intelligence levels. 
 
 S Ltd is a large business that produces online tax returns for businesses 
and individuals. It has a large cash surplus and has invested significantly in its IT infrastructure in the last several years. It currently has a large database which stores a wide variety of information about its customers. 
The CEO of S believes that S has failed to fully understand its market. He 
has proposed that S adopt a Big Data approach. This would involve expanding the current database to enable the storage of information recorded on customer tax returns.

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 S is confident that it could use this to tailor its products and services to 
customer needs, as well as identify possible additional services that could 
be offered to customers. It does not believe that its rivals have adopted this approach to date. 
Which of the following concerns should S have about the use of Big Data 
in this way? 
A High setup costs B Lack of IT knowledge C Privacy issues D Lack of competitive advantage 
 
 BDT company is an on-line retailer and gathers data on a range of 
business factors such as its sales patterns, the economy, its customers 
and competitors, and the market for its products. 
BDT has convened a board meeting to discuss how the company should 
manage the data.  The marketing director believes that insufficient use is currently being made of the information contained within the data and wishes to exploit the opportunities it presents.  The marketing department is not clear how best to classify the data but wishes to understand the patterns within it. The IT director is concerned that the data changes almost daily and will need continual updating.  
Which of the following comments made by directors at the board meeting 
are correct? 
Select all that apply A BDT will need to use supervised machine learning to interrogate the 
data. 
B Moving to cloud computing would help BDT to store the vast 
volumes of data it is currently gathering. 
C The speed of data change being faced by BDT is often described as 
its Veracity. 
D Big Data refers specifically to the amount of financial data being 
gathered by a company on its customers’ purchasing patterns. 
E It will be vital for BDT to analyse all the data it collects and so 
maximise the available information.

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 PL is a global firm of accountants and business advisors offering a large 
range of services to a wide range of clients. The company originally 
offered just two services (accounting and audit), but has branched out in the last ten years to provide tax, forensic accountancy (in partnership with a large law firm), consulting, insolvency and certain niche advisory services such as environmental reporting. 
Evaluate the advantages to PL of adopting a Big Data approach. 
7 Blockchain 
What is blockchain technology 
A blockchain has been described as a decentralised, distributed and public 
digital ledger that is used to record transactions across many computers so that 
the record cannot be altered retroactively without the alteration of all subsequent blocks and the consensus of the network. 
Alternatively, it has been defined by the Bank of England as a technology that 
allows people who do not know each other to trust a shared record of events. 
Benefit of a blockchain 
key risk associated with the use of IT systems and the internet. This is because traditional systems have been ‘closed’, and so modifications to data have been carried out by just one party. If the system is hacked, there is little control over such modification to prevent it from happening. 
 
Illustration 16 – credit cards 
 A simple illustration is the relati onship that individuals have with their 
banks or credit card companies. If a transaction is carried out with either 
(for example, you use your credit card to pay for goods or services) there is only one party that records the transaction, your credit card company. How is that company to know that the transaction is valid? If the details appear reasonable, the transaction will be authorised. This allows those who carry out credit card fraud to make their (illegal) gains.

488  
• In a blockchain system, transacti ons are recorded by a number of 
participants using a network which operates via the internet.  The same 
entered, it is recorded by not just two parties, but instead by all of the parties that make up the overall chain. This can happen because all of the records in the blockchain are public ally available and distributed across 
• When a transac tion takes place (for example, bet ween a buyer and a 
seller) the details of that deal are recorded by everyone – the value, the time, the date and the details of those parties involved. All  of the ledgers 
that make up the blockchain are updated in the same way, and it takes the agreement of all participants in the chain to update their ledgers for the transaction to be accepted. 
• The process of verifying the transaction is carried out by computers; it is 
effectively the computers which make up the network that audit the transaction. If all of the computers review the transaction and verify that the details are correct, the systems of all participants in the blockchain have updated records. The computers work together to ensure that each transaction is valid before it is added to the blockchain. This decentralised network of computers ensures that a single system cannot add new blocks to the chain. 
block using a cryptographic hash generated from the contents of the previous block. This ensures that the chain is never broken and that each block is permanently recorded. It is intentionally difficult to alter past 
transactions in the blockchain because all of the subsequent blocks must be altered first. 
It is this control aspect of blockchain technology which addresses the main concern of cyber security. If anyone should attempt to interfere with a transaction, it will be rejected by those network parties making up the blockchain whose role it is to verify the transaction. If just one party disagrees, the transaction will not be recorded.  
 
Illustration 17 – Cryptocurrency 
 Bitcoin is a digital currency that was introduced in 2009. Other 
cryptocurrencies exist, such as Ethereum and Litecoin. 
over the internet. Unlike traditional currencies, Bitcoin is decentralised, meaning it is not controlled by a single bank or government. Instead, Bitcoin uses a peer-to-peer (P2P) payment network made up of users with Bitcoin accounts. 
Bitcoins can be acquired in 2 different ways: 1) exchanging other 
currencies for bitcoins; and 2) bitcoin mining.

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The first method is by far the most common, and can be done using a 
Bitcoin exchange such as Mt.Gox or CampBX. These exchanges allow users to exchange sterling, dollars etc. for bitcoins. 
Bitcoin mining involves setting up a computer system to solve maths 
problems generated by the Bitcoin network. As a bitcoin miner solves these complex problems, bitcoins are credited to the miner. The network is designed to generate increasingly more complex maths problems which ensures that new bitcoins are generated at a consistent rate. 
When a user obtains bitcoins, the balance is stored in a secure ‘wallet’ 
that is encrypted using password protection. When a bitcoin transaction takes place, the ownership of the bitcoins is updated in the network on all ledgers, and the balance in the relevant wallets updated accordingly. 
There is no need for a central bank to authorise transactions, since they 
are verified by those computers that make up the system. This therefore has the advantages of speed, reduced cost (transaction fees are small, typically $0.01 per transaction), and increased security. 
and no transaction limits. Bitcoins can be used around the world, but the currency is only good for purchasing items from vendors that accept Bitcoin. 
 
 TRS company is a component manufacturing company.  It is one of a 
number of companies working together as part of a just-in-time supply chain for the production of medical sterilisation units.   
A meeting has been convened by the heads of the companies involved to 
discuss a secure way for the companies to transact with each other and provide absolute certainty over the current location and ownership of goods. 
Which ONE of the following digital technologies would be MOST likely to 
achieve this objective? 
A Machine learning B Blockchain technology C Process automation D Cloud computing 
The relevance of Blockchain technology to finance professionals 
Much of the accountancy profession is concerned with ascertaining or 
measuring rights and obligations over property, or planning how best to allocate financial resources.  For accountants, using blockchain provides clarity over ownership of assets and existence of obligations and can dramatically improve efficiency.

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Examples of how blockchain can enhance the accounting profession include: 
• Reducing the costs of maintaining and reconciling ledgers  • Providing absolute certainty over the ownership and history of assets 
• Helping accountants gain clarity over available resources  
• Freeing up resources to concentrate on planning and valuation, rather 
than record-keeping. 
8 Data visualisation 
 Data visualisation is a general term that describes any attempt to take 
data and help people to understand it better by presenting it in a visual context. Patterns, trends, correlations and other relationships that might otherwise not be noticed in a narrative-type presentation can become clearer and more obvious when presented using some sort of data visualisation software. 
Presentation of information 
Presenting information in a diagrammatic form has been around for many years. Standard charts and graphs from using spreadsheet software have helped users appreciate content at a glance. However, as data analytics has become more sophisticated and the use of Big Data more commonplace, the way in which data is presented has had to evolve. In the digital era, the use of data visualisation tools and technologies are seen as essential to be able to analyse meaningfully massive amounts of information and to be able to make data-driven decisions. 
There are many common general types of data visualisation, including: 
• Charts • Tables 
• Graphs 
• Maps 
• Infographics 
• Dashboards. 
More specific examples of methods to visualise data include: 
• Bubble clouds • Cartograms 
• Heat maps 
• Histograms 
• Radial trees. 
This is not an exhaustive list, merely some examples in the ways in which data 
can be presented.

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 Illustration 18 – Motor insurance 
 An article on the World Economic Forum website (“How businesses can 
benefit from visual analytics”) cites the example of how data visualisation 
can be of use to companies that sell motor insurance. 
Historically, the insurance industry has offered vehicle insurance cover 
based on age, sex, previous claims, location, etc. It is now able to offer usage-based vehicle insurance, alternatively called pay-as-you-drive (PAYD) insurance to its customers. 
The insurance value under such schemes is determined based on type of 
vehicle used, distance covered, vehicle braking pattern, etc. Volumes of 
such data are collated and stored through as telematics tracking device. 
However, insurance companies find it challenging to exploit the data in analysing and rolling out suitable premiu ms across all sections of their 
customers. As a result, this means that they might operate at a sub-optimal level. 
This can be overcome by means of data visualisation. For example, for a 
selected geographic category, provision can be made to show a map with bubbles for each customer segment. 
The map can then be zoomed in to multiple sub-layers to study the 
relationship between two parameters and seek correlations in real time. For example, the insurance company can determine the appropriate premium by comparing parameters such as age of the insured, gender, profession, type of road driven, average miles driven per year, probability of accident, etc. 
This helps the insurance companies to price their products and charge 
different sections of their customers accordingly. 
 
 Illustration 19 – Pharmaceutical companies 
 Visual analytics can be used in the pharmaceutical industry to compare 
gene sequence from multiple patients in real time. This enables the pharmaceutical companies to analyse new trends and take better-informed decisions on drugs trials. Additionally, it helps them to modify their research methodologies as per the results of trials so far and therefore enables them to bring their drugs to market more quickly. 
In essence, data visualisation techniques help organisations to understand their home-grown data in more detail and therefore to exploit it better to achieve growth and flexibility. This will then lead to competitive advantage as the organisation moves ahead of its rivals through being proactive in its markets rather than having to follow a trend.

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 The board of BUL company is meeting to discuss the staffing levels 
needed in its large retail store.  The store’s visitor numbers fluctuate 
throughout the day, with differing patterns on different week days.  The board wants to understand how the density of customer numbers changes over each day in order to identify peak periods and quieter times. 
The sales director is considering how best to illustrate the fluctuations in 
customer numbers.  
Which ONE of the following types of data visualisation would be most 
suitable for the sales director to use? 
A Heat map B Radial tree C Cartogram D Pie chart 
9 3D Printing 
 
 3D Printing, also known as Additive Layer Manufacturing (ALM) is a  
process whereby three-dimensional solid objects are created from digital files. Each item produced is created by laying down successive layers of  material, each of which is a thinly-sliced horizontal cross section of the final object. The end product is gradually built up by repeatedly adding these cross sections. 
Applications for 3D Printing 
Until the mid-2000s, the only viable application for 3D printing was with soft plastic, and this was limited. However, the technology has advanced significantly, and the range of materials that can be used in 3D printing applications has expanded enormously. It is now seen in sectors of industry as diverse as aerospace, car manufacturing, electronics, healthcare and education. 
 
Illustration 20 – Airbus 
 Airbus Group uses 3D printers for tooling, prototyping and making parts 
for test flights and aircraft in commercial service. The Airbus A350 is a 
long-range, twin-engine airliner, and is the first Airbus aircraft with both fuselage and wing structures made primarily of carbon fibre reinforced polymer. 
More than 1,000 of the plane’s components are now 3D-printed. The 
Group sees this as an important step in reducing manufacturing waste and making its aircraft lighter, resulting in greater fuel efficiency and less harmful to the environment.

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Benefits of 3D Printing 
3D Printing has several stated benefits, including: 
• Reduced waste – it is estimated that 3D printing generates 5–10% waste 
material (which can then be recycled or reused) instead of the much 
higher rate of waste that results from traditional manufacturing techniques that create a part by cutting away a solid block of material, rather than building it up layer by layer. 
• Eliminate transport costs  – as production can occur at the point where 
the product is required, t he organisation will  not have to incur shipping 
costs to have it brought in from a 3rd party supplier. 
• Less environmental impact  – the reduction in ‘travel miles’ in getting the 
product to its required location will mean lower overall carbon emissions. 
• Shorter lead times  – components can be produced as they are required, 
meaning lower lead times between identifying a need and taking possession of the product. This should result in less requirement for holding inventory and therefore reduced investment in working capital. 
• Greater customisation  – the component may be tailored better to specific 
requirements if made in-house. 
• Increased profitability  – if a component can be made in-house rather 
than sourced from a supplier, the organisation will not have to pay an element of overall profit to that supplier to give them a return. This should result in increased margins for that organisation. 
• Social benefits  – in certain sectors of industry, 3D Printing can help solve 
social issues that traditional manufacturing processes cannot. 
 
Illustration 21 – 3D Printing in the construction industry 
 Apis Cor is a construction company based in San Francisco. Founded in 
2014, it claims to have created a 3D Printer that is capable of building an entire house in just 24 hours – and that will last for 175 years. 
Not only does this mean that construction can be hugely accelerated to 
meet global housing shortages (traditional houses naturally take much longer to build), but Apis Cor built its first house in Stupino in Russia at a time when construction would not normally take place because of the cold (usually cement cannot be used when temperatures drop below 5 degrees centigrade). Apis Cor placed its 3D Printer inside a large tent when temperatures outside went as low as –35 degrees. 
The video showing the house being built can be seen here: www.youtube.com/watch?v=xktwDfasPGQ Dubai has announced that 25% of the emirate’s new buildings will be 
made by 3D printers by 2025. The Dubai Future Foundation claims that this strategy will reduce labour by 70% and cut costs across different sectors by as much as 90%.

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 Illustration 22 – 3D Printing in the healthcare industry 
 There are many applications for 3D printing in the healthcare industry, 
including hearing aids, personal prosthetics, dental crowns, surgical 
implants and facial reconstruction. This is because 3D printing allows for much greater personalisation, meaning that a bespoke product can be created for a particular person’s needs and style/shape of body. This also has benefits to the healthcare providers – if units are made bespoke to each consumer, there is no need to buy items in bulk. 
3D printing also has uses in creating pills and tablets. For example, if a 
patient suffers from multiple ailments, a bespoke pill can be made aimed 
at solving different illnesses simu ltaneously. The 3D printed pill can 
contain multiple drugs at once, each with different release times. This can 
make life much simpler for patients. 
Problems of 3D Printing 
There are however a number of problems of 3D printing, including: 
• Cost – the cost of creating a 3D printer can be high, meaning that small 
businesses may find it a technological area that is beyond their financial 
means. 
• Quality concerns  – the fact that products made using a 3D printing 
process can be bespoke means that there is no universally accepted standard. This then leads to concerns over quality, strength and reliability, meaning that organisations forego the potential benefits of 3D printing for the perceived lower risk in traditional manufacturing processes. 
• Lack of skills – as with any new technology, 3D printing requires specific expertise. Until it is firmly established, organisations may struggle to recruit/train staff to have skills needed to exploit it properly. 
• Legal concerns  – 3D printing may make it possible for manufacturers to 
“steal” the intellectual property of companies by copying products that, under traditional manufacturing laws, they would not be allowed to make. It is possible that new legislation will need to be drafted to cover such areas, but this takes time. 
• Environmental impact – a study at Loughborough University in 2009 
found that a 3D printed product would have taken as much as 50-100 times the amount of energy to produce compared to traditional moulded manufacturing techniques. Furthermore, plastic is commonly used in 3D printing, and the environmental concerns over use of such product are growing. 
 • Ethical concerns  – for example, in the healthcare industry, 
pharmaceutical companies have to go through rigorous trials before a product can be licenced for sale by the regulatory bodies. Creating a bespoke medication for a particular patient may mean that such approval processes are not possible.

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 BQP hospital uses surgical implants in many operations – for example in 
the treatment of hip, knee and other joints.  Once an operation has been 
scheduled, the implants are ordered from external suppliers, and then transported to the hospital via road and rail.  Implants are often an inexact fit so high volumes of inventory are held to provide surgeons with the greatest possible choice. 
After reviewing the increasing costs associated with the use of surgical 
implants the hospital’s Technical Director has suggested BQP should acquire a 3-D printer to make the components within the hospital. 
Which THREE of the following potential outcomes are MOST likely 
should BQP decide to acquire the 3-D printer? 
A Improved implant quality B Reduced expenditure on shipping C Greater customisation D Higher inventory levels E Shorter lead times 
10 Process Automation 
 
 Process automation (also known as Robotic, Digital or Business Process 
Automation) refers to the use of digital technology to perform a process or processes to accomplish a workflow or function. Or, to put it another way, processes that used to be done manually become automated. 
A simple illustration is the example of Apis Cor in the previous section, which has devised a means of building a house using a 3D printer instead of traditional labourers. 
As part of digital transformation, processes can be automated in almost any 
industry.

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 Illustration 23 – Airports 
 Much of the process for checking in and dropping bags off at airports 
has now been automated, meaning that passengers no longer have to 
wait in (sometimes l ong) q ueues in order to rece ive their boarding 
passes and check their luggage in. 
The boarding pass can be printed at home or simply shown via a smart 
phone, having been emailed in advance by the airline. 
Machines with scales enable passengers to weigh and print the 
relevant baggage tags on arriving at the airport. The bag is then simply dropped off at one of the conveyor belts, leaving the passenger to go 
straight to security checks and passport control.  
Automation results in a speedier and more satisfying experience for the 
passenger, and cost reductions for the airline as it no longer has to employ as many check-in staff. 
Benefits of Process Automation 
There are a number of benefits associated with Process Automation: 
• Productivity – employees can be released from mundane activities and 
redeployed to more va lue-adding tasks. 
• Accuracy  – as processes are automated, this eliminates the risk of 
human error. This should mean that the right result, decision or calculation 
is achieved at the first attempt. 
• Consistency – identical process and tasks should be achieved in 
standardised activities, resulting in no variations. 
• Audit trail  – automation of activities should result in a complete log being 
recorded of all tasks carried out and the outcomes. This can be essential for compliance purposes. 
• Flexibility – if processes are subject to spikes or troughs in demand (for 
example, a seasonal business) automating the process will allow the 
organisation to deal better with such variations without compromising quality or service. 
 • Staff retention – if repetitive or mundane activities can be carried out in 
the workplace automatically, employees can be redeployed on more 
stimulating jobs of work, resulting in greater job satisfaction. This is particularly important in roles requiring skilled or semi-skilled staff. 
• Availability – automated processes can be carried out 24/7, 365 days a 
year. 
 • Cost savings  – significant cost savings can be produced through 
automation, as certain roles can become redundant in the organisation.

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 Illustration 24 – Finance departments 
 Many organisations have typically busy month-end procedures, whereby 
results for the month just passed are collated into templates, variances 
calculated and commentary provided in order to give management a detailed basis on which to make future decisions about the business. This can be a stressful time for finance staff, as a lot of work has to be completed in a short space of time. 
Relevant software can be introduced which enables data to be drawn 
automatically from integrated sources to complete the necessary templates. Furthermore, if the software is sophisticated enough to be able 
to interrogate the source data, variance commentary can be provided 
with little or no human intervention. This can result in a much speedier reporting process with less stress for finance staff. 
Challenges of Process Automation 
• Lack of integration in IT systems – in large businesses with many 
different components to IT, there may be a lack of integration that makes process automation impossible without first investing significant time and money in making the systems more aligned. For example, in a group comprising a parent company and many subsidiaries, it might be possible to automate processes in just 1 company but not across the group as a whole because the IT systems are incompatible. 
 • Lack of standardisation  – automation works when processes are high 
volume, based on set rules, repetitive and needing no element of human 
judgement. Organisations where this is not found will struggle to benefit 
from process automation. 
• Reluctance to reduce headcount – the automation of work processes 
has a natural consequence in many people’s eyes that it leads to job losses. This may not necessarily be the case; it can be argued that people are still a necessary resource, but will be deployed to more value-adding activities rather than routine and repetitive work. However, there may be resistance from employees if they feel that their positions are threatened. 
 • Cost – acquiring or developing the necessary software may be beyond the 
budget of the organisation, even though it might produce long-term cost savings. 
• Lack of skills – this may be within the business itself. For example, new skills will be needed in implementing, monitoring and servicing the automated systems, and may require new roles to be created and filled. 
Alternatively, it could be in terms of software providers. Process 
Automation is still a young industry, and it may be that there are not 
enough suppliers with the necessary skills to create the solution needed for a particular organisation or industry.

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 BHJ is a tax advisory organisation operating in H-Land.  It has a large 
number of offices, many acquired in the last two years, and most of its IT 
systems have not yet been integrated. Clients come to BHJ requiring a range of services from the completion of their routine tax returns to the provision of detailed tax advice about the implications of a group restructuring.  The tax authorities in H-Land have strict compliance requirements for tax returns which must be fully supported with the relevant corroborating documentation. BHJ is growing fast; its highly skilled workforce is currently struggling to cope with the workload and a 
back log of work is building up.   
The board of BHJ is meeting to discuss how best to manage the 
organisation’s growth.  The IT director has suggested that BHJ should introduce business process automation into its service provision business model.  Not all of the directors are currently in support of the idea.  
Based on the information provided, which of the following comments 
about process automation made by BHJ’s directors are correct? 
Select ALL that apply. A BHJ’s lack of IT systems integration would be no obstacle to the use 
of process automation. 
B The use of process automation could help to reduce the back log 
currently faced by BHJ. 
C Process automation could simplify the provision of the compliance 
documentation required by the tax authorities. 
D Process automation would allow BHJ to make better use of its 
highly skilled workforce. 
E Process automation would not be suitable for BHJ because some 
clients require highly technical advice.

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 During a business conference about the issues involved in process 
automation, its potential drawbacks ar e being discussed.  Managers from 
several companies are comparing the features of the businesses they 
work for and considering the reasons why process automation may therefore not be suitable. 
Which THREE of the following business features would be an obstacle to 
process automation? 
A The accuracy of processes is of vital importance to product safety. B A highly unionised workforce will make it difficult for the company to 
reduce its headcount in routine work roles. 
C The relevant processes are subject to significant fluctuations in 
demand. 
D The company currently has no IT department and a severely limited 
budget. 
E The company’s processes are run on a large number of 
unintegrated systems.

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 The correct answer is E 
Digitisation is the process of converting information into a digital format. 
All businesses can adopt this approach.  It may help the company to achieve operational efficiencies but it also offers opportunities for innovation, expansion and competitive advantage.  It does not mean that a company must use cloud computing nor that all devices must be able to access the internet.  However the process of introducing a successful programme should not be underestimated and simply setting up a business unit to manage the process will not be sufficient.  Top level responsibility and full organisational buy in will be needed.    
 
RTY is using supervised learning where the machine is given data 
classifications and then applies them to the data.  Unsupervised learning is used where no clear classifications can be identified in advance and the algorithms are used to explore the data and find the intrinsic patterns.  Reinforcement learning is where the algorithm has a result to achieve (like maximising returns) and then interacts with the environment to learn the best way to achieve it.  Feature learning is a technique used in machine learning which allows the system to discover what is needed to identify features or classifications from raw data. 
 
 The correct answers are B, C and E 
One of the main advantages of mobile computing is that it allows workers 
greater flexibility to work remotely.  However all the additional devices (such as tablets and laptops) which are then joined to the company’s network increase the risk of unauthorised access and so endpoint security will need to be strengthened.  The need to keep client data confidential does not preclude the use of cloud computing and indeed many companies do keep such data ‘in the cloud’ but hackers may be more likely to target cloud service providers than individual businesses and so care must be taken to select a reliable provider. Additionally with cloud computing no actual data is stored on the remote device, so losing it would not carry the same risks of losing sensitive data.

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 The correct answers are A and D 
The key component of items included in the Internet of Things is that they 
communicate without human intervention using the internet. This would therefore exclude devices such as laptops and barcode readers which require human involvement and the in-car satellite navigation systems which do not currently access the internet.  The warehouse sensors and wrist mounted health monitors are examples of items included in the Internet of Things. 
 
S already has a significant amount of IT infrastructure and seems to have 
the relevant skills to maintain, suggesting that this would not be a problem of adopting Big Data. The fact that the organisation would be the first in its industry to adopt this approach (which it seems confident will improve its service provision) would also seem to suggest that it will gain competitive advantage from such a move. 
However, storing such a large amount of personal information opens up 
the organisation to issues surrounding privacy and data protection. Customers may be unwilling to allow t he company to use their personal 
data in this way and there may be legal implications as well. 
 
Big Data includes all types of internal and external data.  It describes the 
position where the collection of data is so large that it becomes difficult to store and process using traditional databases and data processing applications. 
Machine learning is where algorithms are used to make predictions and 
recommendations by processing data and experiences.  Unsupervised learning means that the algorithm interrogates input data without being given any explicit output variable and is needed where the data can’t be classified as is the situation here.  Supervised learning requires human input to first classify the data which BDT cannot do.

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The speed by which data changes is known as its ‘Velocity’.  Big Data 
analytics can help the companies to control and manage this flow of data.  However firms should be wary of spending resources on analysing data that cannot provide it with valuable information, and care should be taken to interrogate only that data that will be genuinely useful. 
Using cloud computing would mean that an external service provider 
would store BDT’s data on the internet rather than companies storing it on its in-premises systems which would provide them with greater capacity. 
 
 Capturing Big Data and having the capability to manage and analyse 
such data has many business benefits, but also comes with risks. 
Companies like PL will gather huge amounts of data about their clients in 
a wide range of different formats. This data will cover fairly straightforward transactional data, such as the clients’ sales history, but will also include less structured data regarding products, services, competitive environment and key personnel. 
Traditionally accountancy and advisory firms would have used the data 
collected to make a very specific conclusion (for example a calculation of tax liability), but wouldn't have harnessed the data gathered to better understand the client and business opportunities for PL. If Big Data management principles were applied, PL could perform analysis on all of this additional information to make decisions regarding cross-selling opportunities, more targeted marketing activity and identify further niche advisory options. 
Despite having access to such a wide variety of data, PL needs to take 
greater care than some companies when using this data. As a professional services firm, they will need to ensure that they are complying with all relevant ethical codes, which may restrict the amount of data shared between departments. PL will also need to observe any relevant data protection legislation as large amounts of data gathered will be sensitive business information about their clients. 
Another area that PL can use Big Data management is during the 
recruitment process. Firms in this industry receive thousands of applications for graduate schemes each year and have traditionally relied on academic qualifications to shortlist candidates. 
A wider range of data through networks such as Facebook and LinkedIn 
can lead to a more meaningful and effective selection process.

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Blockchain technology allows for the synchronisation of all data and 
transactions across a network and each member must verify the transaction before it can be approved. It is increasingly being used to link supply chains as it provides certainty over the current location and ownership of goods.  
Process automation is the conversion of processes that used to be done 
manually so that they become automated.  Machine learning is where algorithms are used to make predictions and recommendations by processing data and experiences.  Cloud computing involves service providers storing software, applications, servers etc. on the internet rather than companies storing them on in-premises systems. 
 
The main use of heat maps is to help visualise the volume of locations or 
events within a collection of data by using variations of colouring.  This would be ideally suited to showing the density of visitor numbers throughout the day with stronger shading being used to represent greater densities. 
A radial tree is used to lay out hierarchical relationships which radiate out 
from a central point.  A mind map is an example of a radial tree.  
A cartogram is a map in which a chosen mapping variable – such as 
population size, or income per head – is substituted for land area or distance and the land sizes are distorted accordingly.  
A pie chart is used to show proportions or percentages between 
categories by dividing a circle into appropriately sized chunks. 
 
If the hospital owns a 3-D printer it will be able to produce more 
components as needed without the need to wait for external deliveries (so lower shipping costs and shor ter lead times) and will be able to 
customise the implants to exactly match the needs of each patient. This should lead to lower inventory levels.  However the quality control mechanisms within the medical supplies market may well be tighter than those over a hospital operated printer and so implant quality may be less certain.

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 The correct answers are B, C and D 
Process automation involves using digital technology to perform 
repeatable work flows or functions.  Completion of routine tax returns would therefore appear to be a suitable process for automation.  It would not matter that some clients require complex advice as process automation can be applied to individual processes and need not be rolled out across all the organisation’s activities.  It could simplify the provision of the audit trail required by the tax authorities in H-Land and since it can run 24/7 it could also help to reduce BHJ’s back log.  However process automation does require integrated IT systems to run effectively and this could be an obstacle to its successful introduction. 
 
Two of the strengths of business process automation are the accuracy 
with which processes can be performed and the way that workflow can be controlled to smooth out fluctuations in demand.  However unintegrated systems and a lack of IT  skills to manage the process (and 
a limited budget to address this lack) will present obstacles that will need to be overcome if the implementation is to be successful.  One of the benefits of the approach is reduction of staff costs on routine processes but this will be problematic if it is difficult to reduce the headcount.

507 
Digital strategy – 
governance and 
strategies 
F1: Describe the governance 
of digital transformation (a) Describe the roles and 
responsibilities of the board and executive leadership in digital strategy 
F3: Discuss the various 
elements of digital strategies Discuss: 
(a) Economics of digitisation (b) Digital ecosystems (c) Digital consumption (d) Data and metrics (e) Leadership and culture 
 
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13

Digital strategy – governance and elements of digital strategies 
508  
 
In the previous chapter, we looked at modern digital technologies and the 
concept of digital disruption. In this chapter we will focus on the role of leadership in introducing and making best use of such technologies, and how digital transformation will affect the strategic thinking and control of the organisations that undergo such change. 
2 The roles and responsibilities of the board and senior 
In order for an organisation to properly take advantage of a move to digital, or to survive digital disruption within its indus try, the executive leadership team will 
organisation will typically be used to . The leadership team will need to 
2 Competitive edge – not only will the leadership need to motivate others within the organisation to see the digital transformation as the right strategy; they will also have to persuade people to potentially change their mindset. The need to adopt an inquisitive attitude, to be prepared to innovate and think outside the box, to experiment and to learn from failures may not be second nature to some, but is likely to be critical in transforming successfully to digital.

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business has done for a long time, but a digital strategy may require it to 
be done in a different way. For example, the planning horizon may need to be shortened, or greater flexibility in troduced – perhaps a move away from 
capital is likely to be necessary, but showing how that capital may be applied and the value that will result might be more problematic. Will investing in cloud technology deliver increased shareholder wealth? If so, how much? And when? There will be greater uncertainty over outcomes, and the leaders of the business will need to be persuasive and articulate a compelling value proposition. 
deliver the requisite value. This will require careful thought on who to collaborate with and how each part of  the ecosystem will contribute. 
Much of the above is discussed in more detail in the following sections.

510  
 GHJ is a successful, long established business.  It has a profitable 
product portfolio and a close relationship with its customers. Many of its 
shareholders have held their shares for many years and take a long-term view of their investment.  One of GHJ’s competitors recently approached the company with an opportunity to collaborate on a new digital product which, if successful, would revolutionise the business area in which it operates and earn profits for both companies.  However sales of the new product would inevitably negatively impact its current product portfolio.  The board has stated that to take up the offer the company would need to 
transform itself into a digital enterprise. 
Which TWO of the following factors are MOST likely to be obstacles to 
the board accepting the opportunity and becoming a digital enterprise? 
A GHJ currently has a successful business model B The company has a close relationship with its customers C The current product portfolio may be negatively impacted D Shareholders currently take a long-term view of investment E The opportunity is being suggested by a competitor 
3 Economics of digitisation 
Organisations that want to become digital enterprises face two fundamental 
obstacles that need to be addressed: firstly, how to deal with the traditional business model that has served them so well for so long. It is being disrupted by digital innovation and no longer works the way that it used to. Secondly, a successful move to being a digital organisation will only work if that business is prepared to disrupt itself – does it have the stomach to do that? 
The risk-averse business manager will naturally be alarmed at the prospect of 
damaging profitability, and will not therefor e embrace a significant change to the 
business model. Critics would point out that such a leader is focussing purely on the present; they are not looking after shareholder value in the long term, which means looking to the future.

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 Illustration 1  – Amazon 
 Amazon has grown to become one of the world’s most valuable 
companies through being prepared to disrupt itself on a number of 
occasions. It’s first business model was based on selling books cheaply over the internet, and offering val ue that bricks and mortar retailers 
such as Waterstones and Borders could not match. But then it produced the Kindle, an e-reader which cannibalised sales of books in hard copy format. 
The company moved from selling books to also selling DVDs, again 
challenging the market share enjoyed historically by organisations such 
as HMV. Amazon subsequently disrupted itself by launching Amazon 
Prime, a streaming service which made customers move away from buying hard copy product. 
It is argued that Amazon’s success is largely due to the vision of its 
founder Jeff Bezos, who has shown bold leadership and created an innovative culture at the company.  
In looking at how to disrupt themselves, organisations should question the ways 
in which they can earn revenues. It used to be that businesses would see 
overall revenue as a very simple outcome: it is volume × price. 
However, in the digital era the ability to generate revenue should be seen in a 
much broader context; in essence, there is more than 1 way to earn a living. Key to recognising potential revenue opportunities is to make use of the wealth 
of data that the organisation has at its disposal i.e. to capitalise on its knowledge via Big Data analytics. Large organisations will have so much information available, both in a B2B and B2C capacity – the secret is to leverage that knowledge to the organisation’s benefit. Furthermore, the cost of both storing and making use of such data is decreasing all the time, making such usage a more viable economic option. 
In assessing the economics of digitisation, business leaders are encouraged to 
stop seeing revenue as being solely the pr eserve of selling a product or service; 
their horizons should be broadened by looking at how networks, sales channels and customer engagement can add value. 
Nine revenue models have become evident fr om the possibilities that digital 
technology presents, some of which the organisation may already adopt, but 
others represent new opportunities: 
• Transaction  – a traditional approach, whereby goods are sold from one 
party to another.  
• Capacity leasing – the organisation has a form of resource, such as 
machine time, asset availability or human time, and supplies such capacity 
to customers.  
• Licensing  – another traditional revenue source – instead of making a 
product itself, the organisation licences its technology, brand or intangible assets to another organisation for a defined period of time.

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• Subscription – products or services are subscribed to and paid for in 
advance. This could be for a short or long period of time. For example, Netflix allows subscribers to cancel their payments at any point in time.  
• Commission – revenue is earned through matching sellers to customers. 
For example, as well as selling its own products through its website, 
Amazon also allows third party retailers to market via the same platform, for a fee.  
• Advertising  – particularly for social media organisations, but not purely 
restricted to such businesses. For example, BT generates revenue through allowing advertisers to use its email platforms. 
• Trading  – it is possible to identify circumstances where the demand/ 
supply market forces are producing a sales value which is mispriced. Traders can use technology to identify opportunities to buy at a low price and sell when more realistic prices are in play.  
• Donations  – acts of philanthropy can result in intangible benefits to the 
donor.  
• Subsidies  – often found in public sector organisations, whereby subsidies 
are given to improve quality of service in areas which cannot be fully funded by traditional revenue models.  
 
Illustration 2  – Michelin 
 
 BVF company is a broadcasting company. 
It is introducing a new film and television streaming service with customers paying a monthly fee to access a wide range of programmes. Where possible, customers will also be offered the opportunity to buy the DVD accompanying a show for a small one-off sum.  Demand for the service is expected to fluctuate so BVF will pay larger organisations to use their spare IT infrastructure as needed. BVF will offer other companies the chance to show short promotional videos at the start of streamed programming in return for a fee.

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 Based on the above information which of the following revenue models 
is BVF’s move into digital technology exploiting? 
Select ALL that apply. A Transactional B Capacity leasing C Subscription D Commission E Advertising 
4 Digital ecosystems 
In chapter 1 the term ecosystem was introduced, and it was identified that it 
relates to all the organisations that collectively work together – either through cooperation or competition – with a view to creating value. The real advantage of the ecosystem is that it is able to deliver greater value than the individual participants acting alone.  
The need for the organisation to recognise that it is part of a broader ecosystem is even more apparent in a digital context. In order to keep up with the increasing demands of customers, organisations need to view themselves as 
part of a broader attempt to create value, otherwise the customer expectations 
are unlikely to be satisfied. This will inevitably mean that the business leader will need to consider how a participant in the ecosystem will impact on his/her own 
organisation’s strategy. What is each organisation’s function within the broader ecosystem?  
For example, it may be that 1 participant is able to operate on a global scale, whilst other participants satisfy local demands. Or that, due to a lack of certain skills in-house, knowledge needs to be shared with other participants who can 
successfully fill that skills gap.  
3 key questions need to be asked with regards to each participant that makes up the ecosystem, and thus how it might impact on any one organisation’s strategy:  
that participant bringing to the party? It may be cloud computing capacity. Possibly distribution capability. Possibly unique software skills. Access to certain markets, perhaps due to owning a particular licence to operate. It makes sense that, for the ecosystem to create the value that is possible, all necessary participants are present.

514  
environment. For example, can the participant operate on a global or just a 
local level? Can it deal with both consumer (B2C) and industrial (B2B) markets?  
• The capability or key value proposition – this is the range of activities 
that participants are able to pursue or undertake in the environment. What is the key value that each participant is able to deliver? 
 
Illustration 3  – Nest 
thermostats that control the central heating system to surveillance cameras and smoke alarms. It has created a new technology platform that offers homeowners a unique experience because it has correctly 
brought in other companies such as Mercedes Benz and LG to bring 
capabilities that Nest itself does not possess.  
5 Digital consumption 
Organisations have always had to evolve to keep up with changing expectations of customers, very often driven by advances in technology.  
For example, in the music industry the accepted offering for listening to music was, for many years, in vinyl and cassette format. This then changed in the 1980s to CD, before the advent of the internet enabled consumers to purchase online and download to mobile devices such as MP3 players. This then progressed further to streaming instead of outright purchase. Each successive development lead to a decline in demand for the previous format (although interestingly there has been a recent resurgence in demand for how it all started, as sales of vinyl have started to grow again!).  
However, since the start of the new millennium, the rate of change has grown considerably, driven by 2 principal factors: organisations are adopting technologies that enable them to transform the experience that customers can enjoy; and the expectations of the customers themselves are changing at a much faster rate. This latter point is only likely to continue, as present and future consumers, who have been born and raised in such a digital world, embrace new technologies more quickly and expect that they will be able to benefit from improvements to their lives as a result, meaning that organisations will find it much more difficult to surprise them.  
Organisations will therefore need to constantly reinvent what they offer to customers if they are to satisfy their rapidly changing expectations.

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understand the key drivers behind such change. The following are identified as key factors:  
ownership, combined with access to the internet (with mobile beginning to exceed broadband). It is estimated that by 2025 the number of smartphone subscriptions will reach 4 billion, with much of the growth coming from emerging economies. 
• Data analytics and the cloud – the increasing use of e-commerce 
In essence, more and more people are becoming connected to technology, enjoying the benefits that it delivers, and demanding that such benefits increase, not just within 1 industry but across industries – there is no reason to believe that advances in 1 area of business cannot be transferred to other areas.  
 
Illustration 4 – Pager 
 Based in New York, Pager is a company that provides on-demand 
health care from local medical professionals via mobile-based services. Users can request services such as check-ups, arranging prescriptions and diagnosis of illnesses from the doct or of their choice within their 
local area. House calls are made within 2 hours of the service being requested. 
from 1 industry (such as Uber and transport requirements) to another (healthcare). It is therefore little surprise that Pager was founded by Oscar Salazar, a former Uber engineer.

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What does the digital customer want? 
number of factors that drive customer demands in the digital era. These include the following:  
that customers expect a product or service that is tailored to their own specific needs. The video streaming service Netflix helps meets this demand by making recommendations on programmes that are likely to be of interest to the viewer based on historic patterns. 
• Anytime, anywhere – there is an expectation of being able to access real 
• Great service (it doesn’t matter who provides it)  – there is less 
instance these days of customers remaining loyal to a provider following an example of poor service. Customers are prepared to shop around for products or services if they have had a bad experience. 
• Transparency – the digital customer expects to have full transparency of 
information about a product or service before they commit to a purchase. This includes details such as precise features of the product, but also extends to how personal information is to be collected and used. Customers are protective of their personal data and want choice in deciding whether or not it is shared. 
customers attaching more importance to independent reviews of products or services than to marketing information provided by the business or reviews from other organisations (such as trade journals). The purchase decision will be influenced by what fellow customers have said, meaning that a poor review can have a disastrous effect on future sales potential.

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Keeping ahead of customer expectations 
The question must therefore be asked: given that customer demands are evolving at such a rapid pace, how can organisations adapt so that they keep up with, or preferably ahead of, those expectations? A seemingly successful offering today could rapidly fall out of favour and lead to a reversal of the organisation’s competitive advantage.  
This can be avoided via the following:  
can be marketed to many customers, there should be a shift in mindset to designing many experiences for one customer. This must be mixed with the ability to constantly learn and adapt as customer needs change. 
• Experiental pilots  – this refers to the need to monitor how customers 
The organisation should be prepared to continuously take products to a 
• Prototyping – instead of waiting until a new product has been perfected 
• Brand atomization – organisations will need to design their offerings so that they can be more widely distributed and be part of the platform that is offered by other providers.

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 In its attempts to keep ahead of customer expectations Geezer, a music 
streaming service, has allowed its technology to be compatible with many 
manufacturers of hardware, including Eros (which makes internet-connected audio systems), Singsam (a manufacturer of smart TVs), and the operating system of the world’s leading computer software manufacturers. 
This is an example of which ONE of the following? 
A Design thinking B Experiential pilots 
C Prototyping 
D Brand atomization 
 
 QPO company supplies utilities to domestic customers.  It has a wide 
range of services on offer. The board of QPO company are discussing the importance of meeting 
the needs of its digital customers.  The marketing director has explained that one factor driving digital demand is the need for contextualised interactions. 
Which ONE of the following strategies would be most appropriate to 
provide customers with contextualised interactions? 
A Streamline the process of selecting, purchasing and receiving the 
services 
B Allow customers to select their own options to create a personalised 
bundle of services 
C Increase the quantity of information provided on each service and 
clarify how personal data will be used 
D Ensure customers can access their account and track the progress 
of any purchases at all time

Chapter 13 
 519 
 BNN company is a manufacturer of interactive video games.  In order to 
maximise the player experience, teams of gamers are paid to play games 
during their ‘beta’ stage (before the design is finalised) and provide BNN with their feedback.  The designers also work to ensure that when they are released the games can be played on multiple platforms to maximise sales.   
Which ONE of the following techniques are being demonstrated by the 
design team at BNN? 
A Knowledge sharing 
B Design thinking 
C Brand atomisation D Experiential pilots E Journey management 
6 Data and metrics 
In chapter 8 the subject of metrics (or KPIs, to use an alternative phrase) was 
introduced, and it was identified that any organisation needs to adopt an appropriate mix of both financial and non-financial metrics as part of its strategic performance management system. This will be no different for a business in the digital era, and very careful thought must be given by management as to what measures should be put in place and how the necessary data relating to those measures can be captured. 
A financial measure that has been given great importance historically has been 
Return on Investment (ROI). Digital transformation will represent a considerable investment, but few companies that have undergone such change have been able to quantify the ROI of their digital initiatives. It is therefore necessary to look for alternative measures, collectively referred to as digital traction 
metrics . 
This will be particularly important if the organisation needs to attract investment from outside sources for the digital transformation to be possible. Such providers of capital are likely to be reassured that the long term prospects are attractive, as it has been proven that organisations with high digital traction are linked to high company valuation. 
Digital traction metrics 
Whilst they cannot give assurance about the ROI that an organisation is 
enjoying from its digital transformation, they do provide evidence as to how attractive the organisation’s products or services are to customers. By looking at a combination of metrics in certain areas, focussing mainly on customer behaviour, the organisation can gauge both the appeal of its products or services, and how quickly they are likely to be adopted in the market.

520  
Digital traction is a combination of metrics in 3 areas: Scale, Active Usage, 
and Engagement . 
• Scale – this relates to the number of people who are showing an interest 
in the product or service. Typical metrics could include the number of visitors; unique users; the number of registered users; growth in registrations per month; or organic user acquisition. 
• Active usage  – this refers to the frequency with which a user interacts 
with the organisation. Appropriate metrics could include the number of active users; daily active users (DAU); monthly active users (MAU); conversion rate; abandon rates; the number of repeat users/customers. 
• Engagement – these measures look at the degree to which the user has 
engaged with the organisation. Suitable metrics may include time spent on site; Net Promoter Score (NPS); customer satisfaction index; posts contributed; number of likes and shares; photos/videos shared/uploaded and views completed. 
There should also be metrics that measure the financial impact of attracting and keeping customers, and assessing whether the organisation is being profitable in such dealings. Two metrics that help with this are: 
• Cost to acquire a typical customer (CAC)  – this can be calculated by 
looking at all expenditure on sales and marketing and dividing by the 
number of new customers won. 
• Lifetime value of a typical customer (LTV) – this can be measured by 
multiplying the average monthly recurring revenue by the average customer lifetime. 
It stands to reason that the LTV needs to be greater than the CAC for the organisation to be profitable. Success can be measured by how much LTV exceeds the CAC. 
Such metrics can also be used to calculate ratios. 2 ratios that will give 
management valuable information are: 
• LTV:CAC  – as mentioned above, this gives insight into profitability and 
cash flow. 
• Months to recover CAC – this can be calculated as CAC/average 
monthly recurring revenue, and is very similar to a payback period 
calculation. 
As was examined in chapter 8, a suitable benchmark for digital metrics would need to be established taking specific industry circumstances into account. 
For example, attracting one new customer per month might be deemed 
acceptable for a high value online company that deals in B2B services, but would not be particularly impressive for Facebook or Instagram.

Chapter 13 
 521 
 Sundog is an online greetings card company. It offers customers the 
opportunity to create customised greetings cards which can be sent 
either to the customer’s home address or straight to the intended recipient. In measuring its digital traction, which THREE  of the following 
would be classed as active usage metrics? 
A The number of customers purchasing from the site each day B The number of customers per day who have purchased from 
Sundog before 
C Feedback ratings from customers 
D The number of customers closing their accounts 
E The number of visitors to the website 
 
 BSR company has recently expanded and has therefore launched a new 
website to promote and sell its new range of products. As the company 
uses a balanced scorecard approach to measure its performance, the board is meeting to discuss the new metrics it will need to include under each of the different perspectives. 
One area of the customer perspective that the board wishes to measure 
is the extent of engagement with the organisation.   
Which TWO of the following metrics would help the board to measure 
customer engagement with BSR? 
A Cost to acquire a typical customer (CAC) B Number of visitors to the site C Time spent on the site per visit D Net Promoter Score (NPS) E Number of daily active users (DAUs)

522  
 MBP company operates in P-Land where the currency is the P$. 
The board of MBP wishes to evaluate the ratio between the cost of 
acquiring a typical customer (CAC) and their lifetime value (LTV). 
The following information is available: Sales and marketing expenditure in the period P$252,000 Number of new customers won in the period 500 Average monthly revenue per customer  P$8 Average customer lifetime 6 years What is MBP’s CAC:LTV ratio? 
A 21:2 
B 7:8 C 21:4 D 8:7 
 
 VDS company wishes to gain some assurances about the success of 
their digital transformation strategy and plans to introduce a series of 
metrics to measure Digital Traction. 
What are the THREE areas in which metrics will be needed to measure 
Digital Traction? 
A Scale B Size C Engagement D Active usage E Data usage 
7 Leadership and culture 
Much has been discussed in the previous sections of this chapter about the 
benefit and impact of introducing digital strategies into an organisation, but there still remains the all-important question of how it can all be made possible. The business will need to ensure that it ha s staff with the right skills, that it can 
attract new recruits as necessary, that the appropriate leadership style is adopted, and that a digital culture is properly fostered. 
These will now be looked at in turn.

Chapter 13 
 523 
Attracting and retaining ta lent in the digital age 
apparent with regards to employing staff. 
informed thanks to increased levels of “inside information”. This has come about because of the presence of agencies and peer reviews. 
 
 Illustration 5 – Glassdoor 
 
Becoming an employer of choice 
Millenials represent a generation that feels empowered to choose where and how 
they work, and employers must recognise this if they are to offer an attractive working proposition. Technology will be an important part of that proposition; the provision and use of technology is considered one of the most important factors in determining job satisfaction. However, it is not the only factor.

524  
 Illustration 6 – Zappos  
corporate culture that employees identify with that makes them want to 
work for the company. This includes having a management structure that is task-orientated, rather than a more formal structure. Employees are encouraged to deal with customers in whatever way is felt appropriate, to use the Zappos Twitter account to air their thoughts, and to work wherever will let them be most creative, such as coffee bars and co-working spaces. 
 
Test your understanding 10  
 VMP company is expanding. The firm’s future strategy is to fully embrace 
digital technology and it therefore ne eds a highly skilled digitally literate 
workforce. It operates a flat organisation structure. The board is meeting to explore the best ways to attract and retain employees.  
The finance director believes that the company should set up a 
performance-based share option scheme.  The human resources director recommends that VMP should expand opportunities for mobile working. The chief executive believes that to understand employee’s aspirations a link to an on-line questionnaire should be sent to all employees for completion. The marketing director has suggested the creation of social work hubs within the building.

Chapter 13 
 525 
If the directors’ suggestions are all put in place, which THREE of the 
following advantages are potential employees MOST likely to anticipate from working with VMP? 
A Identification of opportunities for progression through the 
B Ability to help formulate company values C Incentives and rewards to work well D Flexible working E Opportunities for collaborative working 
Creating a workforce with digital skills 
In a recent survey conducted by PwC, almost three quarters of CEOs cited 
skills shortages as a threat to their bus inesses, and 81% claimed to be looking 
being created in companies, which demand different skills sets. 
The table below shows roles that might now be relevant for certain aspects of an organisation: 
 
manager Scrum master Web project 
manager Digital 
marketing 
design 
learning 
manager 
officer 
Officer 
director 
Listening 
Officer  
 
Illustration  7 – Lockheed Martin 
programme whereby its engineers, scientists and IT professionals 
volunteer to meet with schoolchildren between the ages of 9 to 12 with a view to building their interest and confidence in science and technology. This is then sustained throughout school and college.

526  
within their talent management prog ramme. This will included the following: 
training strategies that are adapted to these. The organisation should look ahead and question where the high value work is likely to be in, say, 3 years’ time compared to today, and train accordingly.  
hiring new, digitally-competent staff, or running exchange programmes with other digital companies and sharing insights. Rotating staff internally to give them exposure to other aspects of the organisation is also common practice within tech giants such as Google and Amazon. 
Bringing leadership to the digital age 
In order for digitisation to work, leaders need to adapt. This may mean a different approach to establishing a corporate structure and also fostering an alternative culture in the workplace. Leaders need to show that they are forward-thinking and progressive, and not just rely on business practices that worked in years gone by. 
of focussing on the mistakes of employees, the organisation should be encouraged to accept failures and to persuade staff to take higher amounts of risk. This will necessarily mean changing the focus on how the organisation performs – it cannot restrict itself to just short term goals, with failure to hit annual targets being seen as career-threatening. Management need to take a longer view of performance, and instil a culture that promotes this. 
should be expanded to encompass a transformation purpose.

Chapter 13 
 527 
• I nnovation promoter   
be introduced into processes in all departments of the organisation.  
 
 MBC company manufactures complex components for use in the 
aerospace industry. It works closely with its customers to develop new products and refine current ones in order to advance their goals as well as its own. Its mission statement is ‘to build the best, to offer the closest partnerships, to always deliver’.   
The company currently has a one-year planning cycle, which is regularly 
updated by reference to economic and competitor data as well as product design plans.  MBC operates a just-in-time service and has set up customer service centres across in ternational time zones so that 
customers can discuss their needs at all times. Back-office services are provided by a dedicated team of long-serving staff and production processes are fully automated. 
The company has just approved a new digital transformation strategy.  In 
order to decide what will be needed to  oversee the process, MBC’s CEO 
has been reviewing the ‘roles for a digital age’ suggested by the  World 
Economic Forum (WEF). 
According to the WEF, which TWO of the following actions does the CEO 
most need to take in order to oversee the desired digital transformation? 
A Drive organisational excellence B Change the strategic planning focus C Revise the mission D Shift to a an on-demand operating model E Promote innovation

528  
Fostering a digital culture 
culture: 
All of this can be accelerated through appointing to a senior position someone who is already well-versed in digital culture.

Chapter 13 
 529 
 GHY company is determined to adapt its established approach to 
business to create a more progressive culture and facilitate flexibility in 
the digital age. 
Which TWO of the following changes would be MOST likely to help GHY 
achieve this goal? 
A A more risk neutral approach B A more risk-averse approach C A more risk-seeking approach D A shorter-term view of success 
E A longer-term term view of success

530  
8 Summary

Chapter 13 
 531 
 The correct answer is A and C 
The new opportunity is an example of digital disruption. The two 
fundamental obstacles to the acceptance of digital disruption are that existing and successful business m odels will need to be changed and 
that a company’s own sales will be disrupted.  However shareholders with a long-term view and a close relationship with its customers should help GHJ to effect the change.  The fact that the opportunity comes from a competitor need not present a major obstacle as working together will effectively strengthen the company against other competition in the market. 
 
 The correct answer is A, B, C and E 
The service being offered by BVF is a subscription service with 
customers offered the opportunity to enter into additional one-off transactions to purchase single DVDs.  The utilisation of other company’s infrastructure is known as capacity leasing, and the sale of promotional video space is a form of advertising.   However BVF is not bringing together sellers and buyers for a commission. 
 
Allowing your design to be built into other manufacturers’ platforms is 
brand atomization, by definition. 
 
To provide contextualised interactions means allowing customers to tailor 
their purchases to their own needs.

532  
 Brand atomisation means designing products so that they can be more 
widely distributed and be used on platforms that are offered by other 
providers.  Experiential pilots involve monitoring the reaction of customers to new experiences. 
Journey management refers to the role leadership must take in helping 
organisations move through a cultural change. Design thinking is a philosophy that focuses on maximising the number of experiences available to one customer rather than maximising the number of customers that might buy one experience.  Knowledge sharing is a 
collaborative approach that is often taken by partner organisations 
working together to achieve a goal. 
 
 The correct answer is A, B and E 
Active usage refers to the frequency with which a user interacts with an 
organisation. This will therefore include the number of active users per day, the number of users who have purchased from the organisation before, and the number of users closing their accounts. 
 
 The correct answer is C and D 
To gauge customer engagement BSR needs to measure a customer’s 
interaction with the organisation. Time spent on the site gives an indication of engagement. The NPS is completed by customers and specifically measures how willing they are to recommend an organisation’s products. 
CAC is a financial measure (often compared with the lifetime value of a 
customer (LTV)). Measuring visitors to the site can indicate the scale  of 
customer interest, and DAUs can help to determine the level of active 
usage .

Chapter 13 
 533 
CAC is expenditure on sales and marketing divided by the number of new 
customers won. 
LTV is measured by multiplying the average recurring revenue by the 
average customer lifetime. 
CAC = P$252,000/500 = P$504 LTV = P$8 × 12 months × 6 years = P$576 504:576 is equivalent to 7:8 
 
 The correct answer is A, C and D 
To measure the success of a digital transformation strategy, a company 
needs to measure Scale (the number of people who are showing an interest in the product or service), Active usage (the frequency with which a user interacts with the organisation) and Engagement (the degree to which the user has engaged with the organisation). 
 
 The correct answer is C, D and E 
A performance-based share option scheme should incentivise and 
reward great work, mobile working improves flexibility and social work 
hubs offer workers the opportunity to collaborate. 
A flat organisation structure may not appear to offer many opportunities 
for promotion as there is little in the way of a hierarchy.  To truly take part in formulating company values employees should be individually consulted by senior management rather than simply sent a generic email.

534  
The company will need to expand its mission statement to encompass a 
transformation purpose and should be looking for ways to automate back-office organisational processes as part of its drive for organisational excellence.   
The company already has an appropriately short one-year planning cycle 
and operates an on-demand operating model allowing customers to drive their own services. The company al so works with its customers to 
innovate to better achieve their goals. 
 
 The correct answer is C and E 
GHY will need to encourage a culture of  risk tolerance and acceptance of 
the value of risk.  Additionally it will need to look beyond annual targets 
towards longer term opportunities.

Index 
 I.1 
3D Printing…..492 
A 
Ansoff's matrix…..278 
Diversification…..283 
Limitations…..282 
B 
Balanced scorecard…..338 
Benefits and drawbacks…..343 Strategy mapping…..342 
Balogun Hope Hailey…..389 
BCG matrix…..289 
BCG recommendations…..292 
Benchmarking…..351 
Big Data…..481 
Benefits…..484 
Gartner's 4Vs…..482 Problems…..485 
Blockchain…..487 
Benefits…..487 
Bounded rationality…..14 
Brainstorming…..245 Braithwaite and Drahos…..45 
Building block model (Fitzgerald and 
Moon)…..349 
C 
Cadbury Report…..70 Change management 
Beer and Nohria…..430 
Change agents…..432 
Ethics…..441 Group and team formation…..415 Resistance to change…..402 
The role of the leadership…..412 
Triggers for change…..386 
Types of organisational change…..389 
Cloud and mobile computing…..475 
Benefits…..475 Risks…..476 
Coaching…..436 
Cognitive dissonance…..165 Competences…..195 
Competence audit…..197 
Core competences…..195 
Threshhold competences…..195 
Competitor analysis…..134 
Grant…..134 
Conglomerate diversification…..286 
Consumer segmentation…..166 
   
 Corporate 
code of ethics…..92 
governance…..70 
political activity…..56, 57 social responsibility…..77, 79, 80, 81, 83, 84     Carroll…..83     Impact of technologies…..91 
Countermediation…..179 
Critical success factors 
Sources of CSFs (Rockart)…..199 
Cross impact analysis…..247 
Customer 
behaviour…..163 
extension…..177     Propensity modelling…..177 relationship management…..172 
Cyert and March…..49, 50 
D 
Data visualisation…..490 
Delphi technique…..244 
Derived demand…..245 
Digital 
disruption…..465 
    Disruptive technology…..465     Surviving digital disruption…..468 strategy     Data and metrics…..519 
    Digital consumption…..514 
    Digital ecosystems…..513     Economics of digitisation…..510     Leadership and culture…..522 
    Roles and responsibilities of leaders…..508 
traction metrics…..519 
Disintermediation…..179 
Divestment…..303 Downstream supply chain management…..163 
E 
EDI…..159 Environmental analysis…..114 
Drivers of change…..115 
E-procurement…..158 
Ethical stances (Johnson, Scholes and 
Whittington)…..94 
EVA…..355 
Extranet…..178 
F 
Forecasting…..242 
Regression analysis…..242 
Time series analysis…..243 
Foresight…..246 
5 Cs…..246 
Fundamental ethical principles…..95

Index 
I.2  
G 
Game theory…..253 
Gap analysis…..238 
Benefits…..241 
Problems…..241 
Global competition…..136 
H 
Horizontal integration…..286 
I 
IIRC…..366 
Industrial segmentation…..164 Industry life cycle analysis…..128 Integrated Reporting…..365 
Capital…..367 
Content elements…..367 
GRI…..369 
Internet of Things (IoT)…..477 
Commercial applications…..479 
Intranet…..178 
J 
Johnson, Scholes and Whittington…..4 
Joint methods of expansion…..299 
Franchising…..301 
Joint venture…..300 
Licensing…..302 
Outsourcing…..302 
Strategic alliance…..300 
K 
Kanter…..434, 442 
Kotter and Schlesinger…..403, 417 
L 
Levels of strategy…..6 
Business strategy…..7 
Corporate strategy…..7 
Functional strategy…..7 
M 
Managing 
decline…..438 supplier relationships…..155 
Marketing…..168 
McKinsey 7S Model…..400 
Mendelow's power/interest matrix…..46 
Mentoring…..435 Methods of growth…..296 
Acquisition…..296 
Merger…..297 
Organic growth…..297 Mission statements…..32 
Characteristics…..33 
Morphological analysis…..246 
Multinational…..304 
N 
Non-market stakeholders…..54 Not for profit organisations…..18 
O 
Objectives…..39 
Primary objectives…..40 
Secondary objectives…..40 
Opportunity mapping…..247 
Organisational culture…..393 
The cultural web…..394 
Organisational ecosystem…..2 
P 
management…..332 
    Communication…..359 
    CSFs…..334     Financial measures…..336     Non-financial measures…..337 
    Problems…..360 
pyramid (Lynch and Cross)…..345 
Perspectives to strategic planning…..20 
Market-led or positioning approach…..21 
Resource-based or competence-led 
approach…..21 
Traditional approach…..20 
PESTEL analysis…..118 
Porter’s 
Five Forces analysis…..121 
Diamond model…..137 Generic Strategies…..271 
    Cost leadership…..272 
    Differentiation…..273     Focus…..273     Limitations…..275 
Value Chain…..203 
    Benefits and criticisms…..209     Primary activities…..204     Support activities…..204 
    Value shop…..210 
    Value system…..205 
Position auditing…..232 
Process Automation…..495 
R 
Real options…..256 
Reintermediation…..179 
Relationship marketing…..169 Relevance trees…..247 Resource audit…..193 
M's model…..194

Index 
 I.3 
S 
Scenario planning…..247 
Seber…..352 
Service level agreements…..158 Six markets model (Payne)…..168 Sources of stakeholder power…..46 
Stage models of change…..423 
Force field analysis…..427 
Lewin's ice cube model…..423 
Stakeholders…..43 
Strategic management accounting…..23 
Strategy evaluation…..305 
SAF model…..306 
Stretch target…..359 
Supply chain…..152 
Push and pull…..154 
Sustainability…..86 
Ten elements…..89 
SVA…..355 
SWOT analysis…..232 System modelling…..243 
T 
The three Es…..19 Think tank…..244 Tom Peters…..445 Transnational…..304 
Triple Bottom Line…..357 
Types of strategy…..1, 9 
Emergent approach (Mintzberg)…..13 
Freewheeling opportunism…..14 Logical incrementalism (Lindblom)…..13 
Rational model…..9 U 
Upstream supply chain management…..155 
V 
Value drivers…..236, 346 
Intangible…..237 Tangible…..236 
Values…..37 
Vertical integration…..284 Vision statements…..36 Visioning…..246

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P.3 
Contents 
  Page 
Paper introduction    P.5 
Chapter 1 Features of Taxation  and the Regulatory 
Environment 1 
Chapter 2 Corporate Income Tax and capital Tax Computations 19 
Chapter 3 International Taxation 53 
Chapter 4 The Regulatory Environment 65 
Chapter 5  Code of Ethics  81 
Chapter 6 Corporate Governance 95 
Chapter 7  The Conceptual Framework 117 
Chapter 8  Introduction to Single  Entity Accounts 143 
Chapter 9 Non-current assets – IAS 16 Property, plant and 
equipment and IAS 36 Impairment of assets 167 
Chapter 10  IFRS 5 Non-current asse ts held for Sale and 
Discontinued Operations 203 
Chapter 11 IFRS 16 Leases  215 
Chapter 12  IAS 2 Inventories & I AS 10 Events after the 
reporting period 235 
Chapter 13 IAS 7 Statement of Cash flows 251 
Chapter 14  Short-term Finance and Investments 291 
Chapter 15  Working Capital Management 309 
Chapter 16 Working Capital Mana gement – Accounts 
Receivable and Payable 341 
Chapter 17  Working Capital Management  – Inventory Control 377 
Chapter 18  Working Capital Manageme nt – Cash Control 403 
Chapter 19  References 427

P.5 
This document references IFRS ® Standards and IAS® Standards, 
which are authored by the Inte rnational Account ing Standards 
Board (the Board), and published in the 2016 IFRS Standards Red 
Book.

P.6 
 
 a detailed explanation of all syllabus areas 
 extensive ‘practical’ materials 
 generous question practice, together with full solutions. 
syllabus topics, and also the facility to  undertake extensive question practice. 
The main body of the text is divided into  a number of chapters, each of which is 
 Detailed learning outcomes.  These describe the knowledge expected 
these before beginning det ailed work on the chapter, so that you can 
 Step-by-step topic coverage.  This is the heart of each chapter, 
containing detailed expl anatory text supported w here appropriate by 
worked examples and exercises. You s hould work carefully through this 
many cases knowledge is cumulative: if you fail to digest earlier material 
 Activities.  Some chapters are illustrated by  more practical elements, such 
 Question practice.  The text contains three styles of question: 
– ‘Integration’ questions – these te st your ability to understand topics 

P.7 
issues in greater depth, particularly focusing on scenarios that are less clear cut than in the objective tests, and thus provide excellent 
practice for developing the skills needed for success in the Management Level Case Study Examination. 
 Solutions.  Avoid the temptation merely to ‘audit’ the solutions provided. It 
gain from a serious attempt of your ow n. However, if you are struggling to 
get started on a question you shoul d read the introductory guidance 
provided at the beginning of the solu tion, where provided, and then make 
your own attempt before referr ing back to the full solution. 
 
examined. 
 
P.8 
 
detail. 
section we briefly outline some tips fo r effective study during the earlier stages 
Planning 
you spend studying. Estimate how much time in total you are going to need for each subject you are studying. Remem ber that you need to allow time for 
revision as well as for init ial study of the material. 
Prepare a written schedule summaris ing the above and stick to it! 
It is essential to know your syllabus. As your studies progress you will become 
syllabus. 

P.9 
(2) Store all your materials in one pl ace, so that you do not waste time 
(4) Your timetable will tell you which topi c to study. However, before diving in 
session. After an hour, allow yourself a short break and move away from your Study Text. With experience, you will learn to assess the pace you need to work at. Each study session should focus on component learning outcomes – the basis for all questions. 
have covered a suitable amount of materi al, vary the pattern by attempting 
a practice question. When you have fini shed your attempt, make notes of 
any mistakes you made, or any areas that you failed to cover or covered 
more briefly. Be aware that all co mponent learning outcomes will be tested 

P.10  
but it can vary from subject to subj ect and from student to  student. However, 
June’, or for overall achievement, such as  ‘I want to be qual ified by the end of 
subject and another. For example, F1 Financial reporting  builds on your 
knowledge of financial accounting from BA3 Fundamentals of financial 
accounting  and lays the foundations for F2 Advanced financial reporting . 
have already learned unless it is refr eshed (look up Ebbinghaus Forgetting 
Curve for more details on this). This make s it more difficult as you move from 
one subject to another: not only will you hav e to learn the new subject, you will 
also have to relearn all the underpinni ng knowledge as well. This is very 

P.11 
qualification to help you keep track of y our progress. Make sure you carefully 

P.12  
 Multiple choice, where you have to  choose the correct answer(s) from a 
 Multiple choice with more choices and answers, for example, choosing two 
 Single numeric entry, where you give  your numeric answer, for example, 
 Multiple entry, where you give several numeric answers. 
 True/false questions, where you state whet her a statement is true or false. 
 Matching pairs of text, for example, matching a technical term with the 
 Other types could be matching text with graphs and labelling 
where an initial scenario leads to a num ber of sub-questions. There will be no 
calculator. This calculator  is on-screen and is availabl e for the duration of the 
screen at any time during the assessment. Candidates are permitted to utilise personal calculators as long as they  are an approved CIMA model. Authorised 
CIMA models are listed here: https:// www.cimaglobal.com/St udying/study-and-
website. 
tutorial. 
questions, with one or more parts. There will be no choice and all questions should be attempted. All el ements of a question must be  answered correctly for 

P.13 
Each subject within the syllabus is di vided into a number of broad syllabus 
topics. The topics contain one or more lead learning outcomes, related component learning outcomes and i ndicative knowledge content. 
(b) To demonstrate the approach likely to  be taken in examination questions. 
The learning outcomes are part of a hierar chy of learning objectives. The verbs 
objective, e.g. 
ratio for a single product or service. 
The verb ‘ calculate ’ indicates a level three l earning objective. The following 
 Exam content sections (reflecting the syllabus document)  
 Lead and component outcomes (refle cting the syllabus document) 
 Representative task statements. 

P.14  
 
Level 5  
quality of 
necessary 
Level 4  
Analysis 
between 
action 
Level 3  
means 

P.16  
F1: Financial Reporting 
What the finance function does and its implications 
A Regulatory environment of financial reporting 10% 
B Financial statements 45% 
C Principles of taxation 20% 
D Managing cash and working capital 25% 
  100%

P.17 
F1A: Regulatory environment of financial reporting 
The preparation of financial statements is regulat ed by laws, standards, generally accepted accounting 
principles and by codes. The regulations ensure that financial statements of different entities are 
comparable and that they present a reasonably accurate picture of the performance, position and 
prospects of the organisation to their users. This section covers who the regulators are, what they do and 
why and how the regulations are applied. The objective is to provide candidates with a strong foundation for preparing and interpreting financial statements. 
 
1 Identify regulators 
and describe their 
role. a. Identify the major 
regulators. 
b. Describe what they do. 
c. Explain why they regulate 
financial reporting. • National regulators 
• IFRS foundation 
• IASB 
• International Organisation 
for Securities 
Commissions (IOSCO) 
• Standard setting process 
• Differences between rules-
based and principles-
based regulations 
• Others such as 
International Integrated 
Reporting Council (IIRC) Who are the regulators who 
determine how financial 
statements are prepared? 
What do they do? What value 
do they contribute to the 
production of financial 
statements? Coverage will 
include national and 
international regulators, stock 
exchange regulators and 
various accounting and 
financial reporting standards 
boards and major influential 
bodies like the IIRC. 
2. Apply corporate 
governance 
principles to 
financial reporting. a. Describe the role of the 
board in corporate 
governance. 
b. Apply corporate 
governance and financial 
stewardship principles to 
financial reporting. • Need and scope for 
corporate governance 
regulations 
regulations Boards have overall 
responsibility for ensuring that 
executives of organisations 
create value for their 
stakeholders and safeguard 
their assets. The role of 
boards is incorporated in 
various corporate governance 
codes. What are the main 
principles as they apply to 
financial reporting and the 
oversight of boards?

P.18  
F1B: Financial statements 
One of the roles of finance is to narrate how organisations create and preserve value. The financial 
statements are the means by which narration is done  to particular audiences. This section enables 
candidates to prepare basic financial statements using financial reporting standards. It covers the main 
elements of the financial statements, what they intend to convey, the key financial reporting standards and 
how they are applied to prepare financial statements. 
 
1. Identify the main 
financial 
statements. a. Identify the main elements 
of financial statements 
contained in the IFRS 
conceptual framework. • Objectives and overall 
purpose of financial 
reporting 
• Qualitative characteristics 
of financial information 
• Reporting entity and its 
boundaries 
• Recognition (and 
derecognition) 
• Measurement bases 
• Presentation and 
disclosure 
• Concept of capital 
maintenance This sets the main principles 
that underpin the preparation 
of financial statements. The 
focus is on the main 
principles. No detailed 
treatments are expected. 
2. Explain specific 
financial reporting 
standards. Explain the specific financial 
reporting standards related to: 
a. Non-current assets 
b. Leases 
c. Impairment 
d. Inventory 
e. Events after the period • IAS 16 – Property, Plant & 
Equipment 
• IFRS 5 – Non-current 
Assets Held for Sale or 
Discontinued Operations 
• IFRS 16 – Leases 
• IAS 36 – Impairment of 
Assets 
• IAS 2 – Inventories 
• IAS 10 – Events After the 
Reporting Period Examine the requirements for 
how major items of the 
financial statements are to be 
recognised, measured and 
disclosed. This covers the 
main areas and not specialist 
topics. 
3. Apply financial 
reporting standards 
to prepare basic 
financial 
statements. Apply financial reporting 
standards to prepare: 
a. Statement of financial 
position 
b. Statement of 
comprehensive income 
c. Statement of changes in 
equity 
d. Statement of cash flows IAS 1 – Presentation of 
Financial Statements 
IAS 7 – Statement of Cash 
Flows Give hands-on experience of 
preparing basic financial 
statements by bringing in all 
the elements.

P.19 
F1C: Principles of taxation 
One of the implications of value creation is how that value is distributed to different stakeholders. Taxation 
is part of this distribution. This section helps candidates distinguish between types of taxes and to 
calculate corporate taxes. In a digital world where revenue is earned through online trading that spans 
national boundaries, candidates are introduced to the issues relating to taxation across international 
borders and the ethics of taxation. 
 
1. Distinguish 
between different 
types of taxes. Distinguish between 
a. Direct versus indirect 
b. Corporate versus personal • Features of direct and 
indirect taxes 
• Features of corporate and 
personal taxes Gives a broad overview of the 
different types of taxes, who 
they affect and why they are 
used. 
2. Calculate tax for 
corporates. a. Explain the basis of 
taxation 
b. Explain the difference 
between accounting profit 
and taxable profit 
c. Calculate corporate tax • Exempt income 
• Income taxed under 
different rules 
• Allowable expenditure 
• Capital allowances 
• Reliefs 
• Tax on sale of asset The focus shifts here to 
corporate taxation. The main 
area covered is the difference 
between accounting profit and 
profit for taxation purposes. 
No national law is applied 
here. The main thing here is 
coverage and application of 
principles. 
3. Explain some 
relevant issues that 
affect taxation. Explain: 
a. Taxation across 
international borders 
b. Ethics of taxation • Corporate residence 
• Types of overseas 
operations (e.g., 
subsidiary or branch) 
• Double taxation 
• Transfer pricing 
• Tax avoidance 
• Tax evasion Given the increase of cross-
border trading and revenue 
generation in the digital world 
what are the key issues 
affecting international 
taxation? What are the ethical 
issues that arise in the 
computation and payment of 
taxes?

P.20  
F1D: Managing cash and working capital 
Cash is the life blood of any organisation. The ability to provide cash, at the appropriate cost when it is 
needed is one  of the key contributions that finance makes to organisations. It fulfils finance’s role of 
enabling organisations to create and preserve value. This section provides candidates with the tools to 
ensure that the organisation has enough cash to ensure its continuing operations. 
 
between the types 
and sources of 
short-term finance. Distinguish between 
a. Types of short-term 
finance 
b. Financial institutions • Trade payables 
• Overdrafts 
• Short-term loans 
• Debt factoring 
• Trade terms 
• Trade partners 
• Banks What are the main types of 
funds needed for the short 
term? Where can those  funds 
be accessed? How  does one 
determine which type or 
source of finance is 
appropriate? 
2. Explain and 
calculate operating 
and cash cycles. Explain and calculate 
a. Operating cycle 
b. Cash flow cycle • Inventory days 
• Trade receivable days 
• Trade payable days The operating and cash cycle 
is one of the main means of 
putting together various 
elements of cash and near-
cash items in a coherent 
manner to explain the cash 
needs of the organisation. 
What are these elements? 
How do they affect the 
availability and adequacy of 
cash for short-term 
operations? 
3. Apply different 
techniques used to 
manage working 
capital. a. Apply policies relating to 
elements of operating and 
cash cycle 
b. Prepare forecasts 
c. Explain risks relating to 
working capital • Receivables management 
• Payables management 
• Inventory management 
• Risk of overtrading 
• Short-term cash flow 
forecasting 
• Investing short-term cash What are the policies that 
organisations should put in 
place to manage working 
capital? How is the 
appropriate level determined, 
forecasted and accessed? 
What are the risks associated 
with accessing such funds?

1 
Features of Taxation 
and the Regulatory 
Environment 
Lead Component outcome 
C1 Distinguish between 
different types of taxes Distinguish between 
a. Direct versus indirect b. Corporate vs personal 
C2 Calculate tax for corporates a.  Explain the basis of taxation 
C3 Explain some relevant 
issues that affect taxation.  Explain 
b. Ethics of taxation Chapter 
1

Features of Taxation and the Regulatory Environment 
2 
1 Session content 
 
Governments need tax revenues to finance expenditure on public services such 
as hospitals, schools, policing, retire ment pensions, social benefits and to 
finance government borrowing. Governm ents can use tax to stimulate one 
sector of the economy and c ontrol another. For example, allowances on capital 
expenditure may develop the manufacturing  sector, while high taxes on tobacco 
and alcohol may discourage sales. 
In Wealth of Nations , Adam Smith proposed that a good tax should have the 
 fair (reflect pers on's ability to pay) 
 absolute (certain not arbitrary) 
 convenient (easy to pay) 
 efficient (low collection costs) 
The 3 major principles of good tax policy are as follows: 
 equity – A good tax should be fairly levied between one taxpayer and 
another. 
 efficiency – A good tax should be cheap and easy to collect, i.e. UK tax 
system uses the PAYE (pay-as-you-ear n) to collect tax at source on 
salaries and wages. 
 economic effects – A good tax should consider the way in which a tax 
should be collected.

Chapter 1 
 3 
 What is a good tax? 
 The American Institution of Certifi ed Public Accountants lists the following 
principles that a good tax policy should have: 
 equity and fairness 
 transparency and visibility 
 certainty 
 economy in collection 
 convenience of payment 
 simplicity 
 appropriate government revenues (determining the amount of tax 
revenues and date of collection) 
 minimum tax gap (the differenc e between actual collection and 
amount due) 
 neutrality 
 economic growth and efficiency 
It is not always possible to incorporate all ten into a tax system 
 
 Definition of terms 
A tax is either a direct or an indirect tax. 
Direct taxes 
These are imposed directly on the person or  enterprise required to pay the tax, 
i.e. tax on personal income such as sala ries, tax on business profits or tax on 
disposals of chargeable assets. The per son or enterprise must pay the tax 
directly to the tax authorities on their inco me. Examples in the UK of direct taxes 
would be income tax, capital ga ins tax or corporation tax. 
Indirect taxes 
This tax is imposed on one part of the economy with the intention that the tax 
burden is passed on to another. The tax is imposed on the final consumer of the 
goods or services. The more the consumer  consumes the greater the tax paid. 
An example would be sales tax such as Value Added Tax (VAT) in the UK.

4 
Tax bases 
A tax base is something that is liable fo r tax. Taxes can be classified by tax 
base, that is, by what is being tax ed. Taxes may be based on the following: 
 Income: For example, income taxes and taxes on an entity's profits. 
 Capital or wealth: For example, taxes on capital gains and taxes on 
inherited wealth. 
 Consumption: For example, excise duties and sales taxes/value-added tax 
(VAT). 
For example, in the US, the Federal government taxes income as its main 
source of revenue. State governments use taxes on income  and consumption, 
while local governments rely almost  entirely on taxing property and wealth. 
Incidence 
The incidence of a tax is the distribution of the tax burden, i. e. who is paying the 
tax. 
 
 What is incidence? 
 Incidence 
This can be split into two elements: 
1 Formal incidence:  this is the person who has direct contact with 
the tax authorities, i.e. who is legally obliged to pay the tax. 
2 Actual incidence:  this is the person who actually ends up bearing 
the cost of the tax, i.e. who actually bears the burden of tax. 
If we consider VAT – the formal incidence would be the entity making the 
sale because they will be responsib le for making the payment to the 
relevant tax authorities. The actual  incidence would be the consumer who 
bears the cost of the ta x when they make a purch ase from the entity. 
Taxable person 
The person accountable for the tax paym ent, e.g. individual or entity. 
Competent jurisdiction  
A taxable person normally pays tax in the country of origin. Competent 
jurisdiction is the tax authority that has the legal power to assess and collect the 
taxes. This is usually the combined res ponsibility of the central government and 
local authorities within a country. The tax law is enforceable by sanction (fines 
or imprisonment). 
Hypothecation 
This means that certain taxes are devoted entirely to certain types of 
expenditure, e.g. road tax is used entirely on ma intaining roads e.g. the London 
congestion charge is used to pay  for transport for the area.

Chapter 1 
 5 
Tax gap 
This is the gap between the ta x theoretically collectable and the amount actually 
collected. The tax authorities will aim to minimise this gap. 
Tax rate structure 
There are three types of taxes: 
(1) Progressive taxes : These take an increasing proportion of income as 
income rises. (E.g. UK In come tax – 20%, 40%, 50%). 
(2) Proportional taxes : These take the same propor tion of income as income 
rises. 
(3) Regressive taxes : These take a decreasing proportion of income as 
income rises. (E.g. UK National Insu rance contributions – 11% then 1%). 
 
 Tax rate structure 
 Progressive tax means the proporti on of tax increases as income 
increases, i.e. salary $10,000 pays ta x of $1,000 = 10% but a salary of 
$20,000 pays tax of $3,000 = 15%. 
Proportionate tax means the propor tion of tax remains the same, 
regardless of the level of income, i.e.  salary $10,000 pays tax of $1,000 = 
10% and a salary of $20,000 pays tax of $2,000 = 10%. 
Regressive tax means the proportion of  tax reduces as income increases, 
i.e. salary $10,000 pays tax of $1,000 = 10% but a salary of $20,000 pays 
tax of $1,800 = 9%. 
Source of tax rules 
The sources of tax rules are as follows: 
 Legislation produced by a national government of t he country, e.g. 
Finance Acts in the UK. 
 Precedents based on previous legislat ion. Tax authorities also issue 
interpretations, e.g. Tax bulletins in the UK. 
 Directives from international bodies such as European Unio n guidelines on 
VAT. 
 Agreements between different countries  such as double tax treaties, e.g. 
UK/US Double tax treaties. 
 Income can be taxed twice 
 Foreign income is often taxed twice,  once in the country of origin and 
once in the country of residency (see chapter 3 for corporate residency). 
In order to avoid this "double taxation" , countries enter into tax treaties, 
(see chapter 2 for types of double taxation relief).

6 
3 Direct taxes 
There are two types of direct tax you need to consider: 
 Tax on trading income 
 Capital taxes 
Tax on trading income 
Trading income relates to income from the main business activity. 
The tax base should be profits. The accounting profit needs to be adjus ted for tax purposes as in many 
countries there are differences betw een what the account ing standards allow 
you to show as an income/expense and what the tax system deems to be the 
income/expense. These adjusted profits will enable you to calculate the taxable 
profit. 
The standard pro-forma is as follows: 
 $ 
 ––– 
Accounting profit X Less income exempt from tax or taxed under other rules (X) 
Add: disallowable expenses X 
Add: accounting depreciation X Less: tax depreciation (X) 
 ––– 
Taxable profit X 
The taxable profit will then be charged at  the appropriate tax rate for that 
accounting period. 
The rules for allowed and disallowed items will vary according to the tax regime 
of the country in question. This will alwa ys be given in the assessment question. 
The calculation of tax on trading income wil l be looked at in further detail in the 
next chapter of this publication. 
Capital taxes 
Capital tax gains are gains made on the disposal of investments and other non-
current assets. The most common assets taxed are listed stocks and shares. 
At a simple level, the gain is calculated as proceeds from sale less cost of the 
asset. 
In most countries, the computation is bas ed on cost but in a few countries an 
allowance is made for inflation. In the UK , the cost can be indexed, in certain 
cases, using the Retail Price Index . Indexation will be calculated on all 
allowable costs from the dat e of purchase to the dispos al date of the asset. This 
indexation allowance will reduce  the gain.

Chapter 1 
 7 
 $ 
Proceeds X 
Less: costs to sell (X)  ––– 
Net proceeds X 
Less: cost of original asset (X) Less: costs to buy (X) 
Less: enhancement costs (X) 
Less: indexation allowance (X)  ––– 
Chargeable gain X 
The chargeable gain will then be charged at  the appropriate tax rate for that 
The calculation of capital taxes will be looked at in further detail in the next 
chapter of this publication. 
4 Indirect taxes 
Types of indirect tax es  
Indirect taxes will either be: 
(1) Unit taxes  
This is a tax based on the number or we ight of items, e. g. excise duties. 
(2) Ad valorem taxes 
This is a tax based on the val ue of items, e.g. sales tax. 
Examples of i ndirect taxes 
(1) Excise duties 
This is a type of unit tax and it is on certain products such as alcoholic 
drinks, tobacco, mineral oils and motor vehicles. It is based on the weight 
or size of the tax base. These duties are imposed to: 
 discourage over consumpt ion of harmful products; 
 to pay for extra costs, such as increased healthcare or road 
infrastructure; 
 to tax luxuries (in the USA, th is would include fishing equipment, 
firearms and air tickets).

8 
The characteristics of commodities that make them most suitable for 
excise duties are: 
 few large producers 
 inelastic demand with no close substitutes 
 large sales volumes 
 easy to define products covered by the duty 
(2) Property taxes 
Many countries impose tax on property  based on either the capital value 
or the annual rental value. Most count ries tax land and buildings although 
in the USA, certain states also impose a tax on cars, livestock and boats. 
(3) Wealth taxes 
Some countries also impose a wealth ta x on an individual’s or enterprise’s 
total wealth. The wealth can include pension funds, insurance policies and works of art. 
(4) Consumption taxes 
These are taxes imposed on the consum ption of goods and added to the 
purchase price. There are two types of consumption tax. 
 Single stage taxes 
Single stage taxes apply to one le vel of production only, for example 
at either the manufacturing, wholes ale or retail level. The USA is a 
country which uses a retail sales tax although the tax rate is determined at the local state gov ernment level instead of at the 
central government or  federal level. 
 Multi-stage sales tax  
This is a tax charged each time a component or product is sold. 
There are two types of multi-stage sales tax: 
Cascade tax, and Valued added tax (VAT). 
(5) Cascade tax 
This is where tax is taken at eac h stage of production and is a business 
cost because no refunds are provided by local government. 
Students will not be required to answe r calculation style questions on 
cascade tax in their examination.

Chapter 1 
 9 
(6) Value added tax (VAT) 
VAT is charged each time a component or product is sold but the 
government allows businesses to cl aim back all the tax they have paid 
(input tax). The entire ta x burden is passed to the final consumer. The 
VAT system is used by almost all countries in the world. 
VAT payable = outpu t tax – input tax 
Output tax – VAT charged on sales to customers  
Input tax – VAT paid on purchases VAT aims to tax most business transactions which are referred to as 
taxable supplies. 
Therefore, suppl ies could be: 
Standard Rated – Taxed at t he standard rate of VAT  
Higher Rated – Taxed at a higher rate Zero Rated – Taxed at a rate of  0% (Basic food, e.g. bread) 
Exempt – Not subject to VAT In the UK, supplies such as food, ch ildren’s clothing and exports are zero 
rated for the purpose of VAT. Businesses who sell zero rated sales are allowed to claim back input VAT on purchases. 
Alternatively, in the UK, supplies such as finance and insurance are 
exempt for the purpose of VAT. Bu sinesses who make exempt sales 
cannot claim back input VAT on purchases. 
You will not be required to know the types of goods and services that are 
zero rated or exempt for the exam; the examiner will make this clear in the 
question. 
 It is important to identify the type of s upply in order to claim back input tax. 
Input tax can only be claimed back on taxable supplies, i.e. zero and 
standard rated goods and services.  Ex empt supplies ar e outside the VAT 
system and VAT cannot be charged to cu stomers but neither can the input 
tax on purchases be claimed back. 
Taxable supplies, therefore, have a selling price exclusive of VAT (net 
price) and a selling price incl usive of VAT (gross price). 
If the exclusive price is gi ven, VAT is calculated by: 
exclusive price × tax rate 
If the inclusive price is given VAT is calculated by: 
inclusive price
100	+	tax rate
	×	tax rate

10 
 VAT registration 
 VAT registration is required by a taxa ble person making a taxable supply. 
A taxable person can be an individual or a company.  
A taxable supply can zero, standard or higher rated sales. They will be required to register for VAT when their taxable turnover 
(zero, standard or higher rated sales) reach a certain limit (this will vary 
from tax year to tax year). 
When registered they must: 
 Issue VAT invoices 
 Keep appropriate VAT records 
 Charge VAT on taxable supplies to customers 
 Be able to claim back VAT from pu rchases that are used for taxable 
supplies 
 Complete a quarterly VAT return and make payments 
For example, in the UK VAT cannot  be recovered on: 
 Cars (unless for resale, i.e. by a car dealer) 
 Entertaining (unless for staff entertaining) 
5 Impact of employee taxation 
Employees are taxed on their earnings under  income tax. Earnings can include 
salaries, bonuses, commissions and benefits in kind. 
Benefits in kind are non-cash  benefits in lieu of further cash payments such as: 
 company cars 
 living accommodation 
 loans 
 private medical insurance 
The basis of assessment is bas ed on the individual country: 
 France – amount earned in previous year 
 Switzerland – average of previous two years’ earnings 
 UK – amount actually received in the current tax year 
Employees can deduct certain expenses which are wholly, exclusively and 
necessary for employment, such as bus iness travel, contributions to pension 
plans, donations to charity through a payroll deduction scheme and professional 
subscriptions.

Chapter 1 
 11 
Both employees and companies have to pay social security taxes based on 
salaries paid to employees. In the UK, this tax is used to fund benefits such as 
the public health service and retire ment benefits and is called national 
insurance. 
Most governments expect enterprises to  withhold tax on employees’ salaries 
and report earnings to the tax authorities. In the UK, this tax system is referred 
to as Pay-As-You-Earn (PAYE). 
The benefits of having a PAYE system are: 
 Tax is collected at source, hence taxpayers are less likely to default 
payment. 
 Tax authorities receive regular pay ments from employers – helps to 
budget cash flows for the government. 
 The tax authority only has to deal with the employer, rather than a number 
of individuals. 
 Most of the administration costs are borne by the employer, instead of the 
government. 
Certain countries, such as the USA, r equire banks to collect property taxes with 
the mortgage payments. In addition to th is, in the USA there is a separate 
Unemployment Compensation Tax. 
 You will not be assessed on the calculat ion of employment taxation but 
you should have a general appreciati on of how an entity deals with 
taxation with regard to employees.  
The standard pro-forma for calculati ng employee tax would be as follows: 
 $ 
 ––– 
Salary X Plus: bonus, commission, benefits X 
Less: subscriptions (X) 
Less: pension contributions (X) Less: charity donations (X) 
Less: personal allowances (X) 
 ––– 
Taxable income X 
The taxable income will then be charged at the appropriate tax rate for the tax 
year. 
This will normally be done by t he entity using the PAYE system.

12 
6 Administration 
Record-keeping 
Enterprises need to keep records to sati sfy tax requirements for the following 
taxes. 
Corporate income tax 
All records required to support their fi nancial statements and also the additional 
documents required to support the adjustm ents made to those statements when 
completing their tax returns. 
Sales tax 
Adequate records should be maintained of  all the sales and purchases records 
such as: 
 Orders and delivery notes 
 Purchase and sales invoices 
 Credit and debit notes 
 Purchase and sales books 
 Import and export documents 
 Bank Statements 
 Cashbooks and receipts 
 VAT account 
Overseas subsidiaries 
Tax authorities would require documentat ion about the transfer pricing policy 
between the subsidiary and the parent. Thes e are the prices charged for goods 
or services provided by one to the other. Most tax authorities require the price to 
be the same as it would be if charged to a third party. 
Overseas subsidiaries will be looked at in more detail in the following chapters. 
Employee tax 
Employers have to keep detailed records of employee tax and social security 
contributions. They will also be requi red to prepare a number of year end 
returns to show the total deductions they have made from employees' wages, 
the employer's contributions and an anal ysis of any other amounts deducted. 
The employer is also required to provide details to the employee. 
Tax authorities set deadlines for the payment  of tax and the submission of the 
tax return. The enterprise will either  be required to pay tax following an 
assessment from the tax aut horities or will pay tax via self-assessment. In the 
UK and the USA, tax is paid via self -assessment. The tax authorities will then 
check the tax return to confirm wh ether the correct tax has been paid.

Chapter 1 
 13 
Minimum retention of records 
There will be a minimum length of time fo r the retention of records; in the UK 
this is six years for all records relating to earnings and capital gains. The purpose of this is to enable the tax author ities to question or challenge records 
up to several years later. 
Payment of tax 
This will depend on the rules of the tax authority and will depend on the type of 
tax that is due. The tax is not always paid when the return is filed, it may 
happen earlier or later. Interest will be charged on late payments of tax. 
Power of tax authorities 
The revenue authorities have various pow ers to impose penalties and interest 
on late payment of tax. In addi tion, they have the power to: 
 Review and query filed returns. 
 Request special reports if they believe inaccurate information has been 
submitted. 
 Examine records of previous years (in the US, tax authorities can go back 
20 years). 
 Enter and search the entity's premises and seize documents. 
 Pass on information to foreign tax authorities. 
Tax avoidance and tax evasion 
Tax avoidance  is tax planning to arrange affairs, within the scope of the Law, to 
minimise the tax liability. This could be setting up a subsidiary overseas in a low tax economy. 
There have been a number of large entit ies that have been accused of tax 
avoidance in recent times. The public perception would be that the entities are 
not paying their fair share of tax and t hese entities have been criticised in the 
press for setting up their tax affairs so  that they pay very little tax. 
This has led to these entities receivin g very negative public ity and often had an 
adverse effect on t he overall business. 
Tax evasion  is the illegal manipulation of t he tax system to avoid paying tax. 
Evasion is the intentional disregard of  the law to escape tax and can include 
claiming a tax deduction for expense s that are not tax deductible, under 
declaring income and claimi ng fictitious expenses. 
The tax authorities use various methods to prevent both tax avoidance and tax 
evasion: 
1 Reducing opportunity, e.g. by deducti on of tax at source and the use of 
third party reporting. 
2 Simplifying tax structure by mi nimising the relief, allowances and 
exemptions.

14 
3 Increasing detection through audit ing tax returns and payments. 
4 Developing good communication between tax authorities and enterprises. 
5 Changing social attitudes towards evasion and avoidance by maintaining 
an honest and customer friendly ta x system. The government should 
create a fair tax system and should encourage an increasing commitment. 
6 Reducing lost revenue by reviewing the penalty structure. 
 
 Test your understanding 1 – Practice questions 
 1 Which of the following is not usually a source of tax rules in a 
country: 
A Local legislation 
B Double tax treaties C Statements of practi ce of tax authorities
  
D International law 
2 What does ‘competent jurisdiction’  mean in the context of an 
enterprise being subject to a tax liability? 
A Country where enterprise has an office 
B Country which has enforcement la ws that apply to an enterprise   
C Country where enterpris e has business operations 
D Country where enterprise has employees 
3 BM has a taxable profit of $30,000 and receives a tax assessment 
of $3,000.  
BV has a taxable profit of $60,000 and receives a tax assessment of 
$7,500. 
BM and BV are resident in the same tax jurisdiction.  
This tax could be said to be: 
A a progressive tax  
B a regressive tax  C a direct tax D a proportional tax

Chapter 1 
 15 
 4 Country IDT has a duty that is levied on all drinks of an 
alcoholic nature where the alc ohol is above 20% by volume. 
This levy is $2 per 1 litre bottle.  This duty could be said to be:  
A Ad valorem tax  
B Unit tax C Direct tax  D VAT 
5 Which ONE of the following pow ers is a tax authority least 
likely to have granted to them? 
A Power of arrest 
B Power to examine records  C Power of entry and search D Power to give information to other countries' tax authorities 
6 List THREE possible reasons why governments set deadlines 
for filing returns and/or paying taxes.

16 
7 Summary diagram

Chapter 1 
 17 
 1 D – International Law. 
2 B – Country that has enforceable laws that apply to an enterprise. 
3 A – $3,000 tax on $30,000 = 10%  and $7,500 tax on $60,000 = 
12.5%. The tax rates increase as the income rises, hence a progressive tax. 
4 B – Unit tax. This is a tax based on the number or weight of items, 
e.g. excise duties. 
5 A – Power of arrest. 6 Answers could be: 
Entities will know when  payment is required; 
It enables the tax authorities to fo recast their cash flows more 
accurately; 
Provides a reference for late payment – useful for applying penalties 
for not paying; 
To prevent entities spending tax money deducted from employees. 
If tax is deducted from employees at source and not paid to the tax 
authorities fairly quickly, there is more chance of an entity spending 
the amount deducted, instead of payin g it to the tax authorities.

19 
Corporate Income Tax 
and Capital Tax 
Computations 
C2. Calculate tax for 
corporates b. Explain the difference 
between accounting profit and taxable profit 
 c. Calculate corporate tax 
  Chapter 
2

Corporate Income Tax and Capital Tax Computations 
20 
 
2 Tax on trading income 
A reminder of the standard pro-forma (c overed in the previous chapter) to 
calculate corporate income tax is as follows: 
 $ 
 –– 
Accounting profit X 
Less: income exempt from tax or taxed under other rules (X) 
  
Add: accounting depreciation X 
Less: tax depreciation (X)  –– 
Remember that the rules for allowed and disallowed items will vary according to 
the tax regime of the country in ques tion. This will always be given in the 
assessment question, so ensure that  you read the question carefully. 
The accounting profit  is the profit before tax shown in the statement of profit or 
loss in the annual fina ncial statements.

Chapter 2 
 21 
Income exempt from tax or taxed under other rules  is any income included 
in the accounting profit which does not relate to the main trading activity, i.e. 
rental income, dividend income, interest  receivable, that maybe taxed under 
other rules or income exempt from taxa tion under that particular country’s rules. 
Disallowable expenses  are expenses that have been deducted from the 
accounting profit, i.e. they are allowa ble under the accounting standards, but for 
tax purposes can't be claimed. These ex penses will differ from country to 
country and the examiner will always tell y ou the rules for that particular country 
in the question. Examples of disallowabl e expenses in the UK are entertaining 
customers, gift aid payment s and political donations. 
Depreciation  is added back because it is an accounting entry that is not 
allowed for tax purposes because it is t oo subjective (i.e. you can choose the 
way to depreciate your assets). It is replaced with tax depreciation. 
Tax depreciation  may be called capital allowances  in the exam. The rules will 
be given in the exam to tell you what can be claimed. It is a replacement for 
depreciation. They are often given on a reducing balance basis. Allowances are given if the asset is owned at the accounti ng date, i.e. no time apportionment for 
mid-year acquisitions. 
As an incentive to encourage new investm ent, certain jurisdictions offer 100% 
first year capital allowances. The entire tax value of the asset is allowed as 
capital allowances in the first year of acquisition.   
 
 Test your understanding 1 – Trading income 
 In year ending 31/03/20X2, an entity G eorge made an accounting profit of 
$80,000. Profit include d $5,500 of entertaining costs which are 
disallowable for tax purposes and  $8,000 of income exempt from 
taxation. 
George has no capital items.  Tax is charged at 25%. 
Calculate the tax payable fo r the year ended 31/03/X2. 
 
 Illustration 1 – Trading income 
 In year ending 31/12/20X1, an entity Zi ppy made an accounting profit of 
$50,000. Profit included $3,500 of entertaining expenses which are 
disallowable for tax purposes and  $5,000 of income exempt from 
taxation. 
Zippy has $70,000 of non-current assets which were acquired on 
01/01/20X0 and are depreciated at 10% on cost. Tax depreciation rates are 20% reducing balance.  
Calculate the accounting depreciati on for the year ended 31/12/X1.

22 
 Solution 
 The accounting depreciation is $70,000 × 10% = $7,000 
 
 Illustration 2 – Trading income 
 Using the information from il lustration 1 calculate the tax 
depreciation for the year ended 31/12/X1. 
 
 Solution 
 Tax depreciation 
WDV at start of year  $56,000 ($70,000 × 80%) 
Tax depreciation at 20% $11,200 The asset had been purchased in the previous accounting period, 
therefore tax depreciation has alre ady been claimed for y/e 31 /12/X0. 
This year's tax depreciation must be calculated on the tax WDV at the 
beginning of the y ear, i.e. $56,000. 
WDV means written down value. This represents the cost of the asset 
less accumulated tax depreciation. 
 
 Illustration 3 – Trading income 
 Using the information from illustra tions 1 and 2 calculate the taxable 
profit for the year ended 31/12/X1. 
 
 Solution 
  
 $ 
Accounting profit 50,000 
Less: exempt income (5,000) Add back: disallowable expenses 3,500 
Add back: depreciation (illustration 1) 7,000 
Less: tax depreciation (illustration 2) (11,200)  ––––––– 
Taxable profit 44,300

Chapter 2 
 23 
 Illustration 4 – Trading income 
 Using the information from illust rations 1 to 3 calculate the tax 
payable for the year ended 31/12/X1. You should assume a tax rate 
of 30%. 
 
 Solution 
  
 $ 
Accounting profit 50,000 Less: exempt income (5,000) 
Add back: disallowable expenses 3,500 
Add back: depreciation (illustration 1) 7,000 Less: tax depreciation (illustration 2) (11,200) 
 ––––––– 
Taxable profit 44,300 
Tax at 30% 13,290 
 
 Test your understanding 2 – Trading income 
 In year ending 31/03/20X2, an entity B ungle made an accounting profit of 
$60,000. Profit include d $4,500 of political donations which are 
disallowable for tax purposes and  $4,000 of income exempt from 
taxation. 
Bungle has $10,000 of plant and machinery which was acquired on 
01/04/20X0 and purchased a new machine costing $5,000 on 01/04/20X1. This new machine is entitl ed to FYAs (first year allowances) 
of 100% instead of the usual tax deprec iation. All plant and machinery is 
depreciated in the accounts at 10% on cost. Tax depreciation rates on 
plant and machinery are 20% reducing balance. 
Bungle also has a building that  cost $100,000 on 01/04/20X0 and is 
depreciated in the accounts at 4%  on a straight line basis. Tax 
depreciation is calculated at 3% on a straight line basis. 
Calculate the total accounting de preciation for the year ended 
31/03/X2. 
 
 Test your understanding 3 – Trading income 
 Using the information from TYU 2 calculate the total tax 
depreciation for the year ended 31/03/X2.

24 
 Test your understanding 4 – Trading income 
 Using the information from TYU's 2 and 3 calculate the taxable profit 
for the year ended 31/03/X2. 
 
 Test your understanding 5 – Trading income 
 Using the information from TYU's 2 to 4 calculate the tax payable for 
the year ended 31/03/X2. You s hould assume a tax rate of30%. 
In the previous illustrations and TYUs we  have used a constant rate of tax to 
calculate the tax payable, e.g. 30%. Ho wever, sometimes the tax rate may 
change during the year and therefore ta xable profits will need to be prorated. 
For tax purposes profits are assumed to be accrued evenly. 
 Illustration 5 – Trading income 
 Using the illustrations 1 to 4, recalc ulate the tax if the rates were as 
follows: 
01/04/X0 – 31/03/X1 = 28% 
01/04/X1 – 31/03/X2 = 30% 
 
 Solution 
 The taxable profit for Zippy wa s $44,300 for accounting period to 
31/12/X1. 
Tax would be: ($44,300 × 3/12 × 28%) + ($44, 300 × 9/12 × 30%) = $13,068.50 
The taxable profit is pro-rated bas ed on the amount of months that fall 
into each of the tax rate periods, i.e. 
01/01/X1 – 31/03/X1 = 3 mont hs at the rate of 28% 
01/04/X1 – 31/12/X1 = 9 mont hs at the rate of 30% 
 
 Test your understanding 6 – Trading income 
 An entity has an accounting period endi ng 30/06/X1 and a taxable profit 
of $800,000. 
The rates of tax were as follows: 01/04/X0 – 31/03/X1 = 26% 01/04/X1 – 31/03/X2 = 28% 
Calculate the tax liability for the period ending 30/06/X1.

Chapter 2 
 25 
3 Balancing allowances and charges 
When an asset is sold any accounting prof it or loss must be disallowed for tax 
purposes and replaced with the tax equivalent known as a balancing allowance 
or charge. 
A balancing allowance (BA) = a tax loss on disposal 
A balancing charge (BC) = a tax profit on disposal 
The tax pro-forma could then be expanded to  include the effe ct of the asset 
disposal as follows: 
 $ 
 –– 
Less: income exempt from  tax or taxed under (X) 
other rules  Add: disallowable expenses X 
Add: accounting loss on disposal of an asset X Less: accounting profit on disposal of an asset  (X) 
Less: tax depreciation (X) 
Add: tax profit on disposal of an asset (BC) X Less: tax loss on disposal of an asset (BA) (X) 
 –– 
 Always remember the tax amount s hould replace the accounting amount, 
i.e. reverse the accounti ng entry and pay tax on the tax profit or receive 
relief on the tax loss. 
When an asset is disposed of, we will calc ulate, for accounting purposes, the 
accounting profit or loss on disposal. This will be calculated by: 
 $ 
Proceeds X 
Less: Carrying amount (SOFP) (X) 
 ––– 
Accounting profit/(loss) X 
If the proceeds are greater than the carrying amount = profit  
If the proceeds are less than the carrying amount = loss 
An accounting profit or loss will be tr eated as disallowable for tax purposes. A 
profit will be deducted from the accounti ng profit (similar to non-trade income) 
and a loss will be added to the accounti ng profit (similar to depreciation).

26 
This will then be replaced by either a balancing charge or allowance for tax 
purposes. 
These are calculated in a similar way as the accounting profit or loss on 
disposal: 
 $ 
Proceeds X 
Less: tax written down value (TWDV) (X) 
 ––– 
Balancing charge/(allowance) X 
If the proceeds are greater than the TWDV = balancing charge 
If the proceeds are less than t he TWDV = balancing allowance 
A balancing charge will be added back to t he accounting profit and a balancing 
allowance will be ded ucted from the accounting profit, when computing the 
taxable profit. 
Capital allowances (tax depreciation) ar e not normally given in the year of 
disposal of the asset – these are replac ed by balancing allowances or charges. 
 
 Test your understanding 7 – Balancing allowances/charges 
 Bungle has $10,000 of plant and machinery which was acquired on 
01/04/20X0 . 
All plant and machinery is depreciat ed in the accounts at 10% on cost. 
Tax depreciation rates on plant and machinery are 20% reducing 
balance. 
All plant and machinery wa s sold for $6,000 on 01/04/X2. 
Calculate the accounting profit or  loss on disposal for the year 
ended 31/03/X3. 
 
 Test your understanding 8 – Balancing allowances/charges 
 Using the information from TYU 7 calculate the tax balancing 
allowance or charge on disposal  for the year ended 31/03/X3. 
 
 Test your understanding 9 – Balancing allowances/charges 
 Using the information from TYU's 7 and 8 calculate the tax payable 
for the year ended 31/03/X3 assuming the accounting profit is 
$50,000 and there are no other tax adju stments. Tax is payable at a 
rate of 25%.

Chapter 2 
 27 
 Test your understanding 10 – Balancing allowances/charges 
 Re-calculate your answer to TYU 9 if the asset was sold for $9,000 
instead of $6,000. 
Trading losses 
When an entity makes a trading loss the asse ssment for that tax year will be nil. 
The entity must now claim loss relief bas ed on the rules of the country's tax 
regime. The assessment will tell you the ru les of the country in the question. 
Possible ways of relieving a loss are: 
 Carry losses forwards agains t future profits of the same  trade. 
 Carry losses backwards against previous periods. 
 Offset losses against group company profits. 
 Offset losses against capital gains in the same period. 
 
 It is important to read the rules of the tax regime for the country. All 
countries are different as some allo w losses to be carried backwards and 
forwards, others only allow losses to be carried forwards. Many countries 
do not allow trading losses to be offset against capital gains in any period. 
 
 Illustration 6 – Trading income 
 In country X, trading losses in any year can be carried back and set off 
against trading profits in the previous  year, and any unrelieved losses can 
be carried forward to set against the firs t available trade profits in future 
years. 
Hall and Co had the following trading prof its and losses in year 1 to 4. 
Year Trading profit/ 
(losses) 
1 25,000 2 (45,000) 
3 15,000 
4 35,000 
What are Hall and Co’s taxable profits in each year?

28 
 Solution 
  
Year Trading 
profit/(loss) Workings 
1 – 25,000 – 25,000 
2 –  
3 – 15,000 – 15,000 
4 30,000 35,000 – 5,000 (bal ance of the loss) 
The trading loss is carried back first against the trading profit in year 1, 
this must be done to the maximum ext ent, i.e. you can't use part of the 
profit for relief if all of it is needed. The balance of the loss must then be 
carried forward against the first available trading profit  in year 3, again 
to the maximum extent required until it  has been relieved in full. There is 
usually no limit on how many years you are able to carry forward a 
trading loss. 
 
 Test your understandi ng 11 – Trading losses 
 In country A, trading losses in an y year can be carried back and set off 
against profits in the previous ye ar, and any unrelieved losses can be 
carried forward to set against profits in future years. 
Looser had the following trading prof its and losses in year 1 to 4. 
profit/(loss) 
1 20,000 2 (45,000) 3 19,000 
4 25,000 
What are Looser's taxable  profits in each year? 
Trading losses on cessat ion of business 
If an enterprise ceases to tr ade, most countries allow t he entity to carry back the 
loss against profits of previous years to generate a tax refund. In the UK, this is 
called Terminal Loss Relief and enables t he loss to be carried back three years. 
The assessment will tell you the terminal loss rules of that country.

Chapter 2 
 29 
 Test your understandi ng 12 – Cessation losses 
 In 20X3, Dunbadly closed its business having made a trading loss of 
$60,000. In Dunbadly’s country of residence, trading losses may be 
carried back two years on a LIFO basis. 
 20X1 20X2 20X3 
 $ $ $ 
Trading profits/losses 100,000 50,000 (60,000) 
What is the impact on t axable profits for each year? 
4 Capital taxes 
current assets. The most common assets taxed are listed stocks and shares. In 
the UK, the common capital tax is called Capital Gains Tax. 
asset. 
indexation allowance will reduce  the gain. 
 $ 
Proceeds X 
Less: costs to sell (X) 
 ––– 
Less: cost of original asset (X) 
Less: costs to buy (X) Less: enhancement costs (X) Less: indexation allowance (X) 
 ––– 
accounting period.

30 
Costs that can be deduct ed from proceeds are: 
 original cost of purchasing the asset 
 costs to buy the assets, i.e.  legal fees, estate agent fees 
 costs to sell the assets, i.e.  legal fees, estate agent fees 
 enhancement/improvement costs, i.e.  extensions to an existing asset 
 indexation allowance – if this exists in the country of residency of the asset 
being disposed of 
 Illustration 7 – Capital taxes 
 An entity bought an asset for $20,000 on 01/02/X0. The asset was sold 
for $50,000 on 21/11/X9. 
Capital gains are taxed at 30%. 
What is the capital tax to  be paid on the disposal? 
 
 Solution 
  
 $ 
Sale proceeds 50,000 
Less: Cost (20,000) 
Chargeable gain 30,000 
Capital tax = $30,000 × 30% = $9,000 
 
 Illustration 8 – Capital taxes 
 An entity bought an asset for $20,000 on 01 /02/X0. The asset was sold 
Indexation allowance c an be claimed at 30% from February 20X0 to 
November 20X9. 
What is the indexation allowance th e entity can claim on disposal of 
the asset? 
 
 Solution 
 The indexation allowance can be clai med on the cost of the asset = 
$20,000 × 30% = $6,000

Chapter 2 
 31 
 Illustration 9 – Capital taxes 
 Using the information from illustra tion 8 calculate the capital tax to 
be paid on the disposal? 
 
 Solution 
  
 $ 
Less:  Cost (20,000) 
 ––––––  30,000 
Less:  Indexation allowance  
20,000 × 30% (illustration 8) (6,000)  –––––– Chargeable gain 24,000 
 –––––– 
Capital tax = $24,000 × 30% = $7,200 
 
 Test your understanding 13 – Capital taxes 
 An entity bought a building for $50,000 on 01/02/X0. They incurred costs 
at the date of purchase of $1,500 for legal fees. 
The building was extended on 01/04/X2 at  a cost of $12,000 and repairs 
to the roof were undertaken on 01/06/X3  after a violent storm, costing 
$5,000. 
The building was sold for $150,000 on 21/11/Y1 and costs to sell were 
incurred of $2,000. 
Calculate the chargeable  gain on the disposal? 
 
 Test your understanding 14 – Capital taxes 
 Using the information from TYU 13 calculate the indexation 
allowance for the asset assuming the following indexation factors 
were given: 
February 20X0 to November 20Y1 was 30% 
April 20X2 to November 20Y1 was 20% 
June 20X3 to November 20Y1 was 10%

32 
 Test your understanding 15 – Capital taxes 
 Using the information from TYU's 13 and 14 calculate the capital tax 
assuming a rate of 30%. 
 
 Items exempt from Capital Tax 
 Usually, certain types of assets are ex empt from Capital Tax. In the UK, 
under capital gains tax, exempt assets include: 
 Qualifying Corporate Bonds 
 private motor vehicles 
 chattels sold for less than £6,000 (tangible movable property) 
 wasting chattels, e.g. boats and animals. 
Certain disposals are exempt from  Capital Gains Tax and include: 
 gifts to charities or certain assets such as works of art 
 gifts to museums or government institutions 
You will not be expected to remember these; the exami ner will state in 
the question if any items are exempt. 
Capital losses 
Most countries keep capital losses separate from trading activities.  
Possible ways of relieving capital losses are: 
 Carry forwards against future capital gains. 
 Carry back against previous capital gains. 
 Offset against trading income  in the current period. 
Most countries only allow capital losse s to be carried forwards against future 
capital gains but the exam iner will explain the rule s of the country in the 
question.

Chapter 2 
 33 
 Illustration 10 – Capital losses 
 In country X, capital losses can be set off against capital gains in the 
same tax year, but unrelieved capital losses cannot be carried back. 
Unrelieved capital losses may be carried forward and set against capital gains in future years. 
Hall and Co had the following taxable gains and losses in year 1 to 4. 
Year Taxable gain/(loss) 
1 3,000 
2 (4,000) 
3 2,500 
4 3,000 
What are Hall and Co’s t axable gains in each year?  
 
 Solution 
  
Year Capital 
gain/(loss) Workings 
1 3,000  
2 –  3 – 2,500 – 2,500 4 1,500 3,000 – 1,500 (balance of the loss 
The capital loss can't be carried back against year 1, only carried forward 
against the  first available  capital gain. There is no limit to how many 
years it can be carried forward for. 
 
 Test your understanding 16 – Loss relief 
 In country Y, capital losses can be set off against capital gains in the 
same tax year, but unrelieved capital losses cannot be carried back. Unrelieved capital losses may be carried forward and set against capital gains in future years. 
Trading losses in any year can be carried back and set off against profits 
in the previous year, and any unrelieved losses can be carried forward to set against profits in future years. T hey cannot be relieved against capital 
gains. 
Robbie and Co had the following trading profits/losses and capital 
gains/losses in years 1 to 3. 
Calculate the taxable gains and profits for all years.

34 
  
gain/(loss) Trading 
1 4,000 27,000 
2 (6,000) (30,000) 
3 9,000 16,000 
 
 Rollover relief 
 In some countries, gains may be pos tponed using rollover relief. Rollover 
relief enables an entity to postpone paying tax on a gain if it reinvests the 
same proceeds in a replacement asse t. The gain is effectively postponed 
until the replacement asset is sold at some time in the future. For 
example, an entity sells an asse t for $100,000, creating a gain of 
$10,000. If the entity decides to re-i nvest the $100,000 proceeds into a 
replacement asset the $10,000 gain c an be deferred in full until the 
replacement asset is sold. 
Some countries may also have rules a llowing partial deferral of the gain 
for partial re-investment. For exam ple the entity sells an asset for 
$100,000, creating a gain of $10,000. If the entity decides to re-invest 
$95,000 of the proceeds into a replac ement asset the country may have 
a rule stating the lower of the gain or the proceeds  not re-invested should 
be chargeable immediately and the rema inder of the gain to be deferred 
until the replacement asset is sold. In this scenario the entity has not re-
invested $5,000 of the proceeds and has created a gain from the first 
sale of $10,000. This would mean the entity must pay tax immediately on 
the $5,000 not re-invested and theref ore the remainder of the gain 
($10,000 – $5,000) would be deferred until the replacement asset is sold. 
Countries which operate this system of  relief will have strict rules on the 
types of assets which will qualify for th is type of relief and the time scales 
in which the replacement asset must be purchased. However, for 
examination purposes you should a ssume the gain can be deferred as 
long a replacement asset is acqui red, as detailed rules are not 
examinable.

Chapter 2 
 35 
 5 Group issues 
A group exists when one entity controls  another entity, commonly through 
acquisition of a certain am ount of ordinary shares (>50%). The entity with 
control is now called the parent com pany and the entity under control is 
described as a subsidiary.  
From a financial reporting perspective , this topic will be investigated 
further within the CIMA F2 syllabus.  However, from an F1 viewpoint, 
groups present some taxation iss ues that must be considered.  
When an entity is part of a group we must consider two issues for tax 
purposes: 
1 Group loss relief and 2 appropriations of profit. 
Group loss relief 
Tax consolidation  enables a tax group to be re cognised, allowing trading 
losses to be surrendered betwe en different entities. 
It is important to appreciate, each entity will still produce their own 
individual accounts and will be taxed individually. Howe ver, if they are part 
of a group for tax purposes it may enable them to transfer losses between 
group members to save tax for the group as a whole. 
Some countries enable losses to be surrendered only between resident 
companies, whilst others allow overseas entities to be included based on profits within that country . Generally, tax groups ar e different from groups 
for accounting purposes. There are various  restrictions on the transfer of 
losses – such as, in the UK, where onl y losses of the current accounting 
period can be surrendered. 
Capital losses  cannot usually be surrendered between group entities. In 
the UK, group entities can transfer owner ship of an asset to a group entity 
at nil gain/nil loss. A capital gain or loss only arises when an asset is sold 
outside the group to a third party. In th is way, the entire capital loss group 
is effectively treated as one entity by the authorities for c apital gains tax. 
 
 Group relief may be used to: 
 Save tax (the surrendering entity may pay tax at a lower rate that the 
group entity receiving the loss). 
 Enable relief to be gained earlier (the surrendering entity may only be 
able to carry losses forwards which result in the entity waiting for loss 
relief).

36 
Appropriations of profit 
Appropriations of profit such as divi dends cannot be deducted in arriving at an 
entity's taxable profits and ar e therefore taxable in the hands of the entity, i.e. 
tax relief is not given for the dividend. 
The dividend is then distributed to the shareholders who may be taxed on the 
income as part of their personal tax. 
As a result, the dividend is often taxed twice. There are four  main systems to 
deal with this situation: 
 Classical system 
 Imputation system 
 Partial imputation system 
 Split rate system 
 Corporate tax system V the personal tax system 
 Classical system 
The shareholder is treated as independe nt from the entity. The dividend 
is taxed twice, firstly as part of the entity's taxable earnings and secondly 
when received by the shareholder as  part of shareholder’s personal 
income. 
Imputation system 
The shareholder receives a tax cr edit equal to the underlying corporate 
income tax paid by the entity. In th is way, the entity is taxed on the 
taxable earnings which are used to  pay the dividend, whilst the 
shareholder receives a full credit and hence pays no tax on the dividend income. 
Partial imputation system 
A tax credit is offered to the s hareholder but only for part of the 
underlying corporate income tax paid by  the entity on its taxable earnings 
used to pay the dividend. 
Split rate system 
These systems distinguish between distri buted profits and retained profits 
and charge a lower rate of corporate in come tax on distributed profits to 
avoid the double taxation of dividends. 
Re-characterising debt 
As a general rule interest is tax deductible and dividends are not. It is 
therefore advantageous fr om a tax perspective for group entities to 
transfer funds from one entity to another  in the form of interest on inter-
company loans rather than dividends.

Chapter 2 
 37 
 Many countries have addressed this issue by limiting the amount of 
interest that is tax deductible. Intere st in excess of this value will be 
classified as a dividend. The rules which govern the amount of interest 
that is eligible for tax relief in this situation are known as thin 
capitalisation rules. 
 
 Test your understanding 17 – Practice questions 
 1 Explain the meaning of  indexation allowance.  
2 An entity has an accounting profit of $100,000 and includes 
entertaining costs of $10,000 and  accounting depreciation of 
$15,000. The entity operates in a c ountry where these expenses are 
disallowed for tax purposes but  tax depreciation of $9,000 is 
allowable. Calculate the taxable profit for the entity . 
3 An entity disposes of an asse t for $40,000 which cost $15,000 to 
purchase plus purchase costs of $2,000. The entity operates in a 
country where indexation allowanc e can be claimed amounting to 
$5,000. Calculate the chargeable gain on disposal . 
4 Explain the meaning of chargeable gains and capital taxes . 
5 Balancing charges increase taxable profits, true or false?  
 
 ABC is an entity with tax residency in  country Z. ABC has an accounting 
profit for the year ended 31 December  20X2 of $430,000, after charging 
the following disallowable expenses: 
Depreciation $21,000  Amortisation $7,500 ABC are entitled to tax depreciation of $25,500 for the year ended  
31 December 20X2. 
Tax is charged at 25% 
ABC's tax payable for the year ended 31 December 20X2 is: 
A $101,125 
B $103,250 C $106,375 
D $108,250

38 
 Test your understanding 19 
 Country A has the following tax regulations in force: 
 The tax year is 1 May to 30 April 
 All corporate profits are taxed at 20% 
 Depreciation cannot be charged against taxable income, tax 
depreciation must be used as alternative. 
 Tax depreciation is allowed at the following rates  
– on buildings 5% straight line 
– on all other non-current tangibl e assets are allowed at 25% 
reducing balance. 
 No tax allowances granted on la nd or furniture or fittings. 
FL commenced trading on 1 May 20X5 when it purchased all its non-
current assets. 
FL's non-current asset balances were: 
 Cost  
1 May 20X5 Carrying 
value 1 May 
20X7 Tax written 
down value  
1 May 20X7 
 $ $ $ 
Land 40,000 40,000 – Buildings 160,000  147,200 144,000 
Plant and equipment 42,000 2,000 23,624 
Furniture and fittings 30,000 10,000 – 
There were no additions of non-current assets between 1 May 20X5 and 
30 April 20X7 however on the 2 May 20X 7, FL disposed of all its plant 
and equipment for $10,000 and purchas ed new plant and equipment for 
$60,000. The new plant and equipment qualified for a first year tax allowance of 50%.

Chapter 2 
 39 
 FL's statement of profit or loss for the year ended 30 April 20X8 
 $ 
Gross profit 420,000 
Administrative expenses (228,000) Gain on disposal of plant and equipment 8,000 
Depreciation – furniture and fittings (10,000) 
Depreciation – buildings (6,400) Depreciation – plant and equipment (12,000) 
Distribution costs (98,000) 
 –––––––  73,600 
Finance cost (14,000) 
 ––––––– Profit before tax 59,600 
 ––––––– 
Calculate FL's corporate income  tax due for the year ended 30 April 
20X8. 
$____________ (Your answer should be ro unded down to the nearest $.) 
 
 Test your understanding 20 
 PMX purchased an asset for $300,000 on 1 September 20X4 on which it 
incurred additional purc hase costs of $2,500. 
PMX is based in country Z who allo w indexation. The relevant index 
increased by 60% in the period fr om 1 September 20X4 to 31 August 
20Y1. 
PMX sold the asset on the 1st of S eptember 20Y1 for $600,000 incurring 
selling costs of $4,500. 
Tax is charged at 25%. 
Assuming all purchase and selling co sts are tax allowable, how 
much tax was due from PMX on the disposal of this asset? 
A $27,875 
B $28,250 C $32,125 
D $73,250

40 
 Test your understanding 21 
 LS, an entity operating in Country N,  purchased land on 1 March 20X6 for 
$2,550,000 incurring purchas e costs as follows: 
 Surveyor fees $15,000 
 Legal fees $24,000 
LS spent a further $45,000 clearing t he land to make it suitable for 
Country N's tax regulations classified all of the expenditure as capital 
expenditure. 
On 1 February 20X9 LS sold the land for $3,000,000, incurring tax 
allowable costs of $18,000. No indexat ion is allowable on the sale of 
land. 
Tax is charged at a rate of 25%. Calculate the capital tax payable by  LS on the disposal of land.  
$________ (Your answer should be r ounded down to the nearest $.) 
 
 Test your understanding 22 – Practice questions 
 1 Accounting depreciation is re placed by tax depreciation: 
A To reduce the amount of depreciation allowed for tax 
B To increase the amount of depreciation allowed for tax 
C To ensure that standard rates of  depreciation are used by all 
organisations for tax purposes 
D So that government can more easily manipulate the amount of 
tax organisations pay 
2 Rollover relief allows:  
A Deferral of the payment of corporate income tax on gains 
arising from the disposal of a business asset 
B Stock values to be rolled over, replacing cost of purchases 
with current values 
C Trading losses to be carried forward or rolled over to future 
periods 
D Capital losses to be carried forwards or rolled over to future 
periods

Chapter 2 
 41 
 3 An imputation system of corporate income tax means: 
A All the underlying corporate income tax on the dividend 
distribution is passed as a credit to the shareholders 
B The organisation pays corporate income tax on its profits and 
the shareholder pays income tax on the dividend received 
C Withholding tax paid on divid ends is passed as a credit to 
shareholders 
D A percentage of the underlying tax is passed as credit to 
shareholders

42 
6 Summary diagram

Chapter 2 
 43 
  
 $ 
Accounting profit 80,000 
Less: exempt income (8,000) 
Add back: disallowable expenses 5,500  –––––– 
Taxable profit 77,500 Tax at 25% 19,375 
 
 Plant and machinery 
Accounting depreciation $1, 500  ($10,000 + $5,000 × 10%) 
Building 
Accounting depreciation $4,000  ($100,000 × 4%) 
Total accounting depreciation = ($1,500 + $4,000) = $5,500 
 
Tax depreciation 
TWDV at start of year $8,000 ($10,000 × 80%) 
Tax depreciation at 20% $1,600 The asset had been purchased in the previous accounting period, 
therefore tax depreciati on has already been claimed for Ye. 31/03/X1. 
This year's tax depreciation must be calculated on the tax written down 
value at the beginning of  the year, i.e. $8,000. 
The new plant and machinery is giv en 100% FYA which means relief in 
given on the total cost in t he year of purchase of $5,000. 
The building tax depreciation of 3% is based on cost of $100,000 = 
$3,000 
Total tax depreciation = ($1, 600 + $5,000 + $3,000) = $9,600

44 
  
 $  
Accounting profit 60,000  Less exempt income (4,000)  
Add back disallowable expenses 4,500  
Add accounting depreciation 5,500  (TYU 2) Less tax depreciation (9,600)  (TYU 3) 
 ––––––  Taxable profit 56,400  
 
 $  
Accounting profit 60,000  
Less exempt income (4,000)  Add back disallowable expenses 4,500  
Add accounting depreciation 5,500  (TYU 2) 
Less tax depreciation (9,600)  (TYU 3) 
 ––––––  
Taxable profit 56,400  Tax at 30% 16,920  
 
 Tax payable is: 
($800,000 × 9/12 × 26%) + ($800, 000 × 3/12 × 28%) = $212,000  
The accounting period runs from 01/07/X0 to 30/06/X1. 
9 months of the accounting period pr ofit (01/07/X0 – 31/03/X1) is charged 
at 26% and 3 months of the acco unting period prof it (01/04/X1 – 
30/06/X1) is charged at 28%. 
 
 Carrying amount at the date of sa le = $10,000 – $2,000 = $8,000  
Accounting depreciation ($10,000 × 10% × 2 years) = $2,000 
Total accounting loss = (proceed s $6,000 – CA $8,000) = $2,000

Chapter 2 
 45 
  
Plant and machinery   
Tax depreciation in year  1 $2,000 ($10,000 × 20%) 
TWDV at start of year  2 $8,000 ($10,000 × 80%) 
Tax depreciation at 20% $1,600  
The total tax depreciati on = $2,000 + $1,600 = $3,600. 
Tax written down value at the date of sale = $10,000 – $3,600 = $6,400 
Total tax loss = (proceeds $6, 000 – TWDV $6,400) = $400  
This $400 would be classed as a balancing allowance  
 
 $  
Accounting profit 50,000  Add accounting loss 2,000 (TYU 7) 
Less tax loss (BA) (400) (TYU 8) 
 ––––––  Taxable profit 51,600  
Tax at 25% 12,900  
 
 $  
Accounting profit 50,000  
Less accounting profit  (1,000) (W1) Add tax profit (BC) 2,600 (W2) 
 ––––––  
Taxable profit 51,600  
(W1) 
Carrying amount at the date of  sale = $10,000 – $2,000 = $8,000 
Total accounting profit = (pro ceeds $9,000 – CA $8,000) = $1,000

46 
 (W2) 
Tax written down value at the dat e of sale = $10,000 – $3,600 = $6,400 
Total tax profit = (proceeds $9, 000 – TWDV $6,400) = $2,600  
This $2,600 would be classed  as a balancing charge  
 
1 – 20,000 – 20,000 
2 –  3 – 19,000 – 19,000 4 19,000 25,000 – 6,000 (bal ance of the loss) 
this must be done to the maximum ext ent, i.e. you cannot use part of the 
to the maximum extent and this means year 4 will be reduced by the 
remainder of the loss $6,000, i.e. ($45,000 – $20,000 – $19,000). Year 4 
will therefore have trading prof its of $19,000 ($25,000 – $6,000). 
 
 $ $ $ 
Trading profits 100,000 50,000 – 
Loss relief (10,000) (50,000) –  ––––––– ––––––– ––––––– 
Revised trading profits 90,000 – – 
On cessation, trading losses must be carried back on a LIFO basis, i.e. 
most recent trading profits are used fi rst. When you carry back make sure 
you relieve the loss against the profit to the maximum possible extent in 
the year, you can't use part of it.

Chapter 2 
 47 
 If the loss has been carried back as far as possible, (years dependent on 
the rule for that country),  and still not fully relieved, then the remainder of 
the loss would be wasted. 
 
  $ 
Sale proceeds  150,000 
Less: cost to sell  (2,000) 
  ––––––– Net proceeds  148,000 Cost to purchase 50,000  
Cost to buy 1,500  
Enhancements 12,000 (63,500)  ––––––– ––––––– 
Chargeable gain  84,500 
NB: Roof repairs are not an allowable co st for deduction, i.e. they are not 
a "new" capital cost or a cost to buy/ sell. They are a cost to replace an 
existing structure. 
 
 The indexation allowanc e would be as follows: 
($50,000 + $1,500) × 30% = $15,450 
12,000 × 20% = $2,400 
Total allowance = $15,450 + $2,400 = $17,850 
The allowance is given based on t he movement in the RPI between the 
purchase date and the disposal date  to give relief for inflation.

48 
  
  $ 
Sale proceeds  150,000 Less: cost to sell  (2,000) 
  ––––––– 
Net proceeds  148,000 Cost to purchase 50,000  
Enhancements 12,000 (63,500)  ––––––– –––––––   84,500 
Less: Indexation allowance   
($50,000 + $1,500) × 30% (15,450)  12,000 × 20% (2,400) (17,850) 
  ––––––– 
Chargeable gain  66,650 
Capital tax = $66,650 × 30% = $19,995 
 
1 4,000 – 
2 – – 3 3,000 13,000 
The capital loss cannot  be carried back against year 1, only carried 
forward against the first available  capital gain. It will be used against the 
gain in year 3 to reduce it to $3,000 ($9,000 – $6,000). 
The trading loss is carried back first agai nst year 1 to reduce the profit to 
nil. The remainder of the loss of $3,000 ($30,000 – $27,000) is carried 
forward against year 3 to reduce the profit to $13,000 ($16,000 – $3,000).

Chapter 2 
 49 
 1 Indexation allowance is a relief given on the disposal of capital 
assets. The relief is based on e.g. the movement in the Retail Price 
Iindex between the date costs were  incurred on the asset and the 
disposal date and represents relief for inflation. The indexation 
allowance will reduce the amount of gain charged for tax purposes. 
2 Taxable profit = $100,000 + $10,000 + $15,000 – $9,000 = 
$116,000 
3 Chargeable gain = $40,000 – $15,000 – $2,000 – $5,000 = $18,000 
4 Chargeable gains are created when asse ts are sold at a profit. They 
are calculated based on the difference between proceeds and 
allowable costs. Capital taxes represent the tax charged on the 
chargeable gains. 
5 True. Balancing charges represent the tax profit on disposal of an 
asset for corporate tax purposes . They are calculated on the 
difference between proceeds and tax written down value. The 
balancing charge will increas e the taxable profits. 
 
 D 
 $ 
Accounting profit 430,000 
Add depreciation 21,000 
Add amortisation 7,500  ––––––– 
 458,500 
less tax depreciation (25,500)  ––––––– 
Taxable profit 433,000 
Tax @ 25% 108,250

50 
 The answer is $5,675 
FL – Corporate income tax   
 $ 
Profit for the year 59,600 
Add back:  Depreciation – buildings 6,400 
Depreciation – plant and equipment 12,000 
Depreciation – furniture and fittings 10,000 Less: Accounting gain on disposal (8,000) 
 –––––– 
 80,000 Less: Tax depreciation  
FYA – Plant and equipment ($60,000 × 50%) (30,000) 
Buildings ($160,000 × 5%) (8,000) Disposal balancing allowance (13,624) 
(Proceeds $10,000 – TWDV $23,624)  
 ––––––  28,376 Tax at 20% 5,675 
 
 A 
 $ 
Disposal proceeds 600,000 Selling costs (4,500) 
 ––––––– 
Net proceeds 595,500 Cost (300,000) 
Additional costs (2,500) 
 –––––––  293,000 
Indexation ($302,500 × 60%) (181,500) 
 ––––––– Taxable gain 111,500 
 ––––––– 
Tax @ 25% 27,875

Chapter 2 
 51 
 The answer is $87,000 
 $ $ 
Disposal proceeds  3,000,000 
Less: Costs of disposal  (18,000)   –––––––– 
  2,982,000 
Acquisition costs:   Purchase cost 2,550,000  
Costs arising on purchase ($15,000 + 
$24,000) 39,000  
Clearing land costs 45,000  
 ––––––––  
  (2,634,000) 
  ––––––––– Taxable gain  348,000 
  ––––––––– 
Tax @ 25%  87,000 
 
 1 C – To ensure that standard rate s of depreciation are used by all 
organisations for tax purposes. 
2 A – Deferral of the payment of co rporate income tax on gains arising 
from the disposal of a business asset. 
3 A – All the underlying corporat e income tax on the dividend 
distribution is passed as a credit to the shareholders.

53 
International Taxation 
C3. Explain some relevant 
issues that affect taxation Explain: 
a. Taxes across international 
borders 
 b. Ethics of taxation 
  Chapter 
3

54 
 
2 International taxation   
Tax in a digital world 
Business are transforming as a resu lt of the developments created by 
technological innovation. Retailers a llow customers to place orders online, 
logistics companies can track parcels  across the globe, education companies 
offer on-line courses enabling students to attend courses simultaneously 
despite being located within different continents, music and entertainment 
companies offer streaming servic es via monthly subscriptions.  
As businesses utilise these new found oppor tunities offered by the digital 
economy, new tax issues and problem s arise. Examples include:  
– which tax jurisdiction should entities pay tax in? – what happens when these companies are taxed in multiple countries? 
Similar tax problems have always existed for multi-national companies, but the 
use of technology has increas ed the regularity of occurrence of these issues – it 
is no longer solely an issue for large companies. 
Tax regulators are having to consider new  ways of ensuring tax is fairly charged 
on the income earned by companies  within the digital economy. 
Corporate residence 
Entities normally pay taxation on their worl dwide income in the country they are 
deemed to be resident in. 
An enterprise is deemed to be resident for tax purposes either in the place of 
incorporation or place of  control/central management. 
Generally an entity will be tr eated as being resident in the country of control, i.e. 
place where the head office is lo cated or board meetings held.

Chapter 3 
 55 
The generation of revenues fr om online activity increas es the complication of 
determining the corporate residence of an entity. If income is generated online 
from various countries, is it correct to have a corporate residence based on the 
location of an entity’s head office? 
This can create ethical issues for dire ctors operating within the digital economy. 
Should they establish residence in the areas where they earn most of their 
profits or should they seek residency in low tax rate tax havens simply to avoid 
taxes? 
Double taxation 
An entity may end up being taxed in mo re than one country, this is called 
double taxation. 
For example, an entity may earn income in  country X, despite being located in 
country Y. 
Double taxation may arise if that income  is taxed in the country where it was 
earned (X) as well as the country wher e the entity is resident (Y). Double 
taxation relief is often avai lable in this situation. 
Double taxation relief 
There are three main methods of  giving double taxation relief: 
1 Exemption – The countries agree on cert ain types of income which will be 
exempt or partially exempt in one country or the other. 
2 Tax credit – Tax paid in one countr y may be allowed as a tax credit in 
another country. Relief is normally restrict ed to the lower of  the foreign or 
country of residency tax. 
3 Deduction – Tax relief is gained by  deducting the foreign tax from the 
foreign income so that only the "net" amount will be subject to tax in the country of residency. 
Types of overseas operations 
An overseas operation can be run as a branch or a subsidiary. 
Subsidiary (see chapter 2 section 4) 
The features of operating as a subsidiary are: 
 The overseas subsidiary is a separ ate entity for tax purposes. The holding 
company will only pay tax on any dividends received from the subsidiary. 
 Loss relief is not available fo r the group because the overseas 
subsidiary will be paying tax und er a different tax regime. 
 The overseas subsidiary cannot claim the same tax depreciation as the 
parent on any assets, although may rece ive an alternative type of tax 
depreciation or the equivalent in the overseas country. Assets transferred 
from the parent may also result in a capital gains tax liability.

56 
Branch 
The features of operat ing as a branch are: 
 The branch is treated as an extension of the activity and all profits from it 
will be subject to local taxation. 
 Loss relief is available for the group. 
 Assets can be transferred between the branch and holdi ng company at no 
gain/no loss. 
 The branch can claim tax depreciation on all assets. 
Types of foreign tax   
Withholding tax 
Some countries will deduct tax at source on items such as interest, royalties, 
rent, dividends and capital gains. The net income (gross payment less tax) is then received by the beneficiary in the foreign country. 
Underlying tax 
When an entity pays out a dividend, it is done so out of post-tax profits. 
Therefore, the amount of profit distributed as a dividend will have already 
suffered tax on profits. 
If an entity receives a dividend from an overseas subsidiary, the dividend will 
have been taxed once in the overseas count ry as part of normal tax on profits, 
and then again in the country of receipt, as  income on dividends. This tax is 
known as underlying tax. 
This is calculated as follows: 
Tax on profits
Profit after tax	×	Gross dividend 	
Both withholding and underly ing tax may be reduced by various methods of 
double tax relief. Methods of double tax reli ef include exemption, tax credits for 
foreign tax suffered, and deduction of fo reign tax from tax due in the home 
country. 
 You will not be assessed on the calculation of foreign taxation but you 
should have a general appreciati on what it represents. 
The following examples are shown for illustrative purposes only and the student 
will not be required to answer this type of question in their assessment.

Chapter 3 
 57 
 Illustration 1 – International taxation 
 Homely is a UK entity and owns 100% of the shares in a foreign entity 
called Faraway. 
During the year Faraway earned the following income: 
Profit before tax $200,000 
Income tax $(40,000) Profit after tax $160,000 
Faraway pays a dividend of $80,000 out of profit after tax to Homely. This 
dividend is subject to 15% withholding tax. 
What is the total foreign tax suffered on the dividend? 
 
 Solution 
  
 $ 
Withholding tax  $80,000 × 15% 12,000 
Underlying tax  
($40,000/$160,000) × $80,000 20,000 
 –––––– 
Total foreign tax 32,000 
This means: 
The dividend distributed by Faraway was $80,000. 
The foreign country deducted withhol ding tax of $12,000 and, therefore, 
the shareholder would only receive $68,000 in cash. 
The profits in Faraway were taxe d before the $80,000 was distributed. 
Therefore, the underlyi ng tax is the amount of tax the dividend has 
already suffered prior to distributio n when it was taxed as a profit. 
 
 Illustration 2 – Double tax relief 
 Use the information from the previous illustration: 
A tax treaty exists between the tw o countries using the tax credit 
method, calculate the tax payable in the UK (Homely’s country of 
residence) assuming a tax rate of 40%.

58 
 Solution 
  
 $ 
Net dividend received 68,000 
Add back WHT 12,000  ––––––– 
 80,000 
Add back UT 20,000  ––––––– 
Gross dividend 100,000 
Total foreign tax  ($100,000 – $68,000) 32,000 
Tax in UK  
Tax at 40% 40,000 
Less DTR (lower of foreign and UK tax) (32,000)  ––––––– 
Tax paid in UK 8,000 
 
 Test your understanding 1 – International taxation 
 Britas is a UK entity and owns 80% of the shares in a foreign entity called 
Cheers. 
During the year, Cheers earned the following income: 
Profit before tax $372,000 
Income tax $(62,000) 
 –––––––– Profit after tax $310,000 
Cheers pays a total dividend of $100,000 out of profit after tax to its 
shareholders. This dividend is su bject to 5% withholding tax. 
Calculate the total foreign tax suffered on the dividend and show 
how double tax relief would apply in  the UK using the tax credit 
method, assuming a rate of 40% tax is charge.

Chapter 3 
 59 
OECD model tax convention 
The OECD model addresses the issues of double residency. 
This model states that bus iness profits of an enterpris e will only be taxable in a 
state if an enterprise has  a permanent establishment in that country. A 
permanent establishment c ould include the following: 
1 A factory 2 A workshop 3 An office 4 A branch 5 A place of management 6 A mine, an oil or gas well, or a plac e of extraction of natural resources 
7 A construction project or building si te if it lasts more than 12 months 
If an entity has a permanent est ablishment in a country, it can be taxed in that 
country, causing a possible problem of double taxation. 
 
 Where an entity is deemed to have re sidency in several countries, the 
OECD model suggests that the entity is  resident in the country of its 
effective management. 
Transfer pricing 
Transfer pricing applies to group situations when either goods are sold inter-
company at a favourable price or loans are made on favourable terms. 
Therefore, this results in transactions  not taking place at "arm’s length" and 
profits of the group are distorted.  
These transactions may arise as an attemp t to avoid tax. An overseas entity 
may be attempting to move profits to another country at a lower tax rate. 
This could damage public perception of t he group. Entities may be criticised for 
not paying their fair share of tax. 
The rules for transfer pricing are as follows: 1 Goods and services – An adjustment  will be made in the corporate tax 
computation for the entit y gaining the tax advantage to reflect profit that 
would have been achieved if the transaction had been arms-length. 
2 Provision of loan finance – If the amount of loan finance provided to a 
connected company exceeds the amount a third party would be willing to 
provide, the loan is not at arms-l ength (it is not at normal commercial 
terms). This is referred to as thin capitalisation. 
Any interest charged on this excess is  not allowable for tax purposes and 
will therefore be disallowed.

60 
 Aston sells to Marvin, a group entit y, 5,000 units at $1.50 each. The 
market value was $3 per each. 
Explain the effect of the transf er pricing legislation on this 
 
 1 Which of the following could NOT be used to indicate an 
enterprise is resident in a country? 
A Country in which directors’ meetings are held 
B Country of incorporation C Country in which control and management is exercised D Country in which goods are sold. 
2 In no more than 30 words, define  the meaning of an overseas 
subsidiary. 
3 Which of the following would not  be subject to a withholding 
tax? 
A Profits of the enterprise 
B Rental profits C Equity dividends 
D Interest received fr om finance companies 
4
 A double taxation treaty between two c ountries usually allows relief 
of foreign tax through a number of methods.  
Which one of the following is not a method of relieving foreign 
tax? 
A Deduction based on lower tax 
B Exemption from corporate tax in one country C Tax Credits (deduction from tax liability) D Loss relief

Chapter 3 
 61 
 5 Permanent establishment is defined under the OECD model in 
several ways.  
Which of the following would not  be classed as a ‘permanent 
establishment’? 
A An office 
B An agent with authority to enter into contracts C A workshop 
D A warehouse used for storage
 
 Test your understanding 4 – Practice questions 
 1 The following details relate to EA:  
– Incorporated in Country A 
– Carries out its main business activities in Country B – Its senior management operate fr om Country C and effective 
control is exercised from Country C 
– Assume countries A, B and C have all signed double tax 
treaties with each other, bas ed on the OECD model tax 
convention. 
Which country will EA be deemed  to be resident in for tax 
purposes? 
A Country A 
B Country B C Country C D Both countries B and C 
2 Explain the meaning of wi thholding and underlying tax.

Chapter 3 
 63 
  
 $ 
Net dividend received 76,000 
WHT 5% 4,000  –––––– 
($100,000 × 80%) 80,000 
UT – $80,000 × (62/310) 16,000  –––––– Gross dividend 96,000 
Total foreign tax  ($96,000 – $76,000) 20,000 
Tax in UK  
Tax at 40% on gross dividend $96,000 38,400 
Less DTR (lower of foreign and UK tax) (20,000)  –––––– 
Tax paid in UK 18,400 
 
 Aston must increase its taxable prof its by $7,500 ($1.50 × 5,000 units). 
The taxable profits must reflect the sale  at market value, i.e. arm’s length 
price of $3 per unit. 
 
 1 D – The correct answer is country in which goods are sold. 
2 An overseas subsidiary is an enter prise resident for tax purposes in 
a foreign country whose share capital is owned by an entity resident in another country. 
3 A – Profits of the enterprise. 
4 D – Loss relief. 
5 D – A warehouse used for storage. 
 
 1 C – Country C. An entity is considered to be resident in the country 
of effective management. 
2 Withholding tax is a tax deducted at  source from a payment before it 
is made to the recipient. Underlying tax is the tax on the profits out 
of which a dividend is paid.

65 
The Regulatory 
A1. Identify regulators and 
describe their role a. Identify the major regulators 
 b. Describe what they do 
 c. Explain why they regulate 
 
  Chapter 
4

The Regulatory Environment 
66 
1  Session content 
 
2 The regulatory environment 
Need for regulation  
Financial statements will be used by s hareholders and many other types of 
users to make decisions. In order t hat they can be re lied upon by users, 
published financial statem ents should be subject to regulation. 
Regulation can also promot e consistency and comparabil ity, so assisting users 
when interpreting financial statements. 
Different countries will be subject to a variety of economic, social and political 
factors. As a result, the way in which published financial statements are 
regulated will vary from  country to country.

Chapter 4 
 67 
 The need for regulation 
 Financial statements and reports fo r shareholders and other users are 
prepared using principles and rules that  can be interpreted in different 
ways. To provide guidance and try and ens ure that they are interpreted in 
the same way each time, some fo rm of regulati on is required. 
We have identified that taxable profit s are based on accounting profit and 
that the number and type of adjustm ents required to compute taxable 
profits varies from country to country. Part of this variation was due to the 
differences in the tax regulations, but part of it was also due to the different approaches to the calculat ion of accounting profit. We have 
identified that in some countries taxable income is closely linked to the 
accounting profit and that accounting rules are largely driven by taxation 
laws. These countries are usually known as code law countries, countries where the legal system originated in Roman law. These countries tend to have detailed laws relating to tradi ng entities and accounting standards 
are usually embodied within the law.  Accounting regulation in these 
countries is usually in the hands of the government and financial reporting is a matter of complying with a set of legal rules. 
In other countries the common law syst em is used, common law is based 
on case law and tends to have less deta iled regulations. In countries with 
common law systems, the accounting regulation within the legal system 
is usually kept to a minimum, with detailed accounting regulations 
produced by professional organisations or  other private sector accounting 
standard-setting bodies. 
Whichever system is adopted, there is  a need for every country to have a 
system for regulating the preparation of financial statements and reports. 
3  Elements of a regulatory environment 
A regulatory environment may consist of any of the following elements: 
 local law; 
 local accounting standards; 
 international accounting standards; 
 conceptual frameworks e.g. Statement of Pr inciples in the UK; 
 requirements of internati onal bodies e.g. EU, IOSCO. 
GAAP (Generally accepted accounting pr actice) encompasses the conventions, 
the rules and procedures necessary to defin e accepted accounting practice at a 
particular time. It includes not only br oad guidelines of general application but 
also detailed practices and procedur es. It includes local legislation 
requirements, accounting standards and any  other local regulations. This will 
therefore vary from country to country  as different countries have different 
regulations, i.e. UK GAAP, US GAAP

68 
 The regulatory environment 
 The regulatory environment for account ing in individual countries will be 
affected by a number of legislat ive and quasi-legislative influences: 
 national company law 
 EU directives or other  trading body directives 
 security exchange rules. 
Why is regulation necessary 
Regulation of accounting information is  aimed at ensuring that users of 
financial statements receive a minimum amount of information that will enable them to make meani ngful decisions regarding their interest in a 
reporting entity. A regulat ion is required to ensur e that relevant and 
reliable financial reporting is achiev ed to meet the needs of shareholders 
and other users. 
Accounting standards on their own would not provide complete 
regulation. In order to fully r egulate the preparati on of financial 
statements and the obligat ions of companies and directors, legal and 
market regulations are also required. 
Principles-based and rules-b ased approaches for accounting 
standards 
Principles-based approach: 
 based upon a conceptual framework such as the IASB's 
Framework® 
 accounting standards are set on the basis of the conceptual 
framework. 
Rules-based approach: 
 ‘Cookbook’ approach 
 accounting standards are a set of  rules which companies must 
follow. 
In the UK there is a principles-bas ed approach in terms of the Statement 
of Principles and accounting st andards and a rules-based approach in 
terms of the Companies Acts, EU di rectives and stock exchange rulings.

Chapter 4 
 69 
 Variation from country to country 
 Accounting and information disclosur e practices around the world are 
influenced by a variety of economic, so cial and political factors. In 
addition to the legal system and tax le gislation, a range of other factors 
that contribute to variations bet ween the accounting regulations of 
countries are discussed below. The wide range of factors influencing the development of accounting regulations  have resulted in a wide range of 
different systems, which has made it  difficult and time-consuming to try 
and harmonise accounting practices around  the world. With the growth in 
international investing, there is a growing need for harmonisation of 
financial statements between countries. 
Sources of finance and capital markets  
There is more demand for financial information and disclosure where a 
higher proportion of capital is raised from external shareholders, rather 
than from banks or family members. Stock markets rely on published 
financial information by entities. Ban ks and family members are usually in 
a position to demand information dire ctly from the entity, whereas 
shareholders have to rely on publicly available information. 
The political system 
The nature of regulation and control exerted on accounting will reflect 
political philosophies and objectives of the ruling party, for example, 
environmental concerns. 
Entity ownership 
The need for public accountability and disclosure will be greater where 
there is a broad ownership of shares as opposed to family ownership or 
government ownership. 
Cultural differences 
The culture within a country can in fluence societal and national values 
which can influence accounting regulations. 
Harmonisation versus standardisation 
Harmonisation tends to mean the proce ss of increasing the compatibility 
of accounting practices by setting bounds to their degree of variation. 
Standardisation tends to imply the impos ition of a rigid and narrower set 
of rules. Standardisation also implie s that one technically correct method 
can be identified for every aspect of accounting and then this can be imposed on all preparers of accounts. 
Due to the variations between countries discussed above, full 
standardisation of accounting practices is  unlikely. Harmonisation is more 
likely, as the agreement of a common conceptual framework of 
accounting may enable a closer harmoni sation of accounting practices.

70 
 The need for harmonisation of accounting standards  
Each country has its own accounting regulation, financia l statements and 
reports prepared for shareholders and ot her uses are based on principles 
and rules that can vary widely from country to country. Multinational 
entities may have to prepare reports on activities on several bases for use in different countries, and this can cause unnecessary financial costs. Furthermore, preparation of financ ial statements based on different 
principles makes it difficult for investors and analysts to interpret and 
compare financial information. This la ck of comparability in financial 
reporting can affect the credibility  of the entity’ s reporting and the 
analysts’ reports and can have a det rimental effect on financial 
investment. As a result, the numbe r of companies using IFRS’s is 
multiplying rapidly. The ability to use the same accounting rules removes 
the many of the problems caused by  a lack of comparability between 
entities.  
The increasing levels of cross-bor der financing transactions, securities 
trading and direct foreign investment has resulted in the need for a single 
set of rules by which assets, li abilities, expenses and income are 
recognised and measured. 
The number of foreign listings on ma jor exchanges around the world is 
continually increasing and many worldwide entities may find that they are 
preparing accounts using a number of different rules and regulations in 
order to be listed on various markets. 
4 International financ ial reporting standards

Chapter 4 
 71 
IFRS Foundation 
The IFRS Foundation was established in March 2001, after it was decided to 
restructure the IASC into two main  bodies: the Trustees and the IASB (see 
below). The IFRS Foundation is a non- profit making body  with a number of 
trustees’. The trustees are responsible for: 
 appointing the members of  the IASB, the Internat ional Financial Reporting 
Interpretations Committee and IFRS Advisory Council; 
 reviewing annually the strategy of the IASB and its effectiveness; 
 approving annually the budget and determi ning the funding of the IASB; 
 reviewing broad strategic issues  affecting accounting standards; 
 promoting the IASB and its work a nd the rigorous application of IASs; 
 establishing and amending operating procedures for the IASB, IFRS 
Interpretations Committee and IFRS Advisory Council. 
International Accounting Standards Board (IASB) 
The IASB consists of a number of mem bers and is responsible for developing 
international accounting standards, now re ferred to as International Financial 
Reporting Standards (IFRS Standards). 
All members are appointed for a te rm of 5 years, renewable once. 
The IASB has complete responsibility fo r all IASB technical matters, including 
the preparation and publicati on of IFRS Standards, Exposure Drafts, withdrawal 
of IFRS Standards and final interpreta tions by the IFRS Interpretations 
Committee. 
The IASB have also adopted all IASs that were previously issued by the IASC. 
IFRS Advisory Council 
The IFRS Advisory Council has approx imately 30 members and provides a 
forum for organisations and individuals to participate in the standard setting 
process. The members are appointed by the trustees from various 
backgrounds, for a renewable term of 3 years and meet three times a year. 
The objectives of the IFRS Advisory Council are: 
 to give advice to the IASB on agenda decisions and priorities in its work; 
 to inform the IASB of the views of organisations and individuals on the 
Council on major standard setting projects; 
 to give other advice to t he Board or to the Trustees.

72 
IFRS Interpretations Committee 
The IFRS Interpretations Committee (fo rmally known as IFRIC), assists the 
IASB by reviewing accounting issues that  are likely to receive divergent or 
unacceptable treatment in the absence of  authoritative guidance, with a view to 
reaching an appropriate accounting treatme nt. It was established in 2002 by the 
IFRS Foundation to replace the Standi ng Interpretations Committee (SIC)®. 
Previously SIC Interpretations were i ssued, now IFRS Inte rpretation Committee 
Interpretations are issued. 
The IFRS Interpretations Committee has two main responsibilities: 
 Review, on a timely basis, new financial reporting issues not specifically 
addressed in IFRSs. 
 Clarify issues where unsatisfactor y or conflicting interpretations have 
developed, with a view to reaching a consensus on the most appropriate 
treatment. 
International Organisation of Securities Commissions (IOSCO) 
IOSCO is the representative body of the world’s securi ties markets regulators. 
Financial information is vital to the operat ion of markets and differences in the 
financial information from entities in diffe rent countries can reduce the efficiency 
of markets. 
IOSCO has been working with the I ASB since 1987 in promoting the 
improvement of Internat ional Standards. Since the mid-1990s IOSCO and IASB 
have been working on a programme of ‘cor e standards’ which could be used by 
listed companies who offer securities abroad. This project was completed in 
1999. 
In May 2000, IOSCO issued a report to its members recomm ending that they 
use International Financial Reporting Standards when preparing their financial 
statements. 
IOSCO representatives also sit as obs ervers on the IFRS Interpretations 
The international integrated reporting council (IIRC) 
The IIRC is a coalition behind the intr oduction of Integrated Reports <IR>. 
Integrated reporting promotes reporting on an entity’s ability to create value. It 
considers the needs of a variety of  stakeholders and enables an entity to 
disclose details regarding all aspects of valu e creation, e.g. staff skills sets, staff 
morale, intellectual property and reputati on. <IR> do not include merely financial 
information and results (like the financial statements).  
The Integrated report and the IIRC are considered in great er depth within the 
CIMA F2 syllabus.

Chapter 4 
 73 
5 Standard-setting process 
There is no strict procedure for the devel opment of an IFRS standard. However, 
the process may involve the following steps: 
 Establishment of an advisory commi ttee to give advice on the issues 
arising on the project. The IASB will consult with this committee and IFRS 
Advisory Committee throughout the process. 
 On major projects, the IASB devel ops and publishes a Discussion Paper 
for public comment. This will give an overview of the issue, possible 
approaches to address the issue, view s of the authors or the IASB and an 
invitation to comment. 
 Following the receipt and review of  comments, an Exposure Draft is 
produced for public comment. The Exposure Draft is based upon the 
earlier Discussion Paper, together wit h the IASB review of feedback 
received from the public – i.e. mainly firms of accountants and companies 
who are likely to be affected by the introduction of a new or changed 
reporting standard. 
The Exposure Draft is therefore the draft reporting standard made 
available for final review, which can still be amended before final approval 
as a reporting standard. 
 Following the receipt and review of comments, the approved IFRS will be 
published, including a date from wh ich it will become effective. 
 The role of national standard setters 
  The harmonisation process has gathered pace in the last few years. 
From 2005 all European listed entities were required to adopt IFRS 
in their group financial statements. Many other countries including 
Australia, Canada and New Zealand decided to follow a similar process. National standard setters are committed to a framework of 
accounting standards based on IFRS. 
 Additionally, the US are committe d to harmonise with IFRS and the 
US’s Financial Accounting Standard Board (FASB) and the IASB 
are aiming for convergence over the next few years. 
 The overall impact of the above is  that the trend towards closer 
international harmonisation of accounting practices is now set. It will 
become increasingly difficult for dom estic standard setters to justify 
domestic standards at odds with IFRSs. 
The role of accounting standa rd setters and the IASB 
 In February 2005, the IASB issued a memorandum setting out the 
responsibilities of the IASB and national  standard setters. It is most 
relevant to those who have adopted or converged with IFRSs’. It 
deals with the responsibilities of  national standard setters to 
facilitate adoption or convergence with IFRS.

74 
  It includes the responsibilities of the IASB to ensure that it makes 
information available on a timely basis so that national standard 
setters can be informed of the I ASB’s plans. Sufficient time should 
be allowed in relation to consulta tive documents so that national 
standard setters have adequate time to prepare the information in 
their own context and to receive comments from their own users. 
 The national standard setters shoul d deal with domestic barriers to 
adopting or converging with IFRS. They should avoid amending an 
IFRS when adopting it in their own ju risdiction, so that the issue of 
noncompliance with the IFRS doe s not arise. They should 
encourage their own constituents to  communicate their technical 
views to the IASB and they themselves should respond with comments on a timely basis. They should also make known any differences of opinion that they have with a project as early as 
possible in the process. 
6 Interaction with local frameworks 
The IASB invites comments from national  standard-setters on Exposure Drafts. 
This enables local standard-setters to cont ribute to the development of IFRS, as 
well as encouraging application of IFRSs by  companies within these localities. If 
IFRSs are similar to national standards, th is will make it easier for entities to 
adopt them.   
The IFRS advisory council also consults national standard-setters and co-
ordinate the agendas and priorities of the IASB and national standard-setters. 
Some countries will adopt IFRS Standards as their local accounting standards, 
or will be heavily influenced by IFRS St andards when preparing local standards. 
This may particularly be the case in  countries without a strong and independent 
accountancy profession. 
A country choosing to adopt international standards ca n apply them in a number 
of ways: 
 Adoption of international standards as  local GAAP – This is usually in 
countries where the accounting prof ession isn't well developed and they 
adopt the international standards with little or no amendments. This is 
quick to implement but does not take into account any specific requirements of that country. 
 International standards used as a model to create local GAAP – This 
involves countries taking the inte rnational standards and then amending 
them to reflect that countries' needs. 
 International standards used as per suasive influence in preparing local 
GAAP – This is where a country alr eady has its own standards but they 
may differ to the IFRS standards. They  will use the IFRS Standards to 
update their local standards to ensur e that they comply with IFRS 
Standards in all material aspects.

Chapter 4 
 75 
Alternatively a country may choose to prepare local GAAP with no reference to 
international standards! 
 
 Test your understanding 1 – Setting standards 
 Yozz is a small developing country which currently has no accounting 
standards and in which a new professi onal accounting body was recently 
created. 
Yozz's government has asked the new professional accounting body to 
prepare a report setting out the count ry's options for developing and 
implementing a set of  high quality financial reporting standards. 
Required: 
As an advisor to the professional  accounting body,  outline THREE 
options open to Yozz for the development of financial reporting 
standards. Identify any advantages or disadvantages for each option. 
 
 Test your understanding 2 – Roles 
 The existing procedures for setting international accounting standards are 
now well established. 
Required: 
Explain the roles of the following in relation to the regulatory environment 
to develop and publish IFRS Standards: 
 The IFRS Foundation; 
 The International Account ing Standards Board (IASB); 
 The IFRS Interpretations Committee. 
 
 Test your understanding 3 – Th e development of a standard 
 Explain how the standard-setting authority approaches the task of 
producing a new financial reporting st andard, with particular reference to 
the ways in which comment or f eedback from interested parties is 
obtained.

76 
 1 Under the current structure of regulatory bodies, which of the 
bodies listed below acts as the overall supervisory body? 
A IFRS Interpretations Committee 
B International Accounting Standards Board C IFRS Advisory Council D IFRS Foundation 
2 Which of the bodies listed below is responsible for reviewing 
IFRS Standards and issuing guidance on their application? 
3 Which of the bodies listed below is responsible for issuing 
IFRS Standards? 
4 Which of the bodies listed belo w is responsible for the 
approval of IFRS Interpretations? 
5 Which of the following best d escribes the role of the IFRS 
Advisory Council? 
A To prepare interpretations of International Accounting 
Standards 
B To provide the IASB with t he views of its’ members on 
standard setting projects 
C To promote the use of Inte rnational Accounting Standards 
amongst its members 
D To select the members of the IASB

78 
 The options are as follows: 
1 Adopting International Financial Reporting Standards (IFRS) as its 
local standards. The advantage of this would be is that this 
approach is quick and cheap to impl ement but has a disadvantage 
that it may not take into account  any specific local traditions or 
variations. 
2 Modelling local standards on the IASB's IFRSs, but amending them 
to reflect local needs and conditions. The advantage of this would be that the standards would be more relevant to the country’s needs 
but still be compliant with international standards. The disadvantages would be that it w ould take longer to create and 
implement and would require someone with expertise to exist within 
the local country to hel p create these standards. 
3 Yozz could develop its own accounting standards with little or no 
reference to IFRSs. The advant age would be that  the standards 
would be specific to the needs of the country but have the disadvantage that they could be l engthy and costly to create. The 
standards may not be compliant wit h international standards and 
also require a person in Yozz with the appropriate expertise to help 
create these standards.

Chapter 4 
 79 
 Test your understanding 2 – Roles  
 The IFRS Foundation 
The IFRS Foundation is an independent organisation made up of 22 
Trustees. The Trustees hold the responsibility for governance and 
fundraising and will publish an annual  report on IASB’s activities, 
including audited financia l statements and priorities  for the coming year. 
They will review annually the strategy of the IASB and its effectiveness and approve the annual budget and dete rmine the basis of funding. 
The Trustees also appoint the member s of the IASB, the IFRS Advisory 
Council and the IFRS Interpretations  Committee. Although the Trustees 
will decide on the operating procedures  of the committees in the IASB 
family, they will be excluded from involvement in technical matters relating to accounting standards. 
The IASB 
The Board has complete responsibil ity for all IASB technical matters, 
including the preparation and issuing of International Financial Reporting 
Standards and Exposure Drafts, and final approval of Interpretations by 
the International Financial Reporting Interpretations Committee. Some of 
the full-time members of  staff are responsible for liaising with national 
standard-setters in order to promot e the convergence of accounting 
standards. 
IASB publishes its standards in a series of pronouncements called 
International Financial Reporting Standar ds (IFRSs). It has also adopted 
the standards issued by the board of its predecessor, the International 
Accounting Standards Committee. 
The Board may form advisory committees or other specialist technical 
groups to advise on major projects and outsource detailed research or 
other work to national standard-setters. 
The IFRS Interpretations Committee provides timely guidance on the 
application and interpretation of IF RSs, normally dealing with complex 
accounting issues that could, in  the absence of guidance, produce wide-
ranging or unacceptable accounting treatments.

80 
 The process for the development of a standard involves the following 
steps: 
 During the early stages of a pr oject, the IASB may establish an 
Advisory Committee to advise on the issues arising in the project. 
Consultation with this committee and the IFRS Advisory Council 
occurs throughout the project. 
 The IASB may develop and publish Discussion Papers for public 
comment. 
 Following receipt and review of comments, the IASB develops and 
publishes an Exposure Draft for public comment. 
 Following the receipt and review of comments, the IASB issues a 
final International Fin ancial Reporting Standard. 
When the IASB publishes a standard, it also publishes a Basis of 
Conclusions to explain publicly how it reached its conclusions and to 
provide background information that ma y help users apply the standard in 
practice. 
Each IASB member has one vote  on technical matters and the 
publication of a Standard, Exposure Draft, or final  IFRS Interpretation 
requires approval by ei ght of the Board’s 15 me mbers. Other decisions 
including agenda decisions and the issue of a Discussion Paper, require a simple majority of the Board mem bers present at a meeting, provided 
that the meeting is attended by at least 50 per cent of the members. 
Meetings of the IASB, IFRS Adviso ry Council and IFRS Interpretations 
Committee are open to public observa tion. Where the IASB issues 
Exposure Drafts, Discussion Papers and other documents for public 
comment, the usual comment per iod is 90 days. Draft IFRS 
Interpretations Committee Interpre tations are exposed for a 60-day 
comment period. 
 
 1 D 
2 A 
3 B 4 B – IFRS Interpretations are subject to IASB approval. 
5 B

81 
Code of Ethics 
describe their role c. Explain why they regulate 
  Chapter 
5

82 
 
Chartered Management Accountants (and r egistered students) have a duty to 
observe the highest standards of conduc t and integrity and, to uphold the good 
standing and reputation of t he profession. They must also refrain from any 
conduct which might discredit the profe ssion. Members and registered students 
must have regard for these guidelines irresp ective of their fiel d of activity, of 
their contract of employment, or of any  other professional  memberships they 
may hold. 
In January 2015, CIMA and the AICPA l aunched the Code of Ethics for CGMAs 
(Chartered Global Management Accountant s). The CGMA code is aligned with 
the requirements contained in the 2015 CI MA code of ethics (Part C) and the 
AICPA code of professional conduct. A ccordingly, CIMA members who hold the 
CGMA designation and are compliant with the CIMA code will also be in 
compliance with the CGMA code. 
CIMA upholds the aims and principles of equal opportunities and fundamental 
human rights worldwide, in cluding the handling of per sonal information. CIMA 
promotes the highest ethical and business standards, and encourages 
members to be responsible professionals. 
Good ethical behaviour may be above that  required by the law. In a highly 
competitive, complex business world, it is essential that CIMA members sustain 
their integrity and remember the trust and confidence which is placed in them by 
whoever relies on their objectivity and professionalism. Members must avoid 
actions or situations which are inconsis tent with their professional obligations.

Chapter 5 
 83 
They should also be guided not merely by the terms but by the spirit of this 
code. 
CIMA members should conduct themselv es with courtesy and consideration 
towards all with whom they have prof essional dealings and should not behave 
in a manner which could be consider ed offensive or discriminatory. 
To ensure that CIMA me mbers protect the good standi ng and reputation of the 
profession, members must inform the institute if they are convicted or 
disqualified from acting as an officer of an entity, or if they are subject to any 
sanction resulting from disciplinary acti on taken by another professional body. 
The CGMA designation is designed to  elevate management accounting and 
further emphasize its importance for busi nesses worldwide. Part C of the code 
is designed to provide guidance to a ll CIMA members around the world who are 
members in business and professional a ccountants in business and, those who 
hold the CGMA credential. When a CGMA is  also a member in public practice 
the CGMA should also comp ly with the applicable guidan ce of the CIMA code of 
ethics and apply the most restrictive provisions. 
Part C of the 2015 CIMA Code of Ethi cs (effective from 1 January 2015) is 
consistent with the Code of Ethics for CGMA designation holders and any future 
substantive revisions to the CIMA c ode will be incorporated into the Code of 
Ethics for CGMA designation holders. Accordingly, CI MA members who are in 
compliance with the CIMA code are also in compliance with the CGMA code. 
If a member cannot resolve an ethical issue by following this code or by 
consulting the ethics support information on CIMA's website, he or she should 
seek legal advice as to both his or her legal rights and any obligations he or she 
may have. The CIMA charter, bylaws and regulations should also be referred to 
for definitive rules on many matter s. For further information see 
www.cimaglobal.com/ethics. 
NB: All references to 'professional account ants' in this code should be taken to 
refer, as appropriate, to CIMA members or regi stered students. 
 
 3 Why are ethics important? 
Ethics relate to fairness, honesty and res ponsibility. Ethics are a set of moral 
principles to guide behaviour. 
They are important because: Accountants should perform their work properly. Ethics descr ibe "how" an entity 
does its business not what it does. If an accountant carried out work in bad faith 
this can affect the accountant (who ma y be disciplined by CIMA), it may have 
an effect on the business, e.g. financia l viability, and in the public sector tax 
payers' money could be wasted.

84 
4 CIMA's code at a glance 
Principles  
Whether you are employed in business or t he public sector or work in practice, 
CIMA's code of ethics can help you to identify and deal with situations where 
your professional integrity may be at risk. The code describes the high ethical 
standards every CIMA member and st udent must demonstrate, and gives 
guidance on how to uphold these. 
Five fundamental principles form the basis  of the code: integrity, objectivity, 
professional competence and due care , confidentiality and professional 
behaviour. These are summarised below , but a full expl anation, along with 
guidance on applying the principles, is ava ilable in the complete code of ethics. 
 Objectivity  means not allowing bias, conflict of  interest, or the influence of 
other people to override your prof essional judgement. To protect your 
objectivity, you should avoid relations hips that could bias or overly 
influence your professional opinion. 
 Professional competence and due care  is an ongoing commitment to 
maintain your level of professional knowledge and skill so that your client 
or employer receives a competent pr ofessional service. This should be 
based on current developments in practi ce, legislation and techniques, 
and you must also make sure that those working under your authority 
have the appropriate training and super vision. Work should be completed 
carefully, thoroughly and diligently, in accordance with relevant technical 
and professional standards, e.g. accountants will use judgement and 
estimation when preparing financial statements such as identifying 
accruals/prepayments, making provisions , counting and valu ing inventory, 
and choosing depreciation methods. 
 Professional behaviour requires you to comply with relevant laws and 
regulations. You must also avoid any action that could negatively affect 
the reputation of the profession. 
 Integrity means being straightforward, honest and truthful in all 
professional and business relationsh ips. You should not be associated 
with any information that you believe contains a materially false or misleading statement, or which is misleading becaus e it omits or obscures 
the facts. 
 Confidentiality  means respecting the confident ial nature of information 
you acquire through professional relati onships such as past or current 
employment. You should not disclose  such information unless you have 
specific permission or a legal or prof essional duty to do so. You should 
also never use confidential info rmation for your or another person’s 
advantage.

Chapter 5 
 85 
The code itself contains further explanati on of these principl es, and examples of 
how they can be applied for both Professi onal Accountants in Business (Part C) 
and Professional Accountants in Practice (Part B). It is impossible to define 
every situation that could create a threat  to the principles, and it is equally 
impossible to set out specific safeguar ds for each case, so instead the code 
sets out common examples of when these principles might be threatened and 
guidance as to what action should be tak en to reduce or remove the threats. 
A principles-based code such as CIMA's is widely considered to be more 
effective than a set of rules. Wher eas there can be a tendency to try and 
circumvent rules, principles are more  flexible and can be  applied in a wider 
variety of situations. Principles al so encourage users to think about the 
underlying intent of the code rather than simply adopting a check-box approach 
to compliance with rules. 
Threats 
To apply the fundamental principles of  the code (integrity, objectivity, 
professional competence and due care , confidentiality, and professional 
behaviour), you first need to be able to i dentify and evaluate existing or potential 
threats to them. If a threat exists that is anything other than trivial, you will need 
to take action to remove the threat or reduce it to an acceptable level. 
Although it is impossible to define all the situations that coul d create a threat to 
the fundamental principles, the code does  identify five categories of common 
threat: 
 Self-interest threats can occur as a result of your own or your close 
family's interests – financial or other wise. These threats often result in 
what is commonly called a 'conflict of  interest' situation. Working in 
business, a self-interest threat could re sult from concern over job security, 
or from incentive remuneration arr angements. For those in practice it 
might be the possibility of losing a client  or holding a financial interest in a 
client. 
 Self-review threats  occur when you are require d to re-evaluate your own 
previous judgement, for example if you have been asked to review and 
justify a business decision you made,  or if you are reporting on the 
operation of financial systems that you were involved in designing or implementing. 
 Familiarity threats can be present when you become so sympathetic to 
the interests of others as a result of a close relationship that your 
professional judgement becomes compro mised. Sometimes this can result 
from long association with business contacts who influence business 
decisions, long association with colle agues, or from accepting gifts or 
preferential treatment  from a client.

86 
 Intimidation threats occur when you are deterred from acting objectively 
by actual or perceived threats. It c ould be the threat of dismissal over a 
disagreement about applying an accounting principle or reporting financial 
information, or it could be a dominant  personality attempting to influence 
the decision making process. 
 Advocacy threats  can be a problem when you are promoting a position 
or opinion to the point that your subs equent objectivity is compromised. It 
could include acting as an advocate on behalf of an assurance client in 
litigation or disputes with  third parties. In general, promoting the legitimate 
goals of your employer does not creat e an advocacy threat, provided that 
any statements you make are not misleading. 
Whilst it is important that  candidates can define ethical issues, they must also 
be able to apply them to a specific scenario and explain their implications. This would be more relevant for the operati onal case study where detailed written 
responses are commonplace. Candidates are likely to be given a scenario and 
will be required to explain t he principles and/or threat s that may result in the 
code not being adhered to. 
Safeguards 
So what should you do if there is a threat  (or potential threat),  to the principles 
of the code? 
CIMA's code of ethics has a 'threats and safeguards' approach to resolving 
ethical issues. This means that if you are in a situation w here there might be a 
threat to any of the code’s fundam ental principles you should first  assess 
whether the threat is significant . If it is, you should to take action to remove 
or mitigate it. 
Safeguards  are actions that will reduce or pr event an ethical issues arising. 
Safeguards can be found in employing orga nisations, such as whistle blowing 
or grievance procedures, or can be embedd ed within the profession in the form 
of standards or legislation.  Safeguards are also the actions that a professional 
accountant takes to resolve an ethical conflict or dilemma. 
If a colleague, employer or client has done something that you think is 
unethical, if you are under pressure to  do something you think goes against the 
principles of the code of ethics or if y ou are facing a conflict of interest, then you 
will need to think about what safeguards or actions to take to resolve it. These 
safeguards could take a number of form s. The code does not describe all the 
safeguards that could be im plemented, but instead gives general guidance for 
handling ethical issues, both for account ants working in business and for those 
in practice.

Chapter 5 
 87 
5 Resolving an ethical dilemma? 
What should you do if you think you mi ght be facing an ethical dilemma? How 
can you decide whether to take action? 
All CIMA students should be able to identify,  explain, resolve or address ethical 
problems. 
If you think something might be unethica l, you will need to think about the 
relevant facts, the ethical issues involv ed, the fundamental principles of CIMA's 
code of ethics that apply and internal  company procedures. You can then 
identify and weigh up alternative c ourses of action, thinking about the 
consequences for those affected. What would be the outcome of going down a 
particular route? How would this compare with the alternatives? 
An ethical dilemma exists when one or more principles of the code are 
threatened. You may have discovered some thing unethical, illegal or fraudulent 
going on where you work, or perhaps you feel that you have been asked to do 
something that compromises your prof essional integrity. Maybe someone is 
putting pressure on you to mislead, or to re port in a way that is inconsistent, or 
goes against accepted accounting standards. 
Conflicts of interest and confidentiality issues are also ethical problems. In 
general, ethical issues should be dealt with by taking actions (called safeguards) to reduce them to a level wher e they are no longer significant or of 
any consequence. 
If you are not sure whether something is  significant, it can help to think about 
what a reasonable third party might think if they had the facts of the situation. 
How would you feel if someone you know discovered how you had acted? 
Would you feel proud or embarrassed by your actions? 
Whether you work in business, the public se ctor, or in practice, the following is a 
process for addressing situations wher e you have discovered possible fraud or 
malpractice or where you feel your prof essional integrity is at risk. If, having 
read this guidance, you are still unsure what to do or would like to talk the matter through, contact CIMA's ethics helpline for more help. 
1 Start by gathering all the relevant information so you can be sure of the 
facts and decide whether there r eally is an ethical problem. 
2 Raise your concern internally. Your manager could be an appropriate 
person to approach, or you could speak  to a trusted colleague. If these are 
not options, consider escalating the issue, such as to your manager's 
boss, to the Board, or perhaps to a non-executive director. There might 
also be an internal grievance or whis tle blowing procedure you can follow. 
If you are in practice, you could rais e your concern with the client, unless 
you suspect money laundering. 
3 If you have raised the issue within the entity, your concerns have not been 
addressed, and you feel that it is a significant or persistent problem, you 
should think about reporting it externally . You could speak to your entity's 
auditors (if you have them) or contac t the relevant trade, industry or 
regulatory authority. Remember that confidentiality still applies, and get 
legal advice to be sure of y our obligations and rights.

88 
4 Finally, if you have exhausted thes e avenues and you are still unable to 
resolve the ethical conflict, you should consider how you could remove yourself from the situation. Someti mes it might be enough to stop working 
with a particular team or client or  to refuse to be associated with a 
misleading report. In the most extr eme cases of significant unethical 
behaviour, however, where this is likely to continue despite your best efforts to resolve it, you may need to  consider resigning. Again, legal 
advice will help to clarify your right s and obligations and should be sought 
before you take the step of resigning. 
Throughout the process, docum ent the steps you take to resolve the issue. For 
example, raise your concern in wr iting and keep copies of relevant 
correspondence. This will allow you to demonstrate how you dealt with the 
problem should you ever need to do so. 
 
Examples of ethical issues 
 Managers face ethical issues all of the time. Examples include: 
 dealing with direct and indirect dem ands for bribes and attempts at 
extortion; 
 dealing with attempts at  unfair competition; 
 expectations of social responsibil ity in relation to society and the 
environment; 
 demand for safety and compliance with legislative standards in 
relation to products and production; 
 honesty in advertising jobs and products; 
 management of closures and redundancies; 
 non-exploitation of countries and people; 
 effects on customer of consuming products; 
 dealing with oppressive governments; 
 fairness in settling pay and work conditions. 
 
 Illustration 1 – Ethical dilemma 
 You work for a large entity as the a ssistant financial controller. One of 
your duties is to reconcile the sale s ledger each month. Every month it 
does not agree and you feel sure it is  associated with irrecoverable debts 
being written off in the individual cu stomer accounts but  not included in 
the nominal ledger. You consider the di fferences to be material and have 
bought this to the attention of t he financial controller but he seems 
unwilling to act. 
Required: 
What action would you take in this situation?

Chapter 5 
 89 
 Solution 
 The main ethical issue is integrity.  It would not be appropriate for an 
accountant to assist someone with a pot entially fraudulent act, or to allow 
misleading information to be presented to others. 
There is also a potential issue of objectivity if you are placed under 
pressure by the financial controll er, as this would mean you have a 
conflict of interest between your per sonal prospects and the requirement 
to behave with integrity. 
The possible actions could be: 
 informing the financial controller of your concern and also formally 
asking the financial controller to address it 
 informing the financial controller that you are going to bring the 
matter to the attention of  the financial director or the audit committee 
It would not be advisable to report exte rnally until legal advice has been 
taken. Hopefully, this situation ca n be resolved with one of the above 
actions. 
 
 Test your understanding 1 – Ethical dilemma 
 You manage a number of trainee accountants whom the entity sponsors 
through training at their first atte mpt at each paper. In June 20X1 you 
employed a final level student who told  you during her interview that she 
did not sit her final exams in May 20X 1 but was going to sit them for the 
first time in November of that year. She had actually sat them in May 
20X1 but worried that she would fail, ta rnishing her record with the entity, 
and also she would not get financial support for her re-sit. She passed her exams in May 20X1. 
Required: 
What action would you take in this matter?

90 
 Test your understanding 2 – Practice questions 
 1 Which of the following is not a fundamental ethical principle 
identified by CIMA? 
A Integrity 
B Objectivity C Confidentiality D Independence 
2 CGMA's code of ethics requires members to comply with five 
fundamental principles. Which of  the following options include 
fundamental principles only? 
A Integrity, objectivity, honesty 
B Professional competence and due care, professional 
behaviour, confidentiality 
C Social responsibility, independence, scepticism D Courtesy, reliability, responsibility 
3 In which of the followi ng situations would the entity be viewed 
as having behaved unethically? 
A Delaying payments to its suppliers despite repeated requests 
to pay 
B Printing warning signs on its potentially dangerous plastic 
packaging 
C Informing investors that the prof its forecasted may not actually 
materialise 
D Stating that it will aim to re cruit more people from ethnic 
minority groups 
4 Mumta thinks it is acceptable to take a "sickie" when she wants 
a day off. Which of the fundament al principles is she flouting?  
B Professional competence and due care C Objectivity D Confidentiality 
5 You have an ethical dilemma.  
What should you do first? 
A Inform the auditors 
B Inform senior management C Inform the appropriate professional body 
D Speak to your immediate supervisor

Chapter 5 
 91 
 6 Monica owns shares in the comp any she works for. Monica receives 
confidential information that could negatively affect the share price 
of her employer.  
What should she do? 
A Talk to her manager and get some advice. 
B Sell her shares immediatel y before she makes a loss. 
C Do nothing. D Report her findings to the newspaper. 
7 Rajesh is being pressured by his employer to change figures in his 
report as it will affe ct his manager's bonus.  
What threat is Rajesh facing? 
A Self-review 
B Intimidation C Advocacy D Confidentiality 
8 Which of the following is not a reason to disclose confidential 
information? 
A Disclosure permitted by law 
B Disclosure as part of required professional duties regarding a 
loan application by t he entity to a bank 
C Disclosure to prevent a fr iend making a financial loss 
D Disclosure as part of professional  duties regarding a legal case 
the entity is dealing with

Chapter 5 
 93 
 The main ethical issue is integrity. 
The new employee has not behaved with integrity by lying, and doing so 
with the deliberate attempt to furthe r her career, and to defraud the entity 
of her examination and tuition fees. Th is must be taken seriously as it 
could suggest that she may not behave wi th integrity in other situations. 
Possible actions could be: 
 the employee should be disciplin ed through the formal corporate 
disciplinary channels, such as  a formal written warning; 
 depending on how serious this is vi ewed, the entity could consider 
dismissal and possible reporting to CIMA. 
 
 1 D 
2 B 
3 A – In situations B and C it is rectifying the results of previous 
doubtful actions. Option D is an example of an entity's ethical aspirations. 
4 A – Mumta is not bei ng honest and truthful 
5 D – your first step should be to report internally to your immediate 
supervisor. If they do not act on your information you would take 
further steps to report higher inter nally and then externally to the 
auditors/professional body. 
6 A – Monica should report her findings to her manager. 
7 B 
8 C

95 
Corporate Governance 
A2. Apply corporate 
governance principles and financial reporting a. Describe the role of the board 
in corporate governance 
 b. Apply corporate governance 
and financial stewardship principles in financial reporting 
  Chapter 
6

96 
1  Session Content 
 
Corporate governance has been around for many years, however in response 
to major accounting scandals (e.g. En ron), regulators sought to change the 
rules surrounding the governance of entit ies, particularly publicly owned ones. 
The purpose was to protect shareholders by giving them more information 
about the entity. 
The US was greatly affected by the "E nron" scandal and decided to use a rules 
based approach driven by the need to be comp liant with legislation, whilst other 
countries, like the UK, decided to us e a principle based approach, enabling 
more flexibility to corporate gov ernance. The UK has seen wide ranging 
economic impacts caused by the over  trading and subsequent liquidation of 
Carillion, with many awarded public sect or contracts unable to be completed  
In the US the Sarbanes Oxley Act (2002)  introduced a set of rigorous corporate 
governance laws and at the same time  the UK Corporate Governance Code 
(previously the Combined Code) introduc ed a set of best practice corporate 
governance initiatives into the UK. 
What is corporate governance? 
 Corporate governance  is the means by which a company is directed and 
controlled . 
The aim of corporate governanc e initiatives is to ensure that entities are run well 
in the interests of their shareholders and the wider community. It concerns such 
matters as: 
 the responsibilities of directors 
 the appropriate composition of the board of directors 
 the necessity for good internal control 
 the necessity for an audit committee 
 relationships with the external auditors.

Chapter 6 
 97 
It is particularly important for publicly  traded entities because large amounts of 
money are invested in them, either by  ‘small’ shareholders, or from pension 
schemes and other financial instituti ons. The wealth of these entities 
significantly affects the health of the economies where their shares are traded. 
 Enron 
 In the year 2000, Enron, a US based energy company, employed 22,000 
people and reported revenues of $101 billion. In late 2001 they filed for 
bankruptcy protection. After a lengthy investigation it was revealed that 
Enron's financial statements were su stained substantially by systematic, 
and creatively planned, accounting fraud. 
Iin the wake of the fraud case the s hares of Enron fell from over $90 each 
to just a few cents each, a numbe r of directors were prosecuted and 
jailed and their auditors, Arthur Anders en, were accused of obstruction of 
justice and forced to stop auditing public  companies. This ruling against 
Arthur Andersen was overturned at a later date but the damage was done 
and the firm ceased trading soon after. 
This was just one of a number  of high profile frauds to  occur at the turn of 
the millennium. 
The Enron scandal is an example of t he abuse of the trust placed in the 
management of publicly traded companies by investors. This abuse of 
trust usually takes one of two forms: 
 the direct extraction from the co mpany of excessive benefits by 
management, e.g. large salaries , pension entitlements, share 
options, use of company assets (jets, apartments etc.) 
 manipulation of the share price by misrepr esenting the company’s 
profitability, usually so that shar es in the company can be sold or 
options ‘cashed in’. 
In response regulators sought to change the rules surrounding the 
governance of companies, particularl y publicly owned ones. In the US the 
Sarbanes Oxley Act (2002) introduc ed a set of rigorous corporate 
governance laws and at the same time  the Combined Code introduced a 
set of best practice corporate gov ernance initiatives into the UK.

98 
 The history of corporate governance 
 The United States 
The collapses of Enron and WorldC om in the United States gave 
renewed impetus to governments to take  action in order to restore public 
confidence in the corporate sector. 
Enron’s problems came about because of unsustainable growth which 
had to be financed through increased borrowing. Following an investigation by the Securities and Exchange Commission, it became 
clear that, in order to hide its ex cessive borrowing and thus maintain 
confidence in its stock, Enron effectively created a number of 
subsidiaries, each a legal entity in  its own right, for the purpose of 
keeping Enron’s borrowing off its bal ance sheet and thus maintaining its 
creditworthiness.  
In December 2001, Enron filed for protection under Ch apter 11 of the 
United States Bankruptcy Code with debts of approximately $3 billion. 
The investigation also revealed that the persons primarily responsible for 
Enron’s fraud and subsequent collapse were the directors, chief executives and the company’s auditors. 
To date there have been guilty pleas in relation to fraud, money 
laundering and insider dealin g by Enron executives and a plea of guilty to 
obstructing justice by destroying En ron-related documents by Arthur 
Andersen, Enron's lead auditor. As may be imagined, the collapse of such a large corporation as Enron and the criminal activities revealed led 
to attention being given to the e ffectiveness of corporate governance 
measures. 
The Sarbanes-Oxley Act was passed in July 2002 seeking to protect 
investors by improving the accuracy of corporate disclosure and reporting 
procedures and increasi ng corporate openness. 
In addition, it had become clear that  in many cases the relationship 
between corporations and their auditors was far too close. Auditors are 
required to carry out their work in dependently of the interests of the 
company’s board or senior executiv es and to provide a check for the 
benefit of the shareholders. Howeve r, the auditors of Enron had 
conspired with the company in attempts  to remove excessive debt from 
the Enron accounts. In practice, the independence of the auditors was 
compromised by the fact that they also received fees from the company 
for acting as financial consultants.  
As a result, the Sarbanes-Oxley Act created the Public Company 
Accounting Oversight Board which is charged with the task of policing the 
auditing of public companies in the Un ited States. All auditors of public 
companies must be registered with t he board which is required to set up 
quality assurance procedures, ethi cs and independent standards to which 
auditors are required to adhere. The Act also prohibits auditors from providing certain non-audit services to the companies for which they act.

Chapter 6 
 99 
 In addition, the Act requires the separat e disclosure of the fees received 
by auditors for audit and all other fees . It follows that the independence of 
the scrutinisers is now also subject to scrutiny! 
The United Kingdom 
In the United Kingdom, there were a number of scandals involving the 
likes of Guinness and Robert Ma xwell and these highlighted the 
continuing ability of directors to in volve public entities in mismanagement. 
These scandals and high-profile  entity frauds made it clear that effective 
control of the directors of public companies was not being carried out by 
the shareholders, with the result that government s and regulators have 
had to look to other means for ef fective control mechanisms. More 
recently further high profile cases which question the effectiveness of 
principle-based approaches to co rporate governance regulation have 
occurred (e.g. the BHS pension scandal). 
Corporate governance of public list ed entities was the subject of 
numerous reports prepared in t he 1990s, including Cadbury and 
Greenbury, which culminated in the issue of the Combined Code. This was later developed into the first dr aft of the UK Corporate Governance 
Code in 1998. 
Europe 
In 2003, the European Commission announc ed that it did not believe it 
necessary to formulate a separate code of European corporate governance. Rather such matters could safely be left to individual member states. However, it did see the need for a common approach to 
be taken in regard to fundamental governance issues throughout the 
European Union. These are to be devel oped over time through the issue 
of Directives. Thus such matters as the greater involvement in management of independent non-executive directors, more information 
regarding directors’ remuneration and gr eater disclosure of and access to 
other financial information should fo rm the basis of the corporate 
governance of all EU member states. It remains to be seen how this will 
be affected by the implications of Brexit, both in Europe and in the UK.

100  
3 Approaches to corporate governance 
There are different approaches  to corporate governance. 
 
 A rules-based approach instils the code into law with appropriate penalties 
for transgression. 
 A principles-based approach requires t he entity to adhere to the spirit 
rather than the letter of the code. The entity must either comply with the 
code or explain why it has not thr ough reports to the appropriate body and 
its shareholders. 
The UK model is a principles-based  one, although since adherence is part of 
stock exchange listing require ments it cannot be consi dered to be voluntary for 
large entities. 
The US model is enshrined into law by virtue of Sarbanes Oxley Act (SOX). It 
is, therefore, a rules-based approach. 
Choice of governance regime  
The decision as to which approach to use for a country can be governed by 
many factors: 
 dominant ownership structure (bank,  family or multiple shareholder) 
 legal system and its power/ability 
 government stru cture and policies 
 state of the economy 
 culture and history 
 levels of capital inflow or in vestment coming into the country 
 global economic and political climate. 
Comply or explain 
A principles-based code requires the entity to state that it has complied with the 
requirements of the code or to explai n why it could not do so in its annual 
report. This will leave shareholders to draw  their own conclusions regarding the 
governance of the entity.

Chapter 6 
 101 
4 Rules-based approach to  corporate governance 
A rules-based approach instils the code into  law with appropriate penalties for 
transgression. An example is the Sar banes-Oxley regulations applicable in the 
US.  
 
 Sarbanes-Oxley (SOX) 
 In 2002, following a number of cor porate governance scandals such as 
 SOX is a rules-based approach to governance. 
 SOX is extremely detailed and carr ies the full force of the law. 
 SOX includes requirements for the Securities and Exchange 
Commission (SEC) to issue certai n rules on corporate governance. 
 It is relevant to US companies, directors of s ubsidiaries of US-listed 
businesses and auditors who are wo rking on US-listed businesses.

102  
 Arguments in favour of a rules-based approach (and against a 
principles-based approach)  
Organisation’s perspective: 
 Clarity in terms of what the ent ity must do – the rules are a legal 
requirement, clarity should exist and hence no interpretation is required. 
 Standardisation for all companies – ther e is no choice as to complying or 
explaining and this creates a sta ndardised and fairer approach for all 
 Binding requirements – non-complianc e breaks laws and is considered a 
crime making it very clear that the rules must be complied with. 
Wider stakeholder perspective: 
 Standardisation across all companies – a level playing field is created. 
 Sanction – the sanction is criminal and therefore a greater deterrent to 
transgression. 
 Greater confidence in regulatory compliance. 
Arguments against a rules-based approach (and in favour of a 
 Exploitation of loopholes – the exacting nature of the law l ends itself to the 
manipulation of loopholes. 
 Underlying belief – the belief is that you must only play by the rules set. 
There is no suggestion that you should want  to play by the rules (i.e. no 
'buy-in' is required). 
 Flexibility is lost – there is no choice  in compliance to reflect the nature of 
the organisation, its size or stage of development. 
 Checklist approach – this can arise as  companies seek to comply with all 
aspects of the rules and start ‘box-ticki ng’ leading to inefficient practices. 
‘Regulation overload’ – the volume of ru les and amount of legislation may give 
rise to increasing costs for businesses and for the regulators. 
Legal costs – to enact new legi slation to close loopholes. 
Limits – there is no room to improv e, or go beyond the minimum level set. 
‘Box-ticking’ rather th an compliance – this does not lead to well governed 
organisations.

Chapter 6 
 103 
5 Principles-based approach  to corporate governance 
Best practice – policies and procedure 
The UK uses a principle based approac h to corporate governance which is 
required for listed entities but guidance for other entities. Entities should either 
comply or explain why t hey haven't applied the code 
Obviously, best practice is intricately tied up with the size and resources of the 
entity in question. For listed entities, the most important  issues of best practice 
are contained in the UK Corporate Gove rnance Code. This was first issued in 
1998 and has been updated at regular intervals since then. 
The UK Corporate Governance Code can be  seen in full on the FRC website at: 
https://www.frc.org.uk/Our-Work/Codes -Standards/Corporate-governance/UK-
Corporate-Governance-Code.aspx  
The Code is not a rigid (or enforced) set of rules. Instead it consists of principles 
(main and supporting) and provisions.  
In the UK all entities quoted on the stock exchange have to comply with the 
FSA listing rules and these include a requirem ent that all entities include in their 
annual report: 
 a statement of how the entity has applie d the main principles set out in the 
Code, and 
 a statement as to whether the ent ity has complied with all relevant 
provisions set out in the Code. 
The main provisions of the Code are: 
 Every entity should be headed by an effective board with collective 
 There should be a clear division of  responsibilities between the Chairman 
and the Chief Executive. 
 No one individual should have unfettered powers of decision. 
 Non-executive directors should constr uctively challenge and help develop 
proposals on strategy. 
Effectiveness 
 The board should have the appropriate balance of skills, experience, 
independence and knowledge. 
 There should be a formal, rigor ous and transparent procedure for the 
appointment of new directors. 
 All directors should receive induction and should regularly update and 
refresh their skills and knowledge. 
 The board should be supplied with quality and timely information to enable 
it to discharge its duties.

104  
 The board and individuals should be subject to a formal and rigorous 
annual evaluation of performance. 
 All directors should be submitted fo r re-election at regular intervals. 
 The board should present a fair, balanced a nd understandable 
assessment of the entity's position and prospects. 
 The board is responsible for deter mining the nature and extent of the 
significant risks it is willing to take in achieving its st rategic objectives. 
 The board should maintain sound ri sk management and internal control 
systems. 
 The board should establish formal and transparent arrangements for 
corporate reporting and risk management  and internal control principles 
and for maintaining an appropriate rela tionship with the entity's auditor. 
Remuneration 
 This should be sufficient to attract, retain and motivate directors of the 
quality required to run the entity succe ssfully, but should not be excessive. 
 This should be structured so as to  link a significant proportion of the 
rewards to corporate and individual performance. 
 There should be a formal and trans parent procedure for developing policy 
on executive remuneration. 
 No director should be involved in dec iding his or her own remuneration. 
Relations with Shareholders 
 There should be a dialogue with shareholders based on the mutual 
understanding of objectives. 
 The board as a whole has responsibilit y for ensuring that a satisfactory 
dialogue with shareholders takes place. 
 The board should use the AGM to communicate with investors and to 
encourage their participation. 
 
 The OECD Principles of Corporate Governance 
 The OECD consists of 34 countries  who want a free market economy 
with one set of rules fo r corporate governance. 
Although there have always been well r un entities as well as those where 
scandals have occurred, the fact that  scandals do occur has led to the 
development of codes of practi ce for good corporate governance. 
Often this is due to pressures exert ed by stock exchanges. In 1999 the 
Organisation for Economic Co- operation and Development, OECD, 
assisted with the development of t heir 'Principles of Corporate

Chapter 6 
 105 
 Governance.' These were intended to: 
 assist member and non-member gov ernments in their efforts to 
evaluate and improve the legal, institutional and regulatory 
framework for corporate gover nance in their countries. 
 provide guidance and suggestions fo r stock exchanges, investors, 
corporations, and other parties that  have a role in the process of 
developing good corporate governance. 
The OECD principles were first published in 1999 and were revised in 
2004. Their focus is on publicly traded entities. However, to the extent 
they are deemed applicable, they are a useful tool to improve corporate 
governance in non-traded entities. 
There are six principles, each backed up by a number of sub principles. 
The principles, and those sub-principl es relevant to the auditor, are 
reproduced on the following page.

106  
 The principles in detail 
 Structure of the Principles  
The six Principles: 
(i) Ensuring the basis for an effective corporate governance 
framework  
The corporate governance framew ork should promote transparent 
and efficient markets, be consistent  with the rule of law and clearly 
articulate the division of responsib ilities among different supervisory, 
regulatory and enforcement  authorities. In other words, making sure 
everyone involved is aware of their individual responsibilities so no 
party is in doubt as to what they are accountable for. 
(ii) The rights of shareholders and key ownership functions 
The corporate governance framewor k should protect and facilitate 
the exercise of shareholders’ rights . The directors are the stewards 
of the entity and should be acting in the best interests of the 
shareholders. However, the exist ence of the cor porate collapses 
mentioned above proves that this  isn't always the case and 
shareholders need protecting from such people. 
(iii) The equitable treatment of shareholders  
The corporate governance framew ork should ensure the equitable 
treatment of all shareholders, including minority and foreign 
shareholders. All shareholders should have the opportunity to obtain effective redress for violation of their rights. 
(iv) The role of stakeholders in corporate governance  
The corporate governance framework should recognise the rights of 
stakeholders established by law or through mutual agreements and 
encourage active co-operation between corporations and 
stakeholders in creating wealth , jobs, and the sustainability of 
financially sound enterprise. 
(v) Disclosure and transparency 
The corporate governance framework should ensure that timely and 
accurate disclosure is made on all material matters regarding the 
corporation, including the fi nancial situation, performance, 
ownership and governance of the entity. Theref ore, the annual 
financial statements should be pr oduced on a timely basis and 
include all matters of interest to the shareholders. For any matters of 
significance arising during the y ear, these should be communicated 
to the shareholders as appropriate.

Chapter 6 
 107 
 (vi) The responsibilities of the board 
The corporate governance framewor k should ensure the strategic 
guidance of the entity, the effect ive monitoring of management by 
the board, and the board’s account ability to the entity and the 
shareholders. The introduction of audit committees and non-executive directors on the board is  the usual way for monitoring 
management. Non-executive directors ar e not involved in the day to 
day running of the entity and are therefore more independent. They 
can evaluate the effectiveness of the executive board on its merits 
and make sure they are carry ing out their duties properly. 
 
 The status of the OECD principles 
  The Principles represent a common basis that OECD Member 
countries consider essential for the development of good 
governance practice. 
 They are intended to be concise,  understandable and accessible to 
the international community. 
 They are not intended to be a subs titute for government or private 
sector initiatives to develop mo re detailed ‘best practice’ in 
6 Corporate governance in action 
Corporate governance guidance generally  incorporates the following:

108  
The role of the board 
 From the principles in the UK Cor porate Governance Code (2016), the key 
roles and responsibilities of directors are to: 
 provide entrepreneurial l eadership of the company 
 represent company view and account to the public 
 decide on a formal schedule of matters  to be reserved for board decision 
 determine the company’s missi on and purpose (strategic aims) 
 select and appoint the CEO, c hairman and other board members 
 set the company’s values and standards 
 ensure that the company’s managem ent is performing its job correctly 
 establish appropriate internal cont rols that enable risk to be assessed and 
managed 
 ensure that the necessary financial and human resources are in place for 
the company to meet its objectives 
 ensure that its obligations to its shareholders and other stakeholders are 
understood and met 
 meet regularly to discharge its duties effectively 
 for listed companies: 
– appoint appropriate NEDs 
– establish remuneration committee – establish nominations committee – establish audit committee 
 assess its own performance and report it annually to shareholders 
 submit themselves for re-election at regular intervals. All directors in FTSE 
350 companies should be put forwar d for re-election every year. 
 Independence of the board 
The Code states as a principle that the board should include a balance of NEDs 
and executives. This is to reduce an unfavourable balance of power towards 
executives. 
The board should consist of half indepen dent NEDs excluding the chair. 
One NED should be the senior  independent director who is directly available to 
shareholders if they have concerns whic h cannot or should not be dealt with 
through the appropriate channels of c hairman, CEO or finance director. 
The primary fiduciary duty that NEDs owe is to the company’s shareholders. 
They must not allow themselves to be captured or unduly influenced by the 
vested interests of other members of the company such as executive directors, 
trade unions or middle management.

Chapter 6 
 109 
There are also concerns over the recr uitment of NED’s and the challenge that 
this may bring to independence. 
Recruiting those with previous industry  involvement can result in a higher 
technical knowledge, a network of c ontacts and an awarene ss of what the 
strategic issues are within the industry. While these might be of some benefit to 
a NED’s contribution, they can ma ke the NED less independent as prior 
industry involvement might also reduce the NED’s ability to be objective and 
uncontaminated by previously held views. 
Accordingly, it is sometimes easie r to demonstrate independence when NEDs 
are appointed from outside the industry. 
In practice, many companies employ a mix of NEDs, and it is often this blend of 
talents and areas of expertise that makes a non-executive board effective. 
Reasons for NED independence 
 To provide a detached and objective view of board decisions. 
 To provide expertise and communicate effectively. 
 To provide shareholders with an independent voice on the board. 
 To provide confidence in corporate governance. 
 To reduce accusations of self-inter est in the behaviour of executives. 
Segregation of Roles 
Best practice recommends that the ro les of Chairman and Chief Executive 
Officer should be held be different people to reduce the power of prominent board members. 
Committees 
The committees act as a control mechanism by having specialists to coordinate 
internal and external auditors, deal wit h remuneration, risk and nominations. 
Internal audit 
Internal audit departments are employees  of the entity who conduct audit 
procedures as per the instruct ions of the directors. They  typically investigate the 
performance and effectiveness of internal  control systems wit hin the entity. 
They will recommend improvements to pr ocesses with the aim of reducing risk 
of fraud or error.

110  
 Further detail  
 Audit Committees 
An audit committee is a committee cons isting of non-executive directors 
which is able to view an entity's affairs in a detached and independent 
way and liaise effectively between t he main board of directors and the 
Best practice for listed entities: 
 The entity should have an audit co mmittee of at least three non- 
executive directors (or, in the case of smaller entities, two). 
 At least one member of the audi t committee should have recent and 
relevant financial experience. 
The objectives of the audit committee 
 Increasing public confidence in t he credibility and objectivity of 
published financial information (i ncluding unaudited interim 
statements). 
 Assisting directors (particularly ex ecutive directors) in meeting their 
responsibilities in respec t of financial reporting. 
 Strengthening the inde pendent position of an entity's external 
auditor by providing an addition al channel of communication. 
The function of the audit committee 
 Monitoring the integrity of  the financial statements. 
 Reviewing the entity's inte rnal financial controls. 
 Monitoring and reviewing the effe ctiveness of the internal audit 
function. 
 Making recommendations in relation to the appointment and 
removal of the external audi tor and their remuneration. 
 Reviewing and monitoring the ex ternal auditor’s independence and 
objectivity and the effectiveness of the audit process. 
 Developing and implementing policy on the engagement of the 
external auditor to supply non-audit services. 
 Reviewing arrangements for conf idential reporting by employees 
and investigation of possible impr oprieties (‘whistleblowing’).

Chapter 6 
 111 
 Benefits: 
 Improved credibility of  the financial statement s, through an impartial 
review of the financial statement s, and discussion of significant 
issues with the external auditors. 
 Increased public confidence in the audit opinion, as the audit 
committee will monitor the independenc e of the external auditors. 
 Stronger control environment, as the audit committee help to create 
a culture of compliance and control. 
 The internal audit function will report to the audit committee 
increasing their independence and adding weight to their 
recommendations. 
 The skills, knowledge and experi ence (and independence) of the 
audit committee members can be an invaluable resource for a 
business. 
 It may be easier and cheaper to a rrange finance, as the presence of 
an audit committee can give a perception of good corporate 
 It would be less burdensome to meet  listing requirements if an audit 
committee (which is usually a li sting requirement) is already 
established. 
Problems: 
 Difficulties recruiting the right  non-executive directors who have 
relevant skills, experience and suffi cient time to become effective 
members of the committee. 
 The cost. Non-executive director s are normally remunerated, and 
their fees can be quite expensive. 
Internal controls and risk management  
One way of minimising risk is to in corporate internal controls into an 
entity's systems and procedures. 
It is the director's respons ibility to implement internal controls and monitor 
their application and effectiveness. 
Auditors are not responsible for t he design and implementation of their 
clients' control systems. Auditors have to assess the effectiveness of 
controls for reducing the risk of mate rial misstatement of the financial 
statements. They incorporate this into their overall risk assessment, 
which allows them to design their further audit procedures.

112  
 1 An entity using a rules-based approach to corporate 
governance means ..... 
A the entity must legally apply the rules. 
B the entity does not have to legally apply the rules but must 
disclose if not applied. 
C the entity does not have to legally apply the rules and need not 
D the entity can ignore the rules. 
2 An entity using a principle- based approach to corporate 
governance, such as the UK Corporate Governance Code, 
means ..... 
A the entity must comply with a di stinct list of legally enforceable 
rules 
B the entity should either comply wit h the principles if the code or 
explain why they haven't applied the code 
C the entity must be a listed company 
D the entity can ignore set regulat ions and apply governance in a 
fashion serving the best inte rests of the directors. 
3 Corporate governance rules were strengthened to:  
A protect shareholders. B protect directors. C protect auditors. D protect employees. 
4 Corporate Governance guidance in cludes the need for segregation 
of duties. 
A practical example of the appl ication of segregation of duty 
principles in the context of  corporate governance would be:  
A the roles of the chairman and CEO are held by different people 
to reduce the power of prominent board members. 
B the roles of employees ar e segregated to prevent fraud. 
C the auditors are independent to employees. D only 1 non-executive director can be on the audit committee.

Chapter 6 
 113 
 5 Corporate governance rules suggests committees should be used 
within an entity.  
Which of the following is NOT a corporate governance driven 
committee? 
A Nominations 
B Audit C Remuneration 
D Leadership

Chapter 6 
 115 
 1 A 
2 B 
The Corporate Governance Code is  not rules based and so A is 
incorrect. 
The principles of the Corporate Governance Code must be followed 
by listed entities but give best prac tice principles that can be applied 
voluntarily by private entities.  Therefore, C is incorrect. 
Principle–based governance codes are not to be applied to ensure 
the directors best interests. If this  was the aim then ethical issues 
would arise and would reduce the credibility corporate governance 
3 A 4 A 
Segregation of duties for employees  does prevent fraud but would 
only be considered part of corporate governance best practice if the segregation involved the dire ctors and board members. B is 
Independence of the auditor from an entity is an auditing ethical 
standard issues rather than relating to corporate governance. It is 
the responsibility of the audit fi rm to ensure independence not the 
entity being audited. As a result C is incorrect. 
The audit committee should consist of only non-executive directors 
and should consist of at least 3 members (or 2 for SMEs). 
5 D

117 
The Conceptual 
Framework 
 
B1 Identify the main elements 
of financial statements a. Identify the ma in elements of 
financial statements contained in the IFRS conceptual framework 
 
  Chapter 
7

The Conceptual Framework 
118  
 
Over time, transactions that entitie s enter into have become increasingly 
complex. Although the detail of the trans actions may vary from situation to 
situation the basic accounting issues ar e often the same. As a result, the IASB 
developed a conceptual fram ework, which lays out t he broad principles that 
should be applied when developing accounting standards and when 
determining an appropriate accounting treatment, 'The Conceptual 
Framework for Financial Reporting'  (the Framework). 
 
 The Framework needs to be regularly updated to keep abreast with 
current market issues and transactions. In March 2018 a new version was issued. Knowledge of the contents of the new Fr amework is testable 
within the 2019 CIMA F1 syllabus. 
3 Purpose and status of the Framework 
According to the Framework, its purpose is to: 
 assist the International Accountin g Standards Board (Board) to develop 
IFRS Standards (Standards) that are based on consistent concepts 
 assist preparers to develop cons istent accounting policies when no 
IFRS Standard applies to a particular transaction or other event, or when 
an IFRS Standard allows a choice of accounting policy 
 assist all parties to underst and and interpret IFRS Standards. 
The Framework is not an accounti ng standard and does not override the 
requirements of any IFRS Standards.

Chapter 7 
 119 
 4 What does the Framework cover? 
The Framework covers the following topics: 
 The objectives of general purpose financial reporting 
 Qualitative characteristics of useful financial information 
 Financial statements a nd the reporting entity 
 The elements of t he financial statements 
 Recognition and derecognition 
 Measurement 
 Presentation and disclosure 
 Concepts of capital and capital maintenance. 
This chapter covers each of these individual areas in detail. 
 5 Objectives of general purpose financial reporting 
The objective of financial reporting is to provide information about the reporting 
entity that is useful to users in making decisions relating to providing resources 
to the entity. 
Users of the financia l statements include: 
– existing and potential investors – lenders – other creditors. Decisions relating to providing resource s to an entity include whether or not to: 
– buy, sell or hold equit y and debt instruments 
– provide or settle loans and other forms of credit – exercise the rights to vote on, or otherwise influenc e, management’s 
actions that affect the use of the entity’s economic resources. 
To make such decisions, users will ne ed information regarding the performance 
(profits), position (asset levels and cl aims against the entity), adaptability and 
prospects of an entity. This enables a ssessment of the st ewardship of the 
directors and their utilisation of the entit y’s resources. Financial reports can 
provide significant elem ents of this detail.

120  
6 Qualitative characteristics of  useful financial information 
For information to be useful it must possess the qualitative characteristics 
outlined in the Framework. 
The Framework splits qualitative char acteristics into two categories: 
(i) Fundamental qualitative characteristics – ‘ must have’  characteristics.  
– Relevance – Faithful representation 
(ii) Enhancing qualitativ e characteristics – ‘ would be nice to have’  
characteristics. 
– Comparability  – Verifiability – Timeliness – Understandability. 
Fundamental qualitative characteristics 
(i) Relevance 
Information is relevant when it influences the economic decisions of users 
by helping them evaluate past, present or  future events or confirming or 
correcting their past evaluations. 
The relevance of information can be a ffected by its nature and materiality. 
Some items may be relevant to users simply because of their nature whereas some items may only become relevant once they are material. 
Hence, materiality is a threshold for t he quality of information rather than a 
primary characteristic in its own right. 
According to the Framework, informati on is material if its omission or 
misstatement could influence the decisions of users. 
Materiality  
Materiality is an entity specific as pect of relevance and depends on the 
size of the item or error judged in the context of the entity’s specific 
financial statements. Mate riality will take differ ent forms and values for 
different entities and, as a result, the Framework does not attempt to 
quantify it.  
 (ii) Faithful representation 
If information is to represent faithfu lly the transactions and other events 
that it purports to represent, they  must be accounted for and presented in 
accordance with their substance and ec onomic reality and not merely their 
legal form. This is described as the concept of applying substance over 
form.

Chapter 7 
 121 
To be a perfectly faithful repres entation, financial information would 
possess the following characteristics: 
Completeness 
To be understandable information must  contain all the necessary 
descriptions and explanations. 
Neutrality 
Information must be neutra l, i.e. free from bias . Financial statements are 
not neutral if, by the selection or pres entation of information, they influence 
the making of a decision or judgement in order to achieve a predetermined 
result or outcome. 
Neutrality is underpinned by the application of prudence . Prudence is an 
accounting mind-set which favours cauti on in situations of uncertainty and 
judgement. Practically applications of  prudence can lead to judgemental 
liabilities being recorded more readily than uncertain assets.  
Free from error 
Information must be free from error within the bounds of materiality. A 
material error or an omission can c ause the financial st atements to be 
false or misleading and thus unrelia ble and deficient in terms of their 
relevance. 
Free from error does not mean perfectly accurate in all respects. For 
example, where an estimate has been used the amount must be 
described clearly and accurately as being an estimate. This phenomena is described as measurement uncertainty . 
Enhancing qualitative characteristics  
There are 4 enhancing characteristics ident ified by the Framework. They are: 
(i) Comparability 
Users must be able to compare financia l statements over a period of time 
in order to identify trends in fi nancial position and performance. Users 
must also be able to compare financial statements of different entities to 
be able to assess their relative financial position and performance. 
In order to achieve comparability, si milar items should be treated in a 
consistent manner from one period to  the next and from one entity to 
another. However, it is not appropriate for an entity to continue accounting 
for transactions in a certain manner if  alternative treatments exist that 
would be more relevant and reliable. 
Disclosure of accounting policies shoul d also be made so that users can 
identify any changes in these policies or differences between the policies 
of different entities.

122  
(ii) Verifiability 
Verifiability occurs if information can be independently confirmed or 
verified by knowledgeable third partie s e.g. could the information be 
audited?  
Verification can be direct or indire ct. Direct verification means verifying 
through direct observation i.e. counting cash. 
Indirect verification means checking the inputs (items included in the 
financial information) to a model , formula or other technique and 
recalculating the outputs (an expected value) using the same methodology 
and then comparing the result i.e. re calculating inventory amounts using 
the same assumption used by an entity su ch as first-in, first-out method. 
(iii) Timeliness 
Timeliness means having information available to decision makers in time 
to be capable of influencing their decisions. Generally, the older the 
information is the less useful it becomes. 
(iv) Understandability 
Information needs to be readily underst andable by users. Information that 
may be relevant to decision making should not be excluded on the 
grounds that it may be too difficult  for certain users to understand. 
Understandability depends on: 
 the way in which information is presented; and 
 the capabilities of users. 
It is assumed that users: 
 have a reasonable knowledge of bus iness and economic activities; 
and 
 are willing to study the info rmation provided with reasonable 
diligence. 
For information to be understandable user s need to be able to perceive its 
significance. 
7 Financial statements and the reporting entity 
The first two chapters of the Framew ork outline issues regarding general 
purpose financial information. The rema ining chapters cons ider the financial 
statements specifically.  
The Framework states that ‘ financial statements provide information about 
economic resources of the reporting enti ty, claims against the entity, and 
changes in those resources and claims, that meet the definitions of the 
elements of financial statements’ (Conceptual Framework para 3.1).

Chapter 7 
 123 
 Objectives of fina ncial statements 
 ‘The objective of financial statem ents is to provide financial 
information about the reporting en tity’s assets, liabilities, equity, 
income and expenses that is useful to users of financial statements 
in assessing the prospects for future net cash inflows to the reporting entity and in assessing mana gement’s stewardship of the 
entity’s economic resources’ (Conceptual Framework, para 3.2). 
That information is provided: 
– in the statement of  financial position, by recognising assets, 
liabilities and equity 
– in the statement of  financial performance by recognising income 
and expenses 
– in other statements (statement of  cash flows, statement of changes 
in equity) and notes. 
Going concern assumption 
The Framework states ‘ financial statements are normally prepared on the 
assumption that the reporting entity is  a going concern and will continue 
in operation for the foreseeable future ’ (Conceptual Framewor k, para 3.9).  
The foreseeable future is not strictly defined but can be gener ally considered as 
being a period of greater  than 12 months. The fi nancial statements are 
prepared under the assumption that the ent ity neither has an intention nor the 
need to liquidate or significantly r educe the scale of its operations.  
If the business was not deemed to be a going  concern, the fi nancial statements 
would be prepared on the break-up basis e.g. all assets are valued using 
realisable values and no ‘non-curr ent’ classifications can be used 
 The accruals concept  is no longer consider ed to be an underlying 
assumption of the financial statements.  However, it is still considered by 
the Framework as an im portant concept used wit hin general purpose 
financial information. 
The accruals concept states events should be dealt with in the accounting 
period they occur, rather than the period in which cash flows occur. 
The reporting entity 
The Framework defines a reporting entity as an entity that chooses to or is 
required to prepare fi nancial statements. 
A reporting entity can be a singl e entity or can comprise of more than one entity. 
If an entity (parent) has cont rol over another entity (subs idiary), two options for 
the preparation of the financ ial statements exist. If a reporting entity comprises 
both the parent and its subsidiaries, the reporting entity’s financial statements 
are referred to as ‘consolidated financial st atements’. If a repo rting entity is the 
parent alone, the reporting entity’s financial statements  are referred to as 
‘unconsolidated financial statements’.

124  
 8 The elements of financial statements 
The elements of financ ial statements are: 
 Assets 
 Liabilities 
 Equity 
 Income 
 Expenses.  
 
 Assets 
The Framework defines an asset as  'a present economic resource 
controlled by the entity as a result of past events. 
An economic resource is a right that has the potential to produce 
economic benefits’ (Conceptual Framework, para 4.2).  
 
 Liabilities 
The Framework defines a liability as  'a present obligation of the entity 
to transfer an economic resource as a result of past events’ 
(Conceptual Framework, para 4.2).  
Equity 
The Framework defines equity as 'the residual interest in the assets of the 
entity after deducting all its liabilities' (Conceptual Framework, para 4.2). 
Income 
The Framework defines income as 'increases in assets or decreases in 
liabilities that result in increases in equity, other than those relating to 
contributions from equity participants'  (Conceptual Framew ork, para 4.2). 
Examples include sales, gains on dispos al of non-current assets and unrealised 
gains. 
Expenses 
The Framework defines expenses as 'decreases in assets or increases in 
liabilities that result in  decreases in equity, other than those relating to 
distributions to equity participants' (Conceptual Framework, para 4.2). 
Examples include expenses that arise in the ordinary course of activities (such 
as wages, purchases and depreciation) and losses (such as losses on disposal of non-current assets and unrealised lo sses e.g. losses on revaluation).

Chapter 7 
 125 
 Assets, liabilities an d equity interest 
 Assets 
economic benefits’ To explain further the parts  of the definition of an 
asset: 
 Right  – a right that generates economic resource could take many 
forms. For instance, an entity may hav e the right to receive cash, to 
receive goods or services or to use an asset. Rights are often created through contracts and legisl ation but can also be created 
through another entity’s past practice. 
 Potential to produce future economic benefit  – The right must 
have the potential for economic resource. 
 For that potential to exist, 
it does not need to be certain, or  even likely, that the right will 
produce economic benefits. It is only necessary that the right 
already exists and that, in at least one circumstance, it would 
produce for the entity economic b enefits beyond those available to 
all other parties. However, whether the resource is recognised as an 
asset is dependent upon the recogniti on criteria outlined within the 
Framework (see section 9 below).  
  Control  – An entity controls an econom ic resource if it has the 
present ability to direct the use of the economic resource and obtain 
the economic benefits that may flow from it. Cont rol is the ability to 
obtain the economic benefits and to restrict the access to others 
(e.g. by an entity being the sole user  of its plant and machinery, or 
by selling surplus plant and machinery). An asset does not have to be legally owned, the key factor is  whether the entity has control 
over the future economic benefits that  the item will provide. A leased 
vehicle could therefore be an asset. 
Liabilities  
to transfer an economic resource as a result of past events’  
For a liability to exist all three of the following will be satisfied: 
 Obligation  –
 An obligation is a duty or responsibility that an entity 
has no practical ability to avoid. These may be legal or constructive. 
A constructive obligation is an obl igation which is the result of 
expected practice rather than requ ired by law or legal contract. 
 Transfer of economic resource  – this could be a transfer of cash, 
of other property or the provision of a service.

126  
  Present obligation as a result of  past events – a present 
obligation exists as a result of past events only if: 
– the entity has already obtained economic benefits or taken an 
action and, 
– as a consequence, the entity may have to transfer an 
economic resource that it w ould not otherwise have had to 
transfer. 
e.g. acceptance of a loan into an ent ity’s bank account creates the right 
to demand repayment of the balance and, as such, a liability exists. 
Equity 
Equity is the residual amount after deduc ting all liabilities of the entity 
from all of the entity's assets. 
Equity may be sub-classified in t he financial statements into share 
capital, retained earnings and other reserves. 
9 Recognition and derecognition 
According to the Framew ork, recognition is ‘ the process of capturing for 
inclusion in the statement of financ ial position or the statement(s) of 
financial performance an item that meets the definition of one of the 
elements of financial statements – an  asset, a liability, equity, income or 
expenses’ (Conceptual Framework, para 5.1). 
Recognition criteria 
To be recognised in the financ ial statements,  items must: 
– meet the definitions of  one of the elements  of the financ ial statements 
– provides  relevant  information regarding the particular element 
– provides a faithful representation  of the particular element 
Relevance 
Indications that the informa tion regarding an element is not relevant  include: 
– it is uncertain whether an asset or liability exists or, – an asset or liability exists, but the pr obability of an inflow or outflow of 
economic benefits is low 
Faithful representation 
Whether the information regarding an element would provide a faithful 
representation is linked to the ability to  measure the element. If there is very 
high measurement uncertainty  (e.g. an exceptionally wide range of possible 
outcomes with probabilities t hat are exceptionally difficu lt to estimate) then it 
could be argued that the inclusion of the element would not provide a faithful 
representation.

Chapter 7 
 127 
Derecognition 
Derecognition is the removal of all or par t of a recognised asset or liability from 
an entity’s statement of fi nancial position. Derecognition normally occurs when 
that item no longer meet s the definition of an asset or of a liability. 
Asset  
Derecognition normally occurs when the entit y loses control of all or part of the 
recognised asset. 
Liability 
Derecognition normally occurs when the entity no longer has a present 
obligation for all or part of  the recognised liability. 
10 Measurement of the elements of financial statements 
The Framework requires t hat the elements recognis ed in financial statements 
are quantified in monetary terms. This r equires the selection of a measurement 
basis. 
There are a number of different ways of  measuring the elements including: 
Historical cost 
Historical cost measures provide monetar y information derived fr om the price of 
the transaction at the date the transaction occurs.  
Unlike current value, historical cost does not reflect changes in values, except 
to the extent that those changes relate to impairment of an asset (which would 
reduce the asset) or a liability becom ing onerous (which would increase the 
liability). 
Asset 
The historical cost of an asset is the va lue of the costs incurred in acquiring or 
creating the asset, comprising the consi deration paid plus transaction costs.  
Liability 
The historical cost of a lia bility is the value of the c onsideration received to incur 
or take on the liability minus transaction costs. 
Current value 
Current value measures provide monet ary information about assets, liabilities 
and related income and expenses, us ing information updated to reflect 
conditions at the measurement date. 
Current value measurement bases include: – Fair value – Value in use – Current cost.

128  
Fair value 
Fair value is the price that would be rece ived to sell an asset, or paid to transfer 
a liability, in an orderly transaction between market participants at the 
measurement date. 
Value in use and fulfilment values 
Assets can use the value in use  as a measurement basis. Value in use is the 
present value of the cash flows, or other economic benefits, which an entity 
expects to derive from t he use of an asset and from its ultimate disposal. 
Liabilities can use the fulfilment value  as a measurement basis. Fulfilment 
value is the present value of the cash, or other economic resources, that an 
entity expects to be obliged to trans fer as it fulfils a liability. 
Current cost 
The current cost of an asset is the cost  to acquire an equivalent asset at the 
measurement date, plus t he transaction costs that would be incurred at that 
date.  
The current cost of a liability is the consideration that would be received for an 
equivalent liability at the measurement date minus the transaction costs that 
would be incurred at that date. 
 
 Historical cost accounting 
 The historical cost approach has the following features: 
 Accounting transactions are recor ded at their original historical 
monetary cost. 
 Items or events for which no monetary transaction has occurred are 
usually ignored altogether. 
 Profit for the period is found by matching income against the cost of 
items consumed in generating the in come for the period (such items 
include non-current assets which depreciate through use, 
obsolescence or the passage of time). 
Advantages of historical cost accounting 
 Easy to understand 
 Straightforward to produce 
 Historical cost accounts are objective and free from bias 
 Historical cost values are reliable and original values can be verified 
based on original invoices/accompanying documents 
 Historical cost accounts do not reco rd gains until they are realised

Chapter 7 
 129 
 Disadvantages of historical cost accounts 
In periods in which prices change significantly, historical cost accounts 
have many deficiencies: 
 the carrying amount of non-current assets is often substantially 
below current value 
 Inventory in the statem ent of financial position re flects prices at the 
date of purchase or manufacture ra ther than those current at the 
year-end 
 Statement of prof it or loss expenses do not reflect the current value 
of assets consumed so profit in real terms is exaggerated 
 No account is taken of the effect of increasing prices on monetary 
items (items designated or settled in cash); and 
 The overstatement of  profits and the understatement of assets can 
reduce the relevance of accounti ng ratio analysis (e.g. return on 
capital employed (ROCE)) 
As a result of the above,  users of accounts can find it difficult to assess 
an entity's progress from year to y ear or to compare the results of 
different operations. 
 
 Example of the deficiencies of historical cost accounts 
 Entity A acquires a new machine in 20X4. This machine costs $50,000 
and has an estimated usef ul life of ten years. 
Entity B acquires an identical one-year  old machine in 20X5. The cost of 
the machine is $48,000 and it has an esti mated useful life of nine years. 
Depreciation charges (straight-lin e basis) in 20X5 are as follows. 
Entity A $50,000/10 = $5,000 
Entity B $48,000/9 = $5,333 
CVs at the end of 20X5 are:   
Entity A $50,000 – $10,000)  (2 × $5,000)  = $40,000 
Entity B $48,000 – $5,333  = $42,667 
Both entities are using identical  machines during 20X5, but the 
statements of profit or loss will show quite different profit figures because 
of adherence to historical cost.

130  
Factors to consider when selecting a measurement base 
An entity should select the base that would provide the most relevant and 
faithful representation of the elem ent being measured in line with the 
fundamental qualitative characteristics.  
The characteristics of the asset and liability being measured should be 
considered when selecting t he measurement base. For ex ample, if the asset is 
volatile in price and highly sensitive to  market factors, then a current value 
approach would be more relevant. If an asse t was to be held in the long-term 
and is stable in value it could considered t hat historical cost provides the more 
relevant (and less costly) information.  
As ever, judgement is to be appli ed when selecting an appropriate 
measurement base and the Framework does not attempt to select the 
appropriate measures for specific elements within specific entities. 
11 Presentation and disclosure 
The Framework includes a chapter cove ring presentation and disclosure within 
the financial statements. 
The chapter includes sections on: – the objective of presentation and disclosure – the classification of: 
(i) assets and liabilities (ii) equity (iii) income and expenses 
– aggregation 
Objective of presenta tion and disclosure 
The chapter considers how the presentat ion and disclosure of information within 
the financial statements adds to the fundamental and enhanc ing qualitative 
characteristics of the information. 
By considering consistent presentation and the inclusion of extra disclosures, 
the relevance, understandability and compar ability of the financial statements 
are improved.  
Classification 
Classification is the sorting of assets, li abilities, equity, income or expenses on 
the basis of shared characteristics fo r presentation and disclosure purposes. 
A specific area to note from  this section is that t he Framework outlines that 
income and expenses are classified and included either: 
– in the statement of  profit or loss or 
– outside the statement of profit or loss, in other  comprehensive income.

Chapter 7 
 131 
The Framework states that, as the statement of profit  or loss is the primary 
source of information about an entity’s fi nancial performance for the period, all 
income and expenses are, in principl e, to be included in that statement. 
However, in exceptional circumstances, the Board may decide to exclude from 
profit or loss income or expenses that arise from a change in  the current value 
of an asset or liability and instead incl ude them in other comprehensive income. 
This is only allowed if the result gives a more relevant view or a more faithful 
representation to the statem ent of profit or loss. 
Aggregation 
According to the Framework, aggregati on makes information more useful by 
summarising a large volume of detail. However, aggregation conceals some of 
that detail. Hence, a balance needs to be found so that relevant information is 
not obscured either by a large amount of  insignificant detail or by excessive 
aggregation. 
12 Concepts of capital and capital maintenance 
There are two concepts of capital: 
 A financial concept of capital.  With this method capital = net assets or 
equity of the entity. This concept shoul d be used if the ma in concern of the 
user of the financial st atements is the maintenance of the nominal value 
invested capital. This is used by most entities to prepare financial 
 A physical concept of capital. With this method capital = productive 
capacity of the entity (measured as uni ts of output per day). This method 
should be used if the main concern of the user of the fi nancial statements 
is the operating capac ity of the entity. 
Capital maintenance means preserving the va lue of the capital of the entity, and 
reporting profit only if the capital of the entity has been increased by activities 
and events in the accounting period. 
 Capital maintenance 
 Capital maintenance is a theoretical concept which tries to ensure that 
excessive dividends are not pai d in times of changing prices. 
Capital maintenance concepts can be classified as follows: 
 Physical capital maintenance (PCM), alternatively known as 
operating capital maintenance (OCM). 
 Financial capital maintenance (FCM). 
Physical capital maintenance (PCM) 
PCM sets aside profits in order to allow the business to continue to 
operate at current levels of activity . In practice, this tends to mean 
adjusting opening capital by specific  price changes

132  
 Example: 
An entity starts trading on 1 January X1  with contribution of $2,000 from 
owners. This is used to purchase 200 units at $10 each, which are sold 
for $2,200 cash. Opening capital is $2, 000 and closing is $2,200 so profit 
is usually measured as $200. 
However, over the year, the price of the units has increased to $10.75 (a 
specific price change hitting the busine ss, rather than general). This is a 
price increase of 7. 5% (10.75 – 10.00/10.00). 
Therefore increase opening capital by  7.5% to $2,150 (1.075 × 2,000) 
Profit is therefor e $2,200 – $2,150 = $50 
Even if the profit is paid out, the entity is left with ca sh of $2,150. This is 
enough to buy 200 more units at $10.75 each. In other words, the productive capacity of the business has been maintained. 
Financial capital maintenance (FCM) 
FCM sets aside profits in order to preserve the value of shareholders’ 
funds in ‘real terms’, i.e. after inflation. 
Can measure the increase in monetar y terms or in terms of constant 
purchasing power: 
 Monetary terms 
An entity starts trading on 1 Januar y X1 with contribution of $2,000 
from owners. This is used to pur chase 200 units at $10 each, which 
are sold for $2,200 cash. 
Opening capital is $2,000 and closing is $2,200 so profit is usually 
measured as $200. 
 Constant purchasing power 
Inflation over time makes com parisons difficult so constant 
purchasing power adjusts for general in dices of inflation – e.g. retail 
prices index. 
If increase in RPI is 5% Increase opening capital by 5% to $2,100 (1.05 × 2,000)  
So profit is only $2,200 – $2,100 = $100.

Chapter 7 
 133 
13 The Framework and the standard-setting process 
The Framework provides a point of re ference to the IASB when developing 
individual standards. Since the standards  will then be developed with reference 
to a common set of concepts the st andards themselves will become more 
consistent. 
The IFRS Interpretations Committee iss ues guidance where issues have arisen 
which are not specifically covered by a standard. The IFRS Interpretations Committee can therefore ensure its gui dance is consistent with agreed 
underlying principles by refe rring to the Framework. 
 
 Test your understanding 1 – Qualitative characteristics 
 The International Accounting Standar ds Board's (IASB's) The Conceptual 
Framework for Financial Reporting identifies fundament al and enhancing 
qualitative characteristics of financial information. 
Required: 
Identify and explain the TW O fundamental qualitativ e characteristics of 
financial information listed in the IASB's Framework. 
 
 Test your understandi ng 2 – IASB objectives 
 The Conceptual Framework for Fi nancial Reporting (Framework) has a 
number of purposes, including: 
 to  assist the International A ccounting Standards Board (Board) to 
develop IFRS Standards that ar e based on consistent concepts 
 to assist preparers to develop c onsistent accounting policies when 
no IFRS Standard applies to a particu lar transaction or other event, 
or when an IFRS Standard allows a choice of accounting policy 
  to assist all parties to underst and and interpret the IFRS Standards. 
Required: 
Discuss how the Framework can help t he IASB achieve these objectives.

134  
 Test your understanding 3 – Practice questions 
 1 In the Conceptual Framework fo r Financial Reporting, which of 
the following is not a qualitat ive characteristic of useful 
financial information? 
A Relevance 
B Faithful representation C Materiality D Understandability 
2 According to The Conceptual  Framework for Financial 
Reporting, which of the follo wing items is an underlying 
assumption when preparing a set  of financial statements? 
A Prudence 
B  Going Concern C Accruals D Comparability 
3 Which of the following items b est defines relevant financial 
information to the users of financial statements? 
A Information that is free from mate rial error, bias and is a faithful 
representation 
B Information that has been prudently prepared C Information that is comparable from one period to the next D Information that influences  the decisions of users 
4 Which of the following criteria need  to be satisfied in order for 
an item to be recognised in  the financial statements? 
(i) It meets the definit ion of an element of the financial statements 
(ii) It is probable that future ec onomic benefits will flow to or from 
the entity 
(iii) It provides relevant information regarding the item 
(iv) The item has a cost or value that can be reliably measured 
A  (i) and (ii)  
B (i) and (iii) 
C (i) and (iv) D (i), (iii) and (iv)

Chapter 7 
 135 
 5 Which of the following measurement bases could be used by 
an entity to recognise an asset according to The Conceptual 
Framework for Financial Reporting? 
A Historical cost 
B Current cost C Value in use D Any of the above 
6 The IASB’s Framework identifie s qualitative characteristics. 
(i) Relevance (ii) Comparability (iii) Verifiability (iv) Understandability (v) Faithful representation. 
Which of the above are not listed as enhancing 
characteristics? 
A (i), (iv) and (v) 
B (ii), (iii) and (iv) C (ii) and (iii) D  (i) and (v) 
7 The Conceptual Framework fo r Financial Reporting provides 
definitions of the elements of financial statement s. One of the 
elements defined by the Framework is ‘expenses’. 
Which of the following represents the definition of ‘expenses’ 
as per the Framework? 
A A present economic resource controlled by the entity as a 
result of past events 
B The residual interest in the a ssets of the entity after deducting 
all its liabilities 
C Decreases in assets or increases in liabilities that result in 
decreases in equity, other than thos e relating to distributions to 
equity participants 
D A right that has the potentia l to produce economic benefits

136  
 8 The International Accounting St andards Board’s (IASB) Conceptual 
Framework for Financial Reporti ng sets out two fundamental 
qualitative characteristics of fi nancial information, relevance and 
faithful representation. 
Which of the following charact eristics would you expect 
information to possess if it is to have faithful representation? 
A Neutrality  
B Relevance C Prudence D Accruals E Completeness  
9 According to the International  Accounting Standards Board’s 
Conceptual Framework for Financia l Reporting, the objective of 
financial statements is: 
‘to provide financial information about  the reporting entity’s assets, 
liabilities, equity, income and expenses  that is useful to _______ of 
financial statements in assessing t he prospects for future net cash 
inflows to the reporting entit y and in assessing management’s 
__________ of the entity’s economic resources’ 
From the options below, fill  in the missing information. 
Directors, users, shareholders , utilisation, stewardship, 
10 The Conceptual Framework fo r Financial Reporting lists the 
qualitative characteristics of financial statements. 
(i) Comparability, (ii) Verifiability, (iii) Timeliness, (iv) Understandability, (v) Relevance, (vi) Faithful representation. 
Which TWO of the above are NOT included in the enhancing 
qualitative characteristics listed by the Framework? 
A (i) and (vii) 
B (ii) and (v) 
C (iv) and (v) 
D (v) and (vi)

Chapter 7 
 137 
 11 According to the Internati onal Accounting Standards Board’s 
Conceptual Framework for Financia l Reporting, which of the 
following are types of capital maintenance? Select all that apply. 
A Human B Physical C Spiritual D Neutral E Intellectual F Financial  
12 To  be recognised in the fi nancial statements,  items must: 
– meet the definitions of  the _________ of the financial 
statements 
– provide  _______ information regarding the particular transaction 
– provide a ________of the particular transaction 
elements, users, components, relevan t, free from error, faithful 
representation, financial, disclosure 
13 According to the Conceptual Fr amework for Financial Reporting, 
which of the followi ng statement s are true? 
A All income and expenses must al ways be included within profit 
or loss 
B Aggregation of information is forbidden C Classification sorts tran sactions based on shared 
characteristics 
D Disclosures notes are not cons idered to be part of the financial 
statements

Chapter 7 
 139 
 The two principal qualitativ e characteristics are: 
Relevance  – Information is relevant when it influences the economic 
decisions of users by helping them  evaluate past, present or future 
events or confirming or corre cting their past evaluations. 
Some items may be relevant to users simply because of their nature whereas some items may only become re levant once they are material. 
Hence, materiality is a threshold quality of information rather than a 
primary characteristic. 
Faithful representation  – If information is to represent faithfully the 
transactions and other events that it pur ports to represen t, they must be 
accounted for and presented in acco rdance with their substance and 
economic reality and not merely their legal form. 
To be a faithful representation of financial performanc e and position, the 
following characteristics should be evident: 
Completeness  – To be understandable information must contain all the 
necessary descriptions and explanations. 
Neutrality  – Information must be  neutral, i.e. free fr om bias. Financial 
statements are not neutral if, by the selection or presentation of 
information, they influence the making of a decision or judgement in order 
to achieve a predetermined result or outcome. 
Free from error  – Information must be free from error within the bounds 
of materiality. A material error or  an omission can cause the financial 
statements to be false or  misleading and thus unreliable and deficient in 
terms of their relevance. 
described clearly and accurately as being an estimate.

140  
 A conceptual Framework provides guidance on the broad principles of 
financial reporting. It highlights ho w items should be recorded, on how 
they should be measured and presented.  The setting of broad principles 
could assist in the development of  accounting standards, ensuring that 
the principles are followed consis tently as standards and rules are 
A conceptual Framework can provide guidance on how similar items are 
treated. By providin g definitions and criteria that can be used in deciding 
the recognition and measurement of items, conceptual Frameworks can 
act as a point of reference for th ose setting standards, those preparing 
and those using financial information. 
The existence of a conceptual Fr amework can remove the need to 
address the underlying issues over and over again. Where underlying 
principles have been established and the accounting standards are based on these principles, there is no need to deal with them fully in each 
of the standards. This will save the standard-setters time in developing 
standards and will again ensure consistent tr eatment of items. 
Where a technical issue is raised but  is not specifically addressed in an 
accounting standard, a c onceptual Framework can help provide guidance 
on how such items should be treated.  Where a short-term technical 
solution is provided by the standard-se tters, the existence of a conceptual 
Framework will ensure that the treatment is consis tent with the broad set 
of agreed principles

Chapter 7 
 141 
 1 C 
2 B 
3 D 4 B 5 D 6 D 7 C 
Option A is the definition of an asset. Option B is the definition of equity. Option D is the definition of an economic resource. 
8 A and E  
The characteristics of faithful representation are completeness, 
neutrality and free from error. 
9 The objective of financial stat ements is to provide financial 
information about the reporting entity ’s assets, liabilities, equity, 
income and expenses that is useful to users  of financial statements 
in assessing the prospects for future net cash inflows to the 
reporting entity and in assessing management’s stewardship  of the 
entity’s economic resources’ 
10 D 11 B, F 12 elements, relevant, faithful representation 
‘To  be recognised in the financ ial statements,  items must: 
– meet the definitions of  the elements of the financial 
– provide  relevant information regarding the particular 
transaction 
– provide a faithful representation  of the particular transaction’ 
13 C 
Income and expenses can, in exceptional circumstances, be 
classified under other comprehen sive income. A is incorrect. 
Significant amounts of content wit hin the financial statements are 
aggregated otherwise the content would be unwieldy. Option B is 
Disclosure notes are considered par t of the financial statements. 
Option D is incorrect.

143 
Introduction to Single 
Entity Accounts 
 
B3. Apply financial reporting 
standards to prepare basic financial statements Apply financial reporting 
a. Statement of financial position 
 b. Statement of profit or loss and 
other comprehensive income 
 c. Statement of changes in 
equity Chapter 
8

Introduction to Single Entity Accounts 
144  
 
2 IAS 1 Presentation of Financial Statements 
All entities preparing their financial statements in acco rdance with International 
Accounting Standards should follow  the requirements of IAS 1 Presentation of 
Financial Statements . IAS 1 prescribes what a set of financial statements 
should contain and how they should be presented. 
Purpose of financial statements 
According to IAS 1 Presentation of Fi nancial Statements  the objective of 
financial statements is to  provide information about the financial position, 
performance and cash flows of an enterprise that is useful in making economic 
decisions. The financial statements will al so show how effectively management 
have looked after the resources of the ent ity, i.e. it will help users assess the 
stewardship of management. 
Contents of financial statements 
IAS 1 defines a complete set of financial statements as: 
 'a statement of financial position 
 either: 
– a statement of profit or loss and other comprehensive income, 
or 
– a statement of profit or loss plus a statement showing other 
comprehensive income

Chapter 8 
 145 
 a statement of changes in equity 
 a statement of cash flows 
 accounting policies note and other expla natory note' (IAS 1, para 10) 
IAS 1 does not require the above titles to be used by entities. It is likely that 
many entities in practice will continue to use the previous terms of balance 
sheet rather than statement of financial position and cash  flow statement rather 
than statement of cash flows. 
Entities are also encouraged to pres ent a financial review by management 
which describes and explains the main features of the entity’s financial 
performance and financial position. 
This chapter looks at the formats of the statement of  profit or loss and other 
comprehensive income, statement of  financial position and statement of 
changes in equity. The statement of cash flow is considered in a later chapter. 
Notes to the financial statements are c onsidered with their relevant standards, 
where appropriate. 
Responsibility for financial statements 
The board of directors (and/ or other governing body) of  an entity is responsible 
for the preparation and presentation of its financial statements. 
3 Concepts and other considerations affecting financial 
Fair presentation 
IAS 1 Presentation of Financial Statements  states that ‘ Financial statements 
shall present fairly the financial posit ion, financial performance and cash 
flows of an entity ’ (IAS 1, para 15). Entities that comply with all relevant IAS's 
will virtually always achieve this objective. 
A fair presentation requires that entities: 
 show a faithful representation of the effects of transactions 
 select definitions and recognition crit eria set down in accordance with the 
conceptual framework and apply account ing policies in accordance with 
IAS 8  Accounting Policies, Changes in Accounting Estimates and Errors  
(not within the F1 syllabus) 
 present information in a manner wh ich provides relevant, reliable, 
comparable and underst andable information; 
 provide additional disclosures if t he requirements of an IFRS Standard or 
IAS are insufficient to enable user s to understand the impact of the 
transaction on the financial position and performance

146  
If, however, an entity feels that comp liance with an IFRS Standard would be 
misleading and that it is necessary to depart from the require ments of an IFRS 
Standard in order to show a fair pres entation, the entity should make the 
following disclosures: 
 that management have concluded that  the financial stat ements do present 
fairly the financial position, financial performance and cash flows 
 that the entity has complied with IF RS Standards except that it has 
departed from an IFRS Standard in order  to show a fair presentation 
 the IFRS Standard that has been departed from, the nature of the 
departure i.e. the treatm ent that the IFRS Standar d would require and the 
reason why such treatment would be misleading and the treatment adopted instead 
 the financial impact of the departure on net profit/loss, as sets, liabilities, 
equity and cash flows 
However, departing from the provisions of  the standards in the interests of fair 
presentation, would be very rare. 
Going concern 
According to IAS 1 Presentation of Fi nancial Statements  financial statements 
should be prepared on the going concer n basis unless management intend to 
liquidate the business or to cease trading. 
Preparing financial statem ents on the going concern basis means preparing 
them on the assumption that  the entity will continue to  trade for the foreseeable 
future. 
Accruals basis 
IAS 1 Presentation of Financial Statements  requires entities to prepare their 
financial statements (except for cash flow  information) using the accruals basis 
of accounting. 
This means that transactions should be recorded in the accounting period to 
which they relate regardless of whether  or not cash has been received or paid. 
This concept also means that expenses should be recognised in the statement 
of profit or loss and other comprehensive in come so as to match against directly 
related income. 
Consistency 
Presentation and classification of items s hould be consistent from one period to 
the next. 
Changes are allowed, if required by an IF RS or if it is deemed more appropriate 
to change the presentation of information.

Chapter 8 
 147 
Materiality and aggregation 
Each material class of similar item s should be presented separately in the 
financial statements. Imma terial amounts should be ag gregated with amounts of 
a similar nature and need not be disclosed separately. 
Omissions or misstatements of items are material if they could influence the 
economic decisions of users. Materiality depends on the size and nature of the 
omission or misstatement. 
Off-setting 
Assets and liabilities, and income and expen ses, should not be offset except 
when offsetting is required or allowed by an IFRS. 
Comparative information 
Comparative information should be disclosed  in respect of the previous period 
for all amounts reported in the financial statements unless an IFRS requires or 
allows otherwise. 
 
 Other requirements 
 Financial statements should be present ed at least annually and should be 
issued on a timely basis (within 6 m onths of the end of the reporting 
period for public entities and 9 months for private entities) to be useful to 
users. 
IAS 1 does not specify the format of  financial statements, but it does 
provide an appendix which sets out illust rative formats for the statements 
to be included in financial statements. In addition, it provides guidance on 
the items that should be disclosed in these statements an d those that can 
be relegated to the notes that acco mpany the statements (see below 
suggested formats).

148  
The statement of financial position 
The suggested format for t he statement of financial position (SOFP) is as 
follows: 
XYZ Statement of Financial Position as at 31 December 20X0 
 $000 $000 
Assets   
Non-current assets   
Property, plant and equipment X  Goodwill X  Other non-current assets X  
 ––  
  X 
Current assets   
Inventories X  Trade and other receivables (e.g. prepayments) X  Cash and cash equivalents X  
 ––  
  X 
Non-current assets held for sale  X 
  –– Total assets  X 
  –– 
Equity and liabilities    
Capital and reserves   
Issued share capital X  
Share premium X  Revaluation reserve X  Retained earnings X  
  –– 
Total equity  X    
Non-current liabilities   
Long-term borrowings X  Provisions X  
 ––    X 
Current liabilities   
Trade and other payables X  
Short-term borrowings X  
Current tax payable X   ––    X   –– Total equity and liabilities  X 
  ––

Chapter 8 
 149 
 The format requires comparative figures  for the previous year, these have 
been omitted as you will not need to prepare comparatives in questions. 
 
 Assessment on single entity accounts will be  in the form of OTQ's. They will 
only test one or two principles at a time. You will not be expected to 
prepare a set of financial st atements in totality.  
 
 Information to be presented in the SOFP 
 IAS 1 Presentation of Financial Statements  requires that, as a minimum, 
the following line items appear in t he statement of financial position 
(where there are amounts to be cla ssified within these categories): 
(a) property, plant and equipment (b) investment property (c) intangible assets (d) financial assets (excluding amou nts shown under (e), (h) and (i)) 
(e) investments accounted fo r using the equity method 
(f) biological assets (g) inventories (h) trade and other receivables (i) cash and cash equivalents (j) the total of assets classified as  held for sale in accordance with 
IFRS 5 Non-current Assets Held for Sale and Discontinued 
Operations  
(k) trade and other payables 
(l) provisions (m) financial liabilities (excludi ng amounts shown under (k) or (l)) 
(n) liabilities and assets for current tax as defined in IAS 12 Income 
Taxes 
(o) deferred tax liabilitie s and deferred tax assets, as defined in IAS 12 
Income Taxes 
(p) liabilities included in disposal gro ups classified as held for sale in 
accordance with IFRS 5 Non-current Assets Held for Sale and 
(q) non-controlling intere st, presented within equity 
(r) issued capital and reserves attr ibutable to owners of the parent 
The above list includes items that t he IASB believes are so different in 
nature or function that they should be separately disclosed, but does not 
require them to appear in a fixed order or format.

150  
 NB. Some of these classes of trans actions are not covered within the F1 
syllabus but are included for completeness purposes.  
Additional line items, headings an d subtotals should be shown in the 
statement of financial posit ion if another IFRS requires it or where it is 
necessary to show a fair presentation of the financial position. In deciding 
whether additional items should be separately presented, management 
should consider: 
 the nature and liquidity of assets  and their materiality (e.g. the 
separate disclosure of monetar y and non-monetary amounts and 
current and non-current assets) 
 their function within the entity (e.g. the separate disclosure of 
operating assets and financial assets, inventories and cash) and 
 the amounts, nature and timing of liabilities (e.g. the separate 
disclosure of interest-bearing and non-interest-bearing liabilities and 
provisions and current and non-current liabilities). 
Assets and liabilities that have a di fferent nature or function within an 
entity are sometimes subject to di fferent measurement bases, for 
example, plant and equipment may be carried at cost or held at a 
revalued amount (in accordance with IAS 16 Property, Plant and 
Equipment ). The use of these different measurement bases for different 
classes of items suggests separate pres entation is necessary for users to 
fully understand the accounts. 
  
 Information to be presented in either the SOFP/notes 
 Further sub-classifications of the li ne items should be presented either in 
the statement of financial  position or in the notes. The size, nature and 
function of the amounts in volved, or the requirem ents of another IFRS will 
normally determine whether the disclosur e is in the stat ement of financial 
position or in the notes. 
The disclosures will vary for each item, but IAS 1 Presentation of 
Financial Statements  gives the following examples: 
(a) tangible assets are analysed (IAS 16 Property, Plant and 
Equipment ) by class e.g. property, plant and equipment, land and 
buildings, etc. 
(b) receivables are analysed between: 
– amounts receivable from trade customers 
– receivables from related parties – prepayments – other amounts

Chapter 8 
 151 
 (c) inventories are classified (IAS 2 Inventories ) into merchandise, 
production supplies, materials, work  in progress and finished goods 
(d) provisions are analysed showin g provisions for employee benefits 
separate from any other provisions 
(e) equity capital and reserves are analysed showing separately the 
various classes of paid-in capital, share premium and reserves 
  
 Share capital and reserves disclosures 
 IAS 1 Presentation of Financial Statements  also requires that the 
following information on share capital and reserves be made either in the 
statement of financial pos ition or in the notes: 
(a) for each class of share capital: 
– the number of s hares authorised 
– the number of shares issued and fully paid, and issued but not 
fully paid 
– par value per share, or that  the shares have no par value 
– a reconciliation of the number  of shares outstanding at the 
beginning and at the end of the y ear, the rights, preferences 
and restrictions attaching to that class, including restrictions on 
the distribution of dividends and the repayment of capital, 
– shares in the entity held by the ent ity itself or by subsidiaries or 
associates of the entity, and 
– shares reserved for issuance under options and sales 
contracts, including the terms and amounts 
(b) a description of the nature and purpose of each reserve within 
owners’ equity  
IAS 1 Presentation of Financial Statements  requires the following to 
be disclosed in the notes: 
–  the amount of dividends that were proposed or declared after 
the reporting period but before the financial statements were 
authorised for issue 
–  the amount of any cumulati ve preference dividends not 
recognised. 
Note: IAS 1 and IAS 10 Events After the Reporting Period  do not 
allow proposed dividends to be included as a liability in the statement of financial position,  unless the dividend was declared 
before the end of t he reporting period.

152  
 Current/Non-current distinction 
 Current assets 
An asset should be classified as a cu rrent asset when it is any of the 
 is expected to be realised in, or is intended for sale or consumption 
in the entity’s normal operating cycle 
 is held primarily for trading purposes 
 is expected to be realised withi n 12 months of the end of the 
reporting period or 
 is cash or cash equivalent 
All other assets should be classified as non-current assets. 
Current liabilities 
A liability should be classified as a current liability when it: 
 is expected to be settled in  the entity’s normal operating cycle 
 is due to be settled within 12 mont hs of the end of the reporting 
period 
 is held primarily for the purpose of being traded or 
 the entity does not have an uncondition al right to defer settlement of 
the liability for at least 12 mont hs after the end of the reporting 
period 
All other liabilities should be clas sified as non-current liabilities. 
4 Statement of changes in equity 
The statement of changes in equity (SOC IE) provides a summary of all changes 
in equity.. 
This includes the effect of  share issues and dividends. 
This statement is useful since the tota l change in equity reflects the increase or 
decreases in the net assets of the enter prise in the period and so reflects the 
change in the wealth of the enterprise in the period.

Chapter 8 
 153 
XYZ Statement of changes in equity for the year ended 31 December 20X0 
 Share 
capital Share 
premium Revaluation 
reserve Retained 
earnings Total 
 $000 $000 $000 $000 $000 
Balance at 31 
December 20W9 X X X X X 
Transfer to retained   (X) X – 
earnings      
Total comprehensive 
income for the period   X X X 
      
Dividends    (X) (X) 
Issue of share capital X X   X  –– –– –– –– –– 
At 31 December 20X0 X X X X/(X) X 
 –– –– –– –– –– 
 
 Dividends and shares 
 Share capital in the SOFP may include both ordinary/equity and 
preference shares. 
Ordinary/equity shares 
 Ordinary/equity shareholders (The terms ordinary and equity are 
used interchangeably) own a percent age of the entity’s net assets. 
 Voting rights are attached to the shares. 
 A year-end dividend may be paid to shareholders based on the 
performance of the entity. 
 The dividend is paid as an amount per share. 
 A dividend will first be proposed by directors, then declared 
(confirmed) and then paid. 
 Ordinary/equity dividends s hould only be accounted for when 
declared. 
 Dividends may be interim, i.e. paid part way through the year and 
final, i.e. declared and/or paid at year-end.

154  
 Ordinary/equity shares will be accounted for as follows: 
Debit Cash/Bank Credit Share capital (nominal value) Credit Share premium (excess of proceeds above nominal value) Ordinary/equity dividends will be accounted for as follows: 
Debit Retained earnings (shown in SOCIE) Credit Cash/Bank 
Preference shares 
 Preference shareholders own a per centage of the entity’s share 
capital. 
 Voting rights are not attached to the shares. 
 A year-end dividend will be paid to shareholders based on a 
percentage of t he investment. 
 Preference dividends should be accounted for on an accruals basis. 
Preference dividends will be accounted for as follows: 
If classified as equity instruments: Debit Retained earnings (SPL) Credit Cash (SOFP) If classified as liability instruments: Debit Finance Cost (SPL) 
Credit Accruals (SOFP) 
 
 Test your understanding 1 – SOCIE  
 An entity Apple has the followi ng balances at 1 January 20X1: 
 $ 
Share capital ($1 nomi nal value) 100,000 
Share premium 50,000 Retained earnings 200,000 
During the year Apple issued 50, 000 shares at $1.20 and paid all 
shareholders a dividend of $0.10 per share. 
Profit after tax amounted to $120,000. 
Required: 
Prepare the statement of changes in equity for the year ended  
31 December 20X1 for Apple.

Chapter 8 
 155 
5 Statement of profit or loss and other comprehensive income 
The Conceptual Framework sets out the need for a statement of performance. It 
does not define whether this is a single statement or two s eparate statements.  
IAS 1 Presentation of Financial Statements applies The Framework’s 
requirements for a statement of perfo rmance by allowing a choice of two 
presentations of prof it or loss and other comprehensive income: 
 A statement of profit or loss and other comprehensive income; or 
 A statement of profit or  loss showing the profit or  loss for the period PLUS 
a separate statement of other comprehensive income, which will also 
include a total for tota l comprehensive income. 
Total comprehensive income  is the profit or loss fo r the period, plus other 
comprehensive income. 
Other comprehensive income (OCI)  is income and expenses that are not 
recognised in profit or loss (i.e. they are recorded in re serves rather than as an 
element of the prof it for the period). 
In F1, other comprehensive income mainly includes any change in the 
revaluation reserve. Further detail on OCI can be found later in this chapter. 
The statement of profit or loss and other comprehensive income would be 
presented as one statement as follows: 
XYZ Statement of profit or loss a nd other comprehensive Income for the 
year ended 31 December 20X0 
 $000 
Revenue X 
Cost of sales (X)  ––––– 
Gross profit/(loss) X/(X) 
Distribution costs (X) Administrative expenses (X) 
 ––––– 
Profit/(loss) from operations X/(X) Income from investments X Finance cost (X) 
 ––––– 
Profit/(loss) before tax X/(X) Income tax expense (X) 
 ––––– 
Profit/(loss) for the period X/(X) 
Other comprehensive income  
e.g. Gain/loss on revaluation X 
 ––––– 
Total comprehensive income for the year X

156  
This analysis of expenses is based on t he function method. This presentation 
method is the format most likely to appear in the OTQ's and case study.  
The alternative method for presentation of expenses is to categorise by the 
nature of expenses. This is commonl y associated with manufacturing entities 
but is not widely utilised.  
 
 Nature of expenses method 
 In this method expenses are presented according to their nature rather 
than their function as follows: 
XYZ Statement of profit or loss and other comprehensive Income for 
the year ended 31 December 20X0 
 $000 
Revenue X Other operating income X 
Changes in inventory of WIP and finished goods (X) 
Work performed by the entity and capitalised X Raw material and consumables used (X) 
Employee benefits expense (X) 
Depreciation and amortisation expense (X) Impairment of property, plant and equipment (X) Other expenses (X) 
Finance costs (X) 
 ––––– Profit/(loss) before tax X/(X) 
Income tax expense (X) 
 ––––– Profit/(loss) for the period X/(X) 
Gain/loss on revaluation X  ––––– 

Chapter 8 
 157 
Material items 
 When items of income and expens es are material, their nature and 
amount shall be disclosed separ ately before operating profit. 
 This may either be done on the face of the statement of pr ofit or loss and 
other comprehensive income or in the notes. 
 Examples: 
– inventory write-offs  
– impairment losses  – restructuring costs  – disposals of property, plant and equipment – litigation settlements  
 The statement of profit or loss us ed to be called the income statement. 
The current revised IAS 1 states eit her title can be used. For assessment 
purposes always use the current title of statement of profit or loss. 
 
Other comprehensive income 
 IAS 1 requires other comprehensive income to be split between two 
headings: 
 items that will not  be reclassified to profit or loss and 
 items that may be reclassified  subsequently to profit or loss 
F1 students will mainly deal with gains or losses arising from revaluations 
of property, plant and equipment in other comprehensive income and 
these should be shown as ‘items that will not be reclassified to profit or 
loss’. 
Items that may be reclassified subs equently to profit or loss could be 
exchange differences on translating fore ign operations, fair value through 
profit or loss financial assets, cash flow hedges and income tax relating to 
any items reclassified (covered in the F2 syllabus).

158  
 Alternative presentation – two separate statements 
 An entity may present two stat ements instead of one: a separate 
statement of profit or loss and a statement of total comprehensive 
income. 
Statement 1 – Statement of profit or loss 
A recommended format for the statement of profit or loss would be as 
follows: 
XYZ Statement of profit or loss  for the year ended 31 December 
20X0 
 $000 
Revenue X 
 ––––– 
 ––––– 
 ––––– 
Statement 2 – Statement of profit  or loss and other comprehensive 
income 
A recommended format for the presentation of total comprehensive 
income as a separate statement would be: 
XYZ Statement of profit or loss and other  comprehensive income for 
e.g. Gain/loss on revaluation X/(X) 
 ––––– 

Chapter 8 
 159 
 Information to be presented in the SPL 
 IAS 1 Presentation of Financial Statements  requires that certain 
information (as a minimum) is presented in  the statement of profit or loss, 
(a) revenue (b) finance costs (c) share of profits and losses of as sociates and joint ventures (beyond 
the scope of this syllabus),  
(d) tax expense (e) a single amount for the total of discontinued operations (see later in 
publication for more detail) 
statement of profit or loss if another IFRS require s it or where it is 
necessary to show a fair present ation of the financial position. 
Materiality, the nature and function of the item ar e likely to be the main 
considerations when deciding whether to include an additional line item in 
the statement of profit or loss. 
 
 Notes to the financial statements 
 Notes to the financial statements no rmally include narrative descriptions 
or more detailed analysis of items in the financial statements, as well as 
additional information such as cont ingent liabilities and commitments. 
IAS 1 also provides guidance on the structure of the accompanying notes 
to financial statements, the acco unting policies and other required 
disclosures. 
The notes to the financial st atements of an entity should: 
(a) present information about the basis  of preparation of the financial 
statements and the specific a ccounting policies adopted for 
significant transactions 
(b) disclose the information require d by other IFRSs that is not 
presented elsewhere in the financial statements 
(c) provide additional information whic h is not presented elsewhere in 
financial statements but is relevant  to an understanding of any of 
them 
Notes to the financial statements should be presented in a systematic 
manner and any item in the financ ial statements should be cross-
referenced to any related information in the notes.

160  
 Notes are normally provided in the fo llowing order, which assists users in 
understanding the financial statements and comparing them with those of 
other entities: 
(a) statement of compliance with IFRSs (b) summary of the significant accounting policies applied (c) supporting information for it ems presented in each financial 
statement in the order  in which each line item and each financial 
statement is presented 
(d) other disclosures, including: 
– contingent liabilities, commitments and unrecognised 
contractual commitments other financial disclosures 
– non-financial disclosures 
Accounting policies 
The summary of significant accoun ting policies in the notes to the 
financial statements should describe the following: 
 the measurement basis (or bases) used in preparing the financial 
statements and 
 each specific accounting policy that is necessary for a proper 
understanding of the financial statements 
 
 1 Which of the following best describes the purpose of financial 
statements according to IAS 1 Presentation of Financial 
Statements ? 
A To provide information that enables users to assess the 
stewardship of management 
B To provide information about the financial position, financial 
performance and cash flows of an enterprise 
C To provide a summary of all financial transactions entered into 
in the accounting period 
D To provide an statement of  profit or loss and other 
comprehensive income and a st atement of financial position

Chapter 8 
 161 
 2 Which of the following are con cepts that should be applied 
when preparing financial statements according to IAS 1 
Presentation of Financial Statements ? 
(i) Going concern 
(ii) Accruals (iii) Consistency 
(iv) Off-setting 
A  (i) and (ii) 
B (i) and (iii) C (i), (ii) and (iv) D All of them 
3 Which of the following items must  be shown on the face of the 
statement of profit or loss a nd other comprehensive income 
according to IAS 1 Presentation of Financial Statements ? 
(i) Revenue 
(ii) Cost of sales (iii) Gross profit (iv) Finance costs 
(v) Income tax expense 
B (i), (ii), (iii) and (iv) C  (i), (iv) and (v) D (i), (ii) and (iii) 
4 Which of the following items woul d be shown in the statement 
of changes in equity? 
(i) Profit for period 
(ii) Dividends paid (iii) Dividends proposed afte r the reporting period 
(iv) Issue of shares 
(v) Revaluation surplus 
A (i), (ii), (iv) and (v) 
B (i), (ii), (iii) and (iv) C (i), (iii), (iv) and (v) D All of them

162  
 5 Which of the following items would be shown as other 
comprehensive income on the stat ement of profit or loss and 
other comprehensive income? 
(ii) Dividends paid (iii) Dividends proposed (iv) Issue of shares 
B (i), (ii), and (iv) C (v) D All of them  
6 According to IAS 1 Presentation of Financial Statements , which 
of the following must be recognised  in the statement of profit 
or loss? 
A Depreciation 
B Equity dividends paid C Revaluation gains D Transfer from a revaluation re serve to retained earnings when 
a revalued asset is sold 
7 According to IAS 1 Presentation of Financial Statements  which 
of the following will appear separ ately in an entity's statement 
A Other income and dividends paid 
B Other income, surplus arising on a revaluation and proceeds 
from a share issue 
C Dividends paid, dividends receiv ed and proceeds from a share 
issue 
D Dividends paid and proceeds from a share issue

Chapter 8 
 163 
 8 Which of the following assets woul d be classified as current 
according to IAS 1 Presentation of Financial Statements 
definition? 
Asset A which is expected to be sold within the next 12 months 
Asset B which is not expected to be sold within the next 12 months 
but expected to be realised with the entity's normal operating cycle 
Asset C which is held primarily for the purpose of being traded but 
for which there is currently no anticipated sale date 
A Asset A only 
B Asset A and Asset B C Asset A and Asset C D All of them

Chapter 8 
 165 
 Apples statement of changes in equity for the year ended 
31 December 20X1 
 Share 
premium Retained 
 $ $ $ $ 
Balance at 1 January 20X1 100,000 50,000 200,000 350,000 Profit for the year – – 120,000 120,000 Issue of share capital (W1) 50,000 10,000  60,000 Dividends paid (W2) – – (15,000) (15,000) 
 –––––– –––––– –––––– –––––– 
Balance at 31 December 
20X1 150,000 60,000 305,000 515,000 
(W1) Share issue = 50,000 × $1 = $50,000 share capital and  
50,000 × $0.20 = $10,000 share premium. 
(W2) Dividend of $0.10 per share is based on 150,000 shares (100,000 
b/wd plus 50,000 issued during the year) 
 
 1 B 
2 D 3 C 4 A 5 C 6 A – All other items will be shown in the SOCIE and not the 
statement of prof it or loss. The revaluatio n gain (option C) will also 
be shown as other comprehensive income. 
7 D – Other income and dividends received form part of the statement 
of profit or loss 
8 D

167 
Non-current assets – 
IAS 16 Property, plant 
and equipment and IAS 
36 Impairment of assets 
B2. Explain specific IFRS 
financial reporting standards Explain the specific financial 
 c. Impairment Chapter 
9

Non-current Assets – IAS 16 Property, plant and equipment and IAS 36 Impairment of assets 
 
168  
1 Session content

Chapter 9 
 169 
2 IAS 16 Property, plant and equipment: definitions  
Property, plant and equipment 
Property, plant and equipment ar e tangible assets that: 
 are held by an entity for use in the production or supply of goods or 
services, for rental to others, or for administrative purposes, and 
 are expected to be used during more than one period. 
You should know these definitions from your earlier studies. Please review to 
ensure that you have sound knowl edge of all of the following. 
The following definitions are taken from IAS 16 Property, Plant and Equipment : 
Carrying amount 
'The amount at which an asset is recognised, after deducting any 
accumulated depreciation and impairment losses. (IAS 16, para 6). 
Cost 
'The amount paid and the fair value of other consideration given to 
acquire an asset at the time of its acquisition or construction'  
(IAS 16, para 6). 
Depreciable amount 
'The cost or valuation of an  asset less its residual value'  (IAS 16, para 6). 
Depreciation 
'The systematic allocation of the depr eciable amount of an asset over its 
useful life'  (IAS 16, para 6). 
Fair value 
'The amount for which an asset can be exchanged between 
knowledgeable, willing parties in  an arm’s length transaction'  
Impairment loss 
'The amount by which the carrying amount exceeds its recoverable 
amount' (IAS 16, para 6).  
Recoverable amount 
'The higher of an asset’s net reali sable value and its value in use' (IAS 16, 
para 6).

170  
Residual value 
'The residual value of an asset is the amount that the entity would 
currently obtain from disposal of th e asset, after deducting the estimated 
costs of disposal, assuming that the asset was already at  the point where 
it would be disposed of (using the age and condition that would be 
assumed to apply at the time of disposal)' (IAS 16, para 6). 
Useful life 
'The period over which the asset is expect ed to be available for use by the 
entity or the volume of out put expected from the asset' (IAS 16, Para 6). 
3 Initial recognition 
In accordance with IAS 16 Property, Plant and Equipment  an asset should be 
recognised as an asset when: 
 it is probable that future economic  benefits will flow to the entity and 
 the cost of the asset can be measured reliably. 
In accordance with IAS 16  Property, Plant and Equipment , the asset should 
initially be measur ed at its cost. This should include: 
 its purchase price 
 directly attributable costs to bring the asset to the location and condition 
necessary for it to be capable of operat ing for its intended use, i.e. site 
preparation, initial delivery costs, installation costs, testing costs, 
professional fees 
 the initial estimate of the cost of dismantling and removing the item and 
restoring the site, where there is an obligation to incur such costs 
The cost of a self-constructed asset is  determined using the same principles. 
Subsequent expenditure 
In accordance with IAS 16 Property, Plant and Equipment,  subsequent 
expenditure should be capitalised when: 
 the expenditure improves the future  economic benefits that the asset will 
generate 
 it replaces a component of an asset and the carrying amount of the 
component replaced is derecognised, e.g.  overhaul of a furnace or a roof 
(where both are separately identified as assets) 
 it is the cost of a major inspection fo r faults and the carr ying amount of the 
previous inspection is derecognised 
The costs of day-to-day servicing shoul d be recognised in the statement of 
profit or loss as incurred.

Chapter 9 
 171 
 Illustration 1 – Initial measurement 
 Which one of the following should  be accounted for as capital 
expenditure? 
A The cost of painting a building B Maintenance of a machine which keeps production at the same 
level 
C The purchase of a car by a garage for resale 
D Legal fees incurred on the purchase of a building 
  
 Solution 
 The answer is D because the legal fees are part of the init ial cost of the 
asset. They are directly attributabl e costs to bring the asset to the 
location and condition necessary for it  to be capable of operating for its 
intended use. 
A and B are examples of revenue expenses. They are maintenance costs 
and must be charged to the statement of profit or loss as an expense. 
C would normally be an example of an a sset to capitalise. However, as 
the business is a garage and the car is being bought for resale, it must be 
treated as a purchase expense (inventor y) and not a non-current asset. 
The car is not a resource for runni ng the business but an item purchased 
with the intention to sell. 
 
 Case Study Question 
 2015 CIMA Professional Qualificati on Syllabus, Operational Level 
Case Study Exam, August 2016 – Question (Modified) 
Pene Lopez calls you into her office and says the following to you: 
"Thomas wants us to produce a m onthly report that puts a monetary 
value on the cost of quality. David used to produce one at his previous 
employment. He claims that it rea lly does emphasise the importance of 
getting it "right first time". 
Now that the building work in the old grain barn is complete and the 
Upper Class Pets' production running smoothly within it, Thomas wants a 
final total of the expenditure involved.  He wants us to capitalise as much 
of the expenditure on the building wo rk as we can. I have produced a 
schedule of the expenditure and will give it to you in a moment.

172  
 I have to be in meetings all day and as Cormac is on leave I want you to 
provide the draft of a briefing pap er for Thomas in which you: 
 firstly, explain quality costs using t he extracts from the minutes that I 
left on your desk to give examples  of the different categories of 
quality costs. I know that you can' t quantify any of these costs right 
now, but please explain how we could get the information that we need to do so 
 secondly, explain, with referenc e to the relevant international 
financial reporting standard rules, what expenditure can be 
capitalised and what cannot. 
Thank you" Pene Lopez then hands you the schedule she prepared of the 
expenditure to convert the grain store into a production unit for UCP 
products. This schedule can be found below. 
Schedule of expenditure for the new production facility 
  TS Architects fees/legal  3,500 
Site preparation Levelling th e floor of the store and 
testing for ground contamination 4,200 
   
Building contractor's cost  420,000 Purchase price of new 
plant and equipment  96,000 
Import duties paid in 
respect of the plant and equipment  8,500 
Installation cost in 
respect of plant and equipment Work undertaken by our 
maintenance staff and selected production workers 6,100 
Training costs Costs required to train installation 
workers 1,700 
Share of general 
overheads  4,000 
Marketing to get new 
customers Additional work undertaken to fill 
the new facility to capacity 3,000 
(note – for the purpose of this illustration quality costs have not 
been discussed as this is not relevant to the F1 exam) 
© Copyright CIMA – 2015 CIMA Profe ssional Qualification Operational 
Level F1 Financial Reporting and Taxa tion Case Study Exam February 
2017

Chapter 9 
 173 
 Case Study Suggested Answer 
Case Study Exam, February 2017 – Suggested Answer  
Note this is an extract from the suggested answer and focuses 
solely on the areas of the case study relevant to the F1 exam, the quality costs are not discussed below. 
ACCOUNTING TREATMENT OF NEW PRODUCTION FACILITY 
COSTS 
IAS 16:  Property, Plant and Equipment  states that expenditure 
associated with an item of pr operty plant and equipment can be 
capitalised if it is either part of t he purchase price (including import duties) 
or directly attributable to getting t he asset ready for its intended use. 
From the schedule the purchase price of the new plant and equipment, 
import duties and building contractor’s co st all into this first category. 
The costs that are directly attributabl e costs include: the architects fees, 
the site preparation cost s, and the installation of the plant and equipment. 
All of these costs are necessary to bu ild and to ensure that the machines 
work correctly. 
The training costs however cannot be c apitalised as they do not meet the 
definition of an asset. Al though the training may lead to future economic 
benefit for our business, we cannot contro l it as the staff are free to leave 
the business at any time. 
The cost of marketing and general over head are not likely to be directly 
attributable and will have to be ex pensed as they are incurred. The 
marketing is an event that  bears no relation to the construction of the new 
facility and the overhead is an apportionment rather than directly incurred, which in accordance with IAS 16 cannot be capitalised. 
2017

174  
 Illustration 2 – Subsequent measurement 
 Which ONE of the follo wing items would we recognise as subsequent 
expenditure on a non-curr ent asset and capitalise as required by IAS 16 
Property, Plant and Equipment? 
A A furnace was purchased five years ago, when the furnace lining 
was separately identified in the accounting records. The furnace 
now requires re-lining at a cost of $200,000. When the furnace is re-
lined it will enable the business to us e the furnace for a further five 
years. 
B An office building was badly damaged in a fire. The cost to restore 
the building to its original condition will be $250,000. 
C A delivery vehicle has broken down and when inspected it was 
discovered a new engine would be r equired estimated at $5,000. 
D A factory is closed for two wee ks each year to enable the entity to 
undertake routine maintenance a nd repairs costing $75,000. 
 
 Solution 
 The answer is A.  
By re-lining the furnace we are enhancing the original asset. By 
extending its useful life, the benef its are being increased beyond the 
assets original performance. 
All other options are revenue expenses  to be charged to the statement of 
profit or loss because they are simp ly repairs to the original asset. 
Measurement after in itial recognition

Chapter 9 
 175 
 An entity may decide to use a comb ination of these two models for 
measuring assets but must make sure that each class of assets uses the 
same model, i.e. use the cost mo del for plant and machinery and the 
revaluation model for land and buildings. 
IAS 16 Property, Plant and Equipment  defines depreciation as  'the systematic 
allocation of the depreciable amount of an asset over its useful life'   
Depreciable amount is the cost/v aluation less residual value. 
The depreciation charge should be recognised in the statement of profit or loss 
unless it is included in the carrying amount of an asset, e.g. depreciation on 
equipment used for development activities. 
Land will not be depreciated since it has an unlimited life. Buildings, however, 
do have a finite life and so  should be depreciated.  
Therefore, if we are given a total for land and buildings we must remember to 
remove the land element from the total before  we calculate the depreciation on 
the building. 
For example, total for l and and buildings amounts to  $100,000. This includes 
land at cost of $20,000. Buildings shoul d be depreciated at 10% on a straight 
line basis. The depreciation would be calculated as ($100,000 – $20,000) × 
10% = $8,000 a year. 
Repair and maintenance does not negate the need to depreciate the asset. 
If the residual value is greater than the carrying amount, the depreciation 
charge is zero. 
 How do we calculate depreciation? 
 Depreciation can be calculated usi ng the straight lin e or the reducing 
balance method. 
The straight line method is based on co st and will be calculated as a % of 
cost. Each year the depreciation charge will be the same. However, if the 
% is not given it can be calculated as: 
Cost – residual value
useful economic life 
Residual value is the amount the ent ity would expect to receive from 
disposal of the asset at the end of  its useful life to the business. 
The reducing balance method is bas ed on the carrying amount of the 
asset (CA). This is usually expressed as a %. It does not  take into account any estimated residual value. 
When the depreciation is calculated the double entry will be: Dr Depreciation expense (SPL) Cr Accumulated depreciation (SOFP)

176  
Changes in depreciation method  
In accordance with IAS 16 Property,  Plant and Equipment, depreciation 
methods should be reviewed periodically. If it is decided that  there has been a 
change in the pattern of consumption of benefits, the depreciation method 
should be changed to reflect this, e.g. a c hange from the straight line method to 
the reducing balance method. 
Any change in the depreciation met hod should be treated as a change in 
accounting estimate and so the new me thod should be applied in the current 
and future accounting periods (for refe rence, this treat ment applies IAS 8 
Accounting Policies, Changes in Account ing Estimates and Errors. IAS 8 is 
outside the scope of the F1 syllabus). Changes in depreciation methods do not 
represent a change in accounting policy an d so depreciation charges of earlier 
periods should not be altered. 
 
 Illustration 3 – Changes in depreciation method 
 An asset was purchased two years ago for $100,000. 
The directors chose to depreciate the asset using t he reducing balance 
method and so used a rate of 20% per annum. 
The directors have decided that a fairer  presentation would be given if the 
depreciation method was changed to the straight line basis and will 
implement the new depreciation met hod in the year ended 30 June 20X1. 
At this time the directors estimated that the useful lif e was eight years 
and that the residual value was $10,700. 
Calculate the depreciation charge fo r the year ended 30 June 20X1 
in respect of this asset. 
 
 Solution 
 The original depreciation charge was: 
Year 1 = Carrying amount × reducing balance depreciation rate = 
$100,000 × 20% = $20,000 
Year 2 = Carrying amount × reducing balance depreciation rate = 
$80,000 × 20% = $16,000 
The asset has been depreciated for 2 years when the change of 
depreciation method occurs and therefore carrying amount would be: 
$100,000 – ($20,000 + $16,000) = $64,000 The carrying amount at the date of the change must be used to 
recalculate the new depreciation charge. 
Carrying amount 30 June X1 – 	residual value
Remaining useful economic life	=	 $64,000 – 	$10,700
8	=	$6,663 p.a.

Chapter 9 
 177 
 Test your understanding 1 – Methods  
 An asset was purchased two years ago for $150,000. The directors 
chose to depreciate the asset usi ng the reducing balance method and so 
used a rate of 25% per annum. The dire ctors have decided that a fairer 
presentation would be gi ven if the depreciation method was changed to 
the straight line basis and will implem ent the new depreciation method in 
the year ended 30 June 20X1.At this time  the directors estimated that the 
remaining useful life was eight year s and that the residual value was 
$8,500. 
Calculate the depreciation charge for the year ended 30 June 20X1 
Changes in useful life and residual value  
On acquiring an asset, its useful lif e and residual value will be estimated. 
Subsequently, it may be appropriate to revise these estimates 
Again, any change in the useful life or resi dual value will result in adjustments to 
the depreciation charge for current and fu ture periods but no changes should be 
made to past accounting periods, i.e. it  is a change in accounting estimate. 
 
 Illustration 4 – Changes in useful life 
 An asset was purchased three years ago for $50,000 at which time it was 
thought that the asset had a resid ual value of $5,000 and a useful 
economic life of ten year s. The directors have decided that as a result of 
using the asset more than was origin ally planned the remaining useful 
economic life is only five years as at 1 July 20X0. Their estimate of residual value has remained unchanged. The asset is depreciated on the 
straight line basis. 
in respect of this asset.

178  
 Solution 
 The original depreciation was: 
Cost –	residual value
Useful economic life	= $50,000 – 	$5,000
10	=	$4,500 p.a. 
The asset has been depreciated for 3 years when the change of UEL life 
occurs and therefore ca rrying amount would be: 
$50,000 – (3 × $4,500) = $36,500 The carrying amount at the date of the change must be used to 
Carrying amount – 	residual value
Useful economic life
	=	 £36,500 – 	$5,000
5	=	$6,300 p.a. 
 
 Test your understanding 2 – Chang es in useful life of an asset 
 An asset was purchased on 1 July 20X1 for $75,000 at which time it was 
economic life of seven years. The dire ctors have decided that as a result 
of not using the asset as much as was originally planned the remaining 
useful economic life is ten years as at 1 July 20X5. Their estimate of 
residual value has remained unchanged. The asset is depreciated on the straight line basis. 
Calculate the depreciation charge for the year ended 30 June 20X6 
 
 4 Revaluations 
As discussed previously in the chapter, IAS 16 Property, Plant and 
Equipment , allows the treatment of assets  to be shown at their revalued 
amount less accumulated depreciation and accumulated impairment losses. 
The revalued amount of an asset is the asset’s fair value at the date of 
revaluation. 
IFRS 13 Fair Value Measurement , published in May 2011 and applicable 
for accounting periods commencing from  1 January 2013, sets out a single 
framework for measuring fair value. 
IFRS 13 defines fair value as 'the price that woul d be received to sell 
an asset or transfer a liability in  an orderly transaction between 
market participants at the measurement date'  (IFRS 13, B2). 
Revaluing to fair value, means th at the item of property plant and 
equipment will reflect the current val ue of the asset at the point the 
revaluation occurs.

Chapter 9 
 179 
 Key revaluation issues to remember include: 
 If an asset is revalued, any accumulated depreciation up to the date 
of the revaluation should be re versed. This will increase the 
revaluation surplus. The revaluation surplus is also described as the 
revaluation surplus. 
 Depreciation will then be calcul ated based on the revalued amount. 
 Revaluations must be made for the w hole of the class of assets, i.e. if 
we revalue one building we must re value the whole of the class of 
buildings at the same time. 
 The frequency of revaluations will  depend upon the volatility of the 
fair values of the asset class.  T he more volatile, the more frequent 
the revaluation. 
Steps to account for a revaluation: 
1 Restate asset cost to the revalued amount. 
2 Remove any existing accumulated depreciation. 3 Transfer the increase in the cost account and the existing accumulated 
depreciation to the revaluation surplus account within equity. 
4 Recalculate current year's depreciation on the revalued amount if 
applicable. 
Upwards revaluations of PPE  
Accounting entries: 
Dr Asset cost (revalued amount – original cost) 
Dr Accumulated depreciation (depreciation up to the revaluation date – at this 
point the balance of this account will be nil) 
Cr Revaluation surplus (revalued amount – previous carrying amount) 
if an asset increases in value we will incr ease the asset cost account (Dr) to the 
revalued amount and increase the revaluation surplus (Cr). This revaluation surplus will appear in the equity section of  the statement of financial position. 
An entity is allowed to gradually release this reserve into retained earnings over 
the life of the asset by reducing the re valuation surplus (Dr) and increasing the 
retained earnings (Cr). This movement  would be seen in the statement of 
changes in equity. However, in the exam ination, the question will make it 
explicitly clear if t he transfer within equity is required to be performed. If it is not 
mentioned, it is not necessary.

180  
 Release of the revaluation surplus 
 On revaluation of an asset, it is permi ssible to either leave the revaluation 
surplus as it is until the revalued asset is sold or, if it is a depreciating 
asset, to release the reva luation surplus into retained earnings gradually 
over the life of the asset. 
If an asset is revalued upwards, future depreciation charges will increase 
and profits will reduc e, despite there being no changes to the operations 
of the entity. As a result the ent ity may opt to perform the transfer 
between equity between revaluation su rplus and retained earnings for the 
amount of excess d epreciation charged. 
The transfer equals the difference in the depreciation charge on the basis 
of the original asset value and on the basis of the revalued amount. 
For example, an entity acquired an asset costing $100,000 on 1 January 
20X5 with a useful life of  ten years. The asset was revalued to $150,000 
on 31 December 20X9. The useful life is unchanged. 
At the revaluation date we must incr ease the asset value to $150,000 and 
remove any accumulated deprecia tion, i.e. $100,000/10 = $10,000 
depreciation per year multiplied by  5 years, (remember we always 
depreciate as normal up to  the revaluation date). 
Debit Accumulated depreciation ($10,000 × 5 years) $50,000 
Debit Asset cost ($150,000 – $100,000) $50,000 
Credit  Revaluation surplus $100,000 
The revaluation surplus reflects the increase in the carr ying amount of the 
asset, i.e. $100,000 – $50,000 = $50,000 increasing to $150,000. 
The new depreciation charge will be based on the revalued amount of 
$150,000 over the remaining life of the asset of 5 years,  i.e. $30,000 p.a. 
This is an increase in depreciation of  $20,000, compared with the original 
depreciation amount of $10,000 p.a. This means each year we could 
release $20,000 from the revaluation surplus to retained earnings as 
follows: 
Debit Revaluation surplus $20,000 
Credit Retained earnings $20,000 
By doing this we are recognising t he revaluation surplus over the 
remaining life of the asset, i. e. $100,000/5 years = $20,000 p.a. 
This would be shown as a movement in the SOCIE. 
We should only do this in a question if we are instructed to do so.

Chapter 9 
 181 
Downwards revaluation of PPE 
Downward revaluation after previous revaluation upwards 
Dr Revaluation surplus (only to revers e the previous revaluation upwards) 
Dr P/L (with any excess once reva luation increase is reversed) 
Cr PPE – Cost account If an asset subsequently decreases in va lue we will reduce the cost account 
(Cr) to the new fair value and decr ease the revaluation surplus (Dr) up to the 
maximum we have previously reval ued for that particular asset .  
Any excess amount must be charged to t he statement of prof it or loss as an 
expense for the year. 
 
Illustration 5 – Revaluation downwards  
 A piece of land was previously revalued upwards in year one by $10,000. 
In year 2, the land is considered to have reduced in value by $15,000.  
We would reduce the cost by $15,000 (Cr). The other side of the entry 
will reduce the revaluation surplu s by $10,000 (Dr) to reverse the 
balances held in revaluation surplu s from the previous revaluation 
upwards and the difference of $5,000 wil l be charged to the statement of 
profit or loss in an appr opriate expense category. 
The journal entry required is: Dr Revaluation surplus $10,000 Dr P/L $5,000 Cr PPE – Cost account $15,000 
 
Any revaluations we make during the year  that affect the revaluation surplus, 
upwards or downwards, must be shown on the face of the statem ent of profit or 
loss and other comprehensive income under the heading ‘other 
comprehensive income’.  
The amount should reflect the movement ma de in the revaluation surplus during 
the year. 
Therefore, using the abov e example we would show the $10,000 increase in 
year one in other comprehensive income , as a gain on revaluation, i.e. a 
positive figure. 
In year two we would show the $10, 000 decrease in other comprehensive 
income, as a loss on revaluation and t he $5,000 expense woul d reduce profits.

182  
 
 Illustration 6 – Revaluations 
 Land was purchased at a cost of $30, 000. It was subsequently revalued 
to: 
Year 1  $40,000 
Year 2  $33,000 Year 3  $24,000 
Show how each of the gains or lo sses will be recorded within the 
revaluation surplus or the stat ement of profit or loss.

Chapter 9 
 183 
 Solution 
 Year 1 
The asset has increased in value from $30,000 to $40,000. 
Dr Asset $10,000 
Cr Revaluation surplus $10,000 
Year 2 
The asset has decreased in value  from $40,000 to $33,000. This 
decrease can be charged against the revaluation surplus because the surplus within equity already has $10,000 in it from year 1 for 
that particular asset. 
Dr Revaluation surplus $7,000 
Cr Asset $7,000 
Year 3 
The asset has decreased in value from $33,000 to $24,000. The 
decrease cannot all be charged ag ainst the revaluation surplus 
because there is only $3,000 left after year 2 for that particular asset. 
The reserve is reduced to nil and then the balance of the decrease is 
charged against profits in the statement of profit or loss. 
Dr Revaluation surplus $3,000 
Dr Statement of pr ofit or loss $6,000 
Cr Asset $9,000 
 
 Illustration 7 – Revaluations 
 Asset A cost $50,000 on 1 January 20X4. This asset has a useful life of 
10 years and is revalued to $25,000 on 31 December 20X9. 
Asset B cost $50,000 on 1 January 20X7. This asset has a useful life of 5 
years and is revalued to $17,000 on 31 December 20X9. 

184  
 Solution 
 Asset A 
On 31 December 20X9 Asset A has a carrying amount of $20,000 (cost 
$50,000 – depreciation $30,000 ($50,000/10  = $5,000 p.a. multiplied by 6 
years). 
The cost account will r educe from $50,000 to £25,000. 
The accumulated depreciation of $30,000 will be removed from the 
books. 
Overall the carrying amount of the asset has increased from $20,000 to 
$25,000. This increase of $5,000 will be credited to the revaluation 
surplus. 
We must remember next year 's depreciation will be based on the 
revalued amount of £25,000 over t he remaining life of 4 years. 
Cr Asset cost $25,000 
Dr Accumulated depreciation $30,000 
Cr Revaluation surplus $5,000 
Asset B 
On 31 December 20X9 Asset B has a carrying amount of $20,000 (cost 
$50,000 – depreciation $30,000 ($50,000/5 = $10,000 p.a. multiplied by 3 
years). 
The cost account will r educe from $50,000 to £17,000. 
The accumulated depreciation removed from the books = $30,000. Overall, the carrying amount of t he asset decreased in value from 
$20,000 to $17,000. The decrease of $3, 000 is charged against profits in 
the SPL. This asset has not been reva lued in the past and therefore does 
not have a revaluation surplus you can use. You cannot use the reserve from Asset A. 
revalued amount of £17,000 over t he remaining life of 2 years. 
Dr Statement of profit or loss expense $3,000 
Cr Asset cost $33,000 
Note: The revaluation surplus relates to asset A. Therefore, only future 
downward valuations of asset A can be set against the revaluation 
surplus.

Chapter 9 
 185 
 Test your understanding 3 – Revaluations  
 Building A was purchased on 01/01/X3 costing $50,000. It has a useful 
economic life of 50 years and no residual value. 
Building B was purchased on 01/01/X3 co sting $100,000. It has a useful 
life of 40 years and no residual value. 
The entity has a policy to revalue it s assets every four years and has 
done so as follows: 
Building A 
Valuation at 31/12/X6 $69,000 
Valuation at 31/12/Y0 $84,000 
Building B 
Valuation at 31/12/X6 $108,000  
Valuation at 31/12/Y0 $64,000 
Show how the revaluations will be  recorded, clearly showing the 
carrying amount of th e assets at 31/12/Y1. 
 
 Further detail on revaluation decreases  
 Revaluation downwards then upwards 
Let us consider what happens when the decrease in value occurs first, 
followed by a subsequent increase in value for the asset. 
For example, If an item of land decreases in value in year one by $10,000 
we will reduce the cost account (Cr) to reflect the new fair value amount 
and charge the decrease immediately to the statement of profit or loss as 
an expense for the year. 
Dr P/L $10,000 Cr Land  $10,000 If the same land was revalued upward s by $15,000 the following year we 
can reverse our previous entry to the statement of profit  or loss and then 
show the excess from the revaluat ion in the revaluation surplus. 
Increase the asset cost account (D r) by $15,000, reverse the previous 
charge to the statement of  profit or loss expens e of $10,000 (Cr) and then 
show the difference of $5,000 in the revaluation surplus (Cr). 
Dr Land $15,000 Cr P/L $10,000 Cr Revaluation surplus $5,000

186  
 Retirement and disposals 
An item of property, plant and equipm ent should be eliminated from the 
statement of financial position on disposal or when the asset is 
permanently withdrawn from use. 
Gain/(loss) on disposal = Net dis posal proceeds – carrying amount 
Gains or losses on disposal should be recor ded in the statement of  profit or loss 
in an appropriate expense category. If we have a loss on disposal this will 
increase the expense and a pr ofit will reduce the expense. 
We will look at retired assets in more  detail later when we look at IFRS 5 Non-
current Assets Held for Sa le and Discontinued Operations . 
Disposal of revalued assets 
When a previously revalued asset is disposed of the gain on disposal is 
measured as the difference between the carrying amount on the SOFP and the 
proceeds received. 
However, if the asset has been revalued in the past, it will have an unrealised 
gain in the revaluation surplus that must now be removed. 
The amount should be transferred from t he revaluation surplus to retained 
earnings. This movement will be seen in the SOCIE and will not affect this 
year's profit. 
 
 Illustration 8 – Disposal of a revalued asset 
 An entity originally purchased a pi ece of land on 01/01/X7 for $100,000. 
On the 31/12/X8 the land was revalued to $150,000. 
The land was sold for $180,000 on 31/12/Y1. 
Calculate the profit or loss on dispo sal to be shown in the statement 
of profit or loss and any revaluat ion adjustments that need to be 
made. 
 
 Solution 
 When the land was revalued the entries would be made as follows: 
This asset increases in value fr om $100,000 to $150,000. The increase is 
credited to the revaluation surplus. 
Dr Asset $50,000 
Cr Revaluation surplus $50,000 
When the asset was sold the carrying amount was $150,000. 
The gain on disposal to the statement  of profit or loss would be $30,000 
($180,000 – $150,000)

Chapter 9 
 187 
 This would be accounted for by: 
Dr Bank $180,000 
Cr Land $150,000 
Cr Profit or loss $30,000 
The revaluation surplus for the land would now be released into retained 
earnings as the gain is now realised. 
Dr Revaluation surplus $50,000 
Cr Retained earnings $50,000 
This would be shown on the SOCIE. 
Disclosure 
IAS 16 Property, Plant and Equipment , requires the following disclosure 
requirements: 
For each class of prop erty, plant and equipment 
 measurement bases, i.e. cost or valuation 
 depreciation methods with usef ul life or depreciation rate 
 gross carrying amount and accumulat ed depreciation at the beginning and 
end of the period  
 reconciliation of additions, dispos als, revaluations, impairments and 
depreciation 
 when assets have been revalued: 
– basis of valuation 
– date of valuation – whether an independe nt valuer was used 
– carrying amount if no revaluation had taken place – revaluation surplus

188  
Property, plant and equipment (PPE) 
The property, plant and equipment note (I AS 16) shows the movements in the 
year for each category of asset. 
 Land and 
buildings Plant and 
equipment Vehicles Total 
 $000 $000 $000 $000 
Cost/Valuation     
At 1 January 20X0 X X X X 
Additions X X X X 
Surplus/(deficit) on revaluations X/(X) – – – Disposals (X) (X) (X) (X) 
 –– –– –– –– 
At 31 December 20X0 X X X X  –– –– –– –– 
Accumulated Depreciation:     
At 1 January 20X0 X X X X Charged during the year X X X X 
Revaluations (X) – – (X) 
Disposals (X) (X) (X) (X) 
 –– –– –– –– At 31 December 20X0 X X X X 
 –– –– –– –– 
Carrying amount     At 1 January 20X0 X X X X 
 –– –– –– –– 
 
 Test your understanding 4 – PPE note 
 A building was purchased many years ago for $200,000. It has been 
depreciated at 2% per annum (50 year life) on the straight line basis and 
the carrying amount of the asset at 1 July 20X0 is $132,000. The 
directors have had the asset valued at $750,000 and would like to incorporate this valuation into t he financial statement s for the year ended 
30 June 20X1. 
Prepare a non-current asset note for the year ended 30 June 20X1 
and calculate the revaluation surplus assuming that: 
(a) the valuation is as at 1 July 20X0 
(b) the valuation is as at 30 June 20X1.

Chapter 9 
 189 
 5 IAS 36 Impairment of Assets 
IAS 36 Impairment of Assets  defines an impairment loss as ' the amount 
by which the carrying amount of an asset exceeds its recoverable 
amount ' (IAS 36, para 6). 
 
An entity should assess at each reporting date whether t here is any indication 
that an asset may be impaired. If such i ndications exist, the recoverable amount 
should be estimated, i.e. an impairment review should be carried out. If no such 
indications exist, it is not necessary  to carry out an im pairment review. 
The following situations may indica te that an asset has been impaired: 
 decline in market value 
 technological, legal or economic changes 
 physical damage 
 plans to dispose of asset. 
 
 Procedures to check for impairment 
 At the end of each repor ting period an entity shoul d assess whether there 
are internal or external indications t hat the value of any asset is impaired. 
In assessing whether there is any indication that an asset may be 
impaired, an entity shall consider  the following indications: 
External sources of information: 
 During the period, an asset’s market  value has declined significantly 
more than would be expected as a resu lt of the passage of time or 
normal use. 
 Significant changes with an adverse effect on the entity have taken 
place during the period within th e markets in which the entity 
operates or to which an asset is dedicated. 
 Market interest rates have increased during the period. These 
increases are likely to affect the di scount rate used in calculating an 
asset’s value in use and so could decrease the asset’s recoverable 
amount.

190  
 Internal sources of information: 
 Evidence is available of obsol escence or physical damage of an 
asset. 
 Significant changes with an adverse effect on the manner in which 
an asset is used or is expected to be used. Examples of such 
changes include the asset becoming idle, plans to discontinue or 
restructure the operation to whic h an asset belongs, and plans to 
dispose of an asset before t he previously expected date. 
 Evidence is available from internal  reporting that i ndicates that the 
economic performance of an asset is, or will be, worse than 
expected. 
Recognition and measurement of an impairment loss  
An impairment loss occurs when the reco verable amount of an asset is below 
its carrying amount,  
An impairment loss should be recorded as an expense in the stat ement of profit 
or loss, unless the asset has prev iously been revalued upwards.  
If the asset had previously been revalued, the impairment can be offset against 
the revaluation surplus. 
 
 Cash-generating units 
 If there is an indication of impairm ent of an asset, the recoverable amount 
must be identified. 
If it is not possible to estimate the recoverable amount of the individual 
asset (e.g. the asset does not produc e its own cash flows to calculate 
value in use), then the entity will extr apolate their impairment calculations 
to incorporate groupings of assets ra ther than simply impairing individual 
assets. 
These groups of assets are called cash-generating units. 
A cash-generating unit is the smallest  identifiable group of assets that 
generates independent cash inflows.

Chapter 9 
 191 
 Illustration 9 – Impairment 
 The following information relates to three assets held by an entity: 
 A B C 
Carrying amount 200 200 200 
Net selling price 220 125 140 
Value in use 160 150 190 
Calculate the impairment losses, if  any, in respect of the three 
assets. 
 
 Solution 
  
 A B C 
Recoverable amount (higher of net selling price 
and value in use) 220 150 190 
Impairment NO (50) (10) 
 
 Test your understanding 5- Impairment 
 A B C 
Net selling price 250 175 160 
Value in use 180 150 180 
assets. 
IAS 36 Impairment of Assets  requires the following di sclosure requirements: 
For each class of prop erty, plant and equipment: 
 The amount of impairment losses recogni sed in the statement  of profit or 
loss during the period and w here it has been included,  i.e. which expense 
category. 
 The amount of reversals for impairment losses recognised in the 
statement of prof it or loss during the peri od and where it has been 
included. 
 The amount of impairment losses rec ognised directly in equity during the 
period. 
 The amount of reversals of impairment  losses recognised directly in equity 
during the period.

192  
 Test your understanding 6 – Practice questions 
 1 An entity purchased a property 15 years ago at a cost of $100,000 
and has depreciated it at a rate of 2% per annum, using the straight 
line basis. The entity had the proper ty professionally revalued at 
$500,000. 
What is the revaluation surplus that will be recorded in the 
financial statements in r espect of this property? 
A $400,000 
B $500,000 C $530,000 D $430,000 
2 An entity owns two buildings, A and B, which are currently recorded 
in the books at carrying amounts of $170, 000 and $330,000 
respectively. Both buildings have recently been valued as follows: 
Building A $400,000 Building B $250,000 The entity currently has a balance on the revaluation surplus of 
$50,000 which arose when building A was revalued several years 
ago. Building B has never been previously revalued. 
What double entry will need to be made to record the 
revaluations of buildings A and B? 
A Dr Non-current assets $150,000 
 Dr Statement of pr ofit or loss $80,000 
 Cr Revaluation surplus $230,000 
B Dr Non-current assets $150,000 
 Dr Statement of pr ofit or loss $30,000 
 Cr Revaluation surplus $180,000 
C Dr Non-current assets $150,000 
 Cr Revaluation surplus $150,000 
D Dr Non-current assets $150,000 
 Dr Statement of pr ofit or loss $50,000 
 Cr Revaluation surplus $200,000

Chapter 9 
 193 
 3 The following information relates to three assets held by an entity: 
 Asset A Asset B Asset C 
 $ $ $ 
Carrying amount 100 50 40 
Value in use 80 60 35 Fair value less cost to sell 90 65 30 
What is the total impairment loss? 
A $15 B $30 C $Nil D $1 
4 On 1 April 20X0 Slow and Steady showed non-current assets that 
had cost $312,000 and accumula ted depreciation of $66,000. 
During the year ended 31 March 20X 1, Slow and Steady disposed 
of non-current assets which had originally cost $28,000 and had a 
carrying amount of $11,200. 
The entity's policy is to charge depreciation of 40% on the reducing 
balance basis, with no depreciation in the year of disposal of an 
asset. 
What is the depreciation charge to the statement of profit or 
loss for the year ended 31 March 20X1? 
A $113,600 B $98,400 C $93,920 D $87,200 
5 A building contractor decides to build an office building, to be 
occupied by his own staff. Tangibl e non-current assets are initially 
measured at cost. 
Which of the following expenses incurred by the building 
contractor cannot be included as a pa rt of the cost of the office 
building? 
A Interest incurred on a specific loan taken out to pay for the 
construction of the new offices 
B Direct building labour costs C A proportion of the contractor’s  general administration costs 
D Hire of plant and machinery for use on the office building site

194  
 6 The purpose of depreciation is to: 
A Allocate the cost less resi dual value on a systematic basis 
over the asset’s useful economic life 
B Write the asset down to its market value each period C Charge profits for t he use of the asset 
D Recognise that assets lose value over time 
7 Which of the following items of property, plant and equipment  
are NOT depreciated: 
A Machinery  
B Land C Buildings with a life in excess of 30 years D Vehicles 
8 Plant and machinery, costing $50,000, was purchased on 1 April 
20X6. This was depreciated for 2 year s at 20 per cent a year using 
the reducing balance method. On 1 April 20X8, some of the 
machinery (original cost $25,000) was sold for $12,000. Replacement machines were acquired on the same date for $34,000. 
What was the carrying amount of plant and machinery at March 
20X9? 
9 Roming Co purchased property costing $440,000 on 1 January 
20X5. The property is being deprecia ted over 50 years on a straight-
line basis. The property was revalued on 1 January 20X9 at $520,000. The useful life was also reviewed at that date and is 
estimated to be a further 40 years. 
Prepare the accounting entries to  record the revaluation and 
calculate the depreciation charge that will apply from 1 January 
20X9.

196  
 Test your understanding 1 – Methods 
Year 1 = Cost $150,000 × 25% = $37,500 
Year 2 = CA $112,500($150,000 – $37,500) × 25% = $28,125 
The asset has been depreciated fo r 2 years when the change of 
depreciation method occurs and therefore CA would be: 
Cost $150,000 – ($37,500 + $28,125) = $84,375 The CA at the date of the change is the carrying amount on the statement 
of financial position for the asse t and must therefore be used to 
CA –	residual value
Remaining useful economic life
	=	 $84,375 – 	$8,500
8	=	$9,484 p.a. 
 
CA – residual value
Remaining useful economic life =  $75,000 – $5,000
7 = $10,000 p.a. 
The asset has been depreciated for 4 years when the change of 
Cost $75,000 – $40,000 = $35,000 
The CA at the date of the change is the carrying amount on the statement 
Remaining useful economic life =  $35,000 – $5,000
10 = $3,000 p.a.

Chapter 9 
 197 
 Test your understanding 3 – Revaluations 
 Asset A 
The asset initially cost increases  by $19,000, ($50,000 to $69,000). 
Depreciation is $10,000 pa ($50, 000/50). Therefore accumulated 
depreciation at 31/12/X6 will be $4,000. 
After 4 years (31/12/X6) the carr ying amount will be $46,000 ($50,000 – 
$4,000). 
The asset increases in value from $46,000 to $69,000. The increase of 
$23,000 is credited to the revaluation surplus. 
Dr Asset cost $19,000 
Dr Accumulated depreciation $4,000 Cr Revaluation surplus $23,000 
The depreciation must now be recalc ulated on the revalued amount for 
the remaining life of 46 years. 
Depreciation is $1,500 pa ($69,000/46) After 4 years (31/12/Y0) the carr ying amount will be $63,000 ($69,000 – 
$6,000) 
The asset cost increases by $15,000, $69,000 to $84,000. This assets carrying amount increases  in value from $63,000 to $84,000. 
The increase of $21,000 is credi ted to revaluation surplus. 
Dr Asset cost $15,000 
Dr Accumulated depreciation $6,000 
Cr Revaluation surplus $21,000 
the remaining life of 42 years. 
Depreciation is $2,000 pa ($84,000/42) 
The carrying amount at 31/12/Y1 will be: 
$84,000 – $2,000 = $82,000 
Asset B 
The asset initially cost increases by $8,000, ($100,000 to $108,000). 
Depreciation is $2,500 pa ($100,000/ 40). Therefore, accumulated 
depreciation at 31/12/X6 is $10,000. 
After 4 years (31/12/X6) the CV will be $90,000 ($100,000 – $10,000)

198  
 This asset's carrying value increases from $90,000 to $108,000. The 
increase of $18,000 is credited to  the revaluation surplus. 
Dr Asset cost $8,000 
Dr Accumulated depreciation $10,000 
Cr Revaluation surplus $18,000 
The depreciation must now be recalculated on the revalued amount for 
the remaining life of 36 years. 
Depreciation is $3,000 pa ($108,000/36) After 4 years (31/12/Y0) the carr ying amount will be $96,000 ($108,000 – 
$12,000) 
The asset cost decreases by $44,000, ($108,000 to $64,000). This assets carrying amount decreases from $96,000 to $64,000. The 
decrease is charged to the revaluation surplus to reduce it to nil and the 
balance is charged against profits. 
Dr Revaluation surplus $18,000 
Dr Statement of prof it or loss $14,000 
Dr Accumulated depreciation $12,000 
Cr Asset $44,000 
Note: The revaluation surplus for building A cannot be used for the 
reduction in value of building B. 
the remaining life of 32 years. 
Depreciation is $2,000 pa ($64,000/32) 
$64,000 – $2,000 = $62,000 
Under IAS 16 we need to revalue with sufficient regularity to ensure that 
carrying amount and fair value are not materially differe nt. It is assumed 
that by revaluing every 4 years in  the question meets this criteria.

Chapter 9 
 199 
  
 (a) (b) 
Non-current asset note $000 $000 
Cost/Valuation   
At 1 July 20X0 200 200 Revaluation 550 550 
 ––– ––– 
At 30 June 20X1 750 750  ––– ––– 
Acc Dep'n   
At 1 July 20X0 (200 – 132) 68 68 Charge for year 23 4 
Revaluation (68) (72) 
 ––– ––– 
At 30 June 20X1 23 0 
 ––– ––– 
Carrying amount   
At 1 July 20X0 132 132 At 30 June 20X1 727 750 
Revaluation surplus 618 622 
 (750 – 132) (750 – 128) 
If the revaluation takes place at t he beginning of the year, the current 
year's depreciation charge should be based on the revalued amount. The 
depreciation charge was based on 2% of  cost, i.e. $4,000 pa. If the 
carrying amount b/fwd is $132,000, it must mean we have already utilised 
the asset for 17 years ($4,000 × 17 = $68,000 depreciation to date). 
When the asset is revalued we must now depreciate the revalued amount 
over the remaining life of 33 years (50 – 17). This will result in the current 
year's depreciation charge of $22,727 ($750,000/33), rounded to 
$23,000. 
If the revaluation takes place at the end of the year, the current year's 
depreciation should be based on the original amount, i.e. $200,000 × 2%. 
The total depreciation to date will then be removed from the books and 
transferred to the revaluation su rplus, i.e. $68,000 + $4,000.

200  
 Test your understanding 5 – Impairment 
  
 A B C 
Recoverable amount 250 175 180 
Impairment No (25) (20) 
NB: Recoverable amount is the higher of the net selling price and value 
in use. 
 
 1 C 
2 D 
Current value 500,000 
CA at date of revaluation  (100,000 – (100,000 × 2% × 15yrs)) (70,000) 
 ––––––– 
Revaluation gain 430,000 
3 A 
 Building A Building B 
Current value 400,000 250,000 Carrying amount (170,000) (330,000)  ––––––– ––––––– Revaluation gain/lo ss 230,000 (80,000) 
The gain on Building A will be credit ed to the revaluation surplus. 
The loss on Building B will be debited to the statement of profit or 
loss expenses because we do not have a balance on the revaluation surplus in respect of building B to net the loss off against. 
We make an overall Dr to non-current assets is $230,000 – $80,000 
= $150,000

Chapter 9 
 201 
 4 A 
 Asset Asset Asset 
 A B C 
 $ $ $ 
Value in use 80 60 35 Fair value less cost to sell 90 65 30     
Valued at higher of value in use/fair value 90 65 35 
Impairment 10 Nil 5 
    
Total Impairment = $15    
5 C 
Carrying amount at 1 April 20X0 $246,000 
($312,000 – $66,000)  Carrying amount of disposal ($11,200)  –––––––– Carrying amount at 31 March 20X1 $234,800 
Depreciation at 40% $93,920 
6 C – Direct costs relating to the asset can be included such as labour 
costs, interest on loans to acquire the asset and hire costs. The 
administration cost is  not a direct cost. 
7 A 8 B 9 The answer is $ 40,000 
 $ 
Cost 1 April 20X6 50,000 20% depreciation (10,000)  –––––– Carrying amount 31 March 20X7 40,000 
20% depreciation (8,000) 
 –––––– Carrying amount 31 March 20X8 32,000 Disposal book value ($25,000 × 80% × 80%) (16,000) (Cost $25,000 – depreciation for 2 years $9,000) –––––– Carrying amount after disposal 16,000 
Purchase 34,000 
 ––––––  50,000 20% depreciation (10,000)  –––––– Carrying amount at 31 March 20X9 40,000  ––––––

202  
 10 The annual charge for depreciati on was $440,000/50 years 5 
$8,800. 
The asset had been used and depreciated for 4 years (2007 to 
2010). 
The carrying amount of the asset at the date of valuation was 
therefore $404,800 (cost of $440,000 – accumulated depreciation of 
$35,200). 
The revaluation surplus is calcul ated as the valuation amount of 
$520,000 less the carrying amount of  the asset of $404,800. The 
surplus is therefore $115,200. 
The revaluation at 1 January 20X9 will be recorded as: 
  $ $ 
Debit Accumulated depreciation 35,200  Debit Cost ($520,000 – $440,000) 80,000  
Credit Revaluation surplus  115,200 
The depreciation charge for 20X9 and beyond will be based on the 
asset’s valuation over the remaini ng useful life of the property. The 
useful life has also been revised to  40 years, so the depreciation will 
now be $13,000, being value of $520,000 over 40 years.

203 
IFRS 5 Non-current 
Assets Held for Sale and 
a. Non-current assets IFRS 5 (Non-current Assets 
Held for Sale and Discontinued Operations) Chapter 
10

IFRS 5 Non-current Assets Held for Sale and Discontinued Operations 
204  
 
The objective of IFRS 5  Non-current Assets Held for Sale and Discontinued 
Operations  is to establish principles for reporting information about discontinued 
operations and non-current a ssets held for sale.  
Definition of discontinued operations 
IFRS 5 Non-current Assets Held for Sale and Discontinued Operations defines 
a discontinued operation as ' a component of an entity that either has been 
disposed of or is classi fied as held for sale, and:  
 that represents a separate major line of business or geographical 
area of operations 
 that is part of a single co-ordin ated plan to dispose of a separate 
major line of business or geogr aphical area of operations, or 
 that is a subsidiary acquired excl usively with a view to resale'. (IFRS 
5, para 32)

Chapter 10 
 205 
 3 Non-current assets held for sale 
In the previous chapter we consi dered disposals of non-current assets. 
The disposal of an asset means the asset has been sold. It was removed 
from our records and a gain or loss on the sale is recorded. 
At the date the financial st atements are prepared, it is possible that parts 
of the business or separate assets may not have physically been disposed 
of but it is obvious that they are no longer going to be used by the entity 
e.g. an empty warehouse surplus to requirements which the entity is 
attempting to sell. The asse t maybe classified as a held for sale asset.  
An entity shall classify a non-current a sset as held for sale if its carrying 
amount will be recovered principally thr ough a sale transaction rather than 
through continuing use. 
Held for sale criteria 
In accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued 
Operations,  assets will be treated as held for sale if all of the following criteria 
are met: 
 it is available for immediate sale in its present condition 
 the sale is highly probable 
 management are committed to a plan to sell the asset 
 an active programme to locate a buyer has been initiated 
 the asset is being actively marketed at a reasonable price 
 the sale is expected to complete  within one year from the date of 
classification 
 it is unlikely that the plan will change signif icantly or be withdrawn. 
 
 All criteria must be met if the non-current asset is to be held for sale. 
For example, for the sale to be hi ghly probable the management must be 
committed to selling the asset and they must have an active programme to 
locate a buyer. The asset must also be available to sell immediately in its 
present condition, i.e. no major repai rs are requirement on a building 
before it could be put on the market to sell. 
The classification of an asset as held for sale has 2 implications to the financial 
statements: 
– measurement – classification.

206  
Measurement of non-current assets held for sale 
 
 Non-current assets ‘held for sale’ are not depreciated. Prior to 
classification as held for sale, the asset will be treated in line with the applicable accounting st andard e.g. Property, pl ant and equipment should 
be depreciated as normal until date of classification as held for sale. 
If the value of the asset held for sale  is less than the carrying amount on 
the statement of finan cial position it should be written down and the 
impairment charged against profit. 
Presentation and disclosure 
 Held for sale assets will be classified as a separate category of current 
asset separately disclosed below t he normal current asset section. 
 
 Illustration 1 – Assets held for sale 
 On 1 January 20X8, an entity Mickey purchases a machine for $20,000. It 
has an expected useful life of 10 year s and nil residual value. The entity 
uses the straight line method of depreciation. 
On 31 December 20X9, the entity decides  to sell the machine. Its current 
market value is $15,000 and the entity is  confident they will find a buyer 
very quickly due to the short supply in the market for this type of machinery. It will cost the entity $500 to dismantle the machine. 
At what value should the machine be included in Mickey's statement 
of financial position at 31 December 20X9?

Chapter 10 
 207 
 Solution 
 Current carrying amount = 8/10 × $20,000 = $16,000 (Mickey has had the 
machine for two years, hence charged two years' worth of depreciation 
against the asset). 
Fair value less costs to sell = $15,000 – 500 = $14,500 The machine qualifies as an "asset hel d for sale" at 31 December 20X9 
so should be valued at the lower of  carrying amount or fair value less 
costs to sell, i.e. $14,500. 
The carrying amount must be writt en down from $16,000 to $14,500. The 
impairment will be charged against profit fo r the year in t he statement of 
profit or loss. 
The machine is no longer depreciated. 
 
 The revaluation model 
 Any assets valued under the revaluatio n model that meet the criteria of 
an asset held for sale should firs t be revalued as normal and then 
separately written down to the fa ir value less costs to sell.  
For example, property plant and equipment measured using the 
revaluation model with a carrying am ount of $10,000 met t he criteria of 
an asset held for sale when the fair  value of the asset was $12,000 and 
the costs to sell were $3,000. 
The asset would first be revalued by $2,000 as per IAS 16 by debiting the 
asset cost account and crediting the revaluation reserve.  
Dr PPE $2,000 Cr Revaluation reserve $2,000 Remove the PPE and show at lower of ca rrying amount or FV less cost to 
sell. The carrying amount is now $12, 000, the FV less cost to sell is 
$9,000 ($12,000 – $3,000). The held for sale asset is recorded at $9,000. 
Dr Held for sale asset $9.000 Dr Profit or loss $3,000 Cr PPE $12,000 This results in the costs to sell being recognised as an immediate 
impairment cost to the SPL. 
The revaluation reserve will be transferred upon disposal to retained 
earnings.

208  
Case Study Exam, Ma y 2017 – Question  
You receive the following email from Aaron Jenkins, Senior Management 
Accountant 
From:  Aaron Jenkins, Senior Management Accountant  
To: Finance Officer 
Subject:  Transfer of production 
As part of the ongoing integration of policies, procedures and systems 
throughout the group, it has been decid ed to transfer production of all 
Ashworth Lea's cars to the Naas pr oduction facility in Mayland. It is 
intended that production at the new fac ility will commence in July and we 
will vacate the existing factory at that time. The plant and equipment 
currently used will be transferred to their production facility. 
We need to decide how we are going to  account for the vacated factory 
premises. At the moment, we don't have a buyer but we are actively 
seeking one. We have had the premises  valued by a specialist surveyor, 
who is confident that we should be able to find a buyer in the next 6 to 9 months. 
Hannah Wilson is on holiday at the moment so the Finance Director has 
asked me to deal with this issue. We will need to review the provisions of IAS 16 Property, Plant and Equipment and IFRS 5 Non-current Assets Held for Sale and Discontinued Operations. 
As part of the integration of t he group's systems, we have also been 
asked to consider the implementati on of an activity based costing system 
which is already being used in the Naas Group. In order to get an idea of how it might operate, I have looked at  the operations in the paint shop 
and prepared a schedule (attached) expl aining some of the different 
activities carried out in that area. At  the moment we treat the paint shop 
as a cost centre and use direct l abour hour absorption rate to produce 
product costings for our cars. 
Prepare a draft report for me covering the following areas: 
How the specific requirement s under IAS 16 Property Plant and 
Equipment and IFRS 5 Non-current Assets Held for Sale and 
Discontinued Operations would apply in respect of the vacated factory 
premises. 
How we could use the activity information, given in the schedule, to produce costings for our cars. Pleas e also provide suggestions and 
explanations, for appropriate cost driver s for each of the activities in the 
schedule.

Chapter 10 
 209 
 Regards 
Aaron Jenkins Senior Management Accountant Ashworth Lea (note for the purpose of this illust ration the cost drivers have not been 
discussed as they are not relevant to the F1 exam) 
Level F1 Financial Reporting and Taxa tion Case Study Exam May 2017 
 
 Case Study Suggested Answer  
Case Study Exam, May 2017 – Suggested Answer  
solely on the areas of the case study relevant to the F1 exam, the cost drivers are not discussed below. 
REPORT ON VACATE D FACTORY AND ABC 
Accounting treatment of  the vacated factory 
The decision about how to treat the vacated factory will depend on 
whether we sell it between now and the financial year end on  
31 December 2017. If we sell the fa ctory before 31 December 2017, we 
will need to derecognise it as part of  property, plant and equipment and 
recognise a profit or loss on disposal in the statement of  profit or loss. 
If we do not sell before 31 December 2017 we will still own the factory but 
we will no longer be using it for busine ss purposes. IFRS 5 requires that it 
should be classified as an asset held for sale if its carrying amount will be recovered through a sale transaction ra ther than through continuing use. 
To be treated as an asset held for sale, it needs to meet certain criteria: 
 It needs to be available for immediat e sale in its present condition. 
We intend to sell the factory as soon as possible after it is vacated 
and it is likely to be in a saleable condition given that we would have been using the space up until July. 
 The sale is highly probable. This  is evidenced by the following: 
A reasonable price has been set. We have taken the advice of 
specialist surveyors regarding price. 
The sale is expected to complete within one year from the date of 
the classification. The surveyor has indicated that they should be 
able to find a buyer withi n the next 6-9 months. 
There is a firm commitment to sell and an active programme to find 
a buyer. Again the fact that we have engaged a specialist surveyor to act on our behalf is evidence of this.

210  
 The vacated factory therefore would m eet all the criteria necessary to be 
recognised separately in the statement  of financial position as 'assets 
held for sale'. Assets held for sale  should be disclosed separately under 
the current asset section of the statement of fi nancial position. 
The value of the factory should be rec ognised at the lower of its carrying 
amount on the date it becomes held fo r sale and the fair value less the 
costs to sell. In order to determi ne the carrying amount we will need to 
depreciate the factory up until the date it becomes held for sale but no 
depreciation is requir ed after that date. 
 
 1 According to IFRS 5 Non-current Assets Held for Sale and 
Discontinued Operations which of the following relate to the 
criteria for an asset held for sale? 
(i) Available for immediate sa le in its present condition 
(ii) Sales is highly probable (iii) The sale is expected to be completed within the next month 
(iv) A reasonable price has been set 
A All of the above 
B i, ii and iii 
C i, ii and iv 
D ii, iii and iv 
2
 According to IFRS 5  Non-current Assets Held for Sale and 
Discontinued Operations  how should non-current assets held 
for sale be valued? 
A Lower of the carrying amount or the fair value 
B Lower of the carrying amount or the fair value less costs of 
disposal 
C Higher of the carrying amount or the fair value D Higher of the carrying amount or  the fair value less costs of 
disposal

Chapter 10 
 211 
 3 At the reporting date an asset is identified as an asset held for sale 
after meeting the criteria  according to IFRS 5 Non-current Assets 
Held for Sale and Discontinued Operations . At the reporting date the 
carrying amount of the asset wa s $150,000 (original cost $200,000 
two years ago). The asset had an original 10 year useful life and the entity has a policy to depreciate assets using the straight-line method. 
What should the depreciation be for the year? 
A $20,000 
B $15,000 C None D $25,000 
4 At the reporting date an asset is identified as an asset held for sale 
after meeting the criteria accordi ng to IFRS 5 Non-current Assets 
Held for Sale and Discontinued Operations. 
Where should the asset appear on the statement of financial 
position? 
A Part of the property, plant and equipment under non-current 
assets 
B It is not shown on the statement of financial position C Separately below non-current assets D Separately below current assets 
5 In order for an asset to be classi fied as held for sale under IFRS 5, 
certain conditions need to be met. 
Which of these is not one  of the conditions? 
A Management has committed it self to scrap the asset. 
B The asset is expected to be sold within 12 months following 
classification to held for sale. 
C It is unlikely that the pl an will be changed significantly. 
D The sale is highly probable

212  
 6 Kat has a year-end of 31st Dece mber. On the 1st January 20X9, it 
classified one of its fre ehold properties as held for sale. At that date 
the property had a carrying amount of $667,000 and had been 
accounted for according to the reva luation model. Its fair value was 
estimated at $825,000 and the costs to sell at $3,000. 
In accordance with IFRS 5 ( Non-current Assets Held for Sale 
and Discontinued Operations ), what amounts should be 
recognised in the financial statements for the year to  31 December 20X9? 
A Statement of profit  or loss gain $155,000  
Statement of prof it or loss impairment loss $3,000  
Revaluation gain nil 
B Statement of profit  or loss gain $158,000  
Statement of prof it or loss impairment loss nil  
C Statement of prof it or loss gain nil 
Revaluation gain $155,000 
D Statement of prof it or loss gain nil 
Revaluation gain $158,000 
7 Which of the following statements are true in relation to assets 
held for sale under IFRS 5 Assets Held for Sale And 
Discontinued Operations ? 
(i) Assets held for sale are always separately disclosed within the 
statement of pr ofit or loss. 
(ii) An asset with a carrying amount of £20,000 and a fair value 
less cost to sell of £18,000 would have suffered a £2,000 impairment. 
A Both. 
B (i) only 
C (ii) only D Neither

214  
 1 C 
2 B 
3 A – The asset does not meet the cr iteria of an asset held for sale 
until the reporting date, hence depreciate the asset as normal for the year. No further depreciation will occur on this asset after the reporting date. 
4 D 5 A 6 D – The asset held for sale will be revalued to the fair value of 
$825,000 creating a gain of $158,000 to  the revaluation reserve. 
The asset held for sale will then be reduced to the fair value less 
costs to sell value of $825,000 – $3,000, i.e. create an impairment 
cost of $3,000. There will not be a gain to the SPL until the asset is 
sold and the gain is realised. 
7 C – The asset held for sale will be valued at the fair value less costs 
to sell, i.e. $18,000. This will redu ce the carrying amount by $2,000 
impairment. Item one is not correct  as the asset held for sale 
appears on the SFP as a separ ate item and not on the SPL.

215 
IFRS 16 Leases 
Lead outcome Component outcome 
b. Leases 
  Chapter 
11

IFRS 16 Leases  
216  
 
An entity may need a particular asset fo r its operations but may not have the 
cash available to purchase the asset outri ght. As a result, the entity may enter a 
lease agreement whereby t he entity gets to use the a sset on a day to day basis 
but pays for the asset via periodic rental payments. 
This is a common method of financi ng utilised by many businesses.  
 
 Definitions 
 
'A lease is a contract, or part of a c ontract, that conveys the right to use 
an asset (the underlying asset) for a pe riod of time in exchange for 
consideration.' 
The lessor  is the 'entity that provides the right to use an underlying asset 
in exchange for consideration.'  
The lessee  is the 'entity that obtains the right to use an underlying asset in 
exchange for consideration.'  
A right-of-use asset 'represents the lessee's rights to use an underlying 
asset for the lease term.' (IFRS 16, Appendix A).  
 
 3 Lessee accounting 
As defined above, the lessee is the entit y using the asset on a day-to-day basis. 
It has the right-of-use of the asse t. The lessee will be paying rentals. 
Basic principle 
At the commencement of the leas e, the lessee should recognise: 
 a lease liability, and 
 a right-of-use asset. 
As ever, the accounting treatment cons iders the initial m easurement and the 
subsequent treatment of a lease.

Chapter 11 
 217 
Initial measurement 
Lease liability  
Per IFRS 16 Leases , the lease liability is initially measured at the present value  
of the lease payments that have not yet been paid.  
Lease payments should include the following:  
 Fixed payments over the lease term. 
 Amounts expected to be payable under residual value guarantees. 
A residual value guarantee is provided by  the lessee and states that the 
underlying asset at the end of the l ease term will not be worth less than a 
specified amount. This reduces t he risk of damage and unauthorised 
usage of the asset.  
 Options to purchase the asset that ar e reasonably certain to be exercised. 
 Termination penalties, if the lease term  reflects the expectation that these 
will be incurred. 
The discount rate should be the rate implicit in the lease . 
If the implicit rate of the lease cannot  be determined, then the entity should use 
its incremental borrowing rate (the rate  at which it could borrow funds to 
purchase a similar asset). 
The right-of-use asset  
The right-of-use asset is initially recognised at cost. 
Per IFRS 16  Leases , the initial cost of the right-of-use asset comprises: 
 The amount of the initial measurement  of the lease liability (see above) 
 Lease payments made at or before the comm encement date 
 Any initial direct costs 
 The estimated costs of removing or  dismantling the underlying asset, as 
per the conditions of the lease. 
The lease term 
The lease term is the length of time t hat the lessee has t he right-of-use of an 
asset.  
To calculate the initial value of the lia bility and right-of-use asset, the lessee 
must consider the length of t he lease term. As per IFRS 16 Leases , the lease 
term comprises: 
 Non-cancellable periods 
 Periods covered by an option to ext end the lease, if they are reasonably 
certain to be exercised 
 Periods covered by an option to terminate the lease, if these are 
reasonably certain not to be exercised.

218  
 Illustration 1 – Initial recognition 
 Sadio leases a machine over a 5 year lease term from BH from  
1 December 20X5. Rental payments of $75,000 are made in advance on 
1 December each year and the firs t instalment has just been paid. 
The useful life of the asset is 7 year s. A lease arrangement fee of $1,500 
was incurred by Sadio. The rate implicit on the lease cannot be readily determined but the rate of increm ental borrowing for Sadio is 8%.  
Ownership of the asset is retained by  the lessor at the end of the lease 
term. 
Required: 
What would be the initial journal entry  required to record the lease on  
1 December 20X5? 
Solution 
The lessee must record a lease li ability and a right-of-use asset. 
The lease liability will be recorded at the present value of lease payments 
that have not been paid. The implicit  rate of the lease is unknown 
therefore, the rate of  incremental borrowing of 8% should be used as a 
discount factor. 
The lease liability will be recorded at: 
 
Date of repayment Lease  
payment 
$ Discount 
factor at 
8% Present 
value 
$ 
1st Dec 20X6 – 20X9 75,000 3.312 248,400 
   –––––––    248,400 
   ––––––– 
The right-of-use asset is recorded at  the lease liability + lease payments 
already made + initial direct  costs = 248,400 + 75,000 + 1,500 = 
$324,900 
The journals required on 1s t December 20X5 are: 
Dr Right-of-use asset  $324,900 
Cr Lease liability  $248,400 
Cr Cash $76,500

Chapter 11 
 219 
 Test your understanding 1 – Dynamic 
 On 1 January 20X1, Dynamic entered into a two year lease for a lorry. 
The contract contains an option to extend the lease term for a further 
year. Dynamic believes that it is r easonably certain to exercise this 
option. Lorries have a useful life of ten years. 
Lease payments are $10,000 pe r year for the init ial term and $15,000 per 
year for the option period.  All payments are due at the end of the year. To 
obtain the lease, Dynamic incurs init ial direct costs of $3,000. The lessor 
reimburses $1,000 of these costs. 
The interest rate for the lease is  not readily determinable. Dynamic’s 
incremental rate of borrowing is 5%. 
Required: 
Calculate the initial carry ing amount of the lease lia bility and the right-of-
use asset and provide the double ent ries needed to record these 
amounts in Dynamic's financial records. 
Subsequent measurement 
Lease liability 
The carrying amount of the lease liability is increased by the interest charge. 
Interest is also recorded in t he statement of pr ofit or loss: 
Dr Finance costs (SPL)  X 
Cr Lease liability (SFP)  X 
The carrying amount of the lease liabi lity is reduced by cash repayments: 
Dr Lease liability  X  
Cr Cash  X 
The layout of the lease table will depend on whether payment s are made at the 
end of the year (in arrear s) or at the start of  the year (in advance). 
Lease liability tables 
Payments in arrears 
Year Balance b/f Interest Payment Balance c/f 
1 X X (X) A 
2 X X (X) B 
Payments in advance 
Year Balance b/f Payment Subtotal Interest Balance c/f 
1 X (X) X X A 
2 X (X) B   
The current liability element will be A – B The non-current liability el ement will be figure B.

220  
The right-of-use asset 
The right-of-use asset is measured using t he cost model. This means that it is 
measured at its initial cost less a ccumulated depreciation and impairment 
losses. 
Depreciation is calculated as follows: 
 If ownership of the asset transfers to the lessee at the end of the lease 
term then depreciation should be char ged over the asset's remaining 
useful life 
 Otherwise, depreciation is charged over  the shorter of the useful life and 
the lease term (as defined previously). 
 
 Other measurement models 
 Note that IFRS 16 does allow other  measurement models varying from 
the cost model to be applied to the ri ght-of-use asset. For example, fair 
value methods or revaluation methods may be applied. 
This is applicable if the right-of-us e relates to an asset that would 
normally be accounted for using these models. 
 Investment properties valued at fa ir value. The right-of-use asset 
can be revalued to fair value, gains or losses to profit or loss 
 Items of property, plant and equipment using a policy of revaluation.  
The right-of-use asset may be reva lued with gains or losses to 
revaluation reserves. 
 
 Illustration 2 – Subsequent treatment 
 Using the details from illustration 1, prepare extracts to the financial 
statements for the year  ended 30 November 20X6. 
Solution 
Journals required on 1st December 20X5 (as noted previously in 
illustration 1): 
Dr Right-of-use asset $324,900 Cr Lease liability $248,400 Cr Cash $76,500 The lease liability is increased by finance charges and decreased by the 
lease repayment each year. The inte rest is recorded using the 8% 
incremental borrowing rate.

Chapter 11 
 221 
 Period Liability Repayment Sub-
total Interest 
8% c/f 
 $ $ $ $ $ 
20X6 248,400 (already made)  248,400 19,872 268,272 
20X7 268,272 (75,000) 193,272 15,462 208,734 
Current liability = 268,272 – 193,272 = $75,000 
Non-current liability = $193,272 Finance costs of $19,872 will be expensed to the stat ement of profit or 
loss. 
The right-of-use asset uses the cost  model as at the year end. As 
ownership is retained by the lessor at  the end of the lease, the right-of-
use asset is depreciated over the shorter of the lease term or the 
remaining useful life of the asset. In this case, this would be the lease 
term of 5 years. 
Depreciation = $324,900/5 = $64,980 Dr Expense $64,980 Cr Right-of-use asset $64,980 
Extracts from the financial statements for the year ended 
30 November 20X6 
 $ 
Statement of profit or loss  
Depreciation 64,980 
Finance cost 19,872 
  
Statement of financial position  
Non-current assets – Right-of-use asset 
(324,900 – 64,980)  
259,920 
Non-current liabilities – Lease liability  193,272 
Current liabilities – Lease liability 75,000 
 
 Test your understanding 2 – Dynamic (continued) 
 This question follows on fr om the previous TYU. 
Required: 
Prepare extracts from Dy namic's financial statement s in respect of the 
lease agreement for the year ended 31 December 20X1.

222  
 GBT entered into a four year lease on 1 January 20X0 for a machine with 
a fair value of $2 million. The leas e contract requires the annual payment 
of $600,000 for four years and the machine has a useful life of five years. 
The interest implicit in the lease is given below. 
Required: 
Prepare extracts from the statement of financial position and statement of 
profit or loss for the year ended 31 December 20X0, assuming that 
instalments are paid in: 
(1) arrears – first payment made on 31 December 20X0 (implicit rate of 
interest 8%) 
(2) advance – first payment made on 1 January 20X0 (implicit rate of 
interest 14%). 
Prepare all answers to the nearest $000. 
 
 GTA entered into an agreement to leas e an item of plant on 1 January 
20X1. The lease requires the annual payment in arrears of $400,000 for 
six years and the machine has a usef ul life of seven years. The lease 
agreement transfers legal title to GT A at the end of the lease agreement. 
The present value of future lease payments was $1,700, 000. No direct 
costs were incurred on setting up the l ease. The interest implicit in the 
lease is 10.84%. 
Required: 
Complete the following extract from t he statement of profit or loss for the 
year ended 31 December 20X1. Give your answers to the nearest $000. 
 $000 
Statement of profit or loss (extract)  
Depreciation charge  
Finance cost

Chapter 11 
 223 
 Test your understanding 5  
 GTA entered into a second agreement to  lease a further item of plant on 
1 January 20X2. This lease requires the annual payment in advance  of 
$400,000 for six years and the machine has a useful life of six years. The 
first repayment has been paid already. The present value of future lease 
payments was $1,300,000. The interest im plicit in the lease is 16%. The 
present value of future repayments was $1,700,000. 
Required: 
Calculate the carrying amount of t he non-current lease liability at 
31 December 20X2. Give your answer to the nearest $000. 
Short-life and low value assets 
If the lease is short-term (less than 12 m onths at the incepti on date) or of a low 
value then a simplified treatment is allowed. 
In these cases, the lessee can choose to recognise the lease payments in profit 
or loss on a straight line basis. No lease liability or right-of-use asset would be 
 
 Low value assets 
 IFRS 16 Leases  does not specify a particu lar monetary amount below 
which an asset would be considered ‘low value’. 
The standard gives the following ex amples of low value assets: 
 tablets 
 small personal computers 
 telephones 
 small items of furniture. 
The assessment of whether an asse t qualifies as having a ‘low value’ 
must be made based on its value when new. Therefore, a car would not qualify as a low value asset, even if it  was very old at the commencement 
of the lease.

224  
 Illustration 3 – Short term or low value lease  
 Zoo Ltd entered into a four year leas e of mobile phones for its sales force 
on 1 January 20X1. The initial deposit is $1,000 on 1 January 20X1 
followed by four annual payments of $1,000 in arrears on 31 December 
each year. The annual payments comm ence on 31 December 20X1. The 
leases are deemed low value by Zoo Ltd. 
What is the charge to the statem ent of profit or loss and what 
amount would appear on the statemen t of financial position at the 
end of the first year of the lease? 
IFRS 16 Leases  permits a simplified treatment for assets with a lease 
period of 12 months or less, or of low value. 
The simplified treatment allows the lease payments to be charged as an 
expense over the lease period,  applying the accruals concept. 
Annual lease rental expense 	=	Total rentals payable
Total lease period 
Total payments = $5,000 (deposit plus (4 × $1,000) rentals) 
Charge to profit or loss = 5,000/4 = $1,250 
In year ended 31 December 20X1, the cash paid was $1,000 deposit plus 
$1,000 rental = $2,000. 
A prepayment of $750 is shown on the statement of fi nancial position. 
Statement of profit or loss (extract) 
 $ 
Lease expense ($5,000/4) 1,250 
Statement of financial position (extract) 
Current assets $ 
Prepayments (paid $2,000 – $1,250 to the P/L) 750 
 
 Test your understanding 6  
 DJT hires laptops, which are considered by DJT to be low value items,  
under a lease for three years with payments to be made as follows: 
Year 1 $5,000 
Year 2 $10,000 Year 3 $6,000 
Prepare extracts from the statem ent of profit or loss and the 
statement of financial position for each of the three years.

Chapter 11 
 225 
 FGH entered into a four year lease on 1 April 20X2 for the use of an item 
of office equipment considered to be of low value. It paid a deposit of 
$600 and will make lease payments of  $1,200 on 31 March 20X3, 20X4, 
20X5 and 20X6. 
In the year ended 31 March 20X3, FGH has recorded all payments 
related to the lease as an expense in the statement of profit or loss. 
Prepare the journal entry required to correct the accounting 
 
 Questions (1) to (3) below are based on the following scenario: 
Cuthbert Ltd has entered into a 5 year  lease for the use of a machine on 
1 January 20X1. The present value of the future repaym ents at the date 
of inception of the lease is $342,600.  Direct costs relating to setting up 
the lease totalled $10,000. Under t he terms of the lease five annual 
instalments of $120,000 are payable at the start of each year. The first 
rental has already been paid. The rate of  interest implicit in the lease is 
15%. The remaining useful life of the asset is 5 years. 
(1) Calculate the finance cost that  would be recognised in the 
statement of profit or loss in the year ended 31 December 20X1 
(to the nearest $).  
(2) Calculate the non-current element of the finance lease liability 
shown in Cuthbert Lt d's statement of financial position as at 
31 December 20X1 (to the nearest $).  
(3) Calculate the carrying amount of the right-of-use asset at 
(4) MB entered into a four year lease for some low value bluetooth 
headsets on 1 November 20X5 and was required to pay an initial deposit of $500, plus the first of four annual payments of $250 
(payable in advance each year). 
Complete the journal entry required to correctly recognise the 
lease for the year ended 31 October 20X6. 
Dr 
Dr Cr Note: In the assessment, you w ould choose the headings for the 
Drs and Crs from a selection of choices.

226  
 (5) A company leases a computer with legal title of the asset passing 
after two years. The company usua lly depreciates computers over 
three years. The company also leases a machine for seven years but legal title does not pass to the lessee at the end of the agreement. The company usually depr eciates machinery over ten 
years. 
Over what period of time shoul d the computer and machine be 
depreciated? 
 Computers Machine 
A 2 years 7 years 
B 2 years 10 years C 3 years 7 years D 3 years 10 years 
(6) A company leases a motor vehicl e. The present value of minimum 
lease payments is $17,355 and the rate implicit in the lease is 10%. The terms of the lease require three annual instalments to be paid 
of $10,000 each at the start of eac h year and the first instalment 
was already paid. 
At the end of the first year of  the lease what amount will be 
shown for the lease liability in the company’s statement of 
financial position under the head ings of non-current liabilities 
and current liabilities? 
 Current liabilities Non-current liabilities 
A  $9,091  $10,000 
B  $10,000  $10,900 C  $10,900  $10,000 D  $10,000  $9,091  
(7) CS acquired a machine using a lease on 1 January 20X7. The lease 
was for a five-year term with rent als of $20,000 per year payable in 
arrears. The present value of the lease rentals was $80,000 and the 
implied interest rate was 7.93% per year. 
Calculate the non-current liability and current liability figures 
to be shown in CS’s statem ent of financial position at 
31 December 20X8. 
Non-current liability _________________ 
Current liability _________________

228  
 The lease term is three years. This is because the option to extend the 
lease is reasonably certain to be exercised. 
The lease liability is calculated as the present value of future payments 
Date  Cash flow 
($) Discount factor 
(5%) Present value 
($) 
31/12/X1  10,000 0.952 9,520 
31/12/X2  10,000 0.907 9,070 31/12/X3  15,000 0.864 12,960 
   –––––– 
   31,550    –––––– 
The initial cost of the ri ght-of-use asset is calculated as the value of the 
liability plus any direct costs and other payments already incurred. The 
calculation is as follows: 
 $ 
Initial liability value 31,550 
Direct costs  3,000 
Reimbursement (1,000)  –––––– 
 33,550 
 –––––– 
The reimbursement reduces the overall direct costs so is removed from 
the capitalised right-of-use asset. 
The double entries to record are as follows: 
 
Dr Right-of-use asset  $31,550 
Cr Lease liability  $31,550 
  
Dr Right-of-use asset  $3,000 Cr Cash  $3,000 
  
Dr Cash  $1,000 Cr Right-of-use asset  $1,000 
This can be summarised as: 
Dr Right-of-use asset  $33,550 
Cr Lease liability  $31,550 Cr Cash $2,000

Chapter 11 
 229 
  
Statement of profit or loss $ 
  
Depreciation (W1)   (11,183) 
Finance costs ( W2)  (1,578) 
  Statement of financial position $ 
  
Non-current assets  
Right-of-use asset (33,550 – 11,183) 22,367 
  
Non-current liabilities  
Lease (W2)  14,284 
  
Current liabilities  
Lease (W2)  8,844 
(W1) The right-of-use asset is deprecia ted over the three year lease term, 
because it is shorter than the useful  life. This gives a charge of 
$11,183 ($33,550/3 years). 
Dr Depreciation (SOPL) $11,183 
Cr Right-of-use asset (SFP) $11,183 
(W2) Lease liability table 
Year-ended  Opening Interest (5%) Payments Closing 
 $ $ $ $ 
31/12/X1  31,550 1,578 (10,000) 23,128 
31/12/X2  23,128 1,156 (10,000) 14,284 
The total lease liability at 31 December 20X1 is $23,128, of which 
$14,284 is non-current and $8,844 ( 23,128 – 14,284) is current.

230  
  
 (1) Arrears  (2) Advance  
 $000 $000 Statement of profit or loss (extract)   
Depreciation (1987/4) /(1,992/4) 497 498 
Finance cost (see workings) 159 195 
   
Statement of financial position (extract)   
Right-of-use asset (1,987 – 497)/ 
(1,992 – 498)  
1,490  
1,494 
Non-current liabilities (see workings) 1,070 987 
Current liabilities (see workings) 476 600 
Workings 
Arrears: The lease liability is calculated as the present value of future payments 
($000)  Discount 
factor (8%) Present value 
($000)  
31/12/X0  600 0.926 556 
31/12/X1  600 0.857 514 
31/12/X2  600 0.794 476 31/12/X3 600 0.735 441 
   ––––– 
  Lease liability 1,987    ––––– 
liability plus any direct costs and other  payments already incurred. In this 
case, the right-of-use asset is equal to the lease liability upon initial 
recognition. 
As at the year end, the right-of-use a sset is depreciated over the lower of 
the lease term or the useful lifetime. In this situation, this is the lease term 
of 4 years. 
At the year end, the lease liability is shown at amortised cost split 
between non-current and current components as calculated below: 
Year Opening Interest 8% Payment Closing 
1 1,987 159 (600) 1,546 
2 1,546 124 (600) 1,070 
Non-current liability at t he end of year 1 = $1,070,000  
Current liability at the end of year 1 = 1,546k – 1,070k = $476,000

Chapter 11 
 231 
 Advance: 
factor (14%) Present value 
($000)  
1/1/X1  600 0.877 526 1/1/X2  600 0.769 461 1/1/X3 600 0.675 405 
   –––––– 
  Lease liability 1,392    –––––– 
recognition plus the advance paymen t. The right-of-use asset equals 
$1,392k + $600k = $1,932k.  
of 4 years. 
Year Opening Payment Revised 
14% Closing 
1 1,392 (–) 1,392 195 1,587 
2 1,587 (600) 987 138 1,125 
Non-current liability at t he end of year 1 = $987,000  
Current liability at the end of year 1 = 1,587k – 987k = $600,000 
NB Please note that using formula s rather than discount factors may 
create rounding errors when comp ared with the above answers.  
 
 $000 
Depreciation (1,700/7) 243 
Finance cost (1, 700 × 10.84%) 184 
Tutorial note re depreciation 
Depreciation is typically charged on a right-of-use asset over the shorter 
of the lease term and the asset's useful  life which, in this case, would be 
6 years. However, as legal title trans fers to GTA at the end of the lease 
term, it is appropriate to depreciate the right-of-use asset over 7 years (as 
GTA will still have the use of the asset after the lease term finishes).

232  
 Non-current portion of lease li ability at 31 December 20X2 = 
$1,108,000 
Lease liability working 
 
Year Opening Payment Revised  
16% Closing 
1 1,300 – 1,300 208 1,508 
2 1,508 (400) 1,108   
 
 Total lease payments = $5, 000 + $10,000 + $6,000 = $21,000. 
Length of lease = three years Annual charge to statement of pr ofit or loss = $21,000/3 = $7,000 
 1 2 3 
Lease expense 7,000 7,000 7,000 
 1 2 3 
Prepayments  1,000 nil 
Accruals 2,000   
Workings 
By the end of year one, a tota l of $7,000 has been charged to the 
statement of profit or loss but only $5,000 has been paid. An accrued 
expense is required in the statement of financi al position of $2,000. 
By the end of year two, a tota l of $14,000 has been charged to the 
statement of profit or loss and $15,000 has been paid.  A prepayment is 
required in the stat ement of financial position of $1,000.

Chapter 11 
 233 
 Total lease payments = 600 + (4 × 1,200) = $5,400 
Length of lease = four years 
Annual charge to statement of prof it or loss = $5, 400/4 = $1,350.  
Expense erroneously charged to statement  of profit or loss in year ended 
31 March 20X3 = 600 + 1,200 = $1,800. 
A prepayment of $450 is required.  
Therefore, the journal entry required to correct the current accounting 
treatment is: 
Dr Prepayments $450 
Cr Statement of pr ofit or loss $450 
 
 (1) Finance cost = $51,390  
342,600 × 15% = $51,390 or see below for lease table. 
(2) Non-current lease liability at  end of year 1 = $273,990 
Year Opening Payment Total Interest 
15% Closing 
 $ $ $ $ $ 
1 342,600 (–) 342,600  51,390 393,990 
2 393,990 (120,000) 273,990 41,099 315,089 
The non-current liability at the end of the year is the amount 
outstanding immediately after next year's payment. 
(3) Carrying amount of the right-of-use asset = $283,560  
The right-of-use asset would be initia lly recorded at the value of the 
lease liability plus payments alr eady made + direct costs = 342,600 
+ 120,000 + 10,000 = $472,600 
The right-of-use asset is depreciated over the lower of the useful life 
and the lease term. The lease term and useful lifetime are both 5 years. Depreciation per annum is 472,600/5 = $94,520. 
The carrying amount in the 2nd year of the lease will be 472,600 – 
(94,520 × 2) = $283,560

234  
 (4) Dr Prepayments $375 
Dr Profit or loss $375 
Cr Cash $750 
Total payments = 500 + (4 × 250) = $1,500 
Lease term = 4 years Therefore, rental expense  each year = 1,500/4 = $375 
Amount prepaid = 750 – 375 = $375  
(5) C –  Assets should usually be depreciated over the lease term. 
However, the 
ownership of the computer transfe rs at the end of the 
lease, so the computer will be depr eciated over its useful life of 3 
years. 
(6) D 
Year Opening Payment Sub-total Interest 
10% Closing  
1 17,355  (–)  17,355  1,736  19,091  
2 19,091  (10,000)  9,091  909  10,000  
 (7) Non-current liability – $35,697  
Current liability – $15,908  
Working: 
Year Opening Interest @ 
7.93% Payment Closing 
20X7 80,000  6,344 (20,000) 66,344 
20X8 66,344  5,261 (20,000) 51,605 20X9 51,605  4,092 (20,000) 35,697 
The total liability at the end of 20X8 = $51,605 
The non-current liability = $35,697 (a mount still owing in one year's 
time) 
The current liability = $15,908 ($51,605 – $35,697)

235 
IAS 2 Inventories and 
IAS 10 Events after the 
reporting period 
d. Inventory e. Events after the reporting 
period 
  Chapter 
12

IAS 2 Inventories and IAS 10 Events after the reporting period 
236  
1 Session content  
 
2 IAS 2 Inventories 
Inventories are assets that are: 
 held for sale 
 in the process of production 
 materials that will be used in the production process 
Measurement of inventories

Chapter 12 
 237 
 Costs not included in inventory 
 Examples of costs that should not  be included in inventory are: 
 abnormal amounts of wasted materials,  labour, or other production 
costs 
 storage costs 
 administration costs that do not c ontribute to bringing the inventories 
to their present location and condition 
 selling and distribution costs 
These costs should be treated as exp enses against profit in the period 
that they arise. 
 
 Determining cost 
 Costs of purchase  include the purchase price,  import duties, handling 
costs and other costs directly connec ted with the acquisition of the goods. 
Costs of conversion  include costs directly related to the units being 
produced, e.g. direct labour costs,  allocation of fixed and variable 
overhead costs incurred in production. 
Variable production overheads  are those indirect costs of production 
that vary directly with the volume  produced, e.g. heat, light and power. 
Fixed production overheads  are those indirect costs of production that 
do not vary directly with the volume produced and remain constant regardless of the number of units  produced, e.g. depreciation of 
machinery, factory administration costs. 
 
 Allocation of overheads 
 The allocation of fixed producti on overheads should be based on the 
normal capacity of the business. Any excess overheads due to 
inefficiencies or production problems s hould be treated as an expense in 
the period that they occur.

238  
 Illustration 1 – Calculation of the cost of inventory 
 The following costs relate to a unit of inventory: 
Cost of raw materials $1.00 
Direct labour $0.50 During the year $60,000 of fixed pr oduction overheads were incurred. 
8,000 units were produced during the y ear which is lower than the normal 
level of 10,000 units. This was as a re sult of a fault with some machinery 
which resulted in 2,000 units having to be scrapped. 
At the year-end, 700 units ar e in closing inventory. 
Required: 
What is the cost of closing inventory? 
 
 Solution 
 Production overheads should be alloca ted based on the normal level of 
production, i.e. 10,000 units. 
$60,000/10,000 units = $6.00 per unit.  Cost per unit: 
 $ 
Raw materials 1.00 
Direct labour 0.50 
Production overheads 6.00 
 –––– Total cost per unit 7.50 
Cost of 700 units in closing inventory = 700 × $7.50 = $5,250. 
 
 Calculation of costs 
If inventory should be valued at cost (when cost is lower than net 
realisable value) either the actual  cost of an item (unit cost) or a 
reasonable approximation to actu al cost should be used.  
A reasonable approximation would be used if the determination of an 
items actual cost is impractical e.g. there are a large num ber of items in a 
particular line of inventory or it is im possible to identify the actual costs.

Chapter 12 
 239 
 The most common approximations are: 
1 First in, first out (FIFO). The clos ing inventory is assumed to consist 
of the latest purchases, i.e. oldest in ventory is sold first. This means 
the closing inventory will be valued  at the most recent purchase 
prices.  
This method of cost valuation would be appropriate for inventory 
lines like bananas in supermarkets. They would be purposely stacked on shelves so that the older ones would sell first.  
2 Average cost (AVCO). The weighted average cost is calculated by 
taking the total purchase price of all units purchased in the period 
divided by the total number of uni ts purchased in the period. This 
can be calculated using periodic or a continuous method – see 
illustration 2 for more detail. 
This method of cost valuation wo uld be appropriate for inventory 
lines like oil in an oil refinery. Inventory would be stored together, 
cost prices would fluc tuate and it would be im possible to distinguish 
between the different cost lines.   
 
 Illustration 2 – Calculation of the cost of inventory 
 Calculation of the cost of invento ry using FIFO and average cost 
The following purchases and sales took  place in Tyrone during the first 
four days of June: 
Day 1 Opening inventory nil Day 1 Purchase 200 units at $15 per unit  Day 2 Purchase 100 units at $18 per unit  Day 3 Sales of 250 units at $30 per unit  Day 4 Purchase 150 units at $20 per unit 
Required: 
Calculate the cost of inventory at the end of day 4 for Tyrone using: 
(a) The FIFO method; 
(b) the average cost method.

240  
 Solution 
 (a) FIFO method 
Total purchases = 200 + 100 + 150 = 450 units  
Sales = 250 units Closing inventory = 450 – 250 = 200 units FIFO method assumes the oldest inv entory is sold first, therefore 
the 200 units remaining must be from  the most recent purchases on 
day 4 (150 units) and the balance from the day 2 purchases (50 units). 
Cost: 
50 × $18 = $900 
150 × $20 = $3,000 
 ––––––  $3,900 
Total cost of clos ing inventory = $3,900 
(b) Average cost method 
Total purchases = 200 + 100 + 150 = 450 units Total cost of purchases = 
200 × $15 = $3,000 
100 × $18 = $1,800 150 × $20 = $3,000  –––––– 
 $7,800 
Weighted average cost = $7,800/450 units = $17.33 per unit 
Total cost of closing inven tory = 200 units × $17.33 = $3,467 
Note  An alternative approach could be to calculate the average cost 
after each transaction,

Chapter 12 
 241 
 After day 2 total purchases: 
Units Price  
200  $15 $3,000 
100  $18 $1,800 
––––––  –––––– 
300  $4,800 
  ––––––    
Average cost $4,800/ 300 $16 per unit 
   
Day 3   
(250) sales   
–––––– AVCO  
50 $16 $800 
   Day 4   
 Price   
150 purchases $20 $3,000 
––––  –––––– 
200  $3,800 
Average cost $3,800/ 200 $19 per unit 
This would result in a higher closing inventory value of $3,800. 
 
 Illustration 3 – Inventory valuation 
 Value the following items of inventory. 
(a) Materials costing $12,000 bought for processing and assembly for a 
profitable special order. Since buying these items,  the cost price has 
fallen to $10,000. 
(b) Equipment constructed for a customer for an agreed price of 
$18,000. This has recently been completed at a cost of $16,800. It has now been discovered that, in order  to meet certain regulations, 
further work with an extra cost  of $4,200 will be required. The 
customer has accepted partial res ponsibility and agreed to meet half 
of the extra cost.

242  
 Solution 
 (a) Value at $12,000. IAS 2 states va lue at lower of cost and NRV. The 
order is profitable and therefore NRV must be higher than cost. 
$10,000 is irrelevant as this is the replacement cost. 
(b) Value at NRV, i.e. $15,900 as below cost, 
NRV = contract price of $18,000 – the entity's share of costs to 
complete $2,100 = $15,900. 
Original cost = $16,800. 
The main disclosure re quirements of IAS 2  Inventories  are: 
 Accounting policy adopted, incl uding the cost formula used. 
 Total carrying amount, classified as follows: 
 $ 
Raw materials X Work in progress X 
Finished goods X 
 ––  X 
This would be disclosed in a note to the financial statements. The total 
amount of closing inv entory will be shown as a current asset on the 
statement of financial posit ion and a reduction to the cost of sales in the 
 Amount of inventories carried at NRV. 
 Amount of inventories recognised as an expense during the period. 
 Details of circumstances that have l ed to the write-down of inventories to 
their NRV. 
 
 3 IAS 10 Events after the Reporting Period 
The purpose of IAS 10 Events after the Reporting Period , is to define to 
what extent events that occur af ter the reporting period should be 
recognised in the financial statements. 
IAS 10 Events after the Reporting Period , defines an event after the end of 
the reporting period as ‘ those events, favourable and unfavourable, 
that occur between the end of the reporting period and the date when 
the financial statements are authorised for issue' (IAS 10, para 3).

Chapter 12 
 243 
IAS 10 identifies two main types of  events after the reporting period: 
adjusting events and non-adjusting events. 
 
 Examples of adjusting and non-adjusting events 
 Adjusting events  are event that gives evi dence of conditions that 
existed at the reporting date. 
Examples of adjusting events would be: 
 Selling inventory post year-end fo r lower than cost price (This is 
evidence that inventory is incorre ctly valued at the year-end). 
 Evidence that a customer has gone into liquidation. 
 Discovery of fraud or error that  existed prior to the year-end. 
 Completion of a court case enter ed into before the reporting date. 
 Completion of an insurance claim relating to an event that occurred 
prior to the year-end. 
 Determination after year end, of the sale or purchase price of assets 
sold or purchased before year end. 
Non-adjusting events  show conditions that have arisen since the 
reporting date, then no adj ustment would be made. 
Examples of non-adjus ting events would be: 
 Acquisition or disposal of a s ubsidiary after the year end. 
 Announcements of a plan to  discontinue an operation. 
 Destruction of an asset by a fire  or flood after the reporting date. 
 Announcements of a pl an to restructure. 
 Share capital transactions  after the reporting date.

244  
  Changes in taxation or exchange rates after the reporting date. 
 Strikes or other labour disputes  
  Equity dividends declared afte r the reporting period but before the 
financial statements ar e authorised for issue  
If an event after the reporti ng date indicates that the entity is no longer a going 
concern, the financial stat ements for the current peri od should not be prepared 
on the going concern basis. 
A non-adjusting event after the reporti ng date should be disclosed (by note) 
where the event has a material e ffect on the financ ial statements. 
The note should disclose 
 The nature of the event. 
 An estimate of the financial effect, or a statement that it is not practicable 
to make such an estimate. The es timate should be made before taking 
account of taxation, with  an explanation of the ta xation implications where 
necessary for a proper understandi ng of the financial position. 
 The date the directors approve fin ancial statements. The date on which 
the financial statements are authorised for issue should be disclosed. 
 
 Illustration 4 – Events after the reporting period 
 Shortly after the reporting date, 31/12/ X0, a major credit customer of an 
entity went into liquidation and it is  expected that none of a $12,000 debt 
will be recoverable. $10,000 of the debt  relates to sales made before the 
year end. 
In the 20X0 financial statements the whole of the debt has been written 
off but one of the directors has point ed out that, as the liquidation is an 
event after the reporting date, the debt should not have been written off 
but disclosure made by a note. 
Advise whether the director is correct. 
 
 Solution 
 The liquidation of the customer is  treated as an adjusting event. Only 
$10,000 debt existed at  the reporting date. 
Under IAS 10 only the existing debt  should be written off in the 20X0 
financial statements. The remaining $2,000 did not exist at the reporting 
date and should be written off in the 20X1 financial statements.

Chapter 12 
 245 
 Test your understanding 1 – E vents after the reporting period 
 Classify each of the following even ts, which all occurred after the 
reporting period, as adj usting or non-adjusting. 
 Adjusting 
event Non-adjusting 
event 
Insolvency of a major customer    
Decline in market value of investments   Loss of non-current assets/inventory due 
to fire or flood   
Discovery of fraud/error showing that the 
FS were incorrect   
Announcement of plan to discontinue 
certain operations   
Evidence concerning the net realisable value of inventory being less than cost   
Resolution of a court case after the 
reporting date   
 
 1 Tracey’s business sells three pro ducts – A, B and C. The following 
information was available at the year-end: 
 A B C 
 $ per unit $ per unit $ per unit 
Original cost 7 10 19 
Estimated selling price 15 13 20 
Selling and distribution costs 2 5 6 Units of inventory 20 25 15 
The value of inventory at the year-end should be: 
A $675 
B $670 C $795 D $550

246  
 2 Item XYZ has 150 items in inventory as at 31 March 20X1. The 
following alternative va luations have been found. 
Which value should be used in the accounts at 31 March 20X1? 
A Net realisable value $4,750 
B Original cost $5,500 C Selling price $7,000 D Replacement cost $6,500 
3 Jackson's year end is 31 December 20X0. In February 20X1, a 
major customer went into liquidati on and the directors’ believe that 
they will not be able to recover the $450,000 owed to them. 
How should this item be  treated in the financial statements of 
Jackson for the year ended 31 December 20X0? 
A The irrecoverable debt should be disclosed by note 
B The financial statem ents are not affected 
C The debt should be provided against D The financial statements should be adjusted to write off the 
irrecoverable debt 
4 Which of the following items are non-adjusting items per 
IAS 10 Events after the Reporting Period ? 
(i) Changes in the rates of fo reign exchange after the year-end. 
(ii) Destruction of machinery by fire after the year-end. 
(iii) Information regarding the pos t year-end selling price of year-
end inventory. 
(iv) Plans for mergers and acquisitions. (v) Insolvency of a customer w ho had a receivable balance at the 
year-end. 
A (i), (ii) and (iv) B (iii) and (v) C (i), (iii) and (v) D (ii), (iii) and (v)

Chapter 12 
 247 
 5 Which of the following could be  classified as an adjusting 
event occurring after the end of the reporting period: 
A A serious fire, occurring 1 m onth after the year-end, that 
damaged the sole production faci lity, causing production to 
cease for 3 months. 
B One month after the year-end,  a notification was received 
advising that a large receivab les balance would not be paid as 
the customer was being wound up. No payments are expected from the customer. 
C A large quantity of parts for a discontinued production line was 
discovered at the back of the warehouse during the year-end 
inventory count. The parts have no value except a nominal scrap value and need to be written off. 
D The entity took delivery of a new  machine from the USA in the 
last week of the financial y ear. It was discovered almost 
immediately afterwards that the entity supplying the machine 
had filed for bankruptcy and woul d not be able to honour the 
warranties and repair contract on  the new machine. Because 
the machine was so advanced, it was unlikely that any local entity could provide maintenance cover. 
6 The following material events took  place after entity X's reporting 
date of 31 October 20X1 but befor e the accounts were authorised: 
– Ordinary dividends were appr oved by the shareholders in 
relation to the year ended 31 October X1. 
– The discovery of an error in relation to the year-end inventory 
valuation. 
Please state the correct accounting treatment: 
A Dividends: Provide for dividend.  
Error: Adjust accounts. 
B Dividends: Disclose dividend.  
C Dividends: Provide for dividend.  
Error: Disclose error. 
D Dividends: Disclose dividend.  
Error: Disclose error.

248  
 7 Bond Ltd has a 31 August year end and on 10 September the 
company received notification that  one of their customers had gone 
into liquidation owing $30,000, $5, 000 of which was from September 
sales. 
Additionally on 10 October the company received $100,000 in 
insurance following a fire to thei r premises which occurred on 28th 
August. 
What amounts will be included in Bond Ltd’s accounts as at 
the year-end under IAS 10 Events after the Reporting Period ? 
A Liquidation rece ivable: $30,000.  
Insurance receivable: $Nil. 
B Liquidation rece ivable: $30,000.  
Insurance receivable: $100,000. 
C Liquidation rece ivable: $25,000.  
D Liquidation receivable: $Nil 
Insurance receivable: $100,000.

250  
  
Insolvency of a major cu stomer Adjusting event 
Decline in market value of  investments Non-adjusting 
event 
Loss of non-current assets/inventories due to 
fire/flood Non-adjusting 
event 
Discovery of fraud/error showing that the FS were 
incorrect Adjusting event 
Announcement of a plan to disco ntinue operations Non-adjusting 
event 
Evidence concerning the NRV of inventories Adjusting event Resolution of a court case Adjusting event 
 
 1 D 
 A B C 
Cost 7 10 19 
NRV 13 8 14 Valuation 20 × 7 = 140 25 × 8 = 200 15 × 14 = 210 
Total Valuation = 140 + 200 + 210 = 550 
2 A – IAS 2 states that inventory should be valued at the lower of cost 
or net realisable value. 
3 D – This is an example of an adjusting event as per IAS 10. 
4 A 5 B 6 B – Dividends are only provided for when they are paid or declared 
at the reporting date, however, discl osure will be made if discovered 
prior to authorisation of the financial statements 
7 D – The liquidation and the insur ance are both adjusting events. As 
a result, the receivable from the liquidated customer will be written 
off for the amount recoverable at the year-end, i.e. $25,000 leaving 
a balance of nil. The insurance re ceivable would be recorded at the 
full amount outstanding as  at the year end.

251 
IAS 7 Statement of Cash 
flows 
B3.Apply financial reporting 
d. Statement of cash flows Chapter 
13

IAS 7 Statement of Cash flows 
252  
 
2 The importance of statements of cash flows 
The statement of cash flows is an impor tant part of the fi nancial statements 
because: 
 It helps users to assess liquidity and solvency – an adequate cash position 
is essential in the short term both to  ensure the survival of the business 
and to enable debts and dividends to be paid. 
 It helps users to assess financia l adaptability – will the entity be able to 
take effective action to alter its ca sh flows in response to any unexpected 
events? 
 It helps the users assess future cash flows – an adequate cash position in 
the longer term is essential to enabl e asset replacement, repayment of 
debt and to fund further expansion. Users will use current cash flow 
information to help them a ssess future cash flows. 
 It helps to highlight where cash is being generated – the cash flow 
statement will clearly det ail cash that is being generated from the core 
activities of the business and other non-operating activities. 
 Cash flows are objective – a cash fl ow is a matter of fact whereas the 
calculation of prof it is subjective. 
 It can help to indicate problems early on.

Chapter 13 
 253 
3 Definitions in IAS 7 
The following definitio ns are from IAS 7 Statement of Cash flows : 
Cash 
Cash ‘comprises cash on hand and at bank including overdrafts and 
demand deposits’ (IAS 7, para 6) 
Cash equivalents 
Cash equivalents are 'short-term, highly liquid investments that are readily 
convertible to known amounts of cash  and which are subject to an 
insignificant risk of changes in val ue, e.g. short-dated treasury bill'  (IAS 7, 
para 6). 
Operating activities 
Operating activities are  'the principal revenue-p roducing activities of the 
enterprise and other activities that ar e not investing or financing activities'  
(IAS 7, para 6). 
Investing activities 
Investing activities are 'the acquisition and disposal  of long-term assets and 
other investments not incl uded in cash equivalents'  (IAS 7, para 6). 
Financing activities 
Financing activities are 'activities that result in  changes in the size and 
composition of the contributed equi ty and borrowings of the entity'  (IAS 7, 
para 6).

254  
Pro-forma statement of cash flow s the year ended 31 December 20X9 
 $ $ 
Cash flows from operating activities   
Profit before taxation X  
Adjustments for:   Depreciation X  
(Profit)/loss on disposal (X)/X  
Interest receivable/investment income (X)  Finance costs X  
 ––––  
Operating profit before wo rking capital changes X  
(Increase)/decrease in inventories (X)/X  
(Increase)/decrease in trade and other receivables (X)/X  
Increase/(decrease) in tr ade and other payables X/(X)  
 ––––  
Cash generated from  operations X  
Interest paid (X)  Tax paid (X)   ––––  
Net cash from operating activities  X Cash flows from investing activities   
Purchase of property, plant and equipment (X)  
Purchase of investments (X)  
Proceeds from sale of pr operty, plant and equipment X  
Proceeds from sale of investments X
  
Interest received X   
Dividends received X  
 ––––  
Net cash from investing activities  (X) Cash flows from financing activities   
Proceeds from issue of ordinary shares X  
Proceeds from issue of preference shares X  
Proceeds from long -term borrowings X
  
Redemption of long- term borrowings (X)   
Dividends paid (X)  
 ––––  Net cash from financing activities  (X)   –––– 
Net increase/(decrease) in cash and cash equivalents  X/(X) 
Cash and cash equivalents at  beginning of period  X/(X) 
  –––– 
Cash and cash equivalents at end of period  X/(X) 
  ––––

Chapter 13 
 255 
 4 Cash flows from operating activities 
The first main heading in the standard statement of  cash flows pro-forma 
is ‘cash flows from operating activities. 
This can be broken down into 'cash generated from operations’, tax paid 
and interest paid.  
Cash generated from operations 
There are two ways the cash generated from operations can be 
calculated. The direct met hod and the indirect method. 
The indirect method is the most  likely to be examined in F1. 
Indirect method 
This method involves a reconciliation from  profit before tax to cash generated 
from operations. 
The working starts with profit  before taxation from the st atement of profit or loss, 
adjusting it for non-cash items and conver ting the income and expenses figure 
from the accruals basis to the cash basis, so that ju st the cash flows generated 
from operating activities remain. 
 $ 
Profit before taxation X Adjustments for:  
(i) Non-cash items  
Depreciation/amortisation/impairments X (Profit)/loss on disposal (X)/X 
(ii) Non-operating items  
Interest receivable/investment income (X) Finance costs X 
 ––– 
Operating profit before wo rking capital changes X 
(iii) Working capital movements  
(Increase)/decrease in inventories (X)/X (Increase)/decrease in trade and other receivables (X)/X Increase/(decrease) in tr ade and other payables X/(X) 
 ––– Cash generated fr om operations X

256  
 Adjustments using the indirect method 
 Depreciation/amortisation 
Depreciation is not a cash flow. 
 Capital expenditure purchases/disposals will be recorded under 
"investing activities" at the time  of the cash outflow/inflow. 
 Depreciation is the writing off of the capital expenditure over its 
useful life and simply an ‘accounti ng entry’. It should be added back 
to profit because it was a non- cash expense deducted from the 
profit. 
Profit/loss on disposal 
When a non-current asset is disposed of: 
 the cash inflow from the sa le (the proceeds) is recorded under 
‘investing activities’ 
 a profit/loss on disposal is calc ulated by comparing carrying amount 
and proceeds which is recorded in t he statement of pr ofit or loss. 
This does not equal the cash flow  and should be removed from the 
reconciliation for cash generated from operations. 
 a loss on disposal should be added back because it is a non-cash 
expense deducted fr om the profit 
 a profit on disposal should be de ducted because it is a non-cash 
reduction to expenses added to the profit. 
Interest receivable/investment income 
Interest received and investment inco me are not considered part of day 
to day operations and will be adjusted wit hin the reconciliation for cash 
generated from operations. 
The amount from the stat ement of profit or loss should be deducted from 
the profit because this is not necessarily the amount that has been 
received (statement of profit or lo ss is prepared on the accruals basis).  
Finance costs 
Finance costs are not considered par t of day to day operations and will 
be adjusted within the reconciliation fo r cash generated from operations. 
The expense from the stat ement of profit or lo ss should be added to the 
profit because this is not necessar ily the amount that has been paid.  
Change in receivables 
 An increase in receivables is a reduction to cash (the more the 
customers owe, the less cash in the bank) and 
 a decrease in receivable is an increase to cash.

Chapter 13 
 257 
 Change in inventory 
 An increase in inventory is a redu ction to cash (the more inventory 
we buy, the less cash in the bank) and 
 a decrease in inventory is an increase to cash. 
Change in payables 
 An increase in payables is an increase to cash (the more the 
suppliers are owed, the more cash we have in the bank) and 
 a decrease in payables is a reduction to cash. 
Direct method 
This method involves simply adding ca sh inflows and deducting cash outflows 
in respect of operating activities. 
 $ 
Cash receipts from customers X 
Cash receipts from other operational sources X Cash payments to suppliers (X) 
Cash payments to employees (X) 
Cash payments for expenses (X)  –– Cash generated fr om operations X 
Comparison of the methods 
IAS 7 encourages, but does not require, the use of the direct method. 
 Indirect method 
– The reconciliation highlights the fa ct that profit and cash are not 
equal. 
– Does not show significant el ements of trading cash flows.  
– Low cost in preparing the information. 
 Direct method 
– Discloses information not shown elsewhere in the financial 
– Shows the cash flows from trading. – Gives the users more information in  estimating future cash flows.

258  
 Illustration 1 – Indirect method 
 The following information is available for an entity Splatter for the year 
ended 30 September 20X1: 
Statement of profit or loss 
 $000 
Revenue 444 Cost of sales (269) 
 –––– 
Gross profit 175 Distribution costs (35) 
Administrative expenses (8) 
 –––– Profit from operations 132 
Finance costs (18) 
 –––– Profit before tax 114 
Income tax expense (42) 
 –––– Profit for the year 72 
The total expenses, i.e. cost of  sales $269 + distribution costs $35 + 
administrative expenses $8, can be analysed as follows: 
 $000 
Wages 72 
Auditors' remuneration 12 Depreciation 84 
Cost of materials used 222 
Profit on disposal of non-current assets (60) 
Rental income (18) 
 –––– 
 312 
The following information is also available: 
 30/09/X1 30/09/X0 
 $000 $000 Inventories 42 24 Receivables 48 42 
Payables (30) (18) 
Required: 
Produce the section of the statement  of cash flows for cash generated 
from operations using the indi rect method for the year ended 
30 September 20X1 in compliance with IAS 7 Statement of Cash Flows.  
 Illustration 1 – Indirect method

Chapter 13 
 259 
 Solution 
 Splatter Statement of cash flows for the year ended 30 September 
20X1 
 $000 
Cash flows from operating activities  
Profit before tax 114 Depreciation 84 
Finance costs 18  –––– 
Operating profit before wo rking capital changes 156 
Increase in inventories (42 – 24) (18) Increase in trade receivables (48 – 42) (6) 
Increase in trade payables (30 – 18) 12 
 –––– Cash generated from  operations 144 
Both inventory and receivable balances  are increasing, hence a reduction 
in cash, i.e. the more money tied up in inventory or the more money owed 
by receivables the less cash we have available in the bank. Therefore, this is shown as a decrease in the statement. 
Payables also increase but this means  we have an increase in cash, i.e. 
the more money we owe suppliers, the longer we are keeping the cash in 
the bank. 
 
 Illustration 2 – Direct method 
 Required: 
Using the information for Splatter in t he previous illustration, produce the 
section of the statement of cash fl ows for cash generated from operations 
using the direct method for t he year ended 30 September 20X1 in 
compliance with IAS 7 Statement of Cash Flows .

260  
 Solution 
  
Splatter Statement of cash flows for the year ended 
30 September 20X1  
 $000 
Cash flows from operating activities  Cash receipts from customers (W1) 438 
Rental income 18 
Cash payments to suppliers (W2) (228) Cash payments to employees (72) 
Cash payments for expenses (12) 
(W1) 
Cash receipts from customers  
 $000 
Opening receivables 42 Sales revenue 444 
Closing receivables (48) 
 –––– Cash received from customers 438 
  
(W2) 
Cash payments to suppliers  
 $000 
Opening inventories 24 
Purchases (ß) 240 Closing (42)  –––– 
   $000 
Opening payables 18 
Purchases (above) 240 Closing payables (30) 
 –––– 
Payments to suppliers 228

Chapter 13 
 261 
 Test your understanding 1 – C ash generated from operations 
 Yog's statement of profit or loss for the year ended 31 December 20X1 
and statements of financial positi on as at 31 December 20X0 and 
31 December 20X1 were as follows: 
Statement of profit or loss for the year ended 31 December 20X1 
 $000 $000 
Sales  360 Raw materials consumed 35  
Staff costs 47  
Depreciation 59  Loss on disposal 9  
 ––––  
  (150)   –––– 
Profit from oper ations  210 
Finance costs  (14)   –––– 
Profit before tax  196 
Income tax expense  (62)   –––– Profit for the period  134 
Statements of financial position as at  
 31 Dec 20X1 31 Dec 20X0 
Assets     
Non-current assets     
Cost  798  780 
Depreciation  (159)  (112) 
  ––––  –––   639  668 
Current assets     
Inventories 12  10  Trade receivables 34  26  
Cash and cash equivalents 24  28  
 ––– 70 ––– 64   –––  ––– 
Total assets  709  732 
  –––  –––

262  
 Equity and liabilities      
Capital reserves     
Share capital  180 170  
Share premium  18 12  Retained earnings  343 245  
  ––– –––  
  541 427  
Non-current liabilities     
Long-term loans  100 250  Current liabilities     
Trade payables 21  15  
Interest payable 7  5  
Income tax 40  35   ––– 68 ––– 55 
  –––  ––– Total equity and liabilities  709  732 
During the year, the entity paid $45, 000 for a new piece of equipment and 
a dividend was paid amounting to $36,000. 
Required: 
Calculate the cash generated from operat ions using the indirect method. 
 
 Test your understanding 2 – Direct method 
 Required: 
Using the information for Yog in the pr evious TYU, produce the section of 
the statement of cash flows for ca sh generated from operations using the 
direct method for the year ended 31 De cember 20X1 in compliance with 
IAS 7 Statement of Cash Flows . 
Other cash flows from operating activities 
Other cash flows that wil l be considered cash flows from operating activities 
may include: 
 interest paid, and 
 income tax paid. 
Income tax paid is included here for completeness purposes. However, the 
CIMA F1 syllabus does not include the accounting for taxation. No questions 
will ever require tax paid to be calcul ated. As a result, the following example 
focusses on the calculation of interest paid.

Chapter 13 
 263 
The cash flow should be calculat ed using the following pro-forma: 
Interest payable 
Bank (ß) X Bal b/d (SOFP) X 
Bal c/d (SOFP) X Profit or loss X 
 –––  ––– 
 X  X 
 –––  ––– 
  Bal b/d X 
 
 Test your understanding 3 – Operating activities 
 Using the information in TYU 1, calc ulate the interest paid by Yog. 
5 Cash flows from investing activities 
Cash inflows from investing activities may include: 
 interest received 
 dividends received and 
 proceeds from the sale of non-current assets.   
Cash outflows from investing activities may include: 
 purchases of non-current assets. 
Interest/Dividends received 
The cash flow for interest and dividends received should be calculated using the 
following pro-forma: 
Bal b/d (SOFP) X Bank (ß) X 
Profit or loss X Bal c/d (SOFP) X 
 –––  ––– 
 X  X 
 –––  ––– 
Bal b/d X

264  
Cash paid to acquire non-current assets 
The cash flow for non-current assets should be calculated using the following 
pro-forma: 
Non-current assets – Carrying amount 
Bal b/d (SOFP) X Disposal (Carrying amount) X 
Additions (cash) X Depreciation for the year X 
Revaluation gain for the year X Bal c/d (SOFP) X 
 –––  ––– 
 X  X 
 –––  ––– 
Bal b/d X   
Cash received on disposal of non-current assets 
The proceeds on disposal of a non-curr ent asset may need to be calculated.  
The proceeds can be determined by usi ng the profit or loss on disposal as 
follows: 
Non-current assets – Disposal account 
Cost X Accumulated depreciation X 
Profit on disposal (SPL) X Loss on disposal (SPL) X 
Bank (ß) X   
 –––  ––– 
 X  X 
 –––  ––– 
 
 Test your understanding 4 – Investing activities 
 Using the information in TYU 1 prepare t he investing activities section of 
the statement of cash flow. 
6 Cash flow from fi nancing activities 
Cash inflows from financi ng activities may include: 
 proceeds from the issue of shares, and 
 proceeds from the issue of loans/debentures. 
Cash outflows from financi ng activities may include: 
 repayments of loans/debentures, and 
 dividends paid.

Chapter 13 
 265 
Proceeds from new share issues 
The proceeds from share issues will be calculated by looking at the movement 
on the share capital and share premium accounts extracted from the statement 
of financial position. A pro-fo rma can be used as follows: 
Share capital and share premium 
  Bal b/d share capital (SOFP) X 
Bal c/d share capital X Bal b/d share premium X 
Bal c/d share premium 
(SOFP) X Proceeds from new shares 
issued (ß) X 
    
 –––  ––– 
 X  X 
 –––  ––– 
  Bal b/d X 
Proceeds/repayments from loan and debentures 
The proceeds/repayment of loans/debentur es will be calculated by looking at 
the movement on the loan/debenture accounts  extracted from the statement of 
financial position. 
Loans 
Repayment of loans (ß) X Bal b/d (SOFP) X 
(SOFP) X Proceeds from loans (ß) X 
    
 –––  ––– 
 X  X 
 –––  ––– 
  Bal b/d X 
Dividends paid 
The dividend payment can either be found in  the statement of changes in equity 
or by looking at the mo vement on the retained earnings account as follows: 
Retained earnings 
Dividend paid (ß) X Bal b/d (SOFP) X 
Bal c/d (SOFP) X Profit or loss for the year X 
 –––  ––– 
 X  X 
 –––  ––– 
  Bal b/d X

266  
 Test your understanding 5 – Financing activities 
 Using the information in TYU 1 produce the financing activities section of 
the statement of cash flows. 
 
 Test your understanding 6 – Statement of cash flows 
 Using all of you answers from TY U 1 and TYU 3-5 to produce the final 
statement of cash flows for Yog. 
 
 Illustration 3 – Statement of cash flows 
 Below are extracts from  the financial statement s of an entity Pincer: 
Statement of profit or loss and ot her comprehensive income for the 
year ended 31 March 20X1 
 $m 
Sales revenue 1,162 Cost of sales (866) 
 –––– 
Gross profit 296 Distribution costs (47) 
Administrative expenses (103) 
 –––– Profit from operations 146 
Interest receivable 79 
Finance costs (55) 
 –––– Profit before tax 170 
Income tax expense (24) 
 –––– Profit for the year 146 
Gain on revaluation 251 
 –––– 
Total comprehensive income for the year 397

Chapter 13 
 267 
 Statement of financial pos ition as at 31 March 20X1: 
 31 March 20X1 31 March 20X0 
 $m $m $m $m 
Assets     
Property, plant and equipment 1,023  600  
Investments 69  68   ––––  ––––  
  1,092  668 Current assets     
Inventories 246  128  
Trade and other receivables 460  373  
Cash and cash equivalents 527  358   ––––  ––––  
  1,233  859 
  –––––  ––––– Total Assets  2,325  1,527 
  –––––  ––––– Equity and liabilities     
Capital and reserves     
Share capital 29  24  
Share premium 447  377  
Revaluation reserve 251  –  Retained profit 116  26  
 ––––  ––––  
  843  427 
Loan 755  555  
 ––––  ––––  
  755  555 
Current liabilities     
Trade and other payables 244  311  
Overdrafts 437  207  Taxation 46  27  
 ––––  ––––  
  727  545   –––––  ––––– Total equity and liabilities  2,325  1,527 
  –––––  –––––

268  
 Additional information: 
 Profit from operations  includes depreciati on on the property, plant 
and equipment of $22 million. The revaluation reserve relates wholly 
to property, plant and equipment. 
 During the year ended 31 March 20X 1, plant and machinery costing 
$1,464 million, which had a carry ing amount of $424 million, was 
sold for $250 million. 
 During the year ended 31 March 20X 1, 25 million 20c shares were 
issued at a premium of $2.80. 
 Dividends paid during the year were $56 million. 
Required: 
Produce a statement of cash flow s for Pincer for the year ended 
31 March 20X1 in compliance with IAS 7 Statement of Cash Flows  using 
the indirect method. 
 
 Solution 
 Pincer Statement of cash flows for the year ended 31 March 20X1 
 $m $m 
Profit before tax 170  Depreciation 22  
Loss on disposal of non-current  assets (250 – 424) 174  
Interest receivable (79)  Finance costs 55  
 ––––  
Operating profit before work ing capital changes 342  
Increase in inventories (246 – 128) (118)  Increase in trade receivables (460 – 373) (87)  
Decrease in trade payables (244 – 311) (67)  
 ––––  Cash generated from  operations 70  
Interest paid (55)  
Income tax paid (W1) (5)   ––––  
Net cash from operating activities  10

Chapter 13 
 269 
 Cash flows from investing activities   
Purchases of property, plant  and equipment (W2) (618)  
Purchase of investments (69 – 68) (1)  
Proceeds of property, pl ant and equipment 250  
Interest received 79  
 ––––  
Net cash from investing activities  (290) 
Cash flow from fi nancing activities   
Proceeds from issue of shares (W3) 75  
Proceeds from long-term borrowing (755 – 555) 200  Dividends paid (56)  
 ––––  
Net cash from financing activities  219   –––– 
Net decrease in cash and cash equivalents  (61) 
Cash and cash equivalents at beginni ng of period  (358 – 207) 151 
  –––– 
Cash and cash equivalents at end of period (527 – 437) 90 
  –––– 
Workings 
(W1) 
Tax 
Bank (ß) 5 Bal b/d (current) 27 
Bal c/d (current) 46 SPL 24 
 –––  ––– 
 51  51 
 –––  ––– 
  Bal b/d (current) 46 
(W2) 
Bal b/d 600 Dep'n 22 
Reval'n 251 Disposal 424 
Bank (ß) 618 Bal c/d 1,023 
 –––––  ––––– 
 1,469  1,469 
Bal b/d 1,023   
(W3)  Proceeds from share issue = 25 million × ($2.80 + 0.20) = $75 
million

270  
Please note, the following two TYUs ar e for illustrative purposes and do not 
reflect exam standard requirements. Candidates will never be asked in the exam to produce a full stat ement of cash flows.  Candidates are likely to be 
tested on extracts from the statement or to determine specific cash flows shown 
within the statement of cash flows 
 
 Test your understandi ng 7 – Practice question 
 Below are extracts from  the financial statements of an entity Poochie: 
Statement of profit or loss for the year ended 31 March 20X1 
 $ 
Revenue 30,650 Cost of sales (26,000) 
 –––––– 
Gross profit 4,650 Distribution costs (900) 
Administrative expenses (500) 
 –––––– Profit from oper ations 3,250 
Investment income 680 
Finance costs (400)  –––––– Profit before tax 3,530 
Income tax expense (300) 
 –––––– Profit for the period 3,230 
 ––––––

Chapter 13 
 271 
 Statements of financial position as at 31 March 20X1 
  20X1  20X0 
 $ $ $ $ 
Assets     
Property, plant and equipment 2,280  850  
Investments 2,500  2,500  
 –––––  –––––    4,780  3,350 
Inventories 1,000  1,950  Trade and other receivables 1,900  1,200  
Cash and cash equivalents 410  160  
 –––––  –––––    3,310  3,310 
  –––––  ––––– Total Assets  8,090  6,660 
  –––––  ––––– 
Equity and liabilities     
Share capital 1,000  900  Share premium 500  350  
Retained earnings 3,410  1,380  
 –––––  –––––    4,910  2,630 
Long term borrowings 2,300  1,040   –––––  –––––  
  2,300  1,040 Current liabilities     
Trade and other payables 250  1,890  
Interest payable 230  100  
Taxation 400  1,000   –––––  –––––  
  880  2,990 
Total equity and liabilities  8,090  6,660 

272  
 Profit from operations is after charging depreciation on the property, 
plant and equipment of $450. 
$80 and with accumulated depreciation of $60, was sold for $20. 
 The receivables at the end of 20X1 includes $100 of interest 
receivable. There was no balance at the beginning of the year. 
 Investment income of $680 is made up of $300 interest receivable 
and $380 dividends received. 
 Dividends paid during the year were $1,200. 
Required: 
Produce a statement of cash flow s for Poochie for the year ended 
 
 Test your understandi ng 8 – Practice question 
 Below are extracts from  the financial statements of an entity Yam Yam: 
year ended 30 September 20X1 
 $000 
Revenue 2,900 
Cost of sales (1,734)  ––––– 
Gross profit 1,166 
Distribution costs (520) Administrative expenses (342) 
 ––––– 
Profit from operations 304 
Investment income 5 Finance costs (19) 
 ––––– 
Profit before tax 290 Income tax expense (104) 
 ––––– 
Profit for the period 186 
Gain on revaluation 50  ––––– 
Total comprehensive income for the year 236

Chapter 13 
 273 
 Statements of financial pos ition as at 30 September 20X1 
 30 September 
20X1 30 September 
20X0 
Assets     
Property, plant and equipment 634  510  
 –––––  –––––    634  510 
Inventories 420  460  
Trade receivables 390  320  
Interest receivable 4  9  Investments 50  0  
Cash at bank 75  0  
Cash at hand 7  5  
 –––––  –––––  
  946  794 
Total Assets  1,580  1,304 
Share capital $0.50 each 363  300  
Share premium 89  92  
Revaluation reserve 50  0  Retained earnings 63  (70)  
 –––––  –––––    565  322 
10% Loan notes 0  40  
5% Loan notes 329  349  
  329  389 
Trade and other payables 550  400  
Bank overdraft 0  70  
Accruals 36  33  Taxation 100  90  
 –––––  –––––    686  593 
Total equity and liabilities  1,580  1,304 

274  
 On 1 October 20X0, Yam Yam issued 60,000 $0.50 shares at a 
premium of 100%. The proceeds were used to finance the purchase 
and cancellation of all of its 10% loan notes and some of its 5% loan notes, both at par. A bonus issue of one for ten shares held was 
made at 1 November 20X0; all s hares in issue qualified for the 
bonus. 
 The current asset investment  was a 30 day government bond. 
 Non-current assets included certai n properties that were revalued 
during the year. 
 Non-current assets disposed of during the year had a carrying 
amount of $75,000; cash receiv ed on disposal was $98,000. 
 Depreciation charged fo r the year was $87,000. 
 The accruals balance includes interest payable of $33,000 at  
30 September 20X0 and $6,000 at 30 September 20X1. 
 Interim dividends paid during the year were $53,000. 
Required: 
Produce a statement of cash fl ows for Yam Yam the year ended 
30 September 20X1 in compliance with IAS 7 Statement of Cash Flows  
using the indirect method. 
 
 Test your understanding 9 – Practice questions 
 1 Barlow uses the ‘indirect method’ for the purpose of calculating cash 
generated from operations in the statement of cash flows. 
The following information is provided for the year ended 
31 December 20X0: 
 $ 
Profit before tax 5,600 Depreciation 956 
Profit on sale of equipment 62 
Increase in inventories 268 Increase in receivables 101 
Increase in payables 322 
What is the cash gene rated from operations? 
A $6,571 
B $6,541 C $6,447 D $5,803

Chapter 13 
 275 
 2 Evans had the following balances  in its statem ent of financial 
position as at 30 June 20X0 and 20X1: 
 20X1 20X0 
10% Loan $130,000 $150,000 Share Capital $120,000 $100,000 Share Premium $45,000 $35,000 
How much will appear in the statement of cash flows for the 
year ended 30 June 20X1 as the total for ‘cash flows from 
financing activities’? 
A $10,000 outflow 
B $10,000 inflow C $50,000 inflow D $50,000 outflow 
3 At 1 January 20X0 Casey had non-cu rrent assets with a carrying 
amount of $250,000. In the year  ended 31 December 20X0, the 
entity disposed of assets with a carrying amount of $45,000 for $50,000. The entity revalued a build ing from $75,000 to $100,000. 
Casey charged depreciation for the y ear of $20,000. At the end of 
the year, the carrying amount of  non-current assets was $270,000. 
How much will be re ported in the statement of cash flows for 
the year ended 31 December 20X0 as the total for ‘cash flows from investing activities’? 
B $10,000 inflow C $35,000 outflow D $50,000 inflow 
The following information relates to Questions 4 and 5: 
IAS 7 requires cash flows to be analysed under three headings – cash 
flows from operating activities, investi ng activities and financing activities. 
Several items that may appear in a ca sh flow statement are listed below: 
(i) Cash paid for the purchase of non-current assets (ii) Dividends received (iii) Interest paid (iv) Repayment of borrowings (v) Tax paid

276  
 4  Which of the above items would appear under the heading 
‘cash flows from in vesting activities’? 
A  i only 
B i and ii C i, ii, iii and iv D ii, iii and iv 
5 Which of the above items would appear under the heading 
‘cash flows from ope rating activities’? 
A i only 
B iii and v C  iii, iv and v D ii, iii and v 
6 How much interest was paid in the year? 
 $000 
Interest accrued b/fwd 600 
Interest charged to the statem ent of profit or loss 700 
Interest accrued c/fwd 500 
A $600,000 
B $700,000 C $800,000 D $1,300,000 
7 At 1 October 20X0, BK had the following balance:  
Accrued interest payable $12,000 credit. During the year ended 30 September  20X1, BK charged interest 
payable of $41,000 to its statement of profit or loss. The closing 
balance on accrued interest payable account at 30 September 20X1 was $15,000 credit. 
How much interest paid shoul d BK show on its statement of 
cash flows for the year ended 30 September 20X1? 
A $38,000 
B $41,000 C $44,000 D $53,000

Chapter 13 
 277 
 8 Interest payable balance at 31 March 20X0 $1,120,000. 
Interest payable balance at 31 March 20X1 $1,140,000. Interest charged to the statement of profit or  loss for the year to 
31 March 20X1 $850,000. 
How much should be included in the statement of cash flows 
for interest paid in the year? 
A $800,000 
B $830,000 C $850,000 D $880,000 
9 During the year to 31st July, Smartypants made a profit of $37,500 
after accounting for depreciation of $2,500. 
During the year non-current asse ts were purchased for $16,000, 
receivables increased by $2,000, inventories decreased by $3,600 
and trade payables increased by $700. 
What was the increase in cash and bank balances during the 
year? 
A $21,300 
B $21,700 C $24,900 D $26,300 
10 Which of the following lists consists  of items that would be added to 
profit before taxation in the calcul ation of net cash from operating 
activities according to IAS 7? 
A Decrease in trade receivables,  increase in trade payables, 
profit on sale of non-current assets. 
B Loss on sale of non-current assets, depreciation, increase in 
trade receivables. 
C Decrease in inventories, deprecia tion, profit on sale of non- 
D Decrease in trade receivables, increase in trade payables, loss 
on sale of non-current assets.

Chapter 13 
 279 
 Yog statement of cash flows for the year ended 31 December 20X1 
 $000 
Profit before taxation 196 
Adjustments for:  Depreciation 59 
Loss on disposal 9 
Finance costs 14  ––– Operating profit before working capital changes 278 
Increase in inventories (12 – 10) (2) 
Increase in trade receivables (34 – 26) (8) Increase in trade payables (21 – 15) 6 
 ––– 
Cash generated from operations 274 
 
 $000 
Cash receipts from customers (W1) 352 
Cash payments to suppliers (W2) (31) 
Cash payments to employees (47)  –––– Cash generated from operations 274 
(W1) 
Cash receipts from customers 
 $000 Opening receivables 26 
Sales revenue 360 
Closing receivables (34)  –––– 
Cash received from customers 352

280  
 (W2) 
Cash payments to suppliers 
 $000 
Opening inventories 10 
Purchases (ß) 37 Closing (12) 
 –––– 
Cost of materials used 35   
 $000 
Opening payables 15 Purchases (above) 37 
Closing payables (21) 
 –––– Payments to suppliers 31 
 
 Interest paid (W1)  (12) 
Workings 
(W1) 
Bank (ß) 12 Bal b/d 5 
Bal c/d 7 Profit or loss 14 
 –––  ––– 
 19  19 
 –––  ––– 
  Bal b/d 7

Chapter 13 
 281 
 Cash flows from investing activities 
Purchase of non-current assets (45) 
Proceeds from sale of non-cu rrent assets ($15 (W1) – 
loss on sale of $9 = $6) 6 
 ––– 
Net cash from investing activities  (39) 
  
(W1) 
Non-current assets – CV 
Bal b/d 668 Disposal (ß) 15 
  Depreciation for the year 59 
Additions 45 Bal c/d 639 
 –––  ––– 
 713  713 
 –––  ––– 
Bal b/d 639   
 
Cash flows from financing activities   
Proceeds from issues of ordinary shares (W1) 16  
Repayment of loans (100 – 250) (150)  
Dividends paid (36)   –––  
Net cash from financing activities  (170) 
(W1) Share issue = (180 + 18) – (170 + 12 ) = $16

282  
 $000 $000 
Profit before taxation 196  Adjustments for:   
Depreciation 59  
Loss on disposal 9  Finance costs 14  
 –––  
Operating profit before work ing capital changes 278  
Increase in inventories (12 – 10) (2)  
Increase in trade receivables (34 – 26) (8)  
Increase in trade payables (21 – 15) 6   –––  
Cash generated from operat ions (TYU 1) 274  
Interest paid (TYU 3) (12)  Income tax paid (TYU 3) (57)  
 –––  
Net cash from operating activities  205 Cash flows from investing activities   Purchase of non-current assets (45)  
Proceeds from sale of non-current assets (TYU 4) 6  
 –––  Net cash from investing activities  (39) 
Proceeds from issues of or dinary shares (TYU 5) 16  
Dividends paid (36)  
  ––– Net cash from financing activities  (170) 
  ––– 
Net decrease in cash and cash equivalents  (4) Cash and cash equivalents at beginning of period  28 
  ––– 
Cash and cash equivalents at end of period  24   –––

Chapter 13 
 283 
 Poochie Statement of cash flows fo r the year ended 31 March 20X1 
 $ $ 
Profit before tax 3,530  Depreciation 450  
Investment income (680)  
Finance costs 400   ––––––  
Operating profit before work ing capital changes 3,700  
Decrease in inventories (1,950 – 1,000) 950  Increase in trade receivables (W4) (600)  
Decrease in trade payables (1,890 – 250) (1,640)  
 ––––––  Cash generated from  operations 2,410  
Interest paid (W2) (270)  
Income tax paid (W1) (900)   ––––––  
Net cash from operating activities  1,240 Cash flows from investing activities   
Purchase of property, plant and equipment (W3) (1,900)  
Proceeds from sale of property, plant and 
equipment 20  
Interest received (W4) 200  
Dividends received 380   ––––––  
Net cash from investing activities  (1,300) Cash flow from fi nancing activities   
Proceeds from issue of shares (W5) 250  
Proceeds from long-term bo rrowing (2,300 – 1,040) 1,260  
   Dividends paid (1,200)  
 ––––––  Cash flows from operating activities   
Net cash from financing activities 310  
 ––––––  
Net increase in cash and cash equivalents  250 Cash and cash equivalents at beginning of period  160   ––––– 
Cash and cash equivalents at end of period  410 
  –––––

284  
 Workings 
(W1) 
Tax 
Bank (ß) 900  Bal b/d 1,000 
Bal c/d 400  Profit or loss 300 
 1,300  1,300 
  Bal b/d 400 
(W2) 
Bank (ß) 270  Bal b/d 100 
Bal c/d 230  Profit or loss 400 
 500  500 
  Bal b/d 230 
(W3) 
Bal b/d 850 Dep'n 450 
  Disposal (80 – 60) 20 
Bank (ß) 1,900 Bal c/d 2,280 
 2,750  2,750 
Bal b/d 2,280   
(W4) 
Interest receivable 
Bal b/d 0 Bank (ß) 200 
Profit or loss 300 Bal c/d 100 
 ––––  –––– 
 300  300 
 ––––  –––– 
Bal b/d 100   
Receivable B/d = $1,200 
Receivables C/d = $1,800 ($1,900 – $100 interest receivable) 
Increase in receivables = $600 
(W5)  
Share issue = ($1,000 + $500) – ($900 + $350) = $250

Chapter 13 
 285 
 Yam Yam Statement of cash flows for the year ended 30 September 
20X1 
 $000 $000 
Profit before tax 290  Depreciation 87  
Profit on disposal of non-curr ent asset (98 – 75) (23)  
Investment income (5)  Finance costs 19  
 –––  
Operating profit before working capital changes 368  Decrease in inventories (420 – 460) 40  
Increase in trade receivables (390 – 320) (70)  
Increase in trade payables (550 – 400) 150  Increase in sundry accruals (W5) 30  
 –––  
Cash generated from operations 518  Interest paid (W2) (46)  Income tax paid (W1) (94)  
 –––  
Net cash from operating activities  378    
 $000 $000 Cash flows from investing activities   
Purchase of property, plant and equipment (W3) (236)  
equipment 98  
Interest received (W4) 10  
 –––  
Net cash from investing activities  (128)

286  
 Cash flow from fi nancing activities   
Proceeds from issue of shares (60 × $1) 60  
Redemption of 10% loan notes (0 – 40) (40)  
Redemption of 5% loan not es (329 – 349) (20)  
Dividends paid (53)  
 –––  
Net cash from financing activities  (53)   ––– 
Net increase in cash and cash equivalents  197 
Cash and cash equivalents at begi nning of period (5 – 70) (65) 
  ––– 
Cash and cash equivalents at end of period  132 
(50 + 75 + 7 + 0)  ––– 
Working 
(W1) 
Tax 
Bank (ß) 94 Bal b/d 90 
Bal c/d 100 Profit  or loss 104 
 –––  ––– 
 194  194 
 –––  ––– 
  Bal b/d 100 
(W2) 
Bank (ß) 46 Bal b/d 33 
Bal c/d 6 Profit or loss 19 
 –––  ––– 
 52  52 
 –––  ––– 
  Bal b/d 6 
(W3) 
Bal b/d 510 Dep'n 87 
Revaluation 50 Disposal 75 
Bank (ß) 236 Bal c/d 634 
 –––  ––– 
 796  796 
 –––  ––– 
Bal b/d 634

Chapter 13 
 287 
 (W4) 
Interest Receivable    
Bal b/d 9 Bank (ß) 10 
Profit or loss 5 Bal c/d 4 
 –––  ––– 
 14  14 
 –––  ––– 
Bal b/d 4   
(W5) 
Accruals b/d (excluding interest) = $33 – 33 = 0 Accruals c/d (excluding interest) = $36 – 6 = 30 
Increase in accruals = 30 
 
 1 C 
Cash flows from operating activities $ 
Profit before tax 5,600 Adjustments for:  Depreciation 956 
(Profit)/loss on disposal (62) 
(Increase)/decrease in inventories (268) (Increase)/decrease in trade and other receivables (101) 
(Decrease)/increase in trade and other payables 322 
 ––––– Cash generated from  operations 6,447 
 ––––– 
2 B 
Repayment of loans (150,000 – 130,000) (20,000) 
Issue of shares ((120,000 – 100,000) + (45,000 – 
35,000)) 30,000 
 –––––– 
Net inflow 10,000  ––––––

288  
 3 A 
Non-current assets 
 $  $ 
Bal b/d 250,000 Disposals 45,000 
Revaluation 25,000 D epreciation 20,000 
Additions (ß) 60,000   
   
  Bal c/d 270,000 
 –––––––  ––––––– 
 335,000  335,000 
Bal b/d 270,000   
 
Purchase of non-current assets (60,000) 
Proceeds from sale of non-current assets 50,000 
 ––––––– 
Net outflow (10,000) 
 ––––––– 
4 B 
5 B 6 C 
 $000  $000 
Bank (ß) 800 Bal b/d (SOFP) 600 
Bal c/d (SOFP) 500 Pr ofit or loss 700 
 ––––  –––– 
 ––––  –––– 
  Bal b/d 500 
7 A 
 $  $ 
Bank (ß) 38,000 Bal b/d (SOFP) 12,000 
Bal c/d (SOFP) 15,000 Pr ofit or loss 41,000 
 53,000  53,000 
  Bal b/d 15,000

Chapter 13 
 289 
 8 B 
 $000  $000 
Bank (ß) 830 Bal b/d (SOFP) 1,120 
Bal c/d (SOFP) 1,140 Pr ofit or loss 850 
 1,970  1,970 
  Bal b/d 1,140 
9 D 
$37,500 + $2,500 – $16,000 – $2,000 + $3 ,600 + $700 = 
$26,300 
10 D

291 
Short-term Finance and 
Investments 
D1.  Distinguish between the 
types and sources of short term finance Distinguish between: 
a. Types of short term finance b. Financial institutions 
D3. Apply different techniques 
used to manage working capital  
  Chapter 
14

Short-term Finance and Investments 
292  
 
2 Short-term finance and financial institutions 
Current liabilities should not be allowed to increase to a level where the cash 
position and liquidity of the company are at risk. This requires careful 
management of short-term finance. 
Financial institutions 
Short term finance can be obtained by an ent ity from a variety of institutions 
such as: 
 Commercial and corporate banks  
 Non-banking financial instit utions e.g. other com panies who provide short 
terms loans with their cash surpluses 
 Trading partners – trading partners are the entities which a business buy 
from or sell to. Finance can be obtai ned from an entity’s trading partners 
through normal business practices (e.g. through trade payables) or via specifically organised financing transac tions (e.g. bills of exchange).

Chapter 14 
 293 
Commercial and Corporate banks 
Commercial and corporate banks are financia l institutions who provide financial 
products for customers (whether individua ls or businesses) with the aim of 
making a profit. They accept deposits from  customers into savings, current or 
investment accounts and will also provi de loans and overdrafts as required. 
Typical high street banks are examples of commercial banks.  
Non- financial institutions 
Short term financing could be sourced from entities whos e main operating 
activities are not necessarily to prov ide finance. Other companies, from any 
industry, with surplus cash may decide to invest its surpluses in shares or debentures of other entities. These investm ents may mature in the short term.   
Trading partners 
Trading partners will often enter into  formal trade agreements . Trade 
agreements are legally defined arrangement s setting out specific, and often 
exclusive, terms and conditions of trade between those involved in the agreement.  
Trade agreements are particularly comm on between exporters and importers 
and are a topical issue within the UK due to  the possible implications of Brexit. 
Will the UK be able to negotiate trade agr eements within the EU or will they 
have to agree trade deals with the US , Canada or further afield? 
3 Types of short term financing 
The main types of short-term finance are: 
 trade payables 
 factoring or invoice discounting of trade receivables 
 bank overdrafts and short-term loans 
 financing exports 
Trade payables 
Payables may be used as a source of short-term finance by delaying payment 
to suppliers. 
By paying on credit the entity is able to ‘fund’  its inventory of material through its 
suppliers. To maximize this benefit, the entity should aim to pay as late as 
possible without damaging its trading re lationship with its suppliers. 
If a cash discount is offered, the entity  must weigh the savi ng from the discount 
against the additional cost of borrowing the funds needed to finance the early 
payment. The entity must also be aware of  whether the funds are available to 
take up the discount.

294  
Benefits of paying suppliers late  Potential problems when paying 
suppliers late 
 alleviates cash flow difficulties 
 cash can earn a return whilst still 
in the paying entity's account 
  loss of any settlement discount 
 could obtain a poor credit rating 
 supplier may stop further 
supplies 
 supplier may increase future 
selling prices to compensate 
 could face legal action from the 
supplier 
 
 Trade payables as a source of short-term funds 
 Suppliers are a source of short-te rm finance because they provide goods 
(inventory) on credit. In some cases,  suppliers might not be paid until 
after the goods they have supplied hav e been re-sold. This occurs, for 
example, in supermarkets. A s upermarket might re-sell the goods 
provided by a supplier many days befor e the supplier is eventually paid. 
It is a well-established business practice that trade credit should be 
agreed, which means that suppliers  finance the business of their 
customers to some extent. 
The amount of trade credit varies fr om one industry to another, and can 
also vary with changes in economic conditions. However, if normal credit terms are 30 days (1 month), and a company purchases, say, $1,200,000 
of goods on credit each year, it is normally financed by $100,000 of trade credit on average (1/12 of t he total annual purchases). 
A huge attraction of trade credit is that it has no interest cost. Unlike 
banks, trade suppliers do not char ge interest on debts unless payment 
occurs after the due date, in which case suppliers might charge interest. 
Trade receivables 
Receivables may be used as a source of short-term finance by: 
 Factoring 
 Invoice discounting 
Factoring 
The debts of the entity are effectively so ld to a factoring company (normally 
owned by a bank). The factor may take on the responsibility to collect the debt for a fee. The factor offers three services: 
1 Debt collection  – The credit control function. This is outsourcing of the 
credit control department to  the factoring entity.

Chapter 14 
 295 
2 Financing  – Funds may be advanced to the company prior to the debt 
being collected. This may provi de the financing element of the 
arrangement. 
3 Credit insurance  – The factor may take the responsibility for 
irrecoverable debt. For this to be the case the factor would dictate to 
whom the entity was able to offer credi t. This is called ‘without recourse’ 
factoring. 
The factor is often more successful at  enforcing credit terms, leading to a lower 
level of debts outstanding. Factoring is t herefore not only a sour ce of short-term 
finance but also an external means of controlling or reducing the level of 
receivables. 
Invoice discounting 
This is a service also provided by a fact oring entity. Selected invoices are used 
as security against which the entity ma y borrow funds. This is a temporary 
source of finance, repayable when t he debt is cleared. The key advantage of 
invoice discounting is that it is a conf idential service and the customer need not 
know about it. 
One use for invoice discounting is as a key financing tool for new businesses 
such as management buyouts (MBOs). The creditworthiness of their customers 
is probably higher than their ow n and is utilised to borrow funds. 
Short-term borrowing 
Short-term cash requirements can also  be funded by borrowing from the bank. 
There are two main sources of bank lending: 
 bank overdraft 
 bank loans 
Bank overdrafts 
Short term, flexible financing linked to company bank accounts that are in 
deficit. Bank overdrafts are mainly provided by the clearing banks and are an 
important source of finance for an entity. 
 Flexibility 
 Only pay for what is used, so 
generally cheaper  Repayable on demand 
 May require security 
 Variable finance costs 
Bank loans 
Bank loans are a contractual agreement for a specific sum, loaned for a fixed 
period, at an agreed rate of interest. They  are less flexible than overdrafts, can 
be more expensive but provide greater security.

296  
Financing exports 
Entities exporting goods to other countri es often have much greater problems 
with credit and finance than entities sell ing goods and services to domestic 
markets. 
Several methods are available for dealing with the problems of financing 
exports and controlling the credit risk. These include: 
 documentary credits 
 bills of exchange 
 export factoring 
 forfaiting 
Documentary credits (irrevocable letters of credit) 
Trading between other countries, can be comp lex, particularly when it will take a 
considerable time to ship the goods from  the exporter’s country to the importer. 
The exporter might want payment as s oon as possible, but the importer needs 
to be satisfied that the exporter has  complied with the terms of the sale 
agreement before paying. 
The problem of guaranteeing payment  can be overcome by using an 
irrevocable letter of credit, also calle d an irrevocable documentary credit. A 
letter of credit is an undertaking given by its issuer t hat payment will be 
guaranteed for the exporter, provided that the exporte r complies with certain 
specific requirements withi n a specified time limit. 
A letter of credit is a document, issued by a bank on behalf of a customer, 
authorising a person to draw money to a specified amount from its branches or 
correspondents, usually in another country , when the conditions set out in the 
document have been met. 
A bill of exchange 
A bill of exchange is used primarily in in ternational trade and binds one party to 
pay a fixed sum of money to another party on demand or at a predetermined 
date. They are similar to post-dated cheques.  
For example, a supplier of goods (the draw er) can draw a bill of exchange on a 
customer (the drawee). The customer , by signing the bill of exchange, 
acknowledges the debt exists and commits to paying it.  
There are two types of bill of exchange: (i) a sight draft/bill – which is payable immediately  (ii) a time draft/bill – which is payabl e  at a predetermined future date (can be 
described as term bills)  
The holder of a bill of exchange can use an accepted time draft to pay a debt to 
a separate third party (one not involved in the bill of exchange so transferring 
the customers debt) , or can di scount it to raise cash (sell it on to a third party 
for a lump sum lower than the outstanding amount).

Chapter 14 
 297 
The drawer and the payee are often the same person.  
A significant characteristic of bills of exchange is that: 
 the drawee is given a period of credi t before having to pay a term bill, but 
 the drawer or payee can obtain paym ent earlier than the bill’s maturity 
date, by means of discounting the bill. 
When a bill is discounted, it is sold in the financial markets at a discount to face 
value. The size of the discount reflects t he rate of interest t hat the buyer of the 
bill requires from holding the bill to maturity. 
Bills of exchange can also be kn own as ‘acceptance credit’.  
Export factoring 
Export factoring is similar to ordinary factoring, with the exception that the 
factoring organisation agrees to factor the client’s export trade receivables 
(overseas trading).  
The factor’s services include administ ration of the receivables ledger and 
collecting payment, and providing factor  finance. The export factor buys the 
sellers overseas receivables for a lu mp sum which is often lower than the 
outstanding debt owed. 
In view of the problems that can aris e with collecting paym ents from customers 
in other countries, the expertise of an export factor can be very helpful, 
particularly for small and medium-siz ed businesses with little experience in 
collecting foreign payments. 
Forfaiting 
Forfaiting is the same as export factor ing except that the seller (exporter) will 
receive 100% of the receivable as a lump sum from the forfaiter.  
The exporter will draw a bill of exchange fr om an importer (the buyer). This bill 
of exchange is purchased by a forfai ting company (typically banks) without 
recourse to the exporter.  
The exporter receives the total amount ow ed, the forfaiter chases the debt and 
the importer settles direct  to the forfaiter.   
The exporter has obtained payment for t he goods, without any risk of having to 
return the money if the importer fails  to meet its payment obligations. 
The key features of forfaiting are that: 
 The importer obtains medium-term financ e for much of the purchase cost 
of the goods. 
 The exporter receives immediate payment. 
 The credit risk is accepted by the fo rfaiting bank, although this risk is 
reduced by the guarantee of the promissory notes (another name for a bill 
of exchange).

298  
4 Short-term investments 
A business might have surplus cash for a period of time. Surplus cash is usually 
temporary and available for several weeks or  months. Eventually it will be used 
to pay suppliers or settle other liabilities , invest in new non-current assets or pay 
a dividend. 
Money in an operational bank account earns no income, because banks do not 
pay interest to businesses for cash in their day-to-day accounts. If a business 
wishes to maximise its profits, it shoul d consider using the cash to earn some 
return in the time when it is te mporarily surplus to requirements. 
Cash surpluses can be invested in a range of short-term interest-earning 
investments such as: 
 Interest-bearing bank accounts 
 Negotiable instruments 
 Short-dated government bonds 
 Other short-term investments 
Investment criteria 
When a business has surplus cash to inve st temporarily, it has to decide which 
investments to select from  the different choices ava ilable. There are several 
criteria that should be consider ed when making these choices: 
 maturity 
 return 
 risk 
 liquidity 
 diversification 
 
 More details 
 Future commitments 
Before investing surplus cash, an entity must consider its future plans. Is 
the cash really surplus to requirem ents or will it be needed in the future? 
Proper planning through forecasts (see chapter 18) will be utilised to 
determine how much cash is surplus and can be invested in the short term investments. The business does not want to miss out on 
opportunities through cash being tied in to short term investments at the 
point that the cash is needed.

Chapter 14 
 299 
 Maturity 
A short-term investment might invo lve investing an amount of money for 
a specific period of time, and receiv ing interest and the payment of a 
principal amount at a specified fu ture date (the ‘maturity’ of the 
investment). If the invest ment is cashed in or so ld before maturity, there 
could be a risk of some loss of market  value or some loss of interest. 
The maturity of a short-term investm ent should ideally be no longer than 
the duration of the cash surplus.  If the cash is needed before the 
investment reaches maturity, the in vestment will have to be ‘cashed in’ 
early, with some risk of loss of capital value or interest. 
Return 
With short-term investments, return  is the interest yield on the 
investment. Some investments offer a higher yield than others. If the 
investment is 'redeemable' (i.e. wher e a capital amount will be repaid to 
the investor) then the capital repayment  will also form part of the return. 
Risk 
Some investments are more risky than others. Risk refers to the 
possibility that the investment might fa ll in value, or t hat there might be 
some doubt about the eventual payment of interest or repayment of 
investment principal. As a general rule, higher-risk investments have to 
offer a higher return in or der to attract investors. 
For example, suppose that two ban ks offer high-interest savings 
accounts to businesses, for which t here is a minimum notice period of 
two weeks for withdrawal of funds. B ank A might be a major bank with a 
‘triple-A’ credit rating, and Bank  B might be a regional bank in a 
developing country. To a ttract investors, Bank B would have to offer a 
higher interest rate on its savings accounts than Bank A, because the 
perceived risk for investors in an invest ment in Bank B would be higher. 
Investing in equities (shares) is high risk. The value of equities depends 
on the profitability and future prospects  of the company, and share prices 
also rise or fall more generally in  line with broader movements in the 
stock market. Since share prices can fall by a large amount in a short period of time, equities are generally  regarded as an unsuitable form of 
short-term investment. 
Short-term investments should us ually be preferred to longer-dated 
investments, because the risk of a fa ll in market value is less. Prudent 
entities should also avoid high-risk investments such as equities, and 
should look for short-term investment s that will keep the value of the 
investment secure.

300  
 Liquidity 
Liquidity refers to the ease with wh ich an investment can be ‘cashed in’ 
quickly, without any significant loss of value or interest. All short-term 
investments are less liquid than cash  in an operational bank account, but 
some are more liquid than others. Fo r example, many savings accounts 
or deposit accounts are reasonably liq uid, and a depositor can often 
withdraw cash immediately losing only several days’ interest. 
In contrast, works of art such as pai ntings might be a pr ofitable long-term 
investment, but they are very illiquid as short-term investments. Paintings 
cannot be sold quickly without a signific ant risk of having to sell at below 
true market value. 
There is a general rule that investor s should not ‘put all their eggs in one 
basket’. They should perhaps diversify by investing in a range of different investments. In this way, if some in vestments perform badly, the investor 
is not exposed to significant losses,  because the other investments in the 
portfolio should perform better. 
However, diversification is less ess ential for investing short-term cash 
surpluses than for investing l ong-term in equities and bonds. 
Interest-bearing accounts 
These can fall into two categories: 
 bank deposit accounts 
 money market deposits 
 
 Deposit accounts 
  Some deposit accounts are ‘instant  access’ accounts, which allow 
the investor to withdraw the m oney without notice and without loss 
of interest. The interest rate is usually low on these accounts, and 
they are used when the investor wants to earn some interest on 
surplus cash, but places great importance on instant liquidity. 
 Some deposit accounts or savings accounts allow the investor to 
withdraw funds without notice, but the investor will suffer some loss 
of interest. For example, a deposit account might require a notice of 
withdrawal of at least seven da ys, but the investor might be 
permitted to withdraw the funds without notice with a penalty of 
seven days’ lost interest. 
 In some cases, an investor mi ght be unable to withdraw funds from 
the account without giving a minimum notice period.

Chapter 14 
 301 
 Money market deposits 
 Money market deposits are amounts of money deposited through a bank 
in the money markets. These are the financial markets for short-term 
borrowing and lending. The money ma rkets are used largely by banks 
and other financial institutions, fo r depositing and lending funds. Banks 
can deposit short-term funds with other  banks, or borrow short-term from 
other banks in the inter-bank market. 
Interest yields in the inter-bank ma rket are often reasonably attractive, 
and it is now quite common for entities with large temporary cash surpluses to arrange with their bank to have the money deposited in the 
money markets (inter-bank market) or at money market interest rates. 
Money invested in a money market deposit cannot be wit hdrawn until the 
deposit matures. It is therefore im portant that money should not be 
invested for a period longer than the in vestor’s expected cash surplus. 
Money market deposits can be for very s hort periods of time, as little as 
one day, or for as long as several months (and even up to one year). However, very short-term deposits shoul d be large amounts of money, so 
that the interest earned justifies the effort of making the deposits. 
Interest earned 
If you are required to calculate the am ount of interest earned on a deposit or 
savings account within a particular peri od of time, calculation is simply: 
  (Amount deposited × annualized interest rate 	×Number of days interest earned
Annual day count	
The annual day count is the number of days in the year, for interest calculation 
purposes. Since a year has either 365 or  366 days (for leap years), you may 
expect this to always be those numbers.  However, in the financial markets, 
there are special conventions for t he number of days in a year. Whereas 
interest on sterling is ca lculated on the assumption of  a 365-day year, interest 
on the US dollar in the money markets is calculated on the assumption of 360 
days in the year. 
Negotiable instruments 
Negotiable instruments ar e financial instruments that may be obtained as 
investments. A key feature of negotiable instruments is  that title passes when 
the instrument is handed from one per son to another. They are ‘bearer 
instruments’, and ownership does not hav e to be recorded in a register of 
owners. This means that a negotiable in strument can easily be sold by one 
person to another or one entity to another. 
Examples of negotiabl e instruments are: 
 bank notes 
 bearer bonds 
 Certificates of Deposit

302  
 Bills of exchange 
 Treasury bills 
The most important negotiable instrum ents as short-term investments are 
Certificates of Deposit and Treasury b ills, and bills of exchange (particularly 
bank bills of high quality banks). 
 
 Certificate of Deposit 
A Certificate of Deposit or CD is a negotiable instrument that provides 
evidence of a short-term deposit with a bank for a fixed term and earning a specified amount of interest. The ma turity of the deposit is usually 90 
days or less, but can be longer. The amount deposited is at least 
US$100,000 (or its equival ent in other currencies) , but usually larger. 
The holder of the CD at maturity ha s the right to take the deposit with 
interest. The CD holder presents the CD at maturity to a recognised 
bank, which will then present the inst rument to the bank holding the 
deposit, and arrange for the withdrawal  of the deposit with interest. 
Until maturity, the money is ‘locke d up’ with the bank, and cannot be 
withdrawn. 
When an organisation has a temporary cash surplus, it might arrange 
with its bank to place the money in a fixed term deposit account, and for the bank to issue a CD. The CD will state the identity of the bank, the 
amount deposited, the maturity date of the deposit and the interest that 
will accumulate. 
 The organisation can hold the CD until maturity and then claim the 
money. 
 Alternatively, if it needs cash bef ore the deposit matures, it can sell 
the CD. There is an active secondar y market in Certificates of 
Deposit, and a company can arrange for its bank to sell a CD on its behalf. 
Another company with a short-term cash  surplus could either arrange its 
own Certificate of Deposit or pur chase an existing CD in the secondary 
market. 
Investment yield on CDs 
Since Certificates of Deposit are negot iable instruments, they are more 
attractive investments than money mark et deposits from the point of view 
of liquidity. A CD holder can sell the CD to obtain funds quickly, whereas 
a money market deposit cannot be wit hdrawn until maturity. Yields on 
CDs are therefore slightly lower t han interest yields on money market 
deposits.

Chapter 14 
 303 
 Bills of exchange 
Bills of exchange have been described ear lier in the chapter, in the 
context of export finance, although they have a broader use and are not 
restricted to export finance arrangements. 
The significance of bills of exchange as a short-term investment is that 
they are negotiable instruments. There is  an active money market for bills 
of exchange (which is called the di scount market) and investors can buy 
bills. The market is particularly active  in bills of exchang e that are payable 
by top-quality banks: in the UK these are sometimes called ‘eligible bank 
bills’. 
The buyer of a bill of exchange obtains the right to receive payment by 
the issuer of the bill when it mature s. A bill of exchange is usually an 
undertaking to pay a fixed sum of money  at maturity, with no interest. An 
investor in a bill will therefore buy t he bill at a discount to face value (and 
hence the right to receive the payment).  Bills of exchange are therefore 
examples of discount paper. 
Although it is possible to buy bills of exchange that have been accepted 
(and so are payable) by trading entitie s, investors place more value in 
bank bills. These are bills of ex change that have been accepted by a 
bank, and are payable by the bank. If t he bank has a high credit status, 
the risk of investing in its bills is very low. 
Yields on bills vary according to t he credit risk associated with the bill, 
and an investor will be prepared to pay more for a top-quality bank bill 
than for a trade bill with much higher credit risk. 
Treasury bills 
Treasury bills are negotiable instrum ents issued by the government, with 
a maturity of less than one year. In pr actice, most Treasury bills have a 
maturity of three months (91 da ys). Treasury bills are used by a 
government to finance short-term cash  requirements, and in countries 
such as the US and the UK, Treasury bills are issued at regular intervals when investors are invited to apply to buy bills in the new issue. 
Since Treasury bills are debts of the government, they have a high credit 
quality, risk is low, and yields for in vestors are also lower than for many 
other short-term investments. Treasur y bills issued by a government and 
denominated in the domestic currency should be risk-free. For example, 
US Treasury bills are risk-free inve stments, because there is no doubt 
that the US government will r edeem the debt at maturity. 
Treasury bills are redeemable at face  value. For example, the US 
government will redeem a 91-day $1, 000 Treasury bill for $1,000 91 days 
after its issue. Since the bills ar e redeemable at par, investors pay less 
than face value to buy them. Like bills of exchange, Treasury bills are 
Although yields on Treasury bills are rela tively low, they can be attractive 
short-term investments because of  their risk-free nature and their 
liquidity. There is a large and active se condary market in Treasury bills, 
such as US Treasury bills in the US  and UK government Treasury bills in 
the UK.

304  
Short-dated government bonds 
Entities can invest temporary surplu s cash in government bonds. If they do: 
 they will receive interest on the due payment dates 
 they can liquidate their investment at  any time by selling the bonds in the 
secondary market 
 if the bonds are short-dated when pur chased, they can hold the bonds to 
maturity and have them redeemed at par. 
However, there is some price risk wit h bonds, particularly longer-dated bonds. If 
interest rates change in the market, the ma rket value of bonds will rise or fall. 
Bond prices rise when interest rates fall,  but prices fall when interest rates go 
up. The movement in price is  greater for longer-dated bonds. 
Other short-term investments 
This chapter has described the short-term  investments that are most commonly 
purchased or used by entities.  There are other short-term investments such as: 
 corporate bonds, and 
 commercial paper (CP). 
These are more likely to be purchased by in vestment institutions rather than by 
entities with a short-term cash surplus. 
 
 Corporate bonds 
Corporate bonds are bonds issued by an entity. They are long-term 
investments, and so unsuitable for inve sting a short-term cash surplus, 
and they can also be a high risk inve stment. Bond prices  fluctuate with 
movements in the general level of interest rates, and corporate bond 
values are also affected by the perce ived credit risk of the entity issuing 
the bonds. 
Commercial paper (CP) 
Commercial paper consists of short- dated negotiable de bt instruments 
issued by an entity, and sold by a bank managing the entity's commercial 
paper programme. In practice, although CP  is negotiable, it is generally 
purchased by large investm ent institutions and held to  maturity. It is not 
normally regarded as a suitable type of short-term investment of cash 
surpluses by a trading entity.

Chapter 14 
 305 
 1 On 1 April 20X4, an entity placed $5 million on deposit at an interest 
rate of 6.25%. The deposit has a ma turity date of 30 June 20X4 (91 
days later). 
Calculate the amount of cash th at the entity will receive on 
maturity of the deposit. 
(There are 360 days in a year for interest purposes.) 
2 Which of the following would not no rmally be used to deal with 
the credit risk associat ed with exporting: 
A Documentary credits 
B Forfaiting C Bills of exchange D Treasury bills 
3 Which of the following fact ors would not normally be 
considered when choosing between different sources of 
investment: 
A Risk 
B Liquidity C Currency D Maturity

Chapter 14 
 307 
 1 The interest on the deposit wil l be $5 million × 6.25% × 91/360 = 
$78,993. 
The interest will be added to the face value of the deposit on 
maturity.  
At maturity the deposit will be $5 million + $78,993 = $5,078,993. 
2 The correct answer is D. 
Treasury bills are used as a source  of investment rather than a way 
for reducing export risks. 
3 The correct answer is C. 
Currency may influence areas such  as risk and liquidity of the 
investment, but the currency itself  would largely be irrelevant as 
long as the investment was within acceptable risk limits and 
sufficiently liquid.

309 
Working Capital 
D2. Explain and calculate 
operating and cash cycles Explain and calculate: 
 b. Cash flow cycle D3. Apply different techniques 
used to manage working capital a. Apply policies relating to 
elements of operating and cash cycle 
working capital 
  Chapter 
15

Working Capital Management 
310  
1 Session Content 
 
2 The elements of working capital 
 Working capital is the capital available for conducting the day-to-day 
operations of an organisation. This is  normally the excess of current 
assets over current liabilities. 
Working capital management is the m anagement of all aspects of both 
current assets and current liabilities, to minimise the risk of insolvency 
while maximising the return on assets.

Chapter 15 
 311 
Investing in working capital has a cost, which can be expressed either as: 
 the cost of funding it, or 
 the opportunity cost of lost invest ment opportunities because cash is tied 
up and unavailable for other uses. 
3 The objectives of work ing capital management 
The main objective of working capital management is to get the balance of 
current assets and current liabilities right. 
 
This can also be seen as the trade-off between cash flow versus profits. 
Current assets are a majo r item on the statement of  financial position and are 
especially significant to smaller firms . Mismanagement of working capital is 
therefore a common cause of business failure.  
Consequences of poor working capital management include: 
 inability to meet bills as they fall due 
 demands on cash during periods of gr owth being too great (overtrading) 
 over-stocking or stock-outs 
 
 The trade-off between liquidity and prof itability and its role in determining a 
business’ overall investment in work ing capital is fundamental to your 
understanding of working capital management for the examination.

312  
 Test your understanding 1 – Liquidity v profitability 
 Fill in the blanks in the table to  identify the advantages of having 
more or less working capital.

Chapter 15 
 313 
 Profitability v liquidity 
 The decision regarding the level of over all investment in working capital is 
a cost/benefit trade-off – liquidity versus  profitability, or cash flow versus 
profits. 
Cash flow versus profit 
Cash flow is as important as profi t. Unprofitable entit ies can survive if 
they have cash. Profitable entities can fa il if they run out of cash to pay 
their liabilities (wages, amounts due to s uppliers, overdraft interest, etc.). 
Some examples of transactions that have this ‘trade-off’ effect between 
cash flows and profits are as follows: 
(a) Purchase of non-current assets fo r cash. The cash is often paid in 
full to the supplier when the asset is delivered, however, profits will 
be reduced over the life of the asset as a result of the depreciation 
charged. 
(b) Sale of goods on credit. Profits will be credited in full once the sale 
has been confirmed, however the cash may not be received for 
some considerable period afterwards. 
(c) With some payments such as tax,  there may be a significant timing 
difference between the impact on repor ted profit and the cash flow. 
Clearly, cash balances and cash flows need to be monitored just as 
closely as trading profits.  
Profitability versus liquidity 
Liquidity in the context of worki ng capital management means having 
enough cash (or ready access to cash) to meet all payment obligations 
when these fall due. The main sources of liquidity are usually: 
 cash in the bank 
 short-term investments that c an be cashed in easily and quickly 
 cash inflows from normal trading operations (cash sales and 
payments by receivables for credit sales) 
 an overdraft facility or other r eady source of extra borrowing. 
The basis of the trade-off is where an entity is able to improve its 
profitability but at  the expense of tying up cash.  
For example, 
 receiving a bulk purchase discount (improved profitability) for buying 
more inventory than is currently  required (reduced liquidity), or 
 offering credit to customers (attr acts more customers so improves 
profitability but reduces liquidity). 
Sometimes, the opposite situation can be seen where an entity can 
improve its liquidity position but at  the expense of profitability. For 
example, offering an early settl ement discount to customers.

314  
4 The working capital cycle 
The elements of the wo rking capital cycle  
 The working capital cycle is the lengt h of time between the entity's outlay 
on raw materials, wages and other expen ditures and the inflow of cash 
from the sale of goods. 
The working capital cycle is easily summarised as: Inventory days + trade receivable da ys – trade payable days = Working 
capital cycle. 
This is also commonly known as the cash operating cycle. 
 
 The faster a firm can ‘push’ items ar ound the cycle the lower its investment 
in working capital will be.

Chapter 15 
 315 
 The working capital cycle 
 The working capital cycle reflects a firm’ s investment in working capital as 
it moves through the production process towards sales. The investment 
in working capital gradually increases,  first being only in raw materials, 
but then in labour and overheads as  production progresses. This 
investment must be maintained thr oughout the production process, the 
holding period for finished goods and up to  the final collection of cash 
from trade receivables. 
(Note: The net investment can be reduc ed by taking trade credit from 
suppliers.) 
Factors affecting the length of the working capital cycle  
The length of the cycle depends on: 
 liquidity versus profitability decisions 
 management efficiency 
 industry norms, e.g. retail versus construction. 
The optimum level of worki ng capital is the amount that  results in no idle cash 
or unused inventory, but does not put  a strain on liquid resources. 
 
 The length of the cycle 
 The length of the cycle depends on how the balancing act between 
liquidity and profitability is resolved, the efficiency of management and the nature of the industry. 
Trying to shorten the cash cycle may have detrimental effects elsewhere, 
with the organisation lacking the cash to meet its commitments and losing 
sales, since customers will generally pr efer to buy from suppliers who are 
prepared to extend trade credit, and who have items available when required. 
Additionally, any assessment of the acceptability or otherwise of the 
length of the cycle must take into account the nature of the business 
involved. 
A supermarket chain will tend to hav e a very low or negative cycle as 
they have very few, if any, credit cu stomers, they have a high inventory 
turnover and they can negotiate qu ite long credit periods with their 
suppliers. 
A construction entity will have a long cycle as their projects tend to be 
long-term, often extending over mo re than a year, and whilst progress 
payments may be made by the customer (if there is one), the bulk of the 
cash will be received towards the end of the project.

316  
 The amount of cash required to fund the working capital cycle will 
increase as either: 
 the cycle gets longer 
 the level of activity/sales increases.  
This can be summed up as follows: 
 
Where level of activity (sales) is constant and the number of days of the 
working capital cycle increase, the amount of funds required for working capital will increase in approximate proportion to the number of days. 
Where the cycle remains constant but ac tivity (sales) increase, the funds 
required for working capital will incr ease in approximate proportion to 
sales. 
It may be a key target for management  to reduce the operating cycle to 
improve the efficiency of the business. 
5 The investment in working capital 
All entities require working capital,  but there is no standard fixed amount 
required. 
The amount required will depend on many factors, such as: 
 the industry within which the firm operates  – in some industries, 
customers expect long payment peri ods (impacting receivables) whereas 
in other industries cash payment s are the norm (low receivables). 
For example, a retail company will us ually have very low receivables 
(because most sales are for cash) but high levels of inventories. 
In contrast, a manufacturing company  will tend to have high levels of 
receivables (long credit terms offered to  attract customers) and high levels 
of work in progress (inventories). 
 the type of products sold  – a business selling perishable products will 
have to keep a lower level of inventory 
 whether products are manufactured or bought in  – a manufacturing 
company will have high levels of raw material and work in progress 
inventory as well as finished goods 
 the level of sales  – if sales are high, it is likely that receivables will be 
high too

Chapter 15 
 317 
 Policies towards working capital management  – different entities can 
have different approaches or strategies towards working capital 
It is essential that an appropriate amount of working capital is budgeted to meet 
anticipated future needs. 
In conditions of uncertainty, entities must  hold some minimal level of cash and 
inventories based on expected revenue, plus an additional safety buffer. 
 
 Working capital investment levels 
 The level of working capital invest ment required is affected by the 
following factors 
1 The nature of the business, e.g.  manufacturing entities need more 
inventory than service entities. 
2 Uncertainty in supplier deliveries. Uncertainty would mean that extra 
inventory needs to be carried in order to cover fluctuations. 
3 The overall level of activity of  the business. As output increases, 
receivables, inventory, etc. all tend to increase. 
4 The entity's credit policy. The tighter  the entity's policy, the lower the 
level of receivables. 
5 The length of the working capita l cycle. The longer it takes to 
convert material into finished g oods into cash, the greater the 
investment in working capital 
6 The credit policy of suppliers. The less credit the entity is allowed to 
take, the lower the level of payables and the higher the net investment in working capital. 
 
 Test your understanding 2 – Wo rking capital investment levels 
 XY has the following expectations for the forthcoming period. 
 $m 
Sales revenue 10 Cost of sales (6) 
Non-production costs (2) 
Net profit 2 
The following working capital ra tios are expected to apply. 
Finished goods inventory days 30 days 
Receivables days 60 days 
Payables days 40 days 
Required: 
Calculate the working capital requirement.

318  
6 Working capital management policies 
 Aggressive, moderate and conservative working capital policies 
The choice of working capital management policy is a matter for 
managerial judgement, and depends to an ex tent on the cost vs risk trade-
off. 
Three possible policies exist to manage working capital: 
(1) Aggressive policy  – This approach attempts to reduce costs by holding 
the lowest levels of cash, inventory and receivables as possible. This produces a short operating cycle. This policy carries the greatest risk of 
illiquidity, as well as the greatest re turns. Financing of the variable and a 
portion of the fixed working capital is  typically sourced through short term 
financing.  
(2) Conservative policy – This approach attempts to reduce risks by holding 
high levels of cash, inventory and re ceivables. This produces a long 
operating cycle. Risks such as stock- outs or liquidity problems are low, 
but, resultantly, costs are increased.  
(3) Moderate policy  – This adopts a middle ground between aggressive and 
conservative approaches.  
 
 More detail on aggressive, moderate and conservative policies 
 A company could pursue a more aggressive approach towards the 
management of working capital or a more conservative (relaxed) 
approach. 
Benefits of a more aggressive approach: 
1 Lower levels of current assets  therefore lower financing costs. 
2 The lower financing costs should result in better profitability. 3 Quicker cash turnover may allo w more reinvestment and hence 
allow the business to expand more quickly. 
Benefits of a more conservative approach: 
1 Lower liquidity risk i.e. less risk of the company running out of cash 
or going into liquidation. 
2 Greater ability to meet a sudden surge in sales demand. 
3 More relaxed credit policy for receivables may improve sales. 
Note: 
Generally the more conservative the approach, the lower the risk, but the 
higher the cost in terms of m oney tied up in working capital.

Chapter 15 
 319 
The traditional approach to  working capital funding 
Traditionally current assets were seen as fluctuating, originally with a seasonal 
pattern. Current assets would then be financed out of short-term credit, which 
could be paid off when not required,  whilst non-current assets would be 
financed by long-term funds (debt or equity). 
This analysis is rather simplistic. In mo st businesses, a proportion of the current 
assets are actually fixed over time , being thus expressed as 'permanent'. 
For example, certain base levels of in ventory are always carried, or a certain 
level of trade credit is always extended.  
Given the permanent nature of a large proportion of current assets, it is 
generally felt prudent to fund a proportion of net current assets with long-term 
finance. 
Short-term financing is generally cheaper  than long-term finance, since short-
term interest rates are generally lower t han long-term rates. However, the price 
paid for reduced cost is increased risk for the borrower, because of: 
 Renewal problems  – short-term finance may need to be continually 
renegotiated as various facilities expire and renewal may not always be 
guaranteed. 
 Stability of interest rates  – if the company is constantly having to renew 
its funding arrangements it will be at the mercy of fluc tuations in short-term 
interest rates. 
An aggressive policy of working capi tal management would expect to finance 
the variable and a portion of the fixed working capital through short term 
financing. 
A conservative approach would use l ong-term funding to finance all of the 
permanent assets (both non-current and current) as well as part of the 
fluctuating current assets. Short-term financing is used only for part of the 
fluctuating current assets. 
Moderate policies matches the short-te rm finance to the fluctuating current 
assets, and the long-term finance to the per manent part of current assets plus 
non-current assets. 
7 Overtrading 
Overtrading  
Healthy trading growth typically leads to: 
 increased profitability and 
 the need to increase investment in non- current assets and working capital. 
If the business does not have access to suffic ient capital to fund the increase, it 
is said to be "overtrading". This can caus e serious trouble for the business if it is 
unable to pay its business payables.

320  
 Test your understanding 3 – Overtrading  
 Over-trading is best described  by which of the following 
statements? 
A It occurs when an entity tries to grow too rapidly, backed by too 
small a capital base 
B It occurs when an entity tries to o perate its equipment too far above 
its designed capacity 
C It occurs when sales grow rapidly,  fuelled by extending longer credit 
periods 
D It occurs when an entity uses short-term finance in preference to 
long-term finance 
 
 Typical indicators of overtrading 
  A rapid increase in turnover 
 A rapid increase in the vo lume of current assets 
 Most of the increase in assets being financed by credit 
 A dramatic drop in the liquidi ty ratios (see next section) 
 
 Solutions to overtrading 
 Overtrading can be a very serious risk, es pecially if there is a possibility 
that the bank will withdraw its overdraft facility. Po tential solutions to the 
problem include: 
 raising more long-term capital, in  the form of new shares or loans 
 slowing down growth to reduce the increases in working capital 
requirements until sufficient cash has been built up to finance it 
 improving working capi tal management, so that  there is a reduction 
in the inventory holding period or a reduction in the average time for 
customers to pay 
8 Working capital ratios 
The periods used to determine the working capital cycle are calculated by using 
a series of working capital ratios. 
The ratios for the individual components (inventory, receivables and payables) 
are normally expressed as the number of  days/weeks/months of the relevant 
statement of profit or loss figure they represent.

Chapter 15 
 321 
Calculation of the working capital cycle 
For a manufacturing business, the working capital cycle is calculated as: 
Raw materials holding period x 
Less: payables’ payment period (x) 
WIP holding period x Finished goods holding period x 
Receivables’ collection period x 
 ––– 
 x 
 ––– 
For a wholesale or retail business, ther e will be no raw materials or WIP holding 
periods, and the cycle simplifies to: 
Inventory holding period x 
Receivables’ collection period x  ––– 
 x 
 ––– 
The cycle may be measured in days, weeks or  months and it is advisable, when 
answering a question, to use the m easure used in the question (although 
typically it will be days). 
 
Test your understanding 4 – Working capital cycle 
 An entity has provided the following information. 
Receivables collection period 56 days 
Raw material inventory holding period 21 days 
Production period (WIP) 14 days Suppliers’ payment period 42 days Finished goods holding period 28 days 
Calculate the length of the working capital cycle

322  
Raw material inventory holding period  
 This is the length of time raw ma terials are held between purchase and 
being used in production. 
Calculated as: 
= Average raw material inventory held
Material usage	×	365 
= ሺOpening inventory ൅	closing inventory ሻ	÷	2
NB. Where usage cannot be calculated, purchases give a good 
approximation. 
 
 Illustration 1 – Working capital ratios 
 XYZ has the following figures from  its most recent accounts. 
 $m 
Average trade receivables 4 Average trade payables 2 Average raw material inventory 1 
Average WIP inventory 1.3 
Average finished goods inventory 2 Sales (80% on credit) 30 
Materials usage 20 
Materials purchases (all on credit) 18 Production cost 23 
Cost of sales 25 
Required: 
Calculate the raw materials holding period. Round your answer to the 
nearest day. 
 
 Solution 
 $1m
$20m	×	365	=	18 days

Chapter 15 
 323 
 WIP holding period 
This is the length of time goods spend in production.  
= 	Average WIP
Production cost	×	365 
NB. Where production cost cannot be calc ulated, cost of goods sold gives 
a good approximation. 
 
 Illustration 2 – WIP holding period 
 Using the information from illustration 1 calculate the WIP holding period. 
Round your answer to the nearest day. 
 
 Solution 
 $1.3m
$23m	× 365		=		21 days 
 
 Finished goods inventory holding period 
This is the length of time fini shed goods are held between purchase/ 
completion and sale. 
= Average finished goods inventory held
Cost of goods sold	×	365 
For all inventory period ratios, a low ratio is usually seen as a sign of 
good working capital management. It is very expensive to  hold inventory 
and thus minimum inventory holding usually points to good practice. 
 
 Illustration 3 – Finished goods inventory holding period 
 Using the information from illustrati on 1, calculate the finished goods 
inventory holding period. Round y our answer to the nearest day. 
 
 Solution 
 $2m
$25m	×	365	=	29 days

324  
 Inventory turnover 
 For each ratio, the corresponding turnover ratio can be calculated 
as 
Inventory turnover ሺno of times ሻ	= 	Cost of goods sold
Average inventory held 
Generally this is less useful. 
Using finished goods information from illustration 1: 
Inventory turnover 	=	 $25m
$2m	=	12.5 times 
Thus finished goods inventory turns round/is turned into sales 12.5 times 
in the year. 
 
 Interpreting inventory periods 
 If inventory days are relatively high,  This may indicate a deliberately 
conservative policy of holding large amount of inventory (as management 
are worried about running out of inventor y, or are stock-piling for a new 
product launch). However, this resu lts in additional finance tied up in 
inventory which could be used mo re effectively elsewhere.  
If cash is paid out when the inventories are purchased, but the cash does 
not come back in until the inventory is sold to a customer, then this 
temporary negative cash flow will have to be financed by the company. 
Moreover, if the inventory is sold  on credit terms and the customer does 
not pay for, say 1 month, then the del ay in getting the cash back in is 
even longer. 
If the inventory is too low, this ma y show an overzealous application of 
the ‘just in time’ concept and consequential risks of running out of inventory. It may also indicate a company meeting a cash flow crisis by running down inventory levels. It may be considered that the 
management are adopting an overly aggre ssive working capital financing 
policy. 
Inventory days needs to be compared to other companies and compared 
to previous years in the same company. Increasing inventory days may be investigated further by separately analysing raw materials (RM), work 
in progress (WIP) and finished goods (FG) to cost of goods sold. An 
increase in RM days may indica te mismanagement in the buying 
department; an increase in WIP may i ndicate production delays. If FG 
days increase, this may be a sign of  decline in demand for the product 
and an increase in obsolete items. 
Inventory levels are very much a balancing act between the risk of stock-
outs and the cost associated with high levels of inventory.

Chapter 15 
 325 
 Trade receivables days 
This is the length of time cr edit is extended to customers.  
Average receivables
Credit sales×365 
Generally shorter credit periods ar e seen as financially prudent but the 
length will also depend upon t he nature of the business. 
 
 Illustration 4 – Receivable days 
 Using the information from illustration 1 calculate the trade receivable 
days. Round your answer to the nearest day. 
 
 Solution 
 $4m
$30m	×	80%	×	365	=	61 days 
 
 Interpreting trade receivables collection periods 
 Businesses which sell goods on credi t terms specify a credit period. 
Failure to send out invoices on time or to follow up late payers will have 
an adverse effect on the cash flow of the business. The receivables 
collection period measures the av erage period of cr edit allowed to 
In general, the shorter the colle ction period the better because 
receivables are effectively ‘borro wing’ from the entity. Remember, 
however, that the level of receivables reflects not only the ability of the 
credit controllers but also the sale s and marketing strategy adopted, and 
the nature of the busine ss. Any change in the level of receivables must 
therefore be assessed in the li ght of the level of sales. 
 
 Trade payables days 
This is the average period of cr edit extended by suppliers.  
=	 Average payables
Credit purchases	×	365

326  
 Illustration 5 – Payable days 
 Using the information from illustration 1 calculate the trade payable days. 
 
 Solution 
 $2m
$18m	×	365	=	41 days 
 
 Complications in calculations 
 There are differences in the way t hat the ratio might  be calculated: 
 Total purchases for the year s hould be used where possible. If the 
figure for purchases is not available,  the cost of sales in the year 
should be used instead. 
 The figure for purchases excludes any sales tax recoverable, 
whereas the carrying amount for pay ables includes sales tax. To 
make a like-for-like comparison,  it might be appropriate to add 
recoverable sales tax back into purchases, or remove the sales tax element from trade payables. Howeve r, this is not usually done. 
 Where available, the average tr ade payables during the year should 
be used, normally calculated as t he average of the trade payables 
at the beginning and the end of the year. However, if you wish to 
compare the average payment period in the most recent year and 
the previous year, and you only have figures for the two years, it will 
be necessary to use the end-of-year  trade payables rather than an 
average value for the year. The sa me issue will arise when making 
receivables calculations. 
 
 Expandable Text  
 The result of this ratio can also be compared with the receivables days. 
An entity does not normally want to o ffer its customers more time to pay 
than it gets from its own suppliers, ot herwise this could affect cash flow. 
Generally, the longer the payables pay ment period, the better, as the 
entity holds on to its cash for longer, but care must be ta ken not to upset 
suppliers by delaying payment, which c ould result in the loss of discounts 
and reliability. 
Generally, increasing payables days suggests advantage is being taken 
of available credit but there are risks: 
 losing supplier goodwill

Chapter 15 
 327 
  losing prompt payment discounts 
 suppliers increasing t he price to compensate. 
It is important to recognise when using these ratios that it is the trend of 
ratios that is important, not the i ndividual values. Payment periods are 
longer in some types of  entity than in others. 
The working capital cycle 
The ratios can then be brought together to produce the working capital cycle. 
 Days 
Raw material inventory days 18 
Trade payables days (41) 
WIP period 21 Finished goods inventory days 29 
Receivables days 61 
 –––– Length of working capital cycle 88  –––– 
The working capital cycle indicates that  it takes the entity 88 days between 
paying for material purchases and rece iving cash back from customers. 
As always this must then be compared with prior periods or industry average for 
meaningful analysis. 
 
Case Study Question 
Case Study Exam, Februa ry 2017 – Question  
On 15 March 2017 you receive the following email from Pene Lopez, 
Finance Director: 
From:  Pene Lopez 
Subject:  Performance of the foundation business 
We will be having a directors' meet ing next week to discuss the 
performance of the business over the la st financial year. I have also been 
tasked with writing a report to cover all aspects of performance. Cormac 
has already prepared the numerical information and narrative for the hive business. He has also prepared the numerical information for the foundation business, for which I woul d like you to draft some of the 
narrative.

328  
 The first section I'd like you to dr aft relates to production overhead 
variances for foundation production. I've attached to this email Cormac's schedule of the variances and what I need is an explanation of what 
these variances mean in terms of the performance of the foundation 
production cost centre. I have had a quick look and I know Thomas is 
going to be surprised that the to tal variance is adverse. We produced 
54,000 more foundations than the 346,000 we had budgeted to produce 
for the year to 28 February 2017 and therefore I know how would have expected this increased production to have led to a favourable variance overall. Also the expenditure varianc e looks quite alarming, although I do 
know that our energy costs were higher than budgeted. In your analysis 
of the variances in Cormac's schedule please also address these points. 
The second section I'd like you to dr aft relates to the working capital 
position for the foundation business. I've attached Cormac's schedule of 
working capital days. The report needs to explain what is likely to have 
caused the movements compared to t he budget and any risk implications 
of these movements to our business. 
Many thanks 
Pene Lopez 
Finance Director 
Mavis Venderby 
Working capital ratios for the foundation business attachment: 
Ratio Actual 
balances at 
year- end  
28 February Budgeted 
balances at the 
year-end  
28 February 
 2017 2017 Raw materials inventory days 52 20 Finished goods inventory days 10 22 
Receivables days (for credit sales) 45 25 
Payables days 49 30 
(note – for the purpose of this illustration the variances have not 
been discussed as they are not relevant to the F1 exam) 
2017

Chapter 15 
 329 
solely on the areas of the case study relevant to the F1 exam, the variances are not discussed below. 
ANALYSIS OF WORKING CAPITAL RATIOS  Raw materials inventory days 
There has been a significant increase in raw materials inventory days, 
meaning that at 28 February 2017 the balan ce is significantly higher than 
we had budgeted. It could be that a signi ficant order of wax and / or wire 
was received just before the year end, especially given the low level of finished goods inventory. Possibly a discount for bulk purchase was available and wax and wire are being stock-p iled ahead of production 
expansion. 
There is no significant risk arising from this increase in raw material 
inventory, especially if it will be used in an expanded production 
facility shortly. Wax and wire h ave a long shelf life and are unlikely 
to deteriorate unless they are not stored correctly. 
Finished goods inventory days 
Finished goods inventory is lower than budgeted. This could be because 
production has not been able to keep up with the volume of sales, given the expanding market and selling to cu stomers in other countries. We 
know that we produced 54,000 more foundation during the year than we 
expected and given the reduction in in ventory days for finished goods it’s 
probable that the increase in sales was even more than this. 
Given that currently we only se ll one foundation product, having a low 
level of finished goods inventory is not necessarily a risky issue as long 
as there are no production problems that  limit what we could produce. 
Receivable days 
Receivable days have increased from a budgeted 25 days to 45 days. 
This is likely the result of selling to  customers located in other countries, 
which we had not budgeted for. Possibl y we have offered them extended 
credit terms to match the credit terms available in their home markets. 
Alternatively, these cu stomers are not as quick to pay as our Tucland 
customers, who we expected to pay on average just a little under the standard credit terms of 30 days. 
The increase is slightly worrying as it could be an indication that the risk 
of us not receiving pay ment from our customer s has increased. This 
could potentially lead to financial loss and we need to review the aged 
receivables report in detail to identify  the specific customers that have 
caused this increase.

330  
 Payable days 
Payable days have increased from a budget  of 30 to 49. This could be 
linked to the increase in raw material  inventory at the year end. If a 
significant order was received at t he end of February, then we will not 
have paid for it yet. However, we need to be careful that we do not over-
stretch our credit terms with our wax and wire supp liers, as this could 
damage our relationships with them. 
2017 
 
 Test your understanding 5 – Raw material holding period 
  
Statement of prof it or loss account extract $ $ 
Revenue  350,000 
Cost of sales  264,400 
Gross profit  85,600 
   
Statement of financial position extract $ $ 
Inventory   
Raw materials 25,000  
Work in progress 33,500  
Finished goods 46,500 105,000 Trade receivables  35,200 
  140,200 
Trade payables  55,200 
Required: 
nearest day.  
 
 Test your understandi ng 6 – WIP holding period 
 Using the information from TYU 5 calculate the WIP holding period . 
Round your answer to the nearest day.

Chapter 15 
 331 
 Test your understanding 7 – Finished goods inventory holding 
 Using the information from TYU 5 calculate the finished goods 
inventory holding period. Round your answer to the nearest day. 
 
 Test your understanding 8 – Receivable days 
 Using the information from TYU 5 calculate the receivable days.  
 
 Test your understand ing 9 – Payable days 
 Using the information from TYU 5 calculate the payable days. Round 
your answer to the nearest day. 
 
 Test your understanding 10 – Working capital cycle 
 Using the information from TYU' s 5 to 8 calculate the working 
Additional points for calculating ratios  
The ratios may be needed to provide ana lysis of an entity's performance or 
simply to calculate the length of the working capital cycle. 
 There are a few simple points to reme mber which will be of great use in 
the examination. 
 Where the period is required in days, the multiple in the ratios is 365, 
for months the multiple is  12, or 52 for weeks. 
 If you are required to compare ra tios between two statements of 
financial position, it is accept able to base each holding period on 
closing figures on the statement of financial position each year, 
rather than an average, in order to see whether the ratio has 
increased or decreased. 
 For each ratio calculated above, the corresponding turnover ratio can 
be calculated by inverting the ratio given and removing the multiple. 
 When using the ratios to appraise performance, it is essential to 
compare the figure with others in the industry or identify the trend 
over a number of periods.

332  
  Ratios have their limitations and care must be taken because: 
– the statement of financial posit ion values at a particular time 
may not be typical 
– balances used for a seasonal business may not represent 
average levels, e.g. a fireworks manufacturer 
– ratios can be subject to window dressing/manipulation – ratios 
concern the past (historic) not the future 
– figures may be distorted by inflation and/or rapid growth. 
 
 Shortening the working capital cycle 
 A number of steps can be taken to shorten the working capital cycle: 
 Reduce raw materials inventory holding. This may be done by 
reviewing slow-moving lines, reorder  levels and r eorder quantities. 
Inventory control models may be cons idered, if not already in use. 
More efficient links with supplie rs could also help. Reducing 
inventory may involve loss of discounts for bulk purchases, loss of cost savings from price rises, or  could lead to production delays due 
to inventory shortages. 
 Obtain more finance from suppliers by delaying payments, 
preferably through negotiation. This c ould result in a deterioration in 
commercial relationships or even lo ss of reliable sources of supply. 
Discounts may be lost by this policy. 
 Reduce work in progress by im proving production techniques and 
efficiency (with the human and practica l problems of achieving such 
change). 
 Reduce finished goods inventor y perhaps by reorganising the 
production schedule and distribution me thods. This may affect the 
efficiency with which customer demand can be satisfied and result ultimately in a reduction of sales. 
 Reduce credit given to custom ers by invoicing and following up 
outstanding amounts more quickly, or possibly offering discount 
incentives. The main disadvantages  would be the potential loss of 
customers as a result of chasi ng too hard and a loss of revenue as 
a result of discounts. 
 Debt factoring, generating immedi ate cash flow by the sale of 
receivables to a third party on immediate cash terms. The main 
disadvantages would be that this ma y be costly to the entity to pay a 
factor. 
The working capital cycle is the time span between incurring production 
costs and receiving cash returns. It says nothing in itself about the 
amount of working capital that will be needed over this period.

Chapter 15 
 333 
 Test your understanding 11 – Practice questions 
 1 Calculate the length of the wo rking capital cycle from the 
following information: 
Raw materials holding period 10 days 
Receivables collection period 60 days Average time to pay suppliers 45 days 
Finished goods inventory holding period 20 days 
Production period (WIP) 5 days 
2 Marlboro estimates the followi ng figures for the coming year. 
Sales – all on credit $3,600,000 
Average receivables $306,000 Gross profit margin * 25% on sales 
Finished goods $200,000 
Work in progress $350,000 Raw materials (balance held) $150,000 
Trade payables $130,000 
Inventory levels are constant. 
* Raw materials are 80% of cost of sales – all on credit. 
Required: 
Calculate the raw materials holding period. Round your answer 
to the nearest day. 
3 Using the information from qu estion 3, calculate the WIP 
holding period.  Round your answer to the nearest day. 
4 Using the information from quest ion 3, calculate the finished 
goods inventory holding period.  Round your answer to the 
5 Using the information from quest ion 3, calculate the receivable 
6 Using the information from quest ion 3, calculate the payable 
7 Using the information from questions 3 to 7, calculate the 
working capital cycle. 
8 Identify which of the following transactions will result in an 
increase in working capital: 
A Writing off a debt as uncollectable 
B Paying the invoice of a trade supplier 
C Selling goods on credit at a profit 
D Buying inventory for cash

336  
 Test your understanding 1 – Liquidity v profitability

Chapter 15 
 337 
 We need to use the ratios to calcul ate statement of financial position 
values in order to construct the projected working capital position. 
    $m 
Inventory = 30 ÷ 365 × $6m =  0.49 
Receivables = 60 ÷ 365 × $10m  1.64 
Trade payables = 40 ÷ 365 × $6m = (0.66) 
    ––––– Working capital required    1.47 
 
 Test your understanding 3 – Overtrading 
 A 
 
 Test your understanding 4 – Working capital cycle 
  
 Days 
Raw materials inventory holding period 21 Less: suppliers’ payment period (42) WIP holding period 14 
Finished goods holding period 28 
Receivables’ collection period 56  –––– Operating cycle (days) 77 
 –––– 
 
 25,000
264,400	×	365	=	35 days 
 
 33,500
264,400 × 365 = 46 days

338  
 46,500
264,400	×	365	=	64 days 
 
 35,200
350,000	×	365	=	37 days 
 
 55,200
264,400	×	365	=	76 days 
 
 The answer is 106 days.  
See summary below:

Chapter 15 
 339 
 1 
 Days 
Raw materials holding period 10 
Production period (WIP) 5 Finished goods inventory holding period 20 
Receivables collection period 60 
 –––  95 
Average time to pay suppliers (45) 
 ––– Working capital cycle 50 
 ––– 
2 Statement of profit or loss 
 $ $ 
Turnover  3,600,000 
Cost of sales   
Materials – 80% (given) 2,160,000  Other (balancing figure) 540,000   ––––––––  
  2,700,000 
  –––––––– Gross profit – 25% (given)  900,000 
  –––––––– 
Raw materials holding period 
$150,000
$2,160,000
	×	365	=	25 days 
3 WIP holding days 
$350,000
$2,700.000	×	365	=	47 days 
4 Finished goods holding period  
$200,000
$2,700.000	×	365																																						 =	27 days 
5 Receivables collection period 
$306,000
$3,600,000	×	365																																							 =	31 days

340  
 6 Trade payables days 
$130,000
$2,160,000	×	365																																							 =	22 days 
7 The working capital cycle is 108 days 
$150,000
$2,160,000	×	365																																							 =	25 days 
Trade payable days 
$130,000
$2,160,000	×	365																																							 =	ሺ22ሻ	days 
WIP holding days 
$350,000
$2,700,000	×	365																																							 =	47 days 
Finished goods holding period 
$200,000
$2,700,000	×	365																																							 =	27 days 
Receivables collection period 
$306,000
$3,600,000 × 365 																																						 = 31 days 
 ––––––– 
 108 days 
8 The correct answer is C 
Items B and D result in no change in working capital. Item B results 
in an equal reduction in both cash and trade payables. Item D results in an increase in inventory but an equal decrease in cash. Writing off a receivable (item A) reduces working capital, because 
there is a reduction in receivabl es but no reduction in current 
liabilities. Selling goods on credit reduces inventory but increases 
receivables by a larger amount (=  the gross profit  on the sale); 
therefore total working capital incr eases by the amount of the gross 
profit.

341 
Management – Accounts 
Receivable and Payable 
elements of operating and cash cycle  
  Chapter 
16

Working Capital Management – Accounts Receivable and Payable 
342  
 
2 Accounts receivable – esta blishing a credit policy 
The balancing act  
When businesses sell to customers, they would like to do it for cash to earn 
profits and stay liquid. However, in cert ain industries, the expectation is that 
sales are made on a ‘buy now, pay later’ basis. This is called selling on credit. On a credit sale, a receivable is created which sits as an asset in the statement 
of financial position of the entit y. In a lot of industries, if you do not sell on credit, 
customers will go elsewhere.  
The problem with selling on credit is that bus inesses have to wait for their cash. 
To manage liquidity appropriately, managem ent must establish a credit policy 
when offering credit to customers. A cr edit policy outlines the businesses terms 
& conditions and internal procedures in  relation to offering credit to their 
customers.   
The optimum level of trade credit ext ended to customers represents a balance 
between two factors: 
 profit improvement from sa les obtained by allowing credit 
 the cost of credit allowed.

Chapter 16 
 343 
 Why have a credit policy? 
 A firm must establish a policy for cr edit terms given to its customers. 
Ideally the firm would want to obtain cash with each order delivered, but 
that is impossible unle ss substantial settlement (or cash) discounts are 
offered as an inducement. It  must be recognised that  credit terms are part 
of the firm’s marketing policy. If the trade or industry has adopted a 
common practice, then it is probably wise to keep in step with it. 
A lenient credit policy may well attr act additional customers, but at a 
disproportionate increase in cost. 
 
Remember this trade-off is a key factor  in determining the entity's working 
capital investment.

344  
 Different payment terms 
 The payment terms will need to consider the period of credit to be 
granted and how the payment will be made. The terms agreed will need 
to specify the price, the date of de livery, the payment date or dates, and 
any discounts to be allowed for early settlement. 
Examples of payment terms may be  
 Payment within a specified period.  For example, customers must 
pay within 30 days. 
 Payment within a specified perio d with discount. For example, a 2 
per cent discount would be given to customers who pay within 10 
days, and others would be requi red to pay within 30 days. 
 Weekly credit. This would require all supplies in a week to be paid 
by a specified day in the following week. 
 Related to delivery of goods. For example, cash on delivery (COD). 
Methods of payment 
Payments from customer s may be accepted in a number of forms, 
including 
 cash 
 Bankers Automated Clearing Service (BACS) 
 cheques 
 banker’s draft 
 standing orders 
 direct debit 
 credit cards 
 debit cards 
 Clearing House Automated Payments System (CHAPS) 
For accounts receivable, the entity' s credit policy will be influenced by 
 demand for products 
 competitors' terms 
 risk of irrecoverable debts 
 financing costs 
 costs of credit control

Chapter 16 
 345 
Receivables management has four key aspects: 
1 Assessing creditworthiness of customers. 2 Setting credit limits. 3 Invoicing promptly and collecting overdue debts. 
4 Monitoring the credit system. 
 This is a useful structure to adopt for examination questions that ask about 
the management of receivables. 
3 Assessing creditworthiness 
A firm should assess the creditworthiness of 
 all new customers immediately,  before offering credit terms 
 existing customers periodically 
Information may come from 
 bank references 
 trade references 
 visit to the customer's premises 
 competitors 
 published information 
 credit reference agencies 
 legal sources of credit information 
 entity's own sales records 
 credit scoring 
 credit rating (large corporate customers only) 
 
 Assessing creditworthiness 
 To minimise the risk of irrecovera ble debts occurring, an entity should 
investigate the credit worthiness of all new customers (credit risk), and 
should review that of ex isting customers from time  to time, especially if 
they request that their credit limit should be raised. Information about a 
customer’s credit rating can be obtai ned from a variety of sources. 
These include 
 Bank references  – A customer’s permission must be sought. These 
tend to be fairly standardised in the UK, and so are not perhaps as 
helpful as they could be.

346  
  Trade references – Suppliers already giving  credit to the customer 
can give useful information about how good the customer is at 
paying bills on time. There is a danger that the customer will only 
nominate those suppliers that are being paid on time. 
 Visit to the customer’s premises  – A sales representative might 
visit the business premises of th e customer. A visit will provide 
information about the actual ‘physica l’ operations and assets of the 
customer, and might provide some r eassurance that the customer’s 
business has substance. 
 Competitors  – in some industries such as insurance, competitors 
share information on customers, including creditworthiness. 
 Published information  – The customer’s own annual accounts and 
reports will give some idea of the general financial position of the 
entity and its liquidity. 
 Credit reference agencies  – Agencies such as Dunn & Bradstreet 
publish general financial details of  many entities, together with a 
credit rating. They will also produce  a special report on an entity if 
requested. The information is provided for a fee. 
 Legal sources of credit information – Instead of using a credit 
reference agency, an entity might che ck available legal records itself 
to find out whether the customer has a history of insolvency or non-
payment. For example, in the UK  information can be obtained from 
the Register of County Court J udgements and from the Individual 
Insolvency Register. 
 Entity's own sales records  – For an existing customer, the sales 
ledgers will show how prompt a pa yer the entity is, although they 
cannot show the ability of  the customer to pay. 
 Credit scoring  – Indicators such as fa mily circumstances, home 
ownership, occupation and age ca n be used to predict likely 
creditworthiness. This is useful when extending credit to the public 
where little other information is available. A variety of software 
packages is available which c an assist with credit scoring. 
 Large corporate customers only: credit rating  – Very large 
entities might have a credit rating fr om one of the major credit rating 
agencies, Moody’s and Standard & P oors. A supplier might use an 
entity's credit rating to decide how much credit to allow, without 
having to carry out a detailed credit check itself.

Chapter 16 
 347 
4 Setting credit limits 
When setting credit limits there are two limits that need to be set 
 the amount of credit available, and 
 the length of time allowed before payment is due. 
Both of these limits might be adjusted in  accordance to the risk profile of the 
customer. 
 
 The 'risk' associated with a customer's  credit status should be based on 
 the customer’s payment record and history of prompt or late 
payments, and 
 any new information that is obtained about the customer, for 
example from its most recent annual  financial statements or recent 
press reports. 
The level of credit available and the l ength of settlement period offered to 
a customer (if across-the-board standard terms are not used) should then 
be based on the assessment of this risk. 
Example 
An entity might group its existing cu stomers into six categories, as 
follows: 
Customer categories 
 Financially 
strong Financially 
stable Financially 
weak 
Prompt payer Category A Category B Category C 
Late payer Category D Category E Category F 
The amount of credit offered to th e customer (and possibly also the 
length of the payment terms) would vary  according to the category of the 
customer. If a customer moves from  one category to a stronger category, 
a higher credit limit (or longer settle ment period) woul d be allowed if 
required. 
If the customer’s credit status does not  improve, a request for more credit 
from the customer should be refused. 
The ledger account should be monitored to take account of orders in the 
pipeline as well as invoiced sales,  before further credit is given.

348  
5 Invoicing and collecting overdue debts 
A credit period only begins once an invoic e is received so prompt invoicing is 
essential. If debts go overdue, the risk of  default increases, therefore a system 
of follow-up procedures is required 
 
 Invoicing and collecting overdue debts 
 The longer a debt is allowed to run, the higher the probability of eventual 
default. A system of follow-up procedures  is required, bearing in mind the 
risk of offending a valued customer to such an extent that their business 
is lost. 
Techniques for ‘chasing’ overdue debts include the following  
 Reminder letters  – these are often regarded as being a relatively 
poor way of obtaining payment, as many customers simply ignore 
them. Sending reminders by email have proven to be more productive than using the postal system  as it is harder for customers 
to claim that they have not received them. 
 Telephone calls  – these can be an efficient way of speeding up 
payment and identifying probl ems at an early stage. 
 Withholding supplies  – putting customers on the ‘stop list’ for 
further orders or spare parts ca n encourage rapid settlement of 
debts.

Chapter 16 
 349 
  Debt collection agencies and trade associations  – these offer 
debt collection services on a fixed fee basis or on ‘no collection no 
charge’ terms. The quality of servic e provided varies considerably 
and care should be taken in selecting an agent. 
 Legal action  – this is often seen as a last resort. A solicitor’s letter 
often prompts payment and many ca ses do not go to court. Court 
action is usually not cost effect ive but it can discourage other 
customers from delaying payment. 
Motivating credit control sta ff using collection targets  
If employees in the payments collection t eam are to operate effectively, they 
need to be convinced of the value of t heir work and their contribution to the 
objectives of the organisation. O ne way of improving performance and 
increasing staff motivation might be to set collection targets. A collection target 
is a target for the amount  of payments to collect for trade receivables within a 
given period of time.  
Targets can be set for 
 individual members of the collection team, and 
 the credit control team as a whole. 
Targets for collection will not be a moti vator, however, unless performance is 
assessed and individuals are rewarded (with a bonus) on the basis of meeting 
or exceeding targets. 
 
 Illustration on collection targets 
 Consider the following example of an entity aiming to set a collection 
target 
At the end of March, the trade rece ivables of M were as follows: 
  $ 
From March sales (100% of sales in the month) 1,200,000 From February sales (70% of sales in the month) 700,000 
From January sales (30% of sales in the month) 270,000 
  2,170,000 
This represents an average of 60 da ys' sales outstanding, made up as 
follows 
  
Days  
From March sales (100% × 31 days) 31 From February sales (70% × 28 days) 20 From January sales (30% × 31 days) 9 
  ––– 
  60   –––

350  
 The entity wants to reduce its av erage day’s sales outstanding from 
60 days to 50 days by the end of April.  Sales in April are expected to be 
$1,100,000, all on credit. It intends to do this by aiming to collect payments of the oldest outstanding receivables. 
Required 
Calculate the collection target that should be set for staff. 
Solution 
 If no money is collected at a ll during April, the days sales 
outstanding would increase from 60 days to 90 days (= 60 days + 
30 days in April). 
 If days sales outstanding is reduced to 50 days, representing the 
most recent sales, these will be the sales in April and 20 days of 
sales in March. 
 To reach the target of 50 da ys by collecting the oldest unpaid 
receivables, the entity must collect  40 days of sales, representing. 
 Days $ 
From March sales * 11 425,806 From February sales 20 700,000 
From January sales 9 270,000 
  ––––––––   1,395,806 
  –––––––– 
* March amount calculated as (11/31 × $1,200,000) 
The collection target for Apr il should therefore be $1,395,806. 
Note  in this example, the collect ion target focuses on the trade 
receivables that have been unpaid for the longest time. A different policy 
could be followed, such as chasing t he customers who are most likely to 
pay early, or chasing customers w ho are overdue with their payment by 
only one or two weeks. 
6 Monitoring the system 
The position of receivables should be r egularly reviewed as part of managing 
overall working capital and correct ive action taken when needed. Methods 
include: 
 age analysis 
 ratios 
 statistical data.

Chapter 16 
 351 
 Monitoring the system 
 Management will require regular information  to take corrective action and 
to measure the impact of giving cr edit on working capital investment. 
Typical management reports on t he credit system will include the 
following points. 
 Age analysis of outstanding debts. 
As an aid to effective credit contro l, an age analysis of outstanding 
debts may be produced. This is simp ly a list of the customers who 
currently owe money, showing the total amount owed and the period 
of time for which the money has been owed. The actual form of the 
age analysis report can vary widely, but a typical example is shown 
below for a sole trader called Robins. 
Account 
number Name Balance Up to 30 
days 31–60 
days 61–90 
days Over 
90 
days 
B002 Brennan 294.35 220.15 65.40 8.80 0.00 
G007 Goodridge 949.50 853.00 0.00 96.50 0.00 T005 Taylor 371.26 340.66 30.60 0.00 0.00 
T010 Thorpe 1,438.93 0.00 0.00 567.98 870.95 
T011 Tinnion 423.48 312.71 110.77 0.00 0.00   ––––––– ––––––– –––––– ––––– ––––– Totals  3,477.52 1,726.52 206.77 673.28 870.95   ––––––– ––––––– –––––– ––––– ––––– Percentage 100% 50% 6% 19% 25% 
To prepare the analysis, either use a computer programme or 
manually analyse each customer a ccount. For each customer, every 
invoice is allocated to the month it was issued. Then when payment is received, the invoice is cance lled from the analysis, leaving the 
total of unpaid invoices for each month. Difficulties analysing the 
balance can occur if the customer pays lump sum on account, rather than specific invoices. Care  must be taken to allocate all 
adjustments other than cash, such as credit notes, discounts given, 
etc. 
The age analysis of trade receivables can be used to help decide 
what action should be taken about debts that have b een outstanding 
for longer than the specified credit  period. It can be seen from the 
table above that 41 % of Robin’ s outstanding trade receivable 
balance is due by Thorpe. It may be that Thorpe is experiencing 
financial difficulties. There may already have been some 
correspondence between the two ent ities about the outstanding 
debts.

352  
 As well as providing information a bout individual customer balances, 
the age analysis of trade receivable s provides additional information 
about the efficiency of cash collect ion. The table above shows that 
over 50 per cent of debts have been outstanding for more than 30 days. If the normal credit period is 30 days, there may be a suggestion of weaknesses in credit cont rol. It may also be useful to 
show the credit limit for each cu stomer on the r eport, to identify 
those customers who are close to , or have exceeded, their credit 
limit. 
The age analysis can also provide information to assist in setting 
and monitoring collection targets fo r the credit control section. A 
collection target could be express ed as a percentage of credit sales 
collected within a specified period or  it could be expressed in terms 
of the average number of  trade receivable days outstanding. When 
trying to achieve a collection ta rget, the age analysis can be very 
useful in identifying large balanc es that have been outstanding for 
long periods. These can be targeted for action to encourage payment. 
– Ratios, compared with the previous  period or target, to indicate 
trends in credit levels and the incidence of overdue and 
irrecoverable debts. 
– Statistical data to identify causes of default and the incidence 
of irrecoverable debts among diffe rent classes of customer 
and types of trade. 
 
 Test your understanding 1 – Credit limits 
 Explain the factors that might be c onsidered when revising a credit limit 
for an existing customer, and list the t ools that a credit controller can use 
to help in making a credit limit decision. 
7 Accounts receivable – calculations   
Costs of financing receivables 
 Key working:

Chapter 16 
 353 
 Test your understanding 2 – Co st of financing receivables 
 Paisley has sales of $20 million for the previous year. Receivables at the 
year-end were $4 million, and the cost of financing receivables is covered 
by an overdraft at the interest rate of 12% p.a. 
Required 
(a) Calculate the receivables days for Paisley 
(b) Calculate the annual cost of financing receivables. 
Early settlement discounts 
Cash discounts are given to encourage early  payment by customers. The cost 
of the discount is balanced against the sa vings the entity receives from having 
less capital tied up due to a lower receivables balance and a shorter average collection period. Discounts may also reduc e the number of irrecoverable debts. 
The calculation of t he annual cost can be expr essed as a formula: 
 
 where no of periods= 365/52/12
no. of days/weeks/months
earlier the money is received 
Notice that the annual cost calculat ion is always based on the amount left 
to pay, i.e. the amount net of discount. 
If the cost of offering t he discount exceeds the rate of overdraft interest, 
then the discount should not be offered. 
 Test your understanding 3 – Early settlement discounts 
 Paisley has sales of $20 million for the previous year, receivables at the 
year end of $4 million and the cost of financing receivables is covered by 
an overdraft at the interest  rate of 12% pa. It is now considering offering a 
cash discount of 2% for pay ment of debts within 10 days. 
Calculate whether the annualised co st of offering the discount and 
state whether you would advise the discount to be offered. 
Evaluating a change in credit policy  
In an examination, you may be required to evaluate whether a proposed change 
in credit policy is financially justifi ed. The illustration below illustrates the 
approach required to carry out this evaluation.

354  
 Evaluating a change in credit policy 
 An example is given below. 
The table below gives information extr acted from the annual accounts of 
Supergeordie. 
 $ 
Raw materials 180,000 
Work in progress 93,360 Finished goods 142,875 
Purchases 720,000 
Cost of goods sold 1,098,360 Sales 1,188,000 
Trade receivables 297,000 
Trade payables 126,000 
The sales director of Supergeordie esti mates that if the period of credit 
allowed to customers was reduced from  its current level to 60 days, this 
would result in a 25 per cent r eduction in sales but would probably 
eliminate about $30,000 per annum bad debt s. It would be necessary to 
spend an additional $20,000 per annum on credit control. The entity at 
present relies heavily on overdraft fi nance costing 9 per cent per annum. 
You are required to make calculati ons showing the effect of these 
changes, and to advise whether they would be financially justified. 
Assume that purchases and inve ntory holdings would be reduced 
proportionally to the reduction in sales value. 
Solution 
The first stage is to identify the reduc tion in the level of working capital 
investment as a result of the change in policy. Inventory and trade 
payables are assumed to fall by 25 per cent in line with sales, but the 
new level of trade receivables will need to be calculated using the trade 
receivable collection formula. 
Reduction in working capital 
 Existing level  New level Change 
 $   $ $ 
Raw materials 180,000 × 75% = 135,000 45,000 
Work in progress 93,360 × 75% = 70,020 23,340 
Finished goods 142,875 × 75% = 107,156 35,719 
Trade receivables 297,000  (W1) 146,466 150,534 
Trade payables (126,000) × 75%  = (94,500) (31,500) 
 –––––––   ––––––– –––––– 
Total 587,235   364,142 223,093  –––––––   ––––––– ––––––

Chapter 16 
 355 
 Working 
(W1) 
Receivable collection period = trade receivables
sales ×  365 
60 = trade receivables
1,188,000 	×	75% ×  365 
Trade receivables = 891,000	×	60
865 
 = $146,466 
The second stage is to consi der the annual costs and benefits of 
changing the credit policy. A key element here is to recognise the saving in finance costs as a result of the reduction in the level of working capital investment recognised above. 
Annual costs and benefits 
  $ 
Saving in finance costs (223,093 × 9%) = 20,078 Reduction in gross profit (1,188,000 – 
1,098,360) = 89,640 × 25% (22,410) 
Reduction in bad debts = 30,000 
Credit control costs = (20,000)   –––––– 
Net saving per annum before tax = 7,668 
  –––––– 
The change in credit policy appears to be justified financially, but it should 
be remembered that there are a number of assumptions built in that could 
invalidate the calculations. 
8 Accounts receivable – factoring 
 Factoring is the 'sale of debts to a th ird party (the factor) at a discount in 
return for prompt cash' (CIMA Official Terminology). 
The debts of the entity are effectively so ld to a factor (normally owned by a 
bank). The factor takes on the responsibility of colle cting the debt for a fee. 
The entity can choose one or both of t he following services offered by the 
factor 
1 debt collection and administration  – recourse or non-recourse 
2 credit insurance

356  
 These are of particular value to 
 smaller firms 
 fast growing firms 
Make sure you can discuss the vari ous services offered and remember 
that non-recourse factoring is more  expensive as the factor bears the 
costs of any irrecoverable debts. 
 
 Debt collection and administration – the factor takes over the whole of the 
entity's sales ledger, issuing in voices and collecting debts. 
Credit insurance – the factor agrees to  insure the irrecoverable debts of 
the client. The factor would then det ermine to whom the entity was able 
to offer credit. 
Some entities realise that, although it is necessary to extend trade credit 
to customers for competitive reas ons, they need payment earlier than 
agreed in order to assist their own ca sh flow. Factors ex ist to help such 
entities. 
Factoring is primarily designed to allo w entities to accelerate cash flow, 
providing finance against outstanding trade receivables. This improves 
cash flow and liquidity. The factor wil l advance up to 80% of the value of 
a debt to the entity. The remainder (minus finance costs) being paid when 
the debts are collected. The factor bec omes a source of finance. Finance 
costs are usually 1.5% to 3% above bank base rate and interest is charged on a daily basis. 
Factoring is most suitable for 
 small and medium-sized firms which often cannot afford 
sophisticated credit and sales accounting systems, and 
 firms that are expandi ng rapidly. These often have a substantial and 
growing investment in receivables, which can be turned into cash by 
factoring the debts. Factoring debts can be a more flexible source of 
financing working capital than an overdraft or bank loan. 
Factoring can be arranged on either a ‘without recourse’ basis or a ‘with 
recourse’ basis. 
 When factoring is without recourse  or ‘non-recourse’, the factor 
provides protection for the client  against irrecoverable debts. The 
factor has no ‘comeback’ or recour se to the client if a customer 
defaults. When a customer of the cli ent fails to pay a debt, the factor 
bears the loss and the client rece ives the money from the debt. 
 When the service is with recourse (‘recourse factoring’), the client 
must bear the loss from any irre coverable debt, and so has to 
reimburse the factor for any money it has already received for the 
debt.

Chapter 16 
 357 
 Credit protection is provided only when the service is non-recourse and 
this is obviously more costly. 
Typical factoring arrangements 
 
1 Saving in administration costs. 
2 Reduction in the need for 
management control. 
3 Particularly useful for small 
and fast growing businesses where the credit control department may not be able to keep pace with volume growth. 1 Likely to be more costly than an 
efficiently run internal credit control department. 
2 Factoring has a bad reputation 
associated with failing companies; using a factor may suggest your company has money worries. 
3 Customers may not wish to deal 
with a factor. 
4 Once you start factoring it is difficult 
to revert easily to an internal credit control system. 
5 The company may give up the 
opportunity to decide to whom credit may be given (non-recourse factoring).

358  
 Benefits and problems with factoring 
 The benefits of factor ing are as follows. 
 A business improves its cash flow, because the factor provides 
finance for up to 80% or more of debts within 24 hours of the 
invoices being issued. A bank providing an overdraft facility secured against an entity's unpaid invoices will normally only lend up to 50% of the invoice value. (Factors will provide 80% or so because they set credit limits and are responsib le for collecting the debts.) 
 A factor can save the entity the administration costs of keeping the 
sales ledger up to date and t he costs of debt collection. 
 If the business were to allow the factor to administer the sales 
ledger, it can use the factor’s cr edit control system to assess the 
creditworthiness of both new  and existing customers. 
 Non-recourse factoring is a conv enient way of obtaining insurance 
against irrecoverable debts. 
Problems with factoring 
 Although factors provi de valuable services, entities are sometimes 
wary about using them. A possible pr oblem with factoring is that the 
intervention of the fact or between the factor’s client and the debtor 
entity could endanger trading relati onships and damage goodwill. 
Customers might prefer to deal with the business,  not a factor. 
 When a non-recourse factoring serv ice is used, the client loses 
control over decisions about grant ing credit to its customers. 
 For this reason, some clients prefer  to retain the risk of irrecoverable 
debts, and opt for a ‘with recourse’ fa ctoring service. With this type 
of service, the client and not t he factor decides whether extreme 
action (legal action) should be taken against a non-payer. 
 On top of this, when suppliers and customers of the client find out 
that the client is using a factor to collect debts, it may arouse fears 
that the entity is beset by cash fl ow problems, raising fears about its 
viability. If so, its suppliers ma y impose more stringent payment 
terms, thus negating the benefit s provided by the factor.

Chapter 16 
 359 
 Test your understanding 4 – Factoring arrangements 
 Edden is a medium-sized entity producing a range of engineering 
products, which it sells to wholesale distributors. Recently, its sales have 
begun to rise rapidly due to economic recovery. However, it is concerned about its liquidity position and is looki ng at ways of improving cash flow. 
Its sales are $16 million pa, and av erage receivables are $3.3 million 
(representing about 75 days of sales). 
One way of speeding up collection from re ceivables is to use a factor. It 
has considered an agreement from an interested factoring entity. 
The factor will pay 80% of  the book value of invoices immediately, with 
finance costs charged on the advance at 10% pa. 
The factor will charge 1% of sales as their fee for managing the sales 
ledger and there will be adm inistrative savings of $100,000. It will be a 
non-recourse agreement – which means  that the fact or will bear the 
responsibility for any irrecoverable debts. 
The entity is currently paying 8%  interest on its overdraft. 
Required 
Calculate the relative costs of usi ng the factor and state whether it 
would be beneficial to the en tity to use this facility.  
9 Accounts receivable – invoice discounting 
 Invoice discounting is a method of ra ising finance against the security of 
receivables without using the sales l edger administration services of a 
factor. 
While specialist invoice discounting fi rms exist, this is a service also 
provided by a factoring entity. Selected invoices are used as security against which the entity may borrow funds . This is a temporary source of 
finance, repayable when the debt is cl eared. The key advantage of invoice 
discounting is that it is a confident ial service, and the customer need not 
In some ways it is similar to the financing part of the factoring service 
without control of credit passing to the factor. 
 
 Ensure you can explain the differ ence between factoring and invoice 
discounting, and the situations wh ere one may be more appropriate than 
the other.

360  
 Invoice discounting 
 Typical arrangement 
 
Invoice discounting is a method of ra ising finance against the security of 
factor. With invoice discounting, t he business retains control over its 
sales ledger, and confidentiality in it s dealings with customers. Firms of 
factors will also provide invoice discounting to clients. 
The method works as follows: 
 The business sends out invoices, statements and reminders in the 
normal way, and collects the debts. With ‘confidential invoice 
discounting’, its customers are unaw are that the business is using 
invoice discounting. 
 The invoice discounter provides cash to the business for a 
proportion of the value of the invoice,  as soon as it receives a copy 
of the invoice and agrees to discount it. The discounter will advance cash up to 80% of face value. 
 When the business eventually co llects the payment from its 
customer, the money must be paid into a bank account controlled by 
the invoice discounter. The invoice discounter then pays the business the remainder of the invoice, less interest and 
administration charges.

Chapter 16 
 361 
 Invoice discounting can help a business that is trying to improve its cash 
flows, but does not want a factor to administer its sales ledger and collect 
its debts. It is ther efore equivalent to the finan cing service provided by a 
factor. 
Administration charges for this serv ice are around 0.5–1 % of a client’s 
turnover. It is more ri sky than factoring since the client retains control 
over its credit policy. Consequently, such facilities are usually confined to 
established entities with high sale s revenue, and the business must be 
profitable. Finance costs are usually in the range 3–4% above base rate, 
although larger entities and those wh ich arrange credit insurance may 
receive better terms. 
The invoice discounter will check the sa les ledger of the client regularly, 
perhaps every three months, to check that its debt collection procedures 
are adequate. 
 
 Illustration of the invo ice discounting process 
 At the beginning of August, Basildon se lls goods for a total value of 
$300,000 to regular customers but dec ides that it requires payment 
earlier than the agreed 30-day cred it period for these invoices. 
A discounter agrees to finance 80% of their face value, i.e. $240,000, at 
an interest cost of 9% pa. 
The invoices were due for payment in early September, but were 
subsequently settled in mid-September, exactly 45 days after the initial transactions. The invoice discounter’s service charge is 1 % of invoice value. A special account is set up with a bank, into which all payments are made. 
The sequence of cash flows is: 
August Basildon receives cash advance of $240,000. 
Mid-September Customers pay $300,000.  
 Invoice discounter receives the full 
$300,000 paid into the special bank account.  
 Basildon receives the balance payable, 
less charges, i.e.  
 Service fee = 1% × $300,000 = $3,000 
 Finance cost = 9% × $240,000 × 45/365 = $2,663 
  ––––––– 
 Total charges $5,663 
  –––––––

362  
  Basildon receives:  
 Balance of payment fr om customer $60,000 
 Less charges $5,663 
  ––––––– 
  $54,337 
  ––––––– 
Summary 
$300,000 
invoiced Total receipts by Basildon: $240,000 + 
$54,337 $294,337 
 Invoice discounter’s fee and interest charges $5,663 
 
2015 CIMA Professional Qualification Syllabus, Operational Level 
Case Study Exam, August 201 8 v5 – Question (Modified) 
You work in Herbaboil, a drinks manufac turer specialising in flavoured tea 
drinks. The entity runs a number of different lines of product, one of which is 
Butler Estates, a high end exotic tea product line.  
Jack Ford, the Head of Finance,  sends you the following email: 
From: Jack Ford,  
To: Finance Officer Subject Butler Estates: Receivables management 
Butler Estates seems to be going from st rength to strength. Only two months 
ago, it was decided that we should target small, independent luxury 
delicatessens and food shops to start stocking Butler Estates tea. This has 
been very successful and we now have ov er 30 new customers as a result. 
The new customers are great news for sales but potentially not so great for 
cash flow. Many of the customers that  we took on two months ago are already 
behind on payments. I’ve sugges ted to the Finance Director , Christie Smith, that 
we think about factoring the receivable balances for these type of customers. 
She isn’t against the idea, although has asked for a briefing paper on the 
benefits and drawbacks of factoring the receivable balances for these 
customers, that can be forwar ded onto the other directors.  
I need you to send me an email in which you: 
 Prepare content for a brie fing paper to the directors which explains the 
potential benefits and drawbacks to the business of factoring the 
receivables balances of the Butler Estates small independent customers. 
Kind regards, 
JF 
© Copyright CIMA – 2015 CIMA Professional  Qualification Oper ational Level F1 
Financial Reporting and Taxation Ca se Study Exam August 2018 v5

Chapter 16 
 363 
Case Study Suggested Answer 
Case Study Exam, August 2018 V5 – Suggested Answer  
Note this is an extract from the s uggested answer and focuses solely on 
the areas of the case study relevant to the F1 exam 
FACTORING OF RECEIVABLES BALANCES OF BUTLER ESTATES 
SMALL INDEPENDENT BUSINESS CUSTOMERS 
Potential benefits: The main benefit of factoring the receiv ables balances of the small independent 
business customers is that we will rece ive the cash from sales to these 
customers more quickly than if we do not  factor. Typically, factors advance 
around 80% of the invoice value on the raising of the invoice, with the 
remainder received a little later. This could be a huge benefit for us because, 
even after only two months, we know that  this type of customer is slow at 
paying which is because they are sm all, probably owner-managed businesses 
where cash flow is very tight. 
Another benefit is that if  we use a non-recourse arrangement, we can transfer 
the risk of irrecoverable debts to the factor . The ability to do this is potentially 
very beneficial for this type of custom er. Small independent retail businesses 
are far more likely to cease trading t han larger more established businesses. 
Another benefit is that a fa ctor will be an expert in credit control and in dealing 
with customers like this. They will have set procedures and will promptly chase 
outstanding amounts. As mentioned above this  is a different type of customer 
than either the Butler Estates financ e departments are used to. Indeed, given 
the rapid growth in this cu stomer base it is unlikely th at we have the resource to 
manage the credit control function effect ively without taking on and training new 
staff. 
Potential drawbacks:  
The main drawback of factoring is its co st. A factor will char ge an administrative 
fee of a percentage of sales revenue. This  is a cost against gross profit and will 
affect our margin. In additi on, the factor will charge a finance fee on the monies 
advanced, which will affect our net prof it. Given the nature of these customers 
and the relatively high risk of non-payment, it is likely that any factor willing to 
over us a service will expect a hi gh level of fees in compensation. 
Another drawback is that our cust omers might not be happy about the 
arrangement. With factoring, unlike in voice discounting, the customer will be 
fully aware of the arrangement because they will receive correspondence with 
the factor. Customers might f eel that they have lost their link to Butler Estates 
and that we do not value their business, es pecially if the factor is aggressive in 
chasing for payment. The potential loss of business needs to be carefully 
considered.

364  
10 Accounts payable – managing trade credit 
Trade credit is the simplest and most import ant source of short-term finance for 
many entities. 
 Again it is a balancing act betw een liquidity and profitability. 
 
By delaying payment to suppliers, entit ies face possible problems such as: 
 suppliers may refuse to supply in future 
 suppliers may only supply on a cash basis 
 there may be loss of reputation 
 suppliers may increase price in future 
Trade credit is normally seen as a ‘free’ source of finance. Whilst this is 
normally true, it may be that  the supplier offers a disc ount for early payment. In 
this case, delaying payment is no longer  free, since the co st will be the lost 
discount. 
 In the examination, you need to be abl e to calculate the cost of this 
discount foregone.

Chapter 16 
 365 
 Trade payables 
 Using trade credit a firm is able to obtain goods (or services) from a 
supplier without immediate payment, t he supplier accepting that the firm 
will pay at a later date. 
Trade credit periods vary from indus try to industry and each industry will 
have what is a generally accepted norm which would be from seven days 
upwards. A typical credit period might be 30 days, but it can range anywhere from 7 to 90 days, dependent on the relative power of the 
supplier and buyer. Normally considerable scope for flexibility exists and longer credit periods are sometimes offered, particularly where the type 
of business activity requires a long  period to convert materials into 
saleable products, e.g. farming. 
Some of the firm's suppliers may offer settlement discounts . However, if 
the firm is short of funds , it might wish to make maximum use of the credit 
period allowed by suppliers regardl ess of the settlement discounts 
offered. Favourable credit terms are one of several factors which 
influence the choice of a supplier. Furthermore, the act of accepting 
settlement discounts has an opportunity cost, i.e. the cost of finance 
obtained from another source to replac e that not obtained from creditors. 
Whilst trade credit may be seen as a s ource of free credit, there will be 
costs  associated with extending credit taken beyond the norm – lost 
discounts, loss of supplier goodwill, more  stringent terms fo r future sales. 
In order to compare the co st of different sources of finance, all costs are 
usually converted to a rate per annum  basis. The cost of extended trade 
credit is usually measured by loss of discount, but the calculation of its 
cost is complicated by such variab les as the number of alternative 
sources of supply, and the general economic conditions. 
Certain assumptions have to be made concerning (a) the maximum delay 
in payment which can be achieved before the supply of goods is withdrawn by the supplier, and (b) the ava ilability of alternative sources of 
supply. 
Also, it is a mistake to reduce worki ng capital by holding on to creditors’ 
money for a longer period than is allo wed as, in the long-term, this will 
affect the supplier’s willingness to supply  goods and raw materials, 
and cause further embarrassment to the firm. 
 
 Test your understanding 5 – Discounts for early payment 
 One supplier has offered a discount to Box of 2% on an invoice for 
$7,500, if payment is made within one month, ra ther than the three 
months normally taken to pay.  
If Box’s overdraft rate is 10% pa, calcul ate if it is financially worthwhile for 
them to accept the discount and pay early?

366  
Age analysis of payables 
The value of an age analysis of trade pay ables is probably less obvious than 
the value of an age analysis of trade re ceivables. However, management needs 
to be aware of 
 the total amount payable to suppliers 
 when the money will be payable 
 the amounts payable to each individual supplier, and how close this is to 
the credit limit avail able from the supplier 
 whether the entity is failing to  pay its trade suppliers on time 
 
 1 Which of the following will not influence an entity's overall 
credit policy. 
A Demand for products 
B Costs of credit control C Volume of purchases D Risk of irrecoverable debts 
2 An entity expects credit sales of  $110,000 in July, rising by $10,000 
each month for the next two mont hs. Outstanding trade receivables 
at the beginning of July were $165,000, representing all of June sales and 22 days of May sales.  Sales in June were $95,000. 
The entity wishes to reduce the av erage day’s sales outstanding to 
45 days by the end of July and 40 days by the end of August. 
On the assumption that the target should be to collect first the 
receivables that have been unpaid for the longest time, calculate the collection targets for 
(a) July, and 
(b) August. 
3 List five methods of carrying ou t a credit check on a potential 
new customer, before deciding whet her to give credit and if so, 
what the credit limit should be.

Chapter 16 
 367 
 4 An entity is considering a change in its credit policy. It has estimated 
that if credit terms are extended from 30 days to 60 days, total 
annual sales will increase by 10% fr om the current level of $12 
million. It has been estimated that as a consequence of the change in credit terms and the higher sales volume, irrecoverable debts would increase from 2% to 3% of sales. The entity's cost of capital 
is 8%. 
The increase in sales would not affect annual fixed costs. The 
contribution to sales ratio is 40%. 
Required 
Calculate the effect of the change in credit policy on the annual 
profit before taxation. Assume a 360-day year of 30 days each 
month. 
5 An entity is offering a cash discount  of 2.5% to receivables if they 
agree to pay debts within one month. The usual credit period taken is three months. 
Calculate the effective annualised  cost of offering the discount 
and should it be offered, if the ba nk would loan to the entity at 
18% p.a? 
6 Calculate the equivalent annual co st of the following credit 
terms: 1.75% discount for pa yment within three weeks. 
Alternatively, full payment must be made within eight weeks of 
the invoice date. 
Assume there are 50 weeks in a year. 
7 Marton produces a range of spec ialised components, supplying a 
wide range of customers, all on cr edit terms. 20% of revenue is sold 
to one firm. Having used generous credit policies to encourage past growth, Marton Co now has to finance a substantial overdraft and is concerned about its liquidity. 
Marton borrows from its bank at 13%  pa interest. No further sales 
growth in volume or value terms  is planned for the next year. 
In order to speed up collection from customers, Marton is 
considering two alternative policies: 
Option one 
Factoring on a non-recourse basis wit h the factor administering and 
collecting payment from Marton Co’s customers. This is expected to 
generate administrative savings of $200,000 pa and to lower the 
average receivable collection per iod by 15 days. The factor will 
make a service charge of 1% of Marton Co’s revenue and also 
provide credit insurance facilitie s for an annual premium of $80,000.

368  
 Option two 
Offering discounts to customers who settle their accounts early. The 
amount of the discount will depend on speed of payment as follows. 
Payment within 10 days of des patch of invoices 3%  
Payment within 20 days of despatch of invoices 1.5% It is estimated that customers r epresenting 20% and 30% of Marton 
Co’s sales respectively will take  up these offers, the remainder 
continuing to take their present credit period. 
Extracts from Marton's most re cent accounts are given below. 
 ($000) 
Sales (all on credit) 20,000 
Cost of sales (17,000)  –––––– 
Operating profit 3,000 
 –––––– Current assets  
Inventory 2,500 
Receivables 4,500 Cash Nil  –––––– 
Calculate the costs and benefits of the entity using option one. 
8 Using the information from question 7 calculate the costs and 
benefits of the entity using option two. 
9 Using the information from questions 7 and 8 identify the most 
financially advantageous policy. 
10 Fredrico has sales of $40 million fo r the previous year, receivables 
at the year end were $6 millio n, and the cost of financing 
receivables is covered by an over draft at the interest rate of 
10% p.a. 
Required: 
(b) Calculate the annual cost  of financing receivables.

370

Chapter 16 
 371 
 There are a number of factors which a credit controller might consider, 
such as: 
 the customers past payment history.  If a customer has usually paid 
on time in the past then a higher credit limit might be approved. 
 any new public information about the customer. For example, if 
recent press reports suggest that the customer might be in financial 
difficulty then it may be unwise to raise a customer's credit limit. 
 a change in the customer's credi t rating. For large customers 
especially, credit ratings are easily obtained and any change to a 
rating should have an impact on the amount of credit offered to the customer. 
In making the decision the credit contro ller will be able to use a variety of 
tools, such as: 
 past customer history 
 an aged receivables report 
 ratio analysis 
 
 (a) Receivables days = $4m ÷ $20m × 365 = 73 days 
(b) Annual cost of financing receivables = $4m × 12% = $480,000. 
 
 Discount as a percentage of amount left to pay = 2 ÷ 98 = 2.04% 
Receivables days are current ly 73 ($4m/$20m × 365), so: 
Saving is 63 days (dropping from 73 days to 10) and there are 365 ÷ 63 = 
5.794 periods in a year 
Annualised cost of discount % is 
(1 + 0.0204)5.794 – 1 = 0.1241 = 12.41%. 
The overdraft rate is 12%. 
It would be marginally cheaper to  borrow the money from the bank 
rather than offer the discount.

372  
  
 Costs of 
factoring Savings 
 $ $ 
Sales ledger administration   
1% × $16m 160,000  Administration cost savings  100,000 
Cost of factor finance 10% × 80%   
× $3.3m * 264,000  Overdraft finance costs 8% × 80%   
× $3.3m saved  211,200 
 ––––––– –––––––– Total 424,000 311,200 
Net cost of factoring 112,800  
The firm will have to balance this cost against the security offered by 
improved cash flows and greater liquidity. 
* 80% of the average receivable bal ance is outstanding at any one time. 
 
 Discount saves 2% of $7,500 = $150 
Financed by overdraft for extra tw o months in order to pay early: 
$7,500 – $150 = $7,350  
10% × 2
12 × 7,350 = ($122.50) 
Net saving = $27.50 
It is worth accepting the discount. 
Alternatively: 
Discount as a percentage of amount to be paid 	= 150
7,350	=	2.04% 
Saving is 2 months and there are 12
2	=	6 periods in a year 
Annualised cost of not taking the di scount (and therefore borrowing from 
the supplier) is (1 + 0.0204)6 –1 = 0.1288 = 12.88% 
The overdraft rate is 10%.   It would be cheaper to borrow the money  from the bank to pay early and 
accept the discount.

Chapter 16 
 373 
 1 The correct answer is C. 
Credit policies consist of the level of credit offered on sales to 
customers and are influenced by t he levels of bad debt risk the 
entity is comfortable with. Purchas es of good have nothing to do 
with an entity's credit risk policy.  
2 Target receivables 
End of July Days  $ 
July sales 31  110,000 
June sales (balance) 14 ( 14/30 × $95,000) 44,333 
 –––  ––––––– 
 45  154,333 
    
End of August Days  $ 
August sales 31  120,000 July sales (balance) 9 (9/31 × $110,000) 31,935 
 40  151,935  –––  ––––––– 
Target collections 
 July August 
 $ $ 
Receivables at the beginning of the month 165,000 154,533 
Sales in the month 110,000 120,000 
 ––––––– –––––––  275,000 274,333 
Receivables at the end of the month (154,333) (151,935) 
 ––––––– ––––––– Target collections in the month 120,667 122,398 
 ––––––– –––––––

374  
 3 Choose 5 from the following list: 
– bank references – trade references – visit to the customer's premises – competitors – published information – credit reference agencies – legal sources of credit information – entity sales records – credit scoring – credit rating (large corporate customers only). 
4 The two options can be analysed as follows: 
 Without the new 
credit policy With the new 
credit policy 
Annual sales $12, 000,000 $13,200,000 
Average trade receivables $1,000,000 $2,200,000  ($12m × 30/360) ($13.2m × 60/360) 
Increase in trade receivables $1,200,000 
Irrecoverable debts $240,000 (= 2%) $396,000 (= 3%) Increase in Irrecoverable debts $156,000    
Increase in annual sales  $1,200,000 
 
 $ $ 
Increase in annual contribution (40%)  480,000 
   Increase in Irrecoverable debts 156,000  
   
Increase in interest cost of receivables (8% 
× $1,200,000) 96,000  
 ––––––– (252,000) 
 ––––––– 
Net increase in profit before tax 228,000  –––––––

Chapter 16 
 375 
 5 Discount as a percentage of amount  to be paid = 2.5/97.5 = 2.56%  
Saving is 2 months and there ar e 12/2 = 6 periods in a year.  
Annualised cost of discount % is (1 + 0.0256)
6 –1 = 0.1638 = 16.38%.  
The loan rate is 18%. It would therefore be worthwhile offering the discount. 
6 The answer is 19.5% 
Step 1 
Work out the discount available a nd the amount due if the discount 
were taken. 
Discount available on a $100 invoice = 1.75% × $100 = $1.75. Amount due after discount = $100 × $1.75 = $98.25 
Step 2 
The effective interest cost of  not taking the discount is:  
1.75 ÷ 98.25 = 0.0178 (rounded to 0.018) for an 8 – 3 = five-week period. 
Step 3 
Calculate the equivalent annual ra te. There are ten five-week 
periods in a year. 
The equivalent interest annual rate is (1 + 0.018)
10 – 1 = 0.195 or 
19.5%. 
7 The relative costs and benefits are as follows: 
Option 1 – Factoring 
Reduction in receivables 
days  = 15 days   
Reduction in receivables = 15 ÷ 365 × $20m  = $821,916 
Effect on profit before tax:    Finance cost saving = (13%  × $821,916)  = $106,849 
Administrative savings  =  $200,000 
Service charge = (1% × $20m) = ($200,000) 
Insurance premium  = ($80,000) 
   –––––––– 
Net profit benefit  = $26,849

376  
 8 The relative costs and benefits are as follows 
Option 2 – The discount 
With year-end receivables at $4.5 million, the receivables collection 
period was: $4.5m ÷ $20m × 365 = 82 days. 
The scheme of discounts would change this as follows: 10 days for 20% of customers  20 days for 30% of customers  82 days for 50% of customers Average receivables days become: (20% × 10) + (30% × 20)  + (50% × 82) = 49 days 
Hence, average receivables woul d reduce from the present  
$4.5 million to 
49 × $20m ÷ 365 = $2,684,932 Finance cost saving = 13% × ( $4,500,000 – $2,684,932) = $235,959  
The cost of the discount: (3% × 20% × $20m) + (1.5% × 30% × $20m) = ($210,000)  
The net benefit to prof it before tax: $25,959 
9 The figures imply that factoring is marginally the more attractive , 
but this result relies on the predicted proportions of customers 
actually taking up the discount and pay ing on time. It also neglects 
the possibility that some customers will insist on taking the discount without bringing forward their pay ments. Marton would have to 
consider a suitable response to this problem. 
Conversely, the assessment of the value of using the factor 
depends on the factor lowering Mart on's receivables days. If the 
factor retains these benefits for itsel f, rather than passing them on to 
Marton, this will raise the cost of  the factoring option. The two 
parties should clearly specify thei r mutual requirements from the 
factoring arrangement on a contractual basis. 
10 The answer is 
(a) Receivables days = $6m ÷ $40m × 365 = 55 days 
(b) Cost of financing receivables = $6m × 10% = $600,000.

377 
Management – Inventory 
Control 
  Chapter 
17

Working Capital Management – Inventory Control 
378  
 
2 The objectives of in ventory management 
Inventory is a major investment for m any entities. Manufacturing entities can 
potentially be carrying inventory equivalent  to between 3 and 6 months’ worth of 
sales depending on where they source thei r inventory from and the relative 
power of suppliers. It is t herefore essential to reduce t he levels of inventory held 
to the necessary minimum.

Chapter 17 
 379 
 
Costs of high inventory levels 
Keeping inventory levels hi gh is expensive owing to: 
 the foregone interest that is lost from tying up capital in inventory 
 holding costs: 
– storage 
– stores administration 
– risk of theft/damage/obsolescence 
 
 Costs of high inventory levels 
 Carrying inventory involves a major working capital investment and 
therefore levels need to be very tightly c ontrolled. The cost is not just that 
of purchasing the goods, but also st oring, insuring, and managing them 
once they are in inventory. 
Interest costs: once goods are purchas ed, capital is tied up in them and 
until sold on (in their current state or  converted into a finished product), 
the capital earns no return. This lost  return is an opportunity cost of 
holding the inventory.

380  
 Other risks:  once stored, the goods will ne ed to be insured. Specialist 
equipment may be needed to transport the inventory to where it is to be 
used. Staff will be requir ed to manage the warehouse and protect against 
theft and if inventory le vels are high, significant investment may be 
required in sophisticated in ventory control systems. 
The longer inventory is held, the great er the risk that it  will deteriorate or 
become out of date. This is true of perishable goods, fashion items and 
high-technology prod ucts, for example. 
Costs of low inventory levels 
If inventory levels are kept too low, the business faces alternative problems: 
 stockouts:  
–  lost contribution 
–  production stoppages –  emergency orders 
 high re-order/setup costs 
 lost quantity discounts 
 
 Stockout:  if a business runs out of  a particular product used in 
manufacturing it may cause interrupt ions to the production process – 
causing idle time, stockpiling of work-in-progress (WIP) or possibly 
missed orders. Alternatively, running out of finished goods or inventory 
can result in dissatisfied customer s and perhaps future lost orders if 
custom is switched to alternative s uppliers. If a stockout looms, the 
business may attempt to avoid it by acquiring the goods needed at short m, the amount of com puterisation more expens ive or poorer quality 
supplier. 
Re-order/setup costs:  each time inventory runs out, new supplies must 
be acquired. If the goods are bought  in, the costs that arise are 
associated with administration – comp letion of a purchase requisition, 
authorisation of the order , placing the order with the supplier, taking and 
checking the delivery and final settlement  of the invoice. If the goods are 
to be manufactured, the costs of setting up the machinery will be incurred 
each time a new batch is produced. 
Lost quantity discounts:  purchasing items in bul k will often attract a 
discount from the supplier. If only small amounts are bought at one time 
in order to keep inventory levels  low, the quantity discounts will not be 

Chapter 17 
 381 
The challenge 
 The objective of good inventory managem ent is therefore to determine: 
 the optimum re-order level – ho w many items should be left in 
inventory when the next order is placed, and 
 the optimum re-order  quantity – how many it ems should be ordered 
when the order is placed 
In practice, this means striking a balance between holding costs on the 
one hand and stock-out and re-o rder costs on the other. 
 
 The balancing act between liquidity and profitability, which might also be 
considered to be a trade-off between holding costs and stock-out/re-order 
costs, is key to any discu ssion on inventory management. 
 
 Terminology 
 Other key terms associated wit h inventory management include: 
 lead time – the lag between when an order is placed and the item is 
delivered 
 buffer inventory – the basic level of inventory kept  for emergencies. 
A buffer is required because both demand and lead time will 
fluctuate and predictions can only be based on best estimates. 
Ensure you can distinguish between the various terms used: re-order 
level, re-order quantity, l ead time and buffer inventory. 
3 Economic order quantity (EOQ) 
For businesses that do not use just in time (J IT) in ventory management 
systems (discussed in more detail below),  there is an optimum order quantity for 
inventory items, known as the EOQ. 
The aim of the EOQ model is  to minimise the total cost of holding and ordering 
inventory.

382  
The calculation 
The EOQ can be found using a formula: 
 
where: 
CO = cost per order 
D = annual demand 
CH = cost of holding one unit for one year. 
 
 Test your understanding 1 – EOQ 
 An entity requires 1,000 units of materi al X per month. T he cost per order 
is $30 regardless of the size of th e order. The annual holding costs are 
$2.88 per unit. 
Required: 
Investigate the total cost of buying t he material in quantities of 400, 500, 
or 600 units at one time. Identify the cheapest option. 
Apply the EOQ formula to pr ove your answer is correct. 
Assumptions 
The following assumptions are made: 
 demand and lead time are constant and known 
 purchase price is constant 
 no buffer inventory held as it is assumed that it is not needed since 
demand and lead times are known with certainty 
 These assumptions are critical and should be discussed when considering 
the validity of the model and its c onclusions, e.g. in practice, demand 
and/or lead time may vary.

Chapter 17 
 383 
 EOQ further information – explanation and derivation 
 To minimise the total cost of hol ding and ordering inventory, it is 
necessary to balance the relevant costs. These are: 
 the variable costs of holding the inventory 
 the fixed costs of placing the order 
Holding costs 
The model assumes that it costs a certain amount to hold a unit of 
inventory for a year. Therefore, as  the average level of inventory 
increases, so too will the total annual holding costs incurred. 
Because of the assumption that demand per period is known and is 
constant (see below), conclusion s can be drawn over the average 
inventory level in relations hip to the order quantity. 
When new batches or items of inv entory are purchased or made at 
periodic intervals, the inventory le vels are assumed to exhibit the 
following pattern over time. 
 
If x is the quantity ordered, the annual  holding cost would be calculated 
as: 
Holding cost per unit (C H)× Average inventory: 
CH	× x
2	
We therefore see an upwar d sloping, linear rela tionship between the re-
order quantity and total annual holding costs.

384  
 Ordering costs 
The model assumes that a fixed cost is incurred every time an order is 
placed (referred to as C O in the formula). Theref ore, as the order quantity 
increases, there is a fall in the num ber of orders required, which reduces 
the total ordering cost. 
If D is the annual expected sales demand, the annual order cost is 
calculated as: 
Order cost per order × no. of orders per annum. 
CO	× D
x	
However, the fixed nature of the co st results in a downward sloping, 
curved relationship. 
 
Total costs 
Because we are trying to balance t hese two costs (one which increases 
as re-order quantity increases and one wh ich falls), total costs will always 
be minimised at the point where the total holding costs equals the total 
ordering costs. This point will be the economic order quantity (when the 
re-order quantity chosen minimise s the total cost of holding and 
ordering).

Chapter 17 
 385 
Dealing with quantity discounts  
Discounts may be offered for ordering in large quantities. If the EOQ is smaller 
than the order size needed for a discount, should the order size be increased 
above the EOQ? 
 
 To work out the answer you should carry out the following steps:  
Step 1: Calculate EOQ, ignoring discounts. 
Step 2:  If the EOQ is below the quantity qualifying for a discount, calculate 
the total annual inventory cost arising from using the EOQ. 
Step 3:  Recalculate total annual inventory costs using the order size 
required to just obtain each discount. 
Step 4:  Compare the cost of Steps 2 and 3 with the saving from the 
discount, and select the minimum cost alternative. 
Step 5: Repeat for all discount levels. 
 
 Test your understanding 2 – EOQ and discounts 
 Wolvo is a retailer of barrels. T he entity has an annual demand of 30,000 
barrels. The barrels cost $12 each. Supplies can be obtained 
immediately, with ordering and tr ansport costs amounting to $200 per 
order. The annual cost of holding one barre l in stock is estimated to be 
$1.20 per barrel. 
A 2% discount is available on orders of at least 5,000 barrels and a 2.5% 
discount is available if  the order quantity is 7,500 barrels or above. 
Required: 
Calculate the EOQ ignoring the discount  and calculate if it would change 
once the discount is taken into account. 
 
 Criticisms of EOQ 
 The EOQ model can be criticised in several ways: 
 It is based on simplifying assumptions, such as constant and 
predictable material usage rates. 
 It will not indicate the optimal purchase quantity when there are 
price discounts for buying in larger quantities. 
 It ignores the problem of managing stock-outs. 
 It is inconsistent with the philoso phy of just-in-time management and 
total quality management.

386  
Case Study Exam, August 201 8 v1 – Question (Modified) 
drinks.  
Subject: New range of infusions – inventory management 
I’ve been working with Steven Gomez, Head of Production, on some of 
the financial implications from ex panding the infusions range of products 
to include Peppermint and Peach & Raspberry flavoured teas.  
Steve has asked me whether the Ec onomic Order Quantity (EOQ) model 
might be a useful tool for managi ng inventory levels. Inventory 
management is going to be particularl y important for the new range 
because there are so many different raw material inputs that need to be 
held, which is going to increase our inventory holding costs. There are 
various bulk discounts available and I know that Steve is keen to take advantage of these as far as possible. 
I would like you to prepare a briefing note that I can send to Steve which: 
 Explains what information we wo uld need to calculate the EOQ for 
infusion raw materials 
 Explains the appropriateness of  using the EOQ model to manage 
the level of inventory held 
Level F1 Financial Reporting and Taxa tion Case Study Exam August 
2018

Chapter 17 
 387 
Case Study Exam, August 2018 – Suggested Answer  
solely on the areas of the case study relevant to the F1 exam 
INVENTORY MANAGEMENT 
Information required to calculate EOQ 
For each type of infusions raw materi al (for example, paper, packaging, 
dried fruit, fruit and herbal leaves ) we will need to establish: 
 Annual demand which will be driv en by the level of anticipated 
production. 
 The cost of an individual order which will include procurement staff 
time, internal administrative cost s and any goods in delivery costs. 
 The cost of holding one unit of in ventory for one year. Holding costs 
will include insurance, storage costs (including energy used in the 
warehouse, staff training costs for safe handling, handling staff 
time) and the finance cost associated with the investment in working capital. 
The appropriateness of the EOQ model : 
In principle, the EOQ model is useful  because it would give us for each 
type of raw material inventory the order quantity which would minimise 
the overall cost of both ordering and hol ding that inventory. However, the 
EOQ model is based on assumptions  which can make its practical 
application difficult. 
The model assumes that demand for the raw material is constant 
throughout the year and can be dete rmined with a reasonable level of 
certainty. There is still considerab le uncertainty regarding how popular 
and successful the new range will be; there is also uncertainty over which 
flavours will be popular. Demand for t he new infusions is likely to 
gradually grow through the year as  more and more people hear about 
and try it. 
It is assumed that the lead time is cons tant or zero, however for us it is 
possible that lead times will vary thr ough the year, especially as a large 
portion of raw materials are pl ant-based and dependent upon harvests 
and crop yields. Both uncertainty in demand and variable lead times can be adjusted for in the EOQ model by setting a safety or buffer level of 
inventory. This increases overall hol ding costs but allows flexibility to 
schedule production where demand is higher than expected or where 
lead times are longer than expect ed. The downside though of holding 
safety inventory is that the risk of obsolescence increases (especially for 
the plant-based materials).

388  
 The model also assumes that purc hase costs are constant with no bulk 
discounts and that holding costs are va riable with the level of inventory 
held. The former of these assump tions can be dealt with by expanding 
the analysis to consider the inventory level that minimises the total of 
holding, ordering and net of disc ount purchase costs. The latter 
assumption is more difficult to ju stify because in reality a significant 
portion of holding costs such as the costs of operating the warehouse are 
fixed in nature. 
In conclusion, the EOQ model is not going to be wholly appropriate to use 
on a practical level. This is because of the uncertainty of future demand 
and because of the nature of our invent ory. However, it could be used as 
a guide with practical factors such  as shelf life of the plant-based 
materials taken into account. 
4 Inventory management systems 
A number of systems have been develo ped to simplify the inventory 
management process: 
 periodic review 
 JIT. 
Periodic review system (cons tant order cy cle system)  
Inventory levels are reviewed at fixed in tervals, e.g. every four weeks. The 
inventory in hand is then made up to a predetermined level, which takes 
account of: 
 likely demand before the next review 
 likely demand during the lead time. 
Thus a four-weekly review in a syst em where the lead time was two weeks 
would demand that inventor y be made up to the likely maximum demand for the 
next six weeks. 
 
 Periodic review systems 
 A company has estimated that, fo r the coming season, weekly demand 
for components will be 80 units. At the most recent stock count, 250 units 
of inventory where counted.  Supplie rs take three weeks on average to 
deliver goods once they have been or dered and a buffer inventory of 35 
units is held. 
If the inventory levels are review ed every six weeks, how many units 
will need to be ordered to ensure the buffer is maintained? 
Solution 
Demand per week is 80 units. The next review will be in six weeks by 
which time 80 × 6 = 480 units will have been used.

Chapter 17 
 389 
 An order would then be placed and dur ing the lead time – three weeks – 
another 80 × 3 = 240 units will be used. 
The business therefore needs to have 480 + 240 = 720 units in inventory 
to ensure a stock-out is avoided. Sinc e buffer inventory of 35 units is 
required, the total number needed is 755 units. 
Since the current inventory level is 250 units, an order must be placed for 
755 – 250 = 505 units. 
 
 Slow moving inventory 
 Certain items may have a high indi vidual value, but be subject to 
infrequent demand. 
In most organisations, about 20% of  items held make up 80% of total 
usage (the 80/20 rule). 
Slow-moving inventory 
Management need to review inventory usage to identify slow-moving 
inventory. An aged inventory analysi s should be produced and reviewed 
regularly so that action can be taken. Actions could include: 
 elimination of  obsolete items 
 slow-moving inventory items onl y ordered when actually needed 
(unless a minimum order quantity is imposed by the supplier) 
 review of demand level estimates on which re-order decisions are 
based. 
A regular report of slow-moving items is useful in that management is 
made aware of changes in demand and of possible obsolescence. 
Arrangements may then be made to reduce or eliminate inventory levels 
or, on confirmation of obsolescence, for disposal. 
Just in Time (JIT) systems 
 JIT is a series of manufacturing and supply chain techniques that aim to 
minimise inventory levels and improve customer service by manufacturing 
not only at the exact time customer s require, but also in the exact 
quantities they need and at  competitive prices. 
In JIT systems, the balancing act is dispensed with. Inventory is reduced to an 
absolute minimum or eliminated altogether. 
Aims of JIT are: 
 a smooth flow of work th rough the manufacturing plant 
 a flexible production process which is responsive to the customer’s 
 reduction in capital tied up in inventory. 
This involves the elimination of all ac tivities performed that do not add value = 
waste.

390  
 Just in time systems 
 JIT extends much further than a c oncentration on inventory levels. It 
centres around the elimination of waste.  Waste is defined as any activity 
performed within a manufacturing com pany which does not add value to 
the product. Examples of waste are: 
 raw material inventory 
 WIP inventory 
 finished goods inventory 
 materials handling 
 quality problems (reject s and reworks, etc.) 
 queues and delays on the shop floor 
 long raw material lead times 
 long customer lead times 
 unnecessary clerical and accounting procedures. 
JIT attempts to eliminate waste at  every stage of t he manufacturing 
process, notably by the elimination of: 
 WIP, by reducing batch sizes (often to one) 
 raw materials inventory, by the suppliers delivering direct to the 
shop floor JIT for use 
 scrap and rework, by an emphasis on total quality control of the 
design, of the process,  and of the materials 
 finished goods inventory, by reduci ng lead times so that all products 
are made to order 
 material handling costs, by re-des ign of the shop floor so that goods 
move directly between adjacent work centres. 
The combination of these c oncepts in JIT results in: 
A JIT manufacturer looks for a single supplier who can provide high 
quality, frequent and reliable  deliveries, rather than the lowest price. In 
return, the supplier can expec t more business under long-term purchase 
orders , thus providing greater certainty  in forecasting activity levels. 
Very often the suppliers will be located close to the company.

Chapter 17 
 391 
 Long-term contracts and single sourcing strengthen buyer-supplier 
relationships and tend to result in  a higher quality product. Inventory 
problems are shifted back onto suppliers, with deliveries being made as required. 
The spread of JIT in the production process inevitably affects those in 
delivery and transportation. Smaller, more frequent loads are required at 
shorter notice. The haulier is regarded as almost a partner to the manufacturer, but tighter schedules  are required of hauliers, with 
penalties for non-delivery. 
Reduction in inventory levels reduce s the time taken to count inventory 
and the clerical cost. However with JI T, although inventory holding costs 
are close to zero, inventory ordering costs are high 
5 Inventory control systems 
Three main systems are used to moni tor and control inventory levels: 
1 reorder level system (whereby invent ory is ordered at a particular, set 
order level) 
2 periodic review system (whereby inv entory is checked and ordered at set 
periods in time) 
3 mixed systems, incorporating elements of both of the above. 
 
 Control systems explained 
 Reorder level system 
With this system, whenever the current  inventory level falls below a pre-
set ‘reorder level’ (ROL), a replenis hment (replacement) order is made. 
Since there is normally a gap (lead time) between the placing of an order and receipt of supplies this has to be allowed for. Buffer inventory is 
usually held as insurance against variations in demand and lead time. 
This system used to be known as the ‘two-bin’ system. Inventory is kept 
in two bins, one with an amount equal to  the ROL quantity, and the rest in 
the other. Inventory is drawn from the latter until it runs out, whence a 
replenishment order is triggered. 
A reorder level system is simple enough to implement if the variables 
(such as average usage, supplier lead time, etc.) are known with 
certainty. In practice, this is rarely the case. 
Periodic review system 
This is also referred to as a ‘const ant cycle’ system. Inventory levels are 
reviewed after a fixed inte rval, for example, on t he first of the month. 
Replenishment orders are issued wher e necessary, to top up inventory 
levels to pre-set target levels. This  means that order sizes are variable.

392  
 Mixed systems 
In practice, mixtures of both sys tems are sometimes used, depending on 
the nature of the probl em, the amount of com puterisation and so on. 
6 Calculating the re-order level (ROL) 
Known demand and lead time 
Having decided how much inventory to re -order, the next probl em is when to re-
order. The firm needs to identify a leve l of inventory which can be reached 
before an order needs to be placed. 
 The ROL  is the quantity of inventory on hand when an order is placed. 
When demand and lead time are known with certainty the ROL may be 
calculated exactly, i.e. RO L = demand in the lead time. 
 
 Test your understanding 3 – ROL  
 Using the data for Wolvo from TYU 2, assume that the entity adopts the 
EOQ as its order quantity and that it now takes two weeks for an order to 
be delivered. 
Calculate how frequently the enti ty will place an order? Calculate 
how much inventory it will have on hand when the order is placed? 
ROL with variable demand or variable lead time 
When there is uncertainty over dem and or lead time are known then the ROL 
will be calculated as maximum demand x maximum lead time . This will lead 
to the creation of buffer stock. 
 Buffer stock 
 Buffer stock is a quantity of inventor y that should not usually be needed, 
but that might be needed if actual demand during the supply lead time 
exceeds the average demand or if l ead times are longer than expected. 
Buffer stock has a cost. The annual cost  of holding buffer stock is the 
amount of the buffer stock multipli ed by the annual holding cost for one 
unit of the inventory item.

Chapter 17 
 393 
 Calculating buffer stock: 
 Units 
Reorder level* X 
(Maximum demand per day, in units × maximum re-order lead 
time)  
  
Average usage Y 
(Average demand per day, in units × average re-order lead 
time)  
  
Buffer Stock X – Y 
* note that this is the ROL when demand or lead time are uncertain. 
Where there is uncertainty, an optimum level of buffer stock (or inventory) 
must be found. 
This depends on: 
 variability of demand 
 cost of holding inventory 
 cost of stockouts 
You will not be required to perform this  calculation in the examination. 
 
 Inventory warning levels 
 Two warning levels might also be used,  to indicate when the quantity of 
an item in inventory is either: 
 higher than should be expected, or 
 below the buffer stock level. 
If the quantity of inventory goes above the maximum level or below the 
minimum level, the inventory ma nager should monitor the position 
carefully, and where appropriate take control measures. 
The maximum inventory level should be: 
 Reorder level 
 Plus reorder quantity 
 Minus [Minimum demand per day/w eek, in units] × [Minimum re-
order lead time]. 
The maximum inventory level will occu r when a new order has just been 
delivered by the supplier, the or der has been delivered within the 
minimum lead time, and demand has been at a minimum during the lead 
time.

394  
 The minimum inventory level  should be the buffer stock level: 
 Minus [Average demand per day/week, in units] × [Average re-order 
lead time]. 
 
 1 Identify which of the following is not a required assumption for the 
basic EOQ model? 
A The lead time is zero B There are no stock-outs C The demand is known and constant D The purchase price is const ant regardless of order quantity 
2 Monthly demand for a product is 10, 000 units. The purchase price is 
$10/unit and the entity's cost of  finance is 15% pa. Warehouse 
storage costs per unit pa are $2/uni t. The supplier charges $200 per 
order for delivery. Holding cost s should include the 15% finance 
costs. 
Calculate the EOQ. 
3 Doris uses component V22 in its construction process. The entity 
has a demand of 45,000 components pa. They cost $4.50 each. 
There is no lead time between order and delivery, and ordering 
costs amount to $100 per order. T he annual cost of holding one 
component in inventory is estimated to be $0.65. 
A 0.5% discount is available on or ders of at least 3,000 components 
and a 0.75% discount is availabl e if the order quantity is 6,000 
components or above. 
4 Using the information from question 3 calculate the total 
annual costs for the entity. 
5 Using the information from questions 3 and 4 calculate the cost 
of ordering 6,000 units and identi fy any savings that could be 
made. 
6 Using the data in question 3 and ignoring discounts, assume that 
the entity adopts the EOQ as its or der quantity and that it now takes 
three weeks for an order to be delivered. 
Calculate how frequently will the entity place an order. 
7 Using the data in question 6 cal culate how much inventory it 
will have on hand when the order is placed.

Chapter 17 
 395 
 8 Which ONE of the following woul d not normally be considered 
a cost of holding inventory?  
A Inventory obsolescence 
B Insurance cost of inventory C Interest cost of cash invested in inventory D Loss of sales from a stock-out. 
9 An entity uses the economic order quantity model (EOQ model). 
Demand for the entity's product is  36,000 units each year and is 
evenly distributed each day. The cost of placing an order is $10 and the cost of holding a unit of inventory for a year is $2. 
How many orders should the entity make in a year? 
A 60 
B 120 C 300 
D 600

396  
7 Summary Diagram

Chapter 17 
 397 
  
 Order quantity 
 400 units 500 units 600 units 
Average inventory 200 250 300 
No. of orders per annum 30 24 20 
 $ $ $ Holding cost –    
average inventory × $2.88 576 720 864 
  
Ordering cost –    no. of orders × $30 900 720 600 Total cost 1,476 1,440 1,464 
Therefore the best option is to order 500 units each time. 
Note that this is the point at which total cost is minimised and the holding 
costs and order costs are equal. 
Solution using the formula: 
 
C
O = 30 
D = 1,000 × 12 = 12,000  C
H = 2.88

398  
 Step 1 Calculate EOQ, ignoring discounts. 
 
CO = $200 
D = 30,000 units  C
H = $1.20 
 
Step 2 As this is below the level for discounts, calculate total annual 
inventory costs. 
Total annual costs for the entity will comprise holding costs plus re-
ordering costs. 
= (Average 
inventory × C H)  + (Number of re-
orders p.a. × C O)  
= 3,162   30,000  
 –––––– × $1.20 + –––––– × $200  2   3,162  
= $1,897.20 + $1,897.53 
= $3,794.73 
Step 3 Recalculate total annual inven tory costs using the order size 
required to just obtain the discount. 
At order quantity 5,000, total costs are as follows. 
= (Average 
inventory × C
H)  + (Number of re-
= 5,000   30,000  
 –––––– × $1.20 + –––––– × $200  2   5,000  
= $3,000 + $1,200 = $4,200

Chapter 17 
 399 
  $ 
Extra costs of ordering in batc hes of 5,000 (4,200 – 3,795) (405) 
Saving on discount 2% × $12 × 30,000 7,200 
 ––––– 
Step 4 Net saving 6,795 
 ––––– 
Hence batches of 5,000 are worthwhile.  
Step 3 (again) 
At order quality 7,500, to tal costs are as follows: 
= (Average 
= 7,500   30,000  
 –––––– × $1.20 + –––––– × $200  2   7,500  
= $4,500 + $800 
= $5,300 
Extra costs of ordering in batches  of 7,500 (5,300 – 4,200) (1,100) 
Saving on extra discount (2.5% – 2%) × $12 × 30,000) 1,800  ––––– 
Step 4 Net saving (again) 700 
 ––––– 
So a further cost saving can be made on orders of 7,500 units. 
Note:  If Step 1 produces an EOQ at which a discount would have been 
available, and the holding cost woul d be reduced by taking the discount, 
i.e. where CH is based on the purchas e price × the cost of finance, the 
EOQ must be recalculated using the new CH before the above steps are 
followed. 
Alternative approach 
An alternative approach is to compar e the total costs at each level and 
choose the lowest total cost as the bes t order level. The total cost will be 
made up of the total purchasing cost s, the holding cost s and the order 
costs as follows: 
Order size 3,162 5,000 7,500 
 $ $ $ 
Total purchase costs 
(30,000 barrels × $12 each) 360,000 360,000  360,000 
Discount nil (7,200) (9,000) 
Holding and order costs 3,795 4,200 5,300 
 ––––––– ––––––– ––––––– 
 363,795 357,000 356,300

400  
 (Note that many of the same calcula tions would be needed in order 
to complete this table) 
This confirms that the best order size would be 7,500 units. 
 
 Test your understanding 3 - ROL 
  Annual demand is 30,000. The origin al EOQ is 3,162. The entity will 
therefore place an order once every 
3,162 ÷ 30,000 × 365 days = 38 days 
 The entity must be sure that t here is sufficient inventory on hand 
when it places an order to last th e two weeks’ lead time. It must 
therefore place an order  when there is two weeks’ worth of demand 
in inventory: 
i.e. ROL is 2 ÷ 52 × 30,000 = 1,154 units 
 
 1 The correct answer is A. 
The EOQ model assumes a known and constant order lead time. 
The lead time does not have to be zero. 
2 The EOQ is 3,703 units 
 
CO = 200 
D = 10,000 × 12 = 120,000 C
H = (10 × 0.15) + 2 = 3.5 
 
3 EOQ = 3,721 units 
 
CO = 100  
D = 45,000  C
H = 0.65

Chapter 17 
 401 
 4 Total annual costs for the entity will comprise holding costs plus re-
= (Average inventory × C H) + (Number of re-orders pa × C O) 
 
= $2,419  
5 At order quantity 6,000, total costs are as follows. 
(6,000 × $0.65/2) + (45,000 × $100 ÷ 6,000) = $2,700 
A saving can be made on orders of 6,000 units as follows: 
 $ 
Extra costs of ordering in batches of (281) 
6,000 (2,700 – 2,419)  Less: Saving on extra discount  
(0.75% – 0.5%) × $4.5 × 45,000 506.25 
 ––––– Net cost saving 225.25 
 ––––– 
6 Annual demand is 45,000. The origin al EOQ is 3,721. The entity will 
3,721 ÷ 45,000 × 365 days = 30 days 
7 The entity must be sure that t here is sufficient inventory on hand 
when it places its order to last the three weeks lead time. It must therefore place an order  when there is three weeks work of demand 
in inventory, i.e. 3/52 × 45,000 = 2,596 units. 
8 D 
9 A  
 
CO = 10 
D = 36,000  C
H = 2 
 
Therefore, EOQ = 600 
If demand = 36,000 units per year and we  order in quantities of 600 
we will need to place 60 or ders per year (36,000/600).

403 
Management – Cash 
Control 
b Prepare forecasts c. Explain risks relating to 
  Chapter 
18

Working Capital Management – Cash Control 
404  
 
2 Reasons for holding cash 
Although cash needs to be invested to earn returns, businesses need to keep a 
certain amount readily available. The reasons include: 
 Transactions motive – cash required to meet day-to-day expenses, e.g. 
payroll, payment of suppliers, etc. 
 Precautionary motive – cash held to give a cushion against unplanned 
expenditure (the cash equival ent of buffer inventory). 
 Investment/speculative motive – cash kept available to take advantage of 
market investment opportunities. 
Failure to carry sufficient cash levels can lead to: 
 loss of settlement discounts 
 loss of supplier goodwill – trade suppliers refuse to offer further credit, 
charge higher prices or downgrade the priority with which orders are 
processed 
 poor industrial relations – if wages are not paid on time, industrial action 
may well result, damaging production in  the short-term and relationships 
and motivation in the medium-term 
 potential liquidation – a court may be petitioned to wind up the entity if it 
consistently fails to pay bills as they fall due.

Chapter 18 
 405 
3 Efficient cash management 
The amount of cash available to an entity at any given time is largely dependent 
on the efficiency with which cash flows are managed.  
The key principles of cash management are: 
 collect debts as quickly as possible 
 pay suppliers as late as possible 
 bank cash takings promptly 
Once again the firm faces a balancing act: 
 
 The main area associated with managing cash is the cash forecast and 
cash flow forecast. 
4 Cash forecasts/budgets  
 A cash forecast (sometimes referred to as a cash budget)  is an estimate 
of cash receipts and payments for a future period under existing 
conditions.

406  
Cash forecasts are used to: 
 assess and integr ate operating budgets 
 plan for cash shortages and surpluses 
 compare with actual spending. 
There are two different techniques t hat can be used to create a cash budget: 
 a receipts and payments forecast 
 a statement of financ ial position forecast 
Receipts and payments forecast 
This is a forecast of cash receipts  and payments based on predictions of sales 
and cost of sales. The timings of the ca sh flows will also need consideration to 
produce a reasonable forecast. 
 
 Preparing forecasts from pla nned receipts and payments 
 Every type of cash inflow and rece ipt, along with their timings, must be 
forecast. Note that cash receipts and payments differ from sales and cost 
of sales in the statement of profit or loss because: 
 not all cash receipts or payments affect the statement  of profit or 
loss, e.g. the issue of new shares  or the purchase of a non-current 
asset 
 some statement of profit or lo ss items are derived from accounting 
conventions and are not cash flow s, e.g. depreciation or the 
profit/loss on the sale of a non-current asset 
 the timing of cash receipts and payments does not coincide with the 
statement of prof it or loss accounting peri od, e.g. a sale made on 
credit 
 irrecoverable debts will never be received in cash and doubtful 
debts may not be received.. 
Approach to preparing a cash forecast: 
Step 1 – Prepare a pro-forma 
There is no definitive format that should be used for a cash forecast. 
However, whichever format you deci de to use, it should include the 
(i) A clear distinction between the cash receipts and cash payments for 
each control period. Your budget shoul d not consist of a jumble of 
cash flows. It should be logica lly arranged with a subtotal for 
receipts and a subtotal for payments. 
(ii) A figure for the net cash flow  for each period. Managers find that a 
figure for the net cash flow helps to  draw attention to the cash flow 
implications of their ac tions during the period.

Chapter 18 
 407 
 (iii) The closing cash balance for each period. The closing balance for 
each period will be the opening balance for the following period. 
The following is a typical format: 
 
Step 2 – Fill in the simple figures 
Some payments need only a small amount of work to identify the correct 
figure and timing and can be entered stra ight into the pro-forma. These 
would usually include: 
 wages and salaries 
 fixed overhead expenses 
 dividend payments 
Step 3 – Work out the more complex figures 
The information on sales and purchases can be more time consuming to 
deal with, e.g.: 
 timings for both sales and purchas es must be found from credit 
periods 
 variable overheads may require in formation about production levels 
 purchases may require calculations based on production schedules 
and inventory balances.

408  
 Test your understanding 1 – Forecast cash receipts 
 The forecast sales for an entity are as follows: 
 January February March April 
 $ $ $ $ 
Sales 6,000 8,000 4,000 5,000 
All sales are on credit and receivabl es tend to pay in the following 
pattern: 
 % 
In month of sale 10 
In month after sale 40 Two months after sale 45 
The entity expects the rate of  irrecoverable debts to be 5%. 
Calculate the forecast cash recei pts from receivables in April. 
 
 Test your understanding 2 – Forecast cash payments 
 A manufacturing business makes and se lls widgets. Each widget requires 
two units of raw materials, which cost $3 each. Production and sales 
quantities of widgets each month are as follows: 
Month Sales and 
production units 
December (actual) 50,000 
January (budget) 55,000 
February (budget) 60,000 March (budget) 65,000 
In the past, the business has maintained its inventories of raw materials 
at 100,000 units. However, it plans to increase raw material inventories to 
110,000 units at the end of January and 120,000 unit s at the end of 
February. The business takes one m onth’s credit from its suppliers. 
Calculate the forecast payments to suppliers for January, February 
and March for raw material purchases. 
 
 It is important to note candidates will not have to prepare a full cash flow 
forecast in your examination but ma y be asked to prepare any part of it. 
The following TYU enables practise of  the entire forecast to improve 
understanding. Exam questi ons will focus on sections of the forecast.

Chapter 18 
 409 
 Test your understanding 3 – Full cash flow forecast 
 The following budgeted statement of prof it or loss has been prepared for 
Quest entity for the four months January to April: 
Sales 60.0 50.0 70.0  60.0 
Cost of production 50.0 55.0 32.5  50.0 
(Increase)/decrease in 
inventory (5.0) (17.5) 20.0 (5.0) 
 ––––– ––––– ––––– ––––– 
Cost of sales 45.0 37.5 52.5  45.0 
Gross profit 15.0 12.5 17.5  15.0 Administration and 
selling overhead (8.0) (7.5) (8.5) (8.0) 
Profit before intere st 7.0 5.0 9.0 7.0 
The working papers provide the fo llowing additional information: 
 40% of the production cost relates to  direct materials. Materials are 
bought in the month prior to the month in whic h they are used. 50% 
of purchases are paid for in the month of purchase. The remainder 
are paid for one month later. 
 30% of the production cost relates to direct labour which is paid for 
when it is used. 
 The remainder of the producti on cost is production overhead. 
$5,000 per month is a fixed co st which includes $3,000 
depreciation. Fixed production overhead costs are paid monthly in arrears. The remaining overhead  is variable. The variable 
production overhead is paid 40% in the month of usage and the balance one month later. 
 The administration and selling cost s are paid quarterly in advance 
on 1 January, 1 April, 1 July and 1 October. The amount payable is 
$15,000 per quarter. 
 Trade payables on 1 January Year  5 are expected to be:  
– Direct materials: $10,000 
– Production overheads: $11,000 
 All sales are on credit. 20% of receivables are expected to be paid 
in the month of sale and 80% in the following month. Unpaid trade 
receivables at the beginni ng of January were $44,000.

410  
  The entity intends to purchase c apital equipment costing $30,000 in 
February which will be payable in March. 
 The bank balance on 1 January Year 5 is expected to be $5,000 
overdrawn. 
Required: 
Prepare a cash forecast for each of the months January to March Year 5 
for Quest. 
Preparing a cash forecast from a st atement of financial position  
This is a forecast derived from predict ions of future statement of financial 
positions. Predictions are m ade of all items except ca sh, which is then derived 
as a balancing figure. 
 
 Illustration 
 Used to predict the cash balance at  the end of a given period, this 
method will typically require forecasts of: 
 changes to non-current assets (acquisitions and disposals) 
 future inventory levels 
 future receivables levels 
 future payables levels 
 changes to share capital and other long-term funding (e.g. bank 
loans) 
 changes to retained profits. 
Example 
CBA is a manufacturing entity in the furniture trade. Its sales have risen 
sharply over the past six months as a result of an improvement in the 
economy and a strong housing market. The entity is now showing signs of ‘overtrading’ and the financial manager, Ms Smith, is concerned about 
its liquidity. The entity is  1 month from its year- end. Estimated figures for 
the full 12 months of t he current year and forecasts for next year, on 
present cash management policies, are shown below.

Chapter 18 
 411 
  Next year Current year 
 $000 $000 
Statement of prof it or loss   
Turnover 5,200 4,200 Less:   
Cost of sales (Note 1) 3,224 2,520 
Operating expenses 650 500  ––––– ––––– 
Operating profit 1,326 1,180 
Interest paid 54 48 Tax payable 305 283 
 ––––– ––––– 
Profit after tax 967 849  ––––– ––––– 
Dividends declared 387 339 Current assets and liabilities at year end:   
Inventory/work in progress 625 350 
Trade receivables 750 520 
Cash 0 25 Trade payables (464) (320) Other payables (incl. dividends) (692) (622) 
Overdraft (11) 0 
 ––––– ––––– Total equity and liabilities 208 (47) 
 ––––– ––––– Note 1:   
Cost of sales includes depreciation of 225 175 
Ms Smith is considering methods of  improving the cash position. A 
number of actions are being discussed: 
Offer a 2 per cent discount to customers who pay within 10 days of 
despatch of invoices. It is estimat ed that 50 per cent of customers will 
take advantage of the new discount sc heme. The other 50 per cent will 
continue to take the average credit period for next year. 
Trade payables and inventory 
Reduce the number of suppliers cu rrently being used and negotiate 
better terms with respec t to flexibility of delivery and lower purchase 
prices. The aim for next year will be to reduce the end-of-year forecast 
cost of sales (excluding depreciation) by 5 per cent and inventory/work in 
progress levels by 10 per cent. However, the number of days’ credit taken by the entity will have to fall to 30 days to help persuade suppliers to improve their prices.

412  
 Other information 
 All sales are on credit. Official terms of sale at present require 
payment within 30 days. Interest is  not charged on late payments. 
 All purchases are made on credit. 
 Operating expenses for next y ear will be $650,000 under either the 
existing or proposed policies. 
 Tax and interest payments are paid in  the year in which they arise. 
 Dividends are paid in the year  after they are declared. 
 Capital expenditure of $550,000 is planned for next year. 
Required: 
(a) Provide a cash flow forecast for next year, assuming: 
(i) the entity does not  change its policies and 
(ii) the entity’s proposals for managing trade receivables, trade 
payables and inventory are implemented. 
In both cases, assume a full twelve-month period, i.e. the changes 
will be effective from day 1 of next year. 
(b) As assistant to Ms Smith, writ e a short report to her evaluating the 
proposed actions. Include comments on the factors, financial and 
non-financial, that the entity s hould take into account before 
implementing the new policies. 
Solution 
(a) All figures in $000s 
 No change With change 
Profit from oper ations 1,326 1,424 
+ depreciation 225 225 
+/– change in trade receivables –230 72 
+/– change in trade payables 144 –86  ––––– ––––– 
Operating profit 1,465 1,635 
Interest paid –54 –48 
Tax paid –305 –305 
Dividends declared –339 –339 Investing activities   
Non-current assets –550 –550 
Inventory –275 –212  ––––– ––––– 
Net cash flow –58 181 
Opening balance 25 25  ––––– ––––– 
Closing balance –33 206 
 ––––– –––––

Chapter 18 
 413 
 Changes implemented 
1 Profit from operations 
Turnover 5200 
Less discounts –52 
Cost of sales –3,074 
(3,224 – 225) × 95% + 225)  Operating expenses  (unchanged) –650 
 –––––– 
Profit 1,424  –––––– 
2
 Change in current assets  
Decrease in trade receivables 
= 520 – [(2,600/365 × 53*) + (2,600/365 × 10*)] = 72  
Decrease in trade payables = [320 – (2,849**/365 × 30)] = 86 Change in inventory = 350 – (625 × 90%) = 212 * Forecast receivables = 750/5,20 0 × 365 = 53, reduces to 10 days 
for 50% of turnover 
** Forecast payables = 3,224 – 225 = 2,999, these reduce by 5% to 
2,849. 
(b) Report 
To: Ms Smith From: Assistant Subject: Proposed working capital policy changes The answer should be set out in report format and include the 
following key points: 
– Comment that cash flow is improved by almost a quarter of a 
million pounds if the pr oposed changes are made. 
– Problems appear to have arisen because trade receivables 
and inventory control have not  been adequate for increased 
levels of turnover. 
– Liquidity: current ratio was 0. 95:1 (all current assets to trade 
and other payables), will be aroun d 1.2:1 under both options. 
Perversely, ratio looks to impr ove even if the entity takes no 
action and causes an overdraft. This is because of high receivables and inventory levels. Moral: high current assets do not mean high cash. Cash ratio perhaps a better measure.

414  
 – Receivables’ days last year was 45, forecast to rise to 53 on 
current policies despite ‘official ’ terms being 30. Entity could 
perhaps look to improve its cr edit control before offering 
discounts. 
– Trade payables’ days were 46, fo recast to rise to 52. Are 
discounts being ignored? Are relationships with suppliers being threatened?* 
– Dramatic increase in inventor y levels forecast: 50 days last 
year, 71 days forecast this year. If change implemented, 
inventory will still be 67 days.* 
– Operating profit percentage fore cast to fall to 25.5% from 
28.1% if no changes made. Perc entage will fall to 27.4% if 
changes implemented; a fall probably acceptable if cash flow improved and overdraft interest saved. 
– Non-financial factors include relationships with customers and 
– Other financial factors, is in crease in turnover sustainable?  
*Using cost of sales figures including depreciation. 
Interpretation of a cash forecast  
Examples of factors to consider when interpreting a cash forecast include: 
 Is the balance at the end of the period acceptabl e/matching expectations? 
 Does the cash balance become a defic it at any time in the period? 
 Is there sufficient finance (e.g. an ov erdraft) to cover any cash deficits? 
Should new sources of finance be sought in advance? 
 What are the key causes of cash deficits? 
 Can/should discretiona ry expenditure (such as asset purchases) be made 
in another period in order to stabilise the pattern of cash flows? 
 Is there a plan for dealing with cash surpluses (such as reinvesting them 
elsewhere)? 
 When is the best time to make discretionary expenditure?

Chapter 18 
 415 
 If we were to examine the cash forecast in TYU 3, the following issues 
might be brought to management's attention: 
This cash forecast forewarns the management of the business that their 
plans will lead to a cash deficit of $16,650 at the end of March. They can 
also see that it will be a short-te rm deficit and can take appropriate 
action. 
They may decide to delay the purchase of the capital equipment for one 
month in order to allow the cash posi tion to move to a positive one before 
the investment is made. Alternativ ely, an extension of the overdraft 
facilities may be arranged fo r the appropriate period. 
If it is decided that overdraft facilities are to be arranged, it is important 
that due account is taken of the timing of the receipts and payments within each month. 
For example, all of the payment s in January may be made at the 
beginning of the month but receipts may not be expected until nearer the 
end of the month. The cash deficit  could then be considerably greater 
than it appears from looking on ly at the month-end balance. 
If the worst possible situation aros e, the overdrawn balance during 
January could become as large as $5,000 (Opening balance) minus $66,000 (January payments) = $71,000 before the receip ts begin to arise. 
If management had used the month-end balances as a guide to the 
overdraft requirement during the period then they would not have 
arranged a large enough overdraft facilit y with the bank. It is important, 
therefore, that they look  in detail at the informat ion revealed by the cash 
forecast, and not simply at the closing cash balances. 
5 Using spreadsheets in cash forecasting 
Many businesses prepare cash forecasts and cash forecasts using a computer 
and spreadsheet software such as Excel®. 
Spreadsheets are useful for cash fore casting for several important reasons: 
 They save time  in preparing forecasts. When the basic ‘model’ has been 
constructed, it is a relatively simple  task to insert figures into the model, 
and leave it to the model to produce the completed forecast. The model, 
once established, can then be used whenever a new forecast is required. 
 They are extremely useful for sensitivity analysis . When there is 
uncertainty in the forecast, the a ssumptions for the forecast can be 
changed and an alternative forecast pr oduced. This allows management 
to consider a range of different po ssible outcomes, without needing much 
time or effort.

416  
 Cash flow forecasts can be consolidated . For example, if the same 
spreadsheet model is used to prepare ca sh forecasts for each division or 
region in the entity, a spreadsheet m odel can also automatically produce a 
consolidated cash flow foreca st for the entity as a whole. 
 
 Sensitivity analysis 
When budgets are prepar ed, there are a very large number of 
assumptions and estimates, for exampl e the estimated sales each month, 
the estimates of costs, assumptions about when receivables will pay and when suppliers will be paid, and so on. Any of these estimates and 
assumptions could turn out to be inaccurate. 
One of the enormous benef its of using spreadsheet s to prepare a cash 
forecast is that it is very easy to carry out sensitivity analysis. 
Sensitivity analysis involves asking 'What if...?' questions, and finding out 
by how much the expected results will c hange if some of the forecasts or 
assumptions are altered. 
For example, what if sales are 10% le ss than predicted, or what if capital 
expenditure is double the amount forecast? Depending on what the 
results of the analysis show, management  might decide to take action to 
reduce the potential risks. 
Consolidation 
As well as being of assistance in preparing cash flow forecasts for 
individual business units, a comput erised spreadsheet package may also 
be used to consolidate individual forecasts into one overall forecast for the organisation as a whole. 
Individual forecasts may be prepared by: 
 the various group entities 
 individual operating units, e.g. branches  of a retail store 
 individual cost centres, e.g. st ores, purchasing, production, service 
centres 
 individual budget holders, e.g. marketing. 
If all the individual forecasts are prepared using the sa me spreadsheet 
software, it will be possible for these to be uploaded to a central 
computer, programmed to produc e a consolidated forecast.

Chapter 18 
 417 
6 Measures to improve a cash forecast situation 
 Introduction 
 An initial cash forecast might predict an unsatisfactory cash flow situation. 
The forecast might indicate that t he entity will have a cash deficit that 
cannot be met by existing short-term borrowing arrangements, such as a bank overdraft facility. 
When this situation occurs, action will need to be taken to manage future 
cash flows in order to improve the fo recast position. The nature of this 
management action will depend upon the answers to the following questions: 
 Does the forecast indicate a continuing trend of an increasing 
surplus or an increasing cash def icit, or do net monthly balances 
move between surplus and deficit on a seasonal basis? 
 What size of cash surpluses are forecast (if any) and for how long 
will they be available? 
 Are the forecast cash deficits wit hin the current overdraft facility? 
 Which cash flows are to some extent  discretionary, either in size or 
timing? 
Cash deficits can arise from: 
 Basic trading factors under lying the business, such as falling sales 
or increasing costs. To correct these, normal business measures 
need to be taken. Sales may be improved by increased marketing activity or revised pricing policies.  Cost cutting exercises may also 
be necessary. 
 Short-term deficiencie s in the working capital cycle, such as an 
exceptionally long average holding period for inventory or a long 
average time to pay by credit customers. 
Possible decisions that could be taken to  deal with forecast short-term cash 
deficits include: 
 additional short-term borrowing 
 negotiating a higher overdraft limit with the bank 
 the sale of short-term inve stments, if t he entity has any 
 using different forms of financing to reduce cash flows in the short term, 
such as leasing instead of buying outright 
 changing the amount of discretionary ca sh flows, deferring expenditures or 
bringing forward revenues. For example: 
– reducing the dividend to shareholders – postponing non-essential capital expenditure

418  
– bringing forward the planned disposal of non-current assets 
– reducing inventory levels, perhap s incorporating ‘just-in-time’ 
techniques (although this will take time to implement) 
– shortening the operating cycle by r educing the time taken to collect 
receivables, perhaps by offering a discount or using a factor or invoice discounting. 
– shortening the operating cycle by  delaying payment to payables. 
 
 Cash surpluses 
 If the forecast shows cash surpluses,  these will be dealt with according to 
their size and duration. Management should consider a policy for how surplus cash should be invested so as  to achieve a return on the money, 
but without investing in items wher e the risk of a fall in value is 
considered too high. The interest or  other return earned can be used to 
improve the overall cash position. Care must be taken to ensure these 
investments can be realised as needed, to fund forecast deficits. 
Where long-term cash surpluses are forecast, management might 
consider other possible uses of the surpluses, such as paying a higher 
dividend or repaying loans and other debts. 
 
 1 A business has estimated that 10% of its sales will be cash sales, 
and the remainder credit sales. It is also estimated that 50% of 
credit customers will pay in the month following sale, 30% two months after sale and 15% th ree months after sale and 
irrecoverable debts will be 5% of credit sales. 
Total sales figures are as follows: 
Month $ 
October 80,000 November 60,000 
December 40,000 
January 50,000 February 60,000 
March 90,000 
Required: 
Prepare a month-by-month budget of cash receipts from sales for 
the months January to March.

Chapter 18 
 419 
 2 Winters expects 75% of sales to be collected in the month of sale, 
20% in the month following and 5% to be irrecoverable debts. At 
31 December 20X4, $50,000 of December’s sales are still outstanding receivables. 
Identify receipts in January from sales in December: 
A 10,000 
B 20,000 C 37,500 D 40,000 
3 An entity sells a range of se rvices, all on credit. Customers on 
average pay as follows: 
 % 
In month after sale 30 
Two months after sale 65 
The organisation expects an irreco verable debt rate of 5%. 
At 1 January Year 2, opening trade receivables were $322,200, 
before deducting any allowance for doubtful debts. Sales in December Year 1 were $213,000. 
Required: 
Calculate the receipts from the o pening trade receivables in January 
Year 2 and in February Year 2 
4 You are given the following budge ted information about an entity: 
 January February March 
Opening inventory in units 100 150 120 
Closing inventory in units 150 120 180 Sales in units 400 450 420 
The cost of materials is $2 per unit. 40% of purchases are paid for 
immediately in cash. 60% of purchases are on credit and are paid 
two months after the purchase. 
Required: 
Calculate the budgeted payments in March for purchases of 
materials. 
5 Identify which of the following is unsuitable as a cash flow to be 
deferred to avoid a tem porary cash shortage: 
A Replacement of office furniture B Investment in a short-term cash deposit C Investment in a long-term strategic expansion D Dividend payment (deferral agreed by the shareholders)

420  

Chapter 18 
 421 
  
Cash from:  $ 
April sales: 10% × $5,000 500 March sales: 40% × $4,000 1,600 
February sales: 45% × $8,000 3,600 
  –––––   5,700 
 
 When inventories of raw material s are increased, the quantities 
purchased will exceed the quantities consumed in the period. 
Figures for December are shown because December purchases will be 
paid for in January, which is in the budget period. 
Quantity of raw material purchased in units: 
 Units of 
widgets 
produced December January February March 
 Units Units Units Units Units 
December 50,000 100,000    
January 55,000  110,000   
February 60,000   120,000  March 65,000    130,000 
Increase in      
inventories  – 10,000 10,000 –  ––––––– ––––––– ––––––– ––––––– 
Total purchase 
quantities 100,000 120,000 130,000 130,000 
 ––––––– ––––––– ––––––– ––––––– 
At $3 per unit 300,000 360,000 390,000 390,000 
Having established the purchases eac h month, we can go on to budget 
the amount of cash payments to suppliers each month. Here, the 
business will take one month’s credit. 
 $ $ $ 
Payment to suppliers 300,000 360,000 390,000 
At the end of March, t here will be payables of $390,000 for raw materials 
purchased, which will be paid in April.

422  
 We can take each item of cash flow in turn, and use workings tables to 
calculate what the monthly cash flows are. 
(W1) Cash from sales 
 Total 
sales Cash 
receipts January Cash 
receipts 
February Cash 
receipts 
March 
 $ $ $ $ Opening 
receivables  44,000 – – 
January 60,000 12, 000 48,000 – 
February 50,000 – 10,000 40,000 
March 70,000 – – 14,000   –––––– –––––– –––––– 
  56,000 58,000 54,000 
  –––––– –––––– –––––– 
(W2) Payments for materials purchases 
Material purchases are made in t he month prior to  the month in 
which they are used, so the starti ng point for working out materials 
purchases and payments for the pur chases is the production costs 
in each month. 
 $ $ $ $ 
Total cost of 
production 50,000 55,000 32 ,500 50,000 
Material cost of 
production (40%) 20,000 22,000 13 ,000 20,000 
Purchases in the 
month 22,000 13,000 20,000 unknown 
Payments are made 50% in the mont h of purchase and 50% in the 
following month. The trade payables at 1 January will all be paid in January, since these represent 50% of material purchases in 
December.

Chapter 18 
 423 
  Purchases January February March 
 $ $ $ $ 
Opening payables 
for materials  10,000   
January 22,000 11, 000 11,000 – 
February 13,000 – 6,500 6,500 
March 20,000 – –10,000  
       –––––– –––––– –––––– 
Total payments  21, 000 17,500 16,500 
(W3) Payments for overheads 
In this example, we have to separ ate fixed and variable overheads. 
Total overhead costs are 30% of production costs (100% – 40% 
direct materials – 30% direct labour). 
 $ $ $ 
production 50,000 55,000 32,500 
Overhead cost of 
production (30%) 15,000 16,500 9,750 
Fixed costs (5,000) (5,000) (5,000) 
 –––––– –––––– ––––– Variable overhead cost s 10,000 11,500 4,750 
 –––––– –––––– ––––– 
Of the monthly fixed overhead costs of $5,000, $3,000 is 
depreciation which is not a cash expenditure. Mont hly fixed cost 
cash expenditure is therefore $2,000. 
The opening balance of unpaid overhead costs at the beginning of 
January must consist of $2,000 fi xed overheads and $9,000 (the 
balance) variable overheads. All these costs should be paid for in January. Variable overheads are paid 40% in the month of expenditure and 60% t he following month. 
 Cost January February March 
Fixed overheads $ $ $ $ Opening payables for 
fixed overheads  2,000   
January 2,000 – 2,000 – 
February 2,000 – – 2,000 
March 2,000 –   
  ––––– –––––– ––––– Total payments  2,000 2,000 2,000 
  ––––– –––––– –––––

424  
  Cost January February March 
Variable overheads $ $ $ $ 
Opening payables for 
variable overheads  9,000   
January 10,000 4,000 6,000 – 
February 11,500 – 4,600 6,900 
March 4,750 – – 1,900 
Total payments  13,000 10,600 8,800 
The other items of cash flow ar e straightforward, although it is 
important to notice that  the payments for administration and selling 
overheads are paid quarterly, and the cash payment ($15,000) is 
not the same as the total overhe ad cost for the quarter. Presumably 
there are depreciation charges within the total costs given. 
Payments for direct labour are 30% of  direct labour costs (= 30% of 
production costs) in the month. 
The cash forecast can be prepared as follows: 
Receipts $ $ $ 
From sales 56,000  58,000 54,000 
Payments    
Capital expenditure – – 30,000 
For direct materials 21,000 17,500 16,500 
For direct labour (30% × prod'n 
cost) 15,000 16,500 9,750 
For fixed production overheads 2,000 2,000 2,000 
For variable production ov erheads 13,000 10,600 8,800 
For admin/selling overhead 15,000 – – 
 –––––– –––––– –––––– Total outflow 66,000 46,600 67,050 
 –––––– –––––– –––––– 
Net cash flow for month (10,000) 11,400 (13,050) 
Opening balance (5,000) (15,000) (3,600) 
Closing balance (15,000) (3,600) (16,650) 
Analysis 
The entity will be overdrawn thr oughout the three-month period, 
therefore it is essent ial that it should have access to borrowings to 
cover the shortfall. The bank might already have agreed an overdraft facility, but this shoul d be at least $16,650 and ideally 
higher, to allow for the possibility t hat the actual cash flows will be 
even worse than budgeted.

Chapter 18 
 425 
 1 The cash forecast is as follows: 
Sales 
month Total sales Cash 
receipts Cash 
receipts 
  January February March 
 $ $ $ $ 
October 80,000 10,800 – – 
November 60,000 16,200 8,100 – December 40,000 18,000 10,800 5,400 
January 50,000 5,000 22,500 13,500 
February 60,000 – 6,000 27,000 March 90,000 – – 9,000 
  –––––– –––––– –––––– Total receipts 50,000 47,400 54,900 
$50,000 represents 25% of Decem ber sales (100% – 75%).  
Total sales in December were therefore $5,000/25% = $200,000. 
Expected amount to be received in January = 20% × $200,000 = 
$40,000. 
3 The trade receivables at the begi nning of January Year 2 represent 
100% of sales in December Year  1 and the unpaid receivables for 
sales in November Year 1. T hey can be analysed as follows: 
 $ 
Total trade receivables 322,200 
Consisting of:  
100% of sales for December Year 1 (213,000)  –––––––– 
Unpaid amounts for sales in  November Year 1 109,200 
 –––––––– 
The unpaid amounts from November Year 1 represent 70% of total 
sales in that month, because 30% pay in the month following sale 
(December Year 1). 
It therefore follows that total sa les in November Year 1 were 
$109,200/70% = $156,000.

426  
 Sales 
month Total sales Cash receipts 
January Cash receipts 
February 
 $ $ $ November 156,000 65% 101,400 – December 213,000 30 % 63,900 65% 138,450 
  ––––––– ––––––– 
  165,300 138,450   ––––––– ––––––– 
4 The budget will be as follows: 
Purchases January 
units February 
units March 
units 
Sales quantity 400 450 420 Less: opening inventory (100) (150) (120) Add: closing inventory 150 120 180 
 –––– –––– –––– 
Production in units = 
units purchased 450 420 480 
Cost of purchase @ 
$2 per unit $900 $840 $960 
 
Payments in March  $ 
For January purchases (60% of $900) 540 
For March purchases (40% of $960) 384 
  –––– Total payments for materials 924 
  –––– 
5 The correct answer is B. 
A short-term deposit is a cash equivalent. Deferring the transfer of 
cash to a short-term deposit wi ll not deal with the problem of a 
temporary cash shortage, because  it will usually be possible to 
withdraw the cash from deposit on dem and, for the loss of some or 
all of the interest.

428  
The Board (2016) The Conceptual Framework for Financial Reporting . London: 
The Board (2016) IAS 1 Presentation of Financial Reporting . London: IFRS 
Foundation. 
The Board (2016) IAS 2 Inventories . London: IFRS Foundation. 
The Board (2016) IAS 7 Statement of Cash Flows . London: IFRS Foundation. 
The Board (2016) IAS 10 Events after the Reporting Period . London: IFRS 
The Board (2016) IAS 16 Property, Plant and Equipment . London: IFRS 
The Board (2016) IAS 36 Impairment of  Assets. London: IFRS Foundation.  
The Board (2016) IFRS 5 Non-current Assets Held for Sale and Discontinued 
Operations . London: IFRS Foundation. 
The Board (2016) IFRS 16 Leases . London: IFRS Foundation.

Index 
 I.1 
A 
A bill of exchange....296 
Accounting 
profit....20 receivable – fa ctoring....355 
receivable – invoic e discounting....359 
receivable....342 
Accruals basis....146 
Actual incidence....4 Ad valorem taxes....7 Adjusting events....243 Advocacy threats....86 Age analysis....366 
Aggressive approach....318 
Appropriations of profit....36 Assets....124, 125 Average cost....239 
B 
Balancing 
allowance....25 
charge....25 
Bank deposit accounts....300 
Bills of exchange....303 Branch....56 
C 
Capital 
losses....32, 35 
maintenance....131 
tax gains....29 
taxes....6, 29 
Carrying amount....169 
Cascade tax....8 
Cash....253 
Control....403 equivalents....253 
flow versus profit....313 
forecast....405 
Cash-generati ng units....190 
Certificate of Deposit....302 CGMA code....82 Changes in residual value....177 Changes in useful life....177 
CIMA's code of ethics....84 
Classical system....36 Commercial paper (CP)....304 Committees....109 Comparability....121 Comparative information....147 
Competent jurisdiction....4 
Completeness....121 Confidentiality....84 Conservative 
approach....318 
policy....318 
Consistency....146 
Consumption taxes....8 Contents of financial statements....144 
Corporate 
bonds....304 Governance....95 
income tax....12 
residence....54 
Cost....169 
of conversion....237 of financing receivables....352 
of purchase....237 
Credit policy....343 
Current 
assets....152 cost....128 
liabilities....152 
D 
Depreciable amount....169 
Depreciation....21, 169, 175 
Direct method....257 Direct taxes....3, 6 Disallowable expenses....21 Disposal of revalued assets....186 
Diversification....300 
Documentary credits....296 
Double taxation....55 
relief....55 
E 
Early settlement discounts....353 
Economic order quantity (EOQ)....381 Employee tax....12 Employee taxation....10 
Enhancing qualit ative characteristics....120 
Enron....97 Equity....124, 126 Ethical threats....85 Evaluating a change in  credit policy....353 
Excise duties....7 
Exempt....9 Expenses....124 Export factoring....297 
F 
Factoring....294 
Fair 
presentation....145 
value....169 
Faithful repres entation....120

Index 
I.2  
Familiarity threats....85 
Financial capital maintenance....132 
Financing 
activities....253, 264 
exports....296 
First in first out (FIFO)....239 
Fixed production overheads....237 
Foreign tax....56 
Forfaiting....297 
Formal incidence....4 Free from error....121 Fundamental qualitative characteristics....120 
G 
GAAP....67 
Going concern....146, 244 Good tax....2, 3 Group loss relief....35 
H 
Higher Rated....9 
Historical cost....127 
accounting....128 
Hypothecation....4 
I 
IAS 1 Presentation of Financial 
Statements....144, 151 
IAS 10 Events After the Reporting Period....151, 
242 
IAS 16 Property, Plant And Equipment....169 
IAS 2 Inventories....236 IAS 36 Impairment of Assets....189 IAS 7 Statement of Cashflows....251 IFRS 13 Fair Value Measurement....178 
IFRS 5 Non-current Assets Held for Sale and 
Discontinued O perations....204 
IFRS Advisory  Council....71 
IFRS Foundation....71 IFRS Interpretati ons Committee....72 
IIRC....72 
Impairment loss....169 Imputation system....36 Incidence....4 Income....124 Indirect 
method....255 
taxes....3, 7 
Initial recogn ition....170 
Integrity....84 Interest earned....301 Interest-bearing accounts....300 Internal audit....109 
International Accounting Standards Board 
(IASB)....71 
International integrated reporting council 
(IIRC)....72 
International Organisation of Securities 
Commissions (IOSCO)....72 
International taxation....54 
Intimidation threats....86 Inventory Control....377 Investing activities....253, 263 
criteria....298 in working capital....316 
yield....302 
Investment/speculative motive....404 
Invoice discounting....295, 359 
L 
Lease liability....217 
tables....219 
term....217 
Leases....216 
Lessee accounting....216 Lessee....216 
Lessor....216 
Liabilities....124, 125 Liquidity v profitability....312 Liquidity....300 Low value assets leases....223 
M 
Material items....157 Materiality and aggregation....147 
Materiality....120 Maturity....299 
Moderate policy....318 
Money market deposits....300 
Multi-stage sales tax....8 
N 
Negotiable instruments....301 
Neutrality....121 
Non-adjusting events....243 Non-current assets held for sale....205 
O 
Objectives of financ ial statements....119 
Objectivity....84 OECD model tax convention....59 Off-setting....147 Operating activities....253

Index 
 I.3 
Other short-term investments....304 
Overseas subsidiaries....12 Overtrading....319 
P 
Partial imputat ion system....36 
Pay-As-You-Earn (PAYE)....11 
Payment of tax....13 Power of tax authorities....13 Precautionary motive....404 Present value....128 Principles-based ap proach....68, 100 
Professional behaviour....84 
Professional competence and due care....84 Profitability versus liquidity....313 Progressive taxes....5 Property taxes....8 
Proportional taxes....5 
Purpose of financ ial statements....144 
Q 
Qualitative characteristics of financial 
statements....120 
Quantity discounts....385 
R 
Realisable (settlement) value....128 Receipts and payments forecast....406 
Re-characteris ing debt....36 
Record-keeping....12 Recoverable amount....169 Regressive taxes....5 
Relevance....120 
Re-order level (ROL)....392 Re-order/setup costs....380 Residual value....170 Return....299 Revaluations....178 
Right-of-use asset....216, 217, 220 
Risk....299 Rollover relief....34 Rules-based approach....68, 100, 101 
S 
Safeguards....86 Sales tax....12 Segregation of  Roles....109 
Self-interest threats....85 Self-review threats....85 
Sensitivity a nalysis....416 
Short-dated government bonds....304 Short-life and low value assets leases....223 
Short-term 
borrowing....295 
finance....292 
investments....298 
Single stage taxes....8 
Source of tax rules....5 
Split rate system....36 Standard Rated....9 
Statement of 
cash flows....252 
changes in equity....152 
Profit or Loss and other Comprehensive Income....155 
Stockout....380 
Subsequent expenditure....170 
Subsidiary....55 
T 
Tax 
avoidance....13 consolidation....35 
depreciation....21 
evasion....13 
gap....5 
on trading income....6, 20 
rate structure....5 
Taxable person....4 
The Conceptual Framework....133 The elements of financ ial statements....124 
The elements of wo rking capital....310 
The Framework....118 The IFRS Interpretations Committee....133 The regulatory environment....66 The revaluatio n model....207 
The statement of financial position....148 The traditional approach to working capital 
funding....319 
The working capita l cycle....314, 327 
Timeliness....122 
Trade credit....364 
Trade payables....293, 365 
days....325 
Trade receivables....294 
Trading losses....27 
Transactions motive....404 
Transfer pricing....59 
Treasury bills....303 
U 
Underlying tax....56 
Understandability....122 
Unit taxes....7 
Useful life....170

Index 
I.4  
V 
Value added tax (VAT)....9 
Variable production overheads....237 VAT payable....9 VAT registration....10 Verifiability....122 
W 
Wealth taxes....8 Weighted average cost....239 Withholding tax....56 
Management....309, 311 ratios....320 
Z 
Zero Rated....9

CIMA 
 
Subject F2 
 
Advanced Financial 
Reporting 
 
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P.3 
Contents 
  Page 
Chapter 1 Long term finance 1 
Chapter 2 Cost of capital 23 
Chapter 3 Financial instruments 49 
Chapter 4 Earnings per share 97 
Chapter 5 Leases 123 
Chapter 6 Revenue from contracts  with customers 137 
Chapter 7 Provisions, contingent lia bilities and contingent 
assets 175 
Chapter 8 Intangible assets 197 
Chapter 9 Income taxes 217 
Chapter 10 Foreign currency transactions 237 
Chapter 11 Group accounts – Subsidiaries (CSOFP) 251 
Chapter 12 Group accounts – Subsidiaries (CSPLOCI) 309 
Chapter 13 Group accounts – Associates and joint 
arrangements 337 
Chapter 14 Consolidated statement o f changes in equity 355 
Chapter 15 Consolidated statement of cash flows 375 
Chapter 16 Foreign subsidiaries 405 
Chapter 17 Related party disclosures 439 
Chapter 18 Integrated reporting 451 
Chapter 19 Analysis of financia l statements 463 
Chapter 20 References 527 
Index  I.1

P.5 
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many cases knowledge is cumula tive: if you fail to digest earli er material 
thoroughly, you may struggle to  understand later chapters. 
• Activities.  Some chapters are illustrated by  more practical elements, such  
as comments and questions desi gned to stimulate discussion. 
• Question practice.  The text contains thr ee styles of question: 
– Exam­style objective test questions (OTQs). – ‘Integration’ questions – thes e test your ability to understa nd topics 
within a wider context. This is par ticularly important with cal culations 
where OTQs may focus on just o ne element but an integration 
question tackles the full calculat ion, just as you would be exp ected to 

P.7 
– ‘Case’ style questions – these test your ability to analyse a nd discuss 
issues in greater depth, particu larly focusing on scenarios tha t are 
less clear cut than in the objecti ve tests, and thus provide ex cellent 
• Solutions.  Avoid the temptation merely to  ‘audit’ the solutions provided.  It 
is an illusion to think that th is provides the same benefits as  you would 
gain from a serious attempt of y our own. However, if you are st ruggling to 
get started on a question you shoul d read the introductory guid ance 
provided at the beginning of the so lution, where provided, and then make 
If you work conscientiously through  this Official CIMA Study Te xt according to 
the guidelines above y ou will be giving your self an excellent c hance of success 
in your objective tests. G ood luck with your studies! 
Quality and accuracy ar e of the utmost importance to us so if y ou spot an error 
in any of our products, please s end an email to mykaplanreporti ng@kaplan.com 
with full details, or follow the link to the feedback form in M yKaplan. 
Our Quality Co­ordi nator will work with our  technical team to v erify the error and 
take action to ensure it is corrected in fu ture editions. 
must be understood and reproduced in an asse ssment environment.  
 
examined. 
 
reading. It is vital to provide y ou with the breadth of knowled ge you will 
need to address the wide range of t opics within your syllabus t hat could 
feature in an assessment question. Reference to this text is vital when 
self­studying.  
 
exercises which give the oppor tunity to assess the understandin g of these 
 
 Illustration  – To help develop an understandi ng of particular topics. The 
illustrative examples are usefu l in preparing for the Test your  

P.8  
 Exclamation mark  – This symbol signifies a  topic which can be more 
difficult to understand. When reviewing these areas, care shoul d be taken. 
 
 New – Identifies topics that are br and new in subjects that build on, and 
 
 Tutorial note  – Included to explain some of t he technical points in more 
detail. 
Passing exams is partly a matter  of intellectual ability, but h owever 
accomplished you are in that res pect you can improve your chanc es 
significantly by the use of appr opriate study and revision tech niques. In this 
section we briefly outline some  tips for effective study during  the earlier stages 
of your approach to the objective  tests. We also mention some t echniques that 
you will find useful at the revision stage. 
Planning 
To begin with, formal planning is essential to get the best ret urn from the time 
you spend studying. Estimate how m uch time in total you are goi ng to need for 
each subject you are studying . Remember that you need to allow time for 
study in each week, and which w eeks you will devote to revision  and final 
question practice. 
Prepare a written schedule summar ising the above and stick to i t! 
It is essential to know your syllabus. As your studies progress  you will become 
more familiar with how long it take s to cover topics in suffici ent depth. Your 
timetable may need to be adapted  to allocate enough time for th e whole 
syllabus. 
Students are advised to refer to the examinati on blueprints (se e page P.13 for 
further information) and the CI MA website, www.cimaglobal.com, to ensure they 
are up­to­date. 
The amount of space allocated to  a topic in the Study Text is n ot a very good 
guide as to how long it will take  you. The syllabus weighting i s the better guide 
as to how long you should spend on a syllabus topic.

P.9 
(1) Aim to find a quiet and undist urbed location for your study , and plan as far 
as possible to use the same per iod of time each day. Getting in to a routine 
helps to avoid wasting  time. Make sure that you have all the ma terials you 
(2) Store all your materials i n one place, so that you do not w aste time 
searching for items every time  you want to begin studying. If y ou have to 
pack everything away after each study period, keep your study m aterials 
in a box, or even a suitcase, whi ch will not be disturbed until  the next time. 
(3) Limit distractions. To make t he most effective use of your study periods 
you should be able to apply tota l concentration, so turn off al l 
entertainment equipment, set your phones to message mode, and p ut up 
your ‘do not disturb’ sign. 
(4) Your timetable will tell you which topic to study. However,  before diving in 
and becoming engrossed in the finer  points, make sure you have an 
overall picture of all the areas  that need to be covered by the  end of that 
session. After an hour, allow your self a short break and move a way from 
your Study Text. With experienc e, you will learn to assess the pace you 
need to work at. Each study se ssion should focus on component l earning 
(5) Work carefully through a c hapter, making notes as you go. W hen you 
have covered a suitable amount of m aterial, vary the pattern by  attempting 
a practice question. When you have  finished your attempt, make notes of 
any mistakes you made, or any areas that you failed to cover or  covered 
more briefly. Be aware that a ll component learning outcomes wil l be tested 
(6) Make notes as you study, and discover the techniques that w ork best for 
you. Your notes may be in the form of lists, bullet points, dia grams, 
summaries, ‘mind maps’, or the wr itten word, but remember that you will 
need to refer back to them at a lat er date, so they must be int elligible. If 
you are on a taught course, make sure you highlight any issues you would 
like to follow up with your lecturer. 
(7) Organise your notes. Make sur e that all your notes, calcula tions etc. can 

P.10   
students move through individual  topics within a subject; and h ow quickly they 
move from one course to the next . We know that there is an opti mum for both, 
but it can vary from subject to subject and from student to stu dent. However, 
using data and our experience of  student performance over many years, we can 
A fixed period of study set out a t the start of a course with k ey milestones is 
important. This can be within a subject, for example ‘I will fi nish this topic by 30 
June’, or for overall achievement, such as ‘I want to be qualif ied by the end of 
next year’. 
Your qualification is cumulativ e, as earlier papers provide a f oundation for your 
subsequent studies, so do not allo w there to be too big a gap b etween one 
subject and another. For example, F2 Advanced financial reporting  builds on 
your knowledge of financia l accounting from F1 Financial reporting  and BA3 
Fundamentals of financial accounting and lays the foundations for long term 
financing and weighted average cost of capital usage within F3 Financial 
strategy . 
We know that exams encourage techniques that lead to some degre e of short 
term retention, the result bei ng that you will simply forget mu ch of what you 
have already learned unless it i s refreshed (look up Ebbinghaus  Forgetting 
Curve for more details on this).  This makes it more difficult a s you move from 
one subject to another: not only will you have to learn the new  subject, you will 
also have to relearn all the under pinning knowledge as well. Th is is very 
inefficient and slows down your o verall progression which makes  it more likely 
In addition, delaying your studi es slows your path to qualifica tion which can 
have negative impacts on your car eer, postponing the opportunit y to apply for 

P.11 
You can use the following diagram showing the whole structure o f your 
qualification to help you keep tr ack of your progress. Make sur e you carefully 
review the 2019 CIMA syllabus trans ition rules and seek appropr iate advice if 
you are unsure about your progre ssion through the qualification .

P.12   
Objective test questions require you to choose or provide a res ponse to a 
The most common types of objec tive test question you will see a re: 
• Multiple choice, where you hav e to choose the correct answer(s ) from a 
list of possible answers. This c ould either be numbers or text.  
• Multiple choice with more choi ces and answers, for example, ch oosing two 
correct answers from a list of ei ght possible answers. This cou ld either be 
• Single numeric entry, where y ou give your numeric answer, for example, 
• Multiple entry, where you give  several numeric answers. 
• True/false questions, where you st ate whether a statement is t rue or false. 
• Matching pairs of text, for exam ple, matching a technical term  with the 
• Other types could be matching  text with gra phs and labelling 
In every chapter of this Study  Text we have introduced these ty pes of 
questions, but obviously we have had to label answers A, B, C e tc. rather than 
using click boxes. For convenienc e, we have retained quite a fe w questions 
where an initial scenario leads to a number of sub­questions. T here will be no 
Guidance re CIMA on­screen calculator 
As part of the CIMA objective te st software, candidates are now  provided with a 
calculator. This calculator is  on­screen and is available for t he duration of the 
assessment. The calculator is ava ilable in each of the objectiv e tests and is 
accessed by clicking the calculat or button in the top left hand  corner of the 
screen at any time during the a ssessment. Candidates are permit ted to utilise 
personal calculators as long as  they are an approved CIMA model . Authorised 
CIMA models are listed here: http s://www.cimaglobal.com/Studyin g/study­and­
All candidates must complete a 15­minute exam tutorial before t he assessment 
begins and will have the opportunity to familiarise themselves with the calculator 
and practise using it. The exam tut orial is also available onli ne via the CIMA 
website. 
Candidates may practise using t he calculator by accessing the o nline exam 
tutorial. 
The objective tests are 90­minut e assessments comprising 60 com pulsory 
questions, with one or more par ts. There will be no choice and all questions 
should be attempted. All element s of a question must be answere d correctly for 

P.13 
CIMA syllabus 2019 – S tructure of subjects  and learning outcome s 
Details regarding the content o f the new CIMA syllabus can be l ocated within 
Each subject within the syllabus  is divided into a number of br oad syllabus 
topics. The topics contain one or  more lead learning outcomes, related 
component learning outcomes and i ndicative knowledge content. 
A learning outcome has two main purposes: (a) To define the skill or abi lity that a well prepared candida te should be able 
to exhibit in t he examination. 
(b) To demonstrate t he approach likely to be taken in examinati on questions. 
The learning outcomes are part of a hierarchy of learning objec tives. The verbs 
used at the beginning of each l earning outcome relate to a spec ific learning 
Calculate  the break­even point, profit tar get, margin of safety and prof it/volume 
tables list the verbs that appear i n the syllabus learning outc omes and 
The examination blueprints and r epresentative task statements 
CIMA have also publis hed examination blueprints giving learners  clear 
expectations regarding w hat is expected of them. 
• Exam content sections (reflec ting the syllabus document)  
• Lead and component outcomes (refle cting the syllabus document)  
A representative task statement i s a plain English description of what a CIMA 
The content and skill level det ermine the language and verbs us ed in the 
CIMA will test up to the level o f the task statement in the obj ective tests (an 
objective test question on a parti cular topic could be set at a  lower level than the 
The format of the objective test b lueprints follows that of the  published syllabus 
Weightings for content sections a re also included in the indivi dual subject 

P.14   
CIMA place great importance on t he definition of verbs in struc turing objective 
tests. It is therefore crucia l that you understand the verbs in  order to appreciate 
the depth and breadth o f a topic and the level of skill require d. The objective 
tests will focus on levels one, tw o and three of the CIMA hiera rchy of verbs. 
However, they will also test levels four and five, especially a t the management 
 
Level 5  
quality of 
necessary 
Level 4  
Analysis 
between 
action 
Level 3  
means 

P.15 
Level 2 
purpose of 
something 
Level 1 
Knowledge 
 
Information concerning formulae and tables will be provided via  the CIMA 

P.16   
F2: Advanced Financial Reporting 
Analysing and communicating insi ghts about the performance of 
the organisation 
A Financing capital projects 15% 
B Financial reporting standards 25% 
C Group accounts 25% 
D Integrated reporting 10% 
E Analysing financial statements 25% 
  100%

P.17 
F2A: Financing capital projects 
For selected strategic (capital investment) projects to be implemented, funds must be sourced at the right 
cost and at the right time. This is a key role of the finance function and shows how it enables the organisation to create value. This section looks at the sources and types of funds and how much they 
cost. 
 
contrast types and 
sources of long-
term funds. Compare and contrast: 
a. Long-term debt 
b. Equity finance 
c. Markets for long-term 
funds • Characteristics of different 
types of shares and long-
term debts 
• Ordinary and preference 
shares 
• Bonds and other types of 
long-term debt 
• Operations of stock and 
bond markets 
• Issuance of shares and 
bonds 
• Role of advisors What are the types of funds 
that can be used to finance 
medium to long-term 
projects? What are their 
unique and shared profiles 
and under what conditions are 
they suitable for organisations 
seeking long-term funds? 
What is the impact of these 
funds on the risk profile of 
organisations? Where can 
these funds be sourced? 
What are the criteria that 
organisations must fulfil to 
access funds from these 
sources? 
2. Calculate cost of 
long-term funds. Calculate: 
a. Cost of equity 
b. Cost of debt 
c. Weighted average cost of 
capital • Cost of equity using 
dividend valuation model 
(with or without growth in 
dividends) 
• Post-tax cost of bank 
borrowing 
• Yield to maturity of bonds 
and post-tax cost of bonds 
• Post-tax costs of 
convertible bonds up to 
and including conversion What is the cost of each type 
of funds? What is the cost of 
the total funds used by the 
organisation to fund its 
projects? How can the 
organisation minimise the 
cost of funds whilst ensuring 
the availability of adequate 
funds at the right time and at 
the same time maintaining an 
appropriate risk profile?

P.18   
F2B: Financial reporting standards 
The finance function is responsible for narrating how organisations create and preserve value. Different 
types of narratives are used for different audiences. Fi nancial reporting is used for external stakeholders. 
This section examines the building blocks for construc ting the narratives in t he financial statements. It 
covers the key financial reporting standards on which the financial statements will be based. 
 
1. Explain relevant 
standards for 
revenue, leases, 
financial 
instruments, 
intangible assets 
and provisions. Explain the financial reporting 
standards for: 
a. Revenue 
b. Leases 
c. Provisions 
d. Financial instruments 
e. Intangible assets 
f. Income taxes 
g. Effect of changes in 
foreign currency rates • IFRS 15  –   Revenue from 
Contracts with 
Customers  
• IFRS 16 – Leases  
• IAS 37 – Provisions, 
Contingent Liabilities and 
Contingent Assets  
• IFRS 9 – Financial 
Instruments  
• IAS 32 – Financial 
Instruments: Presentation 
• IAS 38 – Intangible 
Assets  
• IAS 12 – Income Taxes  
• IAS 21 – Effect of 
Changes in on Foreign 
Exchange Rates  How should important 
elements of the financial 
statement be treated in the 
books? What principles 
should underpin these? How 
do financial reporting 
standards help to ensure this? 
Using financial reporting 
standards terminology this 
part will be looking at issues 
in recognition and 
measurement. The most 
important issues will be 
considered here. 
2. Explain relevant 
standards for group 
accounts. a. Explain the financial 
reporting standards for the 
key areas of group 
accounts • IAS 1 – Presentation of 
Financial Statements  
• IAS 27 – Separate 
• IAS 28 – Investment in 
Associates and Joint 
Ventures  
• IFRS 3 – Business 
Combinations  
I• FRS 5 – Non-current 
Discontinued Operations  
• IFRS 10 – Consolidated 
• IFRS 11 – Joint 
Arrangements  What are the key principles 
that should govern the 
preparation of group 
accounts? How are they 
reflected in financial reporting 
standards? The approach 
should focus on the aspects 
of group accounts that are 
essential for discussions with 
the rest of the business. 
Therefore, the emphasis 
should be on awareness 
creation and basic 
understanding of the technical 
elements.

P.19 
F2C: Group accounts 
Organisations sometimes acquire or merge with other organisations to improve their strategic 
performance, position and prospects. The performanc e and position of combined operations are reported 
through group accounts. This section covers the application of the relevant financial reporting standards to 
prepare group accounts. The topics covered are those that are essential to conducting conversations with different parts of the business about the perfor mance of the group and its component parts. 
 
1. Prepare group 
accounts based on 
IFRS. Prepare the following based 
on financial reporting 
standards: 
a. Consolidated statement of 
financial position 
b. Consolidated statement of 
c. Consolidated statement of 
changes in equity 
d. Consolidated statement of 
cash flows • IAS 1 – Presentation of 
Ventures 
Combinations 
Arrangements This is about the preparation 
of basic group accounts 
applying the financial 
reporting standards learned in 
the previous section. Basic 
issues is required. Thus, it 
should cover the rules of 
consolidation, goodwill, 
foreign subsidiaries, minority 
interests and associated 
companies. These should be 
placed in the context of the 
organisation’s strategy as 
executed through mergers 
and acquisitions and the 
setting up of subsidiaries. In 
addition, it can be linked to 
the performance management 
of responsibility centres. 
2. Discuss additional 
disclosure issues 
related to the group 
accounts. Discuss disclosure 
requirements related to: 
a. Transaction between 
related parties 
b. Earnings per share • IAS 24 – Related Party 
Disclosures 
• IAS 33 – Earnings Per 
Share What other issues should be 
disclosed outside the financial 
statements? Why? Again, the 
focus is on building 
awareness and basic 
issues in order to equip 
finance professionals to 
conduct meaningful 
discussions with the rest of 
the organisation about the 
performance, position and 
potential of the organisation.

P.20   
F2D: Integrated reporting 
In a multi-stakeholder world, there has been a call for broader forms of reporting to cover wider audiences 
and issues of concern to them. The International Integrated Reporting Framework developed by the International Integrated Reporting Council (IIRC) is one of the most influential frameworks that seeks to 
fulfil this role. This section introduces candidates to the Framework and its components. 
 
1. Discuss the 
International <IR> 
Framework 
activities. a. Describe the role of the 
Reporting Council. 
b. Explain integrated 
thinking. 
c. Discuss the International 
<IR> Framework. • Context of integrated 
reporting 
• International Integrated 
Reporting Council 
• Integrated thinking 
• International <IR> 
Framework 
• Benefits and limitations of 
the Framework This section looks at the 
International <IR> Framework 
as a means of addressing the 
need for wider forms of 
reporting in a multi-
stakeholder world. It 
introduces the role of the IIRC 
and uses the concept of 
integrated thinking as the 
foundational concept of the 
Framework. It also discusses 
the Framework, its benefits 
and limitations. 
2. Explain the Six 
Capitals of 
Integrated 
Reporting. Explain the measurement and 
disclosure issues of: 
a. Financial capital 
b. Manufactured capital 
c. Intellectual capital 
d. Human capital 
e. Social and relationship 
capital 
f. Natural capital • Definition of the six 
capitals 
• Measurement and 
disclosure issues relating 
to the six capitals The six capitals are a key part 
of the International <IR> 
Framework. This section 
defines the six capitals and 
explains the measurement 
and disclosure issues relating 
to them.

P.21 
F2E: Analysing financial statements 
The analyses of financial statements enable organisations to explain their performance and to compare 
their performance and prospects over time and against others. It can show how vulnerable they and their business models are to disruption. This section shows how these analyses are conducted and their 
limitations. 
 
1. Analyse financial 
statements of 
organisations. Analyse financial statements 
to provide insight on: 
a. Performance 
b. Position 
c. Adaptability 
d. Prospects • Ratio analysis 
• Interpretation of ratios 
• Reporting of ratios along 
the dimensions of the 
Gartner Data Analytics 
maturity model – 
descriptive, diagnostic, 
predictive and prescriptive 
• Link to organisation’s 
business model The financial statements 
narrate how organisations 
using financial numbers. 
Analyses of financial 
statements allows finance 
professionals to go beyond 
the numbers and put the 
narrative into everyday 
business language to facilitate 
discussions and collaboration 
with the rest of the 
organisation. The analysis 
could be based on the 
Gartner Data Analytics model 
which presents information as 
predictive and prescriptive. 
Thus, it will cover hindsight, 
insight and foresight into the 
organisation’s performance, 
position, resilience (or 
adaptability) and prospects. 
The analyses can be linked to 
the organisation’s business 
model. 
2. Recommend 
actions based on 
insights from the 
interpretation of 
financial 
statements. a. Recommend actions • Linkages between 
different areas of 
• Predictive and prescriptive 
ratios 
• Impact of 
recommendations on 
wider organisational 
ecosystem Draw logical conclusions from 
the analysis. The focus is 
mainly predictive and 
prescriptive areas of data 
analytics. The 
recommendations should also 
be organisation wide and 
must encompass the 
ecosystem. A link with the 
business model framework in 
E2 is essential. 
3. Discuss the 
limitations of the 
tools used for 
interpreting 
financial 
statements. Discuss: 
a. Data limitations 
b. Limitations of ratio 
analysis • Quality and type of data 
used 
• Comparability – both in 
segment and 
internationally What are the limitations of the 
data and techniques used in 
the analyses of financial 
statements? How do they 
affect the recommendations? 
How could they be 
overcome?

1 
Long term finance 
A1:  Compare and contrast 
types and sources of long term funds Compare and contrast: 
(a)  Long-term debt (b)  Equity finance (c)  Markets for long-term 
funds 
 
  Chapter 
1

2 
 
Syllabus area F2A ‘Financing capi tal projects’ is covered in th e first two 
chapters of this text. Financing c apital projects makes up 15% of the syllabus. It 
consists of two main areas –  sources of long term finance (Chap ter 1) and the 
cost of long-term f unds (Chapter 2). 
Sources of long term finance 
If a company has a large cash sur plus, it may be able to afford  to undertake 
new investment projects without having to resort to external so urces of finance. 
However, if external funds are r equired, the company might rais e finance from 
the following sources: 
1 The capital markets: 
– new share issues, for example by companies acquiring a stock 
market listing for  the first time 
– rights issues – issues of marketable debt. 
A company must be quoted/listed on a recognised stock exchange in 
order to be able to raise finance  from the capital markets. 
2 Bank borrowings – long-term l oans or short-term loans, includ ing bank 
facilities such as revolving credit facilities (RCFs) and money  market lines. 
3 Government and similar sources. In general, finance can be raised fr om Equity or Debt sources. 
3 Equity finance 
Equity is another name for shares  or ownership rights in a busi ness. 
Important terminology 
Share  – a fixed identifiable unit of capital in an entity which norm ally has a fixed 
nominal value, which may be quite  different from its market val ue.

Chapter 1 
 3 
Shareholders receive returns from  their investment in shares in  the form of 
dividends, and also capital g rowth in the share price. 
Ordinary shares 
Ordinary shares (sometimes also  referred to as ‘equity shares’)  pay dividends at 
the discretion of the entity's  directors. The ordinary sharehol ders of a company 
are the owners of the company and they have the right to attend  meetings and 
vote on any important matters. 
On a winding-up of a company, the ordinary shareholders are sub ordinate to all 
other finance providers (i.e. they  receive their money last, if  there is any left 
after all other finance pr oviders have been paid). 
Preference shares are shares tha t pay a fixed dividend, which i s paid in 
preference to (before) ordinary share dividends, hence the name . 
Also, on a winding-up of a compa ny, the preference shareholders  are 
subordinate to all the debt holder s and creditors, but receive their payout before 
ordinary shareholders. 
 
 More details on preference shares 
 Comparison of preference shares with debt and with ordinary 
shares 
Preference shares pay a fixed proportion of the share's nominal  value 
each year as a dividend. This is  why they are often considered to behave 
in a way which is more similar  to debt finance (fixed annual re turns) 
rather than ordinary shares (vari able dividend at the discretio n of the 
directors). 
However, unlike interest on deb t finance, preference share divi dends are 
paid out of post-tax profits, s o there is no tax benefit to a c ompany of 
paying preference share dividends. 
Also, there are certain circumst ances (e.g. where a company has  
insufficient distributable prof its) when the company will be gi ven 
permission to not pay its preference share dividends in a year.  This is not 
the case with debt interest, which  is an obligation every year,  whether or 
not the company can afford  to make the payment. 
The lack of tax relief on divide nds mentioned above explains wh y 
preference shares are relatively unattractive to companies comp ared with 
bank borrowings and other forms of  fixed rate security such as bonds. 
However, they do have some appeal to risk-averse investors look ing for a 
relatively reliable income stream.

4 
 Different types of preference shares 
There are four types of preference shares: 
• cumulative preference shares, fo r which dividends must be roll ed 
forward if the company is unable to pay the dividend i.e. if a 
dividend is not paid in year 1 , that dividend has to be paid in  year 2 
along with the 'normal' dividend for year 2 
• non-cumulative preference s hares, for which missed dividends d o 
not have to be paid later. There is no roll forward of dividend s 
• participating preference shar es, which give the holder fixed 
dividends plus extra earnings b ased on certain conditions (in a  
similar way to ordinary shares) 
• convertible preference shares , which can be exchanged for a 
specified number of ordinary shar es on some given future date. 
Also, note that some preferenc e shares are redeemable, meaning that 
holders will be repaid  their capital (usually at par) a pre-det ermined future 
date. 
Example of convertibl e preference shares 
Convertible preference shares are  fixed-income securities that the 
investor can choose to turn into a certain number of ordinary s hares after 
a predetermined time span or  on a specific date. 
The fixed-income component offers a  steady income stream and so me 
protection of the investor's capi tal. However, the option to co nvert these 
securities into ordinary shares  gives the investor the opportun ity to gain 
from a rise in the share price. 
Convertibles are particularly a ttractive to those investors who  want to 
participate in the rise of hot gro wth companies while being ins ulated from 
a drop in price should the ordinar y share price growth not live  up to 
expectations. 
If a company were to issue some 5% $10 nominal value preference  
shares, convertible to ordinary shares in five years' time, the  investor 
would receive a fixed amount of $ 0.50 each year for the first f ive years.

Chapter 1 
 5 
 In five years' time though, the in vestor would have the choice to keep the 
preference shares or convert to a  number of ordinary shares. Th e 
conversion ratio would have been set when the preference shares  were 
first issued. For example it coul d be 3, i.e. each preference s hare could 
be converted into 3 ordinary shares. 
In this example, the investor w ould be keen to convert if the o rdinary 
shares on the conver sion date were worth more than $3.33 ($10/3 ). 
For example, if the ordinary s hare price growth  has been impres sive and 
the shares are actually worth $4.50 each on the conversion date , the 
investor could trade a single pr eference share (value $10) for 3 ordinary 
shares worth $13.50 in total. 
The shares in a listed, or quoted, company will be traded on a capital market. 
Capital markets 
Capital markets (or stock mark ets) must fulfil both primary and  secondary 
functions. 
Primary function: 
The primary function of a stock market is to enable companies t o raise new 
finance (either equity or debt). T hrough the stock market, a co mpany can 
communicate with a large pool of potential investors, so it is much easier for a 
company to raise finance in this  way, rather than contacting in vestors 
individually. 
Note that in the UK, a company mus t be a plc before it is allow ed to raise 
finance from the public on the stock market. 
Secondary function: 
The secondary function of a sto ck market is to enable investors  to sell their 
investments to other investors. A listed company's shares are t herefore more 
marketable than an unlisted com pany's, which means that they te nd to be more 
attractive to investors.

6 
 Listed v private companies 
 Private vs public companies 
A limited company may be 'private ' or 'public'. A private limit ed company's 
disclosure requirements are light er, but for this reason its sh ares may not 
be offered to the general public ( and therefore cannot be trade d on a 
public stock exchange). This is th e major distinguishing featur e between 
a private limited company and a public limited company. Most 
companies, particularly small companies, are private. 
Private limited company (Ltd in UK terminology) 
A private company lim ited by shares, usually called a private l imited 
company, has shareholders with limited liability and its shares  may not be 
offered to the general public, unl ike those of a public limited  company 
(see details below). 
'Limited by shares' means that th e company has shareholders, an d that 
the liability of the shareholders to creditors of the company i s limited to 
the capital originally invest ed, i.e. the nominal value of the shares and 
any premium paid in return for th e issue of the shares by the c ompany. 
A shareholder's personal assets a re thereby protected in the ev ent of the 
company's insolvency, but money i nvested in the company will be  lost. 
The company will have "Ltd" afte r its name to indicate its stat us as a 
private company. 
Public limited company (plc in UK terminology) 
A public limited company is a lim ited liability company that ma y sell 
shares to the public. It can be ei ther an unlisted company, or a listed 
company on the stock exchange. T he company will have "plc" afte r its 
name to indicate its status as a public limited company. 
A stock exchange listing 
When an entity obtains a listing (or quotation) for its shares on a stock 
exchange this is referred to as a flotation or an Initial Publi c Offering 
(IPO). 
Advantages of a listing 
• Once listed, the market will prov ide a more accurate valuation  of the 
entity than had been prev iously possible. 
• Creates a mechanism for buying and selling shares in the futur e at 
will.

Chapter 1 
 7 
 • Raise profile of entity, which  may have an impact on revenues,  
credibility with suppliers and long -term providers of finance. 
• Raise capital for future investment. 
• Makes employee share sc hemes more accessible. 
Disadvantages of a listing 
• Costly for a small entity (flo tation, underwriting costs, etc. ) 
• Making enough shares available to  allow a market, and hence lo ss 
of at least some control o f the original owners. 
• Reporting requirements are more onerous. 
• Stock exchange rules for obtaini ng a quotation can be stringen t. 
UK capital markets 
There are two important c apital markets in the UK: 
• the full Stock Exchange – a ma rket for larger companies. Entry  
costs are high and scrutiny is ver y high for companies listed o n the 
'full list', but the profile of a  Stock Exchange listed company 's shares 
is very high, so the shares  are extremely marketable 
• the Alternative Investment Marke t (AIM) – a market for smaller  
companies, with lower associat ed costs and less stringent entry  
criteria. 
The operation of stock exchanges 
Prices of shares on the stock exchange are determined by the fo rces of 
supply and demand in the market. Fo r example, if a company perf orms 
well, its shares become attracti ve to investors. This creates d emand 
which drives up the price of the shares. 
Conversely, investors who hold shares in an underperforming com pany 
will try to sell those shares, c reating supply in the market. T his drives 
down the price of the shares.

8 
 The role of advisors in a share issue 
 Investment banks  usually take the lead role i n share issues and will 
advise on: 
• the appointment of other spec ialists (e.g. lawyers) 
• stock exchange requirements 
• forms of any new capita l to be made available 
• the number of shares to be i ssued and the issue price 
• arrangements for underwriting 
• publishing the offer. 
Stockbrokers  provide advice on the va rious methods of obtaining a 
listing. They may work with inve stment banks on identifying ins titutional 
investors, but usually they are i nvolved with smaller issues an d placings. 
Institutional investors  have little direct inv olvement other than as 
investors, agreeing to buy a cer tain number of shares. They may  also be 
used by the entity and its advisors to provide an indication of  the likely 
take up and acceptable offer pric e for the shares. Once the sha res are in 
issue institutional investors have a major influence on the eva luation and 
the market for the shares. Pensio n funds are examples of instit utional 
investors. 
Registrars to an issue will provide administrative  functions such as 
collecting and proce ssing applications from p otential investors , 
monitoring payments due and made to  and from investors and prov iding 
advice and information regarding s hare issues to stock exchange s, 
investors and i ssuing entities.  
Public and Investor relations will work with the entity to ensure 
communications regarding the shar e issue are transparent, infor mative 
and are understandable to those in vesting. If successful, the w ork of 
public and investor relations coul d improve the uptake of the s hare issue 
and increase the market val ue of the issued shares.  
Reporting accountants will provide advice regar ding the impact on the 
financial statements o f any potential shares issues. They must consider 
the wider ramifications upon the economic decisions of the user s of the 
financial statements caused by t he potential share issues e.g. 
implications on loan covenants. 
Underwriters are financial institutions tha t help corporations raising 
finance by taking on the risk asso ciated with a new issues and attempting 
to promote the new share issue to 3rd party investors. The underwriters 
take on the risks associated with  the share issues but retain p art of the 
proceeds from raising the finance.

Chapter 1 
 9 
4 Methods of issuing new shares 
The three most commonly used m ethods of issuing new shares are:  
• an IPO (initial public offering) or flotation 
• a placing 
• a rights issue (see section 5). 
An IPO is suitable when an entit y seeks a listing on a stock ma rket for the first 
time. 
Placings and rights issues are r elevant for entities that alrea dy list their shares 
on a stock market and are seek ing further financing through a n ew share 
issues. 
Initial public offering (IPO) 
IPOs occur when a company seeks to  be listed on a stock market for the first 
time. These offers may be of compl etely new shares or they may derive from 
the transfer to the public of som e or all of the shares already  held privately. 
Shares are offered for sale to i nvestors, through an issuing ho use. The offer 
could be made: 
• at a fixed price set by the company 
• in a tender offer. 
For a tender offer, investors a re invited to tender for new sha res at their own 
suggested price. All shares bei ng offered are sold at the best price that would 
generate the required finance.

10 
 
 Further information on tenders and IPO's 
 Tender offers 
A tender offer is an alternative  to a fixed price offer. Under a tender offer, 
subscribers tender for the shar es at, or above, a minimum fixed  price. 
Once all offers have been received  from prospective investors, the 
company sets a "strike price" and allocates shares to all bidde rs who 
have offered the strike price o r more. The strike price is set to make sure 
that the company raises the requi red amount of finance from the  share 
issue. 
Once the strike price has been set, all bidders who offered the  strike price 
or more are allocated shares, and they all pay the strike price  irrespective 
of what the original bid was. 
Example of a tender offer 
Bragg Co needs to raise $20m to inv est in a new project. The co mpany 
has asked investors for tender o ffers and the following offers have been 
received: 
Maximum price offered ($ per s hare) No of shares requested at t his price 
 (in millions) 
2.0 5.0 
2.2 4.1 2.4 1.9 2.6 3.2

Chapter 1 
 11 
 The strike will be set at the hi ghest possible level that gener ates the 
required amount of finance. This is to make sure that the compa ny does 
not issue more shares than it has  to. This ensures that the dil ution of the 
existing shareholders' holding i s kept to a minimum. If Bragg C o sets the 
strike price at $2.60, only 3.2 million shares will be issued, raising $8.32m 
in total ($2.60 × 3.2m). This is  not acceptable since $20m is n eeded. 
If Bragg Co sets the strike pri ce at $2.40, 5.1m shares will be  issued 
(being 1.9m to the people who bid $2.40 and 3. 2m to the people who bid 
$2.60). Therefore the total financ e raised will be $2.40 × 5.1m  = $12.24m. 
Again, not sufficient. 
If Bragg Co sets the strike pri ce at $2.20, 9.2m shares will be  issued 
(being 4.1m to the peopl e who bid $2.20, 1.9 m to the people who  bid 
$2.40 and 3.2m to the peopl e who bid $2.60). T herefore, the tot al finance 
raised will be $2.20 × 9. 2m = $20.24m. This is now enough to sa tisfy 
Bragg Co's financing requirements. 
Hence, to ensure that $20m is raised from the tender offer, the  strike 
price would be set a t $2.20 and any investo r who bid $2.20 or m ore 
would be allocated shares at the strike price of $2.20. 
Placing 
Shares are placed directly with certain investors (normally ins titutions) on a pre-
arranged basis. 
In this type of issue the shares  are not offered to the public,  but the issuing 
house will arrange for the shares  to be issued to its instituti onal clients. This 
method is very popular, being c heaper and quicker to arrange th an most other 
methods. However, it does not no rmally lead to a very active ma rket for the 
shares after flotation. 
5 Rights issues 
A rights issue is where new shares  are offered for sale to exis ting shareholders, 
in proportion to the size  of their shareholding. 
The right to buy new shares ahead of outside investors is known  as the 'pre-
emption rights' of shareholders. N ote that the purpose of pre-e mption rights is to 
ensure that shareholders have an opportunity to prevent their s take being 
diluted by new issues. Pre-empti on rights are prot ected by law,  and can only be 
waived with the consent of shareholders. 
Rights issues are cheaper to org anise than a public share issue . 
An issue price must be set which is: 
• low enough to secure acc eptance of shareholders, but 
• not too low, so as to avoid e xcessive dilution of the earnings  per share.

12 
 Rights issues – further detail 
A rights issue may be defined as: 
• Raising of new capital by givi ng existing shareholders the rig ht to 
subscribe to new shares in propo rtion to their current holdings . 
These shares are usually issued at a discount to market price.  
Explanation 
In a rights issue, the entity s ets out to raise additional fund s from its 
existing shareholders. 
It does this by giving them the opportunity to purchase additio nal shares. 
These shares are normally offer ed at a price lower than the cur rent share 
price quoted. The entity cannot off er an unlimited supply at th is lower 
price, otherwise the market pri ce would fall to this value. Acc ordingly the 
offer they make to the existing shareholders is limited. For ex ample they 
may offer one new share  for every four held. 
Selection of an issue price 
In theory, there is no upper limi t to an issue price but in pra ctice it would 
never be set higher than the prev ailing market price (MPS) of t he shares, 
otherwise shareholders will not b e prepared to buy as they coul d have 
purchased more shares at the exis ting market price anyway. Inde ed, the 
issue price is normally set at a  discount on MPS. This discount  is usually 
in the region of 20%. In theory,  there is no lower limit to an issue price but 
in practice it can never be lowe r than the nominal value of the  shares. 
Subject to these practical limitat ions, any price may be select ed within 
these values. However, as the i ssue price selected is reduced, the 
quantity of shares that has to be issued to raise a required su m will be 
increased. 
Selection of an issue quantity 
It is normal for the issue price  to be selected first and then the quantity of 
shares to be issued. The effec t of the additional shares on ear nings per 
share and dividend cove r should be considered (these ratios wil l be 
covered later). The selected additional issue quantity will the n be related 
to the existing share quantity fo r the issue terms to be calcul ated. The 
proportion is normally stated in  its simplest form, for example , 1 for 4, 
meaning that shareholders may sub scribe to purchase one new sha re for 
every four they currently hold.

Chapter 1 
 13 
Market price after issue 
• After the announcement of a rights issue there is a tendency f or share 
prices to fall. 
• The temporary fall is due to uncertainty about: 
– consequences of the issue – future profits – future dividends. 
• After the actual issue the ma rket price will normally fall aga in because: 
– there are more shares in iss ue (adverse affect on earnings pe r 
share), and 
– new shares were issued a t market price discount. 
'Cum rights' 
When a rights issue is announced , all existing shareholders hav e the right to 
subscribe for new shares, and so  there are rights ('cum rights' ) attached to the 
shares, and the shares a re traded 'cum rights'. 
'Ex rights' 
On the first day of dealings in t he newly issued shares, the ri ghts no longer exist 
and the old shares are now traded 'ex rights' (without rights a ttached). 
Theoretical prices/values 
Theoretical 'ex rights' price i s the theoretical price that the  class of shares will 
trade at on the first trading day a fter issue. It is calculated  as follows: 
 
(N × cum rights price) + Issue price
N + 1 
 
N = number of shares required to be held in order to receive on e rights issued 
share (e.g. 1 for 4 ri ghts issue, N = 4).

14 
 Illustration 1 – Rights issue 
 Lauchlan plc has 2m $1 ordinary shares in issue, with a curren t market 
value of $5 per share. It offers a  1 for 4 rights issue at $4 p er share. 
TERP 
The cum rights price = $5 
Issue price = $4 N = 4 Therefore, TERP = [(4 × $5) + $4]/5 = $4.80 
NB. The calculation of TERP woul d not be a requirement to an ex am question 
within syllabus area F2A1. It is included here for illustration  purposes only. 
However, it will be revisited in  chapter 4 EPS and the calculat ion could be a 
question as part of syllabus area F2C2. 
Implications of a rights issue 
(a) From the viewpoin t of the shareholders: 
– they have the opti on of buying shares at preferential price 
– they have the option of withdrawing cash b y selling their rig hts 
– they are able to maintain thei r existing relative voting posi tion (by 
exercising the rights). 
(b) From the viewpo int of the company: 
– it is simple and cheap to implement – it is usually successful ('fully subscribed') – it often provides favourable publicity. 
6 Debt finance 
This is the loan of funds to a business without conferring owne rship rights. The 
key features of debt f inancing arising from  this 'arm's length relationship' are: 
• Interest is paid out of pre-tax  profits as an expense of the b usiness. 
• It carries a risk of default i f interest and principal payment s are not met.

Chapter 1 
 15 
Security – charges 
The lender of funds will normally r equire some form of security  against which 
the funds are advanced. This m eans that, in the event of defaul t, the lender will 
be able to take assets in exchang e of the amounts owing. There are two types 
of 'charge' or security tha t may be offered/required: 
1 Fixed charge  – The debt is secured against a specific asset, normally 
land or buildings. This form of s ecurity is preferred because, in the event 
of liquidation, it puts the l ender at the 'front of the queue' of creditors. 
2 Floating charge  – The debt is secured against underlying assets that are 
subject to changes in quantity or value e.g. inventory. The flo ating charge 
can cover any other assets that a re not already subject to fixe d charges. 
This form of security is not as strong; again it confers a meas ure of 
security on liquidation as a 'pr eferred creditor', meaning the lender is 
higher in the list of creditors than otherwise. 
Covenants 
A further means of limiting the ri sk to the lender is to restri ct the actions of the 
directors through the means of c ovenants. These are specific re quirements or 
limitations laid down as a c ondition of taking on debt financin g. They may 
include: 
1 Dividend restrictions  – Limitations on the level of dividends a company is 
permitted to pay. This is designe d to prevent excessive dividen d payments 
which may seriously weaken the company's future cash flows and thereby 
place the lender at greater risk. 
2 Financial ratios  – Specified levels below which  certain ratios may not fall, 
e.g. debt to net assets ratio, current ratio. 
3 Financial reports  – Regular accounts and financial  reports to be provided 
to the lender to monitor progress. 
4 Issue of further debt  – The amount and type of debt that can be issued 
may be restricted. Subordinated d ebt (i.e. debt ranking below t he existing 
unsecured debt) can usually still be issued.

16 
 Examples of long term deb t finance – terminology 
 Bank finance 
Money market borrowings 
The money market consists of fin ancial institut ions and dealers  in money 
or credit who wish to either borrow or lend. 
The money market is used by par ticipants as a means for borrowi ng and 
lending in the short term, from s everal days to just under a ye ar. This 
contrasts with the capital ma rket for longer-term funding, for example 
bonds and equity. 
The core of the money market c onsists of interbank lending – ba nks 
borrowing from, and lending to, eac h other. However, large prof it-making 
entities will also borrow and lend on the money market. 
Revolving credit facilities (RCFs) 
Under a RCF the borrower may use or withdraw funds up to a pre-
approved credit limit. The amount o f available credit decreases  and 
increases as funds are borrowed and then repaid. 
The borrower makes payments based only on the amount they've 
actually used or withdrawn, plu s interest and the borrower may repay the 
borrowing over time or in full at any time. 
RCFs are very flexible debt fi nancing options, and they enable a 
company to minimise interest pay ments because the amount of fun ds 
borrowed fluctuates over time and is never more than the compan y 
needs. 
Often the RCF will be o ffered by a single bank, or in the case of a large 
amount of finance required, a sy ndicate (group) of banks may of fer the 
RCF to reduce the risk to any one lender. 
Bonds 
A bond is a debt security, in whic h the issuer owes the holders  a debt 
and, depending on the terms of th e bond, is obliged to pay inte rest (the 
coupon) and/or to repay the princi pal at a later date. i.e. a b ond is a 
formal contract to repay borrow ed money with interest at fixed intervals. 
Thus a bond is like a loan: the issuer is the borrower (debtor) , the holder 
is the lender (creditor) and more c ommonly referred to as the i nvestor, 
and the coupon is the interest. B onds provide the borrower with  external 
funds to satisfy long-term funding requirements.

Chapter 1 
 17 
 Bonds and shares are both securi ties which can be traded in the  capital 
markets, but the majo r difference between the two is that share holders 
have an equity stake in the comp any (i.e. they are owners), whe reas 
bondholders have a creditor stake in the company (i.e. they are  lenders). 
Another difference is that bonds  usually have a defined term, o r maturity, 
after which the bond is redeemed, w hereas shares may be outstan ding 
indefinitely. 
 
 Capital markets – further detail 
 Issuing debt finance (bonds) in t he capital markets enables an  entity to 
borrow a large amount of finance  from (potentially) a wide rang e of 
potential investors. 
The bond market can essentially be broken down into three main groups: 
issuers, underwriters and purchasers. 
Issuers 
The issuers sell bonds in the c apital markets to fund the opera tions of 
their organisations. This area of  the market is mostly made up of 
governments, banks a nd corporations. 
The biggest of these issuers is  the government, which uses the bond 
market to help fund a country's operations. Banks are also key issuers in 
the bond market, and they can r ange from local banks up to 
supranational banks such as the European Investment Bank. The f inal 
major issuer is corporations , which issue bonds to finance oper ations. 
Underwriters 
The underwriting segment of the bond market is traditionally ma de up of 
investment banks and other financia l institutions that help the  issuer to 
sell the bonds in the market. 
In most cases, huge amounts of fi nance are transacted in one of fering. 
As a result, a lot of work needs to be done to prepare for the offering, 
such as creating a prospectus and other legal documents. In gen eral, the 
need for underwriters is g reatest for the corp orate debt market  because 
there are more risks associ ated with this type of debt.

18 
 The underwriters sometimes place  the bonds with specific invest ors 
('bond placement'), or they can at tempt to sell the bonds more widely in 
the market. Alternatively, under  a medium term not e (MTN) progr amme, 
the issuer (via the underwriter) can issue debt securities on a  regular 
and/or continuous basis. 
Purchasers 
The final players in the bond ma rket are those who buy the bond s. 
Buyers basically include every g roup mentioned as well as any o ther type 
of investor, including the individual. 
Governments play one of the lar gest roles in the market because  they 
borrow and lend money to other governments and banks. Furthermo re, 
governments often invest in bonds  issued by other countries if they have 
excess reserves of that country's money as a result of trade be tween 
countries. For example, Japan is a major holder of U.S. governm ent debt, 
such as U.S. gilts. 
7 Other sources of finance 
Retained earnings/exi sting cash balances 
An entity can use its curren t cash balances to finance new inve stments. 
There is a common misconception t hat an entity with a large amo unt of retained 
earnings in its statement of fi nancial position can fund its ne w investment 
projects using these retained earnings. This is not the case. 
An entity can only use internal  sources of finance to fund new projects if it has 
enough cash in hand. 
The level of retained earnings r eflects the amount of profit ac cumulated over the 
entity's life. It is not the same as cash. 
Sale and leaseback 
This means selling good quality fix ed assets such as high stree t buildings and 
leasing them back over many yea rs (25+). Funds are released wit hout any loss 
of use of assets. 
Any potential capital gain  on assets is forgone. 
Sale and leaseback is a popular  means of funding for retail org anisations with 
substantial high street property  e.g. Tesco, Marks and Spencer.  
Grants 
These are often related to te chnology, job creation or regional  policy. They are 
of particular importance to sma ll and medium-sized businesses ( i.e. unlisted). 
Their key advantage is that they  do not need to be paid back. 
Grants can be provided by local governments, national governmen ts, and other 
larger bodies such as  the European Union.

Chapter 1 
 19 
Debt with warrants attached 
A warrant is an option to buy sha res at a specified point in th e future for a 
specified (exercise) price. Wa rrants are often issued with a bo nd as a 
sweetener to encourage investor s to purchase the bonds. 
The warrant offers a po tential capital gain where the share pri ce may rise above 
the exercise price. 
The holder has the option to buy t he share on the exercise date  but can also 
choose to sell the warrant before that date. 
Convertible debt 
This is similar in effect to att aching a warrant to a debt inst rument (as described 
above) except that the option to  convert to shares (the warrant ) cannot be 
detached and traded separately. 
With convertible debt, the debt i tself can be converted into sh ares at a 
predetermined price at a date or  range of dates in the future. For example, a 
$1m loan has an option to conver t into 10 new shares for every $100 of loan in 
3 years’ time. 
This has the effect of giving t he debt holder a potential capit al gain over and 
above the return from the repaym ent of the debt. If the value o f the shares is 
greater than value of the debt on  the exercise date, then conve rsion should be 
made by the investor. If the s hare value is lower than the debt  value, the 
investor should retain the debt to maturity. 
Venture capital 
This is finance provided to y oung, unquoted profit-making entit ies to help them 
to expand. It is usually provided in the form of equity finance , but may be a mix 
of equity and debt. 
Venture capitalists generally a ccept low levels of dividends an d expect to make 
most of their returns as capita l gains on exit. A typical exit route is an IPO or 
flotation, which enables the v enture capitalist to sell his sta ke in the entity on the 
stock market. 
Business angels 
Business angels are similar to v enture capitalists. Venture cap italists are rarely 
interested in investing in very small businesses, on the ground s that monitoring 
progress is uneconomic. 
Business angels are wealthy in vestors who provide equity financ e to small 
businesses.

20 
 
 Test your understanding 1 (further OTQs) 
 1 ________ preference shares are  those for which dividends mus t be 
paid in a following year if they a re not paid in the current ye ar. 
________ preference shares give t he holder fixed dividends plus  
extra earnings based on certai n conditions being achieved. 
Select the correct words to complete the above sentences, 
from the following options: 
convertible, cumulative, irredeem able, participating, redeemabl e 
2 Capital markets fulfil two f unctions, one of which is to enab le 
investors to sell investments to other investors. 
Is this the primary function or  secondary function? Select the 
correct answer below. 
A Primary function. 
B Secondary function. 
 3 When fixing security, a lender  of funds will prefer a f_____ __ 
charge. 
Select the correct word to com plete the above sentence, from 
the following options: 
fixed, floating

22 
 
 1  Cumulative  preference share are those for which dividends must 
be paid in a following year if they  are not paid in the current  year.  
Participating  preference shares give the holder fixed dividends plus 
extra earnings based on certai n conditions being achieved.  
2 B Secondary function  
The primary function is to enabl e companies to raise new financ e. 
3 When fixing security, a l ender of funds will prefer a fixed  charge. 
Note:  a floating charge secures t he debt against the underlying 
assets that are subject to c hanges in quantity and value wherea s a 
fixed charge is against a specif ic asset. Therefore a fixed cha rge is 
preferable as, in the event of a  liquidation, the lender would have a 
right to the specific asset secured. The fixed charge holder wo uld be 
paid earlier than a float ing charge holder.

23 
Cost of capital 
A2: Calculate cost of long 
term funds Calculate: 
(a)  Cost of equity  (b)  Cost of debt (c)  Weighted average cost of 
capital  
 
  Chapter 
2

24 
 
The weighted average cost of capi tal (WACC) measures the averag e cost of an 
entity's finance. Entities often use the WACC as a discount rat e in net present 
value (NPV) calculations. 
The WACC is derived by first estim ating the cost of each source  of finance 
separately (e.g. ordinary shar es, debt, preference shares) and then taking a 
weighted average of these indivi dual costs, using the following  formula: 
 
k0	=	ke ൤VE
VE	+	VD൨+ kd ൤VD
VE	+	VD൨ 
 
k0 = WACC 
3 The cost of equity – k e 
The cost of equity is the rate o f return that ordinary sharehol ders expect to 
receive on their investment. T he main method of computing k e is the dividend 
valuation model (DVM).

Chapter 2 
 25 
The dividend valuation model (DVM) 
The DVM states that the current  share price is determined by th e future 
dividends, discounted at the inve stors' required rate of return . 
P଴	= d
ke 
where k e = cost of equity 
d = is the constant dividend P
0 = the ex div market price of the share 
This is a variant of the formu la for a PV of a perpetuity. 
We can re-arrange the formula to get the one below: 
The dividend valuation model with constant dividends 
 
ke	= d
P଴ 
 
 DVM – further detail 
 The DVM is a method of cal culating cost of equity. 
This model makes the assumption that the market price of a shar e is 
related to the future dividend in come stream from that share, i n such a 
way that the market price is a ssumed to be the present value of  that 
future dividend income stream. 
This is known as the fundamental  theory of share valuation. 
 
 Cum div and ex di v share prices 
 The ex dividend ('ex div') value of a share is the value just after a 
dividend has been paid. Occasiona lly in questions, you may be g iven a 
share price just bef ore the paymen t of a dividend (a 'cum div' price). In 
this case, the value of the upc oming dividend should be deducte d from 
the cum div price to give the ex div price. 
For example, if a dividend of 20 cents is due to be paid on a s hare which 
has a cum div value of $3.45, the ex div share price to be ente red into the 
DVM formula is $3.45 – $0.20 = $3.25.

26 
 Illustration 1 – k e with constant dividends  
 The ordinary shares of Jones p lc are quoted at $4 per share. A  dividend 
of 30 cents is about to be paid. T here is expected to be no gro wth in 
dividends. 
Required: 
Calculate the cost of equity. 
Solution 
ke= 30
400 – 30 = 8.1% 
 
 Test your understanding 1 (OTQ style) 
 The ordinary shares of Smith plc are quoted a t $12 per share. A dividend 
of 75 cents per share is about to  be paid. There is expected to  be no 
growth in dividends. 
Required: 
Calculate the cost of equity. Giv e your answer to 1 decimal pla ce. 
Introducing growth 
The dividend valuation mode l with constant growth 
 
ke= d1
P0+	g  
or 
ke= d0(1	+	g)
P0	+	g 
 
Where: 
g = a constant rate of growth in dividends d
1 = dividend to be pai d in one year's time 
d0 = current dividend 
P0 = the ex div market price of the share

Chapter 2 
 27 
 Illustration 2 – k e with constant dividend growth  
of 30 cents is about to be paid. T he expected growth rate of di vidends is 
5%. 
Required: 
Solution 
ke= 30 × 1.05
400 – 30 + 0.05 = 13.5% 
 
 Test your understanding 2 (OTQ style) 
 The ordinary shares of Smith plc are quoted at $12 per share. A dividend 
of 75 cents per share is about to be paid. The expected growth rate in the 
dividend is 8%.  
Required:  
Calculate the cost of equity. Give  your answer to 1 decimal pla ce. 
Estimating growth within the DVM 
The growth rate used in the cost  of equity calculation will not  always be 
provided within the information relating to the question. It ma y be required to be 
separately calculated. 
Two main methods to calculate div idend growth exist. They are: 
• the averaging method 
• the growth model based upon t he profit retention rate. 
NB. The examiner may also give you  the growth rate within question s. You will 
not always be expected to calculate the growth. 
1 Averaging method (Historical method)  
g	= ඨdo
dnn
 –	1 
Where d o = current dividend 
 d n = dividend n years ago

28 
 Illustration 3 – k e and averaging method for dividend growth  
 A company paid a dividend of 8 c ents per share eight years ago . The 
current dividend is 13 cents. T he current share price is $2.76 ex div. 
Required 
Solution 
To work out growth g = (13/8)
1/8 – 1 = 0.0626 = 6.26% 
NB. To the power of 1/8 i s equal to the 8th root. 
To work out the cost of equity K
e = (13 × 1.0626/276 ) + 0 .0626 = 0.1126 = 11.26% 
 
2 Growth model based upon the profit retention rate  
g = r × b 
NB. This formula is provided in t he formulae sheet within the e xam. 
Where: g = dividend growth rate r = percentage rate of return the company receives on its inves tment 
b = proportion of funds retained (a ka proportion of profits not  distributed as 
dividends)

Chapter 2 
 29 
 Assumptions of the growth model based on retention rate 
 The rationale behind the model i s that an increase in the leve l of 
investment by a company (caused by profits not paid out as divi dends) 
will give rise to an increase in future dividends. 
The two key elements in determini ng future dividend growth will  be the 
rate of reinvestment by the comp any (aka, the rate of retained profits) 
and the required return gener ated by the investments. 
There are a number of assumptions  required to apply this model:  
• the entity must be all equity financed 
• the retained profits are the onl y source of additional investm ent 
• a constant proportion of each y ear's earnings is retained for 
reinvestment 
• projects financed from retained earnings earn a constant rate of 
return. 
 
 Illustration 4 – k e and growth using profit retention rate  
 The ordinary shares of Klopp ar e quoted at $7.00 cum div. A di vidend of 
50c is just about to be paid. The company has an annual return of 
reinvested funds of 12% and each year pays out 70% of its profi t after tax 
as dividends. 
Required: 
Calculate the cost of equity. Give  your answer to 2 decimal pla ces. 
Solution 
Firstly work out the growth rate 
g = r × b = 12% × 30% = 3.6% 
NB. 70% of the profits are paid as dividends meaning 30% of the  profit is 
retained. 
 Then work out the cost of equity 
Ke = [(d 0 × (1 + g)/P 0] + g 
= [0.5 × 1.036/(7  – 0.5)] + 0.036 
= 11.57%

30 
 The cost of preference shares 
 Preference shares usually pay a constant level of dividend, wh ich is 
quoted as a percentage of nominal  value. Hence, the cost of pre ference 
shares (k p) can be calculated using a fo rmula very similar to the one 
covered earlier for k e in a no growth situation. The formula is: 
 
kp	= d
P0 
 
d = is the constant dividend 
P0 = the ex div market price of the share 
kp = the cost of preference shares 
4 The cost of debt – k d 
The cost of debt is the rate of return that debt providers requ ire on the funds 
that they provide. 
The value of debt is assumed to  be the present value of its fut ure cash flows. 
Features 
1 Debt is tax deductible and hence interest payments are made n et of tax. 
2 Debt is always quoted in $100 nominal units or blocks. 
3 Interest paid on the debt is st ated as a percentage of nomina l value. This 
is known as the coupon rate. It i s not the same as the cost of debt. The 
amount of interest payable on the debt is fixed. The interest i s calculated 
as the coupon rate multiplied by  the nominal value of the debt.  
4 Debt is redeemable at par (nomin al value) or a t a premium or discount. 
5 Interest can be either fixed or floating (variable) on borrow ings, but bonds 
normally pay fixed rate interest. 
kd for bank borrowings 
The cost of debt for bank borrowings is simply k d = r (1 – T) 
where: 
 r = annual interest rat e in percentage terms 
T = corporate tax rate

Chapter 2 
 31 
kd for irredeemable, or undated, bonds 
It is highly unusual for a bond to  be irredeemable but, if it w ere, the cost of debt 
could be calculated as follows: 
 
kd	= i(1 – T)
P0 
 
Where: 
 i = interest paid each year (per $100 of bond) 
T = marginal rate of tax P
0 = ex interest market price o f the bonds, normally quoted per 1 00 unit nominal 
Note that this formula can also be applied to redeemable bonds where the 
redemption value is equal to the current market price or as an approximation for 
long-dated debt. 
For bonds trading at par, P 0 is the nominal value and so this formula can be 
simplified to k d = r(1–T), where r is the interes t rate, expressed in percentage  
terms. 
 
 Illustration 5 – k d for long-dated bonds  
 The 10% long-dated bonds of an ent ity are quoted at $130 ex in t. 
Corporation tax is  payable at 30%. 
Required: 
Calculate the net of tax cost of debt. 
Solution 
kd= 10(1 – 0.30)
130 = 5.4%

32 
 Test your understanding 3 (OTQ style) 
 The 8% long-dated bonds of an ent ity are quoted at $127 ex int . 
Corporation tax is  payable at 25%. 
Required: 
Calculate the net of tax cost of debt. Give your answer to 1 de cimal 
place. 
The internal rate of return (IRR) 
The IRR is the discount rate which gives a zero NPV. 
Calculation 
It can be estimated by working ou t the NPV at two different int erest rates (L, the 
lower rate, and H, the higher rat e) and then using the followin g (linear 
interpolation) formula: 
 
L	+ ൬NPV L
NPV L– NPV H൰ (H –	L) 
 
This formula does appear in your  formula sheet provided in the exam.  
kd for redeemable bonds 
The k d for redeemable bonds is given by t he IRR of the relevant cash flows. 
The relevant cash flows would be (assuming that there is no one  year delay in 
the tax saving): 
Year Cash flow  
0 Market value of the bond (or nominal value if being 
issued or is trading at par) (P0) 
1 to n Annual interest payme nts net of tax i(1 – T) 
n Redemption value of the bond RV 
There are three steps  to ensuring an accurate computation: 
1 Identify the cash flows. Note  that the interest payments shou ld be included 
net of tax when calculating t he cost of debt for bonds from the  viewpoint of 
the issuer. 
2 Choose 2 discount factors and ca lculate two NPVs (preferably one –ve 
and one +ve). 
3 Calculate the IRR.

Chapter 2 
 33 
 Illustration 6 – k d for redeemable bonds  
 An entity has some 10% bonds quot ed at $95.00 ex int redeemabl e at 
par in five years' time. Corpor ation tax is paid at 31%. 
Required: 
Calculate the entity's cost of debt. 
Solution Cash flows 
Year 0 $95.00 
Year 1 – 5 $10 (1 – 0.31) = $6.90 Year 5 $100.00 
Discounting 
Year Cash flow Disc. fact. 
@ 6% Present 
value Disc. fact. 
@ 10% Present 
value 
0 (95.00) 1 (95.00) 1 (95.00) 
1 – 5 6.90 4.212 29.06 3.791 26.16 
5 100 0.747 74.70 0.621 62.10 
Total   +8.76  –6.74 
 
IRR	=	6%	+	൤ሺ10% –	6%ሻ	× 8.76
(8.76 + 6.74) ൨=	8.26% 
 
 Test your understanding 4 (OTQ style) 
 An entity has some 8% bonds quot ed at $92.00 ex int redeemable  at par 
in three years' time. Corporat ion tax is paid at 27%. 
Required: 
Calculate the entity's cost of debt. Give your answer to 2 deci mal places.

34 
 The cost of convertible bonds 
 Convertible bonds offer the investor a choice of cash or share s on the 
redemption date. 
In practice, particularly if t he value of the cash and shares o ption is very 
similar, some investors will choo se cash for liquidity reasons,  whereas 
other investors may choose shar es, hoping for large dividend re turns in 
In order to calculate the cost o f convertible bonds, we make a simplifying 
assumption that all investors will make the same decision. 
Illustration 
Consider a 10% $100 bond which is redeemable at par in 5 years,  or 
convertible into 10 shares a t that time. The bond is issued at par. The 
current share price is $8.60 and historically, dividends (and h ence share 
prices) have grow n at 5% per annum. 
The tax rate is 20%. 
Step 1 – Work out which conversi on option is likely to be used 
To decide which option is likel y to be chosen by investors, we compare: 
• the value of the cash option , that is $100 (redemption at par)  
• the value of the conversion opt ion, i.e. 10 × ($8.60 × 1.055) = 
$109.76. 
Hence, it is assumed that all in vestors will choose the convers ion option. 
Step 2 – Determine the cost of capital 
The cost of the convertible debt is calculated in a similar way  to the cost 
of redeemable debt but the value of the highest conversion opti on is used 
as the cash flow at redemption. 
It is the IRR of: 
Year Cash flow $ 
0 Market value of the loan (P 0) 
1 to n Annual net interes t payments i(1 – T) 
n The higher of the cash and the conversion 
option C 
Cash flows 
Year 0 $100.00 
Year 1 – 5 $10 (1 – 0.2) = $8 Year 5 $109.76

Chapter 2 
 35 
 
IRR 
@ 5% Present 
value 
0 (100.00) 1 (100.00) 1 (100.00) 
1 – 5 8 4.329 34.63 3.791 30.33 
5 109.76 0.784 86.05 0.621 68.16 
Total   +20.68  –1.51 
 
IRR	=	5%	+	൤ሺ10% –	5%ሻ	× 20.68
(20.68 + 1.51) ൨=	9.66% 
 
Cost of the convertible debt is 9.66% 
5 Weighted Average Cost of Capital (WACC) 
The weighted average cost of capi tal (WACC) is the average cost  of the entity's 
finance (equity, bonds, bank loans , and preference shares) weig hted according 
to the proportion each elemen t bears to the total pool of funds . 
In the analysis so far carried out, each source of finance has been examined in 
isolation. However, the practica l business situation is that th ere is a continuous 
raising of funds from various sources. These funds are used, pa rtly in existing 
operations and partly to finance new  projects. There is not nor mally any 
separation between funds from different sources and their appli cation to specific 
projects.

36 
 
In order to provide a measure fo r evaluating these projects, th e cost of the pool 
of funds is required. This is var iously referred to as the comb ined or weighted 
average cost of capital (WACC). 
The general approach is to calcula te the cost of each source of  finance, then to 
weight these according to their importance in the financing mix . 
Procedure for calculating the WACC 
Step 1  Calculate weights for each source of capital. 
Step 2  Estimate the cost of each source of capital. 
Step 3  Multiply the proportion of the to tal of each source of capital  by the cost of 
that source of capital. 
Step 4  Sum the results of step 3 to g ive the weighted average cost of  capital. 
Formula – given in the assessment 
k0	=	ke ൤VE
VE	+	VD൨ 
 
 Alternative WACC formula 
 Using market values for a firm  with equity, debt and preferenc e shares in 
its capital structur e, the WACC would be: 
 
k0= keVe	+	 kPVP	+	 kdVd
Ve	+ 	VP	+ V d 
 
where Ve, Vp and Vd are the mark et values of equity, preference  shares 
and debt respectively.

Chapter 2 
 37 
 Test your understanding 5 (OTQ style) 
 Rebmatt Co has a capital structure as follows. 
 Cost of capital 
% Book value  
$m Market value  
$m 
Bank loans   6   5   5 Bonds 10   8   5 Ordinary shares  15 18 30 
Required:  
Calculate Rebmatt’s WACC, using market values as weights. Give your 
answer to 2 decimal places. 
 
 Test your understanding 6 (integration question) 
 The following is an extract fro m the statement of financial po sition of Gate 
Co at 30 September 20X4: 
 $  
Ordinary shares of 25 cents each 250,000 
Reserves 350,000 
7% preference shares of $1 each 250,000 
15% long-dated bonds 150,000 
 –––––––– 
Total long-term funds 1,000,000 
 –––––––– 
The ordinary shares are curr ently quoted at $1.25 each, the bon ds 
trading at $85 per $100 nominal and  the preference shares at 65  cents 
each. The ordinary dividend of 10 cents has just been paid, and  the 
expected growth rate in the divi dend is 10%. Cor poration tax is  at the rate 
of 30%. 
Required: 
Calculate the weighted average co st of capital fo r Gate Co. Giv e your 
answer to 1 decimal place.

38 
 Problems with the c omputation of WACC 
 Which sources of finance to include 
The above examples have concentr ated on the cost of long-term f inance. 
Firms also raise finance from shor t-term sources, e.g. overdraf ts, short-
term loans, trade credit etc. It is possible to calculate a cos t for short-term 
finance and we need to decide w hether it should be included in our 
calculations. The usual argumen t is that the weighted average c ost of 
capital is a tool for appraising lo ng-term invest ments and as t hese should 
only be financed by long-term f unds then the costs of short-ter m funds 
should be excluded. However, if it is clear tha t short-term fin ance is being 
used to fund long-term project s, then it should be included. 
Loans without market values 
Bank loans do not have market v alues in the same way as bonds. All we 
can do in this case is to take the book value of loans as an ap proximation 
of market value. 
Cost of capital for small entities 
There are important factors whi ch are relevant to the cost of c apital of 
small entities: 
• If the entity is unquoted, then obtaining the cost of finance is much 
more difficult. 
• The lack of liquidity offered by  the entity's securities, plus  the 
smaller size of the entity, tend to make finance more expensive . 
6 When can WACC be used as a discount rate? 
The WACC is often used as a di scount rate when using net presen t value or 
internal rate of return calcul ations. However, this is only app ropriate if the 
following conditions are met: 
1 The capital structure is const ant. If the capital structure c hanges, the 
weightings in the WACC will also change. 
2 The new investment does not car ry a different business risk p rofile to the 
existing entity's operations. 
3 The new investment is margi nal to the entity. If we are only looking at a 
small investment then we w ould not expect any of k e, kd or the WACC to 
change materially. If the investmen t is substantial it will usu ally cause 
these values to change.

Chapter 2 
 39 
7 Yield to maturity (YTM) 
The yield to maturity 
So far in this chapter we have s een how the WACC requires calcu lations of the 
cost of equity (k e) and the cost of debt (k d). The cost of equity and the cost of 
debt is considered from the pers pective of an entity raising fi nance. 
This section will cover the calc ulation of the yield to maturit y (aka the yield on 
debt). 
The yield to maturity is very similar to the calculation of k d. The main difference 
is that the yield to maturit y is calculated from the investor's perspective (the 
entity/person PROVIDING the finance). 
An investor who purchases a trad ed debt instrument (e.g. a bond ) receives a 
return, known as a 'yield', in  the form of the annual interest (or 'coupon') 
payments and, if the debt is redeem able, the final redemption p ayment. Before 
making the investment, the inve stor will be inte rested in deter mining the 
percentage return. This will allow  the investor to make an info rmed decision as 
to whether they consider the invest ment worthwhile. It also all ows comparison 
against other similar investments.  This return is also known as  the 'yield to 
maturity' (YTM), or 'redempti on yield', on the bond and it is d efined as: 
YTM = effective average annual per centage return to the investo r, relative to 
the current market v alue of the bond. 
As investors do not obtain tax relief from any interest receive d, YTM is 
calculated using pre-tax intere st receipts. This means that tax  is not deducted 
from any interest received within  the YTM calculation (As previ ously noted, k d 
will consider post-tax interest within its calculation. Tax is deducted from interest 
within k d calculations). 
If the bond is irredeemable, the calc ulation is very simple. Ho wever, it becomes 
more complex if the bond is redeemable. 
Yield on irredeemable debt 
For irredeemable debt: 
YTM = (annual interest received/ current market value of debt) ×  100% 
The yield calculation is always calculated in units of $100 nom inal value of 
bond.

40 
 Illustration 7 – YTM for irredeemable bonds  
 Knife plc, a UK listed company , has some 5% coupon, $100 nomin al 
value, irredeemable bonds in issue , which have a current market  value of 
$95. 
Required: 
Calculate the yield to maturity for these bonds. 
Solution 
YTM = (annual interest/current market value) × 100% 
= (5/95) × 100% = 5.26% 
Note that the coupon rate is appli ed to the nominal value to ca lculate the 
annual interest, but otherwise, t he nominal value is not used i n the 
 
 Test your understanding 7 (OTQ style) 
 Fork plc, a UK listed company , has some 7% coupon, $100 nomina l 
$93.50. 
Give your answer to 2 decimal places. 
Required: 
Yield on redeemable debt 
For redeemable debt: YTM = the internal rate of ret urn (IRR) of the bond price, the annual interest 
received and the fi nal redemption amount. 
This ensures that the yi eld calculation inco rporates a return i n the form of the 
final redemption amount as we ll as the annual interest amounts.  
 
Illustration 8 – YTM for redeemable bonds  
 Knife plc also has some 7% c oupon, $100 nominal value bonds in  issue, 
which are redeemable at a 10% pre mium in 5 years. The current m arket 
value of the bonds is $98. 
Required: 
Calculate the yield to maturity for these bonds.

Chapter 2 
 41 
 Solution 
The yield to maturity for t hese redeemable bonds is found by ta king the 
IRR of the current market value (98 at t 0), the annual interest (7 per 
annum from t 1 to t 5), and the redempt ion amount (110 at t 5), as follows: 
 
Time $ DF 5% PV DF 10% PV 
t0 (98) 1 (98) 1 (98) 
t1 – t 5 7 4.329 30.30 3.791 26.54 
t5 110 0.784 86.24 0.621 68.31 
   –––––  –––––   
   18.54  (3.15) 
Hence IRR = 5% + [(10% – 5%) ×  18.54/(18.54 + 3. 15)] = 9.27%. 
 
 Test your understanding 8 (OTQ style) 
 Fork plc also has some 4% c oupon, $100 nominal value bonds in issue, 
which are redeemable at a 7% prem ium in 3 years. The current ma rket 
value of the bonds is $95. 
Required: 
 
 Test your understanding 9 (further OTQs) 
 1 KM plc has 500,000 $1 par value  shares in issue that are tra ding at 
$1.35. It has recently paid a di vidend of $60,000. Dividends ar e 
expected to grow by 5% per annum. 
The cost of equity is: 
A 8.9% 
B 9.3% C 14.3% D 15.2% 
2 CG has in issue 6% irredeemabl e debentures currently quoted a t 
$92 per $100 nominal value. CG pays corporate income tax at a 
rate of 20%. 
Calculate the post-tax cost of debt. Give your answer as a 
percentage to one decimal place.

42 
 3 RP's cost of equity is 12% and  the yield on its debt is 7%. I ts debt to 
equity ratio is 3:2 based on book  value and 5:3 based on market  
value. The corporate in come tax rate is 25%. 
Calculate the weighted averag e cost of capital (WACC). Give 
your answer as a percenta ge to one decimal place. 
4 Joe plc, a UK listed company , has some 6% coupon, $100 nomina l 
value, irredeemable bonds in issue , which have a current market  
value of $96.25. 
Calculate the yield to maturity for these bonds. State your 
answer to two decimal places. 
5 Gary plc has some 5% coupon, $100 nominal value bonds in issu e, 
which are redeemable at an 8% pre mium in 5 years. The current 
market value of the bonds is $94. 
answer to two decimal places.

44 
  
ke	=  0.75
12 – 0.75 = 6.7% 
 
ke =  0.75 × 1.08
12 – 0.75 + 0.08 = 15.2% 
 
kd =  8 (1 – 0.25)
127 = 4.7% 
 
 Cash flows 
Year 0 $92.00 
Year 1 – 3 $8 (1 – 0.27) = $5.84 Year 3 $100.00 
Year Cash 
flow Disc. fact. 
@ 12% Present 
value 
0 (92.00) 1 (92.00) 1 (92.00) 
1 – 3 5.84 2.723 15.90 2.402 14.03 
3 100 0.864 86.40 0.712 71.20 
Total   +10.30  –6.77 
 
IRR = 5% + ሾሺ12% – 5% ሻ× 10.30
(10.30 + 6.77)ሿ =	9.22%

Chapter 2 
 45 
 The calculation is carried out as follows: 
 
 Market value Cost of 
capital Weighted 
cost 
Source $m Proportions  %  
Bank loans 5 0.125 × 6% = 0.75 
Bonds 5 0.125 × 10% = 1.25 
Ordinary shares 30 0.75 × 15% = 11.25 
 ––– ––––  –––– 
 40 1.00  13.25 
 
WACC = 13.25% 
 
 Solution: 
Market values of the securities: 
Equity  = 1,000,000 × $1.25 = $1,250,000 
Preference = 250,000 × $0.65 = $162,500 
Bonds  = 150,000 × 85% = $127,500 So total value = 1,250,000 + 162,500 + 127,500 = $1,540,000 
Cost of equity (k
e) = 
10 × 1.1
125+ 0.10 = 18.8% 
Cost of preference shares (k p) = 
7
65	= 10.8% 
Cost of bonds (k d) = i(1 – T)/P 0 
15(1 – 0.3)
85	= 12.4%

46 
 Weighted average cost of capital 
 
cost 
Source $000 Proportions  % 
Equity 1,250 0.812 × 18.8% = 15.3 
Preference shares 162. 5 0.106 × 10.8% = 1.1 
Bonds 127.5 0.082 × 12.4% = 1.0 
 ––––– –––––    –––– 
 1,540 1.00  17.4 
 
WACC = 17.4% 
 
 YTM = (annual interest/current market value) × 100% 
= (7/93.5) × 100% = 7.49% 
 
Year  $ DF 5% PV DF 10% PV 
0 (95) 1 (95) 1 (95) 
1–3 4 2.723 10.89 2.487 9.95 
3 107 0.864 92.45 0.751 80.36 
   –––––  ––––– 
   8.34  (4.69) 
 
Hence IRR = 5% + [(10% – 5%) ×  8.34/(8.34 + 4.69)] = 8.20%

Chapter 2 
 47 
 1  C Cost of equity = 14.3%  
ke	= 12 × 1.05
135	+ 0.05 = 14.3% 
Dividend per share = $60,000/500,000 = $0.12 
Dividend has already been paid so  don't deduct it from market p rice 
of share (price is already ex div) 
2 Post-tax cost of debt = 5.2% 
(6 × 0.8)/92 = 5.2% 
3 WACC = 7.8%  
WACC = (7 × 0.75 × 5/8) + (12 × 3/8) = 3.3 + 4.5 = 7.8% 
4 6.23%  
YTM = (annual interest/current market value) × 100% = (6/96.25) × 100% = 6.23% 
5 8.0%  
Year $ DF 5% PV DF 10% PV 0 (94) 1 (94) 1 (94) 1–5 5 4.329 21.65 3.791 18.96 5 108 0.784 84.67 0.621 67.07 
   
–––––  –––– 
   12.32  (7.97) 
Hence IRR = 5% + [(10% – 5%) × 12.32/(12.32 + 7.97)] = 8.04%

49 
Financial instruments 
B1: Explain relevant financial 
reporting standards for revenue, leases, financial instruments, intangible assets and provisions Explain the financial reporting 
(d)  Financial instruments   
 
  Chapter 
3

50 
 
Syllabus area F2B covers Financ ial reporting standards. Chapter  3 to 10 
inclusive cover topics that fa ll under this syllabus area. Fina ncial reporting 
standards makes up 25% o f the F2 syllabus.  
The first financial reporting standards covered in this chapter  are relevant to the 
accounting of financial instruments.   
Definitions 
 A financial instrument is 'any contract that gives rise to a financial 
asset of one entity and a financia l liability or equity instrum ent of 
another entity'  (IAS 32, para 11). 
 
Think of financial assets as any thing that can be used to finan ce a business. 
As seen in chapter 1, businesses can raise  finance for themselves via debt or 
equity. When raising finance, an entity may use financial liabi lities and equity 
instruments. 
Businesses can also provide  finance for other entities e.g. banks giving loans 
to customers, companies acquiri ng debentures. When providing fi nance an 
entity will create a financial asset.

Chapter 3 
 51 
 'A financial asset is  any asset that is: 
• cash  
• an equity instrument of another entity  
• a contractual right to receive cash  or another financial asset from 
another entity  
• a contractual right to exchange f inancial instruments with anot her 
entity under conditions that a re potentially favourable'  (IAS 32, 
para 11). 
Examples of financial assets are: 
• Investments in ordinary shares of another entity 
• Investments in debentures/loan stock/loan notes/bonds i.e. len ding money 
to another entity. 
 
 'A financial liability  is any liability that is a contractual obligation: 
• to deliver cash or another fina ncial asset to another entity 
• to exchange financial instrume nts with another entity under 
conditions that are potentially unfavourable' (IAS 32, para 11). 
Examples of financial liabilities include: 
• Issue of debentures/loan sto ck/loan notes/bonds i.e. borrowing  money 
from another entity 
• Trade payables 
• Loans from financial institutions. 
 
 An equity instrument is 'any contract that evidences a residual 
interest in the assets of an en tity after deducting all of its liabilities'  
(IAS 32, para 11). 
An example of an equity instrument would be: 
• an issue of ordinary shares.

52 
Accounting standards 
There are three accounting standar ds that deal with financial i nstruments: 
• IAS 32 Financial instruments: presentation 
• I F R S® 7 Financial instruments: disclosures  
• I F R S® 9 Financial instruments.  
IAS 32 deals with the classification of financial instruments a nd their 
presentation in financ ial statements. 
IFRS 7 deals with t he disclosure of financial instruments in fi nancial statements. 
This standard is not examinable in the F2 syllabus.  
 
 IFRS 9 deals with how financial instruments ar e measured and wh en they 
should be recognised in  financial statements. 
IFRS 9 is a new standard and is e ffective for annual periods be ginning on or 
after 1 January 2018. This is a  new addition to the CIMA F2 syl labus. IFRS 9 
supersedes IAS® 39 Financial instruments: recognition and measurement , the 
stipulations of which are  no longer examinable. 
 
 Why issue a new accounting standard? 
 In recent years, there has been a huge growth worldwide in the  variety 
and complexity of financial instru ments in international financ ial markets. 
The impact of recent corporate sc andals (e.g. Enron, Parmalat) and the 
global economic crisis were fe lt by individuals and businesses alike. 
Financial instruments, and the a ccounting of which, were right at the 
heart of these significant events. 
In the aftermath of t he economic crisis, numerous concerns abou t the 
accounting practices used for fina ncial instruments were raised  which led 
to demand for changes to the acc ounting standards. Problems inc luded 
• there had been significant growt h in the number and complexity  of 
financial instruments  
• accounting standards had not devel oped in line with the growth  in 
instruments 
• financial instruments were f ound to be overst ated and unrealis ed 
losses were not recognised 
• companies could choose when to recognise profits on instrument s 
in order to smooth overall profits. 
As a result, IFRS 9 was issued which introduces robust new clas sification 
rules for financial instrum ents and adopts a more prudent accou nting 
approach aimed at reduci ng the risks described.

Chapter 3 
 53 
3 Classification of financial in struments in the issuing entity  
IAS 32 Financial instruments: presentation  provides the rules on classifying 
financial instruments as liabilit ies or equity. These are detai led below. 
 
 Presentation of liabi lities and equity 
The issuer  of a financial instrument must classify it as a financial liab ility or 
equity instrument on initial reco gnition according to its subst ance. 
Financial liabilities 
The instrument will be classified  as a liability if the issuer has a contractual 
obligation:  
• to deliver cash (or another fi nancial asset) to the holder 
• to exchange financial instrum ents on potentially  unfavourable terms. 
Equity instruments 
A financial instrument is only an equity instrument if there is  no such contractual 
obligation. 
 
 Illustration 1 – Preference shares 
 The above definitions ensure tha t substance over form is refle cted and 
that any obligations are corre ctly presented as liabilities. 
Consider the classification o f redeemable preference shares. Le gally they 
are called shares, however, if we consider their characteristic s, a different 
interpretation could be applied.  
The entity receives an inflow o f cash upon their issue, it then  makes 
annual payments based on a percentage of the nominal value of t he 
'shares' and, at a specified poin t in the future, the cash is r epaid. From a 
commercial perspective, they are j ust like a loan. As a result,  the 
substance dictates that they s hould be classified as debt instr uments. 
Even if the preference shares a re not redeemable, they are stil l typically 
considered to be liabilities if t hey are 'cumulative'. This mea ns that there 
is a contractual obligation to pay the preference dividends in a future 
period if they cannot be paid out in the current year.

54 
Interest, dividends, losses and gains 
• The accounting treatment of i nterest, dividends, losses and ga ins relating 
to a financial instrument follows  the treatment of the instrume nt itself. 
• For example, dividends paid in respect of preference shares cl assified as 
a liability will be charged as a  finance expense through profit  or loss. 
• Dividends paid on shares classi fied as equity will be reported  in the 
statement of changes in equity th rough retained earnings. 
Offsetting a financial asset a nd a financial liability 
IAS 32 states that 'a financial asset and a financ ial liability may only be 
offset in very limited circumstances. The net amount may only b e reported 
when the entity:  
• has a legally enforceable ri ght to set off the amounts, and  
• intends either to settle on a ne t basis, or to realise the asse t and 
settle the liability simultaneously'  (IAS 32, para 42). 
 
 4 Recognition and measurement of financial instruments 
IFRS 9 Financial instruments,  provides guidance on when financial instruments 
should be recognised in the fi nancial statements and how they s hould be 
measured. 
Initial measurement of financial instruments 
 
 IFRS 9 Financial instruments  says that a financial instrument should be 
initially recognised at its fair value .  
Subsequent measurement of financial instruments 
Issued equity instruments (where the entity issues shares to ra ise finance) are 
not re-measured after initial recognition. 
Subsequent measurement of other  financial instruments depends o n how that 
particular financial instrument is classified. 
This text will cover the initia l recognition and subsequent tre atment of financial 
liabilities and financial assets i n turn, starting below with f inancial liabilities.

Chapter 3 
 55 
5 Financial liabilities 
NB. An entity will raise finance by ISSUING  bonds/loan stock/debentures. This 
creates a financial liability. 
 
 Exam scenarios regarding financia l instruments often include te rminology 
that initially can seem daunting . Below is an example of a typi cal financial 
liability and the subsequent tabl e includes an explanation of s ome of the 
terminology used. 
“An entity issues 5% $100 debent ures at a discount of 4%. The d ebenture 
is redeemable after 5 years at a premium of 10%.” 
Term  Definition Equivalent from example 
Par value Headline value of a 
debenture/bond. Can also be described as the nominal value. $100  
Coupon rate Minimum i nterest repayment 
per annum based on par values.   5% × $100 = $5 interest 
repayment each year (in cash) 
Discount If the loan is issued at a 
discount, the cash amount received from the loan is less than the par value. Discount of 4% = 4% of 
$100 = $4 
The amount initially 
received would be $96. 
Redemption date Date of repayment of capital 
element of loan aka the maturity date. 5 years 
Premium Extra am ount repayable at 
redemption date based on par values. $10 
10% premium on par value 
of $100 = repayment of $110 (premium of $10) 
Effective interest 
rate The rate of interest that 
spreads the total finance costs, including discounts, premiums and coupon rate repayments, across the life of the loan at a constant rate. None given but it can be 
determined via an internal rate of return calculation. 
In exam questions the 
effective interest rate will be given.

56 
Initial measurement of financial liabilities 
 
 IFRS 9 Financial instruments  says that a liability should be initially 
recognised at its fair value .  
Directly attributable transacti on costs (e.g. professional fees  directly 
related to the issue or acquisi tion of a financial instrument) are capitalised 
unless classified as fair val ue through profit or loss.  
Capitalised transaction costs ar e deducted from the liability. 
If the financial liability is c lassified as fair value through profit or loss, then 
transaction costs are expensed wit hin the statement of profit o r loss. 
Subsequent measurement o f financial liabilities 
Subsequent measurement of financ ial liabilities depends upon th e classification 
of the financial liability. There are two possible categories o f financial liability.

Chapter 3 
 57 
Amortised cost 
• Financial liabilities will norma lly be measured as at the year -end at 
amortised cost. The amortised co st in the first year of a liabi lity is the 
amount initially recorded, plu s interest, less repayments. 
• The interest will be charged on  the outstanding balance at the  effective 
rate. This is the internal rate of return of t he instrument.  
The simplest way to prepare a work ing for amortised cost is to use the following 
table. 
Year Opening 
balance Effective 
interest % 
(P/L) Coupon paid 
% Closing 
balance (SFP) 
 $  $  $  $  
1 X X (X) X 2 X X (X) X 3 X X (X) X 
The opening balance in year 1 is the net proceeds (i.e. after d eduction of any 
discounts and i ssue costs): 
• Dr Cash 
• Cr Liability 
Effective interest is calcul ated on the opening balance each pe riod and is 
charged to the statement of p rofit or loss (P/L): 
• Dr Finance costs (P/L) 
The coupon paid is the coupon pe rcentage multiplied by the par/ nominal value 
of the debt: 
• Dr Liability 
• Cr Cash 
The closing balance is the amorti sed cost shown on the statemen t of financial 
position (SFP) at t he reporting date.

58 
 Illustration 2 – amortised cost 
 A company issues 5% loan notes at their nominal value of $20,0 00. The 
loan notes are repayable a t par after 4 years. 
When the loan notes are issued: 
Dr Bank $20,000 Cr Loan notes $20,000 
Financial statement extr acts over the 4 year term 
Note:  Because the loan is repayable at par (face/nominal) value of 
$20,000, the coupon rate is equal  to the effective rate. 
Statement of profit or loss (P/L) 
 
Year 1 2 3 4 
 $  $  $  $  Finance costs (W1)  (1,000) (1,000) (1,000) (1,000) 
Statement of financial position (SFP) 
 
Year 1 2 3 4 
 $  $  $  $  
Non-current liabilities 20,000 20,000   
Current liabilities   20,000 0 
(W1)  Amortised cost table 
 
interest 5% 
5% Closing 
balance 
(SFP) 
 $  $  $  $  
1 20,000 1,000 (1,000) 20,000 2 20,000 1,000 (1,000) 20,000 
3 20,000 1,000 (1,000) 20,000 
4 20,000 1,000 (1,000)  20,000  
The notes are repaid at par ($20 k) at the end of year 4 = balan ce of 0. 
 
 Test your understanding 1 (integration question) 
 A company issues 0% loan notes at their nominal value of $40,0 00 at the 
beginning of the year. The loan no tes are repayable at a premiu m of 
$11,800 after 3 years. The effect ive rate of interest is 9%. 
Required: 
(a) What amount will be recorded as a financial liability when the loan 
notes are issued? 
(b) What amounts will be shown in  the statement of profit or lo ss and 
statement of financial position for years 1–3?

Chapter 3 
 59 
 Test your understanding 2 (integration question) 
 A company issues 5% redeemable pr eference shares at their nomi nal 
value of $10,000. The preference s hares are repayable at a prem ium of 
$1,760 after 5 years. The effect ive rate of interest is 8%. 
Required: 
Explain how the instrument shoul d be classified in accordance w ith 
IAS 32 Financial instrum ents: Presentation . 
What amounts will be shown in the statement of profit or loss a nd 
statement of financial position for years 1–5? 
 
 Test your understanding 3 (integration question) 
 Fratton issues $360,000 of r edeemable 2% debentures at a disco unt of 
14% on 1 January 20X5. Issue co sts were $5,265. The debenture w ill be 
redeemed on 31 December 20X7 at par. Interest is paid annually in 
arrears and the effective interest rate is 8%. 
Required: 
Show the effect of the transacti on on the statement of financia l position 
and statement of profit or loss fo r the three year term of the debenture. 
 
 A company issues 4% loan notes with a nominal value of $20,000 . 
The loan notes are issued at a  discount of 2.5% and $534 of iss ue costs 
are incurred. 
The loan notes will be repayable a t a premium of 10% after 5 ye ars. The 
effective rate of interest is 7%. 
Required: 
The value recorded on initial m easurement of the loan notes is:  
A $18,966 B $19,466 C $19,500 D $20,034

60 
 An entity issues 3% bonds with a nominal value of $150,000. Th e bonds 
are issued at a discount of 10% a nd issue costs of $11,450 are incurred. 
The bonds will be repayable at a p remium of $10,000 after 4 yea rs. The 
effective rate of interest is 10%. 
The initial recogniti on of the bonds was correctly recorded by the entity at 
$123,550. However the entity has not re-measured the bonds and has 
instead expensed the interest pai d to the statement of profit o r loss. 
Required: 
Calculate the carrying amount o f the bonds that should be prese nted in 
the statement of financial pos ition at the end of year 1. 
6 Presentation of compound instruments 
 A compound instrument  is a financial instrument that has characteristics 
of both equity and liabilities. 
Convertible bonds are compound instruments. They are currently debt but can 
be converted into equ ity shares at certain points in the future . 
As we've already seen in earlie r chapters, the bondholder has t he prospect of 
acquiring cheap shares in an entit y, because the terms of conve rsion should be 
generous. Even if the bondholder want s cash rather than the sha res, they will 
be likely to accept the conversi on and then sell the shares at market price to 
make a profit. 
In exchange though, the bondholders normally have to accept a b elow-market 
rate of interest, and will have to w ait some time before they g et the shares that 
form a large part of their return . There is also the risk that the entity’s shares will 
under-perform, making the conversion unattractive. 
Upon initial recognition, IAS 32 requires compound financial in struments to be 
split into their component parts: 
• a financial liability (the debt) – measured as the present val ue of the future 
cash flows, including redemption,  using a discount rate that eq uates to the 
interest rate on similar inst ruments without conversion rights 
• an equity instrument (the option  to convert into shares) – cal culated as the 
balancing figure. 
These must be shown separately in the financial statements. The  equity 
balance would be held as a separat e reserve within the statemen t of financial 
position. It is commonly held und er the heading of ‘Other compo nents of equity’ 
and is separate from share c apital and share premium.  
Subsequently, the liability com ponent is measured at amortised cost and the 
equity component remains unchanged. 
Any transaction costs would be pro-rated between equity and lia bility 
component based on their values.

Chapter 3 
 61 
 Illustration 3 – Compound instrument  
 On 1 January 20X1, Daniels issued a $50m three year convertibl e bond 
at par. 
• There were no issue costs. 
• The coupon rate is 10%, payable annually in arrears on 
31 December. 
• The bond is redeemable at par on 1 January 20X4. 
• Bondholders may opt for conversi on. The terms of conversion ar e 
two 25 cent shares for every $1 owed to each bondholder on 
1 January 20X4. 
• Bonds issued by similar compani es without any conversion right s 
currently bear interest at 15%. 
• Assume that all bondholders opt for conversion in full. 
Accounting treatment 
On initial recognition, the met hod of splitting the bond betwee n equity and 
liabilities is as follows: 
• Calculate the present value of the debt component by discounti ng 
the cash flows at the market rat e of interest for an instrument  similar 
in all respects, except that it does not have conversion rights . 
• Deduct the present value of the d ebt from the proceeds of the issue. 
The difference is the equity component.

62 
 1  Splitting the proceeds  
The cash payments on the bond should be discounted to their 
present value using the interest rate for a bond without the conversion rights i.e. 15%. 
Date  Cash 
flow Discount 
factor 
@ 15% Present 
value 
  $000  $000 
20X1–X3 Interest 5,000 2.283 11,415 
01/01/X4 Redemption 50,000 0.658 32,900 
    –––––– 
Present value = the liability component   44,315 Equity (balancing figure)  5,685 
    –––––– 
Net proceeds of issue  50,000     –––––– 
The journal entry required  to record the issue is: 
Dr Bank $50m 
Cr Financial Liability $44.315m 
Cr Equity (bal fig) – other reserves $5.685m 
2 Subsequent remeasurement of liability component  
 Opening 
interest rate 
15% Payments Closing 
balance 
20X1 44,315 6,647 (5,000) 45,962 20X2 45,962 6,894 (5,000) 47,856 
20X3 47,856 7,144* (5,000) 50,000 
* Note that the effective inte rest in 20X3 is rounded (due to t he 
discount factors having only been applied to 3 decimal places) to 
ensure that the closing balance e quals the redemption amount of  
$50 million. 
Note:  The equity component is not r emeasured after initial 
recognition.

Chapter 3 
 63 
 3 The conversion of the bond  
The carrying amounts at 1 January 20X4 are: 
 $000 
Equity – other reserves 5,685 
Liability – bond 50,000  ––––––– 
 55,685 
 ––––––– 
The conversion terms are two 25c shares for every $1, so $50m ×  2 
= 100m shares, which have a nominal value of $25m. The 
remaining $30.685 million should be classified as the share 
premium, also within equity. Ther e is no remaining liability, b ecause 
conversion has extinguished it. 
The journal entry on conversion would be: 
Dr Liability $50m Dr Equity – other reserves $5.685m Cr Share capital $25m Cr Share premium $30.685m 
 
 An entity issues 2% converti ble bonds at their nominal value o f $36,000 
The bonds are convertible at any ti me up to maturity into 120 o rdinary 
shares for each $100 of bond. A lternatively, the bonds will be redeemed 
at par after 3 years. Similar non-convertible bonds would carry  an interest 
rate of 9%. 
The entity is preparing its financ ial statements for the year e nded 
31 December 20X1. They are not s ure how to record the convertib le 
bonds and have credited the £36,000 cash received to non-curren t 
liabilities and recognised the in terest paid in the year as a f inance cost. 
Required: 
(a) Prepare the journal entry t hat should have been applied to correctly 
record the initial recognition of the convertible bonds on 1 Ja nuary 
20X1. 
(b) Prepare extracts from the st atement of profit or loss and s tatement 
of financial position for the year ended 31 December 20X1. 
(c) What are the journal entries  required to correct the entity 's 
accounting records in the year ended 31 December 20X1?

64 
 A company issues 4% convertible bonds at their nominal value o f 
$5 million on 1 January 20X3. 
Each bond is convertible at any ti me up to maturity into 2 ordi nary shares 
for every $1 bond. Alternativel y the bonds will be redeemed at par after 
3 years. 
The market rate applicable to  non-convertible bonds is 6%. 
Required: 
Complete the following journal ent ry required to record the ini tial 
recognition of the convertible bonds on 1 January 20X3. Give yo ur figures 
to the nearest $000: 
 $000 
Dr Bank 5,000 
Cr Financial Liability  
Cr Equity  
  
 A company issues 100,000 5% conv ertible bonds with a nominal v alue of 
$100 each on 1 January 20X0. 
Each bond is convertible at any ti me up to maturity into 120 or dinary 
shares for every $100 bond. Alter natively the bonds will be red eemed at 
par after five years. 
The market rate of interest for a similar five year term bond w ith no 
conversion option is 7%. 
Upon initial recognition, the liability component of the bond w as correctly 
calculated and recognised as $9,180,000 and the equity componen t was 
$820,000. 
Required: 
Calculate the carrying amount o f the liability component that w ould be 
shown in the statement of financia l position at 31 December 20X 0. Give 
your answer to the nearest $.

Chapter 3 
 65 
 7 Financial assets 
An entity that  provides  finance to another entity will account for a financial 
asset.  
Finance can be provided through equity or debt financial assets . 
If an entity ACQUIRES shares, i t will own an equity financial a sset. 
If an entity ACQUIRES bonds/debent ures/loan stock, it will own a debt financial 
asset. 
Initial measurement of financial assets 
 
 IFRS 9 Financial instruments,  says that a financial asset should be initially 
recognised at its fair value (which is typically cash paid/received).  
Directly attributable transacti on costs (e.g. professional fees  directly related to 
the issue or acquisition of a f inancial asset) are capitalised unless the financial 
asset is classified as fair v alue through profit or loss.  
Capitalised transac tion costs are added  to the asset. 
If the financial asset is classi fied as fair value through prof it or loss, then 
Subsequent measurement of financial assets 
Subsequent measurement of financ ial assets depends on how the f inancial 
assets have been classified. 
Classification depends upon whether the financ ial asset is an e quity financial 
asset or a debt financial asset.

66 
Subsequent measurement of investments in equity financial asset s 
Remember, if an entity ACQUIRES  shares, it is an equity financi al asset.

Chapter 3 
 67 
 Test your understanding 9 (integration question) 
 A company invested in 10,000 shar es of a listed company in Nov ember 
20X7 at a cost of $4.20 per share . Transaction costs relating t o the 
investment were $1,300. At 31 De cember 20X7, the shares have a 
market value of $4.90. The shares  are held for trading purposes . 
Required: 
(a) Prepare extracts from the st atement of profit or loss for t he year 
ended 31 December 20X7 and a stat ement of financial position as  
at that date. 
(b) Explain how the treatment w ould differ if there was no plan  to sell 
the shares and the company opts  to use the FVOCI designation. 
 
 Test your understanding 10 (OTQ style) 
 MNB acquired 100,000 shares in AB on 25 October 20X0 for $3 pe r 
share. The investment resulted in MNB holding 5% of the equity shares 
of AB. The related transaction co sts were $12,000. AB's shares were 
trading at $3.40 on 31 December 20X0. The investment has been 
classified as held for trading. 
Required: 
The journal entry required to r ecord the change in fair value o f the 
investment in shares a t 31 December 20X0 is: 
A Dr Investment $28,000 Cr  Profit or loss $28,000 
B Dr Investment $28,000 Cr R eserves/Other comprehensive 
income $28,000 
C Dr Investment $40,000 Cr  Profit or loss $40,000 
D Dr Investment $40,000 Cr R eserves/Other comprehensive 
income $40,000

68 
Subsequent measurement of investments in debt financial assets 
Remember, if an entity ACQUIR ES debentures/loan notes/bonds, it  is a debt 
financial asset. 
There are three classifica tions of debt financial assets: 
• Amortised cost 
• Fair value through other com prehensive income (FVOCI) 
• Fair value through profit or loss. 
At initial recognition, an ent ity will designate a debt financi al asset as either 
FVOCI or at amortised cost dependent upon the outcome of two te sts: 
• The business model test 
• The contractual cash flow test. 
The business model test 
To determine the category of debt financial asset, the business model test  
considers the entity’s strategi es regarding investments in debt .  
Does the entity invest in debt fi nancial assets with an intenti on to keep financial 
assets, to sell them to other inv estors or do they expect to ho ld some and sell 
some of the financial assets?  
The contractual cash flow test 
The contractual cash flow test states that the contractual term s of the debt 
financial asset give rise to cas h flow receipts that are solely  repayments of: 
• principal (the capital element of the debt),and 
• interest on the princi pal amount outstanding. 
If the cash flows received are deemed to consist of cash flows relating to 
anything else, then the financial asset does not comply with th e contractual 
cash flow test. As a result, the fair value through profit or loss (FVPL)  
category should be used (see below). 
For example, investments in conv ertible bonds are often issued at lower than 
market value interest rates to  compensate for the bond holder h aving the option 
to redeem the loan in the form of  cash or shares. The cash flow s are also 
considered payment for the extr a choice of method of redemption . As a result 
convertibles do not comply with  the contractual cash flow test as payment is 
received for something other than capital and interest.

Chapter 3 
 69 
An investment in a debt financial asset is classified and measu red at amortised 
cost if: 
• the entity’s business model is to hold and collect all  of the asset’s 
contractual cash flows, and 
• the terms of the financ ial asset create the receipt of cash fl ows that are 
solely repayments of interest and principal amount outstanding (passes 
the contractual cash flow test). 
Fair value through other comprehensive income (FVOCI) 
An investment in a debt financial asset is classified and measu red at fair value 
through other comprehensive income if: 
• the entity’s business model is to hold some  of the assets until maturity 
and to sell some  of the financial assets, and  
solely repayments of interest and principal amounts outstanding  (passes 
If the entity considers holding some of the financial assets to  maturity and 
selling some of the financial a ssets as being integral to the b usiness model of 
the entity, the FVOCI model shoul d be used. For example, holdin g financial 
assets yet selling financial a ssets to raise funds to take adva ntage of other 
investments with better returns. 
 
 If the entity sells a debt financ ial asset due to unforeseen ci rcumstances 
(e.g. an increase in credit ri sk leading to the sale of the fin ancial asset), 
the intention of the entity may not have been to sell. This wou ld not 
necessarily qualify as an intent ion to hold some and sell some of the debt 
financial assets. The amortised cost classification would still  be applicable 
as the entity’s business model i s still to hold until maturity.  Sales are 
infrequent and incidental. 
Fair value through profit or loss (FVPL) 
If no designation as either amort ised cost or fair value throug h other 
comprehensive income has occurred, the debt financial asset is classified and 
measured at fair value through profit or loss.

70 
Debt financial asset accounting: Summary

Chapter 3 
 71 
• The amortised cost of an asset equals: initial cost plus inter est less cash 
received. 
• The interest will be charged at th e effective rate. This is th e internal rate of 
return of the instrument. 
table: 
interest 
% (P/L) Cash received 
(coupon) % Closing 
 $  $  $  $  
The opening balance in year 1 is t he total investment (cash inv ested plus 
transaction costs): 
• Dr Asset 
• Cr Cash 
Effective interest is calcul ated on the opening balance and is credited to the 
statement of profit or loss (P/L) as finance income: 
• Dr Asset 
• Cr Finance income (P/L) 
The coupon received is the c oupon percentage multiplied by the face value of 
the instrument: 
• Dr Cash 
• Cr Asset 
The closing balance is the figur e for the statement of financia l position (SFP) at 
the reporting date.

72 
 Test your understanding 11 (integration question) 
 JS company invests $5,000 in 1 0% debentures at the start of th e year. 
The debentures will be repaid at a  premium at the end of their term. The 
business model applie d by JS is to hold  the debentures until th is time. 
The effective rate of interest is 12%. 
Required: 
Prepare extracts from the statem ent of profit or loss and state ment of 
financial position for years 1 and 2 of the inst rument's term. 
Fair value through other comprehe nsive income (debt investments ) 
If classified as a debt FVOCI financial asset, the business mod el will be both to 
hold and sell the financial assets. 
The FVOCI financial asset will be  measured as at the year-end u sing fair value 
with gains or losses recorded in  other comprehensive income (OC I) and equity 
in the statement of financial position. 
The debt financial asset still ear ns interest income and will r eceive coupon rate 
interest repayments. The intere st income is calculated based up on the figures 
as if the debt financial asset wer e classified at amortised cos t.  
The revalued fair value amounts do not affect the interest inco me. 
 
 Please note that calculations  of FVOCI financial asset values are 
specifically excluded from t he syllabus. You need awareness of the 
category but you will not need to cal culate values within the f inancial statements 
for FVOCI debt financial assets.

Chapter 3 
 73 
 Test your understanding 12 – Tokyo 
 On 1 January 20X1, Tokyo bou ght a $100,000 5% bond for $95,000 , 
incurring issue costs of $2,000 . Interest is received in arrear s. The bond 
will be redeemed at a premium o f $5,960 over nominal value on 
31 December 20X3. The effective rate of interest is 8%. The fai r value of 
the bond was as follows: 
31/12/X1  $110,000 
31/12/X2  $104,000 
 Required: 
Explain, with calculations, how the bond will ha ve been account ed for 
over all relevant years if: 
(a) Tokyo planned to hold the bond until the redem ption date. 
(b) Tokyo intends to sell the bond in the short term. 
The requirement to recognise an impairment on debt instruments held at 
amortised cost is to be ignored. 
8 Derivative finan cial instruments 
 Definition of derivatives 
According to IFRS 9 Financial instruments, a derivative is a financial instrument 
that derives its value from the valu e of an underlying asset, price,  rate or 
index. 
• Underlying items include equiti es, bonds, commodities, interes t rates, 
exchange rates and stock ma rket and other indices. 
• Derivative financial instrument s include futures, options, for ward contracts, 
interest rate and currency swaps. 
 
 Characteristics of a derivative 
A derivative has all of the fo llowing characteristics: 
• Its value changes in response  to changes in the underlying ite m 
• It requires little or no initial investment 
• It is settled at a future date.

74 
 The risks associated  with derivatives 
 • Derivatives were originally  designed to hedge against fluctuat ions in 
agricultural commodity prices on the Chicago Stock Exchange. It  
was noted that they also could be used by risk takers purely in  a 
speculative manner. For instance , a speculator would pay a smal l 
amount (say $100) now for the cont ractual obligation to buy a 
thousand units of wheat in three months’ time for $10,000. If i n three 
months’ time one thousand units of wheat costs $11,000, then th e 
speculator would make a pro fit of $900 (11,000 – 100 – 10,000).  
This would be a 900% return on th e original investment over 3 
months, which is one of the attr actions of derivatives to specu lators. 
But if the price had dropped to $9,000, then the trader would h ave 
made a loss of $1,100 ( 100 + 1,000) despite t he initial investm ent 
only having been $100. 
• This shows that losses on der ivatives can be far greater than the 
historical cost carrying amount ( $100 cost in this example) of the 
related asset. Therefore, sharehol ders need to be given additio nal 
information about derivatives in order to assess the entity’s 
exposure to loss. 
• In most cases, entering into a  derivative is at a low or no co st. 
Therefore, it is important that  derivatives are recognised and 
disclosed in the financial statem ents as they have very little initial 
outlay but can expose the entity to  significant gains or losses . 
 
 Recognition and measurement 
 
All derivatives are accounted as  fair value through profit or l oss (FVPL). 
A derivatives gains (or losses)  fluctuate as t he underlying ite m's price moves. 
On the date of initial recognition , no price movements would ha ve occurred so 
fair value is typically nil (as long as there is no cost of ent ering the derivative). 
At each reporting date, the derivat ive is restated to fair valu e and recorded as a 
financial asset or financial liabi lity on the statement of fina ncial position. Any 
gains/losses are taken to the statement of profit or loss. 
Types of derivative  
• Forward  – the obligation to buy or se ll a defined amoun t of a specific  
underlying asset, at a specified price at a specified future da te. 
• Forward rate agreements  – a contract to fix the interest charge on a 
floating rate loan. 
• Futures contracts  – the obligation to buy or sell a standard quantity of a 
specific underlying item a t a specified future date. 
• Swaps  – an agreement to exchange perio dic payments at specified 
intervals over a specified time period.

Chapter 3 
 75 
• Options  – the right, but not the obligat ion, to buy or sell a specific  
underlying asset, at a specified pr ice, on or before a specifie d future date. 
 
 Types of derivatives – further detail 
 Forward contracts 
The holder of a forward contrac t is obliged to buy or sell a de fined 
amount of a specific underlying a sset, at a specified price at a specified 
future date. For example, a forw ard contract for foreign curren cy might 
require £100,000 to be exchange d for $150,000 in three months’ time. 
This is the same as stating t hat the entity is buying $150,000 at an 
exchange rate of $1.5:£1. 
If the rate of exchange in 3 m onths was $1:£1, then $150,000 co uld be 
bought at £150,000. By entering the  forward to buy at $1.5:£1, the entity 
makes a gain on the derivative of $50,000. They pay £100,000 in  the 
contract but would have had to pay £150,000 without the contrac t. By 
being in the derivative, they sav e $50,000. This would be recor ded as a 
financial asset within t he financial statements. 
If the rate in 3 months was $2: £1, the entity would make a loss  of 
$25,000. By being in the forward contract, the entity pays £100 ,000. They 
would pay £75,000 to buy the $150, 000 without the forward contr act. This 
would be recorded a financia l liability of $25,000. 
Forward currency contracts may be used to minimise the risk on amounts 
receivable or payable in foreign currencies. These risk managem ent 
strategies are called hedge a rrangements and are outside the sc ope of 
the F2 syllabus.

76 
 Forward rate agreements 
Forward rate agreements can be us ed to fix the interest charge on a 
floating rate loan. For example, a  company has a $1m dollar flo ating rate 
loan, and the current rate of int erest is 7%. The rates are res et to the 
market rate every si x months, and the company cannot afford to pay 
more than 9% interest. The company  enters into a six month forw ard rate 
agreement (with, say, a bank) at 9 % on $1m. If the market rates  go up to 
10%, then the bank will pay them $5,000 (1% of $1m for 6 months ) 
which, in effect, reduces their  finance cost to 9%. If the rate s only go up 
to 8% then the company  pays the bank $5,000. 
Futures contracts 
Futures contracts oblige the hol der to buy or sell a standard q uantity of a 
specific underlying item at a spec ified future date. Futures co ntracts are 
very similar to forward contract s. The difference is that futur es contracts 
have standard terms (off-the-s helf) and are traded on a financi al 
exchange, whereas forward contracts are bespoke (tailor made) a nd are 
not traded on a financial exchange. 
Swaps 
Two parties agree to exchange per iodic payments at specified in tervals 
over a specified time period. F or example, in an interest rate swap, the 
parties may agree to exchange fix ed and floating rate interest payments 
calculated by reference to a not ional principal amount. This en ables 
companies to keep a balance betw een their fixed and floating ra te 
interest payments without hav ing to change the underlying loans . 
Options 
These give the holder the right, b ut not the obligation, to buy  or sell a 
specific underlying asset on or b efore a specified future date.  
An option to buy is called a ca ll option. An option to sell is described as a 
put option.  
If the option is in the money (th e entity makes a gain), the op tion will be 
exercised. If the option is out o f the money (is making a loss) , there is no 
obligation to exercise the opti on. The option will be allowed t o lapse. 
Options carry less risk than forw ard or future contracts. Howev er, as a 
result they require greater initi al outlay to enter when compar ed to 
forwards and future contracts.

Chapter 3 
 77 
 Illustration 4 – derivative financial instrument  
 Entity A enters into call opti on on 1 June 20X5, to purchase 1 0,000 $1 
equity shares in another entity on  1 November 20X5 at an exerci se price 
of $10 per share. The cost of t he option is $1 per share to be acquired. 
A has a year end of 30 September. 
By 30 September, the fair value of each option has increased to  $1.30. 
A exercises the opti on on 1 November and t he shares are classif ied as 
fair value through profit or loss . The share price at this date  is $12. 
On 1 June 20X5 the cost of t he option is recognised: 
Debit Call option (10,000 × $1) $10,000 
Credit Cash $10,000 
On 30 September the increase in fair value is recorded: 
Debit Call option (10, 000 × ($1.30 – 1)) $3,000 
Credit Profit or loss –  gain on option $3,000 
On 1 November the option is exerc ised, the shares recognised an d the 
call option derecognised. As the s hares are financial assets at  fair value 
through profit or loss, they a re recognised at $120,000 (10,000  × the 
current market price of $12). 
Debit Investment in shar es at fair value $120,000 
Credit Cash (10,000 × $10) $100,000 Credit Call option (10,000 + 3,000 carrying amount) $13,000 
Credit Profit or loss – further gain (β) $7,000 
The total gain recognised is $10,000 which equates to $1 per sh are, 
being the difference between the share price of $12 and the pri ce paid of 
$11 ($1 for the option and $10 upon exercise) . As $3,000 has al ready 
been recognised in the year ended 30 September 20X5, the remain ing 
$7,000 is recognised upon exercise.

78 
 Test your understanding 13 (integration question) 
 B entered into a forward contra ct on 30 November 20X1 to buy p latinum 
for $435m on 31 March 20X2. The c ontract was entered into on 
30 November 20X1 at nil cost. 
B does not plan to take delivery of the platinum but to settle the contract 
net in cash, i.e. B hopes to generat e a profit from short term price 
fluctuations. 
The year end is 31 De cember 20X1 and the pr ice of platinum has moved 
to $455m at that date. 
On 31 March 20X2, the value o f the underlying item has changed such 
that the equivalent purchase o f platinum would now cost $442m. 
Required: 
Prepare journal entries to rec ord the above transaction. 
 
 Test your understanding 14 (integration question) 
 On 1 March 20X1, ABC decided to enter into a forward foreign e xchange 
contract to buy 5 million florin s for $1 million on 31 January 20X3. ABC's 
reporting date is 30 June. 
Relevant exchange rates were as follows: 
1 March 20X1 $1 = 5 florins 
30 June 20X1 $1 = 4.7 florins 
30 June 20X2 $1 = 4.2 florins 
Required: 
Prepare relevant extracts from A BC's statement o f profit or los s and other 
comprehensive income and statem ent of financial position to ref lect the 
forward foreign exchange contra ct at 30 June 20X2, with compara tives.

Chapter 3 
 79 
 Test your understanding 15 (OTQ style) 
 AB entered into a forward cont ract on 31 January 20X1 to purch ase 
B$1 million at a contracted rate  of A$1:B$0.75 on 31 May 20X1. The 
contract cost was A$nil. AB pr epares its financial statements t o 31 March 
each year. 
At 31 March 20X1, an equivalent c ontract for the purchase of B$ 1 million 
could be acquired at a  rate of A$1:B$0.80. 
Required: 
Which one of the following shows  the impact of the forward cont ract on 
profit or loss in the year ended 31 March 20X1: 
A A$83,333 gain B A$83,333 loss C A$1,250,000 loss D A$1,333,333 gain 
9 Other aspects of IFRS 9 
IFRS 9 also includes details reg arding the accounting of impair ments of 
financial assets, derecognition o f financial instruments and he dge accounting. 
However, all of these issues are  out of the scope of the CIMA F 2 syllabus. As a 
result no further content will be included on these topics.

80 
 Test your understanding 16 (further OTQs) 
 1 A financial instrument is any contract that gives rise to a financial 
________ of one entity and a  financial ________ or ________ 
instrument of another entity. 
Select the correct words to co mplete the above sentence, from 
asset, bond, equity, liability, obligation, share 
2 PT issued 1 million 4% cumulat ive redeemable $1 preference 
shares on 1 January 20X1. 
Which of the following statem ents are TRUE in respect of the 
above financial instrument? Select all that apply. 
A At the date of issue, PT woul d credit equity share capital wi th 
$1 million. 
B If the preference shares were issued at a discount, the 
effective rate of interes t would be lower than 4%. 
C The dividends of $40,000 paid ea ch year would be recognised 
in the statement of changes in equity. 
D The preference shares woul d be remeasured each year at 
amortised cost using the effective interest rate. 
 3 SQ issued $2 million 5% conver tible bonds on 1 January 20X1 at 
par value. The bond is redeemable a t par after 5 years or can b e 
converted into equity shares on  the basis of 2 shares for every  $1 of 
bond. 
The prevailing market rate a t 1 January 20X1 for similar bonds 
without conversion rights was 10% per annum. 
Calculate the carrying amount of the liability element of the 
bonds at 31 December 20X1 (to the nearest $). 
$_________ 
4 BD entered into a forward c ontract on 31 August 20X1 to purch ase 
B$3 million at a contracted rate  of A$1: B$1.5 on 30 November 
20X1. The contract cost was $n il. At 31 October 20X1, BD's 
financial year end, an equivalent contract for the purchase of B$3 
million could be acquired a t a rate of A$1: B$1.7. 
Complete the following journal entry to record the financial 
instrument in the financial state ments of BD for the year ended  
31 October 20X1 (state the a mount to the nearest A$). 
Dr 
Cr Note:  In the assessment, you may have to choose the headings for 
the Dr and Cr from a selection of choices.

Chapter 3 
 81 
5 KM made an investment in a deb t instrument on 1 June 20X0 at its 
nominal value of $2 million. The in strument carries a fixed cou pon 
interest rate of 6% and the in strument will be redeemed at a 
premium on 31 May 20X4. KM’s bus iness model is to hold debt 
investments until thei r redemption date. 
How should this instrument be  classified in the financial 
statements of KM? 
A Financial liability 
B Fair value through profi t or loss financial asset 
C Amortised cost D Fair value through other compreh ensive income financial asset  
 6 CG acquired 20,000 equity shares  in FM on 1 November 20X2 fo r 
$5 per share. The related trans action costs were $2,500. The 
investment was classified as fa ir value through other comprehen sive 
income. At 31 December 20X2, CG' s reporting date, FM's shares 
were trading at $6.25. 
The requirement per IFRS 9 to i nclude impairment can be ignored . 
How would the gain on the  investment be measured and 
recorded in CG's statement o f profit or loss and other 
comprehensive income for the y ear ended 31 December 20X2? 
A Gain of $22,500 recorded in profit or loss 
B Gain of $22,500 recorded in o ther comprehensive income 
C Gain of $25,000 recorded in profit or loss D Gain of $25,000 recorded in o ther comprehensive income 
7 AF acquired an equity investmen t on 1 January 20X1 for its fa ir 
value of $12,000. Transaction co sts of $350 were also incurred.  The 
investment was classified as FVOCI. 
The fair value of the shares r ose to $13,500 on 31 December 20X 1, 
the entity's reporting date. 
The amount shown within other comprehensive income 
relating to the investment in shares for the year ended 31 December 20X1 is: 
A $13,500 
B $1,850 C $1,500 
D $1,150

Chapter 3 
 83 
 (a) When the loan notes are issued: 
Dr Bank $40,000 Cr Loan notes $40,000 
(b) Financial statement extracts 
 
Year  1 2 3 
 $  $  $  
Finance costs (W1)  (3,600) (3,924) (4,276) 
 
Year  1 2 3 
 $  $  $  
Non-current liabilities 43,600   Current liabilities  47,524 0 
 
(W1) Amortised cost table 
 
interest 9% 
(P/L) Coupon 
paid 0% Closing 
balance 
(SFP) 
 $  $  $  $  
1 40,000 3,600 – 43,600 
2 43,600 3,924 – 47,524 3 47,524 4,276 –  
   (51,800) 0 
The loan notes are repaid at par  i.e. $40,000, plus a premium o f 
$11,800 at the end of year 3.

84 
 The redeemable natur e of the preference shares means that ther e will be 
an outflow of economic resources at the redemption date and the refore 
the instrument meets the definit ion of a financi al liability an d should be 
classified as such. 
Year  1 2 3 4 5 
 $  $  $  $  $  Finance costs (W1)  (800) (824) (850) (878) (908) 
Year  1 2 3 4 5 
 $  $  $  $  $  Non-current liabilities  10,300 10,624 10,974   
Current liabilities    11,352 0 
interest 8% 
paid 5% Closing 
balance 
(SFP) 
 $  $  $  $  
1 10,000 800 (500) 10,300 
2 10,300 824 (500) 10,624 3 10,624 850 (500) 10,974 4 10,974 878 (500) 11,352 5 11,352 908 (500)  
   (11,760) 0 
Note:  Effective interest rate is m ultiplied by opening balance. 
Note:  Coupon rate is multiplied by fa ce value of debt i.e. $10,000.

Chapter 3 
 85 
 Amortised cost table  
Year  Opening 
interest 
8% (P/L) Coupon 
paid 2% Closing 
balance 
(SFP) 
  $ $ $ $ 
1 (W1) 304,335 24,347 ( 7,200) 321,482 
2  321,482 25,718  (7,200) 340,000 
3  340,000 27,200 (7,200)  
   ––––––– (360,000) 0    77,265   
   
–––––––   
Note:  Coupon rate is multiplied by  the par value of the debt. 
The total finance cost will be as follows: 
  $  
Redemption value (at par) 360,000 
Payments 2% × 360,0 00 × 3 years 21,600 
  –––––––– 
  381,600 
Net proceeds (W1)   (304,335) 
  –––––––– 
Total finance cost  77,265 
  –––––––– 
The total finance cost will be al located at a constant rate bas ed upon 
carrying amount over the life of  the instrument. The constant r ate is 
known as the effective interes t rate and is 8% for these redeem able 
debentures. The annual finance cost is calculated using the 8% effective 
interest rate as illustrated in  the amortised cost table above.  
(W1) Net proceeds = opening balance  
 $  
Nominal value 360,000 
Discount 14% (50,400) 
Issue costs (5,265) 
 ––––––– 
 304,335 
 –––––––

86 
 The correct answer is A = $18,966 
Working 
 $  
Nominal value 20,000 
Discount 2.5% (500) 
 –––––– 
Cash received 19,500 
Issue costs (534) 
 –––––– 
 18,966 
 –––––– 
 
 Carrying amount of bonds at the end of year 1 = $131,405 
Amortised cost working 
balance  Effective 
interest 10% 
paid 3% Closing 
 $  $  $  $  
1 123,550 12,355 (4,500) 131,405 
Note:  Coupon rate is multiplied by  the par value of debt.

Chapter 3 
 87 
 ( a )  Journal entry to initially recognise convertible bonds:  
Dr Bank $36,000 Cr Financial Liability $29,614 Cr Equity (bal fig)   $6,386 
 
Year Cash flow 
(W1) Discount 
factor 9% Present 
value  
 $      $      
20X1–X3 720 2.531 1,822 
20X3 36,000 0.772 27,792 
   
–––––– 
   2 9 , 6 1 4  
   –––––– 
(W1) Cash flow = 2%  × 36,000 = $720 
(b) Statement of profit or loss year ended 31 December 20X1 
 $  Finance costs (W2)    (2,665) 
Statement of financial pos ition at 31 December 20X1 
 $  
Equity  Equity option   6,386 Non-current liabilities (W2)  31,559 
(W2) Amortised cost table  
interest 
9% (P/L) Coupon 
balance 
(SFP)  
 $  $  $  $  
20X1 29,614 2,665 (720) 31,559 
Note:  Coupon rate is multiplied by the par value of the debt.

88 
 (c) Journal entries required  
Dr Non-current liabilities $6,386 
Cr Equity reserve $6,386 being the correct treatment of t he initial recognition, after s plitting 
the liability and equity component. 
Dr Finance costs (2 ,665 – 720) $1,945 
Cr Non-current liabilities $1,945 being the adjustment to finance co sts to reflect the effective rate 
applied to the liability component. 
 
 Journal entry to record initia l recognition of convertible bon ds: 
 
 $000 
Cr Financial Liability 4,735 
Cr Equity (bal fig) 265 
 
Year Cash flow (W1) 
 Discount factor 
6% Present value 
 
 $   $  
1–3    200,000 2.673    534,600 
3 5,000,000 0.840 4,200,000 
   ––––––––– 
   4,734,600 
   ––––––––– 
(W1) Cash flow = 4% ×  5,000,000 = $200,000 
 
 Carrying amount of liability component at 31 December 20X0 
= $9,322,600 
interest 7% 
paid  Closing 
balance 
(SFP)  
 $  $  $  $  
1 9,180,000 642,600 ( 500,000) 9,322,600 
Note:  Coupon rate is multiplied by par  value of the debt (5% × 10m).

Chapter 3 
 89 
 (a) The financial assets are equity financial assets. They are  classified 
as fair value through profit or lo ss as the shares are held for  trading 
purposes. 
Initial recognition 
Recorded at fair value = 10,000 × 4.2 = $42,000. Transaction co sts 
are expensed to profit or loss. 
Dr FVPL $42,000  Dr Expense – Finance cost $1,300 Cr Cash $43,300 
Subsequent treatment 
Revalue to fair value at the year-end. 
Gains or losses to profit or loss Fair value at year end = 4.9 × 10,000 = $49,000 
Gain = 49,000 – 42,000 = $7,000 Dr FVPL financial asset 7,000 Cr P/L 7,000  
 $  
Gain on financial assets  7,000 Finance cost (1,300) 
Statement of financial position 
 $  
Current assets  Investments  49,000 
(b) The equity financial asset has been designated as fair valu e 
through other comprehensive income  (FVOCI) as the shares are 
not held for trading and the irre vocable designation has been 
applied.  
The transaction costs would be added to the financial asset upo n 
initial recognition rather than being expensed, therefore the i nitial 
asset would be recognised at an amount of $43,300. 
To record the purc hase of the shares 
Dr FVOCI financial asset $43,300 Cr Cash $43,300

90 
 As at the year end, the FVOCI s hould be revalued to fair value with 
gains or losses taken to other comprehensive income (OCI). A FVOCI reserve would be held in equity on the statement of 
financial position.  
The asset would be recognised as non-current on the statement o f 
financial position and the subs equent gain of $5,700 (49,000 – 
43,300) would be taken to res erves and shown as other 
comprehensive income in the stat ement of profit or loss and oth er 
Dr FVOCI financial asset $5,700 Cr Equity/OCI $5,700 
It would be presented in other com prehensive income as an item 
that may not be reclassified subsequently to profit or loss. 
 
 The correct journal entry is C: 
Dr Investment $40,000 
Cr Profit or loss $40,000 The investment is held for tradi ng and should be classified as fair value 
through profit or loss. The trans action costs of $12,000 are ex pensed and 
the initial recognition of the investment would be $300,000. Th e fair value 
at the year-end is $340,000 ( $3.40 × 100,000) and the gain in p rofit or 
loss is $40,000. 
 
 Statement of profit or loss (P/L) 
 
Year 1 2 
 $  $  
Finance income 600 612 
 
Year 1 2 
 $  $  
Non-current assets   Financial assets 5,100 5,212

Chapter 3 
 91 
 (W1) Amortised cost table 
 
interest 
12% (P/L) Coupon 
received 
10% Closing 
balance 
(SFP)  
 $  $  $  $  
1 5,000 600 (500) 5,100 2 5,100 612 (500) 5,212 
Note: Coupon rate is multiplied by  par value of the investment.  
 
 (a) The business model is to hol d the asset until redemption. Therefore, 
the debt instrument will classifi ed to be measured at amortised  cost. 
The asset is initially recognise d at its fair value plus transa ction 
costs of $97,000 ($95,000 + $2,000). 
Interest income will be recognise d in profit or loss using the effective 
rate of interest. 
 
b/f Interest 
(8%) Receipt c/f 
 $  $  $  $  
y/e 31/12/X1 97,000 7 ,760 (5,000)  99,760  
y/e 31/12/X2 99,760 7 ,981 (5,000)  102,741  
y/e 31/12/X3 102,741 8 ,219 (5,000)  105,960 
In the year ended 31 December 20X 1, interest income of $7,760 w ill 
be recognised in profit or loss and the asset will be held at $ 99,760 
on the statement of financial position. 
In the year ended 31 December 20X 2, interest income $7,981 will  
be recognised in profit or loss and the asset will be held at $ 102,741 
In the year ended 31 December 20X 3, interest income of $8,219 w ill 
be recognised in profit or loss.

92 
 (b) The bond would be classified as fair value through profit or loss. 
The asset is recognised at its f air value of $95,000. The trans action 
costs of $2,000 would be exp ensed to profit or loss. 
In the year ended 31/12/X1, int erest income of $5,000 ($100,000  × 
5%) would be recognised in pro fit or loss. The asset would be 
revalued to $110,000 with a gai n of $15,000 ($110,000 – $95,000 ) 
recognised in profit or loss. 
On 1/1/X2, the cash proceeds o f $110,000 would be recognised an d 
the financial asset w ould be derecognised. 
 
 On 30 November 20X1 (contract date): 
Derivative has no value. 
On 31 December 20X1 (reporting date): 
Dr Derivative (fi nancial asset) $20m 
Cr P/L (gain) $20m 
On 31 March 20X2 (settlement): 
Dr P/L (loss) $13m 
Cr Derivative (fi nancial asset) $13m 
To record the further  change in fair value 
Dr Bank $7m Cr Derivative (t o derecognise) $7m 
To record the settlement of the contract 
 
 ( a )  Extracts from financial statements  
Statement of profit or loss for year ended 30 June 20X2 
 
 20X2  
$ 20X1  
$ 
Gain on derivative (W2)  126,646 63,830 
 ––––––– ––––––– 
 
Statement of financial position at 30 June 20X2 
 
 20X2 20X1 
 $  $  
Derivative asset (W1)  190,476 63,830 

Chapter 3 
 93 
Workings 
(W1) Value of derivative  
 $  
Value of forward contract at 1 March 20X1  
(Fl 5m/5) – 1m Nil Value of forward contract at 30 June 20X1  
(Fl 5m/4.7) – 1m   63,830 
Value of forward contract at 30 June 20X2  (Fl 5m/4.2) – 1m 190,476 
(W2) Gain  
 $  
Gain for year ended 30 June 20X1 63,830 
Gain for year ended 30 June 20X2  
(190,476 – 63,830) 126,646 
 
 The correct answer is B = A$83,333 loss 
The value of the derivative will be the difference between the value of the 
contract when settled compared wit h the cost of B$1 million bei ng 
purchased at the year-end rate. 
Cost of B$1 million at the contra cted rate of B$0.75 = 1 m/0.75  = 
A$1,333,333 
Cost of B$1 million at the year- end rate of B$0.80 = 1 m/0.8 = 
A$1,250,000 
Therefore, the derivat ive results in a li ability at the year-en d date of 
A$83,333 (1,333,333 – 1, 250,000) as the contra ct has unfavourab le 
terms when compared to the year end rate. The loss on the deriv ative 
would be charged to the statement of profit or loss in the year  to 
31 March 20X1. 
Note:  the journal entry to record the derivative would be 
Dr P/L (loss) A$83,333 Cr Derivative liability A$83,333

94 
asset  of one entity and a financial liability  or equity  instrument of 
another entity (I AS 32, para 11). 
2 D is the only correct statement.  
A is incorrect as the preferenc e shares should be recognised as  a 
liability, not equity. 
B is incorrect. A discount on i ssue would be an additional cost  and 
therefore would increase the effe ctive rate of interest rather than 
decrease it. 
C is incorrect. The dividends pai d would be expensed through pr ofit 
or loss as a finance cost rather  than being shown as a dividend  paid 
3 The carrying amount of the liab ility element of the bonds at 
31 December 20X1 is $1,683,210 (W2). 
 
Year(s) Cash flow 
(W1)  Discount 
factor 10% Present 
value 
 $   $  
1–5 100,000 3.791 379,100 
5 2,000,000 0.621 1,242,000 
   ––––––––– 
   1,621,100 
   ––––––––– 
 
(W1)  Cash flow = 5% × 2 million = $100,000 
(W2)  Amortised cost table 
 
interest 
10% (P/L) Coupon 
balance  
(SFP)  
 $  $  $  $  
20X1 1,621,100 162,110 ( 100,000) 1,683,210 
 
4 Dr P/L – loss on deri vative A$235,294 
Cr Derivative liability A$235,294 
Cost of B$3 million at the contra cted rate of B$1.5 = 3m/1.5 = A$2m 
Cost of B$3 million at the year- end rate of B$1.7 = 3m/1.7 = 
A$1,764,706 
The contracted rate has unfav ourable terms compared to the year  
end rate and therefore the derivative result s in a liability.

Chapter 3 
 95 
 5  C is the correct answer.  
A is not correct as KM made an in vestment. They provided financ e 
therefore it is a financial asset rather than liability. 
B is not correct as KM intends to  hold the debt until all cash flows 
are received. It is not holding  the investment for trading purp oses so 
FVPL is incorrect. 
D is not correct as KM’s busi ness model is not to hold and sell  debt 
financial assets.  
KM intends to hold the financial asset until maturity. Amortise d cost 
is the acceptable classification.  
6 B is the correct answer.  
A and C are not correct as gai ns on FVOCI investments are 
recognised through other comprehensive income. 
D is not correct as the trans action costs are added to the asse t at 
initial recognition. 
The gain is ($6.25 × 20,000) – ( ($5 × 20,000) + $2,500) = $22,5 00. 
7 D is the correct answer  
The gain recorded in e quity within the FVOCI reserves and held 
within other comprehensive income i s calculated as $1,150 (13,5 00 
– (12,000 + 350)).

97 
Earnings per share 
C2: Discuss additional 
disclosure issues related to the group accounts Discuss disclosure 
requirements relating to: 
(b)  Earnings per share 
 
  Chapter 
4

98 
 
2 Earnings per share 
Earnings per share (EPS) is widel y regarded as the most importa nt indicator of 
a company's performance. 
It is also used in the calculati on of the price earnings ratio,  a ratio closely 
monitored by analysts for list ed companies. The price earnings ratio is equal to 
market price per share divided by earnings per share and gives an indicator of 
the level of confidence in t he company by the market. 
Consequently, EPS is the topic of its own accounting standard, IAS 33, which 
details rules on its calculation and presentation to ensure con sistent treatment 
and comparability between companies. 
3 Basic EPS 
The basic EPS calculation is: 
 
EPS = Earnings
Number of shares 
 
This is expressed as dollars or cents per share (cents if the a mount is less 
than $1). 
• Earnings: Net profit attributabl e to ordinary equity sharehold ers of the 
parent entity, i.e. group profi t after tax less profit attribut able to non-
controlling interests and irr edeemable preference share dividen ds. 
• Number of shares: Weighted aver age number of ordinary shares o n a time 
weighted basis. 
Issue of shares at full market price  
An issue at full market price b rings additional resources to th e entity, but the 
impact on earnings is only from t he date of issue. Therefore th e number of 
shares are time apportioned.

Chapter 4 
 99 
 Illustration 1  – Issue of shares at market price  
 A has earnings of $300,000 durin g the year ended 31 December 2 0X6. 
On 1 January 20X6, A had share c apital of 100,000 $1 shares. On  1 
March 20X6 a further 60,000 shar es were issued at $3.25 per sha re. 
Required: 
Calculate basic EPS for y ear ended 31 December 20X6 
Solution 
 
EPS =  $300,000
(100,000 × 2/12) +  (160,000 × 10/12) 
 
EPS = $300,000
150,000 
 
EPS = $2 per share 
 
 A company issued 200,000 shares a t market price ($3.00) on 1 J uly 
20X8. There was no issue of shar es in the year ended 31 Decembe r 
20X7. 
Relevant information 
 20X8 20X7 
Profit attributable to the ordinary 
shareholders for the year ending 31 December  
 
$550,000  
 
$460,000 
Number of ordinary shares in issue at 
31 December  
1,000,000  
800,000 
Required: 
Calculate the EPS for the year s ended 31 Decem ber 20X7 and 20X8 .

100  
 Gerard's earnings for the year  ended 31 December  20X4 are $2,2 08,000. 
On 1 January 20X4, the issued shar e capital of Gerard was 8,280 ,000 
ordinary shares of $1 each. The company issued 3,312,000 shares  at full 
market value on 30 June 20X4. 
Required: 
Calculate the EPS for Gerard fo r the year ended 31 December 20X 4. 
Bonus issue/Scrip issues 
Bonus issues are issues of shares to current shareholders, base d upon the 
shareholder's current shareholding , for free (no cash is raised ). 
Bonus issue may also be refe rred to as scrip issues. 
A bonus issue: 
• does not provide additional resources to the issuer. 
• means that the shareholder owns the same proportion of the bus iness 
before and after the issue. 
 
 In the calculation of EPS: 
• the bonus shares are deemed to have always been in issue and t herefore 
are reflected for the full period. 
• the comparative figures are also restated to include the bonus  shares. 
The EPS calculation becomes: 
 
No. of shares before bonus × bonus fraction 
 
Bonus fraction = No. of shares after bonus issue
No. of shares before bonus issue 
 
E.g. Company B holds 100,000 shar es and makes a 1 for 10 bonus issue. 
100,000/10 = 10,000 ne w shares issued. 
 
Bonus fraction = 110,000
100,000	=	 11
10 
• to adjust the comparative figur es, multiply the previous year' s basic EPS 
by the inverse of the bonus fr action, i.e. 100,000/110,000 or 1 0/11.

Chapter 4 
 101 
 Illustration 2 – Bonus issue 
 A company makes a bonus issue of one new share for every five existing 
shares held on 1 July 20X8. 
 20X8 20X7 
 
$550,000  
 
$460,000 
1,200,000  
1,000,000 
Basic EPS for year ended 31 Decem ber 20X8 (with comparative) 
Calculation of EPS in 20X8 accounts. 
 
20X8 $550,000
1,200,000= 45.8c 
 
20X7 $460,000
1,200,000= 38.3c 
 
In the example above, the computat ion for the comparative has b een 
reworked in full. However, if last year's EPS is given then cal culate the 
comparative EPS by multiplying  this by the bonus fraction inver ted. 
Last year's EPS = 46c ($460,000/1m) The bonus fraction is: 
 
1,200,000
1,000,000 or 6
5 
 
Therefore, the compar ative restated is 
46c × 5/6 = 38.3c 
 
 At 1 April 20X2, Dorabella had  7 million $1 ordinary shares in  issue. It 
made a bonus issue of one share fo r every seven held on 31 Augu st 
20X2. Its earnings for the year were $1,150,000. 
Dorabella's EPS for the year  ended 31 March 20X2 was 10.7c. 
Required: 
Calculate the EPS for the year  ending 31 March 20X3, together w ith the 
comparative EPS for 20X2 tha t would be presented in the 20X3 
accounts.

102  
 At 1 May 20X3, Rose had 900 milli on $1 ordinary shares in issu e. It made 
a bonus issue of one share for ev ery 9 held on 1 September 20X3 . Its 
profit before tax for the year  was $800m and the income tax exp ense for 
the year was $250m. 
Required: 
Calculate the basic EPS for the year ended 30 April 20X4. Give your 
answer in cents. 
 
a bonus issue of one share for ev ery 9 held on 1 September 20X3 . 
Rose's EPS for the year ended 30 April 20X3 was 40.0c. 
Required: 
Calculate the comparative EPS t hat would be presented in the fi nancial 
statements for the y ear ended 30 April 20X4. 
 
 Rights issue  
Rights issues: 
• contribute additional  resources; and 
• are normally priced below full market price. 
Therefore, they combine the char acteristics of issues at full m arket price and 
bonus issues. 
Determining the weighted average c apital, therefore, involves t wo steps as 
follows: 
1 adjust for the bonus element in  the rights issue, by multiply ing capital in 
issue before the rights iss ue by the following fraction: 
 
Actual cum rights price (CRP)
Theoretical ex rights price (TERP) 
 
– The cum rights pric e will be given to you in the exam questio n. It is 
the share price on the last tradi ng day before the rights issue , i.e. the 
price of a share 'including' the rights. 
– The theoretical ex-rights pric e is the theoretical share pric e after the 
rights issue has occurred. This must be calculated. 
2 calculate the weighted average capital in the issue on a time  apportioned 
basis.

Chapter 4 
 103 
 Illustration 3 – Theoretical ex rights price 
 The theoretical ex rights price was introduced in the chapter on Long 
term finance. Here's a remi nder of how to calculate it. 
C makes a 1 for 4 rights issue at $1.90 per share. 
The cum rights price o f C's shares is $2.00. 
Calculation of the TERP 
 Number of shares × Price = Value 
Before rights 4 × 2.00 = 8.00 Rights issue 1 × 1.90 = 1.90 
 
–––    ––– 
After rights  × ?   
We are looking for the theoretic al ex rights price (TERP), i.e.  the price of 
a share after the rights issue , denoted by a question mark abov e. 
Simply calculate the total val ue after the issue and divide it by the total 
number of shares after the issue. 
 Number of shares × Price = Value Before rights 4 × 2.00 = 8.00 Rights issue 1 × 1.90 = 1.90 
 
–––    ––– 
After rights 5 × ?  9.90 
TERP = 9.90/5 = 1.98 The fraction to therefore apply (t o the shares before the right s issue) to 
adjust for the bonus element is: 
CRP/TERP = 2/1.98

104  
 Illustration 4  – Rights issue  
 A company issued one new share fo r every two existing shares h eld by 
way of rights at $1.50 per share on 1 July 20X8. Pre-issue mark et price 
was $3.00 per share. 
 20X8 20X7 
shareholders for the year ending 31 December $550,000 $460,000 
31 December 1,200,000 800,000 
Calculation of basic EPS for ye ar ended 31 December 20X8, with 
comparative 
20X8 
 
Earnings
Weighted average number of shares (W1)	= $550,000
1,080,000 = 50.9 cents 
 
20X7 
The prior year EPS must be adjus ted to reflect the bonus elemen t in the 
rights issue. 
EPS = 57.5c ሺW3ሻ	× $2.50 (W2)
$3.00	= 47.9 cents 
 
NB: To restate the EPS for the prev ious year simply multiply EPS b y the 
inverse of the rights issue bonus fraction. 
(W1) 20X8 Weighted aver age number of shares 
The number of shares before the rights issue must be adjusted f or 
the bonus element in the rights i ssue using the theoretical ex rights 
price. 
6/12 × 800,000 × 3.00/2.50 (W2)  480,000 
6/12 × 1,200,000 600,000 
 ––––– ––– 
 1,080,000 
 ––––– –––

Chapter 4 
 105 
 (W2)  Theoretical ex rights price  
 2 shares @ $3.00 $6.00 
 1 share @ $1.50 $1.50 
  –––––– 
 3 shares $7.50 
  –––––– 
Theoretical ex rights price = $7.50/3 $2.50 
   
(W3) 
20X7 EPS = $460,000 
  –––––––– 
  800,000 
 = 57.5 cents 
   
 On 31 December 20X1, the issued share capital of a company con sisted 
of 4,000,000 ordinary shares of 25c  each. On 1 July 20X2 the co mpany 
made a rights issue in  the proportion of 1 for 4 at 50c per sha re when the 
shares were quoted at $1.15. The pr ofit after tax for the year ended 
31 December 20X2 wa s $425,000. The reported earnings per share for 
the year ended 31 Dece mber 20X1 was 8c. 
Required: 
Calculate the basic EPS for the year ended 31 December 20X2, to gether 
with the comparative for 20X1 t hat would be presented in the 20 X2 
financial statements. 
 
 At 1 May 20X3, Rose had 900 milli on $1 ordinary shares in issu e. Its 
earnings for the year ended 30 April 20X4 was $550m. 
On 1 July 20X3, a rights issue  took place of 1 share for every 4 held at 
$2. The market price of each shar e immediately before the right s issue 
was $2.50. 
Required: 
Complete the formula below to p rovide the bonus fraction that w ould be 
applied to the pre-issue number o f shares in the calculation of  the 
weighted average number of share s of Rose for the year ended 30  April 
20X4. 
$ 
–––––– 
$

106  
 At 1 January 20X3, Lily had 400 m illion $1 ordinary shares in issue. On 
1 August 20X3, a rights issue t ook place of 1 share for every 5  held at 
$2.75. The market price of each s hare immediately before the ri ghts 
issue was $3.25. 
The theoretical ex rights price of the rights issue is $3.17. 
Required: 
Calculate the weighted average number of shares that would be u sed in 
the basic earnings per share ca lculation for the year ended 31 December 
20X3. Give your answer in millions to one decimal place. 
 
 Test your understanding 9 (OTQ style) 
earnings for the year  ended 30 April 20X4 we re $550m and its EP S for 
the previous year, ended 30 April 20X3, was 40.0c. 
was $2.50. 
Required: 
Calculate the comparative basic  EPS that would be reflected in the 
financial statements for the year ended 30 April 20X4. Give you r answers 
in cents to 1 decimal place. 
 
 Test your understanding 10 (case style) 
 XYZ has made a couple of share i ssues over the past few years.  The 
directors have been reviewing the calculation of the basic earn ings per 
share and have noticed that the ca lculation of the weighted ave rage 
number of shares is not consisten t each year. The first share i ssue was a 
bonus issue to existing shareholder s. The second was an issue a t full 
market price. 
Required: 
Prepare a brief note to  the directors explaining why a bonus is sue and 
issue at full market price are tr eated differently in the calcu lation of basic 
earnings per share.

Chapter 4 
 107 
4 Diluted earnings  per share (DEPS) 
Equity share capital may change in  the future owing to circumst ances which 
exist now. The provision of a d iluted EPS figure attempts to al ert shareholders 
to the potential impact of t hese changes on the EPS figure. 
Examples of dilutive factors are: 
• the conversion terms for convertible bonds (or convertible pre ference 
shares) 
• the exercise price for options ( or subscription price for warr ants). 
When the potential ordinary shar es are issued the total number of shares in 
issue will increase and this can have a dilutive effect on EPS i.e. it may fall. It 
will fall where the increase in s hares outweighs any increase i n profits, e.g. from 
a reduction in finance costs once debt has been converted. 
Basic principles of calculation 
 To deal with potential ordinary shares, adjus t basic earnings a nd number 
of shares assuming convertibles , options, etc. had converted to  equity 
shares on the first day of the accounting period, or on the dat e of issue, if 
later. 
DEPS is calculated as follows: 
 
Earnings + notional extra earnings
Number of shares + notional extra shares 
 
 Importance of DEPS 
 The basic EPS figure could be mi sleading to users if at some f uture time 
the number of shares in issue wi ll increase without a proportio nate 
increase in resources. For exa mple, if an entity has issued bon ds 
convertible at a later date into  ordinary shares, on conversion  the number 
of ordinary shares will rise, no fresh capital will enter the e ntity and 
earnings will therefore only rise  by the savings made by no lon ger having 
to pay the post-tax amount of int erest on the bonds. Often the earnings 
increase is proportionately less  than the increase in the share s in issue. 
This effect is referred to as ‘dilution’ and the shares to be i ssued are 
called ‘dilutive potentia l ordinary shares’.

108  
 IAS 33 therefore requi res an entity to disclose the DEPS, as we ll as the 
basic EPS, calculated using current earnings but assuming that the worst 
possible future dilution has a lready happened. Exi sting shareho lders can 
look at the DEPS to see the effec t on current profitability of commitments 
already entered into to issue ordinary shares in the future. 
For the purpose of calculating DEPS, the number of ordinary sha res 
should be the weighted average number of ordinary shares calcul ated as 
for basic EPS, plus the weighted average number of ordinary sha res 
which would be issued  on the conversion of all the dilutive pot ential 
ordinary shares into ordinary s hares. Dilutive potential ordina ry shares 
are deemed to have been converted in to ordinary shares at the b eginning 
of the period or, if later, the date of the issue of the potent ial ordinary 
shares. 
 The principles of convertible bon ds and convertible preference shares are 
similar and will be dealt with together. 
If the convertible bonds/prefer ence shares had been converted: 
• the interest/dividend would be saved therefore earnings would be higher 
• the number of shares would increase. 
Note:  Interest on bonds is tax deducti ble however pr eference dividen ds do not 
attract tax relief. Therefore, the interest adjustment should o nly be reflected net 
of tax in the case of bonds. 
Note:  If there is an option to conver t the debt into a variable numb er of ordinary 
shares depending on w hen conversion takes place, the maximum po ssible 
number of additional shares is used in the calculation. 
 
 Illustration 5 – Convertible debt and DEPS  
 A company has the following balances: 
• $500,000 in 10% cumulative irre deemable preference shares of $ 1 
• $1,000,000 in ordinary shares  of 25c = 4,000,000 shares. 
Income taxes are 30%. On 1 April 20X1, the company issued convertible bonds for cash.  
Assuming the conversion was full y subscribed there would be an 
increase of 1,550,000 ordi nary shares in issue. 
The liability element of t he bonds is $1,250,000 and the effect ive interest 
rate is 8%, resulting in an annua l gross interest charge of $10 0,000.

Chapter 4 
 109 
 Trading results for the years ended 31 December were as follow s: 
 
 20X2  
$ 20X1  
$ 
Profit before interes t and tax 1,100,000 991,818 
Interest on convertible bonds (100,000) (75,000) 
 –––––––– ––––––– 
Profit before tax 1,000,000 916,818 
Income tax (300,000) (275,045) 
Profit after tax 700,000 641,773 
Calculation of basic and dilute d EPS for years ended 31 Decembe r 
20X1 and 20X2. 
 20X2 20X1 
Basic EPS $ $ 
Profit after tax 700,000 641,773 Less: Preference dividend (10% × 
$500,000)  
(50,000)  
(50,000) 
 
––––––– ––––––– 
Earnings 650,000 591,773 
EPS based on 4,000,000 shar es 16.25c 14.8c 
DEPS 
Earnings as above 650,000 591,773 
Notional extra earnings:   
Interest on the convertible bonds (only 
9 months in 20X1)  
100,000  
75,000 
Less: Income tax on interest at 30% (30,000) (22,500) 
Adjusted earnings 720,000 644,273 
EPS based on 5,550,000 shar es 13.0c 11.6c 
Convertible preference shares a re dealt with on the same basis,  except 
that often they do not qualify fo r tax relief so there is no ta x saving 
foregone to be adjusted for.

110  
 Test your understanding 11 (OTQ style) 
 A company had 8.28 m illion shares in iss ue at the start of the  year and 
made no new issue of shares duri ng the year ended 31 December 2 0X4, 
but on that date it had in iss ue convertible loan stock 20X6–20 X9. 
increase of 2,070,000 ordinary s hares in issue. The liability e lement of 
the loan stock is $2, 300,000 and the effectiv e interest rate is  10%. 
Assume a tax rate of 30%. 
The earnings for the year were $2,208,000 giving rise to a basi c earnings 
per share of 26.7 cents. 
Required: 
Calculate the fully diluted EPS  for the year ended 31 December 20X4. 
Options and warrants to subscribe for shares  
An option or warrant gives t he holder the right to buy shares a t some time in the 
future at a predetermined price. 
The cash received by the entity when the option is exercised wi ll be less than 
the market price of the shares, a s the option will only be exer cised if the 
exercise price is lower than the market price. The increase in resources does 
not match the increase there woul d be in resources if the issue  of shares were 
at market value. The options wi ll therefore have a dilutive eff ect on EPS. 
 
 The total number of shares issu ed on the exercise of the option  or 
warrant  is split into two: 
• the number of shares that would have been issued if the cash r eceived 
had been used to buy shares at fai r value (using the average pr ice of the 
shares during the period) 
• the remainder, which are treated like a bonus issue (i.e. as h aving been 
issued for no consideration). 
The number of shares issued for no consideration is added to th e weighted 
average number of shares w hen calculating the DEPS. 
These 'free' shares are equal to: 
 
No. of options × FV – EP
FV 
 
FV = fair value of the share price 
EP = exercise price of the shares

Chapter 4 
 111 
 Illustration 6 – Options and DEPS  
 On 1 January 20X7, a company has  4 million ordinary shares in issue 
and issues options over another m illion shares. The profit afte r tax for the 
year attributable to ordi nary shareholders is $500,000. 
During the year to 31 December 20X7 the average fair value of o ne 
ordinary share was $3 and the exer cise price for the shares und er option 
was $2. 
Required: 
Calculate of basic EPS and DEPS  for the year ended 31 December 20X7 
Solution 
Basic EPS = $500,000
4,000,000	= 12.5c 
 
Options 
 $  
Earnings 500,000 
 ––––––––– 
Number of shares  
Basic 4,000,000 
Options (W1)  333,333 
 ––––––––– 
 4,333,333 
 ––––––––– 
 
The DEPS is therefore $500,000
4,333,333	= 11.5c 
 
(W1) Number of free shares issued 
 
Free shares = No. of options ×FV – EP
FV  
 
Free shares = 1,000,000 × 3.00 – 2.00
3.00	= 333,333

112  
 Test your understanding 12 (OTQ style) 
made no issue of shares during  the year ended 31 December 20X4,  but 
on that date there were outst anding options to purchase 920,000  ordinary 
$1 shares at $1.70 per share. The  average fair value of ordinar y shares 
was $1.80. Earnings for the year  ended 31 December 20X4 were 
$2,208,000 giving rise to a basic EPS of 26.7c. 
Required: 
Calculate the fully DEPS for t he year ended 31 De cember 20X4. 
 
 Test your understanding 13 (OTQ style) 
 On 1 January 20X1, Pillbox, a l isted entity, had 10 million $1  ordinary 
shares in issue. The earnings fo r the year ended 31 December 20 X1 
were $5,950,000. Pillbox made no new issue of shares during the  year. 
The basic earnings per share was therefore 59.5 cents. 
Pillbox is subject to incom e tax at a rate of 30%. 
On 1 January 20X1 Pillbox issu ed convertible bonds. Assuming th e 
conversion was fully subscribed  there would be an increase of 2 ,340,000 
ordinary shares in issue. The li ability element of the bonds is  $2,600,000 
and the effective interest rate is 10%. 
Required: 
Calculate the diluted EPS for t he year ended 31 De cember 20X1. 
 
 Test your understanding 14 (OTQ style) 
were $5,950,000 and Pi llbox made no new iss ue of shares during the 
year. The basic earnings per share  for the year was therefore 5 9.5c. 
Throughout the year ended 31 Decem ber 20X1 there were outstandi ng 
options to purchase 74,000 ordi nary $1 shares at $2.50 per shar e. The 
average fair value of one or dinary $1 share was $4. 
Required: 
Calculate the diluted EPS for t he year ended 31 De cember 20X1.

Chapter 4 
 113 
 Test your understanding 15 (further OTQs) 
 Questions (1) to (3) below ar e all based on the following scena rio: 
On 1 January 20X9, CSA, a listed entity, had 3,000,000 $1 ordin ary 
shares in issue. On 1 May 20X 9, CSA made a bonus issue of 1 for  3. 
On 1 September 20X9, CSA issued 2,000,000 $1 ordinary shares fo r 
$3.20 each. The profit before tax of CSA for the year ended 31 December 
20X9 was $1,040,000. The income tax expense for the year was 
$270,000. 
The basic earnings per share for  the year ended 31 December 20X 8 was 
15.4 cents. 
On 1 November 20X9, CSA issued c onvertible loan stock. Assuming  the 
conversion was fully subscribed  there would be an increase of 2 ,400,000 
ordinary shares in issue. The li ability element of the loan sto ck is 
$4,000,000 and the ef fective interest rate is 7%. 
CSA is subject to income  tax at a rate of 30%. 
Required: 
1 Calculate the basic earnings per share to be reported in the financial 
statements of CSA for the y ear ended 31 December 20X9 in 
accordance with the requirements of IAS 33 Earnings Per Share. 
2 Calculate the comparative EPS  that would be presented alongsi de 
the basic EPS in the financial st atements for the year ended 
31 December 20X9 in accordance wit h the requirements of IAS 33 
Earnings Per Share. 
3 Calculate the diluted earni ngs per share for the year ended 
31 December 20X9, in accordance with the requirements of IAS 33  
The following scenario relat es to question 4 only. 
On 1 July 20X2 SJL, a listed entity, had 6 m illion $1 ordinary shares in 
issue. On 1 March 20X3, SJL made a rights issue of 1 for every 3 shares 
held at a price of $4. The market  price for the shares on the l ast day of 
quotation cum rights was $5 per s hare. SJL's earnings for the y ear ended 
30 June 20X3 were $4.5 million. 
4 Calculate the basic earnings per share to be reported in the financial 
statements of SJL for the year  ended 30 June 20X3, in accordanc e 
with the requirements of I AS 33 Earnings Per Share. 
The following scenario relat es to question 5 only. 
The ordinary shareholders of DPR  held options to purchase 200,0 00 
$1 ordinary shares at $4.25 per s hare. The average fair value o f one 
$1 ordinary share in the per iod in question was $5.15. 
5 What number of shares should be  added to the denominator of t he 
diluted EPS calculation to reflect the free shares that exist w ithin the 
options (to the nearest whole number of shares)?

Chapter 4 
 115 
  
20X7 					Earnings per share = $460,000
800,000 = 57.5c 
 
Issue at market price 
Date Actual number 
of shares Fraction of 
year Total 
1 Jan 20X8 800,000 6/12 400,000 
1 July 20X8 1,000,000 6/12 500,000 
  ––––––– 
Number of shares in EPS calculation  900,000 
  ––––––– 
 
20X8 					Earnings per share = $550,000
900,000 = 61.1c 
 
Since the 200,000 shares have only generated additional resourc es 
towards the earning of profits  for half a year, the number of n ew shares is 
adjusted proportionately. Note t hat the approach is to use the earnings 
figure for the period without adj ustment, but divide by the ave rage 
number of shares weighted on a time basis. 
 
 Issue at full market price 
Date Actual number of 
shares Fraction of 
year Total 
1 January 20X4 8,280, 000 6/12 4,140,000 
30 June 20X4 11,592,000  (W1)  6/12 5,796,000 
  –––––––– 
Number of shares in EPS calculation  9,936,000 
  –––––––– 
(W1)  New number of shares  
Original number 8,280,000 
New issue 3,312,000 
 ––––––––– 
New number 11,592,000 
The earnings per share for 20X4 would now be calculated as: 
 
$2,208,000
9,936,000= 22.2c

116  
 The number of shares issued on 31  August 20X2 is 7,000,000 × 1 /7 = 
1,000,000 
The EPS for 20X3 is 1,150, 000/8,000,000 × 100 c = 14.4c 
The bonus fraction is (7 + 1)/7 = 8/7 20X2 adjusted comparative = 10. 7 × 7/8 (bonus fraction inverted ) = 9.4c. 
 
 Basic EPS = 55c 
The number of shares after the i ssue on 1 Septem ber 20X3 is 900 m × 
10/9 = 1,000m 
The earnings for the year ended 30 April 20X4 is $800m – $250m = 
$550m 
Therefore, the EPS for the year  ended 30 April 20X4 is $550m/1, 000m = 
55c 
 
 Comparative EPS = 36.0c 
The bonus fraction = 10/9 (1 new share for every 9 held). 
The comparative = 40.0 × 9/10 (bonus fraction inverted) = 36.0c . 
 
 20X2 EPS 
 
EPS = $425,000
4,754,902 (W1) = 8.9c per share 
20X1 EPS 
Applying correction factor to cal culate adjusted comparative fi gure of 
EPS: 
 
8c × Theoretical ex rights price
Actual cum rights price = 8c × 1.02 (W2)
1.15  = 7.1 c per share

Chapter 4 
 117 
 (W1)  Current year weighted average number of shares  
price. 
 
6/12 × 4,000,000 × 1.15/1.02 (W2)  2,254,902 
6/12 × 5,000,000 (*) 2,500,000 
 ––––––––– 
 4,754,902 
 ––––––––– 
(*) 4m × 5/4 = 5m 
(W2)  Theoretical ex rights price  
   $  
Prior to rights issue 4 s hares worth 4 × $1.15 = 4.60 
Taking up rights 1 share cost 50c = 0.50 
 ––  –––– 
 5  5.10 
 ––  –––– 
 
i.e. theoretical ex rights price of each share is $5.10 ÷ 5 = $ 1.02 
 
 The fraction to apply to the pr e-issue number of shares is: 
 
$2.50
$2.40 (W1) 
 
(W1) Theoretical ex rights price  
   $  
Prior to rights issue 4 s hares worth 4 × $2.50 = 10.00 
Taking up rights 1 share cost $2.00 = 2.00 
 ––  ––––– 
 5  12.00 
 ––  ––––– 
i.e. theoretical ex rights price of each share is $12 ÷ 5 = $2. 40

118  
 Weighted average number o f shares = 439.2 million 
7/12 × 400m × 3.25/3.17 239.2m 
5/12 × 480m (*) 200.0m 
 ––––––– 
 439.2m 
 ––––––– 
(*) 400m × 6/5 = 480m 
 
 Comparative EPS = 38.4 cents per share 
 
40c × 2.4 (W1)
2.5 = 38.4c per share 
 
(W1) Theoretical ex rights price 
   $  
 ––  ––––– 
 5  12.00 
 ––  ––––– 
i.e. theoretical ex rights price of each share is $12 ÷ 5 = $2. 40 
The rights bonus fraction to appl y in the weighted average 
calculation for the cu rrent year is 2.50/2.40. 
This is inverted and multiplied by the previous year's EPS in o rder to 
restate the comparative. 
 
 Note to directors 
You have correctly noticed that th e calculation of the weighted  average 
number of shares for the basic ear nings per share is different depending 
on whether a bonus issue or full market price issue has been ma de. The 
reason for this difference is explained below. 
A bonus issue does not raise any new finance and therefore the profit for 
the year will have bee n generated with the same level of resour ces 
throughout the year. As the issue results in no additional reso urces it is 
treated as if it has always been in  existence. For this reason,  comparative 
figures also need to be restated.

Chapter 4 
 119 
 The issue at full market price b rings additional resources whic h will 
impact on profits from  the date of issue. T herefore a weighted average 
number of shares is used to calcu late EPS, so that the numerato r and 
denominator are stated on a like for like basis. 
Also, please note that the propor tions held by shareholders aft er a bonus 
issues remain unaffected whils t the proportions of shares held by 
shareholders after a full marke t prices share issue may changes  (as new 
investors may acquire the shares). 
Please let me know if you have any further queries on the matte r. 
 
 Diluted EPS = 22.9 cents per share 
If this loan stock was convert ed to shares the impact on earnin gs would 
be as follows. 
 $  $  
Basic earnings  2,208,000 
Add notional interest saved   ($2,300,000 × 10%) 230,000  
Less tax relief foregone $230,000 × 30% (69,000)  
 
–––––––  
  161,000 
  ––––––––– 
Revised earnings  2,369,000 
  ––––––––– 
Number of shares if loan converted   
Basic number of shares  8,280,000 
Notional extra shares  2,070,000 
  ––––––––– 
Revised number of s hares  10,350,000 
  ––––––––– 
 
DEPS = $2,369,000
10,350,000  = 22.9c

120  
  
 $  
Earnings 2,208,000 
 ––––––––– 
Basic 8,280,000 
Options (W1)  51,111 
 ––––––––– 
 8,331,111 
 ––––––––– 
 
The DEPS is therefore $2,208,000
8,331,111 = 26.5c 
 
 (W1) Number of free shares issued  
Free shares = No. of s hares under option × FV – EP
FV 
 
Free shares = 920,000 × 1.80 – 1.70
1.80 = 51,111 
Tutorial note: 
An alternative way of viewing t he above calculation (of the fre e shares) is 
Finance raised via exercise of options would be $1.70 × 920,000  = 
$1,564,000 
To raise this amount of finance vi a a market price issue would require 
$1,564,000/$1.80 = 868,889 shares 
Therefore, the number of free s hares awarded in the option sche me = 
920,000 – 868,889 = 51,111 
 
 Diluted EPS 
 
Earnings (5.95m + (10% ×  $2.6m × 70%)) $6,132k 
 ––––––– 
Shares (10m + 2.34m) 12,340k 
  
Diluted EPS 49.7c

Chapter 4 
 121 
 
Earnings $5,950k 
 ––––––– 
Shares (10m + (74k × (4 – 2.50)/4)) 10,028k 
  Diluted EPS 59.3c 
  
 1  Basic earnings per share = 16.5 cents 
Profit after tax ($1,040 ,000 – $270,000)  $770,000 
Weighted average number of shares   At 1 January 20X9 3,000,000  
Bonus issue 1,000,000  
Full market price issue (2,000,000 × 4/12) 666,667    4,666,667 
   
Basic EPS for 20X9 $770, 000/4,666,667  16.5 cents 
   
2 Comparative EPS (restat ed) = 11.6 cents 
Last year's EPS 15.4c × 3/4 bonus  fraction inverted = 11.6c 
3 Diluted earnings per share = 11.4 cents  
Reported profit after tax ( as in answer (1)) $770,000  
Plus post tax saving of finance costs   
(70% × 7% × $4m × 2/12) $32,667  
  $802,667 Weighted average number of shares:   
As reported in ans wer (1) 4,666,667  
Weighted average dilu tion from potential 
share issue  
400,000  
(2,400,000 × 2/12)  5,066,667 
   
Fully diluted EPS $802, 667/5,066,667  15.8 cents

122  
 4 Basic EPS = 65.4 cents  
 
EPS = $4,500,000
6,877,193 (W1) = 65.4 cents 
 
(W1) Current year weighted average number of shares  
The number of shares before the rights issue must be adjusted 
for the bonus element in the ri ghts issue using the theoretical  
ex rights price. 
8/12 × 6m × 5/4.75 (W2)  4,210,526 
4/12 × 8m 2,666,667 
 ––––––––– 
 6,877,193 
 ––––––––– 
 
(W2) Theoretical ex rights price  
   $  
Prior to rights issue 3 shares worth 3 × $5 = 15 
Taking up rights 1 share cost $4 = 4 
 –––  –––– 
 4  19 
 –––  –––– 
i.e. theoretical ex rights price of each share is $19 ÷ 4 = $4. 75 
5 Number of free shares = 34,951  
Free shares = 200,000 × (5 .15 – 4.25)/5.15 = 34,951

123 
Leases 
(b)  Leases 
 
  Chapter 
5

Leases  
124  
 
An entity may need a particular asset for its operations but ma y not have the 
cash available to purchase the asset outright. As a result, the  entity may enter a 
lease agreement whereby the entit y gets to use the asset on a d ay to day basis 
This is a common method of financ ing utilised by many businesse s.  
 
'A lease is a contract, or part of a contract, that conveys the  right to use 
an asset (the underlying asset) for a period of time in exchang e for 
The lessor  is the 'entity that provides the ri ght to use an underlying asset 
The lessee  is the 'entity that obtains the right  to use an underlying asset in 
A right-of-use asset 'represents the  lessee's rights to use an un derlying 
asset for the lease term.' (IFRS 16, Appendix A).

Chapter 5 
 125 
3 Lessee accounting 
 Lessee accounting is c overed within F1. It is assumed knowledge  at CIMA 
F2. 
 
4 Lessor accounting 
in exchange for consideration.' (IFRS 16, A ppendix A). 
The lessor provides the asset to t he lessee and receives paymen ts. 
A lessor must classify its leases as finance or operating lease s. 
Finance leases and operating leases  
 
Indications of a finance lease 
To determine whether a lease is  a finance or operating lease, t he substance of 
the lease agreement should be cons idered. According to IFRS 16 Leases , a 
lease is probably a finance leas e if one or more of the followi ng apply: 
• Ownership is transferred to t he lessee at the end of the lease . 
• The lessee has the option to pur chase the asset for a price su bstantially 
below the fair value of the asset and it is reasonably certain the option will 
be exercised. 
• The lease term is for the major part of the asset's useful lif e. 
• The present value of the minimu m lease payments amounts to 
substantially all of the fair value of the asset. 
• The leased assets are of such a specialised nature that only t he lessee 
can use them without m ajor modification. 
• The lessee bears losses arising  from cancelling the lease. 
• Lessee has ability to continue  the lease for a secondary perio d at a rate 
below market rent.

Leases  
126  
 Illustration 1 – Classification of lease 
 A company has entered into a f our-year lease to provide a mach ine to a 
customer. The lease rentals of $100,000 are payable annually in  
advance, with an optional secondar y period of three years at re ntals of 
80%, 60% and 40% of the previous annual rental withi n the prima ry 
period. It is agreed that these rent als represent a fair commer cial rate. 
The machine has a useful life o f eight years and a cash value o f 
$600,000. 
Would this lease agreement be a  finance lease or an operating 
lease? 
Solution 
The contracted lease term is onl y for half of the useful life o f the machine 
and there is no strong  likelihood that the co mpany will exercis e the option 
in four years' time, because the option is priced at fair value , not a 
discount. Thus the risks and rewards of ownership have not pass ed to 
the lessee and this lease should be treated as an operating lea se. 
Operating leases 
Accounting treatment for an operating lease 
• Lease receipts are shown as inc ome in the statement of profit or loss on a 
straight line basis over the te rm of the lease, unless another systematic 
basis is more appropriate. 
• Any difference between amount s charged and am ounts paid will b e 
recognised as accrued income or def erred income in the statemen t of 
financial position.

Chapter 5 
 127 
 Illustration 2 – operating lease 
 Mosala Ltd entered into a four y ear operating lease on 1 Janua ry 20X1 to 
rent a combine harvester to Manur e. Mosala provided an initial rent free 
period of 12 months f ollowed by three annual payments of $2,000  in 
arrears on 31 December each y ear. The annual payments commence on 
Prepare extracts from the financi al statements of Mosala Ltd fo r the 
year ended 31 December 20X2? 
Total receipts = $6,000 (3 × $2,000) 
Rental income spread over l ease term = 6,000/4 = $1,500 
In year 1, no cash was received creating an accrued income bala nce of 
$1,500. 
 Dr Accrued income 1,500 Cr Rental income 1,500 In year 2, cash of $2,000 was received Dr Cash $2,000 Cr Rental income 1,500 Cr Accrued income 500 
Statement of profit or loss fo r year ended 31 December 20X2 
(extract)  
 $  
Operating lease in come ($6,000/4) 1,500 
Statement of financial positi on as at 31 December 20X2 (extract ) 
Accrued income (1, 500 – 500) 1,000 
 
 RLP entered into a three year operating lease on 1 May 20X2 to  provide 
the use of an item of office equipment. It received a deposit o f $750 and 
will receive lease payments o f $500 on 30 April 20X3, 20X4 and 20X5. 
In the year ended 30 April 20X3, R LP has recorded all receipts related to 
the lease as income in the st atement of profit or loss. 
Calculate the income to be recognised in the statement of profi t or 
loss for the year ended 30 April 20X3.

Leases  
128  
Finance leases 
At the inception of a lease, le ssors present assets held under a finance lease as 
a receivable.  
Net Investment of the lease 
The finance lease receivable is equal to the net investment of the lease . 
This is calculated as the pres ent value of all unreceived: 
• Fixed rental payments 
• Variable rental payments 
• Residual value guarantees (amo unts the lessee guarantees that the 
leased asset will be worth at the end of the lease) 
• Unguaranteed residual values 
• Termination penalties 
The payments are discounted at the rate implicit in the lease. 
 
 Illustration 3 – Calculating the net investment 
 On 31 December 20X1, Rain leas es a machine to Snow on a three year 
finance lease and will receive $1 0,000 per year in arrears. Sno w has 
guaranteed that the machine will have a market value at the end  of the 
lease term of $2,000. 
The interest rate implic it in the lease is 10%. 
Required  
Calculate Rain’s net investment i n the lease as at 31 December 20X1. 
Solution 
The net investment in the lease must include the present value of: 
• fixed lease payment 
• residual value guarantees that are expected to be paid. 
 
Date Description Amount Discount 
rate Present 
value 
20X2 Receipt 10,000 0.909 9,090 
20X3 Receipt 10,000 0.826 8,260 20X4 Receipt 10,000 0.751 7,510 20X4 Guaranteed 
residual value  
2,000  
0.751  
1,502 
    
–––––– 
 Net investment in lease  26,362 
    –––––– 
A receivable of $26,362 is recogni sed. The asset leased would b e 
derecognised and any difference ta ken as a gain or loss to the statement 
of profit or loss.

Chapter 5 
 129 
The carrying amount of the lease receivable is:  
• increased by the finance income earned 
• decreased by the cash receipts. 
 
 Test your understanding 2 (OTQ style)  
 Brendan Ltd leases machinery to  Stirling Ltd on 1 January 20X1 . The 
lease is for four years at an annual cost of $2,000 payable ann ually in 
arrears. The useful life of the asset is deemed to be 4 years. The normal 
cash price (and fair value) of t he asset is $5,710, the same as  its carrying 
amount, and there is no residual  value. The present value of th e 
minimum lease payment is $5,710. T he implicit rate of interest is 15%. 
Required: 
What will be the total receivable  shown on the SOFP and the imp act to 
the SOPL of Brendan Ltd for the year ended 31st December 20X1? 
A Receivable $5710, P/L $857 expense B Receivable $5710, P/L $857 income C Receivable $4567, P/L $857 income D Receivable $4567, P/L $857 expense 
 
 Test your understanding 3 (OTQ style)  
 Freddy Ltd leases machinery to May Ltd on 1 January 20X1. The lease is 
for 4 years with an ann ual rental repayment of $4,000 payable a nnually in 
advance. The useful life of the asset is deemed to be 4 years a nd the 
present value of lease payments equalled the carrying amount of  the 
asset on inception. The implic it rate of interest is 15%.  
Required: 
What will be shown on the statem ent of financial position and t he 
statement of profit or loss of F reddy for the year ended 31st D ecember 
20X1? 
A Receivable $11,420, P/L income $1,713  B Receivable $10,502, P/L income $1,370 
C Property plant and equipment $ 12,000, P/L expense $4,000 
D Receivable $9,132, P/L income $4,000

Leases  
130  
 Test your understanding 4 (further OTQs) 
 1 In lessor accounting, in a _________ lease arrangement, the risks 
and rewards of the asset leased ar e transferred to the lessee, 
whereas in __________ lease arr angements they remain with the 
lessor. 
finance, operating 
2 Milner Ltd hires out industrial machinery to customers on lon g-term 
operating leases. On 1 January 20X1 , Milner entered into a 7 ye ar 
lease on a transportabl e drilling rig. The te rms of the lease a re: 
• $175,000 payable on 1 January 20X1 
• Six rentals of $70,000 payabl e on 1 January 20X2 – 20X7 
Required: 
What will be shown in Milner Ltd 's SOFP and SOPL for the year 
ended 31 December 20X1 in relati on to the lease arrangement? 
A SOFP No impact, P/L rental income $175,000 B SOFP Deferred income $90,000 , P/L rental income $85,000 
C SOFP Deferred income $85, 000, P/L rental income $90,000 
D SOFP Accrual 70,000, P/L  rental expense $70,000 
3 Emilia leases an asset to its  customer on 1 January 20X5. The  
lease term is 5 years. The leas e payments of $10,000 are receiv ed 
in arrears. The economic lifetim e of the asset is 8 years. The fair 
value of the asset was $40,000 wh ich is equal to the present va lue 
of the minimum lease payments. T he rate implicit in the lease w as 
8%. Emilia prepares accounts with a year end of 31 December. 
Which of the following statements are true?  
A  Emilia will record a right-o f-use asset and lease liability when 
entering the lease agreement 
B The lease receivable would have a carrying amount of $40,000 
at the year end 
C Investment income of $3,200 is  recorded within the statement 
D Emilia still records and depreciates the asset leased to the 
customer

Chapter 5 
 131 
 4 IFRS 16 outlines the accounti ng treatment used by lessors. 
Which of the following statem ents regarding lessor accounting 
are true?  
A As leased assets are owned by the lessor, lessors will always  
record the asset they are leasin g to a customer within their 
statement of financial position  
B Operating leases require the re cognition of a receivable valu ed 
at the net investment in the lease 
C if the present value of minimum  lease payments is the majorit y 
of a leased asset’s fair value , this indicates a finance lease 
D Lessors will always record inv estment income within profit or  
loss regardless of the type of lease  
5  Which TWO of the following situa tions would normally lead to a 
lease being classified  as a finance lease?  
A The lease transfers ownership of the asset to the lessee by t he 
end of the lease term 
B The lease term is for approximately half of the economic life  of 
the asset 
C The lease assets are of a specialised nature such that only t he 
lessee can use them without m ajor modifications being made 
D At the inception of the lease,  the present value of the minim um 
lease payments is 60% of what the leased asset would cost to purchase 
6 On 1 October 20X3, Fresco leased  an item of plant under a fiv e-
year finance lease agreement to a customer. The plant had a cas h 
purchase cost of $25 million. The  agreement had an implicit fin ance 
cost of 10% per annum and requir ed an immediate deposit of $2 
million and annual rental s of $6 million paid on 30 September e ach 
year for five years.  
What would be the net investment of the lease recorded by  
Fresco? 
A $18,394 
B $22,176 C $24,176 D $25,000

Chapter 5 
 133 
 Correct rental income for stateme nt of profit or loss in the ye ar 
ended 30 April 20X3 = $750 
Total lease receipts = 750 + (3 × 500) = $2,250 
Length of lease = three years Annual rental income to stateme nt of profit or loss = $2,250/3 = $750 
 
 C 
As Brendan Ltd is leasing out t he asset to Stirling Ltd, the qu estion is set 
from the perspective of the lessor. 
The lease term is all of the usef ul economic lifetime. The pres ent value of 
the minimum lease payments of t he lease is equal to the fair va lue of the 
asset. This indicates that the risk and rewards transfer to the  lessee. The 
lease is a finance lease. 
The asset should be derecognised and a receivable of $5,710 (th e net 
investment in the lease) is re corded at the 1st January 20X1. 
To work out the receivable outst anding at 31st December 20X1: 
 
Year  Balance b/f  
($) Interest income 
@15%  ($) Receipt  
($) Carried forward  
($) 
1 5,710 857 (2,000) 4,567 
Therefore, the year-end rece ivable on the SOFP = $4,567. 
The SOPL includes rental income  = $857 
NB. No profit or loss would ar ise from the derecognition of the  asset as 
the carrying amount is equal to the net investment in the lease . 
 
 B 
asset. This indicates that the ri sk and rewards transfer to the  lessee. The 
The asset should be derecognised (t herefore, option C is incorr ect) and a 
receivable of $13,132 (the net inv estment in the lease) is reco rded at the 
1st January 20X1.

Leases  
134  
The net investment in the lease is calculated as follows: 
rate (15%) Present 
value 
Year1 Receipt 4,000 1 4,000 
Yr 2-4 Receipt 4,000 2.283 9,132 
    –––––– 
 Net investment in lease  13,132 
    –––––– 
For rental receipts in advance , cash receipts are taken before interest is 
calculated. As a result, the receivable outstanding at 31st Dec ember 
20X1 for Freddy is: 
 
Year  Balance 
b/f ($) Receipt  ($) Sub-
income 
@15%  ($) Carried 
forward  ($) 
1 13,132 (4,000) 9,132 1,370 10,502 
Therefore, the year-end rece ivable on the SOFP = $10,502. 
The SOPL includes interest income  = $1,370 
 
 1 In lessor accounting, in a finance  lease arrangement, the risks and 
rewards of the asset leased are  transferred to the lessee, wher eas 
in operating lease arrangements they r emain with the lessor. 
2  The correct answer is B  
Rental income to the SOPL will be determined by spreading the 
total rental receipts (includi ng deposits and inc entives) using  the 
The rental income in 31 Dece mber 20X1 is calculated as: 
(175,000 + (70,000 × 6 ))/7 = 595,000/7 = $85,000 
As cash received in 20X1 ($175, 000) is higher than the rental 
income within the SOPL, defe rred income of $90,000 ($175,000 – 
$85,000) will be recognised in the SOFP. 
Deferred income = $90,000 Rental income = $85,000

Chapter 5 
 135 
 3 The correct answer is C   
Interest income of $3,200 is recor ded within the statement of 
profit or loss 
Emilia provides the cu stomer with a lease where the risks and 
rewards transfer to the lessee . The lease is a finance lease. T his is 
noted due to the present value of  the minimum lease payments 
being equal to the fair value and  the lease term being the majo rity 
of the economic lifet ime of the asset. 
As a result, Emilia should derec ognise the asset, recording a l ease 
receivable at the net investmen t in the lease and a gain or los s on 
disposal. Interest income will be recorded at the rate implicit  in the 
lease. This would be recor ded at $3,200 (40,000 × 8%).  
Option A is incorrect as right-o f-use assets and lease liabilit ies are 
recorded by the lessee, not the lessor. 
Option B is incorrect as the leas e receivable would have a carr ying 
amount of $33,200. This is calcula ted as the initial net invest ment in 
the lease plus interest income less lease receipts (40,000 + 3, 200 -
10,000).  
Option D is incorrect as it cons iders the lease as an operating  lease 
instead of a finance lease. 
4 The correct answer is D 
Lessors will always record investment income within profit or 
loss regardless of the type of lease. 
Lessors within an operating lease will record rental receipts a s 
income within their profit or loss on a systematic basis over t he life 
of the lease. 
Lessors providing a finance lease will record investment income  
based on the lease receivable ×  implicit rate of the lease. 
Option A is incorrect as assets  will be derecognised from the l essors 
accounts under finance lease arrangements. 
Option B is incorrect as it is  finance leases that record the l ease 
receivable at the net investment i n the lease, not operating le ase 
arrangements. 
Option C is incorrect as a financ e lease is indicated when the 
present value of the minimum leas e payments is substantially al l the 
fair value of the asset, not the ma jority of the fair value.   
5 The correct answers are A and C 
The lease term needs to be the majo rity of the useful life, and  the 
present value of the lease paym ents should be substantially all  of 
the fair value of the asset. Ther efore B and D are incorrect.

Leases  
136  
6 The correct answer is C 
In the accounts of the lessor, a  finance lease will initially 
derecognise the leased asset, rec orded a receivable at the net 
investment of the lease and record  a gain or loss in profit or loss. 
The requirement asks for the net i nvestment of the lease. This is the 
receivable initially recorded and is calculated as the present value of 
the fixed payments in the lease plus any guaranteed and 
unguaranteed residual values. 
The net investment of the lease is calculated as follows: 
 Receipt  ($) Discount factor PV ($) 
t0 2,000 1 2,000 
t1-5 6,000 3.696 22,176 
   –––––– 
   24,176 
   ––––––

137 
Revenue from contracts 
with customers 
(a)  Revenue   
 
  Chapter 
6

Revenue from contracts with customers 
138  
 
2 IFRS 15 Revenue from contracts with customers 
 IFRS 15 defines revenue as ‘Income arising in the course of an entity’s 
ordinary activities’  (IFRS 15, appendix A). 
Revenue does not include: 
• Proceeds from sale of non-current assets 
• Sales tax and other similar taxes 
• Other amounts collected on behal f of others. For example, in a n agency 
relationship, the agent would only recognise commission. 
 
 3 5-step approach 
IFRS 15 – Revenue recogniti on: A five step process  
An entity recognises revenue by  applying the following five ste ps: 
1 Identify the contract  
2 Identify the separate performan ce obligations within a contract  
3 Determine the transaction price  
4 Allocate the transaction price to  the performance obligations i n the 
contract  
5 Recognise revenue when (or as) a performance obligation is 
satisfied.

Chapter 6 
 
 139 
The 5 steps can be easily remember ed using the acronym, COPAR: 
• Contract 
• Obligations 
• Price 
• Allocate price 
• Recognise revenue. 
The five steps will be considered  in more detail in this sectio n. However, the 
following illustration may help you to gain an understanding of  the basic 
 
 Illustration 1 – The five steps 
 On 1 December 20X1, Wade receiv es an order from a customer for  a 
computer as well as 12 months  of technical support. Wade delive rs the 
computer (and transfers its legal t itle) to the customer on the  same day. 
The customer paid $420 upfront. The computer sells for $300 and  the 
technical support sells for $120. W ade’s year end is 31 Decembe r 20X1. 
The 5 steps would be applied to  this transaction as outlined be low:  
Step 1 – Identify the contract 
There is an agreement between Wade and its cu stomer for the pro vision 
of goods and services. 
Step 2 – Identify the separate pe rformance obligations within a  
contract 
There are two performance obligat ions (promises) within the con tract: 
• The supply of a computer 
• The supply of technical support. 
Step 3 – Determine the transaction price 
The total transaction price is $420. 
Step 4 – Allocate the transaction price to the performance 
obligations in the contract 
Based on standalone sales prices , $300 should be allocated to t he sale 
of the computer and $120 should be allocated to the technical s upport. 
Step 5 – Recognise revenue when (or as) a performance obligatio n 
is satisfied 
Control over the computer has been passed to the customer so th e full 
revenue of $300 should be rec ognised on 1 December 20X1. 
The technical support is provided  over time, so its revenue sho uld be 
recognised over time. In the y ear ended 31 December 20X1, reven ue of 
$10 (1/12 × $120) should be recogni sed from the provision of te chnical 
support.

140  
The five steps of revenue recogn ition will now be considered in  more detail. 
 
 Step 1: Identify the contract 
IFRS 15 Revenue from contracts with customers  says that a contract is an 
agreement between two or  more parties that c reates rights and o bligations. 
A contract does not need to be written.  
An entity can only account for revenue if the contract meets th e following 
criteria: 
• the parties to the contract hav e approved and are committed to  fulfilling 
the contract  
• each party’s right s can be identified 
• the payment terms can be identified 
• the contract has commercial substance, and 
• it is probable that t he entity will be paid . 
 
 Example 1 – Identifying the contract  
 Aluna has a year end o f 31 December 20X1. 
On 30 September 20X1, Aluna signed a contract with a customer t o 
provide them with an asset on 31 December 20X1. Control over th e asset 
passed to the customer on 31 Dece mber 20X1. The customer will p ay 
$1m on 30 June 20X2. 
By 31 December 20X1, as a re sult of changes in the economic cli mate, 
Aluna did not believe that it was  probable that they would coll ect the 
consideration that Aluna was ent itled to. Therefore, the contra ct cannot 
be accounted for and no rev enue should be recognised. 
 
 Step 2: Identifying the separate performance obligations within  a 
contract 
Performance obligations are pro mises to transfer distinct goods  or services to a 
customer. 
Some contracts contain more than  one performance obligation. Fo r example: 
• An entity may enter i nto a contract with a customer to sell a car (one 
performance obligation) , which includes one year’s free servicing and 
maintenance (another separate performance obligation).  
• An entity might enter  into a contract wit h a customer to provi de a course of 
5 lectures (one performance obligation) , as well as to provide a textbook 
on the first day of the course (another separate performance 
obligation) . 
The distinct performance obligat ions within a contract must be identified.

Chapter 6 
 
 141 
An entity must decide if the nat ure of a performance obligation  is: 
• to provide the specified goods o r services itself (i.e. it is the principal), or 
• to arrange for another party to p rovide the goods or service ( i.e. it is an 
agent). 
If an entity is an agent, then rev enue is recognised based on t he fee or 
commission to which it is entitled. 
 
 Illustration 2 – Agency sales  
 Rosemary's revenue includes $2 million for goods it sold actin g as an 
agent for Elaine. Rosemary earned a commission of 20% on these sales 
and remitted the difference of $1.6 million (included in cost o f sales) to 
Elaine. 
Required: 
How should the agency sale be tr eated in Rosemar y's statement o f profit 
or loss? 
Solution 
Rosemary should not have includ ed $2 million in its revenue as it is 
acting as the agent and not the pr incipal. Only the commission element of 
$400,000 ($2 million × 20% ) can be recorded in revenue. The fol lowing 
adjustment is ther efore required: 
 $  
Dr Revenue 1,600,000 
Cr Cost of sales 1,600,000 
  
 Step 3: Determining the transaction price 
In accordance to IFRS 15 Revenue from contracts with customers,  the 
transaction price is the  amount of consideration an en tity expects in exchange 
for satisfying a performance obligation. 
When determining the transaction price, the following must be c onsidered: 
• variable consideration 
• significant financing components  
• non-cash consideration 
• consideration payable to a customer.  
 Variable consideration 
If a contract includes variable consideration (f or example, a b onus based on 
delivery of the contract), i t shall be included within ‘the transaction  price if it is 
highly probable that a significant reversal in the amount of cu mulative 
revenue will not occur when th e uncertainty is resolved’ (IFRS 15, para 56).

142  
 
 Illustration 3 – Variable consideration 
 On 1 December 20X1, Bristow pro vides a service to a customer f or the 
next 12 months. The consideratio n is $12 million. Bristow is en titled to an 
extra $3 million if, after twelve  months, the number of mistake s made falls 
below a certain threshold. 
Required: 
Discuss the accounting treatment of the above in Bristow’s fina ncial 
statements for the year ended 31 December 20X1 if: 
(a)  Bristow has experience of provi ding identical services in the 
past and it is highly probable that the number of mistakes 
made will fall below the acceptable threshold.  
(b)  Bristow has no experience of p roviding this service and is 
unsure if the number of mist akes made will fall below the 
threshold. 
Solution: 
The $12 million consid eration is fixed. The $3 million consider ation that is 
dependent on the number of mista kes made is variable. 
Bristow must estimate the vari able consideration. It could use an 
expected value or a most likel y amount. Since there are only tw o 
outcomes, $0 or $3 million, then a most likely amount would bet ter predict 
the entitled consideration. 
(a)  Bristow expects to hit the target. Using a most likely amo unt, the 
variable consideration would be valued at $3 million. 
Bristow must then decide whether to include the estimate of var iable 
consideration in the transaction price. 
Based on past experience, i t seems highly probable that a 
significant reversal in revenue recognised would not occur. Thi s 
means that the transaction price is $15 million ($12m + $3m). 
As a service, it is likely that  the performance obligation woul d be 
satisfied over time. The revenue recognised in the year ended 3 1 
December 20X1 would  therefore be $1.25 mill ion ($15m × 1/12). 
(b)  Depending on the estimated likelihood of hitting the targe t, the 
variable consideration would eit her be estimated to be $0 or $3  
million. 
Whatever the amount, the estimat ed variable consideration canno t 
be included in the transaction price because it is not highly p robable 
that a significant reversal in  revenue would not occur. This is  
because Bristow has no experience of providing this service. Therefore, the transaction price is $12 million.

Chapter 6 
 
 143 
satisfied over time. The rev enue recognised in the year ended 3 1 
December 20X1 wo uld be $1 million ($12m × 1/12). 
 
Note that if a product is sold wit h a right to return it (e.g. a two week returns 
policy) then the consi deration is considered to be variable. Th e entity must 
estimate the likelihood of any r eturns and record revenue based  upon the 
amounts that are highly lik ely not to be returned.  
As a result of such arrangement s, a refund liability should be recorded. The 
refund liability should equal the consideration received (or re ceivable) that the 
entity does not expect to be entit led to as a result of returns  (and so will be 
refunded to the customer). 
 
 Illustration 4 – Rights to return products  
 Nardone enters into 50 contracts with customers. Each contract  includes 
the sale of one product for $1,000. C ash is received upfront an d control 
of the product transfers on delivery. Customers can return the product 
within 30 days to receive a full refund. Nardone can sell the r eturned 
products at a profit. 
Nardone has significant experienc e in estimating returns for th is product. 
It estimates that 48 produc ts will not be returned. 
Required: 
How should the above tran saction be accounted for? 
Solution: 
The fact that the customer can return the product means that th e 
consideration is variable. 
The estimated variable consider ation is $48,000 (48 products × $1,000). 
The variable consideration shoul d be included in the transactio n price 
because, based on Nardone’s experi ence, it is highly probable t hat a 
significant reversal in the cu mulative amount of revenue recogn ised 
($48,000) will not occur. 
Therefore, revenue o f $48,000 and a refund liability of $2,000 ($1,000 × 2 
products expected to be retu rned) should be recognised. 
The journal entry to record the sale is: 
Dr Cash $50,000 
Cr Revenue $48,000 
Cr Refund liabi lity $2,000

144  
 Financing 
In determining the transaction pr ice, an entity must consider i f the timing of 
payments provides the customer o r the entity with a significant  financing benefit. 
The existence of a financing el ement to the sale can be indicat ed by: 
• a difference between the amoun t paid and the cash selling pric e 
• an extended time period betwe en the transfer of the goods or s ervice and 
the payment date. 
If there is a significant financ ing component, then the conside ration receivable 
needs to be discounted to present v alue using the rate at which  the customer 
would borrow. 
 
 Illustration 5 – discounted present value 
 A retailer of electrical goods o ffers two year 0% finance on i tems offered 
for sale at $3,000. The cash pri ce of the goods is $2,500. The rate of 
interest on the retailers borrowing is 7%. 
How should this transaction be r ecorded in the first 12 months after 
the sale? 
As the customer will take 2 year s to pay and a difference betwe en the 
cash price and the repayment exist s, this contract includes a s ignificant 
financing element.  
The discount factor for $1 receiv able in two years’ time with a  7% interest 
rate is 0.873. 
The revenue from sale of the goods  is the present value of the amount 
receivable in two years’ time , i.e. $2,619 (3,000 × 0.873). 
Dr Receivable $2,619 Cr Revenue $2,619 
The discount on the receivable b alance is then unwound over the  two 
year period up to the date of rec eipt and the interest is recog nised as 
finance income. Therefore, after  one year the adjustment would be: 
Dr Receivable $183  (2,619 × 7%) Cr Finance income (P/L) $183  
Note that this is in accordance with IFRS 9  Financial Instruments. The 
receivable balance is a financial asset shown at amortised cost .

Chapter 6 
 
 145 
 Test your understanding 1 – Rudd (integration question) 
 Rudd enters into a contract with a customer to sell equipment on 
31 December 20X1. Control of th e equipment transfers to the cus tomer 
on that date. The price stated in  the contract is $1m and is du e on 
31 December 20X3. 
Market rates of interest availabl e to this particular customer are 10%. 
Required: 
Explain, with supporting calcula tions, how this transaction sho uld be 
accounted for in the financial st atements of Rudd for the year ended 31 
December 20X1, 20X2 and 20X3. 
 
 Non-cash consideration 
Customers do not always pay using cash or credit. The customer may pay 
using shares in their entity, s hare options or using other asse ts.  
Any non-cash consideration s hould be valued at fair value.  
 
 Illustration 6 – Non- cash consideration 
 Dan sells a good to Stan. Contro l over the good is transferred  on 1 
January 20X1. The consideration received by Dan is 1,000 shares  in 
Stan with a fair value of $4 each . By 31 December 20X1, the sha res in 
Stan have a fair value of $5 each. 
Required: 
How much revenue should be recogni sed from this transaction in the 
financial statements of Dan for the year ended 31 December 20X1 ? 
Solution: 
The contract contains a singl e performance obligation. 
Consideration for the transacti on is non-cash. Non-cash conside ration is 
measured at fair value. 
Revenue should be recognised at $4,000 (1,000 shares × $4) on 1  
January 20X1. 
Any subsequent change in the fair  value of the shares received is not 
recognised within revenue but ins tead accounted for in accordan ce with 
IFRS 9 Financial Instruments.

146  
 Consideration payable to a customer 
Sometimes amounts are paid to cus tomers as part o f the contract . These 
payments are often an incentiv e to encourage completion of the sale. 
If consideration is paid to a c ustomer in exchange for a distin ct good or service, 
then it is essentially a purchas e transaction and should be acc ounted for in the 
same way as other purchases from suppliers. For example, suppli ers may sell 
their produce to supermarkets bu t may also have to pay the supe rmarket for 
shelf space.   
If the considerati on paid to a customer is not in exchange for a distinct good or 
service, an entity should acco unt for it as a reduction of the transaction price. For 
example, a car manufacturer sell s their newest m odel electric c ars to car 
dealerships but has t o pay the dealer to ins tall chargers at th e dealer’s premises.   
 
 Illustration 7 – Consideration payable to a customer  
 Golden Gate enters into a contra ct with a major chain of retai l stores. The 
customer commits to buy at least $20m of products over the next  
12 months. The terms of the cont ract require Golden Gate to pay  $1m to 
compensate the customer for cha nges to its retail stores to acc ommodate 
the new products. 
By the 31 December 20X1, Golden  Gate has transferred products w ith a 
sales value of $4m  to the customer. 
Required: 
How much revenue should be recogni sed by Golden Gate in the yea r 
ended 31 December 20X1? 
Solution 
The payment made to the customer  is not in exchange for a disti nct good 
or service. Therefore, the $1m paid to the customer is treated as a 
reduction to the transaction price. 
The total transaction price is being reduced by 5% ($1m/$20m). 
Therefore, Golden Gate reduces t he transaction price of each go od by 
5% as it is transferred. 
By 31 December 20X1, Golden Ga te should have recognised revenue  of 
$3.8m ($4m × 95%).

Chapter 6 
 
 147 
 Step 4: Allocate th e transaction price 
Contracts can inclu de a number of performanc e obligations e.g. sales of 
products including warranty peri ods. Prices should be allocated  to each 
separate performance obligat ion within a contract.  
The total transaction price should be allocated to each perform ance obligation 
in proportion to stand-alone selling prices. 
The best evidence of a stand-alo ne selling price is the observa ble selling price 
of a good or service sold separately. 
If a stand-alone selling price is  not directly observable, then  the entity estimates 
the stand-alone selling price. 
Discounts 
In relation to a bundled sale, any discount should generally be  allocated across 
each component in the transaction. 
The entire discount should only be allocated to a specific indi vidual component 
of the transaction if that componen t is regularly sold separate ly at a discount. 
 
 Test your understanding 2 – Sh red (integration question) 
 Shred sells a machine and one y ear’s free technical support fo r 
$100,000. It usually sells the machine for $95,000 but does not  sell 
technical support for this machi ne as a stand-alone product. Ot her 
support services offered by Shred attract a mark-up of 50%. It is 
expected that the technical s upport will cost Shred $20,000. 
Required: 
How much of the transaction pric e should be allocated to the ma chine 
and to the technical support? 
 
 Step 5: Recognise revenue 
Revenue is recognised 'when (or as) the entity satisfies a performance 
obligation by transferring a prom ised good or service to a cust omer'   
(IFRS 15, para 31). 
At the start of a contract, for each performance obligation ide ntified, an entity 
must determine whether it satis fies the performance obligation:  
• at a point in time (se e section 4 below), or 
• over time (see section 5).

148  
4  Satisfying a performance ob ligation at a point in time  
The performance obligation is sat isfied at a point in time when  a customer 
obtains control  of a promised asset. 
Control of an asset refers to t he ability to direct the use of,  and obtain 
substantially all of, the remaining benefits from the asset.  
Control includes the ability to pre vent other entities from obt aining benefits from 
an asset i.e. an entity can restrict the assets use. 
 
 The following are indicators  of the transfer of control:  
• ‘ The entity has a present right  to payment for the asset 
• The customer has legal title to the asset 
• The entity has transferred ph ysical possession of the asset 
• The customer has the significant  risks and rewards of ownershi p of 
the asset 
• The customer has accepted the asset.’ (IFRS 15, para 38) 
Specific applications – whe n does control transfer? 
The point at which control is trans ferred to a customer and rev enue can be 
recorded can be complicated to determine. Varying terms and con ditions can 
lead to uncertainty as to the a ccounting treatment of particula r types of sale 
transactions. Directors have been  known to attempt to take adva ntage of this 
uncertainty by manipulating the accounts in their favour, often  leading to 
inappropriate revenue recognition. 
The following section looks at s ome of these more complicated “ sales” in detail 
and gives guidance to help deter mine the appropriate accounting  treatments 
using IFRS 15.   
• consignment inventory 
• sale and repurchas e arrangements.

Chapter 6 
 
 149 
Consignment inventory 
Consignment inventory  is inventory which: 
• is legally owned by one party 
• is held by another party, on te rms which give  the holder the r ight to sell the 
inventory in the normal course o f business or, at the holder’s option, to 
return it to the legal owner. 
This type of arrangement is co mmon in the motor trade. 
The manufacturer sells inventor y to the dealer which the dealer  can then sell on 
to a 3rd party customer. The sa le comes with an option to retur n the items to 
the manufacturer if not sold by the dealer. 
 
Inventory is legally owned by the manufacturer until: 
• the dealer sells inventory onto a third party, or 
• the dealer’s right to return expi res and the inventory is stil l not sold. 
However, the inventory is physically held by the dealer. 
Revenue should only be recorded if control of the asset sold tr ansfers to the 
third party customer. Consignmen t inventory meets most of the c onditions 
described above for recording re venue at a point in time. Howev er, particular 
attention should be paid to the need for the customer to hold t he risks and 
rewards  of ownership.

150  
Accounting for consignment inventory arrangements 
If the risks and rewards transfer to the customer, the sale is recorded. 
If the risks and rewards are not d eemed to have transferred to the customer, no 
sale is recorded.

Chapter 6 
 
 151 
 Illustration 8 – consignment inventory  
 Carmart, a car dealer, obtains i nventory from Zippy, its manuf acturer, on 
a consignment basis. The purchase price is set at delivery. Usu ally, 
Carmart pays Zippy for the car  the day after Carmart sells to a  customer. 
However, if the car remains unsol d after six months then Carmar t is 
obliged to purchase the car. Ther e is no right of return. Furth er, Carmart 
is responsible for insurance and maintenance from delivery. 
Required: 
Describe how Zippy should acco unt for the above scenario. 
Solution: 
Revenue can be recorded at a poin t in time if the customer obta ins 
control of the promised asset. I ndicators of a customer obtaini ng control 
include whether  the customer has legal ti tle to the asset, the customer 
has the significant risks and rewa rds of ownership of the asset  and the 
customer has accepted delivery of the asset. It is obvious that  Carmart 
has accepted delivery. However , whether the risks and rewards h ave 
transferred to Carmart is less clear cut.  
Indicators regarding the transfe r of risk and rewards  to Carma rt include: 
• Carmart faces the risk of slow movement and obsolescence as it  is 
obliged to purchase the car and has no right of return. 
• As prices are set at delivery , Carmart is exposed to risks of 
damaging the car. 
• Carmart insures and maintains the cars. 
• Carmart faces the risk of theft. 
• Carmart can sell the cars to the public. 
Carmart has the risk of ownership associated with these cars. T herefore, 
Zippy records revenue and derecogni ses the cars from inventory on the 
date of delivery.

152  
 Test your understanding 3 (case style) 
 On 1 January 20X6 Gillingham, a  manufacturer, entered into an 
agreement to provide Canterbury, a  retailer, with machines for resale. 
The terms of the agreement are: 
• Canterbury pays the cost of insur ing and maintaining the machi nes. 
• Canterbury can also display the machines in its showrooms and use 
them as demonstration models. 
• When a machine is sold to a c ustomer, Canterbury pays Gillingh am 
the factory price at the time the machine was originally delive red. 
• All machines remaining unsold si x months after their original 
delivery must be purchased by Can terbury at the factory price a t the 
time of delivery. 
• Gillingham can require Canterbury to  return the machines at an y 
time within the si x-month period. 
• Canterbury can return unsold machines to Gillingham at any tim e 
during the six-month per iod, without penalty. 
At 31 December 20X6, the agreem ent is still in force and Canter bury 
holds several machines which were  delivered less than six month s 
earlier. 
Required: 
In relation to the above arrangem ent, which entity should recog nise the 
machines as inventory for the period that they are held by Cant erbury? 
Sale and repurchase agreements  
A sale and repurchase agreement i s where an entit y sells an ass et but retains a 
right to repurchase the asset a t some point in the future.  
Sale and repurchase agreements ar e common in property developme nts and in 
maturing inventories such as whisky or cheese. 
The asset has been ‘legally’ sold , but there is either a commit ment or an option 
to repurchase the asset at a later date. 
The point in time at which to recognise revenue depends upon wh ether the 
control has transferred to the customer. 
Factors to consider when determi ning who has control of the ass et: 
• Has the entity transferred the all of risks and benefits of th e asset (and 
therefore control)? 
e.g. can the entity still use t he asset? Does the entity bear c osts 
associated with the asset? 
• Was the asset "sold" at a pri ce different to market value?

Chapter 6 
 
 153 
• Is the entity obliged to  repurchase the asset? 
• If the entity has the option to  repurchase the asset are they likely to 
exercise this option? 
• Is the sale is to a bank or financing company? 
• Is repurchase at a fixed  price or market value? 
 
 Illustration 9 – sale and repurchase  
 Xavier sells its head office, w hich cost $10 million, to Yorri ck, a bank, for 
$10 million on 1 January. Xavier has the option to repurchase t he 
property on 31 December, four year s later, at $14.64 million. X avier will 
continue to use the property as normal throughout the period an d is 
responsible for the maintenance and insurance. The head office was 
valued at $18m at transfer on 1 January and is expected to rise  in value 
throughout the four year period. T he effective interest rate is  10%. 
Required: 
Giving reasons, show how Xavier should record the transaction d escribed 
above during the first year following transfer. 
Solution: 
Per IFRS 15, revenue is only reco rded at a poin t in time if con trol is 
transferred to the customer. 
Factors to consider: 
• The option to repurchase is likel y to be exercised as the opti on 
repurchase price is lower than th e actual expected value at the  
repurchase date. 
• Xavier continues to insure and maintain the property. 
• Xavier will benefit from a rising property price, as repurchas e is at a 
fixed price rather than market value.

154  
• Xavier continues to benefit from use of the property. 
Xavier should continue to rec ognise the head office as an asset  in the 
statement of financial position, a s the risks and rewards of ow nership 
remain with Xavier. No revenue is  recorded on the sale. This is  a secured 
loan with total interest of $4.64 million ($14. 64 million – $10  million) over 
the four year period. 
To record the secured loan: 
  $ m  
Dr Bank 10 
Cr Liability 10 
Interest should be accrued over t he four year period at the eff ective rate 
of 10%. In the first year this  amounts to 10% × 10m = 1m. 
     $ m  
Dr Finance cost 1 
Cr Liability 1 
 
 Test your understanding 4 (case style) 
 On 1 April 20X4, Triangle sold m aturing inventor y that had a c arrying 
amount of $3 million, to Factor all, a finance house, for $5 mil lion. 
Its estimated market value at this  date was in excess of $5 mil lion and is 
expected to be $8.5 milli on as at 31 March 20X8. 
The inventory will not be ready fo r sale until 31 March 20X8 an d will 
remain on Triangle's prem ises until this date. 
The sale contract includes a clause allowing Triangle to repurc hase the 
inventory at any time up to 31 March 20X8 at a price of $5 mill ion plus 
interest at 10% per annum c ompounded from 1 April 20X4. 
The proceeds of the sale have been debited to the bank and the sale 
(and associated profit ) has been recognised in Triangle's state ment of 
Required: 
(a) Discuss how the sale of inv entory should be accounted for i n 
accordance with the principles of IFRS 15  Revenue from contracts 
with customer s. 
(b) Prepare any account ing adjustments required to Triangle's f inancial 
statements for the y ear ended 31 March 20X5.

Chapter 6 
 
 155 
5 Satisfying a performance obligation over time 
An entity satisfies a perform ance obligation and, corresponding ly, should 
recognise revenue over time, if o ne of the following criteria i s met: 
• the customer simultaneously recei ves and consumes the benefits 
provided by the entity’s per formance as the entity performs  
i.e. the entity provides a servi ce (Kaplan classroom courses, c leaning and 
maintenance services). 
• the entity’s performance creates or enhances an asset (for exam ple, 
work in progress) that the cust omer controls as the asset is cr eated 
or enhanced  
i.e. construction work to create a new building/structure on la nd owned by 
the customer. 
• the entity’s performance does not  create an asset with an alter native 
use to the entity and the enti ty has an enforceable right to pa yment 
for performance completed to date' (IFRS 15, para 35) 
i.e. construction of highly specialised assets. 
Accounting for revenue recorded over time 
 'For each performance obligation satisfied over time, an entity  shall 
recognise revenue over time by m easuring the progress towards 
complete satisfaction of that performance obligation'  (IFRS 15, 
para 39). 
Methods of measuring progress include: 
• output methods (such as surveys of performance or time elapsed  as a 
proportion of total contract price/time) 
• input methods (such as costs in curred to date as a proportion of total 
expected costs). 
As a result, revenue will be reco gnised based on the amount of progress made 
compared to the total price. 
 
 Cleanezee Ltd provides industria l cleaning services to their c lients. On 
1 July 20X2, Cleanez ee Ltd agreed a 12 month contract to clean a 
disused warehouse for Dirtee Co  totalling $120,000 payable in a dvance. 
The reporting date is 30 September 20X2. 
Required: 
Complete the following journal entry to record the above transa ction in 
the financial statements for t he year ended 30 S eptember 20X2. 
Dr Cash $120,000 Cr Revenue $ _________ Cr _________  $_________

156  
Scenarios whereby performance ob ligations are satisfied over ti me could 
commonly involve construction co mpanies building an asset for a  customer. As 
long as the construction company  is not able to use the asset, and has a right to 
payment for work to date, revenue would be recognised over time . 
 
 In calculating the entries to be made for such contracts, the f ollowing 
4-step approach c an be helpful: 
Step 1  – Calculate overall profit or loss 
Step 2  – Determine the progre ss towards completion 
Step 3  – Determine figures for inclusio n in the statement of profit o r loss 
Step 4  – Determine figures for inclusio n in the statement of financia l position. 
Step 1 – Calculate overall profit or loss 
 $  
Contract price X Less: Costs incurred to date (X) 
Less: Estimated costs to complete (X) 
 
–––– 
Overall profit/(loss) X/(X) 
 –––– 
If the expected outcome is a profit : 
• revenue and costs should be reco gnised according to the progre ss of the 
contract. 
If the expected outcome is a loss: 
• the whole loss should be recognis ed immediately creating a pro vision for 
an onerous contract as per I AS 37 (see chapter 8). 
If the expected outco me or progress is unknown  (often due to it being in the 
very early stages of the contract): 
• revenue should be recognised only  to the level of recoverable costs 
incurred. 
This results in no profits being recorded on a contract with un known outcomes. 
Step 2 – Determining the  progress of a contract 
There are two acceptable method s of measuring progress towards satisfying a 
performance obligation: 
• Input methods – commonly based on costs incurred e.g. (costs i ncurred to 
date/total costs) × 100% = % complete 
• Output methods – based on perform ance completed, such as work 
certified to date e.g. (work cer tified/contract price) × 100% =  % complete.

Chapter 6 
 
 157 
Step 3 – Statement of profit or loss 
If profitable (from step 1) 
 $  
Revenue (Total price × progress %) less revenue recognised in 
previous years  
X 
Cost of sales (Total costs × progress %)  less  cost of sales 
recognised in previous years  
(X) 
 –––– 
Profit X 
 –––– 
If loss making (from step 1) 
 $   
X  
Cost of sales β (X)  β 
 ––––  
Total loss on contract (from step 1) (X)  
 ––––  
 
 The balancing figure (β) is a short cut to achieve the relevant  cost of sales. 
The cost of sales would actually be made up of the costs matchi ng the 
stage of progress (% × total co sts) plus an addi tional amount r ecognised as 
a provision for an onerous lease . The provision would ensure th e entire loss 
on the contract is recorded immed iately. However, for ease of p resentation, 
cost of sales is reflec ted within these materials as a balancin g figure. 
Step 4 – Statement of financial position  
Some contracts where performance obligations are satisfied over  time will be 
large scale projects and can span a number of years. Billing is  difficult to keep 
accurate as progress continues. A s a result, the full amount of  work performed 
may not have been billed or amount s in excess of the work perfo rmed may 
have been billed to the customer.  
At the year end, this discrepan cy in billing will create a contract asset or 
liability , recorded in the statement of fi nancial position. This will be  calculated 
as shown below: 
 $  
Costs to date (actual costs, not necessarily cost of sales) X 
Profit/(loss) to date X/(X) 
Less: Amount billed to date (X) 
 –––– 
Contract asset/(liability) X/(X) 
 –––– 
 
 These figures are cumulative  and not annual.

158  
 Contract asset or liability 
 IFRS 15 is not prescriptive about the treatment of contract as sets or 
As alternatives to the term 'contract asset', IFRS 15 also allo ws the terms 
receivable and work-in-progress to be used. If revenue exceeds cash 
received, this could be includ ed within trade receivables. If c osts to date 
exceed cost of sales, this could be included within inventory, as work-in-
progress. 
If the cash received exceeds t he revenue recognised to date, th ere will 
be a contract liability (acting e ffectively as deferred income) . 
If a contract is loss making, ther e will be a provision recorde d to 
recognise the full loss under the onerous contract, as per IAS 37. This 
can either be termed as a contra ct liability or a provision. 
 
 Illustration 10 – input method contract  
 Softfloor House Ltd specialises i n the construction of trendy bars and 
gastro-pubs for their customers.  The projects generally take a number of 
months to complete. The company has three contracts in progress  at the 
year ended April 20X1 . Softfloor have an enforceable right for payment 
for work completed to date. 
 A B C 
 $000 $000 $000 
Costs incurred to date 200 90 560 
Estimated costs to c omplete 200 110 140 
Contract price 600 300 750 
Progress billings 40 70 630 
Softfloor calculates the percent age of completion by using the cost basis. 
Required: 
Calculate the effects of the abov e contract upon the financial statements.

Chapter 6 
 
 159 
 Solution 
These contracts lead to the creat ion of an asset that is contro lled by the 
customers. As a result, the rev enue from these contracts should  be 
recorded over time. A 4-step appr oach is followed to determine the 
impact to the financial statements as follows: 
Overall contract profit 
 A B C 
 $000 $000 $000 Contract price 600 300 750 Costs incurred to dat e (200) (90) (560) 
Estimated costs to complete (200) (110) (140) 
 
–––– –––– –––– 
Gross profit 200 100 50 
% of completion on cost basis 
A 200/400 = 50% B 90/200 = 45% C 560/700 = 80% 
 A B C 
Revenue (% × contract price) 300 135 600 Costs (% × total cost) (200) (90) (560) 
 
Gross profit 100 45 40 
 A B C 
Costs incurred 200 90 560 
Profit recognised 100 45 40 Less: progress billings (40) (70) (630) 
 
Contract assets/(liabilities) 260 65 (30)

160  
 Illustration 11 – output method contract  
 Hardfloor House Ltd constructs  and refurbishes nightclubs on b ehalf of 
their customers. The project generally takes a number of months  to 
complete. The company has three c ontracts in progress at the ye ar 
ended April 20X1. 
 A B C 
Costs incurred to date 320 540 260 
Estimated costs to complete 40 90 120 Contract price 416 684 400 
Work certified to date 312 456 200 
Progress billings 250 350 230 
Hardfloor House Ltd calculates t he percentage of completion by using the 
work certified basis. 
Required: 
Calculate the effects of the above contract upon the financial statements. 
Solution 
 A B C 
Contract price 416 684 400 Costs incurred to date (320) (540) (260) 
Estimated costs to complete (40) (90) (120) 
 
Gross profit 56 54 20 
% of completion on work certified basis 
A 312/416 = 75% 
B 456/684 = 66.67% C 200/400 = 50% 
 A B C 
Revenue (% × contract price) 312 456 200 
Costs (% × total cost) (270) (420) (190) 
 
Gross profit 42 36 10

Chapter 6 
 
 161 
 Statement of financial position (extract) 
 A B C 
Costs incurred 320 540 260 
Profit recognised 42 36 10 
Less: progress billings (250) (350) (230) 
Contract asset 112 226 40 
    
 Illustration 12 – contract s spanning number of years  
 Continuing from illustration 8, a ll three contracts were compl eted in the 
next financial period with the fo llowing cumulative results: 
 
 A B C 
Total costs incurred  to date 370 640 380 
Contract price 416 684 400 Progress billings 410 670 390 
Required: 
Calculate the effects of the above contracts upon the financial  statements 
in the next financial period. 
Solution 
 A B C 
Revenue (100% × contract price) – 
amounts recognised   
104  
228  
200 
Costs (100% × total cost) – amounts 
recognised  
(100)  
(220)  
(190) 
 
Gross profit 4 8 10 
 A B C 
Costs incurred (cumul ative) 370 640 380 
Profit recognised (cumulative) 46 44 20 
Less: progress billings (cumulative) (410) (670) (390) 
Contract assets 6 14 10

162  
Explanatory note 
Contract A: 
Revenue $416,000 – $312, 000 already recognised = $104,000 this year. 
Cost $370,000 – $270,000 already recognised = $100,000 this yea r. 
Annual profit $104, 000 – $100,000 = $4,000 
Overall profit = $416,000 – $370,000 = $46,000 
Contract B: 
Revenue $684,000 – $456, 000 already recognised = $228,000 this year. 
Cost $640,000 – $420,000 already recognised = $220,000 this yea r. 
Annual profit = $228, 000 – $220,000 = $8,000. 
Overall profit = $684,000 – $640,000 = $44,000 
Contract C: 
Revenue $400,000 – $200, 000 already recognised = $200,000 this year. 
Cost $380,000 – $190,000 already recognised = $190,000 this yea r. 
Annual profit = $200, 000 – $190,000 = $10,000 
Overall profit = $400,000 – $380,000 = $20,000. 
 
 Hindhead Ltd constructs specia list equipment for its customers  for use in 
the building industry. Each piec e of equipment takes between on e and 
two years to build and so the entity is required to account for  construction 
contracts. Hindhead has an enfor ceable right to payment for per formance 
completed to date. 
The entity has four contracts in process at the year-end 30 Apr il 20X1: 
 
 A B C D 
 $000 $000 $000 $000 Contract price 500 890 420 750 Work certified to date 375 534 280 – 
Costs incurred to date 384 700 468 20 
Estimated costs to com plete 48 115 168 650 
Progress billings 360 520 224 – 
Required: 
Prepare extracts from the financ ial statements for each of the four 
projects, assuming that revenues  and profits are recognised on the work 
certified basis.

Chapter 6 
 
 163 
 Test your understanding 7 (further OTQs) 
 1 On 1 April 20X3, LJB sold a freehold property to a finance h ouse for 
$7 million. The contractual terms  require LJB to repurchase the  
property on 31 March 20X6 for $8. 8 million. LJB has the option to 
repurchase on 31 March 20X4 for $7.6 million or on 31 March 20X 5 
for $8.2 million. Prior to dis posal, the carrying amount of the  
property was $6 million. 
At 31 March 20X4, LJB decided  not to take up the option to 
repurchase. 
Which of the following statements are TRUE in respect of LJB's 
financial statements for the ye ar ended 31 March 20X4? Select 
A As the option to repurchase has not been exercised, LJB 
should derecognise the property and record a profit on disposal of $1 million in the statement of profit or loss. 
B LJB would recognise the property  as part of its non-current 
assets at 31 March 20X4. 
C LJB would recognise a liabilit y of $7 million in its statemen t of 
financial position a t 31 March 20X4. 
D Finance costs of $0.6 milli on will be recorded in the LJB 
statement of profit or loss duri ng the year ended 31 March 
20X4.  
2 EC signs a contract with a cust omer to deliver an off the she lf IT 
system on 1 July 20X2 and to provi de support services for a thr ee 
year period from that date. The to tal contract price is $600,00 0 and 
EC would normally sell equival ent IT systems (without the suppo rt 
service) for $450,000. 
Calculate the amount of revenue  that should be recognised in 
EC's statement of profit or lo ss in respect of the above contra ct 
in the year ended 31 December 20X 2. (State your answer in $.)

164  
 3 The following information rela tes to a contract to construct an asset 
for a customer for which rev enue should be recorded over time: 
 
 $  
Contract price 5 million 
Work certified to date 2 million 
Costs to date 1.8 million Estimated costs to complete 2.2 million 
 
What is the revenue, cost of sales and gross profit that should  
be recognised in accordance with  IFRS 15, assuming that the 
entity's policy is to calculat e performance obligation progress  
on the input (costs incurred) basis? 
 Revenue Cost of sales Gross profit 
A $2 million $1. 8 million $200,000 
B $2 million $1. 6 million $400,000 
C $2.25 million $1. 8 million $450,000 
D $2.25 million $2 million $250,000 
4 The following information rela tes to a contract to construct an asset 
for customer for which revenue should be recorded over time: 
 
 $  
Contract price 300,000 Work certified to date 120,000 
Costs to date 150,000 
Estimated costs to complete 200,000 
 
What are the cost of sales and gross profit figures that should  
on the output (work certified) basis?  
 Cost of sales Gross profit 
A $170,000 $50,000 loss 
B $100,000 $20,000 C $140,000 $20,000 loss D   $70,000 $50,000

Chapter 6 
 
 165 
 5  An internet travel agent rec eives $5,000 on 1 April 20X2 for  
arranging a holiday to Cyprus. I t will pass on 90% of this amou nt to 
the holiday company, with paym ent due on 15 June 20X2. The 
customer will deal directly with  the holiday company in the eve nt of 
any problems. 
The travel agent's financial r eporting date is 31 May 20X2. 
Required: 
Which one of the following statem ents is correct in respect of the 
treatment of the travel agent’s a rrangement within their financ ial 
statements for the y ear ended 31 May 20X2? 
A The travel agent should  recognise $5,000 as revenue 
immediately and should accrue fo r the $4,500 pay ment to the 
holiday company, recognising the expense as a cost of sale. 
B The travel agent should r ecognise $500 as revenue and 
$4,500 as deferred income. 
C The travel agent should recognise $500 as revenue and 
$4,500 as a payable. 
D The travel agent should not rec ognise any revenue. The entire  
$5,000 should be credited  to deferred income.  
6 A company is currently accountin g for a contract to construct  an 
asset controlled by the customer . The contract price is $2 mill ion 
and work certified at the year- end is $1.3 million. Costs incur red to 
date amount to $1.4 million and it i s estimated that a further 
$1 million will be incurr ed in completing this project. $1.3 mi llion has 
been invoiced to the customer. 
What is the amount that should be  recorded in the statement of 
financial position for contract  assets or liabilities in relati on to 
this contract? Stage of complet ion is calculated on an input 
(costs incurred) basis. 
A $nil 
B $0.1m liability C $0.3m asset D $0.3m liability

Chapter 6 
 
 167 
 Due to the length of time betw een the transfer of control of t he asset and 
the payment date, this contrac t includes a significant financin g 
The consideration must be adjus ted for the impact of the financ ing 
transaction. A discount rate s hould be used that reflects the 
characteristics of t he customer i.e. 10%. 
Revenue should be recognised w hen the performanc e obligation is  
satisfied. 
Revenue, and a corresponding rece ivable, should be recognised a t 
$826,000 ($1m × 0.826) on 31 December 20X1. 
Each year, the discount on the re ceivable will be unwound by 10 %, taking 
the increase to finance income. 
For the year to 31 December 20X 2, this will mean that the recei vable 
increases by $82,600 ($826,000 × 10%), with $82,600 being shown  as 
finance income in the statement o f profit or loss. This would m ake the 
receivable $908,600 at 31 December 20X2. 
For the year to 31 December 20X 3, the receivable would increase  by 
$90,860 ($908,600 × 10%), with the increase also being taken to  finance 
income. This makes the receivabl e $1m (subject to a small round ing 
difference) at 31 December 20X3 equalling the cash received fro m the 
customer on that date (D r Cash, Cr Receivable). 
 
 The selling price of the mach ine is $95,000 based on previous selling 
prices for the product. 
There is no observabl e selling price for t he technical support.  Therefore, 
the stand-alone selling pric e needs to be estimated. 
Based on the information provided  regarding the cost of the tec hnical 
support, the selling price can be es timated. The selling price of the 
service would be $30, 000 ($20,000 × 150%). 
The total standalone selling pric es of the machine and support are 
$125,000 ($95,000 + $30,000). T otal consideration receivable is  only 
$100,000. The customer is rece iving a discount of 20% 
($25,000/$125,000) for purchasing a bundle of goods and service s. 
IFRS 15 says that an entity must  consider whether the discount relates to 
the whole bundle or to a particu lar performance obligation. As the 
technical support is not normally sold separately, it cannot be  deemed to 
be normally sold at a discount. A s a result, the discount is ap portioned 
across both performance obligat ions within the contract.

168  
The transaction price allocat ed to the machine is $76,000 ($95, 000 × 
80%). 
The transaction price allocated  to the technical support is $24 ,000 
($30,000 × 80%). 
The revenue will be re cognised when (or as) the performance obl igations 
are satisfied. 
 
 Revenue can be recorded at a poi nt in time when control is tra nsferred to 
the customer. Control transfers  if the risk and rewards of owne rship are 
held by the customer.  
Factors indicating that the ri sks and benefits of ownership are  with 
Canterbury: 
• Canterbury pays the cost of insur ing and maintaining the machi nes, 
suggesting they are exposed to t he risk of theft and breakdown.  
• Canterbury can display the machines and use them as 
demonstration vehicles, suggesting  they have a certain level of  
control over the machines  held on their premises. 
• The price paid by Canterbury is  determined at the time of deli very, 
suggesting that Canterbury will ei ther benefit or suffer from a ny 
subsequent sale at a different price. 
• Canterbury is required to purc hase any machines that they have  
held for a six month period. 
Gillingham: 
time within the six-month per iod, suggesting that Gillingham st ill 
exercises control over the machines. 
during the six-month period, without penalty. Therefore, they c an 
transfer the significant risk of obsolescence back to Gillingha m. 
As a result, the risks and rewa rds do not transfer until such t ime as the 
assets are sold by Canterbury to  a third party or the 6 month t ime period 
elapses (when Canterbury is fo rced to pay Gillingham). Revenue can 
only be recorded at that point in time. 
Control is not transferred to  Canterbury on delivery. Gillingha m should 
record no revenue and continue  to recognise the goods within it s 
inventories.

Chapter 6 
 
 169 
 ( a )  Accounting treatment  
IFRS 15 does not allow revenue to  be recognised until control h as 
transferred to the buyer. 
There is a clause allowing Tri angle to repurchase the inventory , 
indicating a sale and repurchas e agreement. Where there is an 
option to repurchase, whether c ontrol has transferred to the bu yer 
must be considered. The likelih ood of the option being exercise d 
should be assessed. 
Triangle can repurchase the inv entory at $7,320,500 at 31 March  
20X8, i.e. $5 million × 1.14 = $7,320,500. Since the market value is 
expected to be $8.5 million at th is time, it is likely that Tri angle will 
repurchase the inventory. 
Furthermore, since the goods remai n on Triangle's premises duri ng 
the 4 years, Triangle is still exposed to the risks of ownershi p and 
have managerial involvem ent/control over the goods.  
A final indicator that this is no t a straightforward sale is th at Triangle 
have received proceeds of $5 m illion whilst the current market value 
is in excess of this amount (No te however that this factor alon e 
would not lead to the conclusion t hat there is not a sale, as T riangle 
may have chosen to sell the goods at a discount). 
In conclusion, control of the a sset is retained by Triangle.  
Triangle should not have recor ded a sale, but instead should ha ve 
recorded a loan of $5 million with a finance cost of 10% per an num. 
The goods should remain in invent ory at their cost of $3 millio n. 
(b) Accounting adjustments  
Journals 
 $ m  Dr Revenue (to reverse the sale) 5 Cr Liability 5 
To correct the entries Tri angle recorded in error. 
 $ m  Dr Closing inventory (SFP) 3 Cr Closing inventory (SP/L) 3 
Reinstate the clos ing inventory. 
 $ m  
Dr Finance cost 0.5 
Cr Liability 0.5 
Record the interest for the year at 10% × $5m = $0.5m.

170  
 Dr Cash $120,000 
Cr Revenue $30,000 Cr Deferred income $90,000 
The cleaning services provided s ees the customer, Dirtee, recei ve and 
consume the benefits of Cleanezee’ s work simultaneously. As a r esult, 
revenue will be recorded over time.  
The entity will use in put methods for determi ning the performan ce 
obligation satisfied. Time elaps ed would be the most appropriat e method 
giving the information provided. 
The contract is for 12 months of which 3 months of the total se rvice has 
elapsed. The entity will recognise  $30,000 (3/12 × $120,000) in  revenue. 
As cash has been received in exce ss of the recognised revenue, deferred 
income of $90,000 ($120,000 – $30, 000) must also be recorded. 
 
 Overall profit/loss on contract 
 A B C D 
Contract price 500 890 420 750 Costs to date (384) (700) (468) (20) 
Costs to complete ( 48) (115)  (168) (650) 
 
––––– ––––– ––––– ––––– 
Total estimated profit 68 75 (216) 80 
% completion on work certified basis 
A 375/500 = 75% 
B 534/890 = 60% C 280/420 = 66.7%  D 0/750 = 0% 
Statement of profit or loss and other comprehensive income 
 
 A B C D 
Revenue (% × contract price or 
recoverable costs))  
375  
534  
280  
20 
Cost of sales (% × total cost or 
β if loss making)  
(324)  
(489)  
(496)β  
(20) 
 –––– –––– –––– –––– 
Gross profit/loss 51 45 (216) –

Chapter 6 
 
 171 
 A B C D 
Costs incurred 384 700 468 20 
Profits/losses recognised 51 45 (216) – 
Progress billings (360) (520) (224) – 
Contract assets 75 225 28 20 
Project C 
A loss has been made on this cont ract of $216,000 therefore we must 
recognise the whole of the loss im mediately. The revenue will b e 
calculated as normal and the cos t of sales becomes the balancin g figure. 
Project D 
Although work has been performed on  this project no work has ye t been 
certified, hence we cannot recogni se a profit in the statement of profit or 
loss. However, we cannot ignore t hat costs have been incurred, hence 
they become the cost of sales and the revenue becomes the same 
amount to recognise a nil profit. 
 
 1  B and D are correct.  
A is not correct. Although the opt ion to repurchase has not bee n 
exercised, there is s till a requirement to repurchase at 31 Mar ch 
20X6 and therefore the risks and re wards of ownership have not 
transferred to the finance house. 
C is not correct. The liability a t the year-end would be $7.6 m illion as 
this is the repurchase price at the reporting date. The extra 
$0.6 million reflects interest for  the year on the liability an d will be 
recorded within the statem ent of profit or loss. 
2 Revenue = $475,000  
Total revenue from support s ervices = 600,000 – 450,000 = 
$150,000 
Annual revenue from support servi ces = 150,000/3 years = $50,00 0 
Revenue to be recognised in cu rrent period = 50,000 × 6/12 = 
$25,000 (for July to Dec). 
Therefore, total revenue to be recognised = 450,000 (for IT sys tem) 
+ 25,000 (for service) = $475,000.

172  
 3  C is the correct answer  
 $ m  
Total revenue 5 
Costs to date (1.8) Costs to complete (2.2) 
 
–––– 
Total profit 1 
% completion = 1.8 mi llion/4 million = 45% 
 $ m  
Revenue (45% × 5) 2.25 Cost of sales (45% × 4) (1.8) 
 
–––– 
Gross profit 0.45 
4 A is the correct answer  
 $  
Total revenue 300,000 Costs to date (150,000) 
Costs to complete (200,000) 
 
–––––––– 
Total loss (50,000) 
  
 $ m  
Revenue (40% ×  300,000) 120,000 
Cost of sales (ß) (170,000) 
 –––––––– 
Gross loss (50,000) 
 
NB. The cost of sales of $170,000 is actually made up the costs  of 
sales as per the stage of com pletion = $140,000 (40% × (150,000  + 
200,000)) + £30,000 provision as onerous contract per IAS 37. 
5 The correct statement is C. 
 The agent will only recognise th e commission element of 10% × 
$5,000 = $500 as revenue. The 90%  balance of $4,500 will be 
shown as a payable balance (due  to the holiday company). The 
$4,500 is not deferred income a s it will not be recognised as 
revenue at a later date.

Chapter 6 
 
 173 
 6  D $0.3m liability 
 
Expected outcome: $m 
Total revenue 2 
Costs to date (1.4) 
Costs to complete (1) 
 –––– 
Total loss (0.4) 
 
 $ m  
Costs to date 1.4 
Recognised loss (0.4) 
Progress billings (1.3) 
 –––– 
Contract liability (0.3)

175 
Provisions, contingent 
liabilities and contingent 
assets 
(c)  Provisions  
 
  Chapter 
7

Provisions, contingent liabilities and contingent assets 
176  
 
The problem  
Until the issue of IAS 37 Provisions, Contingent Liabilities and Contingent 
Assets , provisions was an accounting area that was open to manipulati on. 
• Provisions were often recognised as a result of an intention t o make 
expenditure, rather than an obligation to do so. 
• Entities would often create prov isions to depress profits in g ood years and 
then reverse them at a later dat e when profits needed a boost ( a technique 
known as profit smoothing). 
• Several items could be aggregated into one large provision tha t was then 
reported as an exceptional item (the ‘big bath provision’). 
• Inadequate disclosure meant that in some cases it was difficul t to 
ascertain the significance of provisions.

Chapter 7 
 177 
As a result, IAS 37 introduced a set of criteria  that must be s atisfied before a 
provision can be recognised. The  standard also requires compreh ensive 
disclosure of any provisions t hat have been made so that users can understand 
the impact that they have had on  the financial performance of t he reporting 
entity. 
3 Provisions 
 A provision is 'a liability of uncertain timing or amount' (IAS 37, 
para 10). 
 
 A liability is 'a present obligation of the ent ity arising from past events, 
the settlement of which is expect ed to result in an outflow fro m the 
entity of resources embodying economic benefits'  (IAS 37, para 10). 
 
 Recognition of a provision 
A provision can be recognised when, and only when, all of the f ollowing 
conditions are met: 
• 'an entity has a present obligati on (legal or constructive) as a result 
of a past event  
• it is probable that an outflow o f resources embodying economic 
benefits will be required to  settle the obligation, and  
• a reliable estimate can be made of the amount of the obligation . 
If any one of these conditions is not met, no provision may be recognised' 
(IAS 37, para 14). 
Obligations 
IAS 37 says that the obligation can be: 
• legal, i.e. arising from 
– a contract – legislation – other operation of law 
• constructive, i.e. the entity has  created a valid expectation via 
– established pattern of past practice – published policy or statement.

178  
 Illustration 1 – constructive obligation  
 A retail store has a policy o f refunding purchases by dissatis fied 
customers, even though it is under  no legal obligation to do so . Its policy 
of making refunds is generally known. 
Should a provision be  made at the year end? 
• The policy is well known and cr eates a valid expectation. 
• There is a constructive obligation. 
• It is probable some refunds will be made. 
• These can be measured us ing expected values. 
Conclusion:  A provision is required. 
Probable outflow 
The outflow of resources must be considered to be more likely t han not. 
Where there are a number of sim ilar obligations, probability is  assessed across 
the entire class o f obligations rather  than individually. 
 
 Illustration 2 – probable outflow  
 An entity sells goods  with a warranty cove ring customers for t he cost of 
repairs required within the firs t 12 months after purchase. Pas t 
experience suggests that 95% o f goods sold will not require a w arranty 
repair. 
Should a provision be made for warranty repairs? 
If each sale were considered indi vidually, no provision would b e made as 
there is only a 5%  probability of the goods being returned for repair. 
However, if sales are consider ed as a whole, there is a high li kelihood of 
5% being returned for repair. Ther efore, a provision should be made for 
the expected cost of repairs to  5% of the goods sold in the las t 
12 months. 
Reliable estimate 
The standard states that situati ons in which a reliable estimat e cannot be made 
should be rare. 
The estimate should be: 
• the best estimate of likely outflow 
• a prudent estimate 
• discounted when time val ue of money is material.

Chapter 7 
 179 
 An entity has a policy of only carrying out work to rectify da mage caused 
to the environment when it is requi red by local law to do so. F or several 
years the entity has been operatin g an oil rig that causes such  damage in 
a country that did not have legi slation in place requiring any rectification. 
A new government has now been e lected in that country and, at t he 
reporting date, has just brought i n legislation requiring recti fication of 
environmental damage. The legislat ion will have retrospective e ffect. 
Required: 
Explain whether a provisi on should be recognised. 
 
 Test your understanding 2 (OTQ style question) 
 You are an accountant working for SZ, a manufacturer that prov ides 
warranties to its cus tomers for all sales . Under the terms of t he warranty, 
SZ undertakes to make good manufac turing defects that become 
apparent within 2 years from the date of sale. Based on past ex perience, 
it estimates that 8% of goods w ill be returned for repair withi n this 2 year 
period. 
Which of the following statemen ts regarding the warranty is tru e if 
IAS 37 is to be correctly applie d within SZ's current year fina ncial 
A The warranty will have no im pact on the accounts of SZ 
B A disclosure is included in  the financial st atements outlinin g the 
potential costs of the warranty 
C A provision for the warranty is recognised in the financial s tatements 
based upon 8% of the total reve nue for the current period 
D A provision for the warranty is recognised of 4% of annual re venue 
as the total cost will be spread ov er the 2 year period in whic h the 
costs are expected to be incurred 
4 Specific applications 
The standard provides additional guidance on how to apply the r ules to specific 
Future operating losses 
Provisions cannot be made for fu ture operating losses as they d o not meet the 
definition of a liability (they a re an expectation rather than an obligation).

180  
Onerous contracts 
An onerous contract is 'a contract in which the unavoidable costs of 
meeting the obligations under th e contract exceed the economic benefits 
expected to be received under it' (IAS 37, para 10). 
Per IAS 37, a provision is requi red for the cheapest option of exiting the 
contract, which is the lower of: 
• cost of fulfilling the contract 
• any compensation/penalties pay able for failing to fulfil it. 
 
 Illustration 3 – onerous contract  
 CEG has ten years left to run a sales contract that has recent ly seen 
costs spiral. The present value of the costs to be incurred on completion 
of the contract, estimated as  at the reporting date, is $50,000 . The cost of 
terminating the contra ct early is $55,000. 
How should the above scenario be accounted for? 
A provision should be made for $50,000 which is the least net c ost of 
exiting the contract. 
To record the provision: 
 $000 
Dr Expense (profit or loss) 50 Cr Provision 50 
When the rental paym ents are subsequently pai d, the provision f or the 
costs of the onerous c ontract will reduce. 
The following entry is posted: Dr Provision Cr Cash 
Restructuring 
According to IAS 37, a restruc turing is a programme planned and  controlled by 
management that materially chan ges the scope of business undert aken or the 
manner in which that business is conducted. 
A provision can only be made if: 
• 'the entity has a detailed formal plan, and 
• has raised a valid expectation in those affected that it will c arry out 
the restructuring by  
– starting to implement it, or  
– announcing it'  (IAS 37, para 72).

Chapter 7 
 181 
A provision can then only be made for costs that are: 
• 'necessarily entailed by the restructuring, and 
• not associated with the ongoing activities of the entity'  (IAS 37, 
para 80). 
Per IAS 37, costs specifically not allowed include retraining/r elocation of 
existing staff, marketing and investment in new systems. 
 
 Illustration 4 – restructuring  
 On 14 June 20X2 a decision is m ade by the board of directors o f KCM to 
close down a division and a detai led plan is drawn up. At the y ear end of 
30 June 20X2, no announcement has  been made in respect of the 
closure and no steps have been ta ken to implement the decision.  The 
expected costs of closing  the division are $750,000. 
Should a provision be made for the expected costs of closing th e 
division? 
No – a board decision is not su fficient to require a provision as no 
obligation exists. 
A detailed formal plan must exis t, however this alone is not su fficient to 
create an obligation. The plan mu st also have been communicated  to 
those affected by it. A construc tive obligation will arise at t his point in time 
as management have t hen created a valid ex pectation that the pl an will 
proceed and they are unlikely to change their mind. 
 
 Test your understanding 3 (OTQ style question) 
 The board of CLH agreed to close down two of its divisions, A and B, at 
its board meeting on 18 Novembe r 20X3. Detailed plans have been  
formalised for each division's closure and these were approved by the 
board at this meeting. 
The current status of each o f the closures is as follows: 
Division A 
Letters have been sent to customers warning them to seek an alt ernative 
source of supply and a redundancy pr ogramme was announced to al l 
staff working in the di vision on 1 December. 
The expected costs of closure a re $2.5 million and this include s $450,000 
for re-deploying staff to other divisions.

182  
 Division B 
The directors want to deal with  the closures one at a time and therefore 
no announcements have ye t been made about the closure of divisi on B. 
The directors are keen to minim ise the effect that the closures  will have 
on staff working in other divis ions and have therefore decided to keep this 
closure quiet for the moment. 
The expected costs of closure a re $1.5 million. All staff are l ikely to be 
made redundant and theref ore no re-deployment costs are include d in 
this estimate. 
Required: 
Which of the following options is the most appropriate accounti ng 
treatment of the above decisions i n the financial statements of  CLH for 
the year ended 31 December 20X3? 
A Division A provides for $2,500, 000. Division B provides for 
$1,500,000. 
B Division A provides for $2,050, 000. Division B provides for 
C Division A provides for $2,050, 000. Division B records nothin g in 
relation to the restruct uring in its accounts. 
D Division A records nothing in r elation to the restructuring i n its 
accounts. Division B records not hing in relation to the restruc turing 
in its accounts. 
 
 Provisions for dismant ling/decommissioning costs 
 When a facility such as an oil well or mine is authorised by t he 
government, the licence normally i ncludes a legal obligation fo r the entity 
to decommission the facility a t the end of its useful life. IAS  37 requires a 
provision to be recognised fo r the decommissioning costs. 
The decommissioning costs form par t of the cost of the asset an d are 
therefore capitalised and exp ensed over the life of the asset ( as part of 
the depreciation charge). 
The provision is only recorded once damage has been incurred to  the 
land upon which the o il well or mine will be located. The oblig ation to 
incur the decommission costs is only created at the point 
damage/changes to the land occurs.

Chapter 7 
 183 
 To record the provision: 
Dr Asset (oil well/mine) 
Cr Provision The provision should be based on  the present value of the expec ted 
decommissioning cost and theref ore, in addition, a finance cost  will arise 
each year as the discount is unwound. 
To unwind the discount: Dr Finance cost (P/L) Cr Provision 
 
 Illustration 5 – decommissioning costs  
 On 1 January 20X1, KJC acquires a mine costing $5 million and,  as part 
of the licence granted by the gov ernment for operation of the m ine, it will 
be required to pay decommissioni ng costs at the end of the mine 's useful 
life of 20 years. The present v alue of these decommissioning co sts is 
$1 million and the discoun t rate applied is 10%. 
KJC depreciate assets on a straight line basis. 
Explain the effect of the abo ve transaction on the financial 
statements of KJC for the year ended 31 December 20X1. 
The total cost to be recognised  for the mine is $6 million (the  $5 million 
purchase price plus the $1 m illion decommissioning cost). 
This will then be depreciated over  20 years, resulting in an an nual 
depreciation charge of $300,000 ( $6 million/20 years). Note tha t, by 
capitalising the decommissioning cost, its effect on profit is spread over 
the 20 year life of the mine. 
The decommissioning costs are reco rded by making a provision. T he 
initial provision is based on t he present value of the costs an d the 
provision is increased each y ear to reflect the unwinding of th e discount 
applied. In the year ended 31 Dece mber 20X1, this would create a 
finance cost of $100,000 (10% × $1 million).

184  
 The overall effect on the financ ial statements fo r the year end ed 
31 December 20X1 is: 
 $000 
Depreciation ($6 m illion/20 yrs) (300) 
Finance cost ($1 million × 10%) (100) 
 $000 
Non-current assets:  Mine ($6m – $300k) 5,700 
Non-current liabilities:  
Provision ($1m + ( 10% × $1m)) 1,100 
  
5 Contingent liabilities and assets 
 A contingent liabi lity is defined as: 
• 'a possible obligation that a rises from past events and whose 
existence will be confirmed only by the occurrence or non-
occurrence of one or more uncerta in future events not wholly wi thin 
the control of the entity, or  
• a present obligation that arises  from past events but is not 
recognised because:  
– it is not probable that an outflow of resources embodying 
economic benefits will be required to settle the obligation, or  
– the amount of the obligation cannot  be measured with sufficient  
reliability'  (IAS 37, para 10). 
Accounting for a contingent liability 
According to IAS 37, a contingent liability is: 
• not recognised 
• disclosed in a note, unless t he possibility of outflow is remo te. 
 
 A contingent asset is defined as a  'possible asset that arises from past 
events and whose existence will be confirmed only by the 
occurrence or non-occurrence of one or more uncertain future 
events not wholly within th e control of the entity'  (IAS 37, para 10).

Chapter 7 
 185 
Accounting for a co ntingent asset 
According to IAS 37, a  contingent asset is: 
• disclosed in a note, if an in flow is considered probable. 
Disclosures required for cont ingent liabilities and assets  
According to IAS 37, the followi ng will be disclosed for contin gent liabilities and 
assets: 
• Description of nature o f contingent liability/asset 
• An estimate of its financial effect 
• An indication of uncertainties r elating to amount or timing of  outflow/inflow 
• For contingent liabilities, the possibility of any reimburseme nt. 
 
 Illustration 6 – contingent liabilities and assets  
 Entity A is suing entity B in  respect of losses sustained from  faulty goods 
supplied by entity B. Entity A' s lawyers are unwilling to state  the likelihood 
of the claim being successful. 
Entity B's lawyers have told ent ity B to expect to have to pay damages 
but are unable at present to pro vide a reliable estimate of the  amount 
payable. 
How would each entity accoun t for the above scenario? 
Entity A has a contingent asset in  the form of damages receivab le. 
However, no disclosure would be likely at this point as conting ent assets 
are only disclosed when they are  considered probable and entity  A's 
lawyers are unwilling to confirm this. 
Entity B has a contingent liabi lity relating to the damages pay able. Entity 
B has a possible liability whi ch would be treated as a continge nt liability. 
Entity B should disclose info rmation about the anticipated paym ent 
unless its probability is considered to be remote.

186  
 Test your understanding 4 (Case style) 
 BH's directors are unsure how to  treat a number of potential t ransactions 
in the financial statements for the year ended 31 August 20X5. Details of 
these transactions are provided below. 
Transaction 1 
A significant amount of inventor y was stolen in July 20X5 and B H has 
made a claim with its insurance provider to recover the value o f the 
goods. It is hoping to receive $1.5 million from the insurer ho wever it has 
not yet received confirmation t hat the claim has been accepted.  It is keen 
however to recognise the $1.5 milli on to cancel out the effect of the stolen 
goods on profit for the year. 
Transaction 2 
A customer is suing BH for produ ction delays caused by the thef t of the 
inventory, as BH was unable to p rovide replacement goods on a t imely 
basis. BH does not believe tha t it is responsible for covering the cost of 
the delay, however BH's lawyers have indicated that there is a possibility, 
based on precedent, that the custom er's claim could be successf ul. 
Transaction 3 
BH has placed an order for plan t and machinery with a purchase cost of 
$4 million. The plant and machin ery has not been delivered at t he  
year-end however BH believes i t should recognise a liability fo r the 
$4 million as it has signed a cont ract with the supplier agreei ng the price. 
Required: 
You have been asked to draft a n ote, to be circulated to the bo ard of 
directors, explaining how t he above transactions should be refl ected in 
the financial statements of BH  for the year ended 31 August 20X 5. 
Please note that the majority of the directors do not have a fi nancial 
background and will not necessa rily understand accounting termi nology.

Chapter 7 
 187 
 Test your understanding 5 (OTQ style question) 
 You work as a CIMA qualified accountant for PK, a small family  business, 
and the Managing Director has s ent you the following email: 
"I've recently found out from our  health and safety manager tha t, due to a 
change in legislation e nacted on 30 November  20X0, we are requi red to 
fit smoke filters to our factor ies by 30 June 20X1. I assume th is means 
that we will have to recognise an expense for the fitting of th e filters in our 
financial statements fo r the year ended 31 De cember 20X0. We wi ll not 
be fitting the filters until June 20X1. Please can you drop me a line and 
confirm whether I'm correct about this. 
Many thanks, Bill." 
Required: 
Which of the following will be the most appropriate response to  Bill's 
email? 
A Your assumptions are correct. An expense and a provision will  be 
required to record the cost of the fitting of t he filters withi n the 
financial statements for the year ended 31 December 20X0. 
B Your assumptions are incorrect.  Only a disclosure of a contin gent 
liability will be required in rel ation to the potential costs o f the fitting 
of the filters within the financia l statements fo r the year end ed 
31 December 20X0. 
C You assumptions are incorrec t. The costs of fitting the filte rs will 
have no impact on the financial statements of PK. Neither 
recognition nor disclosure of t he costs is required for the yea r ended 
D William, I am afraid I do not k now the answer to your query. I will be 
unable to perform the adequate res earch required to provide you  
with an appropriate answer unless I am paid an off the books bo nus 
in cash. 
Summary 
The accounting treatment can be summarised as follows: 
 
Degree of probability of an outflow/ inflow of resources Liability Asset 
Virtually certain Recognise Recognise 
Probable Make 
provision Disclose by 
note 
Possible Disclose by 
note No 
Remote No  
disclosure No 
disclosure

188  
 Test your understanding 6 (OTQ style question) 
 1 HH has announced the closure o f one of its divisions prior t o its 
reporting date and is uns ure which costs to include in its prov ision. 
The closure is expected to take  place on 1 March 20X5 and HH's 
reporting date is 30 November 20X4. 
Which of the costs should be rec ognised within a provision for 
closure of the division as at 30 November 20X4? Select all that  
apply. 
A Redundancy costs 
B Operating loss expected for per iod from 1 December 20X4 to 
1 March 20X5 
C Legal and professional fees  relating to closure 
D Staff retraining 
2 KJ operates in the oil industr y and causes contamination. It runs its 
operations in a country in whic h there is no environmental 
legislation. KJ has a widely pub lished environmental policy in which 
it undertakes to clean up all contamination that it causes and it has 
a record of honouring this policy. 
A KJ should not make a provisi on as there is no legislation 
requiring it to incur costs of cleaning up the contamination. 
B KJ has created a constructive  obligation by publishing its 
environmental policy and therefor e a provision is required. 
C KJ should make a provision for  the costs of cleaning up the 
contamination that it i s expected to cause. 
D KJ should disclose a contingent l iability in case it decides to 
incur the clean-up costs fo r contamination caused.

Chapter 7 
 189 
 3 Which one of the following situat ions would require a provision  
in the financial statements of FM at its reporting date, 
31 October 20X2?  
A The government introduced new l aws on data protection which 
come into force on 1 January 20X3. FM's directors have 
agreed that this will require a l arge number of staff to be 
retrained and have produc ed a reliable estima te of the costs of  
this training. 
B FM have a policy of making refunds to customers for any 
goods returned within 28 days of sale and has done so for 
many years. It is under no obligat ion to make the refunds. It 
anticipate that 5% of sales  made in October 20X2 will be 
returned by 28 November 20X2. 
C FM has recently purchased an item of machinery and health 
and safety legislation requires th at a major overhaul should be  
carried out once every 3 years. F M have estimated the cost of 
the overhaul and are pl anning to make a provision of 1/3 of the  
cost to represent the asset's use to date. 
D FM is being sued by a custome r for faulty goods supplied. 
FM's lawyers have estimated that  there is a 40% likelihood of 
the customer's claim being su ccessful and believes that a 
reliable estimate can be made o f the damages that would be 
payable. 
 4 LR have claimed compensation of $30,000 from another entity for 
breach of copyright. The solicitors of LR have advised that the ir 
claim is 80% likely to succeed. 
Which one of the following is t he correct treatment of the 
above situation in the financial statements of LR? 
A An asset of $30,000 should be recognised in the financial 
B An asset of $24,000 should be recognised in the financial 
C The claim should be disclos ed in a note to the financial 
D The financial statements shoul d not recognise or disclose any  
information about the claim.

190  

Chapter 7 
 191 
 As the new legislation will have retrospective effect, there i s a present 
obligation arising from the dam age already caused by the oil ri g and 
therefore a provisi on should be made, assuming that a reliable estimate 
can be made of the costs involved. 
 
 C 
The accounting standard that is being applied he re is IAS 37 Pr ovisions, 
contingent liabilities and contingent assets. To recognise a pr ovision, the 
entity will Dr P/L Cr Provision . This accounting standard lists  three 
recognition criteria that, if sa tisfied, result in the recognit ion of a provision 
in the financial statements. They are: 
• a present obligation is creat ed arising from a past event 
• it is considered probable tha t an outflow of resources will be  
required to satisfy the obligation 
• the outflow can be reliably estimated. 
In this case, there is a present obligation arising from a past  event. By 
offering warranties SZ have creat ed a contractual obligation to  make 
repairs for any sales made in the past 2 years. The sale itself  is the past 
event giving rise to the obligation. 
It must be considered probable  that there will be an outflow of  resources 
required to satisfy the obligati on. The entire class of sales s hould be 
considered when assessing the pr obability and, from SZ's past 
experience, it is considered pr obable that 8% of the goods will  require 
repair. The provision is ther efore based on this amount. 
The provision should be recorded based on total costs to be inc urred. 
The provision will record the es timate for total costs in full based on the 
position as at the year end. The provision is r ecorded based on  8% of 
current year revenue.

192  
 Finally, a provision can only reco rded if a reliable estimate c an be made 
of the outflow required. This s houldn't be a problem for warran ty repairs 
as past experience can be used to  calculate the average cost of  a repair 
and we have information abou t the number of goods sold. 
A disclosure would be required i f there was a possible chance o f incurring 
the costs. This would be disclos ed as a contingent liability (s ee section 5 
later). This is not relevant a s SZ considers a probable likelih ood of 
incurring the costs bas ed on past experience. 
To show nothing in the accounts is  only relevant if the chances  of 
incurring the costs are remote.  
 
 C 
Division A provides for $2,050,000. Division B records nothing in 
The accounting treatment is gov erned by IAS 37 Provisions, Cont ingent 
Liabilities and Contingent Assets, which states that a provisio n should 
only be made for closure of a div ision if there is a formal det ailed plan 
and it has been communicated to t hose who will be affected by i t. It also 
contains rules on what c osts should be provided. 
Division A 
As notice of the closure has been sent to customers and staff i nvolved, a 
valid expectation has been created  that the closure of the divi sion will go 
ahead. A constructive obligation t herefore exists and provision  should be 
made for the costs of closure. On ly the costs necessarily entai led by the 
closure should be included in t he provision. The costs of redep loyment 
($450,000) are associated with the ongoing activities and shoul d 
therefore be excluded from the provision. 
Assuming that the other closure costs meet the cr iteria necessa ry, a 
provision of $2,050,000 would be made in the financial statemen ts for the 
year ended 31 De cember 20X3. 
Division B 
Although there is a detailed fo rmal plan for th is closure, it h as not been 
communicated outside the board o f directors and therefore no ob ligation 
exists at the year end. Therefore,  no provision should be made for the 
expected costs of closure of division B.

Chapter 7 
 193 
 Note to Directors 
As requested, I've prepared this note to explain how three tran sactions 
should be reflected in the financia l statements for the year en ded 
31 August 20X5. 
Transaction 1 – $1.5 million poten tial receipt from insurer re theft of 
inventory 
Unfortunately, we cannot recognise  this $1.5 million in the fin ancial 
statements as we are not certain  that we will receive the money . 
This is known in accounting te rms as a contingent asset and, if  we 
consider it probable (greater t han 50% chance) that the claim w ill be 
accepted and the amount will be re ceived then we should disclos e 
information about it (the nature of the claim and the likely am ount) in a 
note to the financial statements.  If however we only consider i t possible 
rather than probable (i.e. less  than 50% chance) then no disclo sure 
should be made at all. 
The amount can only be recognised as an asset when its receipt 
becomes virtually certain. This would be when the insurer confi rms that it 
will pay the money out. 
Transaction 2 – customer cla im re production delays 
The claim by the customer is an example of a contingent liabili ty and 
should be disclosed in a note to  the financial statements unles s its 
likelihood is considered 'remote'. 
The delay in providing the goods to  the customer gives rise to a potential 
obligation and the la wyer's opinion suggests that the likelihoo d is more 
than remote. We should therefor e disclose information about the  claim in 
a note to the financ ial statements. 
If we actually thought that the likelihood was probable (>50% c hance) 
and a reliable estimate could be made of the damages payable th en a 
provision would be required and we  would have to recognise the 
expected damages as an expense in t he statement of profit or lo ss. 
The probability is a matter of j udgement and this is something that should 
be discussed further with the lawyers. 
Transaction 3 – contract for purchase of plant and machinery 
The obligation to pay $4 million does not arise until the plant  and 
machinery has been delivered and accepted by BH. Therefore no l iability 
would be recognised until then.

194  
 C 
The costs of fitting the filter s will have no impact on the fin ancial 
statements of PK. Neither recogni tion nor disclosure of the cos ts is 
required for the year ended 31 December 20X0. 
To recognise a provision as per  IAS 37, the following criteria must be 
met: 
Although the legislat ion has already been en acted, the requirem ent to fit 
the smoke filters does not ari se for another six months after t he reporting 
date. As a result, as at the year  end, there is no 'past event giving rise to 
a present obligation'. 
If no obligation exists in the  first place, the likelihood of t he outflow of 
resources being probable, possibl e or remote is irrelevant. The refore, PK 
should not create a provision and  recognise an expense; neither  should 
they disclose the costs as a c ontingent liability. Nothing will  be recorded 
in the financial statements in r elation to these potential cost s. 
It's also worth noting that, ev en if there was a requirement to  fit the filters 
by the reporting dat e and PK had not done so , PK would still no t have to 
make a provision for the cost of  fitting the filters. There is only an 
obligation to incur the cost w hen the filters have been install ed. The 
directors may deliberately refuse  to incur the costs. However, as a result, 
PK would be required to make a provision for any fines or penal ties 
arising from non-compliance with  the legislation (i.e. fines in curred for not 
fitting the filters). 
CIMA qualified accoun tants are required to  comply with the CIMA  ethical 
guidance and principles. To refu se to perform their duties as a n 
accountant (for which it could be assumed a salary would be pai d to the 
accountant) unless further compens ation is paid could be an att empt to 
extort money from the PK business. The request to receive the b onus "off 
the books" and in cash could be a direct attempt to evade tax. Either way, 
this response would be deemed to  be unethical and unprofessiona l. It 
would be wholly inappropriate  to respond in such a manner.

Chapter 7 
 195 
 1  Costs A and C  
B is incorrect as provisions c annot be made for future operatin g 
losses. 
D is incorrect as staff traini ng relates to the ongoing activit ies of the 
business. 
2 B is the correct statement. 
A is incorrect. Although there is  no legal obligation, there is  a 
constructive obligation and ther efore a provisio n is still requ ired. 
C is incorrect. A provision woul d be made only for contaminatio n 
that had already been caused (as  there must be a past event 
resulting in a present obligation). 
D is incorrect. As KJ has created a constructive obligation, it  is not 
considered to be contingent. 
3 B is the correct answer.  
A is incorrect. There is no ob ligation at the reporting date. 
C is incorrect. There is no pres ent obligation to carry out the  
overhaul (the entity could choos e to sell the asset instead). 
D is incorrect. This would be a contingent liability. It fails to meet the 
recognition criteria for a prov ision as it is not considered pr obable 
(more likely than not). 
4 C 
An asset cannot be recognised until it is virtually certain (80 % would 
not suggest this). As the success of the claim is considered 
probable however, disclosure wo uld be made of this contingent 
asset.

197 
Intangible assets  
(e)  Intangible assets    
 
 Chapter 
8

Intangible assets 
198  
 
 1  IAS 38 Intangible Assets  
As per IAS 38 Intangible Asse ts, an intangible asset is ' an identifiable non-
monetary asset without physical substance (IAS 38, para 8).  
Intangible assets include items such as: 
• licences and quotas 
• intellectual property, e .g. patents and copyrights 
• brand names 
• trademarks 
An asset is identifiab le if it is both: 
• separable, and 
• arrives from contractual or ot her legal rights' (IAS 38, para 12). 
An asset is deemed separable if t he asset can be bought or sold  separately 
from the rest of the business. 
As a result, goodwill arising fr om the acquisition of a busines s is not accounted 
for as an intangible asset a s per IAS 38. It cannot be sold ind ividually without 
disposing of the rest of the ent ity. Therefore, it is IFRS 3 Business 
combinations,  and not IAS 38, that considers t he accounting of goodwill in s uch 
circumstances.

Chapter 8 
 199 
2  Recognition of intangible assets 
To be recognised in the financial statements, an intangible ass et must meet 
• 'the definition of an intangible asset, and 
• meet the recognition criteria'  of the framework (IAS 38, para 18) 
 
Internally-generated intangibles 
Generally, internally-gener ated intangible assets cannot be capitalised , as 
they cannot be identified separat ely from the costs associated with running the 
business. They rarely meet the recognition criteria outlined in  the framework as 
they are not capable of r eliable measurement.  
The following internally-generat ed intangibles can never be rec ognised: 
• goodwill 
• brands 
• publishing titles 
• newspaper mastheads 
• customer lists 
• intellectual property 
This accounting treatment is controversial. Under this approach , an entity that 
generates significant benefits th rough its intellectual propert y or its investments 
in staff development (e.g. creat ive design industries, football  clubs) will have a 
statement of financial position th at could greatly undervalue t he entity.

200  
 Brands 
 • The accounting treatment of b rands has been a matter of 
controversy for some years. IAS 38 Intangible Assets  has now 
ended the controversy by stating  that internally -generated bran ds 
and similar assets may never be recognised. 
• Expenditure on internally-gen erated brands cannot be distingui shed 
from the cost of developing the business as a whole, so should be 
written off as incurred. 
• Where a brand name is separately acquired and can be measured 
reliably, then it should be separat ely recognised as an intangi ble 
non-current asset, and accounted fo r in accordance with the gen eral 
rules of IAS 38. 
Purchased intangibles 
Purchased intangibles should be recognised at cost , which could be cash or 
the fair value of shar es given in exchange 
The cost should include the purc hase price plus any directly at tributable costs of 
preparing the asset for its intended use. 
 
 Intangible purchased separately 
An intangible asset purchased separ ately from a business should  be 
capitalised at cost. 
Intangibles acquired with in a business combination 
Where an identifiable intangibl e asset is acquired within an ac quisition of 
a business and it can be measured reliably on initial recogniti on, it should 
be capitalised separately from p urchased goodwill. The asset's cost will 
be its fair value. 
If the fair value of an intangibl e asset purchased as part of a n acquisition 
of a business cannot be measured reliably, the intangible asset  should 
not be recognised and will be included within goodwill.  
The cost of an intangible asset 
As per IAS 38 Intangible assets , the cost of an intangible asset 
comprises: 
• its price to purchase, includi ng import duties and non-refunda ble  
taxes on acquisition, after deduc ting trade discounts and rebat es 
• any directly attributable cos t of preparing the asset for its intended 
use.

Chapter 8 
 201 
Examples of directly a ttributable costs are: 
• costs of employee pay arising di rectly from bringing the asset  to its 
working condition 
• professional fees.  
Examples of costs that are not a cost of an intangible asset ar e: 
• costs of introducing a new produ ct or service (including costs  of 
advertising and promotional activities) 
• costs of conducting business in a  new location or with a new c lass 
of customer (including c osts of staff training) 
• administration and other  general overhead costs. 
3 Subsequent measurement of intangible assets 
To account for intangible assets  as at the reporting date, ther e is a choice 
between: 
• the cost model 
• the revaluation model. 
The cost model 
• The intangible asset should be ca rried at cost less amortisati on and any 
impairment losses. 
• This model is more commonly used in practice. 
The intangible asset is amortis ed over the useful life, with th e annual expense 
being shown in the statement of profit or loss each year.  
An intangible asset with a finite useful life  must be amortised over that life, 
normally using the straight-line method with a zero residual va lue. 
An intangible asset with an indefinite useful life:  
• should not be amortised 
• should be tested for impairment  annually, and more often if th ere is an 
actual indication of possible impairment. 
Intangible assets are regarded as  having an indefinite life if there is no 
foreseeable limit to the period ov er which the asset is expecte d to generate net 
cash inflows for the entity.

202  
 Amortisation 
 The depreciable amount of an int angible asset should be allocat ed on a 
systematic basis over the best est imate of its useful life. Amo rtisation 
should start from the date the asset is available for use. 
The useful life of an intangibl e asset should take account of s uch things 
as: 
• the expected usage of the asset 
• possible obsolescence and expec ted actions by competitors 
• the stability of the industry 
• market demand for the products and services that the asset is 
generating. 
The method of amortising the asset should reflect the pattern i n which the 
assets’ economic benef its are expected to be consumed by the en tity. If 
that proves difficult to determi ne, then the stra ight-line meth od is 
acceptable. The residual value o f the intangible should be assu med to be 
zero unless there is a commitm ent from a third party to purchas e the 
asset or the entity intends to s ell the asset and a readily ava ilable active 
market exists. The annual amortis ation amount will be charged t o profit or 
loss as an expense. 
The useful life and method of amo rtisation should be reviewed a t least at 
each financial year-end. Changes to u seful life or method of am ortisation 
should be effective as soon as th ey are identified and should b e 
accounted for as changes in acco unting estimate s (IAS 8 – not  testable 
within the F2 syllabus), by adjus ting the amortisation charge f or the 
current and future periods. 
The revaluation model 
Intangible assets may be revalu ed to their fair value. The fair  value should be 
determined by an active market. 
An active market exists where all of the following conditions a re met: 
• items traded in the market are homogenous 
• willing buyers and sellers can be found at any time 
• prices are available to the public. 
IAS 38 states that active market s for intangible assets are rar e, and specifically 
prohibits the revaluation of pat ents, brand names, trademarks a nd publishing 
rights. 
Most intangible assets have va lue because of their uniqueness, and are 
therefore, unlikely to be hom ogeneous.  Certain licences or quo tas (e.g. taxi cab 
licences, farm milk quotas) may  fit this model and could possib ly be revalued, 
but most other intangible assets will not.

Chapter 8 
 203 
4  Derecognition of intangible assets 
An intangible asset is derecognised:  
(a) on disposal; or (b) when no future economic benef its are expected from it. 
A gain or loss on disposal is re corded in profit or loss, being  the difference 
between proceeds on disposal and  carrying amount of the intangi ble asset. 
Gains or losses from disposing in tangible assets are not includ ed within 
revenue. 
5 Research and development 
Technology is rapidly playing a part in everyday life, whether in the workplace or 
as part of an individual’s social  activities. In an ever-expand ing digital world, the 
need for entities to consider how  to benefit from the use of ne w technology is 
more important than ever. Whethe r researching how to best gain efficiencies 
through use of up-to-date softw are and hardware, or developing new products 
to sell to tech-loving consumer s, companies nowadays are much m ore 
dependent and influenced by tec hnological innovation. 
Research and development is not res tricted to just areas of tec hnology. The 
need for research and developmen t will extend to any industry ( e.g. 
pharmaceuticals, cosmetics, education, construction), and any a spect of a 
business’ operations (e.g. envir onmental and social implication s, product 
development, recruitmen t, training methods).   
IAS 38 deals with the accounting of research and development co sts.

204  
 
It is only expenditure incurred af ter the recognition criteria have been met which 
should be recognised as an asset. Development expenditure recog nised as an 
expense in profit or loss canno t subsequently be reinstated as an asset. 
If an item of plant is used in t he development process, the dep reciation on the 
plant is added to the development  costs in intangible assets du ring the period 
that the project meets  the development crite ria.  That is becau se the economic 
benefit gained from the plant in this period is only realised w hen the development 
project is complete and production is underway.  
The depreciation will eventuall y be taken to t he statement of p rofit or loss as part 
of the amortisation of the development costs once the project i s underway. 
Amortisation 
Development expenditure should be amortised over its useful lif e as soon as 
commercial production begins.

Chapter 8 
 205 
 Illustration 1 – Research and development 
 CD is a manufacturing entity t hat runs a number of operations i ncluding a 
bottling plant that bottles car bonated soft drinks. CD has been  developing 
a new bottling process that will allow the bottles to be filled  and sealed 
more efficiently. 
The new process took a year to d evelop. At the start of develop ment, CD 
estimated that the new process w ould increase output by 15% wit h no 
additional cost (other than the ex tra bottles and their content s). 
Development work commenced on 1 May 20X0 and was completed on 
20 April 20X1. Testing at the end of the development confirmed CD’s 
original estimates. 
CD incurred expenditure of $180, 000 on the above development. 
CD plans to install the new proce ss in its bottling plant and s tart operating 
the new process from 1 May 20X1. 
The end of CD’s reporting period is 30 April. 
Required: 
(a) Explain the requirements of  IAS 38 Intangible Assets for th e 
treatment of development costs. 
(b) Explain how CD should treat i ts development costs in its fi nancial 
statements for the y ear ended 30 April 20X1. 
 
 Solution 
 (a) Development expenditure c an only be regarded as an intangi ble if it 
meets the criteria of IAS 38. If th e criteria are not met the c ost must 
be written off as research costs  to the statement of profit or loss.  
The criteria to capitalise development costs are as follows: 
–  the project is expe cted to be profitable 
– the intention to use o r sell the developed item 
–  resources to complet e the project exist 
–  technically feasible to  complete the project 
–  the ability to use or sell the asset –  the expenditure can be reliably measured  
Capitalised development costs  are then amortised over the 
products’ expected useful life.

206  
 (b) All of the above criteria  seem to have been met by CD’s new  
process: 
–  it is technically feasible, i t has been tested and is about to be 
implemented 
–  it has been completed and CD intends to use it –  the new process is estimated to  increase output by 15% with 
no additional costs other than di rect material costs hence 
profitability 
–  the expenditure can be measured at $180,000 
CD will treat the $180,000 developm ent cost as an intangible no n-current 
asset in its statement of financia l position at 30 April 20X1. Amortisation 
will start from 1 May 20X1 when  the new process starts operatio n. 
 
 An entity has incurred the follo wing expenditur e during the cu rrent year: 
(a) $100,000 spent on the initial design work of a new product – it is 
anticipated that this design will be taken forward over the nex t two 
year period to be dev eloped and tested with a view to productio n in 
three years' time. 
(b) $500,000 spent on the testing of a new production system wh ich 
has been designed internally and w hich will be in operation dur ing 
the following accounting year. T his new system should reduce th e 
costs of production by 20%. 
How should each of these costs be  treated in the financial 
statements of the entity? 
 
(i) A brand name relating to a s pecific range of chocolate bars , 
purchased for $200,000. By the year  end, a brand specialist had  
valued this at $250,000. 
(ii) $500,000 spent on developing a new line of confectionery, including 
$150,000 spent on researching  the product before management 
gave approval to fully fund the project. 
(iii) Training costs for staff  to use a new manufacturing proce ss. The 
total training costs amounted to  $100,000 and staf f are expecte d to 
remain for an average of 5 years. 
Explain the accounting treatme nt for the above issues.

Chapter 8 
 207 
 Illustration 2 – Amortisati on of development expenditure 
 Improve has deferred developm ent expenditure of $600,000 relat ing to 
the development of New Miracle B rand X. It is expected that the  demand 
for the product will stay at a hi gh level for the next three ye ars. Annual 
sales of 400,000, 300,000 and 200, 000 units respectively are ex pected 
over this period. Brand X sells for $10. 
How should the development ex penditure be amortised?  
Solution 
There are two possibilities for writing off the development exp enditure: 
• Write off in equal instalments ov er the three-year period, i.e . 
$200,000 pa. 
• Write off in relation  to total sales expec ted (900,000 units).   
Year 1 (400,000/900,000)  × $600,000 = $266,667  
Year 2 (300,000/900,000)  × $600,000 = $200,000  
Year 3 (200,000/900,000)  × $600,000 = $133,333 
 
 Case Study Questions 
 2015 CIMA Professional Qualificati on Syllabus, Case Study Exam,  
May 2017 – Question  
You receive an email from Gillia n Ashworth, the Finance Directo r  
From:  Gillian Ashworth, Finance Director 
Subject:  Contract agreements and R&D expenditure 
I have just come out of a meetin g with Dr Robert Voss, the Rese arch & 
Development Director and Roger A shworth, the Managing Director.  
We have been in negotiations with  two major oil companies to op en 20 
hydrogen fuelling stations throughou t Mayland. This is excellen t news for 
us - at last we will start to r eap the benefits of the hard wor k and money 
that has gone into developing th e fuelling system. The long-ter m potential 
is excellent, hydrogen fuelled ca rs are the future and we are n ow one of 
the major players in that market. 
Dr Voss mentioned that the profit  from the contracts would init ially be 
very low as all the research and development expenditure incurr ed in 
developing the fuelling system would be charged to profit and l oss in the 
first year

208  
 Please send him an email explai ning how we will  treat the expen diture on 
the new product in the financia l statements under  IAS 38 Intang ible 
Assets. 
Regards Gillian Ashworth  
Finance Director  Ashworth Lea 
 © Copyright CIMA – 2015 CIMA Professional Q ualification Case Study 
Exam May 2017 
 
 2015 CIMA Professional Qualification Syllabus,  
EMAIL TO DR VOSS 
Accounting for R&D Expenditure 
The accounting for R&D is dealt with under IAS 38, Intangible Assets . 
Research expenditure 
Research is investigation underta ken to gain new scientific or technical 
knowledge and understanding. According to IAS38, research expen diture 
must be written off as an expens e. The expenditure that we incu rred in 
researching the technology for  the fuelling system has therefor e already 
been written off to the st atement of profit or loss 
Development expenditure 
Development is the application of research findings or other kn owledge to 
plan or design for the production of new or substantially impro ved 
processes, products or services before the start of commercial 
production. IAS38 allows for dev elopment expenditure to be capi talised 
provided it meets certain criteria: 
• The technical feasibility of c ompleting the intangible asset ( so that it 
will be available for use or sal e): we have already completed t he 
development of the fuelling system and are about to sell it. 
• Intention to complete and use or  sell the asset: we have alrea dy 
opened our first fuelling station and are in negotiations with major oil 
companies to open more sta tions in the future. 
• Ability to use or sell the a sset: the opening of the fuelling station 
confirms the ability to use the asset and we have established t hat 
there is a market for the product.

Chapter 8 
 209 
• Existence of a market or, if to  be used internally, the useful ness of 
the asset: we have already est ablished that there is a market f or the 
product. 
• Availability of adequate techni cal, financial, and other resou rces to 
complete the asset: the asset has already been completed. 
• The cost of the asset can be m easured reliably: the costs rela ting to 
the new product have been separately recorded. 
 Once we recognised that the pr oject to develop the fuelling sy stem met 
the criteria above, the developm ent expenditure was capitalised  and is 
shown in our statement of financ ial position as an intangible a sset. 
Treatment of capitalised development expenditure 
The development expenditure tha t has already been capitalised w ill be 
amortised, in accordance with  the accruals concept, over its fi nite life. 
Amortisation will begin in this fi nancial year as the asset is now available 
for use. 
© Copyright CIMA – 2015 CIMA Profe ssional Qualification Case St udy 
 
 1 Cowper plc has spent $20,000 re searching new cleaning chemic als 
in the year ended 31 December 20X0. They have also spent 
$40,000 developing a new cleaning product which will not go int o 
commercial production until next y ear. The development project 
meets the criteria  laid down in IAS 38 Intangible Assets . 
How should these costs be treated  in the financial statements 
of Cowper plc for the year  ended 31 December 20X0? 
A $60,000 should be capi talised as an intangi ble asset on the 
statement of financial position. 
B  $40,000 should be ca pitalised as an intangible asset with 
subsequent amortisation taken to profit or loss. $20,000 should  
be expensed as research costs i n the statement of profit or 
loss. 
C  $40,000 should be ca pitalised as an intangible asset and 
should not be amortised. $20, 000 should be expensed as 
research costs in the st atement of profit or loss. 
D  $60,000 should be expensed as  research costs in the 
statement of profit or loss

210  
 2 Thom Co is an entity that hol ds a number of intangible assets . Thom 
Co’s finance director is unsure of their accounting treatment. 
Which TWO of the fo llowing items should Thom Co capitalise 
as intangible assets? 
A  a purchased brand name -“Yorke” 
B  purchased staff training courses C  Thom Co’s inter nally generated brand 
D  licences and quotas 
3 Sam Co has provided the followi ng information as at 31 Decemb er 
20X6: 
(i) Project A – $50,000 has been spent on market research 
regarding potential product options during the year. 
(ii) Project B – $80,000 had been sp ent on this project in the 
previous year and $20,000 this year. The project was capitalised in the previous y ear.  During 20X6, it was decided 
to abandon this project as it w ould not operate profitably. 
(iii) Project C – $100,000 was s pent developing a prototype 
product. The expenditure meets t he criteria of IAS 38 and is to  
be capitalised.  
Which of the following adjust ments will be made in the 
financial statements as at 31 December 20X6? 
A  Reduce profit by $70,000 and incr ease non-current assets by 
$100,000 
B  Reduce profit by $150,000 and in crease non-current assets by  
$100,000 
C  Reduce profit by $130,000 and in crease non-current assets by  
$180,000 
D  Reduce profit by $130,000 and in crease non-current assets by  
$100,000 
4 Which of the following statem ents concerning the accounting 
treatment of research and development expenditure are NOT 
true, according to IAS 38 Intangible Assets?  
A Research is original and pl anned investigation undertaken wit h 
the prospect of gaining new k nowledge and understanding. 
B Development is the applic ation of research findings. 
C Depreciation of plant used s pecifically on developing a new 
product can be capitalised as part of development costs. 
D Research expenditure, once  treated as an expense, can be 
reinstated as an asset once development conditions are met.

Chapter 8 
 211 
5 Sharrakazam is a console games  developer who offers access to  
their games via monthly subscrip tions paid by their customers.  
 Which of the following should be included in a company’s 
statement of financial posit ion as an intangible asset under IA S 
38 Intangible Assets ? 
A Internally developed softwar e that manages customer access 
to the subscription services 
B Internally generated goodwill cr eated from the success of 
Sharrakazam’s latest rel eased game – FIFO 2019 
C Intellectual property created by Sharrakazam’s games writing 
staff 
D Payments made on the successful  registration of a copyright 
for Sharrakazam’s newest in-dev elopment game – GTA (Great 
Tax Accountant) XX. 
6 During the year to 31 Decem ber 20X8, X Co incurred $200,000  
development costs for a new p roduct. In addition, X Co spent 
$60,000 on 1 January 20X8 on machiner y specifically used to hel p 
develop the new product and $40, 000 on building the new product ’s 
brand identity. Commercial produ ction of the new product is 
expected to start during 20X9. 
The machinery is expected to las t 4 years with no residual valu e. 
What amount should be capitali sed within intangible assets 
during the year ended 31 December 20X8? 
$  __________ 
7 Which TWO of the following criteria must be met before 
development expenditure is cap italised according to IAS 38 
Intangible Assets ? 
A the  project is deemed to be technically feasible 
B  future revenue must be received from the project 
C the ability to use or sell the item in development is held by  the 
entity 
D performance obligations within  the contract can be identified

212  
 8 For each issue, identify the correct accounting treatment in 
Madeira's financial statements: 
 Capitalise 
as 
intangible Expense 
$400,000 developing a new process 
which will bring in no revenue but is expected to bring significant cost savings   
$400,000 developing a new product. 
During development a competitor launched a rival product and now Madeira is hesitant to commit further funds to the process   
$400,000 spent on marketing a new 
product which has led to increased sales of $800,000   
$400,000 spent on designing a new 
corporate logo for the business

214  
 Test your understanding 1 – R and D 
 (a) These costs are research c osts as they are only in the ear ly design 
stage and must be written off to t he statement of profit or los s for the 
period. 
(b) These appear to be developm ent costs that meet the capitali sation 
criteria, i.e. expect to compl ete, will produce economic benefi ts, etc. 
Therefore these costs should be capitalised as an intangible as set 
on the SOFP. Amortisation will not begin until production start s. 
 
 (i) The brand name is a purchas ed intangible asset, so can be 
capitalised at the cost of $200,000. 
Intangible assets can only be reva lued if an active market exis ts. 
This is unlikely here, as the brand name will no t be a homogene ous 
item. Therefore the item shoul d be held under the cost model. 
The brand should be written off ov er its expected useful life. If this 
has an indefinite useful life t hen no amortisation is charged. 
However, an annual impairment r eview would be required. 
(ii) The $500,000 relates to res earch and development. Of the t otal, 
$150,000 should be expensed to the statement of profit or loss,  as 
management had not displayed either  the intention to complete, or 
the release of the res ources to complete. 
Therefore $350,000 can be capitalised as an intangible asset as  
development costs. 
(iii) The training costs must be expensed in the statement of p rofit or 
loss. The movement of staff canno t be controlled, and therefore  
there is no way of restricti ng the economic benefits. If the st aff 
leave, the company receives no benefit.

Chapter 8 
 215 
 1  C is the correct answer 
$20,000 is research and should be written off as incurred.  $40 ,000 
should be capitalised as a devel opment asset, but is not amorti sed 
until commercial production begins. 
2 A and D are the correct answers 
Training expenditure cannot be c apitalised as Thom Co cannot 
control the future economic benef its arising from training thei r staff. 
This is because the staff member s may leave Thom Co and find 
employment elsewhere. 
Internally generated brands  cannot be capitalised. 
3 B is the correct answer   
The expenditure in relation to p rojects A and B should be expen sed 
as research costs during the year.  
The costs capitalised in the pr evious year for project B would be 
expensed during 20X6 as the project would fail to meet the crit eria 
for treatment as developm ent costs per IAS 38. 
Project C should be capitalised as development costs and will 
increase the value of non-current assets. 
4 D is the correct answer   
Development costs can only be capitalised if they met the 
capitalisation criteria. The prev iously expensed research did n ot 
meet the criteria at the point o f incurring the costs and so sh ould 
never be capitalised. 
5 D is the correct answer  
Internally generated intangible assets cannot be recognised. 
Options A-C  describe interna lly generated int angible assets. 
6 $215,000   
The development costs of $200,000 can be capitalised, as can th e 
depreciation on the asset wh ile the project is being developed.  The 
asset is used for a year on the project, so the depreciation fo r the 
first year ($60,000/4 years = $15,000) can be added to intangib le 
assets. The $40,000 is expenditu re contributing towards an 
internally generated brand and cannot be capitalised. 
7 A and C are the correct answers   
There is no need for revenue, t here needs to be probable econom ic 
benefits which may come in the fo rm of cost savings as well as 
revenue. 
The identification of performanc e obligations is a factor to co nsider 
when recognising revenue under IFRS 15.

216  
8 
as 
which will bring in no revenue but is expected to bring significant cost savings   
During development a competitor launched a rival product and now Madeira is hesitant to commit further funds to the process   
product which has led to increased sales of $800,000   
corporate logo for the business  

217 
reporting standards  Explain the financial reporting 
(f)  Income taxes 
 
  Chapter 
9

218  
 
2 IAS 12 Income taxes 
IAS 12 Income taxes  covers the general principles of accounting for tax. 
The income tax expense in the st atement of profit or loss typic ally consists of 
three elements: 
• current tax expense for the year 
• under or over provisions in rel ation to the tax expense of the  previous 
period 
• deferred tax. 
Current tax 
Current tax is the estimated amo unt of tax payable on the taxab le profits of the 
enterprise for the period. 
Taxable profits are th e profits on which tax is payable, calcul ated in accordance 
with the rules of local tax authorities.

Chapter 9 
 219 
At the end of every accounting period, the entity will estimate  the amount of tax 
payable in respect of the period . This estimate is normally rec orded as a period 
end adjustment by making t he following double entry: 
Dr Income tax expense (SPL) Cr Income tax liability (S FP – current liability) 
Under and over provisions 
Income tax for the period is a ccrued in one financial period an d then settled in 
the next. The amount settled often differs from the amount accr ued in the 
previous year's financial stat ements. The difference between th e amount 
accrued (in the previous year) an d the amount settled (in the c urrent year) is 
recorded in the current year's inc ome tax expense as an under o r over provision 
relating to the prior period. 
Amount settled > amount previou sly recognised => under-provisio n. This 
creates an additional ta x expense (debit). 
Amount settled < amount previousl y recognised => over-provision . This creates 
a reduction in tax expense (credit). 
 
 Example 1 
 Simple has estimated its income  tax liability for the year end ed 
31 December 20X4 at $180,000. In t he previous year the income t ax 
liability had been estimated as $150,000. 
Required: 
Calculate the tax charge that will be recognised in the stateme nt of profit 
or loss for the year ended 31 De cember 20X4 if the amount that was 
actually agreed and settled with t he tax authorities in respect  of 20X3 
was: 
(a) $165,000 (b) $140,000 State what the income tax liabili ty would be at 31 December 20X 4 in each 
of the above circumstances.

220  
 Example 1 answer 
 ( a )  Under provision  
Statement of profit or loss charge: 
 $  
Current tax expense for year 180,000 
Add: under-provision re lating to prior year 
(165,000 – 150,000)  
15,000 
 ––––––– 
Income tax expense 195,000 
 ––––––– 
(b) Over provision  
 $  
Less: over-provision relating to prior year  
(150,000 – 140,000)  
(10,000) 
 ––––––– 
Income tax expense 170,000 
 ––––––– 
 
In both situations, the income ta x liability at 31 December 20X 4 
would be $180,000 (reflecting the current year's liability only ). 
By making an adjustment to the inco me tax expense to reflect th e 
under/over provision, the remain ing balance relating to the pre vious 
period has been written off through profit or loss. 
3 Deferred tax 
 Deferred tax is: 
• the estimated future  tax consequences of transactions and events 
recognised in the financia l statements of the current  and previous  
periods. 
Deferred tax does not represent t he tax payable to the tax auth orities. 
Deferred tax  is a basis of allocating tax char ges to particular accounting 
periods. It is an application of t he accruals concept and aims to eliminate a 
mismatch between: 
• accounting profit , the profit before tax figure in the statement of profit or 
loss, and 
• taxable profit , the figure on which the tax authorities base their tax 
calculations.

Chapter 9 
 221 
The differences between accounti ng profit and taxable profit ca n be caused by: 
• permanent differences (e.g. exp enses not allowed for tax purpo ses) 
• temporary differences (e.g. exp enses allowed for tax purposes but in a 
later accounting period) 
Only temporary differences are ta ken into account when calculat ing deferred 
tax. 
 
 Temporary differences  are differences between the carrying amount of 
an asset or liability in the stat ement of financial position an d its tax base 
(i.e. the amount attributed to  it for tax purposes). 
Examples of temporary differences include: 
• certain types of income and expe nditure that are taxed on a ca sh, rather 
than an accruals basis, e.g . certain provisions 
• the difference between the depr eciation charged on a non-curre nt asset 
and the actual tax allowances g iven (see the expandable text be low for an 
example of this scenario). 
 
 The accounting problem 
 One important reason why deferred  tax should be recognised is that profit 
for tax purposes may differ from  the profit shown by the financ ial 
statements. Such a difference may be caused by permanent or 
temporary factors. For example , if expenses in the statement of  profit or 
loss are not allowed for tax purposes, a permanent difference  arises. 
Nothing can be done about that, and  the increased tax charge ju st has to 
be accepted. 
A temporary difference  arises when an expense is allowed for both tax 
and accounting purposes, but the  timing of the allowance differ s. For 
example, if relief for capital ex penditure is given at a faster  rate for tax 
purposes than the depreciation in  the financial statements, the  tax charge 
will be lower in the first year s than it would have been based on the 
accounting profit, but in subsequ ent years the tax charge will be higher. 
It is important to remember that only temporary differences give rise to 
deferred tax . 
For example, an item of plant and machinery is purchased by U i n 20X0 
for $300,000. The asset’s estimated useful life is 6 years, fol lowing which 
it will have no residual value. Pla nt and machinery is deprecia ted on a 
straight-line basis. 
Tax depreciation for this item is  given at 25% on the straight- line basis for 
the first 4 years.

222  
 Let us first calculate the figur es that would appear in the fin ancial 
statements over the six-y ear life of the asset: 
 
Financial statements 20X 0 20X1 20X2 20X3 20X4 20X5 
 $000 $000 $000 $000 $000 $000 
Opening carrying amount 300  250 200 150 100 50 
Accounting depreciation 
charge  
50  
50  
50  
50  
50  
50 
 –––– –––– –––– –––– –––– –––– 
Closing carrying amount 250 200 150 100 50 0 
Depreciation is charged at $50,000 per annum ( $300,000/6 years) . 
Now let us look at how this asse t would be treated for tax purp oses: 
 
Tax computation 20X0 20X1 20X2 20X3 20X4 20X5 
 $000 $000 $000 $000 $000 $000 Opening carrying amount 300 225 150 75 0 0 
Tax depreciation 75 75 75 75 – – 
 
–––– –––– –––– –––– –––– –––– 
Tax base 225 150 75 0 0 0 
We can see from comparing the above two tables that the carryin g 
amount of the asset per the acco unts differs from the tax base.  The 
annual reduction in the carrying amount applied by  the entity ( that is, 
accounting depreciation) differs f rom the reduction applied in the tax 
computation. By the end of the asset’s useful life, the two hav e caught 
up, as they both show the asse t with a carrying amount of 0, bu t the 
different treatment over 6 y ears creates the need for deferred tax. 
4 Accounting for deferred tax 
Deferred tax is accounted for us ing a statement of financial po sition approach 
1 Establish the temporary diffe rence at the year-end = carrying  amount of 
net assets less the tax base. 
2 Deferred tax balance (for SFP) = temporary difference × tax r ate 
Note that this could be a li ability or asset, depending on whet her the future 
tax consequence would increase or decrease the tax payable. 
– It will be a deferred  tax liability if the carrying amount of  net assets is 
greater than the tax base. This is  the situation where there ar e 
taxable temporary differences. 
– It would be a deferred tax a sset if the carrying amount of ne t assets 
was lower than the tax base. In t his situation there would be 
deductible temporary differences.

Chapter 9 
 223 
3 Deferred tax expense/credit (for SPL&OCI) = increase/decrease  in 
deferred tax balance in year. 
The cumulative deferred tax bal ance in the statement of financi al position would 
be presented as a non-current  item. 
The movement in the deferred ta x balance is usually recognised as an 
adjustment to the income tax exp ense in the statement of profit  or loss. 
However, according to IAS 12 Income taxes , if it relates to an item that has 
been recognised in other compreh ensive income then the deferred  tax impact 
should also be recognised in ot her comprehensive income. This i s covered in 
more detail later in the chapter. 
 
 Illustration 1 – Deferred tax accounting  
 Messy Ltd has purchased an a sset for $300 and this will be dep reciated 
over three years on a straight line basis. 
The tax depreciation will be $14 0 in year 1, $110 in year 2 and  $50 in 
year 3. 
The current tax rate is 30%. 
Required: 
Prepare the journal entries requir ed to record the deferred tax  on the 
above asset for years 1, 2 and 3. 
Solution 
 
Year SFP carrying 
amount Tax base Temporary 
difference Difference × 
30% 
 $  $  $  $  
1 300 300   
 (100) (140)   
 –––– ––––   
 200 160 40 12 
2 (100) (110)   
 –––– ––––   
 100 50 50 15 
3 (100) (50)   
 –––– ––––   
 0  0  0  0  
The difference at 30% represents  the total deferred tax liabili ty required in 
the statement of financial posit ion. The difference is a taxabl e temporary 
difference because the accountin g depreciation is less than the  tax 
depreciation, i.e. the carrying amount in the SFP is greater th an the tax 
base.

224  
 The movement in the difference a t 30% represents the increase/ 
(decrease) in the deferred tax liability required for the year.  These are the 
entries to be made to the stat ement of profit or loss. 
Statement of profit or loss Year 1 Year 2 Year 3 
Income tax expense/(credit) 12 3 (15) 
Statement of financial position    
Non-current liabilities    
Deferred tax 12 15 0 
Journal entries 
Year 1  
Dr Income tax expense (SPL) $12 Cr Deferred tax liability (SFP) $12 
Year 2  
Dr Income tax expense (SPL) $3 Cr Deferred tax liability (SFP) $3 
Year 3  
Dr Deferred tax liability (SFP) $15 Cr Income tax expense (SPL) $15 
 
 Illustration 2 – Deferred tax accounting  
 An entity, Dive, provides the  following information regarding its assets 
and liabilities as at 3 1 December 20X1. 
 Carrying 
difference 
Assets 
A machine cost $100,000. Depreciation of $18,000 has been charged to date. Tax allowances of $30,000 have been claimed.    
Accrued interest 
receivable in the statement of financial position is $1,000. The 
interest will be taxed when 
received.

Chapter 9 
 225 
Trade receivables have a 
carrying amount of $10,000. The revenue has already been included in taxable profit.    
Inventory has been written 
down by $500 to $4,500 in the financial statements. The reduction is ignored for tax purposes until the inventory is sold.    
Current liabilities include 
accrued expenses of $1,000. This is deductible for tax on a cash paid basis.    
Accrued expenses have 
a carrying amount of $5,000. The related expense has been deducted for tax purposes.    
Required : 
Complete the table with carryi ng amount, tax base and temporary  
difference for each of the assets and liabilities and calculate  Dive's 
deferred tax balance as at 31 D ecember 20X1. The applicable tax  
rate is 30%. 
Solution: 
 Carrying 
amount Tax base Temp. 
 $  $  $  
Non-current asset 82, 000 70,000 12,000 
Interest receivable 1,000 Nil 1,000 
Receivables 10,000 10,000 Nil Inventory 4,500 5,000 (500) Accrual (cash basis for  tax) (1,000) Nil (1,000) 
Accrual (already had tax reli ef) (5,000) (5,000) Nil

226  
 The net temporary difference as at the reporting date is as fo llows: 
 $  
Non-current assets 12,000 
Interest receivables 1,000 Receivables – 
Inventory (500) 
Accrual (cash basis for tax) (1,000) Accrual (already had tax relief) – 
––––– 
 1 1 , 5 0 0  
––––– 
There will be a deferred tax liability because the carrying amo unt of the net 
assets and liabilities exceeds their net tax base. The deferred  tax liability 
is calculated by applying the re levant tax rate to the temporar y difference. 
The deferred tax liability is therefore $3,450 ($11,500 × 30%).  
Assuming that there is no opening deferred tax liability, the f ollowing 
accounting entry is required: 
Dr Tax expense (P/L) $3,450  Cr Deferred tax liability (SFP)  $3,450 
 
 Aquarius Ltd’s draft financial statements for the year ended 3 1 December 
20X9 show a profit before tax of $170,000. At 31 December 20X9 there 
are cumulative taxable temporar y differences of $50,000, i.e. t he carrying 
amount of the net assets is higher  than the tax base by this am ount. 
Current tax for the year at 30% has been estimated at $33,000. 
For the year ended 31 December 20X8, the financial statements h ad a 
profit before tax of $145,000. At 31 December 20X8 the cumulati ve 
taxable temporary differences  were $40,000 and current tax for the year 
at 30% was $30,000. 
Required: 
For the years ended 31 December  20X8 and 31 December 20X9: 
(a) Prepare the journal entry to r ecord deferred tax for the ye ars ended 
31 December 20X8 and 20X9. 
(b) Prepare extracts from the st atement of profit or loss for t he year 
ended 31 December 20X9 and the stat ement of financial position at 
31 December 20X9, both with comparatives, showing how the 
current and deferred tax would be reflected.

Chapter 9 
 227 
 Parker Ltd’s statement of fi nancial position includes a number  of assets 
and liabilities that give rise to  temporary differences as foll ows at the 
current reporting date: 
 Carrying 
amount Tax base 
 $000 $000 
Property, plant and equipment (1) 26,500 18,000 
Financial assets (2) 1,020 1,000 Trade receivables (3) 5,700 6,500 
   
Warranty provision (4) (1,200) 0 
Long-term borrowings (2) (22,200) (19,500) 
 
1 Property, plant and equipment i s depreciated in the financial  
statements on a straig ht line basis over the assets' useful liv es. Tax 
depreciation is 30% on a reducing balance basis. 
2 The financial asset and long-te rm borrowings are measured usi ng 
the amortised cost method in t he financial statements. Tax is 
payable/receivable on interest a nd any redempti on premium on a 
cash received/paid basis and ther efore a temporary difference 
arises. 
3 Trade receivables have a gross receivables balance of $6.5 mi llion 
however Parker Limited has creat ed a specific allowance against  
$800,000 which is four months old  at the reporting date. Bad de bts 
only become tax deductible after 12 months. 
4 Parker Limited offers one year  warranties on its products. Wa rranty 
costs are tax deductible when wa rranty repairs are incurred. 
The corporate income tax rate is 25%. 
Required: 
Calculate the deferred tax bal ance on the above assets and liab ilities at 
the reporting date, clearly stati ng for each item whether the d eferred tax 
balance would be an asset or liability. 
5 Deferred tax on losses 
In accordance with IAS 12 Income taxes , a deferred tax asset is recognised on 
unutilised losses carried forward (as there will be a future ta x benefit when the 
losses are offset agai nst future profits). 
However, the asset can only be re cognised to the extent that it  is probable that 
future taxable profits will be av ailable against which the loss es can be utilised.

228  
 Simpson Limited has only been tr ading for two years and has no t yet 
made a profit. It has losses ava ilable for carry forward of $75 ,000. It 
expects to make profits of $25,000 per annum for the next two y ears but 
is not in a position to est imate profits beyond this. 
The current corporate income tax rate is 30%. 
Required: 
Prepare the journal ent ry to record the defer red tax arising on  the losses. 
6 Deferred tax impact in OCI 
Any deferred tax charge/credit th at relates to an item that has  been recognised 
in other comprehensive income shoul d also be recognised in othe r 
The most common example of this  relates to the revaluation of n on-current 
assets: 
• When an asset is revalued upward s, it increases the carrying a mount of 
the asset but it does not affect the tax base. 
• The cumulative temporary differ ence increases and this gives r ise to an 
additional deferred tax liability. 
• The revaluation surplus is rec ognised in other comprehensive i ncome. 
• Therefore, the movement in the deferred tax liability that rel ates to the 
revaluation surplus should also  be recognised in other comprehe nsive 
income. 
 
 Test your understanding 4 (integration question) 
 On 1 January 20X8, Simone Limit ed decided to revalue its land for the 
first time. The land was original ly purchased 6 years ago for $ 65,000 and 
it was revalued to its current m arket value of $80,000 on 1 Jan uary 20X8. 
The difference between the ca rrying amount of Simone's net asse ts and 
the (lower) tax base at 31 De cember 20X8 was $27,000. These 
temporary differences included  the impact of the revaluation de scribed 
above. Any other temporary differ ences were caused by accelerat ed 
capital allowances on other non-current assets. 
The opening deferred tax liab ility at 1 January 20X8 was $2,600  and 
Simone's tax rate was 25%. 
Required: 
Prepare the journal ent ry required to record the movement in de ferred tax 
in the year ended 31 December 20X 8 in the financial statements of 
Simone Limited.

Chapter 9 
 229 
 Test your understanding 5 (further OTQs) 
 1 Tamsin plc’s accounting re cords show the following: 
Income tax payable for the year $60,000 Opening deferred tax liability $3,200 Closing deferred tax liability $2,600 
Calculate the income tax expen se that would be recognised in 
Tamsin plc's statement of pr ofit or loss for the year. 
2 On 1 January 20X1 Pegasus plc acquired motor vehicles at a co st 
of $100,000. The carrying amoun t of the motor vehicles at 
31 December 20X2 was $60,000 and the ta x base was $56,250. 
The corporate income tax rate was 30%. 
Calculate the deferred tax li ability at 31 December 20X2. 
3 A piece of machinery cost $500.  Tax depreciation to date has 
amounted to $220 and depreciati on charged in the financial 
statements to date is $100. The rate of income tax is 30%. 
Which three of the followi ng statements are TRUE? 
A The tax base of the asset is $280 
B The tax base of the asset is $400 C The cumulative temporary difference is $120 D The cumulative temporary difference is $220 E The asset gives rise to a deferred tax asset of $36 F The asset gives rise to a deferred tax liability of $36 
G The asset gives rise to a deferred tax liability of $66 
4 ST has unused tax losses o f $150,000 at its reporting date, 
31 December 20X3. It estimates  that it will make profits of $12 0,000 
over the next five years but cannot be certain of profitability  beyond 
five years' time. 
Calculate the deferred tax asset  that should be recognised in 
ST's statement of financial pos ition at 31 December 20X3 in 
respect of the losses. 
5 In the statement of financial pos ition of XY at 31 March 20X9  there 
is a warranty provision of $350, 000. The balance on the provisi on at 
the end of the previous year was  $275,000. Warranty costs are 
deducted for tax purposes on a cash paid basis.

230  
 The corporate income tax rate is 20%. 
Calculate the charge or cred it that would appear in the 
statement of profit or loss of X Y for the year ended 31 March 
20X9 in respect of the deferre d tax arising on the above 
warranty provision. State your a nswer in $ and clearly state 
whether the amount would be a debi t or credit in the statement 
of profit or loss. 
6 AB made an investment of $250, 000 in equity shares in another  
entity on 1 June 20X3. It classifi ed the investment as fair val ue 
through other comprehensive income  (FVOCI) and the fair value o f 
the investment at 31 October 20X3, the reporting date, was 
$280,000. 
AB will pay tax on the shares whe n they are sold. The tax base of 
the shares is ther efore $250,000 (their original cost). 
Complete the journal entry belo w to record the deferred tax 
arising on the FVOCI investment in  the financial statements of 
AB for the year ende d 31 October 20X3. 
Dr Cr 
Note:  in the assessment, you would choose the headings for the 
Dr and Cr from a selection of choices. 
7 WS revalued its property, pl ant and equipment upwards by 
$100,000 for the first time on 31 December 20X3, its reporting date. 
Prior to the revaluation, the ca rrying amount of the property, plant 
and equipment was $850,000 and t he tax base was $625,000. 
WS's tax rate is 25%. Its defe rred tax liability brought forwar d in 
respect to the property, plan t and equipment was $62,000. 
Which three of the f ollowing statements are TRUE in respect of 
deferred tax on the above prop erty, plant and equipment? 
A The deferred tax liability a t 31 December 20X3 is $56,250 
B The deferred tax liability a t 31 December 20X3 is $81,250 
C There is a deferred tax credi t to profit or loss in the year ended 
31 December 20X 3 of $5,750 
D There is a deferred tax char ge to profit or loss in the year 
ended 31 December 20X3 of $5,750 
E There is a deferred tax c harge reflected through other 
comprehensive income in the year ended 31 December 20X3 
of $19,250 
F There is a deferred tax c harge reflected through other 
of $25,000

232  
 ( a )  Journal entries for deferred tax 
Year ended 31 December 20X8 
Deferred tax liability = $40,000 × 30% = $12,000 
Dr Income tax expense (SPL) $12,000 Cr Deferred tax liability (SFP) $12,000 
Year ended 31 December 20X9 
Deferred tax liability = $50,000 × 30% = $15,000 
Expense (increase in liabilit y) = $15,000 – $12,000 = $3,000 
Dr Income tax expense (SPL) $3,000 
Cr Deferred tax liability (SFP) $3,000 
(b) Statement of profit or loss fo r year ended 31 December 20X9 
(extract)  
 20X9 20X8 
 $  $  Profit before tax 170,000 145,000 Income tax expense (W1)  (36,000) (42,000) 
 
Profit for the year 134,000 103,000 
Statement of financial position at 31 December 20X9 (extract) 
 20X9 20X8 
 $  $  
Non-current liabilities:   
Deferred tax liability (f rom (a)) 15,000 12,000 
Current liabilities:   
Income tax payable 33,000 30,000 
(W1)  Income tax expense  
 31/12/X9 31/12/X8 
 $  $  
Current tax 33,000 30,000 
Deferred tax (from (a)) 3,000 12,000 
 –––––– –––––– 
 36,000 42,000 
 –––––– ––––––

Chapter 9 
 233 
  
 Temporary 
difference Deferred 
tax balance 
(25%) Deferred 
tax liability 
/asset 
 $000 $000  
Property, plant and 
equipment  
8,500  
2,125  
liability 
Financial assets 20 5 liability Trade receivables (800) (200) asset 
    
Warranty provision (1,200) (300) asset 
Long-term borrowings (2,700) (675) asset 
    
 Dr Deferred tax asset (SFP) $15,000 
Cr Statement o f profit or loss (SPL) $15,000 
The temporary difference is $75,000 (the value of the losses av ailable for 
carry forward). However, a defe rred tax asset can only be recog nised to 
the extent it is probable that t hese losses can be utilised and , based on 
current estimates, the recove rability is only $50,000 (2 × $25, 000 profit). 
Therefore a deferr ed tax asset of only $50,000 × 30% = $15,000 can be 
 
 Journal entry for deferred tax 
Deferred tax liability c/ f = $27,000 × 25% = $6,750. 
Amount relating to revaluation surplus on land = ($80,000 – $65 ,000) × 
25% = $3,750. 
Increase in deferred  tax liability to be re corded = $6,750 – $2 ,600 = 
$4,150. 
Of which, $3,750 should be charged  to revaluation reserve and t he 
remainder charged to profit or loss. 
Dr Income tax expense (SPL) $400 Dr Revaluation reserve (SFP) $3,750 Cr Deferred tax liability (SFP) $4,150 
The impact to revaluation reserve during the year would be note d as part 
of the movements in other compr ehensive income within the SOPLO CI.

234  
 1  Income tax expense = $59,400 
 $  
Current tax expense 60,000 
Decrease in deferred tax li ability (3,200 – 2,600) (600) 
 –––––– 
 59,400 
 –––––– 
 
2 Deferred tax liability at 31 December 20X2 = $1,125  
Temporary difference = 60,000 – 56,250 = 3,750 
Deferred tax liability = 30% × 3,750 = 1,125 
3 A, C and F are true  
The tax base of the a sset = $500 – $220 = $280 
The cumulative temporary diffe rence = $400 (CV) – $280 = $120 
This results in a deferred ta x liability of $120 × 30% = $36 
4 Deferred tax asset = $30,000 
 $  
Losses – capped to the extent t hey are recoverable 120,000 
Tax rate × 25% 
 ––––––– 
 30,000 
 ––––––– 
 
5 Impact in statement of prof it or loss = $15,000 credit 
 $  
Deferred tax asset at year end (20% × 350,000) 70,000 
Deferred tax asset at start of y ear (20% × 275,000) 55,000 
 ––––––– 
Increase in deferred tax asset 15,000 
 ––––––– 
  
6 Dr FVOCI  reserve $7,500 
Cr Deferred tax liability $7,500 
Temporary difference = $280,000 ( carrying amount of asset) less  
$250,000 (tax base) = $30,000 
Deferred tax liabi lity = $30,000 × 25% 
Gain recorded in FVOCI reserve,  therefore the tax effect should  also 
be recorded in FVOCI reserve. T he annual movement in the FVOCI 
reserve will be detailed as part of OCI within SOPLOCI.

Chapter 9 
 235 
  7  The correct statements are B, C and F 
Deferred tax liability at 31 December 20X3 
 $  
Carrying amount of PPE ( 850,000 + 100,000) 950,000 
Tax base (625,000) 
 –––––––– 
Temporary difference 325,000 
 –––––––– 
 81,250 
 –––––––– 
  
Deferred tax reflected in OCI 
 $  
Revaluation surplus 100,000 
 ––––––– 
 25,000 
 ––––––– 
Deferred tax impact in profit or loss 
 $  
Liability at year end 81,250 Less liability at start of year (62,000) 
 
––––––– 
Total increase in deferr ed tax liability 19,250 
Less: reflected in OCI (25,000) 
 ––––––– 
Credit to SPL (5,750)

237 
transactions 
reporting standards Explain the financial reporting 
(g)  Effects of changes in 
foreign currency rates 
  
  Chapter 
10

Foreign currency transactions 
238  
 
2 IAS 21 The effects of changes in  foreign exchange rates  
IAS® 21 deals with: 
• the definition of functional  and presentation currencies 
• accounting for individual trans actions in a foreign currency 
These two areas are considered as part of the “Explain relevant  financial 
reporting standards” syllabus cont ent. Only this content is cov ered within 
this chapter .  
• translating the financial statem ents of a foreign subsidiary.  
This area is considered part of  the “Prepare group accounts” se ction of 
the syllabus. This content is deal t with separately in Chapter 16.  
3 Functional and presentation currencies 
 The functional currency  is 'the currency of the primary economic 
environment in which the entity operates'  (IAS 21, para 8). In most 
cases this will be the local currency. 
An entity should consider the fo llowing when determining its fu nctional currency: 
• 'The currency that mainly in fluences sales prices for goods and  
services 
• The currency of the country w hose competitive forces and 
regulations mainly determine the  sales prices of goods and serv ices 
• The currency that mainly influe nces labour, material and other costs 
of providing goods and services' (IAS 21, para 9)

Chapter 10 
 
 239 
'The following factors ma y also be considered: 
• The currency in which funding fr om issuing debt and equity is 
generated 
• The currency in which receipts fr om operating activities are us ually 
retained' (IAS 21, para 10).  
The entity maintains its day-to- day financial records in its fu nctional currency. 
 
 The presentation currency  is the currency in which the entity presents its 
financial statements. This can be  different from the functional  currency, 
particularly if the entity in question is a foreign owned subsi diary. It may 
have to present its financial st atements in the currency of its  parent, even 
though that is different to its  own functional currency. 
 
 Illustration 1 
 Chive is an entity located in  a country whose currency is doll ars ($). 
Seventy per cent of Chive’s sa les are denominated in dollars an d 30% of 
them are denominated in sterling (£). Chive does not convert re ceipts 
from customers into other currenc ies. Chive buys most of its in ventories, 
and pays for a large proportion o f operating costs, in sterling . 
Chive has two bank loans outstandi ng. Both of these loans are 
denominated in dollars. 
Required: 
What is the functional currency of Chive? Solution: 
Firstly, the primary indicators  of functional currency should b e applied. 
Most of Chive’s sales are denomi nated in dollars and so this wo uld 
suggest that the dollar is its func tional currency. However, si nce a lot of 
the costs of the business are denominated in sterling, it could  be argued 
that its functional currency is sterling. 
Since the primary indicators o f functional currency are not cle ar cut, it is 
important to look at the secondary indicators. Receipts are ret ained in 
both dollars and sterling. Howev er, funding is generated in the  form of 
dollar loans, which further sugges ts that the dollar might be C hive's 
functional currency. 
All things considered, it would seem that the functional curren cy of Chive 
is dollars. This means that any business transactions that are 
denominated in sterling must be tr anslated into dollars in orde r to record 
them.

240  
4 Translation of foreign currency transactions 
Where an entity enters into a transaction denominated in a curr ency other than 
its functional currency, that tr ansaction must be translated in to the functional 
currency before it is recorded. 
 
 Foreign currency transactions 
 Whenever a business enters into a  contract where the considera tion is 
expressed in a foreign currency , it is necessary to translate t hat foreign 
currency amount into the functional  currency for inclusion in i ts own 
accounts. Examples include: 
• imports of raw materials 
• exports of finished goods 
• importation of foreign manuf actured non-current assets 
• investments in foreign securities 
• raising an overseas loan. 
• The transaction will initially be recorded by applying the spo t exchange 
rate, i.e. the exchange rate at the date of the transaction. 
Exam questions will always give  relevant exchange rates within the content. 
Subsequent measurement – settled transactions 
When cash settlement occurs, for example payment by a receivabl e, the settled 
amount should be translated using  the spot exchange rate on the  settlement 
date. 
If this amount differs from that  recorded when the transaction occurred, there 
will be an exchange diff erence which is taken to the statement of profit or loss in 
the period in which it arises.

Chapter 10 
 
 241 
 Example 1 
 An entity based in the US se lls goods to the UK for £200,000 o n 
28 February 20X3 when the ex change rate was £0.55: $1. 
The customer pays in April 20X 3 when the rate was £0.60:$1. 
The functional currency of the entity is the $. 
Required: 
How does the US entity account f or the transaction in its finan cial 
statements for the y ear ended 31 July 20X3? 
 
 On the sale: 
Translate the sale at the spot rat e prevailing on the transacti on date. 
£200,000/0.55 = $363,636 
  $  
Dr Receivables 363,636 Cr Sales 363,636 
When the cash is received: 
Dollar value of cash rece ived = $333,333 (£200,000/0.60) 
Loss on transaction $3 0,303 (363,636 – 333,333) 
  $  
Dr Bank 333,333 Dr P/L (loss) 30,303 
Cr Receivables 363,636 
   
 On 1 April 20X8, Collins Co bu ys goods from an overseas suppli er, who 
uses Kromits (Kr) as its functi onal currency. Collins Co uses t he dollar ($) 
as its functional currency, The goods are priced at Kr54,000. P ayment is 
made 2 months later  on 31 May 20X8. 
The prevailing exchange rates are: 1 April 20X8  Kr1.80 : $1 31 May 20X8 Kr1.75 : $1 
Required: 
Record the journal entries for these transactions.

242  
Subsequent measurement – unsettled transactions 
The treatment of any outstanding  foreign currency balances rema ining in the 
statement of financial position at the year-end will depend on whether they are 
classified as monetar y or non-monetary. 
Monetary items Non-monetary items 
Currency held and assets or liabilities 
to be received or paid in currency. Other items in the statement of 
E.g. cash, receivables, payables, 
loans E.g. non-current assets, inventory, 
investments 
Treatment: Treatment: 
Retranslate using the closing rate 
(year-end exchange rate) Do not translate 
 i.e. leave at historic rate 
Any exchange difference arising on the retranslation of monetar y items must be 
taken to the statement of profi t or loss in the period in which  it arises. 
 
 Example 2 
 A US entity sells apples to an entity based in Moldovia where the 
currency is the Moldovian pound (Mo l). The apples were sold on 
1 October 20X1 for Mol 200,000 and were paid for in February 20 X2. 
The rate on 1 October 20X 1 is US $1: Mol 1.55. 
The rate on 31 December 20X1 (t he reporting date) is US $1: Mol  1.34. 
Required: 
statements for the year  ended 31 December 20X1?

Chapter 10 
 
 243 
 Example 2 answer 
Mol 200,000/1. 55 = $129,032 
  $  
Dr Receivables 129,032 
Cr Sales 129,032 
At the reporting date: 
The receivables balance is a m onetary item and must be retransl ated 
using the closing rate. 
Mol 200,000/1. 34 = $149,254 
Gain = $20,222 ( 149,254 – 129,032) 
  $  
Dr Receivables 20,222 
Cr P/L (gain) 20,222 
   
still outstanding at the reporti ng date of 30 June 20X8. 
The prevailing exchange rates are: 1 April 20X8  Kr1.80 : $1 30 June 20X8 Kr1.70 : $1 
Required:  

244  
 
 ABC Co has a year end of 31 De cember 20X1 and uses the dollar ($) as 
its functional currency. 
On 25 October 20X1 ABC Co buy s goods from a Swedish supplier fo r 
Swedish Krona (SWK) 286,000.  
Rates of exchange: 25 October 20X1 $1 = SWK 11.16 16 November 20X 1 $1 = SWK 10.87 
31 December 20X 1 $1 = SWK 11.02 
Required: 
Show the accounting treatment f or the above transactions if: 
(a) A payment of SWK286,000 is  made on 16 November 20X1. 
(b) The amount owed remains out standing at the year-end date. 
 
 Test your understanding 4 (F oreign transaction OTQ style) 
 Data for Questions 1 to 3 
An entity based in the US, with a functional currency of USD ($ ), sold 
goods overseas for Kr200,000 on 28 March 20X3 when the exchange  
rate was Kr0.65:$1. 
The customer paid in April 20X3 when the rate was Kr0.70:$1. 
The exchange rate at the year  ended 30 June 20X 3 was Kr0.75:$1.  
1 Prepare the journal entries to r ecord the sale of the goods by 
the US entity. 
 
2 Show the journal entries to recor d the payment in April 20X3. 
 3 If the amount was outstanding at t he year-end, what would the 
gain or loss in the statement of profit or loss be? 
$ __________ 
4 An entity based in  the US purchased goods  for Kr350,000 on 28  
March 20X3 when the exchan ge rate was Kr3.5: $1. 
The exchange rate at the year ended 30 June 20X3 was Kr2.5:$1. 
If the goods were unsold at the  year-end, what should be the 
value of inventory within the stat ement of financial position a s 
at the year ended 30 June 20X3? 
$ __________

Chapter 10 
 
 245 
5 An entity, with a  functional currency of $, bought land on cr edit for 
Kr100,000 when the exchange rate w as 1Kr/$0.85.  At the year en d 
the entity had not paid its supp lier. The exchange rate at the year-
end was 1Kr/$0.92. 
Which of the following amount s would be recorded in the 
financial statements at the year end? 
A  Property, plant and equipment $92,000 
B  Other comprehensive income $8,951 C  Foreign exchange loss $7,000 D  Trade payable  $85,000

Chapter 10 
 
 247 
 Initial transaction 
Translate at historic rate on 1 April, Kr54,000/1.8 = $30,000 
Dr Purchases $30,000 
Cr Payables $30,000 
On settlement 
Translate at historic rate on 31 May, Kr54, 000/1.75 = $30,857 
Dr Payables $30,000 
Dr SPL – foreign exchange loss $857 Cr Cash $30,857 
 
At the reporting date 
Payables are monetary items, so retranslate at the closing rate  on 
30 June, Kr54,000/1.70 = $31,765 
Dr SPL $1,765 ( $31,765 – $30,000) 
Cr Payables $1,765 
Leave closing inventory at the or iginal cost, as inventory is a  non-
monetary item 
Dr Inventory $30,000 
Cr Cost of sales $30,000

248  
 (a) Original transaction 
25 October 20X1 Value = 286,000/11.16 = $25,627 
Dr Purchases $25,627 
Cr Payables $25,627 16 November 20X1 Paym ent 286,000/10.87 = $26,311 
Dr Payables $25,627 
Dr SPL $ 684 (Balancing figur e, 26,311 – 25,627) 
Cr Cash $26,311 
(b) If the amount remains outstanding:  
31 December 20X1 Retranslate  payable 286,000/11.02 = $25,953 
Dr SPL $ 326 (25,953 – 25,627) 
Cr Payables $326 
Note:  The inventory would not be re stated and would remain at the 
original transaction price of $25,627. 
 
 1  On the sale: 
Kr200,000/0.65 = $307,692 
 $  
Dr  Receivables  307,692 
Cr  Revenue 307,692 
2 Loss on translation = $307, 692 – $285,714 = $21,978 
The journal entries  would be as follows: 
Dr  SPL  (Balancing figure) $21,978 
Dr  Bank (Kr200,000/0.70)  $285,714 
Cr  Receivables (Original amount) $307,692 
3 $41,025. The monetary item must be retranslated at the 
reporting date rate of exchange: 
Dollar value at the reporting date = Kr200,000/0. 75 = $266,667 
This results in a reduction in t he receivables (and therefore a  foreign 
exchange loss) of $41, 025 ($307,692 – 266,667). 
For tutorial purposes the jour nal entry would be as follows:  
Dr  SPL  $41,025 
Cr  Receivables  $41,025

Chapter 10 
 
 249 
4 $100,000   
At the reporting dat e no adjustment will be made at year-end to  the 
inventory because inventor y is a non-monetary item. 
The transactions would be recorded as follows: 
28 March 20X3 
Translate the purchase at the hist oric rate (the rate prevailin g on the 
transaction date). 
Kr350,000/3.5 = $100,000  Dr Purchases $100,000 Cr Payables $100,000 
30 June 20X3 
Inventory would remain unc hanged at the reporting date. 
 5 C 
At acquisition: 
Kr100,000 × 0.85 = $85,000 
Dr  Non-current asset $85,000 
Cr  Payables $85,000 
The land is a non-monetary asse t and remains at $85,000 at the 
year end.  
Payables, as a monetar y item, must be retr anslated at the closi ng 
rate Kr100,000 × 0.92 = $92,000 
This results in an increas e in the payables of $7,000 
Loss on translation = $92,000 – $85,000 = $7,000 
Dr  P/L (loss) $7,000 
Cr  Payables $7,000

251 
Group accounts – 
Subsidiaries (CSOFP) 
B2: Explain relevant financial 
reporting standards for group accounts (a) Explain the financial 
reporting standards for the key areas of group accounts 
C1:  Prepare group accounts 
based on IFRS 
 Prepare the following based 
on financial reporting standards: 
(a) Consolidated statement 
of financial position  
 
  Chapter 
11

Group accounts – Subsidiaries (CSOFP) 
252  
 
As a company grows, opportunities may present themselves to exp and further 
by acquiring other entities. The motives to acquire another com pany are 
manyfold: 
–  to reduce competiti on in the market place 
– to diversify into new markets  (whether industry markets or ge ographical 
markets) 
– to bring expertise in-house (e .g. retailers bringing manufact uring in-house) 
– to benefit from synergies a rising from the acquisition. 
In certain circumstances, the ent ity may be required to produce  a further set of 
financial statements which incorp orate all the members of a gro up of 
The individual financia l statements of the me mbers of the group  are still 
required to be prepared as well as the group financial statemen ts.  
This chapter investigates the ci rcumstances which create the ne ed for group 
financial statements a nd the processes involved in their prepar ation.

Chapter 11 
 253 
3 What is a group? 
IFRS 10 – Consolidated  financial statements 
 
Parent 
 
Control 
 
Subsidiary 
 
A group will exist where one com pany (the parent) controls anot her company 
(the subsidiary). 
IFRS 10 Consolidated Fi nancial Statements  sets out the definition of control 
and gives guidance on how to ident ify whether control exists. 
In accordance with IFRS 10, 'an investor controls an investee if and only if 
the investor has all of t he following elements:  
• power over the investee (see definition of power below)  
• exposure, or rights, to variable returns from its involvement w ith the 
investee, and  
• the ability to use its power over the investee to affect the am ount of 
the investor's returns'  (IFRS 10, para 7). 
Power is defined as "existing rights that give the current ability to direct the 
relevant activities" (IFRS 10, para 10), i.e. the acti vities that significantly affe ct 
the investee's returns. 
Power is generally considered to  have been achieved when an inv estor owns 
>50% of the voting rights in an ent ity. Voting rights are typic ally acquired 
through the purchase of ordinary shares in the acquired entity.  
However, the definition of power  is more wide ranging than simp le consideration 
of the percentage shareholding.  
 
 Example of control  
  JO owns 49% of the ordinary s hare capital HN The remaining 51 % of the 
shares in HN are held by numer ous investors with very small 
shareholdings (no greater than 5% ). JO the right to appoint the  majority 
of the board of directors and ens ures that its representatives attend and 
vote at HN’s meetings. 
JO despite not having greater th an 50% of HN would be deemed to  
control HN. JO has the ability to u se its voting rights to dire ct the strategic 
decisions of HN which would affe ct profitability and thus varia ble returns.

254  
Consolidated financial statement s should be prepared when the p arent has 
control over one or m ore subsidiaries (fo r examination purposes  control is 
usually established based on owne rship of more than 50% of the voting rights). 
The method of consolidat ion applied is known as acquisition accounting . 
Acquisition accounting 
In accordance with IFRS 10 Consolidated financial statements , the following 
rules are applied: 
• The parent and subsidiaries' asse ts, liabilities, income and e xpenses are 
combined in full. This represent s the 100% control that the par ent has over 
the subsidiary. 
• Goodwill is recognised in accor dance with IFRS 3 (revised) Business 
Combinations.  
• The share capital of the group is the share capital of the par ent only. 
• Intra-group balances and transac tions are eliminated in full ( including 
profits/losses on intra-group trans actions still held in assets  such as 
inventory and non-current asse ts – the PUP adjustment). 
• Uniform accounting policies must be used. 
• Non-controlling interests ar e presented within equity, separat ely from the 
equity of the owners of the parent . Profit and total comprehens ive income 
are attributed to the owners o f the parent and to the non-contr olling 
interests. 
 
 Exemption from group accounts 
 A parent need not present consol idated financial statements if  it meets all 
of the following conditions: 
• 'it is a wholly owned subsidiary o r a partially-owned subsidiar y 
and its owners, including those not otherwise entitled to vote,  
have been informed about, and do not  object to, the parent not 
presenting consolidated financial statements  
• its debt or equity instruments are not traded in a public marke t 
• it did not file its financial s tatements with a securities 
commission or other regulatory or ganisation for the purpose of 
issuing any class of instruments in a public market  
• its ultimate parent produces cons olidated financial statements 
available for public use that comply with IFRS standards'  
(IFRS 10, para 4).

Chapter 11 
 255 
4 Standard consolidation workings 
For the consolidated stateme nt of financial position  
Note : the workings have been numbered  for referencing purposes. In the 
assessment however you would not have to produce all workings t o answer a 
question. 
(W1)  Group structure  
P 
  
Date of acquisition  
      %   
S 
 (W2)  Net assets of subsidiary 
 Acquisition 
date  Reporting 
date 
Share capital X  X 
Retained earnings X  X Other reserves X  X 
Fair value adjustments X  X PUP adjustment (if sub is 
seller)  
–   
(X) 
 ––––  –––– 
 X   X  
 –––– Difference = 
post-acquisition 
reserves ––––

256  
(W3)  Goodwill 
 
Fair value of P's investment in S X 
Value of NCI at acquisition (u sing fair value or proportionate 
share of net assets method)  
X 
Less: subsidiary's net assets at acquisition (W2)  ( X )  
 –––– 
Goodwill at acquisition X Impairment (X) 
 –––– 
Goodwill at reporting date X  –––– 
(W4)  Non-controlling interest  
Value of NCI at acquisition (a s in goodwill calculation) X 
NCI% × post-acquisition reserves (W2)  X  
NCI% × impairment (W3)  (for fair value method only) (X) 
 –––– 
NCI at reporting date X  –––– 
(W5) Consolidated reserves  
 Retained 
earnings Other 
reserves 
Parent's reserves X X 
PUP adjustment (if parent is seller) (X) – Sub: P% × post-acquisition reserves (W2)  X  X  
Impairment (P% only for fa ir value method) (X) – 
 –––– ––––  X  X  
 –––– –––– 
5 Non-controlling interest and goodwill 
By definition, a subsidiary is an entity that is controlled by another entity – the 
parent. Control is normally achie ved by the parent owning a maj ority i.e. more 
than 50% of the equity shares  of the subsidiary. 
Non-controlling interest (NCI) s hareholders own the shares in t he subsidiary not 
owned by the parent entity. 
NCI shareholders are considered  to be shareholders of the group  and thus their 
ownership interest in the subsid iary is reflected within equity . 
When calculating goodwill at ac quisition the value of the NCIs is added to the 
value of the parent’s investment i n the subsidiary so that the value of the 
subsidiary as a whole (100%) is compared against all of its net  assets.

Chapter 11 
 257 
IFRS 3 Business Combinations  allows two methods to be used to value the NCI 
at the date of acquisition: 
• F a i r  v a l u e  
• Proportionate share of net assets method. 
IFRS 3 permits groups to choose how to value NCI on an acquisit ion by 
acquisition basis. In other words , it is possible for a group t o apply the fair value 
method for some subsidiaries and the proportionat e share of net  assets method 
for other subsidiaries. 
Fair value method 
The fair value of the non-contro lling interest may be calculate d using the market 
value of the subsidiary’s shares  at the date of acquisition or other valuation 
techniques if the subsidiary’s shares are not traded in an acti ve market. In the 
assessment, you will be told the fa ir value of the NCI or will be given the 
subsidiary’s share price in or der to be able to calculate it. 
Proportionate share of net assets method 
Under this method, the NCI is meas ured by calculating the share  of the fair 
value of the subsidiary’s net assets at acquisition. 
 
 Illustration 1 – Goodwill  
 Sherriff purchased 60% of Notti ngham’s 3,000 shares on 1 Janua ry 
20X9. Sherriff paid $5,500 cash for  their investment. At 1 Janu ary 20X9, 
the value of Nottingham’s net a ssets was $5,000. Nottingham’s s hare 
price at this date was $2.25. 
Required: 
Calculate the goodwill arising on the acquisition of Nottingham , valuing 
the NCI: 
(a) Using the fair value method (b) Using the proportionate s hare of net assets method. 
Solution 
Goodwill 
 Fair value 
method Proportionate 
share of net 
assets 
method 
 $  $  
Fair value of P's investment 5,500 5,500 
Value of NCI at acquisition (W1/W2)  2,700 2,000 
Less: value of S's net assets (5,000) (5,000) 
 
–––––– –––––– 
Goodwill at acquisition 3,200 2,500 

258  
(W1)  NCI holding – fair value method  
The subsidiary’s share price is  provided and so this is used to  value 
the NCI's 40% holdi ng in Nottingham. 
The NCI owns: 
40% × 3,000 shares = 1,200 shares 
The fair value of this shareholding is: 
1,200 × $2.25 = $2,700 
(W2)  NCI holding – proportionate s hare of net assets method 
The NCI's 40% holding is simply  valued by taking this proportio n of 
the subsidiary’s net assets  at acquisition of $5,000. 
40% × $5,000 = $2,000 
 
 Wellington purchased 80% of the equity share capital of Boot f or 
$1,200,000 on 1 Ap ril 20X8. Boot’s share c apital is made up of 200,000 
$1 shares and it had retained earnings of $800,000 at the date of 
acquisition. The fair value of the NCI at 1 April 20X8 was $250 ,000. 
Required: 
Calculate the goodwill arising on the acquisition of Boot, valu ing the NCI: 
 
 Ruby purchased 75% of the equity s hare capital of Sapphire for  
$2,500,000 on 1 Ap ril 20X8. Sapphire’s share capital is made up  of 
500,000 $1 shares and it had re tained earnings of $1,500,000 at  the date 
of acquisition. The fair value of the NCI at 1 April 20X8 shoul d be 
calculated by reference to the su bsidiary’s share price. The ma rket value 
of a Sapphire share at 1  April 20X8 was $6. 
Required: 
Calculate the goodwill arising on  the acquisition of Sapphire, valuing the 
NCI: 
(a) Using the fair value method (b) Using the proportionate s hare of net assets method.

Chapter 11 
 259 
 Goodwill and NCI 
 Prior to a revision to IFRS 3 in 2008, it was only permitted t o recognise 
the NCI using the proportionate s hare of net assets method. Thi s method 
resulted in only the goodwill attr ibutable to the parent shareh olders being 
recognised in the consolidated a ccounts. Using the information from 
TYU 1, consider the following alte rnative calculation of goodwi ll under this 
method: 
 $000 
Fair value of P's investment 1,200 
P% × sub's net assets at acquisition (80% × 1,000) (800) 
 ––––– 
Goodwill at acquisition 400 
 ––––– 
In the above calculation, rather  than adding in the NCI’s share  (20%) of 
the subsidiary’s net assets and then subtracting 100% of these net 
assets, just the parent’s share (80%) has been deducted from th e fair 
value of the parent’s holding. Thi s achieves the same answer fo r goodwill 
but more clearly demonstrates w hy valuing the NCI at the propor tionate 
share of net assets is equival ent to only the goodwill attribut able to the 
parent’s holding being recognised. 
This method was considered incons istent with the treatment of t he other 
assets of the subsidiary. Since  the group controls the assets o f the 
subsidiary, they are fully cons olidated in the group accounts, i.e. 100% is 
added in line by line . Goodwill is an asset o f the subsidiary i n exactly the 
same way that property, inventory , etc, are assets  of the subsi diary. So if 
property and inventory are cons olidated in full, goodwill shoul d be treated 
in the same way. 
Therefore, when IFRS 3 was revis ed in 2008, the option of valui ng the 
NCI at fair value was introduced. T his recognises that the valu e of the 
NCI should also reflect the goodwi ll attributable to their hold ing. Again, 
using the information from TYU 1 , this can perhaps be more clea rly 
illustrated using the following alternative goodw ill calculatio n under the 
fair value method: 
 $000 $000 
Fair value of P's investment 1,200  P% × sub's net assets at acquisition 
(80% × 1,000)  
(800)  
 
––––––  
Goodwill attributable to P shareholders  400 
Fair value of NCI 250  
NCI% × sub's net assets at acquisition 
(20% × 1,000)  
(200)  
 ––––––  
  5 0  
  –––––– 
Goodwill at acquisition  450 
  ––––––

260  
 In this alternative calculation, the subsidiary’s net assets ha ve simply 
been deducted in two separate st ages rather than on a single li ne as per 
the answer to TYU 1. 
These alternative calculations  for goodwill will achieve the co rrect 
answers, but for assessment purposes it is recommended that you  use 
the format applied in T YU 1. You will only ever have to apply o ne pro-
forma for the calculation of goodwill and the di fference will b e how the 
NCI is valued. 
It is worth noting that the fair  value of the NCI is not normal ly 
proportionate to the fair value of the parent’s holding. Again,  using TYU 1 
to illustrate, the parent’s holdi ng of 80% is four times that o f the NCI’s 
20% holding. However, the fair v alue of the parent’s holding of  
$1,200,000 is more than four times  that of the NCI’s holding wh ich has a 
fair value of $250,000. This is because the parent’s 80% holdin g provides 
control of the subsidiary and so  the value of an 80% holding is  
proportionately more as it include s a premium for obtaining con trol. 
6 Impairment of goodwill 
IFRS 3 requires that goodwill is t ested at each reporting date for impairment. 
This means that goodwill is revie wed to ensure that its value i s not overstated in 
the consolidated statemen t of financial position. 
If an impairment loss exists, good will is written down and the loss is charged as 
an expense in the c onsolidated statement of profit or loss. 
This charge against profits will result in a reduction in the e quity section of the 
CSFP. How the impairment loss is charged against equity in the CSFP will 
depend on the method adopted fo r valuing the NCI. 
As discussed in the expandable t ext 'Goodwill and NCI', valuing  the NCI at fair 
value is equivalent to recognisi ng goodwill in full, i.e. goodw ill attributable to 
both the parent and NCI shar eholders is recognised. 
Consequently, any impairment l oss is charged to both the parent  and NCI 
shareholders in the equity secti on of the CSFP in accordance wi th their 
percentage holdings. 
To record the impairment loss: 
• Reduce goodwill by the full amoun t of the impairment loss (Cr) . 
• Reduce NCI equity by the NCI% of the impairment loss (Dr). 
• Reduce consolidated retained ea rnings by the P% of the impairm ent 
loss (Dr).

Chapter 11 
 261 
As discussed in the expandable t ext above, valuing the NCI at t he proportion of 
the subsidiary’s net assets i s equivalent to recognising only t he goodwill 
attributable to the parent shareholders. 
Consequently, any impairment lo ss is only charged to the parent  shareholders 
in the equity section of the CSFP. 
• Reduce goodwill by the amount o f the impairment loss (Cr). 
• Reduce consolidated retained ea rnings by the amount of the imp airment 
loss (Dr). 
The chapters on group financial st atements use t he preparation of full 
group accounts to illustrate t he topic and improve understandin g of the 
concepts covered. However, in  the exam, candidates will never h ave to produce 
the full set of group accounts . Exam questions will require cal culations of figures 
from the group accounts or prepar ation of extracts from the gro up accounts.  
 
 Illustration 2  
 P acquired 75% of the equity share capital of S on 1 April 20X 2, paying 
$900,000 in cash. At this date, the retained earnings of S were  $300,000. 
Below are the statements of fi nancial position of P and S as at  31 March 
20X4: 
 P S 
 $000 $000 
Non-current assets 1,650 750 
Investment in S 900 − 
Current assets 450 650 
 3,000 1,400 
Equity   
Share capital 1,500 500 Retained earnings 900 400 
Non-current liabilities 100 50 
Current liabilities 500 450 
 
It is group policy to value the NC I at fair value at the date o f acquisition. 
The fair value of the NCI in S at 1 April 20X2 was $275,000. 
As at 31 March 20X4, goodwil l was impaired by $60,000. 
Required: 
(a) Prepare a consolidated state ment of financial position as a t 
31 March 20X4. 
(b) Show how the CSFP would c hange if the propor tionate share o f net 
assets method were used to value  the NCI at acquisition instead .

262  
 Illustration 2 answer  
 (W1) Group structure  
P 
  
 75% 1 April 20X2, 
i.e. 2 years since acquisition 
  
S 
(W2)  Net assets of subsidiary 
 
date 
Share capital 500  500 
Retained earnings 300  400 
 800  900 
 ––––– 100 = post 
acquisition 
reserves ––––– 
 
These post-acquisition reserves  belong to the shareholders of t he 
subsidiary, i.e. 75% to the par ent and 25% to the NCI sharehold ers 
and are allocated accordingly in  the NCI and consolidated reser ves 
workings (4 and 5 in this example). 
(W3)  Goodwill  
 $000 
Fair value of P's investment 900 
Fair value of NCI at acquisition 275 
Less: sub's net assets at acquisition (W2)  (800) 
 –––– 
Goodwill at acquisition 375 
Impairment (60) 
 –––– 
Goodwill at reporting date 315 
 ––––

Chapter 11 
 263 
 (W4) Non-controlling interest equity  
 $000 
Value of NCI at acquisition (W3)  275 
NCI% × post acquisition reserves (25% × 100 (W2) ) 25 
NCI% × impairment (25% × 60 (W3) ) (15) 
 ––––– 
 285 
 ––––– 
 
The NCI is measured at its fair value of $275,000 at the date o f 
acquisition, as given in the ques tion. Since acquisition the 
subsidiary has made gains of $100, 000, as shown in (W2). The NC I 
shareholders are entitled to 25%  of these gains. Thus, their ho lding 
has increased in value by $25,000. 
However, because the NCI holding  has been valued at acquisition  
under the fair value method, the NCI shareholders are charged w ith 
their 25% share of the $60,000 im pairment loss arising on goodw ill. 
This reduces their share of t he group’s equity to $285,000 at t he 
reporting date. 
 Retained 
earnings 
Parent's reserves 900 
Sub (75% × 100 (W2) ) 75 
Impairment (75% × 60 (W3) ) (45) 
 ––––– 
 930 
 ––––– 
The only reserve in this questi on is retained earnings. The ret ained 
earnings figure in the CSFP repr esents those belonging to the 
parent shareholders. This is made up of the parent entity’s ret ained 
earnings plus their share (75%) of the subsidiary’s post acquis ition 
profits less their share of any  impairment losses on goodwill. Since 
the NCI has been valued using t he fair value method, the parent  
shareholders are charged with t heir 75% share of the impairment  
loss. 
Now that we have completed t he workings, the CSFP can be 
completed. Remember that: 
– Parent and subsidiary's assets  and liabilities are combined i n 
full. 
– Consolidated share capital is parent share capital only. 
– The investment in S that is in cluded in P's individual statem ent 
of financial position is replaced with goodwill. 
– The NCI is part of group equity and should be shown 
accordingly.

264  
 Consolidated statement of fina ncial position as at 31 March 
20X4 
  $000 
Non-current assets (1,650 + 750) 2,400 
Goodwill (W3)   315 
Current assets (450 + 650) 1,100 
  –––––– 
  3,815 
  –––––– 
Equity   
Share capital  1,500 
Retained earnings (W5)   930 
  –––––– 
  2,430 
Non-controlling interest (W4)   285 
  –––––– 
Total equity  2,715 
Non-current liabilities (100 + 50) 150 
Current liabilities (500 + 450) 950 
  –––––– 
  3,815 
  –––––– 
It is perhaps worth noting tha t the net assets i.e. assets 
($3,815,000) less liabilities ( $150,000 + $950,000) of the grou p at 
the reporting dat e are $2,715,000. 
This represents the net assets t hat are under the control of th e 
group. 
The net assets are owned by t he shareholders of the group and t his 
is reflected within the equity s ection of the CSFP. A group is owned 
by two sets of shareholders – t he parent shareholders and the N CI 
shareholders. The parent’s share of equity is $2,430,000 whilst  the 
NCI’s share is $285,000.

Chapter 11 
 265 
 (b) If the proportionate share of net assets method were used, this 
would change the goodw ill & NCI calculations. Since goodwill is  
impaired this method would also c hange retained earnings as the  
parent shareholders would now su ffer the full amount of the 
impairment loss. 
Note:  It is being assumed that the ques tion would still state that t he 
impairment loss aris ing on goodwill is $60,000. (In reality, if  goodwill 
were being measured using the proportionate share of net assets  
method, this would result in a di fferent impairment loss compar ed to 
that arising under the fair value method.) 
(W3), (W4), (W5) and t he CSFP would become: 
(W3) Goodwill  
 $ 0 0 0  
Fair value of P's investment 900 Value of NCI at proport ionate share of net 
assets (25% × 800 (W2))  
200 
 
––––– 
Goodwill at acquisition 300 
 ––––– 
Goodwill at reporting date 240 
 ––––– 
(W4)  Non-controlling interest equity 
 $000 
Value of NCI at acquisition (W3)  200 
NCI% × post acquisition reserves 
(25% × 100 (W2) )  
25 
 ––––– 
 225 
 ––––– 
 Retained 
earnings 
Impairment (W3)  (60) 
 ––––– 
 915 
 –––––

266  
20X4 
  $000 
Goodwill (W3)   2 4 0  
  –––––– 
  3,740 
  –––––– 
   
Equity   
Retained earnings (W5)   9 1 5  
  –––––– 
  2,415 
Non-controlling interest (W4)   2 2 5  
  –––––– 
  2,640 
   
  –––––– 
  3,740 
  –––––– 
 
 P acquired 75% of the 5 million issued ordinary shares of S on  1 April 
20X5, paying $6.5m in cash. At  this date, the retained earnings  of S were 
$2.5m. 
The retained earnings reported in the financial statements of P  and S as 
at 31 March 20X8 ar e $10.8 million and $4.5 million respectivel y. 
The group policy is to measure non-controlling interest at fair  value at the 
date of acquisition. The fair v alue of the non-controlling inte rest was 
$2 million on 1 April 20X5. 
An impairment review performed on 31 March 20X8 indicated that 
goodwill on the acqui sition of S had been impaired by 20%. 
Required: 
1 Calculate the amounts that will appear in the consolidated st atement 
of financial position of the P gr oup as at 31 March 20X8 for: 
(a) Goodwill (b) Consolidated retained earnings (c) Non-controlling interest.

Chapter 11 
 267 
 2 Re-calculate the above am ounts that would appear in the 
consolidated statement of financ ial position of t he P group as at 
31 March 20X8 if group policy was to measure non-controlling 
interest at the proportionate shar e of net assets at the date o f 
acquisition. 
7 Mid-year acquisitions and the consolidated statement of 
The consolidated statement of fi nancial position (CSFP) reflect s the position at 
the reporting date and, t herefore, figures on the face of the C SFP should never 
be time apportioned. 
However, you may be required to  time apportion results in order  to calculate the 
reserves at acquisition (for t he net assets working). Depending  on the 
information provided, you wil l be required to either: 
• Subtract the profits for the pos t-acquisition portion of the y ear from the 
closing reserves balance, or 
• Add the profits for the pre- acquisition portion of the year to  the opening 
reserves balance. 
 
 Illustration 3 – Mid-year acquisition in CSFP 
 An entity is acquired on 1 Mar ch 20X9. Its profits for the yea r ended 
31 December 20X9 ar e $12,000 and its retained earnings at the r eporting 
date are $55,000. 
Retained earnings at acquisi tion will be $55,000 – (10/12 × $12 ,000) = 
$45,000. 
8 Intra-group balances 
Intra-group balances and transacti ons must be eliminated in ful l, as the group is 
treated as a single entity and, th erefore, cannot trade with or  owe money to 
itself. 
• Intra-group balances are elimi nated from the consolidated stat ement of 
• Any profit still held within t he group's assets from intra-gro up trading 
should also be elimi nated (the provision for unrealised profit (PUP) 
adjustment).

268  
 Intra-group balances – in transit items 
 When eliminating intra-group re ceivables and payables, the acc ount 
balances may disagree. This is most likely to be due to cash in  transit or 
goods in transit. 
Cash in transit 
Cash has been sent by one group ent ity, but has not been receiv ed and 
so is not recorded in the books of the other group entity. The following 
adjustment will be required: 
Dr Bank (with the amount in tr ansit i.e. the difference) 
Dr Payables (with the lower amount) Cr Receivables (wit h the higher amount) 
Goods in transit 
Goods have been sent by one entity, but have not been received and so 
are not recorded in the books of  the other group entity. The fo llowing 
Dr Inventory (with the amount i n transit i.e. the difference) 
 
 Extracts from the st atements of financial position of P and it s subsidiary S 
at 31 December 20X8 are as follows: 
 P S 
 $000 $000 
Inventory 750 140 
Receivables 650 95 Cash 400 85 
   
Payables 900 200 
P acquired 100% of S five years ago. 
P and S traded with each  other and, at the reporting date, P ow ed S 
$25,000. This balance is stated af ter P had recorded that they had sent a 
cheque for $5,000 to S shortly befor e the year-end which S had not 
received by the reporting date. 
Required: 
What balances would be shown in  P's consolidated statement of f inancial 
position at 31 December 20X8 fo r each category of current asset  and 
current liabilities?

Chapter 11 
 269 
 Illustration 4 answer  
 Extracts from P's consolidated s tatement of financial position at 
31 December 20X8 
  $000 
Inventory (750 + 140) 890 
Receivables (650 + 95 – 30 (W1) ) 715 
Cash (400 + 85 + 5) 490 
Payables (900 + 200 – 25) 1,075 
   
(W1)  Intra-group balances  
The question states that P owes S $25,000 i.e. a payable. This is to 
be eliminated by r educing payables. 
The question states that there is  cash in transit at the report ing date 
of $5,000. This needs to be reco rded by increasing cash. 
The intercompany receivable t hat needs to be eliminated is 
therefore calculated as  a balancing figure: 
  $000 Dr Payables ↓ 25 Dr Cash ↑ 5 Cr Receivables ↓ 30 
   
 Provision for unrealised p rofit (PUP) in inventory 
 P and S may sell goods to each other, resulting in a profit be ing recorded 
in the selling entity's financia l statements. I f these goods ar e still held by 
the purchasing entity at the y ear-end, the goods have not been sold 
outside of the group. The profit i s therefore unrealised from t he group's 
perspective and s hould be removed. 
The adjustment is also required to  ensure that inventory is sta ted at the 
cost to the group i.e. the cos t when the goods were first acqui red by the 
group, not the cost to the purchas ing entity after the intra-gr oup transfer. 
PUP adjustment = profit on inv entory still held in group at yea r end 
In the consolidated statement o f financial position, deduct fro m: 
• Net assets at reporting date column  (in net assets working) if S 
sells  the goods or Consolidated reserves if P sells the goods – 
thereby removing the profit from the appropr iate entity's retai ned 
earnings figure. 
• Inventory on the face of the CSFP.

270  
 The 'PUP' adjustment 
 Parent sells to subsidiary 
P sells goods to S for $400 at c ost plus 25%. All goods remain in the 
inventory of S at t he end of the year. 
Profit made on the sale 25
125 × 400 = 80. 
Individual financial statements 
P records profit 80 
S records inventory 400 
Group financial statements should show: 
Profit 0 Inventory 320 
PUP adjustment in Consol SFP 
Dr Group retained earnings ↓ 80 
Cr Group inventory (CSFP) ↓ 80 
The group profit figure for t he parent will be reduced as it is  the parent 
that recorded the pr ofit in this case. 
It is important to note that the adjustment takes place in the group 
accounts only. The individual acc ounts are correct as they stan d and will 
not be adjusted as a result. 
Subsidiary sells to parent 
Dr Sub's net assets at reporting date ↓ 80 
The subsidiary’s profit will be reduced as it is the subsidiary  that recorded 
the profit in this case. The r eduction in the subsidiary’s prof its needs to be 
shared between the parent and NC I shareholders in the NCI reser ve & 
consolidated reserves workings . By adjusting for the PUP in the  net 
assets working, this split will automatically be split between the two 
reserves. S’s profits are shared between the parent and the non -
controlling interest shareholders.

Chapter 11 
 271 
 Cost structures 
 The cost structure of the intr a-group sale may be given to you  in one of 
two ways. 
Mark up on cost (Cost plus) 
If, for example, goods are sold  for $440 and there is a 25% mar k up on 
cost, you need to calculate the profit included within the $440 . 
 %  $   
Revenue 125 440  
Cost of sales 100   
 –––– ––––  
Gross profit 25 88 = 440 × 25/125 
 –––– ––––  
The PUP is $88. 
Gross profit margin 
The gross profit margin gives  the profit as a percentage of rev enue. 
Using the same figures as above bu t with a gross profit margin of 25%. 
 
 %  $   
Revenue 100 440  
Cost of sales 75   
 –––– ––––  
Gross profit 25 110 = 440 × 25/100 
 –––– ––––  
The PUP is $110. 
 
 Illustration 5  
 The following summarised statem ents of financia l position are provided 
for P and S as at 30 June 20X8: 
 P S 
 $000 $000 
Non-current assets 8,000 5,000 
Investment in S 7,000 – 
Inventory 1,600 850 
Receivables 1,350 950 
Cash and cash equi valents 850 400 
 18,800 7,200 

272  
 Equity   
Share capital $1 10,000 4,000 Share premium 2,000 500 Retained earnings 5,050 1,400 
Payables 1,750 1,300 
 
P acquired 90% of S two years ago for $7,000,000 when the balan ce on 
the retained earnings of S was  $800,000. It is group policy to value NCI 
at fair value at acquisition and t he fair value of the NCI was $650,000 at 
this date. 
S sells goods to P at a profit m argin of 20%. As a result at th e reporting 
date, P’s records showed a payab le due to S of $50,000. However  this 
disagreed to S’s receivables balance of $60,000 due to cash in transit. 
At the reporting date, P held $100,000 of goods in inventory th at had 
been purchased from S. 
There has been no impai rment of goodwill. 
Required: 
Prepare the consolidated statemen t of financial position at 30 June 20X8. 
 
 Illustration 5 answer  
 Consolidated statement of financ ial position as at 30 June 20X8  
 
  $000 
Non-current assets (8,000 + 5,000) 13,000 Goodwill (W3) 2,350 
Inventory (1,600 + 850 – 20 (W7) ) 2,430 
Receivables (1,350 + 950 – 60) 2,240 
Cash and cash equiva lents (850 + 400 + 10 (W6) ) 1,260 
  
–––––– 
  21,280 
  –––––– 
Equity   
Share capital  10,000 Share premium  2,000 
Retained earnings (W5) 5,572 
Non-controlling interests (W4) 708 
  
–––––– 
  18,280

Chapter 11 
 273 
 Current liabilities   
Payables (1,750 + 1,300 – 50) 3,000 
  –––––– 
  21,280 
  –––––– 
 
Note:  The intra-group balances are adj usted for on the face of the 
consolidated statement of financ ial position. The PUP adjustmen t, 
calculated in W7, should be dedu cted from the carrying amount o f 
inventory at the reporting date.  
(W1)  Group structure 
P 
  
 90% 2 years since 
acquisition  
 
S 
(W2) Net assets of subsidiary 
 
 Acquisition  Reporting 
date 
 $000  $000 
Share capital 4,000  4,000 
Share premium 500  500 
Retained earnings 800  1,400 PUP (W7)  –  (20) 
 
–––––  ––––– 
 5,300  5,880 
  580 
Post acq'n profit  
Note:  As the subsidiary made the sale s on which the profit is unreal ised, 
it is their retained earnings t hat must be reduced. Therefore t he PUP 
adjustment is reflected at the reporting date in (W2) above.

274  
 
 (W3) Goodwill  
 $000 
Fair value of P's investment 7,000 
Value of NCI at acquisition (at fair value) 650 Fair value of sub's net assets at acquisition (W2)  (5,300) 
 
––––– 
Goodwill at acquisition 2,350 
Impairment – 
 ––––– 
Goodwill at reporting date 2,350 
 ––––– 
 $000 
Value of NCI at acquisition (W3)  650 
NCI% × post acquisition reserves (10% × 580 (W2) ) 58 
 ––––– 
 708 
 ––––– 
(W5) Reserves  
 Retained earnings 
 $000 Parent's reserves 5,050 Sub (90% × 580 (W2) ) 522 
 
––––– 
 5 , 5 7 2  
 ––––– 
(W6) Intra-group balances  
  $000 
Dr Payables ↓ 50 Dr Cash ↑ 10 Cr Receivables ↓ 60 
(W7)  PUP 
Profit in inventory = 20% × $100,000 = $20,000

Chapter 11 
 275 
 P S 
 $000 $000 Non-current assets 14,200 10,200 
Investment in S 14,500 – Current assets   
Inventory 5,750 3,400 
Receivables 4,250 2,950 Cash and cash equiva lents 2,500 1,450 
 
 41,200 18,000 
 
Equity   
Share capital $1 20,000 5,000 
Retained earnings 12,600 7,900 Current liabilities   
Payables 8,600 5,100 
 
P acquired 80% of S three year s ago for $14,500,000 when the ba lance 
on the retained earnings of S w as $5,800,000. It is group polic y to value 
NCI at acquisition at the propor tionate share of the net assets . 
P sells goods to S. As a resul t, at the reporting date S’s reco rds showed a 
payable due to P of $550,000. Howev er this disagreed to P’s rec eivables 
balance of $750,000 due  to cash in transit. 
During the current year, P had sold $1,500,000 (selling price) of goods to 
S of which one third is held in  S’s inventory at the year end. The selling 
price was based on a mark-up of 25%. 
An impairment loss of $1,000, 000 should be char ged against good will at 
the reporting date. 
Required: 
(a) Calculate the P group balanc es as at 30 June 20X8 for: 
(i) Goodwill (ii) Consolidated retained earnings  (iii) Non-controlling interest.  
(b) Recalculate the following am ounts at 30 June 20X8 to reflec t what 
they would have been if S had sold the goods to P instead. 
(i) Consolidated retained earnings (ii) Non-controlling interests.

276  
 Provision for unrealised profi t (PUP) in Non-current assets 
 P and S may sell non-current asset s to each other, resulting i n a profit 
being recorded in the selling ent ity's financial statements. If  these non-
current assets are still held by  the purchasing entity at the y ear-end, the 
profit is unrealised from the gr oup’s perspective and should be  removed. 
The profit on disposal should be removed from the seller’s book s (net 
assets working (at reporting dat e) if the sub is the seller, co nsolidated 
reserves working if the parent is the seller). 
In addition to the profit, there is depreciation to consider. 
Prior to the transfer, the asse t is depreciated based on the or iginal cost. 
After the transfer depreciation is  calculated on the transfer p rice, i.e. a 
higher value. Therefore depreciati on is higher after the transf er and this 
extra cost must be eliminated in  the consolidated financial sta tements, 
i.e. profits need to be increased. 
The extra depreciation that has  been charged should be removed from 
the purchaser’s books. 
Adjustment required – CSFP: 
• Profit on disposal – reduce S's net assets working at reportin g date 
if S sells the asset or reduce consolidated reserves if P sells  the 
asset. 
• Extra depreciation – increase c onsolidated reserves if S sells  the 
asset or increase S's net assets  at reporting date if P sells t he 
asset. 
• Decrease the non-current asset i n the CSFP with the net amount . 
Adjustment required – CSCI: 
• Deduct profit on disposal 
• Add back excess depreciation char ged (therefore reduce related  
expense category) 
• In NCI share of profit working: 
– If P is seller, add back excess depreciation charged by S 
– If S is seller, deduct profit on disposal made by S.

Chapter 11 
 277 
 Illustration 6  
 P acquired 80% of the share capital of S some years ago. P’s r eporting 
date is 31 August. P transfers an asset on 1 March 20X7 for $75 ,000 
when its carrying amount is $60,000 . The remaining useful life at the date 
of sale is 2.5 years. The group depreciation policy is straight  line on a 
monthly basis. 
Required: 
What adjustment is required in th e consolidated financial state ments of P 
for the year ended 31 August 20X8? 
Solution 
Profit recorded on the sa le: $75,000 – $60,000 = $15,000 
Extra depreciation: ($75,000 – $60,000) × 1.5/2.5 = $9,000 
Adjustment required: 
Dr Consol RE/profit ↓ $15,000 Cr Sub's net assets at repor ting date/profit ↑ $9,000 
Cr NCA (CSFP) ↓ $6,000 
In the CSOPLOCI, the NCI calcula tion should include an adjustme nt to 
add back the excess depreciation  of $9,000 charged by the subsi diary 
since the date of transfer. 
Using the same example as abov e, but if S had sold the asset to  P, the 
adjustment would be: 
Dr Sub's net assets at reporti ng date/profit ↓ $15,000 
Cr Consol RE/profit ↑ $9,000 Cr NCA (CSFP) ↓ $6,000 
In the CSOPLOCI, the NCI calcula tion would include an adjustmen t to 
reduce the subsidiary's profi t by $15,000 to eliminate the prof it on 
disposal of the intra-group transfer.

278  
9 Goodwill – further detail and fair values 
The calculation of goodwi ll is governed by IFRS 3 Business Combinations.  
Goodwill is a residual amount cal culated by comparing, at acqui sition, the value 
of the subsidiary as a whole and  the fair value of its identifi able net assets at 
this time. A residual amount may e xist as a result of the subsi diary’s: 
• Positive reputation 
• Loyal customer base 
• Staff expertise. 
Goodwill is capitalised as an in tangible asset on the consolida ted statement of 
financial position (CSFP). It is subject to an annual impairmen t review to ensure 
its value is not overstated on the CSFP. 
Goodwill is calculated as: 
 
Fair value  of consideration trans ferred (by parent) X 
NCI at acquisition (at fair val ue or proportionate share of net  
assets) X 
Fair value  of sub's net assets at acquisition (X) 
 –––– 
Goodwill at acquisition X 
Impairment (X) 
 –––– 
Goodwill at reporting date X 
 –––– 
 
 Negative goodwill 
 Occasionally, the consideration pa id for the subsidiary may be  less than 
the fair value of the identifi able net assets at acquisition. T his may arise 
when the previous shareholders ha ve been forced to sell the sub sidiary 
and so are selling their hol ding at a bargain price. 
This situation gives rise to ' negative goodwill' at acquisition  and 
represents a credit balance. It i s viewed as a gain on a 'barga in purchase' 
(essentially a discount received)  and is credited directly to p rofits and so 
the group’s retained earnings. 
As you can see from the above pro- forma calculation, the elemen ts of goodwill 
at acquisition are based on fair values (at the date of acquisi tion of the 
subsidiary).

Chapter 11 
 279 
Definition of fair value 
 
 Fair value is defined in IFRS® 13 Fair Value Measurement  as 'the price 
that would be received to sell an asset or paid to transfer a l iability in 
an orderly transaction between  market participants at the 
measurement date'  (IFRS 13, para 9). 
We have already seen the two acc eptable methods for measuring t he non-
controlling interest at the ac quisition date. The next two sect ions look at the 
rules for measuring the fair v alue of the consideration transfe rred by the parent 
upon acquiring the subsidiary; and the fair value of the net as sets of the 
subsidiary at the date of acquisition. 
Fair value of parent's consideration 
The value of the consideration paid by the parent for its holdi ng in the subsidiary 
can comprise of a number of ele ments and, according to IFRS 3 Business 
combinations , each must be measured at its fa ir value at the date of acquis ition. 
The parent should already have refl ected this amount in its ind ividual statement 
of financial position. 
The types of consideration  that may be included are: 
• Cash (FV = amount paid) 
• Shares issued by the parent (FV =  market price of shares issue d) 
• Deferred consideratio n (FV = present value) 
• Contingent consideration (FV = probability weighted present va lue). 
Exclusions from consideration 
The following should never be rec ognised as part of considerati on paid: 
• Legal and professional fees (and other directly attributable c osts of 
acquisition) 
• Provisions for future losse s in subsidiary acquired. 
Directly attributable costs of a cquisition are expensed to the parent’s statement 
of profit or loss. This is becaus e they are not part of what th e parent gives in 
return for the shareholding in t he subsidiary and, resultantly,  are not included in 
the consideration paid to acquire the shares. 
Provisions for future losses or  expenses are not part of the va lue of the parent’s 
holding in the subsidiary. They are  not included in the conside ration paid. 
However, future losses may be recorded in the parent’s individu al financial 
statements as a provision (an out standing, uncertain liability) , if it is in 
accordance with IAS 37 Provisions, Contingent Liabilities and Contingent 
Assets’ recognition criteria.

280  
Deferred consideration 
This is consideration, normally  cash, which will be paid in the  future. 
It is measured at its present val ue at acquisition for inclusio n within the goodwill 
calculation, i.e. the futu re cash flow is discounted. 
It is recorded in the parent’s indi vidual financial statements by: 
Dr Investments Cr Deferred consideration liability 
Every year after acquisition, t he liability will need to be inc reased to reflect 
unwinding the discount. The increas e in the liability is charge d as a finance 
cost. Therefore, the entry rec orded in the parent’s individual financial 
statements is: 
Dr Finance cost (and so reduces  the parent’s retained earnings)  
Cr Deferred consideration liability 
Contingent consideration  
Contingent consideration is cons ideration that may be paid in t he future if 
certain future events occur or c onditions are met. For example,  cash may be 
paid in the future if certain  profit targets are met. 
According to IFRS 3, c ontingent consideration is measured at it s fair value at 
the date of acquisition, to be c onsistent with how other forms of consideration 
are measured. This will typica lly be based on a probability wei ghted present 
value. 
Adjustments to the value of cont ingent consideration arising fr om events after 
the acquisition date, e.g. a pro fit target not being met, are n ormally 
charged/credited to profits.

Chapter 11 
 281 
 Illustration 7 – Fair value of consideration paid  
 Malawi has acquired 80% of the shares in Blantyre. The conside ration 
consisted of: 
1 Cash paid $25,460. 2 Malawi issued 10,000 shares to t he shareholders of Blantyre, each 
with a nominal value of $1 and a market value of $4. 
3 Cash of $20,000 to be paid one y ear after the da te of acquisi tion. 
4 Cash of $100,000 may be paid one year after the date of 
acquisition, if Blantyre achieves  a certain profit target. It i s thought 
that there is only a 40% chance that this will occur. The fair value of 
this consideration is to be m easured as the present value of th e 
expected value. 
5 Legal fees associated with the acquisition amounted to $15,00 0.  
A discount rate of 10% should be used. 
Required: 
Calculate the fair value of Mal awi’s consideration paid for Bla ntyre to be 
used in the goodwill calculation. 
Solution 
 $  
Cash 25,460 
Shares (10,000 × $4) 40,000 Deferred consideration ($20,000 × 0.909) 18,180 
Contingent consideration ( $100,000 × 40% × 0.909) 36,360 
 
––––––– 
Total FV of considerati on paid by parent 120,000 
 ––––––– 
The cash payment of $20,000 in one year’s time is deferred cons ideration 
as it is guaranteed that it will be paid. The future cash flow of $20,000 is 
discounted back to present value by applying the discount facto r as 
obtained from discount tables (se e Formulae & Tables at front o f text) 
using an interest rate o f 10% in 1 years’ time. 
The cash payment of $100,000 in one year’s time is contingent 
consideration as it is dependent on Blantrye achieving a profit  target. The 
question states that the fair val ue is to be the present value of the 
expected value. The expected val ue is 40% × $100,000 = $40,000 as it 
takes into account the expected probability of the profit targe t being 
achieved. This is then discounted  to present value by applying the 
appropriate discount factor using an interest rate of 10% in 1 years’ time.

282  
 Test your understanding 5 (integration question) 
 Duck has invested in 60% of Wicke t’s 10,000 $1 equity shares. D uck paid 
$5,000 cash considerat ion and issued 2 shares  for every 3 share s acquired. 
At the date of acquisition the market value of a Duck share was  $2.25. 
Duck agreed to pay $3,000 cash 2  years after acquisition. A fur ther 
$1,000 in cash will be pai d 3 years after acquisition if Wicket  achieves a 
certain profit target. The fair  value of this contingent consid eration was 
deemed to be $700. 
It is group policy to measure NCI a t fair value at the date of acquisition. 
The fair value of the NCI at ac quisition was $10,000 and the fa ir value of 
Wicket’s net assets was $15,000. 
Legal and professional fees incu rred in relation to the acquisi tion were 
$2,000. 
Assume a discount rate of 10%. 
Required: 
Calculate the goodwill arising on the acquisition of Wicket. 
 
 Test your understanding 6 (OTQ style) 
 Kane acquired 75% of Aaron's $1 equity shares on 1 January 20X3 . 
Kane paid $1,000,000 a t the date of acquisition and agreed to p ay a 
further $2,500,000 2 year s after acquisition. 
Legal and professional fees of $ 150,000 were paid in respect of  the 
Assume a discount rate of 8%. 
Required: 
Calculate the fair value of the consideration that would be rec ognised in 
the calculation of goodwill on acquisition of Aaron. 
Fair value of subsidiary's net assets 
According to IFRS 3 Business combinations , at acquisition, the subsidiary’s net 
assets must be measured at fair v alue for inclusion within the consolidated 
The group must recognise the fair value of the identifiable  assets and liabilities 
of the subsidiary acquired. 
• According to IAS 37 Provisions, contingent li abilities and contingent  
assets, and IFRS 3 Business combinations,  an asset is identifiable if it 
either: 
– is capable of being separated (s old separately, regardless of  whether 
the subsidiary actually intends to sell it), or 
– arises from contractual or other legal rights.

Chapter 11 
 283 
• An asset or liability may only be recognised if it meets the d efinition of an 
asset or liability as at the acquisition date. 
– For example, costs relating to  restructuring the subsidiary t hat will 
arise after acquisition do not m eet the definition of a liabili ty at the 
date of acquisition and are no t included in the consolidation. 
These requirements c an create differences between the accountin g of 
transactions in the individual a ccounts of the subsidiary compa red to the 
treatment within the consoli dated accounts. For instance: 
• Intangible assets 
Certain internally generated intangible a ssets, such as brand n ames, 
patents and client lists, are not  recognised in the subsidiary’ s individual 
financial statements bu t may be recognised on consolidation. 
These intangibles are no longer  internally gener ated as the par ent has 
acquired them as part of the acqui sition of the subsidiary. The y are 
identifiable and should be included in the c onsolidated financi al 
statements at thei r fair value. 
• Contingent liabilities 
By definition, conti ngent liabilities are not  recognised in the  subsidiary’s 
individual financial statements (t hey are disclosed by note in accordance 
with IAS 37).  
On consolidation, however, a c ontingent liability will be recog nised as a 
liability if its fair value can be measured reliably, i.e. it i s recognised even if 
it is not probable.

284  
 Measuring fair value 
 IFRS 3 provides the following gu idance on measuring the fair v alue of 
certain assets/liabilities: 
 
Item Valuation 
Property, plant and equipment Market value. If there is no evidence of market 
value, depreciated replacement cost should be used. 
Intangible assets Market value. If none exists, an amount that 
reflects what the acquirer would have paid otherwise. 
Inventories (i) Finished goods should be valued at 
selling prices less the sum of disposal costs and a reasonable profit allowance. 
(ii) Work in progress should be valued at 
ultimate selling prices less the sum of completion costs, disposal costs and a reasonable profit allowance. 
(iii) Raw materials should be valued at current 
replacement costs. 
Receivables, payables and loans Present value of future cash flows expected to 
be received or paid. Disco unting is unlikely to 
be necessary for short-term receivables or payables. 
  
 Illustration 8 – Fair value of net assets  
 Brussels acquired 100% of the s hare capital of Madrid paying 
consideration of $8 million. 
At acquisition, the statement o f financial position of Madrid s howed equity 
share capital of $3m and retai ned earnings of $3.25m. Included in this 
total is: 
• Freehold land with a carrying amount of $400,000 but a market 
value of $950,000. 
• Machinery with a carrying amount o f $1.2m. No reliable market 
value exists for these items. T hey would cost $1. 5m to replace as 
new. The machinery has an expected life of 10 year s and Madrid’ s 
machines are 4 years old. 
• The fair value of all other asse ts and liabilities is approxim ately 
equal to carrying amount.

Chapter 11 
 285 
 Madrid’s brand name was interna lly generated and so is not reco gnised 
in their statement of financial position. However, valuation ex perts have 
estimated its fair value to be $500,000. 
The directors of Brussels int end to close down one of the divis ions of 
Madrid and wish to provide for operating losses up to the date of closure 
which are forecast as $729,000. 
An investment in plant and mach inery will be required to bring the 
remaining production line of Madr id up to date. This will amoun t to 
$405,000 in the next 12 months. 
Required: 
Calculate the goodwill arising on the acquisition of Madrid. 
 
 Illustration 8 answer  
 The fair value of the subsidiary ’s net assets is used in the c alculation of 
goodwill. Start by setting up a net assets working and filling in the 
subsidiary’s share capital and retained earnings at acquisition  – this gives 
us the carrying amount of the ne t assets at acquisition. Note t hat since 
the question only requir es the calculation of goodwill, only th e net assets 
at acquisition are required. 
Net assets of subsidiary 
 $000 
Share capital 3,000 
Retained earnings 3,250 
 ––––– 
Carrying amount of NA at acquisition 6,250 
 ––––– 
Now consider the adjus tments required to adjust the net assets from their 
carrying amounts to their fair values. 
Land – this requires an upwards adjustment of $550,000 (fair va lue of 
$950,000 less carrying amoun t value of $400,000). 
Machinery – the fair value is  not given and so needs to be calc ulated. It 
will be measured as the depreciated replacement cost. Madrid’s 
machines have an expected life o f 10 years and ar e 4 years old.  
Therefore, their remain ing life is 6 years. 
Depreciated replacement cost =  6/10 × $1,500, 000 = $900,000 
Since their carrying amount is $1. 2m and their fair value is $0 .9m, a 
downwards fair value adjustm ent of $300,000 is required.

286  
 Brand – an upwards adj ustment of $500,000 is required as its ca rrying 
amount is currently zero but its  fair value is $500,000. Note t hat the brand 
can be recognised on consolidat ion as the fact that it has a fa ir value 
indicates it is separable. 
The provision for future operat ing losses does not represent a liability at 
acquisition since there is no pas t event giving rise to an obli gation. 
Similarly, the future investmen t in machinery does not represen t assets 
that exist at acquisition and so cannot be recognised. 
Now process these adj ustments to complete  the net assets workin g: 
 $000 
Fair value adjustments  
Land 550 
Machinery (300) 
Brand 500 
 ––––– 
Fair value of sub's net assets 7,000 
 ––––– 
Now the goodwill calculation c an be completed. Note that there is no NCI 
as the parent has acquired 100% of the subsidiary. 
Goodwill 
 $000 
Fair value of P's investment 8,000 
Fair value of sub's net assets at acquisition (working) (7,000)  
 ––––– 
Goodwill on acquisition 1,000 
 ––––– 
  
Recording fair value adjustments 
The fair value of the subsidiary ’s net assets at acquisition re presents the 'cost' 
of the net assets to the group at th e date of acquisition. Reco rding fair value 
adjustments is in accordance wit h the historical cost concept. 
It also ensures an accurate meas urement of goodwill. Assuming t he fair value 
of the subsidiary’s net assets  is higher than their carrying am ount, goodwill 
would be overstated if the fair v alue adjustments were not reco gnised.

Chapter 11 
 287 
To record fair value adjustments in the CSFP 
• Adjust the net assets working at acquisition and the reporting  date as 
appropriate: 
– The fair value adjustment arise s at acquisition so there shou ld 
always be an adjustment to the net a ssets at the date of acquis ition. 
– The net assets at the reporting date should also be adjusted unless 
you're told that the assets/li abilities to which the adjustment  relates 
are no longer hel d by the group. 
• Reflect the reporting date adj ustment on face of CSFP. 
Impact on post-acqui sition depreciation 
Fair value adjustments often in volve adjustments to non-current  asset values 
which, consequently, involve an adjustment to depreciation. 
Depreciation in the group acc ounts must be based on the carryin g amount of 
the related non-current asset in  the group accounts. Therefore,  if the non--
current asset values are adjust ed at acquisition then a depreci ation adjustment 
must be made in the post-acquisition period. 
To record depreciation adj ustments in the CSFP: 
• Adjust net assets working in rep orting date column to reflect the 
cumulative impact on depreciati on of the fair value adjustment.  
• Also reflect adjustment on the face of CSFP. 
• The extra depreciation will r educe the post-acquisition profit s of the 
subsidiary included in consolidat ed reserves and NCI calculatio ns.

288  
 Illustration 9 
for King and Lear as at 31 December 20X7: 
 King Lear 
 $000 $000 
Non-current assets 1,300 1,200 
Investment in Lear 1,900 – Current assets 200 450 
 
––––– ––––– 
 3,400 1,650 
Equity   
Share capital ($1) 2,000 750 
Retained earnings 1,250 300 Current liabilities 150 600 
 
King purchased 80% of Lear’s equity  shares on 1 January 20X5 fo r 
$1.9m when Lear’s retained earnings were $100,000. 
It is group policy to measure the non-controlling interests at fair value at 
acquisition and the fair value o f the non-controlling interests  in Lear on 
1 January 20X5 was $400,000. At this  date Lear’s non-current as sets had 
a fair value of $1m and the asse ts had a remaining useful econo mic life 
of 5 years. Their carrying amoun t at the date of acquisition wa s $850,000. 
As at 31 December 20X7, an impai rment loss of $50,000 has arise n on 
goodwill. 
Required: 
(a) Prepare the consolidated stat ement of financial position at  
31 December 20X7.

Chapter 11 
 289 
 Illustration 9 answer  
 ( a )  Consolidated statement of fina ncial position as at 31 December 
20X7  
  $000 
Non-current assets (1,300 + 1,200 + 150 – 90) 2,560 
Goodwill (W3) 1,250 
Current assets (200 + 450) 650 
  ––––– 
  4,460 
  ––––– 
Equity   
Share capital  2,000 
Retained earnings (W5) 1,298 
Non-controlling interests (W4) 412 
  ––––– 
  3,710 
Current liabilities (150 + 600) 750 
  ––––– 
  4,460 
  ––––– 
 
Note:  The carrying amount of non-curr ent assets is adjusted to 
reflect the fair value adjustm ent and subsequent depreciation. 
(W1) Group structure  
King 
  
 80% 1 Jan 20X5 i.e. 3 years 
since acquisition 
  
Lear

290  
 (W2)  Net assets of subsidiary  
date 
 $000  $000 
Share capital 750  750 Retained earnings 100  300 
Fair value adjustment 
(1,000 – 850)  
150   
150 
Depreciation adj 
(150 × 3/5)  
–   
(90) 
 
 1,000  1,110 
  110 Post 
profit  
 
Note:  The fair value adjustment i s made at acquisition and 
then repeated at the reporting dat e along with any additional 
depreciation that will have been charged (on the fair value 
uplift) in the post-acquisition period. 
 $000 
Fair value of P's investment 1,900 Value of NCI at acquisi tion (fair value) 400 
Fair value of sub's net assets at acquisition (W2)  (1,000) 
 
–––––– 
Goodwill at acquisition 1,300 
Impairment (50) 
 –––––– 
Goodwill at reporting date 1,250 
 –––––– 
(W4)  Non-controlling interests  
 $000 
Value of NCI at acquisition 400 
NCI% × post acquisition reserves  
(20% × 110 (W2) )  
22 
NCI% × impairment (20% × 50) (10) 
 –––– 
 412 
 ––––

Chapter 11 
 291 
 (W5) Consolidated retained earnings  
 $000 
Parent's reserves 1,250 
Sub (80% × 110 (W2) ) 88 
Impairment (80% × 50) (40) 
 ––––– 
 1,298 
 ––––– 
 
 Information for TYUs 7 to 9 
 BN acquired 75% of the 1 million issued $1 ordinary shares of AB on 
1 January 20X0 for $1,850,000 when AB 's retained earnings were 
$885,000. 
The carrying amount of AB's net a ssets was considered to be the  same 
as their fair value at the date o f acquisition with the excepti on of AB's 
property, plant and equipment. The carrying amount of these ass ets was 
$945,000 and their market value was $1,100,000. The property, p lant and 
equipment of AB had an estimated us eful life of 5 years from th e date of 
acquisition. BN depreciates all as sets on a straight line basis . 
AB sold goods to BN with a sales value of $400,000 during the y ear 
ended 31 December 20X1. All of thes e goods remain in BN's inven tories 
at the year end. AB makes a 20% g ross profit margin on all sale s. 
The retained earnings reported in the financial statements of B N and AB, 
as at 31 December 20X1, are $4,200,000 and $1,300,000 respectiv ely. 
$570,000 on 1 January 20X0. 
An impairment review performed on 31 December 20X1 indicated th at 
goodwill on the acquisition of AB had been impaired by 20%. No 
impairment was recognised in the year ended 31 December 20X0.

292  
 Required 
Calculate the carrying amount o f goodwill that will appear in t he 
consolidated statement of financ ial position of  the BN group at  
31 December 20X1. 
 
 Required 
Calculate the balance on consoli dated retained earnings at 31 D ecember 
20X1. 
 
 Required 
Which three of the following st atements are true in respect of BN's non-
controlling interest? 
A The non-controlling is include d as a separate part of equity on the 
face of the consolidated sta tement of financial position 
B The non-controlling interest i s a credit balance and should b e 
presented within non- current liabilities 
C The non-controlling interest s hould be debited with its share  (25%) 
of the post-acquisition reserves of AB 
D The non-controlling interest is adjusted to reflect its share  of the 
goodwill impairment 
E Upon acquisition of AB, BN will initially credit the NCI with  its fair 
value of $570,000 
F The unrealised profit adjustment  results in an increase in th e NCI 
figure 
10 Treatment of investment as FVOCI  
In the parent's individual financia l statements, an investment in a subsidiary is 
likely to be classified as fair  value through other comprehensi ve income 
(FVOCI), in accordance with IFRS 9 Financial instruments (see Financial 
Instruments chapter). 
This means that the in vestment will have b een remeasured to fai r value since 
the date of acquisiti on, with any gains or losses arising being  taken to other 
components of equity.

Chapter 11 
 293 
Upon consolidation, these gains  or losses should be reversed ba ck out so that 
the investment is restated to its fair value at  the date of acquisition (for 
inclusion in the goodwill calc ulation). The entity will Dr Othe r components of 
equity (FVOCI reserve) Cr Investment in S.  
 
 Illustration 10 –  Reversal of FVOCI  gains/losses 
 Root acquired 80% of the share capital of Warner on 1 January 20X2 for 
$750,000. The investment in Warner  was classified as FVOCI in t he 
books of Root and is held at fair  value. The gains earned to da te are 
included in other components o f equity of Root. The fair value of the 
investment at 31 December 20X4 , the reporting date, is $1,150,0 00. The 
gain on the financial asset is not  a real gain to the group. No  financial 
asset is recorded in the group a ccounts, only Root’s individual  company 
The amount to be eliminated from  Root's SFP upon consolidation is the 
fair value at the repor ting date of $1,150,000. 
The amount to be included in the goodwill calculation is the fa ir value at 
the date of acquisition, i.e. $750,000. 
The gain of $400,000 (1,150,000 – 750,000) that has been record ed in 
other components of equity since  the date of acquisition must b e 
reversed out upon consolidation.  Dr Other components of equity 400 
Cr Investment 400.  
 
 Test your understanding 10 (further OTQs) 
  1 P owns 75% of S. S sells goo ds to P for $5,200 with a margi n of 
20%. 40% of these goods have subs equently been sold on by P to 
external parties by the reporting date. 
Which one of the following ad justments would P make in 
relation to the above goods when preparing the consolidated 
statement of financial position? 
A Dr Consolidated retained earni ngs $520, Cr Inventory $520 
B Dr Consolidated retained earnings $390, Dr NCI $130, 
Cr Inventory $520 
C Dr Consolidated retained earni ngs $624, Cr Inventory $624 
D Dr Consolidated retained earnings $468, Dr NCI $156, 
Cr Inventory $624

294  
 2 Paul acquired a 100% investmen t in Simon on 1 July 20X2. The 
consideration consisted of: 
– the transfer of 200,000 shares i n Paul with a nominal value o f 
$1 each and a market price on t he date of acquisition of $4.25 
each 
– $250,000 cash paid on 1 July 20X2 – $1,000,000 cash, payable on 1 Ju ly 20X4 (a discount rate of 
8% should be used to value the liability). 
Calculate the value of the cons ideration that Paul should use 
when calculating goodwill arisi ng on the acquisition of Simon. 
3 K acquired 60% of the ordinary s hare capital of S on 1 May 20 X7 for 
$140,000. The investment was cla ssified as FVOCI with any 
associated gains or losses rec orded within othe r components of 
equity in K's individual financial statements. The investment i s 
recorded at its fair value of $162,000 as at 30 November 20X7. 
At 30 November 20X7, the other  components of equity balance in 
the individual statements of f inancial position of K and S was 
$28,000 and $10,000 respectively. A t the date of acquisition, S  did 
not have any other components of equity in its statement of fin ancial 
position. 
Calculate the other component s of equity balance that would 
appear in the consolidated state ment of financial position of 
the K group as at 30 November 20X7. 
The following scenario relates to questions (4) and (5). 
Aston acquired 85% of Martin's 250,000 $1 ordinar y shares on 1 January 
20X4 for $480,000 when the retai ned earnings of Martin were $90 ,000. 
At the date of acquisition, the fa ir value of Martin's property , plant and 
equipment was $50,000 higher than its carrying amount. It was e stimated 
to have a remaining useful lif e of ten years at this date.

Chapter 11 
 295 
 At 31 December 20X7, the carr ying amount of property, plant and  
equipment in the individual statem ents of financial position of  Aston and 
Martin was $800,000 and $390,000 respectively. 
It is group policy to measure NCI a t fair value at acquisition and the fair 
value of the NCI in Martin on 1 January 20X 4 was $70,000. 
4 Calculate goodwill arising on the acquisition of Martin. 
5 Calculate the carrying amount of property, plant and equipment 
that would appear in the consolidated statement of financial 
position of the Aston group as at 31 December 20X7. 
6 P acquired 75% of the equity shar e capital of S several years  ago 
when S's retained earnings wer e $3,250,000. Goodwill arising on  
the acquisition was $2,000,000 and this was considered to have 
been impaired by 20% by 30 September 20X7. I t is group policy t o 
measure NCI at fair value a t the date of acquisition. 
P acquired 25% of the equity share capital of V on 1 October 20 X6 
in a contractual arrangement that will give P joint control ove r V. V's 
retained earnings at the date of acquisition were $925,000. 
The retained earnings reported in the financial statements of P , S 
and V as at 30 September 20X 7 are $1,570,000 , $5,250,000 and 
$1,165,000 respectively. 
Calculate the amount that woul d appear in the consolidated 
statement of financial pos ition of the P group as at 
30 September 20X7 for conso lidated retained earnings. 
7 RW acquired 65% of the equity s hare capital of SR on 1 April 20X6 
for $950,000 when the carrying amount of SR's net assets was $450,000. It is group policy to meas ure non-controlling interes t at 
fair value at the date of acquisi tion and the fair value of the  NCI in 
SR at 1 April 20X6 was $350,000. 
The only fair value adjustment m ade was to increase property, p lant 
and equipment by $75,000. The rema ining useful life of these 
assets at acquisition was 5 years. 
The net assets reported in the fi nancial statement s of SR at 
31 March 20X8 are $650,000. 
Calculate the amount that would appear in the equity section of  
the consolidated statement of financial position of the RW 
group as at 31 March 20X8 for non-controlling interests.

Chapter 11 
 297 
 Goodwill 
 ( a )   
Fair value 
method  (b) 
Proportionate 
assets 
method  
 $000 $000 
Fair value of P's investment  1,200 1,200 NCI: 
Fair value (given)  
250  
Proportionate share of net assets 
(20% × 1,000 (W2) )   
200 
Less: S's net assets at acquisition (W2)  (1,000) (1,000) 
 
Goodwill at acquisition 450 400 
   
P 
  
 80% 1 April 20X8   
S 
(W2) Net assets of subsidiary  
 $000 
Share capital 200 
Retained earnings 800 
 ––––– 
 1,000 
 –––––

298  
 Goodwill 
 ( a )   
Fair value 
method  (b) 
assets method  
 $000 $000 
Fair value of P's investment  2,500 2,500 
NCI: Fair value (25% × 500 × $6)  
750  
(25% × 2,000 (W2) )   
500 
Less: S's net assets at 
acquisition (W2)   
(2,000)  
(2,000) 
 
Goodwill at acquisition 1,250 1,000 
P 
  
 75% 1 April 20X8   
S 
 $000 
Share capital 500 
Retained earnings 1,500 
 ––––– 
 2,000 
 –––––

Chapter 11 
 299 
 ( a )  Goodwill  
 ( 1 )   
Fair value 
method  (2)  
assets 
method  
 $000 $000 
Fair value of P's investment 6,500 6,500 Value of NCI at acquisition   
– at fair value 2,000  – at proportionate share of net 
assets (25% × 7,500 (W1) )   
1,875 
Less: sub's net assets at 
acquisition (W1)   
(7,500)  
(7,500) 
 
Goodwill at acquisition 1,000 875 
Impairment (20% × goodwill at 
acquisition)  
(200)  
(175) 
Goodwill at reporti ng date 800 700 
   
 ( b )  Consolidated retained earnings  
 ( 1 )   
Fair value 
method  (2)  
 $000 $000 
Parent's reserves 10,800 10,800 Sub (75% × 2,000 (W1) ) 1,500 1,500 
Impairment loss   
– FV method (75% × 200 (part a)) (150)  
– Proportionate share of net assets 
method (part a)   
(175) 
 
 12,150 12,125 

300  
 (c) Non-controlling interest  
 ( 1 )   
Fair value 
method  (2) 
 $000 $000 
Value of NCI at acquisition (as in 
goodwill)  
2,000  
1,875 
(25% × 2,000 (W1) )  
500  
500 
NCI% × impairment (25% × 200 
(part a))  
(50)  
– 
 2,450 2,375 
(W1) Net assets of subsidiary  
date 
 $000  $000 
Share capital 5,000  5,000 Retained earnings 2,500  4,500 
 
 7,500  9,500 
  2,000 post-acq'n 
profit  
 
 ( a )  ( i )  Goodwill  
 $ 0 0 0  
Fair value of P's investment 14,500 Value of NCI at acquisition (20% × 10,800 (W2) ) 2,160 
Less: sub's net assets at acquisition (W2)  (10,800) 
 
–––––– 
Goodwill at acquisition 5,860 
Impairment (1,000) 
 –––––– 
Goodwill at reporting date 4,860 
 ––––––

Chapter 11 
 301 
 (ii)  Consolidated retained earnings  
 Retained 
earnings 
 $ 0 0 0  
Parent's reserves 12,600 Sub (80% × 2,100 (W2) ) 1,680 
PUP (W4)  (100) 
 
–––––– 
 13,180 
 –––––– 
(iii)  Non-controlling interest  
 $000 
Value of NCI at acquisition  2,160 
NCI% × post-acquisition reserves (20% × 2,100 (W2) ) 420 
 –––––– 
 2,580 
P 
  
80% 3 years since 
acquisition   
S 
date 
 $000  $000 
Share capital 5,000  5,000 
Retained earnings 5,800  7,900 
 ––––––  –––––– 
 10,800  12,900 
  2,100 Post-
acquisition profit

302  
 (W3) Intra-group balances  
  $000 
Dr Payables ↓ 550 
Dr Cash ↑ 200 Cr Receivables ↓ 750 
(W4) PUP 
Profit on sale = 25/ 125 × $1,500,0 00 = $300,000 
Profit in inventory = 1/3 × $300,000 = $100,000  
(b) Revised amounts, S selling to P  
(i) Consolidated retained earnings  
 Retained 
earnings 
 $000 
Parent's reserves 12,600 
Sub (80% × 2,000 (W2) ) 1,600 
 
–––––– 
 13,200 
 –––––– 
(ii) Non-controlling interest  
 $000 Value of NCI at acquisition  2,160 
NCI% × post-acquisition reserves (20% × 2,000 (W2) ) 400 
 
–––––– 
 2,560 
 –––––– 
 
The overall impact on the reserv es of the seller being S rather  than 
P is that the NCI reserve is $20, 000 lower and the group reserv es 
are $20,000 higher. This is becau se 20% of the PUP adjustment 
has been re-allocated against the NCI. 
The PUP adjustment would be deducted in W2 rather than 
W5, resulting in post-acquisition profits in the subsidiary of 
2,000 (after adjustment). 
date 
 $000  $000 
Share capital 5,000  5,000 Retained earnings 5,800  7,900 
PUP (W7)    (100) 
 
 10,800  12,800 
  2,000 Post-

Chapter 11 
 303 
 Goodwill 
 $  
Fair value of consideration transferred by P  
Cash 5,000 Shares (60% × 10,000 ×  2/3 × $2.25) 9,000 
Deferred consideratio n ($3,000 × 0.826) 2,478 
Contingent consideration 700 
 
–––––– 
 17,178 
Value of NCI at acquisition (at fair value) 10,000 
Fair value of sub's net assets at acquisition (15,000) 
 –––––– 
Goodwill on acquisition 12,178 
 –––––– 
Goodwill at reporting dat e (in CSFP) 12,178 
 –––––– 
 
Note:  the legal and professional fees a re not included in the calcul ation 
of goodwill. They should be expens ed to the statement of profit  or loss. 
 
 Fair value of cons ideration = $3,142,500 
 $  
Cash 1,000,000 Deferred consideration ($2. 5 million × 0.857) 2,142,500 
 
–––––––– 
 3,142,500 
 –––––––– 
 
of goodwill. They should be expens ed to the statement of profit  or loss.

304  
 Goodwill = $304,000 
 $  $  
Consideration transferred  1,850,000 
Non-controlling interest at fair value  570,000 
Net assets at the date of acquisition:   Carrying amount $(1,000, 000 + 885,000) 1,885,000  
Fair value increase $(1,100,000 – 
945,000)  
155,000  
  (2,040,000) 
  
––––––––– 
Goodwill on acquisition  380,000 
Impairment 20% in 20X1  (76,000) 
  ––––––––– 
Goodwill as at 31 Dece mber 20X1  304,000 
  ––––––––– 
The net assets at acquisition have been incorporated into the a bove 
calculation. You can alternativ ely use a net assets table to ca lculate the 
amount of $2,040,000 shown above. S ee the solution to TYU 5 for  this 
alternative working. Note tha t you would only need the acquisit ion column 
for the calculation of goodwill. 
 
 Consolidated retained earnings 
 B N  A B  
 $  $  
As reported in SFP 4,200,000 1,300,000 
Less pre-acquisition reta ined earnings  (885,000) 
Accumulated depreciation on PPE FV 
adjustment ($155,000 × 2/5 years)   
(62,000) 
Impairment of goodwill (as in TYU 4 
above)   
(76,000) 
Unrealised profit ( $400,000 × 20%)  (80,000) 
  ––––––– 
  197,000 
  ––––––– 
Group share of AB ( $197,000 × 75%) 147,750  
 ––––––––  
 4,347,750  
 ––––––––

Chapter 11 
 305 
 Tutorial note: The calculation of post-acqu isition reserves is shown 
within the consolidated retai ned earnings calculation (right-ha nd column). 
Notice that the goodwill impairmen t has also been included. As NCI is 
valued using the fair value me thod, the goodwill impairment is included 
here so that the group share is i ncluded in the consolidated re tained 
earnings figure. Alternatively, y ou can calculate the post-acqu isition 
reserves using a net assets table as follows:  
date 
 $000  $000 
Share capital 1,000  1,000 
Retained earnings 885  1,300 
(1,100 – 945)  
155   
155 
Depreciation adj (155 × 
1/5 × 2 yrs)  
–   
(62) 
PUP adj (400 × 20%)   (80) 
Goodwill impairment   (76) 
 2,040  2,237 
  197 Post 
reserves  
The goodwill impairment has been included in the net assets wor king so 
that the group share of it is ca lculated and included in the co nsolidated 
retained earnings. This is a s lightly alternative approach to t he exercises 
we've seen so far, where it has  been included wit hin consolidat ed 
retained earnings on a separate line. The overall result is the  same and 
either method can be used. 
Consolidated retained earni ngs (using net assets table): 
 $  
Parent's retained earnings 4,200,000 
Group share of post-acquisition reserves (75% × 
197,000 (net asset working))  
147,750 
 ––––––––– 
 4,347,750 
 –––––––––

306  
 The correct statements are A, D and E 
B is incorrect, as NCI is part o f equity rather than liabilitie s 
C is incorrect, as the NCI would be credited  with its share of the post-
acquisition reserves (not debited) 
F is incorrect, as the unrea lised profit would result in a reduction  (not 
increase) in the NCI 
 
  1  D is the correct answer. 
PUP adjustment = $5,200 × 20% × 60% = $624 and this is deducted  
from inventory. 
The adjustment is split between NCI and parent shareholders as S, 
the subsidiary, was the seller. 
75% × $624 = $468 is deducted fr om consolidated retained 
earnings. 
25% × $624 = $156 is deducted from NCI. 
2 Value of consideration = $1,957,000  
 $000 
Shares (200,000 × $4.25) 850 
Cash 250 
Deferred consideration ($1,000,000 × 0.857) 857 
 ––––– 
 1 , 9 5 7  
 ––––– 
  
3 Other components of equity = $12,000  
 $  
K's other components of equity 28,000 
Reversal of gains on investment in subsidiary 
(162k – 140k)  
(22,000) 
K's share of S's post-ac quisition other components 
(60% × 10k)  
6,000 
 –––––– 
 12,000 
 ––––––

Chapter 11 
 307 
 4  Goodwill = $160,000  
 $  $  
Consideration transferred  4 8 0 , 0 0 0  
Non-controlling interest at fair value  70,000 
Net assets at the date of acquisition:   
Share capital 250,000  Retained earnings 90,000  
Fair value increase 50,000  
  (390,000) 
  
–––––––– 
Goodwill on acquisition  160,000 
  –––––––– 
5 Property, plant and equipment = $1,220,000 
 $  
Aston 800,000 
Martin 390,000 
Fair value increase at acquisition 50,000 Fair value depreciation  (50,000 × 4/10) (20,000) 
 
–––––––– 
Goodwill on acquisition 1,220,000 
 –––––––– 
6 Consolidated retained earnings = $2,830,000  
 
7 Non-controlling interest equity = $409,500  
 $  
Value of NCI at acquisition 350,000 
Share of S's post-acquisition retained earnings 
(35% × (650k – 450k))  
70,000 
Share of FV depreciation (35%  × 75k × 2/5) (10,500) 
 ––––––– 
 409,500 
 ––––––– 
  $ 0 0 0  
P's retained earnings 1,570 
Share of S's post-acquisiti on retained earnings (75% × 
(5,250k – 3,250k))  
1,500 
Share of goodwill impairment ( 75% × 20% × 2,000k) (300) 
Share of V's post-acquisiti on retained earnings (25% × 
(1,165k – 925k))  
60 
 –––––– 
 2,830 
 ––––––

308  
 You can use a net assets worki ng to calculate the adjusted pos t-
acquisition reserves of the subsidiary and then bring this into  your 
main NCI calculation if you pref er (the depreciation adjustment  has 
been shown separately in  the above working). 
 
date 
 $000  $000 
Carrying amount 450  650 
Fair value adjustments:     Property, plant and 
equipment  
75   
75 
Depreciation on PPE adj  
(75 × 2/5)  
–   
(30) 
 
 525  695 
  170 Post 
reserves  
Non-controlling interest 
 $  
Value of NCI at acquisition 350,000 Share of S's post-acquisition retained earnings 
(35% × 170k)  
59,500 
 
––––––– 
 409,500 
 –––––––

309 
Group accounts –
Subsidiaries (CSPLOCI) 
B2: Explain relevant 
financial reporting standards for group accounts (a)  Explain the financial 
reporting standards for the key areas of group accounts.  
(b)  Consolidated statement 
of profit or loss and other comprehensive income  
 
  Chapter 
12

Group accounts – Subsidiaries (CSPLOCI) 
310  
 
2 Consolidated statement o f profit or loss and other 
The principles of conso lidation as per IFRS 10 Consolidated financial 
statements are continued within t he statement of profit or loss and other 
comprehensive income (CSPLOCI). 
A statement of profi t or loss and other compr ehensive income re flects the 
income and expenses generated by  the net assets shown on the st atement of 
financial position. It incorporates  two separate statements: th e statement of 
profit or loss and t he statement of other c omprehensive income.  
Since the group controls the ne t assets of the subsidiary, the income and 
expenses of the subsidiary shoul d be fully included in the cons olidated 
statement of comprehensive inco me i.e. add across 100% of the p arent plus 
100% of the subsidiary.

Chapter 12 
 311 
Pro forma for the CSPLOCI 
Consolidated statement of profit  or loss and other comprehensiv e income 
for the year ended..... 
 $ 
Revenue (100% P + 100% S) X 
Cost of sales (100% P + 100% S) (X) 
 ––– 
Gross profit X 
 ––– 
Operating expenses (100% P + 100% S) (X) 
 ––– 
Profit from operations X 
Investment income (100% P + 100% S) X 
 ––– 
Profit before tax X 
Income tax expense (100% P + 100% S) (X) 
 ––– 
Profit for the year X 
 ––– 
Other comprehensive income (100% P + 100% S) X 
 ––– 
Total comprehensive income X 
 ––– 
Profit attributable to:  
Parent shareholders (balancing figure) X 
Non-controlling interests (W) X 
 ––– 
 X 
 ––– 
Total comprehensive income attributable to:  
Parent shareholders (balancing figure) X Non-controlling interests (W) X 
 
––– 
 X 
 –––

312  
Consolidation adjustments and th e consolidated statement of pro fit or 
loss and other comprehensive income (CSOPLOCI) 
Mid-year acquisitions 
If the subsidiary was acquired mid-year then only the post-acqu isition results 
should be consolidated. Unless to ld otherwise, it is normal to assume that 
results accrue evenly over the per iod and therefore the results  of the subsidiary 
should be time apportioned so that only the post-acquisition re sults are 
consolidated. 
Intra-group investment income 
Dividends paid by the subsidia ry to the parent should be elimin ated upon 
consolidation from the par ent's investment income. 
Non-controlling interests 
According to IFRS 10 Consolidated financial statements , the profit for the year 
and the total comprehensive income for the year are analysed be tween the 
amounts attributable to the ow ners of the paren t and the amount s attributable to 
the non-controlling interest. Thi s analysis is presented at the  bottom of the 
consolidated statement of prof it or loss and it is common for t he NCI figures to 
be calculated (working shown belo w) with the amounts attributab le to the 
owners of the parent then being c omputed as a balancing figure.  
Goodwill impairment 
If the fair value method has been  used to value the non-control ling interests at 
acquisition, the NCI share of profit will be adjusted to reflec t their share of any 
goodwill impairment loss. 
Where the proportionate share of  net assets method is used, all  of the goodwill 
impairment is allocated to the parent (as previously discussed)  and therefore no 
adjustment is made to the NCI figure.

Chapter 12 
 313 
Standard consolidation workings 
Non-controlling interest  share of profit/TCI 
The share of profit and total comprehensive income that belongs  to the NCI is to 
be calculated as follows: 
 $  $  
Sub's profit for the year per S's SOPLOCI 
(time apportioned if mid-year acquisition – see Ch 12 section 8)  
 
X  
FV depreciation adjustment (See Ch 12 
section 10)  
(X)  
PUP – if S is seller (See Ch 12 section 9) (X)  
Impairment expense (fair value method 
only (See CH 12 session 6)  
(X)  
 
––––  
Adjusted profit X  
NCI share of profits   × NCI%  X 
Sub's other comprehensiv e income per S's 
SOPLOCI (time apportioned if mid-year acquisition)  
 
X  
 
––––  
Adjusted TCI X  
NCI share of total comprehensive 
income  × NCI%   
X 
There are various adjustments t hat may have to be made to the s ubsidiary's 
profit when calculati ng the NCI's share.

314  
 Illustration 1  
 On 1 July 20X9 Zebedee acquire d 75% of the equity shares of Xa vier. 
The following statements of pro fit or loss and other comprehens ive 
income have been produced by Zebedee and Xavier for the year en ded 
31 December 20X9. 
 Zebedee Xavier 
 $000 $000 
Revenue 1,260 520 
Cost of sales (420) (210) 
Gross profit 840 310 
Operating expenses (300) (150) 
Profit from operations 540 160 
Investment income 36 – 
Profit before tax 576 160 
Income tax expense (130) (26) 
Profit for the year 446 134 
Other comprehensive income 100 50 
Total comprehensive income 546 184 
1 At 31 December 20X9, goodwill arising on consolidation was 
reviewed for impairment. An im pairment loss of $15,000 had 
arisen which should be charged  to operating expenses. It is gro up 
policy to measure NCI at fair v alue at the date of acquisition.  
2 Zavier paid a dividend of $32,000 on 30 Nove mber 20X9. 
Required: 
Prepare the consolidated statem ent of profit or loss and other 
comprehensive income for the Zebedee group for the year ended 
31 December 20X9.

Chapter 12 
 315 
 Illustration 1 answer  
 Look out for mid-year acquisiti ons as the results of the subsi diary may 
need to be time apportioned. In this scenario, only 6 months of  the 
subsidiary's results should be consolidated as the subsidiary w as 
acquired half way through the year. 
Zebedee 
Consolidated statement of profit  or loss and other comprehensiv e 
income for the year ended 31 December 20X9 
 $000 
Revenue (1,260 + (5 20 × 6/12)) 1,520 
Cost of sales (420 + (210 × 6/12)) (525) 
 ––––– 
Gross profit 995 
Operating expenses ( 300 + (150 × 6/12) + 1 5 impairment) (390) 
 ––––– 
Profit from operations 605 
Investment income (36 – 24 (W1) ) 12 
 ––––– 
Profit before tax 617 
Income tax expense (130 + (26 × 6/12)) (143) 
 ––––– 
Profit for the year 474 
Other comprehensive income  (100 + (50 × 6/12)) 125 
 ––––– 
Total comprehensive income 599 
 ––––– 
Parent shareholders (bal ancing figure) 461 
Non-controlling interests (W2)  13 
 ––––– 
 474 
 ––––– 
Parent shareholders (bal ancing figure) 580 
Non-controlling interests (W2)  19 
 ––––– 
 599 
 –––––

316  
 Workings 
(W1)  Intra-group dividend/investment income 
Sub paid $32,000 
Parent received ( 75% × 32,000) $24,000 
Always look out for intra-group dividends in CSOPLOCI questions . 
Any dividend paid by the subsid iary will have partly been recei ved 
by the parent (depending on their per centage holding) and this 
needs to be eliminated from investment income upon consolidation. 
(W2)  NCI share of profit and total comprehensive income 
 
 $000 $000 
Sub's profit (134 × 6/12) 67  
Impairment expense (15)  
 –––  
 5 2   
NCI share of profits × 25%  13 
Sub's OCI (50 × 6/12) 25  
 –––  
 7 7   
NCI share of total comprehensive income × 25%  19 
For each consolidation adjustmen t, consider whether it affects the 
non-controlling interest. Here,  there is goodwill impairment an d, as 
the NCI is measured at fair v alue, the NCI's portion of the 
impairment charge should be allo cated against the NCI profit. 
By deducting the impairment expense from the subsidiary's profi t 
prior applying the NCI%, the NCI's  share of the impairment char ge 
is allocated to the NCI figure.

Chapter 12 
 317 
 Given below are the statement s of profit or loss and other 
comprehensive income for Paris and its subsidiary London for th e year 
ended 31 December 20X5. 
 Paris London 
 $000 $000 
Revenue 3,200 2,560 
Cost of sales (1,200) (1,080) 
Gross profit 2,000 1,480 
Operating expenses (560) (400) 
Profit from operat ions 1,440 1,080 
Investment income 160 – 
Profit before tax 1,600 1,080 
Income tax expense (400) (480) 
Profit for the year 1,200 600 
Other comprehensive income 300 100 
Total comprehensive income 1,500 700 
Paris acquired 80% of London’s equi ty shares on 1 October 20X5.  
1 Goodwill was calculated valui ng the NCI at fair value at the date of 
acquisition. At 31 December 20X 5, it was determined that goodwi ll 
arising on the acquisition had been impaired by $30,000. 
Impairments are charged  to operating expenses. 
2 London paid a dividend of $150,000 on 15 December 20X5. 
Required: 
Prepare a consolidated stateme nt of profit or loss and other 
comprehensive income for the year ended 31 December 20X5.

318  
3 Intra-group balances 
itself. 
• Intra-group transactions are e liminated from t he consolidated statement of 
profit or loss and other  comprehensive income 
adjustment). 
 
 P and S may sell goods to each other, resulting in a profit be ing 
recorded in the selling entity's  financial statements. If these  goods are 
still held by the purc hasing entity at the year-end, the goods have not 
been sold outside of the group. The profit is therefore unreali sed from 
the group's perspective and should be removed. 
group, not the cost to the purchas ing entity after the intra-gr oup 
transfer. 
In the consolidated statem ent of profit or loss: 
• Add to cost of sales (to reflec t reduction in closing inventor y and 
profit) 
• If S is the seller, adjust the NCI to reflect their share of t he PUP 
adjustment. 
NB. The total intragroup revenue and cost of sales will also be re moved 
from the consolidated SPL as a separate adjustment to the PUP. 
 
PUP adjustment in Consol SOPLOCI 
The PUP adjustment of 80 is  always added to cost of sales, rega rdless 
of which entity made the profit.

Chapter 12 
 319 
When calculating the split of p rofit between owners of the pare nt and 
NCI, the NCI share of profit would be adjusted for the PUP adju stment 
if the subsidiary was the seller only. 
 
two ways. 
 %  $   
 –––– ––––  
 –––– ––––  
 
 %  $   
 –––– ––––  
 –––– ––––  
The PUP is $110.

320  
 Below are the statements of pro fit or loss for Rome and its su bsidiary 
Madrid for the year  ended 30 June 20X9. 
 Rome Madrid 
 $000 $000 
Revenue 10,350 8,400 
Cost of sales (6,200) (5,150) 
Gross profit 4,150 3,250 
Operating expens es (2,450) (1,600) 
Profit before tax 1,700 1,650 
Income tax expense (550) (450) 
Profit for the year 1,150 1,200 
   
1 Rome acquired 60% of Madrid’s  equity shares on 1 July 20X7 
paying $6 million. At this date, th e value of Madrid’s net asse ts 
was $5 million. It is Rome’s g roup policy to value NCIs at 
acquisition using the proportionat e share of net assets method.  As 
at 30 June 20X9, it was determi ned that goodwill on acquisition  
had been impaired by 20%. No impairment loss had arisen 
previously. 
2 During the year ended 30 June 20X9, Rome sold $1 million of 
goods to Madrid at a margin o f 30%. Half of these goods 
remained in the inventory of M adrid at the reporting date. 
Required: 
(a) Prepare a consolidated state ment of profit or loss for the Rome 
Group for the year ended 30 June 20X9. 
(b) Assume now that Madrid had sold the goods to Rome instead 
(all other details remain the sa me). Prepare the analysis of pr ofit 
attributable to parent sharehol ders and NCI for the year ended 
30 June 20X9 in this situation.

Chapter 12 
 321 
profit is unrealised from the gr oup’s perspective and should be  
removed. 
– If P is seller, add back exce ss depreciation charged by S 

322  
when its carrying amount is $60,000 . The remaining useful life at the 
date of sale is 2.5 years. The group depreciation policy is str aight line 
on a monthly basis. 
Required: 
What adjustment is required in th e consolidated financial state ments of 
P for the year ended 31 August 20X8? 
Solution 
In the CSOPLOCI, the NCI calcula tion should incl ude an adjustme nt to 
Using the same example as abov e, but if S had sold the asset to  P, in 
the CSOPLOCI, the NCI calculati on would include an adjustment t o 
disposal of the intra-group transfer.  
4 Fair value adjustmen ts and the CSPLOCI 
To record depreciation adjus tments in the CSOPLOCI: 
• An adjustment should be made to  reflect the impact of the fair  value 
adjustment on the current y ear's depreciation charge. 
• As this depreciation charge relates to the subsidiary's assets , the 
adjustment should be reflected in  the calculation of profit att ributable to the 
NCI.

Chapter 12 
 323 
 Illustration 3 
 King purchased 80% of Lear’s equity  shares on 1 January 20X5 fo r 
It is group policy to measure the non-controlling interests at fair value 
at acquisition and the fair val ue of the non-controlling intere sts in Lear 
on 1 January 20X5 was $400,000. At this date Lear’s non-current  
assets had a fair value of $1m a nd the assets had a remaining u seful 
economic life of 5 years. Their carrying amount at the date of 
acquisition was $850,000. 
goodwill. 
Required: 
Explain the impact that the fair  value adjustment would have on  the 
consolidated statement of comp rehensive income for the year end ed 
31 December 20X7. 
 
 Illustration 3 answer  
 Impact in consolidated statement of profit or loss and other 
comprehensive income  
The fair value adjustment of $150, 000 results in an additional 
depreciation charge of $30,000 ( $150,000/5) each year in the 
consolidated financ ial statements. 
This adjustment should be added to t he relevant expense categor y 
and would also be deducted from  the subsidiary's profit when 
calculating the profi t attributable to the NCI.

324  
 P acquired 75% of the equity shar es of S on 1 December 20X8. B elow 
are their statements of profit or loss and other comprehensive income 
for the year ended 31 March 20X9: 
 P S 
 $  $  
Revenue 300,000 216,000 
Cost of sales and operating expenses (215,000) (153,000) 
Profit from operati ons 85,000 63,000 
Finance costs (16,000) (9,000) 
Profit before tax 69,000 54,000 
Taxation (21,600) (16,200) 
Profit for the year 47,400 37,800 
Other comprehensive income 25,000 3,000 
Total comprehensive income 72,400 40,800 
 
1 In the post-acquisition peri od P sold $50,000 of goods to S a t a 
margin of 20%. S held $10,000 of t hese goods in inventory at th e 
year end. 
2 A fair value adjustment of $150, 000 was recorded at acquisiti on to 
increase the value of S’s property, plant & equipment. These assets have a remaining useful  economic life of 5 years at 
acquisition. Depreciation is c harged to operating costs. 
3 Goodwill was reviewed for impai rment at the year end. It was 
determined that an impairment lo ss of $3,000 had arisen which i s 
to be charged to operating expens es. It is group policy to meas ure 
NCI at the proportionate share of  net assets at acquisition. 
Required: 
comprehensive income for t he year ended 31 March 20X9.

Chapter 12 
 325 
 Test your understanding 4  integration question  
 The following information relates to the next 4 questions  
On 1 July 20X4, Tudor purchased 80% of the shares in Windsor. T he 
summarised draft statement of p rofit or loss and other comprehe nsive 
income for each company for the year ended 31 March 20X5 was as  
follows: 
 Tudor Windsor 
 $000 $000 
Revenue 60,000 24,000 Cost of sales (42,000) (20,000) 
 
Gross profit 18,000 4,000 
Operating expens es (6,000) (200) 
Profit from operat ions 12,000 3,800 
Investment income 75 – 
Finance costs – (200) 
Profit before tax 12,075 3,600 
Taxation (3,000) (600) 
Profit for the year 9,075 3,000 
Other comprehensive income 1,500 500 
Total comprehensive income 10,575 3,500 
 
1 The fair values of Windsor’s a ssets at the date of acquisitio n were 
mostly equal to their carrying am ounts with the ex ception of pl ant, 
which was stated in the books at  $2 million but had a fair valu e of 
$5.2 million. The remaining useful  life of the plant in questio n was 
four years at the date of acquisi tion. Depreciation is charged to 
cost of sales and is time appor tioned on a monthly basis. 
2 In the post-acquisition period Tudor sold Windsor some goods for 
$12 million with a margin of 25% . By the year end Windsor had 
sold $10 million of these goods (a t cost to Windsor) to third 
parties. 
3 Tudor invested $1 million in Win dsor’s 10% loan notes on 1 Ju ly 
20X4. 
4 At 31 March 20X5, it was dete rmined that an impairment loss o f 
$100,000 had arisen in respect of goodwill. It is group policy to 
measure NCI at fair value at ac quisition. Impairment losses sho uld 
be charged to operat ing expenses. 
Required: 
comprehensive income for the Tudor Group for the year ended 31 
March 20X5.

326  
 1 P acquired 80% of the equity shares of S two years ago. At t he 
date of acquisition, the fair val ue of S's net assets was the s ame 
as the carrying amount with the ex ception of property, plant an d 
equipment, whose fair value was higher. Property, plant and equipment had an estimated useful  life of 5 years from the date  of 
P purchased goods from S during  the year and 50% of the items 
remain in P's inventories at the year end. S earns a 20% mark-u p 
on all sales. 
Goodwill impairment arose in t he current year. It is group poli cy to 
measure NCI at the proporti onate share of net assets. 
S paid a dividend of $200,000 two m onths before the year end. 
Which of the following adjust ments would be taken into 
account when calculating the pr ofit attributable to the non-
controlling interest in the conso lidated statement of profit or  
loss of the P group for the year ended 31 August 20X6? 
A Provision for unrealised profit 
B Depreciation arising from the fair value adjustment C Goodwill impairment D Elimination of intra-g roup dividends received 
Data for Questions (2) to (4) 
Hard acquired 75% of the ordinar y share capital of Work on 1 Ap ril 20X8. 
The summarised statement of profit or loss for the year-ended 3 1 March 
20X9 is as follows: 
 Hard Work 
 $ m  $ m  
Revenue 120 48 
Cost of sales (84) (40) 
 –– –– 
Gross profit 36 8 Distribution costs (5) (0.1) 
Administration expenses (7) (0.3) 
 
–– ––– 
Profit from operations 24 7.6 
Investment income 0.15 – 
Finance costs – (0.4) 
 ––– ––– 
Profit before tax 24.15 7.2 Tax (6) (1.2) 
 
––– ––– 
Profit for the year 18.15 6

Chapter 12 
 327 
During the year, Work sold goods too Hard for $24m, which had o riginally 
cost $18m. By the year-end, Hard had sold $20m (at cost to Hard ) of 
these goods to third parties. 
Goodwill impairment of $600,000 needs  to be recorded for the cu rrent 
year and treated as an adm inistration expense.  
NCI is calculated using  the fair value method. 
2 The PUP adjustment for the year-ended 31 March 20X9 is: 
A $1m B $2m C $5m D $6m 
3 What is the amount of profit attributable to the NCI for the y ear-
ended 31 March 20X9? 
A $1.1m 
B $1.5m C $1.25m D $1.35m  
4 What is the total amount for revenue and cost of sales to be 
shown in the consolidated statement of profit or loss for the 
year-ended 31 March 20X9? 
 Revenue Cost of sales 
A $144m $100m 
B $168m $124m C $192m $148m D $144m $101m

328  

Chapter 12 
 329 
 Consolidated statement of profit  or loss and other comprehensiv e 
income 
 $000 
Revenue (3,200 + (2 ,560 × 3/12)) 3,840 
Cost of sales (1,200 + (1,080 × 3/12)) (1,470) 
 –––––– 
Gross profit 2,370 
Operating expenses (560 + ( 400 × 3/12) + 30 imp) (690) 
 –––––– 
Profit from operations 1,680 
Investment income (160 – 120 (W1) ) 40 
 –––––– 
Profit before tax 1,720 
Income tax expense (400 + (480 × 3/12)) (520) 
 –––––– 
Profit for the year 1,200 
Other comprehensive income  (300 + (100 × 3/12)) 325 
 –––––– 
Total comprehensive income 1,525 
 –––––– 
Parent shareholders (bal ancing figure) 1,176 
Non-controlling interests (W2)  24 
 –––––– 
 1,200 
 –––––– 
Parent shareholders (bal ancing figure) 1,496 
Non-controlling interests (W2)  29 
 –––––– 
 1,525 
 –––––– 
Workings 
(W1) Intercompany dividend 
Sub paid $150,000 
Parent received (80%  × $150,000) = $120,000

330  
 (W2)  NCI share of profit and total comprehensive income 
 
 $000 $000 
Sub's profit (600 × 3/12) 150  
Impairment expense (30)  
 ––––  
 120  
NCI share of profit × 20%  24 
Sub's OCI (100 × 3/12) 25  
 ––––  
 145  
NCI share of TCI × 20%  29 
   
 (a) Consolidated statement of profit or loss 
 $ 0 0 0  
Revenue (10,350 + 8,400 – 1,000 (W2) ) 17,750 
Cost of sales (6,200 + 5,150 – 1,000 (W2)  + 150 (W2) ) (10,500) 
 –––––– 
Gross profit 7,250 
Operating expenses  (2,450 + 1,600 + 600 (W1) ) (4,650) 
 –––––– 
Profit before tax 2,600 
Income tax expense (550 + 450) (1,000) 
 –––––– 
Profit for the year 1,600 
 –––––– 
Parent shareholders (balancing figure) 1,120 Non-controlling interests (1,200 × 40%) 480 
 
–––––– 
 1,600 
 –––––– 
 
NB. Impairment is not deducted in the NCI working as the NCI has 
been valued using the proportionat e method. The PUP adjustment 
is also not deducted, as t he parent made the profit. 
Workings 
(W1) Goodwill and impairment  
 $000 
Fair value of P's investment 6,000 NCI at proportionate share of net assets (40% × 
5,000) 2,000 
Fair value of sub's net assets at acquisition (5,000) 
 
––––– 
Goodwill at acquisition 3,000 
 ––––– 
Impairment (20% × 3,000) 600 
 –––––

Chapter 12 
 331 
 (W2)  Intercompany sales and PUP 
Intercompany sales of $1, 000,000 to be eliminated by 
reducing both revenue and cost of sales 
PUP adjustment to increase cost of sales: 
Goods in inventory = 1/2 × $1,000 ,000 = $500,000 
Profit in inventory = 30 % × $500,000 = $150,000 
(b) Analysis of profit attributable  to parent shareholders and NCI 
Profit attributable to: 
 
Parent shareholders (bal ancing figure) 1,180 
Non-controlling interests ((1,200 – 150) × 40%) 420 
 –––––– 
 1,600 
 –––––– 
 
As the subsidiary made the unrea lised profit, the PUP adjustmen t 
is deducted from the subsidiary's  profit prior to applying the NCI%. 
 
income for the year ended 31 March 20X9 
 $  
Revenue (300,000 + (4 /12 × 216,000) – 50,000 (W2) ) 322,000 
Cost of sales and operating ex penses (215,000 + (4/12 
× 153,000) – 50,000 (W2)  + 2,000 (W2)  + 10,000 (W3) + 
3,000 imp)  
 
(231,000) 
 ––––––– 
Profit from operations 91,000 
Finance costs (16,000 + ( 4/12 × 9,000)) (19,000) 
 ––––––– 
Profit before tax 72,000 
Taxation (21,600 + (4/ 12 × 16,200)) (27,000) 
 ––––––– 
Profit for the year 45,000 
Other comprehensive income (25, 000 + (4/12 × 3,000)) 26,000 
 ––––––– 
Total comprehensive income 71,000 
 ––––––– 
Parent shareholders (bal ancing figure) 44,350 
Non-controlling interests (W4)  650 
 ––––––– 
 45,000 
 –––––––

332  
 Total comprehensive income attributable to:  
Parent shareholders (bal ancing figure) 70,100 
Non-controlling interests (W4)  900 
 ––––––– 
 71,000 
 ––––––– 
Workings 
P 
  
75%   
 1 December 20X8 
i.e. 4 months since acquisition  
  
S 
(W2)  Intercompany sales and PUP  
Intercompany sales of $50,000 to  be eliminated by reducing both  
revenue and cost of sales 
PUP adjustment to increase cost of sales: Profit in inventory = 20% × $10,000 = $2,000 
(W3) Depreciation adjustment  
Fair value adjustment = $150,000 
Depreciation adjustment = 1 /5 × 4/12 × $150,000 = $10,000 
(W4)  NCI share of profit and total comprehensive income 
 
 $  $  
Sub's profit for the year per S’s SCI (4/12 × 37,800)  
12,600  
Depreciation adjustment (W3)  (10,000)  
 ––––––  
 2,600  
NCI share of profits × 25%  650 Sub's other comprehensive income per S's SCI 
(4/12 × 3,000)  
1,000  
 
––––––  
 3,600  
NCI share of total comprehensive income × 25%  900

Chapter 12 
 333 
income for the year ended 31 March 20X5 
 $000 
Revenue (60,000 + (9/ 12 × 24,000) – 12,000 (W2) ) 66,000 
Cost of sales (42,000 + (9 /12 × 20,000) – 12,000 (W2) + 
500 (W2)  + 600 (W3) )  
(46,100) 
 ––––––– 
Gross profit 19,900 
Operating expenses (6,000 + (9 /12 × 200) + 100 imp) (6,250) 
 ––––––– 
Profit from operations 13,650 
Investment income (75 – 75 (W4) ) – 
Finance costs (( 9/12 × 200) – 75 (W4) ) (75) 
 ––––––– 
Profit before tax 13,575 
Taxation (3,000 + (9 /12 × 600)) (3,450) 
 ––––––– 
Profit for the year 10,125 
Other comprehensive income ( 1,500 + (9/12 × 500)) 1,875 
 ––––––– 
Total comprehensive income 12,000 
 ––––––– 
Parent shareholders (bal ancing figure) 9,815 
Non-controlling interests (W5)  310 
 ––––––– 
 10,125 
 ––––––– 
Parent shareholders (bal ancing figure) 11,615 
Non-controlling interests (W5)  385 
 ––––––– 
 12,000 
 –––––––

334  
 Workings 
Tudor 
  
80%   
 1 July 20X4 i.e. 9 months 
since acquisition  
  
Windsor 
(W2)  Intercompany sales and PUP 
Intercompany sales of $12,000,00 0 to be eliminated by reducing 
both revenue and cost of sales 
PUP adjustment to increase cost of sales: Goods in inventory = 12m – 10m = $2,000,000 
Profit in inventory = 25% × $2,000,000 = $500,000 
Fair value adjustment = $5.2m – $2m = $3.2m 
Depreciation adjustment = 1 /4 × 9/12 × $3. 2m = $600,000 
(W4) Intercompany interest  
Windsor paid interest to Tudor =  10% × $1 m × 9/12 = $75,000 
(W5) NCI share of profit and total comprehensive income  
 $000 $000 
Sub's profit for the year per  S's SCI (9/12 × 3,000) 2,250  
Depreciation adjustment (W3)  (600)  
Impairment (fair value method) (100)  
 
––––––  
 1,550  
NCI share of profits × 20%  310 Sub's other comprehensive income per S's SCI 
(9/12 × 500)  
375  
 
––––––  
 1,925  
NCI share of total comprehensive income × 20%  385

Chapter 12 
 335 
 1  Adjustments would be made for A and B. 
C would not be adjusted as NCI is measured using the 
proportionate share of net asse ts and therefor e all goodwill 
impairment should be charged  to the parent shareholders. 
D is not adjusted as it is elim inated from the parent's investm ent 
income and has no impact on the subsidiary's profit.

337 
Associates and 
Joint arrangements 
reporting standards for 
group accounts (a) Explain the financial
reporting standards forthe key areas of groupaccounts.
based on IFRS Prepare the following based on financial reporting standards: 
(a) Consolidated statement
of financial position
(b) Consolidated statement
of profit or loss and othercomprehensive incomeChapter 
13

Group accounts – Associates and joint arrangements 
338  
 
A group will always include one enti ty over which the parent ha s control (the 
subsidiary).The group could also  include further investments in  other entities 
which, whilst not creating cont rol in the entity, still provide  the parent with a 
greater level of impact upon the investee than shareholdings cl assified as 
In this chapter, we will consider  the impact to the group accou nts of investments 
in: 
• Associates 
• Jointly controlled entit ies (joint arrangements) 
These investments are designated  their own elevated status with in the group 
accounts and have specific account ing standards outlining their  accounting 
treatments. It is important to understand the theoretical conce pts behind their 
accounting treatments as well as the quantifiable treatment of each within the 
group financial statements. 
3 Investments in Associates 
'An associate  is 'an entity over which the investor has significant 
influence' (IAS 28, para 3) and wh ich is neither a subsidiary nor a joint venture 
of the investor. 
 
 Associates – further detail 
 Significant influence  is defined as 'the power to participate in the 
financial and operating policy d ecisions of the investee but no t 
control or joint contro l of those policies' (IAS 28, para 3). 
'A holding of 20% or more of t he voting power is presumed to gi ve 
significant influence unless i t can be clearly demonstrated tha t this is not 
the case. At the same time, a hol ding of less than 20% is assum ed not to 
give significant influence unle ss such influence can be clearly  
demonstrated'.

Chapter 13 
 339 
IAS 28 explains that an investor  probably has significant influ ence if: 
• 'It is represented on the board of directors.  
• It participates in policy-m aking processes, including decisions  
about dividends or other distributions.  
• There are material transactions between the investor and 
investee.  
• There is interchange of managerial personnel. 
• There is provision of essential technical information'  (IAS 28, 
para 6). 
Associates are accounted for using equity accounting  in accordance with 
IAS 28. 
They are not consolidated as the parent does not have control. 
Consolidated statement o f financial position  
The CSFP will include a single li ne within non-current assets c alled 'Investment 
in associate' calculated as: 
Investment in associate 
 $  
Cost of investment X 
Add: share of post-acquisition reserves X Less: impairment losses (X) Less: PUP (if A has inv entory – see later) (X) 
 
––– 
 X  
 ––– 
The share of post-acquisition reserves, impairment losses and P UP would also 
be recorded in Consolidat ed retained earnings. 
The CSOPLOCI will include a single  line before profit before ta x called 'Share of 
profit of associate' calculated as: 
Share of associate's profit for the year X 
Less: impairment loss (X) 
Less: PUP (if A is seller – see later) (X) 
 ––– 
 X  
 ––– 
If the associate has other compr ehensive income, the investor’s  share will also 
be recorded in the other  comprehensive income section of CSOPLO CI.

340  
 IAS 28 Investments in Associ ates and Joint Ventures 
 The equity method of accounting is normally used to account fo r 
associates and joint ventures in  the consolidated financial sta tements. 
The equity method should not be used if: 
• the investment is classified as held for sale in accordance wi th 
IFRS 5, or 
• the parent is exempted from hav ing to prepare consolidated 
accounts on the grounds that it is itself a wholly, or partiall y, owned 
subsidiary of another company (IFRS 10). 
4 Consolidation adjustments 
 Adjustments required 
 Inter-group transactions & balances 
Inter-group transactions (receivabl es, payables, sales and purc hases) 
between the group (whether with t he parent or subsidiary) and t he 
associate are not eliminated withi n the CSOPLOCI or CSFP. This is 
because the associate is outside of the group. The transactions /balances 
are with a third party to the group and so may be reported with in the 
group financial statements. The a ssociate is not 100% consolida ted 
therefore no elimination of i nter group transactions is needed.  
However, unrealised profit  on transactions must be eliminated  on 
consolidation as the group take s a share of the transaction. 
Provisions for unrealised profit (PUP)  
IAS 28 requires unrea lised profits on trans actions between the group and 
the associate to be eliminated . Only the investor’s share of th e profit is 
removed since the group financia l statements only reflect the i nvestor’s 
share of the associate pr ofits in the first place. 
Associates PUP adjustment =  P% × profit in inventory 
Parent sells to associate 
In the CSFP: 
• Reduce consolidated re tained earnings (Dr) 
• Reduce investment in associate (Cr) 
When the parent sells to the associ ate the profit must be elimi nated from 
the investment in the associate because the inventory is in the  books of 
the associate. The associates' inventory is not consolidated so  we cannot 
remove the profit from the inventory line on the CSFP.

Chapter 13 
 341 
In the CSOPLOCI: 
• Increase cost of sales 
Associate sells to parent 
• Reduce inventory (Cr) 
When the associate sells to the parent the profit must be elimi nated from 
the inventory. The parents' invent ory is consolidated which inc ludes the 
inventory purchased from the asso ciate. The profit is removed f rom the 
inventory line on the CSFP. 
• Reduce share of profit of associate 
 
 Associate PUP with parent the seller 
 P owns 40% of the equity shares of A. 
P has sold $200,000 of goods to A a t a mark-up on cost of 25%. 
At the reporting date, 60% of thes e items remain in A's invento ry. 
The intercompany sale of $200,000 is not eliminated in the cons olidated 
financial statements. However. a P UP adjustment is calculated a s: 
Goods in inventory 60%  × $200,000 = $120,000 
Profit in inventory 25/125 × $120,000 = $24,000 
PUP 40% × $24,000 = $9,600 
The adjustment will be: 
Dr Cost of sales $9,600 Cr Investment in associate $9,600 
In the CSPLOCI, cost of sales will increase. In the CSFP, retained earnings wi ll, therefore, be reduced. The  
investment in associat e will also be reduced. 
The associate is holding the inv entory, but the associate’s inv entory is not 
consolidated on the inventory line in the CSFP and so it is not  appropriate 
to reduce inventory.

342  
 PUP with associate the seller 
 Using the same information as above but with the associate sel ling to the 
parent, the adjustment will now be: 
Dr Income from associate $9,600 Cr Inventory $9,600 
In the CSOPLOCI, share of profi t of associate will reduce. 
In the CSFP, retained earnings wi ll therefore be reduced. Inven tory will 
also be reduced as it is the par ent company holding the invento ry. 
 
 Below are the statements of fi nancial position of three entiti es as at 
 Tom James Emily 
 $000 $000 $000 Non-current assets    
Property, plant & equi pment 959 980 840 
Investments: 630,000 shares in James 805 – – 
168,000 shares in Emily 224 – – 
 
––––– ––––– ––––– 
 1,988 980 840 
Current assets    
Inventory 380 640 190 
Receivables 190 310 100 
Cash and cash equivalents 35 58 46 
 ––––– ––––– ––––– 
TOTAL ASSETS 2,593 1,988 1,176 
Equity    
Share capital ($1 s hares) 1,120 840 560 
Retained earnings 1,232 602 448 
 2,352 1,442 1,008 
Current liabilities    
Trade payables 150 480 136 
Taxation 91 66 32 
TOTAL EQUITY & LIABI LITIES 2,593 1,988 1,176 
Additional information: 
1 Tom acquired its shares in James on 1 January 20X9, when Jame s 
had retained earnings of $160,000. NCIs are to be valued at the ir 
fair value at the date of acqui sition. The fair value of the NC I holding 
in James at 1 January 20X9 was $250,000.

Chapter 13 
 343 
2 Tom acquired its shares in Em ily on 1 January  20X9 when Emily  
had retained earnings of $140,000. 
3 An impairment test at the y ear-end shows that the goodwill fo r 
James remains unimpaired but t hat the investment in Emily is 
impaired by $2,000. 
Required: 
Prepare the consolidated statemen t of financial position for th e year 
ended 31 December 20X9. 
 
 Consolidated statement of financ ial position as at 31 December 
20X9 
 $000 
Goodwill (W3)  55 
Property, plant & equipment (959 + 980) 1,939 
Investment in associate (W6)  314.4 
 ––––––– 
 2,308.4 
Current assets  
Inventory (380 + 640) 1,020 Receivables (190 + 310) 500 
Cash and cash equiva lents (35 + 58) 93 
 
––––––– 
TOTAL ASSETS 3,921.4 
 ––––––– 
Equity  
Share capital ($1 shares) 1,120 Retained earnings (W5)  1,653.9 
 
––––––– 
 2,773.9 
Non-controlling interest (W4)  360.5 
 ––––––– 
 3,134.4 
Trade payables (150 + 480) 630 
Taxation (91 + 66) 157 
 ––––––– 
TOTAL EQUITY & L IABILITIES 3,921.4 
 –––––––

344  
 Workings 
  T o m    
 630/840   168/560  = 75%   = 30% 1 Jan X9 (1 year)    1 Jan X9 (1 year) 
  James  Emily 
(W2) Net assets of sub  
date 
 $000  $000 
Share capital 
($1 shares)  
840   
840 
Retained earnings 160  602 
 
 1,000  1,442 
  Post-acquisition 
profits = 442  
 $000 
Fair value of parent's investment 805 NCI at fair value 250 
 
–––––– 
Goodwill at acquisition/reporting date 55 
 ––––––

Chapter 13 
 345 
 (W4) Non-controlling interests  
 $000 
NCI at acquisition at fair value (W3)  250 
NCI% of post-acquisition reserves (25% × 442 (W2) ) 110.5 
 ––––– 
 360.5 
 ––––– 
  
(W5) Group retained earnings  
 $000 
P's retained earnings 1,232 S: 75% of post-acquisition profits  
(75% × 442 (W2) ) 331.5 
A: 30% of post-acquisition profits (W6)  92.4 
A: impairment (W6)  ( 2 )  
 
–––––– 
 1,653.9 
 –––––– 
  
(W6)  Investment in associate  
 $000 
Cost of investment 224 
P% × post acquisition profit s (30% × (448 – 140)) 92.4 
Less: impairment (2) 
 ––––– 
 314.4 
 ––––– 
In the question, the investment i n Emily is included in Tom’s S FP at its 
cost of $224,000. The investmen t was made at the start of the y ear. 
This becomes the starting point  for equity accounting i.e. the starting 
point for the calculation o f investment in associate. 
At acquisition the retained earni ngs of Emily were $140,000 and  at the 
reporting date they are $448,000. T herefore the post-acquisitio n reserves 
of Emily are $308,000 of which 30% belong to Tom i.e. $92,400. This 
increases both the value of inv estment in associate and retaine d 
earnings. 
At the reporting date, the invest ment is impaired by $2,000. Th is is a 
reduction in the value of the Inve stment and is an expense and so also 
reduces retained earnings.

346
P acquired 80% of the 1 million is sued $1 ordinary shares of S  on 
1 October 20X3 for $1.5 million. S's retained earnings were $35 0,000 at 
this date. 
P acquired 30% of the 500,000 iss ued $1 ordinary shares of A on 
1 October 20X7 for $300,000 when A' s retained earnings were $36 0,000. 
The retained earnings reported in the financial statements of P , S and A 
as at 30 September 20X8 were  $2 million, $750,000 and $400,000 
respectively. An impairment review performed on 30 September 20X8 indicated t hat 
there was no impairment to the goodwill arising on  the acquisit ion of S, 
however the investment in A was impaired by $5,000. 
Required: 
Calculate the amounts that woul d appear in the c onsolidated sta tement of 
financial position for the P gr oup as at 30 September 20X8 for:  
(a) Investment in associate
(b) Consolidated retained earnings.
5 IFRS 11 Joint Arrangements 
IFRS 11 Joint Arrangements defines two types of arran gement in which there is 
joint control – a joint venture  and a joint operation – and sets out the accounting 
treatment of each. 
A joint arrangement  is 'an arrangement of which two or more parties 
have joint control' (IFRS 11, para 4). 
Joint control  is 'the contractually agreed sharing of control of an 
arrangement, which exists only when decisions about the relevant 
activities require the unanimous  consent of the parties sharing  control' 
(IFRS 11, para 7). 
A joint venture  is a 'joint arrangement whereby the parties that have 
joint control of the arrangement  have rights to the net assets o f the 
arrangement'  (IFRS 11, para 16). 
Joint ventures are accounted for using the equity method of acc ounting in 
accordance with IAS 28 Investments in Associates and Joint Vent ures. 
Therefore, a joint venture is accounted for in the same way as an associate.

Chapter 13 
347 
Joint operations 
 A  joint operation  is a "joint arrangement whereby the parties that 
have joint control of the arra ngement have rights to the assets , and 
obligations for the liabilities, relating to the arrangement"  (IFRS 11, 
para 15). 
Under IFRS 11, a joint arrangemen t will either be a joint venture or a joint 
operation. A joint operation wi ll exist where the arrangement i s not 
structured through a separate vehicle. 
A joint operator would account fo r its share of the assets, lia bilities, 
revenues and expenses relating to  its involvement with the join t operation 
in accordance with the relevant IFRSs. 
6  IAS 27 Separate Financial Statements 
IAS 27 Separ ate financial statements outlines  how parent companies should 
account for their investments in subsidiaries , associates and joint ventures  
within the individual financia l statements of the parent. 
The standard outline that they are acc ounted for either: 
When an entity prepares separate financial statements, investments in 
subsidiaries, associates, and jointly controlled entities are accounted for either:  
• at cost, or
• in accordance with IFRS 9 Financial Instruments , or
• using the equity method as described in IAS 28 Investments in Associates.
Test your understanding 2 (further OTQs) 
 1 A joint _________ is where the parties that have joint cont rol of the 
arrangement have rights to the ne t assets of the arrangement. 
A joint _________ is w
here the parti es that have joint control of the 
arrangement have rights to the a ssets, and obligations for the 
liabilities, relating to the arrangement. 
arrangement, control, operation, venture 
 2 The P group (compris ing P and its subsidia ries) acquired 30%  of the 
equity share capital of A on 1  October 20X6, paying $750,000 in  
cash. This enabled P to exercise si gnificant influence over the  
operating and financial policies of A. The balance on A's retai ned 
earnings at this date was $1,500,000.  
During the current year, A sold goods to P for $800,000 at a margin 
of 25%. P still held one quarter of the goods in inventory at 
30 September 20X8.

348
At 30 September 20X8, an impairm ent review was carried out and it 
was determined that the investment in A was impaired by $35,000 . 
A's retained earnings at 30 S eptember 20X8 wa s $2,500,000. 
statement of financial position of the P group as at 
30 November 20X7 for th e investment in A. 
3 The P group (compris ing P and its subsidia ries) acquired 30% of the 
equity share capital of A on 1 Oc tober 20X6, enabling P to exer cise 
significant influence over the operating and financial policies  of A. 
A made a profit for the year ended 30 June 20X7 of $600,000. 
Profits are deemed to accr ue evenly over the year. 
Between 1 October 20X6 and the r eporting date, A sold goods to P 
for $600,000 at a margin of 20%. P still held one quarter of th ese 
goods in inventory at 30 June 20X7. 
At 30 June 20X7, an impairment r eview was carried out and it was 
determined that the investment i n A was impaired by $20,000. 
statement of profit or loss of t he P group for the year ended 
30 June 20X7 in respect of the investment in A. 
4 Which of the following are likely to be accounted for as an 
associate in the consolidated f inancial statements of TN? 
(i) A 25% shareholding in ZT. TN can appoint a director to the
board. There are 4 directors on the board in total, and none
have control.
(ii) A 25% shareholding in ZU. Z U is 70% owned by a company
called TU.
(iii) A 25% shareholding in ZV. T N also has an arrangement with
other shareholders allowing TN access to 55% of the votingrights in TN.
A (i) only
B (i) and (ii)C (ii) and (iii)D All three

Chapter 13 
349 
5 B bought 30% of A on 1 July 20X 4. A's statement of profit or loss for 
the year shows a profit of $400, 000. A paid a dividend to B of 
$50,000 on 1 December. At the year  end, the investment in A was  
judged to have been im paired by $10,000. 
What will be shown under 'Share o f profit from associate' in th e 
consolidated statement or profit or loss for the year ended 
31 December 20X4? 
A Nil 
B $50,000 C $60,000 D $110,000 
6 Which TWO of the following issu es would require adjustment 
in a consolidated stateme nt of financial position?  
A A balance owed from the parent to the associate 
B Cash in transit from the associate to the parent C Unrealised profit relating to  goods sold from the associate t o 
the parent 
D The value of the associate is  impaired at the end of the year

350
7 Chapter summary

Chapter 13 
 351 
 ( a )  Investment in associate  
 $ 0 0 0  
Cost of investment 300 P% × post-acquisition prof its (30% × (400 – 360)) 12 
Less: impairment (5) 
 
–––––– 
 3 0 7  
 –––––– 
(b) Consolidated retained earnings  
 $000 
P's retained earnings 2,000 S: 80% × (750 – 350) 320 A: 30% × (400 – 360) 12 
A: impairment (5) 
 
–––––– 
 2,327 
 ––––––

352  
 Test your understanding 2 (further OTQs) 
 1 A joint venture  is where the parties tha t have joint control of the 
A joint operation  is where the parties that have joint control of the 
2 Investment in associat e (A) = $1,015,000  
 $  
Cost of investment 750,000 
Share of post-acquisition profits (30% × (2,500–
1,500)) 300,000 
Less: impairment (35,000) 
 –––––––– 
 1,015,000 
 –––––––– 
The unrealised profit is not deduc ted from the investment in 
associate as the inventory is held by the parent at the year-en d 
(it would be deducted from g roup inventory instead). 
3 Share of associate profit = $106,000  
 $  
Profit of A in the post-acquisition period 
(600,000 × 9/12)   
450,000 
Unrealised profit (600,000 × 20% × 1/4) (30,000) 
 ––––––– 
 420,000 
P group share × 30% 
 ––––––– 
 126,000 
Less: impairment (20,000) 
 ––––––– 
 106,000 
 4 A  
 Item (ii) is likely to be r egarded as a financial asset, as TN  has no 
significant influence. Item (iii) i s likely to be classed as a subsidiary, 
as TN are able to exercise control.

Chapter 13 
 353 
 5 B 
Share of profit of associate = $50,000  (30% ×($400,000 × 6/12) – $10,000) The dividend would no t have been in A’s statement of profit or loss 
(they are paid out of retained earnings), so no adjustment for this 
would be made to the associates share of profit.  
The share of associates’ prof it needs to be time-apportioned fo r the 
six months of ownership, with the $10,000 impairment then deducted. 
6 C and D  
 Inter-group balances between t he parent and associate are not 
adjusted, whether there are item s in transit or not. Unrealised  profits 
and impairments are items that m ust be adjusted in the consolid ated 
statement of financial position.

355 
Consolidated statement 
of changes in equity 
reporting standards for group accounts (a)  Explain the financial 
reporting standards for the key areas of group accounts. 
(c)  Consolidated statement 
 
  Chapter 
14

Consolidated statement of changes in equity 
356  
 
 2 Consolidated statement of ch anges in equity – the basics 
The statement of changes in equity e xplains the movement in the  equity section 
of the statement of financial pos ition from the previous report ing date to the 
current reporting date. 
From a group perspective, the eq uity of the group belongs partl y to the parent 
shareholders and partly to the NC I shareholders. A consolidated  statement of 
changes in equity (CSOCIE) will t herefore be made up of two col umns 
reflecting: 
• The changes in equity attribut able to parent shareholders, mad e up of 
share capital, share premium , retained earnings  and any other r eserves 
• The changes in equity attribut able to NCI shareholders. 
NB. In practice the CSOCE will hav e a total column. This is not  included in the 
examples within this chapter. 
The basic CSOCIE pro -forma is as follows: 
 
 Parent shareholders NCI shareholders 
 $000 $000 
Equity brought forward (b/f) X X 
Comprehensive income X X 
Dividends   
P's dividend (X)  NCI% × S's dividend  (X) 
 
–––– –––– 
Equity carried forward (c/f) X X 
 –––– ––––

Chapter 14 
 357 
Equity b/f 
Parent shareholders 
This is made up of the share capi tal, share premium, retained e arnings and any 
other reserves as report ed in last year’s CSFP. 
Share capital and share premiu m is that of the parent company o nly. The 
retained earnings and other res erves are cons olidated and will need to be 
calculated using a working (the group reserves working). 
Therefore, to calculate conso lidated equity attributable to the  parent 
shareholders b/f, the same forma t can be used as for group rese rves but 
starting with the parent’s equity  rather than just the parent’s  reserves. By doing 
this, the parent's share capital and premium will also be inclu ded. Remember, 
we're calculating the position at the start of t he year so only  use the subsidiary’s 
post acquisition reserves  up to the b/f date. 
NCI shareholders 
This is the NCI figure that woul d have been reflected in last y ear's CSFP and 
can be calculated using the typi cal NCI working. Remember to us e only post-
acquisition reserves up to the b/f date. 
Comprehensive income 
These figures come from the foot  of the consolid ated statement of profit or loss 
and other comprehensive income (C SPLOCI) where the total compre hensive 
income of the group is split between the parent and NCI shareho lders. You will 
need to demonstrate your knowledge of this statement to calcula te the 
consolidated figures for in clusion in the CSOCIE. 
Dividends 
The CSOCIE reflects the divid ends which are being paid outside of the group, 
i.e. the parent company’s divide nd and the share of the subsidi ary’s dividend 
paid to non-controlling interest shareholders. 
Note that the share of the subsid iary’s dividend that has been paid to the parent 
company will have been eliminated  in the group accounts as it i s an intra-group 
Equity c/f 
Similar to the balances b/f, the equity c/f figures can be calc ulated using a 
working similar to group reserv es but remembering to include th e parent’s share 
capital and share premium balanc es as well as their retained ea rnings/other 
reserves. In other words the work ing will start with the parent ’s equity c/f (rather 
than just its reserves). 
When including the subsidiary, post-acquisition reserves up to the c/f date 
(i.e. reporting date) will be used. 
This is the NCI figure as calcula ted for a CSFP using the stand ard NCI reserve 
working.

358  
 The following are the statem ents of changes in equity for Fulh am and 
Putney for the year ended 31 March 20X7: 
 
 Fulham Putney 
 $  $  
Equity b/f 132,500 60,000 
Comprehensive income 85,500 21,000 
Dividends (10,000) (6,000) 
 ––––––– –––––– 
Equity c/f 208,000 75,000 
Fulham acquired 80% of Putney’s equity shares on 1 April 20X4 w hen 
Putney’s net assets had a fair  value of $35,000. No fair value 
adjustments were required at ac quisition. It is Fulham’s group policy to 
record NCIs at fair value at a cquisition. The NCI holding in Pu tney had a 
fair value of $7,500 at t he date of acquisition. 
Required 
Prepare the consolidated statement of changes in equity for the  year 
ended 31 March 20X7. 
 
 Consolidated statement of chang es in equity for the Fulham grou p 
for the year ended 31 March 20X7 
 
 Parent 
shareholders NCI shareholders 
 $  $  
Equity b/f 152,500 12,500 Comprehensive income 97,500 4,200 
Dividends   
P's dividend (10,000)  NCI% × S's dividend  (1,200) 
 
––––––– –––––– 
Equity c/f 240,000 15,500 
 ––––––– ––––––

Chapter 14 
 359 
 Workings 
Equity attributable to pare nt shareholders b/f and c/f 
Equity b/f and c/f attributable to the parent shareholders can be 
calculated using the format of  the group reserves working but s tarting 
with the parent's equi ty rather than simply the parent's reserv es. This 
ensures that other elements of e quity such as share capital and  share 
premium are also included: 
 B/f C/f (i.e. reporting 
date) 
 $  $  
Parent's equity 132,500 208,000 
Sub: P% × post acquisition reserves  
(80% × (60,000 – 35,000)) 20,000  (80% × (75,000 – 35,000))  32,000 
 
 152,500 240,000 
The post-acquisition reserves are  calculated by comparing the n et assets 
at the start/end of the year ( depending on whether we're calcul ating 
equity b/f or c/f) and their val ue at the date of acquisition. It is important to 
remember that net assets equal equity – so the net assets figur es at the 
start and end of the year can be picked up from the individual entity 
SOCIEs provided in the question. 
NCI b/f and c/f 
The NCI share of equity c/f is  the figure that  would be present ed on the 
face of the consolidated state ment of financial position. To ca lculate the 
b/f figure produce a similar work ing but based on opening rathe r than 
closing figures where necessary. 
date) 
 $  $  
Fair value of NCI at acqn 7,500 7,500 
NCI% × post acquisition reserves   
(20% × (60,000 – 35,000)) 5,000  (20% × (75,000 – 35,000))  8,000 
 
 12,500 15,500 

360  
 Total comprehensive income figures 
The foot of the consolidated st atement of profit or loss and ot her 
comprehensive income should now be replicated in order to calcu late the 
split of total comprehensive inco me between the parent and NCI 
shareholders. It is important to  remember that the total compre hensive 
income of the group will be 100% o f the parent plus 100% of the  
subsidiary (subject to time appor tionment) plus/minus any conso lidation 
adjustments. 
Since the subsidiary has paid a dividend, the intra-group eleme nt of this 
will have been eliminat ed on consolidation. 
 $  
P and S comprehensive income  (85,500 + 21,000) 106,500 
Less elimination of inter-co dividend (80% × 6,000) (4,800) 
 ––––––– 
 101,700 
 ––––––– 
Parent shareholders (bal ancing figure) 97,500 
Non-controlling interest s (20% × 21,000) 4,200 
 ––––––– 
 101,700 
 ––––––– 
  
 Rather than calculating the co mprehensive income attributable to P's 
shareholders as a balancing figure , an alternative working is a s follows: 
 
 $  
P comprehensive income 85,500 
Ps share of sub comprehensive income (80% × 21,000) 16,800 
 –––––– 
 97,500 
 –––––– 
This method may be slightly qui cker. Calculate the NCI share of  
comprehensive income first, and then add the remaining parent’s  share 
of the subsidiary's comprehensive income to 100% of the parent' s 
Finally, the dividend figures can be calculated on the face of the CSOCIE 
pro-forma.

Chapter 14 
 361 
 The following are the statem ents of changes in equity for Isli ngton and 
Southwark for the y ear ended 31 March 20X7: 
 
 Islington Southwark 
 $  $  
Equity b/f 210,000 125,000 
Comprehensive inco me 50,000 35,000 
Dividends (15,000) (10,000) 
Equity c/f 245,000 150,000 
Islington acquired 75% of Southwar k’s equity shares on 1 April 20X4 
when Southwark’s net assets had a fair value of $80,000. No fai r value 
adjustments were required at ac quisition. It is Islington’s gro up policy to 
record NCIs at fair value at a cquisition. The NCI holding in So uthwark 
had a fair value of $25,000 a t the date of acquisition. 
Required 
 
 Data for test your understandi ngs 2 and 3 (OTQ data set questio ns) 
 The following information is r elevant for the next 3 TYU’s. 
On 1 January 20X5, Thunder acquir ed 80% of the equity share cap ital of 
Lightning when the net assets  of Lightning were $65,000.  
The following are the statement s of changes in equity for the y ear ended 
31 December 20X6: 
 Thunder Lightning 
 $  $  
Equity b/f 156,000 80,000 
Comprehensive inco me 24,000 13,800 
Dividends (10,000) (1,000) 
Equity c/f 170,000 92,800 
 
1 At the date of acquisition, the  fair value of Lightning's net  assets 
was deemed to equal their book value. 
2 Thunder’s group policy is to rec ord the NCI at fair value at 
acquisition. The fair value of t he NCI holding in Lightning was  
$23,000 at acquisition. 
3 Both Thunder and Lightning pai d their divide nds on 30 June 20 X6.

362  
 Test your understanding 2 (OTQ data set questions) 
 Required: 
What will be the figures shown fo r total comprehensive income r elating to  
Parent shareholders and NCIs within the cons olidated statement of 
changes in equity for Thunder Group? 
 Parent shareholders NCI shareholders A $34,240 $2,760 B $35,040 $2,760 C $37,000 $2,560 D $37,800 $2,760 
 
 Test your understanding 3 (OTQ data set questions) 
 Required: 
What will be the figures shown fo r dividends paid to Parent sha reholders 
and NCIs within the consolidat ed statement of changes in equity  for 
Thunder Group? 
 Parent shareholders NCI shareholders A $10,000 $100 B $10,000 $200 C $10,000 $1,000 D $10,800 $200

Chapter 14 
 363 
 Test your understanding 4 (OTQ style questions) 
 1 WM owns 75% of the equity shar e capital of MY. The equity 
attributable to the non-controllin g interest at 31 December 20X 3 was 
$650,000. The total comprehensive income of MY for the year ended 31 December 20X4 was $300, 000. Dividends were paid by 
both group entities dur ing the year ended 31 December 20X4. The  
dividends paid by M Y were $60,000. 
Calculate the closing balance on equity attributable to the NCI  
that would be reflected in the consolidated statement of changes in equity at 31 December 20X4. 
2 There are a number of transactions/classes of transactions th at you 
would expect to see on the face  of the consolidated statement o f 
changes in equity. 
For each of the headings below, identify whether they would 
appear on the face of the consolid ated statement of changes in 
equity and, if so, which column(s)  they would affect (by placin g 
X(s) in the relevant boxes). 
  Equity attributable 
to: 
 Not in 
CSOCE Parent NCI 
Comprehensive income for 
year    
Dividends paid to parent 
shareholders    
Finance costs    
Dividends paid to NCI    
Gain on FVPL financial asset    
Dividend paid by associate

364
 3  The following data relates to scenarios 3,4 and 5 
HN owned 80% of the $100,000 equity share capital of AE at 31 
March 20X0 when the retai ned earnings were $250,000.  
The statements of changes in eq uity for each entity as at the 3 1 
March 20X2 are shown below: 
Statement of changes in equity for the year ended 31 March 
20X2: 
Required: 
What will be the parent’s share  of total comprehensive income 
shown within the consolidated s tatement of changes in equity 
for the year ended 31 March 20X 2? Answers are presented in 
$000s. 
A 1,403 
B 1,423 C 1,441 D 1,466 
4 Required: 
What is parent’s dividend paid within the consolidated 
statement of changes in equity for the year ended 31 March 20X2? Answers are presented in $000s. 
A 20 
B 25 C 80 D 100 
5 Required: 
Calculate the Parent’s equity b rought forward included in the 
consolidated statement of chang es in equity for the year ended 
31 March 20X2? HN AE 
$000 $000 
Equity b/f 2,500 450 
Comprehensive income 1,250 216 
Dividends paid on 1 Jan 20X2 (100) (25)

Chapter 14 
 365 
 The information below relates to questions (6) and (7). 
CR acquired 70% of the equity shar e capital of TM on 1 January 20X1 
when TM's net assets had a ca rrying amount of $3,125,000. At th e date 
of acquisition, an adjustment o f $625,000 was made to increase TM's 
plant and equipment to fair val ue. The plant and equipment had a 
remaining life of 10 years at thi s time. No other fair value ad justments 
were considered necessary. 
It is group policy to measure the non-controlling interest at f air value at 
the date of acquisition and the  fair value of the non-controlli ng interest in 
TM on 1 January 20X 1 was $1,500,000. 
Goodwill has been tested for impai rment and none has arisen sin ce 
The individual statements of c hanges in equity of CR and TM for  the year 
ended 31 December 20X4 are: 
 CR TM 
 $000 $000 Equity b/f 14,500 6,600 Comprehensive income 2,750 1,500 Dividends paid on 1 Jan 20X2 (200) (100) 
 
Equity c/f 17,050 8,000 
   
6 Calculate the equity attributable  to the parent shareholders at  
1 January 20X4 (i.e. the br ought forward figure in the 
31 December 20X4).  
7 Which one of the following statements is INCORRECT in 
respect of the consolidated state ment of changes in equity for 
the year ended 31 December 20X4?  
A The statement will show the fu ll dividend paid by the parent 
and the NCI share of the divid end paid by the subsidiary. 
B The closing balance in the par ent shareholders' column will 
agree to the consolidated retain ed earnings balance in the 
consolidated statement of financial position. 
C The closing balance in the NC I column will agree to the NCI 
equity balance in the consoli dated statement of financial 
position. 
D 100% of the parent's comprehensive  income is reflected in the  
comprehensive income for the year attributable to the parent 
shareholders and the subsidiary's comprehensive income is split between parent shareholders and NCI.

366
3 Chapter summary

Chapter 14 
 367 
 Consolidated statement of chang es in equity for the year ended 
31 March 20X7 
 Parent 
shareholders NCI 
 $  $  
Equity b/f (W4/W3)  243,750 36,250 
Comprehensive income (W5)  68,750 8,750 
Dividends   
P's dividend (15,000)  NCI% × S's dividend ( 25% × 10,000) (2,500) 
 
Equity c/f (W4/W3)  297,500 42,500 
Workings 
Islington 
 
75% 
  
1 April 20X4 i.e. 3 years 
Southwark 
(W2)  Net assets of subsidiary  
 Acq B/f C/f (i.e. 
reporting 
date) 
 $  $  $  
Net assets = equity 80,000 125,000 150,000 
    
  Post-
reserves = 
45,000 Post-
reserves = 
70,000

368  
 (W3)  NCI share of equity  
 B/f C/f (i.e. 
reporting 
date) 
 $  $  
NCI at acqn at fair value 25,000 25,000 NCI% × post acquisition reserves   
(25% × 45,000 (W2) ) 11,250  
(25% × 70,000 (W2) )  17,500 
 
 36,250 42,500 
(W4) Parent's share of equity  
reporting 
date) 
 $  $  
Parent's equity 210,000 245,000 
Sub: P% × post acquisition reserves   (75% × 45,000 (W2) ) 33,750  
(75% × 70,000 (W2) )  52,500 
 
 243,750 297,500 
(W5) Comprehensive income  
 $  
P comprehensive income 50,000 Less elimination of i nter-co dividend 
(75% × 10,000)  
(7,500) 
P share of sub comp rehensive income 
(75% × 35,000)  
26,250 
 
–––––– 
 68,750 
 –––––– 
Non-controlling interest s (25% × 35,000) 8,750 
 ––––––

Chapter 14 
 369 
 Tutorial note: 
The comprehensive income working above can alternatively be set  out as 
follows: 
 $  
P and S comprehensive income  (50,000 + 35,000) 85,000 
Less elimination of inter-co di vidend (75% × 10,000) (7,500) 
 ––––––– 
 77,500 
 ––––––– 
Parent shareholders (bal ancing figure) 68,750 
 ––––––– 
 77,500 
 ––––––– 
  
 Correct answer A 
 Parent 
 $  $  
   
Total comprehensive income 34,240 (W3)  2,760 (W2)  
  
Workings 
 Thunder 
 
80% 
NCI 20%  
1 January 20X5 (2 years ago) 
 
  Lightning

370  
 (W2)  NCI share of S’s total comp rehensive income (TCI) 
  $  
NCI share of S’s TCI 13,800 × 20% 2,760 
 
(W3) Parent share of total comprehensive income  
 $  
Parent comprehensive income 24,000 
Less inter-co dividend recei ved (80% × 1,000) (800) 
Parent share of subsidiary comp income 
(13,800 – 2,760 (W2) )  
11,040 
or ((80% × (13,800))  
 –––––– 
 34,240 
  
 Correct answer B 
 Parent 
 $  $  
Dividends   
100% P's dividend (10,000)  
NCI% × S's dividend ( 20% × 1,000) (200) 
Dividends were paid by Lightning  on 30 June 20X6. 20% of those 
dividends were paid to NCIs. T he rest were received by Thunder (the 
parent) and are cancelled as  intragroup transactions.

Chapter 14 
 371 
 1  Closing balance on equity attri butable to NCI at 31 December 
20X4 = $710,000  
 $000 
NCI equity b/f at 1 January 20X4 650 
Comprehensive income (25% × 300) 75 
Dividends paid (25% × 60) (15) 
 ––––– 
 710 
 ––––– 
  
2  
  Equity attributable to: 
 Not in 
year  x x 
shareholders  x  
Finance costs x   
Dividends paid to NCI   x 
Gain on FVPL finance asset x   
Dividend paid by associate x   
Finance costs and gains on FVPL  financial assets are recorded 
within the statement of profit o r loss. Their respective impact s would 
be included within comprehensive income for the year but will n ot be 
shown separately within the CSOCE.   
Associate dividends paid do not i mpact the CSOCE. The investmen t 
in associate and the group investm ent income within the stateme nt 
of profit or loss are adjusted as an inter-company transaction for the 
share received by the parent.

372  
 3  A 1,403  
 
Total comprehensive income for group  
 $ 0 0 0  
Parent’s comprehensive income 1,250 
Parent’s share of subsidiary’s comprehensive income 173 
(80% × 216k)  less Parent’s share of sub’ s dividends paid (20) 
(80% × 25k) ––––– 
 1 , 4 0 3  
 
––––– 
4 D 100 
The amount shown as d ividend paid within  the consolidated 
statement of changes in equity consists of the parent’s (HN’s) dividend paid only. T his was $100,000.   
5 Equity attributable to paren t shareholders b/f (in $000s) = 2 ,580 
 $000 
Parent's equity b/f 2,500 
Sub: P% × post acquisition reserves b/f 80 
(80% × (450 – (100 + 250))  
 
––––––––– 
 2,580 
 ––––––––– 
 
6 Equity attributable to parent  shareholders b/f = $16,801,250  
 $  
Parent's equity b/f 14,500,000 Sub: P% × post acquisition reserves b/f  
(70% × 3,287,500 (see below)) 2,301,250 
 
––––––––– 
 16,801,250 
 ––––––––– 
 Acq  B/f 
 $000  $000 
Net assets = equity 3,125  6,600 
Fair value adjustment 625  625 
Depreciation adjustment 
(625 × 3/10)    
(187.5) 
 3,750  7,037.5 
 Post-acquisition reserves = 3,287.5

Chapter 14 
 373 
 7 The incorrect statement is B.  
The closing balance in the par ent shareholders column represent s 
equity  attributable to the parent shar eholders'. This includes 
consolidated retained earnings bu t also the parent's share capi tal, 
share premium and the parent's s hare of any other reserves.

375 
of cash flows 
 
  Lead outcome Component outcome 
B2:  Explain relevant financial 
C1:  Group accounts based on 
IFRS 
 Prepare the following based on 
financial reporting standards: 
(d)  Consolidated statement 
of cash flows Chapter 
15

Consolidated statement of cash flows 
376  
 
2 Objective of statements of cash flows  
• IAS 7 Statement of cash flows  provides guidance on the preparation of a 
statement of cash flows. 
• The objective of a statement of c ash flows is to provide infor mation on an 
entity’s changes in cash and cash  equivalents during the period . 
• The statement of financial pos ition and statement of profit or  loss and 
other comprehensive income (SOPLOC I) are prepared on an accrual s 
basis and do not show how the business has generated and used c ash in 
the accounting period. 
• The SOPLOCI shows profits on an accruals basis even if the com pany is 
suffering severe cash flow problems. 
• Statements of cash flows enable users of the financial stateme nts to 
assess the liquidity, solvency  and financial adaptability  of a business. 
 Definitions: 
 
• 'Cash consists of cash in ha nd and deposits repayable upon 
demand, less overdrafts. This incl udes cash held in a foreign 
currency.  
• Cash equivalents are short-term, highly liquid investments that  are 
readily convertible into known  amounts of cash and are subject to an 
insignificant risk of  changes in value.  
• Cash flows are inflows and outfl ows of cash and cash equivalent s' 
(IAS 7, para 6).

Chapter 15 
 377 
3 Classification of cash flows 
IAS 7 Statement of cash flows  does not prescribe a specific format for the 
statement of cash flows, although it requires that cash flows a re classified under 
three headings: 
• cash flows from operating acti vities, defined as the entity’s principal 
revenue earning activities and ot her activities that do not fal l under the 
next two headings 
• cash flows from investing acti vities, defined as the acquisiti on and disposal 
of long-term assets and other inves tments (excluding cash equiv alents) 
• cash flows from financing acti vities, defined as activities th at change the 
size and composition of the entity’s equity and borrowings. 
 
 Classification of  cash flows 
 Cash flows from operating activities 
There are two methods of calcula ting the cash from operations. 
• The direct method  shows operating cash rec eipts and payments. 
This includes cash receipts from customers, cash payments to 
suppliers and cash payments to  and on behalf of employees. The 
Examiner has indicated that the direct method will not be exami ned 
and is not considered furt her within this text. 
• The indirect method  starts with profit befor e tax and adjusts it for 
non-cash charges and credits, to reconcile it to the net cash f low 
from operating activities. 
IAS 7 permits either method. Under the indirect method adjustments are needed for a number of 
items, the most frequently occurring of which are: 
• depreciation, amortisation and impairment 
• profit or loss on dispos al of non-current assets 
• change in inventory 
• change in receivables 
• change in payables.

378  
Cash flows to appear under this heading include: 
• cash paid for property, plan t and equipment and other non-curr ent 
assets 
• cash received on the sale of p roperty, plant and equipment and  
other non-current assets 
• cash paid for investments in o r loans to other entities (exclu ding 
movements on loans from financial institutions, which are shown  
under financing) 
• cash received for the sale of i nvestments or the repayment of loans 
to other entities (again exclud ing loans from financial institu tions). 
Cash flows from financing activities 
Financing cash flows mainly compr ise receipts or repayments of principal 
from or to external providers of finance. 
Financing cash inflows  include: 
• receipts from issuing shares  or other equity instruments 
• receipts from issuing debentur es, loan notes and bonds and fro m 
other long-term and shor t-term borrowings (ot her than overdraft s, 
which are normally included in  cash and cash equivalents). 
Financing cash outflows  include: 
• repayments of amounts borro wed (other than overdrafts) 
• the capital element of lease rental payments 
• payments to reacquire or redeem the entity’s shares. 
Interest and dividends 
There are divergent and strongl y held views about how interest and 
dividends cash flows should be cl assified. Some regard them as part of 
operating activities, because they  are as much part of the day to day 
activities as receipts from cust omers, payments to suppliers an d 
payments to staff. Others regar d them as part of financing acti vities, the 
heading under which the instruments giving rise to the payments  and 
receipts are classified. Still ot hers believe they are part of investing 
activities, because this is w hat the long-term finance raised i n this way is 
used for.

Chapter 15 
 379 
 IAS 7 allows interest and divid ends, whether received or paid, to be 
classified under any of the thr ee headings, provided the classi fication is 
consistent from period to period. 
The practice adopted in this exam is to classify: 
• interest received as a cash fl ow from investing activities 
• interest paid as a cash flow  from operating activities 
• dividends received as a cash flow from investing activities 
• dividends paid as a cash flow from financing activities. 
4 Pro-forma statement of cash flows 
Group statement of cash flows 
 
Cash flows from operating activities $ $ 
Group profit before tax X  Adjustments for:   
Finance costs X  
Investment income (X)  Share of associate's profit (X)  
Depreciation X  
Amortisation X  Impairments of goodwill X  
Profit/loss on sale of proper ty, plant and equipment (X)/X  
 
–––––  
 X   
(Increase)/decrease in inventory (X)/X  (Increase)/decrease in receivables (X)/X  
Increase/(decrease) in payables X/(X)  
 
–––––  
Cash generated from operations X  
Interest paid (X)  Tax paid (X)  
 
–––––  
Net cash from operating activities  X

380  
Cash flows from investing activities   
Sale proceeds on disposal of property, plant and 
equipment  
X  
Purchases of property, plant and equipment (X)  
Investment income received X  Dividends received from associate X  
Acquisition of subsidiary, net of cash balances (X)/X  
 
–––––  
Net cash used in investing activities  X 
   Cash flows from financing activities   
Loans – issue/repayment X/(X)  
Share issues X  
Dividends paid to NCI (X)  Dividends paid to parent shareholders (X)  
 
–––––  
Net cash used in financing activities  X 
  ––––– 
Increase/decrease in cash and cash equivalents  X/(X) 
Opening cash and cash  equivalents  X 
  ––––– 
Closing cash and cash equivalents  X 
  ––––– 
 5 The consolidated statement of cash flows 
Single entity statem ents of cash flows have already been assess ed in F1. 
In the F2 assessment, questions are  more likely to focus on the  group aspects 
of a consolidated statement of cas h flows. The pro-forma of the  consolidated 
statement of cash flows is exact ly the same as the pro-forma fo r the single 
entity cash flow but with some e xtra complications resulting fr om group issues. 
A typical question will ask you  to calculate a cash-flow figure /adjustment that 
would be presented on t he statement of cash flows. You may also  be tested on 
which section of the statemen t a particular figure would appear  under and 
therefore you should have good k nowledge of the pro-forma state ment itself 
(shown above). 
A balancing figure approach is typi cally used to calculate a ca sh-flow 
figure/adjustment. By plotting t he movements in the statement o f financial 
position balance from the beginni ng to end of a period the cash  flow/adjustment 
is derived as the missing figure. 
NB: In the exercises in this chapter , workings have been shown usi ng both 
column format and T account forma t. It is important that you ch oose the method 
that works best for you – the one  that helps you get to the rig ht answer!

Chapter 15 
 381 
In a consolidated statement of cas h flows, there are specific i ssues that you 
may be required to deal with: 
• Dividends paid to non-controlling interests (financing cash ou tflow) 
• Dividends received from the asso ciate (investing cash inflow) 
• Cash flows related to the acquisition of a subsidiary during t he year (cash 
received/paid net of the sub's cash balance) 
• If there has been an acquisition of a subsidiary during the ye ar, its impact 
will need to be considered when us ing workings to calculate cas h flows. 
Dividends paid to non-controlling interests 
• When a subsidiary has paid a di vidend, only the share paid to the non-
controlling interest is reflect ed in the consolidated financial  statements (the 
share paid to the parent is elim inated as an intra-group transa ction). 
• The dividends paid to the non-c ontrolling interests should be disclosed 
separately from the dividends p aid to the parent shareholders i n the 
• To calculate the amount paid , reconcile the non-controlling in terest in the 
statement of financial position  from the opening to the closing  balance. 
 
 Illustration 1 – Dividend paid to NCI  
 The following information has be en extracted from the consolid ated 
financial statements of WG for  the years ended 31 December: 
 
 20X7 20X6 
 $000 $000 
NCI in consolidated SFP 780 690 NCI's total comprehensive inc ome in CSOPLOCI 120 230 
Required: 
What is the dividend paid to non- controlling interests in the y ear 20X7? 
Solution 
Steps: 
1 Set up a working (column or T account style). 
2 Insert the opening and closing balances and the NCI share of total 
comprehensive income (TCI) for the year. 
3 The balancing figure is t he cash paid to the NCI.

382  
 Non-controlling interests 
 $000 
Bal b/f 690 Comprehensive income att ributable to the NCI 120 
 
––––– 
 810 
Dividends paid (balance) (30) 
 ––––– 
Bal c/f 780 
 ––––– 
or 
  $000   $000 
Dividends paid (bal fig) 30 Balance b/f 690 
Balance c/f 780 Share of TCI in year 120 
 810  810 
Watch out for an acquisition of a s ubsidiary in the year. This will affect the 
NCI and will need to be taken a ccount of in the working, showin g the NCI 
that has been acquired or d isposed of in the period. 
Note that, where the column forma t is produced, the result is t he NCI 
column from the consolidated statement of changes in equity. 
 
 Information for TYUs 1 and 2 
 Extracts from Group A's conso lidated financial statements for the year 
ended 31 December 20X1 are shown below. 
Extract from consolidated state ment of financial position as at  
31 December: 
 20X1 20X0 
 $000 $000 Retained earnings 4,325 1,625 Non-controlling interests 580 440 
Extract from consolidated stateme nt of profit or loss and other  
comprehensive income for y ear ended 31 December 20X1: 
 $000 
Equity shareholders of the parent 3,200 
Non-controlling interest 300 
 
–––––– 
 3,500 
 ––––––

Chapter 15 
 383 
Total comprehensive income attributable to: 
Equity shareholders of the parent 3,800 Non-controlling interest 500 
 
–––––– 
 4,300 
 –––––– 
  
 Required: 
Using the information above, cal culate the dividends paid to th e non-
controlling interest that would be reflected within cash flows from 
financing activities in the cons olidated statement of cash flow s of Group A 
for the year ended 31 December 20X1. 
 
 Test your understanding 2(OTQ style) 
 Required: 
Using the information above, cal culate the dividends paid to th e parent 
shareholders that would be reflec ted within cash flows from fin ancing 
activities in the consolidated statement of cash flows of Group  A for the 
year ended 31 De cember 20X1. 
Dividends received from associates 
• Associates generate cash flows into the group to the extent th at dividends 
are received out of the pr ofits of the associate. 
• Such dividends received from a ssociates should be disclosed se parately 
in the statement of cash flows. 
• To calculate the amount receiv ed, reconcile the investment in associate in 
the statement of financial pos ition from the opening to the clo sing balance. 
• The share of profit/loss of the associate is a non-cash item i ncluded within 
profit and therefor e will be an adjustment i n the operating act ivities section 
of the statement of cash flows. 
• If other comprehensive income inc ludes any share of OCI of the  associate 
then this should be taken into a ccount when calculating the cas h flow, but 
should not be adjusted for within operating activities as it is  not part of 
profit.

384  
 Illustration 2 – Dividend received from associates  
financial statements of H for the year ended 31 De cember 20X1: 
income 
 $000 
Profit from operations 734 
Share of profit of associate 48 
 ––––– 
Profit before tax 782 
Income tax expense (304) 
 ––––– 
Profit for the period 478 
Other comprehensive income: 
Share of other comprehensiv e income of associate 12 
  
Group statement of financial position 
 20X1 20X0 
 $000 $000 
Investment in associate 466 456 
Required: 
Show the figures relevant to the a ssociate to be included in th e group 
statement of cash flows for t he year ended 31 De cember 20X1. 
 Solution 
When dealing with the dividend fr om the associate, the process is the 
same as we have already seen wi th the non-controlling interest.  
Set up a working (column or T-a ccount format) and bring in all the 
balances that relate to the asso ciate. When you balance the acc ount, the 
balancing figure will be the cash r eceived from the associate. 
(W1) Dividend received from associate 
 $000 
Bal b/f 456 
Share of OCI of associate 12 
 ––––– 
 516 
Less Bal c/f (466) 
 ––––– 
Dividend received from associate 50 
 –––––

Chapter 15 
385 
(W1) Dividend received from associate  
or 
Associate 
$000 $000 
Balance b/f 456 Dividend received 
(bal fig) 50 
Profit of associate 48 
OCI of associate 12 Balance c/f 466 
516 516 
Extracts from statement of cash flows for the year ended 31 December 20X1 
$000 
Cash flows from operating activities 
Adjustment for: Share of profit of associate (48) 
Dividend received from associate (W1)  
50 
Test your understanding 3 (OTQ style) 
Group B’s statement of profit or l oss reports ‘Share of profit  of associate’ 
of $750,000 and the statement of other comprehensive income rep orts 
'Share of other comprehensive in come of associate' of $25,000. The 
opening and closing st atements of financial position show: 
Closing Opening 
$000 $000 
Investment in associate 500 200 
Required: 
Calculate the dividends receiv ed from associate that would appe ar within 
cash flows from investing activi ties in the consolidated statem ents of cash 
flows of Group B.

386  
Acquisition of subsidiaries 
Standard accounting practice 
• If a subsidiary joins or leaves a group during a financial yea r, the cash 
flows of the group should include the cash flows of that subsid iary for the 
same period that the results of th e subsidiary are included in the statement 
of comprehensive income. 
• Cash payments to acquire subsid iaries must be reported separat ely in the 
statement of cash flows under investing activities. 
Acquisitions 
• In the statement of cash flows we must record the actual cash flow for the 
purchase, not the net assets acqui red. The cash outflow is net of any cash 
balances purchased with the subsidiary. 
• All assets and liabilities acqui red must be included in any wo rkings to 
calculate the cash movement for an item during the year. If the y are not 
included in deriving  the balancing figure, the incorrect cash f low figure will 
be calculated. This applies to all assets and liabilities acqui red and also to 
the NCI reconciliation (to calcul ated dividends paid to NCI). 
 
 Illustration 3 – Mid-year acquisitions  
 The extracts of an entity’s stat ement of financial position is  shown below: 
 20X8 20X7 
 $  $  Inventory 74,666 53,019 
During the year, a subsidiary wa s acquired. At the date of acqu isition, the 
subsidiary had an invent ory balance of $9,384. 
Required: 
Calculate the movement on invent ory for the statement of cash f lows. 
Solution 
At the beginning of the year, the inventory balance of $53,019 does not  
include the inventory of the subsidiary. 
At the end of the year, the inventory balance of $74,666 does  include the 
inventory of the newly acquired subsidiary. 
In order to calculate the correc t cash movement, the acquired i nventory 
must be excluded as it is dealt wit h in the cash paid to acquir e the 
subsidiary. The comparison of th e opening and closing inventory  figures 
is then calculated on the same basis. 
The movement on inventory is: (74,666 – 9,384) –  53,019 = $12,2 63 
increase. This is shown as a negative adjustment in cash flows from 
operating activities.

Chapter 15 
 387 
 
 The following are extracts from  a group’s consolidated financi al 
 Closing 
balance Opening 
balance 
 $000 $000 
Group statement of finan cial position extracts  
Receivables 500 400 
Loans 300 600 
During the accounting period, a s ubsidiary was acquired. Extrac ts from 
the individual statements of f inancial position are as follows:  
  Acquired 
  $000 
Receivables  70 
Loans  80 
Required: 
Demonstrate how the above transac tions would be reflected in th e 
consolidated statement of cash flows. 
 Solution 
Consolidated statement of cash flows (extracts) 
 $000 
Adjustments for:  
Increase in receivables (W1)  ( 3 0 )  
Cash flows from financing activities  
Repayment of loans  (W2)  (380) 
 
(W1)  Receivables  
 $000 
Opening balance 400 
  Acquisition of subsidiary 70 
 
––––– 
 4 7 0  
Increase in receivables  (= deduction in operating 
activities)  
30 
 ––––– 
Closing balance 500 
 –––––

388  
(W2) Loans  
 $000 
Opening balance 600 
  
Acquisition of subsidiary 80 
 ––––– 
 680 
Therefore redemption/cash  paid (bal figure) (380) 
 ––––– 
Closing balance 300 
 ––––– 
  
 Group P’s opening and closing statements of financial position  show the 
 Closing Opening 
 $000 $000 Non-current assets (NBV) 500 150 
During the year, the group acquir ed a 75% shareholding in a sub sidiary 
which held non-current assets  of $200,000 at the acquisition da te. 
Depreciation of $50,000 was charged during the period. 
No disposals of non-current asse ts occurred during the year. 
Required: 
How much cash was spent on non- current assets in the year? 
 
 Group R’s opening and closing statements of financial position  show the 
 $000 $000 Inventory 100 200 
Receivables 300 200 Payables 500 200 
During the period the group acquired a subsidiary with the foll owing 
working capital: 
 $000 
Inventory 50 
Receivables 200 
Payables 40

Chapter 15 
 389 
Required: 
Prepare the extracts required in r espect of movements in workin g capital 
that should be shown in the operat ing activities section of the  statement 
of cash flows? 
 
 The group financial statements o f Linford are given below: 
income for the year ended 30 September 20X9 
 $ m  
Revenue 600 
Cost of sales (300) 
 ––––– 
Gross profit 300 
Operating expenses (150) Finance costs (44) 
Share of associate profit 17 
 
––––– 
Profit before tax 123 
Taxation (35) 
 ––––– 
 88 
Other comprehensive income:  Gain on revaluation of PPE 15 
 
––––– 
 103 
 ––––– 
Parent shareholders 78 
Non-controlling interests 10 
 ––––– 
 88 
 ––––– 
Parent shareholders 91 
Non-controlling interests 12 
 ––––– 
 103 
 –––––

390  
 Consolidated statements of financial position as at 
 30 Sept 20X9 30 Sept 20X8 
 $m $m $m $m 
Goodwill 25  19  
Property, plant and equipment 240  280  
Investments in associates 80 345 70 369 
 ––––  ––––  
Inventory 105  90  
Receivables 120  100  Cash and cash equivalents 30  75  
 
––––  ––––  
  255  265 
  ––––  –––– 
  600  634 
  ––––  –––– 
     
Share capital  100  100 
Retained earnings  194  142 Revaluation reserve  103  90 
Non-controlling interest  72  40 
  
––––  –––– 
  469  372 
12% loan stock –  90  Deferred taxation 30  24  
 
––––  ––––  
  30  114 
Trade payables 65  55  Taxation 10  8  
Overdraft 26  85  
 
––––  ––––  
  101  148 
  ––––  –––– 
  600  634 
  ––––  ––––

Chapter 15 
 391 
 Notes to the accounts 
1 Acquisition of subsidiary 
During the year ended 30 September 20X9, Lin ford purchased 80% 
of the issued equity share capita l of Christie for $100m, payab le in 
cash. The net assets of Christie at the date of acquisition wer e 
assessed as having fair values as follows: 
 $ m  
PPE 60 
Inventory 30 Receivables 25 
Bank and cash 10 
Trade payables (15) Taxation (5) 
 
––––– 
 105 
 ––––– 
 
It is group policy to measure NC I at the proportionate share of  the 
fair value of net assets at acquisition. 
2 Goodwill  
Goodwill suffered an impai rment during the year. 
3 Property, plant and equipment  
The only disposal in the year w as of land with a carrying amoun t of 
$90m. The profit on disposal o f $10m is included within operati ng 
expenses. Depreciation of $58m w as charged on PPE in the year. 
Required: 
Prepare the consolidated statemen t of cash flows for Linford gr oup for the 
year ended 30 S eptember 20X9.

392  
 1  Which three of the following items would be included in the 
'cash flows from investing act ivities' section of the 
consolidated statement of cash flows?  
A Acquisition of subsidiary, net of cash acquired 
B Goodwill on acquisition of subsidiary C Gain on disposal of pr operty, plant and equipment 
D Investment income received E Dividends received from associate F Share of associate profit 
2 FG's consolidated statement of financial position shows recei vables 
of $6,500,000 at 31 May 20X2 an d $5,300,000 at 31 May 20X1. FG 
acquired 80% of the share capita l of AB on 1 January 20X2, when  
AB had a receivables balance of $2,200,000. 
Calculate the adjustment that should be made to profit to 
reflect the movement in recei vables within the operating 
activities section of the consolid ated statement of cash flows 
of the FG group for the year ende d 31 May 20X2. Clearly state 
whether the amount should be a dded to or deducted from 
profit. 
3 SB's consolidated statement o f financial position shows an 
investment in associate of $3, 200,000 at 30 November 20X4 and 
$1,200,000 at 30 November  20X3. SB's share o f associate profit for 
the year ended 30 Nove mber 20X4 was $2,300, 000 and its share of  
associate other comprehensiv e income was $150,000. 
There were no acquisitions or di sposals of associates in the ye ar 
ended 30 November 20X4. 
Which of the following is the a mount that would be shown as 
dividends received from associate  in the investing activities 
section of the consolidated state ment of cash flows of the SB 
group for the year ende d 30 November 20X4? 
A $300,000 
B $450,000 C $2,000,000 D $4,450,000

Chapter 15 
 393 
 4 Which one of the following stat ements is INCORRECT in respect  of 
the preparation of the consolidat ed statement of cash flows? 
A Dividends from associate are a cash inflow within investing 
B Dividends to non-controlling inte rest are a cash inflow withi n 
financing activities. 
C A gain on disposal of property , plant and equipment should be  
deducted from profit in the cash fl ow from operating activities  
section as it is a non-cash i tem included within profit. 
D Goodwill impairment should be added back to profit in the cas h 
flow from operating activities s ection as it is a non-cash item  
included within profit. 
5 The carrying amount of property , plant and equipment (PPE) in  XY's 
consolidated statement of financ ial position was $8,900,000 at 
31 March 20X2 and $9,500,000 at 31 March 20X1. There were no 
disposals or revaluation of PPE in the year. Depreciation of 
$1,000,000 was charged to profit in  the year ended 31 March 20X 2. 
XY disposed of 20% of its shares  in ABC on 31 October 20X1 but 
retained a controlling interes t. The PPE in ABC at the date of 
disposal was $1,100,000. 
Calculate the cash outflow fro m purchase of PPE that would be 
shown in the investing activiti es section of the consolidated 
statement of cash flows of th e XY group for the year ended 
31 March 20X2.

Chapter 15 
 395 
 Dividend paid to NCI = $360k 
 $000 Non-controlling interests ($000) 
Opening NCI 440   Bal b/f 440 
NCI share of TCI 500 Di vs paid (β) 360 NCI share 
of TCI 500 
Divi paid (bal) (360) Bal c/f 580   
 ––––  ––––  –––– 
Closing NCI 580  940  940 
      
 Dividend paid to P = $500k 
Retained 
earnings $000  
Retained earnings ($000) 
Op. bal 1,625   Bal b/f 1,625 
Parent share of 
profit  
3,200 Divs paid (β) 500 Parent 
share of profit  
 
3,200 
Divi paid (bal) (500) Bal c/f 4,325   
 –––––  –––––  ––––– 
Cl. bal 4,325  4,825  4,825 
NB The P's share of profit is tak en to group RE's. Not P's share of total 
comprehensive income. Only  profits impact RE's.

396  
 Dividend received f rom associate = $475k 
 $000 Investment in Associate ($000) 
Opening 
investment in associate  
 
200 Bal b/f 200   
Share of profits 750 Share of 
profits  
750 Divis 
received (β)  
475 
Share of OCI 25 Share of 
OCI  
25   
Dividend 
received from assoc (bal)  
 
(475)   Bal c/f 500 
Closing 
 
500   
 
975   
 
975 
      
 Cash spent on NCAs = $200k 
 
 $000 Non-current assets ($000) 
Opening NBV 150 Bal b/f 150 Depreciation 50 
Depreciation (50) New sub 200   
New sub 200 Additions – 
cash (β)  
200   
    Bal c/f 500 
Additions – cash 
(β)  
200  ––––  –––– 
 ––––   
550   
550 
Closing NBV 500  ––––  –––– 
 ––––

Chapter 15 
397 
Test your understanding 5 (integration question) 
Extracts to be included w ithin cash generated from operations ( in 
$000s) 
Decrease in inventory 150 
Decrease in receivables 
100 
Increase in payables 260 
$000 Inventor y ($000) 
Opening 
inventory 200 Bal b/f 200 
New sub 50 New sub 50 
Decrease (β) 150  
Decrease (β) (150) Bal c/f 100  
Closing inventory 100 250 250 
$000 Receivabl es ($000) 
Opening rec'bles 200 Bal b/f 200 
New sub 200 New sub 200 
Decrease (β) 100  
Decrease (β) (100) Bal c/f 300  
Closing rec'bles 300 400 400 
$000 Payables ($000)  
Opening payables 200 Bal b/f 200 
New sub 40 New sub 40  
Increase (β) 260 
–––– Bal c/f 500 Increase (β) 260 
Closing payables 500 –––– –––– 
–––– 500 500 
 –––– ––––

398  
 Group statement of cash flows  for Linford for year ending 
30 September 20X9 
Cash flows from operating activities $m $m 
Group profit before tax 123  
Adjustments for:   Depreciation 58  
Goodwill impairment (W1)  10  
Profit on sale of property (10)  Share of associate's profit (17)  
Finance costs 44  
 
––––  
 208  Decrease in inventory ((105 – 90) – 30) 15  
Decrease in receivables  ((120 – 100) – 25) 5  
Decrease in payables ((65 – 55) – 15) (5)  
 
––––  
Cash generated from  operations 223  
Finance costs paid (44)  
Tax paid (W3)  (32)  
 ––––  
Net cash from operating activities  147 
 
Proceeds on disposal of p roperty (90 + 10) 100  
Purchase of property, plant and equipment (W2)  (33)  
Dividends received from associate (W6)  7   
Acquisition of sub, net of cash balances (100 – 10) (90)  
 ––––  
Net cash used in investing activities  (16) 
Repayment of loan – 12% loan stock (90)  
Dividends paid to NCI (W5)  ( 1 )   
Dividends paid to parent shareholders (W4)  (26) (117) 
 –––– –––– 
Increase in cash and ca sh equivalents  14 
Brought forward cash and cash equivalents 
(75 – 85)   
(10) 
  –––– 
Carried forward cash and cash  equivalents (30 – 26)  4 
  ––––

Chapter 15 
 399 
 Workings 
(W1) Goodwill  
 $ m  
Bal b/f 19 
Acquisition of sub (below) 16 
 –––– 
 3 5  
Impairment (balance) (10) 
 –––– 
Bal c/f 25 
 –––– 
  
Or 
Goodwill  
B/f 19 Impairment (balance) 10 
Acquisition of subsidiary 
(below) 16 C/f 25 
 ––––  –––– 
 35  35 
 ––––  –––– 
Goodwill of acquired sub: 
 $ m  
Fair value of P's investment 100 
NCI at proportion of net assets (20% × 105) 21 Fair value of sub's net assets at acquisition (105) 
 
–––– 
Goodwill at acquisition 16 
 –––– 
(W2) PPE  
 $ m  
Bal b/f 280 Revaluation 15 
New subsidiary 60 
Depreciation (58) Disposal (90) 
 
–––– 
 207 
Cash paid for new assets (balance) 33 
 –––– 
Bal c/f 240 
 ––––

400  
 O r  
PPE 
B/f 280 Depreciation 58 
Revaluation 15 Disposal 90 
New sub 60 C/f 240 
Bank (balance) 33   
 ––––  –––– 
 388  388 
 ––––  –––– 
(W3)  Taxation  
 $ m  
Bal b/f (8 + 24) 32 SP/L charge 35 
New subsidiary 5 
 
–––– 
 7 2  
Cash paid (balance) (32) 
 –––– 
Bal c/f (10 + 30) 40 
 –––– 
Or 
Taxation 
Bal c/f (10 + 30) 40 Bal b/f (8 + 24) 32 
  SP/L charge 35 
  New sub 5 
Bank (balance) 32   
 ––––  –––– 
 72  72 
 ––––  ––––

Chapter 15 
 401 
 (W4)  Dividends paid to parent shareholders 
 
 $ m  
Bal b/f (on retained earnings) 142 Profit for the period (attributable to parent) 78 
 
–––– 
 220 
Cash paid (balance) (26) 
 –––– 
Bal c/f 194 
 –––– 
Or 
C/f 194 B/f 142 
  Profit 78 
Divis paid (balance) 26   
 ––––  –––– 
 220  220 
 ––––  –––– 
 
(W5) Non-controlling interests 
 $ m  
Bal b/f 40 
NCI share of total comprehensive income per 
CSOPLOCI  
12 
New subsidiary (105 × 20%) 21 
 –––– 
 73 
Dividends paid (balance) (1) 
 –––– 
Bal c/f 72 
 ––––

402  
 O r  
C/f 72 B/f 40 
  Comp income 12 
Bank (balance)  1 New sub (105 × 20%) 21 
 ––––  –––– 
 73  73 
 ––––  –––– 
 $ m  
Bal b/f 70 Share of profits 17 
 
–––– 
 87 
Cash received (balance) (7) 
 –––– 
Bal c/f 80 
 –––– 
Or 
B/f 70 C/f 80 
Share of profit 17 Bank (balance) 7 
 ––––  –––– 
 87  87 
 ––––  ––––

Chapter 15 
 403 
 1  Items A, D and E  
B is not a cash flow and will not appear anywhere in the 
C and F would be adjus tments to profit reflected in the cash fl ows 
from operating activities  section of the statement. 
2 Movement in receivables = $1,000,000 addition 
i.e. positive adjustment in operating activities section 
 
 $000 
Bal b/f 5,300 Acquisition of subsidiary 2,200 
 
–––––– 
 7,500 
Decrease (balance) (1,000) 
 –––––– 
Bal c/f 6,500 
 –––––– 
 
3 B Dividends received fro m associate = $450,000 
Positive figure in invest ing activities section 
 $000 
Bal b/f 1,200 
Profit from associate 2,300 OCI from associate 150 
 
––––– 
 3,650 
Dividends received (balance) (450) 
 ––––– 
Bal c/f 3,200 
 –––––

404  
 O r  
Associate ($000) 
Bal b/f 1,200   
Profit from associate 2,300   
OCI from associate 150 Dividends received – 
balance  
450 
  Bal c/f 3,200 
 3,650  3,650 
 
4 B is incorrect  
NCI dividends are a cash outflow, not inflow. 
5 Cash outflow from pu rchase of PPE = $400,000  
 $000 
Bal b/f 9,500 Depreciation (1,000) 
 
––––– 
 8,500 
Cash paid (bal fig) 400 
 ––––– 
Bal c/f 8,900 
 ––––– 
There is no adjustment for the di sposal of shares as a controll ing 
interest remains and therefore XY will continue to consolidated  
ABC's property, plant and equipment.

405 
Foreign subsidiaries 
(a-d) Statement of financial 
position, statement of profit or loss and other comprehensive income, statement of changes in equity, and statement of cash flows 
 
  Chapter 
16

406  
 
reporting standards” syllabus c ontent. These topics are covered  in detail 
within Chapter 11.  
• translating the financial stat ements of a for eign operation. 
the syllabus. Only this content  is covered within this chapter . 
3 Groups containing foreign subsidiaries 
Within an increasingly global eco nomy, groups including acquisi tions and 
mergers of companies based ov erseas are common place. 
If a parent is to acquire control of a subsidiary that uses a d ifferent functional 
currency from the parent, complic ations regarding the consolida tion arise.  
The two main complications are: 
• the translation of the foreign cu rrency subsidiary into the pa rent’s 
functional currency 
• the resulting calculation and recognition of foreign currency exchange 
gains or losses

Chapter 16 
 
 407 
 4 Translating the financial statements of a foreign subsidiary 
If the functional currency of a s ubsidiary is different to that  of the parent entity, it 
will be necessary to translate the subsidiary's financial state ments into the 
parent's presentation curren cy prior to consolidation. 
This is done using the 'closing rate' or 'net investment' metho d and the following 
exchange rates should be us ed in the translation: 
Income and expenses – ave rage rate for the year. 
• Assets and liabilities – closing rate i.e. the rate at the rep orting date 
• Goodwill of subsidiary – closing rate. 
 5 Exchange gains or lo sses on translation 
Exchange differences arise upon  translation of the subsidiary a nd can be 
separated into two main components: 
• Exchange difference on net assets  – arising as opening net assets are 
initially translated at the opening  rate, the comprehensive inc ome for the 
year (i.e. movement on net asse ts) will have been translated at  average 
rate and the closing net assets o n the statement of financial p osition are 
then translated at the closing rate. 
• Exchange difference on goodwill  – goodwill brought forward will have 
been previously translated at the current year's opening rate ( the previous 
year's closing rate), any impai rment in the year will be transl ated at 
average rate in the statement of profit or loss and the year-en d goodwill is 
then translated at closing rate i n the statement of financial p osition. 
The sum of these two exchange differences is recognised within other 
comprehensive income. The group share of these foreign exchange 
differences would be held in a se parate reserve within equity i n the statement of 
The exchange difference on net a ssets is always split between p arent and NCI 
based on the group shareholdings. 
The treatment of the goodwill exchange difference depends upon the method 
used for valuing the NCI – fair v alue method or proportionate m ethod. If the fair 
method is used, a portion of t he exchange difference is allocat ed to parent and 
the NCI. Otherwise, if the propor tionate method is used, the ex change 
difference is allocated only to the parent.

408  
To calculate the exchange differences, the following pro-formas  can be used. 
Exchange difference on net assets for the year 
 A $  
Closing net assets at closing rate X 
Less opening net assets at opening rate (X) Less comprehensive income for t he year at average rate (X) 
 
––––– 
Exchange gain/(loss) X/(X) 
 ––––– 
Exchange difference on goodwill for the year 
 A $  
Closing goodwill at closing rate X Less opening goodwill a t opening rate (X) 
Add back impairment for the year at relevant rate X 
(question should provi de guidance on the rate used to translate  
impairment)  
 
––––– 
 X / ( X )  
Exchange gain/(loss) ––––– 
 
 Illustration 1 – Exchange difference on translation of subsidia ry 
 To help understand the exchange d ifference, consider the follow ing 
scenario. 
A subsidiary, whose functional c urrency is the Dit (D), prepare s its 
financial statements for the year ended 31 December 20X1 and th e 
movement on net assets is as follows: 
 D000 
Opening net assets at 1 January 20X1 15,000 Comprehensive income  for the year ended 
31 December 20X1  
1,750 
 
–––––– 
Closing net assets at 31 December 20X1 16,750 
 –––––– 
  
 The parent's presentation curr ency is the dollar ($) and excha nge rates 
were as follows: 
At 1 January 20X1 5 Dits = $1 At 31 December 20X1 7 Dits = $1 
Average rate for the year ended 31 December 20X1 6.2 Dits = $1

Chapter 16 
 
 409 
 The brought forward net assets wer e translated at last year's c losing rate 
(= this year's opening rate) in last year's consolidated financ ial 
statements. The comprehensive in come has been translated at ave rage 
rate for inclusion in the cons olidated statement of comprehensi ve income 
for the year. The closing net a ssets have been translated at th is year's 
closing rate for inclusion in t he consolidated statement of fin ancial 
position. 
This gives rise to the fo llowing exchange difference: 
 
 D000 Exchange 
rate $000 
Opening net assets 15,000 5 3,000 
Comprehensive income 1,750 6.2 282 
Exchange difference (bal)   (889) 
Closing net assets 16,750 7 2,393 
Another way of presenti ng this calculation is: 
 
rate $000 
Closing net assets at closing 
rate  
16,750  
7  
2,393 
Less opening net assets at 
opening rate  
(15,000)  
5  
(3,000) 
Less comprehensive income 
for the year at average rate  
(1,750)  
6.2  
(282) 
   –––––– 
Exchange difference arising on 
translation of subsidiary    
(889) 
   –––––– 
A further exchange difference t hen arises upon c onsolidation as  goodwill 
is recognised at the closing rate  in the consolidated statement  of financial 
position each year and , therefore, is re-tr anslated from openin g to closing 
rate.

410  
 
 Example 1 
 This example walks you through  the entire process of preparing  a set of 
consolidated financial statements with a fore ign subsidiary. No te that you 
will not be asked to do this i n full in your assessment, but un derstanding 
the process will help you to ans wer any questions that arise. 
P acquired 75% of the share capi tal of S on 1 January 20X5 for 
500,000Fr, when the retained earni ngs of S were 120,000Fr. The 
functional currency of S is Fr. T he functional currency and pre sentation 
currency of P is $. 
 Statements of financial pos ition at 31 December 20X6 
 P S 
 $000 Fr000 Non-current assets 1,250 850 Investment in S 100 − 
Current assets 325 150 
 
 1,675 1,000 
Share capital 700 250 
Reserves 675 350 Liabilities 300 400 
 
Statements of profit or loss and other comprehensive income for  the 
year ended 31 December  20X6 (summarised) 
 P S 
 $000 Fr000 Revenue 600 150 Expenses (475) (90) 
 
Profit for the year 125 60 
Other comprehensive income – – 
Total comprehensive income 125 60 

Chapter 16 
 
 411 
 Exchange rates: 
1 January 20X5 $1 = 5.0Fr 
31 December 20X5 $1 = 4.2Fr 31 December 20X6 $1 = 4.5Fr Average for the year ended 31 De cember 20X5 $1 = 4.6Fr 
Average for the year ended 31 De cember 20X6 $1 = 4.4Fr 
P has a policy of measuring NC I at acquisition at fair value. T he fair value 
of the NCI holding in S at acqui sition was 160,000Fr. The goodw ill has 
been impaired by 10% in the year  ended 31 December 20X5 and a 
further 10% of its carrying amoun t in the current year. The imp airment 
each year has been translated a t the average rate for the year.  
Required: 
Prepare the consolidated statem ent of financial position and co nsolidated 
statement of profit or loss and ot her comprehensive income for the year 
ended 31 December 20X6. 
Note:  Work to the nearest $1,000. 
 
 Example 1 answer  (the basics) 
 P Group consolidated statement  of financial position at 
31 December 20X6 
 $000 
Goodwill (W3)  52 
Non-current assets  (1,250 + 189 (W1) ) 1,439 
(325 + 33 (W1) ) 358 
 
–––––– 
 1,849 
 –––––– 
Share capital 700 
Reserves (W5)  715 
Non-controlling interests (W4)  45 
Payables  (300 + 89 (W1) ) 389 
 
–––––– 
 1,849 
 ––––––

412  
Workings: 
Translation of sub's financial statements A good starting point is to trans late the basic financial state ments of the 
subsidiary so that the figures a re in the presentation currency  of the 
parent ready for adding across on the face of the main statemen ts. 
(W1)  Translation of S's statement  of financial position at 
31 December 20X6  
Using closing rate of 4.5 $000 
Non-current assets (850/4.5) 189 
Current assets (150/4.5) 33 Liabilities (400/4.5) 89 
Translation of S's statement  of profit or loss and other 
comprehensive income for the  year ended 31 December 20X6 
Using average rate of 4.4 $000 
Revenue (150/4.4) 34 Expenses (90/4.4) (20) 
 
––––– 
Profit/TCI for year (60/4.4) 14 
 ––––– 
To complete the consolidated st atement of financial position th e 
usual workings should then be pr epared: net assets, goodwill, N CI 
reserve and group (consolidated) reserves. 
When preparing the net assets wor king, translate the net assets  at 
acquisition using the acquisiti on rate and the net assets at th e 
reporting date using  the closing rate. 
The difference between the two will reflect the translated post -
acquisition reserves (for inclus ion in both the NCI reserve and  group 
reserve workings). This figure includes both the movement in po st-
acquisition reserves and the cumu lative exchange difference to date 
on the net assets of the subsid iary. The detailed answer that f ollows 
this solution demonstrates this point.

Chapter 16 
 
 413 
 Acquisition date Reporting date 
 Fr000 Fr000 Share capital 250 250 Reserves 120 350 
 
–––– –––– 
 370 600 
 –––– –––– 
Translation rate Acquisition ra te = 5 Closing rate = 4.5 
 –––– –––– 
Translated net assets 
($000)  
74  
133 
 –––– –––– 
 Post-acquisition reserves = 59 ($000) 
Goodwill 
When calculating goodwill, start in the functional currency of the 
subsidiary and then translate into the presentati on currency of the 
parent using three different rat es: acquisition rate, opening r ate and 
closing rate. 
The difference between opening and closing rate will be part of  the 
exchange difference to be recogni sed within other comprehensive  
income for the year. 
The difference between acquisi tion and closing rate will be par t of 
the foreign currency translation  reserve that has arisen since the 
subsidiary was acquired and sh ould be included in the group 
reserves working.

414  
 Fr000 
Fair value of P's investment 500 
NCI at fair value 160 Fair value of sub's net assets at acquisition (W2)  (370) 
 
––––– 
Goodwill at acquisition 290 
Impairment year ended 31 Dec 20X5 (10% × 290) (29) 
 ––––– 
Gross goodwill at 31 December 20X5 261 
Impairment year ended 31 Dec 20X6 (10% × 261) (26) 
 ––––– 
Goodwill at reporting date 235 
 ––––– 
Translation of goodwill:  
 $000 
At acquisition date (290/5) 58 
Less impairment in y/e 31 Dec 05 at average rate (29/4.6) (6) 
Exchange difference y/e 31 De c 05 (balancing figure) 10 
 ––––– 
At 31 Dec 05 (261/4.2) 62 
Less impairment in y/e 31 Dec 06 at average rate (26/4.4) (6) 
Exchange difference y/e 31 De c 06 (balancing figure) (4) 
 ––––– 
At 31 Dec 06 (235/4.5) 52 
 ––––– 
NCI 
When preparing the non-c ontrolling interests working, remember 
that this is a reserve and builds up over time. 
• The value at acquisition should be translated at the acquisiti on 
rate. 
• The post-acquisition reserves have already been translated in 
the net assets working. 
• Any impairment will also hav e been translated in the goodwill 
working. 
• Remember to include the NCI's  share of any cumulative 
exchange difference on goodwill i f NCI is measured using the 
fair value method at acquisition.  This exchange difference has 
already been calculated in the goodwill working.

Chapter 16 
 
 415 
 (W4)  Non-controlling interests in the CSFP  
 $000 
NCI at acquisition (160/5) 32 
NCI% × post acquisition reserves (25% × 59 (W2) ) 15 
NCI% × cumulative impairm ent loss (25% × (6 + 6 (W3) )) (3) 
NCI% × cumulative exchange difference on goodwill 
(25% × (10 – 4) (W3) )  
1 
 –––– 
 4 5  
 –––– 
Group reserves 
The group reserves working then  follows on from t he NCI reserve  as usual. 
The first figure to i nclude is the parent's reserves (already i n the parent's 
presentation currency). The group reserves then include the rem aining 
(parent's) s hare of the figures partly  included in  the NCI rese rve working. 
(W5)  Group reserves  
 $000 
P 675 S: (75% × 59) 44 
Impairment (75% × (6 + 6)) (9) 
Exchange difference on goodwi ll (75% × (10 – 4)) 5 
 
––––– 
 7 1 5  
 ––––– 
 
 Finally, to complete the consolid ated statement of profit or lo ss and other 
comprehensive income for the y ear, we need to calculate the cur rent year 
exchange difference on net assets.  
(W6) Exchange difference for the year  
 $000 
Closing net assets at closing rate (W2)  1 3 3  
Less opening net assets at opening rate (600 – 60)/4.2 (129) 
Less comprehensive income for the year at average 
rate (W1)   
(14) 
 ––––– 
Exchange difference on net assets for the year (10) 
Current year exchange difference on goodwill (W3)  ( 4 )  
 ––––– 
Total exchange difference for the year (14) 
 ––––– 
The exchange difference on net a ssets is split between parent a nd NCI 
based on the percentage holdings. 
As the NCI has been measured usi ng the fair value method, the 
exchange difference on goodwill shoul d also be allocated betwee n parent 
and NCI.

416  
 Statement of profit or loss and other comprehensive income 
We can now complete the consoli dated statement of profit or los s and 
other comprehensive income, incl uding the above exchange differ ence 
for the year within othe r comprehensive income. 
P Group consolidated statement  of profit or loss and other 
 
 $000 
Revenue (600 + 34 (W1) ) 634 
Expenses (475 + 20 (W1)  + 6 impairment (W3) ) (501) 
 ––––– 
Profit for the year 133 
Items that may be reclassified subsequently to profit or loss:  
Foreign exchange difference (W6)  (14) 
 ––––– 
Total comprehensive income 119 
 ––––– 
Profit for the year attributable to:  
Parent shareholders (balance) 131 Non-controlling interest (25% × (14 (W1) – 6 (W3) )) 2 
 
––––– 
 133 
 ––––– 
  
 $000 
Total comprehensive income attributable to:  Non-controlling interes t (2 (above) – (25% × 14 (W6) ) (2) 
Parent shareholders (balance) 121 
 
––––– 
 119 
 –––––

Chapter 16 
 
 417 
 Example 1 answer (detailed) 
 In the net assets working (W2),  the movement in post-acquisiti on 
reserves each year can be anal ysed further. This will enable us  to 
accurately calculate the foreign currency translation reserve. 
To analyse the movement we firs tly need to calculate the compre hensive 
income of the subsidiary for t he year ended 31 De cember 20X5: 
Movement on net assets of subsidiary 
 Fr000 
Net assets at acquisition (1 Jan X5) 370 
Comprehensive income for y/ e 31 Dec X5 (bal fig) 170 
Comprehensive income for y/ e 31 Dec X6 (S's SCI) 60 
 –––– 
Net assets at 31 Dec X6 600 
 –––– 
  
Now consider the movements each year, including the exchange 
difference that arises when the closing net assets are translat ed at 
closing rate for the consolidat ed statement of financial positi on. 
Movement on post-acquisition reserves 
 $000 
Net assets at acquisition (1 J an X5) at acquisition rate 
(370/5)  
74 
Comprehensive income for y/ e 31 Dec X5 at average rate 
(170/4.6)  
37 
Exchange difference for y/ e 31 Dec X5 (bal fig) 18 
 –––– 
Net assets at 31 Dec X5 at closi ng rate (370 + 170)/4.2 129 
 
Comprehensive income for y/ e 31 Dec X6 at average rate 
(60/4.4)  
14 
Exchange difference for y/ e 31 Dec X6 (bal fig) (10) 
 –––– 
Net assets at 31 Dec X6 at clo sing rate (600/4.5) 133 
 ––––

418  
 Therefore the post-acquisition reserves of 59 ($000) shown in W2 is: 
 
 $000 
Movement in post-acquisiti on reserves (37 + 14) 51 
Foreign exchange differences (18 – 10) 8 
 –––– 
 59 
 –––– 
In the basic approach above, a c ombined reserves working was 
presented in working 5. However, in practice all the exchange d ifferences 
arising on translation of the subs idiary are held in a separate  foreign 
currency translation reserve. The retained earnings reserve and  foreign 
currency reserve in the above ex ample would therefore be: 
(W5a) Group retained earnings  
 $000 
P 675 
S: 75% × 51 (movement on rese rves excl. exchange diffs) 38 
Impairment (75% × (6 + 6) (W3) ) (9) 
 –––– 
 704 
 –––– 
  
 (W5b)Group foreign curre ncy translation reserve  
 $000 
Exchange differences on net assets of subsidiary since 
(75% × 8) 6 
Exchange difference on goodwi ll since acquisition  
(75% × (10 – 4)) 5 
 –––– 
 11 
 –––– 
Group retained earnings plus fore ign currency translation reser ve = 704 + 
11 = 715 as shown in W5 usi ng the combined approach.

Chapter 16 
 
 419 
 Test your understanding 1 (Furth er practice integration questio n) 
 Paul is an entity whose functi onal and presentational currency  is the 
dollar ($). On 1 January 20X7, P aul acquired 80% of the share c apital of 
Simon, an entity whose functi onal currency is the Franc. Simon’ s 
reserves at this date showed a ba lance of Fr4,000. Paul paid Fr 21,000 
for the investment in Simon. 
Below are the financia l statements of Paul and Simon for the ye ar ended 
Statements of financial pos ition at 31 December 20X8 
 
 Paul Simon 
 $  F r  
Non-current assets 60,000 25,000 Investment in Simon 4,200  
Current assets 35,800 15,000 
 
 100,000 40,000 
Equity   
Share capital 50,000 15,000 
Reserves 20,000 14,000 
 70,000 29,000 
Current liabilities 30,000 11,000 
year ended 31 December 20X8 
 Paul Simon 
 $  F r  Revenue 25,000 10,000 
Operating expenses  (10,000) (4,000) 
 
Profit from operati ons 15,000 6,000 
Finance costs (5,000) (1,500) 
Profit before tax 10,000 4,500 
Tax (3,000) (1,000) 
Profit for the year 7,000 3,500 
Total comprehensive income 7,000 3,500 

420  
 Exchanges rates have been as follows: 
 Fr: $1 
1 January 20X7 5 
31 December 20X7 3 31 December 20X8 2 
Average for the year ended 31 December 20X8 2.5 
It is Paul’s policy to measure NCI at fair value at the date of  acquisition 
and the fair value of the non-contro lling interest in Simon was  deemed to 
be Fr4,500 at this date. Good will had been reviewed for impairm ent as at 
31 December 20X7 bu t none had arisen. At 31 December 20X8, it w as 
determined that goodwill shoul d be impaired by Fr1,000. 
Required: 
Prepare the consolidated statem ent of financial position and th e 
consolidated statement of prof it or loss and other comprehensiv e income 
for the year ended 31 December 20X8. 
 
 Fair value adjustments in a foreign subsidiary 
 To deal with fair value adjustmen ts in a foreign subsidiary, a pply the 
following rules: 
• On the face of the consolidat ed statement of fi nancial positio n, 
translate the fair value adjustm ent using the closing rate 
• In the statement of profit or loss, translate any fair value 
depreciation adjustment relati ng to the current year using the 
average rate. 
The impact of the fair value adj ustment would then need to be c arefully 
considered when calculating the exchange difference for the yea r on the 
net assets: 
• The profit for the year should be adjusted for the current yea r fair 
value depreciation 
• The opening and closing net assets  should be adjusted for the fair 
value adjustment less accumulate d depreciation at that point in  
time. 
Example 4 below demonstrates h ow the fair value adjustment woul d 
affect the exchange diff erence calculation.

Chapter 16 
 
 421 
 Example 2 
 In Example 1, P acquired 75% o f the share capital of S on 1 Ja nuary 
20X5 for Fr 500,000, when the rese rves of S were Fr 120,000. S' s total 
share capital was Fr 250,000 and  the reserves at the current re porting 
date of 31 December 20X6 were  Fr 350,000. The fair value of the  NCI at 
the date of acquisition was Fr  160,000 and it was group policy to 
measure NCI at fair value at acquisition. 
S's total comprehensive income fo r the year ended 31 December 2 0X6 
was Fr 60,000. 
Relevant exchange rates were as follows: 1 January 20X5 $1 = 5Fr 31 December 20X5 $1 = 4.2Fr 31 December 20X6 $1 = 4.5Fr Average for the year ended 31 December 20X5 $1 = 4.6Fr 
Average for the year ended 31 December 20X6 $1 = 4.4Fr 
 Let's now assume that, at the dat e of acquisition, the fair va lue of S's net 
assets equalled carrying amount wit h the exception of an item o f plant 
whose fair value exceeded carryi ng amount by Fr 200,000. The pl ant had 
a remaining useful life at the date of ac quisition of 10 years.  
The carrying amounts of property , plant and equipment of P and S at 
31 December 20X6 we re $1,250,000 and Fr 850, 000 respectively. 
In a change to the scenario in Exam ple 1, let's also assume tha t goodwill 
has not been impaired. 
Required: 
Calculate the following amount s that would appear in the consol idated 
financial statements of the P gr oup for the year ended 31 Decem ber 
20X6 (work to the nearest $): 
1 Carrying amount of property, p lant and equipment at 31 Decemb er 
20X6 
2 Total exchange difference aris ing on translation of S that wo uld be 
recognised in other comprehens ive income for the year.

422  
 In Example 1, the first step was to translate the financial st atements of S. 
If there is a fair value adjustm ent then this can be built into  this 
translation. 
(W1) Translation of S's net  assets at 31 December 20X6 
 
Non-current assets (850 + 200 FV – 40 dep)/4.5 224 
(Note: FV depreciati on = 200 × 2/10)  
We can then answer the first requi rement – as all that is left is to add the 
translated figure to the parent's  property, plant and equipment . 
1 Carrying amount of property, plant and equipment at 
31 December 20X6 = $1,474,000  
 $000 
PPE  
(1,250 + 224 (W1) ) 1,474 
  
 To calculate the exchange diffe rence for the year we need to p erform the 
goodwill calculation an d we also need to consider the movement on net 
assets for the year. 
(W2)  Goodwill  
 Fr000 
Fair value of Ps investment 500 
NCI at fair value 160 
Fair value of sub's net assets at acquisition 
(250 + 120 + 200 FV)  
(570) 
 ––––– 
Goodwill at acquisition and reporting date 
(no impairment)  
90 
 ––––– 
 $ 0 0 0  At acquisition date (90/5) 18 
Exchange difference y/e 31 De c 05 (balancing figure) 3 
 ––––– At 31 Dec 05 (90/4.2) 21 
Exchange difference y/e 31 De c 06 (balancing figure) (1) 
 ––––– At 31 Dec 06 (90/4.5) 20  –––––

Chapter 16 
 
 423 
 In Example 1, to calculate the exchange difference arising on n et assets 
we started with the closing ne t assets and worked backwards. An  
alternative is to work forwards  and leave a line for the exchan ge 
difference (a balancing figure) before calculating the closing position. This 
can be useful in determining t he opening net assets position of  the 
subsidiary, which is the closi ng position less the comprehensiv e income 
for the year. 
As you can see below, the fair v alue adjustments are then built  into the 
calculation prior to translati on. The fair value adjustment les s cumulative 
depreciation is added to the clos ing net assets and the current  year fair 
value depreciation is deducted fr om S's total comprehensive inc ome for 
the year. 
(W3) Net assets 
 Fr000 Rate $000 
Opening net assets    (Closing less CI for year) 720 4.2 171 
Comprehensive income for year 
(60 – 20 FV dep'n)  
40  
4.4  
9 
Exchange difference (bal fig)   (11) 
 
Closing net assets 
(250 + 350 + 200 – 40)  
760  
4.5  
169 
(SC + reserves + FV adjustment) –––––  ––––– 
We now have the figures to answer requirement 2. 
2 Total exchange difference for year = $12,000 loss  
 Exchange difference in OCI: 
 $000 
Exchange loss on goodwill (W2)  ( 1 )  
Exchange loss on net assets (W3)  (11) 
 ––––– 
Total exchange loss for the year (12) 
 –––––

424  
6 Foreign subsidiaries: k ey examinable issues 
Assessment questions are likely  to focus on the calculation and  accounting 
treatment of the exchange differenc es. You may also be tested o n the impact of 
translation on individual figures  from the conso lidated stateme nt of profit or loss 
and other comprehensive income and statement of financial posit ion. 
The key things to remember are: 
• Profit or loss and other compr ehensive income items are transl ated at 
average rate  each year. 
• Assets and liabilities are translated at closing rate  each year. 
• Exchange differences arising on  the retranslation of the subsi diary (on net 
assets and goodwill) are recognised within other comprehensive 
income . 
• The exchange difference on net a ssets is attributed between pa rent 
shareholders and NCI based on t heir percentage holdings. 
• The exchange difference on goodw ill will be attributed as foll ows: 
– All to parent shareholders, if NCI is measured using proporti on of net 
assets method 
– Between parent shareholders an d NCI (based on their percentag e 
holdings) if the NCI is measured using the fair value method 
– Note that this is consistent with the treatment of goodwill i mpairment. 
 
 Test your understanding 2 (Data set OTQ style) 
 Upper acquired 85% of the equity  shares of Lower, an entity wh ose 
functional and presentation curr ency is the Dinar (D), on 1 Jan uary 20X1 
for cash consideration of D750, 000. The carrying amount of the net 
assets of Lower at the date of a cquisition were D500,000 and th is 
equated to fair value with the exce ption of an item of plant wh ose fair 
value was D120,000 higher than c arrying amount. The asset had a  
remaining useful life of 5 year s at the date of acquisition and  depreciation 
is charged on a straight line basis. 
It is group policy to measure non -controlling interest at fair value at the 
date of acquisition and the fair  value of the non-controlling i nterest in 
Lower on 1 January 20X1 was D150,000. 
At the 31 December 20X4, the ca rrying amounts of Upper's and Lo wer's 
property, plant and equipment w ere $950,000 and D440,000 respec tively. 
The carrying amount of Lower's ne t assets at 31 December 20X4 w as 
D620,000 and its total comprehensiv e income for the year ended 
31 December 20X 4 was D75,000. 
Goodwill is tested for impairment  annually but none was conside red to 
have arisen as at 31 December 20X4. 
The Upper group's presentat ion currency is the $.

Chapter 16 
 
 425 
Relevant exchange rates are: 
Date D to $1 
1 January 20X1 7.8 31 December 20X3 9.0 31 December 20X4 8.2 
Average rate for year ended 31 December 20X4 8.6 
Required: 
Calculate the property, plant and equipment figure that would b e 
presented in the consolidated fi nancial statement s of the Upper  group for 
the year ended 31 De cember 20X4. 
State your answer to the nearest $. 
 
 Test your understanding 3 (Data set OTQ style) 
 Required: 
Using the information from the pr evious TYU for Upper group, ca lculate 
the goodwill arising on the acquisi tion of Lower as shown withi n the 
Upper group consolidated statemen t of financial position as at 
31st December 20X4. 
 
 Test your understanding 4 (Data set OTQ style) 
 Required: 
the total exchange difference ar ising on the translation of Low er that 
would be presented in o ther comprehensive income for the year e nded 
State your answer to the nearest $.

426  
 Test your understanding 5 (Data set OTQ style) 
 HB presents its consolidated fi nancial statement s in $. HB has  one 
subsidiary FA which uses £ as it s functional currency. FA is no t wholly 
owned. FA was acquired on 1 Januar y 20X1 at a cost of £3,800,00 0. The 
fair value of the net assets of F A at the acquisition date was £2,000,000. 
The goodwill of FA has been calcul ated using the FV method. The  FV of 
non-controlling interest as at  the acquisition date was £400,00 0. There 
has been no impairment of FA's goodwill. 
Relevant exchange rates are 
1st Jan 20X1 $1/£2.0 
31st Dec 20X1 $1 /£2.5 
Average rate for the year  ended 31st Dec 20X1 $1/£2.25 
31st Dec 20X2 $1/£1.5 
Average rate for the year  ended 31st Dec 20X2 $1/£1.75 
Required: 
What is the value of goodwill of F A as shown on the consolidate d 
statement of financial position  for the year ended 31st Dec 20X 2 (to the 
nearest $)? 
A 880,000 B 977,778 C 1,100,000 D 1,466,667 
 
 Test your understanding 6 (Data set OTQ style) 
 Required: 
Using the information from the pr evious TYU for the HB group, w hat is 
the annual foreign currency gain or loss on translation of good will 
recorded in other comprehensive income for the year ended 31st Dec 
20X2? Figures in bra ckets denote a loss. 
A ($366,667) B $366,667 C ($586,667) D $586,667

Chapter 16 
 
 427 
 Test your understanding 7 (Data set OTQ style) 
 Required: 
Using the information from the pr evious TYU for the HB group, w hich one 
of the following statem ents is incorrect? 
A The annual foreign currency gain or loss on the translation o f FA's 
net assets should be shown in o ther comprehensive income 
B FA's functional currency is £'s  therefore FA's head office is  based in 
a country which uses £'s 
C FA's NCI's will be allocated a share of the annual foreign cu rrency 
gain or loss from translating FA's goodwill 
D FA's statement of financial pos ition is translated at the clo sing rate 
and the consolidated statement of profit or loss is translated using 
the average rate 
 
 Test your understanding 8 (Foreign consolidation OTQ style) 
 1 IAS 21 provides guidance on how to account for foreign curre ncy 
transactions and subsidiaries. 
Which of the following statemen ts are TRUE? Select all that 
apply. 
A The functional currency is the currency in which an entity mu st 
present its financial statements. 
B Subsidiaries must present t heir financial statements in the 
presentation currency of their parent. 
C When determining functional curr ency, entities should select 
the currency in which the majori ty of its purchases are made. 
D When translating a foreign subs idiary, the exchange differenc e 
should be recognised in profit. 
E When translating a foreign subs idiary, the exchange differenc e 
should be recognised as other comprehensive income. 
F The presentation currency is  decided by the directors.

428  
 2 P owns 80% of the equity share capital of its foreign subsidi ary F. 
F prepares financial stat ements in groats. Both entities have a  
reporting date of 31 March. At 1  April 20X3, the net assets of F were 
20 million groats. The total comp rehensive income of F for the year 
ended 31 March 20X4 was 2,200,000 groats. F does not pay 
dividends and goodwill was fully w ritten off prior to 31 March 20X3. 
The presentation currency of P is the dollar, $. 
 
Date Groats to $1 
31 March 20X3 2.5 
31 March 20X4 2.0 
Average rate for year ended 31 March 20X4 2.2 
 
Calculate the exchange gain th at would be recorded in other 
comprehensive income in the consolidated financial statements of the P group for th e year ended 31 March 20X4 in 
respect of its subsidiary F (stat e your answer to the nearest $ ). 
3 North acquired 75% of the equi ty shares of South on 1 October  
20X1 for Fr180,000. The carrying am ount of the net assets of So uth 
at the date of acquisition was Fr98,000 and this was considered  to 
be the same as fair value. 
It is group policy to measure non -controlling interest at fair value at 
the date of acquisition and the  fair value of the non-controlli ng 
interest in South on 1 Oc tober 20X1 was Fr45,000. 
Goodwill is tested for impai rment annually. There was no 
impairment in the year ended 30 September 20X2, however 
goodwill was considered to have been impaired by 20% in the yea r 
ended 30 September 20X3. The im pairment was translated at 
average rate for inclusion in the statement of consolidated pro fit or 
loss. 
The North group's presentat ion currency is the $. 
Exchange rates are: 
 
Date Fr to $1 
1 October 20X1 3.0 30 September 20X2 2.7 30 September 20X3 2.4 Average rate for year ended 30 September 20X3 2.5 
Calculate the exchange gain on goodwill in the year ended 
30 September 20X3 that woul d be recognised in other 
comprehensive income. Give y our answer to the nearest $.

Chapter 16 
 
 429 
 4 Complete the sentences below by  placing one of the options in 
each of the spaces (you may need t o use the same option more 
than once).  
When a foreign operation is inc luded in a consolidated set of 
financial statements, the assets  and liabilities of the operati on will be 
translated at ___________ rate in  the statement of financial po sition 
and the income and expenses w ill be transla ted at ___________ 
rate in the consolidated state ment of profit or loss and other 
An exchange difference arises on net assets and goodwill and th is 
should be recognised each year i n the statement of ___________.  
The exchange difference is cal culated by translating the openin g 
position at the ___________ rate, t he closing position at the 
___________ rate and any movements in the year (typically) at t he 
___________ rate. 
Options: 
acquisition; average; closing; opening; other comprehensive 
income; profit or loss 
5 Yorkshire holds an 80% holding in Humber, an overseas entity.  The 
Yorkshire group's presentation currency is $ and Humber's 
functional currency is the Groat  (Gr). The carrying amount of 
property, plant and equipment (PPE) i n Yorkshire's statement of  
financial position at the repor ting date is $1,700,000. Humber' s PPE 
at the same date has a ca rrying amount of Gr 800,000. 
Yorkshire acquired Humber 3 y ears ago and, at the date of 
acquisition, the fair value of Humber's PPE exceeded carrying amount by Gr 250,000. The PPE had a remaining useful life at th is 
date of 10 years. 
Humber is the only subsidia ry in the Yorkshire group. 
Date Gr to $1 
Acquisition (3 years ago) 7.5 
Reporting date 6.2 
Average rate for year 6.4 
Calculate the carrying amount of property, plant and equipment 
that would be recognised in the consolidated statement of financial position of the Yorksh ire Group at the reporting date . 
Give your answer to the nearest $.

Chapter 16 
 
 431 
 Consolidated statement of financ ial position at 31 December 20X 8 
 $  
Goodwill (W3)  2,750 
Non-current assets (60, 000 + (25,000/2)) 72,500 
Current assets (35,800 + (15,000/2)) 43,300 
 ––––––– 
 118,550 
 ––––––– 
Equity  
Share capital 50,000 Reserves (W5)  29,720 
 
––––––– 
 79,720 
Non-controlling interests (W4)  3,330 
Current liabilities (30, 000 + (11,000/ 2)) 35,500 
 ––––––– 
 118,550 
 ––––––– 
income for the year ended 31 December 20X8 
 $  
Revenue (25,000 + (1 0,000/2.5)) 29,000 
Operating expenses (10, 000 + (4,000/2.5) + 400 (W3) ) (12,000) 
 ––––––– 
Profit from operations 17,000 
Finance costs (5,000 + (1,500/2.5)) (5,600) 
 ––––––– 
Profit before tax 11,400 
Tax (3,000 + (1,000/2.5)) (3,400) 
 ––––––– 
Profit for the year 8,000

432
Other comprehensive income
Item
s that may be reclassified subsequently to profit or loss: 
Foreign exchange gains (W7)  5,583 
–––––– 
Total comprehensive income 13,583 
–––––– 
Parent shareholders (balance) 7,800 NCI shareholders (W6)  200 
–––––– 
8,000 
–––––– 
Total comprehensive income attributable to: Parent shareholders (balance) 12,266 NCI shareholders (200  + (5,583 × 20% (W7) ) 1,317 
–––––– 
13,583 
–––––– 
Workings 
Paul 
80% 2 years ago 
Simon 
Acquisition 
date Reporting 
date 
Fr Fr 
Share capital 15,000 15,000 
Retained earnings 4,000 14,000 
19,000 29,000 
Translation Acq'n rate = 5 Closing rate = 2 
Translated net asset 
($000) 3,800 14,500 
Post-acq'n reserves (incl. exc hange diff)             10,700

Chapter 16 
 
 433 
 F r  
Fair value of P's investment 21,000 
NCI at fair value 4,500 
Fair value of sub's net assets at acquisition (W2)  (19,000) 
 –––––– 
Goodwill at acquisition/ start of the year 6,500 
Impairment (1,000)  –––––– 
Goodwill at reporting date 5,500 
 –––––– 
 
Translation of goodwill:   $  At acquisition (6,500/5) 1,300 
Exchange difference prior to c urrent year (bal fig) 867 
 –––––– 
Opening goodwill at opening  rate (6,500/3) 2,167 
Impairment in current year at average rate 
(1,000/2.5)  
(400) 
Exchange difference curr ent year (bal fig) 983 
 –––––– 
Goodwill at reporting date (5,500/2) 2,750 
 –––––– 
(W4) Non-controlling interests  
 $  
NCI at acquisition (4,500/5) 900 NCI% × post acquisition reserves 
(20% × 10,700 (W2) )  
2,140 
NCI% × impairment (20% × 400) (80) 
NCI% × exchange diff on goodwill 
(20% × (867 + 983) (W3) )  
370 
 –––––– 
 3 , 3 3 0  
 –––––– 
(W5)  Reserves  
 $  
Paul 20,000 Simon: (80% × 10,700 (W2) ) 8,560 
Impairment (80% × 400) (320) 
Exchange difference on goodwill 
(80% × (867 + 983) (W3) )  
1,480 
 –––––– 
 29,720 
 ––––––

434  
 (W6) NCI share of profits  
 F r  
S's profit for the year 3,500 
Impairment (fair value method) (1,000) 
 –––––– NCI share of profits (Fr) 2,500 
 –––––– 
× 20% 500 
  
Translated at average rate (500 @ 2.5) $200 
  
 (W7)  Foreign exchange difference for OCI  
 $  
Closing net assets at closing rate (W2)  14,500 
Less opening net assets at opening rate 
(29,000 – 3,500)/3  
(8,500) 
rate (3,500/2.5)  
(1,400) 
 –––––– 
Exchange difference on net assets 4,600 Exchange difference on goodwill (W3)  983 
 –––––– 
Total exchange difference for the year 5,583  –––––– 
  
 Property, plant and equipment  
 $  
Upper 950,000 Lower (440,000 + 120,000(FV) – 96,000 (below))/ 8.2 56,585 
 –––––––– 
CV of consolidat ed PPE 1,006,585 
 –––––––– 
Working – FV depreciation  
 D  
FV depreciation (120, 000 × 4/5) 96,000

Chapter 16 
 
 435 
 Translated at the closing ra te of 8.2D/$1 = 280,000/8.2 = $34, 146. 
Goodwill 
 D  
Fair value of Upper's investment 750,000 
NCI at fair value at acquisition 150,000 Fair value of Lower's net assets at acquisition 
(500,000 + 120,000)  
(620,000) 
 ––––––– 
Goodwill at acquisition and reporting date 280,000 
  
 Total exchange difference for year (for OCI) 
 $  
Exchange difference on net assets (W1)  6,718 
Exchange difference on goodwill (W2)  3,035 
 –––––– 
Total exchange gain for the year 9,753 
(W1)  Net assets  
 D Rate $ 
Closing net assets    
(620,000 + 120,000 – 96,000) 
(Net assets + FV adj – FV dep of 120 × 4/5)  
 
644,000  
 
8.2  
 
78,537 
Less    
Opening net assets (Closing 
less CI for year)  
593,000  
9.0  
(65,889) 
year (75,000 – 24,000 FV dep)  
51,000  
8.6  
(5,930) 
   –––––– Exchange difference (bal fig)   6,718    –––––– 
    
(W2)  Goodwill translation 
 $  
At closing rate (280,000/8.2) 34,146 
At opening rate (280, 000/9.0) 31,111 
 –––––– Exchange gain for year 3,035

436  
 D $1,466,667 
 £  
Cost of investment 3,800,000 
NCI at acquisition 400,000 All FA's net assets ay acquisition (2,000,000) 
 ––––––––– 
 2,200,000 
FA's goodwill will be tr anslated at the closing rate for inclus ion within the 
consolidated statement of financ ial position of HB group as at the year 
ended 31st Dec 20X2. The clos ing rate is $1/£1.5. 
Goodwill = 2,200,000/ 1.5 = $1,466,667 
 
 D $586,667 
Annual forex gain from tran slating FA's goodwill 
  $  
Goodwill at closing rate £2,200,000/1.5 1,466,667 
Goodwill at opening rate  £2,200,000/2.5 (880,000) 
  –––––––– 
  586,667 
   
 B – FA's functional currency is £ 's therefore FA's head office is 
based in a country which uses £'s 
The location of an entity's head office is not a factor in dete rmining the 
functional currency of an entity . Factors that are considered w hen 
determining functional currency are: 
• The currency that mainly influe nces sales prices for goods and  
services 
• The currency of the country whos e competitive forces and 
regulations mainly determine the sales prices of goods and serv ices 
• The currency that mainly infl uences labour, material and other  costs 
of providing goods and services. 
NB. FA's goodwill has been calculat ed using the fair value meth od. 
Therefore, any share of the gai n or loss on translation will be  allocated 
between the parent and the NCI. 
If the goodwill was calculated us ing the proportionate method, the 
exchange gain or loss relates to  the parent only. There is no n eed to 
allocate any to NCI's.

Chapter 16 
 
 437 
 
 1 E and F are the true statements.  
A is incorrect. An entity can c hoose a presentation currency th at 
differs to its func tional currency. 
B is incorrect. Subsidiaries m ay choose to present their financ ial 
statements in the pres entation currency of t he parent (and may be 
under pressure to do so) but there is no regulatory requirement  to 
do so. 
C is incorrect. When determining  functional currency, the curre ncy 
that mainly influences sales pri ces and the currency that mainl y 
influences labour, material and other  costs should be considere d. 
Costs are not given prefer ence over sales prices. 
D is incorrect. The exchange diffe rence arising on translation of a 
foreign operation is recognised as  other comprehensive income. 
2 Exchange difference = $2,100,000  
 $000 
Closing net assets at closing rate (20m + 2.2m)/2.0 11,100 
Less opening net assets at opening rate 20m/2.5 (8,000) 
rate 2.2m/2.2  
(1,000) 
 –––––– 
Exchange difference on net assets 2,100 
No exchange difference on good will as fully written off – 
 –––––– 
Total exchange difference for the year 2,100 
 –––––– 
  
 3 Exchange gain on goodwill for y ear ended 30 September 20X3 
= $5,456  
 F r  
Fair value of parent's  investment 180,000 
NCI at fair value at acquisition 45,000 
Less fair value of net asse ts at acquisition (98,000) 
 ––––––– 
Goodwill at acquisition/st art of the year 127,000 
Impairment (20% × 127,000) (25,400)  ––––––– 
Goodwill at repor ting date 101,600 
 –––––––

438  
 
Translation of goodwill: $ 
Opening goodwill at opening rate  (127,000/2.7) 47,037 
Impairment in current y ear at average rate  
(25,400/2.5) (10,160) Exchange difference curr ent year (bal fig) 5,456 
 ––––––– 
Goodwill at reporting dat e (101,600/2.4) 42,333 
 ––––––– 
  
4 When a foreign operation is i ncluded in a consolidated set of  
translated at closing  rate in the statement o f financial position and 
the income and expenses  will be translated at average  rate in the 
consolidated statement of prof it or loss and other comprehensiv e 
income. 
An exchange difference arises  on net assets and goodwill and th is 
should be recognised each y ear in the statement of other 
comprehensive income . 
position at the opening  rate, the closing position at the closing  rate 
and any movements in the year (typically) at the average  rate. 
5 Property, plant and equipment = $1,857,258 
 $  
Yorkshire 1,700,000 
Humber (800,000 + 250, 000 (FV) – 75,000 
(below))/6.2  
157,258 
 –––––––– CV of consolidat ed PPE 1,857,258 
 –––––––– 
 G r  
FV depreciation (250, 000 × 3/10) 75,000

439 
Related party 
disclosures 
C2:  Discuss additional 
disclosure issues related to the group accounts 
 Discuss disclosure 
(a)  Transactions between 
 
  Chapter 
17

Related party disclosures 
440  
 
Related party relationships are a normal feature of business. 
The existence of a related party  relationship and transactions with related 
parties may affect the profit or loss of an entity. It is there fore important for 
users to be aware of related parties and any transactions that have occurred in 
3 IAS 24 Related Party Disclosures 
 A related party is 'a person or entity that is related to the entity that is 
preparing its financial statements (the reporting entity)'  (IAS 24, 
para 9). 
A relationship typically exists if control, joint control, comm on control or 
significant influence exists bet ween the party and the reportin g entity. 
Typical related parties are: 
• Key management personnel 
• Close family members o f key management personnel 
• Entities that are members of t he same group (including parent,  
subsidiaries, associates and joint ventures).

Chapter 17 
 
 441 
Note however that the followi ng are normally considered not to be related 
parties: 
• 'two entities simply because they  have a director/member of key  
management personnel in common  
• two joint venturers simply beca use they share joint control of a joint 
venture  
• providers of finance 
• key customers and suppliers'  (IAS 24, para11). 
Key management personnel 
 Key management personnel are 'those persons having authority and 
responsibility for planning, directing and controlling the acti vities of 
the entity, directly or indirect ly, including any director (whe ther 
executive or otherwise) of that entity'  (IAS 24, para 9). 
Close family members 
 'Close members of the family of a person are those family membe rs 
who may be expected to influence , or be influenced by, that per son 
in their dealings with the entity. 
They would include: 
• children  
• spouse or domestic partner  
• children, and other dependents, o f spouse or domestic partner'  
(IAS 24, para 9). 
 
 Related parties – the detail 
 'A person or close member of that  person's family is related to  a 
reporting entity if that person: 
• has control or joint contro l over the reporting entity  
• has significant influence over the reporting entity  
• is a member of the key management personnel of the reporting 
entity or of a parent of the reporting entity'  (IAS 24, para 9). 
'An entity is related to a repor ting entity if any of the follo wing 
conditions applies: 
• The entity and the reporting entity are members of the same 
group  
• One entity is an associate or join t venture of the other entity

442  
 • Both entities are joint ventu res of the same third party  
• One entity is a joint venture of a third entity and the other e ntity 
is an associate of the third entity  
• The entity is a post-employment be nefit plan for the benefit of  
employees of either the reporting entity or an entity related t o 
the reporting entity  
• The entity is controlled or jo intly controlled by a person 
identified as a related party to the reporting entity  
• A person identified as a related party of the reporting entity has 
significant influence over the e ntity or is a member of the key  
management personnel of the entity'  (IAS 24, para 9) 
 
 Related parties – exclu sions from definition 
 'In the context of this standard , the following are not necessa rily 
related parties: 
(a) two entities simply because th ey have a director or other 
member of key management personnel in common, 
notwithstanding the above de finition of ‘related party’  
(b) two venturers simply because they share joint control over a 
joint venture  
(c) providers of finance  
(d) trade unions  
(e) public utilities  
(f) government departments and agencies, simply by virtue of 
their normal dealings with an entity (even though they may 
affect the freedom of action of a n entity or participate in its  
decision-making process)  
(g) a customer, supplier, franchisor , distributor or general agent 
with whom an entity transact s a significant volume of 
business, merely by virtue of the resulting economic 
dependence'  (IAS 24, para 11).

Chapter 17 
 
 443 
4 Disclosure requirements 
 A related party transaction is 'a transfer of resources, services or 
obligations between a reporting e ntity and a related party, reg ardless 
of whether a price is charged'  (IAS 24, para 9). 
'Where there have been transacti ons between the entity and a re lated 
party, the entity is required to disclose: 
• The nature of the relat ed party relationship  
• The nature of the transaction  
• The amount of the transaction 
• Any outstanding balance re lating to the transaction 
• Any provisions for doubtful debts  remaining to the amount of an y 
outstanding balance'  (IAS 24, para 18). 
 
 Disclosure requirements 
 The standard concerns the disclos ure of related party transact ions in 
order to make readers of financial statements aware of the posi tion and 
to ensure that the financial stat ements show a true and fair vi ew. 
If there have been transactions b etween related parties, an ent ity shall 
disclose the nature of the relat ed party relationship as well a s information 
about the transactions and outstandi ng balances necessary for a n 
understanding of the pot ential effect of the relationship on th e financial 
In certain circumstances the ex istence of a related party shoul d be 
disclosed, regardless of whether  or not there have been any tra nsactions. 
Disclosures that related party t ransactions were made on terms 
equivalent to those that prevail in arm’s length transactions a re made 
only if such terms can be substantiated. 
'At a minimum, disclosures shall include: 
• the amount of the transactions  
• the amount of outstanding ba lances: their terms and 
conditions, including whether they are secured, and the nature 
of the consideration to be prov ided in settlement and details o f 
any guarantees given or received  
• provisions for doubtful debts related to the amount of 
outstanding balances  
• the expense recognised during the period in respect of bad or 
doubtful debts due from related parties'  (IAS 24, para 18).

444  
 In addition, IAS 24 requires an entity to disclose 'key management 
personnel compensation in tota l and for each of the following 
categories:  
• short-term employee benefits  
• post-employment benefits  
• other long-term benefits  
• termination benefits  
• equity compensation benefits'  (IAS 24, para 17). 
 
 Examples of related parties 
 Examples of related party transactions would be: 
• 'Purchases/sales of goods (even  if no price is charged) 
• Purchases/sales of property or other assets  
• Rendering/receipt of services  
• Leasing arrangements  
• Management contracts  
• Finance arrangements, e.g. loan guarantee'  (IAS 24, para 21). 
 
 Example 1 
 You decide to set up a business in an office block offering tr aining 
facilities. Your brother is the owner of the building and in or der to help 
you start your busine ss, he agrees to give you your office with  no charge 
for a four year period. 
After three successful years of b usiness your student numbers h ave 
doubled and you decide to take ear ly retirement and sell your b usiness. 
Your business is put up for sale. 
Explain what information shoul d be disclosed in the accounts 
regarding this transaction and why it is important to do this.

Chapter 17 
 
 445 
 You must disclose: 
• the nature of the related party  transaction, i.e. rental of pr emises 
• the related party, i.e. your  brother owns the building 
• the amount of the transaction, i .e. the fact that you have use  of the 
premises rent free and how much rent you are saving (based on t he 
'market rate' for the rent al of these premises). 
This information is important fo r a prospective buyer of the bu siness 
because they will need to be awar e of these facts when they loo k at the 
profits for the business. If you did not disclose this matter, the prospective 
buyer would think they could make  similar profit s if they purch ased the 
business. Although the profit figu res are correct, they are dis torted by the 
fact that the new owners would in cur a rent charge for that bui lding, 
hence the profits would reduce, a ssuming all things remain the same. 
 
 Test your understanding 1 (case style) 
 CB is an entity specialising in importing a wide range of non- food items 
and selling them to retailers. G eorge is CB’s founder and chief  executive. 
He owns 40% of CB’s equity shares: 
• CB’s largest customer, XC acco unts for 35% of CB’s revenue. XC  
has just completed negotiations wit h CB for a special 5% discou nt 
• During the accounting period, G eorge purchased a property from  
CB for $500,000. CB had previously declared the property surplu s 
to its requirements and had valued it at $750,000. 
• George’s son, Arnold is a direc tor in a financial institution,  FC. 
During the accounting period, F C advanced $2 million to CB as a n 
unsecured loan at a favourable rate of interest. 
Required: 
You are an accountant working fo r CB and you have been asked by  the 
Financial Director to prepare a briefing note, to be presented at the next 
Board of Directors meeting, exp laining the extent to which the above 
transactions should be classified and disclosed in CB's financi al 
statements in acco rdance with IAS 24 Related Party Disclosures .

446  
 The Finance Director tells you th at the Board are not intereste d in the 
generic rules of IAS 24. They just want to know about any discl osure 
requirements for the specific  transactions mentioned above. 
He also let you know that George is  particularly keen to avoid disclosing 
his purchase of the property and believes he shouldn't have to as the 
property is not required by the business anymore. He is happy h owever 
for the bank loan to be disclos ed as he believes shareholders w ill be 
pleased that a favourable rate of interest has been achieved. 
 
 Test your understanding 2 (OTQ style questions) 
 1  Which of the following would be r egarded as a related party of 
entity RP? 
C, a key customer of RP 
P, the direct parent entity of RP UP, the parent of P and the ultima te parent of the group in whi ch RP 
is consolidated 
Mr D, a director of P Mrs D, the wife of Mr D, a director of P 
O, an entity that is not part of the UP group but of which Mr D  is also 
a director 
2 Which of the following are not r elated parties of the reporting  
entity RP in accordance with IAS 24? 
S, who supplies approximately 75% of the goods purchased by RP 
V, a joint venture in which R P can exercise joint control 
J, the other party that shares j oint control of V with RP 
MS, a member of key management personnel of RP MS2, an entity in which MS is a lso a member of key management 
personnel 
B, the main finance provider of RP

448  
 Briefing note on compliance with  IAS 24 Related Party Disclosur es 
As requested, I've explained the requirements of IAS 24 with re spect to 
each of the transactions identified. 
Discount awarded to largest customer 
According to IAS 24, a customer with whom an entity transacts a  
significant volume of business is not a related party merely by  virtue of 
the resulting economic dependence. X C is therefore not a relate d party 
and the negotiated discount does  not need to be disclosed. 
Purchase of property 
A party is related to an entity if it has an interest that give s it significant 
influence over the entity. A party  is also related to an entity  if he/she is a 
member of the key managemen t personnel of the entity. 
George satisfies both of these definitions. His 40% holding dem onstrates 
the ability of exert significan t influence and his chief execut ive role clearly 
makes him a member of key management personnel. 
Therefore the sale of the proper ty for $500,000 must be disclos ed as a 
related party transaction and its valuation should also be disc losed so 
that users of the financial sta tements can understand the impac t that the 
transaction has on the  financial statements. 
Even if the transaction was a t market value, it should still be  disclosed. 
There is no option to avoid dis closure in these circumstances. 
Bank loan with favourable interest rate 
Providers of finance are not rel ated parties simply because of their 
normal dealings with the entity. H owever, if a party is a close  member of 
the family of any individual categ orised as a related party, th ey are also a 
related party. As Arnold is Geor ge’s son and George is a relate d party, 
Arnold is therefore also a rel ated party. The loan from FC will  need to be 
disclosed along with the details o f Arnold and his involvement in the 
arrangements.

Chapter 17 
 
 449 
 1  The related parties of RP ar e: P, UP, Mr D and Mrs D  
Key customers (C) a nd an entity that shares a director in commo n 
(O) are specified by IAS 24 as not being related parties. 
All of the other parties above are mentioned in the definition of a 
related party. 
2 The parties that are not related  to RP are: S, J, MS2 and B  
Key suppliers (S), joint venturer s who share control of a joint  
venture (J), an entity that has a member of key management 
personnel in common (MS2) and pr oviders of finance (B) are 
specified by IAS 24 as no t being related parties. 
Joint ventures (V) and a person who has control or significant 
influence over the entity (MS) are  included in the definition o f a 
related party.

451 
Integrated reporting 
D1:  Discuss the Integrated 
Reporting <IR> 
Framework (a) Describe the role of the 
Reporting Council (IIRC)
(b) Explain integrated 
Thinking
(c) Discuss the international 
<IR>  framework
D2:  Explain the Six Capitals 
of integrated reporting Explain the measurement and 
disclosure issues of:  
(a) Financial Capital
(b) Manufactured Capital(c) Intellectual Capital(d) Human Capital(e) Social and Relationship
Capital
(f) Natural CapitalChapter 
18

452  
1 Overview of chapter 
 
2 Financial and non-financial reporting 
This chapter covers syllabus ar ea F2D Integrated reporting. Thi s makes up 10% 
of the syllabus. Integrated reporti ng was covered briefly withi n F1 and will be 
significantly expanded upon at s trategic level within F3.  
Financial reporting 
According to the Inte rnational Accounting St andards Board's (IA SB's) 
conceptual framework, the objective of financial reporting is t o 'provide 
information about the reporting enti ty that is useful to existi ng and potential 
investors, lenders and other cr editors in making decisions abou t providing 
resources to the entity'. 
Financial statements pr ovide historic financial information, bu t they do not 
provide a full picture of how the entity is performing.  
Non-financial reporting 
To help users make decisions, i t may be helpful to provide info rmation relating 
to other aspects of an entity' s performance found outside of th e scope of the 
financial statements, such as: 
• how the business is managed; 
• its future prospects;

Chapter 18 
 453 
• the entity's policy on the environment; 
• its attitude towards social responsibility etc. 
There has been increasing pressu re for entities to provide more  information in 
their annual reports beyond just th e financial statements since  non-financial 
information can also be impor tant to users' decisions. 
Following the onset of the banki ng crisis in 2007, created by a n apparent 
dependence on short term financial  factors rather than financia l capitals over 
longer time scales and other form s of capital, it was felt that  a paradigm shift in 
reporting priorities was required.  
Financial statements have traditi onally only reported the finan cial capitals of 
companies in detail, and have no t presented detailed informatio n on the non-
financial capital base. 
This type of corporate reporting no longer fully reflects the n eeds of users of 
accounting information in the 21st century. 
The International Integrated Repo rting Council (IIRC) has produ ced a 
revolutionary framework known as  the Integrated Reporting frame work (<IR> 
framework). The <IR> approach proposes a fundamental change to the way 
that entities are managed and report to stakeholders. 
3  Introduction to Integrated Reporting <IR>  
What is integrated reporting? 
Integrated reporting is the proc ess of producing an integrated report.  
An integrated report should be a si ngle document which is the o rganisation’s 
primary report – in most juris dictions, the equivalent of the A nnual Report. 
The primary purpose o f an integrated report is to explain to pr oviders of 
financial capital how  an entity creates value over time.  
Integrated Reporting <IR> demonst rates the linkages between an organisation’s 
strategy, governance and financia l performance and the social, environmental 
and economic context within which the ent ity operates. 
By reinforcing these connections , Integrated Reporting can help  business to 
take more sustainable decisions  and enable investors and other stakeholders to 
understand how an organisati on is really performing.  
 
Integrated thinking 
Integrated thinking is  defined within the <I R> framework as ‘ the active 
consideration by an organisation of the relationships between i ts various 
operating and functional units and the capitals that the organi sation uses 
or affects.’ <IR> framework IIRC.

454  
At the heart of <IR> is the growin g realisation that a wide ran ge of factors 
determine the value of an organisa tion – some of these are fina ncial or tangible 
in nature and are easy to accoun t for in financial statements ( e.g. property, 
cash), while many, such as intel lectual capital, competition an d energy security, 
are not. The consideration of how both the fi nancial and non-fi nancial factors 
contribute to an entit y’s value is called integrated thinking. 
Historically, significant emphas is has been placed on monitorin g and assessing 
the financial value of businesse s. Directors and shareholders u se the financial 
statements to assess the entity’s  financial value. For example,  financial capital 
(cash) can be invested in proper ty, plant and equipment to impr ove efficiency 
and bottom line profitability. 
Integrated thinking pr omotes the realisation that not all value  held by the entity 
is created via such financially driven investment. Value is als o created through 
staff well-being and motivation , through the intellectual prope rty and skills of the 
entity’s staff, from the natural  surroundings and resources (la nd, water, 
minerals) within the proximity of the entity, from the reputati on of the entity with 
stakeholders and the wider communi ty and not just from making p rofits.   
<IR> is needed by busine ss and investors. Bus inesses need a rep orting 
environment that is conducive to  understanding and articulating  their strategy, 
which helps to drive performanc e internally and attract financi al capital for 
investment. Investors need to understand how the strategy being  pursued 
creates value over time.  
Each element of an Integrated Report should provide insights in to an 
organisation’s current and future performance. 
4 International Integrated  Reporting Council (IIRC) 
Background 
The International Integrated R eporting Council (IIRC) was forme d in August 
2010 and aims to establish integr ated reporting as the norm wit hin mainstream 
business practice.  
The IIRC aims to create a globally  accepted framework (<IR> fra mework) for a 
process that results in comm unications by an organisation about  value creation 
over time.  
The IIRC brings together a cross  section of representatives fro m corporate, 
investment, accounting, securitie s, regulatory, academic and st andard-setting 
sectors as well as civil society . This coalition is promoting t he communication of 
value creation across industrie s as the next step in reporting for business.

Chapter 18 
 455 
 The mission of the IIRC 
 The IIRC’s mission is  to create the globally accepted International 
<IR> Framework that elicits from organisati ons material information 
about their strategy, governance,  performance and prospects in a clear, 
concise and comparable format. 
The International <IR> Framew ork will underpin and accelerate t he 
evolution of corporate reporti ng, reflecting developments in fi nancial, 
governance, management commentary and sustainability reporting.  
The IIRC will seek to secure the adoption of <IR> by report pre parers and 
gain the recognition of standard setters and investors. 
Objective of the IIRC 
At the time of its formation, t he IIRC's stated objective was t o develop an 
internationally accepted integr ated reporting framework by 2014  to create the 
foundations for a new reporting m odel to enable organisations t o provide 
concise communications of how  they create value over time. 
After a consultation process , the IIRC published the first vers ion of its 
'International Integrated Reporti ng Framework' in December 2013 . 
5 The <IR> Framework 
The <IR> Framework is intended as  guidance for all businesses p roducing 
integrated reports.  
Its executive summary states "I t is anticipated that, over time , <IR> will become 
the corporate reporting norm. N o longer will an organisation pr oduce numerous, 
disconnected and static communications. This will be delivered by the 
process of integrated thinking , and the application of principles such as 
connectivity of information."  
The objective of the <IR> framework 
● to establish guiding principle s and content elements that gov ern the 
overall content of an integrated report 
● to explain the fundamental conc epts that underpin integrated reports. 
The concept of integrated thinking 
Integrated Reporting (<IR>) is seen by the IIRC as the basis fo r a fundamental 
change in the way in which ent ities are managed and report to s takeholders. 
A stated aim of <IR> is to suppor t integrated thinking and deci sion-making. 
Integrated thinking is descri bed in the <IR> Framework as "the active 
or affects".

456  
Purpose and objectives of  integrated reporting 
The <IR> Framework sets out the purpose  of an integrated report as follows:  
"The primary purpose of an int egrated report is to explain to p roviders of 
financial capital how a n entity creates value over time. An int egrated report 
benefits all stakeholders interes ted in an entity’s ability to create value 
over time, including employees, customers, suppliers, business partners, 
local communities, legislators, r egulators, and policy-makers."  
The objectives  for integrated r eporting include: 
• To improve the quality of info rmation available to providers o f financial 
capital to enable a more effici ent and productive allocation of  capital 
• To provide a more cohesive and efficient approach to corporate  reporting 
that draws on different reporti ng strands and communicates the full range 
of factors that materially affe ct the ability of an organisatio n to create value 
over time 
• To enhance accountability and stew ardship for the broad base o f capitals 
(financial, manufactured, inte llectual, human, social and relat ionship, and 
natural) and promote understanding of their interdependencies 
• To support integrated thinking , decision-making and actions th at focus on 
the creation of value over the short, medium and long term. 
Fundamental concepts for <IR> 
There are three fundamental c oncepts underpinning integrated re porting: 
1  Value creation for the or ganisation and for others 
Value created by an or ganisation over time manifests itself in increases, 
decreases or transformations of t he capitals (see 3) below) cau sed by the 
organisation’s business ac tivities and outputs.   
An organisation’s activities, its  interactions and relationship s, its outputs 
and the outcomes for the various  capitals it uses and affects, influence its 
ability to continue to draw on these capitals in a continuous c ycle. 
2 The value creation process 
At the core of the value creation process is an entity’s busine ss model, 
which draws on various capitals  and inputs, and by using the en tity’s 
business activities, creates out puts (products, services, by-pr oducts, 
waste) and outcomes (internal a nd external consequences for the  
capitals). 
 Tutorial Note 
An understanding of the way which  the <IR> framework considers the two 
concepts above is not required in C IMA F2. Value creation is co vered in more 
detail within P2 and business m odels contributing to value is c onsidered within 
E2.  The concepts will be explored  further within strategic lev el. At this stage, 
candidates only need an awarene ss that the concepts exist.

Chapter 18 
 457 
 
 3  The capitals 
The capitals are the resources and the relationships used and a ffected by the 
They are identified in the <IR> Framework as: ●  financial ●  manufactured ●  intellectual ●  human ●  social and relationship, and  
●  natural capital. 
These categories of capital ar e not required to be adopted in p reparing an 
entity’s integrated r eport, and an integrat ed report may not co ver all capitals – 
the focus is on capitals tha t are relevant to the entity. 
The stock and flow of capitals 
The capitals are stocks of val ue that are increased, decreased or transformed 
through the activities and output s of the organisation. For exa mple, an 
organisation’s financial capital is increased when it makes a p rofit, and the 
quality of its human capital is i mproved when employees become better trained. 
The overall stock of capitals is not fixed over time. There is a constant flow 
between and within the capitals a s they are increased, decrease d or 
transformed. For example, when an organisation improves its hum an capital 
through employee training, the re lated training costs reduce it s financial capital. 
The effect is that financial capital has been transformed into human capital. 
Although this example is simple  and presented only from the org anisation’s 
perspective, it demonstrates the continuous interaction and tra nsformation 
between the capitals, albeit wit h varying rates and outcomes. 
Many activities cause increases , decreases or transformations t hat are far more 
complex than the above example an d involve a broader mix of cap itals or of 
components within a capital (e .g. the use of water to grow crop s that are fed to 
farm animals, all of wh ich are components of natural capital). 
Categories and descript ions of the capitals 
For the purpose of the <IR> Frame work, the capitals are categor ised and 
described as follows: 
• Financial capital  – The pool of funds that is: 
–  available to an organisation  for use in the production of go ods or the 
provision of services 
–  obtained through financing, suc h as debt, equity or grants, or 
generated through operations  or investments.

458  
• Manufactured capital  – Manufactured physical o bjects (as distinct from 
natural physical objects) that a re available to an organisation  for use in the 
production of goods or the provision of services, including: 
–  buildings 
–  equipment 
–  infrastructure (such as r oads, ports, bridges, and waste and  water 
treatment plants) 
 The objects contribute to the pr oduction process rather than b eing the 
actual output. 
 Manufactured capital is often cr eated by other organisations, but includes 
assets manufactured by the repor ting organisation for sale or w hen they 
are retained for its own use. 
• Intellectual capital  – Organisational, know ledge-based intangibles, 
–  intellectual property, such as  patents, copyrights, software , rights and 
licences 
–  'organisational capital' suc h as tacit knowledge, systems, p rocedures 
and protocols 
• Human capital  – People’s competencies, c apabilities and experience, 
and their motivations to innov ate, including their: 
–  alignment with and support fo r an organisation’s governance 
framework, risk management approach, and ethical values 
–  ability to understand, develop and implement an organisation ’s 
strategy 
–  loyalties and motivations fo r improving processes, goods and  
services, including their ab ility to lead, manage and collabora te 
Human capitals are needed for pr oductive work. Enhancing human capital 
through education and training is  central to a flourishing enti ty and wider 
economy. 
• Social and relationship capital  – The institutions and the relationships 
within and between co mmunities, groups of stakeholders and othe r 
networks, and the ability to share information to enhance indiv idual and 
collective well-being.  
Social and relationship capital includes: 
–  shared norms, and common values and behaviours 
–  key stakeholder relationshi ps, and the trust and willingness  to 
engage that an organisation has dev eloped and strives to build and 
protect with external stakeholders 
–  intangibles associated with t he brand and reputation that an  
organisation has developed 
–  an organisation’s soci al licence to operate

Chapter 18 
 459 
• Natural capital  – All renewable and non-r enewable environmental 
resources and processes that provide goods or services that sup port the 
past, current or future prosper ity of an organisation. It inclu des: 
–  air, water, land, minerals and forests –  bio-diversity and eco-system health. 
Natural capital within an entit y will consider those factors th at absorb, 
neutralise or recycle wastes and  processes – e.g. climate regul ation, 
climate change, CO
6 Benefits and limitations 
Benefits and limitations of Integrated Reporting 
Benefits Limitations 
●  Increase in the level of 
forward-looking information provided enabling more informed user decisions ●   Potential for bias as  reports 
are not required to be audited 
●  Disclosure of new previously 
undisclosed information increases users understanding ●   Reluctance to disclose 
information for fear of losing competitive advantages 
●  Improved stakeholder 
reputation due to increased transparency ●   May provide too much 
information for users to digest 
●  Integrated thinking may lead to 
improved efficiencies within organisations  
Benefits and limitations of the <IR> framework 
●  Provides guidance for 
preparers  as to concepts and 
contents of the integrated report ●  Principle based rather than 
rule based leads to increased 
subjectivity and potential bias 
●  Being principles based 
enables the applic ation of the 
framework by entities operating in any industry ●  Difficult to compare across 
different entities and sectors 
●  Increases user familiarity with 
the terminology and structure  used within the <IR> ●  Requires experienced staff to 
apply concepts properly

460  
 Test your understanding 1 (O bjective test questions) 
 1  Which THREE of the following are objectives of Integrated 
Reporting, as identified by th e International Integrated 
Reporting Council (IIRC)?  
A  To support integrated thin king and decision making 
B  To communicate the impacts o f economic, environmental and 
social and governance performance 
C  To improve the quality of inf ormation available to providers  of 
financial capital 
D  To increase the quantity of inf ormation available to provide rs 
of financial capital 
E  To provide a more cohes ive and efficient approach to 
2  The <IR> framework outlines 6  capitals that are used and aff ected 
by an organisation. 
Which of the following are identified by the <IR> framework as 
types of capital? Select all that apply 
A Human  
B Animal C Social D Educational E Economic 
3 Which of the following orga nisations produced the <IR> 
framework?  
A The International Acco unting Standards Board 
B The Integrated Reporting  Corporation C The Global Reporting Initiative D The International Integr ated Reporting Council 
4 Lucas Co is a well-establis hed manufacturing company with 
operations in many countries. Its  products have an excellent 
 In Lucas Co’s Integrated Report, how would it present this 
A It would not disclose this  information explicitly  
B As part of its disclosure of s ocial and relationship capitals    
C As part of its disclosure of intellectual capitals   
D As part of its disclosure of manufactured capitals

Chapter 18 
 461 
5 Which one of the following coul d be construed as a limitation 
of <IR>? 
A increased integr ated thinking 
B Competitors obtain impr oved levels of understanding 
regarding the entity 
C <IR> creates an over-emphas is on value cr eation and long-
term prospects 
D <IR>  requires disclosure of i nformation regarding capitals 
not reflected within th e financial statements 
6 Banana Co is an entit y operating at the luxury end of the tec hnology 
sector. The business incurs a l ot of research expenditure and h as 
numerous patented innovat ions not shown as assets within their 
Based on the information provid ed, which of the following 
capitals would require significan t disclosure within Banana’s 
<IR>? 
A  Intellectual 
B  Manufacturing C  Human D  Financial

462  
 Test your understanding 1 (O bjective test question) 
 1 The answer is A, C and E. 
(B) is an objective of sustai nability reporting but not <IR> 
(D) is irrelevant – investors a re more interested in the qualit y, not 
the quantity, of inform ation available. 
2 The answers are  A and C 
3 D 
  The IIRC produced the <IR>  framework. IIRC stands for 
International Integrated Reporting Council. 
4  B 
 Social and relationship capitals  include intangibles associate d with 
the brand and reputati on that an organisation has developed. 
5  B 
 Increased information given to c ompetitors may create strategi c 
disadvantages to the entity. 
 The remaining options would be deemed benefits of integrated 
reporting.  
6 A 
 Intellectual capitals include organisational, knowledge-based 
intangibles and intellectual pr operty, such as patents, copyrig hts, 
software, rights and licences.

463 
Analysis of financial 
E1:  Analyse financial 
statements of organisations 
 Analyse financial statements to 
provide insight on: 
(a) Performance (b) Position (c) Adaptability (d) Prospects  
E2:  Recommend actions 
based on insights from the interpretation of financial statements  
 (a) Recommend actions 
 
E3:  Discuss the limitations of 
the tools used for interpreting financial statements 
 Discuss 
(a)  Data limitations (b)  Limitations of ratio 
analysis 
 
  Chapter 
19

Analysis of financial statements 
 
464  
 
Previous studies and chapters within this textbook focus on how  to prepare the 
financial statement s of an entity.  
This chapter focusses on the sk ills required to analyse and int erpret these 
financial statements. This is a  separately defined syllabus are a of F2, covering 
25% of the examination.   
Big data  
As per concepts investigated withi n E2 and to be investigated i n further studies, 
data analytics are becoming of huge prevalence for corporations  when striving 
to create and preserve value. 
With widespread technological dev elopments enabling the accurat e and easy 
collation of huge amounts of specif ic data, everyday life is be coming awash with 
the ability to analyse, interpre t and conclude upon all sorts o f different sources 
of data. The applications can be seen on a daily basis and affe ct all walks of life 
e.g: 
– Improved analysis of sporting ev ents e.g. distances covered, misplaced 
passes, number of fairways hit (or missed) in golf 
– Political implications e.g. i mproved polling and approval ass essments, 
targeted cyber-attacks and viral campaigns to create political instability

Chapter 19 
 465 
– Fitness and well-be ing data enabling monito ring of personal p erformance 
and targeted goal setting 
– Meteorology trends predicting behaviours in weather patterns.  
Corporations have been quick to  take advantage of the new oppor tunities 
presented as a result of modern data analytics within their str ategies for wealth 
and value creation e.g. targeted marketing campaigns using sear ch engine 
results and trending social media  topics to provide personalise d consumer pop-
ups and advertising. 
Analysts often use analytical mo dels to help with the process o f making 
conclusions and in developing ap plications for the findings fro m their gathered 
data. 
One such approach is the Gartner D ata Analytics Maturity model.  
Gartner Data Analytics Maturity model 
The Gartner Data Analytics Matu rity model groups data analytics  into 4 
separate stages. The stages outline  the evolution of the use of  data analytics by 
an entity. The stages are: 
– Descriptive (what happened?) – Diagnostic (why it happened?) – Predictive (what is going to happen?) – Prescriptive (how can we mak e it happen/prevent it happening? ) 
These stages enable analysts to imp rove the conclusions made, m aturing from 
conclusions created with hindsig ht (within the descriptive and diagnostic 
stages), to providing insight about the potential future effect s of the data (within 
the predictive stage) and cumulati ng in proactive decisions whi ch focus upon 
applying foresight (within the prescriptive stage).  
This approach utilised by the Gart ner Data Analytics Maturity m odel can be 
applied to analysing the  financial statements.  
The IASB®'s Conceptual Framework for Financial Reporting states: 
'The objective of financial re porting is to provide financial i nformation 
about the reporting entity that  is useful to existing and poten tial investors, 
lenders and other creditors in  making decisions about providing  
resources to the entity'  (IASB Conceptual Fram ework para 1.2).  
Interpretation and analysis of t he financial statements is the process of 
arranging, examining and compari ng the results in order that us ers are 
equipped to make such decisions.

466  
Key areas to consider when per forming an analysis of the financ ial statements 
are: 
• identification of the user of the analysis 
• an understanding of the nature o f the business, industry and o rganisation 
• identification of relevant s ources of data for analysis 
• numerical analysis of the data available 
• interpretation of the results of the analysis. 
3 Users of the analysis 
It is important to identify the ty pe of user for whom an analys is is being 
prepared, as different users hav e different needs. It is import ant that any 
analysis exercise is oriented to wards the needs of the particul ar user who 
requires the analysis. 
There is a wide range of user gr oups that may be interested in an entity’s 
financial statements. Historica lly the financial statements hav e been prepared 
for investors. However, other u sers will also be interested in them. 
 
 Users of financial statements 
 Present and potential investors 
Both present and potential invest ors are interested in informat ion that is 
useful in making buy/sell/hold decisions. Will the entity be ab le to 
generate cash in the future? How risky is the investment? Does its 
financial performance exceed that of other p otential investee e ntities? 
How much is the investment likel y to yield in capital growth an d/or 
dividend? Analysis of the financia l statements can help to answ er these 
questions. There is a range of ratio s of particular interest to  the investor 
group; most of which are out of  the scope of the F2 examination  (e.g. 
P/E, dividend yield). In addition , return on capital employed ( ROCE) and 
related performance and asset m anagement ratios are likely to b e of 
interest to this group of users. 
Lenders and potential lenders 
Lenders are principally interest ed in assessing whether or not the loans 
that they have made are likely to  be repaid, and whether or not  the 
related interest charge will be paid in full and on time. Poten tial lenders 
require analysis of financial st atements in order to assist the m in deciding 
whether or not to lend. Lender groups  are likely to be particul arly 
interested in ratios such as in terest cover and gearing, and wi ll be 
interested in the nature and long evity of other categories of l oan to the 
entity.

Chapter 19 
 467 
Suppliers and other creditors 
This group is interested in inf ormation that helps them to deci de whether 
or not to supply goods or services  to an entity. Availability o f cash will be 
of particular interest, together with such evidence as is avail able in 
general-purpose financial statem ents about the entity’s record in paying 
its creditors on time. Working c apital ratios and the working c apital cycle 
may be appropriate calculations  to undertake when analysing fin ancial 
statements for the benefit o f this class of user. 
Employees 
In large organisations employees a re likely to be particularly interested in 
one part of the entity’s operations. They may, therefore, find segmental 
information to be useful. More generally, they need to be able to assess 
the stability and performance of t he entity in order to gauge h ow reliable it 
is likely to be as a source o f employment in the longer term. E mployees 
are likely to be interested in d isclosures about retirement ben efits and 
remuneration. 
Customers 
Customers may be in a vulnerable position if ther e are few pote ntial 
suppliers in a market for goods . They may therefore be interest ed in 
assessing the risks which threaten  their supplier. Potentially they may be 
interested in takeover opportuniti es in order to ensure the con tinuing 
supply of a particular raw material. 
Governments and their agencies 
The governmental group is in a pos ition to require special-purp ose 
reports. Tax computations would  fall into this category. Howeve r, general-
purpose reports may also be of u se, for example in gathering st atistics on 
particular industries. 
The general public 
Members of the public may have s pecial interests in the activit ies of 
certain entities, especially whe re, say, an individual entity d ominates the 
local employment market. Pressure  groups and their members woul d 
also fall under the umbrella cat egory of ‘general public’, and their needs 
will vary according to their spec ial interest. Environmental is sues are of 
increasing concern to many peop le, and it is likely that pressu re groups 
will take a particular interes t in firms that are perceived as polluters. 
Analysis of the financial statem ents for this type of user woul d tend to 
focus on any additional volunt ary disclosures made about the en tity’s 
environmental policies, on provis ions and contingent liabilitie s related to 
environmental damage, and on capita l investment (e.g. investmen t in 
new plant). For more on voluntar y disclosures see Chapter 17 on  
Integrated reporting.

468  
4 Understanding the entity 
It is often thought that financial a nalysis involves purely the  application of a 
standard set of numerical calcu lations to a set of published ac counts. This is 
only one part of the task. 
Having a solid understanding o f the markets and industry an ent ity operates 
within will improve the conclu sions made from analysing the acc ounts.  
Financial statement analysis shou ld look beyond the numbers to provide 
narrative insight into the per formance and position of an entit y. The financial 
statements could be us ed in conjunction with <IR> (if available ) to garner a 
detailed understanding of the over all developments within an en tity (providing 
both a financial and non-fi nancial perspective).  
The history of the ent ity underlies the curr ent position and fu ture outlook. 
Furthermore, the owners and their individual characteristics wi ll influence 
factors such as the level of ri sk in the entity a nd dividend po licy. Knowledge of 
the quality, qualifications and experience of management will a ssist in 
evaluating the performance and position of the entity. 
Financial analysis requires an understanding of the products, s ervices and 
operating characteristics of the entity. This will assist in un derstanding data 
such as revenue, profitability, i nventories and working capital . 
The entity operates within an indu stry consisting of entities w ith similar 
operating characteristics. If the analysis requires comparison of the entity with 
the industry norms, it is import ant to identify the key charact eristics of the 
industry and to establish benchmar ks such as gross profit ratio s, receivables 
collection days etc. 
5 Relevant sources of data 
In practice, the analyst needs to c onsider carefully the possib le sources of 
information available about an entity, starting with the annual  report. This will 
contain financial information bu t there may be additional volun tary disclosures 
that will be helpful to the analys t, such as the entity’s envir onmental impact, 
employment reports, graphs, pie c harts and ratio calculations. 
In the management level case st udy, pre-seen material will be p rovided in 
advance of the assessment and it  will be important to consider how this 
information might be helpful in  performing any analysis require ments that 
appear in the assessment.

Chapter 19 
 469 
6 Numerical analysis of the data  
Financial statements c an be used to analyse: 
– Performance, how profitable t he entity is during the year, ma inly via its 
statement of profit or loss. 
– Position, the entity’s ownersh ip of assets and obligations, m ainly via its 
statement of financial position 
– Adaptability, how easily can an entity adapt to take advantag e of 
opportunities that may arise (w hether expected or unexpected), mainly 
through assessment of cash positi ons, working capital structure  and 
– Prospects, what does the future  hold for the entity? How succ essful are 
investments and projects antici pated to be? Profits, cash flows , asset 
base, financing structure are a ll used to analyse whether the e ntity will 
operate successfully and continue going forward 
This section focusses on introduc ing and explaining the calcula tion of ratios as 
part of this analysis. 
However, do not forget that these ratios are there to help with  the analysis and 
are not always necessary. The same  conclusions are often made b y reviewing 
the movements in figures or look ing for unusual fluctuations in  the data e.g. 
operating profit margins can lead  to a conclusion of improved p erformance but 
so could simply reviewing the ac tual operating profit figures! 
Ratios 
There are a variety of ratios  that can be used when assessing a n entity's 
financial statements and they fa ll into four broad categories: 
• Efficiency/activity ratios 
– Working capital ratios – Asset turnover ratios 
• Capital structure ratios 
– Gearing – Interest cover. 
The financial statements provi ded below will be used to demonst rate how to 
calculate and interpret these rati os across test your understan dings (TYUs) 
1 to 4.

470  
 Financial information for TYUs 1 to 4 
 Below are the financial statem ents for T for the years ended 3 0 June 
20X5 and 20X6: 
Statement of profit and loss a nd other comprehensive income 
 
 20X6 20X5 
 $000 $000 
Revenue 180 150 
Cost of sales (65) (60) 
Gross profit 115 90 
Operating expenses (40) (29) 
Share of profit of associate 59 – 
Finance costs (24) (10) 
Profit before tax 110 51 
Tax (14) (13) 
Profit for the year 96 38 
Other comprehensive income:   Items that may be reclassified subsequently to profit or loss:  
Gains on revaluation of FVOCI financial assets  14 5 
Items that will not be recla ssified to profit or loss:  
Revaluation of PPE 30 – 
 
Total comprehensive income 140 43 
Summarised statements of changes in equity 
 20X6 20X5 
 $000 $000 
Opening balance 100 82 
Issue of shares 3 – Total comprehensive income for the year 140 43 
Dividends (25) (25) 
 
Closing balance 218 100 

Chapter 19 
 471 
 Statements of financial position 
  20X6  20X5 
Non-current assets  $000  $000 
Property, plant and equipment  266  190 
Investment in associate  250  – 
Other financial assets  31  17 
  ––––  –––– 
  547  207 
Inventory 15  12  
Receivables 49  37  Cash and cash equivalents –  1  
 
––––  ––––  
  64  50 
  ––––  –––– 
  611  257 
  ––––  –––– 
Equity     
Share capital  12  10 
Share premium  5  4 Revaluation surplus  30  – 
FVOCI reserve  21  7 
Retained earnings  150  79 
  
––––  –––– 
Total equity  218  100 
Long term borrowings 335  110  
Deferred tax 14  15  
 ––––  ––––  
  349  125 
Trade payables 12  11  
Overdraft 9  –  
Taxation 13  11  Provisions 10  10  
 
––––  ––––  
  44  32 
  ––––  –––– 
  611  257 
  ––––  ––––

472  
 Test your understanding 1 (integ ration question) – Profitabilit y 
 Required: 
For each of the two years, calcu late the following ratios for T  and suggest 
reasons why the ratios have changed. 
 20X6 20X5 
Gross profit margin   
 Gross profit
Revenue	× 100%   
Operating profit margin   
Operating profit
Revenue × 100%   
Profit before tax margin   
Profit before tax
Effective tax rate   
Tax expense
Profit before tax* × 100%   
* Share of profit of associate  should be excluded from profit, as it is 
already net of tax 
Return on capital employed 
 Operating profit
Capital employed × 100% 
Operating profit = G ross profit less operat ing (admin and distr ibution) 
expenses 
Capital employed = equity (share capital plus reserves) + inter est bearing 
borrowings – non-current assets t hat do not contribute to opera ting profit 
(such as financial assets and investments in associates)

Chapter 19 
 473 
Analysing profitability ratios and data  
Start by looking at the first li ne in the statement of profit o r loss and other 
comprehensive income: revenue. H as it gone up or down and what is the 
percentage increase or decrease? A change in revenue may be due  to a 
change in selling price or s ales volume or both. 
Gross profit margin  is the percentage of revenue re tained after costs of sale 
are deducted. Entities will aim to  sell many products with a lo w margin or 
potentially fewer products with a high margin. A change in gros s profit margin 
may be due to a change in produc t mix, for example selling more  of a product 
with a higher margin or converse ly bringing a new product to ma rket with a low 
margin to gain market share. 
The operating profit margin  is the trading or operati ng profit in relation to 
revenue, expressed as a percent age. The difference between gros s profit 
margin and operating profit mar gin is the operating costs of th e entity such as 
administration costs,  telephone costs and adv ertising costs. Yo u need to use 
any background information prov ided to assess how these expense s may differ 
to the prior year or  to another entity. 
Profit before tax margin  expresses the relationship between profit before tax 
and sales. Profit for this purpos e would be after deduction of finance costs. An 
alternative is to calculate  profit after tax margin. 
Non-current asset policies  (see Illustration 1) can hav e a substantial effect on 
ratios and comparison between ent ities. For example, whether as sets are 
measured at historical cost or are revalued. Depreciation charg es will be higher 
for revalued assets. Depreciation  may be categorised as a cost of sale or 
operating expense. 
Exceptional items  such as a profit on disposal  of a non-current asset should 
be removed from the analysis to enable comparisons to be made. 
Effective tax rate  assesses the extent of the impact that tax has on the entity's  
profit. 
Return on capital employed (ROCE)  is a very useful measure when analysing 
performance. It assesses the effi ciency with which the entity u ses its assets to 
produce profit. You should consid er any changes in capital empl oyed and, for 
example, whether an increase occu rred towards the end of an acc ounting 
period and hence there has not y et been an opportunity for the entity to use the 
capital to generate increased profit.

474  
 Further analysis of profitability 
 Revenue 
Problems can arise in making a valid interpretat ion of movement s in 
revenue. For example: 
• Accounting policies on revenue recognition may vary between 
entities. There may be inconsis tencies between accounting perio ds, 
especially where the entity derives some or all of its revenue from 
long-term contracts. 
• Inflation may account for some  of the increase in price. 
• A detailed breakdown of revenue  for the entity may not be avai lable. 
Understanding the reasons for mo vements in revenue may help to 
explain movements in costs such as cost of sales, advertising, selling and 
distribution costs. If revenue in creases, then a similar increa se in these 
revenue-related costs could be expected. Conversely, an increas e in, 
say, marketing and advertising ex penditure might help to explai n an 
increase in revenue. 
This ratio is expected to be mo re or less constant from one yea r to the 
next within an entity. Even if t here is an increase in direct c osts, an 
efficient entity could be expec ted to pass on the increases in the form of 
increased sales prices. However, t his may not be the case in re ality. 
The gross profit margin require s a detailed breakdown in order to gain an 
understanding of movements. Idea lly, the analyst requires infor mation 
relating to opening and closing in ventories, purchases, direct wages and 
overheads. Further information as  to the following items would be 
required in order to evaluate gross profit margin fully: 
• breakdown by product, geographi cal area or other segment 
• inventory valuation policies 
• overhead allocation methods 
• purchasing details such as bul k discounts, purchasing errors, 
wastage or theft 
• selling prices of differen t products over the period. 
Obviously, much of this informati on is not available from an en tity's 
annual report. Some entit ies do not even report gross profits.

Chapter 19 
 475 
 Operating profit margin 
Operating profit is the profit  from the trading activities of t he business; it 
comprises profits after operati ng costs, but before finance cos ts, tax, 
investment income and any share of profits from an associate. N ote that 
IAS 1 revised does not encourage  the reporting o f operating pro fit as a 
separate line item, alt hough there is nothing  to prevent entiti es providing 
additional information. 
Profit before/after tax margin 
Where comparing profit year on year, it is important to allow f or any 
exceptional charges or credits . Also, it would be sensible when  
calculating profit after tax ma rgin to take into account any la rge 
adjustments in respect of under or over-provided tax provisions . 
Effective tax rate 
This will help to understand the impact that tax has on the ove rall profit 
for the year. Tax is a consequenc e of being profitable and, to a certain 
extent, the impact of tax on profit s is outside the control of the entity, 
however it should be considered w hen making investment decision s. 
Return on capital employed (ROC E) is a measurement that is freq uently 
used in the analysis of financial st atements. This shows the ov erall 
performance of the entity, expre ssed as a percentage return on the total 
investment. It measures management’s  efficiency in generating p rofits 
from the resources available. 
Consistency of numer ator and denominator is important in this r atio. 
Therefore, in calculating RO CE, the numerator should include pr ofit 
before any deductions for finance co sts. If capital employed in cludes a 
bank overdraft, the profit figure used in the calc ulation shoul d exclude 
interest paid and payable on the overdraft. 
The basic capital employed figur e (the denominator) is equity ( including 
share capital, reserves and NCI ) and interest bearing borrowing s. An 
adjustment should then be made to r emove the carrying amount of  any 
non-current asset that does not cont ribute to operating profit (the 
numerator) in order to provide co nsistency. A classic example o f this is 
an investment in associate. The share of associate profit is pr esented in 
the statement of profit or loss below operating pr ofit, therefo re the value 
of the investment in associate should be deducted from the capi tal 
employed figure.

476  
 EBITDA 
 EBITDA is an acronym for earni ngs before interest, tax, deprec iation and 
amortisation. 
In recent years many large entit ies have adopted EBITDA as a ke y 
measure of financial performanc e. Sceptics suggest that they do  this in 
order to publicise a higher measur e of earnings than profit fro m 
operations (this type of measuremen t is sometimes cynically ref erred to 
as EBBB – earnings befor e the bad bits). 
However, it does make some sense  to measure EBITD A, provided th at 
the user fully understands what i s included and what is left ou t. 
Depreciation and amortisation ar e accounting adjustments, not 
representing cash flows that a re determined by management. It c an 
therefore be argued that exclu ding these items in assessing ear nings 
eliminates a major area wher e management bias can operate. 
Unfortunately, EBITDA is conse quently often misunderstood as be ing a 
measurement of cash flow, which  it is not. Even though two cate gories of 
non-cash adjustment are eliminat ed, financial statements are pr epared 
on an accruals basis. EBITDA make s no adjustments in respect of  
accruals or working capital move ments, and so is emphatically n ot a cash 
flow measurement. 
 
 Required: 
Using the financial information fo r TYU 1 – 4, calculate the EB ITDA for 
20X6 and 20X5. 
The following further information is also available: 
 20X6 20X5 
Depreciation 6 3

Chapter 19 
 477 
 Illustration 1 – Effect of non-cu rrent asset policies on ratios  
 The following information has be en extracted from the financia l 
statements of A, B and C for the year ended 30 September 20X4: 
 
 A B C 
Statement of profit or loss $000 $000 $000 
Revenue 200 200 200 
Operating costs (160) (190) (170) 
Profit from operations 40 10 30 
Share capital 50 50 50 
Retained earnings 90 60 50 Revaluation surplus  210  
 
Capital employed  140 320 100 
Operating profit margin 20% 5% 15% 
Return on capital employed 28.6% 3.1% 30% 
Entity A 
A had purchased an asset costing $200,000 4 years ago. The asse t is 
being depreciated on t he straight-line basis over 10 years. The refore, 
$20,000 of depreciation has been charged to this year's stateme nt of 
profit and loss and the asset has  a carrying amount of $120,000  in the 
B and C as entities hold assets s imilar to that acquired by A. However, 
they adopt different accounting po licies as described below. Th ey are 
identical to A in all other respects.

478  
 Entity B 
B revalued the asset to its cu rrent value of $350,000 at the st art of the 
current year. As a result, a revaluation gain of $210,000 has b een 
recognised and depreciation has been increased to $50,000 per a nnum, 
i.e. additional depreciation o f $30,000 has been charged to the  statement 
of profit and loss in the current year. 
The revaluation has caused the operating profit margin to fall due to the 
extra depreciation. Return on capi tal employed has also fallen due to the 
revaluation surplus being incl uded in capital employed. 
Hence the entity looks to be generating a lower return. 
Entity C 
C has been leasing the asset under  a 12 month rental agreement,  paying 
an annual rental of $30, 000 which has been c harged to operating  
expenses.  No right-of-use asse t or lease liability is recorded  for such a 
short lease. 
This causes the operating profit  margin to fall due to the leas e payments 
being higher than depreciation. How ever, the return on capital employed 
is higher than A since the asset i s not included on the stateme nt of 
financial position but is still being used by the business to g enerate sales. 
 
 Test your understanding 3 (integ ration question) – Liquidity 
 Required: 
Using the financial statements pr ovided for T, calculate the fo llowing 
ratios for T and suggest why t he ratios may have changed. 
 20X6 20X5 
Current ratio (shown as ratio)   
Current assets
Quick ratio (shown as ratio)   
(Current assets – Inventory)
Current liabilities

Chapter 19 
 479 
 Test your understanding 4 (integ ration question) – Efficiency 
 Required: 
 20X6 20X5 
Inventory holding period (in days)   
Inventory
Cost of sales × 365 days   
Receivables collecti on period (in days)   
Receivables
Revenue × 365 days   
Payables payment period (in days)   
Trade payables
Asset turnover    
Revenue
Capital employed   
Non-current asset turnover   
Revenue
Non-current assets 	(that contribute to revenue )    
   
Analysing liquidity 
The analysis of the liquidity o f an entity shoul d start with a review of the actual 
bank balance  in absolute terms. Has the bank balance increased or decreased  
significantly? It could be tha t the overdraft is near to its pe rmitted limit or that 
high cash resources indicate a good takeover prospect. 
The current ratio  compares current assets to curr ent liabilities. A ratio greate r 
than 1 indicates there are more  current assets than current lia bilities. The 
current ratio guides us to the ex tent the entity is able to mee t its current 
liabilities as they fall due. 
The quick ratio  compares current assets, excluding inventory, to current 
liabilities. The quick ratio gives a better indicator of liquid ity if the inventory of an 
entity is difficult to realise in to cash, for example, a whisky  distillery that requires 
a number of months to matu re before being sold.

480  
Analysing efficiency/activity 
The inventory holding period  indicates how much worki ng capital is tied up in 
goods in the warehouse by giving  an average number of days that  inventory is 
held before being sold. An entit y must balance the need to supp ly goods on 
time to customers with the risk of obsolescence. 
The receivables coll ection period  tells us the number of days it takes on 
average to receive payment from credit customers. It should be based on the 
credit agreement with customers. C ash should be collected effic iently whilst 
bearing in mind customers in  a strong negotiating position. 
The payables payment period  is the length of time it takes to pay suppliers for 
goods bought on credit. This is eff ectively a free source of fi nance but the 
business should make sure supplie rs are paid on a timely basis to avoid the risk 
of stock-outs. 
Asset turnover  measures how much revenue is  being generated from the 
overall capital invested. It is a measure of the efficiency/act ivity of the capital. 
Non-current asset turnover  is a similar calculation but measuring the 
efficiency/activity of non-curr ent assets only. There are many variations of this 
ratio that can provide useful i nformation, such as total asset turnover and 
working capital turnover. 
Over-trading 
When an entity grows r apidly there is a ri sk of over-trading, i .e. expanding the 
entity without adequate long term o r short term finance. Invent ory, receivables 
and payables increase but there is  a decline in cash and the en tity may be 
unable to pay its suppliers as debts fall due. 
Entities in this position s hould look to raise long-term financ e. This will enable 
the entity to improve its inv entory and credit control and, by reducing its 
inventory and receivable days, improve its cash-flow. 
Other options include factoring of receivables or invoice disco unting facilities.

Chapter 19 
 481 
 Further analysis of liquidi ty and efficiency/activity 
 Short term liquidity 
The quick ratio recognises tha t the time taken to convert inven tory into 
cash in many entities is signi ficantly longer than other curren t assets and 
so gives a more conservative v iew of liquidity. However, it is important to 
select ratios suitable for the circumstances of the entity. If inventory is an 
insignificant amount (as it would be, for example, in most serv ice 
entities), there is little point i n calculating the quick ratio . 
There is no standard number that should be expected in these 
calculations; it should depend on t he industry and should be li nked to 
other areas of the analysis. The higher the ratio, the more liq uid the 
entity, but high liquidity can it self be a problem. It may mean  that the 
entity is unable to utilise cash effectively by investing it pr ofitably. 
The length of the working capita l cycle can assist in determini ng the 
immediate effects of the financ ial position on  the bank balance . 
The working capital cycle compri ses cash, receivables, inventor y and 
payables. The entity uses cash to  buy inventory. Additional inv entory may 
be purchased on credit. 
Inventories are sold and become receivables. Receivables pay an d then 
the entity has cash available to  repay payables or buy further inventory. 
The total length of the working capital cycle is the inventory holding 
period plus the receivables days less the payables days, which 
approximates to the total time it takes to purchase the invento ry, sell the 
inventory and receive cash. 
Inventory holding period 
The ratio gives the number of da ys that inventory, on average, has 
remained in the warehouse. If only a closing figure is availabl e for 
inventory, then that can be used . However, the result must be t reated 
with some caution, as the closi ng figure may be unrepresentativ e, 
particularly if the nature of t he entity's business is seasonal . An average 
stock level should be used if the closing stock figure is deeme d not 
representative. 
A retail or cash-based entity may have zero or very low receiva bles days. 
Note that, where an entity se lls for both cash and on credit, i t will be 
necessary to split revenue into the two types.

482  
 Payables days 
Current payables comprise a form  of finance which is free, or a lmost free. 
However, there may be costs such as loss of prompt payment disc ount 
and loss of supplier goodwi ll where excessive time is taken to pay. 
Efficiency is measured relative  to industry norms, receivables days and 
supplier terms. 
To calculate the working capita l cycle, if figures are not avai lable for 
credit sales and credit purchases  (as may well be the case if t he data 
source is a set of published accoun ts), an approximation may be  
obtained by using total revenue a nd cost of sales respectively,  but the 
results of such ratio calculati ons must be treat ed with caution . 
Asset turnover/utilisation 
This calculation shows how much revenue is produced per unit of  capital 
invested. 
This ratio shows the productivity of assets in generating sales . It should 
be noted that this ratio is not a lways useful or informative. W here an 
entity is using assets that are  nearing the end of their useful  lives, having 
been subject to annual depreciation charges over a relatively l ong period, 
the ratio is likely to be rat her high. Similarly, where an enti ty uses the 
historical cost convention, unmod ified by revaluation, asset va lues are 
also likely to be relatively low , an effect which is more intru sive as the 
assets age. Also, in labour-int ensive entities, where the non-c urrent asset 
base is low, the ratio tends  to lack significance. 
Note that, where possible, the average asset figure over the ye ar should 
be used in the denominator of the  fraction. This is likely to g ive a more 
consistent and representative re sult. External users of annual reports do 
not have access to monthly informa tion with which to calculate an 
average, but opening and closing  figures often give a reasonabl e 
The denominator should exclude any assets that do not contribut e to 
revenue as these would distort the ratio.

Chapter 19 
 483 
 Test your understanding 5 (int egration question) – Gearing 
 Required: 
Using the financial statements pr ovided for T in TYU 1, calcula te the 
following ratios for T and suggest w hy the ratios may have chan ged. 
 20X6 20X5 
Gearing (%)   
Debt
Debt + Equity   
Gearing alternative (shown 
as ratio)   
Debt
Equity   
Interest cover (number of 
times covered)   
Finance costs   
Average rate of borrowing 
(%)   
Finance costs
Borrowings   
Dividend cover (number of 
Profit for the year
Dividends   
   
Analysing capital structure ratios and data  
Gearing  is an important measure of ri sk and a guide to the long term s olvency 
of the entity. It is calculated by taking long term debt as a p ercentage of total 
capital employed, i.e. long term debt plus shareholders' funds.  Alternatively it 
can be calculated by taking deb t as a percentage of equity, or shareholders' 
funds. Make your calcula tion clear in the exam. 
It is important to assess the gearing ratio against the industry  average  and to 
ensure that the debt finance is p ut to good use to generate rev enue and profits. 
The interest charged on debt finance should be compared to interest rates  
available to the entity from ot her sources. Also, debt is often  secured on assets  
for security so there needs to  be sufficient assets for this to  be possible.

484  
Interest cover  indicates the number of times pr ofits will cover the interest 
charge; the higher the ratio, the better. When looking at inter est cover, the 
stability of profits  is important as the interest m ust be paid consistently out of 
available profits ot herwise the entity may default on its debt and may have to 
repay it at short notice. 
Average rate of borrowings  indicates the typical inte rest rate that the entity 
pays on its debt finance. A high rate would suggest that lender s consider the 
entity to be a relatively high risk. 
Dividend cover  indicates the number of times profits will cove r the dividend;  
the higher the ratio the better as shareholders may expect a su stainable 
dividend payment. 
 
 Further analysis of capital structure 
 The gearing (or leverage) ratio  is an important measure of ris k. 
It is important to analyse, particu larly for users such as shar eholders and 
creditors, the ability to satisfy  debts falling due after one y ear. There are 
two elements to consider: repay ment of capital and payment of i nterest. 
The statement of financial posit ion shows the current liquidity  and capital 
structure of the entit y, that is the short- term liquidity and t he level of fixed 
prior charge capital. 
The statement of profit or loss shows the profitability of the business 
generally, indicating its ability  to generate cash, some of whi ch may be 
available to repay debt. 
The capital structure of the ent ity provides information about the relative 
risk that is accepted by shar eholders and creditors. As long-te rm debt 
increases relative to shareholders’ funds, then more risk is as sumed by 
long-term creditors and so they w ould require higher rewards, t hereby 
decreasing resources available  for the shareholders. As risk in creases, 
creditors require higher inter est in order to compensate for th e higher 
risk. 
However, the use of debt by man agement in their capital structu re can 
assist in increasing profits av ailable to shareholders. Cash re ceived into 
the entity from l enders will be used to generate revenue and pr ofits. As 
interest costs are fixed, any p rofits generated in excess of th e interest 
costs will accrue to the sharehol ders. There is, however, a neg ative side 
to the use of debt in the entity . If the cash from the debt doe s not raise 
sufficient profits then the fixed interest c ost must be paid fi rst and so 
profits available to shareholder s are decreased, and may be ext inguished 
completely.

Chapter 19 
 485 
 Gearing 
Gearing is calculated by taking long term debt as a percentage of total 
capital employed, i.e. long term debt plus shareholders' funds.  Long-term 
debt includes debentures, mortgages and other long-term debt, i ncluding 
redeemable preference shares. Any  bank overdraft would be inclu ded to 
the extent that it is actually  a source of long-term finance. W hether 
overdrafts are deemed long-term ( therefore used in gearing) or short-
term (not used in gearing) would be explicitly stated within an y exam 
question. Shareholders’ funds compr ise of equity share capital and 
reserves. 
Interest cover 
Although the use of debt may gen erate higher prof its for shareh olders 
there is a limit to its use. T his may be gauged from the statem ent of profit 
or loss by focusing on the pr ofitability and interest repayment s in the 
interest cover ratio. 
 
 The return on capital employed of YK has increased from 12.5% to 
16.4% in the year to 31 December 20X4. 
Required: 
Which one of the following would be a valid reason for this inc rease? 
A YK has acquired a significan t amount of property, plant and 
equipment close to the year end. 
B YK has revalued its land and build ings for the first time thi s year, 
resulting in an increas e in carrying amount. 
C YK raised long-term borrowings  to finance the payment of a 
significant dividend. 
D A significant number of YK's a ssets were fully written down a t the 
previous year end.

486  
 Test your understanding 7 (integration question) 
 The financial statements of DF G for the year ended 31 December  20X1 
are provided below: 
Statements of financial position at 31 December 
 
 20X1 20X0 
 $m $m $m $m 
Non-current assets      
Property, plant and equipment 254  198  
Investment in associate 24  –  
 ––––  ––––  
  278  198 
Inventories 106  89  
Receivables 72  48  
Cash and cash equivalents –  6  
 ––––  ––––  
  178  143 
  ––––  –––– 
Total assets  456  341 
  ––––  –––– 
Equity     
Share capital ($1 equity shares) 45  45  Retained earnings 146  139  
Revaluation surplus 40  –  
 
––––  ––––  
  231  184 
Long-term borrowings  91  91 Current liabilities     
Trade and other payables 95  66  
Short-term borrowings 39  –  
 
––––  ––––  
  134  66 
  ––––  –––– 
  456  341 
  ––––  ––––

Chapter 19 
 487 
 Statement of profit or loss and ot her comprehensive income for the 
year ended 31 December 
 20X1 20X0 
 $ m  $ m  
Revenue 252 248 
Cost of sales (203) (223) 
Gross profit 49 25 
Distribution costs (18) (13) 
Administrative expenses (16) (11) Share of profit of associate 7 – 
Finance costs (12) (8) 
 
Profit before tax 10 (7) 
Income tax expense (3) 2 
Profit for the year 7 (5) 
Other comprehensive income:   
Items that will not be recla ssified to profit and loss  
Revaluation gain on PPE 40 – 
Total comprehensive income for the year 47 (5) 
Required: 
Calculate the following ratio s for DFG for the year ended 31 De cember 
20X1 and its comparative period: 
• Gross profit margin 
• Operating profit margin 
• Profit for the year margin 
• Gearing (debt/equity) 
• Current ratio 
• Quick ratio 
• Receivables collection period 
• Payables payment period 
• Inventory holding period 
• Return on capital employed 
• Non-current asset turnover 
• Interest cover.

488  
 Test your understanding 8 (case style) 
 You work as an accountant for XYZ. The finance director has as ked you 
to analyse the financial statement s of DFG, the entity whose fi nancial 
statements are includ ed in the previous TYU above, as the board  of 
directors are considering acqui ring the business. DFG supplies the 
building trade. The finance direct or commented that he had revi ewed the 
information on DFG's website and  there were lots of positive me ssages 
about the entity's future, includi ng how it had secured a new s upplier 
relationship in 20X1 resulting in  a significant i mprovement in margins. 
In addition to the financial state ments, he has obtained the fo llowing 
information about DFG: 
1 Long term borrowings  
The long term borrowings are repayable in 20X3. 
2 Contingent liability  
The notes to the financial statem ents include details of a cont ingent 
liability of $30 million. A major  customer, a house builder, is  suing 
DFG, claiming that it supplied f aulty goods. The customer had t o 
rectify some of its building wo rk when investigations discovere d that 
a building material, which had recently been supplied by DFG, w as 
found to contain a hazardous subst ance. The initial assessment 
from the lawyer is that DFG is likely to lose the case although  the 
amount of potential damages could not be measured with sufficie nt 
reliability at the year-end date. 
3 Revaluation  
DFG decided on a change of accounti ng policy in the year and no w 
includes its land and buildings  at their revalued amount. The 
valuation was performed by an em ployee of DFG who is a qualifie d 
valuer. 
Required: 
Using the financial information fr om the previous TYU and the a dditional 
information above, analyse the fi nancial performance of DFG for  the year 
to 31 December 20X1 and its financ ial position at that date to assess its 
suitability as an acquisition tar get for XYZ. Discuss your find ings in a 
report address to the Board of Directors.

Chapter 19 
 489 
7  Financial statement analysis and the Gartner Data Analytics 
Maturity model 
Users may apply the Gartner Data Analytics Maturity model to cr eate focussed 
decision-making and improve conc lusions from their financial st atement 
analysis.  
From the perspective of a potentia l investor analysing the acco unts of a target 
company, the 4 stages of the Gart ner model could provide a fram ework for 
effective analysis.  
Stage 1 – Descriptive (what happened?) 
Reviewing the financia l statements from one year to the next or  in comparison 
with another company w ould enable descriptive analysis (what ha ppened?) e.g. 
return on capital employed (ROCE)  is lower in the target entity  than in other 
potential acquisitions. 
Stage 2 – Diagnostic (why it happened?) 
Determining an expla nation for why the movement occurred would provide 
diagnostic analysis e.g. the tar get entity invested heavily in property, plant and 
equipment towards the end of the per iod leading to a lower ROCE . 
Stage 3 – Predictive (wha t is going to happen?) 
Consideration of future performa nce will provide greater insigh t into the 
potential of the target. This wi ll be considered as predictive analysis e.g. due to 
the significant investment alr eady incurred, the likelihood of improved future 
performance is increased. 
Stage 4 – Prescriptive (wha t can be done about it?) 
Financial statement analysis can also provide prescriptive conc lusions 
regarding future strategic decis ions regarding the target.  How  can we make the 
investment a success? What strat egies would improve the target company 
performance? e.g. whether new pr oducts are required to boost sa les, what new 
geographical locations should be operated within for maximum ef ficiency and 
wealth creation? 
Overall, the Gartner Data Anal ytics Maturity model can enable p roactive 
responses and strategies to be applied to financial statement a nalysis.

490  
8 Actions resulting from fin ancial statement analysis 
It is important for any type of f inancial statement analysis to  provide actions and 
conclusions specific to the needs  of the user of the analysis. Analysts will focus 
on the predictive stage of analysi s to determine prescriptive s olutions. 
Actions are dependent upon the spec ific scenario provided withi n the exam but 
include: 
– pursuing the acquisition of a  particular target company 
– deciding whether (or not) to  continue to provide finance to a  credit 
customer 
– searching for alternative s uppliers if it is considered that a current supplier 
may go bust 
– deciding what strategic approac h the business should take e.g . which 
product lines should be cont inued to be offered? 
– decisions regarding selling or  retaining current investments in shares 
– agreeing to provide new financi ng or withdrawing current fina nce from 
borrowers. 
 9 Limitations of analysis of financial statements 
Financial statements analysis has  its limitations. It may be ne cessary to 
illustrate awareness o f these limitations in your assessment (o r discuss them in 
the case study). 
It is important to answer the ques tion requirement carefully, i .e. are you asked 
for limitations of financial info rmation or the limitations of using ratios for 
analysis?  
Limitations of financia l reporting information 
• Only provide historic data. 
• Only provide financial information. 
• Filed at least 3 months after reporting date r educing its rele vance. 
• Limited information to be able  to identify trends over time. 
• Lack of detailed information. 
• Historic cost accounting does n ot take into account inflation.  
Difficulties in drawing comparis ons between different entities  
• Comparisons affected by changes  in the entity's business, for example 
selling an operation. 
• Different accounting policies bet ween different entities, e.g.  revaluations. 
• Different accounting practices between different entities, e.g . debt 
factoring, lease v buy decisions.

Chapter 19 
 491 
• Different entities within the same industry may have different  activities. 
• Non-coterminous accounting periods. 
• Different entities may not be comparable in terms of size. 
• Comparisons between entities operating in d ifferent countries will be 
influenced by different legal and regulatory systems, the relat ive strength 
and weakness of the national ec onomy and exchange rate fluctuat ions. 
Limitations of ratio analysis 
• Where ratios have been provided , there may be discrepancies be tween 
how they have been calculated fo r each entity/period, e.g. gear ing. 
• Distortions when using year-end figures, particularly in seaso nal industries 
and when entities have diffe rent accounting dates. 
• Distortions due to not being ab le to use most appropriate figu res, e.g. total 
sales revenue rather than credit s ales when calculating receiva bles days. 
• It is difficult to identify reas ons behind ratio movements wit hout significant 
Creative accounting 
• Timing of transactions may be delayed/speeded up to improve re sults, 
e.g. not investing in non-curr ent assets to ensure ROCE does no t fall. 
• Profit smoothing using choices allowed, e.g. inventory valuati on method. 
• Classification of items, e.g. expenses v non-current assets; o rdinary v 
exceptional. 
• Off-balance sheet financing to  improve gearing and ROCE. 
• Revenue recognition policies. 
• Managing market expectations. 
These are, of course, generic limit ations that are not necessar ily applicable to 
all entities in all circumstances . If asked to discuss limitati ons (in the case study) 
or when attempting a F2 examina tion question, your discussion o r answer must 
be applied to the unique traits o f an entity, for example: if y ou have been asked 
to compare two entities it mak es sense to consider whether they  use the same 
accounting policies (e.g. deprec iation rates) and business meth ods 
(e.g. acquiring or leasing assets)..

492  
 Limitations of financia l reporting information 
 The objective of financial statem ents is set out in the IASB’s  Conceptual 
Framework for Financial Reporting: 
'The objective of general purpo se financial reporting is to pro vide 
financial information about the r eporting entity that is useful  to 
existing and potential investors , lenders and other creditors i n 
making decisions about providi ng resources to the entity.'  (IASB 
Conceptual framework para 1.2 ). 
A rather substantial limitation of financial statements, is, ho wever, then 
explained in the following paragraphs: 
'... general purpose financial r eports do not and cannot provid e all 
of the information that existin g and potential investors, lende rs and 
other creditors need. Those user s need to consider pertinent 
information from other sources, f or example, general economic 
conditions and expectations, polit ical events and political cli mate, 
and industry and company outlooks.  (IASB Conceptual framework 
para 1.6).  
Other parties, such as regulator s and members of the public oth er 
than investors, lenders and other creditors, may also find gene ral 
purpose financial reports useful. However, those reports are no t 
primarily directed to these other groups.'  (IASB Conceptual 
framework para 1.10). 
It appears that although financial statements may be useful to a wide 
range of users, their usefulness is limited. The principal draw back is the 
fact that financial statements ar e oriented towards events that  have 
already taken place. However, ther e are other significant limit ations of the 
information contained in a set o f financial statements. These c an be 
summarised under the followi ng principal headings. 
Timeliness 
By the time financial statements ar e received by users, 2 or 3 months or 
longer may have elapsed since t he year end date. The earliest o f the 
transactions that contribute to t he income and expense items 
accumulated in the statement o f profit or loss will have taken place 
probably 15 or more months previously. 
In some jurisdictions there ma y be a requirement for large, lis ted entities 
to produce half-yearly or even quarterly financial statements. Where 
these are available, the timeli ness problem is reduced. However , the 
comprehensiveness of the inform ation may be limited in comparis on to 
what is produced in the annual re port. For example, quarterly s tatements 
may include only a statement of profit or loss without a statem ent of 
financial position or statemen t of changes in equity. Also, it is possible 
that they will have not been subjec t to verification in the for m of audit.

Chapter 19 
 493 
 Comparability 
Comparisons over time for one entity 
Comparisons over time between t he financial statements of the s ame 
entity may prove to be invalid , or only partially valid, becaus e significant 
changes have taken place in the ent ity. The disclosure provisio ns of 
IFRS® 5 Non-current Assets Held for Sale and Discontinued Operations  
may assist the analyst if the ent ity plans to sell an operation . However, it 
may not be possible to discern t he effect of other significant changes. For 
example, an entity that makes a n investment in a new non-curren t item, 
say a major addition to its pr oduction facilities coupled with a significant 
increase in working capital, is not obliged to disclose any inf ormation 
about how well or badly the new  investment has performed. 
The analyst may, for example, be able to see that the entity’s profitability 
overall has decreased, but the explanations could be as follows : 
• The investment has proved to be very successful, but its succe ss is 
offset by the rapidly declining profitability of other parts of  the 
entity's productive capacity. As  these elements are gradually 
replaced over the next 2 or 3 year s, profitability is likely to  increase 
overall. 
• The investment has proved to  be less successful than expected and 
is producing no better a return t han the worn-out machinery it 
replaced. 
• Although productive capacity has  increased, the quality of goo ds 
overall has declined, and the ent ity has not been able to maint ain its 
margins. 
Financial statements simply do not provide sufficient informati on to permit 
the analyst to see these fi ner points of detail. 
Comparisons over time and inflation 
Comparability over time is oft en threatened by the effects of p rice 
inflation. This can, paradoxical ly, be particularly insidious w here the 
general rate of inflation in the economy is comparatively low b ecause 
analysts and others are not consci ous of the effect. For exampl e, 
suppose that the rate of price i nflation applicable to a partic ular entity has 
been around 2.5 per cent per year over a 5-year period. Sales i n 20X3 
were reported at $100,000. A direc tly comparable level of sales  in 20X4 
would be $102,500 ($100, 000 × 1.025). Therefore, sales in 20X4 would 
have to have increased to more than $102,500 befor e any real in crease 
could be claimed. However, the analyst, seeing the two figures alongside 
each other on the statement of p rofit or loss, and knowing that  inflation is 
running at a low level, may very well not take this factor into  account.

494  
 Differences in accounting poli cy and accounting practices 
Changes in accounting policy and a ccounting practices may affec t 
comparability over time in the sa me entity. Also, when comparin g the 
financial statements of two or m ore entities, it is likely that  there will be 
some differences in accounting policy and/or practice between t hem. 
The type of differences which mak e comparisons difficult includ e the 
• Different approaches to valuation of non-current assets, as 
permitted under IAS® 16 Property, Plant and Equipment. An entity 
that revalues its non-current a ssets on a regular basis, as per mitted 
by that standard, is likely to hav e higher carrying amounts for  its 
assets than an entity that carri es non-current assets at deprec iated 
historical cost. Also, the deprec iation charges of the revaluin g entity 
are likely to be higher. The two entities are therefore not str ictly 
comparable. 
• Different classifications of e xpenses in the statement of prof it or 
loss. It is not always easy to dec ide whether or not expenses s hould 
be classified as part of cost of sales or operating expenses. I f 
entities classify similar ex penses under the different headings  their 
gross profit margins will not be comparable. 
• More or less conservative approaches to judgements about the 
impairment of assets. Impairment r eview inevitably involves som e 
degree of estimation. 
Only the first of these three it ems relates, strictly speaking,  to an 
accounting policy difference. T he other two relate to variation s in respect 
of judgemental issues. Where there is a difference in formal ac counting 
policies adopted it is possible  to discern this from the financ ial statements 
(through accounting policy disclo sure notes) and to make some k ind of 
adjustment to achieve comparabilit y. However, judgemental matte rs are 
almost impossible to adjust for.

Chapter 19 
 495 
 Entities in the same sector 
Entities may appear to be compar able in that they operate in th e same 
business sector. However, each entity has unique features, and a 
particular entity may not be stri ctly comparable with any other . Segment 
disclosure does allow for a more detailed approach to compariso ns, 
although as we will see later in the chapter: 
• not all entities are required by accounting standards to make 
segment disclosures. 
• identifying segments is, necessa rily, a judgemental matter. It  is quite 
possible that one entity would i dentify a particular part of it s 
business as a reportable segm ent, whereas another would not 
make the same judgement. 
Non-coterminous accounting periods 
Financial statements are prepared to a par ticular date annually . The 
annual financial statements of a n entity with a year end of 31 December 
are not strictly comparable with  those of an entity with a June  year end. 
The difference is only 6 months, but significant events may hav e occurred 
in the industry or the economy as a  whole that affect the state ments 
prepared to the later date bu t not those prepared to the earlie r date. 
Size of the entity 
It may be inappropriate to compare  two entities of very differe nt sizes, or 
to compare a listed with a non-listed entit y. A large entity ma y be able to 
take advantage of economies of scale that are unavailable to th e small 
entity, but that is not to say t hat the smaller entity is ineff icient. It may, 
relatively speaking, be a bette r manager of the resources avail able to it. 
Conversely, a smaller entity ma y be able to react more rapidly to changes 
in economic conditions, because it can be easier to effect radi cal change 
in that environment. 
Listed entities are subject to a  great deal of additional regul ation and their 
activities are far more likely  than those of an unlisted entity  to attract 
media coverage. Their share pric es are widely advertised and ar e 
sensitive to alterations in ma rket perceptions. It can be less acceptable 
for a listed entity to take risks or any course of action that might affect a 
regular flow of dividends to shar eholders. By contrast, an unli sted entity 
whose shares are held by a lim ited number of people may be able  to 
make investment decisions that r esult in a curtailment of divid ends in the 
short term in exchange for projec ted higher returns in the long -term. So, 
operational flexibilit y varies between entities, and this may m ean that 
their financial statem ents are not really comparable, or at lea st, that 
comparisons must be treated with caution.

496  
 Verification 
Although regulations r elating to audit vary from one country to  another, it 
is likely that, in most jurisdi ctions, the financial statements  of larger 
entities are audited. However, s maller entities’  financial stat ements may 
not be subject to audit, and so th e analyst has no external rep ort on their 
validity or the fairness of their presentation. 
International issues 
Where the financial st atements of entities based in different c ountries are 
being compared, there may be furt her sources of difference in a ddition to 
those already covered in this section. 
• The entities may be subject to  differing tax regimes. 
• The financial statements may be based on different legal and 
regulatory systems. For example , traditionally, German, French and 
Spanish financial statements have been pr epared in accordance 
with tax regulation (e.g. the depr eciation allowances provided for in 
the financial statement s are exactly those allowable for tax 
purposes). The preparation of Bri tish and Irish financial state ments, 
by contrast, is focused much m ore upon the objective of achievi ng a 
true and fair view, and the link between accounts for tax purpo ses 
and accounts for filing and pr esentation purposes has been 
relatively weak. 
• The relative strengths and weak nesses of a national economy, a nd 
of the exchange rate relating to i ts national currency, may pro duce 
cyclical differences in the prof itability of business entities.  These 
effects may have the result of r educing comparability of the fi nancial 
statements of two ent ities located in different countries. 
Provision of non-financial information 
It was noted earlier in this sec tion: ‘... financial reports do  not and cannot 
provide all the information tha t existing and potential investo rs, lenders 
and other creditors need to make decisions’ (the IASB’s Concept ual 
Framework for Financial Reporting ). Major listed entities have tended, in 
recent years, to provide more non-financial information in thei r financial 
statements, and it is increasi ngly common to find disclosures r elating to, 
for example, environmental iss ues. However, there is a dearth o f 
regulation relating to non-financ ial disclosure, and users cann ot rely on 
finding a consistent level of h igh quality information in annua l reports. 
Entities may adopt <IR> which g oes some way to improving levels  of 
non-financial disclosure but, of c ourse, as <IR> is voluntary, not every 
entity will prepare one and so the information cannot be relied  upon to be 
available. Also, due to disclos ures being non-co mpulsory, the c ontent 
included does not a lways allow comparis on between entities.

Chapter 19 
 497 
 Limitations of ratio analysis 
 Calculation method 
The only accounting ratio to hav e a prescribed method of calcul ation is 
earnings per share which is regu lated through IAS 33 Earnings p er share. 
In respect of some of the other  accounting ratios, there may be  more than 
one valid method of calculation . There are, for example, two pe rfectly 
valid approaches to the calculat ion of gearing. When making 
comparisons between financial st atements it is important to ens ure that 
the same method of calculation is  used consistently, otherwise the 
comparison will not be valid. 
Many ratios are calculated usi ng average figures. Often the ave rage is 
based on only two figures: the op ening and closing. However, th ese may 
not be representative of a true average figure, and so any rati os 
calculated on the basis of such a figure will be unreliable. Th is effect is 
noticeable in entitie s with seasonal operations. For example, s uppose 
that an artificial Christmas tr ee business starts building up i ts inventory 
from a low point at the beginni ng of February, gradually accumu lating in 
order to build up to a maximum l evel at the beginning of Novemb er. 
Eighty-five per cent of its annual  sales total is made in Novem ber and 
December. 
If the entity has an a ccounting year end o f 31 January (which w ould make 
sense as there’s not much going on at the time of year), invent ory will be 
at its lowest level. (Opening inve ntory + closing inventory)/2 will certainly 
produce an average inventory fi gure but it will not be represen tative of the 
entity's level of activity in the intervening months. 
The idea of the norm 
Sometimes we attempt to set nor ms for ratios: for example, that  the 
current ratio should ideally be around 2, or 1.5 or 2.5. Howeve r, setting 
norms is both unrealistic and unhel pful. Some entities can, and  do, 
operate successfully with a subst antial excess of current liabi lities over 
current assets. Such entities ty pically sell for cash, so don’t  have 
receivables, turn over their inv entory very quickly (perhaps be cause it’s 
perishable) but manage to take the maximum amounts of credit fr om their 
suppliers.

498  
 Inappropriate use of ratios 
Not all ratios are useful or app licable in all business situati ons and the 
analyst must take care over the se lection of ratios to use. For  example, 
an entity may have a mixture of cash and credit sales, but it w ould 
normally not be possible to disti nguish between them armed only  with the 
information included in the annual  financial statements. Howeve r, seeing 
a line for revenue and a line for receivables, the analyst (or student) 
might assume that it was theref ore sensible to work out the num ber of 
days sales represented by receiv ables. The ratio would be inacc urate 
and the analyst could be seriously misled by it. 
Limited usefulness of ratios 
Ratios, and more importantly t heir analysis, may contribute to an 
understanding of an ent ity’s business operations but quite ofte n they 
simply lead to more questions that cannot be answered due to la ck of 
available information. 
A related point is that stand-al one ratios are generally of ver y limited use. 
The analyst may be able to calcula te that a business’s gross pr ofit 
percentage is 14.3 per cent for a particular year. In isolation , that piece of 
information is really quite use less. It’s reassuring to know th at the entity 
has actually made a positive gro ss profit, but without comparat ors, it’s 
hard to say much more than that. 
 
 Creative accounting 
 Defining the nature and scope of creative accounting is not 
straightforward. Despite the bes t efforts of accounting regulat ors there 
remains wide scope for the use of judgement in matters such as the 
determination of useful lives o f assets and allowances for irre coverable 
The term ‘creative accounting’  is commonly used to suggest a ra ther 
suspicious approach to accounting. It carries connotations of manipulation of figures, deliberat e structuring of series of tr ansactions 
and exploitation of loopholes in the rules. 
It should be noted that the director s have a legal responsibili ty to ensure 
that the financial statements re flect a fair presentation of th e performance 
and position of the entity over th e reporting period. Any creat ive 
accounting techniques would be li kely to contravene this rule a nd would 
be considered highly unethical.

Chapter 19 
 499 
 In addition, the auditors will cons ider the possibility of crea tive accounting 
carefully when forming their opi nion on the financial statement s. If they 
believe that a fair presentation is not reflected they will ask  the directors 
to make amendments and, in the ev ent that the directors refuse to do so, 
the auditors would be required to  amend their opinion according ly. 
Methods employed by creative accountants 
Financial statements c an be manipulated in many ways, some more  
acceptable than others. Methods include the following: 
Altering the timing of transactions 
For example, the despatch of sales  orders could be hurried up o r delayed 
just before the year end to either  increase or decrease sales f or the 
reporting period. Other examples include delaying sales of non- current 
assets and the timing of resear ch and development expenditure. If an 
entity needs to improve its resul ts it may decide upon a lower level of 
research and development activit y in the short term in order to  reduce 
costs. Delaying the replacemen t of worn-out assets falls into t he same 
category. Some people would regar d this type of ‘manipulation’ as falling 
outside the definition o f creative accounting. 
Artificial smoothing 
This approach involves the expl oitation of the elements of choi ce that 
exist in accounting regulation . Although the International Acco unting 
Standards Board (the Board) has w orked hard to reduce the numbe r of 
allowed alternative treatments,  there remains some scope for ar tificial 
adjustments in respect of, for ex ample, the choice of inventory  valuation 
method, the estimated useful lives of non-current assets, and t he choice 
between valuation of non-current  assets at revalued amounts or 
depreciated historical cos t that is permitted by IAS 16 Property, Plant and 
Equipment.  
A change in accounting policy would, of course, have to be note d in the 
year in which it occurs, but its  effects are not so easily disc ernible after 
that first year. 
One of the grey areas  that persists in accounting is the classi fication of 
debit items as either expenses o f the current year or as non-cu rrent 
assets. If items are classified as non-current assets they do n ot impact 
(unless they are depreciated) on the reported income for the pe riod.

500  
 One of the best known cases of m isclassification in recent year s occurred 
in the US long-distance phone com pany WorldCom. Over a 3 year p eriod 
the entity improperly  reported $3.8 billi on of expenses as non- current 
assets, thus providing a considerable boost to reported earning s. The 
entity is also reported as havi ng manipulated provisions in ord er to 
increase reported earnings. In this  particular case, the scale of the 
irregularities has been such tha t senior officers were prosecut ed, found 
guilty and subsequently  jailed for fraud. 
Other areas of the financial stat ements which pr ovide opportuni ties for 
creative accounting via classifi cation include the categorisati on of 
expenses and income as except ional and the decisions about 
classification as reportable s egments where the entity is requi red to 
undertake segment reporting. 
Exclusion of liabilities 
Under-reporting liabilities in t he statement of financial posit ion can help to 
improve accounting ratios. For e xample, the calculation of gear ing would 
be affected and total capital em ployed would be reduced, so tha t return 
on total capital employed woul d appear to be higher. Entities h ave 
sometimes been able to take adv antage of loopholes in accountin g 
regulation to arrange off-balanc e sheet financing in the form o f subsidiary 
undertakings that are technically excluded from consolidation. This was 
demonstrated in the Enron case, w here so-called Special Purpose  
Entities (aka unconsolidated stru ctured entities)  were set up t o provide 
finance to the business; these SPEs were, however, excluded fro m 
consolidation so that their liabi lities did not appear in the g roup financial 
statements. Regulations  have been revised to make this more dif ficult, 
with the recent introduction of IFRS 10: Consolidated Financial 
Statements  being an example. However , off-balance sheet financing 
remains a problem. 
The analyst must read the notes t o the financial statements car efully to 
be aware of any contingencies. A  contingent liability is where the 
probability of occurrence is less  than 50% but it is not remote . Where an 
item is noted as a contingent lia bility together with a note of  the estimated 
financial impact, it may be useful t o calculate the impact on t he entity’s 
liquidity and to work out account ing ratios both with and witho ut the item.

Chapter 19 
 501 
 Recognition of revenue 
Aggressive accounting often expl oits revenue recognition rules.  Some 
examples of inappropriate rev enue recognition include: 
• recognising revenue from sales t hat are made conditionally 
(i.e. where the purchaser has th e right to return the goods for  an 
extended period, or where experi ence shows that returns are lik ely) 
• failing to apportion subscrip tion revenue over the appropriate  
accounting periods but inst ead recognising it immediately 
• recognising revenue on goods shipped  to agents employed by the  
entity 
• recognising the full amount of r evenue when only partial shipm ents 
of goods have been made 
• recognising revenue from future  long-term sales earlier than 
appropriate e.g. longer term contract s were control passes at a  point 
in time but recorded as if perform ance obligations are satisfie d over 
time.    
The adoption of IFRS 15 Revenue from contracts with customers  
attempts to utilise robust rules  for recognising revenue and re duces the 
abilities for subjectivity s urround revenue recognition.  
Managing market expectations 
This final category of manipulatio n has nothing to do with mass aging an 
entity's figures, but it does inv olve the way the entity presen ts itself to the 
world. Reporting by listed entit ies, especially in the US marke t, is driven 
very much by analysts' expectati ons. It may be easier to massag e their 
expectations rather than to impro ve the reported results by use  of 
creative accounting techniques. Directors of listed entities me et analysts 
in briefing meetings where they  have the opportunity to influen ce 
analysts' expectations by foreca sting fairly poor figures. When  the entity 
then proceeds to turn in a better result than expected, the mar ket's view 
of the shares may be enhanced. Thi s is a psychological game of bluffing 
which may backfire on the repor ting entity if analysts become a ware of 
what it is doing. 
The motivation to use creative accounting 
Various research studies have ex amined the issue of managerial 
motivation to use creative acc ounting. The following have been identified 
as significant factors: 
Tax avoidance 
If income can be understated or e xpenses overstated, then it ma y be 
possible to avoid tax.

502  
Increasing shareholder confidence 
Creative accounting ca n be used to ensure an appropriate level of profits 
over a long period. Ideally, this  would show a steady upward tr ajectory 
without nasty surprises for the shareholders, and so would help  to avoid 
volatility in share prices, and would make it easier to raise f urther capital 
via share issues. 
Personal gain 
Where managerial bonuses are link ed to profitability there is a  clear 
motivation for managers to ensure  that profits hit the necessar y threshold 
to trigger a bonus payment. 
Indirect personal gain 
There is a market in managerial ex pertise in which demand often  appears 
to outstrip supply. A manager’s personal reputation in the mark etplace 
will almost certainly be enhanced by association with entities that have 
strong earnings records. So, a lthough the pay-off may not be ei ther 
immediate or obvious, there is  likely over the longer term to b e a reward 
in terms of enhanced reputation a nd consequent higher earning p ower. 
Following the pack 
If managers perceive that every ot her entity in their sector is  adopting 
creative accounting practices, t hey may feel obliged to do the same. 
Meeting covenants 
Sometimes, lenders insist on special covenant arrangements as a  
condition of making a loan: for ex ample, they may stipulate tha t an 
entity’s current ratio should no t fall below 1.5:1, or that gea ring never 
exceeds 35 per cent. In such ca ses, if the entity cannot meet t hose 
covenants that it has agreed to, the lender may be able to insi st upon 
immediate repayment or to put th e entity into liquidation. Wher e an entity 
is in danger of failing to meet i ts covenants, there is an obvi ous incentive 
for managers (especially if they  genuinely feel that the diffic ulty is short-
term in nature) to massage the fi gures so that the covenant is,  
apparently, satisfied. 
10 Additional information 
It is likely that the information available in the financial st atements is not enough 
to produce a detailed and thorough analysis of the entity. This  is particularly the 
case given the limitations of fi nancial reporting information d iscussed in the 
previous section. 
You may require additional inf ormation, financial and non-finan cial, to develop a 
better understanding of the entity' s business and its industry.  In the 
assessment, it is imperative tha t you relate any additional inf ormation requested 
to the entity in the question, and  to the user for whom the rep ort is being 
prepared.

Chapter 19 
 503 
It is essential that any further  information requested would be  reasonably 
available to the user i.e. don' t suggest that a non-controlling  shareholder would 
be able to access board minutes or internal documentation. They  cannot.  
However they can access any pub lically available information li ke the financial 
Some examples of additional i nformation are listed below. 
You may require additional financial  information such as: 
• budgeted figures 
• other management information 
• industry averages 
• figures for a similar entity 
• figures for the entity ov er a longer period of time. 
You may also require other non-financial  information such as: 
• market share 
• key employee information 
• sales mix information 
• product range information 
• the size of the order book 
• the long-term plans of management. 
 
 A colleague is looking to inves t some surplus cash and has ide ntified an 
entity that she believes has a p romising future. However, havin g 
reviewed the financial statements she is a little concerned by the profit 
before tax margin which has falle n in the most recent financial  year due 
to a significant increase in adm inistrative expenses. She is al so 
concerned that the cash position has worsened.

504  
 Which three of the following opt ions would be considered realis tic next 
steps for your colleague to take p rior to making an investment decision? 
A Write to the Chief Financial Officer and request a breakdown of 
administrative expenses to under stand the cause of the increase . 
B Review the narrative reports published alongside the financia l 
statements to see whether they p rovide an explanation of the fa ll in 
margin. 
C Obtain a copy of any interim fi nancial statements published s ince 
the previous year end to check whether the fall in profit is 
temporary. 
D Review the financial press for any recent articles concerning  the 
future prospects of the business. 
E Review the cash flow for ecasts of the business. 
F Obtain confirmation from the entity's bank that it will conti nue to 
 
 Information for TYUs 10 and 11 
 MLR prepares its financial stat ements in accordance with IFRS 
Standards and is liste d on its local stock exchange. It is cons idering the 
acquisition of an overseas oper ation. Two geogr aphical areas ha ve been 
targeted, A-land and B-land. Ent ity A operates i n A-land and en tity B 
operates in B-land. Each entity is  listed on its local stock ex change. 
The most recent financial statem ents of entities A and B have b een 
converted into MLR's currency  for ease of comparison. The finan cial 
indicators from these financial statements and those of MLR are  provided 
below. 
 MLR A B 
Revenue $600m $210m $400m Gross profit margin 32% 28% 19% Profit before tax/revenue × 100 18% 10% 11% 
Gearing 37% 66% 26% 
Approx. rate of borrowings 8% 5% 10%

Chapter 19 
 505 
 Which one of the following statem ents is NOT a realistic concl usion that 
could be drawn from the above information? 
A A's higher gross profit margi n suggests that it is benefiting  from 
greater economies of scale than B. 
B A and B have similar profit before tax ma rgins but different gross 
margins, which could be due to di fferent classification of expe nses. 
C A's high gearing ma y be a consequence of relatively low inter est 
rates available. 
D B's approximate rate of borro wings suggest that lenders consi der it 
to be higher risk than either MLR or A. 
 
 The following statements concern  the use of ratio analysis to make a 
decision about investing in A or B. 
 Which one of the st atements is false? 
A The entities are lis ted on different stock exchanges and may be 
using different accounting standards. This will reduce the 
comparability of the financial indicators. 
B The entities may use differ ent accounting policies and this c ould 
affect comparisons of specific r atios (i.e. cost model v revalu ation 
model for property, plant and equi pment would affect comparison  of 
gearing). 
C Using only one year's worth o f data gives no indication as to  
whether the entities are growing or in decline. 
D As A and B operate in diffe r geographical locations, they may  pay 
different rates of tax and this will affect comparison of the m argin 
ratios presented. 
11 Analysis of the statement of cash flows 
The cash flow of an entity is r egarded by many users as being o f primary 
importance in understanding its operations. After all, an entit y that cannot 
generate sufficient cash will, sooner or later, fail. 
The statement of cash flows prov ides valuable information for t he analysis of an 
entity’s operations and position.  
The statement of cash flows pr epared in accordance with IAS 7  Cash flow 
statements  categorises cash flow under thre e principal headings: cash flo ws 
from operating activities, cash  flows from investing activities  and cash flows 
from financing activities.

506  
As well as comparing these tota ls from year to year, cash flows  in the following 
areas should be reviewed: 
• cash generation from trading operations 
• dividend and interest payments 
• investing activities 
• financing activities 
• net cash flow. 
There are also useful ratios t hat can be calculat ed – see expan dable text below. 
Cash generation from trading operations 
The figure should be compared to  the profit from operations. Th e reconciliation 
note to the statement of cash fl ows is useful in this regard. O vertrading may be 
indicated by: 
• high profits and lo w cash generation 
• large increases in inventory, receivables and payables. 
Dividend and interest payments 
These can be compared to cash generated from trading operations  to see 
whether the normal operations can sustain such payments. In mos t years they 
should. 
The nature and scale o f an entity’s investment in non-current a ssets is clearly 
shown. 
A simple test may be to compar e investment and depreciation. 
• If investment > depreciation, the entity is investing at a gre ater rate than its 
current assets are wearing out – this suggests expansion. 
• If investment = depreciation, the entity is investing in new a ssets as 
existing ones wear out. T he entity appears stable. 
• If investment < depreciation the non-current asset base of the  entity is not 
being maintained. This is potent ially worrying as non-current a ssets are 
generators of profit. 
The changes in financing (in pure cash terms) are clearly shown . Gearing can 
be considered at this point. It w ould be useful to comment on t he impact that 
such changes will have on the gearing ratio.

Chapter 19 
 507 
Cash flow 
The statement clearly shows the end result in cash terms of the  entity's 
operations in the year. However , do not overstate the importanc e of this figure 
alone.  
A decrease in cash in the year  may be for very sound reasons (e .g. there was 
surplus cash last year) or may be the result of timing of trans actions (e.g. a new 
loan was raised just after the end of the accounting period). 
 
 Cash flow ratios 
 Return on capital employed: cash 
 
Cash generated from operations
Capital employed	× 100 
For many external users, cash is  a more significant indicator t han profit 
and this ratio should be calculated  where the information is av ailable. 
Cash generated from ope rations to total debt 
 
Total long term borrowings 
This gives an indication of an entity’s ability to meet its lon g-term 
obligations. The inverse rati o can also be calculated: 
 
Total long-term borrowings
This provides an indication of how many years it would take to repay the 
long-term borrowings if all o f the cash generated from operatio ns were to 
be used for this purpose. 
Net cash from operating activiti es to capital expenditure 
 
Net cash from operating activities
Net capital expenditure× 100 
This gives some idea of the ext ent to which the entity can fina nce its 
capital expenditure out of cash  flows from operating activities . If it cannot 
meet its capital expenditure fr om this source, then some kind o f longer-
term financing is likely to be required. However, this ratio co uld be 
misleading unless calculated and compared for several years.

508  
 Test your understanding 12 (case style) 
 SCF is considering the acquisi tion of FGH, one of its supplier s. SCF 
always looks carefully at the li quidity position of potential a cquires, having 
been exposed to cash flow problem s in earlier acquisitions. If acquired, 
SCF would like to retain the existing management team of FGH. 
You work as an accountant for SC F and the Managing Director has  
asked you to perform an analysis of FGH's most recent statement  of cash 
flows to determine how well t he management team is controlling cash. 
FGH has been trading for a number  of years and is currently goi ng 
through a period of expansion of its core business area. 
The statement of cash flows fo r the most recent year ended 31 D ecember 
20X0 for FGH is presented below. 
 $000 $000 
Profit before tax 2,200  
Adjustments for:   Depreciation 380  
Gain on sale of investments (50)  
Loss on sale of property, plant and equipment 45  Investment income (180)  Interest costs 420  
 
–––––  
 2,815  
Increase in trade receivables (400)  
Increase in inventories (390)  Increase in payables 550  
 
–––––  
Cash generated from  operations  2,575 
Interest paid  (400) 
Income taxes paid  (760) 
  ––––– 
Net cash from operating activities  1,415

Chapter 19 
 509 
  
Acquisition of subsidiary, net of cash acquired (800)  
Acquisition of property, plant and equipment (340)  
Proceeds from sale of equipment 70  Proceeds from sale of investments 150  
Interest received 100  
Dividends received 80  
 
–––––  
Net cash used in investing activities  (740) 
Proceeds of share issue 300  
Proceeds from long term borrowings 300  Dividend paid to equity sharehol ders of the parent (1,000)  
 
–––––  
Net cash used in financing activities  (400) 
  ––––– 
Net increase in cash and cash equivalents  275 
Cash and cash equivalent s at the beginning of 
the period   
110 
  ––––– 
Cash and cash equivalents at the end of the period 385 
  ––––– 
Required: 
Prepare a memo to the Managing Director assessing the cash 
management of FGH based on your analysis of the st atement of ca sh 
flows.

510  
 Test your understanding 13 (further OTQs) 
 Note:  there are TYUs earlie r in the chapter that assess the calculat ion of 
ratios. This section concent rates on interpretation. 
1 Anderson has a bank overdraft a nd a current ratio of 1:1. 
Which ONE of the following act ions would increase the current 
ratio? 
A Offering cash discounts to customers to encourage speedier 
payment 
B Paying suppliers ahead of schedul e to obtain cash discounts 
C Selling inventory on credit at book value 
D Increasing the allowance for doubtful receivables 
2 The Port Erin fishmonger and t he Port Erin bookseller both op erate 
on a 50% mark-up on cost. However , their gross profit margins a re: 
Fishmonger 25% Bookseller 33% 
Which one of the following stat ements would validly explain 
the higher gross profit m argin of the bookseller? 
A There is more wast age with inventories o f fish than inventori es 
of books 
B The fishmonger has a substantial bank loan whereas the 
bookseller's business in entirely financed by family 
C The fishmonger has expensive h igh street premises whereas 
the bookseller has cheaper back street premises 
D The fishmonger's sales rev enue is declining whereas the 
bookseller's is increasing

Chapter 19 
 511 
 3 The following statements alleged ly refer to the conclusions t o be 
drawn when using ratio analysis  to interpret the financial stat ements 
of an entity. 
Which two of the following statements are TRUE? 
A An entity can only increase its gross prof it margin by 
increasing its selling prices or reducing its costs per unit of  
B With other things remaining equal, an upwards revaluation of 
non-current assets would lead to a  reduction in the return on 
capital employed. 
C An entity can increase its re turn on capital employed in the 
short term by postponing replac ement of aged non-current 
assets. 
D An upwards revaluation of non- current assets will result in a n 
increase in the gearin g of an entity. 
4 JA and GB operate in the same  industry and are of a similar s ize. 
The non-current asset turnover rat ios of the two entities are a s 
follows: 
JA 2.5 GB 1.7 
Which of the following st atements would be VALID 
explanations of the differences in  the non-current asset ratio of 
the two entities? Select all that apply. 
A JA has a policy of revalui ng its non-current assets whereas G B 
uses the cost model. The revaluations normally reflect an increase in value. 
B JA's non-current assets  are older than GB's. 
C GB's non-current assets are under-utilised at present. D GB has acquired non-current a ssets in the final month of the 
accounting period, whereas JA last purchased significant non-current assets in the prev ious accounting period.

512  
 5 The following information has b een obtained for two potential  
acquisition targets, A and B, w ho operate in the same industry.  
 A B 
Revenue $160m $300m Gross profit margin 26% 17% Profit before interest and tax margin 9% 11% 
Which two of the following stat ements are VALID conclusions 
that could be drawn from the above information? 
A A's gross profit margin is hi gher as A would be expected to 
have achieved more econom ies of scale than B. 
B The difference between gross pr ofit margins could be due to 
the entities classifying their costs differently between cost o f 
sales and operating expenses. 
C The difference between profit before interest and tax margins  
could be due to the entities cla ssifying their costs differentl y 
between cost of sales and operating expenses. 
D A has lower operati ng expenses than B. 
E B has lower operati ng expenses than A.

514  
 Profitability: 
  20X6 20X5 
Gross profit margin Gross profit
Revenue 115/180 = 63.9% 90/150 = 60% 
Operating profit margin Operating profit
Revenue (115-40)/180 = 
41.7% (90–29)/150 = 
40.7% 
Profit before tax margin PBT
Revenue 110/180 = 61.1% 51/150 = 34% 
Profit before tax margin 
(excluding Associate)  (110–59)/180 = 
28.3%  
(excluding Associate) Tax expense
PBT – Assoc 14/(110–59) = 
27.5% 13/51 = 25.5% 
Return on capital 
employed Operating profit
Capital employed (115–40)/ 
(218+335+9–250) 
= 24.0% (90–29)/ 
(100+110) = 
29.0% 
(Note: CV of Associate is 
deducted from capital employed)

Chapter 19 
 515 
 Possible reasons why T's ratios have changed: 
Gross profit margin increased: 
• Increase in sales due to incr easing volume sold and so economi es 
of scale result in lowe r costs per unit sold 
• Increase in sales price per unit 
• Changes in product mix. 
Operating profit margin sm aller increase (than GPM): 
• Increase in expenses such as  advertising to boost revenue 
• Increased depreciation charges f ollowing acquisitions of non-c urrent 
assets 
• Poor control of costs since rev enue increased by 20% but opera ting 
expenses increased by 38%. 
Profit before tax margin significant increase: 
• Due to share of profit of associate 
• Removing this shows an actual reduction in margin 
• Increased borrowing to fund exp ansion has resulted in 140% 
increase finance costs. 
Effective tax rate increase: 
• Effect of change in legislation 
• Under-provision in previous year. 
• Fall due to significant increase in capital employed, not gene rating 
as significant an improv ement in operating profit 
• Large increase in long term bor rowings to fund investment in n on-
current assets during year. If a cquired near year-end, will not  have 
generated returns yet 
• Non-current assets also revalued – this increases capital empl oyed 
but will not lead to an improvemen t in profit (it distorts the ratio).

516  
 EBITDA = Earnings before intere st, tax, depreciation and amort isation. 
 
 20X6 20X5 
Profit for the year (PAT) 96 38 
Add back   
Tax 14 13 
Interest (finance costs) 24 10 Depreciation 6 3 
 
–––– –––– 
 140 64 
   
 Liquidity ratios: 
  20X6 20X5 
Current ratio Current assets
Current liabilities 64/44 = 1.5:1 50/32 = 1.6:1 
Quick ratio (Current assets – Inventory)
Current liabilities 49/44 = 1.1:1 38/32 = 1.2:1 
Overall liquidity situat ion has deteriorated: 
• Current and quick ratios have bot h fallen slightly but not yet  at levels 
that give cause for concern. T he main reason for the reduction is the 
cash balance changing from pos itive to negative in 20X6. 
• The increasing invent ory holding and receiv ables collection pe riods 
(see efficiency ratios below) have been funded by an overdraft 
rather than an equivalent increas e in the payables payment peri od.

Chapter 19 
 517 
 Efficiency/activity ratios: 
  20X6 20X5 
Inventory 
holding period Inventory
Cost of sales × 365 days 15/65 × 365 = 84 
days 12/60 × 365 = 
73 days 
Receivables 
collection period Receivables
Revenue × 365 days 49/180 × 365 = 
99 days 37/150 × 365 = 
90 days 
Payables 
payment period Trade payables
Cost of sales × 365 days 12/65 × 365 = 67 
days 11/60 × 365 = 
67 days 
Asset turnover Revenue
Capital Employed 180/(218+335+9–
250) = 0.58 times 150/(100+110) 
= 0.71 times 
Non-current 
asset turnover Revenue
NCAs (that cont. to revenue) 180/266 = 0.68 
times 150/190 = 0.79 
times 
Possible reasons why T's  ratios have changed: 
Inventory holding period increased: 
• Build-up of inventory levels a s a result of increased capacity  
following expansion o f non-current assets 
• Increasing inventory levels i n response to increased demand fo r 
product 
• Expectation of higher demand after year end 
• Lack of control over inventory. 
Receivables collection period increased: 
• Deliberate policy to  attract customers 
• Poor credit control procedures 
Payables payment period unchanged. Asset/non-current asset turnover: 
• Revaluation of non-current asse ts will reduce asset turnover b ut not 
a "real" deterioration in efficiency 
• Significant increase in non-cu rrent assets during year. If acq uired 
near year-end, will not have generat ed returns/revenue for full  year 
yet.

518  
 Capital structure 
  20X6 20X5 
Gearing Debt
Debt + Equity (335+9)/ 
(335+9+218) = 
61.2% 110/(110+100) = 
52.4% 
Gearing (alternative) Debt
Equity (335+9)/218 = 
1.6:1 110/100 = 1.1:1 
NB. Gearing may be 
shown as a % or a ratio. 
The exam question make it explicit regarding how to present your answer.  
  
Interest cover Operating profit
 (115–40)/24 = 3.1 
times (90–29)/10 = 6.1 
times 
Average rate of borrowing Finance costs
Borrowings 24/(335+9) = 
7.0% 10/110 = 9.1% 
Dividend cover Profit for year
Dividends 96/25 = 3.8 times 38/25 = 1.5 
times 
Gearing increase and interest cover reduction: 
• Significant increase in long-term borrowings – to finance acqu isition 
of associate/PPE 
• Increase in loan significantly g reater than increase in equity  finance 
• Gearing ratio appears quite high and interest cover falling cr eates 
concern 
• Interest cover may increase next year when full year's impact of 
investment reflected. 
Average rate of borrowing has fallen: 
• New borrowings at lower rate 
• Loans taken out mid-way through year, so full year's cost not yet 
reflected. 
Dividend cover significantly increases, principally due to asso ciate profit.

Chapter 19 
 519 
 D is the valid reason. 
A is incorrect. A significant i nvestment close to the year-end would result 
in a large increase in capital em ployed with little increase in  profit, 
therefore ROCE would reduce. 
B is incorrect. A revaluation in creases equity and therefore ca pital 
employed with no corresponding increase in profit. 
C is incorrect. The reduction in  retained earnings would be net ted off 
against the increase in long-term bo rrowings so capital employe d would 
not be affected. 
 
 20X1 20X0 
Gross profit margin 49/252 × 100  = 19.4% 25/248 × 100 = 10.1% 
Operating profit 
margin (49 – 18 – 16)/252 × 100 = 6.0% (25 – 13 – 11)/248 × 100 = 
0.4% 
Profit for year 
margin 7/252 ×100 = 2.8% (5)/2 48 × 100 = (2.0)% 
Gearing (91+39)/231 × 100 = 56.3% 91/184 × 100 = 49.5% 
Current ratio 178/134 = 1.3:1 143/66 = 2.2:1 
Quick ratio (178 – 106)/134 = 0.5:1 (143 – 89)/66 = 0.8:1 
Receivable days 72/252 × 365 day s = 104 days 48/248 × 365 days = 71 days 
Payable days 95/203 × 365 days = 171 days 66/223 × 365 days = 108 
days 
Inventories days 106/203 × 365 days = 191 days 89/223 × 365 day s = 146 
days 
employed (49 – 18 – 16)/ (231+ 91 – 24) = 
15/298 × 100 = 5.0% (25 – 13 – 11)/ (184 + 91) = 
1/275 × 100 = 0.4% 
Non-current asset 
turnover 252/254 = 1.0 248/198 = 1.3 
Interest cover (49 – 18 – 16)/ 12 = 1.3 times (25 –13 – 11)/8 =  0.1 times

520  
 To: Board of Directors of XYZ 
From: Accountant Subject: Report on financial per formance and position of DFG 
The revenue of DFG has only marg inally increased in the year by  1.6%, 
however profit margins have a ll increased significantly. In par ticular the 
gross profit margin has increas ed from 10% to 19%, which is lik ely to be 
as a result of reduced purchase prices from the new supplier co ntract that 
was secured in the year. Whilst  this is a very positive and imp ortant step 
for DFG (given its low margin i n the previous year) it will be important to 
establish whether this reduced co st also means a reduced level of 
quality. If quality is being compro mised then this increase in margin may 
be short-lived as customers may  be driven away in the longer te rm. 
In addition, the switch in suppl ier may be responsible for the lawsuit. It is 
a risky strategy for DFG to pur sue aggressive revenue and margi n 
targets at the expense of suppl ying good quality products. Alth ough a 
contingent liability of $30 million is included in the notes, t he lawyer's 
assessment is that DFG is likely  to lose the court case and the  pay-out 
may be more. There is already ser ious pressure on DFG's finance s and it 
may not survive if the pay-out is any more or if other customer s decide to 
sue. There is therefore a signifi cant risk to the going concern  of the entity. 
Both administration and distribut ion costs have increased signi ficantly 
when compared to a 1.6% increase in revenue. Whilst these costs  are 
not that large in relation to revenues, it may suggest that man agement do 
not have good control of overheads. The impact of legal fees as  a result 
of the court case may also be se en with the increase of expense s. 
ROCE has increased overall due to  the increases in operating ma rgins 
described above. However, revaluat ion surplus recorded during t he year 
would reduce ROCE. The increase i n ROCE would be greater if the  
impact of the revaluation where  to be removed. ROCE without the  
revaluation is calculated as 15/(298 – 40) × 100 = 5.8% compare d to last 
years’ ROCE of 0.4%. 
The increase in total comprehens ive income is largely due to th e 
revaluation gain reported within other comprehensive income. Th e 
valuation was performed by an in ternal member of staff, which i s perhaps 
not as ideal as someone external , however the financial stateme nts have 
been finalised and so I assume they  have been audited and that the 
valuations are fair. We should co nsider why the directors have 
chosen 
this year to change the policy – as it could be an attempt to b oost income 
and reduce gearing to make furthe r borrowing easier, especially  as the 
long term borrowings will need to  be repaid or re-negotiated re latively 
soon. However, it maybe shows good commercial sense to ensure t hat 
assets that are to be used as sec urity for finance are at the m ost up-to-
date valuation.

Chapter 19 
 521 
 The overall liquidity of DFG is on the low side at 1.3:1 and ha s fallen 
significantly from 20X0. One cont ributing factor to the worseni ng liquidity 
is the significant increase in i nventories in the year. This co uld be as a 
result of bad publicity about bel ow standard goods and customer  orders 
being cancelled. There is then an increased risk of obsolete in ventories. 
This is reinforced by the invent ories days which have increased  from 
146 days to 191 days. Receivables  days have also increased from  
71 days to 104 days, and this could be as a result of disputed invoices. 
DFG may then have a problem with slow/non-payment of these debt s. 
Payables days have increased fr om 108 days to 171 days and this  could 
be resulting from a deliberate attempt by DFG to improve cash f low by 
delaying payment, particularly in response to the struggle to r ecover cash 
from their customers, or extende d credit terms given by the new  supplier 
to attract DFG's business. 
The cash position of DFG is cl early a concern as the cash has m oved 
from a positive balance to an overdraft and the long term borro wings are 
soon to be repaid or re-negotiate d. This coupled with the poor working 
capital management would indicate  that DFG must raise some addi tional 
funding if it is to survive. The gearing ratio shows deteriorat ion on the 
previous year, despite an incr ease in equity from the revaluati on. 
However, it is likely to be the lack of interest cover that wou ld put lenders 
off. It is unlikely that DFG coul d afford to pay interest on an y additional 
funding. 
I would recommend that you do not c onsider investing in DFG at this 
time. If they lose the court cas e and have a large settlement t o pay this 
could result in the entity co llapsing and despite the fact that  details of this 
are only in the notes, the serious ness of it should not be over looked. The 
entity may struggle to survive anyway as there is a lack of cas h and 
funding options (and it should be not ed that DFG did not pay a dividend 
in 20X1). The increases in prof itability are not enough of an i ndicator of a 
stable/growing entity – especially an entit y involved in the bu ilding trade 
which is known for its sensit ivity to the economy around it. 
 
 Realistic next steps are B, C and D. 
Options A, E and F are not availa ble to minority shareholders.

522  
 A is not a realistic conclusion. 
A has much lower revenue than B and  therefore B should be achie ving 
more economies of scale than A. 
 
 D is false. 
The tax rate will have no effec t on the ratios presented. The p rofits used 
in the margin calculations are before  tax. 
 
 Memo to Managing Director 
Firstly, FGH has managed to generat e significant cash from oper ating 
activities which is a positive  sign for any business wishing to  be a going 
concern, particularly since it appears that FGH i s expanding. I n addition 
to the inflow of cash from tradi ng, the directors have clearly made some 
good investment decisions as in vestment income of $180,000 has been 
included in the year and also  profit of $50,000 has been earned  from the 
sale of these investments. 
It does look as if FGH needs to imp rove working capital as rece ivables 
have increased in the year and it looks like the entity has in turn withheld 
payment to payables with an in crease of $550,000. The increase in 
receivables may be a deliberate attempt to secure new customers  by 
offering them favourable credit te rms but it is essential that good working 
capital management is not comprom ised. We may also wish to comp are 
our existing credit terms with FG H with those that they are off ering to 
their other customers. 
The increase in inventories has  probably arisen in order to mee t future 
expected demand from the expansion. It should be noted that FGH  has 
acquired a subsidiary during t he year, although the effect of t he 
subsidiary on the working capi tal balances wil l have been adjus ted for in 
the completion of the statement of cash flows.

Chapter 19 
 523 
 The expansion is shown in two ar eas of investment, with the acq uisition 
of a subsidiary and in the purc hase of property, plant and equi pment. The 
sale of property, plant and equi pment for $70,000 resulted in a  loss of 
$45,000. It's possible that the exp ansion has resulted in the n eed for new 
equipment and hence management have  taken the view to sell some  of 
the old equipment whilst there is still a second hand market fo r it. The 
sale of investments for $150,000 has probably been undertaken i n order 
to generate funds for the expans ion. The only note of caution i s that 
these investments se em to be profitable and hence given that a 
proportion has been sold during t he year, future income from in vestments 
will be reduced. 
A significant dividend has been paid out. The existing sharehol ders may 
be stripping cash out of the busi ness prior to selling their sh ares to us. 
A good sign however is that FGH  has managed to fund its expansi on 
without increasing the overall gearing of the business, as equa l amounts 
of debt and equity have been rais ed as new finance. It indicate s good 
stewardship of assets when long te rm expansion is financed by l ong term 
financing. FGH appears to have used a mixture of long term fina ncing 
and retained earnings generated in  the year, together with the sale of 
some investments to fund the ex pansion. However, this is not to  the 
detriment of shareholders as they  have still received a signifi cant 
dividend during the y ear and it's possible that the new investm ents in a 
subsidiary and PPE will generate greater returns in the future than the 
investments which have been sold . In times of expansion, howeve r, a 
more modest dividend may hav e negated the need for long term 
financing and the interest costs associated with it. 
Overall, the cash position of t he business has improved by $110 ,000 over 
the course of the year and theref ore, even taking into account the 
expansion and signific ant dividend, FGH do not appear to have a ny 
significant liquidity issues.

524  
 1  B 
By paying suppliers ahead of sc hedule there woul d be a reductio n in 
payables and a smaller increase in the overdraft (as the paymen t 
would be reduced by the discount) . Therefore liabilities in tot al 
would decrease (by the amount o f the discount) and the current 
ratio would increase. 
A is not correct. The reduction in the overdraft would be lower  that 
the reduction in the receivables and therefore the current rati o would 
decrease. 
C is not correct. There would be a reduction in inventory and 
increase in liabilities therefor e the current ratio would decre ase. 
D is not correct. This would r educe receivables and therefore t he 
current ratio would decrease. 
2 A 
The fishmonger's inventories are  perishable and so me will there fore 
be written off, creating an addi tional expense within cost of s ales 
and reducing the gro ss profit margin. 
B is not correct. The bank loan would create finance costs but these 
are not expensed withi n gross profit. 
C is not correct. The costs of  the premises w ould be charged wi thin 
operating expenses rat her than cost of sales (they are selling 
expenses). 
D is not correct. Regardless of s ales volumes, if the mark up i s 50% 
then a change in volume would no t affect the gross profit margi n. 
3 B and C are correct.  
An upwards revaluation of non-cu rrent assets increases equity a nd 
therefore capital employed. It is also likely to reduce profit (if the 
assets are depreciable) as i t will lead to higher depreciation 
charges. 
When an entity continues to use f ully depreciated assets there will 
be a positive effect on return on capital employed, as there wi ll be 
no further depreciation charged but the assets and they will ha ve nil 
carrying amount, but they will co ntinue to generate profits. 
A is not correct. An entity can im prove its gross profit margin  by 
changing its sales mi x and selling greater  proportional volumes  of 
high margin products. 
D is not correct. Revaluation wo uld increase equity and therefo re 
reduce gearing.

Chapter 19 
 525 
 4  B, C and D are correct.  
Old non-current assets inflate t he ratio as the carrying amount  is low 
and is included in the denominator. 
A relatively low asset turnover  also suggests that the assets a re not 
generating sufficient revenue. They are under-utilised. 
An alternative answer would be i f the assets have been acquired  
towards the end of the financial period, as the full cost would  be 
included in the denominator but ther e wouldn't yet be a year's worth 
of revenue in the numerator. 
A is incorrect. An upward revalu ation would increase non-curren t 
assets and, as this is the denomi nator, would make non-current 
assets relatively low. 
5 B and E are correct. 
Difference classification of ex penses of two ent ities will affe ct any 
comparison of gross profit. 
The operating expenses  of both entities can be calculated from the 
information provided. 
 A B 
 $ m  $ m  
Gross profit (gross pr ofit margin × revenue)  
(26% × $160m) 41.6  (17% × $300m)  51 
Operating profit (oper ating profit margin 
× revenue)   
(9% × $160m) 14.4  
(11% × $300m)  33 
 
––––– –––– 
Operating expenses 27.2 18 
A is incorrect. Economies of sca le would not be a valid conclus ion 
for A having the better gross marg in as it is the smaller entit y - its 
revenue is only 53% of B's and th e two entities operate in the same 
sector. 
C is incorrect. Different classi fication of expenses between co st of 
sales and operating expenses shoul d have no effect on profit be fore 
tax (which includes both categorie s). It only affects gross pro fit. 
D is incorrect. See above calculation.

528  
The Board (2016) Conceptual Framework for Financial Reporting.  London: 
IFRS Foundation. 
The Board (2016) IAS 7 Statement of Cash Flows.  London: IFRS Foundation. 
The Board (2016) IAS 12 Income Taxes.  London: IFRS Foundation. 
The Board (2016) IAS 18 Revenue.  London: IFRS Foundation. 
The Board (2016) IAS 21 The Effects of Changes in Foreign Exchange Rates.  
London: IFRS Foundation. 
The Board (2016) IAS 24 Related Party Disclosures.  London: IFRS Foundation. 
The Board (2016) IAS 27 Separate Financial Statements.  London: IFRS 
The Board (2016) IAS 28 Investments in Associates and Joint Ventures.  
The Board (2016) IAS 32 Financial Instruments: Presentation.  London: IFRS 
The Board (2016) IAS 33 Earnings per Share.  London: IFRS Foundation. 
The Board (2016) IAS 36 Impairment of Assets.  London: IFRS Foundation. 
The Board (2016) IAS 37 Provisions, Contingent Liabilities and Contingent 
Assets.  London: IFRS Foundation. 
The Board (2016) IAS 38 Intangible Assets.  London: IFRS Foundation. 
The Board (2016) IAS 39 Financial Instruments:  Recognition and measurement. 
The Board (2016) IFRS 3 Business Combinations.  London: IFRS Foundation. 
The Board (2016) IFRS 7 Financial Instruments:  Disclosure. London: IFRS 
The Board (2016) IFRS 8 Operating Segments.  London: IFRS Foundation. 
The Board (2016) IFRS 9 Financial Instruments.  London: IFRS Foundation. 
The Board (2016) IFRS 10 Consolidated Financ ial Statements.  London: IFRS 
The Board (2016) IFRS 11 Joint Arrangements.  London: IFRS Foundation. 
The Board (2016) IFRS 12 Disclosure of Interests in Other Entities . London: 
The Board (2016) IFRS 13 Fair Value Measurement . London: IFRS Foundation. 
The Board (2016) IFRS 15 Revenue from contracts with customers . London: 
The Board (2016) IFRS 16 Leases . London: IFRS Foundation. 
Integrated Reporting framewor k (<IR> framework), IIRC

Index 
 I.1 
<IR> Framework.....455 
A 
Acquisition accounting.....254 
Additional informati on (in analysis).....502 
Advisors.....8 Amortisation.....202 
Amortised cost (Financial assets).....71 
Amortised cost (Fi nancial liabilities).....57 
Analysing profitab ility ratios.....473 
Analysis of the statem ent of cash flows.....505 
Analysis, limitations.....490 Asset turnover.....479 
Associates.....338 
Assumptions of the growth model based on 
retention rate.....29 
Average rate of borrowing.....483, 484 
Averaging method.....27 
B 
Bank borrowings.....2 Bank finance.....16 Basic EPS.....98 
Benefits and limitations.....459 
Bonds.....16 Bonus issue.....100 
Brands.....200 
Business  
angels.....19 
model test.....68 
C 
Capital markets.....2, 5, 16, 17 
Capital structure ratios.....469, 483 Cash and cash equivalents.....376 
Cash flow ratios.....507 
Cash flows from financing activities.....378 Cash in transit.....268 
Characteristics of a derivative.....73 
Classification of cash flows.....377 
Close family members.....441 
Compound instruments.....60 
Conceptual Framework.....465 Consideration.....279 Consignment inventory.....149 Consolidated cash flows – Acquisition and 
disposal of subsidiaries.....386 
Consolidated  
financial statements.....253 reserves.....256 statement of cash flows.....380 
statement of changes  in equity.....356 
statement of financial position.....255 statement of profit  or loss and other 
comprehensive income.....310 
Construction.....156 Constructive obligation(s).....177, 178 
Contingent  
asset.....184 
considerati on.....279, 280 
liability.....184, 283 
Contract asset/liability.....157, 158 
Contractual cash flow test.....68 
Control.....253 
Convertible  
bonds.....60 debt.....19, 60, 108 
preference shares.....4 
Cost of  
capital.....24, 35 convertible bonds.....34 
debt  for bank borrowings.....30 
debt for redeemable bonds.....32 debt.....30 
equity.....24 
preference shares.....30 plus.....271, 319 
structures.....271, 319 
Covenants.....15 Creative accounting.....491, 498 
Cum  
div.....25 
rights.....13 
rights price.....102 
Cumulative preference shares.....4 
Current ratio.....478 
D 
Debt  
finance.....14 with warrants attached.....19 
Deferred  
consideration.....280 
tax impact in OCI.....228 
tax on losses.....227 tax.....220 
Definition.....198

Index 
I.2  
Derivatives.....73 
recognition and measurement.....74 
Diluted EPS.....107 Direct method.....377 
Disclosure - Related parties.....443 Dismantling/decommissioning costs.....182 
Dividend cover.....483, 484 
Divdend growth (within DVM model)  
averaging method (His torical method).....27 
constant growth.....26 
profit retention.....28 
restrictions.....15 
Dividend valuation model (DVM).....25 
E 
Earnings.....98 
per share.....98 
EBITDA.....476 Effective tax rate.....472, 473 
Efficiency ratios.....479 Efficiency/activity ratios.....469, 480 Equity  
accounting.....339, 346 
finance.....2 
instruments.....51, 53 
Ex div.....25 
Ex rights price.....13 Exceptional items.....473 Exchange  
difference on goodwill.....408 
difference on net assets for the year.....408 
gains or losses on translation of a foreign     subsidiary.....407 
F 
Fair value......56, 278,  279, 282, 420 
method (goodwill).....257 through other comprehensive income (debt 
investments).....68, 72 
through profit or loss.....56, 65, 68 
Finance leases.....125, 128 
Financial asset(s).....50, 51, 65 
business model test.....68 initial measurement.....65 
the contractual cash flow test.....68 
Financial  
liabilities – subsequent measurement.....56 liabilities.....53, 55 liability.....51 
ratios.....15 reports.....15 
assets – subseque nt measurement.....65 
Financial instruments.....50 
initial recognition.....54 definition.....50 subsequent measurement.....54 
Five step process (revenue).....138 
Fixed charges.....15 Floating charges.....15 Foreign  
currency transactions.....240 
subsidiary translation.....407 
Forward 
contracts.....74 rate agreements.....74 
Functional currency.....238 
Fundamental concepts.....456 Futures contracts.....74 
FVOCI.....292 
G 
Gearing.....483, 485 Goods in transit.....268 
Goodwill.....254, 256, 278, 407, 408 
Grants.....18 
Gross profit margin.....271, 319, 472 
Groups.....253 
Growth model based upon the profit 
retention.....28 
I 
IAS 27 Separate Financ ial Statements.....347 
IAS 32 Classification.....53 
Impairment.....256, 260, 278, 312, 339 Income taxes.....218 
Indirect method.....377 
Initial measurement of  
financial instruments.....54 financial liabilities.....56 
Initial public offering (IPO).....9 
Input methods (revenue over time).....156 Institutional investors.....8 Intangible assets.....198, 283 
Integrated reporting.....452 
Integrated thinking.....453 Interest cover.....483, 484, 485 
Internal Rate of Return (IRR).....32, 40 
Internally generated intangible assets.....199

Index 
 I.3 
International Integrated Reporting Council 
(IIRC).....454 
Intra-group  
balances.....254, 267, 318 investment income.....312 
Introduction.....453 
Inventory holdi ng period.....479 
Investment  
banks.....8 
in associate.....339 
Issuers (of bonds).....17 
J 
Joint  
arrangements.....346 
control.....346 
operations.....347 venture.....346 
K 
kd.....30 
ke.....24 
Key management personnel.....441 
L 
Leases.....124 
Legal obligations.....177 
Lessee.....124 
accounting.....125 
Lessor.....124 
Limitations of analysis.....490 
Liquidity ratios.....479 Listed v private companies.....6 
Long term finance.....2 
M 
Mark up on cost.....271, 319 Methods of issuing new shares.....9 
Mid-year acquisitions.....267, 312 Monetary items.....242 
Money market borrowings.....16 
N 
Negative goodwill.....278 Net assets of subsidiary.....255 
Net Investment of the lease.....128 Non-controlling  
interest.....254, 256, 312, 313, 356 
interest share of profit/TCI.....313 
Non-coterminous accoun ting periods.....495 
Non-cumulative pref erence shares.....4 
Non-current  
asset policies.....473 
asset turnover.....479 
Non-monetary items.....242 
O 
Obligations.....177 
Offsetting a financial asset and a financial 
liability.....54 
Onerous contracts.....180 
Operating leas es.....125, 126 
Operating profit margin.....472 
Options.....75, 110 Ordinary shares.....3 
Other sources of finance.....18 
Output methods (revenu e over time).....156 
Over-trading.....480 
P 
Participating pref erence shares.....4 
Payables payment period.....479 
Performance obligations.....138 
Permanent differences.....221 Placing.....11 Power (in groups).....253 
Preference shares.....3 
Presentation cu rrency.....239 
Primary function of capital markets.....5 
Profit before tax margin.....472 
Profitability ratios.....473 Pro-forma statement of cash flows.....379 
Proportion of net assets method (goodwill).....257 
Provisions.....177 
Provisions for unrealised pr ofit (PUP).....269, 318, 
340 associates.....340 
in Non-current assets.....276, 321 
Purchased inta ngibles.....200 
Purchasers of bonds.....18 
Q 
Quick ratio.....478

Index 
I.4  
R 
Ratios.....469 
Receivables colle ction period.....479 
Recognition.....199 
Recording fair value adjustments.....286 Related parties.....440 Related party  
disclosure.....440, 443 
transactions.....443 
Research and development.....203 
Restructuring.....180 
Return on capita l employed.....472 
Revaluation.....202 
Revenue.....138 
allocate the transaction price.....147 determining the transaction price.....141 identify the contract.....140 
recognise revenue.....147 
separate performanc e obligations.....140 
Revolving Credit Facilities (RCFs).....16 
Right-of-use asset.....124 
Rights issues.....11, 102 
S 
Sale and leaseback.....18 Sale and repurchas e agreements.....152 
Satisfying  
a performance obligation at a point in 
time.....148 
a performance obligat ion over time.....155 
Scrip issues.....100 
Secondary function of capital markets.....5 
Security – charges.....15 
Significant in fluence.....338 
Sources of  
data.....468 long term finance.....2 
Statements of cash flows.....376 
Stockbrokers.....8 Subsequent measurement.....201 
Substance over form.....53 
Swaps.....74 
T 
Temporary differences.....221 Tenders.....10 The capitals.....457 
Theoretical ex rights price.....13, 102 Translating the financial statements of a foreign 
operation.....407 
Translation of foreign currency 
transactions.....240 
U 
Underwriters.....17 
Users of financial statements.....466 
V 
Venture capital.....19 
W 
Warrants.....19, 110 Weighted average  
capital.....102 
cost of capital.....24, 35 
Y 
Yield on irredeemable debt.....39 
Yield on redeem able debt.....40 
Yield to Maturity (YTM).....39

P.2   
 
       Published by: Kaplan Publishing UK Unit 2 The Business Centre, Molly Millars Lane, Wokingham, Berk shire RG41 2QZ 
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ISBN: 978-1-78740-355-0 Printed and bound in Great Britain.

P.3 
Contents 
  Page 
Chapter 1 Strategic financial objectives 1 
Chapter 2 Non-financial objectives 63 
Chapter 3 Development of financ ial strategy 109 
Chapter 4 Financing – Equity finance 141 
Chapter 5 Financing – Debt finance 175 
Chapter 6 Financing – Capital structure 209 
Chapter 7 Dividend policy 247 
Chapter 8 Financial risk 275 
Chapter 9 Currency risk management 315 
Chapter 10 Interest rate risk management 389 
Chapter 11 Financial and strategic implications of mergers 
and acquisitions 433 
Chapter 12 Business valuation 471 
Chapter 13 Pricing issues and post-transaction issues 537 
Index  I.1

P.10   
subject and another. For example, F3 Financial strategy  builds on your 
knowledge of long­term sources of finance from F2 Advanced financial reporting  
as well as risks and control and c apital investment decision ma king from P2 
Advanced management accounting.  

P.11 
review the 2019 CIMA syllabus tr ansition rules and seek appropr iate advice if 

P.16   
F3: Financial Strategy 
Create financial strategy, evalua te and manage financial risk a nd 
assess organisational value 
A Financial policy decisions 15% 
B Sources of long­term funds 25% 
C Financial risks 20% 
D Business valuation 40% 
  100%

P.17 
F3A: Financial policy decisions 
The overall strategy of the organisation must be supported by how its finances are organised. This 
requires an understanding of the different strategic fi nancial objectives and policy options that are open to 
organisations. The choice of these objectives and po licy options will be heavily influenced by the financial 
market requirements and the regulatory environment in which the organisation operates. This section examines these issues. 
 
1. Advise on strategic 
financial objectives. a. Analyse different types of 
b. Advise on financial 
c. Advise on non-financial 
objectives. • Profit and not-for-profit 
• Quoted and unquoted 
companies 
• Private and public sector 
• Value for money, 
maximising shareholder 
wealth 
• Earnings growth, dividend 
growth 
• Impact of underlying 
economic conditions and 
business variables on 
financial objectives 
• Enhancing the value of 
other non-financial capitals 
(human capital, intellectual 
capital and social and 
relationship capital) 
• United Nations 
Sustainability 
Development Goals This section is about aligning 
financial objectives and 
policies to the strategies of 
the organisation. The key aim 
is to make sure that the 
organisation has a proper 
basis to determine what types 
of funds to access and how to 
use those funds. To do this 
effectively finance 
professionals must be able to 
evaluate the opportunities and 
constraints placed on them in 
the operating environment – 
particularly financial market 
requirements, the impact of 
taxation and the requirements 
of industry and financial 
market regulators. 
2. Analyse strategic 
financial policy 
decisions. Analyse the following policy 
decision areas: 
a. Investment 
b. Financing 
c. Dividends 
d. Interrelationships between 
policy decision areas • Use of policy decisions to 
meet cash needs of entity 
• Sensitivity of forecast 
financial statements and 
future cash position to 
these policy decisions 
• Consideration of the 
interests of stakeholders 
external influences 
on financial 
strategic decisions. Discuss the influence of the 
following on financial strategic 
decisions 
a. Market requirements 
b. Taxation 
c. Regulatory requirements • Lenders’ assessment of 
creditworthiness 
• Consideration of domestic 
and international tax 
• Consideration of industry 
regulations such as price 
and service controls

P.18   
F3B: Sources of lo ng­term funds 
What types of funds are available to organisations to finance the implementation of their strategies? How 
much of each type should they go for? And what is the impact on the organisation? Where and how do they get these funds? And how do they provide incentives to providers of such funds so that the funds are 
available at the right time, in the right quantities and at  the right cost? These are some of the questions covered by this section. 
 
1. Evaluate the capital 
structure of a firm. Evaluate: 
a. Choice of capital structure 
b. Changes in capital 
structure • Capital structure theories 
(traditional theory and 
Miller and Modigliani (MM) 
theories) 
• Calculation of cost of 
equity and weighted cost 
of capital to reflect 
changes in capital 
structure 
• Impact of choice of capital 
structure on financial 
• Structuring debt/equity 
profiles of companies in a 
group How should important 
of recognition and 
2. Analyse long-term 
debt finance. Analyse: 
a. Selecting debt instruments 
b. Target debt profile 
c. Issuing debt securities 
d. Debt covenants 
e. Tax considerations • Types of debt instruments 
and criteria for selecting 
them 
• Managing interest, 
currency and refinancing 
risks with target debt 
profile 
• Private placements and 
capital market issuance of 
debt 
• Features of debt 
covenants 
3. Evaluate equity 
finance. a. Evaluate methods of 
flotation 
b. Discuss rights issues • Methods of flotation and 
implications for 
management and 
• Rights issues, choice of 
discount rates and impact 
on shareholders 
• Calculation of theoretical 
ex-rights price (TERP) and 
yield adjusted TERP 
4. Evaluate dividend 
policy. Evaluate policy in the 
a. Cash dividends 
b. Scrip dividends 
c. Share repurchase 
programmes • Features and criteria 
• Impact on shareholder 
value and entity value, 
performance

P.19 
F3C: Financial risks 
There is always a risk that the organisation will not  be able to attract eno ugh funds to finance its 
operations and in extreme conditions will fail to survive as a result. This section covers the sources of such 
risks and how to evaluate and manage such financial risks appropriately. 
 
sources and types 
of financial risks. Discuss: 
a. Sources of financial risk 
b. Types of financial risk • Economic risk 
• Political risk 
• Currency risk 
• Interest rate risk Managing risks related to 
finances is similar to 
managing other types of risks 
in general approach and 
methodology. However, there 
are specific differences such 
as the sources and types of 
financial risks, how they can 
be quantified and ways in 
which they are managed. This 
section looks at the very 
specific issues related to 
managing financial risks 
within a general risk 
management framework 2. Evaluate financial 
risks. a. Evaluate how financial 
risks are quantified • Theory and forecasting of 
exchange rates (e.g. 
interest rate parity, 
purchasing power parity 
and the Fisher Effect) 
• Value at risk 
3. Recommend ways 
of managing 
financial risks. a. Recommend ways to 
manage economic and 
political risks 
b. Discuss currency risk 
c. Discuss interest rate risk 
instruments • Responses to economic 
transaction and translation 
risks 
• Operations and features of 
swaps, forward contracts, 
money market hedges, 
futures and options 
• Techniques for combining 
options in order to achieve 
specific risk profile such as 
caps, collars and floors 
• Internal hedging 
techniques

P.20   
F3D: Business valuation 
The primary objective of all strategic activity is to create and preserve value for organisations. How does 
the organisation know whether it has succeeded in this objective? Sometimes, in order to implement strategies, organisations have to acquire other organisations. How does the acquirer determine the value 
of its acquisition? This section covers how to use techniques in business valuation to answer such questions. 
 
of valuation. Discuss: 
a. Listing of firms 
b. Mergers and acquisitions 
(M&A) 
c. Demergers and 
divestments • Reasons for M&A and 
divestments 
• Taxation implications 
• Process and implications 
of management buy-outs 
• Acquisition by private 
equity and venture 
capitalist This section looks at the 
conditions under which 
organisations need to 
calculate their own value or 
the value of other 
organisations or sub-units 
thereof. It introduces 
candidates to valuation 
techniques. Of particular 
importance in the digital world 
is the valuation of intangibles. 
This links also to how to 
report intangible value and 
their drivers in integrated 
reporting. In addition, how 
should digital assets be 
valued? One of the reasons 
for valuation is when merging 
or acquiring firms. How 
should such deals be 
structured, implemented  and 
closed? For example what 
should the forms of the 
consideration be? What are 
the terms of the acquisition? 
How does one enable benefit 
realisation, particularly for 
synergies once the acquired 
organisation has been 
integrated into the acquiring 
organisation? 2. Evaluate the 
various valuation 
methods. a. Evaluate different 
valuation methods 
b. Discuss the strengths and 
weaknesses of each 
valuation method • Asset valuation 
• Valuation of intangibles 
• Different methods of 
equity valuation (share 
prices, earnings valuation, 
dividend valuation, 
discounted cash flow 
valuation) 
• Capital Asset Pricing 
Model (CAPM) 
• Efficient market 
hypothesis 
3. Analyse pricing and 
bid issues. Analyse: 
a. Pricing issues 
b. Bid issues • Forms of consideration 
• Terms of acquisition 
• Target entity debt 
• Methods of financing cash 
offer and refinancing 
target entity debt 
• Bid negotiation 
4. Discuss post-
transaction issues. Discuss: 
a. Post-transaction value 
b. Benefit realisation • Post-transaction value 
incorporating effect of 
intended synergies 
• M&A integration and 
synergy benefit realisation 
• Exit strategies

1 
Strategic financial 
A1: Advise on strategic 
financial objectives (a) Analyse different types of 
organisations and their objectives 
(b) Advise on financial 
(c) Advise on non-financial 
• Profit and not for profi t (NFP) organisations 
• Quoted and unquoted companies 
• Private and public sector organisations 
• Value for money, maximis ing shareholder wealth 
• Earnings growth and dividend growth 
• Impact of underlying econom ic conditions and business 
variables on financial objectives 
  
 Chapter 
1

Strategic financial objectives 
2 
 
 Definitions of key terms 
 Mission:  Fundamental objective(s) of an entity, expressed in general 
terms. (CIMA Official  Terminology, 2005) 
Mission statement: Published statement, appar ently of the entity's 
fundamental objective(s). This ma y or may not summarise the tru e 
mission of the entity. (CIMA  Official Terminology, 2005) 
Objectives, hierarchy of: Arrangement of the objectives of an entity into 
a number of different levels, wit h the higher levels being more  general 
and the lower levels more specif ic. These levels may be mission , goals, 
targets or, alternatively: str ategic objectives, tactical objec tives or 
operational objectives. 
 
 2 The mission and objectives of an entity 
The mission and objectives o f an entity will differ depending o n: 
• the type of entity (for example  for-profit or not -for-profit) 
• the needs of the entity's different stakeholders. 
This chapter defines the differ ent types of entity and consider s who the entity's 
key stakeholders are. It then loo ks at different objectives, bo th financial 
objectives and non-financial.

Chapter 1 
 3 
 Definitions of different types of entity 
 For-profit and not-for-profit entities 
Most companies operate on a for- profit, or profit seeking basis . This 
means that their primary objective  is to make a profit and ther efore to 
satisfy their shareholders. 
Most public sector entities oper ate on a not-for-profit basis, in that they 
usually have other primary objec tives, often non-financial in n ature. 
Unincorporated and incorporated entities 
An incorporated entity (sometimes called a company or corporati on) is 
legally a separate entit y from its owner(s). 
Conversely, an owner and an uninc orporated entity are legally t he same, 
so the owner personally bears a ll the risks of the business. 
Unincorporated entitie s are usually sole tr aders or partnership s. 
Quoted and unquoted entities 
Once an entity has been incorpor ated, it can apply to a stock e xchange to 
have its shares quoted (or lis ted) on the exchange. It can be e xpensive to 
secure a stock exchange listing , so only large companies tend t o become 
quoted. 
A listing on an exchan ge makes it much easier for shareholders to buy 
and sell the entity's shares. 
Private sector and pub lic sector entities 
A private sector entit y is owned by private investors, whereas a public 
sector entity is owned by t he government of a country. 
Other types of entity 
A charitable entity (charity)  is a type of not-for-pro fit entity. It differs 
from other types of not-for-profit entities in that it centres on not-for-profit 
and philanthropic goals as well as  social well-being (e.g. acti vities serving 
the public interest or common good). 
An association  or union  is a group of individual s who enter into an 
agreement to form an entity to acc omplish a purpose. Common exa mples 
include trade associations, tr ade unions and professional assoc iations 
(like CIMA).

4 
3 Objectives of different types of entity 
It is generally accepted that the pr imary strategic objective o f a for-profit entity 
(i.e. a commercial company ) is the long-term goal of the maximisation of the 
wealth of the shareholders. 
Entities such as public sector bodies (e.g. schools, hospitals) , charities, trade 
unions and associations (such a s accountancy bodies) are not ru n to make 
profits but to benefit prescri bed groups of people. For example , the primary 
objective of a charity is to purs ue whatever charitable objecti ves it was set up 
for. 
Since the services provided are limited primarily by the funds available, 
secondary objectives are to raise  the maximum possible funds ea ch year (net of 
fund-raising expenses), and to u se the funds efficiently to max imise the benefit 
generated. 
 
 Objectives of specifi c types of entity  
 There are some interesting extr a points to note regarding obje ctives 
when we consider the issues facing the following specific types  of entity: 
Incorporated v unincorporated 
An incorporated entity is likely  to have several owners, and th erefore 
there is the potential for great er conflict of stakeholder obje ctives than 
with an unincorpor ated entity. 
Quoted v unquoted 
A quoted company faces far more scr utiny from its many investor s and 
from the financial market in general. 
Also, because of this increased scrutiny, it is arguably more i mportant 
that a quoted company sets appropr iate non-financial objectives  relating 
to its relationship with the environment and its staff. 
Charities 
Charites are usually establishe d to raise money for a specific cause, and 
to spend the money raised in the most effective way. 
However, increasingly charitie s are setting up retail outlets a nd trying to 
generate profits through trading . In some cases, the charities are making 
investments and therefore taki ng risks in order to try to incre ase returns. 
This sort of strategy used to be associated only with profit se eking 
organisations and would have onc e seemed inappropriate behaviou r for 
charities. However, it has becom e the norm for most charities n ow.

Chapter 1 
 5 
4 Objectives and stakeholders 
 Definition of stakeholders 
 Stakeholders: Those persons and entities that have an interest in the 
strategy of an entity. Stakehol ders normally include shareholde rs, 
customers, staff and the local co mmunity. (CIMA Of ficial Termin ology, 
2005) 
The decisions made by an entit y's managers depend on the ultima te objectives 
of the entity. 
Academic studies have shown t hat entities often have many, sometimes  
conflicting , objectives. 
This is a consequence of having many stakeholders with both lon g- and short-
term goals, such as: 
• Equity investors (ordinary shareholders) 
• The community at large 
• Company employees 
• Company managers/directors 
• Customers 
• Suppliers 
• Finance providers 
• The government 
 
 Stakeholder conflicts 
Faced with a broad range of sta keholders, managers are likely t o find they 
cannot simultaneously meet all th e stakeholders' objectives. 
For example the managers of a f or-profit entity will find it di fficult to maximise 
the wealth of their shareholders and keep all the other stakeho lders content. 
In this case, the main strategic objective may be interpreted a s achieving the 
maximum profit possible, consis tent with balancing the needs of  the various 
stakeholders in the entity. 
Such a policy may imply achievin g a satisfactory return for sha reholders, whilst 
(for example) establishing com petitive terms and conditions of service for the 
employees, and avoiding pol luting the environment.

6 
 Example of conflicts of objectives – agency theory 
 Agency theory: Hypothesis that attempts t o explain elements of 
organisational behaviour thr ough an understanding of the relati onships 
between principals (such as s hareholders) and agents (such as c ompany 
managers and accountants). A conflic t may exist between the act ions 
undertaken by agents in furtherance  of their own self-interest,  and those 
required to promote the intere sts of the principals. (CIMA Offi cial 
Terminology, 2005) 
Agency theory 
A possible conflict can arise when  ownership is separated from the day- 
to-day management of an entity. In  larger entities, the ordinar y shares are 
likely to be diversely held, and so the actions of shareholders  are likely to 
be restricted in practical terms . The responsibility of running  the entity will 
be with the board of directors, w ho may only own a small percen tage of 
the shares in issue. 
The managers of an entity are e ssentially agents for the shareh olders, 
being tasked with running the ent ity in the shareholders’ best interests. 
The shareholders, however, hav e little opportunity to assess wh ether the 
managers are acting in the s hareholders’ best interests. 
5 For-profit entities 
Introduction to objectives of for-profit entities 
As stated above, the primary objec tive of a for-profit entity i s the maximisation 
of shareholder wealth. 
However, this objective always ha s to be balanced with other ob jectives, driven 
by the needs of the other key stakeholder groups. 
For-profit entities will theref ore have a mix of financial and non-financial 
Financial objectives of  for-profit entities 
The financial objectives of a f or-profit entity will be created  after considering the 
following factors: 
Equity investors (ordinary shareholders) 
Within any economic system, the equity investors provide the ri sk finance. 
There is a very strong argument f or maximising the wealth of eq uity investors. 
In order to attract funds, the company has to compete with othe r risk-free 
investment opportunities, e.g. gov ernment securities. The share holders require 
returns from the company in te rms of dividends and increases in  share prices.

Chapter 1 
 7 
Finance providers 
Providers of loan finance (ban ks, loan creditors) will primaril y be interested in 
the ability of the firm to repay  the finance including interest . As a result it will be 
the firm's ability to generate cash both long and short term th at will be the basis 
of the goals of these providers. 
Risk exposure 
Risk can be measured according to finance theory. 
Some risks – for example exchan ge-rate risk and interest-rate r isk – can be 
managed by the use of hedging me chanisms. Shareholders and enti ties can 
therefore choose how m uch risk they wish to be exposed to for a  given level of 
return. However, risk can take  many forms, and the theory does not deal with 
risk exposure to matters such as  recruitment of senior personne l or competitor 
activity. 
Directors should set risk policie s according to an agreed risk appetite which 
reflects the risk appetite of the shareholders. 
Examples of specific financial objectives of for-p rofit entitie s 
In order to achieve the overa ll objective of maximising shareho lder wealth, but 
also to address the other issues i dentified above , entities sho uld set specific 
financial targets in order to both communicate direction and me asure 
Profitability 
e.g. annual 10% improvement in earnings, or earnings per share.  
Dividends 
e.g. annual 5% increase in dividends. 
Cash generation 
e.g. annual 10% improvemen t in operating cash flow. 
Gearing 
e.g. a maximum [debt to (deb t + equity)] ratio of 40%. 
In order to assess wh ether the entity has achieved its financia l objectives, ratio 
analysis can be used (covered in m ore detail towards the end of  this chapter).

8 
 More on financial objectives of for-profit entities 
 Financial performance indicators 
Return to investors 
The return from ownership of shar es in a profit-making entity c an be 
measured by the formula: 
Annual return to investors =  P1 – P0 + Dividend
P0 
This is the capital appreciati on on the shares (the difference between P 1 
and P 0 – the share price at the end and  the start of the year respect ively), 
plus dividends received during  the year. The measure reflects t he fact 
that both share price growth and dividends are important to inv estors. In 
fact, investors can still make gains (through the capital appre ciation of 
their shares) even if the entit y never pays out a dividend. 
Poor liquidity is a gr eater threat to the survival of an entity  than is poor 
profitability. Unless the entit y is prepared to fund growth wit h high levels 
of borrowings, cash generation is v ital to ensure investment in  future 
profitable ventures. In the privat e sector the alternative to c ash via 
retained earnings is borrowing. 
Value added 
This is primarily a measure of performance. It is usually defin ed as 
revenues less the cost of purchased materials and services. It represents 
the value added to an entity’s pr oducts by its own efforts. A p roblem here 
is comparability with other indus tries – or even with other ent ities in the 
same industry. 
Profitability may be defined as t he rate at which profits are g enerated. It is 
often expressed as profit per unit of input (e.g. investment). However, 
profitability limits an entity’s focus to  one output measure – profit. It 
overlooks quality, and this limit ation must be kept in mind whe n using 
profitability as a measure of suc cess. Profitability as a measu re of 
decision-making has been criticised because: 
• it fails to provide a systematic  explanation as to why one bus iness 
sector has more favourabl e prospects than another; 
• it does not provide enough insi ght into the dynamics and balan ce of 
an entity’s individual business units, and the balance between them; 
• it is remote from the actions t hat create value, and cannot th erefore 
be managed directly in any bu t the smallest entities; 
• the input to the measure may vary  substantially between entiti es.

Chapter 1 
 9 
Nevertheless, it is a well-known and accepted measure which, on ce the 
input has been defined, is read ily understood. Provided the inp ut is 
consistent across entities and ti me periods, it also provides a  useful 
comparative measure. 
Return on assets (RoA) 
This is an accounting measure, c alculated by dividing annual pr ofits by 
the average net book value of asse ts. It is therefore subject t o the 
distortions inevitable when prof it, rather than cash flows, is used to 
determine performance. Distorting  factors for interpretation an d 
comparison purposes include depreciation policy, inventory reva luations, 
write-off of intangibles such as  goodwill, etc. A further defec t is that RoA 
ignores the time value of money, although this may be of minor concern 
when inflation is very low. 
RoA may not adequately reflect how  efficiently assets were util ised: in a 
commercial context, taking accoun t of profits but not the asset s used in 
their making, for whatever reas on, would overst ate an entity’s 
Market share 
Market share is often seen as an objective for an entity in its  own right. 
However, it must be judged in th e context of other measures suc h as 
profitability and shareholder val ue. Market share, unlike many other 
measures, can take quality into  account – it must be assumed th at if 
customers do not get the qualit y they want or expect, then the entity will 
lose market share. 
Gaining market share must be se en as a long-term goal of entiti es to 
ensure outlets for their products  and services, and to minimise  
competition. However, market s hare can be acquired only within limits if a 
monopoly situation is  to be avoided. 
Competitive position 
The performance of an entity mus t be compared with that of its 
competitors to establish a stra tegic perspective. A number of m odels and 
frameworks have been suggested by organisational theorists as t o how 
competitive position may be determined and improved. A manager 
needing to make decisions must know  by whom, by how much, and w hy 
he is gaining ground or bei ng beaten by competitors. 
Conventional measures, such as a ccounting data, are useful but no one 
measure is sufficient. Instead, an array of measures is needed to 
establish competitive position . The most difficu lt problem to o vercome in 
using competitive position as a s uccess factor is in collecting  and 
acquiring data from competitors.

10 
Non-financial objectives of for-profit entities 
The non-financial objectives o f a for-profit entity will be cre ated after considering 
the following stakeholder issues: 
Company employees 
Returns = wages or salaries. How ever, maximising the returns to  employees 
does assume that finance can be ra ised purely on the basis of s atisficing the 
returns to finance providers. The employees' other interests al so include job 
security and good conditions of employment. 
Company managers/directors 
Such senior employees are in an ideal position to follow their own aims at the 
expense of other stakeholders . Their goals will be both long-te rm (defending 
against takeovers, sales maximisat ion) and short- term (profit m argins leading to 
increased bonuses). 
Suppliers 
Suppliers to the organisation w ill have short-term goals such a s prompt 
payment terms alongside long-term requirements including contra cts and 
regular business. The import ance of the needs of suppliers will  depend upon 
both their relative size and the number of suppliers. 
The government 
The government will have politic al and financial interests in t he firm. Politically it 
will wish to increase exports and decrease imports whilst monit oring companies 
via the competition authorities. Financially it requires long-t erm profits to 
maximise taxation income. 
The community at large 
The goals of the community will be broad but will include such aspects as legal 
and social responsibilities, po llution control and employee wel fare. 
Environmental concerns 
In pursuit of shareholder wealth m aximisation, historically dec isions have often 
been made that led to pollution or  other environmental problems . Increasingly, 
entities are becoming aware of th eir environment al responsibili ties. Many 
entities now produce environmenta l reports alongside their fina ncial statements 
to emphasise their commitment t o environmental issues. This is covered in 
more detail in Chapter 2 : 'Integrated Reporting'. 
Customer pressure 
Entities are increasingly co ming under pressure from knowledgea ble 
customers. Customers are more and more keen to ensure that enti ties they 
trade with behave ethically and res ponsibly. Therefore, decisio n makers have to 
take account of customers' wis hes, even if there appears to be a short-term 
conflict with the shareholder wea lth maximisation objective.

Chapter 1 
 11 
If customers are not satisfied  they will take their business el sewhere and the 
entity will lose market share and go into liquidation. Measurin g customer 
satisfaction is difficult to do  formally, as the inputs and out puts are not readily 
defined or measurable. Surveys and questionnaires may be used b ut these 
methods have known flaws, mainl y as a result of respondent bias . 
Examples of specific non-financia l objectives of for-profit ent ities 
Non-financial objectives can be used to direct managers' attent ion towards key 
stakeholder requirem ents, to ensure that  the entity balances th e needs of its 
different stakeholders and minimi ses the conflict between the d ifferent 
stakeholder groups. 
Also, achievement of non-financial objectives can improve the i mage of the 
entity from the perspective of i ts stakeholders. This can have a knock-on effect 
on sales and profitab ility and hence can help  to create additio nal wealth for 
shareholders in the longer term. 
Non-financial objectives can be categorised under the following  headings: 
Human 
This considers the relationship of the entity wit h its staff, s o objectives could 
cover increasing the amount of tr aining provided, or reducing t he level of staff 
turnover 
Intellectual 
This considers the intangible a ssets of the entity, such as its  brand and 
reputation. Objectives could focu s on improving the brand recog nition. 
Natural 
This considers the entity's res ponsibility towards the environm ent, so objectives 
might include reducing the leve l of pollution and increasing th e amount of 
recycling. 
Social 
This considers the entity's res ponsibility towards its local co mmunity. A social 
objective could be to make sure a t least 50% of the employees l ive within a 5 
mile radius of the entity's premises. 
Relationship 
This considers the entity's res ponsibility towards key stakehol ders such as 
suppliers and customers. A relat ionship objective could be to p ledge to offer all 
suppliers longer term contracts an d to pay them o n time, in ord er to improve the 

12 
6 Not-for-profit entities 
Objectives of not-for-profit entities 
Not-for-profit entities such as public sector bodies (e.g. scho ols, hospitals), 
charities, trade unions and associ ations (such as accountancy b odies) are not 
run to make profits but to benefit prescribed groups of people.  For example, the 
primary objective of a charity is  to pursue whatever charitable  objectives it was 
set up for. 
This can be measured as the 'val ue for money' (VFM) generated. 
Satisfying many different stakeholders 
Before we look at VFM in detail , it is worth noting that not-fo r-profit entities will 
still have a mix of financial and non-financial objectives (jus t like for-profit 
entities discussed above) and will  still have to try to satisfy  many different 
There will often be different v iews of what the objectives of a  not-for-profit entity 
should be, and therefore, whether  appropriate objectives have b een achieved. 
What value does one put on curi ng an illness, or saving a life?  Should the 
success of a hospital be measured by shorter waiting lists? The se are societal 
matters, the discomfort being one of the reasons they are place d firmly in the 
public sector, rather than being l eft to the ‘survival of the f ittest’ philosophy 
associated with the co mpetitive markets. 
A public sector college will set objectives relating to the num ber of students, the 
number of courses, the ratio of lecturers to students, and so o n. It will also seek 
its customers’ assessm ents of the standard o f, for example it’s  lecturing and 
catering, and compare them with preset targets. In the language  of strategic 
financial management, these are answers to the question ‘How we ll did we do 
what we chose to do?’ that is, 'how effective  were we in meeting the 
objectives?'

Chapter 1 
 13 
 Public sector entities 
 Public sector entities are bodi es such as nationalised industr ies and local 
government organisations. They repr esent a significant part of many 
countries' economies and sound  financial management is essentia l if their 
affairs are to be conducted effi ciently. The major problem here  lies in 
obtaining a measurable objective. 
Financial objectives in the public sector 
For a stock market listed com pany we can take the maximisation of 
shareholder wealth as a worki ng objective and know that the 
achievement of this objective c an be monitored with reference t o share 
price and dividend payments. For a  public sector entity the sit uation is 
more complex. 
The entity's mission statement will lay out its key objectives.  However, 
generally such entities are run in the interests of society as a whole and 
therefore we should seek to attai n the position where the gap b etween 
the benefits they provide to soc iety and the costs of their ope ration is the 
widest (in positive terms). 
The cost is relatively easily  measured in accounting terms. How ever, 
many of the benefits are intangibl e. For example, the benefits of such 
bodies as the National Health Ser vice or Local Education Author ities are 
almost impossible to quantify. 
Such government organisations tend  to use a low discount rate i n 
investment appraisals (to take a ccount of 'time preference') an d have 
complex methods of quantifying n on-financial benefits in a stan dard NPV 
analysis. 
Economists have tried to evaluat e many public sector investment s 
through the use of cost benefit analysis, with varying degrees of success. 
Problems are usually e ncountered in evaluatin g all the benefits . 
Regulation 
It is worth remembering that o rganisations that have had a publ ic sector 
history or are themselves natur al monopolies are often regulate d in order 
to ensure the public are not t he victims of t he monopoly power these 
companies enjoy. This regulation can take many forms but can in clude 
the capping of the selling prices, the taxing of super profits or simply a 
limit on the profits  these entities are allowed to make.

14 
 Specific objectives of public sector entities 
 Traditionally, managers have focu sed on financial measures of 
performance and progress, but incr easingly, entities in both th e private 
and public sectors are using non-financial indicators to assess  success 
across a range of crite ria, which need to be chosen to help an entity meet 
its objectives. 
A number of common objectives ar e discussed below, in the conte xt of 
public sector entities. 
In the public sector this choice  has not been available in the past, and all 
growth has been funded by governm ent. However, in the face of 
government-imposed cash limits, l ocal authorities and other pub lic-sector 
entities are beginning to raise debt on the capital markets, an d are 
therefore beginning to  be faced with the same choices as profit -making 
entities. 
Value added represent s the value added to an entity’s products by its 
own efforts. 
A problem here is com parability with other i ndustries – or even  with other 
entities in the same industry. 
Many public sector entities – fo r example those in the health s ervice – are 
now publishing information on their own value added. 
Although the concept of profit in its true sense is absent from  most of the 
public sector, profitability may be used to relate inputs to ou tputs if a 
different measure of output is us ed – for example: surplus afte r all costs, 
to capital investment.

Chapter 1 
 15 
 Return on assets (RoA) 
In the public sector, the conc ept of profit is absent, but it i s still not 
unrealistic to expect entities to  use donated assets with maxim um 
efficiency. If depreciation on su ch assets were to be charged a gainst 
income, this would depress the amount of surplus income over 
expenditure. Other poi nts which may affect interpretation of Ro A in the 
public sector are: 
• difficulty in determining value; 
• there may be no resale value; 
• are for use by community at large; 
• charge for depreciation may hav e the effect of ‘double taxatio n’ on 
the taxpayer. 
Market share is a measure that i s becoming increasingly relevan t to the 
public sector – for example uni versities and health provision. Health 
providers must now ‘sell’ their services to trusts established to ‘buy’ from 
them. Those providers which are seen to fail their customers wi ll lose 
market share as the trusts will buy from elsewhere (within cert ain limits). 
The public sector is increasingl y in competition with other pro viders of a 
similar service both in the private and public sectors. 
For example hospitals now have  to compete for the funds of heal th trusts. 
Their advantage is that it is easie r to gain access to data fro m such 
competitors than it is in the private sector. 
Public sector entities tend to be risk averse because of the po litical 
repercussions of failure and the fa ct that taxpayers, unlike sh areholders, 
do not have the option to inves t their money in less (or more) risky 
ventures. 
Assessing value for money in  not-for-profit entities 
Not-for-profit entities are oft en appraised according to the 'v alue for money' 
(VFM) that they generate. 
Value for money may be defined as  "performance of an activity i n such a way 
as to simultaneously achieve economy, efficiency and effectiven ess." (CIMA 
Official Terminology, 2005) 
This means making the optimum use  of available resources to ach ieve the 
intended outcome.

16 
VFM has three constituent elements: 
Economy:  minimising the cost of resour ces used or required (inputs) – 
spending less 
Efficiency:  the relationship between the out put from goods or services and  the 
resources to produce them – spending well 
Effectiveness:  the relationship between the in tended and actual results of 
public spending (outcome s) – spending wisely. 
These elements can be referre d to by the umbrella term 'cost effectiveness' . 
Besides these three ‘Es, a fourth  ‘E’ is applied in some places : 
Equity:  the extent to which services ar e available to and reach all pe ople that 
they are intended to – spending fairly. Some people may receive  differing levels 
of service for reasons other than differences in their levels o f need. 
Overview of VFM

Chapter 1 
 17 
 More detail on VFM 
 Measurement of VFM 
In practice, value for money is difficult to measure, and it is  a relative 
rather than an absolute measure. 
Value for money audit or study 
A value for money audit is defi ned as an "investigation into wh ether 
proper arrangements have been made  for securing economy, effici ency 
and effectiveness in the use of res ources." (CIMA Official Term inology, 
2005) 
A value for money study focuses on a specific area of expenditu re, and 
seeks to reach a judgement on w hether value for money has been 
achieved. Good value for money c an be defined as the optimal us e of 
resources to achieve t he intended outcomes. 
The purpose of a VFM study is not to question policy objectives , but to 
provide independent and rigorous analysis on the way in which m oney 
has been spent to achieve those policy objectives. 
As well as reaching an overall conclusion on value for money, a  VFM 
study will make recommendations on how to achieve better value for 
money and to improve the services under examination. In some 
circumstances, a follow-up study is conducted to measure progre ss 
against the recommendations made. 
Typically, a study will use a mi x of quantitative and qualitati ve methods. 
The methods commonly used include: 
• Financial analysis 
• Analysis of management information 
• Interviews or focus groups wit h departmental and other staff 
• General research 
• Surveys of practitioner s or service users 
• Benchmarking with other organi sations or other countries. 
Real world difficulties 
In reality, a VFM audit will us ually focus on either effectiven ess or on 
economy and efficiency. This is because the two sides of VFM ar e often 
in partial conflict; you can have a better service (but spend m ore) or a 
cheaper service (often of lower  quality). Therefore the differe nt elements 
are typically looked at wit hin separate VFM audits.

18 
 Illustration 1 – A practical example of VFM 
 Practical example: Value for mone y (taken from the website of t he 
UK National Audit Office) 
A local authority sets up a new  programme to reduce litter drop ping. One 
of its early steps is to agree with stakeholders a set of outco mes for the 
programme. The effectiveness of t he programme is to be judged o n the 
extent to which it reaches i ts outcomes in a year. 
In this case, the programme ach ieves 97% of its outcomes and 
councillors declare they have ‘c ome within a whisker of winning  the battle 
against litter’. The programme was effective. 
However, the programme cost more  than expected and overspent it s 
budget by 25 per cent. This was bec ause the programme managers 
allowed costs to over-run in t heir drive to meet the outcome. T he 
programme was not economical. 
The cost over-run prompts a revi ew of the service. This conclud es that, 
outcome for outcome, it was more expensive than similar program mes in 
neighbouring areas. The progr amme was not efficient. 
If programme objectives had been exceeded sufficiently, the pro gramme 
may have been cost-effective des pite the overspend. However, 
programme managers could still be criticised for exceeding the budget. 
The most disadvantaged parts of t he area were also those with t he 
biggest litter problems and these neighbourhoods improved more,  from a 
lower base, than wealthier places. The programme was equitable.  
Note how effectiveness (achieving  the outcomes) partly conflict ed with 
the economy and efficiency (high overspends and cheaper project s in 
other regions). 
7 International operations 
Increasingly in the mo dern business environm ent, entities are e xpanding across 
national boundaries into m any different countries. 
Although there are risks associ ated with such strategies, the s trategic and 
financial benefits to an entity can be enormous. 
In many ways, the objectives o f an entity tradi ng international ly will be the same 
as those of an entity based in  just one country. However, there  are some 
additional considerations.

Chapter 1 
 19 
Strategic implications of  international expansion 
The main strategic implications  of international  expansion are:  
Competition 
Foreign markets may have weaker  competition. A firm facing a co mpetitive 
domestic market will benefit from  finding a foreign market wher e it has a 
monopoly. 
Country factors 
Some countries have cheap sources of natural raw materials and cheap labour 
costs. Locating production facilit ies in these countries will b ring significant cost 
savings. Also, some countries' governments offer grants and che ap loans to 
foreign investors to att ract inward investment. 
Benefits to the customer 
Locating in a different country c ould move an entity closer to existing 
customers, so reducing delivery  times and improving relationshi ps. Also, it is 
likely to bring an entity closer  to a pool of potential new cus tomers. 
As the entity gets bi gger, international expansion might be the  best way of 
continuing to generate economies of scale. 
Risk management 
International expansion will leav e an entity less exposed to a single economy. 
Factors such as interest rates, inflation, government policy an d exchange rates 
from more than one econom y will impact a business with internat ional 
operations. This will reduce the economic and political risk to  the entity. 
Financial implications of international expansion 
The primary corporat e objective – to maxim ise shareholder wealt h – has been 
referred to earlier in this chapter. 
The main financial benefit of an international investment is th e positive NPV and 
consequent gain to shareholders of undertaking an attractive pr oject. 
However, also consider the fo llowing other financ ial implicatio ns of international 
Impact on the financial statements 
If the foreign projec t assets are denominated  in foreign curren cy, they will have 
to be converted into the domesti c currency for the purposes of consolidation. If 
exchange rates fluctuate from one year to the next, the value o f these assets 
will also fluctuate, giving ( unrealised) exchange gains or loss es in the entity's 
accounts. This is known as trans lation risk, however it does no t impact the 
actual cash flows of the busi ness and is often left unmitigated .

20 
Impact on the cost of capital 
International investments will o ften be more risky to an entity  than its normal 
domestic investments. Therefore , it is likely that the entity's  cost of capital will 
change to reflect this increased risk. 
8 Financial performance evaluation 
Investors (both shareholders an d lenders) will often appraise t he financial 
performance of an organisation , to assess whether the organisat ion represents 
a good investment. If it is show n that the organisation's finan cial performance is 
declining, the shareholders may dec ide to sell their shares, an d the lenders 
might change their assessment of t he organisation's creditworth iness. 
In an exam question, you might als o be asked to use ratio analy sis to assess 
whether an entity has met i ts financial objectives. 
 
 To appraise financial performance , it is necessary to first cal culate ratios 
under the following headings: 
• profitability ratios, 
• lender ratios, 
• investor ratios. 
The calculation of these ratios i s covered in the rest of this chapter. 
However, as well as performing the calculations, it will also b e important to be 
able to interpret the figures, s o you will find detailed explan ations of how to 
interpret the ratios throughout. 
9 Profitability ratios 
Several profit figures (gross pr ofit, operating profit, net pro fit) can be identified in 
a typical statement of profit or loss. 
Profitability is a key performanc e indicator for an entity. In order to assess 
performance accurately, it is im portant to compare figures cons istently from one 
year to the next. 
 
 Definitions of different profit figures 
 Profit figures in the statement of profit or loss 
Gross profit  = Sales – Cost of Sales 
Gross profit margin= Gross profit
Revenue × 100 
Generally, a high profit margin i s perceived to be indicative o f good 
performance.

Chapter 1 
 21 
Operating profit  = profit from the trading activi ties of an entity i.e. sales –
operating costs, but before financ e costs (interest) and tax. 
Net profit  = Profit after deduction of the finance costs (interest) and t ax 
EBITDA 
EBITDA is an acronym for earnings  before interest, tax, depreci ation and 
amortization. In recent years  many large entities have adopted EBITDA 
as a key measure of financial per formance. Sceptics suggest tha t they do 
this in order to publicise a hi gher measure of earnings than pr ofit from 
operations (this type of measurement is sometimes cynically ref erred to 
as EBB – earnings before the bad bits). 
However, it does make some sense to measure EBITDA, provided th at 
Depreciation and amortization ar e accounting adjustments, not 
measurement of cash flow, which  of course it is not. Even thoug h two 
categories of non-cash adjustme nt are eliminated, financial sta tements 
are prepared on an accr uals basis. EBITDA makes no adjustments in 
respect of accruals or working c apital movements, and so is emp hatically 
not a cash flow measurement. 
 
 There are two measures critical  to any analysis of profitabilit y: 
1 Return on Capital Employed (ROCE) 
2 Return on Equity (ROE) 
Return on capital employed (ROCE) 
Return on capital employed (ROC E) is a measurement that is freq uently used in 
the analysis of financ ial statements. 
It shows the overall performance of the entity, expressed as a percentage return 
on the total investment. It m easures management’s efficiency in  generating 
profits from the resources available. 
ROCE is expressed as a percent age, and is calculated as follows : 
ROCE  = Operating profit
Capital employed × 100 
where Capital employed = The to tal funds invested in the busine ss, i.e. 
shareholders' funds + long term deb t, or total assets less curr ent liabilities.

22 
Return on equity (ROE) 
ROE gives an indication as to how well the company has performe d in relation 
to its shareholders, the mos t important stakeholder. 
ROE is expressed as a percentage , and is calculated as follows:  
ROE = Net profit
Equity × 100 
where Equity = The book value of shareholders' funds 
It is useful to compare the ROE  to the ROCE to measure the amou nt of the 
return underlying the business  that pertains to the shareholder . Note, however, 
that they are not directly co mparable, ROE being based on net p rofit and ROCE 
based on operat ing profit. 
 
 Asset turnover 
  
Asset turnover = Revenue
Capital employed 
This calculation is usually exp ressed as a simple ratio, rather  than as a 
percentage. It shows how much rev enue is produced per $ of inve stment 
in capital employed. 
Return on capital employed – Further analysis 
When trying to analyse ROCE, it can be useful to break it down as follows into 
two component ratios: 
ROCE = Operating profit m argin × Asset turnover 
The relationship becomes clear  when we put the ratio calculatio ns into the 
formula: 
Capital employed × 100  = Operating profit
Revenue × 100  × Revenue
Analysing the component ratios ma y throw some light on the caus e of a change 
in ROCE. 
For example, a fall in R OCE could be caused by: 
• generating lower sales from the company's capital (lower asset  turnover), 
and/or 
• generating a lower profit margi n on the sales which have been achieved 
(lower operating profit margin).

Chapter 1 
 23 
 Test your understanding 1 (Integration question) 
 A company is considering two  funding options for a new project . The new 
project may be funded by GBP10m o f equity or debt. Below are th e 
forecast financial statements re flecting both methods of fundin g. 
Statement of financial position extract 
 Equity Debt 
 GBPm GBPm Long term liabilities (10% bonds)  0.0  10.0 
 — —
– — — – 
Capital   
Share capital (50 pence)  11.0  3.5 
Share premium  4.0  1.5 
Reserves 5.0  5.0 
 — — – — — – 
 20.0  10.0 
 — — – — — – 
Statement of profit or loss extract 
 GBPm 
Revenue 100.0 
Gross profit  20.0 Less expenses (excluding  finance charges) (15.0) 
 — —
– 
Operating profit  5.0 
 — — – 
Corporation tax is  charged at 30%. 
Required: 
(a) Calculate the oper ating profit margin and the asset turnove r. 
(b) Calculate Return on Capital Employed and Return on Equity, and 
compare the financial performanc e of the company under the two 
funding methods. 
(c) What is the impact on the company's performance of financin g by 
debt rather than equity?

24 
 Interpretation of profitability ratios 
In general terms, high levels of p rofitability are desirable. 
An entity with high profit mar gins and a high ROCE is usually p erceived to be 
performing well. Similarly, if the ratios grow over time, this is usually perceived 
to be positive. 
The ideal value for the profit ability ratios will vary from ind ustry to industry, so 
be sure to compare the figures to  previous years and to other s imilar 
businesses if possible. 
10 Lender ratios 
 Definition of gearing 
 CIMA’s Official Terminology p rovides the following definition of gearing: 
“... the relationship between an entity’s borrowings, which inc ludes both 
prior charge capital and long- term debt, and its shareholders’ funds.” 
 
 Gearing is the mix of debt to equi ty within a firm's permanent capital. 
There are two particula rly useful measures: 
1 Capital gearing – a statement of financial position (balance sheet) 
measure. 
2 Interest cover – a statem ent of profit or loss measure. 
Capital gearing – a measure of capital structure 
There are two key meas ures of capital gearing: 
Capital gearing = Debt
 
 Debt
Debt + Equity × 100 
The calculation of capital gear ing can be done in a number of d ifferent ways. In 
the exam, you'll be told  which formula to use. 
The most commonly used formula i n practice and in the exam is  
debt/(debt + equity) i.e. the second formula here. 
Constituent elements of debt and equity 
Debt includes redeemable prefer ence shares, bank borrowings and  bonds 
(overdrafts may be included if they are long-term finance sourc es). 
Equity includes ordinary and i rredeemable preference shares (pl us reserves if 
the valuation is at book value).

Chapter 1 
 25 
Market values and book values 
Wherever possible, market values  should be used in preference t o book values 
for the capital gearing ratio. 
When using market values, care mu st be taken when calculating t he market 
value of equity: 
When equity is valued using book values it must include any res erves and 
retained profits that are attr ibutable to the ordinary sharehol ders that is: 
Book value of equity  = ordinary share capital + reserves 
When market values are used, res erves must be excluded since th ey are 
considered to be already incorpor ated into the market price of the shares, that 
is: 
Market value of equity  = Number of shares × Share price 
 
 Interest cover 
The interest cover ratio indica tes the number of times profits will cover the 
interest charge; the higher the ratio, the better. 
Interest cover = Profit before interest and tax
The interest cover ratio is us ed by lenders to determine the vu lnerability of 
interest payments to a drop in profit. 
As an alternative to the formula  shown here, investors often us e EBITDA rather 
than profit before interest and tax in the formula, because EBI TDA is a better 
approximation to the cash generat ed by the business (and availa ble to pay 
interest with). 
 
 The debt ratio 
 Another useful ratio is the ra tio of long-term debt to total a ssets, which is 
calculated as follows: 
Debt ratio = Total long term debt
Total assets 
This can provide very useful in formation for credi tors as it me asures the 
availability of assets in the bus iness in relation to the total  debt.

26 
 Test your understanding 2 (Integration question) 
 Statement of financia l position for X Co 
 U S D m  
Non-current assets (total) 23.0 
Current assets (total) 15.0 
TOTAL ASSETS 38.0 
Equity and Liabilities  Ordinary share capital 10.0 Ordinary share premium 4.0 
Preference share capi tal (irredeemable)  1.5 
Reserves 1.5 Non-current liabilities  
10% bonds  8.0 
Current liabilities  Trade creditors  8.0 
Bank overdraft 5.0 TOTAL EQUITY & L IABILITIES 38.0 
X Co statement of profit or loss extract 
 U S D m  
Operating profit (PBIT) 4.0 Finance Charges  (1.0) 
 — —
– 
Profit before tax (PBT)  3.0 
Tax @ 30% (0.9) 
 — — – 
Net profit 2.1 
 — — – 
Required: 
(a) Calculate the interest cov er for X Co, and the capital gear ing ratio 
(on the assumption that the over draft is to be used in the long  term 
so should be includ ed within debt). 
(b) Comment on the results o f your calculations in part (a). 
11 Investor ratios 
Investors will wish to assess t he performance of the shares the y have invested 
in (against competing entities in  the same sector, against the market as a 
whole, and over time). 
There are a number of r atios which will be o f specific interest  to investors (both 
debt investors and equity investors).

Chapter 1 
 27 
 Market price per share 
 The market price per share us ed throughout the following ratio  formulae 
is the ex-dividend market price. 
Ex-dividend means that in buying a share today, the investor wi ll not 
participate in the forthc oming dividend payment. 
Sometimes in an examination, the market price may be quoted cum - 
dividend which means with divide nd rights attached. Here the in vestor will 
participate in the forthcoming di vidend if purchasing the share  today. 
Arguably the investor will be willing to pay a higher price for  the share, 
knowing that a dividend payment  is forthcoming in the near futu re. 
The relationship between the cu m-dividend price and the ex-divi dend 
price is then: 
Ex-dividend market price = Cum-d ividend market price – Forthcom ing 
dividend per share. 
Before we can calculate any rat ios we need to calculate a key m easure of 
return, the Earnings per share (EPS). 
Number of ordinary shares in issue 
where Earnings = Profit distri butable to ordinary shareholders,  i.e. after interest, 
tax and any prefer ence dividend. 
 
 More details on EPS 
 An important point to remember i s that EPS is a historical fig ure and can 
be manipulated by changes in acc ounting policies, mergers or 
acquisitions, etc. 
Market analysts and company exe cutives occasionally appear obse ssed 
about EPS as a performance measur e, an obsession which many thi nk is 
quite disproportionate to its true value. 
It is future earnings which should  concern investors, a figure far more 
difficult to estimate. 
 
 P/E ratio 
The P/E ratio is a measure of g rowth; it compares the market va lue (a measure 
of future earnings) to  the current earnings. 
P/E ratio = Current share price
EPS 
or, alternatively, Total market c apitalisation/Total earnings.

28 
The higher the P/E ratio, the gr eater the marke t expectation of  future earnings 
growth. This may also be de scribed as market potential. 
Earnings yield 
The P/E ratio is the reciprocal  (in maths, a number or quantity  divided into 1) of 
the earnings yield. 
Earnings yield = EPS
Current share price 
or, alternatively, Total earnings /Total market capitalisation. 
The market price will incorporat e expectations of all buyers an d sellers of the 
entity’s shares, and so this is an indication of the future ear ning power of the 
entity. 
Dividend-payout rate 
The cash effect of payment of d ividends is measured by the divi dend-payout 
rate. 
Payout rate = Dividend per share
EPS 
or, alternatively, Total d ividend/Total earnings. 
The relationship between the abov e investors’ ratios is usually  that an entity 
with a high P/E ratio has a low  dividend payout ratio as the hi gh growth entity 
needs to retain more resources in  the entity. A more stable ent ity would have a 
relatively low P/E ratio and higher dividend-payout ratio. 
When analysing financial statements  from an investor’s point of  view it is 
important to identify the objec tives of the investor. Does the investor require 
high capital growth and high risk , or a lower risk, fixed divid end payment and 
low capital growth? 
 
 Dividend yield 
This is the relationship of t he dividend paid to the current ma rket value of a 
share. 
Dividend yield = Dividend per share
or, alternatively, Total dividend/ Total market capitalisation. 
However, the dividend represent s only part of the overall retur n from a share. 
The other part of the return is  the capital gain from an increa se in the value of 
the share. The capital gain from  a share may well be far more s ignificant than 
the dividend.

Chapter 1 
 29 
 Dividend cover 
Dividend cover measures the abilit y of the entity to maintain t he existing level of 
dividend and is used in conjunction with t he dividend yield. 
Dividend cover = Earnings per share
Dividend per share 
or, alternatively, Total earnings/Total dividend. 
The higher the dividend cover th e more likely it is that the di vidend yield can be 
maintained. 
Dividend cover also gives an indi cation of the level of profits  being retained by 
the entity for reinvestment by considering how many times this year’s dividend 
is covered by this year’s earnings. 
 
 Test your understanding 3 (Integration question) 
 Lilydale Co has 5m ordinary shares in issue. Its results for t he year are: 
 USD000 
Profit before tax  750 
Tax (150) 
 — — – 
Profit after tax (PAT) 600 
Ordinary dividend – proposed  (150) 
 — — – 
Retained profit  450 
 — — – 
The market price per share is c urrently 83 cents cum-dividend. 
Required: 
Calculate the following ratios: (a) Price/earnings ratio  (b) Dividend payout rate  (c) Dividend yield, and (d) Dividend cover. 
Earnings growth and dividend growth 
An analysis of growth rates o f earnings and dividends can enabl e investors to 
make an assessment of the per formance of an entity. 
High growth rates in earnings and dividends are usually viewed positively.

30 
Calculations 
The growth rate for a single year is: 
[(current figure/last year's figure) – 1] × 100% Over a number of years (n), the implied compound annual growth rate is:  
[
n √ (current figure/earliest year's figure) – 1] × 100% 
So for example, if earnings per s hare have grown from $0.28 to $0.33 over a 4 
year period, the implied co mpound annual growth rate is: 
[4 √ (0.33/0.28) – 1] × 100% = 4.19% per year 
 
 Test your understanding 4 (O bjective test question) 
 ALB Co has the followi ng financial objectives: 
• to achieve an average earnings  growth of at least 6% per annum  
• to keep its gearing, measured as  [debt/(debt + equity)] by mar ket 
value, below 35% 
In the last three years, ALB Co' s operating profit has grown fr om $4.0 
million to $4.6 million , and its profit after tax has grown fro m $2.3 million 
to $2.9 million. 
ALB Co has 1 million $1 shares i n issue, trading at $1.88, and 
$1,000,000 of bonds, tradi ng at $106 per cent. 
Which of the objectives has ALB Co achieved? 
A  Both objectives 
B  Just the gearing objective C  Just the earnings growth objective D  Neither objective 
12 Sensitivity of the attainment  of financial objectives to cha nges 
in economic and business variables 
Changes to economic and business variables 
When economic variables (such a s inflation rates and interest r ates) and / or 
business variables (such as ma rgins and volumes) change, it is important to be 
able to assess the likely impact on the entity and its chances of achieving its 
financial objectives. 
For example a change in interest  rates in the economy might cau se an entity's 
financing costs to rise, and ther efore might make it more diffi cult for the entity to 
achieve a profitability target.

Chapter 1 
 31 
 More detail on interest rates and inflation 
 The effects of interest rate changes 
Changes in interest rates affe ct the economy in many ways. The 
following consequences are the ma in effects of an increase in i nterest 
rates: 
Spending falls  – expenditure by consumers, both individual and 
business, will be reduced. This occurs because the higher inter est rates 
raise the cost of credit and det er spending. If we take incomes  as fairly 
stable in the short term, higher i nterest payments on credit 
cards/mortgages, etc., leave less income for spending on consum er 
goods and services. This fall in  spending means less aggregate demand 
in the economy and thus unemployment results. 
Asset values fall  – the market value of financial assets will drop, 
because of the inverse relations hip (between bonds and the rate  of 
interest) explained earlier. Thi s, in turn, will reduce many pe ople’s wealth. 
It is likely that they will react to  maintain the value of thei r total wealth and 
so may save, thereby further r educing expenditure in the econom y. This 
phenomenon seems to fit the UK r ecession of the early 1990s whe n the 
house-price slump deepened the econom ic gloom. For many consume rs 
today a house, rather than bonds, is their main asset. 
Foreign funds are attracted into the country  – a rise in interest rates 
will encourage overseas financial speculators to deposit money in the 
country’s banking institutions because the rate of return has i ncreased 
relative to that in other countri es. Such funds could be made a vailable as 
loans to firms in that country  by the banking sector. 
The exchange rate rises  – the inflow of foreign funds raises demand for 
the domestic currency and so pus hes up the exchange rate. This has the 
benefit of lowering import prices and thereby bearing down on d omestic 
inflation. However, it makes ex ports more expensive and possibl y harder 
to sell. The longer-ter m effect on the balanc e of payments coul d be 
beneficial or harmful  depending on the elasticity of demand and  supply 
for traded goods. 
Inflation falls  – higher interest rates affect th e rate of inflation in three 
ways. First, less demand in the economy may encourage producers  to 
lower prices in order to sell. T his could be achieved by squeez ing profit 
margins and/or wage levels. Second , new borrowing is deferred b y the 
high interest rates and so dem and will fall. Third, the higher exchange 
rate will raise export prices and  thereby threaten sales which in turn 
pressurises producers to cut cos ts, particularly wages. If work ers are laid 
off then again total demand is r educed and inflation is likely to fall.

32 
 The effects of inflation 
Inflation is defined simply as ‘r ising prices’ and shows the co st of living in 
general terms. 
If the rate of inflation is low , then the effects may be benefi cial to an 
economy. Business people are en couraged by fairly stable prices  and the 
prospect of higher profits. Howev er, there is some argument abo ut 
whether getting inflation below 3 % to, say, zero, is worth the economic 
pain (of, say, higher unemploym ent). There is agreement, though , that 
inflation above 5% is harmful –  worse still if it is accelerati ng. The main 
arguments are that such inflation: 
Distorts consumer behaviour  – people may bring forward purchases 
because they fear higher prices la ter. This can cause hoarding and so 
destabilise markets, creat ing unnecessary shortages. 
Redistributes income – people on fixed inco mes or those lacking 
bargaining power will become rela tively worse off, as their pur chasing 
power falls. This is unfair. 
Affects wage bargainers  – trades unionists on behalf of labour may 
submit higher claims at times of  high inflation, particularly i f previously 
they had underestimated the future  rise in prices. If employers  accept 
such claims this may precipita te a wage–price spiral which exac erbates 
the inflation problem. 
Undermines business confidence  – wide fluctuations in the inflation 
rate make it difficult for entr epreneurs to predict the economi c future and 
accurately calculate prices and investment returns. This uncert ainty 
handicaps planning and production. 
Weakens the country’s competitive position  – if inflation in a country 
exceeds that in a competitor count ry, then it makes exports les s attractive 
(assuming unchanged exchange rates)  and imports more competitiv e. 
This could mean fewer sales of that country’s goods at home and  abroad 
and thus a bigger trade deficit. F or example the decline of Bri tain’s 
manufacturing industry can be par tly attributed to the growth o f cheap 
imports when they were experienci ng high inflation in the perio d 1978–
1983. 
Redistributes wealth  – if the rate of interest is be low the rate of inflation, 
then borrowers are gaining at th e expense of lenders. The real value of 
savings is being eroded. This we alth is being redistributed fro m savers to 
borrowers and from payables to rec eivables. As the government i s the 
largest borrower, via the nati onal debt, it gains most during i nflationary 
times.

Chapter 1 
 33 
Interest rate parity theory 
In economic theory, the impact of interest rates on the expecte d exchange rate 
is given by the interest  rate parity theory. 
Interest rate parity formula 
F0 = S 0 × ሺ1 + r varሻ
ሺ1 + r baseሻ 
where 
S0 = spot rate of exchange 
F0 = forward rate of exchange 
rvar and r base are the interest rates associat ed with the variable and base 
currencies respectively. For e xample, if an exchange rate is qu oted as  
GBP/USD 1.65 (i.e. G BP 1 = USD 1.65) then t he GBP is the base c urrency and 
the USD is the variable one. 
The interest rate parity theory shows that the forward rate of exchange can be 
found by adjusting the spot rat e of exchange to reflect the dif ferential in interest 
rates between the two countries. 
 
 Test your understanding 5 (O bjective test question) 
 BBL Co is based in country G, w here the functional currency is  the G$. 
Some of BBL Co's suppliers are based in the UK, and they invoic e BBL 
Co in British pounds (G BP). Therefore, the directors of BBL Co keep a 
close eye on the exchange rate between the G$ and the GBP, and they 
use the interest rate parity t heory to estimate the likely futu re exchange 
rates. 
The current spot rate is G$/GBP 1.88 (that is G$ 1 = GBP 1.88),  and the 
expected interest rates in the UK and country G respectively ar e 5% and 
8% over the next year. 
What is the forecast spot rate in one year's time using the int erest 
rate parity theory and assuming th at the current forward rate i s the 
best forecast of the future spot rate? 
A  G$/GBP 1.18 
B  G$/GBP 1.83 C  G$/GBP 1.93 D  G$/GBP 3.01

34 
 
 Test your understanding 6 (O bjective test question) 
 The financial director of JW Co i s attempting to estimate the likely 
exchange rate in 1 years’ time, s o that he can assess the likel y value of 
the entity's foreign currency income. 
JW Co is based in country C (f unctional currency C$) and it mak es some 
sales in the USA, denominated in U S dollars (USD). Sales in 1 y ear's 
time are expected to be USD 400,000. 
The spot rate of exchange is C$/US D 23.35 (that is C$ 1 = USD 2 3.35). 
Interest rates in the USA and co untry C are expected to be 2% a nd 6% 
respectively over the next year. 
What is the expected exchange rat e in 1 years’ t ime, using the 
interest rate parity theory, a nd what is the expected value of the 
USD sales when translated into C$? 
A  Exchange rate: C$/USD 24.27, v alue of sales: C$ 9.708 millio n 
B  Exchange rate: C$/USD 24. 27, value of sales: C$ 16,481 
C  Exchange rate: C$/USD 22.47, v alue of sales: C$ 8.988 millio n 
D  Exchange rate: C$/USD 22. 47, value of sales: C$ 17,802 
 
Interest rate parity and other sim ilar theories ar e covered in more detail in 
Chapter 9: ‘Currency risk management’. 
The impact on financial ratios of changes in interest rates, ex change rates 
and inflation 
A change in economic variables s uch as interest rates, exchange  rates and 
inflation can have an impact on an entity's ability to meet its  objectives. 
For example, a change in exchan ge rates could impact selling pr ices and hence 
profitability ratios, and could pr event an entity from achievin g an earnings 
If you are asked in the exam to  assess the likelihood of an ent ity achieving a 
given objective, you should revi se the financial statements to reflect the 
expected change and then recalcul ate the necessary ratios.

Chapter 1 
 35 
 Test your understanding 7 (O bjective test question) 
 Tillman Co is an unquoted manufac turing company based in count ry T, 
whose functional currency is the T$. 
Extracts from its most recent fi nancial statement s are shown be low: 
 T $  m  
 — —
– 
 — — – 
Tillman has T$ 8 million of long  term borrowings, on which it p aid interest 
of 10% last year, and it has 20 million T$ 1 shares in issue. 
Tillman Co expects its interes t rate to rise by two percentage points next 
year (to 12%). Also, a strengt hening of the currency in Tillman  Co's main 
export market will cause the T$ v alue of Tillman Co's gross pro fit to rise 
to T$ 25 million next year. 
What is the likely impact on Till man Co's earnings per share (E PS), 
assuming that all other factors remain the same next year? 
A  Increase by 20%  
B  Increase by 25% C  Increase by 115% D  Increase by 215% 
The impact on financial ratios of changes in margins and volume s 
A change in business variables suc h as margins and volumes of a ctivity can 
also have an impact on an entity' s ability to meet its objectiv es. 
For example, a fall in sales vol ume can impact profitability ra tios and could 
prevent an entity from achieving an earnings growth objective. 

36 
 Test your understanding 8 (O bjective test question) 
 MATT Co is a manufacturing co mpany based in country M, whose 
functional currency is the M$. 
 M $  m  
Long term liabilities (10% bonds) 8.0 
 — — – 
Capital  
Share capital (M$ 0.50 par) 10.0 Share premium  1.0 
Reserves 3.0 
 — —
– 
 14.0 
 — — – 
 M $  m  
Gross profit  20.0 
Less expenses (excluding  finance charges) (15.0) 
 — — – 
 — — – 
MATT Co expects its volume of s ales to increase by 5% next year , and 
its gross profit margin to reduc e by 4 percentage points (so fo r example if 
the margin were currently 40%, i t would reduce to 36% next year ). 
What is the likely impact on MA TT Co's earnings per share (EPS) , 
assuming that its capital struc ture, tax rate and other expense s stay 
constant? 
A  Increase by 5%  
B  Increase by 1% C  Decrease by 20%  D  Decrease by 76%

Chapter 1 
 37 
13 The use of published acco unts for ratio analysis 
When external stakeholders, suc h as potential investors and len ders, try to 
assess the performance of an ent ity, the most readily available  source of 
information is the published accounts of the entity. 
In trying to interpret the ratios  calculated from the published  accounts figures, it 
is important to understand the lim itations of the published fig ures. 
Limitations of published accounts  figures for ratio analysis 
• Published accounts are historic r ecords, not forward looking. However, in 
many countries there are additio nal local regulations which req uire or 
encourage companies to present addi tional information as part o f their 
published accounts. This may incl ude the directors' view of the  company's 
prospects, environmental data, m arket informati on, gender pay g aps and 
much more. This fits with the global drive towards integrated r eporting, 
which is discussed more in Chapter 2. 
• The statement of profit or loss is prepared using the accruals  concept, so it 
is difficult to relate the figur es to the entity's cash positio n. However the 
inclusion of the cash flow state ment in the published accounts helps to 
give an impression o f the cash position. 
• The published accounts have histor ically contained only financ ial 
information. In recent years ent ities have been encouraged to r eport on 
wider issues (such as environmen tal and social issues), so user s of the 
accounts are able to see a fulle r view of the entity's performa nce. 
These points are covered more  fully in the next chapter. 
14 End of chapter objective test questions 
 Test your understanding 9 (O bjective test question) 
 The share price of Woundale Co r ose from $2.00 to $2.30 last y ear. 
During the year, the company pai d out a dividend of $0.12 per s hare. 
What was the annual return to investors last year? 
A 15% 
B 21% C 30% D 42%

38 
 Test your understanding 10 (O bjective test question) 
 Q Co is an entity that was se t up by the government of Country  Q to 
produce electricity for the country's citizens. 
Five years ago it was privatis ed as the government of Country Q  opened 
up the energy market to competit ion. The shares of Q co are now  owned 
by both private inve stors and institutions , and are traded on C ountry Q's 
What kind of entity is Q Co? 
A  Public sector, for-profit entity 
B  Public sector, not -for-profit entity 
C  Private sector, for-profit entity D  Private sector, not-for-profit entity 
 
 Test your understanding 11 (O bjective test question) 
 Value for money is an importan t objective for not-for-profit o rganisations. 
Which action is LEAST consiste nt with increasing value for mone y? 
A  Using a cheaper source of goods  without decreasing the quali ty of 
not-for-profit organisation services 
B  Searching for ways to diver sify the finances of the not-for- profit 
C  Decreasing waste in the provis ion of a service by the not-fo r-profit 
D  Focusing on meeting the objec tives of the not-for-profit org anisation 
 
 Test your understanding 12 (O bjective test question) 
 Blunderbuss Co is a listed com pany with 1 milli on $1 shares in  issue and 
long term bank borrowings of $5 million. The bank interest rate  in the 
most recent year was 8%, but thi s is expected to change to 10% for the 
whole of next year. 
The company made an operating pr ofit of $1.84 million last year . 
What will be the change in the i nterest cover of Blunderbuss Co  
next year, on the assumption that  operating profits will stay 
constant? 
A  25% increase  
B  20% decrease  C  25% decrease  D  20% increase

Chapter 1 
 39 
 Test your understanding 13 (O bjective test question) 
 Angela Co is a listed company. 
It has 1 million $0.25 par value or dinary shares in issue, and $100,000 
worth of $100 par value bonds. 
The shares were originally issue d at a premium of $0.05 per sha re, and 
the bonds were issued at a 10% d iscount to par value. The share s and 
the bonds are trading at $1. 22 and $102 respectively. 
What is the gearing ratio of Ange la Co, calculated as [debt / ( debt + 
equity)] and using market values? 
A 7.7% 
B 8.4% C 23.1% D 28.6% 
 
 Test your understanding 14 (O bjective test question) 
 Your manager has asked you to com pute the Return on Capital 
Employed for your company. 
Which of the following profit f igures would you use in the 
calculation? 
A  Gross profit 
B  Net profit C  Operating profit D  EBITDA 
 
 Test your understanding 15 (O bjective test question) 
 Shepley High School had a problem with hi gh levels of pupil ab senteeism 
in the last academic year, so t he senior management team decide d to 
implement a new rewards progra mme in an attempt to reduce the 
number of pupils missing classes. 
The plan was to reward all pupils  with a sticker on a chart for  every day 
that they attended all their cla sses. Then, at the end of each week, all 
pupils with five stickers on t he chart (i.e. t hose with a perfe ct attendance 
record) were entered into a pri ze draw with a tablet computer a s the prize 
for the winner. 
The end of the academic year is now  approaching, and the value for 
money (VFM) of the programme is being assessed.

40 
 Key observations: 
• The cost of the programme has  been lower than budgeted, becaus e 
the school managed to get an unexpected bulk discount on 
purchases of the prize tablet computers. 
• The level of absenteei sm has remained almost constant compared  
with the previous year. 
• A local newspaper has run a negative campaign about the 
programme, accusing the school o f wasting money and 'bribing' 
pupils to attend classes. The head teacher has defended the 
programme, but has admitted tha t other schools in the area mana ge 
to achieve lower levels of abs enteeism despite not running such  
expensive rewards programmes. 
Which of the following is the best  summary of the results of th is 
Value for Money review? 
A Economy, effectiveness and efficiency have all been achieved 
B Economy and efficiency have been achieved, but not effectiven ess 
C Economy and effectiveness have been achieved, but not efficie ncy  
D Only economy has been achieved 
 
 Test your understanding 16 (O bjective test question) 
 The most recent state ment of financial position of Johnson Co is as 
follows: 
Assets $000 
Non-current assets 23,600 Current assets 8,400 
 
––––– 
 32,000 
 ––––– 
Equity and liabilities  
Capital and reserves  
$1 Ordinary shares 8,000 
Retained earnings  11,200 
 ––––– 
 19,200 
6% Unsecured bond 8,000 
Current liabilities  4,800 
 ––––– 
 32,000 
 –––––

Chapter 1 
 41 
 Johnson Co made an operating prof it of $3.0 million and a net p rofit of 
$2.5 million in the year. 
What is the return on equity of Johnson Co? 
A 13.0% 
B 15.6% C 31.3% D 37.5% 
 
 Test your understanding 17 (O bjective test question) 
 The P/E ratios of AA Co and BB Co  are 7.8 and 9.8 respectively . 
Which TWO of the following stateme nts are definitely correct ba sed 
on this information? 
A  AA Co's share price is lower than BB Co's 
B  The market perception of BB Co is better than that of AA Co 
C  AA Co is an unquoted company and BB Co is a quoted company 
D  The risk associated with BB Co must be higher than the risk 
associated with AA Co 
E  BB Co's earnings yield  is lower than AA Co's 
 
 Test your understanding 18 (O bjective test question) 
 Josh Co is an all equity fi nanced company. It made sales in th e most 
recent accounting period of $10. 5 million, and achieved an oper ating 
profit margin of 12%. 
The directors expect sales to i ncrease by 10% next year, and th e 
operating profit margin to fall  to 10% in difficult trading con ditions. 
What is the likely change in ope rating profit, assuming all els e 
remains the same? 
A  No change 
B  $0.105 million decrease  C  $0.100 million increase  D  $1.050 million increase

42 
 Test your understanding 19 (O bjective test question) 
 Ghoo Co is a company that has 50, 000 shares in issue (nominal value 
$0.50 per share). The value of its  capital employed in the most  recent 
statement of financial posit ion was $0.35 million. 
Statement of profit or loss for the most recent accounting peri od 
 $000 
Revenue 285.1 
Cost of sales  (120.9) 
 ––––– 
Gross profit  164.2 
Operating expenses  (66.9) 
 ––––– 
Operating profit  97.3 
Finance costs  (10.0) 
 ––––– 
Profit before tax  87.3 
Taxation (21.6) 
 ––––– 
Profit after tax 65.7 
A trainee accountant has computed t he return on capital employe d 
(ROCE) and the earnings per share (EPS) of Ghoo Co. 
Select the TWO numbers that are incorrect in the workings. 
ROCE = $87,300
$350,000 × 100 
EPS = $65,700
$25,000 
 
 Test your understanding 20 (O bjective test question) 
 An investor in Hook Co has calcu lated that the company's divid end 
payout ratio is 25% and that the current dividend yield is 4%. 
What is the P/E ratio of Hook Co? 
A 100 
B 16 C 6.25 D 29

Chapter 1 
 43 
 Test your understanding 21 (O bjective test question) 
 Cherry Co has the following acco unting ratios, based on its mo st recent 
financial statements: 
Gross profit margin = 18.6%  Operating profi t margin = 10.4%  
Asset turnover = 1.5 Interest cover = 4.3 
What is the return on capit al employed of Cherry Co? 
A  It is impossible to tell from such limited information 
B 15.6% C 21.8% D 27.9% 
15 End of chapter c ase style questions 
 Test your understanding 22 (Case style question) 
 (a) You are a newly appointed Fi nance Manager of an Educationa l 
Institution that is mainly gov ernment-funded, having moved from  a 
similar post in a service entity in the private sector. The obj ective, or 
mission statement, of this Instit ution is shown in its publicit y material 
as: 
‘To achieve recognized standards o f excellence in the provision  of 
teaching and research.’ 
The only financial performance measure evaluated by the 
government is that the Instituti on has to remain within cash li mits. 
The cash allocation each year  is determined by a range of non-
financial measures suc h as the number of re search publications the 
Institution’s staff have achiev ed and official ratings for teac hing 
quality. 
However, almost 20% of total ca sh generated by the Institution is 
now from the provision of course s and seminars to private secto r 
entities, using either its own o r its customers’ facilities. Th ese 
customers are largely unconcer ned about research ratings and 
teaching quality as t hey relate more to academic awards such as  
degrees. 
The Head of the Institution aims  to increase the percentage of 
income coming from the private sector to 50% over the next 5 ye ars. 
She has asked you to advise on how the management team can 
evaluate progress towards achiev ing this aim as well as meeting  the 
objective set by the governm ent for the activities it funds.

44 
Required: 
Discuss the main issues that an in stitution such as this has to  
consider when setting objectives.  Advise on whether a financial  
objective, or objectives, could or should be determined; and wh ether 
such objective(s) should be made public. 
(b) The following is a list o f financial and non-financial perf ormance 
measures that were in use in your  previous profit-making entity : 
Financial Non-financial 
Value added  Customer satisfaction 
Profitability  Competitive position Return on investment Market share 
Required: 
Choose two of each type of mea sure, explain their purpose and 
advise on how they could be used b y the Educational Institution  
over the next 5 years to assess how  it is meeting the Head of t he 
Institution’s aims. 
Note:  A report format is not required in answering this question. 
 
 Test your understanding 23 (Case style question) 
 The directors of ABC, a conglom erate listed on a stock exchang e, are 
appraising one of their wholly-ow ned subsidiaries, XYZ, with a view to 
disinvestment. The subsidiary is primarily involved in the manu facture 
and distribution of car care products. 
Financial data for XYZ are s hown in the table below. 
Required: 
(a) Calculate three ratios for  each of the two years 20X1 and 2 0X2 
which you consider to be appropr iate for the evaluation of the 
subsidiary's gearing and profitability over  the two-year period . Your 
selection of ratios should ensur e measurement of the company's 
performance in both areas. 
 (30 minutes)

Chapter 1 
 45 
 (b) Prepare a report for the manage ment of ABC. This report sho uld 
discuss the following: 
(i)  the performance of the subsidiary during the past two year s, 
using the ratios calculated in  part (a) to guide your comments;  
(ii) the limitations of the type of historical analysis you hav e just 
provided; 
(iii) suggestions for the parent c ompany's future course of act ion in 
respect of the subsidiary, incl uding comment on an appropriate 
procedure for valuing the company; 
(iv) other, non-financial information which would be useful to the 
directors of ABC before  they make any decision. 
Summary accounts for XYZ 
 20X2 20X1 
 £000 £000 Non-current assets (plant & equip) 2,650 2,255 Other long-term assets (Note 1)  750 675 
Cash and marketable securities 195 162 
Receivables 765 476 
Inventory and work-in-progress 1,250 893 Other current assets 150 91 
 ——— ——— 
Total assets 5,760 4,552 
Shareholders' funds 2,520 1,726 
Long-term debt 2,250 1,976 Other long-term liabilities (Note 2)  275 206 
Current liabilities 715 644 
 ——— ——— 
Total equity & liabi lities 5,760 4,552

46 
 Extracts from the statement of pr ofit or loss for the years end ed 
31 December 
 20X2 20X1 
 $000 $000 Turnover 6,575 5,918 Cost of goods sold 5,918 5,444 
Other expenses 658 592 
Other income 23 20 
 ——— ——— 
Earnings before finance charges and tax 22 (98) 
Finance Charges 395 339 
Tax on ordinary activities  (Note 3)  (120) (149) 
 ——— ——— 
Net loss (253) (288) 
Notes: 
1 Other long-term assets are mot or vehicles and office equipmen t.  
2 Other long-term liabilities are finance leases. 
3 The tax shown in the 20X1 pr ofit and loss extract will be rec overed 
in 20X2. 
Other financial information 
 $000 
Depreciation 20X2 175 Net realisable value of inventory 1,091 
Net realisable value of plant and equipment 3,907 
Inventory and work-in-pr ogress at 1 January 20X1 850 
Receivables at 1 January 20X1 435

Chapter 1 
 47 
 (a) Asset turnover = 100m/20m  = 5.0 times 
 Operating profit margin  = 5m/100m × 100  = 5% 
  Equity finance Debt finance 
(b) Return on capital employed  = 5m/20m × 100 = 5m/20m × 100 
  = 25% = 25% 
Working: 
 GBPm GBPm 
Operating profit 5.0 5.0 Interest 0.0 (1.0)  —— —— 
 5.0 4.0 
Tax (@30%) (1.5) (1.2)  —— —— 
Net profit 3.5 2.8 
Return on equity = 3.5m/20m  × 100 = 2.8m/10m × 100 
  = 17.5% = 28% 
The financial performance of the two funding options is exactly  the 
same for ROCE. This should not be a surprise given that ROCE is  
an indication of performance before financing, or underlying 
(c) When considering the ROE we  see that the geared option achi eves 
a higher return than the equity option. This is because the deb t 
(10%) is costing less than the re turn on capital (25%). The exc ess 
return on that part funded by debt passes to the shareholder 
enhancing their return. 
The only differences between ROCE and ROE wil l be due to 
taxation and gearing.

48 
 ( a )  Capital gearing ratio 
Debt = 5m + 8m = USD13m Equity = 10m + 4m + 1.5m + 1.5m = USD17m Either = 13m/17m × 100 = 76.5% Or = 13m/(13m + 17m) × 100 = 43.3% Interest cover = 4m/1m = 4 times 
(b) The capital gearing figure l ooks to be a high percentage, b ut without 
further analysis of trends and in dustry average figures, it is difficult 
to conclude whether the gearing is too high or whether it is at  an 
acceptable level based on this value alone. 
The interest cover measure atte mpts to equate the earning of pr ofits 
with ability to pay interest as it falls due. There will be som e 
correlation between the two; how ever, it is very risky to equat e 
profits earned to cash flow. 
However, a value of 4 indicates  that the entity was easily able  to 
meet its interest obligations i n the most recent accounting per iod, 
and that the interest payments ar e not particularly vulnerable to a 
drop in profits. 
 
EPS = Profit distributable to ordinary shareholders
= 600,000/5m = USD 0.12 
DPS (dividend per share) = Ordinary dividend
= 150,000/5m = USD 0.03 
Share price (ex-dividend) =  0.83 – 0.03 = USD 0.80 
(a) Price/earnings rat io = 0.80/0.12 = 6.7 
(b) Dividend payout rat e = 0.03/0.12 = 25%  
(c) Dividend yield = 0.03/0.80 = 3.75% 
(d) Dividend cover = 0.12/0.03 = 4

Chapter 1 
 49 
 The answer is (C).  
Earnings growth: 
Focus on earnings, so profit aft er tax. From $2.3 million to $2 .9 million 
amounts to approximately 26% gro wth in total (=  [2.9/2.3] – 1).  
Over three years, the annual grow th is found by taking [3√ 1.26 ] – 1 = 
8%, so above the target of 6 % – objective achieved. 
Gearing: 
Debt value is $1 million ×  (106/100) = $1.06 million 
Equity value is 1 millio n × $1.88 = $1.88 million 
So [debt/(debt + equity )] = [1.06/(1.06 + 1. 88)] = 36%, so abov e the target 
of 35% – objective not achieved. 
 
 The answer is (B). 
The G$ is the base currency and t he GBP is the variable, so the  forward 
rate is 1.88 × (1. 05/1.08) = 1.83 
 
 The answer is (D). 
23.35 × 1.02
1.06 = 22.47 
so 400,000 USD equates to  (400,000/22.47 = ) C$17,802 
 
 The answer is (C). 
Earnings per share is (profi t after tax (PAT)/no. of shares) 
Current situation 
Current profit before tax = T$ 5 .0 m (operating pr ofit) – T$ 0. 8 m (interest) 
= T$ 4.2 m 
Therefore PAT = 70% × T $ 4.2 m = T$ 2.94 m. 
There are 20 million s hares in issue, henc e EPS = (T$ 2.94 m/20  m)  
= T$ 0.147.

50 
 Next year's forecast 
Gross profit will be T$  25m and interest will be (12% × T$ 8 m)   
= T$ 0.96 m. 
Profit before tax = T$ 25 m – T$  15 m – T$ 0.96 m (interest) = T$ 9.04 m 
Therefore PAT = 70% × T$ 9.04 m = T$ 6.33 m. Hence EPS  
= (T$ 6.33 m/20 m) = T$ 0.3165 
This EPS of T$ 0.3165 is 215% of  the previous year's T$ 0.147, so this is 
an increase of 115%. 
 
Current profit before tax = M$ 5 .0 m (operating pr ofit) – M$ 0. 8 m 
(interest) = M$ 4.2 m 
Therefore PAT = 70% × M $ 4.2 m = M$ 2.94 m. 
There are 20 million s hares in issue, hence EPS = (M$ 2.94 m/20  m)  
= M$ 0.147. 
Next year's forecast 
Revenue will be M$ 100 m ×  1.05 = M$ 105 million. 
Current gross profit margin is  20% (20/100) so next year's marg in will be 
16%. 
Profit before tax = (16% × M$ 105 m) – M$ 15 m – M$ 0.8 m (inte rest)  
= M$ 1.0 m 
Therefore PAT = 70% × M$ 1. 0 m = M$ 0.70 m. Hence EPS  
= (M$ 0.70 m/20 m) = M$ 0.035 
The EPS of M$ 0.035 is only 24% o f the previous year's M$ 0.147 , so this 
is a decrease of 76%. 
 
The annual return to investors is: 
Annual return to investors = (P1 – P0) + Dividend
P0 
where P 0 is $2.00, P 1 is $2.30 and Divid end is $0.12.

Chapter 1 
 51 
When the entity was privatis ed, it changed from being a public sector to a 
private sector entity. The fa ct that its shares are traded on t he stock 
market and that it operates in a competitive market place sugge sts that it 
is a for-profit entity. 
 
VFM is about achieving economy , effectiveness and efficiency. 
(A) achieves economy, (C) achie ves efficiency and (D) achieves 
 
Interest cover is (operati ng profit/interest payable) 
Last year = $1.84m/($5m × 8%) = 4.60 Next year = $1.84m/( $5m × 10%) = 3.68 
i.e. a decrease of 20% 
 
 The answer is (A). 
Market value of debt is $100,000 × (102/100 ) = $102,000 
Market value of equity =  1 million × $1. 22 = $1,220,000 
Therefore, gearing is [ 102/(102 + 1,220)] = 7.7% 
 
 The answer is (C).

52 
Economy – achieved since the cos t of the programme was below bu dget. 
Effectiveness – not achieved si nce there has been no improvemen t in the 
level of absenteeism. 
Efficiency – not achieved. Other s chools manage to get better r esults at a 
lower cost, so this programme h as not been an efficient use of resources. 
 
Return on equity uses the net p rofit figure. ($2.5 million) and  the equity 
value is equal to the value of t he ordinary share capital plus reserves 
($19.2 million). 
 
 The answer is (B) and (E). 
A high P/E ratio shows that inv estors have confidence in the co mpany. 
Earnings yield is the reciprocal  of P/E ratio, so a high P/E wi ll correspond 
to a low earnings yield. 
 
Last year's operating profit was  $10.5 million × 12% = $1.260 m illion 
Next year's is expected to be ($10.5 million × 1.10) × 10%  
= $1.155 million 
i.e. a decrease of $0.105 million

Chapter 1 
 53 
 The workings have been corrected  below. The bold figures are t he ones 
that were incorrect. 
ROCE = $97,300
$50,000 
Explanation: 
ROCE uses operating pr ofit, not profit after interest. EPS uses  the 
number of shares, not  the value of them. 
 
Dividend pay-out ratio is (divi dend per share/earnings per shar e), 
dividend yield is (di vidend per share/share price) and P/E rati o is (share 
price/earnings per share). 
Therefore, P/E ratio =  (dividend pay-out rat io/dividend yield).   
Alternatively, make up some num bers to help you manipulate the 
formulae. 
For example, if dividend pay-ou t ratio is 25%, assume that divi dend per 
share is $0.25 and EPS is $1. T hen, if dividend yield is 4%, th e share 
price must be $6.25 si nce we have already assumed that dividend  per 
share is $0.25. 
Hence P/E ratio = Share price/EPS = $6.25/$1 = 6.25 
 
ROCE can be found by multiplying  asset turnover and operating p rofit 
margin.

54 
 (a) The main issues to consider are: 
–  Who are the main stakeholders? –  Where is the financing coming  from, and in what proportions?  
–  Are there other, higher level objectives that will supersede  
those set by the Institution, fo r example political aims/goals by 
the government? 
–  Does the objective need to be measurable? –  How can one objective meet a ll the competing aims of the 
stakeholders? 
–  Will information on the Educat ional Institution’s performanc e 
be publicly available? 
Setting a financial objective has the main advantage of being 
measurable. If it is made public , it can also be compared with other, 
similar, institutions if they a lso set and make public their ob jective 
and their subsequent performance . One objective will probably b e 
insufficient, especially as the In stitution has two main market s with 
very different require ments, costs and revenue structures. 
The disadvantages of setting and ma king public an organisation’ s 
objectives are: 
–  The Educational Instituti on may not be allowed freedom to 
choose its own policies, for example on charging fees or 
selection of state-funded students. 
–  Political decisions may no t affect all publicly funded insti tutions 
in the same way or to the same extent. 
–  Cost allocation between state -funded business and private- 
sector business may be difficu lt and politically sensitive. 
(b) Examiner’s Note 
The question asks for comments on  two performance indicators 
from each list, four criteria in all. In this answer comments a re 
provided for all six criteria. C andidates may only receive mark s for a 
maximum of two indicators from each list (i.e. no compensation 
between the lists.) 
Traditionally, financia l measures hav e been the fo cus of manage ment 
attention. Increasingly companies  are using non-fi nancial indic ators 
to assess success across a range of criteria, whi ch need to be 
chosen to help a company meet its objectives. However, an indic ator, 
which is appropriate for one g roup of stakeholders in an organi sation, 
may not be suitable fo r another group.

Chapter 1 
 55 
Also, indicators that are suitabl e for short-term performance 
assessment may be unsuitable, o r not optimum, for the long term . 
The objective, or mission statem ent, of this institution is ent irely 
qualitative (and subjective) and makes no concession to financi al 
considerations or constraints. 
sales value less the cost of purchased materials and services. It 
represents the value added to a c ompany’s products by its own 
efforts. A problem here is com parability with other industries or even 
other companies in the same industry. 
It is less common in the public sector, although the situation is 
changing and many public sector organisations are now publishin g 
information on their own value a dded, for example, in the healt h 
service. 
In respect of teaching, value added could be measured by the 
percentage of students who leave with a qualification. In post-
graduate or executive education , it could be the increase in sa lary or 
improved jobs/job prospects obt ained by graduates on obtaining 
their qualification. This may no t precisely measure the qualita tive 
aspects of the Institution’s objec tives, but could provide a cl ose 
In respect of research, the measur e is much easier to apply and  
interpret. Research output can be measured by the number of sta ff 
publications in various  categories of journal. 
Profitability may be defined as t he rate at which profits are 
generated. It is often expressed as profit per unit of input (e .g. 
investment). However, profitab ility limits an organisation’s fo cus to 
one output measure – profit. It ove rlooks quality and this limi tation 
needs to be kept in mind when usi ng it as a measure of success.  
Profitability as a measure of dec ision-making has been criticis ed 
because 
– it fails to provide a systematic  explanation as to why one 
business sector has more favo urable prospects than another; 
– it does not provide enough in sight into the dynamics and 
balance of an enterprise’s indi vidual business units and the 
balance between them; 
– it is remote from the actions  that actually create value and 
cannot therefore be managed directly  in all but the smallest of  
organisations; 
– the input to the measure may vary substantially between 

56 
However, it is a well-known and accepted measure that, once the  
consistent across organisations and time periods it also provid es a 
useful comparative measure. Alt hough the concept of profit in i ts 
true sense is absent from most of  the public sector, profitabil ity may 
be used to relate inputs to output s if a different measure of o utput is 
used, for example surplus after all costs to capital investment . 
In the case of the educational i nstitution, a problem may be 
determining the value of the init ial investment, which may have  been 
purchased by the government m any years ago and appear to have 
cost nothing. A notional value co uld be attached to these asset s for 
the purpose. Profits would be fees  and other income less costs of 
salaries and other expenses. Not ional rents or depreciation wou ld 
also have to be estimated. 
This measure would have little re levance to the Institution’s o nly 
stated objective and it s calculation is fr aught with uncertaint ies and 
unknowns. This would be a measure  that the organisation might 
wish to introduce some time in  the future, but first it needs t o 
estimate the value of its assets  and the true nature of its cos ts. 
Return on investment (ROI) 
This is an accounting measure, w hich is calculated by dividing 
annual profits by the average net book value of assets. It is, 
therefore, subject to the distort ions inevitable when profit ra ther than 
cash flows are used to determine performance. Distorting factor s for 
interpretation and comparison pur poses include depreciation pol icy, 
stock revaluations, write off o f intangibles such as goodwill. A further 
defect is that ROI ignores the  time value of money, although th is 
may be of less concern when infl ation rates, and therefore mone y 
discount rates, are very low. 
Return on assets may not adequat ely reflect how efficiently ass ets 
were utilised; in a commercial c ontext taking account of profit s, but 
not the assets used in their making, for whatever reason, would  
overstate a company’s performa nce. In the public sector, the 
concept of profit is absent, but it is still not unrealistic to  expect 
organisations to use donated asse ts with maximum efficiency. If  
depreciation on such assets were  to be charged against income, 
this would depress the amount of s urplus income over expenditur e. 
Other points which may affect i nterpretation of ROI in any publ ic 
sector organisation, including educational institutions are: di fficulty 
in determining value; assets may  have no re-sale value; they ar e, or 
were originally intended, for use by the community at large and  any 
charge for depreciation may hav e the effect of ‘double taxation ’ on 
the taxpayer.

Chapter 1 
 57 
 As with profitability , the relevance of this measure at the pre sent 
time and to the stated objective  is limited. First of all, it n eeds to 
This measure can be linked to market share. If customers are no t 
satisfied, they will take their business elsewhere and the comp any 
will lose market share or go into  liquidation. Measuring custom er 
satisfaction is difficult to do formally, as the inputs and out puts are 
not readily defined or measurable . Surveys and questionnaires m ay 
be used, but these methods have k nown flaws, mainly as a result  of 
respondent bias. It can, of course, be measured indirectly by t he 
level of sales and incr ease in market share. 
In the United Kingdom, t he Citizens’ Charter was designed to he lp 
‘customers’ of public services gain satisfaction and redress if  they 
do not, for example refunds on la te trains. There are many crit eria 
for determining customer satisfact ion in an educational institu tion, if 
we assume the ‘customer’ is the student. For example: 
– Evaluations by students at t he end of modules or entire 
programmes. There are problem s of bias with this type of 
measure, but this is true of all surveys. 
– Quality audits by government agencies a nd other regulatory 
bodies. 
– Internal peer reviews. 
However, the customer could also  be the employer or sponsor of 
the graduating student. Surveys of s atisfaction from this type of 
customer are less likely to be biased. 
This type of measure will already  be in place and possibly to a  
greater extent than in many private -sector institutions. If the  
Institution wishes to increase its proportion of private fundin g, then it 
needs to focus on developing its su rveys of employers and likel y 
providers of research funding. 
The performance of a business n eeds to be compared with that of  
its competitors to establish a strategic perspective. A number of 
models and frameworks have been suggested by organisational 
theorists as to how a competitiv e position may be determined an d 
improved. A manager needing to mak e decisions must know by 
whom, by how much and why he is gaining ground or being beaten 
by competitors.

58 
 Conventional measures such as a ccounting data are useful, but n o 
one measure is sufficient. Instead , an array of measures is nee ded 
to establish competitive positi on. The most difficult problem t o 
overcome in using competitive pos ition as a success factor is i n 
collecting and acquiring data from competitors. 
The public sector is increasingl y in competition with other pro viders 
of a similar service, both in t he private and public sector. Fo r 
example, universities must now  compete for government funding o n 
the basis of research output as well as meeting a range of targ ets 
for student recruitment. Their advantage is that it is easier t o gain 
access to data from such compet itors than is possible in the pr ivate 
sector, as all this information is ultimately in the public dom ain. Less 
publicly available is data on t he amount of privately-funded te aching 
obtained by public-sector educ ational institutions. 
This measure will also be alr eady extensively used by the 
Institution, certainly in res pect of its competitive position f or students 
worldwide. Where it might need  to develop its measures and 
improve its measurem ent data is in respect of privately-funded or 
sponsored students or courses. 
Market share, a performance indica tor that could conceivably be  
included under the financial hea ding as well as non-financial, is often 
seen as an objective for a com pany in its own right. However, i t must 
be judged in the context of oth er measures such as profitabilit y and 
shareholder value. Mar ket share, unlike many  other measures, ca n 
take quality into acc ount as, it must be assu med, if customers do not 
get the quality they want or expe ct the company will lose marke t 
share. 
Gaining market share must be seen as a long-term goal of 
companies to ensure outlets for their products and services and  to 
minimise competition. However , market share can only be acquire d 
within limits if a monopoly si tuation is to be avoided. 
It is a measure that is becoming increasingly rel evant to the p ublic 
sector, for exampl e universities and the health service. In edu cational 
institutions, the market share within the home country can be 
measured quite easily  by reference to stu dent numbers, in total  and 
by programme/cou rse. It is more difficul t to compare market sha re 
worldwide. However, th is measure of market share is on volume n ot 
value. Some institutions have high value programmes, such as 
MBAs, that distort this s imple volume measure. 
This institution needs to determi ne its mix of programmes and 
courses and set targets aimed at s pecific markets, for example to 
achieve x per cent of the ma rket share of home-based MBA 
students by 2xxx. Such a target b y itself will not be a guide t o the 
quality of teaching and would nee d to be combined with other 
measures, such as customer satisfaction.

Chapter 1 
 59 
 Key answer tips 
Part (a): There are many other a lternative ratios which could h ave been 
calculated (other than those bel ow), as long as between them th e five 
ratios cover the efficiency, pro fitability and liquidity of the  company. It 
would also be possible to calcula te different figures for each ratio, 
depending on whether the 'other financial information' was used , whether 
year-end or average statement o f financial position figures wer e used, 
etc. What is important is that y ou show clearly how you have de rived 
each of your chosen ratios, and that you do not overrun the tim e allowed 
for this part of the question. 
(a) The following ratios can be calculated from the figures in the 
summary accounts: 
Profitability ratios 
  20X2 20X1 
 Opening profit 22 (98) Return on Capital Employed = –––––––––––––– ––––––––––– ––––––– –––– 
 Capital employed 2,520 + 2,250 1,726 + 1,976 
  = 0.0046 = (0.0265) 
    Operating profit margin O perating profit 22 (98) 
 ––––––––––––– ––––– ––––– 
 Sales 6,575 5,918 
  = 0.33% = (1.66%) 
Gearing ratios 
At 31 Dec 20X2, gearing = 2,250
2,250 + 2,520 = 47% 
At 31 Dec 20X1, gearing = 1,976
1,726 + 1,976 = 53% 
(b) 
Report 
To:  The Management of ABC 
From:   The Management Accountant 
Date:   X-X-20XX 
Subject:  Proposed disinvestment of XYZ 
This report has been prepared to appraise the financial perform ance of 
our wholly-owned subsidiary XYZ , with a view to recommending wh ether 
the company should be divested. The analysis has used XYZ's sum mary 
accounts for 20X1 and 20X2.

60 
 Analysis of recent performance 
Gearing has fallen over the peri od as a result of the new equit y injection 
exceeding the increase in net borrowings. 
The company was struggling to pay its finance charge in 20X1 ou t of 
available profits; although the profitability situation has imp roved slightly 
in 20X2, finance charges payable still exceeds available profit s so that a 
net loss is reported. 
Limitations of historical analysis 
The analysis above has been carri ed out on the summary accounts  of 
XYZ for 20X1 and 20X2 which wer e presumably drawn up under the 
historical cost convention. In a  period of changing prices such  accounts 
can become misleading, for instanc e with the depreciation charg e being 
calculated on the out-o f-date historical cost of the fixed asse ts. Capital 
gearing ratios such as calcula ted above do not give the true pi cture; it 
would be more helpful if the summ ary accounts could be restated  under a 
current cost basis. 
There is the further conflict tha t a decision is to be made abo ut the future 
based on an analysis of the past. T he summary accounts give a h istorical 
record of what has happened over the last two years, but give n o 
evidence of the company's likely future prospects. The decision  as to 
whether XYZ should be divested s hould be taken on the basis of future 
opportunities and threats to whi ch the company will be exposed.  
A final weakness of analysis fr om accounts is that conventional  
accounting statements do not rec ognise a number of important as sets 
that a company might have – a tr ained workforce, a new product about to 
be launched on to the market whi ch has been fully researched, o ther 
sorts of inherent goodwill. It is impossible to look at the ful l picture of a 
company's situation while thes e assets have been ignored.

Chapter 1 
 61 
 Future course of action 
Given that ABC has subscribed an extra $1m of share capital of XYZ 
within the past 12 months, it seem s premature to be considering  divesting 
the company. It is perhaps more reasonable to allow the newly i nvested 
funds to settle down and reap the benefits for which, presumabl y, the 
investment was made. However, if ABC insists on divestment, the re is a 
choice between closing the busi ness (and selling the assets pie cemeal) 
or selling the business as a goi ng concern. If the assets are t o be sold 
piecemeal, their relevant values  are their net realisable value s, e.g. 
inventory $1.091m and plant and equipment $3.907m. An aggregate  total 
of the net assets valued at net r ealisable value would be the m inimum 
acceptable offer. 
In the more likely situation o f selling the business as a going  concern, the 
value of the business forgone i f sold would be the aggregate of  the 
forecast cash flows arising to  ABC from XYZ, discounted at ABC' s cost of 
capital. Such a computation r equires many estimates to be made,  
including future growth of XYZ's  business and of the car care p roducts 
business sector as a whole. It m ay only be possible to identify  a range of 
possible values, but even if it c ontains a degree of estimation  the 
exercise will still be valuable. 
Other valuable non-financial information 
Several valuable items of non- financial information have alread y been 
identified above which would be useful to the directors of ABC before 
they make any decision: 
(i)  the financial results of XYZ  on a current cost basis, i.e.  after the 
effects of price changes  have been eliminated; 
(ii) whether the company has signi ficant intangible assets not currently 
recognised in the accounts; 
(iii) the future prospects for t he company and its place in its  business 
sector if it is retained within the ABC group; 
(iv) whether a prospective pur chaser of the company has already  been 
identified; 
(v) the effect on the morale o f the remaining workforce if the company 
is closed or sold. 
Please let me know if I can be of any further assistance. 
Signed: The management accountant

63 
Non-financial objectives 
financial objectives (c) Advise on non-financial 
• Enhancing the value of other  non-financial capitals (human 
capital, intellectual capital and social and relational capital ) 
• United Nations Sustai nability Development Goals 
  
  Chapter 
2

64 
 
provide a full picture of how the entity is performing. 
to other aspects of an entity's performance, such as: 
• its future prospects; 
their annual reports beyond just th e financial statements since  non- financial 
information can also be impor tant to users' decisions.

Chapter 2 
 65 
The important additional non-fi nancial information can be repor ted in a number 
of ways. 
For example, the Global  Reporting Initiative ( GRI) has produced  guidelines that 
propose additional disclosures in addition to the standard disc losures required 
in the financial statements. In particular, the GRI guidelines suggest that entities 
should disclose economic, environmental and social performance indicators. 
Alternatively, the Internationa l Integrated Repor ting Council ( IIRC) has 
produced a revolutionary framewor k known as the Integrated Repo rting 
framework (<IR> framework). T he <IR> approach proposes a fundam ental 
change to the way that entities are managed and report to stake holders. 
This chapter first looks at the limitations of financial statem ents as a basis for 
performance appraisal. It then ex plains the GRI guidelines and the concept of 
Integrated Reporting (<IR>). 
3 Limitations of financial state ments in reflecting the value a nd 
stewardship of the non-financial capital base 
Capitalism relies on the effici ent allocation of capital to del iver returns to 
investors over the short, medium  and long term. It is the job o f companies to 
manage the financial capital tha t investors provide and also to  create and 
preserve the value generated fr om other forms of non-financial capital such as 
people, trademarks/copyright s and natural resources. 
The western model of capitali sm has been ques tioned following t he onset of the 
banking crisis in 2007 because of its apparent dependence on sh ort term 
financial factors over other fo rms of capital and longer time s cales. 
Financial statements have traditi onally only reported the finan cial capital of 
Unfortunately, this type of corporate reporting no longer refle cts the needs of 
users of accounting informa tion in the 21st century. 
Link to Integrated Reporting (<IR>) 
Resilient capitalism needs financ ial stability and sustainabili ty in order to 
succeed – and Integrated Reporti ng is intended to underpin both  of these 
problems through communicating to  providers of financial capita l the information 
that they need. 
cash), while many such as inte llectual capital, competition and  energy security 
are not.

66 
<IR> reflects the broad and l onger-term consequences of the dec isions 
organisations make, based on a wi de range of factors, in order to create and 
sustain value. <IR> enables an organisation to communicate in a  clear, 
articulate way how it is drawi ng on all the resources and relat ionships it utilises 
to create and preserve value in  the short, medium and long term , helping 
investors to manage risks and allo cate resources most efficient ly. 
Link to the GRI guidelines 
The GRI guidelines encourage organi sations to disclose extra in formation when 
communicating with key stakeholde rs. Economic, environmental an d social 
factors disclosed alongside the standard financial statements e nable investors 
and other stakeholders to make a mu ch better assessment of an o rganisation's 
overall performance. 
The extra disclosures can be m ade in a separate environmental /  sustainability 
or corporate social responsibil ity document, or as part of the management 
commentary presented with the fi nancial statements. The disclos ures are 
usually made by reference to the GRI guidelines, but this is no t mandatory in all 
jurisdictions. 
4 The Global Reporting Initiative (GRI) 
Overall aim of the GRI 
The GRI suggests that entities r eport performance indicators so  that users can 
monitor their performance from  economic, environmental and soci al 
perspectives. 
GRI guidelines 
• The most accepted framework fo r reporting sustainability is th e Global 
Reporting Initiative’s (GRI's) S ustainability Reporting Guideli nes. 'G4' – the 
fourth version of the guideli nes – was issued in May 2013. 
• The G4 Guidelines provide unive rsal guidance for reporting on 
sustainability performance. They  are applicable to all entities  including 
SMEs and not-for-profit entities worldwide. 
• The G4 Guidelines consist of pri nciples and discl osure items. The 
principles help to define repor t content, quality of the report , and give 
guidance on how to set the r eport boundary. The disclosure item s include 
disclosures on management of issues , as well as performance ind icators 
• Applying these guidelines is m andatory in some jurisdictions b ut voluntary 
in others.

Chapter 2 
 67 
Further information 
The Global Reporting Initiative website is  www.globalreporting.org . 
The financial statements of com panies that have applied the GRI  guidelines are 
listed (in the 'Disclosure Dat abase') with a link to their repo rts. 
 
 Background to and objectives of the G4 guidelines 
 Preface to the G4 guidelines 
The following quote from the pref ace to the G4 guidelines expla ins the 
background to the G4 updat e of the GRI guidelines: 
“The GRI Sustainability Reporting Guidelines are periodically r eviewed to 
provide the best and most up-to- date guidance for effective sus tainability 
reporting. The aim of G4, the f ourth such update, is simple: 
to help reporters prepare susta inability reports that matter, c ontain 
valuable information about the organization’s most critical 
sustainability-related issues, and make such sustainability rep orting 
standard practice. 
It is crucial for society and mark ets that sustainability repor ting evolves in 
terms of content, and from an exc eptional activity undertaken b y a 
minority of leading companies to a standard practice. 
Together with being more user-fri endly than previous versions o f the 
Guidelines, G4 has an increas ed emphasis on the need for organi zations 
to focus the reporting process and final report on those topics  that are 
material to their business and t heir key stakeholders. This ‘ma teriality’ 
focus will make reports more relevant, more credible and more u ser- 
friendly. This will, in turn, enable organizations to better in form markets 
and society on sustainability matters.” 
Materiality considerations 
Materiality is placed at the c entre of the new sustainability r eporting 
guidelines issued by the Global Repor ting Initiative (the so-ca lled 'G4' 
guidelines). 
G4 aims to improve the common language of corpor ate reporting, 
focusing heavily on the issues t hat are material to the organis ation and 
important for stakeholders. 
CEOs worldwide have identified  the need to build public trust a s a crucial 
part of improving operational e ffectiveness and engaging with c ustomers 
following the financial crisis. S ustainability reporting, says the GRI, plays 
a key role in this, with non-fi nancial reporting being singled out as a 
particularly effective means of c ommunicating long-term commitm ent to 
G4 does not reward reporting o f large quantities of indicators but requires 
companies to indicate and explai n omissions of standard or mate rial 
disclosures.

68 
Overview of the GRI's G4 Guidelines document 
The GRI's G4 Guidelines were published in May 2013, in a 94 pag e document 
in 7 sections. A brief, secti on-by-section overview of the cont ents of the G4 
document is given immediately be low, followed by a more detaile d overview of 
the key elements. 
 
 Overview of the GRI's G4 Guidelines 
 Sections 1 and 2: The purpose of  the Guidelines and how to use the 
Guidelines 
These sections expla in that there are two elements to the Guide lines, 
namely: 
• Reporting Principles and Standard Disclosures (covered in Sect ion 
4 and the first part of Section 5), and 
• Implementation Manual (cove red in detail in Section 5). 
They then give a step-by-step gu ide to using the Guidelines and  
preparing a sustainability report. 
Section 3: Criteria to be applie d by an organization to prepare  Its 
sustainability report ‘in accordance’ with the Guidelines 
This section explains that an ent ity can either prepare its sus tainability 
report using Core disclosures or Comprehensive disclosures. 
Both options can be applied by a ll entities, regardless of thei r size, sector 
or location. 
The Core option provides the ba ckground against which an entity  
communicates the impacts of its  economic, environmental and soc ial and 
governance performance. The Comp rehensive option builds on the Core 
option by requiring more extens ive reporting of the entity’s st rategy and 
analysis, governance, and ethics and integrity. 
A table in this section shows wh ich of the detailed disclosures  from the 
later Section 5 are needed for eac h of the Core and Comprehensi ve 
options. 
Section 4: Reporting principles 
In this section, the key reporti ng principles are outlined. The se are 
essentially the required charac teristics of the Report Content and the 
Report Quality. 
The Principles for Defining Report Content are given as: 
• Completeness

Chapter 2 
 69 
• Balance 
• Accuracy 
• Clarity 
• Reliability 
Section 5: Standard Disclosures 
This is the largest section of the G4 Guidelines document, cove ring 65 
pages. 
It covers in specific detail t he Standard Disclosures required,  after first 
explaining that there are two different types of Standard Discl osures 
(General Standard Disclosures and  Specific Standard Disclosures ), and 
outlining the subheadi ngs that should be used within each type.  
General Standard Disclosures 
• Organizational Profile 
• Identified Material Aspects and Boundaries 
• Stakeholder Engagement 
• Report Profile 
• Ethics and Integrity 
• Disclosures on Management Approach 
• Indicators 
Then, the Guidelines explain how  to separate the Indicators int o three 
Categories – Economic, Environmental  and Social. The Social Cat egory 
is further divided into four sub-Ca tegories, which are Labor Pr actices and 
Decent Work, Human Rights, Soc iety and Product Responsibility. 
Sections 6 and 7: Quick links and definitions of key terms used  
These final sections show how the  G4 Guidelines link to other i mportant 
sustainability reporting  guidelines, such as the OECD Guideline s for 
Multinational Enterprises, and t he UN's Guiding Principles on B usiness 
and Human Rights. 
Then, the document finishes with a glossary of key terms.

70 
Disclosures required by the GRI guidelines 
The Specific Standard Disclosures  are divided into two parts (Disclosures on 
Management Approach and Indicators). These disclosures cover th e specific 
Disclosures on Management Approach (DMA) 
The DMA is intended to give the entity an opportunity to explai n how the 
economic, environmental and social  impacts related to material Aspects are 
managed. The DMA also provides c ontext for the performance repo rted by 
Indicators (see below). 
Indicators 
Indicators give information on  the economic, environmental and social 
performance of an entity related to its material Aspects. Discl osures have to be 
made in each of these three ca tegories (economic, environmental  and social 
performance). 
• Economic  
The economic  dimension of sustainability concerns the entity’s impacts 
on the economic conditions of i ts stakeholders, and on economic  systems 
at local, national , and global levels. 
The Economic Category  illustrates the flow of c apital among different 
stakeholders, and the main economi c impacts of the entity throu ghout 
society. 
• Environmental  
The environmental  dimension of sustainability concerns the entity’s 
impact on living and n on-living natural syst ems, including land , air, water 
and ecosystems. 
The Environmental Category  covers impacts related to inputs (such as 
energy and water) and outputs (such as emissions, effluents and  waste). 
In addition, it covers biodiversity, transport, and product and  service-
related impacts, as well as envir onmental compliance and expend itures. 
• Social  
The social  dimension of sustainability conc erns the impacts the entity ha s 
on the social systems wit hin which it operates. 
The Social Category  includes the sub-Categories: 
1 Labor Practices and Decent Work 2 Human Rights 3 Society 4 Product Responsibility 
Most of the content in the sub- Categories is based on internati onally 
recognised universal standards o r other relevant international references.

Chapter 2 
 71 
Examples of disclosures 
The G4 guidelines encourage disclosure of various 'aspects' in the three key 
categories: Economic, Env ironmental and Social. 
Based on the above guidance, the so rt of disclosures entities m ight make to 
comply with the G4 guidelines are: 
Economic 
Aspect Example of disclosures 
Economic performance Revenues/cos ts, levels of pension contribu tions, 
taxes paid and subsidies received 
Market presence (i.e. the 
economic impact on the local area) Comparison of wage rates  to other firms locally, 
proportion of senior managers hired from the local community 
Indirect economic impacts Exten t of investment in infrastructur e projects 
Procurement practices Proporti on of spending with local supplie rs 
Key aspect Example of disclosures 
Materials Materials used by  weight or volume, and the 
proportion of materials u sed in production that 
are recycled 
Energy Total fuel consumptio n, reductions in the energy 
requirements of sold products and services 
Biodiversity The nature of signifi cant impacts on biodiversity 
e.g. species affected and duration of impact 
Emissions Total emissions of greenhouse gases and ozone 
depleting substances, emissions reductions achieved as a direct resul t of initiatives to reduce 
emissions 
Products and services 
(environmental aspects) How the environmental impact of products 
services is mitigated, and what proportion of products and packaging ma terials is reclaimed 
Supplier Environmental 
Assessment The percentage of new suppliers that were 
screened using environmental criteria 
Social – Labor practices and decent work 
Employment (i.e. an 
overview of the entity's staff and policies) Rate of staff turnover , number of new staff 
appointed, benefits provi ded to staff (e.g. life 
insurance, parental leave) 
Training and education Average ho urs of training provided per e mployee 
Diversity and equal 
opportunity Analysis of employees (and members of the 
entity's governance bo dies) by age, gender, 
ethnic background, disability etc.

72 
Social – Human rights 
Investment The number/per centage of the entity's 
investments and contract s that underwent human 
rights screening 
Freedom of association and 
collective bargaining Measures taken to support rights to exercise 
freedom of association (e.g . joining a trade union) 
and collective bargaining 
Assessment (of the entity's 
operations) The number/percentage of t he entity's operations 
that have been subject to  human rights reviews 
(e.g. by groups such as A mnesty International) 
Social – Society 
Local communities Operations with local community engagement 
and those with signific ant actual/potential 
negative impacts on local communities 
Public policy Financia l donations to political parties analysed  
by country and by recipient 
Anti-competitive behaviour Number o f legal actions faced by the  entity 
relating to anti-com petitive behaviour and 
violations of monopoly legislation 
Social – Product responsibility 
Customer health and safety A s ummary of breaches of health and safety 
legislation reported by customers, and a summary of the results o f any investigations 
Marketing communications A lis t of products sold by the entity that are 
banned or restricted in some markets, a summary of any investigations by the authorities into non-compliance with regulations on advertising/promotions 
Customer privacy The number of c omplaints received regarding 
customer privacy issues (for example leaks, thefts or losses of customer data)

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 73 
 Detailed list of aspects and categories of disclosures 
 Categories and aspects  in the G4 guidelines 
The examples in the tables abov e show some of the key disclosur es 
under the G4 guidelines. For compl eteness, the lists below show  all the 
aspects listed in the guidelines . For more examples, see the GR I's 
website (www.glo balreporting.org). 
Economic 
• Market Presence 
• Indirect Economic Impacts 
• Procurement Practices 
• Materials 
• Energy 
• Water 
• Effluents and Waste 
• Products and Services 
• Compliance 
• Transport 
• Overall 
• Supplier Environmental Assessment 
• Environmental Grievance Mechanisms 
Social  – the Social category is split i nto four sub-categories, each with 
several aspects associated with it as follows: 
Labor Practices and Decent Work 
• E m p l o y m e n t  
• Labor/Management Relations 
• Diversity and Equal Opportunity 
• Equal Remuneration for Women and Men 
• Supplier Assessment for Labor Practices 
• Labor Practices Grievance Mechanisms

74 
Human Rights 
• Investment 
• Freedom of Association and Collective Bargaining 
• Child Labor 
• Forced or Compulsory Labor 
• Security Practices 
• Indigenous Rights 
• Assessment 
• Supplier Human Rights Assessment 
• Human Rights Grievance Mechanisms 
Society 
• Anti-corruption 
• Public Policy 
• Anti-competitive Behaviour 
• Supplier Assessment for Impacts on Society 
• Grievance Mechanisms for Impacts on Society 
Product Responsibility 
• Product and Service Labelling 
• Marketing Communications 
• Customer Privacy 
• Compliance

Chapter 2 
 75 
 General Standard Disclosures 
 As well as the Specific Standar d Disclosures identified above,  the GRI 
guidance proposes seven General Standard Disclosures . These 
disclosures cover general issues  related to the entity, rather than 
information specific to its performance. 
Strategy and Analysis 
These disclosures provide a gener al strategic view of the entit y’s 
sustainability, in order  to provide context for subsequent, mor e detailed 
reporting. 
Organisational Profile 
These disclosures provide an over view of organisational charact eristics, 
in order to provide context for subsequent more detailed report ing. 
Identified Material Aspects and Boundaries 
These disclosures provide an over view of the process that the e ntity has 
followed to define the Report Con tent, the identified material Aspects and 
their Boundaries. (Note that the word Aspect is used throughout  the 
Guidelines to refer to the list o f subjects covered by the Guid elines.) 
Stakeholder Engagement 
These disclosures provide an ov erview of the entity’s stakehold er 
engagement during the reporting period. 
Engaging with stakeholders is t he basis for good corporate gove rnance 
but this is often something tha t entities either ignore or unde restimate. 
There are many ways to engage wit h stakeholders, especially as social 
media channels become more sophi sticated. A direct dialogue wit h 
stakeholders is important for two reasons: 
• as a PR and marketing exercise 
• to take a direct pulse of the entity’s performance and to asse ss how 
well its products are received. 
Report Profile 
These disclosures provide an over view of the basic information about the 
report, such as the reporting per iod, date of previous report a nd whether 
Core or Comprehensive disclosure has been used. 
Governance 
These disclosures provide an overview of the highest governance  body of 
the entity (for example, t he Board of Directors).

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Ethics and Integrity 
These disclosures provide an ov erview of the entity's values, p rinciples, 
standards and norms, al ong with its internal  and external mecha nisms for 
seeking advice or reporting conc erns on ethics and matters of i ntegrity. 
Principles for defining cont ent of the GRI disclosures 
Section 4 of the G4 Guidelines p rovides the following principle s for defining 
report content: 
Stakeholder inclusiveness 
The reporting entity s hould identify its st akeholders and expla in in the report 
how it has responded to their ex pectations and interests. 
Sustainability context 
The report should present the ent ity’s performance in the wider  context of 
Materiality 
Organisations are faced with a wide range of topics on which th ey could report. 
Relevant topics are those that m ay reasonably be considered imp ortant for 
reflecting the organisation’s ec onomic, environmental and socia l impacts, or 
influencing the decisions of sta keholders, and, therefore, pote ntially merit 
inclusion in the repor t. Materiality is the  threshold at which Aspects become 
sufficiently important tha t they should be reported. 
Coverage of all the material t opics and indicators should be en ough to reflect 
significant impacts and allow st akeholders to assess the report ing entity’s 
Non-disclosure 
In exceptional cases, if it is not possible to disclose certain  required information, 
the report should clearly: 
• Identify the information  that has been omitted. 
• Explain the reasons why the in formation has been omitted. 
In addition, the applicable expl anation of omission from the li st below should be 
provided: 
• A Standard Disclosure, part o f a Standard Disclosure, or an In dicator is 
not applicable; the reason why i t is considered to be not appli cable should 
be disclosed 
• The information is subject to s pecific confidentiality constra ints; those 
constraints are to be di sclosed by the organisation

Chapter 2 
 77 
• The existence of specific lega l prohibitions; a reference to t he specific 
legal prohibitions should be made 
• The information is currently unav ailable. In the case of the u navailability of 
data, the organization should disc lose the steps being taken to  obtain the 
data and the expected ti meframe for doing so 
The organisation should recogni se, however, that a large number  of omitted 
Standard Disclosures may invalid ate its ability to claim that i ts sustainability 
report has been prepar ed ‘in accordance’ with the Guidelines. 
 
 Principles for defining report quality 
 As well as the principles for defining report content identifi ed above, 
Section 4 of the G4 Guidelines p rovides the following principle s for 
defining report quality: 
Balance 
The report should reflect both positive and negative aspects of  an entity’s 
performance to enable a reas oned overall assessment. 
Comparability 
Issues and information should be reported consistently. Reporte d 
information should be presented in a  way which allows stakehold ers to 
assess trends over time and compar e the entity to other organis ations. 
Accuracy 
The reported information should be sufficiently accurate and de tailed for 
stakeholders to assess the entity’s performance. 
Reporting should occur regularly  and in time for stakeholders t o make 
informed decisions. 
Clarity 
Information should be underst andable and accessible. 
The entity should gather, record,  compile, analyse and disclose  
information and processes used in the preparation of a report i n a way 
that they can be subject to exami nation and that establishes th e quality 
and materiality of the information.

78 
The process of putting together a  report in accordance with the  GRI 
guidelines 
The GRI's 'G4' Guidelines docum ent sets out the following four step approach 
to putting together a report. 
Step 1: Identification 
• Consider the GRI Aspects lis t and other topics of interest 
• Apply the Principles of Sustai nability Context and Stakeholder  
Inclusiveness: Identify the As pects – and other relevant topics  – based on 
the relevant economic, environment al and social impacts related  to all of 
the organisation’s activities, p roducts, services, and relation ships, or on 
the influence they have on the assessments and decisions of sta keholders 
• Identify where the impacts occu r: within or outside of the org anisation 
• List the Aspects and other topics considered relevant, and the ir 
Boundaries 
Step 2: Prioritisation 
• Each Aspect and other topic considered relevant for: 
–  the significance of the organi sation’s economic, environment al and 
social impacts 
–  the influence on stakeholder  assessments and decisions 
• Identify the material Aspects  by combining the assessments 
• Define and document thresholds ( criteria) that render an Aspec t material 
• For each material Aspect identif ied, decide the level of cover age, the 
amount of data and narrative e xplanation to be disclosed 
• List the material A spects to be included in the report, along with their 
Boundaries and the level of coverage 
Step 3: Validation 
• Apply the Principles of Comp leteness and Stakeholder Inclusive ness: 
Assess the list of material Aspects against Scope, Aspect Bound aries and 
Time to ensure that the repor t provides a reasonable and balanc ed 
representation of the organisation ’s significant economic, envi ronmental 
and social impacts, and enables s takeholders to assess the orga nisation’s 
• Approve the list of identified mate rial Aspects with the relev ant internal 
senior decision-maker 
• Prepare systems and processes  to gather the information needed  to be 
disclosed 
• Translate the identified materi al Aspects into Standard Disclo sures – DMA 
and Indicators – to report against. 
• Determine which information is a vailable and explain those for  which it still 
needs to establish management appr oaches and measurements syste ms

Chapter 2 
 79 
Step 4: Review 
Inclusiveness: Review the Aspects  that were material in the pre vious 
• Use the result of the review to i nform Step 1 I dentification f or the next 
reporting cycle 
5 Integrated Reporting (<IR>) 
The objective of integrated repor ting is to try to create a mor e holistic and 
balanced view of the company bei ng reported upon, bringing toge ther material 
aspects such as strategy, governance, performance and prospects  in a way that 
reflects the commercial, social and environment al context withi n which it 
operates. 
The basics of integrated reporti ng were covered earlier in the CIMA syllabus. 
Link between sustainability and <IR> 
Sustainability reporting (in acco rdance with the GRI guidelines  explained above) 
is an intrinsic elemen t of integrated reporting. 
Sustainability reporting is f undamental to an organisation’s in tegrated thinking 
and reporting process, in provid ing input into the organisation ’s identification of 
its material issues, its strategi c objectives, and the assessme nt of its ability to 
achieve those objectives and create value over time. 
 
 More on the link between sustainability and <IR> 
 From the GRI 'G4' Guidelines 
"Sustainability reporting is a p rocess that assists organizatio ns in setting 
goals, measuring performance and managing change towards a 
sustainable global eco nomy – one that combines long term profit ability 
with social responsibility and env ironmental care. Sustainabili ty reporting 
– mainly through but not limited  to a sustainability report – i s the key 
platform for communicating the organization’s economic, environ mental, 
social and governance performanc e, reflecting positive and nega tive 
impacts. 
The Aspects that the organization  deems to be material, in resp onse to 
its stakeholders’ expectations and interests, drive sustainabil ity reporting. 
Stakeholders can include those w ho are invested in in the organ ization as 
well as those who have other rel ationships with the organizatio n. 
Integrated reporting is  an emerging and ev olving trend in corpo rate 
reporting, which in general aim s primarily to offer an organiza tion’s 
providers of financial capital wi th an integrated representatio n of the key 
factors that are material to i ts present and future value creat ion.

80 
Integrated reporters build on sustainability reporting foundati ons and 
disclosures in preparing their integrated report. Through the i ntegrated 
report, an organization provides a  concise communication about how its 
strategy, governance, performanc e and prospects lead to the cre ation of 
value over time. Therefore, the integrated report is not intend ed to be an 
extract of the traditional annual report nor a combination of t he annual 
financial statements and the su stainability report. However, th e integrated 
report interacts with other repor ts and communications by makin g 
reference to additional detail ed information that is provided s eparately. 
Three fundamental concepts 
Value creation for the orga nisation and for others 
An organisation’s activities, its  interactions and relationship s, its outputs and the 
outcomes for the various capita ls it uses and affects influence  its ability to 
continue to draw on these capitals in a continuous cycle. 
The capitals 
organisation, which are identified in the <IR> Framework as fin ancial, 
manufactured, intellectual, human , social and relationship, and  natural capital. 
However, these categories of c apital are not r equired to be ado pted in preparing 
an entity’s integrated report, and an integrated report may not  cover all capitals 
– the focus is on capitals that are relevant to the entity. 
The value creation process 
At the core of the value creation process is an entity’s busine ss model, which 
draws on various capitals and in puts, and by using the entity’s  business 
activities, creates outputs (p roducts, services, by-products, w aste) and 
outcomes (internal and external  consequences for the capitals).  
 
 More on the capitals 
 The stock and flow of capitals 
All organisations depend on various forms of capital for their success. In 
the <IR> Framework, the capitals  comprise financial, manufactur ed, 
intellectual, human, social and relationship, and natural, alth ough as 
explained below, organisations  preparing an integrated report a re not 
required to adopt this categorisation. 
The capitals are stocks of val ue that are increased, decreased or 
transformed through the activiti es and outputs of the organisat ion. For 
example, an organisation’s financ ial capital is increased when it makes a 
profit, and the quality of its hum an capital is improved when e mployees 
become better trained.

Chapter 2 
 81 
The overall stock of capitals is not fixed over time. There is a constant 
flow between and within the capita ls as they are increased, dec reased or 
transformed. For example, when an organisation improves its hum an 
capital through employee training , the related training costs r educe its 
financial capital. The effect is  that financial capital has bee n transformed 
into human capital. Although this  example is simple and present ed only 
from the organisation’s perspecti ve, it demonstrates the contin uous 
interaction and transformation bet ween the capitals, albeit wit h varying 
rates and outcomes. 
Many activities cause increases , decreases or transformations t hat are far 
more complex than the above exampl e and involve a broader mix o f 
capitals or of components with in a capital (e.g . the use of wat er to grow 
crops that are fed to f arm animals, all of which are components  of natural 
capital). 
For the purpose of the <IR> Fra mework, the capitals are categor ised and 
–  available to an organization fo r use in the production of go ods 
or the provision of services 
generated through operations or investments 
• Manufactured capital  – Manufactured physical objects (as distinct 
from natural physical objects) t hat are available to an organis ation for 
use in the production of goods or the provision of services, in cluding: 
–  buildings –  equipment –  infrastructure (such as roads , ports, bridges, and waste and  
water treatment plants) 
• Manufactured capital is often cr eated by other organisations, but 
includes assets manufactured by the reporting organisation for sale 
or when they are retained for its own use. 
–  intellectual property, such as  patents, copyrights, software , 
rights and licences 
–  'organizational capital' suc h as tacit knowledge, systems, 
procedures and protocols 
• Human capital  – People’s competencies, capabilities and 
experience, and their motivati ons to innovate, including their:  
–  alignment with and support for an organization’s governance 
framework, risk management approach, and ethical values

82 
–  ability to understand, develop and implement an organization ’s 
strategy 
• Social and relationship capital  – The institutions and the 
relationships within and bet ween communities, groups of 
stakeholders and other networ ks, and the ability to share 
information to enhance individual and collective well-being. So cial 
and relationship capital includes: 
engage that an organisation has devel oped and strives to build 
and protect with exte rnal stakeholders 
–  an organisation’s soci al licence to operate 
resources and processes that provide goods or services that support the past, current or future prosperity of an organisati on. It 
includes: 
–  air, water, land, minerals and forests –  biodiversity and eco-system health. 
Not all capitals are equally relevant or applicable to all orga nisations. 
While most organisations interact with all capitals to some ext ent, these 
interactions might be relative ly minor or so indirect that they  are not 
sufficiently important to incl ude in the int egrated report. 
Role of the capitals in the <IR> Framework 
The Framework does not require  an integrated report to adopt th e 
categories identified above or to be stru ctured along the lines  of the 
capitals. Rather, the primary r easons for including the capital s in the 
Framework are to serve: 
• As part of the theoretical under pinning for the concept of val ue 
creation 
• As a guideline for ensuring organ isations consider all the for ms of 
capital they use or affect. 
Organisations may categorise the capitals differently. For exam ple, 
relationships with external sta keholders and the intangibles as sociated 
with brand and reputati on (both identified as part of social an d 
relationship capital here), migh t be considered by some organis ations to 
be separate capitals, part of ot her capitals or cutting across a number of 
individual capitals.

Chapter 2 
 83 
Similarly, some organisations def ine intellectual capital as co mprising 
what they identify as human, 'st ructural' and 'relational' capi tals. 
Regardless of how an organisati on categorises the capitals for its own 
purposes, the categories identifie d above are to be used as a g uideline to 
ensure the organisation does no t overlook a capital that it use s or affects. 
6 How should the extra in formation be presented? 
This chapter has so far explaine d the benefits of using either the GRI guidelines 
and/or the <IR> framework to enhanc e the quality of information  presented to 
stakeholders. However, a question  remains regarding what form t he extra 
information should take, and whet her it should be presented as a separate 
document or as part of the entit y's published financial stateme nts. 
Within the introduction to the <I R> framework document, it says :  
"An integrated repor t should be a designated, identifiable comm unication, 
and should be more than just a su mmary of information in other 
communications. Critically, it mus t make explicit the connectiv ity of 
information to communicate how value is created over time. 
An integrated report may be eit her a standalone report or be in cluded as a 
distinguishable, prominent and accessible part of another repor t or 
communication. For example, it m ay be included at the front of a report 
that also includes the entity’ s financial statements." 
Therefore, the information is o ften presented as part of an ent ity's management 
commentary (MC) and included as part of the report containing t he entity's 
Purpose of the Management Commentary (MC) 
The International Financial Repor ting Standards (IFRS) Practice  Statement on 
Management Commentary provides a b road, non-binding framework f or the 
presentation of management comment ary that accompanies financia l 
statements that have been prepared in accor dance with Internati onal Financial 
Reporting Standards. 
It sets out the principles, qualit ative characteristics and ele ments that are 
necessary to provide users of fi nancial statement s with useful information. As 
the guidance is in the form of a p ractice statement (rather tha n an IFRS) 
compliance with it is voluntary , however where an entity choose s to apply the 
practice statement it should expl ain the extent to which it has  been applied.

84 
Management commentary is a narra tive report that provides a con text within 
which to interpret the financia l position, financ ial performanc e and cash flows of 
an entity. Management are able to  explain their objectives and strategies for 
achieving those objectives. Use rs routinely use the type of inf ormation provided 
in management commentary to help  them evaluate an entity’s pros pects and its 
general risks, as well as the su ccess of management’s strategie s for achieving 
the entity's stated objectives . For many entities, management c ommentary is 
already an important element of t heir communication with the ca pital markets, 
supplementing as well as complem enting the financial statements . 
The practice statement helps  management to produce the manageme nt 
commentary that will be reported alongside the financial statem ents prepared in 
accordance with IFRS. The users are identified as existing and potential 
shareholders, together wit h lenders and creditors. 
 
 Framework for presentation of the MC 
 The following principles should be applied when considering th e content 
of the management commentary: 
(a) it should provide management’s  perspective of the entity’s 
performance, position and progress; 
(b) it should supplement and comple ment information presented i n the 
financial statements; 
(c) it should have an orie ntation to the future; 
(d) it should possess the qualitativ e characteristics of releva nce and 
faithful representation as descr ibed in the IASB's Conceptual 
Framework for Financial Reporting. 
The management comment ary should provide in formation to help us ers 
of the financial reports to asse ss the performance of the entit y and the 
actions of its management relative  to stated strategies and pla ns for 
progress. That type of commentary will help users of the financ ial reports 
to understand risk exposures and s trategies of the entity, rele vant non- 
financial factors and other issues  not otherwise included withi n the 
Management commentary should prov ide management’s perspective o f 
the entity’s performance, posit ion and progress and therefore s hould 
derive from the information t hat is important to management in managing 
the business.

Chapter 2 
 85 
 Many entities produc e a 'Management Commentary' (known in the UK as 
the Operating and Fi nancial Review). 
Required: 
(a) Explain why entities produce such a commentary together wit h a 
brief description of the typical information that it might cont ain. 
(b) From the perspective of a use r of financial statements, exp lain the 
advantages and disadvantages  of such a report. 
7 Future developments 
Problems with the current appro ach to non-financial reporting 
The sections above hav e highlighted the dev elopments in non-fin ancial 
Due to the voluntary nature of  these disclosures their impact a nd effectiveness 
will depend on various factors: 
• Relevance:  how much weight do/will investors, employees and 
consumers give to these factors, compared with that given to fi nancial 
factors (so return on investm ent, employee benefits and price, 
respectively)? 
• Reliability:  how much can the performanc e measured in these areas be 
relied on? How sure can users of  this information be that it is  a faithful 
representation of what has occu rred, as opposed to a selective view 
focusing on the successes? Are ther e external assurance process es that 
can validate the information, perhaps using the GRI guidelines?  
• Comparability:  is the information produced by  different entities pulled 
together on a com parable basis, using simi lar measurement polic ies, so 
that the users can make info rmed choices between entities? If n ot, all that 
can be measured is an entity’s performance compared with its ow n 
performance in previous periods. 
The fact that there are two comp lementary sets of guidelines (G RI and <IR>) is 
certainly a problem, as is the fa ct that compliance with the gu idelines is 
voluntary in many  jurisdictions. 
Future developments 
The International Accounting St andards Board (IASB) and Interna tional 
Integrated Reporting Council (II RC) have recently announced an agreement 
that will see the two organisati ons deepen their cooperation on  the IIRC’s work 
to develop an integrated corpor ate reporting framework. The agr eement 
formalises the strong relationshi p that already exists at multi ple levels between 
the two organisations.

86 
As part of the agreement, the tw o bodies will work together to communicate 
about work on their respective fr ameworks and to aim for comple mentarity and 
compatibility in t he ongoing development of the two standards. 
They have also agreed to work together to identify ways in whic h <IR> and 
financial reporting standards can  be aligned to strengthen corp orate reporting, 
and have committed to having regular, frequent and meaningful i nformation 
exchanges on what they are each doing. 
This will ensure that, where ther e are overlapping interests, t hey express a 
common opinion where possible. 
It is likely that at some point i n the future, regulation will be introduced to 
formalise this link between the two organisations. 
 
 Test your understanding 2 (Case style question) 
 Company B owns a chemical plant, producing paint. 
The plant uses a great deal of energy and releases emissions in to the 
environment. Its by-product is ha rmful and is treated before be ing safely 
disposed of. The company has been fined for damaging the enviro nment 
following a spillage of the toxi c waste product. Due to stricte r monitoring 
routines set up by the company , the fines have reduced and in t he 
current year they have not been in  breach of any local environm ent laws. 
The company is aware that emi ssions are high and has been stead ily 
reducing them. They purchase elec tricity from renewable sources  and in 
the current year have employed a temporary consultant to calcul ate their 
carbon footprint so they can take steps to reduce it. 
Required: 
(a) Explain why companies may wis h to make social and environme ntal 
disclosures in their annual repor t. Discuss how this content sh ould 
be determined. 
(b) Discuss the information that could be included in Company B ’s 
environmental report. 

Chapter 2 
 87 
8 United Nations Sustain ability Development Goals 
In September 2015 the 193 member s tates of the United Nations a dopted a 
new global 15 year plan to help “end extreme poverty, fight ine quality and 
injustice, and to protect our  planet”. At the heart of this pla n were 17 
Sustainability Develo pment Goals (SDG):  
 
The UN recognises that to achie ve these goals it will require s trong links 
between governments, companies  and the general public. These SD Gs are 
now frequently being r eported on within an in tegrated reporting  framework (as 
of Feb 2018, 40% largest 250 global c ompanies discussed SDGs in  their 
corporate reports). Companies  who adopt and support these goals  can see 
many long term benefits such as: 
• Improved reputation with custo mers for being socially responsi ble 
• A healthier and more skilled workforce  
• Greater growth opportunities in developing countries as their economy 
strengthens, giving the populatio n more disposable income 
• Continued supply of raw materia ls from a sustainable source, h elping to 
secure the long term future of the business 
• Reduced risks of regulatory breaches and ba d publicity

88 
Linking the SDGs with integrated reporting 
Integrated reporting provides a  framework to help senior manage ment focus on 
SDGs and build them into the org anisation’s long term strategy.  
Integrated reporting encourages  management to look at external factors that 
may impact the organisation’s abi lity to create value for its s takeholders.  
Both the <IR> Framework and GR I G4 Guidelines requires organisa tions to 
consider how the exte rnal environment (and explicitly social an d environmental 
issues) impact value creation. M any of these factors, such as p opulation, 
human rights, poverty, education and climate change all relate directly to a 
number of the SDGs. 
Once these external factors ar e examined, management should ide ntify and 
evaluate which SDGs will help th e organisation to create the mo st value to its 
capitals, then develop medium and long term strategies to achie ve this. 
This is likely to create more i ntegrated thinking and build rel ationships both 
between internal depar tments within the organisation, and also between the 
organisation and external stakeholders. 
These targets, strategies and value creation can and should be reported within 
the integrated report, along with  both the posit ive and negativ e ways in which 
the organisation impact the SDGs 
Two real life exam ples (prepared by Vodaf one and Samsung) are s hown below. 
 
 Case Study – Vodafone’s Sustainable Business Report 
 Vodafone’s “Sustainable Busines s Report” (which can be found o n the 
company’s website) starts by s etting out the report’s aims: 
“In our Sustainable Business Repo rt, we give an overview of our  ambition 
of what we are trying to achieve  through our sustainable busine ss 
strategy, together with our progress to date. 
The Report also provides an ov erview of the full range of backg round 
information and material non-fina ncial disclosures, including i nsights into 
the ethical challenges that infor m our business principles and that 
influence the controls we have pu t in place to ensure our opera ting 
practices meet our (and our s takeholders’) expectations.” 
UN SDGs 
The Vodafone report acknowledges  the importance of the UN SDGs and 
has a section explaining how the company addresses five of thes e goals 
in particular. The detail from t his section of the report is sh own below: 
“We focus on five of the UN SDGs 
We believe our busin ess can have the greatest impact on five of  the UN 
SDGs through our networks, produc ts and services and through th e work 
of the Vodafone Foundation.

Chapter 2 
 89 
SDG 4: Quality education 
Ensure inclusive and equitable quality educati on and promote li felong 
learning opportunities for all. 
Vodafone and the Vodaf one Foundation use mobile technology to e nable 
young people to have access to develop their digital skills and  to provide 
learning opportunities for st udents. The provision of free or s ubsidised 
education resources and technology  – particularly to marginalis ed 
groups, including refugees – o ffers enhanced opportunities to a chieve 
academic success and therefore improved life opportunities. 
Examples of our contribution: 
Over 419,000 people have enrolled in t he Vodafone Egypt 
Foundation’s Knowledge is Power  adult literacy programme. 
Over 500,000 refugee students have accessed free, quality educa tion 
content with no data charges  as part of the Vodafone 
Foundation’s Instant Schools for Africa  programme. 
SDG 5: Gender equality 
Achieve gender equalit y and empower all women and girls. 
Vodafone provides women with acce ss to life-enhancing services 
unlocking socio-economic opportuni ties and helping to address 
inequality. We also champion the inclusion of women in the work place, 
highlighting their vital role i n our success and adopting a pro gressive 
stance to encourage others. 
We have connected an additional 13.3 million female customers t o 
mobile in our emerging markets since 2016. 
29% of our management and leadership  roles are held by women. 
SDG 8: Decent work and economic growth 
Promote sustained, inclusive and  sustainable economic growth, f ull and 
productive employment and decent work for all. 
Youth unemployment is a signific ant global social and economic 
challenge in many of our markets . At the same ti me, the nature of work is 
changing as advances in technology are leading to the automatio n of 
many job categories and digital skills become ever more importa nt in the 
workplace today. Those skills are in short supply and as a resu lt, many 
digital jobs remain unfilled. U rgent action is needed to suppor t young 
people to understand how they can c ontribute to the digital eco nomy.

90 
 Examples of our contribution: 
Over 111,000 unique user s completed of our Future Jobs Finder  platform 
in the first ten days since launch.  
We estimate over 14, 000 young people were provided with a digit al 
workplace experience during the year. 
SDG 9: Industry, innovation and infrastructure 
Build resilient infrastructure , promote sustainable industriali sation and 
foster innovation. 
Extending Vodafone’s networ ks to connect the unconnected and im prove 
broadband access enhances global in frastructure and the opportu nities 
that flow from that. Many of our p roducts and services promote 
sustainable industrial devel opment and foster innovation. 
Our network infrastructure comp rises 310,000 base station sites , 65,000 
computer servers, 4,200 buildin gs (including 500 technology cen tres). 
We invested EUR 7.3 billion durin g the year to maintain and upg rade our 
digital infrastructure to deliv er improved coverage and access to high-
speed networks. 
SDG 13: Climate action 
Take urgent action to combat c limate change and its impacts. 
We aim to reduce the energy requir ed to run our networks while meeting 
increasing customer demand for dat a and are seeking to increase  the 
proportion of our electricity t hat comes from renewable sources , through 
the launch of two new energy goa ls. In parallel, our Internet o f Things 
(IoT) services play a significan t role in helping our customers  to operate 
more efficiently and reduce their greenhouse gas (GHG) emission s. 
During the year, we reduced the amount of GHG emissions per pet abyte 
of data carried on our network by 40%. 
We have helped our customers to sa ve an estimated 2.1 tonnes of  
CO 2e for every tonne we generated  through our own activities.

Chapter 2 
 91 
 Case Study – Samsung’s Sustainability Report 
 The “Sustainability” section on Samsung’s website explains the  
company’s approach to sustainability by using a formula: 
Value of Samsung sustainability =  Economic Value + Social Value  
Where 
• Economic Value is “Maximise profits and shareholder values 
(products and services innovation)” 
and  
• Social Value is “Contribute to a  sustainable society (Attainme nt of the 
UN SDGs)” 
The company goes on to explain how both Economic Value and Soci al 
Value are created, as follows: 
“Economic Value Creation 
Our endeavours to bring innovative technology and products pave  the 
way to generate profits and secure  new growth drivers. We striv e to 
embed innovation into the fabric o f our corporate culture while  creating 
synergies through the use of ext ernal resources to pursue open 
innovation. In so doing, we take a  step closer to building an e cosystem to 
develop innovative products tha t cater to the needs of today’s rapidly-
shifting market. 
Social Value Creation 
As a global corporate citizen, w e at Samsung create social valu es in a 
way that is aligned with the UN Sustainable Development Goals ( SDGs): 
Especially, we pinpointed goals tha t are highly relevant to our  business 
conduct and are analysing our negat ive/positive impact in attai ning these 
goals. Furthermore, we will discover and fully explore business  
opportunities that contribute  to reaching the UN SDGs.” 
Focus on UN SDGs 
As mentioned in this Social Value Creation introdu ction, in Sam sung’s 
detailed “Sustainability Report” ( which can be accessed from a link on the 
company’s website) each of the UN  SDGs is highlighted and asses sed in 
terms of how relevant it is to S amsung. Once the relevance has been 
graded (on a three point scale –  low, medium or high) the repor t then 
looks at the potential impact (ei ther positive or negative) and  explains 
Samsung’s status and future plan . An extract from the report is  shown 
below.

92 
 Extract from Samsung’s “Sustainab ility Report” showing UN SDGs 
Goal Relevance Potential impact Our status Future plan 
SDG 1: No 
poverty Medium (+) Improve 
access through technology, 
services.  
(-) Exert a direct 
or indirect impact on environmental 
destruction that 
may affect local residents’ 
livelihood. Operate 
citizenship programs that 
guarantee 
access to information to all 
regardless of 
abilities or 
economic status. 
Operate the Tech 
Institute digital skills program to 
offer employment 
training to underprivileged / 
marginalized 
populations so that they become 
economically independent. Pursue 
technological innovation that 
meets social needs. 
Improve the 
quality of 
employment 
training programs 
and expand 
support. 
SDG 4: 
Quality 
education High (+) Increase 
access to education by 
using ICT. Provide quality 
education / 
training in the EU. 
Provide career 
development programs aligned with the life 
cycle needs of employees. Expand and 
improve education and digital skills 
program. 
Support 
individuals with strengthening 
their job expertise. 
SDG 5: 
Gender 
equality High (+) Strengthen 
female leadership 
in the workplace 
and support female-led 
 Operate education 
programs for 
females - 
Designer School in Nepal, 
women domestic 
violence in Italy. 
Operate work 
programs that ensure maternity protection 
(Mommy Room in Vietnam). Expand 
support for digital 
education for women. 
Strengthen 
gender equality as 
part of our corporate culture. 
SDG 6: 
Clean water and 
sanitation Medium (+) Ensure the 
sustainable use and management 
of water resources. 
(-) Exert an 
indirect impact on 
the shortage of water resources in 
local communities. Manage water 
resource risks in the workplace and 
monitor the quality of effluent. Reach 50 
tons/KRW 100 million in intensity 
based use of 
water resources 
by 2020.

Chapter 2 
 93 
Summary 
This enables the reader of the “S ustainability Report” to see a t a glance 
which of the UN SDGs are most im portant from Samsung’s point of  view 
and should help to reassure the r eader that the company takes i ts 
sustainability responsibil ities very seriously. 
9 End of chapter objective test questions 
 Test your understanding 3 (O bjective test question) 
 HRJ Co is about to prepare a su stainability report for the fir st time, 
following the Global Reporting  Initiative Guidelines. 
The directors are currently pr eparing the section covering Gene ral 
Standard Disclosures. 
Which TWO of the follo wing headings should NOT appear in this 
section? 
A  Society 
B  Strategy and Analysis C  Human Rights D  Stakeholder Engagement E  Governance 
 
 Which THREE of the following are Content Elements as defined by  
the International Integrated R eporting Council's <IR> Framework ? 
A  Strategic focus and future orientation 
B  Performance C  Business model D  Governance E  Stakeholder relationships

94 
 Eunice Co has followed the Global  Reporting Initiative (GRI) G 4 
guidelines and is preparing to i ssue a sustainability report in  accordance 
with the guidelines. 
Which of the following statements  relating to incomplete disclo sure 
is correct? 
A  Information may only be omi tted if it is subject to either l egal 
prohibitions or confi dentiality constraints 
B  Where legal restrictions pr ohibit disclosure, no further dis closure is 
required 
C  Where information is omitted due to confidentiality constrai nts, these 
should be explained 
D  Where information is unavaila ble, it is suffi cient to state that this is 
the case 
 
 Which THREE of the following ar e defined by the Global Reportin g 
Initiative as being Principles for Defining Report Quality: 
A Timeliness  
B Materiality C Clarity D Reliability E Completeness 
 
 Which THREE of the following are objectives of Integrated 
Reporting, as identified by the  International Integrated Report ing 
Council (IIRC)? 
B  To communicate the impacts o f economic, environmental and so cial 
and governance performance 
D  To increase the quantity of inf ormation available to provide rs of 
E  To provide a more cohesive and efficient approach to corpora te 
reporting

Chapter 2 
 95 
 Which THREE of the following are  Guiding Principles as defined by 
A  Conciseness 
B  Materiality C  Connectivity of information D  Outlook E  Basis of preparati on and presentation 
 
 Vinus Co is a UK based company . It is preparing a sustainabili ty report in 
accordance with the Global Report ing Initiative's G4 guidelines . 
The company recently made a polit ical donation to the oppositio n party 
during the UK general e lection campaign. 
Under which category would this  information be disclosed in Vin us 
Co's sustainability report? 
A  Economic 
B  Social – Society C  Social – Human rights D  There is no requirement in t he G4 guidelines to disclose pol itical 
donations 
 
 QQ Co has prepared a draft Int egrated Report following the Inte rnational 
Integrated Reporting Council's <IR> Framework. 
Which THREE of the headings bel ow have been placed in the wrong  
section of the report? 
Guiding principles 
B  Stakeholder relationships 
C  Governance 
D  Disclosures on Management Approach (DMA) 
Content elements 
E  Organisational overview and external environment 
F  Strategy and resource allocation 
G Outlook 
H Consistency and comparability

96 
Initiative as being Principles for Defining Report Content: 
A  Sustainability context 
B  Materiality C  Stakeholder inclusiveness D  Reliability E  Balance 
 
 Yootha Co is preparing an Int egrated Report for the first time . 
The directors feel that the ei ght 'Content Elements' headings l isted in the 
<IR> Framework won't enable them  to present the information abo ut their 
company in the most user-friendly way. Hence, they are planning  to use a 
different set of headings to struc ture their Integrated Report.  
What does the <IR> Framework s ay about using different report 
headings? 
A Companies are not allowed to u se different headings. The eigh t 
'Content Elements' headings mus t be used to enable users to 
compare different companies'  Integrated Reports easily. 
B Companies can use different r eport headings for the 'Content 
Elements'. The given headings are only provided as suggestions.  
C  The eight 'Content Elements'  headings must be used if a comp any 
is presenting Core Disclosures, but different headings can be u sed 
for Comprehensive Disclosures. 
D  Different headings can be us ed in a company's first Integrat ed 
Reports, but by the time a com pany produces its third annual 
Integrated Report, the eight 'Cont ent Elements' headings listed  in 
the <IR> Framework have to be used. 
 
 Which TWO of the following headi ngs are not one of the 17 Unite d 
Nations Sustainable Development Goals (SDGs)? 
A  Zero hunger 
B  Quality education C  Internet for all 
D  Climate action 
E  Recycling more F      Gender equality

Chapter 2 
 97 
10 End of chapter c ase style questions 
 Test your understanding 14 (Case style question) 
 It is becoming increasingly comm on for listed entities to prov ide non- 
financial disclosures intended to i nform stakeholders about the  business’s 
environmental policies, impacts  and practices.  Supporters of s uch 
voluntary disclosures argue tha t stakeholders have a right to b e informed 
about environmental issues in this way. However, there are also  
arguments against this type of disclosure. 
Required: 
Identify and explain  the principal argum ents against voluntary disclosures 
by businesses of their environment al policies, impacts and prac tices. 
 
 Test your understanding 15 (Case style question) 
 The directors of World Energy , a public limited company, feel that their 
financial statements do not address a broad enough range of use rs’ 
needs. The company’s main busine ss is the generation and supply  of 
electricity and gas. 
They have reviewed the published  financial statements and have realised 
that there is very little info rmation about their corporate env ironmental 
The company discloses the follo wing social and environmental 
information in the financial statements: 
Corporate Environmental Governance 
• the highest radiation dosage  to a member of the public 
• total acid gas emissions and global warming potential 
• contribution to clean air  through emission savings 
The company wishes to enhance its disclosures but is unsure as to what 
the benefits would be for the co mpany and what constitutes curr ent 
practice. The problem that the di rectors envisage is how to mea sure and 
report the company’s performance. 
Required: 
Explain the factors that pro vide encouragement to companies to disclose 
social and environmental informa tion in their financial stateme nts, briefly 
discussing whether the content of s uch disclosure should be at the 
company’s discretion. (30 minutes)  
Describe how the current disclos ure by World Energy of its ‘Cor porate 
Environmental Governance’ cou ld be extended and improved. 

98 
 
 Test your understanding 16 (Case style question) 
 The directors of Glowball, a public limited com pany, have disc ussed a 
study by the Institute of Env ironmental Management which indica ted that 
over 35% of the world’s 250 larg est corporations are voluntaril y releasing 
green reports to the public to pro mote corporate environmental 
performance and to attra ct customers and investors. They have h eard 
that their main competitors are applying the ‘Global Reporting 
Initiative’(GRI) in an effort t o develop a worldwide format for  corporate 
environmental reporting. 
However, the directors are unsur e as to what this initiative ac tually 
means. Additionally they require advice as to the nature of any  legislation 
or standards relating to envir onmental reporting as they are wo rried that 
any environmental report produced by the company may not be of 
sufficient quality and may detra ct and not enhance their image if the 
report does not comply wit h recognised standards. 
Glowball has a reputation for ens uring the preservation of the 
environment in its business activities. 
Required: 
Prepare a report suitable for pres entation to the directors of Glowball in 
which you discuss the current r eporting requireme nts and guidel ines 
relating to environmental reporting. (30 minutes)

Chapter 2 
 99 
 ( a )  The need for management commentary  
Financial statements,  although useful, have limitations in that  they 
are highly summarised and prov ide historic information. 
Management commentary (MC) aims to  overcome these limitations 
by having a forward looking  focus and enabling management to 
expand on the information present ed in the financial statements . 
The management commentary provi des a narrative to the financial  
statements. It can therefore be used to explain the financial r esults 
within the context of the environm ent in which the entity opera tes. 
For example, whilst the financial results may not on their own be 
viewed as positive, the managemen t commentary provides director s 
with the opportunity to explain th at, within the context of the  
economic climate, the results s hould be considered positive. 
The typical information contained within management commentary 
would be: 
–  description of the nature of the entity's activities 
–  the entity's objectives and strategies to achieve those 
–  description of the entity's resources and the risks facing t he 
business 
–  narrative review of the current year's results –  key performance indicators –  non-financial information such as employment and 
environmental policies 
–  outline plan for the future  development of the business 
(b) Advantages and disadvantages to users  
The MC will provide information regarding the future prospects of an 
entity. This should enhance the users' ability to make more 
appropriate investment decisions. 
The narrative information should  give users a better understand ing 
of the performance and pos ition of the entity. 
Producing an MC voluntarily shows  the entity as being transpare nt 
and willing to communicate. Users may wish to consider such factors, as well as financial in formation, when making investme nt 
decisions.

100  
 Users can gain information on no n-financial factors addressed b y 
the entity such as how  the skills of the workforce contribute t o the 
performance of the entity and wh ether the entity have a respons ible 
attitude to the environment. 
Since the MC is voluntarily pr oduced, it is unlikely to be prep ared in 
a consistent manner between entit ies. Therefore users may not b e 
able to perform any meaningful comparison between different 
entities. 
Disclosing information regarding  future prospects of an entity may 
raise the expectations of users. Users may be disadvantaged in the 
future if the performance does not meet these expectations. 
The content of an MC i s at the discretion o f the directors. The y may 
therefore choose to only disclos e positive information. This re duces 
the reliability of the document for the users. 
The content of the MC is not audited. Again, this reduces the l evel 
of reliance that users may be willing to place on the informati on. 
 
 (a) The way in which companies m anage their social and environ mental 
responsibilities is a high leve l strategic issue for management . 
Companies that activel y manage these respon sibilities can help 
create long-term sust ainable performance in an increasingly 
competitive business environment. 
Reports that disclose transpar ent information will benefit 
organisations and their stakehol ders. These stakeholders will h ave 
an interest in knowing that the company is attemp ting to adopt best 
practice in the area. Instituti onal investors will see value in  the 
‘responsible ownership’ prin ciple adopted by the company. 
Although there is no universal ‘ best practice’, there seems to be 
growing consensus that high perfo rmance is linked with high qua lity 
practice in such areas as recrui tment, organisational culture, training 
and reduction of environmental r isks and impact. Companies that  
actively reduce environmental ri sks and promote social disclosu res 
could be considered to  be potentially more sustainable, profita ble, 
valuable and competitive. Many c ompanies build their reputation  on 
the basis of social and environmen tal responsibility and go to 
substantial lengths to prove tha t their activities do not explo it their 
workforce or any other section of society.

Chapter 2 
 101 
 Governments are encouraging disclos ure by passing legislation, for 
example in the area of  anti-discrimination and by their own exa mple 
in terms of the depth and breadth o f reporting (also by requiri ng 
companies who provide services t o the government to disclose su ch 
information). External awards and endorsements, such as 
environmental league tables and employer awards, encourage 
companies to adopt a more strate gic approach to these issues. 
Finally, local cultural and soci al pressures are causing greate r 
demands for transparency of reporting. 
There is no IFRS that determines  the content of an environmenta l 
and social report. While companies  are allowed to include the 
information they wish to disclos e, there is a lack of comparabi lity 
and the potential that only the positive actions will be shown.  
A common framework that provides  guidelines on sustainability 
reporting would be useful for bot h companies and stakeholders. 
The Global Reporting Initiative ( GRI) provides guidelines on th e 
content of a sustainability repor t, but these are not mandatory . 
However, a number of compani es prepare their reports in 
accordance with the guidelines a nd the GRI is becoming the 
unofficial best practice guide in this area. 
(b) Company B’s environmental  report should include the followi ng 
(i)  A statement of the environm ental policy covering all aspec ts of 
business activity. This can incl ude their aim of using renewabl e 
electricity and reducing their ca rbon footprint – the amount of  
carbon dioxide released into t he environment as a result of 
their activities. 
(ii) The management systems  that reduce and minimise 
environmental risks. 
(iii) Details of environment al training and expertise. 
(iv) A report on their environment al performance including veri fied 
emissions to air/land and water , and how they are seeking to 
reduce these and other environm ental impacts. Company B’s 
activities have a significant i mpact so it is important to show  
how this is dealt with. The emissi ons data could be graphed to 
show it is reducing. If they hav e the data, they could compare 
their carbon dioxide emissions o r their electricity usage over 
previous periods. Presenting th is information graphically helps  
stakeholders see how the business is performing in the areas 
it is targeting.

102  
 (v) Details of any environment al offence that resulted in 
enforcement action, fine, etc . and any serious pollution 
incident. They can disclose how fines have been reducing and state that there have not been any  pollution incidents in the 
current period. 
(vi) A report on historical tr ends for key indicators and a 
comparison with the corporate targets. 
 
 The answer is (A) and (C). 
These two sections should appea r in the social category of the specific 
standard disclosures, not the gener al standard disclosures. 
 
 The answer is (B), (C) and (D). 
The other two headings are Guidi ng Principles, not Content Elem ents, as 
defined by the <IR> Framework. 
 
Where information is omitted due  to confidentiality constraints , these 
should be explained. 
 
 The answer is (A), (C) and (D). 
The other two are Principles fo r Defining Report Content accord ing to the 
GRI. 
 
 The answer is (A), (C) and (E). 
(B) is an objective of sustainability reporting. (D) is irrelevant – investors a re more interested in the qualit y, not the 
quantity, of information available.

Chapter 2 
 103 
 The answer is (A), (B) and (C). 
The other two headings are Conten t Elements, not Guiding Princi ples, as 
 
Political donations have to be disclosed as part of the Public Policy 
aspect of the Social (Society) category. 
 
 The answer is (C), (D) and (H). 
(C) and (H) are simply the wrong way round i.e. Governance is r eally a 
content element and Consistenc y and comparability is a guiding principle. 
(D) should not appear in an Int egrated Report. However it would  appear 
as a specific standard disclosure in a sustainability report pr epared using 
the GRI Guidelines. 
 
The other two are Principles fo r Defining Report Quality accord ing to the 
GRI. 
 
Note that the Core and Comprehensiv e Disclosures mentioned in ( C) 
relate to the GRI G4 guideli nes, not the <IR> Framework. 
 
 The answers are (C) and (E). 
Internet for all is not one of t he specific goals, however impr oving access 
to technology would form part of the ‘Industry, Innovation and 
Infrastructure’ goal. 
Similarly recycling is not a s pecific goal, however it could co me under the 
goals for ‘ Responsible consumpt ion and production’, ‘ Life on land’ and 
‘Life below water’

104  
 Many of the arguments against discl osure stem from the fact th at 
disclosure is still voluntary. E ven in countries such as the UK , where 
many companies are now legally required to disclose relevant information, there may be few act ual requirements as to what ex actly 
should be disclosed. 
Several problems result: 
• The information disclosed may no t be complete or reliable. 
Environmental disclosures no rmally appear in the Chairman’s 
Statement, in the Operating and Financial Review or in a ‘stand  
alone’ environmental report. Theref ore they do not normally hav e to 
be audited and can be fr amed in very general terms. Entities ca n 
present information selectively so as to present their activiti es in a 
positive light. 
• A wide variety of information is disclosed and this may be bot h 
narrative and numerical (in the fo rm of key performance indicat ors). 
This means that is difficult to c ompare the performance of diff erent 
entities. Non-financial performanc e indicators may not be well 
understood by users and the basis o f their calculation may not be 
adequately explained. 
• The information may not be discl osed consistently from year to  year. 
This means that users cannot assess any progress that is being made. 
• Not all businesses disclose inf ormation. Those that do are oft en 
under particular pressure to pro ve their ‘green’ credentials (f or 
example, large public utility com panies whose operations direct ly 
affect the environment) or becaus e they have de liberately built  their 
reputation on environm ental friendliness or  social responsibili ty. This 
means that (understandably) the publ ic may view environmental 
reporting as little more than a cyn ical public relations exerci se and 
not pay much attention to any information presented. 
Some believe that ther e are fundamental probl ems to do with dis closure 
itself, rather than with the rele vance or reliability of the in formation: 
• Separate environmental reports and/ or disclosure in the Operat ing 
and Financial Review are no subs titute for clear disclosure of 
environmental costs in the financ ial statements themselves. Thi s 
would provide a far greater inc entive for entities to act respo nsibly. 
• Equally, disclosure does not sol ve the environmental problems that 
are disclosed. There is a school  of thought that believes that 
encouraging and praising voluntary disclosur e could create the 
impression that disclosure, in itself, is enough.

Chapter 2 
 105 
 Management may also have argum ents against disclosure: 
• Producing environmental disclosur es is time consuming and cost ly, 
particularly where these are in tended to be genuinely useful. I t may 
also harm a company’s reputati on, rather than enhancing it. A u seful 
report must be even handed , and must publish bad news as well a s 
good. Even if the company acts in good faith, there is a danger  that 
disclosure will be seen as merely  a public relations exercise. 
• A company that presents itself a s environmentally responsible in a 
‘standalone’ report may  find that this has an impact on the fin ancial 
statements. Undertaking publicly t o carry out particular course s of 
action (for example, to clean up environmental dam age) will cre ate 
a constructive obligation to do so, even where there is no lega l 
 
 Answer to the first task 
The way in which companies manage  their social and environmenta l 
Companies that activel y manage these respon sibilities can help create 
long term sustainable performance in an increasingly competitiv e 
business environment. 
Greater transparency in this ar ea will benefit organisations an d their 
stakeholders. These stakeholders will have an interest in knowi ng that 
the company is attempting to adopt best practice in the area. I nstitutional 
investors will see valu e in the ‘responsible ownership’ princip le adopted 
by the company. Although there is  no universal ‘best practice’ there 
seems to be growing consensus tha t high performance is linked w ith high 
quality practice in such areas  as recruitment, organisational c ulture, 
training and reduction of envir onmental risks and impact. Compa nies that 
actively reduce environmental ri sks and promote social disclosu res could 
be considered to be potentially m ore sustainable, profitable, v aluable and 
competitive. 
Many companies build their reputat ion on the basis of social an d 
environmental responsibility and go to substantial lengths to p rove that 
their activities do not exploit t heir workforce or any other se ction of 
society. Governments are encouragi ng disclosure by passing legi slation, 
for example in the ar ea of anti-discriminat ion and by their own  example in 
terms of the depth and breadth o f reporting (also by requiring companies 
who provide services to the gov ernment to disclose such informa tion). 
External awards and endorsements , such as environmental league tables 
and employer awards, encourage co mpanies to adopt a more strate gic 
approach to these issues. Finally, local cultural and social pr essures are 
causing greater demands for transparency of reporting.

106  
There are arguments for giving organisations the freedom to det ermine 
the contents of such reports and for encouraging common practic es and 
measures. Standardised reports m ay fail to capture important in formation 
in individual organisations and ma y lead to ‘compliance’ rather  than 
‘relevance’. At the same time , best practice would encourage 
consistency, comparability and re liability, providing a common framework 
which companies and stakehol ders might find useful. 
Answer to the second task – Corpor ate environmental governance 
The reporting of corporate envir onmental governance by World En ergy 
could be improved by including the following information in the  financial 
• a statement of the environmental  policy covering all aspects o f 
business activity 
• the management systems whic h reduce and minimise 
environmental risks (reference s hould be made to internationall y 
recognised environmental  management systems) 
• details of environmental  training and expertise 
• a report on their environmental p erformance including disclosi ng 
verified emissions to air/land and water, and how they are seek ing 
to reduce these and other environm ental impacts. Operating site  
reports could be prepared for lo cal communities for businesses with 
high environmental impacts 
• details of any environmental offe nce that resulted in enforcem ent 
action, fine, etc., and any serious pollution incident 
• a report on historical trends for key indicators and a compari son with 
the corporate targets 
• a simple environmental statem ent of comprehensive income and 
statement of financial position in cluding income and value deri ved 
from the environment, ex penditure on natural  resources, licence s 
etc., investment in ant i-pollution equipment. 
The environmental performance statements and r eport should be a udited 
and verified to recognise environ mental and auditing standards,  and 
companies should perhaps have a health, safety and environment 
committee.’

Chapter 2 
 107 
 Report to the Directors of Glo wball – Environmental Reporting 
The following report details the current reporting requirements  and 
guidelines relating to E nvironmental Reporting. 
Current reporting requirements and guidelines 
The initial goal of environmental reporting was simply to demon strate a 
company’s commitment to the env ironment. However, the debate ha s 
moved on and the central objecti ve of any environmental report is now to 
communicate environm ental performance. 
Wider ranging objectives may also  be attributed to the report, such as 
acknowledging shared responsibil ity for the environment, differ entiating 
the company from its competitors , obtaining social approval for  operating 
practices and demonstrating regulatory compliance. 
Reports in practice vary from a  simple public relations stateme nt to a 
detailed examination of the com pany’s environmental performance . 
Environmental accounting disclos ure is an assortment of mandato ry and 
voluntary requirements. 
Not all companies report on envir onmental performance and those  that 
do report often focus on only se lected aspects of performance. It is 
typically only the leaders in environmental reporting that repo rt in a 
comprehensive manner. 
In the UK, environmental reporti ng is voluntary although disclo sure of 
environmental matters such as t he business’s impact on the envi ronment 
is encouraged in a company’s ‘Oper ating and Financial Review’ b y the 
ASB’s Reporting Stat ement on best practic e on the operating and  
financial review. Accounting st andards on non-current assets, p rovisions, 
and research and development costs  mention the need to disclose  
environmental effects. 
This voluntary position contrast s with the situation in Denmark  and the 
Netherlands, which have passed l egislation making environmental  
disclosure mandatory for the larger companies. In the USA, the 
SEC/FASB environmental accounting standards are obligatory, alt hough 
the standards may not be policed as closely as other accounting  
standards. The International Acco unting Standards Board has not  as yet 
issued a standard in this area. H owever, IAS 37 Provisions, Con tingent 
Liabilities and Contingent Assets  requires disclosure of potent ial 
environmental liabilities in certain circumstances.

108  
 There is a range of codes of pra ctice and environmental reporti ng 
guidelines that have been publish ed. The Global Reporting Initi ative’s 
Sustainability Reporting Guidelin es, published by the Coalition  of 
Environmentally Responsible Econom ies (CERES), has become the d e 
facto standard worldwide. The GR I provides a set of principles to enable 
investors and others to assess environmental performance. 
There is a whole range of gover nmental, academic, professional body 
and international agencies tha t have published reports and guid elines 
that can be accessed and downlo aded from the Web. Under the Eco  
Management and Audit Scheme (EMAS) , companies can sign up to 
agree to a specific code of pra ctice, but the report must be va lidated by 
an accredited environ mental verifier. 
The Companies Act 2006 now require s the directors of UK quoted 
companies to report on environmental matters, the company’s emp loyees 
and social/community issues. 
In summary, environmental repor ts can enhance a company’s reput ation 
and standing, and the use of env ironmental reporting will expan d. 
Currently, except in a few s pecific countries, this form of act ivity reporting 
is voluntary and, therefore, the ex tent of disclosure varies si gnificantly. 
However, until regulation and standards are developed, the 
completeness and consistency o f environmental r eports will not be 
achieved. Similarly best practic e in the attestation of the rep orts also 
needs establishing. 
Environmental reporting is impor tant to large companies as it i s no 
passing phase. The main question  is as to the form and content of the 
environmental report.

109 
Development of financial 
strategy 
A2: Analyse strategic 
financial policy decisions 
 Analyse the following policy 
(a) Investment  (b)  Financing 
(c)  Dividends (d)  Interrelationships 
between them 
A3: Discuss the external 
influences on financial strategic decisions Discuss the influence of the 
following on financial strategic decisions 
(a) Market requirements (b) Taxation 
(c) Regulatory requirements 
• Use of policy decisions to  meet cash needs of entity 
• Sensitivity of forecast financia l statements and future cash 
position to these policy decisions 
• Considerations of the inte rests of stakeholders  
• Lenders' assessment of creditworthiness  
• Consideration of domestic and international taxation 
• Consideration of industry r egulations such as price and 
service controls Chapter 
3

Development of financial strategy 
110  
 
 Strategy:  A course of action, including t he specification of resources 
required, to achieve a specific objective. (CIMA  Official Termi nology, 
2005) 
Financial strategy  is the aspect of strategy w hich falls within the scope 
of financial management, which will include decisions on invest ment, 
financing and dividends. 
Strategic financial management:  The identification of the possible 
strategies capable of m aximising an entity’s net present value,  the 
allocation of scarce capital re sources among the competing oppo rtunities 
and the implementation and monitoring of the chosen strategy so  as to 
achieve stated objectives. (CI MA Official Terminology, 2005) 
The importance of financia l strategy to an entity 
An entity's financial managers mus t plan their courses of actio n to achieve the 
entity's financial objectives. 
The key consideration is how  should the entity generate cash, a nd what is the 
best use of this key finite resource? 
For example, should new investm ents be undertaken, and how larg e a dividend 
should be paid? 
This chapter identifies the three key decisions in financial st rategy and looks at 
the links between them.

Chapter 3 
 111 
 2 The key decisions of financial strategy 
We saw in the earlier Chapter 1: 'Objectives', that entities us ually have financial 
objectives that encourage investment and growth. 
However, before any investment decisions can be made, the entit y's managers 
will have to assess whether they have enough cash to make the n ew 
investments, or whether additi onal finance will have to be rais ed. 
Therefore, the three key decisi ons in financial strategy are: 
• Investment – what projects s hould be undertaken by the organis ation? 
• Financing – how should the necessary funds be raised? 
• Dividends – how much cash shoul d be allocated each year to be paid as a 
return to shareholders, and how muc h should be retained to meet  the cash 
needs of the business? 
These three areas are ver y closely interlinked. 
Investment decision 
Financial managers have responsibil ity for the allocation of fi nancial resources 
to achieve the organisation's obj ectives. An important part of their job is to 
understand the short, m edium and long-term capital requirements  for 
investment in fixed assets and wo rking capital that fits with t he overall strategy. 
Whilst financial managers are unlik ely to be solely responsible  for the final 
choice of capital investment pro jects to be undertaken, they wi ll be actively 
involved in the evaluation of po ssible investment opportunities . 
 
 More detail on the investment decision 
 When considering whether a proje ct is worthwhile, a company mu st 
consider its implications. Any potential investment is likely t o affect: 
• The liquidity of the company  – All projects involve cash flows in 
and out. The size and timing of suc h flows should be considered  
when appraising projects. If an ai m of investment appraisal is to 
satisfy shareholders then it is important to remember that, if a 
company has no cash, it cannot pay a dividend. 
• The reported profit and earnings  – All projects will change the 
revenues, expenses and asset values shown in the financial accounts. If shareholders are concerned about such statistics a s 
earnings per share, then the effe ct of investments on reported 
figures must be part of the investment appraisal.

112  
 • The variability of cash flows and earnings  – Investors are 
concerned about the variability of r eturns from their investmen ts. 
The greater the variability, the greater the risk, and therefor e the 
greater the return they will require. Thus, when appraising pot ential 
projects, managers shoul d consider not only the likely size and  
direction of cash flows and prof its but also whether they are l ikely to 
add to or reduce the variability of such flows. 
Financing decision 
For both non-current asset and work ing capital investment, the financial 
manager must decide on the mos t appropriate type and source of funding. 
This will include such considerations as: 
• the extent to which requirem ents can be funded internally, fro m the 
organisation's operations. This will involve considerations of dividend 
policy and tax implications; 
• if new, externally provided, finance is required, whether it s hould be in the 
form of equity or debt finance. Thi s may affect the level of ge aring (the 
ratio of debt to equity finance) w hich can have implications fo r returns 
required by the prov iders of capital; 
• the extent to which working c apital should be financed by long -term 
finance or short-term credit. 
 
 More detail on the financing decision 
 Financing decisions relate to acquiring the optimum finance to  meet 
financial objectives and seeing  that non-current assets and wor king 
capital are effectively managed. 
Optimum level of cash to hold 
The first decision that the fi nancial manager will have to make  is how 
much cash should be held by the business as a buffer against unexpected costs. 
Key considerations are: 
• Trade off (too much cash v too little cash) 
Holding too little cash will pot entially leave the entity subje ct to 
liquidity problems and possible liquidation. However, holding t oo 
much cash has an opportunity c ost (lost interest on deposits, o r 
returns on attractive investment s) and leaves an entity vulnera ble to 
a takeover bid. The financial manager has to balance the trade- off 
between these issues and identify  the optimum level of cash to hold.

Chapter 3 
 113 
 • Flexibility  
Holding cash means that the entit y can adjust its business plan  (for 
example pursue a takeover opport unity or invest in a new projec t) 
rapidly without needing to  raise finance first. 
• Expectations of shareholders 
An entity needs to consider whether its shareholders could make  
better use of the cash themselv es. The shareholders invest mone y 
in the expectation t hat the entity will invest it to create wea lth. 
Theoretically, the entity should only hold cash if the managers  
expect to be able to use it to  increase the wealth of the 
Sources of finance 
The financial manager must posse ss a good knowledge of the sour ces of 
available funds and their respec tive costs, and should ensure t hat the 
entity has a sound capital struct ure, that is, a proper balance  between 
equity capital and borrowings. Suc h managers also need to have a very 
clear understanding of the differe nce between profit and cash f low, 
bearing in mind that profit is of  little avail unless the entit y is adequately 
supported by cash to pay for asse ts and sustain the working cap ital cycle. 
Financing decisions also call fo r a good knowledge of evaluatio n of risk: 
excessive borrowing carries hig h risk for an entity’s equity be cause of the 
priority rights of the lenders. 
A major area for risk-related dec isions is in establishing fore ign 
subsidiaries, where an entity is v ulnerable to currency fluctua tions. 
Foreign debt is often appropria te to create a hedge of the chan ge in value 
of the net investment in the subs idiary as a result of currency  
movements. 
Benefits of matching character istics of investment and financin g 
The matching approach to financi ng is where the profile of the of the 
entity’s financing matches the pr ofile of the assets being fund ed. 
This principle can be applied to  the matching of maturities. 
For example, using long-term  finance to fund both non-current a ssets and 
permanent current assets, and fin ancing fluctuating current ass ets by 
short-term borrowings. 
It makes sense to fund long term assets with long term finance since it 
gives security that the finance wi ll be in place for the life o f the asset, and 
also so that the economic benefit s from the assets can help rep ay the 
finance. 
The finance will mature (and hopef ully be repaid where applicab le) at a 
similar time to the asset being disposed of. New finance can th en be 
obtained to fund the replacement asset.

114  
Nearly all companies will have a certain level of current asset s and 
working capital permanently tied up in the business (e.g. a min imum level 
of receivables and inventory). Since this is always required, i t is often 
called ‘permanent current asse ts’ and is often funded with long  term 
finance. 
Dividend decision 
Dividends provide important ret urns to shareholders and can be seen as an 
indicator of success of the bus iness. Shareholder returns compr ise both 
increase in share price and cash  in the form of dividends. 
When deciding on the type of inv estment and level of finance ne eded, the 
financial manager must have regard  for the potential effects on  the risk and 
level of dividends payable to s hareholders. If the shareholders  are not happy 
with their return, they will be reluctant to invest further, wh ich in turn will affect 
the funding available for future  investment. However, the cash needs of the 
business must also be considered. 
The business may wish to retain cash resources to finance inves tments rather 
than increase gearing by raising new funding. Cash resources ma y also be 
retained in order to provide r apid access to funds to respond t o investment 
opportunities that might arise in the future or to provide flex ibility in the face of 
poor trading conditions. 
The dividend decision t hus has two elements: 
• the amount to be paid out, and 
• the amount to be retained to s upport the growth of the entity ( note that this 
is also a financing decision). 
The level and regular growth o f dividends represent a significa nt factor in 
determining a profit-making entit y’s market value, that is, the  value placed on its 
shares by the stock market. 
 
 Links between the three key decisions 
It is clear from the discussions a bove that the three areas are  closely 
interrelated. 
Investment decisions cannot be ta ken without consideration of w here and how 
the funds are to be raised to fi nance them. The type of finance  available will, in 
turn, depend to some extent on t he nature of the project – its size, duration, risk, 
capital asset backing, etc. 
Dividends represent the payment of r eturns on the investment ba ck to the 
shareholders, the level and risk of which will depend upon the project itself, and 
how it was financed. 
Debt finance, for example, can be cheap (particularly where int erest is tax 
deductible) but requires an intere st payment to be made out of project earnings, 
which can increase the risk of  the shareholders' dividends.

Chapter 3 
 115 
3 The impact of investment, financing and dividend decisions on  
financial ratios 
It is important to consider the inter-relationship between inve stment, financing 
and dividend decisions when asse ssing the impact of the decisio ns on the 
entity's ratios. 
Examples of inter-relationships 
1 An investment decision to under take a profitable project, fin anced by 
raising new debt or equity finance , may impact several importan t investor 
and lender ratios such as earning s per share, earnings yield an d interest 
cover.  
 
 Seed Co is considering an invest ment of $20m which is expected  have 
an NPV of $8m, and is expected to  increase profit before intere st and tax 
by $4m per annum. 
Extracts from the most recent fi nancial statements of Seed Co: 
Statement of financia l position extracts $m 
Share capital ($1 shares)  16 
Reserves 48 
Long term borrowings  56 
Statement of profit or loss extracts $m 
Profit before interest and tax 15.0 Interest (4.0)  —— 
Profit before tax  11.0 
Tax at 30% (3.3)  —— Profit after tax (earnings) 7.7 
 —— 
The current share price of S eed Co is $2.70 per share. 
The directors of Seed Co are cons idering two alternative ways o f 
financing the new investment. 
• borrow the $20m at an inte rest rate of 6% per annum, 
• raise the funds using a 1 for 2 rights issue at $2.50 per shar e. 
Assume that this would cause the share price after the issue 
(BEFORE taking account of the project NPV) to fall to $2.63.

116  
 Required: 
(a) Prepare profit forecasts fo r Seed Co for next year under bo th 
financing options, assuming that  the new project goes ahead. Us e 
the forecasts to calculate the impact of the project and each 
financing option on Se ed Co's interest cover, earnings per shar e 
and earnings yield ratios. 
(b) Based on the results of your  calculations, discuss the like ly reaction 
of the shareholders and the lend ers to each of the possible 
financing options. 
2 Financing requirements and cash  available for payment of divi dends are 
determined based on the overall c onsideration of the forecast f uture cash 
flows arising from investment decisions, business strategy and forecast 
business and economic variables. 
 
 Test your understanding 2 (O bjective test question) 
 The Finance Director of CP has c alculated that the company nee ds to 
raise some additional long term funds to provide finance for th e following 
three proposals. 
• CP’s trade payables are current ly $3.15 million. Suppliers hav e 
expressed dissatisfaction that t he company currently takes 45 d ays 
to pay. They would like to be paid 10 days quicker. 
• The bank overdraft has been close  to its limit for the last 6 months, 
and the bank is putting pressure on CP to reduce the overdraft from 
its current level of $2. 2 million to $2 million. 
• Over the past three years t he annual revenue of CP has stagnat ed, 
so the directors are consideri ng expanding operations. Capital 
expenditure of $1 m illion would be required  to expand the exist ing 
distribution facilities. 
How much finance needs to be rai sed in total to fund these thre e 
proposals? 
A $1.90 million  
B $3.65 million  C $4.35 million  D $6.35 million

Chapter 3 
 117 
3 A change in dividend policy can have an immediate impact on s ome 
investor ratios such as dividen d cover and dividend yield. Howe ver, there 
may also be other, less obvious, i mpacts. For example, reducing  the level 
of dividend paid out one year could increase the amount of fund s available 
for re-investment, so there mi ght well be an increased level of  growth in 
profit which could impact ratio s such as earnings per share. 
 
 Illustration 1 (Integration question) 
 Elbow Co is an all equity financ ed company with a functional c urrency of 
British pounds (GBP). It has 10 million GBP 1 shares in issue. The 
directors of Elbow Co are consid ering a change in dividend poli cy at the 
end of this year. 
Historically the company has pai d out 30% of its profits as a d ividend. 
However, the directors have iden tified a new project that they want to 
invest in. The necessary funds fo r investment could be found by  cutting 
the dividend payout ratio to 10%  of profits for this year only.  
Forecast profits for the curren t year are GBP 10 million. Next year's 
profits will be 15% hig her if the dividend is cut and the new p roject 
undertaken. Otherwise, profi ts will stay constant. 
Required: 
Calculate the dividend per shar e and the earnings per share for  this year 
and next year, on the assumption that: 
(a) the dividend is cut and t he project is invested in. 
(b) the dividend pay-out is le ft unchanged and the project is n ot 
undertaken. 
Solution: 
Current year: 
The current year's profit is fo recast to be GBP 10 million, so whether the 
dividend is cut and the project is undertaken or not, the earni ngs per 
share (EPS) will be 
GBP 10m/10m = GBP 1. If the dividend is cut, to 10%  of profits, the dividend per sha re (DPS) will 
therefore be 10% of this, i.e. GBP 0.10. 
If the dividend is not cut, so re mains at 30% of profits, the d ividend per 
share (DPS) will be 30% of this, i.e. GBP 0.30.

118  
 Next year: 
No project: 
Next year's profit is forecas t to stay at GBP 10 million if the  project is not 
undertaken, so EPS will be 
GBP 10m/10m = GBP 1. DPS is expected to stay at 30% of this, so will be GBP 0.30. 
With project: 
Next year's profit is forecast to  grow by 15% (to GBP 11.5 mill ion) if the 
project is undertak en, so EPS will be 
GBP 11.5m/10m  = GBP 1.15 
We are told that the dividend cut i s expected to be for only on e year, so 
DPS next year will revert to 30%  of EPS, i.e. 30% × GBP 1.15 = GBP 
0.345 
4 Objectives and economic forces 
When setting the company's financ ial strategy the financial man ager is often 
influenced by external economic forces. 
For example, significant ex pansion and an incr ease in dividends  may become 
uneconomic if interest rates are set to rise (thus increasing t he amount payable 
to banks and other deb t finance providers). 
 
 External influences on financial strategy 
 Major influences include: 
• The need to maintain good invest or relations and provide a 
satisfactory return on investment 
• Limited access to sources of finance, either due to weak 
creditworthiness or lack of li quidity in the banking sector and  capital 
markets 
• Gearing level. The main argumen t in favour of gearing is that 
introducing borrowings into the c apital structure attracts tax relief on 
interest payments. The argument against borrowing is that it introduces financial risk into the entity. Financial managers h ave to 
formulate a policy that balanc es the effects of these opposing 
features. 
• Debt covenants. These are clauses  written into debt agreements  
which protect the lender's inter ests by requiring the borrower to 
satisfy certain criteria (e.g. a  minimum level of interest cove r) 
• Government influence (see below) 
• Regulatory bodies (see below)

Chapter 3 
 119 
• Major economic influences, such as interest rates, growth in G DP, 
inflation rates and exchange rate s. The effects of interest rat e and 
inflation changes on the ec onomy are covered below. 
• Accounting concepts. 
Government influence 
Governments often play a large part in influencing business act ivity. 
Some examples of the way in whi ch governments can have an influ ence 
are as follows: 
• Employment policy. Governments play a major role in attempting  to 
stimulate employment. They can do this by funding vocational 
training programmes and fundi ng employment programmes. 
• Regional policy. Governments ma y make funds available to suppo rt 
regions of high unemploymen t and social deprivation. 
• Taxation policy. The government  raises taxes on the profits 
generated by profit-making entit ies and on shareholders’ divide nds. 
• Legislation. Laws set out how  people can and should behave 
towards one another, and particularl y, how business should be 
conducted. 
 
 Regulatory requirements 
 Developing financial strategy  in the context of regulatory 
The financial manager must have a proper understanding of those  
aspects of legislation which impa ct upon entities. Such legisla tion will 
include the Companies Acts, heal th and safety regulations, laws  relating 
to consumer protection and consum er rights, laws relating to co ntract and 
agency, employment law and laws r elating to protection of the 
environment and promot ing competition. 
Listed companies also have to com ply with Stock Exchange regula tions, 
and entities which operate in som e high profile industries will  also find 
regulatory bodies monitoring thei r performance. For example, in  the UK, 
Oftel (telecommunications), Ofc om (media) and Ofwat (water) hav e been 
set up by the government to monit or and regulate their respecti ve 

120  
 Regulatory bodies 
A clear set of objectives is requi red for each regulatory body.  In general 
terms, a regulatory bo dy will have the power  to impose price co ntrols or 
service controls (i.e. to dictate  prices or the quality of serv ice delivered). 
The objectives may be cl assified under three headings: 
1 The promotion of competition. 
2 The protection of customers from monopoly power. 3 The promotion of social and macroeconomic objectives. 
1 Competition  
Where a market is not competitiv e, or is in the early stages of  
becoming so, there is a need for r egulators whose role is to tr y to 
balance the interests of t he various stakeholders. 
Important issues for regulation ar e the prevention of ‘cross-su bsidy’, 
that is the transferring or offl oading of portions of overhead costs 
from lower- to higher-margin pr oducts, the limitation of non-pr ice 
barriers affecting the entry o f new competitors, and assuring 
reasonable quality of product in re lation to price. Non-price b arriers 
could include trade restrictions , or restricted access to suppl ies or 
distribution channels. 
2 Monopoly power 
Where market participants are judged to possess significant mar ket 
power, and where there is no other protectio n for customers, 
controls on prices and on quality of service may be considered.  
3 Social objectives 
Government objectives may incl ude the availability and affordab ility 
of services in particular areas  and to particular groups such a s 
customers in remote rural areas . Regulators often use a 'public  
interest test' to assess whether an entity's strategy is accept able – 
for example strategies comprom ising national security could be 
blocked.

Chapter 3 
 121 
5 The impact of taxati on on financial strategy 
The financial manager will have to consider the taxation implic ations of all his 
decisions when setting the entity' s financial strategy. For com panies with 
operations in several countri es, there will be both domestic an d international tax 
implications. 
Specific tax rules differ from  country to country, but some gen eral points are 
explained below. 
Domestic tax implications 
Any profits generated by a new i nvestment project will be taxab le. However, tax 
allowable depreciation will norma lly be available on assets pur chased, to 
reduce the overall tax liability. 
Debt interest is tax deductible . Therefore if the entity decide s to finance new 
investments through debt finance , there will be tax savings whe n the interest is 
paid. This is not the case wit h dividends to shareholders (if e quity finance is 
used). 
Dividends to shareholders will be tax ed under income tax rules.  However, if the 
entity chooses not to pay out a d ividend, any increases in shar e price will be 
taxed under capital gains tax rule s when the shares are sold. T herefore, most 
investors have a preference as  to whether they'd like the entit y to pay out a 
dividend or not. 
Where the entity meets certain conditions its shares may be iss ued under 
special schemes that a llow the investor tax relief on the inves tment, and/or 
when the shares are sold. An ex ample is the Enterprise Investme nt Scheme in 
the UK, which is intended to enc ourage investors to subscribe f or new shares in 
unquoted trading companies. 
International tax implications 
The main additional tax consider ation for an entity with intern ational operations 
is how to minimise the overall  tax liability of the internation al entity. 
For example, a decision will need to be made as to where the he ad office of the 
entity should be located. Multinat ional companies are often att racted to set up 
their operations in a low tax economy. 
Also, the group's transfer prici ng policy will be an important consideration. Tax 
authorities only allow transfer prices that are set at a fair, 'arm's length' level, so 
there is no opportunity to manipul ate the entity's tax liabilit y. The authorities will 
disallow any transfer prices tha t are considered to be set pure ly for the 
purposes of moving as much profi t as possible into the lowest t ax country. 
The tax authorities also monitor royalties and management charg es alongside 
transfer prices. Any royalties  or management charges paid from one group 
company to another will not be a llowed if the authorities feel that they are being 
used to increase profits in one group company (based in a low t ax country) at 
the expense of another (based in a higher tax country).

122  
6 The lender's assessment of creditworthiness 
When an entity (a borrower) is s eeking to raise debt finance, t he lender (for 
example the bank) will carry out  an assessment of the borrower to decide 
whether to lend. 
Information presented by the borrower to the lender 
In order to apply for the debt fi nance from a bank or other len der, an entity will 
have to put together a business plan. This will contain importa nt information 
regarding the borrower's plans, such as: 
• the purpose, amount and dur ation of the borrowing 
• detailed cash flow forecasts, s howing the likely cash flows of  the borrower 
and aiming to show the lender tha t the prospects for the borrow er are 
good 
• an explanation of how the borro wer is proposing to repay the b orrowing. 
Assessment of creditworthiness by the lender 
The lender will carry out an a ssessment of the potential borrow er by considering 
the following information: 
• Analysis of business plan 
The lender will perfo rm a detailed analysis of the business pla n presented 
by the potential borrower. This will include detailed ratio ana lysis of the 
potential borrower's recent acc ounts and forecasts (see detail on ratio 
analysis below). 
• Business prospects of t he potential borrower 
An analysis of the business pl an will give the lender an initia l insight into 
the business prospects of the borrower. However, it will be imp ortant for 
the lender to carry out further analysis in an attempt to build  up an 
independent assessment of the pros pects of the borrower. For ex ample, 
the lender will assess 
–  the quality and track record  of the borrower's management 
–  the risk profile of the company –  the prospects for the industry sector – e.g. c ompetitor grow th, market 
share trends etc. 
• Security available 
The lender will look  at the statement of fi nancial position of the potential 
borrower to assess whether there are assets that could be used to provide 
security for the borrowings. Lendi ng the money secured on asset s of the 
borrower would significantly r educe the risk to the lender.

Chapter 3 
 123 
• Credit rating 
The credit rating of the borrower is also an important factor. An entity with 
a poor credit rating will find it m ore difficult to borrow mone y. If the lender 
does decide to lend, a higher int erest rate would be charged to  
compensate for the risk  taken on by the lender. 
• Other borrowings and covenants 
The risk to the lender will be hi gher if the potential borrower  is already 
highly geared and has debt covenants attached to its existing b orrowings. 
If the potential borrower has ot her borrowings and hence intere st 
commitments, this could increas e the risk to the new lender by reducing 
the amount of cash available to pay the interest on the new bor rowing and 
possibly reducing the availabilit y of assets to be used as secu rity. 
The existence of covenants on ex isting borrowings could also ca use 
problems for a new lender, especia lly if the covenants give pri ority to 
existing lenders over  any new lenders. 
Use of ratio analysis 
The analysis undertaken by the l ender will use many of the rati os that were 
covered in Chapter 1: 'Objectives'. 
The key objective of the lender  will be to assess the liquidity  of the potential 
borrower i.e. whether the borrowe r's cash flows will be suffici ent to pay the 
interest and repay the capital according to the proposed repaym ent schedule. 
For example, the interest cover  ratio will be particularly impo rtant, since it gives 
an idea of how likely it is t hat the firm will continue to be a ble to meet its interest 
payments even if profits fall. 
Lenders might be even more interes ted in calculating interest c over with regard 
to EBITDA or cash (rather than pr ofits) to give a more practica l measure of 
cover. 
Other ratios such as t he stock market ratios (P/E ratio in part icular) will also give 
the lender a feel for how the rest  of the market views the firm . If the firm has a 
high P/E ratio, its growth prospects are good, so lending to su ch a firm would be 
perceived as low risk.

124  
 Rationale for analysing gearing 
 Analysis of capital structure 
The gearing ratio is an important measure o f risk. It is import ant to 
analyse, particularly for users such as shareholders and credit ors, the 
ability to satisfy debts falli ng due after one ye ar. There are two elements 
to consider: repayment of capi tal and payment of interest. 
The assessment of an entity’s gearing risk can be identified fr om two 
areas. The statement of financial pos ition shows the current li quidity and 
capital structure of  the entity, that is t he short-term liquidi ty and the level 
of fixed prior charge capital . The statement of profit or loss shows the 
profitability of the ent ity generally, indicating its ability t o generate cash, 
some of which may be available to repay debt. 
The capital structure of the en tity provides information about the relative 
risk that is accepted by shareho lders and creditors. As long-te rm debt 
increases relative to share-holders’ funds then more risk is as sumed by 
decreasing resources available for the shareholders. As risk in creases, 
creditors require higher interes t in order to compensate for th e higher risk. 
the business from lenders will be used to generate revenue and profits. 
As interest costs are fixed, any profits generated in excess of  the interest 
to the use of debt in the busi ness. If the cash from the debt d oes not raise 
completely. 
Interpretation of gearing ratios 
A high proportion of debt finance in the entity's capital struc ture is seen 
as being risky by the entity's s hareholders (which causes them to 
demand higher returns on  their equity – see  the later chapter: 'Financing 
– Capital structure' for more details). 
However, it is difficult to gi ve any practical guidance as to w hat a 'safe' 
level of gearing might be. Compar e the gearing ratio to prior y ears and 
budgets, and to the gearing ratio of similar entities, to asses s whether it 
looks too high. Also, consider i n particular the level of non-c urrent assets 
on the statement of financial pos ition which could be used for security. A 
high level of non-current assets ( much higher than the current value of 
debt finance) indicates that potent ially the entity should be a ble to raise 
more debt finance quite easily.

Chapter 3 
 125 
 Statement of profit or loss 
An interest cover ratio less t han 1 indicates that the entity i s having 
trouble servicing its debt financ e. The higher the ratio is abo ve 1, the 
easier it should be for the entit y to continue paying its inter est, so the less 
risky the entity appears to be. 
However, note that a lack of cas h, rather than a lack of profit , is usually 
the reason why a company fails to  meet its interest obligations . This is 
why analysts often substitute EBI TDA (or even cash flow) into t he formula 
instead of profit, to give a mo re useful measure of cover. 
Independent credit rating agencies 
In order to help with the assessm ent of creditworthiness, credi t ratings issued 
by an independent credit rating agency will often be considered . 
Moody's and Standard and Poor's ( S&P) are the two biggest credi t rating 
agencies. Each of these agencies aims to provide a rating syste m to help 
investors determine the risk asso ciated with investing in a spe cific company, 
investing instrument or market. 
So for example, for a public issu e of bonds, the company will o btain a specific 
rating for that issue from a rat ing agency before the issue tak es place. 
Setting credit ratings 
These large credit rating agencie s monitor the performance of a ll major 
businesses and rate them according  to how likely it is that the y will be able to 
afford to repay any debts. 
The rating agency will focus on: 
• Plans and forecasts of the company 
• The strength and trends in the i ndustry in which the company o perates 
and the company's competitive pos ition within that industry. 
• Country risks – the polit ical and regulatory risks 
• The quality of the m anagement team, including experience and t rack 
record 
• Corporate attitude to risk taking 
• Financial position – including capital structure and current d ebt profile 
• Financial ratios 
• Any parental support such as guarantees.

126  
Updating of credit ratings 
The ratings agencies are const antly assessing the performance o f entities, and 
will update their ratings regularly. 
For example, if an entity releas es some worse-than-expected fin ancial results, 
or if market analysts predict tha t an entity is likely to perfo rm worse than 
previously thought, the ratings agenc ies may react by downgradi ng the entity's 
credit rating, or warning of a possibly future downgrade by iss uing a Negative 
Outlook statement. 
This could have a significant i mpact on the enti ty's plans to r aise new finance e.g. 
the entity might have  to delay a planned de bt issue until such time that the rating 
rises again, or an issue currently  in progress might not be ful ly subscribed. 
 
 The meaning of credit ratings 
 The different credit rating agenc ies use different terms to de scribe high 
risk and low risk companies or is sues, as shown by the followin g table: 
Moody's S & P Grade Risk 
Aaa AAA Investment Lowest risk 
Aa AA Investment Low risk 
A A Investment Low risk Baa BBB Investment Medium risk Ba, B BB,B Junk High risk 
Caa, Ca, C CCC,CC,C Junk Highest risk 
C D Junk In default 
A rating can refer to an entity' s specific financial obligation  or to its 
general creditworthiness. 
Thus, for S&P, an 'AAA' rating signifies the highest investment  grade and 
means that there is very low cr edit risk. 'AA' represents very high credit 
quality; 'A' means high credit quality, and 'BBB' is good credi t quality. 
These ratings are considered to be investment grade, which mean s that 
the security or entity being ra ted carries a quality level that  many 
institutions require when c onsidering investments. 
Ratings that fall under 'BBB' (for  S&P) are considered to be sp eculative 
or junk grade. This is i ndicative of high risk. 
The link between credit ratings and interest rates 
An entity rated 'AAA' (the bes t rating) by Standard and Poor's is a very low risk 
investment. 
Consequently, a lender would genera lly set a relatively low int erest rate on a 
loan to an 'AAA' entity. By cont rast, a lower rated entity woul d generally have to 
pay higher rates of interest (or  might struggle to raise debt f inance at all if its 
rating were especially low). 
This is because risk and return a re always linked: if an invest or is likely to face 
high risks, he demands a high retu rn to compensate him for this  risk.

Chapter 3 
 127 
7 End of chapter objective test questions 
 Which of the following financia l ratios is likely to be of LEAS T 
interest to a lender when assessi ng the creditworthiness of a 
borrower? 
A  Interest cover 
B  Gearing C  Operating profit margin D  EBITDA to finance charges ratio 
 
 White Co has 1 million shares in issue. The shares have a nomi nal value 
of $1 and are currently  trading at $2.00. White Co's P/E ratio is 7.05. 
The directors are considering raising $400,000 in order to unde rtake a 
new project. It is expected that  the new project will cause ear nings to rise 
by $30,000 each year. 
If White Co uses a 1 for 4 right s issue to raise the finance, w hat is 
the expected earnings per share ( EPS) of White Co after the fin ance 
has been raised and the project undertaken? 
A $1.60 
B $1.41 C $0.28 D $0.25 
 
 A company has 20 million $0.50 or dinary shares in issue and th e current 
share price is $1.33. 
A proposed new project is expecte d to have an IRR of 15% and an  NPV 
of $8 million and require s an initial invest ment of $10 million . 
If the market is efficient and the share price moves to reflect  this 
information on the day that the  project is announced, what is t he 
theoretical movement in the  share price on that day? 
A No change 
B $0.40 increase C $0.90 increase D $0.20 increase

128  
 Lazaretto Co is a listed com pany. It has 1 million $1 shares i n issue, 
trading at $3.01, and 10,000, 5% coupon bonds with par value $1 00 and 
market value $95. 
The company made an operating pr ofit of $1.33 million last year . 
The directors are considering issuing 5,000 new secured bonds a t their 
par value of $100. The c oupon rate will be 4%. 
What will be the interest cover  of Lazaretto Co in the year aft er the 
bonds are issued, on the assumption that operating profits will  stay 
constant? 
A 19.0 
B 26.6 C 28.0 D 66.5 
 
 Company X's bonds have a BBB cr edit rating according to Standa rd and 
Poor's credit rating agency, wh ile Company Y's bonds have an A rating. 
Which THREE of the followi ng statements are true? 
A  Both companies' bond s are investment grade 
B  Both companies' bonds carry a low level of risk 
C  The investors in Company X's  bonds will require a higher rat e of 
return than those in Company Y's bonds 
D  The coupon rate on Company X 's bonds will be higher than the  
coupon rate on Company Y's bonds 
E  A movement to a BB rating woul d represent a downgrade for bo th 
companies

Chapter 3 
 129 
 The directors of McCombs Co, an unlisted compan y, have identif ied an 
attractive (positive NPV) proje ct which is expected to generate  positive 
cash flows for the company over a five year period. Finance is needed to 
fund the purchase of a new mac hine to use in the project. 
Which of the following financ ing decisions would be most 
appropriate in these circumstances? 
A Extend the overdraft to fund the investment  
B Issue new shares to existing shareholders  C Issue some new bonds on the market D Arrange a term loan with the bank 
 
 Which TWO of the follo wing actions are MOST likely to increase 
shareholder wealth? 
A  The average cost of capital is decreased by a recent financi ng 
decision 
B  The financial rewards of direc tors are linked to increasing earnings 
per share 
C  The board of directors decides  to invest in a project with a  positive 
net present value 
D  The annual report declares full compliance with the corporat e 
governance code 
 
 BB Co hopes to pay out an incr eased dividend to satisfy its sh areholders, 
despite the fact that earnings h ave fallen by 3% this year. 
Which of the following is NOT a  likely consequence of this acti on? 
A  The company will have less ca sh available for new investment  
projects 
B  The shareholders' w ealth will increase 
C  The company is more likely to  have to raise finance from new  
sources if it wants to  make new investments 
D  The gearing of the co mpany will increase

130  
 MFW is considering a $1 million expansion of its business. 
The directors are considering either debt finance in the form o f a 7% 
bond, or issuing 400,000 ordinary s hares at a price of $2.50 to  raise the 
necessary funds. 
The expansion will ge nerate $500,000 of extra  operating profit each year. 
MFW pays tax at 25%. Key investo r ratios for MFW are currently as 
follows: 
Gearing  = (debt/equity) = $2. 5m/$7.2m = 34.7% 
Interest cover  = (Earnings before interes t and tax/Interest payable)  
= $2,522,000/$223,000 = 11.3 times 
Earnings per share (EPS)  = (Profit after tax/No. of shares)  
= $1,724,000/3, 000,000 = $0.575 
Which of the following statements is correct? 
A  Interest cover is reduced using either source of finance 
B  EPS increases more by using debt C  Equity reduces gearing and gives the best EPS 
D  EPS and interest cover both worsen using debt 
8 End of chapter case style question 
 Test your understanding 12 (Case style question) 
 CCC is a local government entity. 
It is financed almost equally by a combination of central gover nment 
funding and local taxation. The  funding from central government  is 
determined largely on a per capi ta (per head of population) bas is, 
adjusted to reflect the scale of deprivation (or special needs)  deemed to 
exist in CCC’s region. A small percentage of its finance comes from the 
private sector, for example from  renting out City Hall for priv ate functions. 
CCC’s main objectives are: 
• to make the region economically p rosperous and an attractive p lace 
in which to live and work 
• to provide service excellence in health and education for the local 
community. 
DDD is a large listed entity wit h widespread commercial and geo graphical 
interests. For historic reasons , its headquarters are in CCC’s region. This 
is something of an anom aly as most entities of DDD’s size would  have 
their HQ in a capital city, or at least a city much larger than  where it is.

Chapter 3 
 131 
 DDD has one financial objective: To  increase shareholder wealth  by an 
average 10% per annum. It also has  a series of non-financial ob jectives 
that deal with how the entity treat s other stakeholders, includ ing the local 
communities where it operates. 
DDD has total net assets of $1.5 bi llion and a gearing ratio of  45% (debt 
to debt plus equity), which is ty pical for its industry. It is currently 
considering raising a substant ial amount of capital to finance an 
Required: 
Discuss the criteria that the two very different entities descr ibed above 
have to consider when setting objectives, recognising the needs  of each 
of their main stakeholder groups. 
Make some reference in your ans wer to the consequences of each of 
them failing to meet its declared objectives. 
(30 minutes)   
MS is a private entity in a com puter-related industry. It has b een trading 
for six years and is managed by i ts main shareholders, the orig inal 
founders of the entity. 
Most of the employees are also shareholders, having been given shares 
as bonuses. None of the shareholder s has attempted to sell shar es in the 
entity so the problem of placing a value on them has not arisen . 
Dividends have been paid every year  at the rate of 60 cents per  share, 
irrespective of profi ts. So far, profits  have always been suffi cient to cover 
the dividend at least once bu t never more than twice. 
MS is all-equity financed at present although $15 million new f inance is 
likely to be required in the near  future to finance expansion. Total net 
assets as at the last balance sheet date were $45 million. 
Required: 
Discuss and compare the relation ship between divi dend policy, 
investment policy and financi ng policy in the context of the sm all entity 
described above, MS, and DDD, the large listed ent ity described  in the 
first part of this question. 

132  
 ( a )  Pre-project ratios: 
Interest cover = $15m/$4m = 3.75 times Earnings per share (EPS) = $7.7m /16m = 48.1 cents per share 
Earnings yield = EPS/Share pric e = $0.481/$2.70 = 0.178, or 17. 8% 
Statement of profit / loss 
forecasts $m – debt 
used $m – rights 
issue 
Profit before interest and tax  
($15m + $4m) 19.0  19.0 
Interest (W1)  (5.2) (4.0) 
 ——— ——— 
Profit before tax  13.8  15.0 
Tax at 30% (4.1) (4.5)  ——— ——— 
Profit after tax (earnings) 9.7  10.5 
 ——— ——— 
(W1)  Interest on the new debt is 6% of $20m i.e. $ 1.2m. Assume 
that interest on the existi ng borrowings stays constant. 
Share price workings: Rights issue 
If the rights issue goes ahead, the value of the shares after t he 
rights issue will be the theoretic al ex-rights price (TERP) of $2.63 
(given). NB: The calculation of this TERP wi ll be covered in detail in 
the later chapter: 'Financ ing – Equity finance'. 
Workings  (for illustration only at the moment): 
TERP = [(N × cum rights pric e) + issue price]/(N+1) 
= [(2 × 2.70) + 2.50]/3 = $2.63 
However, since the rights iss ue will be used to fund the new pr oject 
with an NPV of $8m, t he value of the projec t will also be refle cted in 
the new share price, increas ing the share price to 
$2.63 + [$8m/(16m shares +  8m new shares)] = $2.96 
Debt finance 
If debt finance is used to fund the new project, the share pric e 
should rise after the project has been taken on, to reflect the  NPV of 
the new project. 
Expected share price = $2.70 + ($8m/16m shares) = $3.20

Chapter 3 
 133 
 Post project ratios – using debt finance: 
Interest cover = $19m/$5.2m = 3.65 times 
Earnings per share (EPS) = $9.7m /16m = 60.6 cents per share 
Earnings yield = $0.606/$3.20 = 0.189, or 18.9%  
Post project ratios – using equity finance:  
Interest cover = $19m/$4m = 4.75 times 
Earnings per share (EPS) = $10. 5m/(16m + 8m) = 43.8 cents per 
share 
Earnings yield = $0.438/ $2.96 = 0.148, or 14.8% 
(b) Debt financing option 
If debt is used to fund the new pro ject, the shareholders are l ikely to 
see the change in EPS and ear nings yield as positive. 
The EPS increases from 48.1 cent s per share to 60.6 cents per 
share, and the earnings yield in creases from 17.8% to 18.9%. Th is 
indicates that Seed Co will potent ially be able to pay out a hi gher 
dividend to the shareholders in future. 
On the other hand, the reduction i n interest cover indicates th at 
Seed Co will face a higher lev el of risk if the debt financing option is 
used i.e. the chance of Seed Co being unable to meet its intere st 
obligations is higher. The higher r isk to shareholders could le ad to a 
fall in the share price if considered to be significant. 
However, in practice it is unlik ely that this issue will worry either the 
shareholders or the l enders greatly, given that the movement in  
interest cover is extremely small (3.75 to 3.65 times). 
Overall, it is likely that bot h shareholders an d lenders will b e quite 
happy with the EPS, earnings yield  and interest cover ratios if  the 
debt finance option is used (assu ming that the expected $4m 
increase in profit and $8m  NPV are achieved). 
Equity finance option 
The lenders will be ha ppy if the rights issue goes ahead, becau se 
there will be no additi onal interest payable and yet profits wi ll 
increase, so the interest cover r atio will rise significantly. This 
means that the chances of Seed Co defaulting on its interest 
payments will be less if th is option goes ahead. 
At first glance, it appears that  the shareholders will not be h appy 
with this option, given that EPS reduces from 48.1 cents per sh are 
to 43.8 cents per share, and also  given that earnings yield fal ls from 
17.8% to 14.8%.

134  
 However, in this situation, wher e a 1 for 2 rights issue has be en 
used, a shareholder who owned 2 s hares before the rights issue will 
now own 3 shares (assuming he took  up his rights). The rights i ssue 
itself makes no difference to t he shareholder's return or wealt h. 
However, the positive NPV of t he project undertaken causes the 
shareholder return and wealth to increase. 
The increase in earnings attri butable to each shareholder's 
shareholding will be viewed posit ively by shareholders, who mig ht 
expect to see increased overall dividends in the future. 
Once again, overall it is likely  that both shar eholders and len ders 
will be quite happy with the EPS, earnings yield and interest c over 
ratios if this financing option is  used (assuming that the expe cted 
$4m increase in profit and $8m NPV are achieved). 
 
Financing requirement is: Reduction in payables = ($3, 150,000 × 10/45) = $700,000 
Reduction in overdraft = (2 ,200,000 – 2,000, 000) = $200,000 
New capital expend iture = $1,000,000 
Therefore, total  = $1,900,000 
 
Lenders are particularly interest ed in the level of gearing (B)  and the 
ability of the borrower to meet i ts interest commitments ((A) a nd (D)). 
 
Currently P/E is 7.05 and share price is $2.00. Therefore, EPS = 
(2.00/7.05 =) $0.284 
With 1 million shares in issue , this amounts to total earnings of 
approximately $284,000 
After the issue, the project will add $30,000 earnings to this,  so earnings 
will become $314,000. 
Total shares will be 1 million existing s hares + 250,000 new on es (1 for 4 
rights). Therefore 1,250,000 in total. 
Hence EPS will be 31 4,000/1,250,000 = $0.25

Chapter 3 
 135 
The NPV of the project is equal  to the increase in wealth of th e 
shareholders (i.e. the in crease in share price). 
Therefore, an NPV o f $8 million, split bet ween 20 million share s means 
an increase of 8/20 = $0.40 per share. 
 
= $1.33m/[(10,000 × $100 × 5%) + (5,000 × $100 × 4%)] = 19.0 
 
Both companies' bonds are indeed investmen t grade bonds (A) – a ll 
ratings of BBB and above are inve stment grade. However, BBB is 
considered to be a medium level  of risk, so both companies' bon ds do not 
carry a low level of risk (B). 
The investors in Company X's b onds will indeed require a higher  rate of 
return (C) because of this high er level of risk, but that does not 
necessarily mean that the coupon r ate on Company X's bonds will  be 
higher than the coupon rate on Com pany Y's bonds (D) (for examp le the 
extra return could be paid in the  form of a premium on redempti on, rather 
than necessarily as an increased coupon rate). 
BB is a lower grading than both A and BBB so a movement to a BB  rating 
would represent a downgrade  for both companies (E). 
 
An unlisted company cannot issue bonds (C). An overdraft (A) is  too 
short term and equity (B) is too long term for the funding of a  five year 
project. 
 
 The answer is (A) and (C).

136  
Shareholder wealth is not affected  by a dividend payment. Geari ng will 
increase though, as there is le ss equity within the company. Al so, the 
financing and investment polic ies will have to change since les s cash is 
available within the company. 
 
Debt 
Interest  = $70,000 and value of debt inc reases by $1m, so the ratios 
become: 
Gearing  = (debt/equity) = $3. 5m/$7.2m = 48.6% 
= $3,022,000/$293,000 = 10.3 times 
= $2,047,000/3, 000,000 = $0.682 
Note that profit after tax = (EBI T – Interest) × (1 – 0.25) 
Equity 
400,000 extra shares and value o f equity increases by $1m, so t he ratios 
become: 
Gearing  = (debt/equity) = $2. 5m/$8.2m = 30.5% 
= $3,022,000/$223,000 = 13.6 times 
= $2,099,000/3, 400,000 = $0.617

Chapter 3 
 137 
 Answer to the first task: 
The key criteria that need to be considered when objective sett ing are as 
follows: 
Stakeholder expectations 
All organisations need to ident ify key stakeholders, examine th eir 
expectations and try to set objectives to m eet them. For CCC 
stakeholders include: 
• Local residents want to see t he provision of quality health 
• Local businesses w ho will be interested in  local infrastructur e when 
deciding whether to invest in t he area. In particular, CCC may be 
keen to ensure that DDD does not c lose its local offices, with 
resulting job losses, and move to the capital city. 
• Central Government committees w ho make funding decisions based  
on local population and deprivation. 
For DDD stakeholders include: 
• Shareholders want to see their w ealth increased through a mixt ure 
of growing dividends and an incr easing share price. DDD has 
reflected this in the objective  to increase shareholder wealth by 10% 
per annum. 
• Customers will expect a certain  level of quality and value for  money, 
depending on the nature of products sold. 
• The local communities affected by DDD will expect them to be g ood 
citizens and operate at high le vels of corporate social respons ibility. 
Stakeholder power 
All organisations wi ll find conflicts betw een stakeholders, so they need to 
consider how to prioritise them . For a company like DDD the exp ectations 
of shareholders come first f or the following reasons: 
• This is usually reflected in c ompanies’ legislation where dire ctors 
have a duty in law to put shar eholder interests first. Many 
governance recommendations focus on protecting shareholder 
• Failure to deliver shareholder ex pectations will result in a f alling 
share price and difficulties rais ing finance. Ultimately, share holders 
have the power to remove director s should they feel dissatisfie d. 
However, this does not mean that o ther stakeholders’ needs are ignored. 
Clearly, if customers are unhappy , then sales will be lost with  a resulting 
fall in profitability  and shareholder wealth.

138  
 For CCC the problem is more complex: 
• It is much more difficult to pri oritise stakeholder expectatio ns. For 
example, given limited funds, s hould community health care need s 
come before educational ones? 
• Even individual stakeholder gr oups have multiple conflicting 
objectives. For example, resi dents want to pay less tax and hav e 
better provision of services. Thus, even if some groups are sat isfied, 
others may still vote  for changes in CCC. 
• With companies, customers pay directly for the products they 
receive, ensuring that custome r needs are addressed. With CCC 
the bulk of its funding comes fr om central government, not the local 
community that benefits from CCC’s actions. Thus the needs of t he 
funding body may take priority over locals needs, otherwise fun ding 
may be cut. ( Note:  This is less likely her e as funding is mainly 
driven by population size.) 
Measurement issues 
For an organisation like DDD, onc e shareholders have been prior itised, 
all decisions can be evaluated by  reference to financial measur es such 
as profitability. While non-fi nancial targets will be incorpora ted as well, 
the ‘bottom line’ will be seen as key. Thus financial targets c an be set for 
most objectives. 
For CCC it is much more difficul t to measure whether it is achi eving its 
stated aims and hence to set targets. 
For example, how do you assess whether somewhere is an ‘attract ive 
place to live and work’ or whether  health and education provisi on is 
‘excellent’? 
Other issues 
All organisations need  to ensure that objectives set relate to controllable 
factors to ensure staff a re motivated to meet them. 
All organisations need to diffe rentiate between cause and effec t and have 
objectives for both. For example , DDD may have an objective of 
customer satisfaction, which w ill need to be translated into ob jectives for 
quality, cost, etc.

Chapter 3 
 139 
 Answer to the second task: 
As described above, companies mak e decisions with the primary 
objective of maximising shareholder wealth. 
Investment decisions 
Potential investments should t hus be assessed us ing NPV or SVA,  rather 
than ROCE to ensure that shar eholder wealth is increased. 
This should be the case for bot h MS and DDD, though the former will 
have more difficulty determining a suitable discount rate as it  is unquoted. 
Dividend decisions 
Once shareholder value has been created, the firm needs to deci de how 
to return those gains to shareholder s – either as dividends or reinvested 
to enhance the share price further. 
Modigliani and Miller argued tha t, given certain assumptions, d ividend 
policy was irrelevant to sharehol der wealth. If a dividend were  cut, for 
example, shareholders could manufacture dividends by selling sh ares 
without any overall loss of wealth . Central to their theory was  the idea 
that shareholders had perfect inf ormation and would understand why a 
dividend policy was changed. 
In the case of MS, shareholders ar e also employees so will have  full 
information regarding any change in  dividend poli cy and will no t thus 
perceive any information conten t in the dividends themselves. H owever, 
should the dividend be cut, s hareholders who r equire income wil l not be 
able to sell shares to generate ca sh as the company is unquoted . MS 
should thus try to continue the stable dividend policy it has a dopted to 
date, even though historical div idend cover is lower than the ‘ rule of 
thumb’ of two. 
In the case of DDD, major insti tutional shareholders will have good 
information from the company but m ay have tax preferences regar ding 
income and capital gains so DDD  should adopt a consistent divid end 
policy to meet their requirement s. DDD will probably have attra cted a 
certain clientele of shareholder  based on previous policies. 
Financing decisions 
Both firms need to raise finance in  order to undertake new inve stments to 
increase shareholder wealth. The i ssue here is whether the fina nce used 
ultimately affects shar eholder wealth as well. 
From a theoretical point of vie w, Modigliani and Miller argued that, in the 
absence of taxation and certain other assumptions, the choice b etween 
debt or equity finance was irrelev ant. With corporation tax the y concluded 
that debt finance was preferable , due to the benefits of the ta x shield.

140  
 With personal taxes the conc lusions depend on the specific 
circumstances of the company and its shareholders. Incorporatin g real 
world factors, many analysts ar gue that there is an optimal gea ring level 
for each company. 
DDD is already at the typical gear ing ratio for its industry so  it would 
reasonable to assume that this is i ts optimal gearing level. Fu ture 
financing should involve a mixt ure of debt and equity to mainta in this 
ratio. 
MS is all-equity financed at pres ent so it should seek to raise  at least 
some of the $15 million required using debt finance to take adv antage of 
the tax relief and lo w costs involved. 
Inter-relationships 
All three types of decisions are  interrelated, thus the financi ng decision 
will affect the cost of capital and, as a consequence, the net benefits 
obtainable from a particular proj ect, thereby influencing the i nvestment 
decision, while the financing decision concerning gearing will affect both 
the other decisions. 
The dividend decision, in determi ning the level of retentions, will affect 
the cash available for investm ent, and the extent to which exte rnal 
sources of funds need to be sough t in financing to optimise ope rations.

141 
Financing – Equity 
finance 
B3: Evaluate equity finance 
 (a) Evaluate methods of 
flotation 
(b) Discuss rights issues 
• Methods of flotation and im plications for management and 
• Rights issues, choice of discount rates and impact on 
• Calculation of theoretical ex -rights price (TERP) and yield 
adjusted TERP  
 
  Chapter 
4

Financing – Equity finance 
142  
 
In Chapter 3: 'Development of fi nancial strategy', the financin g decision was 
identified as one of the three key decisions of financial strat egy (along with the 
investment decision and  the dividend decision). 
This chapter and the next two lo ok at the financing decision of  an entity in more 
detail. 
First, this chapter introduces the factors to consider when mak ing the 
fundamental financing decision i.e. should equity finance or de bt finance be 
used? 
Then, this chapter covers the main sources of equity finance an d the next 
chapter looks at debt finance. 
Finally, Chapter 6: 'Financing – C apital structure' considers t he theoretical and 
practical implications of changing  the entity's capital structu re (i.e. the mix of 
long-term debt and equity finance).

Chapter 4 
 143 
 2 General introduction to financing 
market listing for the first time; 
– rights issues; – issues of marketable debt (e.g. bonds). 
3 Venture capital funds. 
This is high risk finance provided by specialist organisations.  The main 
problem is that the providers o f venture capital funding tend t o demand 
significant equity participati on in a company and will also wan t to influence 
the policy of the company. 
4 Government and similar sources. 
In general, finance can be raised fr om Equity or Debt sources. 
 
 Criteria for selecti ng sources of finance 
To decide whether debt or equi ty should be used to fund a new i nvestment, the 
following factors will be considered: 
• cost of the different sources of finance 
• duration – for how lon g is finance required? 
• lending restrictions – for exa mple security and debt covenants  
• gearing level (also called capita l structure – co vered in deta il in the next 
chapter). 
• liquidity implications – the ab ility of the business to servic e the new debt, 
allocating sufficient cash resources to meet interest and capit al repayment 
obligations 
• the currency of the cash flows associated with the new project  
• impact of different financing opt ions on the financial stateme nts, tax 
position and financial st akeholders of the entity

144  
• availability – availability o f finance depends on the creditwo rthiness of the 
borrower and also the willingnes s of lenders to extend credit ( for bank 
borrowings) or liquidity of the capital markets (for equity and  bonds). 
In an exam, you will need to iden tify how these general factors  apply to the 
specific circumstances of the entity in the question, in order to identify the 
preferred choice of finance in  a particular situation. 
 
 More details on financing criteria 
 Cost 
Each source of finance has a different cost. With debt capital,  a company 
must pay interest on the debt, and to raise new debt finance it  must pay a 
current rate of interest to pers uade investors to provide capit al. The cost 
of interest is an allowable expens e for tax purposes, so the co st of debt 
capital to a company is the inte rest cost less the tax relief o n the interest. 
This fact, and the fact that the providers of debt finance have  lower risk 
than the providers of equity fi nance tend to make debt finance cheaper 
than equity. 
The cost of equity capital is the return that ordinary sharehol ders expect 
on their investment, in the form of current dividends and expec tations of 
dividend and share pr ice growth in the future. Although a compa ny does 
not have a legal obligation to  pay dividends to its shareholder s, it must 
provide a satisfactory return  to support the share price. Witho ut the 
prospect of good returns, investors will not subscribe for new equity when 
the company needs to raise new capital. 
It is important here to apprecia te that debt finance tends to b e cheaper 
than equity. This is because prov iders of debt take lower risks  than 
providers of equity and therefor e earn less return. Interest on  debt 
finance is also normally corporat ion tax deductible, returns to  equity are 
not. The period of the finance will  also affect the cost as lon g-term 
finance tends to be more expen sive than short-term finance. 
Duration 
Equity capital is long-term ‘pe rmanent’ capital. Most debt capi tal, on the 
other hand, is obtained for a fix ed term. The length of borrowi ng can 
range from very short term (ove rdraft facility) to long-term. B ank loans are 
generally for no longer than the m edium term (say, five to seve n years) 
whereas debt finance raised by issu ing bonds can be for a much longer 
term. 
When a company is decid ing whether to obtain long-term or short -term 
capital, it should apply the ru le: ‘Long-term assets should be financed by 
long-term funds’. Short-term asse ts, such as inventories and re ceivables, 
should normally be financed by a m ixture of short-term and long -term 
funds.

Chapter 4 
 145 
Thus we would expect to see work ing capital financed partly by short-
term facilities such as trade pay ables and a bank overdraft, wh ilst non-
current assets should be funded by long-term sources of finance . This 
rule might be broken to gain a ccess to cheap short-term funds, 
particularly short- term trade payables (which have no obvious cost) but 
the risks involved shou ld be appreciated. 
Lending restrictions 
Security is often required for debt finance. This could be deri ved from 
existing assets or new assets to be acquired. Assets such as la nd and 
buildings hold their value bette r and are easier for a lender t o sell than, 
say, plant and machinery. 
Debt covenants are clauses wri tten into existing debt agreement s which 
protect the lender's interests b y requiring the borrower to sat isfy certain 
criteria. 
Examples of debt covenants are: 
• the interest cover mus t not fall below 5, and 
• the ratio of non-current liabilit ies to equity must not increa se beyond 
0.75:1. 
The lender will be r eassured that the risk associated with the borrower 
will not change dramatically as lo ng as such covenants are not breached. 
Gearing 
Gearing is the ratio of debt to  equity finance. A high gearing ratio can be 
very risky. Although hi gh gearing involves the use of cheap deb t finance, 
high levels of debt also create an obligation to meet interest payments 
and debt principal repayment sc hedules. If these are not met th e 
company could end up in liquidati on. A company should try to ac hieve a 
satisfactory balance between eq uity finance and medium- and lon g-term 
debt for its long-term funding, to  benefit from the lower cost of debt 
finance without exposing itself to  the risks arising from exces sive debt 
obligations. 
The currency of the cash flows associated with the new project 
If the cash flows from the invest ment project are expected to b e 
denominated in a foreign currency , the entity may decide to rai se finance 
denominated in the same foreign currency, to reduce the risk of  
exchange rate movements by matchi ng the receipts from the proje ct with 
the servicing costs of the finance.

146  
 The impact of different financ ing options on the financial 
statements, tax position and fina ncial stakeholders of the enti ty 
Investors (both debt holders and shareholders) will use ratio a nalysis to 
assess the performance of the bu siness. It is therefore importa nt that 
management consider the impact o f any new financing on the fina ncial 
statements of the business. For  example, raising debt finance w ill affect 
the Return on Equity of the busi ness, as well as the interest c over and 
gearing ratios. 
Also, raising debt finance will gi ve rise to interest payments which are tax 
deductible, so impacting the tax position of the business. 
The existing financial stakeholde rs of the business (debt holde rs and 
shareholders) will be constantly m onitoring the business's perf ormance, 
so it will be import ant for management to cle arly explain the r ationale for 
any new financing method which impacts the financial statements  or the 
tax position. 
Availability 
Not all companies have access to  all sources of finance. Small 
companies traditionally have pr oblems in raising both equity an d long- 
term debt finance. Remember that m any firms do not have an unli mited 
choice of funding arrangements. 
The availability of debt financ e is enhanced if an entity has a  good credit 
rating. The more creditworthy a borrower is assessed as being, the more 
likely it is that funds will be relatively easy to raise. 
nominal value, which may be quite  different from its market val ue. (CIMA 
Ordinary shares pay dividends a t the discretion of the entity's  directors. The 
ordinary shareholders of a compa ny are the owners of the compan y and they 
have the right to attend meetings  and vote on any important mat ters. 
other finance providers (i.e. t hey receive their money last, if  there is any left 
after all other finance pr oviders have been paid).

Chapter 4 
 147 
Preference shares are a form of equity that pays a fixed divide nd, which is paid 
in preference to (before) ordi nary share dividends, hence the n ame. 
 
 Comparison of preference shares with debt and with ordinary sha res 
in a way which is more simila r to debt finance (fixed annual re turns) 
insufficient distributable prof its) when the company will be al lowed to skip 
its preference share dividends in a year. This is not the case with debt 
interest, which is an obligation every year, whether or not the  company 
can afford to make the payment. 
relatively reliable income stream. 
Different types of preference shares 
• cumulative preference shares, fo r which dividends must be paid  
including skipped dividends i.e . if a dividend is skipped one y ear, the 
skipped dividend has to be paid the following year along with t he 
'normal' dividend; 
• non-cumulative preference shares, for which skipped dividends do 
not have to be paid later; 
similar way to ordinary shares); and 
specified number of ordinary shar es on some given future date.

148  
holders will be repaid  their capital (usually at par) on some f uture date. 
would receive a fixed amount o f $5 each year for the first five  years. 
In five years' time though, the in vestor would have the choice to keep the 
shares on the conver sion date were worth m ore than ($10/3 =) $3 .33. 
the shares are actually worth $4.50 each on the conversion date , and 
Preference shares, especially con vertible preference shares, ar e often 
used in the context of Management B uyouts (MBOs) – see details in the 
later chapter on 'Financial and  strategic implications of merge rs and 
acquisitions'. 
The primary function o f a stock market is t o enable companies t o raise new 
finance (either equity or debt) . Through the stock market, a co mpany can 
communicate with a large pool o f potential investors, so it is much easier for a 
company to raise finan ce in this way, rather than contacting in vestors individually.

Chapter 4 
 149 
attractive to investors. 
 
 Private limited company (Ltd in UK terminology) 
company, has sharehol ders with limited liabi lity and its shares  may not be 
the liability of the shareholders  to creditors of the company i s limited to 
any premium paid in return for th e issue of the shares by the c ompany. A 
shareholder's personal assets are  thereby protected in the even t of the 
disclosure requirements are li ghter, but for this reason its sh ares may not 
company on the stock exchange. 
(IPO). 
• Realisation of paper profits, and mechanism for buying and sel ling 
shares in the future at will.

150  
• Raise profile of entity, which  may have an impact on revenues,  
credibility with suppliers and lo ng-term providers of finance. 
Impact of a listing on key stakeholders 
Shareholders will norma lly benefit from a listing, in that thei r shares 
become more marketable. The list ing can have a positive impact on the 
reputation of the company, so c onsequently the share price may rise. 
The improvement in the company's  reputation and profile that re sults 
from a listing can also benefi t the managers and the employees of a 
company. Listed companies tend to  be larger and less likely to fail, so 
can afford to offer better pay and career progr ession opportuni ties. 
The better reputation of a list ed company also impacts its cred it rating 
and therefore reduces the risk of non-payment to suppliers and lenders. 
Listed companies are more likely  to be viewed favourably by len ders, and 
to be granted generous cr edit terms by suppliers. 
is very high, so the shares a re extremely marketable. 
• the Alternative Investment Market (AIM) – a market for smaller  
criteria. 
Many other countries have a si milar set up, inc luding Japan, Ge rmany and 
the USA. 

Chapter 4 
 151 
 
 Methods of issuing new shares 
The three most commonly used  methods of issuing shares are: 
A  IPO (initial public offering), or flotation 
B  Placing  
C  Rights issue  
If a company already has a listing  on a stock market then the c ompany will 
either raise new funds by means o f a rights issue, or by means of a placing. An 
IPO is more suitable when a co mpany seeks a listing on the stoc k exchange for 
the first time. 
These three methods will now  be covered in turn below. 
A  An IPO (or flotation) 
could be made at a fixed price set by the company, or in a tend er offer investors 
are invited to tender for new shar es issued at their own sugges ted price. All 
shares being offered are subseq uently sold at the best price at  which they 
would be taken up. 
B  Placing  
 
 More details on IPOs and placings 
 Initial Public Offerings (IPOs) 
These offers may be of completel y new shares or they may derive  from 
the transfer to the public of som e or all of the shares already  held 
privately. An issuing house, normally a merchant bank, acquires  the 
shares and then offers them to  the public at a fixed price. 
The offers are usually made in t he form of a prospectus detaile d in 
newspapers, sometimes in an abbr eviated form. Buying new issues  
through the prospectus in the new spaper avoids dealing charges.  
Other examples of such issues include: 
• government privatisations; and 
• privately held shares transferred to the public. 
It is easier for prospective purc hasers to form a judgement abo ut such 
entities where there is some track record , rather than with off ers for a 
completely new entity.

152  
 Stagging 
Some investors apply for new i ssues in the hope of selling imme diately 
and reaping a quick profit. For  this to succeed the number of s hares 
purchased must be sufficiently high to cover selling charges. F or 
oversubscribed issues, the allo cation may be scaled down and th e 
applicant may receive only a sma ll number of shares. The strate gy of 
selling immediately is called stagging (and inve stors who do it  are called 
stags). 
This is often successful since c ompanies typically price new is sues 
conservatively in order to ensure the shares are sold and the r equired 
finance raised. This can often l ead to an immediate share price  rise post 
issue. 
There have been some notable succe sses for stags, particularly in some 
of the privatisation issues, bu t there have also been cases whe re the 
initial dealing price has been substantially  below the offer pr ice. 
An IPO lock-up period 
An IPO lock-up period is a contractual restriction that prevent s insiders 
who are holding a co mpany's shares, before it goes public, from  selling 
the shares for a per iod usually lasting 90 to 180 days after th e company 
goes public. Insiders include co mpany founders, owners, manager s, 
employees and venture capitalists. 
The purpose of an IPO lock-up per iod is to prevent the market f rom being 
flooded with a large number of shar es, which would depress the share 
price. 
Insiders' selling activities can have a particularly strong imp act on a 
company's share price when the company has recently gone public  
because these shareholders typica lly own a relatively large per centage of 
the company's shares, while onl y a small percentage of shares a re sold 
to the public. 
Tender offers 
A tender offer is an alternativ e to a fixed price offer. 
Under a tender offer, subscriber s tender for the shares at, or above, a 
minimum fixed price. Once all offers have been received from pr ospective 
investors, the company sets a 'st rike price' and allocates shar es to all 
bidders who have offered t he strike price or more. 
The strike price is set to mak e sure that the company raises th e required 
amount of finance from the share issue. 
of what their original bid was.

Chapter 4 
 153 
 Example of a tender offer 
Bragg Co needs to raise $20 million  to invest in a new project.  The 
company has asked investors fo r tender offers and the following  offers 
have been received: 
Maximum price offered  
($ per share) No. of shares requested at  
this price (million) 
2.00 5.0 
2.20 4.1 
2.40 1.9 
2.60 3.2 
The strike will be set at the hi ghest possible level that gener ates the 
not issue more shares than it has  to, so that the dilution of t he existing 
shareholders' holdings is kept to a minimum. 
If Bragg Co sets the strike pri ce at $2.60, onl y 3.2 million sh ares will be 
issued, raising $8.32 million in  total ($2.60 × 3.2 million). T his is not 
acceptable, since $20 million is needed. 
If Bragg Co sets the strike pri ce at $2.40, 5.1 million shares will be issued 
(being 1.9 million to the people w ho bid $2.40 and 3.2 million to the 
people who bid $2.60). Therefore, t he total finance raised will  be $2.40 × 
5.1 million = $12.24 million, whi ch again is not sufficient. 
If Bragg Co sets the strike pri ce at $2.20, 9.2 million shares will be issued 
(being 4.1 million to the people who bid $2.20, 1.9 million to the people 
who bid $2.40 and 3.2 million to  the people who bid $2.60). 
Therefore, the total finance rais ed will be $2.20 × 9.2 million  = $20.24 
million, which now is sufficient. 
Hence, to ensure that $20 milli on is raised from the tender off er, the strike 
price would be set at $2.20, and any investor who bid $2.20 or more 
Placings 
A placing (sometimes c alled a 'placement' or 'private placement ') is the 
sale of securities to a relativel y small number of select inves tors as a way 
of raising capital. 
Investors involved in private p lacements are usually large bank s, mutual 
funds, insurance companies and pension funds.

154  
 Private placement is the opposite of a public issue, in which s ecurities are 
made available for sale on the open market. Since a private pla cement is 
offered to a few, select indivi duals, the placement does not ha ve to be 
registered or public ly announced. In many cases, detailed finan cial 
information is not disclosed and the need for a prospectus is w aived. 
Finally, since the placements ar e private rather than public, t he average 
investor is only made aware of th e placement after it has occur red. 
This method is very popular, bei ng cheaper and quicker to arran ge than 
most other methods. However, it does not normally lead to a ver y active 
market for the shares after flotation. 
 
 Private equity 
 Private equity firms are taking an increasingly important role  as equity 
Private equity is equity capita l that is not quoted on a public  exchange. It 
consists of investors and funds t hat make investments directly into private 
companies or conduct buyouts of public companies that result in  a 
delisting of public equity. 
Capital for private equity is r aised from retail and institutio nal investors, 
and can be used to fund new technol ogies, expand working capita l within 
an owned company, make acquisiti ons, or to strengthen a balance  sheet. 
The majority of private equity c onsists of institutional invest ors and 
accredited investors who can co mmit large sums of money for lon g 
periods of time. Private equity  investments often demand long h olding 
periods to allow for a turnaround o f a distressed company or a liquidity 
event such as an IPO or sale to a public company. 
The size of the private equity mar ket has grown steadily since the 1970s. 
Private equity firms will somet imes pool funds together to take  very large 
public companies private. Many p rivate equity firms conduct lev eraged 
buyouts (LBOs), where large am ounts of debt are issued to fund a large 
purchase. 
Private equity firms will then tr y to improve the financial res ults and 
prospects of the company in the hope of reselling the company t o another 
firm or cashing out via an IPO.

Chapter 4 
 155 
 Advisors to an IPO 
 Investment banks  usually take the lead role i n an IPO and will advise 
on: 
• the appointment of other spec ialists (e.g. lawyers); 
• stock exchange requirements; 
• forms of any new capital  to be made available; 
• the number of shares to be iss ued and the issue price; 
• arrangements for underwriting; 
Stockbrokers  provide advice on the vari ous methods of obtaining a 
Institutional  investors  have little direct inv olvement other than as 
issue institutional investors hav e a major influence on the eva luation and 
the market for the shares. 
 
 C  Rights issue 
The right to buy new shares ahead of outside investors is known  as the 'pre- 
Rights issues are far cheaper to o rganise than a public share i ssue, but may be 
more expensive than a placing. 
• low enough to secure acc eptance of shareholders; but 

156  
 More details on rights issues 
A rights issue may be defined as: " Raising of new capital by gi ving 
existing shareholders the right to  subscribe to new shares in p roportion to 
their current holdings. These shar es are usually issued at a di scount to 
market price." (CIMA Official Terminology, 2005) 
price quoted, otherwise sharehol ders will not be prepared to bu y, since 
they could have purchased more s hares at the existing price any way. 
The entity cannot offer an unlimit ed supply at this lower price , otherwise 
the market price would fall to th is value. Accordingly the offe r they make 
to the existing shareholders is limited. For example they may o ffer one 
new share for every four held. 
Underwriting 
Underwriting avoids the possibi lity that the entity will not se ll all of the 
shares it is issuing, and so rec eive less funds than it expects . 
Underwriters are normally financial institutions such as mercha nt banks. 
In return for a fee, they agree  to buy any shares that are not subscribed 
for in the issue. Underwriters re ceive their fee whether or not  they are 
required to take up any unsubscribed shares. 
The underwriting costs could pot entially be avoided through a d eep- 
discounted rights issue. In such an issue, the issue price is s et at a large 
discount to the current market pri ce so reducing the possibilit y of 
shareholders not taking up their rights.

Chapter 4 
 157 
shares to be issued becomes a pa ssive decision. The effect of t he 
additional shares on earnings per share, dividend per share and  dividend 
cover should be considered. The selected additional issue quant ity will 
then be related to the existing share quantity for the issue te rms to be 
calculated. The proportion is no rmally stated in its simplest f orm, for 
example, 1 for 4, meaning that s hareholders may subscribe to pu rchase 
one new share for every four they currently hold. 
 
 Terms of a rights issue 
 The issue price for a rights i ssue can be set by the company. 
For example, if Lauchlan Co want ed to raise $2m for a new inves tment 
project, it could issue 1m shar es at $2 each, or 500,000 shares  at $4 
each, or 250,000 shares at $8 each, etc. 
To decide on the final terms of th e issue, the current share pr ice needs to 
be considered. 
Assume that in this example, Lau chlan Co currently has 2m $1 or dinary 
shares in issue, with a curren t market price of $5 per share. 
Issuing new shares at anything greater than the existing share price of $5 
per share would not help to enc ourage investors to take up thei r rights. In 
order to attract investors, a di scount on current market value is usually 
offered. 
However, note that if the new s hares were issued at (say) $2 ea ch, this 
would require 1m new shares to b e issued, and so many new share s 
would have a big impact on the company's earnings per share. 
In this case, it would seem sensible to balance the various req uirements 
by offering the new shares to inves tors at $4 per share. This i s sufficiently 
below current market price to giv e an incentive to the sharehol ders to 
take up their rights, while at t he same time only requiring 500 ,000 new 
shares to be issued, so restrict ing the impact on earnings per share. 
If the new shares were offered to  existing shareholders at $4 p er share, 
500,000 new shares would need to be issued. Given that there ar e 2m 
shares currently in issue, the new issue would be announced as a '1 for 4 
rights issue at $4 per s hare'. (2m/500,000 = 4).

158  
–  consequences of the issue; –  future profits; and –  future dividends. 
–  there are more shares in iss ue (adverse effect on earnings p er 
share); and 
–  new shares were issued at market price discount. 
 
 'Cum rights' 
When rights issue is announced, a ll existing shareholders have the right to 
subscribe for new shares, and so  there are rights ('cum rights' ) attached to 
the shares, and the shares  are traded 'cum rights'. 
On the first day of dealings in t he newly issued shares, the ri ghts no longer 
exist and the old shares are now traded 'ex rights' (without ri ghts 
attached). 
 
 Theoretical prices/values 
(a) Theoretical 'ex rights' pri ce is the theoretical price that  the class of shares 
will trade at on the first tradi ng day after issue. It is calcu lated as follows: 
N + 1
 
(b) Theoretical 'value of right s' per share is calculated as: 
(Theoretical ex rights pr ice – issue price)/N 
where N = no of rights required to buy 1 share

Chapter 4 
 159 
 Rights issue illustration 
 TERP 
Using the figures for Lauchlan C o (in the section 'Terms of a r ights issue' 
above), where: 
Cum rights price = $5 Issue price = $4 N = 4 Therefore, TERP = [(4 × $5) + $4]/5 = $4.80 
Value of the rights 
Also, the value of the rights = (4 .80 – 4) = $0.80 per new shar e, or 0.80/4 
= $0.20 per old share. 
 
 (a) Plover Co has 1 million GBP1 ordinary shares quoted at GBP 4.50 
ex div. It is considering a 1 fo r 5 rights issue at GBP4.20 per  share. 
Required: 
Calculate the theoretical  ex rights share price. 
(b) Assume that Plover Co int ends to use the funds raised to fi nance a 
project with an N PV of GBP300,000. 
Note:  The NPV method has been c overed earlier in the CIMA 
syllabus. 
Required: 
Calculate the theoretical ex ri ghts share price if the project is 
undertaken.

160  
 Yield adjusted ex-rights price 
 The calculations of theoretical ex-rights price above assume t hat the 
additional funds raised will generate a return  at the same rate  as existing 
funds. If an entity expe cts (and the market agrees) that the ne w funds will 
earn a different return than is  currently being earned on the e xisting 
capital then a ‘yield-adjusted’  TERP should be calculated. 
Yield adjusted TERP = [Cum rights price × N/(N + 1 )] + [(Issue price/N + 1) × (Y
n/Y0)] 
where Y
0 = Yield on ‘old’ capital 
Yn = Yield on ‘new’ capital 
Cum rights price = $5 Issue price = $4 and the rights issue was a 1 for 4 issue,  and also assuming: 
• the rate of return (yield)  on the new funds = 15% 
• the rate of return on the existing funds = 12% 
The yield-adjusted ex-rights price becomes: Yield adjusted TERP = (5 × 4/5) + [(4/5) × (15/12)] = $5 
Alternatively, this is 1 new shar e at $4 × (15/12), plus 4 old shares at $5 
each i.e. $25 in tota l, or $5 per share. 
Notice that if the new funds are e xpected to earn a return abov e the rate 
generated by existing funds, ther e will be less dilution of the  market price 
than suggested by the origi nal TERP calculation. 
Note:  If you are given the NPV of the new project which the rights i ssue 
has funded (as in the Test your  understanding question above), the yield 
adjusted TERP is calculated as: 
(Original company market capitalisa tion + NPV of project + righ ts issue 
proceeds)/New total number of shares

Chapter 4 
 161 
Courses of action open  to a shareholder 
Possible actions for a shareholder are: 
• do nothing. (Sharehol ders may be protected from the consequenc es of 
inaction by the company selli ng the rights on behalf of inactiv e 
shareholders); 
• renounce the rights and sell  them on the market; 
• exercise the rights (that is buy  all the shares at the rights price); 
• renounce part of the rights and take up the remainder. 
 
 Illustration of actions open to a shareholder 
 A shareholder receiving notificati on of a rights issue from an  entity has a 
number of options available. 
Consider the position of a shar eholder in Lauchlan Co (from the  above 
example in the 'Terms of a rights issue' section. 
If the shareholder owns 1,200 shar es (worth $5 each), in the 1 for 4 rights 
issue he will be offered 300 new shares at $4 each. 
Option 1 – Do nothing. 
In this situation, the market v alue of the investment could be expected to 
fall by $240 from $6,000 to $5, 760 (1,200 shares at $4.80). 
The company would normally reserve the right to sell any ‘unacc epted’ 
shares for the best price available in the market. After having  deducted 
any expenses and, of course, $4 per share, the balance would be  sent to 
the shareholder. This cash balance  could fully or partially com pensate the 
shareholder for the reduction in market value. The shareholder’ s 
percentage share of the entity would reduce. 
Option 2 – Sell the rights. 
In this situation, the shareholder  decides to sell the right to  buy the 
shares at $4 each to another inves tor. A rational investor woul d not be 
expected to pay more than 80 cent s per share (TERP – $4) for su ch a 
right. The existing shareholder mi ght receive $240 (300 at 80 c ents) less 
any dealing costs incurred. The shareholder’s percentage share of the 
entity would be reduced. 
Option 3 – Fully subscribe for the new shares. 
In this situation, the shareholder  will have to increase the va lue of the 
shareholding by paying the ent ity $1,200 for the 300 new shares . The 
shareholder will then own 1,500 s hares which, using TERP, will be 
valued at $7,200. The shareholder ’s percentage share of the ent ity will be 
maintained.

162  
 Option 4 – Sell some rights to buy some new shares. 
In this situation, the shareholder  may be unable or  unwilling t o invest 
more funds in the entity. Since  the rights can normally be sold  in the 
market, the shareholder could se ll sufficient of the rights to purchase the 
balance. In the Lauchlan Co example , each block of 5 rights sol d at 80 
cents raises sufficient cash to purchase one new share at $4. T he 
shareholder could sell 250 at 80 c ents to raise $200 which woul d be 
sufficient to purchase 50 at $4. T he value of the investment wi ll be 
maintained at $6,000 but the shar eholder’s percentage share of the entity 
 
 Implications of a rights issue 
–  they have the opti on of buying shares at preferential price;  
–  they have the opti on of withdrawing cash  by selling their ri ghts; 
–  they are able to maintain t heir existing relative voting pos ition (by 
–  it is simple and cheap to implement; –  it is usually successful ('fully subscribed'); –  it often provides favourable publicity. 
 
Test your understanding 2 (Integration question) 
 Molson Co has a paid-up ordinar y share capital of EUR2,000,000  
represented by 4 m shar es of 50 cents each. 
Earnings after tax in the most r ecent year were EUR750,000 of w hich 
EUR250,000 was distri buted as dividend. The current price/earni ngs ratio 
of these shares, as reported in  the financial press, is 8. 
The entity is planning a major investment that will cost EUR2,0 25,000 
and is expected to produce a positive NPV of EUR402,400. 
The necessary finance is to be ra ised by a rights issue to the existing 
shareholders at a price 25% below  the current market price of t he entity’s 
shares. 
Required: 
(a) Calculate: 
(i)  the current market price o f the shares already in issue;  
(ii) the price at which the rights issue will be made; 
(iii) the number of new shar es that will be issued;

Chapter 4 
 163 
(iv) the price at which the s hares of the entity should theoret ically 
be quoted on completion of the ri ghts issue (i.e. the ‘ex-right s 
price’), ignoring inci dental costs and assuming that the market  
accepts the entity’s forecast of project NPV. 
(b) It has been said that, provi ded the required amount of mone y is 
raised and that the market is made  aware of the earning power o f 
the new investment, the financia l position of existing sharehol ders 
should be the same whether or not they decide to subscribe for the 
rights they are offered. 
Required: 
Illustrate and comment on this statement. 
4 End of chapter objective test questions 
 A company, whose shares currently sell at $75 each, plans to m ake a 
rights issue of one share at $60  for every four existing shares . 
What is the theoretical ex-rights price of the shares after the  issue? 
A $75.00 
B $72.00 C $67.50 D $63.00 
 
 Park Co is hoping to raise $460, 000 through a rights issue to fund a new 
project. 
Currently it has 1 million $1 shar es in issue, trading at $1.45 . The 
directors think that a discoun t of 20% will be required to enco urage 
investors to take up their rights. 
What should the terms of  the rights issue be? 
A  1 for 2 
B  2 for 5 C  1 for 1 D  2 for 3

164  
 Lambchop Co has 1 million shares  in issue and it wants to rais e some 
new finance by undertaking a 1 for 5 rights issue at $4.40 per share. 
The theoretical ex ri ghts price is $4.90. 
What was the share price before t he rights issue (to two decima l 
places)? 
A $4.40 
B $4.82 C $4.90 D $5.00 
 
 Which of the following statemen ts regarding preference shares a re 
true? 
A  Preference shares pay a div idend each year, being a fixed 
percentage of market value 
B  Preference share dividends a re tax deductible, just like deb t interest 
C  The cost of preference shares  is generally higher than the c ost of 
debt, but lower than the co st of ordinary shares 
D  Preference shares are somet imes convertible and sometimes 
cumulative, but they are never redeemable 
 
 DCD is a manufacturer of heavy construction equipment. It has 
manufacturing facilities around the world. 
DCD’s Ordinary Share Capital ha s a nominal val ue of $70 million  ($0.50 
shares) and the current marke t price per shar e is $6.00. 
Proposed new manufacturing facility 
The Board is planning to build  a new manufacturing facility and  has 
already identified a suitable site and prepared a schedule of f orecast 
cash flows arising from the project. 
It is expected that the proposed ne w facility would be fully op erational 
within a year of the initial investment and that the project wo uld generate 
a rate of return on funds inves ted of 20%. This is greater than  the return 
on existing funds of 15% due to th e greater efficiency of the n ew 
manufacturing facility.

Chapter 4 
 165 
 Rights issue 
The Board has decided to use a r ights issue to finance the init ial 
investment of $250 million. The new shares will be issued at a discount of 
40% on current market price. 
What is the approximate yield ad justed theoreti cal ex-rights pr ice of 
the DCD shares? 
A $4.90 
B $5.20 C $5.60 D $6.93 
 
 Alan Jones owns 2,000 shares in Bifold Co, a listed company wi th an 
issued share capital of 10m ord inary $1 shares with a current m arket 
price of $1.80 per share. 
The company has just publicly an nounced its intention to pursue  a 1-for-2 
rights issue at $1.00 per share  to raise funds for a new projec t with a net 
present value of $2m. 
What will be the change in the  overall wealth of Alan Jones 
(compared to his current wealth ) if he chooses to subscribe for  his 
rights? 
A  $267 loss  
B No change  C  $200 gain  D  $400 gain

166  
 Audrey Co needs to raise $4 mil lion to invest in a new project . The 
1.00 4.2 
1.10 3.7 
1.20 2.2 1.30 1.2 
At what price would the strike price be set, and how much finan ce 
would be raised in total? 
A Strike price: $1.00, Total  funds raised $4.20 million  
B Strike price: $1.10, Total  funds raised $4.07 million  
C Strike price: $1.20, Total  funds raised $4.08 million 
D Strike price: $1.20, Total  funds raised $4.20 million 
 
 Maximo Co has some $1, 8% pref erence shares in issue. The shar es are 
currently trading at $1.10. 
The preference shares are redeemabl e at a 4% premium in three y ears' 
time, or alternatively they wil l be convertible into two ordina ry shares on 
that date. 
Maximo Co's ordinary shares hav e a nominal value of $0.25 and t hey are 
trading at $0.48. The ordinary shar e values have grown at 3% pe r year in 
recent years, and this level of g rowth is expected to continue.  
What value (per preference shar e) is the rational investor like ly to 
receive in three years' time if h e chooses the better of the 
conversion or the redemption option? 
A $0.99 
B $1.04 C $1.05 D $1.14

Chapter 4 
 167 
 JJ Co has in issue 1.2 million shares, currently valued at $3 each, and a 
rights issue is being considered. 
The rights issue will be either: 
• 1 for 4 at $2.50 per share, or 
• 1 for 3 at $1.875 per share. 
Assuming that all shareholders  take up their rights, and that t here 
are no issue costs, what will be the effect of the rights issue  on each 
shareholder's total wealth bef ore taking account of any positiv e NPV 
generated by investing the new capital? 
A Total wealth increases m ore under the 1 for 4 scheme  
B Total wealth increases m ore under the 1 for 3 scheme  
C Total wealth is unc hanged under both schemes 
D Total wealth decreas es under both schemes 
 
 MNO is planning a rights issue at a 30% discount to the curren t share 
price, in order to raise $7 million. 
It currently has 10 million shares  in issue, trading at $2.00 p er share. 
The directors are trying to cal culate the theoretical value of a right per 
existing share, so that they can inform shareholders what the l ikely 
proceeds will be if shareholders dec ide to sell their rights ra ther than take 
them up. 
What is the theoretical value of a right per existing share in these 
circumstances? Enter your answer  in the box below, in $ and to two 
decimal places. 
 
$

168  
5 End of chapter case style question 
 Test your understanding 13 (Case style question) 
 KB has a paid-up ordinary shar e capital of $1,500,000 represen ted by 6m 
shares of 25 cents each. It has  no debt finance. Earnings after  tax in the 
most recent year were $1,200,000. T he P/E ratio of the entity i s 12. 
The company is planning to make a large new investment which wi ll cost 
$5,040,000 and is considering rais ing the necessary finance thr ough a 
rights issue at 192 cents. 
Required: 
(i)  Calculate the current marke t price of KB’s ordinary shares . 
(ii) Calculate the theoretical e x-rights price, and state what factors in 
practice might invalidate your calculation. 
(iii) Briefly explain what is meant by a deep-discounted rights  issue, 
identifying the main reasons why  an entity might raise finance by 
this method. 

Chapter 4 
 169 
 (a) The theoretical ex ri ghts price (TERP) is: 
N + 1 
= [(5 × 4.50) + 4.20]/6 = GBP4.45 
Alternatively, TERP can be calc ulated by looking at the total v alue of 
all the shares as follows: 
=ቆሺ1m	×	£4.50ሻ	+	(1
5×1m	×	£4.20)
1m	+ 1
5	×	1mቇ 
= GBP4.45 
(b) The NPV of the project is GBP300,000, so in an efficient ma rket, 
this will be the gain in wealth  of the shareholders if the proj ect is 
The total number of shares in issue is now 1 million + (1/5 × 1 million) = 1.2 million 
Thus, the theoretical share price after the rights issue, and a fter 
undertaking the project is 
4.45 + (300,000/1.2  million) = GBP4.70 
 
 (a) (i)  Current market price of shares already in issue: EPS = 
750,000/4m = EUR 0.1875 
Therefore, since the P/E ratio is 8, the price per share is 8 ×  
0.1875 = EUR 1.50 
(ii) Price at which rights iss ue will be made: EUR1.50 × 75% = 
EUR1.125 
(iii) Number of new shares tha t will be issued: EUR2,025,000/EU R 
1.125 = 1.8 million 
(iv) 1.8m new shares are being issued at EUR1.125 per share, 4m  
existing shares are in issue with a market price of EUR 1.50 
per share, and the new proje ct will have an NPV of EUR 
402,400. 
Hence, the TERP is [(4m × 1.50) + (1.8m × 1. 125) + 402,400 ]/5.8m = EUR 1.453

170  
 Alternatively:  Ignoring the project initia lly, and using the formula 
from the formula sheet, 
TERP	= (N × cum rights price) + Issue price
N + 1 
= [(4m/1.8m) × 1.50 + 1.125 ]/(4m/1.8m) + 1 = EUR 1.384 
and with the new project worth N PV = EUR402,400, this increases  
to 1.384 + (402,400/5.8m) = EUR 1.453 as before 
(b) This statement can be illustrated as follows: 
For every 20 shares held, the ri ghts issue means another 9 shar es. 
At least in theory, the selling price of the right to purchase one share 
will be EUR 1.453 less EUR 1. 125, that is, EUR 0.328. 
A shareholder with 20 shares ta king up the rights will have wea lth of 
 E U R  
Market value of 29 shares at EUR1.453 each 42.137 
Less: Cost of taking up right s of nine new shares  
at EUR1.125 each  (10.125) 
 –––––– 
 3 2 . 0 1 2   –––––– 
  
A shareholder with 20 shares se lling the rights will have wealt h of: 
  
EUR Market value of 20 shares at EUR1.453 each 29.060 
Add: Sale of nine rights at EUR0.328 each  2.952  –––––– 
 3 2 . 0 1 2  
 –––––– 
The above calculations, however, assume no transaction costs. 
Furthermore, the market may read a particular message into the 
rights issue that would a ffect the calculations. 
 
[(4 × $75) + $60]/5 = $72

Chapter 4 
 171 
A discount of 20% on the shares  that are trading at $1.45 means  an issue 
price of $1.16. 
To raise $460,000 by issuing s hares at $1.16 means that (460,00 0/1.16 
=) 396,552 shares need to be i ssued (i.e. approximately 400,000 ). 
400,000 new shares compared to 1 m illion existing shares is a r atio of 2 
to 5. 
 
The TERP is: 
N + 1 
Therefore: 
4.90 = [(5 × share pric e) + $4.40]/(5 + 1) 
So the share price was $5.00 before the rights issue. 
 
 The answer is (C) only. 
Preference share dividends are a  fixed percentage of NOMINAL va lue 
(A) and they are NOT tax deductibl e (B). Preference shares are 
sometimes redeemable (D). 
Because the risk to a preference share investor is lower than t hat of an 
ordinary shareholder but higher t han that of a debt holder, the  cost of 
preference shares does tend to lie between the co sts of the oth er two 
types of finance (C).

172  
A 40% discount to current market price is 60% × $6 = $3.60 Therefore, to rais e $250m, 69.44 million sh ares will have to be  issued 
($250m/$3.60). With 140m shares c urrently in issue, this amount s to 
(approximately) a 1 fo r 2 rights issue. 
Yield adjusted TERP = [Cum rights price × N/(N + 1)]  + [(Issue price/N + 1) × (Yn /  Y0 )] 
= [$6 × 2/3] + [( $3.60/3) × (20/15)] 
= $5.60 
 
Current wealth is 2,000 × $1.80 = $3,600 
Ex rights price incorporati ng the $2m NPV project will be 
[(10m × $1.80) + (5m × $1.00)  + $2m]/15m shares = $1.6667 
Therefore, if he subscribes for his rights (1,000 extra shares)  his total 
share value will increase to  (3,000 × $1.6667) = $5,000 
The cost of taking the ri ghts was 1,000 × $1.00 = $1,000 
Hence his total wealth will be $5,000 – $1,000 = $4,000 (a gain  of $400) 
 
If Audrey Co sets the strike pri ce at $1.20, 3.4 million shares  will be 
issued (being 1.2 milli on to the people who bid $1.30 and 2.2 m illion to 
the people who bid $1.20). 
Therefore, the total finance rais ed will be $1.20 × 3.4 million  = $4.08 
million.

Chapter 4 
 173 
The redemption option will  be worth $1 × 1.04 = $1.04 
The conversion option will be wo rth (assuming 3% per year growt h 
continues): 
(1.03) 3 × $0.48 × 2 = $1.05 
The rational investor woul d choose the higher amount. 
 
Total wealth is always unaffect ed by the rights issue itself. W ealth only 
changes as a consequence of the NPV generated by any project in vested 
in. 
 
 The answer is $0.20 . 
An issue price at a 30% discoun t means $2.00 × (1 – 0.30) = $1. 40 
To raise $7 million using an i ssue price of $1.40, we need to i ssue 
5 million shares (i.e. $7m/$1.40) . Therefore this rights issue is a 1 for 2 
issue (5 million new shares bei ng issued and 10 million existin g shares). 
TERP is: 
N + 1 
i.e. [(2 × $2.00) + $1.40]/(2 + 1) = $1.80 
and so the value of a right per e xisting share is (Theoretical ex-rights 
price – issue price)/N  ($1.80 – $1.40)/2 = $0.20

174  
 (i)  Earnings per share (EPS) =  Profit after taxation/No of sh ares = 
1,200,000/6m = $0.20 
Market price = EPS × P/ E = 0.20 × 12 = $2.40 
(ii) Number of shares issued in  rights issue = 5,040,000/$1.92 = 
2,625,000 
Therefore, TERP = [(6m × $2.40) + (2.625m × $1.92)]/ 
(6m + 2.625m) = $2.254 
Factors that may invalidate this  calculation in practice includ e: 
–  adverse factors affecting the value of KB’s shares between 
setting the terms of the rights issue and the issue date (e.g. a 
market crash); 
–  whether the market considers t he forecast return from the ne w 
funds to be realistic; 
–  the increased number of shares  in issue may affect their 
marketability, causing a further  reduction in the ex-rights sha re 
price; 
–  if shareholders do not take up  their rights, shares will be left 
with the underwriters,  which will depress  the share price; 
–  the new project may be seen by investors as more risky than 
existing projects, with no corre sponding increase in return; 
–  investors’ expectations of  future dividends per share may 
change as a consequence of the incr ease in the share capital. 
(iii) A deep-discounted rights iss ue is an issue where the issu e price is 
set well below the current market price of the shares. In some cases, the discount has been as m uch as 40% on the pre-issue 
price. The issue price must st ill, however, be above the nomina l 
value to comply with company law . If share prices are volatile,  there 
is a risk that the ma rket price will fall below the rights issu e price, 
which would lead to undersubscrip tion. A deep-discounted rights  
issue should avoid this potential problem. 
The lower issue price does mean t hat more shares will need to b e 
issued to raise the same level  of finance, with a consequent im pact 
on future dividends per share and earnings per share.

175 
Financing – Debt finance 
B2: Analyse long term debt 
finance Analyse: 
(a) Selecting debt 
(b) Target debt profile (c) Issuing debt securities (d) Debt covenants (e) Tax considerations 
• Types of debt instruments and cr iteria for selecting them 
• Managing interest, currency and refinancing risks with target 
debt profile 
• Private placements and capi tal market issuance of debt 
• Features of debt covenants Chapter 
5

176  
1  Overview of chapter  
 
The previous chapter considered d ifferent sources of equity fin ance. Now we 
move on to look at the differ ent sources of debt finance. 
This chapter looks at the differ ent sources of d ebt finance, an d the criteria to 
consider when trying to manage the risk associated with an enti ty's debt finance. 
It concludes by introducing the im portant 'lease v buy' decisio n.  
2 Debt finance 
Debt finance is the loan of funds  to a business without conferr ing ownership 
rights.  
If the borrower does not make the interest and principal paymen ts when they 
fall due, the lender can apply to t he courts to have the borrow er liquidated (or 
“wound up”).

Chapter 5 
 177 
Tax considerations 
Debt is a tax-effici ent form of financing.  
Interest is paid out of pre-tax  profits as an expense of the bu siness. Therefore, 
paying interest reduces the tax able profits o f the business and  hence the tax 
payable. 
This means that the cost of ser vicing the debt (from the compan y’s point of 
view) is cheaper than the stated ra te of interest on the borrow ing. 
For example, if a company borrows  money from the bank at an int erest rate of 
5% per year, and if the tax rate  is 20%, the post-tax cost of d ebt from the 
company’s point of view is only 4% (5% × (1 – 0.20)). 
(See the later Chapter 6: 'Financin g – capital structure' for m ore details on this.) 
2 Floating charge  – The debt is secured against the general assets of the 
business. This form of security is not as strong; again it conf ers a measure 
of security on liquidation as a ' preferred credit or', meaning t he lender is 
Covenants 
include: 
2 Financial ratios  – Specified levels which cer tain ratios may not breech, 
e.g. minimum interest cover, max imum gearing rati o, minimum EBI TDA / 
finance cost. 

178  
 More details on covenants 
Covenants are put in place by l enders to protect themselves fro m 
borrowers defaulting on their obl igations due to financial acti ons 
detrimental to themselves or the business. 
Covenants are most o ften represented in term s of financial rati os which 
must be maintained for businesse s which lend, such as a maximum  debt- 
to-asset ratio or other such ratios. Covenants can cover everyt hing from 
minimum dividend payments to level s that must be maintained in working 
capital to key employees remai ning with the firm. Once a covena nt is 
breached, the lender will typically have the right to call back  the obligation 
from the borrower. 
Impact on lender and borrower 
Debt covenants benefit both t he lender and the borrower: 
• debt restrictions could protec t the lender by requiring or pro hibiting 
certain activities of the l ender: in other words, debt covenant s 
should restrict the borrower from  making decisions that would b e 
detrimental to the lender; and 
• debt restrictions could benefit t he borrower by reducing the c ost of 
borrowing (e.g. through lower in terest rates and higher credit 
ratings). 
Debt covenants do not aim to pla ce a burden on the borrower. De bt 
covenants are used to solve t he agency problems among the 
management (i.e. of the borrowin g company), debt holders, and 
shareholders that arise due to th e differences in the objective s of the 
borrower and the lender. 
Positive and negative debt covenants 
Debt covenants can be eit her positive or negative. 
Negative debt covenants state wha t the borrower cannot do and m ay 
include the following: 
• Incur additional long-term debt ( or require that additional bo rrowing 
be subordinated to the original borrowing) 
• Pay cash dividends exc eeding certain threshold 
• Sell certain assets (e.g. sell accounts receivable) 
• Enter into leases 
• Combine in any way with another  firm (e.g. takeover, merger) 
• Compensate or increase salaries of certain employees

Chapter 5 
 179 
 Positive debt covenants state wha t the borrower must do and may  
• Maintain certain mini mum financial ratios 
• Maintain accounting records in  accordance with generally accep ted 
accounting principles 
• Provide audited financial statem ents (normally within a specif ied 
amount of time after the year-end) 
• Perform regular maintenance of assets used as security 
• Maintain all facilities in good working condition 
• Maintain life insurance policie s on certain key employees 
• Pay taxes and other liabilities when due 
Examples of covenants 
The most common financial rati os used in debt covenants include  the 
following: net debt to cash flow , net debt to EBITDA, interest cover, 
tangible net worth, net worth, gea ring ratio, current ratio, ca sh interest 
cover, debt to equity, etc. 
In the above listed ratios, the sa me term can have different me anings in 
different debt agreements. For example: 
Debt: total debt, funded debt, fun ded debt less cash, etc.  
Cash flow: cash from operations, EBIT, EBITDA, etc. 
According to research, covenants  that most commonly lead to tec hnical 
default include net worth (or t angible net worth) and current r atio. 
Breach of a covenant 
When a debt covenant is breached by  the borrower, the lender ha s a 
range of alternative responses, i ncluding the following (non-ex haustive 
list): 
• Waive the breach and  continue the loan 
• Waive the breach and impos e additional constraints 
• Require penalty payment 
• Increase interest rate 
• Demand immediate r epayment of the loan 
• Increase security needed 
• Terminate debt agreement 
It is usually better for the bo rrower to approach the lender if  they suspect 
a breech is likely to occur. E arly negotiations can be started to minimise 
any penalties. This may include giving the lender details of a recovery 
plan, additional security or  parent company guarantees.

180  
A debt covenant breach represent s a breach of contract. Lender’ s 
response to the breach of contra ct usually depends on the sever ity of the 
breach as well as the terms of the debt agreement. When a debt 
covenant breach is not severe, u sually lenders either waive the  breach or 
impose additional constr aints on the borrower. 
 
 Types of debt finance 
Debt may be raised from two gener al sources – banks or capital markets. 
Bank finance 
For companies that are unlisted , and for many listed companies,  the first port of 
call for borrowing money  would be the banks. 
These could be the high street b anks or, more likely for larger  companies, 
merchant banks. 
Terms and conditions are negotia ble dependent on the term of th e borrowing, 
the amount borrowed, and the cr edit rating of the company wishi ng to make the 
borrowing. 
As an alternative to borrowing  funds from a bank, a listed comp any may issue 
(long term) bonds or (short term) commercial paper in the capit al markets. 
Criteria for selecti ng debt instruments 
Most companies can borrow from banks, but view direct borrowing  from a bank 
as more restrictive and expens ive than selling bonds on the cap ital market. 
Entities deciding whether iss ue a bond or borrow from a bank to  finance a 
particular investment should consider 
• liquidity, 
• timescale and 
• c o s t  
as determining factors.

Chapter 5 
 181 
 Detailed considerations: Criteria to consider 
 Entities use bonds and bank bo rrowings to finance investment p rojects. 
These range from short-term to long-term investments and cover a 
variety of reasons including infr astructure development and cor porate 
expansions. Generally speaking , a bond is meant to finance a lo ng-term 
investment, whereas a bank borrowi ng is more suitable for short -term 
needs. But that is not always the case. In recent years, financ ial 
managers have shifted their atte ntion to the bond market as it offers 
liquidity, lower overall costs and the flexibility entities nee d to run their 
Accessibility to the market is a key feature that differentiate s the bond 
market from bank borrowings. Wh ile the latter is open for most corporate 
entities, the bond market implies costly and cumbersome hurdles  for the 
aspiring company. Only those that have overcome the process can  
operate in the bond market. 
There is a tendency for small and medium sized enterprises (SME s) to 
use bank borrowings. Clearly, loc al banks provide financial sup port, 
satisfy liquidity needs and a r ange of other banking services o n a daily 
basis. Eventually, banks engage in a  long relationship with SME s that 
benefits the entity w henever the need for capital arises. This relationship 
provides flexibility when it com es to agree on the terms and co nditions of 
the lending. A bank borrowing oft en allows borrowers to pay off  the 
borrowing partly or totally, at any  time, with little or no war ning. A 
downside, however, is that repaym ent charges are typically link ed to 
regional interest rates and other  admin fees subject to the whi m of the 
bank. Lenders are also capable o f substantially changing the te rms of the 
deal, but borrowers can take thei r accounts elsewhere assuming there is 
another lender available. 
On the bond market, entities need  to build up a reputation. The y need to 
communicate their credit quality , which should determine the in terest rate 
on the bond. Bonds have highly s tandardised terms and condition s. 
Standardisation plays an importan t role for entities. It enable s the entity to 
reach a wider range of investo rs and creates liquidity. 
Both types of funding entail operat ional costs, but there are d ifferences 
between them. Entering the bond mark et might be rather difficul t and 
expensive, but once in, the cost s reduce significantly. This is  because the 
lending agreement is based on t he standardised terms defined by  the 
issuer. 
Borrowing from a bank, as discuss ed earlier, implies submission  to the 
terms set out by the bank as we ll as dealing with sometimes unc ertain 

182  
 Examples of long-term deb t finance: Terminology 
lending in the short-term, from  several days to just under a ye ar. This 
Under a RCF the borrower may use or withdraw funds up to a pre-  
needs. 
Bonds 
formal contract to repay borrowed money with interest at fixed intervals. 

Chapter 5 
 183 
 Bonds and shares are both securities which can be traded in the  capital 
after which the bond is redeemed, whereas shares may be outstan ding 
Commercial paper 
Large, well-established listed companies with good credit ratin gs may 
issue short-term unsecured money  market securiti es, referred to  as 
commercial paper. 
This commercial paper will genera lly mature within 9 months, ty pically 
between a week and 3 months. Howev er, 3 month commercial paper is 
often "rolled over", with a new  issue every 3 months, so the co mpany can 
increase or decrease the amount issued regularly. 
This can be risky if used for longer term finance, because ther e may be 
insufficient investor interes t at one of these issue dates. The refore, the 
company would need to arrange back-up, stand-by facilities. 
Commercial paper can be traded at any time before the maturity date. 
 
 More details on the ca pital market (bond market) 
Issuers 
major issuer is corporates, whi ch issue bonds to finance operat ions. 
sell the bonds in the market.

184  
 In most cases, huge amounts of fi nance are transacted in one of fering. 
need for underwriters is greatest  for the corporate debt market  because 
there are more risks associ ated with this type of debt. 
The underwriters sometimes place  the bonds with specific invest ors 
the market. Alternatively, under  a medium term note (MTN) progr amme, 
 
 How to issue bonds on the market 
 Listing and admission to t he London stock exchange 
The admission proces s in the UK is made up of two stages; listi ng and 
admission to trading. 
Listing 
If the bond issuer is not already a  listed company, it must fir st apply to 
become listed on the London stock exchange. 
Admission of companies to the Offi cial List is controlled by th e UK Listing 
Authority (UKLA), a division of the Financial Conduct Authority  (FCA). 
The FCA retains responsibility for the approval of prospectuses , however 
issuers seeking admission to t he Official List will also need t o submit 
listing particulars to the UKLA. 
A debt issuer seeking a London listi ng for its securities must apply for 
admission to the Official List ( a ‘listing’) through the UKLA. The listing is 
dependent on the securities gai ning admission to trading on the  Main 
Market through satisfying the Ex change’s admission and disclosu re 
standards.

Chapter 5 
 185 
 The listing process can take as little as three days depending on the 
complexity of the transaction and  the completeness of the listi ng 
document submitted for approval. A ppointing adviser s with exten sive 
experience of listing and agreeing  the timetable well in advanc e should 
help shorten the process. 
Admission to trading 
In February 2010 London Stock Exch ange launched an electronic, order- 
driven trading service for UK government, corporate and suprana tional 
bonds, called the Order book for Re tail Bonds (ORB). This aims to offer 
retail investor’s efficient acce ss to an on-screen secondary ma rket in 
retail denominated London listed debt instruments. This new tra ding 
service was introduced in response  to demand from private inves tors in 
the UK for a cost effective and transparent mechanism for gaini ng access 
to fixed income securities and to  develop the market for retail  
denominated bonds in the UK. 
For admission to the ORB, the Admissions team at London Stock 
Exchange require docum entation to be submi tted at least 11 days  prior to 
the admission date. This documen tation should include an electr onic 
copy of the base prospectus and the relevant pricing supplement /final 
terms document, a copy of the rele vant board minutes relating t o the 
issue, confirmation of the mark et maker who will be supporting the 
security, and an indicative open ing price for the security. 
Market making 
To ensure that all instruments available on the ORB are tradabl e and 
have prices available throughou t the day it is a requirement fo r all bonds 
admitted to the ORB to have at l east one registered market make r. 
The issuer can act as market mak er to their own securities or c an engage 
the services of a third party bro ker, however the market maker must be a 
member firm of London Stock Exc hange and be authorised to deal.  
The market maker will be required  to quote two-way prices (buy and sell) 
in the security throughout the continuous trading period. 
The prices must be within a maxi mum spread requirement which is  
determined by the trading segmen t and trading sector of the sec urity. 
There is also a minimum volume  (equivalent to nominal value) of  
securities which must be quoted on either side. 
To register in a security the ma rket maker must complete and su bmit a 
registration information form. The market maker has no obligati on to 
quote in more than one security and there is no fee payable to register in 
ORB securities.

186  
International debt finance 
Large companies can borrow money i n foreign currencies as well as their own 
domestic currency from banks at home or abroad. 
The main reason for wanting to borrow in a foreign currency is to fund a foreign 
investment project or foreign subsidiary. 
The foreign currency borrowing pr ovides a hedge of the value of  the project or 
subsidiary to protect against c hanges in value due to currency movements. The 
foreign currency borrowing can be  serviced from cash flows aris ing from the 
foreign currency investment. 
 
 More detail on foreign currency borrowings 
 The choice of currency for debt finance  
In the developed countries of the world, companies can choose w hich 
currency they prefer for both bank borrowings and bonds. In mos t 
developing countries, companies will need to raise finance in a n 
international currency such as US dollars. 
Eurobond markets 
Eurobonds are bonds issued on the in ternational capital markets . They 
can be denominated in any major international currency (i.e. no t 
necessarily denominated in euro) . Eurocurrency bonds may be lis ted on 
the domestic currency stock exchange but cannot be traded throu gh that 
exchange. They are usually beare r instruments and pay interest annually, 
gross of tax. 
This is in contrast to domesti c bonds which are both listed and  traded on 
the local stock exchange, and ar e usually registered bonds, tha t is, 
registered to a named holder. 
The Eurobond market is a self-re gulated off-shore market. Self- regulation 
is promoted by the International  Capital Market Association (IC MA) who 
set rules for members to follow in  areas such as processing tra nsactions 
and payment of commission.

Chapter 5 
 187 
3 Target debt profile 
The next chapter ('Financing – C apital structure') discusses th e factors an entity 
will have to consider when choosi ng what its overall capital st ructure (mix of 
debt and equity finance) should be. 
Once an entity has dec ided how much debt f inance is needed, sev eral issues 
need to be considered as the entit y aims to achieve its target debt profile. In 
particular, the following questions need to be answered: 
• Should the entity borrow at a fixe d or a floating (variable) r ate? 
• Should the debt have a short-te rm or a long-term repayment dat e? 
• Should domestic currency or fore ign currency borrowings be use d? 
The answers to these questions wil l determine the level of inte rest rate, 
refinancing and currency risk  that the entity will face. 
Interest rate risk 
Interest rate risk is the risk o f gains or losses on assets and  liabilities due to 
changes in interest rates. It will occur for any organisation w hich has assets or 
liabilities on which interes t is payable or receivable. 
 
The exposure to interest ri sk will depend on the amount of inte rest bearing 
assets or liabilities that an entity holds and the type that th ese are (floating or 
fixed rate). 
Refinancing risk 
Refinancing risk is associated with  interest rate risk because it looks at the risk 
that borrowings will not be re financed or will not be refinance d at the same 
rates. 
The reasons for this could include: 
• Lenders are unwilling to lend or  only prepared to lend at high er rates. 
• The credit rating of the company  has reduced making it a more 
unattractive lending option. 
• The company may need to refinanc e quickly and therefore have d ifficulty 
in obtaining the best rates. 
The use of longer-term debt finance reduces the refinancing ris k. Short-term 
debt finance has to be regularly r epaid and then renegotiated i f additional 
finance is needed, so the refinancing risk is higher. 
 Currency risk 
Currency risk is the risk that ari ses from possible future move ments in an 
exchange rate. It is a two-way ri sk, since exchange rates can m ove either 
adversely or favourably. 
Currency risk affects any organisation with:

188  
• assets and/or liabilities in a foreign currency 
• regular income and/or expendi tures in a foreign currency 
• no assets, liabilities or trans actions that are denominated in  a foreign 
currency. Even if a company does not deal in any currencies, it  will still 
face a risk since its competit ors may be faring better due to f avourable 
exchange rates on their transactions. 
Currency risk and interest rate ri sk are covered in more detail  in Chapter 8: 
‘Financial risk’, and several risk management techniques are co vered in 
Chapter 9: ‘Currency risk managem ent’ and Chapter 10: ‘Interest  rate risk 
management’. 
 
 4 Other sources of finance 
There is a common misconception  that a company with a large amo unt of 
retained earnings in its balance sheet (statement of financial position) can fund 
its new investment projects usi ng these retained earnings. This  is not the case. 
A company can only use internal  sources of finance to fund new projects if it 
has enough cash in hand. 
company's life. It is not the same as cash. 
substantial high street property  e.g. Tesco, Marks and Spencer.

Chapter 5 
 189 
Grants 
larger bodies such as  the European Union. 
This is similar in effect to att aching a warrant to a debt inst rument except that 
the warrant cannot be detached a nd traded separately. The conve rtible debt is 
where the debt itself can be conv erted into shares at a predete rmined price at a 
date or range of dates in the future. 
above the return from the debt int erest. If the value of the sh ares is greater than 
that of the debt on the exerci se date, then conversion will be made by the 
investor. If, however, the share value is lower than the debt v alue, the investor 
may retain the debt to maturity. 
Venture capital is covered in m ore detail in the later chapter on 'Financial and 
strategic implications of m ergers and acquisitions'. 

190  
Government assistance 
Governments will often have a num ber of schemes, aimed at provi ding 
assistance to: 
• small- and medium-sized pr ofit-making entities; 
• entities wanting to expand or r elocate in particular regions; 
• promote innovation and technology; 
• projects that will create new j obs or protect existing ones. 
You do not need to have knowledge of any specific scheme, but r elevant 
discussion of methods of governmen t assistance in your own coun try will earn 
credit in the examination. 
 
 5 The lease v buy decision 
If a new project requires the use of an asset, such as a machin e, a business 
often has the choice of whether t o buy the asset outright, or w hether to lease it. 
 
Lease 
A lease is a commercial arrange ment where an equipment owner (t he lessor) 
conveys the right to use the equi pment in return for payment by  the equipment 
user (the lessee) of a specifi ed rental over a pre-agreed perio d of time. 
Reasons for leasing 
• It is a readily available form of finance, especially for plan t and equipment 
or motor vehicles. It is therefore very convenient for companie s to enter 
into such arrangements. 
• It removes the need for a signi ficant capital outlay at the be ginning of a 
project's life i.e. it avoids  the need to find the capital at t he outset. 
• It may be cheaper in financial  terms than conventional debt fi nancing i.e. 
the effective interest rate on leasing may be less than the int erest payable 
on a loan. This is because a l ease is asset-backed finance and so is less 
risky for the lender. Consequently , lenders may therefore be pr epared to 
offer a lower rate of interes t than on a standard borrowing.

Chapter 5 
 191 
 The lease v buy decision 
 Lease-or-buy decisions 
The evaluation of the lease-or-buy  decision is not a pure finan cing 
decision as it also involves int eractions with the investment d ecision. 
The decision to lease or buy an asset is a financing decision t hat will be 
made only once the decision to i nvest in the asset has been tak en. The 
decision to invest in the asse t would be determined by discount ing the 
operational costs and benefits from using the asset at the cost  of capital 
normally used by the entity to eva luate projects, typically its  weighted 
average cost of capital. Investi ng in the asset would be justif ied if a 
positive NPV is  obtained. 
The financing decision is then c oncerned with identifying the l east-cost 
financing option.  
In evaluating the financing decis ion, it is usually assumed tha t the entity 
would have to borrow funds in or der to purchase the asset. 
 
 Lease v buy evaluation 
If an asset is needed for a major new investment, and the asset  can be leased, 
then a critical decision is: 
• should the asset be leased?; or 
• should the asset be purchased a nd the purchase cost financed b y debt 
issue? 
In the exam you may need to eval uate the lease against the borr owing to buy 
option to determine which woul d be better in financial terms. 
The traditional approach to the ev aluation is to use the NPV me thod i.e. 
determine the present value cos t of leasing and compare this to  the present 
value cost of borrowing to buy. 
 
 Note:  The NPV method (Net Present V alue) was covered earlier in the 
CIMA syllabus.  
 
 Note on discount rate 
In the lease v buy evaluation, i t is considered that the risk a ssociated with the 
lease option is comparable to t he risk associated with the borr ow to buy option. 
Hence the same discount rate sh ould be used for both NPV calcul ations. 
The discount rate to use is the post-tax cost of debt finance  – clearly this rate 
applies to the borrow to buy opti on, and it is considered to be  appropriate to the 
leasing option too, since the pos t-tax cost of debt is effectiv ely the opportunity 
cost of leasing.

192  
 Penny Co wishes to invest in a new lorry costing $130,000. The  lorry has 
a life of four years and no scrap proceeds are expected to be a vailable 
after this period. Tax allowable depreciation is available at 2 5% on a 
reducing balance basis. The company can borrow at 12% pre-tax. 
The lorry could alternatively be leased for a cost of $40,000 p er year 
payable in arrears for four year s. Assume for now that the full  lease 
payment is a tax deductible expen se and that no tax allowable 
depreciation can be claimed on a leased asset. Corporation tax is 33% 
payable one year  in arrears. 
Required: 
Determine whether the company shoul d lease or purchase the asse t. 
Further calculations on lease interest 
In the above example, to simplify the calculations, we were tol d specifically that 
the full lease payment was to be treated as a tax deductible ex pense. 
In reality, it will usually be ju st the interest element of the  lease payment which 
is tax deductible. In this case, the first step is to calculate  the interest element, 
using either the actuarial met hod, or the sum of digits method.  
The following illustration s hows how both methods work. 
 
 Assume that KL Co has the opti on to buy an asset for USD100,00 0, or to 
lease it by paying USD29,500 per year in arrears for 4 years. 
Clearly, the interest element in  the lease amounts to (4 × USD2 9,500) – 
USD100,000 = USD1 8,000 in total.  
This interest can be allocated to  years using either the actuar ial method, 
or the sum of digits method. 
Actuarial method 
Here the implied interest rate is found by using an IRR approac h. As a 
short cut, the 4 year annuity fact or at the IRR can be found by  dividing 
the cost of the asset by the annual interest payment (i.e. 
100,000/29,500).  
This gives a 4 year annuity fact or of 3.390, which (from tables ) is very 
close to the 7% factor. Hence, the implied interest rate in the  lease is 
(approximately) 7%.

Chapter 5 
 193 
 Now, the interest can be allocat ed to individual years using th e following 
table: 
USD Year 1 Year 2 Year 3 Year 4 
Opening balance 100,000 77,500 53,425 27,665 
+ Interest (7% × Op Bal) 7,000 5,425 3,740 1,937 – Lease payment (29,500) (29, 500) (29,500) (29,500) 
Closing balance 77,500 53,425 27,665 102 
Note:  The closing balance at the end of year 4 should be zero. The 
difference is due to rounding. 
The lease interest payments hav e now been allocated to years, s o can 
be used to calculate the tax relief each year. 
Sum of digits method 
This is a simpler way of alloca ting interest, based on the sum of digits 
formula: 
n(n+1)/2 
In this example, the lease payment s are to be made over 4 perio ds, so 
the sum of digits is 10 (working: 4 × 5 /2 = 10) 
Hence, the interest allocation is: 
Year 1 4/10 × 18,000 USD7,200 
Year 2 3/10 × 18,000 USD5,400 
Year 3 2/10 × 18,000 USD3,600 
Year 4 1/10 × 18,000 USD1,800 
Once again, the tax relief on the lease interest can now be cal culated 
easily. 
Note: The sum of digits method is an allowable and quick approximatio n 
of the actuarial method. 
 
 Following on from the informati on in the Illustration above: 
Assume that KL Co has the option  to buy an asset immediately fo r 
USD100,000, or to lease it by pay ing USD29,500 per year in arre ars for 4 
years. 
Other information 
• KL Co is liable to corporate ta x at a marginal rate of 30% whi ch is 
settled at the end of the year  in which it arises. 
• KL Co accounts for depreciation  on a straight-line basis at th e end 
of each year 
• Under the buy option, tax deprecia tion allowances on the full capital 
cost are available in equal insta lments over the first four yea rs of 
operation.

194  
 • Under the lease option, both t he accounting depreciation and t he 
interest element of the lease payments are tax deductible. 
Required: 
Advise KL Co whether the asse t should be leased or bought, assu ming 
that the interest on the lease sh ould be allocated using the ac tuarial 
method. Use a discount rate of 5% in your evaluation. 
6 End of chapter objective test questions 
 A company is evaluating the decis ion whether to lease an asset  or to buy 
it outright using newly borrowed funds. 
Which of the following is the B EST discount rate to use for the  
evaluation, assuming that the deci sion has already been taken t o 
acquire the asset? 
A  Post tax cost of debt 
B  WACC C  Cost of equity D  Pre-tax cost of debt 
 
 Which THREE of the following statements about eurobonds are 
correct? 
A  Entities that issue eurobonds k eep a register of their eurob ond 
holders 
B  Eurobonds are traded on the inte rnational capital markets 
C  They are sometimes  denominated in euros 
D  They are sometimes denominated in US dollars E  Eurobond interest is normally paid semi-annually (every six months)

Chapter 5 
 195 
 The following information relates  to an asset which a company is 
considering leasing or buying. 
• Life of asset 10 years 
• Cost if purchased $28,000 
• Residual value $3,000 
• Lease details: Ten annual repaym ents of $3,800 to begin at sta rt of 
lease 
The shareholders view  the adoption of the lease as being an equ ivalent 
risk to borrowing at an afte r-tax cost of 10% per annum. 
The first lease payment (or the purchase price) would be due on  1 
January 20X2. The purchase price would not be eligible for tax 
depreciation allowances but lease payments would be allowed as a 
deduction from profit for tax purposes. 
The firm has a 31 December year  end and pays corporation tax at  35% 
one year after the year end in  which profits are earned. 
It makes sufficient pro fits to obtain tax relief on lease payme nts as soon 
as they arise. 
What (to the nearest $100) is the  net after-tax benefit of leas ing the 
asset as opposed to buying it? 
A $1,200 
B $4,200 C $8,600 D $18,300 
 
 Reef Co needs to raise some deb t finance and the directors wan t to limit 
the entity's exposure to refinanc ing risk and interest rate ris k. 
Although the overall debt prof ile of an entity should be consid ered to fully 
assess the overall risk, as a general rule 
• refinancing risk is likely to  be greater wit h ________________ __ 
(long term / short term) debt, and 
• interest rate risk is likely  to be greater with ______________ ____ 
(fixed rate / floating rate)  debt 
(Enter the correct phrase from the choice given.)

196  
 An entity may issue convertible unsecured loan stock because 
A  it is cheaper to ser vice than ordinary debt 
B  sales and earnings are expec ted to fall over the next few ye ars 
C  if conversion takes place, i t will not disturb the firm’s ge aring ratio 
D  if conversion takes place , it will generate additional capit al funds for 
the firm

Chapter 5 
 197 
7 End of chapter case style question 
 Test your understanding 8 (Case style question) 
 XTA plc is the parent entity of a transport and distribution g roup based in 
the United Kingdom. T he group owns and oper ates a network of 
distribution centres and a fleet o f trucks (large delivery vehi cles) in the 
United Kingdom. It is currently p lanning to expand into Contine ntal 
Europe, operating through a new s ubsidiary entity in Germany. T he 
subsidiary will purchase distri bution centres in Germany and in vest in a 
new fleet of trucks to be based a t those centres. The German su bsidiary 
will be operationally in dependent of the UK parent. 
Alternative proposals have been pu t forward by Messrs A, B and C, 
Board members of XTA plc on ho w best to structure the financing  of the 
new German operation as follows: 
• Mr A:  ‘I would feel much more comfo rtable if we were to borrow in 
our base currency, British pounds  (GBP), where we already have 
long-standing banking relationshi ps and a good reputation in th e 
capital markets. Surely it woul d be much more complicated for u s to 
borrow in euros (EUR)?’ 
• Mr B:  ‘I am concerned about the expo sure of our consolidated 
statement of financial position an d investor ratios to GBP/EUR 
exchange rate movements. How wil l we be able to explain large 
fluctuations to our shareholders?  If we were to raise long-term  euro 
borrowings, wouldn’t this avoid e xchange rate risk altogether? We 
would also benefit from euro in terest rates which have been 
historically lower than UK rates.’ 
• Mr C:  We know from our market res earch that we will be facing stiff 
competition in Germany from local  distribution companies. This is a 
high-risk project with a lot of c apital at stake and we should finance 
this new venture by XTA plc rai sing new equity finance to refle ct this 
high risk.’ 
Assume that today is Saturday 1 Oc tober 20X5. A summary of the latest 
forecast consolidated statement  of financial position (balance sheet) for 
the XTA Group at 31 December 20X5 is given below. It has been 
prepared BEFORE taking into acc ount the proposed German investm ent:

198  
  GBP million 
Assets  
Total assets 450 
Equity 250 Long term borrowings  
(there were no other non- current liabilities) 150  
Current liabilities  50 
 – – – –  
Total equity and liabilities 450  – – – –  
The proposed investment in Germ any is scheduled for the final q uarter of 
20X5 at a cost of GBP 60m for the distribution centres, and GBP  20m for 
the fleet of trucks when translat ed from euros at today’s excha nge rate of 
GBP/EUR1.50 (that is GBP1 = EUR 1.50). There is a possibility t hat the 
euro could weaken against GBP to  GBP/EUR 2.00 by 31 December 
20X5, but it can be assumed tha t this will not occur until afte r the 
investment has been made. The subs idiary’s statement of financi al 
position at 31 Decemb er 20X5 will only cont ain the new distribu tion 
centres and fleet of trucks matc hed by an equal equity investme nt by 
XTA plc and will only become operationally  active from 1 Januar y 20X6. 
Required: 
(a) Write a memorandum  to the Board of XTA plc to explain the 
advantages and disadvantages of u sing each of the following 
sources of finance: 
–  a rights issue versus a pla cing (assuming UK equity finance is 
chosen to fund the new German subsidiary); and 
–  a euro bank borrowing vers us a euro-denominated Eurobond 
(assuming euro borrowings are chosen). (15 minutes) 
(b) Evaluate EACH of the alternat ive proposals of Messrs A, B a nd C 
for financing the new German subs idiary and recommend the most 
appropriate form of financing fo r the group. Support your discu ssion 
of each proposal with 
–  a summary forecast consolidated statement of financial 
position for the XTA group at 31 December 20X5 incorporating 
the new investment; and 
–  calculations of gear ing using book values 
using year end exchange rate s of both GBP/EUR 1.50 and 
GBP/EUR 2.00. (30 minutes)

Chapter 5 
 199 
 The discount rate is the post-tax cost of debt ∴12% (1 – 0.33) = 8.04% 
≈ 8%. 
Assumptions: 
1 Asset is purchased on first day of year 1. 
2 Tax is delayed by 1 year. 
Buy asset 
Tax allowable depreciation 
  Tax @ 33% Date 
0   130,000   
1 TAD   32,500/97,500  10,725  2 
2 TAD   24,375/73,125  8,044  3 
3 TAD   18,281/54,844  6,033  4 4 SCRAP   0   
  ———   
Balancing allowance  54,844  18,099  5 
  ———   
 
Year Cash flow PVF @ 8% PV 
0 (130,000) 1 (130,000) 
1 − − − 
2 10,725 0.857 9,191 
3 8,044 0.794 6,387 4 6,033 0.735 4,434 
5 18,099 0.681 12,325 
   ———
– 
   (97,663) 
   ——— – 
Lease asset 
Year Lease Tax Net PVF @ 8% PV 
1 (40,000)  (40,000)  (0.926) (37,040) 
2 (40,000) 13,200 (26, 800) 0.857 (22,968) 
3 (40,000) 13,200 (26, 800) 0.794 (21,279) 
4 (40,000) 13,200 (26, 800) 0.735 (19,698) 
5  13,200 13,200 0.681 8,989 
     ——— – 
     (91,996) 
     ——— – 
Decision: 
On purely financial grounds it is better to lease rather than b uy the asset.

200  
 Buy option 
 T0 T 1–T4 
Purchase cost  (100,000)  
Tax relief on tax depreciation  
(30% × 100,000/4)  7 , 5 0 0  
Discount factor (5%) 1  3.546 
Present value (100,000)   26,595  ––––––– –––––– 
Net present value (73,405)  
i.e. Buying the asset to underta ke the project will cost USD 73 ,405 in 
present value terms. 
Lease option 
 T
1 T 2 T 3 T 4 
Lease payment  (29,500)  (29, 500)  (29,500)  (29,500) 
Tax relief on 
depreciation and lease interest (W1)  9,600  9,128  8,622  8,081 
 –––––– ––––––  ––––––  –––––– 
 (19,900) (20,372) (20, 878)  (21,419) 
 –––––– –––––– –––––– –––––– Discount factors (5%) 0.952 0.907 0.864 0.823 
 ––––––  –––––– ––––––  –––––– 
Present value (18,945)  ( 18,477)   (18,039)  (17,627) 
Net present value (73,088)    
i.e. Leasing the asset to under take the project will cost USD 7 3,088 in 
present value terms.

Chapter 5 
 201 
  (W1)  Tax relief calculation 
 T1 T 2 T 3 T 4 
Implied interest  
(from Illustration 3 earlier in the chapter) 7, 000  5,425  3,740  1,937 
Depreciation  25,000  25,000  25,000  25,000  –––––– –––––– –––––– –––––– 
 32,000  30,425  28,740  26,937 
 –––––– –––––– –––––– –––––– Tax relief (30%) 9,600    9,128  8,622 8,081 
Note:  The tax relief on the lease in terest is included in the evalua tion as 
a relevant cash flow, but the l ease interest itself is not a ca sh flow, so is 
not included. 
Conclusion: 
The lease option is cheaper so should be undertaken on financia l 
grounds. However, the difference is  so marginal that it will be  important to 
undertake sensitivity analysis, and to consider other non-finan cial factors 
before a final decision is made. 
Note that we are assuming that t he positive NPV of any cash flo ws 
arising from the new project m ust exceed the negative NPV assoc iated 
with the cost of the asset, to g ive an overall positive NPV. 
 
Eurobonds are bearer instrument s, so no register of bond holder s is kept 
(A). Interest is norma lly paid annually (E). 
They are traded on international c apital markets (B) and can be  
denominated in any major global  currency – (C) and (D).

202  
PV of buying = $28,000 – ( $3,000 × 0.386) = $26,842 
PV of lease payments (years 0-9)  = $3,800 × (1 + 5.759) = $25,6 84 
PV of lease tax relief (years 2- 11) = $3,800 × 0. 35 × 5.586 = $ 7,429 
So the benefit of leasing is 26,842 – 25,684 + 7,429 = $8,587 
 
 As a general rule 
• refinancing risk is lik ely to be greater with short term  debt, and 
• interest rate risk is lik ely to be greater with floating rate  debt. 
 
One of the main advantages of issu ing CULS is the lower return that it 
demands due to the attraction of t he option of conversion to eq uity, i.e. it 
is cheaper to service than ordinary debt. 
If sales and earnings are expecte d to rise (not fall), it may b e beneficial to 
issue CULS rather than to issue effectively underpriced equity (B). 
If conversion takes place the  firm’s gearing ratio will change (C). No extra 
capital is generated on conversion (D). 
 
 ( a )  Rights issue versus placing 
Advantages of a rights issue 
–  no dilution of ownersh ip by current shareholders 
–  reliable (can be underwritten) 
Disadvantages of a rights issue 
–  limits potential investor s to current shareholder base 
(placements can be marketed  to a wider selection of 
institutional investors) 
–  more complex and more e xpensive than a placing 
–  takes longer to arrange than a placing

Chapter 5 
 203 
 Euro bank borrowing versus euro-denominated eurobond 
Advantages of a euro bank borrowing 
–  direct contact with lender 
–  flexible terms –  promotes good bank relationship –  access to a wider source of f unds via syndicated credit from  a 
panel of banks 
–  not dependent on a good rating –  relatively quick and cheap to arrange 
Disadvantages of a euro bank borrowing 
–  does not give access to lar ge, deep international capital 
markets which may support larger issues 
–  better rates possible from Eurobonds –  longer maturities may be harder  to obtain from a bank (for 
example 20 years) 
Examiner’s note: 
The answer to (a) above has been given in list form as a study aid, 
but in a case study examination , candidates would be expected t o 
provide a memorandum, with short paragraphs (which could be in 
bullet point form) for each point. 
(b) Revised statements of financi al position (balance sheets) 
The balance sheet of the German subsidiary is translated at clo sing 
rate since the company is operationally independent of the UK 
parent. 
Table A: Mr A's proposal – long term borrowings in GBP 
 Ex rate 
GBP/EUR1.50 Ex rate 
GBP/EUR2.00 
 GBP million GBP million 
Total assets 530 510 
    (450 + 120/1.50) (450 + 120/2.00) 
Equity and liabilities   
Equity (balancing figure) 250 230 Long term borrowings 230 230 
Current liabilities 50 50 
 –––– –––– Total equity and liab ilities 530 510 
 –––– ––––

204  
 Table B: Mr B's proposal –  long term EUR borrowings 
 Ex rate 
Total assets 530 510  (450 + 120/1.50) (450 + 120/2.00) 
Equity (balancing figure) 250 250 Long term borrowings 230 210 
   
 (150 + 120/1.50) (150 + 120/2.00) Current liabilities 50 50 
 –––– –––– 
Total equity and liab ilities 530 510 
 –––– –––– 
Table C: Mr C's proposal –  UK (GBP) equity funding 
 Ex rate 
 (450 + 120/1.50) (450 + 120/2.00) 
Equity and liabilities   Equity (balancing figure) 330 310 
Long term borrowings 150 150 
Current liabilities 50 50  –––– –––– 
 –––– –––– 
Table D: Gearing levels 
Current position (debt to debt p lus equity) = 150/(150 + 250) 
= 37.5% 
Scenario: Ex rate 
Mr A 48% 50% 
Mr B  48% 46% 
Mr C 31% 33%

Chapter 5 
 205 
 Evaluation of Board members’ comments 
Mr A: GBP-denominated borrowings 
Reputation in the UK markets:  Mr A’s comment on the advantage of 
GBP borrowings due to reputation in  the UK capital markets is n ot 
valid since banks providing G BP loans should be equally willing  to 
provide euro loans and a good reput ation in the capital markets  will 
extend beyond the United Kingdom. 
Foreign exchange risk:  There is, however, a major exchange risk 
arising from funding euro-based a ssets with GBP borrowings, 
arising mainly from the retrans lation of the net investment in the 
subsidiary at the year end and t he effect this has on equity va lues 
and gearing levels. This is illus trated in Table A, where the v alue of 
equity has fallen from GBP 250m to  GBP 230m as a result of the 
weakening of the euro against GBP  from a rate of GBP/EUR 1.50 t o 
GBP/EUR 2.00. 
The effect on gearing is seen in  Table D where a fall in the va lue of 
the euro leads to deterioration in gearing levels from 48% to 5 0%. 
Impact on gearing:  The use of borrowings has a major impact on 
gearing level, with debt/equity deteriorating from 37.5% to 48%  (at 
GBP/EUR 1.50). Euro-denominated borrowings have a similar 
impact at current exchange rates. 
Other exchange risk:  There is also an exchange risk on the GBP 
value of the repatriation of eur o profits to the United Kingdom  via 
dividends, interest and management charges. 
Mr B: euro-denominated borrowings 
Lower euro interest rates:  This is not a valid argument since, under 
interest rate parity, spot rates are expected to move to compen sate 
for lower euro interest rates and so any gain on interest payme nts is 
likely to be offset by a loss on  the capital value of the borro wing 
when it is repaid. 
Exchange risk and equity values:  Euro borrowings provide a natural 
hedge by matching the currency of  the assets with that of the 
funding used to finance those a ssets. At the statement of finan cial 
position date, the exchange gain or  loss on retranslating the n et 
investment in the German subsid iary will be substantially match ed 
by an equal and opposite gain or loss on retranslating the euro  
borrowings. This is illustrated in  Table B, where a weakening o f the 
euro borrowings against GBP is seen to have no impact on the value of equity.

206  
 Note:  It could be noted that the hedge accounting provisions of 
IFRS 9 can be applied to avoid vol atility in reported profit fi gures. 
Without hedge accounting, gains and losses on the borrowing wou ld 
be recognised in profit for the year whereas gains and losses o n the 
investment in the German subsid iary would be recognised as part  of 
equity under IAS 21. If hedge acc ounting is permitted, the hedg e 
provided by the borrowing can be  designated as such and exchang e 
rate movements on both the in vestment and the borrowing 
recognised as changes in the value of equity. 
Exchange risk and gearing levels:  The gearing ratio has again 
deteriorated markedly as a res ult of increased borrowing. In 
addition, gearing levels are exp osed to exchange rate changes. In 
this case, gearing has improved  from 48% to 46% as a result of a 
fall in the value of the euro, but a negative impact would have  
resulted from a strengthening of the euro against GBP. 
Mr C: UK equity 
Risk profile:  Mr C is correct in his asse rtion that equity finance is 
more suitable than long-term bo rrowings for a high risk project , 
since dividends can be cut or r educed if profits are lower than  
expected, whereas the interest o n borrowings always has to be p aid 
in full at each due date. 
Exchange risk:  However, with equity fi nance denominated in GBP 
and the investment being linked  to the value of the euro, there  is no 
natural hedge of exchange rate ri sk arising on the revaluation of the 
net investment in Germany. Table C shows that the value of equi ty 
would fall from GBP 330m to GBP 310m  as a result of a fall in t he 
value of the euro from GBP/EUR 1.50 to GBP/EUR 2.00 and there 
would be a deterioration i n gearing from 31% to 33%. 
Gearing levels:  These are at a much mo re acceptable level of 
around 31%. Indeed, additi onal long-term borrowings may not be 
practical if lenders are conc erned about the already high geari ng 
levels in the group and/or if t he new venture has a high risk p rofile. 
In this case, the company may have no choice but to raise new equity finance. 
The German distribution cent re and transport fleet should be 
financed by long-term euro borrowings  (which would be designate d 
as a hedge under IFRS 9 and hedge a ccounting provisions applied , 
as noted above) in or der to match the currency and maturity of the 
assets to be funded and remove exp osure of equity and reported 
profit to exchange rate gains and losses. 
It would be preferable for such euro borrowings to be raised by  the 
German subsidiary so that the euro borrowing interest can be pa id 
out of euro earnings. This also p rovides the opportunity for re ducing 
the cost of funding by securing  the borrowings on the euro asse ts.

Chapter 5 
 207 
The proportion of new long-term bo rrowings may be restricted by  
– German tax authority regulati ons on minimum capitalisation 
levels. 
– Value of assets in the German subsidiary that can be used for  
security. 
– Level of parent company l oan guarantees offered (where 
additional security is required). 
– Debt capacity of the group (tha t is acceptable gearing level) . 
To the extent that long-term borro wings are not possible, the g roup 
should consider a rights issue or placing to raise additional e quity 
finance.

209 
Financing – Capital 
structure 
B1: Evaluate the capital 
structure of a firm Evaluate: 
(a)   Choice of capital structure (b)   Changes in capital 
structure 
• Capital structure theories (traditional theory and Miller and 
Modigliani (MM) theories) 
• Calculation of cost of equity and weighted cost of capital to 
reflect changes in capital structure 
• Impact of choice of capital stru cture on financial statements 
• Structuring debt/equity prof iles of companies in a group 
  Chapter 
6

Financing – Capital structure 
210  
 
Introduction to capital structure 
An analysis of capital structur e, using the gearing ratio and i nterest cover, is 
important when trying to assess t he risk associated with a busi ness. 
This chapter looks at capital stru cture in detail. In particula r we shall consider 
the implications for the busi ness of a change in capital struct ure. 
When a business changes its capi tal structure, there will be an  impact on its 
financial ratios and an impact on its weighted average cost of capital (WACC). 
The impact on financial ratios is covered later in the chapter,  but we start with a 
detailed analysis o f the impact on WACC of a change in capital structure. 
2 The impact on WACC of a cha nge in capital structure 
The WACC formula was introduced earlier in the CIMA syllabus: 
ko	=	keg൤VE
VE	+	VD൨+	kd(1–	t)൤VD
VE	+	VD൨ 
It is clear that if a company changes  its capital structure (ge aring level), the 
WACC will change, since the ratio of debt to equity is a key va riable in the 
formula.

Chapter 6 
 211 
Also, since the value of an ent ire company (debt plus equity) c an be calculated 
as the present value of its post- tax operating cash flows (befo re financing) 
discounted at the WACC, when the WACC changes so does the value . (See the 
later Chapter 12: 'Business val uation' for more details on this .) 
Several studies have focused on  this link between capital struc ture and 
company value. The key question is: 
“What capital structure should t he company aim for in order to maximise 
the company's value?” 
The main studies are: 
• the traditional view; 
• the Modigliani-Miller v iew, ignoring taxation; 
• the Modigliani-Miller view, ta king into account the tax relief  on debt interest 
payments. 
These studies are based on diffe rent assumptions and come to di fferent 
conclusions. They are covered below. 
In order to understand the differe nt views, it is vital to unde rstand the two 
opposing forces which impact on t he WACC as capital structure c hanges. 
 
 The two opposing forces which impact WACC

212  
 Impact on WACC of an increase in gearing 
 As an entity increases the amoun t of debt in its capital struc ture, two 
opposing forces impact on the we ighted average cost of capital:  
Downward force on the WACC 
In general, the entity's cost o f debt finance is cheaper than i ts cost of 
equity finance, for two reasons: 
• Interest is an obligation which has to be paid out each year, 
whereas dividends are paid only if the company can afford them.  
This means that debt holders face  less risk, so accept lower re turns. 
• Interest is a tax deductible exp ense, whereas dividends are pa id out 
of post-tax profits. This furt her reduces the cost of debt for the 
company. 
Therefore, as the ent ity increases its gearing by raising more debt 
finance, the greater proportion of (cheaper) debt in the capita l structure 
exerts a downward force on the WACC. 
Upward force on the WACC 
As the gearing level increases, the extra interest payments to debt 
holders mean that the likelihood of the entity bei ng able to af ford to pay 
dividends to shareholders reduces . This increases the risk perc eption of 
the shareholders, so they deman d higher returns to compensate f or the 
increased risk. 
This increase in the cost of equi ty exerts an upward force on t he WACC. 
Net effect 
Clearly, the two factors identif ied have opposing impacts on th e weighted 
average cost of capital. The key questions are: 
Which of the two forces is stronger? What is the net effect of these two factors? 
There is no simple answer to  these questions. In fact, the diff erent 
gearing theories propose diffe rent answers to the questions, ba sed on 
different assumptions. 
However, an understanding of these  two factors, and these key 
questions, is crucial to a sound understanding of the capital s tructure 
theories covered in this chapter.

Chapter 6 
 213 
 Impact of capital structure on the equity investor 
 High gearing exists  when an entity has a  large proportion of p rior charge 
capital in relation to equity and low gearing exists when there  is a small 
proportion of prior charge capi tal. High gearing increases the financial 
risk of the equity investor but t he reward can be in the form o f increased 
dividends when profits rise. If,  however, profits falter, the e quity investor 
can expect to be the first to feel  the effect of the reduction in profits. 
Low gearing or no geari ng may not necessarily be in the equity investor’s 
best interests because the entit y might then be failing to expl oit the 
benefits which borro wing can bring. 
Provided that the return generat ed from borrowed funds is great er than 
the cost of those funds, capital gearing could be increased. Th e extent to 
which it is prudent for an entity to  increase its capital geari ng will depend 
upon many variables such as the ty pe of industry within which t he entity 
operates, the cost of funds in the market, the availability of investment 
opportunities and the extent to w hich the company can continue to 
benefit from the ‘tax shield’. 
The ordinary share price of h ighly geared entities will tend to  be 
depressed in times of rising interest rates. 
 
 3 Traditional view 
According to the 'traditional' v iew of gearing and the cost of capital, as an 
organisation introduces debt into its capital structure the wei ghted average cost 
of capital will fall because initially the benefit of cheap deb t finance more than 
outweighs any increases in the cost of equity required to compe nsate equity 
holders for higher financial risk. 
As gearing continues to increas e the equity holders will ask fo r increasingly 
higher returns. The cost of equity  therefore rises as gearing i ncreases. 
Eventually this increase in the co st of equity will start to ou tweigh the benefit of 
cheap debt finance, and the weight ed average cost of capital wi ll rise. At 
extreme levels of gearing the cost of debt will also start to r ise (as debt holders 
become worried about the security  of their loans) and this will  also contribute to 
an increasing weighted av erage cost of capital. 
The diagram below demonstrat es this position in which: 
• k e is the cost of equity; 
• k d is the cost of debt; 
• k o is the overall or weighted average cost of capital.

214  
Traditional view of geari ng and the cost of capital 
 
X = optimal level of gearing , where ko is at a minimum. 
The traditional view therefore cl aims that there is an optimal capital structure 
where the weighted average cost o f capital is at a minimum. Thi s is at point X in 
the above diagram. 
At point X the overall return r equired by investors (debt and e quity) is 
It follows that at this point t he combined market value of the entity's debt and 
equity securities will also be ma ximised (because the value of the entity's debt 
and equity and the WACC are invers ely related – discounting the  future 
operating cash flows at a lower cost of capital will give a hig her value.) 
Optimal capital structure

Chapter 6 
 215 
 4 Capital structure: Modi gliani and Miller's view 
In 1958, the two American economi sts, Professors Modigliani and  Miller, 
challenged the traditional view of  gearing and the cost of capi tal. Over a 20- 
year period they put forward a  number of propositions as to why  the traditional 
view of gearing might be wrong. 
They began by assuming that the effect of tax relief on debt in terest could be 
ignored. 
Modigliani and Miller without tax (1958) 
The 1958 proposition was that com panies which operate in the sa me type of 
business and which have similar operating risks must have the s ame total 
value, irrespective of their capital structures. 
Their view is based on the belie f that the value of a company d epends solely 
upon the future post tax (pre fi nancing) operating income gener ated by its 
assets. 
The way in which the funding i s split between debt and equity s hould make no 
difference to the total value of the company (equity plus debt) . In fact, one of M 
& M's assumptions is that the in vestors are indifferent between  personal and 
corporate gearing. 
Thus, the total value of the company will not change with geari ng. This means 
that its weighted average cost o f capital will not change with gearing, and will be 
the same at all levels of gearing. 
Their view is represented in the following diagrams. 
Modigliani and Miller view (no taxation)

216  
 
If the weighted average cost of c apital is to remain constant a t all levels of 
gearing, it follows that any benefit from the increased proport ion of cheaper debt 
finance (downward force on the WA CC) must be exactly offset by the increase 
in the cost of equity (up ward force on the WACC). 
The essential point made by M &  M is that, ignoring taxation, a  company should 
be indifferent between all possibl e capital structures. This is  at odds with the 
beliefs of the traditionalists. 
M & M support their case by demons trating that market pressures  will ensure 
that two companies identical in every aspect apart from their g earing level will 
have the same overall market value. 
Modigliani and Miller with tax (1963) 
In 1963, M & M amended their mo del to include the impact of cor poration tax. 
This alteration changes the resu lts of their analysis significa ntly. 
Previously they argued that companies that differ only in their  capital structure 
should have the same total val ue of debt plus equity. This was because it was 
the size of a firm's operating earnings stream that determines its value, not the 
way funding was split between debt and equity. 
However, the corporation tax syst em carries a distortion under which returns to 
debt holders (interest) are tax ded uctible for the company, whe reas returns to 
equity holders are not. M & M,  therefore, conclude that geared companies have 
an advantage over ungear ed companies, i.e. they pay less tax an d will, 
therefore, have a greater marke t value and a lowe r weighted ave rage cost of 
capital.

Chapter 6 
 217 
Graph of M & M model with tax 
 
As gearing increases, the WACC steadily decreases, and hence th e value of 
the company (debt plus equity) increases. 
In the presence of tax, the downw ard force on the WACC (the imp act of the 
greater proportion of debt financ e) is stronger than the upward  force (the 
increase in cost of equity). 
If the other implications of the M & M view are accepted, the i ntroduction of 
taxation suggests that the higher  the level of taxation, the lo wer the combined 
cost of capital. 
 
 Modigliani and Miller (M & M) formulae 
M & M developed the following fo rmulae that can be applied to f inding the 
value, cost of equity or WACC of  companies that have a given le vel of business 
risk, but changing capital structure. 
 With tax Value of the company (debt+equity) V
g = V u + TB 
Cost of equity k eg = k eu + (k eu – k d) VD(1 – t) / V E 
WACC  k adj = k eu [1 – (V D t / (V E + V D))] 
 where V = Value of company (V
g = value of geared company,  
Vu = value of ungeared company) 
 k e = Cost of equity (k eg = cost of equity in geared co,  
keu = cost of equity in ungeared co) 
 k d = Cost of debt (must be gross of tax) 
 k adj = the weighted average cost o f capital in a geared company 
 B , V D = MV of debt

218  
 V E = MV of geared company's equity 
 T, t = Corporation tax rate  WACC = weighted average cost of capital  TB is often referred to as the present value of the tax shield  
The without-tax formulae are si mply a special case of the with- tax formulae, 
where t = 0. 
 
Interpreting the M & M graphs and formulae 
 Without tax 
Company value (V g = V u ) 
The graph showed a horizontal lin e for company value in the M &  M 
without tax theory. 
This is backed up by the formula , which shows that if T=0, the values of 
an ungeared company and an equival ent ungeared company are the 
same. 
WACC (k adj = k eu) 
The graph also showed a horizonta l line for WACC in the M & M w ithout 
tax theory. 
Again, the formula backs this up. If t=0, the formula reduces t o kadj = k eu. 
This shows that the WACC of the geared company is always the sa me as 
the WACC of an equivalent ungear ed company, irrespective of the  level 
of gearing. 
With tax 
Company value (V g = V u + TB ) 
The graph showed an upward slopi ng line for company value in th e M & 
M with tax theory. 
This is backed up by the formula, which shows that the higher t he value 
of B (value of debt), the greater  the value of the entire compa ny should 
be. 
As the company increases its gear ing, the value of the entire c ompany 
(debt plus equity) increases. 
Cost of equity (k eg = k eu + (k eu – k d) VD (1 – t) / V E) 
The cost of equity slopes upwar ds as gearing increases under M & M's 
assumptions, because shareholder s face higher risk so demand hi gher 
returns. 
We can see from the formula that the k eg increases as the amount of debt 
(VD) increases relative to  the value of equity (V E).

Chapter 6 
 219 
Note that the inclusion of (1 – t) in the formula has the impac t of reducing 
the slope of the line if the tax rate increases. Most important ly, this means 
that the cost of equity in the M & M with tax theory will alway s increase 
less steeply than in the without ta x theory. This helps to expl ain why the 
upward force on WACC is smaller in the with tax theory, and hen ce why 
the downward force on the WACC caused by the (net of tax) cheap  debt 
finance is the net stronger forc e in the with tax theory. 
WACC [k adj = k eu (1 – V D t / (V E + V D)] 
The formula shows that WACC will reduce as gearing (measured by  debt 
divided by (debt + equity)) incr eases. This is seen on the grap h as a 
downward sloping line. 
 
 Test your understanding 1 (Int egration question) – no tax 
 X Co is identical in all operat ing and risk characteristics to  Y Co, except 
that X Co is all equity financed a nd Y Co is financed by equity  valued at 
$2.1m and debt valued at $0. 9m based on market values. X Co and 
Y Co operate in a country w here no tax is payable. 
The interest paid on Y Co’s  debt is $72,000 per annum, and it p ays a 
dividend to shareholders of $378, 000 per annum. X Co pays an an nual 
dividend of $450,000. 
Required: 
(a) Calculate the value of X Co. 
(b) Calculate the cos t of capital for X Co. 
(c) Calculate the cost of equity  for Y Co, and the cost of debt  for Y Co. 
(d) Calculate the weighted av erage cost of capital for Y Co. 
 
 Test your understanding 2 (Int egration question) – with tax 
 X Co is identical in all opera ting and risk characteristics to  Y Co, except 
that X Co is financed only by e quity valued at $3m  whereas Y Co  has debt 
valued at $0.9m (based on marke t value) as part of its capital structure. X 
Co and Y Co operate in a country where tax is payable at 33%. 
dividend to shareholders of $401, 760 per annum. X Co pays an an nual 
Required: 
(a) Calculate the value of the equity of Y Co.  
(c) Calculate the cost of equi ty for Y Co, and the cost of debt  for Y Co. 
(d) Calculate the weighted av erage cost of capital for Y Co.

220  
 M & M's assumptions 
• There exists a perfect capital market in which there are no in formation 
costs or transaction costs. 
• Debt is risk free and k d remains constant at all levels of gearing. 
• Investors are indifferent bet ween personal and corporate geari ng. 
• Investors and companies can bo rrow at the same rate of interes t. 
M & M’s key belief was that the ma rket would not reward compani es for 
something that could be achieved  at zero cost and zero risk. If  the market 
believes that a company has made  too little use of gearing, the n investors can 
correct that by borrowing, and us ing the borrowed funds to buy more shares. 
This would give exactly the sa me effect as the company borrowin g more, but 
only if the assumptions listed above are valid. 
 
 5 Capital structure in the real world 
We need to adjust M & M's theorie s to also take into account re al life factors. 
The most unrealistic of M & M’s  key assumptions is that debt is  risk free.  
In reality, there is a greater r isk to both the lenders and sha reholders with very 
high levels of gearing. This is  the risk that the company is un able to service the 
debt and end up in financial dist ress or even insolvent. 
In reality, lenders will ask for higher interest if they percei ve that there is a 
greater risk of default. 
Practical considerations 
This then leaves the problem of how  companies determine their c apital 
structures in the real world. 
The main practical considerations are: 
• The company's ability to borrow money (the company's 'debt cap acity') 
• Existing debt covenants 
• Increasing costs of debt finance as gearing rises 
• Views of other stakeholders and rating agencies 
• Tax exhaustion

Chapter 6 
 221 
 More detail on practical considerations 
 The company's ability to borro w money (the company's 'debt 
capacity') 
• The maximum level of borrowing  that a company can comfortably 
support is referred to a s its debt capacity. ( Definition  of debt 
capacity from CIMA Official T erminology, 2005 is the "extent to  
which an entity can support and/ or obtain loan finance.") 
• A company can only increase its gearing if it can find a lende r who 
will provide it with debt finance . In recessionary times, this should 
not be taken for granted. 
• A company's capacity to borrow is increased if it is able to o ffer 
good quality, valuable assets as collateral. 
• Debt capacity is function of a company’s credit-worthiness 
(introduced in an earlier c hapter) and credit scoring. ( Definition  of 
credit scoring from CIMA Offi cial Terminology, 2005 is the 
"assessment of the credit-worthi ness of an individual or compan y by 
rating numerically a number o f both financial and non-financial  
aspects of the target's presen t position and performance.") 
Existing debt covenants 
• Debt covenants reduce the flex ibility of management. Existing debt 
covenants may even prevent the co mpany from borrowing more. 
• Management must keep the company w ell within the terms of the 
existing covenants (keeping plenty of 'leeway' or 'headroom') t o 
ensure that the flexibility of  the company is maximised. 
Increasing costs of debt finance as gearing rises 
• M & M assumed that debt was r isk free, and that kd would be 
constant at all levels of gearing . In reality, an increased lev el of 
gearing is likely to be perceiv ed as risky by lenders, so the i nterest 
rates on borrowings generally inc rease as gearing increases. 
Views of other stakeholde rs and rating agencies 
• The gearing theories focus on t he position of the shareholders  and 
the lenders at different levels of gearing. In reality, the vie ws of other 
stakeholders should also be cons idered. In particular, many 
stakeholders perceive high leve ls of gearing to be risky. This could 
impact on the credit score or cr edit worthiness of the company.  A 
reduction in credit worthiness ma y be evidenced by a credit rat ing 
downgrade by one of the credit rating agencies.

222  
 • For example, 
–  customers may be concer ned about buying goods from 
companies that have poor credit worthiness (due to concerns 
about warranties and guar antees being honoured) 
–  suppliers might not want to supply, or advance credit (due t o 
the risk of default) 
–  employees and managers migh t choose to leave if they fear 
for their job security. 
• All these factors will damage t he company's prospects and 
Tax exhaustion 
• M & M's with tax theory suggests  that the benefits of tax reli ef on 
debt interest will help to reduce t he company's cost of capital  at all 
levels of gearing. This is not the case in practice. 
• At some level of gearing the interest payable will be so high that 
taxable profit will be reduced to  zero. Beyond this point, ther e will be 
no further benefit of raising debt finance. 
• However, in order for tax exhaus tion to apply, the company mus t be 
making a loss and will have breached any interest cover covenan ts. 
The company is therefore likely to  have much greater problems t o 
contend with than the loss of tax relief. 
 
 6 The impact on financial rat ios of a change in capital 
structure 
When an entity changes its financing (capital structure), there  will be an impact 
on ratio analysis (especia lly the gearing ratio). 
The impact of a change in financi ng on ratio analysis – the gea ring ratio 
The two key measures of gearing are: 
O R            Debt
Note: Both of these measures are used in practice, but the first one is more 
commonly used. 
Clearly if an entity changes its c apital structure by raising n ew finance as either 
debt or equity, these gearing ratios will change. 
Exam questions often test the calc ulation of gearing ratios bef ore and after a 
change in capital structure.

Chapter 6 
 223 
 USDm 
Non-current assets (total) 23.0 Current assets (total) 15.0 
 USDm 
Operating profit (PBIT) 4.0 
Finance Charges  (1.0)  ——– 
Tax @ 30% (0.9)  ——– 
 ——– 
X Co is considering raising add itional debt finance of USD 6m. The 
interest rate on the new debt will be 12% per annum. Operating profit is 
expected to stay constant aft er the new finance has been raised . 
What will be the interest cover  and the capital gearing ratio 
(measured as debt / (debt + equi ty) at book value, and includin g the 
bank overdraft as part of debt) for X Co after the new finance has 
been raised? 
A Interest cover 2.33, gearing 52.8%  
B Interest cover 2.33, gearing 56.9%  
C Interest cover 1.22, gearing 52.8% 
D Interest cover 1.22, gearing 56.9%

224  
 Illustration 1 – More complex gearing ratio calculation 
 PPP is considering raising $250 million new finance to fund th e 
acquisition of QQQ. QQQ is consi dered to have a value to PPP of  $270 
million. 
Extracts from PPP's statemen t of financial position show: 
 $ m  
Long term borrowings  950 
Share capital ($1 shares)  500 
Retained reserves  400 
The directors of PPP haven't y et decided whether debt or equity  finance 
should be used to fund the takeov er. However, if equity is to b e used, the 
new shares will be issued at a pri ce of $2.60 per share. The cu rrent 
market share price is $2.90 per share. 
Required: 
Calculate the gearing ratio m easured as (debt/(debt + equity)):  
(a) before the acquisition of QQQ, (b) after the acquisition, assu ming that debt finance is used t o fund the 
takeover, 
(c) after the acquisition, assu ming that equity finance is used  to fund 
the takeover. 
In all cases, present your calcu lations using both book values and market 
values. 
Solution: 
Gearing based on book values 
Pre-acquisition  950 /[950 + (500 + 400)] = 51.4%  
Post-acquisition – 
using debt (950 + 250)/[(950 + 250) + ( 500 + 400 + 20 (W1))] 
= 56.6%  
using equity 950/[950 + (500 + 400 + 250 + 20 (W1) )] = 44.8%  
(W1) Since QQQ is worth $270m to PPP but the purchase price is 
$250m, the value of PPP's equity will increase by $20m irrespec tive 
of how the purchase is financed.

Chapter 6 
 225 
 Gearing based on ma rket values (W2) 
Pre-acquisition  950/[950 + 1,450] = 39.6%  
using debt (950 + 250)/[(950 + 250) + (1,450 + 20)] = 44.9%  
using equity 950/[950 + (1,450 + 250 + 20)] = 35.6%  
(W2) Market value of existing shar es = $2.90 × 500m = $1,450m 
Note:  The issue price of the new shar es ($2.60) is irrelevant when 
calculating the gearing ratios. Of course the issue price does affect the 
number of shares issued and theref ore other ratios such as EPS (see 
further examples below), but gea ring ratios are calculated base d on total 
values of equity and debt so the i ssue price is not relevant he re. 
Debt covenants 
A useful application of the im pact of financing decisions on ra tio analysis is in 
the context of debt covenants. 
For example, the gearing ratio is often used in debt covenants – an entity might 
have to keep its gearing ratio bel ow a given percentage to comp ly with its debt 
covenants. 
If you are asked in the exam to assess the impact of a decision  on a given debt 
covenant, you should calculate the necessary ratio assuming the  decision has 
been made and then compare the result to the given target. 
For example, if the covenant r equires that gearing should not e xceed 30% 
(measured as (debt/(debt + equity )) you should calculate the ra tio (assuming 
the decision has been m ade) using the formula given, and see if  the result 
remains below 30%. 
 
 Grass Co has a debt covenant tha t requires its gearing ratio ( measured 
as debt/(debt + equity) using book  values) to be less than 50%,  and its 
interest cover to be greater than 2. 
Extracts from its recent financia l statements show that it has 100,000 $1 
shares in issue and it has a 10%  interest bank borrowing of $60 ,000. It 
made a profit before interes t and tax last year of $15,000, and  overall 
accumulated retained earnings are $25,000. 
The current share pric e is $1.40 per share. 
The directors of Grass Co are c onsidering borrowing an extra $2 0,000 
from the bank as a secured borrowi ng at an interest rate of 6% per 
annum.

226  
 Annual profits are expected to s tay constant, but the share pri ce is 
expected to fall to $1.35 per shar e to reflect the shareholders ' perception 
of increased financial risk. 
Assuming the new finance is raised , which of the f ollowing show s 
Grass Co's position with reg ard to its debt covenant: 
A  Gearing: MET, Interest cover: MET 
B  Gearing: FAILED, Interest cover: MET C  Gearing: FAILED, Interest cover: FAILED  D  Gearing: MET, Interest cover: FAILED 
7 Structuring the debt/equit y profile of group companies 
Individual companies and groups o f companies both have to decid e on an 
appropriate capital structure by  considering the various theore tical and practical 
points covered earlie r in this chapter. 
However, there are additional cons iderations for groups of comp anies. 
General considerations for groups of companies 
Tax issues 
Within a group of companies, it m akes sense to maximise borrowi ngs in 
regimes with the highest tax ra te, to increase the amount of ta x relief available. 
Tax relief can be limited though, b y transfer pricing issues an d by thin 
capitalisation rules – see below for details. 
Country risk 
There will be less exposure to r isk if an entity borrows funds in the country 
where it generates its net incom e. Any servicing costs for the finance can then 
be paid out of the income generat ed without worrying about exch ange rate 
Type of finance provided by the parent 
Note that if debt and equity are both supplied by the parent co mpany, the 
choice between debt and equity finance for a subsidiary has no cash 
implications in the context of g roups, unlike the situation for  a single company. 
This is because both are financed in cash by the parent and the refore can be 
funded by the parent by ei ther debt or equity. 
The choice of capital structure fo r a subsidiary is therefore i ndependent of the 
decision regarding the appropriate  group capital structure.

Chapter 6 
 227 
Transfer pricing adjustments may be necessary for transactions between 
connected companies, to ensure that companies cannot reduce the ir tax 
liabilities by using a transfer  price that is below or above an  arm's length price. 
In the context of capital structure, this means that if one com pany in a group 
has borrowed money from another c ompany in a group, an adjustme nt will be 
necessary if it is deemed that the interest rate charged is not  set at a market 
rate. 
 
 Illustration 2 (Objective test question) 
 Vulture Co is a wholly o wned subsidiary of Red Co. 
It has borrowed $100,000 from Red Co, at an annual interest rat e of 2%. 
The market rate of int erest is 5% per annum. 
What is the annual interest payment  from Vulture Co to Red Co, and 
what is the adjustment needed for tax purposes? 
A  Interest $5,000, tax pu rposes adjustment $3,000 
B  Interest $2,000, tax pu rposes adjustment $3,000 
C  Interest $5,000, tax pu rposes adjustment $2,000 
D  Interest $2,000, tax pu rposes adjustment $5,000 
Solution: 
The answer is (B). 
Annual interest payment =  $100,000 × 2% = $2,000 
However, at market rate of inter est (5%) the interest paid woul d have 
been $100,000 × 5% = $5,000. 
Therefore an adjustment of $3, 000 (5,000 – 2, 000) will be made to 
Vulture Co and Red Co's accounts  for tax purposes. Vulture Co w ill 
reduce its profits fo r tax purposes and Red Co will increase it s profits by 
the same amount. 
Thin capitalisation rules 
When a company pays a dividend , there is no tax relief for the payment. When 
it pays interest on borrowings, t he interest is tax allowable. This means that 
companies would prefer to be financed through borrowings (debt)  rather than 
through shares (equity). 
The thin capitalisation rules ai m to stop companies from gettin g excessive tax 
relief on interest. 
This occurs (usually) because t hey have entered into a borrowin g with a related 
party that exceeds the amount a t hird party lender would be pre pared to lend. 
(Note that the additional borrowin g is most likely to be provid ed by the parent 
company within a gr oup structure.)

228  
The rules ensure that 
• interest on the part of the borrowing that an independent thir d party would 
be prepared to lend the co mpany is allowable 
• the excess is disallowed 
• the borrowing capacity of the i ndividual company and its subsi diaries is 
considered (but not th e rest of the group). 
Factors determining thin capitalisation 
The tax authorities will usually  look at two areas to determine  whether they 
believe a company is thinly capitalised: 
• Gearing  
–  This is measured as the ratio of debt to equity. –  A higher proportion of debt c ould cause thin capitalisation problems. 
–  In the UK a limit of around 50: 50 is considered by the tax a uthorities 
to be reasonable. 
• Interest cover  
–  This is the ratio of earnings  before tax and interest to int erest on 
borrowings. 
–  It measures how risky  the loan is for the lender. 
–  Many commercial lenders will look for a ratio of around 3, s o this is 
the figure considered by the ta x authorities to be reasonable. 
 
Illustration 3 (Integration question) 
 Archer plc is UK company, which i s a wholly owned subsidiary o f Berry 
Inc, a company resident in Babylonia. 
Archer borrows GBP100, 000 from Berry Inc pay ing a market rate o f 
interest of 8%. Archer had to bor row from Berry Inc as its UK b ankers 
were not prepared to lend i t more than GBP60,000. 
Required: 
Advise Archer plc of how much in terest on borrowings it is like ly to have 
relieved for tax purposes. 
Solution: 
A third party was only prepared  to lend Archer plc GBP60,000. 
As it has borrowed GBP100,000 fr om its parent company, it is li kely that 
interest on the excess GBP40,00 0 will be disallowed for tax pur poses. 
Therefore, of the GBP8,000 intere st Archer plc pays to Berry In c, only 
GBP4,800 is likely to be allowed for tax.

Chapter 6 
 229 
 Test your understanding 5 (Integration question) 
 Eagle Co is a wholly owned subsidiary of White Co. 
Extracts from Eagle Co's financia l statements for the last acco unting 
period are s hown below: 
 $ m  
Share capital 10.0 
Reserves 15.6 
Bank borrowing 8.5 Borrowing from parent company 20.0 
The annual interest rate payable on both the bank borrowing and  the 
borrowing from the parent company  is 4%. The borrowing from the  parent 
company was 25% more than Eagle Co could have raised from the b ank 
at that time. 
The tax authorities consider a c ompany to be thinly capitalised  if its 
gearing ratio (debt : equity) is above 50:50. 
Required: 
Calculate the amount of Eagle Co 's interest payable on the pare nt 
company borrowing that will be allowable for tax relief. 
8 End of chapter objective test questions 
 Modigliani and Miller’s 1958 'wit hout tax' gearing theory concl udes 
that: 
A  There is an optimum  gearing level at whi ch the value of the 
company is minimised 
B  There is an optimum  gearing level at whi ch the value of the 
company is maximised 
C  The value of the company is unaffected by the gearing level 
D  The value of the company reduces  as the gearing level increa ses 
E  The value of the company incre ases as the gearing level incr eases

230  
 A company has: 
• Current cost of equity of 12% 
• Ungeared cost of equity of 10% 
• WACC of 9.25% 
• Market value of equity of $210 million 
• Market value of debt of $70 million 
• Tax rate of 30% 
The company plans to raise $20 million of debt and use these fu nds to 
repurchase shares. 
According to Modigliani and Mille r’s theory with tax, WACC woul d 
move to: 
A 8.62% 
B 10.35% C 9.06% D 10.87% 
 
 The traditional view of gearing concludes that: 
A  There is an optimum  gearing level at which the cost of capit al is 
minimised 
B  There is an optimum  gearing level at which the cost of capit al is 
maximised 
C  The cost of capital continual ly reduces as the gearing level  
increases 
D  The cost of capital continually  increases as the gearing lev el 
increases 
E  The cost of capital is unaffected by the gearing level

Chapter 6 
 231 
 Ghost Co's most recent statemen t of financial position shows l ong term 
borrowings of $12.4 million, share capital ($1 shares) of $6.8 million and 
accumulated reserves of $5.2 million. 
Ghost Co is considering raisi ng $4 million of new long term deb t finance 
to fund the acquisition of Face Co. 
Face Co is considered to have a value to Ghost Co of $4.5 milli on. The 
current market share price for Ghost Co is $2.90 per share. 
What will be the gearing ratio – measured as (debt/(debt + equi ty)) at 
book value – after the acquisition? 
A 69.2% 
B 59.2% C 56.7% D 49.8% 
 
 Until recently, VV was an ungear ed company with a cost of equi ty of 
13%. It recently issued some debt finance and its cost of equit y increased 
to14%. 
If VV pays tax at a rate of 20%, and if the yield required by V V’s 
lenders is 8%, what is the gearing level (measured as (debt/equ ity)) 
of VV according to Modigliani a nd Miller’s theory with tax: 
A 0.25 
B 0.20 C 0.33 D 0.30

232  
 BB is an all-equity financed com pany with a cost of equity of 10%. 
The directors of BB are proposin g to raise $200 million to inve st in a new 
project. This investment will ca rry similar risk to BB’s curren t business. It 
is proposed that the investment  will be financed by either 
• a rights issue of shares, or 
• an issue of an undated bond carry ing 5% interest pre-tax (this  rate 
is deemed to reflect the returns  required by the market for the  risk 
and duration of the bond). 
Earnings before interest and ta x for BB are forecast to be $100  million in 
the first year after the new i nvestment. Subsequently, earnings  are 
expected to remain at a constant  level each year. The corporate  income 
tax rate is 20%. This is not expected to change. 
According to Modigliani and Mille r’s theory with tax, BB’s valu e if it 
issues the bond and undertakes this project will be: 
A $   840 million  
B $1,000 million  C $1,040 million D $1,200 million 
 
 Which THREE of the following are key assumptions of Modigliani 
and Miller’s 1963 gearing theory? 
A  The capital market is strongly efficient 
B  Debt is risk free C  Cost of equity stays const ant at all levels of gearing 
D  Companies do not pay tax E  Investors and companies can borrow at the same rate of inter est

Chapter 6 
 233 
 The following information relate s to Present Co, a geared comp any that 
pays tax at 25%: 
• Current cost of equity 14% 
• Ungeared cost of equity 12% 
• WACC 11.4% 
Market value of equity is $400 m illion and market value of debt  is $100 
million. Present Co plans to rai se $50 million of debt and use these funds 
to repurchase shares. 
move to: 
A 12.55% 
B 10.76% C 12.98% D 11.12% 
 
 Modigliani and Miller’s 1963 Theory of Capital Structure with T ax 
assumes that 
A  The cost of equity remains c onstant regardless of gearing le vel 
B  A company is liable to tax, but not its shareholders C  Companies can borrow at zero cost D  Financial distress does not carry any cost 
 
 Which THREE of the following r easons are most likely to result in an 
entity using equity (rather tha n debt) finance to fund a new 
investment project? 
A  the project is a short-term project 
B  the entity has a very low level of gearing C  the banks are unwilling to lend , having just downgraded the entity's 
credit rating 
D  the project's cash flows are likely to be variable, and migh t even be 
negative in the first year 
E  the entity is a service busi ness with very few tangible asse ts

234  
9 End of chapter case style questions 
 The finance director of Netra plc , a company listed on the UK' s AIM 
(Alternative Investment Market) , wishes to estimate what impact  the 
introduction of debt finance is lik ely to have on the company's  overall cost 
of capital. The company is curre ntly financed only by equity. 
Netra plc Summarised capital structure 
 £000 
Ordinary shares (25 pence par value) 500 
Reserves 1,100 
 –––––  1,600  ––––– 
The company's current share pr ice is 420 pence, and up to £4 mi llion of 
fixed rate irredeemable debt could be raised at an interest rat e of 10% 
per annum. The corporate tax rate is 33%. 
Netra's current earnings before interest and tax are £2.5 milli on. These 
earnings are not expected to cha nge significantly for the fores eeable 
future. 
The company is consider ing raising either: 
(i)  £2 million in debt finance; (ii) £4 million in debt finance In either case the debt finance will be used to repurchase ordi nary 
shares. 
Required: 
(a) Using Miller and Modigliani's  model in a world with corpora te tax, 
estimate the impact on Netra's cost of capital of raising: 
(i)  £2 million; and (ii) £4 million in debt finance. 
State clearly any assumptions that you make. 
(b) Briefly discuss whether or not the estimates produced in pa rt (a) are 
likely to be accurate. (30 minutes)

Chapter 6 
 235 
 Test your understanding 17 (Case style question) 
 Canalot Co is an all equity com pany with an equilibrium market  value of 
GBP32.5 million and a cost of capital of 18% per year. 
The company proposes to re-purc hase GBP5 million of equity and to 
replace it with 13% irredeemable bonds. 
Canalot's earnings before intere st and tax are expected to be c onstant for 
the foreseeable future. Corporat e tax is at the rate of 35%. Al l profits are 
paid out as dividends. 
Required: 
Explain and demonstrate how this  change in capital structure wi ll affect: 
1  the market value; 2  the cost of equity; and 3  the cost of capital of Canalot Co, using the assump tions of Modigliani and Miller. 
Explain any weaknesses of both  the traditional and Modigliani a nd Miller 
theories and discuss how useful  they might be in the determinat ion of the 
appropriate capital structure for a company. 

236  
 ( a )  V g = V u + TB 
so given that T = 0, V
g = V u 
so the value of X Co is the sa me as the value of Y Co,  
($2.1m + $0.9m) $3m 
(b) Assuming no growth in divide nds, using the dividend valuati on 
model, 
keu = Dividend/V E = 450,000/3,000,000 = 15% 
(c) Cost of debt for Y Co  (assuming debt is irredeemable) 
kd = Interest/V D = 72,000/900,000 = 8% 
Cost of equity for Y Co:  
Using M & M's formula: 
keg = keu + (k eu – k d) VD(1 – t)/V E 
keg = 15% + (15% – 8%) × 0.9/2.1 = 18%  
(Alternatively, using the dividend valuation model, 
keg = Dividend/V E = 378,000/2,100,000 = 18%) 
As shown on the graphs, the geared company has a higher cost of  
equity. 
(d) Weighted average cost of capital: 
WACC = (18% × 2.1/3) + (8% × 0.9 /3) = 15% Again, notice that this corre sponds to the graphs seen above. I n the 
no tax case, the WACC is constan t irrespective of capital struc ture. 
 
so given that T = 0.33, 
Vg = 3,000,000 + (33% × 900,000) = $3,297,000 
so the value of the equity = 3 ,297,000 – 900,000 (value of debt ) 
= $2,397,000 
model, 
keu = Dividend/V E = 450,000/3,000,000 = 15%

Chapter 6 
 237 
keg = k eu + (k eu – k d) VD(1 – t)/V E 
keg = 15% + (15% – 8%) × 900,000 × (1 – 0.33)/2,397,000 = 16.76% 
equity. 
WACC = (16.76% × 2,397/3,297) + ( 8% × (1 – 0.33) 900/3,297) 
= 13.65% 
Alternatively, using M & M's formula: k
adj = keu (1 – tL) = 15% (1 – 3 3% × 900/3,297) = 13.65% 
Again, notice that this corre sponds to the graphs seen above. I n the 
with tax case, the WACC reduces as  the level of debt in the cap ital 
structure increases. 
 
Interest cover  = 4m/(1m + (12% × 6m)) = 2.33 times 
Capital gearing ratio 
Debt = 5m + 8m + 6m = USD19m 
Equity = 10m + 4m + 1.5m + 1.5m = USD17m 
D/(D+E) = 19m/(19m + 17m) × 100 = 52.8% 
 
 The answer is (A). Both cov enant terms will still be met after  the finance 
is raised. 
Before  the finance is raised: 
Gearing (BOOK VALUES) = 60, 000/(60,000 + (100,000 + 25,000)) = 32% 
Interest cover = 15,000/(10% × 60,000) = 2.5 After  the finance is raised: 
Gearing (BOOK VALUES) = (60,0 00 + 20,000)/(60,000 + 20,000 + 
(100,000 + 25,000)) = 39% 
Interest cover = 15,000/[(10% ×  60,000) + (6% × 20,000)] = 2.1

238  
 Interest payable on the paren t company borrowing and charged t hrough 
the accounts is ($20m × 4%) = $0.8m 
Current gearing (debt : equity) is  (20m + 8.5m)/(10.0m + 15.6m)  i.e. 
$28.5m/$25.6m 
Accordingly the company is cons idered to be too thinly capitali sed by the 
tax authorities, and the thin  capitalisation rules apply. 
The amount of interest on the par ent company borrowing disallow ed for 
tax purposes will be ($20m  × 25/125 × 4%) = $0.16m 
Therefore the amount of interes t on the parent company borrowin g that is 
tax allowable is (0.8m – 0.16m) = $0.64m 
 
Modigliani and Miller’s 1958 geari ng theory is the 'no tax' the ory. It 
concludes that the value of t he company is unaffected by the ge aring 
level. 
 
WACC = k eu (1 – tL) 
where k eu is given as 10%, t is 30% and L is the gearing level measured 
as (debt/debt+equity)). 
Gearing working: 
The value of the company was $ 280 million (210 equity and 70 de bt). 
Therefore, using the equation V g = V u + TB, 
280 = V u + (30% × 70) 
so V u = $259 million 
Hence, with the new gearing level, V
g = 259 + (30% × 90) = $286 million 
and therefore, WACC = 0.10 × [1 – (30% × 90/286)] = 9.06%

Chapter 6 
 239 
The traditional view of gearing concludes that the cost of capi tal follows a 
U shaped curve, and therefore th at there is an optimum gearing level at 
which the cost of capital is minimised. 
 
Debt will rise to $12. 4m + $4m = $16.4m. 
Equity will rise (because of the extra value generated by the t akeover) to 
$6.8m + $5.2m + $0.5m = $12.5m 
Therefore, [D/(D+E)] = 16. 4/(16.4 + 12.5) = 56.7% 
 
M & M's formula is: k
eg = k eu + (k eu – k d) VD(1 – t)/V E 
where k d is the yield to the debt holder s. Plugging the given numbers i n 
shows: 
0.14 = 0.13 + [(0.13- 0.08) VD(1 – 0.20)/V E] 
So rearranging the equation gives V D/VE = 0.25 
 
Modigliani and Miller’s formula is: V
g = V u + TB 
Therefore, the value of the co mpany if it funds the project usi ng the bond 
is V u (the value if the company conti nued to be all equity financed) plus 
20% × $200 million (i .e. $40 million). 
Vu can be found by discounting the earnings figure as a perpetuit y.  
So V u = $100m (1 - 0.20)/0.10 = $800 million 
Therefore, V g = $800 million + $40 m illion = $840 million

240  
 The answer is (A), (B) and (E). 
The key assumptions of Modigliani  and Miller’s 1963 gearing the ory are: 
• Companies do pay tax 
• The capital market is strongly efficient 
• There are no transaction costs 
• Debt is risk free 
• Cost of debt stays constant at all levels of gearing 
• Investors are indifferent bet ween personal and corporate geari ng 
• Investors and companies can bo rrow at the same rate of interes t 
So the correct three points were (A), (B) and (E) (i.e. the cap ital market is 
strongly efficient, debt is ri sk free and investors and compani es can 
borrow at the same rate of interest). 
 
where k eu is given as 12%, t is 25% and L is the gearing level measured 
The value of the company was $ 500 million (400 equity and 100 d ebt). 
500 = V u + (25% × 100) 
so V u = $475 million 
g = 475 + (25% × 150 ) = $512.5 million 
and therefore, WACC = 0.12 × [1  – (25% × 150/512.5)] = 11.12%

Chapter 6 
 241 
Under M & M's theory, the cost o f equity rises as gearing incre ases (A) 
and the risk of debt is nil so c ompanies can borrow at low cost  (but not 
zero cost) (C). 
Both shareholders and companies a re assumed to pay tax in the 1 963 
theory (B). 
In their 1963 theory, M & M assum ed that there were no costs to  financial 
distress and liquidation (D). 
 
 The answer is (C), (D) and (E). 
Short term projects (A) shoul d not be funded by long term equit y finance. 
A low level of geari ng would generally mean  that the entity is not fully 
benefitting from the tax advant ages of debt finance (B). 
Few tangible assets (E) and a poor  credit rating (C) would make  raising 
debt finance more difficult. For a  project with variable cash f lows (D), the 
necessity of making interest payments each year could cause fin ancial 
distress. 
 
 (a) Assuming that all earnings  are paid out as dividends, the current 
cost of equity (and overall cost o f capital) is total earnings divided by 
the market value of the company's shares: 
 £000 
Earnings before finance charges and tax 2,500 
Taxation 825 
 — — – 
Earnings = dividends  1,675 
 — — – 
The market value of equity is tw o million shares × 420 pence pe r 
share = £8.4 million. 
Ke = £1,675,000
£8,400,000 = 19.94% 
If equity is replaced by debt the value of the company will inc rease. 
V geared = V ungeared + TB (tax rate × amount of debt)

242  
 With £2 million debt 
V geared = 8,400 + (2, 000 × 0.33) = 9,060. 
 £000 
Total value of the company 9,060 
Market value of debt 2,000 
 — — – 
Value of equity 7,060 
 — — – 
With £4 million debt 
V geared = 8,400 + (4, 000 × 0.33) = 9,720 
 £000 
Total value of the company 9,720 
Market value of debt 4,000 
 — — – 
Value of equity 5,720 
 — — – 
 
Cost of equity £2 million 
debt £4 million 
debt 
 £000 £000 
Earnings before f.charges and tax 2,500  2,500 
Finance charges  (200)  (400) 
 2,300  2,100 
Taxation (33%)  (759)  (693)  Earnings/dividends  1,541  1,407 
 
Cost of equity K e =  1,541/7,060  1,407/5,720 
 = 21.83%  = 24.60% 
WACC 
£2 million debt: 
WACC = 21.83 × 7,060
9,060 + 10 (1 – 0.33) 	2,000
9,060 = 18.49% 	
£4 million debt: 
WACC = 24.60 × 5,720
9,720 + 10 (1 – 0.33) 	4,000
9,720 = 17.23%

Chapter 6 
 243 
 Alternative method of calculation 
Or alternatively using WACC = K eu൬1 – Dt
E + D൰ 
WACC = 19.94 ൬1 –	2,000	×	0.33
7,060	+	2,000൰=	18.49% 
WACC = 19.94 ൬1 –	4,000	×	0.33
5,720	+	4,000൰=	17.23% 
The higher the level of gearing , the lower the cost of capital 
becomes, due to the benefit from tax relief on finance charges.  
(b) As debt is introduced into the capital structure it is like ly that the cost 
of capital will initially fall. H owever, the estimates produced  in (a) 
may not be accurate because: 
(i)  They rely on the assumptions  of the Modigliani and Miller (M & 
M) model, many of which are unrea listic such as the capital 
market is perfectly efficient, debt is risk free, information i s 
costless and readily available, t here are no transaction costs,  
investors are rational and ma ke the same forecasts about the 
performance of companies, and investors and companies can 
borrow at the risk-free rate. 
(ii) Only corporate taxation is considered and not the impact o f 
other forms of taxation in cluding personal taxation. 
(iii) M & M assumed that debt is permanent. (iv) The estimates ignore possibl e costs that might be incurred  as 
gearing increases, which woul d reduce share price and 
increase the cost of equity (and possibly debt). These include 
bankruptcy costs, agency cost s and tax exhaustion. 
(v) Inaccuracies exist in the  measurement of the data required for 
the model.

244  
Market value 
Modigliani and Miller's hypothesis  including the effects of cor poration tax 
suggests that: 
 V g = V u + TB 
Where V g is the value of the geared company 
 V u is the value of an equi valent ungeared company 
 B is the market value of debt  T is the rate of corporation tax In the case of Canalot:  V
u = GBP32.5 million 
 B = GBP5 million  T= 35%  
∴ Vg = 32.5m + 5m × 35% = GBP34.25m 
The original value wa s GBP32.5 million. 
This therefore repr esents an increase o f GBP1.75 million. 
Cost of equity 
Modigliani and Miller propose the following formula for calcula ting the 
cost of equity of a geared company: 
Keg	= K eu+(Keu – K d)× Vd)ݐ
Ve	 
Where K eg is the cost of equity of the geared company 
 K eu is the cost of equity of an equivalent ungeared company 
 K d is the cost of debt before tax 
 V d is the market value of debt 
 V e is the market value of equity 
 t is the rate of corporation tax  K
eu = 18% (given) 
 K d = 13% 
 V d= 5m 
 V e = V g – D = 34.25m – 5m = 29.25m

Chapter 6 
 245 
 ∴ Ke = 18% + (18% –13% )5
29.25 × (1 – 0.35) 
 = 18.56%. 
The cost of equity has increased by 0.56%, reflecting the incre ase in 
financial risk as a result of gearing. 
Using Modigliani and Miller's formula: 
WACC = K eu൤1 – Dt
D	+ V e൨ 
WACC  = 18%൤1 –	5	×	0.35
34.25൨ 
WACC	=	17.08% 
Alternatively the traditional w eighted average cost of capital formula may 
be used, i.e. 
WACC = 18.56% × 29.25
34.25  + 13%(1 – 0.35) × 5
34.25 
WACC  = 17.08% 
The previous WACC was equal to  Keu, i.e. 18%. It has therefore 
decreased by 0.92%, reflecting  the tax benefits of increased ge aring. 
Answer to the second task: 
The traditional view of capital st ructure theory is intuitive o nly; it is not 
based on any empirical evidence or computation and therein lies  its major 
weakness. 
It argues that there exists an opt imal capital structure where the overall 
cost of capital is minimised and thus the company value is maxi mised. 
This is based on the fo llowing propositions: 
• as gearing increases the cost of equity rises due to the incre ase in 
financial risk, but thi s is outweighed by the lower cost of deb t and so 
the overall cost of capital decreases; 
• as gearing continues to increase the cost of equity rises more  
sharply, such that this effec t is greater than the effect of th e lower 
cost of debt and the cost of capital rises; 
• therefore there exists a mini mum optimal cost of capital 
The theory is useful in as much a s it highlights the fact that financing and 
capital structure may affect a  company's value but it gives no suggestion 
as to where that optimal level lies.

246  
 Modigliani and Miller's theory, h owever, was initially based on  empirical 
evidence and followed by quantific ation. Their hypothesis which  includes 
the effects of corporate taxes (an adjustment to their original  model) 
suggests that the optimal capital structure comprises 99.9% deb t. Since 
this policy is not adopted by com panies there must be certain f laws in this 
theory, the most important of wh ich was later corrected by Mill er himself, 
i.e. the effect of personal taxes. 
Other common criticisms of t he model include the following: 
• the use of unrealistic a ssumptions, for instance: 
–  there are no transaction costs; –  information is freely available; 
–  individuals can borrow on t he same terms as companies; 
–  individuals are prepared to  exchange personal gearing for 
corporate gearing; 
• costs associated with high leve ls of gearing are not considere d. 
These may include the following: 
1 Bankruptcy costs 
As gearing reaches high leve ls the probability of bankruptcy 
increases and if bankruptcy o ccurs there will be associated 
costs. These include the liqui dation fees and the loss on the 
disposal of assets in a forced sales situation. 
2 Tax exhaustion 
The benefit derived from increasin g the level of gearing relate s 
to the tax relief obtained by com panies on returns paid to debt , 
i.e. interest. However, at ver y high levels of gearing there is  
the possibility that the company  will not have sufficient taxab le 
profits from which to deduct the debt interest. In this situati on 
the advantage of geari ng up will be lost. 
3 Agency costs 
These relate to constraints imposed on the company by 
providers of finance through rest rictive covenants contained 
within terms of agreement. Such constraints are aimed to 
protect the interest of (prima rily) the debt holders when a 
company finds itself in a potentia lly difficult situation close  to 
bankruptcy. 
As a result of the above and the effect of personal taxes, it i s 
clear that benefits related to i ncreased gearing do not continu e 
indefinitely. The final position is not well defined, but it ma y be 
possible that there exists a poi nt where the cost of capital is  
minimised before the additional  costs of high gearing outweigh 
the benefits. Thus, if managers are able to quantify such costs  
and benefits, this adapted theory may be of use to them in 
identifying an appropriate l evel of gearing to adopt.

247 
Dividend policy 
B4: Evaluate dividend policy Ev aluate policy in the following 
areas: 
(a) Cash dividends  (b) Scrip dividends  (c) Share repurchase 
programmes 
• Features and criteria 
• Impact on shareholder value and  entity value, financial 
statements and performance 
 
  Chapter 
7

248  
 
2 Dividend policy 
One long-standing question in c orporate finance is: Is sharehol ders' wealth 
affected by a company's dividend policy? 
Notice that the question is not a sking whether dividends matter  – of course they 
do (as we know from the dividend  valuation model) – what the qu estion asks is 
whether the chosen policy matters . Examples of such policies ma y include: 
(i)  paying a const ant annual dividend; 
(ii) paying out a constant p roportion of annual earnings; 
(iii) increasing dividends in line with the annual rate of infl ation, etc; 
(iv) paying out what's left after financing all future investme nt – the residual 
policy. 
 
 The key factors to consider in relation to the payment of divid ends are:  
1 Modigliani and Miller's (M &  M) dividend irrelevancy argument  
2 The interests of shareholders (t he clientele effect and the b ird-in-the- hand 
argument) 
3 The signalling effect or information content of dividends 4 The cash needs of the entity

Chapter 7 
 249 
Dividend irrelevancy: Modig liani and Miller's theory 
M & M's dividend irrelevancy t heory says that the pattern of di vidend payout 
should be irrelevant. As long as  companies continue to invest i n positive NPV 
projects, the wealth of the shar eholders should increase whethe r or not the 
company makes a dividend payment this year. 
 
 M & M's Dividend Irrelevancy Theory 
 M & M's argument here is built up as follows: 
(i)  The return on a share is determined by the share's (system atic) risk. 
(ii) The return itself is deliv ered to shareholders in two part s: one part is 
the dividend paid and t he other is the capi tal gain/loss in the  share 
price. 
(iii) The dividend decision tha t a company makes is a decision as to 
how the return is delivered: how  much of the annual earnings sh ould 
be paid out as dividends and how  much of the annual earnings 
should be retained and re-invest ed within the company – and so 
flow through to shareholders in the  form of a capital gain on t he 
share price. 
(iv) As the dividend dec ision does not affec t the risk of the s hares, it 
does not affect their return. All t he dividend decision therefo re does 
is to determine how the return is  to be split up between divide nds 
and capital gains. 
(v) Do shareholders mind how thei r returns are split between di vidends 
and capital gains? The answer acco rding to M & M  is: no, they d o 
not if we assume: 
(a) There are no taxes (really, t here are no differences betwee n 
the taxation on dividends  and on capital gains). 
(b) Shares can be bought and sold  free of any transaction costs  
(such as stock-brokers' commission). 
M & M argue that shareholders c an 'manufacture' a dividend poli cy 
irrespective of the company polic y. For instance, if a person i s holding 
shares for income but the company  withholds a dividend, the sha reholder 
can sell some of the shares to  replace the lost income. 
The assumptions that M & M make play a key role. Obviously, if 
dividends were taxed and capita l gains were tax free, sharehold ers would 
mind how their return was deliver ed – they would strongly prefe r it to be 
delivered in the form of capital gains rather th an dividends. 
Similarly, investors who were holding shares for the income the y 
generated would mind how  their return was delivered if they had  to incur 
transaction costs when realising  their capital gains so as to t urn them into 
income – such investors would st rongly prefer if the return wer e delivered 
in the form of dividends, r ather than capital gains.

250  
However, given their assumptions  hold good, M & M could claim t hat 
shareholders are indifferent bet ween dividends and capital gain s and so 
the dividend decision/the divid end policy that the company purs ues is 
irrelevant. 
The interests of shareholders 
It is critical that a business satisfies the needs of its share holders with its 
dividend policy. If the sharehol ders don't feel that the busine ss's dividend policy 
meets their expectations, they will sell their shares, perhaps causing the share 
price to fall. 
Two important considerations i n the context of shareholders' in terests are the 
clientele effect and the bird-in-the-hand argument: 
Clientele effect 
In the real world, there are diffe rential tax treatments of div idends and capital 
gains, and there are transacti on costs on share dealings. 
As a result, shareholders are con cerned as to how their return is delivered to 
them by the company. Thus companies  should follow a consistent dividend 
policy so as to ensure that they  gather to them a clientele of shareholders who 
like that particular policy. 
Thus the argument here is that t he actual dividend policy that a company 
follows is unimportant but, havi ng decided on a particular poli cy, it should then 
keep to it. 
The bird-in-the-hand argument 
This analysis puts forward a very simple argument. 
Some investors may find capital gains more tax-efficient than d ividends, and 
some investors will avoid transac tion costs if their returns ar e delivered in the 
form of capital gains rather t han dividends; despite all this, investors generally 
have a strong preference for dividends. 
The reason given is that a divi dend is certain and investors pr efer a certain 
dividend now, to the promise of uncertain future dividends (ari sing out of 
retaining and re-investing earnings). 
The signalling effect 
Investors read 'signals' into t he company's dividend decision a nd that these 
signals say as much about the co mpany's future financial perfor mance as they 
say about its past financial performance. 
Thus management will not necessar ily reduce the dividend per sh are just 
because last year's performance was poor, if they believe that next year's 
performance will be good. 
If this analysis is correct, and investors do indeed read signa ls into the dividend 
decision, then the dividend decis ion becomes important: it beco mes important 
for the company not to g ive the wrong signal.

Chapter 7 
 251 
 More details on signalling 
 It is widely believed that there are two very strong dividend signals: 
1 a reduction in the dividend per share signals that the compan y is in 
financial difficulties; 
2 a failure to pay out any divi dend at all signa ls that the com pany is 
very close to receivership. 
Thus a company must take great care when settings dividend leve ls and 
ensure that the market is kept fu lly informed of future prospec ts. 
These ideas are very widely held in practice and this view is s upported by 
Lintner who discovered that d ividend growth lagged two to three  years 
behind earnings growth. This evid ence can be interpreted to mea n that 
managers are reluctant to increas e the dividend per share until  they are 
confident that they will be able to  maintain that new level of dividends in 
the future (and will not be s ubsequently obliged to reduce the dividend 
per share). 
However, there are exceptions to  this interpretation. For many years, 
Apple Computers paid no dividends to its inv estors, preferring instead to 
reinvest the profits back into  the business to fund new investm ents and to 
reduce the requirement to raise  finance externally. Despite the  absence 
of a dividend, the market res ponded positively to Apple through out, and 
the share price rose strongly. 
In conclusion, although paying di vidends (or not paying dividen ds) can 
give investors a signal as to how successful the company is lik ely to be in 
future, it is not the only impor tant indicator to investors. Ot her factors 
such as investment plans, gearin g levels, strategy and quality of 
management are also important as investors assess the likely su ccess of 
a business. 
The cash needs of the entity 
We saw in the earlier Chapter 3: 'Development of financial stra tegy' that the 
investment, financing and dividend  decisions are all inter-link ed. 
Therefore, it is important to also consider the impact of inves tment and 
financing when consider ing dividend policy. Different types of business will have 
very different cash needs and w ill therefore have to set their dividend, 
investment and financing policies accordingly. 
• A small company, or a company with a poor credit rating, will often 
struggle to raise finance from ext ernal sources, so its cash ne eds might 
have to be met by restricting t he amount of dividends it pays o ut. 
• A growing company will have many  potential investment opportun ities. 
The cash needs for these new inv estments will have to be met by  
balancing dividend policy alongsid e external finance sources.

252  
• A well-established, stable comp any might well be cash rich, in  which case 
it might be able to afford to pay out large dividends without c ompromising 
its internal cash needs. 
 
 How to reconcile these differing views of dividend policy in th e real 
world 
Given these contrasting views , how are managers to decide on th e dividend 
policy that they should pursue? 
The answer is that, in the real w orld, like so much else in cor porate finance, 
managers have to make a judgement a fter taking many varying fac tors into 
account. 
In this process they will consider: 1 What dividends are the sharehol ders expecting (e.g. the clien tele effect)? 
2 What are the cash needs of the company? 3 What dividend did the company pay last year? Consider the sig nal that a 
dividend announcement will give. 
However they will also take in to account a range of other facto rs, such as: 
1 Is it legal to pay out a dividend? 2 Is the cash available  to pay out a dividend? 
3 Do we have a minimum gearing ra tio imposed on the company as a 
financial covenant i n a debt agreement? 
4 What is the tax impact for shareholders of paying dividends?  
5 What investment opportunities does the company face? 6 How difficult/expensive is  it to raise external finance? 
7 What has been the rate of infla tion (and so what dividend inc rease is 
needed to maintain the purchasing power of last year's dividend s)? 
8 What has been the capital gain/ loss in the share price over t he last year? 
3 Dividend policy in practice

Chapter 7 
 253 
In practice, there are a num ber of commonly adopted dividend po licies: 
• stable dividend policy 
• constant payout ratio 
• zero dividend policy 
• residual approach to dividends. 
Stable dividend policy 
Paying a constant or constant ly growing dividend each year: 
• offers investors a predictable cash flow 
• reduces management opportunities to  divert funds to non-profit able 
activities 
• works well for mature firms  with stable cash flows. 
However, there is a risk that  reduced earnings would force a di vidend cut with 
all the associated difficulties. 
Constant payout ratio 
Paying out a constant proportion of equity earnings: 
• maintains a link bet ween earnings, reinves tment rate and divid end flow but 
• cash flow is unpredictable for the investor 
• gives no indication of managemen t intention or expectation. 
Zero dividend policy 
All surplus earnings are invested back into the business. Such a policy: 
• is common during the growth phase 
• should be reflected in i ncreased share price. 
When growth opportunities are ex hausted (no further positive NP V projects are 
available): 
• cash will start to accumulate 
• a new distribution policy will be required. 
Residual dividend policy 
A dividend is paid only if no fu rther positive NPV projects ava ilable. This may be 
popular for firms: 
• in the growth phase 
• without easy access to alt ernative sources of funds.

254  
However: 
• gives constantly changing sign als regarding management expecta tions. 
Ratchet patterns 
Most firms adopt a variant on t he stable divid end policy – a ra tchet pattern of 
payments. This involves paying ou t a stable, but rising dividen d per share: 
• Dividends lag behind earnings, b ut can then be maintained even  when 
earnings fall below the dividend level. 
• Avoids ‘bad news’ signals. 
• Does not disturb the tax position of investors. 
 
4 Scrip/bonus dividends and share repurchase 
Scrip dividends 
A scrip dividend (or bonus/scrip i ssue) is where shareholders a re offered bonus 
shares free of charge as an alte rnative to a cash dividend. 
They are useful where the comp any wishes to retain cash in the business or 
where shareholders wish to reinv est dividends in the company bu t avoid 
brokerage costs of buying shares . There may also be tax advanta ges of 
receiving shares rather than ca sh in some jurisdictions. 
If all shareholders opt for bonus shares, the scrip issue has t he effect of 
capitalising reserves. Reserve s reduce and share capital increa ses.

Chapter 7 
 255 
The disadvantage to shareholders is that, unlike reserves, shar e capital is non-
distributable in the future. In addition, both share price and earnings per share 
are likely to fall due to the great er number of shares in issue , although the 
overall value of each shareholde r’s shares and share in future earnings should, 
theoretically, remain unchanged. 
However, it has the important advantage to the issuer of retain ing cash in the 
business while still achieving a distribution of reserves. 
 
 Example of a scrip dividend 
 A recent issue by Santander bank  in February 2011 was set up i n a 
similar manner to a rights issue except that the rights were is sued without 
charge. 
Shareholders were given rights to  receive additional Santander shares 
and three options for thei r allotment of rights: 
1 Sell the rights off market to  Santander and receive a fixed c ash 
amount. 
2 Sell the rights on market and receive cash. 3 Hold the rights and receive new Santander shares, 1 share for  every 
65 rights held. 
Share repurchase 
A share repurchase can be used to  return surplus cash to shareh olders. 
It tends to be used when the com pany has no posit ive NPV projec ts to invest 
the cash in, so it returns the cash to shareholders so that the y can make better 
use of it rather than it sitting id le (in cash investments) in the company. 
Alternatively, a share repurchase can be used to privatise a co mpany, by 
buying back a listed company's s hares from a wide pool of inves tors. However, 
this is rare. 
Share repurchase v one-off large dividend 
As an alternative to a share r epurchase, a company may decide t o use a one-
off large dividend to return su rplus cash to shareholders. 
If all shareholders agree to the re purchase, both a share repur chase and a one-
off large dividend have the same i mpact on the cash, and the ge aring of the 
company (they reduce the value of equity, so increase the geari ng and hence 
financial risk and cost of equity ). Although the impact on shar eholder value is 
the same for any individual s hareholder, the impac t on the pric e per share will 
differ. A dividend results in a  lower share price as the number  of shares remains 
the same, but a share repurchase is unlikely to affect the indi vidual share price 
but only the number of shares in issue.

256  
The one-off dividend has the advant age of certainty of ultimate  payout. 
However, a share repurchase has the following advantages: 
• investors can choose whether or not to sell their shares back (they may 
prefer to keep the shares if they  feel that future returns will  be high) 
• it avoids the risk of a false dividend signal – after a one-of f large dividend, 
the shareholders may be disappoi nted when the higher level of d ividend is 
not maintained in the future. 
5 The impact of scrip dividends and share repurchase on 
The impact of a scrip dividend on  shareholder wealth is nil. Th ere are more 
shares in issue but the overall shareholder value stays the sam e, hence the 
share price decreases. 
For example, if price per shar e is $11 and if a shareholder has  100 shares, then 
after the issue of a 10% scr ip dividend, the number of shares i ncreases to 110. 
Hence, price per share will decrease to $1100/110 = $10. 
The impact of a scrip dividend on  the entity's performance meas ures / ratios is: 
• total shareholder’s equity (in  the statement of financial posi tion) remains 
the same 
• it doesn’t change the capital stru cture (and gearing ratio) be cause the 
equity value stays the same. 
 
 LL is a large listed company. Its  $1 ordinary shares are quote d on the 
local stock exchange. 
Equity comprises: 
• Ordinary share capita l ($1 shares) $1,500m 
• Reserves $500m 
LL's share price is  $1.90 per share. 
The Board of LL is aware that t he market is expecting LL to pay  a 
dividend of $200m to be paid at t he year end, but in order to f und the 
investment in an important new p roject, the Board is considerin g offering 
a scrip dividend of 1 share for ev ery 12 shares held instead of  a cash 
dividend. 
Profit after tax and interest i s forecast to be $380 million in  the current 
financial year.

Chapter 7 
 257 
 What is the expected share price of LL after the scrip dividend  has 
been issued? (to 2 decimal places) 
A $0.16 
B $1.75 C $1.90 D $2.03 
The impact of a share repurchase on shareholder wealth is the s ame as the 
impact of a cash dividend being paid. 
The impact of a share repurchase on the entity's performance me asures / ratios 
is different from the impact o f a cash divide nd though. After a  share repurchase 
there will be fewer shares in iss ue, so the earnings per share of the entity will 
increase. 
 
 McGreggor Co has 10,000 shares i n issue, trading at $50 per sh are. The 
Board is considering returni ng cash of $50,000 to shareholders either as 
a cash dividend or as a share repurchase. 
Required: 
Calculate the wealth of a shar eholder who currently owns 100 sh ares in 
each case. 
Solution: 
Cash dividend 
Dividend per share = ($50, 000/10,000 shares) = $5 
Therefore, ex-dividend s hare price = $50 – $5 = $45 
So the shareholder who owns 100  shares will have wealth of:  
Dividend received + Share value = (100 × $5) + ( 100 × $45) = $5,000

258  
 Share repurchase 
Number of shares repurchased in total will be ($50,000/$50) = 1 ,000 i.e. 
10% of the total 10,000 shares. 
Therefore there will now be (10,000 – 1,000 =) 9,000 shares in issue, with 
a value of 
[(10,000 × $50) – $50,000]/[ 10,000 – 1,000] = $50 each 
So the shareholder who owned 100 s hares before the repurchase w ill 
now have wealth of: 
Cash received in share r epurchase + Share value 
= (10 × $50) + (90 × $50) = $5,000 
 Mr Smith is an investor who is considering buying shares. 
Mr Smith is retired, so does not r eceive a regular income from any 
source. He therefore pays little (if any) income tax. However, he does 
have several valuable assets that  he could sell if he needed to . 
Which TWO of the follo wing companies have dividend policies tha t 
most closely match Mr Smith's requirements? 
Company A  – follows the residual divi dend policy advocated by 
Modigliani and Miller 
Company B  – follows a zero dividend policy, preferring to reinvest all 
profits back into the business 
Company C  – follows a stable dividend poli cy where each year's dividend 
is 3% higher than the year before 
Company D  – pays out a dividend each year of 20% of earnings per 
share

Chapter 7 
 259 
 A company plans to return surp lus cash to shareholders by payi ng a 
special dividend, making it clear  to investors that this is a o ne-off event. 
The company is funded by a mix  of debt and equity and currently  does 
not have any unused bank fa cilities available. 
Which of the following is the MOS T likely consequence of this p lan? 
A  The share price would rise due to the signalling effect of t he special 
dividend 
B  Shareholder wealth would decreas e by the value of cash paid as a 
special dividend 
C  The company would become less vulnerable to a hostile takeov er 
bid 
D  The company would become more able to respond promptly to ne w 
business opportunities 
 
 A company has 10 million $0.50 s hares in issue. The company is  
planning to repurchase 1 million of these shares at a price of $1.50 each. 
Currently, the company's cash balance is $2 m illion and its ear nings per 
share is $0.20. 
What will be the cash balance a nd the earnings per share (EPS) after 
the share repurchase? 
A  Cash: $1.5 million, EPS: $0.22 
B  Cash: $0.5 million, EPS: $0.20 C  Cash: $1.5 million, EPS: $0.20 D  Cash: $0.5 million, EPS: $0.22 
 
 Honeybear Co has 6 million shares  in issue, trading at $5.20 p er share. 
The directors have decided to off er a 3 for 5 scrip dividend to  
What will be the company's share price after the scrip dividend  has 
been issued? 
A $1.95 
B $3.12 C $3.25 D $8.67

260  
 Redhead Co has 100 milli on $1 shares in issue, trading at $2.2 4. It also 
has $70 million of bonds in issue, trading at $106 per cent. 
After several years of growth , the company has accumulated a ca sh pile 
of $20 million. The directors hav e decided to repurchase some o f the 
company's shares at market value in order to return this cash p ile to the 
What will be the gearing level o f Redhead Co after the share 
repurchase? (measured as debt/(de bt + equity) using market valu es) 
A 24.9% 
B 26.7% C 41.2% D 46.7% 
 
 Which THREE of the following stra tegies are most likely to enha nce 
A  Increasing cash for bonuses 
B  Increasing the di vidend payout ratio 
C  Increasing brand reput ation and recognition 
D  Investing in project s with a positive NPV 
E  Moving profitable operat ions to low tax regimes 
 
 P Co is considering paying ou t a large one-off special dividen d to return a 
large amount of cash to its shareholders. 
Which TWO of the following are valid arguments in favour of suc h a 
policy? 
A  If P Co has no foreseeable us e for the cash, it should be re turned to 
investors so that they can put it to better use 
B  It sends a positive signal to t he market, unlike a share rep urchase 
C  A large payment in a single year reduces the risk of a misle ading 
signalling effect 
D  It is likely to increase shareholder wealth E  Paying the cash out is likel y to provide protection against hostile 
take-over

Chapter 7 
 261 
 Mr Jones is an investor who is  considering buying shares. 
Mr Jones is a chartered managem ent accountant who works for a l arge 
listed company. He earns a large salary from his employment and  pays 
income tax at the highest marginal  rate. However, he has few va luable 
assets and has never previously m ade any taxable capital gains.  
Which TWO of the following compa nies have dividend policies tha t 
most closely match Mr Jones's requirements? 
share 
 
 Which of the following statemen ts is consistent with Modigliani  and 
Miller’s dividend irrelevancy theory? 
A  A policy of steady growth in  dividends is preferable to a re sidual 
dividend policy 
B  Shareholder wealth can be maxi mised by retaining a high 
percentage of earnings 
C  The share price is NOT affe cted by a dividend payment 
D  Shareholder return can be m easured as the aggregate of divid ends 
plus growth in share price

262  
7 End of chapter case style questions 
 Test your understanding 11 (Case style question) 
 KK is a listed manufacturing co mpany that is wholly equity fin anced. 25% 
of the shares are held by membe rs of an extended family group. KK has 
adopted 31 December as it s financial year end. 
In previous years, KK has maint ained a dividend pay-out rate of  80% of 
earnings. However, some board mem bers have recently questioned 
whether such a policy is appropr iate. Some board members suppor t the 
80% pay-out but others have sugges ted that a lower dividend is 
necessary in order to help finance expansion in manufacturing c apacity to 
take advantage of new markets  that are opening up in Asia. 
It is too late to change the dividen d for the current financial  year, 20X3, 
since the dividend for the year  is about to be paid. The first time that a 
change in dividend policy c ould be adopted is in 20X4. 
Additional financial information for KK: 
• It is standard practice for KK to pay dividends once a year ba sed on 
forecast earnings for that year. 
• Dividends are paid at or shortl y before the end of the year. 
• A dividend of $ 0.50 in respec t of the current f inancial year (20X3) 
has already been declared. This wa s based on the historical pay -out 
rate of 80% of forecast earni ngs for 20X3 of $  12.5 million. 
• Historically, KK has achieved a return on reinvested funds of 16%. 
• KK has a cost of equity of 14.7%. 
• There are currently 20 m illion shares in issue. 
• Today’s share price is $ 5.00 (cum div). 
Possible reduction in dividend pay-out 
The board of KK is considering cutting the regular dividend pay -out rate 
from 80% to 50% of earnings wit h effect from 20X4. If agreed, t his would 
be made public by an announcement on 1 January 20X4. 
The board is aware that there woul d be a delay of 12 months bet ween 
cutting the dividend pay-out rat e and realising any benefit in terms of 
higher earnings as a result of th e higher level of reinvested f unds. 
Discussions regarding a possibl e change in the dividend pay-out  rate 
have so far been internal and on ly known by the management team  at 
KK. No announcement has yet been made about a possible change i n 
dividend policy and the share pr ice does not yet reflect the po ssibility of a 
cut in pay-out rate.

Chapter 7 
 263 
Growth formula 
g = r × b 
• Where g = annual growth 
• r = return on reinvested funds 
• b = proportion of funds retained 
Required: 
Calculate the following performa nce measures for KK for both ye ars 
20X4 and 20X5 assuming a reduction in KK’s dividend pay-out to 50% of 
earnings from 20X4 onwards: 
• Growth rate using the gr owth formula provided. 
• Earnings. 
• Dividend per share. 
 (20 minutes) 
 
 DIVS plc is a large internat ional company with widespread inte rests in 
advertising, media and various cons ultancy activities associate d with 
sales promotion and marketing. I n recent years the company's ea rnings 
and dividend payments, in real te rms, have grown on average by 15% 
and 12% per year respectively. The company is likely to have su bstantial 
cash surpluses in the coming y ear, but a number of investment 
opportunities are being consider ed for the subsequent two years . The 
senior managers of the company are  reviewing their likely fundi ng 
requirements for the next two  to three years and the possible 
consequences for dividend policy. 
At present the company has a debt : equity ratio of 1 : 5, meas ured in 
market value terms. It does not w ant to increase this ratio at the present 
time but might need to borrow to  pay a maintained dividend in t he future. 
The senior managers of the company  are discussing a range of is sues 
concerning financial strategy i n general and divi dend policy in  particular.

264  
 Required: 
Assume you are an independent financ ial advisor to the board of  DIVS 
plc. Write a report to the board which discusses the following issues: 
(i)  The re-purchase of some of  the company's shares in the com ing 
year using the forecast surplus  cash, the aim being to reduce t he 
amount of cash needed to pay div idends in subsequent years. Oth er 
implications of share repurchas e for the company's financial 
strategy should also be considered. 
(ii) The advisability of borro wing money to pay dividends in ye ars 2 and 
3. 
(iii) The likely effect on the company's cost of equity if the company 
decides on share repurchase and / or further borrowing. 
 (45 minutes)  
 
 STR is a well-established market ing consultancy in a country w ith a low 
interest rate. STR is a successful  business which has experienc ed rapid 
growth in recent years. There are 20 million $1 ordinary shares  in issue. 
These ordinary shares are quoted on a recognised stock exchange  and 
40% are owned by the founders of t he business. Dividends were 4 0 cents 
per share in 20X3 and grew by  5% per annum bet ween 20X3 and 20X 6. 
This pattern is expected to c ontinue beyond 20X6. Dividends are  paid in 
the year in which they are declared. 
Extracts from the financial stat ements for the past three years  are as 
follows: 
 $million $million $million 
Profit before tax  21.6  24.4  26.7 
Tax expense 7.7  2.6  4.3 Net cash generated after 
deducting interest, tax and net capital expenditure, but excluding ordinary dividends 19.2  (7.1) 18.8

Chapter 7 
 265 
• The opening cash balance in 20X4  for cash and cash equivalents  
was $6 million; 
• The opening book value of equi ty in 20X4 was $60 million; 
• Long-term borrowings remained a t $50 million throughout the th ree 
years and the annual gross intere st cost on the borrowings was $1 
million; 
• There were a number of disposal s of non-current assets in 20X4  
and an exceptionally hi gh level of capital expenditure in 20X5.  
The directors have noticed the build-up of cash and cash equiva lents. 
They are concerned that this might not be in the best interest of the 
shareholders and could have an adver se effect on the share pric e. 
Various proposals have been made to  reduce the level of cash an d cash 
equivalents. 
Required: 
(a) Calculate the following financ ial information for STR for e ach of the 
years 20X4 to 20X6: 
–  Closing cash balance; –  Closing book value of equity. 
 (10 minutes) 
(b) Analyse and discuss the fi nancial performance of the entity  from the 
viewpoint of both the lenders and shareholders, referring to th e 
information calculated in part ( a) above and making appropriate  
additional calculations. Up to 6 m arks are available for calcul ations. 
(c) (i)  Discuss the comparativ e advantages and disadvantages o f a 
share repurchase versus a  one-off dividend payment. 
 (15 minutes) 
(ii) Advise the directors of STR  on alternative financial strat egies 
that they could consider that wou ld reduce the level of surplus  
cash. 
 (15 minutes)

266  
In theory, shareholder wealth is unaffected by a scrip dividend . 
Consider a typical shareholde r with 120 shares. Under the terms  of the 
scrip dividend, this shareholder w ould receive an entitlement t o one new 
share for every 12 held. That i s, the right to acquire 10 new s hares 
(where 10 = 120/12). 
This may give the shareholder  the illusion of increased 'value'  as he now 
holds 130 shares. However, the company itself has not changed i n value 
and so the total value that thos e shares represent is unchanged . 
Therefore, the value of each s hare after the scrip issue will b e ($1.90 × 
120)/130 = $1.75 
 
 The answer is (C) and (D). 
Mr Smith has no other r egular income, so he would prefer to inv est in a 
company that pays out a dividend each year. 
Company C would be his preferred choice – it gives a predictabl e payout. 
Company D would be his second c hoice – a dividend will be paid each 
year, although the amounts could be variable. 
Companies A and B would not give Mr Smith the income he needs. 
Selling shares to manufacture d ividends would not be appealing to Mr 
Smith because he has capital gains  already but pays very little  income 
tax, so he would prefer d ividends to capital gains. 
 
Having paid out a large amount o f cash as a dividend there woul d be 
much less chance of a predator w anting to take over the company .

Chapter 7 
 267 
The amount of cash required for the repurchase is 1 million sha res at 
$1.50 each, so $1.5 million in to tal. Hence, cash will fall fro m $2 million to 
$0.5 million. 
The new number of shares in iss ue will be (10 m illion – 1 milli on =) 9 
million, so assuming that earni ngs stay constant, the EPS will be (total 
earnings/9 million). 
Currently, earnings are $0.20 × 10 million = $0.20 million. The refore, EPS 
will be $0.20 million/9 million = $0.22 after  the repurchase. 
 
A scrip dividend does not change the value of the overall compa ny, 
therefore the total co mpany value will still be: 
6 million × $5.20 = $31.2 million. 
After the 3 for 5 scrip issue , the number of shares in issue wi ll be: 
6 million + (6 million × 3/5) = 9.6 million. 
Therefore, the shar e price will be $31.2 million/9.6 million = $3.25. 
 
Market value of debt is $70m × 1.06 = $74.2m Current market value of equity i s 100m × $2.24 = $224m, so afte r the 
share repurchase it will be $204m. 
Therefore (D/(D+E)) = 74. 2/(74.2 + 204) = 26.7% 
 
 The answer is (C), (D), and (E). 
Cash for bonuses (A) would cause more money to be paid out of t he 
business, leaving less for reinvestment. 
Increasing the dividend payout r atio (B) without any underlying  increase 
in positive NPVs generated would make no difference to sharehol der 
wealth.

268  
 The answer is (A) and (E). 
Paying a dividend of any sort s hould not impact shareholder wea lth - only 
undertaking a positive NPV proj ect can enhance shareholder weal th (D). 
A large payment in a single year  would increase the risk of a m isleading 
signalling effect (C). 
Both special dividends and share repurchases can send positive signals 
to the market (B). 
 
 The answer is (A) and (B). 
Mr Jones has a large regular incom e, so he would prefer to inve st in a 
company that pays out as little as  possible in dividends. If Mr  Jones ever 
does need an income from his inves tments, selling shares to cre ate 
capital gains would be the most tax efficient approach. 
 
M & M's theory said that the pat tern of dividends is irrelevant . The key 
point is that any positive N PV projects should be undertaken. H ence (A) 
and (B) are incorrect. 
Although shareholder wealth will not be affected by a dividend payment, 
the share price wil l be under M & M's theor y. A large dividend will convert 
shareholder wealth from share value  to cash, so the share price  will fall 
even though overall sh areholder wealth stays the same. Therefor e (C) is 
 
measure 20X3 20X4 Workings 20X5 Workings 
Earnings 
growth (%) 3.2 3.2 No change as 
reinvestment of 
additional retained 
earnings not actioned 
until this year 8 g = r × b  
= 16% × 50%  
= 8% 
Earnings ($m) 12.5 12.9 = $ 12. 5 million × 1.032 13.932 = $ 12. 9 million  
× 1.08 
Dividend per 
share ($) 0.50 0.3225 = 12.9m × 50% /20m 0.3483 = (13.932  
× 50%)/20m 
where 3.2% = r × b = 16% × 20%

Chapter 7 
 269 
 Report 
To: Board of Directors, DIVS plc  
From:  Independent financial advisor  
Date:  XX/XX/XX 
Re: Dividend policy and other financing issues 
You are currently considering th e current and future position o f the 
company as regards dividend pay ments and financing over the nex t two 
to three years, in the light of y our current cash surplus and t he investment 
opportunities available to  you from next year. 
This report addresses the following issues: 
• the implications of share re-pur chase to reduce future dividen d 
payments; 
• borrowing funds to finance dividends; 
• the possible effects on cost o f equity if either or both of th e above 
actions are taken. 
(i)  Share re-purchase  
You are likely to have substantia l cash surpluses in the coming  
year. Your first decision is to decide how much to distribute, bearing 
in mind both your investment fi nancing requirements in the futu re 
and the possible reactions of s hareholders and other market 
players. In the current climate, i t is expected that 'spare' ca sh, in 
excess of that required for spec ific profitable investment 
opportunities, should be returned  to the shareholders to do wit h as 
they wish. 
You have some investment opportuni ties open to you in the near 
future. Whether or not you have to  retain some of the current 
surplus cash to fund these wil l depend upon the extent to which  you 
expect there to be spare funds  generated in the next two or thr ee 
years. 
Once the amount to be distribut ed (if any) has been decided upo n, 
you then need to decide whether to  return it to all the shareho lders 
as a dividend, or to some of t hem in the form of a share re-
purchase. The latter option will result in only a small number of 
shareholders – likely to be the la rge institutional investors –  
receiving cash, although their proportionate holding, and there fore 
entitlement to future di vidends, will be reduced. 
Other shareholders will have to s ell shares, incurring transact ion 
costs, to 'manufacture' divi dends should they need them.

270  
 It should be noted that a share re- purchase is administratively  more 
complex in that it requires prio r approval from a general meeti ng of 
shareholders (assuming the Articl es of Association provide that  it 
can happen at all). It is also no longer possible for instituti ons to 
reclaim tax on the di stribution in the UK. 
The two types of distribution wi ll also affect share prices dif ferently. 
When a dividend is declared, the value of the shares falls from  cum- 
div to ex-div, the shareholders  having had some of their capita l 
investment realised as cash. 
In theory, if the share re-purc hase is made at current market p rice, a 
share re-purchase should leav e the individual share price 
unchanged – there has been a reduction in total market value in  
proportion to the total number of shares in issue. 
It should also be noted that a sha re re-purchase would result i n a 
higher future EPS figure than i f a normal dividend had been pai d. 
However this should not affect the market's perception of the h ealth 
of the company, as it is purely a result of the same earnings b eing 
spread over a smaller number of shares. 
Overall, it would appear that ther e is no particularly strong a rgument 
for a share re-purchase in pre ference to a dividend payment to all 
shareholders. Whilst you may see this as a means of reducing future dividend payments, it is likely that the remaining shareholders, who would be holdi ng a greater proportion of shar es 
than previously, would expect a h igher dividend per share. If t his 
expectation is not met, share pr ices may be affected adversely.  
(ii) Borrowing to pay dividends 
If it is decided to distribute an amount in the current year th at cannot 
be maintained (with planned grow th) in future years out of 
operational cash flows, then addi tional funds will need to be 
borrowed. 
This will raise the company's gearing level above the current 1 :5 
debt:equity ratio, with two cons equences. First, the company wi ll be 
funded by a greater proportion o f cheap finance, particularly a s debt 
interest is tax deductible. Second, shareholders may perceive a  
greater risk as being attached to  their dividends, as more of t he 
earnings are attributed to fixed in terest payments. It is a que stion of 
finding the optimum balance bet ween these two effects. 
(iii) Effect on cost of equity 
The probable effect of increasing  the gearing level will be, as  
discussed in (ii) above, to increas e the required return by (co st of) 
equity. Borrowing will directly a ffect the gearing level, by in
creasing 
the debt element.

Chapter 7 
 271 
 The payment of a dividend or a s hare repurchase will also incre ase 
the gearing level, by lowering t he value of the equity (as disc ussed 
in (i) above, a dividend results  in a lower share price with th e 
number of shares being maintained ; a share repurchase results i n a 
maintained share price with a lower number of shares). 
Thus both actions may result in a higher cost of equity. 
Overall recommendations 
It is advised that any surplus c ash over and above the needs of  all 
positive NPV investm ents should be paid out in the form of a di vidend. 
This 'residual' dividend policy may lead to fluctuating dividen ds, however, 
and institutional investors gener ally prefer a steady dividend pattern; you 
will need to keep a careful eye on your share price to ensure i t is not 
being adversely affected in the long term. 
Should you need to borrow in t he future, you should find this t o your 
advantage, as your current geari ng level is quite low, and the benefits of 
cheaper debt should outweigh any increase in cost of equity. 
 
In part (a) ensure that your wor kings are clearly set out. In p art (b) it is 
vital that you discuss any ratio s calculated rather than simply  presenting 
the examiner with a set of numbers. Part (c ) is bookwork and a good 
reminder that you need to be famili ar with all aspects of the s yllabus. 
(a) Cash balances 
 $m $m $m 
Net cash flow before divi dends 19.2  (7.1) 18.8 
Dividends (W1)   (8.4) (8.8) (9.3) 
Net cash flow 10.8  (15.9) 9.5 
Cash b/f 6  16.8  0.9 
Cash c/f 16.8  0.9   10.4 
 –––– –––– ––––

272  
 Book value of equity 
 $m $m $m 
Profit before interest a nd tax (bal) 22.6 25.4 27.7 
Interest (1.0) (1.0) (1.0) 
Profit before tax 21.6 24.4 26.7 
Tax expense (7.7) (2.6) (4.3) 
Profit after tax 13.9 21.8 22.4 
Dividends (W1) (8.4) (8.8) (9.3) 
Retained profit 5.5 13.0 13.1 
Book value of equity b/f 60 65.5 78.5 
Book value of equity c/f 65.5 78.5 91.6 
(W1) Dividends  
20X4: dividend = 20 million × $0.40 × 1.05 = $8.4 million 
20X5: dividend = $8.4 milli on × 1.05 = $8.82 million 
20X6: dividend = $8.82 million × 1.05 = $9.261 million 
(b) Additional calculations  
Interest cover 22.6× 25.4× 27.7× 
Dividend cover 1.65× 2.48× 2.41× 
Earnings per share (c ents) 69.5 109 112 
Gearing = debt net of cash/(debt + equity) 
Debt 50 50 50 Cash 16.8 0.9 10.4 
 
–––– ––––– ––––– 
Debt net of cash 33.2 49.1 39.6 
Equity 65.5 78.5 91.6 
 –––– ––––– ––––– 
Debt (net) + equity 98.7 127.6 131.2 
Gearing 33.6% 38.5% 30.2% 
 –––– ––––– –––––

Chapter 7 
 273 
 Return on equity 
Profit before tax 21.2% 27.8% 24.5% 
Return on capital employed, using net debt + equity 
Return on capital 22.9% 19.9% 21.1% 
Comments 
The financial performance from t he shareholders’ point of view has 
generally been encouraging: 
–  Both earnings per share and  the book value of equity have 
been increasing. 
–  Dividends have increased. –  Return on equity has cons istently been above 20%. 
–  Financial gearing has fall en in 20X6 and dividend cover is n ow 
over two, indicating lower ri sk attached to the dividends. 
The only area of worry, however , is that return on equity fell from 
20X5 to 20X6. 
The financial performance from t he lenders’ point of view has b een 
less convincing. On a positive note: 
–  Interest cover is very high and rising, suggesting a low def ault 
risk. 
–  Gearing fell in 20X6, again suggesting less risk for lenders . 
However, 
–  STR had poor cash flow i n 20X5. Lenders may wish to see 
more detailed analysis of cas h flow to determine if any 
underlying probl ems persist.

274  
 (c) (i)  The relative advantages  of a share repurchase verses a  one-
off dividend are as follows: 
Share repurchase One-off dividend 
• A repurchase may be 
more tax efficient than a dividend for some shareholders. 
• A reduction in the 
number of shares should boost EPS. 
• Increased gearing as 
equity is reduced. This is only an advantage if STR is moved closer to its optimal gearing level. 
• Does not create an 
expectation of higher future dividends. On the contrary, less cash will be needed for future dividends due to fewer shares. • A dividend may be more 
tax advantageous for some shareholders. 
• All shareholders are 
treated fairly. 
• The amount of cash 
paid is more certain – with a repurchase it will not be known in advance how many shareholders will choose to sell. 
(ii) Alternative strategies for  reducing a cash surplus include  the 
• increase the growth rate of dividends 
• long-term equity investments – e.g. acquire other firms 
and/or buy stakes in rivals, customers, etc. 
• reduce debt by repaying borrowings 
• increase capital expenditure 
• increase investment in re search and development – e.g. 
to enter new markets.

275 
Financial risk 
C1:  Discuss the sources 
and types of financial risks 
 Discuss: 
(a) Sources of financial risk (b) Types of financial risk 
C2:  Evaluate financial risks 
 (a) Evaluate how financial 
risks are quantified 
C3:  Recommend ways of 
 (a) Recommend ways to 
manage economic and political risks 
• Economic risk 
• Interest rate risk 
• Responses to economic, transaction and translation risks 
 
          Chapter 
8

276  
 
Introduction – definition of financial risk 
Financial risk is 'a risk of a  change in a financial condition such as an exchange 
rate, interest rate, credit rati ng of a customer, or price of a  good'. 
Political risk is not necessar ily a financial risk but is inclu ded here because often 
financial risk is from the perspective of foreign business acti vities. Political risk 
is essentially to do with the wi der risks of foreign direct inv estment. 
2 Political risk 
Political risk is the risk faced by an overseas investor, that the host country 
government take adverse action against, after the company has i nvested. 
It can take different forms and th e threats (financial and non- financial) can 
include: 
• Risk of confiscation or destr uction of overseas assets 
• Commercial risks because foreig n governments discriminate agai nst 
overseas firms e.g. quotas, tariffs, other taxes 
• Restricted access to local borrowings 
• Insisting on resident investors  or a joint venture with a loca l company 
• Restrictions on repatriating cash (capital or dividends) 
• Restrictions on conversion of the currency 
• Rationing the supply of foreign currency 
• Exchange rate volatility due to political actions 
• A minimum number of local nationals to be employed 
• Price fixing by the government 
• Minimum percentage of l ocal components to be used 
• Invalidating patents 
• Claiming compensation for past actions

Chapter 8 
 277 
 More on sources of political risk 
 Whilst governments want to enc ourage development a nd growth th ey are 
also anxious to preve nt the exploitation o f their countries by 
multinationals. 
Whilst at one extreme, assets mi ght be destroyed as the result of war or 
expropriation, the most likely pr oblems concern changes to the rules on 
the remittance of cash out of  the host country to the holding c ompany. 
Exchange control regulations,  which are generally more restrictive in 
less developed countries. For example: 
• rationing the supply of foreign currencies which restricts res idents 
from buying goods abroad 
• banning the payment of dividends  to foreign shareholders such as 
holding companies in multinatio nals, who will then have the pro blem 
of blocked funds. 
Import quotas  to limit the quantity of goods th at subsidiaries can buy 
from its holding company to se ll in its domestic market. 
Import tariffs  could make imports (from  the holding company) more 
expensive than domesti cally produced goods. 
Insist on a minimum shareholding , i.e. that some equity in the 
company is offered to resident investors. 
Company structure  may be dictated by the hos t government – requiring, 
for example, all investments to  be in the form of joint venture s with host 
country companies. 
Discriminatory actions 
• Supertaxes imposed on foreign firms, set higher than those 
imposed on local businesses with  the aim of giving local firms an 
advantage. They may even be deliber ately set at such a high lev el 
as to prevent the business from being profitable. 
• Restricted access to local borrowings  by restricting or even 
barring foreign owned enterprises from the cheapest forms of finance from local banks and dev elopment funds. Some countries 
ration all access for foreign in vestments to local sources of f unds, to 
force the company to import fore ign currency into the country. 
• Expropriating assets  whereby the host country government seizes 
foreign property in the national i nterest. It is recognised in 
international law as the right o f sovereign states provided tha t 
prompt consideration at fair mar ket value in a convertible curr ency is 
given. Problems arise over the exact meaning of the terms promp t 
and fair, the choice of currency , and the action available to a  
company not happy with the compensation offered.

278  
Management of political risk 
Companies cannot prevent political risk, but they should seek t o minimise it 
whenever the risk appears significant. 
Before undertaking a foreign di rect investment, a company needs  to assess its 
exposure to political risk by: 
• Using political ranking tables  such as Euromoney magazine tabl es; 
• Evaluating the country's macro -economic situati on – balance of  payments, 
unemployment levels, per capita i ncome, inflation, exchange rat e policy, 
rate of economic growth; 
• Evaluating the current gover nment's popularity, stability and attitude to 
foreign investment, together wit h the attitude of opposition pa rties; 
• Looking at the historical st ability of the political system; 
• Looking at changing religious and cultural attitudes; 
• Taking advice from the company's bank (if there is a represent ative office 
in the overseas country) and the company’s home embassy in the 
overseas country. 
Some methods of minimising risks are as follows: 
• Prior negotiation (concession agreements and planned divestmen t) 
• Structuring investment (local sourcing of mat erials and labour ) 
• Entering into foreign joint ventures 
• Obtaining agreements and contra cts with overseas government 
• Using local financing 
• Plans for eventual ownership/part-ownership by foreign country 's 
 
 More on managing political risk 
 Joint ventures.  A company might go into a  joint venture with one or 
more partners. A joint vent ure can reduce risk because: 
• if each joint venture partner c ontributes a share of the fundi ng for 
the venture, the investment at risk for each partner is restric ted to 
their share of the total invest ment (although, the upside is re duced 
because each party has less inve sted in this potentially lucrat ive 
venture) 
• if a local company is selected as a joint venture partner, the  
likelihood of winning major contracts in t he country might be m uch 
greater. Some governments have m ade the involvement of a local 
company in a joint venture a condi tion of awarding contracts to  
consortia involving a foreign company 
• the local venture partner has a better understanding of the lo cal 
political risks and can manage t hem more effectively than a 
foreigner would be able to. Also the government might be less 
inclined to act against the intere sts of the local venture part ner.

Chapter 8 
 279 
Pre-trading agreements.  Prior to making the investment, agreements 
should be secured if possible with the local government regardi ng rights, 
remittance of funds and local equ ity investments and (where app ropriate) 
the award of government c ontracts to businesses. 
Gaining government funding.  In some situations, it might be possible to 
gain government funding for a proj ect or contract, with the gov ernment 
being either a customer, a backe r or a partner for the deal. If  government 
funding can be obtained: 
• the government will have an inte rest in the transaction reachi ng a 
successful conclusion 
• there should be little or no ri sk of exchange c ontrol regulati ons 
preventing the withdrawal o f profits from the country. 
Local finance.  A company might try to obtain local finance for an 
investment in a particular count ry. The availability of local f inance might 
depend on the state of t he banking and capital markets in the c ountry 
concerned. The major advantage of local finance is that it crea tes 
liabilities in the foreign currency, and so reduces: 
• translation exposures: assets i n the foreign currency can be o ffset 
against liabilities in the same currency 
• transaction exposures, in the se nse that interest costs will b e 
payable in the foreign currency and can be paid from income in the 
same currency. 
Raising finance locally might als o help to maintain the interes t of the local 
government in the success of the business, and there is less ri sk that the 
assets will be confiscated. 
Planning for the eventual part-ow nership or full ownership of t he 
business by locals.  Target dates might be set in advance of making the 
investment for the eventual par t-ownership or full ownership of  the 
business by local people. The tr ansfer of ownership should be e xtended 
over a long-term, partly to ensur e that a satisfactory return o n investment 
is obtained but also to encourage the local government to under stand the 
long-term benefits of f oreign investment. 
 
 Test your understanding 1 – Polit ical risk (Integration questio n) 
 A UK company is planning to bui ld and operate a factory in Wes t Africa. 
Required: 
Discuss the potential political r isks that may arise and recomm end risk 
mitigation strategies that coul d be implemented to bring these risks to a 
satisfactory level.

280  
3 Interest rate risk 
 As defined in the ear lier Chapter 5: ‘Financing - Debt finance’ , interest rate 
risk is the risk of gains or lo sses on assets and liabilities d ue to changes in 
interest rates. It will occur fo r any organisation which has as sets or 
 
 Interest rates and LIBOR 
 Non-financial organisations normally  have many more interest-be aring 
liabilities than interest-beari ng assets. These include bank lo ans and 
overdrafts, and issues of bonds  or debentures. As a general rul e: 
• interest on bank loans and overdrafts is payable at a variable rate  
or floating rate , with the interest s et at a margin above a 
benchmark rate such as the base rate or the London Inter Bank 
Offer Rate (LIBOR) 
• interest on most bonds, debentur es or loan stock is at a fixed rate . 
When interest is at a floating rate, the amount of interest pay able in each 
period is set by reference to t he benchmark interest rate on a specific 
date, such as the starting date fo r the interest period. For ex ample, 
suppose that a company has a bank  loan on which it pays interes t every 
six months at 50 basis points above LIBOR. (100 basis points = 1%, 
therefore 50 basis points = 0.50%.) At t he start of an interest  period, the 
six-month LIBOR rate might be,  say, 4.75%: if so, the company w ould 
pay interest at the end of the si x months at 5.25% for the six- month 
period. If LIBOR moves up or dow n, the interest rate payable ev ery six 
months will go up or d own accordingly. 
(Note:  LIBOR is the London Interbank Offe red Rate. It is a money mark et 
rate at which top-rated banks are able to borrow short-term in the London 
sterling or eurocurren cy markets. There are LIBOR rates for maj or traded 
currencies, including the US do llar, euro and yen, as well as s terling 
(British pounds).) 
Exposure to interest rate risk 
assets or liabilities that it hol ds and the type that these are  (floating or fixed 
rate). 
Types of interest rate risk exposure 
• Floating rate loans:  If a company has floating rate loans, changes in 
interest rates alter the amount o f interest payable or receivab le. This 
directly affects cash flows and profits and the risk therefore is quite 
obvious. 
• Fixed rate loans:  If a company has fixed rate l oans interest rate risk still 
exists. Even though interest charges themselves will not change , a fixed 
rate can make a company uncompetitive if its costs are higher t han those 
with a floating rate and interes t rates fall. (Remember interes t rate risk can 
be about assets or liabilities – a n asset that pays a fixed rat e of interest 
will be worth less if i nterest rates rise.)

Chapter 8 
 281 
 More on fixed rate exposure 
 Companies with fixed rate borro wings are also exposed to inter est rate 
risk, because by paying a fixed rate of interest on its liabili ties, a company 
runs the risk that: 
• if interest rates fall, it will be unable to benefit from the lower rates 
available in the market, because it is committed to paying fixe d 
rates, and 
• competitor organisations might have floating rate liabilities,  and so 
will benefit from lower interest costs, and so improve their profitability and comp etitive strength. 
 
The same, of course, is true in reverse for a company that has fixed or floating 
rate deposits/investments. 
Measuring exposure to interest rate risk 
Floating rate loans 
Interest risk exposure is the to tal amount of floating rate ass ets and liabilities. 
The higher the value of loans t he greater the exposure to chang es in interest 
rates. 
Fixed rate loans 
This is measured by the total am ount of fixed rate assets or li abilities together 
with average time to maturity and average interest rate. Longer  periods of tie-in 
at fixed rates could be beneficia l, or more costly, to business es depending on 
what market rates are and also w hat the future expectations of interest rate 
changes are. It is expectati ons that determine risks. 
 
 Illustration of interest rate risk exposure 
 Block has the following liabilities at 1 January Year 1: 
• Bank loans $400 million, interes t at LIBOR + 50 basis points 
• $50 million floating rate bonds , interest at LIBOR + 25 basis points 
• $200 million 6.5% bonds, r edeemable 30 June Year 3 
• $350 million 6% bonds, redeemable 30 September Year 4

282  
 Interest rate exposure: 
The company has floating rate liabilities of $450 million and f ixed rate 
liabilities of $550 million. 
Average interest rate of fixed rate liabilities: 
$200m × 6.5% $13m  
$350m × 6% $21m  
––––––– –––––––  
$550m of loans with $34m of interest = 6.18% average rate 
The average interest rate woul d be compared to other companies in the 
same industry to ascertain whethe r it was higher or lower, whil st bearing 
in mind the general expectation of movement in the base rate. F or 
example, if Block's average rate  is higher than the competitors  and the 
base rate is expected to fall, t hen it will be deemed more risk y because 
Block will pay more interest in  the future compared to its comp etitors. 
Average time to maturity of fixed rate liabilities: 
$200m × 2.50 years 500.00  
$350m × 3.75 years 1,312.50  
 –––––––  
 1,812.50  
1,812.50/$550m 3.30 years av erage remaining life 
Time to maturity creates a separat e measure of exposure. Again Block's 
average time to maturity will be co mpared to its competitors. I f the time to 
maturity is longer than the com petitors and rates are expected to fall then 
Block is more risky since it has tied itself in to longer term fixed rate 
borrowings, paying out too much i nterest and possibly incurring  a 
redemption penalty if it tried  to restructure its debt. 
Refinancing risk is associated wi th interest rate risk because it looks at the risk 
that loans will not be refinanc ed or will not be refinanced at the same rates. 
• The credit rating of the company  has reduced making them a mor e 
in obtaining the best rates.

Chapter 8 
 283 
4 Currency risk 
 Currency risk is the risk that ari ses from possible future move ments in an 
Currency risk affects any organisation with: 
face economic risk since its co mpetitors may be faring better d ue to 
favourable exchange rates on their transactions. 
 Currency risk can be categoris ed into three types: economic, tr ansaction 
and translation exposure. 
Economic risk 
Economic risk is any change in th e economy, home or abroad, whi ch can affect 
the value of a transaction befor e a commitment is made i.e. pay ment or receipt. 
A company may not have any transa ctions in a foreign currency i .e. it buys and 
sells in its home currency, but i t is still affected by economi c risk. 
This can be due to several factors: 
• Competitive position – even i f a company trades wholly in its own 
currency, other companies can ca use it to lose money in the for m of 
reduced sales. For example, if a  competitor company trades (eit her buys 
or sells) abroad where the curre ncy is more favourable – cheape r for 
supplies, or allows a higher pri ce for sales, then the competit or will be 
more profitable. Conv ersely, if the exchange rates are adverse for the 
competitor, they woul d be less profitable. 
• Elasticity of demand – exchange rates can make a company's pro ducts 
more or less expensive. When an exchange rate makes the product  more 
expensive, say, the demand for that product will probably fall.  However, if 
the product is available at a l ower price from another company,  who 
perhaps trades in a different cu rrency which enables the produc t to be 
made and sold more cheaply, then demand does not fall but trans fers to 
that other company. Therefore th e home company has lost sales, is less 
profitable and sharehol der returns will fall.

284  
• Pricing – currency movements c an affect pricing decisions, eve n if an 
entity has no foreign operations  and does not trade internation ally. For 
example, a Scottish s heep farm could sell lamb exclusively to l ocal 
supermarkets and have no imports o r exports whatsoever. The far mer 
must still be aware of exchange rates because a strengthening o f the 
British Pound against, say, the New Zealand Dollar will make it  cheaper 
for farmers to import New Zealand  lamb and the farmer may have to 
reduce his prices in response. 
In effect, economic risk is the va riation in the value of the b usiness (i.e. the 
present value of future cash flows) due to unexpected changes i n the 
economy. 
Management of economic risk 
One way the risk can be reduced is to diversify globally, meani ng that a 
company can reduce its risk by having operations located all ov er the world or 
by doing business with other com panies located in other parts o f the world. This 
is portfolio theory – the idea o f reducing risk by 'not having all your eggs in one 
basket'. This can be broken down into: 
Diversification of p roduction and sales 
If a firm manufactures all its products in one country and that  country’s 
exchange rate strengthens, then the  firm will find it increasin gly difficult to export 
to the rest of the world. Its futu re cash flows and therefore i ts present value 
would diminish. However, if it had established production plant s worldwide and 
bought its components worldwide (a policy which is practised by  many 
multinationals, e.g. Ford) it is unlikely that the currencies o f all its operations 
would revalue at the same time.  It would therefore find that, a lthough it was 
losing on exports from some of i ts manufacturing locations, thi s would not be 
the case in all of them. Also  if it had arranged to buy its raw  materials worldwide 
it would find that a s trengthening home curr ency would result i n a fall in its input 
costs and this would com pensate for lost sales. 
Diversification of suppliers and customers 
Similarly a company could divers ify its supplier and customer b ase so that if the 
currency of, say, one supplier st rengthens, purchasing could be  switched to a 
cheaper supplier. 
Diversification of financing 
When borrowing internationally, fi rms must be aware of foreign exchange risk. 
When, for example, a firm borrows  in Swiss francs it must pay b ack in the same 
currency. If the Swiss franc  then strengthens against the home currency this 
can make interest and principal r epayments far more expensive. However, if 
borrowing is spread across many cu rrencies it is unlikely they will all strengthen 
at the same time and theref ore risks can be reduced.

Chapter 8 
 285 
Borrowing in foreign currency is only truly justified if return s will then be earned 
in that currency to finance repaym ent and interest. Internation al borrowing can 
also be used to hedge the adverse economic effects of local cur rency 
devaluations. If a firm expects  to lose from devaluations of th e currencies in 
which its subsidiaries operate it can hedge this exposure by ar ranging to borrow 
in the weakening currency. Any l osses on operations will then b e offset by 
cheaper financing costs. 
Note that diversification (of any type) will not necessarily he lp in extreme 
circumstances e.g. during a global recession. 
Marketing 
A way of managing economic risk is quite simply to have a very good marketing 
ploy that enables you to convince  your customers that your prod uct is the one to 
buy despite it being more expensive! 
 
 More on economic risk 
 Economic risk is the possibility  that the value of the company  (the present 
value of all future post tax ca sh flows) will change due to une xpected 
changes in future economies (which  includes exchange rates). Th e size 
of the risk is difficult to measur e as economies can change sig nificantly 
and unexpectedly. Such changes can affect firms in many ways: 
• Imagine a UK company  had an investment i n South East Asia 
during the late 1990s. They would have suffered some economic 
risk due to the economic downturn in that part of the world at that 
time. An economic downturn can reduce trade and have an impact 
on foreign currency exchange ra tes. This means that the UK 
company's investment might be worth less upon first glance. However, the wider implications m ight include the fact that the  
factory makes goods for export. T hen the downturn might reduce 
costs. Meanwhile if the competit ion are manufacturing in the 
'booming' West and costs are hi gher (material and wage inflatio n) 
then the Asian subsidiary may h ave the competitive advantage. 
Therefore, the economic  downturn may not be wholly downside ris k. 
• Suppose a UK company invests i n a subsidiary in Africa. The 
currency of the African country d epreciates each year for sever al 
years. The cash flows remitted to  the UK are worth less in GBP 
terms each year, causing a reduc tion in the investment value. 
• A French company buys raw materi als that are priced in US doll ars. 
It converts the raw materials in to a finished product which it exports 
to Japan. Over several years t he euro appreciates against the d ollar 
but depreciates against the yen. T he euro value of the French 
company's income increases while the US dollar cost of its materials decreases, resulting in an increase in value of the 
company's cash flows.

286  
 • Insisting on dealing in only t he home currency may affect the foreign 
demand for its products if the pou nd appreciates or their relat ionship 
with suppliers if the pound weakens. 
• Consider a UK company exporting  goods or services to Spain, in  
competition with (say) US compa nies. In this case, if the US do llar 
weakens relative to the euro (e ven if the pound remains unchang ed 
against the euro), it will become c heaper for the Spanish custo mers 
to import those goods and servic es from the US supplier if the order 
is denominated in the foreign cu rrency. Even if the order is 
denominated in euros (the Spanish  currency) the euro price from  
the US supplier might not conver t into enough GBP to make it 
worthwhile for the UK company. 
• Deciding to acquire resources , say equipment in Italy, with a view to 
supplying goods or services to the UK market. In this case the company’s costs are in euros with expected revenues in GBP. If the 
GBP were to weaken against the eur o, the costs of the operation  
could become uneconomic. 
However, many of the above examples  are not as straightforward as they 
might first seem, due to the comp ensating actions of economic f orces. 
For example, if the exchange ra te of a South American country 
depreciates significantly, it is probably due to high inflation . If the South 
American subsidiary of a UK com pany increases its prices in lin e with 
inflation in South America, its  cash flows in the local currenc y will 
increase. However, these will be converted at a depreciating ex change 
rate to produce (theoretically) a constant GBP value of cash fl ows. 
Alternatively, if the subsidiary  does not increase its prices, it may 
increase its sales volume by se lling at a lower price. Therefor e the 
subsidiary / group has not 'lost out'. 
 
 Measurement of economic exposure 
 Although economic exposure is di fficult to measure it is of vi tal 
importance to firms as it concer ns their long-run viability. Ec onomic 
exposure cannot be ignored as it could lead to reductions in th e firm’s 
future cash flows or an increas e in the systemat ic risk of the firm, 
resulting in a fall in shareholder wealth. 
There are a very lim ited number of factors that can be observed  to 
attempt to quantify economic expos ure, which include the price elasticity 
of demand for products. For examp le, as prices rise demand usua lly falls, 
but the rate at which it falls and the resulting cash flows wil l impact on the 
value of a company. The price rise could be due to a change in the 
exchange rate.

Chapter 8 
 287 
 Economic risk example 
 Imagine a fictitious airport, XL,  in country X with the Britis h pound (GBP) 
as its currency. 
XL services passengers that live in its own country (20%) and 
passengers that travel from  other countries (80%). 
90% of the travellers passing thr ough XL are holiday makers whi le the 
other 10% travel for business purposes. 
The fuel bought by the airlines  passing through XL is mainly bo ught in the 
US where the currency is the USD. 
Why is the company exposed to currency risk? 
Passenger numbers will be affected by the strength of the GBP: 
• Only 20% of passengers live in t he UK and travel within the co untry 
on internal flights. The other 80% will be exposed to foreign 
currency movements making their trips more or less expensive. F or 
example, a holiday maker from t he UK will find a holiday in the  US 
more expensive if the GBP weakens against the USD and may choose not to travel. Similarly passengers from outside the UK may 
choose other destinations if the GBP strengthens against their home 
currency. 
• Most passengers are travelling on holiday so they have a much 
wider choice of destinations than business travellers. A busine ss 
person may have to go to a parti cular country because that is w here 
the customer or supplier is bas ed. In theory, 90% of XL's custo mers 
could change their travel plans  and that could reduce demand fo r 
XL's routes. 
• Movements in the value of the G BP could affect interest rates and 
that may also prevent holiday mak ers from travelling due to the  
increase in the cost of their mortgage. 
• If the GBP weakens against the USD, say, then fuel, for exampl e, 
may become more expensive. This could force the airlines to rai se 
prices which might reduce passe nger numbers or the number of 
flights. 
How can the risks you have identified be managed? 
The first step is to always cons ider whether ther e are any natu ral hedges. 
For example, a strong GBP would gi ve holiday makers from countr y X 
more spending money when they tr avel abroad. However, that will  also 
increase the airlines' costs w hen converted to their home curre ncy and so 
fares may increase. These fact ors might offset each other. 
Once the airport has established  the overall impact of the stre ngthening 
or weakening of the GBP the next s tep would be to hedge that ri sk. For 
example, if the strengthening was  discovered to be bad then the  airport 
might borrow in USD to create a hedge.

288  
 It would also be worth diversifyi ng the routes covered by the a irlines. It 
might be worth offering airli nes that travel to popular destina tions a 
discount for flying from XL. The cost of the discount could be viewed as 
an investment in managing currency risk. 
 
 Which of the following can r educe economic risk for a UK 
company? 
A Diversifying activities across the UK 
B Diversifying production and sales C Diversifying suppl iers and customers 
D Diversification of financing 
 
 Transaction risk 
This is the risk related to buy ing or selling on credit in fore ign currencies. There 
is a danger that, between the time  of the transaction and the d ate of the cash 
flow, exchange rates will have mo ved adversely. This risk, unli ke the translation 
risk, actually affects the ca sh flows of the business. 
 
 Illustration of transaction risk 
 A UK company purchases goods on six months’ credit from a US s upplier 
for USD150,000. At th e time of the transaction, the exchange ra te was 
GBP 1/USD1.8000 and t he expected payment for the purchase was G BP 
83,333 (USD150,000/1.8000). 
However, suppose that the exchange rate changes in the next six  
months, and the dollar strengthens  in value to GBP 1/USD1.5000.  The 
company must acquire the USD150,000 to make the payment, and if  it 
buys this dollar currency at t he exchange rate when the date of  the 
payment is due, the actual cos t will be GBP 100,000. This is GB P 16,667 
more than originally expected . The UK company has been exposed to a 
transaction liability in US dolla rs for six months, and as a re sult of the 
dollar increasing in value duri ng that time, an unexpected ‘los s’ of GBP 
16,667 arose. 
The exchange rate might have mo ved the other way. If the exchan ge rate 
when the payment was due had changed  to GBP 1/USD2.0000, with t he 
dollar falling in value, it would cost only GBP 75,000 to acqui re the dollars 
to make the payment. This is G BP 8,333 less than originally exp ected, 
therefore there would be a ‘pro fit’ of GBP 8,333 on the favoura ble 
exchange rate movement.

Chapter 8 
 289 
 A UK company has just despatched a shipment of goods to Sweden . The 
sale will be invoiced in Swedi sh kronor, and payment is to be m ade in 
three months’ time. 
Neither the UK exporte r nor the Swedish importer uses the forwa rd 
foreign exchange market to cover exchange risk. 
If the British pound were to we aken substantially against the 
Swedish kronor, what would be the  foreign exchange gain or loss  
effects upon the UK exporter a nd the Swedish importer? 
A UK exporter: Gain/Swedi sh importer: No effect 
B UK exporter: No effect /Swedish importer: Gain 
C UK exporter: Loss/Swedi sh importer: No effect 
D UK exporter: Gain/Swedish importer: Gain 
 
 Test your understanding 4 – H Co (Integration question) 
 H Co (a UK company) expects to  make the following transaction in six 
months' time: 
• USD100,000 purchases from US suppliers. 
Exchange rates are as follows: Rate today USD1/GBP 0.5556 Rate in six months  USD1/GBP 0.5420 
Required: 
Calculate the payment required in  GBP if H Co makes the payment  now 
or in six months’ time. 
Management of transaction risk 
This will be covered in detail in the next chapter. 
Translation risk 
This arises when a company has a ssets or liabilities denominate d in foreign 
currencies. The risk is that exc hange rate volatility will caus e the value of assets 
to fall or liabilities to increas e resulting in losses to the c ompany.

290  
 More on translation risk 
 The financial statements of overseas subsidiaries are usually translated 
into the home currency in order t hat they can be consolidated i nto the 
group’s financial statements. Not e that this is  purely a paper- based 
exercise – it is the translati on not the conversion of real mon ey from one 
currency to another. 
Settled transactions 
When a company enters into a tr ansaction denominated in a curre ncy 
other than its functional currency (which could be the home cur rency or 
that of its parent),  that transaction must be translated into t he functional 
currency before it is recorded . The transaction will initially be recorded by 
applying the spot rate. However  when cash settlement occurs the  settled 
amount will be translated using  the spot rate on the settlement  date. If 
this amount differs from that u sed when the transaction occurre d, there 
will be an exchange diff erence which is taken to the income sta tement in 
the period in which it arises. 
Unsettled transactions 
The treatment of any 'foreign' i tems remaining on the statement  of 
financial position at the year  end will depend on whether they are 
Monetary items include cash, r eceivables, payables and loans, a nd they 
are re-translated at the clos ing rate (year-end spot). 
Non-monetary items include non-current assets, inventory and 
investments, and are not re-trans lated but left at historic cos t. 
For example, if a company has a fo reign subsidiary which includ es 
property, plant and equipment this  will be valued at the date i t was 
acquired (or revalued). However , if these assets were acquired using a 
loan, then the loan is translated at the closing rate (current spot) which 
could be very different to the spot when the assets were bought . This 
gives rise to currency risk becaus e the assets and liabilities no longer 
offset each other. (This is cov ered by the 'temporal method' in  
International Accounti ng Standard (IAS) 21.) 
The reported performance of an ov erseas subsidiary in home-base d 
currency terms can be severely di storted if the re has been a si gnificant 
foreign exchange movement.

Chapter 8 
 291 
 Any foreign exchange gains or lo sses are recorded in equity. Th ey are 
unrealised and will only become realised when the subsidiary is  sold. 
Unless managers believe that the co mpany's share price will fal l as a 
result of showing a translation exposure loss in the company's accounts, 
translation exposure should not n ormally be hedged. (The compan y's 
share price, in an efficient mar ket, should only react to expos ure that is 
likely to have an impact on cash flows.) 
However, research shows that com pany directors do spend (in som e 
people's opinion – wa ste) money hedging translation risk. The 
management of translation risk is o ften considered to be dysfun ctional 
behaviour.  
Management of translation risk 
Any change in parity will affect reported pr ofits (and hence ea rnings per share), 
total assets, borrowings, net w orth (and hence gearing) but – t o repeat – it will 
not have affected the measured cash flow in the period being re ported on. 
Academic theory argues that trans lation risk, of itself, need n ot concern financial 
managers, but in practice, there are two strong arguments in fa vour of the 
relevance of translation risk: 
1 Although it does not affect the value of the entity as a whol e, it can affect 
the attribution of that value bet ween the different stakeholder s. Higher 
gearing may lead to higher inter est rates being charged on bank  loans, 
either directly in accordance with clauses in borrowing agreeme nts or 
indirectly as a result of the co mpany’s credit rating being red uced. The 
banks benefit at the expense o f the equity investors in the bus iness. If the 
treasurer is pursuing an objecti ve of maximising shareholder we alth, he 
will want to manage this risk. 
2 If the accounts are being used ‘beyond their design specifica tion’, for 
example as the basis for calcula ting bonus payments for directo rs and 
senior managers, then there is a te mptation to protect the curr ent year’s 
figures, even though it is known that doing so has a long-term cost. This is 
comparable to pulling profit int o the current year, knowing tha t it will both 
reduce next year’s profit and re sult in tax being paid earlier than 
The former is a good reason, bu t the latter is often the real r eason for managing 
translation risk 
 
 The risk that exchange rates will  cause assets to fall in value , or 
liabilities to increase in value, resulting in losses to a comp any is 
called: 
A Transaction risk 
B Translation risk C Economic risk D Currency risk

292  
5 Using financing packages to split risks 
As discussed in the earlier chapt ers on financing, different fi nance options carry 
differing levels of risk and retu rn for the investors concerned . The two extremes 
are: 
• Equity (ordinary share capital)  usually carries the highest ri sk (unsecured, 
uncertain dividend, share price may fall, last in line in the e vent of a 
liquidation) but potentia lly the highest return. 
• Loan capital is usually lower r isk (secured, specified interes t) but has a 
lower typical return. 
In between these extremes are a wide range of alt ernatives with  differing 
risk/return profiles. 
For example, venture capitalist s often like to invest in unquot ed companies via 
convertible loan stock to skew their risk exposure: 
• If the company concerned performs  moderately then the risk exp osure 
effectively amounts to getting interest paid and the loan redee med at 
some future point (usually within 5 years). 
• If the investment performs badl y then the downside exposure is  limited to 
getting some interest paid and pe rhaps their investment back in  the event 
of a winding up. 
• If the investment performs we ll, then the company is usually p repared for 
flotation when the VC  will convert the debt into equity to sell  a large 
number of shares at a high profit. 
Any financing package can be assessed by how it shares risks an d returns out 
between different investors. 
 
 Test your understanding 6 – MacD onald Farm (Case style question ) 
 Context  
The entire share capital of Mac Donald Farm Ltd is owned by Ken 
MacDonald and his wife, Jane. Its business is owning and runnin g a 
1,200 acre farm, growing a r ange of fruit and vegetables. 
Due to changes in farm subsidies and increasing customer pressu re from 
large supermarket chains, MacD onald Farm Ltd faces a sharp decl ine in 
its annual trading profits, which i n recent years have averaged  $180,000.

Chapter 8 
 293 
 Ken MacDonald is therefore invest igating using 200 acres to set  up a 
new exclusive 18-hole golf course . Preliminary research suggest  that 
planning permission will be forthc oming and demand projections are 
encouraging, given that membership  waiting lists at the two exi sting golf 
clubs in the area exceed 350. If  the project goes ahead, the ne w golf club 
is expected to be much better appointed than the two existing c ourses 
nearby. 
The golf club company 
It is proposed that MacDonald Fa rm Ltd will sign a 100-year lea se with a 
new company, Calum Golf Club Ltd , which will pay an annual rent  of 
$50,000 to MacDonald Farm Lt d for use of the land. 
The issued capital of the golf c lub company will be two $1 shar es, owned 
by Mr and Mrs MacDonald, and the re mainder of its  initial fundi ng will be 
$2 million in the form of 15% per annum irredeemable loan stock . Fifty 
local business men, including Mr MacDonald, have each agreed to  
purchase $40,000 of this stock . The terms of the debenture loan  stock 
issue prohibit a dividend being pa id on the two ordinary shares  so that 
any surplus is applied for the benefit of the club and its memb ers. 
Of the funds thus raised, $450, 000 will be spent on converting the arable 
land to become a landscaped golf course. A further $50,000 will  provide 
working capital. 
The club house company 
The remaining $150,000 will be us ed to purchase a 25% stake in a 
separate company, Tarpon Club H ouse Ltd, that will develop and operate 
a club house. This will have confer ence facilities, a sports ha ll, two bars 
and a restaurant. A local property  company will subscribe the o ther 75% 
of the share capital o f Tarpon Club House Ltd. 
Calum Golf Club Ltd will pay an annual rent of $50,000 for the use of the 
club house, but Tarpon Club Hous e Ltd will manage and run all f acilities 
offered there, taking the pr ofits that will be earned. 
When ready to commence business in January 20X6, the new golf c lub 
will be much better appointed than  the two existing Norbridge c ourses, 
and the only serious competition  for comparable leisure facilit ies will 
come from three hotels in Norbrid ge itself and a country house four miles 
away.

294  
 Costs and revenues 
Annual operating expenses of Cal um Golf Club Ltd are budgeted a t 
$900,000. 
On the revenue side, Calum Golf Cl ub Ltd’s share of profits on the 
investment in Tarpon Club House Ltd is expected to total $200,0 00 in 
20X6, the first year of operati ons. Green fees, chargeable to n on-
members using the golf course, are  expected to amount to an add itional 
$100,000 a year. 
On the assumption that target mem bership levels are achieved, a nnual 
subscriptions are initially to  be set at $1,000 for each member . This will 
be $200 less than for full member ship at the two rival golf clu bs in the 
area. In addition, no joining f ees will be payable in the first  year of 
operation, but thereafter (as with the other two clubs) they wi ll be equal to 
one year’s subscription. 
Breakeven analysis 
Based on the above data the brea k-even point for Calum Golf Clu b Ltd 
has been estimated at 600 members: 
Expected fixed costs $900,000 Income from Club House $200,000 Green Fees Income $100,000 Net costs to be covered $600,000 Membership fee $1,000 Break-even membership 600 
Required: 
Write a brief report  to Mr and Mrs MacDonal d regarding the prop osed golf 
club explaining their risk/return  profile under different possi ble scenarios. 
6  Value at risk 
Value at Risk (VaR) allows inv estors to assess the scale of the  likely loss in 
their portfolio at a defined le vel of probability. It is becomi ng the most widely 
used measure of financial risk an d is also enshrined in both fi nancial and 
accounting regulations. 
VaR is based on the assumption t hat investors care mainly about  the probability 
of a large loss. The VaR of a portfolio is the maximum loss on a portfolio 
occurring within a given period of time with a given probabilit y (usually small). 
• Calculating VaR involves usi ng three components: a time period , a 
confidence level and a lo ss amount or percentage loss. 
• Statistical methods are used to  calculate a standard deviation  for the 
possible variations in the va lue of the total portfolio of asse ts over a 
specific period of time.

Chapter 8 
 295 
• Making an assumption that possibl e variations in total market value of the 
portfolio are normally distribut ed, it is then possible to pred ict at a given 
level of probability the maximu m loss that the bank might suffe r on its 
portfolio in the time period. 
• A bank can try to control the risk in its asset portfolio by s etting target 
maximum limits for value at risk over different time periods (o ne day, one 
week, one month, three months, and so on). 
• VaR may be calculated as standar d deviation × Z-score (where t he Z- 
score can be found from the norma l distribution tables). 
 
 Normal distribution 
 Normal distributions can be s een when we measure things such a s: 
• Exam results 
• Staff performance gradings 
• The heights of a group of people etc. 
A normal distribution has the  following characteristics: 
The mean is shown in the centre  of the diagram and the curve is  
symmetrical about the mean. This means that 50% of the values w ill be 
below the mean and 50% of the val ues will be above the mean. 
Note:  The mean, median and mode will all be the same for a normal 
distribution. 
How far the values spread out from  the mean is the standard dev iation. 
This can be seen in the following diagram:

296  
 The total area under the curve is equal to 1. 
If we can think of a standard no rmal distribution curve with th ree standard 
deviations as follows: 
 
In general 68% of values are wit hin one deviation (between -1 a nd 1), 
95% of values are within two st andard deviations (between -2 an d 2) and 
99.7% of values are within thr ee standard deviations (between - 3 and 3). 
From this we can see that if we  look at a set of data which fit s a normal 
distribution the majority of val ues will occur closer to the me an, with fewer 
and fewer occurring the furt her from the mean we move. 
A standard normal di stribution has: 
• a mean of 0 
• a standard deviation of 1. 
This special distribution is denoted by z and can be calculated  as: 
 
Where: 
z is the score x is the value bei ng considered 
µ is the mean 
is the standard deviation 
This calculation is used to c onvert any value to standard norma l 
distribution.

Chapter 8 
 297 
 Looking up the normal dis tribution tables 
Once we have calculated our 'z sc ore' we can look this up on th e normal 
distribution table to find the area under the curve, which equa tes to the 
percentage chance (probability)  of that value occurring. 
So if we calculated a z score of 1 .00. From the table the value  is 0.3413. 
This means that (0.3413 ÷ 1.0) o r 34.13% is the area shown from  0 - 1 on 
the diagram 
 
From this we can deduce that 34. 13% would be the area shown fro m 0 -1 
on the diagram. So we can say th at 68.26% of values will fall w ithin one 
standard deviation (-1 to 1). 
 
 VaR calculation 
 For VaR , there are two types  of calculation to consider: 
1 The confidence level that the result will be above a particul ar figure 
– this is referred to as a one tail test. 
2 The confidence level that a fi gure will be within a particula r range – 
this is referred to a s a two tail test. 
In both cases we are working backwards from the percentage to f ind the 
value of x. 
One tail test 
If you are asked to calculate t he 95% VaR, this is a one tail t est. As we 
are looking at risk, it is usua lly about being 95% certain that  the outcome 
will be above a particular value. 
50% of the distribution is on one side of the mean, so within t he tables we 
are looking for the value as c lose as possible to 0.4500 (45%).

298  
 
Two tail test 
If you are asked about being 95% certain the result is within a  range, the 
area would look like this: 
 
We would be looking for 0.4750 in  the tables, 47.5% above and b elow the 
mean.

Chapter 8 
 299 
 One tail test example 
 Z is a bank. The management account ant of Z has estimated that  the 
value of its asset portfolio a t year end will be  $1,500 million , with a 
standard deviation o f $300 million. 
Required: 
Calculate the value at risk of  the portfolio, at a 97.5% confid ence level. 
(Express your answer in $ , rounded to the nearest million.) 
Solution: 
The Z value for a one-tail 97.5% c onfidence level is 1.96 (from  the 
Normal Distribution tables). 
VaR = standard deviation × Z value, so the 
VaR = $300 million × 1.96 = $588 million 
This means there is a 2.5% chanc e that the value of the portfol io will be 
(1,500 - 588) $912 million or below. 
 
 Two tail test example 
 AL, a UK based company is expec ting to receive USD 10 million from a 
US customer. The value in GBP is  dependent on the exchange rate  
between the USD and the GBP. 
The mean exchange rate is USD 1. 25/GBP 1 and the daily volatili ty of the 
USD/GBP exchange rate is 0.25%. 
Required: 
What is the range of values tha t AL will be 95% confident of re ceiving in 1 
day? 
Solution: 
The mean value of the USD 10 m illion is GBP 8 m illion (USD 10 m illion ÷ 
USD 1.25/GBP 1) The daily stan dard deviation is (0.25% × GBP 8 million 
=) GBP 20,000 
As we are looking at a range, this  is a two tail test, to be 95 % confident 
this will be within 47.5% of the mean on either side. 
First find 0.4750 in the normal tabl es, this is a z value of 1. 96.  
VaR = Z × Std deviation = 1.96 × 20,000 = GBP 39,200 
This means that AL is 95% confi dent that the value will be with in GBP 
39,200 of the mean. 
Therefore AL is 95% confident t he amount received will be betwe en GBP 
7,960,800 and GBP 8,039,200. 
Given the 1 day VaR, we can eas ily calculate the VaR for longer  holding 
periods as: 
n day VaR = 1 day VaR × √n The VaR increases wit h the holding period. Thus, the longer the  holding 
period, the greater the VaR.

300  
 Further examples of VaR 
 Suppose a UK company expects to receive USD 14 million from a US 
customer. The value in GBP to t he UK company will depend on the  
exchange rate between the USD and t he GBP resulting in gains or  losses 
as the exchange rate changes. Assum e that the exchange rate tod ay is 
USD 1.75/GBP 1 and that  the daily volatility of the USD/GBP exc hange 
rate is 0.5%. 
Required: 
Calculate the 
(a) 1-day 95% VaR (b) 1-day 99% VaR (c) 5-day 95% VaR (d) 30-day 99% VaR 
Solution: 
The value of the USD 14 million today is GBP 8 million (USD 14 million ÷ 
USD 1.75/GBP 1) with a daily s tandard deviation of GBP 40,000 ( 0.5% × 
GBP 8 million). 
(a) The standard normal value (Z) associated with the one-tail 95% 
confidence level is 1.645 (see No rmal Distribution tables). Hen ce, 
the 1-day 95% VaR is 1.645 ×  GBP 40,000 = GBP 65,800. This 
means that we are 95% confident t hat the maximum daily loss wil l 
not exceed GBP 65,800. Alternativel y, we could also say that th ere 
is a 5% (1 out of 20) chance that the loss would exceed GBP 65,800. 
(b) The standard normal value (Z) associated with the one-tail 99% 
confidence level is 2.33 (see No rmal Distribution tables). Henc e, the 
1-day 99% VaR is 2.33 × GBP 40 ,000 = GBP 93,200. Thus, there is  
a 1% (1 out of 100) chance tha t the loss would exceed GBP 93,20 0. 
(c) If we wanted to calculate the VaR for a longer period of 5 days, at 
the 95% level the calculation would be: 
5 day 95% VaR = 1 day 95% VaR  × √5 = GBP 65,800 × 2.236 = 
GBP 147,133 
There is a 5% chance that the company’s foreign exchange loss 
would exceed GBP 147,133 over the next 5 days. 
(d) Similarly, the 30-day 99% VaR would be: 
1 day 99% VaR × √30 = GBP 93,200 × 5.477 =  GBP 510,477 
This illustrates the longer the holding period, the greater the  VaR.

Chapter 8 
 301 
 More on value at risk (VaR) 
 The Basel committee establishe d international standards for ba nking 
laws and regulations aimed at pro tecting the international fina ncial 
system from the results of the co llapse of major banks. Basel I I 
established rigorous risk and c apital managemen t requirements t o ensure 
each bank holds reserves suffici ent to guard against its risk e xposure 
given its lending and investment practices. Regulators require banks to 
measure their market risk using a risk measurement model which is used 
to calculate the Value at Risk (VaR). 
However, the global financial cris is has identified substantial  problems 
with banks’ governance procedures in terms of understanding ope rational 
risk and applying risk measuremen t models like VaR. This has be en 
emphasised by the number of banks  that have failed or required 
government support – Northern Rock and Bradford and Bingley in the 
UK; Bear Sterns and Washington Mut ual in the US amongst others.  
The problem is that VaR is based on historical observations, wh ich 
means that it cannot allow for the possibility of an extreme ev ent that is 
not predicted by past trends. For  example, in the lead up to th e Credit 
Crunch, banks evaluated the va lue of their mortgage portfolios (and 
made lending decisions) on the basi s that house prices had rise n 
consistently for years. The banks assumed that this trend would  continue, 
but unfortunately it didn't. 
 
 Test your understanding 7 (Integration question) 
 A company expects to receive USD  10 million from a US customer . The 
value in GBP will dep end on the exchange rate changing. Assume that 
the exchange rate today is USD  1.6667 / GBP 1 and that the dail y 
volatility of the USD/G BP exchange rate is 0.5%. 
Required: 
What is the 10-day 95% VaR? 
 
 Test your understanding 8 – Valu e at risk (Integration question ) 
 A bank has estimated that the expected valu e of its portfolio in two 
weeks’ time will be $50 million , with a standard deviation of $ 4.85 million. 
Required: 
Calculate and comment upon the value at risk of the portfolio, assuming a 
95% confidence level.

302  
 Sadie Co trades regularly with s uppliers and customers in fore ign 
countries. Three months ago the company agreed to buy a large 
shipment of raw materials on cr edit from a foreign supplier. 
By the time Sadie Co paid for t he shipment last week, the excha nge rate 
had moved significantly, causing t he cost of the raw materials to be 10% 
more than originally expected. 
What type of risk is  this an example of? 
A Translation risk B Economic risk 
C Political risk  D Transaction risk 
 
 A UK company has just despatc hed a shipment of goods to Sweden . The 
sale will be invoiced in Briti sh pounds, and payment is to be m ade in 
A UK exporter: No effect /Swedish importer: Gain 
B UK exporter: No effect /Swedish importer: Loss 
 
 The management accountant of Sweep Bank has estimated that the  
value of its asset portfolio a t the coming year end will be $1, 000 million, 
with a standard deviati on of $350 million. 
What is the value at risk of the  portfolio, at a 95% confidence  level? 
A $424 million 
B $576 million C $950 million D $1,576 million

Chapter 8 
 303 
 A UK based company expects to r eceive EUR 5 million from a Fre nch 
customer. The value in GBP will depend on the exchange rate cha nging. 
Assume that the exchange rate t oday is EUR 1.2500 / GBP 1 and t hat 
the daily volatility of the E UR/GBP exchange rate is 0.3%. 
What is the 5-day value at risk , at a 90% confidence level? (ro unded 
to the nearest GBP’000) 
A GBP 15,000 
B GBP 34,000 C GBP 44,000 D GBP 77,000 
 
What is the upper limit of the r ange of values that the company  will 
be 95% confident of receiving in 1 day? (rounded to the nearest  
GBP’000) 
A GBP 4,024,000 
B GBP 4,020,000 C GBP 3,976,000 D GBP 3,980,000

304  
8 End of chapter case style questions 
 Test your understanding 14 – Equip (Case style question) 
 Equip is a UK company that is a major exporter o f agricultural  equipment 
to Australia, New Zealand and  throughout Europe. All production  facilities 
are in the United Kin gdom. The majority of raw materials and to ols are 
also sourced in the United Kingdom , with a few imports from Eir e, priced 
in British pounds. Major competit ors are based in  the United St ates and 
Germany. There are plans to set up a manufacturing subsidiary i n 
Australia, funded in part by an Au stralian dollar loan to be ta ken out by 
Equip. The new manufacturing facility would be used to source t he 
Australian and New Zealand markets. 
Required: 
(a) Describe the potential curr ency exposures faced by this com pany 
before setting up the manufacturing subsidiary.  
(b) Consider the effects of se tting up the new manufacturing su bsidiary 
in Australia with respect to the following: 
(i) Will any of the exposures ident ified in (a) above be reduce d? 
(ii) What new currency expos ures will the group face? 

Chapter 8 
 305 
 Test your understanding 15 – Ec onomic risk (Case style question ) 
 Scenario 
R is a large retail organisation  that imports goods from Austra lia for sale 
in its home market, where the currency is the R$. The directors  of R are 
aware that the company is subjec t to significant economic expos ure to 
movements on the AUS $ because any appreciation of the AUS $ wi ll 
increase the cost of goods for re sale. R has attempted to creat e a partial 
hedge against this by placing all of its cash reserves in an AU S $ bank 
account. That way the losses asso ciated with any increase in co st prices 
will be partially offset by a gain on the bank account. 
Trigger 
The directors are concerned tha t the translation gains and loss es on the 
AUS$ bank balance are visible  to shareholders, whereas the offs etting of 
economic exposure is not and so their hedging policy may be 
misunderstood. The AUS bank account has a balance of AUS$30m. T he 
exchange rate is presently R$3 to AUS$1. 
Required: 
(a) Prepare a briefing note advis ing the directors on the matte rs that 
they would have to consider in or der to determine the extent of  R’s 
economic exposure. 
(b) Evaluate the valid ity of the directors’  concern that “the t ranslation 
gains and losses on the AUS$ b ank balance are visible to 
shareholders, whereas the offsetti ng of economic exposure is no t 
and so their hedging policy may be misunderstood”. 

306  
 By entering into another country , the UK company is exposing i tself to 
significant political risk. 
Political risk arises due to po litical interference in either t he company’s 
own country of operation, or any country it chooses to expand i nto. 
It can also be generated by neig hbouring countries if West Afri ca could 
be affected. If, for example, the UK company intends to ship go ods from 
WA then these ships may become a  target by the pirates with a c ost in 
the form of lost goods in transit and delays in production. 
West Africa’s political risk c an be viewed from different level s of 
government: 
Local government 
Local political risk arises from  the influence of local council s or state 
governments. It manifests itsel f in the decisions made by local  
government that may negatively affe ct the factory (such as busi ness 
rates increases, or indirect taxation). Ideally, the UK company  should try 
to source a representative from  the local government on to the factory 
project. 
National government 
Government decisions will also i mpact upon the factory. For exa mple, the 
National government may have offe red tax incentives for the fir st few 
years of the project but might increase taxes or even introduce  new 
streams of taxation such as green taxes in  later years. They ma y also 
take punitive measures such as penalising businesses they see a s 
operating incorrectly (e.g. low w ages), or businesses operating  at odds 
with their specified aims and objectives. 
International government 
International bodies such as the UN can also be a source of pol itical risk 
for businesses if they find out abo ut activities of which they disagree e.g. 
low wages. 
Although the new factory might ser ve both parties aims and obje ctives 
now, there may come a point in ti me in the future where the res pective 
governments of the UK & West Afr ica disagree on an issue, which  could 
have serious repercussions for t he UK company in the long run. 
In addition, if West Africa had a relatively new government thi s would also 
be a concern, insofar that if t heir term in office was short an y future 
government may reverse the decis ions taken by their predecessor s. 
Political risk also covers legal  and compliance risk to an exte nt. The UK 
company should ascertain whether  there are any additional laws in West 
Africa of which they should be awar e. The use of local lawyers should 
help.

Chapter 8 
 307 
 Mitigation strategies 
Mitigating political risk is nev er easy, as governments tend to  be far more 
powerful than individual compani es. However, there are some met hods of 
reducing the risk. One such method would be for the UK company to 
invite locals (employees, local  government) to become part owne rs in the 
factory. 
Another option is for it  to provide the foreign government with  details of 
an eventual exit strategy that will leave the business in the h ands of 
locals. 
Neither of these strategies may be acceptable to the UK company . 
 
Diversifying globally  would be better than diversifying across the UK. 
Having operations across the wo rld will reduce r isk – portfolio  theory. 
 
 The answer is (A).  
• The Swedish importer is unaffect ed as he is invoiced in his lo cal 
currency 
• The UK exporter will gain as t he kronor received can be conver ted 
into more pounds. 
 
 Value of transacti on at original rates 
    GBP 
USD 100,000 purchases @ 0 .5556  55,560 payment 
Value of transacti on at future rates 
USD 100,000 purchases @  0.5420  54,200 payment 
The amount saved by paying in six  months’ time is GBP1,360. Thi s 
saving arises due to the exchan ge rate moving in your favour. 
Do not forget that you would hav e had approximately GBP55,000 i n the 
bank for six months longer, earning interest which makes this a n even 
better option.

308  
Transaction risk is the risk o f buying or selling on credit. 
Economic risk is any change in th e economy, home or abroad, whi ch can 
affect the value of a transaction before a commi tment is made. 
exchange rate. 
 
 Report 
To: Mr and Mrs MacDonald 
From:  An advisor 
Date:  Today 
The risk/return profile of the proposed golf club investment 
Introduction This report has been prepared to analyse the risk/return profil e of Mr and 
Mrs MacDonald if they undertake t he proposed development of Cal um 
Golf Club. 
Risk appetite/objectives 
Given increasing pressure on farm  income we have assumed that t he 
primary objective with the golf c lub investment is to provide a  low risk 
source of income to compensate fo r anticipated falls in profit.  
We have analysed your risk expos ure under the fo llowing scenari os: 
Scenario 1: the golf club is extremely successful: 
• You will receive an annual ren t of $50,000 and interest of $6, 000 on 
the debentures. 
• No dividends can be paid on profits. 
• Presumably you will also have a 100% share in a successful gol f 
company, although no informati on has been given as to the 
possibility of selling this. Als o the value of the shares will be limited 
by the restriction on dividends. 
Scenario 2: the golf club just hits its BEP of 600 members: 
• No dividends can be paid on profits.

Chapter 8 
 309 
 Scenario 3: the golf club fails to hit its BEP 
• In the short term the club c ould borrow funds if required to b e able 
to meet its cost commitments so  it is likely that you will stil l receive 
an annual rent of $50,000 and inte rest of $6,000 on the debentu res. 
• Given your investment via lim ited shares, you will not face an y 
further liability for club losses. 
• However, if faced with the prospect of making an ongoing loss,  the 
golf club may decide to start try ing to cut costs. The choices are not 
attractive – it could cut salar y and maintenance costs but this  would 
undermine its competitive strategy  of differentiation, making t he 
situation worse. 
Scenario 4: the golf club cannot pay interest on the debentures 
• If the interest is not paid , then the debenture holders may in sist on 
the appointment of a receiver to  liquidate their investment. 
• In such a scenario it is unlikel y that any rent will be paid. If this 
occurs, then it is not clear if t he farm can reclaim the land a nd sell 
the club house, perhaps even return ing the land to arable use. 
Conclusion and preliminary recommendations 
Unless the golf club does very badly, you should receive a stea dy income 
of $56,000 per annum, equating to  around $280 per acre, conside rably 
higher than the $150 per a cre earned on arable land historicall y. The 
investment gives a higher ret urn than arable farming and at a l ower risk, 
and is thus recommended on  financial grounds. 
However, before proceeding, w e recommend that you seek to 
clarify/address the following risk areas: 
• What is the legal position conc erning the land and club house 
should rent not be paid? 
• What assets are the debentures s ecured on, if any, as this wil l affect 
possible outcomes should interest not be paid? 
 
 The value of USD 10 million toda y is GBP 6 million (USD 10 m/1 .6667) 
with a standard deviation of GBP 30,000 (0.5% × GBP 6 million).  
The one-tail 95% confi dence level is 1.645. 
Hence a ten day 95% VaR is 1.6 45 × GBP 30,000 × √10 = GBP 156,0 58 
 
 At the 95% confidence level the value at risk = 1.645 × 4.85 =  $8 million 
(1.645 is the normal distribution value for a one-tailed 5% pro bability level 
– this can be taken from the no rmal distribution tables). 
As the information is for the 2 we ek period, and not a daily me an or 
standard deviation, there is no need to use the n day VaR adjus tment.

310  
There is thus a 5% probability  that the portfolio value will fa ll to $42 
million or below. 
 
• The UK exporter will be unaffected as he receives his own curr ency. 
• The Swedish importer will gain b ecause he’ll be able to buy mo re of 
the (weak) pounds with his (str ong) Swedish currency. 
 
At a 95% confidence level the va lue at risk = 1.645 × $350 mill ion = $576 
million (1.645 is the normal dist ribution value for a one-taile d 5% 
probability level – this can be ta ken from the normal distribut ion tables). 
standard deviation, there is no need to use the n day VaR adjus tment. 
There is thus a 5% probability  that the portfolio value will fa ll to $424 
million or below ($1,000 million - $576 million). 
 
The value of EUR 5 million today is GBP 4 million (EUR 5 m/1.20 00) with 
a standard deviation of GBP 12, 000 (0.3% × GBP 4 million). 
The one-tail 90% confidence leve l is (approximately) 1.28. 
Hence a five day 90% VaR is 1. 28 × GBP 12,000 × √5 = GBP 34,346

Chapter 8 
 311 
The mean value of the EUR 5 m illion is GBP 4 m illion (EUR 5 mil lion ÷ 
EUR 1.2500/GBP 1). 
The daily standard deviation is ( 0.3% × GBP 4 million =) GBP 12 ,000 
VaR = Z × Std deviation = 1.96 × 12,000 = GBP 23,520 
23,520 of the mean. 
3,976,480 and GBP 4,023,520. 
 
 (a) Transaction risk: 
Sales revenue denominated in Aus tralian dollars, New Zealand 
dollars euros, other. 
Economic risk: 
Purchase costs denominated in Bri tish pounds but sourced from 
Eire. 
Price pressure from competitors in the United States and German y 
(this will be affected by the curre ncy cost base of these compa nies). 
Translation risk: 
Minor as Equip has no foreign subs idiaries – just retranslation  of 
year-end currency debtors. 
Overall assessment: 
Mismatch of British pounds cos t base versus exposed sales 
revenue. 
(b) (i) Reduction in exposure: 
• Australian dollar transaction risk. 
• Australian dollar economic risk. 
• Exposure from competit ors is not eliminated. 
(ii) New exposures, to the ex tent that they do not net out: 
• Translation risk from incor porating subsidiary accounts. 
• Translation risk arising fr om the Australian dollar debt. 
• Transaction risk as a result of the Australian dollar 
dividend payments to the UK. 
The end result will depend on t he success of the Australian ope ration, the 
actual figures involved and any increase in local sales that ma y naturally 
result from a greater presence in Australia. For example, expos ure to 
New Zealand dollars could increa se if sales to New Zealand were  to 
increase

312  
 ( a )  Briefing note  
To: The Board 
From:  A.N. Accountant 
Subject:  Determining the extent o f R’s economic exposure 
Dear Sirs, Economic exposure is generally d ifficult to measure, but an 
understanding can be obtained by i dentifying the factors that w ill 
lead to economic exposure. Generally, these boil down to identi fying 
the effects of changes to cost pr ices and selling prices, both for the 
entity itself and for it s competitors. R's purchase prices may be 
affected by movements in the AU S$. The actual effects may not b e 
linear because R's Australian supp liers may not pass on the ful l 
effects of the currency movemen t. The suppliers may believe tha t 
the market for these products is sensitive to price rises and s o the 
suppliers may choose to absorb some of the increased cost themselves. The likelihood of t hat happening wil l be determined  in 
part by the availability of sim ilar goods from economies that a re not 
bound by the AUS$. 
Currency movements may force R  to raise its selling prices to 
customers. That makes the elas ticity of demand for R's products  
important. It may be that price s are inelastic and that consume rs are 
willing to buy just as much even if the price rises slightly. R 's 
competitors may also buy produc ts priced in AUS$ and that will 
reduce R's problem to an extent b ecause all competing products will 
be affected in the same manner. 
(b) The financial statements will show the gains and losses ari sing on 
R's currency holdings. The shareh olders may be concerned that t he 
company's assets are exposed in t his way and that they are risk ing 
a serious loss if the AUS$ dec lines against the R$. The economi c 
exposure that is being hedged w ill be apparent from the fact th at the 
company will generate less rev enue and make less profit when th e 
AUS$ is high. This will not appear anywhere as a single, visibl e item 
or disclosure in the financial statements.

Chapter 8 
 313 
 The shareholders could be forg iven for believing that the only 
exposure is with respect to the AUS$ balance. There is nothing to 
prevent the directors from exp laining their strategy to the 
shareholders. It does not matter t hat there is a lack of symmet ry in 
accounting for the different cu rrency exposures provided the 
shareholders accept this explan ation. This is, however, a 
complicated area and it would be l egitimate for the directors t o worry 
that the shareholders will misund erstand. If the shareholders b elieve 
that the directors' policy is m isguided then it could undermine  their 
confidence in the board. Technica lly, the directors are suppose d to 
pursue the maximisation of sharehol der wealth and so they shoul d 
always act in accordance with t he shareholders‟ best interests.  It 
would be dishonest to leave the co mpany exposed to a manageable  
risk for no good reason simply because the shareholders may misinterpret the directors' behaviour.

315 
Currency risk 
 (b) Discuss currency risk 
• Theory and forecasting of excha nge rates (e.g. interest rate 
parity, purchasing power par ity and the Fisher effect) 
• Operations and features of sw aps, forward contracts, money 
market hedges, futures and options 
• Internal hedging techniques 
  
  Chapter 
9

Currency risk management 
316  
 
Understanding exchange rates 
The foreign exchange, or forex , market is an international mark et in national 
currencies. It is highly compet itive and virtually no differenc e exists between the 
prices in one market (e.g. N ew York) and anot her (e.g. London).  
Exchange rates 
 An exchange rate is expressed in terms of the quantity of one c urrency 
that can be exchanged for one un it of the other currency – it c an be 
thought of as the price of a currency. For example: 
1 USD = 0.6667 GBP 
This means that 0.6667  GBP will buy 1 USD, i.e. the price of a USD is 0.6667 
GBP. Hence: 
• to convert from USDs to GBPs  you must multiply by 0.6667 
• to convert from G BPs to USDs you must divide by 0.6667. 
(Note:  This could also be stated as  USD1 = GBP 0.6667, or USD1: GBP 
0.6667. You may see any of these expressions in exam questions.  By 
convention exchange rates are ex pressed (and rounded) to four d ecimal places, 
though this may not always be t he case for information provided  in questions.)

Chapter 9 
 317 
Spot rate 
This is the rate given for a tr ansaction with immediate deliver y. In practice this 
means it will be settled wit hin two working days. 
Inverting exchange rates 
Exchange rates may also be expr essed the other way round, i.e. the USDs are 
expressed in terms of GBPs  instead of vice versa. 
e.g. the above spot r ate 1 USD = 0.6667 GBP 
may be expressed in terms of USDs  to GBPs by dividing the rate into 1, 
i.e. 1 ÷ 0.6667 = 1.5000 
Therefore an equiva lent illustration of the rate is: 
1 GBP = 1.5000 USD 
 Spread 
Banks do not operate wholly for the greater good; in fact they wish to make a 
profit out of the deal. This means that they need to earn a margin  or spread  on 
the deal, as well as commission and fees. 
e.g. 1 GBP = 1. 5500 – 1.4500 USD 
• the rate at which the bank will sell the variable currency (US Ds) in 
exchange for the base currency (G BPs) is 1.4500 USD. (i.e. the rate at 
which it will buy GBPs). 
• the rate at which the bank will buy USDs in exchange for GBPs is 1.5500 
USD. (i.e. the rate at wh ich it will sell GBPs). 
The key to understanding our (t he company's) position is to ide ntify that the 
bank always wins, hence in the ex ample above the bank buys GBP LOW and 
sells GBP HIGH. 
 
 Illustration of spread prices 
 The rate quoted is 1 G BP = 1.4330 – 1.4325 USD. 
• Company A wants to buy 100,00 0 USD in exchange for GBP. 
• Company B wants to sell 200,00 0 USD in exchange for GBP. 
Required: 
Identify which rate the bank  will offer each company.

318  
 Company A  wants to buy USD100,000 in e xchange for GBP (so that the 
bank will be selling USDs and buying GBPs): 
• If we used the lower rate of 1 .4325, the bank would sell dolla rs for 
GBP69,808 
• If we used the higher rate of 1 .4330, the bank would sell doll ars for 
GBP69,784. 
Clearly the bank would be bette r off selling dollars (and buyin g GBP) at 
the lower rate of 1.4325. 
Company B  wants to sell USD200,000 in exchange for GBP (so the 
bank would be buying USDs  and selling GBPs): 
• If we used the lower rate of 1.4325, the bank would buy dollar s for 
GBP139,616 
• If we used the higher rate of 1 .4330, the bank would buy dolla rs for 
GBP139,567 
The bank will make mor e money buying dollars  (and selling GBP) at the 
higher rate of 1.4330 
 
 Test your understanding 1 – Sp read (Integration question) 
 Assume that the spread is GBP 1 = USD 1.5500 – 1.4500. Conside r the 
situations of three UK-based companies: 
(a) A Ltd imports goods from Texas  to the value of USD100,000. 
Payment is cash on delivery; wha t is the cost in GBP of this 
purchase? 
(b) B plc exports goods to Califor nia valued at USD50,000. Rece ipt of 
payment is immediate on deliver y of the goods; what is the valu e of 
GBP received? 
(c) C Ltd wishes to buy a produc t from US that is for sale in t he UK at 
GBP12 each; at  what dollar price must it purchase the product?  
Cross rates 
You may not be given the exch ange rate you need for a particula r currency, but 
instead be given the relationship it has with a different curre ncy. You will then 
need to calculate a cross rate.  
For example, if you have a rate in GBP1/USD and a rate in GBP1/ EUR, you can 
derive a cross rate for EUR1/USD  by dividing the GBP1/USD rate by the 
GBP1/EUR rate.

Chapter 9 
 319 
 Illustration of cross rate calculation 
 A French company is to purchase materials costing USD100,000. You 
have the following information: 
GBP1/USD 1.9000  GBP1/EUR 1.4500 
Required: 
Calculate the value o f the purchase in euros. 
Solution: 
The solution could be calculated in two stages: 1 Convert the purchase into GBP: 
USD100,000/1. 9000 = GBP52,632 
2  Convert the GBP value into euros 
GBP52,632 × 1. 4500 = EUR76,316 
However, an easier alternative , particularly if there are a num ber of 
transactions to convert, is to  calculate a cross rate: 
The EUR1/USD rate will be 1.9000/1.4500 = 1.3103 
The value of the transaction is therefore: USD100,000/1.3103 = EUR76,318 
 
 The exchange rate for USD/GBP is  USD1.4417/GBP1 and the exchan ge 
rate for EUR/GBP is 1.1250. 
Required: 
How many US dollars a re there to the Euro? 
 
 Test your understanding 3 – Cross rates (Integration question) 
 A US company has to pay EUR100, 000 for a machine. You have the  
GBP1/EUR1.5300 GBP1/USD1.8700 
Required: 
What is the cost of th e machine in dollars?

320  
2 Exchange rate theory 
Forecasting exchange rates 
A company may wish to forecast  exchange rates for a number of s hort-term and 
long-term reasons. These may include: 
 
 More on forecasting exchange rates 
 • Foreign debtor and creditor balances  – Our balances in other 
currencies may change dramatically  over the short-term in terms  of 
our domestic currency. If we are unable to forecast with some 
degree of certainty we open ourse lves up to potentially very 
damaging exchange rate losses. 
• Working capital  – For a company with subsidiaries overseas it is 
important to be able to forecast m ovements in exchange rates ov er 
the medium-term to better fac ilitate the funding of those balan ces. 
• Pricing – Movements in exchange rate s may force the company to 
revise its pricing strategy in an individual country. This may be in 
response to a movement in the ex change rates between the countr y 
of manufacture and that of sale. A lternatively it is possible t hat an 
exchange rate movement favouring a competitor may also lead to a 
revision of prices. 
• Investment appraisal of foreign subsidiaries  – A longer-term 
forecast of exchange rate mov ements will be needed to identify the 
impact on a NPV anal ysis of the economic risks of a project.

Chapter 9 
 321 
• In the short-term rates may fl uctuate due to market sentiment and 
speculation  which are not easily explained  theoretically, over the longer-
term more fundamental factors take effect. 
• If we could forecast exchange ra tes with some degree of accura cy this 
would reduce the transaction ri sk faced by a company, and may a llow it to 
minimise hedging costs. 
 
 Why exchange rates fluctuate 
 Changes in exchange rates resu lt from changes in the demand fo r and 
supply of the currency. These c hanges may occur for a variety o f reasons 
Speculation 
Speculators enter into foreign exchange transactions with a vie w to 
making a profit from their expec tations of the currency’s futur e 
movements. If they expect a currency to devalue, they will shor t sell the 
currency with the hope of buying i t back cheaply at a future da te. 
Balance of payments 
Since currencies are required  to finance international trade, c hanges in 
trade may lead to changes in exchange rates. In principle: 
• demand for imports in the US r epresents a demand for foreign 
currency or a supply of dollars 
• overseas demand for US exports  represents a demand for dollars  or 
a supply of the currency. 
Thus a country with a current acc ount deficit where imports exc eed 
exports may expect to see its ex change rate depreciate, since t he supply 
of the currency (imports) will ex ceed the demand for the curren cy 
(exports). 
Any factors which are likely to  alter the state of the current account of the 
balance of payments may ultimate ly affect the exchange rate. 
Government policy 
Governments may wish to change t he value of their currency. Thi s can 
be achieved directly by devaluat ion / revaluation, or via the f oreign 
exchange markets (buying of selli ng their currency onto the mar kets).

322  
 Capital movements between economies 
There are also capital movements between economies . These 
transactions are effectively sw itching bank deposits from one c urrency to 
another. These flows are now more important than the volume of trade in 
goods and services. 
Thus supply/demand for a currency may reflect events on the cap ital 
account. Several factors may lead  to inflows or outflows of cap ital: 
• changes in interest rates : rising (falling) interest rates will attract a 
capital inflow (outflow) and a demand (supply) for the currency  
• inflation rates:  asset holders will not wish to  hold financial assets in 
a currency whose value is falling because of inflation. 
These forces which affect the demand and supply of currencies, and 
hence exchange rates, have been inc orporated into a number of f ormal 
models. 
 
We shall consider three relat ed theories that together should g ive some insight 
into exchange rate movements: 
1 Purchasing power parity theory (PPPT) 2 Interest rate parity theory (IRPT) 3 The International Fisher Effect 
Purchasing power parity theory (PPPT) 
This theory suggests the rate of e xchange will be directly dete rmined by the 
relative rates of inflation suffe red by each currency. If one c ountry suffers a 
greater rate of inflation than another its currency should be w orth less in 
comparative terms. 
The basis of PPPT is the 'Law of One Price': 
• identical goods must cost the same regardless of the currency in which 
they are sold. 
• if this is not the case then arbitrage  (buying at the lower price, selling at 
the higher price) will take place  until a single price is charg ed. Remember 
this is where a commodity that a ppears cheap is bought by many traders. 
The sellers then realise that t hey can put up their price due t o the 
commodities popularity. Demand wil l then fall at this higher pr ice and 
potential profits have been compet ed away. However, imagine tha t this 
commodity has to cross a countri es border – it would be easy to  cross the 
border from, say Switzerland to France to buy cheaper groceries . If many 
Swiss did this it might affect t he Swiss Franc/Euro exchange ra te. 
However it is much more difficul t to make the same saving if yo u live in the 
UK even if you believe that t he GBP/Euro is out of line.

Chapter 9 
 323 
 PPPT 
 A company is going to buy a non- current asset at a cost of USD 30 
million. If the current rate is G BP1/USD1.5000 this would mean that in 
GBP terms it would cost GBP20 million.  
What would be the prices in one year in each country given that  the 
inflation rate in the US i s 8% and in the UK is 5%? 
The US market The UK market 
Year 0 (now) USD30m G BP1/USD1.5000 GBP20m 
Inflation 8%  5% 
Year 1 USD32.4m  GBP21m 
What is the effective exch ange rate in one year’s time? 
We can divide the US price by t he UK price to calculate the rev ised 
exchange rate: 
Rate =  32.4
21.0 = 1.5429 
 
 Rule:  The country with the higher in flation will suffer a fall (depr eciation) in 
their currency. 
 
The PPPT formula gives 
 I + i f 
Future spot rate = Current spot rate × –––––––  I + i
h 
if rate of inflation in the foreign country 
ih rate of inflation in the home country spot rate in terms of 1 unit of home 
currency/foreign currency (e.g. GBP1/USD….) 
In the above illustration, the futu re spot rate would be calcul ated by 
 
1.500 × =  1.08
1.05 = 1.5429 
 
 Test your understanding 4 (Integration question) 
 The USD and GBP ar e currently trading at GBP1/USD1.7200. 
Inflation in the US is expected  to grow at 3% pa , but at 4% pa in the UK. 
Required: 
What will be the future spot rate in a year’s time? (Give your answer to 4 
decimal places)

324  
 Problems with PPPT in practice 
 • Is the law of one price justif ied? In many markets it is appar ent that 
the suppliers or manufacturers c harge what the market will bear , 
this differing from one market to another. 
• The costs of physically moving some products from one place to  
another mean that there will always  be a premium in some market s 
in relation to another. 
• Differing taxation regimes may dramatically affect the costs o f a 
product in one market to that in another. 
• Manufacturers may be able to su ccessfully differentiate produc ts in 
each market to limit the amoun t of arbitrage that occurs. 
Is PPPT a good predictor of future spot rate? 
PPPT certainly does explain the reasoning behind much of the mo vements in 
exchange rates but is not a ver y good predictor of exchange rat es in the short- 
to medium-term. 
Reasons for this include: 
• Future inflation rates are onl y an estimate and often cannot b e relied upon 
to be accurate. 
• The market is dominated by specul ation and currency investment  rather 
than trade in physical goods. 
• Government intervention in both direct (e.g. management of exc hange 
rates) and indirect ways (e.g.  taxation policies) can nullify t he impact of 
PPPT. 
Interest rate parity theory (IRPT) 
This theory is based on very sim ilar principles to that of PPPT . 
The IRPT claims that the differ ence between the spot and the fo rward exchange 
rates is equal to the differentia l between interest rates avail able in the two 
currencies. 
 
 The forward rate  is a future exchange rate , agreed now, for buying or 
selling an amount of curren cy on an agreed future date.

Chapter 9 
 325 
 IRPT 
 An investor has USD 5 million to  invest over one year in eithe r dollars 
(USD) or sterling (GBP) . His options are to: 
• Invest in dollars at the prevaili ng dollar interest rate of 10 .16% or, 
• Convert the dollars to GBP at  the prevailing spot rate 
(GBP1/USD1.5000) and inve st in GBP at 7.1%. 
The one-year forward rate  is GBP1/USD1.5429. 
Analysing the options open to this investor:  
 
In one year USD 5.508 million mu st equate to GBP 3.570 million,  so what 
you gain in extra interest you lo se in an adverse movement in e xchange 
rates. The effective exchange rate is 
 
Exchange rate =   5.508
3.570 = 1.5429 
 
which equals the forward rate f or one year. The forward rate mo ves to 
bring about interest rate parit y between the currencies. 
 
 Rule:  IRPT predicts that the country with the higher interest rate w ill see 
the forward rate for its curr ency subject to a depreciation 
 
 The IRPT formula gives: 
 
Forward rate = Current spot rate × l + ௙ 
l + ௛ 
Where 
ints f money risk-free rate of inter est for the foreign currency 
ints h money risk-free rate of interes t for the home currency spot ra te in 
terms of 1 unit of home currency/fo reign currency (e.g. GBP1/US D)

326  
 A treasurer can borrow in Swiss fr ancs (CHF) at a rate of 3% p a or in the 
UK at a rate of 7% p. a. The current rate o f exchange is GBP1/CH F 10. 
Required: 
What is the likely rate of exchang e in a year’s time? (Give you r answer to 
4 decimal places) 
 
 More on IRPT 
 The interest rate parity model s hows that it may be possible t o predict 
exchange rate movements by referri ng to differences in nominal 
exchange rates. If the forwar d exchange rate for GBP against th e USD 
was no higher than the spot rate but US nominal interest rates were 
higher, the following would happen: 
• UK investors would shift funds t o the US in order to secure th e 
higher interest rates, since t hey would suffer no exchange loss es 
when they converted USD back into GBP. 
• The flow of capital from the UK t o the US would raise UK inter est 
rates and force up the s pot rate for the USD. 
The IRP theory holds because of arbitrage . Arbitrageurs actively seek 
out anomalies in the exchange ra te market. They buy and sell cu rrency to 
make a profit (buy at a low pric e and sell at a high price, as with any 
commodity). If many arbitrageur s do this, the exchange rate alt ers 
(differences in supply and deman d will alter the price), the ex change rate 
moves and the anomaly then disappear s. Arbitrage is discussed m ore 
fully later in this chapter. 
Is IRPT applicable to determining forward rates? 
The only limitation on the univers al applicability of this rela tionship will be due to 
government intervention. These ma y arise in a number of ways in cluding the 
• Controls on capital markets  – The government may limit the range and 
type of markets within thei r financial services system. 
• Controls on currency trading –  These may be in the form of a limit on 
the amount of currency that may  be taken out of a country or th e use of an 
'official' exchange rate that does  not bear any relation to the  'effective' rate 
at which the markets wish to trade. 
• Government intervention in the market  – The government may attempt 
to control or manipulate the ex change rate by buying or selling  their own 
currency.

Chapter 9 
 327 
The International Fisher Effect 
The International Fis her Effect claims that  the interest rate d ifferentials between 
two countries provide an unbias ed predictor of future changes i n the spot rate of 
exchange. 
• The International Fisher Effec t assumes that all countries wil l have the 
same real interest rate, although nominal or money rates may di ffer due to 
expected inflation rates. 
• Thus the interest rate differ ential between two countries shou ld be equal to 
the expected inflation differential. 
• Therefore, countries with higher expected in flation rates will  have higher 
nominal interest rates, and vice versa. 
 
 The Fisher effect 
 As seen in your earlier studies, the Fisher effect looks at th e relationship 
between interest rates and inflat ion. Inflation is the differen ce between 
the real return on in vestment (real inter est) and the nominal r eturn 
(nominal interest rate). The re lationship between the nominal r ate of 
interest, the real rate of inter est and inflation can be expres sed by the 
formula: 
[1 + nominal rate] = [1 + real r ate] × [1 + inflation rate] 
Example 
One-year money market interest ra tes in the UK are 5.06%. Infla tion in 
the UK is currently r unning at 3% per annum. 
The real one-year interest rate in the UK can be calculated as follows: 
[1.0506] = [1 + real rate] × [1.03] [1 + real rate] = 1.0506/1.03 = 1.02  Real rate = 0.02 or 2% per year. 
The nominal or market interest rates in any country must be suf ficient to 
reward investors with a suitable real return plus an additional  return to 
allow for the effects of inflation.

328  
 Test your understanding 6 – Pa rity (Integration question) 
 Spot USD1/EUR0.9050 
Interest rates p.a. on short- term government securities 
US treasury  6.0% Eurozone  4.5% 
Inflation rates 
US  2.0% Eurozone  1.3% 
Required: 
Calculate using the parity rela tionships (PPPT and IRPT) the th eoretically 
correct forward rates. Determine  the reasons for a difference b etween the 
two, if one arises. 
 
 Test your understanding 7 – G c lothing (Case style question) 
G is a major clothing retailer, specialising in fashionable clo thes for young 
people. G has shops in every major town and city in its home co untry. G’s 
customers are extremely consci ous of brand names and G must sto ck 
the latest products from the biggest and most popular manufactu rers in 
order to remain competitive. 
Most of G’s most popular brands a re imported from the USA. The clothes 
are expensive to import because the Government in G’s country i mposes 
a tariff, which requires G (and a ll other importers) to pay a t ax on all 
clothing imports. The Government’s reason for imposing this tar iff is to 
protect local manufacturers from foreign competition. G is loca ted in a 
relatively prosperous country and wages are fairly high. 
G has been losing sales to a maj or competitor, which is based i n G’s 
home country and has shops in the same towns and cities as G, w hich 
sells the same range of clothing but at a lower p rice. G attemp ted to 
compete on price, but stopped doi ng so when it became apparent that 
the competitor could under cut any price that G set.

Chapter 9 
 329 
 G has investigated the compet itor’s trading strategy. It appear s that the 
competitor is able to exploit anomalies in the market by buying  its 
inventory in a neighbo uring country and bringing it across the border. 
Two of the countries that adjoin  G’s home country are not parti cularly 
prosperous. Many forei gn suppliers, including G’s suppliers, su pply 
goods to distributers (and also dir ectly to retailers) in those  countries at 
lower prices than they do in G’s home country because they are aware 
that the final consumers there ha ve low incomes and are not abl e to pay 
high prices for brand name cloth ing. Furthermore, those neighbo uring 
countries do not charge tari ffs on clothing imports. 
Trigger 
G’s home country is part of a tr ading bloc which includes the 
neighbouring country from which t he competitor is suspected of buying its 
inventory. There are no physica l barriers to regulate the borde rs between 
countries within that bloc. Lega lly, any goods imported from a 
neighbouring country are subject to  tariffs, but G suspects tha t the 
competitor has not been declari ng these imports to the Governme nt 
department responsible for collecti ng tax and so the competitor  has 
benefitted from both c heaper purchase prices  and the evasion of  the 
tariff. 
Some of G’s senior managers have recommended that G should copy  its 
competitor by cancelling all c ontracts with the major US manufa cturers 
and buying all goods from intermedi aries in a neighbouring coun try. 
Others recommend reporting their suspicions to the manufacturer s and to 
the Government. 
Required: 
As G's management accountant, prepar e a briefing note for the B oard: 
(a) Discussing the argument that purchasing power parity theory  should 
prevent exporters from charging different prices in different 
(b) Discussing the potential risks and benefits to G of buying its 
inventory from intermediarie s in the neighbouring countries 
(c) Recommending actions that t he Government in G’s home countr y 
could take in order to determine whether G’s competitor had bee n 
evading the tariff on imported clothing. 

330  
Arbitrage 
Arbitrage is the simultaneous purc hase and sale of a security i n different 
markets with the aim of making a risk-free profit through the e xploitation of any 
price differences between the tw o markets. (CIMA Official Termi nology) 
(The purchase and sale does not nec essarily have to be a securi ty. It could be 
as simple as buying apples in one market and selling them in an other at a 
higher price.) 
Arbitrage is mainly used by speculators  rather than as a hedging tool. 
Arbitrage differences are short- term. When other traders see di fferences in the 
price of a commodity they will exploit them and the prices will  converge. The 
differences will disappear a s equilibrium is reached. 
Some kinds of arbitrage are comp letely risk-free – this is pure  arbitrage. For 
instance, if Euros are availabl e more cheaply in London than in  New York, 
arbitrageurs can make a risk-fr ee profit by buying euros in Lon don and selling 
an identical amount in New York . Opportunities for pure arbitra ge have become 
rare in recent years, partly because of the globalisation of fi nancial markets and 
immediate access to information via the use of the internet. Th is enables almost 
anyone, who understands what they are doing, to trade and poten tially make a 
profit (although it costs a gr eat deal to buy immediate access to the real-time 
market prices and the anomalies ar e usually so small that arbit rageurs have to 
invest heavily in order to make  the deals worthwhile after deal ing costs). 
 
 More on arbitrage 
 For example, imagine you bought  and sold fruit and vegetables on a 
market stall. One day a custome r asks for a kilo of apples.  
You don't have any apples but you know where you can get some. 
Having ascertained that the cust omer will pay up to GBP1 per ki lo, you 
contact a competitor who has app les on another market stall. Th ey are 
selling at GBP0.90 per kilo. You offer to buy the kilo of apple s at 
GBP0.90, collect them from the other market stall, and sell the m for 
GBP1 making GBP0.10 profit.  
If enough customers ask for apples , eventually the competitor w ill realise 
that there is an increased dem and for apples, which appear to b e in short 
supply, and they will in crease their price.  
This effectively eliminates t he opportunity for arbitrage profi ts. 
The same principle can be applie d to any commodi ty. It is commo nly 
used by 'day-traders' with exchange rates.

Chapter 9 
 331 
 Day-trading on exchange rates 
 A day-trader is someone who belie ves she can spot short term 
speculative movements and benefi t from them. She looks for an 
apparently 'cheap' currency and then sells it quickly, at a pro fit, to 
someone who needs it. 
Example of day-trading 
Margaret is a day-trader (based in the UK) looking for arbitrag e 
opportunities on the currency ma rket. On 1st June she thinks sh e has 
spotted a difference in the market for USD. 
She can buy USD 2 for EUR1.50 . She can buy one euro for GBP0.80 . 
She can sell dollars for USD 1. 50/GBP1. She has GBP100,000 avai lable 
to invest for the purpose of making a profit. 
Margaret converts her GBP in to  EUR: GBP100,000/0.80 = EUR125,0 00 
Margaret then converts  her EUR into USD: (E UR125,000/1.5) × 2 =  
USD166,667 
Margaret now sells the USD : USD166,667/1.50 = GBP111,111 
Margaret has made a risk-fr ee profit of GBP11,111. 
Conclusion on day-trading 
Unfortunately it is difficult to j udge whether day-traders are successful, 
because they would lose their adv antage if they admitted to bei ng able to 
spot mispriced assets! 
 
 Test your understanding 8 (Integration question) 
 A speculator can buy USD2 for G BP1, sell one EUR for GBP0.80 a nd 
can sell USD for USD1.50/EUR1. T here is GBP1,000, 000 available to 
invest for the purpose of making a profit. 
Required: 
What is the possible profit u sing arbitrage opportunities? (Giv e your 
answer in GBP to the nearest GBP 100). 
 
 Test your understanding 9 – U co mpany (Case style question) 
 U is an administrative assist ant in the treasury department of  a 
multinational company. U was che cking some current market valua tions 
when she noticed an anomaly in t he rates associated with the US D/GBP 
exchange rates. 
The spot rate for converting G BP to USD was 1.556 USD to the GB P. 
The three month forward rate for  converting USD back to GBP was  1.499 
USD to the GBP. 
U’s bank was prepared to lend GBP at a fixed rate of 5.08% per annum. 
The bank was also prepared to offe r a fixed rate for USD deposi ts of 
5.12%.

332  
U printed these figures out and spoke to the company treasurer because 
she believed that there was an arbitrage opportunity. The treas urer 
agreed that U’s figures indicated  that an opportunity existed, but said that 
the opportunity would have disa ppeared in the time that it had taken her 
to walk across the office. 
U asked why the multinational co mpany did not pay greater atten tion to 
the possibility of arbitrage oppor tunities. The treasurer repli ed that 
“Arbitrage is a full-time occupat ion and it is a rather risky c ommercial 
venture. I am happy to leave the potential profits to the arbit rageurs who 
have made it their business to tr ade in that way”. The treasure r also 
stated that the company’s treasur y department is a cost centre and that 
he had no desire to make i t into a profit centre. 
Required: 
(a) Calculate the potential gai n that could have been made by t he 
company if it had borrowed GBP 10m in order to exploit the 
anomaly that she had identified. 
(b) (i) Evaluate U’s argument t hat the company could profit fro m this 
opportunity. 
(ii) Evaluate the treasurer’s a rgument that arbitrage is a risk y 
commercial venture. 
(c) Evaluate the treasurer’s vie w that it is better for the com pany’s 
treasury department to operate as a cost centre rather than as a 
profit centre. 
3 Financial risk management 
The stages in the financial risk management process are essenti ally the same 
as in any risk management process: 
1 identify risk exposures 2 quantify exposures 3 decide whether or not to hedge 4 implement and moni tor hedging program. 
Hedge or not? 
Hedging can involve the reducti on or elimination of financial r isk by passing that 
risk onto someone else. Or interna l hedging techniques involve reducing risk by 
creating an offsetting position  that has a tendency to cancel a ny risks. 
Benefits of hedging 
• hedging can provide ce rtainty of cash flows which will assist in the 
budgeting process 
• risk will be reduced, and hence m anagement may be more incline d to 
undertake investment projects 
• reduction in the probability of fi nancial collapse (bankruptcy )

Chapter 9 
 333 
• managers are often risk-averse s ince their job is at risk. If a company has 
a policy of hedging it may be perce ived as a more attractive em ployer to 
risk-averse managers. 
Arguments against hedging 
• shareholders have diversified t heir own portfolio, thus furthe r hedging by 
the business may harm s hareholders’ interests 
• transaction costs associated with hedging can be significant 
• lack of expertise within the bus iness, particularly with regar ds to use of 
derivative instruments 
• complexity of accounting and tax issues associated with the us e of 
derivatives. 
Derivatives 
A derivative is a financial instru ment whose value depends on t he price of some 
other financial asset or underlying  factor (such as oil, gold, interest rates or 
currencies). 
The directors of an organisation  will decide how to use derivat ives to meet their 
goals and to align with t heir risk appetite. 
Derivatives have the following uses: 
• Hedging:  used as a risk management tool t o reduce / eliminate financial  
risk. 
• Speculation:  used to make a profit from predicting market movements. 
• Arbitrage:  used to exploit price differences between markets. (This will be 
short-term only. If a commodity appears to be cheap, demand wil l increase 
which will push up the price. H ence the price differential, whe re a gain 
could be made in the past, has now closed.) 
For the purposes of this subjec t we are interested in the hedgi ng use of 
Treasury function 
The treasury function exists in every business, though in a sma ll business it 
may be absorbed into the accounti ng or company secretarial work . 
The main functions  of treasury are: 
• managing relationships with the banks  – regarding the investment of 
surplus cash or making arrangement s to allow deficits of cash, or to 
arrange hedging. 
• working capital and liquidity management  – to ensure that sufficient but 
not excessive amounts of cash ar e available on a daily basis to  fund 
inventory, payables and receivables. 
• long-term funding management  – providing cash for longer term 
investments such as non-current a ssets or arranging mortgages /  
debentures.

334  
• currency management  – dealing with all currencie s which will entail both 
internal and external hedging te chniques, sourcing currencies, managing 
foreign currency bank accounts. 
 
 More on the treasury function 
 Organisational structure 
The treasurer has the capacity to  make large gains or losses in  a short 
period of time, particularly w hen trading in financial derivati ves. As a 
result it is important to define and carefully monitor the resp onsibility and 
authority associat ed with treasury. 
There are a number of differing st ructures for the treasury act ivity within a 
business. The two key debates are discussed below. 
Profit centre or cost centre 
Should the treasury activities be accounted for simply as a cos t centre, or 
as a profit centre in its own right (making prof it out of tradi ng activities)? 
Advantages of operating as a profit centre, as opposed to cost centre 
include: 
• a market rate is charged to business units throughout the enti ty, 
making operating costs realistic 
• the treasurer is motivated to p rovide services as efficiently and 
economically as possible. 
The main disadvantages are: 
• the profit concept brings the te mptation to speculate and take  
excessive risk 
• management time can be wasted on discussions about internal 
charges for the treasury activities 
• additional administrativ e costs will be incurred. 
Centralised or decentralised 
Many large companies operate a centralised treasury function, w hich has 
merits and limitations. 
Risks associated with cent ralised treasury include: 
• a lack of motivation towards managing cash in the subsidiaries , 
since any cash that is received is swept up to head office to b e 
managed from the group’s perspective. 
• the risk that, should head office c ommit some error in their t reasury 
operations, the financial health  of the whole group could be pl aced 
in jeopardy.

Chapter 9 
 335 
 Risks associated with dec entralised activity are: 
• that one company might pay large overdraft interest costs, whi le 
another has cash balances in han d earning low interest rates. 
• the risk of not generating the profits for the group that woul d be 
earned if the group funds were ac tively managed by a treasury 
operation seeking profit s rather than individual executives jus t 
seeking to minimise costs. 
 
 Corporate treasury policies 
 A UK retailer 
A well-known UK retailer 'operat es a centralised treasury funct ion to 
manage the Group’s funding require ments and financial risks in line with 
the Board approved treasury polic ies and procedures, and delega ted 
authorities. … Group Treasury also  enters into derivative trans actions, 
principally interest r ate and currency swaps and forward curren cy 
contracts. The purpose of these transactions is to manage the i nterest-
rate and currency risks arising  from the Group’s operations and  financing. 
It remains Group policy not to hol d or issue financial instrume nts for 
trading purposes, except where financ ial constraints necessitat e the need 
to liquidate any outstanding inve stments. The treasury function  is 
managed as a cost centre and does not engage in speculative tra ding. 
The principal risks faced by t he Group are liquidity/funding, i nterest rate, 
foreign currency risks and counterparty risks. 
(a) Liquidity/funding risk  
The risk that the Group could be unable to settle or meet its 
obligations as they fall due at a reasonable price. 
The Group’s funding strategy ens ures a mix of funding sources 
offering flexibility and cost e ffectiveness to match the requir ements. 
(b) Counterparty risk  
Counterparty risk exists where  the Group can suffer financial l oss 
through default or non-performance by financial institutions. 
Exposures are managed through Group tr easury policy which limit s 
the value that can be placed wi th each approved counterparty to  
minimise the risk of loss. The counterparties are limited to th e 
approved institutions with secure  long-term credit ratings A+/A 1 or 
better assigned by Moody’s and Standar d & Poor’s respectively, 
unless approved on an exception bas is by a Board director. Limi ts 
are reviewed regularly  by senior management.

336  
 (c) Foreign currency risk  
Transactional foreign currency ex posures arise from both the ex port 
of goods from the UK to overseas  subsidiaries, and from the imp ort 
of materials and goods directly s ourced from overseas suppliers . 
Group treasury hedge these exposu res principally using forward 
foreign exchange contracts progre ssively covering up to 100% ou t 
to 18 months. Where appropriate  hedge cover can be taken out 
longer than 18 months, with Board approval. The Group is primar ily 
exposed to foreign exchange ri sk in relation to GBP against 
movements in USD and EUR. 
(d) Interest rate risk  
The Group is exposed to interest rate risk in relation to the G BP, 
USD, EUR and Hong Kong dollar (HKD) variable rate financial 
assets and liabilities. 
The Group’s policy is to use deriv ative contracts where necessa ry to 
maintain a mix of fixed and floating rate borrowings to manage this 
risk. The structure and maturity o f these derivatives correspon d to 
the underlying borrowings  and are accounted fo r as fair value o r 
cash flow hedges as appropriate. 
Capital policy 
The Group’s objectives when managi ng capital are to safeguard i ts ability 
to continue as a going concern in  order to provide optimal retu rns for 
shareholders and to maintain an e fficient capital structure to reduce the 
In doing so the Group’s strategy i s to maintain a capital struc ture 
commensurate with an investmen t grade credit rating and to reta in 
appropriate levels of liquidity  headroom to ensure financial st ability and 
flexibility. To achieve this s trategy the Group regularly monit ors key credit 
metrics such as the gearing rati o, cash flow to net debt see (n ote 29) and 
fixed charge cover to maintain  this position. In addition the G roup 
ensures a combination of appropr iate committed short-term liqui dity 
headroom with a divers e and smooth long-term debt maturity prof ile. 
During the year the Group mainta ined an investment grade credit  rating 
of Baa3 (stable) with Moody’s a nd BBB-(stable)  with Standard & Poor’s, 
and through the successful tender o f GBP200m of existing short- dated 
bonds in conjunction with a new G BP400m 10 year bond issue exte nded 
the average fixed debt m aturity by one year  to ten years and in creased 
short-term liquidity by GBP200m. 
In order to maintain or re-align  the capital structure, the Gro up may adjust 
the number of dividends paid to s hareholders, return capital to  
shareholders, issue new shares o r sell assets to reduce debt.

Chapter 9 
 337 
 Test your understanding 10 – J electronics (Case style question ) 
 Scenario 
J manufactures specialised elec tronic equipment in the UK. 
All of J’s directors come from  an electronic engineering backgr ound and 
the small administrativ e staff provides bas ic clerical and book -keeping 
support. 
Trigger 
The company has just won its  first export order and will receiv e payment 
of USD 15 million in th ree months. J’s Chief Executive is conce rned that 
the USD may decline against the G BP during the three months and  has 
asked the company’s bank to offe r a guaranteed price for the cu rrency 
when it is received. 
The bank has offered to enter int o a forward contract with J at  a rate of 
GBP1 = USD 1.65. 
J’s Chief Executive is unhappy wit h this offer because the pres ent 
exchange rate is GBP1 = USD 1.60 . Given the size of the transac tion, 
this constitutes a major additi onal cost that J had not budgete d for when 
setting its selling price. J’s C hief Executive would rather wai t until the 
payment is received in the hope t hat the spot rat e at that time  is better 
than the GBP1 = USD 1. 65 offered by the bank. 
J’s Chief Executive is concerned that the differential rate bei ng charged 
by the bank is unfair. He believe s that global economics are so  
complicated that it is impossibl e to forecast exchange rate mov ements 
and the movements in the exchange rate are just as likely to be  
favourable as unfavourable to J  over the next three months. 
J’s bank manager has poi nted out that the rate offered is in li ne with 
market expectations and that it i s unrealistic for the Chief Ex ecutive to 
ask the bank to commit itself to  guaranteeing that today’s exch ange rate 
can be obtained on a transaction t hat will occur in three month s. 
The bank manager has recommended t hat J appoints a full-time 
corporate treasurer to take on t he responsibility of the treasu ry function 
and relieve the Chief Executive of that burden. 
Required: 
Write a briefing not e to the Board: 
(a) Evaluating the bank manager’s r ecommendation to appoint a 
corporate treasurer. 
(b) Recommending, stating reasons, the steps that the directors  of J 
should take in the selection of a  suitable person for the role of 

338  
4 Transaction risk management 
Transaction risk was identifi ed in the previous chapter as one of the three types 
of currency risk. There are se veral methods of managing exposur e to 
transaction risk. As a general rul e the simplest and most conve nient methods 
are used by any business. 
The methods can be split as follows:  
 
The differences between internal  and external hedging can be ve ry significant: 
• Internal hedging is often more e ffective for dealing with econ omic risk; 
• Internal hedging is often cheaper  and simpler to understand; 
• External hedging is m ore complex, so it is usually undertaken by skilled 
staff in treasury departments. 
5 Internal hedging 
If a company wants to remove transaction risk, it is possible t o hedge this 
internally in a number of ways, including: 
• Invoice in home currency. 
• Leading and laggi ng payments. 
• Offsetting – matching, netting and pooling. 
• Countertrade.

Chapter 9 
 339 
 More on internal hedging techniques 
 Invoice in home currency 
If a UK business invoices in G BP and only accepts invoices from  
suppliers in GBP then it partly removes currency risk. The curr ency risk is 
transferred to the customer or su pplier. However economic risk is not 
removed – the value of the bus iness will still  fall if the over seas 
competition are 'winning' with  their overseas trade in foreign currencies. 
This method does give some very practical business issues: 
• The customers and suppliers may  not be prepared to accept all the 
currency risk and therefore they  will not trade with the busine ss. 
• The other parties may not be prepared to accept the same price s 
and will require discounts on sa les or premiums on purchases. 
• There are other ways of hedgi ng risks that mean that the risk of 
transacting in foreign currency is acceptable. 
Leading and lagging 
This is a method of trying to makes gains on foreign currency p ayments. 
Leading is making a payment befor e it is due, and lagging is de laying a 
payment for as long as possible. T his is effective if the compa ny has a 
strong view about the future mov ements in the exchange rate. 
For example, a company has to make a USD100,000 payment to a US  
supplier. The payment is due in t wo months' time but could be p aid 
immediately or delayed until thr ee months' time. Sterling is ex pected to 
depreciate in value against the US dollar over the next three m onths. In 
this case the company would wan t to pay as early as possible an d 
therefore lead. To check this, c onsider that if the rate went f rom 
USD:GBP 2.0000 to USD:GBP 1.5000, t he payment in GBP would go 
from GBP50,000 to GBP66,667. The co mpany would obviously want t o 
only pay GBP50,000. 
Problems with leading and lagging include: 
• Early payment will cost a com pany in interest foregone on the funds 
that have been disbursed early; 
• The payee will not be happy that payment may become overdue, 
especially if the currency is expected to fall; 
• It requires the company to take a view on exchange rates i.e. 
speculate. There is a risk t hat the company will be wrong.

340  
 Offsetting 
Matching 
This technique involves matching assets and liabilities in the same 
currency. Financing a foreign in vestment with a foreign loan wo uld 
reduce the exposure to exchang e risk since as the rate changes 
favourably on one it would move  adversely on the other. 
Netting 
Netting normally involves the us e of foreign currency bank acco unts. If a 
company knows it will be both re ceiving and paying in foreign c urrency, it 
can reduce exchange risk by using  the foreign receipts to cover  the 
foreign payments. The netti ng will work best if the dates of th e receipt 
and payment are as near  together as possible. 
In a group, netting can be done across the group by a treasury function. 
This would mean that if one subsid iary is making foreign paymen ts and 
another subsidiary is taking fore ign receipts, the group can ne t the two 
off. 
Pooling 
Pooling is a system of managing cash. When a business has sever al 
bank accounts in the same curre ncy, it might be able to arrange  a system 
with its bank(s) whereby the bal ances on each bank account in t he same 
currency are swept up into a c entral account at the end of each  day, 
leaving a zero balance on every account except the central acco unt. 
Overdraft balances and positiv e cash balances are all swept up into the 
central account maximising inte rest earned and minimising any b ank 
charges or interest payable. 
This does not provide a system  for hedging against FX risk, but  can be 
an efficient system for cash m anagement. It avoids overdraft co sts on 
individual bank accounts, and it  enables the treasury departmen t to make 
more efficient use of any cash surpluses. 
For an efficient system of cash pooling, there needs to be a ce ntralised 
cash management system. The current organisation allows each subsidiary to operate their ow n cash management system. Pooling  can 
be organised by each subsidiary . However, it might be even more  
efficient if subsidiaries operati ng in the same currencies shar ed the same 
pooling system, hence it is best o perated by a central treasury  function. 
Countertrade 
This involves parties exchangin g goods and services of equivale nt value. 
It is the old fashioned bartering and avoids any type of curren cy 
exchanges. However the tax autho rities do not like this method – if cash 
does not change hands it is difficu lt to establish the value of  the 
transaction and any related sales tax payable. For this reason,  
countertrade is not very common since it can lead to disputes w ith the tax 
authorities and take up management time.

Chapter 9 
 341 
 Matching 
 A company wishes to fund a USD1m investment and uses a USD1m 
loan. The exchange rate is USD1.8 :GBP1 on the date the investme nt is 
made, but the GBP strengthens to U SD2:GBP1 six months later. 
The company has matched it s assets and liabilities: 
Investment (asset) 
At acquisition (USD1m/1.8) = GBP555.6k 
Six months later ( USD1m/2) = GBP500k 
Loan (liability) 
Whether at acquisition or six mont hs later, the asset and the l oan are 
worth the same as each other. 
 
 Netting 
 Division A is due to receive U SD1m on Friday. Division B has a  payable 
of USD700,000 due on the same day. 
Because the receipt is at the sa me time as the payment, the com pany 
should use the receipt of USD1m  to pay their supplier USD700,00 0. This 
would minimise any transaction co sts arising from buying USD700 ,000 
from the bank. 
The USD300,000 left could be kep t in a USD bank account for lat er USD 
payments, saving on further trans action costs in later months, or it could 
be converted into the home curren cy (now, or at some time in th e future 
when rates are more favourable). 
6  External hedging 
If a company wants to remove transa ction risk it is also possib le to hedge this 
externally in a number  of ways including: 
• Netting centres; 
• Forward contracts; 
• Money market hedges; 
• Futures; 
• Options; 
• Swaps.

342  
7 Netting centres 
Multilateral netting is a treas ury management technique used by  large 
companies to manage their intercompany payment processes, usual ly involving 
many currencies. Netting can yi eld significant savings from red uced foreign 
exchange trading. 
A netting centre collates batches of cash flows between a defin ed set of 
companies and offsets them agains t each other so that just a si ngle cash flow to 
or from each company takes place  to settle the net result of al l cash flows. 
The netting process takes place on a cyclical basis, typically monthly, and is 
managed by a central entity ca lled the netting centre. 
Although netting centres are o ccasionally used to net off cash flows in just one 
currency, it is more usual for a netting centre to manage cash flows in several 
currencies. In a multiple curr ency netting system, each company ’s cash flows 
are converted to an equivalent a mount in the company’s base cur rency, so that 
the company still has only a sing le net position to settle in t hat currency. 
A netting centre is typically used by a multinational company t hat has many 
production and sales divisions i n a number of countries. Direct  billing in many 
currencies by each company can l ead to excessive foreign exchan ge trading, in 
which individual companies may  be both buying and selling the s ame 
currencies many times over. The objective of using a netting ce ntre is to reduce 
the overall foreign exchange volume traded and thereby cut the amount of 
foreign exchange spread paid by t he company to manage all the c urrency 
conversions. 
 
Without netting, each company se ttles its receipts and payments  directly and 
individually with each of the other companies.

Chapter 9 
 343 
 
After using a netting centre, eac h company pays or receives a s ingle local 
currency balance to or from the netting centre. 
For netting to be successful par ticipants must agree on a numbe r of issues such 
as: 
– Currencies – Which currencies will be used for invoicing? The y may be the 
buyer's, the seller's or a third currency. 
– Credit period – Ideally all par ticipants should have the same  credit periods 
but there may be variations for th ose participants who are long  or short of 
funds. 
– Settlement dates – The netting settlement dates and the netti ng cycle 
timetable must be known by all  the participants and adhered to.  Netting 
periods must also be decided e.g. weekly, monthly etc. 
– Exchange rates – The exchange rates to be used in the netting  must be 
agreed. Will it be spot or forwar d rates, mid at 11-00 am or so me budgeted 
in-house rate? Rates should be ‘arms length’ as there would be potential 
tax issues otherwise. 
– Conflict resolution – Multila teral netting may be payment dri ven, 
receivables driven or both. E ither way disagreements will arise  as to who 
owes what to whom so a process fo r sorting these issues out so that the 
items may be included  in the netting will need to be in place. If not 
resolved then items may have to  be pulled from  the netting proc ess. 
– Management – will it be a bes poke system or bank managed.

344  
8 Currency forward contracts 
 A forward contract is an agreem ent to buy or sell a specific am ount of 
foreign currency at a given futu re date using an agreed forward  rate. 
This is the most popular method of hedging currency transaction  risk. The 
company is able to fix in advance an exchange rate at which a t ransaction 
will be made. 
The risk is taken by the bank who  are better able to manage the ir 
exposure. A proportion of their exposure will no rmally be avoid ed by 
writing forward contracts for opposite trades on the same day. 
 
 Illustration of currency forward contract 
 It is now 1 January and Y plc wil l receive USD10 million on 30  April. 
It enters into a forward exchange contract to sell this amount on the 
forward date at a rate of GBP1/U SD1.6000. On 30 April the compa ny is 
guaranteed GBP6.25 million (USD10 million/1.6000). 
The transaction risk has been remo ved (if the receipt arrives o n time). 
Features and operation 
Forward contracts are a commitm ent, and as a result they have t o be honoured 
even if the rate in the contrac t is worse than the rate in the market. 
Forward contract rates  are often quoted at a premium  or discount  to the 
current spot rate. 
• A discount means that the curren cy being quoted (e.g. USD) is expected 
to fall in value in relation to t he other currency (e.g. GBP). If a currency 
falls in value then you need more of that currency to buy a sin gle unit of 
the other, i.e. we need more do llars to buy a single pound. 
• A discount is often referred to a s ‘dis’, a premium as ‘prem’.  
• These can be quoted in cents (i.e . USD0.01) and shown as ‘c’ i n the 
quote. 
In most exam questions you can use the following rule for obtai ning a forward 
rate from the spot rate: 
• add a forward discount to the spot rate ( 'add:dis' ) 
• subtract a forward premiu m from the spot rate. 
(Note : This rule is only applicable w here the exchange rate is quote d as 
‘amount of foreign currency  to a home currency unit’.) 
(Also note that discounts and pr emiums derive from the interest  rate parity 
formula, in theory.)

Chapter 9 
 345 
Remember that you will need to be aware of whether the premium or discount is 
quoted in, say, dollars or cents. It would usually be cents. Th ere are 100 cents 
in a dollar. (Similarly there ar e 100 cents in a euro.) This af fects how you add or 
deduct the discount or premium in terms of decimal places. 
For example, if the dollar was currently 1.5000 and there was a  premium of 0.5 
c (c means cents, and t here are 100 cents in a dollar so this i s half a cent) this 
makes the forward rate  1.4950 (1.5000 – 0.0050). 
 
 Test your understanding 11 (Integration question) 
 Calculate the forward contract b id and offer prices in the foll owing 
situation: 
(i) The current spot rate is GBP1=USD1.5500 – 
1.4500 
 and, one month forward rate is quoted at 0.55 – 0.50 c dis 
(ii) The current spot rat e is GBP1= EUR1.7150 – 
1.6450 
 and, one month forward rate i s quoted at 0.68 – 0.75 c pm 
 
 Test your understanding 12 (Integration question) 
 EEFS Ltd (a UK company) sold goods to the value of USD2.0 mill ion. 
Receipt is due in 90 days. 
The current spot rate is G BP1 = USD 1.5430 – 1.5150. 
There is a three-month discount fo rward of 2.5 cents – 1.5 cent s. 
Required: 
What is the amount of GBP that E EFS Ltd will re ceive under the forward 
contract? Give your answer in GBP to the nearest GBP 100. 
 
 Advantages and disadvantages 
The advantages of forward contracts are that they: 
• Are simple, and so have low transaction costs; 
• Can be purchased from a high street bank; 
• Fix the exchange rate; 
• Are tailored, so are flexible  to amount and delivery period. 
The disadvantages are that there is: 
• A potential credit risk since t he company is contractually bou nd to 
sell a currency, which it may not  have received from its custom er; 
• No upside potential.

346  
 More on disadvantages of forward contracts 
 There are two key disadvant ages of forward contracts: 
It is a contractual commitment  which must be completed on the due 
date. 
This means that if a payment from  the overseas customer is late , the 
company receiving the payment and wishing to convert it using i ts 
forward exchange contract will hav e a problem. The existing for ward 
exchange contract must be sett led, although the bank will arran ge a new 
forward exchange contra ct for the new date when the currency ca sh flow 
is due. 
To help overcome this problem an ‘option date’ forward exchange 
contract  can be arranged. This is a forw ard exchange contract that 
allows the company to settle a forward contract at an agreed fi xed rate of 
exchange, but at any time between  two specified dates. If the c urrency 
cash flow occurs between these  two dates, the forward exchange 
contract can be settled at the agreed fixed rate. 
It is inflexible . It eliminates the downside ri sk of an adverse movement in 
the spot rate, but also prevent s any participati on in upside po tential of 
any favourable movement in the spot rate. Whatever happens to t he 
actual exchange rate, the forwar d contract must be honoured, ev en if it 
would be beneficial to exchange cu rrencies at the spot rate pre vailing at 
that time.

Chapter 9 
 347 
 Test your understanding 13 – J electronics (Case style question ) 
 J manufactures specialised electronic equipment in the UK. The  company 
has just won its first export or der and will receive payment of  USD 15 
million in three months. J’s Chie f Executive is concerned that the USD 
may decline against the GBP during  the three months and has ask ed the 
company’s bank to offer a guarant eed price for the currency whe n it is 
received. 
exchange rate is GBP1 = USD 1. 60. Given the size of the transac tion, 
ask the bank to commit itself to guaranteeing that today’s exch ange rate 
can be obtained on a transaction that will occur in three month s. 
All of J’s directors come from an electronic engineering backgr ound and 
support. 
Required: 
Prepare a note to your finance dire ctor evaluating the respecti ve 
arguments of J’s Chief Execu tive and the bank manager about the  rate 
offered by the bank on the forward contract. 

348  
9 Money market hedges (MMH) 
 The money markets are markets fo r wholesale (large-scale) lendi ng and 
borrowing, or trading in short-te rm financial instruments. Many  companies 
are able to borrow or deposit f unds through their bank in the m oney 
markets. 
Instead of hedging a currency expos ure with a forward contract,  a company 
could use the money markets to lend or borrow, and achieve a si milar result. 
Since forward exchange rates ar e derived from spot rates and mo ney market 
interest rates (see IRPT earlier in this chapter), the end resu lt from hedging 
should be roughly the sa me by either method. 
 The basic idea of an MMH is to c reate assets and liabilities th at 'mirror' the 
future assets and liabilities. 
Rule:  The money required for the transaction is exchanged at today's  spot rate, 
and is then deposited/borrowed on t he money market to accrue to  the amount 
required for the transaction in the future. 
Note:  Interest rates are used for t he depositing / borrowing. The ra tes are 
usually quoted per annum. If you r equire a six monthly rate the n you simply 
divide by 2. If you require a quar terly rate, then divide by 4.  
 
 Money market interest rates 
 Money market interest rates are available for any length of bo rrowing or 
deposit period, up to about one y ear. Banks quote rates for sta ndard 
periods, such as overnight, one week, one month, three months, six 
months and one year. 
Two rates are quoted: 
• The higher  rate is the interest r ate that the bank will charge on 
loans. 
• T h e  lower  rate is the interest r ate that the bank will pay on 
deposits . 
All rates are quot ed on an annual basis. 
Example 
A London bank quotes the  following interest rates on US dollars : 
1 month 
USD LIBOR 3¼ – 3 ⅛ 
In the above example, suppose tha t a company wanted to borrow U S 
dollars for one month. The bank  would charge 3¼% per annum.

Chapter 9 
 349 
 For the purpose of your examina tion, you can assume that the ra te for 
one month is one-twelfth of the rate for one year; therefore in  this 
example, the actual interest fo r one month w ould be 3¼%/12 = 
0.270833%. If the company borrowed , say, USD 1 million for one month, 
it would repay the loan plus int erest of USD2,708.33 at the end  of the 
loan period. 
• The basic idea is to avoid future  exchange rate uncertainty by  making the 
exchange at today’s spot rate instead. 
• This is achieved by depositing/ borrowing the foreign currency until the 
actual commercial transa ction cash flows occur:

350  
 Test your understanding 14 (Integration question) 
 A UK company is due to receive U SD12,000 in 6 months’ time fro m a 
customer. 
The USD/GBP forward rate is 1.9550 – 1.9600 and t he spot rate i s 
1.9960 – 1.9990. 
Interest rates in the US to bo rrow are 12% and to lend are 11%.  In the 
UK interest rate to borrow are 11% and to lend are 10%. 
Required: 
If the company chooses to use a  money market hedge, how much wi ll it 
receive in GBPs in 6 months’ time? 
 
 Test your understanding 15 – DD Lt d – 1 (Integration question) 
 DD Ltd (a UK company) is requi red to make a payment of EUR1.3m illion 
in six months' time. The compan y treasurer has established the following 
rates going forward: 
Spot rate GBP1 = EUR1.5095 – 1.5050 Six month GBP1 =  EUR1.5162 – 1.4895 
Money market rates (pa): 
 Loan  Deposit 
Euro  4.0%  2.5% 
Sterling  4.6%  3.1% 
Required: 
What is the GBP cost of m aking the payment using 
(a) a money market hedge? (b) a forward contract hedge? 
 
 Test your understanding 16 – DD Lt d – 2 (Integration question) 
 Re-perform the forward contra ct and MMH assuming the business will 
receive EUR 1.3 million in six months’ time.

Chapter 9 
 351 
The advantages of money market hedges are that they: 
• Ensure there is no currency ri sk because exchange takes place today. 
• Have fairly low transaction costs. 
• Offer flexibility (especially if customer delays payment). 
The disadvantages are that: 
• They are complex. 
• It may be difficult to get an ov erseas loan in the case of a f oreign currency 
receipt. 
Further comments 
• Interest rate parity implie s that a money market hedge should give the 
same result as a forward contract. 
• This approach has obvious cash  flow implications which may pre vent a 
company from using this method, e .g. if a company has a conside rable 
overdraft it may be impossible  for it to borrow funds now. 
10 Currency futures 
 In essence this form of hedging is very similar to the use of a  forward 
contract. The critical differenc e is that, whereas using a forw ard contract 
requires the preparation of a spec ial financial instrument 'tai lor-made' for 
the transaction, curre ncy futures are standardised contracts fo r fixed 
amounts of money for a limit ed range of future dates. 
Futures are derivatives contra cts and as such can be traded on futures 
exchanges. The contract which guarantees the price (known as th e futures 
contract) is separated from the transaction itself, allowing th e contracts to be 
easily traded. 
Denomination 
Futures contracts are limited to  a small range of currencies an d are typically 
denominated in terms of dollars (US D). There are also markets i n euro (EUR) 
denominated futures contracts but th is is relatively new and mu ch less common. 
Given USD denominated currency fu tures, we would simply know th em in terms 
of the other currency, i.e. the  GBP1/USD future will be known a s GBP contracts 
or EUR1/USD futures are k nown as EUR contracts.

352  
Futures are standardised contra cts for standardised amounts. Fo r example, the 
Chicago Mercantile Exchange (CME) trades sterling futures contr acts with a 
standard size of GBP62,500. Only w hole number multiples of this  amount can 
be bought or sold hence they rarel y cover the exact foreign cur rency exposure. 
Process 
There is a three step process wh ich can be followed to answer a  futures 
question: 
Step 1: Set up 
Set up the hedge by addressing 3 key questions: 
• Do we initially buy or sell futures? 
To decide whether to buy or sell  futures, the simplest way is t o follow this rule: 
identify the currency of the futu res contract (e.g. GBP) and th en do the same to 
the futures that you intend to do to that currency (e.g. buy or  sell). 
• Which expiry date should be chosen? 
Settlement takes place in three- monthly cycles (March, June, Se ptember or 
December). It is normal to choose  the first contract to expiry after the required 
conversion date. 
• How many contracts? 
Step 2: Contact exchange 
Pay the initial margin. Then wait  until the transaction/settlem ent date. 
Margin: The futures exchange requi res all buyers and sellers of  futures to pay a 
deposit to the exchange when they buy or sell. This deposit is called an initial 
margin. This margin is returned when the position is closed out . 
Step 3: Closing out 
At the end of the contract's term the position is closed out. T his means that on 
expiry of the contract the trading position is aut omatically re versed. Any profit or 
loss is computed and cleared, and  the underlying commodity is r etained by the 
trader. 
The margin is refunded by the exchange. The value of the transaction is c alculated using the spot rate on the transaction 
date. 
 Concept 
In essence we are hedging or spe culating on the movement of the  exchange 
rate on the futures market

Chapter 9 
 353 
 More on futures contracts  
 When a futures contact is bought or sold, the buyer or seller must deposit 
an initial margin  with the exchange. If losses ar e incurred, the buyer or 
seller may be called on to deposit additional funds (variation margin) 
with the exchange. Equally, profits  are credited to the margin account on 
a daily basis as the contra ct is 'marked to market'. 
Most futures contracts are clos ed out before their settlement d ates by 
undertaking the opposite transaction  to the initial futures tra nsaction, i.e. 
if buying currency futures was  the initial transaction, it is c losed out by 
selling currency futures. 
Effectively a future works lik e a bet. If a company expects a U SD receipt 
in 3 months’ time, it will lose out if the USD depreciates rela tive to GBP. 
Using a futures contract, the company ‘bets’ that the USD will depreciate. 
If it does, the win on the bet canc els out the loss on the tran saction. If the 
USD strengthens, the gain on the tr ansaction covers the loss on  the bet. 
Ultimately futures ensure a vi rtual no win/no loss position. 
 
 It is 15 October and a treasurer  has identified the need to co nvert euros 
into dollars to pay a US supplie r USD12 million on 20 November.  The 
treasurer has decided to use Dec ember euro futures contracts to  hedge 
with the following details: 
• Contract size EUR 200,000. 
• Prices given in USD p er EUR (i.e. EUR1 = …). 
• Tick size USD 0.0001 or  USD 20 per contract. 
He opens a position on 15 Octobe r and closes it on 20 November.  Spot 
and relevant futures prices are as follows: 
Date  Spot  Futures price 
15 October  1.3300  1.3350  
20 November  1.3190  1.3240 
Calculate the financial positio n using the hedge described.

354  
 Solution 
Step 1  1 Buy or sell initially? 
2 Which expiry date? 3 How many contracts?  1 We need to sell EUR 
(to buy USD), so sell futures now. 
2 Transaction date is 
20 November, so choose December futures (the first to expire after the transaction date). 
3 Cover USD 
12m/1.3350 = EUR 8.99 million, using EUR 200,000 contracts, hence 8.99m/0.2m = 44.9, which we will round to 45 contracts. 
Step 2  Contact the exchange – 
state the hedge  Sell 45 December futures 
(at a futures price of EUR1/USD 1.3350)  
Step 3  Calculate profit/loss in 
futures market by closing out the position. Initially: Sell at 1.3350 
Close out: Buy at 1.3240 Difference is USD0.011 per EUR1 profit 
45 × EUR200,000 
covered, 
so total profit is 0.011 × 45 × 200,000 = USD99,000  
Step 3 
continued Transaction at spot rate on 
20 November:  
Need to pay USD12m less 
profit = USD11.901m, 
needed at spot rate of 
EUR1/USD1.3190 Cost in EUR is EUR 
9,022,744

Chapter 9 
 355 
 Ticks 
 A tick is the minimum price move ment for a futures contract. 
Take for example a sterling futu res contract for a standard amo unt of 
GBP 62,500 in sterling. The cont racts are priced at the exchang e rate, in 
US dollars, and the tick size (mi nimum price movement) is USD0. 0001. 
If the price of a sterling futu res contract changes from, say, USD 1.7105 
to USD 1.7120, the price has r isen USD 0.0015 or 15 ticks. 
The significance of a tick for fu tures trading is that every on e tick 
movement in price has the same money value. 
GBP 62,500: every movement in t he price of the contract by one tick is 
worth USD6.25, which is G BP 62,500 at USD0.0001 per GBP1. 
 
 Basis and basis risk 
 The current futures price is us ually different from the curren t ‘cash 
market’ price of the underlying item. In the case of currency f utures, the 
current market price of a currenc y future and the current spot rate will be 
different, and will only start to  converge when the final settl ement date for 
the futures contract approaches. This difference is known as th e 'basis '. 
At final settlement date for t he contract (in March, June, Sept ember or 
December) the futures price and the market price of the underly ing item 
ought to be the same; otherwise s peculators would be able to ma ke an 
instant profit by trading between  the futures market and the sp ot ‘cash’ 
market. 
Most futures positions are closed out before the contract reach es final 
settlement. When this happens, ther e will inevitably be a diffe rence 
between the futures price at clo se-out and the current spot mar ket price 
of the underlying item. In other  words, there will still be som e basis. 
Because basis exists, an esti mate can be made when a hedge is c reated 
with futures about what the size o f the basis will be when the futures 
position is closed.

356  
 Example 
In February, a UK company wishes  to hedge a currency exposure a rising 
from a US dollar payment that wil l have to be made in May, in t hree 
months' time. The current spot exchange rate is USD1.5670 and t he 
current June futures price is U SD1.5530. The basis is therefore  140 
points in February. 
If it is assumed that the basis w ill decline from 140 points in  February to 0 
in June when the contract reaches  final settlement (say four mo nths 
later), we can predict that the basis will fall from 140 in Feb ruary by 105 
points (140 × 3 months/4 months ) to 35 points in May, when it i s intended 
to close the futures position. 
Basis risk  is the risk that when a hedge is c onstructed, the size of the 
basis when the futures position is closed out is different from  the 
expectation, when the hedge was created, of what the basis ough t to be. 
In the example, when the futures position is closed in May, the  actual 
basis might be, say 50 points , which is 15 points higher than e xpected 
when the hedge was constructed. 
 
The advantages of currency futures contracts are that they: 
• Offer an effective 'fix ing' of exchange rate; 
• Have no transaction costs; 
• Are tradable. 
• A foreign futures market mus t be used for GBP futures; 
• They require up front margin payments; 
• They are not usually for the pr ecise tailored amounts that are  required. 
 
 Test your understanding 17 (Integration question) 
 A UK company sells goods to a U S company to the value of USD 
2,650,000 in August. It is now June and spot is USD 1.9800/GBP 1. A 
June futures contract is quoted as USD 1.9790. A September futu res 
contract is quoted as USD 1.9000 . Sterling futures are traded i n contracts 
of GBP 62,500. The UK company alwa ys buys the minimum number of  
contracts, being prepared to l eave un-hedged any small residual  amount. 
Required: 
Calculate how many cont racts should be bought.

Chapter 9 
 357 
11 Currency options 
 A currency option is a right, bu t not an obligation, to buy or sell a currency 
at an exercise price  on a future date. 
If there is a favourable movement  in rates the company will all ow the option to 
lapse , to take advantage of the favour able movement. The right will only be 
exercised  to protect against an adverse m ovement, i.e. the worst-case 
scenario. 
As a result of this, options sound very attractive, BUT they ha ve a cost. 
Because options limit downside risk but allow the holder to ben efit from upside 
risk, the writer of the opti on will charge a non-refundable  premium  for writing 
the option. 
It is possible for the holder of t he option to calculate the ga ins and losses on 
using options: 
The gain if the option is  exercised: this is the 
difference between the exercise price (option strike price) and the market price of the underlying item X 
Less: The premium paid to purchase the option (X) 
 
–––– 
 X  
 –––– 
There are two types of option: 
• A  call option gives the holder the ri ght to buy the underlying curren cy. 
• A  put option gives the holder the righ t to sell the underlying curren cy. 
 
 Test your understanding 18 – UK exporter (Integration question)  
 A UK exporter is due to receive  USD 25 million in 3 months' ti me. Its bank 
offers a 3 month dollar put opt ion on USD 25 million at an exer cise price 
of GBP1/USD1.5000 at a pre mium cost of GBP 300,000. 
Required: 
Show the net GBP receipt if the fu ture spot is either USD 1.600 0 or USD 
1.4000.

358  
 Illustration of currency options 
 A typical pricing schedule for  the EUR currency option on the 
Philadelphia (US) exchange is as follows. 
Strike 
price CALLS   PUTS   
 Jun Sept Dec Jun Sept Dec 
115.00 1.99 2.25 2. 47 0.64 1.32 2.12 
116.00 1.39 2.03 2.28 1.00 1.56 – 117.00 0.87 1.55 1.81 1.43 2.22 – 
118.00 0.54 1.08 1.30 – – – 
• Here, the options are for a cont ract size of EUR 125,000 and p rices 
(both strike price and premia) are quoted in USD (cents) per EU R 1. 
• So to buy a call option on EUR 125,000 with an ex piry date of 
September and at a strike price of EUR 1 = USD 1. 1700 would cos t 
1.55 cents per euro , or USD 1,937.50. 
• Similarly, the premiu m on a June put at a strike price of 115. 00 
(EUR 1 = USD 1.1500) w ould cost 0.64 cents per euro, or USD 800 . 
The decision as to which exercis e price to choose will depend o n cost, 
risk exposure and expectations. 
• In the exam it is unlikely t hat you will be given such a wide range of 
values – it is more likely to  have just one call and one put op tion 
price 
Options hedging calculations 
Step 1:  Set up the hedge by addr essing 4 key questions: 
• Do we need call or put options? 
• What is the strike price? 
Step 2:  Contact the exchange. Pay the up- front premium. Then wait unti l the 
transaction/settlement date. 
Step 3:  On the transaction date, compare  the option price with the pre vailing 
spot rate to determine whether t he option should be exercised o r allowed to 
lapse. 
Step 4:  Calculate the net cash flows – beware that if the number of co ntracts 
needed rounding, there will be some  exchange at the prevailing spot rate even 
if the option is exercised.

Chapter 9 
 359 
 In- and out-of-the money options 
 The strike price for an option might be higher or lower than t he current 
market price of the underlying item. 
For example, a call option migh t give its holder the right to b uy GBP 
125,000 in exchange for USD at USD  1.7900, and the current spot  rate 
could be higher than USD 1.7900, below USD 1 .7900 or possibly U SD 
1.7900 exactly. 
• If the exercise price for an opt ion is more favourable to the option 
holder than the current ‘spot’ ma rket price, the option is said  to be 
in-the-money.  
• If the exercise price for an opt ion is less favourable to the option 
out-of-the-money. 
• If the exercise price for the option is exactly the same as th e current 
‘spot’ market price, it is said to be at-the-money. 
An option holder is not obliged  to exercise the option, and wil l never do 
so if the option is out-of-the-money. An option will only ever be 
exercised if it is in-the-money. 
However, when an option is first purchased, or during the perio d before 
the expiry date, an option might be out-of-the-money. 
Options that start out -of-the-money might become in-the-money i f the 
market price of the underlying item changes. On the other hand,  an 
option that starts out-of-the-m oney might stay out-of-the-money  until 
expiry, and so will lapse without being exercised 
 
The advantages of currency options are that: 
• They offer the perfect hedge (dow nside risk covered, can parti cipate in 
upside potential). 
• There are many choices of strik e price, dates, premiums, etc. 
• The option can be allowed to l apse if the future transaction d oes not arise. 
• Traded sterling currency options a re only available in foreign  markets. 
• There are high up-front pre mium costs (non-refundable).

360  
 Test your understanding 19 (Integration question) 
 A company is due to receive USD  3 million in 3 months' time. 
The spot rate is USD 1.9500/G BP but the company is worried that  the 
USD will weaken. They have been o ffered a three month put optio n on 
USD at USD 1.9700/GBP, cos ting USD 0.02 per GBP. 
Required: 
If the company chooses to buy and  then exercise the option, wha t is its 
net receipt in GBP? 
The Black-Scholes model 
Writers of options have to deci de what level of premium to set,  and for this they 
use complex option pr icing models. These models are also used t o calculate 
the fair value of an option at any given date (useful for finan cial reporting 
purposes). 
In the exam you will not be expect ed to calculate option values , but you are 
expected to be aware of the fact ors that affect the option pric e. The most 
common option pricing model us ed is the Black-Scholes model. 
The basic principle of the Black- Scholes model is that the mark et value, or 
price, of a call option cons ists of two key elements: 
– The intrinsic value of the option. – The time value of the option. Between these two elements there are five variables affecting t he price of a call 
option. 
Intrinsic value 
This is the difference between  the current price of the underly ing asset and its 
option strike (exercise) price . For the market value of a call option to rise, one or 
both of the following variables must change: 
1 Current price of the underly ing asset must increase. 
2 Strike price must fall (hence making it more likely that the option will be 
exercised, and so is worth something). 
Time value 
This reflects the uncertainty s urrounding the intrinsic value, and is impacted by 
three variables: 
1 Standard deviation in the daily v alue of the underlying asset . The more 
variability that is demonstrat ed, the higher the chance that th e option will 
be 'in the money' and so  will be exercised. 
2 Time period to expiry of t he option. A longer time period wil l increase the 
likelihood that the asset value in creases and so the option is exercised. 
3 Risk free interest rates. Hav ing a call option means that the  purchase can 
be deferred, so owning a call opt ion becomes mor e valuable when  interest 
rates are high, since the money  left in the bank will be genera ting a higher 
return.

Chapter 9 
 361 
 Limitations of the Black-Scholes model 
 The basic form of the Black-Scho les model has been illustrated  above. It 
is widely used by traders in opti on markets to give an estimate  of option 
values, and more expensive scienti fic calculators include the m odel in 
their functions so that the ca lculations can be carried out ver y quickly. 
However, the model in its basic f orm does suffer from a number of 
limitations: 
• It assumes that the risk-free in terest rate is known and is co nstant 
throughout the option’s life. 
• The standard deviation of retur ns from the underlying security  must 
be accurately estimated and has  to be constant throughout the 
option’s life. In practice st andard deviation will vary dependi ng on 
the period over which it is calc ulated; unfortunately the model  is very 
sensitive to its value. 
• It assumes that there are no tr ansaction costs or tax effects involved 
in buying or selling the opt ion or the under lying item. 
Certain of these limitations can be removed by more sophisticat ed 
versions of the model, but the basic model is complicated enoug h for the 
purposes of this text. 
The discussion of the value of options does not just relate to currency options 
but is relevant to interest rat e options and other assets or li abilities. 
For example, a company may wish  to purchase an option to buy a factory which 
is under construction. The company  might pay a premium to the b uilder of the 
factory which entitles them to fi rst option to buy the complete d factory (not a 
commitment to buy). If in the fo llowing months the council, say , change the 
planning guidelines a nd no further developm ents can be construc ted, then the 
option becomes very valuable  if another company then wishes to build a factory 
in the same location because it could be sold on (subject to th e builder's 
agreement) at a profit. 
 
 Which of the following is not a factor upon which an option val ue 
depends: 
A The current share price 
B The standard deviation of return on underlying share 
C The time to expiration of the option 
D The number of shares in issue

362  
12 Swaps 
A cross currency swap allows a c ompany to swap a currency it cu rrently holds 
for a different currency for a  fixed period, and then swap back  at the same rate 
at the end of the period. 
The company's counterparty in a cross currency swap would gener ally be a 
bank. 
A cross currency sw ap has two elements: 
• An exchange of principals in di fferent currencies, which are s wapped back 
at the original spot rate. 
• An exchange of interest rates  – the timing of these depends on  the 
individual contract. 
It works in a very similar way to  an interest rate swap, so is covered in detail 
straight after interest rate sw aps in Chapter 10: ‘Interest rat e risk management’. 
13 Chapter summary 
This chapter has covered lots of different ways of reducing exp osure to 
currency risks. The different hedging methods were categorised at the start of 
the chapter into internal m ethods and external methods. 
Bear in mind that there are some  risks that can be better cover ed by internal 
methods and some that can be better covered by external methods . It is really 
important for the exam to be abl e to identify what the risk is and to be able to 
match a suitable hedging method  to the specific risk (rather th an just suggesting 
forward contracts as a sol ution to every problem!) 
For example, many students lose  marks because they don’t look b eyond the 
financial instruments e.g. an economic risk arising from the fa ct that a UK 
company exports to the US and could suffer if the USD weakens c ould be 
hedged by matching its USD revenues  with USD costs - ideally by  importing 
materials priced in USD. A studen t in the exam would lose marks  for trying to 
hedge this sort of exposure with (external) hedging instruments  that have 
limited life spans.

Chapter 9 
 363 
14 End of chapter object ive test questions 
 If the interest rate on USD depos its is 8%, the interest rate o n EUR 
deposits is 5%, and the spot rat e is USD/EUR0.9200, what is the  one 
year forward rate predicted to be if interest rate parity holds ? 
A USD/EUR0.9463 
B USD/EUR1.0567 C USD/EUR0.8944 D USD/EUR1.1180 
 
 Test your understanding 22 (O bjective test question) 
 The spot rate for Swiss fran cs is GBP1/CHF 1 .6734 – 1.6802. 
The three month forward pr emium is 0.0200 – 0.0250. 
If you wanted to sell your CHF f orward what exchange rate would  
you receive from the bank? 
A 1.6552 
B 1.6534 C 1.6934 D 1.7052 
 
 Test your understanding 23 – Option costs and premiums 
 Pricing schedule for Sterling cu rrency options on the Philadel phia (US) 
exchange. 
The contract size is GBP 31,250,  all figures are quoted in USD (cents). 
Strike 
 Mar Jun Sept Mar Jun Sept 
145.00 1.41 2.57 3.82 – 0.42 0.87 
146.00 1.21 2.34 3. 41 0.15 0.81 1.27 
A company wants to buy a call op tion at a strike price of 1.460 0 with an 
expiry date of March; another c ompany wants to set up a put opt ion with 
a strike price of 1.4500 expiring in June.

364  
 Which of the following statements are correct? 
A The cost of each contract for  the call option is USD 378.125 
B The cost of each contract fo r the call optio n is GBP 378.125 
C The cost of each contract fo r the call option is USD 131.25 
D The cost of each contract fo r the call optio n is GBP 131.25 
E The premium for each put opt ion contract is USD 131.25 
F The premium for each put opt ion contract is GBP 131.25 
G The premium for each put opt ion contract is GBP 378.125 
 
 Test your understanding 24 (O bjective test question) 
 Which of the following are char acteristics of an ‘over the coun ter 
option’ as compared to an  ‘exchange traded option’? 
A Can be customised to meet the customer’s needs in terms of 
amount and duration. 
B Settlement at maturity. C Easy to liquidate the position. D Potential to benefit from fa vourable exchange rate changes. 
 
 Test your understanding 25 (O bjective test question) 
 Which of the following would decrease the intrinsic value of a put 
option? (Select ALL that apply) 
A An increase in the time to expiry 
B A decrease in the market value of the share 
C A decrease in the volatility value of the share 
D A decrease in the strike price 
 
 Test your understanding 26 (O bjective test question) 
 Which of the following will increase the value of a call option ? (Select 
ALL that apply) 
A An increase in the strike price 
B An increase in the time to expiry 
C A decrease in the volatility of the share 
D A decrease in the market value of the share

Chapter 9 
 365 
 Test your understanding 27 (O bjective test question) 
 Which of the following is an ex ternal hedging technique? (Selec t all 
that apply.) 
A A forward contract 
B A money market hedge C Pooling D A futures contract 
 
 Test your understanding 28 (O bjective test question) 
 A UK company has sold goods to a Danish company and will 
receive 300,000 Danish Kroner in  3 months’ time. Which of the 
following would hedge its position? 
A Selling a call optio n on Danish Kroner 
B Buying a put opti on on Danish Kroner 
C Using the forward market to buy Kroner at the 3 month forward  rate 
D Buying Danish Kroner futures

366  
 Test your understanding 29 – L (Case style question) 
 L manufactures specialised paper p roducts for sale in its home  country, 
Country B. The market is very pri ce sensitive. Some of L’s comp etitors 
are based in its home country and others export to Country B. 
The manufacturing process is no t particularly skilled, but it i s very labour 
intensive. L’s largest costs a re for wages and flax fibre (the basic raw 
material used in manufacturing L’s products). Almost 60% of L’s  total 
manufacturing cost is for wages. 
L’s directors are considering moving production offshore to Cou ntry R, a 
developing country that has low  wage rates. The products will t hen be 
transferred to Country B for sale. 
L’s home currency is the BND. Count ry R’s currency is the RTD. At 
present, the exchange rate is 1.00 BND = 2.50 RTD. 
L presently pays an hour ly rate of 6.00 BND  to its production s taff. 
Workers with comparable skill lev els would be paid 2.75 RTD per  hour in 
Country R. 
Flax fibre is sold as a commodity  on the global markets. It is priced in US 
Dollars (USD). All of L’s purc hases of flax fibre are imported.  
Shipping flax fibre to the new fa ctory would be much cheaper th an 
shipping it to L’s home country. T hose savings would pay for th e cost of 
shipping the finished products to L’s home country for sale. 
L’s directors are currently aski ng for information that will he lp them with 
an appraisal of the financial vi ability of the new factory. L’s  Chief 
Economist has reported that there are no credible long-term eco nomic 
forecasts available. She has, how ever, obtained some basic econ omic 
indicators that could be used to  predict future wage rates: 
 Country B Country R 
Interest rates per annum 5.00% 9.00% 
General inflation per  annum 2.00% 4.70%

Chapter 9 
 367 
 Required: 
(a) (i) Produce a forecast of  the hourly rate in BND that will be paid 
to employees in Country R in  five years’ time. You must 
explain the assumptions tha t you have made at each stage of 
your calculations. 
(ii) Evaluate the assumptions t hat were made and explained in ( a) 
(i) explaining why reality coul d differ from what you assumed. 
(b) Discuss the Production Direc tor’s statement that the price of flax 
fibre is irrelevant to the decis ion to move production to Count ry R 
because flax fibre is pri ced in terms of USD. 
(c) Advise L’s board of the political risks that L will be taki ng in its home 
country if it proceeds with this project. 
 
 Test your understanding 30 – S (Case style question) 
 S has been studying some of t he fundamental economic data rela ting to 
both the USA and the Eurozone. S he believes that her understand ing of 
economics gives her an advantage over many other market partici pants. 
She believes that she has spotte d an anomaly in t he pricing of futures for 
the EUR to USD exchange rate. 
The contract value is USD 125,000. The tick size is 0.0001, which giv es a tick value of USD 12.50.  
The current spot markets v alue 1 EUR = USD 1.3036. 
The rate offered by the futures markets is USD 1.3004 for deliv ery in 
three months. 
The interest rates offered on depo sits are 3.000% per annum on EUR 
deposits and 2.000% per annum on USD deposits. 
S notes that the markets expec t the USD to strengthen against t he EUR. 
However, S’s own personal analysi s of various economic and poli tical 
indicators suggests that the USD will actually weaken to 1 EUR = USD 
1.350. She intends to exploit this d ifferent view by entering i nto a futures 
contract that will require her to deliver USD in three months. 
S has discussed this arrangement with a broker, who has advised  her 
that it will be possible for her to  enter into a contract which  meets her 
requirements, but that she will ha ve to make an initial margin payment of 
15% of the EUR value of the futu re. In addition, she may be req uired to 
deposit further margin during the life of the contract. The bro ker will not 
pay any interest on the margin deposits.

368  
 S has personal savings of EUR 100,000 that she can use to inves t in this 
venture. She does not believe t hat she will ever be asked to pr ovide 
additional margin and so she in tends to use as much of her fund s as 
possible to invest in the initial margin. 
Required: 
(a) Calculate the gain S will ma ke writing a futures contract, assuming 
that she invests the maximum po ssible amount that she can affor d 
in the initial margin and that her expectations turn out to be 
accurate. 
(b) Discuss the risks that S wil l be taking if she enters into this contract. 
(c) Explain why S chose to use a  futures contract as the basis for her 
speculation in the market. 
 
 Test your understanding 31 – Ma rcus (Integration question) 
 Marcus, based in France, has rec ently imported raw materials f rom the 
USA and has been invoiced for USD 240,000, payable in three mon ths' 
time. 
In addition, it has also export ed finished goods to Japan and A ustralia. 
The Japanese customer has been invoiced for USD 69,000, payable  in 
three months' time, and the Aust ralian customer has been invoic ed for 
AUD 295,000, payable in  four months' time. 
Current spot and forward rates are as follows: 
EUR1/USD  
Spot 0.9850 – 0.9830 Three months’ forw ard 0.9545 – 0.9520 
AUD1/EUR  
Spot: 1.8920 – 1.8890 Four months’ forwar d: 1.9540 – 1.9510 
Current money market rates (p er annum) are as follows: 
USD: 10.0% – 12.0% 
AUD: 14.0% – 16.0% EUR: 11.5% – 13.0% 
Required: 
Show how the company can hedge its exposure to FX risk using: 
(i) the forward markets; (ii)  the money markets; and in each case, determine whic h is the best hedging technique .

Chapter 9 
 369 
 Test your understanding 32 – UK co mpany (Integration question) 
 A UK company will receive USD 2.5 million from an American cus tomer in 
three months’ time in February. 
Currently: 
Futures GBP contracts 
(GBP62,500) December GBP1/USD 1.5830 
  March GBP1/USD 1.5796 
Margins are USD1,000 per contract.  
GBP1/USD forward rates:  Spot 1.5851 – 1.5842 
  One month 0. 53 – 0.56 c pm 
  Three month 1.64 – 1.72 c pm 
28 February: 
Assume that the spot rat e moves to 1.6510 – 1.6490 
March futures have a price of 1.6513 
Required: 
Calculate the GBP receipt using a forward contract and a future .

370  
 (a) A Ltd will need to sell G BP and buy USD and therefore the bank is 
buying GBP and selling USD. The bank always buys GBP low and 
sells GBP high and therefore t he rate is GBP1 = USD1.4500. 
Cost is therefore USD100, 000 ÷ 1.4500 = GBP68,966. 
(b)  B plc is receiving USD and therefore t he bank will buy USD  and sell 
GBP. The rate is theref ore GBP1 = USD1.5500. 
Receipt is therefore USD50, 000 ÷ 1.5500 = GBP32,258. 
(c)  C Ltd is importing goods and therefore needs to sell GBP a nd the 
bank needs to buy GBP. The rate is  therefore GBP1 = USD1.4500. 
The product must therefore co st GBP12 × 1.4500 = USD17.40. 
 
 The implied cross rate is USD/GBP divided by EUR/GBP = 
1.4417/1.1250 = 1.2815 
 
 The USD1/EUR cross rate  will be calculated as: 
1.5300/1.8700 = 0.8182 i.e . USD1/EUR0.8182. 
The cost of the machine is therefore: EUR100,000/0.8182 = USD122,220 
 
1.7200 × 1.03
1.04 = USD1.7035 
 
10 × 1.03
1.07 = CHF9.6262 to GBP 1

Chapter 9 
 371 
 Test your understanding 6 (Integration question) 
 PPPT 
 
Future spot rate = 0.9050 × 1 + 0.013
1 + 0.02 
 
 = EUR 0.8988 
IRPT 
Forward rate = 0.9050 × 1 + 0.045
1 + 0.06 
 
 = EUR 0.8922 The rates are similar, but no t identical under the two differen t forecasting 
methods. 
Using the Fisher Effect, the r eal rate of interest can be found  in both US 
and Eurozone. 
US: 
(1 + m) = (1 + r) ( 1 + i) (1+ 0.06) = (1 + r)(1 + 0.02)  Hence r = 3.9% 
Eurozone: 
(1 + m) = (1 + r) ( 1 + i) (1 + 0.045) = (1 + r)(1 + 0.013)  Hence r = 3.2% For the PPPT and the IRPT to giv e identical predicted rates, th e 
International Fisher Effect must h old, which states that real r ates of 
interest are identical in all countries. This is apparently not  the case. 
Other factors that may affect t he prediction of exchange rates include: 
• Transaction costs of shifting money and making investments. 
• Lack of mobility of capital and goods, and the costs associate d with 
this. 
• Political intervention. 
• Cultural differences between different countries. 
• Central bank action. 
• Trader activity. 
• Key commodity prices (e.g. oil is priced in US dollars).

372  
 Briefing note 
To: The Board of G 
From:  Management accountant 
Subject:  Currency risk management 
Dear Sirs, 
This briefing note covers three issues: 
(a) The argument that purchasing power parity theory should pre vent 
exporters from charging different  prices in different countries . 
(b) The potential risks and benefit s to G of buying its invento ry from 
intermediaries in the neighbouring countries. 
(c) Recommends actions that the Go vernment in G’s home country 
(a) Purchasing power parity theory (PPP)  
Purchasing power parity theory ( PPP) suggests that a commodity 
will sell for the same amount acr oss the world, regardless of t he 
currency in which it is priced . That is because of arbitrage. I t is 
illogical that customers will buy  goods in their home country i f they 
can buy them elsewhere and import them more cheaply. 
There is considerable evidence  that PPP does not hold in realit y. 
There are some fairly obvious reasons for that. With very few exceptions, it is unlikely to  be convenient to buy goods from a cross 
an international border. Trave l and transportation costs will 
frequently exceed any savings. 
There can be artificial factors,  such as tariffs and differenti al pricing 
practices by suppliers. 
(b) The potential risks and benefits  to G of buying its inventory 
from intermediaries in t he neighbouring countries  
The only benefit is the obvious  one that G will possibly be abl e to 
reduce its costs. Those savings will make it easier to compete with 
other retailers who are us ing the same sources. 
The fact that this behaviour is i llegal in G’s home country mea ns 
that the company may be open to p rosecution. The staff who are 
responsible for making the a rrangements may also be held 
personally responsible, which wil l harm G’s reputation if any o f them 
are prosecuted. Staff may refus e to act illegally, which could 
undermine discipline in G and could lead to problems in process ing 
partially completed transactions.

Chapter 9 
 373 
 G’s contract will be with foreign intermediaries, who may offer  a 
lower standard of service than t he manufacturer. Any disputes o ver 
quality or delivery may lead to  G being unable to obtain an ade quate 
resolution. The intermediaries ma y not offer the full range of new 
designs and may not be able to m eet all of G’s requirements for  
volume. 
The manufacturers may be unwil ling to encourage G to buy from 
intermediaries because they will lose the benefits of different ial 
pricing in the two markets. T hey may report G to the authoritie s or 
take G to court to prev ent it from stocking or selling these “g rey 
imports”. The manufacturers may then refuse to sell goods to G in 
the future in order to deter ot her retailers from copying this practice. 
(c) Actions that the Government  in G’s home country could take  
The government can inspect the reta iler’s books to determine wh ere 
it obtains its goods. Given that m ost of the fashion clothes ap pear to 
be imported, there ought to have been duty paid on virtually al l of 
the retailer’s purchases. The to tal duty paid should be roughly  
equivalent to the total purchases  multiplied by the rate of dut y. 
The retailer is unlikely to recor d all transactions accurately in its 
bookkeeping records if it is def rauding the revenue authorities . The 
government should check that the pur chase records are accurate by 
going back to basic records, suc h as sales recorded by individu al 
shops. There should be a realisti c relationship between the lev el of 
sales and the level of purchases . If the gross profit percentag e is 
very high then that would sug gest that purchases are being 
understated. 
The customs authorities should conduct spot checks of vehicles 
crossing into the country as a ma tter of routine anyway. Custom s 
officers should be instructed to look out for goods despatched to the 
competitor by anyone ot her than the original manufacturer. Any 
such goods should be seized and the relevant paperwork 
investigated to determine whether duty has been paid. 
The revenue authoritie s can conduct spot inspections of goods 
being delivered to the competitor ’s premises. Again, the origin  of the 
goods should be investigated for unpaid duty. The authorities c an 
always levy an estimated charge on the competitor and force the  
competitor to prove that suc h a payment is not appropriate. 
 
 GBP 66,700 
The speculator should 1  Convert GBP into USD: 1, 000,000 × 2 = USD2,000,000 
2  Convert USD into EUR: 2, 000,000/1.50 = EUR1,333,333 
3  Now sell the EUR: 1, 333,333 × 0.80 = GBP1,066,667 
The speculator has made a ri sk-free profit of GBP66,667.

374  
 Test your understanding 9 (Int egration/Case style question) 
 (a) Principle of borrowing, depos iting and selling resulting b alance 
forward  
–  Borrow GBP 10m 
–  Convert to USD at spot rat e = GBP10m x 1.556 = USD 
15.560m 
–  Deposit at 5.12% for three m onths. Interest = USD 15.560m × 
5.12% × 3/12 = USD 0.1992m 
–  Total deposit by end of three months = USD 15.560m + 0.1992 
= USD 15.7592m 
–  Sell USD forward = USD 15.7592m/1.499 = GBP 10.5131m 
–  Interest on GBP borrowings  = GBP 10m × 5.08% × 3/12 = 
GBP 0.127m 
–  Total repayment = GBP 10.1270m –  Gain = GBP 10.5130 – 10.1271 = GBP 0.3861m 
(i)  U has clearly identified t he possibility of an arbitrage p rofit that 
could be exploited without risk  to the company. Interest rate 
parity suggests that if the USD is expected to strengthen 
against GBP then the interest rat e offered for USD deposits 
should be lower than the rates on  GBP. The fact that it wasn’t 
made it possible to borrow in  GBP, deposit in USD, sell the 
resulting USD forward, all in t he knowledge that the resulting 
GBP balance would be more th an enough to settle the GBP 
loan. 
Any business opportunity that o ffers a positive return in 
absolute terms from zero inves tment with zero risk must be 
highly desirable. U has found such an opportunity through 
good luck. Simple economics suggest that markets will not 
offer positive returns to parti cipants who do not invest anythi ng 
and who do not take any risk and so such opportunities will 
either require great skill to i dentify or considerable good luc k. 
(ii) In practice, arbitrageurs dr aw attention to anomalies by m oving 
funds to exploit them and the in consistencies are quickly 
corrected to make further profits  impossible. That explains why  
U’s treasurer did not ask U to act on her discovery. 
Professional arbitrage compani es use electronic trading to 
seek out these opportunities and exploit them. U discovered the opportunity by chance, but it is unlikely that she would have been able to put the vari ous trades in place quickly 
enough to beat the professionals.

Chapter 9 
 375 
 The very nature of arbitrage m eans that the trades themselves 
are risk free, but ther e are considerable co sts associated with  
arbitrage operations. Arbitrageur s must pay a great deal for 
real-time market data, which is a substantial fi xed cost. There  
is also substantial investmen t in the IT systems and other 
facilities. It is entirely possi ble that there will be too few 
opportunities offered by the market to generate an adequate 
return to cover those costs and pr ovide a realistic return on 
The anomalies that arise tend to  be far smaller than those 
discovered by U. Arbitrage requi res very large transactions to 
generate sufficient profit in absol ute terms to make the proces s 
worthwhile. Participants must be sufficiently liquid to meet 
margin requirements and to have the confidence of the 
institutions who have to accept the bids being made. 
The financial institutions whi ch create the markets have an 
incentive to avoid creating ar bitrage opportunities and they ar e 
clearly going to use sophistic ated systems of their own to 
avoid doing so. There will also  be competition from other 
arbitrageurs, all of whom will be attempting to move more quickly than anybody else so tha t they enjoy all of the profit.  
(c)  Generally, the treasury department provides a service to t he entity, 
by managing cash flows and dealing with banks and other sources  
of finance. The treasury aims to  reduce the costs borne by the entity 
and the intention is that these savings will more than offset t he cost 
of running the department. 
The treasury can only become a profit centre if it develops a 
revenue stream. Normally that inv olves speculating in the finan cial 
markets in order to generate gains. There are two competing 
arguments relating to speculation: 
One is that the treas ury department has considerable expertise.  
Speculation is a zero sum game that involves being able to out- think 
the market and buy or sell mispri ced financial instruments. The  
treasury department could use it s natural advantage over other 
market participants, who have a lesser understanding and inferi or 
data to trade at a profit. 
The counter-argument is that act ive trading in the markets invo lves 
leaving positions exposed to lo ss and so there is a risk. Losse s can 
arise when trades are unsuccessf ul. The entity would be bidding  
against counterparties who may be even more skilled and better 
informed. 
It is generally difficult to make a consistent profit from spec ulation. 
Markets are generally efficient and most participants – even tr ained 
corporate treasurers – should ac cept that the market prices are
 
correct. Active trading will incr ease costs and also increase r isks for 
the entity.

376  
Subject:  Appointment of a corporate treasurer 
Dear Sirs, (a) A corporate treasurer coul d strengthen J’s management team.  At 
present, there is nobody with any  particular expertise in 
accountancy or finance in the com pany. The fact that J has secu red 
an order of this magnitude suggest s that the company is of a si ze 
where it requires more attenti on to be paid to financial manage ment. 
The fact that the order was for export suggests that there is a  need 
for support in this area, particu larly given that the chief exe cutive’s 
discussion with the bank indicate s a lack of understanding. 
It could be argued that it would make more sense to appoint a 
qualified accountant to manage al l aspects of the accounting 
function, including treasury ma tters. A qualified treasurer is trained in 
greater depth to manage the relationship with the bank and to manage receipts and payments.  A professionally qualified 
accountant holding, say, the CIMA  qualification should have suf ficient 
skill in treasury matters to deal with the treasury needs of a medium-
sized and growing company and should be able to contribute to o ther 
areas such as the development of management accounting and financial reporting. 
There is a danger that the company’s needs would not justify su ch an 
appointment and that t he costs would outwe igh the benefits. The re 
is a danger that appointing an acc ountant or treasurer will pro ve a 
distraction from the basic busi ness of manufacturing and sellin g 
electronics if the appointee feels it necessary to table report s and 
ask the board to fine-tune financial decisions. 
It may be that J would be better advised to take on a part-time  
accountant rather than a full-time  treasurer. That would strike  a 
balance between the conflicti ng arguments for and against an 
appointment.

Chapter 9 
 377 
 (b) The first step is to define t he role clearly so that J can decide on the 
skills and experience tha t the treasurer will require. 
It would be worth appointing a recr uitment agency to assist wit h 
identifying suitable candidates . J’s board has no experience to  draw 
upon in identifying experts in th is area and so it would make m ore 
sense for the company to ask a specialist agency to produce a 
shortlist. 
The final interview should be con ducted by J’s directors. Even if the 
recruitment agency has shortlist ed a suitable candidate it is 
important that the board is satis fied that it can work with thi s 
individual. 
J should insist on s eeing a detailed CV and checking up on all 
references. The board will not rea lly be in a position to provi de 
detailed oversight of this indivi dual, which makes competence a n 
issue, and the appointee will be in a significant position of t rust with 
respect to J’s bank balances, which makes honesty important too . 
 
 (i) Add a discount to get the forward rate. 
Spot rate 1.5500  –  1.4500  
 0.0055   0.0050  
Forward rate 1.5555  –  1.4550  
(ii)  Subtract a premium  to get the forward rate. 
Spot rate 1.7150 – 1.6450 
Subtract premium (0.0068)  (0.0075) 
Forward rate 1.7082 – 1.6375 
 
 GBP 1,275,500 (rounded) 
EEFS Ltd is expecting a receip t of USD, and therefore wishes to  buy 
GBP from the bank. The bank will s ell GBP high and therefore th e rate is 
1.5430 (current spot). The discoun t of 2.5c must be added to th e rate 
thus giving a rate of 1.5680. 
The GBP receipt is therefore USD2m ÷ 1.5680 = GBP 1,275,510

378  
 Note 
Subject:  Forward contract offer rate 
Dear Finance Director, The Chief Executive is correct  in stating that changes in the e xchange 
rate cannot be predicted with any c ertainty, but that does not mean that 
today’s rate is the best forecast  of the rate that will prevail  in three 
months’ time. The capital market s use differences in interest r ates to 
establish the anticipated rate between two currencies, which su ggests 
that there will be an observable difference in the interest rat es available 
on GBP versus USD which will expl ain the forward rate on offer.  The 
interest rate on USD is, presuma bly, higher at present, which i mplies that 
the USD is expected to weaken against GBP and so it is perfectl y 
realistic for the bank to offer an inferior rate for three mont hs compared to 
spot. 
The bank manager’s argument seems to take the question of the 
differential rates for granted . The fact that the offer is cons istent with 
market sentiments suggests that t here is a rational basis to ex pect the 
USD to decline. If the market rat e was unrealistic then there w ould be 
arbitrage opportunities that woul d enable market participants t o exploit 
the market’s pricing error and t hat market error would be corre cted very 
quickly. 
The Chief Executive’s argument t hat J should leave this positio n 
unhedged suggests that it is illogica l to pay a premium in retu rn for a 
reduction in risk. There is clear ly a possibility that J will e njoy an upside if 
the position if left unhedged and t he USD weakens by less than the 
amount anticipated by the bank’s  forward rate. The question is whether 
the associated possibility of a  loss outweighs the potential ga in. 
The fact that J has not taken the possibility of changing excha nge rates 
into account in pricing this sal e is irrelevant. J is going to receive USD 
15m regardless of the fact that  a higher price should have been  charged 
to reflect anticipated c hanges in the exchange rate.

Chapter 9 
 379 
 The company should borrow from  the bank just enough to end up owing 
exactly USD12,000 
• Amount borrowed = USD 12,000/1.06 = USD 11,321. 
They should convert this into GBP at spot 
• Converted amount = 11, 321/1.9990 = GBP 5,663. 
They should then invest this for 6 months in the UK 
• End up with 5,663 × 1. 05 = GBP 5,946 (fixed, certain sum) 
 
 DD Ltd 
(a) The money market hedge to pay  EUR in six months' time requi res 
DD Ltd to borrow in GBP, transla te to EUR and deposit in EUR. 
A payment of EUR1.3 million in six  months (only 1.25% interest)  will 
require a EUR deposit now of (EUR1,300,000 ÷ 1.0125) EUR1,283,951. This means that wit h a spot rate of 1.5050 the GB P 
loan will need to be GBP853,124. 
The loan of GBP853,124 will increas e over the six months to the  
date of repayment by 2.3% and will therefore be GBP872,746. 
The cost is therefore GBP872,746. 
(b) The forward contract will us e the six-month forward rate of  1.4895 
for buying EUR. 
The cost is therefore (E UR1,300,000 ÷ 1.4895) GBP872,776 
There is virtually no differenc e between the two methods. This is 
expected because any significant d ifference would mean that pro fit 
could be made simply by conver ting one currency into another.

380  
 Under an MMH the company would bo rrow EUR now, translate into GBP 
and deposit for six months. 
The borrowing would be EUR1,300,000 ÷ 1.02  EUR  1,274,510 This would translate now i nto 1,274,510 ÷  GBP 844,326 
1.5095 
By growth for interest for si x months this  GBP 857,413 
becomes 
Forward contract 
The forward contract would give: 
EUR 1,300,000 ÷ 1.5162 GBP 857,407 
 
 22 
USD 2,650,000/(1.9000 × GBP 62,500) = 2 2.32 contracts  
(rounded down to 22) 
 
 Dividing by the smallest GBP1/U SD rate gives the highest GBP r eceipt –
the premium is paid no matter w hat so it should be ignored for the 
purposes of determining whether  to exercise the option. 
Future spot USD 1.6000 
• Exercise the option. 
• USD 25m/USD1.5000 = GBP 16. 67m less GBP300,000 premium 
gives a net receipt of GBP 16.37m 
Future spot USD 1.4000 
• Abandon the option. 
• USD 25m/USD 1.400 0 = GBP 17.86m le ss GBP 300,000 premium 
gives a net receipt of GBP 17.56m

Chapter 9 
 381 
 The GBP received upon exerci se will be 3,000, 000/1.9700 = GBP 
1,522,843. 
The cost of the option will be 0.02 × 1,522,843 = USD 30,457. 
At spot this cost in GBP is 30,457/1.9500 = GBP 15,619. 
Therefore the net receipt wil l be 1,522,843 – 15, 619 = GBP 1,50 7,224 
 
 The answer is (D).  
A, B and C are stated as factors affecting option prices in the  Black – 
Scholes model 
 
(1 + r € )/(1 + r $) × Spot €/$ = Forward €/$ 
(1 + 0.05)/(1 + 0. 08) × 0.92 = 0.8944 
 
A bank buys high and sells low so  the appropriate spot rate is 1.6802. 
A premium should be deducted . 1.6802 – 0.0250 = 1.6552 
 
 Statements A and E are correct. 
Call: GBP 31,250 × USD 0. 0121 = USD 378.125 
Put: GBP 31,250 × USD 0. 0042 =  USD 131.25  
 
 The answer is (A) and (B).  
Exchange traded options are easier  to liquidate as there is an active, 
liquid secondary market. Both types  of option allow the holder to benefit 
from favourable movements.

382  
A and B would increase t he value of the option. 
C would decrease the value of t he option – but would not affect  its 
intrinsic value (difference bet ween the MV and the strike price ) 
 
 The answer is (B).  
All the others would reduce the value 
 
 The answer is (A), (B) and (D). 
Pooling is where the balances o f all subsidiaries are kept toge ther when 
considering interest rates and overdraft limits. It should redu ce interest 
payable, increase interest ear ned and prevent overdraft limits being 
breached. 
 
C and D would be used to  hedge a Kroner payment. 
A (selling options) is  not a hedging method. 
 
 (a) (i) The forecast hourly rat e is assumed to grow in line wi th the 
rate of inflation in the proposed host country. We assume that 
the inflation rate will remain constant for five years. 
Over five years, the inflation rate will compound by (1.047)5-1 
= 25.8%. The forecast hourly rat e is 2.75 RTD + 25.8% = 3.46 
RTD. 
We assume that the exchange ra tes will move in line with the 
differences in the interest rat es. We assume that those rates 
will remain constant. 
Over five years the rates wil l change as follows (1.09/1.05)5 = 
1.21. 
The exchange rate wil l be 1 BND = 2.50 × 1.21 = 3.025 RTD. 
The hourly rate in BND = 3.46/3.025 = 1.14 BND

Chapter 9 
 383 
 (ii) The first assumption is t hat wages will move in line with 
inflation in the host country. Giv en that prices are rising it 
seems likely that L will have to  pay more for wages. The actual  
rises that will be granted will va ry in accordance with the 
bargaining power of the employee s and so it is unlikely that th e 
actual rises will closely ma tch the rate of inflation. 
Given that L is a multinationa l operating in a developing 
country, it may have to pay ris es that exceed the rate of 
inflation in order to avoid  claims of exploitation. 
Interest rate parity suggests t hat the expected exchange rates 
will move very closely in line with the differential interest r ates. 
That does not mean that the ac tual rates will turn out in 
accordance with expectations. The governments of either country may decide to manage their interest rates in order to 
strengthen or weaken thei r exchange rates. 
(b) It could be argued that a kilo of fibre will cost a specifi c number of 
USD regardless of whether it is imported to the home country or  the 
host. Basic costing suggests that the value is irrelevant, part icularly 
when transportation does not affect pricing. 
Unfortunately, things are mor e complicated because L will be 
importing finished paper, which c ontains flax fibre, rather tha n flax 
fibre itself. Transfer prici ng arrangements will mean that the paper 
will have to be sold to L’s tradi ng subsidiary in the home coun try at 
the open market price for paper. Changes in the price of the 
underlying raw materials may not d irectly affect the market pri ce in a 
linear manner and so the price of  flax fibre could change the t axable 
profits in the two countries. 
(c) The most immediate problem i s that L will make its present 
employees redundant. That will undermine the company’s reputation. Customers may buy  their paper from other suppliers 
rather than be associated with L . The home government may also 
be concerned that L has exporte d jobs and may take sanctions 
against the company. It could, for example, grant contracts to other 
L will also come under suspicion  for operating in a developing 
country. Activists in the home c ountry may feel that L is explo iting 
badly paid workers in t he developing country. 
Even if such accusations are unfounded L may suffer responses 
ranging from negative press comm ent to demonstrations at its 
remaining locations.

384  
 (a) The margin requirement means  that S can write forwards wor th a 
maximum of EUR 100,000/15% = EUR 666,667. 
The USD value = 666,667 × 1.3004 = USD 866,934. 
S can write 866,934/ 125,000 = 6 contract s = USD 750,000. 
S will have to pay a margin o f USD 750,000/1.3004 × 15% = EUR 
86,512. 
If she deposited that sum for three months she would earn inter est 
of EUR 86,512 × 3% /4 = EUR 649. 
If her predictions prove accurate , the cost of closing out her position 
will be 750,000/1.350 = EUR 55 5,556 for th e USD 750,000. 
The counterparty’s cost will be 750,000/1.3004 = EUR 576,746. 
The overall position will be se ttled by a net payment of EUR 
576,746 – 555,556 – 649 = EUR 20,541in favour of S. 
(b) The most obvious risk is t he upside risk that she will earn  a 
significant return from her ab ility to identify an anomaly in t he 
market. If she is confident then she must compare the possibili ty of 
a capital gain of EUR 576, 746 – 555,556 = EUR 21,190 against th e 
opportunity cost of interest fo regone of EUR 649. This seems li ke a 
relatively small risk, provided S has not overstated the probab ility of 
success. 
The downside risk is that the gai n will not materialise and she  will 
have tied up her finances needlessl y. The market’s expectation is 
that the spot rate will match the rate implied by her future co ntract. 
The currency markets for the US D and the EUR are both highly 
visible and are the subject of intense scrutiny. It would possi bly be 
easier to develop better insights into smaller economies that d o not 
attract the same degree of st udy. The financial loss is very li mited in 
this case. 
It is possible that the USD wi ll strengthen further than the ma rket’s 
expectations, in which case s he will be faced with the prospect  of a 
loss when she closes out her pos ition. For example, if the USD 
strengthens to 1.2 then closing ou t her position will cost a ne t EUR 
576,746 – (750,000/1.2)  = EUR 48,254. In theory, this speculati ve 
loss could be substantial. In pra ctice, it is to be hoped that there will 
not be a massive movement of the EUR against the USD. 
There could be a problem if the exchange rates move against her  
because S may be required to depos it additional margin. The fac t 
that she could only write a whol e contract would mean that she will 
have some of her EUR 100,000 left to meet such a contingency, b ut 
her position may be abandoned if she canno t keep up with margin  
requests. 
The fact that the exchange require s margin deposits will indemn ify S 
against any default by the counterparty.

Chapter 9 
 385 
 (c) It would probably be difficult fo r S to exploit her expecta tions in any 
other way. She appears to be ba sed in the eurozone. She could 
borrow USD in order to finance a EUR deposit, which would yield  a 
profit when the USD loan was r epaid using weakened currency. 
Doing so would almost certainly i nvolve fairly disproportionate  
transaction costs. 
Borrowing and investing directly w ould also limi t her ability t o profit 
from her insight. Using a derivat ive such as a future makes it 
possible to gear up her position. If she borrowed, say, EUR 100 ,000 
worth of USD (to match her sav ings) then she would benefit from  a 
position worth that amount. She can create a pos ition with an 
exposure of USD 750,000 by inves ting only EUR 86, 512 in margin.  
Futures contracts make it possibl e for S to speculate via a reg ulated 
market, where the exchange will pr otect parties’ interests. Tha t 
would also make it relatively eas y to close out her position in  the 
event that she started to feel  uneasy about the prospects of 
success. 
Realistically, the downside is limited to the extent to which t he USD 
could strengthen. If she invested in  some other instruments, su ch as 
options, she could lose everything if the option expired out of  the 
money

386  
 USD Exposure 
As Marcus has a USD receipt (US D 69,000) and payme nt (USD 240,0 00) 
maturing at the same time (three months), it can match them aga inst 
each other to leave a net liabi lity of USD 171,000 to be hedged . 
(i) Forward market hedge 
Buy USD 171,000 three mont hs' forward at a cost of: 
USD 171,000/0.9520 = E UR179,622 payable in three months' time. 
(ii) Money market hedge 
The money market hedge to pay USD  in three months' time require s 
Marcus to borrow in EUR, transla te to USD and deposit in USD. 
A payment of USD 171,000 in three months (only 2.5% interest) w ill 
require a USD deposit now of (17 1,000 ÷ 1.025) USD166,829. This  
means that with a spot rate of  0.9830 the EUR loan will need to  be 
EUR 169,714. 
The loan of EUR 169,714 will increas e over the three months to the 
date of repayment by 3.25% and will therefore be EUR 175,230. 
The cost is theref ore EUR 175,230. 
In this case the money mar ket hedge is a cheaper option. 
AUD  Receipt  
Converting exchange rates to home currency 
EUR1/AUD Spot 0.5294 – 0.5285 Four months forward: 0.5126 – 0.5118 AUD 295,000 to be hedged. 
(i) Forward market hedge  
Sell AUD 295,000 f our months' forward at a cost of: 
AUD 295,000/0.5126 = E UR 575,497 receivable in four months' 
time 
(ii) Money market hedge  
The money market hedge to recei ve AUD in four months' time 
requires Marcus to borrow in AUD, translate to EUR and deposit in 
EUR. 
A receipt of AUD 295,000 in four mont hs (only 5.33% interest) w ill 
be balanced with a AUD loan now of (295,000 ÷ 1.0533) AUD 
280,072. This means that with a spot rate of 0.5294 the EUR 
deposit will need to be EUR 529,037. 
The deposit of EUR 5 29,037 will increase ov er the four months t o 
the date of repayment  by 3.83% and will t herefore be EUR 549,29 9. 
In this case, more will be received in euros under the forward hedge.

Chapter 9 
 387 
 Test your understanding 32 (Integration question) 
 Forward contract 
 
2,500,000
ሺ1.5851 –0.0164 ሻ = GBP 1,593,676 
 
Futures 
Time line 
 
Step 1: Set up – 30/11 
• Downside risk will be if GBP rises in value. 
• Bet that GBP will rise on futures market. 
• Buy March GBP futures 
• No. of contracts = 
 
USD 2.5m  
––––––––––  
USD 1.5796 = 25 ––––––––––  
GBP 62,500  
 
• Buy 25 March futures contracts @ USD 1.5796 
• Deposit margin= 
25 × USD 1,000
USD 1.5842= (GBP 15,781)

388  
 Step 3: Close out – 28/2 
• Futures profit: 
Difference = 1.6513 – 1.5796 = 0.0717. 
Profit = 0.0717 × 25 × 62,500 = USD 112,031 
+ margin returned (USD  25,000) = USD 137,031 
• Convert receipt & profit at spot = USD 2.5m + USD 137,031
USD 1.6510= GBP 1,597,233 
Net futures position (net o f initial margin payment) 
= GBP 1,597,233 – GBP 15,781 
= GBP 1,581,452 With benefit of hindsight, the  forward contract would have been  a 
better choice.

389 
C3: Recommend ways of 
 (c) Discuss interest rate risk 
• Operations and features of swaps, forward contracts, …. 
• Techniques for combining options  in order to achieve specific 
risk profile such as caps, collars and floors 
  Chapter 
10

Interest rate risk management 
390  
 
Interest rates 
Lending and depositing rates 
A bank will quote two interest rat es to a customer – a lending rate and a 
depositing rate. The lending rate  is always higher than the dep ositing rate 
because the bank wants  to make a profit. 
London Inter Bank Offer Rate (LIBOR) 
This is the interest at which a m ajor bank can borrow wholesale  short-term 
funds from another bank in  the London money markets. 
• There are different LIBOR rates  for different lengths of borro wing, typically 
from overnight to one year. 
• Most variable rate loans are lin ked to LIBOR and therefore a l oan at 
LIBOR + 2% (where LI BOR is 4.5%) would mean that the customer w ould 
pay interest at 6.5% on the loan. 
 
 LIBOR, LIBID and basis points 
 LIBOR  
Each top bank has its own LIBOR r ates, but an ‘official’ averag e of 
LIBOR rates is calcula ted each day by the Br itish Bankers Assoc iation. 
The LIBOR rates that it publishes , the BBA LIBOR rates, are use d as 
benchmark rates for some financial instruments, such as short-t erm 
interest rate futures.

Chapter 10 
 391 
 LIBOR is important b ecause London is the world's major money ma rket 
centre. However, other financial centres have similar benchmark  interest 
rates in their money market. For e xample, the banks of the euro zone 
produce an alternative benchmark rate of interest for the euro.  This is 
called euribor, but it is similar in concep t to euro LIBOR, wit h the only 
difference that the average rate  is calculated daily from data submitted by 
a completely different panel of banks. 
Most floating rate loans for com panies are linked to LIBOR. For  example, 
a company might borrow at 1.25%  above LIBOR. In the language of  the 
financial markets, 1% = 100 basis points , so a loan at 1.25% above 
LIBOR might be called a loan a t LIBOR plus 125 basis points. If  it pays 
interest every six months, the interest payable at the end of e ach period 
will be set with reference to t he LIBOR rate at the beginning o f the period. 
LIBID 
LIBID stands for the London Interbank  Bid Rate. It is less impo rtant than 
LIBOR, but you might come across it. LIBID is the rate of inter est that a 
top-rated London bank c ould obtain on short- term wholesale depo sits 
with another bank in the London money  markets. LIBID is always lower 
than LIBOR. 
2  Interest rate risk and its management 
The concept of interest rate ri sk was discussed in Chapter 1: ‘ Objectives’. Along 
with the risk to cash flow and/ or competitiveness, companies fa ce the risk that 
interest rates might change in value (upside risk as well as do wnside risk), and 
between the point when the comp any identifies the need to borro w or invest and 
the actual date when  they enter into the transaction. For examp le, a company 
might anticipate that they will need to borrow in the future bu t do not yet know 
exactly how much or when. If in t he interim, interest rates ris e the delayed 
decision will cause higher int erest payments in the future. 
 
 Compared to exchange rates, inter est rates are less volatile, b ut changes 
in them can still be substantial. 
 
The “term structure of interest r ates” provides an implicit for ecast (according to 
market expectations) that is not guaranteed to be correct but i s the most 
accurate forecast available. 
 
 Term structure of  interest rates 
 The “term structure of interes t rates” is the relationship bet ween interest 
rates or bond yields and differ ent terms or maturities. It is a lso known as 
a “yield curve”, and it plays a central role in an economy.  
The term structure reflects ex pectations of market participants  about 
future changes in interest rates  and their assessment of moneta ry 
policy conditions.

392  
In general terms, yields increase in  line with maturity, giving  rise to an 
upward-sloping yield curve i.e . bonds with longer  maturity date s tend to 
have higher yields (interest rates). 
In theory, the shape of the yield curve reflects expectations o f future 
interest rates. A borrower who requires a ten-year loan might b e tempted 
by the possibility of taking ou t a succession of one-year loans  if short-
term debt is cheaper. The market's  expectation is that the over all cost of 
the debt would be the same in ei ther case (ignoring transaction  costs). 
The one-year rates can  be expected to increase in a manner that  means 
the average interest would be the same as that on a ten-year lo an. 
 
Just like currency risk, inter est rate risk management techniqu es can be split 
between internal and external methods. 
 
3 Internal hedging 
Internal (or operating) hedging strategies for managing interes t rate risk involve 
restructuring the company's asse ts and liabilities in a way tha t minimises 
interest rate exposure. These include: 
• Smoothing – the company tries to maintain a certain balance between its 
fixed rate and floating rate borrowing. The portfolio of fixed and floating 
rate debts thus provide a nat ural hedge against changes in inte rest rates. 
There will be less exposure to t he adverse effects of each but there will 
also be less exposure to favour able movements in the interest r ate. 
• Matching – the company matches its asse ts and liabilities to have a 
common interest rate (i.e. loan and investment both have floati ng rates). 
• Netting – the company aggregat es all positions, both assets and liabili ties, 
to determine its net exposure.

Chapter 10 
 393 
 Marks and Spencer's funding and  interest rate hedging policy 
 The Group’s funding strategy is  to ensure a mix of financing m ethods 
offering flexibility and cost e ffectiveness to match the requir ements of the 
Group … Interest rate risk primar ily occurs with the movement o f sterling 
interest rates in relation to  the Group’s floating rate financi al assets and 
liabilities. Group policy for inte rest rate management is to ma intain a mix 
of fixed and floating rate borro wings. Interest rate risk in re spect of debt 
on the balance sheet is reviewed on a regular basis against for ecast 
interest costs and covenants. A number of interest rate swaps h ave been 
entered into redesignate fi xed and floating debt. 
4 External hedging 
To manage the risk of interest r ates moving bef ore an agreed lo an or deposit 
date, the following techniques can be used: 
 Over-the-counter (OTC) 
instruments Exchange traded 
'Fixing' 
instruments Forward rate agreements (FRA s) Interest rate futures 
'Insurance' 
instruments Interest rate guarantees (IRGs), 
(sometimes called caps/floors or options) Interest rate options 
'Fixing' instruments lock a com pany into a particular interest rate providing 
certainty as to the future cash  flow, whilst 'insurance' instru ments allow some 
upside flexibility in the intere st rate i.e. the company can be nefit from favourable 
movements but are protected  from adverse movements. 
OTC instruments are bespoke, tailo red products that fit the com panies’ needs 
exactly. Exchange traded instrum ents are ready-made and standar dised. 
These will be discussed in more detail in the following section s. 
5 Forward rate agreements (FRAs) 
 An FRA is a forward contract on an interest rate for a future s hort-term 
loan or deposit. An FRA can ther efore be used to fix the intere st rate on a 
loan or deposit starting at a date in the future. 
It is a contract relating to the level of a short-term interest  rate, such as three-
month LIBOR or six-m onth LIBOR. FRAs are normally for amounts g reater than 
GBP 1 million. 
 An important feature of an FRA is that the agreement is indepen dent of 
the loan or deposit itself. 
• It is about the rate of interest on a notional amount of principal (loan or 
deposit) starting at a future date.

394  
• The FRA does not replace taki ng out the loan (deposit) but rat her the 
combination  of the loan (deposit) and the FRA result in a fixed effective 
interest rate. 
Settlement of FRAs 
When an FRA reaches it s settlement date, t he buyer and seller m ust settle the 
contract. 
• If the fixed rate in the agreem ent (the FRA rate) is higher th an the 
reference rate (LIBOR), the buyer  of the FRA makes a cash payme nt to 
the seller. The payment is for th e amount by which the FRA rate  exceeds 
the reference rate. 
• If the fixed rate in the agreem ent (the FRA rate) is lower tha n the 
reference rate (LIBOR), the selle r of the FRA makes a cash paym ent to 
the buyer. The payment is for th e amount by which the FRA rate is less 
than the reference rate. 
Setting up the hedge 
Hedging is achieved by a combinat ion of an FRA with the ‘normal ’ loan or 
deposit. 
• Borrowing (hence concerned about i nterest rate rises) 
The firm will borrow the required sum on the target date and wi ll thus 
contract at the market int erest rate on that date. 
Previously the firm will have bought a matching FRA from a bank or other 
market maker and thus receive  compensation if rates rise. 
• Depositing (hence concerned about a fall in interest rates) 
The firm will deposit the required sum on the target date and w ill thus 
Previously the firm will have sold a matching FRA to a bank or other 
market maker and thus receive  compensation if rates fall. 
In each case this combination effectively fixes the rate. 
Terminology 
In the terminology of the markets , an FRA on a notional three-m onth 
loan/deposit starting in five mont hs’ time is called a ‘5–8 FRA ’ (or ‘5v8 FRA’). 
Pricing 
FRA's will be priced according to  the current bank base rate an d future 
expectations of its movements. T he bank will try to predict the  interest rate at 
the date of inception of the borrowing and over its duration, a nd add on a profit 
margin. The bank will expect to m ake a profit for the risk they  are taking in 
lending a company money and ther efore any FRA will be priced at  some 
amount above the base rate for a borrower. The amount above the  base rate 
will depend on several factors in cluding the banks attitude to their estimated 
interest rate (how sure they are  in their prediction) and also the reputation of the 
company they are lending to.

Chapter 10 
 395 
 Illustration of hedging using FRAs 
 A company wishes to borrow GBP 10 million in six months' time for a 
three-month period. It can norma lly borrow from its bank at LIB OR + 
0.50%. The current three-month LI BOR rate is 5.25%, but the com pany is 
worried about the risk of a sharp ri se in interest rates in the  near future. 
A bank quotes FRA rates of: 
3 v 9: 5.45 – 5.40 %  6 v 9:  5.30 – 5.25% 
Required: 
(a) How should the company est ablish a hedge against its intere st rate 
risk using an FRA? 
(b) Suppose that at settlement dat e for the FRA, the LIBOR refe rence 
rate is fixed at 6.50%. What will be the effective borrowing ra te for 
the company? 
Solution: 
(a) The company wants to fix a borrowing rate, so it should buy  an FRA 
on a notional principal amount o f GBP 10 million. The FRA rate is 
for a 6 v 9 FRA, and the FRA ra te is therefore 5.30% (you will have 
to buy from the bank at the higher r ate – remember the bank alw ays 
wins!). 
(b) At settlement date interest r ates have risen and the refere nce rate is 
higher than the FRA rate. The FRA will therefore be settled by a 
payment to the FRA buyer of 1.20% (6.50% – 5.30%). 
 %  
Actual interest rate on th ree-month loan (7.00) 
(LIBOR + 0.50%)  Gain on FRA 1.20 
 
––––– 
Effective interest cost (5.80) 
 ––––– 
This effective interest cost is  the FRA rate of 5.30% plus the 0.50% 
margin above LIBOR t hat the company must pay  on its borrowing.

396  
 It is 30 June. A company needs a $10 million 6 month fixed rat e loan from 
1 October which it intends to hedge using a forward rate agreem ent 
(FRA). The relevant FRA rate is 6% on 30 June. 
Required: 
What would the net payment on t he loan be if interest rates ros e to 9% by 
1 October? 
 
 Test your understanding 2 – Coope r Co – 1 (Integration question ) 
 It is 31 October and Cooper Co is  arranging a six-month $5 mil lion loan 
commencing on 1 July, based on LIBOR. Cooper wants to hedge aga inst 
an interest rate rise using an FRA. The current LIBOR is 8%. 
Required: 
(a) evaluate the use of the FRA if LIBOR turned out to be 9% on  1 July. 
(b) re-evaluate the FRA if  LIBOR on 1 July was 5%. 
6 Interest rate guarantees (IRGs) 
 Interest rate guarantees are opti ons on FRAs so the treasurer h as the 
choice whether to exercise or not. 
IRGs are sometimes referred to as interest rate options  or interest rate 
caps/floors . 
They are over-the-counter instru ments arranged directly with a bank and have a 
maximum maturity of one year. 
A company wishing to borrow  in the future could hedge by buying  an FRA so 
would need an IRG that provides a call option on FRAs. 
A company wishing to deposit in the future could hedge by selling an FRA so 
would need an IRG that provides a put option on FRAs. 
The company would only exercise  the option to protect against a n adverse 
interest rate movement.

Chapter 10 
 397 
 Decision rules 
 
IRGs are more expensive than t he FRAs as one has to pay for the  flexibility to 
be able to take advantage o f a favourable movement. 
 
 Test your understanding 3 – Coope r Co – 2 (Integration question ) 
an interest rate rise using an  IRG. The current LIBOR is 8%. 
The IRG fee is 0.25% p.a. of the loan. 
Required: 
(a) evaluate the use of the IRG i f LIBOR turned out to be 9% on  1 July. 
(b) re-evaluate the IRG if  LIBOR on 1 July was 5%. 
7 Interest rate futures (IRFs) 
 IRFs are similar in principle to  forward rate agreements in tha t they give a 
commitment to an interest rate for a set period. 
They are tradable contracts and oper ate for set periods of thre e months, and 
terminate in March, June, S eptember and December. 
As with currency futures, the futures position will normally be  closed out for 
cash and the gain or loss will be used to offset changes in int erest rates. 
There are two types of IRFs 
 
(Note:  These notes concentrate on STIR s which are more common.)

398  
The future operates by the cust omer making a commitment to effe ctively 
deposit or borrow a fixed amount o f capital at a fixed interest  rate. The notional 
sterling deposit/loan on the LI FFE (London futures exchange) is  GBP 500,000. 
Pricing 
The future is priced by deducting  the interest rate from 100. 
• if the interest rate is 5% the  future will be priced at 95.00.  
• the reason for this is that if i nterest rates increase, the va lue of the future 
will fall and vice versa i f interest rates reduce. 
Gains and losses  on STIRs are calculated by ref erence to the interest rate at 
the date of close out. The differ ence between the futures price  at inception and 
close will be the gain or loss. 
Futures hedging calculations 
Companies can hedge using futures by buying or selling a number  of futures 
contracts that cover a  loan period and value. 
• Most companies use futures to hedge borrowings  and therefore hedge 
against an increase in the interest rate. 
• To do this the company sells futures . 
IRFs are complicated by a num ber of factors including: 
• Contract sizes and standard c ontract lengths (3 months). 
• Margins/deposits payable  at the start of the hedge. 
• Speculators – who dom inate the market. 
 
 More information on hedging with IRFs 
 Hedging against the risk of a ri se in interest rates with STIRs  
If a company plans to borrow short-term  in the future and wants to 
create a hedge against the risk of a rise in interest rates bef ore then: 
• It should set up a position with  futures that will give it a p rofit if 
interest rates go up. The profi t from futures trading will offs et the 
higher interest cost on the loan , when it is eventually taken o ut. 
• On the other hand, if the intere st rate goes down, the effect of the 
hedge will be to create a loss on t he futures position, so that  the 
benefit from borrowing at a lower i nterest rate on the actual l oan, 
when it is taken out, will be offs et by the loss on the futures  position. 
This hedge is created by selling  short-term interest rate futures.

Chapter 10 
 399 
 The futures position should be closed  when the actual loan period 
begins, by buying an equal number of futures contracts for the same 
settlement date. 
• If interest rates have gone up, t he market price of futures wil l 
have fallen.  A profit will be made from fu tures by having sold at one 
price to open the position and t hen buying at a lower price to close 
the position. The prof it should offset the increased interest r ate. 
• If interest rates have gone dow n, the price of futures will hav e 
risen.  A loss will be made from futures  by having sold at one price 
to open the position and then buy ing at a higher price to close  the 
position. The loss should offse t the lower interest rate. 
The company should have eliminat ed any downside or upside risk,  and 
be paying the interest rate it wanted. 
 
 Global Inc wishes to borrow $9, 000,000 for one month starting in 
5 weeks’ time. The base rate of in terest is currently 3% and th e treasurer 
of Global decides to fix the rate  by selling interest rate futu res at 96.90. 
The market rate subsequently ris es by 25 basis points to 3.25%.  As soon 
as the loan is agreed, the treasur er closes out Global’s positi on by buying 
a matching number of c ontracts at 96.65. 
Required: 
(a) Calculate the number of contract s required (Note: One 3-month 
contract is for $1,000,000).  
(b) Demonstrate that, in this case, the gain on the futures 
contracts exactly matches the extra interest on the loan. 
 
 Assume that today is the 31st of January. 
A company is going to borrow $2, 000,000 in two months' time for  a period 
of three months. It fears that  the current interest rate will r ise from its 
current level of 5%, so it wants to use $500,000 3-month intere st rate 
futures to hedge the position. 
Data from the futures market: 
March futures price = 94.90 June futures price = 94.65 
Required: 
Calculate the result of the re levant futures hedge on the assum ption 
that interest rates have risen to 7% and the futures price has moved 
to 93.00 in two months' time.

400  
 Imperfect hedge with IRFs 
 One problem is that  futures are for a standard size  of contract, whereas 
the amount of the loan or depos it to be hedged might not be an exact 
multiple of the amount of the futu re contract’s notional deposi t.  
For example, suppose that a company wishes to hedge against the  risk 
of a rise in the three-month LI BOR rate for a three-month loan of USD 
9,250,000. Futures could be sold  to hedge the expos ure, but the  number 
of contracts sold would have to be either 9 or 10 (notional dep osit = USD 
1 million per contract). How ever, the unhedged amount is likely  to be 
small (perhaps immaterial) in c omparison to the hedged amount. 
A second problem is the existence of basis risk : the future rate (as 
defined by the future prices) mov es approximately but not preci sely in line 
with the cash market rate. 
The current futures price is us ually different from the current  ‘cash 
market’ price of the underlyin g item. In the case of interest r ate futures, 
the current market price of an in terest rate future and the cur rent interest 
rate will be different, and will onl y start to converge when th e final 
settlement date for the future s contract approaches. This diffe rence is 
known as the ' basis '. 
market (arbitrage). 
between the futures price at clo se-out and the current market p rice of the 
underlying item. In other words , there will still be some basis . 
 
 FRAs vs. STIRs 
 Short-term interest rate future s are an alternative method of h edging to 
FRAs. They have a number of similarities. 
• Both are binding forward contra cts on a short-term interest ra te. 
• Both are contracts on a not ional amount of principal. 
• Both are cash-settled at the start of the notional interest pe riod. 
FRAs have the advantage that they  can be tailored to a company’ s exact 
requirements, in terms of amount o f principal, length of notion al interest 
period and settlement date. 
However, futures are more flex ible with regard to settlement, b ecause a 
position can be closed  quickly and easily at any time up to set tlement 
date for the contract. 
Given the efficiency of the financ ial markets, the difference b etween the 
two in terms of effective interes t rate is unlikely to be large .

Chapter 10 
 401 
 Hedging with bond futures 
 Bond futures might be used to hedge t he risk of a change in the pric e of 
bonds over the next few months. T hey can be particularly useful  to bond 
investors for hedging against the risk of a rise in long-term i nterest rates 
and a fall in bond prices. 
Suppose that an investment insti tution has a quantity of UK gov ernment 
bonds and its financial year- end is approaching. It would like to secure 
the value of its bond portfolio  and hedge against the risk of a  rise in long-
term interest rates and fall in bond prices over the next few m onths. 
It can do this with bond futures.  As with hedging with STIRs, a  hedge is 
constructed so that if interes t rates move adversely, an offset ting gain will 
be made on the bond futures positi on. For a bond investor, a he dge can 
be constructed whereby if inter est rates go up and bond prices fall, there 
will be a loss on the bond portfolio but an offsetting gain on the bond 
futures position. 
Bond futures fall in value wh en interest rates go up. For a bond 
investor, the required hedge is therefore to sell bond futures . If the 
interest rate goes up, both  the bonds and the bond futures will  fall in 
value. The futures position can be  closed by buying futures at a lower 
price than the original sale pr ice to open the position. The ga in on the 
futures position should match t he loss in the value of the bond s 
8 Exchange traded interest rate options 
The future and options market pr ovides a product that can cap i nterest rates for 
borrowers like an IRG. 
 
 This option gives its buyer the right to buy or sell an interes t rate future, at 
a specified future date at a fix ed exercise rate, i.e. to effec tively have the 
'right to bet' on an interest rat e increase as shown on the fut ures market. 
 
Because they are an option as opposed to a commitment, they req uire the 
option holder to pay the writer of the option a premium.  
The characteristics of an option are: 
• They can fix the interest amount , or can be allowed to lapse t o take 
advantage of a favourable movement in interest rates. 
• They are for a given interest period (e.g. six months) startin g on or before 
a date in the future. 
(Note:  Interest rate options are only options on interest rates and n ot an option 
to take a loan. The loan is taken quite independently of the op tion.)

402  
Given that these are options to buy or sell futures, all the fu tures information is 
still valid, for example: 
• The standard size of the contra cts, i.e. GBP 500,000, USD 1,00 0,000, etc. 
• The duration of the contract , i.e. 3 month contracts. 
• Maturity dates end of March, J une, September and December. 
(Standard contracts are only  for exchange traded options. It is  possible to 
purchase a bespoke option – vari able contract sizes and dates, provided a 
willing counterpar ty can be found.) 
A call option gives the holder the right to buy the futures contract. 
A put option gives the holder the right to sell the futures contract. 
You always buy the opt ion – buy the right to buy or buy the rig ht to sell. 
 
 It is 4 July. A company needs to  deposit GBP 5 million for 6 m onths from 
1 November and, to limit interes t rate risk exposure, intends t o hedge 
using options on short term int erest rate futures (STIRs). The notional 
sterling deposit/loan fo r STIRs is GBP 500,000. 
Which of the following statemen ts is/are true? (Select all that  apply) 
A The company will nee d 10 options contracts 
B The company will nee d 20 options contracts 
C The company will nee d 5 options contracts 
D The company will need put options 
E The company will need call options

Chapter 10 
 403 
 It is now the 31st of August. 
Tolhurst Co needs to borrow $10m in  1 month's time , for a 6 mon th 
period. The current marke t interest rate is 5%. 
The following information is ava ilable regarding $500,000 3-mon th 
September interest rate options: 
Exercise price Call Put 
94.75 1.02 0.18 
Premia are quoted in %. 
Required: 
Calculate the result of the optio ns hedge if the interest rate has 
risen to 7.5% and if the Septemb er futures price has moved to 9 2.50 
in one month's time. 
Collars 
• Premiums can be reduc ed by using a collar. 
• Simultaneously buying a put and selling a call option creates a collar, 
hence a cap and floor is creat ed but premium is saved. 
• F o r  e x a m p l e  
 %  Cap at 5.75%, pay a premium (0.77) Floor at 5.25%, receive a premium 0.16 
 
–––– 
Net cost (0.61) 
 –––– 
 
• The premium saved comes at the expense of giving up the benefi ts of any 
interest rate falls below the floor value. 
 
 More on collars 
 • A company buys an option to pro tect against an adverse movemen t 
whilst allowing it to take advant age of a favourable movement i n 
interest rates. The option will be more expensive than a future s 
hedge. The company must pay for the  flexibility to take advanta ge of 
a favourable movement. 
• A collar is a way of achieving some flexibility at a lower cos t than a 
straight option.

404  
 • Under a collar arrangement, the company limits its ability to take 
advantage of a favourable movemen t. It buys a cap (or ceiling) by 
buying the right to sell (a put option) as normal but also sell s a floor 
(by selling the right to buy - a c all option) on the same futur es 
contract to a counterparty, but wit h a different exercise price . 
• The floor sets a minimum cost f or the company. The counterpart y is 
willing to pay the company for th is guarantee of a minimum inco me. 
Thus the company gets paid for limiting its ability to take adv ance of 
a favourable movement if the in terest rate falls below the floo r rate. 
The company does not benefit ther efore the counterparty does. 
 
• It involves a company arranging both a minimum and a maximum 
limit on its interest rates pay ments or receipts. It enables a company 
to convert a floating rate of interest into a semi-fixed rate o f interest.

Chapter 10 
 405 
9 Swaps 
Introduction to swaps 
Swap  – a contract to exchange payments of some sort in the future. (CIMA 
Swaps can be used to change the inte rest rate or currency profi le of borrowings 
(e.g. fixed to floating and EUR  to GBP borrowings) in line with  capital structure 
targets and to manage risk. 
When considering what kind o f debt finance should be used, risk , cost and 
practicality will be ke y considerations. 
Examples 
• Interest rate swap  
–  It might be cheaper for a co mpany to issue a bond plus enter  a swap 
to change the interest profile t han raise floating rate bank bo rrowings 
directly. In this case an intere st rate swap is being used to a lter the 
interest rate profile of the borrowings from fixed to floating rates. 
• Cross currency swap  
–  In some cases where a com pany requires foreign currency 
borrowings, it may be easier and cheaper to raise funds in its own 
local currency and, at the same  time, enter into a swap to chan ge the 
currency profile to the required currency. In this case, the en tity could 
use a borrowing in its own curr ency and a cross currency swap t o 
access the foreign currency funds. 
–  In other cases, it may be c heaper for a company to borrow in  a global 
currency such as USD or EUR and  then use a cross currency swap 
to change the currency profile to  the home currency or a second  
foreign currency. 
–  A common example of a cross currency swap is that of a paren t 
company raising finance in a popul ar global currency (e.g. USD or 
EUR) and then swapping that into different currencies to lend o n to 
foreign subsidiaries which requi re borrowings denominated in th eir 
own currencies. Even GBP com panies may find it cheaper to issue  
bonds in EUR and then swap back into GBP. 
Interest rate swaps 
 
 An interest rate swap is an agr eement whereby two parties agree  to swap 
a floating stream of interest pay ments for a fixed stream of in terest 
payments and vice versa. There is  no exchange of principal. 
• In practice interest rate swaps  are probably the most common f orm of 
interest rate hedge used by com panies because they can hedge 
borrowings of anywhere between a  year and 30 year s and therefor e can 
be used for long-term borrowings.

406  
• In our syllabus we only consider  the 'plain vanilla' swap of f ixed or floating 
rate (or vice versa) without any  complications that can occur i n practice. 
• Banks act as swap counterparties. 
• There is a large and liquid mark et in swaps in major currencie s and banks 
will quote bid/offer rates agains t a reference rate such as 6 m onth LIBOR 
or 12 month LIBOR. 
Note:  LIBOR (the London Interbank Offer ed Rate) is the most widely u sed 
benchmark or reference rate for s hort-term interest rates world wide, although 
the swap could relate to Euribor, say. 
Calculations involving the bank's quoted swap rates 
In practice a bank normally a rranges the swap and will quote th e following: 
• The ‘offer rate’ at which the bank is willing to receive a fix ed interest cash 
flow stream in exchan ge for paying LIBOR. 
• The ‘bid rate’ that they are willing to pay in exchange for re ceiving LIBOR. 
• The difference between these gi ves the bank’s profit margin an d is usually 
at least 2 basis points. 
Alternatively, in an exam questi on you might be given the two r ates (without any 
reference to the bid/offe r terminology) as follows: 
XX Bank's swap rates are 3.00% –  3.10% against 12 month LIBOR.  
In order to decide which is the appropriate rate to use in a gi ven situation, 
always remember that the bank wi ll have set the swap rates to e nsure that it 
makes a profit margin. 
So in this example, if a company  wanted to pay a fixed rate to the bank in 
exchange for a receipt of the LIBOR rate (to  swap a floating ra te into a fixed 
rate), 3.10% would be paid by the company to the bank. 
Alternatively, if a company wanted  to pay LIBOR rate in exchang e for a fixed 
receipt (to swap a fixed rate i nto a floating rate), only 3.00%  would be paid by 
the bank to the company. 
Diagrammatic example

Chapter 10 
 407 
So, considering the numerical exa mple above in the context of t he diagram: 
• Company D wants to swap a fixed rate to a floating rate, so wo uld pay 
LIBOR to the bank in exchange for 3.00% 
• Company E wants to swap a floa ting rate to a fixed rate, so wo uld pay 
3.10% to the bank in exchange for LIBOR 
• The bank would make a profit by setting up swaps with both Com pany D 
and Company E, because the LIBOR payments net off, and the fixe d rate 
received by the bank is bigger t han the fixed rate paid. 
 
 Test your understanding 8 (Integration question)  
 Company A can borrow at a fixed ra te of 5% or at a floating ra te of 
LIBOR + 12 bas is points. 
Swap rates are 4.90 – 4.95 against 12-month LIBOR. 
Required : 
What is the cheapest way for the company to obtain floating rat e finance? 
The interest fixing date and the  interest cash flows in an inte rest rate 
swap 
In the above Illustration, we s howed the net interest rate that  would be paid by 
Company A in the swap arrangemen t, but exam questions might als o ask you to 
calculate the interest cash flows. 
In the case of Company A in the  Illustration above, the net int erest rate was 
LIBOR + 0.10%, so clearly the over all interest cash flow would be calculated by 
applying the actual LIBOR rate pl us 0.10% to the value of Compa ny A's 
However, it is important to not e that the LIBOR rate will fluct uate daily, so in 
order to work out the interest cas h flows in a swap, an 'intere st fixing date' is 
agreed when the swap is set up, and it is the LIBOR on this fix ing date that is 
used in the calculation. 
Generally the interest fixing dat e is the start date of the swa p period. 
 
 Spray Co has a $10 million fix ed rate borrowing. It has entere d an 
interest rate swap to swap the interest to a floating rate for a three year 
period. 
The bank has quoted a swap rate o f 4.10% for LIBOR, with intere st fixing 
dates on the start date of eac h year of the swap agreement. 
Spray Co's fixed rate of interest is 4.40%. LIBOR on the start date of year  2 of the three year swap agreem ent was 
4.25%, but this had risen to 4.58%  by the end of year 2 (12 mon ths later). 
What is the difference in Spray  Co's overall net interest paid in the 
year (year 2 of the swap agreeme nt) as a consequence of using t he 
swap?

408  
A  $15,000 saving 
B $15,000 extra cost  
C $18,000 extra cost  D $48,000 extra cost 
Advantages of using in terest rate swaps 
• To manage fixed and floating rate  debt profiles without having  to change 
underlying borrowing. 
• To hedge against variations in in terest on floating rate debt,  or conversely 
to protect the fair value of fi xed rate debt instruments. 
• A swap can be used to obtain cheaper finance. For example, it may be 
cheaper to obtain floating rate  finance by, say, issuing a bond  and 
swapping into a floating rate r ather than borrowing at floating  rate directly 
from a bank. 
Disadvantages of using interest rate swaps 
• Interest rates may change in the  future and the company might be locked 
into an unfavourable rate. 
• Creditworthiness of the bank –  the company and the bank arrang e to 
make payments to each other for  a fixed period. The company mus t 
therefore be confident about the creditworthiness of the bank b efore 
signing up to the swap. 
 
 Ocean Co has a $5 million float ing rate borrowin g at a rate of  LIBOR + 
0.50%. 
The directors have set up a swap , to fix the company's interest  rate for a 
period of three years, from 1 Janu ary 20X0 to 31 December 20X2.  
The bank's quoted swap rates are 3.80% – 4.00% for LIBOR, with 
interest fixing dates on the star t date of each year of the swa p 
agreement. 
LIBOR information: 
• LIBOR on 1 January 20X1 was 4.10% 
• LIBOR on 1 July 20X1 was 4.05% 
• LIBOR on 31 Decemb er 20X1 was 3.75% 
What was the difference in Ocean Co's overall net interest paid  in 
the year 20X1 as a conse quence of using the swap? 
B  $5,000 saving C  $2,500 extra cost D  $12,500 extra cost

Chapter 10 
 409 
Cross currency swaps 
bank. 
Characteristics of a cross currency swap 
• In effect a cross curren cy swap has two elements: 
–  An exchange of principals in d ifferent currencies, which are  swapped 
back at the original spot rate. 
–  An exchange of interest rat es – the timing of these depends on the 
• The swap of interest rates coul d be ‘fixed for fixed’, 'floati ng for floating' or 
‘fixed for floating’ 
• The company entering the cro ss currency swap will end up with the 
currency it needs and also the ty pe of interest rate it prefers  (fixed or 
floating). 
 
 Test your understanding 11 (Integration question)  
 ABC Co is a US company that has  issued a 100 million Swiss Fra ncs 
(CHF) Eurobond on which it pays interest six-monthly at an annu al fixed 
rate of 6%. 
ABC Co has many operations in t he USA, so wants to swap its CHF  into 
US dollars (USD) using a fixed  for fixed cross currency swap. 
ABC Co's bank has quoted a cross currency swap exchange rate of  
CHF/USD 1.10 (that is, CHF 1 = U SD 1.10), and fixed interest ra tes of 
5.5% on USD in exchange for 6% on CHF, with interest payable se mi-
annually (that is, every six months). 
Required: 
Show how the fixed for fixed cr oss currency swap would work in the 
circumstances described, assumi ng the swap is only for one year  and 
that interest is paid every six months. 
 
 Smiths Co is a UK based compan y that has borrowed 10 million B ritish 
pounds (GBP) at a fixed interest r ate of 5.25% per year, with i nterest paid 
annually. 
The company is planning to expa nd into Europe so wants to swap GBP 
10 million for Euros (EUR), and its  fixed interest rate for a f loating rate. 
The bank has quoted a cross curr ency swap exchange rate of GBP/ EUR 
1.30 (that is, GBP 1 = EUR 1.30) and interest rates of LIBOR + 0.50% on 
EUR in exchange for 5.25% on GBP, with interest paid annually.

410  
Assume that LIBOR is 5% at the start date of the swap.  
Required: 
Show how the fixed for floating cross currency swap would work in the 
that interest is paid at the end of the year. 
Advantages of using cr oss currency swaps 
• A cross currency swap is a usefu l tool for changing the curren cy profile of 
debt. 
• This may help reduce interest costs where debt can be raised m ore easily 
or at a competitive rate in a se cond currency and it proves to be cheaper 
or easier overall to borrow in  one currency and simultaneously enter into a 
swap to change the currency profile  into another currency or se veral 
different currencies as required. 
• Cross currency swaps may also  be used as part of a broader str ategy for 
managing currency risk. For examp le, by obtaining foreign curre ncy 
borrowings to on-lend to foreign subsidiaries denominated in th eir local 
Disadvantages of using cross currency swaps 
• The main disadvantage is that, as in an interest rate swap , t here is a risk 
that the other party to the contra ct might default on the arran gement. This 
is an even greater risk for cr oss currency swaps because: 
–  the cash flows are in differ ent currencies (and hence there can be no 
agreement to net them as there c ould be for interest rate swaps ), 
AND 
–  final principals are exchanged (again, unlike interest rate swaps). 
10 End of chapter objec tive test questions 
 
 Borrowers will wish to hedge aga inst an interest rate rise by: 
A Selling futures now and selli ng futures on the day that the i nterest 
rate is fixed 
B Selling futures now and buyi ng futures on the day that the in terest 
C Buying futures now and selling  futures on the day that the in terest 
D Buying futures now and buying  futures on the day that the int erest 
rate is fixed

Chapter 10 
 411 
 It is 24 May. A company needs to borrow GBP 20 million for 9 m onths 
from 1 December and, to limit int erest rate risk exposure, inte nds to 
hedge using short term interest ra te futures (STIRs). The notio nal sterling 
deposit/loan for STIRs is GBP 500,000. 
Which of the following statements is/are true? (Select all that  apply) 
A The company will need 240 futures contracts 
B The company will need 120 futures contracts 
C The company will need 40 futures contracts 
D The company will set up  the hedge by buying futures 
E The company will set up  the hedge by selling futures 
F The futures hedge will eliminate all interest rate risk for t he company 
 
 An option whereby the lender set s a maximum and minimum intere st rate 
simultaneously is called: 
A A cap B A floor C A collar D An interest rate guarantee 
 
 Company A can borrow at 6% fixed or LIBOR + 0.2% variable and would 
like a variable rate. Company B c an borrow at 6.5% fixed or LIB OR + 
0.4% variable and woul d like a fixed rate.  
If the companies agree to share t he differential equally, what is A’s 
effective loan rate? 
A 5.70% 
B 5.85% C LIBOR + 0.35% D LIBOR + 0.05% 
 
 Which of the following is an in ternal hedging technique? (Selec t all 
B Netting C Smoothing 
D Matching

412  
 An interest rate derivative char acterised by being available fo r any 
amount, redeemable on any date, pay ment on settlement and trade d 
over the counter, is called: 
A An interest rate swap 
B A forward rate agreement C An interest rate future D An interest rate option 
 
 In relation to interest rate hedging, which of the following 
statements is correct? (Select all that are relevant) 
A The flexible nature of inter est rate futures means that they can 
always be matched with a specif ic interest rate exposure 
B Interest rate options carry an obligation to the holder to co mplete the 
contract at maturity 
C Forward rate agreements are t he interest rate equivalent of f orward 
exchange contracts 
D Matching is where a balance is m aintained between fixed rate and 
floating rate debt 
 
 Brasil Co has a $10 million bo rrowing, on which it is currentl y paying a 
floating rate of LIBOR+0.55%. The directors are concerned that interest 
rates are going to rise, so they  are considering an interest ra te swap to 
manage the company's exposure to risk. 
The bank has quoted Brasil Co a s wap rate of 2.86% against LIBO R. 
What is Brasil Co's net payment if it enters the swap? 
A  LIBOR + 2.86%  
B  2.31% C  2.86% D  3.41%

Chapter 10 
 413 
 Mouse Co has a $10 million borro wing on which it pays interest  at a fixed 
rate of 4.35%. 
The company's directors predic t that interest rates will fall o ver the next 
12 months, so they want to use an interest rate swap to enable them to 
benefit from this predicted movement. 
The bank is quoting swap rates o f 4.19% – 4.29% against 12 mont h 
LIBOR. 12 month LIBOR is currently 4.04%. 
What will be Mouse Co's interest  payment at the end of the year , 
assuming that the company uses the swap and that LIBOR has 
fallen to 3.90% by the year end? 
A $396,000 
B $406,000 C $410,000 D $420,000

414  
11 End of chapter c ase style questions 
 Test your understanding 22 – IR h edging (Case style question) 
 Scenario 
Assume you are the Treasurer o f AB, a large UK based engineerin g 
company, and that it is now May 20X4. 
Trigger 
You have forecast that the company  will need to borrow GBP 2 mi llion by 
the end of September 20X4 for at least 6 months. The need for f inance 
will arise because the company  has extended its credit terms to  selected 
customers over the summer period . The company’s bank currently 
charges customers such as AB 7. 5% per annum interest for short- term 
unsecured borrowing. However, you believe interest rates will r ise by at 
least 1.5 percentage points over  the next 6 months. You are con sidering 
using one of three alternativ e methods to hedge the risk: 
• forward rate agreements; or 
• interest rate futures; or 
• an interest rate guarantee (a borrower’s option or short-term cap). 
You can purchase an interest rat e cap at 7% per annum for the d uration 
of the loan to be guaranteed. You w ould have to pay a premium o f 0.1% 
of the amount of the loan. As part of the arrangement, the comp any will 
agree to pay a ‘floor’ rate of 6% per annum. 
Required: 
Prepare a briefing note to the Finance Director discussing the features of 
each of the three alternative methods of hedging the interest r ate risk and 
advise on how each might be usef ul to AB, taking all relevant a nd known 
information into account. 

Chapter 10 
 415 
 Test your understanding 23 – Gymbob (Case style question) 
 Scenario 
Gymbob plc is a national chain o f gyms listed on the UK Stock M arket. It 
was set up nearly twenty years ag o, and has 40 branches nationw ide 
each having essentially the same  facilities – a dry side includ ing a gym 
with running machines, cross trainer s, rowing machines and weig hts, and 
a wet side including a swi mming pool, sauna, spa pool, and stea m room. 
There are daily classes for both the wet and dry side activitie s, held by 
various full-time and freelance instructors. 
Trigger 
The directors of Gymb ob have heard of a riv al gym chain being p ut up for 
sale for GBP 20 million. Gymbob w ould be very keen to acquire t heir 
competitor, since the gyms are  well patronised and in locations  that 
complement Gymbob’s current por tfolio. Gymbob would be able to raise 
most of the purchase price in c ash or by liquidat ing investment s, but 
would still need to borrow GBP 5 million. It is anticipated tha t, all going 
well, they would need to borrow t he GBP 5 million in 3 months’ time for 
only a one-year period. Current i nterest rates are 7% for this type of loan, 
and Gymbob’s directors would no t want to pay more than this sin ce they 
have other commitments. They are c onsidering the use of a forwa rd rate 
agreement, interest rate future o r an interest rate option. 
Required: 
Prepare an email to the finance di rector explaining how each of  the three 
interest rate hedging alternativ es might be useful to Gymbob. 

416  
 Test your understanding 24 – Sw aps (Case style question) 
 You are contacted by AB’s bank  and informed that another of th e bank’s 
clients, a smaller company in t he same industry, is looking for  a swap 
partner for a similar amount of bo rrowing for the same duration . The 
borrowing rates applicable to AB and RO are as follows: 
 Floating Fixed  
AB LIBOR + 0.3% 7.5% 
R0 LIBOR + 0.5% 8.5% 
Required: 
Prepare a briefing note to  the finance director: 
(a)  Commenting briefly on why swaps may be used. 
(b)  Recommending how the two companies could co-operate in a s wap 
arrangement to their mutual benef it, including the option of ch anging 
the type of loan normally prefe rred. Support your recommendatio n 
with appropriate calculations. 
(c)  Discussing the advantages and disadvantages of arranging a  swap 
through a bank rather than negotiati ng directly with a counterp arty. 

Chapter 10 
 417 
 Test your understanding 25 – QW (Case style question) 
 Scenario 
You are the treasurer of QW plc, a company with diversified, in ternational 
interests. The company wishes to  borrow GBP 10 million for a pe riod of 
three years. Your company’s cre dit rating is good, and current market 
data suggests that you could borro w at a fixed rate of interest  of 8% per 
annum or at a floating rate of L IBOR + 0.2% per annum. You beli eve that 
interest rates are likely to f all over the next three years, an d favour 
borrowing at a floating rate. 
Trigger 
Your company’s bankers are current ly working on raising a three -year 
loan for another of their customer s, ER plc. This company is sm aller and 
less well known than QW plc, and its credit rating is not as hi gh. ER plc 
could borrow at a fixed rate of 9.5% per annum or a floating ra te of 
LIBOR + 0.5%. ER plc has indicat ed to the bank that it would pr efer a 
fixed-rate loan. Your bankers ha ve suggested you engage in a sw ap 
which might benefit both compani es. The bank’s commission would  be 
0.2% of the benefits to the two parties. Your counterpart in ER  plc 
suggests that the commission fees  and swap benefit s should be s hared 
equally. 
Assume that interest is paid a t the end of each twelve-month pe riod of 
the loan’s duration and that the principal is repaid on maturit y (i.e. at the 
end of three years). 
Required: 
Write a report to the board which: (i)  describes the characteri stics and benefits of interest rat e swaps 
compared with other forms of in terest rate risk management, suc h 
as forward-rate agreements and interest rate futures. 
(ii)  explains the course of ac tion necessary to implement the swap 
being considered with ER plc, and  calculates and comments on th e 
financial benefits to be gained from the operation. 

418  
 $300,000 
• At 9% the company will pay $450, 000 (9% × $10 million × 6/12).  
• The FRA receipt will be $150,000 ($10 million × (9 % – 6%) × 6/ 12) 
• Net payment $450, 000 – $150,000 = $300,000 
• Or to simplify, the company wi ll essentially pay  6% × $10 mill ion × ½ 
year = $300,000. 
 
 31 October: 
Cooper would purchase FRA 8–14 @ 8% 
1 July: 
(a) LIBOR = 9% % pa 
 Cooper will pay loan interest (9.00) 
 Claim on FRA 1.00 
  ––––– 
 Net interest (8.00) 
  ––––– 
(b) LIBOR = 5%  % pa 
 Pay loan interest (5.00) 
 Pay out on FRA (3.00) 
  ––––– 
  ––––– 
Remember that the point of an FR A is to manage future risk. In reality 
there is no point in looking at the past to see whether rates r ose or fell. 
Perhaps the only worthwhile reas on for doing this would be to m easure 
the ability of the Tr easury department in guessing what will ha ppen to 
interest rates.

Chapter 10 
 419 
Cooper would purchase IRG 8–14 @ 8% 
1 July:  
(a) LIBOR = 9% (exercise option) % pa 
 Cooper will pay loan interest (9.00)  Pay fee (0.25) 
 Claim on IRG 1.00 
  
––––– 
 Net interest (8.25) 
  ––––– 
(b) LIBOR = 5% (allow option to lapse)  % pa 
 Pay loan interest (5.00)  Pay fee (0.25) 
  
––––– 
 Net interest (5.25) 
  ––––– 
Note:  When LIBOR has fallen the IRG a llows Cooper to take advantage 
of the lower interest rates . BUT the fee is still paid! 
Remember again that the point o f an IRG is to manage future ris k. In 
reality there is no point in looking at the past to see whether  rates rose or 
fell. Perhaps the only worthwhile  reason for doing this would b e to 
measure the ability of the Treas ury department in guessing what  will 
happen to interest rates. 
 
 (a) Number of contracts = (9 ,000,000/1,000,000) × 1/3 = 3 
(b) Extra interest cost on l oan = 0.25% × 9,000,000 × 1/12 = $1 ,875 
Gain on futures: Sell at 96.90 and close out by buying at 96.65 , so 
gain is 0.25% per contract. 
Total gain is 0.25% × 3 contract s × ($1,000,000 × 3/12) = $1,87 5

420  
 • Buy or sell futures? Sell , since we are borrowing 
• Number of contracts = (2 ,000,000/500,000) × 3/3 = 4 
• Which expiry date? March contra cts – match the transaction dat e of 
31st March. 
Contact the exchange:  We need to sell 4 March c ontracts at a price of 
94.90 
Two months later: 
Transaction: Interest will be $2m × 3/12 × 7% = $35,000 
Futures market: 
• Gain per contract = (94 .90 – 93.00) = 1.90% 
• Total gain is 1.90% × 4 contra cts × ($500,000 × 3/12) = $9.500  
Hence, net cost = $35,000 – $9,500 = $25,500 (i.e. a net interest rate of 5.10%) 
 
STIRS are standardised for 3 m onth notional deposits or loans, so the 
number of contracts = (5 million/ 500,000) × (6 months/3 months)  = 20 
The company wishes to deposit funds  so would set up a hedge on the 
futures market by buying futures, so will need call options. 
 
 Set up hedge: 
• Call or put options? Put here (option to sell futures), to cov er a 
• How many contracts? ($10m/$500k) × (6/3) = 40 
Contact exchange:  We need to buy 40 Septem ber put options with an 
exercise price of 94.75. 
Premium payable upfront = 0.18%  × 40 × $500,000 × 3/12 = $9,000 . 
1 month later: 
Transaction:  Interest = 7.5% × $10m × 6/12 = $375,000 
Futures/options market: 
Exercise the put opti on i.e. sell at 94.75 
Close out: Buy at futures price of 92.50 
Gain is 2.25% × 40 contra cts × $500,000 × 3/12 = $112,500 
So, the net interest cost is $375,000 – $112,500 = $262,500 (pl us the 
initial premium of $9,000).

Chapter 10 
 421 
  
Fixed rate borrowing (5.00%) 
Payment to bank under swap (LIBOR)  Receipt from bank under swap (lower rate) 4.90% 
 
––––––––––––– 
Net interest rate after swap (LIBOR + 0.10%) 
 ––––––––––––– 
Open market cost – no sw ap (LIBOR + 0.12%)  
Saving 2 basis points 
 
Solution: 
Actual borrowing (4.40%) 
Payment to bank (LIBOR) Receipt from bank 4.10% 
 
–––––––––––––– 
Net interest rate after swap (LIBOR + 0.30%) 
 –––––––––––––– 
The interest fixing date is the start date of the year, so this  overall net rate 
of LIBOR + 0.30% can be calculat ed as 4.25% (LIBOR on the year 2 start 
date) + 0.30% = 4.55%. 
Hence, Spray Co pays 4.55% int erest on its $10 million borrowin g 
($455,000 in the year) rather than the 4.40% fixed rate it woul d have paid 
without the swap ($440, 000 in the year). 
This is an extra cost of $15,000. 
 
Solution: 
Actual borrowing (LIBOR + 0.50%) 
Payment to bank (higher rate) (4.00%) Receipt from bank  LIBOR 
 
Net interest rate after swap  (4.50%) 
The interest fixing date is the start date of t he year (1 Janua ry 20X1), so 
the relevant LIBOR rate is 4.10%. 
Hence, Ocean Co paid 4.50% overa ll net interest on its $5 milli on 
borrowing ($225,000 in the year) ra ther than the (4.10% + 0.50%  =) 
4.60% rate it would have paid without the swap ($230,000 in the  year). 
This is a saving of $5,000.

422  
 Timing Explanation Cash flows 
Now Exchange principals (at swap rate 
of CHF1 = USD 1.10) Pay CHF 100m to 
the bank and receive USD 110m 
6 mths' time Pay swap interest to bank  
(5.5% × USD110m × 6/12) Pay USD 3.025m 
 Receive swap interest from bank 
(6% × CHF100m × 6/12) Receive CHF 3m 
 Pay Eurobond interest Pay CHF 3m 
End of year Pay swap interest to bank  
 Pay Eurobond interest  
(6% × CHF100m × 6/12) Pay CHF 3m 
 Swap back principals (at swap 
rate of CHF1 = USD 1.10) Pay USD 110m to 
the bank and receive CHF 100m 
The net result is that ABC Co has the use of the USD 110 millio n for the 
year, and effectively pays intere st on this amount (in USD) at 5.5%.

Chapter 10 
 423 
  
Timing  Explanation Cash flows 
Now Exchange principals  
(at swap rate of GBP1 = EUR 1.30) Pay GBP 10m to the 
bank and receive EUR 13m 
End of 
year Pay swap interest to bank  
((LIBOR + 0.50%) × EUR 13m) Pay EUR 0.715m (on 
the assumption that the start date of the swap is the interest rate fixing date and hence LIBOR is 5%) 
(5.25% × GBP 10m) Receive GBP 0.525m 
 Pay interest on original borrowing 
(5.25% × GBP 10m) Pay GBP 0.525m 
 Swap back principals  
(at swap rate of GBP1 = EUR 1.30) Pay EUR 13m to the 
bank and receive GBP 10m 
The net result is that Smiths Co  has the use of the EUR 13 mill ion for the 
year, and effectively pays floatin g rate interest on this amoun t (in EUR) at 
LIBOR + 0.50%. 
 
The interest rate risk arises between the present day and when the loan 
is taken out – the rate may rise and cost the borrower more. A borrower 
should sell an interest rate futu re now at a low interest rate (100 – r 
where r is, say, 5% = 95) and buy it later at the higher rate ( 100 – r where 
r is say 10% = 90). Buying a t 90 and selling at 95 creates the profit you 
will need to offset the in creased borrowing cost. 
 
STIRS are standardised for 3 m onth notional depos its or loans, so the 
number of contracts = (20 milli on/500,000) × (9 months/3 months ) = 120 
The company wishes to borrow funds  so would set up a hedge on t he 
futures market by selling  futures. 
Statement F is incorrect – giv en the loan is needed to be taken  out on the 
1 December, the company w ould still be exposed to basis risk .

424  
A cap sets an interest rate ceiling. A floor sets an interest rate lower limit. A collar sets a maximum and a minimum interest rate. 
An interest rate guarantee is an alternative name for an intere st rate 
option. 
 
A will effectively pay LIBOR + 0 .2% – 0.15% (sp read differentia l) = 
LIBOR + 0.05% 
 
Forward contracts require the use of a third party such as a ba nk. 
 
By definition the answe r is an FRA. Futures are for specific am ounts and 
dates. Options require a premium to  be paid up front and not up on 
settlement. Swaps do not requi re payment on settlement 
 
Note: 
• A is false because interest rat e futures have standardized siz es, 
which may not match the actual exposure 
• B is false as options give t he right but not the obligation 
• D – in terms of interest rates m atching involves ensuring asse ts and 
liabilities have a common type of interest ra te (e.g. loan and 
investment both have floating rates)

Chapter 10 
 425 
Brasil Co is currently p aying LIBOR + 0.55%. 
A swap rate of 2.86% for LIBOR  means that Brasil Co will pay th e bank 
2.86% in the swap in e xchange for LIBOR. 
Therefore, Brasil Co's net paym ent is (LIBOR + 0.55%) + 2.86% –  LIBOR 
= 3.41%. 
 
Actual borrowing (4.35%) 
Payment to bank (LIBOR) 
Receipt from bank (lower rate) 4.19% 
Net interest rate after swap  (LIBOR + 0.16%) 
The interest rate fixing date is normally the start date of the  swap 
agreement, so LIBOR of 4.04% is  the relevant value here. 
Hence, interest payable at LIBOR  + 0.16% amounts to (4.04% + 0. 16% 
=) 4.20%. 
Overall net interest is theref ore 4.20% × $10 million = $420,00 0. 
 
To: The finance director 
From:  The treasurer 
Subject:  Interest rate risk hedging 
Dear finance director, With all three methods of hedging interest rate risk, a time li mit has to be 
decided for the period of the hedge . With a Forward Rate Agreem ent 
(FRA) or an interest rate guarant ee (option/cap), the time limi t must be 
specific, with an agreed settlemen t date or expir y date, say si x months 
exactly from the contract/transaction date. With futures, the h edge would 
be for six months from  any date up to the settlement date for t he futures, 
which in this question w ould probably be September. 
It is assumed here that the requi red hedge is for exactly six m onths in all 
three cases.

426  
 FRA 
An FRA is an over-the-counter i nstrument that can be arranged w ith a 
bank, fixing the interest rate on a notional principal amount f or a given 
period of time, in this case six months. The noti onal six-month  interest 
period would start fr om an agreed date in Sep tember, in four mo nths’ 
time, so the FRA would be a 4v10 FRA. FRAs are only available f or quite 
large principal amounts (at least USD 1 million) and can be arr anged up 
to about two years into the future. 
A company wishing to fix an inte rest rate for borrowing should buy an 
FRA. Here, AB should buy a 4v10 FRA on a notional principal amo unt of 
GBP 2 million. The bank would spec ify an interest rate for the FRA, which 
might be about 7.5% in this case. 
The FRA is not an agreement to bo rrow the funds required. AB mu st 
arrange to borrow the GBP 2 m illion separately . AB will borrow GBP 2 
million at the current market rat e of interest in September, wh atever this 
happens to be. The FRA would be settled by: 
• a payment from the bank to AB i f the benchmark interest rate ( here 
probably the six-month LIBOR rate) is higher  than the FRA rate;  or 
• a payment from AB to the bank if the benchmark rate is lower t han 
the FRA rate. 
The hedge works because the interes t payment on the actual borr owing 
plus or minus the settlement amo unt for the FRA should fix the overall 
effective borrowing cost for AB . For example, if the interest r ate does rise 
by 1.5 percentage points to 9% and AB borrows at this higher ra te, it 
would receive a payment under t he FRA agreement worth the equiv alent 
of about 1.5%, thereby reducing  the net borrowin g cost to about  7.5% 
(depending on the actual  rates that apply). 
Interest rate futures 
Short-term interest rate future s are exchange-traded instrument s. A short 
sterling future is a notional  three-month deposit of GBP 500,00 0, traded 
on LIFFE. 
A company wishing to fix a rate  for borrowing should sell inter est rate 
futures. Since AB wants to hedge  the borrowing cost for GBP 2 m illion for 
six months, it should sell 8 futu res [(GBP 2 million/GBP 500,00 0) × (6 
months/3 months)] and set up a ‘short hedge’. It could sell eit her 
September or December futures,  depending on when  the interest p eriod 
will begin, and when the September futures contract expires dur ing the 
month.

Chapter 10 
 427 
 The interest rate is in the pric e of the future. Prices are quo ted at 100 
minus the interest rate, so if AB were to sell September future s, say, at 
92.50, this would 'fix' its borro wing rate at 7.5%. As the futu re approaches 
settlement date, if the interes t rate has risen to 9%, the mark et price of 
September futures should have mo ved to about 91.00. AB could th en 
close its position by buying 8 September futures, and making a profit of 
1.50 (150 points) on eac h contract of its futures dealing. A pr ofit of 150 
points on 8 futures would be wo rth GBP 15,000 (150 points × 8 c ontracts 
× GBP 12.50 per point). This is  equivalent to interest at 1.5% on GBP 2 
million for six months. 
AB would borrow GBP 2 million a t the market rate. If this is 9% , the net 
borrowing cost would be 9% less t he value of the profit on futu res trading 
(1.5%) giving a net effecti ve interest cost of 7.5%. 
Since interest rate futures ar e only available in standardised amounts and 
dates, they are less flexible t han FRAs, and so possibly less a ttractive to 
AB. 
Interest rate guarantee 
This is a type of borrower’s opt ion but with characteristics of  an interest 
rate collar. Unlike an FRA or fu tures which are binding contrac ts on both 
parties, it is not a binding commi tment on the option holder. I f AB buys 
this instrument at a cap strike price of 7% (and a notional pri ncipal 
amount of GBP 2 million for six m onths), for expiry in Septembe r, it will 
exercise its option if the inte rest rate at expiry is higher th an 7%. It will 
then receive the interest value of the difference (on GBP 2 mil lion for six 
months) between the actual inter est rate (six-month LIBOR) and the cap 
rate of 7%. 
However, in this case, if the in terest rate falls below 6%, the  option 
counterparty (a bank) will exerci se a floor option, and require  AB to pay 
the difference between the ac tual interest rate and 6%. 
As a result, AB is able to fix  the benchmark interest rate betw een 6% and 
7%. So if AB can borrow at, say, L IBOR + 0.50%, the interest ra te 
guarantee would fix its actual borrowing cost between 6.5% and 7.5%, 
plus the cost of the guarantee. 
Arranging this guarantee would co st GBP 2,000 (0.1% of GBP 2 mi llion), 
which is equivalent to interest o f 0.2% on GBP 2 million for si x months. 
The premiums payable on interest  rate guarantees can be expensi ve and 
must be paid up-front, which c an be compared to an FRA on which  no 
premium is payable.

428  
 Usefulness of the instruments to AB 
All three instruments can hel p AB to hedge against the risk of a rise in 
FRAs and futures are binding co ntracts, so that the hedge effec tively 
fixes the borrowing cost. The in terest rate guarantee is a form  of option, 
so that AB can benefit from lower  interest rates if they are be tween 6% 
and 7%. However, the guarant ee has to be paid for. 
All three instruments are arr anged for a fixed amount and a fix ed 
borrowing period, which means t hat a hedge might not be perfect . For 
example, if it turns out that AB needs to borrow  GBP 2.5 millio n for seven 
months starting in five months ’ time, none of the hedges would be 
perfect. 
 
 Email 
To: Finance director 
Subject:  Interest rate risk management 
Dear finance director, Forward rate agreements offer Gy mbob the facility to fix the fu ture 
interest rate on borrowings for a specified period. For example , if 
Gymbob entered into an FRA with a bank in 3 m onths’ time one ye ar at a 
guaranteed 7%, then if the interes t rate rose the bank would ha ve to pay 
Gymbob the difference. On the ot her hand, if the interest rate fell, 
Gymbob would still have to pay  the bank the difference. No matt er which 
way the interest rate moved, Gymbob would pay 7%. 
FRAs do not involve any actual l ending of the prin cipal sum of GBP 5 
million. This can be done with the same or a different bank, or  other 
lender. 
FRAs are usually for at least G BP 1 million, and can be arrange d for up 
to 2 or 3 years in the future, s o FRAs appear to  be a suitable way for 
Gymbob to manage intere st rate exposure. 
Interest rate futures are bindi ng contracts between seller and buyer to 
take delivery of a specified inte rest rate commitment on an agr eed date at 
an agreed price. They can be used to protect against interest r ate rises 
and are available for a ma ximum of 1 – 2 years. 
Futures contracts are sold now i n the expectation that, as inte rest rates 
rise the contract value will fa ll, and they can then be purchas ed at a lower 
price, generating a profit on t he futures deal. The profit comp ensates for 
the actual rises in interest rat es experienced by companies tha t have 
borrowed funds from banks and else where. If the interest rate m oves in 
the opposite direction to that e xpected, a futures loss will oc cur, but this 
will be offset by cheaper inter est costs in the market.

Chapter 10 
 429 
 All contracts require a small initial deposit or margin. 
Futures should allow Gymbob to  hedge successfully against incre ases in 
the interest rate, although a perfect hedge is rare. 
Interest rate options such as c aps, floors and collars guarante e that the 
interest rate will not rise abov e, or fall below, an agreed fix ed level during 
a specified time period commenc ing sometime in the future. The interest 
rate protection for Gymbob is s imilar to that given by an FRA. 
However, options involve the pay ment of a premium to the seller  of the 
option, whether or not the option is exercised. No premium is p ayable 
with an FRA. 
Also, whilst protecting downside risk (an interest rate rise), Gymbob can 
take full advantage of favourable interest rate movements. 
For example, if inter est rates fall, the opti on is left to laps e and Gymbob 
will borrow the GBP 5 million from  the market at the lower rate . However, 
if rates rose, then Gymbob woul d exercise the option to guarant ee a 
maximum cost of 7%. 
However, the premium involved wit h an option can be prohibitive ly 
expensive. A way to lower this w ould be to take out a collar (a  cap and a 
floor). 
If you have any queries, pleas e do not hesitate to ask. 
Best wishes A.N. Accountant 
 
Subject:  Interest rate swaps 
(a) Interest rate swaps can have several uses. 
– They can be used by companies to arrange fixed rate 
borrowing, when direct access to  fixed rate funding (the bond 
markets) is not possible, for example, if the company is too 
small or would not have a su fficiently good credit rating. 
– Occasionally, they can be used to  obtain lower cost borrowing ,  
through interest rate arbitrage . This opportunity exists in the  
case of RO and AB. 
– They can be used to alter the pr oportions of fixed and variab le 
rate funding in a company's debt  mix without the expense of 
redeeming existing debt and issui ng new debt in its place, and 
so can be used to manage exposu re to risk from possible 
future interest r ate movements.

430  
(b) AB is a larger company than RO, so we see that AB has cheap er 
borrowing rates in both the float ing rate as well as the fixed rate 
market. However, while RO onl y has to pay 0.2% more in the 
floating rate market, it has to pay a full 1.0% m ore for fixed rate 
debt. This creates an opportuni ty to reduce their combined 
borrowing costs by 0.8% (1% – 0.2%). 
AB has a comparative advantage in  the fixed rate market, since it is 
cheaper by 1% than RO, compared to j ust 0.2% in the floating ra te 
market. So, the companies could co-operate to their mutual bene fit 
if: 
– AB borrows at a fixed rate and swaps into floating rate; and 
– RO borrows at a floating rate, where it can borrow 
comparatively more favourably t han at a fixed rate (only 0.2% 
more), and swap in to a fixed rate. 
The opportunity for arbitrage is 0 .8%, which means that if they  share 
this equally, both will borrow 0.4%  more cheaply than if they 
borrowed directly at a floating rate in the case of AB or at a fixed 
rate in the case of RO. 
A swap could be a rranged as follows: 
– AB borrows in the fixed rate  market at 7.5% and pays LIBOR 
to RO. 
– RO borrows in the floating rate market at L IBOR + 0.5% and 
pays a fixed rate of 7.6% to AB. 
The net effect is as follows: AB pays 7.5% to the bank, receive s 7.6% from RO and pays LIBOR 
to RO which equates to  LIBOR – 0.1%. 
RO pays LIBOR + 0.5% to the bank, r eceives LIBOR from AB, and 
pays 7.6% to AB which equates  to a payment of 8.1%. 
These net borrowing rates are eac h 0.4% less than AB could borr ow 
at a floating rate or RO coul d borrow at a fixed rate 
(c) In practice, most swaps are  arranged through banks that run  a 
'swaps book'. There are severa l advantages in dealing with a ba nk 
rather than directly  with another company. 
– In dealing with a bank, there is no problem about finding a 
swaps counterparty with an equal and opposite swapping 
requirement. The bank will arrange a swap to meet the specific 
requirements of each individual  customer, as to amount and 
duration of the swap. 
– In dealing with a bank, the cr edit risk is that the bank migh t 
default, whereas in dealing dire ctly with another company, the 
credit risk is that the other com pany might default. Banks are 
usually a much lower credi t risk than corporations.

Chapter 10 
 431 
 – Banks are specialists in swaps, and are able to provide 
standard legal swaps agreements . The operation of the swap 
is likely to be administrativ ely more straightforward. 
The significant drawback to u sing a bank is that the bank will want 
to make a profit from its oper ations. In practice, it will gene rally do 
this by charging different swap ra tes for fixed rate payments a nd 
fixed rate receipts on differen t swaps. In terms of the RO and AB 
situation, where there is a cr edit arbitrage opportunity of 0.8 %, if a 
swaps bank were to be used to a rrange a separate swap with each  
company, it might take a profit o f, say, 0.2%, leaving just 0.6 % of 
benefit to be shared between RO and AB. 
 
 REPORT 
To: The Board of QW plc 
From:  The Treasurer 
Date:  XX-XX-XX 
(i) A swap is an agreement betw een two parties to exchange the cash 
flows related to specific underly ing obligations. In an interes t rate 
swap, the cash flows are the inte rest payments arising on princ ipal 
amounts. For example, company  A might have outstanding 
borrowings of GBP 1m with annual i nterest fixed at 10%, whilst 
company B has borrowings of GBP 1m with annual interest paid at  a 
floating rate of LIBOR + 1%. 
If company A and company B agree on an interest rate swap, they  
agree to take on the other’s inter est obligations, so that comp any B 
will pay fixed annual interest of GBP 100,000 pa, while company  A 
will now pay floating interest of LIBOR + 1% on GBP 1m. Such a 
swap might be entered into if com pany A thought that interest r ates 
were going to fall, while com pany B thought they would rise. 
A forward rate agreement (FRA) i s a contract in which two parti es 
agree on the interest rate to be paid for a period of time star ting in 
the future, for example for a th ree-month period starting in si x 
months’ time. The contract is sett led in cash; exposure is limi ted to 
the difference in interest rates  between the FRA agreed rate an d the 
actual rate, based on the notional agreed principal. 
An interest rate futures contra ct is a standardised form of FRA  
traded on an investment exchange. E ach contract is for a specif ied 
nominal amount of a specified financ ial instrument on a specifi ed 
date.

432  
 The advantages of swaps compared to  other forms of interest rat e 
risk management are as follows: 
– Swaps allow a company to restructure its capital profile with out 
the expense of actually redeemi ng existing borrowings. Fixed 
borrowings can be changed to floati ng rate, or floating to fixe d, 
without incurring the transaction costs and possible redemption penalties associat ed with actual redemption. 
– Using the principle of compar ative advantage, companies with 
different credit ratings can reduc e their cost of borrowing, by  
borrowing at different costs in different markets. 
– Swaps can offer access to capital markets for companies 
which would not norma lly be allowed to par ticipate due to their  
low credit rating, by swapping borrowings with a company with 
a higher credit rating. 
(ii) We (QW plc) could borrow a t a fixed 8%, while ER plc borro ws at a 
floating LIBOR + 0.5%, and then sw ap the interest obligations. Total 
interest paid by both par ties is LIBOR + 8.5%. 
The alternative is for us to borro w at a floating LIBOR + 0.2%,  while 
ER plc borrows at a fixed 9.5% . Total interest then paid by bot h 
parties is LIBOR + 9.7%. 
Clearly the swap is advantageous, s ince total interest is 1.2% less 
than the alternative. The bank’s commission is 0.2%, leaving 1%  (or 
GBP 100,000) as the net benefit to  be shared between the two 
companies. ER plc has opportunist ically proposed that the net 
benefit should be shared equally bet ween the two companies. Sin ce 
our credit rating is better t han ER’s, it would be fairer for u s to 
receive more than 50%, though this  is a matter for negotiation.  
As a final point, it should be noted  that, if we are confident that 
interest rates are going to fa ll over the next three years, it will 
probably be better to take out fl oating rate borrowings from th e start, 
rather than take out fixed rate borrowings and swap these for 
floating rate. We would not hav e to share the benefits of falli ng 
interest rates with any third party or pay the swap’s commissio n 
payment to the bank. The decisio n therefore depends on how 
confident we are that interest r ates will fall as expected. Ple ase 
contact me again if I can be of any further help to you in this  or any 
other matter.

433 
Financial and strategic 
implications of mergers 
and acquisitions 
D1: Discuss the context of 
valuation Discuss: 
(a) Listing of firms 
(b) Mergers and acquisitions 
(M&A) 
(c) Demergers and 
divestment 
• Reasons for M&A and divestments 
• Process and implications of management buy-outs  
• Acquisition by private equity and venture capitalist 
 
  Chapter 
11

Financial and strategic implications of mergers and acquisition s 
434  
 
The term ‘merger’ is usually use d to describe the joining toget her of two or more 
entities. 
Strictly, if one entity acquires a majority shareholding in ano ther, the second is 
said to have been acquired (or ‘t aken over’) by the first. If t he two entities join 
together to submerge their separat e identities into a new entit y, the process is 
described as a merger. 
In fact, the term ‘merger’ is o ften used even when an acquisiti on/takeover has 
actually occurred, because of t he cultural impact on the acquir ed entity – the 
word merger makes the arrangemen t sound like a partnership betw een equals.

Chapter 11 
 435 
 Types of merger/acquisition 
 Mergers and acquisitions can be classified to reflect the natu re of the 
enlarged group: 
• Horizontal integration  results when two entities in the same line of 
business combine. For example, r ecent bank and building society  
mergers are a good ex ample of this type of integration. 
• Vertical integration  results from the acquisition of one entity by 
another which is at a different l evel in the ‘chain of supply’ – as an 
example, UK breweries have mov ed heavily into the distribution of 
their product via public houses. 
• A conglomerate  results when two entities in unrelated businesses 
combine. 
2 The reasons for growth by acquisition or merger 
Specific reasons for m erger/acquisition 
The following reasons have been s uggested as to why entities me rge or 
acquire. 
• Increased market share/power.  In a market with limited product 
differentiation, price may be t he main competitive weapon. In s uch a case, 
large market share may enable an ent ity to drive prices – for e xample 
reducing prices in the short term  to eliminate competition befo re increasing 
prices later. 
• Economies of scale.  These result when expansion of the scale of 
productive capacity of an entity (or industry) causes total pro duction costs 
to increase less than proporti onately with output. It is clear that a merger 
which resulted in horizontal or vertical integration could give  such 
economies since, at the very least, duplication would be avoide d. But how 
could a conglomerate merger giv e economies? Possibly through ce ntral 
facilities such as offices, a ccounting department s and computer  
departments being rationalised. (I ndeed, both sets of managemen t are 
unlikely to be needed in  their entirety.) 
• Combining complementary needs.  Many small entities have a unique 
product but lack the engineering a nd sales organisations necess ary to 
produce and market it on a lar ge scale. A natural course of act ion would 
be to merge with a la rger entity. Both ent ities gain something – the small 
entity gets ‘instant’ eng ineering and market ing departments, an d the large 
entity gains the revenue and other  benefits which a unique prod uct can 
bring. Also if, as is likely, t he resources whic h each entity r equires are 
complementary, the merger may w ell produce further opportunitie s that 
neither would see in isolation.

436  
• Improving efficiency.  A classic takeover target would be an entity 
operating in a potentially lucra tive market bu t which, owing to  poor 
management or inefficient operati ons, does not fully exploit it s 
opportunities. Of course, being ta ken over would not be the onl y way of 
improving such a poor performe r, but such an entity’s managers may be 
unwilling to give themselves the sack. 
• A lack of profitable investment  opportunities – surplus cash.  An entity 
may be generating a subs tantial volume of cash, but sees few pr ofitable 
investment opportunities. If it does not wish to simply pay out  the surplus 
cash as dividends (because of its  long-term dividend policy, pe rhaps), it 
could use it to acquire other entities. A reason for doing so i s that entities 
with excess cash are usually r egarded as ideal targets for acqu isition – a 
case of buy or be bought. 
• Tax relief.  An entity may be unable to claim  tax relief because it does no t 
generate sufficient profits. It ma y therefore wish to merge wit h another 
entity which does gener ate such profits. 
• Reduced competition.  It is often one benefit of mer ger activity – provided 
that it does not fall foul of t he competition authorities. 
• Asset-stripping.  A predator acquires a target and sells the easily 
separable assets, perhaps closing down or disposing of some of its 
• Big data opportunities.  When one entity takes over another, the 
knowledge and expertise of the tar get entity can increase the a mount of 
big data available to the predat or, to enable the combined firm  to develop 
better competitive advantage. 
 
 More on big data opportunities 
 What is Big Data? 
There are several definitions o f Big Data, the most commonly us ed 
referring to large volumes of data beyond the normal processing , storage 
and analysis capacity of typical database application tools.  
Big Data will often include much  more than simply financial inf ormation 
and can involve other organisatio nal data which is operational in nature 
along with other internal and exte rnal data which is often unst ructured in 
form. 
One of the key challenges of deal ing with Big Data is to identi fy 
repeatable business patterns in t his unstructured data. Managin g such 
data can lead to significant bus iness benefits su ch as greater competitive 
advantage, improved productivity  and increasing levels of innov ation.

Chapter 11 
 437 
Why is Big Data so important? 
Several major business benefits arise from the ability to manag e Big Data 
successfully: 
• Driving innovation by reducing ti me taken to answer key busine ss 
questions and therefore make decisions 
• Gaining compet itive advantage 
• Improving productivity 
The relevance of Big Data in mergers / acquisitions 
These points link directly into  the reasons for merger / acquis ition 
presented above.  
For example even befor e considering Big Data specifically we st ated that 
combining complementary needs is a key reason for merger / acqu isition. 
The acquisition of a company with a large database of customers  (and 
potential customers) w ould be an example o f this that also inco rporates 
Big Data. The acquiring company  would get access to this databa se, and 
also to the skills of the targe t company staff who have collect ed and 
analysed the Big Data. 
 
 MONEY is a company operating in the financial services industr y offering 
high net worth client’s private banking facilities and investme nt advice. It 
has recently been approached by t he Board of CASH, a company 
providing business loans and ot her forms of borrowing to small 
businesses and start-up companies . The directors of CASH are lo oking to 
sell the company to raise the capi tal to start a new venture an d believe 
the company would be a good st rategic fit with MONEY. 
Required: 
Advise MONEY how the acquisition of CASH will give rise to Big Data 
 
 The following reasons why entitie s merge are of questionable va lidity:  
• Diversification, to reduce risk . While acquiring an entity in a different line of 
activity may diversify away ri sk for the entities involved, thi s is surely 
irrelevant to the shareholders. T hey could have performed exact ly the 
same diversification simply by holding shares in both entities.  The only 
real diversification produced is  in the risk attaching to the m anagers’ and 
employees’ jobs, and this is likel y to make them more complacen t than 
before – to the detriment of s hareholders’ future returns.

438  
• Shares of the target entity ar e undervalued. This may well be the case, 
although it would conflict with  the efficient markets theory. H owever, the 
shareholders of the entity planning  the takeover would derive a s much 
benefit (at a lower administrativ e cost) from buying such under valued 
shares themselves. This also ass umes that the acquirer entity’s  
management are better at valuing shares than professional inves tors in 
the market place. 
Synergy 
Synergy may be defined as two or m ore entities coming together to produce a 
result not independently obtainable. 
For example, a merged entit y will only need one marketing depar tment, so there 
may be savings generated compar ed to two separate entities. 
Importance of synergy in mergers and acquisitions 
For a successful business combi nation we should be looking for a situation 
where: 
MV of combined company (AB) > MV of A + MV of B 
Note:  MV means Market Value here. 
If this situation occurs we have experienced synergy, where the  whole is worth 
more than the sum of the parts. Thi s is often expressed as 2 + 2 = 5. 
It is important to note that sy nergy is not automatic. In an ef ficient stock market 
A and B will be correctly valued be fore the combination, and we  need to ask 
how synergy will be achieved, i.e . why any increase in value sh ould occur. 
Sources of synergy 
There are several reasons why synergistic gains arise. These br eak down into 
• operating economies , such as economies of sca le and elimination of 
inefficiency, 
• financial synergy , such as the reduced risk caused by diversification, 
• other synergistic effects , such as market power.

Chapter 11 
 439 
 Detailed examples of synergy 
 Synergy from operating economies 
Economies of scale  – Horizontal combinations (acquisitions of a 
company in a similar line of bus iness) are often claimed to red uce costs 
and therefore increase profits due to economies of scale. These  can 
occur in the production, marketi ng or finance areas. Note that these gains 
are not automatic and diseconomie s of scale may also be experie nced. 
These benefits are sometimes also claimed for conglomerate 
combinations (acquisition of com panies in unrelated areas of bu siness) in 
financial and marketing costs. 
Economies of vertical integration  – Some acquisitions involve buying 
out other companies in the same p roduction chain, e.g. a manufa cturer 
buying out a raw material supplie r or a retailer. This can incr ease profits 
by 'cutting out the middle man'. 
Complementary resources  – It is sometimes argued that by combining 
the strengths of two companies a  synergistic result can be obta ined. For 
example, combining a company  specialising in research and 
development with a company stro ng in the marketing area could l ead to 
gains. 
Elimination of inefficiency  – If the victim company i s badly managed, its 
performance and hence its value c an be improved by the eliminat ion of 
inefficiencies. Improvements c ould be obtained particularly in the areas of 
production, marketing and finance. 
Financial synergy 
Several financial arguments are proposed in this area. 
Diversification  – The argument goes that diversification normally 
reduces risk. If the earnings o f the merged companies simply st ay the 
same (i.e. no operating economie s are obtained), there could st ill be an 
increase in value of the com pany due to the lower risk. 
Diversification and financing  – If the future cash  flow streams of the 
two companies are not perfectly  positively correlated (i.e. if they are 
forecast to fluctuate in differ ent ways) then, by combining the  two 
companies, the variability of t heir operating cash flow may be reduced. A 
more stable cash flow is more a ttractive to creditors and this could lead to 
cheaper financing. 
The 'boot strap' or P/E game  – It is sometimes argued that companies 
with high P/E ratios are in a good  position to acquire other co mpanies as 
they can impose their high P/E ra tio on the victim firm and inc rease its 
value.

440  
 Other synergistic effects 
Surplus managerial talent  – Companies with hi ghly skilled managers 
can make use of this resource onl y if they have problems to sol ve. The 
acquisition of inefficient companies  is sometimes the only way of fully 
utilising skilled managers. 
Surplus cash  – Companies with large amount s of surplus cash may see 
the acquisition of other companies  as the only possible applica tion for 
these funds. Of course, increased dividends could cure the prob lem of 
surplus cash, but this may be re jected for reasons of tax or di vidend 
stability. 
Market power  – Horizontal combinations may  enable the firm to obtain a 
degree of monopoly power that could increase its profitability.  Removing 
competition from a market in this  way could attract the attenti ons of the 
competition authorities, e.g. t he Competition and Markets Autho rity in the 
UK, who could rule the acquisition unlawful. 
Speed  – Acquisition may be far fast er than organic growth in obtaini ng a 
presence in a new and growing market. 
By considering all the above s ources of synergy, a company can work 
towards increasing the post-me rger value of the newly formed jo int 
company. 
 
 Williams Inc is the manufacture r of cosmetics, soaps and shower  gels. It 
also markets its products using its own highly successful sales  and 
marketing department. It is seen as  an employer of choice and a s such 
has a talented and loyal workforce with a history of developing  new and 
exciting products which have so ld well. It is now considering e xtending its 
range, however it has currently a  build-up of unfulfilled order s due to a 
lack of capacity. 
GSL is a well-known herbal rem edy for skin problems. GSL Co was  
founded by three brothers in the 1950s and until  the death of t he 
remaining brother in 2007 has per formed well – however the new 
Chairman has limited experience and the company has not perform ed 
well over recent years. GSL has a  dedicated team of herbalists who have 
developed products, which would f ind a ready market – however, there is 
insufficient funds and expertise to  correctly market these prod ucts and 
market share is low. 
Williams’ products and GSL’s pr oducts are made using similar pr oduction 
technologies and their financial and administrative systems are  similar 
and it is hoped savings can be made here. 
Required: 
Identify any potential synergy gains that would emerge from a m erger of 
Williams and GSL. 

Chapter 11 
 441 
 
 The impact of mergers and ac quisitions on stakeholders 
 Impact on acquiring comp any's shareholders 
The existence of synergy has been  discussed above as a key bene fit to 
shareholders of an acquisition. A ll companies have a primary ob jective to 
maximise shareholder wealth, so it is clear tha t if synergy can  be achieved, 
an acquisition should benefit the acquiring company's sharehold ers. 
Impact on the target company's shareholders 
The acquiring company will often pay a premium to the sharehold ers of 
the target company, to encourage t hem to sell their shares. The refore 
there is also a financial benef it to them when a takeover happe ns. 
Impact on lenders/debt holders 
Debt will often be repayable in the event of a change in contro l. It all 
depends on whether the bank borro wings and bonds contain a chan ge in 
control clause. With bank borro wings they almost certainly will . The risk 
profile of the acquirer may be quite  different from that of the  original 
borrower and the bank will not wish to become exposed to a high er credit 
risk. Bonds may be the same. 
The acquirer is therefore likely  to need to arrange new financi ng, debt 
and/or equity financing as appropr iate in advance of the takeov er. 
Impact on managers and staff 
In many acquisitions, an easy wa y to generate synergy is to mak e some 
staff redundant to avoid there bei ng duplication of roles. Ther efore, the 
managers and employees, particularly of the target company, oft en view 
a takeover with dread. However , the managers of the acquiring c ompany 
often see takeovers as an oppor tunity, to demand higher salarie s and 
bonuses now that they manage a larger company. 
The acquirer may wish to retain many managers whos e knowledge a nd 
skills may be essential to the su ccessful continuation of the b usiness, at 
least in the short term. In such a  case, the acquirer may seek assurance 
and contractual tie-ins to ensure that such people remain with the 
business for a certain period of time. 
Impact on society as a whole 
Governments monitor takeovers carefully, and if they feel that a takeover 
will not be in the best interests  of society as a whole, the ta keover can be 
investigated and sometimes st opped. Competition law in most cou ntries 
prevents monopolies being created w hich might be able to exploi t their 
power to take advantage of customers.

442  
Problems with acquisitions 
If an acquisition generates the ex pected synergy, shareholders in both the 
acquiring company and the target should see an increase in weal th. 
However, not all mergers and acquisitions are successful. 
Synergy will not automatically a rise. Unless the management of the two entities 
can work together effectively, there is a chance that any forec ast benefits of the 
new arrangement might not be realised. 
In many cases, the forecast synergy is not achieved, or is not as large as 
expected. It may be th at the premium paid on  acquisition by the  acquirer was 
too high, so the shareholder val ue of the acquirer actually red uced as a result of 
the acquisition. 
Also, cultural clashes between the two companies can make the i ntegration of 
the two businesses very difficult. 
Another reason for failure is  that the opportunity cost of the investment could be 
too high. This means that the ac quirer realises that the funds tied up in the 
acquisition could have been better used, to generate higher ret urns elsewhere. 
 
 Detailed reasons why mergers/acquisitions fail 
 The fit/lack of fit syndrome 
There may be a good fit of products  or services, but a serious lack of fit in 
terms of management styles or  corporate structure. 
Lack of industrial or commercial fit 
Failure can result from a horizont al or vertical takeover where  the 
acquired entity turns out not to  have the product range or indu strial 
position that the acquirer antici pated. Usually in the case whe re a 
customer or supplier is acquir ed, the acquirer knows a lot abou t the 
acquired entity; even so, there may be aspects of the acquired entity’s 
operations which may cause unexpec ted problems for the acquirer , such 
that, even in these cases, a pro spective acquisition should be planned 
very carefully and not be based so lely on experience gained fro m a direct 
relationship with the acquired entity. 
Lack of goal congruence 
This may apply not only to the acquired entity but, more danger ously, to 
the acquirer, whereby disputes ove r the treatment of the acquir ed entity 
might well take away the benefit s of an otherwise excellent acq uisition.

Chapter 11 
 443 
 ‘Cheap’ purchases 
The ‘turn around’ costs of an ac quisition purchased at what see ms to be 
a bargain price may well turn out to be a high multiple of that  price. In 
these situations, the amount of resources in terms of cash and 
management time could well also dam age the acquirer’s core busi ness. 
In preparing a bid, a would-be ac quirer should always take into  account 
the likely total cost of an acqui sition, including the input of  its own 
resources, before deciding on ma king an offer or setting an off er price. 
Paying too much 
The fact that a high premium is  paid for an acquisition does no t 
necessarily mean that it will fail . Failure would result only i f the price paid 
is beyond that which the acquirer considers acceptable to incre ase 
satisfactorily the long-term wealth of its shareholders. 
Failure to integrate effectively 
An acquirer needs to have a work able and clear plan of the exte nt to 
which the acquired company is to  be integrated , and the amount of 
autonomy to be granted. At best , the plan should be negotiated with the 
acquired entity’s management and st aff, but its essential requi rements 
should be fairly but firmly carried out. The plan must address such 
problems as differences in managem ent styles, incompatibilities  in data 
information systems, and continu ed opposition to the acquisitio n by some 
of the acquired entity’s staff. F ailure to plan can – and often  does – lead 
to failure of an acquisition, as it leads to drift and demotiva tion, not only 
within the acquired entity but als o within the acquirer itself.  
Every aspect of a prospective a cquisition, as it will affect th e would-be 
acquirer, should be weighed up bef ore embarking on a bid. Probl ems of 
integration have a much better chance of being resolved before bidding 
action is taken than they do a fter the event, when many more 
complications can ensue. 
Even if a product fit is satisfac tory, the would-be acquirer sh ould be 
satisfied that the aspects of it s own operation affected by the  bid will be 
properly adaptable to the new activ ities. Running the rule care fully over 
one’s own operations may yield vit al information as to areas wh ich may 
need adaptation before a bid can be contemplated, and provide v ital 
clues to appropriate areas for se arch when a bid has actually b een 
launched. One factor of special importance is a clear assessmen t of the 
flexibility of one’s ow n information systems.

444  
 Inability to manage change 
Several of the above points str ess the need for an acquirer to plan 
effectively before and after an ac quisition if failure is to be  avoided. But 
this in itself calls for th e ability to accept change – perhaps  even radical 
change – from established routin es and practices. Indeed, many 
acquisitions fail mainly because  the acquirer is unable – or un willing – 
reasonably to adjust its own acti vities to help ensure a smooth  takeover. 
One such situation is where the acquired company has a demonstr ably 
better data information system than  the acquirer, which it migh t be greatly 
in the acquirer’s interest to adopt.  
3 Tax implications of me rgers and acquisitions 
There are several tax implicat ions of mergers and acquisitions:  
• differences in tax rates and double tax treaties 
• group loss relief 
• withholding tax. 
Differences in tax rates and double tax treaties 
Different countries around the wo rld have different tax rates. Therefore, if one 
company acquires another company  based in a different country, there are 
likely to be different tax rates  for the two companies in the g roup. 
The OECD (Organisation for Econom ic Cooperation and Development ) is an 
organisation of developed countries  whose main purpose is to ma intain financial 
stability and the expansion of world trade. 
In order to help avoid double ta xation between countries, the O ECD has 
published a model Double Taxation  Convention with an accompanyi ng 
commentary. 
Significance of the OECD model double tax treaty 
Whenever a double tax treaty is d rawn up between two countries (or an old 
treaty is renegotiated) the OECD model is used as a guide. 
Detailed knowledge of specific tr eaties is not required in your  examination. The 
main function of any treaty is to  avoid double taxation and to decide which 
country shall have the right to tax income. 
Members of a group of companies m ay surrender losses to other p rofitable 
group members for corresponding accounting periods. 
Losses surrendered must be set against the claimant company’s t axable total 
profits of a ‘correspondi ng’ accounting period.

Chapter 11 
 445 
(Note that in this context, a c orresponding accounting period =  any accounting 
period falling wholly or partl y within the su rrendering company ’s accounting 
period.) 
Key considerations for group loss relief 
Tax planning primarily seeks to ensure losses are used within t he group to save 
the most tax. Accordingly, losse s are first set against profits  taxed at the highest 
rate. 
Group relief is only available  for losses and profits generated  after a company 
joins a group. It is not possibl e to have group relief for prea cquisition losses or 
to relieve preacquisition profits. 
Group relief ceases to be availabl e once arrangements are in pl ace to sell the 
shares of a company. This will us ually occur sometime before th e actual legal 
sale of the shares. 
A withholding tax, also called a retention tax, is a government  requirement for 
the payer of an item of income  to withhold or deduct tax from t he payment, and 
pay that tax to the government. 
In the context of groups of comp anies, withholding taxes need t o be considered 
when one company makes payments  to another within the group (fo r example 
as dividends, or interest on loans). 
Typically the withholding tax is  treated as a payment on accoun t of the 
recipient's final tax liability. 
It may be refunded if it is dete rmined, when a tax return is fi led, that the 
recipient's tax liability to the government which received the withholding tax is 
less than the tax withheld, o r additional tax may be due if it is determined that 
the recipient's tax liability is more than the withholding tax.  
 4 The role and scope of competition authorities 
Introduction to compe tition authorities 
During a takeover, it is import ant that the companies comply wi th relevant 
legislation and regulations. 
Competition aut horities monitor takeov ers and mergers on behalf  of national 

446  
General principles 
The role of the competition aut horities varies from country to country but as a 
general rule their aims are: 
• to strengthen competition 
• to prevent or reduce anti- competitive activities 
• to consider the public interest. 
If the competition authorities fi nd that a proposed merger or t akeover is ant- 
competitive, they have  the power to block t he takeover complete ly, or to allow it 
to proceed subject to certain cond itions being met  (for example  the combined 
entity might be required to sell off some of its retail outlets  after the acquisition). 
 
 More detail on competition authorities 
 Many bids, because of their size , will require review by the c ompetition 
authorities, and a lim ited number will subs equently be investig ated if the 
authorities think that a merger m ight be anti-competitive or ag ainst the 
public interest. 
Anti-competitive 
An anti-competitive merger or acquisition can be defined as one  that 
leads to a substantial lessening  of competition or one that wou ld 
significantly impede effe ctive competition. 
In many countries, 'anti-compet itive' is deemed to be the creat ion of a 
new entity that will hav e 25% or more of the share of a market.  
Public interest 
To assess whether a merger or ac quisition is in the 'public int erest', the 
competition authorit ies will consider factors such as: 
• National security (including security of energy and food suppl ies) 
• Media quality 
• Financial stability (e.g. prote cting the stability of banks an d financial 
services) 
Investigations 
Investigations may take several  months to complete during which  time 
the merger is put on hold, thus g iving the target company valua ble time to 
organise its defence. The acqui rer may abandon its bid as it ma y not wish 
to become involved in a time  consuming investigation. 
The authorities may simply accep t or reject the proposals or ac cept them 
subject to certain conditions.

Chapter 11 
 447 
Examples 
In recent years, the competition authorities in the UK have inv estigated 
several UK energy company merger s and also mergers in the UK 
supermarket industry.  
In 2018 they are investigating a potential mer ger between ASDA and 
Sainsbury’s to decide whether t he merger will be allowed to go ahead.  
They also have put forward proposals to reduce the dominance of  the 
‘Big Four’ accountancy firms (KPM G, Deloitte, Ernst & Young and  
Pricewaterhouse Coopers) wit hin the UK audit sector. 
In addition, if the offer gives rises to a concentration (i.e. a potential 
monopoly) within the EU, the Eu ropean Commission may initiate 
proceedings. This can result in c onsiderable delay, and constit utes 
grounds for abandoning a bid.  
In March 2017 the European Commissi on blocked a proposed merger  of 
the London Stock Exchange and Deut sche Borse (who operate the 
Frankfurt stock exchange)  due to this reason. 
5 Divestment 
Divestment: Disposal of part of its activities by an entity. (CIMA Official  
Terminology, 2005). 
Reasons for divestment 
The reasons for divestment include: 
The sum of the parts of the entit y may be worth more than the w hole 
As identified earlier in this chapt er, businesses which combine  will attempt to 
find areas where resources can be combined to generate synergy.  However, it 
may be that a business with many  disparate parts actually ends up suffering 
from the opposite effect. For exa mple, the company could be spe nding a lot of 
money trying to integrate busines s units together where there a re no apparent 
benefits. 
In such situations, the divestm ent of part of the business shou ld be considered. 
Divesting unwanted or l ess profitable parts 
If there is an underperforming bus iness unit which fails to mee t general 
company performance targets, d ivestment should be considered. T he 
opportunity cost of holding onto  the underperforming business u nit could be 
very high.

448  
However, management should always c onsider the effect of the di vestment on 
the other parts of the company. F or example, if a division is s old off which 
previously performed some work for other business units within the company, 
disposing of that business unit will lead to the other parts of  the business having 
to buy in goods and services from third parties. 
Strategic change (e.g. to shift the strategic focus onto the co re activities) 
A part of the business which oper ates in a different market sec tor from the rest 
of the group may be considered fo r divestment. Increased focus on the 
company's core activities should help to develop the expertise of management 
and staff, and the strength of the company's brand. 
A response to crisis 
In a crisis, when cash is needed qui ckly, a part of the busines s might be 
divested if an attractive offer is received. 
The most common examples of div estments are sell offs (trade sa les), spin offs 
and management buyouts. 
 
 More on divestment: Se ll-offs and spin-offs 
 Sell-off (or trade sale) 
A sell-off is the sale of part o f an entity to a third party, u sually in return 
for cash. 
The most common reasons for a sell-off are: 
• to divest of a less profitabl e business unit if an acceptable offer is 
received – this could be through a management buyout – see below; 
• to protect the rest of the bus iness from takeover – a part of the 
business which is attractive to a  purchaser may be sold off to avoid 
the whole company being taken over; 
• to generate cash in a time of crisis. 
A sell-off may disrupt the rest o f the organisation if key staf f or products 
from within the organi sation are part of the business unit sold  off. 
Spin-off (or demerger) 
In a spin-off (or demerger) a new  entity is created, where the shares of 
that new entity are owned by t he shareholders of the entity tha t made the 
transfer of assets into the new  entity. There are now two entit ies, each 
owning some of the assets of the original single entity. The ow nership 
has not changed, and in theory the value of the two individual entities 
should be the same as the value of the original single entity.

Chapter 11 
 449 
Reasons for spin-offs 
Spin-offs may be justified as follows 
• they allow investors to identify  the true value of a business that was 
hidden within a lar ge conglomerate; 
• they should lead to a clearer management structure; 
• they reduce the risk of a takeov er bid for the core entity. 
6 Management buyouts 
Definition of a management buyout (MBO):  Purchase of a business from its 
existing owners by members of t he management team, generally in  association 
with a financing institution. ( CIMA Official Terminology, 2005)  
Overview of an MBO 
In an MBO, the purchaser of t he business is not another company  (like in a sell-
off/trade sale), but the existing management. 
Usually the management provide som e of the capital for the buyo ut, but the 
majority is provided by other fi nanciers such as venture capita lists and financial 
institutions. 
 
 MBOs: Considerations for the divesting company 
 Members of the buyout team may possess detailed and confidenti al 
knowledge of other parts of t he vendor’s business and the vendo r will 
therefore require satisfactory warranties over such aspects whi ch it will 
not be able to control. 
More seriously, key members of the MBO team may have skills vit al to 
the vendor’s operation, especially  in regard to information ser vices and 
networking. 
A vendor may be reluctant to allow key players to end their con tracts of 
service to take part in an MBO, b ecause losing vital operationa l skills can 
hardly be compensated by forms of warranty.

450  
 MBOs: Considerations for the management team 
 Considerations before an MBO 
MBOs are not dissimila r to other acquisitions and many of the f actors to 
be considered will be the same. 
• Do the current owners wish to sell?  – The whole process will be 
much easier (and cheaper) if the current owners wish to sell. 
However, some MBOs have been  concluded despite initial 
resistance from the current owners. 
• Potential of the business  – The management team engaged in the 
buyout will be making the switch f rom a relatively safe salarie d 
position to a risky ownership pos ition. They must, therefore, e nsure 
that the victim business will be a long-run profit generator. T his will 
involve analysing the performanc e of the busine ss and drawing u p a 
business plan (products, markets , required new investment, sour ces 
of finance, etc.) for future operat ions. Research shows that MB Os 
are less likely to fail than ot her types of new ventures, but s everal 
have collapsed, and managers mus t appreciate the risks they are  
taking and attempt to reduce t hem as far as possible. 
• Loss of head office support  – On becoming an independent firm 
many of the services that are ta ken for granted in a large 
organisation may be lost. The impor tance of these services vari es 
from one industry to another but  provision will have to be made  for 
support in the areas of finance , computing, research and 
development, etc. Although head offi ce fees might be saved, aft er 
the buyout these support services can involve considerable expe nse 
when purchased in t he outside market. 
• Quality of the management team  – The success of any MBO will 
be greatly influenced by the qual ity of the management team. It  is 
important to ensure that all func tional areas (marketing, sales , 
production, finance) are represent ed and that all managers are 
prepared to take the required risks . A united approach is impor tant 
in all negotiations and a clear r esponsibility st ructure should  be 
established within the team. 
• The price  – As in any takeover situat ion the price paid will be 
crucial in determining the l ong-term success of the acquisition . The 
usual valuation techniques may  be employed, often with more 
confidence as managers are likely  to have a clearer idea of the  
future prospects of t he firm. Care must be taken to ensure that  all 
relevant aspects of the busine ss are included in the package. F or 
example, trademarks and patents ma y be as important as the 
physical assets of t he firm. In a similar way, responsibilities  for 
redundancy costs, etc. mus t be clearly defined.

Chapter 11 
 451 
 Financing the MBO 
In an MBO, unlike a co rporate-backed takeov er, the acquiring gr oup usually 
lacks the financial resources to fund the acquisition. 
For small buyouts the price ma y be within the capabilities of t he management 
team, but it is unlikely that m any managers could raise the lar ge amounts 
involved in some buyouts. 
Several institutions specialise in providing funds for MBOs. Th ese include the 
• venture capitalists; 
• banks; 
• private equity firms; 
• other financial institutions. 
 
 Terminology: Leveraged buyout 
 A leveraged buyout occurs when an investor, typically a privat e equity 
firm, acquires a controlling inte rest in a company's equity and  where a 
significant percentage of the purchase price is financed throug h leverage 
(borrowing). 
Leveraged buyouts involve institut ional investors and financial  sponsors 
(like private equity firms) maki ng large acquisitions without c ommitting all 
the capital required  for the acquisition. 
 
 The role of venture capitalists 
 Venture capitalists 
Typically venture capitalists will be prepared to advance funds  for five to 
ten years, and will expect annual returns on their funds of 25%  or more 
(compounded and received at exi t, rather than annually). They n ormally 
expect to take one or more seats on the board of directors (but  not a 
majority). 
The specific types of finance and conditions attached vary from  one 
investment to another, but key poi nts to be considered include the 
following. 
The form of finance  – The management team may need the venture 
capitalists to contribute more  than 50% of the total funding, b ut will 
always want to keep at least 50% o f the equity for themselves ( a 
controlling stake). Therefore, this limits the amount of equity  finance that 
can be raised from the venture capitalist.

452  
 However, raising too much from  the venture capitalist as debt f inance can 
lead to an unacceptable rise in  the level of gearing in the bus iness 
(perhaps for example if the comp any has debt covenants which li mit the 
gearing level). 
Therefore, venture capitalists o ften provide their funds as a m ix of equity 
and debt, in order to give themse lves security (the debt) while  allowing 
them to participate if thi ngs go well (the equity). 
As a compromise, convertible pr eference shares are often used. This 
ensures that the venture capita list can benefit in the longer t erm if the 
company is successful (by conver ting to equity) but in the shor t term the 
control stays with  the management team. 
The preference shares usually c arry covenants to protect the ve nture 
capitalist's position. These limit the actions that can be take n without the 
venture capitalist’s approval. E xamples might include paying di vidends on 
ordinary shares, amending the Ar ticles of Association or sellin g assets. 
Exit strategy  – The most important fact that any investing institution will 
want to know is how and when they  will get their money back. Th e exit 
strategy is an important part o f the agreement to advance money  in the 
first place. Exit strategies ar e explained more fully later in this chapter. 
Ongoing support  – The management team s hould also consider the 
venture capitalist's willingness  to provide funds for later exp ansion plans. 
Some venture capitalists also off er other services such as mana gement 
consultancy to their clients. 
 
 The role of private equity firms 
 Private equity is sometimes c onfused with venture capital beca use both 
terms refer to firms that inves t in companies and exit through selling their 
investments (often using methods  such as initial public offerin gs (IPOs)). 
However, there are major differe nces between pr ivate equity and  venture 
capital firms. 
Private equity firms mostly buy m ature companies that are alrea dy 
established. The companies may be deteriorating or not making t he 
profits they should be due to ine fficiency. Private equity firm s buy these 
companies and streamli ne operations to increase revenues. Ventu re 
capital firms, on the other hand, m ostly invest in start-ups wi th high 
growth potential. 
Private equity firms often buy 100% ownership of the companies in which 
they invest. As a result, the pr ivate equity firms are in total  control of the 
company after the buyout. Venture capital firms invest in 50% o r less of 
the equity of the companies.

Chapter 11 
 453 
 Most venture capital firms prefe r to spread out their risk and invest in 
many different companies. If one s tart-up fails, the entire fun d in the 
venture capital firm is not affe cted substantially. By contrast , private 
equity firms prefer to c oncentrate all their efforts in a singl e company. 
Since they invest in already established and mature companies, the 
chances of absolute losses from s uch investments are minimal. 
 
 Details on financing MBOs 
 Financiers tend to favour estab lished businesses with reliable  cash flows 
(to pay down the debt) and a clear exit route. 
They like definitive plans, but s ay they prefer them brief and to the point. 
The emphasis should be on the co mpetences of the team, and the 
market opportunity to  be exploited, with detailed financial num bers 
(focussing on cash flow) put int o an appendix. How services pre viously 
supplied by group departments, or  fellow subsidiaries, will be replaced is 
likely to be a key item. 
Managers will be r equired to invest some of their own money and  this will 
take the form of shares with spec ial features, for example a hi gh 
proportion of any disposal value. 
Suggested financial structure 
Capital structures are inevitably complex, with several levels of 
risk/reward: 
• Secured borrowings  are usually obtained from a bank, with a first 
charge on the assets taken over by the venture. 
• The provider of senior debt  will require a first-ranking security over 
all the assets involved in the MBO venture and, usually, over t he 
capital of the MBO as evidenced by shares in the new entity. 
Security will also involve undertakings from the MBO team 
regarding the provision of financ ial information and the settin g of 
restrictions on the MBO’s capac ity to raise other debt finance and to 
dispose of assets. 
• Junior debt  is usually called mezzanine finance, which is an 
intermediate stage between seni or debt and equity finance in 
relation to both risk and return. The return on mezzanine finan ce 
can comprise a mixture of deb t interest and the ability to conv ert 
part of the debt into equity, perhaps  by the conversion of warr ants. 
By this means the lender can in tim e have a share in the premiu m 
resulting from eventual exit fr om the venture. The debt interes t will 
carry a risk premium, as it is subordinate to the senior debt a nd with 
less security: it may even be unsecured.

454  
 • Venture capital  is a form of equity  provided mainly by institutional 
investors, whose reward will usua lly be in some form of dividen ds, 
probably preferential, combined with appreciation of their MBO 
equity holding which will build up a capital gain for when the 
investment is realised. 
• The last link in the st ructural chain is the equity holding granted to 
the MBO team  itself which, if their acti vities are successful, will 
provide a substantial capital ga in when the venture is exited, either 
through flotation or by ot her means. Meanwhile, the MBO 
management will draw salaries or  fees for their services. 
 
 MBOs: Considerations for the financiers 
 Key points for investors – us ually banks or other institutions  – in deciding 
whether to support an MBO are as follows: 
• What is actually for sale, and wh y? It may be a division or su bsidiary 
of an entity which no longer fits  that entity’s strategy, or it  may be 
separable assets such as a factor y or group of retail outlets. 
• Whether the activities are profi table and enjoy a satisfactory  cash 
flow. The prospective returns mus t justify the operational and 
financial risks involved. Profits m ust be sustainable and cash flow 
adequate to sustain the level of activities proposed. 
• Whether the management is suffic iently strong. This point is 
particularly significant if the MB O relates to loss-making acti vities, 
although sufficient allowance mus t be made for the possibility that 
its existing owners may be burdeni ng it with excessive overhead s. 
Financial competence and marketi ng skills in the MBO’s sector a re 
especially important. 
• Whether the price is reasonable  and a sufficient contribution is 
being made by the managers. The managers should have some 
financial involvement and the futu re prospects for the new enti ty 
should be demonstrable, especially  in a ‘turn-around’ situation . 
These points are important as t he main risks associated with MB Os, and 
hence the reasons why they may fail are: 
• the bid price offered by the MBO team might be too high; 
• a lack of experience in key  areas such as financial management ; 
• a loss of key staff who either  perceive the buyout as too risk y, or do 
not have capital to invest; 
• a lack of finance; 
• problems in convincing emplo yees and fellow colleagues of the 
need to change working practices or to accept redundancy.

Chapter 11 
 455 
 Investors, probably instituti ons, backing the MBO will initiall y hold a 
majority of the equity, with a re latively small minority of sha res held by the 
managers. 
Although the backers must be prepar ed to hold their investment for the 
long term, they and the managers will be looking to the entity growing 
successfully to the point where it  can be launched on the stock  exchange. 
At this stage, a market value c an be obtained for the equity an d, if 
desired, some portion of the in vestment can be realised. 
Where the backers desire a lowe r-risk element in their investme nt, they 
can require that some part of i t will be in the form of redeema ble 
convertible preference shares. T his can give them priority in o btaining 
income through a preference di vidend and preferent ial rights of  
repayment if the entity should fa il. There is also the prospect  of 
redemption if the entity does no t develop satisfactorily, or co nversely, the 
convertible aspect will allow bac kers eventually to increase th eir equity 
holding if the entity s hould prove successful. 
7 Exit strategies 
Overview of exi t strategies 
The investors and financiers in an MBO will want to realise a p rofit from their 
investment in the medium term. 
Debt finance will normally have a specified repayment date, so the debt 
providers will have a clear exit route (a ssuming the borrowing company has 
performed in line with expectati ons and can afford to repay the  debt as 
planned). 
Exit strategies for equity holders 
For the providers of equity, the exit route is not as easy to i dentify. 
The most common exit route for an equity investor is the sale o f the shares to 
another investor. This could be through one of the following me thods: 
Trade sale 
If the MBO company receives an offe r for all its shares from an other company, 
the financiers will be able to rea lise their investment. Howeve r, in a trade sale, 
all the shares are normally acqui red by the bidding company, so  the 
management would have to sell thei r shares in their own company  too. They 
may not be happy to do this, because the appeal of an MBO to ma nagers is that 
they will own their own com pany rather than have to report to o ther 
shareholders.

456  
IPO (Initial Public Offering) 
An IPO or flotation on the stock market was introduced in the e arlier chapter on 
'Financing – Equity finance'. 
An IPO gives the financiers who w ant to sell their shares the c hance to do so on 
the stock market. If the manager s want to keep hold of their sh ares, they will be 
able to do so. 
The problem with an IPO is that  the company will have to satisf y certain 
stringent criteria in order to j oin the stock exchange, and the re will be significant 
costs associated with the listing. 
After an IPO, the shares will be freely traded, which should in crease their 
marketability and hence their va lue. On the other hand, the com pany becomes 
much more susceptible to takeover  when its shares are listed. 
Independent sale to a nother shareholder 
The managers could try to incr ease their shareholdings in the c ompany by 
'buying out' the other financiers. 
This would be expensive, but i f the managers could afford it, i t would prevent 
other external shareholders buyi ng the shares and having a say in the running 
 BB is a listed company located in Country B. It i s a retail cl othing 
business which operates a lar ge number of branded retail stores  
throughout Country B. Its functional  currency is the B$. BB cur rently has 
five distinct brands, each owned and managed by a separate busi ness 
unit. Each business unit runs its own chain of retail stores. B B is seeking 
to sell QQ, one of these busine ss units, in a management buyout . 
A selling price of B $ 450 million has been ag reed. It is antici pated that the 
effective date of the dis posal will be 1 July 20X4. 
The managers of QQ hav e been in discussions with a bank and a v enture 
capitalist regarding the financi ng for the MBO. The proposal is  that the 
managers will put in B $45 million of equity , and the venture ca pitalist 
B$180 million (for class B equi ty shares with limited voting ri ghts). Then 
the venture capitalist and the bank will each invest B$112.5 mi llion as 
debt finance. 
The venture capitalist expects a  return on the equity portion o f its 
investment of at least 25% a year  on a compound basis over the first 4 
years of the MBO. No dividends a re to be paid during this perio d.

Chapter 11 
 457 
 What is the minimum total equit y value of QQ on 30 June 20X8 
required in order to satisfy the  venture capitalist’s expected return? 
A B$225.0 million 
B B$360.0 million C B$439.5 million D B$549.3 million 
 
 The directors of a company are  considering whether to dispose of one of 
its subsidiaries. 
The directors of the subsidiary  are interested in a management buy-out. 
There is a potential conflict of  interest if, during the negoti ation 
phase of the management buy-out, the directors of the subsidiar y 
company were to: 
A  Lease some new vehicles to updat e the company's distribution  
facilities 
B  Accept projects with high net present values C  Perform a revaluation of assets D  Employ more staff in the subs idiary’s administration office 
 
 Stan Co is a large multinati onal company. It has operations in  several 
markets (including clothing, f ood and furniture) and geographic al 
locations. Although Stan Co was o riginally a manufacturing comp any, it 
has expanded its operati ons into distribution and retailing in recent years. 
The directors of Stan Co have decided to acquire the entire sha re capital 
of Ball Co, a small company that brews beer and sells it throug h its own 
network of bars. 
What sort of business combination is this? 
A  Vertical integration 
B  Horizontal integration C  A conglomerate D  A management buyout

458  
 NN sells electrical goods and operates a number of retail outl ets in a 
particular region of the country. NN is in the process of acqui ring the 
share capital of QQ, a company t hat sells the same type of prod ucts in 
the same region of the country t hrough its own retail stores. P ost-
acquisition NN would be the lar gest retailer of electrical good s in that 
region. NN and QQ have perfectly positively correlated cash flo w streams 
because they operate in the same  market sector and location. 
Which THREE of the following would be most likely to be 
synergistic benefits to NN of purchasing QQ? 
A  Cash benefit by sale and lease back of retail store property acquired 
B  Increased sales due to owning a larger portfolio of retail o utlets 
C  Increased profit due to reduc ed competition in the region 
D  Reduction in staff costs due  to elimination of duplicated 
administrative roles 
E  Cost savings due to economies of scale in purchasing activit ies 
 
 The directors of GG Co have decided to sell off one of the com pany's 
subsidiaries, HH Co, for $100 million. 
The managers of HH Co are keen to  set up a management buyout in  
order to take control of their company. 
They have proposed the following financing package, after lengt hy 
discussions with bankers and venture capitalists: 
 $ million 
Equity invested by managers  
($1 'A' shares carrying 1 vote each) 10 
Equity invested by venture capitalist  
($1 'B' shares carrying 1 vo te for every 10 shares) 30 
Borrowing from venture capitalist – unsecured,  
10% interest rate, redeem able in five years  30 
Borrowing from bank – secur ed, 6% interest rate, 
redeemable in five years  30 
TOTAL 100

Chapter 11 
 459 
 Which THREE of the following st atements about the financing 
package are false? 
A  The managers own enough of the equity to enable them to vote  and 
carry decisions in a general meeting. 
B  The venture capitalists own enough of the equity to prevent the 
managers from voting and carrying decisions in a general meetin g. 
C  If HH Co were to go into li quidation, the bank borrowing wou ld take 
priority over all the other sources of finance. 
D  The bank borrowing interest rat e is lower than that on the b orrowing 
from the venture capitalists because the bank borrowing is a 
mezzanine loan. 
E  If HH Co were to go into li quidation, the bo rrowing from the  venture 
capitalists would take priority over all the other sources of f inance. 
 
 Which THREE of the following r easons are often stated as valid 
justification for an acquisition,  in that they help to increase  
A  Diversification of risk B  Reduction of competition 
C  Big data opportunities D  Better career prospects for directors E  Asset stripping 
 
 The directors of Hood Group have decided to sell off a loss-ma king 
subsidiary, Tucker Co. A managem ent team from Tucker Co has 
expressed an interest i n buying the company. 
For which one of the following r easons would the parent company  
be likely to agree to sell Tucker C o to the management team rat her 
than an external buyer, if the MBO team and the external buyer have 
both offered the same price? 
A  To avoid redundancy costs 
B  To avoid non-cooperation fr om management and employees hosti le 
to the divestment 
C  Because the MBO team knows mo re about the company than the 
external buyer 
D  To raise the cash more quickly

460  
 Test your understanding 10 (Case style question) 
 Country T and Country V are separ ated by sea but linked by a r ail tunnel. 
They have different currencies (T$ and V$ respectively) but are  part of 
the same Trade Group which prom otes free trade between its memb ers 
and has authority over membership  countries in matters relating  to 
TNL is a public listed company, based in Country T, which owns and 
operates the rail link between Count ry T and Country V. Trains that travel 
through the tunnel carry passenge rs, cars and other vehicles su ch as 
trucks. 
TNL was first listed on 1 June 20X4 by offer for sale of 100 mi llion 
ordinary shares to the public at a price of T$ 3.70. Today, 21 November 
20Y3, the share price is just T$  2.95. The fall in the share pr ice since 
20X4 is largely the result of d isappointing growth and market c oncerns 
about TNL’s ability to renegotiate bank borrowings that are sho rtly due for 
repayment. The ordinary shares a re held by a large number of in dividual 
shareholders as well as by large institutions and pension funds . The 
number of shares in issue re mains unchanged since 20X4. 
Debt funding is in the form of bank borrowings from a consortiu m of 10 
banks to a total principal val ue of T$ 190 million. The borrowi ngs were 
taken out on 1 June 20X4 and have  a 10 year term. New borrowing s are 
currently being negotiated to fi nance the repayment of the orig inal 
borrowings on 1 June 20Y4. 
There is strong price competit ion between TNL and two independe nt ferry 
companies, TT and VV which ar e based in Countries T and V 
respectively. Prices are generally  low for travel by ferry sinc e ferries are 
less convenient as they oper ate less frequently and have longer  journey 
times than the rail tunnel link . TT has incurred losses in the past two 
years. 
The board of TNL has approached  ferry company TT with a view to  
acquiring it. The directors o f TT are opposed to the bid and ha ve referred 
the bid to the regional competit ion authorities of both Country  T and the 
Trade Group. 
Required: 
Discuss the possible reasons why T NL may wish to acquire TT, an d 
explain: 
• Why the competition authorities in Country  T and in the Trade 
Group might be concerned about t he proposed acquisition. 
• The possible actions that the co mpetition authorities could ta ke and 
the implications of these for TNL. 

Chapter 11 
 461 
Advise TNL on: 
• The factors that the banks are likely to consider when decidin g 
whether or not to renew the loans made to TNL. 
• Other appropriate sources of fi nance that should be considered . 
 (30 minutes) 
 
 Country Y 
Country Y is a large industrialis ed country with strong motor v ehicle and 
construction industries. The gla ss industry supplies glass to t hese 
industries as well as to speciali st users of glass such as cont act lens 
manufacturers. There are five maj or glass manufacturing entitie s, each 
with market coverage in Country  Y of between 5% and 40%. 
Entity Q 
Entity Q is a quoted entity and a ma jor player in the glass ind ustry. It has 
a market share in Country Y o f approximately 35%. It is an old,  well- 
established entity with a number  of factories used to manufactu re glass 
both locally and abroad. It has a s table, but unexciting, growt h rate of 3% 
per annum and is facing increasin g competition from new glass 
manufacturing entities setting up in its key markets. However, Q’s high 
earnings levels of earlier years have resulted in relatively lo w levels of 
debt. 
The head office building of Q i s in the far north of Country Y in a remote 
geographical area. It is a consid erable distance from the capit al city and 
major centres of population in t he south of the country. The bu ilding is 
much larger than the entity requi res and several floors are uno ccupied. 
The management team of Q is highl y experienced; the majority of  the 
senior managers have worked for Q for the whole of their workin g lives. 
The computer systems of Q were written especially for the entit y, but are 
in need of replacement in favour o f something more flexible and  
adaptable to changing circumstances. 
Entity Z 
Entity Z, with a market share in  Country Y of 10%, is a compara tively new 
and small, but fast growing unquo ted family-owned entity. It sp ecialises in 
certain niche markets for high security and extra heat-resistan t glass. The 
patents for this specialist glass were developed by the founder  owner 
who now acts as Managing Direct or. The development of the busin ess 
has largely been funded by high le vels of borrowings at rates o f interest 
well above standard market rates . In addition, the directors ha ve often 
been required to provide persona l guarantees against personal a ssets.

462  
The management team of Z works in  the capital city of Country Y , which 
is in the more prosperous souther n part of the country. Z has a  
manufacturing base on the outski rts of the capital city. 
The management team of Z is enthus iastic to grow the business, but is 
continually frustrated by a la ck of financial an d human resourc es and 
marketing network that would enabl e Z to expand into internatio nal 
markets. Also, on a personal l evel, many of the senior managers  own a 
substantial number of shares in Z and are keen to realise some of their 
capital gains and become  financially more secure. 
The computer systems of Z cons ist of a basic accounting package  and an 
internal network of PCs. Spreads heet packages are widely used f or 
budgeting and other financ ial reporting. 
Takeover bid 
The directors of Q have approach ed the directors of Z with a vi ew to 
making a takeover bid  for Z. A conditi on of the bid would be th e retention 
of the current management team of Z , who have vital knowledge o f the 
specialist manufacturing techniq ues required to manufacture the  product 
range of Z. The directors of Z have been initially quite positi ve about the 
bid. 
Both parties are concerned tha t the deal may be referred to Cou ntry Y’s 
Competition Directorate, which  regulates the country’s competit ion policy, 
for approval and that conditions may be imposed that could make  the 
takeover less attractive. 
Required: 
(a) Explain the role of competit ion authorities such as Country  Y’s 
Competition Directorate. 
(b) Advise the directors of Q and Z on the potent ial problems o f 
merging the management structu re and systems of the two entitie s 
and how these could be minimised. 
(c) Discuss whether the choice of c apital structure for the new  
combined entity is likely to affe ct the overall value of the en tity. 
Include references to Modigliani  and Miller’s (M & M’s) theory of 
capital structure in your answer. 

Chapter 11 
 463 
 Big Data management involves usi ng sophisticated systems to ga ther, 
store and analyse large volumes o f data in a variety of structu red and 
unstructured formats. Companies a re collecting increasing volum es of 
data through everyday transactions  and marketing activity. If m anaged 
effectively this can lead to m any business benefits although th ere are 
risks involved. 
If MONEY acquires CASH it will ge t access to a significant amou nt of 
new data regarding a potentially brand new customer base. MONEY  
needs to consider whether this new  data is going to be manageab le and 
whether it will provide useful information. 
If, following the acquisition, the  two companies are going to c ontinue to 
be managed as completel y separate entities t hen it may be compl icated 
to integrate the systems to be able to perform sophisticated an alysis 
across the two sets of data. MON EY therefore need to be clear w hat the 
objective of such analysis may be and whether the business bene fits 
make it worthwhile. 
MONEY would need more informati on on the current customer base of 
CASH to identify if there are any l ikely cross-selling opportun ities. 
Although CASH provides loans to  small businesses and start-ups,  it is 
quite possible that some of thes e companies wil l have entrepren eurs in 
control who will be high net wor th individuals, if not now then  at some 
point in the future. Having acce ss to information about such in dividuals 
can allow MONEY to produce more  targeted marketing activity and  
increase its client base relati vely easily. This can work both ways as 
CASH can identify from MONEY’s clients possible lending opportu nities 
as some of these clients are likely to be business owners. 
If the two companies are concer ned that their individual client s may not 
like being targeted by other com panies, another option is to us e the data 
available to expand the produc t range for each entity. So MONEY  could 
offer its clients an increased r ange of borrowing options and C ASH could 
offer its clients investment advice.

464  
 • Operating efficiencies – the unused capacity at GSL can be use d to 
produce Williams' products withou t adding to costs and capacity . 
• Marketing synergies. 
• If the cash flow streams of W illiams and GSL are not perfectly  
positively correlated then by ac quiring GSL – Williams may redu ce 
the variability of their operat ing cash flow. This being more a ttractive 
to investors may lead to cheaper financing. 
• The ‘dedicated’ herbalists of GS L and the R+D st aff of William s may 
be a complementary resource. 
• Fixed operating and administ rative costs savings. 
• Consolidation of manufacturing capacity on fewer and larger si tes. 
• There may be bulk buying discounts. 
• Possibility of joint adver tising and distribution. 
• GSL is badly managed – thus the elimination of inefficiency co uld 
allow for financial synergy. 
 
The VC is making a B$ 180 milli on equity investment. To generat e a 
return of 25% a year on a com pound basis this investment will n eed to 
grow to B$ 439.5 million (= B$ 1 80 million × (1.25)4) at the en d of 4 
years. 
The VC investment represents 80% (= 180/(180 + 45) × 100%) of t he 
equity, therefore the total equity  value will need to be B$ 549 .3 million 
(= B$ 439.5 million/0.80). 
 
All the other decisions are ones  that would be perfectly accept able in the 
normal course of business. 
The value of the subsidiary's assets is likely to be a key issu e when 
determining the consideration to  be paid in the MBO, so revalui ng assets 
could be contentious.

Chapter 11 
 465 
The two businesses seem to have very little in common, so the 
combination would be referr ed to as a conglomerate. 
 
The two businesses operate in t he same region so combining them  
should lead to an opportunity to c ombine administrative roles ( D), make 
more profit due to less competit ion (C) and wield greater purch asing 
power over suppliers (E). 
 
 The answer is (B), (D) and (E). 
The managers do own enough of the equity to enable them to vote  and 
carry decisions in a general meet ing; they have 10 million vote s and the 
venture capitalists have 3 million votes (A). 
If HH Co were to go into liquidation, the secured  bank borrowing would 
take priority (C). 
 
 The answer is (B), (C) and (E). 
Diversification of risk (A) c an be done more effectively by inv estors rather 
than companies. 
Directors should only undertake ac quisitions if there are benef its to 
shareholders, rather than consideri ng their own career prospect s (D).

466  
When an MBO team wants to buy a  company, they will almost certa inly 
be reluctant to co-operate with  the sale to an outside buyer. 
Although the MBO team will k now more about the company than an 
outside buyer (C) this is not a m atter of direct concern to the  selling 
company. 
Since the parent company has tw o potential buyers, avoiding red undancy 
costs (A) is not an issue eit her. Either purchaser would have t o consider 
the need for redundancies after t he takeover. There would be no  cost to 
the parent. 
There is no particular reason wh y a sale to an MBO team would b e 
quicker than a sale to an ex ternal purchaser (D). 
 
TNL may wish to acquire TT in order to: 
• Gain economies of scale/synergi stic benefits. For example, TNL  and 
TT could share the same booking internet site. 
• Increase market power. By offe ring ferry services as well as r ail 
services, TNL will have increased  influence over ferry prices i n 
addition to rail prices.  This increase in power could be used to its 
• Increase customer loyalty. M arketing promotions (e.g. frequent  
traveller schemes) could be s hared across TNL and TT, reducing 
marketing costs and increasing cu stomer loyalty and convenience  
by offering a ‘one-stop’ shop fo r both rail and ferry tickets. 
• Increase market share through cr oss subsidies or a price war. TNL 
could offer rail link passenger r educed cost ferry tickets or c ross 
subsidise the ferry business by reducing fares for the ferries (financed by higher priced rail link tickets) in order to build  its market 
share of the ferry business. TNL could use a price war in the f erry 
business to build market share and destroy competition, funding  by 
profits from the ra il link business. 
• Obtain tax relief. TNL may be able to make use of tax losses 
incurred by TT by offsetting lo sses against any profits in TNL.  
Competition author ities intervene where i t is considered that t he bid 
would have a serious effect on co mpetition in the market by giv ing 
significant market power to a par ticular market participant or where the 
bid is contrary to public interest.

Chapter 11 
 467 
 The competition author ities of the Trade Gr ouping would be part icularly 
interested due to the reduction in  competition that would arise  in a key 
communication link between two c ountries in the Union. Country T’s 
competition authorities may be less concerned as the move would  give 
Country T a competitive advantage over Country V. 
In this case, there is a high risk to TNL that the competition authorities 
find grounds to investigate the proposed acquisition further. I f TNL were 
to own all ferry and rail links  from Country T, it could be in a position to 
control prices and affect compet ition  It already has a monopol y position 
in respect of the rail link and it m ay not be considered in the  public 
interest to also allow TNL to ac quire significant control over the ferry 
operation. For example, it could raise prices for rail link pas sengers and 
cross-subsidise the ferry busi ness in an attempt to put VV out of 
business. 
Whatever the final result, refer ring the bid to the regulatory authorities 
can be expected to significantly  delay the bid and create uncer tainty and 
costs for TNL at this key time when it needs to renegotiate ban k 
borrowings. If they decide to int ervene, the regulatory authori ties would 
have the power to either prev ent the acquisition going ahead or  impose 
certain conditions on TNL. Such conditions might include, for e xample, 
price constraints or a requirem ent to operate the ferries from a port that is 
not so close to the rail link tunnel. 
Answer to the second task 
Issues that the banks are likely to consider: 
• How will TNL pay back the orig inal borrowings if the banks do not 
agree to renew the loans? Would t he banks be likely to get any 
money back anyway? 
• To what extent would the referra l to the competition authoriti es 
affect TNL – for example, what p rice controls might be imposed and 
how would that affect TNL’s profitability? 
• What is the likely impact on TN L’s future results of acquiring  TT? 
Would it be likely, in practice , to realise synergistic benefit s from the 
acquisition? 
• Can TNL afford to buy TT; how w ould it be financed? Given that  it is 
likely to be a hostile bid then TNL will need to pay a signific ant 
premium for TT. 
• TNL’s latest long term cash forecast and the sensitivity of ca sh flow 
to other possible government int ervention (e.g. green taxes) or  
market prices (e.g. fuel and ex change rates, especially regardi ng V$ 
costs and V$ selling prices (r egarding sales wit hin Country V)) .

468  
 • How do the credit ratings agencie s view TNL? Have they put TNL  
on ‘Negative outlook’ to indicate  the possibility of a downgrad e in 
the next few months. How should  this impact on the banks’ 
willingness to lend and on the interest rate offered? 
• Deterioration in gearing levels – and hence risk. 
–  Gearing on 1 June 20X4 : 34% (= 190/(190 + 370)) 
–  Current gearing: 39% (= 190/(295 + 190)) 
• Management reputation – has the or iginal team left? What is th e 
background and reputati on of the current team? 
• Impact of government assistance. If the tunnel is seen as 
strategically important for the Country might the Government st ep in 
and provide support to TNL. This would reduce the banks’ risk. 
Other sources of finance: 
Rights issue 
TNL may have to ask shareholders  for cash by means of a rights issue if 
banks are unwilling to renew borro wings. However, investors may  not be 
willing to invest additional sum s of money in a company that ha s seen 
such a decline in the value of i ts shares in the last 10 years.  
If the banks are unwilli ng or unable to rollover the borrowings , it is likely 
to be very difficult for TNL to  be able to obtain finance from other sources 
such as, for example, bonds, becaus e of its poor credit worthin ess. 
Indeed, TNL may have no choice but to ask shareholders for cash  by 
means of a rights issue if ban ks are unwilling to renew the ban k 
Under a rights issue: 
• Shareholders would be given t he right to buy additional shares  in 
proportion to their existing shar eholding at a discount to the current 
• The share price is likely to fall, largely as a result of the discount. 
However, a rights issue is a r isky option in this case since th e cash would 
be used to repay debt. Shareholders prefer to subscribe new cap ital to 
finance new projects and hence pr omote future growth and return s. 
Shareholders may not be willing to help finance the repayment o f debt, 
especially since they have alread y seen their previous investme nt in TNL 
lose value. 
The size of the rights issue coul d also be a problem – at a 20%  discount 
shares would be issued at T$ 2. 36 per share before taking issue  costs 
into account. This equates to 80.5 million shares which is an 8 0.5% 
increase in the number of shares c urrently in issue. At this sc ale it is 
unlikely that any rights issue would be wholly successful. Even  if the 
company were highly successful, s hareholders may not have the f unds or 
may be unwilling to make t he additional investment.

Chapter 11 
 469 
 Equity is more costly to servi ce than debt and could lead to a reduction in 
the value of the company due to  the loss of the tax benefit on debt 
interest. 
Government funding 
If the business is seen as key to Country T’s trade position, t hen the 
government may be prepared to st ep in and offer funding as a la st resort 
rather than see the company fail and the rail link cease to ope rate. This 
would result in conditions bei ng imposed on TNL which might res trict its 
operations and future development. 
 
 (a) The Competition Directora te is a government-run or funded body 
which aims to protect competitio n within the local marketplace.  Its 
brief will vary from country to  country, but a Competition Dire ctorate 
should consider the following issues: 
–  Whether a merger or acquisiti on is in the public interest. F or 
example, there may be a policy  to prevent all reservoirs being 
under one body for security reasons; 
–  Whether there would be subst antial lessening of competition,  
leading to the risk o f price setting and less competitive prici ng 
so that the consumer is forced  to pay an inflated price for 
goods or services; 
–  The ability to measure whether  competition is still operatin g 
and prices set fairly after the merger has taken place. For 
example, for public utilities, t here needs to be a sufficiently  
large number of utility entitie s to enable the regulator to 
compare prices wit h other entities in  the same market. 
(b) Potential problems in merging th e management structures and 
how to minimise them 
Potential problems that could be raised include the following: 
–  The importance of retaini ng the current management team. 
This is key to the success of t he merger and plans to develop 
the business of Z; 
–  Different locations (opposing ends of the country); –  Spare capacity in the office  building in the north of the co untry, 
but the management team of Z may w ell not be willing to move 
out of the capital. On the ot her hand, moving the management 
of Q down to the capital would result in an expensive empty 
office block in the north that m ay stand empty and, cost aside,  
there may not be a suitable o ffice building to house the 
combined entity in or near to the capital city.

470  
 Possible solutions: 
–  Offer the current managemen t team an attractive salary 
package; 
–  Obtain guarantees backed by financial incentives for 
management to stay with the business; 
–  Determine which key employ ees and managers are willing to 
relocate and which operations n eed to be centralised and then 
identifies the lowest cost solution. 
Potential problems in mergi ng the systems and how to 
minimise them 
Potential problems include: 
–  Completely different type o f systems at present: PC network 
for Z and bespoke system for Q.  It is unlikely that Q could 
operate on a network of PCs and t he transition would, in any 
case, be very problematic. On t he other hand, it is unlikely th at 
the different nature of the busi ness of Z would fit well into t he 
bespoke system that Q operates. 
Possible solution: 
–  The management may need to  agree to run the systems 
independently and bui ld an effective interface. 
(c) Under M & M, capital structur e is irrelevant if you ignore taxes. 
However, if tax is included, debt becomes cheaper because of th e 
tax shield and the value of the entity therefore increases as t he 
proportion of debt increases. Afte r a certain point, the entity  reaches 
its debt capacity. That is, the le vel of debt at which there is  a high 
risk of financial distress and both lenders and shareholders de mand 
increased returns to compensate fo r the higher levels of risk. 
From the information provided in the question, it would appear that 
Q is currently borrowing at level s well below its debt capacity  and 
would therefore increase the val ue of the entity by taking on a  
higher proportion of debt. 
Similarly, Z could well be borro wing in excess of its debt capa city 
and so its value would be enhanced by reducing the proportion o f 
debt on its statement o f financial position. 
It is therefore highly likely tha t both entities would benefit from the 
improved capital structure tha t would result from a merger or 
takeover if Q were to fund the  takeover of Z using debt or were  to 
acquire Z together with it s high levels of debt.

471 
Business valuation 
D2: Evaluate the various 
 
 (a)  Evaluate different 
(b)  Discuss the strengths and 
valuation method  
• Asset valuation 
• Different methods of equity valuation (share prices, earnings 
valuation, dividend valuation , discounted cash flow valuation) 
• Capital Asset Pricing Model (CAPM) 
• Efficient market hypothesis 
 
  Chapter 
12

472  
 
 2 Introduction to business valuation 
Business valuation is not a pre cise, scientific process. The va lue of a business 
is affected by: 
• reported sales, profits and asset values 
• forecast sales, profits and asset values 
• type of industry 
• level of competition 
• range of products sold 
• breadth of customer base 
• perspective – the buyer and t he seller will often have differe nt 
expectations and hence may val ue the business differently. 
The valuation methods covered in this chapter give suggested va lues of a 
business. 
The final value is then agreed bet ween buyer and seller after a  process of 
negotiation.

Chapter 12 
 473 
 Valuation of quoted a nd unquoted companies 
 Quoted (listed) companies 
A quoted (or listed) com pany will have a sto ck market value (or  market 
capitalisation). 
If small numbers of shares are bei ng traded on the stock market , this 
share price will be used by traders. 
However, if one company is attemp ting to take over another by a cquiring 
the majority of the shares, the market capitalisation value wil l not 
necessarily give a suitable val ue for the transaction, since th e 
shareholders will not have any incent ive to sell their shares a t the current 
In order to encourage the shar eholders in the target company to  sell their 
shares, a premium is normally o ffered on top of the current sto ck market 
In conclusion, when valuing a lis ted company, the current stock  market 
share price should be used as a s tarting point for the calculat ions rather 
than as a definitive final figure. 
Unquoted (unlisted) companies 
An unquoted (or unlisted) company has no stock market value. Al so, 
there is likely to be less publis hed information available whic h might help 
a purchaser to assess the value of an unlisted company. Unless there 
has been a recent private sale of the company's shares for a kn own 
value, the valuation process for an unlisted company is usually  quite 
complex. 
When valuing an unlist ed company, estimates  often have to be ma de, 
based on available information ta ken from similar listed compan ies 
('proxy' companies). 
The valuation methods shown belo w often value unlisted companie s 
using data derived from proxy lis ted companies e.g. cost of equ ity, beta, 
dividend yield, P/E ratio. 
In practice, it can be difficult to  find a similar listed compa ny. 
The final answer may have to be discounted by 25% to 35% to acc ount 
for: 
• relative lack of marketabili ty of unquoted shares – it is more  difficult 
for investors to sell their shar es if the company is not listed  
• lower levels of scrutiny, ther efore greater ri sk of poor quali ty 
• higher risk of being a smaller , less well-regarded company wit h, 
possibly, a more volatile earnings record.

474  
3 The different valuation methods 
There are three basic wa ys of valuing a business: 
Asset based valuation method 
The business's assets form the ba sis for the valuation. Asset b ased valuation 
methods are difficult to apply to  businesses with high levels o f intangible assets, 
but this chapter covers methods of valuing intangible as well a s tangible assets. 
Earnings based valuation method 
The projected earning s for a business will give an indication o f the value of that 
business. For example, a busi ness with high forecasted earnings  will be 
attractive to a potential purc haser, and hence wil l be valued h ighly. In this 
chapter, we shall see how earning s can be used in business valu ation. 
Cash flow based methods 
In theory, a business's value s hould be equal to the present va lue of its future 
cash flows, discounted at an appr opriate cost of capital. This chapter explains 
how to identify and forecast futu re cash flows, and how to choo se an 
appropriate discount rate. 
Specifically, we shall see how t he dividend valuation model can  be used to 
value the business based on it s expected dividend payments, and  a discounted 
cash flow approach can be used to  value the overall cash flows of the business. 
 
 When should each method be used? 
Although the most important thi ng is to know how to use the var ious methods to 
calculate values, it is also nec essary to understand the circum stances in which 
each is most appropriate. 
For example asset-based valuati ons have very limited relevance for entities 
which are going concerns espec ially if they have substantial in tangible assets. 
In each of the following secti ons, the various valuation method s are explained 
together with the circumstances i n which they might be most app ropriate. 
 
 4 Asset based valuation 
In this method the company is view ed as being worth the sum of the value of its 
assets. 
Remember to deduct borrowings when arriving at an asset value i f just the 
equity is being acquired, but no t if only the physical assets a nd related liabilities 
are being purchased without acqui ring any liability for the bor rowings.

Chapter 12 
 475 
An asset based valuation is most useful when a company is being  broken up, 
rather than purchased as a going concern. Since the method does  not 
incorporate the valuation of i ntangible assets, it usually give s a low valuation 
figure, which helps the parties to  set a minimum price in a tak eover situation. 
Asset valuations are therefore lik ely to be more useful for cap ital-intensive 
businesses, than for service bus inesses, where many of the asse ts are 
intangible. 
Alternative asset valuation bases 
The asset valuation can be ca lculated in various ways: 
Book value 
This method suffers from being la rgely a function of depreciati on policy, for 
example, some assets may be wr itten down premat urely and others  carried at 
values well above their real wor th. Original costs  may be of li ttle use if assets 
are very old, or if asset replac ement has been irregular over t ime. 
Thus, this method is of little use in practice. 
Replacement value 
This method calculates the cost o f replacing the business's ass ets, which may 
be relevant if the assets are going to be used on an on-going b asis, or if the 
bidder wants to estimate the mini mum price that would have to b e paid to buy 
the assets and set up a similar business from scratch (especial ly if an estimate 
of intangible value can be added on). 
Break-up value/Net realisable value 
Individual assets are valued at t he best price obtainable, whic h will depend partly 
on the second-hand market and par tly on the urgency of realisin g the asset. 
This method can be used to set a m inimum selling price for the vendors, as they 
could liquidate the business as a n alternative to selling the s hares. 
If a company has any tradable invest ments, including shares or digital assets 
such as cryptocurrency (e.g. Bi tcoin, Litecoin), these should b e valued at their 
current market price. 
The strengths and weaknesses  of asset based valuations 
The main strengths of asset-based valuations are: 
• the valuations are fairly readily available; 
• they provide a minimum value of the entity. 
The main weaknesses of asset-based valuations are: 
• future profitability e xpectations are ignored;

476  
• statement of financial position valuations de pend on accountin g 
conventions, which may lead to v aluations that are very differe nt from 
market valuations; 
• it is difficult to allow for t he value of intangible assets. T he valuation of 
intangibles is cover ed in detail below. 
   More detail on asset based valuation 
 An asset based valuation method  for a listed co mpany will usua lly give a 
value considerably lower than t he market value of all the compa ny's 
shares (the market capitalisation value). 
So it should be obvious that shar eholders/the market does not v alue the 
company on the basis of the stat ement of financial position's a ssets. 
Shareholders are not buying the company for its assets but for the 
income those assets can produce. 
This future income is generated  from the use of the statement o f financial 
position assets together with the intangible assets like highly  skilled 
workforce, strong management team  and competitive positioning o f the 
company's products. 
Thus assets in the crude sense of statement of financial positi on values 
are only one dimension of a com pany's overall value (in a norma l going 
concern situation).

Chapter 12 
 477 
 The summarised balance sheet (st atement of financial position)  of Owen 
at 31 December 20X7 is as follows: 
Non-current assets 23,600 
Current assets 8,400 
 –––––– 
 32,000 
 –––––– 
Capital and reserves  $1 Ordinary shares 8,000 
 
–––––– 
 19,200 
Non-current liabilities  6% Unsecured bond 8,000 
 
–––––– 
 32,000 
 –––––– 
Required: 
Calculate the value of one ordina ry share in Owen, using an ass et 
based valuation method. 
Fowler is wanting to make a bid for Owen. It has estimated that the replac ement cost of Owen's non-curren t 
assets is $40 million. 
Required: 
Calculate the value of a share in  Owen from Fowler's perspectiv e.

478  
 Ray plc, a UK listed manufacturi ng company, is considering a t akeover 
bid for Ribbon Ltd, a smaller, unlisted company in the same ind ustry. 
Ribbon Ltd has been making losses i n the last 2 years, so it is  considered 
that an asset based me thod should be used to value the business . 
Extracts from Ribbon Ltd’s Stat ement of Financial Position 
Assets GBP000 
Non-current assets (Note 1) 1,207 
Current assets (Note 2) 564 
 ––––– 
 1,771 
 ––––– 
GBP1 Ordinary shares  100 
Retained earnings  553 
 ––––– 
 6 5 3  
5% bonds  600 
Current liabilities  518 
 ––––– 
 1,771 
 ––––– 
Note 1: The non-current assets compris e of specialised equipment. To 
replace the equipment would cost G BP1.5m, but if Ribbon Ltd wer e to be 
closed down, the assets would sell for no more than GBP1m. 
Note 2:  Receivables contain an amount o f GBP120,000 from a large 
customer which has just gone into  liquidation. A contract for t he same 
customer, included in work in pr ogress (inventory) at a value o f 
GBP30,000 will now have to be scrapped. 
Required: 
Calculate the expected valuati on of Ribbon Ltd, from the perspe ctive of 
Ray plc. Explain and justify your figures.

Chapter 12 
 479 
5 Valuation of intangible assets 
Definition of intangible assets 
Intangible assets (intangibles) lack physical properties and re present legal 
rights or competitive advantages developed or acquired by an ow ner.  
In order to have value, intangi ble assets should generate some measurable 
amount of economic benefit to the owner, such as incremental tu rnover or 
earnings (pricing, volume and be tter delivery, amongst others),  cost savings 
(process economies and marketing cost savings) and increased ma rket share 
or visibility.  
Owners can exploit intangibles eit her in their own business (di rect use) or 
through a licence fee or r oyalty (indirect use).  
 
 Characteristics of  intangible assets 
 Intangible assets show the following four characteristics: 
Identifiability 
Intangible assets can be identif ied specifical ly with reasonabl y descriptive 
names and should see some evidenc e or manifestation of existenc e such 
as a written contract, licence, d iskette, procedural documentat ion or 
customer list, amongst others. T he intangible assets should hav e been 
created at an identifiable time  (or event) and be subject to te rmination at 
an identified time (or event). 
Manner of acquisition 
Intangible assets can be purc hased or developed internally. 
Determinate or indeterminate life 
A determinate life will usually be established by law or contra ct or by 
economic behaviour and should have come into existence at an 
identifiable time as the resu lt of an identifiable event. 
Transferability 
Intangible assets may be bought, s old, licensed or rented and a re subject 
to the rights of priva te ownership, ensuring a legal basis for transfer. 
Specific examples of intangible assets 
The “International Glossary of Bus iness Valuation Terms” is a g lossary of 
business valuation terms that def ines intangible assets as “non -physical assets 
such as franchises, trademarks, p atents, copyrights, goodwill, equities, mineral 
rights, securities and contracts (as distinguished from physica l assets) that 
grant rights and priv ileges, and have value for the owner.”

480  
Many of these intangible assets a re also referred to as intelle ctual capital, which 
can be defined as the value of an organisation's employee knowl edge, skills, 
business training or any proprie tary information that may provi de the company 
with a competit ive advantage. 
 
 More on intellectual capital 
 The term ‘intellectual capital’  has many complex connotations and is 
often used synonymously with in tellectual property, intellectua l assets 
and knowledge assets. Intellectual  capital owned by a business is an 
important intangible asset. 
Intellectual capital can be thought of as the total stock of ca pital or 
knowledge-based equity that the ent ity possesses. As such, inte llectual 
capital can be both the end resu lt of a knowledge transformatio n process 
or the knowledge itself that is transformed into intellectual p roperty or 
intellectual assets of the firm.  This can include information g athered 
through ‘Big Data’ analysis. 
Intellectual capital includes: 
• Human resources – The collectiv e skills, experience and knowle dge 
of employees. For a lot of service based businesses, this is li kely to 
make up the bulk of the company’s value 
• Intellectual assets – Knowledge which is defined and codified such 
as drawing, computer progr am or collection of data 
• Intellectual property – Intelle ctual assets which can be legal ly 
protected such as pat ents and copyrights. 
Brands 
Intellectual property is legally  defined and assigns property r ights to such 
things as patents, tr ademarks and copyrights. 
These assets are the only form o f intellectual capital that is regularly 
recognised for accounting purposes. 
However, accounting conventions based upon historical costs oft en 
understate their value. 
Companies can’t recognise inter nally generated goodwill in thei r 
accounts, but on acquisition the value of any brand should be e stimated 
and recognised.

Chapter 12 
 481 
 Digital assets 
 Increasingly, digital assets a re becoming a major part of many  business’s 
intangibles. 
Digital assets include: 
• Websites and apps 
• Branding 
• Cryptocurrency  
• Domain Names 
• And many more other forms of digital data 
Valuation of intangibles (includi ng digital assets) is covered in detail 
below, but there are additional co nsiderations that make the va luation of 
digital assets even more complex  than the valuation of other in tangibles. 
Changing regulations 
Digital assets are a relatively  new phenomenon and therefore as  new 
assets and technologies develop , regulations surrounding the as sets 
develop too.  
When acquiring a busi ness with lots of digital assets, the acqu iring 
company needs to consider emergi ng regulations that could threa ten 
future revenue streams 
For example, governments and ot her regulatory aut horities are c urrently 
consulting on potential regulat ory models to shape the developm ent of 
artificial intelligence, and are paying much closer attention t o how an 
organisation’s use of data affect s both consumers and markets. 
Usage rights 
Digital assets are of ten created in partner ship with third part y consultants, 
so it is vital to consider us age rights when acquiring a compan y with 
digital assets.  
Due diligence procedures should be designed to identify which p arty or 
parties have usage rights over th e digital assets before the ac quisition 
takes place. For example, uncer tainty over the ownership of cod e created 
by contract consultants could ca use the acquirer to pull out of  the deal. 
Valuation of intangible assets 
It is recognised that intangible as sets often have a significan t value. Indeed 
many entities have intangible as sets that are far more valuable  than their 
tangible assets.  
Intangibles may also be of signi ficant importance to shareholde rs and other 
stakeholders, and are often a ke y part of integrated reporting.   
The basic asset based methods cov ered earlier do not incorporat e this value.

482  
There are three basic ways of v aluing the intangible assets of an entity: 
1 Market approach: 
Here the intangible asset is va lued by comparing the asset to a n identical 
(or very similar) one that has r ecently been traded in an arm’s  length 
Unfortunately, for many intangibl e assets, such information is difficult if not 
impossible to obtain. Publicly a vailable information usually re flects the 
market capitalisation of an ent ire business, not individual int angible assets.  
However, it might be possible  to find direct market evidence fo r intangibles 
such as carbon emission rights , internet domain names and licen ces (for 
radio stations, for example). 
2 Cost approach: 
For some intangibles like inter nally developed software (e.g. w ebsites or 
apps) a cost approach to valuati on can be used. Historic cost c ould be 
easy to identify, but in most c ases, replacement cost new (the cost of a 
similar new asset) is the most d irect and meaningful cost appro ach to 
estimating the value of an asset. 
The problem with all cost appr oaches is that they ignore the am ount, 
timing and duration of future economic benefits, as well as the  risk of 
performance within a com petitive environment. 
3 Income approach: 
Income based models are best us ed when the intangible asset is income 
producing or when it allows an a sset to generate cash flow.  
Just as in other valuation assi gnments (see later notes in this  chapter), an 
income approach technique conv erts future benefits (such as cas h flows 
or earnings) to a single, disc ounted amount, usually as a resul t of 
increased turnover or cost savings. 
One of the main difficulties wit h an income approach method is 
distinguishing the cash flows uni quely related to the intangibl e asset from 
the cash flows related to the whole company. 
Among the most common income bas ed methods is the “Relief from 
royalty method”, where the cost s avings (or income enhancement)  from 
using an intangible such as a tr ademark or patent are directly estimated. 
Under this “Relief from royalty  method”, value is based on the payment 
that would have been made had a th ird party licenc e been used ( for the 
right to employ the asset to earn benefits). 
Another common income based approac h is a multi-period excess 
earnings model, such as the Calcul ated Intangible Value (CIV) m ethod.

Chapter 12 
 483 
Calculated Intangible Value (CIV) method 
The CIV method has been developed to  estimate the value of a co mpany’s 
intangible assets that do not appear in its statement of financ ial position. It is 
used alongside the basic asset val uation to give a more accurat e valuation of all 
the company’s assets (both  tangible and intangible). 
The CIV method is based on a com parison of the total return tha t the company 
is producing against the return th at would be expected based on  industry 
average returns on tangible assets.  
Any additional return is assumed  to be the return on intangible  assets. 
This additional return is assum ed to continue in perpetuity and  can be 
converted into a present day val ue for intangibles (the Calcula ted Intangible 
Value, or CIV) by discounting a t the company’s cost of capital.  
The value of intangible assets  thus calculated is then added to  the value of the 
tangible assets of the busine ss to generate a total value. 
i.e. Total value of the entity = Value of tangible assets + CIV  
CIV is an adaption of the asset v aluation method and suffers fr om the same 
drawback as the basic asset valua tion method, in that it is bas ed on historical 
figures. Unlike DCF valuations ( covered later in this chapter) which look forward 
into the future and are based on  forecast future outcomes when valuing a going 
concern. 
Other drawbacks of CIV include: – CIV assumes future growth in  income from intangibles will be constant at 
the cost of capital. 
– CIV is based on prof it rather than cash flow. 
– CIV is based on an industry ave rage return which might not be  
representative of the company being valued. 
 
Illustration of the CIV calculati on (Objective test question) 
 UUU Co is a financial servic es company based in the USA. 
It reported a profit before tax in the most recent financial ye ar of USD 
28.5 million, and the value of its  tangible assets is USD 210 m illion. 
The average return on tangible assets for firms in the financia l services 
industry is 9%. The tax rate is 25% and UUU Co's cost of capita l is 14%. 
What is the value of UUU Co  using the CIV approach? 
A USD 51.4 million 
B USD 217.2 million C USD 238.5 million D USD 261.4 million

484  
Solution: 
The answer is (D). 
Workings: 
  USDm 
Current pre-tax profit  28.5 Less: Industry ROA × Tangible assets 9% × 210m  (18.9) 
  — —
– 
Excess annual return (pre-tax)  9.6 
  — — – 
Post-tax excess annual retu rn 9.6m × (1–0.25)  7.2 
CIV (assuming constant perpet uity) 7.2m × 1/0.14  51.4 
Therefore, the total value o f UUU Co is estimated to be 
210m + 51.4m = USD 261.4m 
 
 Chapman Co has just reported a pre-tax profit of $24.29m, and the value 
of its tangible assets in its st atement of financial position i s $128.66m. 
The average return on assets for companies in the same industry  is 10%. 
The tax rate is 30% and Chapman Co's cost of capital is 16%. 
What is the value of Chapman Co using the CIV approach? 
A $179m B $153m 
C $137m D $50m 
 
 6 Earnings based valuations 
In an earnings based valuation , the earnings of the business ar e forecasted and 
then an 'earnings mul tiple' is applied. 
This earnings multiple could si mply be a number  negotiated betw een buyer and 
seller (e.g. a business could be valued at 3 times earnings), o r it could be a 
perpetuity factor based on a suit able cost of capital. In this latter case, the 
earnings forecast is being taken as an approximation of cash fl ow and 
effectively a discounted cash fl ow approach is being used (see more details 
later in the chapter). 
The most commonly used approach i s to take a suitable P/E ratio  as the 
earnings multiple.

Chapter 12 
 485 
P/E valuation method 
The P/E valuation method is a v ery simple method which values t he equity of a 
business by applying a suitable P/E ratio to the business's ear nings (profit after 
tax). 
Value of company's equity = Total  post-tax earnings × P/E ratio  
Value per share = EPS × P/E ratio 
 
 Using the P/E valuation formula 
 The P/E ratio method is the simp lest valuation method. It reli es on just 
two figures (the post-tax ear nings and the P/E ratio). 
Post-tax earnings 
The current post-tax earnings, or EPS, for a company can easily  be found 
by looking at the most recent published accounts. However, thes e 
published figures will be historic, whereas  the earnings figure  needed for 
valuation purposes should be an ex pected, future earnings figur e. 
It is perfectly acceptable to u se the published earnings figure  as a starting 
point, but before performing the va luation, the historic earnin gs figure 
should be adjusted for  factors such as: 
• one-off items which will not rec ur in the coming year (e.g. de bt write 
offs in the previous year); 
• directors' salaries which migh t be adjusted after a takeover h as 
been completed; 
• any savings ('synergies') whi ch might be made as part of a 
takeover. 
P/E ratio 
The P/E ratio for a listed com pany is a simple measure of the c ompany's 
share price divided by i ts earnings per share. 
The P/E indicates the market's p erception of the company's curr ent 
position and its future prospects . For example, if the P/E rati o is high, this 
indicates that the company has a  relatively high share price co mpared to 
its current level of earnings, s uggesting that the share price reflects good 
growth prospects of the company. 
An unlisted company has no mark et share price, so has no readil y 
available P/E ratio. Therefore , when valuing an unlisted compan y, a 
proxy P/E ratio from a similar listed company is often used.

486  
 Proxy P/E ratios 
As explained above, an unlisted company will not have a market- driven 
P/E ratio, so an industry average P/E, or one for a similar com pany, will 
be used as a proxy. 
However, proxy P/E ratios are al so sometimes used when valuing a listed 
company – of course if a listed ent ity's own P/E ratio is appli ed to its own 
earnings figure, the calculation will just give the existing sh are price. 
In particular, proxy P/E ratio s are used in the context of boot strapping, 
which is covered in  the next chapter. 
 
 Molier is an unquoted entity with a recently reported after-ta x earnings of 
$3,840,000. It has issued 1 million ordinary shares with nomina l value of 
$0.50 each. A similar listed ent ity has a P/E ratio of 9. 
What is the current value of one ordinary share in Molier using  the 
P/E basis of valuation? 
A $34.56 million 
B $69.12 million C $34.56 D $69.12 
The strengths and weaknesses  of P/E method valuations 
The main strengths of P/E method valuations are: 
• they are commonly used and are well understood; 
• they are relevant for valuing a controlling interest in an ent ity. 
The main weaknesses of P/E method valuations are: 
• they are based on accounting pr ofits rather than cash flows; 
• it is difficult to identify a suit able P/E ratio, particularly  when valuing the 
shares of an unlisted entity; 
• it is difficult to establish the relevant level of sustainable  earnings.

Chapter 12 
 487 
 Company X is considering a bid for Company Y. 
X has earnings of $3m per annum, and Y has earnings of $1.5m pe r 
annum. The P/E ratio of X i s 12 and that of Y is 8. 
If the takeover proceeds, it is ex pected that synergies of $0.5 m per 
annum will be generated, and that t he combined company will hav e a P/E 
ratio of 11. 
Required: 
Calculate the maximum price th at X should pay for Y, and the mi nimum 
price that Y should accept. 
 
 Earnings yield method 
 In some questions, you may not be given the P/E ratio, but you  may be 
given the Earnings Yield instead. 
The earnings yield is the recipr ocal of the P/E ratio i.e. Earn ings Yield = 
1/ (P/E ratio). Hence, 
Value of company = Total earnings/Earnings Yield 
Value per share = EPS/Earnings Yield 
Understanding and interpre tation of Earnings Yield 
Some deeper analysis is desirable , for example examining the tr end of 
share price over a number of qua rters in the light of any event s such as 
profits warnings and acquisition s (or rumours thereof), and the  likely 
effect that they have had on earnings. 
The stability of Earnings Yield i s often as important as its gr owth, bearing 
in mind that in a general way the market is absorbing new infor mation to 
try to assess a sustainable level of EPS on which to base growt h for the 
future. Clearly, effective grow th is dependent on a stable base , and the 
trend of Earnings Yield over time  is to an extent a reflection of this factor. 
A prospective acquirer would , of course, be concerned to assess  the 
worth of a prospective target on the basis of its becoming part  of the 
acquiring entity, and the valuat ion will especially need to tak e into 
account the expectations of the target’s shareholders.

488  
 A further point relates to the ac quirer’s intentions regarding the target. If, 
for example the latter entity is to be partially demerged, that  is certain 
parts disposed of other entities in which they would provide a better fit, 
then the share price valuatio n may well be greater than if the whole target 
entity was to be retained. Nev ertheless, any such break-up 
considerations will need to take  into account all the stakehold ers, 
including employees, suppliers and customers of the target, as any 
serious demotivation will take a way from the goodwill value of the 
acquisition and quite possibly damage that of the acquiring ent ity itself. 
 
 7 Cash flow valuation: The dividend valuation model 
Dividend Valuation Model (DVM) Theory 
The theory states that the val ue of the company/share is the pr esent value of 
the expected future dividends, d iscounted at the shareholders’ required rate of 
return. 
This links to the NPV method cove red earlier in your studies, w here the 
discounted cash flows from a proje ct represented the gain in we alth to 
shareholders if the proj ect were undertaken – wealth (share val ue) is linked to 
discounted future cash flows. 
If we assume that all cash flows  to equity are paid out as divi dends, the DVM 
would therefore give the same r esult as valuing a company by di scounting cash 
flows to equity at the cost of equity. 
DVM formula 
E i t h e r        P o=do
ke       P o= do(1+g)
ke – g 
Assuming: a constant dividend or constant growth 
Note that: 
g = forecast future growt h rate in dividends, and: 
Po = Value of company, when do = Total dividends 
Po = Value per share, when do = Dividends per share

Chapter 12 
 489 
Also, note that the simple formula  (when assuming a constant di vidend) is just a 
rearrangement of the standard dividend yield formula: 
Dividend yield = (Dividend/ Share price) × 100% 
In fact, the formulae presented he re are just short-cuts which can be applied if 
there is no growth, or if there is constant growth in dividends  into perpetuity. 
The dividend valuation model in its most basic form is just a c ash flow 
discounting model, which can be us ed for any set of discrete fu ture dividend 
cash flows even if they don't gro w at a constant rate in perpet uity. 
i.e. Value = (Dividend in 1 year  × 1 year discount factor) + (D ividend in 2 years 
× 2 year discount factor) +....etc. 
 
 Target has just paid a divid end of EUR250,000. It has 2 millio n shares in 
issue. 
The current return to shareholders  in the same industry as Targ et is 12%, 
although it is expected that an additional risk premium of 2% w ill be 
applicable to Target, being a sm aller and unlisted company. 
Required: 
Calculate the expected va luation of Target, if 
(a) dividends are expec ted to be constant 
(b) dividends are expected  to grow at 4% per annum. 
 
 Forecasting growth – Gordon's growth model 
Gordon’s growth model was devel oped by the economist Myron Gord on. 
It attempts to derive a future gro wth rate, rather than simply extrapolating 
the historical growth rate. 
Gordon argued that an increase in  the level of investment by a company 
will give rise to an increase in  future dividends. Therefore, t he two key 
elements in determining future  dividend growth will be the rate  of 
reinvestment by the company a nd the return generated by the 
investments. 
Formula 
Gordon's growth model formula is: 
g = r × b where r = return on reinvest ed funds and b = proportion of fund s retained.

490  
Example 
Bennett Co generates an average ret urn on its investments of 10 % per 
year. In recent years the compan y has paid out 40% of its earni ngs as a 
dividend. 
Using Gordon's growth model, the ex pected future growth rate is : 
g = r × b = 0.10 × (1 – 0 .40) = 0.06 (6% per year) 
There are a number of assumpti ons that underpin this model: 
• the entity must be all equity financed; 
• retained profits are the only source of additional investment;  
• a constant proportion of each y ear’s earnings is retained for 
reinvestment; 
return. 
The strengths and weaknesses o f dividend-based valuations 
The strengths of divide nd-based valuations are: 
• value is based on the present val ue of the future dividend inc ome stream 
(cash flow to an investor), s o the method has a sound theoretic al basis; 
• they are useful for valuing mi nority shareholdings where the s hareholder 
only receives dividends from the entity, over which he has no c ontrol. 
The main weaknesses of using the dividend valuation model are: 
• it is very difficult to foreca st dividends and dividend growth , especially in 
perpetuity. For example, how c an we predict whether there will be 
sufficient worthwhile projects to  invest in over such a long te rm period? 
And what about the normal life cycl e of a business – this could  be the 
initial growth part of the cycle and not sustainable in the lon g term. Also, 
what about a new company that has  yet to pay a dividend, that w ould be 
given a zero value under DVM bu t could actually be worth a cons iderable 
sum of money; 
• particularly for unlisted co mpanies, it can be difficult to es timate the cost of 
equity (note that in the exam, i f you are not given the cost of  equity, you 
should use CAPM to derive it, or use proxy company information) . Also, 
for unlisted companies, a consistent dividend policy with const ant growth 
rate is unlikely.

Chapter 12 
 491 
Uneven growth rates 
The dividend valuation model form ula cannot be used directly wh en the annual 
growth rate is expected to change. 
In such cases, the entity’s lif espan should be segmented into t he periods for 
which the varying growth rates  apply, and value each separately . 
 
issue. 
applicable to Target, being a sm aller and unquoted company. 
Required: 
Calculate the expected valuation of Target, if dividends are ex pected to 
stay constant for 3 years, then grow at 4% per annum thereafter . 
Solution: 
Separate the future dividend str eam into two parts: first, the constant 
dividends for 3 years, then the growing perpetuity thereafter. 
First 3 years 
Present value of expected divi dends = 250,000 × AF1–3 (14%) = 
EUR0.580m 
Perpetuity from year 4: 
Use the given DVM formula, t hen adjust for the fact that the di vidend 
stream starts in year 4, not year 1 as normal: 
[(250,000 × 1.04)/0.14–0.04)] ×  DF3 (14%) = EUR 1.755m 
Total value = 0.580m +  1.755m = EUR 2.335m 
or 2.335/2 = EUR1.17 per share.

492  
 Western Co has paid out a stead ily growing dividend over the l ast few 
years, where dividends have grow n at 2% per year. The company's  cost 
of equity is 10% and the dividend just paid (at the most recent  year end) 
was $1.5 million in total. 
Western Co has 10 million shares  in issue and its shares are va lued at 
$1.91. 
Change of future plans 
A new chief executive has jus t been appointed. He has expressed  his 
intention to change the dividend policy of Western Co, as follo ws: 
The next dividend (in 1 year’s  time) will be half of what it wo uld have 
been under the previous dividend po licy. Then, the chief execut ive 
hopes to be able to increase the dividend by 10% per year for t he 
next three years, before increas ing the dividend at 5% per year  in 
perpetuity. 
Required: 
Calculate the likely change in s hare value if the new policy is  introduced, 
on the assumption that the divi dend valuation model is used to value the 
shares and that the proposed changes have been publicly announc ed to 
the market. 
Concluding thoughts on the divi dend valuation model (DVM) 
The DVM demonstrates the underlyi ng principle that a company is  worth the 
sum of its discounted  future cash flows. 
However, DVM is based on very sim plistic model, but does provid e a useful 
analytical tool for investors to  use to evaluate different assu mptions about 
growth and future prospects. 
The challenge is to make the mo del as applicable to reality as possible, which 
means using the most reliable assumptions available. 
 
 8 Cash flow valuation: Dis counted cash flow method 
Overview of the method 
Under the discounted cash flow (DCF ) method, a value for the eq uity of the 
entity is derived by estimati ng the future annual after-tax cas h flows of the 
entity, and discounting these ca sh flows at an appropriate cost  of capital. This is 
theoretically the best way of val uing a business, since the dis counted value of 
future cash flows represents  the wealth of the shareholders. 
The cost of capital used to di scount the cash flows should refl ect the systematic 
risk of the cash flows.

Chapter 12 
 493 
 The expected after-tax cash fl ows of Thomas, an all equity fin anced 
company with 2 million shares  in issue , will be as follows: 
Year GBP 
1 120,000 
2 100,000 
3 140,000 4 50,000 
5 onwards 130,000 
A suitable cost of capital for evaluating Thomas is 12%. 
What is the value of Thomas's equi ty (in total) using the DCF b asis 
of valuation? 
A  GBP 392,050 
B  GBP 1,006,300 C  GBP 1,083,333 D  GBP 1,475,383 
More details on cash flows and cost of capital 
Cash flows to equity 
Ideally, cash flows to equity should be used in DCF valuations rather than post-
tax post-financing cash flows. 
Cash flows to equity are similar to post-tax post-financing cas h flows, except 
that they include average sustai nable levels of capital and wor king capital net 
cash flow investments over the longer term rather than this yea r's figures. 
Post-tax cash flows (after financ ing charges) are often used as  an 
approximation for cash flows to equity. 
However, where sufficient info rmation is provided in a question  to enable cash 
flows to equity to be calculated , cash flows to equity should b e used in the DCF 
valuation instead of post-ta x post-financing cash flows.

494  
 Free cash flow 
 The concept of 'free cash flow' 
Free cash flow is the cash gener ated by the business that is 'f reely' 
available for distribution to i nvestors after having met all th e immediate 
obligations of the business and inve stment in working capital a nd in non- 
current assets that is necessa ry to sustain on-going operations . 
There are many different wa ys of defining free cash flow. 
In CIMA materials and F3 OTQs  you will find the following terms  being 
used: 
Cash flow to equity refers to c ash flow generated by the compan y after 
tax, reinvestment needs and debt-re lated cash flows. That is, c ash flow 
attributable to equity investors. 
Cash flow to all investors refe rs to cash flow generated by the  company 
after tax and reinvestment needs  but before debt-related cash f lows. That 
is, cash flow attributable to a ll investors, both debt and equi ty investors. 
Free cash flow to equity is su stainable cash flow to equity, an d free cash 
flow to all investors is sustainab le cash flow to all investors . 
Use of cash flows to equity 
The value of the shareholders’ st ake (equity) in an entity is t he sum of the 
future cash flows to equity di scounted at the cost of equity. 
Note that if we assume  that a company pays out all of its cash flow to 
equity as a dividend, the DCF com pany valuation method (where c ash 
flows to equity are discounted at cost of equity) will give exa ctly the same 
result as the DVM valuation me thod introduced earlier in the ch apter, 
where the cash flows to equity u sed in the DCF calculation are assumed 
to grow at a constant rate and th e same growth rate is used in the DVM 
The problem of lack of information 
In a project appraisal, the ca sh flows generated from the proje ct are 
easily identifiable, but in a busi ness valuation they can be ha rder to 
identify and quantify. 
This is because there are so m any of them, and because the nece ssary 
information does not usually exist in the public domain. 
Therefore, for busine ss valuation, we oft en have to estimate ca sh flows 
using readily-available accounting information.

Chapter 12 
 495 
 How to calculate cash flo w data from profit data 
  
Cash flow to equity Cash  flow to all investors 
1 Start with pr ofit before 
interest and tax (PBIT). 1 Start with PBIT. 
2 Deduct tax for the year (see 
note, below) and interest to give profit for the year. 2 Deduct tax for the year, 
excluding tax relief on interest (see note, below). 
3 Adjust for non-cash items 
(e.g. add back depreciation). 3 Adjust for non-cash items 
(e.g. add back depreciation). 
4 Adjust for cash items such 
as capex/disposal of non-current assets; changes in working capital; new debt raised/debt repaid. 5 Adjust for cash items such as 
capex/disposal of non-current assets; changes in working capital. 
Note:  Tax can be calculated as 
(PBIT – interest) × tax rate. Or, if tax depreciation allowances differ 
from depreciation, tax is: (PBIT + 
depreciation – tax depreciation allowances – interest) × tax rate. Note:  Tax can be calculated as 
PBIT × tax rate. Or, if tax depreciation allowances differ from 
depreciation, tax is: (PBIT + 
depreciation – tax depreciation allowances) × tax rate 
 
 Example of free cash flow to all investors 
 The recently published accounts of Matty show the following fi gures: 
 $ million 
Profit before interest and tax 220 Interest 40 
Profit after interest but before tax 180 
Tax expense (tax rate 20%) 36 Depreciation  8 
Capital expenditure  70 
Increase in working capital 10 Debt repayment 15 
Required: 
Calculate the free cash flow to  all investors in the year.

496  
 Solution: 
 $ million 
Profit before interest and tax 220 Less tax expense based on PBI T: 20% × $220m  (44)  
Plus depreciation  8 
Less capital exp enditure  (70) 
Less increase in working capital  (10) 
 
–––– 
Free cash flow to all investors 104 
 –––– 
 
 Example of free cash flow to equity 
 $ million 
Profit before interest and tax 220 
Interest 40 Profit after interest but before tax 180 
Tax expense (tax rate 20%) 36 
Depreciation 8 Capital expenditure 70 
Increase in working capital 10 
Debt repayment 15 
Required: 
Calculate the free cash fl ow to equity in the year. 
Solution: 
 $ million 
Profit for the year  (220 – 40 – 36) 144 
Plus depreciation 8 
Less capital exp enditure (70) 
Less increase in working capital (10)  Less debt repayment (15) 
 
–––– 
Free cash flow to equity 57 
 ––––

Chapter 12 
 497 
 Another example of fr ee cash flow to equity 
 The recently published accounts of Carey show the following fi gures: 
Operating profit (after deducti ng depreciation of USD 3m) = USD  32m 
Interest paid = USD 2m Taxation = USD 9m Capital expenditure = USD 4m, whi ch is assumed to represent a 
sustainable level of inves tment in non-current assets. 
Required: 
Solution: 
Free cash flow to equity = 32m +  3m – 2m – 9m – 4m = USD 20m 
 
 An appropriate cost of capital 
The introductory parag raph above explained t hat 'an appropriate  cost of capital' 
should be used for discounting . In some exam questions, you wil l be told 
directly which cost of capital  to use. However, in other cases you will be 
expected to either calculate o r select an appropriate cost of c apital. It is then 
important to understand the fo llowing relationships: 
Use of cost of equity as a discount rate 
The cost of equity can be used to  discount the cash flows TO EQ UITY (i.e. 
post-tax cash flows AFTER finan cing charges) in order to value the equity in a 
company directly. 
Use of WACC as a discount rate 
WACC can be used to discount the cash flows TO ALL INVESTORS (i .e. post-
tax cash flows BEFORE financing c harges) when valuing a project  or an entity 
(debt + equity value). To find  the company's equity value, the value of debt 
would need to be deducted. 
In summary:

498  
Note that the equity valuation me thod is likely to more appropr iate for divisions 
since they commonly report on a pre-financing basis. They do no t have their 
own capital structure and ther efore the cost of financing that is required to 
calculate entity value. 
Use of proxy company information 
The cost of capital used must reflect the risk of the entity's cash flows. 
For listed companies, it is norma lly quite easy to identify the  cost of capital, 
using the huge amount of informati on which is publicly known ab out the listed 
company. However, for an unlisted company, or perhaps a divisio n of a 
company, it is much more difficu lt (due to lack of available in formation) to 
identify an appropriate  cost of capital. 
If a cost of capital is not given , or if is difficult to derive  one, a proxy cost of 
capital from a similar listed co mpany could be used instead. Mu ch more detail 
on deriving a suitable cost of c apital is presented in the next  section below. 
 
 Test your understanding 9 (Integration question) 
 Chassagne Co is considering maki ng a bid for Butler Co, a riva l 
company. 
The following information should  be used to value Butler Co. 
 GBP 
 m  
Revenue 285.1 Cost of sales  (120.9) 
 
––––– 
Operating expenses (inc depr eciation GBP 12.3m)  (66.9) 
 ––––– 
Profit from operations  97.3 
 ––––– 
 ––––– 
Profit after tax 65.7

Chapter 12 
 499 
• selling prices are expected to  rise at 3% per year for the nex t 3 
years and then stay constant thereafter. 
• sales volumes are expected to r ise at 5% per year for the next  3 
• assume that cost of sales is a co mpletely variable cost, and t hat 
other operating expens es (including depreciation) are expected to 
stay constant. 
• Butler Co invested GBP 15m in non-current assets and GBP 2m in  
working capital last year. Thes e annual amounts are expected to  
stay constant in future. 
• Butler Co's financing costs are expected to stay constant each  year 
• the marginal rate of tax is 28% , payable in the year in which the 
liability arises. 
• assume that book depreciation equals tax depreciation. 
• Butler Co has 500 milli on shares in issue. 
• the WACC of Butler Co is 9% and its cost of equity is 12%. 
Required: 
Calculate the value of the equity  in Butler Co (in total and pe r share) by 
forecasting future cash flows  to equity and discounting them to  present 
value using cost of equity. 
The strengths and weaknesses  of cash-based valuations 
The strengths of this method of valuation are: 
• theoretically this is the best method of valuation; 
• it can be used to place a max imum value on the entity; 
• it considers the time value of money. 
The weaknesses of this method are: 
• it is difficult to forecas t cash flows accurately; 
• it is difficult to determine an appropriate discount rate; 
• what time period should we eva luate in detai l and then how do you value 
the company's worth beyond this period? i.e. the realisable val ue at the 
end of the planning period; 
• the basic NPV method does not eva luate further options that ma y exist. 
However, the approach can be modi fied, by adding decision trees  and 
probabilities to the analysis, to enable us to assess the sensi tivity of the 
results to potential vari ations in cash flows;

500  
• the basic model assumes that the discount rate and tax rates a re constant 
through the period, although again th is problem can be overcome  by using 
sensitivity analysis and other methods of analysing risk such a s 
probabilities and decision trees. 
9 Deriving a suitable cost of capital for discounting 
In some questions, you will be to ld what the cost of capital of  the entity is, so it 
will be clear what cost of capita l to use for discounting the f orecast cash flows. 
However, in some questions you m ay only be given information fo r a proxy 
entity (if information for your  chosen entity is not available) . 
When using a proxy cost of capita l, care must be taken to ensur e that it reflects 
the business risk and the capita l structure of  the entity being  valued. 
If necessary, a risk adjusted co st of capital could be used. 
Risk adjusted cost of capital 
In the earlier chapter on 'Financi ng – Capital structure' we sa w how to use 
Modigliani and Miller's (M & M 's) equations to adjust an entity 's cost of equity or 
cost of capital to reflect a d ifferent capital structure. 
In this chapter we shall revisi t the M & M equations and also c over the Capital 
Asset Pricing Model (CAPM), which  can also be used to derive a risk adjusted 
cost of capital for discounting. 
Modigliani and Miller's (M & M's) equations 
M & M's equations relating to c ost of equity and cost of capita l were introduced 
in the earlier chapter on 'Financi ng – Capital structure'. They  are shown again 
below: 
WACC  k adj = k eu [1 – (V D t / (V E + V D)] 
where V E = value of equity, V D= value of debt 
ke = Cost of equity (k eg = cost of equity in geared co, k eu = cost of 
equity in ungeared co) 
kd = Cost of debt (must be gross of tax) 
kadj = the weighted aver age cost of capital in a geared company t =  
Corporation tax rate 
WACC = weighted average cost of capital

Chapter 12 
 501 
 Illustration 2 (Integration question) 
 Eamon Co is forecast to generate a constant stream of post-tax  cash 
flows (after interest charges) of $10m per year. 
The company is not listed, and no cost of equity has been calcu lated. 
However, a similar listed entity , Frank Co, which operates in t he same 
business sector has a cost of equity of 10%. 
Frank Co is all equity financed wh ereas Eamon Co has 20% debt a nd 
80% equity by market values. The  tax rate is 30%, and the yield  on 
Eamon's debt is 4%. 
Required: 
Calculate the value of Eamon Co, using the discounted cash flow  
method. 
Solution: 
The given post-tax and post-interest cash flows need to be disc ounted 
using an appropriate cost of equity. 
Although Frank Co operates in the same business sector, its gea ring is 
different. Hence, a risk adjust ed cost of equity (suitable to E amon Co's 
circumstances) would be (u sing M & M's formula): 
keg = k eu + (k eu – k d) (1 – t) V D / V E 
= 10% + (10% – 4%) (1 – 0.30) 20/80 
= 11.05% Therefore, the value of Eamon Co's equity is $10m/0.1105 = $90. 5m 
The Capital Asset Pricing Model (CAPM) 
The CAPM enables us to calculate  the required return from an in vestment given 
the level of risk associated wit h the investment (measured by i ts beta factor). 
Before showing how the CAPM formu la can be used to derive a sui table risk-
adjusted cost of capital for di scounting, we first need to intr oduce the model and 
explain the terminol ogy surrounding it. 
In order to explain how the CA PM works, it is first necessary t o introduce the 
concepts of systematic and unsystematic risk.

502  
 Systematic and unsystematic risk 
There are two element s that make up the ri sk associated with a company: 
• Unsystematic (or specific) risk is the risk of the company's c ash flows 
being affected by specific factor s like strikes, R&D successes,  systems 
failures, etc. 
• Systematic (or market) risk is  the risk of the company's cash flows being 
affected to some extent by general  macro-economic factors such as tax 
rates, unemployment or interest rates. 
 
The impact of diversification 
By holding a portfolio of investm ents, the unsystem atic risk is  diversified away 
but the systematic risk is not, s o will be present in all portf olios. 
For example, the retu rn from a single investment in an ice-crea m entity will be 
subject to changes in the weather – sunny weather producing goo d returns, 
cold weather poor returns. By it self the investment could be co nsidered a high 
risk. If a second investment were made in an umbrella entity, w hich is also 
subject to weather changes, but in the opposite way, then the r eturn from the 
portfolio of the two investment s will have a much- reduced risk  level. This 
process is known as diversifica tion, and when continued can red uce portfolio 
risk to a minimum. 
If an investor enlarges his por tfolio to include approximately 25 shares the 
unsystematic risk is reduced to c lose to zero, the implication being that we may 
eliminate the unsystem atic portion of overall risk by spreading  investment over 
a sufficiently diversified portfolio.

Chapter 12 
 503 
The capital asset pricing model ( CAPM) enables us to calculate the required 
return for a well-diversified in vestor who is not subject to un systematic risk. 
If we can measure the systematic r isk of a company or investmen t, the CAPM 
will enable us to calculate t he level of required return. 
β (beta) factor 
The method adopted by CAPM to measur e systematic risk is an ind ex, β (beta). 
The β factor is the measure o f a share's volatility in terms of  market risk. 
The β factor of the market as a whole is 1. Market risk makes m arket returns 
volatile and the ß factor is si mply a yardstick against which t he risk of other 
investments can be measured. 
The β factor is critical to appl ying the CAPM; it illustrates t he relationship of an 
individual security to the market  as a whole, or conversely the  market return 
given the return on an individual security. 
Beta values fall into four cat egories, with the following meani ngs: 
(i)  β > 1 The shares have more  systematic risk than the stock market 
average. 
(ii)  β = 1 The shares have the same  systematic risk as the stock 
market average. 
(iii) β < 1 The shares have less systematic risk than the stock market 
average. 
(iv) β = 0 The shares have no ri sk at all (if part of a well-di versified 
portfolio). 
A share's beta val ue can be interpreted quite precisely: 
β = 1.25 : The shares have 25% more  systematic risk than the average 
level on the stock market. 
β = 0.80 : The shares have 20% less systematic risks than the 
average. (i.e. they only hav e 80% of the average level). 
 
 The security market line (SML) 
 The security market line (SML) gives the relationship between systematic 
risk and return. We know two relationships: 
1 The risk-free security 
This carries no risk and theref ore no systematic risk and there fore 
has a beta of zero. 
2 The market portfolio 
This represents the ultimate in di versification and therefore c ontains 
only systematic risk. It has a beta of 1.

504  
 The results may be plotted: 
 
Rf is the point on the graph where  the line intersects the axis, and then 
the higher the systemat ic risk, the higher the required rate of  return. 
The SML and the relationship bet ween required return and risk c an be 
shown using the formula shown below. 
Formula – given in the exam 
ke = R f + [R m – R f] β 
where k
e = required return from individual security 
β = beta factor of i ndividual security 
Rf = risk-free rate of interest 
Rm = return on market portfolio 
Note:  In exams, the question will somet imes refer to t he market prem ium – this 
is the difference between Rm and Rf. It is the long term market  premium that 
should be used in CAPM if this is different from current market  rates. 
 
 Calculating beta factors 
 Beta factors for a company are  calculated statistically from p ast observed 
returns; for example the London Bu siness School ‘Risk Measureme nt 
Service’ is published quarterly, u sing monthly returns from the  previous 
five years to calculate each quoted share’s beta. 
Such an analysis begs two questions: 
• Is it reasonable to use a beta fa ctor, calculated from the pas t, as the 
basis of decision-making about the future? 
• Are beta values observ ed to be stable over time?

Chapter 12 
 505 
Beta values tend to be more stabl e for highly diversified share s such as 
investment trusts than for more focused companies. Naturally be ta will 
only be stable if the company’s syst ematic risk remains the sam e, i.e. the 
company carries on the same are as of business in the long term.  
Since betas are calculated stat istically, the calculated beta v alue will be 
more reliable the more separate data went into its calculation.  Therefore 
the longer the period u nderlying the calcul ations the better. 
However if the beta wil l be used to estimate a required rate of  return for a 
future project, it is importan t that the company’s risk class i n future will be 
more or less unchanged by accepti ng the project. Many businesse s deal 
with this apparent paradox by usin g a sector average beta rathe r than 
using their own calculated beta. 
The CAPM gives a required return  for a given level of risk (mea sured by the 
beta factor). 
Therefore, if we can estimate t he level of risk associated with  an entity (the beta 
of the entity), we can use CAPM to  give a required return to sh areholders. 
This required return to shareholde rs is essentially the cost of  equity which can 
then be used to derive an appropr iate WACC for the entity. 
 
 Alpha values 
 If the CAPM stated that we should expect, on average, an annua l return 
of 16.5%, this does not mean that  the shares will produce a ret urn 
(dividend yield plus capital gain) of 16.5% each year. Remember , shares 
are a risky investment which pro duces an uncertain annual retur n. 
Suppose in one particular year, Company A shares produce an act ual 
return of 18%. The shares are s aid to have produced a positive 
'abnormal' return of 1.5% – tha t is, 1.5% hig her than the expec ted return. 
The alpha value of a share is s imply its average abnormal retur n. 
Suppose Company A shares have an alpha value of +2%, this impli es 
that in the recent past the s hares have, on average, produced a  return of 
16.5% + 2% = 18.5%. 
Alpha values can be ei ther positive or negat ive, and in a perfe ct world 
they should be zero. In other wor ds the average return that the  shares 
actually do produce should be the same as the return indicated by 
CAPM. However, the world isn't perfect and so that will not alw ays 
happen. Hence we get positive and negative alpha values.

506  
 Criticisms of the CAPM 
1 CAPM is a single per iod model. This means that the values cal culated are 
only valid for a finite period of time and will need to be reca lculated or 
updated at regular intervals. 
2 CAPM assumes no transaction co sts associated with trading sec urities. 
3 Any beta value calc ulated will be based on historic data whic h may not be 
appropriate currently. This is par ticularly so if the company h as changed 
the capital structur e of the business or t he type of business i t is trading in. 
4 The risk free rate may change co nsiderably over short periods  of time. (5)  
CAPM assumes an efficient inves tment market where it is possibl e to 
diversify away risk. This is not necessarily the case, meaning that some 
unsystematic risk may remain. 
6 Additionally, the idea that all unsystematic risk is diversif ied away will not 
hold true if stocks change in terms of volatility. As stocks ch ange over time 
it is very likely that the portfo lio becomes less than optimal.  
7 CAPM assumes all stocks relate  to going concerns, this may no t be the 
case. 
Asset betas, equity betas and debt betas 
In order to calculate cost of equity and / or WACC for use in b usiness valuation, 
we first need to expand our under standing of beta factors. 
• The beta factor is a measure o f the systematic risk of an enti ty relative to 
• This risk will be dependent on t he level of business risk and the level of 
financial risk (gearing) a ssociated with an entity. 
• Hence, the beta factor for a geared company will be greater th an the beta 
factor for an equiva lent ungeared company. 
The relationship between t he beta factors for ungeared and gear ed companies 
is given by the following formula (given in the exam): 
βu= βg ൤VE
VE + VDሾ1–tሿ൨+ βdቈVDሾ1–tሿ
VE + VD ሾ1–tሿ቉ 
where 
βg = the equity (geared) beta meas ures the systematic business ri sk and the 
systematic financial risk of a company's shares 
βu = the asset (ungeared) beta measur es the systematic business r isk only 
βd = the debt beta measures the risk associated with the debt fin ance. Usually we 
assume that debt is risk free and hence the debt beta is zero. If this is the case, 
the second term in the given fo rmula disappears and the formula  becomes: 
βu= βg ൤VE
VE + VDሾ1–tሿ൨

Chapter 12 
 507 
 More on systematic risk 
 The entity's systematic risk is i mportant in the CAPM formula.  
Remember: 
• Shareholders are only interested in systematic risk because th ey 
hold well-diversified portfolios. Systematic  risk of an entity is 
measured by its beta. 
• Shareholders in a gear ed company suffer two types of systemati c 
risk i.e. business and financial risk. 
• The business risk of a company r efers to the risk of the opera ting 
cash flows. 
• Financial risk is the increased volatility of dividend payment s to 
shareholders as gearing increases. 
From the M & M analysis, we know t hat a share's systematic risk  can be 
split up between the systematic business  risk and the systematic 
financial  risk. 
Systematic business risk arises  out of the risky nature of the company's 
business caused by: 
• revenue sensitivity; 
• proportion of fixed to variable production costs. 
Systematic financial risk arises  out of how the company has fin anced 
itself – its gearing or capital structure. 
 
 Use of the formula: Degearing and regearing beta factors 
For example, suppose a question  tells you that the ABC company has a gearing 
ratio (D : E) of 1 : 2 ; the shares have a beta value of 1.45 (t he equity beta); and 
the corporation tax rate is 30%. Then: 
βu = 1.45  × 2
2 + 1 × (1 –  0.30) = 1.074 
Note:  If a question only states the beta, assume it is an equity bet a. Also, if 
there is no menti on of a debt beta, assume it is zero. 
This indicates that shareholders in ABC have a beta value/syste matic risk 
exposure of 1.45. Of t his value, 1.074 arises out of the risky nature of the 
company's business (its busine ss risk) and the rest (i.e. 1.45 – 1.074 = 0.376) 
arises out of the financial ri sk caused by the company's capita l structure. 
Notice four very important i mplications of this analysis: 
1 A company's equity beta will al ways be greater than its asset  beta, except 
2 if it is all equity financed ( and so has no financial risk), when its equity beta 
and asset beta wil l be the same.

508  
3 Companies in the same 'area o f business' (i.e. same business risk) will 
have the same asset beta, but 
4 companies in the same area of b usiness will not have the same  equity 
beta unless they also happen to have the same capital structure . 
As we shall see, the third of t hese points is particularly impo rtant. 
Application to business valuation 
There are two ways in which t he gearing/degearing formula above  can be used 
in order to derive a cost of equi ty and/or a WACC that can be u sed in business 
Both methods start from the a ssumption that you have been given  an equity 
beta for a proxy company. 
• Method 1:  Use the formula to derive t he proxy entity's ungeared beta 
factor. Assume that this beta fa ctor also reflects the business  risk of the 
entity being valued, so regear th is ungeared beta to reflect th e capital 
structure of the entit y being valued. Then use CAPM to derive a  cost of 
equity for the entity being valued  and (if necessary) use this ke in the 
standard WACC formula to fi nd the entity's WACC. 
• Method 2: Use the formula to derive t he proxy entity's ungeared beta 
factor, then use CAPM to find an 'ungeared cost of equity' (keu ) for the 
proxy entity. On the assumption t hat this keu is also a measure  of the 
ungeared cost of equity of the ent ity being valued (same busine ss risk), 
use M & M's WACC formula to cal culate the WACC of the entity be ing 
valued. 
(Note:  Method 2 can only be used to cal culate WACC, whereas Method 1 
derives both cost of equity and WACC.) 
Both methods will now be illustr ated, to show that they give th e same answer 
for WACC. 
 
 Illustration 3 (Integration question) 
 We are trying to value the comp any Garvey Co, an unlisted comp any with 
an estimated debt:equity ratio of 1:2. Post-tax cash flows befo re financing 
charges have been forecasted, so a suitable WACC is now needed for 
discounting. Since Garvey Co is an unlisted company, it has bee n difficult 
to derive a WACC for Garvey Co directly, because the necessary 
information is not readily avail able. Therefore, it has been de cided to use 
proxy information as a starting point. 
Information for Rocket Co, a listed company in the same busines s sector 
as Garvey Co is as follows: 
 Rocket Co 
Current geared (equity) beta 1.86 
Current capital structure rati o (D:E by market value) 1:1

Chapter 12 
 509 
 The tax rate is 30% and the retu rn on the stock market has been  12% per 
annum in recent years. Debt is a ssumed to be risk free and has a pre-tax 
cost of 5% per annum. 
Required: 
Calculate a suitable WACC for Garvey Co. 
Solution:  
Method 1 
Step 1 
Rocket Co's ungeared / asset beta is  calculated and then used a s an 
estimate of Garvey Co's asset beta (because Garvey Co and Rocke t Co 
are in the same area of busine ss and so will have the same asse t beta). 
Since debt is risk free, use 
βu= βg ×൤VE
VE + VDሾ1–tሿ൨ 
βu= 1.86 ×  ൤1
1 + 1 (1 – 0.30)൨= 1.09 
Step 2 
A geared / equity beta for Garvey C o is calculated next. As we know, an 
equity beta reflects both system atic business risk and systemat ic financial 
risk. Garvey Co's equity beta will reflect the business risk of  Garvey Co 
and Rocket Co, and the capital stru cture of Garvey Co (1:2 D:E) . 
Using: β g = βu [1 + (V D (1 – t)/V E )  
So: β g = 1.09 [ 1+ (1 × (1 – 0.30)/2)] 
So: β g = 1.47 
Step 3 
This equity beta is then input int o the CAPM to give a cost of equity 
capital for Garvey Co: 
ke = R F + [R M – R F] βg 
ke = 5% + [12% – 5%] × 1.47 = 15.3% 
Step 4 
The WACC is now calculated us ing the standard WACC formula: 
ko = keg൤VE
VE + VD൨+ kdሺ1– tሻ൤VD
VE + VD൨ 
= 15.3% × (2/3) + 5% × (1 –  0.30) × (1/3) = 11.4%

510  
 Method 2 
Step 1 
As above, the existing geared/equ ity beta of Rocket Co is degea red, to 
give an ungeared/asse t beta of 1.09. 
Step 2 
Input this ungeared beta into t he CAPM formula to give an ungea red cost 
of equity (k eu) 
keu = 5% + [12% – 5%] × 1.09 = 12.6% 
Step 3 
Use the M & M WACC formula: 
kadj = k eu (1 – tL) 
= 12.6% (1 – 30% × (1/3 )) = 11.4% as before. 
 
 QQQ is planning a takeover bid  for ABC, a telecoms company wit h a D : 
E ratio of 1 : 3. 
The cash flows (after tax but bef ore interest) for ABC have bee n 
forecasted, and now the directors of QQQ are tryi ng to estimate  a 
suitable WACC to use for discounting. 
XYZ is a 'typical' listed tele coms company. It has an equity be ta of 1.25 
and a D : E ratio of 1 : 2. 
Assume that RF = 6%, RM = 14%, and  the tax rate is 30%. It is a ssumed 
that corporate debt is risk-free (and so the debt beta is zero) . 
Which of the following is a W ACC that could be used in the 
valuation of ABC? 
A 12.4% 
B 14.8% C 15.1% D 18.3%

Chapter 12 
 511 
 The EMH and business valuation 
 Implications of the Efficient Ma rket Hypothesis (EMH) in busine ss 
valuation 
The level of efficiency in the market is very important when co nsidering 
the value of a business. 
According to the Efficient Marke t Hypothesis (EMH) the share pr ice is a 
sum of all the known informati on about a company. As such the s hare 
price is always a ‘fair price’  and a true valuation – a particu lar share is 
neither under or over valued at any point in time.  
This means that without additional  information, currently not t aken into 
account by the share price, no investor will be able to ‘beat t he market’. 
The only way to get higher retur ns, would be to invest in highe r risk 
(higher beta factor) investments. 
Weak form of efficiency 
In the weak form of market effic iency, the share price will ref lect any and 
all information that can be disce rned by past trends in share p rices. The 
day traders and other investors who attempt to speculate by stu dying 
past trends and predicting future  movements will be wasting the ir time 
(and money) if markets a re weak form efficient.  
If such speculators can foresee movements then their actions wi ll have 
the effect of updating the share price. The very fact of them, say, buying 
shares that are going to increas e in price will push up the pri ce. 
Semi-strong form of efficiency 
In the semi-strong form of the EM H, the share price will reflec t all 
information that is publicly ava ilable. Analysts who study pres s reports, 
financial statements and economic figures in order to identify mispriced 
shares are wasting their time i f the semi-strong form of the EM H is true.  
Again, though, it could be possible  to benefit from the ability  to follow 
news in real time and to respond to  events before they become p ublic 
knowledge. Investors generally sub scribe to information sources  that give 
immediate access to news as soon as it is released, and before it has 
been broadcast. Again, their res ponse to such news will enable the 
market to update itself because a  flurry of sales by major inve stors will 
signal that "bad" news has  become available.  
Strong form of efficiency 
In the strong form of the EMH, th e share price will reflect all  information, 
even if it has not been made public ly available. That may not s eem 
credible, but information could be leaked because of, say, insi der trading. 
The markets may not know why blo cks of shares are being purchas ed or 
sold, but the fact that someone is trading will suggest that un known 
person is in possession of some  facts and the price may respond  
accordingly. Insider trading is  illegal, but that does not alwa ys deter 
perpetrators.

512  
Impact on business valuation 
The EMH does not necessarily m ean that it is wrong to pay a pre mium 
over the market price in order  to acquire control. The bidder i s usually 
hoping to benefit from an exploit able synergy. Even so, the EMH  
suggests that the markets will take  the possibility of a future  bid into 
account in setting prices.  
Weak form efficiency might suggest t hat patterns of past trades  can be a 
sign of a future bid. Semi-st rong efficiency might suggest that  any 
information that suggests the possi bility of a bid (perhaps a l oss-making 
company that requires the suppor t that could only be obtained f rom being 
incorporated into a larger gr oup) will affect the price. Strong -form 
efficiency suggests that share prices could rise because a dish onest 
employee who knows about an impendi ng bid could start to buy sh ares in 
the target company and so signal  the possibility of positive ne ws. 
 
 Summary of valuation methods: When should each be used? 
 This chapter has covered the di fferent valuation methods in tu rn, and has 
separately identified  the strengths and weaknesses of each of t he 
methods. 
To conclude, we should consider t he circumstances in which each  
valuation method is most useful. 
Asset based methods 
The asset based valuation methods  are most appropriate when val uing 
capital intensive businesses with plenty of tangible assets. 
For a service business, the asse t based approach is likely to s ignificantly 
undervalue the business, unless some effort is also made to val ue the 
intangible assets of the business. 
Note however that in times o f uncertainty, the asset based appr oach 
avoids the need to forecast future  earnings or cash flows, so i t may be 
favoured in these circumstances. 
Dividend valuation model (DVM) 
The DVM is a suitable valuati on method when valuing a minority 
shareholding in a company, because if an investor purchases a m inority 
stake, the dividends represent the  forecast income from the inv estment, 
which will impact his wealth. 
If the investor were to purchas e a majority stake, it would be more 
relevant to consider overall co mpany cash flows or asset values  as a 
basis for the valuation.

Chapter 12 
 513 
 P/E method and discount ed cash flow method 
Both these methods are based on  forecasts of the future, and of ten use 
proxy information from proxy c ompanies. These factors may be di fficult to 
identify in practice. 
Providing that the forecasts ar e accurate, these methods value the 
business based on its future pro spects, so automatically includ e a 
measure of the goodwill / intangibl e assets associated with a b usiness. 
For service businesses, these me thods are generally preferred t o the 
asset based methods. 
10 End of chapter objective test questions 
 A company is planning to sell a w holly owned subsidiary (B) on  1 January 
20X1 and is preparing a valuation  for B as at that date using a  discounted 
cash flow approach. 
• The net operating cash flows of  B are forecast to be $250 mill ion in 
the year to 31 December 20X1 and are expected to remain at this  
level every year thereafter. 
• New equipment at a cost of $200 million will need to be paid f or on 
1 January 20X1. Tax depreciation  allowances can be claimed over  4 
years on a straight line basis on this equipment. 
• The corporate income tax rate i s 30%. Tax is paid a year in ar rears. 
• Assume all cash flows arise a t the end of the year unless stat ed 
otherwise. 
• B has a financial year ending  31 December each year. 
The trainee accountant has begun to  produce an analysis of net cash 
flow for the valuation which is s hown below. All figures are in  $ million.

514  
 Select the TWO grid squar es that contain an error. 
Time (years) 0 1 2 3–5 6+ 
Net operating cash flow (NO CF) – 250 250 250 250 
Tax on NOCF – – (75) (75) (75) New equipment (200) – – – – 
Tax relief on new equipment – 15 15 30 – 
 
 Company XX is using the Calculat ed Intangible Value (CIV) comp any 
valuation method to value its intangible assets. 
Key data: 
• XX has a WACC of 12%, cost of debt of 7% and cost of equity of  
14% 
• Net profit before ta x for XX is $50 million 
• XX’s tangible assets are $67 million 
• Average industry return on tangible assets is 16% 
• Corporate income tax is 20% 
Complete the following CIV calculation: 
CIV = [$50 million – ([UNKNOWN FIGURE 1] × $67 million) ]  
× [UNKNOWN FIGURE 2]/0.12 
[UNKNOWN FIGURE 1] is A 0.16 B 0.12 C 0.07 D 0.14 [UNKNOWN FIGURE 2] is E 0.80 F 0.20 G 1.20 H 1.80

Chapter 12 
 515 
 You are a management account ant working for Mega Co. 
The directors of Mega Co have as ked you to prepare some busines s 
valuation calculations for a potential target company, Mini Co.  
They are particularly keen for you to use an asset based valuat ion 
method. 
Which THREE of the following are potential problems with valuin g 
Mini Co using an asset based method? 
A  The asset based method might under-value Mini Co if it has 
significant intangible assets 
B  The asset based method might o ver-value Mini Co if it has re cently 
revalued its non-current assets 
C  The asset based method will not  be useful if Mini Co has bee n 
making losses in recent years 
D  The asset based method ignores  the future prospects and earn ings 
potential of Mini Co 
E  Mega Co, as the acquiring com pany, will be interested in the  
replacement cost valuation of Min i Co's assets, but replacement  
costs might not be readily available. 
 
 You have been asked to calculate  the equity beta factor for VE RA. 
Introductory data: 
• BLAIZE is a listed company in the same industry as VERA. It ha s an 
equity beta of 1.45. 
• Gearing levels – (debt/equity) by market value: 
–  VERA 45/55 –  BLAIZE 30/70 
• Tax rate is 25%. The beta of debt is 0.10.

516  
 Which one of the following shows the correct formula for ungear ing 
the proxy company’s equity beta (which would be the first step in 
trying to calculate an equity beta for VERA): 
A β u =1.45 × 70
100 + 0.10 × 30
100 
B β u =1.45 × 55
55 + 45 (1 – 0.25) + 0.10 × 45 (1 – 0.25)
55 + 45 (1 – 0.25) 
C β u =1.45 × 40
40 + 30 (1 – 0.25) + 0.10 × 30 (1 – 0.25)
40 + 30 (1 – 0.25) 
D β u =1.45 × 70
70 + 30 (1 – 0.25) + 0.10 × 30 (1 – 0.25)
70 + 30 (1 – 0.25) 
 
 The systematic risk of an project's return is the result of 
uncertainties in the return caused by 
A  factors unique to the project 
B  factors unique to the ent ity undertaking the project 
C  factors unique to the industr y to which the project belongs 
D  nationwide economic factors

Chapter 12 
 517 
 The board of directors of Predat or plc, a UK company, is consi dering 
making an offer to purchase Tar get Ltd, a private limited compa ny in the 
same industry. If Tar get Ltd is purchased it is proposed to con tinue 
operating the company as a going concern in the same line of bu siness. 
Summarised details from the mos t recent financial statements 
(statements of financial positio n and statements of profit or l oss) of 
Predator and Target are shown below: 
 Predator plc as at 
31 March Target Ltd as at 
31 March 
 £m £m £000 £000 
Freehold property  33  460 Plant and equipment  58  1,310 
Inventory 29  330  
Receivables 24  290  Cash 3  20  
less current liabilities (31) 25 (518) 122 
 —— —— —— ——
– 
  116  1,892 
  ——  —— – 
Financed by: Ordinary 
shares   35 160 
Reserves   43 964 
   —— —— – 
Shareholders’ funds   78 1,124 
Medium term bank 
borrowings   38 768 
   —— —— – 
   116 1,892 
   —— —— – 
Predator plc, 50 pence ordinary shares, Target Ltd, 25 pence or dinary. 
 Predator plc Target Ltd 
Year PAT Dividend PAT Dividend 
T5 14.30 9.01 143 85.0 
T4 15.56 9.80 162 93.5 
T3 16.93 10.67 151 93.5 T2 18.42 11.60 175 102.8 
T1 20.04 12.62 183 113.1 
NB: T5 is five years ago and T1 is the most recent year.

518  
Target's shares are owned by a s mall number of private individu als. Its 
managing director, who receives  an annual salary of £120,000, 
dominates the company. This is  £40,000 more than the average sa lary 
received by managing directors of similar companies. The managi ng 
director would be replaced i f Predator purchases Target. 
The freehold property has not been revalued for several years a nd is 
believed to have a market value of £800,000. 
The value of plant and equipmen t in the statement of financial position is 
thought to reflect its replacem ent cost fairly, but its value i f sold is not 
likely to exceed £800,000. Approxim ately £55,000 of inventory i s obsolete 
and could only be sold as scrap for £5,000. 
The ordinary shares of Predator  are currently trading at 430 pe nce ex-div. 
A suitable cost of equity for Tar get has been estimated at 15%.  
Both companies are subject to corporation tax at 33%. 
Required: 
Estimate the value of Target Ltd  using the different methods of  valuation 
and advise the board of Predator a s to how much it should offer  for 
Target's shares. 
 
 AB is a telecommunications consul tancy based in Europe that tr ades 
globally. It was established 15 y ears ago. The four founding sh areholders 
own 25% of the issued share capi tal each and are also executive  
directors of the entity. 
The shareholders are considerin g a flotation of AB on a Europea n stock 
exchange and have started discussi ng the process and a value fo r the 
entity with financial advisors . The four founding shareholders,  and many 
of the entity’s employees, are tec hnical experts in their field , but have 
little idea how entities such as theirs are valued. 
Assume you are one of AB’s finan cial advisors. You have been as ked to 
estimate a value for the entity and explain your calculations a nd approach 
to the directors. You have obtai ned the following information.

Chapter 12 
 519 
 Summary financial data for the past three years and forecast re venue 
and costs for the next two years is as follows: 
Statements of profit or loss for the years ended 31 March 
 20X4 
(actual) 20X5 
(actual) 20X6 
(actual) 20X7 
(actual) 20X8 
(actual) 
 EURm EURm EURm EURm EURm 
Revenue 125.0 137.5 149.9 172.0 198.0 
Cash operating 
costs 37.5 41.3 45.0 52.0 59.0 
Depreciation 20.0 22.0 48.0 48.0 48.0 
 –––– –––– –––– –––– –––– 
Pre-tax earnings 67. 5 74.2 56.9 72.0 91.0 
Taxation 20.3 22.3 17.1 22.0 27.0 
Statements of financial position at 31 March 
Assets EURm EURm EURm Non-current assets    Property, plant and equi pment 150 175 201 
Current assets 48 54 62 
 
 198 229 263 
Equity    
Share capital (EUR 1 shares) 30 30 30 
Retained earnings 148 179 203 
 178 209 233 
Current liabilities 20 20 30 
 198 229 263 
Note:  The book valuations of non-curren t assets are considered to re flect 
current realisable values.

520  
 Other information/assumptions 
• Growth in after tax cash flow s for 20X9 and beyond (assume 
indefinitely) is expected to be 3% per annum. Cash operating co sts 
can be assumed to remain at th e same percentage of revenue as i n 
previous years. Depreciation will fluctuate but, for purposes o f 
evaluation, assume the 20X8 char ge will continue indefinitely. Tax 
has been payable at 30% per annum  for the last three years. Thi s 
rate is expected to c ontinue for the foreseeable future and tax  will 
be payable in the year in wh ich the liability arises. 
• The average P/E ratio for tele communication entities’ shares q uoted 
on European stock exchanges has  been 12.5 over the past 12 
months. However, there is a wi de variation around this average and 
AB might be able to command a ra ting up to 30% higher than this ; 
• An estimated cost of equity capi tal for the industry is 10%; 
• The average pre-tax return on  total assets for the industry ov er the 
past 3 years has been 15%. 
Required: 
(a) Calculate a range of values  for AB, in total and per share,  using 
methods of valuation that you c onsider appropriate. Where relev ant, 
include an estimate of value  for intellectual capital. 
(b) Discuss the methods of valuat ion you have used, explaining the 
relevance of each method to an entity such as AB. Conclude with  a 
recommendation of an approximate fl otation value for AB, in tot al 
and per share. 
Note:  A report format is not required for this question.

Chapter 12 
 521 
 Assuming the statement of financ ial position values are realis tic, the 
valuation is: 
 $000 
Less: 6% Unsecured bond  (8,000)  
Less: Current li abilities  (4,800) 
 
–––––– 
 1 9 , 2 0 0  
 –––––– 
So the value per share is  $19,200,000/8, 000,000 = $2.40 
(Note that the asset value o f $19,200,000 is equal to the value  of the 
ordinary share capita l plus reserves.) 
Fowler's perspective 
Value per share = ($ 19,200,000 + $40,000,000  – $23,600,000)/8,0 00,000 
= $4.45

522  
 
GBP000  Explanation/justification 
Non-current assets 1,500  Ray plc is buying the 
business, so would have to buy the machinery from scratch if it decided on the alternative of organic growth. The realisable value will be a useful minimum value from Ribbon Ltd’s perspective, but it is not relevant to Ray plc. 
Current assets (564–120–30)  414  The inventory and 
receivables relating to the bankrupt customer will not be acquired by Ray plc. 
They are therefore excluded 
from the valuation. 
Less: 5% bonds  (600)  Less: Current liabilities  (518)   In order for Ray plc to 
takeover Ribbon Ltd, it needs to buy the equity of the business. After the takeover, Ray plc will be responsible for meeting these liabilities, so they should be included in the valuation of Ribbon Ltd. 
 
–––––  
 796  
 –––––  
Value per share = GBP 796,000/100,000 = GBP 7.96

Chapter 12 
 523 
Workings: 
  $ m  
Current pre-tax profit  24.29 
Less: Industry ROA × Tangible a ssets 10% × 128.66m (12.87) 
  — –—– 
Excess annual return  11.42 
  — –—– 
Post-tax excess annual return  11.42m × (1–0.30) 7.99 
CIV (assuming constant perpet uity) 7.99m × 1/0.16 49.94 
Therefore, the total value o f Chapman Co is estimated to be 
128.66m + 49.94m = $178. 60m (approx $179m) 
 
Workings: 
EPS = 3,840,000/1,000,000 shares = $3.84 
Value per share = P/E × EPS = 9 × $3.84 = $34.56 
 
 The maximum that X should be prepared to pay for Y is the tota l increase 
in value generated by taking over Y, i.e. 
Value of combined  = 11 × (3 m + 1.5m + 0.5m)  = $55m 
Less value of X = 12 × 3m  = $36m Max. price to pay = $19m.  
However, the shareholders of Y will value their company at 8 × 1.5m = 
$12m since they will not have enough information to enable them  to value 
the expected synergies. 
The price paid by X to take over Y is then likely to fall somew here 
between these two valuations , depending upon the negotiating sk ills of 
the buyer and seller.

524  
  
(a) Po = 250,000
0.14 
 = EUR 1.786 million, or 1.786/ 2 = EUR 0.893 per share. 
  
(b) Po = 250,000 × 1.04
0.14 – 0.04 
 = EUR 2.6 million, or 2.6/ 2 = EUR 1.30 per share. 
 
 Dividend in 1 year would have b een $1.5 million × 1.02 = $1.53  million. 
Therefore under the new  policy it will be half of this i.e. $0. 765 million. 
So the present value of dividends  for the next four years, disc ounted at 
10%, will be: 
(0.765 × 0.909) + (0.765 × 1.10 × 0.826) +  (0.765 × 1.102 × 0.751)  
+ (0.765 × 1.103 × 0.683) 
= $2.780 million After the first four years, the dividends will settle into a gr owing 
perpetuity, whose present value is: 
[(0.765 × 1.10
3 × 1.05)/0.10 – 0.05] ×  0.683 = $14.604 million 
Therefore, the total value is $2.780 million + $14.604 million = $17.384 
million, or approximately $1.74 per share for each of the 10 mi llion 
shares. 
This is a fall of $0.17 per share. 
 
Workings: 
Year GBP DF (12%) PV 
1 120,000  0.893 107,160 2 100,000  0.797 79,700 3 140,000  0.712 99,680 
4 50,000  0.636 31,800 
5 130,000  0.567 73,710 
   
––––––– 
  NPV 392,050 
   ––––– ––

Chapter 12 
 525 
 However, this ignores cash flow s after year 5. Assuming the yea r 5 cash 
flow continues to infinity, t his has a present value of: 
130,000/0.12 = G BP 1,083,333 
This has a present value today of: GBP 1,083,333 × 0.56 7 = GBP 614,250 
This gives a total present value (value of equity) of: 614,250 + 392,050 =  GBP 1,006,300 
 
GBPm Year 1 Year 2 Year 3 etc 
Sales (×1.03 ×1.05) 308.3 333.5 360.6 Cost of sales (×1.05) (126.9) (133.3) (140.0) 
 
Gross profit 181.4 200.2 220.6 
Operating expenses ( 66.9) (66.9) (66.9) 
Financing costs (10.0) (10.0) (10.0) 
Forecast profit before tax 104.5 123.3 143.7 
Less Taxation (28%) ( 29.3) (34.5) (40.2) 
Add back depreciati on 12.3 12.3 12.3 
Less Capital expenditure (15.0) (15.0) (15.0) 
Less Working capital investment (2.0) (2.0) (2.0) 
Forecast cash flows to equity 70.5 84.1 98.8 
 ––––– ––––– –––––––– 
DF 12% 0.893 0.797 0.797/0.12 
Present value 63.0 67.0 656.2 
So the net present value = GBP786.2m 
This is the total value o f the equity in Butler Co. 
With 500 million shares in iss ue, this corresponds to a value o f 
786.2/500 = GBP 1. 57 per share.

526  
Workings: 
Method 1 
Step 1 
XYZ's asset beta is calculated an d then used as an estimate of ABC's 
asset beta (because ABC and XYZ ar e in the same area of busines s and 
so will have the same asset beta). 
Using: βu= βg ×൤E
E + D ሾ1–tሿ൨ 
 βu= 1.25 × ൤2
2 + 1 ሾ1 – 0.30 ሿ൨= 0.926 
Step 2 
An equity beta for ABC is cal culated next. As we know, an equit y beta 
reflects both systematic busi ness risk and systematic financial  risk. ABC's 
equity beta will reflect ABC's business risk and ABC's gearing of 1:3. 
E + D ሾ1–tሿ൨ 
 0.926 = βg ×൤3
3 + 1 ሾ1 – 0.30 ሿ൨ 
 0.926 = β g × 0.811 
 0.926
0.811 = βg = 1.14  
Step 3 
This equity beta is then input i nto CAPM to give a cost of equi ty capital 
for ABC: 
Ke = 6% + [14% – 6%] × 1.14 = 15.12%

Chapter 12 
 527 
 Step 4 
ABC's WACC is now calculated. 
However, before we can do this c alculation, we need to identify  ABC's 
after-tax cost of debt capital. In  many questions this informat ion is given, 
but here it is not. 
If you need a cost of debt in order to answer a question, but a re not given 
one, then you can make use of the  fact that we are allowed to a ssume 
'corporate debt is risk-free'. In these circumstances: 
kd = R F 
and k d(1–t) = R F(1–T)  
Therefore: k d(1–t) = 6% (1 – 0.3) = 4.2% 
Hence the WACC can be calculated using: 
WACC = k e × E
V + kdሺ1–tሻ × D
V = 15.12%  × 3
4 + 4.2%  × 1
4 = 12.4% 
Alternatively: Method 2 
Step 1 
As above, the existing geared/equit y beta of XYZ is degeared, t o give an 
ungeared/asset beta of 0.926. 
Step 2 
keu = 6% + [14% – 6%] × 0.926 = 13.4% 
Step 3 
Use the M & M WACC formula k adj = k eu (1 – tL) 
=13.4% (1 – 30% × (1/4 )) = 12.4% as before.

528  
 The two cells containing errors  are highlighted in bold below:  
Tax on NOCF – – (75) (75) (75) 
New equipment (200) – – – – Tax relief on new equipment – 15 15 30 – 
The new machine is bought on 1 January 20X1, so the first tax 
depreciation allowance will be claimed at the end of 20X1. Howe ver, 
because tax is paid a year in arrears in this scenario, the tax  relief on this 
first allowance would only be re ceived one year later, at the e nd of 20X2 
(corresponding to year 2 in the table). 
The 30 in the 'year 3-5' column  implies that $30m of tax relief  would be 
received each year in year 3, 4 and 5. This is not the case. Th e figures 
should be split into separate c olumns for years 3, 4 and 5. 
The tax relief figures should appe ar as $15m each year in years  2, 3, 4 
and 5. 
 
 [UNKNOWN FIGURE 1] is (A) 0.16 and [UNKNOWN FIGURE 2] is (E) 
0.80 
The missing figures were industry return on assets as [UNKNOWN 
FIGURE 1] and (1-tax rate)  as [UNKNOWN FIGURE 2]. 
 
 The answer is (A), (D) and (E). 
If Mini Co has recently revalued its assets, arguably the asset  based 
method will be more accurate (B). 
If Mini Co has been making losses  recently, asset based valuati ons are 
unaffected (C). Admittedly earning s based valuations might be m ore 
problematic. 
 
Use the given formula, and make  sure that Ve and Vd are the equ ity and 
debt values for the proxy com pany (BLAIZE in this case).

Chapter 12 
 529 
Systematic risk reflects variati ons in the return of a security  due to 
general market factors. 
 
 The approaches to use for valuation are: 
1 Asset valuation 2 Dividend valuation model 3 P/E ratio/Earnings valuation. 
 1 Asset valuation 
Target is being purchased as a goi ng concern, so realisable val ues 
are irrelevant. 
 £000 
Net assets per accounts (1,892 – 768)  1,124 
Adjustments to freehold property (800 – 460)  340 
Adjustment to inventory (50) 
 ——— 
Valuation 1,414 
 ——— 
 Say £1.4m 
2 Dividend valuation model 
The average rate of growth in Ta rget's dividends over the last four 
years is 7.4% on a compound basis. 
Growth working:  (113.1/85.0
)(1/4) – 1 = 0.074 
The estimated value of Target u sing the dividend valuation mode l is 
therefore: 
Valuation £113,100 × 1.074
0.15 – 0.074 = £1,598,281 Say £1.6m  
3 P/E ratio/Earnings valuation 
A suitable P/E ratio for Tar get will be based on the P/E ratio of 
Predator as both companies a re in the same industry. 
P/E of Predator: 70m × £4.30
£20.04 or 430
28.63 = 15

530  
 Target's maintainable earnings are: 
£183,000 + (£40,000 × 67% ) = £209,800 after adjusting for the 
savings in the direct or's remuneration. 
The estimated value is ther efore £209,800 × 15 = £3,147,000, say 
£3.1m. 
Advice to the board 
On the basis of its tangible asse ts the value of Target is £1.4 m, which 
excludes any value for intangibles. 
The dividend valuation give s a value of around £1.6m. 
The earnings based valuation indi cates a value of around £3.1m,  which is 
based on the assumption that no t only will the current earnings  be 
maintained, but that t hey will increase by t he savings in the d irector's 
remuneration. It is also based on  a proxy P/E ratio of 15 which  was taken 
from a much larger listed com pany with a higher level of histor ic growth. 
Arguably this P/E ratio is too hi gh for the circumstances of Ta rget. 
On the basis of these valuations  an offer of around £2m would a ppear to 
be most suitable. The director s should, however, be prepared to  increase 
the offer to: 
Maximum price: 
It is worth noting that the maximu m price Predator should be pr epared to 
offer is: 
The NPV of the combined group after the acquisition X 
The NPV of the acquiring compan y before the acquisition (X) 
 —– 
Maximum price X 
 —– 
If synergy occurs this could just ify a higher price than shown by the 
valuation methods  illustrated. 
The comment on the maximum price is particularly appropriate in  this 
question as this an example of hor izontal integration where con siderable 
synergies normally exist.

Chapter 12 
 531 
 (a) Calculations  
Methods that could be considered are: 
–  Asset value –  Market capitalisation –  Dividend/earnings valuation model –  NPV 
Each method is calculated as follows: 
Asset value 
The statement of financial posit ion for 20X6 shows net assets o f 
EUR233m (€233m). However, this ent ity clearly has substantial 
intellectual capital, which the value of tangible assets in the  
statement of financial position do es not reflect. An estimate o f the 
value of an intangible asse t can be attempted as follows. 
This method involves taking the excess returns on tangible asse ts 
and uses this figure as a basis  for determining the proportion of 
return attributable to intangible assets. 
1 Calculation of average pre- tax earnings for three years: 
(€67.5m + €74.2m + € 56.9m)/3 = €66.2m 
2 From the statement of financial position the average year end  
tangible assets over the last th ree years is calculated as: 
(€198m + €229m + €263m)/3 = €230m 
3 The return on assets is calc ulated by dividing earnings by 
average assets as follows: 
(€66.2m/€230m) × 100 = 28.8% 
4 The industry’s return on assets  for this same three years is 
15% (as per the scenario). 
5 Multiply the industry average pr e-tax return on assets by the  
entity’s average tangible a ssets to show what the average 
telecoms entity would earn  from that amount of tangible 
assets: 
€230m × 15% = €34.5m Subtract this from the entity’s pre-tax earnings: €66.2m – €34.5m = €31.7m This figure shows how much mo re AB earns from its assets 
than the average telecommunications company.

532  
 6 The after tax premium attri butable to intangible assets is 
(a) Three-year average income tax rate = 30% 
(b) Excess return = €31.7m (c) Multiply (i) by (ii) = €9.5m (d) (ii)–(iii) = €22.2m 
7 The NPV of the premium is calcu lated by dividing the premium 
by the entity’s cost of capital as follows: 
€22.2m/0.08 = €277m If the NPV of the estimated val ue of intellectual capital is 
added to the value of net tangibl e assets we get €263m + 
€277m = €540m, less current liab ilities gives a net figure of 
€510m. 
Tutorial Note:  Candidates would have gained credit for any 
valid attempt to place a value on intellectual capital. 
Market capitalisation/PE method 
If we use the industry average P/E of 12.5 the potential value is 
€497.5m. If AB can command a rati ng up to 30% higher, this valu e 
rises to €646.7m. 
Note:  €497.5m is calculated as €56. 9m (20X6 pre-tax earnings) 
less €17.1m (taxation) multipli ed by 12.5 (industry average P/E ) 
Dividend/earnings model 
There is insufficient informa tion to use the DVM, although earn ings 
could be used as a proxy. However , as the future growth rate is  not 
constant the simplified model  cannot be used. The NPV approach 
would give broadly similar results. 
NPV 
 20X7 20X8 
 EURm EURm 
After tax profit 50 64 Add: Depreciation 48 48 
 
Cash flow 98 112 
DF 10% 0.909 0.826 
PV 89 93

Chapter 12 
 533 
 DCF of cash flows for 20X9 and beyond are 
€112m × 1.03 × 0.826/(0. 10 – 0.03) = €1.361m 
NPV = €89m + €93m +  €1,361m = €1,543m 
Tutorial Note:  The calculations here use  the industry average cost 
of capital. An acceptable alter native would use 8%, the earning s 
yield (reciprocal of P/E ratio o f 12.5). In this case the NPV w ould be 
€2,164m. 
Summary of valuations 
 Total Per share 
 EURm EUR 
Asset value 233 7.70 
Asset value including intellectual 
capital 510 17.00 
PE method 497–647 16.57–21.57 NPV 1,543 51.43 
(b) Discussion of methods and recommendation  
Asset value has little relevance except in specific circumstanc es 
such as a liquidation or disposal  of parts of a business. Asset  value 
is of even more limited usefulnes s in an entity such as AB, whi ch 
earns a substantial proportion of i ts income from intellectual capital 
that generally does not feature in the statement of financial p osition. 
Market capitalisation / PE method 
The P/E basis of valuation has t he advantage that it bases valu e on 
the future earnings of the entity . In a listed entity, the P/E ratio is 
used to describe the relationshi p between the share price (or m arket 
capitalisation) and earnings per s hare (or total earnings). It is 
calculated by dividi ng the price per share by the earnings per share. 
Market capitalisation is the s hare price multiplied by the numb er of 
shares in issue. Market capitalis ation is not necessarily the t rue 
value of an entity as it can be a ffected by a variety of extran eous 
factors but for a lis ted entity it provides a benchmark that ca nnot be 
ignored in, say, a take -over situation. 
In the case of an unlisted entity , a P/E ratio that is represen tative of 
similar quoted entities might be used as a starting point for a rriving 
at an estimated market value, based upon the present earnings o f 
the unlisted entity. The potentia l market capitalisation would be the 
entity’s latest earnings multip lied by the benchmark P/E ratio.

534  
 AB is an unlisted entit y so it does not have a market capitalis ation or 
a quoted P/E ratio. Applying the industry average P/E provides a 
benchmark but not a very good one. As noted in the scenario, th ere 
is a wide variation around th is average. Also, although not sta ted, 
the definition of the industry is likely to be very broad. A be tter 
approach might be to find an entity similar to AB and apply its  P/E. 
Again, this is very rough and r eady. As AB is unlisted there ar e 
arguments for both lowering and r aising the P/E as compared wit h 
either a proxy entity or the i ndustry average. The Financial Ad visor’s 
estimate is that AB could co mmand a rating 30% higher than the 
industry average. It is not clear  how this estimate was made, a s an 
argument could be made for loweri ng the P/E ratio to reflect th e 
higher risk and lower liquidity o f such entities. It would be m ore 
appropriate to use the NPV meth od and adjust the discount rate – 
as discussed below. 
NPV/Earnings method 
Forecasting cash flows and disco unting at a specific risk adjus ted 
discount rate is the theoretically  correct valuation method. Th e 
valuation here uses the industr y average cost of equity. Using an 
industry average suffers from t he problems noted above. Also, t he 
cost of equity will include an el ement of return for financial risk if 
entities have debt in their capita l structure. Many entities in cluded in 
the industry average will have substantial debt finance. 
What is needed here is an exercise  to calculate a more accurate  
cost of capital. As with using  the P/E ratio approach, discusse d 
above, finding a proxy entity may be more reliable than using a n 
industry average. 
As shown in the summary table in  part (a), the likely market va lue 
ranges from €233m (net tangible a ssets) to €1,543m (NPV). The 
NPV valuation is substantially higher than any of the others. W hile 
this method is theoretically co rrect, the reliability of the re sults does 
of course depend on the accuracy of  the forecast cash flows and  the 
discount rate used. Using growth  in perpetuity (although a sens ible 
simplification for examinati on purposes) is unrealistic. 
None of the figures produced by th is exercise is wholly reliabl e, 
neither is it expected to be, as  this is simply an estimate bas ed on 
incomplete information. The ma in recommendation must be to 
conduct a more detailed evaluation involving other advisors suc h as 
the entity that will be responsib le for the flotation. It needs  also to be 
established what percentage of t heir shareholding each director  
wishes to sell on flotation and ho w many new shares will need t o be 
reissued. The calculations hav e been made on the current number  
of shares in issue to the di rectors/founding shareholders.

Chapter 12 
 535 
 However, if a recommendation has  to be made, a flotation value in 
the region of €600m or €20 per s hare would be conservative. 
(Tutorial Note: Any sensible recommendation, or argument for not 
making one on the evidence avai lable, would gain credit.) 
A secondary recommendation woul d be to split the shares in 
readiness for a flotation. The s hare prices produced by all val uation 
methods, except asset value, are  ‘heavy’ – that is buyers would  not 
get many shares for their money. More shares would need to be i n 
issue to allow a reasonably liquid market in them.

537 
Pricing issues and  
post-transaction issues 
D3: Analyse pricing and bid 
issues 
 Analyse: 
(a) Pricing issues (b) Bid issues 
D4: Discuss post transaction 
issues Discuss: 
(a) Post transaction value (b) Benefit realisation 
• Forms of consideration and terms of acquisition 
• Methods of financing a cash o ffer and refinancing target 
entity debt 
• Post-transaction value inco rporating effect of intended 
synergies 
• M&A integration and syner gy benefit realisation 
• Exit strategies 
 
  Chapter 
13

Pricing issues and post-transaction issues 
538  
 
The last two chapters have cover ed business valuation and strat egic issues 
associated with acquisitions and me rgers, in particular the con cept of synergy. 
This chapter continues to look a t acquisitions and mergers, but  we now move 
on to look at practical matters  such as what form of considerat ion should be 
used in an acquisition (for exa mple cash or a share exchange) a nd the 
negotiation process that surrounds a bid. 
 
 2 Defences against hostile takeover bids 
Any listed company needs to be aw are that a bid might be receiv ed at any time. 
The directors of a company subject to a hostile takeover bid sh ould act in the 
best interests of their sharehol ders. However, in practice they  will also consider 
the views of other s takeholders (such as employees, and themsel ves). 
If the board of directors of a target company decides to fight a bid that appears 
to be financially attractive to  their shareholders, then they s hould consider one 
of the following defences: 
• Pre-bid defences 
–  Communicate effect ively with shareholders 
–  Revalue non-current assets –  Poison pill –  Change the Articles of Associ ation to require 'super majorit y' 
approval for a takeover

Chapter 13 
 539 
• Post-bid defences 
–  Appeal to their own shareholders –  Attack the bidder –  White Knight –  Counterbid – sometimes called a 'Pacman' defence 
–  Refer the bid to the Competition authorities 
 
Details of takeover defences 
 Pre-bid defences 
Communicate effectively with shareholders 
This includes having a public rel ations officer specialising in  financial 
matters liaising constantly wit h the entity’s stockbrokers, kee ping analysts 
fully informed, and speaking to journalists. 
Revalue non-current assets 
Non-current assets are revalued to  current values to ensure tha t 
shareholders are aware of tr ue asset value per share. 
Poison pill strategy 
Here a target company takes step s before a bid has been made to  make 
itself less attractive to a pot ential bidder. The most common m ethod is for 
existing shareholders to be giv en rights to buy future bonds or  preference 
shares. If a bid is made before the date of exercise of the rig hts, then the 
rights will automatically be conver ted into full ordinary share s. 
Super majority 
The Articles of Association are altered to require that a highe r percentage 
(say 80%) of shareholders have to vote for the takeover. 
Post-bid defences 
Appeal to their own shareholders 
For example, by declaring that th e value placed on the target c ompany's 
shares is too low in relation  to the real value and earning pow er of the 
company's assets, or alternativel y that the market price of the  bidder's 
shares is unjustifiably high and is not sustainable.

540  
 A well-managed defensive campaign would include: 
(i)  Aggressive pub licity on behalf of the co mpany preferably b efore a 
bid is received. Investors may be told of any good research ide as 
within the company and of the m anagement potential or merely be  
made more aware of the company's achievements. 
(ii) Direct communication with  the shareholders in writing stre ssing the 
financial and strategic reasons  for remaining independent. 
Note:  Under the City Code in the UK, any  forecasts must be examined 
and reported on by the auditors o r consultant accountants. 
Attack the bidder 
Typically concentrating on the bidder’s management style, overa ll 
strategy, methods of increasi ng earnings per share, dubious acc ounting 
policies and lack of capital investment. 
White Knight strategy 
This is where the directors of t he target company offer themsel ves to a 
more friendly outside interest. T his tactic should only be adop ted in the 
last resort as it means that the company will lose its independ ence. This 
tactic is acceptable provided t hat any information given to a p referred 
bidder is also given to a hostile  bidder. The alternative compa ny's 
management will be considered to be sympathetic to the target 
company's management. 
Counterbid, or Pacman defence 
Where the bidding co mpany is itself the subject of a takeover b id by the 
target company. 
Competition authorities 
The target entity could seek gov ernment intervention by bringin g in the 
Competition author ities. For this to be effective it would have  to be proved 
that the takeover was against the public interest. 
 
 3 The form of consideration for a takeover 
When one firm acquires another, two  questions must be addressed  regarding 
the form of consideration for the takeover: 
1 what form of consideration s hould be offered? Cash offer, or share 
exchange, or earn-out are t he three main choices. 
2 if a cash offer is to be made , how should the cash be raised?  The choice 
is generally debt finance or a rig hts issue to generate the cas h (if the entity 
does not have enough cash already).

Chapter 13 
 541 
 
The key considerations regardi ng these two questions are outlin ed below. 
Form of consideration 
Cash 
In a cash offer, the target com pany shareholders are offered a fixed cash sum 
per share. 
This method is likely to be suit able only for relatively small acquisitions, unless 
the bidding entity has an accumulation of cash. 
• When the bidder has sufficient c ash the takeover can be achiev ed quickly 
and at low cost. 
• Target company shareholders have  certainty about the bid's val ue i.e. 
there is less risk compared to a ccepting shares in the bidding company. 
• There is increased liquidity to  target company shareholders, i .e. accepting 
cash in a takeover, is a good wa y of realising an investment. 
• The acceptable consid eration is likely to  be less than with a share 
exchange, as there is less risk to  target company shareholders.  This 
reduces the overall cost of t he bid to the bidding company. 
• With larger acquisitions the bidder must often borrow in the c apital 
markets or issue new shares in or der to raise the cash. This ma y have an 
adverse effect on gearing, and also cost of capital due to the increased 
financial risk. 
• For target company shareholders, i n some jurisdictions a taxab le 
chargeable gain will arise if shar es are sold for cash, but the  gain may not 
be immediately chargeable to  tax under a share exchange. 
• Target company shareholders may be unhappy with a cash offer, since 
they are 'bought out' and do not participate in the new group. Of course, 
this could be seen as an advantage of a cash offer by the biddi ng 
company shareholders if they wan t to keep full control of the b idding 
company. 
Share exchange 
In a share exchange, the bidding company issues some new shares  and then 
exchanges them with the targe t company shareholders. The target  company 
shareholders therefor e end up with shares i n the bidding compan y, and the 
target company's shares all end up  in the possession of the bid ding company. 
Large acquisitions almost always involve an exchange of shares,  in whole or in 
part.

542  
• The bidding company does not have to raise cash to make the pa yment. 
• The bidding company can ‘boot s trap’ earnings per share if it has a higher 
P/E ratio than the acquired entit y (terminology explained later  in this 
chapter). 
• Shareholder capital is increas ed – and gearing si milarly impro ved – as the 
shareholders of the acquired com pany become shareholders in the  post-
acquisition company. 
• A share exchange can be used to  finance very large acquisition s. 
• The bidding company’s shareholder s have to share future gains with the 
acquired entity, and the curr ent shareholders will have a lower  
proportionate control a nd share in profits o f the combined enti ty than 
before. 
• Price risk – there is a risk  that the market price of the bidd ing company's 
shares will fall during the bidd ing process, which may result i n the bid 
failing. For example, if a 1 for 2 share exchange is offered ba sed on the 
fact that the bidding company's shares are worth approximately double the 
value of the target company's shares, the bid might fail if the  value of the 
bidding company's shares falls before the acceptance date. 
Earn-out 
 
 Definition of an earn-out arrangement:  A procedure whereby 
owners/managers selli ng an entity receive a portion of their co nsideration 
linked to the financial performanc e of the business during a sp ecified 
period after the sale. The arr angement gives a measure of secur ity to the 
new owners, who pass some of the  financial risk associated with  the 
purchase of a new entity to the sellers. (CIMA Official Terminology, 2005)  
The purchase consideration is s ometimes structu red so that ther e is an initial 
amount paid at the time of acqui sition, and the balance deferre d. 
Some of the deferred balance will usually only become payable i f the target 
entity achieves specifi ed performance targets.

Chapter 13 
 543 
 More details on earn-out arrangements 
 Earn-out arrangements are often employed when the buyers and s ellers 
disagree about the expected growth  and future performance of th e target 
company. 
A typical earn-out takes place over a three to five year period  after the 
acquisition and may involve 10% - 50% of the purchase price bei ng 
deferred and paid across during that period. 
Earn-outs are popular among privat e equity investors, who do no t 
necessarily have the expertise to  run a target business after a cquiring it, 
as a way of keeping the previous owners involved following the acquisition. 
Example: 
An entrepreneur selling a busi ness is asking $2 million based o n 
projected earnings, but the buyer  is willing to pay only $1 mil lion based 
on historical performance. 
An earn-out provision might struc ture the deal so that the entr epreneur 
receives more than the buyer's o ffer only if the business achie ves certain 
targets. For example the earnout m ight set the purchase price a t $1 
million plus 10% of gross sale s over the next three years. 
Earn-out targets 
The financial targets used in an earn-out calculation may inclu de 
revenue, net income, EBI TDA or EBIT targets. 
Sellers tend to prefer revenue as the simplest measurement, but  revenue 
can be boosted through business ac tivities that hurt the bottom  line of the 
company. On the other hand, buyers  tend to prefer net income as  the 
most accurate reflection of ove rall economic performance, but t his 
number can be manipulated downwar d through extensive capital 
expenditures and other fr ont-loaded business expenses. 
Some earn-outs may be based on entirely non-financial targets s uch as 
the development of a product or the execution of a contract. 
Limitations of earn-outs 
Earn-outs have several  fundamental limitations. 
They generally work best when t he business is operated as envis ioned at 
the time of the transaction, rat her than in circumstances where  the 
business plan changes, often in  response to a change in the bus iness 
environment. 
In some transactions, the buyer m ay have the ability to block t he earn-out 
targets from being met. Outside  factors may also impact the com pany's 
ability to achieve earn-out targets. 
Sellers need to negotia te earn-out terms very carefully, taking  into 
account all these issues.

544  
 Summary of the key issues relati ng to forms of consideration 
 Considerations of diff erent stakeholders 
In order to evaluate which form of consideration is appropriate  in a 
particular case, it is important to assess the positions of bot h the target 
company's shareholders, and the bi dding company and its shareho lders. 
Position of the target co mpany's shareholders 
The target company's shareholders may want to retain an interes t in the 
business, in which case a cash offer would not be welcomed. How ever, 
there is a greater certainty o f value with a cash offer (share prices 
fluctuate, so in a share exchan ge the target company's sharehol ders 
cannot be completely sure whether  they are receiving an appropr iate 
valuation for their shares). 
Position of the bidding comp any and its shareholders 
The bidding company will have to i ssue new shares if it is to u ndertake a 
share exchange. This may require  the consent of shareholders in  a 
general meeting. The shareholders may be concerned in a share exchange that their control of t he bidding com pany will be dilu ted by the 
issue and exchange of shares. 
Another key consideration is the impact of the takeover on the bidding 
company's financial statements. An issue of new shares could re duce the 
level of earnings per share (a mea sure which is often used as a  key 
performance measure by market anal ysts). However, if a cash off er is 
made, the raising of the necessary  cash could have a significan t impact 
on the gearing of the bidding company. 
Methods of financing a cash offer 
If the bidding company has a lar ge cash surplus, it might be ab le to make a 
cash offer without raising any new finance. 
However, in most cases, this will not be the case, so various f inancing options 
will have to be considered by t he bidding company. The main two  options are 
debt or a rights issue. 
Note that the amount of finance needed might be higher than exp ected if there 
is a plan to repay the target ent ity debt at the  time of the ta keover. This can 
sometimes be a requirement of t he target entity's lenders, as s tipulated in a 
debt covenant. 
If target entity debt has to be repaid, the bidding company's t otal cash 
requirement will need to cover the cost of purchasing the equit y shares and the 
value of the target entity debt.

Chapter 13 
 545 
Debt 
The bidding company could borro w the required cash from the ban k, or issue 
bonds in the market. 
The advantage of using debt in this situation is the low cost o f servicing the 
debt. However, raising new debt fi nance will increase the biddi ng company's 
gearing. This will increase the ri sk to the bidding company's s hareholders, so 
might not be acceptabl e to the shareholders. 
If the bidding compan y shareholders do not want to suffer the i ncreased risk 
which debt finance would bring, t he alternative would be for th e bidding 
company to offer a rights issue  to its existing shareholders. T he funds raised 
can then be used to buy the shar es in the company being acquire d. Gearing 
levels are thereby protected. 
From the shareholders' point of v iew, the problem with this fin ancing option is 
that it is the shareholders them selves who have to find the mon ey to invest. 
 
 Evaluating a share for share exchange 
One popular question is to commen t on the likely acceptance of a share for 
share offer.  
It is vitally important to be abl e to identify the likely syner gy generated in the 
acquisition in order to assess t he attractiveness of the offer accurately. 
The procedure is as follows: 
• Value the predator company as an independent entity and hence calculate 
the value of a share in that company. 
• Repeat the procedure for the victim company. 
• Calculate the value of the comb ined company post integration.  
This is calculated as: 
Value of predator company  as independent company X 
Value of victim company as independent company X 
Value of any synergy X 
Total value of combined company X 
 — –  
• Calculate the number of s hares post integration: 
Number of shares originally  in the predator company X 
Number of shares issued to victim company X 
 — –  
Total shares post integration X 
 — –  
• Calculate the value of a share in the combined company, and us e this to 
assess the change in wealth of the shareholders after the takeo ver.

546  
 Company A has 200m shares with a current market value of GBP4 per 
share. Company B has 90m shares with a current market value of GBP2 
per share. 
A makes an offer of 3 new shares  for every 5 currently held in B. A has 
worked out that the present value  of synergies will be GBP40m. 
Required: 
Calculate the expected value o f a share in the combined company  
(assuming that the given share pr ices have not yet moved to ant icipate 
the takeover), and advise the shareholders in company B whether  the 
offer should be accepted. 
Solution: 
MV of A = GBP800m MV of B = GBP180m PV of synergies = GBP40m TOTAL = GBP1,020m No. of new shares = 200m +  (3/5) × 90m = 254m 
New share price = 1, 020m/254m = GBP4.02 
 Shares MV Old wealth Change 
A 200m GBP804m GBP800m GBP4m 
B (3/5) × 90m = 54m GBP216m GBP180m GBP36m 
The wealth of the shareholders i n company B will increase by GB P36m 
as a consequence of the takeover. This is a (36/180) 20% increa se in 
wealth. 
Company B's shareholders should be advised to accept the 3 for 5 share 
for share offer.

Chapter 13 
 547 
 Further numerical illustrati on (Integration question) 
 Initial example – cash offer 
Summary of information regarding  Entity A and Entity B, two UK 
companies (currency GBP, or £): 
 Entity A Entity B 
Market price per share (£) 75 15 
Number of shares 100,000 60,000 
Market value (£) 7,500,000 900,000 
Required: 
If A intends to pay £1.2m cash for B, what is the cost premium if: 
(a) the share price does no t anticipate the takeover; 
(b) the share price of Entity B includes a ‘speculation’ elemen t of £2 per 
share? 
Solution: 
(a) The share price accurately r eflects the true value of the e ntity (in 
theory). 
Therefore, the cost t o the bidder is simply  £1,200,000 – £900,0 00, 
that is, £300,000. 
Entity A is paying £300,000 fo r the identifi ed benefits of the 
takeover. 
(b) The cost is £300,000 + ( 60,000 × £2), or £420,000. 
Follow up example – share exchange 
Suppose A offers 16,000 shares ( £1.2m/£75) instead of £1.2m cas h. The 
cost appears to be £300,000 as bef ore, but because B’s sharehol ders will 
own part of A, they will benefit fr om any future gains of the c ombined 
entity. Their share will be (16, 000/(16,000 + 100,000)), or 13. 8%. 
Further, suppose that the benefit s of the combination have been  
identified by A to have a pres ent value of £400,000 (i.e. A thi nks that B is 
really worth £900,000 + £400,000, o r £1.3m). Therefore, the com bined 
entity of A and B is worth £7.5m + £1.3m , or £8.8m. 
Required: 
Calculate the true cost of the  takeover to the acquirer’s share holders.

548  
 Solution: 
 A B 
Market value: £8.8m × proportion £7.586m £1.214m 
Number of shares current ly in issue 100,000 60,000 
Price per share (£) 100,000 20.23 
What we are attempting to do her e is to value the shares in the  entity 
before the takeover is complet ed, based on estimates of what th e entity 
will be worth after the merger. T he valuation of each entity al so 
recognises the split of the expe cted benefits which will accrue  to the 
combined form once the merger has taken place. 
The true cost to A can now be calculated as follows: 
 £  
60,000 B shares at £20.23  1,213,800 
Less: Current market value (900,000) 
 –––––––– 
Benefits being paid to B 's shareholders  313,800 
 ––––– ––– 
 
 Test your understanding 1 (Case style question) 
 Mavers Co and Power Co are listed on the Stock Exchange. 
Relevant information is as follows: 
 Mavers Co Power Co 
Share price today $3.05 $6.80 
Shares in issue 48 million 13 million 
Mavers Co wants to acquire 100%  of the shares of Power Co. 
The directors are considering offering 2 new Mavers Co shares f or every 
1 Power Co share. 
Required: 
Evaluate whether the 2 for 1 s hare for share exchange will be l ikely to 
succeed. 
If necessary, recommend revised te rms for the offer which would  be likely 
to succeed. 

Chapter 13 
 549 
 Bootstrapping and pos t-acquisition values 
In the previous examples, we we re told specifically what the va lues of the 
separate companies were before t he takeover, and the synergy ge nerated by 
the takeover was also given. 
Sometimes we might have to der ive these figures, using the boot strapping 
method as in the follo wing illustration. 
 
 Illustration 2 (Case style question) 
  
 Post-tax  
profit P/E ratio Pre-acquisition 
value 
Company C  $10m  16  $160m 
Company D  $1m  8  $8m 
If Company C takes over Company D, t he post-acquisition value o f the 
combined company can be estimated by applying Company C's P/E r atio 
to the combined post-tax profit. 
This is known as bootstrapping , and it is based on the assumption that 
the market will assume that the management of the larger compan y will 
be able to apply common approach to  both companies after the ta keover, 
thus improving the performance o f the acquired company by using  the 
methods that they have been using on their own company before t he 
takeover. 
Value of (C+D) post-acquisiti on = 16 × ($10m + $1m) = $176m 
Thus, the value of the synergy is this combined value, less the  values of 
the individual companies  pre-acquisition, i.e. 
$176m – $160m – $8m = $8m 
4 Treatment of target entity debt 
In looking at forms of considerat ion above, we have assumed tha t the takeover 
bid will need to be sufficient to  attract the target entity sha reholders to want to 
sell their shares. 
However, in many takeovers, the consideration needs to be great er than this, to 
deal with any 'material adverse  change clauses' attached to the  target entity's 
Treatment of debt in the target entity 
A material adverse change clause is often used to make the targ et entity's 
borrowings repayable if the company is sold.

550  
Therefore, when cons idering how to fund a takeover, the bidding  company will 
have to ensure that sufficient f unds are available to purchase the shares from 
the target entity's shareholde rs, and to repay the debt in the target entity. 
 
 Example: 
Company P is considering a ta keover bid for Company H. 
The $2.2 million borro wings in Company H are repayable if Compa ny H is 
acquired. 
Therefore, Company P is consid ering one of the following offers : 
• P to pay $ 4.9 million in cash ($ 2.7 million cash to H’s shar eholders 
PLUS $ 2.2 million to finance the repayment of H’s borrowings).  
• Exchange two P $ 0.50 ordinary shares for each H ordinary shar e 
held PLUS P to pay H $ 2.2 million in cash to finance the repay ment 
of H’s borrowings. 
Comments: 
• Note that the bids look very  similar to the ones seen earlier in the 
chapter, but they now contain a re ference to the extra payment 
required to repay the debt 
• We need to be careful with busine ss valuation here. For exampl e, in 
the previous chapter: 'Busine ss valuation' we saw that: 
–  applying an appropriate P/E rat io to the company's earnings,  
or discounting forecast cash  flows to equity using cost of 
equity gives the value of the EQUITY, whereas: 
–  discounting forecast cash fl ows to all investors using WACC 
gives the value of the WHOLE EN TITY (equity plus debt), and: 
–  an asset valuation could be ei ther an EQUITY valuation or an  
ENTITY valuation, depending wha t is included in the valuation 
• Therefore, when deciding what s ize of offer should be made, it  is 
critical to assess whether the va luation figure already include s the 
value of both debt and equity or whether it is just an equity 
• Note that in the circumstances  described in the offer above, P  would 
need to consider how to finance t he cash offer of $4.9 million (e.g. 
by borrowing), but it would also  have to consider the possibili ty of 
borrowing under the share for share exchange offer.

Chapter 13 
 551 
 BB is considering a takeover bid for QQ. 
BB has prepared a valuation of Q Q based on a forecast of cash f lows 
before financing charges, discoun ted at an appropriate weighted  average 
cost of capital. The valuation is $130 million. 
If BB does acquire QQ, QQ's debt o f $20 million wil l become rep ayable. 
If BB wants to make a cash offer,  what should the value of the cash 
offer be in total? 
A  $20 million 
B $110 million C $130 million D $150 million 
5 The post-merger or post-acquisition integration process 
Introduction to the post-merger or post-acquisition process 
Mergers and acquisitions often  fail to deliver the anticipated synergies as a 
result of failing to effectively in tegrate the newly acquired e ntity into the parent. 
Poor planning and a la ck of information to g uide the integratio n plans ahead of 
the acquisition will lead to pos t-acquisition integration probl ems. 
Druker’s Golden Rules 
P. F. Druker (1981) identified fi ve Golden Rules to apply to po st-acquisition 
integration. 
1 Ensure a ‘common core of unity ’ is shared by the acquired ent ity and 
acquirer. Shared technologies or m arkets are an essential eleme nt. 
2 The acquirer should not just th ink ‘What is in it for us?’, b ut also ‘What can 
we offer them?’. 
3 The acquirer must treat the pr oducts, markets and customers o f the 
acquired entity with respect. 
4 Within 1 year, the acquirer shoul d provide appropriately skil led top 
management for the acquired company. 
5 Within 1 year, the acquirer should make several cross-entity promotions of 
staff.

552  
 Post-acquisition value enhancing strategies 
 The following are key points to  consider when determining stra tegy for 
the combined entity: 
• The integration strategy must be in place before the acquisiti on is 
finalised. 
• Review each of the business unit s for potential cost cuttings/  
synergies or potential asset dis posals. It is possible there ar e outlets 
more valuable to another entity,  but it is important they are i n good 
shape before they are sold. How ever, more than this is needed f or a 
full effective enhancement progra mme and a position audit could  be 
carried out. 
• Consider the effect on the wo rkforce and determine how many, i f 
any redundancies are likely and what the cost will be. 
• Risk diversification may well lower the cost of capital and th erefore 
increase the value of the entity. 
• The entity’s cost of capita l should be re-evaluated. 
• Make a positive effort to co mmunicate the post-acquisition 
intentions within the entity to  prevent de-moti vation and avoid  
adverse post-acquisition e ffects on staff morale. 
• There may be economies of sca le to identify and evaluate. 
• Undertake a review of assets, or resource audit, and consider 
selling non-core elements or redundant assets. 
• There may well be a need to purs ue a more aggressive marketing  
strategy. 
• The risks of the acquisition need to be evaluated. 
• There needs to be harmonisati on of corporate objectives. 
Impact on ratios or performance measures 
Following the completion of an acquisition the purchaser will n eed to examine 
thoroughly the financial and mana gement accounting records of e ach business 
unit of the acquired entity. 
Thus, the directors of the acqui rer will be particularly intere sted in the financial 
condition of those units which t hey might plan to dispose of. 
From a strategic point of view t hese are likely to be of more u se to another 
entity with whom they would form a  better fit. However, it is s till essential that 
financially and operationally t hey should be in as good shape a s possible to 
ensure that a good price can be obtained for them.

Chapter 13 
 553 
 Hall Co has just acquired a s ubsidiary called Wodgits as part of a larger 
acquisition. Hall Co has no other  subsidiaries in the same busi ness 
sector as Wodgits, so management a re considering disposing of W odgits. 
A small listed compan y called Bigwodge, whose core business is similar 
to Wodgits, has been identified , and by using all published and  any other 
information reasonably available,  the following analysis has be en 
prepared: 
 Wodgits Bigwodge 
Return on Capital Employ ed (ROCE) 14.9% 25.0% 
Asset turnover 1.3 times 1.8 times 
Net profit margin 11.5% 13.9% Current ratio 1.5 times 2.2 times 
Inventory holding per iod 68 days 57 days 
Receivables collection period 54 days 43 days Payables payment period 49 days 37 days 
Other key information: 
• Bigwodge has a P/E ratio of 18. 
• Wodgits made an operating pr ofit of $860,000 last year. 
• Wodgits has total non-current asset s of $4.87m, out of which l and 
and buildings comprise $2.5m. It s net assets at book value are 
$5.77m. 
• The tax rate is 33%. 
Required: 
As the management accountant of Ha ll Co, prepare a report to th e 
directors in which you analyse th e performance of Wodgits compa red 
with Bigwodge, and recommend a pr ice which Hall Co ought to see k for 
the disposal of Wodgits. 
Solution: 
Report to the directors of Hall Co 
Wodgits’ inadequate ROCE seems to be mainly due to a low rate o f asset 
turnover, which we must carefully investigate. 
We know that land and buildings  account for $2.5m of Wodgits’ f ixed 
asset total of $4.87m and it is important to establish how much  of this 
property value represents redundant assets. As to plant and mac hinery, it 
may be that this is substantially  new or revalued, in which cas e the 
assets may be of good value and t he faults may lie mainly in un der-
capacity working or production inefficiencies.

554  
 Much more serious, however, would be a situation where the plan t is old 
and requiring heavy maintenance , and would be hard put to cope with 
increased volume of throughput. 
If the first of these pl ant scenarios is correct, then Wodgits may well fetch 
a reasonable price, as a bidder, possibly Bigwodge themselves, would be 
obtaining good assets to add to th eir own evidently successful 
performance in their sector. If  the second scenario applies, th en we might 
find it difficult to obtain net a sset value for the assets rema ining after sale 
of the redundant properties. 
Current ratio 
Wodgits’ current ratio and invent ory holding period are fairly good, but 
before we put the unit up for sale , we would improve our prospe cts for a 
reasonable price by taking early a ction in regard to both recei vables and 
payables. Both are too high and we should aim to tighten up cre dit control 
and also bring payables down to t he more acceptable level which  
Bigwodge's payables payment peri od indicates is appropriate for  the 
industry sector. 
Conclusions 
Assuming that we can find tha t, say, $1.5m of land and building s are 
redundant and can be separately so ld, and that the plant scenar io is 
favourable or can be made so, t hen it would not seem to be too difficult to 
make the remainder of Wodgits  a saleable proposition. 
Thus if we can assume no debt i nterest, and taxation of 33%, th en after- 
tax profits could be $576,000 ($860,000 × 0. 67), and as Bigwodg e’s 
current P/E is 18, we might achie ve for Wodgits a P/E of 9 or 1 0 which 
suggests a price of between $5.2 and $5.8m, which is comfortabl y above 
an asset value of $4.3m ($5.8m  – $1.5m assets sold). 
 
 The impact of an acquisition on t he acquirer’s post-acquisition  share 
price 
A very important aspect for an acquirer is the post-acquisition  effect on its 
earnings per share (EPS), and the impact on the share price and  P/E ratio 
arising from the market’s perce ived views on the acquisition. 
Once again, detailed analysis o f the accounts, and comparison t o other 
companies in similar business se ctors can help to assess whethe r the likely 
impact will be favourable.

Chapter 13 
 555 
 Simple example of t he impact on EPS 
 Assume that the new entity starts  with a prospective EPS of 13 .1 cents 
based on combined profits of acq uirer and acquired of $8.4m, an d 64m 
shares in issue, and if these ear nings could be maintained in y ear 1 
(post-acquisition) they would appear not to be diluted. 
However, if the acquirer is ex pected from its previous performa nces to 
attain 10% per annum growth in normal (money) terms, then for y ear 1 
EPS of 13.1 cents × 1. 10 would be 14.4 c ents, and arguably if t his is not 
attained then dilution will s eem to have taken place. 
A serious threat to an acquirer’ s EPS is the ‘getting to know y ou’ costs 
and also the ‘reverse synergy’ e ffects of 2 + 2 = 3, which sadl y seems to 
be the fate of numerous acquisitions. 
A major question is whether the present value of the combined e arnings, 
including assumed lon ger-term profit improvements, really takes  into 
account all the downside costs of  putting two different entitie s together, 
each with its own management style. 
 
 Illustration of strategic issues 
 You are acting as financial advis er to a public entity, H plc,  in the hotel 
business. H plc is considering a  takeover bid for the shares of  G Limited. 
Information relating to G Ltd  is given in the table below. 
G Limited operates in the gam ing and betting industry. 
The company was established 7 y ears ago, and the two founder di rectors 
still provide the necessary tec hnical and marketing skills. The y own 60% 
of the issued share capital, t he balance plus the long-term loa n capital 
having been subscribed by a fi rm of venture capitalists. 
Extracts from the annual reports of G  Limited are given below. 
Required: 
Discuss the extent to which each of the following six reasons m ight apply 
to the proposed acquisition of G Limited by H plc. Support your  answers 
with appropriate analysis of the data provided. 
(i)  Access to innovation (ii) Growth in earnings per share (iii) Achievement of operating economies (iv) Reduction of risk through diversification (v) Access to liquid funds (vi) Improved asset backing for borrowing.

556  
 Data relating to G Ltd – extracts from annual reports 
Year to 30 June 20X8 20X7 20X6 
 £000 £000 £000 
 860 684 547 
Operating profit 55 68 16 
Loan interest (20) (14) (12) 
Taxation (9) (6) – 
Net profit 26 48 4 
Tangible non-current assets:    
Cost 224 174 133 Less depreciation 54 34 23 
 
 170 140 110 
Development costs    
Cost 254 189 129 
Less written off 176 109 53 
 78 80 76 
Inventory 30 40 31 
Receivables 109 72 57 
Cash 1 14 5 
 140 126 93 
TOTAL ASSETS 388 346 279 
Equity    
Share capital (25p shares)  100 100 100 
Retained profit reserve  61 35 (13) 
 161 135 87 
Long-term liabilities 160 160 160 
Current liabilities  67 51 32 
TOTAL EQUITY AND LIABILITIES 388 346 279 
 
––––– ––––– –––––

Chapter 13 
 557 
 Solution: 
(i)  Access to innovation 
To comment upon this fully would require detailed statement of 
profit or loss information. H owever, the development costs 
capitalised on the statement of financial position give an indi cation 
of considerable increase in dev elopment as opposed to research 
expenditure which ha s been undertaken, assuming that this does 
not reflect changes in accounting policy. 
Against this, the high rate of w rite-off suggests that the life  of 
developed products may well be short. 
As innovation depends on people, H p lc should identify and take  
steps to retain key staff in the event of a takeover. 
(ii) Growth in earnings per share 
The impact of the acquisition on  the earnings per share of H pl c will 
depend upon the price paid and whet her the price included share s 
of H plc. 
The past profit performance of G Li mited and forecast earnings are 
certainly erratic and lower in r elation to revenue. This may be  due to 
poor management, in which case the  firm could be turned around 
and earnings improved or it could be uncontrollable factors in which 
case earnings might be low and volatile in the future. 
The counter-view would be to s uggest that if the rapid growth o f the 
past 3 years can be maintained, t hen there must be opportunitie s for 
boosting earnings even if the pr ofit forecasts do not reflect t his. 
(iii) Achievement of operating economies  
The achievement of such economi es depends upon integration of 
similar businesses. Given tha t hotels and gaming and betting ar e 
closely linked there may be scope  for such economies if gamblin g 
operations already occur or are planned at the hotels of H plc.  
(iv) Reduction of risk thr ough diversification 
G Limited has volatile earnings a nd is more likely to increase the 
risk profile of H plc than reduce it. 
(v) Access to liquid funds 
Although there is no ready cas h in G Limited, t he entity has ha d a 
satisfactory liquidity position  for several years with current ratios of 
between 2.9 (20X6)  and 2.1 (20X8). 
However, it should be noted tha t the position has worsened slig htly 
over recent years. It is probable  that since the hotel industry  
typically has fairly low liqui dity, acquiring G Limited will im prove the 
liquidity position of the comb ined entity as c ompared with H pl c.

558  
 ( v i )  Improved asset backing for borrowings 
Tangible non-current assets at cost less depreciation have 
increased dramatically dur ing the period 20X6–20X8. 
Obviously comments which can be made are limited due to a lack of 
categorisation of assets and det ail of movements. However, the low 
depreciation charge suggests tha t there is land and buildings o r long 
leasehold property among the assets. 
Such assets provide good security  for borrowing, and as assets are 
at cost the borrowing capacity may well be higher as it will re flect 
market values. 
 Mr A and Mr B incorporated a new company five years ago. 
The company has grown extremely  quickly and Mr A and Mr B still  own 
100% of the share capital in the company. 
They now feel that the company needs an injection of funds to e nable it 
to grow further. Mr A and Mr B want to keep a controlling inter est in their 
company, and they feel that the co mpany's growth prospects woul d be 
damaged by disposing of any part of it. 
Which TWO of the following strategies could Mr A and Mr B 
consider? 
A  Spin off 
B  Initial public offering (IPO) C  Private equity buy-in D  Management buy-out E  Trade sale of the whole company to a competitor

Chapter 13 
 559 
 Ravenglass Co is the subject of a  takeover bid from Irton Co. An offer of 
$5 per share has been made to the Ravenglass Co shareholders. 
Irton Co has recently taken over  several other companies and ha s gained 
a reputation as an asset stri pper. The directors of Ravenglass Co don't 
feel that the takeover would be in the best interests of the sh areholders 
and other stakeholders of Ravenglass Co, so they are keen to pr event 
the takeover from going ahead. 
Which THREE of the following st rategic defence methods could be  
used by the directors of R avenglass Co in this situation? 
A  Poison pill 
B  Super majority C  White knight D  Pacman E  Appeal to the shareholders 
 
 Paolo Co acquires an other company and pays a price that repres ents a 
higher P/E valuation than the current P/E of Paolo Co. 
The purchase consideration is paid by issuing new Paolo Co shar es. 
There is no synergy arising from  the takeover. Paolo Co has som e debt 
in its capital structure. 
Which of the following would be  the LEAST likely consequence of  
this takeover? 
A  A reduction in gearing for Paolo Co 
B  A dilution of earnings of Paolo Co C  An increase in the share price after the takeover 
D  A reduction in the proportionat e stake in the company of exi sting 
Paolo Co shareholders

560  
 ASH Co has made a bi d for GIANT Co, in an attempt to take it o ver. 
The bid is a 1 for 2 shar e for share exchange. 
Currently, ASH Co has 1 million shares in issue, trading at $6. 33. GIANT 
Co has 200,000 shares in issue trading at $2.96. 
It is expected that $100,000 of s ynergy will be generated by th e takeover. 
What is the expected share price  in the combined company after the 
takeover? 
A $5.92 
B $6.33 C $6.38 D $7.02 
 
 In Co is hoping to make a succe ssful takeover offer for Out Co . 
In Co is a successful company bu t it has relatively low cash re serves. Its 
gearing ratio has stayed fairly  constant at around 15% in recen t years 
(measured as debt/(debt + equity) by market values) and its int erest 
cover is 5.50. 55% of the equity  in In Co is still owned by the  founding 
family. This holding has reduced fr om 75% in the last three yea rs, as the 
family has sold off shares to generate much-needed income. 
Which of the following is likely to be the best way of structur ing an 
offer for Out Co? 
A  Cash offer, funded from existing cash resources 
B  Cash offer, funded by a rights issue C  Cash offer, funded by borrowings D  Share for share exchange

Chapter 13 
 561 
 Alpha Co has a P/E ratio of 16 and post-tax earnings of $200,0 00. 
Beta Co has a P/E ratio of 21 and post-tax earnings of $800,000 . 
Beta's directors estimate that i f they were to acquire Alpha th ey could 
save $100,000 (after tax) annually  on administrative costs in r unning the 
new combined company. Additionally  they estimate that the P/E r atio of 
the new company would be 20. 
On the basis of these estimates, what is the maximum that Beta 
should pay for the entire  share capital of Alpha? 
A $6.3 million  
B $5.2 million  C $4.2 million  D $2.0 million 
 
 Two all-equity financed companies, R and S, have identical bus iness 
risks. 
Company R is valued at $40 m illion and Company S at $8 million.  The 
two companies merge via a share exchange which results in R 
shareholders holding 80% of the s hares of the new merged compan y. 
As a result of synergy, surplu s assets of $5 million are sold i mmediately 
without affecting the future pro fitability of the merged compan y. Half of 
the proceeds of the disposal are i nvested in a project with a n et present 
value of $1 million. 
What will be the gains to the  shareholders of Company R? 
A $4.8 million  
B $3.2 million  C $1.2 million  D $0.8 million

562  
 (a) One theoretical method of v aluing a company's shares is to  
calculate the present value of fu ture dividends using a discoun t rate 
that reflects the risk of the bus iness. In respect of large, li sted 
companies, current evidence sugges ts that this is far too simpl istic a 
view of how company values and s hare prices are determined. 
Required: 
Comment on the reasons why share prices may be substantially 
different from the level sugges ted by theory. Include brief com ments 
on the relevance of P/E ratios and asset values in share price 
determination. 
(b) ML Co is an expanding clot hes retailing company. It is all equity 
financed by ordinary share capita l of $10 million in shares of 50 
cents nominal. The company's res ults to the end of March 20X9 
have just been announced. Pre-tax p rofits were $4.6 million. Th e 
chair's statement included a fo recast that earnings might be 
expected to rise by 5% per annum i n the coming year and for the  
foreseeable future. 
CO, a children's clothes group, has an issued ordinary share ca pital 
of $33 million in $1 shares. Pre-t ax profits for the year to 31  March 
20X9 were $5.2 million. Becaus e of a recent programme of 
reorganisation and rationalisation,  no growth is forecast for t he 
current year but subsequently con stant growth in earnings of 
approximately 6% per annum is pr edicted. CO has had an erratic 
growth and earnings record in t he past and has not always achie ved 
it's often ambitious forecasts. 
ML Co has approached the sharehol ders of CO with a bid of two 
new shares in ML Co for every th ree CO shares. There is a cash 
alternative of 135 cents per share. 
Following the announcemen t of the bid, the market price of ML C o 
shares fell while the price of s hares in CO rose. Statistics fo r ML Co, 
CO and two other listed com panies in the same industry 
immediately prior to the bid announcement are shown below. All 
share prices are in cents. 
20X8 Company Dividend yield 
% P/E 
High Low    
225 185 ML Co 3.4  15 145 115 CO 3.6  13 
187 122 HR 6  12 
230 159 SZ 2.4  17

Chapter 13 
 563 
Both ML Co and CO pay tax at 33% . ML Co's cost of capital is 12 % 
per annum and CO's i s 11% per annum. 
Required: 
Assume you are a financial anal yst with a major fund manager. Y ou 
have funds invested in both ML Co and CO. 
–  Assess whether the pr oposed share for share offer is likely to 
be beneficial to the sharehol ders in ML Co and CO, and 
recommend an investment s trategy based on your 
calculations. 
–  Comment on other information  that would be useful in your 
assessment of the bid. Assume th at the estimates of growth 
given above are achieved and t hat the new company plans no 
further issues of equity. 
State any assumptions that you make. 
 
 Oscar Wills is the chief executi ve of OW plc, a UK listed comp any. The 
entity has been trading for 5 year s. Oscar is ambitious and aim s to make 
his entity market leade r within 5 years. 
He makes an offer to acquire W ilde plc, an older quoted entity of similar 
size to OW but with a profit rec ord that has been erratic in re cent years. 
Wills is of the opinion that Wil de lacks marketing strength and  feels that 
he could make the entity much more profitable. 
A summary of the financial data before the bid is as follows: 
 OW Wilde 
Number of shares in issue 40m 44m 
Earnings available to ordi nary shareholders £4m £4.4m 
P/E ratio 20 10 
OW – estimated financia l data post-acquisition 
Estimated market capitalisation  £167.7m 
Estimated share price  262 p 
Estimated EPS  13.1 p Estimated equivalent value o f one old Wilde share 143 p 
• The offer is six OW shares for eleven Wilde shares. 
• The offer is not expected to res ult in any immediate savings o r 
increases in operational cash fl ows, but in future, Oscar Wills  
expects the EPS to grow by 10% per annum.

564  
 Required: 
(a) Show how Oscar Wills calculated his estimate of post-acquis ition 
values. Discuss the assumptions made by Oscar Wills, and calculate an alternative post-ac quisition value for the company . 
(b) If Wilde’s shareholders rejec ted the bid, calculate the max imum 
price OW could afford pay wit hout reducing its shareholders’ we alth 
(assuming Oscar Wills’ estimate o f post-bid market value is cor rect). 
(c) Explain why OW would wish to  make the acquisition and comme nt 
on likely post-acquisition e ffects on the P/E ratio. 
(d) Discuss other post-acquisiti on impacts that the directors o f OW plc 
should consider. 

Chapter 13 
 565 
 Calculations 
Value of Mavers Co = $3.05 × 48m shares = $146.4m 
Value of Power Co = $6. 80 × 13m shares = $88.4m 
Total value (assuming no synergist ic gains) = 146.4 + 88.4 = $2 34.8m 
Number of shares post-integrat ion = 48 million + (2 × 13 millio n)  
= 74 million 
So the post-integration share price will be: 
$234.8m/74 million = $3.173 
Mavers 48m  $152.3m  $146.4m  +$5.9m 
Power  2 × 13m = 26m  $82.5m  $88.4m  –$5.9m 
Advice 
The Power Co shareholders will no t accept a 2 for 1 share for s hare 
exchange since it causes their wealth to reduce. 
In order for the Power Co shar eholders to be encouraged to acce pt the 
offer, it must offer t hem a gain in wealth. 
To make sure that Mavers Co is va luing Power Co at its current market 
value, the value of the offer needs  to be ($6.80 × 13m shares) $88.4m in 
total. 
Given the current Mavers Co shar e price of $3.05, this amounts to 
$88.4m/$3.05 = 28.98m shares in Mavers Co. 
An exchange of 28.98m Mavers Co s hares for the 13m Power Co sha res 
represents a ratio of 28. 98m to 13m or 2.23 to 1. 
However, if the terms of the offe r were to be exactly 2.23 Mave rs Co 
shares for every 1 share in Pow er Co, there would be no incenti ve for the 
Power Co shareholders to sell (f inancially, they’d be indiffere nt between 
keeping their existing shares and  exchanging them for Mavers Co  
shares). 
In order to encourage Power Co’s  shareholders to sell, a premiu m would 
have to be offered. 
Hence, an offer of (say) 2.5 Mav ers Co shares for every 1 share  in Power 
Co would probably be needed to enc ourage the Power Co sharehold ers 
to sell.

566  
 Position of Mavers Co shareholders 
In this situation, where no synergi stic gains are included in t he 
calculations, a gain to Power  Co's shareholders will result in a 
corresponding loss to the Mavers C o shareholders. Clearly Maver s Co 
would not want to proceed with the  takeover in these circumstan ces. 
Unless some synergies can be gener ated, to improve the wealth o f the 
overall company after the acquisi tion, there is no way of struc turing the 
deal so that both sets of s hareholders will be satisfied. 
 
A forecast of cash flows befor e financing charges, discounted a t an 
appropriate weighted average cost o f capital, gives a valuation  for the 
whole entity, both debt and equity. 
Therefore, to acquire the shar es and pay off the debt, this val ue ($130 
million) should be paid. 
 
 The answer is (B) and (C). 
A spin-off would not actually generate any cash and a managemen t 
buyout would split the business up  or (if it was to be for the whole 
company) take a controlling inte rest away from Mr A and Mr B. A  trade 
sale of the whole company would  not leave Mr A and Mr B with a 
controlling interest. 
 
(A) and (B) are defences tha t would have to be set up before  a bid was 
made.

Chapter 13 
 567 
If Paolo Co buys another company and values the target company on a 
higher P/E ratio, and if there is  no synergy, there will be a r eduction in the 
earnings per share of Paolo Co ( B). Since the acquisition is pa id for by 
using new shares, the gearing rati o of Paolo Co will fall (A), and existing 
shareholders will own a smaller proportionate stake in the comp any (D). It 
is unlikely that the share pric e will increase; in view of the reduction in 
earnings per share, it is more lik ely that the share price will  fall after the 
takeover. 
 
Total value of the combined company will be: (1m × $6.33) + (200,000 × $2.96) + 100,000 = $7,022,000 
The number of shares in the combined company will be: 
1 million + [(1/2) ×  200,000] = 1,100,000 
Therefore the share price will be $7,022,000/1 ,100,000 = $6.38 
 
In Co's gearing appears to be quite  low and interest cover is q uite high, 
so it shouldn't cause any problems to increase borrowings (C). 
Low cash reserves would rule out  a straight cash offer (A), and  the fact 
that the family owners have been selling off shares would seem to rule 
out a rights issue (B). 
A share for share exchange (D) w ould change the control of In C o, and 
would probably reduce the family 's holding to lower than 50%, s o should 
not be undertaken unless the fam ily owners accept that they wil l lose 
their control of the company.

568  
Expected value of Alpha and Beta combined is: 
20 × (200,000 + 800,000 + 100,000) = $22 million 
Beta's current value is 21 × 800,000 = $16. 8 million. 
Therefore the value of Alpha to  Beta is the difference between these two 
figures, i.e. $5.2 million. 
 
Value of merged company  ($ million) = 40 + 8 + 5 + 1 = $54 mill ion 
R's shareholders have 80%  (i.e. $43.2 million) 
This is a gain of $3.2 million. 
 
 (a) Given the wording, you rea lly need to explain why the divi dend 
valuation model may break down , as it is the 'theory' specifica lly 
mentioned in the question. You pr obably have time only to menti on 
a couple of drawbacks with each approach. 
A common way of valuing the or dinary shares in a company is 
discounting all future dividends  anticipated from holding the s hares. 
Although having a ring of truth, it often fails to give a price  which 
corresponds to the current marke t price, due to its inherent fl aws: 
–  It requires constant dividend growth, which in turn implies a 
constant retention ratio and retu rn on re-invested funds. It is  
possible to cope with varying grow th rates but the calculation 
is awkward. 
–  It requires a continuous suppl y of investment opportunities 
through time to justify retention. 
–  It can give nonsensical results e.g. zero current dividend 
generates zero value, thus ignori ng the value of the firm's 
assets and/or its earnings stream. 
–  It is only suitable for valui ng minority stakes in a firm be cause 
it ignores the opportunities for m anagers to restructure firms to 
improve earnings and cash flow . The key to value is not the 
portion of profit paid out to shar eholders but the earning powe r 
of the business.

Chapter 13 
 569 
Price earnings (P/E) ratios 
This is not a method of valuing shares of quoted firms – P/E ra tios 
are the product of valuation. When  the market sets a value, the  
resulting share pric e divided by the last r eported earnings giv es the 
P/E ratio. Generally, a high P/E ratio indicates that a company  is 
expected to grow its earnings  rapidly in the future. 
The P/E ratio can be used to c ross-check against the value of o ther 
companies – if their relative P/E  ratios look out of line, it m ay 
suggest under- or overvaluation some where. P/E ratios can also be 
used when valuing the shares  of unquoted companies, taking due 
care when interpreting the accounting data used. 
Asset Value (AV) 
The AV is the value per share of  the firm's assets net of all l iabilities 
i.e. the owners' stake in the fi rm. It has some merit for unlis ted 
companies whose shares are not t raded, but it is highly unrelia ble 
for many reasons: 
–  Based on IFRS, asset values in  the Statement of Financial 
Position are primarily designed  to satisfy the directors' duty to 
account for past performance. 
–  It can be distorted by accounti ng practices e.g. different 
depreciation policies. 
–  Revaluation of assets is no t mandatory (except in the proper ty 
sector) so asset values could seriously understate market 
values. 
–  It is only valid at one point i n time, the statement of fina ncial 
position date. 
–  It (usually) ignores intangi bles such as brands and market 
standing. 
–  It may exclude some liabiliti es – 'off-balance sheet' debts like 
operating lease obligations  and warranty commitments. 
–  Inventory values quickly out date in some industries, and som e 
receivables / debtors may be doubtful. 
The AV provides merely a floor to  equity value – usually, the m arket 
value is many times the AV because  the market is valuing future  
earnings capacity. A discounted ca sh flow approach is the most 
appropriate method of valuation.

570  
 (b) The length of answer tha t you can offer will be limited. Th e bulk of 
your time will be spent on comput ation. The solution presented here 
gives a step-by-step guide t hat you would need to follow, rathe r than 
just a summary of the results. 
Basic information 
 ML CO Combined 
Profit after tax (PAT) for 
each firm is    
ML: (0.67 × $4.6m) $3. 082m $3.484m $6.566m 
CO: (0.67 × $5.2m)    Given respective P/E 
ratios, market values are:    
ML: (15 × $3.082) $46. 23m $45.29m $91.52m 
CO: (13 × $3.484)    Given the number of 
shares, share price is:    
ML: ($46.23m/20,000) $2.31 $1.37  
CO: ($45.29m/33,000)    
EPS:    
ML: ($3.082/20,000) 15.41c 10.56c  CO: ($3.484/33,000)    
Analysis 
No. of shares post-bid: 
20,000 + (2/3 × 33,000) = 42,000 
Expected market prices 
post-bid = Total market value/no of shares 
 = (91,520/42,000) = $2.18 Value of bid at post-issue 
price = (2 shares × $2.18) = $4.36 
Cash value of bid per 3 
shares offered: ($1.35 × 3) = $4.05

Chapter 13 
 571 
 Assessment 
Assuming no changes in the level of market prices, and no re-ra ting 
of the sector, ML share price wo uld fall post-acquisition to $2 .18. At 
this price, the value of the 2-fo r-3 share offer should attract  CO 
shareholders. They would be getti ng shares worth (2 × 2.18) 
= $4.36 in exchange for shares cu rrently worth (3 × 1.37) = $4. 11.  
The share-for-share offer is als o worth more than the cash 
alternative: $4.36 vs $4.05. 
This is a 'reverse takeover', w here the shareholders of the tar get 
end up holding a majority stake i n the expanded company – but w ho 
gains from this? 
Former CO shareholders would ho ld (22,000/42,000) × 91.52m 
= $47.939m of the value of t he expanded firm, a gain of  
(47.939m – 45.290m pre-bid v alue of CO) = $2.649m. 
ML shareholders would lose $2.649m , making the share-financed 
deal distinctly unattractive to them. 
Conversely, the cash offer woul d create wealth for ML sharehold ers 
i.e. they give $4.05 for some thing worth $4.11 pre-bid. 
The advice to the fund manager is : 'accept the bid in respect o f CO 
shares and sell ML shares in the market if you can achieve a pr ice 
above $2.18'. 
Other information required 
The advice given hinges on the behaviour of ML's share price – it 
has already fallen on the announce ment, but by how much? It may  
already be too late if the marke t is efficient, as it would alr eady have 
digested the information c ontained in the announcement. 
Also: 
–  What benefits are expected fr om the merger i.e. cost savings  
and synergies? To make sense of the bid, ML must be setting the PV of these benefits above $2.649m to yield a positive 
NPV for the acquisition. 
–  How quickly are these benefit s likely to show through? Any 
delay in exploiting these lowers the NPV. 
–  It is feasible that the market  might apply a higher P/E rati o to 
the expanded company – may be not as high as ML's but 
possibly at the market average, c urrently 14.25, compared to 
the weighted average P/E ratio for ML/CO of 14. 
–  Is ML likely to sell part of C O's operations? And to whom? I f 
ML has already lined up a buyer, i t must expect to turn a profi t 
on the deal.

572  
 –  Is the bid likely to be def ended by the target's managers, 
fearful for their jobs? If so, a  higher bid might be expected. 
–  Is a White Knight likely to  appear with a high er bid on more  
favourable terms? 
–  Are there competiti on implications likely to attract the int erest 
of the authorities? 
 
 ( a )  
 OW Wilde OW + Wilde 
Earnings (£m) 4 4.4 8.4 
Number of shares (m) 40 44 64 
EPS (p) 10 10 13.1 
P/E ratio 20 10 20 Share price (p) 200 100 262 
MV (£m) 80 44 167.7 (estimate) 
Post-acquisition: 
% of entity owned by  OW (40/64) 62.5%  
% of entity owned by W ilde (24/64)  37.5% 
Market value (% × £167.7m) 104.8 62.9 No. of shares pre-acquisition (m) 40 44 Post-acquisition price per e xisting share (p) 262 143 
Oscar Wills has applied his own pre-acquisition P/E ratio to th e 
combined earnings of the new entity. 
The difference between the combi ned market values pre-acquisiti on 
(£124m) and the estimated marke t value post-acquisition (£167.7 m) 
is £43.7m. 
This is Wilde’s pre-acquisition  earnings multiplied by the diff erence 
between the entity’s pre-acquisi tion P/E and the combined post-  
acquisition P/E (20 – 10 = 10). EPS for Oscar Wills appears to have 
increased from 10 p to 13.1p bec ause of this ‘bootstrapping’ ef fect. 
In the absence of any immediate commercial benefits, or the 
disclosure of new information dur ing the bid, there is no reaso n why 
the market value of the combined  entity should be any different  from 
the total of the two individual entities’ market values – that is, 
£124m. This would suggest the follo wing post-acquisition prices  per 
existing share: 
Wills: £124m × 62.5% = £77.5m  or 194p per existing share 
compared with 200p per share now. 
Wilde: £124m × 37.5% = £46. 5m or 106p per existing share 
compared with 100p per share now.

Chapter 13 
 573 
There is a transfer of wealth  from Wills’ shareholders to Wilde ’s, 
because the terms of the offer are slightly m ore generous than the 
ratio of the old share prices. 
The pre-acquisition prices s uggest 1-for-2, not 6-for-11. 
(b) –  Estimated value o f combined firm (per OW) £168m 
–  Value of OW before merger £80m 
–  Maximum price £88m 
This is £44m over the existing va lue of Wilde’s shares. It can be 
reconciled by multiplying the hi storic earnings by the differen ce 
between Wilde’s P/E and OW’s P/E  – that is £4.4m × (20 – 10). 
(c) OW plc may have had the follo wing among their reasons for m aking 
a bid for Wilde plc: 
–  Expectation of growth.  OW is an ambitious entity and it sees 
in Wilde a means of growing fast er and more cheaply than by 
internal expansion, especia lly as Wilde seems to be a 
‘slumbering heavyweight’ relative to OW. 
–  Management and technical staff.  Wilde’s results may be 
erratic, but OW is aware that i n terms of size and quality of 
main products Wilde is a signifi cant player in its market secto r. 
It is reasonable to assume ther efore that Wilde may be 
suffering from poor administr ative as well as marketing 
management, which could cons iderably undervalue the 
earning potential of its products . By means of more aggressive 
marketing and improved adminis tration, OW believes that 
dramatic profit improvements are possible. Also Wilde may 
possess strong technical exper tise which OW might find 
difficult and expensive to obt ain by internal development. 
–  Market share.  If Wilde is in the same  industry sector as OW, 
this could well be a main reason for the bid, in which case 
OW’s shareholders might have less reason to be concerned 
over the price. Thus if the acqui sition led to OW’s market shar e 
rising fairly quickly to make t he new entity se cond or third in  its 
sector, and not excessively fa r below the leader, it could begi n 
to wield significantly greater  influence in that sector. 
–  Synergy savings.  Wilde may have a number of ‘dogs’ (Boston 
Consulting Group term for bad failure) among its business units, which OW may be much l ess prepared to pour resources 
into, even though some may be t he Wilde chairman’s ‘pets’. 
However, if this aspect is k nown to the market, then the 
synergy savings may well attract a higher bidder.

574  
 –  Risk reduction.  From the comparative P/E ratios it seems 
evident that Wilde is regarded by  the market as being much 
riskier than OW, and this could well be due to Wilde being an 
acquirer of struggling entitie s, bought at cheap prices, possib ly 
even in sectors only remotely r elated to Wilde’s core business.  
Such entities often turn ou t to be disasters, taking up 
disproportionate am ounts of the acquirer’s valuable 
management time. At OW, Mr W ills does not believe in 
keeping a ‘kennelful of dogs’! and the profit improvement 
suggested is likely to come no t only from more aggressive 
marketing but from a concentration of resources on key products, thereby reducing ri sk in the new entity. 
Next, the acquirer needs to be co ncerned at the post-acquisitio n 
effects on its P/E ratio. 
On the basis of the pre-acquisiti on estimates, Mr Wills looked to 
maintain OW’s own P/E ratio o f 20 (262p/13.1p), but on the more  
realistic basis of assuming a va lue of 194 p per share – which 
assumes that OW inherits the gr eater risks of Wilde’s current 
operations – then, as shown above , for the new entity the marke t 
capitalisations should be simp ly added together, making £124m a nd 
the P/E ratio becom es 194p/13.1p = 14.8. 
However, we must now consider t he possibility of downside costs  in 
year 1; thus even assuming that OW has taken several steps to improve Wilde’s operations and perhaps made some significant 
asset sales, an upset to earnings  caused by ‘teething troubles’  could 
do more than offset the effect of  the improvements. Thus, EPS o f, 
say, 13.5p for year 1 (instead of 14.4p, showing 10% expected 
growth), which one would expec t to yield a P/E ratio of 
approximately 15.2 (13. 5p/13.1p × 14.8), migh t well fall back t o 
about 13, or even 12. Downside fa ctors often seem to the market  to 
be more significant than improvements. 
Clearly then, at the time of ma king its bid, it would have been  most 
unwise for OW to pay excessively  for ‘synergy savings’ and not to 
give due regard to possible adver se post-acquisition impacts. 
(d) Further post-acquisition aspects 
Position audit 
As an initial move, OW will need  to do much more than analyse k ey 
financial factors of each of W ilde’s units. OW’s management wil l 
need to get a proper understanding of the main ‘stakeholders’ o f 
each Wilde unit, for example, staff, customers and suppliers, a nd an 
appreciation of the products or services provided. In company planning, this wide-ranging survey  is of the nature of a ‘posit ion 
audit’, which should help consider ably in speeding up the ‘gett ing to 
know you’ aspect which is so im portant if the full benefits of 
the 
acquisition are to be obtained.

Chapter 13 
 575 
Improving efficiency 
It is better for OW to approach W ilde more as a management 
consultant rather than to dem and immediate changes without 
adequate explanation. Administrativ e savings mainly involve peo ple, 
and OW must try to ensure that the logic of its proposals is cl early 
explained to Wilde’s management and  staff, and as far as possib le 
their cooperation gained. 
Redundancies need to be worked ou t fairly but firmly with an 
emphasis on voluntar y redundancy as far as possible; the main 
purpose must be to reduce the res entment of those who are losin g 
their jobs and to provide as muc h help as possible by way of 
counselling or assistance in job seeking. In these situations 
uncertainty should be avoided, a s it tends to demotivate the en tire 
workforce, and rumour is liabl e to feed greedily on rumour. 
Even if Mr Wills is convinced that Wilde’s marketing needs to b e 
more aggressive, he should firs t of all make himself fully awar e of 
the nature of Wilde’s marketing policies and of their customers  and 
competitors. If Wilde is substant ially in the same market secto r as 
OW, there may be certain valuab le niches occupied by Wilde whic h 
OW would do well to retain. 
Profit improvement 
The financial analysis of Wilde’s units suggested above will he lp to 
pinpoint the areas where profit imp rovements can be obtained, b ut it 
is essential that a comprehensiv e action plan is then prepared,  as 
far as possible in co-operat ion with Wilde’s management, and 
reasonable time allowed for the phasing-in of significant chang es. 
It is not helpful to go ‘stompi ng around’ offices and factories , thereby 
emphasising the perceived incom petencies of Wilde personnel. It  
may be that many faults, espec ially of inadequate systems, may 
already be recognised by Wilde st aff and, faced with the necess ity 
of correcting them, they may be quite willing to join in making  
appropriate changes. Sadly, it is o ften the case that obstinate  
managers may be standing in the way of improvement, and in this  
situation OW is in a good posit ion to take quick but fair and f irm 
action, possibly by grasping t he nettle of making major changes  in 
Wilde’s organisation structure i f this is seen to be necessary for a 
more profitable operation.

576  
 Asset sales 
Here it is often the reluctanc e of top management to dispose of  
redundant assets and ‘dog’ units, e ven though it is recognised that 
keeping them represents a seri ous waste of management time and 
scarce resources. OW will need to m ake it quite clear as to whi ch 
activities are to be retained, which merged with OW units and w hich 
disposed of, but in all cases t he logic of each move should be 
clearly explained to the Wilde management and staff affected. T his 
assumes, of course, that OW has thought through what it intends  to 
do, which again is a good reason  for first carrying out a posit ion 
audit before taking action on Wilde’s operations. 
Effective communication 
Finally, a qualitative factor of  the utmost importance, as by e ffective 
communication we mean that OW mu st do all possible to ensure 
that Wilde is on the same ‘wave length’ as itself. New reporting  
systems and procedures should on ly be introduced after proper 
consultation, in which OW will ne ed to make clear their purpose s 
and ensure that changes will not caus e serious disruption to Wi lde’s 
operations. This is especially tr ue in seeking computer system 
compatibility, which will call not only for careful planning bu t an 
acceptance by OW that in this, as with other system changes, a sufficient period of parallel r unning may be an essential proce dure. 
There should be reas onable opportunities fo r Wilde staff to hav e 
contact with those of OW and vi ce versa, especially through 
participation in training proc edures and conferences; also Wild e staff 
should be encouraged to feel that p romotional prospects through out 
the new entity will be open to them. 
All the points made in this se ction concerning redundancies, 
changes and reorganisati on created by the acquisition of Wilde 
apply equally to the need for OW  to keep its own staff properly  
informed, otherwise demotiva tion may also affect OW with 
consequent damage to its own pro fitability whatever happens wit h 
Wilde. 
Perhaps, in the end, the most eff ective post-acquisition strate gy that 
OW can apply to Wilde and itself i s to provide an atmosphere in  
which both sides are able to talk  freely with each other, seeki ng co-
operation wherever possible , and even though some of OW’s 
actions – improving profitabilit y and making asset sales – may be 
very hurtful to Wilde, at least things can probably be made somewhat more acceptable if the justification for them is prope rly 
explained to all concerned, and that includes any of OW’s own s taff 
who may also be affected.

Index 
 I.1 
A 
Acquisition, 434 
Advisors to an IPO, 155 
Agency theory, 6 
Alpha values, 505 Arbitrage, 322, 330 Asset  
based valuation, 474 
beta, 506 
turnover, 22 
B 
Bank finance, 180 
Basis risk, 355 
Beta factor, 503 
Big data opportunities, 436 Bird-in-the-hand  argument, 250 
Black-Scholes model, 360 Bonds, 182 Book value, 475 
Bootstrapping, 549 
Business  
angels, 189 
plan, 122 
valuation, 472 
C 
Call option, 357 
Capital Asset Pricing Model (CAPM), 501 Capital markets, 148, 180 Capital structure, 210 
in the real world, 220 
Cash flow  
to all investors, 494 
to equity, 493 
valuation, 488 
Cash  
needs of the entity, 251 
offer, 541 
Clientele effect, 250 Collars, 403 Commercial paper, 183 
Competition authorities, 445 
Conglomerate, 435 Constant payout ratio, 253 Convertible  
debt, 189 
preference shares, 148 
Cost of equity, 497 Countertrade, 340 
Covenants, 177, 225 
Credit rating, 123 
agencies, 125 Creditworthiness, 122 
Criteria for selecting sources of finance, 143 
Cross  
currency swap(s), 362, 409 
rates, 318 
Currency  
futures, 351 
options, 357 
risk, 187, 283 
D 
Day-trading, 331 
Debt  
beta, 506 finance, 176 
ratio, 25 
with warrants attached, 189 
Defences, 538 Demerger, 448 Derivatives, 333 Disclosures on Management Approach (DMA), 
70 
Discounted cash flow method, 492 Diversification, 502 Divestment, 447 Dividend  
cover, 29 decision, 114, 248 
growth, 29 
payout rate, 28 
policy, 248 
Valuation Model (DVM), 488 
yield, 28 
Domestic tax implications, 121 
E 
Earnings  
based valuations, 484 
growth, 29 per share (EPS), 27 
yield method, 487 
yield, 28 
Earn-out, 542 
EBITDA, 21 
Economic risk, 283 Efficient Market Hypothesis (EMH), 511 Equity  
beta, 506 
finance, 146 
Eurobonds, 186 Exchange  
rate theory, 320 rates, 316 
Exit strategies, 455 External  
economic forces, 118 
hedging, 341, 393

Index 
I.2  
F 
Financial  
objectives, 6 performance evaluation, 20 
reporting, 64 
risk management, 332 
risk, 276 
strategy, 110 
Financing  
a cash offer, 544 decision, 112, 142 
Flotation, 151 Foreign currency borrowings, 186 Form of consideration for a takeover, 540 For-profit entity, 3 Forward  
contracts, 344 Rate Agreements (FRAs), 393 
Forward rate, 324, 344 Free cash flow, 494 
G 
G4 Guidelines, 66 Gearing, 24, 124, 210, 222 
General Standard Disclosures, 75 
Global Reporting In itiative (GRI), 66 
Gordon's growth model, 489 Grants, 189 Gross profit margin, 20 
Group loss relief, 444 
Groups of companies, 226 
H 
Hedging, 332 Horizontal integration, 435 
I 
Impact of taxation, 121 Indicators, 70 Inflation, 31 Intangible assets, 479, 481, 483 
Intellectual capita l, 479, 480, 481 
Interest  
cover, 25 
rate futures, 397 
Rate Guarantees (IRGs), 396 
rate options, 401 
Rate Parity Theory (IRPT), 324 
rate parity, 33 
rate risk, 187, 280, 391 
rate swaps, 405 
rates, 31, 390 
Internal hedging, 338, 382 International  
debt finance, 186 
Fisher Effect, 327 
Integrated Reporti ng Council (IIRC), 79 
operations, 18 
tax implications, 121 
Intrinsic value, 360 Investment decision, 111 
Investor ratios, 26 
Invoice in home currency, 339 IPO (Initial Public Offering), 151 
J 
Joint venture, 278 
L 
Lagging, 339 Law of One Price, 322 Leading, 339 
Lease, 190 
Lease v buy, 190 Lender ratios, 24 Limitations of financial statements, 65 Listing, 149, 184 London Inter Bank Offer Ra te (LIBOR), 280, 390 
M 
Management  
buyout, 449 
Commentary (MC), 83 
Margin (futures contracts), 353 Market making, 185 
Merger, 434 
Mission statement, 2 Modigliani and Miller (M & M) formulae, 217, 500 
with tax, 216 
without tax, 215 
dividend irrelevancy theory, 249 
Money market  
borrowings, 182 
hedge, 348 
N 
Net Present Value, 191 
Net realisable value, 475 
Netting centres, 342 
Nominal rate of interest, 327 
Non-financial  
objectives, 10 
reporting, 65 
Normal distribution, 295 Not-for-profit entity, 3

Index 
 I.3 
O 
Objectives, 2 
Offsetting, 340 
One tail test, 297 
One-off large dividend, 255 Operating profit margin, 22 Ordinary shares, 146 
P 
P/E ratio, 27, 485 P/E valuation method, 485 Parity theories, 33 Placing, 151 Political risk, 276 Post-acquisition integration process, 551 
Post-bid defences, 539 
Pre-bid defences, 538 Preference shares, 147 Principles for de fining content, 76 
Principles for defini ng report quality, 77 
Private  
equity, 154, 452 
limited company, 149 
sector entity, 3 
Profitability ratios, 20 Proxy P/E ratios, 486 
Public  
Published accounts, 37 Purchasing Power Parity Theory (PPPT), 322 Put option, 357 
Q 
Quoted entity, 3, 473 
R 
Ratchet patterns, 254 Real rate of interest, 327 
Refinancing risk, 187, 282 
Regulatory requ irements, 119 
Replacement value, 475 Residual dividend policy, 253 Return  
on assets, 9 On Capital Employed (ROCE), 21 
On Equity (ROE), 22 
to investors, 8 
Revolving Credit F acilities (RCFs), 182 
Rights issue, 155 Risk adjusted cost of capital, 500 S 
Sale and leaseback, 188 Scrip dividends, 254 
Security, 177 
Sell-off, 448 Sensitivity, 30 Share, 146 
exchange, 541 
repurchase, 255 
Signalling effect, 250 Sources of finance, 143 
Specific Standard Disclosures, 70 
Spin-off, 448 Spot rate, 317, 344 Stable dividend policy, 253 Stagging, 152 
Stakeholders, 5, 544 
Strategy, 110 Suitable cost of capital for discounting, 500 Sustainability reporting, 79 Swaps, 405 Synergy, 438 
Systematic risk, 502 
T 
Target debt profile, 187 
Tax implications of merger s and acquisitions, 444 
Tender offers, 152 
Term structure of interest rates, 391 
Terms of a rights issue, 157 The capitals, 80 Theoretical  
'ex rights' price, 158 'value of rights', 158 
Thin capitalisation rules, 227 
Ticks, 355 
Time value, 360 Trade sale, 448 Traditional view of gearing, 213 Transaction risk, 288, 338 Translation risk, 289 
Treasury function, 333 
Treatment of target entity debt, 549 Two tail test, 298 
U 
Underwriting, 156 Unquoted entity, 3, 473 Unsystematic risk, 502

Index 
I.4  
V 
Value  
added, 8 at Risk (VaR), 294 
For Money (VFM), 15 
Venture capital, 189, 451 Vertical integration, 435 
W 
WACC (Weighted Average Cost of Capital), 210, 
497 
Withholding tax, 445 
Y 
Yield adjusted ex-r ights price, 160 
Yield curve, 391 
Z 
Zero dividend policy, 253

P.2   
 
form or by any means electronic, mechanical, ph otocopying, recording or otherwise without the 
Notice 
any advice given to third parties. Please cons ult your appropriate professional adviser as 
Kaplan is not responsible for the content of exter nal websites. The inclusion of a link to a third 
ISBN: 978-1-78740-196-9 Printed and bound in Great Britain

P.3
Contents 
Page 
Syllabus area P1A: Cost accounting for decision and control  
Chapter 1 Rationales for costing 1 
Chapter 2 Traditional costing 21 
Chapter 3 Activity-based costing 59 
Chapter 4 Other costing te chniques 87
Chapter 5 Variance analysis 125 
Chapter 6 Further variance analysis 191 
Syllabus area P1B: Budgetin g and budgetary control  
Chapter 7 Preparing budgets 237 
Chapter 8 Forecasting techniques 299 
Chapter 9 Budgetary control 329 
Syllabus area P1C: Short-term commercial decision making  
Chapter 10  Relevant costs and decision making 365 
Chapter 11 Break-even analysis 413 
Chapter 12 Linear programming 465 
Syllabus area P1D: Risk and uncertainty in the short-term  
Chapter 13  Risk and uncertainty in  the short-term 493 
Chapter 14  Applying knowledge to ca se study questions 537

P.6  
 
organised on the following pattern:  Detailed learning outcomes.  These describe the knowledge expected 

P.7 
Quality and accuracy are of t he utmost importance to us so if you spot an error 
 
examined. 
 
P.8  
 Exclamation mark  – This symbol signifies a topic which can be more 
 
detail. 
Planning 
each subject you are studying. Remem ber that you need to allow time for 
With your study material before you, decide which chapters you are going to study in each week, and which weeks you will devote to revision and final question practice. 
syllabus. 
are up-to-date. The amount of space allocated to a topi c in the Study Text is not a very good 
guide as to how long it will take you. The syllabus weighting is the better guide 

P.9 
(1) Aim to find a quiet and  undisturbed location for your study, and plan as far 

P.10   
subject and another. For example, P1 Management accounting  builds on your 
knowledge of costing and decision making from BA2 Fundamentals of 
management accounting  and lays the foundations for P2 Advanced 
Management accounting  and all strategic papers. 
have already learned unless it is re freshed (look up Ebbinghaus Forgetting 

P.11 
review the 2019 CIMA syllabus transiti on rules and seek appropriate advice if 

P.12   
questions of this type in the objective tests. Guidance re CIMA on-screen calculator 
website. 
tutorial. 

P.13 
topics. The topics contain one or more lead learning outcomes, related 
A learning outcome has two main purposes: 
(a) To define the skill or ability that a well prepared candidate should be able 
The learning outcomes are part of a hier archy of learning objectives. The verbs 

P.16   
P1: Management Accounting 
What the finance function does 
A Cost accounting for decision and control 30% 
B Budgeting and budgetary control 25% 
C Short-term commercial decision-making 30% 
D Risk and uncertainty in the short term 15% 
  100%

P.17 
P1A: Cost accounting for decision and control 
This section is about understanding why costing is done and what it is used for. It introduces candidates to 
the basic building blocks of costin g and how to apply them in the costing methods and techniques 
organisations use. In a fast-changing digital world this understanding is critical and can enable candidates to develop their own ways of calculating costs when existing methods are no longer appropriate. Digital 
costing is introduced in this section. 
 
between the 
different rationales 
for costing. a. Define costing 
b. Distinguish between the 
rationales for costing • Inventory valuation 
• Profit reporting 
• Cost management and 
• Decision-making This seeks to address the 
following pertinent questions: 
What are reasons for 
calculating costs? What types 
of costs are appropriate for a 
particular purpose and why? 
2. Apply the main 
costing concepts to 
organisations and 
cost objects. a. Explain the main costing 
concepts 
b. Apply costing concepts to 
different organisations and 
cost objects • Cost elements 
• Costs structure 
• Cost behaviour 
• Cost drivers 
• Costing applied to different 
types of organisations 
• Costing applied to digital 
cost objects Examine the basic building 
blocks of costing and how 
they apply to different types of 
organisations and operating 
contexts (e.g., manufacturing 
and service sectors). How has 
the digital world affected the 
nature of these building 
blocks of costing? 
3. Apply costing 
methods to 
determine the costs 
for different 
purposes. Apply the following: 
a. Cost accumulation, 
allocation, apportionment 
and absorption 
b. Standard costing 
c. Variance analysis (without 
mix and yield variance) 
d. Activity based costing 
e. Digital costing • Trace, classify and 
allocate costs 
• Marginal costing 
• Absorption costing 
• Price and rate variances 
• Usage and efficiency 
variances 
• Interpretation of variances 
costing using ABC 
• Advantages of ABC over 
other costing systems 
• Features of digital costing Investigate how costs are 
traced, classified, 
accumulated, allocated, 
apportioned and absorbed to 
arrive at the costs of a 
product, service or other cost 
object. Calculate the costs of 
products or services using 
various costing methods. 
Determine which costing 
methods are appropriate and 
why?

P.18   
P1B: Budgeting and budgetary control 
Taken together, budgeting and budgetary control is one way the finance function enables and shapes how 
organisations create and preserve value. This section examines the various reasons organisations 
prepare and use budgets, how the budgets are prepared,  the types and sources of data, the technologies 
used to improve the quality of budgets, how budget s are implemented and the impact on the people who 
work with the organisation. 
 
for budgeting. a. Explain the role of 
budgets. 
different rationales for 
budgeting. • Planning 
• Coordination 
• Motivation 
• Control Why do organisations prepare 
budgets? In what ways are 
the different rationales for 
preparing budgets compatible 
with each other? How do 
organisations get the most out 
the budgeting process? 
2. Prepare budgets. a. Explain forecasting and its 
relationship with 
budgeting. 
b. Prepare master budgets. 
c. Conduct what-if analysis in 
d. Describe the technologies 
available for improving 
budgeting. • Time series and trend 
analysis to forecast sales 
volumes 
• Components of master 
budgets and their 
• Limiting factors 
• Stress testing budgets 
• Big data analytics and 
budgets 
• Alternative approaches to 
budgeting What is the process by which 
budgets are prepared? What 
types of budgets are required 
by organisations? What data 
do they use and where do 
they get the data from? How 
are those budgets prepared 
and presented? What 
technologies are available for 
improving the quality of the 
budgets? 
3. Discuss budgetary 
control. Discuss: 
a. The concept of budgetary 
control 
b. Human dimensions of 
budgeting • Feedback and feedforward 
control 
• Flexed budgets 
• Target setting and 
motivation 
• Controllable and 
uncontrollable outcomes 
• Dysfunctional behaviours 
in budgeting 
• Ethical considerations in 
budgeting What is budgetary control? 
Describe and discuss how 
and why the budgetary control 
system provides feedback 
and feedforward to the 
organisation. What are the 
behavioural impacts of 
budgetary control and how 
are they managed?

P.19 
P1C: Short-term commerc ial decision-making 
Organisations cannot foresee every opportunity that might arise during their operations, so they need 
mechanisms by which to identify and take advantage of these opportunities as they arise. The primary 
objective of this section is to guide candidates in how to do this in the short term through effective 
decision-making. The finance function supports such decisions (e.g., pricing and product choice) using 
techniques such as relevant revenue and cost analysis and break- even analysis. Candidates are introduced to these techniques and the concepts that underpin the techniques. They are expected to be 
able to apply the techniques to support short-term decision-making. 
 
1. Describe the main 
types of short-term 
decisions made by 
organisations. a. Describe pricing and 
revenue maximising 
b. Describe product 
decisions. • Marginal and full cost 
recovery for pricing 
decisions 
• Differences in pricing and 
revenue maximisation for 
the short term and long 
term 
• Product mix Describe the types of short-
term decisions organisations 
make and the circumstances 
that give rise to them. What 
do these short-term decisions 
seek to achieve? How 
important are they to 
performance of 
organisations? The emphasis 
is on both revenue and costs. 
underlying 
concepts used for 
short-term 
decision-making. a. Explain the objectives of 
decision-making. 
b. Explain the underlying 
concepts of short-term 
decision-making. • Implications of commercial 
decision-making in the 
short term 
• Relevant revenues 
• Relevant costs 
• Difference with profit 
reporting What are the objectives and 
underlying concepts that are 
used to guide short-term 
decision-making and why? 
Distinguish between those 
concepts of revenue, costs 
and information from other 
concepts. 
3. Apply appropriate 
support short-term 
decisions. Apply the following to support 
short-term decision-making: 
a. Relevant cost analysis 
b. Break-even analysis 
c. Product mix decisions with 
d. Data and technology • Make or buy decisions 
• Discontinuation decisions 
• Multi-product break-even 
analysis 
• Use of data and 
technology to analyse 
product mix decisions 
short-term decision-
making Use data (financial and non-
financial) and the appropriate 
concepts and techniques to 
support decision-making to 
achieve organisational 
objectives of value creation 
and preservation.

P.20   
P1D: Risk and uncertainty in the short term 
Budgets and decisions focus on the future. This introduces uncertainties and risks that need to be 
identified, assessed and managed. The aim of this section is to help candidates identify, assess and 
manage the risks and uncertainties associated with the short term. 
 
1. Apply basic risk 
management tools 
in the short term. a. Explain nature of risk and 
uncertainty in short term. 
b. Apply basic sensitivity 
analysis to budgeting and 
making. • Stress testing 
• Sensitivity and what-if 
analysis 
• Probability distributions 
• Decision trees What types of risks and 
uncertainties do organisations 
face when preparing and 
implementing budgets and 
when making short-term 
decisions? How are those 
risks and uncertainties 
identified, assessed and 
managed?

1 
Rationales for costing 
A1. Distinguish between the 
different rationales for costing (a) Define costing 
(b) Distinguish between the 
rationales for costing 
A2. Apply the main costing 
concepts to organisations and cost objects (a) Explain the main costing 
elements 
  Chapter 
1

2 
1 Chapter overview diagram 
 
In this chapter we will introduce cost  and management accounting. These will 
be defined and their purpose explained. It will be important t hat you understand 
the reasons for calculating costs and how management accounting can play a 
role in the operations of a business. 
For students who have studied at the CIMA  Certificate level much of this 
chapter will be familiar to you. 
2 Management and cost accounting 
Accountancy involves the measurement, analysing and reporting of financial 
and non-financial information to help managers, shareh olders and other 
interested parties make decisions about organisations. As a student of CIMA, a major focus of  your studies will be on a part of 
accountancy called management accounting.  
 The CIMA Terminology  defines management accounting  as 'the 
application of the princi ples of accounting and financial management to 
create, protect, preserve and increase value for the stakeholders of for-
profit and not-for-profit enterprises in the public and private sectors.' 
Cost accounting is a sub-set of managem ent accounting. Cost accounting is 
focused more on calculating the costs of a product or service and extending this 
into potentially controlling and managing th is cost. It means th at the focus is 
often on short-term improvements and decisions. 
 
 The CIMA Terminology defines cost accounting  as 'the gathering of cost 
information and its attachment to co st objects, the establishment of 
budgets, standard costs and actual co sts of operations, processes, 
activities or products; and the analysis of variances, profitability or the 
social use of funds.’ 
Cost accounting tends to be more useful  for operational and tactical decisions.

Chapter 1 
 3 
 Operational and tactical decisions 
 Operational decisions are decisions made main ly be low level managers 
which focus on day-to-day resource m anagement. It will involve decisions 
such as where to employ staff, wh at type and how much staff to use, 
which machines to employ, w hat materials to use etc. 
Tactical decisions are employed by middle-level managers and are more 
medium term in scope. It will involv e decisions on areas such as staff 
training and recruitment, changing suppliers, purchasing new machines 
etc. 
 
Management accounting will take a broader  view of the business and take 
decisions that include a more strat egic basis with a longer-term view. 
 
 Strategic decisions 
 Strategic decisions are made by t he highest level of management in an 
organisation. These decisions will consider areas such as whether to 
launch a new product, whether to expand into new markets or whether to 
buy other organisations. 
Cost accounting mainly focuses on quantitative data such as how much a piece 
of material costs or ho w long staff should spend on providing a particular 
service (i.e. quantitative data is data t han can be measured, often in financial 
terms). 
Management accounting will expand this by  adding qualitative data such as the 
impact on customer satisfaction or empl oyee motivation. Qualitative data is 
much more difficult to measure and quantify. 
A comparison to financial accounting 
Now that we are clear about the meaning of management accounting we can 
compare it with anothe r branch of accounting, financ ial accounting, which you 
will study as part of your  CIMA qualification. 
 
 The CIMA Terminology  defines f inancial accounting as 'classification 
and recording of the monetary transacti ons of an entity in accordance with 
established concepts, principl es, accounting standards and legal 
requirements and their presentation, by means of statement s of profit or 
loss, statements of financ ial position and cash flow  statements, during and 
at the end of an accounting period'. 
Look back at the definition of management  accounting and you will see that 
these two are very different.

4 
 Details on the differences 
 You can see from this that the role of the fi nancial accountant is much 
more clearly defined and narrower than that of the management 
accountant. There is also a legal aspect to financial accounting. It is a 
legal requirement for organisations to  produce financial statements which 
show a true and fair view of their financial position for each accounting 
period. There is no legal requirem ent to have management accounting. 
Financial accounting is also gover ned by many rules and regulations 
whereas there are no rules coveri ng how the management accountant 
provides information. They will prov ide whatever is required by their 
managers in whatever format suit s the particular organisation. 
Financial accountants deal with histor ical (past) financial information, 
while management accountants deal with all types of information (financial and non-financial) both historical and future. 
The main role of financial accounting is to produce the statutory financial 
statements, whereas management a ccountants provide any information 
needed by management. 
It is important from this to see t hat the audiences using management and 
financial accounting information are different. Management accountants 
provide information internally to m anagers. The statutor y financial reports 
produced by the financial accountants ar e available to the public and to 
anyone who has an interest in the organisation. 
The differences can be summarised as follows: 
Financial accounting Management accounting 
For external use For internal use 
Statutory requirement At the discretion of management 
Concerned with the production of 
statutory accounts for an organisation Concerned with the provision of information to management to aid decision making 
Governed by many rules and regulations Not governed by rules or regulations, can be provided in any format 
 
 Example 1 
 Consider the followi ng statements relating to  management accounting: 
(i) The main purpose of management accounting statements is to 
provide a true and fair view of  the financial position of an 
organisation at the end of an accounting period. 
(ii) Management information may be presented in any format deemed 
suitable by management.

Chapter 1 
 5 
 Which of the above statements is/are true? 
A (i) and (ii) 
B (i) only C (ii) only D neither 
3 The purpose of management accounting 
While providing information for decisi on making is clearly key to what 
management accountants do, their role  is usually expanded to include three  
main elements: 
 Planning  
 Control  
 Decision making . 
These three purposes of management accounting (planning, control and 
decision making) form the basis  of your Management Accounting  subject . Each 
of these areas will be looked at in  detail throughout this text book. 
Planning 
Planning involves establishing the objectives and goals of an organisation, 
i.e. what they are trying to achieve,  and formulating relevant strategies (long-
term actions to improve an organisation’s position) that can be used to achieve 
those objectives and goals. 
The management accountant will create budgets  which explain the potential 
impacts of different course s of action. These budgets ar e financial plans of what 
will occur based on different assumptions. 
Budgets are looked at in more detail in the budgeting chapter. 
Control 
Control is the process of monitoring,  measuring, evaluating and correcting 
actual results to ensure that the or ganisation’s plans are being achieved. 
Information relating to the actual results of an organisation must be gathered 
and can be compared to the budget. The differences between the actual and 
the budgeted results can be calculated and reported to management. These are 
known as variances . This type of information facilitates managers to determine 
whether the organisation is in or out of  control and take corrective action if 
We will study variances in detail in later chapters.

6 
Decision making 
We have seen already that decision ma king involves considering information 
that has been provided and making inform ed decisions. In most situations, 
decision making involves making a choice  between two or more alternatives. 
Managers need reliable information to compar e the different courses of action 
available and understand what the conseq uences might be of choosing each of 
them. 
Managers at different organisati onal levels will take di fferent type of decisions 
(operational, tactic al and strategic).  
 
 XYZ is a successful pizza restaurant which currently operates a chain of 
four restaurants, all of whic h offer the same standard menu. 
Consider the following decisions which XYZ may have to make and 
suggest at what levels of mana gement these decisions would be 
made. 
 Start producing frozen pizzas and selling these through supermarkets. 
 Hire a new waiter in one of the restaurants. 
 Decide on the pricing of t he dishes on the standard menu. 
 Open a new restaurant. 
Solution 
 Starting production and sales of frozen pizzas is a fundamental 
change to what the company curr ently do and involves entering a 
new market. This would therefore be a strategic  decision. 
 Hiring a new waiter would be an operational  decision as it involves 
a day to day decision which should be able to be made at a lower 
level. 
 Deciding on the pricing is likely to be a tactical  decision. In general, 
the strategic decisions decide on which markets in which to operate and tactical decisions will decid e on how to operate within these 
markets. Pricing would come under this remit. 
 Opening a new restaurant is a more  difficult one. In this case a 
decision to expand the number of restaurants would likely be a 
strategic  decision. In some much lar ger organisations this type of 
decision would be made considered a tactical decision. However given that XYZ only has four re staurants, then the decision to open 
a fifth would likely be made by the senior managers.

Chapter 1 
 7 
 Example 2 
 LMN is an international clothing m anufacturer specialising in producing 
waterproof jackets. 
Match the following decisions to the type of decision that is being 
made: 
Decision  Level 
A decision to take over a rival company in order 
to expand its production into different markets  Strategic 
A decision on the ordering of material for production  Tactical 
A decision about the pricing of  the products  Operational 
 
4 The management accountant 
At this point it is worth looking in more detail at the various roles management 
accountants play in organisations and how  this has changed over the years. 
The whole of the accountancy profession is  changing, and this is especially true 
for the management accountant. 
 
The traditional management accountant was largely involved in reporting 
business results to management, but th is is no longer the case. Management 
accountants today are seen as value-adding business partners  and are 
expected to not only forecast the future  of the business, but to assist in 
delivering this future by identifying opportunities for enhancing organisational 
performance. Management accountants now work alongside business 
managers as mentors, advisors and drivers of performance. 
Management accountants are an integral pa rt of any business, providing a 
variety of information to management for the purposes of planning, control and 
decision making. Management accountants o ften hold senior positions in the 

8 
 CIMA's definition of the role  of the management accountant 
 The work of the Chartered Mana gement Accountant (produced by 
CIMA): 
Chartered management accountants help organisations establish viable 
strategies and convert them into profit  (in a commercial context) or into 
value for money (in a not-for-profit cont ext). To achieve this, they work as 
an integral part of mult i-skilled management teams in carrying out the: 
 formulation of policy and setting of corporate objectives 
 formulation of strategic plans derived from corporate objectives 
 formulation of shorter-term operational plans 
 acquisition and use of finance 
 design of systems, recording of events and transactions and 
management of information systems 
 generation, communication and interpretation of financial and 
operating information (such as product costs) for management and 
other stakeholders 
 provision of specific information and analysis on which decisions 
(such as how many units to produc e or what products to make) are 
based 
 monitoring of outcomes against plans (such as budgets) and other 
benchmarks and the initiation of re sponsive action for performance 
improvement 
 derivation of performance meas ures and benchmarks,  financial and 
non-financial, quantitative and qualitativ e, for monitoring and control; 
and 
 improvement of business systems and processes through risk 
management and internal audit review. 
Through these forward-looking roles and by application of their expert 
skills management accountants help organisations improve their 
performance, security, growth and competitiveness in an ever more 
demanding environment. 
We will start to look at some  of these functions in the Management 
Accounting  syllabus, and others will be st udied in later subjects. 
It can be seen from this that there is no one clear definition of the role of 
the management accountant. Their work , experience and responsibilities 
are extraordinarily varied and continue to change to reflect the changing 
needs of stakeholders.

Chapter 1 
 9 
5 The importance of understanding costs 
 The word ‘cost’  can be used in two contexts. It can be used as a noun, for 
example when we are referring to the co st of an item. Alternatively, it can 
be used as a verb, for example we can sa y that we are attempting to cost 
an activity, when we are undertaking the tasks necessary to determine the 
costs of carrying out the activity. 
The understanding of costs is fundament al to your accounting studies. 
In financial accounting all costs must  be recorded so that profit can be 
calculated and the true and fair financia l position can be presented in the 
In management accounting an understanding of costs is required in order to 
carry out the three main functions of planning, control and decision making. If 
we understand and calculate costs, we can use this information in a number of 
ways such as: 
 Determining the cost to manufacture a product or provide a service can be 
used to record costs in the financial statements. 
 The cost per unit can be used to va lue inventory in the statement of 
 Cost information can inform decisions  on our products or services. Product 
and service costs can be used to determine the selling price we should 
charge for our products or services. For example, if the cost per unit is 
$0.30, the business may decide to pric e the product at $0.50 per unit in 
order to make the requir ed profit of $0.20 per unit. 
 Knowing the profit (or, as we will see in a late r chapter, the contribution of 
a product) can help determine the produc ts and services we should supply 
and in what quantity. 
 The cost can also act as a benchmar k for future performance. Differences 
from the expected (or standard) cost can be calculated (known as 
variances) and evaluated. 
 
 The cost transformation model 
 The CGMA cost transformation model is designed to help businesses to 
achieve and maintain cost competitiveness.  
The model has six suggested changes for organisations aimed at 
achieving this objective. These changes are: 
 Creating a cost conscious cultur e – the organisation should aim to 
be a cost leader so that its cost s are lower than rivals and set a 
competitive benchmark. Everyone in the organisation should be 
motivated and enabled to reduce cost s in whatever way possible. 
Technology can play a key role in reducing costs. 
 Understanding cost drivers – this involves investigating costs to 
determine why they change and how di fferent variables impact on 
the cost. Plans should be put in plac e to reduce the drivers of costs 
as well as the costs themselves.

10 
  Managing the risks that come from a cost conscious culture – for 
example, reducing cost may result  in reducing quality and customer 
satisfaction. The organisation should have a clear risk management 
process in place to identify, assess and manage such risks. 
 Ensuring products and services ar e profitable – it will be important 
that every product or service makes a positive contribution to overall 
organisational profits. This wi ll involve understanding what drives 
costs for each individual produc t and allocating shared costs to 
products as accurately as possible. 
 Maximising value from new produ cts – the potential profitability of 
new products should be assessed before production begins. Also, 
as part of product design, the product or service should be made to be as flexible as possible so that it appeals to or can be adapted to satisfy as many customer segments as possible. 
 Consider the environmental impac t of products – negative impacts 
(such as creating unnecessary waste) can add costs as well as damaging reputation and sales. 
The model suggests a number of t ools and models which can be used in 
order to achieve these changes. M any of these tools will be employed 
across your CIMA studies, some of t hem in this text, such as Activity 
Based Costing which considers cost  drivers and how these can be used 
to allocate shared costs to products. 
Cost units, cost centres and cost objects 
Costs can be attributed to cost units, cost centres or cost objects. 
 The CIMA Terminology  defines a cost unit  as ‘a unit of product or service 
in relation to which costs are ascertained’. 
This means that a cost unit can be anything for which it is possible to 
ascertain the cost . The cost unit selected in each situation will depend on a 
number of factors, including the amount  of information available and the 
purpose for which the cost unit will be used. 
A cost unit can be anything which is m easurable and useful for cost control 
purposes. For example, a company manufacturing a mobile phone might 
calculate the cost per mobile phone. Or perhaps if the phones are made and 
sold in very large quantities the co st per 1,000 phones might be used instead. 
Not all cost units will be for tangible item s. Intangible items cannot be seen and 
touched and do not have physical subst ance but they can be measured, for 
example the cost per chargeable hour of accounting service. 
 
 A cost centre  is a production or service location, a function, an activity or 
an item of equipment for whic h costs are accumulated. 
A cost centre is one type of responsibi lity centre. Responsibility centres will be 
covered in the budgeting chapter. A cost ce ntre is used as a ‘collecting place’ 
for costs.

Chapter 1 
 11 
The cost of operating the cost centre is determined for the period, and then this 
total cost is related to the cost units which have passed through the cost centre. 
An example of a production cost centre could be the machine shop in a factory. 
The production cost for the machine shop might be $100,000 for the period. If 
1,000 cost units have passed through this cost centre we mi ght say that the 
production cost relating to the ma chine shop was $100 for each unit. 
Other examples of a cost centre  are a canteen department, a project 
management team or a subsidiary of a company. Costs could be collected for 
each of these cost centres.  Every organisation will have its own cost centres for 
accumulating costs. 
 
 The CIMA Terminology  contains the following for cost objects:  ‘For 
example a product, service, centre, ac tivity, customer or distribution 
channel in relation to which costs are ascertained.’ 
All of the cost units and cost centres we have described in this chapter are 
therefore types of  cost object. 
Classification of costs 
In order to calculate costs we need to understand them. A key to this is 
understanding different ways in which costs can be classified. 
There are three main ways to classify costs: 
 by behaviour 
 by element 
 by nature 
What follows is some revision on thes e different types of  classification 
Classification of costs accord ing to their behaviour 
Before calculating costs we need to understand how different costs behave. 
In cost accounting we typically classi fy costs by three types of behaviour: 
 Fixed costs – costs which don’t change as the activity level changes 
 Variable costs – costs which change in direct proportion to changes in the 
activity level 
 Semi-variable costs – costs which hav e both fixed and variable elements.

12 
 Different cost behaviours 
 Many factors affect the level of cost s incurred; for instance, inflation will 
cause costs to increase over a period of time. In management 
accounting, when we talk about cost behaviour we are referring to the way in which costs are affected by fluct uations in the level of activity. The 
level of activity can be measured in many different ways. For example, 
the number of units produced, miles travelled, hours worked, percentage 
of capacity utilised and so on. 
An understanding of cost behaviour patterns is essential for many 
management tasks, particularly in the areas of planning, decision-making 
and control. It would be impossible for managers to forecast and control 
costs without at least a basic kno wledge of the way in which costs 
behave in relation to the level of activity. 
Fixed cost 
The CIMA Terminology defines a fixed co st as ‘a cost which is incurred 
for an accounting period that, within ce rtain output or turnover limits, 
tends to be unaffected by fluctuations in the levels of activity (output or 
turnover)’. 
Examples of fixed costs are rent, rates, insuranc e and executive salaries. 
However, it is important to note that this is only true for the relevant range 
of activity. Consider, fo r example, the behaviour of the rent cost. Within 
the relevant range it is possible to  expand activity without needing extra 
premises and therefore the rent cost  remains constant. However, if 
activity is expanded to the critical  point where further premises are 
required, then the r ent cost will increase to a new, higher level. This cost 
behaviour pattern can be described as a stepped fixed cost. The cost is 
constant within the relevant range fo r each activity level but when a 
critical level of activity is reached, the total cost incurred increases to the 
next step. 
This warning does not only apply to fixed costs: it is never wise to attempt 
to predict costs for activity leve ls outside the range for which cost 
behaviour patterns have been established. 
Also, whilst the fixed cost total ma y stay the same within a relevant 
activity range, the fixed cost per uni t reduces as the activity level is 
increased. This is because the same am ount of fixed cost is being spread 
over an increasing number of units.

Chapter 1 
 13 
 Variable cost 
The CIMA Terminology defines a variable cost as a 'cost that varies with 
a measure of activity’. 
Examples of variable costs are direct  material, direct labour and variable 
overheads. In most examination situat ions, and very often in practice, 
variable costs are assumed to be linear. Although many variable co sts do approximate to a linear function, this 
assumption may not always be realis tic. Non-linear variable costs are 
sometimes called curvilinear variable costs. There may be what are 
known as economies of scale whereby each successive unit of activity adds less to total variable cost than the previous unit. An example of a variable cost which follows this pattern could be the cost of direct material 
where quantity discounts are available. 
On the other hand, there may be what  are known as diseconomies of 
scale which indicates that each successi ve unit of activity is adding more 
to the total variable cost  than the previous unit. An example of a variable 
cost which follows this pattern coul d be the cost of direct labour where 
employees are paid an accelerating bonus for achieving higher levels of 
output. The important point is that managers should be aware of any 
assumptions that have been made in estimating cost behaviour patterns. 
They can then use the information which is based on these assumptions with a full awareness of its possible limitations. 
Semi-variable cost 
A semi-variable cost is also referred to as a semi-fixed, hybrid, or mixed 
cost. The CIMA Terminology defines it  as ‘a cost containing both fixed 
and variable components and thus par tly affected by a change in the 
level of activity’. 
Examples of semi-variable costs are gas and electricity. Both of these 
expenditures consist of a fixed am ount payable for the period, with a 
further variable amount which is rela ted to the consumption of gas or 
electricity. Alternatively, the cost might remain constant up to a certain level of 
activity and then increase as the vari able cost element is incurred. An 
example of such a cost might be the rental cost of a photocopier where a 
fixed rental is paid and no extra charge is made for copies up to a certain 
number. Once this number of copies is exceeded, a constant charge is 
levied for each copy taken. 
Classification of costs accord ing to their element  
As well as classifying costs by their behaviour costs can also be classified 
according to their element. 
Classifying costs according to their el ement means grouping costs according to 
whether they are material, labour  or expense  cost. These are the three main 
cost elements.

14 
 Cost elements 
 Materials  are the components bought in by  the company which are used 
in manufacturing the product. For exam ple, the materials used by a food 
producer could be meat or vegetables. Material costs include the cost of 
obtaining the materials and receivi ng them within the organisation. 
Labour  costs are the costs of the people working for the organisation. 
These costs include wages and sa laries, together with related 
employment costs. 
Expense  costs are the regularly incurr ed costs of running the business 
such as rent, business rates, utility costs, insurance, postage, telephones 
and similar items. 
Note:  Within the cost classification s there can be subdivisions; for 
example, within the materials classifi cation the subdivisions might include 
 Raw materials, that is, the basic raw material used in the 
manufacturing process. 
 Components, that is, complete  parts that ar e used in the 
 Consumables, that is, cleaning materials, etc. 
 Maintenance materials, that is, s pare parts for machines, lubricating 
oils, etc. 
This list of subdivisions is not exh austive, and there may even be further 
subdivisions of each of these groups . For example, the raw materials 
may be further divided according to t he type of raw material, for example 
steel, plastic, glass, etc. 
Classification of costs according to their nature  
When costs are classified having r egard to their nature, the broadest 
classification of this ty pe is to divide costs into direct  costs and indirect  costs. 
 Direct costs – costs which can be direct ly traced to the cost object that we 
are trying to cost. 
 Indirect costs – costs which cannot be directly traced to a single cost 
object. 
 
 Direct and indirect costs 
 Direct costs  can be clearly identified with the cost object we are trying to 
cost. For example, suppose that a furn iture maker is determining the cost 
of a wooden table. The manufacture of  the table has involved the use of 
timber, screws and metal drawer handl es. These items are classified as 
direct  materials . The wages paid to the machine operator, assembler 
and finisher in actually making the table would be classified as direct 
labour . The designer of the table may be entitled to a royalty payment for 
each table made, and this would be classified as a direct expense .  
The total of all direct costs is known as the PRIME COST .

Chapter 1 
 15 
 Indirect costs  cannot be directly attributed to a particular cost unit, 
although it is clear that they have been incurred in the production of the 
table. These indirect costs are often referred to as production overheads . 
Examples of indirect produc tion costs are as follows: 
Cost incurred Cost classification 
Lubricating oils and cleaning ma terials Indirect material 
Salaries of factory supe rvisors Indirect labour 
Factory rent and power Indirect expense 
It is important to realise that a part icular cost may sometimes be a direct 
cost and sometimes an indirect cos t. It depends on the cost object we are 
trying to cost. 
For example, consider a member of a quality inspection department in a 
production factory. The salary for this  employee will be a direct cost for 
the cost centre (the quality inspection depar tment) if that is the object that 
we are trying to cost. But it woul d be an indirect cost for the units 
produced in the factory (the cost units) as it cannot be directly traced to 
one individual cost unit.  
 
Another way of classifying costs by their nature is to classify a cost as a period 
or product cost. 
 Product costs – costs which are only  incurred if production takes place. 
 Period costs – costs which are incurred due to the passage of time. 
 
 Product and period costs 
 Product costs  would include direct materi al, direct labour and absorbed 
production overheads. Therefore if an organisation does not produce any 
items it will not incur any product costs. 
Period costs  include costs such as rent and rates, insurance, directors’ 
salaries and depreciation. These cost s accrue on daily, monthly or annual 
basis and will still accrue even if an organisation does not produce any 
items. 
 
 It will be vital for most of the chapters in this syllabus that you understand 
the behaviour, elements and nature of  different types of cost.

Chapter 1 
 17 
7 Practice questions 
 Direct costs are: 
A costs that can always be ident ified with a single cost object 
B all costs that are expens ed to the Income Statement 
C costs that can be attributed to a single accounting period 
D costs that change in direct pr oportion to the number of units 
produced. 
 
 Consider the following information characteristics. 
For each, decide which characteristi c is most appropriate at the 
strategic level and which would be more appropriate at the 
operational level. 
 
 Strategic Operational 
Detailed/Summarised   
Historical/Future   
Focused/Wide ranging   
Frequent/Infrequent   
 
 State which three of the following characteristics relate to financial 
accounting: 
A For internal use 
B Governed by rules and regulations C Required by law D Output is mainly used by external parties E One of its main pur poses is planning

18 
Example and test your  understanding answers 
 Example 1 
 C 
Statement (i) is incorrect as providi ng a true and fair view of the financial 
position of the organisation is only relevant to financial accounting. 
 
 Example 2 
A decision on the ordering of material for production  Operational 
A decision about the pricing of  the products  Tactical 
 
 A 
Direct costs are costs directly attri butable to the item being costed, which 
can be a single unit or a batch of cost units. D may be true but is the 
definition of a variable cost. Direct costs will normally be charged to the 
Income Statement (option B), but not all costs t hat are charged to the 
Income Statement will be direct costs. Direct costs are attributed to units 
(or batches) not accounting periods. 
 
Strategic Operational 
Subjective Objective 
Summarised Detailed 
Future Historical 
Wide ranging Focused 
Infrequent Frequent

Chapter 1 
 19 
 B, C and D 
A and E relate to management accounting. 
Management accounting is internally focused and one of its main 
purposes is planning. 
Financial accounting is governed by rules and regulations, required by 
law and its output is mainly used by external parties.

21 
Traditional costing 
A3. Apply costing methods to 
determine the costs for different purposes (a)  Cost accumulation, 
allocation, apportionment and absorption 
C1. Describe the main types of short-term decisions made by organisations (a)  Describe pricing and 
revenue maximisation decisions 
  Chapter 
2

22 
 
Having understood why it’s so important for the business to determine the cost 
of its products or services, we now need to  consider how we can calculate this 
cost. The first two ways of doing this are examined in this chapter. 
2 Absorption costing 
 The aim of traditional absorption cost ing is to determine the full production 
cost per unit. 
 
When we use absorption costing to determi ne the cost per unit, we focus on the 
production costs only.

Chapter 2 
 23 
We can summarise these costs into a cost card: 
 $ 
Direct materials per unit X 
Direct labour per unit X 
Production overhead per unit (Note 1) X  –– 
Full production cost per unit X  –– 
Note 1: 
All production overheads must be absor bed into units of production, using a 
suitable basis, e.g. units produced, labour hours or machine hours. The 
assumption underlying this method of absor ption is that over head expenditure is 
connected to the volume produced. 
If, for example, units produced are used as the basis, the absorption rate is 
 
Total budgeted overhead cost (allocated and apportioned) 
Budgeted production volume 
 
 Example 1 
 A company accountant has gathered t ogether some cost information for 
her company's product as follows: 
 Cost 
Direct materials $4 per kilogram (kg) used  
Direct labour $22 per hour worked Variable overheads  $6 for each hour that direct labour work 
She has also determined that fi xed production overheads will be 
$400,000 in total. Overheads are absorbed on a per unit basis. 
Investigation has shown that each unit of the product uses 3 kilograms of 
material and needs 2 hours of direct labour work. Sales and production were budget ed at 20,000 units, but only 16,000 
were actually produced and 14,000 actually sold. There was no opening inventory. 
Required: 
Produce a standard cost card using absorption costing and value the 
company's closing inventory on that basis.

24 
 More on calculating absorption rates 
 It is relatively easy to estimate the cost per unit for direct materials and 
labour. In doing so we can complete t he first two lines of  the cost card. 
However, it is much more difficult  to estimate the production overhead 
per unit. This is an indirect cost and so, by its very nature, we do not 
know how much is contained in eac h unit. Therefore, we need a method 
of attributing the production overheads to each unit. 
Review of overhead absorption procedure 
Accounting for overhead costs in an absorption costing system can be 
quite complex, and production overhead costs are first allocated, then 
apportioned and finally absorbed into product costs (or service costs). 
 Overhead allocation.  Indirect production costs are initially allocated 
to cost centres or departments. Allo cation is the process of charging 
a cost directly and in full to t he source of the expenditure. For 
example, the salary of a mainte nance engineer would be allocated 
to the engineering maintenance department. 
 Overhead apportionment.  The overhead costs that have been 
allocated to cost centres and cost  codes other than direct production 
departments must next be apportioned to direct production 
departments. Apportionment is the process of sharing on a fair 
basis. For example, factory rental costs might be apportioned between the production departments on the basis of the floor area 
occupied by each department. Si milarly, the costs of the 
engineering maintenance department might be apportioned 
between production departments on t he basis of the operating 
machine hours in each department. At  the end of the apportionment 
process, all the production ov erheads have been allocated or 
apportioned to the direct  production departments. 
 Overhead absorption . An absorption rate is calculated for each 
production department. This is the rate at which production overheads will be added to the cost of production going through the 
When the department produces a single product, production volume can 
be measured as the number of unit s produced, and the absorption rate 
would be a rate per unit produced. 
More usually, organisations produce different products or carry out non-
standard jobs for customers, and production volume is commonly 
measured as one of the following: 
 direct labour hours worked in  the department, and the absorption 
rate is a rate per direct labour hour worked 
 machine hours worked in the department, and the absorption rate is 
a rate per machine hour operated 
 sometimes the cost of direct labo ur might be used as a measure of 
production volume, and the absorption rate is then calculated as a 
percentage of direct labour cost.

Chapter 2 
 25 
 This often results in a factory wide absorption rate. This is used when all 
products produced in the factory us e the same type of labour or 
machines. Dividing total factory indi rect costs by, say, total direct 
machine hours results in this absorpti on rate that can be charged to all 
products based on the number of machi ne hours used. So, for example, if 
all products are produced on the same machines and a factory wide 
absorption rate of $40 per mach ine hour has been determined, every 
product will be charged $40 worth of overheads for every machine hour 
that they use. 
Predetermined absorption rates 
Although it is possible to calculate abs orption rates using actual overhead 
costs and actual production volume, this is not the usual practice. This is 
because: 
 It is usually inconvenient to wa it until the end of an accounting 
period to work out what the absorption rates should be. In 
absorption costing systems, overhead costs are added to the cost of 
production as it passes through each stage in the production process, and overhead costs are absorbed when the production 
happens. 
 A predetermined rate is required to enable a price to be estimated. 
 Overhead costs may vary thr oughout the year. The overhead 
absorption rate smooths variat ions in overheads by applying an 
average overhead cost to each unit of product throughout the year. 
The normal practice is therefore to  absorb production overhead costs at a 
predetermined rate, based on budgeted overhead expenditure and budgeted production volume. 
This however can lead to an over-o r under-absorption of the overheads 
when compared to the act ual overheads incurred. 
This over-or under-absorption  can be calculated as follows: 
= (Budgeted overhead rate per unit × ac tual units) – Actual overheads 
incurred 
 
 Absorption advantages/disadvantages 
 Advantages of absorption costing 
The arguments used in favour of abs orption costing are as follows: 
 Fixed production costs can be a large proportion of the total 
production costs incurred. Un less production overheads are 
absorbed into product costs, a la rge proportion of cost would be 
excluded from the measur ement of product costs. 
 Absorption costing follows the ma tching concept (accruals concept) 
by carrying forward a proportion of  the production cost in the 
inventory valuation to be matched aga inst the sales value when the 
items are sold.

26 
  It is necessary to include fixed production overhead in inventory 
values for financial statements;  absorption costing produces 
inventory values which includ e a share of fixed production 
overhead. 
 Analysis of under-/over-absorbed overhead may be useful for 
identifying inefficient utilisat ion of production resources. 
 There is an argument that in the longer term, all costs are variable, 
and it is appropriate to try to  identify overhead costs with the 
products or services that cause th em. This argument is used as a 
reason for activity-based costing (ABC ). ABC is a form of absorption 
costing, and is described in a later chapter. 
Disadvantages of absorption costing 
There are serious disadvantages wit h using absorption costing to 
measure costs and profits. 
 The apportionment and absorption of overhead costs is 
arbitrary 
The way in which overhead co sts are apportioned between cost 
centres and absorbed into production costs is subjective and many 
methods of cost allocation may be deemed appropriate. Although 
the process attempts to be ‘fair’, it is arbitrary. 
For example, suppose that a factor y rental cost is apportioned 
between production departments on the basis of the floor area for 
each department. This might seem a fair way of sharing out the costs, but it is still subjective . Why not apportion the costs on the 
basis of the number of employees  in each department? Or why not 
allow for the fact that some of  the accommodation might be more 
pleasant to work in than others? In a manufacturing environment, production overheads might be absor bed on the basis of either 
direct labour hours or machine hours. However, choosing one 
instead of the other can have a signi ficant effect on job costs or 
product costs, and yet it still relies on a subjective choice. 
It may be easier in some department s than others. If a department 
is labour intensive then allocations can be made on the basis of 
labour hours worked. Or if the depar tment is machine intensive then 
allocations can be made on the basis of machine hours. But not every department will have th is clear distinction. 
 Profits vary with changes in production volume  
A second criticism of absorption co sting is that profits can be 
increased or reduced by changes in inventory levels.  
For example, by increasing outpu t, more fixed overhead is absorbed 
into production costs, and if the ex tra output is not sold, the fixed 
overhead costs are carried forward in  the closing inventory value. 
This can encourage managers to ove r-produce in order to inflate 
profits.

Chapter 2 
 27 
3 Marginal costing 
Marginal costing is a costing method wh ich charges products or services with 
variable costs alone. The fixed costs are treated as period costs and are written 
off in total against the contribution of the period. 
Marginal cost 
Marginal cost is the extra cost arising as  a result of produci ng one more unit, or 
the cost saved as a result of pr oducing one less unit. It comprises: 
 Direct material 
 Direct labour 
 Variable overheads 
 
 Example 2 
 Use the same data as that provided in Example 1. 
Required: 
Produce a standard cost card using marginal costing and value the 
company's closing inventory on that basis. 
 
 Marginal costing advantages/disadvantages 
 Advantages of marginal costing 
 It is a simpler costing system, because there is no requirement to 
apportion and absorb overhead costs. 
 Marginal costing reflects the behavi our of costs in relation to activity. 
When sales increase, the cost of sales rise only by the additional 
variable costs. Since most decision-making problems involve 
changes to activity, marginal cost ing information is more relevant 
and appropriate for short-run dec ision-making than absorption 
costing. 
 Marginal costing avoids the di sadvantages of absorption costing, 
described above. 
Disadvantages of marginal costing 
 When fixed costs are high relati ve to variable costs, and when 
overheads are high relative to direct  costs, the marginal cost of 
production and sales is only a small proportion of total costs. A 
costing system that focuses on marg inal cost and contribution might 
therefore provide insuffici ent and inadequate information about 
costs and product profitability. Margin al costing is useful for short-
term decision-making, but not for measuring product costs and 
profitability over the longer term. 
 It could also be argued that the treatm ent of direct la bour costs as a 
variable cost item is often unrealis tic. When direct labour employees 
are paid a fixed wage or salary, t heir cost is fixed, not variable.

28 
4 Absorption and marginal costing profit statements 
Absorption costing format 
 
 $ $ 
Sales  X 
Less: Cost of sales   
Opening inventory X  
+ Production costs X  
 –––  
 X  
Less:  Closing inventory (X)  
 ––– (X)   –––   X 
(Under) / over absorption  +X 
  ––– 
Gross profit  X 
Less:  Selling, distribution and administration costs,   
Variable X  
Fixed X  
 –––  
  (X)   ––– 
Net profit/(loss)  X 
  ––– 
Marginal costing format 
 $ $ 
Sales  X 
Less: Variable  cost of sales   
+ Variable  production costs X  
 –––   X  
Less:  Variable  selling, distribution and administration costs  (X) 
  ––– 
Contribution   X

Chapter 2 
 29 
Contribution   X 
Less:  Fixed costs    
Production X  
Selling, distribution and admin. X  
 –––  
  (X) 
  ––– 
  ––– 
 
 Example 3 
 Perry Ltd makes and sells a single pr oduct with the following information: 
 $/unit 
Selling price 50 
Direct material 15 
Direct labour 10 Variable overhead 5 
Fixed overheads are $5,000. Budgeted and actual output and sales are 
1,000 units. 
(a)  Using absorption costing: 
(i)  calculate the pr ofit for the period 
(ii)  calculate t he profit per unit. 
(b)  Using marginal costing: 
(i)  calculate the contribution per unit 
(ii)  calculate the total contribution (iii)  calculate the pr ofit for the period. 
5 Reconciling the profits 
The differences between the two prof its can be reconciled as follows: 
 $ 
Absorption costing profit X 
(Increase)/decrease in inventor y × fixed overheads per unit (X)X 
 –––– 
Marginal costing profit X 
 ––––

30 
 Justification 
 The profit differences are caused by the different valuations given to the 
closing inventories in each period. Wi th absorption costing, an amount of 
fixed production overhead is carried fo rward in inventory to be charged 
against sales of later periods. 
If inventories increase, then absorpt ion costing profits will be higher than 
marginal costing profits. This is be cause some of the fixed overhead is 
carried forward in inventory instead of being written off against sales for 
If inventories reduce, then marginal  costing profits will be higher than 
absorption costing profit s. This is because the fixed overhead which had 
been carried forward in inventory wit h absorption costing is now being 
released to be charged against the sales for the period. Marginal costing and absorption cost ing systems give the same profit 
when there is no change in inventories. 
Profit differences in the long term 
In the long term the total reported profit will be the same whichever 
method is used. This is because all of  the costs incurred will eventually 
be charged against sales; it is merely the timing of the sales that causes 
the profit differences from period to period. 
 
 Example 4 
 The details are exactly the same as  for Example 3, but output and sales 
are now 3,000 units instead of 1,000. 
Calculate the profit for the peri od using both absorption and marginal 
costing? Answer the question in any way that you want. 
 
 Example 5 
 Z Limited manufactures a single product, the budgeted selling price and 
variable cost details of which are as follows 
 $ 
Selling price 15.00 Variable costs per unit:  
Direct materials 3.50 Direct labour 4.00 Variable overhead 2.00 
Budgeted fixed overhead costs ar e $60,000 per annum charged at a 
constant rate each month. 
Budgeted production is 30,000 units per annum.

Chapter 2 
 31 
 In a month when actual production  was 2,400 units and exceeded sales 
by 180 units, identify the profit re ported under absorption costing: 
A $6,660 
B  $7,570 C $7,770 D  $8,200 
 Profits from one period to  the next can be reconcil ed in a similar way. 
For 
example, the difference bet ween periods can be explai ned as the change in unit 
sales multiplied by the contribution per  unit if using marginal costing. 
 
 Further explanation on reconciling profits between periods 
 Just like reconciling profits bet ween the two accounting systems can be 
achieved via a proforma, similar pr oformas can be used for reconciling 
profits between one period and the nex t using the same accounting 
system as follows: 
Marginal costing reconciliation 
 $ 
Profit for period 1 X Increase/(decrease) in sales × contribution per unit (X)X 
 –––– 
Profit for period 2 X 
 –––– 
Absorption costing reconciliation 
This is a little trickier as the reco nciliation needs to be adjusted for any 
over/under-absorptions that may hav e occurred of fixed overheads. 
 $ 
Profit for period 1  X Increase/(decrease) in sale s × profit per unit X(X) 
(Over–)/under-absorpti on in period 1 (X)/X 
Over– /(under)-absorption in period 2 X/(X)  –––– 
 –––– 
Note: 
You must be careful with the direction of the absorption. For example, an 
over-absorption in period 1 makes profit  for that month hi gher, therefore it 
must be deducted to arrive at peri od 2’s profit. On the other hand, an 
over-absorption in period 2 makes peri od 2’s profit higher than period 1’s, 
therefore it must be added in the reconciliation.

32 
6  Pricing strategi es based on cost 
Pricing decisions is an element of t he decision making part of the syllabus 
which will be explored again in a later chapter when we look at how pricing 
should be set for one-off or short-term dec isions. In any pricing decision there 
are four key factors to consider: 
 Costs – the organisation needs to ensur e that the price is sufficient to 
cover the cost of producing the product or providing the service. 
 Competitors – organisations will oft en monitor the prices of competing 
products/services to ensure that the pr ice set for their own product/service 
is in line with the organisa tion’s competitive goals. 
 Customers – the value placed on the product by customers will often 
determine how the product/service is priced. Organisations will consider 
how much the customer is willin g to pay for the product/service. 
 Corporate objectives – pricing will o ften have a link to the organisation’s 
overall strategic objectives. If, for example, an organisation is trying to 
break into a market and gain market s hare it might set an initially low price 
in order to attract customers to th e product/service. On the other hand, if 
the organisation wants to project an image of quality and difference then it 
might set a high price in order to do this. 
The cost of the product or service is ther efore one of the elements that can 
impact on the selling price of a product or service. For many organisations it will 
be the key determinant of the selling price . Often referred to as 'cost-plus 
pricing', this involves adding a mark-up to  the cost of the product or service in 
order to arrive at the selling price. 
 
 Choosing the mark up percentage 
 A standard mark-up is used by some  organisations, such as government 
contractors and some job costing companies, but the majority of 
companies vary the percentage to refl ect differing market conditions for 
their products or services. This mark-up may be influenced by factors such as: 
 The amount that customers are w illing to pay. For example, the 
product may have a high perceived value (if, say, it is in short 
supply) which would therefore enc ourage the organisation to use a 
higher mark up. 
 The level of competition that the product will experience. If the 
product has many close competitors and substitutes then the organisation may be forced to use a lower mark up. 
 The organisation's objectives. For example, when first trying to 
break into a market and gain market awareness and market share an organisation might use a lower mark-up percentage. 
 Alternatively, the profit mark- up may be fixed so that the company 
makes a specific return on capital based on a particular capacity utilisation.

Chapter 2 
 33 
Under different circumstances there may be different interpretations of what 
gets included in the 'cost' element of cost  plus pricing. In some circumstances 
full cost may be used (including absorbed overheads), in other circumstances it 
might be more appropriate to use marginal cost. 
Full cost plus pricing 
Using this method, the selling price fo r the product is determined as follows: 
 
Selling price = Full cost per unit × (1 + mark-up percentage) 
 
So that, for example, if the full cost  was $40 and the organisation was using a 
15% mark-up percentage then the selling pr ice would be set at $46 (i.e. $40 × 
1.15). 
Full cost can be interpreted in different ways. It will always include the full 
production cost, including all absorbed ov erheads. But some organisations may 
also interpret it to include sales,  distribution and administration costs. 
(Note : typically, the more costs that are included in the full cost then the lower 
that the mark up percentage used is likely to be). 
 
 Illustration – Full cost-plus pricing  
 A company is replacing product A with an updated version, B, and must 
calculate a base cost, to which will be added a mark-up in order to arrive at a selling price. The following variable costs hav e been established by 
reference to the company’s experience with product A, although they may 
be subject to an error margin of + or – 10 % under production conditions 
for B: 
 $ per unit 
Direct material 4 
Direct labour (1/4  hr @ $16/hr) 4 
Variable manufacturing overhead s (1/4 hr of machine time 
@ $8/hr) 2 
 ––– 
Total variable cost per unit 10 
 ––– 
As the machine time for each B would be the same as for A, the company 
estimates that it will be able to produce the same total quant ity of B as its 
current production of A, which is 20,000 units. 
The production facilities currently us e 50,000 hours of machine time for 
all of the company’s products (incl uding A) and this should be used as 
the basis for absorbing fixed costs.  Current fixed costs are $240,000 for 
the production facilities, $200,000 for selling and distribution, and 
$180,000 for administration.

34 
 For costing purposes, the 20,000 units of B can be assumed to consume 
10 per cent of the total selling, di stribution and administration costs. 
Alternative 1,  using conventional absorption costing principles and 
building in the conser vative error margin 
 $ 
Variable production costs (as above) 10.0 
Add: allowance for underestimate (10%) 1.0 
Add: fixed manufacturing cost 1/4 hour of machine time @ 
$4.80/hour ($240, 000/50,000 hours) 1.2 
 ––– 
Full cost 12.2 
 ––– 
Alternative 2 , as 1 but including administrative costs 
 $ Base cost as under 1 above 12.2 
Add: fixed administrativ e costs ($180,000 × 10% = 
$18,000/20,000 units) 0.9 
 ––– Full cost 13.1 
 ––– 
Alternative 3,  as 2 but including selling and distribution costs 
 $ Base cost as under 2 above 13.1 
Add: fixed selling and distri bution costs ($200,000 × 10% = 
$20,000/20,000 units) 1.0 
 ––– 
Full cost 14.1 
 ––– 
Depending on the analysis adopted, the fu ll cost varies from $12.20 to 
$14.10. The full cost rises with eac h alternative, as an increasing 
proportion of the total costs is recover ed. The profit mark -up built into the 
pricing formula is therefore likely to fall with each alternat ive from 1 to 3 
 
 Advantages and disadvantages of  full cost plus pricing 
 A number of advantages are claim ed for full cost-plus pricing: 
(1)  The required profit will be made if budgeted sales volumes are 
achieved. 
(2)  It is a particularly useful method in contract costing industries such 
as building, where a few large in dividual contracts can consume the 
majority of the annual fixed cost s and the fixed costs are low in 
relation to the variable costs.

Chapter 2 
 35 
 (3)  Assuming the organisation knows it s cost structures, full cost-plus is 
quick and cheap to employ. Its rout ine nature lends itself to 
delegation, thus saving management time. 
(4)  Full cost-plus pricing can be usef ul in justifying selling prices to 
customers; if costs can be shown to have increased, this 
strengthens the case for an incr ease in the selling price. 
However, there are a number of problems  with full cost-plus pricing: 
(1)  There will always be problems a ssociated with the selection of a 
‘suitable’ basis on which to charge fixed costs to individual products 
or services. Selling prices can s how great variation, depending on 
the apportionment basis chosen. Th is can lead to over-or under-
pricing relative to competitors causing the firm to either lose 
business or make sales at an unintentional loss. 
(2) If prices are set on the basis of  normal volume, and actual volume 
turns out to be considerably lower, overheads will not be fully recovered from sales and predicted profits may not be attainable. 
(3)  The mark up can be very arbi trary and may not properly account for 
factors such as competition leve ls, how much customers are willing 
to pay etc 
Marginal cost-plus pricing 
Selling price = Marginal cost per unit × (1 + mark-up percentage) 
 
To the accountant, marginal cost is t he same as variable cost. In setting the 
selling price using this method a larger  mark-up percentage is added because 
both fixed costs and profit must be covered. 
It is a particularly useful method w hen determining a minimum acceptable 
selling price (for example, for a one-o ff product order) and this is examined in 
more detail in a later chapter. 
 
 Benefits and problems when us ing marginal cost pricing 
 Some of the reasons for using marginal  cost in preference to full cost are 
as follows: (1) It is just as accurate as total cost-plus pricing. A larger mark-up 
percentage is added because both fi xed costs and profit must be 
covered, but the uncertainty over t he fixed costs per unit remains in 
both pricing methods. 
(2)  Knowledge of marg inal cost gives management  the option of pricing 
below total cost when times are bad, in order to fill capacity. 
(3)  It is particularly useful in prici ng specific one-off contracts because it 
only accounts for costs which are likely to change because of the 
new contract. This pricing decision is covered in more detail in a later chapter.

36 
 (4) It also recognises the existenc e of scarce or limiting resources. 
Where these are used by competi ng products and services it must 
be reflected in the selling price if prof it is to be maximised. If there is 
a scarce or bottleneck resource th e aim must be to maximise the 
total contribution from the limiting factor. The contribution that each 
alternative product or service ma kes from each unit of the scarce 
resource must be calculated and a suitable profit margin added. 
The main criticisms of ma rginal cost pricing are: 
(1)  Like any cost based pricing method , it ignores other factors such as 
levels of competition, customer attitudes etc. 
(2)  The mark-up becomes even more arbitrary than that used in full 
cost plus as now it must also include a subjective element which 
allows for the selling price to co ver fixed costs. For this reason, 
many accountants argue that marginal cost plus pricing should only 
be used for marginal (short-te rm or one-off) decisions. 
Target return on capital 
As well as determining the selling price by adding a mark-up on cost, an 
organisation may also set the mark-up at a level that provides a target return on 
the investment that ha s been made in the product. 
The mark-up is calculated as: 
Profit mark-up = Targeted return on investment in the 
product/budgeted level of production  
The targeted return on inve stment is calculated as: 
Targeted return on investment in the produc t = Total investment in the product × 
targeted rate of return 
 
 Example 6 
 This method involves determining the amount of capital invested to 
support a product. For example, some  fixed or non-current assets and 
certain elements of working capital such as inventory and trade 
receivables can be attributed to individual products. 
The selling price is then set to achi eve a specified return on the capital 
invested on behalf of the product. T he following exampl e will demonstrate 
how the method works. LG Ltd manufactures product B. Da ta for product B are as follows 
Direct material cost per unit $62 
Direct labour cost per unit $14 
Direct labour hours per unit 4 hours Production overhead absorption rate
  $16 per direct machine hour 
Mark-up for non-production overhead 
costs 8% of total production cost

Chapter 2 
 37 
 LG Ltd sells 1,000 units of product B each year. Product B requires an 
investment of $400,000 and the target ra te of return on investment is 
12% per annum. 
Calculate the selling price for one uni t of product B, to the nearest cent. 
 
 Target return on sales 
 An organisation can use a similar technique to determine a selling price 
which provides a target return on sa les. This pricing method involves 
determining the full cost of a cost  unit and then adding a mark-up that 
represents a specified percentage  of the final selling price. 
WP Ltd manufactures product A. Da ta for product A are as follows: 
Direct material cost per unit $7 
Direct labour cost per unit $18 
Direct labour hours per unit 2 hours Production overhead absorption rate
  $6 per direct labour hour 
costs 5% of total production cost 
WP Ltd requires a 15% return on sales revenue from all products. 
Calculate the selling price for product A, to the nearest cent. 
Solution 
 $ per unit 
Direct material cost  7.00 
Direct labour cost  18.00 
 –––––– 
Total direct cost 25.00 
Production overhead absorbed (2 hours × $6) 12.00 
 –––––– 
Total production cost 37.00 
Mark-up for non-production costs (5% × $37.00) 1.85 
 –––––– 
Full cost 38.85 
Profit mark-up (15/85* × $38.85) 6.86 
 –––––– 
Selling price 45.71 
 –––––– 
*Always read the question data carefully. The 15% required return is 
expressed as a percentage of the sa les revenue, not as a percentage of 
the cost.

38 
Profit margin 
As an alternative calculation, the exami ner may provide a prof it margin rather 
than a mark-up on cost. The selling pr ice using a profit margin can be 
Selling price = Total cost ÷ (1 – required margin) 
The decision as to what gets included in the total cost (for example, whether 
that is the absorption or marginal cost ) and the associated calculations required 
to get to the total cost will be the same as when using a mark-up on cost. 
 
 Example 7 
 A product has a total production cost  of $60. Determine the selling price 
for the product if the com pany wants to achieve: 
(a)  a 20% mark-up on total production cost 
(b)  a 20% margin on total production cost

40 
8 Practice questions 
 Scenario 
Saturn, a chocolate manufactu rer, produces three products: 
 The Sky Bar, a bar of solid milk chocolate. 
 The Moon Egg, a fondant f illed milk chocolate egg. 
 The Sun Bar, a biscuit and nougat based chocolate bar. 
Information relating to each of  the products is as follows: 
 Sky 
Bar Moon 
Egg Sun 
Bar 
Direct labour cost per  unit ($) 0.07 0.14 0.12 
Direct material cost per unit ($) 0.17 0.19 0.16 
Actual production/sales ( units) 500,000 150,000 250,000 
Direct labour hours per  unit 0.001 0.01 0.005 
Direct machine hours per unit 0.01 0.04 0.02 Selling price per unit ($) 0.50 0.45 0.43 
Annual production overhead = $80,000    
Tasks 
Using traditional absorption costing, calculate the full production cost per 
unit and the profit per unit for each pr oduct. Explain the implications of 
the figures calculated. (Time allowed: 20 minutes)  
 
 E plc operates a marginal costi ng system. For the forthcoming year, 
variable costs are budgeted to be 60% of  sales value and fixed costs are 
budgeted to be 10% of sales value. 
If E plc increases its selling prices by  10%, but if fixed costs, variable 
costs per unit and sales volume re main unchanged, identify the effect on 
E plc's contribution: A a decrease of 2% B an increase of 5% C an increase of 10% D an increase of 25%

Chapter 2 
 41 
 When comparing the profits repo rted under marginal and absorption 
costing during a period when the level of inventories increased, identify 
which of the following st atements would be true: 
A absorption costing profits will be higher and closing inventory 
valuations lower than those under marginal costing 
B absorption costing profits will be higher and closing inventory 
valuations higher than t hose under marginal costing 
C marginal costing profits will be higher and closing inventory 
valuations lower than those under absorption costing 
D marginal costing profits will be lower and closing inventory 
valuations higher than t hose under absorption costing 
 
 Exe Limited makes a single product whose total cost per unit is budgeted 
to be $45. This includes fixed cost of $8 per unit based on a volume of 
10,000 units per period. In a period,  sales volume was 9,000 units, and 
production volume was 11,500 units. T he actual profit for the same 
period, calculated using absor ption costing, was $42,000. 
If the profit statem ent were prepared using margi nal costing, identify the 
profit for the period: 
A $10,000 B $22,000 C $50,000 D $62,000

42 
 Scenario 
Keats plc commenced business on 1 Ma rch making one product only, the 
standard cost of which is as follows: 
 $ 
Direct labour 5 
Direct material 8 Variable production overhead 2 
Fixed production overhead 5 
 ––– Standard production cost 20 
 ––– 
The fixed production overhead figure has been calculated on the basis of 
a budgeted normal output of 36,000 units per annum. 
You are to assume that actual fix ed overheads were as expected and 
that all the budgeted fixed expenses are incurred evenly over the year. 
March and April are to be taken as equal period months. Selling, distribution and adm inistration expenses are: 
Fixed  $120,000 per annum Variable  15% of the sales value The selling price per unit is $35 and the number of units produced and 
sold were: 
 March April 
 (units) (units) 
Production 2,000 3,200 
Sales 1,500 3,000 
Tasks 
(a) prepare profit statements for each  of the months of March and April 
using: 
(i) absorption costing, and (ii) marginal costing 
(b) prepare a reconciliation of the pr ofit or loss figures  given in your 
answers to (a)(i) and (a)(ii) acco mpanied by a brief explanation. 
(Time allowed: 20 minutes)

Chapter 2 
 43 
 If inventory levels have increased dur ing the period, the profit calculated 
using marginal costing would be _____ (choose between 'higher' and 
'lower') than the prof it when compared with t hat calculated using 
absorption costing. 
 
 Identify which of the following statements would be true: fixed 
production overheads will always  be under-absorbed when: 
A actual output is lower than budgeted output 
B actual overheads incurred ar e lower than budgeted overheads 
C overheads absorbed are lo wer than those budgeted 
D overheads absorbed are lo wer than those incurred 
 
 A company uses a standard absorption costing system. The fixed 
overhead absorption rate is based on labour hours. 
Extracts from the company’s record s for last year were as follows: 
 Budget Actual 
Fixed production over head $450,000 $475,000 
Output 50,000 units 60,000 units 
Labour hours 900,000 930,000 
The ______ (choose between 'over' and 'under') -absorbed fixed 
production overheads for the year were $______ (fill in the value). 
 
 GY Ltd budgets to produce and sell 3,800 units of product R in the 
forthcoming year. The amount of c apital investment attributable to 
product R will be $600,000 and GY Ltd requ ires a rate of return of 15% 
on all capital invested. 
Further details concerning product R are as follows: 
Direct material cost per unit $14 
Direct labour cost per unit $19 
Variable overhead cost per unit $3 
Machine hours per unit 8 
Fixed overhead is absorbed at a ra te of $11 per machine hour.

44 
 Required: 
Calculate all answers to the nearest cent. 
(a) The variable cost of product R is $ ______per unit. (b) The total (full) cost of product R is $ ______per unit. 
(c) The selling price of product R wh ich will achieve the specified return 
on investment is $ ______per unit. 
 
 A company manufactures a range of products one of which, product Y, 
incurs a total cost of $20 per unit. The company incurs a total cost of 
$600,000 each period and the directors wish to achieve a return of 18% 
on the total capital of $800, 000 invested in the company. 
Required: 
Based on this information the cost-plus selling price of one unit of product 
Y should be $______ 
 
 Scenario 
ML is an engineering company that s pecialises in providing engineering 
facilities to businesses that cannot just ify operating their own facilities in-
house. ML employs a number of engin eers who are skilled in different 
engineering techniques that enable ML to provide a full range of 
engineering facilities to its customers. 
Most of the work undertaken by ML is  unique to each of its customers, 
often requiring the manufacture of spare parts for its customers’ 
equipment, or the building of new equipm ent from customer drawings. As 
a result most of ML’s work is shor t-term, with some jobs being completed 
within hours while others may take a few days. To date, ML has adopted a cost plus approach to setting its prices. This 
is based upon an absorption costing syst em that uses machine hours as 
the basis of absorbing overhead costs into individual job costs. The 
Managing Director is concerned that, over recent months, ML has been 
unsuccessful when quoting for work with the consequence that there has 
been an increase in the level of unus ed capacity. It has been suggested 
that ML should adopt an alternativ e approach to its pricing based on 
marginal costing since ‘any price t hat exceeds variable costs is better 
than no work’. 
Tasks 
With reference to the above scenario: 
(a) briefly explain absorption and ma rginal cost approaches to pricing 
(b) discuss the validity of the comment  ‘any price that exceeds variable 
costs is better than no work’. 

Chapter 2 
 45 
 Example 1 
 Standard cost card 
  $ 
Direct materials per unit 3 kgs × $4/kg 12 Direct labour per unit 2 hrs × $22/hr 44 
Variable overheads 2 hrs × $6/hr 12 
Production overhead per unit (note)  20   ––– 
Full/absorption cost per unit  88 
  ––– 
Note: 
Production overhead per unit in the standar d cost card should be based 
on budgeted production. Therefore in this example they will be 
($400,000/20,000 units =) $20 per unit. 
Inventory valuation 
If 16,000 units were produced and 14,000 units sold then there will be 
2,000 units in closing inventory. 
Valuing that inventory at the absor ption cost will give a value of 
= 2,000 × $88 = $176,000 
 
 Example 2 
  $ 
Direct materials per unit 3 kgs × $4/kg 12 
Direct labour per unit 2 hrs × $22/hr 44 Variable overheads 2 hrs × $6/hr 12   ––– 
Marginal cost per unit  68 
  ––– 
Note: 
Fixed production overhead is not include d in a marginal costing standard 
cost card. 
Valuing that inventory at the marg inal cost will give a value of 
= 2,000 × $68 
= $136,000

46 
 Example 3 
 (a) (i) 
  $ $ 
Sales  1,000 units × $50   50,000 
Direct materials  1,000 units × $15  15,000  
Direct labour  1,000 units × $10  10,000  
Variable overheads 1,000 units × $5 5,000  
Fixed overheads   5,000  
  ––––––  
   35,000 
   –––––– 
Profit    15,000 
   –––––– 
(ii) 
Profit per unit= 	$15000
1,000 units=15/unit 
 
(b) (i) Contribution per unit = $50 – ($15 + $10 + $5) = $20 
(ii) Total contribution = $20/ unit × 1,000 units = $20,000 
(iii) 
 $ Contribution  $20/unit × 1,000 units 20,000 
Fixed cost 5,000 
 –––––– Profit 15,000 
 –––––– 
The two systems give the same profit provided there is no 
change in inventory.

Chapter 2 
 47 
 Example 4 
 Either marginal costing or absorpti on costing principles can be used. The 
two systems will give the same profit as there is no change in inventory 
(production = sales). Marginal cost ing will be simpler and is illustrated 
first. 
 $ 
Contribution  
$20/unit × 3,000 units 60,000 
Fixed cost 5,000  –––––– 
Profit 55,000 
 –––––– 
  $ $ 
Sales  3,000 units × $50   150,000 
Direct materials  3,000 units × $15  45,000  
Direct labour  3,000 units × $10  30,000  
Variable overheads  3,000 units × $5  15,000  
Fixed overheads  3,000 units × $5  15,000  
  ––––––     (105,000) 
Over-absorption of fixed ov erheads ($15,000 – $5,000) 10,000 
   –––––– 
   55,000 
   –––––– 
Notice that we did not use the $15 per unit profit figure. Unlike 
contribution per unit, profit per unit is not constant.

48 
 Example 5 
 B 
A common short-cut in multiple choi ce questions is to calculate the 
marginal costing profit and then use the reconciliati on of profits to get to 
the absorption co sting profit. 
First of all – the profit  under marginal costing: 
Contribution per unit = $15 – (3.50 + 4.00 + 2.00) = $5.50 
No of units sold = 2,400 – 180 = 2,220 
 $ 
$5.50/unit × 2,220 units 12,210 
Fixed cost  
$60,000 p.a./12 months 5,000 
 –––––– 
 7,210 
 –––––– 
As production is greater than sales,  absorption costing will show the 
higher profit. 
Difference in profit = change in invent ory × fixed produc tion overhead per 
unit. Difference in profit = 180 units × $2/unit = $360. Therefore, profit r eported under absorption co sting = $7,210 + 360 = 
$7,570. 
The FOAR was worked out as 	=	Budgeted overheads
Budgeted level  of activity= $60,000
30,000 units ൌ	$2 per unit

Chapter 2 
 49 
 Example 6 
 The selling price is calculated as follows: 
 $ per unit 
Direct material cost 62.00 
Direct labour cost 14.00 
 ––––––– Total direct cost 76.00 
Production overhead absorbed (4 hours × $16) 64.00 
 ––––––– Total production cost 140.00 
Mark-up for non-production costs (8% × $140) 11.20 
 ––––––– 
Full cost 151.20 
Profit mark-up (see working) 48.00 
 ––––––– Selling price 199.20 
 ––––––– 
Working: 
Target return on investment in  product B = $400,000 × 12% = $48,000 
Target return per unit of product B = $48,000/1,000 units = $48 
 
 Example 7 
 (a) a 20% mark-up on total production cost 
Selling price = $60  × 1.20 = $72 
Note: Mark up 
= % of cost Margin 
 = % of sales  
The profit is $12 20% 17% 
(b) a 20% margin on total production cost 
Selling price = $60 / (1 – 0.2 ) = $75 
 = % of sales  
The profit is $15 25% 20%

50 
 As mentioned, it is relatively easy to  complete the first two lines of the 
cost card. The difficult part is ca lculating the production overhead per 
unit, so let’s start by considering th is. We need to absorb the overheads 
into units of production. To do this, we will first need to calculate an 
overhead absorption rate (OAR): 
 
OAR = Production overhead
Activity level= (this is $80,000, as per the question
(this must be chosen) 
 
The activity level must be appropriate  for the business. Saturn must 
choose between three activity levels: 
 Units of production – This would not be appropriate since Saturn 
produces more than one type of pr oduct. It would not be fair to 
absorb the same amount of overhead into each product. 
 Machine hours or labour hours – It  is fair to absorb production 
overheads into the products based on the labour or machine hours 
taken to produce each unit. We must  decide if the most appropriate 
activity level is machine or labour hours. To do this we can look at 
the nature of the proc ess. Production appears to be more machine 
intensive than labour intensive because each unit takes more 
machine hours to produce than it does labour hours. Therefore, the 
most appropriate activity level is machine hours. 
Working – OAR 
OAR = $80,000 production overhead
(0.01 × 500k) + (0.04 × 150k) + (0.02 × 250k) hours 
 
= $80,000
16,000 hours 
 
= $5 per machine hour 
We can now absorb these into the units of production: 
 Sky Bar Moon Egg Sun Bar 
Production overheads ($)    
= machine hours per unit × $5 0.5 0.20 0.10 
This is the difficult part done.

Chapter 2 
 51 
 We can now quickly complete the cost card and answer the question: 
Direct labour cost per unit 0.7 0.14 0.12 
Direct material cost per unit 0.17 0.19 0.16 
Production overhead per unit 0.05 0.20 0.10  ––––– ––––– ––––– 
Full production cost per unit 0.29 0.53 0.38 
Selling price per unit 0.50 0.45 0.43 
Profit/(loss) per unit 0.21 (0.08) 0.05 
 ––––– –––––  –––––  
Outcome of absorption costing 
Based on absorption costing, the Sky Bar and the Sun Bar are both 
profitable. However, the Moon Egg is loss making. Managers would need 
to consider the future of the Moon Egg.  They may look at the possibility of 
increasing the selling pric e and/or reducing costs. If this is not possible, 
they may make the decision to st op selling the product. However, this 
may prove to be the wrong decision bec ause absorption costing does not 
always result in an accurate calculat ion of the full production cost per 
unit. ABC can be a more accurate method of calcul ating the full 
production cost per unit and as a resu lt should lead to better decisions. 
ABC is explored in the next chapter. 
 
 D 
The easiest way to answer this ques tion is to make up a number for 
sales, say $1,000, then the relationships will be much easier to visualise. 
If sales = $1,000, then: Variable cost = 60% × $1,000 = $600 
 $ 
Sales 1,000 
Variable cost 600  ––––– 
Contribution 400 
 –––––

52 
 New situation 
 $ 
Sales (10% higher) 1,100 
Variable cost 600 
 ––––– Contribution 500 
 ––––– 
Contribution increases by $100, whic h is an increase of 25% on its 
original value. 
Fixed cost should be ignored as it  does not affect contribution. 
 
 B 
 
 B 
Production is greater than sales, so  absorption costing will have the 
unit. Difference in profit = 2,500 units × $8/unit = $20,000. Therefore, profit repor ted under marginal costing = $42,000 – 20,000 = 
$22,000.

Chapter 2 
 53 
 (a) (i) 
 $ $ $ $ 
Sales  52,000  105,000 
Cost of sales     
Opening stock (W1) 0  10,000  
Production costs (@$20/unit) 40,000  64,000  
 ––––––  ––––––   40,000  74,000  Less closing inventory (@$20/unit) (W2) 10,000  14,000  
 ––––––  ––––––    30,000  60,000   ––––––  ––––––   22,500  45,000 (Under)/over-absorption (W3) (5,000)  1,000   ––––––  –––––– Gross profit  17,500  46,000 Selling and other costs     
Fixed (W4) 10,000  10,000  Variable 7,875  15,750  
 ––––––  ––––––    17,875  25,750   ––––––  –––––– Net Profit/Loss  (375)  20,250   ––––––  ––––––

54 
 (ii) 
 $ $ $ $ 
Sales  52,500  105,000 
Variable cost of sales    
Opening inventory 
(W1) 0  7,500  
Variable production costs (@$15/unit) 30,000  48,000  
 ––––––  ––––––   30,000  55,500  Less: closing inventory (@$15/unit) (W2) 7,500  10,500  
 ––––––  ––––––    22,500  45,000   ––––––  ––––––   30,000  45,000 Variable selling and other  costs 7,875  15,750 
  ––––––  –––––– Contribution  22,125  44,250 
Fixed costs     
Production 15,000  15,000  Selling etc. 10,000  10,000  
 ––––––  ––––––    25,000  25,000   ––––––  –––––– Profit/Loss  (2,875)  19,250   ––––––  –––––– 
Workings 
(W1) The closing inventory for March becomes the opening stock 
for April. 
(W2) 
 Units Units 
Opening inventory 0 500 Production 2,000 3,200 
 2,000 3,700 Less sales 1,500 3,000 
Closing inventory 500 700

Chapter 2 
 55 
 (W3) Under-/over-absorption is the difference between overheads 
incurred and overheads absorbed. 
“Overheads incurred” means act ual overheads and we are told 
that the actual fixed overheads were as expected. Therefore 
the actual overheads incurred are the same as the budgeted 
fixed overheads. Budgeted fixed overhead  
= $5 per unit × 36,000 units  = $180,000 per annum 
This works out as = $15,000 per month 
March   
Overheads incurred  15,000 
Overheads absorbed $5/unit × 2,000 units 10,000 
  ––––––– Under-absorption  (5,000) 
  ––––––– 
April   
Overheads absorbed $5/unit × 3,200 units 16,000 
  ––––––– 
Over-absorption  1,000 
  ––––––– 
(W4) Selling and other costs fixed overhead = $120,000/12 = 
$10,000 per month. 
(b) If there is no change in invent ory, the 2 systems give the same 
profit. If production is greater than sales then absorption costing 
shows the higher profit. 
Difference in profit = change in  inventory × fixed production 
overhead cost per unit In both March and April, production is greater than sales and thus 
absorption costing will show the higher profit (the smaller loss in 
March). 
Marginal costing profit/loss (2,875) 19,250 
Difference in profit   
(2,000 – 1,500) × $5 per unit 2,500  
(3,200 – 3,000) × $5 per unit  1,000 
 ––––––– ––––––– Absorption costing prof it/loss (357) 20,250 
This difference occurs because margi nal costing writes off the entire 
fixed overhead in the period incurr ed, whereas absorption costing 
carries forward some fixed production overhead into the next period 
in the valuation of closing inventory.

56 
 Missing word: lower 
Marginal costing values inventory at  a lower amount because it does not 
include fixed overheads in the valuati on. Therefore as inventory levels 
increase the value of closing inve ntory under marginal costing will be 
lower. This will give a higher co st of sales and a lower profit. 
 
 D Under-absorption occurs when the amount absorbed is less than the 
actual overheads incurred. 
 
 The over -absorbed fixed production over heads for the year were $65,000  
Absorption rate =$450,000
900,000 = $0.50/hour 
Absorbed 60,000 units × 18 hrs/unit × = $540,000 
overheads  $0.50/hour 
Actual overheads  =  $475,000 Over-absorption  =  $65,000 
 
 (a) The variable cost per uni t of product R is $36.00 per unit. 
Direct material $14 + direct labour $19 + variable overhead $3 = 
$36. 
(b) The total (full) cost of product R is $124.00 per unit. 
Variable cost $36 + fixed overhead (8 hours × $11) = $124.  
on investment is $147.68 per unit. 
Working: 
Required return from in vestment in product R  
= $600,000 × 15% = $90,000 
Required return per unit so ld = $90,000/3,800 units = $23.68 
Required selling price = $124.00 full cost + $23.68 = $147.68

Chapter 2 
 57 
 The cost-plus selling price of  one unit of product Y should be $24.80.  
Required annual return = $800,000 × 18% = $144,000 
Return as a percentage of to tal cost = 144,000/$600,000 = 24% 
Required cost-plus selling pr ice = $20 + (24% + $20) = $24.80  
 
 [Make sure that you focus your ans wer on absorption and marginal cost 
approaches to pricing (not costing). A main issue is therefore how the 
level of mark-up is determined. Your answer should take a balanced view 
of the comment in the short and long term. While it may be true in the 
short term, under certain circumstances  a price which does not generate 
a profit in the long term could not be acceptable.] 
(a) An absorption cost approach to pricing involves adding a profit 
margin to the full cost of the prod uct. The full cost is calculated by 
taking prime cost and adding a shar e of overhead which, in ML’s 
case, is absorbed using machine hours. A marginal cost approach to pricing takes the variable cost of the 
product and adds a mark-up to cover fixed cost and profit. Fixed 
overheads are not absorbed to product but are treated as a period 
cost in the accounts. 
The mark-up added using a marginal  costing approach would have 
to be greater than that under an absorption costing approach to 
ensure that the same profit leve l is achieved. Mark-ups may be 
varied depending on the market condi tions. ML’s work is unique to 
each of its customers and it may therefore be difficult to estimate a 
suitable mark-up. 
(b) The comment ‘any price that ex ceeds variable costs is better than 
no work’ may have some validity in t he short term. In the case of a 
company like ML, which has unused capacity, fixed costs will be 
incurred in the short term irrespecti ve of workload, i.e. the fixed 
costs will not change as no extra capac ity is required (for example, 
premises will not have to be expa nded in order to accommodate the 
extra production), and they can th erefore be ignored for decision 
making purposes. Any price that ex ceeds variable cost will provide 
some contribution and will reduce losses. 
Care must be taken that special prices based on variable cost do 
not become the normal expectation or  upset existing customers who 
are paying a price whic h generates a profit.

58 
 In the long run fixed cost must be covered and a profit made in 
accordance with company objecti ves. An absorption costing 
approach may not provide an accura te total product costs and an 
activity-based approach may improve the accuracy of total costs 
and enable ML to identify those products or customers which 
generate most profit. 
If resources are scarce (i.e. they  cannot easily be obtained at the 
prices or rates contained in the standard cost card) then this 
statement is not true, even in t he short term, as scarce resources 
typically cost a premium and the ma rginal cost will increase. This 
concept will be explored in the decis ion making chapter later in the 
text.

59 
Activity-based costing 
concepts 
(b) Apply costing concepts to 
different organisations and cost objects 
A3. Apply costing methods to determine the costs for different purposes (d) Activity based costing 
  Chapter 
3

60 
 
2 Modern production environments 
Modern producers have changed t he way that they produce so that they have: 
 much more machinery and computerised manufacturing systems 
 smaller batch sizes 
 less use of 'direct' labour 
This has had the following impact on production costs:  
 more indirect overheads (for exampl e, insurance and depr eciation of the 
machines and computers) 
 less direct labour costs 
This means that the traditional  methods of costing (m arginal and absorption) 
produce standard cost cards that are less useful due to inaccurate product 
costs: 
 the largest cost of production is  indirect overheads but these are 
categorised together in one figure that  lacks detail and is not useful to 
 because management does not know w hat the component s are of the 
largest production cost (indirect ov erheads) they cannot implement proper 
cost control 
 the costs are often allocated betw een products on the basis of direct 
labour hours – despite the fact that direct labour is becoming a smaller 
proportion of product costs and does not fairly reflect the relationship 
between the products and t he indirect overheads 
 because costs are inappropriately or inaccurately shared between 
products it means that the total production cost can be wrong which can 
lead to poor pricing and production decisions. 
Activity based costing (ABC) has been developed to solve the  problems that 
traditional costing methods creat e in these modern environments.

Chapter 3 
 61 
 Traditional costing problems 
 Problems with traditional absorption costing 
Traditional absorption costing char ges overhead costs to products (or 
services) in an arbitrary way. In product costing, overheads are absorbed 
on the basis of the volume of pr oduction in each production department 
or centre. The basis for setting an absor ption rate is volume-related, such 
as an overhead absorption rate per unit produced, a rate per direct labour 
hour or a rate per machine hour. 
The assumption underlying this method of costing is that overhead 
expenditure is connect ed to the volume of production activity. 
 This assumption was probably valid many years ago, when 
production systems were based on labour-intensive or machine-
intensive mass production of fairly  standard items. Overhead costs 
were also fairly small relative to  direct materials and direct labour 
costs; therefore any inaccuracy in the charging of overheads to 
products costs was not significant. 
 The assumption is not valid in a complex manufacturing 
environment, where production is based on smaller customised 
batches of products, indirect cost s are high in relation to direct 
costs, and a high propor tion of overhead activities – such as 
production scheduling, order handling and quality control – are not 
related to production volume. 
 For similar reasons, traditional ab sorption costing is not well-suited 
to the costing of many services. 
The criticism of absorption costing is that it cannot calculate a ‘true’ 
product cost that has any valid meaning. Overheads are charged to 
departments and products in an arbitrar y way, and the assumption that 
overhead expenditure is related to di rect labour hours or machine hours 
in the production departments is no longer realistic. 
Problems with marginal costing 
There are also major problems with ma rginal costing, but for different 
reasons. In marginal costing, products  or services are valued at their 
marginal cost, and profitability is a ssessed by calculating the contribution 
earned from each product or service.  Fixed costs are assumed to be 
time-related and are charged against profit s as a cost for the period. This 
can be a useful costing method w hen variable costs are a large 
proportion of total costs. The main criticisms of marginal costing as a method of measuring 
product costs and prof itability are that: 
 variable costs might be small in relation to fixed costs 
 ‘fixed’ costs might be fixed in re lation to production volume, but they 
might vary with other activities t hat are not volume-related or even 
production-related. 
In many manufacturing and service environments, it  is therefore 
inappropriate to treat ov erhead costs as fixed per iod costs, and they 
should be charged to products or serv ices in a more meaningful way

62 
3 Activity-based costing 
Activity-based costing (ABC) is an alternat ive approach to product costing. It is 
a form of absorption costing, but , rather than absor bing overheads on a 
production volume basis, it fi rstly allocates them to cost pools  before absorbing 
them into units using cost drivers.  
 A cost pool  is an activity that consumes resources and for which 
overhead costs are identified and allo cated. For each cost pool, there 
should be a cost driver. 
 A cost driver  is a unit of activity that cons umes resources. An alternative 
definition of a cost driver is a fa ctor influencing the level of cost 
 
 Imagine the machining department in  a traditional absorption costing 
system. The OAR would be based on machine hours because many of 
the overheads in the machine department  would relate to the machines, 
e.g. power, maintenance, machine deprec iation, etc., so using a machine 
hour basis would seem fair. However, not only does the machine 
department have machine related costs, but also in an absorption costing 
system, it would also have picked up a share of rent and rates, heating, 
lighting, building deprecia tion, canteen costs, pers onnel cost, etc. These 
costs would also be absorbed on a machine hour basis, because everything in the machine department  is absorbed on machine hours and 
whilst this is fair for power, main tenance and machine depreciation, it is 
inappropriate for the other costs. 
ABC overcomes this problem by not using departments as gathering 
points for costs, but instead using activities, and there would, for 
example, be a machine-related activity  to which power would be charged, 
machine depreciation would be charged, and machine maintenance would be charged. It would not pick up a share of personnel costs or rent 
or rates or indeed anything not machi ne related. ABC's flexibility thus 
reduces the incidence of arbitrary appor tionments.

Chapter 3 
 63 
 Identifying activities and drivers 
 If a business decides to adopt activity-based costing to measure the 
costs and profitability of its products or  services, it must identify the key 
activities that consume resources and the cost driver for each of those 
 There might be a large number of different activities, but in an 
accounting system it is usually necessary to simplify the overhead 
cost analysis and select a fairly sma ll number of activities. If a large 
number of activities are identif ied and used in ABC, the task of 
analysing costs becomes more complex and time-consuming, and 
the value of the additional accura cy might not justify the cost and 
effort. 
 For any activity there might be just one cost driver or several 
different cost drivers. Where there are several cost drivers, it is 
necessary to select just one for the purpose of ABC analysis. 
Identifying activities 
The main activities that consume overhead resources differ from one type 
of business to another. A useful approach to identifying suitable activities 
within a business is to consider four different categories of activity or 
transaction: 
 Logistical transactions.  These are activities or transactions 
concerned with moving materials or people, and with tracking the 
progress of materials or work through the system. 
 Balancing transactions.  These are concerned with ensuring that 
the resources required for an operati on are available. For example, 
the buying department has to make sure that raw materials are 
available to meet pr oduction requirements. 
 Quality transactions.  These are concerned with ensuring that 
output or service levels meet quality requirement s and customer 
expectations. Inspections and hand ling customer complaints are 
both examples of quality transactions. 
 Change transactions.  These are activities required to respond to 
changes in customer demand, a c hange in design specifications, a 
scheduling change, a change in produc tion or delivery methods, and 
so on. 
For any business, there could be impor tant resource-consuming activities 
in each of these categories.

64 
 Identifying cost drivers 
For each selected activity, there shoul d be a cost driver. The chosen cost 
driver must be: 
 Relevant.  In other words, there s hould be a connection between the 
cost driver and the c onsumption of resource s for the activity. 
 Easy to measure.  Measuring the units of co st driver and identifying 
the products or services to which they relate needs to be a fairly 
easy and straightforward process. 
Often, the cost driver is the number of  transactions relating to the activity. 
 the cost of setting up machinery for a production run might be driven 
by the number of set-ups (j obs or batches produced) 
 the cost of running machines might be driven by the number of 
machine hours for which the machines are running 
 the cost of assembling the pr oduct may be based on the number of 
direct labour hours 
 the cost of order processing mi ght be related to the number of 
orders received 
 the cost of dispatch might be re lated to the number of orders 
dispatched or to the wei ght of items dispatched 
 the costs of purchasing might be related to the number of purchase 
orders made 
 the costs of quality control might  be related to the number of 
inspections carried out, or to t he incidence of rejected items. 
It is possible to identify three types of cost driver: 
Transaction drivers 
Here, the cost of an activity is affe cted by the number of times a particular 
action is undertaken. Examples would include number of set-ups, number 
of power drill operations, number of batches of ma terial received, number 
of purchase orders, etc. 
Duration drivers 
In this case, the cost of the activity  is not so much affected by the number 
of times the action is undertaken as by the length of time that it takes to 
perform the action, e.g. set-up costs ma y not be related to the number of 
set-ups so much as to the set-up time, because some products involve 
more complicated and time cons uming set-ups than others. 
Intensity drivers In this case, efforts would be dire cted at determining what resources 
were used in the making of a product or  service, e.g. rather than charging 
all purchase orders with the same co st per order, we might determine 
that overseas orders involve mo re work than home orders and apply a 
weighting to the overseas order s to reflect the extra work.

Chapter 3 
 65 
Calculating the full producti on cost per unit using ABC 
There are five basic steps to calculating an activity based cost: 
Step 1: Group production overheads into activities, according to how 
they are driven. 
 A cost pool is the grouping of cost s relating to a particular activity 
which consumes resources and for which overhead costs are 
identified and allocated. For each cost pool, there should be a cost driver. 
Step 2: 
 Identify cost drivers for each activity, i.e. what causes these 
activity costs to be incurred. 
 A cost driver is a factor that infl uences (or drives) the level of cost. 
Step 3: Calculate a cost dr iver rate for each activity. 
 The cost driver rate is calculated in the same way as the absorption 
costing OAR. However, a separate co st driver rate will be calculated 
for each activity, by taking the acti vity cost and dividing by the cost 
driver information. 
Step 4: Absorb the activit y costs into the product. 
 The activity costs should be absor bed by applying the cost driver 
rate into the individual products. 
Step 5: Calculate the full production cost and/ or the profit or loss. 
 Some questions ask for the product ion cost per unit and/ or the 
profit or loss per unit. 
 Other questions ask for the total production cost and/or the total 
 
 Example 1 
 A manufacturing business makes a produc t in two models, model M1 and 
model M2. Details of the two products are as follows. 
 Model M1 Model M2 
Annual sales 8,000 units  8,000 units  
Number of sales orders 60 250 
Sales price per unit $54 $73 
Direct material cost per unit $11 $21 Direct labour hours per unit 2.0 hours 2.5 hours 
Direct labour rate per hour $8 $8 
Special parts per unit 2 8 Production batch size 2,000 units 100 units 
Setups per batch 1 3

66 
  $ Cost driver 
Setup costs 97,600 Nu mber of setups 
Material handling costs 42, 000 Number of batches 
Special part handling costs 50,000  Number of special parts 
Invoicing 31,000 Number of sales orders 
Other overheads 108,000 Direct labour hours 
 ––––––––  Total overheads 328,600  
 ––––––––  
A customer has indicated an interest in placing a large order for either 
model M1 or M2, and the sales manager  wished to try to sell the higher-
priced model M2. 
Required: 
(a) Calculate the profit per unit for each model, using ABC. 
(b) Using the information above id entify which product the sales 
manager should try to sell on the basis of the information provided 
by your ABC analysis. 
 
 ABC in service industries 
 Activity based costing was originally developed for manufacturing 
industries. But it has now gained widespread use in many service 
organisations such as hospitals, accountancy practices, banks and 
insurance companies. It is just as important for these businesses to 
control costs, maximise the use of re sources and improve pricing as it is 
in a manufacturing business. 
Boomer Jones is a firm of business advis ors. It offers two services to its 
clients – tax advisory services (TAS) and business advisory services 
(BAS). Revenue from service is expec ted to be $3m. The cost for each 
service is budgeted as follows: 
 TAS BAS 
 $ $ Direct labour 300,000 400,000 
Overheads (W1) 3,000,000 2,000,000 
 ––––––––– ––––––––– Total costs 3,300,000 2,400,000 
Revenue 3,000,000 3,000,000 
 ––––––––– ––––––––– Profit/(loss) (300,000) 600,000

Chapter 3 
 67 
 Workings 
(W1) Overhead recovery rate 
Total budgeted overheads = $5m 
Total budgeted direct labour hour s = 25,000 hours (15,000 hours in 
TAS, 10,000 hours in BAS) Recovery rate per hour of service provided = $200 per hour 
Budgeted overheads include material costs within the firm which are negligible. 
Switch to ABC 
As labour costs have become a lesser proportion of total costs and 
overheads have become more significant, Boomer Jones wants to examine a switch to activity based costing (ABC). The finance director has put together the following information on overheads: 
   Drivers 
 Cost ($) Cost Driver TAS BAS 
Marketing 500,000 Number of  client lunches 500 3,500 
Client 
meetings 1,000,000 Number of clients 9,000 1,000 
Data input 1,500,000 Co mputer hours 10,000 5,000 
Analysis and 
research 1,500,000 Research h ours 5,000 10,000 
Training and 
development 500,000 Number of staff 1,000 1,000 
This has allowed the finance direct or to re-allocate the overheads and 
create a new charge out rate  for clients as follows: 
 TAS BAS 
 $ $ 
Direct labour 300,000 400,000 Overheads   
Marketing 62,500 437,500 Client meetings 900,000 100,000 Data input 1,000,000 500,000 
Analysis of research 500,000 1,000,000 
Training and develop ment 250,000  250,000  
 ––––––––– ––––––––– Total costs 3,012,500 2,687,500 
 ––––––––– ––––––––– Profit/(loss) (12,500) 312,500

68 
 Boomer Jones now has a bette r understanding of its costs. TAS 
continues to make a loss but Boomer Jones now better understands the 
reasons behind it. It could, for example, seek out ways to reduce the amount of computer hours needed for client work by either training staff 
to use the computers more efficient ly or seeking out more efficient 
software. 
From this illustration it can be seen how service organisations can get 
great benefit from a switch to activity based costing. 
4 When is ABC relevant? 
ABC is a more expensive system to operate than traditional costing, so it should 
only be introduced when it is appropriate to  do so. Activity-based costing could 
provide much more meaningful informa tion about product costs and profits 
when: 
 indirect costs are high re lative to direct costs 
 products or services are complex 
 products or services are tailored to customer specifications 
 some products or services are sold in large numbers but others are sold in 
small numbers. 
In these situations, ABC will often result  in significantly different product or 
service overhead costs, compared wit h traditional absor ption costing. 
The difference between traditional co sting and ABC costing will also be 
dependent on the makeup of the overhead cost. Overhead costs can be divided 
into 4 different types of activities 
(i) Unit-level activities – where the cons umption of resources is very strongly 
correlated with the number of units produced. 
(ii) Batch-level activities – where t he consumption of resources is very 
strongly correlated with the number of batches produced. 
(iii) Product-level activities – where c onsumption of resources may be related 
to the existence of particular products. 
(iv) Facility-level activities – where th e cost cannot be related in any way to the 
production of any parti cular product line.

Chapter 3 
 69 
 Comparison to traditional costing 
 Any unit cost, no matter how it is der ived, can be misinter preted. There is 
temptation to adopt a simplistic approac h, which would say, for example, 
that if it cost $1,000 to  produce ten units, it will cost $10,000 to produce 
100 units. As we know, this in incorre ct in the short term, owing to the 
existence of short-term fixed costs. The ABC approach does not 
eliminate this problem anymore than the traditional approach. The 
alternative to presenting full absorpti on costing information in a traditional 
costing system has been to provide the user with a marginal costing 
statement which disti nguishes clearly between the variable cost of 
production and the fixed cost of production.  This carries an implication for 
the decision-maker that if the vari able cost of production is $50 for 10 
units, the additional cost of produci ng a further 40 units will be 40 × $5 = 
$200. 
Activity-based costing, on the other  hand, can provide the user with a 
more sophisticated breakdown of cost. This breakdown relates cost to the 
level of activities undertaken. The st ructure of reporting will vary from 
company to company, but Cooper (1992)  has suggested that four levels 
of activity, which he terms a hierar chy of cost, will commonly be found in 
practice. These are shown below: (i) Unit-level activities.  These are activities wh ere the consumption of 
resources is very strongly corre lated with the number of units 
produced. Costs traditionally defined as  direct costs would fall into 
this category, for example dire ct material and direct labour. 
(ii) Batch-level activities.  Some activities – for example, machine set- 
up, materials handling and batch ins pection – consume resources in 
proportion to the number of batch es produced, rather than in 
proportion to the number of units  produced. By identifying the 
consumption of resources at a batc h rather than a unit level, it is 
easier than in a traditional costing system for a user to visualise the 
changing cost that will come about in the long term by changing a 
product mix or production schedule. 
(iii) Product-level activities.  Consumption of resources by, for example, 
administration, product s pecification or purchasing may be related to 
the existence of particular products. If the activity is performed to 
sustain the existence of a particular product line, it is a product-level 
activity. 
(iv) Facility-level activities.  Even within an ABC system, it is accepted 
that there are some costs that rela te simply to being in business and 
that therefore cannot be related in  any way to the production of any 
particular product line. Grounds ma intenance, plant security and 
property taxes would be exampl es of this type of cost.

70 
 Consideration of (i)–(iv) shows t hat the difference between traditional 
costing and ABC costing will be d ependent on the proportion of overhead 
cost that falls into each of the four  categories. If this overhead is made up 
primarily of (i) and (iv), it is obvious  that the tradition al approach and the 
ABC approach will lead to very similar product costs. However, if the bulk 
of overhead cost falls into category ( ii) and/or category (iii), there will be a 
very significant differe nce between the two. 
The debate as to whether ABC is actua lly a new technique, or whether it 
simply encourages a more accurate tr acing of costs to products in a 
manner that is perfectly consistent  with the tradition al approach, is 
interesting but sterile – and misses t he point of ABC, as is demonstrated 
in the rest of this chapter. Neverthele ss, it is worth pointing out that ABC 
product costs are full absorption costs and, as such, suffe r from the same 
type of deficiencies in a decision -making context as do traditional full 
absorption costs – they are histor ical, based on current methods of 
organisation and operation and, at t he level of the product, contain 
allocations of joint/common costs, etc. 
However, it can be strongly argued t hat ABC has an important ‘attention-
directing’ role to play in both cost management and decision-making. 
ABC is defined in the CIMA Official Terminology as: 
an approach to the costing and monitoring of activities which involves tracing resource consum ption and costing final outputs. 
Resources are assigned to activities , and activities to cost objects 
based on consumption estimates. T he latter utilise cost drivers to 
attach activity costs to outputs. 
In decision-making, it is arguable that activity-based costs are much more 
helpful than traditional costs in determining the costs relevant for 
decision-making and, more particularly, in drawing attention to the likely 
impact on long-run variable cost s of short-term decisions. 
Advantages and disadvantages of ABC 
 
 more accuracy  not always relevant 
 better cost understanding  still need arbitrary cost allocations 
 fairer allocation of costs  need to choose appropriate drivers 
and activities 
 better cost control  complex 
 can be used in complex 
situations  expensive to operate 
 can be applied beyond 
production  
 can be used in service 
industries

Chapter 3 
 71 
 Advantages and disadvantages of ABC 
 ABC has a number  of advantages: 
 It provides a more accurate cost per unit. As a result, pricing, sales 
strategy, performance management and decision making should be 
improved (see next section for detail). 
 It provides much better insight in to what drives overhead costs. 
 ABC recognises that overhead costs are not all related to production 
and sales volume. 
 In many businesses, overhead costs are a significant proportion of 
total costs, and management needs  to understand the drivers of 
overhead costs in order to manage the business properly. Overhead 
costs can be controlled by managing cost drivers. 
 It can be applied to derive realistic costs in a complex business 
 ABC can be applied to all over head costs, not just production 
overheads. 
 ABC can be used just as easily in service costing as in product 
costing. 
Disadvantages of ABC: 
 ABC will be of limited benefit if  the overhead costs are primarily 
volume related or if the overhead is  a small proportion of the overall 
cost. 
 It is impossible to allocate all overhead costs to specific activities. 
 The choice of both activities and cost drivers might be inappropriate. 
 ABC can be more complex to ex plain to the stakeholders of the 
costing exercise. 
 The benefits obtained from ABC mi ght not justify the costs. 
The implications of switching to ABC 
The use of ABC has potentially si gnificant commercial implications: 
 Pricing can be based on more realistic cost data. 
– Pricing decisions will be impr oved because the price will be based on 
more accurate cost data 
 Sales strategy can be more soundly based. 
– More realistic product costs as a result of the use of ABC may enable 
sales staff to: 
– target customers that appeared unprofitable using absorption 
costing but may be pr ofitable under ABC 
– stop targeting customers or market segments that are now 
shown to offer low or negative sales margins.

72 
 Decision making can be improved. 
– Research, production and sales effort  can be directed towards those 
products and services which ABC has identified as offering the 
highest sales margins. 
 Performance management  can be improved. 
– Performance management should be enhanced due to the focus on 
selling the most profitable product s and through the control of cost 
drivers. 
– ABC can be used as the basis of budgeting and longer term forward 
planning of overhead costs. The more realistic budgeted overhead 
cost should improve the system of performance management.

74 
6 Practice questions 
 An organisation has a single production process with expected material 
receipt and inspection costs of $35, 000 for the next period. The following 
budgeted information has been obtained for the period: 
 Product Product Product 
 A B C 
Production quantity (uni ts) 2,000 1,500 800 
Batches of material 20 10 5 
The organisation uses an acti vity based costing system. 
The amount of material and inspection costs attributed to Product B in the 
period will be: 
A $6.67 B $6.98 C $10.89 D $19.97 
 
 PB manufactures and sells three pr oducts, E, G and F. Budgeted costs 
for machine running time for the next year are $4,560,000. 
The following information is given on budgeted plans for each product: 
 E F G 
Production quantity (uni ts) 5,000 4,000 6,000 
Machine hours per unit 2 4 2 
Labour hours per unit 1 2 4 Machine set ups 10 6 8 
To the nearest $, the machine runni ng cost per unit for Product F using 
activity based costing will be $_____

Chapter 3 
 75 
 A bank regularly samples business cu stomer accounts and reviews these 
for risks to the bank. These review co sts totalled $1,050, 280 in the last 
period. The following budgeted information has been obtained for the 
period: 
 Sole traders Partnerships Companies 
Number of customers 250,000 10,000 90,000 
Number of reviews 100,000 3,000 18,000 
The bank uses an activity based costing system. 
To the nearest $, the total amount of re view costs attributed to sole trader 
customers is $_____ 
 
 A company manufacturers three pr oducts with total production overheads 
of $2,600,000. The company uses an ABC system and has identified 
associated cost drivers: 
Activity cost pool Cost driver Cost 
associated 
with activity 
cost pool 
Receiving/inspecting quality 
assurance Purchase requisitions $1,400,000 
Production scheduling/machine 
set-ups Number of batches $1,200,000 
Details on the three products are as follows 
 P R S 
Number of customers 10,000 20,000 30,000 
Number of reviews 1,200 1,800 2,000 
Number of set ups 240 260 300 
The receiving/inspecting quality assu rance cost per unit attributed to 
product P is: 
A $25.20 B $33.60 C $36.00 D $280.00

76 
cost pool 
set-ups Number of bat ches $1,200,000 
 P R S 
Production (units) 10,000 20,000 30,000 
Number of purchase r equisitions 1,200 1,800 2,000 
The charge out rate for production  scheduling/machine set-ups used to 
attribute the cost to product S is $_____ 
 
 An organisation has a single produc tion process with expected material 
handling costs of $13,650 for the next period. 
The following budgeted information has  been obtained for the period: 
 X Y Z 
Production quantity (units) 2,000 1,500 800 
Batches of material 10 5 16 Data per product unit 240 260 300 
Direct material (sq. metres) 4 6 3 
Direct material ($) 5 3 6 
The organisation uses an activity based costing system and the cost 
driver for material handling is t he quantity of material (sq. metres) 
handled. 
The amount of material handling cost s attributed to Product X in the 
period will be: A $2.81 B $2.83 C $14.05 D $14.15

Chapter 3 
 77 
 A small accountancy firm provides three services as follows: 
 Statutory 
audit Tax 
services Other 
services 
Budgeted services 5,000 10,000 40,000 
Budgeted labour hours per service 18 2 4 
Average number of  reviews per 
service 3 0.5 2 
Other services include services such as pension planning, business 
consultancy and business valuations. 
The budgeted activity cost for reviews was $55,000. To the nearest cent, if an ABC system  is used by the accountancy firm, 
how much review cost is attac hed to each statutory audit service? 
A $0.55 
B $1.65 C $3.00 D $3.67
 
 Machine set up costs are likely to be classed as which type of activity in 
the hierarchy of costs? A Unit level activity B Batch level activity C Product level activity D Facility level activity
 
 Scenario 
Fixed overhead absorption rates are often calculated using a single 
measure of activity. It is suggested that fixed overhead costs should be 
attributed to cost units using multiple measures of activity (Activity Based 
Costing). 
Task 
Explain Activity Based Costing and how  it may provide useful information 
to managers. 
(Your answer should refer to both the setting of cost driver rates and 
subsequent overhead cost control). 
(Time allowed: 10 minutes)

78 
 Explain the benefits of using multiple  activity bases for variable overhead 
absorption. 
(Time allowed: 10 minutes ) 
 
 Explain the factors that should be c onsidered when selecting cost drivers 
for an activity based costing system. 
 (Time allowed: 10 minutes ) 
 
 Scenario  
An organisation manufactures three pr oducts in a single process. It has 
used absorption costing in the pas t and absorbed overheads on the basis 
of direct labour hours. It has prepared the following standard cost card for 
each product on that basis: 
 X Y Z 
Direct material 5.00 3.00 6.00 Direct labour 3.60 6.00 9.00 
Production overhead 7.53 12.50 18.75 
 –––––– –––––– ––––––  $16.10 $21.50 $33.75 
The accountant has proposed a switch to activity based costing and has 
prepared revised standard cost ca rds on that basis as follows: 
 X Y Z 
Direct material 5.00 3.00 6.00 
Direct labour 3.60 6.00 9.00 
Production overhead    Material receipt/inspection 2.52 1.69 10.08 
Process power 6.46 3.23 2.15 
Material handling 2.61 4.22 2.11  –––––– –––––– –––––– 
Cost per unit $20.39  $18.13 $29.32 
 –––––– –––––– ––––––

Chapter 3 
 79 
 Process power has been charged to pr oducts on the basis of the number 
of drill operations carried out on eac h product. A cost driver for drill 
operations of $1.0773 has been determined. 
Task: 
Using the power drill costs as an illustra tion, explain the relevance of cost 
drivers in activity based costing. 
(Time allowed: 10 minutes) 
 
 Scenario Cabal makes and sells two products, Plus and Doubleplus. The direct 
costs of production are $12 for one unit of Plus and $24 per unit of Doubleplus. 
Information relating to annual produc tion and sales is as follows: 
 Plus Doubleplus 
Annual production and sales 24,000 units 24,000 units 
Direct labour hours per unit 1.0 1.5 
Number of orders 10 140 
Number of batches 12 240 Number of setups per batch 1 3 Special parts per unit 1 4 
Information relating to producti on overhead costs is as follows: 
 Cost driver Annual cost 
  $ Setup costs Number of setups 73,200 
Special parts handling Number of special parts 60,000 
Other materials handling Num ber of batches 63,000 
Order handling Number of orders 19,800 
Other overheads – 216,000   ––––––   432,000 
  –––––– 
Other overhead costs do not have an identifiable cost driver, and in an ABC 
system, these overheads would be recove red on a direct l abour hours basis

80 
 The following cost cards were created for the products using a traditional 
absorption costing system: 
 $ $ 
Direct costs 12.00 24.00 
Production overhead  7.20 10.80  –––––– –––––– 
Full production cost 19.20 34.80 
The accountant has also prepared the following standard cost card to 
support a suggestion that the company switch to an ABC costing system: 
 $ $ Direct costs 12.00 24.00 Production cost per unit 4.33 13.67 
Full cost 16.33 37.67  –––––– –––––– 
Tasks: 
(a) Explain the reasons for the diffe rences in the production cost per 
unit between the two methods. 
(b) Explain the implications fo r management of us ing an ABC system 
instead of an absorpt ion costing system. 
(Time allowed: 10 minutes)  
Note: 
 $ $ 
Assume the selling prices are $25.00 $40.00 
Using absorption costing sales margins are 23.2% 13.0% 
ABC sales margins are 34.7% 5.8%

Chapter 3 
 81 
 Example 1 
 Solution 
(a) 
Workings M1 M2 Total 
Number of batches 4 80 84 
Number of setups 4 240 244 
Special parts 16,000 64,000 80,000 
Direct labour hours 16,000 20,000 36,000 
 
Activity Cost  M1 M2 
 $  $ $ 
Setups 97,600 Cost per  setup $400 1,600 96,000 
Materials 
handling 42,000 Cost per bat ch $500 2,000 40,000 
Special parts handling 50,000 Cost per part $0.625 10,000 40,000 
Invoicing 31,000 Cost per order $100 6,000 25,000 
Other overheads 108,000 Cost per hour  $3 48,000 60,000 
 ––––––  –––––– –––––– 
 328,600  67,600 261,000 
 
 M1 M2 
 $ $ $ $ 
Sales   $432,00   584,000  
Direct materials 88,000   168,000   
Direct labour  128,000   160,000   
Overheads  67,600   261,000   
 ––––––  ––––––  Total costs  
283,600   589,000  
  ––––––  –––––– 
Profit/(loss)   148,400   (5,000) 
Profit/loss per unit  18.55   (0.625) 
  ––––––  ––––––

82 
 (b) The figures suggest that model M2 is less profitable than M1. The 
sales manager should try to persu ade the customer to buy model 
M1. Note that the apparent loss on M2 does not necessarily mean 
that production should be ceased.  To assess this management 
should consider the incremental rele vant cash flows involved – e.g. 
is the product making positive co ntribution, how many overheads 
are avoidable? They could also c onsider ways to reduce the cost 
drivers for the product to reduce its share of the overheads and 
convert the product loss into a profit. 
 
 Firstly a cost driver must be det ermined. For material receipts and 
inspections this is likely to be bas ed on the number of batches produced: 
Material receipt and inspection  =$35,000	
20 + 10 + 5=	$1,000 per batch 
These should then be charged to eac h product. For product B, the cost 
per unit will be: 
Product Y  $1,000/batch × 10 batches/1,500 units  = $6.67/unit Option A is the correct answer 
 
 Machine running time cost is likely to be driven by the machine hours. 
Total number of machine hours 
 E G F 
Machine hours (Production units × 
hours per unit) 10,000 16,000 12,000 
Charge out rate = $4,560,000/38,000 ma chine hours = $120 per machine 
hour 
Cost per unit for Product F = $120 per  machine hour × 2 hour per unit = 
$240

Chapter 3 
 83 
 Firstly a cost driver must be determined for the review costs: 
 
Review costs driver rate  =$1,050,280 	
100,000 + 3,000 + 18,000=	$8.68 per review 
 
The total amount charged to sole trader accounts will be: Product Y  $8.68 per review × 100,000 reviews  = $868,000  
 
 Cost driver rate: 
Receiving/inspecting quality assurance 	(based on purchase requisitions) 	=$1,400,000 	
5,000=	$280 
Charge to product P = $280 × 1,200/10,000 = $33.60 Option B is the correct answer. 
 
Production scheduling/machine set-ups (based on number of set-ups)  =$1,200,000 	
800=	$1,500 
 
 Firstly a cost driver must be determined: 
 
Material handling  = 	$13,350 
(2,000 × 4) + (1,500 	× 6) + (800 × 3)  
  = $0.70361 per sq. metre handled 
 
These should then be charged to eac h product. For product X, the cost 
per unit will be: Product X $0.70361/m
2 of material × 4m2 = $2.81 
Option A is the correct answer.

84 
 The most appropriate cost driver  for reviews woul d be the number of 
reviews per service. 
Total number of reviews = (5,000 × 3)  + (10,000 × 0.5) + (40,000 × 2) = 
100,000 Cost per review = $55,000/100,000 = $0.55 The review cost for statutory audit services = $0.55 × 3 = $1.65 
The correct answer is option B. 
 
 Machines are likely to be set-up fo r production of a batch of units. The 
associated costs would t herefore be classed as a batch level activity. 
Option B is the correct answer. 
 
 Activity Based Costing (ABC) is a system of full costing which recognises 
that the more traditional method of abs orption costing using cost centre 
absorption rates may not prov ide accurate product costs. 
ABC identifies the activities of a production process and the extent to 
which individual products make use of  those activities. Costs are then 
estimated for each of these activities which are referred to as cost pools. 
The number of times which the activity  is expected to be carried out is 
also estimated and a cost driver rate calculated:  
Estimated cost of  pool
Estimated number of times activity is to be performed   
 An individual product will probably ma ke use of a number of different 
activities, and a proportion of the cost of each activity will be attributed to 
the product using these predete rmined cost driver rates. 
The actual costs of each cost pool together with the num ber of times the 
activity is performed will be colle cted and a comparison made with the 
corresponding estimated values. This is similar to the comparison of 
actual and budgeted costs and volumes using the traditional absorption 
costing approach except that there are likely to be a greater number of 
cost driver rates using ABC than the one per cost centre absorption rate 
found in traditional absorption costing.

Chapter 3 
 85 
 Such an approach is beneficial because it identifies overhead costs with 
their cause, rather than assuming t hat they are all driven by a single 
cause. 
This should enable management to control such costs more easily, the 
variances reported will be more meaningful and this will help management to control costs. 
 
 The cost driver for a particular activi ty is the factor t hat causes a change 
in the cost of the activity . For the cost driver to be useful there must be an 
identifiable relationship between the co st and the cost dr iver, i.e. changes 
in the number of cost drivers must  cause corresponding changes in the 
total cost incurred on the activity. 
Another major consideration is the ease of accurately recording the 
number of cost drivers incurred. If the process of recording the cost 
drivers is very complex and time -consuming then the cost of the 
recording system might outweigh the benefits derived from the information obtained. 
 
 A cost driver is that factor which is most clos ely related to the way in 
which the costs of an activity are incu rred. It could be said to cause the 
costs. Under ABC an organisation does not  need to restrict itself to just 
one overall overhead absorption rate . An organisation can choose 
whatever basis it considers suitable  to charge overheads to the product. 
Examining process power in this  organisation, under traditional 
absorption costing Product Z was the dearest for process power merely 
because it used the most labour hours per unit – a fact completely and 
utterly unconnected with the way in which process power costs are incurred. Under ABC the accountant has  likely investigated the business 
and actually taken the time to find out what factor is most closely related 
to the cost and use that factor to charge overheads. The outcome is that 
Product X should be the dearest because it uses the most power drill 
ABC supporters would argue that this cost/power drill operation is useful 
information. The costs of power dr ill operations for product X is not 
insignificant and in fact is nearly as mu ch as the direct material cost and 
direct labour cost comb ined. It would be inconcei vable that the direct 
material costs and direct labour costs would not be very carefully 
controlled and yet under traditional absor ption costing the process power 
costs would be included within the general overheads and would not be 
subject to such severe scrutiny.

86 
 Under ABC, once we realise that power drill operations cost $1.0773 
each then when designing new products , the organisation would have 
better cost information and thus would be able to make better informed 
 
 (a) The reasons for the difference in  the production cost per unit 
between the two methods  
– The allocation of overheads under absorption costing was 
unfair. This method assumed that  all of the overheads were 
driven by labour hours and, as a result, the Double Plus 
received 1.5 times the production overhead of the Plus. 
– However, this method of absorption is not appropriate. The 
overheads are in fact driven by a number of different factors. 
There are five activity costs, each one has its own cost driver. By taking this into account we end up with a much more accurate production overhead cost per unit. 
– Using ABC, the cost per unit of a Double Plus is significantly 
higher. This is because the Double Plus is a much more complex product than the Plus. For example, there are 140 
orders for the Double Plus but only 10 for the Plus and there 
are 4 special parts for the D ouble Plus compared to only one 
for the Plus. As a result of this  complexity, the Double Plus has 
received more than three time s the overhead of the Plus. 
– This accurate allocation is important because the production 
overhead is a large proporti on of the overall cost. 
(b) The implications of using ABC  
– Pricing – pricing decisions will be improved because the price 
will be based on more accurate cost data. 
– Decision making – this should also be improved. For example, 
research, production and sales effort can be directed towards the most profitable products. 
– Performance management – sh ould be improved. ABC can be 
used as the basis of budgeting and forward planning. The 
more realistic overhead should result in more accurate budgets and should improve the process of performance 
management. In addition, an im proved understanding of what 
drives the overhead costs should result in steps being taken to reduce the overhead costs and hence an improvement in 
– Sales strategy – this should be more soundly based. For 
example, target customer s with products that appeared 
unprofitable under absorption co sting but are actually 
profitable, and vice versa.

87 
Other costing techniques 
A2. Costing concepts (b) Costing concepts for 
cost objects. 
A3. Costing methods (e) Digital costing 
  Chapter 
4

88 
 
Previous chapters have looked at the most common costing methods used by 
organisations. However, there are other costing methods which may be used by 
organisations, either because it suits t he way that the organi sation operates or 
because the organisation wants to more  fully understand its costs. Better 
costing methods may lead to better decision making. 
2 Joint product costing 
The purpose of costing is to calculat e the cost of each cost unit of an 
organisation's products. In order to do this the costs of each unit should be 
gathered together and recorded in  the costing system. This is the overall aim, 
but the methods and system used will differ from organisation to organisation as 
the type of products and production met hods differ between organisations. 
There are two main types of costing system: 
 Specific order costing , where the costs of distinct products or services 
are collected. Individual cost units ar e different according to individual 
customer’s requirements. The main ex ample of specific order costing is 
job costing where costs are attribut ed to a specific job (such as, for 
example, the cost of providing a service to one particular client).  
Batch costing is also a form of s pecific order costing, although costs will 
be attributed to specific batches rather  than specific order s or customers.  
These costing systems are usually asso ciated with absorption or activity 
based costing methodology, and the cost s calculated for each batch or 
each job produced are normally a fully absorbed production cost. 
 Continuous costing , where a series of similar products or services are 
produced. Costs are collected and aver aged over the number of products 
or services produced to arrive at a co st per unit. An example of continuous 
costing is joint product costing.

Chapter 4 
 89 
 Cost units 
 The cost units of different organisations  will be of different types and this 
will tend to necessitate different cost ing systems. The main types of cost 
unit are as follows: 
 Individual products designed and pr oduced for individual customers. 
Each individual product is a co st unit. Job costing is used. 
 Groups of different products possibl y in different styles, sizes or 
colours produced to be held in inventory until sold. Each of the 
batches of whatever style, size or colour is a cost unit. Batch costing 
is used. 
 Many units of identical products  produced from a single production 
process. These units will be held in inventory until sold. Each batch from the process is a cost unit. Process costing is used. Process costing often requires the use of joint product costing 
 
Some products may be produced at the sa me time in the same process before 
being separated for sale or further indi vidual processing. These products are 
known as joint products and the separation point is known as the split-off point. 
For example, different types of car bonated drinks might use a common starting 
process where syrup, sweeteners and malt  are added before they are split up 
and individual flavourings added. Joint costs are the total of the raw mate rial, labour, and overhead costs incurred 
up to the initial split-off point.  
 
Joint costs and common costs 
 A joint cost is the cost of a proc ess that results in more than one main 
product. A common cost is a cost re lating to more than one product or 
service. The term ‘joint cost’ refers to the co st of some common process before a 
split-off point after which various joint products and by-products can be 
identified. ‘Common costs’ is a wider  term that need not relate to a 
process. For example, the absorpti on of fixed production overheads in 
total absorption costing described in an earlier chapter is an example of 
assigning common costs to cost units. 
The joint costs can not normally be direct ly attributable to individual joint 
products or by-products. Therefore, arbitr ary allocations may have to be used 
instead.

90 
 Joint products and by-products 
 The nature of process costing is t hat the process incurs joint costs and 
often produces more than one product. These additional products may be 
described as either joint products or  by-products. Essentially joint 
products are all the main products, wher eas by-products are incidental to 
the main products. 
 Joint products are two or more  products produced by the same 
process and separated in processi ng, each having a sufficiently 
high saleable value to merit recognition as a main product. 
 A by-product is output of some value produced incidentally in 
manufacturing something else (main product). 
These definitions still leave scope for subjective judgement, but they 
provide a basis for such judgement. The distinction is important because 
the accounting treatment of joint and by-products differs. Costs incurred 
in processing prior to the separat ion of the products are known as joint 
costs. 
 
Methods of joint cost apportionment 
There are many ways in which joint costs can be apportioned to products such 
as: 
 physical measurement 
 market value at point of separation 
 net realisable value/net relative sales value 
In turn, the methods will result in differ ent inventory valuations and, therefore, 
different recorded profits.

Chapter 4 
 91 
 Further details and explanation 
 Accounting for joint products 
Joint products are, by definition, subject to individual accounting 
procedures. 
Joint costs will require apportionment  between products for inventory 
valuation purposes. The main bases for appointment are as follows: 
 Physical measurement of joint products:  Joint costs can be 
apportioned to the units of output  of each joint product. When the 
unit of measurement is different, e. g. litres and kilos, some method 
should be found of expressing them in a common unit. Some joint 
costs are not incurred equally for a ll joint products: such costs can 
be separated and apportioned by intr oducing weighting factors. 
Alternatively, a technical estimate  of relative usage by each product 
may be made by the organisation. 
 Market value:  Joint costs can be apportioned on the basis of the 
market value of each joint product at the point of separation. The effect is to make each product appear to be equally profitable. 
 Net realisable value : Where certain products are processed after the 
point of separation, further proc essing costs may be deducted from 
the market values before joint costs are apportioned. 
It is essential to realise that apportionment is, of necessity, an arbitrary calculation and product cost s that include such an apportionment can be 
misleading if used as a basis for decision-making. 
Accounting for by-products 
Either of the following methods ma y be adopted: the proceeds from the 
sale of the by-product may be treated as pure profit, or the proceeds from 
the sale, less any handling and selling expenses, may be used to reduce 
the cost of the main products. 
If a by-product needs further processing to improve its marketability, the 
cost will be deducted in arriving at net revenue. Note that recorded profits 
will be affected by the method adopted if  inventories of the main product 
are maintained.

92 
 Example 1 
 An organisation produces two join t products Product A and Product B. 
The total joint costs are $750 and the following information is provided on 
each product: 
 Kgs 
produced Kgs 
sold Selling price 
per kg Joint 
Cost 
Product A 100 80 $5  
    $750 
Product B 200 150 $2  
Apportion the joint costs between the products using the following 
apportionment methods: 
 
 Joint costs in decision making 
 Even if careful technical estimates are made of relative benefits, any 
apportionment of common costs or joint costs will inevitably be an 
arbitrary calculation. When providing information to assist decision-
making, therefore, t he cost accountant will emphasise cost and revenue 
differences arising from the decision. 
The main decisions involv ing joint products are: 
 To carry out the whole process or not. This decision is made by 
considering the total revenues and co sts of the process. A decision 
cannot be taken to just process some  of the products as all products 
are produced simultaneously. The basis of common cost 
apportionment is irrelevant but the common costs in total are 
relevant. 
 Whether or not to further proc ess products. This decision is based 
on the incremental costs and incr emental revenues of further 
processing. Revenue and cost at the split-off point are irrelevant to 
the decision as they will not change. 
Decision making on joint products is ex plored in more detail in a later 
chapter.

Chapter 4 
 93 
3 Throughput accounting 
Throughput accounting is very similar to ma rginal costing, but it can be used to 
make longer-term decisions abou t capacity/production equipment. 
Throughput accounting is based on three concepts: throughput, inventory (or 
investment) and operating expenses. T he basic premise is that managers 
should aim to increase throughput while simultaneously reducing inventory and 
operational expense. 
 
 Throughput 
In throughput accounting, the only cost that is deemed to  relate to volume of 
output is the direct material  cost. All other costs (inc luding all labour costs) are 
deemed to be fixed. These fixed costs ma y be called Total Factory Costs (TFC). 
Throughput contribution = Revenue – Totally variable costs 
The aim of throughput accounting is to maximise this measure of 
throughput contribution. 
Since totally variable costs are norma lly just raw materials and bought-in 
components, it is often convenient to define throughput contribution as: 
Throughput contribution = Revenue – direct material costs 
 
 Conversion costs 
 A distinction can be made between material and other manufacturing 
costs. These other manufacturing costs are sometimes collectively 
referred to as conversion costs. Ther efore, costs such as direct labour, 
factory rent, equipment depreciation, inspection costs etc. will come 
together under the heading of conversion co sts. This is a term that you 
may encounter in questions on this topic. 
This is defined as all the money the busi ness invests to buy the things that it 
intends to sell and all the money tied up in assets so that the business can 
make the throughput. Investment theref ore includes unused raw materials, 
work-in-progress and unsold finished goods. It can also include non-current 
assets if these are used for buying or  creating materials (such as equipment 
and buildings used to produce materials or research and development costs 
that can be attributed to its creation). 
Operating expenses 
Operating expenses are defined as all the money a business spends to produce 
the throughput (i.e. to turn t he inventory into throughput). It  is not correct to think 
of operating expenses as fixed costs. They are costs that are not totally 
variable.

94 
Profit reporting 
Since a business makes its money from throughput, management accounting 
systems should focus on the value of throughput created. Profit should 
therefore be repor ted as follows (illustrat ive figures are included): 
  $ 
Revenue  750,000 
Raw material cost (totally variable cost) 200,000   ––––––– 
Throughput contribution  550,000 
Operating expenses  400,000   ––––––– Net profit  150,000 
  ––––––– 
 
Super variable costing 
 Throughput accounting has been described as a form of ‘super-variable 
costing’ because the concept of thr oughput has similarities to the concept 
of contribution. It could therefore be  seen as an alternative to marginal 
costing as a costing method. However, this is not an accurate description. 
This is because in throughput accounti ng, the concept of product cost is 
rejected. The throughput earned by indivi dual products is calculated, but 
no attempt is made to charge opera ting expenses to products. This 
makes throughput accounting radically di fferent from both traditional cost 
accounting systems such as absorpti on costing and marginal costing and 
also from activity based costing. 
Inventory should be valued at the purc hase cost of its raw materials and 
bought-in parts. 
It should not include any other costs, not even labour costs. No value is added 
by the production process, not even by  labour, until the item is sold. 
 
 Example 2 
 A company makes 1,000 units of an item during a period and sells 800 
units for $8,000. Costs of production were as follows: 
 $ 
Materials 3,000 Direct labour 2,000 Fixed production overhead 1,000 
Other overhead 1,000

Chapter 4 
 95 
 Actual production volume and pr oduction overhead expenditure were 
both the same as budgeted. 
Required: 
Calculate the profit for the period using: 
(a) absorption costing (b) marginal costing (c) throughput accounting. 
4 Multi-product decision maki ng in throughput accounting 
The usual requirement in questions is to maximise contribution (given that fixed 
costs are unaffected by the production decisi on in the short run) per unit of the 
limiting factor. In throughput accounti ng the approach should be to maximise 
the throughput contribution earned.  
 Maximising throughput 
 Using throughput accounting, the ai m should be to maximise throughput, 
on the assumption that operating expe nses are a fixed amount in each 
period. 
 If the business has more capacity t han there is customer demand, it 
should produce to meet the demand in full. 
 If the business has a constraint that prevents it  from meeting 
customer demand in full, it should ma ke the most profitable use that 
it can of the constraining resource . This means giving priority to 
those products earning the highest  throughput contribution for each 
unit of the constraining re source that it requires. 
This goal is achieved by determining what factors prevent the throughput 
being higher. This constraint is called a bottleneck. A bottleneck may be a 
machine whose capacity limits the output of the whole production 
process. The aim is to identify the bottlenecks and remove them, or, if this is not possible, ensur e that they are fully ut ilised at all times. Non-
bottleneck resources should be scheduled and operated based on the constraints within the system, and should not be used to produce more than the bottlenecks can absorb. 
The following provides a step-by-step technique for resolving the problem 
Step 1:  identify the bottleneck constraint. 
Step 2:  calculate the throughput contribution per unit for each product. 
Step 3:  calculate the throughput contri bution per unit of the bottleneck 
resource for each product. 
Step 4:  rank the products in order of the throughout contribution per unit of the 
bottleneck resource. 
Step 5:  allocate resources using this ranking and answer the question.

96 
 Example 3 
 The following data relates to two products manufactured by DJ 
 Product Product 
 X Y 
Selling price per unit $15 $20 
Direct material cost per unit $10 $11    
Maximum demand (units) 25,000 30,000 
   Time required on the bottleneck (hours per unit) 2 6 
The firm has 80,000 bottleneck hours available each period. 
Total factory costs amount to $128,000 in the period. 
Required: 
Calculate the optimum product mix and the maximum profit. 
 
 Contrasting TA with the limiting factor approach 
 Illustration  
A company produces two products, A and B, the production costs of 
which are shown below: 
 A B 
 $ $ 
Selling price per unit 10 10 
Direct material cost per unit 5 9  5 9 
Maximum demand (units) 5 9 
 ––– ––– Time required on the bottleneck (hours per unit) 25 37 
 ––– ––– 
Fixed overhead is absorbed on the bas is of direct labour cost. 
The products pass through two proce sses, Y and Z, with associated 
labour cost of $10 per dire ct labour hour in each. The direct labour time 
taken associated with the two produc ts for these processes is shown 
below: 
Process Product A Product B 
Y 10 mins 39 mins 
Z 20 mins 15 mins

Chapter 4 
 97 
 Selling prices are set by the market. The current market price for A is $65 
and that for B, $52. At t hese prices, the market will absorb as many units 
of A and B as the company can produce.  The ability of the company to 
produce A and B is limited by the c apacity to process the products 
through Y and Z. The company operates a two-shift system, giving 16 
working hours per day. Process Z is a single-process line and 2 hours in 
each shift will be downtime. Proc ess Y can process two units 
simultaneously, although this doubles the requirement for direct labour. 
Process Y can operate for the full 16 working hours each day. 
Required: 
What production plan should the company  follow in order to maximise 
profits? 
Solution 
In order to find the profit maximi sing solution in any problem, the 
constraints which prevent the profit fr om being infinite must be identified; 
the greater the number  of constraints, the more difficult the problem is to 
solve. In the simplest case, where there is only one binding constraint, 
the profit maximising solution is fo und by maximising the contribution per 
unit of the scarce resource, that  is binding constraint. Linear 
programming (covered in a later chapter) may be used to solve the 
problem where more than one constraint  is binding for some, but not all, 
feasible solutions. 
Where the number of products  is limited to two, and such constraints are 
relatively few in number, the problem  can easily be expressed graphically 
to reveal the profit maximising solution, and/or the problem can be 
expressed in the form of a set of  simultaneous equatio ns. As the number 
of potentially binding constraints increases, the use of a computer 
becomes the only feasible way to solve the necessary number of 
simultaneous equations. 
In this question, the only constraint is  the company’s ability to process the 
product. The total daily processing time for processes Y and Z are: 
 Maximum process time Y = 2 × 16 hours × 60 minutes = 1,920 
minutes 
 Maximum process time Z = 12 ho urs × 60 minutes = 720 minutes

98 
 So the maximum number that coul d be produced of each of the two 
products is: 
 Product A Product B 
 Maximum units Maximum units 
 1,920  1,920  
Y –––––– = 192 –––––– = 49.23  10  39  
     
 720  720  Z –––––– = 36 –––––– = 48 
 20  15  
In the case of both products, the maximum number of units which can be 
produced in Process Y exceeds the number that can be produced in 
Process Z, and thus the c apacity of Process Y is not  a binding constraint. 
The problem therefore becomes one of  deciding how to allocate the 
scarce production capacity of Process Z in such a way as to maximise 
profit. 
Traditional approach – maximisi ng the contribution per minute in 
Process Z 
Contribution of A = $65 (selling pr ice) – $20 (variable cost) = $45 
Contribution of B = $52 (selling pr ice) – $28 (variable cost) = $24 
Contribution of A per minute in process Z = $45/20 = $2.25 Contribution 
of B per minute in process Z = $24/15 = $1.60 
The profit maximising solution is  therefore to produce the maximum 
possible number of units of A, 36, giving a contribution of $45 × 36 = 
$1,620. 
Throughput approach – maximisi ng throughput contribution per 
minute in bottleneck resource Z 
Throughput of A = $65 (selling pric e) – $10 (material cost) = $55 
Throughput of B = $52 (selling pric e) – $10 (material cost) = $42 
Throughput contribution of A per mi nute in process Z = $55/20 = $2.75 
Throughput contribution of B per mi nute in process Z = $42/15 = $2.80 
number of units of B, 48, giving a throughput contribution of $42 × 48 = 
$2,016. It is clear that, given the different  solutions, the two approaches cannot 
both lead to profit maximisation. Which technique is correct depends on 
the variability or otherwise of labour  and variable overheads, which in turn 
depends on the time horizon of the decision. This type of profit 
maximisation technique is a short-te rm one and in today’s world labour is 
likely to be fixed in the short te rm and so it can be argued that TA 
provides the more correct solution. Variable overheads would need to be 
analysed to assess their variability.

Chapter 4 
 99 
 Marginal costing rose to popularity in the 1930s when labour costs were 
usually variable as the workforce wa s usually paid on a piece-rate basis. 
Since then textbooks, at least, have  always assumed that labour is a 
variable cost in the shor t term. All that has happene d with TA is that it 
tends to recognise the present reality,  which is that most cost excluding 
materials are now fixed in the short term. 
The marginal costing approach should of course be modified to 
accommodate this, as it requires only variable costs to be used to 
calculate contribution. If only material  costs are variable, then only those 
costs should be used in the calculation of contribution. Thus there should 
be no difference between the tw o systems in this respect. 
Throughput accounting measures 
Various performance measures have been devised to help measure throughput: 
 
Return per factory hour =Throughput contribution
Product' s time on the bottleneck resource	
 
Cost per factory hour =Total factory cost
Total time on the bottleneck resource 
 
Throughput accounting ratio =Return per factory hour
Cost per factory hour	
 
 Explanation of the ratios 
 The return per factory hour shows the value added by the organisation 
and managers are encouraged to maximi se this (for example, by 
increasing throughput or reducing t he time taken in the process). 
The cost per factory hour shows the co st of operating the factory in terms 
of overheads, labour costs etc. 
The throughput accounting ratio measures the return from a product 
against the cost of running the fact ory. Some people would argue that 
only products with a throughput account ing ratio greater than 1 are 
worthwhile. This is because the ratio is  telling us that the return that is 
made at this point is less than the co st of producing that return. For 
example, if the return was $2 per hour  but it was costing $4 per hour to 
operate the factory, t hen the throughput accounting ration would be 0.5. 
This could easily be benchmarked against the target of 1 to tell us that 
production is not worthwhile. 
But notice that the return per fact ory hour and the throughput accounting 
ratios are for each individual product, whereas the cost per  factory hour is 
for the company as a whole. So it could be argued that a throughput 
accounting ratio of less than 1 does  not reveal the full story.

100  
 Example 4 
 Calculate the throughput accounting ra tio for each product in the previous 
example. 
 
 Criticism of throughput accounting 
 A criticism of throughput accounting is  that it concentrates on the short 
term, when a business has a fixed supply of resources and operating 
expenses are largely fixed. 
It is more difficult to apply throughput  accounting concepts to the longer 
term, when all costs are variable, and va ry with the volume of production 
and sales or another cost driver. This criticism suggests that alt hough throughput accounting could be a 
suitable method of measuring profit  and performance in the short term, 
an alternative management accounting method, such as activity based 
costing, might be more appropria te for measuring and controlling 
performance from a l onger-term perspective. 
 
 5 Costing digital products  
 
 A digital product typically refers to a product that is stored, delivered 
and consumed in an electronic format.  
The products can be delivered in many ways such as through a website, a 
mobile phone application or em ail. One digital product may be offered in various 
forms. For example, a company may rel ease a game that can be played on its 
website or via IOS or Android apps. A di gital product can also refer to digital 
media that will be distribut ed such as a television pr ogramme or music album.  
 
 Digital products as bundles of features 
 Digital products can sometimes be seen as a gathering together of 
individual product features.  Features can be added and changed by  individual consumers giving 
each user a bespoke experience through choosing the features that they 
want and don’t want. It may therefore be that individual features need to 
be costed in order to determine selli ng prices for each feature. It is 
common, for example, for computer or console games to launch with a 
basic set of features which gamer s can then add to through additional 
downloadable content. It may even be that features become products in their own right when 
unbundled from the product. For ex ample, Facebook’s messenger 
feature is now available as a s eparate app and has its own development 
team that is separate from Facebook’s core activities.

Chapter 4 
 101 
Digital products are often undertaken as i ndividual jobs so that  to some extent 
job costing techniques can be very relev ant in costing digital products. But 
products are often much more difficult to  cost than tradit ional products for a 
number of reasons, such as: 
 Marginal costs can be virtually zero for many digital products and most 
costs are likely to be fixed in nature. This means that digital products are 
expensive to produce but cheap to r eproduce, since the unit cost of 
reproduction is negligible. 
 There is often no standard time or cost  that can be attributed to digital 
products making the use of st andard costing inappropriate. 
 Drivers for overheads can be ve ry difficult to determine. 
 The timing of costs can be difficult to estimate and can extend over a 
number of accounting periods. Many of the product costs will be upfront 
and pre-launch such as design and dev elopment. Many other costs will be 
post-launch such as royalties and ma rketing costs. But some costs may 
be incurred over both periods such  as testing and platform costs. 
 The lifespan of digital products can vary greatly. Some products, say a 
weather forecast, may last and have value for only a day, whilst others, 
such as an e-book, can have a life that spans decades. It will be necessary to establish the total costs over the lifetime of  the app and then 
compare this to the expected benefit s in terms of increased revenue. 
Determining the lifetime of an app can be very difficult particularly when there are rapid changes in technology as there is at the present time. 
 Many product features or functions might be shared amongst a number of 
products. The finance function then needs to determine how to absorb these costs into each individual product.  
 
 More details on digital product costs 
 Digital products will have a wide variety of costs that may be very 
different to the costs incurred in tr aditional products. There are likely to 
be little or no material costs and more overheads, for example.  
The cost structure for di gital media may be very different. Much of the 
cost will be fixed in nature and incurr ed upfront. For example, in making a 
music album there will be studio cost s, fees for session musicians, 
editing and mastering costs and ar twork and photography costs. But 
there will then be costs associated wit h marketing that may be incurred 
over the next 6 to 12 months. There will,  finally, be royalty costs paid to 
the recording artist and writer(s) that  may be paid for numerous years. It 
is likely that it is only this final cost  that will be truly vari able in nature as it 
is likely to be payable based on each di stribution of the content (for 
example, each time the album is pl ayed on a platform such as Spotify). 
Much of these costs reflect only the direct costs of the music album. 
There may be many more indirect cost s that are attri buted to the album 
that come from the record label etc.

102  
 Digital product costs can be difficu lt to budget as there is often no 
standard cost for cost items or other  standard costing elements such as a 
standard time for activities. For ex ample, studio costs are normally 
incurred per day but it can be difficult to estimate the number of days that 
will be required. It is also very comm on for the time taken to exceed the 
budget and therefore there may be an argument for including some initial 
slack in the budget and adding extra days in order to account for such 
eventualities. Also, when budgeting cost s such as royalty fees some 
estimate needs to be made regarding act ual sales or distribution levels. 
Some typical costs and cost patterns are explored below. 
Staff costs 
Many staff costs will be specific to the product or project. For example, 
particularly in mobile phone app design,  staff tend to be employed for the 
development of that pa rticular app / product. Staff are typically paid a 
fixed fee or a fee per day. Once  the app has been developed these staff 
are no longer required or used. It  means that, although there may be 
some permanent staff costs for pr eparing updates and providing product 
maintenance, the majority of staff co sts are often upfront and pre-launch 
with very little ongoing costs post-launch.  
Infrastructure, platform and payment types 
There will be costs associated with the platform on which digital products 
will be launched. Many organisations choose to launch on one platform 
as a trial of the product before launching into other platforms.  
This means that these costs can be a combination of immediate and 
predictable costs for the in itial target platform wit h then potential further 
costs if the product is launched on other platforms in the future. 
Infrastructure services include infr astructural components such as where 
the app is hosted, where data is st ored and how the data is delivered. 
This will include the cost of serv ers (where the app is hosted); data 
storage; content delivery net work (CDN) and images data. 
Similar decisions will be taken on acceptable payment types where an 
organisation might only initially acc ept one type of payment type but over 
time start to accept more met hods. Each payment type added to the 
product would incur addition al costs for the product. 
Functionality 
Individual product functions may be costed separately. For example, 
features may be required to allow func tionality such as push notifications; 
social media and chat; SMS and email messaging. 
It may be that functions can be re-used in other products and costs 
absorbed accordingly. For example, in a mobile phone app there may be 
a payment function for accessing addi tional content. This payment 
function may be usable across a number of applications.  
Likewise, if a product uses functions or designs from previously created 
products then these will need to be costed to the new product in some 
way.

Chapter 4 
 103 
 Design and development 
Likewise there may be shareable des ign elements for products. Many 
computer games, for example, use the same game ‘engine’. For 
example, the Frostbite engine is us ed in games as varied as FIFA, 
Battlefield and Need for Speed. The co st of employing the engine would 
have to be absorbed into each individual product, most likely as an 
overhead cost. 
But each product is also likely to have its own design and development 
costs. These would be direct costs and are most likely to be pre-launch 
costs. 
Marketing  
The majority of marketing costs will be incurred post launch although 
some may be incurred prior to launch if the organisation wants to build 
expectations, provide previews, do open market testing pre-launch etc. 
Many digital products will be allocat ed a fixed marketing budget which will 
need to be carefully planned. 
IT Support services and testing 
Ongoing technical support is a critic al component of any app deployment. 
IT specific maintenance costs for infrastructure will also be required since 
servers, data storage, CDN and image dat a will all require some level of 
monitoring and maintenance. 
Testing will be a key factor and co st before the digital product is 
launched. But it is a cost that may be an ongoing one as developers may 
be required to provide updates to appl ication programming interfaces 
(APIs) and fix bugs after the product launch. This will incur additional 
post-launch costs. 
Royalty and license costs 
There may also be royalty and license costs for the product. Royalties 
are often based on sales and will theref ore be difficult to budget for and 
incurred post-launch, possibly over a number of accounting periods. 
License fees tend to be a fixed amount paid on production of the product 
pre-launch. 
Inventory costs 
A major advantage of digital products is  that there will be  no inventory of 
the product. This not only eliminat es the associated inventory holding 
costs but avoids the need for inventory valuation by the accounting 
function. 
Administrative services 
We will need an intuitive, powerful, accessible and user-friendly 
administration dashboard to enable the organisation to effectively 
administer the apps. Administrative costs are the most difficult to 
anticipate as they will largely depend and differ based on each individual app. The administration dashboard will allow the organisation to manage 
the content of the apps; manage the functional serv ices detailed above; 
update the apps; manage user profile s; collect and analyse user 
behaviour; control access by us ers and enable data or user 
segmentation.

104  
Digital products and decision making 
Digital products have low marginal costs and, once created, the majority of fixed 
costs are sunk (i.e. money has already been spent on areas such as developing 
the product and cannot be recovered so should be ignored for any future 
decisions). In decision making, for ex ample when trying to decide on a selling 
price for the product, normally only margin al costs are considered and sunk (or 
historic) costs are ignored.  
Decisions are also complicated by t he fact that digital products can be 
consumed simultaneously by more than one user (for example, more than one 
user might be reading the sa me e-book at the same ti me). It means that the 
same, identical product can be sold over  and over again at virtually no extra 
cost to the business. Cost benefit analysis for launching new  products, for example, will be 
complicated for digital products due to m any of the problems explored in this 
section such as: 
 The timing and frequency of costs will be difficult to estimate. Some costs may be upfront (such as development  costs), others will be ongoing (such 
as royalties) whilst others (such as the cost of providing updates or for 
moving to new platforms) will be one-off future costs. Forecasts will have 
to be made for the time taken for each activity, the number of staff 
required for each element, prospective sales volumes, etc. 
 Some costs for shared functions (such as payments or digital images) may have to be shared and absorbed across a number of products and it can be difficult to determine the driv ers associated with these costs. 
 Determining benefits will be complicat ed by the unknown lifespan of the 
product and the fact that the same product can be sold over and over 
again. 
Many of the decision making techniques that follow in this syllabus (such as, 
say, linear programming) are therefore ve ry complicated for digital products. But 
using these techniques on digital products is beyond the scope of this syllabus and the decision making techniques whic h follow will focus only on physical 
products (and services).  
 
6 Digital costing  
 
We have seen so far in this study text that determining the cost of a product or 
service is an important but sometimes complex task for organisations. We have 
only had to deal with one or two types of materials, labour and overheads. 
Some organisations may make a product requiring hundreds or thousands of 
components. Boeing, for example, estima te that their B737 aircraft has 367,000 
parts. A typical car will have over 30,000 components. To cost such a product 
using techniques covered so far in th is syllabus would be a very long and 
cumbersome task.

Chapter 4 
 105 
Thankfully, in the age of technology , digital costing systems have been 
developed in order to perform this task. These systems use product designs 
and specifications alongside web connec tions to markets and suppliers to 
provide real time cost informati on on components and product parts.  
The systems can provide information on marginal, total and average product 
costs that are much more detailed than those produced from non-digital 
systems, the information is obtained more quickly and product costs become more accurate. 
Digital costing systems use technology to  allow them to understand and ‘read’ 
product designs and plans in order to  find the best components to achieve 
product goals. They can gather and feed in formation into manufacturing times 
to make the entire operation more efficient, flexible  and effective. 
These can bring large operational and st rategic benefits to organisations who 
employ such systems. 
Features and benefits of digital costing systems 
Digital costing systems gather information from the internet in real time. This is 
done by linking systems those of suppliers and marketplaces. This allows the 
system to automatically compare prices  and suppliers, giving the organisation 
access to the cheapest (or quickest is that is what is desired) components available. This can give significant  cost savings to the organisation.  
The system will be constantly up-to-date a nd reflecting current information. This 
allows the organisation to change and adapt to changes in its supply chain environment. 
The organisation will have access to mo re suppliers. This can bring other 
benefits (outside of cost savings) such a quicker lead times and access to more 
variety of resources. It can also  help alleviate scarcity problems for 
organisations who face a shortage of resources in the short term. Although digital costing syst ems can be expensive to implement when they are 
up and running they have low operational co sts. Because the process is fully 
automated there is no time burden for cost accountants. The time saved by cost 
accountants in the long term can vastly outweigh the cost of implementing the 
system. Digital costing systems have built in analytics and intelligence capabilities. They 
can analyse changes over time, supplier flexibility etc. This can allow 
organisations to better understand the changing nature of costs. More advanced systems have the capability to make suggestions to buying 
behaviour. They may suggest newly available types of components (subject to limits expressed within product design set up) which can change and improve 
product design. In this way the organi sation can achieve improved, cheaper and 
more efficient operations that are constantly evolving. 
Digital costing systems have the ability to accurately cope with hundreds of 
purchasing decisions at one time. They  are also easy to use and quickly 
understood by decision makers.

106  
The organisation will receive better, more up-to-date information on the cost of 
its product(s). This will include better k nowledge of drivers and absorption of 
costs to products. Digital costing system s will automate this process and their 
better understanding of cost drivers should re sult in a more accurate and useful 
product cost.  
Digital costing allows for a more det ailed break-down of overheads with more 
personalised cost drivers. This can help in cost control and pricing decisions. 
Digital costing systems are fully int egrated systems and make large use of 
microservices. For example, the tec hnology might have a microservice that 
computes lead times, another that tells t he factory manager to make provisions 
for the delivery, another that tells the finance department when and who to pay 
etc. (The microservices can be built in-house, bought in as off-the-shelf 
packages or, for larger organisation,  purchased as bespoke, personalised 
services from developers). This all happens  digitally so that there is much less 
bureaucracy and the entire system is qui cker, easier and cheaper to operate. 
Digital costing systems ma ke cost behaviour much easier to understand. There 
is clearer information on the split of semi -variable costs so that organisation’s 
better understand the costs wh ich are truly variable. 
These systems allow for the calculation of  cost per customer, cost per location 
etc. This allows better customer prof itability evaluation which can lead into 
customer decision making such as offe ring discounts to particular customers or 
setting prices for bespoke products or services. Digital costing allows for granular decisions. Prices for components, for 
example, may only differ by a fraction of  a cent. Traditional costing would have 
ignored this detail, but if an organisation is  dealing in very large volumes moving 
from one component supplier to another in order to save a fraction of a cent per 
component may make significant overall cost savings. The product cost may constantly change as market prices and conditions 
change. Many organisations are moving towa rds adaptive or dynamic pricing of 
their products which is facilitated by digita l costing. This allows selling prices to 
be changed quickly and easily based on ne w information on the cost of the 
product or market conditions. 
Other organisations may use a system know n as target costing. This system is 
used when the selling price is less contro llable so that profit is very much 
dependent on meeting a target cost rather  than adjusting selling prices. A digital 
costing system can determine whether (and how) a target cost can be achieved 
in order to reach a target level of profit.

108  
 The total production cost of joint products can be apportioned between 
products using which of the following methods? (Tick all that apply) 
(1) Weight 
(2) Sales revenue (3) Selling prices (4) Net realisable value 
 
 Products A and B are manufactured in a joint process. The following data 
is available for a period: 
Joint process costs  $30,000 
Output Product A 2,000 kg 
 Product B 4,000 kg    
Selling price: Product A $12 per kg 
 Product B $18 per kg 
What is Product B’s share of the join t process costs if the sales value 
method of cost appor tionment is used? 
A $7,500 
B $18,000 C $20,000 D $22,500 
 
 Charleville operates a continuous process producing three products and 
one by-product. Output fr om the process for a month was as follows: 
Product Selling price per 
unit Units of output from 
process 
1 $18 10,000 
2 $25 20,000 3 $20 20,000 
4 (by product) $2 3,500 
Total output costs were $277,000. 
The unit valuation for Product 3 (using the sales revenue basis for 
allocating joint costs) was $_____ (Fill in the missing number)

Chapter 4 
 109 
 Scenario 
A business makes four products, W, X,  Y and Z. Information relating to 
these products is as follows: 
 W X Y Z 
Sales price/unit $20 $25 $18 $40 
Materials required/un it $10 $15 $11 $22 
Labour hours/unit 4 5 2 6 
Monthly sales demand ( units) 500 800 1,000 400 
There is a limit to t he availability of labour, and only 8,000 hours are 
available each month. 
Task: 
Identify which products the busine ss should produce using a throughput 
accounting approach. 
 
 A company manufactures a product t hat requires machine time of 1.5 
hours per unit. Machine time is a bo ttleneck resource, due to the limited 
number of machines available. Th ere are 10 machines available and 
each machine can be used for up to 40 hours each week. The product is 
sold for $85 per unit and the material cost per unit is $42.50. Total operating expenses are $8,000 each week. 
Required: 
Calculate the throughput accounting ratio.

110  
 Scenario 
Justin Thyme manufactures four products , A, B, C and D. Details of sales 
prices, costs and resource requirement s for each of the products are as 
follows. 
 Product  Product  Product  Product  
 A B C D 
 $ $ $ $ 
Sales price  1.40 0.80 1.20 2.60 
Materials cost 0.60 0.30 0.60 1.00 Direct labour cost  0.40 0.20 0.40 1.00 
 
Minutes  Minutes  Minutes  Minutes  
Machine time per unit 5 2 3 6 Labour time per unit 2 1 2 5  
Units  Units  Units  Units  
Weekly sales demand 2,000 2,000 2,500 1,500 
Machine time is a bottleneck resour ce and the maximum capacity is 400 
machine hours each week. Operating cost s, including direct labour costs, 
are $5,440 each week. Direct labour costs are $12 per hour, and direct 
labour workers are paid for a 38-hour week, with no overtime. 
Tasks: 
(a) Identify the quantities of each product that should be manufactured 
and sold each week to maximise profit using a throughput 
accounting approach and calcul ate the weekly profit. 
(b) Calculate the throughput accounting ratio at this profit-maximising 
level of output and sales. 
(Time allowed: 15 minutes)

Chapter 4 
 111 
 The following data relate to the si ngle product made by Squirrel Ltd: 
Selling price per unit $16 
Direct material cost per unit $10 
Maximum demand (units) per period 40,000 
Time required (hours) in Process X, per unit 1 Time required (hours) in Process Y, per unit 1.5 
The capacities are 35,000 hours in Process X and 42,000 hours in 
Process Y. 
The total factory costs are $105,000 in the period. 
Tasks: 
(a) Identify the process bottleneck. 
(b) Calculate the throughput accounting ratio. (Note:  This would be two separate questions in an examination)  
 
 A company manufactures three produc ts: W, X and Y. The products use 
a series of different machines, but there is a common machine that is a 
bottleneck. The standard selling price and standard cost per unit for each 
product for the next period are as follows: 
 W X Y 
 $ $ $ 
Selling price 180 150 150 
Cost:    
Direct material 41 20 30 Direct labour 
30 20 50 
Variable production overheads 24 16 20 Fixed production overheads 36 24 30  
––––  ––––  ––––  
Profit 49 70 20  
Time (minutes) on bottleneck machine 7 10 7 
(a) Using a traditional limiting f actor approach, the rank order 
(best first) of the products would be:  
A W, X, Y 
B W, Y, X C X, W, Y 
D Y, X, W

112  
 (b) Using a throughput accounting approach, the rank order (best 
first) of the products would be:  
A W, X, Y 
B W, Y, X C X, W, Y D Y, X, W 
(Note:  This would be two separate questions in an examination)  
 
 Which of the following is most likel y to be true of a digital product? 
A Marginal costing will be the most appropriate costing system 
B Activity based costing could be used to absorb indirect overheads C Standard costing will play a vita l role in costing the product 
D Throughput accounting will be commonly used 
 
 Which of the following is not likely to  be a benefit of a digital costing 
system? A Costing information is more up-to-date 
B The costing system can deal with a higher volume of components 
C The number of cost drivers will be reduced D The costing system will be chea per to operate than non-digital 
systems

Chapter 4 
 113 
 Example 1 
 Apportionment by physical measurement 
 Joint cost
Kgs produced= $750
300 = $2.50 per kg for A+B  
Trading results 
 Product A  Product B  Total 
  $  $ $ 
Sales 80 × $5.00 400 150 × $2.00 300 700 
Cost of sales 80 × $2.50 200 150 × $2.50 375 575   ––––  –––– –––– 
Profit/(Loss)  200  (75) 125 
  ––––  –––– –––– Value of closing 
inventory 20 × $2.50 50 50 × $2.50 125  
  ––––  ––––  
Total share of joint costs 
(Cost of sales + inventory) 250  500  
The main point to emphasise about jo int products is the production mix. 
In this case the production ratio is 100 : 200 which means that, in order to 
obtain 1 kg of A, it is necessary also to produce 2 kg of B. Although in the 
longer term it may be possible through research and development work to 
change the mix, in many processes this is not possible and for exam 
purposes you should assume that the ratio of output is fixed. 
In attempting to assess the profitabi lity of the common process it is 
necessary to assess the overall position as follows: 
  $ 
Sales value of product A 100 × $5 500 Sales value of product B 200 × $2 400 
  –––– 
  900 Joint cost  750 
  –––– 
Profit  150   –––– 
This total profit figure should be us ed to evaluate the viability of the 
common process.

114  
 Referring back to the trading results, it  is important to appreciate that the 
‘loss’ on B has been created by the joint cost apportionment, i.e.: 
 $ 
Selling price 2.00 
Share of joint cost 2.50 
 –––– Loss 0.50 
 –––– 
A decision not to produce and sell pr oduct B is not possible because, if 
product B were not produced, then neit her could product A be produced. 
A further point to note is that invent ory of B could not be valued in the 
financial statements at $2.50 bearing in mind that inventory should be 
valued at the lower of cost and net realisable value. 
Apportionment by market value  at point of separation
 
 Sales  
value of 
production Proportion Joint cost 
apportionment Per kg 
 $ $ $ $ 
A 100 × $5 500 5/9 417 4.17 
B 200 × $2 400 4/9 333 1.67    ––––  
   750  
   ––––  
Trading results:     
  A B Total 
Sales  400 300 700 
Cost of sales  333.6 250.5 584.1   –––– –––– –––– 
Profit  66.4 49.5 115.9 
     Profit/sales  16.6% 16.5%  
Closing inventory (20 × 4.17) (50 × 1.67)  
  83 83  
Notes: 
(1) Apportionment is on the basis of proportionate sales value of 
(2) Profit margin for each product is the same (with a small rounding 
difference). 
(3) This approach provides a more rea listic estimate of cost to use for 
valuing inventory of B, i.e. $1.67

Chapter 4 
 115 
 Apportionment by net realisable value 
This approach should be used in situat ions where the sales value at the 
split-off point is not known – either because the product is not saleable, or 
if the examiner does not tell you – or  if specifically asked for by the 
examiner. 
Further information needed: 
Further processing costs 
 Selling price after 
further processing 
$280 + $2.00 per kg $8.40 
$160 + $1.40 per kg $4.50 
Apportionment of joint costs: 
 $ $ Final sales value of  production 840 900 
(100 × $8.40; 200 × $4.50) 480 440 Further processing cost   280 + 100 × $2; 160 + 200 × $1.40)   
 360 460  ––––– ––––– 
 
Joint cost apportionment (360 : 460) 329 421 Joint cost per kg $3.29 $2.10 
Trading result (for common process only): 
 $ $ $ 
Sales   700 Joint cost  750  Less: Closing inventory    A 20 × $3.29 66   
B 50 × $2.10 105   
 –––––     (171)  
  –––––  
Cost of sales   579    ––––– 
Profit   121 
   –––––

116  
 Notes: 
(1) As we know sales value of product B at the point of separation is $2, 
we can see that this method result s in an unrealistic inventory value 
of $2.10. Bear in mind that this  approach should only be used where 
the sales value at the split-off point is not known, or if instructed to 
use it by the examiner. 
 
 Example 2 
 The valuation of closing inventory is: 
 $1,200 ($6,000 × 200/1,000) in absorption costing 
 $1,000 ($5,000 × 200/1,000) in marginal costing 
 $600 ($3,000 × 200/1,000) in throughput accounting. 
Profit statements (a) Absorption costing 
Value of closing inventory = $1,200 
 $ $ 
Sales  8,000 Cost of production 6,000  
Less: Closing inventory 1,200  
 –––––  Cost of sales  4,800 
  ––––– 
Gross profit  3,200 Non-production overhead  1,000 
  ––––– Profit  2,200   –––––

Chapter 4 
 117 
 (b) Marginal costing  
Value of closing inventory = $1,000 
 $ $ 
Sales  8,000 
Cost of production 5,000  
Less: Closing inventory 1,000   –––––  
Cost of sales  4,000 
  ––––– Contribution  4,000 
Fixed overhead  1,000 
Non-production ov erhead  1,000 
  ––––– 
Profit  2,000 
  ––––– 
(c)  Throughput accounting  
Value of closing inventory = $600 
 $ $ Sales  8,000 
Material costs 3,000  
Less: Closing inventory 600   –––––  
Cost of sales  2,400 
  ––––– Throughput  5,600 
Operating expenses  4,000 
  ––––– Profit  1,600 
  –––––

118  
 Example 3 
  
 Product 
 $ $ 
 X Y 
Selling price 15 20 
Direct material 10 11 
 ––– ––– Throughput 5 9 
No. of bottleneck hours per unit 2 6 
   Return per factory hour 2.50 1.50 
 1st 2nd 
 
 Units Bottleneck 
hrs per 
unit Bottleneck 
hrs Throughput 
$ 
Product X 25,000 2 50,000 125,000 
Product Y 5,000
Bal 6 30,000Bal 45,000 
   –––––– ––––––    80,000 170,000 
   –––––– –––––– Total factory cost    128,000 
    –––––– 
Gross profit    42,000     –––––– 
 
 Example 4 
  Product A Product B 
 
Return per factory hour  = 	Throughput per unit
Bottleneck hrs per unit 						=		15 – 10
2 hrs     							20 – 11
6 hrs    
= $2.50  = $1.50 
Cost per factory hour   =Total factory cost
Total bottleneck  =$128,000
80,000 hrs
= $1.60   
 
Throughput accounting ratio  =	Return per factory hour
Cost per  factory hour  									=										$2.50
$ 1.60  										$1.50
$1.60  
= 1.56  = 0.94 
Product X has the higher throughput accounting ratio and thus should be 
given priority over Product Y.

Chapter 4 
 119 
 1, 2 and 4 are all recognised ways of splitting joint costs. Selling prices 
(i.e. per unit) are not an acceptable basis as this does not take into 
account the relative volumes of each joint product. 
 
 The correct answer is answer D. 
 Output  
(kg) Sales value  
($) Apportionment Joint costs  
($) 
Product A 2,000 24,000  (24/96) 7,500 
Product B 4,000 72,000  (72/96) 22,500 
  96,000  30,000 
 
 The unit valuation for Product 3 (using the sales revenue basis for 
allocating joint costs) was $ 5 
Total sales revenue  = ($18 × 10,000) + ($25 × 20,000) +   ($20 × 20,000)   = $1,080,000 
Joint costs to be allocated  = $277,000 – ($2 × 3,500) 
 = $270,000  Allocation rate  = (270,000/1,080,000)  = 0.25 of sales revenue Joint costs allocated to  = 0.25 × ($20 × 20,000)  
Product 3  = $100,000 Per unit  = $100,000/20,000 units  = $ 5 per unit

120  
 The business should seek to maximise the total throughput. 
 W X Y Z 
 $ $ $ $ 
Sales price/unit 20 25 18 40 
Materials required/unit 10 15 11 22  ––– ––– ––– ––– 
Throughput/unit 10 10 7 18 
 ––– ––– ––– ––– Labour hours/unit 4 5 2 6 
Throughput/labour hour $2.50 $2.00 $3.50 $3.00 
Priority 3rd 4th 1st 2nd 
The production volumes that will maximi se throughput and net profit are: 
Product Units Labour 
hours Throughput 
$ 
Y 1,000 2,000 7,000 
Z 400 2,400 7,200 
W 500 2,000 5,000 
  –––––    6,400  
X (balance) 320 1,600 3,200 
  ––––– ––––– 
  8,000 22,400 
 
 Throughput per bottleneck machine hour = ($85 – $42.50)/1.5 hours = 
$28.33 
Operating expenses per bottleneck machine hour = $8,000/(10 × 40) = 
$20 
Throughput accounting ratio = $28.33/$20 = 1.42

Chapter 4 
 121 
 (a) Step 1:  Determine the bottleneck constraint 
The bottleneck resource is ma chine time. 400 machine hours 
available each week = 24,000 machine minutes. 
Step 2:  Calculate the throughput per unit for each product 
 A B C D 
 $ $ $ $ 
Sales price 1.40 0.80 1.20 2.80 
Materials cost 0.60 0.30 0.60 1.00 Throughput/unit 0.80 0.50 0.60 1.80 
Step 3:  Calculate the throughput per machine minute 
Machine time 
per unit 5 minutes 2 minutes 3 minutes 6 minutes 
Throughput per 
minute $0.16 $0.25 $0.20 $0.30 
Step 4: Rank  
Rank 4th 2nd 3rd 1st 
Step 5:  Allocate resources using this ranking and answer the 
question. 
The profit-maximising weekly output and sales volumes are as 
follows. 
Product Units Machine 
minutes Throughput 
per unit Total 
throughout 
   $ $ 
D 1,500 9,000 1.80 2,700 
B 2,000 4,000 0.50 1,000 
C 2,500 7,500 0.60 1,500 
  –––––––   
  20,500   
A (balance) 700 3,500 0.80 560 
  –––––––  –––––––   24,000  5,760 
  –––––––  ––––––– 
Operating expenses   5,440     ––––––– 
Profit    320 
    –––––––

122  
 (b) Throughput per machine hour: $5,760/400 hours = $14.40 
Cost (operating expenses) per  machine hour: $5,440/400 hours = 
$13.60. 
TPAR: $14.40/$13.60 = 1.059 
 
 (a) Process bottleneck  
 
Capacity in Process × 35.000
1	=	35,000 units per period 
 
Capacity in Process × 42.000
1.5	=	28,000 units per period 
 
Process Y has the lower capacity and therefore this is the 
bottleneck. 
(b) Throughput accounting ratio 
 
Throughput per unit = $16 – $10 = $6 
 
Return per factory hour  = 	$6
1.5 = $4 
 
Cost per factory hour 	=	$105,000
42,000 hours = $2.50 
 Throughput accounting ratio = 	$4
$2.50
 = $1.60 
 
As the throughput accounting ratio is greater than 1 it provides a 
satisfactory result.

Chapter 4 
 123 
 (a) A 
 X X Y 
 $ $ $ 
Contribution 85 94 50 
Time at bottle neck 7 10 7 Contribution per minute 12 9 7 
Rank 1 2 3 
(b) B 
 X X Y 
 $ $ $ Throughput* 139 130 120 
Time at bottle neck 7 10 7 Throughput per minute 20 13 17 
Rank 1 3 2 
* throughput = sales less material costs 
 
 The correct answer is answer B. 
There is likely to be very little mate rial or marginal costs for digital 
products and therefore marginal cost ing and throughput accounting are 
unlikely to be useful for digital products. 
There is also likely to be very little standardisation of costs between 
digital products which reduces the role of standard costing. 
But activity based costing could be used to absorb indirect overheads as 
long as cost drivers and levels of ac tivity could be reasonably estimated. 
 
 The correct answer is answer C. 
The number of cost drivers is likely to  increase. Overheads will be split by 
more detailed analysis and each will have its own cost driver. This is likely to increase the number of  cost drivers in the system. 
The other statem ents are true.

125 
Variance analysis 
determine the costs for different purposes (b) Standard costing 
(c) Variance analysis (without 
  Chapter 
5

126  
 
2 Standard costing a nd variance analysis 
 Standard costing is a technique which establishes predetermined 
estimates of the costs of products and services and then compares these 
predetermined costs with actual cost s as they are incurred. The 
predetermined costs are known as standard costs and the difference 
between the standard cost and actual cost is known as a variance. 
 
 Further explanation of standard costing 
 Whenever identical operations are performed or identical products are 
manufactured many times over, it should be possible to decide in 
advance not merely what they are expec ted to cost, but also what they 
ought to cost. 
Similarly, when a standard service is pr ovided many times over, it should 
be possible to establish in advance how the service should be provided, 
how long it should take and how much it should cost. 
 A standard  is 'a benchmark measurem ent of resource usage or 
revenue or profit generation, set in  defined conditions' (CIMA Official 
Terminology). 
 A standard cost  for a product or service is a predetermined 
(planned) unit cost, based on a standard specification of the 
resources needed to supply it and t he costs of those resources. 
A standard cost is based on technical specifications for the materials, labour time and other re sources required and the prices 
and rates for the materials and labour. 
Standard costs can be prepared using either absorption costing or 
marginal costing. 
 A standard price  for a product or service is the expected price for 
selling the standard product or se rvice. When there is a standard 
sales price and a standard cost per unit, there is also a standard 
profit per unit  (absorption costing) or standard contribution per 
unit (marginal costing).

Chapter 5 
 127 
 Types of standard 
There are four main types of standard: 
Attainable standards 
 They are based upon efficient (but not perfect) operating conditions. 
 The standard will include allowances for normal material losses, 
realistic allowances for fati gue, machine breakdowns, etc. 
 These are the most frequent ly encountered type of standard. 
 These standards may motivate employ ees to work harder since they 
provide a realistic but  challenging target. 
Basic standards 
 These are long-term standards which remain unchanged over a 
period of years. 
 Their sole use is to show trends ov er time for such items as material 
prices, labour rates and effici ency and the effect of changing 
methods. 
 They cannot be used to highlight current efficiency. 
 These standards may demotivate employees if, over time, they 
become too easy to achieve and, as a result, employees may feel 
bored and unchallenged. 
Current standards 
 These are standards based on cu rrent working conditions. 
 They are useful when current conditions are abnormal and another 
standard would provide m eaningless information. 
 The disadvantage is that they do not  attempt to moti vate employees 
to improve upon current working conditions and, as a result, 
employees may feel unchallenged. 
Ideal standards 
 These are based upon perfe ct operating conditions. 
 This means that there is no wastage or scrap, no breakdowns, no 
stoppages or idle time; in short, no inefficiencies. 
 In their search for perfect qua lity, Japanese companies use ideal 
standards for pinpointing areas wher e close examination may result 
in large cost savings. 
 Ideal standards may have an adverse motivational impact since 
employees may feel that the st andard is impossible to achieve. 
The process by which the total differenc e between actual cost and standard is 
broken down into its different elements is known as Variance Analysis.

128  
 Variance analysis 
 Variances can be calculated for both costs and sales. Cost variances 
analyse the difference between actual  costs and standard costs. Sales 
variances analyse the differenc e between actual and budgeted sales 
prices and sales volumes. 
Where standard costing is used, va riance analysis can be an important 
aspect of performance measurement and control. It is defined in the 
CIMA Official Terminology as ‘the ev aluation of performance by means of 
variances, whose timely reporting should maximise the opportunity for 
managerial action’. 
Variance reports comparing actual results with the standards or budget 
are produced regularly , perhaps monthly. 
 
 A variance is the difference between actual results and the budget or 
standard. 
Taken together, cost and sales variances  can be used to explain the difference 
between the budgeted prof it for a period and t he actual profit. 
When actual results are better than expected results, a favourable (F)  variance 
occurs. 
When actual results are worse than expected results, an adverse variance (A) 
occurs.  
 The difference between budgetary control and variance analysis 
 Budgetary control is covered in a later chapter and is concerned with 
controlling total costs across an area of responsibility, whereas standard 
costing and variance analysis ar e concerned with unit costs. 
In order to use standard costing, a standard unit must be made or a 
standard action be performed. Budgetary c ontrol is more flexible and can 
be used to control costs even when a wide variety of activities are 
undertaken. It can even be applied to discretionary expenditure such as 
research, which is much harder  to use for standard costing. 
One disadvantage of using budgetary c ontrol is that whilst it limits 
expenditure it does not provide a basis for measuring the efficiency of 
that expenditure. 
A standard costing system is integr ated with the actual accounting 
system whereas budgetary control operates as a reporting system 
external to the accounting system.

Chapter 5 
 129 
Variance groups 
Variances can be divided into three main groups: 
 sales variances 
 variable cost variances 
– material variances 
– labour variances – variable overhead variances 
 fixed overhead variances 
3 Sales variances 
The difference between a budgeted profit and the actual profit achieved in a 
period is explained by both cost variances  and sales variances. Cost variances 
explain the differences between act ual costs and budgeted or standard costs. 
Sales variances explain the e ffect of differences between: 
 actual and standard sales prices, and 
 budgeted and actual sales volumes. 
Sales price variance 
A sales price variance shows the effect on profit of a 'change in revenue caused 
by the actual selling price differing  from that budgeted ' (CIMA Official 
Terminology). It is calculat ed as the difference between: 
(a) Standard selling price mu ltiplied by the actual num ber of units sold, and 
(b) Actual selling price multiplied by  the actual number of units sold. 
 
 Proforma 
  
Sales price variance  $ 
Units sold should have sold for (actual sales units × standard 
sales price per unit) X 
They did sell for (actual sales revenue) Y 
  –––– 
Sales price variance  X–Y 
  –––– 
This variance is favourable if actual sales revenue is higher than sales at 
the standard selling price, and adverse if  actual sales revenue is lower 
than standard.

130  
Sales volume variance 
The sales volume variance is a 'measure of  the effect on cont ribution/profit of 
not achieving the budgeted volume of sale s' (CIMA Official Terminology). It is 
the difference between actual and budgeted sales volumes valued at either 
standard profit, in an absorption costing system, or standard contribution in a 
marginal costing system. 
 
 Proforma 
  
Sales volume variance  Units of sale 
 Units 
Actual sales volume X 
Budgeted sales volume Y 
 –––– Sales volume variance X–Y 
 –––– 
the standard selling price, and adverse if actual sales revenue is lower 
than standard. 
The variance in units can then be valued in one of three ways: 
 at the standard profit per unit  – if using absorption costing 
 at the standard contribution per unit  – if using marginal costing 
 at the standard revenue per unit  – this is rarely used and you should 
only do so if it is specifically  asked for in an exam question. 
 
 Example 1 
 Walter Dean Ltd has budgeted sale s of 400 units at $25 each. The 
variable costs are expected to be $18 per unit, and there are no fixed 
costs. 
The actual sales were 500 units at $20 each and costs were as expected. Calculate the selling price varianc e and the sales volume contribution 
variance.

Chapter 5 
 131 
 Example 2 
 The following data is available for t he most recent month of sales: 
Sales units 320 380 
Selling price per unit $45 $42 
Total cost per unit $23 $22 Variable cost per unit $17 $15 
Calculate the sales variances, calcul ating the sales volume variance 
using absorption costing, marginal costing and standard revenue per unit. 
As well as calculating variances y ou may also have to determine possible 
causes for variances. 
Here are potential causes of the sales variances: 
Sales price 
(1) Higher-than-expected discounts offered to customers to persuade them to 
buy larger, bulk quantities. 
(2) Lower-than-expected discounts, perhaps  due to strength of sales demand. 
(3) The effect of low-price offe rs during a marketing campaign. 
(4) Market conditions forcing an industry-wide price change. 
Sales volume 
(1) Successful or unsuccessful  direct selling efforts. 
(2) Successful or unsuccessful marketing efforts (for exampl e, the effects of 
an advertising campaign). 
(3) Unexpected changes in customer needs and buying habits. 
(4) Failure to satisfy demand due to production difficulties. (5) Higher demand due to a cut in selli ng prices, or lower demand due to an 
increase in sales prices. 
4 Direct material cost variances 
This section has three variances. The di rect material total variance, which 
shows the total difference in the amount spent on materials, and this can also 
be split into two further components – the materials price and materials usage 
variances 
Direct material total variance 
The difference between: 
(a) the standard direct material co st of the actual production and 
(b) the actual direct material cost.

132  
 Proforma 
  
Direct material total variance  $ 
Actual quantity of output should cost (standard) X 
 did cost Y 
  –––– Total cost variance  X–Y 
  –––– 
 
 Example 3 
 James Marshall Ltd makes a single product with the following budgeted 
material costs per unit: 
2 kg of material A at $10/kg 
Actual details: 
Output 1,000 units 
Material purchased and used 2,200 kg Material cost $20,900 
Calculate the direct material total variance. 
A total material variance actually conve ys very little useful information. It needs 
to be analysed further. It can be analysed into two sub-variances: (1) a direct material price variance, i. e. paying more or less than expected for 
materials and 
(2) a direct material usage variance, i. e. using more or less material than 
expected for the actual output. 
 
 CIMA definitions 
 The total direct materi al variance is defined as: 
measurement of the difference bet ween the standard material cost 
of the output produced and the material cost incurred. 
The material price variance is defined as: 
the difference between the actual price paid for purchased materials 
and their standard cost. 
The material usage variance is defined as a variance which:  
measures efficiency in the use of  material, by comparing standard 
material usage for actual production with actual material used, the 
difference is valued at standard cost. (all taken from CIMA Official Terminology).

Chapter 5 
 133 
Direct material price variance 
It is calculated as the difference between: 
(a) standard purchase price per kg (or per litre for liquids) and 
(b) actual purchase price multiplied by the actual quantity of material purchased or used. 
Note that the material price variance c an be calculated either at the time of 
purchase or at the time of usage.  
 
Proforma 
  
Actual quantity of material s should cost (standard) X 
 did cost (actual) Y 
  –––– Direct materials price variance  X–Y   –––– 
 
 The impact of inventory valuation 
 If inventory is valued at standard cost, then the calculation should be 
performed using the quantity of materials purchased. This will ensure that 
all of the variance is eliminated as  soon as purchases are made and the 
inventory will be held at standard cost. 
If inventory is valued at actual co st, then the calculation should be 
performed using the quantit y of materials used. This means that the 
variance is calculated and eliminated on each item of inventory as it is 
used up. The remainder of the inventor y will then be held at actual price, 
with its price variance still ‘attached’, until it is used and the price variance 
is calculated. 
Direct material usage variance 
(a) the standard quantity of material spec ified for the actual production and 
(b) the actual quantity used  
multiplied by the stand ard purchase price.

134  
 Proforma 
  
Direct materials usage variance  $ 
Actual output produced should use (standard 
quantity) X 
 did use (actual quantity) Y 
  –––– 
Direct materials price varianc e (in material quantity) X–Y 
  –––– 
× standard price (per uni t of material) $P 
Direct materials usage 
variance  (X–Y) 
 
 Example 4 
 For example 3, calculate the pric e and usage variances for materials. 
 
 An alternative method 
 Using the data in Example 3, calcul ate the same variances for materials 
using the following format: 
 
Note:  This assumes purchases = issues and/or the price variance is 
calculated at the time of issue.

Chapter 5 
 135 
The potential causes of the material variances are as follows: 
Material price 
(1) Using a different supplier, who is either cheaper or more expensive. 
(2) Buying in larger-sized orders, and getting larger bulk purchase discounts. 
Buying in smaller-sized orders and losing planned bulk purchase 
(3) An unexpected increase in the prices charged by a supplier. 
(4) Unexpected buying costs, su ch as high delivery charges. 
(5) Efficient or inefficient buying procedures. 
(6) A change in material quality, resulti ng in either higher or lower purchase 
prices. 
Material usage 
(1) A higher-than-expected or lower-than-ex pected rate of scrap or wastage. 
(2) Using a different quality of material (higher or lower quality) could affect 
the wastage rate. 
(3) Defective materials. 
(4) Better quality control. (5) More efficient work procedures, resu lting in better material usage rates. 
(6) Changing the labour mi x which impacts on wastage if different types of 
labour make more/less errors. 
(7) Changing the materials mix to obtai n a more expensive or less expensive 
mix than the standard. 
5 Direct labour cost variances 
This section has four variances. The di rect labour total cost variance, which 
shows the impact of any overall change in  the amount spent on labour, and this 
can also be split into two further components – the labour rate and labour 
efficiency variances. In some scenarios we  might also see a labour idle time 
variance. 
Direct labour total variance 
(a) the standard direct labour cost  of the actual production and 
(b) the actual cost of direct labour.

136  
 Proforma 
  
Direct labour total variance  $ 
 did cost Y 
  –––– 
Total cost variance  X–Y 
  –––– 
 
A total labour variance can also be anal ysed further. It can be analysed into two 
sub-variances: 
(1)  a direct labour rate variance, i.e.  paying more or less than expected per 
hour for labour and 
(2)  a direct labour efficiency variance, i. e. using more or less labour hours per 
unit than expected. 
 
 The total direct labour variance is defined as one which: 
indicates the difference between t he standard direct labour cost of 
the output which has been produced and the actual direct labour 
cost incurred. 
The direct labour rate variance is defined as one which: 
indicates the actual cost of any change from the standard labour 
rate of remuneration. 
The direct labour efficiency variance is defined as: 
standard labour cost of any change from  the standard level of labour 
efficiency. 
(all taken from CIMA Official Terminology).  
Direct labour rate variance 
(a) standard rate per hour and the (b) actual rate per hour 
multiplied by the actual hours that were paid for.

Chapter 5 
 137 
 Proforma 
  
Direct labour rate variance  $ 
Number of hours paid should cost/hr (standard) X 
 did cost (actual) Y   –––– 
Direct labour rate variance  X–Y 
  –––– 
 
Direct labour efficiency variance 
(a) the standard hours specified for the actual production and 
(b) the actual hours worked  
multiplied by the standard hourly rate. 
 
 Proforma 
  
Direct materials usage variance $ 
Actual output produced should take (standard hours) X 
 did take(actual hours) Y 
  –––– Direct labour efficiency 
variance (in hours) X–Y 
  –––– 
× standard rate per hour  $P Direct labour efficiency 
variance  $P × (X–Y) 
 
 Example 5 
 Ivan Korshunov provides a pension consultancy service and has the 
following budgeted/standard information: 
Budgeted services 1,000 
Labour hours per unit 3 Labour rate per hour $80 
Actual results  
Number of services provided 1,100 Hours paid for and worked 3,400 hours 
Labour cost $283,000 
Calculate rate and efficiency variances for labour.

138  
Idle time and idle time variances 
During a period, there might be idle time , when the work force is not doing any 
work at all. 
When idle time occurs, and if it is recorded, the efficiency variance should be 
separated into two parts: 
 an idle time variance 
 an efficiency variance during active working hours. 
If there is no standard idle time set, then the idle time variance is always 
adverse , because it represents money ‘wasted’. 
 
 Idle time definition 
 The purpose of an efficiency variance should be to measure the 
efficiency of the work force in t he time they are actively engaged in 
making products or delivering a service. CIMA Official 
The direct labour idle time variance is defined as:   
this variance occurs when the hours paid exceed the hours worked 
and there is an extra cost caused by this idle time. Its computation 
increases the accuracy of the l abour efficiency variance. (CIMA 
Official Terminology). 
 
 A product has a standard direct labour  cost of $15, consisting of  
1.5 hours of work for each unit at a cost of $10 per hour. During April,  
100 units were produced. The direct labour workers were paid $2,000 for 160 hours of attendance, but the idle time  records show that 30 hours in 
the month were recorded as idle time. 
(a) We can record an idle time variance of 30 hours (A). This is costed 
at the standard rate per hour, $10, to  give an idle time variance of 
$300(A). 
(b) The efficiency variance should then be calculated using the active 
hours worked, not the total hours paid for. 
  Hours 
  $ 
Actual output produced should take (standard hours) (1oo hrs × 1.5 hr s per unit) 150 
 did take (160 – 30 hrs) 130   –––– Direct labour efficiency variance (in hours) 20F   –––– × standard rate per hour  $10/hr Direct labour efficiency variance  $200 F   ––––

Chapter 5 
 139 
 Example 6 
 Melanie Mitchell Ltd makes a single product with the following 
information: 
Budget/Standard 
Output  1,000 units  
Hours  6,000  Labour cost  $42,000 
Actual 
Output  900 units  
Hours paid  5,500  Hours worked  5,200  Labour cost  $39,100 Calculate appropriate variances for labour 
 
 Expected idle time 
 Some organisations may experience idle time on a regular basis. For 
example, if demand is seasonal or irr egular, but the organisation wishes 
to maintain and pay a constant number of workers, they will experience a 
certain level of ‘expected’ or ‘norma l’ idle time during less busy periods. 
In this situation the standard labour  rate may include an allowance for the 
cost of the expected idle time. Only  the impact of any unexpected or 
abnormal idle time would be included in the idle time variance. If actual 
idle time is greater than standard then t he variance is adverse; if it is less 
than standard then it w ould be favourable. 
Example 
LBC offer a public bus service for lo cal journeys at a popular holiday 
resort. It experiences seasonal de mand for its product. During the next 
period the company expects that ther e will be an average level of idle 
time equivalent to 20% of hours pa id. The company’s standard labour 
rate is $9 per hour before the adjustment for idle time payments. 
The standard time for each journey is 3 active (productive) hours. 
Actual results for the period were as follows: Number of journeys  3,263  Actual hours paid for  14,000  Actual active (productive) hours  10,304 
Required: 
Calculate the following variances for the period: 
(i) the idle time variance 
(ii) the labour efficiency variance.

140  
 Solution 
The basic standard rate per hour mu st be increased to allow for the 
impact of the idle time: 
 
Standard rate per hour worked =$9.00
0.8 = $11.25 
The variances can now be evaluated at this increased hourly rate. 
Idle time variance 
 Hours  
Expected idle time = 20% × 14,000 hours paid 2,800  
Actual idle time = 14,000 – 10,304 hours 3,696   ––––––  
Variance (hours) 896 A 
Standard rate per hour worked $11.25   ––––––  Idle time variance $10,080 A 
 ––––––  
Labour efficiency variance 
 Hours  
3,263 journeys should have taken (×3) 9,789  
But did take (productive hours) 10,304   ––––––  
Variance (hours) 515 A 
Standard rate per hour worked $11.25   ––––––  
Labour efficiency variance $5,794 A 
 ––––––  
 
Possible operational causes of t he labour variances are as follows: 
Labour rate 
(1) An unexpected increase in basic rates of pay. 
(2) Payments of bonuses, where these are recorded as direct labour costs. 
(3) Using labour that is  more or less experienced  (and so more or less 
expensive) than the 'standard'. 
(4) A change in the composition of the work force, and so a change in 
average rates of pay.

Chapter 5 
 141 
Labour efficiency 
(1) Taking more or less time than expected to complete work, due to 
inefficient or efficient working. 
(2) Using labour that is  more or less experienced  (and so more or less 
efficient) than the 'standard'. 
(3) A change in the composition or mix of  the work force, and so a change in 
the level of efficiency. 
(4) Improved working methods. 
(5) Industrial action by the work force: 'working to rule'. (6) Poor supervision. (7) Improvements in efficiency due to an unexpected 'learning effect' amongst 
the work force. 
(8) Unexpected lost time due to production bottlenecks and resource 
shortages. 
6 Variable overhead variances 
Variable overhead variances are sim ilar to direct labour variances. 
 In standard product costing, a vari able production overhead total variance 
can be calculated, and this can be anal ysed into an expenditure variance 
and an efficiency variance. 
 With service costing, a variable overhead total variance can be calculated, 
but this might not be analysed any further. 
Since variable production overheads are normally assumed to vary with labour 
hours worked, labour hours are used in calculations . This means, for 
example, that the variable production overhead efficiency variance uses exactly 
the same hours as the direct  labour efficiency variance. 
 
 Details on the variances 
 Variable production overhead total variance 
(a) the standard variable overhead cost  of the actual production and 
(b) the actual cost of variable production overheads. 
Variable production overhead total variance $ 
 did cost Y   –––– 
Total variance  X–Y 
  ––––

142  
 A total variable production over head variance can also be analysed 
further. It can be analysed into two sub-variances: 
(1) a variable production overhead expe nditure variance, i.e. paying 
more or less than expected per hour for variable overheads and 
(2) a variable production overhead effici ency variance, i.e. using more 
or less variable overheads per unit than expected. 
The official CIMA definitions are as follows: The variable production overhead tota l variance is defined as one which: 
measures the difference between the variable overhead that should 
be used for actual output and vari able production overhead actually 
used. (CIMA Official Terminology). 
The variable production overhead expenditure variance is defined as one 
which: 
indicates the actual cost of any change from the standard rate per hour. Hours refer to either l abour or machine hours depending on 
the recovery base chosen for variable production overhead. 
(CIMA Official Terminology). 
The variable production overhead efficiency variance is defined as the: 
standard variable overhead cost of  any change from the standard 
level of efficiency. (CIMA Official Terminology). 
Variable production overhead expenditure variance 
  $ 
Number of hours worked s hould cost/hr (standard) X 
  –––– 
Variable production overhead expenditure variance X–Y   –––– 
Variable production overhead efficiency variance 
  $ Actual output produced shoul d take (standard hours) X 
 did take (actual hours) Y   –––– Efficiency variance (in hours) X–Y   –––– 
× standard variable overhead rate per hour $P 
Variable production overhead efficiency variance $P × (X–Y)

Chapter 5 
 143 
 Example 7 
 The budgeted output for KB for May was 1,000 units of product A. Each 
unit requires 2 direct labour hours. Variable overheads are budgeted at 
$3 per labour hour. 
Actual results: 
Output 900 units  
Labour hours worked  1,980 hours 
Variable overhead $5,544  
Calculate appropriate variances for variable overheads. 
 
 Alternative method 
 Using the same example, calculate appropriate variances for variable 
overhead using the following format:

144  
 Idle time variances and variable production overhead 
 The analysis of variable production ov erhead variances is affected by the 
existence of idle time. It is usually assumed that variable production 
overhead is incurred during active hours only. 
The variable production overhead effici ency variance is calculated in the 
same way that the direct labour ef ficiency variance is calculated when 
there is idle time. The variable production overhead expen diture variance, when there is 
idle time, is the difference between: 
 the standard variable overhead cost of the active hours worked, and 
 the actual variable overhead cost. 
 
 Example 8 
 Extracts from the standard cost ca rd of a product are as follows: 
 $/unit  
Direct labour  2 hours × $15 per hour  30  
Variable production overhead  2 hours × $4 per hour  8 
 During May, 200 units were produced.  The direct labour workers were 
paid $6,600 for 440 hours of work, but t he idle time records show that  
20 hours in the month were recorded as idle time. Actual variable 
production overhead expenditu re incurred was $1,530. 
Calculate the labour and variable overhead variances. 
7 Fixed production overhead cost variances 
Fixed production overhead total variance 
The amount of overhead absorbed for each unit of output is the standard fixed 
overhead cost per unit. The total cost variance is therefore calculated as 
follows: The difference between: (a) the standard fixed production ov erhead cost absorbed by the actual 
production (i.e. the amount of fixed overhead actually absorbed into 
production using the standard absorption rate), and 
(b) the actual fixed prod uction overheads incurred.

Chapter 5 
 145 
 Proforma 
 Fixed production overhead total variance 
  $ 
Overheads (Actual output × standard fixed production X 
absorbed overhead absorption rate)  
Actual fixed overhead incurred Y 
 –––– 
Variable production overhead expenditure variance X  Y 
  –––– 
 
 Under/over-absorption 
 In standard absorption costing, the to tal cost variance for fixed production 
overhead variances is the amount of  over-absorbed or under-absorbed 
overhead. Over-absorbed overhead is  a favourable variance, and under-
absorbed overhead is an adverse variance. 
Under/over-absorption is the differ ence between the overheads incurred 
and the overheads absorbed The under/over-absorption occurs because the OAR is based upon two 
predictions – the budgeted fixed ov erhead and the budgeted level of 
activity. If either or both predictio ns are wrong there will be under/over-
absorption and there will be a fi xed overhead total variance. 
 If the actual expenditure is diffe rent from the bu dgeted expenditure 
there is an expend iture variance and 
 If the actual production is di fferent from t he budgeted production 
there is a volume variance. A fixed production overhead volume 
variance represents the amount of  fixed overhead that has been 
under- or over-absorbed due to the fact that actual production 
volume differed from the budgeted production volume. 
Fixed production overhead expenditure variance 
(a) budgeted fixed prod uction overhead and 
(b) actual fixed production overhead.

146  
 Proforma 
 Fixed production overhead expenditure variance 
 $ 
Budgeted fixed overhead X 
Actual fixed production overhead incurred Y  –––– 
Fixed production overhead ex penditure variance X–Y 
 –––– 
An expenditure variance can be calc ulated for fixed production overhead. 
A similar variance can be calculated (i f required) for other fixed overhead 
costs: 
 a fixed administration overhead expenditure variance 
 a fixed sales and distribution overhead expenditure variance. 
Fixed production overhead volume variance 
The volume variance is calculated as the difference between: 
(a) Budgeted output in units and (b) Actual output in units multiplied by the standard fixed overhead cost per 
unit. 
 
 The fixed overhead volume variance does  not occur in a marginal costing 
system. 
 
 Proforma 
 Fixed production overhead volume variance 
  Units 
Actual output produced  X 
Budgeted output  Y 
  –––– 
Volume variance (in units) X–Y   –––– 
× standard fixed overhead rate per unit  $F 
Fixed production overhead volume variance  $F × (X–Y) 
You may be aware that the fixed production overhead volume variance 
can be sub-divided into a fixed production overhead capacity and fixed 
production overhead efficien cy (explained later).

Chapter 5 
 147 
 Example 9 
 The following data relates to the fi xed production overhead costs of 
producing widgets in March: 
Budgeted fixed production ov erhead expend iture $4,375 
Budgeted production volume (widgets) 1,750 units 
Standard fixed producti on overhead cost:  
(0.25 hours @ $10 per hour) $2.50 
Number of widgets produced in March 1,800 units Actual fixed production ov erhead expenditure $4,800 
Required: 
Calculate the fixed production overhead expenditure and volume 
variances in March 
It has been shown in an earlier chapter that , where products ta ke different times 
to produce, it is not always suitable to have fixed overheads allocated on a per unit basis. A labour hour basis may be more suitable, for example. 
It may therefore be necessary to work out the fixed overhead volume variance 
based on the fixed overhead absorption rate  per hour, rather than the rate per 
unit. This is needed when an organisation has more than one product and an absorption rate per unit is not appropriate. 
The variance is calculated by compar ing the cost of the standard hours for 
actual production with the total budgeted fixed overhead. 
 
 A cosmetic dental practice offers tw o types of treatment, teeth whitening 
and teeth straightening. The treatments last for varying amounts of time 
and fixed overheads are allocated to treatments based on labour hours 
spent on the treatment. In the month of September total fixed overheads 
were budgeted to be $40, 000 and the services were budgeted to have 
the following total labour hours: 
Service  Whitening  Straightening  
Budgeted hours  460  540 
During September there were 190 t eeth straightening treatments which 
took on average 2.8 hours per treatment  compared to a standard time of 
3 hours per treatment. 
Calculate the fixed overhead volume va riance for the teeth straightening 
service for September.

148  
 Solution 
The fixed overhead absorption rate per hour is: 
= $40,000 / (460 hours + 540 hours) = $40 per hour 
The budgeted overhead cost for the t eeth straighteni ng treatment is: 
= 540 hours × $40 per hour = $21,600 
The standard cost of the standard hours worked is: 
= 190 treatments × 3 hours per tr eatment × $40 per hour = $22,800 
The variance = $22,800 – $21,600 = $1,200 Favourable 
Fixed overhead capacity and efficiency variances 
In absorption costing systems, if t he fixed overhead is absorbed based on 
hours , then the fixed overhead volume variance can be subdivided into 
capacity and efficiency variances. 
 The capacity variance measures whether the workforce worked more or 
fewer hours than budgeted for the period: 
 $ 
Actual hours × FOAR per hour X 
Less Budgeted expenditure (X)  ––– 
Fixed overhead capacity variance X 
 ––– 
The efficiency variance measures whether  the workforce took more or less 
time than standard in producing their output for the period: 
 $ 
Standard hours for actual production × FOAR per hour X 
Less Actual hours × FOAR per hour (X)  ––– 
Fixed overhead efficiency variance X 
 ––– 
Together, these two sub-variances explain wh y the level of activity was different 
from that budgeted, i.e. they combine to give the fixed overhead volume 
variance.

Chapter 5 
 149 
 Example 10 
 The following information is available for a company for Period 4. 
Fixed production overheads  $22,960  
Units  6,560 The standard time to produce each unit is 2 hours 
Actual 
Fixed production overheads  $24,200  
Units  6,460  Labour hours  12,600 hrs 
Required: 
Calculate the following: 
(a) fixed overhead absorption rate per hour (b) fixed overhead capacity variance (c) fixed overhead efficiency variance (d) fixed overhead volume variance. 
 
 Marginal costing fixed production overhead variances 
 In marginal costing, fixed production overheads are not absorbed into the 
cost of production. For this reas on, there is no fixed production overhead 
volume variance. The only fixed production overhea d variance reported in standard 
marginal costing is a fixed produ ction overhead expenditure variance. 
This is the difference between ac tual and budgeted fixed production 
overhead expenditure, as described above for absorption costing. 
Potential causes of fixed and variabl e overhead variances are as follows: 
(1) Fixed overhead expenditure adverse va riances are caused by spending in 
excess of the budget. A more detailed anal ysis of the expenditure variance 
would be needed to establish why act ual expenditure has been higher or 
lower than budget. 
(2) The fixed overhead volume variance  (and therefore the capacity and 
efficiency variance) is caused by c hanges in production volume (which in 
turn might be caused by changes in sales volume or through increased or 
decreased labour productivity). 
(3) Variable production overhead expenditu re variances are often caused by 
changes in machine running costs (for ex ample, if electricity rates have 
changed). 
(4) Variable production overhead efficien cy variances: the causes are similar 
to those for a direct labour efficiency variance.

150  
8 Possible interdepende nce between variances 
In many cases, the explanation for one va riance might also explain one or more 
other variances in which case the variances are inter-related. 
For control purposes, it mi ght therefore be necessary to look at several 
variances together and not in isolation. Some examples of interdependence between variances are listed below. 
 Using cheaper materials will result in  a favourable material price variance, 
but using the cheaper material in production might increase the wastage 
rate (adverse material usage) and cause a fall in labour productivity (adverse labour and variable overhead efficiency). 
A more expensive mix of materials (adv erse mix variance) might result in 
higher output yields (favourable yiel d variance). Mix and yield variances 
are covered in the next chapter. 
 Using more experienced labour to do the work will result in an adverse 
labour rate variance, but productivity might be higher as a result 
(favourable labour and variable overhead efficiency). 
 Changing the composition of a team might result in a cheaper labour mix 
(favourable mix variance) but lower pr oductivity (adverse yield variance). 
 Workers trying to improve productivity  (favourable efficiency variance) in 
order to win a bonus (adverse rate  variance) might use materials 
wastefully in order to save ti me (adverse materials usage). 
 Cutting sales prices (adverse sales pr ice variance) might result in higher 
sales demand from cust omers (favourable sales volume variance). 
9 Operating statement 
An operating statement is a top-level variance report, reconciling the budgeted 
and actual profit for the period. 
An operating statement star ts off with the expected figure, e.g. budgeted or 
standard profit or contribution or cos t, etc. and ends up with the corresponding 
actual figure. In between we list all the appropriate variances in as much detail 
as possible. The format will be similar to the follo wing, the numbers have no significance. 
They are purely for illustration purposes.

Chapter 5 
 151 
Operating Statement for Period 12 
 $ $ $  
Budgeted gross profit   100,000  
Sales volume profit variance   15,000 F 
   ––––––––  Budgeted profit from actual sales 
volume   115,000  
Sales price variance   28,750 F 
   ––––––––     143,750  
   Adverse Favourable   
Cost variances      
Direct material A Price 3,100    
 Usage  10,000   
Direct material B Price  3,050    Usage  7,500   
Direct labour Efficiency  7,000   
 Rate  12,000    Idle time  3,000   Variable overhead Efficiency 4,000    
 Expenditure  3,500   
Fixed Prod overhead Ex penditure  11,500   
 Volume 30,400    
  ––––––– –––––––   
  37,500 57,550 20,050 F   ––––––– ––––––– –––––––  
Actual gross profit    163,800  
    –––––––  
In some questions the usage variance wi ll be sub-divided into mix and yield 
variances. This is covered in the chapter on 'Advanced Variances' later in the 
text.

152  
 Variance reporting 
 Variances should be reported to m anagement at the end of each control 
period, for example at the end of each month. T here might be a hierarchy 
of control reports: 
 a top level report reconciling budgeted and actual profit should be 
prepared for senior management 
 variance reports might be prepar ed for individual managers with 
responsibility for a particu lar aspect of operations. 
For example, regional sales managers might be sent variance reports 
showing sales price and sales volu me variances for their region. 
Production managers might be sent varianc e reports relating to materials 
usage, labour efficiency and other items of expend iture under their 
control. Similarly, detailed repor ts on overhead expenditure variances 
might be sent to the managers res ponsible for departmental spending. 
Variance reports should be provided as  soon as possible after the end of 
each control period, since there is a risk that variance information might 
be considered ‘out of date’ if it is received severa l weeks after the control 
period has ended. 
 
 Example 11 
 SM is a manufacturing company whic h produces a variety of products. 
The following information relates to one of its products – Product W: 
Standard cost data 
  $ $ 
Selling price   100 
Direct Material X 5 kg 15  Direct Material Y 4 kg 20  
Direct labour @ $8/hr 24  
Variable overheads  18  Fixed overheads  6  
  –––  
   83    ––– 
Profit per unit   17 
   ––– 
The budgeted production is 24,000 uni ts per annum evenly spread 
throughout the year, with each cal endar month assumed to be equal. 
March is a bad month in terms of sale s revenue and it is expected that 
sales will only be 1,700 units during the month. Fixed overheads were 
expected to be $144,000 per year and are absorbed on a labour hour 
basis.

Chapter 5 
 153 
 Actual results for the m onth of March were that sales were 2,200 units at 
a price of $90. There was no change in  inventory of fi nished goods or raw 
The purchases during the month were 11,300 kg of material X at $2.80 
per kg and 8,300 kg of material Y at $5.30 per kg. 4,800 labour hours were worked at a rate of $8.10 per hour and 1,600 
hours at $8.30. The actual variable overheads for t he period were $33,000 and the fixed 
overheads were $12,500. The company uses an absorption co sting system and values its raw 
materials at standard cost. 
Required: 
Calculate appropriate variances for t he month of March in as much detail 
as possible and present an operating statement reconciling budgeted 
profit with actual profit. 
You are not required to calculate mi x or yield variances as Sam Mendes 
Ltd does not sub-analyse the material usage variance. 
 
 Variances in service industries 
 In the exam, you are just as likel y to encounter service industries as 
manufacturers. These could be la w firms, healthcare providers, 
accountants, banks etc. The calculat ions, however, will still follow the 
same principles as in manufacturing. 
The standard cost schedule for hospi tal care for a minor surgical 
procedure is shown below. 
Staff: patient ratio is 0.75:1 
  $ 
Nursing costs 2 days × 0.75 × $320 per day 480 
Space and food costs 2 days × $175 per day 350 Drugs and specific materials  115 
Hospital overheads 2 days × $110 per day 220 
  ––––– Total standard cost  1,165 
  –––––

154  
 The actual data for the hospital ca re for one patient having the minor 
surgical procedure showed that the pat ient stayed in hospital for three 
days. The cost of the dr ugs and specific materials for this patient was 
$320. There were 0.9 nurse s per patient on duty durin g the time that the 
patient was in hospital. The daily rates for nursing pay, space and food, 
and hospital overheads were as expected. 
Prepare a statement that reconciles the standard cost with the actual 
costs of hospital care for this pat ient. The statement should contain FIVE 
variances that will give useful information to the manager who is 
reviewing the cost of hospital ca re for minor surgical procedures. 
Solution 
  $ $ 
Standard cost for 2-
day procedure   1,165  
Length of stay 
variances     
Nursing costs 1 day × 0.75 × $320 per day 240A  
Space and food costs 1 day × $175 per day 175A   
Hospital overheads 1 day × $110 per day 110A   
  ––––– 525 A 
   ––––– 
Standard cost for 3-day 
stay   1,690  
Drug and specific cost 
variances   205 A 
Nursing staff variance 3 days × (0.90 – 0.75) × $320 
per day  144 A 
   ––––– 
Actual cost   2,039  
 
10 Variance analysis using ABC costing 
As part of variance analysis managers will need to establis h standard costs. 
Activity based costing is one method for determining costs and hence will have 
implications of some of the variances calculated. 
Compared to traditional absorption costing,  the use of ABC is most likely to 
impact overhead variances. 
Typically, standard costs can be co mpared to actual and an overhead 
expenditure and efficiency variance calculated.

Chapter 5 
 155 
 An ABC approach to the analysis of  overhead costs is possible. This 
follows the ABC logic that all ov erheads are variable if one understands 
what they vary with. Let us illustra te the approach with a simple example. 
Example 
XX produces the Unit and all overheads are associated with the delivery 
of Units to its customers. Budget  details for the period include $8,000 
overheads, 4,000 Units output and 40 custom er deliveries. Actual results 
for the period are $7,800 overheads, 4,200 Units output and 38 customer 
deliveries. 
The overhead cost variance for the period is 
 $  
Actual cost 7,800  
Standard cost (4,200 units  × $2 per unit) 8,400  
 ––––  
Cost variance 600 F 
 ––––  
Applying the traditional fixed overhead cost variance analysis gives the 
following result: 
  $  Volume variance ($8,400 standard – $8,000 budget) 400 F 
Expenditure variance ($8,000 budget – $7,800 actual) 200 F 
  ––––  
Cost variance  600 F 
  ––––  
Adopting an ABC approach gives the following result: 
  $  
Efficiency 
variance (42 standard – 38 actual del iveries) × $200 800 F 
Expenditure 
variance [(38 deliveries × $200) – $7,800] 200 A 
  ––––  
  ––––  
The ABC approach is based on an a ssumption that the overheads are 
essentially variable (but variable with the delivery num bers and not the 
Units output). The ABC cost varianc es are based on a standard delivery 
size of 100 Units and a standard cost per  delivery of $200. Both of these 
figures are derived from the budget. The activity variance reports the cost 
impact of undertaking more or less  activities than standard, and the 
expenditure variance reports  the cost impact of paying more or less than 
standard for the actual activities undertaken.

Chapter 5 
 157 
11 Practice questions 
 The following data relates to the budget  for a company producing widgets 
in March: 
Budgeted production and sales 1,750 
(widgets) units 
Standard cost per unit: $ 
Direct materials 6.00 Direct labour 3.00 
Variable production overhead 0.75 Fixed production overhead 2.50 
 ––––– 
 12.25 
Standard sales price 18.52  ––––– 
Standard profit per unit 6.00 
 ––––– Number of widgets produced and sold 1,800 
in March units Actual sales revenue $32,300 
Required: 
Calculate the sales price and sales vo lume profit variance. What would 
be the sales volume contribution vari ance if standard marginal costing 
were used? 
 
 Major Caldwell makes and sells a singl e product. Each unit of the product 
requires 3 kg of material at $4 per kg. 
The actual details for last period were  that 1,200 units of finished goods 
were produced, 3,600 kg of material were purchased for $14,800 and 
3,520 kg were used. 
Major Caldwell maintains its ra w materials account at standard. 
Calculate appropriate variances for materials.

158  
 The standard direct material and labour costs for a product are: 
  $ 
Direct material A 2 kg × $ 4 per kg 8 
Direct material B 0.5 litres × $6 per litre 3 
Direct labour 0.75 hours × $12 per hour 9   ––– 
  20 
  ––– 
During November, the company made 3,200 units and sold 2,900. Actual 
production costs were: 
  $ 
Direct material A 6,100 kgs 25,000 
Direct material B 1,750 litres 11,600 Direct labour 2,200 hours paid 28,000 
 (only 2,000 hours worked)  
Required: 
Calculate the following variances: 
 direct materials price 
 direct materials usage 
 direct labour rate 
 direct labour idle time 
 direct labour efficiency. 
 
 Jack Doherty makes a single produc t with the following standard cost 
details per unit. 
  $ 
Direct materials 5 kg @ $4/kg 20 Direct material B 4 hrs @ $6/hr 24 
Actual results were that 1,000 units  were produced and sold. The actual 
hours paid for were 4,100 and the hours worked were 3,900. The actual 
labour cost was $27,060. The number of  kg purchased in the month was 
5,200 kg for $21,320 and the number of kg used was 4,900 kg. The 
company calculates the material price variance at the time of purchase. 
Calculate appropriate variances for materials and labour.

Chapter 5 
 159 
 Axelrod makes and sells a single pr oduct with the following information: 
Standard/Budget 
Material 3,000 kg @ $5 per kg 
Labour  5,000 hours @ $6 per hour 
Actual 
Output 1,100 units   Material Purchased 3,600 kg for $18,720  Used 3,400 kg  
Labour hrs Paid for 5,200 hrs for $32,760 
 Worked 4,900 hrs  
Axelrod maintains its raw material a ccount at standard cost. Calculate the 
variances for materials and labour. 
 
 IR hospital provides surgical tr eatments which require 3 standard hours 
per treatment. Fixed overheads  are budgeted at $12,000 and are 
absorbed on a labour hour basis. The hospital budgeted to provide 1,000 
treatments during March. 
Treatments 1,100 
Labour hours 3,080 hours Overheads incurred $13,000 
Calculate appropriate variances for fixed overhead. 
 
 The electronic crime division of a local police stati on had the following 
information for Period 4: 
Budget  Fixed overheads $22,960 
Reported crimes 6,560 
The standard time to deal with each crime is 2 hours  
Actual  
Fixed overheads $24,200 
Reported crimes 6,460 Labour hours 12,600 hrs

160  
 Required: 
If the division uses an absorption cost ing system, calculate the following: 
(a) FOAR per labour hour 
(b) Fixed overhead expenditure variance (c) Fixed overhead capacity variance (d) Fixed overhead efficiency variance (e) Fixed overhead volume variance. 
 
 Last month, 40,000 production hour s were budgeted in CTD, and the 
budgeted fixed production overhead co st was $250,000. Actual results 
show that 38,000 hours were wo rked and paid, and the standard hours 
for actual production were 35,000. CTD operates a standard absorption 
costing system. What was the fixed production overhead capacity variance for last 
month? 
A $12,500 Adverse B $12,500 Favourable C $31,250 Adverse D $31,250 Favourable 
 
 Scenario 
Malcolm Reynolds makes and sells a single product, Product Q, with the 
following standard specification for materials: 
 Quantity Price per 
kg 
 kg $ 
Direct material X 12 40 Direct material Y 8 32 
It takes 20 direct labour hours to pr oduce one unit with a standard direct 
labour cost of $10 per hour.  
The annual sales/production budget is 2,400 units evenly spread 
throughout the year. The standard se lling price was $1,250 per unit. 
The budgeted production overhead, all fixed, is $288,000 and 
expenditure is expected to occur evenly over the year, which the 
company divides into 12 calendar mont hs. Absorption is based on direct 
labour hours.

Chapter 5 
 161 
 For the month of October the follo wing actual information is provided. 
 $ $ 
Sales (220 units)  264,000 
Direct materials used 159,000  Direct wages 45,400  
Fixed production overhead 23,000  
 –––––––    227,400 
  ––––––– Gross profit  36,600 
Administration costs 13,000  Selling and distribution costs 8,000  
 –––––––    21,000 
  ––––––– 
Net profit  $15,600   ––––––– 
Costs of opening inventories, for each material, were at the same price 
per kilogram as the purchases made during the m onth but there had 
been changes in the materials inventory levels as follows: 
 1 October 30 October 
 kg kg 
Material X 680 1,180 Material Y 450 350 
Material X purchases were 3,000 kg at $42 each. 
Material Y purchases were 1,700 kg at $30 each. The number of direct labour hours worked was 4,600 and the total wages 
incurred $45,400. 
Work-in-progress inventories and fi nished goods inventories may be 
assumed to be the same at t he beginning and end of October. 
Tasks: 
(a) to prepare a standard product co st for one unit of product Q 
showing the standard selling price and standard gross pr ofit per unit 
(b) to calculate appropriate variances  for the material s, labour, fixed 
production overhead and sales, noting that it is company policy to 
calculate material price variances at  time of issue to production and 
that Malcom Reynolds does not ca lculate mix and yield variances 
(c) to prepare a statement for management reconciling the budgeted 
gross profit with the actual gross profit.

162  
 Flexed budgets for the co st of medical supplies in a hospital, based on a 
percentage of maximum bed o ccupancy, are shown below: 
Bed occupancy  82%  94% 
Medical supplies co st $410,000  $429,200 
During the period, the actual bed o ccupancy was 87% and the total cost 
of the medical s upplies was $430,000. 
Identify the medical supplies expenditure variance: A $5,000 adverse B $12,000 adverse C $5,000 favourable D $12,000 favourable 
 
 A company has a sales budget of $145,000 per month for the financial 
year January to December. However, by the end of May, the cumulative 
sales variances for the year to date are: 
Sales price variance  $30,000 (A) Sales volume contribution variance  $16,000 (A)  
The standard contribution/sales rati o is 40%. The marketing department 
has now estimated that sales for t he next three months will be $120,000 
per month, but for the re st of the year, monthly sales should rise to 
$148,000. 
Required: 
Prepare a statement as at the end of May that compares budgeted and 
forecast sales revenue and contribution for the year as a whole. Ignore 
variable cost variances. 
 
 A company has prepared an activity-based budget for its stores 
department. One activity concerns inventory counts which has an activity 
based cost driver of $800 per in ventory count (based on a budgeted 
activity of 50 counts per year). 
During the year there were 52 counts and the actual cost for inventory 
counts was $40,560. To the nearest $, the va lue of the variance for inventory counts in the 
year was $_____

Chapter 5 
 163 
 One activity for the tax department of a large accountancy firm is to 
perform follow-up visits to clients to investigate and resolve issues that 
have arisen as part of its tax work fo r that client. Information for this 
activity for the year was as follows: 
Clients  2,000 2,100 
Follow up visits  4,000 3,600 Activity cost  $180,000 $168,000 
Required: 
Calculate the overhead expenditure  variance and the overhead efficiency 
variance for the follow up activity. 
 
 A dental practice uses standard cost ing and variance analysis. Match the 
variance to the most likely cause: 
Variance: 
(a) adverse materials price 
(b) adverse labour efficiency (c) favourable fixed overhead volume (d) adverse sales price 
Potential causes: 
(i) more dental treatments were carried out than was budgeted 
(ii) new competition entered the market (iii) new dentists were recruited (iv) new suppliers were used  
 
 ML produces a single product for wh ich the following data are given: 
Standards per unit of product: Direct material  4 kg at $3 per kg Direct labour   2 hours at $6.40 per hour 
Actual details for given financial period: 
Output produced in units  38,000 
Direct materials:  $ 
purchased 180,000 kg for 504,000 issued to production 154,000 kg  
Direct labour 78,000 hou rs worked for 546,000

164  
 There was no work in progress at the beginning or end of the period. 
From this information the following  variances have been calculated: 
Variance Favourable Adverse 
 $ $ 
Direct labour efficiency  12,800 
Direct labour rate  46,800 Direct materials usage  6,000 
Direct materials price 30,800  
(based on issues to production)   
State whether in each of the follo wing cases, the comment given and 
suggested as the possible reason for the variance, is consistent or 
inconsistent with the variance calculated: (place a tick in the appropriate 
column)  
Variance  Consistent? Inconsistent? 
Direct labour efficiency variance: the 
efficiency of labour  was commendable   
Direct labour rate variance: the union 
negotiated wage increase was $0.60 per hour lower than expected   
Direct materials usage variance: 
material losses in production were less than had been allowe d for in the 
standard   
Direct materials price variance: the 
procurement manager has ignored the economic order quantity and, by obtaining bulk quantities, has purchased material at less than the standard price

Chapter 5 
 165 
 Example 1 
 Selling price variance 
 $  
Standard selling price 25  Actual selling price 20  
 ––––––  
 5  A × Actual no of units sold × 500  
 ––––––  
 2,500  A  ––––––  
Sales volume contribution variance 
 Units  
Standard selling price 400  Actual selling price 500  
 ––––––  
 100  F × Standard contribution per unit × $7  
 ––––––  
 $700 F  ––––––  
In this scenario there are no fixed co sts, so the answer is the same 
whether we are using margi nal or absorption costing.

166  
 Example 2 
  
Sales price variance  $  
Units sold should have sold for (380 units × $45 per unit) 17,100  
They did sell for (actual sales revenue) 15,960  
  ––––––  
Sales price variance  1,140 A 
  ––––––  
Absorption costing 
Sales volume profit variance Units  
Actual sales volume 380  Budgeted sales volume 320  
 ––––––  
Sales volume variance 60 F × standard profit per un it ($45 – $23) × $22  
 ––––––  Sales volume profit variance $1,320 F  ––––––  
Marginal costing 
Sales volume contribution variance Units  
 ––––––  
Sales volume variance 60 F × standard contribution per  unit ($45 – $17) × $28  
 ––––––  Sales volume contribution variance $1,680 F  ––––––  
Standard revenue per unit 
Actual sales volume 380  
Budgeted sales volume 320  
 ––––––  Sales volume variance 60  F 
× standard selling per unit × $45  
 ––––––  Sales volume revenue variance $2,700 F  ––––––

Chapter 5 
 167 
 Example 3 
 Direct material total variance 
 $  
Standard cost of actual output   
2 kg × 1,000 units × $10/kg 20,000  
Actual cost 20,900   ––––––  
 900 A  ––––––  
 
 Example 4 
  
Direct materials price variance:  $ 
Actual quantity of material s should cost (standard)  
2,200 kgs $10/kg  22,000 
 did cost (actual) 20,900   –––––– Direct materials price variance  1,100 F 
  –––––– 
   
Direct materials usage variance:  $ 
quantity)  
1,000 units 2 kgs/unit 2,000 
 did use (actual quantity) 2,200   –––––– 
Direct materials usage variance (in material quantity) 200 A × standard price (per unit of material) $10   –––––– 
Direct materials usage variance  2,000 A 
  ––––––

168  
 Example 5 
  
Direct labour rate variance:  $ 
Number of hours worked should cost/hr (standard)  
3,400 hours $80/hr  272,000 
 did cost (actual) 283,000 
  –––––– 
Direct materials price variance  11,000 A   –––––– 
   Direct labour efficiency variance:  Hours 
 should take (standard hours) Actual services provided 1, 100 3 hrs per service 3,300 
 did take (actual hours) 3,400 
  –––––– 
Direct materials usage variance (in hours) 100 A 
× standard rate per hour  $80/hr   –––––– 
Direct labour efficiency variance  $8,000 A 
  –––––– 
 
 Example 6 
  
The rate variance looks at the rate of PAY so it looks at the hours PAID.  
(5,500 – 5,200) × $7 per hour $2,100 A 
Or the idle time variance is si mply the difference between the $38,500 
and the $36,400 above = $2,100 A.

Chapter 5 
 169 
 Example 7 
  
Variable production overhead expenditure variance: $ 
Number of hours worked s hould cost/hr (standard)  
1,980 hours $3/hour 5,940 
 did cost (actual) 5,544 
  –––––– 
Variable production overhead expenditure variance 396 F 
  ––––––    
Variable production overhead efficiency variance: Hours 
Actual output produced shoul d take (standard hours)  
900 units 2 hours/unit 1,800 
 did take (actual hours) 1,980 
  –––––– Efficiency variance (in hours) 180 A 
× standard variable overhead rate per hour $3 
  –––––– Variable production overhead efficiency variance $540 A   –––––– 
 
 Example 8 
 (a) The idle time variance is 20 hours × $15 = $300 (A). 
(b) The efficiency variances are then calculated based on the active 
hours worked, not on the total hours paid for. 
Efficiency variances: Hours 
Actual output produced should take  
 (standard hours)  
200 units 2 hours/unit 400  did take (440 – 20) 420 
  –––––– 
Efficiency variance (in hours) 20 A   –––––– 
 
Hours × standard direct labour rate per hour $15   –––––– Direct labour efficiency variance $300 A 
  –––––– 
Hours × standard variable overhead rate per hour $4   –––––– Variable production overhead efficiency variance $80 A 
 ––––––

170  
 (c) The variable production overhead expenditure variance is based on 
active hours only, since variable production overhead cost is not 
incurred during idle time. 
420 hours $4/hour 1,680 
 did cost (actual) 1,530 
  –––––– 
Variable production overhead expenditure variance 150 F 
  –––––– 
 
 Example 9 
  
Fixed production overhead expenditure variance: $ 
Budgeted fixed overhead 4,375 Actual fixed overhead incurred 4,800  –––––– 
Fixed production overhead expe nditure variance 425 (A) 
 –––––– 
 
Fixed production overhead volume variance: Units 
Actual output produced 1,800 
Budgeted output 1,750  –––––– 
Volume variance  (in units) 50 
× standard fixed overhead rate per unit $2.50 
 –––––– 
Fixed production overhead volume variance $125 (F) 
 ––––––

Chapter 5 
 171 
 Example 10 
 (a) FOAR = $22,960/(6,560 units × 2 hours) = $1.75 per hour 
(b) Actual hours × FOAR $  
12,600 × $1.75 22,050  
Less Budgeted expenditure (22,960)  
 ––––––  Capacity variance $910 A 
 ––––––     (c) Standard hours × FOAR $  
6,460 × 2 × $1.75 22,610  Less Actual hours × FOAR   
12,600 × $1.75 (22,050)  
 ––––––  
Efficiency variance $560 F 
 ––––––  
   
(d) The fixed overhead volume variance  is the sum of the capacity and 
efficiency variances, i.e. 
$910 (A) + $560 (F) = 350 (A). This can be proved as follows: 
Standard hours × FOAR per hour $  
(6,460 × 2 hours × $1.75) 22,610  Less: Budgeted expenditure (22,960)  
 ––––––  
Total variance $350  A  ––––––

172  
 Example 11 
 Standard product cost 
  $ $ 
Standard selling price   100 
Material X 5 kg @ $3/kg 15  Material Y 4 kg @ $5/kg 20  
Direct labour 3 hrs @ $8/hr 24  
Variable overheads 3 hrs @ $6/hr 18  Fixed overheads (W1) 3 hrs @ $2/hr 6  
  –––  
   83    ––– 
Standard profit per unit   17 
   ––– 
 
Fixed overhead expenditure variance 
 $  
Budgeted cost 12,000  
Actual cost 12,500   ––––––  
 500  A 
 ––––––

Chapter 5 
 173 
 Fixed overhead volume variance 
 Units  
Budgeted output 2,000  
Actual cost 2,200   ––––––  
 200 F 
× Standard fixed overhead cost per unit × $6   ––––––  
 $1,200 F 
 ––––––  
Sales volume profit variance 
 Units  
Actual sales 2,200  Budgeted sales 1,700  
 ––––––  
 500 F × Standard profit per unit × $17  
 ––––––  
 $8,500 F  ––––––  
 Units  
Actual selling price 90  Standard selling price 100  
 ––––––  
 10 A × Actual no of units sold × 2,200  
 ––––––  
 $22,000 A  ––––––  
Operating statement 
 $ $ $ 
Budgeted gross profit  (W2)   28,900 
Sales volume profit variance   8,500 F 
   –––––– 
Budgeted profit on actual sales   37,400 
Selling price variance   22,000 A    –––––– 
   15,400

174  
   Favourable Adverse  
Cost variances     
Material X Usage 
Price  
2,260 900  
Material Y Usage 
Price 2,500  
2,490  
Direct labour Efficiency 
Rate 1,600  
960  
Variable overhead Efficiency 
Expenditure 1,200 
5,400   
Fixed prod over head Expenditure 
Volume  
1,200 500  
  –––––– ––––––  
  14,160 4,850 9,310 F   –––––– –––––– –––––– 
    24,710 
    –––––– 
Workings 
(W1) Budgeted fixed overheads ar e $144,000 per year and the budgeted 
output is 24,000 units for the year. Thus the budgeted/standard 
fixed cost per unit is $6. 
The overheads are absorbed on di rect labour hours and each unit 
takes 3 hours. Therefore the budget ed/standard fixed overhead is 
$2 per hour ($6 ÷ 3 hours). 
(W2) Budgeted profit = $17 per unit × Budgeted sales of 1,700 units = 
$28,900 
(W3) 
  $ $ 
Sales 2,200 units × $90  198,000 
Material X 11,300 kg × $2.80/kg 31,640  
Material Y 8,300 kg × $5.30/kg 43,990  Direct labour (4,800 hrs × $8.10) + (1,600 
hrs × $8.30) 52,160  
Variable overhead  33,000  Fixed overhead  12,500    ––––––  
   173,290 
   –––––– Actual profit   24,710 
   ––––––

Chapter 5 
 175 
  
Units sold should have sold for (1.800 units × $18.25 per 
unit) 32,850 
They did sell for  (actual sales revenue) 32,300 
  –––––– Sales price variance   550 (A) 
  –––––– 
 
Sales volume variance Units 
Actual sales volume 1,800 
Budgeted sales volume 1,750 
 –––––– 
Sales volume variance 50 × standard profit per unit × $6 
 –––––– 
Sales volume profit variance $300 (F)  –––––– 
The contribution per unit is $8. 50 ($18.25 – 6.00 – 3.00 – 0.75) 
 –––––– Sales volume variance 50 
× standard contributio n per unit × $8.50 
 –––––– 
Sales volume contribution variance $425 (F)  ––––––

176  
  
Direct material A price variance:  $ 
6,100 kgs $4/kg 24,400 
 did cost (actual) 25,000 
  –––––– Direct material A price variance  600 A 
  –––––– 
 
Direct material A usage variance   
quantity)  
3,200 units 2 kgs/unit 6,400 
 did cost (actual quantity) 6,100 
  –––––– 
Direct materials price variance  (in kgs) 300 F 
× standard price (per kg) $4   –––––– Direct material A usage variance $1,200 F 
  ––––––

Chapter 5 
 177 
 Direct material B price variance: $ 
1,750 litres $6/litre 10,500 
 did cost (actual) 11,600 
  –––––– 
Direct material B price variance  1,100 A 
  –––––– 
 
Direct material B usage variance:  
Actual output produced should use (standard quantity)  
3,200 units 0.5 litres/unit 1,600 
 did cost (actual quantity) 1,750 
  ––––– 
Direct materials price variance   (in litres) 150A × standard price (per litre) $6 
  ––––– 
Direct material B usage variance $900 A   ––––– 
 
Direct labour rate variance:  $ Number of hours paid should cost (standard)  
2,200 hours $12/hr 26,400 
 did cost (actual) 28,000   –––––– Direct labour rate variance  1,600 A 
  –––––– 
Idle time variance: 
There are 200 hours of idle time. At a standard cost of $12 per hour, this 
gives an idle time variance of 
= 200 hours × $12/hour 
= $2,400 A 
Direct labour efficiency variance: $ 
Actual output produced shoul d use (standard hours)  
3,200 units 0.75 hrs per unit 2,400 
 did take (actual hours) 2,000 
  –––––– Direct labour efficiency variance (in hours) 400 F 
× standard rate per hour  $12/hr 
  –––––– Direct labour efficiency variance $4,800 F 
  ––––––

178  
  
The rate variance looks at the rate of PAY so it looks at the hours PAID . 
(4,100 – 3,900) × $6 per hour $1,200 A 
Or the idle time variance is si mply the difference between the $23,400 
and the $24,600 above = $1,200 A

Chapter 5 
 179 
  
(5,200 – 4,900) × $6 per hour $1,800 A 
Or the idle time variance is si mply the difference between the $29,400 
and the $31,200 above = $1,800 A

180  
 Fixed overhead total variance 
 $ 
Standard cost of actual output  
$12/unit × 1,100 treatments 13,200 
Actual cost 13,000  –––––– 
 200 F  –––––– 
 $ Budgeted cost 12,000 
Actual cost 13,000 
 ––––––  1,000 A 
 –––––– 
Fixed overhead volume variance 
 Units 
Budgeted treatments 1,000 
Actual treatments 1,100  ––––––  100 F 
× Standard fixed overhead cost per treatment × $12 
 ––––––  $1,200 F 
 –––––– 
Under-/over-absorption 
 $ Overheads incurred 13,000 
Overheads absorbed  
$4/direct labour hour × (3 hour s × 1,100 treatments) 13,200 
 –––––– Over-absorption 200  ––––––

Chapter 5 
 181 
 The overhead absorption rate is  based on direct labour hours and = 
 
Budgeted overheads 
Budgeted level of activity 
 
OAR =$12,000
1,000 treatments × 3 hrs	$4/direct labour hour 
 
It would now be very natural to calculate the overheads absorbed by 
multiplying the OAR by the actual num ber of hours, i.e.  3,080, but in a 
standard costing system, the overheads are absorbed on the standard 
hours, not the actual hours. 
The standard hours are the standard hour s of actual output, 3 hours × 
1,100 units = 3,300 hours. 
Fixed overhead capacity variance 
Actual hours × FOAR $ 
3,080 hours × $4 12,320 Less: Budgeted expenditure (12,000) 
 –––––– 
Capacity variance $320 (F)  –––––– 
Standard hours × FOAR $ 3,300 hours × $4 13,200 
Less: Actual hours × FOAR  
3,080 × $4 (12,320)  –––––– 
Efficiency variance $880 (F) 
 ––––––

182  
 (a) FOAR = $22,960 ÷ (6,560 units × 2 hours per reported crime) = 
$1.75 per hour 
(b) Fixed overhead expenditure variance 
 $ 
Budgeted fixed overhead 22,960 
Actual fixed overhead 24,200 
 –––––– Variance 1,240 A 
 –––––– 
Fixed overhead expenditure variance – three line method 
AH AR = $24,200 
Variance = $1,240 A 
BH SR = $22,960 
(c) Fixed overhead capacity variance 
 Hours 
Budgeted hours worked = 2 hours × 6,560 reported 
crimes 13,120 
Actual hours worked 12,600 
 –––––– 
Variance 520 A 
 –––––– 
Variance in $ = 520A hours × sta ndard FOAR $1.75/hr = $910 A 
Fixed overhead capacity variance – three line method 
 Variance = $910 A  AH SR = 12,600 × $1.75 = $22,050 
(d) Fixed overhead efficiency variance 
 Hours 
Actual 6,460 crimes, shoul d take 2 hours per reported 
crime 12,920 
Actual 6,460 crimes, did take 12,600 
 –––––– 
Variance 320 F 
 –––––– 
Variance in $ = 320F hours × st andard FOAR per hour $1.75 = 
$560 F 
Fixed overhead efficiency variance – alternative method 
AH SR = 12,600 × $1.75 = $22,050 
Variance = $560 F  
SH SR = (6,460 × 2) × $1.75 = $22,610

Chapter 5 
 183 
 (e) Fixed overhead volume variance 
 Units 
Budgeted reported crimes 6,560 
Actual reported crimes 6,460 
 ––––– Variance 100 A 
 ––––– 
Variance in $ = 100 A reported cr imes × standard hours of 2 × 
standard FOAR per hour $1.75 = $350 A 
Fixed overhead volume variance – alternative method 
Variance = $350 A  
SH SR = (6,460 × 2) × $1.75 = $22,610 
Note:  The fixed overhead volume variance of $350A is the total of 
the capacity and efficiency variances ($910 A + $560 F). 
 
 A 
Actual hours × FOAR per hour $  
38,000 × $250,000/40, 000 hours 237,500  
Budgeted expenditure 250,000   ––––––  
Capacity variance $12,500 A 
 ––––––  
 
 (a) Standard product cost  
  $ $ 
Standard selling price   1,250 
Material X 12 kg @ $40/kg 480  Material Y 8 kg @ $32/kg 256  
Direct labour 20 hrs @ $10/hr 200  
Production overhead (W1)  120    –––  
   1,056 
   –––––    194 
   –––––

184  
 (b) Material X variances  
 
Fixed overhead variance 
 Units 
Budgeted output (2,400 units p.a. ÷ 12 months) 200 
Actual output 220 
 ––––––  20 F 
× Standard fixed overhead cost per unit ×120 
 ––––––  $2,400 F 
 –––––– 
This can be sub-divided into the efficiency and capacity variances:

Chapter 5 
 185 
 Fixed overhead efficiency variance 
 Hours 
Standard hours for actual production 4,400 
Less Actual hours (4,600) 
 –––––– Fixed overhead efficiency variance – hours 200 A 
FOAR $6 
 ––––––  1,200 A 
 –––––– 
 $ 
Actual hours × FOAR per hour (4,600 hours × $6 per 
hour) 27,600 
Less Budgeted expenditure ($288,000/12 months) (24,000) 
 –––––– Fixed overhead capacity variance 3,600 F 
 –––––– 
 $ 
Standard selling price 1,250 Actual selling price ($264,000/220 units) 1,200 
 ––––––  50 A × Actual no of units sold × 220 
 –––––– 
 $11,000 A  –––––– 
Selling volume profit variance 
 Units 
Budgeted sales 200 Actual sales 220 
 –––––– 
 20 F 
× Standard profit per unit ×194 
 –––––– 
 $3,800 F 
 ––––––

186  
 (c) Operating statement  
 $ $ $ 
Budgeted gross profit (W4)   38,800 
Sales volume profit variance   3,880 F 
   –––––– Standard profit on actual sales   42,680 
Sales price variance   11,000 A 
   ––––––    31,680 
   –––––– 
 
  Favourable Adverse  
Material X Usage 5,600    Price  5,000  
Material Y Usage  1,280   Price 3,600   
Direct labour Efficiency  2,000   Rate 600   
Fixed prod 
overhead Expenditure 1,000   
 Efficiency  1,200  
 Capacity 3,600   
  14,400 9,480 4,920 F   ––––––  ––––––  –––––– 
Actual gross profit   36,600     –––––– 
Workings: 
(W1) Fixed over head per unit = $288,000/2,400 units = $120 per 
unit. With labour taking 20 hours per unit this equates to a 
FOAR of $6 per hour 
(W2) 
 Material X Material Y 
 Kg Kg 
Op inventory 680 450 + Purchases 3,000 1,700  –––––– –––––– 
 3,680 2,150 
– Cl inventory 1,180 350 
 –––––– –––––– Materials issued/used 2,500 1,800 

Chapter 5 
 187 
 (W3) Budgeted fixed overhead per  month = $288,000/12 = $24,000 
(W4) Budgeted profit = 200 units × $194 = $38,800 
 
 B 
  429,200 – 410,000 
Contribution marg in = ––––––––––––––– 
  94% – 82% 
 = $1,600 for every 1% change 
Budget for 87% occupancy = $429,200 – (7 × 1600)  = $418,000 
Medical expenditure variance = 418,000 – 430,000 
 = $12,000 Adverse 
 
 $ Sales volume (contribution) variance 16,000 (A) Standard contribution/sales ratio: 40% 
Sales volume variance in sales revenue 40,000 (A) 
Sales price variance 30,000 (A) Budgeted sales for the first 5 months (× 145,000) 725,000 
Actual sales revenue for the first five months 655,000 
Expected sales for the next 3 months (× 120,000) 360,000 
Expected sales for the final 4 months (× 148,000) 592,000 
Forecast sales for the year 1,607,000 
 
 $ Forecast sales for the year (actual revenue) 1,607,000 
Cumulative sales price variances 30,000 (A) Forecast sales at standar d sales prices 1,637,000 
Standard contribution/sales ratio 40% Forecast contribution at standard sales price $654,800 
Cumulative sales price variances $30,000(A) 
Forecast contribution at ac tual sales prices $624,800 
Statement of budgeted and forecast annual results, as at end May 
 Budget Forecast Variance 
 $ $ $ Sales revenue (145,000 × 12) 1,740,000 1,607,000 133,000 (A) 
Contribution (1,740,000 × 40% ) 696,000 624,800 71,200 (A)

188  
  
Activity Expected 
cost Actual 
cost Variance 
 $ $ $ 
Inventory counts (based on 52 counts) 41,600 40,560 1,040  (F) 
 
 Variable overhead expenditure variance 
  $ 3,600 actual visits should co st ($180,00/4,000 visits =) 
$45 per visit 162,000 
3,600 actual visits did cost  168,000 
  ––––––– 
Variance  $6,000 A 
Variable overhead efficiency variance 
  Visits 
2,100 actual clients should 
require (4,000 visits/2,000 clients 
=) 2 visits per client 4,200 
2,100 actual clients did 
require  3,600 
  ––––––– 
Variance  600 F 
Variance = 600 F visits × standard cost of $45 per visit = $27,000 F 
 
 Variance  Most likely cause 
adverse materials price  new suppliers were used  
adverse labour efficiency  new dentists were recruited favourable fixed overhead  more dental treatments were carried 
volume  out than was budgeted adverse sales price  new competition entered the market

Chapter 5 
 189 
 (i) Direct labour efficiency variance:  Inconsistent. The workforce were 
inefficient. 
(ii) Direct labour rate variance: In consistent. In fact the wage increase 
was $0.60 per hour higher than expected. 
(iii) Direct materials usage variance: Inconsistent. If the losses had been 
less than expected then the usage variance would have been 
favourable. 
(iv) Direct materials price varianc e: Consistent. A bulk purchase 
discount should lead to cheaper materials and hence a favourable material price variance.

191 
Further variance 
analysis 
determine the costs for 
different purposes (c)  Variance analysis (without 
  Chapter 
6

Further variance analysis 
192  
 
This chapter examines how some of t he variances calculated in the previous 
chapter can be further analysed in order to  give more detailed information to 
management. It is critical that you hav e gained a thorough understanding of the 
variances in the previous chapter bef ore embarking on your studies of this 
chapter. 
2 Sales mix and quantity variances 
The sales volume variances that we have calculated so far have been based on 
organisations that sell only one product, but  many organisations will sell more 
than one product. 
If these products are related and substitut able then the organisation might want 
to determine the impact that this has on pr ofits. This is the aim of sales mix and 
quantity variances. They take the sales volume variance and provide more 
detail by splitting it into  these two component parts. 
This might prove very useful to, say, a movie franchise which may set targets 
for a mix of cinema ticket sales, disc sa les, streaming sales and merchandising 
sales. The franchise might, for example,  expect 30% of sales to come from 
merchandising. The sales mix variance t hen becomes very useful to the 
franchise by examining the im pact on profits if this 30% ta rget is not met or if it 
is exceeded. 
Note:  No valid information would be obtained if these variances are calculated 
for unrelated products sold to different markets since the factors which influence 
demand and preferences in these market s would be different. For example, no 
meaningful information would result if t hese variances were calculated by a 
company who, say, make beds as well as an android tablet.

Chapter 6 
 193 
There are a number of steps involved in  calculating the sales mix and quantity 
variances. 
Step 1 – the standard mix 
The first step is to compare the changes  in the proportion of sales made up by 
each product. This means determining w hat the actual sales for each product 
would have been if the sales proportions  had remained unchanged. This is 
known as the standard mix . This is the key part of  the mix calculation. 
 
The actual total sales is split between the two products based on the originally 
planned proportions. 
 
 Example 1 
 A car wash and valeting business offe rs two services to customers which 
had the following budgeted informati on for the next budget period: 
Service Exterior Full 
Volume 800 200 
Contribution per service $4 $12 
The actual results for the period were: 
Volume 720 480 Contribution per service $5 $10 
Required: 
Calculate the sales mix variance (in units) for each type of service. 
Step 2 – valuation  
The first step showed us that there has  been a change in mix – customers have 
bought less of the exterior and more of  the full service (as a percentage of 
sales) than the company was expecting. 
The next step is to determine the impact that this has had on profits. There are 
two ways to do this (and you need to follow the instructions in questions as to 
which to use): 
 the individual units method 
 the weighted average contribution method 
The individual units method  
In the individual units method each pr oduct’s variance is multiplied by the 
standard margin. If using marginal costing this will be the standard contribution 
per unit, for absorption costing we would mu ltiply by the standard profit per unit.

194  
 Example 2 
 Required: 
Value the variances calculated in Ex ample 1 using the individual units 
method. 
The size of this impact on profits is us eful to the managem ent of the company. 
Management can further investigate as to why the change may have happened 
(i.e. why did customers switch from one product to another?). When favourable, 
the management can look to replicat e this change, or when adverse the 
management can look to counteract the r easons for customers switching to the 
product/service with the lower contribution. 
The weighted average contribution method  
The first step in this approach is to calc ulate a weighted average contribution for 
the products. This is based on the budget ed sales and contri bution. For the 
products in our example the weighted average contribution would be calculated 
 
Product Budgeted 
sales Contribution Total 
contribution 
Exterior 800 $4 3,200 
Full 200 $12 2,400  –––––  –––––– 
 1,000  5,600 
 –––––  –––––– 
The weighted average contribution is ($5,600 / 1,000 units) $5.60. 
To value the sales mix variance the weighted average cont ribution is deducted 
from the contribution pe r unit for each product. 
 
 Example 3 
 Required: 
Value the variances calculated in Ex ample 1 using the weighted average 
contribution method.

Chapter 6 
 195 
 Superiority of the weighted average method 
 The weighted average method for t he mix variance is seen as being 
superior to the individual units method.  It is easier to see the impact of 
each individual product or service when it is measured against the 
average price.  
The weighted average method provi des better variances for control 
purposes. In the example above, the exterior service now shows as 
having a favourable variance (the variance was adverse when we used the individual units method). This is  more representative of what has 
happened in this scenario: by selling less of the least profitable product (and therefore more of the most pr ofitable product) the impact on the 
profits will be greater. Swit ching sales away from the exterior services 
into full services has a positive (fav ourable) impact on profits for both 
products. 
Step 3 – sales quantity variance 
The sales quantity variances ignores the change in mix and focuses on the impact of profit from selling more or less units than was budgeted. Therefore 
 
the budgeted sales volume for each pr oduct is deduced from the standard mix 
 
This can then be valued in two ways: 
 in total using the weighted average contribution 
 by product using the indi vidual units contribution 
Again, follow the instructi ons given in questions as to which method to use. 
The weighted average method  
The total difference between the act ual sales and the budgeted sales is 
multiplied by the weight ed average contribution. 
 
 Example 4 
 Required: 
Calculate the sales quantity variance for Example 1 in total. 
A more detailed analysis of the sales quantity variance can be achieved by 
breaking it down by individ ual product or service. 
The standard mix is compared to the budgeted sales for each product and the 
difference is valued at the standar d contribution for that product.

196  
 Example 5 
 Required: 
Calculate the sales quantity variance for Example 1 using the individual 
units method. 
 
This gives more useful information to  managers as it explains the impact on 
profits for the change in volume of each type of product (assu ming that the mix 
between products had remained unchanged).  
 Benefits and problems of mix and quantity variances  
 Benefits 
 The sales mix variance can allow an organisation identify trends in 
sales of individual elements of it s total product sales. For example, 
they may find that although over all sales are improving (as 
suggested by the sale quantity or  sales volume variance being 
favourable, that one individual pr oduct has shown a period-on-period 
decline in volume). 
 The sales quantity variance can be used to indicate changes in the 
size of the market and/or the ch ange in the market share for an 
 The sales mix variance may indica te future directions for sales 
strategies – organisations would aim to repeat any favourable 
variances by identifying and exploiting their causes. 
 The sales mix variance can be used to gauge the success or failure 
of new marketing campaigns. For example, if an organisation were 
to launch a special edition of its product, it might be able to 
determine the impact that this has on its profits as well as any adverse impact it might have had on sales of its regular product. 
 Responsibility accounting is improved when the sales volume 
variance is split between the sa les mix and quantity variance as 
different managers might be responsib le for different elements of 
sales. The sales quantity variance, fo r example, will indicate whether 
the sales team have performed we ll overall, whereas the mix 
variance will then provide info rmation on the success of those 
responsible for applying the mix of sales.

Chapter 6 
 197 
 Problems 
 Like any variance, it will be import ant for the user to consider the 
controllability of the variance before making performance review 
decisions based on the output. For example, an adverse sales 
quantity variance might have been caused by an uncontrollable change in government restrictions on sales of the product, rather 
than having being caused by the ac tions of the sales team/manager. 
Also, it may be that a strategy to  change the mix also has an impact 
on the quantity variance. For example,  it may be that the car wash 
company has improved quantity ov erall because it has moved 
upmarket by deliberately targeting more full services and changing its mix. 
 Likewise, variances should be cons idered as a whole rather than on 
an individual basis due to thei r interdependence. Managers would 
have to be aware, for example, t hat sales volume variances might 
be affected by decisions taken in  production (such as a change in 
materials or labour used). 
 The sales mix variance is only relevant if the products have some 
sort of relationship between t hem. Examples of this are: 
– the products are of the same type  but of a different variety (for 
example, where there are 'norma l' and 'special' editions of a 
product 
– the products are complement ary (for example, where a 
company sells both ebooks and ereaders) 
– the products can be substituted fo r each other (for example, a 
company might sell Eur opean and Asian holidays). 
 It can sometimes be difficult to apply these techniques in 
organisations which have very broad product ranges. It can be 
difficult to determine which product s are complementary, which are 
substitutes etc. and often comput er based techniques are needed to 
perform the detailed calculations. 
Overall, these can be complex calcul ations that might only apply for 
certain organisations. But for manager s who can interpret these well, 
sales mix and quantity variance analysis can provide vital information on sales trends, marketing effects, marketing position and variance 
responsibility.

198  
3 Planning and operational variances 
One reason that a variance may arise may be that the original plan has 
subsequently been found to be inappropriate. Th is might arise, for example, if 
suppliers have increased the cost of raw materials and this has not been 
accounted for in the original standard cost card. In that case the total variance 
must be split into two constituent parts: 
 the planning variance  – this is the part of the variance caused by an 
inappropriate original (ex-ante) standard, and 
 the operational variance  – this is the part of the variance attributable to 
decisions taken within the busine ss that has caused a change between 
the revised (ex-post) standar d and the actual results. 
 
 Further explanation 
 Forecasts by their nature are unrelia ble, and yet most standards are set 
on a forecast basis, i.e. ex ante  or before the event. A planning variance 
arises from an inability to make exac t predictions of future costs and 
revenues at the budgeting stage. 
If it were possible to set standards with the benefit of hindsight, i.e. ex 
post or after the event, managers would be able to see more clearly what 
amount of variances was genuinely attributable to  operating performance 
(operational variances)  and what amount to difficulties or errors in 
setting the original standard (planning variances).  Such information 
should improve operational control and may also provide guidance for the 
improvement of planning procedures. The planning variance is usually  regarded as uncontrollable and has 
arisen because the original  standard was not reflec tive of the attainable 
standard. The operational va riance is controllable. 
Operational variances 
Operational variances are variances that are assumed to have occurred 
due to operational factors. These are materials price and usage 
variances, labour rate and effici ency variances, variable overhead 
expenditure and efficiency varian ces, fixed overhead expenditure 
variances, and sales variances. 
Operational variances are calculated with the ‘realistic’ ex post standard. 
They are calculated in exactly the same way as described in earlier 
chapters, the only difference being that  the ex post standard is used, not 
the original standard.

Chapter 6 
 199 
 Planning variances 
A planning variance measures t he difference between the budgeted and 
actual profit that has been caused by errors in the original standard cost. 
It is the difference between the ex-ante and the ex post standards. 
 A planning variance is favourable  when the ex post standard cost is 
lower than the original ex ante standard cost. 
 A planning variance is adverse when the ex post standard cost is 
higher than the original  ex ante standard cost. 
Controllability and responsibility 
Management will wish to draw a distinction between these two variances 
in order to gain a realistic measure of operational efficiency. As planning 
variances are self-evidently not under the control of operational 
management, it cannot be held responsible  for them, and there is thus no 
benefit to be gained in spending time investigating such variances at an operational level. Planning variance s may arise from faulty standard-
setting, but the responsibility for th is lies with senior, rather than 
operational management. 
 
 Example 6 
 A government department is responsib le for awarding entry visas for 
overseas residents wishing to enter t he country. Details of actual and 
budget labour costs for the department for period 9 are: 
Applications 500 550 
Labour hours 1,000 1,200 Labour cost 5,000 5,100 
However, a relaxation in the government's legal entry checks for 
overseas residents subsequent to t he preparation of the budget resulted 
in a 25% increase in standard labour efficiency, such that it is now 
possible to assess 5 applications in stead of 4 applications using 8 hours 
of labour – giving a revised standa rd labour requirement of 1.6 hours 
(thus $8 labour cost) per application. 
Required: 
Calculate all relevant labour variances for the period.

200  
 Example 7 
 A company budgets to sell 1,000 units  of its new product with the 
following standard information: 
 $ $ 
Standard sales price per unit  200 Standard costs per unit   
Raw materials (10 kg at $10) 100  Labour (6 hours at $8) 48 (148) 
 ––––    –––– Standard contribution per unit  52   –––– Actual results for the first year were as follows:   
 $000 $000 Sales (1,000 units)  316 Production costs (1,000 units)   
Raw materials (10,800 kg) 
194.4   
Labour (5,800 hours) 69.6 (264) 
 ––––    –––– Actual contribution (1,000 units)  52   –––– 
The managing director made the follo wing observations on the actual 
results: 
In total, the performance agreed wit h budget; nevertheless, in every 
aspect other than volume, there were large differences. Sales were made at what was felt to be the highest feasible price, but we 
now feel that we could have sold for $330 with no adverse effect on 
volume. Labour costs rose dramatica lly with increased demand for the 
specialist skills required to produc e the product, and the general market 
rate was $12.50 per hour – although we  always paid below the general 
market rate whenever possible. 
The raw material cost that was expected at the time the budget was 
prepared was $10 per kilogram. However,  the market price relating to 
efficient purchases of the material during the year was $17 per kilogram. 
It is not proposed to request a vari ance analysis for the first year’s 
results. In any event, the final cont ribution was equal to that originally 
budgeted, so operations must have been fully efficient. 
Required: 
Despite the managing director’s reluct ance to calculate it, produce an 
operating statement for the period ignoring the impact of any planning 
Calculate the impact of the planni ng variances for the business.

Chapter 6 
 201 
4 Causes of plan ning variances 
There must be a good reason for deciding t hat the original standard cost is 
unrealistic. Deciding in re trospect that expected cost s should be different from 
the standard should not be an arbitrary decision, aimed perhaps at shifting the 
blame for poor results from poor operational management to poor cost 
estimation. 
A good reason for a change in the standard might be: 
 a change in one of the main materials used to make a product or provide a 
service 
 an unexpected increase in the price of materials due to a rapid increase in 
world market prices (for example, t he price of oil or other commodities) 
 a change in working methods and procedures that alters the expected 
direct labour time for a product or service 
 an unexpected change in the rate of pay to the work force. 
 
 More than one planning error 
 A situation might occur where the di fference between the standards is in 
two (or more) items. 
In these circumstances, the rules fo r calculating planning and operational 
variances are as follows: 
 Operational variances are calc ulated against the most up-to-date 
revision 
 The total planning variance will be the difference between the 
original standard or budget and the mo st up-to-date revision. This 
can then be further divided between each individual planning error. 
For example, the original standard cost for a product was $4 per kg and 
the actual cost was $6 per kg. Two planning variances were discovered. 
Firstly, the accountant had assumed that a bulk discount on purchases 
would arise but this was never lik ely, and it meant that the standard 
should have been set at $4.60 per kg, Se condly, a worldwide shortage of 
materials led to an industry wide incr ease of $1 per kg to the cost of 
materials. This means that the most up-to-dat e standard cost would have 
been $5.60 per kg. The operational va riance would ther efore be $0.40 
($6 – $5.60) per kg adverse and the total planning variance would be 
$1.60 ($5.60 – $4) per kg. The planning variance could then be split 
between the two effects: there is a $0.60 per kg adverse variance caused 
by the failure to gain the bulk discount, and a $1 per kg adverse variance caused by the market conditions.

202  
5 Benefits and problems of planning variances 
Benefits Problems 
 More useful 
 Up-to-date 
 Better for motivation 
 Assesses planning  Subjective 
 Time consuming 
 Can be manipulated 
 Can cause conflict 
 
 Benefits of planning and operational variances 
(1) In volatile and changing environments, standard costing and 
variance analysis are more useful using this approach. 
(2) Operational variances provide up to date information about current 
levels of efficiency. 
(3) Operational variances are lik ely to make the standard costing 
system more acceptable and to have a positive effect on motivation. 
(4) It emphasises the importance of  the planning function in the 
preparation of standards and helps to  identify planning deficiencies. 
Problems of planning and operational variances 
(1) There is an element of subjectivity in determining the ex-post 
standards as to what is 'realistic'. 
(2) There is a large amount of l abour time involved in continually 
establishing up to date standards and calculating additional 
(3) There is a great temptation to put  as much as possible of the total 
variances down to outside, uncontrollable factors, i.e. planning variances. 
(4) There can then be a conflict bet ween operating and planning staff. 
Each laying the blame at each other's door. 
On the face of it, the calculation of operational and planning variances is 
an improvement over the traditional analysis. However, you should not 
overlook the considerable problem of data collection for the revised 
analysis: where does this information come from, and how can we say with certainty what should have b een known at a particular point in  time?

Chapter 6 
 203 
6 Working backwards 
An excellent way of testing whethe r you really understand the reasons for 
and the calculation of operating varianc es is to ‘work backwards’ from 
standard cost data and variances to ar rive at the actual results. 
In these scenarios the examiner wil l provide you with the variance and 
give you one other piece of informati on (either the origi nal standard or the 
actual results). You then must use this information to determine the 
missing information. 
For example, we know that:  Total materials variance = Standard mate rial cost for actual production – 
Actual material cost If the question gave you the variance and the actual material cost you 
would rearrange this formula to ca lculate the standard material cost: 
Standard material cost = Total material s variance + Actual material cost 
A useful approach is to use the formu la or proforma from the previous 
chapter, fill in the information that you have been given in the scenario, 
then re-arrange the equations to det ermine the missing information. 
 
Example 8 
A manufacturer has the following info rmation on labour costs for July: 
Production (units) 180,000 200,000 
Labour costs ($) $720,000 $760,000 
The standard cost for labour is bas ed on a labour rate of $30 per hour. 
The labour rate variance was $10,000 adverse. 
What was the actual labour rate per hour in July? 
A $29.61 per hour 
B $30.00 per hour C $30.40 per hour D $30.81 per hour

204  
 Detailed example on working backwards 
 Q operates a system of standard cost ing and in respect of one of its 
products, which is manufactured within a single cost centre, the following 
information is given. 
For one unit of product the standard mate rial input is 16 litres at a 
standard price of $2.50 per litre. The standard labour rate is $5 per hour 
and 6 hours are allowed to produce one unit. Fixed production overhead 
is absorbed at the rate of 120% of direct labour cost. During the last 4 
weeks accounting period the following occurred. 
 The material price variance was extracted on purchase and the 
actual price paid was $2.45 per litre. 
 Total direct labour cost was $121,500. 
 Fixed production overhead cost incurred was $150,000. 
Variances included: 
 Favourable Adverse 
 $ $ 
Direct material price 8,000  
Direct material usage  6,000 Direct labour rate  4,500 
Direct labour efficiency 3,600  
Fixed production over head expenditure  8,000 
Required: 
Calculate the following for the 4-week period: 
(a) budgeted output in units (b) n umber of litres purchased 
(c) number of litres used above standard allowed 
(d) actual units produced 
(e) actual hours worked (f) average actual direct  labour rate per hour. 
Solution 
The best thing to do as a first step is  to pull together a ll of the standard 
cost information to calcul ate a standard cost per unit. 
 $ 
Direct material (16 lit res × 2.5 per litre) 40 
Direct labour (6 hour s × $5 per hour) 30 
Fixed production overhead ($30 × 120%) 36  –––– Total 106 
 ––––

Chapter 6 
 205 
 Calculating the required figures is now just a series of exercises in logic. 
These exercises can seem difficult to  the novice – but the logic becomes 
simple and obvious with familiarity. 
(a) If actual fixed production over head was $150,000 and the fixed 
production overhead expenditure variance was $6,000 adverse, 
then it follows that the budget fixed overhead was $144,000. From 
this it follows that the budget must have been 4,000 units (that is, 
$144,000 budgeted overhead/$36  standard overhead cost per unit). 
(b) If the standard material purchas e price was $2.50 per litre and the 
actual purchase price was $2.45, t hen it follows that the material 
price variance is $0.05 per litre fa vourable. We are told that the 
material price variance was $8,000 fa vourable, so it follows that 
160,000 litres must have been purc hased (that is, $8,000 price 
variance/$0.05 price variance per litre). 
(c) If the direct material usage va riance was $6,000 adverse and the 
standard price of materials is $2.50 per  litre, then it follows that the 
number of litres used above t he standard allowance is 2,400 
($6000/$2.50 per litre). 
(d) If the actual direct labour  cost was $121,500 and labour cost 
variances totalling $900 adverse ($4,500 adverse rate plus $3,600 
favourable efficiency) were ex perienced, then the standard labour 
cost for the output achieved was $120,600. It follows that the units 
produced were 4,020 (that is, $1 20,600 standard labour cost/$30 
standard labour cost per unit). 
(e) The total hours actually worked is 24,120 standard hours worked 
(that is, 4,020 units produced at  6 standard hours per unit) minus 
the 720-hour favourable labour e fficiency variance (that is, $3,600 
efficiency variance/$5 standard rate per  hour). This gives a total of 
23,400 actual hours worked. 
(f) If the actual labour cost wa s $121,500 and the actual hours worked 
was 23,400, then it follows that th e actual wage rate per hour was 
$5.1923.

Chapter 6 
 207 
 A beauty salon offers two types of treatment, Standard and Deluxe, 
details for the current period as follows: 
 Standard mix Standard profit Average profit 
 (treatments) ($ per tr eatment) ($ per treatment) 
Standard 2 5  Deluxe 3 6  
Total 5 ((2×5)+(3×6))/5 5.60 
Budget sales – 200 units Standard and 300 units Deluxe 
Actual sales – 180 units Standard and 310 units Deluxe 
Required: 
(a)  calculate the sales quantity profit variance 
(b)  calculate the sales mix profit variance using the individual method 
(c)  calculate the sales mix profit  variance using the weighted average 
method. 
 
 Holmes uses one raw material fo r one of their products. The standard 
cost per unit at the begi nning of the year was $28, made up as follows: 
Standard material cost per unit = 7 kg per unit at $4 per kg = $28. 
In the middle of the year the supp lier had changed the specification of the 
material slightly due to problems exper ienced in the country of origin, so 
that the standard had to be revised as follows: 
Standard material cost per unit = 8 kg  per unit at $3.80 per kg = $30.40. 
The actual output for November wa s 1,400 units. 11,000 kg of material 
was purchased and used at a cost of $41,500. 
Calculate 
(a) material price and usage variances using the traditional method 
(b) the planning and operational material variances.

208  
 The following data relates to Skilled Labour Grade ST1 
Standard labour hours per unit  5 hours  Standard labour rate  $10 per hour  Actual production  250 units  Actual labour hours  1,450 hours  Actual labour cost  $13,050 During the month there was an unfor eseen shortage of the Skilled Labour 
Grade ST1. Semi-skilled workers (G rade ST2) were hired. As a 
consequence of this, the standard time was revised to 6 hours per unit. 
Required: 
Calculate labour rate and efficien cy variances using a planning and 
operational approach. 
 
 A company uses standard marginal  costing. Last month the standard 
contribution on actual sales was $44,000 and the following variances 
arose: 
Total variable costs variance  $6,500 Adverse Sales price variance  $2,000 Favourable Sales volume contribution variance  $4,500 Adverse 
What was the actual cont ribution for last month? 
A $33,000 
B $35,000 C $37,500 D $39,500 
 
 WC is a company that installs kitchens and bathrooms for customers who 
are renovating their houses. Some in stallations are highly customised 
designs for specific jobs. The company operates with three di visions: Kitchens, Bathrooms and 
Central Services. The costs of the Central Services division are charged 
to the other divisions based on t he budgeted number of jobs to be 
undertaken by the other two divisions.

Chapter 6 
 209 
 The budgeting and reporting system of WC is not very sophisticated and 
does not provide much detail for t he Directors of the company. The 
budgeted details for last year were: 
 Kitchens Bathrooms 
Number of jobs 4,000 2,000 
 $ $ 
Average price per job 10,000 7,000 Average direct costs per job 5,500 3,000 
Central services recharge per job 2,500 2,500 
 –––––– –––––– Average profit per  job 2,000 1,500 
The actual results were as follows: 
Number of jobs 2,600 2,500 
 $ $ 
Average price per job 13,000 6,100 Average direct costs per job 8,000 2,700 Central services recharge per job 2,500 2,500 
Average profit per  job 2,500 900 
The actual costs for the Central Services division were $17.5 million. 
Required: 
(a) Calculate the budgeted and actual  profits for bot h the Kitchen and 
Bathroom division and for the whole company for the year. 
(b) Calculate the sales price variances and the sales mix profit and 
sales quantity profit variances. 
(c) Prepare a statement t hat reconciles the budget ed and actual profits 
and shows appropriate variances in as much detail as possible. 
(d) Using the statement that you prepared in par t (c) above, discuss the 
performance of the company for the year.

210  
 The expected contribution per unit of the product manufactured by ATS is 
$26, ascertained as below: 
  $ $ 
Selling price   110 
    
Material 8 kg × $3/kg 24  Labour 6 hours × $10/hour 60  
  ––––  
   84    –––– 
Contribution/unit   26 
   –––– 
The expected contribution was $31, 200. The actual contribution was 
$38,800 as shown below: 
  $ $ 
Actual sales revenue 1,000 units @ $135  135,000 
Actual material cost 7,800 kg × $4/kg 31,200  Actual labour cost 6,250 hours × $10.40/hour 65,000    ––––––  
   96,200 
   –––––– Actual contribution/unit  38,800 
   –––––– 
The Sales Director made the policy decision to sell at $5 above the 
prevailing market price of $125, s uggesting that if t hey did suffer a 
decrease in volume, ATS would still be be tter off. It was also accepted that 
an efficient purchasing officer could have purchased at around $4.50 per 
kg. 
There was no inventory movement of ei ther materials or finished goods in 
Required: 
Prepare a variance statement which would be most helpful to the 
management of ATS, which clearly  takes planning and operational 
variances into consideration.

Chapter 6 
 211 
 A company budgeted to make and sell 2,000  units of its only product, for 
which the standard marginal cost is: 
  $ 
Direct materials 4 kilos at $2 per kilo 8 
Direct labour 3 hour s at $6 per hour 18 
  ––– 
  26 
  ––– 
The standard sales price is $50 per  unit and the standard contribution 
$24 per unit. Budgeted fixed costs were  $30,000, giving a budgeted profit 
of $18,000. 
Due to severe material shortages, the company had to switch to a less 
efficient and more expensive material , and it was decided in retrospect 
that the realistic (ex po st) standard direct materi al cost should have been 
5 kilos at $3 per kilo = $15 per unit. Actual results were as follows: Actual production and sales: 2,400 units 
  $ $ 
Sales revenue   115,000 Direct materials 12,300 kilos at $3 per kilo 36,900  
Direct labour 7,500 hours at  $6.10 per hour 45,750  
  ––––––  Total variable costs   82,650 
   ––––– 
Actual contribution   32,350 Actual fixed costs   32,000 
   ––––– 
   350    ––––– 
Required: 
Prepare an operating stat ement with planning and operational variances 
that reconciles the budgeted and actual profit figures.

212  
 Gooch makes a single product and operates a standard costing system. 
The following variances, standard costs and actual results relate to 
period 6: 
Variances 
Direct material price variance  1,012 
Direct material usage variance  1,380 
Direct labour rate variance  920 
Direct labour efficiency variance 3,680  Variable overhead expenditure variance  1,288 
Variable overhead efficiency variance 920  
   
Standard cost data   
  $/unit 
Direct materials 2 kg @ $3/kg 6 Direct labour 3 hrs @ $8/hr 24 
Variable overheads 3 hrs @ $2/hr 6 
Fixed overheads 3 hrs @ $4/hr 12 
  –––––– 
  $48   –––––– 
Fixed overheads were budgeted at  $24,000 and the budgeted profit per 
unit was 20% of the selling price.  Budgeted sales were 1,900 units. 
Material purchased and used $16,192 
Labour cost $52,440 Variable overhead cost $14,168 
Fixed overhead cost $23,500 
Selling price per unit was $3 lo wer than budget and there was no 
change in inventory levels. 
You are required to calculate the: (a) actual output (b) actual material price per kg (c) labour hours worked (d) fixed overhead volume variance (e) fixed overhead expenditure variance (f) sales volume profit variance (g) selling price variance (h) budgeted profit (i) actual profit

Chapter 6 
 213 
 Scenario 
RBF Transport, a haulage contractor, operates a standard costing system 
and has prepared the following report for April 20X0: 
 $ $ $ 
Budgeted profit   8,000 
Sales volume profit variance   880 (A)    ––––––– 
   7,120 Selling price variance   3,560 (F) 
   ––––––– 
   10,680 
 
Cost variances  A F  
Direct labour – rate 
– efficiency  
240 1,086  
Fuel – price 
– usage 420 
1,280   
Variable overhead – expenditure 
180 280  
Fixed overhead – expenditure 
– volume  
1,760 400  
  3,880 1,766 2,114 (A) 
Actual profit    8,566 
    –––––– 
The company uses delivery miles as its cost unit, and the following details 
have been taken from the budget wo rking papers for April 20X0: 
(1) Expected activity  200,000 delivery miles 
(2) Charge to customers  $0.30 per delivery mile 
(3) Expected variable cost per delivery mile: 
Direct labour (0. 02 hours)  $0.08 
Fuel (0.1 litres)  $0.04 Variable overhead (0 .02 hours)  $0.06

214  
 The following additional information has  been determined from the actual 
accounting records for April 20X0. 
 Fixed overhead cost 
 Fuel price 
 Direct labour hours 
Tasks: 
(a) Calculate for April 20X0: 
(i) the actual number  of delivery miles 
(ii) the actual direct  labour rate per hour 
(iii) the actual number of litres of fuel consumed 
(iv) the actual variable overhead expenditure. 
(b) State TWO possible causes of the fuel usage variance. 
(Time allowed for part (b): 5 minutes) 
(c) Prepare a report, addressed to the transport operations manager, 
explaining the different types of standard which may be set, and the 
importance of keeping standards  meaningful and relevant. 
(Time allowed for part (c): 15 minutes) 
 
 Scenario 
It might be argued that onl y operational variances have significance for 
performance measurement. Planning vari ances cannot be controlled and 
so have little or no value for performance reporting. 
Task: 
State briefly, with your reason(s), whether you agree with this point of 
view. 

Chapter 6 
 215 
 Example 1 
 Firstly, we record the actual sales for each product: 
Product Actual 
sales 
quantity     
Exterior 720     
Full 480     
 –––––     
 1,200      –––––     
Then we determine the standard mix. Th is takes the actual sales and 
applies the proportion of sales for each product in the budget. In this 
example the exterior service was budgeted to be 800 out of 1,000 total services i.e. 80% of budgeted sales. If  this ‘mix’ hadn’t changed it should 
have made up 80% of actual sale s i.e. 80% × 1,200 services = 960 
services. A similar calculation can be done for the full service. 
sales 
quantity Actual 
sales at 
budget mix    
Exterior 720 960    
Full 480 240    
 ––––– –––––    
 1,200 1,200     ––––– –––––    
The difference between these (actual sa les less the standard mix) is the 
mix variance in units. 
sales 
sales at 
budget mix Difference   
Exterior 720 960 240 A   Full 480 240 240 F   
The total in the ‘Difference’ column should always be nil.

216  
 Example 2 
 We are given a contribution for each service (the company must be using 
marginal costing): 
sales 
sales 
at 
budget 
mix Difference Contribution Mix 
variance 
($000) 
Exterior 720 960 240 A $4 960 A 
Full 480 240 240 F $12 2,880 F  ––––– –––––   ––––––– 
 1,200 1,200   1,920 F 
 ––––– –––––   ––––––– 
The proportion of sales (mix) has moved away from exterior services and 
towards full services. Because full se rvices have a greater contribution 
per service this has a positive im pact overall on company profits. 
 
 Example 3 
sales 
sales 
at 
budget 
variance 
($000) 
Exterior 720 960 240 A $4 – $5.60 384 F Full 480 240 240 F $12 – $5.60 1,536 F 
 1,200 1,200   1,920 F  ––––– –––––   ––––––– 
The total mix variance is still the same but the breakdown between the 
products has changed.

Chapter 6 
 217 
 Example 4 
 Actual sales = 1,200 units 
Budgeted sales = 1,000 units 
Variance = 200 units Favourable Valued at the weighted average c ontribution = 200 units × $5.60 
 = 1,120 Favourable This could be done on a product-by-product basis if necessary: 
Product Stan’d 
mix Budget 
sales Difference Standard 
contribution Mix 
variance 
($000) 
Exterior 960 800 160 F $4 640 F 
Full 240 200 40 F $12 480 F  ––––– –––––   ––––––– 
 1,200 1,000   1,120 F 
 
 Example 5 
sales 
at 
budget 
mix Budget 
sales Difference Contribution Mix 
variance 
($000) 
Exterior 960 800 160 F $4 640 F Full 240 200 40 F $12 480 F 
 1,200 1,000   1,120 F  ––––– –––––   ––––––– 
 
 Example 6 
 The total labour cost variance for per iod 9 is $400 favourable (i.e. $5,500 
standard cost less $5,100 actual cost).  This may be analysed as follows: 
Planning variance: 
Original (ex-ante) standard less t he revised (ex-post) labour cost 
(550 applications × $10) – (550 applic ations × $8) = $1,100 favourable

218  
 Operational variances: 
Labour efficiency: 
(standard (ex-post) hours less actual  hours) × standard hourly rate ((550 
applications × 1.6 hours) – 1, 200 hours) × $5 = $1,600 adverse 
Labour rate: (standard rate – actual rate) × actual hours  
($5 – $4.25) × 1,200 = $900 favourable 
Note that the three component variances add up to $400 favourable. In this case, the separation of the labour cost variance into operational 
and planning components indicates a lar ger problem in t he area of labour 
efficiency than might otherwise have  been indicated. The operational 
variances are based on the revised standard and this gives a more 
meaningful performance benchmark than the original standard. 
 
 Example 7 
 Operating statement 
 $  
Budgeted contribution 52,000  
Sales price variance 116,000 F 
 –––––––   168,000  
 
Cost variances  Fav Adv   
Direct 
material 
price ($10 × 
10,800) 
– $194,000  86,400   
Direct 
material 
usage (10,000 – 
10,800) × 
$10  8,000   
Direct labour rate ($8 × 5,800) – $69,600)  23,200   
Direct labour 
efficiency (6,000 – 
5,800) × $8 1,600    
  ––––– ––––––   
  1,600 117,600 116,000 A   ––––– –––––– –––––––  
    52,000  
    –––––––

Chapter 6 
 219 
 As the managing director states , and the above analysis shows, the 
overall variance for the company was zero: the adverse cost variances 
exactly offset the favourable sales pr ice variance.However, this analysis 
does not clearly indicate the effici ency with which the company operated 
during the period, as it is impossible to tell whether some of the variances 
arose from the use of inappropriate standards, or whether they were due 
to efficient or inefficient implement ation of those standards. In order to 
determine this, a revised ex post plan should be constructed, setting out 
the standards that, with hindsight, should have been in operation during 
the period. These revised ex post st andards are shown under (B) below. 
 (A)  (B)  (C)  
 Original 
plan $ Revised 
ex ante 
plan $ Actual 
result  $ 
Sales  200,000  330,000  316,000 
 (1,000 × $200) (1,000 × $330) (1,000 × $316) Materials  100,000  170,000  194,400 
 (10,000 × $10) (10,000 × $17) (10,800 × $18) 
Labour  48,000  75,000  69,600  (6,000 ×$8) (6,000 × $12.50) (5,800 × $12) 
 
 $ $ 
Planning variances (A – B)   
Sales price 130,000 F  Materials price 70,000 F  Labour rate 27,000 F  
 –––––––    33,000 F Operational variances   
Sales price (B – C) 14,000 A  Materials price (10,800 × $1) 10,800 A  Materials usage (800 × $17) 13,600 A  Labour rate (5,800 × $0.50) 2,900 F  Labour efficiency (200 hrs × $12.50) 2,500 F  
 –––––––  
  33,000 A 
A comparison of (B) and (C) produces  operational variances, which show 
the difference between the results that  were actually achieved and those 
that might legitimately have been achiev able during the period in question. 
This gives a very differ ent view of the period’s operations. For example, on 
the cost side, the labour rate va riance has changed from adverse to 
favourable, and the material price vari ance, while remaining adverse, is 
significantly reduced in comparison to that calculated under  the traditional 
analysis; on the sales side, the sales price variance, which was particularly 
large and favourable in the traditional analysis, is transformed into an 
adverse variance in the revised approac h, reflecting the fact that the 
company failed to sell at prices that were actually available in the market.

220  
 A comparison of the original plan (A ) with the revised plan (B) allows the 
planning variances to be identified.  As noted at the beginning of this 
section, these variances are uncontroll able by operating, staff, and may or 
may not have been controllable by the or iginal standard-setters at the start 
of the budget period. Wher e a revision of standards is required due to 
environmental changes that were not foreseeable at the time the budget 
was prepared, the planning variances ar e truly uncontrollable. However, 
standards that failed to anticipate k nown market trends when they were 
set will reflect faulty standard-setti ng: it could be argued that these 
variances were controllable (avo idable) at the planning stage. 
 
 Example 8 
 C  $30.40 
The standard cost of actual hours wo rked = actual cost – labour rate 
variance = $760,000 – $10,000 = $750,000 
The actual hours worked = $750,000 / $30 per hour = 25,000 hours The actual rate per hour = $760,000 / 25,000 hours = $30.40 per 
hour 
 
 (a) Sales quantity profit variance  
It is apparent that the overall sale s volume profit variance for the 
period is $40 adverse (that is (2 0 units adverse of Standard times 
$5) plus (10 units favourable of Deluxe times $6). We can split this into a sales quan tity profit variance (effectively a 
yield variance) and a sales mix profit variance. The sales quantity 
profit variance is calculated as follows: 
(Actual units – budgeted units) × we ighted average profit per unit 
(500 units budget – 490 units actual ) × $5.60 average profit = $56 A 
(b) Sales mix profit variance (usi ng the individual units method)  
 Standard 
mix Actual 
mix Variance 
(treatments) Profit per 
treatment Variance 
    ($) ($) 
Standard 196 180 16 (A) 5 80 (A) 
Deluxe 294 310 16 (F) 6 96 (F) 
Total 490 490   16 (F) 
The standard mix is the total unit sale s (490) multiplied by 2/5 to give X 
and 3/5 to give Y.

Chapter 6 
 221 
 (c) Sales mix profit variance (usi ng the weighted average method) 
 Standard 
mix Actual 
treatment Weighted 
average 
profit Difference Variance 
    ($) ($)  ($) 
Standard 196 180 16 (A) 5 5.60 0.60 (A) 9.60 (F) 
Deluxe 294 310 16 (F) 6 5.60 0.40 (F) 6.40 (F) 
 ––––– ––––     –––––– 
Total 490 490     16.00 (F) 
The Standard variance is favourabl e overall because, although the 
company sold less of that treatment t han the standard mix, this is the less 
profitable treatment. 
This perhaps explains the superio rity of the weig hted average method 
overall. Overall we have sold more of the more profit able treatment and 
less of the least profitable treatment  so that it can be argued that both 
variances are in the company's favour and should be favourable. 
 
 (a) Traditional variances  
Actual quantity × Actu al price = $41,500  
 Price variance  $2,500 F 
Actual quantity × Standard price = (11,000 × $4) $44,000  
 Usage variance  $4,800 A Standard quantity × Standard price = (1,400 × 7 × $4) $39,200  
(b) Planning variances 
  $ Original standard quantity × Original standard price 
(1,400 × 7 × $4) 39,200 
Revised standard quantity × Revised standard price 
(1,400 × 8 × $3.80 ) 42,560 
 
 ––––––– 
Planning variance $3,360 A 
 ––––––– 
 
Operational variances    
AQ × AP =  $41,500  
 Price variance  $300 F AQ × RSP = (11,000 × $3.80) $41,800  
 Usage variance  $760 F RSQ × RSP = (1,400 × 8 × $3.80) $42,560

222  
  
 D $39,500 
 $ 
Standard contribution on actual sales 44,000 
Add: Favourable sales price variance 2,000 
Less: Adverse total variable costs variance (6,500) 
 –––––– 
Actual contribution $39,500

Chapter 6 
 223 
 (a) Budgeted and actual profits  
Budget Kitchens Bathrooms Total 
 $m $m $m 
Sales 40 14 54 
Direct costs (22) (6) (28) Central services (10) (5) (15) 
Budgeted profit 8 3 11  ––––– ––––– ––––– 
 
Actual Kitchens Bathrooms Total 
 $m $m $m 
Sales 33.8 15.25 49.05 
Direct costs (20.8) (6.75) (27.55) 
Central services (6.5) (6.25) (17.50)  –––––– –––––– –––––– 
Actual profit 6.2 2.25 4.00 
(b) Sales variances  
Sales price variance Kitchens Bathrooms Total 
Standard sales price 10 7.0  
Actual sales price 13 6.1   –––––– ––––––  
Variance 3 F 0.9 A  
Actual sales quantity × 2,600 × 2,500   –––––– ––––––  
Sales price variance 7,800 F 2,250 A 5,550 F 
Sales mix profit variances  
 Standard 
mix Actual 
(units) Profit per 
unit ($) Variance 
($m) 
Kitchens 3,400 2,600 800 (A) $2,000 1.60 (A) 
Bathrooms 1,700 2,500 800 (F) $1,500 1.20 (F)  –––––– –––––   –––––– 
Total 5,100 5,100   0.40 (A) 
 –––––– –––––   ––––––

224  
 Sales quantity profit variances 
 Standard 
mix Actual 
($m) 
Kitchens 3,400 4,000 600 (A) $2,000 1.20 (A) 
Bathrooms 1,700 2,000 300 (F) $1,500 0.45 (F)  –––––– –––––   –––––– Total 5,100 6,000   1.65 (F)  –––––– –––––   –––––– 
Check 
Sales volume variances 
Kitchens  (4,000 – 2,600) × $2,000 = $2.8m A Bathrooms  (2,000 – 2,500) × $1,500 = $0.75m F Total $2.05m Sales volume variance  = mix variance + quantity variance  = $0.4m A + $1. 65m A = $2.05 m 
(c) Reconciliation of profits  
 $m 
Budgeted profit (from part a) 11 
 
 Favourable Adverse   
 ($m) ($m)   Sales price variances (from part b)     
–  kitchens 7.80    –  bathrooms  2.25   Sales mix variance (from part b)     
–  kitchens  1.60   –  bathrooms 1.20    Sales quantity variance (from part b)     
–  kitchens  1.20   –  bathrooms  0.45   Direct costs (W1)     –  kitchens  6.50   –  bathrooms 0.75    Central services (W2)     –  volume (kitchens)  3.50   –  volume (bathrooms) 1.25    –  expenditure  2.50    –––– ––––    11.00 17.00 7 A    –––  Actual profit (from part a)   4     –––

Chapter 6 
 225 
 Workings 
(W1) Direct cost variances:  
Kitchens 2,600 × (5,500 – 8,000) = $6.5m A 
Bathrooms 2,500 × (3,000 – 2,700) = $0.75m F 
(W2) Central services volume variances:  
Kitchens (4,000 – 2,600) × $2,500 = $3.5m A  Bathrooms (2,500 – 2,000) × $2,500 = $1.25m F Central services expenditure variance = $15m – $17.5m = 
$2.5m A 
(d) Performance of the company for the year  
(Actual profit at $4m is $7m below budgeted profit, a shortfall of 
64%). The main causes are as follows: 
– an overall fall in the total volume of sales resulting in a sales 
quantity variance of $1.65m A.  The lower than expected 
volume has also resulted in central services costs being under 
absorbed as shown by the volume variances (net impact $2.25A). 
– the sales mix has also switched from more profitable kitchens 
to less profitable bathrooms and this is reflected in the sales mix variance of $0.4m A. 
– the impact of the lower volume of kitchen sales has been 
partially offset by the favourable pr ice variance for kitchens. It is 
possible that a higher proportion of jobs are of the highly 
customised category rather than the ‘off the shelf’ packages. 
This has led to higher average prices being charged but also higher direct costs being incurre d. The opposite seems to have 
occurred with bathrooms. 
– Central services costs have exceeded budget by $2.5m. This 
may be due to higher costs incurred designing customised jobs. 
It would be worth investigating wh ether the extra price charged for 
customised designs is covering all of the additional costs incurred. 
Higher prices may be necessary or better control of costs. 
Tutorial note:  For part (a): The info rmation given in the question 
suggests that an OAR of $2,500 per j ob is used to absorb central 
services costs. This means that  there is under absorbed central 
services cost of 17.5 – 6.5 – 6. 25 = $4.75m. There is no indication 
that this is charged to the other divisions, but total costs must be 
shown to arrive at total profit.

226  
 Operating statement for ATS  
  $ $ 
Original budgeted 
contribution 1,200 × $26  31,200 
Sales volume contribution 
variance (1,000 – 1,200) × $26  5,200 A 
   –––––– 
Budgeted contribution on 
actual sales   26,000 
Sales price ($110 – $130) × 1,000 20,000 F  
Material price ($3 – $4.50) × 8 × 1,000 12,000 A  
   8,000 F 
   –––––– Revised contribution on actual sales  34,000 
Sales price ($130 – $135) × 1,000 5,000 F  Material price ($4.50 – $4) × 7,800 3,900 F  Material usage (8,000 – 7,800) × $4.50 900 F  
Labour rate ($10 – $10.40) × 6,250 2,500 A  
Labour efficiency (6,000 – 6,250) × $10 2,500 A    ––––––  
   4,800 F 
   –––––– Actual contribution   38,800 
   ––––––

Chapter 6 
 227 
 In this example, since the change in both the material usage and material 
price are inter-related, the total planni ng variance only is reported in the 
operating statement below. 
 $  
Budgeted profit 18,000  
Budgeted fixed costs 30,000  
 –––––  Budgeted contribution 48,000  
Planning variance 16,800  (A) 
 –––––  Revised budgeted contribution 31,200  
Sales volume contribution variance 9,600  (F) 
 –––––   40,800  Operational variances   
Sales price 5,000  (A) Materials usage 900  (A) 
Direct labour rate 750  (A) 
Direct labour efficiency 1,800  (A) 
 –––––  
Actual contribution 32,350  Budgeted fixed costs 30,000  
Fixed cost expenditure variance 2,000  (A) 
 –––––  Actual profit 350  
 –––––  
Materials price $  
12,300 kilos should cost (× $3) 36,900  
They did cost 36,900  
 –––––  
Direct materials price variance 0  
 –––––  
Materials usage Kilos  
2,400 units of product should use (× 5 kilos) 12,000  
They did use 12,300  
 –––––  Direct materials usage variance (in kilos) 300  (A) 
Standard price per kilo (ex post) $3  
 –––––  
Direct materials usage variance $900 (A) 
 –––––

228  
 Labour rate $  
7,500 hours should cost (× $6)  45,000  
They did cost 45,750  
 ––––––  
Direct labour rate variance 750  (A) 
 ––––––  
Labour efficiency Hours  
2,400 units of product s hould take (× 3 hours)  7,200  
They did take 7,500  
Direct labour efficiency variance (in hours) 300  (A) Standard rate per hour  $8  
 ––––––  
Direct labour efficiency variance $1,800  (A) 
 ––––––  
Sales price $  
2,400 units should sell for (× $50)  120,000  
They did sell for  115,000  
 ––––––  
Sales price variance 5,000  (A) 
 ––––––  
Fixed overhead expenditure $  
Budgeted fixed costs  30,000  
Actual fixed costs 32,000  
 ––––––  
 ––––––  
Sales volume Units  
Budgeted sales 2,000  
Actual sales 2,400   ––––––  
Sales volume variance (in units) 400  (F) 
 ––––––  Standard contribution per unit $24  
Sales volume contribution variance $9,600  (F) 
 ––––––

Chapter 6 
 229 
Material costs $/unit  
Ex ante standard per unit (4 kilos × $2) 8.0  Ex post standard per unit (5 kilos × $3) 15.0   ––––––  
Planning variance per unit 7.0  (A) 
Actual units produced × 2,400   ––––––  
Total planning variance $1,800  (A) 
 ––––––  
 
 (a) This is a 'backwards' question. Rather than calculat ing the variances 
ourselves, we have been given some  of them. We have to find 
some other information which is mi ssing. We will use the variances 
to work backwards to find that missing information. 
The starting point is usually to find a variance which mentions the 
missing information, i.e. for part (a ) we are asked for the actual 
output. We need to find a variance wh ich mentions the actual output 
somewhere along the line. 
One set of variances which would work are the material variances. 
The first line of the format is SQSP, where SQ is the standard 
quantity of the actual output.  
We plug in the information that we know, and we can then work 
backwards to find the missing information.

230  
 
(b) We have already worked out a lot of the figures t hat we need for the 
material variances. We can carry on from where we left off in part 
(a).

Chapter 6 
 231 
 (c) Labour variances  
 
(d) Fixed overhead volume variance  
 Units 
Budgeted output 2,000 
Actual output 2,300 
 ––––––  300 F 
× Standard fixed overhead cost per unit ×12 
 ––––––  $3,600 F 
 –––––– 
(e) Fixed overhead expenditure variance  
 $ 
Budgeted output 24,000 
Actual output 23,500 
 ––––––  500 F 
 ––––––

232  
 (f) Sales volume profit variance  
 Units 
Actual sales 2,300 
Budgeted sales 1,900 
 ––––––  400 F 
× Standard profit per unit ×12 
 –––––– 
= $4,800 F 
 –––––– 
The profit margin is 20% of selling price. A profit margin of 20% is 
the same as a mark-up of 25%. Thus  we know standard cost to be 
$48 per unit, standard profit  must be 25% of that, must be $12 per 
unit. 
(g) Selling price variance  
 $ 
Actual selling price 57 
Standard selling price 60 
 –––––– 
 3 A 
× Actual no of units sold × 2,300 
 –––––– 
= 6,900 A 
 –––––– 
We know that standard cost is  $48 per unit and we the standard 
profit (from part (f)) is $12. Therefore standard selling price = $48 + 
$12 = $60. 
(h) Budgeted profit = 1,900 uni ts × $12 per unit = $22,800. 
(i) 
  $ $ 
Sales 2,300 units × $57  131,000 
Direct material  16,192  
Direct labour  52,440  Variable overhead  14,168  
Fixed overhead  23,500  
  ––––––     106,300 
   –––––– 
Actual profit   24,800    ––––––

Chapter 6 
 233 
  
This is a very good test of the depth of your knowledge of variances. The 
basic technique is to set out your no rmal computations of the variances, 
putting in the figures you know and working back to those you don’t. Often the results from one will be needed in another, so do all the related 
variances together. 
(a) (i) Budgeted fixed overhead cost/mile 
 ($15,600 + $400)   
 = –––––––––––––– = $0.08/mile  
 200,000   
    
 Volume variance = $1,760 (A)  
 Volume difference = $1,760 ÷ $0.08    = 22,000 miles(A)  
  = 200,000 – 22,000  
  178,000  (ii)  $0.08   Standard rate/hr = –––––  
  0.02  
 Rate variance = $4/hour    = $1,086 (F)  
  = $1,086 / 3,620 = $0.30/hr (F) 
 Actual rate $4.00 – $0.30 = $3.70/hr 
(iii) 
 $0.04  Standard price/litre = –––––  
 0.1     
 = $0.40/litre  
Actual price/litre = $0.42/litre  Price variance/litre = $0.02 (A)  
Total price variance = $420 (A)  
 $420  
Actual number of litres = ––––– = 21,000 
 $0.02

234  
 (iv) Variable overhead variances 
 
(b) Two possible causes of an adverse fuel usage variance are: 
(i) Spillage of fuel occurred on filling vehicle fuel tanks. 
(ii) Vehicles are in need of servicing and as a result fuel usage is 
excessive.

Chapter 6 
 235 
 (c) To:  Transport Operations Manager 
From:   Management Accountant 
Date:   XX – XX – XX 
Subject:  Standard costs 
This report explains the type of standard cost which may be set and 
Types of standard A standard cost is a prediction of the cost per unit expected in a 
future period. It is dependent on esti mates of resource requirements 
per output unit and the price to be paid per resource unit. 
There are three types of standard which may be set and these are 
often referred to as: 
– current standard – attainable standard; and – ideal standard. The current standard uses existing efficiency and achievement 
levels as the standard for the future period. This does not 
encourage improvement and may also allow existing inefficiencies 
to continue unnoticed. 
The attainable standard sets a tar get which requires improvements 
in performance if it is to be achi eved, but these are small and are 
considered to be achievable (or atta inable). This form of standard is 
believed to be the best motivator to a manager. The ideal standard assumes a perfect working environment (which 
never exists for a prolonged period). This is impossible to achieve. 
Keeping standards useful 
Standards are useful as a basis for performance evaluation. If such 
comparisons are to be valid the standard must reflect the current 
method of working AND resource pr ices which are realistic. If 
standards are not kept up to date t hey are no longer meaningful and 
thus their usefulness is reduced. 
I recommend that attainable st andards should be used, and that 
they should be reviewed regularly. Please contact me if you wish to 
discuss this further.

236  
 A performance reporting and m anagement control system depends on 
both reliable planning as well as c ontrol over operating activities. 
Some planning variances might be caus ed by factors that could not have 
been foreseen in advance. However, some planning variances might be 
caused by weaknesses in the planning process. If so, they can be significant and indicate the need for better planning procedures in the 
future.

237 
Preparing budgets 
B1. Distinguish between the 
different rationales for budgeting (a) Explain the role of budgets 
budgeting 
B2. Prepare budgets (b) Prepare master budgets 
(c) Conduct what-if analysis in 
budgeting 
(d) Describe the technologies 
available for improving budgeting 
D1: Apply basic risk management tools in the short term (b) Apply basic sensitivity 
analysis to budgeting and short term decision making. 
  Chapter 
7

238  
1  Chapter overview diagram 
 
2 Budget 
A quantitative or financial plan relating to the future. It can be for the company 
as a whole or for departments or functions or products or for resources such as 
cash, materials, labour,  etc. It is usually for one year or less. 
3 Purposes of budgeting 
Budgets have several different purposes: 
(1) planning (2) control and evaluation (3) co-ordination (4) communication (5) motivation (6) authorisation

Chapter 7 
 239 
 Purposes of budgets explained 
 Budgets have several different purposes: 
(1) Planning  
Budgets compel planning. T he budgeting process forces 
management to look ahead, set ta rgets, anticipate problems and 
give the organisation purpose and direction. Without the annual 
budgeting process the pressures of  day-to-day operational problems 
may tempt managers not to plan for future operations. The 
budgeting process encourages manager s to anticipate problems 
before they arise, and hasty decisions  that are made on the spur of 
the moment, based on expedi ency rather than reasoned 
judgements, will be minimised. Co rporate planners would regard 
budgeting as an important  technique whereby long-term strategies 
are converted into shorter-term action plans. 
(2) Control and evaluation  
The budget provides the plan against which actual results can be 
compared. Those results which are out-of-line with the budget can 
be further investigated and co rrected. The performance of a 
manager is often evaluated by measuring his success in achieving his budgets. The budget might quite possibly be the only quantitative reference point available. 
(3) Co-ordination  
The budget serves as a vehicle th rough which the actions of the 
different parts of an organisation can be brought together and reconciled into a common plan.  Without any guidance managers 
may each make their own decisions believing that they are working 
in the best interests of the organisation. A sound budgeting system 
helps to co-ordinate the different activities of the business and to 
ensure that they are in  harmony with each other. 
(4) Communication  
Budgets communicate targets to  managers. Through the budget, 
top management communicates its expectations to lower-level 
management so that all mem bers of the organisation may 
understand these expectations and can co-ordinate their activities to 
attain them. 
(5) Motivation  
The budget can be a useful device for influencing managerial behaviour and motivating managers to perform in line with the organisational objectives. 
(6) Authorisation  
A budget may act as formal authorisation to a manager for expenditure, the hiring of  staff and the pursuit of the plans contained 
in the budget.

240  
Advantages and disadvantages of budgeting 
 budgets ensure that the 
organisation’s actions are 
matched to the organisation’s goals and that these goals are communicated throughout the organisation  preparing budgets can be time 
consuming for staff and management and may distract from the business’ core operations 
 creating a budget forces 
management to consider the future and how the business’ environment (both internally and externally) might change  predicting future changes is very 
subjective and relies on the ability of the preparer of the budget to 
make these predictions as accurately as possible 
 it means that organisations 
are better placed to cope with 
change and can act as an 
early warning system for problems  budgets can create conflicts and 
barriers between budget holders 
rather than know ledge sharing and 
coordination 
 budgets force management to 
consider the cost and 
profitability of products, departments, functions etc.  the use of budgets can encourage 
short-termism where, for example, discretionary expenditure such as staff training is reduced in order to meet budget targets 
 this in turn can force 
management to consider the value added by these products, departments or functions  budgets focus on financial 
outcomes rather than broader measures of success such as customer satisfaction, quality etc. 
 budgets improve decisions on 
resource and cash allocation, financing and investment  budgets can encourage managers 
to spend what is in the budget, even if it is not necessary, to guard against reductions to next year's budget. 
 having budgets facilitates 
performance evaluation in areas such as the use of variance analysis  using budgets can deter innovation 
and enterprise as  staff become 
focused on meeting the targets rather than exce eding them or 
responding to changing market needs

Chapter 7 
 241 
 Difficulties in budgeting for global companies 
 Many organisations will operate across many countries and continents. 
This can make the budgeting process more difficult as these 
organisations will be facing a high level of diversity in these markets in 
areas such as: 
Area of diversity Complexity in budgeting 
Currency Although dealing in mult iple currencies can easily be 
accommodated by most budgeting systems, the problem lies in that curre ncies are not stable and are 
instead likely to fluctuate regularly. It means that 
targets set in one currency will be constantly moving when converted to another currency. It will also mean that a business unit that has  reported performance in 
its local currency may see that it’s performance is viewed very differently when the results are translated back to the ‘home’ or central currency. 
Legal framework Plans will have to be adjusted for different laws and regulations relevant to th e location of the business 
unit. It may mean, fo r example, that sources of supply 
have to be changed if some components must be sourced locally (which may, in turn, impact on product quality) or that sta ff training and welfare must 
be changed to reflect local rules and customs. 
This makes it much more difficult to have central 
rules and policies that apply across the global 
organisation and may even result in greater conflict between business units if each one is treated differently. 
Customer tastes and competitor actions Differences in taste in cult ure can force organisations 
to adapt products and services. This can require different types of materi als and labour, for example, 
meaning that more localised targets and standards are required, adding further  complexity to the 
budgeting system. 
Likewise, local competitors will compete in different 
ways such as having different pricing and 
promotional strategies. It  means that the budgeting 
system may have be further decentralised in order to allow local business unit managers the ability to react to this. But this can lead to a lack of consistency across the organisation if, say, one local manager decides to pursue a strategy  of under-cutting rivals 
on price whilst a manager in a different location, facing different competitors, decides to offer enhanced services and quality.

242  
 Political 
climate Business units operating in different countries will be dealing with different gover nments. They therefore 
might experience different levels of political 
‘interference’. Governments can have policies and laws on what type of labour can be used, how much labour should be paid, what goods can be brought into or out of the country , etc. This therefore can 
require further decentra lisation of the budgeting 
process and adds further layers of complexity for budget prepares and evaluators.  
 
4 Functional budgets and the master budget 
A master budget  for the entire organisation brings  together the departmental or 
activity budgets for all the departments or  responsibility c entres within the 
The structure of a budget depends on t he nature of the or ganisation and its 
operations. In a manufacturing organisa tion, the budgeting process will probably 
consist of preparing several functional budgets , beginning with a sales 
budget. All budgets will be prepared for the same budget period. 
 
 The budget period 
 Before preparing a budget, the organisation should decide the budget 
period.  The budget period  is the time for which t he budget is prepared. This is 
typically 1 year which reflects the fa ct that the financia l reports for most 
organisations cover 1 year periods. Bu t a budget can be for any length of 
time that suits management purposes.  The budget period must not be too shor t otherwise too much time is 
spent in regularly preparing t he budget and evaluating performance 
against the budget. But it also should not be too long as things are likely 
to change more over longer periods which means the budget becomes out of date and also eval uation happens less often as  is less useful as 
targets are less relevant. 
Principal budget factor 
When a key resource is in short supply and affects the planning decisions, it is 
known as the principal budget factor  or limiting budget factor.  
It is usually assumed in budgeting that  sales demand will be the key factor 
setting a limit to what the organisati on can expect to achieve in the budget 
period. 
When the principal budget factor has  been determined this should be the 
starting point for all other budgets.

Chapter 7 
 243 
 Other limiting factors 
 In most organisations the princi pal budget factor is sales demand: a 
company is usually restricted from making and selling more of its 
products because there would be no sales demand for the increased output at a price which would be a cceptable and/or profitable to the 
company. 
Occasionally, however, there might be a shortage of a key resource, such 
as cash, raw material supplies, skill ed labour or equipment. If a resource 
is in restricted supply, and the s hortage cannot be overcome, the budget 
for the period should be determined by how  to make the best use of this 
key budget resource, rather  than by sales demand. 
Principles such as linear programming, key factor analysis and 
throughput accounting could then be used to determine production plans. 
 
 Budget preparation 
These stages in budgeting are illus trated in the following diagram:

244  
 Explanation of each budget 
 You can see from this t hat the principal budget fact or is the starting point 
in the process. It is generally sales, as shown in the diagram. 
Step 1:  The sales budget considers how many units can be sold. 
Step 2:  The production budget considers how many units must be 
produced to meet the budgeted sales level. 
Note:  The difference between the sales and the production budgets is 
the inventory of finished goods. 
Step 3:  The material, labour and over head budgets can be established, 
based on the production budget.   
Note: The material budget is generally calc ulated in two parts, firstly the 
quantity of material required in produc tion, then the quantity of material 
required to be purchased. The di fference between these will be the 
inventory of raw materials. Material losses in production and idle time must be taken account of in 
the material and labour budgets. Step 4:  Non-production budgets. Budgets for non-production costs, such 
as selling and distribution cost s, must also be considered. 
Steps 5, 6 and 7:  The master budget, comprising the statement of profit 
or loss, cash budget and statement of financial position can be pulled 
together from the individual budgets. 
More specifics on each budget: 
 Sales budget.  Budget for future sales, expressed in revenue terms 
and possibly also in units of sale. The budget for the organisation as 
a whole might combine the sales budgets of several sales regions. 
 Production budget.  A production budget follo ws on from the sales 
budget, since production quantities are determined by sales volume. 
The production volume will differ from sales volume by the amount of any planned increase or decrease in inventories of finished goods 
(and work-in-progress). 
In order to express the production  budget in financial terms (production 
cost), subsidiary budgets must be prepared for materials, labour and 
production overheads. Several departm ental managers could be involved 
in preparing these subsidiary budgets. 
 Direct materials usage budget.  This is a budget for the quantities 
and cost of the materials requi red for the planned production 
quantities. 
 Materials purchases budget.  This is a budget fo r the cost of the 
materials to be purchased in the period. The purchase cost of direct 
materials will differ from the mate rial usage budget if there is a 
planned increase or decrease in di rect materials inventory. The 
purchases budget should also include the purchase costs of indirect materials.

Chapter 7 
 245 
  Direct labour budget . This is a budget of the direct labour costs of 
production. If direct labour is a variable cost, it is calculated by 
multiplying the production quantities (i n units) by the budgeted direct 
labour cost per unit produced. If direct  labour is a fixed cost, it can 
be calculated by estimating the payroll cost. 
 Production overheads.  Budgets can be produced for production 
overhead costs. Where a system of  absorption costing is used, 
overheads are allocated and appor tioned, and budgeted absorption 
rates are determined. 
 Administration and sales a nd distribution overheads.  Other 
overhead costs should be budgeted. 
 Budgeted statement of profit or  loss, cash budget and balance 
sheet.  Having prepared budgets for sa les and costs, the master 
budget can be summarised as an statem ent of profit or loss for the 
period, a cash budget and a balance sheet (or statement of financial 
position) as at the end of the budget period. 
If the budgeted profit, cash position or balance sheet  are unsatisfactory, 
the functional budgets should be re vised until a satisfactory planned 
outcome is achieved 
 
 Example 1 
 Newton manufactures three produc ts; the expected sales for each 
product are shown below. 
 Product 1 Product 2 Product 3 
Sales in units 3,000 4,500 3,000 
Opening inventory is expected to be: 
Product 1 500 units Product 2 700 units Product 3 500 units Management have stated their desire to  reduce inventory levels and 
closing inventories are budgeted as: Product 1 200 units Product 2 300 units Product 3 300 units Three types of material are used in  varying amounts in the manufacture 
of the three products. Material requi rements per unit are shown below: 
Material M1 2 kg 3 kg 4 kg 
Material M2 3 kg 3 kg 4 kg 
Material M3 6 kg 2 kg 4 kg

246  
 The opening inventory of mate rial is expected to be: 
Material M1 4,300  kg 
Material M2 3,700  kg 
Material M3 4,400  kg 
Management are keen to reduce inventory levels for materials as well 
and closing inventories are to be much  lower. Expected levels are shown 
below: 
Material M1 2,200  kg 
Material M2 1,300  kg 
Material M3 2,000  kg 
Material prices are expected to be 10%  higher than this year and current 
prices are $1.10/kg for material M1, $3.00/kg for material M2 and 
$2.50/kg for material M3. 
Two types of labour are used in pr oducing the three products. Standard 
hours per unit are shown below: 
Skilled labour 3 1 3 
Skilled labour 3 3 4 
Skilled labour are to be paid at the rate of $6/hour and semi-skilled labour 
at the rate of $4/hour. 
Required: 
Prepare budgets for: 
(a) production (in quantity) (b) materials usage (in quantity) (c) materials purchases (in quantity and value) (d) labour (in hours and value). 
Cash budgets and cash flow forecasts 
 A cash forecast  is an estimate of cash receipts and payments for a future 
period under existing conditions. 
 A cash budget  is a commitment to a plan for cash receipts and payments for a 
future period after taking any action necessary  to bring the forecast into line with 
the overall business plan. Cash budgets are used to: 
 compare with actual spending.

Chapter 7 
 247 
There are two different techniques that  can be used to create a cash budget: 
 a balance sheet forecast. 
and cost of sales and the timings of the cash flows relating to these items. 
 
asset 
 some statement of profit or loss items are derived from accounting 
statement of profit or loss accounting period, e.g. a sale is 
recognised in the statement of pr ofit or loss when the invoice is 
raised, yet the cash payment from the receivable may not be 
received until the following period or later 
 irrecoverable debts will never be received in cash and an allowance 
for irrecoverable debts may not be received at all. When you are 
forecasting the cash receipts from customers you must remember to adjust for these items. 
The following approach is a comprehensive step-by-step guide to how a management accountant might go about  preparing a full cash budget. 
Understanding this process should help you in your understanding and 
interpretation of cash budgets, but you will not be required to prepare a 
full cash budget in  an examination. 
Step 1 – Layout 
There is no definitive layout that should be used for a cash budget. 
However, it will typically include the following: 
cash flows. It should be logically  arranged with a subtotal for 
receipts and a subtotal for payments.

248  
 (ii) A figure for the net cash flow for each period. It could be argued that 
this is not an essential feature of a cash budget. However, you will 
find it easier to prepare and use a cash budget in an examination if 
you include the net cash flow. Also , managers find in practice that a 
implications of their ac tions during the period.  
(iii) The closing cash balance for each control period. The closing 
balance for each period will be the opening balance for the following 
period. 
The following is a typical layout: 
 
figure and timing and can be entered stra ight into the proforma. These 
 purchase of non-current assets.

Chapter 7 
 249 
 Step 3 – Work out the more complex figures 
periods 
and inventory balances. 
 
 Example 2 
  
 $ $ $ $ 
pattern: 
 % In month of sale  10 In month after sale  40  Two months after sale  45 The organisation expects the rate of irrecoverable debts to be 5%. 
Interpretation of a cash budget 
Examples of factors to consider when interpreting a cash budget include: 
 Is the balance at the end of the period acceptable/ matching expectations? 

250  
 Example 3 
 HT has prepared a cash budget for the fi rst three months of the year as 
follows: 
 $ $ $ 
Receipts    
 –––––– –––––– –––––– Payments    
For direct material s 21,000 17,500 16,500 
For direct labour (30% × pr od'n cost) 15,000 16,500 9,750 
For fixed production overheads 2,000 2,000 2,000 For variable production ov erheads 13,000 10,600 8,800 
For admin/selling overhead 15,000 – –  –––––– –––––– –––––– Total outflow 66,000 46,600 67,050 
Net cash flow for month (10,000) 11,400 (13,050) Opening balance (5,000) (15,000) (3,600)  –––––– –––––– –––––– 
Required: 
Explain the usefulness of this budget to  the business and the issues that 
it raises. 
5 Sensitivity analysis and stress testing budgets 
Budgets are based on assumptions about the future. Each and every one of 
these assumptions could be wrong. It will therefore be important  to test what 
might happen to a budget if the assumptions change. 
There are various approaches to this issue and one of the most widely used is 
‘sensitivity analysis’. 
A sensitivity analysis exercise involves  revising the budget on the basis of a 
series of varied assumptions. One assumption can be changed at a time  to 
determine the impact on the budget overall.  For example, if sales quantities 
were to be changed the impact on profits, cash flow etc. could be observed. 
When changing more than one variable at  a time it may be better to use 
spreadsheets to simplify and speed up the process.

Chapter 7 
 251 
 Example of sensitivity analysis 
 An organisation has a budget for the fi rst quarter of the year as follows: 
 $ 
Sales: 100 units @ $40 per unit 4,000 
Variable costs: 100 units @ $20 per unit (2,000) 
Fixed costs (1,500)  –––––– 
Profit 500 
 –––––– 
There is some uncertainty over the variable cost per unit and that cost 
could be anywhere between $10 and $30, with $20 as the ‘expected’ 
outcome. We are required to carry out a sensitivity analysis on this. 
One approach to this would be to pr esent the budget shown above as an 
‘expected’ case but with two other cases as ‘worst’ and ‘best’ possible 
outcomes. 
Worst-case budget ($30 unit variable cost) 
 $ 
Variable costs: 100 units @ $30 per unit (3,000) Fixed costs (1,500)  –––––– 
Profit (500) 
 –––––– 
 
 Stress testing budgets  
Stress testing a budget involves a more  substantial examination of how a 
budget would cope under pressure from  changes. It is more complex than 
simply changing one assumption (which is  what occurs in sensitivity analysis). 
 
 A stress test examines how a budge t would perform or function 
under severe or unexpected pressure.  
For example, it may test a budget to ex amine the consequences of the loss of a 
major customer.  Budgets rarely go to pl an (as can be seen from our chapter on 
variance analysis). But if an organisati on has stressed tested its budgets it will 
be better prepared for when things go wrong and have a better idea of whether 
it can cope and how to react

252  
 Some organisations run stress test s drills in order to get a full 
understanding of their fi nancial and strategic pos ition. Consider the 
following example: 
A business wants to test its abilit y to cope with the loss of a major 
customer. It has therefor e placed all income from  that customer in a 
certain month in a separate bank account that can’t be accessed for 
normal business use. The business then continues to operate as normal but does not access these funds and when funds are required the business needs to find ways to adapt without the funds that would be 
available from this customer. 
This will indicate whether the bus iness could survive without this 
customer for a month and what stre sses it might put on the business. 
Perhaps it had to extend its overdr aft or delay the purchase of new 
equipment. Or the company might fi nd that it is not happy with the 
interest received on the money that  it placed on deposit from the 
customer. There may have been some positives – maybe there was a 
better focus on getting cash in ear lier from other customers.  
The stress test drill can identify new areas of efficiencies (such as in 
credit control over other customers) or inefficiencies (getting effective 
returns on cash invested). These less ons learnt can be built into budgets 
and plans and make the business perform better in the future by building 
on its successes and removing its failures during the stress test period. 
 Stress testing ensures that budgets and the organisation can withstand the 
pressures, both expected and unexpected,  that are likely to be put on the 
business over the budget period.  
 
The need for stress testing 
 Stress testing can play a strategic ro le. The results of a stress test can 
indicate why a strategy may not be su ccessfully realised or implemented, 
it can identify areas of inefficienc y and it can make a business more 
‘agile’ and adaptable to changes in its business environment. 
Stress testing allows risks to be quant ified. Many businesses might be 
able to state that sales will fall if  the economy were to move into a 
recession but a company who has stressed tested its budgets for such an 
event would be able to say not only by how much sales would fall, but also to explain the impact on profit s and cash as well as the company’s 
plans to minimise the impact and adjust its strategies. 
Stress tests may be imposed on the business by lenders. If, say, a 
company is borrowing money in order  to finance a new project and the 
loan will last 10 years, a lender may want to know how the company will 
cope with a rise in interest rates or if  the project returns are only half of 
what the company are expecting.

Chapter 7 
 253 
 There may also be infrequent expenditure  that is not accounted for in the 
budget. For example, if an employee l eaves and has to be replaced there 
will be costs involved in recruitment, training and lost productivity. These 
are often not planned for in the budget  but should be stress tested. In 
simple terms, the org anisation can then set cash aside for these 
instances of infrequent and sometimes unexpected elements of 
expenditure rather  than have all ‘available’ cash tied up in investments 
meaning that there is a shor t-term shortage of cash  available to meet the 
extra burden placed on the organisation. 
Stress testing is not just testing for the survival of the organisation. It may 
be that an organisation expects sales to increase by 40% this year and 
has therefore put in place an employee recruitment programme 
throughout the year. If sales fail to increase by 40% the company may not 
go out of business, but it will need to consider what to do with any staff 
recruited or how to delay or cancel  any outstanding recruitment. Warning 
signs need to be identified and plans put in place for when these warning 
signs are triggered. If, for example, sales fail to increase at all in the first quarter then it is 
unlikely that annual sales will rise by 40%. So the company could place 
on hold all second quarter recruitment  and look for ways to redeploy any 
staff already recruited (which might in  itself create growth elsewhere in 
the business). 
Considering these events prior to  the budget launch will allow the 
company to more quickly and effectiv ely react to the stresses placed on 
the budget. This proactivity is much better than being reactive to changes 
in the organisation’s environment. In choosing to outline the ways in 
which stresses might affect the co mpany’s position, more informed 
decisions can be made about where it is the company’s focus should lie. 
Sources of business stress 
There are many sources of stress that may be placed on an organisation 
(both internally and externally) such as: 
 technology which makes the pr oduct obsolete or uncompetitive 
 changes in customer or consumer tastes 
 the economy changes from a boom to a recession (or vice versa) 
 rivals creating a better product or finding ways to stand out better to 
customers 
 a cybersecurity attack 
 a workforce strike 
 failure of or faults in production systems. 
This list is not comprehensive and every organisation will face many 
more risks than these. But the list shoul d illustrate that  the stresses can 
come from both internal and external events.

254  
 Organisations should be constantly assessing these stresses and then 
testing their budgets to evaluate their ability to cope with any or all of 
these at any point in time. Stress te sting will also identify correlations 
between events – how, for example, changes in the strength of the 
economy might also impact on the re lative strength of a country’s 
currencies. The impact of both event s happening concurrently might then 
be stress tested. 
Stress testing goes beyond simple ‘w hat-if’ analysis which often focuses 
on changing one or two variables in the budget. Stress testing evaluates 
the impact of entire scenarios on an organisation. For example, a 
company that exports to foreign ma rkets might assess how a change in 
currency movements might impact on its business. The currency 
fluctuations may impact on the com pany sales price but it may also 
impact on the entire domestic econom y so that unemployment rates 
change, consumer spending levels change or inflation rates change. These would impact on a number of va riables in the budget system such 
as sales volume, wage rates, import costs etc.  
Stress testing for industries 
Stress tests may even be employed to an industry as a whole rather than 
to or by individual companies with in that industry. Every year, for 
example, the International Monetary Fund conducts its own stress testing 
of various countries banking se ctors, with the aim of giving an 
independent overview of bank solvency. This can have many uses. For example, governments in the country might have an indication of whether 
financial aid is required for particula r banks, whether public funds need to 
be better safeguarded or whether more regulation is required for banks to 
provide better safeguards or to im plement their own stress tests. 
Stress testing and software 
Stress tests are usually computer- generated simulation models that test 
hypothetical scenarios. Major organi sations will have developed their own 
software and systems which tailors the tests to their situations. But 
smaller organisations should also be st ress testing their budgets even if it 
is using bespoke and simple software such as Excel. 
The scenarios that are planned for and tested for should be plausible. 
Stress testing can be a complicated,  time-consuming and expensive 
exercise. It is therefor e important that risks and events are evaluated for 
plausibility before the stre ss testing process is initiated. The resources 
available for the testing must al so be considered so that smaller 
organisations might only test 5 or 6 events whereas larger organisations 
might test up to 20 events. 
 In objective test questions you ma y have to adjust budgets for events or 
stresses that impact on more than one variable in the budget.

Chapter 7 
 255 
 Example 4 
 A manufacturer is concerned about the potential loss of a major client. 
The manufacturer has already prepared the following budget for the year: 
 $000 
Revenue 480 Cost of sales 200 
Other operating costs 80 
 –––– Net profit 200 
 –––– 
The manufacturer wants to stress test  the budget for the loss of the major 
customer who makes up 25% of its tota l sales. This customer provides a 
gross margin of 15% on sales. 
What would be the revis ed budgeted profit if the customer’s sales were 
lost? A $182,000 B $80,000 C $110,000 D $150,000 
Stress testing is actually an element of  budgetary control (which is covered in 
more detail in a later chapter). It has, however, been covered in this chapter as 
it typically requires the preparation of a new budget. 
6 Budget data 
There are many sources of informati on that can be used as the basis for 
budgeting. If, for example, sales is the principal budget fact or the following are 
examples of where information on expecte d future sales levels might come 
from: 
 General economic data – information on changes to the economy such as 
expected growth in the economy or changes in consumer spending is 
regularly published 
 Public announcements – competit ors and customers may publicly 
announce their plans for the future which may impact on sales and pricing expectations 
 Historic sales trends – these can be examined to identify patterns and 
changes in existing buyer habits and tastes 
 Market research – all of the above can be verified through independent 
market research 
 Business unit consultation – for organisations where budgets are set 
centrally, regular communication with managers of individual business unit 
managers may provide better insight into  local conditions and expectations

256  
A new, growing area of information for budgeti ng setting is in the use of big data 
analytics. This can supplement and enhance the data from sources such as 
those listed above. 
 
 Using big data in budgeting  
 
Big data is used to refer to the lar ge volume of data, both structured and 
unstructured, that is available to organisations on a day-to-day basis. This 
information is often in digital fo rm and created outside the organisation and 
available to everyone. 
 
 Big data can be analysed in order to provide insights that lead to 
better decisions based on more informed knowledge.  
 
Big data analytics has become the catch- all term for gathering, analysing, and 
using massive amounts of digital informa tion to improve business operations. 
Big data analytics enable organisations  to make decisions based on data 
instead of business instinct.  
 
 Sources of big data 
 Big data can come from a range of sources such as: 
 Media (including social media). This  involves tracking media such as 
press reports, podcasts and industry briefings as well as social media 
such as YouTube, Twitter or Facebook  visits and comments etc. It is 
often free and easy to obtain and can quickly provide valuable 
insights on consumer preferences and changing trends. 
 The web. Data on the web is wi dely available and can often have 
more structure (such as on sites such as Wikipedia or Investopedia). 
Data can be accessed quickly and ther e is a vast, diverse repository 
of information available. 
 Machine generated. Machines c an be programmed to gather data. 
For example, a household device such as Amazon Alexa might gather data on what was searched for, what media was accessed 
and from where, what are devices are connected etc. 
 Databases. There is likely to be a wide variety of unstructured and 
unanalysed data within an organisations own databases on customers, suppliers, inventory etc. 
Organising this data into structured  and useful information can be time 
consuming and expensive. Many larger  organisations will use specialist 
staff and software to perform this task. 
But big data is not just useful for large businesses with high budgets set 
aside for its collection and analysis. Ther e is lots of information available 
to organisations of any size. There are already tools built into the 
programs businesses use each day.

Chapter 7 
 257 
 Businesses of all sizes can take advantage of the analytics available in 
their Twitter, Facebook and other soci al media accounts. For example, 
organisations can examine which types of posts get the most likes or 
retweets. Website analytics can te ll which pages are most popular, how 
long users spent on individual pages, how many visitors returned to the 
website etc. Accounting software may be able to tell which days are more 
popular for certain types of products, which day of the week a particular 
customer is likely to place an order etc. 
As well as (sometime expensive) s pecific data analytic software, many 
new business software applications are having built-in analytic tools, with 
dashboards that can pull it  all together. But it s hould be noted that even 
the best technology cannot deliver benefits without the knowledge to use 
it properly. This is why many organisa tions are creating specific roles for 
data analytic experts. 
Benefits of big data analytics for budgeting 
The principal budget factor is often the sa les forecast. But this can often be very 
subjective and due to a high degree of uncertainty. There can also be uncertainty when estimating costs and other  assumptions within the budgets.  It 
may even be that some data is not include d in the budget as it is seen as being 
unquantifiable.  
The use of big data can reduc e many of these problems. 
 
 Benefits of big data 
 Big data can help to answer what were previously thought to be 
unanswerable questions such as ‘what wi ll rivals do next?’, ‘how will 
consumer tastes change?’, ‘why are cu stomers switching to substitute 
products?’ etc. Some of the benefits of using big data include: 
 Organisations can react more quickly than rivals in the marketplace 
giving them a competitive edge. This can be achieved by better 
tracking of consumer trends as we ll as the actions of competitors 
 This, in turn, can allow organisations to be better prepared and more proactive towards expec ted changes in the industry. 
 Tracking consumer feedback and ta stes can mean that non-value 
adding activities or failures in syst ems can more easily be identified 
and removed. 
 Customer interactions and relationship management can be improved resulting in better repeat  business and customer loyalty.  
 Business operations can be exami ned and analysed in order to find 
areas for streamlining and simplificat ion resulting in cost reductions 
and efficiencies. 
 Employees can be provided with better information and make better local and operational decisions.

258  
  Customer needs are more readily  identified meaning that new 
product ideas can be more easily formulated and market tested.  
 Business performance can be better tracked and analysed against a 
wider set of criteria. 
Big data and stress testing 
Big data analytics can play a key role in stress testing. It can help in the 
following ways: 
 Identify stress events 
 Help quantify the effe cts of stress events 
 Hep test the validity of assumptions  in measures to deal with stress 
 Identify correlations for stress events 
 Create and identify warning signs  / triggers for stress events 
 
Big data can reduce the uncertainty in budget estimates, validate budget 
assumptions, fill in the gaps for missing data, create expectations for business 
and environment changes and identify corr elations in those changes. It will 
provide valuable insights and make an organisation more proactive to changes 
which should lead to better budgets and better decisions which will aid strategic 
implementation and development and generate greater success for the 
 
 Real world examples 
 Logistics 
UPS uses telematics to improve per formance. Delivery vehicles are 
equipped with sensors which monitor data on speed, dire ction, braking 
performance, drive train performanc e and other mechanical aspects of 
the vehicle. This information is then used to optimise maintenance 
schedules and improve efficiency of delivery routes saving time, money and reducing wastage. 
Data from the vehicles is combi ned with customer dat a, GPS information 
and data concerning the normal behaviour of delivery drivers. Using this 
data to optimise vehicle performance and routes has resulted in several 
significant improvements: 
 Over 15 million minutes of idling time were eliminated in one year. 
This saved 103,000 gallons of fuel. 
 During the same year 1.7 million miles of driving was eliminated, 
saving 183,000 gallons of fuel.

Chapter 7 
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 Retail 
It is widely reported that Walmart tra cks data on over 60% of adults in the 
US. Data gathered includes online and instore purchasing patterns, 
Twitter interactions and trends, weat her reports and major events. This 
data, according to the company, ensur es a highly personalised customer 
experience. Walmart detractors critic ise the company’s data collection as 
a breach of human rights and believe the company uses the data to make 
judgements and conclusions on personal information such as sexual orientation, political view and even intelligence levels. 
Entertainment 
Netflix has 150 million users worl dwide who watch 140 million hours of 
programmes per day. The company uses information gathered from 
analysis of viewing habits to inform decisions on which shows to invest in. 
Analysing past viewing figures and understanding viewer populations and 
the shows they are likely to watch a llows the analysts to predict likely 
viewing figures before a show has even aired. This can help to determine 
if the show is a viable investment. 
Problems in using big data 
Big data analytics must overcome a number  of problems, oft en explained by the 
characteristics of big data (oft en referred to as the 3V’s): 
 Volume – there is often too much data to analyse 
 Variety – the data comes in various forms 
 Velocity – it is created and changed at great speed. 
  Volume – there is a massive amount of big data available and not all 
of it will be of use to the organisa tion. Someone in the organisation 
will have to decide what data to collect, how to store it, most 
importantly, how to structure it in to something useful. Big data is 
typically unstructured and messy and it can only be of use to an 
organisation if these characteristics can be removed. 
 Variety – there is no consistent wa y in which big data is presented. It 
can be tweets, text, pictures, vi deos, graphs etc. The data needs to 
be organised and interpreted before it can be analysed. 
 Velocity – digital information is uploaded and updated on a second-
by-second basis. It will need to be processed quickly and constantly monitored. This is why software oft en play a critical role in big data 
analytics in that it can collect, organise and change information at 
greater speeds than organisations  could do using traditional 
analytical techniques.

260  
There may be other problems in perf orming big data analytics such as: 
 Because the data is often freely ava ilable it can be used and analysed by 
rivals so that any competitive advantage gained may be very short lived. 
 It requires a significant investment in IT in order to store, organise and 
manage the data. 
 The 3V’s is often extended to a 4th V, veracity. This suggests that users of 
big data must determine whether the dat a is accurate, representative and 
can be trusted. Earlier it was suggest ed that sites such as Wikipedia or 
Investopedia might be used as sources of information, for example, but 
these sites are openly edited and t heir accuracy cannot be taken for 
granted. 
 Likewise, the data can be distorted by data outliers. This is data that does 
not appear to fit in with other  data that has been gathered. 
 
 Data outliers 
 Data outliers are pieces of data that do not appear to fit in to the pattern of 
normal results. 
For example, consider the following data for website visitors over the last 
year (in thousands): 
 Jan Feb Mar Apr May Jun July Aug Sep Oct Nov Dec 
Visitors  140 150 145 150 140 65 145 150 140 150 150 140 
It can be seen that most months are within five thousand visitors of 
145,000. But June does not appear to follow this pattern. It is well below the normal results. June’s result is an outlier. 
Note: outliers are often more easily  spotted through the use of data 
graphs. For example, if the data a bove was represented as a scatter 
graph then the June results would very quickly stand out. If data outliers are included in data the results are skewed towards the 
outlier. In our example, if June’s re sult is ignored completely and we 
calculate the average number of monthly visitors to  the website we get an 
average of 145.5 which would give a very  fair representation of the data. 
But when June’s result is included in the average the average falls to 138.8 giving a very different impre ssion of the overall data. Analysis and 
interpretation of the data w ould likewise be very different. 
This is not to say that outliers should be ignored completely. The outliers themselves could contain valuable dat a. In our example, June’s result 
could indicate some seasonality, t he impact of negative press reports in 
the month of June, a webs ite failure in June etc. For that reason data 
outliers are often investigated separatel y from data that more readily fits 
into overall patterns.

Chapter 7 
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 Data outliers are more common in bi g data – due to its obvious size and 
variability. One way of coping with dat a outliers in big data is to use a 
trimming approach. For example, if  we wanted to examine the average 
time taken per page on visits to a par ticular page on our website we might 
‘trim’ the data by ignoring the longes t and shortest 5% of visitors. This 
would exclude people who have click ed on the page but left it open long 
after they have finished reading it as  well as excluding people who clicked 
on the page by accident. The remaining 90% of data would be used in the 
website analytics to give a more  useful piece of information. 
Care must therefore be taken when using big data to make decisions. 
6 Periodic vs rolling budgets 
Periodic budget 
A periodic budget shows the costs and re venue for one period of time, e.g. a 
year and is updated on a periodic basis, e.g. every 12 months. 
Rolling budgets (continuous budgets) A rolling budget is a ‘budget continuously updated by adding a further 
accounting period (month or quarter) when the earliest accounting period has 
expired’ (CIMA Official Terminolog y). Rolling budgets are also called 
‘continuous budgets’. Rolling budgets are fo r a fixed period, but this need not be 
a full financial year. 
Reasons for rolling budgets 
The reason for preparing rolling budgets is to deal with the problem of 
uncertainty in the budget, when greater ac curacy and reliability are required. A 
common example is cash budgeting . Cash management is often a critical 
element of financial managem ent in organisations, and it is essential to have 
reasonably reliable forecasts of cash flow s, especially over the course of the 
next few days, weeks or months. An  organisation might therefore produce 
rolling budgets (= revised forecasts) fo r cash flow. The cash budget period 
might be three or six months, an d rolling cash budgets might be prepared 
monthly. 
 
 Illustration 2 
 If rolling annual budgets are prepar ed quarterly, four rolling budgets will 
be prepared each year, each for a 12-m onth period. A new quarter is 
added at the end of the new budget peri od, to replace the current quarter 
just ending : 
 One budget might cover the peri od 1 January – 31 December Year 
1. 
 The next rolling budget will cover 1 April Year 1 to 31 March Year 2. 
 The next rolling budget will cover 1 July Year 1 to 30 June Year 2. 
 The next quarterly rolling budget will cover 1 October Year 1 to 
30 September Year 2, and so on.

262  
 Reasons for rolling budgets  
 The reason for preparing rolling budget s is to deal with the problem of 
uncertainty in the budget, when greater accuracy and reliability are 
required. A common example is cash budgeting . Cash management is 
often a critical element of financial management in organisations, and it is 
essential to have reasonably reliable fo recasts of cash flows, especially 
over the course of the next few da ys, weeks or months. An organisation 
might therefore produce rolling budgets (= revised foreca sts) for cash 
flow. The cash budget period might be three or six months, and rolling 
cash budgets might be  prepared monthly. 
Another example is budgeting in condi tions subject to rapid financial 
change. When a budget is prepared, t he forecasts on which it is based 
might be uncertain due to the probabi lity of significant financial changes 
during the budget period. For example: 
 The forecast rate of cost infl ation/price inflation might be high 
 The business might be affected by changes in an exchange rate, 
such as the sterling/US dollar ra te and the exchange rate might be 
extremely volatile and subject to large movements within relatively 
short periods of time 
 When there is a large amount of uncertainty in the budget, it might 
be appropriate to prepare rolling budget s at regular intervals, in 
order to have plans that are reasonably realistic and achievable. 
Advantages and disadvantages of rolling budgets 
 They reduce uncertainty in 
budgeting.  Preparing new budgets regularly 
is time-consuming. 
 They can be used for cash 
management.  It can be difficult to communicate 
frequent budget changes. 
 They force managers to look 
ahead continuously.  
 When conditions are subject to 
change, comparing actual results 
with a rolling budget is more realistic than comparing actual results with a fixed annual budget.

Chapter 7 
 263 
 For years, senior managers at  REL Consultancy Group handled 
budgeting and revenue forecasting much  the way most other companies 
do. As year-end approached, they woul d evaluate performance, set sales 
targets for the upcoming year and then work to see that everyone met or 
exceeded the goals. 
Unfortunately, the process didn’t alwa ys produce the intended results. 
‘Invariably,’ recalls Stephan Payne, president of the London-based global 
management consulting firm, ‘one of the account directors would land a 
couple of good clients early in the y ear and make his annual budget well 
before the year closed. More  often than not, he’d then  take his foot off the 
gas and coast.’ To make the budgeting pr ocess more timely and relevant, 
the firm embraced a more complex, al beit intuitive, approach to financial 
forecasting – the rolling budget.  Rather than creating an annual financial 
forecast that remains static fo r the year, he and his colleagues now 
produce an 18-month budget  and then update projections every month –
in effect, recalculating the whole budget. As the fi rm’s actual sales figures 
come in each month, directors plug t hem into their forecasting model in 
place of what they had projected, then roll the budget forward one more 
month. 
No more free rides 
The result: an always-current financial forecast that reflects not only the 
company’s most recent monthly result s but also any material changes to 
its business outlook or the economy.  In addition, it provides fewer 
opportunities for account directors to ride the coattails of past 
‘Now, even the guy who booked a million dollars’ worth of business in 
one month can’t sit still because 30 days later, we’re going to have an 
entirely new forecast,’ Payne says, adding, ‘It’s a dynamic process that 
makes a lot more sense.’ 
Although traditional 1-year budgets ar e still the norm at most companies 
large and small, many accountants ar gue that rolling budgets can be a far 
more useful tool. Unlike static budgets, they encourage managers to 
react more quickly to changing ec onomic developments or business 
conditions. They discourage what is t oo often a fruitless focus on the past 
(‘Why didn’t we meet our numbers?’) in favour of a realistic focus on the 
future. And they produce forecasts t hat, over the near term, are never 
more than a few months old, even when companies are rolling them 
forward on a quarterly basis – the mo re common approach – rather than 
REL’s monthly basis.

264  
 ‘A static budget simply doesn’t reflect the pace of business today,’ says 
Jill Langerman, CPA, president and CFO of the accounting firm Fair, 
Anderson & Langerman in Las Vegas. ‘If at mid-year you add a new 
product to your line-up, you want to calculate the costs and profit margins 
associated with that and re flected those calculations in your budget OSC 
to reflect the impac t that it will have on your remaining product lines. That 
way, you can set an accurate performance target and make informed 
decisions about whether you’re now fr ee to invest more in the remaining 
product lines or perhaps add a new line. If you’re not incorporating these 
new analyses into your budget, it bec omes a rather useless document.’ 
Implementing rolling budgets doesn’t  necessarily require any 
fundamental change in the way a company has been doing its budgets – except, of course, it no  longer does the job just  once a year. However, 
companies that decide to step up to  rolling budgets may want to take 
advantage of the decision to make a c hange and consider what else they 
can do to improve the process. After all, if a company can get everyone 
on board to make such a fundamental  change, a further nudge to make 
the process more effective and effici ent in other ways may be possible, 
too. 
Taken from: 
‘Budgets on a roll: recalculating a business’s outlook several times 
a year’ 
Randy Myers, Journal of Acc ountancy, December 2001. © 2001. 
Reprinted with permission of AICPA 
7 Alternative approaches to budgeting 
There are many different starting positi ons in the creation of budgets. In this 
section we look at three different ways in which the budgeting process might 
begin. 
Incremental budgeting 
 The traditional approach to budgeting is to take the previous year's budget 
and to add on a percentage to allow for inflation and other cost increases. In addition there may be other adjustment s for specific items such as an 
extra worker or extra machine.

Chapter 7 
 265 
  Fairly small changes are made to the current year’s budget. For 
example, adjustments might be made to allow for a planned 
increase or decline in sales volume, and for inflationary increases in 
sales prices and costs. 
 A check is then made to ensure t hat the budget produced in this 
way meets the performance tar gets of the organisation. For 
example, the company might have a target of keeping the operating 
costs to sales ratio at less than, say, 60%. 
In a static business environment, in cremental budgets are little more than 
‘last year’s budget plus a percentage amount for inflation’. 
Advantages and disadvantages of incremental budgeting 
 simple  backward looking 
 cheap  builds on previous inefficiencies 
 suitable in stable environments  doesn't remove 
waste/inefficiencies 
 most practical  unsuited to changing 
environments 
  targets are too easy 
  activities are not justified 
  encourages over-spending 
 
 The advantage of incremental budgeti ng is that it is an easy, quick and 
cheap method of preparing budgets for what may be many cost centres 
in a large organisation. However, t he traditional approach has severe 
disadvantages. 
(1) It is a simple, lo w-cost budgeting system. 
(2) If the business is fairly stabl e, the budgets produced by this method 
might be sufficient for management needs. 
(3) There are some items of co st where an incremental budgeting 
approach is probably the most practi cal. For example, the easiest 
way of budgeting telephone expenses fo r the next year might be to 
base the planned cost on the previous year’s budget (or possibly 
actual costs in the current year).

266  
(1) The main disadvantage is that it assumes that all current activities 
should be continued at the current level of operations and with the 
same allocation of resources. 
(2) It is backward-looking in nature, since next year’s budget is based 
on what has happened in the past. In a dynamic and rapidly-
changing business environment, th is approach to planning is 
inappropriate. 
(3) It is often seen as a desk-bound planning process, driven by the 
accounts department. 
(4) The performance targets in t he budget are often unchallenging, 
based on past performance. In cremental budgeting does not 
encourage managers to look for ways of improving the business. 
(5) When there are excessive costs in the budget for the current year, 
these will be continued in the future . Incremental budgeting is not a 
planning system for cutting out waste and overspending. 
(6) Consideration will not be given to the justification for each activity. 
They will be undertaken merely because they were undertaken the previous year. 
(7) Different ways of achieving t he objective will not be examined. 
(8) Past inefficiencie s will be continued. 
(9) Managers know that if they fail to  spend their budget, it is likely to be 
reduced next period. They theref ore try to spend the whole budget, 
regardless of whether or not the expenditure is justified 
ZBB is one method which may be used to overcome these problems. 
Zero-based budgeting 
 ZBB may be defined as: 
 
'A method of budgeting whereby all activi ties are re-evaluated each time a 
budget is formulated. Each functional bud get starts with the assumptions that 
the function does not exist, and is at zero cost. Increments of costs are 
compared with increments of  benefits, culminating in the planned maximum 
benefit for a given budgeted cost.' Zero-based budgeting (ZBB) is  a radical alternative to  incremental budgeting. In 
ZBB, all activities and costs are budgeted from scratch (a zero base). For every 
activity, managers look at its costs and its purpose, and consider whether there 
are alternative ways of doing it. Inessent ial activities and costs are identified 
and eliminated, by removing t hem from next year’s budget.

Chapter 7 
 267 
 ZBB in practice 
 Implementing ZBB 
All activities are subjected to t he most basic scrutiny, and answers 
sought to such fundamental question as: 
(a) Should the activity be undertaken at all? (b) If the company undertakes the ac tivity, how much should be done 
and how well should it be done (e.g. should an economy or a deluxe 
service level be provided)? 
(c) How should the activity be per formed – in-house or subcontracted? 
(d) How much would the various al ternative levels of service and 
provision cost? 
In order to answer these questi ons, all existing and potential 
organisational activities must be de scribed and evaluated in a series of 
‘decision packages’, giving the following four-step process to a ZBB exercise: 
(1) Determine the activities that are to be used as the object of decision 
packages – the provision of home support for the elderly or 
provision of catering facilities for the workforce, for example – and 
identify the manager responsible for each activity. 
(2) Request the managers identified in  (1) above to prepare a number 
of alternative decision packages for those individual activities for 
which they are responsible. (At least three packages are normally requested: one that sets out what  could be delivered with funding 
maintained at the current level;  one for a reduced level of funding, 
e.g. 80% of the current leve l; and one for an enhanced level of 
funding, e.g. 120% of the current level.) 
(3) Rank the decision packages in or der of their contribution towards 
the organisation’s objectives. 
(4) Fund the decision packages accord ing to the ranking established 
under (3) above until the avai lable funds are exhausted. 
Adoption of ZBB 
ZBB has been adopted more widely in t he public sector than the private, 
although examples of organisation s regularly adopting a full ZBB 
approach are rare. Full-scale ZBB is so  resource-intensive that critics 
claim that its advantages are outweig hed by its implementation costs. 
However, it is not necessary to  apply ZBB to the whole of an 
organisation; benefits can be gained from it s application to specific areas. 
For example, in the public sector, a decision could be made regarding the 
overall size of the ch ildcare budget, and ZBB could be applied to allocate 
resources within that particular field; similarly, in a business organisation, 
ZBB could be applied to individual di visions on a rotational basis. This 
selective application ensures that a thorough reappraisal of activities is 
undertaken regularly, but not so regularly that the process itself is a major 
drain on organisational resources.

268  
 Notwithstanding the criticisms, the ma in plank of the ZBB approach – the 
rejection of past budgets as a planning baseline – is being increasingly 
accepted. 
 
 A company is conducting a ZBB exercise, and a decision package is 
being prepared for its mate rials handling operations. 
 The manager responsible has id entified a base package for the 
minimum resources needed to per form the materials handling 
function. This is to have a team of five workers and a supervisor, 
operating without any labour-savi ng machinery. The estimated 
annual cost of wages and salaries, with overtime, would be $375,000. 
 In addition to the base package, the manager has identified an 
incremental package. The company could lease two fork lift trucks at a cost of $20,000 each year. This would provide a better system because materials could be stacked higher and moved more quickly. Health and safety risks fo r the workers would be reduced, 
and there would be savings of $5,000 each year in overtime payments. 
 Another incremental package has been prepared, in which the 
company introduces new computer software to plan materials handling schedules. The cost of buying and implementing the 
system would be $60,000, but the benefits are expected to be improvements in efficiency that  reduce production downtime and 
result in savings of $10,000 each year in overtime payments. 
The base package would be considered essential, and so given a high priority. The two incremental pack ages should be evaluated and ranked. 
Here, the fork lift trucks option might be ranked more highly than the computer software. 
In the budget that is eventually deci ded by senior management, the fork 
lift truck package might be approved, but the computer software package 
rejected on the grounds that  there are other dem ands for resources with 
a higher priority.

Chapter 7 
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Advantages and disadvantages of ZBB 
 creates an environment that 
accepts change  time-consuming 
 better focus on goals  expensive 
 forward looking  encourages short-termism 
 improves resource utilisation  management may lose focus on the 
true cost drivers 
 better performance measures  managers require new budgeting 
skills 
 focuses managers to examine 
activities  can result in arbitrary decisions 
 
 It helps to create an organisati onal environment where change is 
accepted. 
 It helps management to focus on company objectives and goals. It 
moves budgeting away from numbe r-crunching, towards analysis 
and decision-making. 
 It focuses on the future rather than on the past. 
 It helps to identify inefficient operations and wasteful spending, 
which can be eliminated. 
 Establishing priorities for activi ties provides a framework for the 
optimum utilisation of resources. Th is assists decision-makers when 
some expenditures are discretionary. 
 It establishes a measure of per formance for each decision package. 
This measure can be used to monitor actual performance and 
compare actual with budget. 
 It involves managers in the budgeti ng process. Unlike incremental 
budgeting, it is not a desk-bound exercise driven by the accounting 
department. Preparation of the de cision packages will normally 
require the involvement of many employees, and thus provides an opportunity for their view to be c onsidered. This involvement may 
produce useful ideas, and promote job satisfaction among the wider 
staff.

270  
 It is a time-consuming exercise. It is unlikely that an organisation will 
have the time to carry out a ZBB exercise every year. 
 There is a temptation to concentra te on short-term cost savings at 
the expense of longer-term benefits. 
 It might not be useful for budgetin g for production activities or 
service provision, where costs and efficiency levels should be well-
controlled, so that budgets can be prepared from forecasts of 
activity volume and unit costs. 
 In applying ZBB, ‘activities’ may continue to be identified with 
traditional functional departments, rather than cross-functional 
activities, and thus distract the attention of management from the 
real cost-reduction issues. For exampl e, it could be argued that the 
costs incurred in a warranty department  are largely a function of the 
reliability of products, which itse lf is a function of actions and 
decisions taken elsewhere. If t he warranty department is treated as 
an activity under ZBB, the focus of the decision packages is likely to 
be on providing the same level of customer service at reduced cost, or enhancing the level of customer service for the same cost. The main driver behind the department’s cost – product reliability – may remain unaddressed in ZBB, as it is with the blanket cut approach. 
 It might require skills from m anagement that the management team 
does not possess. 
 The ranking process can be difficul t, since widely-differing activities 
cannot be compared on quantitative m easures alone. For example, 
it might be difficult to rank pr oposals for spending on better service 
quality, improvements in safety in the work place or more spending 
on new product development. 
Activity-based budgeting 
 Introduction  
 In a manufacturing business, budgeti ng for direct costs is relatively 
straightforward. The costs of dire ct materials and direct labour are 
assumed to vary with production, and once production levels have been estimated, budgeting the dire ct costs of production is a matter of simple 
arithmetic. 
Budgeting for overhead costs is not so simple. Traditionally, there has 
been a tendency to take an increment al approach in budgeting for 
overhead costs, and prepare next year's budget by simply adding a percentage to the current year budget, to allow for inflation. Zero-based 
budgeting is one method of bringing great er discipline to the process of 
budgeting for overhead activities and cost s. Another method is activity-
based budgeting.

Chapter 7 
 271 
 As its name should suggest, activity-based budgeting (ABB) takes a 
similar approach to activity-based cost ing. ABB is defined as: 'a method of 
budgeting based on an activity framework and utilising cost driver data in 
the budget-setting and variance feedback processes' (CIMA Official Terminology). 
Whereas ZBB is based on budgets (decision packages) prepared by responsibility centre managers, ABB is based on budgeting for activities. 
In its simplest form, ABB is simply about using costs determined via ABC to 
prepare budgets for each activity. The basic approach of ABB is to budget the costs for each cost pool or activity as follows: 
(1) The cost driver for each activity is  identified. A forecast is made of the 
number of units of the cost driver that will occur in the budget period. 
(2) Given the estimate of the activity leve l for the cost driver, the activity cost 
is estimated. Where appropriate, a cost  per unit of activity, known as the 
cost driver rate , is calculated. 
(There will also be some general overhead co sts that are not activity-related, 
such as factory rental costs and the salary  cost of the factor y manager. General 
overhead costs are budgeted separately.)  
 Consider the following example: 
Septran operates two rail services. T he Northern line operated for 20,000 
hours last year. It had 200 full time st aff. The Southern line operated for 
39,000 hours last year. It had 300 full ti me staff. Eight train staff are 
needed for each journey on both lines. The total overhead for indirect 
wages was $39m. 
Next year the government want to promote greater use of train services 
in the north of the country. Septran ex pect this to result in approximately 
10,000 more journey hours for the Nort hern line. Because of transfers 
between services and other knock on effects, this is also likely to result in 
an extra 5,000 journey hours for the Southern line. 
The company want to use an ABB approach to budget for the indirect 
wages cost next year. 
Step 1 
Firstly, the company need to determine how costs should be allocated to 
each service (each service effectively becomes a 'cost pool'). This might 
be the number of journe ys or the number of full time employees. For 
indirect wages Septran believe that the number of full time staff would be 
the most appropriate way to alloca te costs to each cost pool.

272  
 Step 2 
The total overheads are then allocated to each cost pool on this basis. 
 Northern line Southern line Total 
 $m $m $m 
Indirect wage cost – split 
200:300 15.6 23.4 39.0 
Step 3 
The company then need to determine the cost driver. Semptrap believe 
that the cost is driven by the num ber of journey hour s in operation. 
 Northern line Southern line 
Indirect wage cost – sp lit 20:30 $15.6m $23.4m 
Number of journey hours  20,000 39,000 
Cost driver rate $780 per 
journey hour $600 per 
journey hour 
Step 4 These established cost drivers will then be used to prepare the budget for 
next year: 
Cost driver rate $780 per journey 
hour $600 per journey 
hour 
Budgeted level of activity 30,000 hours 44,000 hours 
Budgeted indirect wage 
cost $23.4m $26.4m 
The total budgeted indirect wage co st for next year will be $49.8m. 
Advantages and disadvantages of ABB 
 useful when overheads are significant  expensive to implement 
 better cost control  only suited to ABC users 
 management  
 useful for TQM environments

Chapter 7 
 273 
 The advantages of ABB are similar to  those provided by activity-based 
costing. 
 It draws attention to the costs of ‘overhead activities’. This can be 
important where over head costs are a large proportion of total 
operating costs. 
 It provides information for the contro l of activity costs, by assuming 
that they are variable, at least in the longer term. 
 It provides a useful basis for monitoring and controlling overhead 
costs, by drawing management att ention to the actual costs of 
activities and comparing actual co sts with what the activities were 
expected to cost. 
 It also provides useful contro l information by emphasising that 
activity costs might be controllabl e if the activity volume can be 
controlled. 
 ABB can provide useful information for a total quality management 
(TQM) programme, by relating the cost  of an activity to the level of 
service provided (for example, stor es requisitions processed) – Do 
the user departments feel they ar e getting a cost-effective service? 
The system however does have some disadvantages:  It is an expensive system to implement. New information systems 
are required and managers need to  be trained in its use. 
 It will also rely on the use of activity based costing (ABC) as the 
standard costing system. 
 
 8 Beyond budgeting  
Beyond budgeting is an approach to budget ing that tries to resolve the 
weaknesses and limitations of traditi onal approaches to budgeting explored 
earlier in this chapter. In particular, many organisations complain that budgets 
do not fully prepare an organisation for pot ential changes in its environment and 
are too often based on assumptions that  things won’t change and that last 
year’s assumptions will continue to be valid. 
 Beyond budgeting is: ‘An idea that companies need to move beyond 
budgeting because of the inherent fl aws in budgeting especially when 
used to set contracts. It is argued t hat a range of techniques, such as 
rolling forecasts and market related targets, can take the place of 
traditional budgeting.’ CIMA Official Terminology

274  
Beyond budgeting approaches are commonl y used in organisations that face 
regular environmental changes or where c ontinuous improvement is critical to 
the organisation’s success. There are some common features of ‘beyond 
budgeting’ systems such as: 
 The use of rolling budgets, produced on a quarterly or monthly basis, as 
an alternative to annual budgeting. These are flexible, do not rely on 
obsolete figures and should result in more  timely allocation of resources. It 
also means that budgets are quickly adjusted for changes in the 
organisation’s environment. 
 A wider range of performance measures  are assessed such as customer 
satisfaction, production times, i nnovation, staff utilisation etc. 
 Targets are often set based on ‘benc hmarks’ observed externally. For 
example, if Amazon can offer guar anteed next day delivery on products 
then this may become the benchm ark for an organisation’s own 
distribution department.  
 There is a greater focus on determi ning and explaining what might happen 
in the future (for example, how might  product design be changed to reduce 
material usage) rather than on what has happened in the past (for example, examining why a materi al usage variance has occurred). 
 Innovation is encouraged and rewarded. 
 Budgets are set at a local level ra ther than being prep ared centrally based 
on organisational goals and then having these provided to local managers 
who might actually understand the local environment better. 
Advantages and disadvantages of beyond budgeting 
 planning is continuous and the 
organisation is more likely to be 
proactive rather than reactive to 
changes in its environment  planning, coordination and 
performance evaluation become 
more complicated. This has the added impact that reward systems 
also become more complex 
 targets become more 
challenging and more market 
focused. They stretch staff and encourage staff to find better ways to do things. They also make the organisation more 
customer focused.  if benchmarks and targets are 
seen as being unachievable then 
effort to achieve them is reduced 
rather than improved 
 the organisation becomes more 
innovative and continuously improves  organisational goals are less clear 
and are not communicated 
throughout the organisation. This means that many key stakeholders such as providers of finance and shareholders lose out as the organisation focuses more 
on customers and innovation

Chapter 7 
 275 
 managers are more involved in 
the decision making process 
which provides better 
information for decisions as well 
as providing better motivation 
for managers  organisations who move to a 
beyond budgeting structure can 
often face a lot of resistance from 
staff and managers where 
traditional budgets may be very deeply ingrained in the organisation’s culture. Is staff fail to fully embrace the new systems and targets then the system is set 
to fail. 
 managers can take decisions 
much more quickly  it may be very difficult or 
impractical for organisations to 
adopt the culture of decentralisation on which 
successful BB depends 
 it creates information systems 
which provide fast and open 
information throughout the 
organisation.  the need for more up-to-date and 
accurate information requires costly investment

Chapter 7 
 277 
10 Practice questions 
 Hopper manufactures two products, X and Y. Budgeted information for 
the next financial year is as follows 
 Product X Product Y 
Budgeted sales 4,000 6,000 
Budgeted closing in ventory 500 300 
Opening inventory 200 400    Direct materials requirements Kg per unit Kg per unit 
Material DM1 1.2 2.0 
Material DM2 0.8 – 
    Material DM1 Material DM2 
 Kg Kg Budgeted closing in ventory 1,000 200 
Opening inventory 3,000 600 
Standard price per kg $0.80 $0.50 
Required: 
In the boxes below, enter the pur chase quantities and cost for both 
materials from a materials purchases budget for the year. 
 Material DM1 Material DM2 
Budgeted purchase quantities (kgs)   
Budgeted cost of purchases ($)

278  
 Scenario 
SRW makes two similar products, the Alpha and Beta, and operates a 
five-day week for both production and sa les. Both products use the same 
material and labour, but Beta requires  more labour and materials than the 
Alpha. The company divides its year into five-week periods for budgetary 
purposes. One of your responsibilitie s is to prepare budgets for the Alpha 
and the Beta. 
You are given the following information to help you prepare the 
production and resource budgets for period 8. 
Forecast sales volumes (units) Days in period Alpha Beta 
Period 8 25 8,460 9,025 Period 9 25 10,575 12,635 
Finished inventories 
 Level There will be 1,692 Alphas and 3,610 Betas in finished 
inventory at the beginning of Period 8. 
 Level The closing inventory of both Alphas and Betas depends on 
the forecast sales in period 9. 
 Level Period 8‘s closing inventory of Alphas must equal 5 days 
sales of Alphas in period 9. 
 Level Period 8‘s closing inv entory of Betas must equal 10 days 
sales of Betas in period 9. 
 Level The first-in-first-out inv entory valuation method is used to 
value closing inventory. 
Production and failure rates 
 Level 10% of Alpha finished prod uction and 5% of Beta finished 
production is faulty and has to be destroyed. This faulty production 
has no value. 
 Level The faulty production aris es from the production technology 
and is only discovered on completion.  The cost of faulty production 
is part of the cost produci ng fault-free Alphas and Betas. 
Materials 
 Each Alpha produced requires 20 kg  of materials and each Beta 
produced requires 40 kg of materials. 
 The opening inventory of material s at the beginning of period 8 is 
64,800 kg. 
 The closing inventory of materi als at the end of period 8 must be 
52,600 kg. 
 The material costs 50c per kilogram.

Chapter 7 
 279 
 Labour 
 Each Alpha produced requires two labour hours and each Beta 
produced requires three labour hours. 
 SRW employs 300 production staff who work 35 hours per five-day 
week. 
 The hourly rate per employee is $10 and if any overtime is required 
the overtime premium is $3 per employee per hour of overtime. 
 Any overtime premium is charg ed to factory overheads and not to 
the cost of production. 
Factory overheads 
 Budgeted overheads are charged to production on the basis of 
labour hours. 
 For Alpha, the budgeted factory ov erheads are $62 per labour hour. 
For Beta, they are $58 per labour hour. 
Tasks: 
(a) Prepare the following information for Period 8: 
(i) Production budgets for Alpha and Beta 
(ii) Material purchases  budget in kilograms and $ 
(iii) Budgeted labour hours to be wo rked, including any overtime 
hours 
(iv) Labour cost budget (v) Total (full) cost of production budget for Alpha and Beta (vi) Full cost of GOOD production per unit for Alpha and Beta 
(Time allowed for pa rt a: 30 minutes) 
The Sales Director has just informed you that the Alpha sales in period 8 
will be 2,000 units more than origi nally forecast. You are told the 
 SRW production employees can wo rk up to a maximum of 5,000 
overtime hours in any five-week period. 
 The material used in Alpha and Beta production can only be made 
by one company and SRW is the only user of the material. Currently 
there is a shortage of the material and the maximum additional 
material that can be obtained is 34,000 kg. 
 The demand for Beta in period 8 will remain at 9,025 units.

280  
 (b) 
(i) Prepare calculations to show whether it is the material or 
labour hours that limits the extr a production of Alpha in period 
8. 
(ii) Prepare a revised production budget in units for Alphas in 
period 8. 
(iii) Calculate the shortfall in the planned extra sales of Alpha 
caused by the limit in extra production. 
(iv) Suggest three ways how this shortfall may be overcome. 
(Time allowed for pa rt b: 30 minutes) 
 
 Twenty per cent of a company’s sale s are made to cash customers. The 
records show that the credit custom ers settle their bills as follows: 
Paid in the month fo llowing the sale 60% 
Paid two months after the sale 38% 
Bad debts 2% Credit customers paying in the mont h following the sale receive a 3% 
discount. Budgeted sales for the forthcoming period are as follows: 
January February March 
$20,400 $29,500 $26,800 
Required: 
Calculate the amount to be shown as receipts from sales in the cash 
budget for March. 
 
production units  
January (budget) 55,000 February (budget) 60,000 
March (budget) 65,000 
110,000 units at the end of January and 120,000 units  at the end of 
February. The business takes one m onth’s credit from its suppliers.

Chapter 7 
 281 
 Required: 
In the following boxes, enter the forecast paym ents to suppliers each 
month, for raw material purchases. 
 $ $ $ 
Payment to suppliers    
 
 A company operates on a single conti nent which is divided into a number 
of individual states, each with thei r own government. Each state shares 
the same single currency. The com pany wants to set budgets for each 
business unit in each state from a central head office. 
Which TWO of the followi ng statements are most likely to be true: 
A  Budgeting will be made easier by t he presence of a single currency 
B Budgeting will be made easier as one single language will be used 
across the continent 
C Budgeting will be more complex if t he currency constantly fluctuates 
D Budgeting will be made more complex if  strategic rivals are different 
in each individual state  
 
 Scenario 
A company makes and sells two products, X and Y, for which the 
budgeted sales price and vari able costs per unit are: 
Variable cost $2 $4 Sales price $5 $8 
Budgeted fixed costs are $140,000. Budget ed sales are 30,000 units of 
Product X and 15,000 units of Product Y. 
Tasks 
(a) Calculate the budgeted profit. 
(b) Calculate how profit would be affected in each of the following 
separate circumstances: 
(i) if the variable cost of Pr oduct Y were 25% higher than 
expected 
(ii) if sales of Product X were 10% less than budgeted 
(iii) if sales of Product X we re 5% less than budgeted and unit 
variable costs of X were 10% higher than budgeted 
(iv) if total sales revenue is the sa me as in the original budget, but 
the sales mix (by revenue) is 50% of Product X and 50% of 
Product Y. 

282  
 Which of the following statements re garding the use of big data is 
most likely to be true? 
A Big data can be cheap to acquire B The veracity of big data is easy to confirm C Using big data makes stress testing budgets less useful 
D Big data stays the same for a long period  
 
 An importer has produced the fo llowing budget for next month: 
 $000 Sales 64,000 
Material costs (28,000) Labour costs (12,000) 
Overhead costs (18,000) 
 –––––– Gross profit 6,000  –––––– 
The importer wants to stress test the budget for a potential change in 
currency rates on the products that it imports. A currency change would 
increase material costs by 10%, only half of which could be passed on to 
the importers powerful customers. 
The revised gross profit fo r the month would be $_______  
 
 Scenario 
For a number of years, the research  division of Z has produced its annual 
budget (for new and continuing proj ects) using incremental budgeting 
techniques. The company is now under new management and the annual 
budget for 20X4 is to be prepared using zero based budgeting techniques. 
Tasks: 
(a) Explain the differences between incremental and zero based 
budgeting techniques. 
(b) Explain how Z could operate a zero based budgeting system for its 
research projects.

Chapter 7 
 283 
 The operating divisions of Z have in the past always used a traditional 
approach to analysing costs into thei r fixed and variable components. A 
single measure of activity was used wh ich, for simplicity, was the number 
of units produced. The new management  does not accept that such a 
simplistic approach is appropria te for budgeting in the modern 
environment and has requested that the managers adopt an activity-
based approach to their budgets for 20X4. 
Tasks: 
(c) (i) Briefly explain activity-based budgeting (ABB). 
(ii) Explain how activity-bas ed budgeting would be implemented 
by the operating divisions of Z. 
(Time allowed: 40 minutes) 
 
 AW Inc produces two products, A and C. In the last year (20X4) it 
produced 640 units of A and 350 units of  C incurring costs of $672,000. 
Analysis of the costs has shown that 75% of the total costs are variable. 
60% of these variable costs vary in  line with the number of A produced 
and the remainder with the number of C. 
The budget for the year 20X5 is now bei ng prepared using an incremental 
budgeting approach. The following additional information is available for 
20X5: 
 All costs will be 4% higher t han the average paid in 20X4. 
 Efficiency levels will remain unchanged. 
 Expected output of A is 750 units and of C is 340 units. 
Required: 
Calculate the budgeted total variable co st of products A and C for the full 
year 20X5? 
 (Time allowed: 10 minutes) 
 
 Identify which of the following budgets  is likely to be the most time 
consuming to construct and manage? 
A A periodic budget based on increm ental budgeting principles 
B A periodic budget based on ZBB principles 
C A rolling budget based on incr emental budgeting principles 
D A rolling budget based on ZBB principles

284  
 Identify which of the following st atements is correct regarding the 
benefits to be gained from using ABB? 
A If there is much inefficiency withi n the operations of a business then 
ABB will identify and remove these areas of inefficiency 
B In a highly direct labour int ensive manufacturing process, an ABB 
approach will assist management in budge ting for the majority of the 
production costs 
C In an organisation currently operat ing efficiently, where the next 
period will be relatively unchanged from the current  one, then ABB 
will make the budgeting process simpler and quicker 
D If an organisation produces many different types of output using 
different combinations of acti vities then ABB can provide more 
meaningful information for budgetary control 
 
 Branch makes and sells two products, P and Q. The following budget has 
been prepared: 
 Product P Product Q 
Sales price per unit $3 $6 
Variable cost per unit $2 $3 
Budgeted fixed costs are $140,000. B udgeted sales are 20,000 units of 
Product P and 50,000 units of Product Q. 
Tasks: 
(b) Calculate by how much the prof it would be reduced if the variable 
cost of Product P were 15% higher than budgeted and the variable 
cost of Product Q were 10% higher than budgeted. 
(c) Calculate by how much the prof it would be reduced or increased if 
total sales revenue is the same as in the original budget, but the 
sales mix (by revenue) is one-thir d Product P and two-thirds Product 
Q. 

Chapter 7 
 285 
 Example 1 
 (a) Production budget  
 units units units 
Sales 3,000 4,500 3,000 + Closing inventory 200 300 300 
 3,200 4,800 3,300 – Opening inventory (500) (700) (500)  ––––– ––––– ––––– 
Production quantity 2,700 4,100 2,800 
(b)  Material usage budget  
 Material 
M1 Material 
M2 Material 
M3 
 kg kg kg Production requirement    
2,700 Product 1 5,400 8,100 16,200 
4,100 Product 2 12,300 12,300 8,200 
2,800 Product 3 11,200 11,200 11,200 
Usage quantity 28,900 31,600 35,600 
(c) Material purchases budget  
 Material 
M3 
 kg kg kg 
+ Closing inventory 2,200 1,300 2,000 
– Opening inventory 4,300 3,700 4,400 
Purchase quantity 26, 800 29,200 33,200 
 × $1.21 × $3.30 × $2.75 
Total purchases $32,428 $96,360 $91,300  ––––– ––––– –––––

286  
 (d) Labour budget   
 Skilled Semi-
skilled 
 hrs hrs 
Production requirement   
2,700 Product 1 8,100 8,100 
4,100 Product 2 4,100 12,300 
2,800 Product 3 8,400 11,200 
Usage quantity 20,600 31,600 
 × $6/hr × $4/hr   ––––– ––––– Total labour cost $123,600 $126,400 
 
 Example 2 
  
 Example 3 
 Interpretation of the cash budget 
The company will be overdrawn th roughout the three-month period, 
therefore it is essentia l that it should have access to borrowings to cover 
the shortfall. The bank might already  have agreed an overdraft facility, 
but this should be at least $16,650 and ideally higher, to allow for the 
possibility that the actual cash flows will be even worse than budgeted. 
The business may decide to delay the purchase of the c apital equipment 
for one month in order to allow the cash position to move to a positive 
one before the investment is made. Al ternatively, an extension of the 
overdraft facilities may be arr anged for the appropriate period. 
If it is decided that overdraft facilitie s are to be arranged, it is important 
that due account is taken of the timing of the receipts and payments within each month.

Chapter 7 
 287 
 For example, all of the paym ents in January may be made at the 
end of the month. The ca sh deficit could then be considerably greater 
January could become as large as $5,000 (Opening balance) minus 
$66,000 (January payments) = $71,000 before the receip ts begin to arise. 
overdraft requirement during the per iod then they would not have 
budget, and not simply at the closing cash balances. 
 
 Example 4 
 A 
Revised budget 
 Original Adjustment Revised 
 $000  $000 
Revenue 480 Less: 25% × 480k = 120k 360 
Cost of sales 200 Less: 85% × 120k = 102k 98 Other operating costs 80  80 
 ––––  –––– 
Net profit 200  182  ––––  –––– 
Lost sales = 25% × 480k = 120k 
Reduction in profit: = 15% × 120k = 18k 
Revised profit = 200k – 18k = 182k

288  
 Materials purchases budget 
 Kg Kg 
To make 4,300 units of X 5,160 3,440 
To make 5,900 units of Y 11,800 0 
Required for production 16,960 3,440 Add: closing inventory 1,000 200 
Deduct: opening inventory (3,000) (600) 
 ––––– ––––– Budgeted purchase quant ities 14,960 3,040 
 ––––– ––––– Standard price per kg $0.80 $0.50 Budgeted cost of purc hases $11,968 $1,520 
 
 (a) (i) Production budget (Period 8)  
 Alpha Beta 
Sales budget 8,460 9,025 
Add: Closing inventory (W1) 2,115 5,054 Less: Opening inventory (1,692) (3,610) 
Good production 8,883 10,469  ––––––– ––––––– Wastage 987 551 
Total production 9,870 11,020  ––––––– ––––––– 
Working 1 – Closing inventory 
 Alpha   Beta 
5   10  
––– × 10,575 = 2,115 units  ––– × 12,635 = 5,054 units 
25   25

Chapter 7 
 289 
 (iv) Labour cost budget   
Direct labour cost 52,800 × $10 = $528,000 
Overtime premium (OH) 300 × $3 = $900 
(v) Full production cost  
 Alpha Beta 
 $ $ Direct material 98,700 220,400 
Direct labour 197,400 330,600 
Overhead: 19,740 hours × $62 1,223,880  
Overhead: 33,060 hours × $58  1,917,480 
 ––––––––– –––––––––  1,519,980 2,468,480 ÷ Good units ÷ 8,883 ÷ 10,469 
 ––––––––– ––––––––– 
Full cost per unit $171.11 $235.79  ––––––––– ––––––––– 
(b) (i) 
Increase in demand 2,000 units  ÷ 0.90  ––––––––– Therefore, increase in production 2,223 units 
 
Hours required 2,223 units × 20 kgs = 4,446 hours Overtime hours available (5,000 hours – 300 
hours) 4,700 hours 
Therefore, labour hours ar e not a scarce resource. 
Kilograms of material 
required 2,223 units × 20 kgs = 44,460 kgs 
Available  34,000 kgs 
Therefore, material is a scarce resource. 
(ii) 
 34,000 hours  
Allowable increase in 
production: –––––––––– 
20 = 1,700 units 
   
New production budget: 9, 870 + 1,700 = 11,570 units

290  
 (iii) 
New production budget:  = 11,570 units 
The extra production 
(new  production – existing production) 
 = 11,570 – 9,870 
 
= 1,700 units 
Good units produced: (1,700 × 90%) = 1,530 units 
Shortfall (when compared to 
the increase in demand of 2,000 units)  =  470 units 
(iv) 
 Reduce planned closing inventory levels 
 Improve wastage rate 
 Reduce production of Beta 
 
 $ 
March sales = 20% for cash ($26,800 × 0.2) 5,360.00 
February credit sales = 80% × 60% received less 3% 
discount ($29,500 × 0.6 × 0.97) 13,735.20 
January credit sales = 80% × 38% received ($20,400 × 0.38) 6,201.60 
 –––––––– 
 25,296.80  –––––––– 
 
 When inventories of raw materi als are increased, the quantities 
paid for in January, which is in the budget period.

Chapter 7 
 291 
 Quantity of raw material purchased in units: 
 Material (@ 2 units per widget) 
 Units of 
widgets 
December 50,000 100,000    January 55,000 110,000   
February 60,000  120,000  
March 65,000   130,000 Increase in 
inventories  10,000 10,000 – 
  –––––– –––––– –––––– –––––– 
Total purchase quantities 100, 000 120,000 130,000 130,000 
At $3 per unit 300,000  360,000 390,000 390,000 
business will take one month’s credit  
 $ $ $ 
Payment to suppliers  300,000 360,000 390,000 
purchased, which will be paid in April. 
 
 A and D 
A single currency will simplify the budget ing process n each individual 
state and avoid problems caused by fl uctuating exchange rates. As the 
company only operates in this one cont inent currency fluctuations will not 
cause major budgeting problems in t he short-term (removing option C as 
a possible correct answer. 
Budget setters should not assume that one single language is used 
across an entire continent and the presence of more than one language 
or dialect will complicate the budgeting process (ruling out option B). Having different strategic rivals in each state will change product pricing, 
design etc. and further comp licate the budgeting process.

292  
 The original budget and ‘what if’ budgets can be constructed quickly using 
a marginal costing approach 
 Product X Product Y Total 
 $ $ $ 
Budgeted sales 150,000  120,000 270,000 
Variable costs 60, 000 60,000 120,000 
 ––––––– ––––––– –––––––– 
Contribution 90,000  60,000 150,000 
 ––––––– –––––––  Fixed costs   140,000    –––––––– Budget profit   10,000    –––––––– 
(b) (i) 
 $ $ $ Budgeted sales 150,000  120,000 270,000 
Variable costs 60,000 (+25%) 75,000 135,000 
   –––––––– Contribution 90,000  45,000 135,000 
Fixed costs   140,000    –––––––– Budgeted profit   (5,000)    –––––––– 
(ii) 
  Product X Product Y Total 
  $ $ $ Budgeted sales (–10%) 135,000 120,000 255,000 Variable costs (–10%) 54,000 60,000 114,000 
    –––––––– Contribution  81,000  60,000 141,000 
Fixed costs   140,000    –––––––– Budgeted profit   1,000    –––––––– 
(iii) 
Sales units  28,500 15,000  
  $ $ $ Budgeted sales (at $5) 142,500 120,000 262,500 Variable costs (at $2.20)  62,700 60,000 122,700 
    ––––––– Contribution  78,800  60,000 139,800 
Fixed costs    140,000     ––––––– Budgeted loss    (200)     –––––––

Chapter 7 
 293 
 (iv) 
  Product X  Product Y Total 
Sales units (135,000/5) 27,000 (135,000/8) 16,875  
  $  $ $ 
Budgeted sales (50%) 135,000 (50%) 135,000 270,000 
Variable costs (at $2) 54,000 (at $4) 67,500 121,500      
––––––  
Contribution  81,000  67,500 148,500 Fixed costs     140,000 
     
––––––  
Budgeted profit    8,500 
    ––––––  
In practice, budget models are usually much more detailed and complex, 
but ‘what if’ analysis can be carried out simply and quickly. 
In the example above, the ‘what if’ scenarios show that  profit might be 
less than expected if actual resu lts are less favourable than the 
assumptions and forecasts in the budget. If any of these results are 
unacceptable, management would need to  consider alternative budget 
strategies for improving budgeted performance or reducing the risk. 
 
 A 
Some big data, such as information held on social media sites, is quickly, 
readily and cheaply available. For ex ample, the number of likes that a 
particular new product video has received on a service such as YouTube 
can be seen by almost anyone. 
But it is difficult to determine its vera city of data such as this (ruling out 
option B) and big data will be constant ly changing (ruling out option D). 
But if the data can be transformed in to useful information then it can 
improve the usefulness of  stress testing budgets by improving accuracy 
and considering wider impac ts (ruling out option C). 
 
 The revised profit for th e month would be $4,600 
 $  $ 
Sales 64,000 +(30,800 – 28,000) / 2 65,400 
Material costs (28,000) X 110% (30,800) 
Labour costs (12,000)  (12,000) Overhead costs (18,000)  (18,000)  –––––––  ––––––– Gross profit 6,000  4,600  –––––––  –––––––

294  
 (a) An incremental budget starts off with  last year’s budget or last year’s 
actual results and adds on a certain percentage to take account of 
expected inflation and/or any ex pected changes in the level of 
activity. It is a very simple, quick and cheap budget to produce, but it does not promote a questioning attitude. Activities are undertaken without thought. They are simply incorporated into the next budget 
because they were in the last budget and nobody has given any thought as to whether the activi ty is still really worthwhile. 
With ZBB, each manager sets out what he or she wishes to accomplish over the forthcoming peri od. For each activity they want 
to undertake, they look at different  ways of achieving the objective 
and they look at providing the se rvice at different levels. They 
estimate the costs and benefits and the activity only takes place if the benefits exceed the costs. Also once all the activities have been 
evaluated, they can be ranked against each other and the company’s resources direct ed to the best activities. 
(b) The managers/researchers res ponsible for each project should 
decide which projects they wish to undertake in the forthcoming 
period. These projects will be a mi xture of continued projects and 
new projects. For the projects wh ich have already been started and 
which the managers want to conti nue in the next period, we should 
ignore any cash flows already incurr ed (they are sunk costs), and we 
should only look at future costs and benefits. Similarly, for the new 
projects we should only look at  the future costs and benefits. 
Different ways of achieving the same research goals should also be investigated and the projects should only go ahead if the benefit 
exceeds the cost. 
Once all the potential projects have been evaluated if there are 
insufficient funds to undertake all the worthwhile projects, then the 
funds should be allocated to the best  projects on the basis of a cost-
benefit analysis. ZBB is usually of a highly subjec tive nature. (The costs are often 
reasonably certain, but usually a lot of  uncertainty is attached to the 
estimated benefits.) This will be ev en truer of a research division 
where the researchers may have thei r own pet projects which they 
are unable to view in an objective light.

Chapter 7 
 295 
 (c) (i) Activity based budgeting is where the budget is based upon a 
number of different levels of activity, i.e. on a number of 
different cost drivers, rather t han being based on just one level 
of activity such as machine hours or output in units. 
The activity based budget will be based upon the number of 
units of the cost driver multipli ed by the cost per  unit of cost 
driver. The cost driver is that factor which actually causes the 
cost and therefore should lead to  a more accurate budget as 
the budgeted cost will be based on the thing that should 
influence that cost. The alternativ e is to use absorption costing 
and assume that all overheads va ry with output or machine 
hours or labour hours or t hat they are fixed.  
(ii) Z may employ an outside spec ialist such as  a management 
consultant who will investi gate the business and determine 
what activities the business undertakes during the course of its operations. 
The consultant will discuss ma tters with the staff and the 
process will normally be time consuming. For each activity, 
efforts will be made to determine the factor which is most 
closely related to the co sts of that activity, i.e. the cost driver. 
The investigation may bring to  light non-value-added activities 
which can then be eliminated.  It should improve the 
understanding of all those involved as to the true relationship 
between cost and level of activity. 
Managers would then estimate th e expected incidence of their 
cost drivers and multiply by the budgeted cost driver rate to get 
the budget for the forthcomi ng period. ABB would be more 
complicated than a traditional budget and the overheads would 
be broken down into many activiti es such as set-up costs, 
materials, handling costs, etc rather than expenses such as 
rent, heating, depreciation, etc. With ABB the majority of the overhead costs would be 
perceived as variable rather than fixed. Of course it is not 
necessary to employ an outside consultant. The company may 
feel that they have their own managers with sufficient skills and 
time to undertake  the exercise.

296  
  
Total variable cost  Variable cost per unit 
20X4:  
Product A $672,000 × 75% × 60% = 
$302,000 $302,000 ÷ 640 units = $472.50 
Product C $672,000 × 75% × 40% = 
$201,600 $201,600 ÷ 350 units = $576 
20X5:  
Product A $472.50 × 1.04 × 750 
units = $368,550 n/a 
Product C $576 × 1.04 × 340 units = 
$203,674 n/a 
 
 D 
Rolling budgets are more time consuming to manage than periodic 
budgets as they must be update more r egularly. ZBB is a more expensive 
system to manage than incremental budgeting as every item must be 
fully justified and investigated before being included in the budget. 
 
 D 
Situation A would be best suited by implementing Zero Base Budgeting. 
Situation B does not require ABB since it has relatively low overheads. 
Situation C would be suitable fo r incremental budgeting. ABB will 
certainly not be quicker.

Chapter 7 
 297 
 Part (a) 
The budgeted profit is $30,000 
 Product P Product Q Total 
 $ $ $ 
Budgeted sales 60,000 300,000 360,000 Variable costs 40, 000 150,000 190,000 
   ––––––– Contribution 20,000  150,000 170,000 
Fixed costs   140,000    ––––––– Budgeted profit   30,000    ––––––– 
Part (b) 
The profit woul d fall by $21,000. 
 $ $ $ 
Budgeted sales 60,000 300,000 360,000 
Variable costs (+ 15%) 46, 000 (+10%) 165,000 211,000 
   –––––– Contribution 14,000 135,000 149,000 
Fixed costs   140,000    –––––– Revised profit   9,000 Original budgeted pr ofit   30,000 
   –––––– Reduction in profit   21,000    –––––– 
Part (c) 
The profit would fall by $10,000 
Sales units 40,000 40,000  
 $ $ $ Budgeted sales (at $3) 120,000 (at $6) 240,000 360,000 
Variable costs (at $2) 80, 000 (at $3) 120,000 200,000 
   –––––– Contribution 40,000  120,000 160,000 
Fixed costs   140,000    –––––– Revised profit   20,000 Original budgeted pr ofit   30,000 
   –––––– Reduction in profit   10,000    ––––––

299 
Forecasting techniques 
B2. Prepare budgets (a) Explain forecasting and its 
relationship with budgeting 
  Chapter 
8

300  
 
 Forecasts in budgeting 
 Budgets are based on forecasts. Forecasts might be prepared for: 
 the volume of output and sales 
 sales revenue (sales volume and sales prices) 
 costs. 
The purpose of forecasting in the budgeting process is to establish 
realistic assumptions for planning. Forecasts might also be prepared on a 
regular basis for the purpose of feedforward control reporting. 
A forecast might be based on simple assumptions, such as a prediction of a 5% growth in sales volume or  sales revenue. Similarly, budgeted 
expenditure might be fo recast using a simple incremental budgeting 
approach, and adding a perc entage amount for inflation on top of the 
previous year’s budget. 
On the other hand, forecasts might  be prepared using a number of 
forecasting models, methods or tec hniques. The reason for using these 
models and techniques is that they might provide more reliable forecasts. 
This chapter describes: 
 the high-low method 
 the uses of linear regression analysis 
 techniques of time series analysis 
These methods are based on data gat hered from the budgeting process 
(covered in an earlier chapter). As discussed in the earlier chapter this 
data can come from areas such as hi storic sales and cost data, economic 
data and market research. But there is a growing use of big data to 
support these other sources of da ta in spotting trends, identifying 
relationships between sets of data or  in forecasting which costs, for 
example, may change in terms of behaviour in the future.

Chapter 8 
 301 
 Forecasting can also be carried out using a diagram (known as a scatter 
diagram). The data is plotted on a graph. The y-axis represents the 
dependent variable, i.e. that vari able that depends on the other. The x-
axis shows the independent variable, i.e. that variable which is not 
affected by the other variable. From the scatter diagram, the line of best 
fit can be estimated. The aim is to  use our judgement to draw a line 
through the middle of data with the same  slope as the data. Because it is 
based on judgement it is potentially less accurate than some of the more 
mathematical approaches used in this chapter. 
More complex models might be used in  practice, but these are outside 
the scope of the syllabus. 
2 The high-low method 
This is a method of breaking semi-vari able costs into their two components. A 
semi-variable cost being a cost whic h is partly fixed and partly variable. 
 
In the exam in computational questions , semi-variable costs must be broken 
down into their 2 components using the high-low method.  
Step 1 Determine the variable costs 
It is important that we start with the highest and lowest output  (activity) and 
their associated costs. 
 
Variable cost per unit =Increase in cost
Increase in activity 
 
Choose either the highest or lowest output  and multiply it by the variable cost 
per unit just calculated. This will tell us the total variable co sts at that output.

302  
Step 2 Find the fixed cost 
A semi-variable cost consists of two components. We have found the variable 
component. What is left must  be the fixed component. If we take the total cost 
and deduct the variable costs (just calcul ated) then we are left with the fixed 
costs. 
Step 3 Calculate the expected cost 
Once the variable cost per unit and the total fixed costs are known, these can 
be used to predict future cost levels. The total expected future costs will be: 
= total fixed costs (from step 2) + [foreca st production (in units) × variable cost 
per unit (from step 1)] 
 
 Example 1 
 Great Auk Limited has had the follo wing output and cost results for the 
last 4 years: 
 Output units Cost 
  $ 
Year 1  5,000 26,000 
Year 2  7,000 34,000 
Year 3  9,000 42,000 Year 4  10,000 46,000 
In year 5 the output is expect ed to be 13,000 units. Calculate the 
expected costs. 
Inflation may be ignored. 
 
 The high-low method with stepped fixed costs 
 Sometimes fixed costs are only fixed wit hin certain levels of activity and 
increase in steps as activity increases  (i.e. they are stepped fixed costs). 
The high/low method can still be used to estimate fixed and variable 
costs. Simply choose two activity le vels where the fixed cost remains 
unchanged. 
Adjustments need to be made for the fixed costs based on the activity 
level under consideration. 
An organisation has the following tota l costs at three activity levels: 
Activity level (units) 4,000 6,000 7,500 
Total cost $40,800  $50,000 $54,800 
Variable cost per unit is  constant within this activity range and there is a 
step up of 10% in the total fixed co sts when the activity level exceeds 
5,500 units.

Chapter 8 
 303 
 What is the total cost at an  activity level of 5,000 units? 
Calculate the variable cost per unit by  comparing two output levels where 
fixed costs will be the same: 
Variable cost per unit = [(54, 800 – 50,000)/(7,500 – 6,000)] = $3.20 
Total fixed cost above 5,500 units = [54,800 – (7,500 × 3.20)] = $30,800 
Total fixed cost below 5,500 units = 30,800/110 × 100 = $28,000 
Total cost for 5,000 units = [(5, 000 × 3.20) + 28,000] = $44,000 
3 Regression analysis 
The high-low method only takes account of two observations – the highest and 
the lowest. To take account of all obs ervations a more advanced calculation is 
used known as linear regression  which uses a formula to estimate the linear 
relationship between the variables as follows:  
 
 Example 2 
 Marcus Aurelius is a small supermarket chain that has 6 shops. Each 
shop advertises in their local newspaper s and the marketing director is 
interested in the relationship betw een the amount t hat they spend on 
advertising and the sales revenue that they achieve. She has collated the 
following information for the 6 sh ops for the previous year: 
Shop Advertising 
expenditure Sales revenue 
 $000 $000 
1 80 730 
2 60 610 3 120 880 4 90 750 5 70 650 6 30 430

304  
 She has further performed some ca lculations for a linear regression 
calculation as follows: 
 the sum of the advertising ex penditure (x) column is 450 
 the sum of the sales revenue (y) column is 4,050 
 when the two columns are multip lied together and summed (xy) the 
total is 326,500 
 when the advertising expenditure is squared (x2) and summed, the 
total is 38,300, and 
 when the sales revenue is squar ed (y2) and summed, the total is 
2,849,300. 
Calculate the line of best fit using regression analysis. 
 
Advertising 
expenditure 
$000 Sales 
$000    
x y xy x2 y2 
80 730 58,400 6,400 532,900 
60 610 36,600 3,600 372,100 
120 880 105,600 14,400 774,400 
90 750 67,500 8,100 562,500 
70 650 45,500 4,900 422,500 
30 430 12,900 900 184,900 
450 4,050 326,500 38 ,300 2,849,300 
 
Interpretation of the line 
Mathematical interpretation (No good! No marks!) 
If x = 0, then y = 300 and then each time x increases by 1 y increases by 5 
Business interpretation (This is  what the examiner wants.) 
If no money is spent on advertising then sales would still be $300,000. 
Then for every additional $1 increase in advertising sales revenue would 
increase by $5.

Chapter 8 
 305 
 Linear regression in budgeting 
 Linear regression analysis can be used to make forecasts or estimates 
whenever a linear relationship is assumed between two variables, and 
historical data is available for analysis. 
Two such relationships are: 
 A time series and trend line.  Linear regression analysis is an 
alternative to calculating moving averages to establish a trend line 
from a time series. (Time series is  explained later in this chapter) 
– The independent variable (x) in a time series is time. 
– The dependent variable (y) is sale s, production volume or cost 
etc. 
 Total costs, where costs consis t of a combination of fixed 
costs and variable costs  (for example, total overheads, or a semi-
variable cost item). Linear regre ssion analysis is an alternative to 
using the high-low method of cost  behaviour analysis. It should be 
more accurate than the high-low method, because it is based on 
more items of historical data, not  just a ‘high’ and a ‘low’ value. 
– The independent variable (x) in total cost analysis is the 
volume of activity. 
– The dependent variable (y) is total cost. 
– The value of a is the amount of fixed costs. 
– The value of b is the variable cost per unit of activity. 
Regression analysis is concerned with establishing the relationship 
between a number of variables. We are only concerned here with linear 
relationships between 2 variables. 
When a linear relationship is id entified and quantified using linear 
regression analysis, values for a and b are obtained, and these can be 
used to make a forecast fo r the budget. For example: 
 a sales budget or fore cast can be prepared, or 
 total costs (or total overhead costs) can be estimated, for the 
budgeted level of activity. 
Forecasting 
The regression equation can be used for predi cting values of y from a given x 
value. 
 
 Example 2 – CONTINUED 
 Marcus Aurelius  has just taken on 2 new stores in the same area and the 
predicted advertising expenditure is expected to be $150,000 for one 
store and $50,000 for the other. 
(a) Calculate the predicted sales revenues. (b) Explain the reliability of the forecasts.

306  
Correlation 
Regression analysis attempts to find the linear relationship between two 
variables. Correlation is concerned with es tablishing how strong the relationship 
is. 
 
 Clearly in the first diagram, the regre ssion line would be a much more useful 
predictor than the regression line in the second diagram. 
Degrees of correlation 
Two variables might be: 
(a) perfectly correlated (b) partly correlated (c) uncorrelated.  
 Different types of correlation explained 
 Perfect correlation 
 
All the pairs of values lie on a stra ight line. There is an exact linear 
relationship between the two variables.

Chapter 8 
 307 
 Partial correlation 
 
In the first diagram there is not an exact relationship, but low values of x 
tend to be associated with lo w values of y, and high values of x tend to be 
associated with high values of y. 
In the second diagram again there is  not an exact relationship, but 
low values of x tend to be associat ed with high values of y and vice 
versa. 
No correlation 
 
The values of the two variables seem to be completely unconnected. 
Positive and negative correlation 
Correlation can be positive or negative. 
Positive correlation means that high values of one variable are 
associated with high values of the ot her and that low values of one are 
associated with low va lues of the other. 
Negative correlation means that low values of one variable are 
associated with high values of  the other and vice versa.

308  
 The correlation coefficient 
The degree of correlation can be meas ured by the Pearsonian correlation 
coefficient, r (also known as the pr oduct moment correlation coefficient). 
r must always be between –1 and +1. 
If r = 1, there is perfe ct positive correlation  
If r = 0, there is no correlation If r = –1, there is perfe ct negative correlation 
For other values of r, the meaning is not so clear. It is generally taken that 
if r > 0.8, then there is  strong positive correlation and if r < –0.8, there is 
strong negative correlation, however mo re meaningful information can be 
gathered from calculating the c oefficient of determination, r
2. 
 
The coefficient of determination 
This measures how good the estimated r egression equation is, designated as r2 
(read as r-squared). The higher the r-s quared, the more confidence one can 
have in the equation. Statistically, the coef ficient of determination represents the 
proportion of the total variation in t he y variable that is explained by the 
regression equation. It has the ra nge of values between 0 and 1. 
For example, if we read the following st atement "factory overhead is a function 
of machine-hours with r2 = 0.80," can be interpret ed as "80% of the total 
variation of factory overhead is ex plained by the machine hours and the 
remaining 20% is accounted for by some thing other than machine-hours." The 
20% is referred to as the error term. 
Limitations of simple linear regression 
(1) Assumes a linear relationship between the variables. 
(2) Only measures the relationship between two variables. In reality the 
dependent variable is affected by many independent variables. 
(3) Only interpolated forecasts tend to  be reliable. The equation should not be 
used for extrapolation. 
(4) Regression assumes that the histor ical behaviour of the data continues 
into the foreseeable future. 
(5) Interpolated predictions are only reliabl e if there is a significant correlation 
between the data.

Chapter 8 
 309 
 Interpolation and extrapolation 
 (1) If the value of x is within the r ange of our original data, the prediction 
is known as Interpolation. 
(2) If the value of x is outside t he range of our original data, the 
prediction is known as Extrapolation. 
In general, interpolation is mu ch safer than extrapolation. 
4 Adjusting forecasts for inflation 
The accuracy of forecasting is affected by the need to adjust historical data and 
future forecasts to allow fo r price or cost inflation. 
 When historical data is used to calcul ate a trend line or line of best fit, it 
should ideally be adjusted to the same index level for pr ices or costs. If the 
actual cost or revenue data is used, without adjustments fo r inflation, the 
resulting line of best fit will incl ude the inflationary differences. 
 When a forecast is made from a li ne of best fit, an adjustment to the 
forecast should be made for anticipated inflation in the forecast period. 
 
 Example 3 
 Production overhead costs at company BW  are assumed to vary with the 
number of machine hours worked. A li ne of best fit will be calculated from 
the following historical data, with cost s adjusted to allow for cost inflation 
over time. 
Year Total production 
overheads Number of 
machine hours Cost 
index 
 $   
20X1 143,040 3,000 192 
20X2 156,000 3,200 200 
20X3 152,320 2,700 224 
20X4 172,000 3,000 235 
Required: 
(a) Reconcile the cost data to a common price level, to remove 
differences caused by inflation. 
(b) If the line of best fit, based on cu rrent (20X4) pric es, is calculated 
as: 
y = 33,000 + 47x where y = total production overhead costs in $ and x = the number 
of machine hours: calculate the expected total over head costs in 20X5 if expected 
production activity is 3,100 machi ne hours and the expected cost 
index is 250.

310  
 The high-low method with inflation 
 The high low method may be distorted in  the presence of inflation. The 
best technique is to strip out the inflat ion, perform the technique as usual 
and then re-apply the inflation. 
A hotel cleaning department uses a co mbination of salaried staff (which 
are a fixed cost paid an annual fix ed salary) supplemented at busy 
periods (such as at the weekend) with part-time staff (seen to be a 
variable cost). It has gathered t he following information on wage cost 
over the last two months. 
 Visitors Total wages ($) 
Month 1 260 7,600 Month 2 300 8,610 
Month 2 corresponded with a wage review. At the start of that month all 
staff received a 5% pay rise. 
The restaurant wants to determine t he estimated wage cost for the next 
month when it is expect ed to have 340 visitors. 
Solution 
Firstly we should strip out the 5% infl ation included in the Month 2 cost so 
that the uninflated wage cost would be $8,200 (i.e. $8,610/1.05). 
Now we can apply the usual high-low technique: 
Variable cost per visitor = [(8,200 – 7,600)/(3 00 – 260)] = $15 
Monthly fixed costs = [ $7,600 – (260 × $15)] = $3,700 
Now we can inflate these estima tes for the Month 2 pay rise: 
Revised variable cost per vi sitor = $15 × 1.05 = $15.75 
Revised total fixed cost  = $3,700 × 1.05 = $3,885 
The total estimated cost for 340 visitors will be: = $3,885 + (340 × $15.75) = $9,240. 
5 Time series analysis 
A time series is a series of figures re corded over time, e.g. unemployment over 
the last 5 years, output over  the last 12 months, etc. 
A time series is often show n graphically as a histogram.

Chapter 8 
 311 
 Examples of a time series 
 Examples of time series  might include the following: 
 quarterly sales revenue totals over a number of years 
 annual overhead costs over  a number of years 
 daily production out put over a month. 
Where the item being measured is subj ect to ‘seasonal’ variations, time 
series measurements are usually taken for each season. For example, if 
sales volume varies in each quarter of  the year, a time series should be 
for quarterly sales. Similarly, if the sa les in a retail store vary according to 
the day of the week, a time seri es might measure daily sales. 
A time series has 4 components: 
(1) The trend (T) (2) Seasonal variations (S) (3) Cyclical variations (C) (4) Residual variations (R) We are primarily interested in the first two – the trend and the seasonal 
variation. 
Time series analysis is a term used to describe techniques for analysing a time 
series, in order to: 
 identify whether  there is any underlying historical trend  and if there is, 
measure it 
 use this analysis of the historical trend to forecast the trend  into the future 
 identify whether  there are any seasonal variations  around the trend, and 
if there is measure them 
 apply estimated seasonal variations to  a trend line forecast in order to 
prepare a forecast season by season. 
In other words, a trend over  time, established from hi storical data, and adjusted 
for seasonal variations, can then be used to make predictions for the future. 
The trend 
Most series follow some sort of long term movement – upwards, downwards or 
sideways. In time series analysis the trend is measured. Seasonal variations 
Seasonal variations are short-term fl uctuations in value due to different 
circumstances which occur at different ti mes of the year, on different days of the 
week, different times of day, et c. Some examples might be: 
 Ice cream sales are highest in summer 
 Sales of groceries are highest on Saturdays 
 Traffic is greatest in the morning and evening rush hours.

312  
 A business might have a flat trend in sales, of $1 million each six months, 
but with sales $150,000 below trend in the first six months of the year and 
$150,000 above trend in the second six months. In this example, the 
sales would be $850,000 in the firs t six months of the year and 
$1,150,000 in the second six months. 
 
 If there is a straight-li ne trend in the time series, seasonal variations must 
cancel each other out. The total of t he seasonal variations over each cycle 
should be zero. 
 Seasonal variations can be measured: 
– in units or in money values, or 
– as a percentage value or index va lue in relation to the underlying 
Trend 
 
 Cyclical and residual factors 
 Cyclical variations 
Cyclical variations are medium-term to long term influences usually 
associated with the economy. These cycl es are rarely of consistent 
length. A further problem is that we  would need 6 or 7 full cycles of data 
to be sure that the cycle was there. 
Residual or random factors 
The residual is the difference bet ween the actual value and the figure 
predicted using the trend, the cyc lical variation and the seasonal 
variation, i.e. it is caused by irregul ar items, which coul d not be predicted. 
Calculation of the trend 
There are three main methods of fi nding the underlying trend of the data: 
(1) Inspection. The trend line can be drawn by eye with the aim of plotting the 
line so that it lies in the middle of the data. 
(2) Least squares regression analysis. The x axis represents time and the 
periods of time are numbers, e.g. Januar y is 1, February is 2, March is 3, 
etc. 
(3) Moving averages. This method attempts to remove seasonal or cyclical 
variations by a process of averaging.

Chapter 8 
 313 
 Calculating a moving average 
 A moving average is in fact a series of averages, calculated from time 
series historical data. 
 The first moving average value in the series is the average of the 
values for time period 1 to time pe riod n. (So, if n = 4, the first 
moving average in the series would be the average of the historical 
values for time period 1 to time period 4.) 
 The second moving average value in the series is the average of 
the values for time period 2 to time period (n + 1). (So, if n = 4, the 
second moving average in the seri es would be the average of the 
historical values for time period 2 to time period 5.) 
 The third moving average value in the series is the average of the 
values for time period 3 to time peri od (n + 2). (So, if  n = 4, the third 
values for time period 3 to time period 6.) 
The moving average value is associated with the mid-point of the time periods used to calculate the average. 
The moving average time period 
When moving averages are used to esti mate a trend line, an important 
issue is the choice of the number of time periods to use to calculate the 
moving average. How many time peri ods should a moving average be 
based on? 
There is no definite or correct answe r to this question. However, where 
there is a regular cycle of time periods, it would make sense to calculate 
the moving averages over a full cycle. 
 When you are calculating a moving average of daily figures, it is 
probably appropriate to calculat e a seven-day moving average. 
 When you are calculating a moving average of quarterly figures, it is 
probably appropriate to calculat e a four-quarter moving average. 
 When you are calculating a moving  average of monthly figures, it 
might be appropriate to calcul ate a 12-month moving average, 
although a shorter-period moving average might be preferred. 
The seasonal variation 
Once the trend has been found, the seas onal variation can be determined. A 
seasonal variation means that some per iods are better than average (the trend) 
and some worse. Then the model can be used to predict future values.

314  
 Measuring seasonal variations 
 The technique for measuring seasonal variations differs between an 
additive model and a multiplicative model. The additive model method is 
described here. 
 Seasonal variations can be estima ted by comparing an actual time 
series with the trend line values calculated from the time series. 
 For each ‘season’ (quarter, month,  day etcetera), the seasonal 
variation is the difference betw een the trend line value and the 
actual historical value for the same period. 
 A seasonal variation can be calculated for each period in the trend 
line. When the actual value is hi gher than the trend line value, the 
seasonal variation is positive. When the actual value is lower than 
the trend line value, the seas onal variation is negative. 
 An average variation for each season is calculated. 
 The sum of the seasonal variations has to be zero in the additive 
model. If they do not add up to zero, the seasonal variations should 
be adjusted so that they do add up to zero. 
 The seasonal variations calculated in this way can be used in 
forecasting, by adding the seasonal  variation to the trend line 
forecast if the seasonal variation is  positive, or subtracting it from 
the trend line if it is negative. 
When a multiplicative model is used to  estimate seasonal variations, the 
seasonal variation for each period is calculated by expressing the actual 
sales for the period as a percentage value of the moving average figure for the same period. 
Forecasting using time series analysis 
Once we have the trend and the seasonal variation, the variations can be added 
on to the trend to find the actual result: 
Actual/Prediction = T + S + C + R 
In exam questions we would not be requir ed to calculate the cyclical variation, 
and the random variations are by nature random and cannot be predicted and 
also ignored. The equation simplifies to: 
Prediction = T + S

Chapter 8 
 315 
 Example of the calculation 
 A small business operating holiday hom es in Scotland wishes to forecast 
next year’s sales for the budget, usi ng moving averages to establish a 
straight-line trend and seasonal variat ions. Next year is 20Y0. The 
accountant has assumed that sales are seasonal, with a summer season 
and a winter season each year. Seasonal sales for the past seven years 
have been as follows: 
 Sales 
 Summer Winter 
 $000 $000 
20X4 124 70 
20X5 230 180 
20X6 310 270 
20X7 440 360 20X8 520 470 
20X9 650  
Required: 
(a) Calculate a trend line based on a two-season moving average. 
(b) Use the trend line to calculate the average increase in sales each 
season. 
(c) Calculate the adjusted seas onal variations in sales. 
(d) Use this data to prepare a sales forecast for each season in 20Y0.

316  
 Solution 
(a) 
Season and 
year Actual 
sales Two-
season 
moving 
total Seasonal 
moving 
average Centred 
moving 
average 
(Trend) Seasonal 
variation 
 (A)   (B) = (A) – (B) 
Summer 20X4 124     
  194 97   
Winter 20X4 70   123.5 – 53.5 
  300 150   
Summer 20X5 230   177.5 + 52.5 
  410 205   
Winter 20X5 180   225.0 – 45.0 
  490 245   
Summer 20X6 310   267.5 + 42.5 
  580 290   
Winter 20X6 270   322.5 – 52.5 
  710 355   
Summer 20X7 440   377.5 + 62.5 
  800 400   
Winter 20X7 360   420.0 – 60.0 
  880 440   
Summer 20X8 520   467.5 + 52.5 
  990 495   
Winter 20X8 470   527.5 – 57.5 
  1,120 560   
Summer 20X9 650     
The trend line is shown by t he centred moving averages. 
(b) The average increase in sale s each season in the trend line is: 
($527,500 – $123,500)/8 seasons  = $50, 500 each season 
(c) Seasonal variations need to add up to zero in the additive model. 
The seasonal variations calculated so far are: 
Year Summer Winter 
 $000 $000 20X4  – 53.5 20X5 + 52.5 – 45.0 
20X6 + 42.5 – 52.5 
20X7 + 62.5 – 60.0 20X8 + 52.5 – 57.5  ––––– ––––– 
Total variations + 210.0 – 268.5

Chapter 8 
 317 
  Summer Winter Total 
Number of measurements 4 5  
Average seasonal variation + 52.5 – 53.7 – 1.2 
Reduce to 0 (share equally) + 0.6 + 0.6 + 1.2  ––––– ––––– ––––– 
Adjusted seasonal variation + 53.1 – 53.1 0.0 
The seasonal variations could be rounded to + $53,000 in summer 
and – $53,000 in winter. 
(d) To predict the sales in 20Y0 we first need to extrapolate the trend 
line into 20Y0 and then adjust it fo r the expected seasonal variation 
 Expected 
trend 
(W1) Adjusted 
seasonal 
variation Forecast 
sales 
Summer 20X9 578.0   
Winter 20X9 628.5   Summer 20Y0 679.0 + 53.0 732.0 
Winter 20Y0 729.5 – 53.0 676.5 
Workings 
(W1) 
If the actual trend in Winter  20X8 was 527.5, then we can 
expect the next trend figure to  be 578 (527.5 plus the average 
increase in trend calculated in  part (b) of 50.5). We can 
continue this process for each trend figure over the next few 
periods. 
 
 Advantages and disadvantages  
 The advantages of forecasting using time series analysis are that: 
 forecasts are based on clearly-understood assumptions 
 trend lines can be reviewed after eac h successive time period, when 
the most recent historical  data is added to the analysis; 
consequently, the reliability of  the forecasts can be assessed 
 forecasting accuracy can possibly be improved with experience. 
The disadvantages of forecasting with time series analysis are that:  there is an assumption that w hat has happened in the past is a 
reliable guide to the future 
 there is an assumption that  a straight-line trend exists 
 there is an assumption that seaso nal variations are constant, either 
in actual values using the additive model (such as dollars of sales) 
or as a proportion of the trend lin e value using the multiplicative 
model.

318  
 None of these assumptions might be valid. 
However, the reliability of a forecast ing method can be established over 
time. If forecasts turn  out to be inaccurate , management might decide 
that they are not worth producing,  and that different methods of 
forecasting should be tried. On the other hand, if forecasts prove to be 
reasonably accurate, management are lik ely to continue with the same 
forecasting method.

320  
 The following extract is taken fr om the production cost budget of S 
Limited: 
Production (units) 2,000 3,000 
Production cost ($ ) 11,100 12,900 
The budget cost allowance for an activity level of 4,000 units would be 
$______. 
 
 The following data have been extrac ted from the budget working papers 
of BL Limited. 
Production volume 1,000 2,000 
 $/unit $/unit 
Direct materials 4.00 4.00 
Direct labour 3.50 3.50 Production overhead – depar tment 1 6.00 4.20 
Production overhead – depar tment 2 4.00 2.00 
Identify the total fixed cost and variabl e cost per unit (circle the correct 
figure in each column) 
Total fixed cost Variable cost per unit 
3,600 7.50 
7,600 9.90 
 
 A company will forecast its quarte rly sales units for a new product 
by using a formula to predict the base sales units and then 
adjusting the figure by a seasonal index. 
The formula is BU = 4,000 + 80Q 
Where BU = Base sales units and Q is the quarterly period number. The seasonal index values are: 
Quarter 1  +196 
Quarter 2  -848 Quarter 3  -212 
Quarter 4  +864

Chapter 8 
 321 
 Identify the forecast increase in sales units from Quarter 3 to Quarter 4: 
A 25% 
B 80 units C 100 units D 1,156 units  
 
 W plc is preparing its budgets for next year. 
The following regression equation has been found to be a reliable 
estimate of W plc's deseasonalised sales in units: 
y = 10x + 420 Where y is the total sales units and x refers to the accountancy period. 
Quarterly seasonal variations have been found to be: 
 
Q1 Q2 Q3 Q4 
+75 +188 –38 –225 
 
In accounting period 33 (which is  quarter 4) identify the forecast 
seasonally adjusted sales units: 
A 525 
B 589 C 750 D 975 
 
 A company has achieved the following sales levels of its key product, 
article B, over the last four years: 
 Sales of article B ('000 units) 
 Q1 Q2 Q3 Q4 
20X3 24.8 36.3 38.1 47.5 
20X4 31.2 42.0 43.4 55.9 
20X5 40.0 48.8 54.0 69.1 20X6 54.7 57.8 60.3 68.9 
Using linear regression numbering 20X3 Q1 as t = 1, through to 20X6 Q4 
as t = 16, and letting x = t and y = T 
The trend equation is: T = 28.54 + 2.3244t Required: 
The forecast sales of B in Quarter 3 of 20X7 are _______ (in ‘000 units 
and rounded to one decimal place)

322  
 Example 1 
 Step 1: Calculate the variable cost per unit 
  Increase in cost 
Variable cost per  unit = –––––––––––––– 
  Increase in level of activity 
   
  $46,000 – $26,000  = –––––––––––––– 
  10,000 units – 5,000 units 
    = $4 per unit 
Step 2: Find the fixed cost 
The fixed cost can be dete rmined either at the high level or the low level. 
 High 
level Low 
level 
 $ $ 
Semi-variable cost 46,000 26,000 
Variable costs   
$4 per unit × 10,000 units 40,000  $4 per unit × 5,000 units  20,000 
Fixed cost 6,000 6,000 
Step 3: Calculate the expected cost 
Therefore cost for 13,000 units = ( 13,000 units × $4 per unit) + $6,000 = 
$58,000

Chapter 8 
 323 
 Example 2 
  
 (a) 
 $000 
Sales revenue = $300k + (5 × $150k) = 1,050 
Sales revenue = $300k + (5 × $50k) = 550 
(b) The second prediction is the more reliable as it involves 
interpolation. The firs t prediction goes beyond t he original data upon 
which the regression line was bas ed and thus assumes that the 
relationship will continue on in the same way, which may not be 
true.

324  
 Example 3 
 (a) As the line of best fit is bas ed on 20X4 prices, use this as the 
common price level. Costs should t herefore be adjust ed by a factor: 
 
Index level to which costs will be adjusted 
Actual index level of costs 
 
Year  Actual 
overheads Cost 
index Adjustment 
factor Costs at 20X4 
price level 
 $   $ 
20X1 143,040 192 × 235/192 175,075 
20X2 156,000 200 × 235/200 183,300 
20X3 152,320 224 × 235/224 159,800 20X4 172,000 235 × 235/235 172,000 
(b) If the forecast number of machi ne hours is 3,100 and the cost index 
is 250: 
Forecast overhead costs = [ $33,000 + ($47 × 3,100 hours)] × 
(250/235) = $178,700 × (250/235) 
= $190,106 
 
 The high-low method Step 1 Calculate the variable cost per unit 
  Increase in level of activity      $12,900 – $11,100 
 = –––––––––––––– 
  3,000 units – 2,000 units    
 = $1.80 per unit

Chapter 8 
 325 
 Step 2 Find the fixed cost 
A semi-variable cost has only got 2 components – a fixed bit and a 
variable bit. We now know the variable part. The bit that’s left must be the 
fixed cost. It can be determined either at the high level or  the low level. 
 High 
level Low 
level 
 $ $ 
Semi-variable cost 12,900 11,000 
Variable part   
$1.80/unit × 3,000 units 5,400  $1.80/unit × 2,000 units  3,600 
 –––––– –––––– Fixed cost 7,500 7,500 
Therefore cost for 4,000 units = 4, 000 units × $1.80 per unit + $7,500 = 
$14,700
. 
 
 We know the cost per unit. We need to  multiply by the number of units so 
that we can find the total cost fo r 1,000 units and 2,000 units. Then we 
can apply the high-low method. 
 –––––– ––––––  17.50 13.70 
× No of units × 1,000 × 2,000 
 –––––– –––––– Total cost 17,500 27,400 
Now we can do the high-low method.

326  
 The high-low method 
Step 1 Calculate the variable cost per unit 
   
  $27,400 – $17,500 
 = ––––––––––––––   2,000 units – 1,000 units 
   
 = $9.90 per unit 
A semi-variable cost has only got  2 components – a fixed bit and a 
 High 
level Low 
level 
 $ $ 
Semi-variable cost 27,400 17,500 
$9.90/unit × 2,000 units 19,800  $9.90/unit × 1,000 units  9,900 
Fixed cost 7,600 7,600 
 
 D 
Sales in quarter 3 (Q = 3)   Base = 4,000 + (80 × 3) = 4,240 Seasonal adjustment  –212 
Actual sales = 4,028 
Sales in quarter 4 (Q = 4)   Base = 4,000 + (80 × 4) = 4,320 
Seasonal adjustment  +864 
Actual sales = 5,184 Overall increase in sales = 5,184 – 4,028 = 1,156 units

Chapter 8 
 327 
 A 
y = 10x + 420 
We are told that x refers to t he accountancy period, which is 33, 
therefore: y = 420 + (33 × 10) = 750 This is the trend, however and we need to consider the seasonal 
variation too. Accounting period 33 is quarter 4. Quarter 4 is a bad 
quarter and the seasonal variation is –225, therefore the expected results 
for period 33 are 225 less than the trend. 
Expected sales = 750 – 225 = 525 units 
 
 72.7 
In 20X7, t takes values 17 to 20. Q uarter 3 will correspond to a t value of 
19. The forecast sales will be: 
Q3 t = 19 T = 28.54 + 2.3244 × 19 = 72.7036

329 
Budgetary control 
B3. Discuss budgetary control (a)  The concept of budgetary 
control 
(b)  Human dimensions of 
budgeting 
  Chapter 
9

Budgeting control 
330  
 
2 The meaning of budgetary control 
Budgetary control is about assessi ng actual performance against budgeted 
performance and taking corrective action when necessary. 
The control system is a systematic approach which te lls managers whether or 
not they are achieving what  they planned to achieve. 
It focuses on total costs for a department or  business unit, and re sponsibility for 
these total costs is allocated to an indi vidual (this is known as responsibility 
accounting). If there are any di fferences between actual and budgeted 
performance (known as a variance), the res ponsible individual can act to either 
correct the budget or to take action to bring the cost back under control 
(whichever is most appropriate).  
 Effective budgetary control 
 Atrill and McLaney identify a number of  characteristics that are common 
to businesses with effective budgetary control: 
 a serious attitude is taken to the system 
 clear demarcation between areas of managerial responsibility 
 budget targets that are challenging yet achievable 
 established data collection, analysis and reporting techniques 
 reports aimed at individual managers 
 fairly short reporting periods 
 timely variance reports 
 action being taken to get operati ons back under control if they are 
shown to be out of control.

Chapter 9 
 331 
3 Feedback and feedforward control 
There are two main types of control system: 
 feedback control  – in this system the aim is to correct problems that have 
been discovered at the period end when the actual results are compared 
with the budget. 
 
 More details on feedback control 
 Feedback control is the comparison of  actual results against expected 
results and if there is a significant diffe rence, then it is investigated and if 
possible and desirable it is corrected. 
It is defined as: ‘Measurement of differences between planned outputs an d actual outputs 
achieved, and the modification of subsequent action  and/or plans to 
achieve future required results. F eedback control is an integral part of 
budgetary control and standard cost ing systems.’ (CIMA Official 
Terminology) Corrective action that brings actual performance closer to the target or 
plan is called negative feedback. Corrective action that increases the difference between actual 
performance and the target or pl an is called positive feedback. 
Feedback control in budgeting 
 An organisation prepares a budge t, and commits resources to 
achieving the budget targets. 
 The business uses its resources to make products or provide 
services. Private sector organisations sell their output. 
 Outputs from the syste m are measured. In b udgetary control, output 
measurements will be quantities of products made or services 
provided, costs incurred, revenues  earned, and profits and return. 
Some non-financial performance measurements might also be 
taken. 
 The measurements provide feed back information to management, 
who compare actual results with the budget. 
 Where a need for control action is identified, the manager 
responsible takes suitable control action. 
With negative feedback, the control ac tion is intended to bring actual 
performance back into line with the budge t. For example, if actual costs 
are higher than budget, control action might be taken to cut costs. 
Similarly, if actual sales volume  is lower than budgeted sales, action 
might be taken to boost sales.

332  
 With positive feedback, control acti on would be intended to increase the 
differences between the budget and actual results. For example, if actual 
sales are higher than budget, control action might be taken to make this 
situation continue. Similarly, when  actual costs are less than budget, 
measures might be taken to keep costs down. 
The manner in which a feedback control loop might work in the context of 
a budgetary control system  may be illustrated by the following diagram: 
 
 feedforward control  – in this system the aim is to anticipate problems 
with the aim of preventi ng them from occurring.  Feedforward control 
should be used in conjunction with feedback control. 
 
 More details on feedforward control 
 Feedforward 
Feedforward is the comparison of the results that are currently expected 
in the light of the latest information and the desired result s. If there is a 
difference, then it is investigated and corrected. 
Feedback happens after the event and discovers that something has 
gone wrong (or right). It is obviously too late to affect the result that has 
just happened, but the idea is that if  we can understand what went wrong 
in the previous period, then we c an stop the problem from recurring.

Chapter 9 
 333 
 Feedforward is more proactive and aims to anticipate  problems and 
prevent them from occurring. 
It is defined as the ‘forecasting of differences between actual and planned 
outcomes and the implementation of ac tions before the event, to avoid 
such differences’ (CIMA Official Terminology). Whereas feedback is based on a comparis on of historical actual results 
with the budget for the period to date, feedforward looks ahead and 
compares: 
 the target or objecti ves for the period, and 
 what actual results are now forecast. 
Advantages and problems wi th feedforward control 
Feedforward control reporting offers t he key advantage that  it is forward-
looking. It informs management what  is likely to happen unless control 
measures are taken. Management c an compare their targets for the 
period with current expectations. 
In contrast, feedback control is backward-looking, and historical 
variances or differences from plan are not necessarily a guide to what will 
happen over the full budget period. 
A problem with feedforward control is  that control reports should be 
produced regularly, which means that forecasts must be updated 
regularly. To implement an efficient feed-forward control system, it is 
therefore necessary to have an efficient forecasting system. Forecasts 
might be prepared using computer models,  with revisions to the forecast 
each month based on updated information about actual results to date, 
and where appropriate by making alterati ons to the basic assumptions in 
the model. 
 
 A departmental manager is respons ible for the cash budget for the 
department for the year. The organi sation uses feedforward control 
systems. 
The cash budget at the start of the year  stated that there would be a cash 
balance of $400,000 at the beginning of J une and that a piece of capital 
equipment costing $320,000 was to  be purchased in the month. 
Two months earlier, in April, using the feedforward control systems in the 
organisation, the manager responsible  for the budget realises that the 
cash budget was optimistic and that, because some credit customers are 
paying later than was expected, the expected cash balance will be only 
$220,000 at the start of June. 
Feedforward control 
Feedback control has two elements her e. Firstly, it has been used to 
identify a problem in advance (i.e. in April). The manager can see that the 
department will not have enough cash in June to purchase the machine 
as planned.

334  
 Secondly, having anticipated the pot ential problem if the machine is 
purchased, it allows the manager to ta ke steps to eliminate the problem 
before it occurs: 
 the department could simply delay the purchase of the machine for 
1 or 2 months 
 or it could negotiate with the supp lier of the equipment to see if they 
would be willing to accept instalments 
 or it could speak to the bank manager and obtain a temporary 
overdraft, etc. 
Control reports 
Feedback control reports and feedforward control reports mi ght be presented at 
the same time but they will have a differ ent, layout, present different information 
and have different uses in that: 
 the feedback control report will look ba ckwards at the performance for the 
period and consider any difference fr om the planned performance for that 
period 
 the feedforward control report will look forward and create expectations 
about expected future performance with the aim of identifying potential 
future issues for resolution. 
 
 A sales manager receives monthly c ontrol reports about sales values. 
The budgeted sales for the year to 31 De cember are $600,000 in total. At 
the end of April the manager might re ceive the following feedback control 
report. 
Feedback control report 
Sales report for April 
 Month Cumulative 
 Budget Actual Variance Budget Actual Variance 
Product $000 $000 $000 $000 $000 $000 
P1 35 38 3 (F) 90 94 4 (F) 
P2 20 14 6 (A) 50 39 11 (A) P3 25 23 2 (A) 50 45 5 (A) 
 ––––– ––––– ––––– ––––– ––––– ––––– 
Total 80 75 5 (A) 190 178 12 (A) 
 ––––– ––––– ––––– ––––– ––––– –––––

Chapter 9 
 335 
 The aim of this report is to asse ss performance in April. The sales 
manager can see that product P3 has had a poor month of sales and has 
achieved $2,000 less sales than expe cted. The manager can also see 
that product P3 is now $5,000 below where it should have been at this 
point in the year. The manager might w ant to take some corrective action 
at this point such as replacing some of the sales team for P3 or reducing 
performance related pay  for that product.  
Feedforward control report 
Alternatively, the sa les manager might be pres ented with a feedforward 
control report, as follows: 
Sales report, April 
 Budget Current forecast Variance 
Product $000 $000 $000 
P1 240 250 10 (F) 
P2 150 120 30 (A) P3 210 194 16 (A) 
Total 600 564 36 (A)  ––––– ––––– ––––– 
This report compares the expected year end totals for each product 
against the original budget for the year . For example, P2 was budgeted to 
achieve sales by the end of the y ear of $150,000, but a revised budget 
for the year now suggest that P2 will only achieve $120,000 of sales by 
the end of December. 
The manager can react to this by s eeking ways to make up the deficit in 
sales in P2 before the y ear end (for example, by improving the marketing 
of P2 or by motivating the sales staff to sell more of P2 before the year 
end). 
4 Fixed and flexible budgets 
A fixed  budget contains information on costs and revenues for one level of 
activity. A flexible  budget shows the same information,  but for a number of different 
levels of activity. Flexible budgets are useful for both planning purposes and 
control purposes. (1) When preparing a flexible budget, managers are forced to consider the 
different scenarios and their responses  to them. Thus for a number of 
different situations, managers will have calculated their costs and 
revenues. If an unexpected event does occur, changing the level of 
activity, management will be better prepared. 
(2) Budgetary control is the comparis on of actual results against budget. 
Where the actual level of activity is different to that ex pected, comparisons 
of actual results agains t a fixed budget can give  misleading results.

336  
 In budgetary control systems ma nagers should always compare 
performance against a flexed budget. 
 
 A company manufactures a single product and the following data show 
the actual results for costs for th e month of April compared with the 
budgeted figures. 
Operating statement for April 
 Budget Actual Variance 
Units produced 1,200 1,000 (200) 
 $ $ $ 
Direct material 19,200 16,490 2,710 
Direct labour 13,200 12,380 820 Production overhead 24, 000 24,120 (120) 
Administration overhead 21,000 21,600 (600) 
Selling overhead 16, 400 16,200 200 
Total 93,800 90,790 3,010 
Note : Variances in brackets are adverse. 
Looking at the costs incurred in Apr il, a cost saving of $3,010 has been 
made compared with the budget. However,  the number of units produced 
was 200 less than budget so some savings in expenditure might be 
expected. It is not possible to tell fr om this comparison how much of the 
saving is due to efficient cost contro l, and how much is the result of the 
reduction in activity. 
The type of budget being used here is a fixed budget.  A fixed budget is 
one which remains unchanged regardless of the actual level of 
activity . In situations where activity levels are likely to change, and there 
is a significant proportion of variable costs, it is difficult to control 
expenditure satisfactor ily with a fixed budget. 
If costs are mostly fixed, then changes in activity levels will not cause 
problems for cost compar isons with fixed budgets. 
A flexible budget  can help managers to make more valid comparisons. 
It is designed to show the allowed ex penditure for the actual number of 
units produced and sold. Comparing this  flexible budget with the actual 
expenditure, it is possible to di stinguish genuine efficiencies and 
inefficiencies.

Chapter 9 
 337 
 Preparing a flexible budget 
Before a flexible budget can be prepared, managers must identify the 
cost behaviour, i.e. which costs are fixed, which are variable and which 
are semi-variable. The allowed expe nditure on variable costs can then be 
increased or decreased as the level of activity changes. You will recall 
that fixed costs are those costs whic h will not increase or decrease over 
the relevant range of activity. The a llowance for these items will therefore 
remain constant. Semi-variable costs have both a fixed and a variable 
element. 
We can now continue with the example. Management has identified that the fo llowing budgeted costs are fixed: 
 $ 
Direct labour 8,400 Production overhead 18,000 
Administration overhead 21,000 
Selling overhead 14,000 
It is now possible to identify the expec ted variable cost per unit produced. 
 Original 
budget Fixed 
cost Variable  
cost Variable 
cost per 
unit 
 
(a) (b) (c) = (a) – (b) (c) ÷ 1,200 
Units produced 1,200     $ $ $ $ Direct material 19,200 – 19,200 16 
Direct labour 13,200 8,400 4,800 4 
Production 
overhead 24,000 18,000 6,000 5 
Administration 
overhead 21,000 21,000 – – 
Selling overhead 16, 400 14,000 2,400 2 
 –––––– –––––– –––––– –––– 
 93,800 61,400 32,400 27 
From this you can see that: 
 administration overhead is fixed 
 direct material is variable 
 direct labour, production over head and selling and distribution 
overheads are semi-variable.

338  
 Now that managers are aw are of the fixed cost s and the variable costs 
per unit it is possible to ‘flex’ the original budget to produce a budget cost 
allowance for the actu al 1,000 units produced. 
The budget cost allowance (or flexed budget) for each item is calculated 
 
Budget cost allowance = Budgeted fixed cost + (number of units 
produced × variable cost per unit) 
 The budget cost allowances can be calculated as follows: Direct material = 0 + (1,000 × 16) = $16,000 Direct labour = 8,400 + (1,000 × 4) = $12,400 
Production overhead = 18,000 + (1,000 × 5) = $23,000 
Administration overhead = 21,000 + 0 = $21,000 Selling overhead = 14,000 + (1,000 × 2) = $16,000 A flexible budget statem ent can now be produced: 
Flexible budget comparison for April 
 Cost 
allowance Actual cost Variance 
 $ $ $ 
Direct material 16,000 16,490 (480) 
Direct labour 12,400 12,380 20 
Production overhead 23,000  24,120 (1,120) 
Selling overhead 16, 000 16,200 (200) 
 ––––– ––––– ––––– Total 88,400 90,790 (2,390) 
Note:  Variances in brackets are adverse. 
This revised analysis shows that in fact the cost was $2,390 higher than 
would have been expected from a pr oduction volume of 1,000 units. 
The cost variances in the flexib le budget comparison are almost all 
adverse. These overspendings were not revealed when the fixed budget 
was used and managers may have been und er the false impression that 
costs were being adeq uately controlled.

Chapter 9 
 339 
 The total budget variance 
 If we now produce a statement sho wing the fixed budget, the flexible 
budget and the actual resu lts together, it is possible to analyse the total 
variance between the original budget and the actual results 
 Fixed 
budget Flexible 
budget Actual 
results Expenditure 
variances 
 $ $ $ $ 
Direct material 19,200  16,000 16,490 (490) 
Direct labour 13,200  12,400 12,380 20 
overhead 24,000 23,000 24,120 (1,120) 
Administration overhead 21,000 21,000 21,600 (600) 
Selling and 
distribution 
overhead 16,400 16,000 16,200 (200) 
 93,800 88,400 90,790 (2,390) 
           5,400 
Volume 
variance (2,390) 
variance  
          
  3,010 
Total 
variance   
The total variance is therefore made up of two parts: 
(1) the volume variance of $5,400 favourable, which is the expected 
cost saving resulting from producing 200 units less than budgeted 
(2) the expenditure variance of $2,390 adverse, which is the net total of 
the over- and under-expenditure on eac h of the costs for the actual 
output of 1,000 units. 
 
Notice that the volume variance is the saving in standard variable cost: 
200 units × $27 per unit = $5,400.

340  
 When you looked at standard costi ng, you learned how some of the 
expenditure variances can be anal ysed between their price and usage 
elements – for example, how much of  the variance is caused by paying a 
different price per hour of labour (the labour rate variance), or per 
kilogram of material (the material  price variance), and how much is 
caused by using a different quantity of  material or labour (the usage and 
efficiency variances). 
 
 Using flexible budgets for planning 
 You should appreciate that while flexible budgets can be useful for 
control purposes they are not particula rly useful for planning. The original 
budget must contain a single target leve l of activity so that managers can 
plan such factors as the resource  requirements and the product pricing 
policy. This would not be possible if they were faced with a range of 
possible activity levels, although managers will of course consider a range of possible activity levels bef ore they select the target budgeted 
activity level. 
The budget can be designed so that the fixed costs are distinguished 
from the variable costs. This will facili tate the preparation of a budget cost 
allowance (flexed budget) for control purposes at the end of each period, 
when the actual activity is known. 
5 Responsibility accounting a nd controllability of costs 
A key aspect of budgetary control is res ponsibility accounting – that is, making 
managers account for the costs (and/ or revenues) for which they have 
responsibility. However this will only work  effectively if managers are appraised 
only on the costs which they can cont rol. The success of responsibility 
accounting relies on the ability of the or ganisation to correctly identify the costs 
that a manager can control. 
Controllable costs are costs which can be influenced by the budget holder 
and are generally  considered to be those which are: 
 variable or 
 directly attributable fixed costs. 
Uncontrollable costs  are costs that cannot be influenced (i.e. their value can 
neither be increased nor decreased) by management action.

Chapter 9 
 341 
 Further details 
 Most variable costs within a departm ent are thought to be  controllable in 
the short term because a manager can influence the efficiency with which 
resources are used, even if they c annot do anything to raise or lower 
price levels. So costs such as direct  labour costs and material costs in a 
manager's department are said to be controllable by that manager. 
Many fixed costs are uncontrollable (or committed) in the short term 
(such as insurance etc.) and thes e are not normally treated as 
controllable costs. But so me fixed costs are directly attributable to a 
department in that, although they are fi xed (in the short term) within the 
relevant range of output, a drastic r eduction in the department‘s output, or 
closure of the division entirely, would reduce or remove these costs. This 
might include costs such as superviso rs' salaries, department rent etc. 
A useful distinction can be made between committed  fixed costs, which 
are costs that are uncontrollable in the short term, but are controllable 
over the longer term; and discretionary  fixed costs, which are costs 
treated as fixed cost items that c an nevertheless be controlled in the 
short term, because spending is s ubject to management discretion. 
Examples of discretionary fixed cost s are advertising expenditure, and 
executive travel and subsistence costs, and these would normally be 
included as directly at tributable fixed costs. 
 
 Example 1 
 The manager of the purc hasing department is given responsibility for the 
total expenditure in her department for the year. In calculating the 
organisation's budgeted profit for the year, the accountant in the organisation included the following  total costs for the purchasing 
department: 
 Total 
 $ 
Direct materials 1,165,000 
Direct labour 28,000 Indirect fixed l abour cost 80,000 
Other fixed overheads 100,000 Share of central overheads 67,000  –––––––– 
Total costs 1,440,000

342  
 It has been determined that the indirect  fixed labour cost and 40% of the 
other fixed overheads are directly  attributable to the department. 
When assessing the total cost vari ance for the department, what total 
cost should be used as the budgeted cont rollable cost for the manager? 
A $1,313,000 
B $1,333,000 C $1,373,000 D $1,440,000 
 
 Recharging uncontrollable costs  
 Focusing solely on controllable costs,  however, can bring in some further 
complications in that it  may mean that uncontrolla ble costs are ignored by 
all managers. In order to rectify this, some organisations decide that even 
uncontrollable costs shoul d be charged to departments 
A summarised report for the profit centres of an organisation might be 
 Centre A Centre B Centre C Total 
 $ $ $ $ 
Revenue 300,000 280,000 420,000 980,000 Variable costs 170,000 100,000 240,00 510,000 
Directly attributable 
costs 70,000 120,000 80,000 270,000 
Controllable costs 240,000  220,000 320,000 780,000 
Attributable gross 
profit 60,000 40,000 100,000 200,000 
Other overhead costs    (180,000) 
    ––––––– 
Net profit    20,000 
A criticism of the controllability a ccounting principle is that managers are 
not encouraged to think about costs for which they are not responsible. In 
the example above, ther e are $180,000 of costs not attributable to any 
profit centre. These might be head office  costs, for example, or marketing 
 Within a system of responsibilit y accounting, there should be cost 
centre managers accountable for these costs. 
 Even so, these overhead costs might be caused to some extent by 
the demands placed on head office administration or marketing 
services by the profit centre managers. 
 When these costs are high, a further  problem is that profit centre 
profits need to be large enough to cover the general non-allocated overhead costs.

Chapter 9 
 343 
 An argument could ther efore be made that  profit centre managers should 
be made accountable for a share of overhead costs that are not under 
their control, and a share of these co sts should be charged to each profit 
centre. Profit reporting w ould therefore be as follows: 
 $ $ $ $ 
Revenue 300,000 280, 000 420,000 980,000 
Variable costs 170,000  100,000 240,00 510,000 
Other overhead costs (50, 000) (50,000) (80,000) (180,000) 
Net profit 10,000 ( 10,000) 20,000 20,000 
Pros and Cons 
The advantages of this approach to responsibility accounting are 
 business unit managers are made aw are of the significance of other 
overhead costs 
 business unit managers are made aware that they need to earn a 
sufficient profit to cover a fair  share of other overhead costs. 
The disadvantages of this approach are that:  business unit managers are made accountable for a share of other 
overhead costs, but they can do nothing to control them 
 the apportionment of other overhead costs between business units, 
like overhead apportionment generally, is usually a matter of 
judgement, lacking any economic or commercial justification. 
6 The behavioural aspects of budgeting 
Senior managers will often get  less junior managers and other members of staff 
involved in creating budgets. This hel ps satisfy one of the purposes of 
budgeting in that it can aid motivation. But it can have a detrimental impact on 
the other purposes such as distorting t he evaluation of act ual performance if 
managers incorporate 'slack' into the budget  in order to make it easier to 
achieve.

344  
 Distorting the purposes of budgeting 
 Involving managers in the completi on of a budget can help achieve some 
of the purposes of budgets but may distort others. 
Some of the purposes that are enhanced by manager involvement are: 
 Planning.  Planning is taking place at many levels, and should be 
more accurate than if it simply takes place at a high level, by 
individuals who are not familiar with the day to day needs of the 
business. More junior managers will have better information as they 
are 'closer to the action' and this should improve the quality of budgets overall. 
 Communication.  There should be more co mmunication across all 
levels of management. It might also make it possible to 
communicate overall strategic goals  to managers by explaining to 
them the purpose of the budget being prepared and how it fits in to 
overall budgets and or ganisational goals. 
 Motivation.  Managers often want to take  on extra responsibilities 
and get further involved in the decision making process. Giving them the power to set budgets might achieve this goal. Managers might also take more personal ownership of achieving budget goals which they have set and be more motivated to achieve what they have promised in the budget. 
Whilst the following purposes might be distorted:  
 Co-ordination.  This may become more complicated and slower. 
This is because, not only does there need to be co-ordination between departments but there also has to be co-ordination 
between the different levels  of management within each 
department. Managers will have to co-ordinate with each other and it may be that inaccuracies occu r in budgets if individual manager 
cannot see the overall ('big') pict ure or do not understand fully the 
organisation's goals for the budget period. 
 Evaluation.  In some instances managers might build 'slack' into a 
budget that they control. This means  that they will make it more 
easily achievable by overstating target costs and/ or understating 
target revenues (if these are in cluded in their budget). This will 
make it easier for them to achieve the budget targets and associated rewards. But it will make the evaluation of budget performance less useful for seni or managers. For example, the 
variance system might only generate favourable variances because the original plan or standard was understated. 
 Authorisation.  It may be harder to cont rol the authorisation of 
budget items if there are no checks on the manager. It may also be 
that managers disagree over budget  responsibility and try to 
allocate costs to other managers ra ther than take responsibility for 
themselves.

Chapter 9 
 345 
 But there this will not always be the case. Every manager and every 
company will react differently to a budgetary control system. For 
example, involvement of managers in one firm might lead to better 
motivation, but other managers may be reluctant to get involved and 
therefore become dissatisfied if they  are asked to get involved in the 
process. 
Conflicts between the goals of budgeting 
These behavioural aspects help expl ain that many of the goals of 
budgeting are contradictory.  One the one side we want to be able to fairly 
evaluate the performance of managers. But we also want to motivate 
managers and therefore, even if managers are not involved in the 
process, managers may find the budget  too challenging and therefore 
reduce their effort. That in turn  would distort any evaluation. 
Likewise, we want budgets to ac t as a way of communicating 
organisational goals. But the budget t hemselves may distort the goals as 
they will be very short-term, be focu sed on cost reduction rather than, 
say, quality aspects, and they will solely focus on financial aspects of the 
organisation's goals. There is ther efore a conflict between aiming to 
achieve financial control and comm unicating the organisation's goals. 
Furthermore, the budget is designed to act as a plan for a manager or department. The manager may therefore follow this plan at the expense 
of other critical success factors that  arise in the internal or external 
environment of the firm. For exam ple, a production manager may 
continue to use the planned materials mix even if the sales department are indicating that customers would prefer a different product design and 
the purchasing department have adjust ed their purchases accordingly. 
The production manager then has to  choose between the plan and inter-
departmental co-ordination. 
Many of the conflicts arise due to the human natur e of a budgetary 
control system. Managers do not always follow organisational goals, they 
do not always think long term, they ma y be wary of moving away from the 
plan etc. This provides a conflic t between many of the goals of a 
budgetary control system which needs to  be considered at a strategic 
level when implement ing such a system. 
Choosing the level of pa rticipation in budgeting 
These behavioural aspects are influenced by the amount of participation that is 
given to managers in the preparation of the budget. It results in organisations 
choosing between two extremes  of budgetary participation: 
 The imposed style.  In this style of budgeting the budget is set centrally 
with little involvement by the budget holder. This reduces the scope for 
slack in the budget, improves co-ordi nation and avoids some of the goal 
congruence issues identified with budgetary participation. 
 The participative style.  In this style the budget holder is involved in 
setting the budget. This should make the budget more accurate and better 
motivate the budget holder to achieve it.

346  
 Imposed style 
An imposed/top-down budget is defined in  CIMA's Official Terminology 
as 'A budget allowance which is set without permitting the ultimate 
budget holder to have the opportunity to participate in the budgeting 
process' 
Advantages of imposed style 
There are a number of reasons why it might be prefer able for managers 
not to be involved in setting their own budgets: 
(1) Involving managers in the setting of budgets is more time 
consuming than if senior m anagers simply imposed the budgets. 
(2) Managers may not have the skill s or motivation to participate 
usefully in the budgeting process. 
(3) Senior managers have the better ov erall view of the company and 
its resources and may be better-placed to create a budget which 
utilises those scarce resources to best effect. 
(4) Senior managers also are awar e of the longer term strategic 
objectives of the organisation an d can prepare a budget which is in 
line with that strategy. 
(5) Managers may build budgetary slack or bias into the budget in order 
to make the budget easy to achieve and themselves look good. 
(6) Managers cannot use budgets to play games which disadvantage 
other budget holders. 
(7) By having the budgets imposed by senior managers, i.e. someone 
outside the department, a more object ive, fresher perspective may 
be gained. 
(8) If the participation is only ps eudo-participation and the budgets are 
frequently drastically changed by s enior management, then this will 
cause dissatisfaction and the effe ct will be to demotivate staff. 
Participative style 
Participative/bottom up budgeting is a 'budgeting system in which all 
budget holders are given the opportunity to participate in setting their own 
budgets'. (CIMA Official Terminology) 
Advantages of participative budgets 
(1) The morale of the management is  improved. Managers feel like their 
opinion is listened to, that their opinion is valuable. 
(2) Managers are more likely to acc ept the plans contained within the 
budget and strive to achieve the ta rgets if they had some say in 
setting the budget, rather than if the budget was imposed upon 
them. Failure to achieve the target that they themselves set is seen 
as a personal failure as well as an organisational failure.

Chapter 9 
 347 
  (3) The lower level managers will have a more detailed knowledge of 
their particular part of the busi ness than senior managers and thus 
will be able to produce more realistic budgets 
Other behavioural aspects of budgeting 
Other aspects that managers may have to incorporate into a budgetary control 
system include: 
 incorporating the achiev ement of personal goals in  order to motivate the 
budget holder 
 achieving goal congruence betwe en the budget holder's goals and the 
organisation's goals 
 avoiding budget holders seeing the budget as a pot of cash that must be 
spent 
 negotiating budgets with the budget holder 
 coping with conflicts with the a ccounting treatment of some costs 
 allowing the budget holder to have so me freedom and not to feel too 
constrained by the budget 
 setting the correct level of 'difficulty' in a budget. 
 
 Achieving personal goals 
To be fully effective, any system of  financial control must provide for 
motivation and incentive. If this requi rement is not satisfied, managers will 
approach their responsibilities in a very cautious and conservative 
manner. Personal goals and ambitions are, in theory, strongly linked to 
organisational goals. These personal goals may include a desire for 
higher income and higher social standi ng. To simultaneously satisfy the 
goals of the organisation and the goals of the individual there must be 
‘goal congruence’. That is, the individ ual manager perceives that his or 
her own goals are achieved by his or her acting in a manner that allows 
the organisation to achieve its goals.  The problem is that reliance on 
budgetary control systems does not alwa ys result in goal congruence. 
The success of a budgetary contro l system depends on the people who 
operate and are affected by it. They must work within the system in an 
understanding and co-operative manner. This can only be achieved by 
individuals who have a total involvement at all stages in the budget process. 
However, it is often found that 
(1) A budget is used simply as a pr essure device. If the budget is 
perceived as ‘a stick with whic h to beat people’, then it will be 
sabotaged in all sorts of subtle ways.

348  
 (2) The budgeting process and subsequent  budgetary control exercises 
induce competition between indivi dual departments and executives. 
Managers may be induced to do things in order to ‘meet budget’ that 
are not in the best interests of the business as a whole. 
(3) Adverse variances attract investigation and censure but there is no 
incentive to achieve favourable variances. 
(4) Failure to distinguish controlla ble from uncontrollable costs in 
budgetary control can alienate manager s from the whole process. 
Failure of goal congruence 
It has been seen that an essential element in budgetary control is 
performance evaluation. Actual re sults are compared with budget or 
standard in order to determine w hether performance is good or bad. 
What is being evaluated is not ju st the business operation but the 
managers responsible for it. The pur pose of budgetary control is to 
induce managers to behave in a manner t hat is to the best advantage of 
the organisation. Compliance with budget  is enforced by a variety of 
negative and positive sanctions. 
When adverse variances are reported for operations then this implies 
poor performance by the managers of the operations. If they are unable 
to correct or explain away the adver se variances, then they may suffer 
negative sanctions. They may have for go salary increases, or they may 
be demoted to a less prestigious post. Other more subtle negative 
sanctions are possible that anyone who has ever worked for a large 
organisation will be aware of. Positive inducements may be offered to encourage managers to avoid 
adverse variances. A manager who meets budget may be granted a 
performance-related salary bonus, prom otion, a new company car or use 
of the executive dining room. 
Consequently, the manager has a considerable incentive to ensure that 
the department or operat ion he/she is responsible for achieves its 
budgeted level of performance. However,  there are a variety of ways of 
doing this that might not be to t he advantage of the organisation as a 
whole. For example, the manager of a pr oduction line can cut costs and hence 
improve its reported perfo rmances by reducing quality controls. This may 
result in long-term problems concer ning failure of products in service, 
loss of customer goodwill and rectificat ion costs – but these are not the 
concern of the production line manager. This is a clear failure of goal 
congruence. The control system is c apable of distorting the pr ocess it is meant to 
serve – or ‘the tail wags the dog’. T he enforcement of a budgetary control 
system requires sensitivity if this is not to happen.

Chapter 9 
 349 
 The budget as a pot of cash 
In some environments managers may co me to consider the budget as a 
sum of money that has to be spent. This arises particularly in service 
departments or public sector organisa tions, the performance of which is 
gauged mainly through comparison of actual and budget spending. 
The manager of a local authority ‘street cleaning’ department may be 
given an annual budget of $120,000 to  clean the streets. The manager 
knows that she will be punished if s he spends more than $120,000 in the 
year. She also knows that if she spends less than $120,000 in the year 
then her budget will probably be reduced ne xt year. Such a reduction will 
involve a personal loss of status in  the organisation and will make her job 
more difficult in the next year. 
In order to ensure that  she does not overspend her annual budget in the 
current year the manager may spend at a rate of $9,000 per month for 
the first 11 months of the year. This can be achieved by reducing the 
frequency of street cleaning and using poor-quality materials. It allows a 
contingency fund to be accumula ted in case of emergencies. 
However, in the final month of the year the manager has to spend 
$21,000 if she wishes to ensure that her  whole budget is fully used. She 
might achieve this by using extr a labour and high-quality materials. 
Does this behaviour make sense? Of course it does not. The whole 
pattern of behaviour is distorted by the control system. It means that local 
residents have a substandard service for 11 months of the year and 
money is wasted in the 12th month. 
It is, however, a fact that suppliers to government departments and local 
councils often experience a surge in orders towards the end of the 
financial year. This surge is caused  by managers placin g orders at the 
last moment in order to ensure t hat their full budget for the year is 
committed. 
Budget negotiation 
Budgets are normally arrived at by a process of negotiation with the 
managers concerned. A budget may actua lly be initiated by departmental 
managers and then corrected as a result  of negotiation with the budget 
officer. 
Clearly, a manager has an incentive to negotiate a budget that is not 
difficult to achieve. This produces a phenomenon known as ‘padding the budget’ or ‘budgetary slack’. A m anager will exagger ate the costs 
required to achieve objectives. This has the following results: 
(1) If the manager succeeds in paddi ng his budget, then the whole 
control exercise is damaged. Co mparison of actual with budget 
gives no meaningful measure of performance and the manager is 
able to include inefficiencies in his operation if he wishes. 
(2) A successful manager becomes one who is a hard negotiator. The 
problem with this is that the negot iations in question are between 
colleagues and not with customers.  ‘Infighting’ may become 
entrenched in the management process.

350  
 (3) A great deal of time and energy that could be directed to the actual 
management of the business is dist racted by what are essentially 
administrative procedures. 
These are all examples of a control system distorting the processes they 
are meant to serve. 
Influence on accounting policies 
Any management accountant who has been engaged in the preparation 
of financial control reports will be fam iliar with attempts by managers to 
influence the accounting policies t hat are used. For example, the 
apportionment of indirect costs be tween departments often contains 
subjective elements. Should securi ty costs be apportioned on the basis of 
floor space or staff numbers? 
The manner in which the indirect  costs are apportioned can have a 
considerable impact on how the perform ance of individual departments is 
perceived. This position creates t he scope and incentive for managers to 
argue over accounting policies. If a manager perceives that her departm ent’s performance is falling below 
budget, then he/she may sift through the costs charged to his/her 
department and demand that some be reclassified and charged 
elsewhere. The time and energy that goes  into this kind of exercise has 
to be diverted from that availabl e for the regular management of the 
business. 
Budget constrained management styles 
When the performance of a manager is assessed by his ability to meet 
budget, then he is likely to adopt a conservative approach to new 
business opportunities that appear . The immediate impact of new 
business ventures is likely to be a rise in capital and operating costs –
with an adverse impact on current per iod profit. The benefits of such 
ventures may only be felt in the long term. Hence, when a new opportunity appears, the manager evaluatin g it may only perceive that its 
acceptance will result in below-budget  performance in the current period 
– and turn it down on this ground alone.  Another consideration is that 
reliance on budgetary control is  an approach to management that 
involves sitting in an office and re ading financial reports. Such an 
approach (in conjunction with features su ch as executive dining rooms) 
may result in an unsatisfactory co rporate culture based on hierarchies 
and social divisions. Large organisati ons that rely heavily on budgetary 
control systems often take on an ‘ossified’ character. 
Yet another consideration is that a reliance on budgetary planning may 
induce managers to favour projects  and developments that are most 
amenable to the construction of budget s. Projects that involve little 
uncertainty and few unknowns are easy to incorporate in budgets and hence managers may be more inclined to adopt such projects than the 

Chapter 9 
 351 
 Projects that involve significant uncer tainties may be attractive if they 
incorporate some combination of high expected returns and low cost 
interim exit routes – but a budget constrained manager may be 
disinclined to adopt such projects si mply because they are difficult to 
incorporate in budgets. Some writ ers suggest that the budgetary 
approach may be particularly inappropria te in a dynamic and turbulent 
The general conclusion concerning this and previous points is that good 
budgetary control can offer certain benefits. However, when budgetary 
control is enforced in a rigid or in sensitive manner it may end up doing 
more harm than good. 
Setting the difficulty  level of targets 
Much of the early academic work on budgets concerned the extent to 
which the ‘tightness’ or looseness’ of  a budget acted as an incentive or 
disincentive to management effort. This was the issue of ‘budget stretch’.  
The main thrust of the findings t hat emerged from these studies was: 
(1) Loose budgets (i.e. ones easily attainable) are poor motivators 
(2) As budgets are tightened, up to a point they become more 
motivational 
(3) Beyond that point, a very tight budget ceases to be motivational.  
The role of budget participation and t he manner in which aspirations and 
objectives are stated was also expl ored in certain studies. It was 
suggested that the participation of  managers in budget setting was a 
motivational factor – but see earlier discussion concerning budget 
padding and negotiation. 
Ethical aspects of budgeting 
Budgeting creates a number of ethical dilemmas for organisations. We have 
already seen one of these dilemmas wher e the level of participation must be 
determined. If managers are allowed to have a high level of participation and a 
bottom-up approach is used this can have a number of ethical im plications such 
as: 
 Inclusion of slack. The manager may make the budget easier to achieve in 
order to protect financial rewards, improve performance appraisals, reduce 
their workload etc. Not only does this unethical practice create 
unwarranted rewards for the budget  holder it can have knock-on 
implications elsewhere in the busine ss. It could mean that resources are 
not allocated to other parts of t he business that require them (thus 
impacting on financial rewards for the business as a whole), it may mean 
that production does not meet customer  demand (so that sales and market 
share are lost) and could have implicat ions for other budget holders (such 
as marketing and recruitment) who are aiming to co-ordinate their 
activities with the activities presented in this budget. The poor ethical practices of the budget holder, caused by the bottom-up approach to budgeting, can therefore fail in achi eving many of the purposes of 
budgeting such as co-ordination, ut ilisation, motivation and evaluation.

352  
 The manager puts personal goals ahead of organisational goals. The 
manager may be more concerned with, sa y, quality of the product or levels 
of staffing than is planned for in the overall organisational plan. This lack 
of goal congruence can mean that the organisation is likely to fail in 
meeting its strategic objectives. For example, in a competitive market an 
organisation might choose to pursue a strategy which aims to sell the 
product at a price which undercuts the se lling price of rivals. This strategy 
will be difficult to achieve if a man ager pursues a strategy of improving 
quality (and therefore increasing costs) which make s it more difficult to 
achieve a low selling price. Like wise, in a gover nment funded health 
service there may be a goal to reduce repeat treatments for patients. But 
this would be frustrated if budget holders create a budget focused on 
reducing time per patient appointment in  order to achieve reduced waiting 
times for patients. 
 The manager might produce overly- optimistic budgets. The manager of a 
subsidiary, for example, may want  potential performance to look as 
favourable as possible in order to prot ect the subsidiary from sell-off or 
closure or to improve their own chances  of promotion. But this can lead to 
further unethical practices such as ov er-stating results or even fraudulently 
recording non-existing sales in order to then satisfy the overly-optimistic 
forecast. If these practices come to  light there can be a very negative 
reaction from wider stakeholders  such as the general public. 
Moving to a top-down approach to budgeting does not offer a solution to the 
ethical dilemmas as this system  can create its own dilemmas: 
 The budget preparer may be putting undue pressure on the budget holder 
to achieve a desired result. Budget preparers often set challenging (or 
‘stretch’ goals) in order to motivate  the budget holder to achieve improved 
performance. This can cause stress for the budget holder as well as 
inducing the budget holder to employ unet hical practices of their own in 
order to achieve the target. 
 Likewise, budget preparers are often a ccused of ‘pseudo’ participation in 
the budget setting process which may in itself be unethical. The budget 
holder is allowed to feel that they have some input and participation in the 
budget but actual decisions are approv ed and controlled centrally. This 
can ultimately lead to poor motivati on and job satisfaction for the budget 
holder with typical repercussions such as poor time keeping, absenteeism 
and even the loss of the employee altogether.

Chapter 9 
 353 
The level of participation considers t he ethical issues with respect to the 
preparation of the budget. But there are further ethical issues in the budgetary 
control process: 
 The budget holder may overstate result s in order to appear to achieve a 
target that they did not actually meet (and this may even be achieved 
through fraudulent practices). This c an result in undue rewards given to 
the budget holder but also to false information being provided to other key stakeholders. For example, high er dividends might be paid to 
shareholders or inaccurate informati on being provided to other providers 
of finance such as banks. In the long te rm this is likely to catch up with the 
organisations when these results are not  maintainable and the associated 
cash from the positive performance is  not built up within the organisation. 
 The budget holder may make decisions which focus on short-term 
performance at the expense of the l ong term good health of the business. 
For example, staff training may be reduc ed in order to meet a cost target, 
thus harming staff development in ca reer paths in the longer term. 
 In order to meet tar gets the budget holder may employ unethical practices. 
For example, in order to achieve a high sales target in a competitive 
market a budget holder might use aggr essive sales tactics on potential 
customers such as over-representing pr oduct features or  putting pressure 
on customers to buy complementary pr oducts that they may not actually 
need. 
 When reviewing the performance of  the budget holder there is often a 
system of ‘management by exception’ in place. This means that budgets 
are only reviewed for unusual areas of performance where there is a 
substantial difference between the ac tual results and the budget. This 
means that managers who achieve a performance that is near to the 
original budgeted performance may feel that they receive no attention and 
consideration. The budget holder c an feel undervalued and demotivated 
by this. 
 If top-down budgeting is used there can be an unethical desire to broaden 
the area of responsibility for what is controllable by the budget holder. For 
example, a subsidiary may be made to  bear the cost of parent company 
accounting costs even though it has no cont rol over this activity. This can 
impact on the appraisal of the subsidiary’s financial performance as removing budget holder trust in the entire budgeting process. 
The budget process therefore needs to find an ethical balance which motivates 
improved and optimal perform ance without creating conf licts of interest and 
motivating dishonest accounting and the im proper allocation of resources. Many 
of these problems are caused by focusi ng on a single fin ancial measure of 
performance which is why many organisati ons are moving to approaches such 
as beyond budgeting approaches covered in the previous chapter.

Chapter 9 
 355 
 The following fixed and flex ible budgets have been prepared: 
 Fixed 
budget  
100% level Flexible 
budget  
90% level 
 $ $ 
Sales 750,000 675,000 Direct variable costs 420,000 378,000 
Overheads 230,000 216,800 
Total costs 650,000 594,800 Profit 100,000 80,200 
Actual sales for the period were  $700,000 and there was an adverse 
sales price variance of $5,000 (A). 
Required: 
Prepare a flexible budget for t he actual level of sales. 
 
 An office manager uses the high-low method to establish the expected 
costs for office expenses, based on the following data for monthly 
expenses: 
 Costs for 6,000 
labour hours Costs for 8,000 
labour hours 
 $ $ 
Heating and light ing 17,000 18,000 
Telephones 7,200 8,400 
Sundry expenses 29,400 33,400 
Variable costs are assumed to va ry with the number of labour hours 
worked in the office during the period. 
In the most recent month, 7,700 labour hours were worked and actual 
costs were as follows: 
 $ 
Heating and lighting 17,600 
Telephones 8,750 
Sundry expenses 32,600 
Required: 
Calculate the cost variances for the month.

356  
 Extracts from the budgets of B Ltd are given below: 
Sales and inventory budgets (units) 
 Period 
1 Period 
2 Period 
3 Period  
4 Period 
5 
Opening inventory 4,000 2,500 3,300 2,500 3,000 
Sales 15,000 20,000 16, 500 21,000 18,000 
Cost budgets ($000) 
 Period 
1 Period 
2 Period 
3 
Direct materials 108.0 166.4 125.6 
Direct labour 270.0 444.0 314.0 
Production overheads (excluding 
depreciation) 117.5 154.0 128.5 
Depreciation 40.0 40.0 40.0 
Administration overhead 92.0 106.6 96.4 
Selling overhead 60.0 65.0 61.5 
(i) Production above 18,000 units incu rs a bonus in addition to normal 
wages rates 
(ii) Any variable costs contained in  the selling overhead are assumed to 
vary with sales. All other variabl e costs are assumed to vary with 
Required: 
(a) Calculate the budgeted production for periods 1 to 4 
(b) Prepare a suitable co st budget for period 4. 
In period 4 the inventory and sales budgets were achieved and the 
following actual costs recorded: 
 $000 
Direct material 176 
Direct labour 458 
Production overhead 181 Depreciation 40 
Administration overhead 128 
Selling overhead 62  –––– 
 1,045 
 ––––

Chapter 9 
 357 
 Required: 
(c) Show the budget va riances from actual 
(d) Criticise the assumptions on which the cost budgets have been 
prepared. 
 
department. The budgeted costs are: 
 Cost driver Budgeted cost 
Receiving goods Number of deliveries $80 per delivery 
Issuing goods from 
store Number of stores requisitions $40 per requisition 
Ordering Number of orders $25 per order 
Counting inventory Nu mber of inventory 
counts $1,000 per count 
Keeping records – $24,000 each year 
Supervision – $30,000 each year Actual results for April were: 
 Activity Actual cost 
  $ 
Receiving goods 45 or ders delivered 3,450 
Issuing goods 100 requisitions 4,400 
Ordering 36 orders 960 
Counting 2 inventory counts 1,750 Record keeping  1,900 
Supervision  2,700 
  –––––– Total costs  15,160 
  –––––– 
Required: 
Prepare a variance repor t for the month.

358  
 Scenario 
The materials purchasing manager is assessed on: 
 total material expendit ure for the organisation 
 the cost of introducing safety me asures, regarding the standard and 
the quality of materials, in accordance with revised government 
 a notional rental cost, allocat ed by head office, for the material 
storage area. 
Task: 
Discuss whether these costs are contro llable by the manager and if they 
should be used to appraise the manager. 
 
 Explain whether a production manager should be accountable for direct 
labour and direct materi als cost variances. 
 (Time allowed: 10 minutes)

Chapter 9 
 359 
 Example 1 
 The correct answer is answer A. 
The shared central overheads should not be included as a controllable 
cost as the manager cannot normally influence costs which are incurred 
elsewhere. All of the variable (dir ect) costs should be included as being 
controllable by the manager. In  terms of the fixed cost s, all of the indirect 
fixed labour cost and 40% of the other fixed ov erheads are directly 
attributable to the department and s hould be included as a controllable 
cost. 
Therefore the total controllabl e costs are = $1, 165,000 + $28,000 + 
$80,000 + (40% × $100,000) = $1,313,000.  
 
 (W1) Actual sales at budgeted prices  
 $ 
Actual sales at ac tual prices 700,000 
Sales price variance 5,000 (A) 
Actual sales at budgeted prices 705,000 
Actual sales are therefore at t he (705/750) 94% activity level. 
(W2) Fixed and variable overheads 
 $ Overheads at 100% activity level 230,000 
Overheads at 90% activity level 216,800 Variable overheads for 10% activity 13,200 
 
 $ Total overheads at 100% activity level 230,000 
Variable overheads at 100% activity level 132,000 
Fixed overheads 98,000 
Flexed budget 94% activity 
 $ $ Sales  705,000 Direct variable costs (420,000 × 94%)  394,800 
Variable overhead (13, 200 × 94/10)  124,080 
Fixed overhead  98,000 
Total overheads  222,080 
Total costs  616,880 
Profit  88,120

360  
  
 Heating and 
lighting Telephones Sundry 
expenses 
 $ $ $ 
Total cost for 8,000 hours 18,000 8,400 33,400 
Total cost for 6,000 hours 17,000 7,200 29,400 
 –––––– –––––– –––––– Variable cost for 2,000 hours 1,000 1,200 4,000 
 –––––– –––––– –––––– Variable cost per hour $0.50 $0.60 $2.00  –––––– –––––– –––––– 
 
expenses 
 $ $ $ Total cost for 8,000 hours 18,000 8,400 33,400 Variable cost for 8, 000 hours 4,000 4,800 16,000 
 –––––– –––––– –––––– Fixed costs 14,000 3,600 17,400  –––––– –––––– –––––– 
For 7,700 hours 
expenses 
 $ $ $ Expected fixed costs 14,000 3,600 17,400 Expected variable cost 3,850 4,620 15,400 
Expected total cost 17,850 8,220 32,800 Actual cost 17,600 8,750 32,600 
 –––––– –––––– –––––– Cost variance 250 (A) 530 (A) 200 (F) 

Chapter 9 
 361 
 (a) 
 Period  
1 Period  
2 Period 
3 Period  
4 Period 
5 
Sales 15,000 20,000 16,500 21,000 18,000 
Add: Closing 
inventory 2,500 3,300 2,500 3,000  
Less: 
Opening inventory (4,000) (2,500) (3,300) (2,500) (3,000) 
 –––––– –––––– –––––– –––––– –––––– 
Production 13,500 20, 800 15,700 21,500 – 
(b) In Period 4, Production = 21,500 units 
  $000 
Direct materials (W1) 172.0 
Direct labour (W2) 465.0 Production overhead (W3) 157.5 
Depreciation  40.0 
Administration overhead (W4) 108.0 Selling overhead (W5) 66.0 
  –––––– 
  1,008.5   –––––– 
Working 1 
$108,000 (Period 1)
13,500 units
 = $8 × 21,500 = $172,000 
Working 2 
Normal wage 	$270,000
13,500 = $20 per unit 
 
Bonus (Period 2) = $444,000 – ( 20,800 × $20) = $28,000 premium 
 
Premium rate: $28,000
2,800 units above 18,000 = $10 per unit 
 
in Period 4, (21,500 × $20)  + (3,500 × $10) = $465,000

362  
 Working 3 
Variable cost per unit = 154 – 117.5
20.8 – 13.5  =	 36.5
7.3 = $5 per unit 
Working 4 
Variable cost per unit = 106.6 – 92.0
20.8 – 13.5  =  14.6
7.3 = $2 per unit 
Working 5 Variable cost per unit 	ൌ 65.0 – 60
20.0 sales – 15.0
 = $1 per unit 
 
Fixed cost = $60,000 – ($1 × 15,000) = $45,000 
In Period 4, ($1 × 21,000) + $45,000 = $66,000 
 P4 
Budget P4 
Actual Variance Adverse/ 
Favourable 
 $ $ $  
Material 172.0 176.0 4.0  
Labour 465.0 458.0 7.0 Adverse 
Production overhead 157.5 181.0 23.5 Favourable 
Depreciation 40.0 40.0 0.0 – 
Administration overhead 108.0 128.0 20.0 Adverse 
Selling overhead 66.0 62.0 4.0 Favourable 
 –––––– –––––– –––––  
 1,008.5 1,045.0 36.5 Adverse 
(d) 
– Linear costs 
– No Incremental fixed costs – Variable cost per unit is constant – Volume the only factor to affect total costs.

Chapter 9 
 363 
  
 $ $ $ 
Receiving goods 45 orders delivered 3,600 3,450 150 (F) 
Issuing goods 100 requisitions 4,000 4,400 400 (A) Ordering 36 orders 900 960 60 (A) 
Counting 2 inventory counts 2,000 1,750 250 (F) 
Record keeping 2,000 1,900 100 (F) 
Supervision 2,500 2,700 200 (A) 
 15,000 15,160 160 (A)  –––––– –––––– –––––– 
 
 The total material expenditure fo r the organisation will be dependent 
partly on the prices negotiated by the purchasing manager and partly by 
the requirements and performance of t he production department. If it is 
included as a target for performa nce appraisal the manager may be 
tempted to purchase cheaper material which may have an adverse effect 
elsewhere in the organisation. 
The requirement to introduce safety  measures may be imposed but the 
manager should be able to ensure t hat implementation meets budget 
targets. A notional rental cost is outside the control of the manager and should 
not be included in a target fo r performance appraisal purposes. 
 
  The production manager will be responsible for managing direct 
labour and direct material usage. 
 However, the manager may not be able to influence: 
– the cost of the material – the quality of the material – the cost of labour – the quality of labour. 
 Performance should be measured agai nst the element of direct cost 
which the manager can control.

365 
Relevant costs and 
decision making 
C1. Describe the main types of short-term decisions made by organisations (a) Describe pricing and 
revenue maximisation 
(b) Describe product 
C2. Explain the underlying concepts used for short-term decision making (a) Explain the objectives of 
(b) Explain the underlying 
concepts of short-term decision making. 
C3. Apply appropriate techniques to support short-term decisions (a) Relevant cost analysis. 
  Chapter 
10

Relevant costs and decision making 
366  
1 Session Content Diagram 
 
2 Introduction to relevant costs and revenues 
Organisations face many decisions, and t hey usually must choose between two 
or more alternatives. Decisions will generally be based on taking the decision 
that maximises shareholder value, so all decisions will be taken using relevant 
costs and revenues. Relevant costs and revenues are those costs and 
revenues that change as a direct result of a decision taken.  
 
 Characteristics of relevant costs 
 In its Official Terminology, CIMA defines 'relevant costs'  and 'relevant 
revenues' as the 'costs and revenues appropriate to a specific management decision; they are repres ented by future cash flows whose 
magnitude will vary depending upon the outcome  of the management 
decision made(...)'. 
Relevant costs and revenues have the following features: (1) They are future costs and revenues  – as it is not possible to 
change what has happened in the pas t, then relevant costs and 
revenues must be future costs and revenues. 
(2) They are incremental or differential  – relevant costs are 
incremental costs and it is the increase in costs and revenues that 
occurs as a direct result of a decision taken that is relevant. Common costs can be ignored for the purposes of decision making. Look out for costs detailed as diffe rential, specific or avoidable. 
CIMA defines 'avoidable costs' as 'the specific costs of an activity or 
sector of a business which would be avoi ded if that activity or sector did 
not exist.'

Chapter 10 
 367 
 For example, if a company is considering shutting down a 
department, then the avoidab le costs are those that would be saved 
as a result of the shutdown. Su ch costs might include the labour 
costs of those employed in the depar tment and the rent al cost of the 
space occupied by the department. The latter is an example of an 
attributable  or specific fixed cost. Costs such as apportioned head 
office costs that would not be sav ed as a result of the shutdown are 
unavoidable costs. They are not relevant to the decision. 
(3) They are cash flows  – in addition, future co sts and revenues must 
be cash flows arising as a direct consequence of the decision taken. 
Relevant costs do not include items which do not involve cash flows (depreciation and notional costs for example). 
In an examination, unless told otherwis e, assume that variable costs are 
relevant costs. 
Non-relevant costs 
A distinction mu st be made between relevant and non-relevant  costs for the 
purposes of management decision-making. 
This has many implications: 
Sunk costs 
A sunk cost has already been incurred and therefore will not be relevant to the 
investment decision. 
Committed costs 
Expenditure that will be incurred in the future , but as a result of decisions taken 
in the past that cannot now be changed. These are known as committed costs 
and are not treated as relevant  costs for decision making. 
Fixed costs 
Should be treated as a whole, and only w here relevant. This means that fixed 
overheads that are "absorbed" /"charged"/"allocated"/"apportioned" to a project 
should be ignored. Only extra/increment al changes in fixed overheads should 
be included in decisions. 
Depreciation is not a cash flow, and so should never  be included in decisions

368  
 Further details  
 Relevant costs are those which wil l be affected by the decision being 
taken. All relevant costs should be considered in management decision-
making. If a cost will remain unalter ed regardless of the decision being 
taken, then it is called a non-rele vant cost or irrelevant cost. 
Costs that are not usually relevant  in management decisions include the 
(a) Sunk or past costs. This is a 'c ost that has been irreversibly incurred 
or committed and cannot therefor e be considered relevant to a 
decision. Sunk costs may also be termed irrecoverable costs' (CIMA 
Official Terminology). An example of a sunk cost is expenditure that 
has been incurred in developing a new product. The money cannot 
be recovered even if a decisio n is taken to abandon further 
development of the new product. The cost is therefore not relevant 
to future decisions concerning the product. 
(b) Expenditure that will be incurred in the future, but as a result of 
decisions taken in the past that  cannot now be changed. These are 
known as committed costs. They can sometimes cause confusion because they are future costs. However, a committed cost will be incurred regardless of the decisio n being taken and therefore it is 
not relevant. An example of this  type of cost could be expenditure 
on special packaging for a new product, where the packaging has been ordered and delivered but not yet paid for. The company is obliged to pay for the packaging even if they decide not to proceed 
with the product; therefore it is not a relevant cost. 
(c) Absorbed fixed overheads that will not increase or decrease as a 
result of the decision being take n. The amount of overhead to be 
absorbed by a particular cost unit might alter because of the decision; however, this is a result of the company’s cost accounting 
procedures for overheads. If the actual amount of overhead incurred 
by the company will not alter, t hen the overhead is not a relevant 
cost. 
(d) Historical cost depreciation. Depreciation is an accounting 
adjustment but does not result in any  future cash flows. They are 
merely the book entries that are des igned to spread the original cost 
of an asset over its useful life. 
(e) Notional costs such as notional rent and notional interest. These are 
only relevant if they represent an identified lo st opportunity to use 
the premises or the finance fo r some alternative purpose. 
In these circumstances, the notional costs would be opportunity costs. This explanation will becom e clearer when you learn more 
about opportunity costs later in this chapter. 
It is essential to look to the future  when deciding which costs are relevant 
to a decision. Costs that have al ready been incurred or  that will not be 
altered in the future as a result  of the decision being taken are not 
relevant costs.

Chapter 10 
 369 
 Example 1 
 As part of a new product develop ment a company has employed a 
building consultant to perfo rm an initial survey. This initial survey has cost 
$40,000. But there will be an ongoing need for her services if the 
company decides to proceed with the project. This wo rk will be charged 
at a fixed rate of $20,000 per annum. 
What relevant cost should be in cluded for the building consultants 
services in the first year when cons idering whether t he project should 
proceed? A $0 B $20,000 C $40,000 D $60,000 
Opportunity cost 
'Opportunity cost' is an important c oncept in decision making. It represents the 
best alternative that is fo rgone in taking the decision . The opportunity cost 
emphasises that decision making is concer ned with alternatives and that a cost 
of taking one decision is the profit or contribution forgone by not taking the next 
best alternative. If resources to be used on projects are scarce (e.g. labour, materials, 
machines), then consideration must be gi ven to profits or contribution which 
could have been earned from alternat ive uses of the resources. 
For example, the skilled labour whic h may be needed on a new project might 
have to be withdrawn from normal producti on. This withdrawal would cause a 
loss in contribution which is obviously  relevant to the project appraisal. 
The cash flows of a single department or division cannot be looked at in 
isolation. It is always the effects on cash  flows of the whole organisation which 
must be considered.  
 
Further details on opportunity costs 
  
An opportunity cost is a special type of relevant cost. It is defined in the 
CIMA Terminology as ‘the value of the benefit sacrificed when one 
course of action is chosen, in preference to an alternative. The 
opportunity cost is represented by t he forgone potential benefit from the 
best rejected course of action.' 
With opportunity costs we are concer ned with identifying the value of any 
benefit forgone as the result of ch oosing one course of action in 
preference to another.

370  
 Examples of opportunity costs 
The best way to demonstrate opportunity costs is to consider some 
examples. 
(a) A company has some obsolete mate rial in inventory that it is 
considering to use for a special cont ract. If the material is not used 
on the contract it can either be so ld back to the supplier for $2 per 
tonne or it can be used on another contract in place of a different 
material that would usually cost $2.20 per tonne. The opportunity cost of using the ma terial on the special contract is 
$2.20 per tonne. This is the value of  the next best alternative use for 
the material, or the benefit for gone by not using it for the other 
contract. 
(b) Chris is deciding whether or not to take a skiing holiday this year. 
The travel agent is quoting an all-incl usive holiday cost of $675 for a 
week. Chris will lose the chance to earn $200 for a part-time job 
during the week that the holiday would be taken. 
The relevant cost of taking the holid ay is $875. This is made up of 
the out-of-pocket cost of $675, pl us the $200 opportunity cost, that 
is the part-time wages forgone. 
Notional costs and opportunity costs 
Notional costs and opportunity costs are o ften similar. This is particularly 
noticeable in the case of notional r ent. The notional rent could be the 
rental that the company is forgoing by  occupying the premises itself, that 
is it could be an opportunity cost. Ho wever, it is only a true opportunity 
cost if the company can actually i dentify a forgone opportuni ty to rent the 
premises. If nobody is willing to pay t he rent, then it is not an opportunity 
cost. 
Avoidable, differential  and incremental costs 
There are two other types of relev ant cost that you will need to know 
about: avoidable costs and differential/incremental costs. 
Avoidable costs 
CIMA defines avoidable costs as ‘the specific costs of an activity or 
not exist’. 
For example, if a company is co nsidering shutting down a department, 
then the avoidable costs ar e those that would be sav ed as a result of the 
shutdown. Such costs might include t he labour costs of those employed 
in the department and the rental co st of the space occupied by the 
department. The latter is an example of an attributable or specific fixed 
cost. Costs such as apportioned head o ffice costs that would not be 
saved as a result of the shutdown are unavoidable costs. They are not 
relevant to the decision.

Chapter 10 
 371 
 Differential/incremental costs 
CIMA defines a differential/incremental cost as ‘the difference in total cost 
between alternatives. This is calculated to assist decision making’. 
For example, if the relev ant cost of contract X is  $5,700 and the relevant 
cost of contract Y is $6,200, we would say that the differential or 
incremental cost is $500, that is the extra cost of contract Y is $500. 
Using incremental costs 
Incremental costs can be us eful if the cost account ant wishes to highlight 
the consequences of taking sequential st eps in a decision. For example, 
the accountant might be pr oviding cost informat ion for a decision about 
whether to increase the number of employees in a department. 
Instead of quoting several different to tal-cost figures, it might be more 
useful to say ‘the incremental cost per five employees will be $5,800 per 
month’. 
Remember that only relevant costs should be used in the calculations.  
 
 Example 2 
 A company which manufactures and sells one single product is currently 
operating at 85% of full capacity, producing 102,000 units per month. The 
current total monthly costs of pro duction amount to $330,000, of which 
$75,000 are fixed and are expected to remain unchanged for all levels of 
activity up to full capacity. A new potential customer has expre ssed interest in taking regular 
monthly delivery of 12,000 units at a price of $2.80 per unit. 
All existing production is sold each mont h at a price of $3.25 per unit. If 
the new business is accepted, existing sales are expected to fall by 2 
units for every 15 units so ld to the new customer. 
What is the overall increase in mont hly profit which w ould result from 
accepting the new business? 
Incremental revenue 
Just as incremental costs are the differences in cost  between alternatives, so 
incremental revenues are the differences in revenues between the alternatives. Matching the incremental costs against t he incremental revenues will produce a 
figure for the incremental gain or  loss between the alternatives. 
3 The relevant cost of variable costs and overheads 
When we put the principles of rele vant and non-relevant costs together, and 
then combine these with the complications  brought in by opportunity costs, we 
have many things to consider in determini ng the relevant costs of areas such as 
materials, labour and overheads. This section looks at some of these costs in more detail in order to develop some cr iteria for determining the relevant cost.

372  
The relevant cost of materials 
The following flow chart should provide a us eful reminder of t he points that must 
be considered when ascertaining the relevant cost of materials: 
 
 Example 3 
 A company is considering a short-term pricing decision for a contract that 
would utilise some material P that it has held in inventory for some time. 
The company does not foresee any other  use for the material. The work 
would require 1,000 kgs of Material P. 
There are 800 kgs of Material P in inventory, which were bought some 
time ago at a cost of $3 per kg. T he material held in inventory could 
currently be sold for $3.50 per kg. T he current purchase price of Material 
P is $4.50 per kg. What is the relevant cost of Mate rial P for the company to use when 
making its pricing decision for the contract closest to?

Chapter 10 
 373 
The relevant cost of labour 
 
 Example 4 
 100 hours of skilled labour are needed fo r a special contract. The staff 
are working at full capacit y at the moment and the workers would have to 
be taken off production of a different product in order to work on the 
special contract. The details of t he other product are shown below: 
 $/unit 
Selling price 60 Direct material 10 
Direct labour 1 hour @ $10/hour 10 
Variable overheads 15 
Fixed overheads 15 
The skilled workers’ pay rate woul d not change, regardless of which 
product they worked on. What would be the relevant cost?

374  
The relevant cost of overheads 
In addition to calculating the relevant co st of materials and labour, you may also 
be required to calculate the relevant cost of overheads. 
 
 Example 5 
 JB absorbs overheads on a machi ne hour rate, currently $20/hour, of 
which $7 is for variable overheads and $13 for fixed overheads. The 
company is deciding whether to underta ke a contract in the coming year. 
If the contract is undertaken, it is estimated that fixed costs will increase 
for the duration of the c ontract by $3,200. The co ntract would require 800 
hours of machine time. 
What is the relevant cost of overheads for the contract? A $3,200 B $5,600 C $8,800 D $16,000 
The relevant cost of non-current assets 
The relevant costs associated with non-current assets, such as plant and 
machinery, are determined in a similar way to the relevant costs of materials. 
 If plant and machinery is to be replac ed at the end of its useful life, then 
the relevant cost is the current replacement cost. 
 If plant and machinery is not to be repl aced, then the relevant cost is the 
higher of the sale proceeds (if sold) and the net cash inflows arising from 
the use of the asset (if not sold).

Chapter 10 
 375 
 Example 6 
 Equipment owned by a company has a net book value of $1,800 and has 
been idle for some months. It co uld now be used on a six months 
contract that is being considered. If not used on this contract, the 
equipment would be sold now for a net  amount of $2,000. After use on 
the contract, the equipment would have no resale value and would be 
dismantled. 
What is the total relevant cost of the equipment to the contract? 
A $0 B $1,800 C $2,000 D $3,800
 
 Example 7 
 The CS group is planning its annual marketing conference for its sales 
executives and has approached the VBJ Holiday company (VBJ) to 
obtain a quotation. VBJ has been tryi ng to win the business of the CS 
group for some time and is keen to provide a quotation which the CS group will find acceptable in the hope that this will lead to future 
contracts. 
The manager of VBJ has produced the following cost es timate for the 
conference: 
 $ 
Coach running costs 2,000 Driver costs 3,000 Hotel costs 5,000 General overheads 2,000  –––––– Sub total 12,000 Profit 30% 3,600  –––––– Total 15,600  –––––– 
You have considered this cost estimate  but you believe that it would be 
more appropriate to base the quotation on relevant costs. You have therefore obtained the follo wing further information: 
Coach running costs represent t he fuel costs of $1,500 plus an 
apportionment of the annual fixed cost s of operating the coach. No 
specific fixed costs would be incu rred if the coach is used on this 
contract. If the contract did not go ahead, the coach would not be in use 
for eight out of the ten days of the conference. For the other two days a 
contract has already been accepted whic h contains a significant financial 
penalty clause. This contract earns a contribution of $250 per day. A replacement coach could be hired for $180 per day.

376  
 Driver costs represent the salary  and related employment costs of one 
driver for 10 days. If the driver is  used on this contract the company will 
need to replace the driver so that VBJ  can complete its existing work. The 
replacement driver would be hir ed from a recrui tment agency that 
charges $400 per day for a suitably qualified driver. Ho tel costs are the 
expected costs of hiring the hotel for the conference. 
General overheads are based upon the overhead absorption rate of VBJ 
and are set annually when the company  prepares its budgets. The only 
general overhead cost that can be s pecifically identified with the 
conference is the time that has been s pent in considering the costs of the 
conference and preparing the quotati on. This amounted to $250. 
Required: 
Prepare a statement showi ng the total relevant cost of the contract. 
Explain clearly the reasons for each of the values in your quotation and 
for excluding any of th e costs (if appropriate). 
4 Decision making based on re levant costing principles 
There are many decisions that an organi sation might have to make which will 
either be to solve short term problem s (such as a short term scarcity of 
resources) or that may only be one-off in nature (such as whether to close a 
particular division). 
The types of decisions that you may be asked to deal with include and which 
are explored in the fo llowing sections are: 
 Limiting factor decisions 
 Make or buy decisions 
 Shutdown decisions, including deleti ng a segment or temporary closure 
 Accept or reject an order decisions 
 Minimum pricing decisions 
 Joint product and further processing decisions. 
In all of these decisions it will be important to remember that only relevant 
costs  should be used in the calculations. 
Limiting factor decisions 
A limiting factor refers to  a resource which prevents a company from achieving 
the output and sales that it  would like to achieve. Businesses often operate 
under short term restrictions on resour ces (for example, staff time may be 
limited during a strike). T hey therefore may not be able to produce all products 
that make a positive contribution and need to prioritise products and choose 
between them.

Chapter 10 
 377 
Single limiting factor 
 
 If there is a just one limiting factor then the rule is to maximise the 
contribution per unit of scarce resource.  
The contribution per unit of each product is calculated and divided by the 
amount of scarce resource each product uses. The higher the contribution per 
unit of scarce resource the greater the priority that should be given to the 
product. 
 
 Once the priorities have been decided the scarce resource is allocated to 
the products in the order of the priorities until used up. 
 
 Limiting factor analysis step-by-step technique 
 The usual objective in questions is to  maximise profit. Given that fixed 
costs are unaffected by the producti on decision in the short run, the 
approach should be to maximise  the contribution earned. 
If there is one limiting fa ctor, then the problem is best solved as follows: 
Step 1:  identify the bottleneck constraint  (also known as the limiting 
factor, key budget factor or principal budget factor). 
Step 2:  calculate the contributi on per unit for each product. 
Step 3:  calculate the contribution per uni t of the bottleneck resource for 
each product. 
Step 4:  rank the products in order of the contribution per unit of the 
bottleneck resource. Step 5:  allocate resources using this ranking and answer the question. 
 
 Example 8 
 A company produces three products, and is reviewing the production and 
sales budgets for the next accounting period. The following information is 
available for the three products: 
 Product P Product Q Product R 
 $ $ $ $ $ $ 
Selling price  600  300  100 Labour ($20 per hour) 300  160  40  Other variable costs 90  68  14   ––––  ––––  ––––    (390)  (228)  (54)   ––––  ––––  –––– Contribution/unit  210  72  46   ––––  ––––  –––– Maximum demand (units)  200  600  1,000 
Labour hours are strictly limit ed to 7,800 hours in total.

378  
 Required:  
(a) Calculate the optimum product mix and the maximum contribution. 
(b) A special contract requires 3,000  labour hours. What is the relevant 
cost of obtaining these hours? 
 
 This technique is the appropriate approach for dealing with a situation 
where there is only one scarce resour ce. If there is more than one scarce 
resource then linear programming would have to be used. Linear 
programming is covered in a later chapter. 
Make or buy decisions 
This is an extension of the limiting factor  problem. If it is possible to buy-in the 
product and therefore avoid t he use of the limiting fact or then the products need 
to be ranked differently: 
 
 Products should be ranked (from highest to lowest) based on the saving 
made (the difference between the buy-in co st and the incremental cost of 
internal production) per usage of the scarce resource.  
 
 Businesses may be faced with the dec ision whether to make components 
for their own products themselves or to concentrate their resources on 
assembling the products, obtaining the components from outside 
suppliers instead of making them 'in house'. 
If the resources are bought in, their purc hase cost is wholly marginal (i.e. 
direct). However, if it is dec ided to manufacture the components 
internally, the comparative costs of  doing so will be the direct materials 
and wages costs, plus the variable fact ory overhead. If the total variable 
costs of internally manufactured components is seen to be greater than 
the cost of obtaining similar com ponents elsewhere, it  is obviously 
uneconomic to produce these items internally. Business therefore need to compare these two costs (the buy-in cost and 
the internal production cost). The te chniques to determine the production 
plan is then based on the same tec hniques used in any other limiting 
factor decision.

Chapter 10 
 379 
 Example 9 
 A company manufactures four co mponents (L, M, N and P) which are 
incorporated into different products. All the components are 
manufactured using the same general purpose machinery. The following 
production cost and machine hour data are available, together with the 
purchase prices from  an outside supplier. 
 L M N P 
Production cost: $ $ $ $ 
Direct material 12 18 15 8 
Direct labour 25 15 10 8 Variable overhead 8 7 5 4 
Fixed overhead 10 6 4 3 
 ––– ––– ––– ––– Total 55 46 34 23 
     Purchase price from outside supplier $57 $55 $54 $50 
 Hours Hours Hours Hours 
Machine hours per unit 3 5 4 6 
Manufacturing requirements show  a need for 1,500 units of each 
component per week. The maximum number of general purpose 
machinery hours available per week is 24,000. 
Required: 
Calculate the number of units which should be purchased from the 
outside supplier. 
Accept or reject decisions 
This might occur where a customer has placed a one-off order for a product or a 
service. 
 
 The selling price will alr eady be known and if it is greater than the relevant 
costs the order should be accepted. 
 
 Example 10 
 A company manufactures two models of a pocket calculator: The basic 
model sells for $5.50, has a direct ma terial cost of $1.25 and requires 
0.25 hours of labour time to produce. The other model, the Scientist, sells 
for $7.50, has a direct material co st of $1.63 and takes 0.375 hours to 
produce. 
Labour, which is paid at the rate of $6 per hour, is currently very scarce, 
while demand for the company’s calc ulators is heavy. The company is 
currently producing 8,000 of  the basic model and 4, 000 of the Scientist 
model per month, while fix ed costs are $24,000 per month.

380  
 An overseas customer has offe red the company a contract, worth 
$35,000, for a number of calculator s made to its r equirements. The 
estimating department has ascertained t he following facts in respect of 
the work: 
 The labour time for the c ontract would be 1,200 hours. 
 The material cost would be $9,000 plus the cost of a particular 
component not normally used in the company’s models. 
 These components could be purchased from a supplier for $2,500 
or alternatively, they could be made internally for a material cost of 
$1,000 and an additional lab our time of 150 hours. 
Required: Advise the management as to the action they should take. 
Shutdown decisions 
This type of decision may involve deleti ng (or shutting down) a segment of the 
business, a product line, a service, etc.  In the normal everyday reporting system 
of the business, it is likely that absor ption costing will be used. It may appear 
under this system that one or more  of the business segments appears 
unprofitable. Closure decisions taken on the basis of full absorption costs 
statements may fail to consi der the fact that certain fixed costs allotted to the 
segment to be discontinued are fixed an d may continue if the segment is 
dropped. The focus for shutdown decisi ons should be whether the costs and 
revenues are avoidable. 
 
 Businesses need to therefore dete rmine the difference between forgone 
revenue from the closure and the increm ental cost savings from closure. 
 
 Example 11 
 Wye plc makes and sells four products . The profit and loss statement for 
April is as follows: 
 W X Y Z Total 
 $ $ $ $ $ 
Sales 30,000 20,000 35,000 15,000 100,000 
Cost of sales 16,000 8,000 22,000 10, 000 56,000 
 ––––– ––––– ––––– ––––– ––––– 
Gross profit 14,000 12, 000 13,000 5,000 44,000 
Overhead cost:      
Selling 8,000 7,000 8,500 6,500 30,000 
Administration 2,000 2,000 2,000 2,000 8,000  ––––– ––––– ––––– ––––– ––––– 
Net profit 4,000 3,000 2,500 (3,500) 6,000 
 ––––– ––––– ––––– ––––– –––––

Chapter 10 
 381 
 The management team is concerned about the results, part icularly those 
of product Z, and it has been suggested th at Wye plc would be better off 
if it ceased production of product Z. The production manager has said 
that if product Z were  discontinued the resour ces which would become 
available could be used to increase production of product Y by 40 per 
cent. You have analysed the cost struct ures of each of the products and 
discovered the following: 
 W X Y Z Total 
 $ $ $ $ $ 
Variable costs 4,800 1,600 13,200 5,000 24,600 
Fixed costs 11,200 6,400 8,800 5,000 31,400 
Cost of sales 16,000 8, 000 22,000 10,000 56,000 
The total fixed costs figure includes $20,000 which is not specific to any 
one product, and which has been apportioned to each product on the basis of sales values. If the quantity of any product increases by more than 25 per cent, then the specific fi xed production cost s of the product 
will increase by 30 per cent. 
The selling overhead comprises a fix ed cost of $5,000 per product plus a 
variable cost which varies in proportion to sales value. The fixed cost is 
not specific to any product but the sa les director believes that it should be 
shared equally by the four products. The administration cost is a fixed c entral overhead cost; it is not affected 
by the products made. 
Required: 
(a) Prepare a statement  which shows clearly the results of continuing to 
produce products W, X, Y and Z at  the same volumes as were 
achieved in April. Present your statement in a format suitable for 
management decision-making. 
(b) (i) Prepare a statement  showing clearly the re sults if product Z is 
discontinued, and the number of units of Y is increased in 
accordance with the producti on manager’s statement. 
(Assume that no change in sellin g price per unit is necessary 
to sell the additional units.) 
(ii) Reconcile the profit calcul ated in (a) and (b) (i) above; advise 
the management team as to whether product Z should be 
discontinued. 
(c) Explain briefly any non-financial factors which should be considered 
before discontinuing a product.

382  
Minimum pricing decisions 
The minimum pricing approach is a useful method in situations where there is a 
lot of intense competition, surplus production capacity, clearance of old 
inventories, getting special orders and/or im proving market share of the product. 
 
 The minimum price should be set at the incremental costs of 
manufacturing, plus opportunity costs (if any). 
 
For this type of pricing, the selling pric e is the lowest price that a company may 
sell its product at – usually the price will be the total relevant costs of 
manufacturing.  
 ABC Company has prepared a summary of  its relevant costs for a special 
order: 
  $ 
(i) Material P 120 
 Material Q (280) 
(ii) Labour – (iii) Variable overhead 600 
(iv) Rent forgone 210 
  –––––  Total relevant cost $650 
  ––––– 
This cost of $650 represents the mini mum price that the company should 
charge for the order if they wish to ma ke neither a profit  nor a loss. As 
long as the customer pays $650 for the order, the company profits will not 
be affected. 
Obviously, this represents the absol ute minimum price that could be 
charged. It is unlikely that ABC woul d actually charge this amount. They 
would probably wish to add a profit ma rgin to improve the company’s 
profits. However, this absolute minimum value does give managers a 
starting point for their pricing decisi on. They know that the company will 
be worse off if the price is less t han $650. If perhaps ABC is tendering for 
the order in competition with other suppliers, they may try to obtain some 
information on the likely prices to be tendered by their competitors. If 
these prices are less than or close to  $650, then ABC knows that they will 
not be able to offer a competitive price. On the other hand, if com petitors are likely to tender  a much higher price, 
then the managers know that they ar e able to price competitively.

Chapter 10 
 383 
Joint products and furthe r processing decisions 
Joint products were examined in a previ ous chapter where costs up until the 
split-off point were allocated to the products. 
With many joint products it is possible to  sell the product at the split-off point or 
to send it through a further process whic h will enhance its value. There are two 
rules to follow when ascertaining whether the further processing is worthwhile: 
(1) Only the incremental costs and re venues of the further process are 
relevant 
 
 (2) The joint process costs are irrelev ant – they are already 'sunk' at the 
point of separation. 
 
 The main decisions invo lving joint products are: 
 To carry out the whole process or  not. This decision is made by 
considering the total revenues and costs of the process. A decision 
are produced simultaneously. Th e basis of common cost 
relevant. 
 Whether or not to further proce ss products. This decision is based 
 
 Example 12 
 A processing company operates a common proce ss from which three 
different products emerge. Each of t he three products can then either be 
sold in a market that has many buyers and sellers or further processed 
independently of each other in thr ee other processes. After further 
processing, each of the products can be sold in the same market for a 
higher unit selling price. 
Which of the following is required to determine whether or not any of the 
products should be further proce ssed? (choose all that apply) 
(i) Total cost of the common process (ii) The basis of sharing the co mmon process cost between the three 
products 
(iii) The cost of each of the three additional processes (iv) The unit selling price of each product after further processing 
(v) The unit selling price of each product before further processing 
(vi) The percentage normal loss of each further process (vii) The actual units of output of each product from the common process

384  
 Qualitative factors in decision making 
 In some decision-making situatio ns, qualitative aspects are more 
important than immediate financial benefit  from a decision. They will vary 
with different business circumstances and are those factors relevant to a 
decision that are difficult or impossi ble to measure in terms of money. 
CIMA's Official Terminology defines 'Q ualitative factors' as 'factors that 
are relevant to a decision but are not expressed numerically'. 
For an organisation faced with a decisi on, qualitative factors may include: 
(1) The state of the economy, and its levels of inflation 
(2) The availability of cash 
(3) Effect of a decision on empl oyee morale, schedules and other 
internal elements 
(4) Effect of a decision on long-term future profitability 
(5) Effect of a decision on a com pany's public image and the reaction of 
customers 
(6) The likely reaction of competitors. 
Conflicts with fi nancial accounting 
The decision making techniques descri bed are more concer ned with the impact 
on cash flow rather than the impact on profits. This is because cash flow is 
more objective and harder to  manipulate t han profits. 
 
 Cash versus profit  
 In the short term, profits and cash flow are different. There are several 
reasons for this: 
 Some items of cash spending and ca sh receipt do not affect profits 
at all. In particular capital re ceipts and capital payments do not 
affect profits. A business could earn  a profit but spend large sums of 
money on capital expenditure, so t hat it makes a profit but has a 
negative cash flow. 
 Profits are calculated after deducting depreciation charges on non- 
current assets. Depreciation is a notional charge, and does not 
affect cash flow at all. It is an accounting device for spreading the 
cost of a non-current asse t over its useful life. 
 Cash flow is affected by the need to invest in operational working 
capital. Operational working capital is defined as the working capital 
a business needs to carry on its day -to-day business operations. It 
consists of its inventory (invent ories) plus its trade receivables 
minus its trade payables. Investing in working capital affects cash flow, and when the total amount of working capital of a business changes, the profits earned in the period will differ from the operational cash flows.

Chapter 10 
 385 
 For accounting purposes, in preparing an income statement  there are two 
possible systems that can be used: 
 Cash accounting 
 Accruals accounting 
These systems will provide different prof it figures for the period based on 
different assumptions about how revenues  and costs are recorded in the 
income statement. 
In a system of accruals accounting,  revenues and costs are reported in 
the period where the sale occurs, even if the cash flows for the sale and 
costs of sale occur in different periods, whereas a system of cash 
accounting records cash payments and cash receipts as they occur within an accounting period. Cash accounting is an accounting method 
where receipts are recorded during t he period they are received, and the 
expenses in the period in which they  are actually paid. Basically, when 
the cash is received for a sale, it is  recorded in the accounting books as a 
sale. Its focus is on determining the operational cash flow for the year. 
However, cash accounting is not gener ally accepted as good accounting 
practice because businesses enter into  transactions that are legally 
enforceable prior to the exchange of ca sh, but the use of cash accounting 
does not reflect any transactions which have taken place but are not yet paid for. 
Accruals accounting is recognised by law, and businesses are required to 
use it to measure their profitability for the purpose of external financial 
 Therefore, the decisions  that an organisation makes may have a different 
impact on cash flows than they have on prof its. This may cause an issue for the 
business in that shareholders (and m any other stakeholders) are not always 
provided with the cash impact of decisi ons. Instead the financial reporting that 
they do receive comes from financial stat ements that focus on profit rather than 
cash. In the long term, the cash impact and the profit impact of a decision should be 
equal. However, in the short term t here is likely to be a difference and 
shareholders are more likely to react to a change in profit than a change in 
cash. There may also be a conflict betw een decision making and performance 
measurement. In making decisions manage rs are encouraged to only consider 
relevant costs. But they might then fi nd that their performance is based on total 
costs, whether relevant or not.

386  
 Further details a nd illustration 
 Managers should make decisions on relevant costs. For example, 
consider a manager who is making a decision on whether to discontinue 
one of many products made by an organisation. The manager would 
ignore, for example, the cost alr eady spent on acquiring survey data on 
future expected sales for the produc t as this would be deemed an historic 
cost. 
Using numbers, imagine if the relev ant benefit of discontinuing the 
product was $4,000 because the survey cost (which is sunk) was 
ignored. The survey cost was $7,000. The manager has made a good 
decision which will increase the organisation’s future cash flows by $4,000. 
But the manager’s performance for the period will not be based on 
relevant costs. Instead it will be ba sed on total controllable cost. The 
decision to carry out the sales survey would be seen as a controllable 
one and therefore the survey cost w ould therefore be deducted from the 
manager’s profit for the year (which  could impact on elements such as 
the manager’s annual bonus. 
The manager’s profit for the year, using the numbers above, would fall by 
$3,000 (the $4,000 net benefit minus the $7,000 controllable survey 
cost). The manager’s performance would look worse in the year despite 
the manager making a good decision wh ich will benefit the organisation 
overall. This type of conflict will be explored more in the CIMA P2 syllabus. 
Therefore, decision makers need to cons ider this when making decisions. This 
could be one of the ‘other factors’ that may be relevant to decisions. 
 5 Ethical considerations in short-term decision making 
This chapter has examined a range of decisions and suggested how decisions 
should be made from a financia l view point. But this is only one aspect of 
decision making. There are many non-fi nancial factors that an organisation 
should consider, including the ethica l implications of its decisions. 
Typically, acting ethical means making decisions that go beyond purely financial considerations and instead considers a much wider scope of stakeholder 
perspectives. Ethical organisations will not simply consider the impact on 
shareholder wealth but will also consi der the impact on employees, customers 
and even wider society.

Chapter 10 
 387 
In this chapter we have considered the relevant costs and revenues in shut-
down decisions. For example, a bank might l ook at the relevant financial cost or 
benefit of closing down a branch in a parti cular location. But if the decision was 
broadened to consider ethical issues then the organisation might consider 
issues such as: 
 The impact on staff. If the branch is closed then staff will be made 
redundant if they cannot (or will not)  be relocated elsewhere within the 
banks operations). The bank may consider how easy or difficult it might be 
for staff to find other em ployment or the impact on staff’s career paths. 
Ethical decision makers may consider paying for staff to retrain for new 
careers or paying a higher redundancy fi gure than is required by law. 
 There may be a knock-on impact on wider  staff morale if staff in other 
locations fear that they too might lose  their jobs. This could impact on staff 
absence and motivation and may lead to  the loss of key staff and an 
inability to hire replacements. Even if st aff in other locations do not fear for 
their job security they may be dissati sfied with the bank’s lack of ethical 
focus and actively seek employment in an organisation that considers 
ethical impacts of decisions alongside financial ones. 
 Customers may be left without a banking service in this location. For many 
customers a switch to mobile, computer and telephone banking can 
replace such services. But for many customers this may not be possible or 
wanted. For example, if the location is  in a rural area with poor or little 
internet or mobile network cove rage then customers may have to use 
physical branches in other locations. This may not be possible for many 
customers such as the elderly or  those who have mobility issues. 
 The local community (who may not even use this bank branch) may also 
be impacted if the closur e results in an empty pr operty that cannot be let 
out to another business or organisation.  This may, for example, detract 
from the attractiveness of the location for new homes or for government 
investment. This can affect the quality of life for the local community as a 
whole. 
 There may be a wider impact on the or ganisation’s reputation if the bank is 
seen to be acting purely on financial intere sts rather than in the interests of 
its wider community. 
Typical questions that an ethical decision maker might ask are: 
 Does this decision make financial sense? 
 What will be the impact on staff, customers and the wider community? 
 Which decision generates the most benef it for the lowest adverse impact 
on wider stakeholders? 
 Can a trade-off be found which creat es the least amount of adverse 
impact on stakeholders? 
 Should/have all stakeh olders be/been consulted? 
 Does the decision conform to organisational values? 
 How can adverse impacts be mitigated?

388  
Acting ethically means going beyond simp le legal or financ ial impacts of 
business decision and instead considering a wider set of viewpoints in order to 
create and preserve organisationa l value. Considering ethical issues as part of 
business decisions can result in some options no longer being available to the 
organisation but it may also open up alte rnative options. It will also mean that 
decisions are more in line with org anisational values and goals which will 
ultimately help the organisation in creating more value for stakeholders. 
Apart from an ethical organisation being,  perhaps, ‘morally correct’, there are 
more quantifiable business benefits fr om acting ethically such as: 
 Acting ethically can lower business ri sk that, for example, should create 
more stable earnings and should make cheaper finance available. Ethics 
is not just a matter of being righte ous: if an organisation has a reputation 
for making unethical decisions it wil l be perceived as being a high risk 
organisation that it might be better not to deal with. 
 Acting ethically can make an organisation attractive to customers, 
collaborators and partners 
 The organisation can also become more attractive to potential employees 
 Less time and cost is spent dealing with investigations by regulatory 
bodies 
 Less is spent on paying damages and fines. 
On the other hand, acting ethically can bring the following problems: 
 If the sole aim of acting ethically is to differentiate the organisation from 
rivals then, unfortunately, the strategy  is easily copied by rivals and any 
advantages can be short-lived 
 Acting ethically typically adds costs to activities 
 Success often relies on trial and error  
 International businesses may have to adopt different ethical approaches in 
different markets. What is consider ed good ethical practice in one country 
may not be considered ethical in anot her. This may give a lack of global 
consistency.

390  
7 Practice Questions 
 Which of the following costs fo r a proposed project are relevant? 
(i) The salary to be paid to a mark et researcher w ho will oversee the 
development of a new product. This is a new post to be created 
especially for the new product but the $12,000 salary will be a fixed 
cost. Is this cost relevant to  the decision to proceed with the 
development of the product? 
(ii) The $2,500 additional monthly running costs of a new machine to be 
purchased to manufacture an established product. Since the new machine will save on labour time, the fixed overhead to be absorbed by the product will reduce by $100 per month. Are these costs 
relevant to the decision to  purchase the new machine? 
(iii) Office cleaning expenses of $125 for next month. The office is 
cleaned by contractors and the cont ract can be cancelled by giving 
1 months’ notice. Is this cost rele vant to a decision to close the 
office? 
(iv) Expenses of $75 paid to the marketing manager. This was to 
reimburse the manager for the cost of  travelling to meet a client with 
whom the company is currently negot iating a major contract. Is this 
cost relevant to the decis ion to continue negotiations? 
(select all costs th at are relevant) 
 
 A company is considering a short-term pricing decision to utilise some 
spare capacity. The item to be ma nufactured and sold would use 1,500 
kgs of raw material Q. 
Material Q is in regular use by the company. It currently has 1,000 kgs in 
inventory, which was purchased last m onth at a cost of $4 per kg. The 
current replacement cost of materi al Q is $4.80 per kg and the current 
inventory could be sold for $4.30 per kg. Calculate the relevant cost of materi al Q for the purposes of this decision

Chapter 10 
 391 
 A mining operation uses skilled labour costing $4 per hour, which 
generates a contribution, after deducti ng these labour costs, of $3 per 
hour. 
A new project is now being consider ed that requires 5,000 hours of 
skilled labour. There is a shortage of  the required labour. Any used on the 
new project must be transferred from  normal working. Calculate the 
relevant cost of using the skilled labour on the projec t. Calculate the 
contribution cash flow that is lost if the labour is transferred from normal 
working. 
Activity 2 
Suppose the facts about labour are as above, but there is a surplus of 
skilled labour already employed (and paid) by the business which is 
sufficient to cope with the new project.  The presently idle men are being 
paid full wages. 
Calculate the contribution cash flow that is lost if the labo ur is transferred 
to the project from doing nothing. 
 
 P Limited is considering whether to continue making a component or buy 
it from an outside supplier. It uses  12,000 of the com ponents each year. 
The internal manufacturing cost comprises: 
 $/unit 
Direct materials 3.00 
Direct labour 4.00 
Variable overhead 1.00 Specific fixed cost 2.50 
Other fixed costs 2.00 
 –––––  12.50 
 ––––– 
If the direct labour were not used to manufacture the component, it would 
be used to increase the production of  another item for which there is 
unlimited demand. This other item has a contribution of $10.00 per unit 
but requires $8.00 of labour per unit. 
The maximum price per component at  which buying is preferable to 
internal manufacture is: A $8.00 B $10.50 C $12.50 D $15.50

392  
 Budgeted data relating to a single-pr oduct firm that is working to full 
capacity are as follows: 
Production and sales for the year  20,000 units Machine capacity available and fully utilised  40,000 hours 
 $ 
Variable cost 8.20 
Fixed cost 1.30 
 ––––– Total cost 9.50 
Selling price 12.50 
 ––––– Net profit per unit 3.00 
 ––––– 
An order is received for 3,000 modified units which will use 6,600 hours of 
machine time and cost $1.00 per unit for additional materials. 
At what price should the firm be indifferent between taking on, and 
rejecting, the order? A $41,790 B $40,500 C $27,600 D $17,190 
 
 Lauda operates a joint process from which four products arise. The 
products may be sold at the separati on point of the process or can be 
refined further and be sold at a pr emium. Information regarding the 
products and the refining process can be found below: 
Products E F G H 
Selling prices per litre ($)     
At separation point 12 16 15 18 
After refining 20 23 25 22 Costs ($)     
Joint process (per litre): 8 8 8 8 
Refining process:     Variable (per litre) 5 5 5 5 
Specific fixed (in total) 1,000 2,000 3,000 4,000 
Budgeted litres 2,000 500 5,000 6,000

Chapter 10 
 393 
 The general fixed overheads in the refining process amount to $30,000. 
Which products should be further processed? 
A E, F and G only B E and G only C G only D None of them 
 
 Company A manufactures four products in two different locations. It 
operates under strict Ju st-In-Time principles and does not hold any 
inventory of either finis hed goods or raw materials. 
Company A has a long-standing agreement  to supply its main customer 
with 100 units of each of  its products Product 1,  Product 2, Product 3 and 
Product 4. No negotiation is possible and the contract must be fulfilled. 
Details of the company’s additional, non-contract related production on 
Site 1 are as follows: 
 Product Product Product Product 
 1 2 3 4 
Selling price  $60 $70 $80 $90 
     
Direct labour, at $8 per hour $16 $8 $12 $16 
Direct Material A, at $3 per 
litre $4.50 $3.00 $0 $3.00 
Direct Material B, at $5 per kg $5.00 $0 $15 $10 
Variable overhead, labour related (*)
 $1.25 $0.63 $0.94 $1.25 
Variable overhead, machine related (*)
 $1.25 $2.00 $0.75 $1.00 
     
Total variable cost  $28.00 $13.63 $28.69 $31.25 
     
Machine hours per unit  5 8 3 4 
Maximum demand per week  900  
units 950 
units 950 
units 900 
units 
(*) An analysis of the variable overhead sh ows that some of it is caused 
by the number of labour hours and the remainder is caused by the 
number of machine hours.

394  
 All the above products use the same resources (materials A and B). 
Currently, the company also purc hases a component, Component Alpha, 
from an external supplier in the US for $50. A single unit of this 
component is used in producing Produc t 5, the company’s only other 
product, on Site 2. Product 5 yields  a positive contribution and does not 
use any materials used by the other products. 
Company A could manufacture Component Alpha on Site 1, but to do so 
would require 2 hours of direct labour , half an hour of machine time as 
well as 1.5 kilogram s of Material B. 
The purchasing director has recently advised you that the availability of 
Direct Materials A and B is to be restricted to 5,000 litres and 6,000 
kilograms every week. This restrict ion is unlikely to change in the near 
future, but no restrictions are expected on any other materials. 
Required: 
(a) Calculate whether Company A should continue to purchase 
Component Alpha or whether it shoul d manufacture it internally. 
(b) Prepare a statement to  show the optimum weekly usage of Site 1’s 
available resources. 
(c) Assuming no other changes, calc ulate the purchase price of 
Component Alpha at which your advice in (a) would change. 
 
 Scenario 
Z is one of a number of companies t hat produce three products for an 
external market. The three products, R,  S and T may be bought or sold in 
this market. The common process acc ount of Z for March 20X7 is shown 
below: 
 Kg $  Kg $ 
Inputs      
Material A 1,000 3,500 Normal loss 500 0 Material B 2,000 2,000 Outputs:   
Material C  1,500 3,000 Product R  800 3,500 
Direct labour   6,000 Product S  2,000 8,750 
Variable overhead  2, 000 Product T 1,200 5,250 
Fixed cost   1,00    
Totals  4,500 17,500  4,500 17,500

Chapter 10 
 395 
 Z can sell products R, S or T after this common process or they can be 
individually further processed and sold as RZ, SZ and TZ respectively. 
The market prices for the products at the intermediate stage and after 
further processing are (Market prices per kg): 
 $ 
R 3.00 
S 5.00 
T 3.50 
RZ 6.00 
SZ 5.75 
TZ 6.75 
The specific costs of the three i ndividual further processes are: 
Process R to RZ – variable cost  of $1.40 per kg, no fixed costs 
Process S to SZ – variable cost  of $0.90 per kg, no fixed costs 
Process T to TZ – variable cost of $1.00 per kg, fixed cost of $600 per 
month 
Tasks: 
(a) Produce calculations to determi ne whether any of the intermediate 
products should be further proce ssed before being sold. Clearly 
state your recommendati ons together with any relevant assumptions 
that you have made. 
(b) Produce calculations to assess t he viability of the common process: 
(i) assuming that there is an exte rnal market for products R, S 
and T; and 
(ii) assuming that there is not an external market for products R, S 
and T. 
State clearly your recommendations.

396  
 Example 1 
 The correct answer is B. 
The initial $40,000 fee wil l be deemed to be a sunk cost – it has already 
been committed and won't be affected by any decision to proceed from 
this point. 
The $20,000 is a future cost. Despite the fact that it is called a fixed cost 
it will only be incurred if the project proceeds. It is therefore and extra or 
incremental cost of t he project and should be included in any future 
 
 Example 2 
 100% capacity = 102,000 ÷ 0.85 = 120,000 units 
Spare capacity amounts to 18,000 units. So there is sufficient slack to 
meet the new order Variable costs = $330, 000 less $75,000 = $255,000 
Variable cost per uni t = $255,000 ÷ 102,000 = $2.50 
Contribution per unit from exis ting product = $3.25 – $2.50 = $0.75 
Contribution per unit from new  product = $2.80 – $2.50 = $0.30 
 $ 
Increase in contribution from new product:  
$0.30 × 12,000 units 3,600 
Fall in contribution from existing product:  
$0.75 × (12,000 ÷ 15) × 2  
= $0.75 × 1,600 (1,200)  ––––– 
Net gain in contribution 2,400 
 
 Example 3 
 1,000 kgs of P: 
 $ Purchase 200 kgs; Current r eplacement price $4.50/Kg 900 
Use 800 kgs from invent ory (800 × $3.50) 2,800 
 ––––– Total $3,700

Chapter 10 
 397 
 Existing product earns a contribution per hour of $60 – $10 – $10 – $15 = 
$25 
Relevant cost = Contribution fo rgone PLUS direct labour cost 
 = $25 + $10  
 = $35 per hour  
Total cost = $35 × 100 hours = $3,500 
 
 Example 5 
  The variable cost per hour of over head is relevant since this cost 
would be avoidable if the contra ct were not undertaken. The 
relevant cost of variable over heads is therefore $7 per machine 
hour. 
 The fixed cost per hour is an abs orption rate. Actual fixed costs 
would not increase by $13 per hour , but by $3,200 in total. The 
incremental relevant cost of fi xed overheads is therefore $3,200. 
 This would make the total cost = (800 hours of machine time for 
variable overheads @ $7 per hour) + $3,200 or fixed overheads = 
$8,800. 
 The correct answer is therefore Answer C. 
 
 Example 6 
 Opportunity cost now = $2,000  (Answer C) 
 
 Example 7 
  
 Note $ 
Relevant costs   
Fuel costs 1 1,500 
Replacement coach 2 360 
Replacement driver 3 80 Hotel costs 4 5,000 
  –––––– 
Total  7,660   –––––– 
Notes: 
(1) The fuel cost is directly trac eable to the contract  and is therefore 
relevant. The apportionment of a nnual fixed costs for operating the 
coach are not relevant. The total fi xed cost would remain the same 
whether the contract were accepted or not.

398  
 (2) The company should hire a replacement coach for two days @ 
$180 per day. This will ensure that the contribution of $250 per day 
continues to be earned from  the other contract. 
(3) The company’s employed driver will be paid whether VBJ wins the 
contract or not. As a consequence of  winning the contract, it would 
become necessary to hire a repl acement driver for two days @ 
$400 per day to cover the existing work. This incremental cost is 
relevant. 
(4) The hotel cost is directly attri butable to the contract and is therefore 
relevant. 
(5) The general overhead that has been traced to the contract ($250) 
should be ignored as this cost is sunk. 
(6) The profit is not a relevant cost.  
 
 Example 8 
 (a) 
 Product 
 P Q R 
Contribution per unit $210 $72 $46 
Hours per unit 15 8 2 Contribution per hour $14 $9 $23 
Rank 2nd 3rd 1st 
 
Product  Units  Hrs/per  
unit Total 
hours Contribution   
per hour Total 
contribution  
R 1,000 2 2,000 $23 $46,000  
P 200 15 3,000 $14 $42,000  
Q 350 8 2,800 $9 $25,200  
   –––––  ––––––  
   7,800  $113,200  
(b) The special contract require s 3,000 SCARCE labour hours. 
Relevant cost = Direct cost + Opportunity cost 
Direct cost 3,000 hrs × $20 $60,000 
Opportunity cost 2,800 hrs × $9 $25,200 
 200 hrs × $14 $2,800 Relevant cost  $88,000

Chapter 10 
 399 
 Example 9 
 Technique 
The following method could be adopted in this example: 
(1) The saving per unit of each pr oduct is calculated. Saving = 
Purchases price – VC to make. 
(2) Divide this by the amount of sca rce resource (a.k.a. limiting factor) 
each product uses. This gives the saving per unit of limiting factor 
(LF). 
(3) Rank. The higher the saving per unit of LF the greater the priority to 
make that should be given to the product. 
(4) Once the priorities have been decided, the scarce resource is 
allocated to the products in the order of the priorities until it is fully 
used up. 
(5) Any products with unsatisfied demand can be satisfied by buying 
from the external source. 
This can be applied as follows: 
(1) Calculate saving = Purchases price – VC to make: 
 L M N P 
External purchase price $57 $55 $54 $50 
Variable costs to make $45 $40 $30 $20 Saving $12 $15 $24 $30 
(2) Calculate the saving per unit of  limiting factor/scarce resource: 
 L M N P 
Saving $12 $15 $24 $30 Scarce resource 
(machine hours) per unit 3 hours 5 hours 4 hours 6 hours 
Saving per unit of the 
scarce resource $4 $3 $6 $5 
(3) Rank 
 L M N P 
Saving per unit of the scarce resource $4 $3 $6 $5 
Rank : product to make in priority 3 4 1 2 
(4) Allocate scarce resource of 24,000 machine hours to production 
Make all Ns (1,500 units). This will use up 1,500 × 4 hours = 6,000 
hours. 
Then, make all Ps (1,500 units). This will use up 1,500 × 6 hours = 
9,000 hours. The cumulative tota l is 6,000 + 9,000 = 15,000 hours. 
Then, make all Ls (1,500 units). This will use up 1,500 × 3 hours = 
4,500 hours. The cumulative total is 15,000 + 4,500 = 19,500 hours.

400  
 This leaves (24,000 – 19,500) = 4,500 hours, in which to make 
4,500
5=	900 units of Products M 
(5) Unsatisfied demand = 1,500 Ms  – 900 Ms = 600 Ms. These will 
have to be bought externally. 
 L M N P 
Variable production co st $45 $40 $30 $20 
External cost $57 $55 $54 $50 
Incremental cost $12 $15 $24 $30 
Hours per unit  3  5  4  6 
Incremental cost per hour $4 $3 $6 $5 
Cheapest per hour 2nd 1st 4th 3rd 
The analysis shows that it is actu ally cheaper to try and make ALL 
the components within the factory. 
Hours required to make 1,500 units of each component: (1,500 × 3) + (1,500 × 5) + (1,500 × 4) + (1,500 × 6) = 27,000 hours 
The company only has 24,000 hours av ailable. So, 3,000 hours of 
work must be sub-contracted. The CHEAPEST component per hour 
must be bought externally. This is component M. 3,000 hours of time on M equates to 3,000 ÷ 5 = 600 units of M.  
 
 Example 10 
 In view of its scarcity, labour is taken as the limiting factor. 
The decision on whether to make or  buy the component has to be made 
before it can be decided whet her or not to accept t he contract. In order to 
do this the contribution per labour hour for normal production must first be 
calculated, as the contract will replace some normal production. 
Normal products Basic Scientist  
 $ $ $ $ 
Selling price   5.50  7.50 
Materials 1.25  1.63  
Labour 1.50  2.25  
 ––––  ––––    2.75  3.88 
  ––––  –––– 
Contribution  2.75  3.62   ––––  –––– 
Contribution per di rect labour hour 
(@0.25/0.375 hours per unit)  11.00  9.64

Chapter 10 
 401 
 Therefore, if the company is to ma ke the component it would be better to 
reduce production of the 'Scientist' model, in order to accommodate the 
special order. 
The company should now compare t he costs of making or buying the 
component. An opportunity cost arises due to t he lost contribution on the scientist 
model: 
Special contract Manufacture 
of component 
 $ 
Materials 1,000 
Labour ($6 × 150 hours) 900 Opportunity cost (150  hours × $9.6533) 1,448 
 ––––––  3,348  –––––– 
Since this is higher than the bought-i n price of $2,500 the company would 
be advised to buy the component from the supplier if they accept the 
contract
. 
The contract can now be evaluated: 
 Contract 
 $ $ 
Sales revenue  35,000 Material cost 9,000  Component 2,500  Labour ($6 × 1,200) 7,200   –––––    18,700   ––––– Contribution  16,300   ––––– Contribution per direct labour hou r (for 1,200 labour hours) $13.58 
Since the contribution is higher than ei ther of the existing products, the 
company should accept the contract assuming this would not prejudice 
the market for existing products. 
Because the contribution is higher fo r the 'Basic' model, it would be wise 
to reduce production of the Scientist model. However, the hours spent on 
producing the Scientist model per m onth are (4,000 units × 0.375 hours 
=) 1,500, and so the contract would displace 80% of the production time 
of the scientist model. The recomm endation assumes that this can be 
done without harming long-term sales of  the scientist model (the scenario 
suggests that the demand for the pr oduct is high and therefore there 
would be no lost sales of t he product in the long term).

402  
 As the customer is overseas, th is seems a reasonable assumption. 
However, if this were not the case t hen the opportunity co st from the lost 
sales of scientific calculators shoul d be deducted from the contribution 
calculated above 
Before finalising the decision there ar e many other factors that should be 
considered such as: 
 whether all costs have been consider ed (for example, extra delivery 
costs for the overseas customer) 
 the potential impact of any foreign exchange rate movements 
 whether this will be a one-off cont ract or whether it will open the 
door for more profitable wo rk with this customer 
 the value of the experience and impact on overseas reputation of 
beginning to export the product 
 the level of competition for the contract 
 the extra administration involved in dealing with a foreign customer 
(such as dealing in a foreign language and performing reasonable 
credit checks etc. 
 the potential impact on existing customers who buy packages of 
basic and scientific models

Chapter 10 
 403 
 Example 11 
 (a) The profit statement needs to  be restated in a marginal costing 
format if it is to be useful for decision-making. 
 W X Y Z Total 
 $ $ $ $ $ 
Sales  30,000 20,000 35,000 15,000  
Variable cost 
of sales 4,800 1,600 13,200 5,000  
Variable selling overhead (*) 3,000 2,000 3,500 1,500  
 –––––– –––––– –––––– ––––––  
Contribution 22,200 16, 400 18,300 8,500  
Specific fixed 
costs (W1) 5,200 2,400 1,800 2,000  
Net benefit 17,000 14,000  16,500 6,500 54,000 
Non-specific fixed cost  of sales  (20,000) 
Fixed selling overhead  (W2)   (20,000) 
Administration costs    (8,000) 
     –––––– 
Net profit     6,000 
     –––––– 
(*) Total overhead less $5,000 fixed cost. 
Workings 
(1) 
 W X Y Z Total 
 $ $ $ $ $ 
Fixed costs 11,200 6, 400 8,800 5,000 31,400 
Non-specific fixed 
costs (*) 6,000 4,000 7,000 3,000 20,000 
 ––––– ––––– ––– –– ––––– ––––– 
Specific fixed costs 5, 200 2,400 1,800 2,000 11,400 
(*) Given as $20,000 apportioned on the basis of sales value 
(3:2:3.5:1.5) 
(2) $5,000 per product × 4 = $20,000

404  
 (b) (i)  Z discontinued 
 $ 
Contribution from 40% additional 7,320 
sales of Y ($18,300 × 0.4)  
Additional specific fixed costs (540) Loss of net benefit from Z (6,500) 
 ––––– 
Net gain 280  ––––– 
(ii) Profit reconciliation 
 $ Existing profit 6,000 Discontinuation of Z (6,500) 
Additional contribut ion from Y 7,320 
Additional specific fixed costs (540) 
 –––––– 
Profit if Z is discontinu ed and Y substituted in 6,280 
 –––––– 
(c) Non-financial factors to consider include: 
(1) Possible redundancies among the workforce 
(2) Signals which it may give to  competitors, who may perceive 
the company as being unwil ling to support its products 
(3) The reaction of customers, par ticularly those who may recently 
have purchased the product. 
Sometimes, even when management  has made the decision to 
discontinue a product or activity, ther e is still a further decision to be 
made: when to discontinue it. T he following exercise shows how 
such a decision could be made. 
 
 Example 12 
 The following costs are relevant: 
(iii) The total cost of each of t he three additional processes – this 
represents the increm ental total cost 
(iv) The unit selling price of each pr oduct after further processing – this 
is required to calculate incremental revenue 
(v) The unit selling price of each product before further processing – 
this is required to calculate incremental revenue 
(vi) The percentage normal loss of each further process – this will be 
required to calculate total output per product after further processing 
(vii) The actual units of output of  each product from the common process 
– this will be required to calcul ate total output per product after 
further processing

Chapter 10 
 405 
 The following costs are not relevant: 
(i) Total cost of the common proce ss – this is related to the common 
cost 
(ii) The basis of sharing the co mmon process cost between the three 
products – this is related to the common cost 
 
 (i) The salary is a relevant cost of  $12,000. Do not be fooled by the fact 
that it is a fixed cost. The cost may be fixed in total but it is definitely 
a cost that is relevant to the decision to proceed with the future 
development of the new product. This  is an example of a directly 
attributable fixed cost. A directly attributable fixed cost may also be 
called product-specific fixed cost. 
(ii) The $2,500 additional running costs are relevant  to the decision to 
purchase the new machine. The saving in overhead absorption is 
not relevant since we are not told that the total overhead 
expenditure will be alte red. The saving in labour cost would be 
relevant but we shall assume that this has been accounted for in determining the additional monthly running costs. 
(iii) This is not a relevant cost for next month since it will be incurred 
even if the contract is cancelled today. If a decision is being made to 
close the office, this cost cannot be  included as a saving to be made 
next month. However, it will be saved in the months after that so it 
will become a relevant cost saving from month 2 onwards. 
(iv) This is not a relevant cost of the decision to  continue with the 
contract. The $75 is sunk and cannot be recovered even if the company does not proceed with the negotiations. 
 
 In regular use, so relevant cost = replacement cost 
Replacement cost for Q = 1,500 kgs × $4.80 
 = $7,200

406  
  
 $ 
Contribution per hour lost  from normal working 3 
Add back: labour cost per hour that is not saved 4 
 –––  7 
 ––– 
The contract should be charged with 5,000 × $7 = $35,000 
Activity 2 
Nothing. The relevant cost is zero. 
 
 D The relevant cost of ma king the product is the vari able cost of $3, $4 and 
$1 AND the specific fixed cost of $2.50.  In addition there is another cost – 
an opportunity cost – every unit of t he component that we make uses $4 
of labour. If $8 of labour were us ed on the other product contribution 
would increase by $10. So therefore there is an extra opportunity cost of 
$5 per $4 of labour. 
 
 A The 6,600 hours of machine time fo r the special order would have 
produced 3,300 units (2 hours each). 
Existing contribution = 3,300 × $4.30  = $14,190 The firm will be indifferent to the new  order if the 3, 000 modified units 
also give $14,190 contribution. Variable cost per unit of  special order = $9.20 
Total variable costs  = 3,000 × $9.20  = $27,600 Therefore required selling price  = $27,600 + $14,190  = $41,790

Chapter 10 
 407 
 D 
Any product with negative additional c ontribution should not be further 
refined 
 E F G H 
Incremental revenue per litre 8 7 10 4 
Variable cost of refining (5) (5) (5) (5) 
 ––– ––– ––– ––– 
Additional contribution fr om refining 3 2 5 (1) 
Decision: Sell at 
split-off 
Now take account of the further proc essing costs. Any profit which does 
not make a an additional profit should not be further refined: 
 
 E F G  
Units 2,000 500 5,000  
Additional total 
contribution($) 6,000 1,000 25,000  
Specific fixed costs (1,000) (2,000) (3,000)  
 ––––– ––––– –––––  Additional profit from re fining 5,000 (1,000) 22,000  
     
Decision: Refine Sell at 
split-off Refine  
Finally, the overall profit or loss on the remaining products should be 
determined: 
Total relevant profit from re fining  ($5,000 + $22,000) 27,000 
General fixed costs of  refining   30,000 
    –––––– 
Total loss from refining    $(3,000)     –––––– 
None of the products shoul d be further processed.

408  
 (a) The Internal Manufacturing cost of Component Alpha is as follows  
 Component 
Alpha 
2 hours of direct labour , at $8 per hour $16.00 
1.5 kg direct Material  B, at $5 per kg $7.50 
  
Variable overhead, lab our related 2 hours $1.25 
Variable overhead, machine related, 0.5 hours $0.125 
  Total variable cost $24.875 
The buying price of the component is $50 per unit. So, if resources 
are readily available, the co mpany should manufacture the 
component, because it is cheaper than buying it. However, due to 
the scarcity of resources in the near  future, the contribution earned 
from the component needs to be compared with the contribution 
that can be earned from  the other products. 
Using Product 1 (though any produc t could be used) the variable 
overhead rates per hour can be calculated: 
Labour related variable ov erhead per unit = $1.25 
Direct labour hours per unit = $16/$8 = 2 hours 
Labour related variable overhead  per hour = $1.25/2 hours = 
$0.625 per hour Machine related variable overhead per unit = $1.25 Machine related variable over head per hour = $1.25/5 hours = 
$0.25 per hour Both material A and material B are limited in supply, but 
calculations are required to deter mine whether this scarcity affects 
our production plans. The resour ces required for the maximum 
demand must be compared with t he resources available to 
determine whether either of the ma terials is a binding constraint. 
 Product 
1 Product 
2 Product 
3 Product 
4 Total 
Existing 
Contract 100 units 100 units 100 units 100 units  
Direct Material A 150 litres 100 litres 0 litres 100 litres 350 litres 
Direct 
Material B 100 kgs 0 kgs 300 kgs 200 kgs 600 kgs

Chapter 10 
 409 
 We can now determine whether Materi al A or Material B is a limiting 
factor: 
 Maximum 
Availability Post-contract 
availability Needed for 
total 
production 
Direct Material A 5,000 litres 4,650 litres 3,200 litres 
Direct Material B 6,000 kgs 5,400 kgs 5,550 kgs 
The scarcity of material B  is a binding constraint and therefore the 
contributions of each product and the component per kg of material B 
must be compared. (At this point, Pr oduct 2 can be ignored because it 
does not use material B): 
 Product 
1 Product 
3 Product 
4 Component 
Alpha 
Contribution $32 $51.325 $58.75  
     Direct Material B 1 kg 3 kgs 2 kgs  
Contribution per kg of 
Material B $32.00 $17.10 $2 9.38 $16.75 (W1)  
 
Rank 1 3 2 4 
Since Component Alpha has the lowest  ranked contribution per usage of 
material B, the company should continue to purchase the 
component so that the available resour ces can be used to manufacture 
Product 1, Product 4 and Product 3. 
We can now determine whether Material  A or Material B is a limiting 
factor: 
(W1) Component Alpha – C ontribution per kg of B 
 $ 
Buying cost of component Alpha 50.00 
Variable production cost  (24.875) 
 ––––––– 
Contribution per component $25.125 
Contribution per kg of Materi al B = $25.125/1.5 kgs of B = $16.75 
(b) Direct material B at $5/kg available: 5,400 kgs 
First, we make Product 1: 900 units  @ 1 kgs per unit = 900 kgs. 
This leaves 4,500 kgs available for the next best-ranking product, 
Product 4. That is enough for (4,5 00 kgs/2 kgs per unit) = 2,250 
units of Product 4. We only need 900 units of Product 4 though i.e. 
1,800 kgs, which leaves (4,500 – 1,800 kgs = 2,700 kgs) available 
for the next product, Product 3. 
Each unit of Product 3 uses 3 kgs of  Material B, we can therefore 
make 900 units of Product 3 .

410  
 Summary 
 Product 1 Product 2 Product 3 Product 4 
Contractual units 100 units 100 units 100 units 100 units 
Non-contractual 
units 900 units 950 units 900 units 900 units 
Total 1,000 units 1,050 units 1,000 units 1,000 units 
(c) The decision concerning the purchase of the component would 
change if the contribution from it s manufacture were equal to the 
least best contribution from the pr oducts using material B. Apart 
from the minimum demand constrai nt the least best usage is 
derived from product 3 which has a contribution per kg of $17.10 
which is $0.35 per kg higher t han that from component Alpha. 
Since each unit of Alpha requires 1. 5 kgs of B then the buying price 
would have to be 1.5 × $0.35 = $0 .525 per component higher than 
at present before it w ould have the same rank as product 3. Thus 
the buying price at which the dec ision would change = $50 + $0.525 
= $50.525. 
 
 (a) On financial grounds, further proce ssing is worthwhile if the further 
processing cost is less t han the incremental revenue. 
Evaluation of further processi ng, based on March 20X7 output and 
assuming no losses in the further process: 
Product Incremental revenue $ Incremental 
cost $ Increase 
/(decrease) in 
profit 
RZ 800 × (6.00 – 3.00)  
= 2,400 800 × $1.40 = 
1,120  
1,280 
SZ 2,000 × (5.75 – 5.00)  
= 1,500 2,000 × 0.90 
= 1,800  
(300) 
TZ 1,200 × (6.75 – 3.50)  
 
= 3,900 1,200 × 1.00 
+ 600  
= 1,800  
 
2,100 
Taking each product individually, it can be seen that products R and 
T should be converted as the incremental revenue exceeds the 
incremental cost of fu rther processing. In the case of T, this 
assumes that the March 20X7 output  is representative of other 
months and that the quant ity produced is sufficient to ensure that 
the incremental revenue covers both the fixed and variable costs. 
However, as TZ can be sold for a relatively high price, volumes would have to drop considerably for this to become an issue.

Chapter 10 
 411 
 This is not true of S. Considered in isolation product S should not be 
converted. However there may be other reasons for producing all 
three products, in particular marketing considerations such as 
whether the company needs to supply all three products in order to 
sell the two profitable products, RZ and TZ. 
(b) (i) If there is a market for R, S and T, and assuming that all 
March 20X7 output can be sold at the prices given: 
Product Selling price 
per kg in $ Output in kgs Sales value in 
$ 
R $3.00 800 2,400 
S $5.00 2,000 10,000 
T $3.50 1,200 4,200 
   ––––––– 
   $16,600 
Total cost of common process in March 20X7 = $17,500 
Loss in March 20X7 = $900 and ther efore the common process is 
not financially viable.  
(ii) If there is not an exter nal market for R, S and T: 
Revenue from selling RZ, SZ, TZ: $ $ 
RZ 800 × $6.00 4,800  
SZ 2000 × $5.75 11,500  TZ 1,200 × $6.75 8,100 24,400 
  ––––––  
Common costs  (17,500) Further costs:   
R –> RZ 800 × $1.40 1,120  
S–>SZ 2,000 × $0.90 1,800  T–>TZ 1,200 × $1.00 + ($600 fixed) 1,800 (4,720) 
  ––––––  
   ––––––– Net benefit  $2,180 
   ––––––– 
Based on this analysis the common process is financially 
viable.

413 
Break-even analysis 
C3. Apply appropriate 
techniques to support short-term decisions (b)  Break-even analysis 
  Chapter 
11

414  
 
One of the most import ant decisions that needs to be made before any 
business even starts, or a new product or service is launched, is ‘how much do 
we need to sell in order to break even?’ By ‘break-even’ we mean simply 
covering all our costs without making a pr ofit. This type of analysis is more 
formally known as Cost-Volume-Pr ofit Analysis (CVP Analysis). 
 
 CVP definition 
 Cost – Volume – Profit analysis is def ined in CIMA's Official Terminology  
as 'the study of the effects on future  profit of changes in fixed cost, 
variable cost, sales price, quantity and mix.' 
CVP analysis is a particular example of ‘what if?’ analysis. A business 
sets a budget based upon various assumptions about revenues, costs, product mixes and overall volumes. CVP analysis considers the impact on the budgeted profit of changes in these various factors. 
Cost-Volume-Profit (CVP) analysis 
CVP analysis makes use of the contribut ion concept in order to assess the 
following measures for a single product: 
 contribution to sales (C/S) ratio 
 breakeven point 
 margin of safety.

Chapter 11 
 415 
 The contribution concept 
 We have previously determined that variable costs are those that vary 
with the level of activity. If we can identify the variable costs associated 
with producing and selling a product or service we can highlight a very 
important measure: contribution . 
Contribution = sales value LESS variable cost 
Variable costs are some times referred to as marginal costs . The two 
terms are often used interchangeably. 
Contribution is so called because it 'contributes' towards fixed costs and 
profit. Once the fixed costs have been fully covered, then any extra 
contribution contributes towards t he profit of the organisation. 
Consider a product with a variable cost  per unit of $26 and selling price of 
$42. Fixed costs for the period are $12,000. 
(a) What is the contribution per unit for the product? (b) If 1,000 units are sold, what  is the total contribution? 
(c) What is the total prof it and the profit per unit at  this level of sales? 
(d) Calculate the total profit for the following levels of sales:  
– 500  – 1,000  – 1,200 
(e) Calculate the contribution per uni t and profit per unit for each level 
of sales. 
Solution: 
(a) Contribution per unit = sales – variable cost  
$42 – $26 = $16 
(b) Total contribution = contributi on per unit × number of units  
$16 × 1,000 = $16,000 
(c) Total profit = total contribution – fixed costs  
$16,000 – $12,000 = $4,000 
Profit per unit = total profit/number of units 
$4,000/1,000 = $4

416  
 (d)  It is easier to use a table for these calculations: 
Units  500 1,000 1,200 
 $ $ $ 
Sales 21,000 42,000 50,400 
Variable cost  13,000 28,000 31,200 
Total contribution 8,000 16,000 19,200 
Fixed costs 12,000 12,000 12,000  –––––– –––––– –––––– 
Total Profit/(Loss) (4,000) 4,000 7,200 
(e) 
Contribution per unit $16  $16  $16  Profit per unit ($8) $4.00 $6 
You can see from this that t he contribution per unit does not 
change, but that the profit per uni t can change significantly as the 
volume changes. 
This makes contribution much more  useful than profit in many 
decisions. In the above example, it would have been quicker to start with 
contribution when working out the profit, as shown below. This 
saves some unnecessary calculations: 
 $ $ $ 
Contribution per unit 16 16 16 × units 500 1,000 1,200 
Fixed costs 12,000  12,000 12,000 
 
C/S ratio 
The contribution to sales ratio is a useful calculation in CVP analysis. It is 
usually expressed as a percentage. It can be calculated as follows. 
 
C/S ratio =Contribution per unit 
Selling price per unit  orTotal contribution 
Total sales revenue  
 
 The C/S ratio is sometimes referred to  as the P/V (Profit/Volume) ratio.

Chapter 11 
 417 
 Explanation of the co ntribution sales ratio 
 The C/S ratio of a product is the proportion of the se lling price that 
contributes to fixed overheads and prof its. It is compar able to the gross 
profit margin. 
A higher contribution to sales ratio means that contribution grows more 
quickly as sales levels increase. Once the breakeven point has been 
passed, profits will accumulate mo re quickly than for a product with a 
lower contribution to sales ratio. 
Breakeven point 
The breakeven point is the point at whic h neither a profit nor a loss is made. 
 At the breakeven point the following situations occur. 
Total sales revenue = Total costs, i.e. Profit = 0 
or 
Total contribution = Fixed costs, i.e. Profit = 0 
 It can be calculated in terms  of numbers of units sold. 
Breakeven point (in terms of  numbers of units sold) =Fixed costs
Contribution per unit  
 It is also possible to calculated in terms of sales revenue using the C/S 
ratio 
Breakeven point (in terms of sales revenue) =Fixed costs
C/S ratio 
Margin of safety 
The margin of safety is the amount by which anticipated sales (in units) can fall 
below budget before a business makes a lo ss. It can be calculated in terms of 
numbers of units or as a percentage of budgeted sales. 
The following formulae are used to ca lculate the margin of safety: 
Margin of safety calculation:  
in units  = Budgeted sales – Breakeven point sales 
as a % of  budgeted sales = 	Budgeted sales – Breakeven sales
Budgeted sales × 100%

418  
 Example 1 
 A company manufactures and sells a si ngle product that has the following 
cost and selling price structure: 
 $/unit 
Selling price 120 
Direct material (22) 
Direct labour (36) Variable overhead (14) 
Fixed overhead (12) 
 –––– Profit per unit 36 
 –––– 
The fixed overhead absorption rate is based on the normal capacity of 
2,000 units per month. 
Assume that the same amount is spent each month on fixed overheads. 
Budgeted sales for next month are 2,200 units. 
Required: 
(i) the breakeven point, in sales units per month 
(ii) the margin of safety for next month 
(iii) the budgeted prof it for next month 
(iv) the sales required to achiev e a profit of $96,000 in a month. 
 
 Using the margin of safety to calculate the expected profit 
 As a short cut to determining the ex pected profit for an organisation, the 
margin of safety can be used as follows: Expected profit = Margin of safety  (in units) × contribution per unit 
This can be best explained through the use of an illustration. 
RT organisation manufactures one product. The product sells for $250, 
and has variable costs per unit of $120.  Fixed costs for the month were 
$780,000. The monthly projected sale s for the product were 8,000. The 
margin of safety can be calculated as: 
First calculate the breakeven sales: 780,000/(250 –120) = 6,000 
Margin of safety in units = projected sales – breakeven sales 
= 8,000 – 6,000 = 2,000 
Margin of safety % = (projected sale s – breakeven sales)/projected sales 
= (8,000 – 6,000)/8,000 = 25%

Chapter 11 
 419 
 The margin of safety can also be used as one route to a profit calculation. 
We have seen that the contribution goes towards fixed costs and profit. 
Once breakeven point is reached the fixed costs have been covered. 
After the breakeven point there are no more fixed costs to be covered 
and all of the contribution goes towards making profits grow. 
In this illustration, the monthly profit  from projected sales of 8,000 would 
be $260,000. 
This can be calculated the normal way: 
Contribution per unit $130 
Total contribution ($130 × 8,000) $1,040,000 
Fixed costs $ 780,000 
 ––––––––– Profit $ 260,000 
 ––––––––– 
Or using margin of safety: 
Margin of safety  = 2,000 units per month  
Monthly profit  = 2,000 × contribution per unit 
 = 2,000 × $130  
 = $260,000 
3 Break even charts 
The information from CVP analysis can be represented diagram atically using a 
break even chart. For example, if we were using the following data in our calculations 
Selling price  $50 per unit Variable cost  $30 per unit Fixed costs  $20,000 per month 
Forecast sales  1,700 units per month 
the results of our analysis could be illustrated on a diagram as follows:

420  
 Interpretation of a break even chart 
 An interpretation of the diagr am would tell us many things: 
 Fixed costs are $20,000 – this is the point at which the total cost line 
cuts the vertical axis. 
 The break-even point occurs at 1,000 units – this is the point at 
which the line for total revenue cr osses the line for total costs. 
 At the break-even point, costs and revenues total $50,000 each – 
this can be found by reading across to t he vertical axis at this point. 
 We can see by reading along the hor izontal axis that the margin of 
safety is 700 units. 
 Budgeted sales are 1,700 units – this is determined by adding the 
margin of safety to the break-even point. 
 
 Example 2 
 Choose from the following list a ll the information than can be easily 
determined from a break even chart (choose all that apply): 
 the break-even point (in units) 
 the break-even point (in terms of total revenue) 
 selling price per unit 
 total fixed costs 
 total costs 
 variable cost per unit 
 margin of safety 
 
 Drawing a break even chart 
  
Learning to draw a chart to scale will provide a firm foundation for your 
understanding of breakeven charts. To gi ve yourself some practice, it 
would be a good idea to follow the step-by-step guide which follows to 
produce your own chart on a piece of graph paper 
A basic breakeven chart records costs and revenues on the vertical axis (y) and the level of activity on the hor izontal axis (x). Lines are drawn on 
the chart to represent costs and sales revenue. The breakeven point can 
be read off where the sales revenue line cuts the total cost line. 
Let's look at constructing the diag ram that has just been illustrated.

Chapter 11 
 421 
  Step 1.  Select appropriate scales for the axes and draw and label 
them. Your graph should fill as much  of the page as possible. This 
will make it clearer and easier to r ead. You can make sure that you 
do this by putting the extremes of the axes right at the end of the 
available space. 
The furthest point on the vertical axis will be the monthly sales 
revenue, that is 
1,700 units × $50 = $ 85,000 The furthest point on the horizontal  axis will be monthly sales 
volume of 1,700 units. 
Make sure that you do not need to read data for volumes higher 
than 1,700 units before you set thes e extremes for your scales. 
 Step 2.  Draw the fixed cost line and l abel it. This will be a straight 
line parallel to the horizontal axis at the $20,000 level. 
The $20,000 fixed costs are incurr ed in the short term even with 
zero activity
. 
 Step 3.  Draw the total cost line and l abel it. The best way to do this 
is to calculate the total costs for the maximum sales level, which is 
1,700 units in our example. Mark this point on the graph and join it to the cost incurred at zero activity, that is, $20,000. 
 $ 
Variable costs for 1,700 units (1,700 × $30) 51,000 
Fixed costs 20,000  ––––––– Total cost for 1,700 units 71,000  ––––––– 
 Step 4.  Draw the revenue line and label it. Once again, the best way 
is to plot the extreme points. The revenue at maximum activity in our 
example is 1,700 × $50 = $85,000. This point can be joined to the 
origin, since at zero activity there will be no sales revenue. 
 Step 5.  Mark any required information on the chart and read off 
solutions as required. You can check that your chart is accurate by 
reading off the breakeven point and then check this against the calculation for breakeven: 
The margin of safety can be seen as the area to the right of the 
breakeven point up to the foreca st sales level of 1,700. 
= 20,000/(50 – 30) = 1,000 units.  
 
Breakeven point in units =Fixed costs
Contribution per unit	
breakeven point up to the foreca st sales level of 1,700.

422  
 The contribution breakeven chart 
One of the problems with the convent ional or basic breakeven chart is 
that it is not possible to read cont ribution directly from the chart. A 
contribution breakeven chart is based on the same principles but it shows 
the variable cost line instead of the fi xed cost line. The same lines for 
total cost and sales revenue are show n so the breakeven point and profit 
can be read off in the same way as wit h a conventional chart. However, it 
is also possible also to read the c ontribution for any level of activity. 
 
Using the same basic example as fo r the conventional chart, the total 
variable cost for an output of 1,700 units is 1,700 × $30 = $51,000. This 
point can be joined to the origin sinc e the variable cost is nil at zero 
activity. 
The contribution can be read as t he difference between the sales 
revenue line and the variable cost line. The form of presentation might be used when it is desirable to highlight 
the importance of contribution and to focus attention on the variable 
costs. Ensure you are familiar with these char ts and that you are able to identify 
all the component parts. 
However, it can be difficult in this diagr am to see how much profit (or loss) is 
made at each level of activity. For this  we would need a profit-volume chart.

Chapter 11 
 423 
4 The profit–volume chart 
The profit volume chart 
Another form of breakeven c hart is the profit–volume chart. This chart plots a 
single line depicting the profit or loss at each level of activity. 
A profit–volume graph for our example is shown below. 
 
 Drawing and interpreting a profit-volume chart 
 Drawing a profit-volume chart 
The vertical axis shows profits an d losses and the horizontal axis is 
drawn at zero profit or loss. 
In order to plot the pr ofit line only two points ar e required and a line is 
plotted through these: 
 Firstly, at zero activity the lo ss is equal to $20,000, that is, the 
amount of fixed costs. 
 Secondly, the line needs to cr oss the horizontal axis at the 
calculated breakeven point (1,000 units). 
Note: the profit–volume chart may al so be called a prof it graph or a 
contribution–volume graph. 
Interpretation 
An analysis of this profit volume chart would highlight the following: 
 The break-even point occurs wher e the line crosses the horizontal 
axis. 
 This would appear to be at 1,000 units. 
 A user of the chart could quickly see the expected profit or loss for 
any expected level of activity. For ex ample, if sales were to be 1,400 
units then a profit of ar ound $8,000 would be expected. 
The main advantage of the profit–volume char t is that it is capable of depicting 
clearly the effect on profit and breakeven point of any changes in the variables.

424  
 Example 3 
 An organisation is considering launch ing a new product, but it has yet to 
determine final production design. This  decision will affect the costs and 
quality of the product, as well as its ultimate selling price. 
Two situations are being considered: 
 In situation (a), a lower product specification will be used, resulting 
in a lower selling price and production cost per unit. 
 In situation (b), a higher product specification will be used, resulting 
in a higher selling price and a hi gher production cost per unit. 
A profit volume chart has been pr epared illustrating the impact of each 
situation as follows: 
 
Answer the following questions bas ed on this profit-volume chart: 
The situation which results in the hi gher contribution per unit is situation 
_____? This is because.... A Situation (a) has a lower production cost per unit B Situation (b) has a higher selling price C Situation (a) has a lower break-even point D The graph for situation (b) has a steeper slope At what level of sales would the or ganisation be indifferent between the 
two options? A 20,000 units B 22,500 units C 30,000 units D 70,000 units

Chapter 11 
 425 
 The impact of cost structures on the break even point 
 Different organisations will have differ ent cost structures. This will often 
be heavily influenced by the industry in which they operate. For example, 
a service company, such as a firm of accountants, will find that most of 
their costs are fixed costs such as sa laries and rent. On the other hand, a 
retailer such as a supermarket is likely to find that most of its costs are 
variable (such as the purchasing costs of the items it is selling). Other 
factors such as the level of comput erisation and mechanisation will also 
impact on the cost structure. 
Operational gearing 
The proportion of costs which are fix ed is referred to as operational 
gearing. There are many different ways to measure operational gearing 
such as taking fixed costs as a perc entage of total costs or by simply 
examining an organisation’s contribut ion to sales ratio. A firm of 
accountants is likely to have a high proportion of fixed costs relative to 
total costs, it is also likely to have a high contribution to sales ratio. The 
firm would then be said to have a high level of operational gearing. 
An organisation with a low operating gear ing will have a sm all proportion 
of fixed costs relative to total cost s and it will have a low contribution to 
sales ratio. 
Changing operational gearing 
Organisations can influence and change their operational gearing if they 
choose. For example, a company gi ving training company is likely to 
have a high level of operational geari ng as it will have to pay fixed cost 
salaries to its lecturers. The co mpany may be concerned that, if the 
economy moves towards a recession, the company will suffer a reduction 
in revenue but still have to pay these fi xed salaries. It will therefore see its 
high level of operational  gearing as a problem. 
The problem can be alleviated by conver ting some of the fixed costs into 
variable costs. It could, for exampl e, move lecturers onto daily rates 
rather than fixed annual salaries. T herefore, if ther e are no courses 
running because of a lack of demand t hen no costs are incurred on staff 
salaries. This reduction in operat ional gearing reduc es the potential 
negative impact from a fall in sales. 
This should highlight that, whilst mu ch of the operat ional gearing of a 
business is determined by its industry, operational gearing can also be 
influenced by the decisions of an organisation’s management. Therefore, 
even organisations who operate in t he same industry can have very 
different levels of operational gearing.

426  
 The impact of operational gear ing on the break-even point and 
profits 
Organisations with high operational gearing will have a higher break-even 
point than organisations with low operat ional gearing. More contribution 
will have to be earned in order to cove r the high levels of fixed costs. 
Because of the high contribution to sales ratio, these organisations will 
also find that small changes in rev enue will have a large impact on profit. 
Therefore, as sales in crease beyond the break-ev en point, profits and will 
increase greatly. 
The opposite will be true for organisations with a low operating gearing. 
However, organisations with low operat ing gearing will perform better as 
sales fall (for example, in a recession)  as they will be able to cut back on 
costs. For example, in a recession a supermarket can reduce its costs by 
purchasing fewer items, but an acc ountancy practice must still pay its 
salaries and rent. 
Operational gearing and the profit volume chart 
Organisations with high operational gear ing are likely to have a steeper 
profit volume chart. For example, c onsider the following diagram for two 
similar sized companies operat ing in the same industry: 
 
Company X has high operational gear ing. As a consequence it has a 
higher break-even point. It can be seen that it has the potential to make 
higher profits at higher sales levels but it will suffer higher losses as sales 
fall (for example, if the economy moves into a recession). 
Company Y has lower operational geari ng (it has converted some fixed 
costs to variable costs). As a consequence it has a lower break-even 
point and doesn’t suffer such high losses as sales fall. But, likewise, it won’t make as much profit if sales units rise to high levels beyond the break-even point.

Chapter 11 
 427 
5 Multi-product break-even analysis 
Where an organisation produces and sells  more than one product, a weighted 
average C/S ratio is calculated by using the formula: 
 
Weighted average C/S ratio  =Total contribution 
Total revenue 
 The breakeven point in sales re venue is then calculated as: 
 
Breakeven revenue  =Fixed costs 
Weighted average C/S ratio 
 
 Explanation of the weighted average calculation 
 The basic breakeven model can be used satisfactorily for a business that 
produces and sells only one product. However, most companies sell a 
range of different products, and the model has to be adapted when one is 
considering a business operation with several products. 
If a company sells multiple products,  break even analysis is somewhat 
more complex. The reason is that t he different products will have different 
selling prices, different costs, and different contribution margins. 
Consequently, the brea k-even point will depend on the mix in which the 
various products are sold. In order to cope with this, CVP analysis assumes that a pre-determined 
sales mix will remain constant  for all volumes of activity. For example, 
if product A makes up 20% of produc tion and sales and product B makes 
up 80%, CVP analysis assumes that these proportions will continue into 
the future. This allows for the calculation of a weighted average contribution 
margin  or a weighted average contribution sales ratio  which can be 
used in the break even calculations . The weightings used in the 
calculations are those from the predetermined sales mix. 
The calculation of the weighted averages is explained in the following 
example. 
 
 Example 4 
 Company A produces Product X and Product Y. Fixed overhead costs 
amount to $200,000 every year. The following budgeted information is 
available for both products for next year:  
Sales price $50 $60 
Variable cost $30 $45 
Budgeted sales (in units) 20,000 10,000

428  
 To the nearest $000, what is t he break even sales revenue? 
A $500,000 
B $582,000 C $628,000 D $800,000 
 
 Margin of safety calculations 
 The basic breakeven model for calculat ing the margin of safety can be 
adapted to multi-product environments. Three alternative approaches are 
considered in the example below. A business operation produces three products, the X, the Y and the Z. 
Relevant details are: 
 Product X Product Y Product Z 
Budgeted sales 400 400 200 
Selling price per unit $9 $7 $5 Variable cost per unit $6 $5 $1 
Contribution per unit $3 $2 $4 
Forecast unit sales 400 400 200 
Fixed costs are $2,000 per period, not attributable to individual products. 
A budget for the forecast is as follows: 
 Product X  Product Y  Product Z  
Total  
Sales revenue  $3,600  $2,800  $1,000  $7,400  
Variable cost $2,400  $2,000  $200  $4,600  
Contribution  $1,200  $800  $800  $2,800  
Fixed costs    $2,000  
    –––––––  
Profit    $800 
    –––––––  
The margin of safety 
The contribution ratio is 37.84% (i.e. $2,800/$7,400). The break even 
point, in terms of sales revenue, can be determined by dividing the total fixed costs ($2,000) by this cont ribution ratio = $2,000/37.84% = $5,285 
The margin of safety is the differe nce between forecast sales and this 
break even sales revenue = $7,400 forecast sales – $5,285 = $2,115. It may also be expressed as a perc entage of forecast sales = $2,115/ 
$7,400 = 28.58%.

Chapter 11 
 429 
6 Establishing a target prof it for multiple products 
The approach is the same as in singl e product situations , but the weighted 
average contribution to sales ratio is now used so that: 
 
Revenue required to generat e a target profit =Fixed costs + required profit
 
 Example 5 
 Referring to the previous example, w hat is the target revenue required (to 
the nearest $000) to achiev e a profit of $300,000? 
A $873,000 B $882,000 C $1,384,000 D $1,455,000 
7 The multi-product profit-volume graph 
In a multi-product environm ent, two lines must be s hown on the profit-volume 
graph: one straight line, where a c onstant mix between the products is 
assumed; and one bow shaped line, where it is assumed that the company sells 
its most profitable product first and then its next most profitable product and so 
on. Example:  
 
 In this example, a ranking of the c/s ra tio of each product wo uld put belts first, 
bags next, shoes thirds and jackets last. This can be seen from the diagram as 
it is the order in which the produc ts appear on the upper of the two lines.

430  
The diagram illustrates two potential break even points: 
 the lower line indicates the breakeven poi nt if the products are sold in the 
standard product mix. 
 the upper line indicates the break-even point if the products are sold in 
order of the c/s ratio ranking. 
 
 Drawing and interpreting a multi-product PV graph 
 We will use the following example to illustrate a step-by-step approach: 
 Sales 
units Selling price 
per unit Variable cost 
per unit 
Bags 1,000 $400 $210 
Belts 2,000 $125 $65 
Shoes 1,500 $150 $95 Jackets 3,500 $300 $215 
Fixed costs amount to $580,000. 
STEP 1:  Calculate the contribution to sales (C/S) ratio of each product 
being sold, and rank the products in order of profitability. 
 C/S ratio Rank 
Bags 0.475 2 
Belts 0.480 1 
Shoes 0.367 3 
Jackets 0.283 4 
STEP 2:  Assuming that the products are so ld in order of their C/S ratio, 
determine cumulative revenue and profit/loss as each product is sold. 
In our example: 
Sales Cumulative 
revenue Individual 
product 
contribution Cumulative 
profit or 
loss 
None $0 $0 $(580,000) 
Belts $250,000 $120,000  $(460,000) 
Bags $650,000 $190,000  $(270,000) 
Shoes $875,000 $82,500  $(187,500) 
Jackets $1,925,000 $297,500 $110,000

Chapter 11 
 431 
 STEP 3:  Draw a graph, showing cumulative  sales revenue on the x-axis 
and the initial cumulative profit  or loss on the vertical axis. 
 
Point K on the graph (on the vertical axis) represents the profit or loss 
when revenue is zero. This will always be the total of the fixed costs. 
Point V on the graph represents the total cumulative revenue (in this 
case, $1,925,000). 
STEP 4:  Starting from point k,  plot the first point of cumulative revenue. 
This represents the revenue from t he product with the highest C/S ratio 
(in this case, belts). The slope of t he line is determined by the C/S ratio 
achieved on sales of that product. We c an see that it goes to the point of 
$250,000 on the revenue axis and –$460, 000 on the profit/loss axis. 
These points can be read from the table created in Step 2.

432  
 STEP 5:  Plot each subsequent point from th e table in Step 2 and join the 
points together with a line. 
In our example, 'Bags' is ranked at 2nd and 'Shoes' at 3rd. The lines 
could be drawn as follows: 
 
Note how the lines become flatter (o r less steep) as they are drawn in 
turn. This reflects the lower C/S ratio of each product. STEP 6:  Draw a final line between the st arting point (k) and the finishing 
point. The final point will be the final figur e from the table in Step 2, where 
cumulative revenue is $1,925,000 (the co-ordinates for the horizontal 
axis) and cumulative profit or loss of $110,000 (the co-ordinates for the 
vertical axis).  
 
It can be seen that the resulting di agram provides two potential break 
even points (i.e. the horizontal axis is crossed twice – indicating that there 
are two points at which profits will be zero). 
The first point that is crossed (the lower value of revenue) represents the 
break-even point if products are sold in the order of highest to lowest C/S 
ratio. The higher break-even point would be achieved if products are sold in a 
constant standard mix.

Chapter 11 
 433 
 Example 6 
 BJS produces and sells the following three products: 
Product X Y Z 
Selling price per unit $16 $20 $10 
Variable cost per unit $5 $15 $7 
Contribution per unit $11 $5 $3 Budgeted sales volume 50,000 units 10,000 units 100,000 units 
The company expects the fixed costs to be $300,000 for the coming year. 
Assume that sales arise throughout the year in a constant mix. 
Required: 
(a) Calculate the weighted aver age C/S ratio for the products. 
(b) Calculate the break-even sales revenue required. 
(c) Calculate the amount of sales re venue required to generate a profit 
of $600,000. 
(d) A multi-product profit-volum e chart (assuming the budget is 
achieved) for the products is provided as follows. 
 
Interpret this diagram for the business. 
8 Sensitivity analysis 
Sensitivity (or 'What-if?') analysis involv es determining the effects of various 
types of changes in the CVP model. These effects can be determined by simply 
changing the constants in the CVP model, i. e., prices, variable cost per unit, 
sales mix ratios etc. For example, it answers questions such as 'What will be the impact on our revenue if variable cost per unit increases by 30%?' 
The sensitivity of revenue to various possible outcomes broadens the perspective of management r egarding what might actually occur before making 
cost commitments. This would be fair ly easy with spread sheets, or other 
software developed to handle these calculations.

434  
 Example 7 
 Vivaldi manufactures and sells four  types of products under the brand 
name Summer, Autumn, Winter and Sp ring. The Sales Mix in value 
comprises the following: 
Brand name Percentage 
Summer 33.33% 
Autumn 41.67% 
Winter 16.67% Spring 8.33% 
 ––––––– 
 100% 
 ––––––– 
Total Budgeted sales are set to reach $600,000 per month. 
Variable costs are as follows: 
Brand name  Summer 60% of selling price Autumn 68% of selling price 
Winter 80% of selling price 
Spring 40% of selling price 
Fixed costs amount to  $159,000 per month. 
Required: 
(a) Calculate the breakeven point fo r the products on an overall basis. 
(b) It has been proposed to change the sales mix as follows, with the 
sales per month remaining at $600,000: 
Summer 25% 
Autumn 40% 
Winter 30% Spring 5% 
 –––––– 
 100% 
 –––––– 
Assuming that the above proposal is implemented, calculate the 
new breakeven point.

Chapter 11 
 435 
9 Advantages and disadvan tages of CVP analysis 
 Provides a target volume  Profits can be affected by 
other factors besides volume 
 Helps the understanding of 
costs and revenues and the 
relationship between them  A small change in the 
assumptions could have a large change in the outcome 
 
 Advantages of CVP analysis 
The major benefit of using breakeven anal ysis is that it indicates the 
lowest amount of activity necessary to prevent losses. 
Breakeven analysis aids Decision Maki ng as it explains the relationship 
between cost, production volume and return s. It can be extended to show 
how changes in fixed costs – variable costs relationships or in revenues 
will affect profit leve ls and breakeven points. 
CVP disadvantages 
Any CVP analysis is based on assumptions about the behaviour of 
revenue, costs and volume. A change in expected behaviour will alter the 
break-even point; in other words, prof its are affected by changes in other 
factors besides volume. Other fact ors include unit prices of input, 
efficiency, changes in production technol ogy, wars, strikes, legislation, 
and so forth. 
A CVP chart must be interpreted in t he light of the limitations imposed by 
its underlying assumptions. The follo wing underlying assumptions will 
limit the precision and re liability of a given cost -volume-profit analysis. 
(1) The behaviour of total cost and total revenue has been reliably 
determined and is linear ov er the relevant range. 
(2) All costs can be divided in to fixed and variable elements. 
(3) Total fixed costs remain constant over the relevant volume range of 
the CVP analysis. 
(4) Total variable costs are direct ly proportional to volume over the 
relevant range. 
(5) Selling prices are to be unchanged. (6) Prices of the factors of pr oduction are to be unchanged (for 
example, material, prices, wage rates). 
(7) Efficiency and producti vity are to be unchanged. 
(8) The analysis either covers a si ngle product or assumes that a given 
sales mix will be maintained as total volume changes. 
(9) Revenue and costs are being com pared on a single activity basis 
(for example, units produced and so ld or sales value of production).

436  
 (10) Perhaps the most basic assumption of all is that volume is the only 
relevant factor affecting cost. Of course, other factors also affect 
costs and sales. Ordinary cost-vol ume-profit analysis is a crude 
oversimplification when these fact ors are unjustifiably ignored. 
(11) The volume of production equals the volume of sales, or changes in 
beginning and ending inventory levels  are insignificant in amount. 
In multi-product situations, CVP a nalysis is further hampered by the 
assumption that the sales mix will re main constant. This is unlikely and it 
also ignores the situation in some organisations where products may be 
inter-related – an increase in sales for one product might result in a decrease in sales for another. For exam ple, a theatre might find that as 
adult ticket sales rise (for  example, if stage shows are more attractive to 
this age group) then there is a corres ponding fall in sales to children. A 
multi-product CVP analysis would ignore this and assume that the ratio of 
adult to child tickets remains constant. 
Also, in multi-product situations, the presence of two potential break even 
points is both confusing and misleading.  It confuses because it is difficult 
for managers to understand (and it is based on a very unlikely 
assumption). But it is also misleading in that as more of each product is 
introduced into the mix (i.e. rather t han selling each product in turn in 
order of its C/S ratio)  then the break even point  will start to increase and 
there will in fact be mult iple break even points.

438  
11 Practice Questions 
 The following information relates to Product Alpha. 
Selling price per unit  $100 
Variable cost per unit  $56 Fixed costs   $220,000 Budgeted sales are 7,500 units. 
Required: 
(a) Calculate the breakeven point in terms of units sold and overall 
sales revenue. 
(b) Calculate the margin of safe ty (expressed as a percentage of 
budgeted sales). 
 
 A company manufactures and sells a single product which has the 
following cost and selling price structure. 
Selling price   
Direct material 22  Direct labour 36  
Variable overhead 14  
Fixed overhead 12   –––  
  84 
  ––– Profit per unit  36 
  ––– 
2,000 units per month. Assume that the same amount is spent each 
month on fixed overheads. 
Budgeted sales for next month are 2,200 units. You are required to calculate: (i) the breakeven point, in sales units per month (ii) the margin of safety for next month 
(iv) the sales required to achiev e a profit of $96,000 in a month 
(v) the contribution to sales ratio (vi) the breakeven revenue that mu st be generated in order to break 
even.

Chapter 11 
 439 
 A break-down of KP's profit in th e last accounting period showed the 
 $000 
Sales 450 
Variable costs (220) 
Fixed costs (160)  ––––– 
Profit 70 
 ––––– 
Due to a downturn in market conditions the company is worried that next 
year may result in losses and would like to know the change in sales that would make this happen. 
Required: 
The percentage fall in sales that w ould be necessary before the company 
would begin to incur losses is ____% (work to two decimal places). 
 
 OT Ltd plans to produce and sell 4,000 units of product C each month, at a 
selling price of $18 per unit. The unit cost of product C is as follows   
 $ per unit 
Variable cost 8 
Fixed cost 4  –––– 
Profit 12 
 –––– 
To the nearest whole number, the m onthly margin of safety, as a 
percentage of planned sales is ____%.

440  
 A company’s summary budgeted operating statement is as follows: 
 $000 
Revenue 400 
Variable costs 240 
Fixed costs 100  ––––– 
Profit 60 
 ––––– 
Assuming that the sales mix does not change, identify the percentage 
increase in sales volume that woul d be needed to increase the profit to 
$100,000: 
A 10% B 15% C 25% D 40% 
 
 Scenario 
A company manufactures five produc ts in one factory. The company’s 
budgeted fixed costs for the next y ear are $300,000. The table below 
summarises the budgeted sales and cont ribution details for the five 
products for the next year. 
Product A B C D E 
Unit selling price $40 $15 $40 $30 $20 Total sales ($000) 400 180 1,400 900 200 
Contribution to sales ratio 45% 30% 25% 20% (10%) 
The following diagram has been prepared to summarise the above 
budget figures:

Chapter 11 
 441 
 Tasks: 
(a) Explain the meaning of point X on the chart. 
(b) Calculate the breakeven revenue for the next year using the 
budgeted sales mix. 
 
 Scenario 
JK has prepared a budget for the next 12 m onths when it intends to make 
and sell four products, details of which are shown below: 
Product Sales in units 
(thousands) Selling price per 
unit $ Variable cost 
per unit $ 
J 10 20 14.00 
K 10 40 8.00 
L 50 4 4.20 
M 20 10 7.00 
Budgeted fixed costs are $240,000 per annum and total assets employed 
are $570,000. 
Tasks: 
(a) Calculate the total contribution earned by each product and their 
combined total contributions. 
The accountant at JK has pr oduced the following profit-revenue 
graph for the products:

442  
 (b) Explain this graph to management, comment on the results shown 
and state the break-even point. 
(c) Describe briefly three ways in which the overall contribution to sales 
ratio could be improved. 
(Time allowed: 30 minutes) 
 
 Scenario 
A summary of a manufacturing company ’s budgeted profit statement for 
its next financial year, when it expect s to be operating at 75% capacity, is 
given below. 
 $ $ 
Sales 9,000 units at $32  288,000 Less:   
direct materials 54,000  direct wages 72,000  production overhead – fixed 42,000  
 – variable 18,000   –––––––    188,000   ––––––– 
Gross profit  102,000 
Less: admin., selling and distribution costs   
– fixed 36,000  
– varying with sales volume 27,000  
 –––––––  
  63,000 
  ––––––– 
Net profit  39,000   ––––––– 
It has been estimated that: 
(i) if the selling price per unit we re reduced to $28, the increased 
demand would utilise 90 per  cent of the company’s capacity without 
any additional advertising expenditure 
(ii) to attract sufficient demand to utilise full capacity would require a 15 
per cent reduction in the current selling price and a $5,000 special 
advertising campaign.

Chapter 11 
 443 
 Tasks: 
(a) Calculate the breakeven point in units, based on the original budget. 
(b) Calculate the profits and breakev en points which would result from 
each of the two alternatives and compare them with the original 
budget. 
(c) The manufacturing company deci ded to proceed with the original 
budget and has asked you to calculate how many units must be sold 
to achieve a profit of $45,500. 
 
 A company makes and sells three products, R, S and T. Extracts from the weekly profit statem ents are as follows: 
 R S T Total 
 $ $ $ $ 
Sales revenue 10,000 15,000 20,000 45,000 
Variable cost of sale s 4,000 9,000 10,000 23,000 
Fixed costs (*) 3,000 3,000 3,000 9,000 Profit 3,000 3, 000 7,000 13,000 
(*) General fixed costs absorbed using a unit absorption rate. 
If the sales revenue mix of products produced and sold were to be 
changed to: R 20%, S 50% and T 30%, t he new average contribution to 
sales ratio would be ______ (choose fr om higher, lower, or remain 
unchanged)?

444  
 MC manufactures one product only, and for the last accounting period 
has produced the simplified prof it and loss statement below: 
 $ $ 
Sales  300,000 
Direct costs   
Direct materials 60,000  Direct wages 40,000  
 ––––––  
Prime cost 100,000  Variable production overhead 10,000  
Fixed production overhead 40,000  
Fixed administration overhead 60,000  Variable selling ov erhead 40,000  
Fixed selling ov erhead 20,000  
 ––––––    270,000 
  ––––––– 
  30,000 
  ––––––– 
The organisation has created the followi ng profit–volume graph from this 
information as follows:

Chapter 11 
 445 
 Examine the following diagrams: 
 
These graphs show increase or de crease in profit by +x or –x. 
Match each diagram to each of the following potential changes to the 
business' assumptions: 
 a decrease in variable cost 
 a decrease in sales volume 
 an increase in fixed cost 
 an increase in sales price

446  
 A company provides three different holiday packages to a popular 
destination. Details on the profits m ade from the packages are as follows: 
 Standard Premium Superior 
 $ $ $ 
Retail price 450 600 800 
Variable costs 70 90 120 Fixed costs 180 200 240 
Profit per package 200 310 440  ––––– ––––– ––––– 
The total annual fixed costs are budgeted to be $200,000 and, whilst 
none of these costs are specific to  any particular package, they are 
charged to packages on the basis of average numbers of service staff per 
package. 
The company expects to sell the pa ckages in the following proportion: 
 Standard 50% 
 Premium 30% 
 Superior 20% 
The annual revenue that needs to be gener ated in order to break even is 
closest to: A $200,000 B $236,000 C $237,000 D $402,000 
 
 A provider of language courses has  three courses with the following 
Product Introductory Intermediate Advanced 
Contribution to sales ratio 40% 80% 60% 
Expected sales mix 60% 30% 10% 
Total fixed costs are budgeted to be $120,000. 
To the nearest $, the total br eak-even revenue is $_______

Chapter 11 
 447 
 A retailer has taken a decision to  decrease its operational gearing by 
outsourcing its home delivery service.  Its total costs at the existing 
budgeted volume will remain the same. 
Which two of the follo wing statements will be true? 
 True? 
Its fixed costs will increase  
Its fixed costs will decrease  
Its contribution to sales ratio will increase  
Its contribution to sales ratio will decrease  
 
 Two profit making organisations in t he same industry have identical levels 
of volume, selling price and total cost s. But Company 1 has a higher level 
of operational gearing than Company 2. Which of the followi ng statement s are true? 
A Company 2 has a higher level of fixed costs as a proportion of total 
costs 
B Company 1 will have a higher break-even point than Company 2 C Company 2 will have a higher contribution to sales ratio than 
Company 1 
D Both companies will break-even at the same number of units sold 
 
 A business has budgeted to produce and sell 400 units in the next month 
and created the following budg eted profit statement: 
 $ 
Sales 8,000 
Total variable costs 2,000 Total fixed costs 4,500 
 ––––– 
Profit 1,500  ––––– 
If the business was to convert 20% of its fixed costs into variable costs, 
what would happen to its break-even revenue? 
A Increase by 20% B Increase by 6% C Decrease by 20% 
D Decrease by 6%

448  
 Example 1 
 (i) Break-even point   
The key to calculating the break even point is to determine the 
contribution per unit. 
Contribution per unit = 120 – 22 – 36 – 14 = $48 
Breakeven point (in terms of  number of units sold) 	=Fixed costs 
Contribution per unit 
 
Breakeven point =$12 × 2,000 units 
$48 
 
Breakeven point = 500 units 
 
(ii) Margin of safety  
Margin of safety = Budgeted sales – Breakeven point sales Margin of safety = 2,200 – 500 Margin of safety = 1,700 units (or 77% of budgeted sales) 
(iii) Budgeted profit  
Once breakeven point has been reac hed, all of the contribution 
goes towards profits because al l of the fixed costs have been 
covered. Budgeted profit = 1,700 units (margin of safety) × $48  
Budgeted profit = $81,600 
(iv) Target profit  
To achieve the desired level of profi t, sufficient units must be sold to 
earn a contribution that covers the fixed costs and leaves the 
desired profit fo r the month. 
 
Unit sales required =Fixed overhead + desired profit 
Contribution per unit
 
Unit sales required =$24,000 + $96,000 
$48 
 
Unit sales required = 2,500 units

Chapter 11 
 449 
 Example 2 
 It would be possible to determi ne the following information: 
 the break-even point (in units) – this can be seen from reading down 
from where total revenue cuts the total cost line and reading along 
the horizontal axis 
 the break-even point (in terms of total revenue) – this can be seen 
from reading along from where total revenue cuts the total cost line 
and reading up the vertical axis 
 total fixed costs – this is the point  at which the total costs line cuts 
the vertical axis 
 total costs – this is a line used in the construction of the chart 
 margin of safety – this is usually indicated on the chart. 
However, it would not be possible to easily determine the following: 
 variable cost per unit. 
The chart deals in total revenue and total costs and individual revenue and cost per unit values are difficult to determine. 
 
 Example 3 
 Note: the profit–volume graph is  the clearest way of presenting 
information like the one presented in this scenario. If we were to attempt to draw two conventional breakeven charts on one set of axes the result would be a jumble, which is very difficult to interpret. 
The profit-volume chart is easier for analysts to interpret. The graph 
depicts clearly the larger profits avail able from option (b). It also shows 
that the breakeven point increases fr om 20,000 units to 22,500 units but 
that this is not a large increase when viewed in the context of the 
projected sales volume. It is also po ssible to see that for sales volumes 
above 30,000 units the profit achieved will be higher with option (b). For 
sales volumes below 30,000 units opti on (a) will yield higher profits (or 
lower losses). 
In answer to the specific questions: 
 Scenario (b) has the higher contribution. 
 This cannot be deduced from the differ ence in selling price or costs. 
For example, having a higher selli ng price would normally lead to a 
higher contribution, but only if the costs remain the same. If selling 
price and costs change then it is di fficult to determine what will 
happen to contribution. This rules out options A and B in the next 
question. 
 It also cannot be deduced from the different break even points as 
this is influenced by the level of fixed costs for each option.

450  
  But the fact that situation (b) has a steeper slope in dicates that as 
volume increases profit is increasing at a higher rate. This would 
indicate that situation (b) has a higher contribution per unit (answer 
D). 
 For the final question, the point  of indifference between the two 
situations would occur when the pr ofit from each si tuation is the 
same. This occurs where their prof it lines cross, at 30,000 units 
(answer C). 
 
 Example 4 
 The breakeven revenue can be calculated as: 
 
Breakdown revenue =Fixed costs 
 
We know that the fixed cost s are $200,000. We need the weighted 
average C/S ratio as follows:  
Weighted average C/S ratio =Total contribution 
 
Weighted average C/S ratio =ሺ20,000 × $20 ሻ	+	(10,000 × $15) 
ሺ20,000 × $50 ሻ	+	(10,000 × $60) 
 Weighted average C/S ratio = 34.375% This indicates that for every $1 of revenue generated, the company will 
earn $0.34 in contribution. The breakeven revenue can now be calculated this way for company A:  
Breakdown revenue =
 
Breakdown revenue =$200,000
0.34375 
 Breakeven revenue = $581,819 Answer B is therefor e the correct answer.

Chapter 11 
 451 
 Calculations in the illustration above provide only estimated information 
because they assume that products X and Y are sold in a constant mix of 
2x to 1y. In reality, this constant mix is unlikely to exist and, at times, 
more Y may be sold than X. Such changes in the mix throughout a 
period, even if the overall mix for t he period is 2:1, will lead to the actual 
breakeven point being diffe rent than anticipated. 
Alternative solution 
An alternative (though potentially more complex solution) to this question 
would be to use the weighted average contribution per unit in the 
calculations (rather than the c/s ra tio). In an exam, you would only use 
this method if there is not enough info rmation available to calculate the 
weighted average contribution sales ratio. 
The weighted average cont ribution per unit can be calculated as follows: 
 
Weighted average contribution per unit =ሺ20,000 × $20 ሻ + (10,000 × $15)  
(20,000 + 10,000) 
 Weighted average contribut ion per = $18.33 per unit 
 The break-even point can then be calculated as follows:  
Breakdown units =Fixed costs  
Weighted average contribution per uni t
 
Breakdown units =$200,000
$18.33 
Breakeven units = 10,911 units 
This represents the total number of uni ts that must be sold in order to 
break even. If we assume that t he pre-determined sales mix still applies 
(i.e. that the company plans to sell twice as many Product X and Product 
Y) then this can be split between the products so that Product X needs to sell two thirds of 10,911 units (i.e. 7,274 units) and Product X needs to 
sell one third of 10,911 (i.e. 3,637 units). 
This would give a target revenue of: 
Sales price $50 $60 Break even sales (in units) 7,274 3,637 Break even revenue $363,700 $218,220 
The total break even revenue woul d then be ($363,700 + $218,220) 
$581,920. 
There is a little bit of a rounding diffe rence but we could still conclude that 
Answer B is the correct answer.

452  
 Example 5 
 To achieve a target profit of $300,000 in Company A: 
 
Sales revenue required for profit of $300,000 	=	(Fixed costs + required profit) 
 
Sales revenue required for profit of $300,000 	=	$200,000 + $300,000 
0.34375 
 
Sales revenue required for pr ofit of $300,000 = $1,454,545 
The correct answer is Answer D. 
 
 Example 6 
 (a) 
Product Contribution Sale s revenue C/S ratio 
 $000 $000  
X 550 800 0.6875 Y 50 200 0.2500 
Z 300 1,000 0.3000 
 ––––– –––––  Total 900 2,000   ––––– –––––  
 
Breakdown revenue =Total contribution 
Total sales
 
$900,000
$2,000,000 
 
= 0.45 or 45% 
(b) 
Breakdown sales revenue required =Fixed costs 
C/S ratio 
 
$300,000
45% 
 
= $666,667

Chapter 11 
 453 
 (c) 
Sales revenue required =Fixed costs = required profit 
C/S ratio 
 
$300,000 + $600,000
0.45 
 
= $2,000,000 
(d) 
The chart is, essentially, a profit/v olume chart. Cumulative profit is 
plotted against cumulative sales revenue. 
Like P/V charts for single products the line drawn star ts at the fixed 
costs below the line. It can ther efore be determined that the fixed 
costs for the business are $300,000. The product lines are then drawn in order of the ranking of their 
contribution/sales ratio. From the diagram we can therefore 
determine that the c/s ra tio of product X must be the highest of the 
three products and that product Y mu st be the lowest of the three 
products. The highest point on the diagram represents the highest potential 
revenue ($2m) and profits for the business ($600,000). Assuming that the products are sold  in the standard sales mix then 
the break-even point is the point at  which the lower line crosses the 
horizontal axis. This is at around $650,000. If, however, the products were sold in  order of their c/s ratios, then 
the higher line shows a potentiall y lower break-even point. The 
higher line indicates that this  would be achieved at around 
$440,000. Note: the table below provides the workings which enabled the chart 
to be drawn. 
Product Contribution  
$000 Cumulative 
Profit/Loss  
$000 Revenue  
$000 Cumulative  
revenue  
$000 
  (300)  0 
X 550 250 800 800 
Z 300 550 1,000 1,800 
Y 50 600 200 2,000

454  
 Example 7 
 (a) To calculate the overall breakeven point (expressed in sales value 
terms), we need to calculate a we ighted average contribution to 
sales ratio. To this end, we will need a total sales revenue, as well 
as a total contribution in $: 
 Summer Autumn Winter Spring Total 
Sales mix 33.33% 41.67% 16.67% 8.33% 100% 
Sales in $ 200,000 250,000  100,000 50,000 600,000 
Less: Variable 
costs in $ 120,000 170,000 80,000  20,000 390,000 
Contribution 80,000 80,000  20,000 30,000 210,000 
Weighted average C/S ra tio = ($210,000/$600,000) 
Weighted average C/S ratio = 35% 
 
Breakeven point ሺsales value ሻ= Fixed costs
 Breakeven point (sales value) = $454,286  
(b) After the change in sales mix, contribution can be calculated as 
follows: 
Sales mix 25% 40% 30% 5% 100% 
Sales in $ 150,000 240,000  180,000 30,000 600,000 
costs in $ 90,000 163,200 144,000  12,000 409,200 
Contribution 60,000 78,800  36,000 18,000 190,800 
Weighted average C/S ra tio = ($190,800/$600,000) 
Weighted average C/S ratio = 31.8% 
Breakeven point ሺsales value ሻ	= Fixed costs
Breakeven point (sales value) = $500,000.

Chapter 11 
 455 
 (a) Break-even point  
Contribution per uni t = $(100 – 56) = $44 
C/S ratio = Contribution per unit 
Selling price per unit  =	$44 
$100  = 0.44 
 
Breakeven point in terms numbers of units sold 
 
= Fixed costs 
 
= $220,000 
$44 	= 5,000 units  
 
Breakeven point in terms of sales revenue 
 
C/S ratio  
 
= $220,000 
0.44 	= $500,000  
 
(Proof: breakeven units × selling price per unit = 5,000 × $100 = 
$500,000) 
(b) Margin of safety  
(as a % of Budgeted sales) 
= Budgeted sales – Break-even sales 
Budgeted sales  × 100% 
 
= 7,500 – 5,000 
7,500 	× 100%  
 
= 33.33%

456  
 (i) The key to calculating the br eakeven point is to determine the 
Contribution point = $120 – ($22 + $36 + $14) = $48 
 
Breakeven point = Fixed overhead  
 
= $12 × 2,000
$48 =	500 units 
 
(ii) Margin of safety = budgeted sales – breakeven point   = 2,200 – 500  = 1,700 units  (or 1,700/2,200 × 100 %) 
 = 77 %  
(iii) Once breakeven point has been reached, all of the contribution 
covered. Budgeted  = 1,700 units margin of safety × $48 contribution per 
  profit unit 
 = $81,600  
(iv) To achieve the desired level of pr ofit, sufficient units must be sold to 
earn a contribution which covers the fixed costs and leaves the 
 
Number of sales units required = Fixed overhead + desired profit 
 
= ሺ$12 × 2,000 ሻ	+	$96,000
$48  
 
= 2,500 units

Chapter 11 
 457 
 (v) Contribution per unit is calcul ated as $120 – $72 sum of variable 
costs = $48 
Contribution to sales ratio = Contribution per unit  
Sales revenue per unit  
 
= $48
$120 
 
= 40%	
(iv) Breakeven revenue can be calculated in two ways 
 
Break even revenue = Monthly fixed costs  
Contribution to sales ratio  
 
= $12 × 2,000 units 
40% 
 
= $60,000  
This could also have been calcul ated as Breakeven Point 500 units 
× Selling price $120 
= $60,000  
 
 Firstly we need to calculate the breakeven sales revenue. 
Because we haven't been given any information on units, we must have 
to use the contribution sales revenue technique: 
 
C/S ratio = Fixed contribution  
Total sales revenue  = (450 – 220) 
450  
 
= 0.511 (or 51.1%) 
Breakeven point (in terms of sales revenue) =  Fixed costs
C/S ratio  
 
Breakeven point (in terms of sales revenue) =  $160,000
0.511  
 
Breakeven point (in terms of  sales revenue) =  $313,000

458  
 Now that we know the break-even posit ion we can calculate the margin of 
safety (this is what is required in  the second element of the question). 
 
Margin of safety (as a % of budgeted sales) =  Budgeted sales – Breakeven sales 
 
Margin of safety (as a % of budgeted sales) =  450 – 313 
450  × 100% 
 
= 0.3044 (or 30.44%) 
This tells us that for the company to fall into a loss making position its 
sales next year would have to fall by over 30.44% from their current 
position. 
 
 Monthly fixed costs = 4,000 units × $4 = $16,000. 
First calculate the breakeven sales: 16,000/(18 – 8) = 1,600 
 = (4,000 – 1,600)/4,000 = 60% 
 
 C 
Contribution margin = 160
400	= 40% 
 
Target revenue = 100 + 100 
40%  = 500 
 
% Increase in revenue = 500400	= 25%

Chapter 11 
 459 
 (a)  Point X on the chart shows t he highest value of sales at which 
break-even will occur, assuming that the budgeted sales value is the 
maximum achievable for each of the products. It looks like that 
breakeven point is achieved when all of E, all of D and some of Cs 
are sold. 
Note that it is not meaningful her e, because it is unlikely that in 
reality, all of D and Es  products will be sold whilst none of As or Bs 
will. 
(b) 
Breakeven revenue = Fixed costs
Weighted average contribution to sales ratio 
 
Breakeven revenue  = $300,000 
24.16% (working 1)  
 
= $1,241,935 
 
Working 1 – Weighted average contribution to sales ratio:  
Product A B C D E Total 
Unit selling price $40  $15 $40 $30 $20  
Total sales ($000) 400 180 1,400 900 200 3,080 
Contribution to sales ratio 45% 30% 25% 20% (10%)  
Contribution ($000) 180 54 350 180 (20) 744 
 
Weighted average C/S ratio = Total contribution $744,000  
Total sales $3,080,000 
 
= 0.2416 or 24.16%

460  
 (a) 
Product Revenue Variable co sts Contribution C/S ratio 
 $000 $000 $000  
J 200 140 60 0.30 
K 400 80 320 0.80 
L 200 210 (10) (0.05) 
M 200 140 60 0.30 
 1,000 570 430  
(b) The products are plotted in the or der of their C/S ratios. The fixed 
costs of the company are $240,000. The chart reveals that if only 
product K is produced, the company  will generate a profit of 
$80,000. The profit of t he company is maximised at $200,000. This 
is achieved by producing Products K, J and M only. 
If all four products are produced then JK Ltd can expect a profit of 
$190,000 from sales revenue of $1,000,000 . If all four products are 
sold in the budget sales mix then the company will break even when 
revenue reaches $558,140. This point has been indicated on the 
graph. This point can also be calculated. Thus: Average contribution/ = 430/ 1,000 = 43% sales ratio 
 
Breakeven point =Fixed costs
Average C/S ratio	
 
= $240,000 
0.43  = $558,140 
Note:  the diagram was constructed using the following product 
Product Contribution Cumulative 
Profit/(Loss) Revenue Cumulative 
revenue 
  (240)  0 
K 320 80 400 400 
J 60 140 200 600 
M 60 200 200 800 
L (10) 190 200 1,000 
(c) The overall C/S ratio could be improved by: 
– Changing the product mix in fa vour of products with above- 
average C/S ratios. In this  example that would mean 
increasing producti on of Product K. 
– Increasing sales prices or cutting production costs. 
– Deleting product L.

Chapter 11 
 461 
 (a) First calculate the current contribution per unit. 
 $000 $000 
Sales revenue  288 
Direct materials 54  
Direct wages 72  Variable production overhead 18  
Variable administration etc. 27  
 –––––    171 
  ––––– 
Contribution  117   ––––– 
Contribution per unit ($117,000/9,000 units)  $13 
  ––––– 
Now you can use the formula to calculate the breakeven point. 
Breakeven point = 
Fixed costs
 = $42,000 + $ 36,000 
$13 = 6,000 units 
(b) Alternative (i)  
Budgeted contribution per unit $13  
Reduction in selling price ($32 – $28) $4  
 ––––  
Revised contribution per unit $8  
 ––––  Revised breakeven point = $78,000/$9  8,667  Units  
Revised sales volume = 9,000 × (90/75)  10,800 Units  
Revised contribution = 10,800 × $9 
$97,200   
Less fixed costs $78,000   
 –––––––  Revised profit 
$19,200  
 –––––––     
Alternative (ii) 
  
Budgeted contribution per unit $13.00  
Reduction in selling price (15% × $32) $4.80  
 –––––––  
Revised contribution per unit $8.20  
 –––––––

462  
 Revised breakeven point = $78,000 + $5,000 
$8.20 10,122 Units 
   
Revised sales volume = 9,000 units × (100/75) 12,000 Units 
Revised contribution = 12,000 × $8.20 $98,400  
Less fixed costs $83,000   –––––––  Revised profit $15,400  
 –––––––  
Neither of the two alternative pr oposals is worthwhile. They both 
result in lower forecast profits. In addition, they will both increase the 
breakeven point and will t herefore increase the risk associated with 
the company’s operations. 
(c) This exercise has shown you how an understanding of cost 
behaviour patterns and the manipulat ion of contribut ion can enable 
the rapid evaluation of the financia l effects of a proposal. We can 
now expand it to demonstrate another  aspect of the application of 
CVP analysis to short-term decision-making. 
Once again, the key is the requir ed contribution. This time the 
contribution must be sufficient to cover both the fixed costs and the 
required profit. If we then divide this amount by the contribution 
earned from each unit, we can determine the required sales volume 
 
Required sales 	= Fixed costs + required profit 
 
= ($42,000 + $ 36,000 + $45,500)
$13 = 9,500 units  
 
 Test your understanding 9  
 Answer: lower 
 R S T Total 
 $ $ $ $ Sales revenue 10,000 15 ,000 20,000 45,000 
Contribution 6,000 5, 000 10,000 22,000 
C/S ratio 0.6 0.4 0.5 0.489 New weightings 20% 50% 30%  New weighted C/S ratio 0.12 0.2 0.15 0.47 
So the new C/S ratio is lower.

Chapter 11 
 463 
 Test your understanding 10  
 (i) An increase in fixed costs 
(ii) A decrease in variable costs 
(iii) An increase in sales price (iv) A decrease in sales volume 
 
 Test your understanding 11  
 The correct answer is option B. 
Package Volume  Contribution 
per package Total 
contribution Selling 
price per 
package Total 
revenue 
  $ $ $ $ 
Standard 50 390 19, 000 450 22,500 
Premium 30 510 15, 300 600 18,000 
Superior 20 680 13, 600 800 16,000 
   ––––––  ––––––    47,900  56,500 
   ––––––  –––––– 
Average C/S ratio = 47,900/56,500 = 0.8478 
Breakeven point = $200,000/0.8478 = $235,908 
 
 Test your understanding 12  
 To the nearest $, the total break-even revenue is $ 222,222  
The weighted average contribution margin is: = [(40% × 60%) + (80% × 30%) + (60%  × 10%)] = [24% + 24% + 6%] = 
54% The break-even point = $120,000/54% = $222,222.

464  
 Test your understanding 13  
  
 True? 
Its fixed costs will decrease Correct 
Its contribution to sales ratio will decrease Correct 
Reducing operational gear ing means converting some fixed costs into 
variable costs. This will reduce the le vel of fixed costs and increase the 
level of variable costs. Increas ing variable costs will decrease the 
contribution per unit and the c ontribution to sales ratio. 
 
 Test your understanding 14  
 Correct answer: B 
Organisations with a higher level of  operational gearing will have a higher 
break-even point than identical or ganisations with lower operational 
gearing. Statement B is true. 
Organisations with a lower operational  gearing will have a lower break-
even point, a lower contribution to sales ratio and lower levels of fixed 
costs. The other st atements are false. 
 
 Test your understanding 15  
 Correct answer: D 
Existing contribution to sales ra tio = ($8,000 – $2,000)/$8,000 = 75% 
Existing break-even revenue = $4,500/75% = $6,000 
Revised contribution to sales ra tio = ($8,000 – $2,000 – $900)/$8,000 = 
63.75% Revised fixed costs = $3,600 Revised break-even revenue = $3,600/63.75% = $5,647 Fall in break-even revenue = $35 3 = 5.89% (approximately 6%)

465 
Linear programming 
techniques to support short-term decision making (c) Product mix decisions with 
constraints. 
(d)  Data and technology. 
  Chapter 
12

466  
 
We saw in an earlier chapter that w hen faced with one limiting factor, we 
calculate the contribution per unit of t he limiting factor and rank the products, 
allocating the scarce resource to the best product and then the next best 
product and so on until the resource is fully utilised. 
If faced with two or more limiting factors, then the situation is more complicated 
and linear programming techniques must be used (and the limiting factors are 
now called constraints ). 
 
 In the previous chapter, you saw how to use basic limiting factor analysis 
to determine the profit-maximising sales mix for a company with a single 
resource constraint. The decision rule  was to allocate the resource to 
products according to the contribution earned per unit of scarce 
resource , subject to any other constraint s such as maximum or minimum 
demands for the individual products. This technique cannot be applied when there is more than one limiting 
factor. In this situation a linear programming  technique is used. 
Linear programming is the name given to  a collection of tools that are 
among the most widely used in management  science. It is essentially a 
technique that encompasses the problem of allocating scarce resources 
between competing activities so as to maximise or minimise some 
numerical quantity, such as contributi on or cost. In business it can be 
applied to areas such as planning produc tion to maximise  profit, mixing 
ingredients to minimise costs, sele cting a portfolio of investments to 
maximise worth, transporting goods to minimise distance, assigning 
people to maximise efficiency and sc heduling jobs to minimise time. 
Linear programming involves the constr uction of a mathematical model to 
represent the decision problem. The model is then solved by an appropriate method or by the use of a computer  package to obtain the 
optimal values for the activities.

Chapter 12 
 467 
 The technique employed will require a bas ic level of mathematics that you 
should have obtained from previous studies 
 
 Algebra revision 
 In this chapter you will need to be familiar with some algebraic 
mathematical techniques. This part of the text provides a revision of the 
ones that are most commonly used in linear programming. 
Understanding inequalities 
Inequalities are treated in almost exac tly the same way as equations. In 
fact an inequality says much the same thing as an equation, except that 
one side will be 
 less than the other (<) 
 greater than the other, (>) 
 less than or equal to the other, ( ≤ ), or 
 greater than or equal to the other.( ≥) 
Inequalities can be manipula ted in the same way as equations, except 
that when multiplying or dividing by a negative number it is necessary to 
reverse  the inequality sign. 
5 – 2x < 25 –2x < 20 (deduct 5 from each side) –x < 10 (divide each side by 2) x > –10 (divide each side by –1, so reverse direction of inequality) 
Using simultaneous equations 
Simultaneous equations are where y ou have two equations that must 
both be satisfied at the same time, of the type: 
3X + 4Y = 18 (i) 
5X + 2Y = 16 (ii) 
which must both be satisfied by the solutions X and Y. 
Provided you multiply both sides of an equation by the same amount, it 
continues to be true. In the solution of these equations, one or both of the 
equations are multiplied by  numbers chosen so that either the X or the Y 
terms in the two equations bec ome numerically identical. 
We have labelled the equations (i) and (ii)  for clarity. Suppo se we were to 
multiply (i) by 5 and (ii) by 3. Both equations would contain a 15X-term that we could eliminate by subtracti on, it being the case that you can add 
or subtract two equations and the result remains true.

468  
 In this case, however, the simplest method is to multiply equation (ii) by 
2, so that both equations will contain 4Y and we can subtract to eliminate 
Y. The full solution is shown below. 
3X + 4Y = 18  (i)  5X + 2Y = 16 (ii) Multiply (ii) by 2: 10X + 4Y = 32 (iii) Subtract (iii) – (i): 7X + 0 = 14 X = 14 ÷ 7 = 2 Substitute X = 2 into  (i) 6 + 4Y = 18 4Y = 18 – 6 = 12 Y = 12 ÷ 4 = 3 Check the results in (ii): 5 × 2 + 2 × 3 = 16 The solution is X = 2, Y = 3. Had we chosen to substitute X = 2 into equation (ii) it would not have 
affected the result but we would then have checked in the other equation 
(i). 
Solving simultaneous linear equations using graphs 
Each equation represents a straight line and solving simultaneous 
equations is the same as identifying the point at which the two lines 
cross. 
This is the graphical interpretation of  the solution of simultaneous linear 
equations, and a graphical method could be used instead of an algebraic 
method (provided that the scale wa s big enough to give the required 
accuracy). 
3 Step-by-step technique 
The technique requires the translation of a decision problem into a system of 
variables, equations and inequalities. 
For examination purposes a five-step procedure is used to construct the 
mathematical model. Any of t hese steps might be examined.

Chapter 12 
 469 
 Product X and Product Y 
 A company produces two products in  three departments. Details are 
shown below regarding t he time per unit required in each department, the 
available hours in each department and the contribution per unit of each 
product: 
 Product X Hours 
per unit Product Y Hours 
per unit Available 
hours 
Department A 8 10 11,000 
Department B 4 10 9,000 
Department C 12 6 12,000 Contribution per 
unit ($) 4 8  
Required: 
Following the procedure for the graphical soluti on, define the optimum 
production plan. 
Step 1 – Define the variables 
The first step is to simplify the equations  by using abbreviations for the products 
or variables. 
 
 Step 1 – Product X and Product Y 
 Let x = number of units of Product X produced. 
Let y = number of units of Product Y produced. 
Step 2 – State the objective function 
The objective function expresses the total contribution  that will be made from 
the production of the two products 
 
 Step 2 – Product X and Product Y 
 The objective of the business is usual ly to maximise profit, and as fixed 
costs are fixed this would mean the objective function is to maximise 
contribution.  
The objective function is stated in  terms of the defined variables. 
Note however that in some questions  the objective function might be to 
minimise costs. If that was the case  then we would create an equation for 
the total cost line. In our illustration the objective functi on is to maximise contribution (we 
should always make this assumption unl ess told specifically otherwise). 
The contribution on each unit of X is  $4 and on each unit of Y, $8. The 
objective function 'Z' is to be maximised is as follows: 
Contribution (Z) = 4x + 8y

470  
 It is important that the contribution  per unit of each product is used in the 
construction of this formula, rather  than, say, the selling price per unit. 
Step 3 – State the constraints 
Each constraint under which the organisa tion operates should be expressed as 
an equation. This involves il lustrating that the total for that resource must be 
less than or equal to the total of t hat resource that is available. 
 
 Step 3 – Product X and Product Y 
 In our illustration, we can see t hat available hours are limited in 
Departments A, B and C and we theref ore can illustrate that the total 
hours in each department must be le ss than or equal to the total hours 
available. 
There are limited hours in Department A (11,000). Within that department 
each unit X takes 8 hours and each unit Y takes 10 hours. So the total 
hours in department A will be 8 hours for every Product X (i.e. 8x when expressed in our formula), and 10 hours for every Product Y (i.e. 10y 
when expressed in our formula). Be cause of the limitation on hours in 
Department A we know that these total hours must be less than or equal 
to 11,000 hours, and this then allows us to express a formu la for the total 
hours equation in Department A as follows: 
8x + 10y ≤ 11,000 
A similar equation can be created for Department B as follows: 
4x + 10y ≤ 9,000 
Likewise, there are limited hours in  Department C and its equation would 
be as follows: 
12x + 6y ≤ 12,000 
Finally, we have to remember that we cannot make negative numbers of 
products, and, therefore, for comp leteness we should state that the 
values for x and y cannot be negative (this is known as the non-negativity constraint) as follows: 
x,y ≥ 0

Chapter 12 
 471 
Step 4 – Draw the graph 
The constraints lines can then be plotted on a graph. 
 
 Step 4 – Product X and Y 
 The graph of the constraints in our illustration would appear as follows: 
 
Each constraint is plotted at  its maximum possible point.  
 
 You will not be asked to construct a gr aph in the examination. But you may 
be given a graph and asked to choose which line represents a particular 
constraint.

472  
This should allow for the identification of the feasible region  of production 
values. 
The feasible region for production is the ar ea formed by the point s a, b, c, d and 
e in the graph for Product X and Product Y.  
 The feasible region 
 The feasible region  represents all the possible production combinations 
that the company may undertake. 
CIMA's Official Terminology defin es a feasible area as 'an area 
contained within all of the constraint lines shown on a graphical 
depiction of a linear progr amming problem. All feas ible combinations of 
output are contained withi n, or located on, the boundaries of the 
feasible region' 
If such an area does not exist, then the model has no solution  
Step 5 – Find the optimum solution 
A profit line  can then be used to determine the out er most point of the feasible 
region. This will be the optimal point of production.  
 The profit line 
 In this step, consider how the objective can be achieved. The graph is 
used to determine the optimum produc tion plan. There are two methods 
that may be used to determine the optimum point  on the graph: 
Method 1: Using simultaneous equations 
In this method we calculate the c oordinates of each vertex (furthest 
points) on the feasible region. Then calculate the contri bution (objective 
function) at each vertex. Method 2: Using an is o-contribution line 
We do not know the maximum value of  the objective function; however, 
we can draw an iso-contribution (or 'profit') line that shows all the 
combinations of x and y that provide the same total value for the 
objective function. 
 If, for example, we need to maxi mise contribution $4x + $8y, we can 
draw a line on a graph that shows co mbination of values for x and y 
that give the same total contribut ion, when x has a contribution of $4 
and y has a contribution of $8. Any total contribution figure can be 
picked, but a multiple of $4 and $8 is easiest. 
 For example, assume 4x + 8y = 4,000. This contribution line could 
be found by joining the points on the graph x = 0, y = 500 and x = 
1,000 and y = 0.

Chapter 12 
 473 
  Instead, we might select a total contribution value of 4x + 8y = 
$8,000. This contribution line could be found by joining the points on 
the graph x = 0, y = 1,000 and x = 2,000 and y = 0. 
 When drawing both of these cont ribution lines on a graph, we find 
that the two lines ar e parallel and the line with the higher total 
contribution value for values x and y ($8,000) is further away from 
the origin of t he graph (point 0). 
 This can be used to identify t he solution to a linear programming 
problem. We draw the iso-contribu tion line showing co mbinations of 
values for x and y that give the sa me total value for the objective 
function. 
 Look at the slope of the contributi on line and, using a ruler, identify 
which combination of values of x and y within the feasible area for 
the constraints is furthest away from  the origin of the graph. This is 
the combination of values for x and y where an iso contribution line 
can be drawn as far to the right as possible that just touches one 
corner of the feasible area. This is the combination of values of x 
and y that provides the solution to  the linear programming problem. 
Given the difficulty in applying Method 2 in a computer-based exam, it is 
more likely that you would have to apply Method 1 in an exam. However, you may not be asked to check all po ints on the feasible region – the 
examiner may tell you which constrai nts form the optimal point so that 
you only have one point of intersection to calculate. 
 
 Step 5 – Product X and Product Y 
 Method 1 
In our example, the co-ordinates of  some of the points can easily be 
determined from the diagram and we can quickly calculate the level of 
contribution made at each of these points 
Potential 
optimal point Production of 
X (units) Production of 
Y (units) Total 
 $ $ $ 
a 0 0 0 
b 0 900 7,200 
e 1,000 0 4,000 
But for the remaining points (c and d) we must use simultaneous 
equations to determine their coordinates. 
Point c occurs where the constraints for Dept A and Dept B intersect. 
Because the point is at the furthest poi nt of each of the lines we know 
that all of the constraint is being used and the less than or equal to sign in 
the equations can be conv erted to an equal sign: 
Dept A: 8x + 10y = 11,000 
Dept B: 4x + 10y = 9,000

474  
 Using simultaneous equations to so lve this problem provides the 
coordinates: 
x = 500, y = 700. Point d occurs where the constraints for Dept A and Dept C intersect. 
Dept C: 12x + 6y = 12,000 Using simultaneous equations to so lve this problem provides the 
coordinates: x = 750, y = 500. We have now got the coordinates for a ll 5 points at the vertex of the 
feasible region and can determine the total contribution at each point: 
Potential 
 $ $ $ 
a 0 0 0 
c 500 700 7,600 
d 750 500 7,000 
The optimal production plan occurs at the point at which contribution is 
maximised (as that was our objective in  Step 2). This occurs at point c, 
where 500 units of Product X are pr oduced, 700 units of Product Y are 
produced and the total c ontribution is $7,600. 
 
 Ensure that you answer the question that has been asked by the 
examiner.  
If asked for the optimal production pl an then you need to state how much 
of each product should be manufactured (i.e. the co-ordinates for the 
optimal point on the diagram). If instead you are asked for the optimal contribution then you must go 
further and calculate the contri bution at the optimal point.

Chapter 12 
 475 
 Method 2 
The line plotted from point  400 on the y axis to point 800 on the x axis is 
the profit line. If you were to put a ruler along this line and move it 
outwards in parallel to that line, the la st point that you would meet in the 
feasible region would be point  C. This tells us that the optimal point in the 
feasible region in our illus tration is at point C. 
We would then use simultaneous equations as in Method 1 to determine 
that the co-ordinates for this point are x = 500 and y = 700. 
The optimum production plan is theref ore to produce 500 units of Product 
X and 700 units of Product Y. Contribution at this point = (500 × $4) + (700 × $8) = $7,600. 
 
 Illustration 1 – Linear programming in practice  
 The airline industry uses linear programming  to optimise profits and 
minimise expenses in their business. 
The products 
Airlines decided to charge different fares for different  seats and promoted 
different prices depending on how ear ly you bought your ticket. This 
required some linear  programming.  
Different prices brought different levels of cont ribution. These therefore 
became the airlines 'products' for the linear programming calculations. 
Through linear programmi ng, airlines were able to find the optimal 
breakdown of how many tickets to se ll at which price, including various 
prices in between. 
The constraints 
Airlines also need to consider plane r outes, pilot schedules, direct and in-
direct flights, and layovers. There are certain standards that  require pilots 
to sleep for so many hours and to have so many days rest before flying 
(so available flying time became a constr aint). Airlines w ant to maximise 
the amount of time that their pilots are in the air, as well. Pilots have 
certain specialisations, as not all pilots  are able to fly the same planes, so 
the number of pilots available becomes a constraint. The most 
controllable factor an airline has is its p ilot’s salary, so it is important that 
airlines use their optimisation teams to keep this expense as low as 
possible. Because all of these cons traints must be considered when 
making economic decisions about the airline, linear programming 
becomes a crucial job. 
Because there is more than one scarc e resource, computers were used 
to create solutions to the problem for airlines.

476  
4 Minimisation problems 
Linear programming enables organisations to  find optimal solutions to economic 
decisions. Generally, this means maximising  but it could aim to minimise costs 
instead; so, rather than finding a contribut ion line touching the feasible polygon 
at a tangent as far away from the origin as possible, the aim is to find a total 
cost line touching the feas ible polygon at a tangent as close to the origin as 
possible . 
5 The slack 
At the optimal production point it is unlik ely that all of the scarce resources will 
have been used up. If one of t he constraints has remaining resources at this 
point this is known as slack. 
 
 Slack and surplus 
 Slack 
This is the amount of a resource that is under-utilis ed when the optimum 
plan is implemented. The actual utilisation is below a maximum 
specification. In other terms, slac k will occur when the optimum does not 
fall on a given resource line. 
Slack is important, because unused resources can be put to another use, 
for example, they could be hir ed out to another manufacturer. A 
constraint that has a slack of zero is known as a scarce resource.  
Scarce resources are fully utilised resources. 
CIMA's Official Terminology defines slack variables as 'the amount of 
each resource which will be unused if a specific linear programming 
solution is implemented.' 
Surplus 
This is utilisation of a resource over and above a minimum. Surpluses 
tend to arise in minimisation of cost problems. For example, a constraint 
may state that it is necessary to produce a minimum of 400 widgets. If the 
optimum plan then recommends produc ing 450 widgets, the surplus in 
this case would be 50 widgets . 
At the optimal production point, there will be no slack in the constraints lines 
that make up the optimal point. These are known as binding constraints.  
The only slack in the system will come fr om the other constraint lines on the 
graph. These are non-binding constraints.

Chapter 12 
 477 
 Slack – Product X and Product Y 
 Slack in Department A, Depar tment B and Department C can be 
calculated based on the optimum so lution where x = 500 and y = 700, 
and production plan slacks are: 
Department A = (500 units of Produc t X × 8 hours) + (700 units of 
Product Y × 10 hours) = 11,000 hours. This uses all available hours in Department A. No slack in A => The 
constraint is binding. 
Department B = (500 units of Produc t X × 4 hours) + (700 units of 
Product Y × 10 hours) = 9,000 hours. 
This uses all available hours in Department B. No slack in B => The 
Department C = (500 units of Product X × 12 hours) + (700 units of 
Product Y × 6 hours) = 10,200 hours. 
There are 12,000 hours available in D epartment C. Theref ore, the slack 
is 12,000 – 10,200 hours = 1,800 hours. There is slack in C => The 
constraint is non-binding. 
6 The shadow price 
It may be that the problem of the scarc e resources can be alleviated by, say, 
buying in the scarce resource at a prem ium price. The extra resource would 
allow the organisation to make more products and create more contribution. 
The maximum premium on price that the organisation would pay for the extra 
resource is known as the shadow price.  
 More details on the shadow price 
 After finding an optimum solution  to a graphical linear programming 
problem, it should be possible to provide further information by 
interpreting the graph more fully, to  see what would happen if certain 
values in the scenario were to change. It is the premium (over and above the normal price) it would be 
worth paying to obtain one more unit of the scarce resource.  
CIMA's Official Terminology defines a shadow price as 'the increase in 
value which would be created by having available one additi onal unit of 
a limiting resource at its original cost. This represents the opportunity 
cost of not having the use of the one extra unit. This information is 
routinely produced when mathematical  programming (esp ecially linear 
programming) is used to model activity.' 
 
The shadow price of a scarce resource is the extra contribution that would arise 
if one more unit of that sca rce resource became available, or it is the drop in 
contribution that would result from having one fewer unit of that scarce 
resource. Non-binding constraint s have no shadow price.

478  
 Shadow prices – Product X and Product Y 
 Shadow prices in Department A: 
We need to calculate the impact if one extra hour of Department A time 
was made available, so that 11,0 01 hours were available. The new 
optimum product mix would be at the in tersection of the two constraint 
lines: 
(i) 8x + 10y = 11,001 hours (ii) 4x + 10y = 9,000 hours With (i) – (ii), 4x = 2,00 1 and therefore x = 500.25 units. 
When substituting x with '500.25' in (i) or (ii) we get y = 699.9 and new 
total contribution is calculated as follows: 
 Units Contribution  
   $ 
X 500.25 $4 2,001.00 Y 699.9 $8 5,599.20 
   ––––––––– 
   $7,600.20 
The original contribution was equal to ( 500 units of X × $4) + (700 units of 
Y × $8) = $7,600.  
Therefore, the increase in  contribution from one extr a hour in Department 
A is $0.20. In other words, the shadow price of an extra hour in 
Department A is $0.20. The company  should be prepared to pay up to 
$0.20 extra per hour. 
Shadow prices in Department B: 
We need to calculate the impact if one extra hour of Department B time 
was made available, so that 9,00 1 hours were available. The new 
lines: 
(i) 8x + 10y = 11,000 hours (ii) 4x + 10y = 9,001 hours With (i) – (ii), 4x = 1,99 9 and therefore x = 499.75 units. 
When substituting x with '499.75' in (i ) or (ii) we get y = 700.2 and new 
   $ 
X 499.75 $4 1,999.00 Y 700.20 $8 5,601.60    ––––––––    $7,600.60

Chapter 12 
 479 
 The original contribution was equal to ( 500 units of X × $4) + (700 units of 
B is $0.60. In other words, the shadow price of an extra hour in 
Department B is $0.60. The company  should be prepared to pay up to 
$0.60 extra per hour. 
Shadow prices in Department C: 
The shadow price of an extra hour in D epartment C is 0, as  there is slack 
in Department C (1,800 hours are still available.) 
7 LP and Decision Making: minimum contractual requirements 
When, in the question, information is given regarding a cu stomer order the 
business has to meet, it is necessary  to take this order into account before 
formulating the Linear Programming problem. 
 
 Example 1 
 ND Ltd produces two products, the Alpha and the Beta. For the next 
quarter, the following information is relevant: Material A:  1,200 kgs are available. 
Per unit of Alpha: 2 kgs Per unit of Beta: 3 kgs 
Material B:  1,500 kgs are available. 
Per unit of Alpha: 5 kgs Per unit of Beta: 2 kgs 
Labour:  2,000 hours are available. 
Per unit of Alpha: 7 hours Per unit of Beta: 5 hours. 
Each unit of Alpha and Beta make a contribution of $8 each. ND Ltd has already agreed a contract to supply 20 Alphas and 20 Betas 
with a key customer. This order, if cancelled, would incur a significant 
financial penalty. 
Required: 
Formulate the Linear Programming problem.

480  
8 Limitations of linear programming 
There are a number of assumptions and limitations to this technique. 
 Linear relationships must exist. 
 Only suitable when there is one cl early defined objective function. 
 When there are a number of variables, it becomes  too complex to solve 
manually and a comput er is required. 
 It is assumed that the variabl es are completely divisible. 
 Single value estimates are used for the uncertain variables. 
 It is assumed that the situation re mains static in all other respects. 
9 Using data and technology in linear programming 
The method seen in this chapter can be a long and complex task for many 
decision makers. It is also limited to the use of only two products. Therefore, 
decision makers are turning to technology to help speed up and ease the burden of such product mix decisions. 
Many widely available spr eadsheet packages such as Microsoft excel have built 
in tools for performing such  tasks. For example, Exce l has a solver tool for 
linear programming scenarios: 
 
It even has tools which can help in both decision making and budgeting such as 
a ‘What-if analysis’ tool: 
 
This can be supplemented with other so ftware which can provide diagrams and 
pictures to help better visualise probl ems and solutions. This can make the 
decisions on the optimal product mix a less challenging task for decision 
makers.

Chapter 12 
 481 
Using such technology can bring many advantages to decision makers such as: 
 More complex scenarios with more data can be worked with. 
 Tasks become quicker and more efficient. 
 Using visualisations can make probl ems and solutions easier for decision 
makers to understand. 
 Formulae and look up tables can be us ed so that if any figure is amended, 
all the figures will be immediately reca lculated. This is very useful for 
carrying out sensitivity analysis. 
 The results can be printed out or di stributed to other users electronically 
quickly and easily. 
However, there are some issues with software that users need to be aware of: 
 Simple, off-the-shelf programmes ma y not have the full capabilities to 
solve all problem scenarios. More  advanced (and expensive) software 
programmes may be required. This ma y only have an overall benefit for 
organisations who expect to make decisions on the optimal product mix 
more often. 
 The output from technology will only be as good as the input. If errors are 
made at the input stage (such as, for example, an incorrect total for a 
constraint) then the output  will not provide the correct solution to the 
organisation’s problem. 
 Using visualisations and graphics can give a simpler and quickly 
understood picture of information but it can hide much of the detail and 
subtleties in the raw data. Decision makers should not make decisions 
based on such simple sources. 
Non-financial data in product mix decisions  
As with all decisions you must be aware t hat the decisions we have explored on 
optimal product mix have focused on sole ly the financial imp lications of the 
decision. There are many more non-financ ial factors that an organisation should 
consider when making decisions (as seen in an earlier chapter). 
Gathering this non-financial information can be done in much the same way as 
gathering data for the purposes of budgetin g – such as consulting staff or 
customers or using availabl e big data. It will also ex perience similar advantages 
and disadvantages. The type of non-financial data that will be relevant to choosing the optimal 
product mix might be: 
 Customer value placed on a product. 
 Competitor plans for competing products. 
 The length of time that a par ticular resource will be scarce. 
 Opportunities to use alternative resources through product redesign. 
 Expected demand for a product. 
 The ethical impacts of removing a product. 
These non-financial considerations shoul d feed in decision maker plans as 
much as financial impacts.

Chapter 12 
 483 
 Solve the equations: 
2X + 3Y = 190 (i) 
7X + 4Y = 340 (ii) 
 
 A company is using linear progra mming to decide how many units of 
each of its two products to make eac h week. Weekly production will be x 
units of Product X and y units of Product Y. At least 50 units of X must be 
produced each week, and at least twice as  many units of Y as of X must 
be produced each week. Each unit of X requires 30 minutes of labour, and each unit of Y requires two hours of labour. There are 5,000 hours of 
labour available each week. 
Which of the following is the correct set of constraints? 
A 0.5x + 2y ≤ 
5,000  
 X ≥ 50 
 y ≤ 2x 
B x + 4y ≤ 5,000 
 X ≥ 50 
 y ≥ 2x 
C 0.5x + 2y ≤ 5,000 
 X ≥ 50 
 y ≥ 100 
D 0.5x + 2y ≤ 5,000. 
 X ≥ 50 
 y ≥ 2x 
 
 An office manager wishes to minimi se the cost of telephone calls made. 
40% of calls in peak hours cost $1 each and the remainder of such calls 
cost $1.50 each. 30% of calls at other  times cost 80c each, 50% of them 
cost 90c each, and 20% of them co st $1 each. These proportions cannot 
be varied, though the total numbers of  calls made in peak hours and of 
calls made at other times can be. 
If x equals the number of calls m ade each day in peak hours, and y 
equals the number of calls  made at other times,  write the manager’s 
objective function into the following box:

484  
 The shadow price of a binding constraint is: 
A The decrease in contribution whic h occurs when increasing the 
constraint limit by one unit 
B The premium (over and above the no rmal price) that the company 
would be willing to pay to suppliers for supplying one more unit of 
the binding constraint 
C The contribution gained from being able to produce one more unit of 
the most profitable product 
D The cost of acquiring one more uni t of the binding constraint from 
suppliers 
 
 Direct labour is currently paid at a ra te of $40 per hour. Direct labour is a 
scarce resource however the work force has agreed to work additional 
hours but the rate is currently in negot iation. Each unit will require 2 hours 
of labour. 
The shadow price of l abour is $12 per hour. 
What is the maximum amount per hour  that the organisation would pay 
for the extra hours? A $12 
B $40 
C $52 D $64 
 
 QT manufactures two products, X and Y. It has created a linear 
programme problem and formulated the objective function as follows: 
Maximise contribution = 20x + 5y Where X = Number of product X produced 
Y = Number of product Y produced 
QT has determined that two materi als, A and B, form the binding 
constraints. The constraints hav e been represented by the following 
formulae: 
(A)  5x + 2y = 11,000 kgs 
(B)  10x + 5y = 25,000 kgs 
The solution to the linear programme  formulation provided a contribution 
of $35,000. However, a new market supplier for material A has been 
found and, although the supplier is more expensive than existing 
suppliers, this may alleviate the material A constraint. 
The shadow price for material A is $_____

Chapter 12 
 485 
 Scenario 
HJK is a light engineering company which produces a range of 
components, machine tools and electr onic devices for the motor and 
aircraft industry. It employs about 1,000 people in 12 main divisions, one 
of which is the alarm systems division. 
Alarm systems division 
HJK produces two types of alarm system, one for offices and homes (X) 
and the other for motor vehicles (Y), on the same equipment. For financial reasons, it is im portant to minimise the costs of production. To 
match the current inventory and dem and position, at least 100 alarm 
systems in total are required each week, but the quantity of one type 
must not exceed twice that of th e other. The inputs necessary for the 
manufacture of one alarm system ar e given below, together with the 
availability of resources each week: 
Type Plating Circuitry Assembly 
X 3 feet 4 units 20 mins 
Y 2 feet 8 units 8 mins Totals available each week 420 feet 800 units 34 hours 
The management accountant estimates that the unit costs of production 
are $100 for X and $80 for Y. Past experience suggests that all alarms 
can be sold. At present, 75 of each alarm system are produced each week. 
Tasks: 
(a) State the objective function and t he constraints for the production of 
alarm systems AND use a graphical method to find the optimal 
product mix. 
(b) Explain briefly any points of significance for management. 
(Time Allowed: 30 minutes)

486  
 Example 1 
  
 Available Required for order Remaining 
Material A 1,200 100 1,100 
Material B 1,500 140 1,380 Labour 2,000 240 1,780 
Required for order: 
Material A: (20*2)  + (20*3) = 100 
Material B: (20*5)  + (20*2) = 140 
Labour: (20*7) + (20*5) = 240 
(1) Define variables 
Let A be the number of Alphas made after  the customer order 
Let B be the number of Betas ma de after the customer order. 
(2) Objective function 
The objective is to maximise contribution C, with C = $8A + $8B 
(3) Constraints 
Material A: 2A + 3B <1,100 Material B: 5A + 2B <1,360 Labour: 7A + 5B <1,760 and A,B ≥ 0 
 
 Test Your Understanding 1 
 Multiply (i) by 4 and (ii) by 3: 
8X + 12Y = 760 (iii)  21X + 12Y = 1020 (iv) Take equation (iii) away from equation (iv): 13X = 260 X = 260 ÷ 13 = 20 Substitute X = 20 in (ii): 140 + 4Y = 340 4Y = 340 – 140 = 200  Y = 200 ÷ 4 = 50 Check in (i): (2 × 20) + (3 × 50) = 40 + 150 = 190 The solution is X = 20, Y = 50

Chapter 12 
 487 
 Test Your Understanding 2 
 D 
 
 Test Your Understanding 3 
 Calculate the weighted average cost per call: 
Peak hours ($1 × 0.40) + ($1.50 × 0.60) = $1.30 
Other times ($0.80 × 0. 30) + ($0.90 × 0.50) + ($1 × 0.20) = $0.89 
Hence the objective is to 
minimise 130x + 89y 
 
 Test Your Understanding 4 
 B 
Option A is incorrect because a shadow price would represent the 
increase in contribution that could be earned from  having more of the 
scarce resource. 
Option C is incorrect because linear  programming only works if product 
units are divisible. Contribution is likely to be stated per unit rather than 
per resource used. For example, l abour would have a shadow price per 
hour rather than per unit. Option D is incorrect because the s hadow price may be very different 
from the price that is quoted by suppliers. The shadow price would allow 
the company to make a decision as to whether the purchase of extra 
supplies is a good decision. Option B is the correct definition of a shadow price. 
 
 Test Your Understanding 5 
 C 
The shadow price represents the hi ghest acceptable premium (over and 
above the normal wage rate) that t he organisation would be willing to 
pay. 
The maximum overall rate that it would pay would therefore be the 
normal rate of $40 per hour plus the shadow price of $12 = $52 per hour.

488  
 Test Your Understanding 6 
 The shadow price for material A is $10 
To calculate the shadow price of material A we add one more unit of 
material A to the constraint formula so that the two constraint formulae 
become: 
(A) 5x + 2y = 11,001 kgs (B) 10x + 5y = 25,000 kgs Multiplying the first constraint by 5 and the second constraint by 2 in 
order to solve these simultaneous equations gives us: (A) 25x + 10y = 55,005 kgs (B) 20x + 10y = 50,000 kgs Solving this provides the opt imal quantity of  each product: 
x = 1,001 units  y = 2,998 units The new total contribution is calculated as follows: 
 Units Contribution per 
unit Total 
   $ 
x 1,001 $20 20,020 
y 2,988 $5 14,990    ––––––– Total   $35,010 
   ––––––– 
The original contribution was $35,000. 
Therefore, the increase in  contribution from one kilo gramme of material A 
is $10 – this is its shadow price. The company should be prepared to pay 
up to $10 extra per kilogramme to the new supplier.

Chapter 12 
 489 
 Test Your Understanding 7 
 (a) Let x = number of alarm systems for o ffices and home 
Let y = number of alarm sys tems for motor vehicles 
Objective function: 
Minimise cost = 100x + 80y 
Subject to: 
Minimum production x + y ≥ 100 
 X ≤ 2y 
 y ≤ 2x 
Plating 3x + 2y ≤ 420 
Circuitry 4x + 8y ≤ 800 
Assembly 20x + 8y ≤ 2,040 
Non-negativity x,y ≥ 0 
Workings for the graph 
We are going to be drawing a number  of straight lines. We need two 
points to define a straight line. T he simplest thing to do in most 
cases is to make x = 0 and calcul ate what y must be to fit the 
equation and then make y = 0 and calculate what x must be. 
x + y = 100 x = 2y y = 2x 
x y x y x y 
0 100 0 0 0 0 
100 0 200 100 100 200 
 
3 x + 2y = 420 4x + 8y = 800 20x + 8y = 2040 
x y x y x y 
0 210 0 100 0 255 
140 0 200 0 102 0

490  
 
Solving the graph 
We are trying to minimise cost, So we want to produce as little x as 
possible, i.e. we want to be as far to the left as possible and we 
want to produce as little y as possi ble, i.e. we want to be as far 
down on the graph as possible. 
We can therefore eliminate some of the possible solutions. The 
optimum solution has to be on a corner, i.e. has to be on an 
intersection of two lines, so the possible solutions are either nodes 
(a), (b), (c), (d) or  (e) (on the graph over the page), We can see, 
however, that node (b) is not as good as node (a) because node (a) 
is both lower down the graph and to the left of node (b) and therefore represents less x and less y and less cost.

Chapter 12 
 491 
 Similarly, node (c) is not as good as node (e). (Node (e) is lower 
down the graph and to the left of  node (c) and theref ore represents 
less x and less y and therefore less cost.) Finally node (d) is not as 
good as node (e) for the same reasons. 
So, the optimum solution is either node (a) or (node (e). Node (a) lies on two lines: x + y = 100 y = 2x This gives a solution of 33.33 units of x and 66.67 units of y. Cost = (33.33 × $100) + (66.67 × $80) = $8,667 
Node (e) lies on 2 lines: x + y = 100 x = 2y This gives a solution of 66.67 units of x and 33.33 units of y. Cost = (66.67 × $100) + (33.33 × $80) = $9,333 
Therefore the optimum solution is to produce 33.33 units of X and 
66.67 units of Y. This minimises cost at $8,667. 
(b) Management should question why HJK is trying to minimise cost. 
HJK Ltd is a commercial organisat ion and therefore its objective 
should be to maximise prof it, not minimise cost. 
The second most interesting point is that the current production plan 
is not feasible. It breaks the constr aint for circuitry, i.e. 75 home and 
office alarms need 4 units each = 300 units in total and 75 motor 
vehicle alarms need 8 units each = 600 in total and 900 units as a 
grand total. This exceeds the available amount of 800.

493 
Risk and uncertainty in 
the short-term 
D1: Apply basic risk management tools in the short term (a) Explain nature of risk and 
uncertainty in the short 
term. 
(b) Apply basic sensitivity 
  Chapter 
13

Risk and uncertainty in the short-term 
494  
 
 Topic overview 
 Many business decisions will involv e an element of risk and uncertainty. 
This chapter looks at how risk and uncertainty can be built into the 
decision making process. This is often achieved by building in 
probabilities for expected outcomes and using expected values and 
decision trees to assess the problem. 
Forecasting and decision making oft en include an element of risk or 
uncertainty. Because they look to the future they often involve estimates 
of future costs and benefits. In this chapter we look at how these risks 
and uncertainty can be built into the decision making process. 
Decision making involves making decisions now about what will happen 
in the future. Events in the futu re can be predicted,  but managers can 
rarely be 100% confident that these predicted future events will actually 
arise. As actual result s emerge managers are likely to discover that they 
have achieved better or worse result s than those predicted originally. 
There are several ways of dealing with th is variability of outcomes. In this 
session we will consider several diffe rent possible outcomes that may 
arise. It is common in practice to consider three possible outcomes; the 
most likely outcome, the pessimistic  (worst possible) outcome and the 
optimistic (best possible) outcome. Analysts may consider more than 
these three possibilitie s, but more information will become more 
complicated and cumbersome to analyse and understand. 
Examination questions will generally pr ovide all the different possible 
outcomes that may arise, together  with the associated chance 
(probability) of the outcome occurring.  It is our task to analyse the 
information given, recommend an appr opriate strategy for management 
to follow and finally to highlight the potential risk involved in the various 
choices.

Chapter 13 
 495 
2 Risk and uncertainty 
The difference between risk and uncertainty 
 When making decisions, a decision make r will aim to account for risk but 
may struggle to account for uncertainty. 
 risk – quantifiable – possible out comes have associated 
probabilities, thus allo wing the use of mathematical techniques 
 uncertainty – unquantifiable – outcomes cannot be mathematically 
modelled. 
 
 Illustration on risk and uncertainty 
 Risk:  there are a number of possible outcomes and the probability of 
each outcome is known. 
For example, based on past experience of  digging for oil in a particular 
area, an oil company may estimate that they have a 60% chance of 
finding oil and a 40% chanc e of not finding oil. 
Uncertainty:  there are a number of possibl e outcomes but the probability 
of each outcome is not known. 
For example, the same oil company may dig for oil in a previously 
unexplored area. The company knows that it is possible for them to either 
find or not find oil but it does not k now the probabilities of each of these 
outcomes. 
One possible approach to dealing with risk is to deploy sophisticated 
modelling techniques in an attempt to improve the reliability of business 
forecasts. The use of trend analysis, encountered earlier in this text, is 
one possibility. Within this chapter we will look at how a simpler expected 
value technique may be of use. 
3 Probabilities and expected values 
One way to account for risk is to de termine an expected value based on the 
range of possible outcomes. 
 An expected value condenses all the different possible outcomes into one 
overall average result by calcul ating a single we ighted average. 
The expected value is not the most likel y result. It may not even be a possible 
result, but instead it finds the average out come if the same event was to take 
place thousands of times. 
Expected value formula 
EV = Σpx  LEARN 
where x represents the future outcome 
and p represents the probability of the outcome occurring

496  
 Example 1 
 A company has identified four possi ble outcomes from a new marketing 
strategy as follows: 
Outcome Profit / (loss) ($) Probability 
A 100,000 0.10 
B 70,000 0.40 
C 50,000 0.30 
D (20,000) 0.20 
Calculate the expected outcome of this strategy. 
 
 Histograms 
 Probability data may be presented diagr ammatically in the form of a 
histogram. The information given in  the example immediately above 
might be presented as follows: 
 
Advantages and disadvantages of EVs 
The single figure of the expected val ue of revenue can hide a wide range of 
possible actual results It is important to  recognise that the expected value is 
simply an average of all the possible outco mes. It does not r epresent the most 
likely outcome and may not even r epresent a possible outcome.  
 
00.050.10.150.20.250.30.350.40.45
ABCDProbabilityHistogram

Chapter 13 
 497 
 An organisation is considering launching a new product. It will do so if the 
expected value of the total revenue is in  excess of $1,000. It is decided to 
set the selling price at $10. After some investigation a number of 
probabilities for different levels of sa les revenue are predicted; these are 
shown in the following table: 
Units sold Revenue Probability Pay-off 
 $  $ 
80 800 0.15 120 
100 1,000 0.50 500 
120 1,200 0.35 420 
  –––– –––––   1.00 EV = 1,040 
The expected sales revenue at a sell ing price of $10 per unit is $1,040, 
that is [800 × 0.15] + [1,000 × 0. 50] + [1,200 × 0.35] . In preparing 
forecasts and making decisions management may proceed on the 
assumption that it can expect sale s revenue of $1,040 if it sets a selling 
price of $10 per unit. The actual outco me of adopting this selling price 
may be sales revenue that is higher  or lower than $1,040. And $1,040 is 
not even the most likely outcome; t he most likely outcome is $1,000, 
since this has the highest probability. 
Another of the limitat ions of using expected value techniques is that it assumes 
that the decision make r is risk neutral.  
There are three main types of decision-maker. 
 Risk neutral  decision-makers consider all possible outcomes and will 
select the strategy that maximises the expected value or benefit. These 
decision makers will focus attention on the expected value. 
 Risk seekers  are likely to select the st rategy with the best possible 
outcomes, regardless of t he likelihood that they wil l occur. These decision 
makers will ignore the expected value. 
 Risk averse  decision-makers try to avoid ri sk. They would rather select a 
lower, but certain, outcome than risk going for a higher pay-off which is 
less certain to occur. 
Using an expected value technique assume s that the investor is risk neutral. 
But decision makers will not normally be risk neutral and they therefore may pay no attention at all to the expected value.

498  
 Illustration 1 looked at determi ning the expected revenue based on 
predicted units sold and their associated expected values. 
Let’s consider the position if the expected outcomes had been very 
different. They might have been as follows: 
 $  $ 
40 400 0.15 60.00 
100 1,000 0.50 500.00 
137 1,370 0.35 479.50 
The expected value of these pay o ffs is again approximately $1,040 
which means that both situations give  rise to the same expected sales 
revenue. 
But the two situations are not the same. The second involves a wider 
dispersal of possible outcomes; h ence it involves higher risk. 
If the decision-makers are risk av erse they will judge the range of 
possible outcomes described in the se cond situation to be worse than the 
first. If the decision-makers are ri sk seekers they may prefer the second 
situation, because of the higher outc ome in the best possible situation. 
However, in this case, the dire downside of $400 may put them off. Whatever the case it can be seen that  the evaluation of the options solely 
on the basis of their expected va lue may not always be appropriate. 
 
 Utility theory 
 Utility is another import ant aspect of risk and uncertainty. The basis of the 
theory is that an individual’s attitude to certain risk profiles will depend on 
the amount of money involved. For example, most people would accept a bet on the toss of a coin, if the 
outcome were that they would win $6 if it came down heads and if it 
came down tails they would pay $4.  The average person would be happy 
to play secure in the knowledge that  they would win if the game were 
repeated over a long enough period; if  not it would still be a good bet. 
But if the stakes were raised so that the win was $6,000 on a single toss 
coming down heads and a loss of $4,000 if it came down tails, the average person might think twice and re ject the bet as being too risky. 
Utility theory attaches weights to the sums of money involved; these are 
tailor-made to the individual’s attitude towards winning and losing certain 
sums of money. 
Therefore, considering a proposed opt ion solely on the basis of its 
expected value ignores the range of possible outcomes.

Chapter 13 
 499 
Overall, the advantages and disadvantages of expected values are summarised 
in the following table: 
 takes account of risk 
 easy decision rule 
 simple  subjective 
 not useful for one-offs 
 ignores attitudes to risk 
 answer may not be possible 
 ignores the spread of outcomes 
 
 Advantages: 
 Takes risk into account by considering the probability of each 
possible outcome and using this  information to calculate an 
 The information is reduced to a single number resulting in easier 
 Calculations are relatively simple. 
 The probabilities used are usually ve ry subjective and difficult to 
determine. 
 The EV is merely a weighted average and therefore has little 
meaning for a one- off project. 
 It assumes that the decision make r is risk neutral and ignores other 
attitudes to risk and uncertainty. 
 The EV may not correspond to any of the actual possible outcomes. 
 The EV gives no indication of the dispersion of possible outcomes 
about the EV, i.e. the ri sk, so that utility theor y is not considered. 
4 Pay off tables 
When evaluating alternative courses of action, management’s decision will often 
depend upon their attitude towards the risk.  To consider the risk borne by each 
alternative it is necessary to consider  ALL the different possible profits/losses 
that may arise. A pay off table is simp ly a table that illustrates all possible 
profits/losses.

500  
 Two way data tables 
 Two way data tables are used to represent inter-related data in an easy 
to understand manner. 
For example, consider a company  who are unsure about both selling 
price and variable cost. They believe that selling price may be either $40 
or $50 depending on differing market conditions, and that variable production cost will be either $20 or $30 depending on wage negotiations currently taking place. 
The company has therefore got a num ber of potential co ntributions per 
unit that could be represented in a two way table as follows: 
 Selling price 
 $40 $50 
Variable production cost   
$20 $20 $30 
$30 $10 $20 
A user can interpret the table quickly and easy. It can be seen, for 
example, that if selling price is $40 and variable product ion costs are $30, 
then the contribution per unit will be $10. 
Two way data tables can be expanded to calculate expected contribution 
from different volume levels. This will be explored further in the following 
illustration. 
 
 Geoffrey Ramsbottom runs a kitchen that provides food for various 
canteens throughout a large organisation. A particular salad is sold to the 
canteen for $10 and costs $8 to prepare. Therefore, the contribution per 
salad is $2.  
Based upon past demands, it is ex pected that, during the 250-day 
working year, the canteens will requi re the following daily quantities: 
On 25 days of the year 40 salads 
On 50 days of the year 50 salads On 100 days of the year 60 salads 
On 75 days 70 salads Total 250 days  
The kitchen must prepare the salad in  batches of 10 meals and it has to 
decide how many it will supply for eac h day of the forthcoming year. 
Required: 
Construct a pay-off table for this da ta and calculate the best number of 
salads to supply each Day.

Chapter 13 
 501 
 Solution: 
The pay-off table would be constructed as follows: 
 If 40 salads will be required on 25 days of a 250-day year, the 
probability that demand = 40 salads is: 
P(Demand of 40) = 25 days ÷ 250 days 
P(Demand of 40) = 0.1 
 Likewise, P(Demand of 50) = 0 .20; P(Demand of  60 = 0.4) and P 
(Demand of 70 = 0.30). 
 Now let's look at the different va lues of profit or losses depending on 
how many salads are supplied and sold. For example, if we supply 
40 salads and all are sold, our profits amount to 40 × $2 = 80. 
 If however we supply 50 salads bu t only 40 are sold, our profits will 
amount to 40 × $2 – (10 unsold salads x $8 unit cost) = 0. 
 Note too that there is an upper limi t to the potential profit in some 
instances. If demand reaches 70 salads we can still only sell 60 
salads and therefore the maximu m profit we can make from 
supplying 60 salads is $120. 
The payoff table would appear as follows: 
  Daily Supply 
Daily 
Demand (salads)  Probability 40 
salads 50 
salads 60 
salads 70 
salads 
40 0.10 $80 $0 ($80) ($160) 
50 0.20 $80 $100 $20 ($60) 60 0.40 $80 $100 $120 $40 
70 0.30 $80 $100 $120 $140 
This could then be used to determine the expected value from each daily 
supply level: 
EV (of supplying 40 salads) = 0.10( 80) + 0.20(80) + 0.40(80) + 0.30 
(80) = 80 EV (50 salads) = 0.10(0) + 0.20(100)  + 0.40(100) + 0.30(100) = 90 
EV (60 salads) = 0.10(–80) + 0.20( 20) + 0.40(120) + 0.30(120) = 80 
EV (70 salads) = 0.10(–160) + 0.20( –60) + 0.40(40) + 0.30(140) = 30 
On the basis of expected values, the best strategy would be to supply 50 
salads and gain an EV of 90.

502  
 Example 2 
  Hofgarten Newsagents stocks a w eekly magazine which advertises 
local second-hand goods. Marie, the owner, can:  
– buy the magazines for 15c each – sell them at the retail price of 25c. 
 At the end of each week unsold magazines are obsolete and have 
no value. 
 Marie estimates a probability distribution for weekly demand which 
looks like this 
Weekly demand in units Probability 
10 0.20 
15 0.55 
20 0.25 
 –––– 
 1.00 
 –––– 
Required: 
(i) Calculate the expected value of demand? 
(ii) If Marie is to order a fixed quant ity of magazines per week, calculate 
how many should be ordered each week, Assume no seasonal 
variations in demand. 
5 Dealing with uncertainty in decision making 
When probabilities are not available, there are still tools available for 
incorporating uncertainty into decision making. 
Maximax 
 The maximax rule involves selecting the alternative that maximises the 
maximum pay-off achievable. 
This approach would be suitable for an optimist who seeks to achieve the 
best results if the best happens.

Chapter 13 
 503 
 Illustration 4 – The 'Maximax' rule 
 Let's apply the maximax rule to the previous illustration on Geoffrey 
Ramsbottom. Geoffrey Ramsbottom's table looks as follows: 
Daily 
Demand 
(salads)  Probability 40 
salads 50 
salads 60 
salads 70 
salads 
50 0.20 $80 $100 $20 ($60) 
60 0.40 $80 $100 $120 $40 70 0.30 $80 $100 $120 $140 
The manager who employs the maxima x criterion is assuming that 
whatever action is taken, the best will happen; he/she is an optimist. 
Here, the highest maximum possible pay-off is $140. Geoffrey should 
therefore decide to supply 70 salads a day. 
 
 Example 3 
 A company is choosing which of thr ee new products to make (A, B or C) 
and has calculated likely pay-offs under three possible scenarios (I, II or 
III), giving the follo wing pay-off table. 
Profit (loss) Product chosen 
Scenario A B C 
I 20 80 10 
II 40 70 100 
III 50 (10) 40 
Required: 
Using maximax, which product would be chosen? 
 
 Maximin 
The maximin rule involves selecting the alternative that maximises the minimum 
pay-off achievable. 
This approach would be appropriate for a pessimist who seeks to achieve the 
best results if the worst happens

504  
 Illustration 5 – The 'Maximin' rule 
 Geoffrey Ramsbottom's table looks as follows: 
Daily 
Demand 
salads 50 
salads 60 
salads 70 
salads 
If we decide to supply 40 salads, the minimum pay-off is $80. 
If we decide to supply 50 salads, the minimum pay-off is $0. If we decide to supply 60 salads, the minimum pay-off is ($80). If we decide to supply 70 salads, the minimum pay-off is ($160). The highest minimum payoff aris es from supplying 40 salads. 
 
 Example 3 continued 
 Required: 
Using the information from Example 3,  apply the maximin rule to decide 
which product should be made. 
 
 The minimax regret rule 
The minimax regret strategy is the one t hat minimises the maxi mum regret. It is 
useful when probabilities for outcomes ar e not available or where the investor 
wants to avoid making a bad decision. Ess entially, this is the technique for a 
‘sore loser’ who does not wish to make the wrong decision. 
‘Regret’ in this context is defined as  the opportunity loss through having made 
the wrong decision.

Chapter 13 
 505 
 Illustration 6 – The 'Minimax Regret' rule 
 If the minimax regret rule is appli ed to Geofrrey Ramsbottom to decide 
how many salads should be made each day, we need to calculate the 
'regrets'. This means we need to find the biggest pay-off for each demand 
row, then subtract all other numbers in  this row from the largest number. 
For example, if the dem and is 40 salads, we will make a maximum profit 
of $80 if they all sell. If we had decided to supply 50 salads, we would achieve a nil profit. The difference, or  'regret' between that  nil profit and 
the maximum of $80 achievable for that row is $80 
Regrets can be tabulated as follows 
 Daily Supply 
Daily Demand 
(salads) 40 
salads 50 
salads 60 
salads 70 
salads 
40 $0 $80 $160 $240 
50 $20 $0 $80 $160 60 $40 $20 $0 $80 
70 $60 $40 $20 $0 
If we decide to supply 40 salads, the ma ximum regret is $60. If we decide 
to supply 50 salads, the maximum r egret is $80. For 60 salads, the 
maximum regret is $160, and $240 fo r 70 salads. A manager employing 
the minimax regret criterion would want  to minimise that maximum regret, 
and therefore supply 40 salads only. 
 
 Required: 
Using the information from Example 3,  apply the minimax regret rule to 
decide which product should be made. 
Perfect and imperfect information 
In many questions the decision makers re ceive a forecast of a future outcome 
(for example a market research group may predict the forthcoming demand for 
a product). This forecast ma y turn out to be correct or incorrect. The question 
often requires the candidate to calc ulate the value of the forecast.

506  
Perfect information The forecast of the future outcome is always a correct 
prediction. If a firm can obtain a 100% accurate prediction they will always be able to undertake the most beneficial course of ac tion for that prediction. 
Imperfect 
Information The forecast is usually correct, but can be incorrect. Imperfect information is not as valuable as perfect 
information. Imperfect informa tion may be examined in 
conjunction with Decision Trees (see later in this 
chapter). 
The value of information (either perfect  or imperfect) may be calculated as 
follows: 
Expected profit (outcome ) WITH the information 
minus 
Expected profit (outcome) WITHOUT the information 
 
 Illustration 7 – The value of information 
 A new ordering system is being cons idered, whereby customers must 
order their salad onlin e the day before. With this new system Mr 
Ramsbottom will know for certain t he daily demand 24 hours in advance. 
He can adjust production levels on a daily basis. How much is this new system worth to Mr Ramsbottom? 
 X P  
Supply = demand Pay off Probability px 
40 $80 0.1 8 
50 $100 0.2 20 60 $120 0.4 48 
70 $140 0.3 42 
   –––––– 
   118 
E.V. with perfect information  = $118 E.V. without perfect information (from the 
original EV calculation)  = $90 
   –––––– 
Value of perfect information  $28 per day 
   ––––––

Chapter 13 
 507 
 Following on from the data provided in Exampl e 3, the company has 
made an estimate of the probability  of each scenario occurring as 
follows: 
Scenario Probability 
I 20% 
II 50% 
III 30% 
However, an external consultant has some information about each likely 
scenario and can say with certai nty which scenario will arise. 
Calculate the value of the exter nal consultant’s information. 
6 Decision trees and mult i-stage decision problems 
 A decision tree is a diagrammatic r epresentation of a decision problem, 
where all possible courses of acti on are represented, and every possible 
outcome of each course of action is shown. 
Decision trees should be used where a probl em involves a series of decisions 
being made and several outcomes arise during the decision-making process. In 
some instances it may involve the use of  joint probabilities – where the outcome 
of one event depends of the outcome of a preceding event. 
 
 Joint probabilities 
 An important element in calculati ons involving decision trees will be in 
dealing with joint probabilities. So far only a very small number of alternatives have been considered in 
the examples. In practice a greater  number of alternative courses of 
action may exist, uncertainty may be associated with more than one variable and the values of variables  may be interdependent, giving rise to 
many different outcomes. 
The following exercise looks at th e expected value of a manufacturing 
decision, where there are three alternative sales volumes, two alternative 
contributions, and three alternative le vels of fixed cost. The number of 
possible outcomes will be 3 × 2 × 3 = 18. 
Example 
A company is assessing the desirab ility of producing a souvenir to 
celebrate a royal jubilee. The mark eting life of the souvenir will be 6 
months only. Uncertainty surrounds the likely sales volume and 
contribution, as well as the fixed costs of the venture. Estimated 
outcomes and probabilities are:

508  
 Units 
sold Probability Cont'n 
per Unit Probability Fixed 
cost Probability 
  $  $  
100,000 0.3 7 0.5 400,000 0.2 
80,000 0.6 5 0.5 450,000 0.5 
60,000 0.1   500,000 0.3 
 1.0  1.0  1.0 
A table can be constructed to repres ent all the possible outcomes from 
this new venture. For example the fi rst possible payoff is that sales are 
100,000 units (30% chance) , the contribution per unit is $7 (50% 
chance) and the fixed costs are $400, 000 (20% chance). This has a joint 
probability of 30% × 50% × 20% = 3% (or 0.03) 
All the possibilities are repres ented in the following table: 
Units 
sold Cont’n 
per 
unit 
$ Total 
Cont'n 
$ 
a Fixed 
Cost 
$ 
b Probability Joint 
Prob. 
c EV of 
net 
cont. 
$ 
(a-b) x 
c 
100,000 7 700,000 400,000 0. 3×0.5×0.2= 0.030 9,000 
 7 700,000 450,000 0.3× 0.5×0.5= 0.075 18,750 
 7 700,000 500,000 0.3× 0.5×0.3= 0.045 9,000 
 5 500,000 400,000 0.3× 0.5×0.2= 0.030 3,000 
 5 500,000 450,000 0.3× 0.5×0.5= 0.075 3,750 
 5 500,000 500,000 0. 3×0.5×0.3= 0.045 0 
80,000 7 560,000 400,000 0. 6×0.5×0.2= 0.060 9,600 
 7 560,000 450,000 0.6× 0.5×0.5= 0.150 16,500 
 7 560,000 500,000 0.6× 0.5×0.3= 0.090 5,400 
 5 400,000 400,000 0. 6×0.5×0.2= 0.060 0 
 5 400,000 450,000 0.6× 0.5×0.5= 0.150 –7,500 
 5 400,000 500,000 0.6× 0.5×0.3= 0.090 –9,000 
60,000 7 420,000 400,000 0. 1×0.5×0.2= 0.010 200 
 7 420,000 450,000 0.1× 0.5×0.5= 0.025 –750 
 7 420,000 500,000 0.1× 0.5×0.3= 0.015 –1,200 
 5 300,000 400,000 0.1× 0.5×0.2= 0.010 –1,000 
 5 300,000 450,000 0.1× 0.5×0.5= 0.025 –3,750 
 5 300,000 500,000 0.1× 0.5×0.3= 0.015 –3,000 
   ––––  –––– ––––– 
Total expected value 1.0  1.0 49,000

Chapter 13 
 509 
 The joint probabilities can be used to  summarise potential outcomes. 
For example, totalling up the joint probabilities for each set of sales 
shows the project has a 55.5 per c ent chance of making a positive 
contribution, a 33 per c ent chance of making a loss, and a 10.5 per cent 
chance of making neither a net contribut ion nor a loss. (For example, to 
calculate the probability of making a lo ss: we can see fr om the next table 
that a loss will arise in 7 situations. So if we add the overall probability of 
this happening we add up the joint pr obabilities associated with each of 
these outcomes – 0.150 + 0.090 + 0.025 + 0.015 + 0.010 + 0.025 + 
0.015 = 0.33).Decisions like this c an be quite hard to visualise and it 
may be more useful to use a decisi on tree to express the situation. 
 
 In an examination you will not be ask ed to create a decision tree, but you 
may want to use one as an aid to ans wering more comp lex risk questions. 
You may also be asked to interpret or  use decision trees in examination 
questions and understanding how they are created should make this 
easier. 
 
 Drawing decision trees 
  
Step 1: Draw the tree from left to  right showing appropriate 
decisions and events/outcomes. 
  
 Label the tree and relevant cash inflows/outflows and 
probabilities associat ed with outcomes. 
Step 2: Evaluate the tree from right  to left carrying out 
these two actions: 
Calculate an EV at each outcome point. 
Choose the best option at each decision point. 
Step 3: Recommend a course of action to management.

510  
 Example 4 
 A business is considering launchi ng a product that will have development 
costs of $6m. There is a 60% chance that the development  of the product 
will be successful. If the launch is not successful then the product will be 
abandoned and the development costs will be lost. 
If the development is a success then the company will continue on to 
marketing the product. There is a 70% chance that the marketing will be 
successful and make a profit of $20m . If the marketing campaign is 
unsuccessful a profit of only $1m is expected. Both profit figures are 
stated after taking account of mark eting costs but before development 
costs. The expected value of the developm ent and marketing plan is $____m 
(round to two decimal places) 
 
 More on decision trees 
 Decision trees force the decision make r to consider the logical sequence 
of events. A complex pr oblem is broken down into smaller, easier-to-
handle sections. The financial outcomes and probabilities are shown 
separately, and the decision tree is ‘r olled back’ by calculating expected 
values and making decisions. In t he examination ensure that only 
relevant costs and revenues are considered. 
Consider the following example: 
A company is planning on drilling for oil.  It can either drill immediately (at 
a cost of $50m) or carry out some  preliminary tests (cost ($10m). 
Alternatively, the company could sell the rights to the site to another 
company for $40m. 
If it decides to drill now there is a 55% chance that it will find oil and 
extract it (with a value of $150m). If further tests are carried out first t here is a 70% chance  that they will 
indicate the presence of oil. The sa les rights would then be worth $65m. 
Alternatively, the company could drill for oil itself at  a cost of $50m. There 
is then an 80% chance that oil extraction (worth $150m) is successful. If further tests are carried out and indicate that no oil is present the value 
of any sales rights would fall to $15m. The company could still decide to 
drill for oil itself- but there is only a 20% chance that it would successfully 
find and extract oil at that point.

Chapter 13 
 511 
 A decision tree for this problem would look as follows: 
 
It is easier to start at the bottom of the tree. The first box shows the first 
decision to be made – to test, to drill or  to sell the rights. If we follow the 
'drill' line/branch, we come a 'chance' point (represented by a circle). This 
shows that if we drill there are two possible outcomes – there is a 55% 
that we find oil and make a positive net  return of $150m. There is also a 
45% that no oil is found and that no return is made. The figure on the 
circle of $82.5m is the expected value calculated from these two 
outcomes. However, the drill line has a cost of $50m so that the overall 
net expected return would be $32.5m – and  it is this figure that should be 
used to compare the drill optio n against the other options. 
The middle branch of the tree shows the expected value from selling the rights – $40m. 
The top branch shows the analysis of t he testing decision. It can be seen 
that there are many more possible out comes and also further decisions to 
made based on whether or not the test s indicate the presence of oil. 
Lines that have a double cross marki ng on them show the best choice to 
be made based on expected values. 
Advice  
The company should undertake geological tests. If the test s indicate that 
oil is present then a drilling programme should be carried out. However, if 
the tests indicate that there is no oil then the company should sell the 
drilling rights. 
This strategy will maximise  expected returns at £43.5m.

512  
 Benefits and problems in using decision trees 
The main value of a decision tree is that it maps out clearly all the 
decisions and uncertain events and ex actly how they are interrelated. 
They are especially benef icial where the outcome of one decision affects 
another decision. For example in t he above, the probability of eventual 
success changes depending on the test outcomes. The analysis is made 
clearer by annotating the tree with probabilities, cash flows, and expected 
values so that the optimum decisi ons (based on expected values) can be 
clearly seen. 
However, drawing a tree diagram is only one way of undertaking a 
decision . It is based on the conc ept of expected value and as such suffers 
from the limitations of th is technique. For example, in this example, if the 
test drilling proves positiv e, the tree indicated t he company should drill, as 
opposed to selling the rights. But if it does there is a 20% chance of it 
losing £50 million. A risk-averse company may well decide to accept the 
safer option and sell the rights and settle for £65 million. 
A number of other factor s should be taken into account when considering 
decision tree-type problems: 
 Assumes risk neutrality.  As mentioned under probability, some 
decision-makers do not choose options which give the greatest 
expected value, because they are ei ther risk seekers or risk averse. 
 Sensitivity analysis.  The analysis depends very much on the values 
of the probabilities in the tree. Th e values are usually the subjective 
estimates of the decision-makers, and, no matter how experienced the people involved are, the val ues must be open to question. 
Sensitivity analysis can be used to consider 'break-even' positions for each variable – i.e. the value fo r a variable (such as probability) 
at which the decision would change.  Sensitivity analysis is covered 
later in this chapter. 
 Oversimplification.  In order to make the tree manageable, the 
situation has often to be greatly si mplified. This makes it appear far 
more discrete than it really is. In pr actice, it is much more likely that 
the outcomes would form a near continuous range of inflows and outflows. This cannot be shown on  a decision tree, and so any 
decision tree usually represent s a simplified situation. 
7 Standard deviations and normal distributions 
Standard deviations and normal distributio ns are ways of measuring risk and 
estimating probabilities for possible outcomes. 
They are mathematical techniques that  were first introduced at the CIMA 
Certificate level. 
Standard deviations 
In order to measure the risk associated with a particular project, it is helpful to 
find out how wide ranging the possibl e outcomes are. The conventional 
measure is the standard deviation.

Chapter 13 
 513 
 The standard deviation compares all the actual outcomes with the 
expected value (or mean outcome). It  then calculates how far on average 
the outcomes deviate from the mean. It is calculated using a formula. 
The basic idea is that the standard deviation is a measure of volatility: the more 
that actual outcomes vary  from the average outcome, the more volatile the 
returns and therefore the more risk in volved in the investment/decision. 
 
 Calculating a standard deviation 
 The standard deviation is calculated using the following formula: 
 
However, the calculation can bec ome a little more complex when 
probabilities need to be taken account of. Let's examine how standard 
deviations are calculated and used by considering the following 
illustration.  
Note:  you would not be expected to per form this calculation in the 
examination, but working through th is illustration should help improve 
your understanding of standard deviation. 
 
 A company is considering whether to make Product X or Product Y. 
They cannot make both products. The estimated sales demand for 
each product is uncertain and the follo wing probability distribution of the 
expected profits for each product has been identified. 
Product X 
Profit  ($) Probability Expected value  ($) 
3,000 0.10 300 3,500 0.20 700 4,000 0.40 1,600 4,500 0.20 900 5,000 0.10 500 
 ––––– –––––  1.00 4,000  ––––– –––––

514  
 Product Y 
2,000 0.05 100 
3,000 0.10 300 4,000 0.40 1,600 
5,000 0.25 1,250 
6,000 0.20 1,200 
 1.00 4,450 
The expected value for each product gives us an average value based 
upon the probability associated with eac h possible profit outcome. If 
profit is used for decision-making, then on that basis Product Y would be produced as it yields the highest return.  
However, let's consider the standard deviation calculations for each 
product: 
Product X 
Profit Deviation from 
Expected value Squared 
deviation Probability Weighted 
amount ($) 
3,000 – 4,000 = –1,000 1, 000,000 0.10 100,000 
3,500 – 4,000 = –500 250, 000 0.20 50,000 
4,000 – 4,000 = 0 0 0.40 0 
4,500 – 4,000 = 500 250, 000 0.20 50,000 
5,000 – 4,000 = 1,000 1, 000,000 0.10 100,000 
   ––––––– 
Sum of weighted squared deviation 300,000 
Standard deviation (the squar e root of the total 
above) 547.72 
Expected value 4,000

Chapter 13 
 515 
 The standard deviation is calculat ed by taking the square root of the 
sum of the weight ed squared deviation. 
Product Y 
amount ($) 
2,000 – 4,450 = –2,450 6, 002,500 0.05 300,125 
3,000 – 4,450 = –1,450 2, 102,500 0.10 210,250 
4,000 – 4,450 = –450 202,500 0.40 81,000 
5,000 – 4,450 = 550 302,500 0.25 75,625 
6,000 – 4,450 = 1,550 2, 402,500 0.20 480,500 
   ––––––– 
Sum of weighted squared deviation 1,147,500 
Standard deviation 1,071.21 
Expected value  4,450 
Summary: 
Product Expected value Standard deviation 
X 4,000 547.72 
Y 4,450 1071.21 
Using an expected value approach the company’s decision would be to 
produce product Y. However, the pr ofit for each product does not 
indicate the range of profits that may result. Examining the standard 
deviation, this allows us to evaluate the likely volatility of the profit for 
each product. Product Y has a higher  standard deviation than Product 
X and is therefore more risky. 
There is not a significant difference in profit for each of the products. 
However, Product X is less risky t han Product Y and therefore the final 
selection will depend on the ri sk attitude of the company. 
The coefficient of variation 
In the above example, w here the expected values where very close but 
the standard deviations are very diffe rent, it was easy to state that 
Product Y is much riskier than Pr oduct X. However, If we have two 
probability distributions with very different expected values their 
standard deviations are not as easily compared and it is much more 
difficult to state which is more risky. 
We can overcome this problem by using the coefficient of variation 
which measures the relative size of the risk for projects that have very 
different standard deviations. 
The variable with the smaller coeffici ent of variation is less dispersed 
than the variable with the larger coeffi cient of variation and is therefore 
less risky.

516  
 Example calculation 
Consider a set of data observations where the results are 2, 7 and 9. 
The mean for this data is 6 {(2 + 7 + 9)/3}. The standard deviation is 
calculated by taking the squares of the three deviations from the mean 
(16 + 1 + 9 = 26) and then calculating the square root of their average 
(√(26/3) = 2.94. 
The coefficient of variation is the standard deviation of the series 
divided by its mean (2.94/6) which is 0.49 in this case. This is usually 
expressed as a percentage (i.e. 49% in this case). The lower this figure 
the lower the risk (when comparing this to other sets of data).  
Using normal distributions to determine probabilities 
In the exam CIMA provides a table of the normal distribution. These are based 
on the principles of the normal distribution curve. 
 
 The normal distribution curve 
 Normal distributions were introduced in  subject BA2 at the Certificate 
level. We typically assume in this paper that data is no rmally distributed. 
A normal distribution is often drawn as a "bell shaped" curve, with its 
peak at the mean in the centre, as shown: 
 
Characteristics of the no rmal distribution curve 
 Normal distribution is a continuous probability distribution. 
 Probabilities are r epresented by areas under the curve. 
 The total area under the curve is 1. 
 The curve is symmetrical and bell shaped. 
 The width of the curve is meas ured in terms of standard deviation. 
 The mean, median and mode are at  the centre of the curve.

Chapter 13 
 517 
The number given in the normal distributi on tables is known as the z score.  
 
 The z score allows us to calculat e the proportion of the distribution 
meeting certain criteria fo r any normal distribution. 
It therefore allows us to determine probabilities. 
 
 Example 5 
 Monthly sales for a company are normally distributed and have a mean of 
$175,000 and a standard dev iation of $5,000. 
Required: 
Calculate the probability that  sales will be below $168,000. 
8 Stress testing: sensitivity analysis 
Stress testing and its importance was considered in t he budgeting chapter. 
Stress testing can also be applied to decis ion making via the use of sensitivity 
analysis. 
 Sensitivity analysis takes each uncertain  factor in turn, and calculates the 
change that would be necessary in that factor before the or iginal decision 
is reversed. 
By using this technique it is possible to establish which estimates 
(variables) are more critical t han others in affecting a decision. 
 
 The process  
 The process is as follows: 
 Best estimates for variables are made and a decision arrived at For 
example, using expected values a profit calculation may indicate 
accepting a project. 
 Each of the variables is then analysed in turn to see how much the 
original estimate can change bef ore the original decision is 
reversed. For example, it may be that the estimated selling price 
can fall by 5% before the profit  becomes negative and the project 
would be rejected. 
 Estimates for each variable can then be reconsidered to assess the 
likelihood of the decision being wr ong. For example, what is the 
chance of the selling price falling by more than 5%?

518  
 A manager is considering a make v buy decision based on the following 
estimates: 
 If made 
in-house If buy in and 
re-badge 
 $ $ 
Variable production costs 10 2 
External purchase costs – 6 
Ultimate selling price 15 14 
Identify the sensitivity of th e decision to the external purchase 
price. 
Step 1:  What is the original decision? 
Comparing contribution figures, t he product should be bought in and re-
badged: 
 If made 
re-badge 
 $ $ 
Contribution 5 6 
Step 2:  Calculate the sensitivity (to the external purchase price) 
For indifference, the contribution from  outsourcing needs to fall to $5 per 
unit. Thus the external purchase price only needs to increase by $1 per 
unit (or $1/$6 = 17%). 
If the external purchase price rose  by more than 17% the original 
decision would be reversed. 
 
 Example 6 
 A manager has identified the follo wing two possible outcomes for a 
process 
Outcome Probability Financial implications ($000s) 
Poor 0.4 Loss of 20 
Good 0.6 Profit of 40 
The expected value has been calculated as EV = (0.4 × –20) + (0.6 × 40) 
= +16. This would suggest that the opportunity should be accepted. 
Required: 
(a) Suppose the likely loss if resu lts are poor has been underestimated. 
What level of loss would change the decision? In effect we want a 
break-even estimate. 
(b) Suppose the probability of a loss has been underestimated. What is 
the break-even probability?

Chapter 13 
 519 
 Strengths and weaknesses 
 Strengths of sensitivity analysis 
 Information will be presented to management in a form which 
facilitates subjective judgement to decide the likelihood of the 
various possible outcomes considered. 
 It identifies areas which are crucia l to the success of the project. If 
the project is chosen, those ar eas can be carefully monitored. 
Weaknesses of sensitivity analysis 
 It assumes that changes to va riables can be made independently, 
e.g. material prices will chang e independently of other variables. 
Simulation allows us to change mo re than one variable at a time. 
 It only identifies how far a variable needs to change; it does not look 
at the probability of such a change. 
 It provides information on the basis of which decisions can be made 
but it does not point to t he correct decision directly.

Chapter 13 
 521 
 A business is considering investing in a new product that will be impacted 
by whether the business can launch the product before rivals. Expected 
returns have been forecasted as follows: 
 Launch before rivals Launch after rivals 
Total product profits $20m $2m 
There is a 40% that the business wil l be able to launch the product before 
rivals. 
The total expected profits from the product are $ ____m (fill in the 
number to the nearest one decimal place) 
 
 A company is considering investing in one of the following projects. 
Project Expected 
value Standard 
deviation 
 $000  $000  
A 850 500 
B 1,200 480 
C 150 200 
D 660 640 
If the company wishes to select the pr oject with the lowest risk factor 
(coefficient of variation) it select w ill select Project _ (E nter the letter of 
the preferred project) 
 
 PT has $8m of debt, on which it pays annual interest of 4%. The 
company's operating cash inflow in the coming year is forecast to be 
$600,000, and currently the company has $80,000 cash on deposit. The 
company has no other lines of credit available. 
Required: 
Given that the annual volatility (s tandard deviation) of the company's 
cash flows (measured over the la st 5 years) has been 40%, the 
probability that Villa Co will default on its interest payment within the next 
year is ____% (fill in the number to the nearest 1 decimal place)

522  
 An investor is an optimist in their a ttitude to uncertainty. The investor is 
considering making one of four possibl e investments, each of which is 
affected by whether the government provide financial assistance in the 
form of a grant. Details on the investments are as follows: 
 Grant not 
awarded Grant  
awarded 
Probability 70% 30% 
Investment A pr ofits ($000) 40 90 
Investment B pr ofits ($000) 60 70 
Investment C profits ($000) 20 140 
Investment D profits ($000) 50 30 
Which investment will the investor choose? 
A Investment A B Investment B C Investment C  D Investment D 
 
 A newspaper seller has prepared t he following payoff table based on 
expected levels of demand each da y and the number of newspapers 
purchased: 
 Newspapers purchased 
 140 160 180 200 
Probability 25% 25% 30% 20% 
Demand     
140 $42 $28 $14 $0 
160 $42 $48 $34 $20 
180 $42 $48 $54 $40 
200 $42 $48 $54 $60 
Unsold newspapers are destroyed at the end of each day. Using a maximin criteria, the number of bananas that should be 
purchased each day is _____

Chapter 13 
 523 
 A business has produced a profit table showing the profit earned 
depending on a combination of uni ts produced and units demanded: 
 Daily demand 
  2,000 3,000 4,000 
 2,000 $40,000 $40,000 $40,000 
Production 3,000 ($40, 000) $60,000 $60,000 
 4,000 ($120,000) ($20,000) $80,000 
Minimax regret matrix 
 2,000 0 A D 
Production 3,000 B 0 A 
 4,000 C B 0 
Match the values for A, B, C and D which should be used in the minimax 
regret table. 
Position  Possibilities 
A  $20,000 
B  $40,000 
C  $80,000 
D  $160,000 
 
 An organisation is making a decision on which of two products to launch. 
Future profit outcomes for each pr oduct will either be high or low. 
It has created the following decision tree to summarise the problem:

524  
 The expected value from the optimal decision is: 
A $1.6m 
B $10.25m C $11.6m D $30.25m 
 
 An organisation is considering laun ching one of two new products and 
has created the following decision tr ee to represent its decision: 
 
The maximum expected value of prof it at decision point A is $_____ 
 
 A company can make either of two new products, X and Y, but not both. 
The profitability of each product depends  on the state of the market, as 
follows: 
Market 
state Profit from 
product Probability 
of market state 
 X 
$ Y 
$  
Good 20,000 17,000 0.2 
Fair 15,000 16,000 0.5 
Poor 6,000 7,000 0.3 
The expected value of perfect information as to the state of  the market is 
_______ (insert the correct figure)

Chapter 13 
 525 
 Scenario 
The Venus Department Store operates a cu stomer loan facility. If one of 
its new customers requests a loan then Venus either refuses it, gives a 
high loan limit, or gives a low loan limit. From a number of years past 
experience the probability that a new cu stomer makes a full repayment of 
a loan is known to be 0.95, whilst t he probability of non-r epayment is 0.05 
(these probabilities being independent of  the size of loan limit). The 
average profit in $, per customer made by Venus is  given by the following 
table. 
 Loan Limit 
 High Low 
Full-repayment 50 20 
Non-repayment –200 –30 
The junior accountant at the store has creat ed a decision tree to 
summarise the store's position on providing credit to customers: 
 
At points A and B calculate Expected Values: At A EV = (0.95 × 50) + (0.05 × (200))  = 37.5   
At B EV = (0.95 × 20)  + (0.05 × (30))  = 17.5

526  
 Task: 
Explain the decision tree to the store's management and recommend 
whether or not credit should be offered to customers. 
The junior accountant has also  prepared the following information 
regarding the use of a credit agency w ho would assess customers before 
any decision was taken. Analysis of the last 1,000 customer ratings by 
this agency have been used in the cons truction of the following decision 
tree: 
 
Workings: 
(W1) A sample of 800 customers have been assessed by the 
agency as being a good risk. Of these 790 did repay the loan. 
This represents 98.75% (790 ÷ 800) of the good risk 
Hence, the remaining 1.25% of the good risk customers did 
not repay the loan. (10 ÷ 800). 
(W2) In a similar way to (W 1), 160 out of the 200 bad risk 
customers did repay the loan, i.e. 80%. 
40 out of the 200 bad risk custom ers did not repay the loan, 
i.e. 20%.

Chapter 13 
 527 
 Expected values 
At A (0.9875 × 50) + (0 .0125 × (200)) = $46.875 
At B (0.9875 × 20) + (0 .0125 × (30)) = $19.375 
At C (0.8 × 50) + (0.2 × (200)) = 0 
At D (0.8 × 20) + (0 .2 × (30)) = $10.00 
At G (0.8 × 46.875) + (0.2 × 10.00) = $39.50 
Expected return with perfect information = $47.50 
Tasks: 
 Explain the difference between im perfect and perfect information. 
 Explain how this applies to t he department store's decision and 
recommend whether a credit agency s hould be used by the store. 

528  
 Example 1 
  
Outcome Profit 
($) Probability Profit x 
Probability 
($) 
A 100,000 0.10 10,000 
B 70,000 0.40 28,000 
C 50,000 0.30 15,000 
D (20,000) 0.20 (4,000) 
   ––––– 
Expected value  49,000 
   ––––– 
Expected profit is $49,000. 
 
 Example 2 
 (i) EV of demand = (10 × 0.20) + (1 5 × 0.55) + (20 × 0.25) = 15.25 
units per week. 
(ii) The first step is to set up a dec ision matrix of possible strategies 
(numbers bought) and possibl e demand, as follows: 
Outcome Strategy (number bought) 
(number demanded) 10 15 20 
10    15    20    
The ‘pay-off’ from each combination of action and outcome is then 
computed: 
No sale: cost of 15c per magazine. 
Sale: profit of 25c – 15c = 10c per magazine. 
Pay-offs are shown for each combi nation of strat egy and outcome. 
Probability Outcome Strategy 
 (number demanded) (number bought) 
  10 15 20 
0.20 10 100 25 (50) 
0.55 15 100 150 75 
0.25 20 100 150 200 
––––  –––– –––– –––– 
1.00  100c 125c 81.25c 
––––  –––– –––– ––––

Chapter 13 
 529 
 Conclusion:  The strategy which gives the highest expected value is to 
stock 15 magazines each week. 
Workings 
(i) If 10 magazines are bought, then 10 are sold no matter how many 
are demanded and the payoff is always 10 × 10c = 100c. 
(ii) If 15 magazines are bought and 10 are demanded, then 10 are sold 
at a profit of 10 × 10c = 100c, and 5 are scrapped at a loss of 5 × 
15c = 75c, making a net profit of 25c. 
(iii) The other contributions  are similarly calculated. 
 
 Example 3 
 Using maximax, an optimist would c onsider the best possible outcome for 
each product and pick the product with the greatest potential. 
Here C would be chosen with a ma ximum possible gain of 100. 
 
  Using maximin, a pessimist w ould consider the poorest possible 
outcome for each product and would ensure that the maximum pay-
off is achieved if the worst result were to happen. 
 Therefore, product A would be chosen resulting in a minimum pay- 
off of 20 compared to a minimum pay-off of (10) for product B and 
10 for product C. 
 
 In the pay-off matrix above, if the market state had been scenario I: 
The correct decision 
would have been:  B (net income $80) 
If A had been chosen instead: The company would have been out of pocket by $60 (i.e. 80 – 20) 
If C had been chosen: It would have been out of pocket by $70 
(i.e. 80 – 10) 
 The opportunity loss associated with each product is: A = $60, B = 
$0, C = $70. 
Scenario II and III can be considered in the same way and the results can 
be summarised in a regret table.

530  
 The completed opportunity loss (‘regr et’) table is thus as follows. 
 Decision 
State A B C 
I 60 0 70 
II 60 30 0 
III 0 60 10 
Maximum regret 60 60 70 
The maximum regret value for: 
A = $60 B = $60 C = $70 The minimum value of these is $60,  hence the minimax regret strategy 
would be either A or B. B would probably be adopted because its second-highest regret outcome 
($30) is lower than the se cond-highest for A ($60). 
 
 Firstly, we have to calculate the expected value without the information. 
EV (A) = 0.2(20) + 0.5(40) + 0.3(50) = 39 
EV (B) = 0.2(80) + 0.5(70) + 0.3(–10) = 48 
EV (C) = 0.2(10) + 0.5(100) + 0.3(40) = 64 So the company would choose project C, with an expected pay-off of 64. 
If the company had perfect informa tion it would act as follows: 
Scenario indicated by 
perfect information Company's 
decision* Pay-off 
I Invest in product B 80 
II Invest in product C 100 
III Invest in product A 50 
* this will be based on the highest expected pay-off in that scenario. For 
example, if scenario I is predicted t he company will face a pay-off of 20 
from product A, 80 from product B, and 10 from product C. It will 
therefore decide to invest in product B. 
The expected value from these decisions would be: EV (C) = 0.2(80) + 0.5(100) + 0.3(50) = 81 This is 17 higher than the expected value (64) when the company had no 
information. Therefore the info rmation has a value of 17.

Chapter 13 
 531 
 Example 4 
 The situation can be summarised in a decision tree as follows: 
 
The expected value at point A = (0 .7 × $20m) + (0.3 × $1m) = $14.3m 
The expected value at point B = (0 .6 × $14.3m) + (0.4 × $0k) = $8.58m 
The value of the development (point  C) = $8.58m – $6m = $2.58m 
When compared to the $0 returns from  not developing it is better to 
develop the product The expected value of the development and marketing plan is $ 2.58 m. 
 
 Example 5 
 The mean is $175,000. $168,000 is $7,000 away from the mean. 
This represents $7k/$5k = 1.40 standard deviations. This is the z score. 
From tables, on the left hand column, look up the z score to one decimal 
place, i.e. 1.4. Look along this row until it meets the column with the 2nd 
decimal place (0.00). The table give s us 0.4192. The normal distribution 
table used has a maximum value of 0.5. We want to determine the 
probability that sales ar e MORE than 1.4 standard deviations away from 
the mean and this is therefore calcul ated as 0.5 – 0.4192 = 0.0808. This 
can then be converted into a percent age by multiplying by 100 = 8.08% 
Hence, the probability of sale s being below $168,000 is 8.08% 
(approximately 8%).

532  
 Example 6 
 (a) The EV would have to decrease by $16,000 before the original 
decision is reversed, i.e. this is the break-even point. 
– Let the loss be L 
Currently, EV = (0.4 × L) + (0.6 × 40) If EV falls to zero: EV of 0 = (0.4 × L) + (0.6 × 40) 0 = 0.4L + 24 – 24 = 0.4L – 24/0.4 = L L = – 60 
– The loss would have to increase from $20,000 to $60,000 
before the decision is reversed. This is a 200% increase in the 
loss. 
(b) The EV would have to decrease by $16,000 before the original 
decision is reversed, i.e. this is the break-even point. – Let the probability of a loss be P and the probabilit y of a profit 
be 1 – P. Currently, EV = (P × –20) + (1 – p × 40) If EV falls to zero: EV of 0 = (P × –20) + (1 – p × 40) 0 = –20P + 40 –40P 60P = 40 P = 40/60 P = 0.67 
– The probability of a loss would have to increase to 0.67 from 
0.4 before the decision is reversed. 
 
 $9.2m 
If there is a 40% chance of launching before rivals there must be a 60% 
chance of launching after rivals. 
The overall expected value = ($20m × 0.4) + ($2m × 0.6) = $9.2m

Chapter 13 
 533 
 If the company wishes to select the project with the lowest risk factor 
(coefficient of variation) it  select will select Project B 
deviation Coefficient 
Of variation 
 $000  $000   
A 850 500 0.59 
B 1,200 480 0.40 
C 150 200 1.33 
D 660 640 0.97 
 
 PT will have expected cash of $600,000 + $80,000 = $680,000. It has an 
interest commitment (outgoing) of $320,000 (= 4% on $8m). If receipts 
fall by $360,000 ($680,000 – $320,000) t he organisation will default on its 
interest commitment. So we need to calculate the probability that the 
cash available will fall by $360,000 over the next year.  
Assuming that the annual cash flow is normally distributed, a volatility 
(standard deviation) of 40% on a cash  flow of $600,000 represents a 
standard deviation of 0.40 × $600,000 = $240,000. Thus, our fall of 
$360,000 represents 360,000/ 240,000 = 1.50 standard deviations. 
From the normal distribution tables, the area between the mean and 1.50 
standard deviations = 0.4332. Hence,  there must be a 0.5 – 0.4332 = 
0.0668 chance of the cashflow being insufficient to meet the interest 
payment i.e. the probability of default is approximately 6.7%. 
 
 C 
If the investor is an optimist it is lik ely to follow a maximax strategy. This 
aims to give the best result in the best case scenario (in the case, the 
best case scenario is that the grant is awarded). The best result for the 
investor in that scenario will be to have gone for Investment C which 
gives the highest pay out from all the possible outcomes available. 
 
 140 
The maximin criteria chooses this best possible return in the worst 
possible outcome. The worst possible outcome in this scenario is that demand is only for 140 newspapers per day, in which case it would provide the highest returns if only 140 newspapers were purchased each day.

534  
  
Position  Value 
A  $20,000 
B  $80,000 
C  $160,000 
D  $40,000 
A regret table shows the shortfall fr om the maximum contribution that 
could be earned at each demand level 
The completed regret table is as follows: 
 2,000 0 $20,000 $40,000 Production 3,000 $80,000 0 $20,000 
 4,000 $160,000 $80,000 0 
 
 The expected value from each product is: 
Product A: ($40m × 0.75) + ( $1m × 0.25) – $20m = $10.25m 
Product B: ($16m × 0.45) + ( $8m × 0.55) – $10m = $1.6m 
So Product A would be selected, and the expected value would be 
$10.25m ( Option B ). 
 
 Decision point A appears to repres ent a decision between the following 
two outcomes 
  Value 
Outsource  $10m 
Invest ($50m × 0.75) + ($8m × 0.25) – $20m $19.5m 
The option to invest would appear to be the optimal decision at point A as 
it has the highest expected value. 
The maximum expected value of profit at decision point A is $ 19.5m

Chapter 13 
 535 
 Without information, the expected profits are: 
Product X: $20,000 × 0.2 + $15,000 × 0.5 + $6,000 × 0.3 = $13,300 
Product Y: $17,000 × 0.2 + $16,0 00 × 0.5 + $7,000 × 0.3 = $13,500 
So without information, pr oduct Y would be selected. 
With perfect information, product X w ould be selected if the market was 
good, and product Y in the other two cases. The expected value would 
then be: 
$20,000 × 0.2 + $16,000 × 0. 5 + $7,000 × 0.3 = $14,100 
The expected value of perfect informa tion is therefore $14,100 – $13,500 
= $600 
 
 First decision tree 
The decision tree provides information on the three possible decisions 
available to the business: 
 the upper most line shows the returns from offering customers a 
high loan limit. It show s that there is a 95%  chance of repayment 
and a respective return of $50. Ther e is also a 5% chance of default 
with a loss of $200. The expected value calculated at point A 
illustrates that this would have an average overall value to the 
business of $37.50. 
 the lowest line provides simila r information on the returns from 
offering a low loan limit. The expect ed value at point B shows that 
this would have an average overall va lue to the business of $17.50. 
 the middle line shows that if a loan limit is refused to the customer 
then the expected return is $0. 
The three values can be compared at point C and the highest expected 
return ($37.50) comes from offeri ng customers a high loan limit. This 
therefore instructs the st ore as to its optimal dec ision policy – if a new 
customer asks for credit, he/she s hould be offered a high loan limit. 
Second decision tree 
There are two types of information pr esented in the junior accountant's 
analysis: 
Perfect 
information This assumes that the credit agency's prediction on 
whether a customer is a good or bad risk is always 
100% accurate. In reality, this is unlikely to be achievable. 
Imperfect information This recognises that the credit agency will not always get their prediction correct. Sometimes good risk customers will be classed as bad risk customers (and 
vice versa). This becomes a more complex problem and the decision tree summarises the information used to come to a decision on the va lue of this information.

536  
  The uppermost line shows the decis ion making process if the credit 
agency indicates that a new custom er will be a good credit risk (i.e. 
they are more than likely to repay the loan). This takes the store to 
decision point E where it must decide between offering a high loan 
limit (the expected value (EV) show s at point A that this would 
generate an average profit of $46.875), refusing credit (the EV is $0) 
and offering a low loan limit (EV = $19.375). So at point E, the best 
decision would be to offer a high loan limit if the agency indicates that the new customer is a good credit risk and this would have an 
EV of $46.875. 
 The line stretching towards decision point F illustrates a similar 
analysis would take place if t he agency indicated that the new 
customer was a bad credit risk. T he optimal policy would be to 
follow along path D where the EV is  $10. So if the agency indicates 
a bad credit risk for a new custom er a low credit loan should be 
offered with an EV of $10. 
 To bring all of this analysis together, points E and F are then 
compared at point G. This takes account of the pr obability of the 
agency indicating either good risk or bad risk and builds in the 
presence of imperfect information.  The EV at point G ($39.50) 
indicates the overall profit to t he business in the presence of this 
imperfect information 
The business is therefore left with thr ee important pieces of information: 
 in the absence of any information, the store can expect to make a 
profit of $37.50 
 in the presence of imperfect in formation from the agency, the store 
can expect to make a profit of $39.50 
 if perfect information could be ac hieved, the store can expect to 
make a profit of $47.50. 
So the value of the information has a maximum value of $10 ($47.50 –
$37.50). The value of the agency's information is $2 ($39.50 – $37.50). 
The store should therefore use th e credit scoring agency provided that 
they charge less than $2 for each credit assessment.

537 
Applying knowledge to 
case study questions 
To understand how to apply technical P1 areas to the relevant Operational Case Study tasks 
  Chapter 
14

Applying knowledge to case study questions 
538  
P1 forms one part of the Operational le vel integrated Case Study. There are 
many skills which you must exhibit in the operational case study (OCS) such as 
presentation. The examiner’s  report from the May 17 ex am, for example, stated: 
“It was pleasing to see that the majori ty of answers were well structured 
with headings and clearly spaced paragraphs. Whilst there are not specific 
marks for formatting, there are a nu mber of advantages to setting out 
answers in this way, not least that it helps the marker to identify the points 
that are being made. In addition, hav ing a clear structure should help 
candidates to ensure that they have addressed all the points that they 
want to. There were a few scripts w here candidates wrote a plan and then 
wrote their answer out in full underneath, repeating what they had in the 
plan. Given that this exam is typed, this sort of approach wastes time, 
although it is good to see that planning is happening!” 
This chapter will however focus on another key skill: the application of your P1 
knowledge. The examiners regularly state that this can be a key differentiator 
between pass and fail in the OCS. The examiner’s report from the May 17 
exam, for example, stated: 
“As is consistent with other exam se ssions, .. applying knowledge from P1 
… to demonstrate technical skills appeared to be … challenging.” 
This chapter will use the May 17 exam to illustrate how this skill can be 
exhibited in exam answers. 
2 Pre-seen material 
The May 17 OCS provided students wit h pre-seen material regarding a 
company called Ashworth Lea (“Ashworth”),  which makes and sells high quality 
luxury sports cars. Some of the ke y details about the company follow: 
 The company is based in the count ry of Mayland and has shareholders as 
follows: the founding families 40%, DOM 15%, INV group 45%. 
 Ashworth sells via over 100 dealership locations in over 40 countries 
around the world. It is felt  that the brand sells itse lf, so marketing focusses 
on customer satisfaction and repeat purchases. 
 30 years ago the business nearly failed and was saved by DOM, who took 
a 60% stake (since reduced to 15%), invested in new production facilities, 
new designs, new engines and marketing. 
 In many respects Ashworth Lea is facing a similar challenge today – sales 
of the Regent model are disappointing,  the company is barely profitable 
and new investment is required to m eet major changes in the industry. 
 In particular, customers are bec oming less brand-loyal and want more 
advanced technological features as standard. There is  an industry-wide 
drive towards ‘connected cars’ and ‘intelligent cars’ and increasing pressure to improve fuel economy and reduce the environmental impact of 
cars, such as through the use of alte rnative fuel systems and electric cars.

Chapter 14 
 539 
 Against such challenges, Ashwor th Lea has not significantly changed 
either its production methods or suppl y chain for many years. On the 
positive side, DOM is committed to supporting the development of self-
drive vehicles and Ashworth Lea has a new model being released in 2017. 
 Similarly the INV group is keen to see change, is helping support the self-
driving cars and is looking to develop an electric car based on hydrogen 
fuel cell technology. 
 Richard Ashworth, the recently appointed Managing Director will thus be 
under pressure to rectify any complacency, initiate change and try to ensure that the company is ready to face the considerable risks and 
uncertainty in the industry. 
Now let’s look at some of the key skills  required in order to score well in the 
case study exam. 
To do this we examine tasks that were set for students – focusing on the P1 
elements and how these required the app lication of your P1 knowledge. 
3 Focusing on the requirement 
Scenario 
Task 3 of Variant 3 of the case study ex am (there are 5 variants in total, each 
with 4 tasks) focused on a discussion of budgets based on forecasts. 
Students were presented with a brief scenario whereby: 
 Ashworth were planning to introduc e a fleet management service for some 
large customers. 
 This would involve providing vehicl es, insuring them, maintaining them 
and selling them again in the future. 
 This new service would require an IT system. 
 A budget was required for the new service and the finance director 
suggested that a zero based budget would be the best approach to do 
this. 
The task 
The requirement asked students to explain how a zero based budgeting 
approach could be used to prepare a new budget for the service. In total there 
were 8 marks for this requirement. 
The suggested approach 
There will always be some marks for knowledge in the exam and you should 
therefore start by briefly explaining  what zero based budgeting (ZBB) is. 
“Using ZBB, every activity has to be ju stified (in comparison to incremental 
budgeting where the figures from last year are used as a base). ZBB is 
applicable for discretionary costs, where any expendit ure or the amount of 
the expenditure is at the discretion of management.“

540  
However, try to make this answer relev ant to the case scenario that you are 
considering. The easiest way to do this is  to consider whether  your definition is 
met in this situation. The next sentence could be: 
“In the case of the new fleet man agement service there is clearly 
discretion over how much we spend although this will be partly determined 
by the contractual agreements with the customers.” 
It is then important to fo cus on the requirement and what has been asked by the 
examiner. The examiner has, for example,  not asked whether ZBB is a good or 
bad idea or how it differs from other budgeting systems. Theref ore the following 
approaches would not score marks: 
 Explaining the benefits of ZBB 
 Explaining the problems of ZBB 
 Comparing ZBB to other budgeting approaches 
 Advantages and disadvantages of  other budgeting approaches 
Taking any of these approaches would ill ustrate more of your knowledge but 
would show little application to t he question that you have been asked. 
Unfortunately, many students adopted some  or all of these approaches, but 
none of these would have scored any credit. 
The question here is about HOW zero  based budgeting would be used. You 
therefore need to explain: 
 the steps that would be needed to create a ZBB 
 how these steps woul d apply in Ashworth 
So, for example, the offici al answer suggests that the first step is to determine 
what activities need to be performed: 
“The new manager will need to determine which activities need to be 
undertaken. The manager will need to consider what services we have agreed to provide to each customer and the activities that will need to be 
undertaken to provide the service. He will also need to estimate how much 
of the activity should be done. The level of each activity will depend on the projected volume both in terms of number of customers and number of 
vehicles. The standard of service to be provided will also need to be considered. For example, when maintaining the vehicles will we also provide a valet service?” 
Notice the use of words such as services, vehicles, customers etc. This makes the answer much more relevant to the scenario and will be the best approach to maximising your marks.

Chapter 14 
 541 
 Official answer to the task 
 Zero based budgeting (ZBB) for fleet management service 
Using ZBB, every activity has to be justified (in comparison to incremental 
applicable for discretionary costs, where any exp enditure or the amount 
of the expenditure is at the discretion of management. 
In the case of the new fleet m anagement service there is clearly 
discretion over how much we spend although this will be partly 
determined by the contractual agreements with the customers. 
The new manager will need to determine which activities need to be undertaken. The manager will need to consider what services we have agreed to provide to each customer and the activities that will need to be 
undertaken to provide the service. He will also need to estimate how much of the activity should be done. The level of each activity will depend on the projected volume both in te rms of number of customers and 
number of vehicles. The standard of service to be provided will also need 
to be considered. For example, when maintaining the vehicles will we 
also provide a valet service? 
The manager should determine a base package (which would be a 
minimum spend). The base package woul d be considered essential. He 
would need to determine what t he base package can achieve and how 
the benefits can be measured and evaluated. The next step is to prepare a number of alternative decision packages. 
He will need to consider how each activity should be done and how much 
each alternative would cost. Z BB encourages managers to consider 
different ways of achieving the same objectives. It will also be important 
to consider whether the additional  costs can be passed on to the 
customer and the potential benefits in  terms of reputation and customer 
loyalty. The evaluated packages would then be presented to the budget 
committee for a final decision about how  we will actually operate the new 
service. In making this decision, the budget committee will take a wider 
view over the whole organisation. This will include resource constraints (not the least of which will be cash ) and the conflicting calls upon these 
constrained resources. The budget co mmittee would review each of the 
decision packages and decide the resour ces that should be allocated to 
the fleet management service depending on the combination of activities 
that are approved. 
ZBB can result in significant cost sa vings, as all activities and costs are 
budgeted from scratch. 
Level P1 Management Accounting Case Study Exam May 2017

542  
4 Applying knowledge to the scenario 
Scenario 
Task 3 of Variant 2 of the case study exam required students to discuss time 
series analysis. 
 Ashworth would launch a new small car model, the Cub 
 It would sell for M$60,000 
 Initially, it would only be sold in Mayland 
Students were also presented with some pub lished market statistics as follows 
New car registrations in Mayland 
Segment 2014 2015 2016 
Small compact 80,377 84,237 70,263 
Compact 813,092 884,892 926,241 
Lower medium 588, 402 647,438 715,604 
Upper medium 208, 462 228,656 249,347 
Executive 119,745 120,147 127,666 
Luxury 8,346 9,766 9,061 
Specialist sport 47,544 42,817 49,118 
Dual purpose 248,003 292,347 355,118 MPV 150,766 166,135 131,085 
Total 2,264,737 2,476,435 2,633,503 
The task 
The first part of the requirement ask ed students to explain how Ashworth could 
apply time series analysis to the figures in  the schedule, to forecast sales of the 
Cub for each quarter of the first year st ating what other information we would 
require to carry out the analysis. 
There will be a small amount  of marks for explaining what time series analysis 
is. 
But the majority of marks here are for examining the data provided and 
explaining whether or not this would be useful to As hworth in attempting to 
employ time series analysis. This does not mean brining in general problems 
from the text concerning the use of time series analysis. Instead you need to 
highlight specific, relevant point s from the data provided such as: 
 It only has three years’ worth of data 
 It isn’t broken down by quarter 
 There is no way to calculate s easonality from t he data provided 
There may be problems in using this me thod over and above the limitations in 
the data provided in that it may be diffi cult to determine where the Cub fits 
within the table (‘small compact’ or ‘compact’) and Ashworth has no internal 
data to rely on.

Chapter 14 
 543 
Notice how these issues are not derived from the text. Instead they come from 
the scenario. This illustrates what the examiner means when explaining to 
students that they need to APPLY knowledge fr om P1 in order to  illustrate their 
technical skills. It is best to 
 use examples from the scenario to support your answer, 
 give examples that are relevant  to the business you are discussing 
 think about implications for this type of business 
 use the scenario and related data rather than rely on just your study text 
 make your knowledge relevant to  the scenario rather than simply 
regurgitate it. 
 
 What not to do 
 As with the previous example on ZBB,  this questions should not be seen 
an as opportunity for you to tell the examiner everything you know about 
time series analysis. Therefore, y ou will not score marks for covering 
areas such as:  the limitations of time series analysis 
 the benefits of time series analysis 
 comparing time series analysis  to other forecasting methods 
 
 Time series analysis 
A time series is a series of figures recorded over a period of time. In this 
case, we have new car registrations in Mayland over the past three 
years. ‘Time series analysis’ is a term used to describe techniques for analysing the time series to deter mine whether there is any underlying 
historical trend and if there is, to us e this analysis to forecast the trend 
into the future. As this is a comple tely new market that we are entering 
and have no company historic data, t he use of industry statistics would 
an appropriate substitute. 
We can also identify whether ther e are any seasonal variations around 
the trend and if there ar e, we can measure the seasonal variation and 
apply these to a trend line forecast in order to forecast season by season. 
We would need to access more detaile d statistics that break the annual 
registrations down into monthly or quar terly registrations. Again, it is 
unlikely that the information we have  available on monthly sales of our 
current models would be useful as the markets are so dissimilar. 
To apply time series analysis to the figures given, we need to firstly 
classify the Cub into one of the segment s. It is most likely to fall into the 
segment of either a ‘small compact’  car or a ‘compact’ car. We can 
compare our small car with the cars  models within each of the segments 
and then decide which segm ent is the best categor y for our small car.

544  
 Once we have established the segment  we then need to identify the trend 
line for that segment. This can be  done either through inspection (where 
the trend line is drawn by eye), using least squares regression analysis or 
using moving averages. 
We then need to establish any cyclical variations which are medium term 
or long term influences usually asso ciated with the econom y. In order to 
do this, we would need data going ba ck a few more years than the three 
years we have available. 
If we were able to obtain data split between quarters or months we could 
use this to calculate the seasonal va riations. Seasonal variations can be 
estimated by comparing an actual time series with the trend line 
calculated from the time series. Fo r each ‘season’ the seasonal variation 
is the difference between the trend li ne value and the actual historical 
value for the same period. The seasonal variations can be used to forecast future sales by adding or subtracting it from the trend line 
forecast. 
Using the trend line and the seasonal variations we can forecast the 
sales in units for the industry for t he following year. We would then have 
to decide what percentage market s hare we would expect the Cub to 
capture and apply this percentage to our  figures for the total market. 
Level P1 Management Accounting Case Study Exam May 2017 
5 Full syllabus coverage 
It is important to recognise that the case  study can examine every part of the P1 
syllabus. 
Scenario 
Task 3 of Variant 2 of the case study ex am (discussed in the previous section) 
also required students to discuss sensitivity analysis. 
The task 
 Explain how sensitivity analysis could be applied 
 Give its advantages and limitations 
 Explain how it could be improved by using probabilities 
Sensitivity analysis does not appear to be a large part of chapter 11. But this 
question illustrates that t he exam team can choose any part of the syllabus and 
make it part of the OCS. You therefore need to avoid question spotting and 
ensure that you have fully covered the syllabus in order to be best prepared for 
the OCS.

Chapter 14 
 545 
The examiner’s comments stated: 
“In the second element of this task, it was obvious that most candidates 
had not studied sensitivity analysis in preparation for this exam. Marks 
were often not awarded because answers were irrelevant or simply wrong. 
It was noted by the marking team that  a lack of knowledge of the subject 
did not deter candidates from writing reams. Future candidates should note that even the most confidently stated, illustrated and fully explained 
points will be awarded no ma rks if they are not factually correct or 
pertinent to the question asked.” 
You then must apply the other techniques  that we have illustrated in this 
chapter such as ensuring you focus on the question asked, covering all aspects 
of the requirement, making y our answer relevant etc. 
 
Sensitivity analysis involves revisi ng the budget on the basis of a series 
of varied assumptions. One assumpti on can be changed at a time to 
determine the impact on the budget overa ll. In this case, we can change 
our assumptions about the volume of sales of the Cub to determine the 
impact on the budgeted profit and cash flow. We will also be able to 
determine by how much our estimate of sales volume can change before we make a loss. Alternatively, we coul d look at the impa ct on profit of 
changing the selling pr ice of the Cub. 
Advantages and limitations of sensitivity analysis 
Sensitivity analysis provides us  with more information about the 
sensitivities of the project for the new car and allows us to make a 
decision about whether we are prepared to accept the risks involved. It 
will also allow us to decide whether it is worth spending time and money 
on further investigation of  the market for the sma ll car. We may decide, 
for example, that it would be worthw hile paying to obtain more detailed 
statistical information or market in telligence on the market segment for 
‘small compact’ or ‘compact’ cars. We can also make contingency plans 
for the eventuality that the sales vo lume turns out to be much lower than 
expected. 
Sensitivity analysis, however, is limit ed as it assumes that changes to 
variables can be made independently  however many variables are 
interdependent; for example, the sales volume of the Cub is likely to be 
very dependent on the selling price set for the Cub. We can establish from the analysis how far the sales volume needs to 
change before we make a loss but it does not tell us the probability of that change happening. We could apply probabilities for different sales 
volumes and then calculate an expect ed value for the sales volume and 
profit. However, the accuracy of t he probabilities will be limited by our 
knowledge of what is a new market for us.

546  
 Alternatively, we could dete rmine the budget using the estimated 
volumes as the ‘expected’ case but also produce a ‘worst-case’ budget 
and a ‘best-case’ budget. This will give us a range of possible outcomes and allow us to make decisions accordingly. 
Level P1 Management Accounting Case Study Exam May 2017  
6 Explaining graphs 
Scenario 
Task 4 of Variant 2 of the case study  exam gave students a linear programming 
graph to discuss. 
Students had to explain the optimal pr oduction plan in a choice between two 
models (products), the Regal and the Royale. Students were also given: 
 Information on three cons training resources – incl uding usage for each of 
two products and overall total availability 
 Maximum demand for the two products under consideration 
The task 
The requirement asked students to 
 Explain the axes, lines, points and areas in the graph 
 Explain how the graph could be used to help make decisions 
Start by explaining the elements of the graph: 
 There were nine lines on the graph – each donated by a separate letter. 
This would provide you with 9 items to explain. 
 The data provided could be used to determine which constraint line was 
which 
 The feasible area was shaded 
 Only one point on the feasible regi on was indicated – this must have been 
the optimal production point 
 Axes and other lines should have been easy to explain, but it was 
important to not forget to do this part of the requirement 
Then explain what the graph tells  us and how it can be useful: 
 Explain what the optimal poi nt means and where it is 
 Consider whether this position is a good idea (what other factors might 
come into play) 
 Briefly consider the problems in using such graphs 
This question concerned linear programmi ng but other graphs such as profit-
volume charts have been examined in t he past. You should still apply the same 
approach – start by explaining what the points/lines etc. ar e on the graph, then 
examine the usefulness of the graph itself.

Chapter 14 
 547 
 Linear programming graph 
X represents the quantity of model Regal to be produced and sold  
Y represents the quantity of model Royale to be produced and sold  
Line A – represents the machine hour constraint 
Line B – represents the l abour hour constraint 
Line C – represents the spec ial component constraint  
Line D & E – represents the IS0 – contribution line  
Line F – represents the demand for the Regal model  Line G – represents the demand for the Royale model Point H – represents the point at  which profit will be maximised  
Area J – represents the feasible area i.e. the area cont aining all the 
possible solutions that satisfy all the constraints 
Identifying the profit-maximising production plan and other factors 
to be considered 
From the graph, we can see that at Point H, the binding constraints are 
machine hours and labour hours. Area J is the feasible region and the 
ISO- contribution line indicates that the further point within this area is 
Point H and this is the point that  will maximise contribution. The 
production plan can be read from the graph as 2,000 units of X and 1,200 
units of Y. 
The optimum production plan given by  the graph may not be the most 
appropriate solution. The graph is  based on Stephen’s recommendation 
to produce the two newer models and produce none of the older model. 
This may not be a good decision; it may be appropriate to produce a small number of all three models.  Our dealers and end customers may 
feel that a choice of only two models is restrictive. 
Whilst the graph shows us the maximum contribution based on the supply of only two models, it may not  be the overall pr ofit maximising 
production mix. The graphical method only allows two products to be 
considered. If we wanted to include all three specialist car models and 
the new small car model, we would need to use the simplex method. 
The production capacity required for the Cub is uncer tain and dependent 
on our estimates of demand. The estimate of demand for the Regal 
model is also important since, alt hough it is not a binding constraint, a 
variation from the estimate of mo re than 300 units will result in the 
production plan no longer being optimal. 

548  
These sections have aimed at illustrati ng how to apply your P1 knowledge in 
the OCS. Be aware, however, that m any other skills are needed in order to 
score well in any case study exam (such as time management, writing skills and 
planning skills). These are explored in more  detail in official material aimed at 
preparing you for the OCS. 
7 Other sample tasks 
The following TYU's contain some other ta sks that were covered in the May 17 
OCS which are relevant to P1 areas. T hese are not the only tasks that covered 
P1 areas, but they should give you furt her evidence of the nature of the tasks in 
the case study. You could attempt these tasks for yourself – but be aware that 
we have only provided a lim ited amount of pre-seen material so there may be 
occasions when the official ans wer refers to mate rial that is not presented in this 
chapter. 
 
 Activity based costing – Variant 5, Task 2 
Scenario 
 Ashworth had now been acquired by a larger group, the Naas Motor 
Company Group 
 Naas used activity based costing in its systems 
 Naas had asked Ashworth to consider employing an activity based 
costing system 
 An existing department was to be used as an example – the paint 
shop 
 This department currently employs a direct labour absorption rate 
 A table of activities and driver s for the department were given as 
follows: 
Activity Description of activity 
Cleansing The vehicle bodies have be pre-treated before the paint 
can be applied. One part of t he pre-treatment is cleansing 
which is intended to remove contaminants, which may 
have been in the body shop, from the product. This is performed over a series of water and cleansing solution 
rinses. Each of the vehicles receives the same number of 
rinses 
Sealing Prior to the coating of  the vehicle body with primers and 
paint, the seams of the body ar e sealed to protect against 
weather effects on the body. A sealant compound is applied along the length of each seam on the car's body. 
The sealant is then baked onto the seam.

Chapter 14 
 549 
 Cavity wax 
application To proof the vehicles as much as possible against 
corrosion – a water-borne, cold-applied, cavity wax is injected into body sections  and panel inners of the 
vehicles. Infra-red lights heat  the bonnet, boot lid or hatch 
to warm the cold wax to encour age it to flow into corners 
and points where water might go 
The task 
 Explain how Ashworth could use ABC 
 Provide suggestions and explanati ons for appropriate cost drivers 
for each of the activities in the schedule 
 
 Attitudes to risk – Variant 5, Task 4 
Scenario 
 Ashworth was considering 3 marketing packages 
 The results of each were impacted by customer reactions 
 Contribution from each was gi ven based on whether customer 
reaction was strong moderat e or weak as follows: 
 Marketing package 
 Package A Package B Package C 
Customer reaction:    
Strong M$450,000 M $400,000 M$425,000 
Moderate M$350,000 M $340,000 M$360,000 
Weak M$275,000 M$300,000 M$250,000 
The task 
The requirement had 2 parts: 
 An explanation of three decision criteria used under conditions of 
uncertainty and how these would be used to select a matching 
package 
 How Ashworth could use probabilities to improve the decision 
making process and what are the lim itations of t he expected value 
approach to decision making.

550  
 Variance analysis – Variant 4, Task 4 
Scenario 
Students were presented with a variance report for self-drive cars for the 
first quarter of the year: 
 M$  M$ 
Budgeted contribution  300,000  
Sales volume contribution planning variance 60,000 A  
Sales volume contribution oper ational variance 90,000 A  
Standard contribution on actual sales volume  150,000  
Planning variances:   Material price variance 23,000 A  Revised standard contribution  
127,000  
Operational variances:   Sales price variance 30,000 A  Material usage variance 15,000 F  
Labour efficiency variance 18,000 F  
Actual contribution  
130,000  
Some additional information was provided: 
 The finance director was concer ned by the performance shown in 
the variance report 
 Ashworth’s new competitor was due to release a new self-drive 
model in November 2016 – this wasn’t accounted for in the budget 
 The operations and production di rector made a change to the 
standard specification which impacted on material costs as higher 
quality materials were used – this wasn’t accounted for in the original budget 
 There were problems in the public perception of the cars following a 
fatal car crash in early February wh ich arose as a result of quality 
failures with the vehicle 
The task 
Produce a report explaining each of the variances, giving suggested 
reasons why they may have arisen.

Chapter 14 
 551 
 Activity based costing 
In order to apply activity-based cost ing (ABC) to our products we would 
need to identify the activities that are carried out within the company. In 
each of our operational areas  there will be a number of activities carried 
out. The activities chosen should be at a reasonable level of aggregation 
based on cost versus benefit. For exam ple, rather than identifying the 
paint shop as a single activity we hav e disaggregated it into a number of 
separate activities which hav e different cost drivers. 
After the activities have been est ablished, the cost of resources 
consumed over a period must be assigned to each activity in a separate 
‘cost pool’. 
In order to assign the activity cost s to a product, the co st drivers that 
cause a change to the cost of activities  are identified. For example in the 
paint shop operation the cost drivers could be as follows: 
Cleansing: 
The cost driver could be number of vehicles. As each of the vehicles 
receive the same number of rinses, t he cost of the activity will depend on 
the number of vehicles. The higher the number of vehicles the more 
water, energy and cleansing solution will be used. 
Sealing: 
The cost driver could be the length of  seams (in metres). The length of 
seams on the vehicles will determine the amount of sealant used and 
therefore the amount of time spent in the process applying and ‘baking’ 
the sealant. 
Cavity wax application: 
The cost driver could be litres of ca vity wax applied. The size of the 
vehicle will determine the quantity of ca vity wax that will be applied and 
therefore the time taken to heat th e wax and ensure it flows into the 
cavities. 
The final stage is to apply the cost  drivers to the product. A pre-
determined cost driver rate is calc ulated based on the total costs of the 
activity and the total number of cost drivers for the period. The activity 
costs would then be charged to t he product groups dependent on their 
usage of the cost drivers. 

552  
 Maximax criterion 
The maximax criterion is where t he decision maker takes an optimistic 
approach. In this approach, the alter native that maximises the maximum 
pay-off achievable under each alternative will be selected. 
The maximum pay-off under each alternative is as follows: 
If we choose Package A = M$450,000  If we choose Package B = M$400,000  If we choose Package C = M$425,000 We would therefore choose Package A. 
Maximin criterion 
Under the maximin criteria we would se lect the alternative that maximises 
the minimum pay-off achievable under each alternative. This is where a 
pessimistic approach is taken. 
The minimum pay-offs are as follows: If we choose Package A = M$275,000  If we choose Package B = M$300,000  If we choose Package C = M$250,000 We would therefore choose Package B 
Minimax regret criterion 
Under this criterion the alternative that minimises the maximum regret 
under each alternative is selected. This  is generally used where we want 
to avoid making a bad decision. ‘Regr et’ refers to the opportunity loss 
through having made the wrong decision. Th is is also where a pessimistic 
approach is taken to the decision. 
We can produce a regret matrix wh ich shows the regret depending on the 
customer reaction to the product and which marketing package we 
choose. For example, if the customer  reaction is strong we would have 
no regret if we had chos en Package A. The regret for each of the other 
two selling prices would be the di fference between a contribution of 
M$450,000 and the contribution for eac h of the marketing packages. 
Having calculated the regret for each different customer reaction, we can 
then establish the maximum regret fo r each marketing package. We then 
choose the marketing package with the minimum of the maximum regrets.

Chapter 14 
 553 
 Use of probabilities 
Probabilities could be used to calculat e the expected value of the total 
contribution. The marketing package that gives the highest expected 
value would then be chosen. Expected value is seen as a risk neutral 
approach to decision making. 
Expected value is calculated by wei ghting each of t he possible outcomes 
by their associated probability. T he expected value is therefore the 
weighted average of the possible out comes based on estimates of their 
probability. Expected value has a number of limitations as follows: 
 The analysis is very dependent on t he estimate of the probabilities 
which are very subjective and dependent on knowledge of the 
market. 
 The expected value is merely a we ighted average if the decision is 
repeated several times. In business,  there are few decisions that 
would be repeated many times. In this case, this is a major one-off 
decision so reliance solely on expected value would not be appropriate. 
 The expected value gives no indicati on of the dispersion of possible 
outcomes around the expected value i.e. the risk. For example, 
Marketing Package B has a relatively narrow range of possible outcomes whereas both Marketing Package A and C have a much wider dispersion. 
 The expected value may not correspond to any of the actual 
possible outcomes as it is an average. 
Calculating the standard deviation of  the data will give us a clearer 
indication of the risk. The standard devia tion is the square root of the sum 
of the squared deviations of each outcome from t he expected value 
taking account of the associated probabilities. The higher the standard 
deviation, the more widely dispersed is  the distribution and therefore the 
greater the inherent risk.  The standard deviation can be considered in 
respect of how comfortable the director s are with the situation in light of 
their attitude to risk. 

554  
 Analysis of variances 
The overall performance as you suggested is significantly worse than 
budget. The budgeted contribution for the period was M$300,000 but the 
actual contribution was M$170,000 lower at M$130,000. 
Looking at the indi vidual variances we can get some indication of the 
reason for the poor performance. 
Total sales volume variance 
From the pre-seen material, we can s ee that the budget for self-drive cars 
for the first half of 2017 was to sell 20 units and make a contribution of 
M$600,000. This has obviously b een split evenly between the two 
quarters. The total variance of M$150, 000 means that only 5 vehicles 
were sold compared to the budget of 10 vehicles. 
Note: the part of this answer that re fers to the number of vehicles is not 
possible to achieve in this exercise given the limited pre-seen information 
presented in this chapter. However it is provided as an illustration of the 
type of information from the pre-s een material that can be used in an 
answer. 
Sales volume contribution planning variance 
The sales volume planning variance  measures the difference between 
the sales volume in the original budget and the sales volume in the 
revised budget multiplied by the standard contribution. The planning 
variance is adverse and has arisen as  the original sales volume budget 
was set too high. The fact that the competitor was planning to launch a 
new self-drive vehicle should have been ta ken into account in the original 
budget and a lower sales volume budget set, hence this is a planning variance. 
Sales volume contribution operational variance 
This variance is adverse therefor e actual volume was lower than the 
revised budgeted volume. The lower sales volume may be at least partly 
due to the effect that the car crash has had on public perception of self-
drive cars. The car crash arose as a result of an operational failure and, 
particularly as the report is directed at the board, this would be reported 
as an operational variance. A sales va riance report directed at the Sales 
Manager for self-drive cars may classi fy the part of the volume variance 
arising as a result of the car cr ash as a planning variance due to the 
principle of controllability – the variance arose as a consequence of 
production failures which were not cont rollable by the Sales Manager. An 
alternative, and perhaps better, approach would be to split the variance between its controllable and uncontr ollable elements. The amount 
specifically relating to the car cras h may however be difficult to determine 
since there will be many other factors that may have led to reduced sales 
volumes.

Chapter 14 
 555 
 Material price planning variance 
The material price planning variance  measures the difference between 
the standard purchase price of materi al in the original budget and the 
standard purchase price of material in  the revised budget multiplied by 
the standard material quantity for the ac tual production volume. It relates 
to the change in the standard specif ication which should have been 
reflected in the original budget. The higher quality material would have 
been more expensive thus resulting in an adverse variance. 
Sales price operational variance 
This variance measures the differ ence in budgeted selling price and 
actual selling price for the actual vo lume sold. The difficulties that were 
being experience with sales volumes ma y have resulted in higher than 
average discounts being given to cu stomers and hence the adverse 
variance. 
Material usage operational variance 
This variance measures the difference in standard quantity of material for 
the actual production volume and the actual material used. The variance 
is favourable, which may be related to  the use of higher quality material. 
If so, this could be argued to be a planning variance as it should have 
been recognised in the original budget that the higher quality material 
would potentially result in less wastage and therefore lower usage. 
Labour efficiency operational variance 
This variance measures the differ ence in standard labour hours for the 
actual production volume and the act ual labour hours. This variance is 
also favourable and may also be related to the change in material 
specification since the workers may have found it easier to work with the 
new higher quality material. 

Index 
 I.1 
A 
Absorption costing.....22 
advantages/disadv antages.....25 
over/under absorption.....25, 145 
problems.....61 
profit statement.....28 
reconciliation to ma rginal costing.....29 
Absorption rate.....24 
Activity based costing.....59, 548 
activities.....69 
advantages and disadvantages.....70 
budgeting.....270 comparison to traditi onal costing.....69 
implications.....71 in service industries.....66 
when to use.....68 
variances.....154 
Algebra revision.....467 
Attainable standards.....127 
B 
Basic standards.....127 Batch-level activities.....69 
Binding constraints.....476 
Break-even analysis.....413 
advantages and disa dvantages.....435 
break-even point.....417 
charts.....419 
impact of cost structures.....425 
margin of safety.....417 
multi-product.....427 
sensitivity.....433 
target profit.....429 
Budgetary control.....329 
behavioural aspects.....343 
Budgeting 
activity based.....270 feedback and feedfor ward control.....331 
fixed and flexible budgets.....335 cash.....246 
forecasting techniques.....300 
incremental.....264 
master budget.....242 
principal budget factor.....242 
process.....243 
purposes.....238 
rolling budget.....261 
sensitivity analysis.....250 
zero based.....266 
By-products.....90 
C 
Case study techniques.....537 
Cash budget.....246 
interpreta tion.....249 
Coefficient of 
determination.....308 
variation.....515 
Committed cost.....367 Constraints.....470 
Continuous costing.....88 
Contribution.....415, 470 
chart.....422 
to sales ratio.....416 
Control.....5 
Correlation.....306 
Cost 
behaviour.....12, 14, 15 
centre.....10 
driver.....62, 64 
objects.....11 
pool.....62 
unit.....10 
Cost-Volume-Profit (CVP) analysis.....414 
Current standard.....127 
D 
Decision making.....6 
and joint costs.....92 
and relevant costs.....376 
in throughput accounting.....95 
joint products.....383 
make or buy.....378 
linear programming.....479 
qualitative factors.....384 
Decision trees.....507 
Depreciation.....367 Direct costs.....14, 15 Duration dr iver.....64 
E 
Expected 
idle time.....139 
values.....495 
value advantages and disadvantages.....496 
F 
Facility-level activities.....69 
Feasible region.....471, 472 
Feedback control.....331 
Feedforward control.....331 Fixed cost.....12, 367 Flexible budgets.....335 Forecasting.....299 
Full cost plus pricing.....33 
Functional budgets.....242 
G 
Goal congruence.....348 
H 
High-low method.....301 
with inflation.....310 
Histograms.....496

Index 
I.2  
I 
Ideal standard.....127 
Idle time.....138, 144 
Imperfect information.....505 
Imposed budgets.....345 Incremental budgeting.....264 Indirect costs.....15 Inflation.....309 Intensity driver.....64 
Inventory valuation.....94 
J 
Joint 
costs.....89 
probabilities.....507 
Joint product costing 
by-products.....90 decision making.....383 
L 
Labour 
idle time.....138 
relevant cost.....373 
variances.....135 
Limiting factor analysis.....96, 376 
Linear programming.....465 
feasible region.....471, 472 
limitations.....480 
minimum contractual  requirements.....479 
shadow price.....477 slack.....476 
surplus.....476 
technique.....468 
M 
Make or buy decisions.....378 
Management accounting.....7, 2 
purpose.....5 
Margin of safety.....417, 428 Marginal costing.....27 
advantages/disadv antages.....27 
pricing.....35 
reconciliation to abs orption costing.....29 
variance analysis.....149 
Mark up.....32 
Master budget.....242 Material 
relevant cost.....372 
variances.....131 
Maximax.....502 
Maximin.....503 Maximising throughput.....95 Minimax regret.....504 Mix and quantity variances 
sales.....192 
Modern production environments.....60 Moving average.....313 Multi-product break-e ven analysis.....427 
charts.....429 
N 
Net realisable value.....91 Normal distribution.....516 
O 
Operational gearing.....425 
Opportunity cost.....369 Overhead 
absorption.....25 
allocation.....24 
apportionment.....24 
relevant cost.....374 
variances.....141 
P 
Participative budgeting.....345 
Pay off tables.....499 
Perfect information.....505 Periodic budget.....261 Planning.....5 
Planning and operat ional variances.....198 
Predetermined absorption rates.....25 
Pricing 
decisions.....382 
strategies.....32 
Prime cost.....14 
Principal budget factor.....242 
Probability.....495 
Product-level activities.....69 Profit margin.....38 Profit–volume chart.....422, 429 
Purposes of budgeting.....238 
R 
Receipts and payments forecast.....240, 241, 247 Reconciling pr ofits.....29 
Regression analysis.....303 
limitations.....308 
Relevant cost.....366 
decision making.....376 
labour.....373 
materials.....371 
non-current assets.....374 
overheads.....374 
Responsibility accounting.....340

Index 
 I.3 
Risk.....495 
attitudes.....497 
Rolling budgets.....261 
S 
Sales 
mix and quantity variances.....192 
variances.....129 
Seasonal variation.....311 
Semi-variable cost.....13 
Sensitivity anal ysis.....433, 545 
budgeting.....250 
with risk.....517 
Shadow price.....477 
Simultaneous equations.....467 
Slack.....476 
Specific order costing.....88 
Standard 
costing.....126 
deviation.....512 
Sunk cost.....367 
Super variable costing.....94 
Surplus.....476 
T 
Target profit.....429 
Target return on 
capital.....36 
sales.....37 
Throughput accounting.....93 
criticisms.....100 decision making.....95 
performance m easures.....99 
profit reporting.....94 
Time series analysis.....310, 543 
Transaction driver.....64 Trend.....311 Types of standard.....127 
U 
Uncertainty.....495 Unit-level activities.....69 Utility theory.....498 
V 
Variable cost.....13 
Variance analysis.....125, 550 
activity based costing.....154 
fixed overheads.....144 
in service industries.....153 
interdepence of variances.....150 labour.....135, 140  
material.....135 
materials.....131 planning and o perational va riances.....198 
reporting.....152 sales.....129, 131 variable overheads.....141 
working backwards.....204  
Z 
Zero-based budgeting.....266

CIMA 
 
Subject P2 
 
Advanced  Management 
 
Study Text

P.2   
 
have been reproduced.  
Notice 
ISBN: 978-1-78740-197-6 

P.3 
Contents 
  Page 
Chapter 1 Activity-Based Costing and Activity-Based 
1 
Chapter 2 The Modern Business Environment 47 
Chapter 3 Costing Techniques 85 
Chapter 4 Data required for decision-making 117 
Chapter 5 The investment decision-making process 139 
Chapter 6 Investment appraisal – further aspects 193 
Chapter 7 The pricing decision 241 
Chapter 8 Responsibility Centres 283 
Chapter 9 Alternative measures of performance 329 
Chapter 10 Transfer pricing 367 
Chapter 11 The treatment of uncertainty and risk in decision making 411 
Chapter 12 Risk Management 489 
Index  I.1

P.7 
 
examined. 
 
exercises which give the opportunity to assess the understanding of these core areas.

P.8  
understanding exercises. 
 
difficult to under stand. When reviewing these areas, ca re should be taken. 
Planning 

P.10   
A fixed period of study set out at the start of a course with key milestones is important. This can be within a subject, for example ‘I will finish this topic by 30 June’, or for overall achievement, such as ‘I want to be qualified by the end of next year’. 
subject and another. For example, P2 Advanced management accounting  
builds on your knowledge of risks, costing and decision making from P1 Management accounting  and lays the foundations for all strategic level papers. 

P.12   
tutorial. 

P.16   
P2: Advanced Management Accounting 
Making medium-term decisions and managing costs and 
A Managing the costs of creating value 20% 
B Capital investment decision-making 35% 
C Managing and controlling the performance of 
organisational units 30% 
D Risk and control 15% 
  100%

P.17 
P2A: Managing the costs of creating value 
Cost management and transformation are priorities for organisations facing intense competition. This 
section examines how to use cost management, quality and process management, and value 
management to transform the cost structures and drivers to provide organisations with cost advantage. 
 
1. Apply cost 
cost transformation 
methodology to 
manage costs and 
improve 
profitability. Apply the following to manage 
costs and improve 
profitability: 
a. Activity based 
management (ABM) 
methodology 
b. Cost transformation 
techniques • Engendering a cost-
conscious culture 
• Logic of ABC as the 
foundation or managing 
costs 
• ABM to transform 
efficiency of repetitive 
overhead activities 
• ABM to analyse and 
improve customer 
improve channel 
performance One of the reasons for 
calculating costs is to enable 
organisations to manage and 
possibly transform their costs. 
ABM is a key technique that is 
used to achieve this objective 
because of its link to ABC. 
This revolves around the logic 
of ABC that links costs to 
resource consumption and 
levels of activity and is related 
to the business model 
framework. Customer and 
channel analysis have 
become very important in the 
digital world – particularly as 
customers shift from products 
and services to experience. 
How profitable are the 
segments and channels they 
use? 
2. Compare and 
contrast quality 
methodologies. Compare and contrast: 
a. Just-in-time (JIT) 
b. Quality management 
c. Kaizen 
d. Process re-engineering • Impact of JIT and quality 
management on 
efficiency, inventory and 
costs 
• Benefits of JIT and TQM 
• Kaizen, continuous 
improvement and cost of 
quality reporting 
• Elimination of non-value 
adding activities and the 
reduction of costs using 
process re-engineering Quality management is an 
important part of managing 
and transforming costs. What 
are the key methodologies? 
How do they affect the costs 
of products, services and the 
channels that are used to 
deliver them? 
3. Apply value 
improve value 
creation. Apply the following to manage 
costs and value creation: 
a. Target costing 
b. Value chain analysis 
c. Life cycle costing • Determination of target 
costs from target prices 
• Components of the value 
chain 
• Profitability along the 
value chain 
• Life cycle costing and its 
implication for market 
strategies Cost transformation must 
always be linked to the value 
that organisations create. This 
part provides the link between 
costs and value.

P.18   
P2B: Capital investment decision-making 
Organisations have to allocate resources and key strategic initiatives to ensure that their strategies are 
properly implemented. Capital investment decision-making is the primary means by which such resources 
are allocated between competing needs. This section covers the criteria, process and techniques that are used to decide which projects to undertake. Of particular interest is the financial appraisal of digital 
transformation projects. 
 
1. Apply the data 
required for 
decision-making. Apply the following for 
decision-making: 
a. Relevant cash flows 
b. Non-financial information • Incremental cash flows 
• Tax, inflation and other 
factors 
• Perpetuities 
• Qualitative issues 
• Sources and integrity of 
data 
• Role of business 
intelligence systems The quality of decisions 
depends on the quality and 
type of data that is available 
to decision-makers. What 
type of data do decision-
makers need for medium-term 
decisions? Where do they get 
this data? In a digital world 
this would come from data 
lakes through to data 
warehouses and business 
intelligence systems. 
2. Explain the steps 
and pertinent 
issues in the 
decision-making 
process. Explain: 
a. Investment decision-
making process 
b. Discounting 
c. Capital investments as 
real options • Origination of proposals, 
creation of capital 
budgets, go/no go 
decisions 
• Time value of money 
• Comparing annuities 
• Profitability index for 
capital rationing 
• Decision to make follow-
on investment, abandon or 
wait (capex as real 
options) What are the steps in the 
investment decision-making 
process for simple as well as 
complex decisions? What key 
concepts underpin the 
techniques that are used? 
What are the criteria for 
accepting projects? How is 
uncertainty dealt with? 
3. Apply investment 
appraisal 
evaluate different 
projects. Apply the following to 
evaluate projects: 
a. Payback 
b. Accounting rate of return 
c. IRR 
d. NPV • Process and calculation 
• Strengths and 
weaknesses 
• Appropriate usage 
• Use in prioritisation of 
mutually exclusive projects This part covers a straight 
forward application of the 
techniques used to appraise 
projects. These should be 
extended to deal with the 
evaluation of digital 
transformation projects that 
do not have the same profile 
as other capital projects. 
4. Discuss pricing 
a. Pricing decisions 
b. Pricing strategies • Pricing decisions for 
maximising profit in 
imperfect markets 
• Types of pricing strategies 
• Financial consequences of 
pricing strategies What pricing strategies are 
open to organisations 
operating in imperfect 
markets? How do these affect 
the capital investment 
decision process?

P.19 
P2C: Managing and controlling the performance of organisational 
units 
The structure and strategies of organisations should align with each other to ensure effective strategy 
implementation. Responsibility centres are the organisational units that are allocated resources and 
charged with implementing organisational strategy. This section shows how to manage the performance of these organisational units to ensure that they achieve the strategic and other organisational objectives. Key concepts, techniques and issues are explored and examined. 
 
centres and 
prepare reports. a. Analyse performance of 
cost centres, revenue 
centres, profit centres, and 
investment centres. 
b. Prepare reports for 
decision-making. • Objectives of each 
responsibility centre 
uncontrollable costs and 
revenue 
• Costs variability, 
attributable costs and 
revenue and identification 
of appropriate measures 
of performance 
• Use of data analytics in 
of responsibility centres What are responsibility 
centres and how should they 
be matched to the strategy of 
organisations? What are the 
KPIs of each type of 
responsibility centre? How is 
their performance evaluated 
and why? What types of 
reports are prepared for 
managers? How do they use  
analytics, visualisation and 
self-service technologies to 
enhance the performance 
management of responsibility 
centres? 
2. Discuss various 
approaches to the 
performance and 
control of 
organisations. a. Discuss budgets and 
performance evaluation. 
b. Discuss other approaches 
to performance evaluation. • Key performance 
indicators (e.g., 
profitability, liquidity, asset 
turnover, return on 
investment and economic 
value) 
• Benchmarking (internal 
and external) 
• Non-financial performance 
indicators 
• Balanced scorecard How are budgets used to 
evaluate the performance of 
responsibility centres? What 
is best practice in this area? 
How are other methodologies 
like the balanced scorecard 
useful in managing 
behavioural and 
transfer pricing 
issues related to 
the management of 
centres. Explain: 
a. Behavioural issues 
b. Use and ethics of transfer 
pricing • Internal competition 
• Internal trading 
• Transfer pricing for 
intermediate goods where 
markets exist and where 
no markets exist 
• Types of transfer prices 
and when to use them 
• Effect of transfer pricing 
on autonomy, and 
motivation of managers of 
on responsibility centre 
and group profitability What are the behavioural 
issues in responsibility centre 
performance management – 
in particular as they affect 
controllable and non-
controllable costs and 
revenue? How should they be 
managed so that 
responsibility centres work 
effectively with each other to 
maximise performance of the 
whole organisation rather 
than each responsibility 
centre? What role can 
transfer pricing play in this 
area?

P.20   
P2D: Risk and control 
Risk is inherent in the operations of all organisations. This section analyses risks and uncertainties that 
organisations face in the medium term. The risks are mainly operational in nature. 
 
1. Analyse risk and 
uncertainty 
associated with 
medium-term 
decision-making. Conduct 
a. Sensitivity analysis 
b. Analysis of risk • Quantification of risk  
• Use of probabilistic 
models to interpret 
distribution of project 
outcomes  
• Stress-testing of projects 
• Decision trees  
• Decision-making under 
uncertainty  What risks do organisations 
face in relation to capital 
and the implementation of 
those decisions? How are 
those risks incorporated in the 
decision-making process and 
managed in the 
implementation of the 
decisions? 
2. Analyse types of 
risk in the medium 
term. a. Analyse types of risk 
b. Manage risk • Upside and downside 
risks  
• TARA framework – 
transfer, avoid, reduce, 
accept 
• Business risks  
• Use of information 
systems and data in 
managing risks

1 
Activity-Based Costing 
and Activity-Based 
A1: Managing the costs of 
creating value Apply cost management and 
cost transformation methodology to manage costs and improve profitability 
(a) Activity Based 
Management (ABM) 
(b) Cost transformation 
techniques 
 
  Chapter 
1

Activity-Based Costing and Activity-Based Management 
2 
1 Chapter summary  
 
2  Knowledge brought forward 
You will already have covered Activity-Based-Costing in previous CIMA papers. 
It is an important technique. In this chapter, we will explore ABC approaches such as Activity-Based Management, Direct Product Profitability, Direct 
Customer Profitability and Distrib ution Channel Profitability. 
3 The importance of understanding costs 
The understanding of costs is fundamental to your accounting studies. 
In financial accounting all costs must be recorded so that profit can be 
calculated and the true and fair value of assets can be presented in the financial statements. 
carry out the three main functions of planning, control and decision making. If we understand and calculate costs, we can use this information in a number of ways such as: 
• Determining the cost to manufacture a product or provide a service can be 
used to record costs in the financial statements as well as to inform 
decisions on our products or services.  
• The cost per unit can be used to value inventory in the statement of 
financial position (balance sheet). 
• Product and service costs can be used to determine the selling price we 
should charge for our products or services. For example, if the cost per unit is $0.30, the business may decide to price the product at $0.50 per unit in order to make the required profit of $0.20 per unit. 
• Knowing the profit (or, as we will see in a later chapter, the contribution of 
a product) can help determine the products and services we should supply and in what quantity. 
• The cost can also act as a benchmark for future performance. Differences 
from the expected (or standard) cost can be calculated (known as variances) and evaluated.

Chapter 1 
 3 
The CGMA Cost transformation model 
The CGMA cost transformation model is designed to help businesses to 
achieve and maintain cost competitiveness: 
 
The model has 6 suggested changes for organisations that come together to achieve this objective. These changes are: 
• Engendering a cost conscious culture – the organisation should aim to be 
a cost leader so that its costs are lower than rivals and set a competitive 
benchmark. Everyone in the organisation should be motivated and enabled to reduce costs in whatever way possible. Technology can play a key role in reducing costs. 
• Managing the risks that come from a cost conscious culture – for example, 
reducing cost may result in reducing quality and customer satisfaction. The organisation should have a clear risk management process in place to identify, assess and manage such risks.

4 
• Connecting products with profitability – it will be important that every 
product or service makes a positive contribution to overall organisational 
profits. This will involve understanding what drives costs for each individual product and allocating shared costs to products as accurately as possible. 
• Generating maximum value through new products – the potential 
profitability of new products should be  assessed before production begins. 
Also, as part of product design, the product or service should be made to be as flexible as possible so that it appeals or can adapt to as many customer segments as possible. 
• Incorporating sustainability to optimise profits: Consider the environmental 
impact of products – negative impacts (such as creating unnecessary waste) can add costs as well as damaging reputation and sales. 
• Understanding cost drivers – this involves investigating costs to determine 
why they change and how different variables impact on the cost. Plans should be put in place to reduce the drivers of costs as well as the costs themselves. 
The model suggests a number of tools and models which can be used in order to achieve these changes. Many of these tools will be employed across your CIMA studies, some of them in this paper, such as Activity Based Costing which considers cost drivers and how these can be used to allocate shared costs to products. 
4  Activity-Based Costing: Basics revisited 
In traditional absorption costing, overheads are charged to products using a predetermined overhead recovery rate. This overhead absorption rate (OAR) is based upon the volume of activity. A full unit cost is computed in order to satisfy financial accounting requirements. 
However, it is always stressed that full product costs, using financial accounting 
principles, are not suitable for decision-making purposes. Instead, decisions should be based on a decision-relevant approach incorporating relevant/incremental cash flows. 
With this approach, decisions such as introducing new products and special 
pricing decisions should be based on a study of only those incremental revenues and expenses that will vary with  respect to the particular decision. 
This approach requires that special studies be undertaken when the need arises. However, studies have shown that the majority of companies base their decision making upon full product cost. 
In the late 1980s Cooper and Kaplan developed a more refined approach for 
assigning overheads to products and computing product cost. This new approach is called activity based costing (ABC). It is claimed that ABC provides product-cost information that is useful for decision-making purposes.

Chapter 1 
 5 
Activity-Based Costing is 'an approach to the costing and monitoring of 
activities which involves tracing resource consumption and costing final 
outputs. Resources are assigned to activities, and activities to cost objects based on consumption estimates. The latter utilise cost drivers to attach activity costs to outputs'. 
 
Traditional systems accurately measure volume-related resources that are consumed in proportion to the number of units produced of the individual products. Such resources include direct labour, materials, energy and machine-
related costs. 
However, many organisational resources exist for activities that are unrelated to 
physical volume. Non-volume related activities consist of support activities e.g.: 
• materials handling • material procurement 
• set-ups 
• production scheduling • first-item inspection activities. 
Traditional product-cost systems, which assume that products consume all 
activities in proportion to their production volumes, thus report distorted product costs. 
5  The ABC procedure 
Cooper and Kaplan stated that it was the support activities that were the cause of many overheads: material handling, quality inspection, setting up machinery, material acquisition, etc. Thus a simple three-step philosophy was developed: 
• support activities cause cost • the products consume these activities 
• cost should, therefore, be charged on the basis of consumption of the 
activities.

Chapter 1 
 7 
 Example 1: Manufacturing Business 
 A manufacturing business makes a product in two models, model M1 and 
Annual sales 8,000 units 8,000 units 
Number of sales orders 60 250 Sales price per unit $54 $73 Direct material cost per unit $11 $21 Direct labour hours per unit 2.0 hours 2.5 hours Direct labour rate per hour $8 $8 
Special parts per unit 2 8 
Production batch size 2,000 units 100 units Setups per batch 1 3 
 
 $ Cost driver 
Setup costs 97,600 Number of setups Material handling costs 42,000 Number of batches Special part handling costs 50,000 Number of special parts Invoicing 31,000 Number of sales orders Other overheads 108,000 
––––––– Direct labour hours 
Total overheads 328,600 
–––––––  
A customer has indicated an interest in placing an order for either model 
M1 or M2, and the sales manager wished to try to sell the higher-priced model M2. 
Required: 
(b) Using the information above identify which product the sales 
by your ABC analysis.

8 
 Favourable conditions for ABC  
 The purpose of moving from a traditional costing system to an activity-
based system should be based on the premise that the new information 
provided will lead to action that will in crease the overall profitability of the 
business. 
This is most likely to occur when the analysis provided under the ABC 
system differs significantly from that which was provided under the traditional system, which is most likely to occur under the following conditions: 
• when production overheads are high relative to direct costs, 
particularly direct labour 
• where there is great diversity in the product range • where there is considerable diversity of overhead resource input to 
products 
• when consumption of overhead resources is not driven primarily by 
volume. 
6  The activity-based cost hierarchy 
Cooper and Kaplan (1991) propose a cost hierarchy framework that maintains 
that costs are driven by, and are variable with respect to, activities that occur at four levels: 
 
Unit-level activities  are performed each time a unit of product is produced. 
They are consumed in direct proportion to the number of units produced. Expenses in this category include: 
• direct labour 
• direct materials 
• energy costs 
• machine maintenance. 
Batch-related activities  are performed each time a batch is produced. The 
cost of batch-related activities varies with the number of batches made, but is 
common (or fixed) for all the units within the batch.

Chapter 1 
 9 
For example, set-up resources are consumed when a machine is changed from 
one product to another. As more batches are produced, more set-up resources are consumed. It costs the same to set-up a machine for a run of 10 or 5,000 units. 
Similarly, purchasing resources are consumed each time a purchasing order is 
processed, but the resources consumed are independent of the number of units included in the purchase order. 
Product-sustaining activities are performed to support different products in 
the product line. They are performed to enable different products to be produced and sold, but the resources consumed are independent of how many units or batches are being produced. 
Cooper and Kaplan (1991) identify engineering resources devoted to 
maintaining accurate bills of materials and routing each product as an example 
of product-sustaining activities. Product design costs and advertising costs of the specific product would also be counted as product-sustaining costs. The expenses of product-su staining activities will tend to increase as the number of 
products manufactured increases. 
Facility-sustaining activities.  Some costs cannot be related to a particular 
product line, instead they are related to maintaining buildings and the facilities. 
• maintenance of the building 
• plant security 
• business rates. 
7  ABC: Benefits and limitations  
Benefits 
1 Provides more accurate product-line costings particularly where non-
volume-related overheads are significant and a diverse product line is 
manufactured. 
2 Is flexible enough to analyse costs by cost objects other than products 
such as processes, areas of managerial responsibility and customers. 
3 Provides a reliable indication of long-run variable product cost which is 
particularly relevant to managerial decision making at a strategic level. 
4 Provides meaningful financial (periodic cost driver rates) and nonfinancial 
(periodic cost driver volumes) measures which are relevant for cost management and performance assessment at an operational level. 
5 Aids identification and understanding of cost behaviour and thus has the 
potential to improve cost estimation. 
6 Provides a more logical, acceptable and comprehensible basis for costing 
work.

10 
1 Little evidence to date that ABC improves corporate profitability. 
2 ABC information is historical and in ternally orientated and therefore lacks 
direct relevance for future strategic decisions. 
3 Practical problems such as cost driver selection. 4 Its novelty is questionable. It may be viewed as simply a rigorous 
application of conventional costing procedures. 
8  ABC and decision making 
Activity-Based Costing has a role in longer-term decision-making. ABC systems are primarily designed to furnish management with cost 
information relating to an organisation's products. 
However, the production of this information is not an end in itself. Indeed it is 
the use to which such activity-based information is put that represents its real purpose, and its value should be assessed against this end-result. 
An ABC system produces historical information relating to its products or 
service provision, which is of much assistance to management in analysing and explaining an organisation's profitability. However, many commentators including Robert Kaplan and Robin Cooper have viewed ABC as supporting major areas of strategic decision making with organisations, these being: 
 
When ABC information is used in the above ways, then it will underpin policy 
decisions of senior management, and will therefore have a significant influence upon the longer term prosperity of an organisation. 
Advocates of the use of ABC for strate gic decision making maintain that its 
values lies in greater accuracy attaching to product costing , which in turn 
increases the degree of reliability of cost information  used for the above 
purposes.

Chapter 1 
 11 
They further maintain that the use of ABC may give an indication for the long-
term variable cost of products , which arguably is the most relevant cost 
information for use in decisions of the above type. Given the inherent 
uncertainty involved in strategic decision making, management may use ABC information in decision-modelling and sensitiv ity analysis to assist in the making 
of such decisions. 
The end product of an ABC system is an estimate of the historical cost of each 
of an organisation's products. However, strategic decision making involves future time periods and thus it is future outlay costs that need to be taken into consideration, as opposed to historical costs. 
Therefore, it is arguable that the results obtained from an ABC system should 
be aimed at assisting in the making of longer-term decisions. This is especially the case if ABC based product costs are viewed as estimates of longer term product costs as 'nothing is forever' and historical costs are susceptible to substantial change, since all factors of production become variable in the longer term. 
Any cost information which has been produced based on past activities must be 
used with caution with regard to longer term decisions. Even so, ABC information may provide a sound starting point for the preparation of cost information to be used in strategic decision making. It has been argued that a significant advantage of ABC over conventional costing systems lies in its suitability for strategic decision making. Kaplan has argued that for decisions of a strategic nature, a long-term perspective is usual and maintains that an ABC system gives product cost information which matches this requirement particularly well. 
This is evidenced by his assertion that 'conventional notions of fixed and 
variable costs are ignored becau se, for the purpose of product cost 
analysis, the time period is long enough to warrant treatment of virtually 
all costs as variable.' 
 
Implementing ABC: Do’s and Don’ts (From the ‘CGMA Cost 
Transformation model’)  
 Actions to take/Do’s  
• Get buy-in from the rest of the business. ABC provides business 
managers, as well as the finance function, with the information 
needed to make value-based decisions. 
• Use ABC for pricing and product prioritisation decisions. 
• ABC should be implemented by management accountants as they 
are best placed to manage the process and to ensure benefits of its 
realisation.

12 
 Actions to avoid/Don’ts 
• Do not get caught up in too much attention to detail and control. It 
can obscure the bigger picture or make the firm lose sight of 
strategic objectives in a quest for small savings. 
• It is important not to fall into the trap of thinking ABC costs are 
relevant for all decisions. Not all costs will disappear if a product is discontinued, an example being building occupancy costs.  
9  Activity-Based Management 
One of the reasons for calculating costs is to enable organisations to manage and possibly transform their costs. Activity-Based Management (ABM) is a key technique that is used to achieve this objective, because of its link to ABC. 
ABM is a ‘ System of management which uses activity-based cost 
information for a variety of purposes including cost reduction, cost 
modelling and customer profitability analysis.’ 
ABM is simply using the information derived from an ABC analysis for cost management. ABM seeks to classify each activity within a process as a value-added or non-value-added activity: 
Non-value-added activities are unnecessary and represent waste. The aim 
should be to eliminate them. For example, time spent dealing with customer complaints is wasted time, but cannot be reduced until the customers have nothing to complain about! 
ABM focuses on activities within a process, decision making and planning 
relative to those activities and the need for continuous improvement of all organisational activity. Management and staff must determine which activities are critical to success and decide how these are to be clearly defined across all functions. 
Everyone must co-operate in defining: 
• cost pools • cost drivers 
• key performance indicators. 
They must be trained and empowered to act; all must be fairly treated and 
success recognised.

Chapter 1 
 13 
10  Outputs from the ABM Information System 
Organisations that are designing and implementing ABM  will find there are five 
basic information outputs: 
 
1 The cost of activities and business processes . Since activities form the 
very core of what a business does, the basic output of the ABM system 
must be to provide relevant cost information about what a business does. Instead of reporting what money is spent for and by whom, costs are assigned to activities. 
2 The cost of non value-added activities . Identification of these wasteful 
activities is invaluable to management as it provides a crucial focal point for management. 
3 Activity based performance measures.  Knowing the total cost of an 
activity is insufficient to measure activity performance. Activity measures of quality, cycle time, productivity and customer service may also be required to judge performance. Measuring the performance of activities provides a scorecard to report how well improvement efforts are working and is an integral part of continuous improvement. 
4 Accurate product/service cost.  Products and services are provided to 
markets and customers through various distribution channels or contractual relationships. Becaus e products and services consume 
resources at different rates and require different levels of support, costs must be accurately determined. 
5 Cost drivers.  The final output from the ABM system is cost driver 
information. With this information it is possible to understand and manage these activity levels. 
• whether to continue with a particular activity 
• how cost structures measure up to those of competitors • how changes in activities and components affect the suppliers and 
value chain.

14 
Clearly ABM and employee empowerment takes a critical step forward beyond 
ABC by recognising the contribution that people make as the key resource in any organisation’s success. 
• It nurtures good communication and team work. • It develops quality decision making. 
• It leads to quality control and continuous improvement. 
ABM will not reduce costs, it will only hel p the manager understand costs better. 
Strategic activity management recognises that individual activities are part of a 
wider process. Activities are grouped to form a total process or service. 
For example, serving a particular customer involves a number of discrete 
activities that form the total service. St rategic activity management attempts to 
classify each activity within the whole as a value-added or non-value added activity. Non-value-added activities are unnecessary and should be eliminated. 
Bellis-Jones (1992) noted that typically prior to the introduction of ABM, 35% of 
staff time was spent on diversionary (non-value-added) activities. After the 
introduction of ABM, total staff time declined and the percentage of time spent 
on diversionary activities fell to 20% of the reduced time. 
Non-value-added activities are often caused by inadequacies within the existing 
processes and cannot be eliminated unless the inadequacy is addressed. 
For example, dealing with customer complaints is a diversionary activity, but it 
cannot be eliminated unless the source of the complaints is eliminated. Another example is machine set-up time. Better product design so that fewer components or more standard components are used will reduce the set-up time between component runs. So management must concentrate on eliminating non-value-added activities. 
But strategic activity management is more than just eliminating non-value added 
activities, important though this is. 
By identifying the cost and value drivers for each activity, the firm can develop 
both the activities and the linkages between them, and so better differentiate the firm from its competitors. In addition, by understanding the factors which influence the costs of each activity, the firm can take action to minimize those costs in the medium term. 
ABC information can be used in an ABM system to assist strategic decisions, 
such as: 
1 Whether to continue with a particular activity. 2 The effect on cost structure of a change in strategy, e.g. from mass 
production to smaller production runs. 
3 How changes in activities and components affect the suppliers and the 
value chain. 
The value chain is simply a large activity map for the organisation and its 
position in the industry chain. It is covered in a later chapter of this Text.

Chapter 1 
 15 
11  Problems with implementing ABC/ABM 
Research has focused on the problems of implementing the ABC system. 
Friedman and Lyne (1999) provide some clues as to why ABC has not been taken up with more enthusiasm from case study research they carried out. Some reasons they draw attention to are: 
1 Where it was devised for a single project that was not taken up the system 
got dropped as well. As communication between business units in a large 
organisation is often not very good, the work was not developed further by other units. 
2 Finance department opposed its implementation. Often finance staff 
appear less than dynamic and unable to perceive the needs of the production staff. 
3 General ledger information too poor to provide reliable ABC information. 
The resulting figures would have been no better than traditional absorption methods. 
Of course, if organisations do not have reliable ABC information then they also forgo the cost management advantages of an ABM system. Since ABC 
provides the basic building blocks of ac tivities, without ABC  there can be no 
ABM. 
 
Illustration – ABC and ABM 
 Tool of the trade (extract) 
Financial Management; London; Nov 2001; Stephanie Gourdie; 
A company in New Zealand is one of the few to have implemented 
activity-based management successfully but it needed careful planning and a radical rethink of company culture. 
Since professors Robert Cooper and Robert Kaplan codified and 
developed activity-based costing, many organisations have implemented it, but few are using it for cost management. The original emphasis of ABC was on developing more accurate product costs. It was based on the principle that resource-consuming activities caused costs, not volume of products, as assumed by traditional cost-allocation methods. Overhead costs were allocated and traced back to activities that consumed resources, such as purchasing, set-ups and material handling. 
A cost driver was then selected for each activity centre. The choice of 
driver was based on two things: it had to measure the resources a 
product used for a particular set of activities; and it had to be linked to the 
changes of costs in the activity centre (cause-effect relationship).

16 
 Cost drivers can include the number of purchase orders, material 
movements or setup hours. The overhead rate for each activity was 
worked out by dividing the activity cost by the capacity of the cost driver. The costs of products were determined by multiplying the number of the cost driver of the activity used by the product, by the overhead rate for that activity, for all activities used by that product. 
ABC systems could then be applied to cost management. This was 
labelled activity based management (ABM), defined by Don Hansen and Maryanne Mowen as "a system-wide, integrated approach that focuses management's attention on activities with the objective of improving customer value and the profit achieved by providing this value". 
The progression to ABM involved a shift in focus from the original ABC 
system – producing information on activity-based product costs to producing information to improve management of processes. The idea is to analyse the activities that make up a company's processes and the cost drivers of those activities, then question why the activities are being carried out and how well they are being performed. ABM provides the activity information and the costs of inefficient activities, and quantifies the benefits of continuous improvements. 
Companies can then improve operations by re-engineering (complete 
redesign of processes), redesigning plant layouts, using common parts, outsourcing or strengthening supplier and customer relationships and developing alternative product designs. 
[…] 
TIPS FOR ABM 
• Get the support of senior management 
• Recognise that ABM requires a major investment in time and 
resources 
• Know what ABM can achieve and what information you want from 
the system 
• Decide which model to use 
• Choose the model approach that emphasises the operational 
understanding of all activities in the business 
• Involve people in the field • Transfer ownership of cost management from the accounts 
department to the departments and processes where costs are 
incurred 
• Don't underestimate the need to manage the change process 
• Link ABM to corporate objectives in the form of increased product 
profitability and added value for customers.

Chapter 1 
 17 
12  Direct Product Profitability (DPP) 
As traditional absorption costing, which normally uses labour hours as a basis 
for absorption, is rarely suitable for service and retail organisations other methods had to be devised. One relatively new way of spreading overheads in retail organisations, which is used in the grocery trade in particular, is direct product profitability (DPP). 
Direct Product Profitability is 'used primarily within the retail sector...DPP 
involves the attribution of both the purchase price and other indirect 
costs (for example distribution, wa rehousing and retailing) to each 
product line. Thus a net profit, as oppo sed to a gross profit, can be 
identified for each product. The cost attribution process utilises a variety 
of measures (for example warehousi ng space and transport time) to 
reflect the resource consumpt ion of individual products'. 
DPP started in the USA in the 1960s at General Electric, and was then taken up and used by Proctor and Gamble in the 1980s. In 1985 the Food Marketing Institute in the USA laid down a standard approach to the system and two years 
later DPP was taken up by the Institute of Grocery Distribution in the UK. The 
system described below was introduced in the late 1980s and has since undergone transformation as activity-based costing has developed. 
Retail organisations traditionally deducted the bought-in cost of the good from 
the selling price to give a gross margin. The gross margin is a useless measure for controlling the costs of the organisation itself or making decisions about the profitability of the different products. This is because none of the costs generated by the retail organisation itself are included in its calculation. For example, it does not include the storage costs of the different goods and these costs vary considerably from one good to another. A method was needed which related the indirect costs to the goods according to the way the goods used or created these costs. 
The table below shows the DPP for Product A. Directly-attributable costs have 
been grouped into three categories and are deducted from the gross margin to determine the product’s DPP. 
Direct product profit for Product A 
 $ $ 
Selling price  1.50 Less: bought-in price  (0.80)   ––––   Gross margin  0.70 Less: Direct product costs:   Warehouse costs 0.16  Transport costs 0.18  Store costs 0.22    (0.56)   ––––   Direct product profit  0.14

18 
Warehouse and store costs will include items such as labour, space and 
insurance costs, while transport costs will include labour, fuel and vehicle 
maintenance costs. The usual way to spread these costs across the different goods sold is in relation to volume or area occupied, as most costs increase in direct proportion to the volume of the product or the space it occupies. 
However, there are some exceptions to this; for example, insurance costs may 
be better spread on value or on a risk index. Risk is greater with refrigerated or perishable goods. Refrigeration costs must only be related to those products that need to be stored in the refrigerator. Handling costs can also be treated in a different manner as they tend to vary with the number of pallets handled rather than the volume of the good itself. The labour involved in shelf-stacking may also need to be spread on a different basis. 
The benefits of DPP may be summarised as: 
• Better cost analysis 
• Better pricing decisions 
• Better management of store and warehouse space 
• The rationalisation of product ranges 
• Better merchandising decisions. 
 
Example 2: DPP 
 A supermarket wholesaler sells over 40,000 product lines to retailers who 
visit the store. It has 45,000 m3 of general storage including 100 m3 of 
cold storage. General overheads are $90,000 and additional cold storage costs are $5,000. Two of the products sold are single frozen desserts (FD) and trays of 48 cans of soft drink (SD). Only frozen desserts are kept in cooled storage. 
The wholesaler pays $0.4 for a FD, which is 0.03 m3 and sells for $4. 
The trays of SD are 0.3 m3 and are bought for $5 and sold for $30. 
Calculated to two decimal places, the net profit per FD is: 
$  
and per crate of SD is  
$

Chapter 1 
 19 
 More On DPP  
 In recent years DPP has developed considerably in parallel with activity-
based costing. DPP has become much more sophisticated and is now 
very similar to activity-based costing. One of the reasons for its development during the 1990s has been the development of EPOS and EFTPOS (electronic point of sale and electronic funds transfer point of sale) systems that have enabled access to the detailed data needed for direct product cost and profitability calculations. 
Indirect costs may be analysed into basic cost categories as follows. 
These are very similar to those discussed later for activity-based costing. 
• Overhead cost. This is incurred through an activity that is not 
directly linked to a particular product. 
• Volume-related cost. Products incur this cost in relation to the space 
they occupy. This is the cost described previously and includes 
storage and transport costs. 
• Product batch cost. This is often a time-based cost. If product items 
(i.e. a number of identical products which are handled together as a 
batch) are stacked on shelves, a labour time cost is incurred. If shipping documents have to be prepared for an order or batch, this again is a labour time cost. 
• Inventory financing costs. This is the cost of tying up money in 
inventory and is the cost of the product multiplied by the company’s cost of capital per day or per week. 
• Each of the categories above w ill contain a number of individual 
activities, such as: 
1 Checking incoming goods 2 Repacking or packing out for storing 3 Inspecting products 4 Refilling store shelf. 
DPP software systems can be purchased to model costs. They require a 
number of key variables to analyse different situations. The variables are: 
(a) Buying and selling prices.  The retailer has the option to adjust the 
selling price. A price increase from a supplier can always be used to 
increase the gross margin, but the higher the selling price relative to other retailers the slower inventory movement is likely to be. 
(b) Rate of sale.  This is critical and needs to be as fast as possible in 
order to minimise space costs at the warehouse and the store, and to avoid loss of interest on money tied up in inventory.

20 
 (c) Inventory-holding size.  The aim is to hold as little inventory as 
possible in keeping with JIT principles without running out of 
inventory. 
(d) Product size.  This is the cubic area that the product occupies and 
is important because space costs per item will be incurred according to size. 
(e) Pallet configuration.  The larger the number of cases on the pallet 
the cheaper handling costs per unit will be. 
(f) Ordering costs.  Obviously fewer orders will be cheaper but fewer 
orders will mean holding more inventory. 
(g) Distribution routes.  Are the goods transported direct to the store or 
is a central warehouse used? Transporting goods direct to the store is a high cost activity for the supplier and it is usually better to use a central warehouse, even for goods with a short shelf life. 
13  Customer Profitability Analysis 
In many organisations, it is just as impo rtant to cost customers as it is to cost 
products. Different customers or groups of customers differ in their profitability. 
This is a relatively new technique that ABC makes possible because it creates cost pools for activities. Customers use some activities but not all, and different groups of customers have different ‘activity profiles’. 
Customer Profitability Analysis is 'the analysis of revenue streams and 
service costs associ ated with specific custom ers or customer groups'. 
Service organisations such as a bank or a hotel in particular need to cost 
customers. A bank’s activities for a customer will include the following types of activities: 
• Withdrawal of cash • Unauthorised overdraft 
• Request for a statement 
• Stopping a cheque 
• Returning a cheque because of insufficient funds. 
Different customers or categories of customers will each use different amounts 
of these activities and so customer profitability profiles can be built up, and 
customers can be charged according to the cost to serve them.

Chapter 1 
 21 
 Examples of CPA in a hotel 
 A hotel may have activities that are provided for specific types of 
customers, such as: 
• well-laid-out gardens 
• a swimming pool 
• a bar. 
Older guests may appreciate and use the garden, families the swimming 
pool and business guests the bar. 
If the activities are charged to the relevant guests a correct cost per bed 
occupied can be calculated for this type of category. This will show the relative profitability and lead to st rategies for encouraging the more 
profitable guests. 
14  Customer profitability curve 
Even a manufacturing organisation can benefit from costing its customers. Not all customers cost the same to serve even if they require the same products. Some customers may be located a long way from the factory and transport may cost more. Other customers may be disruptive and place rush orders that interrupt production scheduling and require immediate, special transport. Some customers need after sales service and help with technical matters, etc. 
When an organisa tion analyses the profitability of its customers it is not unusual 
to find that a Pareto curve exists. That is 20 per cent of customers provide 
80 per cent of the profit. This may be illustrated by a customer profitability 
curve . For example:

22 
The diagram above shows that the last 80% of customers do not all generate 
profit. The last 50% actually reduce the total profit. There is no point in serving these customers as the situation stands but it may be foolish just to refuse to serve them. Instead it may be better to turn them into profitable customers if this is possible. A multifunctional team should be set up to find ways of making these customers profitable. 
Usually it is the small volume/order customers who are unprofitable because of 
high production batch costs and order processing, etc. One organisation introduced a third party wholesaler into the supply chain and significantly reduced the cost of serving the small order customers. At the same time the organisation found that the product range and service to the small customers improved, and so the company saved costs and the customer received an improved service. 
 
Illustration – CPA  
 XY provides accountancy services and has three different categories of 
client: 
• limited companies • self-employed individuals 
• employed individuals requiring taxation advice. 
XY currently charges its clients a fee by adding a 20% mark-up to total 
costs. Currently, the costs are attributed to each client based on the hours spent on preparing accounts and providing advice. XY is considering changing to an activity based costing system. The annual costs and the causes of these costs have been analysed as follows: 
 
Accounts preparation and advice $580,000 
Requesting missing information $30,000 
Issuing fee payment reminders $15,000 
Holding client meetings $60,000 
Travelling to clients $40,000

Chapter 1 
 23 
 The following details relate to three of XY’s clients and to XY as a whole: 
 
 Client XY 
 A B C  
Hours spent on preparing 
accounts and providing advice  
1,000  
250  
340  
18,000 
Requests for missing information 4 10 6 250 
Payment reminders sent 2 8 10 400 
Client meetings held 4 1 2 250 
Miles travelled to clients 150 600 0 10,000 
Required: 
Prepare calculations to show the effect on fees charged to each of these 
three clients of changing to the new costing system. 
Solution 
Cost driver rates: 
Accounts preparation and advice  $580,000/18,000 hours = $32.222 
per hour  
Requesting missing information  $30,000/250 times = $120 per request
 
Issuing fee payment reminders $15,000/400 times = $37.50 per 
reminder 
Holding client meetings $60,000/250 meetings = $240 per 
meeting 
Travelling to clients $40,000/10,000 miles = $4 per 
mile

24 
 Client costs: 
 Client 
 A B C 
Accounts preparation and advice $32,222 $8,055 $10,955 
Requesting missing information $480 $1,200 $720 
Issuing fee payment reminders $75 $300 $375 
Holding client meetings $960 $240 $480 
Travelling to clients $600 
–––––– $2,400 
–––––– $0 
–––––– 
Total costs $34,337 $12,195 $12,530 
Total costs on original basis (*) $40,280 $10,070 $13,695 
Client fees – new basis (W1) $41,204 $14,634 $15,036 Client fees – original basis $48,336 $12,084 $16,434 
Increase/(Decrease) $(7,132) $2,550 $(1,398) 
(*) $725,000/18,000 hours = $40.28 per hour 
(W1) Client fees calculations, new basis  
Client A: Total costs $34,337 × (1 + 20% mark-up on costs) = 
$41,204 
Client B: Total costs $12,195 × (1 + 20% mark-up on costs) = 
$14,634 
Client C: Total costs $12,530 × (1 + 20% mark-up on costs) = 
$15,036 
15  Pareto analysis 
Pareto analysis is based on the 80:20 rule that was a phenomenon first observed by Vilfredo Pareto, a nineteenth century Italian economist. He noticed that 80 per cent of the wealth of Milan was owned by 20 per cent of its citizens:

Chapter 1 
 25 
This phenomenon, or some kind of approximation of it (70:30, etc.), can be 
observed in many different business situations. The management accountant can use it in a number of different circumstances to help direct management’s attention to the key control mechanisms or planning aspects. 
The Pareto phenomenon often shows itself  in relation to profitability. Often 
around 80 per cent of an organisation’s contribution is generated by 20 per cent 
of the revenue. A situation similar to this can be seen in the figure below, where the contributions of five products are plotted on a cumulative basis. Twenty per cent of the sales revenue generates 80 per cent of the contribution: 
 
It is not always advisable to delete products from the range if they are not very profitable or their price cannot be increased, without carrying out careful analysis. The poor performers may be new products establishing themselves in the market and they may have a profitable future. However, the products that generate the largest proportion of the contribution need to be looked after. One reason for their profitability may be a high degree of branding which increases the contribution margin per unit. The company must continue to spend money promoting the brand so as to keep it in front of the public. 
Pareto analysis has a number of different uses in business: 
• Instead of analysing products, customers can be analysed for their relative 
profitability to the organisa tion. Again, it is often found that approximately 
20 per cent of customers generate 80 per cent of the profit. There will 
always be some customers who are less profitable than others, just as 
some products are less profitable than others.

26 
• The key with customers is to make sure that the overall profile does not 
degenerate and the aim should be to improve the profile . This can be 
seen in the figure below, where the solid line represents the present 
position and the two dotted lines represent a change in performance for the better and worse. The 'better profile' dotted line shows improved performance in the sense that customers are contributing more evenly to the profit, thus stabilising the position of the organisation. With the ‘worse profile’, the loss of, say, two of the best customers might seriously jeopardise the organisation’s future: 
 
Another use for Pareto analysis is in inventory control where it may be found that only a few of the goods in inventory make up most of the value. A typical 
analysis of inventory may reveal the situation shown as follows: 
Product Value % of % of volume Action 
A High value 70% 10 Control carefully 
B Medium value 20% 20 Medium control 
C Little value 10% 70 No control 
The outcome of this type of analysis may be to increase control and safeguards 
on the 10 per cent of the inventory that is of a particularly high value and to remove or reduce the controls on the inventory that is of little value. Alternatively it may be found that a few items take up most of the storage space and therefore storage costs are unduly high for these items. It may be possible to move towards a just-in-time system for these items only, thus saving money and space. 
Another study might relate to activity-based costing and overheads. It may 
show that 20 per cent of an organisation’s cost drivers are responsible for 
80 per cent of the total cost. By analysing, monitoring and controlling those 
cost drivers that cause most cost, a better control and understanding of overheads will be obtained.

Chapter 1 
 27 
Procedure 
1 Rank the data in descending order. 2 Find each figure as a percentage of the total. 3 Turn this into a cumulative percentage. 4 It is possible to draw a diagram to illustrate the principle, e.g. a component 
bar chart or a cumulative frequency graph. 
 
Pareto analysis and charts 
 ABC Limited manufactures and sells seven products. The following data 
relates to the latest period: 
Product Contribution in $000 
P 96 
Q 36 
R 720 
S 240 
T 12 
U 60 
V 24 
––––– 
 1,188 
––––– 
To prepare a Pareto chart of product contribution and comment on the 
results, the first step is to rearrange the products in descending order of contribution and calculate the cumulative contribution: 
 
Product Contribution in $ Cumulative 
Contribution in 
% 
R 720 720 61 
S 240 960 81 
P 96 1,056 89 
U 60 1,116 94 
Q 36 1,152 97 
V 24 1,176 99 
T 12 
––––– 1,188 100 
 1,188 
–––––

28 
 The cumulative data can now be used to produce the required Pareto 
chart showing product contribution: 
 
The analysis shows that more than 80 per cent of the total contribution is 
earned by two products: R and S. The position of these products needs protecting, perhaps through careful attention to branding and promotion. The other products require investigation to see whether their contribution can be improved through increased prices, reduced costs or increased volumes. 
16  Distribution channel profitability 
Distribution channels are in simple terms the means of transacting with customers. The channel is the point of purchase. It is not necessarily the point of communication, payment, delivery and after sales support. Companies may transact with their customers through direct channels e.g. sales teams, telephone, shops, Internet, or through indirect channels e.g. retailers, wholesalers, resellers, agents. 
Regardless of whether a company’s channels are direct or indirect, they should 
always consider the ultimate needs of the customer and therefore use the channels to ensure that those needs are satisfied. Customers will look for ease of access to the supplier, reciprocal communication, products and services which satisfy their needs, prompt delivery, after sales support to name but a few. 
The channel a company selects is therefore a critical driver to business 
profitability. A company should not only ai m to satisfy the needs of the customer 
but must also ensure that the products and services that they are providing are profitable. The method of channel distribution chosen can account for a significant proportion of total cost and choosing the wrong channel can result in significant losses for that particular product or service.

Chapter 1 
 29 
 Example 3: Distribution channel profitability 
 Crale & Co manufactures replacement batteries for smartphones. The 
battery retails for $40 and costs $10 to make.  Crale & Co currently sells 
1 million batteries every year through its e-commerce website, and 1 million batteries a year via its network of retail distributors across the country.  
Overheads incurred to recruit and retain website administrators amount 
to $800,000 yearly, and other employee costs amount to $310,000 for the e-commerce channel.  
Via its retail distribution network, the company must also offer a $1.50 
discount per unit to distributors; also, the administrative cost of 
processing retail orders amounts to $620,000.  
Required: 
(a) Which of the two channels is more profitable for Crale & Co? Further analysis of Crale & Co’s financial data reveals that: 
• 2% of the batteries sold via the website go unpaid every year, 
due to payment fraud; 
• Packaging and distribution costs linked to the website 
operation have been calculated at $0.80 per battery.  
• Furthermore, 50% of the batteries ordered on the website 
qualify for free shipping due to web promotional vouchers. 
Batteries which qualify for this free shipping incur an additional cost of $1.20 per battery to process the vouchers and ship to customers (not including the $0.80 packaging and distribution costs mentioned above). 
• The cost of shipping inventory in bulk to distributors is $1 per 
unit. 
(b) In light of this further analysis, which of the two channels is now more profitable?  
Key aspects that the company needs to consider in relation to their distribution channels include; access to the customer base, brand awareness, competitiveness, achieving sales and market targets, speed of payment, customer retention rates and most importantly of all profitability.

30 
 Distribution Channel Profitab ility and digital techniques 
 The world of retailing has changed dramatically in the past decade. The 
advent of the online channel and new additional digital channels such as 
mobile channels and social media have changed retail business models, the execution of the retail mix, and shopper behaviour. 
Unilever  
Customer and channel information in Unilever is gathered in standardised 
‘People Data Centres’ (PDCs) to look at all their “people data”. People data come from traditional ‘Customer Relationship Management’ (CRM) systems, ‘social media harvesting’ (a  way to collect data from social 
media platforms unobtrusively and automatically), contact with customer service, any information from marketing initiatives or consumer research.  
Unilever wanted to create one IT structure and one focal point for the 
business, so everyone knows where the data sits and how to make use of it. The ‘People Data Centres’ (PDCs) are actual physical spaces. The social listening aspect is heavily fuelled by Twitter data. 
Employees (including cost accountants) can create their own specific 
queries and requirements to identify precise insights and ultimately control costs better. 
Ben & Jerry’s Ice Cream 
It has been observed that about 80% of all Ben and Jerry’s gets sold on a 
Saturday. Week after week, a constant sales spike is noted on Saturdays. However, it had also been observed that most of the conversations on social media happen on Thursdays and Fridays, not on Saturday. Now, for the ice cream category, this is rather intriguing, because ice-cream is typically a ‘point of purchase’ sale (the decision to purchase is made in the store, not before). That is the preconceived notion on which brands and advertising usually works. But Ben and Jerry’s appears to be a little different. People actually think about their Ben and Jerry’s purchase a couple of days ahead on a Thursday, which means consumers are open to digital influence on that day. Therefore, why run ads on a Monday or Tuesday, when probably 99% of impressions are wasted? But on Thursdays and Fridays, the value of impressions may go up 5% or 10%. That is a dramatic difference on the same level of advertising spend. 
Source: ‘Digital leadership’, Cap Gemini Consulting

Chapter 1 
 31 
Costing channels  
In companies, it is just as important to cost channels as it is to cost products 
and customers. Different channels will differ in profitability. 
Activity based costing information makes this possible, because it creates cost pools for activities. Channels will use some activities but not all, and different 
channels will have different ‘activity profiles’.  
This makes channel profitability analysis  possible, and allows companies to 
build up distribution channel ‘profitability profiles’. So, it becomes possible to 
identify costly distribution channels for low margin products or services supplied through direct channels, which should be supplied through indirect channels instead. This is a typical example of cost transformation: switching channels would result in reduced channel distri bution costs, and a better profitability 
profile for the product or service.

32 
17  Practice Questions 
 Objective Test Question 1: ABC vs. traditional costing 
 Company A manufactures three smartphones. Company A currently 
operates a traditional absorption costing system, but has decided to use 
an activity based costing (ABC) system on a trial basis for its procurement operation. A time-based cost driver is used to charge the procurement costs to the smartphones under the ABC system. The following unit manufacturing costs have been determined using both traditional absorption costing and activity based costing: 
 
 Traditional 
absorption 
tiActivity Based 
Costing 
Smartphone Type 1 $90 $108 
Smartphone Type 2 $102 $104 
Smartphone Type 3 $95 $85 
Place each of the following statements in a grey cell, against the product 
to which it is most likely to relate: 
 
Smartphone Type 1  
Smartphone Type 2  
Smartphone Type 3  
 
This smartphone uses 
a lot of parts and 
materials that are 
readily available. It 
does not require any 
special order: only 
one supplier is 
involved, who has 
been supplying 
Company A for years. 
All the components 
are readily available 
in the warehouse. 
Assembling the phone 
is very 
straightforward, and 
does not incur any 
specific costs. This smartphone has 
relatively few 
components that are 
generally purchased 
in bulk. However, the 
camera components 
require a special order 
to a supplier 
overseas. 
 This smartphone uses 
difficult to obtain, and 
so puts the buying 
department under 
pressure.

Chapter 1 
 33 
 Objective Test Question 2: Activity Based Management 
 An engineering company is thinking about implementing activity-based 
management principles. Which of the following is a correct definition of 
activity-based management? Select the ONE definition that applies. 
(i) ABM is an approach to the costing and monitoring of activities which 
involves tracing resources consumption and costing final outputs. 
Resources are assigned to activities and activities to cost objects based on consumption estimates. The latter utilise cost drivers to attach activities costs to outputs. 
(ii) ABM involves the identification and evaluation of the activity drivers 
used to trace the cost of activities to cost objects. It may also involve selecting activity drivers with potential to contribute to the cost management function, with particular reference to cost reduction. 
(iii) ABM is a method of budgeting based on an activity framework and 
utilising cost driver data in the budget setting and variance feedback 
(iv) ABM is a system of management which uses activity-based cost 
information for a variety of purposes including cost reduction, cost modelling and customer profitability analysis. 
(v) ABM is a grouping of all cost elements associated with an activity.
 
 Objective Test Question 3: Direct Product Profitability 
 AB plc is a supermarket group which incurs the following costs: 
(i) The bought-in price of the good 
(ii) Inventory financing costs (iii) Shelf refilling costs (iv) Costs of repacking or 'pack out' prior to storage before sale. AB plc's calculation of Direct Pr oduct Profitability would include: 
A  All of the above costs B  All of the above costs, except (ii) C  All of the above costs, except (iv) D  Costs (i) and (ii) only E  Cost (i) only

34 
 Data Set Question: Walken Supermarkets 
 Walken Supermarkets sells over 30,000 product lines. It wishes to 
introduce Direct Product Profitability analysis and a team of management 
accountants have ascertained the following information relating to the 
following year: 
Budgeted weekly overhead $ 
Warehouse costs 75,000 
Supermarket costs 40,000 per supermarket Transportation costs 400 per delivery 
The warehouse is expected to handle 10,000 cubic metres (m
3) of goods. 
Each supermarket will handle 5,000 m3 of goods each week.  
Each transportation vehicle holds 40 m3 of goods. 
Three products sold by Walken are Kitchen Roll (KR), Tinned Spaghetti 
(TS) and Toothpaste (T): 
 KR TS T 
Retail price per item $1.00 $0.60 $1.75 Bought-in price per item $0.60 $0.30 $1.00 
Number of items per case 10 25 40 
Number of cases per m
3 20 30 20 
Time in warehouse 1 week 2 weeks 3 weeks 
Time in supermarket 2 weeks 4 weeks 2 weeks 
Required: 
Calculate the following figures, in $, to four decimal places: 
  
The net profit per kitchen roll $  
   
The net profit per tin of spaghetti $  
   
The net profit per tube of toothpaste $

Chapter 1 
 35 
 Case Study Style question: Casamia 
 PRE-SEEN MATERIAL 
Casamia plc purchases a range of good quality gift and household 
products from around the world; it then sells these products through ‘mail order’ or retail outlets. The company receives ‘mail orders’ by post, telephone and Internet. Retail outlets are either department stores or Casamia plc’s own small shops. The company started to set up its own shops after a recession in the early 1990s and regards them as the flagship of its business; sales revenue has gradually built up over the last 10 years. There are now 50 department stores and 10 shops. 
The company has made good profits over the last few years but recently 
trading has been difficult. As a consequence, the management team has decided that a fundamental reappraisal of the business is now necessary if the company is to continue trading. 
Meanwhile, the budgeting process for the coming year is proceeding. 
Casamia uses an activity-based costing (ABC) system and the following estimated cost information for the coming year is available: 
Retail outlet costs: 
   Per Year 
Activity Cost 
driver Rate per 
cost driver Department 
store Own shop 
Telephone queries and 
request to Casamia  
Calls  
$15  
40 calls  
350 calls 
Sales visits to shops and stores by Casamia 
sales staff  
 
Visits   
$250   
2 visits   
4 visits 
Shop orders Orders $20 25 orders 150 orders 
Packaging Deliveries $100 28 deliveries 150 
deliveries 
Delivery to shops Deliveries $150 28 deliveries 150 
Staffing, rental and service costs for each of Casamia plc’s own shops 
cost on average $300,000 a year.

36 
 Mail order costs: 
  Rate per cost driver 
Activity Cost  driver Post Telephone Internet 
Processing 'mail orders' Orders $5 $6 $3 
Dealing with 'mail order' queries Orders $4 $4 $1 
     
  Number of packages per 
order 
Packaging and deliveries for 
'mail orders' – cost per package 
$10 Packages 2 2 1 
The total number of orders through the whole 'mail order' business for the 
coming year is expected to be 80,000. The maintenance of the internet link is estimated to cost $80,000 for the coming year. The following additional information for the coming year has been prepared: 
 
 Department 
store Own shop Post Telephone Internet 
Sales revenue per 
outlet $50,000 $1,000,000    
order    
$150  
$300  
$100 
Gross margin: mark-up on purchase costs  
30%  
40%  
40%  
40%  
40% 
Number of outlets 50 10    
Percentage of 'mail 
orders'    
30%  
60%  
10% 
Expected Head office and ware housing costs for the coming year: 
 
 $ 
Warehouse $2,750,000 
IT $550,000 
Administration $750,000 
Personnel $300,000 
––––––––– 
Total $4,350,000 
–––––––––

Chapter 1 
 37 
 Task: Report 
You receive the following email from the Financial Controller:

38 
Example and OT answers 
 Solution 
(a) 
 
 $  $ $ 
Setups 97,600 Cost per setup $400 1,600 96,000 Materials handling 42,000 Cost per batch $500 2,000 40,000 
Special parts 
handling 50,000 Cost per part $0.625 10,000 40,000 
Other overheads 108,000 
––––––– Cost per hour $3 48,000 
–––––– 60,000 
––––––– 
 328,600 
–––––––  67,600 
–––––– 261,000 
––––––– 
 
  M1 M2 
 $ $ $ $ 
Sales  432,000  584,000 
Direct materials 88,000  168,000  Direct labour 128,000  160,000  
Overheads 67,600 
––––––  261,000 
––––––  
Total costs  283,600 
––––––  589,000 
–––––– 
Profit/(loss)  148,400 
––––––  (5,000) 
–––––– 
Profit/loss per unit  18.55 
––––––  (0.625) 
–––––– 
(b)  The figures suggest that model M2 is less profitable than M1. The 
sales manager should try to persuade the customer to buy model 
M1. Note that the apparent loss on M2 does not necessarily mean that production should be ceased. To assess this management should consider the incremental relevant cash flows involved – e.g. is the product making positive contribution, how many overheads are avoidable? They could also consider ways to reduce the cost drivers for the product to reduce its share of the overheads and convert the product loss into a profit.

Chapter 1 
 39 
 Example 2: DPP 
 The cold storage was included in the space of general storage, and 
therefore the frozen desserts should be allocated a share of the general costs as well as the cold storage costs. 
General storage = $90,000/45,000 = $2 m3 Cold storage = $5,000/100 = $50 m3 Net profit of FD = $4 – $0.4 – 0.03 m3 × ($50 + $2) = $2.04  Net profit of SD = $30 – $5 – (0.3 m3 × $2) = $24.40
 
 (a) The website is without question the more profitable channel, offering 
an extra $1.01 in margin per battery. 
 
 Website (e-
commerce) Retail 
Retail price $40 $40 
Direct costs ($10) ($10) 
Contribution per unit $30 $30 
Unit sales 1,000,000 1,000,000 
Total contribution $30,000,000 $30,000,000 
Website administration overheads ($800,000)  
Other employee overheads ($310,000)  
Cost of discounts to distributors $1.50 
per battery   
($1,500,000) 
Admin cost of processing retail orders  ($620,000) 
Net profit $28,890,000 $27,880,000 
Net profit per unit $28.89 $27.88

40 
 (b) When all channel-related costs are taken into account, the retail 
distribution channel becomes more profitable than the e-commerce 
channel.  The management decisions that will be made as a result of this more thorough analysis will be far different. 
 
commerce) Retail distribution 
Total net profit as in (a) $28,890,000 $27,880,000 
Bad debts (Payment fraud) (W1) ($800,000)  
Cost of free shipping (W2) ($600,000)  
Packaging and distribution costs ($800,000)  
Cost of shipping inventory in bulk (W3)   
($1,000,000) 
Net profit $26,690,000 $26,880,000 
Net profit per unit $26.69 $26.88 
Workings: 
(W1) Payment fraud applies to 2% × 1,000,000 = 20,000 batteries   20,000 × $40 revenue per battery = total non-payment $800,000 (W2) Free shipping applies to 50% × 1,000,000 = 500,000 batteries   500,000 × $1.20 cost per battery = $600,000 (W3) Cost of shipping inventory in bulk applies to all batteries for retail  1,000,000 batteries × $1 per battery = $1,000,000 shipping cost.

Chapter 1 
 41 
  
Smartphone Type 1 This smartphone uses a lot of parts and 
materials that are difficult to obtain, and so 
puts the buying department under 
pressure. 
Smartphone Type 2 This smartphone has relatively few 
components that are generally purchased 
in bulk. However, the camera components 
require a special order to a supplier 
overseas. 
Smartphone Type 3 This smartphone uses a lot of parts and 
materials that are readily available. It does 
not require any special order: only one 
supplier is involved, who has been 
supplying Company A for years. All the 
components are readily available in the 
warehouse. Assembling the phone is very 
straightforward, and does not incur any 
specific costs. 
Smartphone 1 has a higher cost under ABC, which suggests a more 
complex item using specific parts and materials. 
Smartphone 2 has a marginally higher cost under ABC, which suggests 
the use of mostly readily available components. 
Smartphone 3 has a lower cost under ABC, which suggests a standard 
product using few, if any, specific or complex components. 
 
 The answer is (iv): ABM uses the information provided by an ABC analysis to improve org anisational profitability. 
Option (I) defines ABC. 
Option (ii) defines activity driver analysis.  Option (iii) defines activity based budgeting.  Option (v) defines an activity cost pool. 
 
 The answer is A: All of the costs described can be identified with specific 
goods and would be deducted from the selling price to determine the direct product profit.

42 
 Warehouse cost $75,000 ÷ 10,000 = $7.50 per m3 
Supermarket cost $40,000 ÷ 5,000 = $8.00 per m3 
Transportation cost $400 ÷ 40 = $10 per m3 
 KR $ TS $ T $ 
Retail price 1.00 0.60 1.75 
Less bought-in price (0.60) (0.30) (1.00) 
Gross margin 0.40 0.30 0.75 
Less overheads:    
Warehouse costs (see workings) 0.0375 0.02 0.0281 
Supermarket costs (see workings) 0.08 0.0427 0.02 
Transportation costs (see workings) 0.05 
––––––– 0.0133 
––––––– 0.0125 
––––––– 
Net profit  0.2325 
–––––––  0.2240 
–––––––  0.6894 
–––––––  
Workings: 
Number of 
items per m3 10 × 20 = 200 25 × 30 = 750 40 × 20 =800 
Warehouse charge: 
Kitchen roll ($7.50 ÷ 200) × 1 week = 0.0375  Tinned spaghetti ($7.50 ÷ 750) × 2 weeks = 0.02  Toothpaste ($7.50 ÷ 800) × 3 weeks = 0.028125 
Supermarket cost: 
Kitchen roll ($8.00 ÷ 200) × 2 weeks = 0.08 Tinned spaghetti ($8.00 ÷ 750) × 4 weeks = 0.0427  Toothpaste ($8.00 ÷ 800) × 2 weeks = 0.02 
Transportation costs: 
Kitchen roll $10 per m
3 (÷ 20 cases per m3) (÷ 10 items per case) = 0.05 
per item 
Tinned spaghetti $10 per m3 (÷ 30 cases per m3) (÷ 25 items per case) = 
0.0133 per item Toothpaste $10 per m
3 (÷ 20 cases per m3)(÷ 40 items per case) =0.0125 
per item

Chapter 1 
 43 
 Case Study Style Question: Casamia  
 REPORT 
To: Financial Controller 
From:  Management Accountant 
Date:  03 June 
Subject: Profitability of different types of sales outlets 
The aim of this report is to determine the expected profitability of the 
different types of sales outlets for the coming year. 
In summary, the calculations in the attached appendices (Appendix 'A' to 
'E') show the following: 
• Casamia's own shops will make a considerable ‘loss’. 
• The department store sales will not generate as good a profit as the 
‘mail order’ side. 
• The telephone mail order, that is 46% of the business, will generate 
104% of the current total profit. 
• The Internet business is not particularly profitable in the coming 
year, but it will presumably grow quite quickly. If this happens, the 
charge for maintaining the Internet, which is expressed by each order, will presumably decline as it is likely to be a semi-fixed cost. 
1 Usefulness of information 
The calculations show the profitability of the different types of outlet 
for the coming year only, which is of some use. For example, it shows that Casamia's own shops make a considerable loss and it would appear, on the surface, that the company would be better off without them, perhaps transferring the business to franchises within department stores. It also indicates that the emphasis of the business should be switched to the mail order side, as it is more profitable and, in particular, to the telephone section. 
2 The need for further information 
However, the latter shows how dangerous this kind of assumption 
can be because the telephone section may have peaked and, in future, growth in the Internet section may be at the expense of the telephone section. Therefore, decisions about future strategies cannot be made on predicted short-term costs and revenues. Any attempt to do so could prove disastrous. Growth in the market, competitors’ moves, customers’ needs and requirements must be the basis for any decisions.

44 
 The ABC costs could, however, be used to highlight areas for cost 
reduction and procedural changes which could assist longer-term profitability. ABC is a method for apportioning costs and it suffers from the same defects as every absorption method. In Casamia's case, the analysis does not look very detailed/accurate and so may be little better than a traditional absorption system. 
The head office and warehousing costs need to be examined in 
detail to determine which type of outlet incurs what part of the cost, as these costs may be caused and used more by some types of outlets than others. If this is so, what would happen to cost if one type of outlet was abandoned and others increased in size? 
3  Other information needed to ma ke a more informed judgement 
is likely to be: 
Customers’ changing purchasing habits Same customer purchases across outlet types, that is, do customers 
buy from shops and order by telephone. 
Competitors’ moves New entrants into the market – especially in the Internet business . Future economic conditions Exchange rate movements – as some goods are imported.  Increase in disposable income The image created by the different types of outlet, that is do their 
own shops create the brand or company name. 
Past data to establish trends. Then, specific information will need to be collected for the 
fundamental reappraisal of the business. For example, if the decision to close Casamia's own shops was being considered, a detailed study of the interrelationship between outlets should be carried out, as having the products on display in shops might be necessary in order to maintain the high level of telephone orders. For instance, potential customers may visit to see colours, quality, and so on. 
Products on display are also a form of advertising for the company 
and this would be lost if the shops were closed.

Chapter 1 
 45 
 Appendix A: Calculation of ne t margin per type of outlet 
 
   Mail order 
Sales revenue 50,000 1,000,000 150.00 300.00 100.00 
Gross margin1  
(50,000 + 1.30, etc.) 11,538 285,714 42.86 85.71 28.57 
Less: Staffing etc.  300,000    
Telephone queries  
($15 × 40, etc.) 600 5,250    
Sales visits ($250 × 2, etc.) 500 1,000    
Orders ($20 × 25, etc.) 500 3,000    
Packaging ($100 × 28, 
etc.) 2,800 15,000    
Delivery ($150 × 28, 
etc.) 4,200 22,500    
Order cost   5.00 6.00 3.00 
Queries   4.00 4.00 1.00 Packing & delivery  
($10 × 2, etc.)   20.00 20.00 10.00 
––––– 
Internet cost
2     10.00 
 8,600 
–––– 346,750 
––––––  29.00 
––––  30.00 
––––  24.00 
––––  
Net margin 2,938 (61,036) 13.86 55.71 4.57 
Net margin/sales 5.9%  9.2% 18.6% 4.6% 
 4th 5th 2nd 1st 3rd 
Appendix B: Calculation of total margin for each type of outlet 
 
Stores Own 
shops Mail order Total 
 $000 $000 Post Telephone Internet $000 
   $000 $000 $000  Total 
revenue 2,500 10,000 3,600 14,400 800 31,300 
Total net margin 146.90 (610.36) 332.64 2,674.08 36.56 2,579.82 
Appendix C: Gross margin calculation for 30% of purchase cost 
 
100 = 0.3X + X 
X = 76.92% 
0.3 X = 23.076% 
$50,000 × 23.076% = $11.538

46 
 Appendix D: Mail order 
Total number of mail orders = 80,000. So number of Internet orders = 
80,000 × 10% = 8,000 
Internet link cost per order = $80,000/8,000 orders = $10 
Appendix E: Calculation of total revenues and net margins ($000) 
 
  Total 
revenue  Total net 
margin 
Department Stores 50 outlets (× $50,000) $2,500 (× 2,938) 146.9 
Own shops 10 outlets (× $1,000,000) 10,000 (× $61,036) (610.36) 
Mail order – post     
80,000 × 30% = 24,000 
orders (× $150) 3,600 (× $13.86) 332.64 
Mail order – telephone     
80,000 × 60% = 48,000 
orders (× $300) 14,400 (× $55.71) 2,674.08 
Mail order – Internet     
80,000 × 10% = 8,000 orders (× $100) 800 (× $4.57) $36.56

47 
The Modern Business 
A2: Managing the costs of 
creating value Compare and contrast quality 
management methodologies 
(a) Just-in-time (JIT) (b) Quality management (c) Kaizen (d) Process re-engineering 
 
   Chapter 
2

The Modern Business Environment 
48 
1  Chapter summary 
 
2  Introduction to the modern business environment 
‘To compete successfully in today's highly competitive global environment 
companies are making customer satisfaction an overriding priority, adopting new management approaches, changing their manufacturing systems and investing in new technologies. These changes are having a significant influence on management accounting systems.' 
Colin Drury in 'Management and Cost Accounting' 
The modern manufacturing environment is very different from the traditional production environment. It means that traditional costing methods are becoming less relevant. 
In this chapter we explore how the modern production system has changed, 
and in the following chapters we examine how costing has adapted to this and created new ways to calculate a product's production cost. 
3  Knowledge brought forward 
You will already have covered some key concepts in Subject P1. We will build on this knowledge in P2 with more aspects of the modern business 
environment, but make sure you are comfortable with the assumed knowledge, 
that should have been brought forward as a base, in the following sections.

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Characteristics of the modern business environment   
Global environment 
• Companies operate in a world economy. 
• Customers and competitors come from all over the world. 
• Products are made from components from around the world. 
• Firms have to be world class to compete. 
• International regulations. 
Flexibility 
• In a global environment, customers have far greater choice than ever 
before. 
• There has been a huge increase in demand for new, cutting-edge 
innovative products. 
• Customers are demanding ever-improving levels of service in cost, quality, 
reliability and delivery. 
• Customers demand flexibility. Companies  need to respond to this in order 
to survive. 
As a consequence of this: 
1 many companies now have very diverse product ranges, with a high level 
of tailor-made products and services 
2 product life cycles have dramatically reduced, often from several years to 
just a few months. 
The move away from standardised units of production towards individual 
customised units means that mass production techniques are redundant. Instead, it is of greatest importance to take an order from placement to completion in the shortest time possible. This means that production processes will be designed differently to accommodate flexibility of production rather than just throughput. 
Employee empowerment 
To ensure this flexibility, managers need to empower their employees to make 
decisions quickly, without reference to more senior managers. By empowering employees and giving them relevant information they will be able to respond faster to customers, increase process fl exibility, reduce cycle times and improve 
morale. 
Management accounting systems are moving from providing information to 
managers to monitor employees to providing information to employees to empower them to focus on continuous improvement.

50 
World Class Manufacturing 
The World Class Manufacturing approach to quality is quite different from the 
traditional approach because the primary emphasis is placed on the resolution of the problems that cause poor quality, rather than merely detecting it. These systems are more proactive and try to prevent problems from occurring in the first place rather than waiting for them to occur and then fixing them. 
The system might be developed formally under Total Quality Management. 
Just-In-Time 
CIMA's Official Terminology defines 'Jus t-in-Time' as a system whose objective 
is to produce or procure products or components as they are required by a 
customer or for use, rather than for inventory. A just-in-time system is a ‘pull’ 
system, which responds to demand, in contrast to a ‘push’ system, in which 
inventory acts as a buffer between the di fferent elements of the system, such as 
purchasing, production and sales.' 
 
JIT production  is defined as: 
A production system which is driven by demand for fi nished products whereby 
each component on a production line is produced only when needed for the 
next stage. 
JIT purchasing  as: 
A purchasing system in which material purchases are contracted so that the 
receipt and usage of material, to the maximum extent possible, coincide. 
These ‘Official Terminology’ definitions give JIT the appearance of being merely 
an alternative production management system, with similar characteristics and objectives to techniques such as MRP. However, JIT is better described as a philosophy, or approach to management, as it encompasses a commitment to continuous improvement and the pursuit of excellence in the design and operation of the production management system. 
 
Toyota 
 Organisations in the West have traditionally used a ‘push’ production flow 
system. This system has the following stages: 
1 Buy raw materials and put them into inventory. 2 Produce a production schedule based on sales forecasts. 3 Withdraw goods from inventory and make products according to the 
production schedule. 
4 Put completed units into finished goods store. 5 Sell from finished goods store when customers request products.  Work in progress (WIP) is an unavoidable feature of such a system.

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 Toyota developed a different system known as JIT. This system is not a 
‘push’ system but a ‘pull’ system. A product is not ‘made’ until the 
customer requests it, and components are not made until they are required by the next production stage. In a full JIT system virtually no inventory is held, that is no raw material inventory and no finished goods inventory is held, but there will be a small amount of WIP, say one-tenth 
of a day’s production. The system works by the customer triggering the final stage of production, the assembly. As the product is assembled, components are used and this in turn triggers the component stage of production and a small amount of WIP is made ready for the next product. So the cycle goes on until the final trigger requests more raw material from the supplier. 
 
If a JIT system is to work satisfactorily, suppliers must deliver several 
times a day and so when the raw material arrives it may go straight into 
the factory and be used immediately. This means that the production lead time (i.e. the time from raw materials entering production to the finished goods emerging) should equal the processing time. In many Western organisations in the past it took several months to make a product from start to finish, despite the fact that if worked on continuously it could be made in, say, two days. The difference in time is largely due to WIP waiting to be used in the next process. It will be apparent that value is only added to the product during the actual processing stages. These have been estimated to represent as little as 10 per cent of the total manufacturing lead time in many companies, and thus up to 90 per cent of production time adds costs but no value. 
JIT requires the following: 1 The labour force must be versatile so that they can perform any 
job within reason to keep production flowing as required. Workers in 
a JIT cell are trained to operate all the machines within it, and perform routine preventive maintenance on them. 
2 Production processes must be grouped by product line,  rather 
than by function in order to eliminate inventory movements between workstations and to speed flow.

52 
 3 A simple, infallible information system . Originally the Japanese 
used a system based on cards which were called Kanban. There 
would be a small container of components (WIP) between each workstation with a Kanban resting on top. When the container was taken for use by the following workstation the card would be taken off and left behind. This would act as a trigger for the previous workstation to produce another container of that component. Nowadays computer systems are likely to be used instead of cards but the basic simplicity of the system should not change. 
4 A ‘get it right first time’  approach and an aim of ‘zero defects’. 
Defects cause breakdowns in the value chain: they stop the flow of production, create expensive rework and lead to late deliveries to customers. 
5 Strong supplier relationships . Suppliers must take responsibility 
for the quality of their goods; the onus is on the supplier to inspect the parts or materials before delivery and guarantee their quality. The considerable savings in inspection costs go happily with the benefits of increased quality to achieve cost reduction – another facet of continuous improvement. This enhanced level of service is obtained by reducing the number of suppliers and increasing the business given to each of them. Longer-term commitments are entered into, assuring the supplier of continuity of demand, and enabling the supplier to plan to meet customers’ production schedules. In essence the supplier becomes a key part of the value chain. 
An important consequence of the ‘pull’ system, is that problems in any part of the system will immediately halt the production line, as earlier 
workstations will not receive the ‘pull’ signal and later stations will not have their own ‘pull’ signals answered. This has the powerful effect of concentrating all minds on finding a long-term solution to the problem. JIT exposes problems within a plant, and forces management to address problems and rectify them, rather than simply burying them by holding excess inventory. 
The aims of JIT are to produce the required items, at the required quality 
and in the required quantities, at the precise time they are required.

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4  TQM (Total Quality Management) 
TQM is the general name given to programmes which seek to ensure that 
goods are produced and services supplied of the highest quality. Its origins lie primarily in Japanese organisations and it is argued that TQM has been a significant factor in Japanese global business success. 
There are two basic principles of TQM: 1 'Get it right, first time.’  TQM considers that the costs of prevention are 
less than the costs of correction. One of the main aims of TQM is to 
achieve zero rejects and 100% quality. One aspect of the Japanese management philosophy is a zero-defect target. 
2 Continuous improvement . The second basic principle of TQM is 
dissatisfaction with the status quo. Realistically, a zero-defect goal may not be obtainable. It does however provide a target to ensure that a company should never be satisfied with its present level of rejects. The management and staff should believe that it is always possible to improve and to be able to get more right next time! 
There are two approaches to Continuous Improvement: Kaizen Costing (in this 
chapter) and Target Costing (in the following chapter.) 
The costs of quality 
Quality costs are divided into compliance costs (or ‘conformance costs’) and 
costs of failure to comply (‘non-conformance costs’). 
Conformance costs are further divided into prevention costs (incurred in 
preventing mistakes from happening) and appraisal costs (incurred in looking for mistakes before a product is manufactured). 
 
 Conformance costs 
 Prevention costs  are the costs of ensuring that defects do not occur in 
the first place. For example: 
1 Routine preventive repairs and maintenance to equipment. 2 Quality training for operatives to improve skills and efficiency. 
Training employees works, provided the employee also understand 
and accept the benefits of such training. Training can occur both inside and outside the workplace. Internal training may include the ideas of team working and quality discussion groups, which are known as quality circles. 
3 Building of quality into the design and manufacturing processes. 
When a product is  designed, its specific ation should consider 
factors that will minimise future rectification costs. Production methods should be as simple as  possible and use the skills and 
resources existing within the sphere of knowledge of the organisation and its employees.

54 
 4 Determining whether quality factors have been correctly engineered 
into the design of products may only be apparent when costs are 
reported on a ‘life cycle’ basis. Effective performance management involves monitoring costs and results over the whole life cycle of a product. Just considering production costs over a one-month period (in the form of traditional standard costing and variance analysis) may be of marginal relevance. 
Appraisal costs are connected with measuring conformity with requirements and include: 
1 Cost of incoming inspections (note that if suppliers adopt a total 
quality approach, the cost of incoming inspections can be eliminated) 
2 Cost of set-up inspections 3 Cost of acquiring and operating the process control and measuring 
Non-conformance costs are divided into ‘internal failure’ costs, that occur when 
the units produced fail to reach the set standard; and ‘external failure’ costs – These arise when the faulty product is not detected until after it reaches the customer. 
 
Non-conformance costs 
 Internal failure  costs include: 
1 Costs of scrap 
2 Reworking costs 3 Manufacturing and process engineering required to correct the 
failed process. 
As we saw under JIT, it is the aim of total quality management (TQM) 
programmes to completely eliminate these internal failure costs by working towards a goal of zero defects. It is contended that, in many companies, the costs of internal failure are so great that a total quality programme can be financed entirely from the savings that are made from it – hence the expression ‘quality is free’ . 
There are several measurable costs of external failure  to deliver a 
quality product: 
1 Marketing costs associated with failed products and loss of 
customer goodwill 
2 Manufacturing or process engineering costs relating to failed 
products 
3 Compensation/replacement for units returned by customers 4 Repair costs 
5 Travel costs to visit sites with faulty products 
6 Liability claims.

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 Example 1: Costs of quality I 
 X Ltd is a manufacturing company. Its monthly quality costs are made up 
 $ 
Cost of re-inspecting previously faulty finished goods 
after reworking them  
5,700 
Cost of scrap 12,000 
Cost of calibrating and measuring testing equipment 8,500 Cost of inspecting incoming material 1,000 
Cost of conducting supplier capability surveys 2,000 
Which one of the following options identifies X's monthly prevention 
costs, appraisal costs and non-conformance costs? 
 
 Prevention costs Appraisal costs Non-conformance 
costs 
A $10,500 $1,000 $5,700 
B $2,000 $1,000 $12,000 
C $2,000 $9,500 $17,700 D $0 $21,500 $1,000 
    
 Example 2: Costs of quality II 
 Quality control costs can be categorised into internal and external failure 
costs, appraisal costs and prevention costs. In which of these four 
classifications would the following costs be included? 
• The cost of a customer service team • The cost of equipment maintenance 
• The cost of operating test equipment. 
 Customer service 
team  Equipment 
maintenance  Test equipment  
A Prevention costs Appraisal costs Internal failure 
costs 
B Prevention costs Internal failure costs Appraisal costs 
C External failure 
costs Internal failure costs Prevention costs 
D External failure 
costs Prevention costs Appraisal costs

56 
It is generally accepted that an increased investment in prevention and 
appraisal is likely to result in a significant reduction in failure costs. As a result of the trade-off, there may be an optimum operating level in which the combined costs are at a minimum. In short, an investment in “prevention” inevitably results in a saving on total quality costs. 
 
Recognising the importance of quality 
1 Accept that the only thing that matters is the customer. The only way to 
stay in business is to relate everything to customer priorities. 
2 Recognise the all-pervasive nature of the customer/supplier relationship. 
This includes internal customers. In a transfer environment, passing sub-standard material down to another division just to claim output is not satisfactory. Ultimately, the company must bear the cost of the defective product/service. 
3 Move from relying on inspecting to a predefined level of quality, to actually 
preventing the cause of the defect in the first place. 
4 Each operative or team of operatives must be personally responsible for 
defect-free production or service in their domain. This should not just be confined to production staff, it should be extended throughout the organisation. For example, sales, personnel, accounting and the after-sales departments should also ensure that their ‘customers’ are happy with their service. 
5 In production there should be a move away from acceptable quality levels 
(AQL) to defect levels measured in parts per million. 
6 Enforce zero defect programmes. These are an obsessive drive to get 
things right first time. Again this should be enforced throughout all departments.

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7 Quality certification programmes such as BS5750/ISO9002 should be 
introduced. Although opinion is divided about these programmes, and they 
are often perceived to be a burden disproportionate to the benefits, the value of a third party audit of control and production procedures to ensure everything is properly controlled has both merit and, in the short term, an influence with customers. 
8 The total cost of quality should be emphasised. Quality does generate 
savings. For example, better trained operators do not waste material nor do they abuse machines and equipment. Other savings can be achieved by reviewing suppliers, preventive machine maintenance and reduction of scrap and rework. 
Commitment to quality 
For TQM to bring about improved business efficiency and effectiveness it must be applied throughout the whole organisation. It begins at the top with the managing director, the most senior directors and managers who must demonstrate that they are totally committed to achieving the highest quality standards. The role of middle management is also crucial. They have to understand the importance of TQM and communicate this and their own commitment to quality to the people for whom they are responsible. It is essential that TQM is adopted by all parts of the organisation. Middle management must ensure that the efforts and achievements of their subordinates receive appropriate recognition, attention and reward. This helps secure everyone’s full involvement – which is crucial to the successful introduction of TQM. 
Quality chains 
Throughout and beyond all organisations, whether they are manufacturing 
concerns, retail stores, universities or hotels, there is a series of quality chains. The ability to meet the customers’ requirements is vital, not only between two separate organisations, but within the same organisation. These quality chains may be broken at any point by one person or by one piece of equipment not meeting the requirements of the customer, internal or external. 
To achieve quality throughout an organisation, each person in the quality chain 
must be trained to ask themselves the following questions: 
Customers 
• Who are my internal customers? 
• What are their true requirements? 
• How do I find out what the requirements are? 
• How can I meet those requirements?

58 
Suppliers 
• Who are my internal suppliers? 
• What are my true requirements? 
• How do I communicate my requirements? 
• Do my suppliers have the capability to meet my requirements? 
Each person in the organisation must also realise that they must respect their 
suppliers’ needs and expectations if those suppliers are able to fully satisfy their requirements. 
Successful implementation of TQM 
An organisation should undertake to achieve each of the following to ensure 
TQM is successful: 
• Total commitment throughout the organisation. 
• Get close to their customers to fully understand their needs and 
• Plan to do all jobs right first time. • Agree expected performance standards with each employee and 
customer. 
• Implement a company-wide improvement process. • Continually measure performance levels achieved. 
• Measure the cost of quality mismanagement and the level of firefighting. 
• Demand continuous improvement in everything you and your employees 
do. 
• Recognise achievements. • Make quality a way of life. 
Quality circles 
A quality circle is a team of four to twelve people usually coming from the same 
area who voluntarily meet on a regular basis to identify, investigate, analyse and solve work-related problems. The team presents its solutions to management and is then involved in implementing and monitoring the effectiveness of the solutions. The voluntary approach and the process by which the team selects and solves its own problems are key features which give the quality circle a special character: a character which is very different to other problem-solving teams. The problems that circles tackle may not be restricted to quality of product or service topics, but may include anything associated with work or its environment. Items such as pay and conditions and other negotiated items are, however, normally excluded.

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Management accounting reports 
Management accounting systems can help organisations achieve their quality 
goals by providing a variety of reports and measures that motivate and evaluate managerial efforts to improve quality – including financial and non-financial measures. 
Traditionally, the management accounting systems focused on output, not 
quality. 
Examples: 
• the strive to reduce the material price variance often led to the use of 
inferior quality material 
• the costs of normal losses were absorbed by good output. 
Non-financial measures include: 
• Number of defects at inspection expressed as a percentage of the number 
of units completed. 
• Number of reworked units expressed as a percentage of total sales value. • Number of defective units delivered to customers as a percentage of total 
units delivered. 
• Number of customer complaints. • Number of defective units supplied by suppliers. 
• Time taken to respond to customer requests. 
5  Throughput accounting and the Theory of Constraints 
The term throughput is defined by the following equation: 
Throughput = Sales revenues less Direct material cost 
The aim of throughput accounting is to maximise this measure of throughput. 
Goldratt and Cox advocate that managers should aim to increase throughput while simultaneously reducing inventory and operational expense. 
This goal is achieved by determining what factors prevent the throughput being 
higher. This constraint is called a bottleneck. A bottleneck may be a machine whose capacity limits the output of the whole production process. The aim is to identify the bottlenecks and remove them or, if this is not possible, ensure that they are fully utilised at all times.  Non-bottleneck resources should be 
scheduled and operated based on the constraints within the system, and should not be used to produce more than the bottlenecks can absorb. 
Goldratt and Cox describe the process of identifying and taking steps to remove the constraints that restrict output as the theory of constraints  (TOC).

60 
The process involves five steps: 
1 Identify the system’s bottlenecks. 
2 Decide how to exploit the bottlenecks. 3 Subordinate everything else to the decision in Step 2. 4 Elevate the system’s bottlenecks. 5 If, in the previous steps, a bottleneck has been broken, go back to Step 1. The bottleneck is the focus of management’s attention. Decisions regarding the 
optimum mix of products must be undertaken. Step 3 requires that the optimum production of the bottleneck activity determines the production schedule of the non-bottleneck activities. There is no point in a non-bottleneck activity supplying more than the bottleneck activity can consume. This would result in increased work-in-progress (WIP) inventories with no increased sales volume. The TOC is a process of continuous improvement to clear the throughput chain of all the constraints. Thus, step 4 involves taking action to remove, or elevate, the constraint. This may involve replacing the bottleneck machine with a faster one, providing additional training for a slow worker or changing the design of the product to reduce the processing time required on the bottleneck activity. Once a bottleneck has been elevated it will g enerally be replaced by a new bottleneck 
elsewhere in the system. It then becomes necessary to return to Step 1. 
Constraints on throughput 
The idea of constraints is central to the throughput approach. Examples of 
constraints may include: 
• inadequately trained sales force 
• poor reputation for meeting delivery dates 
• poor physical distribution system 
• unreliability of material supplies, delivery and/or quality 
• inadequate production resources 
• inappropriate management accounting system. 
The only cost that is deemed to relate to volume of output is the direct material 
cost. All other costs (including labour costs) are deemed to be fixed. These fixed costs may be called total factory costs (TFC).

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The role of the accountant in a throughput environment is to devise measures 
which will help production staff to achi eve a greater volume of throughput. 
Attention should be drawn to the financial effects of bottlenecks. For example if a bottleneck resource fails to operate for one hour a whole hour’s throughput is lost. Various performance measures have been devised to help measure throughput: 
Return per factory hour 	= Throughput per unit
Product time on the bottleneck resource
 
Cost per factory hour = Total factory costs
 
Throughput accounting ratio = Return per factory hour
Cost per factory hour 
 
The accountant may advise management on how the TA ratio may be 
maximised. 
 
 Example 3: Throughput Accounting 
 X Limited manufactures a product that requires 1.5 hours of machining. 
Machine time is a bottleneck resource, due to the limited number of 
machines available. There are 10 machines available, and each machine can be used for up to 40 hours per week. 
The product is sold for $85 per unit and the direct material cost per unit is 
$42.50. Total factory costs are $8,000 each week. 
Calculate 
(a) the return per factory hour 
(b) the TPAR. 
6  Kaizen costing 
Continuous improvement, or ‘Kaizen’, is an integral part of the just-in-time 
management philosophy. ‘Kaizen’ is a Japanese term meaning to improve processes via small, incremental amounts rather than through large innovations. Kaizen costing is a planning method used during the manufacturing cycle that emphasises reducing variable costs of a period below the cost level in the base period. The target reduction rate is the ratio of the target reduction amount to the cost base. 
• The organisation should always seek perfection. Perfection is never 
achieved, so there must always be some scope for improving on current 
methods and procedures. Improvements should be sought all the time. 
• Improvements will be small and numerous rather than occasional and far-
reaching.

62 
• Cost reduction targets are set and applied on a more frequent basis than 
standard costs. Typically these targets are set on a monthly basis whereas 
standards within a traditional standard costing system are set annually or 
perhaps semi-annually. The table below ( adapted from Monden and  Lee) 
points out the differences between the two techniques: 
 
Standard costing concepts Kaizen costing concepts 
Cost Control  system Cost Reduction  system 
Assume current 
manufacturing conditions. Assume 'Continuous Improvement' in manufacturing. 
Meet cost performance standards. Achieve cost reduction targets. 
Standard cost techniques Kaizen costing techniques 
Standards are set annually or semi-annually. Cost reduction targets are set and applied monthly. 
Cost variance analysis involving standard costs and actual costs. Continuous Improvement (Kaizen) is implemented during the year to attain target profits or to reduce the gap between target profit and estimated profit. 
Investigate and respond when standards are not met. Cost variance analysis involving target Kaizen costs and actual costs reduction amounts. 
 Investigate and respond when target Kaizen 
amounts are not attained. 
 
 Tool: Kaizen  
 Kaizen is a philosophy of customer-driven improvement. Its aim is to 
create a culture of continuous quality, cost and delivery (QCD) 
improvement across the value chain ( See ‘value chain’ later in this Text ). 
Kaizen is based on three areas of improvement: housekeeping; waste 
elimination; and standardisation. In contrast to top-down approaches to driving improvements, like business process re-engineering, Kaizen democratises continuous improvement through the principle that the person performing the operation is most knowledgeable about it and, therefore, best qualified to improve it. 
Everyone in the business is expected to be on the lookout for 
opportunities to eliminate waste in their workplaces and to implement them with their co-workers. Waste includes excessive effort (‘muri’) and excessive process (‘mura’) – for example defects, over-engineering and over-stocking.

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 A business’ strategy should champion the values and behaviours 
expected of all employees in relation to Kaizen and provide guidance for 
employees on what is expected of them personally. Leaders across the business should cultivate participation in Kaizen activities and be seen themselves to engage in Kaizen activities. Individuals and teams should be rewarded for their contributions and results celebrated. 
A Kaizen activity typically consists of the following steps: 
• Standardise an operation or activity • Measure the operation 
• Compare measurements against requirements 
• Innovate to meet requirements and increase productivity 
• Standardise the new, improved operation 
• Repeat on a continuous basis. 
What benefits does Kaizen provide? 
Kaizen’s focus on housekeeping aims to enhance an employee’s 
workplace (“gemba”) by continuously improving cleanliness, ergonomics and safety, which in turn should improve morale and motivation. 
It eliminates waste by minimising, for example, time wasted retrieving 
tools; fatigue; injury caused by poor workspace ergonomics; the number of human operations needed to perform a process. 
Standardisation provides a standard against which operations can be 
compared. Deviations from standards highlight the need for remedial action (Kaizen) or to revise the standard. Standards are also key to knowledge management: they are a store of best practice, provide learning material for newcomers, and are the basis for performance management and performance improvement. 
Implementing Kaizen? Questions to consider: 
• Does strategy encourage buy-in from all employees and empower 
them to experiment in their workplace to improve operations? 
• What motivating factors need to be implemented to encourage 
employees’ participation in improvement activities on an ongoing 
basis? 
• What training is needed to ensure all employees understand the 
company’s approach to continuous improvement? 
• What facilitation is needed to ensure improvement is ongoing, 
e.g. quality circles?

64 
 Actions to take: Do’s 
Ensure management is seen to be enacting Kaizen in its workspaces. 
• Make Kaizen a strategy. 
• Provide a budget for Kaizen activity. 
• Measure the effectiveness of Kaizens. 
• Celebrate small improvements. 
• Align recognition and award frameworks to the business’ Kaizen 
• Empower employees to implement Kaizens autonomously. • Train all employees in the business’ Kaizen philosophy. 
• Compile baseline data to enable future comparison. 
Actions to avoid: Don’ts 
Don’t try to exert management control over Kaizen activities. 
• Avoid bureaucracy in Kaizen activities. 
• Don’t tie Kaizen to short term KPIs. 
 
 Example 4: Kaizen costing 
 Kaizen costing emphasises: 
A  The need to bring about efficiency and effectiveness 
B  Continuous improvement C  A 'push' production flow system D  The rapid elimination of all internal failure costs 
 
 Example 5: Kaizen costing II 
 The following statements have been made about Kaizen costing. Select 
ALL that apply: 
• The focus is on eliminating waste, improving processes and 
systems and improving productivity. 
• In Kaizen costing, employees are often viewed as the cause of 
problems. 
• In Kaizen costing, costs are reduced by implementing continuous 
• The aim of Kaizen costing is to achieve cost reduction targets.

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7  Business Process Re-engineering 
The continuous improvement philosophy contrasts sharply with the concept 
underlying business process re-engineering (BPR). BPR is concerned with making far-reaching one-off changes to improve operations or processes. 
Michael Hammer & James Champy define BPR as 'the fundamental rethinking 
and radical redesign of business processes to achieve dramatic improvements in critical contemporary measures of performance such as cost, quality, service and speed.' In other words, BPR focuses on amending existing processes, streamlining processes that are already in place. 
Five stages are normally recognised in any BPR project: 
• Develop the business vision and process objectives. State which 
improvements are expected from processes based on some overall 
business vision of Total Quality Management. 
• Identify the processes to be redesigned. Most firms tend to focus on the 
more important processes, although significant improvements may still be 
obtained by redesigning inefficient processes in any part of the organisation. 
• Understand and measure the existing processes so that a baseline 
against which to measure improvement is set. 
• Identify 'IT levers' that can be used to apply change. 
• Design and build a prototype to show which changes are possible, and 
involve customers before implementing any revised system. 
For example, consider a car manufacturing process. Cars are assembled by 
passing them along a conveyor belt, and adding parts to each one in a predetermined order, to arrive at the finished product. This process can be improved in terms of efficiency by making robots do some of the repetitive and less skilled operations. In this way, the process is being re-designed, to include and enhanced IT element to make it more efficient, and less prone to errors. In other words, BPR is being used to improve the existing process.

66 
 Business process re-engineering 
 A business process consists of a collection of activities that are linked 
together in a co-ordinated manner to achieve a specific objective. 
Business process re-engineering involves examining business processes and radically redesigning these processes to achieve cost reduction, improved quality and customer satisfaction. BPR is all about major changes to how business processes operate. 
Material handling is an example of a business process and may consist 
of the following separate activities; material requisitioning, purchase requisitioning, processing purchase orders, inspecting materials, storing 
materials and paying suppliers. This process could be re-engineered by 
sending the material requisitions directly to an approved supplier and entering into an agreement which entails delivering high quality material in accordance with the production requirements. This change in business process could result in cost reduction by the elimination of; the administration involved in placing orders, the need for material inspection and storage. By re-engineering the material handling business process the company will reduce costs without compromising the quality of the products delivered to customers. 
 
 Example 6: BPR 
 Which of the following statements are TRUE regarding BPR? Select all 
• BPR achieves incremental improvements in performance. • BPR increases the organisation’s ability to meet customers’ needs. 
• BPR uses technology to find innovative ways to do business. 
• BPR increases organisational complexity as activities are 
decoupled. 
• BPR can be used as a pretext for staff reductions and as a 
‘quick fix. 
Value-added analysis  
This BPR re-engineering pattern looks at the process (or sub-process) from a 
customer’s perspective. A process or activity is said to add value if it increases the worth of a product or service to the customer (for example, adding a sun-roof to a car).To be classified as ‘val ue-adding’, an activity must meet three 
criteria:  
1 the customer is willing to pay for the output 2 the activity physically changes the output in some way 3 the activity is performed correctly at the first attempt.

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Value-adding activities are distinct from ‘non-value-adding activities’, such as: 
• preparation and set-up  • control and inspection  
• simply moving a product from one place to another without physically 
changing it  
• activities that result from delays or failures of any kind.  
Non value-adding activities are those that do not increase the worth of the 
product to the customer. Common examples are ‘inspection time’ and ‘idle time’ in manufacturing. It is usually not possible to eliminate these activities but it is often possible to minimise them.  
Obviously, some of them (for example set-up activities) may be essential for the 
value-added activity to take place. These essential support activities are known as value-enabling activities, and cannot be eliminated altogether. However, they should be done simply and cost-effectively to allow resources to be focused as much as possible on the value-added activities. 
 
Example 7: Value-adding and non-value adding activities 
 Indicate which of the following activities are value-adding, or non-value-
adding, by dragging and dropping the tiles on the right (‘Value adding 
activity’ and ‘Non-value adding activity’ tiles) in the correct position: 
 
Reporting    
Assembly    
Design engineering    
Transferring materials between two non-adjacent workstations   
Value 
adding 
activity 
Inspecting parts for quality defects   
 
Processing returned materials   Non-value 
adding 
activity 
Project coordination    
Obtaining approvals    
Painting

68 
8  Supply chain management 
Supply chain management is often explained with reference to Porter’s value 
chain and value systems. A supply chain is the network of customers and suppliers that a business deals with. 
Recent decades have seen an increasing rate of globalisation of the economy 
and thereby also of supply chains. The days when products were produced and consumed in the same geographical area are long past. In fact it is often the case that the different components of a product come from all over the globe. Such a trend causes longer and more complex supply chains and thus changes the requirements within supply chain management. This, in turn, affects the effectiveness of the IT systems employed within the supply chain. A longer supply chain often results in a lengthening of order-to-delivery lead times. 
Supply chain management considers logistics but also relationships between 
members of the supply chain, identification of end-customer benefit and the organisational consequences of greater inter-firm integration to form ‘network organisations’. 
Supply chain management may be broken down into several areas: 
Purchasing 
It is important for a company to work closely with its suppliers. A true 
partnership will enable a better, faster and more reliable service. Purchasing 
costs can be reduced by more than 10% when information systems are linked. Day-to-day purchasing, progress chasing and stock control can all be eliminated. 
Inventories 
Efficient inventory control relies upon accurate customer records, well-managed 
customer information and effective inventory-control information systems. A close collaboration with suppliers an d customers will enable inventory levels 
to be kept to a minimum. Working more closely with the supply chain partners will require mutual trust and investment in  technology, but it will bring benefits to 
all concerned. 
Customer ordering 
From the customer’s perspective the ordering process should be fast, flexible 
(meet individual customer needs) and efficient. A satisfied customer is more likely to return for repeat orders. Factors such as price, quality, availability from inventory etc. are important, but a fully automated fulfilment procedure also plays a key part in overall customer satisfaction. On-line ordering is becoming a prerequisite for many customers today. 
Orders should be processed smoothly within the firm. Purchasing, inventory 
control, marketing and accounts should all be linked to the customer-ordering process.

Chapter 2 
 69 
Delivery and logistics 
Delivering to the customer is often the culmination of all the business 
processes. Customers will expect fast, reliable, accurate and predictable delivery schedules. Tracking systems such as radio frequency identification (RFID) enable companies to trace the physical progress of the customer order. With RFID objects are tagged. During manufacturing and delivery the whereabouts of the order can then be traced electronically and remotely (items can be detected up to 100 feet away from the sensor). In the US many large companies such as Wallmart are already requiring their suppliers to use RFID. 
Some companies use third party distributors. As technology becomes more 
complex and sophisticated outsourcing becomes more attractive. Some companies leave distribution to professional logistics companies. 
A significant trend in recent years has been for organisations and government 
bodies to concentrate on their core competencies. Outsourcing involves the buying in of components, sub-assemblies, finished products and services from outside suppliers rather than supplying them internally. It may be regarded as a management strategy by which an organisation delegates major non-core 
functions to specialised, efficient service providers. 
Traditionally the insourcing/outsourcing decision was focused on a make-or-buy 
decision for manufacturing functions. However companies are now beginning to apply the decision analysis to nearly all functions and activities. 
For example, the following functions are now coming under the outsourcing 
spotlight: sales; design and development, IT and distribution. 
Advantages and disadvantages of insourcing 
 
Higher degree of control over inputs Requires high volumes 
Increases visibility over the process High investment 
Economies of scale/scope to use 
integration Dedicated equipment has limited flexibility 
 Not a core competence

70 
Advantages and disadvantages of outsourcing 
 
Greater flexibility Possibility of choosing wrong 
supplier 
Lower investment risk Loss of visibility and control over process 
Improved cash flow Possib ility of increased lead times 
Concentrates on core competence  
Enables more advanced technologies to be used without making investment

Chapter 2 
 71 
9  Practice Questions 
 Objective Test Question 1: Just-in-time 
 The adoption of JIT normally requires which one of the following factors 
to increase? 
A  Inventory levels B  Work-in-progress levels C  Batch sizes D  Quality standards 
 
 Objective Test Question 2: Quality Costs 
 Match the cost to the correct cost category:  
Costs 
(a) Reliability studies 
(b) Returned material processing and repair (c) Quality audits (d) Quality control investigations of failures 
Cost categories 
• Prevention costs 
• Appraisal costs 
• Internal failure costs 
• External failure costs

72 
 Objective Test Question 3: TQM 
 Use the words and phrases in the table provided below to complete 
the following paragraphs: 
 
quality  output  production 
problems 
     
Total Quality 
Management (TQM)  customer 
goodwill  quality 
     
delays  buffer inventory   
In a company operating on JIT principles, the absence of inventories 
deprives production of a safety net or '_____________'. This exposes the 
business to production problems or ___________and, ultimately, to lost sales and damaged  _________________. 
In this context, the adoption of a ____________ philosophy is key. In this, _____________ is a feature rooted in the production process and every 
individual is responsible for the quality of his/her ______________. 
This will encourage good quality at all times and therefore minimise 
_________that would otherwise occur due to poor _________________. 
 
 Objective Test Question 4:  BPR II 
• BPR is often used as the pretext for staff reductions • BPR is a long term approach to gaining a competitive advantage. 
• BPR overlooks the impact on human resources 
• BPR increases organisational complexity 
• BPR focuses too much on improving existing business rather than 
developing new and better lines of business

Chapter 2 
 73 
 Data Set Question: Throughput accounting 
 The following data relates to three products manufactured by BJS Ltd: 
 
 Product 
X Product 
Y Product 
Z 
Selling price per unit $12 $16 $14 
Direct material cost per unit $3 $10 $7 
Maximum demand (units) 15,000 40,000 20,000 Time required on the bottleneck (hours 
per unit)  
3  
1.5  
7 
The firm has 80,000 bottleneck hours available each period, and total factory costs amount to $100,000 in the period. 
Task: Calculate the following: 
The TPAR (throughput accounting ratio) for Product X  
  
The TPAR (throughput accounting ratio) for Product Y  
  
The TPAR (throughput accounting ratio) for Product Z  
  
The maximum profit achievable by BJS, in $ (this 
involves a calculation of the optimum product mix).

74 
 Case Study Style Question – X Ltd 
X Ltd manufactures and distributes three types of car (the C1, C2 and 
C3). Each type of car has its own production line. The company is worried by extremely difficult market conditions, and forecasts losses for the forthcoming year. 
Current operations 
The budgeted details for next year are as follows: 
 
  C1  C2 C3 
 $ $ $ 
Direct materials 2,520 2,924 3,960 
Direct labour 1,120 
––––– 1,292 
––––– 1,980 
––––– 
Total direct cost per car 3,640 
––––– 4,216 
––––– 5,940 
––––– 
    
Budgeted production (cars) 75,000 75,000 75,000 Number of production runs 1,000 1,000 1,500 
Number of orders executed 4,000 5,000 5,600 
Machine hours 1,080,000 1,800,000 1,680,000 
Annual overheads 
 Fixed Variable 
 $000 $ Set-ups 42,660 13,000 per production run 
Materials handling 52,890 4,000 per order executed 
Inspection 59,880 18,000 per production run Machining 144,540 40 per machine hour 
Distribution and warehousing 42,900 3,000 per order executed

Chapter 2 
 75 
 Proposed JIT system: impact on costs (Source: JIT External 
Consultants Ltd) 
The introduction of the JIT system would have the following impact on 
costs (fixed and variable): 
Direct labour Increase by 20% Set-ups Decrease by 30% Materials handling Decrease by 30% Inspection Decrease by 30% Machining Decrease by 15% Distribution and warehousing Eliminated Task: Email 
You receive the following email from the Chief Financial Officer 
(CFO): 
 
 Email attachment reads as follows (extract from report by JIT 
External Consultants Ltd): 
Introducing JIT in your company: 
We have lots of experience in introducing Just-In-Time (JIT) measures 
in businesses similar to X Ltd. 
It is our view that many of X Ltd competitors have already introduced 
this type of JIT measures. We are certain that in order to remain 
competitive and achieve concrete cost savings, X Ltd should 
implement JIT measures as a matter of urgency.

76 
Answers to examples and objective test questions 
 The correct answer is C. 
Re-inspecting previously faulty goods incurs internal failure costs , 
occurring prior to delivery of the product to the customer. These are non-
conformance costs. Likewise, scrap co sts are internal failure costs of 
non-conformance. 
Costs of calibrating testing equipment are associated with measuring 
products/services to assure conformance to quality standards. These are appraisal costs. Likewise, costs of inspecting incoming material will be classified as appraisal costs. 
The costs of conducting supplier capability surveys are prevention costs, 
incurred to prevent poor quality in products or services. 
 
 The correct answer is D. 
A customer service team deals with customer queries and complaints 
from outside the organisation, typically after goods have been delivered to the customer. The costs of this team arise from quality failures and are preventable. They are external failure costs. Maintenance is intended to prevent machine breakdowns and so to prevent quality failures, and they are therefore prevention costs. Test equipment is used for inspection/appraisal. 
 
 Return per factory hour = ($85 – $42.50)/1.5 hours = $28.33 
Cost per factory hour = $8,000/(10 × 40 hours) = $20  
TPAR = $28.33/$20 = 1.4165

Chapter 2 
 77 
 The answer is B, Continuous Improvement. 
Kaizen Costing is one of two approaches of Continuous Improvement; 
(target costing being the other). 
Kaizen is the Japanese term for making improvements to a process 
through small incremental amounts, rather than through large innovations. Kaizen costing is applied during the manufacturing stage of the product's life cycle. This focuses on achieving cost reductions through the increased efficiency of the production process. Improvement is the aim and responsibility of every worker in every activity, at all times. 
Through continual efforts significant reductions in cost can be achieved 
over time. In order to encourage continual cost reductions an annual (or monthly) Kaizen cost goal is established. Actual results are then compared with the Kaizen goal and then the current actual cost becomes the base line for setting the new Kaizen goal the following year. 
 
 • Kaizen focuses on eliminating waste, improving processes and 
systems and improving productivity. TRUE  
problems. FALSE : one characteristic of Kaizen is that it involves all 
employees and all areas of the business. 
improvement. TRUE  
• The aim of Kaizen costing is to achieve cost reduction targets. 
TRUE  
 
 • BPR achieves incremental improvements in performance. FALSE  
• BPR increases the org anisation’s ability to meet customers’ needs. 
TRUE  
• BPR uses technology to find innovative ways to do business. TRUE  
decoupled. FALSE  
• BPR can be used as a pretext for staff reductions and as a ‘quick 
fix. TRUE

78 
 Example 7: Value-adding and non-value adding activities 
 
Reporting Non-value 
adding activity   
Assembly Value adding 
activity   
Design engineering Value adding 
activity   
Transferring materials between two non-adjacent workstations Non-value 
adding activity  
Value  
adding 
activity 
Inspecting parts for quality defects Non-value 
 
Processing returned materials Non-value 
adding activity  Non-value 
adding 
activity 
Project coordination Non-value 
Obtaining approvals Non-value 
Painting Value adding 
activity

Chapter 2 
 79 
 Objective Test Question 1: Just-in-Time 
 Answer D. An increase in quality standards is one of the key factors that 
allows the other items listed to be reduced. 
 
 (a) Prevention costs 
(b) External failure costs 
(c) Appraisal costs (d) Internal failure costs
 
 In a company operating on JIT principles, the absence of inventories 
deprives production of a safety net or 'buffer inventory' . This exposes 
the business to production problems or delays  and, ultimately, to lost 
sales and damaged customer goodwill . 
In this context, the adoption of a TQM (Total Quality Management)  
philosophy is key. In this, quality  is a feature rooted in the production 
process and every individual is responsible for the quality of his/her 
output . 
This will encourage good quality at all times and therefore minimise production problems  that would otherwise occur due to poor quality . 
 
 Objective Test Question 4: BPR II 
 • BPR is often used as the pretext for staff reductions TRUE  
• BPR is a long term approach to gaining a competitive advantage. 
FALSE  
• BPR overlooks the impact on human resources TRUE  
• BPR increases organisational complexity FALSE  
developing new and better lines of business TRUE

80 
  
The TPAR (throughput accounting ratio) for Product X 2.4 
  
The TPAR (throughput accounting ratio) for Product Y 3.2 
  
The TPAR (throughput accounting ratio) for Product Z 0.80 
  
The maximum profit achievable by BJS, in $ (this involves 
a calculation of the optimum product mix). 200,000 
  
 Cost per factory hour = $100,000/80,000 = $1.25 
 
 Product  
X Product 
Y Product 
Z 
Direct material cost per unit ($3) ($10) ($7) 
 ––– ––– ––– 
Throughput p.u. $9 $6 $7 
Time required on the bottleneck 3 1.5 7 
Return per factory hour $3 $4 $1 
T. A. ratio $3/$1.25 $4/$1.25 $1/$1.25 
 = 2.4 : 1 = 3.2 : 1 = 0.80 
 2nd 1st 3rd 
Ranking 
 
Product Number 
of units Hours 
throughput 
Y 40,000 1.5 60,000 $4 $240,000 
X 6,666 3.0 20,000 $3 $59,994 
   80,000  $299,994 
Less total factory costs   ($100,000) 
Total profit   $199,994

Chapter 2 
 81 
 To: Charles Fern Oxley, X Ltd 
Date: 04 June 
Subject:  Successful implementation of JIT 
The following report includes some calculations on JIT-related savings 
we can expect in X Ltd. It also explains some of the conditions that are necessary for the successful implementation of a JIT manufacturing system within X Ltd. 
Savings: 
  Original budget
  JIT  
 $000  $000   $000  
Set-ups 42,660     
$13,000 × 3,500  45,500 
–––––––  88,160  –30%  61,712  
Materials handling 52,890     
$4,000 × 14,600 58,400 
–––––––  111,290  –30%  77,903  
Inspection 59,880     
$18,000 × 3,500 63,000 
–––––––  122,880  –30%  86,016  
Machining 144,540     
$40 × 4,560,000 182,400 
–––––––  326,940  –15%  277,899  
Distribution & 
warehousing 42,900     
$3,000 × 14,600 43,800 
–––––––  86,700 
–––––––  – 
–––––– 
  735,970   503,530

82 
     
Direct material  $000   
($2,520 × 75,000) +  705,300 705,300 
($2,924 × 75,000)    
($3,960 × 75,000) +    
[189,000 + 219,300 +    
297,000]    
Direct labour     
($1,120 × 75,000) + 329,400  395,280 
($1,292 × 75,000)    
($1,980 × 75,000) +    
[84,000 + 96,900 +    
148,500]    
Total costs –––––––– 
1,770,670 
––––––––  –––––––– 
1,604,110 
–––––––– 
  $166,560  
–––––––   
Conditions that are necessary for the successful implementation of a JIT 
manufacturing system within X Ltd include: 
Supplier relationships 
JIT systems require a huge reduction in inventory levels. In order to 
facilitate this, inventory order sizes mu st be small. Hence suppliers must 
be capable of AND willing to deliver small quantities on a regular basis. X Ltd will need to have a good relationship with its accredited suppliers. 
JIT systems aim to eliminate raw material inventories. In order to do this, 
suppliers must be capable of achieving all aspects of quality – delivering the correct quantity to the correct location at the correct time. Ideally suppliers should also deliver defect-free items. 
Quality issues 
For JIT to be effective achieving the highest possible levels of quality is 
essential. Production scheduling becomes demand-based and in order to meet customers’ requirements quality problems need to be eliminated. It is often necessary to implement a quality programme such as Total Quality Management. The aim is to prevent the problems in the first place. 
Quality should be considered from several angles:  From suppliers – as mentioned above. In machinery – equipment should be well-maintained to avoid breakdown 
and the manufacture of sub-standard output. 
In staff – all staff should be appropriately trained and skilled to carry out 
the task required of them.

Chapter 2 
 83 
 Education and training 
JIT will only be successful if our employees are willing to make it so. All 
levels of staff throughout the organisation should be appropriately trained and educated as to the objectives of the new system and the benefits that it will bring to X Ltd. 
Work scheduling 
Cellular manufacturing or group technology brings great benefits for JIT 
companies. This is where whole products are made within each manufacturing cell. X Ltd appears to have this system already as each 
car has its own production line. 
Information systems 
The new management systems that will be put in place will require new 
information systems. There will be major changes in the communication line with suppliers and the work scheduling system may need redeveloping in order to cope with the new pull-system. 
Financing 
Appropriate funds must be available to finance the development and 
implementation of JIT. Without sufficient funding JIT will fail. 
In order to move forward with the JIT proposal we should investigate 
which of the conditions can be met. 
Should you require any further advice, then please do not hesitate to 
contact me. 
AN Accountant 
Management Accountant X Ltd E: mact@xltd.co.uk 
T:0161 233 3434

85 
Costing Techniques 
A3: Managing the costs of 
creating value Apply value management 
techniques to manage costs and improve value creation 
(a) Target costing (b) Value chain analysis (c) Life Cycle costing 
 
  Chapter 
3

86 
 
You will already have covered some of th ese concepts in P1. We will build on 
this knowledge in P2 with more aspects of some key costing techniques, but 
make sure you are comfortable with the assumed knowledge, that should have been brought forward as a base, in the following sections. 
3  Background 
Because traditional overhead absorption was designed for production companies, it dealt with production costs only and, as a consequence, it is less suitable for service or retail organisations. Also, because inventory had to be valued at full production cost only in the published accounts, other costs such as R&D, administration, and marketing have not been related to products. 
When traditio nal absorption costing evolved last century, overheads were 
only a small part, say, 10 per cent of the cost of production for the average 
company. Direct labour costs were much higher, say, 50 per cent of the cost of the product. This meant that the absorption method spread 10 per cent of 
costs on the basis of 50 per cent of costs. Because overheads were such a 
small part of total costs any inaccuracies in the absorption process were small and insignificant and did not distort product costs. 
A few organisations may have this cost structure today, and in such cases 
traditional absorption costing is perfectly adequate. Most companies, however, now have those percentages reversed and it creates a considerable degree of inaccuracy if 50 per cent of the costs are spread on the behaviour of 10 per cent of the costs. Yet it is vital that an organisation’s costing system spreads overheads accurately. 
Traditional absorption costing was not designed to make decisions of a short-
term nature, and can never be used for this purpose. Marginal costing (variable costing) should be used when short-term decisions on matters such as product/service profitability are required. But if long-term decisions need to be made, an absorption costing system is needed. The system must be accurate and for all the reasons outlined above, total absorption costing is unlikely to produce the required accuracy; alternative costing techniques are needed.

Chapter 3 
 87 
4  Target costing 
Target costing is driven by external market factors. Marketing managers first 
estimate the performance characteristics and market price requirements in order to achieve a desired market share for a proposed product. A standard profit margin is then subtracted from the projected selling price to arrive at the target cost for the product. The product development team must then, through its product and process design decisions, attempt to reach the product’s target cost. 
One of the definitions of target costing reads as follows: 
Target costing is a pro-active cost control system. The target cost is 
calculated by deducting the target profit from a pre-determined selling price 
based on customers' views. Functional Analysis, value analysis and value 
engineering are used to change production methods and/or reduce expected 
costs so the target is met. 
The target profit requirement should be driven by strategic profit planning 
rather than a standard mark-up. In Japan this is done after consideration of the medium-term profit plans which reflect management and business 
strategies over that period. Once it is set, the target profit is not just an 
expectation; it is a commitment agreed by all the people who have any part in achieving it. Therefore the procedures used to derive the target profit must be scientific, rational and agreed by all staff responsible for achieving it; otherwise no-one will accept responsibility for achieving it. 
This procedure is just the opposite of that followed by many companies today 
in which the product is designed with little regard either to the manufacturing process or to its long-run manufacturing cost. With this traditional procedure of first designing the product and then giving the design to process engineers and costs analysts, the product cost is developed by applying standard cost factors to the materials and processes specified for the design. Frequently, this cost may be well above that which can be sustained by market prices and the product is either aborted or, if marketed, fails to achieve desired profitability levels. 
Using target cost in the concept and design stages  
With the target-cost approach, the new product team, consisting of product 
designers, purchasing specialists, and manufacturing and process people, works together to jointly determine product and process characteristics that permit the target cost to be achieved. The target cost approach is especially powerful to apply at the design stage, since decisions made at this stage have leverage to affect long-run costs. 
The great majority of manufacturing costs become locked in early in the life 
cycle of the product. Once the product is released into production, it becomes much harder to achieve significant cost reductions. Most of the costs become committed or locked in much earlier than the time at which the major cash expenditures are made.

88 
The target-costing approach is a vital total cost control tool because research 
has shown that up to 90 per cent of costs are ‘built in’ at the product’s design stage. Below are some examples of costs that become locked in place at the design stage: 
• The design specification of the product including extra features • The number of components incorporated in the product 
• Design of components 
These should be designed for reliability in use and ease of 
manufacture. Wherever possible standard parts should be used because they are proven to be reliable and will help reduce inventory and handling costs. Where new components are required it is important that their manufacturing process is considered before the component is finally designed so that they can be manufactured as cheaply as possible consistent with quality and functionality. 
• Type of packaging required 
This includes product packaging and packing per case and per pallet. The aim is to protect the product and to minimise handling costs by not breaking pallets or cases during distribution. 
• The number of spare parts that need to be carried 
This ties in with the number of components used. Parts must sometimes be held for up to 15 years or so. They may be made while the product is still in production and st ored for years, which is costly. 
The alternative is to disrupt current production to make a small batch of a past component, which is very costly. 
Target costing is an iterative process that cannot be de-coupled from design. The pre-production stages can be categorised in a variety of different ways; in the detailed discussion below five different stages are used and the different activities are now listed. 
1 Planning  
This includes fixing the product concept and the primary specifications 
for performance and design. A very brief product concept might be a small, town car for two people with a large amount of easily-accessible luggage space and low fuel consumption – aimed at those in their mid-twenties and so style is important. (In reality the concept would be much fuller.) Value engineering and analysis (VE) could be used to identify new and innovative, yet cost-effective, product features that would be valued by customers and meet their requirements. 
Once the concept has been developed a planned sales volume and 
selling price, which depend on each other, will be set, as well as the required profit discussed earlier. From this the necessary target cost (or allowable cost as it is often known) can be ascertained. 
Target cost = Planned selling price – Required profit

Chapter 3 
 89 
 Example 1: Target Costing 
 A company requires a return of 12% in the coming year on its 
investment of $1,000,000 in product J. The selling price of product J is 
set at $52.00 for each unit, and sales for the coming year are expected to reach 5,000 units. What is the target cost for each unit for the coming year? 
A $24 B $28 C $44 D $50 
 
2 Concept design  
The basic product is designed. The target cost is now divided into 
smaller parts reflecting the manufacturing process - see diagram below. First an allowance for development costs and manufacturing equipment costs are deducted from the total. The remainder is then split up into unit costs that will cover manufacturing and distribution, etc. The manufacturing target cost per unit is assigned to the functional areas of the new product. For example, a functional area for a ballpoint pen might be the flow of ink to the tip and a functional area for a car might be the steering mechanism. 
The breakdown of target cost

90 
3 Basic design  
The components are designed in detail so that they do not exceed the 
functional target costs. Value engineering is used to get the costs down to the target. If one function cannot meet its target, the targets for the others must be reduced or the product redesigned. 
4 Detailed design 
The detailed specifications and cost estimates are set down from the 
basic design stage. 
5 Manufacturing preparation  
The manufacturing process, including new machines, is designed in keeping with the target cost. Standards for the materials and labour hours that should be used are set. These values are presented to the staff in the factory immediately after they are set so that approval can be given. 
The purchasing department negotiates prices for bought-in 
components. 
 
Example 2: Target Costing and the cost gap 
 The predicted selling price for a product has been set at $56 per unit. 
The desired mark-up on cost is 25% and the material cost for the product is estimated to be $16 before allowing for additional materials to allow for shrinkage of 20% (for every 10 kg of material going in, only 8 kg comes out).   
Labour is the only other cost, and 2 labour hours are needed. What is the most the business can pay per hour if a cost gap is to 
be avoided? $_______________ 
Target costing for existing products 
Cost control is not forgotten once the product goes into production. 
Manufacturing performance is measured to see if the target is being achieved. The reasons for doing this are: 
1 to see who is responsible for any cost excess and to offer them help; 
and 
2 to judge whether the cost-planning activities were effective. If after three months the target cost is missed by a large margin an 
improvement team is organised which will conduct a thorough value analysis (VA) and will stay in existence for about six months.

Chapter 3 
 91 
Although the Japanese use standard costing to some extent they do not 
consider it to be suitable for ongoing cost control. They see standard costing as part of budget accounting where the same value is maintained throughout the budget period, whereas they use target costing to control production cost and as a consequence revise it monthly. Monden (1989) expressed the limitations of standard costing this way: 
‘Since standard costing systems have constraints from a financial 
perspective, they are inappropriate measures for management. A typical constraint is the infrequency in which quantity standards, such as processing time per production unit or material requirements, are revised. 
Normally these standards are maintained at the same level throughout the 
year.’ 
Target costing, therefore, continues to be used to control costs throughout 
the product’s life. After the initial start-up stage target costs will be set through budgets, which in Japan tend to be set every six months rather than yearly. This type of target costing is a different technique in the eyes of the Japanese and they call this Genka Kaizen. It is widely used in Japan; about 80 per cent of assembly environments use it. If a manager cannot meet the target cost for a function, a committee will be set up to help achieve it. All costs including both variable and fixed overheads are expected to reduce on a regular basis, usually monthly. 
Target costing is widely used among industries in different countries. 
Mercedes, Toyota, Nissan, and Daihatsu in the car industry, Matsushita, Panasonic and Sharp in the electronics industry, and Apple, Compaq and Toshiba in the personal computer market all use target pricing and target costing. 
 
Example 3: Reducing the cost gap 
 Which of the following would be a legitimate strategy to reduce a 
cost gap for a product that existed  in a competitive industry with 
demanding shareholders? 
A Increasing the selling price B Reducing the expectation gap by reducing the selling price 
C Reducing the desired margin on the product D Mechanising production in order to reduce average production 
cost

92 
The impact of technology to reduce costs 
 Technology eliminating costs as a barrier to entry: The CGMA 
Cost Transformation Model 
 Technology is eliminating cost as a barrier to entry. Fixed costs of 
production are now becoming less costly. For example: 
• Computer aided design (CAD) software has become a 
commodity, with some basic versions free to download. 
• 3D printing is making the printing of components that previously 
needed costly machining processes. 
• Digital technology has made it technically possible produce a film 
at a fraction of the fixed cost that used to be needed. 
Uber 
In some disruptive business models variable costs are significantly 
reducing. An example of this is transport company Uber. After setting up a web based platform (its primary fixed cost) all that remains to grow its business is for operators (individuals or fleet operators) to sign up to the Uber platform at very low marginal cost to Uber. 
With rapid and ongoing improvements in communications and logistics 
competitors can be anywhere. Increasingly, producers are having to change the way they do business to maintain competitiveness. The supply chains of the largest businesses have become global to take advantage of lower cost centres and the ready availability of high calibre people globally. Components of business models retained as core competencies have to be continuously improved to generate value on a sustainable basis. 
Tata  
‘‘After 2008, we were feeling the effects of an economic climate where 
a strong pound was making imports cheaper than locally produced goods and impacting our sales volumes. The steel industry is fixed cost intensive and reducing our variable costs would not have a significant enough impact. Our challenge was to find a way to re-structure our fixed costs base and differentiate our sales.” 
Claire Osmundsen-Little, ACMA, CGMA, Finance Controller, 
Packaging, 
Tata Steel Europe

Chapter 3 
 93 
 
Standard costing Target costing 
A Push  system: a standard cost 
per unit (onto which a mark-up is 
added) is the basis for calculating the selling price. A Pull system that requires 
understanding of market demand and competition, so that the price required to achieve a target market share or sales level can be set. 
An Internal  tool in mass production 
environments that do not emphasise continual improvement. Driven by External  market prices and 
may not be attainable in the short term. 
A Cost control  technique. A Cost reduction  activity. 
A Reactive  technique – the selling 
price of a new product will be determined by estimating its standard cost and adding the required profit margin to the cost. A Proactive  technique that starts 
before the design of the product is formalised. Once this target price has been determined, a required long-term profit margin is agreed. It is only once the target cost has been agreed that the design team can begin their work. Our products must be designed with a pre-determined cost ceiling. 
 
 Target costs and standard costs 
 There are some similarities between target costs and standard costs 
but the significance of a target cost lies in the process of how it is developed. They both provide unit cost targets but here the similarity ends and significant differences include: 
• The focus upon what a product should cost in the long term. In 
constructing the target cost of a new item consideration should 
first be given to the price at which the product should be sold in order to attract the desired market share. Once this selling price has been determined the required profit margin needs to be deducted in order to arrive at the target cost. A standard cost would tend to be based on attainable standards of efficiency whereas a target cost may incorporate a cost gap which can only be achieved over a longer term. 
• A market orientated approach. The use of standard costs which 
have been derived from target costs ensures that external factors that are related to the marketplace are taken into account. A standard cost is usually based on production cost information only.

94 
 • Focus on continual improvement. The target cost may incorporate 
a series of cost targets which are continuously reduced until the 
target is achieved. A standard is normally set at the outset of production and may not be reviewed on a regular basis. 
• Team approach. Target costing requires that all departments 
working on the product should be involved in the target costing exercise and should contribute to the target cost being achieved. This includes research and development, marketing and sales as well as production. This contrasts with standard costs which are normally production costs only. 
• A target cost will be set before major development costs are 
incurred. This allows cost reductions to be designed into the product or a decision to be made to abandon the product if the required cost target cannot be achieved. In contrast, standards are set when production commences, by which time 70% to 80% of costs may already be committed. 
 
 Kaizen costing and Target costing  
 Kaizen  is the Japanese term for making improvements to a process 
through small incremental amounts, rather than through large innovations. 
Target costing is aimed at reducing the costs incurred because of the 
way the product is designed, and occurs at the very start of the process. 
Kaizen costing is applied during the manufacturing stage of the 
products life cycle. Kaizen costing therefore focuses on achieving cost reductions through the increased efficiency of the production process. Improvement is the aim and respons ibility of every worker in every 
activity, at all times. Through continual efforts significant reductions in cost can be achieved over time. In order to encourage continual cost reductions an annual (or monthly) Kaizen cost goal is established. 
Actual results are then compared with the Kaizen goal and then the 
current actual cost becomes the base line for setting the new Kaizen goal the following year. It should be noted however that as the products are already at the production stage the cost savings under Kaizen costing are smaller than target costing. Because cost reductions under target costing are achieved at the design stage where 80–90% of the product costs are locked in, more significant savings can be made.

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5  Value analysis/Value engineering 
Value analysis (value engineering) helps to design products that meet 
customer needs at a lower cost, while assuming the required standard of quality and reliability.  
Value analysis  relates to existing products. Value engineering  relates to 
products that have not yet been produced.  
CIMA's Official Terminology  definitions read as follows: 
Value analysis is 'the systematic interdisciplinary examination of factors 
affecting the cost of a product or service, in order to devise means of 
achieving the specified purpose most economically at the required standard 
of quality and reliability'. 
 
Value engineering is 'the (re)design of an activity, product or service so that 
value to the customer is enhanced while costs are reduced or at least 
increased by less than the resulting price increase). 
Value analysis/engineering focuses on activities that add value to the 
product/service as perceived to the customer . It examines business 
activities, and questions why they are being undertaken, and what contribution they make to customer satisfaction: 
• What do customers want? 
• What do customers regard as significant in the buying function: 
function, appearance, longevity or disposal value? 
The purpose of value analysis is to identify any unnecessary cost elements 
within the components of goods and services. It is more comprehensive than simple cost reduction, because it examines the purposes or functions of the product and is concerned with establishing the means whereby these are achieved. Any cost data that do not add value to the product or service should be eliminated. 
Types of value 
Cost value:  this is the cost incurred by the firm producing the product. 
Exchange value:  the amount of money that  consumers are willing to 
exchange to obtain ownership of the product, i.e. its price. 
Use value:  this is related entirely to function, i.e. the ability of a product to 
perform its specific intended purpose. A basic small car provides personal 
transport at a competitive price and is reasonably economic to run.

96 
Esteem value:  this relates to the status or regard associated with ownership. 
Products with high esteem value will often be associated with premium or 
even price-skimming prices. 
Value is a function of both use and esteem. Value analysis aims to maintain 
the esteem value in a product, but at a reduced cost value. The result of value analysis is to achieve an improved value/cost relationship. 
Method of value analysis 
• Determine the function of the product and each component that is used 
within the product. 
• Determine the existing costs associated with individual components. 
• Develop alternative solutions to the needs met by the components. This 
may involve design changes, manufacturing method, materials used, 
etc. 
• When analysing a co mponents a ques tioning attitude should be 
adopted. Some of these points may be considered: 
–  How does this component contribute to the value of the product?  –  How much does it cost? –  Are all its features and specifications absolutely necessary?  –  Is there another similar part that may be used? –  Can an alternative part be used? –  Will an alternative design perform the same function? 
• Evaluate the alternatives and their anticipated effect. 
• Implement the recommendations. 
A key aspect of this is to understand which features of the product are 
essential to customer perceived quality, and which are not. This process is known as ‘value analysis’. Attention should be focused more on reducing the costs of features perceived by the customer not to add value. So, value analysis will often lead to the reduction of components used in a product, the use of alternative, cheaper components and the standardisation of parts across several product lines. (Value-adding activities and non-value adding activities were discussed in the previous chapter.)

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6  Functional analysis 
Functional analysis  is defined in CIMA's Official Terminology as an analysis 
of the relationships between product functions, their perceived value to the 
customer and their cost of provision. 
Functional analysis uses the functions of a product as the cost object and is 
used either in initial designs or in the review of existing products. It can be 
extended to services, overhead expenses, and organisation structure and even to the overall strategy of the company.
 
The central theme of functional analysis is, like value analysis, customer focus. An important aspect when gathering information is to identify the functions of the product that customers’ value and identify alternative ways of achieving these functions.  
So, for example, a newsletter sent out by an accounting company may have 
the functions of advertising services, keeping clients up to date with new developments, providing details of social events and networking opportunities. There may be many ways of achieving these functions, e.g. by sending out letters, by sending emails or by posting information on a website. Analysis will be carried out to find out which alternative achieves the required function at the least cost. 
Once an alternative has been chosen, it must be implemented. Then, 
performance is measured to assess the degree to which the objective has been achieved. Lessons may be learned to help in future functional analyses. 
 
Functional analysis 
 In functional analysis, the company will first break down the product 
into its many functions. For example, a mobile phone may offer an 
MP3 player, a voice-recording feature, a camera and an internet browser in addition to the ability to make and receive calls and texts. 
Research is also carried out to identify the importance the customer 
attaches to each feature. This information may be obtained from a mixture of past purchasing patterns and customer interviews and questionnaires. Research will also be carried out into the amount the customer would be willing to pay for the final product – this can be used to find the overall target cost for the product by deducting an appropriate profit margin. 
The company will then calculate the target cost of providing each of 
these functions. This is calculated as a percentage of the overall target cost based on the relative importance of each feature to the customer. 
The next step will be to compare the expected cost to provide each 
function with the target cost. If the expected cost of the function exceeds the target (i.e. has a value ratio of less than one) then the function should be either modified, re-evaluated and an alternative found, or eliminated.

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7  The value chain 
The value chain is a linked set of value-creating activities starting from basic 
raw material sources or component suppliers through to the ultimate end-use product or service delivered to the customer. Co-ordinating the individual parts of the value chain together creates conditions to improve customer satisfaction, particularly in terms of cost efficiency, quality and delivery. A firm which performs the value chain activities more efficiently, and at a lower cost, than its competitors will gain competitive advantage. 
The value chain was designed by Professor Michael Porter of the Harvard 
Business School (1985). 
Porter’s value chain 
 
It is necessary to understand how value chain activities are performed and 
how they interact with each other. The activities are not just a collection of independent activities but a system of interdependent activities in which the performance of one activity affects the performance of other activities. 
The activities which comprise the value chain are as follows:  
These are the activities which involve the physical movement of raw 
materials and finished products, production of goods and services, marketing sales and subsequent services to outputs of a business unit. 
1 Inbound logistics – which entail receiving, storing, materials handling, 
warehousing, inventory control, vehicle scheduling, returns to suppliers. 
2 Operations – which entail transferring inputs into final product form 
(e.g. machining, packaging, assembly, equipment maintenance, testing, 
printing and facility operations).

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3 Outbound logistics – which entail distributing the finished product 
(e.g. finished goods warehousing, material handling, operation of 
delivery vehicles, order processing and scheduling). 
4 Marketing and sales – which entail inducing and facilitating buyers to 
purchase the product (e.g. advertising, activities of sales personnel, preparation of quotations, channel selection, channel relations, pricing of goods and services). 
5 Service – which entails maintaining or enhancing the value of the 
product after the sale has taken place (installation, commissioning, repair, training, parts supply and product adjustment). 
Support activities are those activities that provide support to the primary 
activities, and also to each other. 
1 Procurement – which entails purchasing of raw materials, consumable 
items and capital items. 
2 Technology development – which entails the use of know-how, 
procedures to be applied and the technological inputs required in every 
activity which forms part of the value chain. 
3 Human resource management – which entails the selection, retention 
and promotion of staff, the appraisal of staff and performance-rewards linkage, management development and employee relations. 
4 Firm infrastructure – which entails general management, accounting 
and finance, quality management and planning activities. 
Each activity within the value chain provides inputs, which after processing constitute added value to the output, which the customer ultimately receives in the form of a product or service or as the aggregate of values at the end of the value chain. 
Each primary and support activity has the potential to contribute to the 
competitive advantage of the business unit by enabling it to produce, market and deliver products or services which meet or surpass the value expectations of purchasers in comparison with those resulting from other value chains. 
Focusing on each of the nine activities enables management to see how 
each creates value that may be understood as the difference between cost and revenue. 
According to Porter, an organisation can develop sustainable competitive 
advantage by following one of two strategies: 
1 Low-cost strategy . Essentially this is a strategy of cost leadership, 
which involves achieving a lower cost than competitors via, for example, 
economies of scale and tight cost control. 
2 Differentiation strategy. This involves creating something that 
customers perceive as being unique via brand loyalty, superior customer service, product design and features.

100  
Shank and Govindarajan (1993) advocate that a company should evaluate its 
value chain relative to the value chains of its competitors or the industry. They suggest the following methodology: 
1 Identify the industry’s value chain and then assign costs, revenues and 
assets to the value acti vities. These activities are the building blocks with 
which firms in the industry created a product that buyers find valuable. 
2 Diagnose the cost drivers regulating each value activity. 3 Develop sustainable cost advantage, either through controlling cost 
drivers better than competitors or by reconfiguring the chain value. By 
systematically analysing costs, revenues and assets in each activity, a firm can achieve low cost. This is achieved by comparing the firm’s value chain with the value chains of a few major competitors, and identifying actions needed to manage the firm’s value chain better than competitors manage their value chains. 
 
Example 4: The Value chain 
 Which of the following is not considered a primary activity in the value 
chain developed by Michael Porter? Select ALL that apply: 
• Sales • Operations 
• Outbound logistics 
• Procurement 
• Inbound logistics 
• Human resources management 
• Firm infrastructure management 
• Technology development
 
8  Life-cycle costing 
Life-cycle costing is the accumulation of costs for activities that occur over 
the entire life cycle of a product, from inception to abandonment. 
According to Berliner and Brimson (1988), companies operating in an 
advanced manufacturing environment are finding that about 90% of a product’s life-cycle cost is determined by decisions made early in the cycle. In many industries a large fraction of the life-cycle costs consists of costs incurred on product design, prototyping, programming, process design and equipment acquisition. This has created a need to ensure that the tightest controls are at the design stage, because most costs are committed or ‘locked-in’ at this point in time. Management accounting systems should therefore be developed that aid the planning and control of product life-cycle costs and monitor spending and commitments at the early stages of a product’s life-cycle.

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Product life-cycle costing 
There are a number of factors that need to be managed in order to maximise 
a product’s return over its life cycle. These are: 
• design costs out of the product 
• minimise the time to market 
• maximise the length of the life cycle itself.  
These factors will be considered in turn. 
Design costs out of the product  
It was stated earlier that between 80% and 90% of a product’s costs were 
often incurred at the design and development stages of its life. That is decisions made then committed the organisation to incurring the costs at a later date, because the design of the product determines the number of components, the production method, etc. It is absolutely vital therefore that design teams do not work in isolation, but as part of a cross-functional team in order to minimise costs over the whole life cycle. 
Minimise the time to market 
In a world where competitors watch each other keenly to see what new 
products will be launched, it is vita l to get any new product into the 
marketplace as quickly as possible. The competitors will monitor each other closely so that they can launch rival products as soon as possible in order to maintain profitability. It is vital, therefor e, for the first organisation to launch its 
product as quickly as possible after the concept has been developed, so that it has as long as possible to establish the product in the market and to make a profit before competition increases. Often it is not so much costs that reduce profits as time wasted. 
Maximise the length of the life cycle itself  
Generally the longer the life cycle the gr eater the profit that will be generated, 
assuming that production ceases onc e the product goes into decline and 
becomes unprofitable. One way to maximise the life cycle is to get the 
product to market as quickly as possible because this should maximise the time in which the product generates a profit. Another way of extending a product’s life is to find other uses, or markets, for the product. Other product uses may not be obvious when the product is still in its planning stage and need to be planned and managed later on. On the other hand, it may be possible to plan for a staggered entry into different markets at the planning stage.

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Many organisations stagger the launch of their products in different world 
markets in order to reduce costs, increase revenue and prolong the overall life of the product. A current example is the way in which new films are released in the USA months before the UK launch. This is done to build up the enthusiasm for the film and to increase revenues overall. Other companies may not have the funds to launch worldwide at the same moment and may be forced to stagger it. 
Skimming the market is another way to prolong life and to maximise the 
revenue over the product’s life. This was discussed in the unit on pricing. 
 
Example 5: Life cycle costing 
 The following statements have been made about the benefits of 
lifecycle costing. Select ALL that apply: 
• Its use may assist management in allocating resources to non-
production activities. 
• A company is in a strong position if all its products are at the 
same phase of the life cycle. 
• Planning and design costs are not included when calculating the 
life cycle costs of a product. 
• Lower costs can be achieved earlier by designing out costs. 
 
 Customer life cycle costing 
 Not all investment decisions involve large initial capital outflows or the 
purchase of physical assets. The decision to serve and retain 
customers can also be a capital budgeting decision even though the initial outlay may be small. For example a credit card company or an insurance company will have to choose which customers they take on and then register them on the company’s records. The company incurs initial costs due to the paperwork, checking creditworthiness, opening policies, etc. for new customers. It takes some time before these initial 
costs are recouped. Research has also shown that the longer a customer stays with the company the more profitable that customer becomes to the company. 
Thus it becomes important to retain customers, whether by good 
service, discounts, other benefits, etc. A customer’s ‘life’ can be discounted and decisions made as to the value of, say, a ‘five-year-old’ customer. Eventually a point arises where profit no longer continues to grow; this plateau is reached between about five years and 20 years depending on the nature of the business. Therefore by studying the increased revenue and decreased costs generated by an ‘old’ customer, management can find strategies to meet their needs better and to retain them.

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 Many manufacturing companies only supply a small number of 
customers, say between six and ten, and so they can cost customers 
relatively easily. Other companies such as banks and supermarkets have many customers and cannot easily analyse every single customer. In this case similar customers are grouped together to form category types and these can then be analysed in terms of profitability. 
For example, the UK banks analyse customers in terms of fruits, such 
as oranges, lemons, plums, etc. Customers tend to move from one category to another as they age and as their financial habits change. Customers with large mortgages, for example, are more valuable to the bank than customers who do not have a large income and do not borrow money. Banks are not keen on keeping the latter type of customer. 
 
 The life cycle cost budget  
 The application of life cycle costing requires the establishment of a life 
cycle cost budget for a given product which in turn necessitates identification of costs with particular products. Actual costs incurred in respect of the product are then monitored against life cycle budget costs. 
A company is in a weak position if all its products are at the same 
phase of the life cycle. If they are all in the growth phase there are problems ahead; if they are all in one of the other phases there are immediate difficulties. 
Companies try to overcome this problem by introducing new products 
that are growing as the old products are declining and by having products with life cycles of different lengths. 
In applying life cycle costing a supplier will recognise that the life of the 
product commences prior to its introduction to the marketplace. Indeed up to 90% of costs result from decisions made prior to its ‘launch’ concerning issues such as functions, materials, components and manufacturing methods to be adopted. 
Life cycle costs may be classified as follows: 
• development costs 
• design costs 
• manufacturing costs 
• marketing costs, and 
• distribution costs.

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 A pattern of costs will emerge over the life cycle of the product. 
Invariably the absolute level of cost s will rise and this trend should 
'track' the pattern of sales of the product. The supplier will always be 
monitoring relevant costs and revenues in an attempt to ensure that the rise in resultant sales revenues is greater than the rise in the attributable costs of the product. 
Moreover, the supplier will expect reductions to occur in the unit cost of 
a product as a consequence of economies of scale and learning and experience curves. In order to maximise the profits earned by a product over its life cycle management need to give consideration to minimising the time required to get the product to the marketplace. This may enable an organisation to 'steal a march' on its competitors who will invariably attempt to launch a rival product at the earliest available opportunity. Hence ‘time to market’ assumes critical significance since it affords an organisation that is first to the marketplace with an opportunity to make profits prior to arrival of competitor products. 
Once the product has reached the marketplace management attention 
should be focused upon maximising the length of the product’s life cycle. In this regard ‘time to market’ is also critical since by definition the earlier a product reaches the marketplace the longer will be its resultant life cycle. 
Management should always be searching for other potential uses of 
the product and/or finding alternative markets for the product. Whilst it may be difficult to envisage other potential uses for product at the planning stage it may be possible for an organisation to draw up a plan which involves the staggered entry of the product into geographically separate markets with the resultant effect of increasing the overall life cycle of the product. A major benefit of this staggered approach which is often adopted by global players lies in the fact that the income streams from one market may be used to fund the launch of the product into another market. 
The application of life cycle costing requires management to consider 
whether the anticipated cost savings that were expected to be achieved via the application of cost reduction techniques, both prior to and following the product’s introduction, have actually been achieved. Its use may also assist management in allocating resources to non-production activities. For example, a product which is in the mature stage may require less marketing support than a product which is in the growth stage.

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 Asset lifecycle costing (The CGMA Cost Management Model)  
 For the user of an asset, the initial purchase price may only be part of 
the ownership cost. Other costs of operating the asset over its life may 
even dwarf the initial purchase price. These could include: maintenance; repair; downtime; energy consumption; consumables consumption; and environmental costs – such as emissions treatment, or compliant or safe material storage or disposal. 
The management accountant should ensure they are aware of all the 
costs associated with safe and compliant acquisition, operation, asset disposal and associated processes – and incorporate these factors 
into the buying decision-making. Since ownership costs can vary 
between rival products at different stages of asset lives, the total ownership costs should be compared on a discounted cash flow basis
. 
Actions to take/Do’s 
Involve people from all relevant functions in product development 
decision making.  
• Encourage a whole-life produc t profitability mindset among 
multidisciplinary teams. 
• Take the customer perspective – minimise the total cost of 
ownership, not just the acquisition cost. 
• Consider the consumption and transformation of natural capital in 
creating products and managing product portfolios – not just the financial costs. 
• Think about the societal impact of product development and 
management, and asset acquisition, operation and disposal. 
Actions to avoid/Don’ts 
Avoid rushing development to be fast to market – 80% of costs are 
locked in at the design phase. 
• Avoid treating natural capital as costless.

106  
 Objective Test Question 1: Target costing 
 The selling price of product Z is set at $250 for each unit and sales for 
the coming year are expected to be 500 units. 
If the company requires a return of 15% in the coming year on its 
investment of $250,000 in product Z, the target cost for each unit for the coming year is: 
A  $145 B  $155 C  $165 D  $175 E  $185 
 
 Objective Test Question 2: Value analysis 
 Casabee was established in 2010 and manufactures a range of kitchen 
utensils, which it makes from material purchased from a number of 
suppliers. The recently appointed Managing Director has expressed increasing concern about the trends in falling sales vo lumes, rising 
costs and hence declining profits over the last two years. 
There is general agreement amongst the managers of Casabee that 
these trends are the result of the increased intense competition that has emerged over the last two years. Casabee continues to have a reputation for high quality, but this quality is now being matched by the competition. 
The competitors are taking Casabee' s share of the market by selling 
equivalent products at lower prices. It is thought that in order to offer 
such low prices, the production costs of the competitors must be lower than Casabee's. Its MD is now proposing the following to improve sales volumes, costs sand profits: 
(i)  We must enter a Value Analysis exercise. Value Analysis is a 
cost reduction and problem solving technique that analyses an 
existing product, in order to identify and reduce or eliminate any costs which do not contribute to value or performance. 
(ii) We must enter a Value Analysis exercise. Value Analysis focuses 
on the value to the customer of each function of the product, and consequently allocates resources to those functions from which the customer gains the most value.

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 (iii) We also must enter a Functional Cost Analysis exercise. 
Functional cost analysis is a method that can be applied to 
examine the component costs of a product or service, in relation to the value as perceived by the customer. Functional cost analysis can be applied to new products, and breaks the product down into its component parts. For example, a kitchen utensil may have the function to be dishwasher- and microwave-safe, and therefore require less manual cleaning. 
(v) Both value analysis and functional cost analysis have potential to 
help Casabee, but Value Analysis is likely to be a more useful technique, because kitchen utensils are products that are sold more on the basis of their use value, rather than their esteem value. 
Which of the foregoing arguments are valid? 
A (i), (iii) and (iv) B (i), (ii), (iii) and (iv) C (i) and (iii) D  (ii) and (iv) 
 
 Objective Test Question 3: Life cycle costing 
 A company has carried out extensive product research and, as a 
result, has just launched a new innovative product unlike anything else 
that is currently available on the market. The company has launched this product using a market skimming pricing policy, i.e. charging very high prices initially. 
The market in which it operates is highly competitive and historically 
success has been achieved by being the first to market with new products. Only a small number of companies have survived in the market, and those that remain are constantly aiming to develop new products either by improving those already in the market, or by extensive product research. 
Select ALL that apply: 
• In the introduction stage, the product is unique and therefore the 
company can charge a high price. 
• In the introduction stage, competitors will buy the product to carry 
out reverse engineering and see how the product works, so that 
they can develop their own similar, but different product. 
• In the introduction phase, the company will seek to avoid this 
competition by maintaining its selling price at the end of the introduction stage.

108  
 • In the growth stage, the company will adopt a lower selling price 
to continue to attract new purchasers of the product. 
• In the growth stage, if the product cannot be differentiated in 
other ways, the company may need further reductions in selling 
price to maintain growth. 
• The growth stage is the ideal time to offer short term one-off 
offers or discounts for multiple purchases. 
• In the maturity stage, the se lling price of the product becomes 
unstable and the product is not financially viable anymore. 
• In the decline stage, the product may continue to be sold, 
provided its margin is positive. 
• If the product's margin is not positive in the decline phase, the 
product may be bundled with other products or sold for less than its unit cost in order to clear the company's inventory of what has become an obsolete product. 
 
 Data Set Question: Target  costing and cost gap 
 Company S is a specialist car manufacturer and intends to produce a 
new, limited edition 'Compact Executive' car in 2016. The car will be called the S2016. The production will be limited to 1,000 units of the S2016 car. 
Company S is considering using a target costing approach and has 
conducted market research to determine the features that consumers require in a car of that type. Based on this market research and knowledge of competitors products, Company S has decided to price the S2016 at $19,950. Company S requires an operating profit margin of 25% of the selling price of the car. Company S uses activity-based costing principles to assign overhead costs to units of production, and details for the forthcoming year are as follows: 
Forecast direct costs for a S2016 car:  Labour $5,000, Material 
$9,500. Forecast annual overhead costs:  Production line costs $4,630,000 
(see note 1) and transportation costs $1,800,000 (see note 2). Note 1: The production line that would be used for S2016 has a 
capacity of 60,000 machine hours per year. The production line time required for one S2016 is 6 machine hours per car. This production line will also be used to make other cars and will be working at full capacity. 
Note 2: Some models of cars are delivered to showrooms using car 
transporters. 40% of the transportation costs are related to the distance travelled.

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 The car transporters are forecast to make a total of 640 deliveries in 
the year, and carry 10 cars each time. The car transporter will always 
carry its maximum capacity of 10 cars. 
The total annual distance travelled by car transporters is expected to 
be 225,000 kms. 50,000 kms of this is for the delivery of the S2016 only. All 1,000 S2016 cars that will be produced will be delivered in the year using the car transporters. 
 
The production line cost per S2016 car  
  
The transportation cost per S2016 car   
  
The total overhead cost per S2016 car  
  
The full product cost for a S2016 car (forecast)  
  
The target cost of a S2016 car  
  
The current cost gap for a S2016 car

110  
 Case Study Style Question – AVN 
AVN designs and assembles electronic devices to allow transmission 
of audio/visual communications between the original source and various other locations within the same building. Many of these devices require a wired solution but the company is currently developing a wireless alternative. 
The company produces a number of different devices depending on 
the number of input sources and the number of output locations, but the technology used within each device is identical. AVN is constantly developing new devices which improve the quality of the audio/visual communications that are received at the output locations. 
Task: Briefing note You receive the following email from the Managing Director:

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 Example 1: Target Costing  
Sales revenue = 5,000 units @$52.00 $260,000 
Return on investment required = $1,000,000 × 12% $120,000 Total cost allowed $140,000 Target cost per unit = $140,000/5,000 $28 
 
 Example 2: Target Costing and the cost gap 
 The maximum rate per hour is $12.40  
 $ 
Selling price 56.00 
Profit (56 × 25/125) 11.20 
Target cost 44.80 
Material cost (16 × 10/8) 20.00 
Labour – 2 hours 24.80 
Labour rate per hour = 24.80/2 $12.40 
  
 Example 3: Reducing the cost gap 
 D 
Answer A is not correct: increasing the selling price is not possible, the 
industry is competitive so product will not sell effectively at higher 
prices.  
Answer B (‘Reduce the ex pectation gap by reducing the selling price’) 
is not target costing.  Answer C (‘Reducing the desired margin on the product’) is not 
possible either: shareholders are demanding, and would expect a good return. 
 
 Example 4: The Value Chain  
 • Procurement is not a primary activity and neither are human 
resource management, firm infrastructure management or technology development.

112  
 Example 5: Life cycle costing 
 • Its use may assist management in allocating resources to non-
production activities. TRUE  (lifecycle costing may assist 
management in allocating resources to non-production activities. 
For example, a product which is in the mature stage may require less marketing support than a product which is in the growth stage.) 
same phase of the life cycle. FALSE  (A company is in a weak 
position if all its products are at the same phase of the life cycle. Companies try to overcome this problem by introducing new products that are growing, as the old products are declining and by having products with life cycle of different lengths. 
life cycle costs of a product. FALSE  
TRUE  
 
 Objective Test Question 1: Target costing  
 Answer: D 
 $ 
Sales revenue 500 units @ $250 125,000 
Return on invst. required 15% × 250,000 37,500 
––––––– 
Total cost allowed 87,500 
Target cost per unit 175 
  
 Objective Test Question 2: Value analysis  
 A 
(ii)  defines Functional Cost Analysis.

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 • In the introduction stage, the product is unique and therefore the 
company can charge a high price. TRUE  
they can develop their own similar, but different product. TRUE  
competition by maintaining its selling price at the end of the introduction stage. FALSE : the company will seek to avoid this 
competition by lowering it selling price towards the end of the introduction stage, to deter competitors from entering the market and also to make its product more affordable to the wider market. 
• In the growth stage, the company will adopt a lower selling price 
to continue to attract new purchasers of the product. TRUE  
other ways, the company may need further reductions in selling price to maintain growth. TRUE 
offers or discounts for multiple purchases. FALSE : the maturity 
stage is the ideal time for this. 
unstable and the product is not financially viable anymore. FALSE  
provided its margin is positive. TRUE  
product may be bundled with other products or sold for less than its unit cost in order to clear the company's inventory of what has become an obsolete product. TRUE

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 Data Set Question: Target  costing and cost gap  
  
The production line cost per S2016 car $463 
  
The transportation cost per S2016 car  $328.75 
  
The total overhead cost per S2016 car $791.75 
  
The full product cost for a S2016 car (forecast) $15,291.75 
  
The target cost of a S2016 car $14,962.50 
  
The current cost gap for a S2016 car $329.50 
Workings: 
$4,630,000/60,000 annual production line machine hours = $77.17 per 
machine hour, $77.17 × 6 machine hours for a S2016 = $463 
Transportation cost 
60% delivery related = $1,080,000 
40% distance travelled related = $720,000 $1,080,000/640 deliveries = $1,687.50 per delivery  $1,687.5/10 cars = $168.75 per car $720,000/225,000km = $3.20 per km travelled $3.20 × 50,000km = $160,000 $160,000/1,000 cars = $160 per car Target selling price $19,950 Profit margin 25% Target cost $14,962.50 Forecast cost $15,291.75 Cost gap $329.25

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 Case Study Style Question – AVN  
 To: Michael Drake, MD 
From : Management Accountant 
Date: 21 November 2014 Subject:  Value chain – Briefing note 
The value chain refers to the sequence of processes through which 
value is added to an organisation’s products and services. The components of the value chain include research and development, design, production, marketing, distribution and customer services. The extended value chain refers to the extension of this sequence outside 
of the organisation to include suppliers and customers. 
The objective of the value chain is to focus the organisation on 
achieving value to the customer. Profit can then be optimised by finding the most effective processes to deliver the required product. The value chain should therefore begin with the customer. Clear requirements should be identified and communicated to departments within AVN. 
The role of research and development will be to develop new products 
that meet customer requirements but are not necessarily constrained by currently available technology. It may be useful to carry out a functional analysis to identify what the customer requires the product to do rather than how it is to be done. In this way R and D may be able to develop new technology which will result in competitive advantage. 
The role of design will be to take a new idea and produce a cost-
effective design. Target costing may be useful to determine the expected market price of the product and, after deducting the required profit margin, find the target cost for which the product must be produced. The design department will try to reduce the cost of the 
product by using standard components and layouts. It will need to liaise with production, distribution and marketing to ensure that the design is cost effective, feasible and will deliver the product at the required quality to the customer. 
At this stage supplies may be involved to help develop new sources of 
material and components. 
The production department must then produce the product efficiently. 
AVN should have determined the price that customers would be prepared to pay for different levels of quality. If the strategy is for high quality/high price products, then AVN may invest heavily in appraisal and prevention activities such as training and inspections to prevent internal and external quality failure costs.

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 Production must also be aware of when the customer requires the 
product. Customers should be able to receive the product as required. 
This may mean that inventories of finished goods are held and the relative costs and benefits of these inventories should be considered. 
Marketing has an important role in informing potential customers of 
new products. This may involve identifying target markets and the most effective marketing policy to adopt. Distribution must ensure that products reach the customer as required. 
AVN may have to decide whether to sell directly to the customer or via 
retailers or wholesalers. The additional costs of a direct sales force and installation teams may have to be weighed against the benefit of remaining in control of the quality of the process and remaining in close contact with customers to be able to develop new improved products. 
Customer services may be a vital link in obtaining feedback from 
customers which may be important in generating repeat sales. It may also be possible to assess the extent to which customers’ requirements have been met. 
AN Accountant Management Accountant X Ltd E: mact@avn.co.uk T: 0191 253 3434

117 
Data required for 
Chapter learning objective 
B1: Capital investment 
decision making Apply the data required for 
(a) Relevant cash flows (b) Non-financial information 
  
 Chapter 
4

Data required for decision-making 
118  
1 Chapter summary 
 
Capital investment decisions normally represent the most important decisions 
that an organisation makes, since they commit a substantial proportion of a firm’s resources to actions that are likely to be irreversible. Many different investment projects exist including the replacement of assets, cost-reduction schemes, new product/service developments, product/service expansions, etc. 
Each of these decisions is based on relevant costing principles. Therefore, a 
recap of relevant costing will be useful. 
The quality of decisions depends on the quality and type of data available to 
decision makers. In a digital world, data needed by medium-term decision makers would come from data lakes, through to data warehouses and business intelligence systems.  
2 Relevant cash flows 
Investment decisions, like all other decisions, should be analysed in terms of cash flows that can be directly attributable to them. 
Relevant costs are those which will be affected by the decision being taken. All 
relevant costs should be considered in management decision-making. 
A relevant cash flow is a 'future, incremental cash flow'. 
• Future  
Only future cash flows that occur as a result of the decision should be 
considered, e.g. any future costs or revenue. 
Sunk costs (i.e. costs that have already been incurred in the past) are not 
relevant to the decision, and should therefore be ignored – we cannot change the past.

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• Incremental  
Only extra cash flows that occur as a result of the decision should be 
considered, e.g. extra costs or revenues. 
Fixed costs should be ignored unless there is an incremental fixed cost as 
a result of the decision. 
Committed costs (i.e. costs that are unavoidable in the future) are not 
affected by the decision and should therefore be ignored. 
Opportunity costs should be included when we are aware of the next best 
alternative use of a resource. 
• Cash flows  
Only cash items are relevant to the decision. For example, depreciation is never relevant, since it is not a cash flow. 
 
 Example 1: Butte Ltd 
 As part of a new product development, Butte Ltd has employed a 
building consultant to perform an initial survey. This initial survey has cost $40,000. But there will be an ongoing need for her services if the company decides to proceed with the project. This work will be charged at a fixed rate of $20,000 per annum. 
What relevant cost should be included for the building consultants 
services in the first year when considering whether the project should proceed? 
A  $0 B  $20,000 C  $40,000 D  $60,000 
 
 Example 2: Relevant costs 
 Identify which of the following costs are relevant to the decisions 
specified: (a) The salary to be paid to a market researcher who will oversee the 
especially for the new product but the $12,000 salary will be a fixed cost. 
Is this cost relevant to the decision to proceed with the development 
of the product?

120  
 (b) The $2,500 additional monthly running costs of a new machine to be 
purchased to manufacture an established product. Since the new 
machine will save on labour time, the fixed overhead to be absorbed 
by the product will reduce by $100 per month. 
Are these costs relevant to the decision to purchase the new 
machine? 
(c) Office cleaning expenses of $125 for next month. The office is 
cleaned by contractors and the contract can be cancelled by giving one month’s notice. 
 Is this cost relevant to a decision to close the office?  
(d) Expenses of $75 paid to the marketing manager. This was to 
reimburse the manager for the cost of travelling to meet a client with 
whom the company is currently negotiating a major contract. 
Is this cost relevant to the decision to continue negotiations? 
3 Opportunity costs 
Opportunity costs are relevant, and should be included in investment decisions. An opportunity cost is a special type of relevant cost. An opportunity cost can be 
defined as 'the value of the benefit sacrificed when one course of action is 
chosen in preference to an alternative. The opportunity cost is represented by the foregone potential benefit from the best rejected course of action' (CIMA Official Terminology). 
With opportunity costs, we are concerned with identifying the value of any 
benefit forgone as the result of choosing one course of action in preference to another. 
Examples of opportunity costs The best way to demonstrate opportunity costs is to consider some examples. (a) A company has some obsolete material in stock that it is considering to 
use for a special contract. If the material is not used on the contract it can 
either be sold back to the supplier for $2 per tonne or it can be used on another contract in place of a different material that would usually cost $2.20 per tonne. 
The opportunity cost of using the material on the special contract is $2.20 
per tonne. This is the value of the next best alternative use for the material, or the benefit forgone by not using it for the other contract. 
(b) Chris is deciding whether or not to take a skiing holiday this year. The 
travel agent is quoting an all-inclusive holiday cost of $675 for a week. Chris will lose the chance to earn $200 for a part-time job during the week that the holiday would be taken. 
The relevant cost of taking the holiday is $875. This is made up of the out-of-pocket cost of $675, plus the $200 opportunity cost, that is the part-time wages forgone.

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Notional costs and opportunity costs  
Notional costs and opportunity costs are often similar. This is particularly 
noticeable in the case of notional rent. The notional rent could be the rental that the company is forgoing by occupying the premises itself. This could be treated as an opportunity cost. However, it is only a true opportunity cost if the company can actually identify a forgone opportunity to rent the premises. If nobody is willing to pay the rent, then it is not an opportunity cost. 
If an examination question on relevant costs includes information about notional 
costs, read the question carefully and state your assumptions concerning the relevance of the notional cost. 
4 Avoidable, differential and incremental costs 
There are two other types of relevant cost that you will need to know about: avoidable costs and differential/incremental costs. 
Avoidable costs CIMA defines avoidable costs as ‘the specific costs of an activity or sector of a 
business which would be avoided if that activity or sector did not exist’. 
For example, if a company is considering shutting down a department, then the 
avoidable costs are those that would be saved as a result of the shutdown. Such costs might include the labour costs of those employed in the department and the rental cost of the space occupied by the department. The latter is an example of an attributable or specific fixed cost. Costs such as apportioned head office costs that would not be saved as a result of the shutdown are unavoidable costs. They are not relevant to the decision. 
Differential/incremental costs CIMA defines a differential/incremental cost as ‘the difference in total cost 
For example, if the relevant cost of contract X is $5,700 and the relevant cost of 
contract Y is $6,200, we would say that the differential or incremental cost is $500, that is the extra cost of contract Y is $500. 
If a cost will remain unaltered regardless of the decision being taken, then it is 
called a non-relevant cost or irrelevant cost. 
Costs that are not usually relevant in management decisions include the 
(a) Sunk or past costs. This is a 'cost that has been irreversibly incurred or 
committed and cannot therefore be considered relevant to a decision. 
Sunk costs may also be termed i rrecoverable costs'  (CIMA Official 
Terminology). An example of a sunk cost is expenditure that has been incurred in developing a new product. The money cannot be recovered even if a decision is taken to abandon further development of the new product. The cost is therefore not relevant to future decisions concerning the product.

122  
(b) Absorbed fixed overheads that will not increase or decrease as a result of 
the decision being taken. The amount of overhead to be absorbed by a 
particular cost unit might alter because of the decision; however, this is a result of the company’s cost accounting procedures for overheads. If the actual amount of overhead incurred by the company will not alter, then the overhead is not a relevant cost. 
(c) Expenditure that will be incurred in the future, but as a result of decisions 
taken in the past that cannot now be changed. These are known as committed costs. They can sometimes cause confusion because they are future costs. However, a committed cost will be incurred regardless of the decision being taken and therefore it is not relevant. An example of this type of cost could be expenditure on special packaging for a new product, where the packaging has been ordered and delivered but not yet paid for. The company is obliged to pay for the packaging even if they decide not to proceed with the product; therefore it is not a relevant cost. 
(d) Historical cost depreciation. Depreciation is an accounting adjustment but 
does not result in any future cash flows. They are merely the book entries that are designed to spread the original cost of an asset over its useful life. 
(e) Notional costs such as notional rent and notional interest. These are only 
relevant if they represent an identified lost opportunity to use the premises or the finance for some alternative purpose. In these circumstances, the notional costs would be opportunity costs. 
It is essential to look to the future when deciding which costs are relevant to a 
decision. Costs that have already been incu rred, or that will not be altered in the 
future as a result of the decision being taken, are not relevant costs. 
5 Incremental revenues 
Just as incremental costs are the differences in cost between alternatives, incremental revenues are the differences in revenues between the alternatives. Matching the incremental costs agains t the incremental revenue will produce a 
figure for the incremental gain or loss between the alternatives. 
Cash flows to include  
The cash flows that should be included are those which are specifically incurred 
as a result of the acceptance or non-acceptance of the project. In some cases, these may be opportunity costs. 
When deciding what figure should be included in any decisi on making situation, 
it sometimes helps to tabulate for a particular element of cost. 
 
Cash flow if project 
accepted – Cash flow if project 
rejected = Relevant cash flow

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 Example 3: Calaveras Ltd 
 Activity 1  
A mining operation uses skilled l abour costing $4 per hour, which 
generates a contribution, after deducting these labour costs, of $3 per 
hour. 
A new project is now being considered that requires 5,000 hours of 
skilled labour. There is a shortage of the required labour. Any used on the new project must be transferred from normal working. Calculate the relevant cost of using the skilled labour on the project. Calculate the contribution cash flow that is lost if the labour is transferred from normal working. 
 Activity 2 
skilled labour already employed (and paid) by the business which is sufficient to cope with the new project. The presently idle men are being paid full wages. 
Calculate the contribution cash flow that is lost if the labour is 
transferred to the project from doing nothing. 
6  Qualitative factors 
In reality, investment decisions are also influenced by many qualitative factors that must also be borne in mind in the investment appraisal exercise. 
 
 Illustration  – qualitative factors  
 Consider the typical example of the proposed purchase of a new 
machine in a manufacturing plant. The machine offers both quantitative 
and qualitative costs and benefits, as below. 
Quantitative costs include: 
• the purchase price of the machine 
• installation and training costs. 
Quantitative benefits include: 
• lower direct labour costs 
• lower scrap costs and items requiring rework 
• lower stock costs.

124  
 Qualitative costs include: 
• increased noise level • lower morale if existing staff have to be made redundant. 
Qualitative benefits include: 
• reduction in product development time • improved product quality and service 
• increase in manufacturing flexibility. 
Because the qualitative factors are difficult to state in numerical terms, they are 
conventionally ignored in the investment appraisal exercise. Such an approach is flawed: qualitative factors that could additionally be brought into the decision need to be pointed out. 
7 Sources of management information  
Data  are facts or figures in a raw, unprocessed format.  Data consists of 
numbers, letters, symbols, raw facts, events and transactions, which have been recorded but not yet processed into a form that is suitable for making decisions. 
To become useful to a decision maker, data must be transformed into 
information.  
Information is data that has been processed in such a way that it has a meaning to the person who receives it. This person may then use this information to improve the quality of decision-making. 
Types of information 
Internal information External information 
• accounting records 
• personnel and payroll information 
• timesheets 
• production information. Examples include: 
• competitor information, 
e.g. prices and product ranges 
• customer information, e.g. with 
regards to their needs 
• supplier information, e.g. prices, 
quality, delivery terms. 
Internal sources of information may be taken from a variety of areas such as the 
sales ledger (e.g. volume of sales), payroll system (e.g. number of employees) or the fixed asset system (e.g. depreciation method and rate).

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Examples of internal data: 
Source Information 
Sales ledger system Number and value of invoices 
Volume of sales 
Value of sales, analysed by customer Value of sales, analysed by product 
Purchase ledger system Number and value of invoices 
Value of purchases, analysed by supplier 
Payroll system Number of employees 
Hours worked Output achieved Wages earned Tax deducted 
Fixed asset system Date of purchase 
Initial cost Location Depreciation method and rate Service history Production capacity 
Production Machine breakdown times 
Number of rejected units 
Sales and marketing Types of customer 
Market research results 
External sources In addition to internal information s ources, there is much information to be 
obtained from external sources such as suppliers (e.g. product prices), 
customers (e.g. price sensitivity) and the government (e.g. inflation rate). 
 
Suppliers Product prices 
Product specifications 
Newspapers, journals Share price 
Information on competitors 
Technological developments National and market surveys

126  
Government Industry statistics 
Taxation policy 
Inflation rates Demographic statistics Forecasts for economic growth 
Customers Product requirements 
Price sensitivity 
Employees Wage demands 
Working conditions 
Banks Information on potential customers 
Information on national markets 
Business enquiry agents Information on competitors 
Information on customers 
Internet Almost everything via databases (public and 
The internal and external information may be used in planning  and controlling 
activities. For example: 
• Newspapers, the Internet and business enquiry agents (such as Dun and 
Bradstreet) may be used to obtain external competitor information for 
benchmarking purposes. 
• Internal sales volumes may be obtained for variance analysis purposes. 
 
 Example 4: Externally  generated information 
 What are the limitations of using externally generated information? 
8 Collecting, analysing and presenting high quality data 
The quality of management information expected by business users is 
expanding both in terms of the range of data to be considered, and the level of analysis required. There is an increased demand for information at all levels.  
From strategic issues to routine ta sks, executives, managers, information 
workers and staff all expect more information and clearer insights to support decision making. Financial information alone does not suffice. Management information must relate financial to non-financial data and not just report past performance, but also monitor the current operations and help to predict the future.

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Benefits 
One key challenge is to extract knowledge from information. Organisations turn 
to technology for help and rely on IT to improve the quality of decision making by getting them the right information at the right time. IT is now regarded as a source of competitive advantage, rather than simply as a driver of cost-efficiency.  
Collecting, analysing and presenting high quality data presents the following benefits to the business:  
• Collaborative working  
Whether managing a remote workforce, running a globalised R&D project or working with customers to design a solution, the organisation will be 
more dependent on the flow of data between different locations inside and 
outside the boundaries of the organisations. ‘The better we are connected to our customers and suppliers, the better off we will all be,’ says Terry Assink, CIO at Kimberly-Clark Corp, a health-and-hygiene company.  
• Customer insight  
Identifying changes in customer behaviour is often cited as the most significant challenge to product and service innovation faced by organisations. A greater understanding of customers’ business or personal needs is similarly essential to the personalisation of products and services. Inventory management will be more responsive, too – many businesses expect demand, not supply, to drive the production of goods and services in the future. Companies employ data analytics to address these challenges, and the quality of feeder data is key. 
• Risk management 
Businesses must prepare all manner of emergency plans, such as data 
backup and recovery.  
• Governance  
Shareholders, managers and board members demand more transparency 
than ever. Significant due diligence processes are regularly established. The quality of corporate governance is increasingly a source of differentiation in its own right, with a noted correlation between brand value and good governance.  
Costs 
The collection, analysis and presentation of high quality data often brings the 
following costs to the business:  
• Software licenses costs – the cost of initially acquiring and deploying the 
software  
• Software maintenance costs  – annual charges

128  
• IT training costs  – the cost of training IT personnel to manage and 
maintain the software and infrastructure  
• User training costs  – the cost of training users to use the software  
• Integration costs  – the cost of making multiple products work together  
• Redundant infrastructure costs  – the cost of managing and maintaining 
multiple data stores, metadata repositories and other components.  
9 Problems associated with collecting, analysing and presenting 
high quality data 
Duplication 
Systems such as Enterprise Resource Planning (ERP) systems have done 
much to improve processes and rationalis e operational data, but information still 
gets duplicated and copied on to multiple systems, making it difficult to ensure consistency and security. Finance, sales and operations reports rarely agree. Even when the data comes from the same ERP source, the reports may not reconcile because of the extraction process.  
Privacy, integrity and security concerns 
IS are exposed to privac y and security issues. Risks can be listed as follows: 
 
Natural disasters  – e.g. fire, 
flood. • Fire procedures – fire alarms, 
extinguishers, fire doors, staff training 
and insurance cover. 
• Location, e.g. not in a basement area 
liable to flooding. 
• Physical environment – e.g. air 
conditioning, dust controls. 
• Back up procedures – data should be 
backed up on a regular basis to allow recovery. 
Malfunction  – of computer 
hardware or software. • Network design – to cope with periods 
of high volumes. 
• Back up procedures (as above).

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Viruses  – a small program that 
once introduced into the system 
spreads extensively. Can affect the whole computer system. • Anti-virus software – should be run and 
updated regularly to prevent corruption of the system by viruses. 
• Formal security policy and procedures, 
e.g. employees should only download files or open attachments from reputed sources. 
• Regular audits to check for unauthorised 
software. 
Hackers  – deliberate access to 
systems by unauthorised persons. • Firewall software – should provide 
protection from unauthorised access to the system from the Internet. 
• Passwords and user names – limit 
unauthorised access to the system. 
e.g. organisations that allow employees to use personal devices at work should ensure that there is a policy for device usage and that technology is used to prevent hackers. 
• User awareness trai ning of the risks 
should be available. 
• Data encryption – data is scrambled 
prior to transmission and is recovered in a readable format once transmission is complete. 
Electronic eavesdropping – 
e.g. users accessing private information not intended for them. • Data encryption – As above, data is 
• Passwords and user names (as above). 
Human errors – unintentional 
errors from using computers and networks. • Training – adequate staff training and 
operating procedures. 
Human resource risk  – e.g. 
repetitive strain injury (RSI), headaches and eye strain from computer screens, tripping over loose wires. • Ergonomic design of workstations 
should reduce problems such as RSI. 
• Anti-glare screens reduce eye strain. 
• Cables should be in ducts.

130  
 Illustration 1 – Virus infection in the NHS 
 In 2017, the NHS (National Health Service) faced a week of chaos after 
hackers demanding a ransom infiltrated the health service’s computer 
system. 
Operations and appointments were cancelled and ambulances diverted 
as up to 40 hospital trusts became infected by a ransomware (malicious software) attack demanding payments to regain access to vital medical records. 
The attack was part of the biggest ransomware attack in history with 
Controls 
There are two forms of IT/IS controls that exist to safeguard the privacy and 
security of data as well as ensuring complete and accurate processing of data: 
General controls  – ensure that the organisation has overall control over its 
information systems, e.g.: 
• Personnel controls – includes segregation of duties, policy on usage, 
hierarchy of access. 
• Access controls – such as passwords and time lock-outs. 
• Computer equipment controls – to protect equipment from destruction, 
damage or theft. 
• Business continuity planning – a ri sk assessment to decide which systems 
are critical to the business continuing its activities. 
Application or program controls  – performed automatically by the system 
and include: 
• Completeness checks to ensure all data is processed. • Validity checks to ensure only valid data is input/processed. 
• Identification and authorisation che cks to ensure users are identified and 
authorised. 
• Problem management facilities to ensure problems ar e recorded/managed 
on a timely basis. 
 
Example 5: Integrity and security 
 Data integrity and security is a particular issue in a database. For data to 
have integrity, it must be accurate, consistent and free from accidental 
corruption. 
Required: 
What controls are required in a database to ensure that data integrity and 
security are maintained?

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In recent years, specialist software houses have developed performance 
management applications to address the shortcomings of the accounting modules offered by the major ERP vendors. These are better than ERP systems for performing activities such as consolidation, budgets and reforecasts.  
Some can also deliver insightful management information directly to managers’ desks. They can be used by business users to view scorecards or dashboards, generate their own reports, drill down for more information or conduct analysis. 
They are a form of business intelligence (BI) application.  
10 Business intelligence systems 
The term business intelligence (‘BI’) is often used to describe the technical architecture of systems that extract, assemble, store and access data to provide reports and analysis.  
‘Business Intelligence’ is also used to describe the reporting and analysis applications or performance management tools associated with that architecture. 
 
Illustration 2 – Walmart 
 It is widely reported that Walmart (Asda) tracks data on over 60% of 
adults in the US. Data gathered includes online and instore purchasing 
pattern, Twitter interactions and trends, weather reports and major events. This data, according to the company, ensures a highly personalised customer experience. 
But business intelligence is not just about hardware and software. It is about a 
company wide recognition that a company’s data is an important strategic asset 
that can yield valuable management information and implement change so that this information is used to improve decision making . 
Business Intelligence (‘BI’) systems provide management accountants with a wider range of information in more accessible formats. In addition to reporting and monitoring, BI systems can provide more forward-looking analysis based on a combination of both financial and non-financial information. 
Business intelligence is about improving decision making. It involves developing 
processes and systems that collect, transform, cleanse and consolidate organisation wide and external data, usually in an accessible store (a data warehouse), for presentation on users’ desks as reports, analysis or displayed on screens as dashboards or scorecards. The term BI is sometimes used to describe this structure or ‘stack’ of software systems and applications.

132  
The typical BI ‘stack’ (or architecture) can be represented as having a series of 
layers: 
 
The base of the ‘stack’ above is usually shown as source data systems from where data is extracted, translated and loaded by extract, transform and load (ETL) software into a data warehouse. Above this is an application layer (or BI layer) and on top of this the presentation or delivery layer which can include executive dashboards, scorecards and other tools that make it easier for managers to find and understand the information and proactively use it in decision making. 
BI is broader than technology. It is about using the information available to a 
business to improve decision making. With technology, the right information can be accessed, analysed and presented at the right time to the right people in the right format. But it must then be used by them to inform evidence based decision making. This requires leadership and cultural change. 
11 Data analytics and data mining  
‘Data analytics’ is the complex analysis , data mining and predictive modelling 
enabled by BI applications which can access both financial and non-financial data from the business’s data warehouse and external sources.  
In other words, ‘data analytics’ is the process of collecting, organising and 
analysing large sets of data to generate trends and other information to aid decision making. 
Amazon, Capital One, Marriott and UPS are identified as companies that 
compete on analytics. These leading companies already have the right focus, culture and people, in addition to the right technology and software in place.

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Data mining 
‘Data mining’ is the process of sorting through data to identify patterns  and 
relationships  within a data set between different items, usually with the use of 
statistical algorithms: For example, data mining could help  identify a 
customer’s buying trends in order to send focused marketing data to each 
customer. 
Business intelligence considers structured data from relational databases and 
brings to light patterns and trends that could guide business decisions. But its scope is now expanding to include unstructured data.  
Structured data: Data that is contained within a field in a data record or file 
(e.g. databases, data warehouses and spreadsheets). In a data warehouse for 
example, everything is archived and ordered in a defined way – the products are inside containers, the containers on shelves, the shelves are in rows, and so on. This is the way that data is stored in a traditional data warehouse. 
Unstructured data: Data that is not easily contained within structured data 
fields, such as pictures, videos, webpages, PDF files, emails or blogs. Often, 
unstructured data is stored in ‘data lakes’. A data lake contains data in its rawest form – fresh from capture, and unadulterated by processing or analysis. 
In a data lake, data is just poured in, in an unstructured way. A molecule of 
water in the lake is equal to any other molecule and can be moved to any part of the lake, where it will feel equally at home. 
This means that data in a lake has a great deal of agility, in that it can be 
configured or reconfigured as necessary, depending on the job the users of data/information want to do with it. Data stored without structure can be more quickly shaped into whatever form it is needed.  
 
Illustration 3 – What is a data lake? 
 In his 2015 article published on the World Economic Forum website, 
Bernard Marr explains the concept of data lakes. Link here to the full 
article: https://www.weforum.org/agenda/2015/02/what-is-a-data-lake/ 
12 Business Intelligence and new business opportunities 
BI can be used for new reports and analysis which should lead to increased profitability through improved operating performance and better strategic focus on profitable products and segments. For example:  
• Sales people who are better informed about a customer’s situation and 
preferences, product holdings, cost to serve and profit margins should be 
able to achieve more profitable sales.  
• Greater transparency enhances performance. Internal benchmarking 
between individuals and divisions which are measured on a consistent basis can help to identify best practice and raise standards.

134  
• Negotiators can be better informed about the economics of current or 
comparable arrangements when agreeing contracts with suppliers or 
customers. Potentially uneconomic arrangements can be identified promptly and renegotiated at the earliest opportunity.  
• Advertising and promotional spend can be better focused on initiatives 
with a higher probability of success based on better analysis of the evidence about the performance of past campaigns.  
• Some data may have value outside the business. For example, 
supermarkets sell EPoS data to their suppliers. In turn, analysis from a financial perspective of data from EPoS (Electronic Point of Sale) and CRM systems can yield valuable insight.  
13 Business intelligence and reducing costs 
Activity based costing solutions are of growing interest as companies look to understand cost allocation at a granular level to be able to reduce costs and improve process efficiencies. 
BI tools can be used to produce management information that is already 
produced in-house. With the benefit of BI, it should be possible to provide this information on a more up-to-date basis, in a more user-friendly format with greater accuracy.  
There should be quantifiable savings in the production of this information and in 
the re-working of figures.  
• BI tools are user-friendly. Users will be empowered to conduct ad hoc 
analysis which would previously have required support from the IT 
function.  
• These savings will include efficiency ga ins, often expressed as numbers of 
full time equivalent (FTE) employees. To realise these as actual cost savings, for example through redundancies, can be difficult but the capacity released can be deployed to provide more valuable support to the business.  
• The BI tools may, to some extent, replace a disparate array of tools 
already being used. This should yield benefits in terms of savings in software licensing and training costs.  
• Virtualisation (bundling applications on a smaller number of servers) can 
save costs as fewer servers will be required.  
• The ability to comply with reporting and regulatory requirements is a form 
of licence to trade. Without a BI solution, these requirements can only be met with ad hoc analysis. There should be a potential saving here too.  
• Changing reporting standards will re quire greater transparency about 
business performance and prospects. Narrative reporting requires commentary on financial and non-financial indicators.  
• Compliance with regulations can require disclosure of data that may not 
be readily accessible without a BI solution.

Chapter 4 
 
 135 
14 Intangible benefits of BI 
Some benefits of BI may be intangible. These too can be of value and 
considered as part of the business case if they will be used by the business to generate value: 
• The use of planning tools and the ability to identify trends early should 
allow a company to forecast more accurately. More prompt closing of 
period end accounts gives an impression of good systems. Over time, these can reduce investors’ perception of the level of risk and increase shareholder value. 
 
Performance management – BI planning tools  
 Enterprise performance management (EPM), corporate performance 
management (CPM), enterprise information systems (EIS), decision support systems (DSS) and management information systems (MIS) are all terms used to describe BI tools which measure key business metrics and present this information as feedback to decision makers and managers of operations or processes.  
Too much business planning can be focused on budgets and financial 
metrics. These are often measures of outcomes in the short run rather than indicators of performance towards achieving strategic intent. Non-
financial metrics may better describe progress towards achievement of 
a sustainable competitive advantage for the long run.  
The financial and non-financial metrics and the click-throughs for 
further analysis most readily available through a packaged application may not be the right ones to present. Tracking the wrong metrics or using the wrong metrics in recognition or reward mechanisms can lead to perverse outcomes.  
The metrics presented and the analysis allowed should enable 
management to investigate properly and take prompt action to improve business performance. Determining what the right metrics to track are and the right lines of enquiry is a challenge which management accountants can help organisations address. 
 
• Greater clarity about which products, segments and customers are most 
profitable and those which are uneconomic can be used to improve the retention of valuable relationships. These can be defended from competitors and business developers can focus attention on winning more relationships with similar potential. The profitability of less economic products or customer relationships might be improved through using lower cost channels, cross-selling or more appropriate pricing.  
• Emerging trends can be spotted earlier and improved or new products and 
segments developed. The challenge is to make these benefits clear so as to win buy-in from business managers and their commitment to make use of the benefits which the IT investment will enable to deliver value.

136  
The initial $40,000 fee will be deemed to be a sunk cost – it has already 
been committed and won't be affected by any decision to proceed from this point. 
it will only be incurred if the project proceeds. It is therefore an extra or incremental cost of the project and should be included in any future decision making. 
 
 (a) The salary is a relevant cost of $12,000. Do not be fooled by the 
mention of the fact that it is a fixed cost, it is a cost that is relevant to the decision to proceed with the future development of the new product. This is an example of a directly attributable fixed cost. A directly attributable fixed cost may also be called a product-specific fixed cost. 
(b) The $2,500 additional running costs are relevant to the decision to 
purchase the new machine. The saving in overhead absorption is not relevant since we are not told that the total overhead expenditure will be altered. The savi ng in labour cost would be 
(c) This is not a relevant cost for next month since it will be incurred 
even if the contract is cancelled today. If a decision is being made to close the office, this cost cannot be included as a saving to be made next month. However, it will be saved in the months after that so it will become a relevant cost saving from month 2 onwards. 
(d) This is not a relevant cost of the decision to continue with the 
contract. The $75 is sunk and cannot be recovered even if the company does not proceed with the negotiations.

Chapter 4 
 
 137 
 Activity 1 
 $ 
Contribution per hour lost from normal working   3 
Add back: labour cost per hour that is not saved   4 
–– 
   7 
–– 
 
Activity 2 
 
 • External information may not be accurate. 
• External information may be out of date. 
• The company publishing the data may not be reputable. 
• External information may not meet the exact needs of the business. 
• It may be difficult to gather external information, e.g. from customers 
or competitors. 
 
 Example 5: Integrity and security 
 • Control of access to workstations. • User identification required for access by individual passwords. 
• Users only see the icons for the functions where they have access 
rights. 
• Restrictions on access to certain aspects of the database, e.g. using 
passwords. 
• Users only to have access to those aspects that they need to do 
their job. 
• Restrictions on use of functions or programs, e.g. writing off debts 
as bad debts. 
• Transaction logs maintained automatically for checking and for 
back-up purposes.

139 
The investment 
decision-making process 
B2: Capital investment 
decision making Explain the steps and pertinent 
issues in the decision-making process 
(a) Investment decision-
(b) Discounting (c) Real options 
B3: Investment appraisal 
techniques (c) IRR (d) NPV 
  
  Chapter 
5

The investment decision-making process 
140  
 
This chapter will focus on the steps that are typically incurred for simple as well 
as complex capital investment decisions. 
One characteristic of all capital expenditure projects is that the cash flows arise 
over the long term (a period usually greater than 12 months). Under this situation, it becomes necessary to carefully consider the time value of money. 
The concept of the time value of money translates into compounding and 
discounting techniques, and the use of discount factors to reflect the cost of capital, or shareholders’ required return, in investment appraisal. 
Capital rationing, a key decision making approach, then applies when 
investment funds are limited and not all profitable projects can be undertaken. 
Flexibility can also be added to investment appraisal with the use of real options 
theory. Conventional investment appraisal techniques typically undervalue flexibility in projects with high uncertainty, and real option theory attempts to classify and value flexibility in general by  taking the ideas of financial options 
pricing, and developing them.

Chapter 5 
 141 
2  The capital investment process 
A decision making model for capital expenditure decisions is shown below: 
 
Stage 1 indicates the objectives or goals of the organisation. Most 
organisations pursue a variety of goals, for example maximisation of profits, maximisation of sales, survival of the firm, achieving satisfactory profits and obtaining the largest share of the market. Achieving profit maximisation in the long term will ensure maximisation of the market value of the shareholders’ 
wealth. The capital investment process seeks to achieve maximisation of wealth by maximising the net present value of future net cash inflows. 
Stage 2 involves the search for investment opportunities. Without a proactive, 
deliberate search for creative projects and opportunities, even the most sophisticated evaluation techniques are worthless. A firm’s prosperity is dependent upon its ability to create investment opportunities.

142  
Stage 3 requires data to be gathered about possible future environments that 
may affect the outcomes of the project. Examples of states of nature include economic booms/recessions, high inflation, world shortages etc. It may be necessary to amend the company objectives (in the medium term at least) and/or to continue searching for new opportunities once the states of nature have been identified. 
Stages 4, 5 and 6  are considered in detail in this chapter and the next chapter. 
Examination questions typically involve listing the various alternatives open to a 
firm, identifying cash flows that are relevant to each opportunity, evaluating the value of these cash flows and finally recommending an optimum investment strategy. 
Stage 7:  It is essential to implement a sound system for approving capital 
investment proposals. Once approval has been obtained and initial outlays have 
been incurred the firm is often committed to the project for several years to come. Approval should not merely be a rubberstamping of the managers’ proposals. A Capital Expenditure Committee should establish an approval procedure that both encourages managers to submit realistic, achievable proposals and ensures that the long-term objectives of the firm are being met. 
Stage 8: The review stage is an important final step. This stage is usually 
achieved by carrying out a post-completion audit or appraisal. The audit is often initiated approximately 12 months into the investment project. 
The capital expenditure committee The Committee is usually responsible for overseeing the capital investment 
process. The functions of such a committee are to: 
• co-ordinate capital expenditure policy 
• appraise and authorise capital expenditure on specific projects 
• review actual expenditure on capital projects against the budget (see next 
section). 
In many organisations, multidisciplinary teams, or working parties, are set up to 
investigate individual proposals and report back to top management on their findings. 
Such a team might comprise: 
• project engineer • production engineer 
• management accountant 
• relevant specialist, e.g. personnel officer, for a project involving sports 
facilities or canteens, safety officers, etc.

Chapter 5 
 143 
In capital investment appraisal,  we initially assume that:  
1 All cash inflows and outflows are known with certainty. 
2 Sufficient funds are available to undertake all profitable investments. 3 There is zero inflation. 4 There is zero taxation. These assumptions are all considered again in the next chapter. 
3 The time value of money 
 
 Money received today is worth more than the same sum received in the 
future, i.e. it has a time value . 
For example, if offered the choice between a certain sum of $100 now, or the 
expectation of $100 in a year's time, th en most (all) people will prefer the $100 
now. However, what if the choice is between $100 now and $105 in one year or 
$110 or...? 
Suppose you are indifferent between $100 now or the expectation of $112 in 
one year – this would indicate that your time value of money can be expressed as an interest rate of 12% per annum. 
Discounted cash flow (DCF) techniques take account of this time value of 
money when appraising investments. 
 
 The time value of money 
 There are three main reasons for the time value of money: 
Consumption preferences 
There is a strong preference for the immediate rather than delayed 
consumption. Investors would typically prefer to receive returns sooner rather than later. They may even be willing to receive smaller returns now. Money, like any other desirable commodity, has a price. Given the choice of $100 now or the same amount in one year, it is always preferable to take the $100 now because it could be invested over the next year at say 10% interest rate to produce $110 at the end of the year. 
Impact of inflation In most countries, in most years, prices rise as a result of inflation. 
Therefore funds received today will buy more than the same amount a year later, as prices will have risen in the meantime. The funds are subject to a loss of purchasing power over time. 
Risk 
The earlier cash flows are due to be received, the more certain they are – 
there is less chance that events will prevent payment. Earlier cash flows are therefore considered to be less risky.

144  
4 Compound interest 
A sum invested today will earn interest. Compounding calculates the future 
value (or terminal value ) of a given sum invested today for a number of years. 
To compound a sum, the figure is increased by the amount of interest it would earn over the period. 
FORMULA FOR COMPOUNDING 
 V = X(1 + r)
n 
Where V = Future value 
 X = Initial investment (present value) 
 r = Interest rate (expressed as a decimal)  
 n = Number of time periods 
 
 Compounding 
 $100 is invested in an account for five years. The interest rate is 10% per 
annum. 
The value of the account after five years can be calculated as follows:  V = 100 (1.10)
5 = $161.05 
Similarly, if your time value of money is 10% per annum, then you would 
be indifferent between receiving $100 now or $161.05 in five years' time. They would have the same value to you. 
 
 Example 1: Compounding 
 $450 is invested in an account earning 6.25% interest p.a. Calculate the 
fund value after 12 years.  
5 Discounting 
Discounting performs the opposite function to compounding. Compounding 
finds the future value of a sum invested now, whereas discounting considers a sum receivable in the future and establishes its equivalent value today. This value in today’s terms is known as the Present Value (PV) . 
 
 In potential investment projects, cash flows will arise at many different 
points in time. Calculating the present value of future flows is a key technique in investment appraisal decisions.

Chapter 5 
 145 
FORMULAE FOR DISCOUNTING 
 Present value = Future value × discount factor LEARN  
Where: Discount factor = 1
ሺ1+rሻn or	ሺ1+rሻ–n GIVEN  
Where: r is the interest rate expressed as decimal  N is the number of time periods (1 + r )
–n can be looked up in discounting tables. It is known as the 
 
 Illustration 1 –  Discounting 
 $5,000 is required in 10 years. $x is invested in an account earning 5% 
interest p.a. 
The value of $x may be established as follows: We know that V = X (1+r)
n  
And we know that V = $5,000 r = 5%  n = 10  So we can insert these values into the formula as follows: $5,000 = X (1 + 0.05)
10 
X = $5,000/1.0510 
x	=	5,000
1.0510	=	$3,070	
 
 Example 2: Discounting I 
 Calculate the present value of $25,000 receivable in six years’ time, if the 
interest rate is 10% p.a. 
 
 The cost of capital 
In the above discussions we referred to the rate of interest. There are a number 
of alternative terms used to refer to the rate a firm should use to take account of the time value of money: 
• cost of capital 
• discount rate 
• required rate of return.

146  
 Whatever term is used, the rate of interest used for discounting reflects the 
cost of the finance that will be tied up in the investment. 
There are four widely used appraisal methods: 
(1) – the Net Present Value, (NPV) that considers the time value of money and 
uses discounted cash flow techniques 
(2)  the Internal Rate of Return (IRR), that also considers the time value of 
money and uses discounted cash flow techniques 
(3) The Payback period, reviewed in the next chapter (4) The Accounting Rate of Return (ARR), reviewed in the next chapter. 
6  Net present value (NPV) 
The net present value (NPV) is the net benefit or loss of benefit in present value 
terms from an investment opportunity. 
NPV is the 'difference between the sum of the projected discounted cash 
inflows and outflows attributable to a capital investment or other long-term project' (Official CIMA Terminology). 
 
 The NPV represents the surplus funds (after funding the investment) earned on the project. This means that it tells us the impact on shareholder wealth. Therefore: 
Decision criteria 
• Any project with a positive NPV is viable. 
• Projects with a negative NPV are not viable. 
• Faced with mutually-exclusive projects, choose the project with the highest 
NPV. 
Note:  the NPV is a surplus. If the NPV is zero or tiny then the project is still 
providing the required rate of return. A positive NPV is desirable and the bigger 
it is the better, but it doesn’t have to be more than zero.

Chapter 5 
 147 
 Illustration 2 – What does the NPV actually mean? 
 NPV is defined as the: 
difference between the sum of the projected discounted cash 
inflows and outflows attributable to a capital investment or other long-term project. 
However, it is often easier to understand it as the surplus of funds 
available to the investor. 
Suppose, in an investment problem, we calculate the NPV of certain cash 
flows at 12% to be ($97), and at 10% to be zero, and yet at 8% the NPV 
of the same cash flows is + $108. Another way of expressing this is as 
follows. 
• If the company's cost of capital is 12% the investor would be $97 out 
of pocket – i.e. the investment earns a yield below the cost of capital. 
• If the company's cost of capital is 10% the investor would break 
even – i.e. the investment yields a return equal to the cost of capital. 
• If the company's cost of capital is 8% the investor would be $108 in 
pocket – i.e. the investment earns a return in excess of the cost of 
capital. 
In other words, an NPV of zero indicates that the project generates an acceptable rate of return and is, therefore, worth accepting because shareholder wealth is being maintained. A positive NPV indicates that the rate offered exceeds the required rate and so shareholder wealth increases. A negative NPV indicates that the project does not earn an acceptable rate of return and so it would reduce shareholder wealth. 
 
 Assumptions used in NPV  
 • All cash flows occur at the start or end of a year. 
Although in practice many cash flows accrue throughout the year, for 
discounting purposes they are all treated as occurring at the start or end of a year. Note also that if today (T
0) is 01/01/20X0, the dates 31/12/20X1 
and 01/01/20X2, although technically separate days, can be treated for discounting as occurring at the same point in time, i.e. at T
1. 
• Initial investments occur at once (T 0), other cash flows start in one 
year’s time (T 1). 
In project appraisal, the investment needs to be made before the cash flows can accrue. Therefore, unless the examiner specifies otherwise, it is assumed that investments (including any working capital requirement) 
occur in advance. The first cash flows associated with running the project 
are therefore assumed to occur one year after the project begins, i.e. at T
1.

148  
 Example 3: Wilson NPV 
 Wilson Ltd is considering a capital investment in new equipment. The 
estimated cash flows are as follows. 
 
Year  Cash flow 
$ 
0 (240,000) 
1 80,000 
2 120,000 3 70,000 
4 40,000 
5 20,000 
The company’s cost of capital is 9%. 
Calculate the NPV of the project to assess whether it should be 
 
 Example 4: Mickey Ltd 
 Mickey Ltd is considering two mutually-exclusive projects with the 
following details: 
Project A 
 
Initial investment $450,000     
Scrap value at the end of 
year 5  
$20,000     
Year: 1 2 3 4 5 
Annual cash flows ($000) 200 150 100 100 100 
Project B 
 
Initial investment $100,000      
year 5  
$10,000      
Year:  1 2 3 4 5 
Annual cash flows ($000)  50 40 30 20 20 
Assume that the initial investment is at the start of the project and the annual cash flows are at the end of each year.

Chapter 5 
 149 
 Required: 
Calculate the Net Present Value for Projects A and B if the relevant cost 
of capital is 10%. 
 
  Project A Project B 
Year Discount 
factor 10% Net cash flow 
$000 PV 
$000 Net cash flow 
$000 PV 
$000 
0      
1      
2      
3      
4      
5      
      
Calculate which project has the highest NPV. 
 
 Advantages and disadvantages of NPV  
 When appraising projects or investments, NPV is considered to be 
superior (in theory) to most other methods. This is because it: 
• considers the time value of money – discounting cash flows to PV 
takes account of the impact of interest, inflation and risk over time. 
(See later sessions for more on inflation and risk.) These significant issues are ignored by the basic methods of payback and accounting rate of return (ARR) 
• is an absolute measure of return – the NPV of an investment 
represents the actual surplus raised by the project. This allows a business to plan more effectively. Neither ARR nor payback is an absolute measure 
• is based on cash flows not profits – the subjectivity of profits makes 
them less reliable than cash flows and therefore less appropriate for decision making 
• considers the whole life of the project – methods such as payback 
only consider the cash flows prior to the payback. NPV takes account of all relevant cash flows 
• should lead to maximisation of shareholder wealth. If the cost of 
capital reflects the investors’ (i.e. shareholders’) required return, then the NPV reflects the theoretical increase in their wealth. For a company, this is considered to be the primary objective of the business.

150  
 However, there are some potential drawbacks: 
• It is difficult to explain to managers. To understand the meaning of 
the NPV calculated requires an understanding of discounting. The 
method is not as intuitive as techniques such as payback. 
• It requires knowledge of the cost of capital. The calculation of the 
cost of capital is, in practice, more complex than identifying interest rates. It involves gathering data and making a number of calculations based on that data and some estimates. The process may be deemed too protracted for the appraisal to be carried out. 
• It is relatively complex. For the reasons explained above, NPV may 
be rejected in favour of simpler techniques. 
7  Internal rate of return (IRR) 
The IRR is the rate of return at which the project has a NPV of zero. 
• If the IRR is greater than the cost of capital, the project should be 
accepted. If the IRR is less than the cost of capital, the project should be 
rejected. 
 
 Further explanation of IRR 
 Using the NPV method, PVs are calculated by discounting cash flows at 
a given cost of capital, and the difference between the PV of costs and the PV of benefits is the NPV. In contrast, the IRR method of analysis is to calculate the exact rate of return that the project is expected to achieve. 
If an investment has a positive NPV, it means it is earning more than the 
cost of capital. If the NPV is negative, it is earning less than the cost of capital. This means that if the NPV is zero, it will be earning exactly the cost of capital. 
Conversely, the percentage return on the investment must be the rate of 
discount or cost of capital at which the NPV equals zero. This rate of return is called the IRR and if it is higher than the target rate of return then the project is financially worth undertaking.

Chapter 5 
 151 
Calculating the IRR (usi ng linear interpolation) 
The steps in linear interpolation are: 
1 Calculate two NPVs for the project at two different costs of capital 2 Use the following formula to find the IRR: 
 
 FORMULA FOR IRR 
 
IRR	=	L	+	NL
NL–	NH×	ሺH –	Lሻ 
where: 
L = Lower rate of interest   H = Higher rate of interest N
L = NPV at lower rate of interest  N H = NPV at higher rate of interest. 
 
 Accuracy of the formula 
 The formula makes an approximation of the IRR by assuming that the 
NPV will move downward in a straight line. In reality the NPV line is 
curved and therefore there will be an element of error in the IRR estimation. The choice of rates to estimate the IRR can affect the answer provided by the formula. 
Ideally you should aim to satisfy two criteria: 
• do not use rates which are too far apart. A 5% difference should be 
sufficient. The further the rates are away from each other than the 
greater the amount of error in the IRR calculation. 
• For a 'normal' project, using one positive and one negative NPV will 
result in the IRR being over estimated. Using two positive NPVs, or two negative NPVs, will result in the IRR being under estimated. The only way to get accuracy is to have both, or at least one guess pretty close to the answer. The interpolation formula can cope with any combination.

152  
 Example 5: Mickey IRR 
 (a)  Calculate the internal rate of return of Project A. 
 
  Project A 
Year Discount factors  
at ?% Net cash flow 
$000  PV 
$000  
0  (450)  
1  200  
2  150  
3  100  
4  100  
5  120  
 
(b)  Calculate the internal rate of return of Project B. 
You are given the following: 
At 10% the NPV was $33,310  
At 20% the NPV is $8,510 At 30% the NPV is ($9,150) 
 
 Illustration 3 – Calculating the IRR using a graph 
 The IRR may be calculated by a linear interpolation, i.e. by assuming a 
linear relationship between the NPV and the discount rate. Plotting a 
graph would give an approximate IRR, but the same point can also be found using a formula. 
Step 1 Calculate two NPVs for the project at two different costs of 
capital. You can choose any costs of capital and get a fair result. However, it helps to find two costs of capital for which the NPV is close to 0, because the IRR will be a value close to them. Ideally, you should use one cost of capital where the NPV is positive and the other cost of capital where the NPV is negative, although this is not essential. You should not waste time in the exam. 
Step 2  Once the two NPVs have been calculated, they and their 
associated costs of capital can be used to calculate the IRR. In other words, we can estimate the IRR by finding the point where a line joining these points would cross the x-axis (the point where the NPV is zero) in a graph plotting the project NPV against various discount rates. 
To calculate the exact IRR requires a more complex technique, best carried out using an Excel spreadsheet. This will not be expected in the exam.

Chapter 5 
 153 
 Example 6: Potential Project 
 A potential project’s predicted cash flows give a NPV of $50,000 at a 
discount rate of 10% and ($10,000) at a rate of 15%. 
Calculate the internal rate of return (IRR). 
 
 Example 7: IRR and decision making 
 A business undertakes high-risk investments and requires a minimum 
expected rate of return of 17% pa on its investments. A proposed capital 
investment has the following expected cash flows: 
 
Year  $ 
0 (50,000) 
1 18,000 
2 25,000 
3 20,000 4 10,000 
State, on financial grounds alone, whether this project should go ahead. 
Note:  you should calculate the NPV of the project at a cost of capital of 
15% and 20%. 
 
 IRR where there are annuities/perpetuities 
 Calculating the IRR of a project with even cash flows  
There is a simpler technique available, using annuity tables, if the project 
cash flows are annuities i.e. where it equal annual cash flows from year 1 onwards. 
1 Find the cumulative discount factor, Initial investment ÷ Annual 
inflow 
2 Find the life of the project, n. 3 Look along the n year row of the cumulative discount factor until the 
closest value is found. 
4 The column in which this figure is found is the IRR. Illustration: Find the IRR of a project with an initial investment of 
$1.5 million and three years of inflows of $700,000 starting in one year.

154  
 NPV calculation: 
  Cash flow DF (c) % PV 
  $000  $000 
T i m e      
0 Investment (1,500) 1 (1,500) 
1 – 3 Inflow 700 (b) (a) 
–––– 
NPV    Nil 
–––– 
 
• The aim is to find the discount rate (c) that produces an NPV of nil. 
• Therefore the PV of inflows (a) must equal the PV of outflows, 
• If the PV of inflows (a) is to be $1,500,000 and the size of each 
inflow is $700,000, the DF required (b) must be 1,500,000 ÷ 
700,000 = 2.143. 
• The discount rate (c) for which this is the 3-year factor can be found 
by looking along the 3-year row of the cumulative discount factors 
shown in the annuity table. 
• The figure of 2.140 appears under the 19% column suggesting an 
IRR of 19% is the closest. 
Calculating the IRR of a project where the cash flows are 
perpetuities  
 
IRR of a perpetuity 	= Annual inflow
Initial investment	×	100 
 
Illustration – Calculating IRR where cash flows are perpetuities 
Find the IRR of an investment that costs $20,000 and generates $1,600 
for an indefinitely long period. 
Solution 
 
IRR	=	Annual inflow
Initial investment 	×	100	=	$1,600
420,000	×	100	=	8%

Chapter 5 
 155 
 Advantages and disadvantages of IRR 
• IRR considers the time value of money. The current value earned 
from an investment project is therefore more accurately measured. 
As discussed above this is a significant improvement over the basic methods. 
• IRR is a percentage and therefore easily understood. Although 
managers may not completely understand the detail of the IRR, the concept of a return earned is familiar and the IRR can be simply compared with the required return of the organisation. 
• IRR uses cash flows not profits. These are less subjective as 
discussed above. 
• IRR considers the whole life of the project rather than ignoring later 
flows (which would occur with payback). 
• The IRR can be calculated when the cost of capital is unknown (say, 
if finance for a project has yet to be determined). It therefore may provide a useful benchmark for appraising potential sources of capital. 
• A firm selecting projects where the IRR exceeds the cost of capital 
would normally increase shareholders' wealth. This holds true provided the project cash flows follow the typical pattern of an outflow followed by a series of inflows, as in the investment examples above. 
However there are a number of difficulties with the IRR approach: 
• It is not a measure of absolute profitability. A project of $1,000 
invested now and paying back $1,100 in a year’s time has an IRR of 
10%. If a company’s required return is 6%, then the project is viable according to the IRR rule but most businesses would consider the absolute return too small to be worth the investment. 
• Interpolation only provides an estimate (and an accurate estimate 
requires the use of a spreadsheet programme). The cost of capital calculation itself is also only an estimate and if the margin between required return and the IRR is small, this lack of accuracy could actually mean the wrong decision is taken. 
For example if the cost of capital is found to be 8% (but is actually 
8.7%) and the project IRR is calculated as 9.2% (but is actually 8.5%) the project would be wrongly accepted. Note that where such a small margin exists, the project’s success would be considered to be sensitive to the discount rate (see session 12 on risk).

156  
 • Non-conventional cash flows may give rise to no IRR or multiple 
IRRs. For example a project with an outflow at T0 and T2 but 
income at T1 could, depending on the size of the cash flows, have a number of different profiles on a graph (see below). Even where the project does have one IRR, it can be seen from the graph that the decision rule would lead to the wrong result as the project does not earn a positive NPV at any cost of capital. 
For example, a project with an immediate outflow of $10m, followed by an inflow of $90m in one year's time and a final outflow of $100m would have the following NPVs: 
 
Discount rate NPV ($m) 
10% –10.8 
29.85% 0 
60% 7.2 
670.5% 0 
1000% –2.64 
  
 The NPV starts off negative, then at rates above 30% will become 
positive, before becoming negative again at rates above 670.5%. This 
could be represented by the dark line in the diagram/graph below 
 
As the size of the project flows reduce the NPV would likewise reduce and the NPV line fall (as in the lower dashed lines). It can therefore be seen that there might only be one NPV (if the line just touches the zero NPV point) or no IRR's at all if the project has negative NPVs at all discount rates. 
Note:  multiple IRRs are usually associated with two or more periods 
when the project has an outflow. The problem doesn’t arise if there is a traditional project with an initial investment, followed by annual inflows. It 
is also highly unlikely to arise if the second outflow is small and/or in the 
very distant future. For example, a project might have very small closure costs at the end, in which case it is still unlikely that there will be more 
than one IRR.

Chapter 5 
 157 
NPV versus IRR 
Both NPV and IRR are investment appraisal techniques which discount cash 
flows and are superior to the basic techniques discussed in the previous session. However only NPV can be used to distinguish between two mutually-exclusive projects, as the following diagram demonstrates. 
 
Explanation of the principle 
 NPV and IRR may sometimes give conflicting advice and recommend 
different projects. 
Consider the following two projects: 
 Initial 
investment  
($m) Year 1 
flow 
($m) Year 2 
flow 
($m) NPV 
($m) @ 
10% IRR 
Project A (10) 0 25 10.7 58.1% 
Project B (10) 10 12 9.0 70.4% 
Project A has the higher NPV but the lower IRR. The choice of project 
appraisal method would therefore affect the choice of project. 
The NPV of these projects could be represented diagrammatically as 
follows: 
 
It can be seen that the NPV curves cross. But the vital piece of 
information is the firm’s cost of capital. This is the actual cost of financing 
the project (i.e. it is the cost that the company will have to pay for financing the initial $10m investment ). Once this cost is met, the 
remaining project surplus (the NPV) can be returned to shareholders. It is therefore the NPV information which will be of more concern to investors or shareholders.

158  
 The IRR is not an actual cost of capital. It instead tells us the cost of 
capital at which the project will break even. This cost of capital might 
never arise. 
The IRR is a useful piece of information when we are examining one 
project. It allows us to determine the highest acceptable cost of capital. But when comparing one project to another, the NPV figure is based on a more appropriate cost of capital. Therefore the NPV of projects should be used when deciding which project in which to invest. 
 
 The advantage of NPV is that it tells us the absolute increase in shareholder wealth as a result of accepting the project, at the current cost of capital. The IRR simply tells us how far the cost of capital could increase before the project would not be worth accepting. 
 
Attitudes to risk 
 The general decision rule in DCF analysis is that where mutually 
exclusive projects are being considered, the one with the highest NPV is preferred. However, some caution should be exercised in the use of this rule. Our earlier exploration of attitude to risk indicated that a low-risk project with a lower expected NPV may be preferred to a high risk project with a higher NPV. 
IRR is normally reported as part of a project appraisal. However, since it 
is a relative measure which lacks an element of scale it should not be 
used to select between alternatives. A large project with a high NPV will normally be preferred to a small project with a lower NPV but a higher IRR. A tiny project can have a very high IRR. But IRR can still be informative since it offers insights into  the return that alternative uses for 
capital offer and this can be a guide to future strategy and decision-making. 
8  The Modified IRR 
A more useful measure is the modified internal rate of return or MIRR. This measure has been developed to counter the above problems since it is unique, gives a measure of the return from a project, and is a simple percentage. 
It is therefore more popular with non-financially minded managers, as a simple 
rule can be applied: 
MIRR = Project's return 
If Project return > company cost of finance → Accept project

Chapter 5 
 159 
The interpretation of MIRR 
MIRR measures the economic yield of the investment under the assumption 
that any cash surpluses are reinvested at the firm’s current cost of capital. 
Although MIRR, like IRR, cannot replace net present value as the principal 
evaluation technique, it does give a measure of the maximum cost of finance that the firm could sustain and allow the project to remain worthwhile. For this reason it gives a useful insight into the margin of error, or room for negotiation, when considering the financing of particular investment projects. 
Calculation  
There are several ways of calculating the MIRR, but the following formula is 
usually used: 
Formula: 
MIRR = [(Terminal value of inflows/Present Value of outflows)1/n] – 1  
where 'n' represents the number of future time periods. 
 
 Example 8: Alpine Ltd 
 A project with the following cash flows is under consideration in a 
company called Alpine Ltd: 
$000 T0  T1  T2  T3  T4 
 (20,000) 8,000  12,000 4,000  2,000 
 
Cost of capital 8% 
Calculate the MIRR. 
9  NPV and IRR with equal cash flows 
Discounting annuities  
 
 When a project has equal annu al cash flows the a nnuity factor may be 
used to calculate the NPV (and hence the IRR).  
An annuity is a constant annual cash flow for a number of years. 
 
 The annuity factor  (AF) is the name given to the sum of the individual DF.  
The PV of an annuity can therefore be quickly found using the formula: 
PV = Annual cash flow × AF 
As when calculating a discount factor, the annuity factors (AF) can be found 
using an annuity formula or annuity tables (cumulative present value tables).

160  
 Annuity factor formula 
 The formula is: 
 
AF	= 1 – ሺ1	+	rሻ–n
r 
 
Where 
r = cost of capital n = the number of periods 
 For example, for a six-year annuity at 10%: 
 
Note:  there is a small difference due to roundings. 
Note:  annuity tables are titled cumulative present value tables in the 
exam. 
 
 Illustration 4 – Annuities 
 Pluto Ltd has been offered a project costing $50,000. The returns are 
expected to be $10,000 each year for seven years. Cost of capital: 10%. To decide whether the project be accepted: 
 
Year Cash flow Discount 
factor Present 
value 
 $  $ 
0 (50,000) 1.000 (50,000) 
1–7 10,000 4.868 48,680 
–––––– 
   (1,320) 
The project should therefore be rejected. The IRR of the project may be calculated as follows:  $10,000 × annuity factor = $50,000 Annuity factor = 5 Using tables and a life of seven years, the closest annuity factor to 5 is 
5.033. This means the IRR is approximately 9%.

Chapter 5 
 161 
Discounting perpetuities 
 
 A perpetuity  is an annual cash flow that occurs forever. 
 
 It is often described by examiners as a cash flow continuing ‘for the 
foreseeable future’. 
The PV of a perpetuity is found using the formula: 
 
PV	= Cash	flow
r 
 
'r' in the formula is the company's required rate of return (or cost of capital). 
or 
 
PV = cash 	flow × 1
r 
1
r is known as the 'perpetuity factor '. 
 
 Illustration 5 – Perpetuities 
 An investment of $50,000 is expected to yield $5,670 per annum in 
perpetuity. The net present value of the investment opportunity if the cost of capital 
is 9% can be calculated as follows: 
NPV = ($50,000) + $5,670 ÷ 0.09 = $13,000 
 
 Example 9: Present Value, annuities, perpetuities 
 Calculate the present value of the following cash flows: 
1 A fifteen year annuity of $300 starting at once. Interest rates are 6%. 2 A perpetuity of $33,000 commencing immediately. Interest rates are 
22%. 
 
 Example 10: IRR, perpetuities 
 Calculate the IRR of an investment of $50,000 if the inflows are: 
(a) $5,000 in perpetuity  (b) $8,060 for eight years.

162  
 Annuities/perpetuities in advance 
 The use of annuity factors and perpetuity factors both assume that the 
first cash flow will be occurring in one year's time. If this is not the case, 
you will need to adjust your calculation. 
Advanced annuities and perpetuities 
Some regular cash flows may start now (at T 0) rather than in one years 
time (T 1). 
Calculate the PV by ignoring the payment at T0 when considering the 
number of cash flows and then adding one to the annuity or perpetuity factor. 
Illustration – Advanced annuities and perpetuities A 5-year $600 annuity is starting today. Interest rates are 10%. Find the 
PV of the annuity. 
Solution 
This is essentially a standard 4-year annuity with an additional payment 
at T
0. The PV could be calculated as follows: 
 
PV = 600 + 600 × 3.17 = 600 + 1902 = $2,502 
The same answer can be found more quickly by adding 1 to the AF: PV = 600 × (1 + 3.17) = 600 × 4.17 = $2,502. Illustration – Advanced perpetuities A perpetuity of $2,000 is due to commence immediately. The interest rate 
is 9%. What is the PV? 
Solution 
This is essentially a standard perpetuity with an additional payment at T
0. 
The PV could be calculated as follows: 
T0 T 1 T 2 T 3 T 4 ..... 
2,000 2,000 → ∞    
 
PV (2,000) + (2,000 × 9% perpetuity formula) 
Again, the same answer can be found more quickly by adding 1 to the 
perpetuity factor. 
 
2,000	× ൬1	+ 1
0.09൰	=	2,000	×	12.11	=	$24,222

Chapter 5 
 163 
 Annuities/perpetuities in arrears 
 Delayed annuities and perpetuities 
Some regular cash flows may start later than T 1. 
These are dealt with by: 
1 applying the appropriate factor to the cash flow as normal 2 discounting your answer back to T
0. 
Illustration – Delayed annui ties and perpetuities 
What is the PV of $200 incurred each year for four years, starting in three 
year’s time, if the discount rate is 5%? 
Solution 
 
Step 1  Discount the annuity as usual 
200 × 4 yr 5% AF = 200 × 3.546 = 709.2  
Note that this gives the value of the annuity at T 2 
Step 2 Discount the answer back to T 0 
709.2 × 2 yr 5% DF = 709.2 × 0.907 = $643 
Annuity or perpetuity factors will discount the cash flows back to give the 
value one year before the first cash flow arose. For standard annuities and perpetuities this gives the present (T
0) value since the first cash flow 
started at T 1. 
However for delayed cash flows, applying the factor will find the value of the cash flows one year before they began, which in this example is T
2. 
To find the PV, an additional calculation is required – the value must be discounted back to T
0. 
Care must be taken to discount back the appropriate number of years. The figure here was discounted back two years because the first step gave the value at T
2. It can help to draw a timeline as above and mark on 
the effect of the first step (as shown with a 1. here) to help you remember.

164  
 Illustration 6 – Annuities 
expected to be $10,000 each year for seven years. Cost of capital: 10%. 
To decide whether the project should be accepted: 
 
value 
 $  $ 
–––––– 
   (1,320) 
$10,000 × annuity factor = $50,000 Annuity factor = 5 
 
time (T 1). 
Solution 
at T
 
The same answer can be found more quickly by adding 1 to the AF: PV = 600 × (1 + 3.17) = 600 × 4.17 = $2,502.

Chapter 5 
 165 
 Illustration – Advanced perpetuities 
A perpetuity of $2,000 is due to commence immediately. The interest rate 
Solution 
This is essentially a standard perpetuity with an additional payment at T 0. 
 
PV (2,000) + (2,000 × 9% perpetuity formula) Again, the same answer can be found more quickly by adding 1 to the 
 
0.09൰	=	2,000	×	12.11	=	$24,222 
 
Some regular cash flows may start later than T 1 . 
0. 
Solution

166  
 Step 1  Discount the annuity as usual 
2. 
0. 
the effect of the first step (as shown with a 1. here) to help you remember. 
10 Changing discount rates 
Throughout this chapter, we have assu med that a company will have a constant 
discount rate. This allows us to use the tables of discount rates that are provided in the exam. However, in reality discount rates might change from year to year. For example, in the next chapter we will see that inflation affects discount rates, and because inflation is not constant discount rates will not be constant. 
In these instances, we cannot use the tables that we are provided with, and 
instead we must calculate each year's discount factor individually using the discounting formula from the start of this chapter. 
 
Illustration 7 – Changing discount rates 
 A company is considering a four year investment. Its cost of capital 
during this period is expected to rise each year as interest rates and 
inflation rates rise in the economy. It expects its cost of capital to be as follows: 
Year 1 10% 
Year 2 12% 
Year 3 15% 
Year 4 16% 
Calculate the discount rate that should be used for each year.

Chapter 5 
 167 
 Answer 
Because the cost of capital is changing each year, we cannot use the 
tables that we are provided with. Instead, we have to calculate the discount rate for each year individually. 
The best way to do this is to divide the discount factor for the previous 
year by (1 + the cost of capital for the year in question). This can be shown as follows: 
 Calculation Discount factor 
Year 0  1.000 
Year 1 1.000/1.10 0.909 
Year 2 0.909/1.12 0.812 
Year 3 0.812/1.15 0.706 
Year 4 0.706/1.16 0.608 
These are the discount factors that would be used in any PV calculation 
employed by the company. 
Note:  this means that the cash flow in year 3, say, has to be discounted 
on the basis that we need a 10% return for year 1, followed by 12% for 
year 2, followed by 15% for year 3. 
This technique can be very important when dealing with inflation in the next 
chapter. 
11 Dealing with non annual periods 
In some instances we may have to deal with cash flows which are not in annual 
terms – for example, costs might be paid in 6 monthly blocks. In these case, we need to pro-rate the discount rate to match the period of the cash flows. 
 
 Illustration 8 – Dealing with non-annual periods 
 If, say, we are given an annual discount rate of 10% but cash flows are 
received in non-annual instalments, in order to calculate the appropriate 
cost of capital to use for calculations we would need to pro-rate the 10% as follows: 
 
Cash flows are 
in... Pro-rata 
formula Calculation Appropriate 
discount rate 
Quarters (1 + i)1/4 –1 (1.10)1/4 –1 2.41 % per quarter 
6 monthly periods (1 + i)1/2 –1 (1.10)1/2 –1 4.88% per 6 months 
Months (1 + i)1/12 –1 (1.10)1/12 –1 0.8% per month 
2 yearly instalments 
 (1 + i)2 –1 (1.10)2 –1 21 % per two years

168  
12  Capital rationing 
If investment funds are unlimited, then all projects with a positive NPV should 
be undertaken. Capital rationing occurs when insufficient funds are available to undertake all beneficial projects. 
 
 Hard and soft capital rationing 
 The term soft capital rationing is oft en used to refer to situations where 
for various reasons the firm internally imposes a budget ceiling on the 
amount of capital expenditure. If the capital is restricted because of external constraints such as the inability to obtain funds from the financial markets, the term hard capital rationing is used. The type of rationing imposed on a firm will not, however, affect our analysis. 
 
 The objective of all capital rationing exercises is the maximisation of the total NPV of the chosen projects’ cash flows at the cost of capital. Thus it becomes necessary to rank projects to enable the optimum combination to be undertaken. 
Underlying assumptions: 
• Individual projects  are divisible. The resulting NPV will be pro-rated. For 
example, if only 25% of the capital is available for a project only 25% of its 
NPV will be earned. 
• Annual cash flows cannot be delayed or brought forward. 
• Capital funds are restricted in just one period (year 0). 
The decision aims to maximise NPV given a single limiting factor. As with other 
decisions with one scarce resource, the opportunities should be ranked according to NPV per $1 invested. This measure is called the profitability index 
(PI). 
Profitability index 	=	NPV of project
Initial cash outflows
 
LEARN  
The optimal investment plan is determined by: 
1 calculating a PI for each project 2 ranking the projects according to their PI 3 allocating funds according to the projects' rankings until they are used.

Chapter 5 
 169 
 Example 11: Capital Rationing 
 A company may undertake any of the following investment projects. 
 
Project Investment required Net Present value 
 $000 $000 
A 3,400 850 
B 2,750 825 C 2,000 720 
D 3,400 680 
E 860 430 F 950 400 
G 1,250 350 
 
 In the next budget period there is only $9 million available for capital 
expenditure projects. Each project is divisible. 
Required: 
(a) If the company ranks the projects according to highest NPVs, which 
projects will be undertaken? Calculate the total NPV. 
(b) If the company selects projects ac cording to their profitability index, 
calculate which projects will be undertaken. Calculate the total NPV 
now. 
13 Discounted Payback Profitability Index (DPBI) 
Alternatively, the index may be shown as a 'discounted payback index' (DPBI): 
 
DPBI	= Present Value of net cash inflows
Initial cash outlay 
LEARN 
This is a measure of the number of times a project recovers the initial funds invested, something that is particularly important if funds are scarce. 
The higher the figure, the greater the returns. A DPBI of less than 1 indicates a 
negative NPV, i.e. that the present value of the net cash inflows is less than the initial cash outlay.

170  
 Dealing with indivisible projects 
 There may be scenarios where 'common sense' has to come into play 
and this general rule has to be ignored. Consider the following example: 
Example 
A company has an investment limit of $800,000 and has to choose 
between the following three projects: 
 
Project Investment Inflow PV NPV PI Rank 
A 600,000 700,000 100,000 0.17 1 
B 500,000 560,000 60,000 0.12 3 
C 300,000 345,000 45,000 0.15 2 
On the basis of the general rule, Project A only would be selected since it 
has the highest PI. But this precludes any other projects, generating an NPV of $100,000 and leaving $200,000 of the capital limit uncommitted. Consequently, NPV is maximised by adopting two projects (B and C) both of which have lower PIs than A. By adopting these two projects we raise total NPV to $105,000. 
In these circumstances, the objective can only be achieved by selecting 
from amongst the available projects on a trial and error basis. Because of the problem of indivisibility this may leave some funds unutilised. Consider another example: 
Example 
PQ has $50,000 available to invest. Its cost of capital is 10 %. The 
following indivisible projects are available.  
 
Project Initial outlay Return p.a. 
to perpetuity 
 $ $ 
1 20,000 1,500 
2 10,000 1,500 
3 15,000 3,000 
4 30,000 5,400 5 25,000 4,800

Chapter 5 
 171 
 Solution 
The first stage is to calculate the NPV of the projects. 
 
Project Initial outlay PV of cash 
flows NPV 
 $ $ $ 
1 20,000 15,000 (5,000) 
2 10,000 15,000 5,000 
3 15,000 30,000 15,000 4 30,000 54,000 24,000 
5 25,000 48,000 23,000 
The approach is then one of considering all possible combinations of 
projects under the investment limit of $50,000. 
The optimum selection of projects is as follows: 
 
Project Initial outlay NPV 
 $ $ 
2 10,000 5,000 
3 15,000 15,000 
5 25,000 
–––––– 23,000 
–––––– 
 50,000 43,000 
–––––– 
Unused funds Nil 
––––––  
Funds available 50,000 
––––––  
   
14  Identifying real options in investment appraisal  
• Flexibility adds value to an investment. 
– For example, if an investment can be staggered, then future costs 
can be avoided if the market turns out to be less attractive than 
originally expected. 
– The core to this value lies in reducing downside risk exposure but 
keeping upside potential open – i.e. in making probability distributions asymmetric. 
– Financial options are an example w here this flexibility can be valued. 
– A call option on a share allows an investor to ‘wait and see’ what 
happens to a share price before deciding whether to exercise the option and will thus benefit from favourable price movements without being affected by adverse movements.

172  
• Real options theory attempts to classify and value flexibility in general by 
taking the ideas of financial options pricing and developing them. 
– A financial option gives the owner the right, but not the obligation, to 
buy or sell a security at a given price. Analogously, companies that 
make strategic investments have the right, but not the obligation, to exploit these opportunities in the future. 
–  As with financial options most real options involve spending more up 
front (analogous to the option premium) to give additional flexibility later. 
• Conventional investment-appraisal techniques typically undervalue 
flexibility within projects with high uncertainty. 
– High uncertainty within a NPV context will result in a higher discount 
rate and a lower NPV. However, with such uncertainty any 
embedded real options will become more valuable. 
There are many different classifications of real options: 
Options to delay/defer 
The key here is to be able to delay investment without losing the opportunity, 
creating a call option on the future investment. 
 
Illustration 9 – Identifying real options – Delay/Defer 
 For example, establishing a drugs patent allows the owner of the patent 
to wait and see how market conditions develop before producing the 
drug, without the potential downside of competitors entering the market. 
Options to switch/redeploy 
It may be possible to switch the use of assets should market conditions change. 
 
 Illustration 10 – Identifying real options – switch/redeploy 
 For example, traditional production lines were set up to make one 
product. Modern flexible manufacturing systems (FMS) allow the product 
output to be changed to match customer requirements. 
Similarly a new plant could be designed with resale and/or other uses in mind, using more general-purpose assets than dedicated to allow easier switching. 
 
 Illustration 11 – Identifying real options – Switch/redeploy 
 For example, w hen designing a fact ory managem ent can choose whether 
to have higher or lower operating gearing. By having mainly variable 
costs, it is financially more beneficial if the factory does not have to operate every month.

Chapter 5 
 173 
Options to expand/contract 
It may be possible to adjust the scale of an investment depending on the market 
 
 Illustration 12 – Identifying real options – expand 
 For example, when looking to develop their stadiums, many football clubs 
face the decision whether to build a one- or a two-tier stand: 
• A one-tier stand would be cheaper but would be inadequate if the 
club's attendance improved greatly. 
• A two-tier stand would allow for much greater fan numbers but 
would be more expensive and would be seen as a waste of money 
should attendance not improve greatly. 
Some clubs (e.g. West Bromwich Albion in the UK) have solved this problem by building a one-tier stand with stronger foundations and 
designed in such a way (e.g. positioning of exits, corporate boxes, etc.) 
that it would be relatively straightforward to add a second tier at a later stage without knocking down the first tier. Such a stand is more expensive than a conventional one-tier stand but the premium paid makes it easier to expand at a later date when (if) attendance grows. 
 
 Illustration 13 – Identifying real options – expand 
 Amazon.com undertook a substantial investment to develop its customer 
base, brand name and information infrastructure for its core book business. 
This in effect created a portfolio of real options to extend its operations 
into a variety of new businesses such as CDs, DVDs, etc. 
Options to abandon 
If a project has clearly identifiable stages such that investment can be 
staggered, then management have to decide whether to abandon or continue at the end of each stage.

174  
 Relevant costs and the decision to abandon 
 During our initial consideration of project appraisals, it was noted that 
past costs were irrelevant to any decision regarding the future of a 
project. This remains true for those occasions when the company has already started a project and wishes to establish whether it should continue with it, or whether it should abandon the project part way through its life. 
The only relevant costs are future costs: these will be compared with 
future revenues to decide the viability of abandonment. Management is often reluctant to take a decision to abandon a project half-way through, 
as it is often considered to reflect a poor past decision; however true this 
may be, it would be even worse to compound the error by making another poor decision. Projects must, therefore, be kept constantly under review. 
Factors in the decision to abandon 
The following considerations must be taken into account in deciding 
whether to continue or abandon a project: 
• future cash outflows associated with the project • future cash inflows associated with the project 
• revenues/costs that would arise if the project were abandoned 
–  other projects, which may be: 
alternatives to the project under consideration 
more profitable uses of funds tied up in the project under 
review. 
Each of these factors must be consciously assessed at each stage of the project’s life and, if it is seen that abandoning the project would be more beneficial than proceeding with it, then an abandonment decision must be made. 
During a post-completion appraisal it may be realised that the project is not 
likely to be so profitable as first thought and the possibility of abandoning it or 
terminating it early should be considered. Past cash flows are, of course, irrelevant to the decision – only future cash flows need to be considered. Abandoning the project is only necessary when the net discounted expected future cash flow of the project becomes negative.

Chapter 5 
 175 
 Illustration 14 – Project abandonment decisions 
 Case I 
A project, P, has expected cash flows as follows: 
 
Year  
$ Cash flow DF @ 10% 
$ PV 
0 (3,500) 1.000 (3,500) 
1 2,000 0.909 1,818 
2 2,000 0.826 1,652 
3 2,000 0.751 1,502 
––––– 
NPV   + 1,472 
––––– 
The initial investment of $3,500 in project P represents the purchase of a 
customised machine, the price of which is known with certainty. Because it is a customised machine its resale value is low; it can only be sold for $1,000 immediately after purchase. Once the machine is bought, therefore, the expected value of abandoning the project would be $1,000 (1.0 × $1,000). This must be compared with the expected value of continuing with the project, which is $4,972 ($1,818 + $1,652 + $1,502). In this case the expected benefits of continuing with the project far outweigh the returns from abandoning it immediately. 
Case II The decision to abandon a project will usually be made as a result of 
revised expectations of future revenues and costs. These revisions may be consistent with the data on which the original investment decision was based, or represent an alteration to earlier expectations. If the decision is consistent with the original data, the possibility, but not the certainty, that 
the project might have to be abandoned would have been known when the project was accepted. In these circumstances, project abandonment is one of a known range of possible outcomes arising from accepting the project. 
In Case I, the cashflows for the project were based on expected value 
techniques. The expected cash flows and probabilities were as follows: 
 
Year 0 Year 1 Year 2 Year 3 
$ p $ p $ p $ 
3,500 0.33 3,000 0.33 3,000 0.33 3,000 
 0.33 2,000 0.33 2,000 0.33 2,000 
 0.33 1,000 0.33 1,000 0.33 1,000 
  –––––  –––––  ––––– 
Expected value  2,000  2,000  2,000

176  
 In year 0, the expected net cash inflow in each year of project P’s 3-year 
life is $2,000. The actual outcome of any of the 3 years is unknown at this 
point, and each of the three possible outcomes is equally likely. The factors that will cause any one of these results to occur may differ each year, or they may be the same each year. In some instances, a particular outcome in the first year may determine the outcome of years 2 and 3 with certainty. For example, the outcome of $3,000 in year 1 may mean that this same outcome will follow with certainty in years 2 and 3. Similarly outcomes of $2,000 and $1,000 in year 1 may be certain to be repeated in years 2 and 3. In year 0, the investor can only calculate the expected net cash flow in years 2 and 3, but with perfect correlation of flows between years these future flows are known with certainty at the end of year 1. If the year 1 inflow is either $3,000 or $2,000, perfect correlation between years will ensure that the actual NPV of the project will be positive. But if the first year’s outcome is $1,000, the investment will have a negative NPV of $1,014, that is ($[3,500] + $1,000 × 2.486). 
Should the project be abandoned? The information is now certain and so 
the decision on whether to abandon should be made using a risk-free interest rate and not the company’s normal cost of capital. If we assume that the risk-free rate is 5 per cent, the present value of continuing at the end of year 1 will be: 
 
Year Cash flow DF @ 5% PV 
$  $  
0 (1,000) 1.000 (1,000) 
1 1,000 0.952 952 2 1,000 0.907 907 
––––– 
PV of continuing after 1 year  + 859 
––––– 
Clearly the project should not be abandoned 
Case III 
Consider another project, Project X with the following expected cash 
flows: 
Year  Discounted cash flow 
$m 
1 (8) 
2 (16) 
3 (24) 
4 55 
–––– 
NPV + 7 
––––

Chapter 5 
 177 
 The company experienced great difficulty in implementing the project in 
year 1, and the actual costs incurred during that year were $16 m. The 
company must then ask itself whether the actual outcome in year 1 necessitates any revision in the expected outcomes of later years. If no revision is required, further costs of $40 m (year 0 values) must be incurred to secure inflows of $55 m (year 0 values). The expected net present value of continuing with project X bey ond year 1 will thus be $15 m (year 0 
values). (Note that adjusting the figures to year 1 values would increase the expected NPV slightly, strengthening the case for continuation.) 
The overall result of the investment would, of course, be negative by 
$1 m, if years 2 – 4 costs and revenues are as forecast. The excess spend of $8m in year 1 is greater than the $7 m net present value originally predicted. However, at the end of year 1 the $16 m is a sunk cost and does not influence a decision on termination made at that time. 
15  Post-completion audit 
The post-completion appraisal of projects provides a mechanism whereby experience gained from current and past projects can be fed into the 
organisation’s decision-making process to aid decisions on future projects. In 
other words, it aids organisational learning. A post-completion appraisal reviews all aspects of an ongoing project in order to assess whether it has fulfilled its initial expectations. It is a forward-looking rather than a backward-looking technique. The task is often carried out by the Capital Expenditure Committee, or an appointed sub-committee. 
 
Further discussion on post-completion audits 
 Benefits of post-c ompletion audit 
1 If managers know in advance that projects are going to be subject to 
a post-completion appraisal they ensure that assumptions and plans 
for the project are more accurate and realistic. 
2 If an appraisal is carried out before the project life ends, and it is 
found that the benefits have been less than expected because of management inefficiency, then steps can be taken to improve efficiency. 
3 It might identify weaknesses in the forecasting techniques and the 
estimating techniques used to evaluate the project. The discipline and quality of forecasting for future investments can be improved. 
4 Managers may be motivated to achieve the forecast results if they 
are aware of a pending post-completion appraisal. 
5 The appraisal reveals the reliability and quality of contractors and 
suppliers involved in the project. 
6 The appraisal may highlight the reasons for success or failure in 
previous projects – thereby providing a learning experience for managers to aid better decision making in the future.

178  
 Problems with post-completion audits 
1 It may not be possible to identify separately the costs and benefits 
of any particular project. 
2 It can be a time-consuming and costly exercise. 
3 Applied punitively, post-completion appraisal may lead managers to 
becoming over-cautious and risk averse. 
4 The strategic effects of a capital investment project may take years 
to materialise and it may never be possible to identify and quantify 
them correctly. 
5 There are many uncontrollable factors in long-term investments. 
A post-completion appraisal will not help managers change these factors in the future. 
Role of post-appraisal in project abandonment 
Those intimately involved with a project may be reluctant to admit, even to themselves, that early problems with a project are likely to continue. When problems are being experienced in project implementation, those involved may be tempted to try to resolve the situation in one of two ways. They can make a change in the original plans and/or incur further expenditure in order to meet the original objective. 
Whether either of these response s is appropriate will depend on the 
particular circumstances of the project but any significant changes or 
deviations should not be undertaken without the formal approval of higher management. The control systems in place will normally require changes of scope to be documented and approved before they are undertaken. It is usually the responsibility of the eng ineers associated with the project to 
ensure that this is done. 
Expected project cost overruns should be highlighted by the routine 
monitoring of project expenditure by accounting staff, and formal approval should be obtained for the anticipated overspend. A prerequisite of approval by top management will often be the provision of the same level 
of detailed justification as was required when the initial funds were sanctioned. These controls ensure that significant changes to the character of a project cannot be made without top management’s approval. However, they do not, of themselves, ensure that the option to terminate a project is considered, although it would be unlikely that management would fail to consider this possibility. 
 Some companies require an audit on all projects that need additional 
funds. The request for further funding would then be considered alongside the audit report. Routine monitoring of projects tends to focus almost exclusively on costs. An audit will review both costs and revenues, and, most importantly, focuses on the future. By checking the continuing validity of both forecast costs and revenues, the post-audit team is in a position to prepare a report to advise management on the wisdom of continuing with the project.

Chapter 5 
 179 
16 Practice Questions 
 Objective Test  Question 1: Discounting II 
 Calculate how much should be invested now in order to have $250 in 
eight years’ time? The account pays 12% interest per annum. 
 
 Objective Test Question 2: Allen Ltd 
 Allen Ltd is considering a project with a three-year life producing the 
following costs and revenues: 
 $ 
Cost of machine 100,000 
Depreciation of machine (for three years) 20,000 p.a. Residual value of machine 40,000 
Annual cost of direct labour 20,000 
Annual charge for foreman (10% apportionment) 5,000 Annual cost of components required 18,000 
Annual net revenues from machine 80,000 
Cost of capital 20% 
Identify which of the following is closest to the net present value of the 
machine: 
A ($13,000) B ($11,380) C $11,610 D $22,370 
 
 Objective Test Question 3: IRR Multiple Choice 
 Identify the correct explanation of the internal rate of return – it is the 
interest rate that equates the present value of expected future net cash 
flows to: 
A  the initial cost of the investment outlay B  the depreciation value of the investment C  the terminal (compounded) value of future cash receipts D  the firm’s cost of capital

180  
 
 Objective Test Question 4: Delayed Annuities 
 The financial director of A Co has prepared the following schedule to 
enable her to appraise a new project. Interest rates are 10%. She wants 
to calculate the PV of the cash flows using two different assumptions regarding the project duration. 
The assumptions are as follows: A  That the real annual cash flow will be $250,000 from Year 4 for the 
B  That the real annual cash flow will be $250,000 from Year 4 to 
Year 18. 
     Assumption Assumption 
     (A) (B) 
Year T
0 T 1 T 2 T 3 T 4 onwards T 4–T18 
Net 
cash 
flow (2,000) (440) 363 399 250 250 
Required: 
Calculate the NPV from the project under 
 
Assumption A  
  
Assumption B

Chapter 5 
 181 
 Case Study Style Question: MN plc 
MN plc has a rolling programme of investment decisions. One of these 
investment decisions is to consider mutually-exclusive investments A, B and C. The following information has been produced by the investment manager.  
 Investment 
decision A Investment 
decision B Investment 
decision C 
 $ $ $ 
Initial investment 105,000 187,000 245,000 
Cash inflow for A: years 1 to 3 48,000   
Cash inflow for B: years 1 to 6  48,000  Cash inflow for C: years 1 to 9   48,000 Net present value (NPV) at 10% 
each year  
14,376  
22,040  
31,432 
Ranking 3rd 2nd 1st 
Internal rate of return (IRR) 17.5% 14% 13% 
Ranking 1st 2nd 3rd 
    
You have just received the following email from MN's Managing Director:

182  
 V = 450(1.0625)12 = $931.45 
 
 X = 25,000/(1.10)6 = $14,112 
 
 Example 3: Wilson Ltd 
 Year  Cash flow 
$ DF at 9% PV 
$ 
0 (240,000) 1.000 (240,000) 
1 80,000 0.917 73,360 2 120,000 0.842 101,040 
3 70,000 0.772 54,040 
4 40,000 0.708 28,320 5 20,000 0.650 13,000 
NPV   + 29,760 
The PV of cash inflows exceeds the PV of cash outflows by $29,760, 
which means that the project will earn a DCF return in excess of 9%, i.e. it will earn a surplus of $29,760 after paying the cost of financing. It should therefore be undertaken. 
 
 Example 4: Mickey NPV 
  
factor Cash 
flow 
$000 Present 
value 
$000 Cash 
flow 
value 
$000 
0  (450) (450) (100) (100) 
1 0.909 200 181.8 50 45.45 
2 0.826 150 123.9 40 33.04 
3 0.751 100 75.1 30 22.53 
4 0.683 100 68.3 20 13.66 
5 0.621 120 74.52 30 18.63 
  NPV = 73.62 NPV = 33.31

Chapter 5 
 183 
 (a) 
  Project A 
Year Discount factors 
at 20% Net cash flow 
$000 PV 
$000 
0 1.000 (450) (450) 
1 0.833 200 167 
2 0.694 150 104 
3 0.579 100 58 
4 0.482 100 48 
5 0.402 120 48 
  NPV @ 20% = (25) 
 
IRR	=	L	+	NL
NL –	NH	×	(H –L)	
 
IRR	=	10	+	74
74 –	ሺ–25ሻ	×	ሺ20	 –	10ሻ	
 
IRR	=	10	+		74
99	×	(10)	
 
IRR = 10 + (0.747 × 10) 
IRR = 17.5% 
(b)  Project B At 10% the NPV was $33,310  At 20% the NPV is $8,510 At 30% the NPV is ($9,150) 
 
IRR	=	20	+ 8,510
8,510 – ሺ–9,150ሻ	× ሺ30 –	20ሻ 
 
IRR	=	20	+	8,510
17,660	×	(10) 
 
IRR = 20 + (0.482 × 10) IRR = 24.8% 
 
 Example 6: Potential project  
 IRR	=	10%	+	50,000
50,000 – 	ሺ–10,000ሻ	×	ሺ15% –	10%ሻ	=	14.17%

184  
  
Year 
$ Cash flow DF @ 
15% 
$ PV @ 
15% DF @ 
20% 
$ PV @ 
20% 
0 (50,000) 1.000 (50,000) 1.000 (50,000) 
1 18,000 0.870 15,660 0.833 14,994 
2 25,000 0.756 18,900 0.694 17,350 3 20,000 0.658 13,160 0.579 11,580 
4 10,000 0.572 5,720 
–––––– 0.482 4,820 
–––––– 
NPV   + 3,440 
––––––  (1,256) 
––––––  
The IRR is above 15% but below 20%. Using the interpolation method : 
1 The NPV is + 3,440 at 15%. 
2 The NPV is – 1,256 at 20%. 3 The estimated IRR is therefore: 
IRR	=	15%	+	3,440
൫3,440 –	ሺ–1,256ሻ൯
	×		ሺ20 	–	15ሻ% 
= 15% + 3.7% = 18.7%
  
The project is expected to earn a DCF return in excess of the target rate 
of 17%, so on financial grounds (ignoring risk) it is a worthwhile investment. 
 
 MIRR = [(TV of inflows/PV of outflows)1/n] – 1  
Here, n = 4 
The inflows occur at T 1, T2, T3 and T 4. With a cost of capital at 8%, their 
terminal value TV may be calculated as follows: 
 T 1 T 2 T 3 T 4 Total 
Cash 
inflow 8,000 12,000 4,000 2,000  
TV 8,000 × (1.08)3 12,000 × (1.08)2 4,000 × (1.08) 2,000 30,395 
 = 10,078 = 13,997 = 4,320   
The Present Value of outflows is $20,000.  
MIRR = [(TV of inflows/PV of outflows)1 /4] – 1  
MIRR = [(30,395/20,000)1/4] – 1 
MIRR = 11.03%

Chapter 5 
 185 
 Example 9: Present Values, Annuities and perpetuities 
 1 This is a standard 14-year annuity with one additional payment at 
T0. 
Step 1: Look up the 14-year AF → 
AF = 9.295 
Step 2: Add 1 → 9.295 + 1 = 10.295 
Step 3: Calculate the PV → 300 × 10.295 = $3,088.50 
2 This is simply a standard perpetuity with one additional payment at 
T0. 
Step 1: Calculate the perpetuity factor → 1/0.22 = 4.545  
Step 2: Add 1 → 4.545 + 1 = 5.545 
Step 3: Calculate the PV → 33,000 × 5.545 = $182,982 
 
 (a) 
Initial investment	×	100	=	$5,000
$50,000	×	100	=10% 
(b) NPV calculation 
  $  $ 
Time     0 Investment (50,000) 1 (50,000) 
1 – 8 Inflow 8,060 (b) (a) 
––––––– 
   NPV Nil 
––––––– 
The aim is to find the discount rate (c) that produces a NPV of nil. 
–  Therefore the PV of inflows (a) must equal the PV of outflows, 
$50,000. 
–  If the PV of inflows (a) is to be $50,000 and the size of each 
inflow is $8,060, the DF required must be 50,000 ÷ 8,060 = 
6.20. 
–  The discount rate (c) for which this is the 8-year factor can be 
found by looking along the 8-year row of the cumulative DFS shown in the annuity table. 
–  The figure of $6.210 appears under the 6% column suggesting 
an IRR of 6% is the closest.

186  
       
Project Investment 
Required Net 
Present 
Value NPV 
ranking Profitability 
Index Index 
ranking 
 $000 $000    
A 3,400 850 1 0.25 6 
B 2,750 825 2 0.30 4 
C 2,000 720 3 0.36 3 
D 3,400 680 4 0.20 7 
E 860 430 5 0.50 1 
F 950 400 6 0.42 2 
G 1,250 350 7 0.28 5 
      
(a) If the company ranks the projects according to highest NPVs, it can 
invest in projects A, B, and C in full, a total investment of $3,400,000 
+ $2,750,000 + $2,000,000 = $8,150,000. Project D can be partially invested in for $9,000,000 – $8,150,000 = $850,000. 
Total NPV = $850,000 + $825,000 + $720,000 + 
($850,000/$3,400,000) × $680,000 = $2,565,000. 
it can invest in projects E, F, C, B, G, a total investment of $7,810,000. Project A can be partially invested in for $1,190,000. 
Total NPV = $430,000 + $400,000 + $720,000 + $825,000 
+$350,000 + ($1,190,000/$3,400,000) × $850,000 = $3,022,500. 
 
 Here, terminal (final) value ‘V’= $250 
V = X(1 + r)n so $250 = X (1.12)8 
X =	$250
2.48 so X sum to invest today = $100.97

Chapter 5 
 187 
 Total relevant cash flows between years 1 and 3 may be calculated as 
follows: 
Annual net revenues from machine $80,000  Annual cost of components required ($18,000)  Annual cost of direct labour ($20,000) A net total of $42,000, that needs discounting using an AF @ 20% for 
3 years = 2.106 (from the tables) 
 
$000 Discount 
value 
0 Initial cost (100)  (100) 
1 – 3 Annual cash 42 2.106 88.452 
3 Residual 40 0.579 23.16 
    11.612 
Net present value = $11,612 
Answer C  
 
 At the IRR, PV of future net cash flows = initial capital outlay. 
Answer A  
 
 Objective Test Question 4: Delayed annuities 
         
      Assumption 
(A) Assumption 
(B) 
Year  T 0 T1 T2 T3 T4 onwards T4–T18 
 $000 $000 $000 $000  $000 $000 
Net cash flow  (2,000) (440) 363 399  250 250 
Perpetuity 
factor  (here 
discounts the 
cash flow to T 3)      1 ÷ 0.1 = 10  
AF (here 
discounts the cash flow to T
3)       15-yr 10% AF  
=7.606 
DFs @ 10%        
 1.000 0.909 0. 826 0.751  0.751 0.751 
PV        
 (2,000) (400) 300 300  1,878 1,428 
NPV (A)        
      78  
NPV (B)       (372)

188  
 Case Study Style Question 
 To:  M. Al-Hiri 
From:  The Management Accountant 
Date:  xx.xx.xx 
Subject:  Investment projects A, B and C 
The investment manager has analysed three mutually-exclusive 
investment opportunities A, B and C. The financial benefits from these opportunities are illustrated below in diagrammatical form. 
 
Reasons for differences between NPV and IRR rankings 
There are two main reasons that NPV and IRR rankings differ: 1 The magnitude of the cash flows. 2 The timing of the cash flows. Magnitude of cash flows  Imagine we were faced with a choice between the following two projects:  
 
Project A 1 Year Cash flow 
  $ 
 0 (105,000) 
 1 48,000  2 48,000 
 3 48,000

Chapter 5 
 189 
    
Project A 2 Year Cash flow 
  $ 
 0 (105)  1 49 
 2 49 
 3 49 
The cash flows in Project A
1 are approximately 1,000 times bigger than 
those in Project A 2. Hence the NPV of Project A 1 will be approximately 
1,000 times bigger than the NPV of Project A 2. The NPV of Project A 1 is 
$14,376, but the NPV of A2 will be just over $16.86. NPV would therefore 
suggest that Project A1 should be preferred. 
Consider the IRRs of A1 and A2. In project A2 the return is $48,000 p.a., 
whereas project A2 yields $49 p.a. The relative percentage return from Project A2 is thus higher than that of Project A1. Hence A2 has a greater IRR than A1. 
The inconsistency in ranking has been caused by the magnitude of the 
figures. 
Timing of cash flows The actual time periods when the cash is generated can produce 
conflicting results. 
Again consider two projects. 
 
  $ 
 1 48,000 
 2 48,000  3 48,000 
   
  $  0 (105,000)  1 130,000 
 2 0 
 3 0 
The NPV of Project A
2 is $13,170 (130 × 0.909 – 105).  
This NPV is lower than the NPV of Project A 1 . 
The magnitude of the cash sums is very similar in both projects. 
If we consider how the NPVs of the two projects reduce as the discount 
rate rises. 
The NPV of A 1 will fall rapidly as the cash flows in the years 2 and 3 very 
quickly reduce in present value terms. The NPV of this project becomes 
zero at a 17.5% discount rate.

190  
The cash in Project A 2 is all received in the first year. This cash sum is 
only $130,000, compared to cash in flows of $144,000 in Project A 1. 
However the value of the year 1 cash flow remains strong even as the 
discount rate rises. 
Indeed, at a discount rate of 17.5% the NPV of A 2 is still positive at 
$5,630 (130 × 1/1.175 – 105). Hence the IRR of Project A
2 MUST be greater than 17.5%. 
Again there has been a conflict in the rankings, this time because of the 
timing of the cash flows. 
These examples should illustrate that it is just as important to consider 
WHEN the cash flows arise as to consider HOW MUCH the cash flows are. It is very important to obtain cash in the early years of a project whilst it holds a high present value. 
Comparison of opportunities A, B and C The capital outlay in Project C is much greater than the other two 
projects. Cash inflows are generated for 9 years. 
At a low cost of capital, this project is worth the most to the company. The 
cash in years 6–9 maintains a high value when discount rates are low. 
However, this project is very sensitive to increases in discount rates. As 
the cost of capital rises the NPV of Project C declines rapidly. This is illustrated in the graph at the beginning of the report. 
Project A is less sensitive to increases in discount rates. All its cash is 
received in years 1 to 3. These maintain a strong value as the discount rate increases. Project A could be said to be the least risky of the three choices if interest rates are volatile. 
Which project should be selected? The company has a cost of capital of 10%. At this rate Project C 
produces a NPV of $31,432. This is of higher benefit to MN plc than either projects A or B. Hence this project should be selected. 
Assumptions: cash flows are known and certain. The cost of capital is 
known. Taxation and inflationary aspects have been ignored. 
If MN plc is very risk averse, Project A may be considered as its NPV is 
more robust to increases in the cost of capital than projects B or C. 
Payback The payback period is the time that elapses before the initial cash outlay 
is recovered. 
The paybacks in the example are: 
 
 Assuming even cash 
flows Assuming year end 
cash flows 
Project A: 2 years 2 months 3 years 
Project B: 3 years 10 months 4 years 
Project C: 5 years 1 month 6 years

Chapter 5 
 191 
Advantages of payback 
1 Exposure to risk.  It is widely recognised that long-term forecasting is 
less reliable than short-term foreca sts. Projects with short paybacks 
tend to be less risky than projects wi th long paybacks. A project with 
a one-year payback is less risky than a project with a 10-year 
payback. Management can have very little confidence in forecasts of events ten years from now. 
2 Liquidity.  Investment opportunities often require significant capital 
outlay. It may be important to recover this capital expenditure quickly for the company to maintain a strong position. Payback illustrates how quickly the capital can be recovered. 
3 Simple measure.  The payback period is not a complicated measure. 
Technical expertise is not required to understand the meaning of payback. 
4 Not subjective. Payback period uses cash flows. Some investment 
appraisal methods use the rather more subjective measure of 
accounting profit (the accounting rate of return). 
Disadvantages of payback 
1 The time value of money is ignored. Each of the projects being 
considered by MN plc generates $48,000. Payback period fails to 
recognise that as time elapses the present value of this cash diminishes. It would be possible to overcome this problem by calculating a discounted payback period. 
2 Cash flows after the payback are ignored. Option C has a payback 
of a little over five years. This information does not reveal that Project C continues to generate cash for four further years. 
3 Not a measure of absolute profitability. Payback fails to indicate 
HOW MUCH each project is worth. It seems naïve to select a project on the basis of payback without considering the amount of benefit received. 
In the example, Project A has a payback of just over two years, however its NPV is only $14,376. 
Project C yields a NPV of $31,432 – more than double A’s NPV. Payback 
period ignores this fact. 
If you require any further information on this matter, please do not 
hesitate to contact me. 
Signed: Manageme nt Accountant

193 
Investment appraisal – 
further aspects 
B3: Apply investment 
appraisal techniques to 
evaluate different projects (a) Payback 
(b) ARR (c) IRR (d) NPV 
  
 Chapter 
6

Investment appraisal – further aspects 
194  
 
1 The payback period. 2 The Accounting Rate of Return (ARR) 3 The Internal Rate of Return (IRR) 4 The Net Present Value (NPV) As seen in the previous chapter, NPV and IRR both consider the time value of 
money: they are discounted cash flow ( DCF) techniques. In this chapter, we will 
introduce alternative investment appr aisal techniques but we will also 
incorporate further complexities in NPV calculations – namely how we deal with tax, working capital and inflation issues. 
2  Other investment appraisal techniques: the payback period 
The payback period is the time a project will take to pay back the money spent on it. It is based on expected cash flows and provides a measure of liquidity and risk (the quicker that an investor can re cover the initial investment the quicker 
they can reinvest it elsewhere and the lower the risk of this particular investment). 
This is the time which elapses until the invested capital is recovered. It 
considers cash flows only.  
Unlike DCF techniques, it is assumed that the cash flows  occur evenly during 
the year.

Chapter 6 
 195 
• Compare the payback period to the company's maximum return time 
allowed and if the payback is quicker the project should be accepted. 
• Faced with a choice between mutually-exclusive projects, choose the 
project with the quickest payback (provided it meets the company's target 
payback period). 
Calculation – constant  annual cash flows 
Payback period 		= Initial investment
Annual cash inflow 
A payback period may not be for an exact number of years. To calculate the 
payback in years and months you should multiply the decimal fraction of a year 
by 12 to the number of months. 
 
 Illustration – Payback 
 An expenditure of $2 million is expected to generate net cash inflows of 
$500,000 each year for the next seven years. 
The payback period for the project may be calculated as follows: 
Payback period 	= $2m
$500,000 
Payback period = 4 years 
 
 Example 1: Payback 
 A project requires an initial investment of $1,000,000 and then earns net 
cash inflows of $150,000 per year for 7 years. 
What is the project’s payback period?  
Calculations – Uneven cash flows 
However, if cash inflows are uneven, the payback has to be calculated by 
working out the cumulative cash flow over the life of a project.

196  
 Example 2: Target Payback 
 A business is considering a project which would last 5 years and have an 
initial investment of $40,000 in machinery. At the end of the project the 
machinery would have a scrap value of $4,000. The project would provide annual net cash inflows as follows: 
 
Year  Net cash flow 
($000) 
1 16 
2 20 3 12 4 12 
5 10 
The company has a target payback period of 2.5 years and new projects 
must also provide and average accounting rate of return of at least 15% p.a. 
Advise the company on whether this project meets the company's 
targets. 
 
 Advantages and disadvantages of payback 
• Simplicity : as a concept, it is easily understood and is easily 
calculated. 
• Improving investment conditions: When investment conditions are 
expected to improve in the near future, attention is directed to those projects that will release funds soonest, to take advantage of the improving climate. 
• Payback favours projects with a quick return: it is argued that these 
are to be preferred because rapid project payback leads to rapid company growth (in fact, such a policy will lead to many profitable investment opportunities being overlooked if their payback period does not happen to be particularly swift). 
 It is also argued that rapid payback reduces the risk of liquidity 
problems – but liquidity problems are best dealt with separately, through cash forecasting. 
• Cash flows: cash flows are much more objective than accounting 
figures such as profit. Profit figures are easily manipulated using accounting policies, whereas this is not possible for cash flows.

Chapter 6 
 197 
• Project returns may be ignored – In particular, cash flows arising 
after the payback period are totally ignored. 
• Timing ignored – Cash flows are effectively categorised as pre-
payback or post-payback, but no more accurate measure is made. 
In particular, the time value of money is ignored. This problem can be overcome if the discounted payback method is used. 
• Lack of objectivity – There is no objective measure as to what length 
of time should be set as the minimum payback period. Investment decisions are therefore subjective. 
• Project profitability is ignored – Payback takes no account of the 
effects on business profits and periodic performance of the project, as evidenced in the financial statements. This is critical if the business is to be reasonably viewed by users of the accounts. 
3  Accounting rate of return (ARR) 
The ARR method calculates a percentage return provided by the accounting profits of the project. 
The most common formula is: 
ARR	=	Average annual profit
Average value of investment 																														 LEARN  
Important notes to the formula: 
• The ‘average annual profit’ is after depreciation. 
• Net cash flow is normally equivalent to ‘profit before depreciation’. 
Average annual profit = Net cash flow less depreciation 
• The average value of the investment represents the average capital 
employed over the life of the project. 
Average value of investment = 	Initial investment plus residual value
2 						LEARN  
Decision criteria • The ARR for a project may be compared with the company's target return 
and if higher the project should be accepted. 
• Faced with a choice of mutually-exclusive investments, the project with the 
highest ARR should be chosen (provided it meets the company's target 
return).

198  
 Example 3: Mickey ARR 
 Project A 
 
Initial investment   $450,000   
Scrap value in year 5  $20,000   
Project B 
 
Initial investment  $100,000   
Scrap value in year 5  $10,000   
Annual cash flows ($000) 50 40 30 20 20 
Required: 
Calculate the ARR for each project, and indicate which project should be 
chosen. 
 
 Example 4: ARR and Payback 
 $50,000 is to be spent on a machine having a life of five years and a 
residual value of $5,000. Operating cash inflows will be the same each year, except for year 1 when the figure will be $6,000. The accounting rate of return (ARR) is measured as average annual profit as a percentage of the initial investment. If the ARR is 30% then identify the payback period: 
A  2.75 years B  2.15 years C  1.85 years D  2.54 years

Chapter 6 
 199 
• Simple to understand: As with 
the payback period, it is easily 
understood and easily calculated. 
• Widely used and accepted. 
• It considers the whole life of 
the project. 
 Link with other accounting 
measures – Return on capital 
employed, calculated annually to assess a business or sector of a business (and therefore the investment decisions made by that business), is widely used and its use for investment appraisal is consistent with that. The ARR is expressed in percentage terms with which managers are familiar. However, neither this nor the preceding point necessarily justify the use of ARR. Disadvantages 
• Ignores the time value of money. 
• Is not a measure of absolute 
• Does not consider cash flows. 
Uses subjective accounting 
profits, which include depreciation. 
 It fails to take account of either 
the project life or the timing of cash flows (and time value of money) within that life. For example, a project with a very long life which has a high ARR might be accepted before a project with a shorter life and marginally lower ARR. The NPV of the shorter project may actually be higher. In example 6, it can be seen that Project B has a much higher ARR but that Project A has a much higher NPV. Project A is the project that should be accepted by management on a financial basis. 
 • It will vary with specific 
accounting policies, and the extent to which project costs are capitalised. Profit measurement is thus ‘subjective’, and ARR figures for identical projects could vary from business to business depending on the accounting policies used. 
• Like all rate of return measures, it 
is not a measurement of absolute gain in wealth for the business 
owners. 
• There is no definite investment 
signal. The decision to invest or 
not remains subjective in view of the lack of an objectively set target ARR. 
• It is concluded that the ARR does 
not provide a reliable basis for project evaluation.

200  
Discounted payback 
One of the major criticisms of using the payback period is that it does not take 
into account the time value of money. As seen in the previous chapter, the discounted payback technique attempts to overcome this criticism by measuring the time required for the present values  of the cash inflows from a project to 
equal the present values of the cash outflows. 
The techniques are identical but the present value of the cash flows is used to 
calculate the cumulative cash flow and to determine the payback period. 
4 Dealing with taxation 
Taxation may have a significant impact on the viability of a capital investment project. Taxation payments and savings in tax payments are clearly cash flows associated with the project. They are relevant, and should be included in investment appraisal. 
There are two tax effects that we need to deal with in investment appraisal, 
which are the effects of corporation tax, and the impact of tax depreciation (also known as capital allowances). 
Typical assumptions are that the taxable profits will be the net cash flows from 
the project less any tax depreciation . 
We also make assumptions about the timing of the payments: corporation tax is 
usually paid in two instalments. Half the tax is payable in the year in which it arises, the balance is paid in the following year. 
The corporation tax rate will be given in the question. Taxation has the following effects on an investment appraisal problem: 
• Project cash flows will give rise to taxation which itself has an impact on 
project appraisal. Normally we assume that tax is paid in two instalments, 
where half the tax is payable in the year in which it arises, and the balance is paid in the following year. However, it is possible for alternative assumptions to be made and so you should read any examination question carefully to ascertain precisely what assumptions are made in the question. 
• Organisations benefit from being able to claim tax depreciation (also 
known as capital allowances) – a tax deductible alternative to depreciation. The effect of these is to reduce the amount of tax that organisations are required to pay. Again it is important to read any examination question carefully in order to identify what treatment is expected by the examiner. A common assumption is that tax depreciation is available on a 25% reducing balance basis. 
Note that the tax depreciation is not a cash flow  and to calculate the tax 
impact we have to multiply each year’s tax depreciation by the corporation tax rate. The effect of tax depreciation is on the amount of tax payable, which is the relevant cash flow.

Chapter 6 
 201 
In dealing with these tax effects it is always assumed that: 
• where a tax loss arises from the project, there are sufficient taxable profits 
elsewhere in the organisation to allow the loss to reduce any relevant 
(subsequent) tax payment (and it may therefore be treated as a cash inflow) and that the company has sufficient taxable profits to obtain full benefit from tax depreciation. 
In practice, the effects of taxation are more complex, and are influenced by a number of factors including the following: 
• the taxable profits and tax rate • the company’s accounting period and tax payment dates 
• whether assets qualify for tax depreciation 
• losses available for set-off. 
A detailed knowledge of tax is not required for this paper. Assumptions and 
simplifications will be made. These will usually be set out clearly in each examination question. It is important to follow the instructions for the treatment of tax in the question being attempted.  
Tax depreciation is used to reduce taxable profits, and the consequent 
reduction in a tax payment should be treated as a cash saving arising from the acceptance of the project. In this examination tax depreciation is generally allowed on the cost of plant and machinery at the rate of 25% on a reducing balance basis. It may also be possible to claim tax depreciation on the costs of installation, such as labour and overhead costs of removing an old machine and levelling the area for the new machine. 
Balancing allowance (or charge) 
When the plant is eventually sold, ther e may be a differ ence between the 
reducing balance amount and the selling price of the asset. An appropriate 
adjustment must be made to ensure that the company receives allowances 
equal to the total allowance allowed (i.e. purchase price less final value).

202  
 Balancing allowances/charges 
 If a business buys a capital asset in one year and sells it several years 
later, the total tax relief it will receive is the tax on the cost of the asset 
less its eventual disposal value. 
For example, if a business buys equipment for $100,000 in Year 0 and 
disposes of it in Year 5 for $20,000, it will receive tax relief on the net cost of $80,000. If the rate of corporation tax is 30%, the reduction in tax payments over the five years would be 30% × $80,000 = $24,000. 
Balancing allowances are given as a final deduction to ensure the full fall 
in value has been allowed. Balancing charges occur where the total tax 
depreciation claimed exceeds the fall in value of the asset. The excess 
claimed is treated as a taxable amount in the year of disposal. 
Timing of the tax savings associated with tax depreciation 
It is likely that the corporation tax will be paid in four quarterly instalments. 
Hence, the benefit of tax saved because of tax depreciation is received when the corporation tax should have been paid. Thus, half the tax is saved in the current year, and half is saved in the year following. 
 
Example 5: Colusa Ltd 
 An asset is purchased for $50,000 by Colusa Ltd. At the end of the 
fourth year it will be sold for $10,000. Tax depreciation is available at 
25 per cent reducing balance and corporation tax is payable at 30 per cent per annum. 
Corporation tax is paid in two instalments, with half the tax payable in 
the year in which it arises, and the balance paid in the following year. 
Required: 
(a) Calculate the tax depreciation each year and the associated 
corporation tax saving. 
(b) Illustrate the timing of the tax savings calculated in part (a). 
 
 For tax purposes care must be taken to identify the exact time of asset 
purchase. 
  
 • Assets are assumed to be bought at T 0. 
• It should be assumed that the asset is bought at the start of the 
accounting period and therefore the first tax depreciation is offset against the year 1 net cash flows.

Chapter 6 
 203 
NPV with tax – Example pro forma (assume a two-year project) 
 
 Year 0 Year 1 Year 2 Year 3 
 $ $ $ $ 
Cash inflows  X X  
Cash outflows  (X) (X)  
  –– ––  
Net cash flow  X X  
Tax on net cash flow  (X) (X) (X) 
Investment (X)    
Scrap value   X  
Tax depreciation savings 
(which would need a separate working)  X X X 
Working capital (X)  X  
Net cash flows (X) X X X 
Discount factor 1.00 x x x 
Present value PV PV PV PV  
 
 Example 6: Amigo Ltd 
 Amigo Ltd is considering investing in a new machine which has a 
capital cost of $25,000. It has an estimated life of four years and a 
residual value of $5,000 at the end of four years. The machine qualifies for tax depreciation at the rate of 25% per year on a reducing balance basis. 
An existing machine would be sold immediately for $8,000 if the new 
machine were to be bought. The existing machine has a tax written down value of $3,000. 
The existing machine generates annual net contribution of $30,000. 
This is expected to increase by 40% if the new machine is purchased. 
Amigo pays corporation tax on its profits at the rate of 30%, with half of 
the tax being payable in the year that the profit is earned and half in the following year. The company’s after tax cost of capital is 15% per year. 
Calculate whether the investment  is worthwhile. Should Amigo 
invest in the new machine?

204  
5 Working capital 
Working capital is treated as an investment at the start of the project, like any 
other investment. Any additional working capital requirements are invested when required. Only the change in working capital is treated as a cash 
flow. 
• Working capital does not qualify for tax relief – so is ignored in the taxation 
and tax depreciation calculations. 
• At the end of the project the working capital is 'released'. This is treated as 
a cash inflow at the end of the project, equal to the total investment in 
working capital (unless told otherwise). 
 
 For a short life project, with cash flows inflating at different rates, it is best to set the NPV calculation out with the cash flows down the side and the time across the top. 
 
Example 7: Camp Ltd 
 Camp plc has produced and marketed sleeping bags for several years. 
The sleeping bags are much heavier than some of the modern sleeping bags being introduced to the market. The company is concerned about the effect this will have on its sales. 
Camp plc are considering investing in new technology that would enable 
them to produce a much lighter and more compact sleeping bag. The new machine will cost $250,000 and is expected to have a life of four years with a scrap value of $10,000. In addition an investment of $35,000 in working capital will be required initially. 
The following forecast annual trading account has been prepared for the 
project: 
 $ 
Sales 200,000 
Material (40,000) Labour (30,000) 
Variable overheads (10,000) 
Depreciation (20,000) 
––––––– 
Annual profit 100,000 
The company’s cost of capital is 10%. Corporation tax is charged at 30% 
and is paid in two instalments, with half the tax payable in the year in 
which it arises, and the balance paid in the following year. Tax depreciation of 25% on reducing balance is available on capital expenditure. 
Required: 
Calculate whether Camp plc should invest in the new technology.

Chapter 6 
 205 
 Example 8: Smith Ltd 
 Smith Ltd has decided to increase its productive capacity to meet an 
anticipated increase in demand for its products. The extent of this 
increase in capacity has still to be determined, and a management meeting has been called to decide which of the following two mutually exclusive proposals – A or B – should be undertaken. 
The following information is available: 
 Proposal A Proposal B 
 $ $ 
Capital expenditure   
Buildings 50,000 100,000 Plant 200,000 300,000 Installation 10,000 15,000 
Net Income 
Annual pre-depreciation profits 
(note (1)) 70,000 95,000 
Other relevant income and expenditure   
Sales promotion (note (2)) – 15,000 
Plant scrap value 10,000 15,000 Buildings disposable value (note 
(3)) 30,000 60,000 
Working capital required over the 
project life 50,000 65,000 
 
 Notes: 
(1) The investment life is ten years. (2) An exceptional amount of expenditure on sales promotion of 
$15,000 will have to be spent in year  2 of proposal B. This has not 
been taken into account in calculating pre-depreciation profits. 
(3) It is the intention to dispose of the buildings in ten years’ time. Using an 8% discount rate, calculate which of the two alternatives 
should be chosen.

206  
6  The impact of inflation on cash flows 
If an exam question involves inflation, we normally have to either adjust the 
cash flows, or adjust the cost of capital. 
 
 Where cash flows have not been increased for expected inflation they are known as current cash flows, or real cash flows. 
 
 Where cash flows have been increased to take account of expected inflation they are known as money cash flows , or nominal cash flows . 
Remember, if they do take inflation into account, they represent expected flows of money, hence the term ‘money cash flows’. 
You can assume that cash flows you are given in the exam are the money cash flows, unless told otherwise. 
If the examiner specifies that the cash flows are in current terms  you will 
generally need to put these in money terms before you can discount them. For 
example, if the question tells you that sales for the next 3 years are $100 in current terms, but are expected to inflate by 10%, then what is actually meant is that the sales will be: 
Year 1: $110 
Year 2: $121 } i.e. these are the cash flows in money terms 
Year 3: $133.10 
Make sure you read the q uestion carefully. Sometimes, you will be given the 
cash flows in Year 1 terms with subsequent inflation. 
• For example, if the question says "Sales will be $100 in the first year, but 
are then going to inflate by 10% for th e next two years", then the sales will 
be: 
Year 1: $100 Year 2: $110  } compare these to the previous example – make sure  
    you understand why they are different! 
Year 3: $121

Chapter 6 
 207 
Methods of dealing with inflation 
The impact of inflation can be dealt with in two different ways – both methods 
give the same NPV. 
 
 The real rate of return 
 If money is invested in an account, it will earn interest. However, 
inflation will have the effect of reducing the value of the return. By deflating the future cash (money) we can find the real return from the investment, i.e. the return at today’s prices. 
Formula 
To find the real rate of return we can use the following formula: 
ሺ1	+	rሻ = ሺ1 + mሻ
ሺ1 + iሻ	
LEARN  
This is where: 
• r is the real rate of return 
• m is the money cost of capital (this is the company's normal cost 
of capital) 
• i is the rate of inflation.

208  
$1,000 is invested in an account that pays 10% interest per annum. 
Inflation is currently 7% per annum. 
Calculate the real return on the investment. 
After 1 year $1,000 will have compounded up to $1,000 × 1.10 = 
$1,100.  
Now deflate this figure to find the real return on the investment: 
$1,100 ÷ 1.07 = $1,028 
Therefore, the $1,000 has increased by 2.8% in real terms. This is the 
real rate. 
It can be calculated using the formula as follows: 
ሺ1	+	rሻ	= ሺ1	+	mሻ
ሺ1	+	iሻ 
 
ሺ1	+	rሻ	= ሺ1	+	0.10ሻ
ሺ1	+	0.07ሻ 
 
(1 + r) = 1.028 
r  = 1.028 – 1 r  = 0.028 = 2.8% 
Using the real rate of return in questions If there is one rate of inflation in the question both the real and money 
method will give the same answer. However it is easier to adjust one discount rate, rather than all the cash flows over a number of years. This is particularly true where the cash flows are annuities. The real method is the only possible method where they are perpetuities. 
Although it is theoretically possible to use the real method in questions 
incorporating tax, it is extremely complex. It is therefore much safer (and easier) to use the money/nominal method in all questions where tax is taken into account. 
 
 Example 9: Flo Ltd 
 A company has a money cost of capital of 21 % per annum. The 
inflation rate is currently estimated at 9% per annum. 
Identify the real cost of capital: A 9% B 11% C 12% D 14%

Chapter 6 
 209 
 Example 10: Storm Ltd 
 Storm Ltd is evaluating project X which requires an initial investment of 
$50,000. Expected net cash flows are $20,000 per annum for 4 years 
at today's prices. However these are expected to rise by 5.5% per annum because of inflation. The firm's cost of capital is 15%. Calculate the NPV by: 
(a) discounting money cash flows (b) discounting real cash flows. 
7 Specific and general inflation rates 
The examples given above had all cash flows inflating at the general rate of 
inflation. In practice, inflation does not affect all costs to the same extent. In some investment appraisal questions you may be given information on more than one inflation rate. In these situations you will have information on both specific inflation rates and general inflation rates. 
 
 Inflation can impact different types of products in different ways: prices don't all rise at exactly the same rate. In situations where you are given a number of specific inflation rates, the real method outlined above cannot 
be used.

210  
 Example 11: Andra Ltd 
 A company is considering a cost-saving project. This involves purchasing 
a machine costing $7,000, which will result in annual savings (in real 
terms) on wage costs of $1,000 and on material costs of $400. 
The following forecasts are made of the rates of inflation each year for 
the next five years: 
Wage costs 10% 
Material costs 5% General prices 6% 
The cost of capital of the company, in real terms, is 8.5%. 
Calculate the NPV of the project, assuming that the machine has a life of 
five years and no scrap value. 
The following gives a useful summary of how to approach examination 
questions. 
 
If a question contains both tax and inflation, it is advisable to use the money 
method.

Chapter 6 
 211 
 The money method 
 To use the real method when cash flows inflate at different rates (specific 
rates) is extremely complex and would involve a lot of calculations. It is 
therefore advisable to always use the money method in these situations. This involves: 
• inflating the cash flows at their specific inflation rates 
• discounting using the money rate. 
Very often the money rate will not be given in the question but will need 
to be calculated. This should be done using the real rate and the general inflation rate. 
 
 Example 12: Thunder Ltd 
 Thunder plc has just developed a new product to be called the Lightening 
and is now considering whether to put it into production. The following information is available: 
(i) Costs incurred to date in the development of Lightening amount to 
$480,000. 
(ii) Production of Lightening will requ ire the purchase of new machinery 
at a cost of $2,400,000 payable immediately. This machinery is 
specific to the production of Lightening and will be obsolete and valueless when production ceases. The machinery has a production life of four years and a production capacity of 30,000 units per annum. 
(iii) Production costs of Lightening (a t year 1 prices) are estimated as 
follows: 
 $ 
Direct material 8.00 
Direct labour 12.00 
Variable overheads 12.00 
 
In addition, fixed production costs (at year 1 prices), including 
straight-line depreciation on plant and machinery specific to this project, will amount to $800,000 per annum. 
(iv) The selling price of Lightening will be $80.00 per unit (at year 1 
prices). Demand is expected to be 25,000 units per annum for the next four years.

212  
 (v) The retail price index is expected to be at 5% per annum for the 
next four years and the selling price of Lightening is expected to 
increase at the same rate. Annual inflation rates for production costs are expected to be as follows: 
 % 
Direct labour 10 
Variable overheads 4 
Fixed costs 5 
  
(vi)  The company’s cost of capital in money terms is expected to be 
15%. 
You may ignore the effects of taxation. 
Unless otherwise specified all costs and revenues should be assumed to 
arise at the end of each year. 
Required: 
Calculate whether Thunder plc should produce Lightening on the basis of 
the information above.  
 Example 13: Leo  
 Leo is contemplating spending $400,000 on new machinery. This will be 
used to produce a revolutionary type of lock, for which demand is expected to last three years. Equipment will be bought on 31 December 20X5 and revenue from the sale of locks will be receivable on the 31 December 20X6, 20X7 and 20X8. Labour costs for the three years, payable in arrears, are estimated at $500,000 per annum in current terms. These figures are expected to rise at the rate of 10% per annum. 
Materials required for the three years are currently in stock. They 
originally cost $300,000; they would cost $500,000 at current prices although Leo had planned to sell them for $350,000. The sales revenue from locks in the first year is projected at $900,000. This figure will rise by 5% per annum over the product’s life. 
 If Leo has a money cost of capital of 13%, identify the net present value 
of the project (to the nearest $000). 
A ($130,000) B ($23,000) C $52,000 
D $126,000

Chapter 6 
 213 
 Deflation 
 Many western economies have very low rates of inflation at present and 
some are even experiencing deflation. Deflation may also apply to certain 
hi-tech materials which get considerably cheaper when they go into mass production. 
Deflation may affect business de cision making in several ways: 
• Investing in projects that have long payback periods may require 
some courage. 
• Borrowing to finance the purchase of assets that are going to fall in 
value may also require some courage: money rates will be low, but 
real rates are higher. 
• It may be difficult to reduce some costs – especially wages – in line 
with deflation. 
• Consumers may defer purchasing decisions if they anticipate that 
prices will fall. 
8 Dealing with questions with both tax and inflation 
Combining tax and inflation in the same question does not make it any more difficult than keeping them separate. 
Questions with both tax and inflation are best tackled using the money method. 
• Inflate costs and revenues, where necessary, before determining their tax 
• Ensure that the cost and disposal values have been inflated (if necessary) 
before calculating tax depreciation. 
• Always calculate working capital on these inflated figures, unless given. 
• Use a post-tax money discount rate. 
 
 Example 14: Ackbono Ltd 
 Ackbono Co is considering a potential project with the following 
forecasts: 
 Now T T T 
Initial investment ($million) (1,000)    
Disposal proceeds ($ million)    200 
Demand (millions of units)  5 10 6 
The initial investment will be made on the first day of the new 
The selling price per unit is expected to be $100 and the variable cost 
$30 per unit. Both of these figures are given in today’s terms.

214  
Tax depreciation is available at 25 per cent reducing balance and 
corporation tax is payable at 30 per cent per annum. 
The company has a real required rate of return of 6.8%. General inflation is predicted to be 3% pa but the selling price is 
expected to inflate at 4% and variable costs by 5% pa 
Calculate the NPV of the project. 
N.B. work in $ millions. 
 
 Example 15: R Ltd 
 November 20X7 In early November 20X7, R Ltd considered manufacturing a new 
product called Sparkle. Up to that time $750,000 had been spent on researching the product. The company estimated that it would take two further years to develop Sparkle to the point of production and by that time it would probably have a lead of 18 months over its chief competitor. R Ltd expected to launch Sparkle on 1 November 20X9 and to produce and sell 100,000 units in the first year if $1.5 million was spent on pre-launch advertising. During the first year of production, R Ltd planned to spend $750,000 on advertising; this level of expenditure would be maintained each year. 
From the second year onwards, the market was expected to increase 
to between 160,000 and 200,000 units. Once the competitor entered the market, it was thought that the competitor would win 50% market share very quickly because of its reputation. 
The development and engineering costs of Sparkle were estimated to 
be $6 million, $2 million of which would be incurred in the first year of development, 20X7/X8. A special piece of equipment costing $500,000 would be required for production and this was to be installed in the month prior to the commencement of manufacture. 
R Ltd planned to set a selling price of $249 a unit on the basis that 
variable manufacturing and distribution costs were expected to be $122 per unit. The company normally sets selling prices so that the contribution/sales ratio is 50% or slightly more. The fixed administrative and space costs that relate to the product, and which would be incurred from the commencement of production, were estimated to be $7.5 million per annum. It was also estimated that working capital of $2.5 million would be needed at the start of production in November 
20X9. 
The product was expected to have a life span of about five years, at 
which time the equipment would be scrapped as having no value. The company estimated its cost of capital to be 12% per annum.

Chapter 6 
 215 
November 20Y0 
Development of Sparkle took six months longer than planned. This was 
largely because it proved necessary to employ two extra members of staff in the engineering department for the technical aspects of the product development. 
The engineering department did not have a budget for this in year 1 
(20X7/X8) and so employment was delayed until the start of the second year, November 20X8, when the budget for the extra funds had been approved. This caused the planned expenditure on development for year 2 to be spread over the 18 month period from the start of year 2 to the middle of year 3. The two new members of staff were employed at salaries of $45,000 each and employment costs were estimated to be 100% of the first year’s salary. As a result, production started six months late in May 20Y0, the pre-launch costs were delayed accordingly and only 55,000 units were sold in the year November 20X9 to October 20Y0. 
As expected, the competitor has decided to enter the market and is 
launching its rival product Glitter this month, November 20Y0. 
R Ltd now predicts the market for 20Y0/Y1 to be 150,000 units and its 
share of this to be 50%. Thereafter the market size will be as forecast previously, i.e. between 160,000 and 200,000 units each year, and the product life cycle will stop at the same  date as planned previously. The 
monetary value of all expenditures and revenues to date has been very close to the estimates and there is no reason to revise future forecasts in this respect. 
Required: 
Using the case of Sparkle in the scenario: (a) Calculate the net present value of the project as perceived at the 
beginning of November 20X7, when R Ltd decided to manufacture 
Sparkle. State clearly any assumptions you make. 
(b) Calculate the revised net present value of the whole project as 
perceived at the beginning of November 20Y0. 
(c)  Describe the position revealed by the figures you have calculated 
in (a) and (b) and on the events which have taken place. Identify what the company should do now?

216  
9  Capital asset replacement decisions 
As the title suggests, this section considers the need to replace old, worn out 
capital assets within a firm. 
There are two distinct types of decisions to consider: 1 Considering mutually-exclusive options with unequal lives. 2 Calculating an optimum replacement cycle. We shall consider each in turn. 
Mutually-exclusive options with unequal lives 
Companies considering the replacement of an asset may be faced with 
alternatives where the life spans of the various machines differ, but the asset is required for the foreseeable future. The options must be evaluated over a comparable number of years. 
In order to compare like with like we will calculate an equivalent annual cost. 
This is similar to an average annual cash flow. Once both machines’ costs have been annualised the cheapest machine can be chosen by comparing annual costs. 
FORMULA 
Equivalent annual cost 	= PV of costs
Annuity factor for year n
 
LEARN 
where n is the machine life time. 
This is best explained by working through an example (the solution at the end of 
the chapter includes an explanation of the technique).

Chapter 6 
 217 
 Example 16: Donald Ltd 
 Donald Ltd is considering replacing an asset with one of two possible 
machines: 
 
Machine X Initial cost $120,000 
 Life 3 years 
 Running costs $20,000 p.a. 
 Residual value nil 
Machine Y Initial cost $60,000 
 Life 2 years 
 Running costs Year 1: $40,000 
  Year 2: $35,000 
The machines will be required into the foreseeable future. The company's 
cost of capital is 10%. 
Required: 
Calculate which machine should be purchased. 
 
 Lowest common multiple method  
 There is an alternative method for comparing machines with different 
lives known as the lowest common multiple method. This is where we find the smallest number, which we can divide into by 
each of a set of numbers and evaluate the NPV cost over this period. 
Example 
If we look again at the decision faced in the previous ‘Donald’ example 
and apply the lowest common multiple method, we have two projects, one with a life of 2 years and one with a life of 3 years. The common multiple is 6 years. We then calculate the NPV of the two options over 6 years and compare the results as follows: 
Machine X 
 
Year Description Cash flow 
$ Discount 
rate  
10% Present 
value 
$ 
0 Outlay 120,000 1.000 120,000 
1 – 3 Running cost 20,000 2.487 49,740 
3 Replace 120,000 0.751 90,120 
4 – 6 Running cost 20,000 1.868 37,360 
   NPV = 297,220

218  
 Machine Y 
 
$ Discount 
rate 
value 
$ 
0 Outlay 60,000 1.000 60,000 
1 – 2 Running cost 35,000 1.736 60,760 
2 Replace 60,000 0.826 49,560 
3 – 4 Running cost 35,000 1.434 50,190 
4 Replace 60,000 0.683 40,980 
5 – 6 Running cost 35,000 1.185 41,475 
   NPV = 302,965 
Machine X should be purchased as it has the least cost option (lowest 
NPV cost). 
Optimum replacement cycles 
Companies purchasing new plant and machinery must decide how often to replace them. Generally, as machinery ages its residual value decreases and the annual running costs increase. However, companies are unlikely to want to replace assets too frequently because of the capital outlay associated with the purchase. 
In the next section we shall calculate the optimum replacement cycle in order to 
minimise long-term costs. 
 
Factors in replacement decisions 
 The factors to be considered include the following: 
• Capital cost of new equipment – the higher cost of equipment will 
have to be balanced against known or possible technical 
• Operating costs – operating costs will be expected to increase as 
the machinery deteriorates over time. This may be the result of: 
–  increased repair and maintenance costs –  loss of production due to ‘down-time’ resulting from increased 
repair and maintenance time 
–  lower quality and quantity of output. 
• Resale value – the extent to which old equipment can be traded in 
for new. 
• Taxation and investment incentives. 
• Inflation – both the general price level change, and relative 
movements in the prices of inputs and outputs.

Chapter 6 
 219 
Method of solution 
1 Consider each possible replacement cycle in turn: 1 year, 2 year, 3 year 
etc. 
2 Calculate the PV of costs for each cycle. 3 Divide this PV by the annuity factor to find the equivalent annual cost. 4 Select the replacement cycle with the lowest equivalent annual cost. 
 
Limitations of replacement analysis 
 The replacement analysis model assumes that the firm replaces like with 
like each time it needs to replace an existing asset. 
However this assumption ignores 
• changing technology – machines fast become obsolete and can 
only be replaced with a more up-to-date model which will be more 
efficient and perhaps perform different functions 
• inflation – the increase in price over time increases the cost 
structure of the different assets, meaning that the optimal replacement cycle can vary over time 
• change in production plans – firms cannot predict with accuracy the 
market environment they will be facing in the future and whether they will even need to make use of the asset at that time. 
 
 Example 17: Supermarket delivery vehicles 
 A supermarket is trying to determine the optimal replacement policy for its 
fleet of delivery vehicles. The total purchase price of the fleet is $220,000. 
The running costs and scrap values of the fleet at the end of each year 
are: 
 Year 1 Year 2 Year 3 Year 4 Year 5 
Running 
costs $110,000 $132,000 $154,000 $165,000 $176,000 
Scrap value $121,000 $88,000 $66,000 $55,000 $25,000 
The supermarket’s cost of capital is 12% per annum.  
Ignore taxation and inflation. 
Identify at the end of which year the supermarket should replace its fleet 
of delivery vehicles.

220  
10 Practice Questions 
 Objective Test Question 1: Mickey Payback 
Project A 
 
Scrap value at the end of year 5 $20,000 
Project B 
 
Initial investment $100,000     
Scrap value at the end of year 5 $10,000     
Assume that the initial investment is at the start of the project and the 
annual cash flows are at the end of each year. 
Which project should the company select, if the objective is to minimise the payback period? 
A Project A B Project B C Either project A or project B, as they have the same payback 
 period 
D Neither project 
 
 Objective Test Question 2: Spring Ltd 
 The management of Spring Ltd are making a decision on whether or 
not to purchase a new piece of plant and machinery which costs 
$100,000. The new machine will generate a net cash flow of $30,000 each year for four years. At the end of the fourth year it will be sold for $20,000. The company’s cost of capital is 5%. Tax depreciation is at 25% reducing balance and corporation tax is 30%. Corporation tax is payable in two instalments, with half paid in the current year and half paid in the following year. 
Required: 
Calculate the net present value of the project and advise management.

Chapter 6 
 221 
 Objective Test Question 3: NPV 
 Spotty Ltd plans to purchase a machine costing $18,000 to save labour 
costs. Labour savings would be $9,000 in the first year and labour rates 
in the second year will increase by 10%. The estimated average annual rate of inflation is 8% and the company’s real cost of capital is estimated at 12%.  The machine has a two year life with an estimated actual salvage value of $5,000 receivable at the end of year 2. All cash flows occur at the year end.  
What is the negative NPV (to the nearest $10) of the proposed investment? 
A $50 
B $270 C $380 D $650 
 
 Case Study Style Question – Scotland Ski Runs 
 A landowner in Scotland proposes to develop a number of ski runs 
down the side of a mountain. The runs will be approximately 5 km long, 
dropping 1,000 metres from the mountain’s summit to a car park. 
You work as a strategy consultant and have been made aware that two 
alternative strategies (each giving the same capacity) are being considered for the development. 
• Low investment , involving the construction of a series of tows to 
haul skiers from the car park to the summit: the initial cost of 
constructing the tows will be $250,000 and tow motors will have to be replaced after five years at a cost of $50,000; operating costs will be $90,000 per year (fixed) and $3.50 per skier (variable). 
• High investment , involving the construction of a cable-car system 
giving a non-stop ride to the summit: the initial cost of constructing the lift will be $1,200,000; operating costs will be $30,000 per year (fixed) and $1 per skier (variable). 
The Regional Tourist Board will subsidis e the initial construction cost of 
the development (using either strategy) by providing a loan for half the value of the initial construction cost. The loan is at an interest rate of 4% repayable over six years on an annuity basis. The Tourist Board requires (as a condition of the loan) that a flat fee of $8 is charged for each skier towed/ lifted to the summit.

222  
 The number of skiers us ing the runs will be dependent on the quality of 
snow cover. The better the snow cover, then the more runs it will be 
possible to open and the longer the runs will be able to stay open. The landowner forecasts that in any 10-year period, and assuming an $8 fee, the seasons will be as follows: 
 
Quality of snow 
cover Number of seasons Number of skiers 
Good 3 60,000 
Moderate 4 40,000 
Poor 3 5,000 
You have just received the following email from the landowner:

Chapter 6 
 223 
  
Payback period = $1,000,000
$150,000 per year 
 
Payback period = 6.67 years, that is 6 years and (0.67 × 12 months), 
so 6 years 8 months. 12%  
 
 Payback period 
After two years $36,000 of the initial $40,000 of the investment has 
been recovered. It will take one third of year 3 ($4,000 required/ $12,000 received in year 3) to recover the remaining investment. 
So the payback period is 2.33 years, which satisfies the target of 
2.5 years. 
Accounting rate of return 
Average annual profit	= Total net cashflows – 	Total
 depreciation
Life of the project 
 
= $70,000 – 	$36,000
5 years 
 
= $6,800 
 
Average investment 			= Initial investment 	+	Scrap value
2 
 
= $40,000 + $4,000
2 
 
= $22,000 
	
ARR 																																	 = $6,800
$22,000 
ARR = 30.9% p.a. 
This is above the target return of 15%. 
Overall 
The investment satisfies both target measures and should therefore be 
accepted.

224  
    
 Project 
A 
$000 Project 
B 
$000 
Total profit before depreciation (total 
operating cash) 650 160 
Less total depreciation (430) (90) 
Total profit after depreciation 220 70 
÷ number of years 5 5 Average annual profit 44 14 
Average value of investment 235 55 
Accounting rate of return 18.7% 25.5% 
Conclusion:  the firm should select project B. 
 
Average annual profit = $50,000 × 30% $15,000 
 × 5 yrs 
Total profit $75,000 
Add back depreciation $45,000 
–––––––– 
Total cash $120,000 
Less year 1 cash flow (6,000) 
–––––––– 
 $114,000 Cash per annum (yrs 2–5) 114/4 $28,500 
Outlay $50,000 Cash inflow after 2 years 6,000 + 28,500 $34,500 Still required $15,500 
Proportion of year 3 to gain balance of cash = 15,500 ÷ 28,500 = 0.54 Hence payback period = 2.54 years 
 
Answer D

Chapter 6 
 225 
 Example 5: Colusa Ltd 
 (a)  Tax depreciation and the associated savings can be calculated as 
follows: 
 
Year  
 Tax 
depreciation Tax saved 
at 30% 
 $ $ $ 
0 – Investment  50,000    
1 – Tax depreciation 12,500  12,500  3,750 
(@25%)      –––––   
 37,500   
2 – Tax depreciation 9,375  9,375  2,813 
 28,125   
3 – Tax depreciation 7,031  7,031  2,109 
 21,094   
4 – Disposal  10,000    –––––   
4 – Balancing allowance  11,094  11,094 
––––––  3,328 
–––––  
Total tax depreciation/tax saved
  40,000  12,000  
 
The total tax depreciation will equal the difference between the initial cost ($50,000) and the residual value ($10,000). The total tax saving will be 30% of the tax depreciation (30% × $40,000). 
(b) 
Year Cash benefit received Total 
1 $1,875 $1,875 
2 $1,875 + $1,407 $3,282 
3 $1,406 + $1,055 $2,461 
4 $1,054 + $1,664 $2,718 
5 $1,664 $1,644

226  
 Example 6: Amigo Ltd  
 (W1) The incremental increase in contribution earned as a result of using 
the new machine is $30,000 × 40% = $12,000 per year. 
(W2) Tax due/paid on incremental contribution earned: 
 
Year Incr. 
Contribution Tax 
due 
(30%) Year tax paid 
   1 2 3 4 5 
1 12,000 3,600 1,800 1,800    
2 12,000 3,600  1,800 1,800   3 12,000 3,600   1,800 1,800  4 12,000 3,600    1,800 1,800 5 12,000 3,600  
––––  
––––  
––––  
––––  
–––– 
   1,800 
–––– 3,600 
–––– 3,600 
–––– 3,600 
–––– 1,800 
–––– 
(W3) Tax depreciation/tax relief 
Existing machine 
The sale of the existing machine leads to a balancing charge of $8,000 – 
$3,000 = $5,000. Tax payable on this is $5,000 × 30% = $1,500. Assume this is paid half in year 0 and half in year 1. 
New machine 
 
Year Bal b/f Tax 
depr 
(25%) Tax 
relief 
(30%) Your relief received 
    1 2 3 4 5 
1 25,000 6,250 1,875 937 938    
2 18,750 4,688 1,406  703 703   
3 14,063 3,515 1,055   528 527  
4 10,547 5,547 1,664  
–––  
––––  
–––– 832 
–––– 832 
––– 
    937 
––– 1,641 
–––– 1,231 
–––– 1,359 
–––– 832 
––– 
* Disposal = $5,000 when the TWDV was $10,547. Therefore the 
Balancing allowance = $5,547

Chapter 6 
 227 
  
All figures $ Year Year Year Year Year Year 
 0 1 2 3 4 5 
sales proceeds 8,000      
Incremental contribution (W1)  12,000 12,000 12,000 12,000  
Capital (25,000)    5,000  
Tax paid (W2)  (1,800) (3,600) (3,600) (3,600) (1,800) 
Tax paid on existing machine (W3) (750) (750)     
Tax relief on new machine (W3)  
–––––– 937 
––––––  1,641 
–––––– 1,231 
––––– 1,359 
––––– 832 
––––– 
Net cash flow (17,750) 10,387 10,041 9,631 14,759 (968) 
DCF @ 15% 1 
–––––– 0.870 
–––––– 0.756 
–––––– 0.658 
––––– 0.572 
––––– 0.497 
––––– 
Present values (17,750) 
–––––– 9,037 
–––––– 7,591 
–––––– 6,337 
––––– 8,442 
––––– (4.81) 
––––– 
 
Net present value = $13,176  
The net present value is positive and therefore it is worthwhile purchasing 
the machine. 
 
 Example 7: Camp Ltd 
 Corporation tax 
Depreciation is not an allowable expense. Therefore, taxable profit = $100,000 + $20,000 = $120,000 p.a. Corporation tax at 30% = $36,000 p.a. Half payable in current year, half payable in year following. 
Capital cost: $250,000 Scrap value: $10,000 Total tax depreciation: $240,000

228  
       
Year Reducing 
balance Tax 
depreciation Tax 
saved 
(30%) Benefit 
received Total 
cash 
benefit 
1 $187,500 $62,500 $18,750 $9,375   $9,375 
2 $140,625 $46,875 $14,063 $9,375 + 
$7,032 $16,407 
3 $105,469 $35,156 $10,547 $7,031 + 
$5,274 $12,305 
4 $10,000 $95,469 $28,641 $5,273 + 
$14,321 $19,594 
5    $14,320 $14,320 
Net present value 
 
Year 0 1 2 3 4 5 
 $ $ $ $ $ $ 
Net inflows  120,000 120, 000 120,000 120,000  
Corporation tax  (18,000) (36,000) (36,000) (36,000) (18,000) 
Tax depreciation  9,375 16,407 12,305 19,594 14,320 
Investment (250,000)    10,000  
Working capital (35,000)    35,000  
 ––––––– –––––– –––––– ––––––  ––––––  ––––– 
Total net flows (285,000) 111,375 100, 407 96,305 148,594 (3,680) 
Discount factors  1.000  0.909  0.826  0.751  0.683  0.621 
 –––––––  –––––– –––––– ––––––  –––––– ––––– 
Present value (285,000) 101,240 82,936 72,325 101, 490 (2, 285) 
Net present value = $70,706 
* working capital of $35,000 is injected in Year 0 and then released in 
Year 4.

Chapter 6 
 229 
 Example 8: Smith Ltd  
 Since the decision has been made to increase capacity (i.e. ‘to do 
nothing’ is not an alternative), the easiest approach is to discount the 
incremental cash flows. 
The tabular approach of the previ ous chapter is still appropriate 
particularly as the project lasts for ten years. 
 
Time  A B B – A 8% PV 
  $000 $000 $000 DF/AF $000 
0 Capital expenditure (260) (415) (155) 1 (155.00) 
0 Working capital (50) (65) (15) 1 (15.00) 
2 Promotion – (15) (15) 0.857 (12.86) 
1–10 Net income 70 95 25 6.710 167.75 
10 Scrap proceeds 40 75 35 0.463 16.21 
–––– 
 Net present value     1.10 
–––– 
The present value of proposal B exceeds that of proposal A at 8% and 
therefore proposal B is preferred. 
 Assumptions 
• The disposal value of buildings is realistic and all other figures 
have been realistically appraised. 
• Expenditure on working capital is incurred at the beginning of the 
project life and recovered at the end. 
• Adequate funds are available for either proposal. • All cash flows occur annually in arrears. 
 
 B 
1.21 / 1.09 = 1.11

230  
 (a)  Discounting money cash flow at the money rate 
 
Year Money 
cash flow Discount 
rate 15% Present 
value 
 $  $ 
0 (50,000)  (50,000) 
1 21,100 0.870 18,357 
2 22,261 0.756 16,829 
3 23,485 0.658 15,453 
4 24,776 0.572 14,172 
  NPV = 14,811 
 
(b)  Discounting the real cash flows at the real rate 
Calculate the real rate. 
ሺ1 + rሻ = ሺ1 + mሻ
ሺ1 + iሻ	
ሺ1 + rሻ = ሺ1 + 0.15ሻ
ሺ1 + 0.055 ሻ	
(1 + r) = 1.0900 
∴ r = 0.09, i.e. 9% 
 
Year Real cash flow Discount rate Present value 
 $ 9% $ 
1–4 20,000 p.a. 3.240 64,800 
  NPV = 14,800 
    
 Example 11: Andra 
 Since the question contains both specific and general inflation rates, the 
money method should be used. 
Step 1 
The money method needs to be calculated using the information provided 
on the real rate of return and the general rate of inflation. 
(1 + i) = (1 + r)(1 + h)  (1 + i) = (1.085)(1.06)  i = 15%

Chapter 6 
 231 
 Step 2 
Inflate the cash flows using the specific inflation rates and discount using 
the money rate calculated above. 
 
 T0 T 1 T 2 T 3 T 4 T 5 
 $ $ $ $ $ $ 
Investment (7,000)      
Wages savings 
(inflating @ 10%)  1,100 1,210 1,331 1,464 1,610 
Materials savings 
(inflating @ 5%)  
––––– 420 
––––– 441 
––––– 463 
––––– 486 
––––– 510 
––––– 
Net cash flow (7,000) 1,520 1,651 1,794 1,950 2,120 
PV factor @ 15% 1.000 
–––––   0.870 
 –––––   0.756  –––––  0,658 –––––  0.572 –––––  0.497 ––––– 
PV of cash flow (7,000) 1,322 1,248 1,180 1,115 1,054 
 
Therefore NPV = $(1,081) which suggests the project is not worthwhile. 
 
 Notes: 
$480,000 development cost is a sunk cost. Depreciation is not a cash flow and should be excluded from the fixed 
costs. 
Depreciation = $2,400,000/4 years = $600,000 p.a. Therefore relevant fixed cost = $800,000 – $600,000 = $200,000. Year 1 cash flows are: 
    $000 
Revenue 25,000 × $80 2,000 – rises at 5% Direct material 25,000 × $8 200 – rises at 4% Direct labour 25,000 × $12 300 – rises at 10% Variable overheads 25,000 × $12 300 – rises at 4% Fixed costs    200 – rises at 5%

232  
  
Year 0 1 2 3 4 
 $000 
Capital (2,400)     
Revenue  2,000 2,100 2,205 2,315 
Direct material  (200) (208) (216) (225) 
Direct labour  (300) (330) (363) (399) 
Variable OH  (300) (312) (324) (337) 
Fixed cost  (200) (210) (221) (232) 
Net cash flow (2,400) 1,000 1,040 1,081 1,122 
15% disc. factor  0.870 0.756 0.658 0.572 
Present value (2,400) 870 786 711 642 
 
The net present value is $609,000. 
Therefore the company should invest in the project.  
 
 Example 13: Leo Ltd 
 All cash flows shown are money cash ($000) 
 
Year Capital Labour Material Revenue 
 Net 
cash 13% 
factors Present 
value 
0 (400)  (350)  (750)  (750) 
1  (550)  900 350 0.885 310 2  (605)  945 340 0.783 266 3  (665.5)  992 326.5 0.693 226 
       ––– 
      NPV = 52 
––– 
Net Present Value = $52,000 
Answer C

Chapter 6 
 233 
       
$ millions T0 T 1 T 2 T 3 T 4 
Sales (W1)  520 1082 675  
Variable costs (W2)  (158) (331) (208)  
Net trading inflows  362 751 467  
Taxation (30%) – in year  (54) (112) (70)  
Taxation – in year (30%)   (55) (113) (70) 
Initial investment (1,000)     
Scrap proceeds    200  
Tax depreciation benefit 
(W3)  37 66 82 55 
Net cash flows (1,000) 345 650 566 (15) 
DF @ 10% (W4) 1 0.909 0.826 0.751 0.683 
PV (1,000) 314 537 425 (10) 
    NPV 266 
 
(W1) Revenue  
Revenue needs to be expressed in money terms.  
Revenue at T 1 = 5m × $100 × (1.04) = $520m.  
Revenue at T 2 = 10m × $100 × (1.04)2 = $1,082m. 
Revenue at T 3 = 6m × $100 × (1.04)3 = $675m. 
(W2) Costs  
Costs need to be expressed in money terms.  Costs at T
1 = 5m × $30 × (1.05) = $158m.  
Costs at T 2 = 10m × $30 × (1.05)2 = $331 m.  
Costs at T 3 = 6m × $30 × (1.05)3 = $208m. 
(W3) Tax depreciation ($m) 
 
depr 
(25%) Tax 
relief 
(30%) Year relief received 
    1 2 3 4 
1 1,000 250 75 37 38   
2 750 188 56  28 28  
3 562 362 109  
–––  
––– 54 
––– 55 
––– 
    37 
––– 66 
––– 82 
––– 55 
––– 
 
*Disposal = $200m when the TWDV was $562m. Therefore the 
balancing allowance = $362. 
(W4) Discount rate  
(1 + m) = (1 + r) × (1 + i) = 1.068 × 1.03 = 1.10, giving a money rate  (m) = 10%.

234  
 (a)  Tip: Set up a table of cash flows. Keep all workings separate from 
this table. 
 
Year 
 Date Advertising Capital 
costs Contri-
bution Working 
capital Net 
cash 
flow 12% 
discount 
value 
  $000 $000 $000 $000 $000 $000 $000 
0 1.11.07        
1 1.11.08  (2,000)   (2,000) 0.893 (1,786) 
2 1.11.09 (1,500) (4,500)  (2,500) (8,500) 0.797 (6,775) 
3 1.11.10 (750)  12,700  11,950 0.712 8,508 
4 1.11.11 (750)  17,145  16,395 0.636 10,427 
5 1.11.12 (750)  11,430  10,680 0.567 6,056 
6 1.11.13 (750)  11,430  10,680 0.507 5,415 
7 1.11.14 (750)  11,430 2,500 13,180 0.452 5,957 
        27,803 
   Less PV of fixed costs: 7,500 × (4.564 – 1.690) (21,555) 
–––––– 
   Net present value 6,24 
–––––– 
 
Production: 
Year   
1 100,000 units 
2 135,000 units* 3 90,000  
4 90,000  
5 90,000  *(160 + 200)/2 180  
1st 6 months 90  
2nd 6 months 45 (50% because of competitor) Total for year 135  
 
Contribution per unit: $249 – $122 = $127 
Assumptions: –  The amount already spent is not relevant – it is a sunk cost. –  The sales figures are the average of the range and the 
competitor takes 50% of market share after 18 months of 
sales. 
–  The equipment has no scrap value after five years. 
–  Working capital is released immediately production ceases.  –  Inflation has been ignored. Conclusion: the NPV is $6,248,000. Hence the project should be 
accepted.

Chapter 6 
 235 
 (b) 
 
Year Date Fixed 
cost Advertising Capital 
costs Contri- 
cash 
flow 12% 
discount 
value 
  $000 $000 $000 $000 $000 $000 $000 $000 
0 1.11.07         
1 1.11.08   (2,000)   (2,000) 0.893 (1,786) 
2 1.11.09   (2,847)  (2,500) (5,347) 0.797 (4,262) 
3 1.11.10 (3,750) (1,875) (1,923) 6,985  (563) 0.712 (401) 
4 1.11.11 (7,500) (750)  9,525  1,275 0.636 810.9 
5 1.11.12 (7,500) (750)  11,430  3,180 0.567 1,803 
6 1.11.13 (7,500) (750)  11,430  3,180 0.507 1,612 
7 1.11.14 (7,500) (750)  11,430 2,500 5,680 0.452 2,567 
–––––  
     Net present value 345.2 
––––– 
 
Development costs:  
Year 1  = $2m 2 2/3 of $4m = $2.667m + $0.180 = $2.847m 3 1/3 of $4m = $1.333m + $0.090 + $0.5m = $1.923m 
Salary costs in Year 2: $180,000 
Salary costs in Year 3: $90,000 Advertising in Year 3: $1.5m + $0.375 (50% of $750,000) = $1.875m 
 
 Method and answer guide Firstly calculate the NPV of costs: 
 
  Machine X Machine Y 
flow Present 
value Cash 
value 
  $000 $000 $000 $000 
0  120 120 60 60 
1 0.909 20 18 40 36 
2 0.826 20 17 35 29 
3 0.751 20 15   
Net present value 170  125

236  
 It is not appropriate to compare these two NPVs. Machine X shows three 
years of costs whereas Machine Y only has two years’ worth of costs. 
Remember that the machines are needed into the foreseeable future, so do not pick the cheapest single purchase. The machine will be replaced many times over the next few years. Because of this we need to find a way of comparing the costs over an equal time period (not unequal years). 
Machine X: 
NPV of one life cycle = $170k EAC = $170k ÷ 2.487  = $68k p.a. 
Machine Y: 
NPV of one life cycle = $125k EAC = $125k ÷ 1.736  = $72k p.a. 
Machine X is the cheapest. 
 
   Replacement Cycle   
 Discount 1 year 2 year 3 year 4 year 5 year 
YearFactor Cash PV Cash PV Cash PV Cash PV Cash PV 
0  (220) (220) (220) (220) (220) (220) (220) (220) (220) (220) 
1 0.893 11 9.8 (110) (98.2) (110) (98.2) (110) (98.2) (110) (98.2) 
2 0.797   (44) (35.1) (132) (105.2) (132) (105.2) (132) (105.2) 
3 0.712     (88) (62.6) (154) (109.6) (154) (109.6) 
4 0.636       (110) (70.0) (165) (104.9) 
5 0.567         (151) (85.6) 
Net present 
value  (210.2)  (353.3)  (486.0)  (603.0)  (723.5) 
÷ Annuity factor ÷ 0.893 –––––– ÷ 1.690 –––––– ÷ 2.402 –––––– ÷3.037 
–––––– ÷ 3.605 –––––– 
Equivalent annual cost (235.4) 
–––––– (209.1) 
–––––– (202.3) 
–––––– (198.6) 
–––––– (200.7) 
–––––– 
            
 Notes: 
• In year 0 the cost of the machine is shown • In each year after that the cash column shows the running costs of 
the machine 
• In the year of sale, net cash flow is scrap less running cost

Chapter 6 
 237 
 • The PV (present value) column represents the cash column 
multiplied by the discount factor for that year 
• The net present value is then the sum of the present values 
• In order to compare net present values an equivalent annual cost is 
calculated by dividing the NPV by the annuity factor for the length of 
the investment. So, for example, the 4 year NPV of $603.0 is divided by the 4 year 12% annuity factor of 3.037 to give an annual equivalent cost of $198.6 
• These equivalent annual costs are compared and the lowest one is 
the optimal replacement cycle. 
Therefore, the most economical replacement cycle is four years.  
 
Project A  Cashflow Cumulative cash flow 
Year 0 (450) (450) 
Year 1 200 (250) 
Year 2 150 (100) 
Year 3 100 0 
Payback period = 3 years 
Project B 
Year 0 (100) (100) 
Year 1 50 (50) 
Year 2 40 (10) 
Year 3 30 20 
10/30 = 0.33333 of a year, i.e. 4 months 
Therefore, payback is 2 years and 4 months. Note: The question states that cashflows only arise at year ends. If they were to 
arise evenly throughout the year then a more accurate payback period would be 2 years and 4 months.

238  
 Before you start a table of cash flows sort out corporation tax and tax 
depreciation benefits. 
Corporation tax 
30% of net cash flows (profits), i.e. 30% of $30,000 = $9,000. 
Half is payable in the year of the profit, and half in the year following, i.e.: 
 
Year Corporation tax 
1 $4,500 
2 $9,000 3 $9,000 
4 $9,000 
5 $4,500 
Capital cost: $100,000 Scrap value: $20,000 Total tax depreciation: $80,000 
 
saved 
cash 
benefit 
1 $75,000 $25,000 $7,500 $3,750 $3,750 
2 $56,250 $18,750 $5,625 $3,750 + $2,813 $6,563 
3 $42,188 $14,062 $4,219 $2,813 + $2,110 $4,922 
4 $20,000 $22,188 $6,656 $2,110 + $3,328 $5,437 
5    $3,328 $3,328 
      
Now you can calculate the net cash flow each year, and discount: 
 
Yr Asset 
 Profits 
 Corporation 
tax Tax 
dep'n 
benefit Total 
net cash Discount 
factor  Present 
value 
 $ $ $ $ $  $ 
0 (100,000)    (100,000)  (100,000) 
1  30,000 (4,500) 3,750 29,250 0.952 27,846 
2  30,000 (9,000) 6,563 27,563 0.907 25,000 
3  30,000 (9,000) 4,922 25,922 0.864 22,397 
4 20,000 30,000 (9,000) 5,437 46,437 0.823 38,218 
5   (4,500) 3,328 (1,172) 0.784 (919) 
      NPV =  12,542

Chapter 6 
 239 
 C  
Money cost of capital = [(1.08 × 1.12) – 1] × 100 = 20.96% 
 
Time t0 t1 t2 
 $ $ $ 
Outlay (18,000)   Labour  9,000 9,900 
Salvage   5,000  
   ––––––    14,900 
   –––––– 
20.96% discount 
factor 1 0.8267 0.6835 
Present value (18,000) 7,440 10,184 
NPV = $(376) or 
$(380) to nearest $10     
    
 Case Study Style Question – Scotland Ski Runs  
 Low investment 
 
Year  Cash 
flow 12% 
discount 
value 
  $000  $000 
0 Initial cost (250) 1.000 (250) 
5 Replacement of 
motors (50) 0.567 (28.35) 
1–10 Fixed costs (90) 5.650 (508.50) 1–10 Contribution (W1) 159.75 5.650 902.6 0 Loan 125 1.000 125.0 1–6 Loan repayment (W2) (23.8) 4.111 (97.8) 
–––– 
    142.9 
High investment 
 
Year  Cash flow 12% 
discount 
value 
  $000  $000 
0 Initial cost (1,200) 1.000 (1,200) 
1–10 Fixed costs (30) 5.650 (169.5) 1–10 Contribution (W1) 248.5 5.650 1,404.0 
0 Loan 600 1.000 600 
1–6 Loan repayment 
(W2) (114.5) 4.111 (470.7) 
–––– 
    163.8

240  
 Workings: 
(W1) Expected values Expected demand = 0.3 × 60 + 0.4 × 40 + 0.3 × 5 = 35,500 skiers Low investment: Contribution p.a. ($8 – $3.50) × 35,500 = $159,750 High investment: Contribution p.a. ($8 – $1) × 35,500  = $248,500 
(W2) Annuity  
Initial loan = PV of repayments PV of repayments = $x per annum × annuity factor 
Low investment 
$125,000 = $X × 5.242 (annuity factor, year 6, 4%) 
∴ $X = $23,800 
$600,000 = $X × 5.242 
∴ $X = $114,500 
Low investment: NPV = $142,900 
High investment: NPV = $163,800 
∴ Adopt high investment strategy.

241 
The pricing decision 
B4: Capital Investment 
Decision-Making Discuss pricing strategies 
(a) Discuss pricing decisions (b) Discuss pricing strategies 
   
   Chapter 
7

242  
 
In this chapter, we will learn about the al ternative strategies that an organisation 
may adopt in the pricing of its products or services. 
The price to be charged to customers for the business’s products or services is 
often one of the most important decisions to be made by managers. Not all businesses are free to determine their own selling prices: for example, some are unable to influence the external price and are obliged to accept the prevailing market price for their goods. For these businesses cost control is an important factor in maintaining profitability. 
Other businesses are in a position to select their selling price. The objectives 
that they pursue in their pricing policy will affect the price to be charged for each product or service. For example, the business may be concerned with profit maximisation: in this chapter you w ill see how managers can use cost and 
demand analysis to determine the theoretical profit-maximising price. 
Other objectives may also affect a company’s pricing policy. For example, the 
company may be seeking to maximise revenue, to gain the largest share of the market, to utilise spare capacity or merely to survive. In this chapter, we will be looking at many of the different aspects which influence a company’s pricing strategy, beginning with the price elasticity of demand. 
There is no knowledge brought forward from Subjects C01 and P1, but you may benefit from reading the Chapter on Cost Behaviour and Pricing Decisions from Certificate Level Subject C04.

Chapter 7 
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4  Price elasticity of demand 
Businesses make a profit by selling goods and services at a price that is higher 
than their cost. Profit is the result of the interaction between cost, volume and price: 
 
For instance, the volume of goods sold affects the cost per unit. If the volume 
increases, the fixed overheads are spread over more units, and so the cost per 
unit decreases. Lower costs give the seller the opportunity to reduce prices and so further increases volumes, or to increase profit margins. Cost is also influenced by price. This is discussed in target costing earlier in this text; the aim is to be able to produce at a target cost which is less than the target selling price. This chapter, however, concentrates on the link between price and volume, and its resulting effect on profit. 
When a business proposes to change the price of a product or service, the key 
question is 'to what degree will demand be affected?' 
The price elasticity of demand  measures the change in demand as a result of 
a change in its price. It can be calculated as follows: 
 
Price elasticity of demand = Change in quantity demanded, as a 	
percentage of demand
Change in price, as a percentage 	
of the price 
 
 Example 1: Elasticity 
 Assume that the sales of a retailer fall from 20 per day to 12 per day 
when the price of a chocolate bar goes up from 40c to 60c. What is the 
price elasticity of demand?

244  
 Interpretation of PED  
 Elastic demand 
If the percentage change in  demand exceeds the percentage change in 
price, then price elasticity will be greater than 1. 
Demand is 'elastic', i.e. very responsive to changes in price. 
• Total revenue increases when price is reduced. • Total revenue decreases when price is increased. 
Therefore, price increases are not recommended but price cuts are 
recommended. 
Inelastic demand 
If the percentage change in demand is less the percentage change in 
price, then price elasticity will be lower than 1. 
Demand is 'inelastic', i.e. not very responsive to changes in price. 
• Total revenue decreases when price is reduced. 
• Total revenue increases when price is increased. 
Therefore, price increases are recommended but price cuts are not 
 
 More on price elasticity  
 Pricing decisions have a major effect on volume sold and, as a 
consequence, on profit generated. One of the major considerations of a pricing decision is therefore the effect of a change in price will have on volume sold. If price is reduced, by how much will demand increase? 
If price is increased, will a small or large decrease in demand occur? 
A complete answer to these questions, if such an answer does indeed exist, will involve a number of different factors in the total marketing mix, but the basic microeconomic analysis of demand is the fundamental starting point. There are two extremes of the price/demand trade off, represented graphically here:

Chapter 7 
 245 
 In (a), the same quantity, Q1, will be sold regardless of the selling price, 
as demand is completely unresponsive to changes in price. Demand is, 
therefore, completely inelastic, and the supplier would (theoretically) have unlimited scope, and considerable incentive, to increase price. In (b), demand is limitless at a particular price, P1, but it would vanish at prices above P1, that is demand is completely elastic. Under these circumstances there is obviously no point in reducing price below P1, as this will cause existing profits to fall. Needless to say, these two extremes are rarely seen in practice, and the more normal situation is represented by one of the following charts: 
 
In both (c) and (d) the supplier is faced with a downward-sloping demand curve, in which reductions in price will result in increased demand and vice versa. This is a negative relationship, or negative correlation, as a decrease in price implies an increase in demand, and vice versa. 
The slope of the line is the critical factor for a pricing decision, and is 
expressed by the following formula: 
 
Elasticity of demand 	= –% change in quantity demanded
% change in  price

246  
 The numerator and denominator are expressed in terms of percentage 
change rather than in any absolute amount, in order to avoid distortions 
caused by the use of different units of measurement. Given the slope of the curve, the negative sign in the numerator has the effect of making the outcome positive, which is generally considered a more convenient representation. If elasticity at a point on the curve is greater than 1, demand is considered elastic. This means that a fall in price increases demand considerably, so that total revenue increases, but an increase in price decreases demand substantially, so that total revenue falls. On the other hand, if point elasticity is less than 1 (i.e. it is inelastic) a fall in price will increase demand, but not by a sufficient amount to maintain the previous revenue level, yet a rise in  price will increase total revenue: 
 
For product A, with elastic demand, a drop in price from P1 to P2 results in a relatively greater increase in sales volume. However, the same drop in price for product B, with inelastic demand, results in a far smaller change in volume. 
Note that the formula measures movement between two discrete points on 
the curve, and that even though the slope itself is constant, elasticity will differ between different points on the curve: 
 
Note that although the price drops from P1–P2 to P3–P4 are equal, the impact on the quantity sold is greater with each fall in price.

Chapter 7 
 247 
 
This is important information for an organisation. For example, when price 
elasticity is high (i.e. more than 1) the organisation will have difficulty in 
situations where cost inflation is higher than price inflation, because putting up prices in line with costs will cause a disproportionately large reduction in demand, and total revenues will decline. In times of inflation it is better to put up prices frequently by a small amount each time, as customers do not appear to notice the increases – or certainly do not react to them. If prices are held and then substantially increased in a single price rise, demand is likely to fall off sharply. In practice the prices of many products (e.g. consumer durable products) need to fall over time in order to increase demand. It is vital, therefore, to make costs fall by the same percentage if margins are to be maintained. 
Different point elasticity can be seen in practice, as customers do not tend 
to react evenly to price increases. For example, $1 or $2 may be a psychological barrier and if price is increased over this level demand drops quite rapidly. If the product is sold in a supermarket the organisation needs to know how customers react to different prices in order to determine which price points are crucial. In the figure below, the rise between 38p and 40p triggers a large reduction in demand. 
To complicate the issue an organisation does not decrease price with the 
aim of increasing volume in isolation. The effect on volume will depend on how competitors react to the price change, and on the price elasticity of the products.

248  
  
Different products in the same industry have different price elasticity 
because they are sold in slightly different markets due to product differentiation. This means that two or more products are sold that have different features, quality, sizes and so on. For example, a Volkswagen Golf GTI (the high-performance model) may enjoy lower price elasticity than the standard Golf 1.4E, so that the price of the former can be increased more safely than can that of the latter. 
The figure above shows two companies. Company A’s product A has a 
highly inelastic demand, while company B’s product B has relatively elastic price elasticity: 
In an industry in which costs of production are rising, the responsiveness 
of demand is an essential factor when deciding on price levels. In the above graph, the company producing product A could increase price by 25 per cent, from $40 to $50, with only a 10 per cent effect on volume (from about 54,000 down to 50,000 units). If the company that produces product B attempts to follow the price rise, its volume will fall from about 54,000 units to approximately 18,000 – the result of very elastic demand. In an industry where prices are falling, then the greater the price elasticity the greater the potential for increasing sales volume. 
It is also important for an organisation to take account of expected 
competitors’ reactions to any price increases the organisation makes. 
One form of competitor reaction can be demonstrated with the kinked 
demand curve which shows ‘price stickiness’. This occurs where competitors tend to follow price cuts with cuts of their own, but do not copy price rises. This is a pattern commonly found in the newspaper industry.

Chapter 7 
 249 
  
If the price is increased beyond the current price of P 1 to P A, since 
competitors do not follow suit, demand will fall away sharply to Q A 
(demand is elastic). If however, the price is dropped to P B, competitors do 
follow, and little is gained in the way of extra sales (from Q 1 to Q B ) – 
demand is inelastic. 
Where this occurs, firms may be reluctant to change their prices and the 
result is price stickiness. 
5  Factors affecting price elasticity 
When making decision s on products, market s and competitors, other factors, 
including the following, should be considered: 
1 Scope of the market. The larger the defined market, the more inelastic is 
the demand for the broader definition of product. For example, the total 
market for transport is relatively inelastic, whereas the market for 21-speed pedal cycles is comparatively elastic. 
2 Information within the market. Consumers may not know of the competing products in sufficient time to reassess their purchasing behaviour. 
3 Availability of substitutes.  The less the differentiation between 
competing products, the greater the price elasticity of those products. Differentiated products benefit from customer awareness and preference, so their demand patterns tend to be more inelastic. 
4 Complementary products. The inter-dependency of products results in price inelasticity, because the volume sales of the dependent good rely on sales of the primary good. The consumer will make a purchase of the complementary product in order to achieve satisfaction from the primary good. For example, the purchase of a radio, remote control toy car or a torch, etc., all require the purchase of the complementary product – batteries.

250  
5 Disposable income. The relative wealth of the consumers over time 
affects the total demand in the economy. Luxury goods tend to have a 
high price elasticity, while necessities are usually inelastic. 
6 Necessities. Demand for basic items such as milk, bread, toilet rolls, etc., tend to be very price inelastic. 
7 Habit. Items  consumers buy out of habit, such as cigarettes are usually 
price inelastic. 
In practice few organisations attempt to set prices by calculating demand and elasticity. This is probably because it is exceptionally hard to determine demand under different circumstances with any certainty. However, most organisations will have some idea of the elasticity of  their products and this will have some 
bearing on the way prices are set. There are a number of different techniques for setting prices that depend on the type of market and product. 
 
Different types of market structures 
 The price that a business can charge for its products or services will be 
determined by the market in which it operates. 
In a perfectly competitive market, every buyer or seller is a 'price taker', 
and no participant influences the price of the product it buys or sells. Other characteristics of a perfectly competitive market include: 
• Zero entry/Exit barriers  – It is relatively easy to enter or exit as a 
business in a perfectly competitive market. 
• Perfect information  – Prices and quality of products are assumed 
to be known to all consumers and producers. 
• Companies aim to maximise profits  – Firms aim to sell where 
marginal costs meet marginal revenue, where they generate the 
most profit. 
• Homogeneous products  – The characteristics of any given market 
good or service do not vary across suppliers. 
Imperfect competition  refers to the market structure that does not meet 
the conditions of perfect competition. Its forms include: 
(a) Monopoly , in which there is only one seller of a good. The seller 
dominates many buyers and can use its market power to set a 
profit-maximising price. Microsoft is usually considered a monopoly. 
(b) Oligopoly , in which a few companies dominate the market and are 
inter-dependent : firms must take into account likely reactions of their rivals to any change in price, output or forms of non-price competition. For example, in the UK, four companies (Tesco, Asda, Sainsbury's and Morrisons) share 74.4% of the grocery market. 
(c) Monopolistic competition , in which products are similar, but not 
identical. There are many producers ('price setters') and many consumers in a given market, but no business has total control over the market price.

Chapter 7 
 251 
 For example, there are many different brands of soap on the market 
today. Each brand of soap is similar because it is designed to get the 
user clean; however, each soap product tries to differentiate itself from the competition to attract consumers. One soap might claim that it leaves you with soft skin, while another that it has a clean, fresh scent. Each participant in this market structure has some control over pricing, which means it can alter the selling price as long as consumers are still willing to buy its product at the new price. 
If one product costs twice as much as similar products on the market, 
chances are most consumers will avoid buying the more expensive 
product and buy the competitors' products instead. Monopolistic products are typically found in retailing businesses. Some examples of monopolistic products and/or services are shampoo products, extermination services, oil changes, toothpaste, and fast-food restaurants. 
6  The profit-maximisation model 
A mathematical model can be used to determine an optimal selling price. The 
model is based on the economic theory that profit is maximised at the output 
level where marginal cost is equal to marginal revenue . 
Full use of the model requires a knowledge of calculus, which is outside the scope of your syllabus. However, you are expected to understand the following basic principles: 
It is worthwhile a firm producing and selling further units where the increase in 
revenue gained from the sale of the next unit exceeds the cost of making it (i.e. the marginal revenue exceeds the marginal cost). However, if the cost of the next unit outweighs the revenue that could be earned from it (i.e. the marginal cost exceeds the marginal revenue), production would not be worthwhile. 
A firm should therefore produce units up to the point where the marginal 
revenue equals the marginal cost : MR = MC  
The basic price equation is given as p = a + bx  
where 
p = price x = quantity demanded a and b are constants, where b is the slope of the curve and is calculated as 
(change in price/change in quantity) 
For example, if you are told that demand falls by 25 units for every increase in 
price of $1, then b = (–1/25) = –0.04 
The marginal revenue  equation can be found by doubling the value of b: 
MR = a + 2bx The marginal cost is the variable cost of production.

252  
 Illustration 1 – The MR = MC diagram 
 Marginal revenue is the additional revenue from selling one extra unit, for 
example: 
 
Quantity Price Revenue Marginal revenue 
1 $70 $70 $70 
2 $60 $120 $50 
3 $50 $150 $30 
4 $40 $160 $10 
5 $30 $150 $(10) 
Marginal cost is the cost from making one more unit. It is usually just the 
variable cost, e.g. MC = $30.

Chapter 7 
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7  Procedure for establishing the optimum price of a product 
This is a general set of rules that can be applied to most questions involving 
algebra and pricing. 
1  Establish the linear relationship between price (P) and quantity demanded 
(Q). The equation will take the form: 
P = a + bQ 
where 'a' is the intercept and 'b' is the gradient of the line. As the price of a 
product increases, the quantity demanded will decrease. The equation of a straight line P = a + bQ can be used to show the demand for a product at a given price: 
 
Note: ‘b’ is always negative because of the inverse relationship between price and quantity. 
2 Double the gradient to find the marginal revenue: MR = a + 2bQ . 
3 Establish the marginal cost MC . This will simply be the variable cost per 
unit. 
4 To maximise profit, equate MC and MR  and solve to find Q. 
5 Substitute this value of Q into the price equation to find the optimum price. 
6 It may be necessary to calculate the maximum profit.

254  
 Illustration 2 – Profit maximising price  
 Maximum demand for a company’s product M is 100,000 units per 
annum. The demand will be reduced by 40 units for every increase of $1 
in the selling price. The company has determined that profit is maximised 
at a sales volume of 42,000 units per annum. 
What is the profit maximising selling price for product M? 
Solution 
In the demand equation, p = a – bx  
where p = price x = quantity demanded a, b = constants Maximum demand is achieved when the product is free, that is, when 
p = 0 
 
 Example 2: The algebraic approach 
 At a price of $200, a company will be able to sell 1,000 units of its product 
in a month. If the selling price is increased to $220, the demand will fall to 950 units. It is also known that the product has a variable cost of $140 per unit, and fixed costs will be $36,000 per month. 
Required: 
(a) Find an equation for the demand function (that is, price as a function 
of quantity demanded) 
(b) Write down the marginal revenue function 
(c) Write down the marginal cost (d) Find the quantity that maximises profit (e) Calculate the optimum price (f) What is the maximum profit?

Chapter 7 
 255 
 Example 3: Maximum profit 
 The total fixed costs per annum for a company that makes one product 
are $100,000, and a variable cost of $64 is incurred for each additional 
unit produced and sold over a very large range of outputs. 
The current selling price for the product is $160. At this price, 2,000 units 
are demanded per annum. 
It is estimated that for each successive increase in price of $5 annual 
demand will be reduced by 50 units. Al ternatively, for each $5 reduction 
in price, demand will increase by $50 units. 
Required: 
(a) Calculate the optimum output and price, assuming that if prices are 
set within each $5 range there will be a proportionate change in 
demand. 
(b) Calculate the maximum profit. 
 
 Example 4: Product K 
 Product K incurs a total cost of $10 per unit sold, as follows. 
 
 $ per unit  
Variable production cost   4 
Variable selling cost   2 
Fixed production cost   3 Fixed selling and administration cost   1 
––– 
Total cost 10 
––– 
The marginal revenue (MR) and demand functions for product K are: 
MR = 200 – 0.4x  p = 200 – 0.2x Where p – price, x = quantity demanded per period. What is the profit-maximising selling pr ice of product K, and what quantity 
will be sold per period at this price?

256  
8  The tabular approach 
When data in the exam is given in tabular form and there is no indication about 
the demand function, and/or when there is no simple linear relationship between output and profit – the tabular approach is likely to be the best to define optimum profit and the associated selling price. 
 
Example 5: Tabular approach 
 XYZ Ltd is introducing a new product. The company intends to hire 
machinery to manufacture the product at a cost of $200,000 per annum. 
However, this will only enable 60,000 units per annum to be produced, although additional machines can be hired at $80,000 per annum. Each machine hired enables capacity to be increased by 20,000 units per annum, but it is not possible to increase production beyond 90,000 units because of shortage of space. 
The minimum rental period is for one year and the variable cost is 
estimated to be $6 per unit produced. There are no other fixed costs that can be specifically traced to the product. Marketing management has estimated the maximum selling prices for a range of output from 50,000 units to 90,000 units. The estimates are as follows: 
 
Units sold 50,000 60,000 70,000 80,000 90,000 90,000* 
Selling price ($) 22 20 19 18 17 15 
* At $15 demand will be in excess of 90,000 units but production capacity 
will limit the sales. 
Required: 
Present relevant financial information to management for the pricing and 
output decision. 
Answer guide 
 
 $ $ $ $ $ $ 
Price per unit 22 20 19 18 17 15 
Variable cost per unit       
Contribution per unit       
Number of units sold 50,000 60,000 70,000 80,000 90,000 90,000 
Total contribution 
($000)       
Less fixed costs ($000)       
Net profit ($000)

Chapter 7 
 257 
9  Limitations of the profit-maximisation model 
The profit-maximisation model does make some attempt to take account of the 
relationship between the price of a product and the resulting demand, but it is of limited practical use because of the following limitations: 
1 It is unlikely that organisations will be able to determine the demand 
function for their products or services with any degree of accuracy. 
2 The majority of organisations aim to achieve a target profit, rather than the 
theoretical maximum profit. 
3 Determining an accurate and reliable figure for marginal or variable cost 
poses difficulties for the management accountant. 
4 Unit marginal costs are likely to vary depending on the quantity sold. For 
example bulk discounts may reduce the unit materials cost for higher 
output volumes. 
5 Other factors, in addition to price, will affect the demand, for example, the 
level of advertising or changes in the income of customers. 
10  Pricing strategies based on cost: Total cost-plus pricing 
Cost-plus pricing involves adding a mark-up to the total cost of the product, in order to arrive at the selling price. 
Unfortunately, since fixed costs are spread over the units of production, the full 
cost of a product will be a function of t he number of units produced, which in 
turn will be a response to the number of units sold. Yet, sales quantity will depend on the price charged for the product, and so the argument is circular. 
Where an order is placed with a jobbing company (a company that makes 
products to order) for a specific quantity of a product made to the customer’s specification, cost-plus may be an acceptable pricing method. But for the majority of organisations this is not the case. Other factors will influence the pricing decision, such as competition and product differentiation. Nevertheless it is reassuring to have some knowledge of cost and price at particular volumes, even if the knowledge is not perfect. 
If an organisation does use cost as the basis for pricing it has to decide whether 
to employ a standard mark-up or whether to vary the mark-up according to the market conditions, type of customer, etc. A standard mark-up is used by some organisations, such as government contractors and some job costing companies, but the majority of companies vary the percentage to reflect differing market conditions for their products. The example below demonstrates total cost pricing, using varying cost assumptions of total cost.

258  
 Total cost-plus pricing 
calculate a base cost, to which will be added a mark-up in order to arrive 
at a selling price. The following variable costs have been established by reference to the company’s experience with product A, although they may be subject to an error margin of + or – 10 % under production conditions for B: 
 $ 
Direct labour (1/4 hr @ $16/hr) 4 
Variable manufacturing overheads (1/4 hr of machine time @ 
$8/hr) 2 
––– 
––– 
estimates that it will be able to produce the same total quantity of B as its 
current production of A, which is 20,000 units. 50,000 machine hours may be regarded as the relevant capacity for the purposes of absorbing fixed manufacturing overheads. Current fixed costs are $240,000 for the production facilities, $200,000 for selling and distribution, and $180,000 for administration. For costing purposes, the 20,000 units of B can be assumed to consume 10 per cent of the total selling, distribution and administration costs. 
Alternative 1 , using conventional absorption costing principles and 
building in the conservative error margin 
 $ 
Variable production costs (as above) 10 Add: allowance for underestimate 10% 1 
––– 
Add: manufacturing cost 1/4 hour of machine time @ 
$4.80/hour ($240,000/50,000 hours) 1.2 
––– 
Base cost 12.2 
––– 
 $ 
Base cost as under 1 above 12.2 
Add: fixed administrative costs ($180,000 × 10% = $18,000/ 
20,000 units)  
0.9 
Base cost 13.1 
–––

Chapter 7 
 259 
 Alternative 3 , as 2 but including selling and distribution costs 
 $ 
Base cost as under 2 above 13.1 
Add: fixed selling and distribution costs ($200,000 × 10% = 
$20,000/20,000 units)  
1.0 
Base cost 14.1 
––– 
Depending on the analysis adopted, the base cost varies from $12.2 to 
$14.1. The base cost rises with each alternative, as an increasing 
proportion of the total costs is recovered. The profit mark-up built into the pricing formula is therefore likely to fall with each alternative from 1 to 3. 
The profit mark-up needs to be based on some assumption. Normally it is fixed so that the company makes a specific return on capital based on a particular capacity utilisation. 
A number of advantages are claimed for cost-plus pricing: (i) The required profit will be made if  budgeted sales volumes are achieved. 
(ii) It is a particularly useful method in contract costing industries such as 
building, where a few large individual contracts can consume the majority 
of the annual fixed costs and the fixed costs are low in relation to the variable costs. 
(iii) Assuming the organisation knows it s cost structures, cost-plus is quick 
and cheap to employ. Its routine nature lends itself to delegation, thus saving management time. 
(iv) Cost-plus pricing can be useful in justifying selling prices to customers; if 
costs can be shown to have increased, this strengthens the case for an increase in the selling price. 
However, there are a number of problems  with cost-plus pricing: 
(i) There will always be problems associated with the selection of a ‘suitable’ 
basis on which to charge fixed costs to individual products or services. Selling prices can show great variation, depending on the apportionment basis chosen. This can lead to over-or under-pricing relative to competitors causing the firm to either lose business or make sales at an unintentional loss. 
(ii) If prices are set on the basis of normal volume, and actual volume turns 
out to be considerably lower, overheads will not be fully recovered from sales and predicted profits may not be attainable. 
(iii) Cost-plus pricing takes no account of factors such as competitor activity. 
(iv) Cost-plus overlooks the need for flexibility in the different stages of a 
product’s life cycle. It takes no acc ount of the price customers are willing 
to pay and price elasticity of demand. The following example illustrates 
this point.

260  
 The variable cost of product A is $10. Fixed manufacturing costs of $1 m 
are spread over an estimated production and sales volume of 200,000 
units, i.e. $5 per unit. This gives a total cost of $15 per unit. The cost-plus approach used by the manufacturer of A, based on a standard mark-up of 40 per cent on the product’s total cost, dictates a selling price of $21. Assuming all costs were as anticipated, and the company managed to sell 200,000 units at the fixed price of $21, a gross profit of $1.2m ($6 × 200,000) would be earned. Suppose, however, that a market survey had indicated the price elasticity of demand for the product shown in the table 
below: 
Price ($) Demand (units) 
19 250,000 
20 240,000 
21 200,000 
22 190,000 23 160,000 
A more correct analysis of the pricing problem would have concentrated 
on maximising total contribution, and therefore total profitability as shown in this table: 
 
Price ($) Variable 
cost Contribution Demand Total 
contribution Profit 
19 10 9 250,000 2.25 1.25 
20 10 10 240,000 2.40 1.40 
21 10 11 200,000 2.20 1.20 
22 10 12 190,000 2.28 1.28 23 10 13 160,000 2.08 1.08 
The decision to use a full cost-plus price of $21 has an associated 
opportunity cost. In failing to take into consideration the market conditions the organisation has forgone an extra profit of $200,000 and its market share is lower than it could have been. 
11  Marginal cost-plus pricing 
To the accountant, marginal cost is the same as variable cost. Some of the reasons for using it in preference to total cost are as follows: 
1 It is just as accurate as total cost-plus pricing. A larger mark-up 
percentage is added because both fixed costs and profit must be covered, 
but the uncertainty over the fixed costs per unit remains in both pricing methods. 
2 Knowledge of marginal cost gives management the option of pricing below 
total cost when times are bad, in order to fill capacity.

Chapter 7 
 261 
3 It is particularly useful in pricing specific one-off contracts because it 
recognises relevant costs and opportunity costs as well as sunk costs. 
4 It also recognises the existence of scarce or limiting resources. Where 
these are used by competing products and services it must be reflected in 
the selling price if profit is to be maximised. If there is a scarce or bottleneck resource the aim must be to maximise the total contribution from the limiting factor. The contribution that each alternative product or service makes from each unit of the scarce resource must be calculated and a suitable profit margin added. 
 
 A company has been producing A successfully for a number of years, 
and demand appears to be static into the foreseeable future at a market price of $15 per unit. A market has just developed in product B, which the company could produce without additional investment in plant, and without increasing or retraining the existing labour force. Unfortunately, however, B uses the same basic direct material as product A, material C – which is in short supply. The company must determine a minimum selling price for B, below which it would not be worthwhile to divert resources from A. 
 Costs for the two products are given in the table below: 
  A B 
Direct material: 6 units of C $3.605 units of C $3.00 @ $0 .60 @ $0.60  
Direct labour: 1/2 hour $3.001/2 hour @ $6.00 $3.00 
@ $6.00   Variable overhead $2.40 
  ––––– $1.00 
   
 $9.00 $7.00 
Selling price $15.00 
  –––––  
   
Contribution $6.00 
  –––––  
Contribution per unit of material C = $6/6 units = $1 
A produces a contribution of $6 using 6 units of C, that is, a contribution 
per unit of C, the limiting factor, of $1. B uses five units of C. The company must therefore seek a contribution of $5 (5 units of material C × $1). So the price must cover the cost of the unit and the lost contribution from C, i.e. be at least $7 + $5 = $12.

262  
12  Criticism of marginal cost-plus pricing 
Marginal costing as a basis for pricing has always had its sceptics. The main 
criticism is based on the following type of scenario: 
There are two companies A and B competing with similar products in a market. 
The market is in recession and sales have decreased. Company A assesses its costs and lowers its price to below total cost, but well above marginal cost, in order to gain more market share. This tactic works; demand is elastic and so company A gains market share at the expense of company B. In order to get back its market share company B reduces its price below that of company A. Both companies now have their original market share but their margins are reduced. Company A then lowers the price again, etc. This continues, until one company is forced out of business. The remaining company now has to increase prices to the original level, which may well be difficult and can incur customer resistance. 
13  Marketing-based pricing strategies 
There are many different pricing strategies, and it may come as a surprise to would-be accountants that cost is only one of many methods and is certainly not universally used as the key method for pricing. 
Premium pricing 
Premium pricing is pricing above competition on a permanent basis. This can 
only be done if the product appears ‘different’ and superior to competition, which normally means establishing a brand name based on one of the following: 
• Quality • Image/style 
• Reliability/robustness 
• Durability 
• After-sales service 
• Extended warranties. 
 
Brands and premium pricing 
 In order to establish a brand, heavy initial promotion is required and the 
name must be constantly advertised or promoted thereafter. Brand 
names, such as, Levi, Mars, Coca-Cola, etc., require many millions of pounds spent on them each year. The benefit is a higher selling price generating a larger profit per unit and customer loyalty, making the product relatively price inelastic. These benefits must, of course, outweigh the cost of keeping the brand name in front of the customers.

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Market skimming 
Skimming is a technique where a high price is set for the product initially, so 
that only those who are desperately k een on the product will buy it. Then the 
price is lowered, making the product more accessible. When the next group of customers have had a chance to buy at that price, the price is lowered again, and so on. The aim of this strategy is usually to maximise revenue . But, on 
occasions, it is also used to prolong the life of older products. 
 
Market skimming and consumer durables 
 Consumer durable companies tend to skim the market. This is done, to a 
certain extent, to recover large research and development costs quite 
quickly. But the products also lend themselves to this treatment as trend-setters are willing to pay a high price to own the latest gismo, and the rest of the population follow their example in later years. Books are also sold this way, with new novels published in hardback at a high price. The hard cover costs little more than a soft cover.  Avid readers of that author will 
buy the hardback book at the high price. A year or so later the book is reissued with a soft cover at a much cheaper price in order to reach a wider audience. 
Price skimming was probably first employed at the end of the eighteenth 
century by Josiah Wedgwood, the famous ceramics manufacturer. He made classical-shaped vases decorated with sprigs of decoration, which he sold to the rich and well-to-do. Naturally he priced his products accordingly. As the designs became old and well known he reduced the price on those lines and introduced new designs at the high price. Thus, he created different tiers of markets for his products, and people who were not so well off could afford a piece which had been in production for some years. This marketing technique helps to prolong a product’s life and extracts the maximum profit from it. 
If demand for a new or innovative product is relatively inelastic, the 
supplier has the chance of adopting a market skimming price strategy. It is usually much easier to reduce prices than increase them, so it is better to begin with a high price, and lower it if demand appears more elastic than anticipated. If profitable skimming is to be sustained beyond the introductory phase, there must be significant barriers to entry to the market, in order to deter too many potential competitors entering attracted by the high prices and returns. In the case of books only one company own the rights to publish. Wedgwood had created an image/brand among the rich and famous which others could not copy, especially if they wished to undercut his prices. Consumer durable products have high manufacturing costs that deter too many companies entering the industry.

264  
Penetration pricing 
Penetration pricing occurs when a company sets a very low price for the new 
product initially. The price will usually be below total cost. The aim of the low price is to establish a large market share quickly by encouraging customers to try the product and then to repeat buy. This type of tactic is used, therefore, where barriers to entry are low. It is hoped to establish a dominant market position, which will prevent new entrants coming into the market because they could not establish a critical mass easily with prices so low. 
 
 In the past, companies used penetration pricing when they introduced a 
new product, such as a new spray polish, through supermarkets. The 
price would be, say, between 60 per cent and 80 per cent of the ultimate price. Customers would buy the new product largely because of its price and, it was hoped, repeat buy either because they did not notice the price increase or because they did not mind paying for a good product. If customers do notice the price increase they are likely to be put off further purchases if the increase is too large. If a company succeeds with this type of pricing it wins a large market share very quickly which competitors will find hard to break into. 
Price differentiation 
If the market can be split into different segments, each quite separate from the 
others and with its own individual demand function, it is possible to sell the same product to different customers at different prices. Marketing techniques can be employed to create market segmentation, if natural demarcation lines are not already in existence. Segmentation will usually be on the basis of one or more of the following: 
• Time (e.g. rail travel is cheaper off-peak, hotel accommodation, 
telecommunications) 
• Quantity (e.g. small orders at a premium, bulk orders at a discount) 
• Type of customer (e.g. student and OAP rates) 
• Outlet/function (e.g. different prices for wholesaler, retailer, end consumer) 
• Geographical location (e.g. stalls and upper circle, urban and rural sites, 
wealthy and poor districts, different countries) 
• Product content (e.g. sporty versions of a small car). 
This type of pricing is of particular use where a service provider (theatre, leisure 
centre, train operator) has a high proportion of fixed costs. By attracting those willing and able to use the service at the less popular time/loc ation will help to 
improve profitability.

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Loss leader pricing 
When a product range consists of one or more ma in products and a series of 
related optional ‘extras’, which the customer can ‘add on’ to the main product, 
the supplier can set a relatively low price for the main product and a high one for the ‘extras’. Obviously, the aim is to stimulate sufficient demand for the former to ensure the target return from sales of the latter. The strategy has been used successfully by aircraft engine manufacturers, who win an order with a very competitively priced main product that can only be serviced by their own, highly priced spare parts. 
 
Loss leader pricing – examples 
 Gillette did not invent the safety razor but the market strategy Gillette 
adopted helped to build market share. Gillette razors were sold at 1/5 of 
the cost to manufacture them but only Gillette blades fitted and these were sold at a price of 5 cents. The blades cost only 1 cent to manufacture and so Gillette made large profits once it had captured the customer. One of the best known uses of this technique in recent years has been the sale of printer ink for home printers. 
Investigations by Which? and by Computeractive magazine showed that 
whilst the price of inkjet printers can be as little as $34, the cost of running the printer over an 18-month period could be up to $1,700. The top brand names for replacement ink cartridges cost more per millilitre than vintage champagne and even where the consumer only buys two replacement cartridges a year, the cost of the ink is likely to be significantly higher than the cost of the initial printer. 
Discount pricing 
Discount pricing is the long-term pricing strategy used by firms such as Ikea and 
Ryanair, based on low cost, high volume and low margins. 
Products are priced lower than the market norm, but are put forward as being of 
comparable quality. The aim is that the product will procure a larger share of the market than it might otherwise do, ther eby counteracting the reduction in selling 
price. However, care must be taken to ensure that potential customers' perceptions of the product are not prejudiced by the lower price. The consumer will often view with suspicion a branded product that is priced at even a small discount to the prevailing market rate.

266  
 Using discounts in pricing (short-term) 
 There are a number of reasons for using discounts to adjust prices: 
1 To get cash in quickly. This is a not always a financially sound 
strategy as the firm may lose more in sales revenues from the 
discount, than they would lose in interest from a bank loan for the same amount. 
2 To differentiate between different types of customer, wholesale, 
retail, etc. 
3 To increase sales volume during a poor sales period without 
dropping the price permanently. 
4 Some industries give discounts as normal practice, for example the 
antique trade, and some retail shops seem to have semi-permanent sales. 
5 Perishable goods are often discounted towards the end of their life 
or the end of the day, or seconds are often sold off cheaply. This may not be a good strategy as it does not improve the company image, and some customers may get wise and delay their purchase until the end of the day when prices are cheaper. 
 
 Example 6: Pricing strategies 
 Place each of the following statements in a grey cell, against the pricing 
strategy to which it is most likely to relate: 
 
Price differentiation on age  
Price differentiation on gender  
Skimming  
Volume discounting  
Loss leader pricing  
Penetration pricing

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Lower admission prices 
for children at certain 
sporting events.   This applies to a 
product with a short life 
cycle, and there is a 
need to recover its 
development costs 
quickly and make a 
profit.  Demand is very 
elastic, and would 
react well to low 
prices. 
     
Lures the customer in 
with a relatively low 
priced product, in order 
to lock the customer in 
to subsequent additional 
purchases of different 
items that are relatively 
highly priced.  Offering a lower price 
per unit for customers 
who do not wish to 
place large individual 
orders, but who 
purchase large 
quantities over time.  Lower admission 
prices for 
females at some 
night clubs. 
     
Controlled pricing 
A significant proportion of the previously nationalised industries in the UK have 
been ‘privatised’ into the private sector, with a constraining influence usually called the industry ‘regulator’. Examples of these regulating bodies are Oftel (telecommunications) and Ofwat (water). 
Many of these companies are in a largely monopolistic situation and so 
regulation of these industries was perceived as desirable. Regulation largely takes the form of controlling price so that the monopolistic companies cannot exploit their unique position. The regulators use selling price as the means of controlling the volume of supply in the i ndustry. They may also decide to specify 
the quality of the product or level of service that must be achieved or to prohibit the company operating in certain sectors. 
When an industry is regulated on selling price, the elasticity is zero. No price 
change is allowed. Not only does this mean that ‘small’ customers pay less than they otherwise would, but large customers pay more than one might expect under more competitive positions. Over recent years all of the monopolistic industries have introduced some kind of discounted price for very large customers, which is beginning to allow genuine competition to enter the market. Gradually other billing companies have been allowed to enter the market and so price has become more flexible.

268  
Product bundling 
Bundling is putting a package of products together to make, for example, a 
complete kit for customers, which can then be sold at a temptingly low price. It is a way of creating value for customers and increasing company profits. It is a strategy that is often adopted in times of recession when organisations are particularly keen to maintain sales volume. One industry where this tactic started in the recession of the early 1990s is the computer industry. A manufacturer might decide to substantially reduce the profit margin on some hardware, such as printers. If, for example, only half its PC purchasers would also buy the company’s model of printer, a bundled package which includes the PC and the printer for a lower combined price may well prove very successful. On the other hand, some customers will be put off by product bundling as they do not want the complete package; they will resent the increased price, however small it is. 
 
Bundling 
 Bundling is profitable in situations in which some buyers value one of the 
items in a bundle relatively highly but the remainder slightly above or 
below cost price. Other buyers place a relatively high valuation on both or all of the items in the bundle. Four fi lm exhibitors, A to D, are willing to 
pay the following prices for two films X and Y: 
A values X at $16,000 and Y at $5,000 B values X at $14,000 and Y at $6,000 C values X at $11,000 and Y at $10,000 D values X at $10,000 and Y at $11,000 The distributor’s marginal cost of supplying each film is $8,000. The distributor offers X and Y separately at $14,000 and $8,000 
respectively, or the pair as a package for $21,000. The result is that A, C and D hire the package and B hires film X only, as the cost of both the bundle and film Y exceed his particular valuations. The distributor’s profit would be ($21,000 × 3) + ($14,000) – ($8,000 × 7) = $21,000. 
However, A might also prefer to hire film X for $14,000, instead of taking 
the package, as the extra cost of the bundle exceeds his valuation of Y by $2,000. If A did choose this option, the distributor’s profit would rise to $22,000, as he does not have to supply either A or B with film Y, which has a supply cost in excess of their valuations: ($21,000 × 2) × ($14,000 × 2) – ($8,000 × 6) = $22,000.

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 Bundling is a particularly efficient means of exploiting price differentiation. 
Buyers are offered a pricing structure in which they are charged higher 
prices for buying the items separately (X + Y = $22,000) than in a package (X + Y = $21,000). Bundling works as a discriminatory device by: 
• Using the package to extract the most from those customers who 
value it most. (In our example C and D, who placed relatively high 
valuations on both films.) 
• Charging a relatively high separate price for the item in the package 
that is valued very highly by some particular buyers. (In our example film X, which was valued very highly by both A and B.) 
If the distributor did not bundle he would make a profit of $19,000, as A and B would purchase product X and C and D would purchase product Y. 
 
 Bundling: Amstrad 
 Bundling can be extremely successful, especially when tried on mature 
products for the first time. For instance, Amstrad had considerable success when it entered the hi-fi market and demystified the technology by being the first company to sell a complete package of amplifier, deck and speakers. This was more than just a pricing strategy: it was a complete marketing strategy. In recent years the telecommunications industry has successfully used this technique; first with TV channel packages, and then more recently extended to TV, broadband and phone bundles. 
Whether a bundling strategy will succeed depends on the predicted 
increase in sales volume and the changes in margin. There are likely to be other cost changes such as savings in product handling, packaging and invoicing costs. Longer-term implications and competitors’ reactions must not be ignored. For example, how will customers react when products are ‘unbundled’? Will this result in a marked decline in sales? Will bundling be seen as an inferior product strategy which will have long-term implications for the brand’s image? Will competitors retaliate by bundling their products? If they do this, will the strategy be successful? 
 
 Pricing with additional features 
 The decision to add extra features to a product is a similar decision to 
bundling products. Most people prefer to have extra features incorporated into the product but they may not be prepared to pay the extra price. Others do not require the extra features and view them as a definite disadvantage. This is likely to be the case with older customers and electrical or electronic equipment. Older people find mastering the equipment quite difficult and they do not want extra features that make operation even more difficult.

270  
14  The product life cycle 
Products and services, like human beings, have a life cycle. This is represented 
by the generic curve shown below: 
 
The length of the life cycle varies considerably from a year or so, for some 
children’s toys, to hundreds of years, as in the case of binoculars, for example. 
The product life cycle is divided into four basic stages as shown in the figure above; each stage has different aims and expectations. 
Price is a major variable over the product life cycle. Depending on market 
structure and demand, different pric ing strategies will be appropriate for 
different stages in the cycle. The four stages in the life cycle and appropriate price strategies are described below: 
(i) Introductory phase  
Demand will be low when a product is first launched onto the market, and 
heavy advertising expenditure will usua lly be required to bring it to 
consumers’ attention. The aim is to establish the product in the market, which means achieving a certain critical mass within a certain period of time. The critical mass is the sales volume that must be achieved in order to make the product viable in the medium term. Depending on the nature of the product, a price penetration (low entry price) policy may be adopted in order to reach the critical mass quickly. On the other hand the market may be skimmed (exploiting those purchasers keen to have the latest product such as plasma screen TVs) and so a high introductory price may be set. 
(ii) Growth  
Once the hurdle of the introductory stage has been successfully negotiated, the product enters the growth stage, where demand shows a steady and often rapid increase. The cost per unit falls because of economies of scale with the greater level of production. The aim at this stage is to establish a large market share and to perhaps become the

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market leader. Market share is easier to obtain during the growth stage 
because the market is growing and increased market share does not have to be gained by taking sales from another company. In a more mature market, market share has to be poached from competitors and their reaction may be unpleasant as they try to hold on to their market share. During the growth stage competitors will enter the market, some of which will not survive into the maturity stage. Despite the fact that competing products will be launched into the growin g market and pricing is often keen 
in order to gain market share, it is usually the most profitable stage for the initial supplier. 
(iii) Maturity  
The increase in demand slows down in this stage, as the product reaches the mass market. The sales curve flattens out and eventually begins to fall. As market maturity is reached the organisation becomes more interested in minimising elasticity. Products have to be differentiated in order to maintain their position in the market and new users for mature products need to be found to keep demand high. Generally, profits will be lower than during the growth stage. 
(iv)  Decline  
When the market reaches saturation point, the product’s sales curve begins to decline. When the market declines price wars erupt as organisations with products which have elastic demand seek to maintain full utilisation of their production capacity. 
Profits can still be made during the early part of this stage, and the 
products will be managed to generate cash for newer products. This will determine how prices are set. Eventually rapidly falling sales inevitably result in losses for all suppliers who stay in the market. This particular product has effectively come to the end of its life cycle, and alternative investment opportunities must be pursued. 
Despite the recent general tendency to shorter life cycles, the length of 
any particular stage within the cycle and the total length of the life cycle itself will depend on the type of prod uct or service being marketed. 
Although the curve will be characterised by a sustained rise, followed by levelling out and falling away, the precise shape of the curve can vary considerably. Life cycles are discussed further earlier in this text.

272  
15  Practice questions 
 OT Question 1: Tabular Approach 
 ABC plc is about to launch a new product. Facilities will allow the 
company to produce up to 20 units per week. The marketing department 
has estimated that at a price of $8,000 no units will be sold, but for each $150 reduction in price one additional unit per week will be sold. 
Fixed costs associated with manufacture are expected to be $12,000 per 
week. 
Variable costs are expected to be $4,000 per unit for each of the first 
10 units; thereafter each unit will cost $400 more than the preceding one. The most profitable level of output per week for the new product is: 
A  10 units B  11 units C  13 units D  14 units E  20 units 
 
 OT Question 2: Delnorte Ltd optimum price 
 Market research by Delnorte Ltd has revealed that the maximum demand 
for product R is 50,000 units each y ear, and that demand will reduce by 
50 units for every $1 that the selling price is increased. Based on this 
information, Delnorte Ltd has calculated that the profit-maximising level of sales for product R for the coming year is 35,000 units. The price at which these units will be sold is: 
A  $100 B  $300 C  $500 D  $700 E  $900

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 OT Question 3: Optimum price 
 Another product manufactured by Delnorte Ltd is product M. At a price of 
$700 for product M there would be zero demand, and for every $40 
reduction in the selling price the de mand would increase by 100 units. 
The variable cost of producing a unit of product M is $60. 
Delnorte Ltd knows that if the demand equation for product M is 
represented by p = a – bx, where p is the selling price and x is the quantity demanded at price p, then the marginal revenue (MR) for product M can be represented by MR = a – 2bx. 
The profit-maximising output of product M is: 
A  100 units 
B  700 units C  800 units D  1,600 units E  1,750 units 
 
 OT Question 4: Fresno Optimum price 
 Fresno Ltd is considering the pricing of one of its products. It has already 
carried out some market research with the following results: The quantity demanded at a price of $100 will be 1,000 units. The quantity demanded will increase/decrease by 100 units for every $50 
decrease/increase in the selling price. The marginal cost of each unit is $35. 
Calculate the selling price that maximises company profit. 
 
 OT Question 5: Glenn Optimum price 
 Glenn Ltd is launching a new product which it expects to incur a variable 
cost of $14 per unit. The company has completed some market research 
to try to determine the optimum selling price with the following results. 
If the price charged was to be $25 per unit, then the demand would be 
1,000 units each period. For every $1 increase in the selling price, demand would reduce by 100 units each period. For every $1 reduction in the selling price, the demand would increase by 100 units each period. 
Calculate the optimum selling price.

274  
 Data Set Question: AB Ltd 
 During the current year AB Ltd planned to produce 150,000 units of its 
main product, a cordless hand drill. Nearing the end of the current year, 
activity so far has corresponded to budget and it is anticipated that average costs for the whole year will be as shown below: 
Average cost per unit (for 150,000 activity level) 
 $ 
Direct material   18 
Direct labour   10 Variable overhead   10 
Fixed overhead   10 
––– 
   48 
The budget for next year is being developed and the following cost 
changes have been forecast: 
Direct material: price increase of 33.3%  Director labour: rate increase of 10%  Variable overhead: increase of 5%  Fixed overhead: increase of 15% The substantial price increase for materials is causing concern and 
alternative sources are being considered. One source quotes a material cost per unit of $20 but tests on samples show that the cheaper materials would increase labour costs by an additional 50c per unit and would lead to a reject rate of 5%. It would also be necessary to install a test and inspection department at the end of manufacturing to identify the faulty items. This would increase fixed costs by an additional $200,000 per year. 
Selling prices are also c onsidered when the budget is being developed. 
Normally, selling prices are determined on a cost-plus basis, the mark-up 
being 50% on unit cost, but there is concern that this is too inflexible as it would lead to a substantial price rise for next year. The sales director estimates that demand varies with price thus: 
 
 $ $ $ $ $ $ $ 
Price/unit 64 68 72 76 80 84 88 
Demand (000 units) 190 170 150 140 125 110 95

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 275 
 Calculate: 
The number of units  where the variable cost 
saving is equal to the incremental fixed costs:   
   
The selling price that would maximise profit for 
next year $  
   
The maximum profit achievable $  
It has been realised that, through better organisation, it would be possible 
to reduce the extra fixed costs of $200,000 originally estimated in 
connection with the cheaper material. 
Required: 
The increase  in fixed costs at which the 
company would be indifferent as to its choice 
of suppliers for materials. $

276  
Examples and objective test questions answers 
 The price elasticity can be calculated as follows: 
% change in price = (increase in price of 20/original price of 40) × 100 = + 
50% 
% change in demand = decrease in demand of –8/original demand of 20) 
× 100 = –40% 
PED = –40/+50 = –0.8 The negative sign is usually ignored in the PED calculation and the PED 
= 0.8. 
 
 (a) b = (220 – 200)/(950 – 1,000) = –0.4  
200 = a –0.4 × 1,000 
a = 200 + 400 = 600. So the demand function is P = 600 – 0.4Q 
(b) To find MR, just double the gradient so that MR = 600 – 0.8Q  MR 
= 600 – 0.8Q 
(c) MC = 140 
(d)  The optimum quantity Q is achieved when the company produces 
units up to the point where marginal revenue equals marginal cost, 
i.e. when MR = MC 
with MR = a + 2bQ i.e. MR = $600 – 0.8Q and MC = $140 so q is achieved when a + 2bQ = $140  i.e. when $600 – 0.8Q = $140 i.e. when Q = 575 units 
(e) P= 600 – 0.4 × 575 = $370 (f) Revenue = Price × Quantity = $370 × 575 = $212,750 
Cost = $36,000 + $140 × 575 = $116,500 Profit = $96,250

Chapter 7 
 277 
 (a)  Let Q = quantity produced/sold 
Gradient 'b'= 
  
b	= Change in price
Change in quantity= $5
$50 
 
B = –0.1 
Price = a – 0.1 Q; $160 = a – 0.1 (2,000) therefore a = $360  
P = $360 – 0.1Q  MR = $360 – 0.2Q  MC = $64 
(b)  To maximise profit, MR = MC.  
Therefore, $360 – 0.2Q = $64 
Q = (360 – 64) ÷ 0.2  = 1,480 Units 
P = 360 * 0.1 = $212  
 (1,480)   Revenue = $212 × 1,480 = $313,760  
Less Costs = ($64 × 1,480) + $100,000 = ($194,720)  Maximum profit = $119,040  
 
 Solution Marginal cost per unit of product K = variable cost per unit = $6 Profit is maximised when marginal cost marginal revenue  
i.e. when 6 = 200 – 0.4x 
x = 485 When x = 485, p = 200 – (0.2 × 485) = 103 
Therefore the profit-maximising selling price is $103 per unit, at which 
price 485 units will be sold per period.

278  
 Example 5: Tabular approach 
  
 $ $ $ $ $ $ 
Variable cost per 
unit (6) (6) (6) (6) (6) (6) 
Contribution per unit 16 14 13 12 11 9 
($000) 800 840 910 960 990 810 
Less fixed costs ($000) (200) (200) (280) (280) (360) (360) 
Net profit ($000) 600 640 630 680 630 450 
To maximise profit, price should be $18, output 80,000 and 1 extra 
machine should be hired. 
 
on age Lower admission prices for children at certain 
sporting events. 
Price differentiation on gender Lower admission prices for females at some 
Skimming This applies to a product with a short life cycle, 
and there is a need to recover its development 
costs quickly and make a profit. 
Volume discounting Offering a lower price per unit for customers 
who do not wish to place large individual 
orders, but who purchase large quantities over 
time. 
Loss leader pricing Lures the customer in with a relatively low 
priced product, in order to lock the customer in 
to subsequent additional purchases of different 
items that are relatively highly priced. 
Penetration pricing Demand is very elastic, and would react well to 
low prices.

Chapter 7 
 279 
 The best approach is to calculate the profit for a range of outputs from 10 
units upwards, then select the output with the highest profit. 
The answer is B 
 
Units Total variable 
costs Selling price 
per unit (W1) Total select 
revenue Total 
10 $40,000 $6,500 $65,000 $25,000 
11 $44,400 $6,350 $69,850 $25,540 
12 $49,200 $6,200 $74,400 $25,200 13 $54,400 $6,050 $78,650 $24,250 
14 $60,000 $5,900 $82,600 $22,600 
20 $102,000 $5,000 $100,000 ($2,000) 
     
 Working 1: Selling Price per unit 
At $8,000, we sell no units, but for each $150 reduction in price one 
additional unit per week will be sold. This means that at $8,000 – $150 = $7,850, we will sell one unit. 
At [$8,000 – ($150 × 2)] = $7,700, we will sell 2 units. At [$8,000 – ($150 × 10)] = $6,500, we will sell 10 units. At [$8,000 – ($150 × 11)] = $6,350, we will sell 11 units. At [$8,000 – ($150 × 12)] = $6,200, we will sell 12 units. At [$8,000 – ($150 × 13)] = $6,050, we will sell 13 units. At [$8,000 – ($150 × 14)] = $5,900, we will sell 14 units. At [$8,000 – ($150 × 20)] = $5,000, we will sell 20 units. 
 
 Answer: B 
In the demand equation p = a – bx When price = 0, demand, x = 50,000 therefore 0 = a – 50,000b (i)  
When price = 1, demand, x = 49,950 therefore 1 = a – 49,950b (ii)  
Subtract 1 = 50b so b = 0.02 Substitute in (i) a = (50,000 × 0.02) so a = 1,000 The demand equation for product R is p = 1,000 – 0.02x  When x = 35,000 units, p = 1,000 – (0.02 × 35,000) = 300

280  
 Answer: C 
In the demand equation p = a – bx 
When price = $700, demand = 0 therefore a = 700 When price = $660, demand = 1 00 therefore 660 = a – 100b  
Substitute for a 660 = 700 – 100b therefore b = 0.4 The demand equation for product M is p = 700 – 0.4x The marginal revenue equation is given by MR = 700 – 0.8x Profit is maximised when marginal cost = marginal revenue, i.e. when 60 
= 700 – 0.8x 
i.e. when x = 800.
 
 Price at which demand equals zero = $100 + (1,000/100) × $50 = $600 
P = $600 – 0.5x 
MR = $600 – x MC = $35 MC = MR $35 = $600 2 x x = $565 p = $600 – $(0.5 × 565)  p = $317.50
 
 Marginal cost (MC) = $14 
Price (P) = $35 – 0.01q Marginal revenue (MR) = $35 – 0.02q  So if MC = MR, then 14 = 35 – 0.02q Q = 1,050 Price = $35 – (0.01 × 1,050) = $24.50

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 281 
    
Current material Cheaper material  
 $ per unit $ 
Direct material 24.00 20.00 
Direct labour 11.00 11.50 
Variable overhead 10.50 
––––– 10.50 
––––– 
Total variable cost 
 45.50 
––––– 42.00 
––––– 
 for 0.95 of a unit 
∴ Cost per unit = $42 
–––– 
  0.95 
 = $44.21 per unit 
Fixed costs last year: $10 × 150,000 = $1,500,000 
∴ Fixed cost in coming year: $1,500,000 × 1.15 = $1,725,000 
If use cheaper material fixed costs increase by $200,000: $1,925,000 
When the com pany switches from the current material to the cheaper 
material, the cost per unit will decrease but the fixed cost will increase. 
At low levels of activity the cheapest material would be the current one, 
taking advantage of the low fixed cost. 
However, as production increases the cheaper material becomes more 
attractive, as one wishes to take advantage of the lower unit cost. At high levels of activity the cheaper material is preferable, the lower unit cost more than compensates for the higher fixed cost. 
So, in conclusion, the material choice is dependent upon the activity 
level. 
Ascertain the level of activity where the purchaser would be indifferent  
between the two materials. 
When switch from regular to cheaper: 
Saving in variable cost is $45.50 – $44.21 = $1.29 per unit.  
Increase in fixed cost is $200,000. Therefore, the number of units where the variable cost saving is equal to 
the incremental fixed cost is: 
$200,000 ÷ 1.29 = 155,038.8 units

282  
 Conclusion 
If production is expected to be 155,038  units or less, use the regular 
supplier. If production is expected to be 155,039  or more, use the 
cheaper material. 
 
Price Demand Variable 
cost per 
unit Contribution 
contribution Fixed 
costs Profit 
$ 000s $ $ $000 $000 $000 
64 190 (44.21) 19.79 3,760.1 (1,925) 1,835.1 
68 170 (44.21) 23.79 4,044.3 (1,925) 2,119.3 72 150 (45.50) 26.50 3,975.0 (1,725) 2,250.0 76 140 (45.50) 30.50 4,270.0 (1,725) 2,545.0 80 125 (45.50) 34.50 4,312.5 (1,725) 2,587.5 
84 110 (45.50) 38.50 4,235.0 (1,725) 2,510.0 
88 95 (45.50) 42.50 4,037.5 (1,725) 2,312.5 
From the table above, it can be seen that profit is maximised when 
125,000 units are sold for $80 each. 
The maximum profit is $2,587,500. The regular supplier should be retained. At 125,000 units the saving in variable costs if the firm switches to the 
cheaper supplier is 
125,000 × $1.29 = $161,250 The company would be indifferent between the two suppliers if fixed 
costs increased by $161,250. 
New fixed cost level = $1,725,000 + $161,250  = $1,886,250

283 
Responsibility Centres 
Chapter learning objectives  
C1: Managing and controlling 
the performance of 
organisational units Analyse the performance of responsibility centres and prepare reports 
(a) Analyse the performance 
of cost centres, revenue 
centres, profit centres, and investment centres 
(b) Reports for decision-
making 
C2: Discuss various 
approaches to the performance and control of organisations (a) Discuss budgets and 
performance evaluation 
(b) Discuss other 
approaches to performance evaluation 
 
  Chapter 
8

284  
1  Chapter summary  
 
Decentralisation, which is also known as divisionalisation, seeks to overcome 
the problem of managing a large organisation by creating a structure based on several autonomous decision-making units.  
The objectives of decentralisation can be listed as 
(a) Ensure goal congruence (b) Increase motivation of management (c) Reduce head office bureaucracy (d) Provide better training for junior and middle management. The major disadvantage of decentralisation is the potential for dysfunctional 
decision making, i.e. where divisions make decisions in their own best 
interests, but which are not good from the overall company point of view. 
The problem can be overcome by introducing a suitable system of performance 
evaluation, that has the following objectives: 
1 Promote goal congruence 2 Encourage initiative and motivation 3 Provide feedback to management 4 Encourage long-term rather than short term views  These objectives can only be achieved with the introduction of responsibility 
centres .

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2  Cost, revenue, profit and investment centres 
In responsibility accounting , a specific manager takes responsibility for a 
particular aspect of the budget. Within the budgetary control system, he or she 
is then accountable for actual performance. Managers are accountable for their area of responsibility. 
The area of operations for which a manager is responsible is called a 
responsibility centre. Within an organisa tion, there could be  a hierarchy of 
responsibility centres. 
• If a manager is responsible for a particular aspect of operating costs, the 
responsibility centre is a cost centre: ‘a production or service location, 
function, activity or item of equipment for which costs are accumulated.’ 
A cost centre could be large or small, such as an entire department or the activities associated with a single item of equipment. 
• If a manager is responsible for revenue, the responsibility centre is a 
revenue centre : the division is only responsible for the generation of 
revenue. The best example of this is the sales department, where there is less focus on costs (sales managers aren`t held responsible for things like overhead cost reduction) and more focus on generating sales. 
• If a manager is responsible for revenue as well as costs, the responsibility 
centre is a profit centre , and the manager responsible is held 
accountable for the profitability of the operations in his or her charge. 
There could be several cost centres within a profit centre, with the cost centre managers responsible for the costs of their particular area of operations, and the profit centre manager responsible for the profitability of the entire operation. 
• If a manager is responsible for investment decisions as well as for 
revenues and costs, the responsibility centre is an investment centre . 
The manager is held accountable not only for profits, but also for the return on investment from the operations in his or her charge. There could be several profit centres within an investment centre. 
Each cost centre, profit centre, revenue centre and investment centre should have its own budget, and its manager should receive regular budgetary control information relating to the centre, for control and performance measurement purposes.

286  
 Example 1: Photocopiers 
 Bryn Ltd sells and repairs photocopiers. The organisation has operated 
for many years with two departments, the sales department and the 
service department, but the departments have no autonomy. The organisation is now thinking of restructuring, so that the two departments become profit centres and the managers of the departments are given autonomy. The individual salaries of the managers will be linked to the profits of their respective departments. 
What are the likely consequences of structuring the departments as profit 
centres? Select ALL that apply. 
• Improved decision making due to local knowledge. 
• Departmental managers will become more motivated and more 
autonomous. 
• Senior management will find the new structure more time-
consuming to handle. 
• Possible loss of control from senior management. • Dysfunctional decision making. 
• Possible duplication of functions and costs. 
3  Responsibility accounting and controllability of costs 
If the principle of controllability is  applied, a manager should be made 
responsible and accountable only for the costs (and revenues) that he or she is 
in a position to control. A controllable cost is a cost ‘which can be influenced by its budget holder’. Controllable co sts are gene rally assumed to be variable  
costs, and directly attributable fixed costs . These are fixed costs that can be 
allocated in full as a cost of the centre. 
It is important to make managers responsible and accountable for costs they 
can control. Without accountability, managers do not have the incentive to control costs and manage their resources efficiently and effectively. 
If the principle of controllability is applied, control reports would make managers 
responsible for the variable costs and directly attributable costs of the centre. A common assumption in management accounting is that controllable costs 
consist of variable costs and directly attributable fixed costs. Uncontrollable costs are costs that cannot be influenced up or down by management action. 
This assumption is not entirely correct, and it should be used with caution. Some items treated as variable costs cannot be influenced or controlled in the 
short term. Direct labour costs are treated as a variable cost, but in reality, the direct labour work force is usually paid a fixed wage for a minimum number of working hours each week. Without making some employees redundant, and unless there is overtime working, the direct labour cost cannot be reduced or increased in the short term because it is really a fixed cost item.

Chapter 8 
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An item that is uncontrollable  for one manager could be controllable by another. 
In responsibility accounting, it is important to identify areas of responsibility. In the 
long term, all costs are controllable. At senior management level, control should 
be exercised over long-term costs as well as costs in the short term. 
The advantages of this approach to responsibility accounting are: • profit centre managers are made aware of the significance of other 
• profit centre managers are made aware that they need to earn a 
sufficient profit to cover a fair share of other overhead costs. 
The disadvantages of this approach are that: • profit centre managers are made accountable for a share of other 
• the apportionment of other overhead costs between profit centres, like 
overhead apportionment generally, is usually a matter of judgement, 
lacking any economic or commercial justification. 
A useful distinction can be made between committed  fixed costs, which are 
costs that are uncontrollable in the short term, but are controllable over the longer term; and discretionary  fixed costs, which are costs treated as fixed 
cost items that can nevertheless be controlled in the short term, because spending is subject to management discretion. 
Examples are advertising expenditure, and executive travel and subsistence 
costs. 
 
Controllable and uncontrollable costs 
 A summarised report for the profit centres of an organisation might be: 
 
 Centre A 
$ Centre B 
$ Centre C 
$ Total  
$ 
Revenue 300,000 260,000 420,000 980,000 
Variable costs 170,000 100,000 240,000 510,000 
Controllable costs 240,000 220,000 320,000 780,000 
Attributable gross profit 60,000 40,000 100,000 200,000 
A criticism of the contro llability accounting principle is that managers are 
the example above, there are $180,000 of costs not attributable to any profit centre. These might be head office costs, for example, or marketing overheads. 
• Within a system of responsibility accounting, there should be cost 
centre managers accountable for these costs.

288  
• Even so, these overhead costs might be caused to some extent by 
• When these costs are high, a further problem is that profit centre 
profits need to be large enough to cover the general non-allocated overhead costs. 
An argument could therefore be made that profit centre managers should be made accountable for a share of overhead costs that are not under their control, and a share of these costs should be charged to each profit centre. Profit reporting would therefore be as follows: 
 
 Centre A 
$ Centre B 
$ Centre C 
$ Total  
$ 
Directly attributable costs 70,000 120,000 80,000 270,000 
Other overhead costs (50,000) (50,000) (80,000) (180,000) 
Net profit 10,000 (10,000) 20,000 20,000 
     
 Example 2: Controllability 
 The materials purchasing manager is assessed on: 
• total material expenditure for the organisation 
• the cost of introducing safety measures, regarding the standard and 
• a notional rental cost, allocated by head office, for the material 
Which of these costs are controllable by the manager, and should be used to appraise him/her? Select ALL that apply. 
4 Pros and cons 
The advantages of this approach to responsibility accounting are: 
• Profit centre managers are made aware of the significance of other 
overhead costs. 
• Profit centre managers are made aware that they need to earn a sufficient 
profit to cover a fair share of other overhead costs.

Chapter 8 
 289 
The disadvantages of this approach are that: 
• Profit centre managers are made accountable for a share of other 
• The apportionment of other overhead cost between profit centres, like 
overhead apportionment generally, is usually just a matter of judgement, 
 
 Responsibility centres and internal markets (extract) 
 Bob Scarlett, Financial Management, April 2007 
An objective must be set for an autonomous responsibility centre. Determining how far that objective has been achieved provides a performance measure for the centre. The system must be adapted to priorities and circumst ances in each case. Accordingly, responsibility 
centres may be grouped under three main headings: 
Cost centre (CC) This is a responsibility centre to which costs are attributed, but not 
earnings or capital. 
CCs can be designed in two alternative ways: either (a) the CC is given a 
fixed quantity of inputs and be required to maximise outputs, or (b) a required level of outputs is specified for the CC which must be achieved with minimum inputs. 
An example of (a) is a public relations department, which is given a fixed 
budget to spend and has to use this to achieve the best possible result. An example of (b) is a cleaning department, which is given certain areas to clean and has to do this at minimum cost. In both cases, the CC manager is allowed a degree of autonomy in making decisions on how the operation is run. But the system guides the manager to act in a manner which is consistent with the interest of the organisation. 
However, the CC offers one particular weakness insofar as it relies on the 
measurement of financial spend to assess performance. There is no direct incentive for the manager to enhance the quality of output. Costs can always be contained by reducing quality. In the case of a CC, quality reduction is not identified by the use of financial performance metrics. 
Many organisations treat their IT departments as cost centres. This often 
has unfortunate consequences.

290  
 The idea that IT is a cost centre and carries no profit or loss is dangerous 
and should be opposed wherever it is encountered, according to Simon Linsley, head of consultancy, IT and development at Philips. Will Hadfield, Computer Weekly, 30 May 2006 
This CW article describes how IT system installation projects were 
usually completed on time and within budget at the electronics firm Philips. However, the manner in which system projects were implemented often gave rise to serious disruption at the operational level, causing stress to the staff of client departments and degraded customer service. 
Profit centres (PC)  
This is a responsibility centre to which costs and revenues are attributed, 
but not capital. 
In the case of a CC, the manager has autonomy as regards either (a) 
outputs or (b) inputs – but not both together. In the case of the PC, the manager has autonomy over both inputs and outputs. The objective of a PC is to maximise profit or achieve a profit target. The manager of the PC is allowed to make decisions concerning both the resources used and output (in terms of both quantity and price) achieved. 
In the case of a PC, reliance on financial performance measures does not 
provide any incentive to lower quality. Lowering quality will impact on sales quantity and/or selling price, which will impact on profit. The PC may also induce other behaviour which is in the interests of an organisation. For example, unit costs within a CC may be minimised by use of long continuous production runs and this pattern of production may be favoured accordingly. But, it is a pattern of production which will result in high inventory holding and/or lowered response levels to individual customer requirements. These last features will adversely impact on profit and, therefore, a sub-optimum pattern of production is less likely to be induced within a PC. 
An IT department within an organisation may be organised as a profit 
centre. Typically, this will involve invoicing client departments for its services and inviting competition from outside consultants for system installation projects. 
IT directors should push for the IT function in their organisation to be 
treated as a profit centre rather than a cost to the business. This was the key message from Glenn Martin, managing director and chief technology officer at financial services firm Cazenove, speaking to the City IT financial services technology forum last week. Christian Annesley, Computer Weekly, 15 November 2005 
Rather than forcing through system installations in a manner which 
minimises costs, IT managers are now incentivised to allow for the full operational requirements of client departments when organising projects.

Chapter 8 
 291 
 The logic behind responsibility centres suggests that an organisation 
should be split into decoupled internal components with decision rights in 
each given to its own management, within certain parameters. Each component trades its services with the others on an arm’s length basis, giving rise to an ‘internal market’. 
This concept was applied widely in the British public sector in the 1990s. 
The BBC under Director General John Birt introduced an internal market amongst its different components – Technology, Production, News and so on. The development of an internal market has also been a feature of NHS reform, whereby different units within the NHS have the character of buyers and providers of services. 
So much for the theory. Practical experience has introduced 
organisations to a concept known as ‘failure of the internal market’. For example, the BBC Gramophone Library was rated as the greatest sound archive in the world and it was traditionally run as a cost centre. During the reforms of the 1990s, it became a profit centre and was required to charge user departments in the BBC for the issue of recordings. 
Music that was previously provided free by the Library now came with a 
charge and it wasn’t cheap. Which is why all the music shops in Oxford Street were busy with BBC researchers buying far cheaper commercial CDs. At the prestigious Radio 4 daytime current affairs programmes, The World at One and PM, staff were barred from using any material from the BBC's gramophone library because the cost was too high. Netribution, ‘BBC axes Producer Choice’, March 2006 
The BBC’s internal market was deeply unpopular and produced 
unintended effects in the way that managers behaved. It has been largely abandoned in recent years. The reality was that the BBC’s Gramophone Library was a vital resource that had to be seen as a cost centre and nothing other than that. 
Responsibility centres and internal ma rkets have much to offer. But 
insensitivity in their use, or their use in inappropriate circumstances, can 
result in them doing more harm than good. 
5  Key performance indicators 
An organisation and its divisions should have certain targets for achievement. Targets can be expressed in terms of key metrics. The term ‘metric’ is now in common use within the context of measurement of performance. It is a basis for analysing performance (both budgeted and actual). 
A budget should not be approved by senior management unless budgeted 
performance is satisfactory, as measured by the key metrics. Actual performance should then be assessed in comparison with the targets. The expression ‘key performance indicators’  might be used.

292  
Key areas of financial performance are: 
• profitability • liquidity 
• asset turnover. 
A key metric for profitability might be the profit/sales ratio  (profit margin), or 
the contribution/sales ratio (contribution margin). 
Senior management might set a target for a minimum profit/sales ratio for the 
budget period, and refuse to authorise a budget unless this minimum target is met in the plan. 
Three key profitability indicators recently examined are the Return on Capital 
Employed (ROCE) the asset turnover and the profit/sales percentage. These can be explained by the use of a diagram and a simply worked example. 
 
There is a direct relationship between the three figures; All figures are used 
twice, meaning A × B = C 
 
Profit
Turnover × Turnover
Capital employed = Profit
 
Profit margin × Asset turnover = ROCE 
 
Capital employed = equity + long-term finance 
Note that we assume that the 'Capital Employed' at the start of the year is the 
one that was used to generate the profits at the end of the year. Therefore the opening capital employed is generally used in OT calculations, unless the question directs you otherwise.

Chapter 8 
 293 
 
 Triangulation [DuPont model of measurement] 
 Extracts from the accounts of The Beta Company read as follows: 
The Beta Company 
 
Income Statement extracts $000  
Sales/Revenue 1,556 
Net profit 67 
  
Statement of Financial Position extracts $000  
Non-current assets 1,380 
Inventories 241 Receivables 201 
Cash – 
Payables (301)  1,521 
  
Shareholders' funds 1,021 
Long-term borrowing 500 
  Capital employed 1,521 
The triangular relationship can be illustrated as follows: 
 
A  PROFIT MARGIN Net profit
Turnover 	= 67
1,556	=		4.306% 
  
B ASSET TURNOVER Turnover
Capital employed	=	1,556
1,521 = 1.023 times 
  
C ROCE Net profit
Capital employed	=	67
1,521 = 4.405% 
  
Liquidity 
Liquidity means having cash, or ready access to cash. Liquid assets are 
therefore cash and short-term investments that can be readily sold if the need arises. In addition, liquidity is improved by unused bank borrowing facilities. 
Liquidity is improved through efficient cash management, and an important 
element of good cash management is control over inventory, trade receivables and trade payables.

294  
A key metric for liquidity might therefore be the current ratio  (which is the ratio 
of current assets to current liabilities), or the quick ratio  or acid test ratio (which 
is the ratio of current assets excluding inventories to current liabilities). 
 
Current ratio 	= Current assets
 
Quick ratio (acid test) = Current assets – inventory
A low liquidity ratio could indicate poor liquidity and a risk of cash flow 
difficulties. The appropriate minimum value for a liquidity ratio varies from one 
industry to another, because the characteristics of cash flows vary between different industries. As a broad rule, however, a current ratio below 2.0 times and a quick ratio below 1.0 times might be considered low. 
Within a budgeting system, senior management might set a target for liquidity, 
in the form of a maximum and minimum acceptable current ratio and/or quick ratio. A current ratio or quick ratio that declines from one year to the next could indicate deteriorating liquidity and greater risk. 
On the other hand, a business can have excessive liquidity, with too much 
capital tied up in working capital . The current ratio and quick ratio should 
therefore not be expected to rise above a maximum acceptable level. We have seen also that an important element of good cash management is 
control over the various parts of working capital, in particular inventory, trade receivables and trade payables.
 
6 Divisional performance measurement 
Type of division Description Typical measures used to assess 
Cost centre Division incurs costs, but has no revenue stream, e.g. the IT support department of an organisation. • Total cost and cost per unit. 
• Cost variances. 
indicators (NFPIs) related to 
quality, productivity & efficiency. 
Revenue centre Division is only responsible for the generation of revenue. Total revenue and revenue per unit. 
Revenue (sales) variances.

Chapter 8 
 295 
Profit 
centre Division has both costs and revenue. 
Manager does not have the 
authority to alter the level of investment in the division. All of the above PLUS: 
• Total sales and market share. • Profit. 
• Sales variances. 
• Working capital ratios 
(depending on the division 
concerned). 
indicators (NFPIs) e.g. related to productivity, quality and customer satisfaction. 
Investment centre Division has both costs and revenue. 
Manager does have the 
authority to invest in new assets or dispose of existing ones. All of the above PLUS: 
• Return On Investment (ROI) 
• Residual Income (RI). 
These measures are used to 
assess the investment decisions made by managers and are discussed in more detail below. 
Important point:  For each of these care must be taken to assess managers on 
controllable factors only. So for example, the manager of a cost centre should only be assessed on controllable costs. 
7 Return On Investment (ROI) 
ROI is a similar measure to ROCE, but is used to appraise the investment decisions of an individual department. 
ROI/ROCE = Divisional controllable profit before interest and tax
Profit can be measured in relation to the financial resources it uses, the 'Capital 
Employed'. ROCE is common at the overall corporate level, whereas ROI is more commonly used for investment appraisal and for divisional performance. 
• ‘Controllable profit’ is usually taken after depreciation but before tax. 
However, in the exam you may not be given this profit figure and so you 
should use the profit figure that is closest to this. Assume the profit is controllable, unless told otherwise. 
• Capital employed is total assets less current liabilities or total equity plus 
long term debt. Use net assets if capital employed is not given in the question.

296  
• Non-current assets might be valued at cost, net replacement cost or net 
book value (NBV). The value of assets employed could be either an 
average value for the period as a whole or a value as at the end of the period. An average value for the period is preferable. However, in the exam you should use whatever figure is given to you. 
 
Example 3: ROI calculation 
 An investment centre has reported a profit of $28,000. It has the following 
assets and liabilities: 
 
 $ $ 
Non-current assets (at NBV)  100,000 
Inventory 20,000  
Trade receivables 30,000  
  50,000 
Trade payables 8,000  
 —–——  
  42,000 
––––––– 
  142,000 
––––––– 
The ROI for the division is $________________%. 
 
 Additional example on ROI 
 Division A of Babbage Group had investments at the year end of 
$56 million. These include the cost of a new equipment item costing $3 million that was acquired two weeks before the end of the year. This equipment was paid for by the central treasury department of Babbage, and is recorded in the accounts as an inter-company loan. 
The profit of division A for the year was $7 million before deducting 
head office recharges of $800,000. 
Required: 
What is the most appropriate measure of ROI for Division A for the 
year? 
Solution 
Since the new equipment was bought just two weeks before the year 
end, the most appropriate figure for capital employed is $53 million, not 
$56 million. 
The figure for profit should be the controllable profit of $7 million.  ROI = $7 million/$53 million = 13.2%

Chapter 8 
 297 
Evaluation of ROI as a performance measure  
ROI is a popular measure for divisional performance. However, it has some 
serious failings which must be considered when interpreting results. 
• It is widely used and accepted, since it is line with ROCE, and ROCE is 
frequently used to assess overall business performance. 
• As a relative measure, the ROI enables comparisons between divisions or 
companies of different sizes. 
• It can be broken down into secondary ratios for more detailed analysis, 
i.e. profit margin and asset turnover. 
• It may lead to dysfunctional decision making, e.g. a division with a current 
ROI of 30% would not wish to accept a project offering a ROI of 25%, as 
this would dilute its current figure. However, the 25% ROI may meet or exceed the company's target. 
• ROI increases with the age of the asset if NBVs are used, thus giving 
managers an incentive to hang on to possibly inefficient, obsolescent machines. 
• It may encourage the manipulation of profit and capital employed figures 
to improve results, e.g. in order to obtain a bonus payment. 
• Different accounting policies can confuse comparisons (e.g. depreciation 
policy). 
 
Example 4: Disadvantages of ROI 
 Nielsen Ltd has two divisions with the following information: 
 
 Division A Division B 
 $ $ 
Profit 90,000 10,000 Capital employed 300,000 100,000 
ROI 30% 10% 
Division A has been offered a project costing $100,000 and giving annual 
returns of $20,000. Division B has been offered a project costing $100,000 and giving annual returns of $12,000. The company’s cost of capital is 15%. Divisional performance is judged on ROI and the ROI –related bonus is sufficiently high to influence the managers’ behaviour. 
Required: 
(a) What decisions will be made by management if they act in the best 
interests of their division (and in the best interests of their bonus)? 
(b) What should the managers do if they act in the best interests of the 
company as a whole?

298  
8 Residual income (RI) 
Residual income is profit (controllable profit, at divisional level), less an imputed 
interest charge for invested capital. 
 
RI = Controllable profit – Notional interest on capital 
 
• Controllable profit (i.e. controllable profit, at divisional level) is calculated in 
the same way as for ROI. 
• The notional interest on capital (sometimes called the ’imputed interest 
charge’) is the capital employed in the division, multiplied by a notional cost of capital or interest rate. 
– Capital employed is calculated in the same way as for ROI. – The selected cost of capital could be the company’s average cost of 
funds (cost of capital). However, other interest rates might be 
selected, such as the current cost of borrowing, or a target ROI. (You should use whatever rate is given in the exam). 
 
Example 5: RI calculation 
 An investment centre has net assets of $800,000, and made profits 
before interest and tax of $160,000. The notional cost of capital is 12%. 
Calculate and comment on the RI for the period . 
 
 Example 6: RI Increase 
 The manager of the 'D' Division is considering investing in a replacement 
machine at the beginning of next year, 2020. If the investment does not go ahead, then the divisional results for 'D' in 
2020 will be (in $000):  
 
Sales 420 
Cost of sales 310 
Gross Profit 110 
Other operating costs 85.2 
Pre-tax operating profits 24.8 
  
Capital invested 212

Chapter 8 
 299 
 If the investment does  go ahead, then the divisional results for ‘D’ in 
2020 will be: 
 
Sales 420 
Cost of sales 279 
Gross Profit 141 
Other operating costs 97.2 
Pre-tax operating profits 43.8 
  
Capital invested 260 
The divisional cost of capital us 8% per annum. 
Should the divisional manager choose to go ahead with the 
investment, the increase in Residual income for the ‘D’ division 
amounts to: 
A $7,840 B $15,160 C $23,000 D $25,180 
Evaluation of RI as a performance measure  
Compared to using ROI as a measure of performance, RI has several 
advantages and disadvantages: 
• It encourages investment centre managers to make new investments if 
they add to RI. A new investment might add to RI but reduce ROI. In such 
a situation, measuring performance by RI would not result in dysfunctional behaviour, i.e. the best decision will be made for the business as a whole. 
• Making a specific charge for interest helps to make investment centre 
managers more aware of the cost of the assets under their control. 
• Risk can be incorporated by the choice of interest rate used: different 
interest rates for the notional cost of capital can be applied to investments with different risk characteristics. 
Disadvantages  
• It does not facilitate comparisons be tween divisions since the RI is driven 
by the size of divisions and of their investments. 
• It is based on accounting measures of profit and capital employed which 
may be subject to manipulation, e.g. in order to obtain a bonus payment.

300  
9  Comparing ROI and RI 
Compared to using ROI (or ROCE) as a measure of performance, RI has 
several advantages and disadvantages. 
1 RI resolves the dysfunctional aspect of the ROI measure. 
2 RI reduces ROCE's problem of rejecting projects with a ROCE in excess 
of the company's target, but lower than the division's current ROCE. 
3 The cost of financing a division is brought home to divisional managers. 
1 RI does not facilitate comparisons between divisions. 2 RI does not relate the size of a division's profit to the assets employed in 
order to obtain that profit. 
3 RI can also mislead, as it increases over time. 
 
Additional example on ROI and RI 
 Two divisions of a company are considering new investments. 
 
 Division X Division Y 
Net assets $1,000,000 $1,000,000 
Current divisional profit $250,000 $120,000 
   
Investment in project $100,000 $100,000 
Projected project profit $20,000 $15,000 
Company’s required ROI = 18% 
Required: 
Assess the projects using both ROI and RI.

Chapter 8 
 301 
 Solution 
Consider divisional performance: 
Without project  
Divisional ROI 25% 12% 
Divisional RI ($) + 70,000 – 60,000 With project   
Investment ($) 1,100,000 1,100,000 
Profit ($) 270,000 135,000 
ROI 24.5% 12.3% 
RI ($) 72,000 – 63,000 Project in isolation   
ROI 20% 15% 
RI ($) + 2,000 – 3,000 
Based on ROI, Division X will reject its project as it dilutes its existing 
ROI of 25%. This is the wrong decision from the company perspective 
as the project ROI of 20% beats the company hurdle of 18%. 
Likewise, Division Y will accept its project, which should be rejected as 
it fails to hit the company target. 
In each case there is a conflict between the company and divisional 
viewpoints. 
RI does not have this problem as we simply add the project RI to the 
divisional figures. 
 
 Example 7: ROI vs RI 
before interest of $160,000. The notional cost of capital is 12%. This is the company's target return. 
An opportunity has arisen to invest in a new project costing $100,000. 
The project would have a four-year life, and would make profits of $15,000 each year. 
Required: 
(a) What would be the ROI with and without the investment? (Base 
your calculations on opening book values). Would the investment 
centre manager wish to undertake the investment if performance is judged on ROI? 
(b) What would be the average annual RI with and without the 
investment? (Base your calculations on opening book values). Would the investment centre manager wish to undertake the investment if performance is judged on RI?

302  
Divisional performance can be compared in many ways. ROI and RI are 
common methods but other methods could be used. 
• Variance analysis – is a standard means of monitoring and controlling 
performance. Care must be taken in identifying the controllability of, and 
responsibility for, each variance. 
• Ratio analysis – there are several profitability and liquidity measures that 
can be applied to divisional performance reports. 
• Other management ratios – this could include measures such as sales per 
employee or square foot as well as indus try specific ratios such as transport 
costs per mile, brewing costs per barrel, overheads per chargeable hour. 
• Other information – such as staff turnover, market share, new customers 
gained, innovative products or services developed. 
 
 Example 8: Comparing divisional performance 
 Comment on the problems that may be involved in comparing divisional 
10  Economic value added (EVA®) 
Economic value added (EVA) is a measure of performance similar to residual income, except the profit figure used is the ECONOMIC profit and the capital employed figure used is the ECONOMIC capital employed. It is argued that the ‘profit’ and ‘capital employed’ figures quoted in the financial statements do not give the true picture and that the accounting figures need to be adjusted to show the true underlying performance. 
The basic concept of EVA is that the performance of a company as a whole, or 
of investment centres within a company, should be measured in terms of the value that has been added to the business during the period. It is a measure of performance that is directly linked to the creation of shareholder wealth. 
The measurement of EVA is conceptually simple. In order to add to its 
economic value, a business must make an economic profit in excess of the cost of the capital that has been invested to earn that profit. 
Calculation: 
 
1 PAT is adjusted to give the Net Operating Profit after tax 
(NOPAT)   
X 
2 Deduct the economic value of the capital employed(*) × cost of 
capital  
(X) 
 ––– 
 X 
 ––– 
(*) The calculation should be based on opening capital employed. We assume 
that the 'Capital Employed' at the start of the year is the one that was used to 
generate the profits during the year. Therefore the opening capital employed is generally used in calculations, unless the question directs you otherwise.

Chapter 8 
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In more detail: 
 
1  NOPAT is calculated from PAT  X 
Add back items that are non-cash, such as:   
Accounting depreciation Note 1 XX 
Provision for doubtful debts Note 2 XX 
Non-cash expenses Note 3 XX 
Interest paid net of tax Note 4 XX 
Add back items that add value, such as:   
Goodwill amortised Note 5  XX 
Development costs Note 6 XX 
Operating leases Note 7 XX 
8 
Take off:   
Economic depreciation Note 8 (X) 
Any impairment in the value of goodwill   
––– 
= NOPAT in cash flow terms  XX 
––– 
2 Deduct the charge for the cost of capital 
Opening capital employed 
Add adjustments to allow for the net replacement cost of tangible non-
current assets 
= Capital invested 
3 Multiply capital invested by the cost of capital x% 
 
= Charge for the cost of capital (X) 
–––– 
= EVA (XX) 
–––– 
 
 More on EVA – Notes on the above calculation 
 Note 1 – Accounting depreciation:  We add this back to PAT, because 
EVA is calculated after profits have been charged with economic 
depreciation (not accounting depreciation). 
Note 2 – Provision for doubtful debts:  Where a company had made a 
provision for doubtful debts, this should be reversed. Any adjustment in 
the income statement for an increase or decrease in the provision for doubtful debts should be reversed. 
Note 3 – Non cash expenses:  These were charged to profit, but must 
be added back because we want NOPAT in cash flow terms. Examples 
of non-cash expenses include depreciation and capitalised development costs.

304  
 Note 4 – Interest paid net of tax:  if tax is at 35%, take interest payments 
and multiply by 0.65. 
Adding this back results in profits that would have been reported had all 
the companies’ capital requirements been financed with ordinary shares. A charge for interest and the tax effect of actual gearing are incorporated into the weighted average cost of capital (so if we leave the interest charge within the NOPAT number it will be double counted). It is the net interest i.e. interest after tax that is added back to reported profit because interest will already have been allowed as an expense in the computation of the taxation liability.  
Note 5 – Goodwill:  Goodwill is a measure of the price paid for a 
business in excess of the current cost of the net separable assets of the business. Payments in respect of goodwill may be viewed as adding value to the company. Therefore any amounts in respect of goodwill amortisation appearing in the income statement are added back to reported profit since they represent part of the intangible asset value of the business. 
Note 6 – Development costs:  Spending by the company on 
development costs should not be charged in full against profit in which 
the expenditure occurs. Instead, it should be capitalised because it has added value to the economic value of capital employed. The adjustment can be made by: 
• Increasing NOPAT by the net increase in capitalised development 
costs, and 
• Increasing the economic value of capital employed by the same 
amount. 
Note 7 – Leases 
All leases should be capitalised. Finance leases w ill have already been 
capitalised but operating leases should be capitalised too. The economic 
value of the capital employed increased to include the current value of the operating lease. The capitalised cost should then be amortised. The value of NOPAT should be increased by the operating lease charge and reduce by the amortisation charge. The net effect to increase NOPAT by the implied interest cost of the operating lease. 
Note 8 – Economic depreciation Considered to be a measure of the economic use of assets during a year. 
Involves a process of valuation. It is the period by period change in the market value of the asset.

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 Example 9: Economic Value Added 
 A company with several divisions has a cost of capital of 6%.  An excerpt 
from Division B’s accounting summary for the period is shown below: 
 
 $ 
Revenue 1,000,000 
Cost of sales 450,000 
 –––––––– Gross profit 550,000 
General administration costs 300,000 
Depreciation 50,000 
Provision for bad and doubtful 
debts* 25,000 
Loan interest @ 5% 5,000 
 –––––––– 
Net profit 170,000 
Net assets at net book value** 500,000 
Bank loan 100,000 
The value of closing Capital Employed is $525,000. 
* Taking total provision to $50,000 ** Replacement cost has been estimated at $700,000.  If assets had 
been valued at replacement cost the depreciation charge would have been $70,000. 
Ignore taxation, what is the economic value added (EVA) of the 
investment centre? 
A $142,500 B $138,000 C $135,000 D $148,500 
Advantages of EVA 
The advantages of EVA are as follows. 
• It is a performance measure that attempts to put a figure to the increase 
(or decrease) that should have arisen during a period from the operations 
of a company or individual divisions within a company. 
• Like accounting return and residual income, it can be measured for each 
financial reporting period. 
• It is based on economic profit and economic values of assets, not 
accounting profits and asset values.

306  
 Measuring and using EVA 
 The principle underlying EVA can be stated as follows. 
• The objective of a company is to maximise shareholder wealth. 
• The value of a company depends on the extent to which 
shareholders expect future economic profits to exceed the cost of 
the capital invested. 
• A share price therefore depends on expectations of EVA. 
• Current performance (EVA) is reflected in the current share price, 
so in order to increase the share price a company must achieve a 
sustained increase in EVA. 
Peter Drucker has written: 'Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources.... Until then, it does not create wealth, it destroys it.' 
Measuring EVA 
The difficulties in applying EVA in practice arise from the problem of 
establishing the economic profit in a period, and the economic value of capital employed. These values are estimated by making adjustments to accounting profits and accounting capital employed. 
• Accounting profits are based on the accruals concept of 
accounting, whereas NOPAT for EVA is based on cash flow 
profits. Adjustments have to be made to convert from an accruals basis to a cash flow basis. 
• Depreciation of non-current assets is a charge in calculating EVA 
as well as accounting profit. Economic depreciation is the fall in the economic value of an asset during the period. 
–  It might be assumed that the accounting charge for 
depreciation is a good approximation of the economic cost of 
depreciation, in which case no adjustment to accounting profit is necessary. 
–  Alternatively, it might be assumed that the economic value of 
the assets are their net replacement cost, in which case economic depreciation will be based on replacement cost. An adjustment to accounting profit should then be made for the amount by which economic depreciation exceeds the accounting charge for depreciation. 
• Similarly, an adjustment might be necessary for intangible non-
current assets such as goodwill.

Chapter 8 
 307 
 • Where a company had made a provision for doubtful debts, this 
should be reversed. Any adjustment in the income for an increase 
or decrease in the provision for doubtful debts should be reversed, and NOPAT increased or reduced accordingly. 
• Spending by the company on development costs should not be 
charged in full against profit in the year the expenditure occurs. Instead, it should be capitalised because it has added to the economic value of capital employed, and it should then be amortised over an appropriate number of years. In practice, the adjustment can be made by: 
–  increasing NOPAT by the net increase in capitalised 
development costs, and 
–  increasing the economic value of capital employed by the 
same amount. 
• All leases should be capitalis ed. Finance leases will have been 
capitalised already, but operating leases should be capitalised 
too, and the economic value of capital employed increased to include the current value of operating leases. Stern Stewart amortise this capitalised cost over five years. In adjusting from accounting profit to NOPAT, the value of NOPAT should be increased by the operating lease rental charge, and reduced by the amount of the amortisation charge. (The net effect is to increase NOPAT by the implied interest cost of the operating lease.) 
Using EVA 
Economic value added can be used to: 
• set targets for performance for investment centres (divisions) and 
the company as a whole 
• measure actual performance 
• plan and make decisions on the basis of how the decision will 
affect EVA. 
When EVA is used to measure performance, Stern Stewart have 
recommended that divisional managers should be: 
• given training to understand the principles of EVA. Stern Stewart 
have found than non-accountants find the concept of EVA fairly 
easy to understand, and they see the link between EVA and changes in shareholder value 
• informed about the interest cost that will be applied for the capital 
charge 
• taught how to calculate EVA for decision-making purposes 
• given a pay incentive based on a bonus for achieving or 
exceeding a target EVA.

308  
 • EVA can also be used for control purposes, by encouraging 
managers to: 
–  identify products and services that provide the greatest EVA, 
and concentrate resources on those 
–  identify customers who provide the greatest EVA, and give 
priority to serving them 
–  identify and eliminate activities that do not add to EVA –  identify capital that is not providing a sufficient return to 
cover its capital cost (such as excess equipment) and seek 
to reduce the capital investment. 
11 Reports for decision making 
Report visualisation, along with the advancement of multimedia technology over recent years, has become a very powerful means of sharing and providing insight around business performance, which can be easily digested by the recipient.  
Report visualisation, through the use of data analytics in performance 
management, is the process of presenting report formats that represent data and information in a pictorial or graphical format . Visualisation helps the recipient to understand the significance of the content more easily than if presented in a traditional report format. 
In today’s modern business environment, the volume of data is far larger than 
ever. Therefore, the art of report visualisation has become increasingly important, as we become overwhelmed by both data and information. 
In recent years, technology providers have embraced the market and developed 
new tools to assist in the production of high-impact visual reports. In parallel, progress in desktop and mobile technology have enabled visualisation to be truly interactive and dynamic. 
A key role of the management accountant is to support effective decision 
making by presenting relevant, timely and accurate information in a manner that enables informed dialogue and decision making. 
Reporting for each type of responsibility centre 
For effective decisions to be taken, the information presented must focus on the 
right key performance indicators (KPIs) that drive true business performance. The overriding principle in deciding how to present data is that one size does 
not fit all .

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Whether reporting is produced at responsib ility centre (=divisional) level, or in 
Head Office, two key areas are fundamental to quality reporting: 
1 Data and master data that are subject to robust control which ensures 
reporting integrity. 
2 Standards in reporting that drive commonality across the whole 
organisation and aid assimilation to the consumer. For example, if ‘red’ is 
consistently used to display an adverse variance, then the reader is not having to ask the question every time. 
The five principles for effective report visualisation 
The following five key principles should always be considered: 1 Ensure data is optimised for report visualisation Once the right measures that are to be reported have been identified, the 
relevant data sources, which might be more than one for each report, also need locating. Key points to consider per data source are: 
• Where is the data source? 
• Can the data be refreshed in time to make the report relevant? 
The second area to consider is the creation of structure or hierarchies 
within the data that facilitates drill down to the reader. This is especially 
important if using tools such as mobile technology where the user is encouraged to drill to the next level with the touch of a finger. 
For example, imagine a report on an iPad showing a map of the world 
featuring a big red variance for sales in Europe. To investigate the sales variances, different di visional managers may want to drill down by: 
• Country or region 
• Product/service 
• Distribution channel. 
This is facilitated by creating a dimensional structure that stores data 
against reporting hierarchies. 
2 The relevant visualisation tool must be applied 
The principal factor in choosing the relevant report visualisation technique 
will undoubtedly be driven by what the user for the report feels comfortable with.

310  
However, there are a few common guiding principles that can be used to 
help match the visualisation to the requirement: 
• Variance analysis is often depicted by using waterfall charts , 
commonly known as bridges . The key benefit delivered is that the 
size of the steps in the bridge are to scale, so the eye naturally 
focuses on the significant movements first. 
 
• In providing an overview of a business area, dashboards  can 
provide a relevant summary. The key to delivering a useful dashboard is identifying what are the four or five relevant key drivers that can be reported on one page or screen. Dashboards provide a summary and often lead to a drill down to the next level, which is likely to be a different report:

Chapter 8 
 311 
• Trend analysis or time-based results are generally shown using line 
charts . Modern planning solutions can also use line charts as the 
visual interface to plan for future periods by establishing a baseline 
and then allowing the planner to drag the chart, which then models the underlying data. 
 
• Where organisations are built up of business areas or regions, 
mapping charts  are useful, especially when presented on an 
interactive interface such as a tablet:

312  
• When comparing data sets that are built up from component parts, 
then a bar chart or side by side pie chart  brings the message to life: 
 
3 An appropriate report layout must be chosen As visualisation skills become more and more important for the 
management accountant, he or she must think of designing a report from the perspective of the graphic designer too. Consider the following: 
• Layout – a simple and clean layout will always deliver a more 
impactful report than a report with too much information. Clear 
headings should be used that help explain what data is being presented. 
• If the report is ‘to be delivered digitally’, then the visible area of the 
page should match the screen, as  scrolling is not desirable. 
• Positioning – the reader’s eye naturally starts to read reports from the 
left-hand corner of the page and continues to the right or down. Therefore, if there is a key message, this should be positioned towards this area to gain optimum impact. 
Colours – the first area to think through with colours is whether the colours you have used make the report attractive to the eye, which engages the reader. 
The second use of colours is to assist  in telling the story. ‘Red’ and ‘green’ 
are used universally to depict ‘positive’ and ‘negative’, so consider 
conditional formatting if appropriate. Colours in related charts should always be consistent -for example, if a product or channel is shown in blue 
in one chart, it should be shown in blue in the next chart too. Finally, 
although colours enliven a chart, it is not a good idea to use too many as the chart will look messy. 
• Scaling – make scaling appropriate to the data and be wary of hiding 
the story through scaling. If your report contains multiple charts, try 
not to mix different scales on the same page, as this can confuse the reader.

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4 The reader experience must be optimised 
Engaging with the report user is key to ensuring the message is 
transmitted effectively from the paper or screen. When reporting in paper, think about the size and weight of the pack and consider dividers to help readers switch between sections. 
For online reporting, there are many more options available to deliver a 
better user experience: 
• Personalised – personalised reporting is key to engaging with users. 
This can be as simple as offering ‘bookmarks’ or ‘favourites’, or as 
complicated as the reporting solution making intelligent reporting suggestions based on the reader’s history or security access. 
• Intuitive – navigating searching around an online report should be 
intuitive and as familiar as searching the web or using a smartphone. Many reporting suites will include home buttons or searches similar to Google to assist in the familia r user experience.  A few reporting 
software providers utilise ‘Gamer Influenced Design’ principles in designing a user experience consistent with a video game. 
• Interactive – with touchscreen computers, tablets and smartphones 
more commonly being used for business, it is often desirable to use touch in an interactive report. Whether choosing the next report or drilling down to the next level, it is much more intuitive to swipe than it is to click the mouse. 
• Customised – a certain group of report users, may want to customise 
their own reports, and this is facilit ated by certain software vendors. 
They can then create their own user experience, but care must be taken to ensure the underlying data model is robust and does not allow the misrepresentation of data by custom-built reports. 
5 Visualisation to the appropriate de livery channel must be optimised 
Reports can be delivered via many different channels, such as desktops, laptops, tablets, mobile devices or paper. It is clear that a mobile phone is considerably smaller than an A4 sheet of paper and therefore logical that in order to produce a powerful report, the design will need to change. 
Many software providers support functionality that automatically renders 
the report and layout based on the delivery device. This is termed ‘author-once/run everywhere’. 
Whilst these tools can help, it is important to consider other aspects, such 
as the user experience. 
For example, the smaller the screen, the less you can show on the start 
page. However, you can provide drill paths and filter options to dig into the next level as required.

314  
You should also consider the urgency of the report requirement. Urgent 
notifications can be sent to mobiles but in order to fully analyse the detail, it might be acceptable to wait until the user is in front of a computer. 
The previous visualisation principles become even more important when 
thinking of various delivery channels. Technology is just the enabler to appropriately satisfy these. 
 
Case Study: A global industrial manufacturer  
 Problem statement: 
The organisation had grown significantly through mergers and 
acquisitions. As a result, it had multiple reporting solutions delivering 
output that satisfied divisional reporting requirements only.  
The company had recently formed a group reporting function tasked with 
providing the CEO and CFO with the insight to drive the whole business. Previously, reports had been pulled together in MS Excel from divisional reporting which led to inconsistencies in data and definitions. These reports were in a traditional row and column tabular format, which required user interpretation. 
Approach 
To address the issue, a summary set of KPIs was developed that linked 
divisional performance to satisfy the strategic goals of the organisation. These KPIs were then expanded into more detailed measures that could be reported on by the divisions to explain variances in performance.  
A mobile dashboard was created that started with a single screen 
reporting the six strategic goals of the organisation and then enabled the user to swipe into further information on a detailed measures (swipe left) view or a divisional (swipe right) view.  
From each view, drop downs were also created to intuitively navigate 
between different views. Conditional formatting and interactive graphs were used to draw the viewer to the issue quickly. 
Benefits 
Providing a consistent view of the group and divisional performance 
based on common KPIs was a giant leap forward for the company.  
The interactive way of viewing performance was seen by all users as a 
much more intuitive method than  sifting through  paper reports.  
The conditional formatting, along with the graphical techniques, removed the need to analyse the numbers, allowing managers to take action more quickly. By being on mobile devices, managers now had instant access to financial performance at their fingertips.

Chapter 8 
 315 
12 Practice Questions 
 Objective Test Question 1: Non-controllable costs 
 Bitluns is a holiday company, that operates more than 100 all-inclusive 
resorts. The performance of the manager of each resort is evaluated 
using financial measures. 
Many of the resort managers are not very happy, because their profit 
reports, that they are assessed on, include a share of head office costs and other costs that they cannot control. 
Use the words and phrases in the table provided below to complete the 
following paragraphs: 
 
controllable  costs  unfair 
     
control  performance  profit 
     
uncontrollable  fair  responsibility 
Uncontrollable costs may be included in the performance report of a _____________ centre so that the report shows the final ___________ of that centre. This is sometimes done to make the manager aware of the other _________________ involved in running the business. 
However, from a performance measurement perspective, if it is the 
_________________ of the manager that is being measured, then it is _______________ to measure their performance on results that include items that are beyond their _________________ 
The solution to this is to include the _____________ items in a separate 
section of the report, and to measure the manager's performance based only on the ________________ items.

316  
 Objective Test Question 2: Controllable RI 
 The manager of a trading division has complete autonomy regarding the 
purchase and use of non-current assets. The division operates its own 
credit control policy in respect of customers but the group operates a central purchasing function through which the division places all orders with suppliers and invoices are paid by head office. 
Inventories of goods for sale are kept in central stores, from which local 
divisions call off requirements for local sales on a monthly basis into a local inventory. 
Divisional performance is assessed on the basis of controllable Residual 
Income. The company requires a rate of return of 'R'. 
Using the following symbols: 
 
Divisional non-current assets  N 
Apportioned net book value of central stores  S 
Divisional working capital   
Receivables D  
Local Inventory I  
Bank B  
Payables (P) 
–––  
  W 
––– 
Divisional net assets  T 
––– 
Divisional contribution  C 
Controllable fixed costs  (F) 
Head Office charges  (H) 
––– 
Divisional net income  G 
––– 
Which ONE of the following formulae calculates the division's 
controllable residual income? 
(i) [C – F] – [(N + D + B) × R] (ii) [C – F] – [(N + D + I + B) × R] (iii) C – [(N + D) × R] (iv) G – (T × R) A  (i) only B (ii) only C (iii) only D  (i) and (iv) only

Chapter 8 
 317 
 Objective Test Question 3: EVA 
 A division has a reported annual profit of $27m. This was after charging 
$6m for the development and launch costs of a new product which is 
expected to have a life of 3 years. 
The division has a risk adjusted cost of capital of 10% per annum, but it 
has a large bank loan, which incurs annual interest charges of 8%. 
The net book value of the division's net assets is $85m. The replacement 
cost of the assets is estimated to be $96m. 
Ignore the effects of taxation. The Division's EVA is: 
 
$m

318  
 Data Set Question: Key me trics and depreciation 
 Tweedle Ltd has two divisions, Division Dee and Division Dum. Tweedle 
founded Dee on 1 January 2013. Dum was an independent business that 
had been formed some years before. Tweedle purchased Dum as a going concern in August 2013. Tweedle's directors are keen to benchmark the two divisions, because they produce similar products. 
Details for the two companies for the year ended 31 December 2013 are 
as follows (in $000): 
 
 Dee Dum 
Revenue 1,650 1,000 
Cost of sales:   
Variable production costs 400  400  
Fixed production costs (including depreciation, 
see note 2) 800  390 
 1,200  790 
 ––––– ––––– GROSS PROFIT 450 210  ––––– ––––– 
Administration costs (fixed) 120 80 
 ––––– ––––– OPERATING PROFIT 330 130 
Non-current assets:   Cost 2,500
 2,000  
Depreciation 500  1,367 
 ––––– –––––  2,000
 633 
 ––––– ––––– Net current assets 200 150
 
Capital employed 2,200 783  
Performance measures   
Return on Capital Employed (ROCE) 15.0% 16.6% Operating profit margin 20.0% 13.0% 
Asset turnover 0.8 1.3

Chapter 8 
 319 
 Notes 
1 Dee and Dum use different depreciation policies. Dee depreciates 
its non-current assets using straight-line depreciation, at the rate of 
20% of cost with no residual value. Dum uses the reducing balance method of depreciation at the rate of 25% per annum. 
2 Included in the fixed element of cost of sales for the year ended 
31 December 2013 is depreciation of $500,000 for Dee and $200,000 for Dum. 
3 Dee's assets are newer. 
Tweedle's management team in charge of Dee have argued that it is 
unfair to compare them with Dum, because the two entities have different depreciation policies and Dum's assets are newer. 
The parent company directors have agreed to restate Dee's results so 
that the assets are assumed to be the same age as Dum's, and the depreciation policy is the same. 
After aligning Dee's operating profits and capital employed, as well as its 
performance measures, restate, for Dee: 
Its operating profit, in $.  
  
Its capital employed, in $.  
  
Its (revised) ROCE, in %.  
  
Its (revised) operating profit margin, in %.   
  
Its (revised) asset turnover.  
  
 Case Study Style Question: Liquidity, profitability 
You work as the Senior Management Accountant in Nordic plc. Its 
chairman, Lars Johansson, has recently been quoted in the press as 
saying: 
'Nordic is doing so well. We have always been a profitable company. 
However, we are following a high growth strategy based on low prices, and this has put pressure on cash flows. We have a number of new clients signed up, and we believe the future is bright.' 
You have also been looking at the first draft budget from the budget 
planners. Compared with the previous budget period, operating costs are expected to be higher. The initial draft budget shows a current ratio of 1.10 at the end of the budget period, and a contribution to sales ratio for the year of 51%.

320  
You have just received the following email:

Chapter 8 
 321 
 All statements are true. 
 
 • Total material expenditure for the organisation FALSE. 
The total material expenditure for the organisation will be dependent 
partly on the prices negotiated by the purchasing manager and partly by the requirements and performance of the production department. If it is included as a target for performance appraisal the manager may be tempted to purchase cheaper material which may have an adverse effect elsewhere in the organisation. 
• The cost of introducing safety measures, regarding the standard 
and the quality of materials, in accordance with revised government legislation TRUE. 
The requirement to introduce safety measures may be imposed but 
the manager should be able to ensure that implementation meets budget targets. 
• A notional rental cost, allocated by head office, for the material 
storage area. FALSE. 
A notional rental cost is outside the control of the manager and 
should not be included in a target for performance appraisal purposes. 
 
 Example 3: ROI calculation 
 ROI : $28,000/$142,000 = 19.7%.

322  
 Example 4: Disadvantages of ROI 
 If he/she acts in the best interests of their own division, only the manager 
of Division B will want to accept the project offered to him/her. 
• If managers want to act in the best interests of the business as a 
whole, only the manager of Division A should accept the project 
offered to him/her. 
(a) 
 $000 $000 
Old ROI 90/300 10/100 
 = 30% = 10% New ROI (90 + 20)/(300 + 100) (10 + 12)/(100 + 100) 
 = 27.5% = 11% 
Will manager want to 
accept project? No Yes 
The manager of Division A will not want to accept the project as it lowers her ROI from 30% to 27.5%. The manager of Division B will like the new project as it will increase their ROI from 10% to 11%. Although the 11% is bad, it is better than before. 
(b) Looking at the whole situation from the group point of view, we are 
in the ridiculous position that the group has been offered two projects, both costing $100,000. One project gives a profit of $20,000 and the other $12,000. Left to their own devices then the managers would end up accepting the project giving only $12,000. This is because ROI is a defective decision-making method and does not guarantee that the correct decision will be made. 
Workings: 
 Division A  Division B 
 $000 $000 
Old ROCE    
Profit  90 10 
 –––– –––– Capital employed 300 100 
Old ROCE 30% 10% 
New ROCE    
Profit  90 + 20 
–––––––– 10 + 12 
–––––––– 
 300 + 100 100 + 100 New ROCE 27.5% 11% Will manager want to accept project? No Yes

Chapter 8 
 323 
 The manager of division A will not want to accept the project as it lowers 
the divisional ROCE from 30% to 27.5%. The manager of division B will 
like the new project as it will increase their ROCE from 10% to 11%. Although the 11% is bad, it is better than before. 
Looking at the whole situation from the group point of view, we are in the 
ridiculous position that the group has been offered 2 projects, both costing $100,000. One project gives a profit of $20,000 and the other $12,000. Left to their own devices then the managers would end up accepting the project giving only $12,000. This is because ROCE is a defective decision making method and does not guarantee that the correct decision will be made. 
There are a number of different ways of making the correct decision. The 
simplest way is to calculate the ROCE of the project itself. 
 
 Example 5: RI calculation 
 If performance is measured by RI, the RI for the period is: 
 $ 
Profit before interest and tax 160,000 
Notional interest (12% × $800,000) 96,000 RI 64,000 
(Note: Capital employed is not available in this question and therefore net 
assets should be used as a substitute value). 
Investment centre managers who make investment decisions on the 
basis of short-term performance will want to undertake any investments that add to RI, i.e. if the RI is positive. 
 
 Example 6: RI increase 
 The answer is B. 
Residual income (RI) = Divisional profit – (cost of capital × net assets) 
RI without  the machine = $24,800 – 8% × $212,000 =$ 7,840 
RI with the machine = $43,800 – 8% × $260,000 =$ 23,800 
Difference = $15,160

324  
 (a) ROI 
 Without the 
investment With the investment 
Profit $160,000 $175,000 
Capital employed $800,000 $900,000 ROI 20.0% 19.4% 
 
ROI would be lower; therefore the centre manager will not want to 
make the investment. since his performance will be judged as having deteriorated. However, this results in dysfunctional behaviour 
since the company's target is only 12%. 
(b)  RI 
  Without the 
investment  With the 
Profit  $160,000  $175,000 
Notional interest ($800,000 × 12%) $96,000 ($900,000 × 12%) $108,000 
RI  $64,000  $67,000 
 
The investment centre manager will want to undertake the 
investment because it will increase RI. This is the correct decision for the company since RI increases by $3,000 as a result of the investment. 
 
 Problems may include: 
• Divisions may operate in different environments. A division earning 
a ROI of 10% when the industry average is 7% may be considered to be performing better than a division earning a ROI of 12% when the industry average is 15%. 
• The transfer pricing policy may distort divisional performance. 
• Divisions may have assets of different ages. A division earning a 
high ROI may do so because assets are old and fully depreciated. 
This may give a poor indication of future potential performance. 
• There may be difficulties comparing divisions with different 
accounting policies (e.g. depreciation). 
• Evaluating performance on the basis of a few indicators may lead to 
manipulation of data. A wider range of indicators may be preferable which include non-financial measures. It may be difficult to find non-financial indicators which can easily be compared if divisions operate in different environments.

Chapter 8 
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 $ 
Accounting profit 170,000 
Add back accounting depreciation 50,000 
Deduct economic depreciation (70,000) Add back increase to doubtful debt provision 25,000 
Add back interest 5,000 
 ––––––– NOPAT (ignoring tax) 180,000 
  
Replacement cost of assets 700,000 Total bad debt provision 50,000  ––––––– 
Economic value of capital employed 750,000 
Cost of capital charge at 6% 45,000   
NOPAT 180,000 
Less capital charge (45,000)  ––––––– 
EVA 135,000 
Option A uses the bank loan cost of 5% instead of the cost of capital. 
Option B fails to add back the bad debt provision to the value of assets, and Option D makes the error of using the value of closing capital employed in the capital charge calculation. 
 
 Uncontrollable costs may be included in the performance report of a 
responsibility centre so that the report shows the final profit of that centre. This is sometimes done to make the manager aware of the other costs involved in running the business. 
performance of the manager that is being measured, then it is unfair to measure their performance on results that include items that are beyond their control. 
The solution to this is to include the uncontrollable items in a separate 
section of the report, and to measure the manager's performance based only on the controllable items. 
 
 Answer B (ii) only.

326  
 Calculation of NOPAT 
 $m 
Accounting operating profit 27 
Add back development and launch costs 6 Less one year’s amortisation of development and launch costs (2) 
––– 
 31 
––– 
Calculation of value of capital employed 
 $m 
Replacement cost of net assets 96 
Add back increase in capitalised launch and development costs 4 
––– 
 100 
––– 
Calculation of EVA 
The correct figure to use for calculating the capital charge is the cost of 
capital, i.e. the 10%. The 8% is a distracter. 
 $m 
NOPAT  31 
Capital charge (10% × $100m) 10 
–––  
EVA 21 
––– 
  
Its operating profit, in $. $566,000 
$991,000 
Its revised ROCE, in %.  
57.15% 
Its revised operating profit margin, in %.  
34.32% 
Its revised asset turnover.  
1.66

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 327 
 Approach: 
First, we have to recalculate Dee's operating profit if the depreciation 
charge contained in the fixed production costs had been calculated using a reducing balance method, which is the method used by Dum. 
At the moment, depreciation for Dee is $500,000 using straight line 
depreciation at 20%. This means $500,000 depreciation charge every year for 5 years, and the assets were originally $2.5 m = the assets in Dee are only 1 year old. 
Calculating the age of assets in Dum: 
In Dum, accumulated depreciation is $1,367,000. This represents 
4 years’ worth of depreciation. (W1), and Dum's assets are therefore 4 years old. 
We then need to 'pretend' that Dee's assets are also 4 years old in order 
to align their age with that of Dum's assets. At the moment, depreciation of $500,000 is included in the fixed element of the cost of sales. 
What would Dee's depreciation charge for the year be if we used a 
reducing balance method of depreciation at the rate of 25% per annum? 
 
 Depreciation charge 
for the year NBV Accumulated 
 @ 25%   
Year 1 625 1,875 625 
Year 2 469 1,406 1,094 
Year 3 352 1,055 1,445 Year 4 264 791 1,709 
Dee's depreciation charge for the year (if we used a reducing balance 
method of depreciation at the rate of 25% per annum) would be $264,000. At the moment, the depreciation charge amounts to $500,000. The difference of $236,000 comes to inflate the operating profit for Dee, which becomes $330,000 + $236,000 = $566,000. 
The divisional Fixed Assets will also change their value. Instead of an 
accumulated depreciation charge of $500,000, we now have an 
accumulated depreciation of $1,709,000. Therefore, the value of fixed assets becomes $791,000 and not $2m as per the question. 
This represents a reduction in fixed assets value of $1,209,000, and 
capital employed becomes $991,000. 
Therefore, ROCE = ($566,000/$991,000) = 57.15%  Operating profit margin = ($566,000/$1,650,000) = 34.32%  Asset turnover = ($1,650,000/$991,000) = 1.66

328  
 Working 1 (in $000) 
 Depreciation 
charge for the 
year @ 25% NBV Accumulated 
Year 1 500 1,500 500 
Year 2 375 1,125 875 
Year 3 281 844 1,156 Year 4 211 633 1,367 
    
 From: AN Accountant  To: Lars Johansson 
Date: 29 July 2014   Subject: Profitability and liquidity 
The first step by the budget planners should be to consider why liquidity 
and profitability are not as good in the draft budget as the minimum targets. There are several possible reasons. 
• The budget allows for higher operating costs, but there is no plan to 
increase sales prices. This will reduce profit margins and cash 
balances, and explain, fully or in part, the unsatisfactory performance ratios for profitability and liquidity. 
• The targets of 1.25 for current ratio and 55% for the contribution/ 
sales ratio might be unrealistic, and should therefore be re-considered. 
• There could be padding (slack) in the budget estimates for 
Please do not hesitate to contact me if I can be of further assistance.  
AN

329 
Alternative measures of 
making 
 
  Chapter 
9

Alternative measures of performance 
330  
 
2  Budgetary control: flexing budgets to measure performance 
 A fixed budget is a budge t produced for a single level of activity. A fixed 
budget will remain the same no matter the volume of sales or production. 
A fixed budget is not particularly useful for control; it is predominantly used 
in the planning stage of budget preparation and is often referred to as the 
original budget.  
 
 A flexible budget is one which, by recognising cost behaviour patterns, is 
designed to change as volume of activity changes. A flexible budget should represent what the costs and revenues were expected to be at different activity levels. It is particularly useful for control as the original (fixed) budget can be flexed to show the costs and revenues for the actual level of activity. 
The key points to note are: 
• A fixed budget is set at the beginning of the period, based on estimated 
production. This is the original budget. At the same time a flexible budget 
may be produced at a range of activity levels. 
• Actual results are compared with the relevant section of the flexible 
budget, that which corresponds to the actual level of activity. This is usually referred to as the flexed budget.

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 331 
Budgetary control and responsibility accoun ting are linked: it is important to 
ensure that each manager has a well- defined area of responsibility and the 
authority to make decisions within that area, and that no parts of the 
organisation remain as 'grey' areas where it is uncertain who is responsible for them. If this is put into effect properly, each area of the organisation’s activities is the responsibility of a manager. This stru cture should then be reflected in the 
organisation chart. 
Each centre has its own budget, and the manager receives control information 
relevant to that budget centre. Costs (and revenue, assets and liabilities where applicable) must be traced to the person primarily responsible for taking the related decisions, and identified with the appropriate department. 
 
Example 1: Wye Group 
 Division A of the Wye Group manufactures one product and when 
operating at 100% capacity can produce 5,000 units per period, but for 
the last few periods has been operating below capacity. 
Below is the flexible budget prepared at the start of last period, for three 
levels of activity at below capacity: 
Level of activity (units) 3,500 4,000 4,500 
 $ $ $ Direct materials 7,000 8,000 9,000 
Direct labour 28,000 32,000 36,000 
Production overheads 34,000 36,000 38,000 Administration, selling and 
distribution overheads  
15,000  
15,000  
15,000 
Total cost 84,000 91,000 98,000  –––––– –––––– ––––––

332  
 In the event, the last period turned out to be even worse than expected, 
with production of only 2,500 units. The following costs were incurred: 
 
 $ 
Direct materials 4,500 
Direct labour 22,000 Production overheads 28,000 
Administration, selling and di stribution overheads 16,500 
 –––––– 
Total cost 71,000 
 –––––– 
Required: 
Use the information given above to prepare the following. 
(a) A flexed budget for 2,500 units. (b) A budgetary control statement. 
 
 Example 2: Bug Ltd 
 Bug Ltd manufactures one uniform product. Activity levels in the 
assembly department are an average level of activity of 20,000 units 
production per four-week period. The actual results for four weeks in October are: 
 Budget 20,000 units Actual 17,600 units 
 $ $ 
Direct labour 20,000 19,540 
Direct expenses 800 1,000 Direct material 4,200 3,660 
Depreciation 10,000 10,000 
Semi-variable overheads 5,000 4,760  40,000 38,960 
Assume that at a level of production of 15,000 units, semi-variable 
overheads are forecast to be $4,500. 
Produce a budgetary control statement showing the actual costs, flexed 
costs and variances produced. 
 
 Controllable costs and revenues are those costs and revenues which result from decisions within the authority of a particular manager or unit within the organisation. These should be used to assess the performance of managers.

Chapter 9 
 333 
Over a long time-span most costs are controllable by someone in the 
organisation. For example – rent may be fixed for a number of years but there may eventually come an opportunity to move to other premises as such: 
• rent is controllable in the long term by a manager fairly high in the 
organisation structure if the opportunity arises to move premises or 
negotiate with the land lord 
• but in the short term rent is uncontrollable even by senior managers. 
There is no clear-cut distinction between controllable and non-controllable costs 
for a given manager. There may be joint control with another manager. The aim under a responsibility accounting system will be to assign and report on the cost to the person having primary responsibility. 
 
Illustration 1 – Controllable and uncontrollable costs 
 An example of the two different approaches to controllable and 
uncontrollable costs is provided by raw materials. The production 
manager will have control over usage, but not over price, when buying is 
done by a separate department. For this reason the price and usage variances are separated and, under the first approach, the production manager would be told only about the usage variance, a separate report being made to the purchasing manager about the price variance. The alternative argument is that if the production manager is also told about the price variance, he may attempt to persuade the purchasing manager to try alternative sources of supply. 
It is recognised that in-correct allocation of costs to managers could result in a 
lowering of morale and a reduction of motivation. 
To be fully effective, any system of financial control must provide motivation and 
incentives. If this requirement is not satisfied, managers will approach their responsibilities in a very cautious and conservative manner. It is often found 
that adverse variances attract investigation therefore failure to distinguish controllable from uncontrollable costs can alienate managers as potentially adverse variances will occur that appear to be under their control but are not. 
When adverse variances are reported this implies poor performance by the 
managers. If they are unable to correct or explain the adverse variances, then they may suffer negative sanctions. They may miss out on a salary increase, or they may be demoted. Positive inducements may be offered to encourage managers to avoid adverse variances. A manager who meets budget may be granted a performance related salary bonus or promotion. If a cost is not controllable by a manager they could be incorrectly penalised or incorrectly rewarded.

334  
It has been seen that an essential element in budgetary control is performance 
evaluation. Actual results are compared with budget or standard in order to determine whether performance is good or bad. What is being evaluated is not just the business operation but the managers responsible for it. The purpose of budgetary control is to encourage managers to behave in a manner that is to the best advantage of the organisation. Compliance with budget is enforced by a variety of negative and positive sanctions so it is essential that costs allocated to managers are controllable by those managers. 
Planning and operational variances 
The standard is set as part of the budgeting process which occurs before the 
period to which it relates. 
This means that the difference between standard and actual may arise partly 
due to an unrealistic budget and not solely due to operational factors. The budget may need to be revised  to enable actual performance to be compared 
with a standard that reflects these changed conditions. 
 
Planning and operational variances may be calculated for sales, materials and 
labour; the operating statement would include a separate line for each variance calculated. 
 
  Traditional variance 
– Compares actual results 
with the original (flexed) budget. 
Planning variance 
– Compares the revised 
(flexed) budget and the original (flexed) budget. 
– Often deemed to be 
uncontrollable. Management should not be held accountable. Operational variance 
with the revised (flexed) budget. 
– Deemed controllable. 
Management held responsible for operational variances.

Chapter 9 
 335 
 Benefits and problems of pla nning and operational variances 
 Benefits of planning a nd operational variances 
• In volatile and changing environments, standard costing and 
• Operational variances provide up to date information about current 
• Operational variances are likely to make the standard costing 
• It emphasises the importance of the planning function in the 
preparation of standards and helps to identify planning deficiencies. 
• There is an element of subjectivity in determining the ex-post 
• There is a large amount of labour time involved in continually 
• There is a great temptation to put as much as possible of the total 
• There can then be a conflict between operating and planning staff, 
each laying the blame at each other's door. 
On the face of it, the calculation of operational and planning variances is an improvement over the traditional analysis. However, you should not overlook the considerable problem of data collection for the revised analysis: where does this information come from, and how can we say with certainty what should have been known at a particular point in time? 
3 Shortcomings of financial indicators 
The use of traditional financial performance metrics is widespread, but the practice has its problems. For example: 
1 They only tell what has happened over a limited period in the immediate 
past. 
2 They give no indication of what is going to happen in the future. 3 They are vulnerable to manipulation and to the choice of accounting policy 
on matters such as depreciation and inventory valuation. 
4 They do not relate to the strategic management of the business and may 
induce ‘short-term ism’, at the expense of motivation, quality and 
efficiency.

336  
4  Non-Financial Performance Indicators 
So, if we wish to obtain a fuller evaluation of performance, then we have to turn 
to a range of non-financial performance indicators (NFPIs). 
Non-financial performance indicators are 'measures of performance based on 
non-financial information that may orig inate in, and be used by, operating 
departments to monitor and control their activities without any accounting 
input.' ( CIMA Official Terminology) 
Non-financial performance measures may give a more timely indication of the levels of performance achieved than financial measures do, and may be less susceptible to distortion by factors such as uncontrollable variations in the effect of market forces on operations. 
Certain academic writers have developed models of performance evaluation for 
strategic advantage. The general thrust behind these is that performance indicators should be developed that relate to the long-term strategic development of the organisation. This follows the principle advocated by management guru/writer Tom Peters: 'What gets measured gets done'. 
The performance indicators adopted for a given business or business segment 
should relate to its key success factors – those things that are most likely to 
determine its success or failure. NFPIs can be expressed in either quantitative or qualitative terms. For example, it might be reported that we have a 5 per cent market share (a quantitative measure) and we are first supplier of preference to almost all our established customers (a qualitative measure). 
Let us consider a number of NFPIs, how they might be expressed and relevant 
information relating to them might be gathered. 
Competitiveness 
 
Regular market surveys drawing on both internal and external sources of 
information can be used to compile reports.

Chapter 9 
 337 
Activity level 
 
Relevant information could be drawn mainly from internal sources, with 
appropriate checks to ensure accuracy. 
Productivity 
 
Again, most of this information could be drawn from internal sources. Quality of service 
 
Again, most relevant information would be available from internal sources but 
this could be reinforced by periodic customer surveys.

338  
 
Relevant information would have to come mainly from customer surveys 
although some internal sources could be selectively used. Customer surveys can be carried out on a regular structured basis or on an occasional informal basis. If a sample of customers is being used to compile information, then care has to be taken that the sample is significant in size and representative in structure. 
Quality of staff experience 
 
Some information could be taken from internal sources but much would have to 
come from colleges and external trainers. Exit interviews and confidential staff opinion surveys could also be used. 
Innovation

Chapter 9 
 339 
This kind of information would have to be taken from a variety of internal and 
external sources. The slightly subjective nature of what constitutes a ‘new product’ is such that this may be an area where an external assessor or consultant might be used to prepare the report. 
These sort of performance indicators have the advantage of being ‘forward 
looking’. That is, they are likely to address factors that relate to how well or badly the business will perform in the future. 
For example, a service business with a high staff turnover rate is at a 
disadvantage. If experienced and qualified staff are constantly leaving and being replaced, then this may not contribute to the quality of service being offered to customers. We have all experienced visits to a shop, travel agent or garage where we have been served by an inexperienced and obviously new member of staff – who is unfamiliar wi th our account history and appears to 
have limited knowledge of the products that he or she is trying to sell. We find it much more satisfactory to be served by an experienced member of staff who knows his or her customers and products. 
Yet, a deterioration in the standard of staff being employed (as evidenced by 
the indicators listed above under quality of staff experience) would not impact greatly on current period ROCE. A focus on current ROCE might actually induce a business to make greater use of poorly paid, junior staff in order to minimise operating costs. The impact of this on the business might be felt only in the long term. 
As with any performance indicator, an NFPI has to be viewed in some context in 
order to be most meaningful. A good co ntrol report will express indicators in 
terms of a deviation from plan, relative to an industry benchmark or as part of a trend analysis covering comparable earlier periods. 
Further, it is best to consider performance indicators as part of a package giving 
a multi-dimensional impression of how the organisation is performing. 
 
Illustration 2 – BAA 
 One example of the use of NFPIs frequently reported in management 
literature is that of BAA plc (formerly the British Airports Authority). This is 
the case of a service company that attempts to evaluate its own performance in terms of the quality it is able to offer to customers. 
It has identified about 12 key success factors which include access, 
aesthetics, cleanliness, comfort, staff competence, staff courtesy, reliability, responsiveness and security . These take on board the factors 
that customers appreciate when using an airport – short distances to walk from point of arrival to point of departure, safety from attack or robbery, easy availability of luggage trolle ys and wheel chairs and so on.

340  
 BAA carries out regular surveys involving interviews with customers, 
consultant reports, analysis of operational data, and monitoring customer 
feedback. Appropriate indicators for each factor are reported and studied through comparison between different airports and trend analysis over time. For example, if airport A persistently reports a higher level of theft from customers than other airports – then this might prompt the introduction of additional security measures at airport A. If complaints about staff courtesy at airport D have been on a persistent upward trend over time, then this might prompt enquiries into staff supervision at that site and/or additional staff training. 
A customer survey might include a question as follows: ‘Your impression of the service available in the cafeterias at Airport B is 
best described as 
A  Most satisfactory B  Satisfactory C  Acceptable D  Less than acceptable E  Unsatisfactory. Answering this involves a qualitative judgement on the part of the 
customer, but the survey results can be reported and evaluated in quantitative terms. For example, if 80% of customers offered A or B answers to this question, then the impression given is that the standard of service at Airport B cafeterias is not a problem– and it may even serve as a model of best practice for other airports. 
This line of discussion leads us into more modern models of performance 
5 Reports in a not-for-profit organisation 
Not-for-profit organisations such as local authorities and charities have their own rules and requirements in terms of accounting. Some of the financial measures we have looked at so far (gross margin, contribution, ROCE) will not always be appropriate in a not-for-profit organisation. 
There are two main problems involved in assessing performance of these 
organisations: 
• the problem of identifying and measuring objectives • the problem of identifying and measuring outputs.

Chapter 9 
 341 
Objectives 
One of the issues in performance evaluation, in any sector, is defining 
organisational objectives. Once that is done, performance indicators can be devised that indicate the extent to which such objectives have been achieved. 
In not-for-profit organisations the objectives may be much more varied, 
reflecting the variety of organisations included in the sector: 
• charities • professional institutions 
• educational establishments 
• government bodies. 
Although the detail will vary depending on the organisation involved, we could 
suggest that the general objective of not-for-profit organisations is to provide the 
best possible service within a limited resource budget: 
• Charities  will have a limited amount of funds available – they will seek to 
use these funds to provide services to as many of their beneficiaries as 
possible. It will be important not to waste money or any other resources. 
• A central government department  (health or education for example) or a 
local authority typically has a limited amount of finance available. Its objective will be to provide the best possible service to the community with the financial constraints imposed upon it. 
The problems of output measurement 
Outputs of organisations in these sectors are often not valued in monetary 
terms. How do we measure the output of a school or hospital? 
Output targets can be set in these situations, but they will always be open to 
debate and argument. 
The not-for-profit sector incorporates a diverse range of operations including 
national government, local government and charities etc. The critical thing about such operations is that they are not motivated by a desire to maximise profit. 
Many, if not all, of the benefits arising from expenditure by these bodies are non-quantifiable (certainly not in monetary terms, e.g. social welfare). The same can be true of costs. So any cost/benefit analysis is necessarily quite judgemental, i.e. social benefits versus social costs as well as financial benefits versus financial costs. The danger is that if benefits cannot be quantified, then they might be ignored. 
Another problem is that these organisations often do not generate revenue but 
simply have a fixed budget for spending within which they have to keep.

342  
 Illustration 3 – Output measures of schools 
 In many countries, governments set targets for schools in the form of 
examination pass rates – a form of output for the school. League tables 
are then published which rank schools based on their pupils’ examination results but: 
• There are many people who argue that the output of a school 
cannot be measured by examination results. They argue the output 
is a wider concept than this such as the concept of value added education. This would look at the improvement in knowledge and ability of pupils over their life at the school. But how do we measure this? 
• Comparing schools performance by publishing league tables of 
examination results is also open to question. It is of course an attempt to carry out comparative analysis of performance allowing 
one school to be measured against another. However, many people 
make the point that the tables do not compare like with like. Different schools have children from different social backgrounds for example, which may be reflected in examination results. 
The 3Es concept 
The 3Es concept is also known as the value for money (VFM) concept. This has been developed as a useful means of assessing performance in an organisation which is not seeking profit. 
The value for money in these organisations is measured through the 3Es, as 
follows: 
• Economy  (an input measure). This measures the relationship between 
money spent and the inputs. Are the resources used the cheapest 
possible for the quality required? 
• Efficiency  (link inputs with outputs). This measures whether the maximum 
output is being achieved from the resources used. 
• Effectiveness  (links outputs with objectives). This measures to what 
extent the outputs generated achieve the objectives of the organisation. 
You should note that VFM still focuses on financial performance. Not-for-profit organisations will also need to consider non-financial performance 
measurements, particularly quality.

Chapter 9 
 343 
 Illustration 4 – Examples of performance measures using the 3Es 
 Hospitals 
(1) Economy  
Comparing the standard cost of drugs used in treatments with the 
actual cost of drugs. 
(2) Efficiency  
Comparing the number of beds in use in a ward with the number of beds available in the ward. 
(3) Effectiveness  
Comparing the current waiting time for patients with the desired waiting time for patients. 
Colleges or universities 
Comparing the standard cost of tutors with the actual cost of the 
tutors. 
Comparing actual tutor utilisation in hours with planned tutor utilisation in hours. 
Comparing actual exam results (% over a certain grade or percentage passes) with desired exam results. 
 
 Example 3: Average class sizes 
 A government is looking at assessing state schools by reference to a 
range of both financial and non-financial factors, one of which is average class sizes. 
Which of the three E’s best describes the above measure? A Economy B Effectiveness C Efficiency D Externality

344  
6  Benchmarking 
Benchmarking is a technique that is increasingly being adopted as a 
mechanism for continuous improvement. CIMA's Official Terminology reads as follows: 
The establishment, through data gathering, of targets and comparators, that 
permit relative levels of performance (and particular areas of 
underperformance) to be identified. The adoption of identified best practices 
should improve performance. 
It is a continuous process of measuring a firm’s products, services and activities 
against other best-performing organisations, either internal or external to the 
firm. The idea is to ascertain how the processes and activities can be improved. Ideally, benchmarking should involve an external focus on the latest developments, best practice and model examples that can be incorporated within various operations of business organisations. It therefore represents the ideal way of moving forward and achieving high competitive standards. 
In addition to monitoring performance through variance analysis, or as an 
alternative to variance reporting, organisations might use benchmarking to 
monitor their performance, and set targets for improved performance. 
The basic idea of benchmarking is that performance should be assessed 
through a comparison of the organisation's own products or services, performance and practices with 'best practice' elsewhere. 
The reasons for benchmarking may be summarised as: 
• To receive an alarm call about the need for change • Learning from others in order to improve performance 
• Gaining a competitive edge (in the private sector) 
• Improving services (in the public sector).

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 345 
 Different types of benchmarking 
 It is important to remember that in order to use benchmarking, it is 
necessary to gather information about best practice. This leads on to the 
problem of how much information is available and where it can be obtained. 
Benchmarking can be categorised according to what is being 
benchmarked and whose performance is being used for comparison (as 'best in class'). 
• Internal benchmarking. With internal benchmarking, other units or 
departments in the same organisation are used as the benchmark. 
This might be possible if the organisation is large and divided into a number of similar regional divisions. Internal benchmarking is also widely used within government. In the UK for example, there is a Public Sector Benchmarking Service that maintains a database of performance measures. Public sector organisations, such as fire stations and hospitals, can compare their own performance with the best in the country. 
 • Competitive benchmarking. With competitive benchmarking, the 
most successful competitors are used as the benchmark. 
Competitors are unlikely to provide willingly any information for comparison, but it might be possible to observe competitor performance (for example, how quickly a competitor processes customer orders). A competitor's product might be dismantled in order to learn about its internal design and its performance: this technique of benchmarking is called reverse engineering. 
• Functional benchmarking.  In functional benchmarking, 
comparisons are made with a similar function (for example selling, order handling, despatch) in other organisations that are not direct competitors. For example, a fast food restaurant operator might compare its buying function with buying in a supermarket chain. 
• Strategic benchmarking.  Strategic benchmarking is a form of 
competitive benchmarking aimed at reaching decisions for strategic action and organisational change. Companies in the same industry might agree to join a collaborative benchmarking process, managed by an independent third party such as a trade organisation. With this type of benchmarking, each company in the scheme submits data about their performance to the scheme organiser. The organiser calculates average performance figures for the industry as a whole from the data supplied. Each participant in the scheme is then supplied with the industry average data, which it can use to assess its own performance.

346  
7  Kaplan and Norton – The balanced scorecard   
The joke 
You're at the airport and there's a little while to your flight. You have a drink to 
pass the time and a person in uniform comes and sits next to you at the bar and after a while you get chatting and you find out that she is the pilot of the aeroplane that you are about to catch. You say that it must be very difficult flying an aeroplane with all those dials and knobs and switches and meters and things, and she says, 'No, not really. All I look at is the speedometer and I figure that if I get my speed right then things are fine.' You look at her a bit funny and you say, 'Well, what about the fuel gauge? Isn't that important?' She says, 'Yes, you're right, it is important and I used to look at it, but now I just look at the speedometer'. Then you say, 'Well what about the altimeter? Surely that's important?' She replies, 'Well, yes it is, but I try and focus on one thing at a time. Once I'm happy with my airspeed then in a few flights' time I might concentrate on altitude' 
The question Kaplan and Norton now ask is would you catch that aeroplane? The point that Kaplan and Norton are trying to make (in the unlikely event that 
you missed it) is that you cannot fly an aeroplane with only one instrument. Nor can you run a business by looking at one performance measure. Kaplan and Norton's Balanced Scorecard focuses on four different perspectives. 
The balanced scorecard

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Robert Kaplan and David Norton published the original article (The Balanced 
Scorecard – Measures That Drive Performance) in the Harvard Business Review in January/February 1992. It has become one of the most requested HBR reprints. 
The traditional performance measure for a business is of course financial, but 
one problem is that the financial measures relate to the past. Another is that the financial accounting model does not adequately consider the value to a company of its intangible assets such as a happy and loyal customer base, well-motivated, well trained and efficient staff and good quality products or services. The Balanced Scorecard incorporates non-financial measures of the drivers of future performance as well as financial measures of past performance. 
In their 1996 book Kaplan and Norton state that 'Several critics have advocated 
scrapping financial measures entirely to measure business unit performance. They argue that in today's technologically and customer-driven global competition, financial measures provide poor guidelines for success. They urge managers to focus on improving customer satisfaction, quality, cycle times, and employee skills and motivation. According to this theory, as companies make 
fundamental improvements in their operations, the financial numbers will take care of themselves.' Kaplan and Norton reply that the use of financial measures still serves a purpose as it is not en ough to improve quality and customer 
satisfaction and generate new products, etc., in the end these improvements have to be converted to financial advantage. 
Kaplan and Norton also ask in their 1996 book are 4 perspectives sufficient? 
They answer their own question by saying that there is no rule that says that every organisation in the world should use exactly the 4 perspectives, and nothing else, but that in general across a variety of companies and industries the 4 perspectives do seem to work. They say that some companies do incorporate extra perspectives such as an environmental perspective, but they have yet to see a company use less than 4. 
It can be seen from the diagram above that a vital part of the Balanced 
Scorecard is the company strategy and the starting point for the creation of a Balanced Scorecard is a company's mission statement or vision. 
Measures for the balanced scorecard 
The following lists give examples of possible measures: 
Financial perspective Goals would be set in terms of 3 main areas and the measures would relate to 
those areas. 
• Survival Cash flow, gearing • Success  Monthly or quarterly sales growth and operating income 
• Prosperity  Increase in market share and ROI.

348  
• Customer profitability • Customer retention 
• Customer satisfaction 
• Customer acquisition 
• Percentage of sales from new products 
• Percentage of on-time deliveries 
• Preferred supplier status 
• Lead time from receipt of order to delivery 
• No of customer complaints. 
Internal business process perspective 
• Percentage of sales from proprietary products 
• New product introduction versus competitors also new product introduction 
versus plan 
• Manufacturing process capabilities • Time to develop next generation of products 
• Cycle time 
• Unit cost 
• Efficiency. 
Learning and growth perspective 
• Employee satisfaction 
• Employee retention 
• Employee productivity 
• Time to market 
• Percentage of products giving 80% of sales.

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 In practice : The Balanced Scorecard (CGMA cost management 
Model) 
 Implementation of the Balanced Scorecard and an alternative 
costing system at the Royal Bo tanic Garden Edinburgh (CIMA case 
study, 2010) 
The Royal Botanic Garden Edinburgh (RBGE) first adopted the Balanced 
Scorecard (BSC) in 2004. The Senior Management Group (SMG),which was responsible for strategy development, used the BSC to answer the ‘who, what, why, where, when’ questions prompted by the four perspectives as they related to the services that the RBGE provides to external stakeholders. 
The original BSC created by the RBGE was employed as the basis of 
strategy and performance reviews. However, the prospect of a strategic review by an international peer group, along with an imperative to demonstrate alignment to the Scottish Government’s National Outcomes, prompted a deeper look at the organisation’s strategic objectives and underlying perspectives. The ensuing revisions included improved alignment between the RBGE’s ‘impact’ perspective and its ‘activity’ perspective. This review also led to the development of an objective costing system linked to an existing performance management system that improved monitoring of performance against strategic objectives. 
Lessons learned 
• The Balanced Scorecard can be adapted to suit an individual 
• The effort and commitment required from senior management to 
transform strategic management processes should not be 
underestimated. 
• Resistance to change may result as individuals become more 
accountable for their actions. 
• Management accountants are well-placed in the organisation to 
become very involved in the development of the Balanced Scorecard and implementation process, thereby becoming an important strategic partner in the business.

350  
 Performance evaluation in the not-for-profit sector 
 An NFP organisation exists to achieve certain objectives and an 
evaluation of its performance in achieving those objectives must have 
regard to a combination of efficiency and effectiveness factors. The organisation should achieve the maximum output from the resources at its disposal (efficiency) and at the same time it should organise those resources in a manner that achieves a given result by the cheapest route (effectiveness). 
Many of the performance indicators considered above can be applied 
to NFPs. For example, in evaluating the performance of a local 
authority one might consider: 
1 Cost per km of road maintained 2 Cost per child in school 3 Cost per square metre of grass verge mown 4 Cost per tonne of sewage disposed of.

Chapter 9 
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These are all quantitative measures and care should be taken in their 
interpretation. For example, town A’ s sewage disposal cost might be half that of town B. Does that mean that A is more efficient than B? Not necessarily, because A might be pumping raw sewage direct into the sea whereas B treats sewage and transports it for disposal. If A is a resort town then its ‘efficiency’ in disposing of sewage might have a variety of adverse knock-on effects. In considering performance one has to consider qualitative factors. A variety of qualitative indicators might also be considered in tandem with the quantitative ones listed above: 
• Number of claims made by motorists arising from pot holed roads

352  
 • Number of local children obtaining 2 A level GCEs or equivalent 
• Rating of local road system by the Automobile Association 
• Number of complaints from visitors concerning smell/taste of sea 
water. 
Benchmarking is probably the most important recent innovation in 
performance evaluation in the NFP sector. The standard benchmarking practice can be used to: 
• Study processes in the organisation and select which are to be 
benchmarked 
• Secure suitable benchmark partners • Compare appropriate figures and indicators with partners 
• Adopt and implement ‘best practices’. 
A benchmark partner for one local authority need not necessarily be 
another local authority. For example, if the activity being benchmarked is ‘office costs’, then one could bench-mark against an insurance company or a mail order company. However, while such benchmark partners might give a local authority an idea about its efficiency in certain areas, they would offer little guidance on effectiveness. If the authority is seeking guidance on the appropriate combination of spend on police, social services, housing and so on in order to provide a certain level of welfare for elderly residents (a quest for effectiveness), then the appropriate benchmark partners would have to be other authorities providing a similar service. 
In the United Kingdom, benchmarking and its associated concept of ‘best 
practice’ are now widely used in public sector performance evaluation. The Department of the Environment rates all local authorities on the basis of periodic reviews. The use of appropriate performance indicators are a central element in these reviews. Such indicators have regard to both quantitative and qualitative factors. 
As with all performance evaluation exercises, it must be appreciated that 
the calculation of a particular indicato r will probably mean little unless it is 
set in some sort of context. Calculating the value of a particular indicator means little, until it is compared with  a budget, set in a trend or set 
against a best practice benchmark. 
One final comment in this area should be made. You are reminded of the 
Peter  principle – ‘What gets measured gets done’ .

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 If a performance evaluation is based on an incorrect or incomplete range 
of metrics, then the system can induce the wrong things to get done. For 
example, in the late 1990s the performance of hospitals was judged on the length of their waiting lists. Specifically, the average time taken for a referred patient to have a first consultation was adopted as a key performance indicator. It is claimed that this induced hospitals to concentrate on patients with minor illnesses since they could be treated quickly and cleared off the list. The small number of patients requiring major treatments often had to wait longer than was the case before the performance indicator was adopted. 
Hospital waiting lists were reduced, but not in a wholly neutral manner. 
Some people gained and some lost as a result of the system. That was never the intention.

354  
8  Practice Questions 
 Objective Test Question 1: Balanced scorecard 
 Suggest performance indicators to include in the Balanced Scorecard of 
a credit card company. 
 
Financial indicators of 
performance: 'Customers' indicators of performance: 
Learning and growth indicators of performance: Internal processes indicators of performance:

Chapter 9 
 355 
 Data Set question: Faster Pasta 
 Faster Pasta is an Italian fast food restaurant that specialises in high 
quality, moderately priced authentic Italian pasta dishes and pizzas. The 
restaurant has recently decided to implement a balanced scorecard approach and has established the following relevant goals for each perspective: 
Perspective Goal 
Customer perspective • To increase the number of new and 
returning customers 
• To reduce the % of customer 
complaints 
Internal • To reduce the time taken between 
taking a customer's order and 
delivering the meal to the customer 
• To reduce staff turnover 
Innovation and learning • To increase the proportion of revenue 
from new dishes 
• To increase the % of staff time spent 
on training 
Financial • To increase spend per customer 
• To increase gross profit margin 
The following information is also available for the year just ended and for 
the previous year. 
 20X8 20X9 
Total customers 11,600 12,000 
–  of which are new customers 4,400 4,750 
–  of which are existing customers 7,200 7,250 
Customer complaints 464 840 
Time between taking order and 
customer receiving meal  
4 mins  
13 mins 
% staff turnover 12% 40% 
% time staff spend training 5% 2% 
Revenue $110,000 $132,000 
–  revenue from new dishes $22,000 $39,600 
–  revenue from existing dishes $88,000 $92,400 
Gross profit $22,000 $30,360

356  
 Task: Answer 'TRUE' or 'FALSE' to the following assertions that 
Faster Pasta has achieved its goals of: 
Increasing the number of new and returning customers  
  
Decreasing the % customer complaints  
  
Reducing the time taken between taking the customer's order and delivering the meal to the customer  
  
Reducing staff turnover  
  
Increasing the proportion of revenue from new dishes  
  
Increasing the % of staff time spent on training  
  
Increasing the spend per customer  
  
Increasing gross profit margin  
  
 Case Study Style question – Benchmarking 
You work as Financial Controller for E5E. E5E is a charity concerned with 
heart disease. Its mission statement is as follows: 
'To fund world class research into the biology and the causes of heart 
disease; To develop effective treatments and improve the quality of life for patients; To reduce the number of people suffering from heart disease; To provide authoritative information on heart disease.' 
E5E obtains funding from voluntary donations from both private 
individuals and companies, together with government grants. Much of the work it does, in all departments, could not be achieved without the large number of voluntary workers who give their time to the organisation and who make up approximately 80% of the workforce. 
E5E does not employ any scientific researchers directly, but funds 
research by making grants to individual medical experts employed within universities and hospitals. In addition to providing policy advice to government departments, the charity’s advisors give health educational talks to employers and other groups.

Chapter 9 
 357 
 You have just received the following email from the Board's 
spokesperson:

358  
 Example 1: Wye Group 
 Solution: 
(a) Flexed budget for 2,500 units 
 $ 
Direct materials (W1) (2,500 × $2) 5,000 
Direct labour (W2) (2,500 × $8) 20,000 Production overheads (W3) 30,000 
Administration, selling and distri bution overheads (W4) 15,000 
Total cost 70,000 
 
Workings: 
(W1) Material is a variable cost – $2 per unit 
 
Variable material cost = 	$7,000
$3,500	=	$2 per unit 	
 
(W2) Labour is a variable cost – $8 per unit. 
 
Variable Labour cost = 	$28,000
$3,500 = $8 per unit 	
 
(W3) Production overheads are semi-variable. Using the high/low 
method, the variable cost is $4 per unit, the fixed cost is 
$20,000. The cost for 2,500 unit s therefore = $20,000 + (2,500 
× $4) = $30,000. 
 
Variable cost per unit = $(38,000 – 34,000)
$4,500 – 3,500 = $4 per unit 
 
Total fixed cost by substituting at high activity level:  
Total cost = $38,000 Total variable cost = 4,500 × $4 = $18,000  Fixed cost = $38,000 – $18,000 = $20,000 
(W4) Other overheads are fixed.

Chapter 9 
 359 
 (b) Budgetary control statement 
 
 Flexed 
budget 2,500 
units Actual 
2,500 
units Variance 
 $ $ $ 
Direct materials 5,000 4,500 500 (F)Direct labour 20,000 22,000 2,000 (A)
Production overheads 30,000 28,000 2,000 (F)
Administration, selling 
and distribution 
overheads  
 
15,000   
16,500   
1,500 (A)
Total cost 70,000 71,000 1,000 (A) –––––– –––––– –––––– 
    
 1 Identify the cost behaviours and calculate the cost per unit 
based on budget  
 Behaviour Cost per unit 
Direct labour variable 20,000/20,000 = $1 
Direct expenses variable 800/20,000 = $0.04 
Direct material variable 4,200/20,000 = $0.21 Depreciation fixed n/a 
Semi-variable overheads semi variable see working 
 
Working for semi-variable overhead  (high low method) 
Variable cost = change in cost/change in activity 
= ($5,000 – $4,500)/(20,000 – 15,000)  = $0.10 Fixed cost = total cost – total variable cost = $5,000 – ($0.10 × 20,000) = $3,000

360  
 2 Produce the budget control statement  
 
 Actual 
17,600 units Flexed 
17,600 units Variance 
 $ $  
Direct labour 19,540 17,600 1,940 A 
Direct expenses 1,000 704 296 A 
Direct material 3,660 3,696 36 F Depreciation 10,000 10,000 – 
Semi-variable 
overheads (W)  
4,760  
4,760  
– 
 38,960 36,760 2,200 A 
 
Working for semi-variable overheads 
Variable element 17,600 × $0.10 = $1,760  Fixed element $3,000 Total cost = $1,760 + $3,000 = $4,760 
 
 C Class sizes are the result of the number of pupils educated (output), the 
number of teachers employed (input) and how well the timetable is organised in using those teachers. Therefore this is a measure of efficiency. 
 
Financial indicators of performance: 
Increase market share year-on-
year 
Increase cardholder's spending 
Increase % fee Reduce debt 'Customers' indicators of 
performance: 
Wean businesses off cheque 
books 
Get banks to switch cards 
Focus on big spenders Issue more cards 
Maintain image 
Add reward programmes 
indicators of performance: 
Outsource IT jobs 
Acquire other companies Improve staff training levels Internal processes indicators 
of performance: 
Increased marketing spend 
Offer more products Achieve economies of scale

Chapter 9 
 361 
 Data Set Question: Faster Pasta 
  
Increasing the number of new & returning customers TRUE 
Measure:  The number of new customers has increased year on year 
from 4,400 to 4,750. This is an 8.0% increase. The number of returning 
customers has also increased slightly from 7,200 to 7,250, i.e. a 1.0% increase. 
Comment:  The company has achieved its goal of increasing the number 
of new and existing customers. It is worth noting that the proportion of 
customers who are returning customers has fallen slightly from 62.1 % to 60.4% of the total customers. This could indicate a small drop in the level of customer satisfaction. 
Decreasing the % customer complaints FALSE 
Measure:  The percentage of customer complaints has increased from 
4% (464 ÷ 11,600) to 7% (840 ÷ 12,000). 
Comment:  Faster Pasta should investigate the reasons for the increase 
in customer complaints and take the required action immediately in order 
to ensure that it can meet this goal in the future. 
Reducing the time taken between taking the customer's order and delivering the meal to the customer FALSE 
Measure:  The time taken has more than tripled from an average of 4 
minutes in 20X8 to an average of 13 minutes in 20X9. 
Comment:  Customers may place a high value on the fast delivery of their 
food. The increase in time may be linked to the increased number of 
customer complaints. If this continues customer satisfaction, and therefore profitability, will suffer in th e long-term. The restaurant should 
take steps now in order to ensure that this goal is achieved going 
forward. 
Reducing staff turnover FALSE 
Measure:  This has risen significantly from 12% to 40% and hence the 
business has not achieved its goal. 
Comment:  The reasons for the high staff turnover should be investigated 
immediately. This may be contributing to longer waiting times and the 
increase in customer complaints. This will impact long-term profitability. 
Increasing the proportion of revenue from new dishes TRUE 
Measure:  This has increased year on year from 20% ($22,000 ÷ 
$110,000) in 20X8 to 30% ($39,600 ÷ $132,000) in 20X9. Therefore, the restaurant has achieved its goal. 
Comment:  This is a favourable increase and may have a positive impact 
on long-term profitability if the new products meet the needs of the 
customers.

362  
  
Increasing the % of staff time spent on training FALSE 
Measure:  This has fallen significantly from 5% to only 2% and hence the 
company is not achieving its goal. 
Comment:  Staff may be unsatisfied if they feel that their training needs 
are not being met. This may contribute to a high staff turnover. In 
addition, staff may not have the skills to do the job well and this would impact the level of customer satisfaction. 
Increasing the spend per customer TRUE 
Measure:  Spend per customer has increased from $9.48 ($110,000 ÷ 
11,600) to $11.00 ($132,000 ÷ 12,000), i.e. a 16.0% increase. 
Comment:  This is a favourable increase. However, the issues discussed 
above must be addressed in order to ensure that this trend continues. 
Increasing gross profit margin TRUE 
Measure:  The gross profit margin has increased year on year from 20% 
($22,000 ÷ $110,000) to 23% ($30,360 ÷ $132,000). Comment:  This is a favourable increase. However, the issues discussed 
 
 Case Study Style question – Benchmarking  
 REPORT 
From:  A.N.A. 
To: Pablo Perez, The Board 
Date:  02.07.2014 
Subject:  Benchmarking 
It is undeniable that in practice, differences between charities and their 
aims make benchmarking principles difficult to apply. 
However, advantages of benchmarking for a charity like ours may be 
listed as follows: 
• A better understanding of the charity's position 
• Highlights particular areas that need changing 
• Can identify problem areas in advance 
• Can be integrated into target-setting, performance appraisal and 
bonuses 
• Could highlight areas where other charities are much more effective 
so perhaps E5E should stop those activities

Chapter 9 
 363 
 • Can be used to overcome complacency 
• Should be particularly useful in improving economy and, to some 
extent, efficiency – all charities have financial constraints and 
benchmarking would highlight areas for improvement 
• Enables better information to be provided to stakeholders – 
particularly useful in supporting applications for government funds. 
However, some disadvantages are also present: 
• Time consuming and expensive to implement 
• Finding suitable comparisons can be difficult 
• Not so useful in improving effectiveness as the stated objectives are 
very difficult to measure: 
–  ‘To fund world class research into the biology and the causes 
of heart disease.’ What is ‘world-class’? 
–  ‘To develop effective treatments and improve the quality of life 
for patients.’ How do you measure ‘quality of life’? 
–  ‘To reduce the number of people suffering from heart disease.’ 
Cause and effect can be difficult to match – can reductions in 
mortality rates be traced directly to E5E’s work? 
–  ‘To provide authoritative information on heart disease.’ How to 
measure what is ‘authoritative’? 
• Not a competitive industry – does it matter if another charity is more 
effective in certain areas? 
• Danger of information overload 
• Problems gathering information when so many staff are volunteers – 
there may be a need for extra training here as well 
• Can be de-motivating if the organisation fails to meet benchmarks. 
In summary benchmarking may help the charity become more economic 
and efficient but will not aid effectiveness.

364  
 Stages in conducting a benchmarking exercise 
There is no universally agreed set of steps to follow when conducting a 
benchmarking exercise – the following is just one suggested answer. 
E5E could use the following steps to conduct a benchmarking exercise: 1 Planning  
–  Decide what you wish to benchmark – for example, fund 
raising, % of funds passed on to recipients, % of funds raised 
from government, % of staff who are volunteers, funds raised per person, etc. 
–  Decide against whom you want to benchmark – this could 
include internal benchmarks (difficult), competitive benchmarks (e.g. other health research charities such as cancer research), activity benchmarks (e.g. universities to assess the educational aspects of E5E) and generic benchmarks (e.g. other communications organisations such as newspapers). 
–  Identify outputs required – e.g. a breakdown of funds collected, 
feedback on talks given. 
–  Determine data collection methodologies – e.g. should 
volunteers record information, should standard forms be prepared for talks, etc. 
2 Data collection  
–  Secondary/background research – getting comparators.  
–  Primary research – from the benchmark. 
3 Analysis   
–  Of the gaps – are they significant? –  Of the factors that create the gaps (enablers) – E5E would 
need to discuss findings with the relevant staff to understand 
why there are differences. For example, the benchmarking charity may have been much larger than E5E. 
4 Implementation of improvement programmes 
–  Implementation planning – for example, visiting best in class 
and observing their methods. 
–  Roll-out of new modus operandi (changes) – for example, 
setting up new training programmes for volunteer staff, 
designing new advertising, training speakers, etc. 
5 Monitoring results  
–  The process should be continuous.

Chapter 9 
 365 
 Dealing with the concerns of staff  
In each of the above stages the concerns of voluntary staff should be 
taken into account: 
• E5E should have meetings to explain to staff why benchmarking is 
being introduced, its benefits and potential problems. 
• Staff should be reassured of senior management commitment to the 
process. 
• They should be consulted when deciding what to benchmark and 
what measures to use. 
• They should be asked to help design new forms if they will be using 
them. 
• They should be asked if they have any experience of benchmarking 
– just because they are volunteers does not mean that they have 
not had jobs where such experience may be gained. 
• Emphasis should be on improvements of the processes rather than 
criticising staff. 
I trust the above helps.  
With regards AN.

367 
C3: Managing and controlling 
organisational units Explain the behavioural and transfer pricing issues related to the management of responsibility centres 
(a) Explain behavioural 
issues 
(b) Use and ethics of transfer 
pricing 
 
  Chapter 
10

368  
 
2  Performance management: behavioural consequences 
When an organisation is structured into profit centres or investment centres, 
authority is delegated to the profit centre or investment centre managers. These managers are given the authority to take decisions at a local level, without having to wait for instructions from head office. 
Control is applied from head office through performance measurement: centre 
managers are held accountable for the profits or returns that they make. 
The purposes of decentralisation should be to: 1 give autonomy to local centre managers in decision-making 2 motivate centre managers to improve performance: with profit centres and 
investment centres, this includes moti vating them to increase profitability 
3 through performance enhancement at a profit centre level, to achieve 
better results for the organisation as a whole. 
Decentralisation can create tension between local centre managers and head 
office management. 
The performance of the managers of profit centres and investment centres will 
be assessed, and the managers themselves will be rewarded, on the basis of the results of their particular centre. Pr ofit centre managers will therefore be 
motivated to optimise the results of their own division, regardless of other profit centres and regardless of the organisation as a whole. 
When head office management believe that a profit centre manager is taking 
decisions that improve the profit centre performance, but are damaging for the interests of the organisation as a whole, they might want to step in and either: 
1 alter the decisions that have been made at profit centre level, or
 
2 make new decisions for the profit centre.  
However, if head office interferes in decision-making at profit centre level, local 
autonomy in decision making is lost.

Chapter 10 
 369 
3  Transfer pricing 
In an organisation with profit centres and investment centres, there will almost 
certainly be some inter-connection between different centres. Some profit centres will supply goods and services to others. 
When inter-divisional  (inter-company) trading takes place between profit 
centres, the centre providing the goods or services to the other will want to earn 
income from the transfer. Unless it receives income from the transfer, it will make 
a loss on the transaction. 
For example, if Division A provides items to Division B that cost $10 each to 
make, Division A must earn at least $10 from the transfer, otherwise it will make a loss. If decision making is delegated to profit centre management, the manager of Division A would refuse to supply Division B unless it is allowed to earn income of at least $10 for each unit. 
Inter-divisional transfers must therefore be priced. The price of the transfer is 
the transfer price. 
• The transfer is treated as an internal sale and an internal purchase within 
the organisation. It provides sales income to the supplying division and is a purchase cost for the receiving division. 
• The sales income of one division is offset by the purchase cost of the 
other division. The transfer therefore affects the profits of the two divisions individually, but has no effect on the profit of the organisation as a whole. 
 
Setting a transfer price: Inter-divisional trading policy  
 The transfer price for inter-divisional transactions is significant because: 
• it determines how the total profit is shared between the two 
divisions, and 
• in some circumstances, it could affect decisions by the divisional 
managers about whether they are willing to sell to or buy from the other division. 
Both divisions must benefit from the transaction if inter-divisional 
sales are to take place. 
• A selling division will not agree to sell items to another division 
unless it is profitable for the selling division to do so. 
• Similarly, a buying division will not wish to purchase items from 
another division unless it is profitable for the division.

370  
 Transfer prices have to be established and agreed . They could be 
decided either centrally or locally. 
• They could be imposed by head office. • Alternatively, they could be decided by commercial negotiation 
between the profit centre managers. 
• If decentralisation is to allow the power of decision making to profit 
centre managers, they should have the authority to agree transfer 
prices by discussion or negotiation between themselves. 
Inter-divisional trading should take place within a broad company policy, that: 
• for a ‘selling division’, given the choice between making a sale to an 
external customer or supplying goods or services to another division 
within the group, the preference should be to sell internally  
• for a ‘buying division’, given the choice between purchasing from an 
external supplier or from another division within the company, the preference should be to purchase internally . 
However, a division should be allowed to sell externally rather than transfer internally, or buy externally rather than internally, if it has a good commercial reason. Good commercial reasons would include an external customer offering a higher price, or an external supplier offering a lower price. 
 
 Example 1: Inter-divisional trading 
 A company has two profit centres, Centre A and Centre B. Centre A 
supplies Centre B with a part-finished product. Centre B completes the production and sells the finished units in the market at $35 per unit. 
Budgeted data for the year: 
Number of units transferred/sold 10,000 10,000 
Materials costs $8 per unit $2 per unit 
Other variable costs $2 per unit $3 per unit Annual fixed costs $60,000 $30,000 
Required: 
Calculate the budgeted annual profit of each profit centre and the 
organisation as a whole if the transfer price for components supplied by Division A to Division B is: 
(a) $20 (b) $25

Chapter 10 
 371 
4  Objectives of transfer pricing 
1 Goal congruence  
Within a divisionalised company, divisional managers will have 
responsibility for and will be judged on their division's performance. They 
will act independently, autonomously and selfishly in the best interests of their own division. They neither know nor care what is happening in other divisions. 
It is the task of the management accounting system in general and the 
transfer pricing policy in particular to ensure that what is good for an individual division is good for the company as a whole. 
2 Performance measurement  
The transfer pricing system should result in a report of divisional profits that is a reasonable measure of the managerial performance. 
3 Maintaining divisional autonomy  
One of the purposes of decentralisation is to allow managers to exercise greater autonomy. There is little point in granting additional autonomy and then imposing transfer prices that will affect the profitability of the division. 
4 Minimising the global tax liability  
When a divisiona lised company operates entirely within one tax regime 
the transfer pricing policy will have a minimal impact on the corporate tax bill. However multinational companies can and do use their transfer pricing 
policies to move profits around the world and thereby minimise their global tax liabilities. 
5 Recording the movement of goods and services 
In practice, an extremel y important function of the transfer pricing system 
is simply to assist in recording the movement of goods and services. 
6 A fair allocation of profits between divisions Most of the advantages claimed for divisionalisation are behavioural. 
Insofar as transfer pricing has a material effect on divisional profit it is essential that managers perceive the allocation of corporate profit as being fair if the motivational benefits are to be retained. 
Needless to say, a number of these objectives can conflict with each other, and prove difficult to achieve in practice. It is highly unlikely that any one method would meet all the firm's requirements in all circumstances the best that can be hoped for is a reasonable compromise.

372  
 Bases for setting a transfer price 
 In broad terms, there are three bases for setting a transfer price: 
1 market-based prices 
2 cost-based prices 3 negotiated prices. A market-based transfer price might be agreed when there is an 
intermediate market for the transferred item. An intermediate market is a term to describe an external market for the goods or services of the selling division. The selling division can therefore make its profits either by transferring the goods or services internally, or selling them in the 
external market. 
 A market-based  transfer price could be: 
• the price for the item in the external market (‘intermediate market’), 
or at a discount to the external market price, to allow for a share of 
the savings in selling costs that the selling division enjoys by transferring internally rather than selling externally. For example, packaging, distribution and warranty costs may be saved by transferring internally. 
A cost-based  transfer price could be: 
• the marginal cost to the selling division of making the product or 
providing the service 
• the selling division’s marginal cost plus a mark-up for profit 
• the full cost to the selling division of making the product, or 
• the selling division’s full cost plus a mark-up for profit. 
When a transfer price is based on cost, it could be actual cost or 
budgeted cost. The most suitable basis would be budgeted cost (or standard cost). 
• Standard costs or budgeted costs are known in advance; therefore 
transfers can be priced as they occur. The selling division can 
invoice the buying division immediately for all items transferred. 
• Actual costs are not known until after the end of the accounting 
period. There would consequently be a delay in pricing transfers and issuing invoices. 
• If transfers are at standard or budgeted cost , the selling division’s 
manager could be motivated to improve profits by keeping actual costs below the standard or budgeted amount.

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 The intermediate market 
 The intermediate market for the products or services of a selling division 
could be: 
• perfect 
• imperfect, or 
• non-existent. 
A perfect intermediate market 
If the intermediate market is perfect, all suppliers to the market are able 
to sell all their output at the prevailing market price. There are no restrictions on sales demand at that price, and no individual supplier dominates market supply. 
When a selling division has a perfect external market for its output, it is 
therefore able to: 
• sell all its output on the external market at the market price, and 
• provided that it can sell at a price above its marginal cost, the only 
limitation on profitability from external sales is the output capacity of 
the division. 
An imperfect intermediate market 
An intermediate market is imperfect when the selling division is unable to 
sell all its output externally at the same market price. This can happen when the division is a dominant influence in the market, and monopoly or oligopoly conditions apply. In order to sell larger volumes of output in the intermediate market, the division is therefore required to reduce the sales price. 
When there is an imperfect intermediate market, the problem of 
identifying a suitable transfer price for inter-divisional sales becomes fairly complex. 
It might be possible to establish for the intermediate market a ‘demand 
curve’, showing the volume of sales demand at different prices. Demand curves are difficult to establish in practice, although some companies do use them. However, demand curves are common in the academic literature on transfer pricing and there could be examination questions on the topic.

374  
 A demand curve 
The rule of market prices is that the total market demand for an item 
varies with the sales price. If the relationship between sales price and sales demand is linear, a demand curve could be expressed by the formula: 
P = a + bQ where P is the sales price for all items sold Q is the quantity of items sold Values can be established for a and b. When the price is a, Q should be 
zero. 
Example 
Division X in Tropp Group has an imperfect intermediate market for its 
product B55. The demand curve for B55 is: 
P = 100 – 0.005Q This demand curve shows that: 
• the maximum sales price is 100, but at this price sales demand 
would be zero 
• for each reduction in price of 0.005, sales demand will increase by 
1 unit 
• at a price of 0, sales demand will be 20,000 units (= 100/0.005). 
Marginal revenue 
Marginal revenue is the extra revenue that will be earned by selling one 
additional unit in the market. In a perfect market, the marginal revenue for a company is always the market price of the item, because all output can be sold at the prevailing market price. 
When the market is imperfect, marginal revenue is  always lower than the 
market price.

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 If you are familiar with differentiation, you will no doubt know how to 
calculate marginal revenue from a demand curve. If you are not familiar 
with differentiation, the following rules should be learned: 
• The demand curve gives a value for P: P = a + bQ • Total revenue = P × Q 
• Substituting, we get: Total revenue = (a + bQ) × Q  
Total revenue = aQ + bQ
2 
• Marginal revenue is found by differentiating aQ + bQ2  
Without going into the details of the arithmetic:  Marginal revenue (MR) = a + 2bQ 
 Example The demand curve for product B55 is: P = 100 – 0.005Q  Total revenue (TR) from selling B55 = (100 – 0.005Q) × Q  TR = 100Q – 0.005 Q
2 
The marginal revenue from sellin g each extra unit of B55 is:  
MR = 100 – (2 × 0.005)Q MR = 100 – 0.010Q 
Maximising profit 
In an imperfect market, profits are maximised by selling output up to a 
volume where marginal revenue = marginal cost. 
The profit-maximising rule of MR = MC comes from economics and, in 
economics, cost includes an element for normal profit. However, the same rule can be applied in accounting, where marginal cost does not include a profit element. 
This rule might have to be applied in order to determine the profit-
maximising output for a company as a whole, and for a profit centre within the company.

376  
5  Transfer Pricing: general rules 
The general rule for decision-making is that all goods and services should be 
transferred at opportunity cost . For performance evaluation, the aim is to set a 
transfer price that will give a fair measure of performance in each division, i.e. profit. 
There are 3 possible situations: 1 A situation where there is a competitive market for an intermediate product 2 A situation where the selling division has selling capacity 3 A situation where there are production constraints, and the selling division 
has no surplus capacity. 
These will be detailed below in turn. 
6  Transfer Pricing: a competitive market for an intermediate 
product 
A perfect market means that there is only one price in the market, there are no 
buying or selling costs and the market is ab le to absorb the entire output of the 
primary division and meet all of the requirements of the secondary division. 
OPTIMUM TP (DM) = MARKET PRICE + ANY SMALL 
ADJUSTMENTS 
 
 TP in a perfect intermediate market 
 Perfect intermediate market and no variable selling costs 
Division A of the Robin Group makes a product A22, which it sells 
externally and to another division in the Group, Division B. Division B uses product A22 as a component in product B46, which it sells externally. There is a perfect external market for both A22 and B46. 
Costs and sales prices are as follows: 
 Division A 
Product A22 Division B 
Product B46 
Variable production cost $12 per unit  
Further variable costs  $15 per unit 
Fixed costs $200,000 $300,000 
Sales price $20 per unit $45 per unit 
Division A can either sell product A22 externally for $20, or transfer the 
product internally to Division B. Unless the transfer price is $20 or more, Division A will prefer to sell externally, in order to maximise its profit. 
Division B can either buy product A22 from external suppliers at $20, or 
buy internally from Division A. If the transfer price exceeds $20, Division B will prefer to buy externally, in order to minimise its costs and so maximise its profit.

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• The only transfer price at which Division A and Division B will be 
willing to trade with each other is $20, the external market price . 
• At a transfer price of $20, each division would produce and sell up 
to its capacity. Each division would maximise its profit by making 
and selling as much as possible, an d the total company profit would 
be maximised. Goal congruence would be achieved. 
• In both Divisions A and B, the manager should be motivated to 
make and sell as much as possible, and to keep costs under control, in order to maximise profit. 
• This price would probably be negotiated freely between the 
managers of Divisions A and B, without head office interference. 
• The performance of each profit centre would be measured on a fair 
basis. 
• If company policy is to encourage inter-divisional sales unless there 
is a good commercial reason for se lling or buying externally, the two 
divisions should trade internally up to the output capacity of the lower-capacity division. 
Another way of stating the ideal transfer price is: 
 $ 
Marginal cost in Division A 12 
Opportunity cost: contribution forgone from external sale by 
transferring a unit to Division B: ($20 – $12) 8 
––– 
Ideal transfer price (= market price) 20 
––– 
It can be seen that, in these circumstances, setting the transfer price as the market price satisfies all of the objectives of a transfer pricing system. 
Perfect intermediate market, but with variable selling costs 
If there are variable selling costs or buying costs in the intermediate 
market: 
• it will cost the selling division more  to sell externally than to transfer 
internally, or 
• it will cost the buying division more to purchase from an external 
supplier than to buy internally. 
It is therefore cheaper and more profitable to transfer internally than to 
sell or buy externally. The cost savings can be reflected in an adjustment to the transfer price, so that both divisions share the benefit.

378  
 Example 
The example of divisions A and B of the Robin Group will be used again, 
except that the costs and sales prices are as follows: 
 
 Division A 
Product A22 Division B Product B46 
Variable selling cost in the external market $3 per unit  
Division A can either sell product A22 externally for $20 to earn a 
contribution of $5 per unit ($20 – $15) or transfer the product internally to Division B to earn a contribution of $8. The manager of Division A would prefer to sell to Division B because it is cheaper and more profitable. The lowest transfer price that Division A would accept is $17. 
 $ 
External selling price 20 
External variable selling cost (3) 
––– 
Minimum transfer price (= market price) 17 
––– 
buy internally from Division A. If the transfer price exceeds $20, Division B will prefer to buy externally, in order to minimise its costs and so maximise its profit. 
• There is a range  of ideal transfer prices, between $17 and $20, at 
which Division A and Division B will be willing to trade with each 
other. 
• If the transfer price is set between $17 and $20, each division would 
produce and sell up to its capacity. Each division would maximise its profit by making and selling as much as possible, and the total company profit would be maximised. Goal congruence would be achieved. 
make and sell as much as possible, and to keep costs under control, in order to maximise profit.

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 379 
 • This price would probably be negotiated freely between the 
However, the manager of Division B might need to be aware that Division A is saving costs by selling internally, in order to extract a price concession in negotiations on the transfer price. 
basis. 
It can be seen that there is a range of prices which will satisfy the general objectives of a transfer pricing system.  
7  Transfer Pricing: the selling division has surplus capacity 
A situation might arise where a profit centre has an intermediate market for its output, and also sells internally, but: 
–  there is a limit to the amount that it can sell externally, and  –  it has spare capacity. In such a situation, the opportunity cost of transferring units internally would be 
nil, and the ideal transfer price would be based on cost, not the external market price. The opportunity cost of transferring units internally is nil because the selling division can meet external demand in full, and still have excess capacity for making inter-divisional sales. The ideal transfer cost would therefore 
be marginal cost. 
OPTIMUM TP (DM) = MARGINAL COST

380  
 Example 2: Spare capacity 
 Alameda Ltd has two divisions, Division Alpha and Division Beta. Division 
Alpha makes widgets, which it can sell externally for $45 as well as 
internally to Division Beta. The marginal cost of making a widget is $30 per unit in Division Alpha, and the division has spare capacity. 
Division Beta turns widgets into another product, the bidget, at a marginal 
cost of $55 per unit. Division Beta can then sell bidgets externally for $120 per unit. External sales of widgets incur a variable distribution cost of $3 per unit: 
 
The lowest transfer price Division Alpha will accept is  
$___________________________ 
 
The problem is that transferring at marginal cost is unlikely to be 'fair' to the 
supplying division. 
There are three possible solutions: (i)  2 part tariff  
The transfer price is marginal cost, but in addition a fixed sum is paid per 
annum or per period to the supplying division to go at least part of the way towards covering its fixed costs, and possibly even to generate a profit. A two-part tariff has a number of disadvantages: 
–  It may not provide motivation to the selling di vision manager. 
–  The measurement of the performance of the selling division may not 
be fair. 
–  The negotiation process may be time consuming and a fair profit may 
have to be imposed by head office.

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 381 
 Archer Group  
 Archer Group has two divisions, Division X and Division Y. Division X 
manufactures a component X8 which is transferred to Division Y. Division 
Y uses component X8 to make a finished product Y14, which it sells for $20. There is no external market for component X8. 
Costs are as follows: 
 Division X 
Component X8 Division Y 
Product Y14 
Variable production cost $5 per unit $3 per unit* 
Annual fixed costs $40,000 $80,000 
 
* Excluding the cost of transferred units of X8.  
Under a two-part tariff transfer pricing arrangement, Division Y would pay: 
1 a fixed fee of $40,000 each year plus possibly a negotiated mark up 
for profit, plus 
2 $5 for each unit of component X8 transferred. A two-part tariff should ens ure that the selling division would not make a 
loss, and would make a profit if its actual costs are less than the agreed 
transfer price fixed fee and/or a profit mark-up has been allowed for in the fixed fee. 
However, there is no incentive for the manager of Division X to produce 
more output. 
 
(ii) Cost-plus pricing  
The transfer price is the marginal cost or full cost plus a mark-up. Using standard costs should be fair and up-to-date. If transfers are made at actual costs instead of standard costs, there is no incentive for the supplying division to control costs, as they can all be passed on to the receiving division. 
(iii) 'Dual pricing'  
Dual pricing is where one transfer price is recorded by the supplying division and a different transfer price is recorded by the buying division. 
An adjustment account in the HQ books holds the differences between the 
divisions.

382  
 Fern Group 
 Fern Group has two divisions, Domestic and Business. Business Division 
manufactures computer desks for business customers. Its annual c apacity is 
15,000 desks, but currently annual demand is only 10,000 desks. 
The marginal cost of making a desk in Business Division is $600, and the 
desks sell for $800. Fixed costs in the Business Division are $1,500,000. 
Domestic Division makes and sells furniture items for retail customers. Its 
manager has seen an opportunity to make some alterations and additions to the Business Division computer desk, and sell it to retail customers as an IT desk for the home. 
The extra cost of amending and improving the Business Division desk 
would be $200 per desk. The Domestic Division manager believes he could sell 5,000 desks for the home each year at $880 each. However, he would not want to pay Business Division more than $560 for each desk. 
Required: 
How might a dual transfer price arrangement help to reach an agreement 
between the two divisions? 
Solution: 
The first step with any transfer pricing problem is to establish what is in 
the best interests of the company as a whole. 
In this example, it is in the interests of the company for Domestic Division 
to make and sell the 5,000 IT desks for the home. 
 
Selling price $880 
Marginal cost in Business Division $600 
Marginal cost in Domestic Division $200 
Total marginal cost for each unit $800 
Contribution for each unit sold $80 
Total increase in annual contribution (5,000 units) $400,000 
The company should want the Domestic Division to make and sell the IT desks, and Business Division has sufficient spare capacity to meet the demand without affecting its own external sales of computer desks. 
However, Business Division will not agree to a transfer price below 
marginal cost. At a transfer price of $560, it would lose $40 for each unit transferred. 
Head office could try to persuade the manager of Domestic Division to 
agree to a transfer price at marginal cost plus. A transfer price between $600 and $680 would share the marginal profits between the two divisions.

Chapter 10 
 383 
 If head office suggested a price above $600, the Domestic Division 
manager might decide to drop the plan to make and sell the IT desks, 
since the hoped-for extra profit might not be sufficient to justify the risk of offering a new product to the market. To get round the problem, head office might decide on dual transfer prices : 
1 Domestic Division should buy desks from Business Division at 
$560 per unit. 
2 Business Division should be paid in excess of marginal cost for 
supplying desks to Domestic Division. A transfer price of $610 might be offered. 
3 The difference $50 ($610 – $560) between the two transfer prices 
would be a charge to head office. 
4 With this arrangement, Business Division would supply 5,000 desks 
to Domestic Division. 
5 Business Division would make additional annual profits of $10 per 
desk ($50,000 in total). 
6 Domestic Division would make a contribution of $120 per desk sold 
($880 – $200 – $560) and so increase annual profits by $600,000. 
7 Head office would take a charge of $50 per desk or $250,000 in total. 
8 The company as a whole would benefit by $50,000 + $600,000 – 
$250,000 = $400,000. 
 
 Example 3: Pool Group 
 Pool Group has two divisions that operate as profit centres. Each centre 
sells similar products, but to different segments of the market: 
• Division P makes product P29 which it sells to external customers for 
$150. Variable costs of production are $45 per unit. The maximum 
annual sales demand for P29 is 5,000 units, although Division P has capacity for 7,000 units. Increasing output from 5,000 to 7,000 each year would result in additional fixed cost expenditure of $8,000. 
• The manager of Division L has seen an opportunity to sell an 
amended version of Product P29 to its own customers, and is interested in buying 2,000 units each year to re-sell externally at $90 per unit. The costs of amending Product P29, for sale as Product L77, would be $25 per unit. However, the manager of Division L will not pay more than $40 per unit of Product P29. 
He argues that Division P will benefit from lower fixed costs per unit 
by working at full capacity. The manager of Division P refuses to sell at a price that does not cover the division’s incremental costs. 
Required: 
Suggest a dual transfer pricing arrangement that might overcome the 
disagreement between the two divisional managers.

384  
8  Transfer Pricing: Production constraints and the division has 
no surplus capacity 
The shadow price is the opportunity cost of the lost contribution from the other 
product or it is the extra contribution that would be earned if more of the scarce resource were available. 
OPTIMUM TP (DM) = MARGINAL COST + SHADOW PRICE 
 
 Example 4: No spare capacity 
Alpha makes widgets, which it can sell externally for $45 as well as internally to Division Beta. The marginal cost of making a widget is $30 per unit in Division Alpha, and the division has no spare capacity. 
Division Beta turns widgets into another product, the bidget, at a marginal cost of $55 per unit. Division Beta can then sell bidgets externally for $120 per unit. External sales of widgets incur a variable distribution cost of $3 per unit: 
 
$___________________________

Chapter 10 
 385 
 Transfer pricing: Behavioural considerations 
 Transfer prices tend to vary over the product life cycle according to Cats-
Baril et al. (1988). During the introductory phase, they suggest a cost plus 
fixed fee or cost plus a profit share. During the growth phase, they suggest a price related to the closest substitute and during maturity a price based on identical products. This is common sense to a large extent. It is probably only during the maturity stage that identical substitutes exist and during the introductory phase there may be no basis other than cost on which to base the price. 
Using any actual cost or cost plus as a transfer price does not motivate 
the supplying division to act in the interest of the group. Standard or 
predetermined costs should always be used in place of actual cost. If actual cost is used, the supplying division is not encouraged to be efficient, and control costs as inefficiencies are passed on to the receiving division by way of a higher transfer price. It is even worse if a mark-up is used because the selling division is encouraged to push up the actual cost as this will increase the mark-up, and increase the division’s profit. Standard costs are at least subject to scrutiny when they are set once a year and the receiving division has a chance to challenge them. If standard cost is used, the selling division has an incentive to control actual costs below that level and so increase its own profits. 
 It is usual to imagine transfer pricing taking place in vertically integrated 
manufacturing organisations. This is not the norm today. Transfer pricing takes place in many different types of organisation and it can have a profound effect on behaviour. For example, a garage carries out a number of different activities that are linked to the activities of another section. The activities include selling new cars, selling old cars, servicing cars sold, general repairs, repairing and servicing used cars accepted in part payment, providing financing and so on. A transfer price is used to transfer a used car accepted in part-payment for a new car between the new car sales and used car sales divisions. A transfer price will also have to be established for transferring the cost of servicing and repairing these cars for sale between the servicing division and the used car sales division. These prices will have considerable implications for the profitability of the different sections and on the actions of the employees when making sales deals. If performance measurement and assessment is to be fair, transfer prices need to be set carefully. 
Transfer prices can also be used to deter competitors. If a vertically 
integrated company concentrates profits at the stage of production where there is least competition, competitors may be attracted to enter. On the other hand, competitors operating at the other stages may be disadvantaged by the low profits the vertically integrated company is taking and they may not be able to achieve a satisfactory return if they are only operating in a limited area of the value chain. Neghandhi (1987) cites cases of US oil companies and Japanese trading and manufacturing companies doing this.

386  
9  International transfer pricing 
Transfers within an international gr oup will often be cross-border, between 
divisions in different countries. With international transfers and international 
transfer pricing, the issues already described in this chapter still apply. In addition, other factors need to be considered. 
10  Different tax rates 
A multinational company will seek to minimise the group’s total tax liability. One way of doing this might be to use transfer pricing to: 
• reduce the profitability of its subsid iaries in high-tax countries, and 
• increase the profitability of its s ubsidiaries in low-tax countries. 
Changes in the transfer price can redistribute the pre-tax profit between 
subsidiaries, but the total pre-tax profit will be the same. However, if more pre-tax profit is earned in low-tax countries and less profit is earned in high-tax countries, the total tax bill will be reduced. 
 
Taxation and transfer pricing 
 Multinational organisations have a natural inclination to set transfer prices 
in order to minimise tax payments. 
Taxation 
If a group has subsidiaries that operate in different countries with different 
tax rates, the overall group corpor ation tax bill could be reduced by 
manipulating the transfer prices between the subsidiaries. 
For example, if the taxation rate on profits in Country X is 25 per cent and 
in Country Y it is 60 per cent, the group could adjust the transfer price to increase the profit of the subsidiary in Country X and reduce the profit of the subsidiary in Country Y. Thus, if the subsidiary in Country X provides goods or services to the subsidiary in Country Y, the use of a very high transfer price would maximise the profits in the lower-tax country, and minimise the profits in the higher-tax country. 
There is also the temptation to set up marketing subsidiaries in countries 
with low corporation tax rates and transfer products to them at a relatively low transfer price. When the products are sold to the final customer, a low rate of tax will be paid on the difference between the two prices.

Chapter 10 
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 The taxation authorities in most countries monitor transfer prices in an 
attempt to control the situation and in order to collect the full amount of 
taxation due. Double taxation agreements between countries mean that companies pay tax on specific transactions in one country only. However, if the company sets an unrealistic transfer price in order to minimise tax, and the tax authority spots this, the company will pay taxation in both countries, that is, double taxation. This additional payment can amount to millions of pounds and, as a result, is quite an effective deterrent. On the other hand, the gains of avoiding taxation may be even greater. 
It appears that lax transfer pricing rules and legal accounting techniques 
let multinationals structure their businesses so that profits are moved to low or no-tax jurisdictions to reduce their liabilities. Losses can appear to be incurred in high-tax jurisdictions, like the UK, to increase allowable tax deductions. 
For example, Starbucks’ UK sales in 2011 were worth £398m. Costa’s UK 
sales were worth £377m. But while Costa paid £15m in corporation tax in 2011/12, Starbucks paid nothing! How is this possible? Even though these 2011 sales were worth £398 million, its costs were recorded as £426.2m, giving a loss of £28.2m. Costa, by contrast, reported a taxable profit of £49.7m. 
So how could reported UK losses be reconciled with an ongoing UK 
operation? The answer lies in transfer pricing. Whilst there is no evidence that the company had broken tax rules in any of the countries where it operated, Starbucks had used transfer pr icing that routed profits to 
Switzerland to reduce their UK profits. The result was that despite Starbucks apparently being a highly successful UK operation, their UK tax liability was almost non-existent. 
All of Starbucks' businesses worldwide,  including in the UK, bought their 
coffee from its Switzerland office, which allegedly charged a 20% mark-up 
on the price at which it bought its coffee in the wholesale market. So, Starbucks bought coffee beans for the UK through a Swiss company, Starbucks Coffee Trading Co. Before the beans reached the UK, they were roasted at a Dutch subsidiary. Corporate profits were taxed at 24 percent in the UK and 25 percent in the Netherlands, whereas profits tied to international trade in commodities like coffee were taxed at rates as low as 5 percent in Switzerland. 
The UK Public Accounts Committee doubted the 20% mark-up that the 
Netherlands based company paid to the Swiss based company on its coffee buying operations, with a further mark up before it sold to the UK, was reasonable. Starbucks agreed that it had a special tax arrangement 
with the Netherlands that made it attractive to locate business there, which the Dutch authorities allegedly asked Starbucks to hold in confidence, and that Switzerland offered a very competitive tax rate: and there we have the public’s perception of transfer pricing, a device to remove profits from the UK to these areas with lower tax.

388  
 Starbucks declined to give details, or comment on what the charges 
indicated about the price its roaster paid its Swiss unit for coffee beans. It 
also declined to say what profit the Swiss coffee-buying unit made. Under Swiss law, the unit was not obliged to publish accounts. 
What was clear was that while its UK subsidiary registered a loss, its 
Dutch roasting operation had only a small profit. In the previous three years, the Amsterdam unit had had an average annual turnover of 154 million euros but recorded average profit  of 1.6 million euros, or 1 percent 
of that, according to its accounts. 
Starbucks was the subject of a UK customs inquiry in 2009 and 2010 into 
the company's transfer pricing practices. This was "resolved without recourse to any further action or penalty", a Starbucks spokesman said. 
Most countries now accept the Organisation for Economic Co-operation and Development’s (OECD) guidelines. These guidelines were produced with the aim of standardising national approaches to transfer pricing as part of the OECD’s charter to encourag e the freedom of world trade. They 
provide guidance on the application of ‘arm’s length’ principles. They state that where necessary transfer prices should be adjusted using an ‘arm’s length’ price, that is, a price that would have been arrived at by two unrelated companies acting independently. 
 
 Example 5: Seacross 
 Seacross Group has two subsidiaries, UKD in the UK and GD in 
Germany. 
UKD makes and sells Product S99. The variable cost of manufacture in 
the UK is £200 per unit and annual fixed costs are £210,000. Product S99 sells for £500 per unit in the UK market and annual demand is 800 units. 
GD in Germany buys 400 units of S99 from UKD each year, adapts them 
for the German market, and sells them for the equivalent of £700 per unit. The variable costs of adapting the product and selling it in Germany are £50 per unit. The cost of shipping the 400 units to Germany is £6,000 and these are paid by GD. Fixed costs in GD are £24,000 each year. 
The rate of taxation on company profits is 30% in the UK and 50% in 
Germany. 
Required: 
What would be the annual after-tax profits of the group if the transfer 
price for S99 is: 
(a) its UK market price, £500 (b) its variable cost of manufacture, £200?

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11  Government action on transfer prices 
Governments are aware of the effect of transfer pricing on profits, and in many 
countries, multinationals are required to justify the transfer prices that they charge. Multinationals could be required to apply ‘arm’s length’ prices to transfer prices: in other words, they might be required under tax law to use market-based transfer prices, to remove the opportunities for tax avoidance. 
Multinationals might set up subsidiary companies in tax havens, trade 
through these companies, and hope to re duce their total tax liabilities. Tax 
avoidance, while legitimate, can be seen as aggressive when it involves using financial instruments and arrangements not intended as a way to obtain tax advantage. So it is also possible that some countries wishing to attract business might have tax laws that are very favourable to business. A country with the status of a ‘tax haven’ might offer: 
• a low rate of tax on profits 
• a low withholding tax on dividends paid to foreign holding companies 
• tax treaties with other countries 
• no exchange controls 
• a stable economy 
• good communications with the rest of the world 
• a well-developed legal framework, within which company rights are 
protected. 
Unlike tax evasion, tax avoidance is not illega l; it is operating within the letter, 
but perhaps not the spirit, of the law. Businesses may therefore be complying 
with the law – but is it ethical? 
12  Transfer pricing to manage cash flow 
Some governments might place legal restrictions on dividend payments by companies to foreign parent companies. 
In this situation, it would be tempting for a multinational to sell goods or services 
to a subsidiary in the country concerned from other divisions in other countries, and charge very high transfer prices as a means of getting cash out of the country. 
This tactic is not possible, however, when the country’s tax laws require that 
transfer prices should be set on an arm’s length basis.

390  
13  International transfer pricing and currency management 
When inter-divis ional transfers are between subsidiaries in different  countries or 
currency zones, a decision has to be made about the currency to select for 
transfer pricing. 
Exchange rates, even for strong currencies, can be very volatile and 
subsidiaries could make unexpected profits or losses from movements in an exchange rate. 
Example: A UK subsidiary sells goods to a US subsidiary for $12.80 per unit. 
The exchange rate was £1 = $1.60 when the transfer price was agreed, and the cost of making each unit in the UK and shipping it to the US is £6. 
When the exchange rate is $1.60, the sterling equival ent value of the $12.80 
transfer price is £8, and the UK subsidiary makes a profit of £2 per unit 
transferred. 
However, if the dollar weakened in value, and the exchange rate moved to 
$2.00, the sterling value of the transfer price would fall to £6.40, and the profit per unit would fall to £0.40. 
The implications for an international group of currency risk in transfer prices are 
(i)  With inter-divisional trading between subsidiaries in different currency 
zones, one subsidiary or the other (or possibly both, if the transfer price is 
set in a third currency) will be exposed to a risk of losses from adverse movements in the exchange rate. 
(ii) When one subsidiary  makes a loss on an adverse exchange rate 
movement, the other will make a profit. 
(iii) The company as a whole should ma nage its exposures to currency risks. 
This might be the responsibility of either the profit centre managers or a treasury department. 
(iv) When it is fairly certain which way an exchange rate might move in the 
future, a multinational company might be tempted to set transfer prices in a currency such that any currency losses arise in the subsidiary in the high-tax country, and currency profits arise in the country with the lower tax rate.

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 Example 6: Multinational computer manufacturer 
 A multinational computer manufacturer has a number of autonomous 
subsidiaries throughout the world. Two of the group’s subsidiaries are in 
America and Europe. The American subsidiary assembles computers using chips that it purchases from local companies. The European subsidiary manufactures exactly the same chips that are used by the American subsidiary but currently only sells them to numerous external companies throughout Europe. Details of the two subsidiaries are given below: 
America 
The American subsidiary buys the chips that it needs from a local 
supplier. It has negotiated a price of $90 per chip. The production budget shows that 300,000 chips will be needed next year. 
Europe 
The chip production subsidiary in Europe has a capacity of 800,000 chips 
per year. Details of the budget for the forthcoming year are as follows: 
Sales: 600,000 chips Selling price $105 per chip Variable costs $ 60 per chip The fixed costs of the subsidiary at the budgeted output of 600,000 chips 
are $20 million per year, but they would rise to $26 million if output exceeds 625,000 chips. The maximum external demand is 600,000 chips per year and the subsidiary has no other uses for the current spare capacity. 
Group directive 
The Managing Director of the group has reviewed the budgets of the 
subsidiaries and has decided that, in order to improve the profitability of the group, the European subsidiary should supply chips to the American subsidiary. She is also thinking of linking the salaries of the subsidiary managers to the performance of their subsidiaries but is unsure which performance measure to use. Two measures that she is considering are ‘profit’ and the ‘return on assets consumed’ (where the annual fixed costs would be used as the ‘assets consumed’). 
The Manager of the European subsidiary has offered to supply the chips 
at a price of $95 each. He has offered this price because it would earn the same contribution per chip that would be earned on external sales (this is after adjusting for increased distribution costs and reduced customer servicing costs).

392  
 Required: 
(a)  Assume that the 300,000 chips are supplied by the European 
subsidiary at a transfer price of $95 per chip. Calculate the impact of 
the profits on each of the subsidiaries and the group. 
(b)  Calculate the minimum unit price at which the European subsidiary 
would be willing to transfer the 300,000 chips to the American subsidiary if the performance and salary of the Manager of the subsidiary is to be based on: 
(i) the profit of the subsidiary (currently $7 million) (ii) the return on assets consumed by the subsidiary (currently 
35%). 
(c)  Write a report to the Managing Director of the group that discusses 
issues raised by the directive and the introduction of performance 
measures. (You should use your answers to parts (a) and (b), where appropriate, to illustrate points in your report.) 
(d)  Briefly explain how multinational companies can use transfer pricing 
to reduce their overall tax charge and the steps that national tax authorities have taken to discourage the manipulation of transfer prices.

Chapter 10 
 393 
14  Practice Questions 
 Objective Test Question 1: Transfer pricing 
 A professional firm has two divisions, a computer consultancy division 
(CSD) and a management advisory division (MAD). Each division 
provides consultancy and advisory services to clients and in the year just ended, the fees earned by CSD were $500,000 and the fees earned by MAD were $700,000. Establishment costs were $400,000 for the year in CSD and $500,000 for the year in MAD. 
In providing services to their clients, each division obtains supporting 
services from the other division. During the year, CSD provided 5,000 hours of services to MAD and MAD provided 2,000 hours of services to CSD. 
It has been agreed that the transfer prices for services should be $20 per 
hour for work done by CSD and $30 per hour for services provided by MAD. 
Required: 
The profit for the year reported by CSD was: 
A $60,000 B $100,000 C $140,000 D $200,000 
 
 Objective Test Question 2: Transfer pricing 
 Hock Group has two divisions, Division P and Division Q. Division P 
manufactures an item that is transferred to Division Q. The item has no 
external market, and 60,000 units produced are transferred internally each year. The costs of each division are as follows: 
 
 Division P Division Q 
Variable cost $10 per unit $12 per unit 
Fixed costs each year $120,000 $90,000 
Head office management decides that a transfer price should be set that 
provides a profit of $30,000 to Division P. What should the transfer price per unit be?

394  
 Objective Test Question 3: Transfer pricing  
 An international group operates in four countries, the US, France, the UK 
and Malaysia. Its divisions in each country trade with each other. There 
are large differences between the countries in rates of taxation on corporate profits. 
The company’s management is reasonably confident that for the next 
year or so, it can predict which of its operating currencies (US dollars, euros, sterling and ringgitts) will rise  in value against the others and 
which will fall. 
Required: 
In which currencies might the group’s management wish to price inter-
company sales within the group? 
 
 Objective Test Question 4: All That Jazz Ltd 
 All That Jazz Ltd (ATJ) has two divisions – the 'Gin' division and the 
'Piano' division. Division 'Gin' manufactures a product called the aye and Division 'Piano' manufactures a product called the bee. Each bee uses a single aye as a component. 'Gin' is the only manufacturer of the aye and supplies both 'Piano' and outside customers. Details of Gin’s and Piano’s operations for the coming period are as follows: 
 
 Division 'Gin' Division 'Piano' 
Fixed costs $7,500,000 $18,000,000 
Variable costs per uni t $280 $590 (*) 
Capacity – Units 30,000 18,000 
* Note: exclude transfer costs  
Market research has indicated that demand for ATJ Ltd’s products from 
outside customers will be as follows in the coming period: 
• the aye: at unit price $1,000 no ayes will be demanded but demand 
will increase by 25 ayes with every $1 that the unit price is reduced 
below $1,000 
• the bee: at unit price $4,000 no bees will be demanded, but demand 
will increase by 10 bees with every $1 that the unit price is reduced below $4,000.

Chapter 10 
 395 
 Required: 
(a) Calculate the unit selling price of the bee (accurate to the nearest $) 
that will maximise ATJ Ltd’s profit in the coming period. 
(b) Calculate the unit selling price of the bee (accurate to the nearest $) 
that is likely to emerge if the Divisional Managers of 'Gin' and 'Piano' 
both set selling prices calculated to maximise divisional profit from sales to outside customers and the transfer price of ayes going from Gin to Piano is set at ‘market selling price’. 
(c) Explain why your answers to parts (a) and (b) are different, and 
propose changes to the system of transfer pricing in order to ensure that ATJ Ltd is charging its customers at optimum prices. 
 
 Data Set Question: Division A and Division B  
 Division A transfers 100,000 units of a component to Division B each 
year. The market price of the component is $25. Division A’s variable cost is $15 per unit, and A's divisional’s fixed costs are $500,000 each year. 
What price would be credited to Division A for each component that it 
transfers to Division B under: 
Dual pricing (based on marginal cost and market price)?   
   
Two-part tariff pricing (where the Divisions have agreed that the fixed fee will be $200,000)?

396  
 Case Study Style Question: Transfer Pricing  
Division A of a large divisionalised organisation manufactures a single 
standardised product. Some of the output is sold externally whilst the remainder is transferred to Division B where it is a sub-assembly in the manufacture of that division’s product. The unit costs of division A’s product are as follows: 
 
Direct material $4 
Direct labour $2 
Direct expense $2 
Variable manufacturing overheads $2 
Fixed manufacturing overheads $4 
Selling and packing expenses – variable $1 
–––– 
 $15 
–––– 
Annually, 10,000 units of the product are sold externally at the standard price of $30. 
In addition to external sales, 5,000 units are transferred annually to 
Division B at an internal transfer price of $29 per unit. This transfer price is obtained by deducting variable se lling and packing expense from the 
external price since these costs are not incurred on internal transfers. 
Division B incorporates the transferred in goods into a more advanced 
product. The unit costs of this product are as follows: 
 
Transferred in item (from Division A) $29 
Direct material and components $23 
Direct labour $3 
Variable overheads $12 
Fixed overheads $12 
––– 
 $80 
–––

Chapter 10 
 397 
 You work as the Company's Management Accountant and you have just 
received the following email from the Manager of Division B: 
 
Partly because of this disagreement, a study of the relationship between 
selling price and demand has recently been made for each division by the company’s sales director. The resulting report contains the following table: 
Customer demand at various selling prices: 
 
 Selling price Demand 
Division A $20 15,000 
 $30 10,000 
 $40 5,000 
   
Division B $80 7,200 
 $90 5,000 
 $100 2,800 
   
 You then get the following email: 
 
Email a reply to Tomasina Stolz, in which you will have established the 
maximum contribution that can be earned by the company and the effect 
that the current transfer pricing system will have; Your email should also establish the likely effect on profits of adopting the manager of Division B’s suggestion of a transfer price of $12.

398  
 Example 1: Inter-divisional trading  
 (a) If the transfer price is $20: 
 Division A Division B  Company 
as a whole 
External sales  0  350  350  
Inter-divisional transfers  200  0  0  
 ——— ——— ——— 
 200  350  350 
 ——— ——— ——— 
Costs    
Inter-divisional transfers  0  200  0  
Other material costs  80  20  100  
Other variable costs  20  30  50  
Fixed costs  60  30  90  
 ——— ——— ——— 
Total costs 160  280  240  
 ——— ——— ——— 
Profit 40  70  110  
 ——— ——— ——— 
(b) If the transfer price is $25: 
 Division A  Division B  
 Company 
as a whole  
Inter-divisional transfers  250  0  0 
 ——— ——— ———  250
 350  350 
 ——— ——— ——— 
Costs    
Inter-divisional transfers  0  250  0  
Fixed costs  60  30  90 
 ——— ——— ——— 
Total costs 160  330  240 
 ——— ——— ——— 
Profit 90 
–––––  20 
–––––  110 
–––––

Chapter 10 
 399 
 Conclusions from the example: 
• The choice of transfer price does not affect the profit of the 
organisation as a whole, provided that there is agreement on the 
quantity of transfers. 
• However, the choice of transfer price affects the profitability of the 
individual profit centres.  
 
 The lowest transfer price Division A will accept is $30. 
Division A has spare capacity. It is alr eady selling all it can to the external 
market, and can make extra widgets for B without losing external sales. 
Therefore, any transfer price must therefore cover A's marginal cost per unit, which is $30 . 
 
 It is in the interests of Pool Group for the additional units to be made and 
sold as Product L77. 
The contribution per unit will be $90 – $45 – $25 = $20. The contribution 
from selling 2,000 units each year ( $40,000) exceeds the additional fixed 
costs of $8,000. 
To cover the incremental costs in Division P, the transfer price needs to be 
$45 + $(8,000/2,000 units) = $49. 
Division L will not pay more than $40. A dual transfer pricing arrangement that might win the agreement of both 
divisional managers is for Division P to receive $49 per unit of P29 and for Division L to pay $40. The difference of $9 per unit or $18,000 in total for the year would be a charge to head office. 
 
 The lowest transfer price Division A will accept is $42. 
Division A has no spare capacity. Every unit A has to supply to B causes 
a loss of external net revenue. Therefore, the transfer price must be at least $42 to 'compensate' A (and the company) for its lost net revenue.

400  
 [Note: This example shows that when two profit centres are in different 
countries, it would be in the interests of the company as a whole to set transfer prices that keep a larger proportion of the total profit in the low-tax country.
 
In this example, the higher transfer price gives more profit to the UK division and less profit to the German division. The total pre-tax profit remains the same, but total tax charges are lower, giving a higher-total post-tax profit for the group.] 
(a)  Transfer price = £500  
 
UKD GD Company as 
a whole  
 £ £ £ 
External sales 400,000 280,000 680,000 
Inter-divisional transfers 200,000 
––––––– 0 
––––––– 0 
––––––– 
 600,000 
––––––– 280,000 
––––––– 680,000 
––––––– 
Costs    Inter-divisional tr ansfers 0 200,000 0 
Other variable costs 240,000 20,000 260,000 
Shipping costs 0 6,000 6,000 
Fixed costs 210,000 
––––––– 24,000 
––––––– 234,000 
––––––– 
Total costs 450,000 
––––––– 250,000 
––––––– 500,000 
––––––– 
Pre-tax profit 150,000 30,000 180,000 Tax (30%:50%) (45,000) 
––––––– (15,000) 
––––––– (60,000) 
––––––– 
After-tax profit 105,000 
––––––– 15,000 
––––––– 120,000 
–––––––

Chapter 10 
 401 
 (b) Transfer price = £200  
 
UKD GD  Company 
as a whole  
 £ £ £ 
Inter-divisional transfers 80,000 
–––––– 0 
–––––– 0 
–––––– 
 480,000 
–––––– 280,000 
–––––– 680,000 
–––––– 
Costs    
Inter-divisional transfers 0 80,000 0 Other variable costs 240,000 20,000 260,000 
–––––– 24,000 
–––––– 234,000 
–––––– 
–––––– 130,000 
–––––– 500,000 
–––––– 
Pre-tax profit 30,000 150,000 180,000 Tax (30%:50%) (9,000) 
–––––– (75,000) 
–––––– (84,000) 
–––––– 
After-tax profit 21,000 
–––––– 75,000 
–––––– 96,000 
–––––– 
    
 Example 6: Multinational computer manufacturer  
 (a) Without the transfer the European subsidiary would make a profit of: 
($105 – $60) × 600,000 – $20m = $7m 
With the transfer the profit would increase to: $45 × 800,000 – $26m = $10m The internal transfer would lead to an increase in cost for the 
American subsidiary of 
300,000 × $5 = $1.5m The net impact on profit for the group would be: 
European 
subsidiary  American 
subsidiary  Group  
Increase of $3m Reduction of $1.5m Increase of $1.5m

402  
 (b)  (i)  Let TP = transfer price required. 
Maximum capacity is 800,000 units so to supply the American 
subsidiary with 300,000 units only 500,000 units can be sold externally. 
Contribution per unit on external sales = $105 – $60 = $45 If contribution remains the same when the transfer price is $95 
then the variable cost per unit relating to internal transfers must be $95 – $45 = $50 
300,000 × (TP – 50) + 500,000 $45 – $26m = $7m  TP – 50 = $7m + $26m – $22.5m/300,000 = $35  So TP = $85 
(ii) 
300,000	×	ሺTP –	50ሻ	+	500,000 	×	$45 –	$26
$26m
	×	100	=	35% 
 
300,000 × (TP – 50) = 35% × $26m – 500,000 × $45 + $26m = 
$12.6m  
TP – 50 = $12.6m/300,000 = $42 So TP = $92 
(c) 
REPORT 
From:  Management Accountant  
Date:  XX.XX.XX 
Subject:  Group Directive 
This report discusses issues raised by the directive and the 
introduction of performance measures. 
Internal transfer of chips 
The European subsidiary has 200,000 units of spare capacity and should, in principle, be prepared to supply these at any price which exceeds incremental costs. For 200,000 units this would be $50 + $6m/200,000 = $80 per unit. (Note that the variable cost of internal transfers is lower than that of external sales – see part b). The American subsidiary would be prepared to accept any price under $90, the price at which the chips can be purchased from a local supplier. For the first 200,000 units there is a range of possible transfer prices which would be acceptable to both subsidiaries of $80 to $90.

Chapter 10 
 403 
 The American subsidiary requires 300,000 units however and the 
additional 100,000 units could only be supplied by reducing the 
supply to external customers. The minimum transfer price acceptable to the European subsidiary would be $95 as this would earn the same contribution per chip as external sales. At this price the American subsidiary would be paying $5 per chip more than from the external market and so would not be motivated to buy internally. 
An average price for all 300,000 units could be set using $80 for the 
first 200,000 units and $95 for the remaining 100,000 units. 
200,000 × $80 + 100,000 × $95/300,000 = $85. It has already been seen in part (b) that this is the minimum price 
the European subsidiary would consider if performance was measured on profit. The American subsidiary would be saving $5 per chip. 
A better solution may be to transfer 200,000 chips internally and 
purchase the remaining 100,000 chips from the external supplier. Assuming the transfer price is set at $80 this would result in a profit for the European subsidiary of 600,000 × $45 + 200,000 × $30 – $26m = $7m. The American subsidiary would reduce costs by 200,000 × $15 = $3m. Group profits would increase by $3m, an increase of $1.5m compared to using a transfer price of $95 (see part a). 
At $80 all of the profit increase was in the American subsidiary. 
Depending on where the transfer price is set in the range $80 to $90 the increase in profit can be divided more equitably between the two divisions. 
Performance measures 
If performance is measured using profit then any price above $85, (for 300,000 units), but below $90 would allow both subsidiaries to increase profits. If return on assets is used however the minimum price that would be acceptable to the European subsidiary would be $92 (part b). The Americ an subsidiary would be unwilling to trade at 
that price. It would be impossible to set a transfer price that would be acceptable to both divisions. 
It would be beneficial for the group if 200,000 chips were transferred internally rather than the current practise of external purchase. Providing the external supplier is willing to supply only 100,000 
chips at $90 per unit this is the preferred option. A performance measurement system based on profit allows a transfer price to be set which would be acceptable to both subsidiaries. This is not the case if return on assets consumed is used.

404  
 (d)  Multi-nationals may have some companies located in countries with 
high rates of corporate tax and others with lower rates. To reduce 
the overall tax charge the aim will be to keep profit as low as possible in high tax rate countries. This can be achieved by charging high transfer prices to companies in high tax countries purchasing goods and set low transfer prices for those companies in high tax countries supplying goods. 
National tax authorities have taken action to discourage 
manipulation of profits. Internal transfers are examined closely and are expected to be at market prices, or where this is not possible, at cost. Heavy fines are imposed on companies suspected of deliberately manipulating transfer prices to avoid tax. 
 
 [Tutorial note: Only the profit reported by CSD is required. Total profit is shown here for information.] 
 Company MAD Company 
External sales 500,000 700,000 1,200,000 
Internal transfers:    5,000 × $20 100,000 – – 
Internal transfers:    
2,000 × $30 – 
––––––– 60,000 
––––––– – 
––––––– 
 600,000 
––––––– 760,000 
––––––– 1,200,000 
––––––– 
Costs    Transfers 60,000 100,000 0 Establishment costs 400,000 
––––––– 900,000 
––––––– 
 460,000 
––––––– 600,000 
––––––– 
Profit 140,000 160,000 300,000 
 
The answer is C.

Chapter 10 
 405 
   
Target profit for Division P $30,000 
Fixed costs of Division P 120,000 
Target contribution of Division P $150,000 
  
 $per unit 
Target contribution per unit (÷ 60,000) $2.50 
Variable cost $10.00 
–––––– 
Transfer price required $12.50 
––––––  
  
 Objective Test Question 3: Transfer pricing 
 Provided the arrangements are permitted by the tax regulations, the 
group should want to increase the chances of higher profits in lower-tax 
countries and lower profits in the higher-tax countries. The companies might agree prices for the year and: 
• sales from a division in a higher-tax country might be priced in the 
weaker currency 
• sales from a division in a lower-tax country might be priced in a 
stronger currency. 
If exchange rates move as expected, profits of the companies in the 
higher-tax countries will be reduced and the companies in the lower-tax country will obtain the matching benefit.

406  
 (a) 
Division Gin Division Piano 
Capacity 30,000 Capacity 18,000 
Marginal cost = $280 Marginal cost = $590 
Fixed cost = $7.5 million Fixed cost = $18 million 
P = 1,000 – 0.04Q P = 4,000 – 0.1 Q 
MR = 1,000 – 0.08Q MR = 4,000 – 0.2Q 
To maximise group profits from sales of bee: 
Marginal revenue from bee = Marginal cost of bee 
4,000 – 0.2Q = 280 + 590 
Q = 15,650 
  
P = 4,000 – 0.1 × 15,650 
 = $2,435 
A unit selling price of $2,435 per bee will maximise ATJ Ltd’s profit 
in the coming period. 
(b) Division Gin; for external sales of aye the division will ensure that: 
Marginal revenue from aye = Marginal cost of aye 
1,000 – 0.04Q = $280 
Q = 9,000 
  
P = 1,000 – 0.04 × 9,000 
 = $640 
This now becomes the internal transfer price and as such forms part 
of Division Piano’s divisional marginal cost. 
Division Piano; for sales of bee they will ensure their division MR = 
divisional MC 
4,000 – 0.2Q = 640 + 590 
Q = 13,850 
  
P = 4,000 – 0.1 ×13,850 
 = $2,615 
of Division Piano’s divisional marginal cost.

Chapter 10 
 407 
 (c)  In part (a) of the question we establish that the group should sell 
15,650 units of bee at $2,435 in order to maximise group profits. 
Under part (b) of the question the manager of Gin is not using a transfer price that will bring about this decision (goal congruency). 
As the divisions are acting autonomously, it is understandable that the manager of Gin will aim to earn a divisional contribution from internal sales of aye. As he sells externally at a price of $640 he may consider that this seems to be a fair price for internal sales. 
However, this internal transfer price then forms part of Division 
Piano’s marginal costs. The divisional marginal costs at this point ($640 + $590) are NOT the same as the true marginal cost of a bee ($280 + $590). The manager of Piano ensures his divisional profits are maximised, however, this does not coincide with the group objective as the wrong cost data is essentially being used. 
To overcome this problem, Head Office could impose a transfer 
price. Given the surplus capacity at Gin division, the TP to guarantee goal congruency should be the Marginal Cost of an aye, that is $280. At this transfer pric e the manager of Piano will record a 
divisional marginal cost of $870 ($280 + $590) and will happily operate at the optimum level, selling 15,650 bees at $2,435. 
However, at a TP of marginal cost the manager of Gin is likely to 
become demotivated as his division receives no reward or benefit for work on internal transfers. Additionally, if divisional profit is used as a performance indicator, the system will fail to measure the performance of division Gin adequately. 
So, as an alternative to the relevant cost being used for the TP, a 
cost based price could be used. Three methods may be employed: 
–  cost plus price. Here a mark-up could be added to the 
marginal cost 
–  two part tariff. This is where the marginal cost is used as the 
UNIT price of an aye, but a fixed fee is paid to Division A from 
Div B each period 
–  dual pricing system could be implemented. Division A sells 
ayes internally recording one TP (say $640 – the external market price of an aye) and Division B records purchases of aye at a different transfer price. Div B could use a TP of $280 – the MC of an aye. Under this system Division B would operate at the optimum level for the group, and Division A would earn a contribution on internal sales. Head office would reconcile the discrepancies with a reconciliation account.

408  
 Data Set Question: Di vision A and Division B 
 Dual price transfer price from division A’s point of view is market price 
$25. This ensures that the supplying division can earn a profit. 
The two-part tariff transfer price per unit is marginal cost $15. 
 
 Case Study Style Question: Transfer Pricing 
 EMAIL 
To: Tomasina Stolz 
From:  A.N. Accountant  
Date:  04.07.2014 
Subject:  Transfer pricing 
(a)  A first step is to calculate the contribution that Division A could earn 
by selling its product on the intermediate external market. 
Division A 
 
Unit price ($) $20 $30 $40 
Demand 15,000 10,000 5,000 
Revenue $300,000 $300,000 $200,000 
Variable costs (at $11 per unit) ($165,000) ($110,000) ($55,000) 
Contribution $135,000 $190,000 $145,000 
 
The optimal policy would be to sell 10,000 units on the intermediate 
market at $30. 
Assuming that Division A does not have any capacity constraints, 
the next step is to calculate how profits would be maximised from sales to the end market. For sellin g to the end market, the variable 
cost to the company is $49 per unit (= $10 in Division A, since there is no variable selling cost with a transfer, and $39 in Division B). 
Division B 
 
Unit price ($) $80 $90 $100 
Demand 7,200 5,000 2,800 
Revenue $576,000 $450,000 $280,000 
Variable costs (at $49 per unit) ($352,800) ($245,000) ($137,200) 
Contribution $ 223,200 $205,000 $142,800

Chapter 10 
 409 
 The optimal policy is to sell 7,200 units at a price of $80. The optimal 
contribution is therefore: 
 $ 
Contribution from sales in intermediate market 190,000 Contribution from sales in end market 223,200 
––––––– 
Total achievable contribution 413,200 
––––––– 
 
At the current transfer price of $29, the maximum contribution might 
not be achieved. In Division B, if the transfer price is $29, the total variable cost of sale for Division B would be $68 (= variable cost $39 + transfer price $29). 
The profits for Division B at each of the possible selling prices would 
be: 
Division B 
 
Variable costs (at £68 per unit) ($489,600) ($340,000) ($190,400) 
Contribution $86,400 $110,000 $89,600 
 
The manager of Division B would choose to sell 5,000 units at a 
price of $90, in order to maximise the division’s profit. This would not achieve goal congruence, and the total company profit would not be maximised. 
 Division A Division B Total 
Maximum contribution obtainable $190,000 $223,200 $413,200 
Contribution if transfer price is $29 $190,000 $205,000 $395,000 
 
Shortfall in profit due to transfer price policy $18,200

410  
 (b)  Transfer price = $12 
The decision about what to sell in the intermediate market would not 
be affected. For Division B, the variable cost of sale, including the transfer price, would be $51 (= $39 + $12). 
 
Division B 
 
Unit price (£) $80 $90 $100 
Variable costs  
(at £51 per unit) ($367,200) ($255,000) ($142,800) 
Contribution $ 208,800 $195,000 $137,200 
 
The Division B manager will now choose to sell 7,200 units at $80 each, in order to maximise profit. 
The total contribution for the company, and for each division, will be: 
Division A 
 
External market sales $190,000 
Internal transfers (7,200 × (12 – 10)) $14,400 
–––––––– 
 $204,400 
–––––––– 
Division B (see above) $208,800 
–––––––– 
Company as a whole $413,200 
–––––––– 
 
Goal congruence is achieved with a transfer price of $12.

411 
The treatment of 
uncertainty and risk in 
D1: Risk and Control Risk and uncertainty 
associated with medium-term 
decision-making  
(a) Conduct sensitivity 
analysis 
(b) Conduct analysis of risk 
 
  Chapter 
11

The treatment of uncertainty and risk in decision making 
412  
 
2  Risk and uncertainty 
Decision making problems (such as whether to launch new products, whether 
to buy machines, choosing between products, etc.) typically involve an 
element of risk and uncertainty. This chapter looks at how the decision making process can take account of risk and uncertainty. This is often achieved by building in probabilities for possible outcomes and using expected values and decision trees to assess the problem.  
Forecasting and decision making often include an element of risk or uncertainty. Because they look to the future, these decisions often involve estimates of future costs and benefits. Events in the future can be predicted, but managers can rarely be 100% confident that these predicted future events will actually arise. As actual results emerge, managers are likely to discover that they have achieved better or worse results than those predicted originally.  
There are several ways of dealing with this variability of outcomes. Here, we consider several different possible outcomes that may arise. It is common in practice to consider three possible outcomes; the most likely outcome, the pessimistic (worst possible) outcome and the optimistic (best possible) outcome. Analysts may consider more than these three possibilities, but more information will become more complicated and cumbersome to analyse and understand. Examination questions will generally provide all the different 
possible outcomes that may arise, together with the associated chance (probability) of the outcome occurring. It is our task to analyse the information given, recommend an appropriate strategy for management to follow and finally to highlight the potential risk involved in the various choices.  
The difference between ri sk and uncertainty  
The decision making process faces the following problems: 
• all decisions are based on forecasts • all forecasts are subject to uncertainty 
• this uncertainty needs to be reflected in the financial evaluation.

Chapter 11 
 413 
 The decision maker must distinguish between: 
• risk – quantifiable – possible outcomes have associated probabilities, 
thus allowing the use of mathematical techniques 
• uncertainty  – unquantifiable – outcomes cannot be mathematically 
modelled. 
 
 Illustration 1 – on risk and uncertainty  
For example, based on past experience of digging for oil in a particular 
area, an oil company may estimate that they have a 60% chance of finding oil and a 40% chance of not finding oil. 
Uncertainty: there are a number of possible outcomes but the 
probability of each outcome is not known. 
 For example, the same oil company may dig for oil in a previously 
unexplored area. The company knows that it is possible for them to 
either find or not find oil but it does not know the probabilities of each of these outcomes. 
modelling techniques in an attempt to improve the reliability of business forecasts. The use of trend analysis, encountered earlier in this text, is one possibility. The key point is to  develop a mathemat ical model to 
predict how future costs will behave having regard to labour becoming more adept at tasks (and hence unit re source requirements falling) the 
more times they are repeated. 
3  Dealing with risk in investment appraisal decisions 
Investment appraisal often involves a degree of uncertainty and risk. This may be dealt with in a number of ways: 
• Adding a risk premium to the discount rate in order to compensate for 
risk: A premium may be added to the usual discount rate to provide a 
safety margin. The premium may vary from project to project to reflect the different levels of risk. 
• Payback period: Estimates of cash flows several years ahead are quite 
likely to be inaccurate and unreliable. It may be difficult to control capital projects over a long period of time. Risk may be limited by selecting projects with short payback periods (though this might also induce short-
termism into the decision making process and longer-term value-adding 
projects may be rejected unnecessarily).

414  
• Sensitivity Analysis – explored in this chapter. 
• Using probability distributions to give  an indication of ri sk – explored in 
this chapter. 
• Monte Carlo simulation – a computerised system that extends sensitivity 
analysis – also explored in this chapter. 
4 Sensitivity analysis 
Sensitivity analysis in NPV questions typically involves posing ‘what if’ 
questions. The NPV is recalculated under different conditions, e.g. what would happen if demand fell by 10%, how would the result be affected if variable costs are 5% higher, etc. 
Alternatively, we may wish to discover the maximum possible change in one of 
the parameters before the opportunity becomes non-viable. 
This maximum possible change is often expressed as a percentage: 
Sensitivity margin 	= NPV
PV of flow under consideration
 
LEARN 
This formula works for total cash flows. It cannot be used for individual units, 
selling prices, variable cost per unit, etc. Have a go at the following example. 
 
 Example 1: Amador Ltd 
 Amador Ltd is considering investing $120,000 in equipment that has a 
life of 15 years. Its final scrap value is $25,000. 
The equipment will be used to produce 15,000 deluxe pairs of rugby 
boots per annum, generating a contribution of $2.75 per pair. Specific fixed costs are estimated at $18,000 per annum. The firm has a 15% cost of capital. 
Required: 
(a)  Calculate the NPV of the project. (b)  Calculate the sensitivity of your NPV to the: 
(i) initial investment (ii) annual contribution (iii) annual fixed costs. 
(c)  Identify the minimum annual sales required to ensure that the 
project at least breaks even.

Chapter 11 
 415 
 Pros and cons of sensitivity analysis 
• No complicated theory to understand. 
• Information will be presented to management in a form which 
facilitates subjective judgemen t to decide the likelihood of the 
• Identifies areas which are crucial to the success of the project. If 
the project is chosen, those areas can be carefully monitored. 
• Indicates just how critical some of the forecasts which are 
considered to be uncertain are. 
Weaknesses of sensitivity analysis • It assumes that changes to variables can be made independently, 
e.g. material prices will change independently of other variables. 
This is unlikely. If material prices went up the firm may be able to increase selling price at the same time and there would be little effect on NPV. A technique called simulation (discussed earlier) allows us to change more than one variable at a time. 
• It only identifies how far a variable needs to change. It does not 
look at the probability of such a change. In the above analysis, sales volume appears to be the most crucial variable, but if the firm were facing volatile raw material markets a 65% change in raw material prices would be far more likely than a 29% change in sales volume. 
• It is not an optimising techniq ue. It provides information on the 
basis of which decisions can be made. It does not point directly to the correct decision. 
5  Probabilities and expected values 
An expected value summarises all the different possible outcomes by calculating a single weighted average. It is the long run average (mean). 
The expected value is not the most likely result. It may not even be a possible 
result, but instead it finds the average outcome if the same event was to take place thousands of times. 
EV = Σpx LEARN 

416  
 Example 2: Ventura Ltd expected values 
 Ventura Ltd is considering launching a new product. It will do so if the 
expected value of the total revenue is in excess of $1,000. It is decided 
to set the selling price at $10. After some investigation a number of probabilities for different levels of sales revenue are predicted; these are shown in the following table: 
 
 $  $ 
120 1,200 0.35 
–––– 420 
–––– 
The expected sales revenue at a selling price of $10 per unit is 
$________________ 
 
 Example 3: Dralin Distribution Co 
 Dralin Distribution Co is considering an investment of $460,000 in a 
non-current asset expected to generate substantial cash inflows over the next five years. Unfortunately, the annual cash flows from this investment are uncertain, but the following probability distribution has been established: 
 
Annual Cash flow Probability 
$  
50,000 0.3 
100,000 0.5 
150,000 0.2 
–––– 
At the end of its five-year life, the asset is expected to sell for $40,000. 
The cost of capital is 5%. 
Calculate whether the investment should be undertaken. 
Furthermore, not all decision-makers will have the same attitude towards risk. 
There are three main types of decision-makers: 
• Risk neutral  decision-makers consider all possible outcomes and will 
select the strategy that maximises the expected value or benefit. 
• Risk seekers  are likely to select the strategy with the best possible 
outcomes, regardless of the likelihood that they will occur. They will apply 
the maximax criteria (covered later). 
• Risk averse  decision-makers try to avoid risk. They would rather select a 
lower, but certain, outcome than risk going for a higher pay-off which is less certain to occur. They will apply the maximin criterion or the minimax regret approach (both covered later).

Chapter 11 
 417 
 For instance, after investigation in the above ‘Ventura Limited’ example 
(example 2), the predicted revenues might have been different. They 
might have been as follows: 
 
Units sold Revenue  
$ Probability  Pay-off 
$ 
  –––– –––––––   1.00 EV = 1,039.50 
Both situations give rise to the same expected sales revenue of $1,040 
(to the nearest $), but the two situations are not the same. The second involves a wider dispersal of possible outcomes; hence it involves higher risk.  
If the decision-makers are risk neutral, their decision making will not be 
affected by the degree of risk in the different situations; these investors would be indifferent between situations of equal expected payoffs, even if one situation (situation 2) is riskier than the other. 
If the decision-makers are risk averse, they will judge the range of 
possible outcomes described in the second situation to be worse than the first.  
If the decision-makers are risk seekers, they may prefer the second 
situation, because of the higher outcome in the best possible situation. However, in this case, the dire downside of $400 may put them off. Whatever the case it can be seen that the evaluation of the options solely on the basis of their expected value may not always be appropriate. 
 
 Example 4: Cement Co part I 
 Cement Co is a listed company specialising in the manufacture of 
cement, a product used in the building industry. The company has been 
a major player in the construction sector of European country, Q, since 
its formation in 1997. It is passionate about customer care and proud of 
its active approach to safety and sustainability (recognising the need to 
minimise any adverse environmental impact of its operations). 
The company operates in a very traditional industry but profits can be 
volatile. Q’s economy has been in recession for the last three years and 
this has had a direct impact on Cement Co’s profitability. Shareholders 
are concerned about this fall in profit and have expressed their desire 
for a secure return. Competitors, keen to find ways of increasing profit 
and market share, in these difficult economic circumstances, have 
started to increase the level of investment in research and development, 
ensuring their products anticipate and meet the needs of its customers.

418  
 When Q entered recession, many workers left the country in search of 
more lucrative and secure work. This has had a significant impact on 
Cement Co which is now facing labour shortages and increased labour 
costs. At the same time, suppliers have also increased their prices 
putting further pressure on Cement Co’s margins. 
The company has found that when weather conditions are good, the 
demand for cement increases since more building work is able to take 
place. Last year, the weather was so good, and the demand for cement 
was so great, that Cement Co was unable to meet demand. Cement Co 
is now trying to work out the level of cement production for the coming 
year in order to maximise profits. The company doesn’t want to miss out 
on the opportunity to earn large profits by running out of cement again. 
However, it doesn’t want to be left with large quantities of the product 
unsold at the end of the year, since it deteriorates quickly and then has 
to be disposed of. The company has received the following estimates 
about the probable weather conditions and corresponding demand 
levels for the coming year: 
 
Weather Probability Demand 
Good 25% 350,000 bags 
Average 45% 280,000 bags 
Poor 30% 200,000 bags 
Each bag of cement sells for $9 and costs $4 to make. If cement is 
unsold at the end of the year, it has to be disposed of at a cost of 
$0.50 per bag. 
Cement Co has decided to produce at one of the three levels of 
production to match forecast demand. It now has to decide which level 
of cement production to select. 
As an incentive to increase profitability a new bonus scheme has just 
been introduced for a select group of Cement Co’s directors. A bonus 
will be received by each of these directors if annual profit exceeds a 
challenging target. 
Required: 
Identify the risks facing Cement Co and assess the impact of different 
risk appetites of ma nagers and sharehol ders on their response to these 
risks.

Chapter 11 
 419 
 Illustration 3 – Further expected value examples 
 Situation 1 
A company buys in sub-assemblies in order to manufacture a product. It 
is reviewing its policy of putting each sub-assembly through a detailed inspection process on delivery, and is considering not inspecting at all. Experience has shown that the quality of the sub-assembly is of acceptable standard 90 per cent of the time. It costs $10 to inspect a subassembly and another $10 to put right any defect found at that stage. If the sub-assembly is not inspected and is then found to be faulty at the finished goods stage the cost of rework is $40. 
Required: 
Advise the company whether or not they should change their policy. 
Solution 
Four outcomes are possible: 
(i) Inspect and find no problems – cost $10. (ii) Inspect and find problems – cost $20. (iii) Do not inspect and no problems exist – no cost. (iv) Do not inspect and problems do exist – cost $40. If sub-assemblies achieve the required standard 90 per cent of the time 
then there is a 10 per cent chance that they will be faulty. 
The expected value of the cost of each policy is as follows: 
 
Inspect [09 × $10] + [01 × $20] = $11 
Do not inspect [0.9 × $0] + [0.1 × $40] = $4 
Taken over a long enough period of time, a policy of not carrying out an 
inspection would lead to a saving in cost of $7 per sub-assembly. On a purely quantitative analysis, therefore, this is the correct policy to adopt. 
However, in the real world such a high level of failures is incompatible 
with a requirement for a ‘quality product’, and the concept of continuous improvement. It would be more useful to ask the supplier some basic questions regarding his quality management, in order to bring about a fundamental shift towards outcome (iii), rather than simply implementing a policy on the basis of such an uncritical analysis of the situation.

420  
 Situation 2 
An individual is considering backing the production of a new musical in 
the West End. It would cost $100,000 to stage for the first month. If it is well received by the critics, it will be kept open at the end of the first month for a further 6 months, during which time further net income of $350,000 would be earned. If the criti cs dislike it, it will close at the end 
of the first month. There is a 50:50 chance of a favourable review. 
Required: 
Should the individual invest in the musical? 
Solution 
The expected value of backing the musical is: [0.5 × $250,000] – [0.5 × $100,000] = $75,000 As this provides a positive return it would be accepted on the basis of 
expected values as the alternative yields zero. However, the expected value can be misleading here as it is a one-off situation and the expected profit of $75,000 is not a feasible outcome. The only feasible outcomes of this project are a profit of $250,000 or a loss of $100,000. 
While almost everybody would welcome a profit of $250,000, not many 
individuals could afford to sustain a loss of $100,000 and they would place a high utility on such a loss. Many investors would be risk averse in such a situation because they would not consider that a 50 per cent chance of making $250,000 was worth an equal 50 per cent risk of losing $100,000; the loss might bankrupt them. On the other hand, if the individual were a multi-millionaire the return of 250 per cent would be 
very appealing and the loss of a mere $100,000 would have a low utility attached to it. 
The two exercises have only had single-point outcomes, that is 
conformity or otherwise with a pre-set quality standard and a successful show or a flop. It is obvious that the two outcomes of the first exercise represent the only possible alternatives and so quantification of the related pay-offs along the lines of the example appears reasonable. It is also obvious that the profit of $250,000 predicted for a successful show in the case of the second exercise is far too precise a figure. It would be more realistic to assume a range of possible successful pay-offs, which will vary, according to the number of seats sold and the price of the seats. If probabilities are attached to each estimate, the expected value of a successful outcome will take account of the range of possible outcomes, by weighting each of them by its associated probability. The 
range of possible outcomes might be as follows.

Chapter 11 
 421 
    
Profit  ($) Probability  Expected value ($) 
(100,000) 0.5000 (50,000) 
200,000 0.1750 35,000 
250,000 0.2000 50,000 
300,000 0.0750 22,500 
350,000 0.0500 
–––––– 17,500 
–––––– 
 1.0000 75,000 
The statement of a range of possible outcomes and their associated 
probabilities is known as a probability distribution. Presenting the distribution to management allows two further useful inferences to be drawn: 
• The most likely successful outcome . That is the successful 
outcome with the highest probability (a profit of $250,000). 
• The probability of an outcome being above or below a particular 
figure. The particular figure will either be the expected value or a 
figure of consequence, such as zero profit, where a lesser 
outcome might have dire consequences. By summing the probabilities for pay-offs of $200,000 and $250,000, it can be concluded that there is a 37.5 per cent probability that profits will be $250,000 or less if the musical is successful. By summing those for $300,000 and $350,000 it can be determined that the probability of a profit of $300,000 or more in the event of success is only 12.5 per cent. 
Advantages and disadvantages of EVs  
• Takes risk into account by considering the probability of each possible 
outcome and using this information to calculate an expected value. 
• The information is reduced to a single number resulting in easier 
• Calculations are relatively simple. 
• The probabilities used are usually very subjective. • The EV is merely a weighted average and therefore has little meaning for 
a one-off project. 
• The EV gives no indication of the dispersion of possible outcomes about 
the EV, i.e. the risk. 
• The EV may not correspond to any of the actual possible outcomes.

422  
 Utility theory  
 Utility is another important aspect of risk and uncertainty. The basis of 
the theory is that an individual’s attitude to certain risk profiles will 
depend on the amount of money involved. For example, most people would accept a bet on the toss of a coin, if the outcome were that they would win $6 if it came down heads and if it came down tails they would pay $4. The average person would be happy to play secure in the knowledge that they would win if the game were repeated over a long enough period; if not it would still be a good bet. But if the stakes were raised so that the win was $6,000 on a single toss coming down heads 
and a loss of $4,000 if it came down tails, the average person might 
think twice and reject the bet as being too risky. Utility theory attaches weights to the sums of money involved; these are tailor-made to the individual’s attitude towards winning and losing certain sums of money. 
Therefore, considering a proposed option solely on the basis of its 
expected value ignores the range of possible outcomes. 
6  Standard Deviation 
In order to measure the risk associated with a particular project, it is helpful to find out how wide ranging the possible outcomes are. The conventional measure is the standard deviation. The standard deviation compares all the actual outcomes with the expected value (or mean outcome). It then calculates how far on average the outcomes deviate from the mean. It is calculated using a formula. 
The basic idea is that the standard deviation is a measure of volatility: the 
more that actual outcomes vary from the average outcome, the more volatile the returns and therefore the more risk involved in the investment/decision. 
 
Illustration 4 – Further details on standard deviations 
σ	=	ඨ∑൫X –	X൯2
n 
σ = standard deviation  Σ = sum of 
x = each value in the data set 
X = mean of all values in the data set 
n = number of value in the data set 
Let’s examine how standard deviations are calculated and used by 
considering the following illustration: 
A company is considering whether to make product X or product Y. 
They cannot make both products. The estimated sales demand for each product is uncertain and the following probability distribution of the NPVs for each product has been identified.

Chapter 11 
 423 
Product X 
 
NPV ($) Probability  Expected value ($) 
3,000 0.10 300 
3,500 0.20 700 
4,000 0.40 1,600 
4,500 0.20 900 5,000 0.10 
–––– 500 
––––– 
 1.00 4,000 
Product Y 
 
2,000 0.05 100 3,000 0.10 300 4,000 0.40 1,600 
6,000 0.20 
–––– 1,200 
––––– 
 1.00 4,450 
produce product Y. However, let's consider the standard deviation calculations for each product: 
Product X 
 
NPV Deviation from 
expected value Squared Probability 
deviation Weighted 
amount  ($) 
3,000 – 4,000 = –
1,000 1,000,000 0.10 100,000 
3,500 – 4,000 = –500 250,000 0.20 50,000 
4,500 – 4,000 = 500 250,000 0.20 50,000 
5,000 – 4,000 = 1,000 1,000,000 0.10 100,000 
––––––– 
Standard deviation 547.72 Expected value 4,000

424  
 Product Y 
 
amount  ($) 
2,000 – 4,450 = –2,450 6,002,500 0.05 300,125 
3,000 – 4,450 = –1,450 2,102,500 0.10 210,250 
5,000 – 4,450 = 550 302,500 0.25 75,625 6,000 – 4,450 = 1,550 2,402,500 0.20 480,500 
–––––––– 
Sum of weighted squared deviation 1,147,500 Standard deviation 1,071.21 
Expected value 4,450 
The expected net present value for each product gives us an average 
value based upon the probability associated with each possible profit outcome. If net present value is used for decision-making, then on that basis Product Y would be produced as it yields the highest return. 
However, the net present value for each product does not indicate the 
range of profits that may result. By calculating the standard deviation, this allows us to identify a range of values that could occur for the profit for each product. Product Y has a higher standard deviation than Product X and is therefore more risky. There is not a significant difference in net present value for each of the products. However, Product X is less risky than Product Y and therefore the final selection will depend on the risk attitude of the company. 
If we have two probability distributions with different expected values 
their standard deviations are not directly comparable.  
We can overcome this problem by using the coefficient of variation (the 
standard deviation divided by the expected value) which measures the relative size of the risk. 
For example, the standard deviation of the numbers 2, 7 and 9 is 2.94. 
The mean is 6 {(2 + 7 + 9)/3}. The standard deviation is calculated by taking the squares of the three deviations from the mean (16 + 1 + 9 = 26) and then calculating the square root of their average ( √(26/3) = 
2.94).  
In this case, equal weighting is given to the three figures. The coefficient 
of variation is the standard deviation of the series divided by its mean which is 0.49 in this case (2.94/6).

Chapter 11 
 425 
 The standard deviation of a range of numbers gives a measure of the 
associated level of uncertainty. The measure is an absolute one and in 
order to allow comparison of two different series where the mean values of the two differ significantly, then the coefficient of variation is used. 
Expected values, standard deviations or coefficient of variations are 
used to summarise the outcomes from alternative courses of action. However, it must be remembered that they do not provide all the relevant information to the decision maker.  
The probability distribution will provide the decision maker with all of the 
information they require. It would be appropriate to use expected values, standard deviations or coefficient of variations for decision making when there are a large number of alternatives to consider i.e. where it is not practical to consider the probability distributions for each alternative. 
 
 Example 5: Marin Ltd standard deviation 
 Marin Ltd is considering investing in one of the following projects. 
 
deviation 
 $000 $000 
A 850 500 
B 1,200 480 
C 150 200 
D 660 640 
It wishes to select the project with the lowest risk factor (coefficient of variation). Identify which project should it select: 
A  Project A B  Project B C  Project C D  Project D 
7 Monte Carlo Simulation 
Monte Carlo Simulation is a computerised system that extends sensitivity 
analysis. Simulation is a modelling techni que that shows the effect of more 
than one variable changing at the same time. 
It is often used in capital investment appraisal. The Monte Carlo simulation method uses random numbers and probability 
statistics. It can include all random events that might affect the success or failure of a proposed project – for example, changes in material prices, labour rates, market size, selling price, investment costs or inflation.

426  
The model identifies key variables in a decision: costs and revenues, say. 
Random numbers are then assigned to each variable in a proportion in accordance with the underlying probability distribution. For example, if the most likely outcomes are thought to have a 50% probability, optimistic outcomes a 30% probability and pessimistic outcomes a 20% probability, random numbers, representing those attributes, can be assigned to costs and revenues in those proportions. 
A powerful computer is then used to repeat the decision repeatedly 
(thousands or even millions of  times), until the outcome starts to 'settle down' 
and give management a view of the likely range and level of outcomes. Depending on the management's attitude to risk, a more informed decision can be taken. 
This helps to model what is essentially a one-off decision using many possible 
repetitions. It is only of any real val ue, however, if the underlying probability 
distribution can be estimated with some degree of confidence. 
 
Monte Carlo Illustration 5 – MP Organisation 
 The MP Organisation is an independent film production company. It has 
a number of potential films that it is considering producing, one of which 
is the subject of a management meeting next week. The film which has been code named CA45 is a thriller based on a novel by a well-respected author. 
The expected revenues from the film have been estimated as follows: 
there is a 30% chance it may generate total sales of $254,000; 50% chance sales may reach $318,000 and 20% chance they may reach $382,000. 
Expected costs (advertising, promotion and marketing) have also been 
estimated as follows: there is a 20% chance they will reach approximately $248,000; 60% chance they may get to $260,000 and 20% chance of totalling $272,000. 
In a Monte Carlo simulation, these revenues and costs could have 
random numbers assigned to them: 
 
Sales Revenue Probability Assign Random Numbers 
(assume integers) 
$254,000 0.30 00 – 29 
$318,000 0.50 30 – 79 $382,000 0.20 80 – 99 
   
Costs    
$248,000 0.20 00 – 19 
$260,000 0.60 20 – 79 
$272,000 0.20 80 – 99

Chapter 11 
 427 
 A computer could generate 20-digit random numbers such as 
98125602386617556398. These would then be matched to the random 
numbers assigned to each probability and values assigned to 'Sales 
Revenues' and 'Costs' based on this. The random numbers generated give 5 possible outcomes in our example: 
 
Random 
number Sales revenue in 
$000  Random 
Number Costs in 
$000  Profit 
98 382 12 248 134 
56 318 02 248   70 
38 318 66 260   58 
17 254 55 260     (6) 
63 318 98 272   46 
     
8 Value at Risk (VaR) 
Value at risk (VaR)  is a measure of how the market value of an asset or of a 
portfolio of assets is likely to decrease over a certain time, the holding period  
(usually one to ten days), under ‘normal’ market conditions. 
VaR is measured by using normal distribution theory. It is typically used by 
investment banks to measure the market risk of their asset portfolios. 
VaR = amount at risk to be lost from an investment under usual conditions 
over a given holding period, at a particular 'confidence level'. 
Confidence levels are usually set at 95% or 99%. For example, for a 95% 
confidence level, the VaR will give the amount that has a 5% chance of being lost. 
 
 A bank has estimated that the expected value of its portfolio in two 
weeks’ time will be $50 million, with a standard deviation of $4.85 
million. 
Required: 
Using a 95% confidence level, identify the value at risk. 
Solution 
A 95% confidence level will identify the reduced value of the portfolio 
that has a 5% chance of occurring. 
From the normal distribution tables, 1.65 is the normal distribution value 
for a one-tailed 5% probability level. Since the value is below the mean, – 1.65 will be needed. 
z = (x – μ)/σ 
(x – 50)/4.85 = –1.65 x = (–1.65 × 4.85) + 50 = 42

428  
 There is thus a 5% probability that the portfolio value will fall to 
$42 million or below. 
 
A bank can try to control the risk in its asset portfolio by setting target 
maximum limits for value at risk over different time periods (one day, one week, one month, three months, and so on). 
 
 Link between Monte Carlo Simulation and VaR 
 In the above Illustration, the expected portfolio value in two weeks' time 
was presented as a normal distribution with a mean of $50m. 
This distribution may well have been created by running a Monte Carlo 
simulation on the likely outcome over the next two weeks. 
Alternatively, the future expected value may have been forecasted by 
using historical data. 
 
 Example 6: Value at risk 
 A bank has estimated that the expected value of its portfolio in 10 days’ 
time will be $30 million, with a standard deviation of $3.29 million. 
Required: 
Using a 99% confidence level, identify the value at risk. 
9  Pay off tables and decision criteria 
When evaluating alternative courses of action, management’s decision will 
often depend upon their attitude towards the risk. To consider the risk borne by each alternative it is necessary to consider ALL the different possible profits/losses that may arise. A pay off table is simply a table that illustrates all possible profits/losses.

Chapter 11 
 429 
 Illustration 7 – Two way data tables 
For example, consider a company who are unsure about both selling 
price and variable cost. They believe that selling price may be either $40 or $50 depending on differing market conditions, and that variable production cost will be either $ 20 or $30 depending on wage 
negotiations currently taking place. The company has therefore got a number of potential contributions per unit that could be represented in a two way table as follows: 
 $40 $50 
$20 $20 $30 
$30 $10 $20 
example, that if selling price is $40 and variable production costs are $30, then the contribution per unit will be $10. 
Two way data tables can be expanded to calculate expected 
contribution from different volume levels. This will be explored further in the following illustration. 
 
canteens throughout a large organisation. A particular salad is sold to the canteen for $10 and costs $8 to prepare. Therefore, the contribution per salad is $2. 
Based upon past demands, it is expected that, during the 250-day 
working year, the canteens will require the following daily quantities: 
On 25 days of the year 40 salads On 50 days of the year 50 salads On 100 days of the year 60 salads On 75 days 70 salads 
Total 250 days 
The kitchen must prepare the salad in batches of 10 meals and it has to 
decide how many it will supply for each day of the forthcoming year.

430  
 Constructing a pay-off table: 
• If 40 salads will be required on 25 days of a 250-day year, the 
• Likewise, P(Demand of 50) = 0.20; P(Demand of 60 = 0.4) and P 
• Now let's look at the different values of profit or losses depending 
on how many salads are supplied and sold. For example, if we 
supply 40 salads and all are sold, our profits amount to 40 × $2 = 80. 
• If however we supply 50 salads but only 40 are sold, our profits will 
amount to 40 × $2 – (10 unsold salads × $8 unit cost) = 0. 
• Note too that there is an upper limit to the potential profit in some 
instances. If, for example, we supply 60 salads then the maximum we can sell is 60 salads with a profit of $2 per unit (and $120 overall). If demand reaches 70 salads we can still only sell 60 salads and therefore the maximum profit we can make from supplying 60 salads is $120. 
Solution 
   Daily supply 
 
 Probability 40 
salads 50 
salads 60 
salads 70 
salads 
Daily 
demand 40 
Salads 0.10 $80 $0 ($80) ($160) 
50 
Salads 0.20 $80 $100 $20 ($60) 
60 
Salads 0.40 $80 $100 $120 $40 
70 
Salads 0.30 $80 $100 $20 $140 
This could then be used to determine the expected value from each 
daily supply level: 
EV (of supplying 40 salads) = 0.10(80) + 0.20(80) + 0.40(80) + 0.30  
(80) = 80

Chapter 11 
 431 
 EV (of supplying 50 salads) = 0.10(0) + 0.20(100) + 0.40(100) + 0.30 
(100) = 90 
EV (of supplying 60 salads) = 0.10(–80) + 0.20(20) + 0.40(120) + 0.30 
(120) = 80 
EV (of supplying 70 salads) = 0.10(–160) + 0.20(–60) + 0.40(40) + 0.30 
(140) = 30 
On the basis of expected values, the best strategy would be to supply 
50 salads and gain an EV of 90.  
10 Maximax, maximin and minimax regret 
When probabilities are not available, there are still tools available for incorporating uncertainty into decision making. 
Maximax 
 
This approach would be suitable for an optimist who seeks to achieve the best results if the best happens. 
 
 Illustration 9 – The ‘Maximax’ rule 
 Let's apply the maximax rule to the previous illustration on 
Geoffrey Ramsbottom 
Geoffrey Ramsbottom's table looks as follows: 
  Probability 40 
salads 50 
salads 60 
salads 70 
salads 
Daily 
demand 40 
50 
60 
70 
Salads 0.30 $80 $100 $120 $140 
The manager who employs the maximax criterion is assuming that 
whatever action is taken, the best  will happen; he/she is a risk-taker. 
Here, the highest maximum possible pay-off is $140. We should 
therefore decide to supply 70 salads a day.

432  
 Example 7: Product Fishy – Maximax 
 Product 'Fishy' is a highly perishable commodity which can be sold on 
the retail market for $20 per case, or for animal food at $1 per case. 
'Fishy' costs $10 per case from the wholesale market, and is only suitable for sale at the retail market for up to 24 hours after purchase. Orders for 'Fishy' must be placed in advance each day. 
Vincent, a market stall owner, has kept the following records of sales of 
the 'Fishy' over the past 50 days, and correctly set up the following payoff table of his profits: 
 
 Supply of cases 
Daily demand 10 cases 20 cases 30 cases 
10 cases $100 $10   ($80) 
20 cases $100 $200 $110 
30 cases $100 $200 $300 
On the basis of using the maximax criteria, Vincent should supply 
________________ cases of 'Fishy'. 
 
 Maximin 
The maximin rule involves selecting the alternative that maximises the minimum pay-off achievable. 
best results if the worst happens. 
 
 Illustration 10 – The ‘Maximum’ rule 
salads 50 
salads 60 
salads 70 
salads 
Daily 
demand 40 
50 
60 
70 
Salads 0.30 $80 $100 $120 $140

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 If we decide to supply 40 salads, the minimum pay-off is $80.  
If we decide to supply 50 salads, the minimum pay-off is $0. 
If we decide to supply 60 salads, the minimum pay-off is ($80).  If we decide to supply 70 salads, the minimum pay-off is ($160).  The highest minimum payoff arises from supplying 40 salads. 
 
 Example 8: Product Fishy – Maximin 
 
20 cases $100 $200 $110 30 cases $100 $200 $300 
On the basis of using the maximin criteria, Vincent should supply 
 
The minimax regret rule 
 
 The minimax regret strategy is the one that minimises the maximum regret. It is useful when probabilities for outcomes are not available or where the investor is risk averse and wants to avoid making a bad decision. Essentially, this is the technique for a ‘sore loser’ who does not wish to make the wrong decision. 
‘Regret’ in this context is defined as the opportunity loss through having made the wrong decision.

434  
 Illustration 11 – The ‘Minimax Regret’ rule 
 Following up from the pay-off table example, Geoffrey Ramsbottom's 
table looks as follows: 
  Probabilit y 40 
salads 50 
salads 60 
salads 70 
salads 
Daily 
demand 40 
50 
60 
70 
If the minimax regret rule is applied to decide how many salads should 
be made each day, we need to calculate the 'regrets'. This means we 
need to find the biggest pay-off for each demand row, then subtract all other numbers in this row from the largest number. 
For example, if the demand is 40 salads, we will make a maximum profit 
of $80 if they all sell. If we had decided to supply 50 salads, we would achieve a nil profit. The difference, or 'regret' between that nil profit and the maximum of $80 achievable for that row is $80. 
Regrets can be tabulated as follows: 
  Daily supply 
  40 
salads 50 
salads 60 
salads 70 
salads 
Daily 
demand 40 Salads $0 $80 $160 $240 
50 Salads $20 $0 $80 $160 
60 Salads $40 $20 $0 $80 70 Salads $60 $40 $20 $0 
If we decide to supply 40 salads, the maximum regret is $60. If we 
decide to supply 50 salads, the maximum regret is $80. For 60 salads, the maximum regret is $160, and $240 for 70 salads. A manager employing the minimax regret criterion would want to minimise that maximum regret, and therefore supply 40 salads only.

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 Example 9: Cement Co Part II 
its formation in 1987. It is passionate about customer care and proud of 
its active approach to safety and su stainability (recognising the need to 
ensuring their products anticipate and meet the needs of its customers. 
When Q entered recession, many workers left the country in search of 
unsold at the end of the year, it has to be disposed of at a cost of $0.50 
per bag.

436  
 Cement Co has decided to produce at one of the three levels of 
Required: 
Evaluate the proposed levels of cement production using methods for 
decision making under ri sk and uncertainty and assess the suitability of 
the different methods used. 
11 Perfect and imperfect information 
In many questions the decision makers receive a forecast of a future 
outcome (for example a market research group may predict the forthcoming demand for a product). This forecast may turn out to be correct or incorrect. The question often requires the candidate to calculate the value of the forecast. 
 
Perfect information The forecast of the future outcome is always a correct prediction. If a firm can obtain a 100% accurate prediction they will always be able to undertake the most beneficial course of action for that prediction. 
Imperfect information The forecast is usually correct, but can be incorrect. Imperfect information is not as valuable as perfect information. Imperfect information may be examined in conjunction with Decision Trees (see later in this chapter). 
The value of information (either perfect or imperfect) may be calculated as follows: 
Expected profit (outcome) WITH the information 
minus 
Expected profit (outcome) WITHOUT the information

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 Illustration 12 – The value of information 
 A new ordering system is being considered, whereby customers must 
order their salad online the day before. With this new system 
Mr Ramsbottom will know for certain the daily demand 24 hours in advance. He can adjust production levels on a daily basis. How much is this new system worth to Mr Ramsbottom? 
 
Supply = demand X 
Pay off P 
Probability px 
40 $80 0.1 8 
50 $100 0.2 20 
60 $120 0.4 48 
––––– 
   118 
E.V. with perfect information = $118 
E.V. without perfect information (from the original 
EV calculation) = $90 
––––– 
Value of perfect information $28 per day 
––––– 
  
12 Decision trees and multi-stage decision problems 
A decision tree is a diagrammatic representation of a decision problem, where 
all possible courses of action are represented, and every possible outcome of each course of action is shown. Decision trees should be used where a problem involves a series of decisions being made and several outcomes arise during the decision-making process. In some instances it may involve the use of joint probabilities – where the outcome of one event depends of the outcome of a preceding event. 
 
Illustration 13 – Joint probabilities 
 So far only a very small number of alternatives have been considered in 
the examples. In practice a greater number of alternative courses of 
action may exist, uncertainty may be associated with more than one variable and the values of variables may be interdependent, giving rise to many different outcomes. 
The following exercise looks at the expected value of a manufacturing 
decision, where there are three alternative sales volumes, two 
alternative contributions, and three alternative levels of fixed cost. The 
number of possible outcomes will be 3 × 2 × 3 = 18.

438  
 Example 
A company is assessing the desirability of producing a souvenir to 
celebrate a royal jubilee. The marketing life of the souvenir will be 6 months only. Uncertainty surrounds the likely sales volume and contribution, as well as the fixed costs of the venture. Estimated outcomes and probabilities are: 
 
Units 
per 
unit Probability Fixed 
  $  $  
60,000 0.1 
–––   
––– 500,000 0.3 
––– 
 1.0 
–––  1.0 
–––  1.0 
––– 
The next table shows the expected value of the net contribution to be $49,000. Totalling up the joint probabilit ies for each set of sales shows 
the project has a 56.5 per cent chance of making a net contribution, a 33 per cent chance of making a loss, and a 10.5 per cent chance of making neither a net contribution nor a loss. (For example, to calculate the probability of making a loss: we can see from the next table that a loss will arise in 7 situations. So if  we add the overall probability of this 
happening we add up the joint probabilities associated with each of these outcomes – 0.150 + 0.090 + 0.025 + 0.015 + 0.010 + 0.025 + 0.015 = 0.33).

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 439 
        
Units 
sold Cont'n 
per 
unit 
$ Total 
Cont'n 
$ 
a Fixed 
Cost 
$ 
b Probability  Joint 
Prob. 
c EV of 
net 
cont. 
$ 
(a-b) x 
c 
100,000 7 700,000 400,000 0.3×0.5×0.2= 0.030 9,000 
 7 700,000 450,000 0.3×0.5×0.5= 0.075 18,750 
 7 700,000 500,000 0.3×0.5×0.3= 0.045 9,000 
 5 500,000 400,000 0.3×0.5×0.2= 0.030 3,000 
 5 500,000 450,000 0.3×0.5×0.5= 0.075 3,750 
 5 500,000 500,000 0.3×0.5×0.3= 0.045 0 
80,000 7 560,000 400,000 0.6×0.5×0.2= 0.060 9,600 
 7 560,000 450,000 0.6×0.5×0.5= 0.150 16,500 
 7 560,000 500,000 0.6×0.5×0.3= 0.090 5,400 
 5 400,000 400,000 0.6×0.5×0.2= 0.060 0 
 5 400,000 450,000 0.6×0.5×0.5= 0.150 –7,500 
 5 400,000 500,000 0.6×0.5×0.3= 0.090 –9,000 
60,000 7 420,000 400,000 0.1 ×0.5×0.2= 0.010 200 
 7 420,000 450,000 0.1 ×0.5×0.5= 0.025 –750 
 7 420,000 500,000 0.1×0.5×0.3= 0.015 –1,200 
 5 300,000 400,000 0.1×0.5×0.2= 0.010 –1,000 
 5 300,000 450,000 0.1 ×0.5×0.5= 0.025 –3,750 
 5 300,000 500,000 
––– 0.1 ×0.5×0.3= 0.015 
––– –3,000 
––––– 
   1.0  1.0 49,000 
Decisions like this can be quite hard to visualise and it may be more 
useful to use a decision tree to express the situation. 
Three-step method 
Step 1:  Draw the tree from left to right showing appropriate decisions and 
events/outcomes. 
 
Label the tree and relevant cash inflows/outflows (discounted to present values if necessary) and probabilities associated with 
outcomes.

440  
Step 2:   Evaluate the tree from right to left carrying out these two actions: 
Choose the best option at each decision point.  
Step 3:   Recommend a course of action to management. 
 
 Example 10: Decision Trees 
 An oil company has recently acquired rights in a certain area to conduct 
surveys and geological test drillings t hat may lead to extracting oil where 
it is found in commercially exploitable quantities. The area is already considered to have good potential for finding oil in 
commercial quantities. At the outset the company has the choice to 
conduct further geological tests or to carry out a drilling programme immediately. On the known conditions, the company estimates that there is a 70% chance of further tests indicating that a significant amount of oil is present. 
Whether the tests show the possibility of oil or not, or even if no tests 
are undertaken at all, the company could still pursue its drilling programme or alternatively consider selling its rights to drill in the area. 
Thereafter, however, if it carries out the drilling programme, the 
likelihood of final success or failure in the search for oil is considered dependent on the foregoing stages. Thus: 
(i) If the tests indicated that oil was present, the expectation of 
success in drilling is given as 80%. 
(ii) If the tests indicated that there was insufficient oil present, then the 
expectation of success in drilling is given as 20%. 
(iii) If no tests have been carried out at all, the expectation of finding 
commercially viable quantities of oil is given as 55%.

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 441 
 Costs and revenues have been estimated for all possible outcomes and 
the net present value of each is given below: 
Outcome Net present value 
 $ millions 
Geological testing (10) 
Drilling cost (50) 
  
Success in finding oil 150 
  
Sale of exploitation rights:  
Tests indicate oil is present 65 
Tests indicate ‘no oil’ 15 
Without geological tests 40 
Required: (a) Prepare a decision tree diagram to represent the above 
(b) For the management of the company, calculate its best course of 
action.  
(c) Explain the value of decision trees in providing management with 
guidance for decision making. Illustrate examples of any situations 
where you consider their use would be of benefit. 
 
 Decision trees force the decision maker to consider the logical 
sequence of events. A complex problem is broken down into smaller, easier-to-handle sections. The financial outcomes and probabilities are shown separately, and the decision tree is ‘rolled back’ by calculating expected values and making decisions. In the examination ensure that only relevant costs and revenues are considered, and that all cash is expressed in present value terms. 
A number of other factors should be taken into account when 
considering decision tree-type problems: 
• Time value of money.  The time value of money should be 
incorporated in the calculations if the project is to last for more 
than one year. The time value of money is discussed in detail later in this text.

442  
 • Assumes risk neutrality . As mentioned under probability, some 
expected value, because they are either risk seekers or risk averse. 
• Sensitivity analysis . The analysis depends very much on the 
values of the probabilities in the tree. The values are usually the subjective estimates of the decision-makers, and, no matter how experienced the people involved are, the values must be open to question. Sensitivity analysis can be used to consider 'break-even' positions for each variable – i.e. the value for a variable (such as probability) at which the decision would change. Sensitivity analysis is covered later in this chapter. 
• Oversimplification . In order to make the tree manageable, the 
situation has often to be greatly simplified. This makes it appear far more discrete than it really is. In practice, it is much more likely that the outcomes would form a near continuous range of inflows and outflows. This cannot be shown on a decision tree, and so any decision tree usually represents a simplified situation. 
 
 Illustration 14 – make vs buy 
 If made in-house If buy in and  
re-badge 
 $ $ 
Identify the sensitivity of the decision to the external purchase 
price. 
Comparing contribution figures, the product should be bought in and re-
badged: 
 If made in-house If buy in and re-
badge 
 $ $ 
Step 2:  Calculate the sensitivity (to the external purchase price). 
For indifference, the contribution from outsourcing needs to fall to $5 per 
unit. Thus the external purchase price only needs to increase by $1 per unit (or $1/$6 = 17%). 
If the external purchase price rose by more than 17% the original 
decision would be reversed.

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13 Conditional probabilities  
Conditional probability is the probability of an event whose calculation is based 
on the knowledge that some other event has occurred. 
The symbol P(A|B) is read as ‘the probability of A occurring given that B has 
already occurred’, and we can say that: 
P (A and B) = P (A|B) x P (B) 
This formula can be rewritten in a variety of ways, depending on what you are trying to find out. 
P(A and B) = P(B|A) × P(A) P(A|B) × P(B) = P(B|A) × P(A) 
 
PሺA/Bሻ	= P ሺA and Bሻ
P ሺBሻ 
 
PሺB/Aሻ = P ሺB and Aሻ
P ሺAሻ 
 
However, this can get a bit mind-boggling. An easier way to deal with this sort 
of problem is to use what is known as a contingency table . 
Contingency tables 
Contingency tables are created by taking the given probabilities, multiplying by 
some convenient number, typically 100 or 1,000 (to make the numbers easy to work with), then drawing a table to show the various combinations of factors which may exist. 
 
Illustration 15 – Contingency tables 
 40% of the output of a factory is produced in workshop A and 60% in 
workshop B. 
Fourteen out of every 1,000 components from A are defective and six 
out of every 1,000 components from B are defective. 
After the outputs from A and B have been thoroughly mixed, a 
component drawn at random is found to be defective. What is the probability that it came from workshop B? 
Solution 
The problem will be solved by drawing a contingency table, showing 
defective and non-defective components and output from workshops A and B.

444  
 Consider 10,000 components. We know that of these 4,000 (40%) will 
be from workshop A and 6,000 (60%) from workshop B.  
 Workshop A Workshop B Total 
Defective    
Non-defective  
–––––  
–––––  
–––––– 
Total 4,000 
––––– 6,000 
––––– 10,000 
–––––– 
Of the 4,000 from workshop A, 14/1,000 – that is 56 – will be defective, 
and from workshop B 6/1,000 – that is 36 – will be defective. Hence, the table can be completed so far: 
Defective 56 36  
–––––  
–––––  
–––––– 
–––––– 
All the remaining figures can be completed as balancing figures, and the 
final contingency table looks like this: 
Defective 56 36 92 
Non-defective 3,944 
––––– 5,964 
––––– 9,908 
–––––– 
–––––– 
The question was: what is the probability that a component came from 
workshop B, given that it is defective? 
Given that it is defective, we know that we are dealing with one of the 
92 components in the top row of the table. We can see that of these 92 components, 36 came from workshop B. 
Hence 
Pሺcame from workshop B given that it is defective ሻ	= 36
92
 
That is 0.39, or 39%. 
There are other ways of solving such problems, but most students will 
find the contingency table method easier, and quicker.

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 Example 11: Conditional probabilities 
 30% of the new cars of a particular model are supplied from a factory X, 
the other 70% from factory Y. 10% of factory X’s production has a major 
fault, 12% of factory Y’s production has such a fault. 
A purchaser’s new car has a major fault: what is the probability that it 
was made at factory Y? 
14 Stress testing 
A stress test is a way of analysing a business to consider how well it could cope in difficult conditions. Stress testing is the process of assessing the vulnerability of a position against hypothetical events (a cyberattack, for example).  
When a business is doing well, it can be difficult to identify how it would fare if 
there was a sudden downturn in the economic environment. 
 
Illustration 16 – Bank of England 
 The Bank of England conducts annual stress tests on each of the major 
UK based banks.  
The stress tests were brought in as a result of the financial crisis in 
2008-2009, and the tests are designed to simulate scenarios that are similar or worse than what happened in the financial crisis. Some of the scenarios used in 2018 were: 
• Property prices falling by 33% • Interest rates rising to 4% 
• UK GDP falling by almost 5% 
The results are then published. If a bank fails the stress test, it has to 
face the reputational damage, and may be required to reduce dividend payments to shareholders to improve its capital position.

446  
 Example 12: Stress testing 
The manufacturer has already prepared the following budget for the 
year: 
  $000 
Revenue  480 
Cost of sales  200 
Other operating costs  80 
  –––– Gross profit  200   –––– 
The manufacturer wants to stress test the budget for the loss of the 
major customer who makes up 25% of  its total sales. This customer 
provides a margin of 15% on sales. 
What would be the revised budgeted profit if the customer’s sales 
were lost? A  $182,000 B  $80,000 C  $110,000 D  $150,000 
Robert Simons, a Harvard business professor, suggested there are 
7 questions that directors business should try to answer to check if their 
business is robust enough. The questions break down into 4 keys areas: 
Prioritisation 
• Who is your primary customer? 
• How do your core values prioritise shareholders, employees, and 
customers? 
Measurement 
• What critical performance variables are you tracking? 
• What strategic boundaries have you set? 
• How are you generating creative tension? 
• How committed are your employees to helping each other? 
• What strategic uncertainties keep you awake at night?

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 Stress testing – 4 key areas 
 Prioritisation 
Simons’ view is that people who work for the organisation cannot be 
customers, and to refer to any internal people/departments as a ‘customer’ means the organisation will lose focus on the true purpose. 
Once your primary customer is established, the majority of resources 
should be used to make sure the company is delivering for their needs. 
In a similar way, the core values of a business must be clearly defined 
and statements that list multiple desirable actions don’t work. There is no right stakeholder to prioritise, but a company must decide who comes first: the shareholder, the customer, or the employees? 
There are various well known sayings: ‘If it matters, measure it’, ‘what 
gets measured gets done’, etc. The key is not to have too many measures on any scorecard. The business must identify the key factors that drive performance, and focus on those. 
The reference to creative tension is unusual, but the idea is that 
disagreement challenges the norms and can produce different ideas and outcomes. Diverse opinions and ideas lead to new ways of doing business. Idea generation is often associated with a positive outlook, but it can actually be the opposite. A positive outlook may be lead to people insisting that everything will eventually work out. The pessimistic view that ‘things aren’t working’ can often lead to a positive change. 
Commitment to mutual help links back to the theory of why 
organisations exist. Working effectively together enhances productivity. If employees trust they are being treated fairly, greater results are to be achieved. 
Finally, as with any control system, flexibility is key. Customer 
preferences change, technology is moving at an incredible pace and business models require frequent updates.

448  
 Stress testing 
 Who is your primary customer? 
M&S have always tried to appeal to a range of age groups, but M&S are 
struggling to keep pace with all the different clothing options. Shoppers are now confused by their range of brands and don’t know what brands are aimed at them. Critics of M&S suggest this is one of their biggest issues, and, in order to turnaround their recent decline, they need to clearly define who they are selling to. 
How do your core values prioritise shareholders, employees, and 
Many companies state in their mission that their purpose is to maximise 
shareholder wealth. Examples abound of companies who make reference to only one stakeholder in their mission, a clear prioritisation of shareholders. 
Employees  Virgin’s Richard Branson believes that the employee should be a 
company’s number one priority. He says a happy and proud employee translates into excellent customer service, and, beyond, to shareholder satisfaction. 
Customers  Google’s mission statement since it started in 1998 has been “to 
organise the world’s information and make it universally accessible and useful.” Serving the end users has been at the heart of what Google do from the day it was founded and is one of the core reasons for the company’s success.  
What critical performance variables are you tracking? In performance management, the advice is to focus on a few key 
metrics.  
What strategic boundaries have you set? Apple are well known using strategic boundaries, in 1998 Steve Jobs 
reduced the product portfolio by over 70%, so the business could focus on doing a few things very well. From a loss-making company in 1997, Jobs turned Apple into the biggest global brand. He famously said “Focus means saying no to the hundred other good ideas.”

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 How are you generating creative tension? 
The matrix structure is an example of how a company can develop 
creative tension. Having dual management means extra pressure on an employee to deliver. Many people find that pressure can help them perform and if managed well it can help companies succeed, many companies have used the matrix structure successfully (for example, P&G and Kraft). 
How committed are your employees to helping each other? While Henry Ford gets all the credit in all business strategy textbooks 
and articles, he had a team working with him. Clarence Avery was the lead developer, Peter Martin the head of assembly and Charles Sorensen was the assistant to Peter Martin. All these individuals combined to help create the assembly line that the model T car so famously came from. 
What strategic uncertainties keep you awake at night? When Alan Mulally became the CEO at Ford in 2006, the business was 
heading towards a $17 billion loss. He implemented a colour coding system for weekly meetings with his executives. As normal green meant good, yellow meant new issues, red meant problems. Mulally couldn’t understand why all the charts were green at the first meeting, a company heading for a $17 billion loss could not all be green. One unit head put up a red chart and highlighted an issue he was having in Canada. Mulally applauded the unit head’s honesty and then they discovered other areas were having the same issues. Through collaboration they were able to find a solution, and that changed the culture at Ford to one where people shared issues to find solutions.  
15 Scenario Planning 
Competence slip and organisational failure have been linked to the notion that management have failed to grasp the way that society is moving and have not conceptualised a possible future marketplace. 
It has been suggested that managers need a picture or scenario of where the 
world may be in a few years' time. For example, how would an accountancy training college meet its objectives under the following circumstances: 

450  
Scenario planning involves the following steps: 
(1) Identify high-impact, high-uncertainty factors in the environment.   Relevant factors and driving forces could be identified through a strategic 
analysis framework such as a PEST analysis. Once identified, factors 
need to be ranked according to importance and uncertainty. For example, in the oil industry there may be a need to form a view of the business environment up to twenty-five years ahead and issues such as crude oil availability, price and ec onomic conditions are critical. 
 For example, oil companies would consider possible political uncertainty 
in oil-producing countries and the attitudes of future governments to 
climate change, pollution and energy policy. 
Precision is not possible but developing a view of the future against 
which to evaluate and evolve strategies is important. 
At 3M, for example, the general manager of each business unit is 
required annually to describe what his or her industry will look like in fifteen years. 
then the likelihood of new entrants will fall.  
(4) ‘Writing the scenario’ – for the most important scenarios (usually limited 
to three), build a detailed analysis to identify and assess future 
As part of this, planners typically develop a set of optimistic, pessimistic 

Chapter 11 
 451 
firm. 
Some strategies make sense whatever the outcome, usually because 
they capitalise on or develop key strengths of the firm. For example, the firm concerned may have a global brand name and could seek to strengthen it by increasing its advertising spend in the short term. However, in many cases, new re sources and competences may be 
Construction of scenarios  
Shell makes use of scenario planning extensively in order to predict future 
changes in the energy industry so that it can attempt to prepare for them. 
 
Example 13: Scenario planning 
 Which THREE off the following are disadvantages of scenario planning? 
A  Bounded rationality 
B  Reduce communication within the organisation C  High cost D  Risk of self-fulfilling prophecy E Waste management time F Discourages creative thinking

452  
16 Practice questions 
 Objective Test Question 1: Ca lculating an expected value 
 A company has identified four possible outcomes from a new marketing 
 
Outcome Profit ($) Probability 
D –20,000 0.20 
The expected outcome of this strategy is $ __________. 
 
 Objective Test Question 2: Hofgarten 
 • Hofgarten Newsagents stocks a weekly magazine which 
advertises local second-hand goods. Marie, the owner, can: 
–  buy the magazines for 15c each  –  sell them at the retail price of 25c 
• At the end of each week unsold magazines are obsolete and have 
no value. 
1  Marie estimates a probability distribution for weekly demand which 
looks like this: 
 
10 0.20 
15 0.55 
20 0.25 
–––– 
 1.00 
–––– 
Required: 
(i) The expected value of demand is ____________units. 
(ii) If Marie is to order a fixed quantity of magazines per week, 
calculate how many that should be?____________ units. 
Assume no seasonal variations in demand.

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 453 
 Objective Test Question 3: Three new products maximax 
 A company is choosing which of three new products to make (A, B 
or C) and has calculated likely pay-offs under three possible scenarios 
(I, II or III), giving the following pay-off table. 
 
Profit (loss) 
Scenario Product chosen  
A B C 
I 20 80 10 
II 40 70 100 
Required: 
 
 Objective Test Question 4: Three new products minimax regret 
 Required: Using the information from ‘Objective Test Question 3’ above, apply the 
minimax regret rule to decide which product should be made. 
 
 Objective Test Question 5: Three new products maximin 
 Required: 
Using the information from ‘Objective Test Question 3’ above, apply the 
maximin rule to decide which product should be made. 
 
 Objective Test Question 6: External consultant 
 Following on from the data provided in ‘Objective Test Question 3’ 
above, the company has made an estimate of the probability of each scenario occurring as follows: 
 
I 20% 
II 50% 
III 30% 
However, an external consultant has some information about each likely scenario and can say with certainty which scenario will arise. Calculate 
the value of the external consultants’ information: 
$______________

454  
 Objective Test Question 7: Sensitivity analysis 
 A manager has identified the following two possible outcomes for a 
process. 
 Outcome Probability Financial 
implications 
($000s)  
The expected value has been calculated as EV = (0.4 × –20) + (0.6 × 
40) = +16. This would suggest that the opportunity should be accepted. 
Required: 
(a) Suppose the likely loss if results are poor has been 
underestimated. What level of loss would change the decision? In 
effect we want a break-even estimate. 
(b) Suppose the probability of a loss has been underestimated. What 
is the break-even probability? 
 
 Objective Test Question 8: Imperfect information 
 Identify the correct description of imperfect information: 
A  costs more to collect than its value to the business 
B  is available only after preliminary decisions on a business venture 
have been taken 
C  does not take into account all factors affecting a business D  may contain inaccurate predictions  
 
 Objective Test Question 9: Three investments 
 Three investors are considering the same investments. The net returns 
from the investments depend on the state of the economy and are 
illustrated as follows: 
 
State of the 
economy Returns from 
investment Probability 
of 
economic 
state 
 A B C  
 $ $ $  
Good 6,000 14,000 3,000 0.1 
Fair 5,000 3,000 5,000 0.4 
Poor 4,000 500 8,000 0.5

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 455 
 Details on the attitudes to risk of the three investors is as follows:  
• Micah is risk neutral 
• Zhang is a risk seeker 
• Jill is risk averse and typically follows a minimax regret strategy 
with her investments. 
Calculate which investment would be best suited to each investor's risk 
attitude. 
 
 Objective Test Question 10: CHARITY ORGANISATION 
 For the past 20 years a charity organisation has held an annual dinner 
and dance with the primary intention of raising funds. 
This year there is concern that an economic recession may adversely 
affect both the number of people attending the function and the advertising space that will be sold in the programme published for the occasion. 
Based on past experience and current prices and quotations, it is 
expected that the following costs and revenues will apply for the function: 
   $ 
Cost: Dinner and 
dance Hire of premises 700 
  Band and entertainers 2,800 
  Raffle prizes 800 
  Photographer 200 
  Food at $12 per person (with 
a guarantee of 400 persons 
minimum)  
 Programme: A fixed cost of $2,000 plus $5 
per page  
Revenues: Dinner and dance Price of tickets $20 per person 
  Average revenue from:  
  Raffle $5 per person 
  Photographs $1 per person 
 Programme: Average revenue from advertising $70 per person

456  
 A sub-committee, formed to examine more closely the likely outcome of 
the function, discovered the following from previous records and 
accounts: 
Number of 
tickets sold Number of 
past occasions 
250 to 349 4 
350 to 449 6 
450 to 549 8 
550 to 649 2 
 
Number of 
programme 
pages sold Number of 
24 4 32 8 40 6 
48 2 
Required: 
Calculate the expected value of the profit to be earned from the dinner 
and dance this year. 
 
 Objective Test Question 11: RS Group 
 The RS Group owns a large store in Ludborough. The store is old-
fashioned and profits are declining. Management is considering what to do. There appear to be three possibilities: 
1 Shut down and sell the site for $15m. 2 Continue as before with profits declining. 3 Upgrade the store. The Group has had problems in the past and experience suggests that 
when stores are upgraded, 60% achieve good results and 40% poor results. 
Because of the doubts, management is considering whether to contact a 
leading market research company to carry out consumer research in Ludborough for $1m. It has been fortunate in obtaining details of the track record of the research company, as follows: 
 
  Actual outcome 
  Good Poor 
Attitude predicted by research Positive 0.85 * 0.10 
Negative 0.15 0.90 
* This means that when the actual results were good the research had predicted this 85% of the time.

Chapter 11 
 457 
 If the research indicates a positive  attitude, management will consider 
deluxe upgrading which will generate more profit but will cost $12m, as 
compared with standard upgrading costing $6m. 
If the research indicates a negati ve attitude, then management will 
consider standard upgrading compared with shutting down and selling 
the site. 
The time scale for the analysis is 10 years and the following estimates 
of returns have been made: 
With Deluxe upgrading:  Good results $40m total present value 
 Poor results $20m total present value  With Standard upgrading:   Good results $25m total present value 
 Poor results $10m total present value If operations continue as before, returns over the next 10 years will be 
$13.03m in present value terms. 
Required: 
(a) prepare a decision tree to represent the above information. Note:  No discounting is necessary for this question as the values are 
already expressed in present value terms. (b) calculate what decisions should be taken.  
(c) explain the basis of your analysis. 
 
 Objective Test Question 12:  X and Y 
 A company can make either of two new products, X and Y, but not 
both. The profitability of each product depends on the state of the 
market, as follows: 
 
Market state Profit from 
product Probability of 
market state 
 X 
$ Y 
$  
Calculate the expected value of perfect information as to the state of 
A  $0 B  $600 C  $800 D  $1,000

458  
 
 Objective Test Question 13: Venus department store 
 The Venus Department Stor e operates a customer loan facility. If one of 
high loan limit, or gives a low loan limit. From a number of years past experience the probability that a new customer makes a full repayment of a loan is known to be 0.95, whilst the probability of non-repayment is 0.05 (these probabilities being independent  of the size of loan limit). The 
average profit in $, per customer made by Venus is given by the following table. 
 
 Loan limit 
 High Low 
   
Required: 
(a) In the past the company has used a selection criterion that is 
totally arbitrary (i.e. it is not influenced by the customer's ability to 
repay). 
Prepare a decision tree to represent the information. Calculate 
the expected value and explain what the management of Venus should do if a new customer requests a loan? 
(b) Venus can apply to an agency to evaluate the credit-rating of a 
customer. This agency would provide a rating for the customer as either a good risk or as a bad risk, this credit-rating being independent of the size of the loan being considered. Analysis of the last 1,000 customer ratings by this agency revealed the following information. 
 
Agency Type of customer  
Credit rating Full-repayment Non-repayment Total 
Good risk 790 10 800 
Bad risk 160 40 200 
Total 950 50 1,000 
 
Determine the value of this credit rating to Venus. 
(c) The Venus management believe that this first agency is not very 
good at selecting full-payers and non-payers. It considers contacting a second agency which guarantees perfect information concerning the credit rating of the customers. 
Explain the meaning of the term 'perfect information' in the 
context of this question. 
Calculate the value of this perfect information.

Chapter 11 
 459 
 Objective Test Question 14: Stress testing 
 An importer has produced the following budget for next month: 
 
  $000 
Sales  64 
Material costs  (28) 
Labour costs  (12) Overhead costs  (18) 
  ––– 
Gross profit  6   ––– 
currency rates on the products that it imports. A currency change would increase material costs by 10%, only half of which could be passed on to the importers powerful customers. 
The revised gross profit for the month would be $_______ (round to the 
nearest $) 
 
 Data Set Question: Two-stage process 
 A product is manufactured in a two-stage process, the stages being 
designated A and B. 
Each process has two machines, named A1 and A2 for process A, and 
B1 and B2 for process B. 
Each unit of finished product must pass through either one of the two 
machines in process A, and then through either one of the two machines in process B. (50% go through A1 and 50% through A2. Similarly for B1 and B2.) 
How many different ways may a product be manufactured?  
The probabilities of a defective product from each machine are as 
follows: 2% for A1, 6% for A2, 4% for B 1, 2% for B2. The defectives 
are thrown out as they occur. 
What is the probability of a perfect item being produced?  
The total production is 10,000 items started every year. The loss on 
each defective item is $10, and the profit on each item is $80. 
 
The expected net profit is  $

460  
 Case Study Style Question: SITERAZE LTD 
Siteraze Ltd is a company which engages in site clearance and site 
preparation work. Information concerning its operations is as follows: 
(a) It is company policy to hire all plant and machinery required for the 
implementation of all orders obtained, rather than to purchase its 
own plant and machinery. 
(b) Siteraze Ltd will enter into an advance hire agreement contract for 
the coming year at one of three levels – high, medium or low, which correspond to the requirements of a high, medium or low level of orders obtained. 
(c) The level of orders obtained will not be known when the advance 
hire agreement contract is entered into. A set of probabilities have been estimated by management as to the likelihood of the orders being at high, medium or low level. 
(d) Where the advance hire agreement entered into is lower than that 
required for the level of orders actually obtained, a premium rate must be paid to obtain additional plant and machinery required. 
(e) No refund is obtainable where the advance hire agreement for 
plant and machinery is at a level in excess of that required to satisfy the site clearance and preparation orders actually obtained. 
A summary of the information relating to the above points is as follows: 
 
   Plant and machinery 
hire costs 
Level of 
orders Revenue  
$000 Probability  Advance 
hire 
$000 Conversion 
premium 
$000 
High 15,000 0.25 2,300  
Medium 8,500 0.45 1,500  
Low 4,000 0.30 1,000  
Low to medium    850 
Medium to high    1,300 
Low to high    2,150 
Variable cost (as a percentage of turnover) 70%

Chapter 11 
 461 
 You have just received the following email from the company's Finance 
Director: 
 
 After submitting your numbers, you then get a second email: 
 
Task:  Reply to both emails from Pedro Rodriguez.

462  
 (a) 
Year   Cash flow 
$ 15% 
discount 
Value   
0 Investment (120,000)  (120,000) 
1–15 Contribution 41,250 5.847 241,189 
1–15 Fixed costs (18,000) 5.847 (105,246) 
15 Scrap value 25,000 0.123 3,075 
–––––– 
    19,018  
–––––– 
 
Net Present Value = $19,018 
(b) (i) If the capital outlay were to rise by more than $19,018 the 
project would cease to be viable. As a percentage increase 
this is: 
Sensitivity margin = $19,018
$120,000 × 100% = 15.85% 
(ii) If the PV of contribution were to fall by more than $19,018 the 
project would cease to be viable. As a percentage change 
this is: 
$241,189 × 100% = 7.89% 
(iii) If the PV of fixed costs were to rise by more than $19,018 the 
this is: 
$105,246 × 100% = 18.07% 
(c)  The break-even point can be calculated as follows: 
To remove the current NPV of $19,018, the PV of contribution 
would have to fall to $222,171 ($241,189 – $19,018). Calculating this as an annual amount can be done using the relevant annuity factor: 
Annual cash amount = $222,171 ÷ 5.847 = $37,997 
Let ‘x’ be minimum sales    
Annual contribution = $2.75 × = $37,997  
Therefore × = 13,817 units

Chapter 11 
 463 
 The expected sales revenue at a selling price of $10 per unit is $1,040, 
that is [800 × 0.15] + [1,000 × 0.50] + [1,200 × 0.35]. In preparing 
forecasts and making decisions management may proceed on the assumption that it can expect sales revenue of $1,040 if it sets a selling price of $10 per unit. T he actual outcome of adopting this selling price 
may be sales revenue that is higher or lower than $1,040. And $1,040 is not even the most likely outcome; the most likely outcome is $1,000, since this has the highest probability. 
 
 Expected annual cash flows are: 
 
Annual cash 
flow (x) Probability (p) PV 
   
50,000 0.3 15,000 
100,000 0.5 50,000 
150,000 0.2 30,000 
   
NPV calculation: 
 
Time Cash flow (x) DF 5% PV 
$ 
    
0 (460,000) 1 (460,000) 
1-5 95,000 4.329 411,255 
5 40,000 0.784 31,360 
–––––– 
NPV =  (17,385) 
–––––– 
As the NPV is negative, the project should not be undertaken.

464  
 An alternative approach would be to calculate three separate NPVs and 
then combine them, giving the following figures: 
 
Annual cash flow 
(x) Probability (p) NPV 
$ 
   
50,000 0.3 (212,190) 
100,000 0.5 4,260 
150,000 0.2 220,710 
ENPV = 0.3 × (–212,190) + (0.5 × 4,260) + 0.2 × (220,710) 
=  (17,385) 
––––––– 
Even though the NPV is negative these figures show that there is a 70% 
chance of the project giving a positive NPV. Some investors may consider the project acceptable on this basis. 
 
 Example 4: Cement Co Part I 
 The primary objective of Cement Co, a listed company, will be to 
maximise shareholder wealth. The directors should, in theory, be acting in the best interests of the shareholders. The shareholders appear to be reasonably risk averse at the moment since they have expressed concern over the fall in profit. 
Cement Co is open to a lot of risk and uncertainty: – Firstly, Q’s economy is in recession which will have a direct impact 
on Cement Co as house building falls and government contracts 
are cut.
 
– At the same time, the company’s costs are increasing due to 
increases in wages and in suppliers’ prices.  
– Cement Co is risking falling behind its competitors who have 
increased investment in research and development. There is a risk 
that Cement Co will not be able to meet the needs of its customers 
as well as its competitors.  
– Cement Co does pride itself on its approach to sustainability and 
safety. However, the industry is characterised by its negative impact on the environment and poor safety record and therefore it is imperative that Cement Co does not lose focus on achieving their sustainability and safety targets. 
– Finally, volatile weather conditions can have a huge impact on the 
building industry and on Cement Co’s profitability. The weather is clearly something that cannot be controlled but the risk should be appropriately managed.

Chapter 11 
 465 
 Directors can take one of three approaches to managing risk: 
– Risk averse directors – will assume the worst outcome and will 
seek to minimise its effect. Some of Cement Co’s directors will be 
keen to take this approach in the hope of securing a satisfactory return for shareholders and securing their positions. 
– Risk seeking directors – will assume the best outcome and will 
seek to maximise its effect. Some of the directors will be risk seeking, hoping to secure an outcome that will maximise profitability and their annual bonus. 
– Risk neutral directors – these dire ctors will be interested in the 
most probable outcome. This would be a sensible approach in situations where the risks remain  unaltered and decisions are 
repeated many times. 
 
 Project B 
of variation 
 $000 $000  
    
 A 99% confidence level will identify the reduced value of the portfolio 
that has a 1% chance of occurring. 
From the normal distribution tables, 2.33 is the normal distribution value 
for a one-tailed 1% probability level. Since the value is below the mean – 2.33 will be needed. 
z = (x – μ)/σ 
(x – 30)/3.29 = –2.33 x = (–2.33 × 3.29) + 30 = 22.3 There is thus a 1% probability that the portfolio value will fall to $22.3 
million or below.

466  
 Example 7: Product Fishy Maximax 
maximum pay-off achievable. Vincent would look at the best possible 
outcome at each supply level, then select the highest one of these. 
If Vincent supplies 10 cases, the best possible outcome is a profit of 
$100. 
If Vincent supplies 20 cases, the best possible outcome is a profit of 
$200. 
If Vincent supplies 30 cases, the best possible outcome is a loss of 
$300. 
Vincent would therefore opt for 30 cases when using the maximax 
criteria. 
 
 Example 8: Product Fishy Maximin 
 The maximin rule involves selecting the alternative that maximises the 
minimum pay-off achievable. Vincent would look at the worst possible outcome at each supply level, then select the highest one of these. 
If Vincent supplies 10 cases, the worst possible outcome is a profit of 
$100. 
If Vincent supplies 20 cases, the worst possible outcome is a profit of 
$10. 
If Vincent supplies 30 cases, the worst possible outcome is a loss of 
$(80). 
Vincent would therefore opt for 10 cases when using the maximin 
criteria.

Chapter 11 
 467 
 Before any of the techniques for decision making under risk and 
uncertainty are applied, it will be necessary to construct a payoff table: 
 
   SUPPLY 
DEMAND Weather Probability 350,000 280,000 200,000 
   Profit 
$000  
350,000 Good 0.25 1,750 (W1)  1,400 1,000 
280,000 Average 0.45 1,085 (W2) 1,400 1,000 
200,000 Poor 0.30 325 640 1,000 
Workings: 
Profit per bag sold in coming year = $9 – $4 = $5 Loss per bag disposed 
of = $4 + $0.50 = $4.50 
(W1) 350,000 × $5 = $1,750,000 (W2) [280,000 × $5] – [70,000 × $(4.50)] = $1,085,000 etc. We can now evaluate the proposed levels of cement production using 
four different methods: 
Method 1: Expected Values 
Use the probabilities provided in order to calculate the expected value of 
each of the supply levels. Good: (0.25 × $1,750,000) + (0.45 × $1,085,000) + (0.30 × $325,000) = 
$1,023,250 
Average: (0.7 × $1,400,000) + (0.3 × $640,000) = $1,172,000 Poor: 1 × 
$1,000,000 = $1,000,000 
The expected value of producing 280,000 bags when conditions are 
average is the highest at $1,172,000, therefore this supply level should be chosen. 
Method 2: Maximin 
Identify the worst outcome for each level of supply and choose the 
highest of these worst outcomes. 
  SUPPLY  
 350,000 280,000 200,000 
 Profit $000 Profit $000 Profit $000 
Worst 325 640 1,000 
The highest of these is $1,000,000 therefore choose to supply only 200,000 bags to meet poor conditions.

468  
 Method 3: Maximax 
Identify the best outcome for each level of supply and choose the 
highest of these best outcomes. 
  SUPPLY  
Best 1,750 1,400 1,000 
The highest of these is $1,750,000 therefore choose to supply 350,000 
bags to meet good conditions. 
Method 4: Minimax Regret 
For each level of demand, identify the right decision (the supply level 
which results in the highest profit) and the regret for the other supply levels. Choose the maximum level of regret at each possible supply level and then choose the level of supply that minimises this maximum regret. 
  SUPPLY  
DEMAND 350,000 280,000 200,000 
 Regret $000 Regret $000 Regret $000 
350,000 Right decision 350 (W3) 750 
280,000 315 (W4) Right decision 400 
200,000 675 360 Right decision 
Maximum regret 675 360 750 
 
(W3) Regret (opportunity cost) = $1,750,000 – $1,400,000 = $350,000 
(W4) Regret (opportunity cost) = $1,400,000 – $1,085,000 = $315,000 
Suitability of the different methods 
The maximin  decision rule looks at the worst possible outcome at each 
supply level and then selects the highest one of these. It is used when 
the outcome cannot be assessed with any level of certainty. The decision maker therefore chooses the outcome which is guaranteed to minimise his losses. In the process, he loses out on the opportunity of making big profits. It is often seen as the pessimistic approach to decision-making (assuming that the worst outcome will occur) and is used by decision makers who are risk averse. It can be used for one-off or repeated decisions.

Chapter 11 
 469 
 The expected value rule calculates the average return that will be 
made if a decision is repeated again and again. It does this by weighting 
each of the possible outcomes with th eir relative probability of occurring. 
It is the weighted arithmetic mean of the possible outcomes. Since the expected value shows the long run average outcome of a decision which is repeated time and time again, it is a useful decision rule for a risk neutral decision maker. This is because a risk neutral person neither seeks risk nor avoids it; they are happy to accept an average outcome. The problem often is, however, that this rule is often used for decisions that only occur once. In this situation, the actual outcome is unlikely to be close to the long run average. For example, with Cement Co, the closest actual outcome to the expected value of $1,172,000 is the outcome of $1,085,000. This is not too far away from the expected value but many of the others are significantly different. 
The maximax  decision rule looks at the best possible outcome at each 
the outcome cannot be assessed with any level of certainty. The decision maker therefore chooses the outcome which is guaranteed to maximise his gain. In the process, he risks making a lower profit. It is 
often seen as an optimistic approach to decision making (assuming the best outcome will occur) and is used by decision makers who are risk seeking. It can be used for one-off or repeated decisions. 
The minimax  regret  decision rule looks at the maximum regret 
(opportunity cost) at each level of supply and aims to choose the level of 
supply which minimises the maximum regret. In the process, he risks making a lower profit. It is often seen as a technique for a ‘sore loser’ who doesn’t want to make the wrong decision.

470  
 Example 10: Decision trees 
 (a) and (b) 
 
Advice: 
The company should undertake geological tests. If the tests 
indicate that oil is present then a drilling programme should be carried out. However, if the tests indicate that there is no oil then the company should sell the drilling rights. 
This strategy will maximise expected returns at $43.5m.

Chapter 11 
 471 
 (c)  The main value of a decision tree is that it maps out clearly all the 
decisions and uncertain events and exactly how they are 
interrelated. They are especially beneficial where the outcome of one decision affects another decision. For example in the above, the probability of eventual success changes depending on the test outcomes. The analysis is made clearer by annotating the tree with probabilities, cash flows, and expected values so that the optimum decisions (based on expected values) can be clearly seen. 
decision. It is based on the concept of expected value and as such suffers from the limitations of this technique. For example, in this example, if the test drilling proves positive, the tree indicated the company should drill, as opposed to selling the rights. But if it does there is a 20% chance of it losing $50 million. A risk-averse company may well decide to accept the safer option and sell the rights and settle for $65 million. 
 
 Using 1,000 as a suitable multiple, i.e. considering 1,000 cars are 
manufactured, the contingency table is: 
 Made at factory.....  
 Factory X Factory Y Total 
Has major fault 30 84 114 
No major fault 270 616 886 
Total 300 700 1,000 
The question was: what is the probability that a car came from factory Y, 
given that it has a major fault? 
Given that a major fault exists, we know that we are dealing with one of 
the 114 cars in the top row of the table. We can see that of these 114 cars, 84 came from Factory Y. 
Hence P(made at factory Y|major fault exists) = 84/114 = 0.737

472  
 A 
 $000  $000 
Revenue 480 Less: 25% × 480k = 
120k 360 
Cost of sales 200 Less: 85% × 120k = 
102k 98 
Other operating costs 80  80 
 ––––  –––– 
Gross profit 200  182 
 ––––  –––– 
 
Alternatively: Lost sales = 25% × 480k = 120k Reduction in profit:= 15% × 120k = 18k Revised profit = 200k – 18k = 182k 
 
 Example 13: Scenario planning 
 The correct answers are ‘A’ (bounded rationality), ‘C’ (High cost) and ‘D’ 
(Risk of self-fulfilling prophecy). 
 
 Expected value calculation 
 
($) 
C 50,000 0.30 15,000 D –20,000 0.20 – 4,000 
–––––– 
Expected value   49,000 
–––––– 
Expected profit is $49,000.

Chapter 11 
 473 
 (i) EV of demand = (10 × 0.20) + (15 × 0.55) + (20 × 0.25) = 15.25 
(ii) The first step is to set up a decision matrix of possible strategies 
(numbers bought) and possible demand, as follows: 
 
 Outcome Strategy (number bought) 
10    
15    20    
 
computed: 
No sale: cost of 15c per magazine. Sale: profit of 25c – 15c = 10c per magazine Pay-offs are shown for each combination of strategy and outcome. 
 
Probability Outcome 
(number 
demanded) Decision 
(number bought) 
  10 15 20 
0.25 
–––– 20 
–––– 100 
–––– 150 
–––– 200 
–––– 
1.00 
–––– EV 
–––– 100c 
–––– 125c 
–––– 81.25c 
–––– 
Conclusion:  The strategy which gives the highest expected value is to 
Workings:  
(ii) If 15 magazines are bought and 10 are demanded, then 10 are 
sold at a profit of 10 × 10c = 100c, and 5 are scrapped at a loss of 
5 × 15c = 75c, making a net profit of 25c. 
(iii) The other contributions are similarly calculated.

474  
 Using maximax, an optimist would consider the best possible outcome 
for each product and pick the product with the greatest potential. 
Here C would be chosen with a maximum possible gain of 100. 
 
The correct decision would have been:  B (net income $80) If A had been chosen The company would have been out of 
pocket instead: by $60 (i.e. 80 – 20) 
• The opportunity loss associated with each product is: A = $60, B = 
$0, C = $70. 
Scenario II and III can be considered in the same way and the results 
can be summarised in a regret table. 
The completed opportunity loss (‘regret’) table is thus as follows. 
 
 Decision 
State A B C 
I 60 0 70 
II 60 30 0 
III 0 60 10 
The maximum regret value for: A = $60 B = $60 C = $70 The minimum value of these is $60, hence the minimax regret strategy 
would be either A or B. 
B would probably be adopted because its second-highest regret 
outcome ($30) is lower than the second-highest for A ($60).

Chapter 11 
 475 
 • Using maximin, a pessimist would consider the poorest possible 
outcome for each product and would ensure that the maximum 
payoff is achieved if the worst result were to happen. 
• Therefore, product A would be chosen resulting in a minimum pay-
off of 20 compared to a minimum pay-off of (10) for product B and 10 for product C. 
 
EV (C) = 0.2(10) + 0.5(100) + 0.3(40) = 64 
So the company would choose project C, with an expected pay-off of 
64.  
If the company had perfect information it would act as follows: 
 
perfect information Company's decision* Pay-off 
example, if scenario I is predicted the company will face a pay-off of 20 from product A, 80 from product B, and 10 from product C. It will therefore decide to invest in product B. 
The expected value from these decisions would be: EV (C) = 0.2(80) + 0.5(100) + 0.3(50) = 81 This is 17 higher than the expected value (64) when the company had 
no information. Therefore the information has a value of 17.

476  
–  Let the loss be L 
Currently, EV = (0.4 × L) + (0.6 × 40)  If EV falls to zero: EV of 0 = (0.4 × L) + (0.6 × 40)  0 = 0.4L + 24 – 24 = 0.4L – 24/0.4 = L 
L = – 60 
–  The loss would have to increase from $20,000 to $60,000 
before the decision is reversed. This is a 200% increase in 
the loss. 
–  Let the probability of a loss be P and the probability of a profit 
be 1 – P. Currently, EV = (P × –20) + [(1–p) × 40)]  If EV falls to zero: EV of 0 = (P × –20) + [(1–p) × 40)]  0 = –20P + 40 –40P 60P = 40 P = 40/60 P = 0.67  
–  The probability of a loss would have to increase to 0.67 from 
 
 D Perfect information is certain to be right about the future. Imperfect 
information may predict wrongly.

Chapter 11 
 477 
 Micah 
As a risk neutral investor Micah will base his decision on the expected 
value of each investment. These are calculated as follows: 
Investment A = ($6,000 × 0.1) + ($5,000 × 0.4) + ($4,000 × 0.5) = 
$4,600 
Investment B = ($14,000 × 0.1) + ($3,000 × 0.4) + ($500 × 0.5) = 
$2,850 
Investment C = ($3,000 × 0.1) + ($5,000 × 0.4) + ($8,000 × 0.5) = 
$6,300 
Micah will therefore choose to invest in Investment C as it has the 
highest overall expected value. 
Zhang 
As a risk seeker Zhang will ignore the expected values and probabilities, 
and she will focus solely on the pay-outs. She will apply the maximax criteria and consider where the highest pay-out might arise. The highest possible return is the $14,000 that arises in a good market state for Investment B. Zhang will therefore choose to invest in Investment B. 
Jill 
To apply the minimax regret criteria Jill will have to create a regret table 
 
State of the economy Regret 
 A 
$ B 
$ C 
$ 
Good 8,000 0 11,000 
Fair 0 2,000 0 
Poor 4,000 7,500 0 
Maximum regret 8,000 7,500 11,000 
Jill will therefore choose to invest in Investment B as it has the lowest 
maximum regret ($7,500) of the three investments.

478  
 Objective Test Question 10: Charity organisation 
 Revenue per person = $20 + $5 + $1 
 
Number 
of 
tickets Probability Revenue Food 
cost Net 
benefit Prob. × 
benefit 
  $ $ $ $ 
300 0.2 7,800 (4,800) 3,000 600 
400 0.3 10,400 (4,800) 5,600 1,680 500 0.4 13,000 (6,000) 7,000 2,800 
600 0.1 
––– 15,600 
 (7,200) 8,400 840 
 1.0  Expected value = 5,920 
 
Number of 
pages Probability Contribution $65 
per page Prob. × 
  $ $ 
24 0.2 1,560 312 32 0.4 2,080 832 
40 0.3 2,600 780 48 0.1 
––– 3,120 312 
 1.0 Expected value = 2,236 
   
Total 
contribution $5,920 + $2,236 = $8,156 
Less fixed costs $2,000 + $700 + $2,800 + $800 + 
$200  
= ($6,500) 
Expected profit  $1,656

480  
 Workings 2, 3 and 4 
A probability tree is the best way of understanding the dependent 
probabilities given in the question. 
The probability of the prediction depends upon whether the results 
are good or poor. 
 
(W2) p(positive attitude) = 0.51 + .04 = 0.55 
(W3) p(good results/positive attitude) =  
p(good results and positive attitude)
p(positive attitude) 
=	0.09
0.45 = 0.20 
ሺW4ሻ		p(good results/negative attitude) = p(good results and negative attitude
p(negative attitude) 
(W5) Expected profit = $40m × 0.6 + $20m × 0.4 = $32m 
(W6) Expected profit = $40m × 0.93 + $20m × 0.07 = $38.6m (W7) The deluxe upgrade provides an expected profit of ($32m – 
$12m) $20m 
(W8) Deluxe upgrade profit = $38.6m – $12m = $26.6m  
Standard upgrade profit = $23.95 – $6m = $17.95m  
 Deluxe upgrade is recommended.  
(W9) Standard upgrade profit = $7m 
Shutdown and sell site = $15m 
 Shutdown and sell is recommended 
(W10)Expected profit = $26.6m × 0.55 + $15m × 0.45 = $21.38m

Chapter 11 
 481 
 (b) In order to maximise expected profit:  
Undertake the market research. 
If the attitude is positive upgrade deluxe. 
If the attitude is negative shutdown and sell the site. 
(c) Comment 
(i) This assumes that all estimates are correct; sensitivity 
analysis could be carried out on each estimate. 
(ii) It is assumed that the RS Group are risk neutral since 
expected values have been used – although the highest 
ENPV has a lower risk than the next highest. 
(iii) Ten years is a long time period over which to predict profits – 
a reasonable period for the life of the store but this makes estimation difficult. 
(iv) Comments on the courses of action open to the RS Group 
have been made in (a). 
 
 Objective Test Question 12: X and Y 
 B 
Without information, the expected profits are: 
Product X: $20,000 × 0.2 + $15,000 × 0.5 + $6,000 × 0.3  = $13,300 Product Y: $17,000 × 0.2 + $16,000 × 0.5 + $7,000 × 0.3  = $13,500 
So without information, product Y would be selected. With perfect information, product X would be selected if the market was 
good, and product Y in the other two cases. The expected value would then be: 
$20,000 × 0.2 + $16,000 × 0.5 + $7,000 × 0.3 = $14,100 The expected value of perfect information is therefore  
$14,100 – $13,500 = $600

482  
  
At points A and B calculate Expected Values 
At A EV = (0.95 × 50) + (0.05 × (200)) = 37.5  
At B EV = (0.95 × 20) + (0.05 × (30)) = 17.5 
At C  compare the EVs of $37.5 and $17.5. 
Recommendation; if a customer requests a loan give him/her a 
high loan limit.

Chapter 11 
 483 
 (b) 
 
Workings: 
(W1) 800 customers have been assessed as being a good risk. Of 
these 790 did repay the loan. This represents 98.75% (790 ÷ 
800) of the good risk customers. 
Hence, the remaining 1.25% of the good risk customers did not repay the loan. (10 ÷ 
800). 
(W2) In a similar way to (W1), 160 out of the 200 bad risk 
40 out of the 200 bad risk customers did not repay the loan, 
i.e. 20%.

484  
 Expected values  
At A (0.9875 × 50) + (0.0125 × (200)) = $46.875 
At B (0.9875 × 20) + (0.0125 × (30)) = $19.375 
At D (0.8 × 20) + (0.2 × (30)) = $10.00 
Decisions 
At E compare A and B. Choose A, i.e. give customers a high loan. 
At F compare C and D. Choose D, i.e. give customers a low loan. 
Expected values 
At G (0.8 × 46.875) + (0.2 × 10.00) = $39.5 
Decision 
At H compare “No agency” (return = $37.50) with the “agency” 
(return = $39.50). 
The information from the agency is expected to increase 
profits by $2 per rating. This is  the value of the information. 
(c)  Perfect information is a forecast that is 100% accurate. In the 
context of this problem it would be the credit rating agency providing an accurate forecast of the customer’s ability to repay the 
loan. 
If the new agency is approached 
 
Forecast Decision Outcome Profit Probability Expected 
value 
Good risk High loan Repay $50 0.95 47.50 
Bad risk Refuse loan Nothing $0 0.05 0 
     $47.50 
 
The expected return with perfect information = $47.50 
The expected return with no information = ($37.50) 
––––––– 
Therefore the value of the information is = $10.00

Chapter 11 
 485 
 The revised profit for the month would be $4,600 
 
 $000  $ 
Sales 64 + (30,800 – 28,000)/2 65,400 
Material costs (28) × 110% (30,800) Labour costs (12)  (12,000) 
Overhead costs (18)  (18,000) 
 –––  –––––– Gross profit 6  4,600 
 –––  –––––– 
    
 The product can be manufactured in four mutually exclusive ways: 
(i) Through A1, then B1 
(ii) Through A1, then B2 (iii) Through A2, then B1 (iv) Through A2, then B2 The probability of a perfect item being produced can be quickly solved 
with contingency tables. The first three columns are completed as illustrated previously, then the probab ilities of producing a perfect item 
by each method are extracted and multiplied. 
 
Contingency table Manufacturing method 
 A1 A2 Total A1B1 A1B2 A2B1 A2B2 
Defective (2%, 6%) 10 30 40     
Perfect 490 
––– 470 
––– 960 
–––– 490/1,000 490/1,000 470/1,000 470/1,000 
 500 
––– 500 
––– 1,000 
––––     
 B1 B2 Total     
Defective (2%, 6%) 20 10 30     
Perfect 480 
––– 490 
––– 970 
–––– 480/1,000 490/1,000 480/1,000 490/1,000 
 500 
––– 500 
––– 1,000 
––––     
Probability of a perfect item 0.2352 0.2401 0.2256 0.2303 
(e.g. 490/1,000 × 480/1,000)

486  
 Therefore, P (Perfect item) = P(A1 B1 or A1 B2 or A2B1 or A2B2) = 
P(A1 B1) + P(A1 B2) + P(A2B1) + P(A2B2) 
= 0.2352 + 0.2401 + 0.2256 + 0.2303 = 0.9312 Since the total production is 10,000 items pa, the expected number of 
perfect items is 0.9312 × 10,000 = 9,312. 
The profit on each of these is £80, therefore the expected profit on the 
perfect items is 9,312 × $80 = $744,960. 
P(perfect item) = 0.9312, and so P(defective item) = 1 – 0.9312 = 
0.0688. 
Therefore, expected number of defects is 0.0688 × 10,000 = 688. The 
loss on each of these is $10, therefore the expected loss on the defective items is 688 × $10 = $6,880. 
The expected net profit = $744,960 – $6,880 = $738,080 . 
This is the average profit that the company might expect to make per 
annum. 
 
 EMAIL 
From:   Senior Management Accountant  
To:  Pedro Rodriguez 
Subject:   The value of perfect information 
Date:   06/05/2014 Hi Pedro, 
Hi Pedro, 
Please find below some notes and calculations. I hope these will 
facilitate your decision about the maximum price to pay the consultant. 
First, let's calculate the contribution for each turnover figure. There is a 
30% C/S ratio: 
 
Turnover 
$000 Contribution 
$000 
15,000 4,500 
8,500 2,550 
4,000 1,200

Chapter 11 
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 Then, we calculate the net margin for each of the different possible 
outcomes: 
 
Advance 
hire 
level Demand 
level Contribution Advance 
hire 
costs Extra 
hire 
costs Net 
margin 
  $000  $000  $000  $000  
High High 4,500 2,300 – 2,200 
 Medium 2,550 2,300 – 250 
 Low 1,200 2,300 – (1,100) 
Medium High 4,500 1,500 1,300 1,700 
 Medium 2,550 1,500 – 1,050 
 Low 1,200 1,500 – (300) 
Low High 4,500 1,000 2,150 1,350 
 Medium 2,550 1,000 850 700 
  Low 1,200 1,000 – 200 
We can then list the expected values at all different level. Starting with 
high hire level: 
EV = (2,200 × 0.25) + (250 × 0.45) + (–1,100 × 0.30) = $332,500 
At Medium hire level 
EV = (1,700 × 0.25) + (1,050 × 0.45) + (–300 × 0.30) = $807,500 
At Low hire level 
EV = (1,350 × 0.25) + (700 × 0.45) + (200 × 0.30) = $712,500 
We can see that the expected net gain is maximised at the medium hire level. 
Managers could either seek risk or avoid it. While the calculations of 
expected values seem to indicate that the medium-usage advance hire contract was the best option, this is only the result when using the weighted average and probabilities. A risk-averse decision maker will examine the options to see which of the demand levels is providing the worst net gains. He will then select the best from these worst outcomes.

488  
 In the case of Siteraze, this would mean selecting the low hire level. 
With a low hire level a net gain of $200,000 or higher is guaranteed. 
However, if the decision maker was a risk seeker, he would select the high hire level in the hope that demand would subsequently be high. This combination would yield a net gain of $2,200,000. 
 
Demand 
level Hire 
decision Net gain 
$000 Probability  px 
High High 2,200 0.25 550.00 
Medium Medium 1,050 0.45 472.50 
Low Low 200 0.30 60.00 
––––––– 
    1,082.50 
 
EV with perfect information $1,082,500 
EV without perfect information $807,500 
Value of the information $275,000 
In conclusion, Siteraze should not pay more than $275,000 to the 
consultant.

489 
Risk Management 
D2: Risk and Control Analyse types of risk in the 
medium term 
(a) Analyse types of risk (b) Managing risk 
 
  Chapter 
12

490  
 
2  What is risk? 
As we’ve seen in previous chapters, ‘risk’ in business is the chance that future 
events or results may not be as expected. 
Risk is often thought of as purely bad (pure or 'downside' risk), but it must be 
considered that risk can also be good – the results may be better than expected as well as worse (speculative or 'upside' risk). 
 
 Downside risk examples 
 The term ‘risk’ is often associated with the chance of something ‘bad’ 
happening, and that a future outcome will be adverse. This type of risk is 
called ‘ downside’ risk  or pure risk , which is a risk involving the 
possibility of loss, with no chance of gain. 
Examples of pure risk are the risk of disruption to business from a severe 
power cut, or the risk of losses from theft or fraud, the risk of damage to assets from a fire or accident, and risks to the health and safety of employees at work. 
Not all risks are pure risks or down-side risks. In many cases, risk is two-
way, and actual outcomes might be either better or worse than expected. 
Two-way risk  is sometimes called speculative risk. For many business 
decisions, there is an element of speculative risk and management are 
aware that actual results could be better or worse than forecast. 
For example, a new product launch might be more or less successful 
than planned, and the savings from an investment in labour-saving equipment might be higher or lower than anticipated.

Chapter 12 
 491 
 Risk and uncertainty  
 All businesses face risk such as in the variability of future potential 
returns. Risk is inherent in a situation whenever an outcome is not 
inevitable. Risk can be managed: the term “risk” is used where it is possible to assign probabilities to the different possible outcomes. 
In contrast, the term “uncertainty” is used where this is not possible. 
Uncertainty, in contrast to risk, arises from ignorance and a lack of information; uncertainty is uncontrollable. By definition, the future cannot be predicted under conditions of uncertainty because there is insufficient information about what the future outcomes might be or their probabilities 
of occurrence. 
In business, uncertainty might be an element in decision-making. For 
example, there might be uncertainty about how consumers might respond to a new product or a new technology, or how shareholders might react to a cut in the annual dividend. Uncertainty is reduced by obtaining as much information as possible before making any decision. 
 
 3  Why incur risk? 
Businesses must be able to identify the principal sources of risk if they are to be able to assess and measure the risks that the organisation faces. 
Risks facing an organisation are those that affect the achievement of its overall 
objectives, which should be reflected in its strategic aims. Risk should be managed and there should be strategies for dealing with risk. 
 
 • To generate higher returns a business may have to take more risk in 
order to be competitive. 
• Conversely, not accepting risk tends to make a business less dynamic, 
and implies a ‘follow the leader’ strategy. 
• Incurring risk also implies that the returns from different activities will be 
higher – ‘benefit’ being the return for accepting risk. 
• Benefits can be financial – decreased costs, or intangible – better quality 
• In both cases, these will lead to the business being able to gain 

492  
For some risks there is a market rate of return e.g. quoted equity – where a 
shareholder invests in a company with the expectation of a certain level of dividend and capital growth. However, for other risks there may not be a market rate of return e.g. technology risk – where a company invests in new software in the hope that it will make their invoice processing more efficient. The important distinction here is that the market compensates for the former type of risk, but might not for the latter. 
4  CIMA's risk management cycle 
Risk management should be a proactive process that is an integral part of strategic management. 
This perspective is summarised in CIMA’s risk management cycle, illustrated 
below: 
 
Source: Chartered Institute of Management Accountants (2002), Risk Management: A Guide to Good Practice, CIMA.

Chapter 12 
 493 
5  Identifying and categorising risks 
Many organisations categori se risks into different types of risk. The use of risk 
categories can help with the process of risk identification and assessment. 
There is no single system of risk categories. The risk categories used by 
companies and other organisations differ according to circumstances. Some of the more commonly-used risk categories are described below. 
 
6  Business risk 
Business risk  is the risk businesses face due to the nature of their operations 
and products. Some businesses for instance are reliant on a single product or small range of products, or they could be reliant on a small key group of staff. The risks can be considered in different categories: 
Strategic risk Risk that business strategies (e.g. acquisitions/product launches) will fail. 
Product risk Risk of failure of new product launches/loss of interest in existing products. 
Commodity price risk Risk of a rise in commodity prices (e.g. oil). 
Product reputation risk Risk of change in product’s reputation or image. 
Operational risk Risk that business operations may be inefficient or business processes may fail.

494  
Contractual inadequacy risk Risk that the terms of a contract do not fully 
cover a business against all potential outcomes. 
Fraud and employee malfeasance Malfeasance means doing wrong, or committing an offence or fraud. This is the risk of actions by employees that result in fraud, an offence or crime. 
Business risks for a company are risks aris ing from the nature of its business 
and operations. Some businesses are inherently more risky than others. 
Strategic risks are risks arising from the possi ble consequences of strategic 
decisions taken by the organisation. For example, one company might pursue a 
strategy of growth by acquisitions, whilst another might seek slower, organic growth. Growth by acquisition is likely to be much more high-risk than organic growth, although the potential returns mi ght also be much higher. Strategic risks 
should be identified and assessed at senior management and board of director level. 
Product risk  is the risk that customers will not buy new products (or services) 
provided by the organisation, or that the sales demand for current products and 
services will decline unexpectedly. A new product launched on to the market might fail to achieve the expected volume of sales, or the take-up will be much slower than expected. For example, the demand for ‘third generation’ (3G) mobile communications services has been much slower to build up than expected by the mobile telephone service providers, due partly to the slower-than-expected development of suitable mobile phone handsets. 
Commodity price risk. Businesses might be exposed to risks from unexpected 
increases (or falls) in the price of a key commodity. Businesses providing commodities, such as oil companies and commodity farmers, are directly affected by price changes. Equally, companies that rely on the use of commodities could be exposed to risks from price changes. For example, airlines are exposed to the 
risk of increases in fuel prices, particularly when market demand for flights is weak, and so increases in ticket prices for flights are not possible. 
Product reputation risk . Some companies rely heavily on brand image and 
product reputation, and an adverse event could put its reputation (and so future 
sales) at risk. Risk to a product’s reputation could arise from adverse public attitudes to a product or from adverse publicity: this has been evident in Europe with widespread hostility to genetically-m odified (GM) foods. There could also 
be a risk from changes in customer perceptions about the quality of a product. For example, if a car manufacturer annou nces that it is recalling all new models 
of a car to rectify a design defect, the reputation of the product and future sales could be affected. 
Operational risk  refers to potential losses that might arise in business 
operations. It has been defined broadly as ‘the risk of losses resulting from 
inadequate or failed internal processes, people and systems, or external events’ (Basel Committee on Banking Supervision) . Operational risks include risks of 
fraud or employee malfeasance, which are explained in more detail later. Organisations have inter nal control systems to manage operational risks.

Chapter 12 
 495 
Contractual inadequacy risk may arise where a business has negotiated 
contracts and other business transactions without adequate consideration of what may happen if things don’t go according to plan. For example, a builder may have a fixed completion date to complete the construction of a house. If he does not complete on time, he may have to pay compensation to the house purchaser. Similarly, there is also a risk that the purchaser does not have the funds when payment is due. This risk may be mitigated by having terms in the contract as to what rights he will have in such circumstances. Clearly, if the builder does not cons ider either or both of thes e possibilities when agreeing to 
build the house, then there is an unidentified and unquantified risk of loss. 
 
7  Risk management 
Risk management  is defined as ‘the process of understanding and 
managing the risks that the organisa tion is inevitably subject to in 
attempting to achieve its corporate objectives’ 
The traditional view of risk management has been one of protecting the 
organisation from loss through conformance procedures and hedging techniques – this is about avoiding the downside  risk. 
The new approach to risk management is about taking advantage of the opportunities to increase overall returns within a business – benefiting from the upside  risk. 
The following diagram shows how risk management can reconcile the two perspectives of conformance and performance: 
 
Source: IFAC, Enhancing Shareholder Wealth By Better Managing Risk

496  
 Risk management and shareholder value 
 Ernst and Young have developed a model of shareholder value in which 
Shareholder value = Static NPV of existing business model + Value 
of future growth options 
which more simply put is ‘the sum of the value of what a company does 
now and the value of what they could possibly do in the future’. 
Good risk management allows businesses to exploit opportunities for 
future growth while protecting the value already created. By aligning risk management activity to what the shareholders consider vital to the success of the business, the shareholders are assured that what they 
value is protected. 
Ernst and Young identify four stages: (a) Establish what shareholders value about the company – through 
talking with the investment community and linking value creation 
processes to key performance indicators. 
(b) Identify the risks around the ke y shareholder val ue drivers – the 
investment community can identify those factors that will influence their valuation of the company. All other risks will also be considered, even if not known by investors. 
(c) Determine the preferred treatment for the risks – the investment 
community can give their views on what actions they would like management to take in relation to the risks. The risk/reward trade-off can be quantified by estimating the change in a company’s market valuation if a particular risk treatment was implemented. 
(d) Communicate risk treatments to shareholders – shareholders need 
to be well informed, as a shared vision is important in relation to the inter-related concepts of risk mana gement and shareholder value. 
8  Risk management strategy 
For many businesses the specific formulation of a risk strategy has been a recent development. 
In the past a formal strategy for managing risks would not be made but rather it 
would be left to individual managers to make assessments of the risks the 
business faced and exercise judgement on what was a reasonable level of risk. 
This has now changed: failure to properly identify and control risks has been 
identified as a major cause of business failure (take Barings Bank as an example).

Chapter 12 
 497 
A framework for board consideration of risk is shown below: 
 
 Risk appetite can be defined as the amount of risk an organisation is 
willing to accept in pursuit of value. This may be explicit in strategies, policies and procedures, or it may be implicit. It is determined by: 
• risk capacity  – the amount of risk that the organisation can bear, and 
• risk attitude  – the overall approach to risk, in terms of the board being 
risk averse or risk seeking. 
The way that the organisation documents and determines the specific parts of its risk strategy will have to link to the business strategy and objectives. 
Overall the risk management strategy is concerned with trying to achieve the 
required business objectives with the lowest possible chance of failure. The tougher the business objectives, however, the more risks will have to be taken to achieve them. 
Residual risk  is the risk a business faces after its controls have been 
considered. 
 
Example 1: Risk 
 Which of the following statements is true? Select ALL that apply. 
• A small company will always have a higher risk appetite than a 
larger company. 
• A company with a divisionalised structure will always seek out risky 
• A functional structure limits risk by limiting diversification. 
• A large company is more risk averse than a small company.

498  
9  Risk management – The TARA framework 
An alternative way of remembering risk management methods is via the 
mnemonic 'TARA': 
Transference . In some circumstances, risk can be transferred wholly or in part 
to a third party, so that if an adverse event occurs, the third party suffers all or most of the loss. A common example of risk transfer is insurance. Businesses arrange a wide range of insurance policies for protection against possible losses. This strategy is also sometimes referred to as sharing . 
Avoidance . An organisation might choose to avoid a risk altogether. However, 
since risks are unavoidable in business v entures, they can be avoided only by 
not investing (or withdrawing from the business area completely). The same applies to not-for-profit organisations: risk is unavoidable in the activities they undertake. 
Reduction/mitigation . A third strategy is to reduce the risk, either by limiting 
exposure in a particular area or attempting to decrease the adverse effects 
should that risk actually crystallise. 
Acceptance . The final strategy is to simply accept that the risk may occur and 
decide to deal with the consequences in that particular situation. The strategy is 
appropriate normally where the adverse effect is minimal. For example, there is nearly always a risk of rain; unless the business activity cannot take place when it rains then the risk of rain occurring is not normally insured against. 
Risk mapping 
A common qualitative way of assessing the significance of risk is to produce a 
‘risk map’ . 
• The map identifies whether a risk will have a significant impact on the 
organisation and links that into the likelihood of the risk occurring. 
• The approach can provide a framew ork for prioritising risks in the 
business. 
• Risks with a significant impact and a high likelihood of occurrence need 
more urgent attention than risks with a low impact and low likelihood of occurrence.

Chapter 12 
 499 
• Risks can be plotted on a diagram or  map, as shown below; the map can 
provide a useful framework to determine an appropriate risk response: 
 
 Example 2: Risk Treatment 
 State whether the following activities would result in a risk retention or 
risk avoidance strategy: 
• An organisation sells a subsidiary in a politically unstable country. 
• The Board of a company decides that they have a low risk appetite 
and therefore reject a potentially profitable contract. 
• The organisers of an outdoor sporting event decide that the risk of 
rain is low, and take no further action regarding the probability of 
rain occurring.

500  
 Example 3: CC Freight 
 CC Freight is a freight forwarding business. It sends containers of freight 
from Heathrow to other airports around the world. It specialises in 
consolidating the freight of different shippers into a single container, in order to obtain the benefit of lower freight charges for large shipments. The price that CC charges its clients covers a share of the airline flight costs and insurance, and provides a margin to cover its running costs and for profit. To make a satisfactory profit, CC needs to fill its containers 
at least 75% full, and at the moment is achieving and average 'fill' of 78%. 
International trade and commerce has been growing in the past year, 
although at a slow rate. 
CC's management is aware that airline flight costs are likely to rise next 
year due to higher fuel costs and because several major airlines (that have been suffering large losses) will be hoping to increase their prices. 
Using the TARA framework, place each of the following risks in a cell of the TARA framework matrix: 
 
Risk 1: Downturn in international trade Risk 2: Insufficient freight to fill containers 
Risk 3: Higher airline flight costs Risk 4: A major airline will go out 
of business 
  
 More on risk mapping 
 The potential loss from an adverse outcome is a function of: 
• the probability or likelihood that the adverse outcome will occur, and 
• the impact of the outcome if it does occur. 
When an initial review is carried out to identify and assess risks, the 
assessment of both probabilities and impact might be based on judgement and experience rather than on a detailed statistical and numerical analysis. 
• In an initial analysis, it might be sufficient to categorise the 
probability of an adverse outcome as ‘high’, ‘medium’ or ‘low’, or 
even more simply as ‘high’ or ‘low’. 
• Similarly, it might be sufficient for the purpose of an initial analysis to 
assess the consequences or impact of an adverse outcome as ‘severe’ or ‘not severe’. 
Each risk can then be plotted on a risk map. A risk map is simply a 2 × 2 table or chart, showing the probabilities for each risk and their potential impact.

Chapter 12 
 501 
 Example 
The following simple risk map might be prepared for a firm of auditors: 
  Impact/consequences 
  Low High 
Probability/likelihood High New audit 
regulations for the 
profession Loss of non-
audit work from 
existing clients 
 Low Increases in 
salaries above the 
general rate of 
inflation Loss of audit 
clients within 
the next two 
years 
Using a risk map A risk map immediately indicates whic h risks should be given the highest 
priority. 
• High-probability, high-impact risks should be given the highest 
priority for management, whether by monitoring or by taking steps to 
mitigate the risk. 
• Low-probability, low-impact risks ca n probably be accepted by the 
organisation as within the limits of acceptability. 
• High-probability, low-impact risks an d low-probability, high-impact 
risks might be analysed further with a view to deciding the most appropriate strategy for their management. 
For each high-probability, high-impac t risk, further analysis should be 
carried out, with a view to: 
• estimating the probability of an adverse (or favourable) outcome 
more accurately, and 
• assessing the impact on the organisation of an adverse outcome. 
This is an area in which the management accountant should be able 
to contribute by providing suitable and relevant financial information.

502  
10 Ethical issues as sources of risk 
A conceptual framework that requires a management accountant to identify, 
evaluate and address threats to compliance with the fundamental principles, rather than merely comply with a set of specific rules which may be arbitrary is in the public interest . 
CIMA's Code of Ethics has a 'threats and safeguards' approach. If identified threats are other than clearly significant, a management accountant should apply safeguards to eliminate the threats or reduce them to an acceptable level such that compliance with the fundamental principles is not compromised. 
 
 The CIMA Code of Ethics  
 As Chartered Management Accountants, students throughout the world 
have a duty to observe the highest standards of conduct and integrity, and to uphold the good standing and reputation of the profession. They must also refrain from any conduct which might discredit the profession. Members and registered students must have regard to these guidelines irrespective of their field of activity, of their contract of employment or of any other professional memberships they may hold. 
The Institute promotes the highest ethical and business standards, and 
encourages its members to be good and responsible professionals. Good ethical behaviour may be above that required by the law. In a highly competitive, complex business world, it is essential that CIMA members sustain their integrity and remember the trust and confidence which is placed on them by whoever relies on their objectivity and professionalism. Members must avoid actions or situations which are inconsistent with their professional obligations. They should also be guided not merely by the terms but by the spirit of this Code. 
CIMA members should conduct themselves with courtesy and 
consideration towards all with whom they have professional dealings and should not behave in a manner which could be considered offensive or discriminatory.

Chapter 12 
 503 
 CIMA has adopted a code of ethics based on the IFAC (International 
Federation of Accountants) code of ethics which was developed with 
input from CIMA and the global accountancy profession. 
The CIMA Code of Ethics is free ly available on CIMA 's website – 
cimaglobal.com > Standards and ethics > Code of ethics. 
consulting the ethics support information on CIMA's website, he or she should seek legal advice as to both legal rights and any obligations (s)he may have. 
The code of ethics is in three parts: 
• Part A establishes the fundamental principles of professional ethics 
and provides a conceptual framework for applying those principles. 
• Parts B and C illustrate how the conceptual framework is to be 
applied in specific situations: 
–  Part B applies to professional accountants in business. –  Part C applies to professional accountants in public practice. 
11  Example threats and safeguards 
of the employer and the fundamental principles  
laws or regulations or against 
professional or technical standards. (Intimidation threat) • Obtaining advice from the 
employer, professional organisation or professional advisor. 
• The employer providing a formal 
dispute resolution process. 
Accountants need to prepare/ 
report on information fairly, objectively and honestly. However, the accountant may be pressurised to provide misleading information.  (Intimidation threat) • Consultation with superiors in the 
employing company. 
• Consultation with those charged 
with governance. 
• Consultation with the relevant 
professional body.

504  
Having sufficient expertise  
stating their level of expertise – and not mislead employers by implying they have more expertise than they actually possess. 
Threats that may result in a lack 
of expertise include time pressure to carry out a duty, being provided with inadequate information or having insufficient experience. • Obtaining additional advice/ 
training. 
• Obtaining assistance from someone 
with relevant expertise. 
close family member has financial 
interests in the employing 
company. Examples include the 
accountant being paid a bonus 
based on the financial statement 
results which he is preparing, or 
holding share options in the 
company. 
(Self-interest threat) • Remuneration being determined by 
other members of management. 
• Disclosure of relevant interests to 
those charged with governance. 
• Consultation with superiors of 
relevant professional body. 
to encourage unethical behaviour. 
Inducements may include gifts, 
hospitality, preferential treatment 
or inappropriate appeals to 
loyalty. 
may be threatened by such 
inducements. 
(Self-interest threat) • Do not accept the inducement! 
• Inform relevant third party such as a 
senior manager. 
pressurised to provide 
inducements to junior members of 
staff to influence a decision or 
obtain confidential information. 
(Intimidation threat) • Do not offer the inducement!

Chapter 12 
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information about their employing organisation confidential unless there is a right or obligation to disclose, or they have received authorisation from their client. 
under pressure to disclose this information as a result of legal processes such as anti-money laundering/terrorism – in this situation there is a conflict between confidentiality and the need for disclosure. • Disclose information in compliance 
with the relevant statutory requirements, e.g. money laundering regulations. 
Whistleblowing  
Situations where the accountant needs to consider disclosing information, where ethical rules have been broken. • Follow the disclosure requirements 
of the employer, e.g. report to those responsible for governance. Otherwise disclosure should be based on the assessment of: legal obligations, whether members of the public will be adversely affected, gravity of the matter, likelihood of repetition, reliability of the information and reasons why employer does not want to disclose. 
12  The public interest 
The distinguishing mark of a profession is the acceptance of a responsibility to 
the public. The accountancy profession's public includes: 
• Clients 
• Credit providers 
• Governments 
• Employers 
• Investors. 
The public interest can be defined as that which supports the good of society as 
a whole, as opposed to what serves the interests of individual members of society, or of specific sectional interest groups.

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For an accountant, acting in the public interest is acting for the collective well-
being of the community of people and institution that it serves. 
The concept of public interest may affect the working of an organisation in a 
number of ways. The actions of the organisation itself may be harmful to society, for example from excessive pollution or poor treatment of the labour force. The government may then decide, in the public interest, to limit the actions of that organisation for the greater good of society as a whole. 
13  Organisations as 'shapers of society' 
Businesses can ma nage their reputational risk either by applying their own 
positional power, or in more specific terms by changing society for the better in terms of the 'public interest.' 
For example, organisations can amend or shape society by the products that 
are made available. It can be argued that McDonald's has assisted poor eating habits in society overall, by making available cheap 'fast food'. 
To be a shaper of society in the public interest, organisations must 'improve' 
society, however that term is defined. For example, it can be argued that Toyota's research into solar powered cars is seen as an obligation to society of providing pollution free transport rather than continuing to manufacture petrol-burning cars. The act of investment in solar power not only shows the company's commitment to this area, but shapes society by raising the issue of environmental concern. 
14 Costs and benefits of information systems 
New information systems may be implemented as part of a business’ risk strategy. When an organisation sees a possibility for introducing a new information system, an evaluation of the new system should be made to decide whether the potential benefits are sufficient to justify the costs. 
The value of information 
• Collecting and processing information for use by managers has a cost. 
• The value of the information to the business must be greater than the cost. 
In other words, the benefits of the new IS should be greater than its cost. If 
this is the case, the new IS is worth implementing. 
 Cost-benefit analysis (CBA) can be used to assess the expected costs and benefits of the IS. 
The benefit of management information must exceed the cost ( benefit > cost) 
of obtaining the information. 
The design of management information systems should involve a cost/benefit 
analysis. A very refined system offers many benefits, but at a cost. The advent of modern IT systems has reduced that cost significantly. However, skilled staff have to be involved in the operation of information systems, and they can be very expensive to hire.

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 Production costs in a factory can be reported with varying levels of 
frequency ranging from daily (365 times per year) to annually (1 time per 
year). Costs and benefits of reporting tend to move as follows, in response to increasing frequency of reporting. 
• Costs:  Information has to be gathered, collated and reported in 
proportion to frequency and costs will move in line with this. 
Experience suggests that some element of diseconomy of scale may set in at high levels of frequency. 
• Benefits:  initially, benefits increase sharply, but this increase starts 
to tail off. A point may come where ‘information overload’ sets in, and benefits actually start to decline and even become negative. If managers are overwhelmed with information, then this actually starts to get in the way of the job. 
 The position may be represented graphically as follows: 
 
An information system is just like any part of a business operation. It incurs costs and it offers benefits. In designing an information system, the accountant has to find some means of comparing the two for different options and determining which option is optimal. In this sense, system design follows the same practices for investment appraisal and decision making. In the above case it can be seen that net benefits (benefits less costs) are maximised at around 120 reports per year – suggesting an optimal information cycle of about 3 days. The system should be designed to gather, collate and report information at three-day intervals. This is an over-simplified example but it serves to illustrate a general logic which can be applied to all aspects of information system design.

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The costs of a new system 
 
system. 
system. 
• Cost of materials, 
e.g. replacement parts. 
• Cost of service support, e.g. IT 
helpdesk. 
Cost classification 
The costs of information can be classified as follows: 
 
Costs of internal information Costs of external information 
Direct data capture costs, e.g. the cost 
of barcode scanners in a supermarket. Direct costs, e.g. newspaper subscriptions. 
Processing costs, e.g. salaries paid to payroll processing staff. Indirect costs, e.g. wasted time finding useful information. 
Indirect costs, e.g. information collected which is not needed or is duplicated. Management costs, e.g. the cost of processing information. 
 Infrastructure costs, e.g. of systems 
enabling internet searches. 
The indirect costs of producing information 
The most expensive cost of producing information is probably the cost of labour. 
People are needed to collect data, input data into the system, process the data and then output the resulting information. Throughout this process, the company needs to pay their wages and thus labour becomes part of the cost of producing inform ation. When new people are hired, a process is changed  or 
software  is upgraded , then staff will require training. 
Training, or re-training, is expensive in terms of: 
1 Paying for the trainer 2 Paying wages for people being trained 3 Paying the wages for someone to do the normal work for the person being 
trained 
4 Paying for the costs of the training venue 5 Lost productivity whilst people are being trained 6 Slower productivity whilst people 'learn on the job'.

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Other indirect costs of providing information  are those that are impossible 
to predict and quantify, and they may include: 
• Loss of staff morale • Delays caused in other projects of the business 
• General dislocation caused by system change 
• Upsetting customers from system change 
• Incompatibility with other systems 
• Unexpected costs of software amendments, tailoring and maintenance 
• Cost of failure due to inappropriate systems or faulty implementation. 
Further, more 'intangible' indirect costs of producing information include: 
• Reduced quality of information, due to information overload 
• Poor decision making, due to information overload 
• Too many areas to focus on – so issues are not followed up 
• Focus on the wrong things – i.e. only on those business areas and targets 
that are easy to measure and report on. 
Benefits of a new Information System 
These benefits could include: 
• Enhanced efficiency and capacity – e.g. resulting in labour savings. 
• Better quality of information – information may be more accurate, 
complete, understandable and timely. 
• Better access to information – e.g. by means of an Intranet. • Improved sharing of information – e.g. through the creation of a database. • Improved communication – e.g. through the introduction of an email 
system. 
• Better decision making and customer service. Although it is sometimes difficult to do so, these benefits should be quantified in 
monetary terms.

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 Cost-benefit analysis 
 A sales director is deciding whether to implement a new computer-based 
sales system. His department has only a few computers, and his sales 
people are not computer literate. He is aware that computerised sales forces are able to contact more customers and give a higher quality of service to those customers. They are more able to meet commitments, and can work more efficiently with production and delivery staff. 
His financial cost/benefit analysis is shown below: 
Costs 
New computer equipment: 
• 10 network-ready PCs with supporting software @ $2,000 each 
• 1 server @ $3,000 
• 3 printers @ $1,000 each 
• Cabling & Installation @ $4,000 • Sales Support Software @ $10,000 Training costs: 
• Computer introduction – 8 people @ $300 each 
• Keyboard skills – 8 people @ $300 each • Sales Support System – 12 people @ $500 each 
Other costs: 
• Lost time: 40 man days @ $150/day 
• Lost sales through disruption: estimate: $10,000 
• Lost sales through inefficiency during first months: estimate: 
$10,000 
Total cost: $76,800 
Benefits 
• Tripling of mail shot capacity: estimate: $30,000/year 
• Ability to sustain telesales campaigns: estimate: $15,000/year 
• Improved efficiency and reliability of follow-up: estimate: $30,000/ 
year 
• Improved customer service and retention: estimate: $20,000/year • Improved accuracy of customer information: estimate: $5,000/year 
• More ability to manage sales effort: $20,000/year 
Total Benefit: $120,000/year

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15 Risks 
Computer systems have unique risk and control issues that need to be 
addressed by the business. As with any risk factor the company needs to make an assessment of the risks and decide on the appropriate level of control to reduce the risks to an acceptable level. 
A risk to a computer system could be anything that prevents the managers 
getting the information they need from the system at the time that they need it. 
 
 Risks to information processing facilities may arise from: 
• Dissatisfied employees might deliberately modify or destroy information in 
the system. 
• A hacker or industrial spy might break into the system. 
• Viruses or malicious software could be introduced. • Accidental mistakes could be made on input to the system. • Inadequate security of the hardware or data. 
• Faults in the hardware system. 
Such risks result in the loss of information (or the loss of its integrity or 
confidentiality), business disruption and a loss of time and money. Costs may be incurred. 
 
Further detail on risks 
 Risks to information security can be categorised as follows: 
 
Risks Description 
Risk of 
hardware theft This risk might seem fairly obvious, but the theft of computer hardware is common. 
Physical damage to hardware and computer media (disks, etc) Physical damage can be caused by: 
• malicious damage • poor operating conditions causing damage to 
equipment and magnetic files 
• natural disasters, such as fire and flooding. 
Damage to data Data can be damaged by hackers into the system, 
viruses, program faults in the software and faults in 
the hardware or data storage media. 
Software, particularly purpose-written software, can 
become corrupted. Programs might be altered by a hacker or computer fraudster. Alternatively, a new version of a program might be written and introduced, but contain a serious error that results in the corruption or loss of data on file.

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mistakes Unintentional mistakes can cause damage to data or loss of data; for example, using the wrong version of computer program, or the wrong version of a data file, or deleting data that is still of value. 
Fraud and industrial espionage This can lead to the loss of confidentiality of sensitive information, or the criminal creation of false data and false transactions, or the manipulation of data for personal gain. 
Data protection legislation 
Some countries give individuals the right to seek compensation against an organisation that holds personal data about them, if they suffer loss through the improper use of that data. In the UK, for example, rights are given to ‘data subjects’ by the Data Protection Act. There could be a risk that an organisation will improperly use or communicate personal data about individuals, in breach of the legislation. 
Erroneous input 
Many information systems, especially those based on transaction 
processing systems and with large volumes of input transactions, are vulnerable to mistakes in the input data. 
• Some input items might be overlooked and omitted. Other 
transactions might be entered twice. 
• There might be errors in the input data, particularly where the data 
is input by humans rather than by electronic data transfer. For 
example, in a system relying on input via keyboard and mouse, data accuracy depends on the ability of the operator to input the data without making a mistake. 
Where input errors are high, the integrity of the data and information becomes doubtful. 
Hacking 
Hacking is the gaining of unauthorised access to a computer system. It 
might be a deliberate attempt to gain access to an organisation’s systems and files, to obtain information or to alter data (perhaps fraudulently). 
Once hackers have gained access to the system, there are several 
damaging options available to them. For example, they may: 
• gain access to the file that holds all the user ID codes, passwords 
and authorisations 
• discover the method used for generating/authorising passwords

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 • interfere with the access control system, to provide the hacker with 
open access to the system 
• obtain information which is of potential use to a competitor 
• obtain, enter or alter data for a fraudulent purpose 
• cause data corruption by the introduction of unauthorised computer 
programs and processing on to the system (computer viruses) 
• alter or delete files. 
Viruses 
A virus is a piece of software that seeks to infest a computer system, 
hiding and automatically spreading to other systems if given the opportunity. Most computer viruses have three functions – avoiding detection, reproducing themselves and causing damage. Viruses might be introduced into a computer system directly, or by disk or e-mail attachment. 
Viruses include: 
• trojans – whilst carrying on one program, secretly carry on another 
• worms – these replicate themselves within the systems 
• trap doors – undocumented entry points to systems allowing normal 
controls to be by-passed 
• logic bombs – triggered on the occurrence of a certain event • time bombs – which are triggered on a certain date. 
 
 Risks and benefits of internet and intranet use 
 Many organisations have intranet systems or use the Internet directly. 
Using an intranet or the Internet has obvious advantages, but also 
creates substantial risks. 
The advantages of intranets and the Internet 
• Employees have ready access to vast sources of external data that 
would not otherwise be available. Using external information can 
help to improve the quality of decision making. 
• Organisations can advertise their goods and services on a website, 
and provide other information that helps to promote their image. 
• Organisations can use the Internet to purchase goods or supplies, 
saving time and money. For example, the Internet is used regularly by businesses to purchase standard items such as stationery, and to reserve hotel rooms and purchase travel tickets.

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 • The Internet/intranet provides a means of operating an e-mail 
system. Communication by e-mail is fast and should remove the 
requirement for excessive quantities of paper. Using e-mails might also reduce the non-productive time spent by employees on the telephone. 
• Intranets create the opportunity for more flexible organisation of 
work. For example, employees who are away from the office can access the organisation’s IT systems and files through the Internet. Similarly, employees can work from their home but have full access to the organisation’s systems. 
The disadvantages of intranets and the internet 
There are disadvantages with using intranets and the Internet. 
• E-mail systems can become inefficient if too many messages are 
sent and users have to look through large amounts of ‘junk mail’ to 
find messages of value. 
• E-mails can be disruptive, especially if a prompt appears on an 
individual’s computer screen whenever a new message is received. 
• Senders of e-mails often expect an immediate reply to their 
messages, and a delay in responding can create bad feelings and ill-will. 
• Employees might waste too much time looking for information on 
the Internet, when the value of the information is not worth the time spent looking for it. 
• Without suitable controls, employees might spend large amounts of 
time on the Internet or exchanging e-mails for their personal benefit, rather than in carrying out their work responsibilities. 
The greatest problem with using intranets and the Internet, however, is the vulnerability of the organisation’s IT systems to: 
• unauthorised access by hackers, including industrial spies • the import of viruses in attachments to e-mail messages and other 
malicious software. 
16  Big Data 
There are several definitions of Big Data, the most commonly used referring to 
large volumes of data beyond the normal processing, storage and analysis capacity of typical database application tools. 
Although Big Data does not refer to any specific quantity, the term is often used 
when speaking about ‘petabytes’ and ‘exabytes’ of data.

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The definition can be extended to incorporate the types of data involved. Big 
Data will often include much more than simply financial information. Examples of data which may input into Big Data systems include: 
• traffic flow monitoring 
• satellite imagery 
• streamed audio content 
• audio downloads 
• web pages content 
• telemetry from consumer and commercially operated vehicles 
• financial market data. 
 
One of the key challenges of dealing with Big Data is to identify repeatable 
business patterns in this unstructured data, significant quantities of which is in text format. Managing such data can lead to significant business benefits such as greater competitive advantage, improved productivity and increasing levels of innovation.

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17  The four V's 
The four V’s represent the defining characteristics of Big Data: 
Velocity 
Data is now streaming from sources such as social media sites at a virtually 
constant rate and current processing servers are unable to cope with this flow and generate meaningful real-time analysis. 
Volume 
The vast quantities of data generated are a key feature of ‘Big Data’: more 
sources of data, and an increase in data generation in the digital age means that the volume of data has increased to a potentially unmanageable level. Data analytics software have enabled very large data sets to be processed; data analytics enable a deeper understanding of customer requirements. For example, organisations can collect large amounts of external data about their customers from customers' use of the internet and social media. 
When this data combines wi th internally gener ated data (from customer loyalty 
cards or transactions recorded at shop tills, for example) a more detailed profile 
of the customer can be established. Within the business, these advances have involved enhancing existing IT infrastructures through the use of cloud computing architectures so that they are capable of holding greater amounts of data. 
Variety 
Traditionally data was structured and in similar and consistent formats such as 
Excel spreadsheets and standard databases. Data can now be generated and collected in a huge range of formats including rich text, audio and GPS data amongst others. 
Veracity 
Veracity (value) is concerned with the truthfulness of the data collected. 
Because of so many different sources, there is an increased risk of inaccuracies. For data to have any value when being used for decision-making in business, it needs to be truthful. This means it must not present a bias, or contain inconsistencies. The use of poor quality data may have expensive and 
far reaching consequences for those organisations which rely on it for making strategically important decisions. For example, an organisation may decide to introduce a type of product in the belief that there is sufficient customer demand for it, which in reality may not be the case.

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 Example 4: Monterey Ltd 
 The Managing Director of Monterey Ltd has recently started looking at 
ways of gathering Big Data for her business. She is concerned that some 
of the sources of data she has chosen are unreliable, and may therefore lead her to inaccurate conclusions. 
Which features may be missing for Monterey's Big Data? A  Variety B  Volume C  Veracity D  Velocity 
 
 How is Big Data is used 
 Consumer facing organisations monitor social media activity to gain 
insight into customer behaviour and preferences. This source can also be 
used to identify and engage  brand advocates and detractors and assess 
responsiveness to advertising campaigns and promotions. 
Sports teams can use data of past fixtures to tracking tactics, player 
formations, injuries and results to inform future team strategies. 
Manufacturing companies can monitor data from their equipment to 
determine usage and wear. This allows them to predict the optimal replacement cycle. 
Financial Services organisations can use data on customer activity to 
carefully segment their customer base and therefore accurately target individuals with relevant offers. 
Health organisations can monitor patient records and admissions to 
identify risk of recurring problems and intervene to avoid further hospital involvement. 
18  Big Data Management and analytics 
Big Data management  is the storage, administration and control of vast 
quantities of both structured and unstructured data. 
The main aim of Big Data management is to ensure the data stored is high 
quality and accessible. Effective Big Data management can leverage large sets of data from a variety of relatively new sources such as social media sites. 
New technologies combine traditional data warehouses with Big Data systems 
in a logical data warehousing architecture. 
Big Data analytics  is the process of scrutinising Big Data to identify patterns, 
correlations, relationships and other insights. This information can have a wide 
reaching effect on the organisation’s competitive strategy and marketing campaigns and can therefore have a direct impact on future profitability.

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Big Data sources  may not fit into currently available data warehouses and Big 
Data analytics may require more advanced software tools than those commonly 
used in traditional data mining. Open source technologies such as Hadoop are increasingly utilised to manage the constantly evolving data processing requirements of Big Data. 
Hadoop is an open source programming framework which enables the 
processing of large data sets by utilising multiple servers simultaneously. 
19  Big Data: Benefits and risks 
Several major business benefits arise from the ability to manage Big Data successfully: 
1 Driving innovation by reducing time taken to answer key business 
2 Gaining competitive advantage 3 Improving productivity. 
 
Big Data Benefits: UPS 
(i) Over 15 million minutes of idling time were eliminated in one year, 
(ii) 1.7 million miles of driving were also eliminated in the same year, 
saving a further 183,000 gallons of fuel. 
However, there are risks associated with Big Data: 
1 Availability of skills  to use Big Data systems, which is compounded by 
the fact that many of the systems are rapidly developing and support is not 
always easily and readily available. There is also an increasing need to combine data analysis skills with deep understanding of industry being analysed and this need is not always recognised. 
2 Security of data  is a major concern in the majority of organisations and if 
the organisation lacks the resource to manage data then there is likely to be a greater risk of leaks and losses. 
3 Data Protection  issues as organisations collect a greater range of data 
from increasingly personal sources (e.g. Facebook). 
It is important to recognise that just because something CAN be measured, this does not necessarily mean it should be. There is a risk that valuable time is spent measuring relationships that have no organisational value.

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 Big Data Risks: Walmart 
 It is widely reported that  Walmart tracks data on over  60% of adults in the 
US, including online and in-store purchasing patterns, Twitter interaction 
Walmart detractors criticise the company's data collection as a breach of 
human rights and believe the company uses the data to make judgements on personal information such as political view, sexual orientation and even intelligence levels.

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20  Practice questions 
 Objective Test Question 1: Benefit of an information system 
 Access to a larger market, targeted marketing, reduced costs and the 
elimination of intermediaries are just some of the benefits that could 
result from the implementation of: 
A  knowledge management systems B  e-commerce C  web 2.0 tools D  enterprise-wide systems 
 
 Objective Test Question 2: Intangible Costs of an information system 
 Which of the following is NOT an intangible cost of a new information 
system? A  The opportunity cost of other projects foregone B  Day to day running costs such as heating and insurance C  Staff disruption during the implementation phase D  The cost of dysfunctional behaviour due to resistance to change 
 
 Objective Test Question 3: TARA framework 
 Chen Products produces four manufactured products: Products 1, 2, 3 
and 4. The company’s risk committee recently met to discuss how the 
company might respond to a number of problems that have arisen with Product 2. 
After a number of incidents in which Product 2 had failed whilst being 
used by customers, Chen Products had been presented with compensation claims from customers injured and inconvenienced by the product failure. It was decided that the risk committee should meet to discuss the options. 
When the discussion of Product 2 began, committee chairman Anne 
Ricardo reminded her colleagues that, apart from the compensation claims, Product 2 was a highly profitable product. 
Chen’s risk management committee comprised four non-executive 
directors who each had different backgrounds and areas of expertise. None of them had direct experience of Chen’s industry or products. It was noted that it was common for them to disagree among themselves as to how risks should be managed and that in some situations, each member 
proposed a quite different strategy to manage a given risk. This was the case when they discussed which risk management strategy to adopt with regard to Product 2.

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Using the TARA framework, place each of the following strategies in a 
grey cell, against the 'TARA' element to  which it is most likely to relate: 
 
Transfer  
Avoid  
Reduce  
Accept  
 
Strategy 1: this would involve discontinuing the activity that is exposing the company to risk. In the case of Chen, this would involve ceasing production of Product 2. 
This would be pursued if the 
impact (hazard) and probability of incurring an acceptable level of liability were both considered to be unacceptably high and there were no options for transference or reduction. Strategy 2: this would involve the company accepting only a portion of the risk. Although an unlikely possibility given the state of existing claims, insurance against future claims would serve to limit Chen’s potential losses and place a limit on its losses. Outsourcing manufacture may be a way of transferring risk if the outsourcee can be persuaded to accept some of the product liability. 
Strategy 3: This would involve seeking to retain a component of the risk (in order to enjoy the return assumed to be associated with that risk) but to reduce it and thereby limit its ability to create liability. Chen produces four products and it could reconfigure its production capacity to produce proportionately more of Products 1, 3 and 4 and proportionately less of Product 2. This would reduce Product 2 in the overall portfolio and therefore Chen’s exposure to its risks. This would need to be associated with instructions to other departments (e.g. sales and marketing) to similarly reconfigure activities to sell more of the other products and less of Product 2. Strategy 4: This would involve taking limited or no action to reduce the exposure to risk and would be taken if the returns expected from bearing the risk were expected to be greater than the potential liabilities. The case mentions that Product 2 is highly profitable and it may be that the returns attainable by maintaining and even increasing Product 2’s sales are worth the liabilities incurred by compensation claims.

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 Objective Test Question 4: Risk appetite 
 
high risk  reduction  risky 
     
avoidance  low risk  TARA 
     
transference  more  appetite 
An organisation is likely to have a portfolio of projects, some incurring more risk than others, so that the overall risk ______________is met from that portfolio. 
A _______________appetite will indica te that the organisation will 
normally seek a higher number of higher-risk/return activities as the 
organisation is willing to accept _______________ risk and its risk capacity has not been reached. However, a ____________ appetite indicates that a higher number of low-risk/lower-return activities will be preferred. 
The way that an organisation manages risk will also affect its risk 
strategy. Using _______________ as an example of risk management, the overall risk strategy of an organisation can be explained as follows: 
• A strategy of primarily self-insurance may limit the organisation’s 
strategy regarding undertaking __________ projects. Self-insurance 
implies risk minimisation as an overall strategy. 
• A risk strategy of risk ____________ may imply an overall strategy 
that incorporates a higher level of risk. However, risk will then be limited by the amount of insurance premiums. Where premiums become too high, the risk strategy determines that, overall, the organisation will seek less risky projects. 
• A strategy of ______________ implies that the organisation wants 
to limit the total amount of risk. 
• Finally, a strategy of risk ______________ may imply that the risk 
capacity of the firm is being reached and while additional risk can be accepted, the amount of risk that can be taken on is limited. 
Risk capacity is also important when determining the desired method of expansion within an organisation. Where the organisation has a high risk capacity the overall risk strategy is likely to be directed to taking on higher risk projects. However, where the organisation’s total risk capacity is being reached, then projec ts with a lower amount of risk will be expected.

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 Case Study Style Question: The ZXC Company 
 The ZXC company manufactures aircraft. The company is based in 
Europe and currently produces a range of four different aircraft. ZXC’s 
aircraft are reliable with low maintenance costs, giving ZXC a good reputation, both to airlines who purchase from ZXC and to airlines’ customers who fly in the aircraft. 
ZXC is currently developing the ‘next generation’ of passenger aircraft, 
with the selling name of the ZXLiner. New developments in ZXLiner include the following. 
• Two decks along the entire aircraft (not just part as in the Boeing 
747 series) enabling faster loading and unloading of passengers 
from both decks at the same time. However, this will mean that airport gates must be improved to facilitate dual loading at considerable expense. 
• 20% decrease in fuel requirements and falls in noise and pollution 
levels. 
• Use of new alloys to decrease maintenance costs, increase safety 
and specifically the use of Zitnim (a new lightweight conducting alloy) rather than standard wiring to enable the ‘fly-by-wire’ features of the aircraft. Zitnim only has one supplier worldwide. 
Many component suppliers are based in Europe although ZXC does obtain about 25% of the sub-contracted components from companies in the USA. ZXC also maintains a significant R&D department working on the ZXLiner and other new products such as alternative environmentally friendly fuel for aircraft. 
Although the ZXLiner is yet to fly or be granted airworthiness certificates, 
ZXC does have orders for 25 aircraft from the HTS company. However, on current testing schedules the ZXLiner will be delivered late. 
ZXC currently has about €4 billion of loans from various banks and last 
year made a loss of €2.3 billion. ZXC’s chief executive has also just resigned taking a leaving bonus of around two years’ salary.

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 You have received the following email from the newly appointed Acting 
Chief Executive: 
 
 Case Study Style Question: ZZ 
 ZZ is a music streaming company s pecialising in classical tracks and 
opera. It has a growing loyal customer base, which has largely been 
created through word of mouth and magazine adverts and editorials. 
You have received the following email from the new Chief Executive:

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 Example 1: Risk 
 None of the statements are true. There is no clear established link 
between corporate size, structure and development and the risk accepted 
• High probability, high impact risk: the business will be affected if 
the average 'fill' from containers falls from its current level of 78%. 
Profits will be unsatisfactory if the 'fill' is less than 75%, suggesting that there could be a high risk of falling and inadequate profitability due to a failure to win enough business. 
• Low probability, high impact risk:  a downturn in international 
trade will affect the volume of freight, and so would reduce CC's 
income. Since international trade has been growing, the likelihood of a downturn would seem to be low. 
• High probability, low impact risk: it seems inevitable that airlines will charge higher prices, but CC can pass on these costs to its own customers, therefore the impact of this risk is low. 
• Low probability, low impact risk:  the collapse of a major airline is 
possible due to high losses, but is perhaps unlikely. If an airline did go out of business, international freight should not be affected, because business would switch to other airlines. 
 
 • An organisation sells a subsidiary in a politically unstable country. 
RISK AVOIDANCE  
and therefore reject a potentially profitable contract. RISK 
AVOIDANCE 
rain occurring. RISK  RETENTION 
 
Likelihood High Higher airline flight 
costs Insufficient freight to 
fill containers 
 Low A major airline will 
go out of business Downturn in 
international trade 
  Low High 
  Impact/consequences

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 Answer C 
Veracity refers to the accuracy and truthfulness of the data. If this is 
missing, it can lead to inaccurate conclusions being drawn. 
 
 Answer B 
E-commerce refers to the conducting of business electronically via some 
sort of communications link and may re sult in access to larger markets, 
targeted marketing, reduced costs and elimination of intermediaries. 
 
 Answer B 
Day to day running costs, such as heating and insurance, should be 
tangible costs. Answers A, C and D all describe intangible costs. 
 
 Objective Test Question 3: TARA framework  
  
Transfer Strategy 2 
Avoid Strategy 1 
Reduce Strategy 3 
Accept Strategy 4 
  
 An organisation is likely to have a portfolio of projects, some incurring more 
risk than others, so that the overall risk appetite  is met from that portfolio. 
A high-risk appetite will indicate that the organisation will normally seek 
a higher number of higher-risk/return activities as the organisation is willing to accept more  risk and its risk capacity has not been reached. 
However, a low-risk  appetite indicates that a higher number of low 
risk/lower-return activities will be preferred. 
strategy. Using TARA  as an example of risk management, the overall risk 
strategy of an organisation can be explained as follows: 
strategy regarding undertaking risky  projects. Self-insurance 
implies risk minimisation as an overall strategy.

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 527 
 • A risk strategy of risk transference may imply an overall strategy 
that incorporates a higher level of risk. However, risk will then be 
limited by the amount of insurance premiums. Where premiums become too high, the risk strategy determines that, overall, the organisation will seek less risky projects. 
• A strategy of avoidance implies that the organisation wants to limit 
the total amount of risk. 
• Finally, a strategy of risk reduction  may imply that the risk capacity 
of the firm is being reached and while additional risk can be accepted, the amount of risk that can be taken on is limited. 
Risk capacity is also important when determining the desired method of expansion within an organisation. Where the organisation has a high risk capacity the overall risk strategy is likely to be directed to taking on higher risk projects. However, where the organisation’s total risk capacity is being reached, then projec ts with a lower amount of risk will be expected. 
 
 Case Study Style Question: The ZXC Company  
 EMAIL 
TO: Jack Van Gus 
FROM: AN Accountant 
SUBJECT:  ZXC – Sources of business risk  
DATE:  19 June 2014 
Hi Jack, 
In response to your email, please find below some notes about the 
potential sources of risks that may affect our business in the coming 
months. 
Product/market risk 
This is the risk that customers will not  buy our new products (or services), 
or that the sales demand for current products and services will decline 
unexpectedly. For ZXC, there is the risk that demand for the new aircraft will be less than expected, either due to customers purchasing the rival airplane or because airpor ts will not be adapted to take the new ZXLiner. 
Commodity price risk 
Businesses might be exposed to risks from unexpected increases (or 
falls) in the price of a key commodity.

528  
 Part of the control systems of the ZXLiner rely on the availability of the 
new lightweight conducting alloy Zitnim. As there is only one supplier of 
this alloy, then there is the danger of the monopolist increasing the price or even denying supply. Increase in price would increase the overall cost of the (already expensive) ZXLiner, while denial of supply would further delay delivery of the aircraft. ZXC needs to maintain good relations with their key suppliers to mitigate this risk. 
Product reputation risk 
Some companies rely heavily on brand image and product reputation, 
and an adverse event could put its reputation (and so future sales) at risk. While the reputation of ZXC appears good at present, reputation will suffer if the ZXLiner is delayed significantly or it does not perform well in test flights (which have still to be arranged). Airline customers, and also their customers (travellers) are unlikely to feel comfortable flying in an aircraft that is inherently unstable. ZXC must continue to invest in R&D and good quality control systems to mitigate the effects of this risk. 
Credit risk 
Credit risk is the possibility of losses due to non-payment by debtors or 
the company not being able to pay its creditors, which will adversely affect the company’s credit rating. 
Given that the ZXLiner has not been sold at present, there are no 
debtors. However, ZXC is heavily dependent on bank finance – any denial of funds will adversely affect ZXC’s ability to continue to trade. 
Credit risk is therefore significant at present. 
Currency risk, or foreign exchange ri sk, arises from the possibility of 
movements in foreign exchange rates, and the value of one currency in 
relation to another. ZXC is currently based in Europe although it obtains a significant number of parts from the USA. If the €/$ exchange rate became worse, then the cost of imported goods for ZXC (and all other companies) would increase. At present, the relatively weak US$ is in ZXC’s favour and so this risk is currently negligible. 
Interest rate risk is the risk of unexpected gains or losses arising as a 
consequence of a rise or fall in interest rates. Exposures to interest rate risk arise from borrowing and investing. As ZXC do have significant bank loans, then the company is very exposed to this risk. As interest rates are expected to rise in the future then ZXC would be advised to consider methods of hedging against this risk.

Chapter 12 
 529 
 Gearing risk 
Gearing risk for non-bank companies is the risk arising from exposures to 
high financial gearing and large amounts of borrowing. Again, ZXC has significant amounts of bank loans. This increases the amount of interest that must be repaid each year. In the short term ZXC cannot affect this risk as the bank loans are a necessary part of its operations. 
Legal risk or litigation risk 
The risk arises from the possibility of legal action being taken against an 
organisation. At present this risk does not appear to be a threat for ZXC. 
However, if the ZXLiner is delayed any further there is a risk for breach of 
contract for late delivery to the HTS company. There is little ZXC can do to guard against this risk, apart from keep HTS appraised of the delays involved with the ZXLiner. 
Regulatory risk 
This is the possibility that regulations will affect the way an organisation 
has to operate. In terms of aircraft, regulation generally affects noise and pollution levels. As the ZXLiner is designed to have lower noise and pollution levels than existing aircraft then this risk does not appear to be a threat to ZXC. 
Technology risk 
Technology risk arises from the possib ility that technological change will 
occur or that new technology will not work. Given that ZXC is effectively 
producing a new product (the ZXLiner) that has not actually been tested yet, there is some technology risk. At worse, the ZXLiner may not fly at all or not obtain the necessary flying certificates. ZXC appear to be guarding against this risk by not decreasing its investment in product development. 
This risk refers to the risks facing organisations from changes in 
economic conditions, such as economic growth or recession, government spending policy and taxation policy, unemployment levels and international trading conditions. 
Demand for air travel is forecast to increase for the foreseeable future, so 
in that sense there is a demand for aircraft which ZXC will benefit from. The risk of product failure is more significant than economic risk. 
Environmental risk 
This risk arises from changes to the environment over which an 
organisation has no direct control, such as global warming, to those for which the organisation might be responsible, such as oil spillages and other pollution.

530  
 ZXC is subject to this risk – and there is significant debate concerning the 
impact of air travel on global warming. At the extreme, there is a threat 
that air travel could be banned, or made very expensive by international taxation agreements, although this appears unlikely at present. ZXC need to continue to monitor this risk, and continue research into alternative fuels etc. in an attempt to mitigate the risk. 
Business probity 
This is the risk that a company does not follow rules of good corporate 
governance or show appropriate ethical awareness. 
In ZXC, the departure of the chief executive with a bonus of more than 
two years’ salary appears to act against business probity – why should the chief executive obtain a bonus when ZXC is making a loss and workers may be made redundant? However, the impact of this risk on ZXC is unclear. It is unlikely to affect sales as customers are more interested in the ZXLiner than the departure of the chief executive. There is more of an association risk in terms of business probity not being followed in other areas such as perceived cost cutting in research and development affecting the quality of the product. Again, ZXC are guarding against this risk. 
However, the board of ZXC should ensure that the remuneration 
committee review directors’ service contracts to ensure risk in this area does not occur in the future. 
With regards  AN Accountant 
 
 EMAIL TO: D. Picton 
FROM : AN Accountant  
DATE : 19 June 2014  
SUBJECT: Big Data  Good Morning Donald,  In response to your email, please find some notes about Big Data. Big Data management involves using sophisticated systems to gather, 
store and analyse large volumes of data in a variety of structured and unstructured formats. Companies are collecting increasing volumes of data through everyday transactions and marketing activity. If managed effectively, this can lead to many business benefits, although there are risks involved.

Chapter 12 
 531 
 Benefits 
As ZZ is a web-based business it is likely that all of its sales transactions 
take place over the internet. This is likely to result in a greater volume of data being collected for each transaction, which ZZ can use to better understand its customer preferences and buying patterns. This can help to ensure that the right type of track is available to customers and can also drive more targeted and effective marketing campaigns. 
One ever-growing source of largely unstructured data is the wide range of 
social media channels now available. ZZ have chosen not to develop social media networks in the belief that customers will not want to engage in this way. The @iloveZZ Twitter feed,  along with its followers, suggests 
that this may no longer be the case and so ZZ have an opportunity to gather data from this source in order to obtain a greater insight into customer interests. 
As ZZ has a loyal customer base, they can also harness the data 
collected through transactions and social media networks to maximise this loyalty. Certain customers may be defined as key advocates of the company’s product and this can be used effectively in marketing campaigns to show the positive customer feedback ZZ receives. 
Risks 
ZZ is currently not using social media and therefore not collecting data in 
this way. There is a risk that the company falls behind its competitors who may well be harnessing the powerful data available from this source. Although ZZ currently has a loyal customer base, these customers may be tempted to switch to other streaming services if they are engaged through Twitter and Facebook based marketing. 
Even if ZZ decides that they should develop a social media strategy there 
is a danger that significant volumes of data are collected and stored but not used properly. Not only will this be a waste of potentially useful information, but it will also cost money and use up storage space on the company’s systems.

Index 
 I.1 
2 part tariff…..380 
3Es…..342, 343 
concept…..342 
A 
Acceptance…..498 Accounting Rate of Return (ARR)…..194, 197 
Acid test ratio…..294 
Activities 
batch-related activities…..8 
facility-sustaining activities…..9 non-value-added activities…..12 product-sustaining activities…..9 unit-level activities…..8 
Activity level…..337 
Activity-Based Costing (ABC)…..1 
activities…..5, 8, 9, 11, 12, 13, 14, 15, 16, 19, 
20, 21, 31, 33 
activity-based cost hierarchy…..8 basics…..4 benefits and limitations…..9 
cost drivers…..4, 5, 12, 13, 16, 26, 33, 38 
cost pools…..12, 20, 31 decision making…..4, 10 definition…..4, 5, 10 
favourable conditions…..8 
Activity-Based Management (ABM)…..1, 2, 12 
Problems with implementation…..15 
Adverse variances…..333 
Algebraic approach…..254 Annuities…..159 Annuity factor…..159, 160, 164 
formula…..160 
Appraisal costs…..53, 54, 55, 76 Attitudes to risk…..158 Avoidable costs…..121 
Avoidance…..498 
B 
Balancing allowance…..201 
Benchmarking…..344, 345, 352, 356, 362 
Benefits of a new Information System…..509 
Big Data…..514, 515, 516, 517, 518, 519, 530 
analytics…..516, 517, 518 
Budgetary control…..331 
Business intelligence systems…..131 
BI ‘stack’…..132 
Intangible benefits of BI…..135 
Business Process Re-engineering…..65 
Buying division…..370 
   
 C 
Calculation…..159 Capital employed…..292, 293, 295, 297, 298, 
318, 322, 323, 324 
Capital expenditure committee…..142 
Capital investment process…..141 
Capital rationing…..168 
hard capital rationing…..168 
soft capital rationing…..168 
CGMA Cost transformation model…..3 
Changing discount rates…..166 
Charities…..341 CIMA's Code of Ethics…..502 CIMA's risk management cycle…..492 
Coefficient of variation…..424, 425 
Committed costs…..119 Committed fixed costs…..287 Comparing ROI and RI…..300 
Competitive benchmarking…..345 
Competitiveness…..336 Complementary products…..249 Compliance costs…..53 
Compound interest…..144 
Conditional probabilities…..443 Confidence levels…..427 Conformance costs…..53 Contingency table…..443 
Continuous improvement…..49, 50, 52, 53, 58, 
60, 61, 62, 63, 64, 65, 77 
Controllability…..288, 321 
of costs…..286 
Controllable 
costs…..332 
profit…..295, 298 
Controlled pricing…..267 
Controls…..130 
Application or program controls…..130 
General controls…..130 
Cooper and Kaplan…..4, 8 
Cost(s) 
and benefits of information systems…..506 
centre…..285, 287, 290, 291, 294, 295 
classification…..508 conscious culture…..3 benefit analysis…..506, 510 
of capital…..145 
of information…..508 of quality…..53, 57, 58 
plus pricing…..257, 381 
Current ratio…..294 
Customer 
perspective…..348, 355 
profitability analysis…..20 
profitability curve…..21 
satisfaction…..338, 348

Index 
I.2  
D 
Data…..124 
analytics…..132, 308 
lake…..133 
mining…..132, 133 
protection…..512, 518 
Decentralisation…..284 
Decision 
criteria…..428 
trees…..437, 441, 470 
Decline…..271 
Deflation…..213 Demand curve…..374 Depreciation…..119, 122, 124 
Differential/incremental costs…..121 
Differentiation strategy…..99 Direct 
data capture…..508 
product profitability (DPP)…..17 
Directly attributable fixed costs…..286 
Discount 
factor…..145 
pricing…..265 
rate…..145 
Discounted Payback Profitability Index 
(DPBI)…..169 
Discounting…..144 
Discretionary fixed costs…..287 
Disposable income…..250 Distribution channel profitability…..28 Divisional 
autonomy…..371 
performance measurement…..294 
Dual pricing…..381 
Duplication…..128 
E 
Economic value added (EVA®)…..302 Economy…..342 Effectiveness…..342 
Efficiency…..342 
Employee empowerment…..14, 49 Ethical issues…..502 Expected value(s)…..412, 415, 416, 417, 419, 
420, 421, 422, 424, 425, 427, 428, 430, 431, 
437, 438, 441, 442, 452, 454, 456, 457, 458, 
463, 467, 469, 471, 472, 473, 475, 477, 481 
advantages and disadvantages of evs…..421 
External 
failure…..54 
information…..124, 137 
sources…..125 
 
 F 
Financial perspective…..347 
Fixed budget…..330 
Flexed budget…..330, 332 Flexibility…..49 Flexible budget…..330 
Fraud and employee malfeasance…..494 
Full product costs…..4 Functional analysis…..87, 97 Functional benchmarking…..345 
G 
Get it right, first time…..53 Goal congruence…..371, 376, 378, 410 Goldratt and Cox…..59 
Gradient…..253 
Growth…..270 
H 
Hacking…..512 
High quality data…..126, 127, 128 
Homogeneous products…..250 
I 
Imperfect 
competition…..250 
information…..436, 454 
Incremental revenues…..122 
Indirect costs of producing information…..508, 
509 
Industrial spies…..514 Inflation…..194, 206, 207, 208, 209, 210, 211, 
212, 213, 219, 221, 230, 231 
money method…..207, 210, 211, 213, 230 
specific inflation…..209 
Information…..125, 126, 507 
systems…..506, 512     risks…..511 
Integrity…..128, 130 
Intercept…..253 Inter-company trading…..369 
Inter-divisional trading…..370 
Intermediate market…..372, 373, 374, 376, 379, 
408, 409, 410 
Internal 
benchmarking…..345 
business process perspective…..348 
failure…..54, 55, 71, 79 
information…..124 Rate of Return (IRR)…..146, 150 
sources…..124 
International transfer pricing 
Different tax rates…..386 
Internet…..508, 513, 514, 516, 531

Index 
 I.3 
Interpolation…..155 
Intranet…..513 Introductory phase…..270 Investment centre…..285, 295, 296, 298, 299, 
301, 305, 324 
J 
Joint probabilities…..437 Just-in-time (JIT)…..47, 50 
Get it right first time…..52 
JIT production…..50 JIT purchasing…..50 
K 
Kaizen…..47, 53, 61, 62, 63, 64, 77 
costing…..53, 77 
Kaplan and Norton…..346, 347 
Key performance indicators…..291 
L 
Learning and growth perspective…..348 Life cycle costing…..85, 100 
asset lifecycle costing…..105 
customer life cycle costing…..102 design costs out of the product…..101 
maximise the length of the life cycle 
itself…..101 
Liquidity…..293, 319, 328 
Loss 
leader pricing…..265, 266, 278 
of information…..511 
Low-cost strategy…..99 
M 
Marginal 
cost…..251 
cost-plus pricing…..260 
revenue…..251, 374, 375, 406 
Market skimming…..263 
Marketing-based pricing strategies…..262 
Maturity…..271 
Maximax…..431 Maximin…..416, 431, 432, 433, 453, 466, 468, 
475 
Maximisation of shareholder wealth…..149 Minimax regret…..433 Money cash flows…..206 Monopolistic competition…..250 
Monopoly…..250 
Monte Carlo simulation…..414, 425, 426, 428 Movement of goods and services…..371 Multimedia technology…..308 
Multi-stage decision problems…..437 
Mutually-exclusive options…..216 N 
NBV…..296 
Necessities…..250 
Net Present Value…..146 
Advantages and disadvantages…..149 
Assumptions…..147 
maximisation of shareholder wealth…..149 
Non value-adding activities…..67 
Non annual periods…..167 Non conformance…..53, 55, 76 
Non-current assets…..293, 296, 318 
Non Financial Performance Indicators…..336 Non relevant costs…..121 Non value adding activities…..96 
NOPAT…..302 
Normal distribution theory…..427 Notional costs…..121, 122 NPV 
versus IRR…..157 
with tax…..203 
O 
Oligopoly…..250 
Opportunity costs…..119, 120 
Optimum 
price…..253, 254, 272, 279 
replacement cycles…..218 
Outsourcing…..69 
Overhead absorption rate (OAR)…..4 
P 
Pareto…..24 
80:20 rule…..24 
Pay off tables…..428 Payback period…..194, 195, 196, 197, 198, 199, 
200, 220, 223, 224, 237, 413 
advantages and disadvantages of payback…..196 
formula…..195 
uneven cash flows…..195 
Penetration pricing…..264 
Perfect…..436, 476, 484, 485, 486 
information…..250 
Perfectly competitive market…..250 
Performance measurement…..371 
Perpetuities…..153, 154, 161, 162, 163, 164, 
165, 166, 185 
Planning and operational variances…..334 Post-completion audit…..177 
Premium pricing…..262 
Prevention costs…..53, 55, 76 Price differentiation…..264 Price elasticity of demand…..243 
factors affecting price elasticity…..249

Index 
I.4  
Pricing strategies…..257 
Primary activities…..98 Principle of controllability…..286 Prioritisation…..446 
Privacy…..128 
Probabilities…..415 Probability distributions…..414, 424, 425 Product bundling…..268 
Product life-cycle costing…..101 
Minimise the time to market…..101 
Productivity…..337 
Profit centre…..285, 295 Profit maximisation model 
limitations…..257 
Profit maximising selling price…..254 Profitability…..292, 328 
index…..168 
Profit-maximisation…..251, 257 Public interest…..502, 505, 506 Pull system…..50 
Q 
Qualitative 
benefits…..124 
costs…..124 
factors…..123 
Quality 
certification programmes…..57 
chains…..57 
circles…..58 management…..47 of service…..337 of staff experience…..338 
Quantitative 
benefits…..123 
costs…..123 
Quick ratio…..294 
R 
Random numbers…..426 
Rate of return…..145 Ratio analysis…..302 Real method…..207 
Real options…..140, 171, 172, 173 
option to switch…..172 
options to abandon…..173 
options to delay…..172 
options to expand…..173 
Real rate of return…..207 
Redeploy…..451 Reduction/mitigation…..498 
Regret…..433, 434, 468, 477 
  Relevant cash flows…..118 
future cash flows…..118 
Incremental cash flows…..119 
Replacement decisions…..216 
Report(s) 
visualisation…..308 
for Decision making…..308 
in a not-for-profit organisation…..340 
Residual income…..298 
accounting…..285, 287, 288, 331, 333 
centres.…..284, 285 
Return on investment…..295 
Revenue centre…..285, 294 
Risk…..489, 490, 491, 492, 493, 494, 495, 496, 
497, 498, 499, 500, 501, 502, 506, 511, 512, 
516, 517, 518, 520, 522, 525, 526, 527, 528, 529, 530, 531 averse…..416, 465 
categories…..493 
CIMA's risk management cycle…..492 downside risk…..490 identification…..493 
management…..489, 492, 495, 496, 498 
mapping…..498 neutral…..416, 465 premium…..413 
seekers…..416 
upside risk…..490 
Risk and uncertainty…..411, 412, 491 
difference between risk and 
uncertainty…..412 
ROI…..295, 296, 297, 298, 299, 300, 301, 302, 
322, 324 
S 
Safeguards…..502, 503 
Scenario planning…..449 
Secondary ratios…..297 
Security…..128, 129, 130, 137, 518 Selling division…..370 Sensitivity analysis…..414, 442, 454, 476 
pros and cons of sensitivity analysis…..415 
Shapers of society…..506 Shareholder value…..496 Shortcomings of financial indicators…..335 
Sources of management information…..124 
Spare capacity…..379 Standard costing…..62, 93 Standard deviation…..422 
Strategic 
risks…..494 
Stress testing…..445, 446, 447, 448, 459, 472, 
485 
Structured data…..133

Index 
 I.5 
Substitutes…..249 
Sunk costs…..118, 121 Supply chain management…..68 Support activities…..99 
Sustainability…..4 
T 
Tabular approach…..256 
TARA framework…..498, 500, 520, 526 
Target cost 
breakdown…..89 
Formula…..88 
Target costing…..53, 85, 87, 88, 90, 91, 93, 94, 
106, 108, 112, 114, 115 definition…..87, 95 
in design stages…..87 
target profit…..87 
Tax liability…..371, 386, 387 
Taxation 
capital allowances…..200 
effects of corporation tax…..200 in NPV calculations…..200 Tax depreciation…..201, 202, 203, 204, 213, 220, 225, 226, 227, 228, 233, 238 
The balanced scorecard…..346 
The Internal Rate of Return 
Advantages and disadvantages…..155 
linear interpolation…..151 
The Modified Internal Rate of Return…..158 
interpretation…..159 
The product life cycle…..270 
Theory of constraints…..59 
steps…..60 
Threats…..503 
Three-step method…..439 
Throughput accounting…..59, 60, 73, 80 Time value of money…..140, 143, 144, 145, 146, 
149, 155, 189 
Total cost-plus pricing…..257, 258 Total Quality Management (TQM) 
Successful implementation…..58 
Toyota…..50, 51 
TPAR…..61 
TQM (Total Quality Management)…..53 Traditional absorption costing…..86 Transfer pricing…..324, 369 
allocation of profits between divisions…..371 
behavioural considerations…..385 
cost-based transfer price…..372 
general rules…..376 Government action on transfer prices…..389 International transfer pricing…..386 
market-based transfer price…..372 
no surplus capacity…..384 objectives of transfer pricing…..371 
surplus capacity…..376, 379, 384, 407 
 Transference…..498 
Trend analysis…..311 Two way data tables…..429 
U 
Uncertainty…..411, 412, 413, 422, 425, 431, 436, 
437, 450, 451, 464, 467, 491 
Uncontrollable costs…..286, 315, 325, 332 Unstructured data…..133 
Utility theory…..422 
V 
Value analysis…..87, 90, 95, 96, 97, 106, 107, 
112 
cost value…..95 esteem value…..96 
exchange value…..95 
method…..96 
use value…..95 
Value at Risk (VaR)…..42 
Value 
added analysis…..66 
adding activities…..67, 96 chain…..98, 99, 100, 115 
chain analysis…..85 
engineering…..87, 95 for money (VFM)…..342 
of information…..506 
Variability…..491 
Variance analysis…..302, 335 
Variety…..516, 517 
Velocity…..516, 517 Veracity…..516, 517, 526 Viruses…..511, 513 
Visualisation…..308, 313 
tool…..309 
Volume…..516, 517 
W 
Whistleblowing…..505 
Work in progress (WIP)…..50 Working capital…..204 World Class Manufacturing…..50 
Z 
Zero 
defect…..56 
entry…..250

P.2   
 
Notice 
ISBN: 978-1-78740-198-3 Printed and bound in Great Britain

P.3 
Contents 
  Page 
Chapter 1 Risk 1 
Chapter 2 Risk management 37 
Chapter 3 Strategy risk 125 
Chapter 4 Reputational risks 199 
Chapter 5 Corporate governance 261 
Chapter 6  Internal controls 335 
Chapter 7 Internal audit 403 
Chapter 8 Cyber security threats 479 
Chapter 9 Cyber security processes 521 
Chapter 10 Cyber security tools, tech niques and reporting 565

P.6  
 
P.7 
 
examined. 
 
P.8  
Planning 
syllabus. 

P.9 

P.10   
important. This can be within a subject, for example ‘I will finish this topic by  
30 June’, or for overall achievement, such as ‘I want to be qualified by the end 
of next year’. 
subject and another. For example, P3 Risk management  builds on your 
knowledge of risks and controls from P2 Advanced management accounting  as 
well as your understanding of the digital environment from the E pillar papers.  

P.12   
website. 
tutorial. 

P.13 
topics. The topics contain one or mo re lead learning outcomes, related 

P.16   
P3: Risk Management 
Analyse, evaluate and manage strategic, operational and cyber risks 
A Enterprise risk 25% 
B Strategic risk 25% 
C Internal controls 25% 
D Cyber risk 25% 
  100%

P.17 
P3A: Enterprise risk 
Not all intended strategies are implemented due to va rious factors. These factors constitute the operating 
enterprise-wide risks of the organisati on. This section covers how to id entify, evaluate and manage these 
risks. 
 
1. Analyse sources 
and types of risk. Analyse: 
a. Sources of risks 
b. Types of risks • Upside and downside risks 
• Risks arising from internal 
and external sources 
• Risks arising from 
international operations 
• Strategic and operational 
risks What are the types and 
sources of risks that would 
prevent organisations from 
implementing their intended 
strategy? 
2. Evaluate risk. a. Evaluate the impact of risk 
b. Assess the likelihood of 
risks 
c. Analyse the interaction of 
different risks • Quantification of risk 
exposure 
• Risk maps What is the impact of the risks 
on the organisation? What 
techniques are available to 
evaluate the impact of such 
risks? 
3. Discuss ways of 
managing risks. Discuss: 
a. Roles and responsibilities 
b. Risk tolerance, appetite 
and capacity 
c. Risk management 
frameworks 
d. Risk analytics • Role of board and others 
in the organisation for 
identifying and managing 
risks 
• Risk mitigation including 
TARA – transfer, avoid, 
reduce, accept 
• Assurance mapping 
• Risk register 
• Risk reports and 
responses 
• Ethical dilemmas 
associated with risk 
management How is risk managed in the 
organisation? How is 
responsibility for various 
aspects of risk management 
distributed in the 
organisation? How does the 
organisation align its risk 
tolerance, appetite and 
capacity to its decisions and 
actions? What risk 
management frameworks are 
there? How is risk information 
communicated to the 
organisation?

P.18   
P3B: Strategic risk 
A fundamental risk of the organisation is that its st rategy is the wrong one and that even if implemented 
perfectly, it will achieve the wrong outcome for the or ganisation. In addition, so me risks are of such high 
significance that they can affect the very existence of the organisation. This section covers where these 
risks emanate from, evaluates them  a nd explains how oversight of such ri sks is critical to the governance 
of the organisation. 
 
1. Analyse risks 
formulating 
strategy. a. Analyse relevance of the 
assumptions on which 
strategy is based. 
b. Discuss potential sources 
and types of disruptions to 
strategy. • Analysis of strategic 
choice 
• Stress-testing strategy What are the risks that the 
strategy of the organisation is 
wrong? What are the sources 
of such risks? How does the 
organisation evolve its 
strategy in a dynamic 
environment to keep it 
relevant? 
2. Evaluate the 
sources and impact 
of reputational 
risks. Evaluate: 
a. Sources of reputational 
risk 
b. Impact of reputational risk 
on strategy • Risks of unethical 
behaviour 
• Impact on brand and 
reputation of organisation What is reputational risk and 
why is it an important 
strategic risk? What are the 
types and sources of 
reputational risks and what is 
their impact on the 
organisation? How can they 
be managed? 
3. Explain 
governance risks. Explain: 
a. The role of board and its 
committees in managing 
strategic risk 
b. Failure of governance and 
its impact on strategy • Separation of the roles of 
CEO and chairman 
• Role of non-executive 
directors 
• Roles of audit committee, 
remuneration committee, 
risk committee and 
nomination committee 
• Directors’ remuneration What is the role of the board 
in risk management? How 
does governance risk occur? 
How is this role governed by 
the various corporate 
governance codes and 
principles?

P.19 
P3C: Internal controls 
Control systems are an integral part of managing ri sks. Various control framew orks have be en developed 
to assist in this process. In addition, the internal audit function performs a vital role in helping to implement 
and monitor implementation and adherence to the control frameworks. This section covers how internal 
control systems can be used effectively in the risk management process. 
 
1. Analyse internal 
control systems. a. Discuss roles and 
responsibilities for internal 
controls. 
b. Discuss the purpose of 
internal control. 
c. Analyse the features of 
internal control systems. • Role of risk manager as 
distinct from internal 
auditor 
• Control systems in 
functional areas 
• Operational features of 
internal control What are the roles of internal 
control systems in managing 
risks? What are its key 
features and why? 
internal controls for 
risk management. a. Discuss the Committee of 
Sponsoring Organisations 
of the Treadway 
Commission (COSO) 
internal control and risk 
management framework. 
b. Assess control weakness. 
c. Assess compliance 
failures. 
d. Recommend internal 
controls for risk 
management. • Governance and culture 
• Strategy and objective 
setting 
• Performance 
• Review and revision 
• Information, 
communication and 
reporting 
• Identifying and evaluating 
control weakness and 
compliance failures This introduces the COSO 
framework as a 
comprehensive way of looking 
at internal controls in risk 
management. The objective is 
to get candidates to 
understand the key elements 
and know how to apply them 
in evaluating internal controls. 
3. Discuss various 
issues relating to 
internal audit in 
organisations. Discuss: 
a. Forms of internal audit 
b. Internal audit process 
c. Effective internal audit 
d. The internal audit report • Compliance audit, fraud 
investigation, value for 
money audit and 
management audit 
• Operation of internal audit 
• Assessment of audit risk 
• Process of analytical 
review 
• Independence, staffing 
and resourcing of internal 
audit 
• Preparation and 
interpretation of internal 
audit reports This part looks at the critical 
role that the internal audit 
function can play in risk 
to create awareness and 
understanding of the various 
issues in internal audit and 
how they link to each other.

P.20   
P3D: Cyber risks 
In a digital world one of the major threats is cyber  risk. How are data and operating systems protected 
from unauthorised access and manipulation?  How are breaches identified, analysed, remedied and 
reported? These are some of the questions covered in this section. 
 
1. Analyse cyber 
threats. Analyse: 
a. Nature and impact of 
cyber risks 
b. Types of cyber risks 
c. Risk of security 
vulnerabilities. • Malware 
• Application attacks 
• Hackers 
• Result of vulnerabilities 
including downtime, 
reputational loss, 
customer flight, legal and 
industry consequences This part looks at where and 
how organisations can be 
vulnerable to cyber threats 
and the type and sources of 
such threats. In addition, it 
looks at the impact such 
threats can have on 
2. Review cyber 
security processes. Review: 
a. Cyber security objectives 
b. Security controls 
c. Centralisation in cyber 
security • Protection, detection and 
response 
• Centralised management 
• Centralised monitoring The principal aim here is to 
enable candidates to 
understand how to manage 
cyber threats through cyber 
security processes. What 
objectives should 
organisations set in this area? 
What controls are available to 
organisations? 
3. Discuss cyber 
security tools and 
techniques. Discuss: 
a. Forensic analysis 
b. Malware analysis 
c. Penetration testing 
d. Software security • System level analysis, 
storage analysis and 
• Reverse engineering, 
decompilation and 
disassembly 
• Network discovery, 
vulnerability probing, 
exploiting vulnerabilities 
• Tiers of software security This part looks at the tools 
and techniques available to 
manage cyber risks. 
Candidates are expected to 
have a basic understanding of 
the techniques and how they 
can be deployed together. 
4. Evaluate cyber risk 
reporting. a. Evaluate cyber risk 
reporting frameworks • Description criteria 
including nature of 
business and operations, 
nature of information at 
risk, risk management 
programme objectives, 
cybersecurity risk 
governance structure etc. How should cyber risks be 
reported? What reporting 
frameworks are available?

1 
Risk 
A1. Analyse sources and types 
of risk (a) Analyse sources of risk 
(b) Analyse types of risk 
A3. Discuss ways of managing 
risks (d) Discuss risk analytics 
  Chapter 
1

Risk 
2 
 
 1 What is risk? 
 
There are many different ways of def ining risk including the following: 
 Risk is a condition in which there ex ists a quantifiable dispersion in the 
possible outcomes from any activi ty. (CIMA official terminology) 
 Risk can be defined as the combination of the probability of an event and 
its consequences (ISO Guide 73) 
 Risk in business is the chance that fu ture events or results may not be as 
expected. 
Risk is often thought of as purely bad (pure or 'downside'  risk), but risk can 
also be good i.e. the results may be better than expected (speculative or 
'upside' risk) as well as worse. 
In order to assess and measure the ri sks that an organisation faces, a business 
must be able to identify the principal sources of risk. Risks facing an 
organisation are those that affect the achievement of its overall objectives 
(which should be reflected in its st rategic aims). Risk should be managed and 
there should be strategies  for dealing with risk.

Chapter 1 
 3 
 Risk and uncertainty 
 The term ‘risk’ is often associated with the chance of something ‘bad’ will 
happen , and that a future outcome will  be adverse. This type of risk 
is called ‘downside’ risk  or pure risk , which is a risk involving the 
possibility of loss, wit h no chance of gain. 
power cut, or the risk of losses from t heft or fraud, the risk of damage to 
assets from a fire or accident, and risks to the health and safety of 
employees at work. 
Not all risks are pure risks or downside risks. In many cases, risk is two-
way, and actual outcomes might be eit her better or worse than expected. 
Two-way risk  is sometimes called speculative risk . In many business 
decisions, there is an element of s peculative risk - and management are 
For example, a new product launch mi ght be more or less successful 
than planned, and the savings from an investment in labour-saving 
equipment might be higher or  lower than anticipated. 
Risk  is inherent in a situation whenev er an outcome is not inevitable. 
Uncertainty , by contrast, arises from ignorance and a lack of information. 
By definition, the future cannot  be predicted under conditions of 
uncertainty because there is insufficient  information about what the future 
outcomes might be or their probabilities of occurrence. 
In business, uncertainty might be an element to be considered in 
decision-making. For example, t here might be uncertainty about how 
consumers will respond to a new pr oduct or a new technology, or how 
shareholders will react to a cut in t he annual dividend. Uncertainty is 
reduced by obtaining as much informa tion as possible before making any 
decision. 
 
 Why incur risk?

Risk 
4 
 It is generally the case that  firms must be willing to ta ke higher risks if they 
want to achieve higher returns: 
 To generate higher returns a busine ss may have to take more risks in 
 Conversely, not accepting risk tends to make a business less dynamic, 
 Incurring risk also implies that the re turns from different activities will be 
 Benefits can be financial – decreased co sts, or intangible – better quality 
 In both cases, these will lead to  the business being able to gain 
For some risks, the level of risk is rewa rded with a market rate of return e.g. 
quoted equity – where a shar eholder invests in a company with the expectation 
of a certain level of dividend and capita l growth. However, for other risks there 
may not be a market rate  of return e.g. technol ogy risk – where a company 
invests in new software in the hope that it will make their invoice processing 
more efficient. The important distinction here is that the market compensates for 
the former type of risk, but might not for the latter. 
 
 Benefits of taking risks 
  
Focusing on low-risk activities can easily  result in a low ability to obtain 
competitive advantage – al though where there is low risk there is also 
only a limited amount of competit ive advantage to be obtained. For 
example, a mobile telephone operator  may produce its phones in a wide 
range of colours. There is little or no risk of the technology failing, but the 
move may provide limited competit ive advantage where customers are 
attracted to a particular colour of phone.

Chapter 1 
 5 
 Some low-risk activities, however, will provide higher competitive 
advantage – when these can be identified. If these can be identified, then 
the activity should be undertaken bec ause of the higher reward. For 
example, the mobile phone operator ma y find a way of easily altering 
mobile phones to make them safer wit h regard to the electrical emissions 
generated. Given that cu stomers are concerned about this element of 
mobile phone use, there is signific ant potential to obtain competitive 
advantage. However, these opportunities are few and far between. 
High-risk activities can similarl y generate low or high competitive 
advantage. Activities with low com petitive advantage will generally be 
avoided. There remains the risk that t he activity will not work, and that the 
small amount of competitive advan tage that would be generated is not 
worth that risk. 
Other high-risk activities may generate significant amount s of competitive 
advantage. These activities may be wo rth investigating because of the 
high returns that can be generated. Fo r example, a new type of mobile 
phone providing, say, GPS features fo r use while travelling, may provide 
significant competitive advantage for t he company; the risk of investing in 
the phone is worthwhile in terms of the benefit that could be achieved. 
The point is, therefore, that if a bu siness does not take some risk, it will 
normally be limited to activities providing little or no competitive 
advantage, which will limit its ability to  grow and provide returns to its 

Risk 
6 
2 CIMA's risk management cycle 
Risk management should be a proactive proc ess that is an integral part of 
strategic management. 
This perspective is summarised in CIMA’s risk management cycle , illustrated 
below: 
 
Source: Chartered Institute of  Management Accountants (2002), Risk 
Management: A Guide to Good Practice, CIMA. 
The risk management cycle is a very important tool for your exam.

Chapter 1 
 7 
 CIMA’s Risk Management Cycle identifie s various activities that should 
be undertaken during risk management. 
Which of the following options sh ows the steps in the correct 
order? 
A Identify risk areas; Develop risk response strategy; Allocate 
responsibilities; Establish risk management group. 
B Establish risk management group; Identify risk areas; Allocate 
responsibilities; Develop risk response strategy. 
C Allocate responsibilities; Ident ify risk areas; Develop risk response 
strategy; Establish risk management group. 
D Establish risk management group; Identify risk areas; Develop risk 
response strategy; Allocate responsibilities. 
3 Types and sources of risk for business organisations  
Identifying and categorising risks 
 Many organisations categorise risks into different types of risk. The use of 
risk categories can help with the pr ocess of risk identification and 
assessment. 
 There is no single system of risk cat egories. The risk categories used by 
companies and other organisations di ffer according to circumstances. 
Some of the more commonly-used ri sk categories are described below.

Risk 
8 
Political, legal and regulatory 
These are the risks that businesses face because of the regulatory regime that 
they operate in. Some businesses may be subj ect to very strict regulations, for 
example companies that could cause pol lution, but even companies that do not 
appear to be in a highly regulated indus try have some regulatory risk. For 
example, all companies are subject to the risk of employment legislation 
changing or customers taking legal action. 
This risk can be broken up into different types: 
Political risk Risk due to political instability. Generally considered to 
be external to the business. 
Legal/litigation risk Risk that legal action wil l be brought against the 
business. 
Regulatory risk Risk of changes in regulation affecting the business. 
Compliance risk Risk of non-compliance with the law resulting in 
fines/penalties, etc. 
 
 More on political, legal and regulatory risks 
 Political risk  depends to a large extent on t he political stability and the 
political institutions in the country or countries in which an organisation 
operates. A change of government can sometimes result in dramatic 
changes for businesses. In an extrem e case, for example, an incoming 
government might nationalise all fo reign businesses operating in the 
country. Even in countries with a stabl e political system, political change 
can be significant. For example, an incoming new government might be 
elected on a platform of higher (or lower) taxation. 
Legal risk  or litigation risk arises from t he possibility of legal action being 
taken against an organisation. For many  organisations, this risk can be 
high. For example, hospitals and hos pital workers might be exposed to 
risks of legal action for negligence. Tobacco companies have been exposed to legal action for comp ensation from cancer victims. 
Companies manufacturing or providin g food and drink are also aware of 
litigation risk from customers clai ming that a product has damaged their 
health. 
Regulatory risk  arises from the possibility t hat regulations will affect the 
way an organisation has to operate. Regulations might apply to businesses generally (for example, competition laws and anti-monopoly 
regulations) or to specific industries. 
Compliance risk  is the risk of losses, possi bly fines, resulting from non-
compliance with laws or regulations. Measures to ensure compliance with 
rules and regulations should be an in tegral part of an organisation’s 
internal control system.

Chapter 1 
 9 
Business risk 
Business risk is the risk businesses face o wing to the nature of their operations 
and products. Some businesses for instance are reliant on a single product or 
small range of products, or they could be reliant on a small key group of staff. 
The risks can be considered in different categories: 
Strategic risk Risk that business strategies (e.g. 
acquisitions/product launches) will fail. 
Product risk Risk of failure of new product launches/loss of 
interest in existing products. 
Product reputation risk Risk of change in product’ s reputation or image. 
Operational risk Risk that business operations may be inefficient or 
business processes may fail. 
Contractual inadequacy 
risk Risk that the terms of a c ontract do not fully cover 
a business against all potential outcomes. 
Fraud and employee 
malfeasance Considered separately later. 
 
 More on business risks 
 Business risks for a company are risks arising from t he nature of its 
business and operations. Some busi nesses are inherently more risky than 
others. 
 Strategic risks  are risks arising from t he possible consequences of 
strategic decisions taken by t he organisation. For example, one 
company might pursue a strategy of growth by acquisitions, whilst another might seek slower, organic gr owth. Growth by acquisition is 
likely to be much more  high-risk than organic growth, although the 
potential returns might also be much higher. Strategic risks should be identified and assessed at s enior management and board of 
director level. 
 Product risk  is the risk that customers will not buy new products (or 
services) provided by the organisation, or that the sales demand for 
current products and services will decline unexpectedly. A new 
product launched on to the market might fail to achieve the 
expected volume of sales, or the take-up could be much slower than 
expected. For example, the dem and for ‘third generation’ (3G) 
mobile communications services was  much slower to build up than 
expected by the mobile telephone service providers, due partly to 
the slower-than-expected developm ent of suitable mobile phone 
handsets.

Risk 
10 
  Commodity price risk.  Businesses might be exposed to risks from 
unexpected increases (or falls) in  the price of a key commodity. 
Businesses providing commodities, such as oil companies and commodity farmers, are directly a ffected by price changes. Equally, 
companies that rely on the use of  commodities could be exposed to 
risks from price changes. For exampl e, airlines are exposed to the 
risk of increases in fuel prices, particularly when market demand for 
flights is weak (so increases in ticket prices for flights are not 
possible). 
 Product reputation risk . Some companies rely heavily on brand 
image and product reputati on, and an adverse event could put their 
reputation (and so future sales) at risk. Risk to a product’s reputation could arise from adverse public attitudes to a product or 
from adverse publicity: this has been evident in Europe with widespread hostility to genetically-m odified (GM) foods. There could 
also be a risk from changes in cu stomer perceptions about the 
quality of a product. For example,  if a car manufacturer announces 
that it is recalling al l new models of a car to  rectify a design defect, 
the reputation of the product and future sales could be affected. 
 Operational risk  refers to potential losses that might arise in 
business operations. It has been def ined broadly as ‘the risk of 
losses resulting from inadequate or fa iled internal processes, people 
and systems, or external events’ (Basel Committee on Banking Supervision). Operational risks in clude risks of fraud or employee 
malfeasance, which are explained in more detail later. Organisations implement inter nal control systems to manage 
operational risks. 
 Contractual inadequacy risk  may arise where a business has 
negotiated contracts and other business transactions without 
adequate consideration of what may happen if things don’t go 
according to plan. For example, a building company may have a fixed completion date for the constr uction of a house. If it is not 
completed on time, they may hav e to pay compensation to the 
house purchaser. Similarly, there is  also a risk that the purchaser 
will not have the funds when paym ent is due. This risk may be 
mitigated by having terms in the c ontract setting out what rights the 
company will have in such circumstances. Clearly, if the building company does not consider either or both of these possibilities 
when agreeing to build the house, then there is an unidentified and 
unquantified risk of loss.

Chapter 1 
 11 
 Which of the following would norma lly be classified as an operational 
risk? 
Select ALL that apply 
A The risk that a new product will fail B The risk of competitors cutting co sts by manufacturing overseas 
C The loss of an experienced supervisor D Raw materials being wasted during the production process due to 
untrained staff 
 
 Which of the following would normally be classified as a strategic risk? 
A Human error 
B Information technology failure C Fraud D Stricter health and safety legislation 
 
 Company Q assembles circuit boards for mobile telephones and relies on 
suppliers to manufacture one of th eir key components. This component 
contains a highly toxic, expensive chem ical which is currently in scarce 
supply across the world. 
Company Q has one main supplier of  the component. This supplier is 
based in a developing country with lo w labour costs. The supplier has 
developed a great deal of expertise in handling the toxic chemical and 
keeping waste to a minimum. Howeve r, there have been allegations that 
rivers local to the supplier have b een polluted with toxic waste from the 
chemical. There are also rumours that the supplier does not provide 
adequate safety equipment for staff working with the chemical. The supplier has informed Company Q that price rises may occur since safe 
storage of the chemical is becoming more expensive. 
Which of the following represent strategic risks to Company Q?  
Select ALL  that apply. 
A Risk that the supplier’s employees are injured through unsafe 
handling of toxic chemicals. 
B Risk that pollution from local rivers is proved to be the result of the 
supplier’s processes and waste. 
C Risk that the supplier is unable to source adequate quantities of 
chemical. 
D Risk that the supplier’s storage fa cilities become more expensive. 
E Risk that the developing country in which the supplier is based 
introduces a minimum wage.

Risk 
12 
This is the risk that changes in the ec onomy might affect the business. These 
changes could be inflation, unemployment ra tes, international trade relations or 
fiscal policy decisions by government. A gain, this risk is considered to be 
external to the business. 
 
 The 'credit crunch' 
 In 2008 there was global banking crisis  which then led to what has since 
been called a 'credit crunch' and, fo r some countries, recession. This 
section looks at the caus es of the banking crisis and its knock-on effects. 
Contributory factor 1: US sub-prime mortgage lending 
In 2001 the US faced recession, due par tly to the events of 9/11 and the 
Dot com bubble bursting, so the US government was keen to stimulate 
growth. As part of this, in 2003,  the Federal Reserve responded by 
cutting interest rates to 1% – t heir lowest level for a long time. 
Low interest rates encouraged people to buy a house backed by a 
mortgage, resulting in house prices rising due to the increased demand 
for housing. As house prices began to  rise, mortgage companies relaxed 
their lending criteria and tried to capitalise on the booming property 
market. This boom in credit was also fuelled by US government pressure 
on lenders to grant mortgages to  people who, under normal banking 
criteria, presented a very high risk of  default. These were the so called 
‘sub-prime mortgages’, with many borro wers taking out adjustable rate 
mortgages that were affordabl e for the first two years. 
This 'sub-prime market' expanded very quickly and by 2005, one in five 
mortgages in the US were sub-prim e. Banks felt protected because 
house prices were continuing to rise so if a borrower defaulted the bank 
would recover its loan. 
In 2006 inflationary pressures in the US  caused interest rates to rise to 
4%. Normally 4% interest rates are not particularly high but, because 
many had taken out large mortgages, this increase made the mortgage payments unaffordable. Also many homeowners were coming to the end 
of their 'introductory offers' and fac ed much higher payments. This led to 
an increase in mortgage defaults. 
As mortgage defaults increased the boom in house prices came to an 
end and house prices started falling. In some areas the problem was 
even worse as there had been a boom in the building of new homes, 
which occurred right up until 2007. It meant that demand fell as supply 
was increasing – causing prices to collapse. Banks were no longer able to recover their loans w hen borrowers defaulted. In many cases they only 
ended up with a fraction of the house value.

Chapter 1 
 13 
 Contributory factor 2: 'Collatera lised debt obligations’ or CDOs 
Normally if a borrower defaults it is the lending bank or building society 
that suffers the loss. As a result t hey are very diligent in verifying the 
credit worthiness of potential borrowers and whether they have the income and security to repay loan s. However, in the US, mortgage 
lenders were able to sell on mortgage debt, in the form of CDOs, to other 
banks and financial institutions. This was a kind of insurance for the 
mortgage companies. It meant that other  banks and financial institutions 
shared the risk of these sub-prime mortgages. 
Using the income from their mortgage book as security, banks sold CDO 
bonds with a three-ti er structure: 
(1) Tier 1 was "senior" or "investment grade" and supposed to be very 
low risk but with a low return. 
(2) Tier 2 was the "mezzanine tranche" and had medium risk and 
medium return 
(3) Tier 3 was the "equity tranche" and had highest risk and return. As money was received on mortgages, it was used to pay the Tier 1 bond 
holders their interest first, then Tier 2 and finally Tier 3, so if borrowers 
defaulted, then Tier 3 holders would su ffer first and so on, like a waterfall 
effect. 
Unfortunately losses were so great t hat Tier 3 and Tier 2 and in some 
cases Tier 1 investors were affected. At  the very least, the value of Tier 1 
bonds fell due to the perceived risks. 
Contributory factor 3: De bt rating organisations 
The CDO bonds were credit-rated for ri sk, just like any other bond issues. 
Maybe because these sub-prim e mortgage debts were bought by 
'responsible' banks like Morgan Stanley  and Lehman Brothers, or maybe 
because they didn't fully understand the CDO structures, risk agencies gave risky Tier 1 debt bundles AAA safety ratings. Normally AAA would denote extremely low risk investments. 
This encouraged many banks and financial institutions to buy them, not 
realising how risky their financial positi on was. The trillions of dollars of 
sub-prime mortgages issued in the US had thus become distributed 
across the global markets, ending up as CDOs on the balance sheets of 
many banks around the world. 
Many commentators have seen this fact or as an example of regulatory 
failure within the financial system.

Risk 
14 
 Contributory factor 4: Banks' financial structure 
Unlike most other commercial enter prises, banks are very highly geared 
with typically less than 10% of their asset value covered by equity. A drastic loss of asset value can soon wipe out a bank’s equity account and it was this risk which led some banks to start selling their asset-backed securities on to the market. 
However, the sellers in this restrict ed market could not find buyers; as a 
result, the values at which these "t oxic assets" could be sold fell and 
many banks around the world found t hemselves in a position with 
negative equity. 
Contributory factor 5: Credit default swaps 
As an alternative (or in addition) to  using CDOs, the mortgage lenders 
could buy insurance on sub-prime debt through credit default swaps or CDSs. 
For example, AIG wrote $440 bill ion and Lehman Brot hers more than 
$700 billion-worth of CDSs. These were the first institutions to suffer 
when the level of defaults  started to increase. 
Warren Buffett called them "financ ial weapons of mass destruction". 
Contributory factor 6: Risk-takers 
There is a school of thought that the risk-takers were taking risks they 
didn't understand. Some risks can be easily understood, however, others 
are far more complicated. 
Implication 1: the collapse of major financial institutions 
Some very large financial institut ions went bust and others got into 
serious trouble and needed to be rescued. For example, 
 In September 2008 Lehman Brother s went bust. This was the 
biggest bankruptcy in corporate histor y. It was 10 times the size of 
Enron and the tipping point into the global crash, provoking panic in 
an already battered financial system , freezing short-term lending, 
and marking the start of the liquidity crisis. 
 Also in September 2008 the US government put together a bailout 
package for AIG. The initial loan wa s for $85bn but the total value of 
this package has been estima ted at between 150 and 182 billion 
dollars. 
 In the UK the Bank of England lent Northern Rock £27 billion after 
its collapse in 2007.

Chapter 1 
 15 
 Implication 2: the credit crunch 
Banks usually rely on lending to each other to conduct everyday 
business. But, after the first wave of  credit losses, banks could no longer 
raise sufficient finance. 
For example, in the UK, Northern Rock was particularly exposed to 
money markets. It had relied on bo rrowing money on the money markets 
to fund its daily business. In 2007, it  simply couldn't raise enough money 
on the financial markets and eventually had to be nationalised by the UK 
In addition to bad debts, the other problem was one of confidence. 
Because many banks had lost money and had a deterioration in their balance sheets, they couldn't afford  to lend to other banks. Even banks 
that had stayed free of the problem  began to doubt the credit worthiness 
of other banks and, as a result, became  reluctant to lend on the interbank 
market. 
The knock on effect was that banks became reluctant to lend to anyone, 
causing a shortage of liquidity in money  markets. This made it difficult for 
firms to borrow to finance expansion plans as well as hitting the housing 
market. 
Many companies use short-term finance rather than long-term. For 
example, rather than borrowing for, say, 10 years a company might take 
out a two year loan, with a view to taking out another two year loan to 
replace the first, and so on. The ma in reason for using this system of 
"revolving credit" is that it should be cheaper – shorter-term interest rates 
are generally lower than longer-term. T he credit crunch m eant that these 
firms could not refinance their loans causing major problems. 
Implication 3: government intervention 
Many governments felt compelled to in tervene, not just to prop up major 
institutions (e.g. Northern Rock and AIG mentioned above) but also to 
inject funds into the money markets to stimulate liquidity. 
Efforts to save major institutions involved a mixture of  loans, guarantees 
and the purchase of equity. 
Usually, central banks try to raise t he amount of lending and activity in 
the economy indirectly, by cutting inte rest rates. Lower  interest rates 
encourage people to spend, not save. But when interest rates can go no 
lower, a central bank's only option is to pump money into the economy directly. That is quantitative easing (QE). The way the central bank does 
this is by buying assets – usually financial assets such as government and corporate bonds – using money it has simply created out of thin air. 
The institutions selli ng those assets (either commercial banks or other 
financial businesses such as insuranc e companies) will then have "new" 
money in their accounts, which then boosts the money supply.

Risk 
16 
 In February 2010 the Bank of  England announced that the UK 
quantitative easing programme, that had cost £200bn, was to be put on 
hold. 
The end result was that many go vernments found themselves with huge 
levels of debt with the corresponding need to repay high levels of interest 
as well as repay the debt. 
Implication 4: recession and "austerity measures" 
The events described above resulted in  a recession in many countries. 
Despite the falling tax revenues that accompany this, some governments would normally try to increase gove rnment spending as one measure to 
boost aggregate demand to stimulate the economy. 
However, the high levels of national  debt have resulted in governments 
doing the opposite and making major cuts in public spending. 
Implication 5: problems refinancing government debt 
In 2010/2011 some countries tried to refinance national debt by issuing 
bonds: 
 A problem facing the Spanish gover nment at the end of 2010/2011 
was the need to raise new borrowing as other government debt 
reached maturity. Spain successfully sold new bonds totalling nearly €3 billion on 12/1/11 in what was seen as a major test of Europe's 
chances of containing the debt cris is gripping parts of the region. 
This was in addition to the Spani sh government cutting spending by 
tens of billions of euros, including cuts in public sector salaries, public investment and social sp ending, along with tax hikes and a 
pension freeze. 
 The problem of refinancing is mo re severe for countries whose 
national debt has a short aver age redemption period (Greece is 
about 4 yrs) but much less of a problem where the debt is long 
dated (e.g. the UK where the av erage maturity is about 14 yrs). 
For others they needed help from other  countries and the International 
Monetary Fund (IMF). 
 Greece received a €110 billi on rescue package in May 2010. 
 At the end of 2010 Ireland received a bailout from the EU, the UK 
and the IMF. The total cost is still being debated but could be as 
high as €85 billion. 
Financial risk is a major risk that affects businesses and this risk is studied in 
much more depth in F3, an awareness of  financial risk is sufficient for P3. 
Financial risk is the risk of a change in a financial condition such as an 
exchange rate, interest rate, credit rati ng of a customer, or  price of a good.

Chapter 1 
 17 
The main types of financial risk are 
Credit risk Risk of non-payment by customers. 
Political risk Risk arising from actions taken by a government that 
affect financial aspects of the business. 
Currency risk Risk of fluctuations in the exchange rate. 
Interest rate risk Risk that interest rates change. 
Gearing risk Risk in the way a business is financed (debt vs. equity) 
(sometimes this is considered part of interest rate risk). 
 
 More on financial risks 
 Financial risks relate to the possibility of changes in financial conditions 
and circumstances. There are seve ral types of financial risk.  
 Credit risk.  Credit risk is the possibility of losses due to non- 
payment by debtors. The exposur e of a company to credit risks 
depends on factors such as: 
– the total volume of credit sales – the organisation’s credit policy – credit terms offered (credit lim its for individual customers and 
the time allowed to pay) 
– the credit risk ‘quality’ of cust omers: some types of customer 
are a greater credit risk than others 
– credit vetting and assessment procedures – debt collection procedures. 
 Currency risk.  Currency risk, or foreign exchange risk, arises from 
the possibility of movements in  foreign exchange rates, and the 
value of one currency in relation to another. 
 Interest rate risk.  Interest rate risk is th e risk of unexpected gains 
or losses arising as a consequence of a rise or fall in interest rates. 
Exposures to interest rate risk arise from: 
– borrowing – investing (to earn interest) or depositing cash. 
 Gearing risk.  Gearing risk for non-bank companies is the risk 
arising from exposures to high financial gearing and large amounts 
of borrowing. 
Technology risk is the risk that technology changes will occur that either present 
new opportunities to businesses, or on the down-side make their existing 
processes obsolete or inefficient.

Risk 
18 
 More on technology risk 
 Technology risk arises from the po ssibility that technological change will 
occur. Like many other categories of  risk, technology risk is a two-way 
risk, and technological change creates both threats and opportunities for 
There are risks in failing to respond to new technology, but there can also 
be risks in adopting new technology. An example of over-investing in new technology was the so-called ‘dot.c om boom’ in the late 1990s and early 
2000s. For a time, there was speculat ion that Internet-based companies 
would take over the markets of  established ‘bricks and mortar’ 
To varying degrees, established co mpanies invested in Internet 
technology, partly as a protective  measure and partly in order to 
speculate on the growth of In ternet commerce.  (Whereas most 
established companies survived the collapse of the ‘dot.com bubble’ in 2001 – 2002, many ‘dot.com’ compani es suffered financial collapse.) 
 
Cyber risk Cyber risk is a focus area fo r organisations now. It is the 
risk of financial loss, disruption, or damage to an organisation caused by issues with the information technology systems they use. 
Cyber risk and how to deal with it is covered in detail in 
chapters 8, 9 and 10. 
Environmental risk is the risk that arises  from changes in the environment such 
as climate change or natural disasters. Some businesses may perceive this risk 
to be low, but for others, for example insurance companies, it can be more 
significant. Insurance companies have to  take environmental risks into account 
when deciding policy premiums, and unus ual environmental circumstances can 
severely alter the results of insurance businesses. 
 
 More on environmental risk 
 Environmental risk arises from changes to the environment: 
 over which an organisation has no direct control, such as global 
warming 
 for which the organisation might be responsible, such as oil 
spillages and other pollution. 
To ensure their long-term survival, so me companies should consider the 
sustainability of their businesses.  When raw materials are consumed, 
consideration should be given to ens uring future supplies of the raw 
material. For example, companies that consume wood and paper should 
perhaps show concern for tree pl anting programmes, and deep-sea 
fishing businesses should consider the preservation of fishing stocks.

Chapter 1 
 19 
 The Japanese tsunami 
 The Japanese tsunami of 2011 illustrates very well the fact that some 
risks can be understood and others are far more complicated. 
The Japanese have some of the best flood defence systems in the world, 
being on the edge of a plate system and regularly experiencing tremors. 
However, even the best defence system is built with a risk factor included 
– using probabilities and model ling by water engineers. 
Whilst it is not possible to prevent  a tsunami, in some particularly 
tsunami-prone countries some measur es have been taken to reduce the 
damage caused on shore. Japan has  implemented an extensive 
programme of building tsunami walls of up to 4.5 m (13.5 ft) high in front 
of populated coastal areas. Other lo calities have built floodgates and 
channels to redirect the water from  incoming tsunami. However, their 
effectiveness has been questioned, as tsunami are often higher than the 
barriers. For instance, the Okushiri, Hokkaid ō tsunami which struck 
Okushiri Island of Hokkaid ō within two to five minutes of the earthquake 
on July 12, 1993 created waves as much  as 30 m (100 ft) tall – as high 
as a 10-story building. The port town of Aonae was completely 
surrounded by a tsunami wall, but the waves washed right over the wall 
and destroyed all the wood-framed struct ures in the area. The wall may 
have succeeded in slowing down and moderating the height of the 
tsunami, but it did not prevent ma jor destruction and loss of life. 
On 11 March, 2011 a 10-meter tsunami sl ammed into the Japanese city 
of Sendai killing hundreds and sweeping  away everything in its wake. 
The wall of water was triggered by t he country’s biggest ever earthquake. 
Cars, lorries and boats bobbed like toys as a wave of debris spread over 
huge swathes of north-eastern Japan. 
An after effect of the ts unami was the malfunctioning of a nuclear plant in 
Fukushima, north of Tokyo, where the reactor’s cooling system overheated. Other nuclear power pl ants and oil refineries had been shut 
down following the 8.9 magnitude quak e. Engineers opted to cover the 
plant in concrete, the techniq ue used at Chernobyl 25 years ago, 
however this failed and experts have since tried to plug the leak using an absorbent polymer. An exclusion zone of 30 kilometres has been advised 
by the Japanese government, which will be long-term. It is thought the 
crack in reactor number two is one s ource of leaks that have caused 
radiation levels in the sea to rise to more than 4000 times the legal limit. 
Food products and water s upplies have been affected. 
Scientists in Europe are convinced this scenario could happen closer to 
home. They have been working on an ear ly warning system for countries 
surrounding the Mediterranean Sea. The region along the Turkish coast 
in the Eastern Mediterranean is c onsidered the most vulnerable. 
In these scenarios, engineers have tried to learn from the past and 
estimate what might happen in the fu ture. However, with the best will in 
the world it is sometimes impossible to  ascertain all the implications of a 
single event, such as a tsunami.

Risk 
20 
Fraud risk 
Fraud risk (a type of operational busi ness risk) is the vulnerability of an 
organisation to fraud. Some businesses are more vulnerable than others to 
fraud and as a result have to have stronger  controls over fraud. Fraud risk is a 
risk that is considered cont rollable by most businesses. 
 
 More on fraud risk 
 Fraud risk is the vulnerability of an or ganisation to fraud. The size of fraud 
risk for any organisation is a factor of: 
 the probability of fr aud occurring, and 
 the size of the losses if fraud does occur. 
For example, a bank will be subject to much higher fraud risk than a 
property investment company due to the desirability of money and the 
potential value that theft could achiev e; it is unlikel y that someone will 
steal a building from an investment company. 
Fraud risk should be managed, by: 
 fraud prevention: ensuring that the opportunities to commit fraud are 
minimised 
 fraud detection and deterrence: dete ction measures are designed to 
identify fraud after it has occurred. If  employees fear that the risk of 
detection is high, they will be dete rred from trying to commit fraud. 
The management of fraud risk should be an element of an organisation’s 
internal control system. 
Corporate reputation risk 
Reputation risk is for many organisati ons a down-side risk as the better the 
reputation of the business the more risk there is of losing that reputation. A 
good reputation can be very quickly eroded if companies suffer adverse media 
comments or are perceived to be untrustworthy.   
This could arise from: 
 environmental performance 
 social performance 
 health & safety performance.

Chapter 1 
 21 
 More on corporate reputation risk 
 Many large organisations are aware of the potential damage to their 
business from events affecting their ‘reputation’ in the opinion of the 
general public or more specific groups  (such as existing customers or 
suppliers). 
Some organisations succeed in being perceived as ‘environmental-
friendly’, and use public relations and advertising to promote this image. 
For many organisations, however, reput ation risk is a down-side risk. The 
risk can be particularly significant fo r companies that sell products or 
services to consumer market s. There have been cases where a 
company’s reputation has been significantly affected by: 
 employing child labour in under- developed countries or operating 
‘sweat shops’ in which employees work long hours in poor 
conditions for low pay 
 causing environmental  damage and pollution 
 public suspicions about the dam age to health from using the 
company’s products 
 investing heavily in countri es with an unpopular or tyrannical 
government 
 involvement in business ‘scandals’ such as mis-selling products 
 management announcements about the quality of the product a 
company produces. 
Managing reputation risk can be complicat ed by the fact that many of 
these factors lie outside the control of the organisation. For example, 
many companies outsource production to third parties who operate in 
countries where labour costs are cheaper. Such arrangements can work 
well, although major multinational co rporations have had their reputations 
tarnished by being associated with third parties who used dubious employment or environm ental policies in order to keep costs down. 
 
Reputational risk is covered in detail in Chapter 4.  
 During their work on Worldcom and Enron, Arthur A nderson (chartered 
accountants and registered auditors) failed to identify serious irregularities 
in these companies. This led to their demise.  
This was mainly due to which ONE of the following? 
A Business risk 
B Political risk C Environmental risk D Reputation risk

Risk 
22 
Employee malfeasance risk 
Malfeasance means doing wrong or commit ting an offence. Organisations might 
be exposed to risks of actions by employees  that result in an offence or crime 
(other than fraud). This, lik e fraud risk, is a type of operational business risk. 
 
 More on employee malfeasance 
 Examples of empl oyee malfeasance are: 
 deliberately making false represent ations about a product or service 
in order to win a customer order , exposing the organisation to the 
risk of compensation claims for mis-selling 
 committing a criminal offence by failing to comply with statutory 
requirements, such as taking prop er measures for the safety and 
protection of employees or customers. 
Risks from illegal activities  by employees should be controlled by suitable 
internal controls, to ensure that employees comply with established 
policies and procedures. 
Risks in international operations 
International businesses are subject to all the risks above but also have to consider extra risk factors, whic h could be due to the following: 
 
Culture A UK business may fail in a venture overseas because it 
does not adapt to the overseas culture. Good knowledge of 
local culture can, however, give companies an advantage. 
Litigation There is a greater litigation ri sk in overseas operations as 
the parent company managemen t may not understand the 
legislation well and are therefor e more at risk of breaching 
it. 
Credit There is often a greater difficu lty in controlling credit risk on 
overseas sales. Chasing debts is more difficult and expensive. 
Items in transit There is a greater risk of losses or damage in transit if 
companies are transporti ng goods great distances 
Financial risks These include foreign exchange ri sks, and interest rate risk 
and are considered in more detail in F3.

Chapter 1 
 23 
 More on risks in international operations 
 Companies that engage in international  operations could face substantial 
risks in addition to country risk. 
 There could be significant cultural differences  between the various 
countries in which the company oper ates. There could be a risk that 
products, services and business practices that are acceptable in one country will be unacceptable in another. Failure to understand a 
national or local culture could mean that a company will fail to 
succeed in establishing its business. 
 A lack of understanding of loca l legislation could expose an 
organisation to litigation risk . When legal action is initiated in a 
different country, a company has to appoint lawyers to represent 
them and rely on their advice on the appropriate and necessary steps to take. 
 When a company exports goods to other countries, there is a risk 
that the goods will be he ld up or lost in transit , and the loss 
might not always be covered by insurance. For example, goods 
might be held up in custom s due to inadequate import 
documentation. 
 When a customer in another c ountry buys goods on credit, the 
exporter is exposed to credit risk. However, the credit risk is often 
greater , because in the event of non- payment by the customer, 
legal action might be more difficult to arrange (and more expensive) 
and the prospects of obtaining payment might be much lower. 
 
 A company has performed a SWOT analysis and has identified two main 
threats: 
 new legislation covering  one of their products; and 
 the bank asking for their loan to be repaid immediately since the 
company failed to pay their most rece nt instalment after the interest 
rate rose. 
Which categories of risk are they best described by?  
A Financial risk 
B Political risk C Reputation risk D Economic risk

Risk 
24 
 Risk identification and management are the responsibility of:  
Select ALL that apply A The Board B The risk manager C The audit committee D Non-executive directors 
 
 Miney plc ("Miney") is a global com pany – incorporated in the USA – that 
extracts valuable mine rals from the earth. 
Mining is a risky business with a death toll averaging 100 deaths per 
annum in the USA alone. Miney has recently had a coal mine collapse 
killing two men and trapping four ot hers for three days.  The accident 
made the national news each day and Miney became a household name. 
Miney is financed purely by equity and has a large cash balance and no debt. It has come to the attention of t he Board that the futu re price of coal 
is forecast to fall, as renewable en ergy sources becomes more reliable. 
Which THREE of the following ri sks would you identify as most 
critical for Miney to assess? 
B Project risk C Reputation risk D Production risk E Health and safety risk F Commodity price risk

Chapter 1 
 25 
 AW company is expanding geographi cally and has ju st appointed Miss X 
as divisional manager of their new branch in Country B. AW has never 
operated in Country B befor e but has a history of successful divisional 
expansion in other countries. 
Which of the following could help  Miss X minimise the risks facing 
AW Company relating to cultural and legal differences between Country B and AW’s curre nt working practices. 
A Recruitment of local staff. B Employing a local firm of solic itors to advise Miss X on local 
legislation and working practices. 
C Replication of previous divisional expansion plans. 
D A marketing campaign to introduce Country B to AW Company. E Secondment of staff from within AW who are experienced in setting 
up new divisions. 
 
 Historically, X has done business with several non-democratic or 
repressive governments. 
In the light of this, which TW O of the following risks should the 
directors of X be mo st concerned with? 
A Technology risk. 
B Corporate reputation risk. C Economic risk. D Fraud risk E Business risk F Financial risk.

Risk 
26 
 You are a management accountant wo rking on proposals to build a dam 
in a developing country in order to generate hydro-electric power and 
enable many homes to have electricity for the first time. The dam is being 
financed by international aid, the total amount of which is currently uncertain. 
You have been made aware of a pressure group which disagrees with 
the proposals since construction of  the dam will damage the local eco 
system. The pressure group have vowed to disrupt the project directly 
through protests. 
You are also aware of negative m edia coverage of the dam which 
accuses your company of making excessi ve profits from the project. In 
addition, the bank financing the initial stages of the project has contacted 
the directors to ask that its involvem ent in the project not be publicised as 
it believes it will damage its reputation. 
Your company’s directors have asked you to present a briefing on the 
project at their next board meeting.  
Which of the following should you include as risks to the project’s 
progression in your briefing to the board? 
A Risk the international aid is not  received or inadequate to fund the 
project. 
B Risk of negative media coverage for the company. C Threats from the pressure group to disrupt the project directly. 
D Risks that the local ec o system will be damaged. 
E Threat that the bank will pull out due to risks to their reputation. 
 
 Test your understanding 12 – ZXC (Case Study) 
 Scenario 
The ZXC company manufactures aircraft. The company is based in 
Europe and currently produc es a range of four diffe rent aircraft. ZXC’s 
aircraft are reliable with low maintenance costs, giving ZXC a good reputation, both to airlines who purchase from ZXC and to airlines’ 
customers who fly in the aircraft. 
Trigger 
with the selling name of the ZXLiner . New developments in ZXLiner 
 Two decks along the entire aircraft ( not just part as in the Boeing 
from both decks at the same time . However, this will mean that 
airport gates must be improved to facilitate dual loading at 
considerable expense.

Chapter 1 
 27 
  20% decrease in fuel requirements and falls in noise and pollution 
levels. 
 Use of new alloys to decrease maintenance costs, increase safety 
and specifically the use of Zitn im (a new lightweight conducting 
alloy) rather than standard wiring to  enable the ‘fly-by-wire’ features 
of the aircraft. Zitnim only has one supplier worldwide. 
Many component suppliers are bas ed in Europe although ZXC does 
obtain about 25% of the sub-contra cted components from companies in 
the USA. ZXC also maintains a significant R&D department working on the ZXLiner and other new products such as alter native environmentally 
friendly fuel for aircraft. 
ZXC does have orders for 25 aircraft from the HTS company. However, 
on current testing schedules the ZXLiner will be delivered late. ZXC currently has about €4 billion of loans  from various banks and last year 
made a loss of €2.3 billion. 
Task 
Write a report to the directors of ZX C identifying the sour ces of risk that 
could affect ZXC, and evaluating t he impact of the risk on the company. 
 
 Test your understanding 13 – Smart meters (Case study) 
 Scenario 
E is an electricity company that has  a large number of  customers. All 
customers’ homes have electricity mete rs with mechanical dials that turn 
to record the consumption of electr icity. Most homes have their meters 
indoors. Customers have to provide E with regular readings from their 
meters in order to ensure that they are billed properly for their electricity 
consumption. Customers can log into their accounts online to input their 
readings or they can telephone E’s ca ll centre to give an operator a 
reading. 
E has a policy that customers must  allow an inspector to read their 
electricity meters at least once per year. This inspection has two purposes. The first is to ensure that the customer has not been 
consistently understating the figures  in order to underpay for their 
electricity and the second is to ensure that the meter has not been tampered with in order to reduce the readings according to the dials. The 
meters are designed so t hat they are difficult to  dismantle without causing 
obvious damage and they also have a seal  that is made out of soft metal 
that will be broken if the meter is ever opened.

Risk 
28 
 E’s inspectors generally visit all the homes within a particular area in the 
course of an evening. As most cu stomers are at home then it is an 
efficient way to conduct the annual checks.  If a customer is not at home 
the inspector leaves a card to request an opportunity to inspect the 
meter. If the customer does not re spond to the card within seven days E 
will send up to four weekly reminder s. Almost all customers comply with 
these requests but a very small mi nority do not respond and E can apply 
to the courts for the right to force entry when that happens. 
Trigger 
E is considering the repl acement of its electricit y meters with new "smart 
meters" which will be located in cu stomers’ homes. These will record 
consumption electronically rather t han mechanically. The information will 
be stored on the meter. The same wires that carry electricity can be used 
to transmit data to and from the me ters and E’s IT system will send coded 
messages to meters to  request readings as and when required. It is 
envisaged that these electronic readings will normally be once every three months, but there is very littl e to prevent E from reading some 
meters far more often. 
Each meter will be fitted with a chip that will transmit a warning if it is 
tampered with either physi cally or electronically. The memory on the 
meters is not affected by power cuts and the meters can restart themselves without losing any data if a power cut occurs. 
Task 
Write a report to the Board of E which: 
(a) Discusses the potential benefits for E that may come about from the 
introduction of smart meters; and 
(b) Evaluates FOUR risks that might ar ise from the introduction of smart 
meters and suggests how eac h risk might be dealt with. 

Risk 
30 
 
 The correct answer is D – Per CI MA’s risk management cycle, a risk 
management group sh ould be formed, risks identified,  understand their scale, 
develop a strategy, implement and allocate responsibility, control and review.  
 
 The correct answers are C and D – A and B are strategic level risks.  
 
 The correct answer is D – A, B and C are operational risks.  
 
 A, B and C 
 Option A: If publicised, poor treatment of employees at Company 
Q’s main supplier could greatly in crease reputation risk to Company 
Q. This may influence Q’s performanc e over a long period of time 
since it may lose support fr om customers, shareholders and 
employees. The fact that Q Com pany may not be able to meet it 
strategic objectives as a result  makes this a strategic risk. 
 Option B: See explanation above, Company Q will be associated 
with the pollution and held responsible for it. 
 Option C: Would almost certainl y compromise Company Q’s ability 
to meet its’ strategic objectives. 
 Option D: Would not affect Co mpany Q’s performance over a long 
period of time. It may lead to a reduc tion in profit margins but only if 
the supplier successfully negot iates a price increase. 
 Option E: See explanat ion for Option D above. 
 
 The correct answer is D – Arthur  Anderson consequently lost their 
reputation as being th e number one accountancy firm in the world and 
consequently many of their customers.

Chapter 1 
 31 
 The correct answers are A and B – Ne w legislation is covered within 
political risk. The repayment of the loan is covered withi n financial risk. 
 
 The correct answers are A, B, C and D – All staff in an organisation are 
responsible for risk. 
 
 C, E and F 
A Financial risk – low risk due to lack of debt finance 
B Project risk – large one off projec ts are not a major aspect of the 
company's business model 
C Reputation risk – high due to accident D Production risk – despite the accident s, there is not a high risk of 
production shortages 
E Health and safety risk – high due to  accident and potential for injury 
in the industry 
F Commodity price risk – high due to  threat from renewable sources 
 
 A and B only 
 Options A and B will help Miss X understand local practices. 
 Option C – Previous divisional expansion plans are likely to be 
culturally appropriate to other  countries and not Country B. 
 Option D – a marketing campaign may cause more cultural issues. 
 Option E – see explanation for option 3 above. 
 
 B and D 
 X should be concerned with their r eputation but also the risk of fraud 
and corruption when dealing with non-democratic governments is 
greater (option D).

Risk 
32 
 A, C and E 
 Options A, C and E will disrupt or halt the project directly. 
 Option B is a risk to the company and not the project. 
 Option D is not a risk to the proj ect’s progression although it may 
end up causing reputation risk for the company. 
 
 To: The directors of ZXC 
Subject:  Sources and evaluat ion of risk at ZXC 
This report covers the identificatio n of risk at ZXC and evaluates each 
risk in turn. Recommendations for ri sk reduction are not given at this 
time. 
This is the risk that customers will not buy new products (or services) 
provided by the organisation, or t hat the sales demand for current 
products and services will decline unexpectedly. 
For ZXC, there is the risk that de mand for the new aircraft will be less 
than expected, either due to customer s purchasing the rival airplane or 
because airports will not be adapted to take the new ZXLiner. 
falls) in the price of a key commodity. 
Part of the control system s of the ZXLiner rely on the availability of the 
new lightweight conducting alloy Zitn im. As there is only one supplier of 
this alloy, then there is the danger of the monopolist in creasing the price 
or even denying supply. Increase in pr ice would increase the overall cost 
of the (already expensive) ZXLiner, while denial of supply would further 
delay delivery of the aircraft. 
Some companies rely heavily on br and image and product reputation, 
and an adverse event could put  its reputation (and so fu ture sales) at risk. 
While the reputation of ZXC appear s good at present, reputation will 
suffer if the ZXLiner is delayed signif icantly or it does not perform well in 
test flights (which have still to be a rranged). Airline customers, and also 
their customers (travellers) are unlikely

Chapter 1 
 33 
movements in foreign exchange rates, and the value of one currency in relation to another. 
ZXC is currently based in Europe alt hough it obtains a significant number 
of parts from the USA. If the €/$ exchange rate  became worse, then the 
cost of imported goods for ZXC (and all other companies) would increase. At present, the relatively w eak US$ is in ZXC’s favour and so 
this risk is currently negligible. 
Interest rate risk is the risk of une xpected gains or losses arising as a 
consequence of a rise or fall in interest  rates. Exposures to interest rate 
risk arise from borrowing and investing. 
As ZXC do have significant bank loans , the company is very exposed to 
this risk. 
Gearing risk 
high financial gearing and large amounts of borrowing. 
Again, ZXC has significant bank loans . This increases the amount of 
interest that must be repaid each year. 
Political risk 
Political risk depends to a large ext ent on the political stability in the 
countries in which an organisation oper ates, the political institutions 
within that country and t he government's attitude towards protectionism. 
As ZXC operates in a politically st able country this risk is negligible. 
At present this risk does not appear to be a threat for ZXC. However, if 
the ZXLiner is delayed any further there is a risk for breach of contract for 
late delivery to the HTS company. 
This is the possibility that regulations  will affect the way an organisation 
has to operate. 
In terms of aircraft, regu lation generally affects noise and pollution levels. 
As the ZXLiner is designed to have lower noise and pollution levels than 
existing aircraft then this risk does not appear to be a threat to ZXC.

Risk 
34 
 Technology risk 
Technology risk arises from the possi bility that technological change will 
occur or that new technology will not work. 
Given that ZXC is effectively produc ing a new product (t he ZXLiner) that 
has not actually been tested yet, there is some technology risk. At worse, 
the ZXLiner may not fly at all or not obtain the necessary flying certificates. 
This risk refers to the risks fa cing organisations from changes in 
economic conditions, such as economic  growth or recession, government 
spending policy and taxation polic y, unemployment levels and 
international trading conditions. 
Demand for air travel is forecast to  increase for the foreseeable future – 
this will lead to a demand for aircraft which ZXC will benef it from. The risk 
of product failure is more significant than economic risk. 
This risk arises both from changes to the environment over which an 
organisation has no direct control, such as global warming, and from those for which the organisation might be responsible, such as oil spillages and other pollution. 
ZXC is subject to this risk – and ther e is significant debate concerning the 
impact of air travel on global warming. At the extreme, t here is a threat 
that air travel could be banned, or m ade very expensive by international 
taxation agreements, although th is appears unlikely at present. 
ZXC will suffer from many risks wh ich will impact on the company. The 
likelihood and impact of each varies, by risk and over time. ZXC should 
implement reduction strat egies where possible.

Chapter 1 
 35 
 To: The Board of E 
Subject:  Smart meters and risk 
This report discusses the benefits of in troducing Smart Meters at E, and 
then evaluates four risks arising from  this action. Recommendations are 
then made to reduce the risks identified. 
(a) The introduction of Smart Meters  
Smart meters will offer the potential to  dramatically reduce operating 
expenses. E will not require meter inspectors to visit customers’ 
homes. There will be far fewer transactions involving call centre staff and so numbers can be r educed there too. 
The new meters may reduce customer fraud and so enhance 
revenues. The fact that they are electronic and not mechanical will 
make it far harder to tamper with readings. 
E will be able to gather a great de al of information about individual 
customers. At present, E can tell how much electricity is being 
drawn from the grid, but it cannot  identify the specific customers 
who are using it. The new meters wil l make it possible to identify 
customers whose demand changes in  response to, say, a major 
sporting event. That may make it easier for E to predict demand in 
advance of such events and so plan more easily. 
E may also be able to gather valuable marketing information. For 
example, some customers will have la rger increases in consumption 
when the weather is cold. E could ta rget such customers with offers 
of alternative pricing plans or discounts on home insulation. 
(b) Risks  
Customer fraud 
If customers learn how to interfer e with the meters then E may lose 
significant amounts of revenue. The new meters may be more difficult to manipulate, but hi story suggests that electronic 
safeguards can be defeated. For ex ample, mobile phones can be 
unlocked and dvds can be pirated despite safeguards. 
E could compare patterns of  energy consumption within 
neighbourhoods and could identify customers whose readings seem 
low. Those customers’ meters  could be inspected for any 
modification. E should publicise any criminal prosecutions as a deterrent to other customers.

Risk 
36 
 Installation 
The installation of these new meters will be a significant 
undertaking. E will have to arrange access to every customer’s home in order to fit the new meters . The logistics of this will be 
complicated because of customers’ work patterns and availability because of work and so on. The ol d system will have to operate in 
parallel with the new while this work is being undertaken and so staff will be stretched. 
E may offer discounts or rebates to customers who offer access at 
convenient times. The discounts shoul d be self-financing if they are 
funded out of the cost savings of  managing a customer’s account 
once the smart meter has been installed. 
IT issues 
It will be difficult for E to fully test  this system befor e installation. 
There will be large numbers of sm art meters in the system and they 
will be communicating over l ong distances. There could be 
unforeseen problems with data bei ng corrupted or lost. If that 
happens then the original meters will have been removed and there 
will be no effective way to put the system back. 
It would be ideal if E could select  a system that has already been 
used successfully by another electricity company. It would be preferable to apply a proven system even if there are more up to 
date versions of the technolog y that might offer enhancements. 
Financial cost 
There will have to be a significant investment in this new system 
and the anticipated benef its may not be realised. The shareholders 
and other stakeholders may be concerned that E is taking a reckless risk by making a substantial investment in a new technology. An adverse outcome coul d mean lower profits or higher 
prices for consumers. 
E could possibly transfer some of t he risk by paying a third party to 
design and implement the new system . The contract could specify 
penalties for any shortcomings in  the operation of the new system. 
E would appear to benefit from t he introduction of Smart Meters. 
However, several risks may arise with their introduction. These risks 
can be reduced, in part, by the m easures suggested in this report.

37 
A2. Evaluate risk exposure (a) Evaluate the impact of risk 
(b) Assess the likelihood of 
risks. 
(c) Analyse the interaction of 
different risks 
A3. Discuss ways of managing risk. (b) Discuss risk tolerance, 
appetite and capacity 
(c) Discuss risk management 
(d) Discuss risk analytics 
C2. Recommend internal 
controls for risk management (a) Discuss the COSO risk 
management framework 
 Chapter 
2

38 
 
 1 Risk management 
Risk management  is defined as: 
‘the process of understanding and managing the risks that the organisation is 
inevitably subject to in attempting to achieve its corporate objectives’ 
 The traditional view of risk managem ent has been one of protecting the 
organisation from loss through c onformance procedures and hedging 
techniques – this is about avoiding the downside  risk. 
 The new approach to risk management  is about taking advantage of the 
opportunities to increase overall re turns within a business – benefiting 
from the upside  risk. 
 The following diagram shows how ri sk management can reconcile the two 
perspectives of conformance and perfo rmance (as discussed previously in 
chapter 1).

Chapter 2 
 39 
 
Source: IFAC (1999) Enhancing Sharehold er Wealth By Better Managing Risk 
 
 Enterprise Risk Management (ERM) 
 Enterprise risk management is the te rm given to the alignment of risk 
management with business strategy  and the embedding of a risk 
management culture into business operations. 
It has been defined as: 'A process, effected by an entity’ s board of director s, management and 
other personnel, applied in strategy  setting and across the enterprise, 
designed to identify potential events that may affect the entity, and 
manage risk to be within its risk appetite, to provide reasonable 
assurance regarding the achiev ement of entity objectives.' 
Committee of Sponsoring Organisati ons of the Treadway Commission 
(COSO) (2003) 
Risk management has transformed from a ‘department focused’ 
approach to a holistic, co-ordi nated and integrated process which 
manages risk throughout the organisation. 
The key principles of ERM include: 
 consideration of risk managemen t in the context of business 
strategy 
 risk management is everyone’s respons ibility, with t he tone set from 
the top 
 the creation of a risk aware culture 
 a comprehensive and holistic approach to risk management 
 consideration of a broad range of risks (strategic, financial, 
operational and compliance) 
 a focused risk management strategy, led by the board (embedding 
risk within an organisation's culture).

40 
 The COSO ERM Framework is represented as a thr ee dimensional matrix 
in the form of a cube which reflects  the relationships between objectives, 
components and different organisational levels. 
 
 The four objectives (strategic, operations, reporting and compliance) 
reflect the responsibility of differe nt executives across the entity and 
address different needs. 
 The four organisational levels (s ubsidiary, business unit, division 
and entity) emphasise t he importance of managing risks across the 
enterprise as a whole. 
 The eight components must functi on effectively for risk management 
to be successful. 
The eight components are closely aligned to the risk management 
process addressed previously, and also  reflect elements from the COSO 
view of an effective internal control system: 
 Internal environment:  This is the tone of the organisation, 
including the risk management philosophy and risk appetite (see 
later in this chapter). 
 Objective setting:  Objectives should be aligned with the 
organisation’s mission and need to be consistent with the 
organisation’s defined risk appetite. 
 Event identification:  These are internal and  external events (both 
positive and negative) which impa ct upon the achievement of an 
entity’s objectives and must be identified.

Chapter 2 
 41 
  Risk assessment:  Risks are analysed to consider their likelihood 
and impact as a basis for determining how they should be managed. 
 Risk response:  Management selects risk response(s) to avoid, 
accept, reduce or share risk. The intention is to develop a set of 
actions to align risks with the entity’s risk tolerances and risk 
appetite. 
 Control activities:  Policies and procedures help ensure the risk 
responses are effectively carried out. 
 Information and communication:  The relevant information is 
identified, captured and communicat ed in a form and timeframe that 
enables people to carry out their responsibilities. 
 Monitoring:  The entire ERM process is monitored and 
modifications made as necessary. 
 
 Ernst and Young (2001) have developed a model of shareholder value in 
which: 
which more simply put is: ‘the sum of  the value of what a company does 
Good risk management allows businesse s to exploit opportunities for 
future growth while protecting the va lue already created. By aligning risk 
management activity to what the s hareholders consider vital to the 
success of the business, the shareholde rs are assured that what they 
value is protected. Ernst and Young identify four stages: 
(a) Establish what shareholders value about the company – through 
talking with the investment community and linking value creation processes to key performance indicators. 
(b) Identify the risks around the ke y shareholder value drivers – the 
investment community can identif y those factors that will influence 
their valuation of the company . All other risks will also be 
considered, including those not  identified by investors. 
(c) Determine the preferred treatment  for the risks – the investment 
community can give their views on  what actions they would like 
management to take in relation to  the risks. The risk/reward trade-
off can be quantified by estimating the change in a company’s market valuation if a particular risk treatment is implemented. 
to be well informed, as a shared visi on is important in relation to the 
inter-related concepts of risk management and shareholder value.

42 
 IFAC highlighted two aspects of risk management which link risk aversion 
and risk seeking activities. They are: 
A Compliance and strategy B Conformance and performance C Compliance and conformance D Performance and strategy 
 
 In 2003 the Committee of Sponsoring Organisations (COSO) outlined six 
key principles of Enterpri se Risk Management (ERM).  
Identify which of the following is/are included.  
A Consideration of risk managemen t in the context of business 
strategy 
B The creation of a risk aware culture C Consideration of a narrow r ange of risks, mainly financial 
D Risk management is the respons ibility of the Risk Committee 
E A comprehensive and holistic approach to risk management 
ERM – Integrating strategy  with performance 2017 
In 2017 COSO produced an update to the ERM framework. The update uses a 
new diagram – the double helix (shown be low) – and the key principle is that 
ERM should be ingrained into everythi ng the organisation does including setting 
the mission, vision and core  values of the entity. 
Risk is inherent in everything an entity does  and it is therefore a risk that a 
strategy chosen by an entity may not be in line with the stated mission, vision 
and core values.

Chapter 2 
 43 
The double helix is broken down into five components: 
1 Governance and culture 
This relates to the internal envir onment and emphases the importance of 
the tone of the organisation. It al so includes ethical behaviour and 
understanding the risk appet ite of the entity. 
2 Strategy and objective setting 
This component is possibly the main focus to the update; it emphases the 
importance of making sure ERM and obj ective setting is aligned to risk 
appetite in the strategic planning stage – to make sure that the strategy 
can be implemented successfully. This  component therefore helps to 
minimise the risk of the wr ong strategy being chosen. 
3 Performance 
This combines the components from  the original cube of event 
identification, risk assessment and risk re sponse. It involves maintaining a 
focus on identifying internal and external events (both positive and negative) which could impact upon t he achievement of an entity’s 
objectives, assessing the likelihood and im pact of these events to prioritise 
their importance, and then developing a response to accept, reduce, avoid 
or share the risk. 
4 Review and revision 
Policies and procedures to help ensure the risk responses are effectively 
carried out, through the selection of ke y metrics. This ensures that the 
entire ERM process is monitored and modifications made as necessary. 
5 Information, communication and reporting 
As always, it is vitally important that  the relevant information is identified, 
captured and communicated in a form and timeframe that enables people 
to carry out their responsi bilities. And that this information is reported to 
the right people and levels, be that  directors or shareholders. 
The cube or the helix 
It is important to note that COSO has not withdrawn the cube (which is why it 
remains part of the P3 syllabus). The cube also provides a useful background to 
the development of  the 2017 update. 
COSO want to encourage organisations to  identify the fram ework that works 
best for their situation, giving the co mpany the best chance to improve their 
performance and of achieving thei r strategy and objectives.

44 
Benefits of ERM  
Benefits of effective ERM include: 
 enhanced decision-making by integrating risks 
 reduced performance fluctuations and fewer interruptions to operations 
 the resultant improvement in inve stor confidence, and hence shareholder 
value 
 focus of management attention on the most significant risks 
 a common language of risk management  which is understood throughout 
the organisation enabling per formance improvement 
 increased ability to benefit from up side risk and reduced susceptibility to 
downside risk 
 reduced cost of finance through effective management of risk. 
 improved utilisatio n of resources 
 increased opportunities for the organisation 
 
 Q Co is a new organisation, but m anagement are keen to maximise their 
chances of achieving their objectives by using ERM. They have recently met to discuss the controls they will use to mitigate the risks they considered to be the most significant. 
Which one of the ERM Integrating strategy with performance 2017 
components does this best describe: 
A Information, communication and reporting 
B Review and revision C Governance and culture D Performance E Strategy and objective setting 
2 Risk management strategy 
Formulation of a risk strategy 
 For many businesses the specific fo rmulation of a risk strategy has been a 
recent development. 
 In the past, a formal strategy for managing risks would not be developed, 
but rather it would be left to indivi dual managers to make assessments of 
the risks the business faced and ex ercise judgement on what was a 
reasonable level of risk. 
 This has now changed: failure to properly identify and control risks has 
been identified as a major cause of busi ness failure (take Barings Bank as 
an example).

Chapter 2 
 45 
A framework for board considerat ion of risk is shown below: 
 Formulating a risk management strategy 
 A risk management strategy needs to be developed to ensure that the 
risk exposures of the organisation are consistent with it s risk appetite. At 
the very least, the risk management capability within the organisation 
should be sufficient to: 
 review its internal control syst em and its adequacy at least annually, 
 ensure that controls ar e properly implemented, and 
 monitor the implementation and effectiveness of controls. 
However, the investment by the organi sation in risk strategy should be 
largely determined by the performanc e requirements of its business 
objectives and strategy: 
 
  Risk appetite  can be defined as the amount  of risk an organisation 
is willing to accept in pursuit of  value. This may be explicit in 
strategies, policies and procedures, or it may be implicit. It is 
determined by: 
– risk capacity  – the amount of risk t hat the organisation can 
bear, and 
– risk attitude  – the overall approach to  risk, in terms of the 
board being risk averse or risk seeking. 
 The way that the organisation documents and determines the 
specific parts of its risk strategy should link to the business strategy 
and objectives 
 Overall risk management strategy is concerned with trying to achieve 
the required business objectives wit h the lowest possible chance of 
failure. The tougher the business objec tives, however, the more risks 
will have to be taken to achieve them. 
 Residual risk  is the risk a business faces after its controls have 
been considered (see later in this chapter for more details).

46 
 More on risk appetite 
 To bring risk management into line with strategic management, an 
organisation should define the amount of risk it is prepared to take in the 
pursuit of its objectives. This willi ngness to accept risk can be stated in a 
mixture of quantitative and qualit ative terms. For example: 
 The board of directors might state how much capital they would be 
prepared to invest in the pursuit of a business objective and the size 
of the loss they would be willing to fa ce in the event that results turn 
out badly. 
 Risk can also be stated qualitatively,  for example in relation to the 
organisation’s reputation. 
In practice, in a large organisation, there will be different levels of risk 
appetite for different operations or di fferent profit centres/investment 
centres within the business. 
Risk appetite factors 
The factors, or business strategies, which could affect the risk appetite of 
the board of a company include: 
Nature of 
product being manufactured A high risk of product failure in certain products 
(e.g. aircraft) must be avoided due to the 
serious consequences of such an event. This will, out of necessity, limit  the risk appetite of the 
board with regard to these specific products. For other products the risk of failure will be less (e.g. a fizzy drink having small changes from the normal ingredients – customers may not even notice the difference). Additionally if a business is taking significant risks with part of its product range it may be limited in the risk it can take with other products. 
The need to 
increase sales The strategic need to move into a new market 
will result in the business accepting a higher degree of risk than trying to increase sales or market share in an existing market. At that stage the business will appear to have a higher risk appetite. 
The background of the board Some board members may accept increased 
risk personally and this may be reflected in the way they manage the company. 
Amount of change in the market Operating in a market place with significant 
change (e.g. mobile telephones) will mean that the board have to accept a higher degree of risk. For example, new  models of phone have to 
be available quickly. 
Reputation of the company If the company has a good reputation then the 
board will accept less risk – as they will not want 
to lose that good reputation.

Chapter 2 
 47 
 The amount of risk an organisation is wi lling to accept in  the pursuit of 
value is known as their: 
A Risk map B Risk appetite C Risk culture D Risk thermostat 
 
 Features of a risk management strategy 
In a CIMA and IFAC (Inter national Federation of Acc ountants) joint report in 
2004 – Enterprise Governance – the following key features of a risk 
management strategy were identified: 
 Statement of the organisation’s attitude to risk – the balance between risk 
and the need to achieve objectives. 
 The risk appetite of the organisation. 
 The objectives of the risk management strategy. 
 Culture of the organisation in rela tion to risk (and the behaviour the 
organisation expects from individ uals with regard to risk-taking). 
 Responsibilities of managers for t he application of risk management 
strategy. 
 Reference should be made to the risk management systems the company 
uses (i.e. its internal control systems). 
 Performance criteria should be defi ned so that the effectiveness of risk 
management can be evaluated. 
 
 An alternative risk management process 
 The Institute of Risk Management  (IRM) developed a risk management 
process containing three elements: 
(1) Risk assessment  is composed of the analysis and evaluation of 
risk through the process of identific ation, description and estimation. 
The purpose of risk assessment is to undertake risk evaluation. Risk 
evaluation is used to make decisions about the significance of risks to the organisation and whether each specific risk should be accepted or treated. 
(2) Risk reporting  is concerned with regular r eports to the board and to 
stakeholders setting out the organisati on's policies in relation to risk 
and enabling the effective moni toring of those policies. 
(3) Risk treatment  (risk response) is the process of selecting and 
implementing measures to modify the risk. 
Residual risk reporting will t herefore follow risk treatment.

48 
3 Identifying, measuring and assessing risks 
Chapter 1 examined the different types of  risks faced by an organisation. It is 
key, however, that businesses can ident ify the risks they face and evaluate the 
effect of these risks on the business. Some risks will be relatively easily borne 
by businesses, but others will be more difficult and more serious in their implications. 
Risk identification 
 The risk identification proce ss will often be controlled by a risk committee  
or risk management specialists (see later in this chapter). 
 The risks identified in the process should be recorded in a risk register , 
which is simply a list of the ri sks that have been i dentified, and the 
measures (if any) that have been ta ken to control each of them. 
 There are a variety of methods that can be used by businesses to identify 
the risks that they face.

Chapter 2 
 49 
 The risk register 
 The risk register is a very impor tant and practical risk management tool 
that should be used by all companies. It takes several days, if not weeks, 
to produce, and needs to be reviewed and updated regularly – often annually (in conjunction with cor porate governance guidelines). 
The risk register is often laid out in  the form of a t abular document with 
various headings: 
(1) The risk title  – stating what the risk might be. 
(2) The  likelihood  of the risk – possibly m easured numerically if a 
scale has been set e.g. 1 is unlikely, 5 is highly likely. 
(3) The impact  of the risk should it aris e. Again this might be graded 
from, say, 1 (low impa ct) to 5 (high impact). 
(4) The risk owner’s  name will be given – usually a manager or 
director. 
(5) The date the risk was identifi ed will be detailed. 
(6) The date the risk was last considered will be given. (7) Mitigation actions  should be listed i.e. what the company has done 
so far to reduce the risk. This might include training, insurance, 
further controls added to the system, etc. 
(8) An overall risk rating  might be given e.g. 1/10, so that 
management can immediately see wh ich risks are the ones they 
should be concentrating on. 
(9) Further actions  to be taken in the future will be listed (if any). 
(10) The 'action lead'  name will be detailed i.e. who is responsible for 
making sure that these future  actions are implemented. 
(11) A due date  will state when the date by which action has to be 
implemented. 
(12) A risk level target might be given i.e. a score lower than that given in 
step 8 above. This might mean that by implementing a control, the 
risk rating is expected to lower from, say, 8 to, say 2 (the target risk 
level). 
For example, using the steps detaile d above, one row of a tabulated risk 
register might show: 
(1) Loss of personal data i.e. unsecure use of mobile devices could 
result in personal identifiable information being lost, stolen or unauthorised access gained. 
(2) Likelihood = 3 
(3) Impact = 5 (4) Risk owner = Mike Smith (IT manager) (5) 1.1.X2 (6) 2.2.X4

50 
 (7) Staff receive training every 2 y ears which highlights the risks. All 
laptops are encrypted. Regular audits are undertaken. Any incidents are reported to the Audit Committee. 
(8) Overall risk rating = 7 (9) Encryption technology to be implemented which meets industry 
standard. 
(10) Mike Smith (11) 31.7.X4 (12) Risk level target = 3 
 
 Risk registers would normally det ail which of the following:  
Select ALL that apply A Risk level before controls are implemented B Risk level after controls are implemented C Responsibility for managing risks D The total cost of a control being implemented 
 
 More on risk identification 
 Some of the common methods of  risk identificat ion include: 
PEST/SWOT analysis PEST (Political, Economic, Social, 
Technological) and SWOT (Strengths, 
Weaknesses, Opportunities, Threats) are very well known and familiar business analysis tools. These models can be used to assess risks by providing a framework to identify and think about the risks in the organisation. 
External advisors Companies may employ external risk 
consultants who will advise on key risks 
and processes that can be used to limit 
and control those risks. Consultants have access to other businesses and as a result may have pools of knowledge not available internally. 
Interviews/questionnaires The company may conduct interviews or 
send questionnaires to key business managers asking them to indicate principal risks.

Chapter 2 
 51 
 Internal audit One of the functions of internal audit 
should be to provide recommendations on controlling risk. As part of their work 
therefore, internal audit assess where the organisation faces risk. 
Brainstorming The business may decide to use more 
informal brainstorming meetings to assess the risks it faces. These meetings have the advantage of accessing many different viewpoints. 
Any of these methods identify risks but at the end of the process it is 
important that the organisation determi nes which its principal risks are. It 
is these principal risks that will dete rmine the controls that need to be put 
in place and the systems that will hav e to be introduced to control and 
manage the risks. 
 
 Quantification of risk exposures 
Quantification of risk is im portant in understanding the ex tent and significance of 
risk exposure. This can be done by meas uring the impact of the risk factor 
(such as exchange rates) on the total value of the company, or on individual 
item such as cash flow or costs. 
 Risks that are identifi ed should be measured and assessed. The extent to 
which this can be done depends on the information available to the risk 
manager. 
 In some companies, particularly in  the banking and insurance industries, 
many risks can be measured statistica lly, on the basis of historical 
 In many other situations, the me asurement and assessment of risk 
depends on management judgement. 
Some quantitative techniques include: 
 expected values and standard deviation 
 volatility 
 value at risk (VaR) 
 regression analysis 
 simulation analysis 
Expected values and standard deviation 
 Some risks can be measured using expected values. 
Expected value = Σ prob X 
where prob = probability, X = outcome

52 
 Expected value of risk 
 When statistical estimates are availabl e for the probabilities of different 
outcomes and the value of each outcome, risk can be measured as an expected value of loss or gain. 
Expected value of loss = p × L Where: p is the probability that  the outcome will occur 
L is the loss in the event t hat the outcome does occur. 
Example 
The finance director of a compan y has to prepare an assessment of 
credit risk for a report to the board.  The company has annual credit sales 
of $12 million, and customers are gi ven 60 days (two months) credit. 
Experience shows that: 
 irrecoverable debts written off amount  to 1.5% of total annual credit 
sales 
 10% of irrecoverable debts wri tten off are subsequently recovered 
by legal action. 
Required: 
(a) What is the credit risk exposure of the company? 
(b) What is the expected loss each year due to credit risk? 
Solution 
(a) The total exposure to credit risk c an be expressed either as the total 
annual credit sales ($12 million) or the exposure to unpaid debts at 
any point in time ($12 million × 2/12 = $2 million). 
(b) For a full year the expected value of loss is = $12 million × 1.5% × 
90% = $162,000 
 
The standard deviation is a measure of t he dispersion of the possible values of 
a given factor, such as ca sh flow, from the expected value or mean. Thus the 
standard deviation provides a measure of volatility – the greater the standard 
deviation, the greater the risk involved. 
Volatility 
 Another way of assessing risk might be looking at potential volatility. For 
example, a company might calculate an expected value based on a range 
of probabilities but also assess the pot ential variation from that expected 
outcome (range or standard deviation).

Chapter 2 
 53 
 Test your understanding 6 – Volatility (Integration) 
 The following are the forecast purchases of raw materials in a future 
month: 
£200,000 30% probability £250,000 50% probability £300,000 20% probability 
Calculate the upside and downside vola tility from expected purchases. 
Value at risk 
Value at Risk (VaR) allows investors to assess the scale of the likely loss in 
their portfolio at a defined level of probabi lity. It is becoming the most widely 
used measure of financial risk and is  also enshrined in both financial and 
VaR is based on the assumption that inve stors care mainly about the probability 
of a large loss. The VaR of a portfolio is the maximum loss on a portfolio occurring within a given period of time wit h a given probability (usually small). 
 Calculating VaR involves using three components: a time period, a 
confidence level and a loss amount or percentage loss. 
 Statistical methods are used to ca lculate a standard deviation for the 
possible variations in the value of the total portfolio of assets over a 
specific period of time. 
 Making an assumption that possible vari ations in total market value of the 
portfolio are normally distributed, it is  then possible to predict at a given 
level of probability the maximum loss that the bank might suffer on its 
 A bank can try to control the risk in  its asset portfolio by setting target 
maximum limits for value at risk over different time periods (one day, one 
 VaR may be calculated as standard deviation × Z-score (the Z-score can 
be found from the normal distribution tables). 
 
 Normal distributions can be found w hen we measure things such as: 
 Exam results 
 Staff performance gradings 
 The heights of a group of people etc 
A normal distribution has the following characteristics: 
The mean is shown in the centre of the diagram and the curve is 
symmetrical about the mean. This means  that 50% of the values will be 
below the mean and 50% of the va lues will be above the mean. 

54 
 How far the values spread out from  the mean is the standard deviation. 
This can be seen in the following diagram:  
 
The total area under the curve is equal to 1. 
If we can think of a standard normal distribution curve with three standard 
 
In general 68% of values are withi n one deviation (between -1 and 1), 
95% of values are within two standard deviations (between -2 and 2) and 
99.7% of values are within three standard deviations (between -3 and 3). 
From this we can see that if we look  at a set of data which fits a normal 
distribution the majority of values wil l occur closer to the mean, with fewer 
and fewer occurring the further  from the mean we move.

Chapter 2 
 55 
 A standard normal distribution has: 
a mean of 0 a standard deviation of 1. This special distribution is denot ed by z and can be calculated as: 
 
Where: 
z is the score x is the value being considered µ is the mean 
 is the standard deviation 
This calculation is used to convert any value to standard normal 
Looking up the normal distribution tables 
Once we have calculated our 'z score' we can look this up on the normal 
distribution table to find the area under  the curve, which equates to the 
percentage chance (probability) of that value occurring. 
So if we calculated a z score of 1.00.  From the table t he value is 0.3413. 
This means that (0.3413 ÷ 1.0) or 34.13% is the area shown from 0 -1 on 
 
From this we can deduc e that 34.13% would be t he area shown from 0 -1 
on the diagram. So we can say that 68. 26% of values will fall within one 
standard deviation (-1 to 1).

56 
 For VaR, there are two types of calculation to consider: 
(1) The confidence level that the re sult will be above a particular figure 
(2) The confidence level that a figur e will be within a particular range – 
this is referred to as a two tail test. 
In both cases we are working backwar ds from the percentage to find the 
value of x. 
If you are asked to calculate the 95% Va R, this is a one tail test. As we 
are looking at risk, it is usually ab out being 95% certain that the outcome 
50% of the distribution is on one side of the mean,  within the tables we 
are looking for as close to 0.4500. 
 
If you are asked about being 95% certain the result is within a range, the 
 
We would be looking for 0.4750 in t he tables, 47.5% above and below the 
mean.

Chapter 2 
 57 
 One tail test 
 Z is a bank. The management accountant  of Z has estimated that the 
value of its asset portfolio at y ear end will be $1,500 million, with a 
standard deviation of $300 million. 
Calculate the value at risk of th e portfolio, at a 97.5% confidence 
level.  (Express your answer in $, rounded to the nearest million.) 
Solution 
The Z value for a one-tail 97.5% conf idence level is 1.96 (from the 
VaR = standard deviation × Z value, so the VaR = USD 300 million × 1.96 = USD 588 million 
This means there is a 2.5% chance t hat the value of the portfolio will be 
(1,500 – 588) $912 million or below. 
 
 Two tail test 
 AL plc, a UK based company are expe cting to receive $10 million from a 
US customer. The value in pounds is dependent on the exchange rate between the dollar and pound. 
The mean exchange rate is $1.25/£ and the daily volatility of the 
pound/dollar exchange rate is 0.25%. 
What is the range of values that AL plc will be 95% confident of 
receiving in 1 day? 
Solution 
The mean value of the $10 million is  £8 million ($10 million ÷ $1.25/£) 
The daily standard deviation is (0 .25% × £8 million =) £20,000 
As we are looking at a range, this is a two tail test, to be 95% confident 
this will be within 47.5% of  the mean on either side. 
First find 0.4750 in the normal tables, this is a z value of 1.96. VaR = Z × 
Std deviation = 1.96 × 20,000 = £39,200 
This means that AL plc is 95% c onfident that the value will be within 
£39,200 of the mean. 
Therefore AL plc is 95% confiden t the sterling amount will be between 
£7,960,800 & £8,039,200. 
Given the 1-day VaR, we can easily calculate the VaR for longer holding periods as: 
n day Var = 1 day Var × √n 
The VaR increases with the holding period. Thus, the l onger the holding period, 
the greater the VaR.

58 
 Example of VaR 
 Suppose a UK company expects to  receive $14 million from a US 
customer. The value in pounds to t he UK company will depend on the 
exchange rate between the dollar and pound s resulting in gains or losses 
as the exchange rate changes. Assume that the exchange rate today is 
$1.75/£ and that the daily  volatility of the pound/dollar exchange rate is 
0.5%. 
Calculate the (a) 1-day 95% VaR (b) 1-day 99% VaR. The value of the $14 milli on today is £8 million ( $14 million ÷ $1.75/£) with 
a daily standard deviation of  £40,000 (0.5% × £8 million). 
confidence level is 1.645 (see Norma l Distribution tables). Hence, 
the 1-day 95% VaR is 1.645 × £40, 000 = £65,800. This means that 
we are 95% confident that the ma ximum daily loss will not exceed 
£65,800. Alternatively, we could also say that there is a 5% (1 out of 
20) chance that the loss would exceed £65,800. 
confidence level is 2.33 (see Normal Distribution tables). Hence, the 
1-day 99% VaR is 2.33 × £40,000 = £93,200. Thus, there is a 1% (1 out of 100) chance that the loss would exceed £93,200. 
If we wanted to calculate the VaR for longer period, say 5 days, at 
5 day 95% VaR = 1 day 95% VaR × √5 = £65,800 × 2.236 = 
£147,133 
There is a 5% chance that t he company’s foreign exchange loss 
would exceed £147,133 ov er the next 5 days. 
Similarly, the 30-day 99% VaR would be: 1 day 99% VaR × √30 = £93,200 × 5.477 = £510,477 
This illustrates the longer the hol ding period, the greater the VaR.

Chapter 2 
 59 
 The Basel committee established international standards for banking 
laws and regulations aimed at prot ecting the international financial 
system from the results of the co llapse of major banks. Basel II 
established rigorous risk and capital management require ments to ensure 
each bank holds reserves sufficient to guard against its risk exposure, 
given its lending and inve stment practices. Regu lators require banks to 
measure their market risk using a ri sk measurement model which is used 
However, the global financial crisis has identified substantial problems 
with banks governance procedures in terms of understanding operational 
risk and applying risk measurement models like VaR. This has been emphasised by the number of ban ks that have failed or required 
UK; Bear Sterns and Washington Mu tual in the US amongst others. 
 
 A company expects to receive $10 million from a US customer. The value 
in £ will depend on the exchange ra te changing. Assume that the 
exchange rate today is $1.6667 / £ and that  the daily volatility of the £/$ 
exchange rate is 0.5%. 
Required: 
What is the 10 day 95% VaR? 
 
 Test your understanding 8 – Va lue at risk (Integration) 
 A bank has estimated that the expec ted value of its portfolio in two 
weeks’ time will be $50 million, with a standard deviation of $4.85 million. 
Required: 
Calculate and comment upon the value at  risk of the portfolio, assuming a 
95% confidence level. 
This can be used to measure a company’s  exposure to several risk factors at 
the same time. This is done by regressi ng changes in the company’s cash flows 
against the risk factors (changes in interest rates, exchange rates, prices of key 
commodities such as oil). The regre ssion coefficients will indicate the 
sensitivities of the company’s ca sh flow to these risk factors. 
The drawback with this technique is that  the analysis is based on historical 
factors which may no longer be predictor s of the company in the future.

60 
Simulation analysis 
This is used to evaluate the sensitivity of  the value of the co mpany, or its cash 
flows, to a variety of risk factors. These risk fa ctors will be given various 
simulated values based on probability distributions, and the procedure is repeated a number of times to obtain the range of results that can be achieved. 
The mean and standard deviation are then ca lculated from these results to give 
an expected value and m easure of the risk. 
This technique can be complex and time -consuming to carry out, and is limited 
by the assumptions of t he probability distributions. 
Other methods of measuring or assessi ng the severity of an identified risk 
include: 
 scenario planning – forecasting various outcomes of an event; 
 decision trees – use of probabilities to estimate an outcome; 
 sensitivity analysis – asking 'what-if?' questions to test the robustness of a 
plan. Altering one variable at a time i dentifies the impact of that variable. 
Drawbacks of the quantification of risk 
Once a risk has been quantified, there is a problem – whether anyone really 
knows what it means. Unless you are a trainee or qualified accountant (or 
similar) this is unlikely, henc e risks are often left unquantified. 
Risk or assurance mapping 
‘risk map’  or sometimes called an 'assurance map'.  
 The Board, the Risk Committee, the Audit Committee and senior 
management from various departments will all be involved in the 
preparation of the map. 
 The map identifies whether a risk  will have a significant impact on the 
 The approach can provide a framework for prioritising risks in the 
business. 
 Risks with a significant impact an d a high likelihood of occurrence need 
more urgent attention than risks with a low impact and low likelihood of 
 A well-structured risk map will highl ight where there are gaps in 
assurances over significant risk areas. 
 Also, duplicated or potentially bur densome assurance processes may be 
 Risks can be plotted on a diagram, as shown below.

Chapter 2 
 61 
 
 The potential loss from an adver se outcome is a function of: 
 the probability or likel ihood that the adverse outcome will occur, and 
 the impact of the outcome  if it does occur. 
When an initial review is carried out  to identify and assess risks, the 
assessment of both probabilitie s and impact might be based on 
judgement and experience rather t han on a detailed statistical and 
numerical analysis. 
 In an initial analysis, it might  be sufficient to categorise the 
probability of an adverse outcome as  ‘high’, ‘medium’ or ‘low’, or 
 Similarly, it might be sufficient for the purpose of an initial analysis to 
assess the consequences or impact of an adverse outcome as 
‘severe’ or ‘not severe’. 
Each risk can then be plotted on a risk map. A risk map is simply a 2 × 2 
table or chart, showing the probabiliti es for each risk and their potential 
impact.

62 
 Example 
The following simple risk map might be prepared for a firm of auditors 
  Low High 
profession Loss of non-audit 
work from 
Low Increases in 
clients within the 
next two years. 
Using a risk map 
A risk map immediately indicates whic h risks should be given the highest 
priority. 
 High-probability, high-impact ri sks should be given the highest 
priority for management, whether by m onitoring or by taking steps to 
 Low-probability, low-impact risks  can probably be accepted by the 
 High-probability, low-impact ri sks and low-probability, high-impact 
risks might be analysed further with a view to deciding the most 
appropriate strategy for their management. 
For each high-probability, high-impact risk, further analysis should be 
carried out, with a view to:  
 estimating the probability of an adverse (or fav ourable) outcome 
 assessing the impact on the organi sation of an adverse outcome. 
to contribute by providing suitabl e and relevant financial information. 
An alternative layout for a risk map (other than the cruc iform style shown 
above) would be a tabular format. T he table might have the following 
columns: 
(1) The risk name e.g. fraud. (2) The likelihood of that risk arising e.g. medium. 
(3) The impact of the risk if  it does arise e.g. high. 
(4) Controls already in place. (5) The risk owner i.e. the name of a manger or director who watches 
out for this risk arising. 
(6) Whether assurance is sufficient. This might be given a score out of, 
say, 10, or a yes/no type response. 
(7) Controls to be implemented in the future.

Chapter 2 
 63 
 Test your understanding 9 – Restaurant (Integration) 
 Suggest a risk that could be included in each quadrant for a restaurant.  
 
 The loss of lower-level staff would best fit which category of a risk map? 
A Low likelihood; low consequence B High likelihood; low consequence C Low likelihood; high consequence D High likelihood; high consequence 
 
 The axes of a risk map include: 
Select ALL that may apply A Likelihood B Volatility C Consequences D Certainty 
 
 HH Ltd is a private rehabilitation centre which provides services for 
people recovering from debilitating inju ries. These services include a 
supported re-introduction to living at home through independent living 
units where clients can ‘practice’ li ving alone but with medical support on 
hand should they need it. 
The managers of HH are aware they operate in a high risk industry. 
Clients are often pres cribed strong medications which must be 
administered correctly by HH staff and there are two ongoing legal disputes over injuries that have occu rred to clients in HH’s independent 
living units. Some of HH’s managers be lieve these risks are simply part of 
their business model and unavoidable, wh ereas others are of the opinion 
that a formal risk management policy should be devised. 
The directors have suggested the m anagers get together to carry out a 
risk mapping exercise.

64 
 Which of the following are benefi ts from a risk mapping exercise?  
Select ALL that apply. 
A Managers will reach a consensus on which are the key risks facing 
HH and will be able to target  the most significant. 
B Managers can use the existence of the risk map to prove they have 
not been negligent in the legal disput es concerning injured clients. 
C The risk of medication being wron gly administered can be assessed 
and a policy devised to r educe it going forward. 
D The risk of injury to clients accessing the independent living units 
can be assessed and prioritised and a policy devised to reduce it going forwards. 
E The existence of a risk map may prevent managers wasting time 
dealing with trivial risks. 
4 Risk response strategy 
So far we have considered the types of  risk a company could be exposed to 
and the way it may choose to assess, measure and bear those risks. The next 
area is to look at the formulation of a strategy to respond to those risks, the general methods that can be used to treat risks and the implementation of such 
a strategy. 
The management of risks involv es trying to ensure that: 
 Exposure to severe risks is minimised. 
 Unnecessary risks are avoided. 
 Appropriate measures of control are taken. 
 The balance between risk and return is appropriate. 
The estimate of the potential loss for each risk should be compared with the 
acceptable risk limit for the company. If  the risk is greater  than the acceptable 
limit, the next stage is to consider  how the risk should be managed or 
controlled, to bring it down in size. 
 
 Risk treatment (management) methods 
Assuming that the business does want to manage its risks a number of methods 
can be used. These methods will lim it the risks, and the overall risk 
management strategy may define how  the risks will be managed and the way 
these methods will interact. 
Avoid risk 
 A company may decide that some activi ties are so risky that they should 
be avoided. 
 This will always work but is impossibl e to apply to all risks in commercial 
organisations as risks have to be taken to make profits.

Chapter 2 
 65 
Transfer risk 
 In some circumstances, risk can be trans ferred wholly or in part to a third 
party. 
 A common example of this is insur ance. It does reduce/eliminate risks but 
premiums have to be paid. 
Pool risks 
 Risks from many different trans actions can be pooled together: each 
individual transaction/item has its potential upside and its downside. The 
risks tend to cancel each other out, and are lower for the pool as a whole than for each item individually. 
 For example, it is common in large gr oup structures for financial risk to be 
managed centrally. 
 Diversification is a similar concept to pooling but usually relates to different 
industries or countries. 
 The idea is that the risk in one area can be reduced by investing in 
another area where the risks are di fferent or idea lly opposite. 
 A correlation coefficient with a value clos e to –1 is essential if risk is to be 
nullified. 
 
 Managing risk by diversification 
 The syllabus refers specifically to t he principle of diversifying risk, but 
states that numerical questions will not be set. It will therefore be useful 
to look in more detail at the e ffect of diversification on risk. 
 Risk can be reduced by diversifying into operations in different 
areas, such as into Industry X and I ndustry Y, or into Country P and 
Country Q. 
 Poor performance in one area will be offset by good performance in 
another area, so diversificat ion will reduce total risk. 
 Diversification is based on the idea of ‘spreading the risk’; the total 
risk should be reduced as the portfo lio of diversified businesses gets 
larger. 
 Diversification works best where returns from different businesses 
are negatively correlated (i.e. move in different ways). It will, 
however, still work as long as the correlation is less than +1.0. 
 Example of poor diversificat ion – swimming costumes and ice 
cream – both reliant on sunny weather for sales. 
 Spreading risk relates to portfolio  management, as an investor or 
company spreads product and market risks. 
 The most common form of divers ification attempts to spread risk 
according to the portfolio  of companies held within a group – based 
on links within the supply chain

66 
 
Spreading risk by portfolio management 
Within an organisation, risk can be sp read by expanding the portfolio of 
companies held. The portfolio can be expanded by integration – linking 
with other companies in the supply chai n, or diversification into other 
areas. 
This is development beyond the present product and market, but still 
within the broad confines of the ‘industry’. 
 Backward integration  refers to development concerned with the 
inputs into the organisation, e.g.  raw materials, machinery and 
labour. 
 Forward integration  refers to development into activities that are 
concerned with the organi sation’s outputs such as distribution, 
transport, servicing and repairs. 
 Horizontal integration  refers to development into activities that 
compete with, or directly comple ment, an organisation’s present 
activities. An example of this is  a travel agent selling other related 
products such as travel insurance and currency exchange services. 
Unrelated diversification 
This is development beyond the present industry into products and/or 
markets that may bear no clear relati onship to their present portfolio. 
Where appropriate an organisation may w ant to enter into a completely 
different market to spread its risk.

Chapter 2 
 67 
 Problems with diversification: 
 If diversification reduces risk,  why are there relatively few 
conglomerate industrial and commerc ial groups with a broad spread 
of business in their portfolio? 
 Many businesses compete by specialising, and they compete 
successfully in those areas where they excel. 
 Therefore, it is difficult for co mpanies to excel in a wide range of 
diversified businesses. There is a possible risk that by diversifying 
too much, an organisation might bec ome much more difficult to 
manage. Risks could theref ore increase with diversification, due to 
loss of efficiency and problems of management. 
 Many organisations diversify their operations, both in order to grow 
and to reduce risks, but they do so into related areas, such as 
similar industries (e.g. banking an d insurance, film and television 
production, and so on) or the same i ndustry but in different parts of 
the world. 
 Relatively little advantage accr ues to the shareholders from 
diversification. There is nothi ng to prevent investors from 
diversifying for themselves by  holding a portfolio of stocks and 
shares from different industries and in different parts of the world. 
 
 Risk reduction can be achieved usi ng which of the following theories? 
A Management theory 
B Systems theory C Portfolio theory D Contingency theory 
 
 Test your understanding 14 – Diversification (Integration) 
 Evaluate whether it is  always a good business strategy for a listed 
company to diversify to reduce risk 
Risk reduction  
 Even if a company cannot totally elimin ate its risks, it may reduce them to 
a more acceptable level by a form of internal control. 
 The internal control would reduce either the likelih ood of an adverse 
outcome occurring or the si ze of a potential loss. 
 The costs of the control measures should justify the benefits from the 
reduced risk. 
 More will be seen on internal controls in chapter 5.

68 
Hedging risks 
 Hedging is consider ed in detail in F3. 
 The concept of hedging is reducing ri sks by entering into transactions with 
opposite risk profiles to deliberately r educe the overall risks in a business 
operation or transaction. 
Risk sharing 
 A company could reduce risk in a new business operation by sharing the 
risk with another party. 
 This can be a motivation for entering into a joint venture. 
 
 Risk management using TARA 
 An alternative way of rememberi ng risk management methods is via the 
mnemonic ' TARA ': 
Transference.  In some circumstances, risk can be transferred wholly or 
in part to a third party, so that if an adverse event occurs, the third party 
suffers all or most of the loss. A common example of risk transfer is 
insurance. Businesses arrange a wide range of insurance policies for 
protection against possible losses. Th is strategy is also sometimes 
referred to as sharing.  
Avoidance.  An organisation might choose to avoid a risk altogether. 
However, since risks are unavoidable in business ventures, they can be 
avoided only by not investing (or withdrawing from the business area 
completely). The same applies to not-for-profit organisations: risk is 
unavoidable in the activities they undertake. 
Reduction/mitigation.  A third strategy is to reduce the risk, either by 
limiting exposure in a particular area or attempting to decrease the 
adverse effects should that risk actually crystallise. 
Acceptance.  The final strategy is to si mply accept that the risk may 
occur and decide to deal with the consequences in that particularly situation. The strategy is appropriate normally where the adverse effect is 
minimal. For example, there is near ly always a risk of rain; unless the 
business activity cannot take place when it rains then the risk of rain occurring is not normally insured against.

Chapter 2 
 69 
Risk mapping and risk responses 
Risk maps can provide a useful fram ework to determine an appropriate risk 
response: 
 
 The death of, or serious injury to, a me mber of staff at wo rk would best fit 
which category on a risk map? 
 
 A risk identified as having a low frequency and a high severity should be 
managed by: 
A Avoiding B Accepting C Transferring D Reducing

70 
 P Company is a large international fa st food retailer with plans to expand 
on a global scale. J is a manager who has relocated to Country X to begin an aggressive standar dised expansion plan. 
Five restaurants have opened so far in the cities of Country X but the 
response from the local population has  been poor. Initial sales targets 
have not been met and the Board of P Company believes that further 
expansion into Country P is at ri sk and it is possible the plan will be 
abandoned. 
J believes that the restaurants hav e not been immediately successful 
because the population of Country  X, although affluent and well 
educated, are not used to the concept  of ‘fast food’. Restaurants in 
Country X are typically expensive and serve fresh food to order. 
Which of the following are appropr iate risk management responses 
for J to discuss with The Board?  
A P Company should embark on a ma rketing campaign within Country 
X. 
B The menus of restaurants in Coun try X should be modified to reflect 
local tastes with more  fresh food included. 
C P Company should stop expansion plans in Country P and choose a 
more appropriate location. 
D P Company should replace J as  the manager of expansion in 
Country X. 
E P Company should abandon their st andardised plan in Country X 
and instead tailor their branding and products to be in line with 
successful local restaurants.

Chapter 2 
 71 
5 The risk cube 
Another way of considering risk and it s management is to use the risk cube. 
Risk equals the volume of the cube  
 
Risk is seen as some combination of a threat , exploiting some vulnerability , 
that could cause harm to an asset . 
Residual risk is the combined function of: 
 a threat less the effect of threat-reducing safeguards; 
 a vulnerability less the effect of  vulnerability-reducing safeguards; and 
 an asset less the effect of asset value-reducing safeguards. 
Managing the risk can be undertaken by reducing the threat, reducing the 
vulnerability and/or reducing the asset value. 
For example, imagine a company sells ma chine parts on credit to industrial 
The threat might be that the customer  doesn't pay for their machine parts. 
The vulnerability might be that the selli ng company has a low cash balance and 
therefore needs the funds to pay its own suppliers. 
The asset is the receivable due. The threat-reducing safeguards might in clude performing a credit check on all 
The vulnerability-reducing safeguards might include holding a minimum cash 
balance at all times to ensure sufficient  cash is available to pay suppliers. 
The asset-reducing safeguards might in clude setting a limit on each receivable 
balance, so that once it is reached no further goods would be supplied to a customer until payment was made.

72 
 Test your understanding 18 – Twinkletoes (Case study) 
 Scenario 
You are the management accountant  of a large private company, 
Twinkletoes. Twinkletoes manufac tures a high volume of reasonably 
priced shoes for elderly people. The company has a trade receivables ledger that is material to the financia l statements containi ng four different 
categories of account. The categories of account, and the risks associated with them, are as follows: 
(i) small retail shoe shops. These accounts represent nearly two thirds 
of the accounts on the ledger by  number, and one third of the 
receivables by value. Some of  these customers pay promptly, 
others are very slow; 
(ii) large retail shoe shops (includi ng a number of overseas accounts) 
that sell a wide range of shoes. So me of these accounts are large 
and overdue; 
(iii) chains of discount shoe shops that buy their inventory centrally. 
These accounts are mostly well-e stablished `high street' chains. 
Again, some of these acc ounts are large and overdue; and 
(iv) mail order companies who sell  the company's shoes. There have 
been a number of large new accounts in this category, although there is no history of irrecove rable debts in this category. 
Receivables listed under (ii) to (iv)  are roughly evenly split by both value 
and number. All receivables are d ealt with by the same managers and 
staff and the same internal contro ls are applied to each category of 
receivables. You do not consider that using the same managers and staff, and the same controls, is nece ssarily the best method of managing 
the receivables ledger. 
Trigger 
Twinkletoes has suffered an increasi ng level of irrecoverable debts and 
slow payers in recent years, mostly  as a result of small shoe shops 
becoming insolvent. The company has also lost several overseas accounts because of a requirement for them to pay in advance. 
Management wishes to expand the overseas market and has decided that overseas customers will in future be allowed credit terms. 
Task 
Management has asked you to classify the risks associated with the 
receivables ledger in order to manage trade receivables as a whole more 
efficiently. You have been asked to classify accounts as high, medium or low risk. 
Write an email to t he finance director: 
(a) Classifying the risks relating to the four categories of trade 
receivables as high, medium or low and explain your classification 
(Note : More than one risk classification may be appropriate within 
each account category.)

Chapter 2 
 73 
 (b) Describing the internal contro ls that you would recommend to 
Twinkletoes to manage the risks associated with the receivables 
ledger under the headings: all custom ers, slow paying customers, 
larger accounts, and overseas customers. 
6 Risk reporting 
Risk reports now form part of UK annual r eports. It is an important disclosure 
requirement. (Examples of these are available on larger companies’ websites. 
Candidates are encouraged to read some.) 
Managers of a business, and external st akeholders, will require information 
regarding the risks facing the business. A risk reporting system would include: 
 A systematic review of the ri sk forecast (at least annually). 
 A review of the risk strategy and responses to significant risks. 
 A monitoring and feedback loop on action taken and assessments of 
significant risks. 
 A system indicating material change to business circumstances, to provide 
an ‘early warning’. 
 The incorporation of audit work as part of the monitoring an information 
gathering process.  
 
 Marks and Spencer plc – Risk report extract 
 Within Marks and Spencer's annual report for 2013 there is a risk report 
section. This has been duplicated in part below. 
It states their approach to risk m anagement and key areas of focus: 
What is our approach to risk management? 
The Board has overall accountability fo r ensuring that risk is effectively 
managed across the Group and, on behalf of the Board, the Audit 
Committee reviews the effectivene ss of the Group Risk Process. 
Risks are reviewed by all business areas on a half-yearly basis and 
measured against a defined set of likeli hood and impact crit eria. This is 
captured in consistent reporti ng formats, enabling Group Risk to 
consolidate the risk information and su mmarise the key risks in the form 
of the Group Risk Profile. 
Our Executive Board discusses the Group Risk Profile ahead of it being 
submitted to the Group Board for final approval. 
To ensure our risk process drives im provement across the business, the 
Executive Board monitors the ongoi ng status and progress of action 
plans against key risks on a quarterly basis. 
Risk remains an important considerati on in all strategic decision-making 
at Board level, including debate on risk tolerance and appetite

74 
 Key areas of focus 
During the year we have focused on a number of key areas: (1) Evolving risk descriptions 
As time progresses, the nature of some Group risks is evolving. To 
ensure we continue to address the most important risks facing the 
Group at this point in time we hav e updated a number of risk titles 
and descriptions. New titles are a ssigned to GM product (2012: Our 
customers) and Food safety and integrity (2012: Food safety). New descriptions are in place for International and Our people. 
(2) Action plans for key risks 
We continue to assess whether sufficient additional mitigating 
activities are underway to reduce t he net risk position of the Group’s 
key risks. By considering net risk on both a one year and three year 
horizon, we are able to identify when mitigating activities will result 
in a tangible risk reduction. We also continue to review the ongoing appropriateness of actions to ensure they are as relevant, timely 
and measurable as possible. 
(3) Influence of risk tolerance 
Risk tolerance and appetite are import ant considerations in strategic 
decision-making at Board level. We also recognise the value in applying the concept of risk tolerance in discussions across all levels of the organisation. It is especially beneficial when 
determining the nature of mitigati ng activities and their role in 
addressing risk likelihood or impact. 
Our principle risks and uncertainties 
As with any business, we face risks and uncertainties on a daily basis. It 
is the effective management of these that places us in a better position to 
be able to achieve our strategic obj ectives and to embrace opportunities 
To achieve a holistic view of the risks facing our business, both now and 
in the future, we consider those that are: 
 external to our business; 
 core to our day-to-day operation; 
 related to business change activity; and 
 those that could em erge in the future. 
Overleaf are details of our principa l risks and the mitigating activities in 
place to address them. It is recogni sed that the Group is exposed to a 
number of risks, wider  than those listed. 
However, a conscious effort has been made to disclose those of greatest 
importance to the business at this moment in time and those that have 
been the subject of debate at recent Board or Audit Committee meetings. 
(Two of the many principle risks and mitigating actions are detailed 
below.)

Chapter 2 
 75 
Economic outlook 
Economic conditions worsen or do not improve, impacting our ability to 
deliver the plan 
As consumers’ disposable incomes come under pressure from price 
inflation and government austerity m easures, trading conditions continue 
to remain a challenge for our business. 
Mitigating activities: 
 Proactive management of costs 
 Regular review of customer feedback and marketplace positioning 
 Continued focus on value proposit ion in the context of a balanced 
product offer, including market leading innovation 
 Ongoing monitoring of pricing and promotional strategies 
 Regular commercial review of product performance 
Food safety and integrity 
A food safety or integrity related incident occurs or is not effectively 
managed 
As a leading retailer of fine qualit y fresh food, it is of paramount 
importance that we manage the safety  and integrity of our products and 
supply chain, especially in light of  the business’ greater operational 
complexity and the heightened risk of  fraudulent behaviour in the supply 
chain. 
 Dedicated team responsible for en suring that all products are safe 
for consumption through rigorous controls and processes 
 Continuous focus on quality 
 Proactive horizon scanning including focus on fraud and 
adulteration 
 Established supplier and depot auditing programme 
(The risk report continues for several pages covering many other risks.) 
The Group Risk Profile reflects the most important risks facing the 
business at this point in time; these risks receive specific attention by the 
Board to ensure that sufficient mitigating activity is in place to reduce net 
risk to an acceptable level. The Group Risk Profile will evolve as these mitigating activities succeed in redu cing the residual risk over time, or 
new risks emerge. As such, we have re moved a number of risks from our 
Group Risk Profile since the prior year: 
Last year we included Business conti nuity on the Group Risk Profile in 
response to the heightened level of ri sk driven by the UK’s summer 2012 
events. With the risk now returning to a normal level it has been removed, 
recognising the strength of our controls in this area

76 
 Financial position, Corporate reputati on, New store format, Key supplier 
failure and IT security have also b een removed in recognition of the 
actions taken to reduce the net risk position. 
The above risks remain important and t hey continue to be monitored as 
part of ‘business as usual’ activities ; however, we consider that they do 
not represent key risks to our business at this time and they have 
therefore been removed fr om the Group Risk Profile. 
Risk interconnectivity 
We continue to recognise the sign ificant interdependency between our 
key risks, which is in part a product of our heavily interconnected business environment (both in term s of systems and processes). The 
following diagrams are based on our cu rrent Group Risk Profile. Both are 
designed to highlight how changes to one risk could impact on those connected to it, and therefore on t he profile as a whole. We have 
incorporated a number of potential emerging risks which do not feature 
on our Group Risk Profile at this point  in time, but could influence our 
business in the longer term, illustrating how emerging risk is considered by the Board. 
 
 A recent SWOT analysis carried out within Y Company showed that the 
organisation is now subj ect to more diverse threats than previously 
documented. This is mainly due to deregulation of Y Company’s industry 
and consequently many new entrants. These new entrants, often from 
other countries, are able to undercut Y Company on price and so gain market share. 
The directors believe they have appropria te measures in place to identify 
and manage the new risks t hat Y Company faces bu t are concerned that 
Y Company’s stakeholders should be able to access information relating to company’s most up to date risks. Y Company’s risk profile has evolved 
since the prior year. 
The company wishes to convey, via an annual risk report, that risk 
remains a key consideration in all strategic decision making.

Chapter 2 
 77 
 Which of the following should be  included in Company Y’s risk 
reporting system? 
A A detailed review of Y Company’s risk strategy and responses to 
risks it faces. 
B A monitoring and feedback loop on action taken and assessments 
of significant risks such as thos e resulting from new entrants. 
C A system indicating material change to Y Company’s industry 
circumstances, to provide an ‘early warning’. 
D The incorporation of audit work  as part of the monitoring and 
information gathering process. 
E A systematic review of the risk forecast (at least quarterly). 
7 Gross and net risk 
Risk reports should show: 
 the gross risk  = an assessment of risk before  the application of any 
controls, transfer or management responses, and 
 the net risk  (or residual risk ) = an assessment of risk,  taking into account 
the controls, transfer and management responses i.e after  any controls 
have been implemented to facilitate a re view of the effectiveness of risk 
responses. 
An example of gross and net risk assessments, utilis ing the risk map 
(impact/likelihood matrix) is shown below:

78 
 If the residual risk is considered to  be too great then the company will 
need to: 
 not expose itself to the risk situation; or 
 put in place better c ontrols over the risk. 
The amount of residual risk a company can bear is ultimately a 
management decision. 
 It is possible to measure that resi dual risk, possibly as a proportion of 
profit/capital/turnover, in order  to help management make that 
judgement. 
 
 Ability to bear risk 
 One approach to assessing the ability to bear a risk is to consider its 
financial consequences in relation to: 
 the organisation’s profits 
 return on capital employed 
 the organisation’s expenditure budget  (not-for-profit organisations). 
For example, suppose that  the financial consequences of a particular risk 
have been estimated as a potential loss of $200,000. For an organisation 
making annual profits of, say, $200 m illion, this might seem relatively 
insignificant. On the other hand, for an organisation with annual profits of 
just $250,000, say, the risk w ould be much more significant. 
An organisation might establish poli cy guidelines as to the maximum 
acceptable residual risk fo r any individual risk, or  set risk limits to the 
maximum acceptable loss on particular operations. 
 
 Gross and net risk example 
 Using the earlier example of the ri sk register we can show gross and net 
(or residual risk): 
result in personal identifiable information being lost, stolen or 
unauthorised access gained. 
(2) Likelihood = 3 (3) Impact = 5 (4) Risk owner = Mike Smith (IT manager) (5) 1.1.X2 (6) 2.2.X4 (7) Staff receive training every 2 y ears which highlights the risks. All 
(8) Overall risk rating = 7 (Gross risk)

Chapter 2 
 79 
 (9) Encryption technology is im plemented which meets industry 
standard. 
(10) Mike Smith (11) 31.7.X4 (12) Risk level = 3 (Net or residual risk) 
By implementing the encryption tec hnology the risk has reduced from a 
score of 7 to a score of 3. This means  that there is still some risk but far 
less than there was. Management will have to consider whether a level 3 
risk is acceptable or whether furthe r controls need to be implemented to 
achieve a lower score, and at what cost. 
 
 TGDW are assessing a new contract to provide maintenance services for 
a prestigious office complex. Should  the complex be unable to function 
for more than 5 hours due an error or om ission by TGDW, they will face a 
fine of sufficient magnitude to cause the company severe financial difficulty. The directors assessed t he gross risk as high impact and due to 
the complexity of the systems mainta ined there is high probability of an 
error occurring. The client is unwi lling to reduce the penalty or to change 
the criteria and TGDW’s in ternal controls are al ready at a high level. 
Using TARA what action should TGDW take? 
A Transfer 
B Avoid C Reduce D Accept 
8 Evaluating risk management strategy 
Once the company has established its risk strategy and decided in what areas it 
will reduce its risks and the methods it  will use to achieve the desired 
reductions, the strategy should be evaluated. 
The purpose of the evaluation is  two-fold, as shown below:

80 
 Has the strategy been successful? 
 Within the risk management strate gy, targets should be included to enable 
the company to assess whether t he risk strategy objectives have been 
achieved. For example, a company might  set a target for risk of faulty 
products at a set number or perce ntage level and then formulate a risk 
strategy to achieve that level. In or der to assess this, a control mechanism 
will need to be set up. The basic c ontrol idea is that the company 
compares the actual results with a required target and assesses whether 
the target has been achieved.  If not, the reasons must be investigated and 
action taken, including possibly a re-assessment of the risk strategy  
Do benefits outweigh costs? 
 The costs and benefits of risk measures such as internal controls can be 
evaluated, and a cost-benefit comparison carried out. 
 The benefits from risk controls should preferably be measured and 
quantified, although some benefits (suc h as protecting the company’s 
reputation) might have to be assessed qualitatively. 
 The evaluation process should be based on the principle that the costs of 
a control measure should not exc eed the benefits that it provides. 
– For example, a company could be very concerned about theft of 
petty cash and therefore introduce c ontrols limiting the cash held to 
£25 and also requiring daily reconcil iations of the cash balance by 
the financial controller, with observati on by a member of the internal 
audit department. 
– This control would probably redu ce theft, but would be very 
expensive for the company to operate and as a result the costs would exceed the benefits. The cont rols set up must be proportionate 
to the potential losses that could occur if the risk results in losses 
 
 Cost-benefit example 
 A manufacturing company is concerned about the rate of rejected items 
from a particular process. The current rejection rate is 5% of items input, 
and it has been estimated that each reje cted item results in a loss to the 
company of $10.Each day 600 items go through the process. 
It is estimated that by introducing ins pections to the process, the rejection 
rate could be reduced fairly quickly to 3%. However, inspections would result in an increase of costs of $70 per day. 
Required: 
How should this control through inspection be evaluated? 
Solution 
The example is a simple one, but it is useful for suggesting an approach 
to risk management and control evaluation.

Chapter 2 
 81 
 What is the objective of the control? 
Answer: To reduce losses from rejected items from the process, initially 
from 5% to 3% of input. 
What is the expected benefit? Answer: A reduction in rejects by 2%  of input, from 5% to 3%. The 
reduction in rejects each day is (2% × 600) 12. Since each reject costs $10, the total daily saving is $120. 
What is the expected co st of the control? 
Answer: $70 per day. Therefore the c ontrol appears to be worthwhile in 
achieving the objective. 
Is the control effective? 
Answer: This should be established by monitoring actual results. For 
example, if the control costs $70 eac h day, but succeeds in reducing the 
rejection rate from 5% to  just 4% (a reduction of 1%), the benefits would 
be only $60 each day and the control w ould not be cost-effective (unless 
the savings are more than $10 per unit). 
 
 Interaction between risks 
Risk identification is very important, bec ause risks are often interrelated. This 
means that if one risk is more likely or will have a more significant impact for an 
organisation, then it may be more likely to  be exposed to other risks or more 
susceptible to other risks. 
This is a theme throughout P3, but it is highl ighted to here to make sure that it is 
something that is in your thought proc esses as you go through the rest of the 
material. 
Here are some examples:

82 
 A café in a busy seaside resort would have compliance risk, it will be 
assessed on its food hygiene and if it  did not meet t he standards that 
have been set it may receive fi nes and it would be published on 
government websites and also on revi ew websites that the food hygiene 
is poor.  
This leads to other risks:  
 Financial risk in that it will have to  pay any fines it receives by a 
particular date. 
 Reputation risk because customer ar e likely to check these things 
and avoid cafés that do not perform  well on this criteria and also 
warn friends, family and colleagues.  
 Litigation risk because someone may become ill after eating at the 
café due to the poor food hygiene and may take legal action against 
the café. 
 
 WZL Plc a waste disposal company, have been found to have knowingly 
breached environmental legislation about the disposal of hazardous 
waste. This is an example of a co mpliance risk and they stand to receive 
a substantial fine as a result. T he issue occurred because an employee, 
despite training and internal policies,  ignored the information that the 
customer provided about the wa ste and how hazardous it was. 
Which of the following risks are likely to increase as a result of this 
breach? 
A Financial risk B Reputational risk C Commodity price risk D Economic risk E Currency risk F Fraud risk 
Another consideration in the interaction between risks is the combining of risks.  
Sometimes for the end result to occur, mu ltiple risks have to combine. Some of 
the techniques in this chapter, such as  expected values, can help to quantify 
that combination.

Chapter 2 
 83 
 Risks combining 
 A company could be considering t he risk of somebody breaking into a 
warehouse to steal some of the invent ory. The company has controls in 
place already, with an alarm system fitted, and security guards patrolling the warehouse. 
They have identified the following: 
 The risk of an intruder ge tting past the alarm is 30% 
 The risk of an intruder getting past the guards is 25% 
This means the overall risk of  the intruder getting in is: 
0.3 × 0.25 = 7.5% 
One of the treatm ents of risk discussed in this chapt er is diversification, and the 
idea of creating a portfolio of products or services to help manage risks. This is 
another example of how risks interact. In this case we are considering the up 
and downside risk that we first discussed in chapter 1.  The portfolio will have different risks and the idea is that t hey could offset one another – one product 
does well while another struggles. In an i deal world all of the organisation’s 
portfolio does well, but if demand is affect ed by different factors then they might 
tend to even out overall.

84 
 9 Risk management role s and responsibilities 
 
If the company being considered is  divisional there may be a risk officer  for 
each division who will help to identify and manage tactical and operational level 
risks.

Chapter 2 
 85 
All employees  have a role and responsibilit y for risk too. You should be aware  
of possible risks (through policies iss ued and training given) and you should be 
audible if you believe a risk needs to be managed (by reporting it to your 
manager or by whistleblowing). 
 
 Roles of the risk committee 
 In broad terms, the risk (management ) committee within an organisation 
has the following main aims: 
 Raising risk awareness and ensuring appropriate risk management 
within the organisation. 
 Establishing policies for risk management. 
 Ensuring that adequate and efficient processes are in place to 
identify, report and monitor risks. 
 Updating the company’s risk pr ofile, reporting to the board and 
making recommendations on the ri sk appetite of the company.  
Supporting these objectives of the risk (management) co mmittee, there 
are many secondary objectives. These objectives may also be contained in the terms of reference of  the risk (management) committee. 
 Advising the board on the risk prof ile and appetite of the company 
and as part of this process overs eeing the risk assurance process 
within the company. 
 Acting on behalf of the board, to ensure that appropriate 
mechanisms are in place with res pect to risk identification, risk 
assessment, risk assurance and overall risk management. 
 Continual review of the company’s  risk management policy including 
making recommendations for amendment of that policy to the board. 
 Ensuring that there is appropriate  communication of risks, policies 
and controls within the company to employees at all management 
levels. 
 Ensuring that there are adequate tr aining arrangements in place so 
management at all levels are aware of their responsibilities for risk 
 Where necessary, obtaining appropriate external advice to ensure 
that risk management processes ar e up to date and appropriate to 
the circumstances of the company. 
 Ensuring that best practices in risk management are used by the 
company, including obtaining and implementing external advice 
where necessary.

86 
 Typical activities carried out by a risk manager include: 
 Provision of overall leader ship for risk management team. 
 Identification and eval uation of the risks affecting an organisation 
arising from that organisation’s bu siness, operations and policies. 
 Implementation of risk mitigation strategies including appropriate 
internal controls to manage identified risks. 
 Seeking opportunities to im prove risk management methodologies 
and practices within the organisation. 
 Monitoring the status of risk mitiga tion strategies and internal audits, 
and ensuring that all reco mmendations are acted upon. 
 Developing, implementi ng and managing risk management 
programmes and initiatives incl uding establishment of risk 
management awareness programme s within the organisation. 
 Maintaining good working relationships with the board and the risk 
management committee. 
 Ensuring compliance with any laws and regulations affecting the 
business. 
 Implementing a set of risk indica tors and reports, including losses, 
incidents, key risk exposures and early warning indicators. 
 Liaising with insurance companies, particularly with regards to 
claims, conditions and cover available. 
 Depending on specific laws of the jurisdiction in which the 
organisation is based, working with the external auditors to provide 
assurance and assistance in their work in appraising risks and controls within the organisation. 
 Again, depending on the jurisdic tion, producing reports on risk 
management, including any statutor y reports (e.g. Sarbanes-Oxley 
(SOX) reports in the US). 
 
 Northern Rock 
 A failure of risk management 
Perhaps the most interesting example of risk and control was the case of 
Northern Rock. In September 2007 Nort hern Rock plc was a top five UK 
mortgage lender, on the FTSE 100 index with over £100 billion in assets. 
Northern Rock raised over 70% of t he money it used in its growing 
mortgage lending business from banks and other financial institutions. 
Following the global credit cr unch that resulted from the crisis in the US 
sub-prime (high risk) mortgage se ctor, banks stopped lending to each 
other and Northern Rock could not raise sufficient cash to cover its liabilities.

Chapter 2 
 87 
 A bank run (the first on a UK bank for 150 years) on Northern Rock by its 
customers led to the gove rnment providing ‘lender of last resort’ funding 
and guarantees for the bank’s depositor s totalling about £20 billion. The 
result was a 90% fall in the bank’s s hare price, a deteriorating credit 
rating and a loss of reputation. The CEO resigned and several directors 
also left the board. 
Northern Rock had a formal approach to risk management, including 
liquidity, credit, operational and mark et risk, fully described in its 
Securities and Exchange Commission f ilings. Northern Rock’s assets 
were sound so there was no significant  credit risk. Market risk was also 
well managed in terms of interest rate and foreign exchange exposure. 
However, despite formal procedures and a demonstrated compliance with regulations, there was an assump tion by managers that access to 
funds would continue unimpeded. The US sub-prime crisis led to liquidity 
risk materialising, causing t he Northern Rock problems. The 
consequence was also the loss of reput ation that follow ed press reports 
which blamed the bank’s management for not having a contingency plan 
to cover the possibility of disruption to its funding – an oper ational risk. It 
is likely that the board of  Northern Rock failed in monitoring both liquidity 
risk and the effectiveness of  the existing controls. 
The lesson of Northern Rock is that we need to move beyond the tick-box 
approach to compliance and that good governance requires a more insightful approach to risk management and internal control.  
 
 An example of how risk could be dealt with in a retail chain 
 A retail group has 480 stores and sale s of £1.5 billion. Risk management 
is part of the internal audit function.  The internal auditor/risk manager has 
said that the motivation for risk management is to ‘establish best practice 
in corporate governance’ but also co mmented that the business recently 
had ‘problems with its fundamental controls’ when ‘senior management 
were looking at refinancing so took their eye off the ball’. 
The risk management process commenced with a brainstorming session 
by the internal audit team.  They cons idered ‘risk drivers’ to identify what 
could go wrong and what controls could be put in place to address these 
risks. The team then held interviews with all managers to determine the 
effectiveness of these controls using a scale from 1 to 5. The threat of a 
control gap was identified and reco mmendations were made. This list 
looked like a risk register, although t he group did not call it that. The 
internal auditor/risk manager did not see value in a risk register, but 
rather saw risk management as  a high level concern.

88 
 The group’s Risk Management Committ ee (RMC) meets every 2 months, 
comprising all business (executive) directors. The list given by the internal audit team to  RMC showed the monetary value of a ‘fundamental 
control breakdown’, from which was deducted the monetary value arising 
from controls implemented, to give a ‘residual risk’ (i.e. the risk after 
controls) and this was assigned a probability. These values were admittedly subjective. The RMC cons idered the risk maps, which showed 
the percentage probability of a threat  arising and the residual monetary 
risk after taking account of controls. The whole process had been centrally driven, with a concern fo r ‘high level’ risks. The big risks 
identified through this process were: supply chain, suppliers, people management, rebates, cost base, key processes, property management, 
market share, product offering and pr icing, brand management, strategic 
management, integration and change, systems and business continuity. 
The group’s most recent development is a Key Control Improvement Plan 
(KCIP) that provides recommendat ions to address the risks. It 
summarises each risk (the example of supply chain failure was given) 
and the ‘mitigating factors’ (i.e. co ntrols) and what still needs to be done. 
The Audit Committee (AC) of the Boar d is made up of four non-executive 
directors, the external auditors, t he finance director and the internal 
auditor/risk manager and is responsib le for monitoring progress in 
relation to the risk maps. The risk maps  also drive the audit plan which is 
agreed by the AC, the busine ss directors and the RMC. 
The most significant issues are dealt with, for example, purchase 
ordering and goods received, new stores , margins. Results are provided 
to the RMC and AC where the val ue of the report is greater than 
£250,000. Internal audit now has more exposure to decision-makers, as 
the risk management role had gi ven them a high profile.  
Going forward, the internal auditor/ risk manager wants to implement a 
Risk Intelligence Report to  provide early warning of risks. This will involve 
looking at key performance indicato rs to identify what the business 
should be concerned with. The manager also wants to introduce a Risk 
Management Marketing Plan to help communicate risk and to pass on 
the responsibility to other manager s – with senior managers making 
presentations to RMC. The internal  auditor/risk manager expects it to 
take another 2 years to establish risk management in the organisation. 
More ‘bottom up’ controls need to be introduced and risk management  
needs to be embedded at the cultural level.

Chapter 2 
 89 
 An example of how risk could be dealt with in an engineering 
consultancy 
 This organisation is privately owned wit h 3,500 employees. A review of its 
financial performance had re vealed that the estima ted cost of project 
over-runs, non-productive time and c ontractual penalties incurred was 
about 2% of annual turnover. This represented an opportunity loss of 
about £3 million per annum against report ed profits of about  £5 million. 
However, the main driver behind risk management was to address the 
rapidly increasing cost of professional  indemnity insurance.  Premiums 
had increased to several million pounds and its excess had increased 
from £5,000 to £500,000 per annum ov er the last few years. The 
organisation had appointed a risk m anager, adopted an offshore ‘captive’ 
insurer and implemented a management  development programme to 
improve the skills of all its managers.  This had included a substantial 
content on risk awareness. 
One of the ways in which it was helping its managers to understand risk 
was to undertake risk assessments as part of every project bid and to 
reflect each risk in pricing. During contract negotiations, each risk could 
be discussed between the lead consultant  and the client. The value of the 
risk could be discussed – in terms of t he control devices that could be put 
in place by the client to reduce the risk and hence reduce that component 
of the project price th at reflected the risk. 
It was anticipated that this collabor ation between consultant and client 
would reduce risk and lead to a more pr ofitable outcome for both parties. 
 
 Test your understanding 22 – L tinned foods (Case study) 
 Scenario 
L manufactures a range of very high quality tinned foods. The company 
was established eight years ago and it has  grown steadily by selling to 
independent grocers in prosperous areas. Most consumers associate 
tinned food with poor quality and are unwilling to pay high prices. 
However, the consumers who buy L’s products are willing to pay a premium for higher quality. 
L’s only large customer is H, a ma jor supermarket chain that has a 
reputation for selling high-quality pr oduce. L began sales to H just under 
a year ago, with H purchasing sma ll quantities of L’s most popular 
product in order to assess demand. A fter a successful period of test 
marketing, H started to place larger  orders with L. Now H accounts for 
20% of L’s sales by volume.

90 
 Trigger 
L has traditionally had a functional or ganisational structure. There is a 
director in charge of each of sales, production, finance and human 
resources. Each director has a te am of senior managers who support 
their function. The hierarchy for organising and supervising staff is 
generally based on this functional stru cture. The only ex ception arose on 
the appointment of Peter, who is t he Account Manager in charge of L’s 
dealings with H. H insisted on the appointment of a designated account 
manager as a condition of placing r egular, large orders with the company. 
Peter is the designated point of contact on all matters between L and H. 
Peter’s job description states that he is responsible for all decisions, 
including pricing, relating to L’ s relationship with H and that he is 
expected to base all such decisions on the promotion of L’s commercial interests. 
There have been a number of compla ints from L’s managers since 
Peter’s appointment. These include several occasions when staff have 
received contradictory instructions. For example, Peter has ordered the 
production department to give priority to  H’s requests for large deliveries, 
even though that has led to regular  orders to other customers being 
delayed. Peter has also told the staf f in the credit control department not 
to press H for payment even though the company had several overdue invoices. 
L’s Sales Director believes that t he company could sell even greater 
quantities to H and that other large s upermarket chains will start placing 
orders in the near future once H has demonstrated that there is a 
demand for high quality tinned food. She has warned L’s Chief Executive 
that additional account managers will have to be employed in the event 
that L starts to supply further supermarket chains. 
Task 
Write a report to the Board of L which: 
(a) Evaluates the potential risks that  might arise from L’s appointment 
of an account manager to deal  with H’s business; and 
(b) Recommends, stating reasons, the changes that L’s board should 
introduce in order to minimise t he threats arising from having an 
autonomous account manager. 
(40 minutes)

Chapter 2 
 91 
 Test your understanding 23 – Dental practice (Case study) 
 Scenario 
D is a dental practice that was est ablished eight years ago. The practice 
was founded by six dentists, eac h of whom has an equal share. 
Trigger 
The six dentists have decided that  they should undertake a formal 
evaluation of the risks affecting their business. To that end, they have 
engaged a consultant to act as a facilitator. 
The facilitator began with a brainstorming session. The dentists were 
provided with a flipchart and they were asked to list as many risks as they 
could think of. Then the risks were tr ansferred to a risk map based on the 
TARA framework. A simplified versi on of the risk map is shown below: 
  Low High 
Probability/likelihood High Reduce 
Negligence 
claims arising 
from failed dental 
implants Avoid 
Cross infection 
Low Accept 
Spiral staircase Transfer/share 
Unknown 
allergies 
All six dentists agreed that each of these risks is worth classifying, but 
there was considerable debate as to where each should appear on the 
risk map. The facilitator has used the opinion of the dentist who identified 
the risk as a starting point and has asked for some discussion as to how best to classify each. 
Dental implants 
Dental implants are false teeth that ar e rooted in the patient’s jaw using 
titanium screws. Fitting an implant  is a very time-consuming and 
expensive procedure that costs the patient in ex cess of GBP 2,000. The 
patient’s bone structure usually accept s the implant and fuses with it to 
form a very strong bond. In 3-5% of ca ses the implant causes an adverse 
reaction and has to be removed. The practice warns patients of this 
possibility and does not offer any refund in this event because the failure is beyond the dentist’s control. Some patients who suffer an adverse 
reaction do seek compensation despite these warnings, alleging 
negligence on the part of the dentist.

92 
 Cross infection 
Cross infection can occur when patient s pass infections on to the dental 
staff (and vice versa) or when dental instruments transmit infections 
between patients. Apart from the need to  work in close proximity to the 
patient, dental procedures always invo lve contact with the patient’s saliva 
and can sometimes involve contact with blood if a tooth is extracted or 
the patient’s gums bleed. 
Spiral staircase 
The dental surgery is located one floor up from street level. Patients enter 
via a narrow hallway and climb to the reception using a narrow spiral staircase. The building cannot be rem odelled to accept a lift or a more 
suitable staircase. 
Unknown allergies 
The dentists are often required to pre scribe antibiotics and other drugs in 
order to treat gum infections. These can cause severe allergic reactions 
that are impossible to foresee unle ss the patient has been prescribed that 
drug in the past and has notified t he practice of this allergy. 
Task 
(a) Discuss the benefits that the dental  practice may obtain from the 
risk mapping exercise described above. 
(b) Critically evaluate t he placing of each of the identified risks in the 
risk map, stating with reasons wh ether or not you agree with the 
placement. 
 
 Test your understanding 24 – B bank (Case study) 
 Scenario 
The B Bank is a large internationa l bank. It employs 6,000 staff in 250 
branches and has approximately 500,000 borrowers and over 1,500,000 
savers. The bank, which was founded in 1856, has an excellent reputation for good customer servic e. The bank’s share price has 
increased, on average, by 12% in  each of the last 10 years. 
Trigger 
There has been much adverse media coverage in many countries, 
including B Bank’s home country, about the alleged excessive bonuses 
received by the directors of banks. A meeting of central bank governors 
from many nations failed to reach agreement on how to limit the size of 
directors’ bonuses. The governor of t he central bank in B Bank’s home 
country is particularly concerned about  this issue, and consequently put 
forward the following proposal:

Chapter 2 
 93 
 “Directors of banks will be asked to pay a fee to the bank for the privilege 
of being a director. This fee will be set by the remuneration committee of 
each bank. Directors will be paid a bonus based solely on appropriate 
profit and growth indicators. The mo re the bank succeeds, the higher will 
be the bonus. This proposal directly links performance of the bank to directors’ pay. I see this as a more  realistic option than simply limiting 
salaries or bonuses by statute as proposed at the recent central bank 
governors’ conference.” 
B Bank board and strategy 
The constitution of the board of B Bank is in accordance with the 
internationally agreed code of corporate governance. 
Overall board strategy has been to  set targets based on previous 
(profitable) experience, with incr eased emphasis on those areas where 
higher potential profits can be made such as mortgage lending (this is discussed below). The bank’s executiv e information systems are able to 
compute relative product profitability,  which supports this strategy. This 
strategy generated substant ial profits in recent years. The last major 
strategy review took place four year s ago. Non-executive directors do not 
normally query the decisions of  the executive directors. 
In recent years, the profile of t he major shareholders of the bank has 
moved. Traditionally the major shareholders were pension funds and 
other longer term investors but now these are overshadowed by hedge 
funds seeking to improve thei r short-term financial returns. 
One of the major sources of revenue for the bank is interest obtained on 
lending money against securities such as houses (termed a “mortgage” in many countries) with repayments being due over periods varying 
between 15 and 25 years. Partly as a re sult of intense competition in the 
mortgage market, the values of the mortgages advanced by B Bank regularly exceed the value of the properties. For example, B Bank has 
made advances of up to 125% of a proper ty’s value. Internal reports to 
the board estimate that property prices  will reverse recent trends and will 
rise by 7% per annum for at least the next 10 years,  with general and 
wage inflation at 2%. B Bank intends  to continue to obtain finance to 
support new mortgages with loans from  the short-term money-markets. 
Task 
Write a report to the Board: 
(a) Evaluating the proposal made by the governor of the central bank; 
and 
(b) Evaluating the risk management st rategy in B Bank (except for 
consideration of directors’ rem uneration). Your evaluation should 
include recommendations for changes that will lower the bank’s exposure to risk. 

94 
 Test your understanding 25 – W consumer (Case study) 
 Scenario 
W is a leading manufacturer of co nsumer electronics devices. The 
company has a significant share of  the markets for mobile phone and 
personal music players (“mp3 players ”).W’s main areas of expertise are 
in design and marketing. The company  has a reputation for developing 
innovative products that set the trend for the market as a whole. New 
product launches attract a great deal of press interest and consequently 
W spends very little on advertising. Mo st of its promotional budget is 
spent on maintaining contact with l eading technology journalists and 
editors. 
Manufacturing and supply 
W does not have a significant manufac turing capacity. New products are 
designed at the company’s research l aboratory, which has a small factory 
unit that can manufacture prototypes  in sufficient quantity to produce 
demonstration models for test and pub licity purposes. When a product’s 
design has been finalised W pays a num ber of independent factories to 
manufacture parts and to assemble products, although W retains control of the manufacturing process. 
W purchases parts from a large number  of suppliers but some parts are 
highly specialised and can only be  produced by a small number of 
companies. Other parts are standar d components that can be ordered 
from a large number of sources. W chooses suppliers on the basis of 
price and reliability. 
All assembly work is underta ken by independent companies. 
Assembly  
work is not particularly sk illed, but it is time cons uming and so labour can 
cost almost as much as parts. 
 W has a large procurement department that organises the 
manufacturing process. A typical cycle for the manufacture of a 
batch of products is as follows: 
 W’s procurement department orders the necessary parts from parts 
suppliers and schedules assembly work in the electronics factories. 
 The parts are ordered by W but are delivered to the factories where 
the assembly will take place. 
 The finished goods are delivered directly to the customer. 
This is a complicated process because each of W’s products has at least 
100 components and these can be purchased from several different countries
.

Chapter 2 
 95 
 Supplier communications 
W insists on communicating with its suppliers via electronic data 
interchange (EDI) for placing orders and also for accounting processes 
such as invoicing and making payment. This is necessary because of the degree of coordination required for so me transactions. For example, W 
may have to order parts from one supplier that are then delivered to 
another supplier to carry out some asse mbly work. Both suppliers have to 
be given clear and realistic deadlines so that the resulting assemblies are 
delivered on time to enable W to meet its own deadlines. 
Trigger 
W recently launched a new range of m p3 players. The launch of the first 
batches of players attracted a great deal of adverse publicity: 
The supplier which produces the unique memory chips used in the mp3 
player was unable to meet the deliver y deadlines and that delayed the 
launch. The supplier owns the patent  for the design of these memory 
chips. 
Supplies of the memory chip are now available. The assembly factories 
have been asked to increase their rates of production to shorten the timescale now that the memory chips have become available. 
Task 
Write a report to W's finance director: 
(a) Evaluating THRE E operational risks associated with the 
manufacture of W’s products including an explanation of how each of these risks could be managed; and 
(b) Evaluating the risks associated wi th the use of EDI for managing 
W’s ordering and accounting processes. 
 
 Test your understanding 26 – SPM (Case study)  
 Scenario 
SPM is a manufacturer and distributor of  printed stationery products that 
are sold in a wide variety of retail stores around the country. There are 
two divisions: Manufacturing and Distri bution. A very large inventory is 
held in the distribution warehouse to cope with orders from retailers who 
expect delivery within 48 hours of placing an order. 
SPM’s management accountant for the Manufacturing division charges 
the Distribution division for all goods transferred at the st andard cost of 
manufacture, which is agreed by each division during the annual budget cycle. The Manufacturing division make s a 10% profit on the cost of 
production but absorbs all production va riances. The goods transferred to 
Distribution are therefor e at a known cost and physically checked by both 
the Manufacturing and the Distributi on division staff at the time of 
transfer.

96 
 Trigger 
The customer order process for SPM’s Distribution division is as follows: 
 SPM’s customer service centre receives orders by telephone, post, 
fax, email and through a new on-li ne Internet ordering facility (a 
similar system to that used by Amazon). The customer service 
centre checks the creditworthi ness of customers and bundles up 
orders several times each day to  go to the despatch department. 
 All orders received by the despat ch department are input to SPM’s 
computer system which checks st ock availability and produces an 
invoice for the goods. 
 Internet orders have been credit checked automatically and stock 
has been reserved as part of the order  entry process carried out by 
the customer. Internet orders automatically resu lt in an invoice being 
printed without additional input. 
 The despatch department uses a copy of the invoice to select goods 
from the warehouse, which are t hen assembled in the loading dock 
for delivery using SPM’s own fleet of delivery vehicles. 
 When SPM’s drivers deliver t he goods to the customer, the 
customer signs for the receipt and the signed copy of the invoice is 
returned to the despatch office and then to the accounts department. 
 SPM’s management accountant fo r the Distribution division 
produces monthly management reports based on the selling price of 
the goods less the standard cost of  manufacture. The standard cost 
of manufacture is deducted from the inventory control total which is 
increased by the value of in ventory transferred from the 
manufacturing division. The control total for inventory is compared 
with the monthly inventory valuat ion report and while there are 
differences, these are mainly the resu lt of write-offs of damaged or 
obsolete stock, which are recor ded on journal entry forms by the 
despatch department and sent to  the accounts department. 
Due to the size of inv entory held, a physical sto cktake is only taken once 
per annum by Distribution staff, at t he end of the financial year. This has 
always revealed some stock losses, although these have been at an acceptable level. Both internal and external auditors are present during 
the stocktake and check selected it ems of stock with the despatch 
department staff. Due to the range of pr oducts held in the warehouse, the 
auditors rely on the despatch department staff to identify  many of the 
products held. 
Task 
(a) Evaluate any weaknesses in the risk management approach taken 
by SPM’s Distribution division an d how this might affect reported 
profitability. (30 minutes)  
(b) Recommend internal control improvements that would reduce the 
likelihood of risk. (15 minutes)

Chapter 2 
 97 
  SPM’s management accountant fo r the Distribution division 
despatch department and sent to the accounts department. 
department staff. Due to the range of products held in the warehouse, the 
auditors rely on the despatch department  staff to identif y many of the 
Task 
(b) Recommend internal control im provements that would reduce the 
likelihood of risk. (15 minutes)  
 
 Test your understanding 27 – ABC (Case study) 
 Scenario 
The operations division of ABC, a lis ted company, has responsibility to 
maintain and support the sophistic ated computer systems used for call 
centres and customer database managemen t. These are relied on by the 
organisation’s retail customers as m any of their sales are dependent on 
access to these systems, which are accessed over the Internet. 
Although there is no risk managem ent department, ABC has a large 
number of staff in the operations division devot ed to disaster recovery. 
Contingency plans are in operation and data are backed up regularly and 
stored off-site. However, pressures fo r short-term profits and cash flow 
have meant that there has been a cont inuing under-investment in capital 
equipment.

98 
 Trigger 
A review of disaster recovery f ound that although data were backed up 
there was a real risk that a severe ca tastrophe such as fire or flood would 
have wiped out computer hardwar e and although data back-up was off-
site, there was no proven hardware fac ility the company could use. While 
managers have relied on consequential loss insurance, they appear to have overlooked the need to carry out actions themselves to avoid or mitigate any possible loss. 
Task 
(a) Advising on the main business issue for ABC and the most 
significant risks that ABC faces; (10 minutes)  
(b) Advising them on their responsibilities for risk management and 
recommending a risk management system for ABC that would more effectively manage the risks of losing business continuity. 
(c) Evaluating the likel y benefits for ABC of an effective risk 
management system for business continuity. (5 minutes)  
10 The exam 
The models and frameworks detailed in this chapter are a starting point for the 
exam, however, candidates need to be able to use their common sense in order 
to relate this material to  exam questions in both t he P3 objective test and the 
strategic case study exam.

100  
 The correct answer is B – By definition.  
 
 A, B and E 
COSO considers a WIDE range of risks, and is the responsibility of 
EVERYONE. 
 
 D 
The management are worki ng on their risk response, which is included in 
the performance component. 
 
 The correct answer is B – A risk map assesses an organisation’s risks on 
the basis of likel ihood and consequence. 
Risk culture is the set of shared a ttitudes, values and practices that 
characterise how an entity considers risk in its day-to-day activities. 
Risk thermostat is the not ion that everyone has a propensity to take risks. 
This varies by person and is influenced by potential rewards and any previous ‘accidents’. 
 
 The correct answers are A, B and C – The total cost of a control is not 
normally detailed on the risk register.

Chapter 2 
 101 
 The expected value of purchases is: 
 £ 
£200,000 × 0.3 60,000 
£250,000 × 0.5 125,000 
£300,000 × 0.2 60,000  –––––– 
 245,000 
 –––––– 
The volatility therefore is: 
Downside (£300,000 – £245,000) £55,000 
Upside (£245,000 – £200,000) £45,000 
The volatility is the possible amou nt away from the expected value. 
 
 The value of $10 million today is  £6 million ($10 m/$1.6667) with a 
standard deviation of £30,000 (0.5% × £6 million). 
The one-tail 95% confidence level is 1.645. Hence a five day 95% VaR is 1.645 × £30,000 × √10 = £156,058 
 
 At the 95% confidence level the va lue at risk = 1.645 × 4.85 = $8 million 
(1.645 is the normal distribution value for a one-tailed 5% probability level 
– this can be taken from the normal distribution tables). 
As the information is for the 2 week period, and not a daily mean or 
standard deviation, there is no need to  use the n day VaR adjustment. 
There is thus a 5% probability that  the portfolio value will fall to $42 

102  
 For a restaurant: 
  Low High 
Probability/likelihood High A staff member is  
taken ill and 
cannot work 
 Head chef 
resigns 
Low Accept 
Spiral staircase Ingredient prices 
Several 
customers 
suffer from food 
poisoning 
 
Each suggestion could arguably be in a different quadrant, depending on 
the restaurant. These are just suggestions. 
 
 The correct answer is B – Low-level staff frequently change jobs in order 
to progress. The severity is low as they are unlikely to be well-
trained/highly skilled and could be r eplaced fairly quickly and easily. 
 
 The correct answers are A and C – The axes are likelihood/probability 
and impact/severity/consequences. 
 
 C, D and E 
 Option A – managers may not ag ree on the key risks facing HH. 
The risk map will force them to discuss risks but not to reach a 
consensus. 
 Option B – the legal disputes are ongoing and a new risk map is 
unlikely to help with historical cases. 
 Options C, D and E are benefits.

Chapter 2 
 103 
 The correct answer is C – Portfolio theory seeks to diversify the 
company’s activities which can reduce risk (by not putting all your eggs in one basket). 
 
 Arguments for and against diversification: 
For 
 Reduces risks and enables company to give more predictable return 
to investors. 
 Attracts investors who w ant low risk investments. 
Against 
 Management may not understand a ll the businesses that the 
company operates in – increases the risk. 
 It is not necessary to diversify for investors – they can diversify 
themselves by investing in a number of different companies. 
 New business areas can attract ri sks – for instance going into a new 
country may increase the risk of not understanding a company 
culture. 
 
 The correct answer is C – The likelih ood of this event would hopefully be 
low as several controls preventing th is should be in place. Staff would 
refuse to work otherwise. The consequence of such an event would be high as it would likely lead to an investigation, legal proceedings, 
compensation and reputational risk. 
 
 The correct answer is C – Low frequency/high severity risks are often 
transferred, by using insurance for example.

104  
 A and B only 
 Option A: Is appropriate since t he population of Country X are not 
familiar with fast food. 
 Option B: Often organisations need to adapt their standardised 
products because of cultural differences. 
 Option C: Significant in vestment is likely to have already occurred in 
Country X and simply pulling out before embarking on other risk 
response plans is unlikely to be appropr iate at this point. In addition, 
the entire strategy of P Company  is based around geographical 
expansion. It will be more difficult in some countries to establish the 
brand. 
 Option D: The poor performance of  restaurants in Country P is 
unlikely to be J’s fault rather it  is due to rolling out standardised 
products in culturally diverse locations. In fact, since J has now built up some experience in Country X, he should be retained to continue 
 Option E: The global brand of P Company is based on uniformity 
and although small tweaks to this make sense to enable the 
restaurants to ‘fit’ wit h the local culture, the brand needs to be 
consistent with values applied globally. 
 
 To:  The Finance Director 
Date:   Today 
Subject:   Risk management at Twinkletoes 
Dear Finance Director, 
Please find attached my classificati on of risks for receivables and a 
recommendation for internal controls. 
(a) Classification of risks for receivables 
(i) Small retail shoe shops  
Despite the fact that individual  accounts in this category have 
small balances, the category as a whole is significant to 
Twinkletoes because of the to tal amounts owed (one-third of 
total receivables), the rising le vel of irrecoverable debts and 
the adverse effect of slow payers on cash flow. It is likely that 
most of these accounts individually are low risk because customers pay promptly and t he amounts are small. Accounts 
that are significantly overdue may be classified as medium 
risk, but probably only if they  are substant ial accounts, 
because all entities must expect to experience a small number 
of small irrecoverable debts. If,  however, a large number of 
accounts are significantly over due, they may be classified as 
high risk.

Chapter 2 
 105 
 (ii) Large retail shoe shops 
Some of these accounts are large and overdue and may 
therefore be classified as medi um or high risk. However, as 
the total value of such a ccounts is around 22% of total 
receivables and the total value of the overdue accounts may 
be small in relation to total receivables, the classification should probably only be medium risk. The classification for 
accounts that are not overdue may be low risk 
Overseas accounts. Whilst these might at first appear to be at 
risk because the accounts are being lost, they represent a small proportion of account s by both number and value 
(customers currently pay in advance). This means that they 
may be viewed as low risk. 
(iii) Chains of shoe shops  
As with the large shoe shops, large and overdue accounts 
might be classified as medium or high risk. However, 'high 
street' chains of well-estab lished shops are less likely to 
become insolvent than less well-established entities and therefore represent a lower risk. This means that the 
classification may be low risk, even for accounts that are large 
and overdue. 
(iv) Mail order companies  
New accounts generally represent an increased risk of 
irrecoverable debts and a large number of new accounts increases this risk. However, there is no history of irrecoverable debts in this category at all so the new accounts may therefore be classified as medium risk. Existing accounts 
within this category may be classified as low risk because there is no history of  irrecoverable debts. 
(b) Internal controls  
(i) All customers  
I would recommend that: – credit checks be performed when new customers seek 
credit, and that cash in advanc e or on delivery is required 
where large orders are placed by new customers; 
– credit limits be set for all cu stomers based on the length 
of the relationship with the cu stomer, the volume of sales 
and their payment history; 
– payment terms be set (say, 30 days for local customers, 
45 days for overseas customers); 
– insurance be taken out against the risk of irrecoverable 
debts. 
These controls will help ensur e that accounts do not become 
overdue, damaging the company's cash flow and increasing 
the risk of irrecoverable debts.

106  
 (ii) Slow paying customers 
I would recommend that: – dedicated staff are assigned to chase slow payers 
regularly for outstanding am ounts and to ensure that a 
`stop' is put on accounts that  are significantly overdue; 
– legal action is taken agains t those customers owing large 
amounts for long periods fo r which there are no good 
reasons. 
(iii) Larger accounts – large shops , chains of shops and mail order 
companies 
I would recommend that: – dedicated staff are assigned to manage the relationship 
with larger customers, par ticularly the mail order 
(iv) Overseas customers  
I would recommend that: – overseas customers be allo wed a credit period of say, 45 
days in order to permit the required bank transfers to take place; 
– overseas customers be required to pay in the currency 
used by Twinkletoes (except  perhaps for large orders 
which may be backed by government guarantees) or in a stable currency which does not fluctuate significantly against the currency used by Twinkletoes. 
If you have any queries, please do not hesitate to ask. Best wishes Management Accountant 
 
 B, C and D 
 Option A – responses to significant risks only. 
 Option E – such a review should be carried out at least annually.

Chapter 2 
 107 
 B – avoid 
It would appear that the gross risk cannot be reduced since the client will 
not renegotiate the level of the penal ty. The impact then remains high 
and as TGDW’s internal controls are al ready at a high level it is unlikely 
that the likelihood can be reduced. 
As the likelihood is high then it is  unlikely that TGDW will able to get 
insurance against this event occurring so transference is not possible. 
Acceptance is unthinkable in this ca se and there appears to be no further 
scope for reduction. 
Therefore unless TGDW are an exce ptionally risk seeking organisation 
they will need to avoid this risk. 
 
 A, B and F 
 Option A – as they will receive a significant fine, this will increase 
the financial pressure on the company. 
 Option B – as disposal of waste is their core work, companies may 
be reluctant to use them having breached regulations. 
 Option F – the issue occurred through employee malfeasance, and 
suggests a lack of controls are in place which could mean that fraud 
is more likely. 
 Option C, D and E – There are no commodities or foreign currencies 
involved and economic risk links to how changes in the economy 
will affect the business. 
 
 To:  The Board of L 
From:   A.N. Accountant 
Subject:   Risks and recommendations regarding account managers 
This report evaluates the potential risks that might arise from L’s 
appointment of an account manager to  deal with H’s business. It then 
goes on to recommend the changes that L’s board should introduce in order to minimise the threats aris ing from having an autonomous account 
manager.

108  
 (a) The risks of appointing an account manager 
L has effectively introduced a ma trix management structure with 
respect to its dealings with H. This  has the potential for a number of 
upside risks. In particular, it me ans that H’s interests will be kept 
under constant review by a desig nated manager. Thus, there is less 
risk that H’s business will be lost  because of an oversight or a 
breakdown in communications. If any of the decision makers at H 
require anything then they know to contact Peter and he will then be responsible for dealing with their request. 
There are a number of downsi de risks arising from this 
arrangement. The most obvious of these is that there may be a 
conflict between Peter’s role as an account manager and the roles of the other functional managers within L. H is an important 
customer, but it accounts for only 20%  of sales by volume and so it 
could be argued that the smaller cu stomers are, collectively, far 
more important than H. Presumably,  H is capable of negotiating 
significant trade discounts and so the additional volume of business is unlikely to be particularly profitable. 
Peter’s role may be important, but t here is a danger that it will lead 
to dysfunctional behaviour on his part. He will be motivated to retain H’s business because that is the w hole point of his employment. H 
will be aware of that a nd may start to pressure  him into granting 
further discounts, extensions of credit and other concessions. 
Peter has already disrupted transactions involving existing 
customers with whom L has an est ablished relationship. The most 
immediate threat is that those cu stomers may cease trade with L. It 
is also possible that such behaviour will lead to conflict between Peter and the functional managers, which will waste time. The functional managers may also becom e demotivated if their efforts 
are thwarted by Peter. 
Junior staff will also be confused by  contradictory instructions. If 
they are unsure whether to obey Peter or their usual functional 
managers then they may delay acting in  order to seek clarification. 
Once they start to question instruct ions from their superiors then the 
overall control environ ment may be undermined. 
(b) Recommendations for change to reduce the threat of 
autonomous account managers  
Firstly, there has to be clear communication between the account 
manager and the functional managers.  It should be made clear that 
any conflict should be discussed and, if possible, resolved by compromise. If, for ex ample, H wishes to place a large and urgent 
order then it may be possible to  ask the production manager to 
increase output so that all potential sales can be made without 
disappointing existing customers.  That will reduce the threat of 
disagreement between the account  manager and the functional 
managers.

Chapter 2 
 109 
 It should be made clear that any conf lict that cannot be resolved by 
compromise should be dealt with in a manner that is in L’s overall best 
interests. It should be made clear that  any dysfunctional behaviour will be 
regarded as a disciplinary matter. T hat will reduce the th reat that the 
account manager will be tempted to act in H’s best interests rather than 
L’s. 
Subordinate staff should be free to stat e that any instruction contradicts 
policy or a previous request. It should then be the functional or account manager’s responsibility to seek a comp romise so that subordinate staff 
have an agreed instruction.  That will avoid the st ress and confusion that 
will arise for junior staf f if they are caught bet ween competing managers. 
Ideally, the account manager should  have been appointed from within L 
and it should be made clear that t he appointee’s continued employment 
is not conditional on retaining H as a customer. An internal appointee will, 
hopefully, have a more immediate loyalt y to L than to H. The assurance 
of continuing employment will redu ce the extent to which H might 
pressure the account manager. 
There should be a clear policy for re solving conflicts between managers. 
It may be that the appropriate functi onal manager should make the final 
decision, on the basis that the busine ss from H is worth only 20% of the 
company’s sales by volume, and those may be subject to a substantial discount because H is the company’s la rgest customer. That should lead 
to a consistent response to any conflicts between managers. 
There are several risks arising fr om the appointment  of an account 
manager, however, these risks can be reduced by improving communication, having a clear policy for conflict resolution and implementing disciplinar y action if necessary. 
 
 (a) The risk-mapping exercise is not an objective process and so the 
resulting diagram is not  an objective or “corre ct” representation of 
the risks faced by the practice. T he dentists should not risk relying 
too heavily on the map itself to determine their overall risk-
management strategies. 
The main benefit to be had from this exercise is that the dentists will 
have the opportunity to discuss the risks facing the practice. 
This communication will mean that  each of the dentists is made 
aware of the threats that have been identified by each of the others. 
That should mean that each of them will have a more 
comprehensive understanding of the risks faced by the practice as a whole.

110  
 The discussion will also ensure that there is an opportunity to 
address colleagues’ understanding of identified risks. It may be that 
some dentists are devoting too mu ch time and effort to managing 
trivial risks. Conversely, potentially serious risks could be misunderstood and overlooked. The discussion will enable the dentists to reach some agreement as to the most appropriate 
response to each risk. A consensus opinion is more likely to be balanced and logical than any individual view. 
The fact that the risks have been identified and discussed can be 
recorded for future reference. In t he event that the practice is ever 
accused of negligence then the fact that a risk was discussed and a 
response put in place may enable t he dentists to argue that they 
acted with reasonable skill and care. That, of course, implies that an 
appropriate response has been put in place for any identified risks. 
It is logical to state that the probabili ty of occurrence is high if this is 
a relatively common procedure. Presumably the failures are caused by random factors that are out of the dentist’s control, such as the 
patient’s overall health or dental  hygiene and so the laws of 
probability will mean that failures will occur from time to time. 
It is natural for a patient who has  spent a significant amount of 
money on a procedure to be aggrieved if that procedure fails and so 
the practice may be accused of ma lpractice. Patients may discount 
the risk of failure when agreei ng to the implant because the 
probability seems reasonably remo te when looking ahead and 
making plans. 
The impact of a claim will be low bec ause it is a known risk that the 
patient has agreed to accept. It will be both difficult and expensive 
for a patient to pursue any forma l claim for a refund or a repeat 
procedure. 
It is important to be clear about w hether the likelihood is expressed 
in terms of gross risk or net. Ev ery dental procedure puts the dental 
staff in close proximity to the patient and will involve contact with 
body fluids. The gross risks are, t herefore, high. The net risks of 
cross infection can, however, be minimised through good hygiene, 
such as the dentist and the nurse wearing disposable gloves that 
are changed between patients and also  face masks to reduce the 
risk of transmitting respiratory infections. 
The impact of causing an infection will be high. This is a preventable 
problem and so there is a risk that any failure will constitute medical malpractice. In the event that a patient complains to the health 
authorities or the dentists’ prof essional body there could be a 
significant penalty. There could also  be a serious threat of adverse 
publicity, with patient s choosing to use another dental practice.

Chapter 2 
 111 
 Spiral staircase 
The staircase could prevent di sabled or infirm patients from 
obtaining access to the practice. It may be that a potential patient 
will choose to make this a matter of  principle and complain that the 
practice has not made adequate provision for the disabled. Legally, the practice is not under any obligation to do more than make reasonable provision for access and t here is no practical solution 
that could be offered. 
It is unlikely that the impact will be significant. The practice is 
already well established, so it has  already attracted a viable number 
of patients who can co pe with this access problem. Any complaints 
can be addressed by a polit e comment to the effect  that the practice 
is located in a building that cannot accommodate a lift or a conventional staircase. 
Given that there is no viable response to  this risk, it really has to be 
accepted in almost any case. D ealing with it would require an 
extreme and potentially disproporti onate response, such as moving 
to new premises. 
Allergies 
The probability that a patient will su ffer an allergic reaction is low. 
Pharmaceutical products are tested  to ensure that they do not 
generally cause reactions. Patients will, hopefully, be aware of most 
allergies that they suffer from and the dental practice can record 
those in patient files. 
The impact of an allergic reaction is probably not high for the 
practice, despite the fact that it  could be a serious matter for the 
patient. Provided the dentist has pr escribed the antibiotic in good 
faith there is very little risk that  the practice will be in trouble for 
prescribing a relevant drug to treat  an infection. The dentist should 
always check that the pat ient’s medical history is up to date in order 
to ensure that there is no reason to  avoid any particular medication. 
Provided that has been done, any reaction will be viewed as an 
unfortunate accident rather than medical negligence.

112  
 To:  The Board of B Bank 
Subject:   Directors bonuses and risk management 
This report covers an evaluation of the governor’s suggestion and an 
evaluation of B banks risk management strategy. 
(a) Evaluate the proposal made by the governor  
The governor of the central bank in  B Bank’s country has suggested 
that directors of banks pay a fee,  and that the bonuses will be based 
on profit and growth indicators. 
Director’s viewpoint 
From the view point of the banks di rectors this will not be a welcome 
solution. The amount of the fee will be questioned – will it be the 
same for all directors? What will the fee be used for? Will it be returned when a director retires? It is likely that there will be much 
unrest and argument before this  proposal is accepted. 
The remuneration committee is to  set the fee. Presumably the 
committee should be an indepen dent one consisting of non-
executive directors (NEDs). The NEDs should not be included under the heading of ‘directors’ and need not pay a fee. 
The target of ‘appropriate  profit and growth indicators’ is very vague. 
What is appropriate to one person e.g. a director may not be 
appropriate to an investor. 
However, the idea of linking pr ofits and bonuses is a better idea 
than simply paying out large bonuse s with little justification (even 
when a bank has made a loss). 
The linking of bonuses with prof it may, however, encourage the 
directors to take excessive risks in order to boost their bonuses. 
Staff viewpoint 
The staff of B Bank may not be happy with this proposal since there 
is no mention of them receiving a bonus. They may fear that all 
profits are paid out to the directors when they feel that they have 
worked hard. 
The directors may not accept this proposal either if  they consider 
the fact that many external factors out of their control can affect the 
bank’s profits. They may work ex tremely hard and still make a loss 
in extreme circumstances due to, say, a fall in the demand for 
mortgages.

Chapter 2 
 113 
 Central bank’s viewpoint 
Finally, the proposal may go against any future decision by the 
governors of the central banks in other nations. 
However, on the plus side, at l east the governor in B Bank’s home 
country is trying to alleviate t he adverse media coverage by doing 
something rather than delaying the issue. 
(b) Evaluation of the risk management strategy  
In the past a formal strategy fo r managing risks would not be made 
but rather it would be left to  individual managers to make 
assessments of the risks the business faced and exercise judgement on what was a reasonable level of risk. 
This has now changed: failure to properly identify and control risks 
has been identified as a major cause of business failure e.g. Barings 
Bank. 
Risk management strategy 
CIMA identified the following key features of a risk management 
strategy: 
 A statement of the organisation ’s attitude to risk – the balance 
between risk and the need to meet objectives 
 The risk appetite of the organisation 
 The objectives of the risk management strategy 
 The culture of the organisation in relation to risk 
 The responsibility of manager s for the application of risk 
management strategy 
 Reference should be made to the risk management systems 
the company uses. i.e. its internal control systems 
 Performance criteria should be defined so that the 
effectiveness of risk management can be evaluated 
B Bank meets only a fe w of these criteria. 
B Bank’s risk management strategy 
A statement of B Bank’s attitude to risk and risk appetite is not 
mentioned in the scenario. Howe ver it can probably be assumed 
that they are risk takers as they are able to achieve an increase in share price of 12% per annum, and attract hedge funds as investors. From the view point of the investors, B Bank’s risk 
management strategy is good.

114  
 The culture of B Banks m anagers will probably be one of risk 
seeking in order to provide t he high returns mentioned. (A risk 
averse manager would feel ve ry uncomfortable in these 
surroundings.) The staff at B Bank  may or may not like the risk 
management strategy. If it provi des them with high salaries then 
they are probably happy. However, these high salaries may only be short-term if an incorrect decision is  made in the future and the bank 
hits hard times or goes bust. Then  the staff may have been happier 
with lower salaries and job security. 
Since a risk management strategy is  not formally mentioned it is 
difficult to say whether managers have been allocated responsibility 
for the application of risk management. For the bank to have traded successfully for over 150 years,  some risk management must take 
place, however, this should be formalised. 
The risk management systems will in clude the bank’s executive 
information system (EIS). It is abl e to compute product profitability 
which supports the targets set on pr evious profitable experience. On 
the plus side, having an EIS is an advantage for B Bank; however, it 
is not being used to its full potent ial. (See recommendations below.) 
Also, B Bank has non-executive di rectors (NEDs) but they are a 
poor internal control since they do not question the decisions of the executive directors. 
Performance criteria to asse ss the effectiveness of the risk 
management strategy are not ment ioned in the scenario, other than 
the targets set on previous experienc e. It seems that while B Bank 
is successful, the targets will just roll forward without any reference 
to what is happening in the exte rnal environment of B Bank. 
Evaluation of the risk management stra tegy in B Bank is two-fold: 
Has the strategy achieved its objectives? This is hard to say since 
no formal strategy has been set. 
Do the benefits outweigh the costs? Most certainly yes. Since the 
setting of the strategy cost nothing (no strategy was set) and large 
returns have been achieved, then the benefits have far outweighed 
the costs. 
Conclusions and recommendations 
Overall, the current risk management strategy in B Bank is not good 
enough. In order to lower the bank’s  exposure to risk the following 
recommendations are made:

Chapter 2 
 115 
 A major strategy review needs to be performed as soon as possible 
since the last one was four year s ago and much has changed since 
then. The management appear to  be adopting an incremental 
approach to planning ahead (using prev ious profitable experiences 
as the basis for their target s). The past is not always a good 
indicator of the future and this could be a very dangerous 
philosophy. B Banks directors need to formally identify the banks attitude to risk, set up a risk commi ttee, and communicate their risk 
attitude and appetite to its management  and investors. They also 
need to perform an environmental analysis in order to prepare themselves for events that may affe ct them in the future. E.g. a 
further fall in house prices. 
returns have been achieved, then t he benefits have far outweighed 
the costs. 
Overall, the current ri sk management strategy in B Bank is not good 
recommendations are made: 
A major strategy review needs to be performed as soon as possible 
then. The management appear to be adopting an incremental approach to planning ahead (using prev ious profitable experiences 
More effective NEDs need to be appointed who will query the 
decisions of the executive director s. They may also be able to 
provide further experience and insi ght into the banking industry and 
its environment that the executive directors don’t have, or don’t have 
the time to consider. 
The property price trend into the future needs to be corroborated 
with external information, not just  internal reports. B Bank should 
obtain independent, external advice on this in case their internal 
department is wrong in its prediction.

116  
 Currently B Bank is obtaining finance to support new mortgages 
with loans from the short-term m oney-markets. This is a very 
dangerous practice should the sour ce of finance dry up. The 
principle of ‘matching’ should be adopted whereby long-term assets 
(mortgages) are matched with long-ter m loans (liabilities). This will 
secure the finance required for the duration of the mortgage and 
avoid ‘renewal risk’. 
B Bank may wish to seek new inve stors. The current investors –
hedge funds, may be driving B Bank down a risky road in order to 
provide them with short-term financ ial returns. B Bank was founded 
in 1856 and presumably has the objec tive of continuing in business 
into the future. Taking high risks to  provide high returns may prevent 
this objective from being met. 
There appear to be more negativ e viewpoints than positive 
viewpoints regarding the governor's proposal and B Bank's risk management strategy could be significantly improved. 
 
 To:  The finance Director 
Subject:   Evaluation of operational ri sk and the use of EDI at W 
Introduction This report covers the evaluation of operational risks at W and suggests 
management techniques to reduce thos e risks. It then goes on to 
consider the risks in using EDI. 
(a) Operational risks  
W is dependent upon a small number of third parties for the 
manufacture of critical component s. If a supplier defaults on a 
delivery then W may run out of produc t to sell. The likelihood of this 
is impossible to predict, but it is a risk that is not under W’s direct 
control. The best safeguard against such problems would be to have more than one potential supplie r for any given item. W should 
make sure that it owns the patents for any components or processes that it relies on, or that it has a licence in place just in 
case it needs to move to an alter native supplier. Penalty clauses will 
not mitigate losses in the event of  any disruption, but they may 
concentrate the attention of its suppliers.

Chapter 2 
 117 
 W has no direct control over the quality of its products, which may 
lead to customer dissatisfaction.  Parts are sourced from many 
different suppliers and so it will be difficult for W to ensure that every component is manufactured to the required tolerances. Manufacturing staff at the com ponent and assembly factories will 
not feel that they are part of W an d they may resent  the fact that 
they do not enjoy the security of working for a large organisation. The owners and managers of the factorie s may not feel that there is 
a huge incentive to do much more than meet the minimum standards for quality and delivery bec ause they may be replaced at 
the conclusion of their contrac t. W can control that risk by 
introducing quality checks on both components and finished goods. W could request samples on a random basis and check these thoroughly. W could also have a policy of rewarding reliable suppliers by retaining them and giving them as much work as possible so that they have an in centive to exceed expectations. 
The global nature of W’s manufacturing process creates logistical 
problems for manufacturing. Manu facturing may be disrupted by 
delays in delivery, which could be outside the control of W and its suppliers. For example, elec tronic components are frequently 
transported by air freight, which can be affected by weather or industrial action. Goods crossi ng international borders can be 
delayed by customs inspections. One way round this would be to localise sources as much as possi ble, with suppliers for minor parts 
such as screws and plastic cases chosen for proximity to the assembly factories even if they are not necessarily the cheapest. W might use a specialist logistics company to manage the transport of 
parts and assemblies so that ther e is clarity as to who is 
responsible for any logistical pr oblems. W might also have a policy 
of keeping safety stocks of all but the most expensive parts and 
assemblies to cover any disruption. 
(b) EDI 
EDI is potentially more efficient than more traditional methods of 
communication. W has a very co mplicated manufacturing process 
and EDI makes it possible to break  the task of ordering and paying 
for a batch of completed mp3 player s much simpler. In theory, this 
system will reduce W’s staffing cost s considerably. The system will 
place orders and will keep track of in ventory as it is received. The 
bookkeeping will be done automatic ally because invoices will be 
received, recorded and passed for payment electronically. 
The problem with W is that it does  not really have a long-term 
relationship with all of its suppliers. It is possible that many of the 
suppliers it uses will be replaced in the medium or even the short 
term if a cheaper source becomes ava ilable. For example, a shift in 
currencies could make an alternative source of labour for fabrication 
tasks cheaper than the present supplie r. Potential suppliers might 
not be prepared to install the nece ssary technology and that could 
restrict W’s sources.

118  
 Another problem is that W might find it difficult to manage the 
processing of invoices and payments.  A supplier could invoice W for 
parts or fabrication work on sub- assemblies that are delivered to 
another third party. W will have no way of verifying that the goods 
being invoiced were, in fact, delivered in good order and so the system will not be able to make payment. Suppliers could be reluctant to accept orders unless they are likely to be paid for promptly and efficiently. 
On a related matter, the lack of human interaction could complicate 
the manufacturing process. Supplie rs of even small parts could 
delay the completion of finished produc ts if their IT systems accept 
electronic orders without any c onsideration of whether the 
requested delivery dates are feasible . A manager in the sales office 
could review incoming orders and ensure that the necessary capacity is available. 
There are several risks identified in this report and risk management 
recommendations made. Although EDI would help W, there are 
many issues which need to be resolved first before EDI could be implemented. 
 
 Test your understanding 26 – SPM (Case study) 
 (a) Risk management is the pr ocess by which organisations 
systematically identify and treat  upside and downside risks across 
the portfolio of all activities with the goal of achieving organisational 
objectives. Risk managem ent increases the probability of success, 
reduces both the probability of  failure and the uncertainty of 
achieving the organisation’s objectives. The goal of risk management is to manage, rather than eliminate risk. This is most 
effectively done through embedding a risk culture into the organisation. 
For SPM’s Distribution division, th ere is a risk of stock losses 
through theft, largely due to the la ck of separation of duties. This 
lack of separation occurs becaus e the Distribution Division: 
– enters all orders to the computer; 
– selects all stock fr om the warehouse; 
– despatches all goods to customers; – receives the signed paperwork evidencing delivery; – writes off stock losses due to damage and obsolescence; – carries out and to a large ext ent controls the annual physical 
stocktake. 
This lack of separation of duties coul d result in stock losses or theft 
that is not identified or not re corded and any stock losses or theft 
may be disguised during the stockt ake due to the expertise of the 
Distribution division which t he auditors appear to rely on.

Chapter 2 
 119 
 These stock losses or theft may not be accurately recorded and the 
reported profits of SPM may overst ate profits if physical inventory 
does not match that shown in the accounting records. Stock of stationery is easy to dispose of and losses can easily happen due to 
error or carelessness, for instance through water damage, dropping and so on. The possibility of theft of  stock which can readily be sold 
in retail stores is also high and th e consequences of not identifying 
stock losses or theft might be severe  over a period of time. There is 
a risk that inventory records may s ubstantially overstate the physical 
stock. There is a serious limitatio n of accounting here as it relies on 
computer records and a stocktake process that may be severely 
impaired and hence there may be hidden losses not reflected in 
SPM’s reported financ ial statements. 
Fraud is dishonestly obtaining an advantage, avoiding an obligation 
or causing a loss to another party. Those committing fraud may be managers, employees or  third parties, including customers and 
suppliers. There are three conditions  for fraud to occur: dishonesty, 
opportunity and motive. If stock theft is occurring, the weakness in systems due to the lack of s eparation of duties provides an 
opportunity. Personnel policies and supervision may influence dishonesty and employment or social conditions among the workforce may influence motive. 
As for all other risks, a risk management strategy needs to be 
developed for fraud. This strategy should include fraud prevention; 
the identification and detection of  fraud and responses to fraud. 
Existing risk treatment does not appear to be adequate due to the 
lack of separation of duties, the po ssibility of fraud and the reliance 
of internal and external auditors on the Distribution division’s staff. 
(b) The main recommendation is for the separation of duties in SPM’s 
distribution division. The customer service centre should process all 
customer orders, even though this may mean transferring staff from 
the despatch department. It may be more effective to use a 
document imaging system to reduce paperwork by converting orders into electronic files that  are capable of being read by 
computer programs and transferr ed to the despatch department. 
Further separation can be carried out  by sending signed paperwork 
evidencing delivery to the account s department and for all write offs 
of stock losses due to damage or obs olescence to be carried out by 
the accounts department. Finally, the reliance on Distribution staff for stocktaking needs to be reduced and accountants and internal auditors need to play a more prominent role in physical counting and reconciling to computer records. 
The second recommendation is for gr eater emphasis on controls to 
prevent dishonesty. These include pre-employment checks, scrutiny 
of staff by effective supervision, severe discipline for offenders and 
strong moral leadership. Motive c an be influenced by providing good 
employment conditions, a sympathet ic complaints procedure, but 
dismissing staff instantaneously  where it is warranted.

120  
 To:  The Board 
Subject:   Risk management 
This report covers: 
(a) The main business issue for ABC and the most significant risks that 
ABC faces; 
(b) The Board's responsibilities for risk management and 
recommending a risk management system for ABC that would more effectively manage the risks of losing business continuity; 
(c) An evaluation of the likely benefits for ABC of an effective risk 
management system for business continuity. 
Risks 
(a) A review of disaster recovery  had identified a lack of hardware back-
up as costs had been continually defe rred from year to year to 
maintain current profits. This has an effect on business continuity for 
both ABC and its retail customers. Insurance is only one type of risk 
treatment and ABC has overlook ed the need to address business 
continuity more proactively and comprehensively. 
The pressure on short-term profits and cash flow is important to 
recognise but the short-term vi ew may lead to medium- and long-
term problems if under-investment c ontinues. This needs to be the 
focus of a risk management exercise  to properly assess, evaluate, 
report and treat the business continuity risk. 
Although a severe catastrophe ma y have a small likelihood of 
occurrence, the impact will be severe and insurance cover is unlikely to be adequate as ABC will not have taken adequate steps to mitigate the loss. Customer aw areness of the risk is likely to 
result in customers moving thei r business elsewhere. Public 
disclosure or a severe catastroph e will have a major impact on the 
reputation of ABC and on ABC’s share price.

Chapter 2 
 121 
 (b) Board responsibilities  
The board is responsible for maintaining a sound system of internal 
control to safeguard shareholders ’ investment and the company’s 
assets. When reviewing management r eports on internal control, the 
board should consider the significant risks and assess how they have been identified, evaluat ed and managed; assess the 
effectiveness of internal controls in managing the significant risks, 
have regard to any significant weaknesses in internal control; consider whether necessary acti ons are being taken promptly to 
remedy any weaknesses and consider whether the findings indicate a need for more exhaustive monito ring of the system of internal 
control. 
Risk management is the process by which organisations 
systematically identify and treat upside and downside risks with the 
goal of achieving organisational  objectives. The goal of risk 
management is to manage, rather than eliminate risk. Initially, there 
needs to be a commitment from the board and top management in 
relation to risk management genera lly and business continuity in 
particular, even if this means a short-term detrimental impact on 
profitability. The board of ABC, through the audit committee, needs 
to be more involved in the risk management process. Individual 
responsibilities for risk managem ent need to be assigned and 
sufficient resources need to be allocated to fund effective risk management for business continuity. 
ABC needs to identify its appetit e for risk, and a risk management 
policy needs to be formulated an d agreed by the board. The risk 
management process needs to identif y and define risk, which needs 
to be assessed in terms of both likelihood and impact. For ABC, the risks have been clearly defined: a loss of business continuity caused by a major catastrophe and the cons equent loss of reputation this 
would involve. 
The likelihood of fire, flood, terrori st or criminal activity and so on 
needs to be assessed, particularly in terms of the risk avoidance 
processes that are already in pl ace. For example, ABC needs to 
evaluate whether there has been  flooding in the area before, 
whether water pipes run near the co mputer facility, whether fire 
prevention measures are in place, whether firewalls are in place and 
have been tested so as to reduce t he likelihood of attack via the 
Internet. An assessment of pr obability of these and other 
catastrophes should be made. Although these may be low probability events, the impact on the business of any such 
catastrophe will be severe

122  
 Risk evaluation determines the significance of risks to the 
organisation and whether each specif ic risk should be accepted or 
treated. It should be emphasis ed that these risks cannot be 
accepted but do need to be treat ed. Risk treatment (or risk 
response) is the process of sele cting and implementing measures to 
reduce or limit the risk. The exis ting contingency plans need to be 
examined in detail. While data a ppear to be backed up regularly and 
stored off-site, there seems to be inadequate back-up for hardware. 
Risk treatment will involve deciding the most cost-effective method 
by which to manage the risk. A pref erred solution given the reliance 
of ABC’s customers on the system  is to have a remote site 
equipped with a second system that  data can be restored onto. 
While this is the most expens ive option there may be business 
benefits in having two sites. A second solution may be to outsource the back-up facility so that ABC cont racts with a third party to have a 
system available if one is needed. A third option is to negotiate with 
suppliers as to the availability of  other sites and t he replacement of 
equipment on a short notice basis . Finally, insurance coverage 
needs to be reviewed and the mitigation decided in consultation with ABC’s insurers. The present met hod of risk management that relies 
only on off-site data back-up is inadequate to assure business continuity. 
As business continuity is so important, the board and audit 
committee need to be involved in the decision-making process about risk treatment. There needs to be regular risk management 
reporting to assess the control syste ms in place to reduce risk; the 
processes used to identify and respond to risks; the methods used to manage significant risks and the monitoring and review system itself. Reporting should take pl ace to business units, senior 
management, internal audit, the board and the audit committee. 
(c) The benefits of effective risk management 
For ABC, the benefits include the maint enance of profitability in the 
medium- and longer-term and the avoidance of sudden losses if business continuity is impeded. The major benefit for ABC in such a 
case is the avoidance of profit  warnings and major exceptional 
items. Additional benefits may include more cost-effective insurance 
cover and reduced premium cost . If the recommendations are 
adopted, despite the increased costs that will almost necessarily be 
incurred, the board of ABC will ha ve greater degree of assurance 
that business continuity will be safeguarded in the event of a 
catastrophe, will continue to satisf y its customers and will maintain 
its reputation with customers,  the public and investors.

Chapter 2 
 123 
 Conclusions 
The main risk for ABC is the lack of a disaster recovery plan as this 
has an effect on business continuity. 
assets. 
The benefits of effective risk ma nagement outweigh the costs.

125 
Strategy risk 
B1. Analyse risks associated 
with formulating strategy (a) Analyse relevance of the 
assumptions on which strategy is based. 
(b) Discuss potential sources 
and types of disruptions to strategy. 
  Chapter 
3

126  
 
 1 Introduction 
In this chapter we look at the risks involved with strategy formulation and 
assumptions on which the strategy is  based. The process of strategy 
formulation is a core topic in E3 and is  developed further there, in P3 we are 
focussed on the risks. However, before we look at the risks involved, we will first 
look at what we mean by the word ‘strategy’. 
 
 2 What is strategy? 
Strategy can be defined in a number  of different ways, including: 
‘A course of action, including the specific ation of resources required, to achieve 
a specific objective.’ 
‘Strategy is the direction and scope of an organisation over the long term: which 
achieves advantage for the organisation through its configurat ion of resources 
within a changing environment, to meet the needs of markets and to fulfil 
stakeholder expectations.’ 
Johnson, Scholes and Whittington (Exploring corporate strategy) 
The core of a company's strategy is about choosing: 
 where  to compete and 
 how to compete. 
It is a means to achieve sustainable competitive advantage . 
In terms of risk management, the test of  a good strategy is whether it enables 
an organisation to use its resources and competencies advantageously in the context of an ever changing environment.

Chapter 3 
 127 
 Strategic (or corporate) planning  involves formulating, evaluating and 
selecting strategies to enable the preparation of a long-term plan of 
action and to attain objectives. 
 
 Levels of strategy 
 Strategy can be broken down into three different levels 
 
This is the highest level of strate gy within the organisation and examines 
the strategies for the organisation as a whole . In particular it focuses 
on which businesses and markets the organisation should operate within. 
Corporate strategy is therefore of ten concerned with issues such as: 
 acquisitions, disposals and diversification 
 entering new industries 
 leaving existing industries. 
Having selected a market, the organi sation must develop a plan to be 
successful in that market. Busine ss strategy therefore looks at how the 
organisation can compete successful ly in the individual markets  that 
it chooses to operate within. 
 achieve advantage over competitors 
 meet the needs of key customers 
 avoid competitive disadvantage. 
Corporate strategy affects the or ganisation as a whole, but business 
strategy will focus upon strategic business units (SBUs).  An SBU is a 
unit within an organisation for which t here is an external market for 
products distinct from other units.

128  
 Functional (or operational) level 
This level of strategy is concerned  with how the component parts of the 
organisation in terms of resour ces, people and processes are pulled 
together to form a strategic architectu re which will effectively deliver the 
overall strategic direction. It looks at the day to day management 
strategies of the organisation . 
 human resource strategy 
 marketing strategy 
 information systems and technology strategy 
 operations strategy. 
These could be unique to the SBU and benefit from being individually 
focused or the corporate unit may seek  to centralise them and so benefit 
from synergy 
 
Remember that all three levels shoul d be linked. A risk for the corporate 
or business level strategy is that it  will only succeed if it is supported by 
appropriate operati onal strategies. 
For instance, a hotel chain may pursue a high level strategy of 
‘excellence in customer care’, but achi eving the goal will be at risk if staff 
do not clean the rooms to an appropriate  standard or cook the meals in 
line with hygiene requirements, etc. T herefore the day to day activities 
must  be focused on achieving the corporate level strategy. 
It is worth mentioning that formulating the stra tegy is the easy part. 
Aligning and implementing the strategy  can be the difficult part. Football 
clubs around the world will all have stra tegies in place to win their league. 
Only one team per league will actually do so!

Chapter 3 
 129 
 Levels of planning 
 Gap is an international clothing retailer.  Classification of different levels of 
Strategic 
 Should another range of  shops be established to target a different 
 Should the company raise more share capital to enable the 
Business 
 Which geographical markets shoul d the new range of shops open 
in? 
 How often should inventories be changed to ensure the business 
 What prices should be charged in t he new stores relative to rivals? 
 How will suitable premises be f ound and fitted out for the new range 
of shops? 
 Which staff should be hired for the new stores? 
 Which IT systems need to be installed in the stores? 
supported by new business and operational level strategies. For example, a risk Gap faced was that poor business strategies for Banana 
Republic (such as pricing goods too high relative to rivals) would have led to the failure of the new stores. Li kewise, poor operational strategies 
(such as poor training for employees in the new stores) would risk damaging Banana Republic's brand and ruin Gap’s overall strategic level 
strategy. 
Whichever approach is chosen, remember  that most different types of 
organisation will need a strategy. This wi ll include companies (large and small), 
unincorporated businesses, multinatio nal organisations and not-for-profit 
organisations such as charitie s, schools and hospitals, etc. 
Anywhere that is likely to have a m anagement accountant is likely to need a 
strategy. Remember that the exam itself  will be based on any of these types of 
organisation. Be prepared for a wide range of scenarios!

130  
 The strategic planning process 
 Having an appropriate strategy is s een as vital to the future success of 
most organisations. So how does an organisation create a strategy? 
There are a number of different m odels that can be adopted. There is no 
single ‘best’ approach – it si mply depends on which one each 
organisation feels is the most  appropriate for their needs. 
The rational model 
The rational model is a logical, st ep-by-step approach. It requires the 
organisation to analyse its existing  circumstances, generate possible 
strategies, select the best one(s) and then im plement them. 
below: 
 
Johnson, Scholes and Whittington took t he stages from the rational model and 
grouped them into three main stages: 
 Strategic analysis 
 Strategic choice  
 Strategic implementation 
Our main focus in P3, is strategic c hoice, and in particular the associated risks 
involved with the choices that an organisation has. 
The following diagram illustrates some of the key considerations in this stage.

Chapter 3 
 131 
 
 The JSW approach 
 A full-price airline in considerin g setting up a ‘no-frills’, low-fare 
subsidiary. The strategic planning pr ocess, according to JSW, would 
include the following elements: 
volume forecasts, availability of c heap landing rights, public concern for 
environmental damage, effe ct on the main brand. 
Strategic implementation:  Setup of new subsidia ry. Staff recruitment 
and training. Acquisition of aircra ft and obtaining of landing slots. 
 
strategic development? 
A Implementation B Strategic analysis C Mission and objectives D Review and control E Strategic planning F Operational strategy 
 
 Benefits of deliberate long-term planning 
 Benefits of adopting a long-term planning approach (such as the 
 Forces managers to look ahead  – formal planning 
methodologies require managers to identify changes in the 
organisation’s circumstances and look at ways to deal with them. This will help to ensur e that the organisation stays relevant in its 
market and survives in the long term.

132  
  Identifies key risks  – by undertaking detailed analysis, 
management can identify key external and internal risks and 
create plans to mitigate them. 
 Improved control  – the organisation is forced to identify a 
mission and objectives. This will be communicated to 
management, meaning that they k now what targets they are 
working towards/being assessed against. This will also improve 
 Encourages creativity  – management will have to generate 
ideas for the organisation, meaning that it can benefit from their 
experience and ability to innovate. 
2.1 Risks of formal planning 
The risks of formal, long-term planning include: 
 Setting corporate objectives  – it may be difficult for the organisation to 
create an overall mission and objective s. This is often due to the 
contradictory needs of key stakeholders.  For example, maximising profit 
for shareholders may require restruct uring the organisation which causes 
employee redundancy.  
 Short-term pressures  – The pressures on management are often for 
short-term results. It can therefore be difficult to motivate managers by 
setting long-term strategies when s hort-term problems can consume their 
entire working day. 
 Difficulties in forecasting accurately  – it may be hard to identify long-
term trends in the market – particu larly as industries are becoming 
increasingly reliant on the rapidly c hanging world of technology. This may 
make it difficult to create a strategy  that is effective for the organisation 
over several years. 
 Bounded rationality  – the internal and external analysis undertaken as 
part of long-term strategi c planning is often incomplete. Any strategies 
developed by the organisation based on this incomplete analysis may be 
ineffective. 
 Rigidity  – Once a long-term plan is created, managers often believe it 
should be followed at all costs – even if it is clearly no longer in the best 
interests of the organisation. This can also lead to the long-term strategy 
stifling initiative as managers refu se to act ‘outside the plan’. 
 Cost – the strategic planning process c an be costly, involving the use of 
specialists, sometimes a specialist department, and taking up 
management time. 
 Management distrust  – the strategic planning pr ocess involves the use of 
management accounting techniques, includ ing forecasting, modelling, cost 
analysis and operational research. This may be unfamiliar to some 
managers, leading to resistance. It is  worth noting that many academics 
mistrust these models – not just managers!

Chapter 3 
 133 
 Alternatives ways to develop strategies 
evolve in response to unexpected ev ents that impact on the organisation. 
Mintzberg referred to thes e as emergent strategies. 
Logical Incrementalism (initially deve loped by Lindblom) suggests that 
current strategy tends to be a small-sca le extension of past policy, rather 
than radical change. He does not belie ve that the rational model of 
decision-making is sensible and suggests that, in the real world, it is 
rarely used. This is because: 
 Strategy is not usually decided  by autonomous st rategic planning 
teams that have time to imparti ally sift all the information and 
possible options before deciding on the optimal solution. 
 Instead, managers have to sift th rough the options themselves. Due 
to time and knowledge constraints (also known as bounded 
rationality), they usually only choose  between relatively few options. 
 This typically leads to strategy be ing small scale extensions of past 
policy – in other words, managers try to make small changes to 
what they know has worked well in the past. 
This approach to strategy has a number of advant ages over the 
traditional rational model. In particular it is often more acceptable to 
stakeholders as consultation, compro mise and accommodation are built 
into the process. In addition, it is less of a cultural shift for the 
organisation to adopt an incremental  approach to strategy as the 
organisation will not be trying to implem ent major shifts in its activities. 
However, incrementalism may mean t hat the organisation has no overall 
long-term plan, causing it to suffer fr om strategic drift, eventually leading 
to it being unable to meet the needs of its customer s. In addition, it could 
mean that the organisation fails to make major changes if needed. 
 
 The emergent model 
 Pfizer, a multinational pharmaceut ical company, developed a drug known 
reported an interesting side-effect. Pf izer sold the drug as Viagra and 
started a new multi-bi llion dollar market.

134  
2.2 Problems with a l ack of formal planning 
There are a number of practical risks involved with not undertaking a formal 
planning approach. 
 Failure to identify threats  – the business is not being forced to look 
ahead. This means that it may fail to  identify key threats, and so will not 
have contingency plans in place to deal  with them, should they arise. 
 Strategic drift  – the organisation does not have an overall plan for the 
future, meaning that it may be difficult for it to effectiv ely compete in its 
market in the long term. 
 Difficulty in raising finance  – investors typically like to know what plans 
the organisation has for the future. If  the company does not have a formal 
plan, it may be difficult to convince shareholders and banks (amongst others) that the company is  a worthwhile investment. 
 Management skill  – freewheeling oppor tunists require managers that are 
highly skilled at understanding and r eacting to the changing market. Less 
able or experienced managers will find th is a difficult approach to use. 
 
 NerdyWordys is a data analytics company specialising in review 
management software. They offer a se rvice to help organisation make 
sense of all the reviews and comment ary about their products on social 
media using linguistics and artificial in telligence (AI). It is small company 
with only 2 directors, one specialisi ng in AI and another in linguistics.  
When they set up the company two y ears ago, they did produce a very 
formal long term plan, considering t he external environment, their skills 
and where they saw the business going. They intend to review this again 
in two years’ time. 
What are the risks to NerdyWordy s of this type of planning? 
A An initial failure to match their strengths to opportunities 
B Strategic drift C Difficulties accurately forecasting demand D Failure to identify key risks to t he strategy when they started  
E Failure to react to a dynamic environment

Chapter 3 
 135 
2.3 Which approach to strategy should we adopt? 
We have identified different approaches to developing a strategy. While we 
have already mentioned that there is no ‘c orrect’ approach, it is important that 
you understand the risks associated with each approach and align them to the risk appetite of each firm in order to  choose the approach that is most 
More formal planning approaches, such as  the rational model (and to a degree 
 exist in relatively stable industries,  meaning there is sufficient time to 
 have relatively inexperienced manager s, as the formal planning approach 
helps to ensure they are familiar with the organisation, as well as providing 
a series of guidelines they can foll ow to help them develop a strategy. 
More informal approaches tend to suit organisations which: 
 are in dynamic, fast changing indust ries where there is little time to 
 have experienced, innovative manager s who are able to quickly identify 
 do not need to raise significant exte rnal finance (external investors 
typically prefer a fo rmal planning approach). 
 
 EJS Plc is a digital image printing company. They operate solely 
through their website and allow organi sations and individuals to set up 
an account and upload digital images directly from various mobile devices to be printed in a variet y of ways (on mugs, t-shirts, phone 
cases and even on photo paper).  
They have a very informal approach to planning and believe that 
flexibility in developing product ideas is the key to their success so far 
in the industry.  
What are the THREE biggest risks to EJS from this approach to 
strategic planning? 
A Failure to capitalise on their popularity and offer an app for easier 
access 
B Difficulty forecasting  C A rigid approach to sales channels D Difficulty establishing corporate sales  
E Failure to react to a dynamic environment 
F A rigid approach stifling creative product ideas

136  
 Boris has decided to set up an independent coffee shop in a country with 
a strong economy. He has analysed the industry and made the choice to 
offer premium coffee with a friendly, personal service in a city centre 
location. 
He’s identified a basement property  with minimal windows and only 
accessible by steep steps on a busy street , with a local trai n station at the 
top of the street that is used by thousands of commuters every day.  At 
the bottom of the street there is a bus stop where several bus services 
drop off most people who are arriving in t he city centre.  It is also near to 
several large employers such as uni versities and local council offices. 
The street that he has chosen has also has two major coffee chains 
based on street level at the t op and the bottom of the street. 
What are the biggest risks to Boris’ strategy? 
A Premium coffee will be unattractive to people in a city 
B The footfall in the area chosen wil l be insufficient for the shop to 
make a profit  
C The basement location may mean  that passers-by do not see the 
shop  
D Customers dislike a friendly personal service in this industry 
E The property chosen will make it diffi cult for Boris to differentiate his 
coffee shop from the other city centre shops  
F The major chains have better locations and busy commuters will 
choose the most convenient shop  to get their coffee from. 
 
games company that operates in c ountry F. You have just found the 
NOTE 
Hi Ali, 
As I'm sure you're aware, HAA is planning to expand abroad, into the 
European market. To support this, we have undertaken a detailed review of our existing operations and the European market. This has been used 
to produce a three-year budget and operational plan for our proposed 
European operations. 
market for new entrants. This is due to the fast-moving, innovative nature 
of the companies currently operati ng there. HAA has a high spend on 
research and development and our director s feel that the company is well 
placed to compete with European games manufacturers.

Chapter 3 
 137 
 I’m meeting with the directors in fi fteen minutes so I need you to make 
some brief notes for me evaluatin g our current approach to strategic 
planning. Can you explain the risks of the current approach? 
Thanks 
Required: 
Draft a response to your  manager, as requested. 
 
 Strategic planning for not-for-pr ofit organisations (NFPs) 
businesses. However, some may invo lve charities, councils, schools, 
hospitals and other organisations where profit is not the main objective. 
With such an 'NFP' a discussion of obj ectives is likely to be problematic 
for the following reasons: 
 It is more likely to have multiple objectives. A large teaching 
hospital may want to give the bes t quality care and treat as many 
patients as possible and train new doctors and research new 
techniques. Conflict is inevitable. 
This is not just an issue for NFPs, profit-seeking organisations 
also have multiple stakeholde rs with conflicting demands. 
 It will be more difficult to measure objectives. How can one 
measure whether a school is educating pupils well? Performance 
in exams? Percentage going on to university? Percentage getting jobs? Percentage staying out of  prison once they leave? 
 There may be a more equal balance of power between 
stakeholders. In a company, th e shareholders hold ultimate 
power. If they do not use it, the di rectors generally get their way. 
In a school, the balance of power  may be more even (or even 
undefined) between parents, gover nors, the headmaster and the 
local education authority. 
 The people receiving the service are not necessarily those paying 
for it. The Government and lo cal NHS trusts determine a 
hospital's funding, not the pati ents. Consequently there may be 
pressure to perform well in natio nal league tables at the expense 
of other objectives. 
In spite of these problems, NFPs are still likely to need strategies. In 
the UK, for example, many public se ctor organisations have to produce 
strategic plans for between one and five years ahead as this is a Government requirement.

138  
 One of the reasons for this is that  the public sector is required to hit 
certain targets and key performance indicators (KPIs), which are set by central government. In a company these targets and KPIs are used to 
ensure that the business is competitiv e. For a public sector organisation, 
they are used by the governm ent to exert control over  the activities of the 
organisation and to ensure that the government’s funding is being used 
appropriately. 
The 3Es 
Public sector organisations and charit ies often have difficulty in using 
traditional private-secto r-based approaches to objective setting since they 
do not make a profit by which thei r success or failure can be measured. 
One way to address this problem is to use the following approach. 
 Economy  looks solely at the level of  inputs, e.g. did the hospital 
 Efficiency  looks at the link between out puts and inputs (the internal 
processes approach). This approach looks at how well inputs have 
been used to achieve outputs – it is  a measure of efficiency. For 
example, what was the average cost  per patient treated? What was 
the average spend per bed over the period? What was the bed 
occupancy rate that this achieved? 
 Effectiveness  looks at the outputs (the goal approach). This looks 
at the ultimate objectives of the organisation, i.e. at output 
measures. For example, for an NHS hospital, have the waiting lists 
been reduced? Have mortality rates gone down? How many 
patients have been treated? 
The best picture of the success of an organisation is obtained by using all 
of the above approaches and by examining both financial and non-financial issues. Think about effectiveness meaning ‘doing the right things’ and efficiency ‘about doing things right’. 
 
 The 3Es 
 Consider O – a large teaching hospit al based in a major city which is 
funded by the Central Government. O may want to analyse its value for 
money using the 3Es in the following ways: 
Economy: 
O is given an annual budget by the Central Government. Economy is 
likely to look at whether this budget has been met. Has O spent more overall than expected? Has more or less been spent on drugs or wages than predicted? These would help O m easure if it has been economical 
with the use of its funds.

Chapter 3 
 139 
looks at O’s internal processes and could include measures such as the average cost per patient, average s pend per hospital bed, or the spend 
per student in the period. 
Effectiveness: 
This looks solely at the outputs of  O’s operations. For example, has O 
had a higher or lower mortality rate  than expected? What percentage of 
students have qualified or pa ssed exams? How long is  the patient waiting 
list at O? 
2.4 The risks associated with the 3Es 
The 3Es do have some risks associated with their use: 
 The wrong choice of measures – just because you can measure 
something doesn’t mean you should. 
 The measures can give contradict ory results, and t hat may mean you 
prioritise one or two of t he measures over the others. 
 Internal confusion over which measures to prioritise, leading to 
demotivated workers and all measures being missed. 
 Economy and efficiency can be in conf lict with effectiveness, given that 
spending more can improve effectivene ss or spending less (and improving 
economy/efficiency) can reduce the effectiveness. 
 Economy and efficiency are often viewed as easier to measure than 
effectiveness and so can be the focus of performance measures or audits. 
 
 The wrong Es 
 A local authority claims handling unit was being measured on the time 
taken to process a claim – efficiency.  What you measure affects the way 
people behave and so, to make sure t heir efficiency rating was high, the 
team discovered it was quickest to pay  every claim that came in without 
investigating if the claim was legitimate. 
 
 H College is a government funded prov ider of education to several 
thousand students in country G. It aims to  ensure that at least 75% of all 
exams sat by its students are passed. 
In the last year, it achieved a pass ra te of 75% on its exams (the same as 
the previous year). The head of the college claimed that this was in spite of the government limiti ng H College’s budget rise to 3%, which meant 
that H College was unable to provi de the level of service it had in 
previous years. Inflation in the economy of country G is 2%.

140  
 The government’s official auditor has  discovered that the cost per student 
has risen by 5% in H College over t he last year, due to internal problems 
in operations. 
H College is expected to offe r value for money (VFM).  
Which aspect of VFM has H College managed to achieve over the 
last year? 
A Efficiency 
B Economy C Effectiveness D Ethical behaviour 
3 Approaches to strategic planning 
While each aspect of strategic planning is  important, firms may prioritise the 
 A traditional approach – stakeholders 
 A ‘market-led’ or ‘positioning’ approach 
 A ‘resource-based’ or ‘competence-led’ approach 
 
 Different priorities 
 A traditional approach – stakeholders 
The traditional approach starts by looking at stakeholders and their 
objectives (e.g. increase EPS by 5% per annum). The emphasis is then on formulating plans to achieve these objectives. 
This approach can be particularly usef ul for not-for-pro fit organisations 
A ‘market-led’ or ‘pos itioning’ approach 
The more modern ‘positioning’ a pproach starts with an analysis of 
markets and competitors’ actions bef ore objectives are set and strategies 
The essence of strategic planning is  then to ensure that the firm has a 
good ‘fit’ with its environm ent. If markets are expe cted to change, then 
the firm needs to change too. The idea is to be able to predict changes sufficiently far in advance to contro l change rather than always having to 
react to it.

Chapter 3 
 141 
 A ‘resource-based’ or ‘competence-led’ approach 
Many firms who have found anticipati ng the environment to be difficult 
have switched to a competence or re source-based approach, where the 
emphasis of strategy is to look at what the firm is good at – its core 
competences. 
Ideally these correlate to the areas that  the firm has to be good at in order 
to succeed in its chosen markets (its critical success factors – these are 
also difficult for competitors to copy. 
3.1 The key risks for each of the differing priorities 
Objectives are very important but th is approach can be risky if objectives 
are set in isolation from market cons iderations and are t hus unrealistic. 
 A ‘market-led’ or ‘ positioning’ approach 
The main risk with the positioning approac h lies in predicting the future. 
Some markets are so volatile that it is impossible to estimate further ahead 
than the immediate short term. 
The risk is that the company become obs essed by the things that they can 
do and lose sight of what is happening in the market and what the customers want – leading to produc ts becoming overly complicated and 
containing features the customer  does not want or understand. 
 
 J Ltd is a company which offers home  television repairs to customers. It 
has an excellent reputation for cu stomer service and good quality 
workmanship. J feels that this has gi ven it a competitive advantage in the 
market. 
J is considering launching a car main tenance and repair service. It feels 
that its excellent reputation is likel y to make such a move successful. 
Which of the following are the key risks that J will face given the 
approach to strategic planning they are adopting? 
A Issues predicting where the market will change B Unrealistic objectives C Losing touch with what the market demands D Stifling creativity through a rigid approach

142  
To:  A 
From: A. B Jones  
Date: 17/05/XX  
Subject:  GYU  
Hi A, You may not have heard of GYU – they are a new client of ours. GYU is 
a large company which manufactures mobile phone handsets. This is an 
extremely competitive market and GY U has recently been struggling to 
keep up with other companies in its se ctor. This is due to the fast-paced 
nature of the market. Ne w handsets with increasi ngly complex features 
are constantly being launched by com petitors and the directors of GYU 
are concerned that the range of handsets manufactu red by the company 
are beginning to look dated. 
the first time in its history, GYU ha s had to cut its dividend. The fall, which 
was around 10%, was met with an angry response by shareholders and 
GYU’s share price has fallen si gnificantly since the announcement. 
While GYU's position appears weak, it is  still seen as a market leader in 
the production of mobile handset softw are. While the reviews of its 
handsets are no longer entirely favourabl e, most customers agree that 
the software on the mobile phones is significantly superior to that 
produced by any of GY U’s competitors. 
I’m about to have a meeting with GYU’s directors for the first time and I 
think they will ask me to advise them about the three different approaches to strategy that GYU coul d use and in particular the risks that 
are associated with each one.  
I’d like you to email me back in the next fifteen minutes and tell me your 
thoughts on these matters. 
Required: 
4 Strategic analysis and choice 
Once the position has been identified, the organisation will be aware of its 
environment and the current strategic capability of the organisation. The 
questions then becomes "What should we do now to enable us to have the best chance of achieving our objectives?" In ot her words, which strategy should we 
follow?

Chapter 3 
 143 
should be deployed in any given circum stance, rather a range of possible 
strategies that could be used singly or jointly. 
4.1 Key decisions to make 
As part of strategic choice there are thr ee key levels of strategy to consider: 
For each SBU, what should be the basis  of our competitive advantage? 
organisation enter the market via organi c growth, acquisition or some form 
of joint expansion method, such as franchising? 
5 Competitive strategy 
Porter’s generic strategies suggests that  competitive advantage arises from the 
selection of a generic strategy which best fits the organisation's environment 
and then organising value-addi ng activities to support the chosen strategy. 
 
Strategic 
segment Focus 
 
Differentiation  – creating a customer perception t hat the product is superior to 
that of competitors so that  a premium can be charged, i.e.  that it is different and 
that customers are willing to pay more for this difference. 
Focus  – utilising either of the above in a narrow profile  of market segments, 
sometimes called niching. 
Porter argues that organisation s need to address two key questions: 
 Should the strategy be one of differentiation or cost leadership? 
 Should the scope be wide or narrow? 
end up being 'stuck in the middle'. This seems to suggest that Porter was advocating that organisations need to ma ke a basic competit ive decision early 
on in the strategic determination process.

144  
5.1 Cost leadership strategy 
This approach is based upon a business or ganising itself to be the lowest-cost 
producer. 
means that the organisation’s product is co mparable to those of its rivals, but is 
made more efficiently. 
 
 Cost leadership 
 Potential benefits are: 
 business can earn higher profits by charging the same price as 
 let’s company build defence against price wars 
 allows price penetration entry strategy into new markets 
 enhances barriers to entry 
 develops new market segments. 
Care needs to be taken when deciding on a pricing strategy as a cost 
leader. Cutting prices to below those of rivals can tr igger a damaging 
price war, as well as potentially s uggesting to customers that the product 
is inferior to those produced by mo re expensive competitors. Cost 
leaders may therefore choose to sell t heir products at a comparable price 
to those charged by rivals, but earn more profit which can be reinvested (such as in advertising, expansion or research and development) to gain 
Value chain analysis is central to i dentifying where cost savings can be 
made at various stages in the val ue chain. Attainment depends upon 
arranging value chain activities so as to: 
 reduce costs by copying rather  than originating designs, using 
cheaper materials and other cheaper  resources, producing products 
with 'no frills', reducing labour  costs and increasing labour 
productivity. 
 achieve economies of scale by high-volume sales allowing fixed 
costs to be spread over a wider production base. 
 use high-volume purchasing to obtain discounts for bulk purchase. 
 locate in areas where cost advantage exists or government aid is 
possible. 
 obtained learning and experience curve benefits.

Chapter 3 
 145 
Risks: 
 There is no fall back if the leadersh ip position is lost, for example 
strengthening of the currency may ma ke imports of substitute goods 
cheaper. 
 The organisation must continually adapt to ensure unit prices are kept low 
and consumer needs are met. 
5.2 Differentiation strategy 
superior to that offered by the compet ition. Differentiation can be based on 
product features or creating/altering c onsumer perception (i.e. through superior 
brand development to rivals). Diffe rentiation can also be based upon process 
 
 Differentiation 
 Benefits: 
 Products command a premium pr ice so higher margins. 
 Demand becomes less price elastic and so avoids costly competitor 
price wars.  
 Life cycle extends as branding becomes possible – hence 
strengthening the barriers to entry. 
Value chain analysis can identify t he points at which these can be 
achieved by: 
 creating products which are superio r to competitors by virtue of 
design, technology, performance, etc. Marketing spend becomes 
important 
 offering superior after-sales service by superior distribution, perhaps 
in prime locations 
 creating brand strength 
 augmenting the product, i.e. adding to it. 
 packaging the product 
 ensuring an innovative culture exists within the company. 
Risks: 
 there is a need to continually  innovate to defend the position 
 smaller volumes 
 associated costs, such as marketing, are higher 
 performance in a recession may be poor.

146  
5.3 Focus strategy 
This strategy is aimed at a segment of the market rather t han the whole market. 
A particular group of consumers are i dentified with similar needs, possibly 
based upon age, sex, lifestyle, income or geography and then the company will 
either differentiate or cost focus in that area. 
 
 Focus 
 Benefits: 
 smaller segment and so smaller inve stment in marketing operations 
 allows specialisation 
 less competition 
 entry is cheaper and easier. 
Requires: 
 reliable segment identification 
 consumer/customer needs to be reliably identified – research 
becomes even more crucial 
 segment to be sufficiently large to enable a return to be earned in 
the long run 
 competition analysis – given the sm all market, the competition, if 
any, needs to be fully understood 
 direct focus of product to consumer needs. 
Risks: 
 if successful it may attract other cost leaders/ differentiators due to 
potential low barriers to entry 
 low volumes may be sold. 
 
 Niching 
 Niching can be done via specialisation by: 
 location 
 type of end user 
 product or product line 
 quality 
 price 
 size of customer 
 product feature. 
If done properly it can avoid confr ontation and competition yet still be 
profitable.

Chapter 3 
 147 
The key risks to consider for the market niche: 
 the niche must be large enough in terms of potential buyers 
 the niche must have growth  potential and predictability 
 the niche must be of negligible interest to ma jor competitors 
 the firm must have strategic capabili ty to enable effective service of the 
niche. 
 
 Casio Electronics Co. Ltd – Casio has sold over 1 billion pocket 
calculators. It follows an industr y-wide cost leadership approach. Its 
calculators are certainly not inferior  products, being able to perform over 
two hundred basic scientific functions . How does it do it? Consider its 
value chain: 
 Operations – mass manufactured in China, which has cheaper 
 Operations – ‘buttons’, display an d instructions manuals are multi– 
 Procurement – mass purchas e/production of components. 
 Outbound logistics – packaging is robust, yet allows a considerable 
number of calculators to  be shipped at any time. 
 
 British Airways (BA) is a mu ltinational passenger airline. It has adopted a 
differentiation approach by offeri ng passengers a higher-quality 
experience than many of its rivals. This  allows it to charge a premium for 
its flights compared to many other ai rlines. Again – examination of its 
value chain may help to expl ain how it achieves this: 
 Procurement – prime landing slot s are obtained at major airports 
 Procurement – high-quality food and dr ink is sourced from suppliers. 
 Operations – well-maintained, clean and comfortable aircraft are 
sourced. 
 Operations – high numbers of attendants on each flight. 
 Marketing – advertising based on quality of service provided. 
 Human resources – training in cust omer care and the recruitment of 
high-quality staff.

148  
 Focus 
 Ferrari is an example of a company t hat focuses on a niche market in the 
automobile industry. It produces ex tremely high quality cars which 
command a high premium price. Howeve r, this means that Ferrari only 
has a very small percentage of the global car market, as the majority of 
consumers are unable to afford its high sales prices. 
fail to justify the company's attention.  In addition the niche may shrink or 
disappear altogether over time as consumer tastes and fashions change. 
5.4 Risks of Porter’s generic strategies 
In spite of its popularity,  there are a number of pr oblems with Porter’s generic 
strategies model, including: 
 Porter argues that any business that  attempts to adopt more than one of 
the generic strategies will become ‘stu ck in the middle’. He suggested that 
this is because a business will be unabl e to successfully implement more 
than one at the same time, leading to st rategic drift. In reality this may be 
too simplistic. 
A number of companies do not fit into one of the classic generic strategies 
and adopt a ‘hybrid’ approach. Successful UK supermarket chain Sainsbury’s uses a slogan ‘Live well for less’, suggesting to its potential 
customers that its produc ts are both lower price than rivals and good 
quality – both differentiation and cost leadership. 
 Cost leadership in itself ma y not give competitive advantage. 
Failure to pass on cost savings to customers through lower prices may 
mean that the business fails to gain an edge over rivals. Passing on the cost savings may trigger a price war with rivals, meaning that the company 
fails to benefit fr om the strategy. 
 Differentiation may not always lead  to a business being able to command 
a high price for its goods. It may be used to generate increased sales 
volume – which Porter argued was typically the purpose of a cost 
leadership approach. 
 
 Company W makes motor vehicles. Se veral years ago, W restructured its 
value chain to significantly reduce production costs and improve quality. 
This was in response to similar ac tivities by its W’s major rivals. 
Because of this, W has been able to maintain its prices at only a slightly 
higher level than those of its competitors, while c ontinuing to produce a 
wide range of cars that are tailored to a variet y of market segments.

Chapter 3 
 149 
 W has recently decided to undertake a significant investment in 
advertising, as it feels that its bran d is one of the most  recognised in the 
market. W wishes to further increase t he desirability of it s brand, which it 
feels could allow it to rais e its prices slightly in the coming year, while still 
Applying porter’s generic strategy model, what are the most likely 
risks of W’s current approach? 
A As the lowest cost producer they could lose their advantage if one of 
their competitors makes significant cost savings. 
B The market is not big enough to generate growth opportunities. C Brand perception helps generate sales. D Low volumes will be sold as the segmentation leads to a narrow 
market. 
E Marketing costs are higher to protect the firms image 
F They may suffer in a recession 
 
 Y is a small business that sells furnitur e in country H. It is considering its 
future corporate strategy. 
The furniture market is dominated by large manufacturers, who have 
large factories as well as close relationships with key suppliers of raw materials. Y is currently the twentieth  largest manufacturer of furniture in 
country H. 
Y’s market analysis has identified t hat there are a m oderate number of 
self-employed individuals in country H who work from home and who desire standard office furniture that is  also fashionable. However, there 
are several companies who have built up established brand names in this sector of the market. 
Y currently makes furniture for sma ll to medium sized businesses (such 
as desks and office chairs). Products in this segment of the market are 
fairly generic as businesses typically choose a furniture supplier based on 
price. There are a large num ber of other suppliers of this style of furniture 
in country H – including severa l of the larger manufacturers. 
Y is concerned that it lacks the appropria te skills to make other types of 
furniture.

150  
 Considering Y’s strategy, which of the following are the most likely 
risks that Y will face? 
A A small niche with limited growth 
B Lack of differentiation C Inability to compete on costs due to economies of scale D Poor marketing effort to publicis e the unique nature of their products 
E Too many competitors targeti ng the same niche as them  
 
 Test your understanding 11 – AVA – (Case style) 
 You work as a senior manager for AVA, an airline company that offers 
regular passenger flights from seve ral countries in country L to 
destinations all over the world. 
cost service with few passenger comforts  or luxuries. Customers have to 
book seats online, with no chance for interaction with an AVA staff 
member. Seats (which are renowned by  customers for their lack of leg 
room) cannot be pre-booked and AVA has a poor record for delays and 
cancellations. 
able to offer its flights at extremely lo w prices. In recent years, however, 
the company’s profits have fallen as the economy of country L has 
started to recover from a long rece ssion. This has led the company to 
start looking at ways of improving profitability. 
Your manager, the finance director (FD) of AVA sends you the below 
email: 
To:  Senior manager  
From:  Johan O’Leary, FD   
Date:  16/09/XX  
Subject:  AVA Strategic direction  
I’ll get straight to the poi nt, the directors feel t hat the company is missing 
out on the lucrative first class servic e market – current ly dominated by 
several major international airlines which are significantly larger than 
AVA. While first class travellers require more services and better facilities, these types of customers pay  a significantly higher ticket price. 
The company would therefore convert t he front section of several of its 
aircraft into ‘first class’ with fe wer seats and more leg room. Passengers 
could book these seats through a s eparate system which would enable 
them to speak to an adviser if t hey had any problems. AVA would also 
offer free food and drink on the flight to first class passengers. This 
service would not be available to standard class customers.

Chapter 3 
 151 
 The airplanes that AVA upgraded would all be based on one of its 
major routes, to maxi mise potential appeal. 
The directors are conc erned that we may be su sceptible to certain 
risks. They would like to examine our existing and first class strategies 
using Porter’s generic strategies, in particular focussing on the risks of these strategies for AVA. 
Thanks FD 
Required: 
Draft the report as reques ted in the FD’s email. 
6 Product-market strategy 
6.1 Ansoff’s matrix 
The product/market growth framework 
Ansoff’s matrix provides a commonly used model for analysing the possible 
strategic directions that an organisation can follow. It is therefor e useful in areas 
of strategic choice:

152  
 Ansoff 
 Market penetration 
The main aim is to increase market share using existing products within 
existing markets. 
Approach 
 new uses of advertising 
 promotions, sponsorships 
 quantity discounts. 
 pricing 
 promotion and advertising 
 process redesign, e.g. Internet/e-commerce 
Key notes: 
 overall market is growing 
 market not saturated 
 competitors leaving or weak 
 strong brand presence by your co mpany with established reputation 
 strong marketing capabilities  exist within your company. 
Aims to increase sales by taking the present product to new markets (or 
new segments). Entering new mark ets or segments may require the 
development of new competencies which serve the particular needs of 
customers in those segments, e.g. cultural awareness/linguistic skills. 
Movement into overseas markets is  often quoted as a good example as 
the organisation will need to build  new competencies when entering 
international markets. 
Approach 
 Add geographical  areas – regional and national 
 add demographic areas – age and sex 
 new distribution  channels.

Chapter 3 
 153 
 Key notes 
 Slight product modifications may be needed 
 advertising in different m edia and in different ways 
 research – primary research at th is point given significance of the 
 company is structured to pr oduce one product and high switching 
costs exist for transfer to other product types 
 strong marketing ability is needed, usually coupled with established 
brand backing, e.g. CocaCola 
Approach: 
 develop product features of a significant nature 
 create different quality versions. 
Key notes: 
Company needs to be innovative and st rong in the area of R&D and have 
an established, reliable marketing database. 
Constant innovation allows for the developing sophistication of 
consumers and customers and ensu res that any product-related 
competitive advantage is maintained. 
Key notes: 
Appropriate when existing markets ar e saturated or when products are 
reaching the end of their life cycle. It  can spread risk by broadening the 
portfolio and lead to ‘syner gy-based benefits’, allegedly. 
This approach goes through periods of  being in and out of favour, and 
debate continues about whet her this is a good strategic option. Critics 
argue that it is madness to take re sources away from known markets and 
products only to allocate them to bus inesses that the co mpany essentially 
knows nothing about. This risk has to  be compensated for by higher 
rewards, which may or may not exist.

154  
 Brand stretching ability is often seen as being the critical success factor 
for successful diversification – this  is a possible discussion point. The 
new business and its strategy may well have 'teething problems' with its 
implementation and this ma y damage brand reputation. 
 Objectives can no longer be met in known markets – possibly due to 
a change in the external environment. 
 Company has excess cash and powerful shareholders; 
 Possible to 'brand stretch' and benefit from past advertising and 
promotion in other SBUs. 
 Diversification promises greater  returns and can spread risk by 
removing the dependency on one product. 
 Greater use of distribution syst ems and corporate resources such 
as research and development, market research, finance and HR 
leading to synergies.  
 
 Ansoff 
  Kellogg’s have repositioned t heir products through various 
‘have you forgotten how good they taste?’ campaign was to remind adults, who buy cereals for their ch ildren, of the virtues of their 
product. 
 Kwik Fit, a motor repair company, t ook the opportunity to cross sell 
insurance to customers on thei r database who had visited their 
outlets to have equipment fitted ( product development –
 Kaplan now sell their ACCA cour ses in Eastern Europe and Asia, 
amongst other countries, rather than just their traditional UK 
markets ( market development ). 
 Virgin, a multinational congl omerate, has expanded into a wide 
range of different activities, incl uding airlines, trains, cosmetics, 
wedding wear and so on ( diversification ). 
6.2 Risks 
Market penetration is the lowest risk opti on in Ansoff’s matrix, but given the risk 
reward trade off, it is also likely to yi eld the lowest return. The key risk therefore 
is that it does not generate the returns the organisation requires. 
For example, a company could increas e their advertising spend significantly, 
but they may well have already reached all of  their target mark et already and so 
fail to increase sales.

Chapter 3 
 155 
Product development increases risk for an organisation – R&D costs can be 
significant in product design and develop ment. If the resultant product is not 
appropriate for their core mark et or if a competitor get s to the market quicker or 
with a better product, then the new product may fail, leading to significant losses. 
New markets can be very varied.  The company could be selling to a new 
segment (for example age range or sex), or  it could be selling in a new country. 
However an organisation chooses to devel op its market it must do thorough 
research into whether their entry into t he market is viable. Failure, as well as 
significant cost of entry and exit, coul d also lead to reputational damage too. 
 
 Market development failures 
  Monsoon clothing entered the male  clothing market for a time, 
having previously focussed on the female market. For a variety of 
reasons, most prominently a la ck of awareness of them selling 
clothes to the male marke t, the development didn’t work. 
 Marks and Spencer have on numerous occasions attempted to 
enter mainland Europe, but have fail ed to get their st rategy right.  
So far the development has not worked, sometimes leading to a 
downturn in fortunes in their core UK market as a result of their 
efforts. 
 
The riskiest option in Ansoff’s matrix. There are different types of diversification, 
related (for example vertic al integration) or unrelated. Both have their risks. 
 Related  is less risky, either buying a s upplier or customer. For example a 
chain of pubs buying a brewery (or vi ce versa). There is knowledge and 
similarities to the current operations, but it can increase your reliance on 
the market you serve and reduce c hoice. If for example you bought a 
supplier and then had issues it would not  be as easy to switch supplier 
given you now owned a competitor. 
 Unrelated  is the most risky approach, this  is entering a market with no 
common thread to the current operations . The key risks with this are a lack 
of knowledge and skills, the co st of entry, the time it  would take to develop 
share in that market. Sometimes th is leads companies to acquire an 
existing company to enter into that market.

156  
7 Acquisition 
acquisitions, merger s or organic growth. 
 
 Acquisition refers to a corporate acti on in which a company buys most, if 
not all, of the target company's ow nership stakes in order to assume 
control of the target firm.  
 
 Mergers are business combinations that  result from the creation of a new 
reporting entity formed from  the combining parties. 
 Note that, for our purposes there is li ttle or no strategic difference in risks 
between an acquisition and a merger. 
 
 Organic growth is growth through inte rnally generated projects, such as 
increased output, customer base expansi on, or new product development. 
 Acquisition may be more expensive than organic growth because the owners of 
the acquired company will need to be paid fo r the risks they have already taken. 
On the other hand, if the company goes for organic growth it mu st take the risks 
itself so there is a trade-off between cost and risk. 
A company can gain synergy by bringing  together complement ary resources in 
advantage to a firm gained by having existing resources which are 
compatible with new products or  markets that the company is 
developing'.  
marketing facilities such as distribut ion channels. Investment synergy may 
result from the joint use of plant  and machinery or raw materials. 
An acquisition must add value in a wa y the shareholder cannot replicate in 
order to avoid the risks associated wit h diversified companies (see Ansoff).

Chapter 3 
 157 
 Benefits of acquisitions over organic growth 
Acquisition has some significant benefits over internal growth. 
 High-speed access to resources – this is particularly true of brands; 
an acquisition can provide a power ful brand name that could take 
 Avoids barriers to entry – acquisition may be the only way to enter a 
market where the competitive stru cture will not admit a new member 
or the barriers to entry are too high. 
 Less reaction from competitors – there is less likelihood of 
retaliation from existing companies because an acquisition does not 
alter the overall capacity of  the competitive arena. 
 It can block a competitor – if Kingfisher’s bid for Asda had been 
successful it would have denied Wa lmart its easy access to the UK. 
 It can help restructure the operating environment  – some mergers of 
 Relative price/earnings ratio – if the P/E ratio is significantly higher 
in the new industry than the present one, acquisition may not be 
possible because it would cause a dilution in earnings per share to the existing shareholders. But if the present company has a high P/E ratio it can boost earnings per s hare by issuing its own equity in 
settlement of the purchase price. 
 Asset valuation – if the acquiri ng company believes the potential 
acquisition’s assets are undervalued, it might undertake an asset-
stripping operation. 
7.1 Risks associated with growth by acquisition 
There are some considerable risks asso ciated with this method of growth . 
 Acquisition may be more costly than internal growth because the owners 
of the acquired company will have to be paid for the risk already taken. On 
the other hand, if the co mpany decides on internal growth, it will have to 
bear the costs of the risk itself. 
 There is bound to be a cultural mism atch between the organisations – a 
lack of ‘fit’ can be significant in knowledge-based companies, where the 
value of the business resides in individuals. 
 Differences in managers’ salaries – another example of cu ltural mismatch 
that illustrates how managers are va lued in different countries.

158  
 Disposal of assets – companies may be forced to dispose of assets they 
had before the acquisition. The al liance between British Airways and 
American Airlines was called off bec ause the pair would have had to free 
up around 224 take-off and landing sl ots to other operators. 
 Lack of knowledge – despite due diligenc e, there is the risk of not knowing 
all there is to know about the business it seeks to buy. 
 Reduction in return on capital em ployed – quite often an acquisition adds 
to sales and profit volume without adding to value creation 
7.2 The key control for an acquisition 
Due diligence 
Due diligence is an investigation of a bus iness prior to signing a contract. It 
relates to the process through which a company will evaluate a target and their assets prior to acquisition. Due diligence should provide information that allows 
for more informed decision making regar ding the acquisition. There is always 
risk involved in any acquisition, but the work done here is designed to help 
reduce the uncertainty and control the risks that the acquirer will face as they go 
through the acquisition and afterwards as the company looks to make a 
success of the combined entity. 
Although due diligence usually goes bey ond simply looking at financial 
information, it is likely that this will be the main part of the investigation. Due 
diligence is a control to reduce the likeli hood of overpaying for a target company  
This process is particularly important if a private company is the target. As such, 
they would not have been subject to t he same scrutiny as a listed company. 
Due diligence would be the first opportuni ty for the acquirer to obtain some of 
the information on the target as it woul d not be available from public sources. 
Possible areas of focus for due diligence: 
 Financial statements 
 Strategic Fit 
 Employee/Management Issues 
 Property 
 Competition commission 
 Intellectual Property 
 Contract review 
 Pending litigation 
 Tax 
 Insurance  
If both parties are aware of  the due diligence activities  that are likely to be 
carried out, the process is more likel y to run smoothly and effectively.

Chapter 3 
 159 
 Due diligence considerations in more detail 
 Financial statements 
Review of the historic financ ial statements, considering: 
 financial metrics 
 reasonableness of the financial forecasts 
 verification of the assets owned and their value 
 analytical review of annual, quarterl y, monthly financial statements, 
potentially going back several years 
This may reveal important info rmation and background knowledge about 
the financial performance (past and futu re) which may impact the price a 
company is willing to pay. External auditors may be used to verify the 
financial information represents a true and fair view. 
Strategic Fit 
Due diligence is not only assessing the target company’s potential future 
performance per the financial forecasts, it is also designed to understand 
how the target will fit strategically within the combined entity. Considerations would be: 
 potential enhancements after the acquisition  
 cost savings and other synergies 
 time and cost of integration. 
Employee/Management Issues 
Acquisition is a time of change an d potential unease amongst staff. The 
due diligence team will also want to  look at whether there are any 
underlying issues that may cause di sruption in the future. Acquiring 
information on the target company’s  organisational structure, labour 
disputes, employee benefits (profit sharing, pension plans and so on) 
would be useful to gauge any potential issues but also compare with our 
own arrangements.  
For example, if talent management at the acquiring company is very 
important it will be important to consider  whether aligning the two entity’s 
policies in the future may cause tu rbulence not just to the target’s 
employees, but to the acquirer too. 
Property 
A review of any premises the target  owns or leases should be undertaken 
to consider if they are in line with the acquirer’s plans would be essential. 
It is unlikely that all the target co mpanies’ locations would be kept after 
acquisition, so the best locations s hould be identified and any locations 
no longer required should be reviewed in terms of break clauses or saleability.

160  
 Competition commission 
If the acquisition or merger is rela ted to companies competing in the 
same industry, thought must be given to the combined market share that 
would materialise. Significant mark et share could prove problematic 
giving rise to regulatory issues with any Competition Commission in 
affected countries. 
Intellectual Property 
An acquisition or merger is rarely  carried out just because of financial 
assets. One of the main reasons in  the modern age is the intellectual 
property of the target and this may also  require valuation. This is likely to 
include, but not limited to: 
 website operations 
 mobile apps 
 data analytics processes. 
The due diligence team may want to look  at whether the target has taken 
appropriate steps to protect its intellectual property (including 
confidentiality agreements with curr ent and former employees regarding 
any data analytics processes).  
Contract review 
The due diligence process is likely to review the material contracts the 
target holds in order to fully understand its commitments. These may 
involve supplier or customer contracts. The acquirer may want to ensure these contacts will be carried forward under new ownership. Although laborious, a contract review  is critical. Without it , the acquirer may not be 
aware of costs, such as terminati ng a contract early, which can pose 
significant financial and operational obligat ions that require consideration.  
Pending litigation 
The acquirer needs to know whether there are any ongoing claims, 
closed claims or pending lit igation. Acquiring a huge legal case would not 
be ideal as part of any deal. 
Tax 
In any acquisition the buyer would need to consider the tax situation of 
the target company, reviewi ng any tax returns and getting an 
understanding of any tax balances  or correspondence with the tax 
authorities of the relevant countries. As  with the litigation,  the buyer does 
not want to end up acquiri ng a large tax liability. 
Insurance  
It will be important to check what insu rance policies the target has in 
place. If the policies do not appear appr opriate in terms of the level of 
cover or excesses, then break clauses and costs to improve the cover would need to be ascertained.

Chapter 3 
 161 
8 Joint methods of expansion 
8.1 Joint development methods 
 joint venture 
 strategic alliances 
 franchising 
 licenses 
 outsourcing 
In any joint arrangement key considerations are: 
 sharing of costs 
 sharing of benefits 
 sharing of risks 
 ownership of resources 
 control/decision making 
 
business entities. Assets are forma lly integrated and jointly owned. 
 sharing cost 
 sharing risk 
 sharing expertise. 
In the UK, an example of a joint vent ure is Virgin Trains – a company 
whose share capital is 51% owned by the Virgin Group and 49% owned by Stagecoach. The joint venture a llowed the two companies to work 
together to take advantage of the privatisation of  the nationalised British 
Rail. 
formed by two or more separate organisa tions for strategic purposes, that 
allocates ownership, operational re sponsibilities, financial risks, and 
rewards to each member, while preserving their separate identity/autonomy.

162  
 Alliances can allow participants to achieve critical mass, benefit from 
is whether or not a new, indepen dent business entity is formed. 
A strategic alliance is often a prelim inary step to a jo int venture or an 
acquisition. A strategic alliance ca n take many forms, from a loose 
informal agreement to a formal joint venture. 
Alliances include partnerships, joint v entures and contracting out services 
Seven characteristics of a well-st ructured alliance have been identified. 
 Strategic synergy  – more strength when combined than they have 
 Positioning opportunity  – at least one of the companies should be 
service; to secure access to raw materials or technology). 
 Limited resource availability  – a potentially good partner will have 
strengths such as access to scarce resources that complement 
weaknesses of the other  partner. One of the partners could not do 
this alone. 
 Less risk  – forming the alliance reduces  the risk of the venture. 
 Co-operative spirit  – both companies must want to do this and be 
 Clarity of purpose  – results, milestones, methods and resource 
 Win-win  – the structure, risks, oper ations and rewards must be 
Some organisations try to retain some  of the innovation and flexibility that 
is characteristic of small companies by forming strategic alliances (closer 
working relationships) with other organisations. They also play an important role in globa l strategies, where the organisation lacks a key 
success factor for some markets. 
An example of a strategic alliance is  that pursued by Starbucks in 2012, 
in an attempt to break into the I ndian coffee shop market. It formed an 
alliance with Tata Global Beverages – a large Indian drinks company –with both parties investing $80m in order to open a number of Starbucks 
stores across India. Starbucks had si gnificant experience of running 
coffee shops, while Tata had strong local knowledge of the growing Indian drinks market.

Chapter 3 
 163 
 Franchising 
The purchase of the right to exploi t a business brand in return for a 
capital sum and a share of  profits or turnover. 
 The franchisee pays the franchisor an initial capital sum and 
thereafter the franchisee pays the fr anchisor a share of profits or 
 The franchisor provides market ing, research and development, 
 The franchisor normally provides the goods for resale. 
 The franchisor imposes strict ru les and control to protect its brand 
 The franchisee buys into a succe ssful formula, so risk is much 
lower. 
 The franchisor gains capital as the number of franchisees grows. 
 The franchisor’s head office can stay  small as there is considerable 
example, around half of all McDonal ds restaurants are franchises. 
Licensing 
proceeds. Licensing differs from a fr anchise because there will be little 
central support. 
In the UK, many beers such as He ineken and Fosters were ‘brewed 
under licence’ in the UK for many year s, with the original  companies that 
developed the beers simply taking a shar e of the proceeds from the local 
brewers. 
organisation, previously done in-house, to specialist providers. Almost 
any activity can be outsourced – exam ples include information technology 
or payroll. 
Mobile telecommunications company  O2 has recently announced plans 
The public sector may also undertake  outsourcing. For example, in 2013 
Barnet Council in London announced pl ans to outsourced much of its 
corporate procurement, IT and HR servic es to Capita – a private sector 
company.

164  
8.2 Key risks of joint development methods 
Regardless of the choice of collaborati on an organisation uses, the key risks of 
partnering with a third party are: 
 Strategic fit  – the partner chosen needs to have a similar strategy 
because by association the two (or more) collaborating firms will affect 
each other’s reputation. 
 
 Innocent and McDonalds 
 Innocent collaborated with McDonalds for a short time, Innocent 
effectively used them as a distribut ion channel for their smoothies.  
The smoothies became a healthy option in McDonalds Happy Meals. The 
logic being that McDonalds wanted to  portray themselves as offering 
healthier alternatives (they have sinc e gone on to offer a lot more healthy 
options), Innocent saw it as an excelle nt way to increase the opportunities 
for people to choose one of their smoothies. It seemed the perfect 
The collaboration did not last very long.  The smoothies were not a 
popular choice, McDonalds customers stuck with their core options of 
milkshakes and fizzy drinks, and Innocent in particular received a lot of criticism for collaborating with a firm that many stakeholders felt went 
against a lot of the core values that Innocent stood for. 
 Cost sharing  – the two companies will hav e to come to an agreement 
over how costs are split or who bears par ticular costs. This can be difficult 
and can lead to disagreements 
 Knowledge sharing  – by partnering with a firm,  there is a risk that an 
organisation may have to reveal so me of its trade secrets, depending on 
how close the collaboration is. Careful consideration must be given to who 
a company collaborates with and what  skills and knowledge they share in 
the collaboration. 
 Profit sharing  – the ultimate aim for most co llaborations is to increase the 
collaborating organisations ’ ability to make m oney, therefore a key 
discussion point must be how the prof its are split and it  must be deemed 
proportionate to the risks each party is taking on in t he collaboration. 
 Loss of control  – partnering with other organisa tions requires trust that 
the partner will perform its work to the same standard as normal. Any 
issues with quality of product or servic e will have a knock on effect to the 
reputation of the other organisation.

Chapter 3 
 165 
 Amazon 
 Internet retailer Amazon operate what  many people refer to as a network 
organisation, where a network of co mpanies collaborate to provide the 
customer with the goods they desire. 
For example, one company manufact ures the product, a retailer may 
offer it for sale through the amazon w ebsite, payment is made via a credit 
or debit card provider and then deliver y is made by a logistics/courier 
firm. 
If anyone of these collaborating organisati ons do not carry out their role in 
the collaboration to the appropriate st andard it can tarnish the reputation 
of Amazon. This is one of the reasons Amazon a sk for feedback-  there 
will be strict targets fo r customer satisfaction levels imposed on those 
organisations allowed to use the Amazon platform. 
 Loss of development opportunities  – collaboration is often used to 
enter into a new geographic market or offer a service/product the company 
did not previously provide. If an alternative approach had been used then 
an organisation could have developed thes e skills themselves rather than 
effectively outsourcing them. 
 
 H Ltd wishes to rapidly expand its popul ar chain of retail stores, but does 
not have the capital needed to do so. It has decided to consider joint development methods in order to aid its growth, but H Ltd’s owner T is 
uncertain about which method to use. 
T is unwilling to allow any other individual or organisation to have 
significant influence over H’s strategic operations as he is used to having the final say over all major decisions within the company. 
staff to continue to be trained centrally , as well as all fixtures, fittings and 
inventory to be purchased from  authorised suppliers only. 
Which of the following methods of joint development would be most 
A Licensing 
B Franchising C Joint venture D Strategic alliance

166  
be the most suitable for t he following circumstances? 
(2) Oil companies are under political  pressure to develop alternative, 
(3) A beer manufacturer wants to mo ve from their existing domestic 
9 International growth 
When deciding whether to expand abroad,  a business has several possible 
strategies that it can adopt: 
 Exporting strategy  – the firm sells products made in its home country to 
perhaps poor sales at home force t he business to export or collapse. 
 Overseas manufacture  – the firm may either m anufacture its products in 
a foreign country and then either impor t them back to its home country or 
sell them abroad. Either way, the fi rm is involved in direct foreign 
investment because it is purchasing c apital assets in another country. For 
example, Nissan Motors is a Japanes e company, but operates plants to 
build its motor vehicles across the world, including North-East England. 
 Multinational  – these firms co-ordinate thei r value-adding activities across 
have engine plants in one country, car body plants in another and electrics in a third. Production capacity is  often duplicated around the world. 
 Transnational  – these are ‘nation-less’ firms  that have no ‘home’ country. 
Employees and facilities are treated ident ically, regardless of where they 
are in the world. The company ma y be listed on several national stock 
exchanges. This is often considered to  be (currently) largely theoretical. 
When deciding between which approaches  to take if expanding abroad, 
consideration should be given to t he risks of international growth: 
 Political risk  – the risk that government po licy may make it difficult to 
operate successfully in the new country. 
 Foreign exchange risk  – the risk that earnings could be reduced by 
currency fluctuations.  
 Need for capital investment  – this will be lower if an exporting strategy is 
used. 
 Risks to customer relationships  – given the distance between the 
manufacturer and its foreign consumers, this can be hard to maintain in an 
exporting strategy.

Chapter 3 
 167 
 Increased risks in the supply chain  – manufacturing at a distance from 
your target market will increase the cost of getting the units to them. 
 Ethical risks  – if operating in countries wit h less developed labour laws, 
 Cultural risks  – managing operations in foreign countries can be difficult 
due to differences in language and cu stoms. This can also make 
advertising and operational  control difficult. 
 
 YH operates a large num ber of food production fac ilities, based in country 
N. In particular, YH’s operations fo cus on the growing and harvesting of 
soft fruit. YH then sorts and grades the fruit, before shipping it to retailers, 
such as large supermarkets. 
YH has struggled to find the amount  of farmland it needs in order to 
expand its production in its home country. In recent years, therefore, YH 
has been buying farmland and facilities in several new countries around the world. This has allowed it to expand its sales into a number of new 
geographical markets and grow its business. 
This business model has been so successful  that a significant majority of 
Which of the following options is th e best match to the international 
A Transnational 
B Exporting C Multinational D Overseas manufacture 
10 Disruption 
In the modern business world, a key strat egic risk to consider is disruption, or, 
to use its full name, disruptive innovation. 
10.1 What is disruptive innovation? 
A disruptive innovation is new devel opment, commonly involving advancement 
in technology, that changes (disrupts) an existing market or potentially creates a 
new market, that leads to the replacement  of an existing market and can often 
lead to well-known firms or products having a significant drop in sales.

168  
 Amazon 
 One of the biggest disruptors is onlin e retailer, Amazon.  The simplicity, 
range of products and the competitive pricing has made them very hard 
to ignore for consumers around the world.  
They have contributed towards many  leading companies struggling or 
failing. In the UK, the online retaile r has been partly responsible for the 
failure of Woolworths, the struggl es at music retailer HMV, and the 
department stores Debenhams an d House of Fraser.  
Focussing on the department stores, the unique selling point of the 
department store was the range of goods that were available under one 
roof, but now people have that range of goods – and more – available to them on one internet site or mob ile phone application. Now, with the 
introduction of the virtual assistan t in an ever increasing number of 
homes, consumers do not even need to  open an app or go online – they 
can buy from Amazon by just saying a few words.  This has been one of 
the key consideration for Amazon – finding ways to make the purchase easier for the consumer. 
Amazon are now moving outside of retail and attempting to disrupt 
markets such as healthcare, l ogistics and even home security. 
10.2 The role of technology in disruption 
Technological advancements play a huge par t in disruptive innovation – where 
a company or an individual identifies how  technology can be used to make life 
easier. Sometimes the disruptio n is an unintended consequence of the 
technological advancement, sometime s the intended disruption doesn’t 
materialise. 
 
 Disruption is not always the end 
 Disruption itself is nothing new, it has been happening for many years, it 
is just that the frequency of disruption is increasi ng, making it more of a 
concern for organisations. 
When the television set first start ed appearing in people’s homes in the 
late 1920s, and then again when home video was first introduced in the late 1970s and early 1980s, th rough VHS and Betamax videos, 
commentators were predict ing the end of cinemas.  
Cinemas still exist, because they have a unique selling poi nt that cannot 
be replicated in the home, even with the continued impr ovement of the 
home experience.  Cinemas have impr oved their offerings (including 
more comfortable seating, better sound, bigger screens) to remain 
relevant and competitive.

Chapter 3 
 169 
10.3 Considerations fo r successful disruption 
Another concern regarding di sruption, strategy and technology is choosing the 
right platform to take to market.  The platform must be one that enables the 
disruptor to maximise the returns from t heir disruption. Some of the factors that 
influence the success of the disruptors are: 
 Simplicity  – the ease of ordering on Amazon  is one of their reasons for 
success as a disruptor. 
 Resources  – using less of a scarce resource or generally being more 
environmentally friendly. For example LE D light bulbs use significantly less 
power than incandescent li ght bulbs and last longer. 
 Cost  – a key consideration for most purchasers whether they are 
individual consumers or businesses and the reason that many battles are 
won.  VHS became the industr y standard in home video ahead of 
Betamax because it was cheaper – even though it was a technically 
inferior product. 
 Accessibility  – the ability to use a device or application makes it a more 
appealing alternative. For exampl e, WhatsApp as a group messaging 
service, is available on all smart phones, while iMessage is only available 
on iOS (Apple) devices. Another exampl e is Blu-ray becoming the industry 
standard for high quality images on DVD over Toshiba’s HD DVD.  One of the factors was that milli ons of people had the facility to play Blu-ray DVDs 
through their PlayStation while very  few HD DVD players had been sold. 
 Quality  – doing something significantly better than it is currently done can 
also be a source of disruption.  
 
 Being out-disrupted 
 In the 1990s Sony were investing in production of a MiniDisc that was 
going to disrupt the CD market. The MiniDisc would be smaller than the 
CD, provide better quality audio and woul dn’t skip if they were knocked 
(so would be more popular for use while exercising).  
The MiniDisc provided all these things, but just as it was breaking into the 
market the MiniDisc was disrupted by digital music.  MP3 & MP4 players 
such as Apple’s iPod entered the mark et offering all benefits of the 
MiniDisc but also used less resource s and increased accessibility by not 
needing a disc to play music.  Instead all music was stored in files on the 
device giving access to hundreds or thousands of songs depending on 
the internal storage on the device. 
MP3 and MP4 players have now been disrupted by increased 
connectivity and improved data access.  Rather than have a certain 
number of songs stored on a device and pay for an individual song or 
album, consumers can pay a monthly f ee to a music provider and stream 
(the simultaneous delivery and use of the media as opposed to 
downloading a media file, then playi ng it later) music through mobile 
telephone networks or using WiFi, giving them access to limitless songs 
at the touch of a screen.

170  
 Electronic maps 
 Another example of disruption is the market for maps.  Previously 
companies who produced maps w ould regularly (at least annually) 
update and reprint all maps. Walkers, hi kers, taxi drivers, haulage drivers, 
a huge variety of people and workers would require up to date information about routes and locations. 
Technological advancements mean t hat most people now have an 
electronic device either specifically for this (Satellite navigation systems) 
or a device that provides a simila r service (most smart phones). These 
electronic maps are live, so ar e updated constantly , and those used on 
the roads even include traffic updates. 
At present map companies  have not gone out of busi ness.  There is still a 
demand for paper maps as electronic data coverage is not comprehensive enough in most count ries. Most map companies have 
changed their mode of operation to  produce paper maps on demand, 
therefore reducing overhead costs and having a more flexible business 
model, but also using their brand name in the industry to launch 
applications for smart devices and making money from these 
 
 Accept change and challenge the current 
 Disruption requires someone or some people to think differently, Apple 
has already appeared in this text book  as an example of a company that 
has done things differently. Steve Jobs once said “You can’t just ask customer what they want and then try to  give that to them. By the time 
you get it built, they’ll want something new.” 
Another example of someone who chal lenges current concepts is Elon 
Musk such as: 
 how we pay for things – PayPal 
 how we interact with comput ers – setting up a company called 
Neuralink that is working on devel oping a brain-computer interface 
 transportation:  
 electric cars – Tesla  
 SpaceX – working on reducing the co st of transportation in space  
 The Boring Company – working on an underground hyperlink 
between New York City, Philadel phia, Baltimore and Washington 
DC, with the aim of reducing t he transport from New York to 
Washington DC to less than 30 minutes. 
Elon Musk is prepared to try somethi ng new and do things differently. He 
probably accepts that not all of the companies he has set up will be 
successful, but he knows that one of t he ways to be successful is to do 
things differently.

Chapter 3 
 171 
 Ebaps Ltd is an online sandwich delivery company, based on the 
outskirts of a major city. The company was set up in an attempt to disrupt 
the lucrative lunchtime sandwich market of the city centre and 
surrounding out of to wn business parks.  
A customer goes onto the website before 10:30 in the morning and 
design their sandwich from the wide vari ety of choices including different 
types of bread, spreads, meats, chees es and other additions like olives 
and sundried tomatoes. They enter their delivery postcode and select a timeslot for delivery to their office or potentially their home if they fall 
within the correct postcodes. The deliver y is carried out by the company’s 
own delivery drivers who are specific ally employed on a part time basis 
by Ebaps. 
As the range is breads and fillings are so extensive Ebaps have chosen 
to charge a premium for the product and service they are offering and each additional sandwich fill ing increases the costs.  The premium is also 
required as they do not yet have ec onomies of scale, and the choice of 
fillings they want to offer means t heir ingredients are quite expensive and 
have a short useful life before they go off. 
After a promising start, the comp any started to have issues with 
production (incorrect fillings in the sandwiches) and delivery (delivery drivers being unable to find the office s). Sometimes, by the time the 
sandwiches were delivered, the cu stomer had been hungry, unable to 
wait for their delivery slot and visited one of the many cafes, sandwich shops, supermarkets or takeaways in the city centre. When the sandwich 
arrived late or with a slight issue ov er the contents, t he customer rejected 
it and refused to pay. 
After redesigning their menu to stream line the choice, initiating an online 
payment process and reducing the de livery radius, the company ceased 
trading after 2 years. 
What are reasons that the disruption failed? 
A The range of choice made order ing and meeting the order too 
complex. 
B The failure to develop a smartpho ne application for ease of ordering 
C High cost in comparison to the establishe d competitors 
D Poor quality ingredients and choice 
E The traditional market wa s much more accessible 
F The target market was too sm all to make the business viable

172  
11 Scenario planning 
Competence slip and organisational failure  have been linked to the notion that 
management have failed to grasp the way that society is moving and have not conceptualised a possible future mark etplace. It has been suggested that 
managers need a picture or scenario of wher e the world may be in a few years' 
time. 
under the following circumstances? 
overseas students. 
11.1 The steps involved in scenario planning 
(1) Identify high-impact, high-uncerta inty factors in the environment. 
Relevant factors and driving forces could be identified using a strategic 
analysis framework such as a PEST analysis. Once identified, factors need to be ranked according to importance and uncertainty. 
For example, in the oil industry ther e may be a need to form a view of the 
business environment up to twenty-fi ve years ahead and issues such as 
crude oil availability, price and eco nomic conditions are critical. 
For example, oil companies would consi der possible political uncertainty in 
oil-producing countries and the attitudes  of future gover nments to climate 
change, pollution and energy policy. 
At 3M, for example, t he general manager of each bus iness unit is required 
annually to describe what his or her indus try will look like in fifteen years. 
(3) Cluster together differ ent factors to identify va rious consistent future 
For example, two key factor s may have been identified as: 
(a) the threat of new entrants (b) new legislation that may reduce the potential for profit. 
Clearly, if new legislation is passed t hat reduces industry profit potential, 
This process usually results in between seven and nine mini-scenarios.

Chapter 3 
 173 
three), build a detailed analysis to i dentify and assess future implications. 
As part of this, planners typically devel op a set of optimistic, pessimistic 
and most likely assumptions about t he impact of key variables on the 
company’s future strategy. 
The result of this detailed scenario construction should include: – financial implications – anticipated  net profits, cash flow and net 
working capital for each of th ree versions of the future 
– strategic implications – possible opportunities and risks – the probability of occurrence, us ually based on past experience. 
firm. 
For example, Shell was the only majo r oil company to have prepared for 
capitalise on or develop key strength s of the firm. For example, the firm 
concerned may have a global brand name and could seek to strengthen it 
by increasing its advertising spend in the short term. 
required for existing strategies to succeed. Alternatively, entirely new 
strategies may be required. 
(6) Monitor reality to see which scenario is unfolding. (7) Revise ("redeploy") scenarios and strategic options as appropriate. 
These need to be well thought  out if they are to be effective. Hence the 
 use a team for a range of opinions and expertise 
 identify time-frame, markets, products and budget 
 stakeholder analysis – who will be t he most influential in the future? 
 trend analysis and uncertainty identification 
 building of initial scenarios 
 consider organisational learning implications 
 identify research needs and develop quantitative models. 
to predict future changes in the energy indu stry so that it can attempt to prepare 
for them.

174  
 How useful is scenario planning? 
 Costly and inaccurate – uses up substantial resources and time 
 tendency for cultural distortion and for people to get carried away 
 the risk of the self-ful filling prophecy, i.e. thinking about the scenario 
 many scenarios considered will not actually occur. 
The upside 
 Focuses management attention on the future and possibilities 
 encourages creative thinking 
 can be used to justify a decision 
 encourages communication via the participation process 
 can identify the sources of uncertainty 
 encourages companies to consi der fundamental changes in the 
 
 Which THREE of the following are di sadvantages of scenario planning? 
A Bounded rationality B Reduced communication within the organisation C High cost D Risk of self-fulfilling prophecy E Wastes management time F Discourages creative thinking 
 
 Test your understanding 17 – UHJ (Case style) 
 UHJ is a multinational company, bas ed in Europe, which manufactures 
aircraft components. This is a fast–m oving, dynamic market with a large 
number of innovative competitors attemp ting to take UHJ’s market share. 
UHJ recently expanded into the No rth American market and set up a new 
division with two factories on the west  coast. Since this expansion, 
however, the North American market has been hit by a significant economic downturn. This downturn has  continued for the last year and 
analysts are uncertain of how far and when it will recover.

Chapter 3 
 175 
 This has led to a large reduction in orders for aircraft components and 
has meant that the No rth American division of UHJ is now barely 
breaking even. Its future profitabilit y for the next few years depends on a 
large order from a North American airline, VTH. VTH will announce a 
decision on this order next month. 
UHJ has recently been approached with an offer by one of its rivals to 
avoid closing the factories as it feels that the closure costs and 
redundancy payouts that would be r equired would be extremely high. 
is concerned that he did not fu lly understand what is involved. 
He has asked you to prepare him so me briefing notes, explaining what 
scenario planning is and how it would benefit UHJ. 
Required: 
 
 Test your understanding 18 – NSF – (Case style) 
 The National Sports Foundation (NSF ) for Country Z is a public body 
Culture. NSF’s role is to suppor t and develop a sporting environment 
across all communities in Country Z and to increase the number of 
people participating in sport. 
NSF is mainly funded by the Government  of Country Z. Up until 2010, it 
employed several hundred staff and also relied upon thousands of 
volunteers throughout Country Z to r un the various sporting clubs and 
associations, such as amateur foot ball clubs and children’s out-of-school 
sports activities. Following cuts in Government funding in 2010, NSF’s 
level of staffing was considerably r educed. This resulted in NSF relying 
more on private sector par tnerships and volunteers. 
Until three years ago, the econom ic, social and technological 
environment in Country Z had been relatively stable, with NSF receiving guaranteed funding from the Governm ent and the numbers of sports 
participants and volunteers being reasonabl y predictable. Therefore, the 
Board of NSF has not considered frequent and regular environmental 
analysis to be necessary. 
occurred in the environment in the la st three years. In addition to 
Government funding cuts, local adm inistrative government bodies have 
been forced to sell off local community sports grounds and facilities to raise finance. Furthermore, the level of financial and operational support 
provided by private sector organisations has also declined due to similar economic challenges. Increasingly stricter regulations and rules have resulted in fewer volunteer s throughout the country.

176  
 The rapid growth in technology- based entertainment products has been 
blamed for the reduction in the number  of young people participating in 
sports. In addition, NSF has failed to consider the changing 
demographics and ageing popula tion of Country Z and the impact that 
this will have on sports parti cipation in future years. 
The Chair of the Board of NSF has recently attended several conferences 
where the value of undertaking t horough ‘environmental analysis’ has 
been discussed. The Chair now realises that there is a serious gap in 
NSF’s knowledge about the environm ent in which it operates and 
considers that if NSF is to continue su ccessfully in the future then it must 
improve its foresight to ac tively plan for the future. 
The Chair has therefore contacted you and asked you to produce some 
briefing notes to help apply this knowledge to NSF. The email is shown below: 
To:  A. Waterman  
From: C. H. Airman  
Date: 15/08/XX  
Subject:  Scenario planning for NSF  
Hi A, Hope you are well. As you know I have recently attended a number of 
conferences on foresight and scenario planning and I want to try and decide how they could be applied to NSF.  I know this is a topic you have 
studied recently and I would like you to outline a few things for me. 
I need you to analyse each of the key st ages that would be included in a 
scenario planning process which could be used by NSF. 
I’m going into a meeting with the ot her board members about this in 
Required: 
Draft the email reque sted by the Chair. 
11.2 Game theoretic approaches to strategic planning 
A key aspect of strategic planning is ant icipating the actions of competitors and 
acting accordingly. Game theory has been us ed to great effect in this matter. 
The results are derived using mat hematical modelling, although the 
mathematics are not necessary for this subject.

Chapter 3 
 177 
In many markets it is important to ant icipate the actions of competitors as 
there is a high interdependency between firms – i.e. the results of my 
choice depend to some extent on your choices as well. 
competitive moves of a set of compet itors and, as such, can be a useful 
tool to analyse and understand different scenarios. 
(2) If a strategy exists that allows a competitor to dom inate us, then our 
Despite the simplicity of these prin ciples, game theory has become very 
complex. 
Many of the bidders for third-generati on mobile phone licences in the 
early 2000s, and the gover nments auctioning those licences, used game 
theory principles. In the UK this resulted in over a hundred rounds of bidding and revenue raised of £22 billion. 
Example 
The most famous example of game t heory is the "Prisoner's dilemma" 
Suppose there are two companies , A and B, who between them 
dominate a market. Both are consi dering whether to increase their 
marketing spend from its current low level. 
 If just one firm decides to increase its spend, then it will see its 
 However, if both increase t he spend then both end up with lower 
returns than at present. 
These could be shown by the following pay -off table (figures = net profit). 
B = 5 A = 3 
B = 10 
B = 3 A = 7 
B = 7

178  
 Viewed individually the dominant strat egy for both firms is to invest 
 If B does not increase spending, then the best plan of action for A 
 If B does increase spending, then the best plan of action for A would 
increase spending and thus end up wors e off than if they  had both kept 
their marketing spend at its current lo w level. Some degree of collusion to 
keep the spend low would benefit both parties. 
Suppose two accomplices perpetrate  a crime together and are later 
arrested by the police. 
having separated both suspects, visit eac h of them to offer the chance of 
betraying their accomplice. Suppose the possible outcomes are as follows: 
 If one testifies (defects from the other) for the prosecution against 
the other and the other remains s ilent (cooperates with the other), 
the betrayer goes free and the silent accomplice receives the full 10-
year sentence. 
 If both remain silent, both pris oners are sentenced to only six 
 If each betrays the other, each receives a five-year sentence. 
Each prisoner must choose to betray t he other or to remain silent. Each 
one is assured that the other would not know about the betrayal before 
the end of the investigation. 
How should the prisoners act? The unique equilibrium for this game is that rational choice leads the two 
players to both play defect, even though each player's individual reward would be greater if they both played cooperatively. 
evenly matched competitors usually re sults in lower profits for all 
concerned and no change in market s hare. No one wins, except the 
customer.

Chapter 3 
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12 Stress testing 
12.1 What is stress testing? 
A stress test in the business world is a way of analysing a business to consider 
how well it could cope in difficult condi tions. When a business is doing well it 
can be difficult to identify how it would fare if there was a sudden downturn in 
the economic environment. 
 
 Bank of England 
The stress tests were brought in as a re sult of the financ ial crisis in 2008-
2009, and the tests are designed to simu late scenarios that are similar or 
worse than what happened in the financial crisis. 
Some of the scenarios used in 2018 were: 
 Property prices falling by 33% 
 Interest rates rising to 4% 
 UK GDP falling by almost 5% 
The results are published and if a bank fa ils the stress test – as well as 
the reputation damage it would caus e – it may be required to reduce 
dividend payments to shareholders to  improve its capital position. 
12.2 How to stress test 
In terms of a business conducting its ow n stress test, Robert Simons, a Harvard 
business professor, suggested there are 7 questions that organisations should 
try to answer to check if their busi ness is robust enough. The questions break 
down into 4 keys areas: 
 Who is your pr imary customer? 
 How do your core values prio ritise shareholders, employees, and 
 What critical performance variables are you tracking? 
 What strategic boundaries have you set? 
 How are you generating creative tension? 
 How committed are your employees to helping each other? 
 What strategic uncertainti es keep you awake at night?

180  
Simons’ view is that people who wo rk for the organisation cannot be 
customers, and to refer to any inte rnal people/departments as a customer 
means the organisation will lo se focus on the true purpose. 
Once your primary customer is est ablished the majority of resources 
should be used to make sure the co mpany is delivering for their needs. 
and statements that list multiple desir able actions don’t work. There is no 
right stakeholder to prioritise, but a company must decide if it’s the 
shareholder, the customer or the employees that  come first, and make 
sure their behaviours are then consistent with this. 
There are various well known saying around this: “If it matters, measure 
it”, “what gets m easured gets done”.  
The key is not to have too many measures on any scorecard but to 
identify the key factor s that drive perform ance and focus on those. 
The boundaries refer to keeping fo cus on the parameters that are 
important and not to drift away from these, by telling employees where to 
focus or where not to. Where to focus is often viewed as the safer option, 
while where not to focus allows more creativity. 
disagreement challenges the norms and can produce different ideas and 
outcomes. Diverse opinions and ideas lead to new ways to do things. 
Often idea generation is often associat ed with a positive outlook, but it 
can actually be the opposite. A pos itive outlook may be lead to people 
insisting that everything will eventually work out, but a pessimistic view 
that things are not working, c an often lead to a positive change. 
Commitment to each other, links back to  the theory of why organisations 
exist – that working effectively toget her helps us achieve our goals more 
easily than working alone. If employ ees feel that they are being treated 
fairly and trust each other they will achieve greater results. 
Finally, as with any control system, flex ibility is important – being able to 
change approach in the ever changi ng world in which businesses 
operate: customer preferences c hange, technology is moving at an 
incredible pace, at some point your business model will become 
outdated. 
Any organisation must be willing to adapt  to the new requirements placed 
on it. To achieve this everyone must  be focussed on what it happening in 
the external environment and feedback anything unusual so that action 
can be taken.

Chapter 3 
 181 
struggling to keep pace with all the di fferent clothing opt ions available. 
Shoppers are now confused by their range of brands and don’t know which brands are aimed at  them. Critics of M&S s uggest this is one of 
their biggest problems and that to turnaround their recent decline they 
need to clearly define who they are selling to. 
How do your core values prioriti se shareholders, employees, and 
shareholder wealth through the industr y they operate in. Companies such 
as Kerr-McGee Corporation (an energy  company in America bought by 
Anadarko another American energy company) and financial services 
company Citigroup are both examples of companies who make reference 
to only one stakeholder in their missi on with a clear prioritisation of 
Employees  
Virgin founder, Richard Branson, belie ves that the employee should be a 
company’s number one priority. He says that if the employee is happy 
and proud of the brand they work for, then that will show in the work that 
they do, so the customer will get exce llent service.  They will therefore 
also be happy and more likely to retu rn and that leads to shareholder 
satisfaction too. 
Customers  
Google’s mission statement since it started in 1998 has been “to organise 
the world’s information and make it uni versally accessible and useful.” 
Serving the end users has been at the heart of what Google does from 
the day it was founded and is one of t he core reasons for its success.  
What critical performan ce variables are you tracking? 
After the rise of vari ous performance management tools, such as the 
balanced scorecard, emphasised the im portance of collecting a range a 
data to assess performance, companies have gone metric crazy. Now the 
advice is to focus on a few key metrics.  DHL are an example of where the board became frustrat ed by the amount of time spent reviewing 
operational data without any  real benefit coming from it. They analysed 
what stakeholders were really intere sted in and streamlined the review 
process.

182  
 What strategic boundaries have you set? 
Apple are well known for setting st rategic boundaries.  In 1998 Steve 
Jobs reduced the product portfolio by over 70% so the company could 
focus on doing a few things very well. The results were incredible, from a company struggling and making losses in 1997, Jobs turned Apple into 
the biggest global brand. He famously said, “Focus means saying no to 
the hundred other good ideas.” 
How are you generating creative tension? 
The matrix structure is an exam ple of how a company can develop 
creative tension, having dual managem ent means extra pressure on an 
employee to deliver. Many people fi nd that pressure can help them 
perform and if managed well it can help companies succeed.  Many 
companies have used the matrix stru cture successfully – for example 
P&G and Kraft. 
How committed are your empl oyees to helping each other? 
While Henry Ford gets all the credi t in business strategy textbooks and 
articles, he had a team working with him. Clarence Avery was the lead developer, Peter Martin the head of assembly and Charles Sorensen was the assistant to Peter Martin. All these people combined to help create 
the assembly line that the model T car so famously came from. 
What strategic uncertainti es keep you awake at night? 
When Alan Mulally became the CEO at  Ford in 2006, Ford were heading 
towards a $17 billion loss. He impl emented a colour coding system for 
weekly meetings with his execut ives. As normal, green meant good, 
yellow meant new issues, red meant  problems. Mulally couldn’t 
understand why all the charts were green at the first meeting as a 
company heading for a $17 billion lo ss could not all be green. One unit 
head put up a red chart and highlighted an issue he was having in Canada. Mulally applauded the unit head’s honesty and then discovered 
other areas were having the same issues. Through collaboration they 
were able to find a solution, and that changed the culture at Ford to one 
where people shared issues to find solutions.  
12.3 Stress testing for no nfinancial companies 
This section started with an example about the Bank of England, linked into the 
financial crash of 2008. As the example suggests it is now common place for 
companies in the financial sector like banks and mortgage lenders to use stress 
testing. It is less prevalent in  companies outside financial sector. 
These nonfinancial companies are not immune from risks and therefore could 
also benefit from stress testing too.  One of the biggest current risks to 
organisations is related to cyber security (discussed in more detail later), but the 
risks of cyber-attacks are not limited to banks, or financial services 
organisations; any company with an online presence can be affected.

Chapter 3 
 183 
The failure of a company, whoever they may be, can have a knock on effect to 
society (through job losses) and other comp anies (lost customers or loss of a 
key part of the supply chain). The proc ess would be the same, regardless of 
whether it was a financial or nonfinancial organisation. 
 
 The need for stress testing 
indicate why strategy may not be su ccessfully realised or  implemented, it 
can identify areas of inefficiency and it  can make a business more ‘agile’ 
and adaptable to changes in its business environment. 
recession, but a company who has stressed tested its budgets for such an event would be able to say not only by how much sales would fall, but 
also to explain the impact on profit s and cash as well as the company’s 
cope with a rise in interest rates or if  the project return s are only half of 
what the company are expecting. 
There may also be infrequent expenditure  that is not accounted for in the 
instances of infrequent and sometimes unexpected elements of expenditure.  This is preferable to having all ‘available’ cash tied up in 
investments leading to a short-term s hortage of cash available to meet 
the extra burden placed on the organisation. 
signs are triggered. 
If, for example, sales fail to increase at  all in the first quarter, then it is 
unlikely that annual sales will rise by 40%. So the company could place all second quarter recruitment on hol d and look for ways to redeploy any 
the business).

184  
 Considering these events prior to the budget launch will allow the 
customers 
come from both internal and external events. 
Organisations should be constantly assessing these stresses and then 
them at any point in ti me. Stress testing will al so identify correlations 
currency movements could impact on its business. The currency fluctuations may impact on the company  sales price, but it may also 
change, consumer spending levels change or inflation rates change. These changes could impact on a num ber of variables in the budget 
system such as sales volume, w age rates, import costs etc.

Chapter 3 
 185 
 Stress testing and software 
software and systems which tailor the test s to their situations. But smaller 
organisations should also be stress test ing their budgets even if it is using 
bespoke and simple software such as Excel. 
The scenarios that are planned for and te sted for should be plausible. 
exercise. It is therefore important that risks and events are evaluated for 
available for the testing must also  be considered – so that smaller 
might test up to 20 events.

186  
13 Summary 

Chapter 3 
 187 
 
 The correct answers are C and E 
It will be very difficult to forecast demand in a dynamic environment such 
as this and particularly so when a company is just starting out. 
They are planning on continuing with the same plan for 4 years, this is a 
long time, particularly in a rapidly changing environment and the strategy 
may fail to take advantage of technological advancements. 
A, B and D are both risks of the le ss formal approach to planning,  
 
A and C, despite their informal approach to planning, they are being rigid 
in only selling though their website. Co mpetitors are likely to offer an app 
for mobile devices offering a more user friendly interface than having to open the web page each time custom ers want to print an image. 
D, because of the lack of planning they  may find it hard to meet large 
orders, and upset some corporate custom ers.  Also they may not be able 
to get finance from a bank to ex pand into larger corporate sales 
B they don’t try to fore cast with this approach. 
E is a risk of a form al planning approach 
F they have a very flexible approach to products

188  
 The correct answers are C, E and F 
The basement location sounds inappr opriate for a premium coffee shop, 
it will be hard to see, and some peopl e will be unable to access it. The 
major chains are closer to t he commuters and busy commuters will 
generally choose convenience and not walk far for a coffee. 
A is incorrect as there are high numbers of both independent and chain 
coffee stores in most ci ties like the one described. 
B is incorrect as the area appears to have excellent footfall, it is just the 
specific location (basement) that limits the footfall. 
E is incorrect as customers rarely complain about friendly, efficient 
service. 
 
HAA is currently using the rational m odel to develop its strategies. This 
involves taking a logical, step-by -step approach. HAA has clearly done 
this by undertaking such detailed plann ing, including strategic analysis of 
the market and the production of  detailed operating plans. 
The key advantage of such an approac h to HAA is the level of 
understanding it will give t hem in the new market. They are currently not 
used to operating in the European market , so the initial strategic analysis 
they have performed will be invaluable. It will give them a picture of their 
own capabilities as well as the European market they will be entering. 
Risks 
However, the new European market is fast-moving and the rational 
approach has a tendency to be rigid and slow to react to changes in the external environment.  This means that HAA could go in with a sound 
strategy but because it is following a three year plan, the strategy could 
become outdated very quickly. 
In particular the European market is  more high-tech and the level of 
innovation by competitors means that HAA will have to be prepared to 
quickly change its approach to deal wit h unexpected developments in the 
market. As the company has produced a detailed operational plan, this 
may stifle their ability to innovate at the same rate as their competitors. 
In addition, given the lack of expe rience that HAA has  in the European 
market, any detailed forecasts it pr oduces may prove to be unreliable. 
This may cause it to make inaccurate decisions based on flawed market predictions.  If these forecast are not revisited and flexed based on the 
information they gain as they develop into the new market, the company 
could become uncompetitive in this new market place very quickly.

Chapter 3 
 189 
Effectiveness looks at the outputs of the organisati on. As H has achieved 
3% in the year (above inflation), but  the efficiency with which H has used 
these inputs has fallen significantly. These factors would indicate a lack 
of efficiency and economy. 
 
J has identified a key resource or c apability – its strong reputation. It is 
now looking for new ways to capitalise on this.  The risk with this approach is losing touch with what the market wants. 
 
take. 
This would involve GYU examinin g its key stakeholders and developing 
objectives that will meet their needs. The two key stakeholders in the scenario are GYU’s customers and shareholders. The shareholders are 
clearly upset with the reduction in t heir dividend and will expect GYU to 
Risks 
for GYU to accomplish in the short term. Given the poor level of its 
finances, it may struggle to either increase dividends or invest enough in 
research and development to update its product line. 
This will involve the examination of  GYU’s competitors and market. Doing 
Risks 
fact that it seems to ha ve fallen so far behind many  of its competitors), it 
may be inherently difficult to achieve in the mobile phone handset market. As the market is changing so rapidl y, it may be difficult for GYU to 
accurately predict future trends and create appropriate strategies.

190  
good at. For GYU, its key area of skill is in the production of mobile 
handset software. It is acknowledged to  be the market leader in this area 
and it appears to be very important to customers. Any future strategies 
should therefore be based around leve raging this area of skill. 
For example, if it feels unable to pr oduce handsets that are competitive, 
GYU could consider focusing on producing software which could then be 
licensed on other manufact urer’s handsets. If this  is a big enough market, 
this could help GYU to turn its business around. 
Risks 
The issue with this approach is that  the company starts to lose 
connection with the customers and how they operate the software. They 
may begin to create applications that  appeal to the software developers 
but that the customer doesn’t understand how to use or doesn’t want the 
features that have been developed. 
Based on the information provided, the resource–based approach seems 
most likely to be best for GYU, as l ong as they maintain a focus on how 
the consumer feels about our software. 
 
 The correct answers are E and F. 
W is currently trying to gain comp etitive advantage by using its brand 
name to differentiate it from its riva ls. Marketing costs can be higher with 
this approach and differentiators are o ften susceptible to tough economic 
A is a risk of being a cost leader B and D are risks of focussing C is a benefit of differentiation. 
 
 The correct answer is A, C and E 
Its size prevents it from achieving the economies of scale of its larger 
rivals, so it cannot compete on cost leadership. 
Y’s current customers seem to main ly be interested in price, so a 
differentiation strategy and any mark eting based on that approach would 
not be worthwhile.

Chapter 3 
 191 
 Finally, there seems to only be one ni che market that Y has identified – 
that of home workers. However this is a relatively small part of the market 
and it appears to be well served by the several existing companies. 
way to outcompete its rivals.  
 
 Test your understanding 11 – (Case Study) 
 Report 
To: J.  O’Leary, FD  
From: Senior manager  
Title:  Risks of AVA first class offering 
Porter argued that organisations could adopt one of three main strategies 
in order to gain competitive advant age – focus, differentiation and cost 
leadership. This report will use Porter’s model to analyse AVA’s strategies, particularly the first class one. 
Current strategy in AVA 
AVA has previously adopted a classic cost leadership approach. It has 
removed a number of ‘extras’ from the service it provides to customers – 
such as excess leg room, direct cust omer service and seat reservations. 
AVA has done this in order to keep its costs low. These savings can then 
be passed onto the customer in the fo rm of low ticket prices, driving up 
demand and enabling AVA to out compete its rivals. 
Cost leadership requires the price elasti city of the market to be high – in 
other words if AVA offers a low price for its product it needs to be able to 
generate a high volume of sales. This will allow it to cover its high fixed 
costs in spite of the relatively lo w contribution made by each ticket sale. 
The risk with this approach is that as the economy in country L has 
returned to growth, it is likely that  customers will have more disposable 
income and therefore be willing to spend more money on flights with 
additional features – such as incr eased leg room. AVA has started to see 
the effect of this as its passenger numbers start to fall.

192  
 First class strategy in AVA 
AVA’s proposed approach is to offer a se ction of ‘first class’ seats to 
customers at the front of each airplane which provide more leg room and 
free food and drink, as well as better customer service. 
This seems to be an attempt to mo ve into a differentiation approach, 
where AVA will be starting to charge a pr emium for some of its flights due 
to additional features that wealthier clients may value. For this to work, 
AVA must be able to offer a real alte rnative to the existing first class 
airline services – either through th e actual services offered to its 
customers or through it s brand name and image. The move into first 
class flights would help to improve AVA’ s profitability as first class tickets 
command higher margins than AVA’s standard tickets. 
Expansion into the first class market  would provide a limited amount of 
diversification for AVA. Its low cost approach would seem to be struggling 
as customers are able to afford bette r quality flights and this problem is 
likely to continue as the economy grows. 
Risks of the proposal 
There are a number of practica l problems with the proposals. 
Firstly, AVA may be struggling to attr act more affluent customers as the 
new first class model is inconsistent  with its brand imag e. AVA has a poor 
reputation in the market for comfort and reliability – things that are likely 
to strongly appeal to first class cu stomers. This may confuse both 
markets, alienating the declining core  market, worried that they are not 
getting the cheapest deal available as  they may be concerned they are 
partially funding the first class passenger s. It would also be unlikely a first 
class passenger would choose to pay a high price for any AVA offering based on the current brand and reputation of the firm. 
In addition, the first class market is  already dominated by several major 
airlines that have experience of ca tering to the needs of this market 
segment. Unless AVA is able to find some  way of offering extra services 
or features that these ri vals don’t offer, it is unlikely that it will ever 
outperform them in the market. 
Staffing considerations are an issue fo r AVA too, staff may feel that their 
position is under threat as they joi ned to offer a particular service for 
AVA. They may worry that this will mean that new staff wil l be recruited to 
serve the customers who buy the new first class service, meaning less standard staff are needed, and may st art looking for alternative 
employment. 
The company may also experience cultural problems – staff who are 
required to serve both types of customers on a flight may find it difficult to 
differentiate their behaviour and offe r an excellent service to some 
customers but not others, leading to co mplaints from first class customer 
who are not getting the premiu m treatment they expect.

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 193 
 Offering the service on its more popular routes will also reduce the 
availability of seats fo r the core market, thes e popular routes may be 
suffering less reduction than some other flights and they may reduce the 
sales to the core market further. 
Overall by proceeding with its firs t class strategy, AVA risks becoming 
‘stuck in the middle’ and failing to com pete effectively withi n the market. It 
may therefore wish to consider an alternative plan which is more in keeping with its current strategy.  
 
T has two major requirements – cons istency with the existing H stores 
form partnerships with third party or ganisations who would work together 
(or set up a jointly owned company) to  operate the new H stores. Again, 
this would lead to H losing control and being forced to compromise with the other organisation(s) he had entered an alliance with. 
Franchising would allow H to control m any of the day to day operations of 
the new stores and would also enable him to still make the key strategic 
decisions for the organisation. The franchisee would have to work within 
the preset guidelines in the franchise agreement, which may include 
central training of staff and supplier selection. 
 
 (1) A franchise arrangement would wo rk well here. There is more than 
entering into franchise agreements would be a quick, effective way 
of expanding. 
(2) Unless the oil companies felt t hat, because of their size, there was 
no need for joint research, development, marketing and lobbying, a strategic alliance of some sort could be useful. Research costs and findings could be shared. Together  they could bring powerful 
pressure to bear on governments to, for example, allow more 
generous time scales for implementation of the new technology. Alternatively, the new energy te chnology could be developed within 
a joint venture organisation. 
(3) Almost certainly, this com pany would expand by licensing local 
brewing companies to make and distribute its product.

194  
YH is currently manufacturing (or gr owing) the bulk of its products 
overseas to meet demand, with some of this produce even finding its way 
back to country N. This would suggest an overseas manufacture strategy. 
YH does grow some of its fruit in its home country, but given that this 
constitutes a minority of its goods, it  cannot be convincingly matched to 
an exporting strategy. 
As YH does not obviously coordinate value adding activities between its 
overseas facilities (they are all sim ilar growing and processing facilities in 
each country) it is not a multinational . The fact that it still has a home 
country in which it is based would indi cate that it is not a transnational. 
 
 The correct answers are A, C and E 
Key considerations in di sruption are simplicity, co st and accessibility. The 
range of options made choosing a sandwich more complicated for the customer and increased the likeli hood of mistakes in making the 
sandwiches. The high volume of exis ting competition with simple fillings 
and lower selling prices made the tr aditional market more accessible ad 
appealing.  
The lack of smartphone application is not  an issue as most of the target 
market would have access to a computer in their work. 
While quality is a key factor in  successful disruption the quality and 
choice of ingredients were not the issue, but mistakes in production 
meant customers were put of f using the service again. 
The lunchtime sandwich market is large and very already very 
competitive so it wasn’t the size of the market. 
 
 Test your understanding 16  
 The correct answers are A, C and D

Chapter 3 
 195 
 Test your understanding 17 – UHJ (Case Study) 
 Briefing Notes 
To:  Manager  
From:  UHJ Senior Manager  
Date:  Today  
Title:  Scenario planning  
UHJ is faced with a dynamic and r apidly changing environment in the 
North American market. Scenario plann ing is the detailed and credible 
analysis of how the business environm ent might develop in the future, 
based on various environmental influenc es and drivers for change. The 
target for this analysis should be ar eas where the organisation considers 
there to be a high degree of unc ertainty or opportunity. 
economic downturn lasting for several y ears, or alternatively beginning to 
reverse immediately. It could also co mpare combinations of events, such 
as: 
 the sale of the division, follow ed by an economic recovery, but the 
 the retention of the division, followed by a continuation of the 
economic downturn, along with the acquisition of the VTH order 
and so on. This approach will ha ve two key benefits: 
(1) It will help the directors of UHJ  to see ‘worst case’ scenarios. 
Should the North American ec onomy suffer a prolonged downturn 
and the division lose the VTH orde r, there could be a significant 
impact on the division, along with the rest of the company. This may 
help the directors to decide how much of a risk maintaining the 
North American division is and wh ether it would be best to sell 
immediately. 
(2) Scenario planning will also help t he directors to anticipate potential 
problems with, or opportunities fr om, the North American division. 
For example, if UHJ wants to sell the division and the VTH order is 
lost, the price it achieves from the sale may well be much lower than is currently on offer. Alternat ively, the market may recover in 
the near future and the sale of the division now may compromise UHJ’s future growth prospects.

196  
 To:  C.H. Airman  
From:  A. Waterman   
Date:  15/08/XX   
Dear C.H. Thank you for your email.  Scenario planning, as a tool, will prov ide NSF with a better understanding 
of what could happen in the environment  in which it operates and help to 
The stages could be as follows: (1) Define the scope of the scenario 
NSF will need to decide what knowle dge is most important to it. 
Consideration of its most important market segments and 
customers and the time fr ame it wishes to consi der (i.e. how far into 
the future) should be paramount. It will need to decide whether the scenario is to be focussed on a specif ic issue e.g. t he impact of the 
technology on the participation of  children or a more blue sky 
approach where it asks a question such as; ‘what is the future of community participation in sport in Country Z?’ 
(2) Identify and map the major stakeholders 
A consideration of who the main stakeholders are in the sporting 
environment should be undertaken and ho w they are likely to drive 
change over the period under consideration. For NSF this would most probably include the Governm ent of Country Z (as the main 
funder), its volunteers and its cust omers. All of these stakeholders 
would need to be evaluated in terms  of their impact and power to 
influence the future activities of NSF. 
(3) Identify the basic trends and uncer tainties affecting the business 
In assessing the trends and factors that would be identified in an 
environmental analysis and considering how they may change in the future, NSF would most pr obably want to focus upon the 
technological advances and the incr easing use of the internet by 
children and young adults and its effect upon sport participation. Since it is very dependent upon the Government for its revenue it 
would also consider the trends in  the economy which would affect 
its income. Also the changing demographics would be a major 
consideration for NSF.

Chapter 3 
 197 
 (4) Identify the key trends and uncertainties 
decide which are the key uncer tainties. These trends and 
uncertainties will be the ‘drivers  for change’ which will require 
contingency planning activities and will shape the future of the 
industry. In the case of NSF th is would certainly include the 
declining Government funding and societal and demographic 
changes. These will be the main drivers forcing change in NSF. 
(5) Construct initial scenario themes, or skeleton outlines 
Possible future scenarios should then be created by forming the key 
trends and uncertainties into coherent themes. Usually two alternative scenarios are produced but  more can be identified if 
necessary. NSF might develop one scenario where the economy continues to be depressed and funding continues to decline with sport becoming less important to society. This would be the 
‘negative’ scenario. The alternative ‘positive’ scenario might feature 
a booming economy with many me mbers of society both 
volunteering and actively participating in sport activities. 
(6) Check for plausibility and internal consistency 
Effective scenarios are both internally  consistent and plausible. This 
means that different directions that the trends have taken in the 
scenario could logically happen t ogether and the events described 
could happen within the timescale chosen. 
become full descriptions of the sector and conditions that are 
expected to prevail in the future timeframe. This is often done by 
writing a detailed piece of narra tive. The managers of NSF would 
need to consider the detailed aspects  of each scenario in terms of 
impact upon NSF’s staff, possible plans for re-training, more 
detailed financial analysis and an ov erall view of the sporting 
environment in Country Z. 
Note: There is no one perfect method of producing scenario plans and 
the following answer is one of a number of ways in which scenarios can be developed. Candidates will be rewar ded for appropriate stages which 
are applied to the NSF. 

199 
Reputational risks 
A2. Risk exposure (c) Analyse the interaction of 
A3. Discuss ways of managing risk (d) Discuss risk analytics. 
B2. Evaluate the sources and 
impact of reputational risks (a) Evaluate sources of 
reputational risk  
(b) Evaluate impact of 
reputational risk on strategy. Chapter 
4

200  
  
1 Reputational risk 
In this chapter we look at risks invo lved with the reputation of an organisation 
and what an organisation can do to mitigate them. Before we look at the risks 
involved, we will first look at  what we mean by reputation. 
Reputation is defined as the beliefs or  opinions that are generally held about 
someone or something. 
1.2 What is reputational risk? 
Reputational risk is ther efore the likelihood of losses occurring due to a 
deterioration in the belief or opinion  held about someone or something.  
Reputation is an area that organisations  are increasing their focus upon, 
partially because there have been some high profile instances of reputational 
damage in recent times, and partially because  of the rise in social media giving 
more customers a voice. 
Reputational damage can be caused by m any factors such as dishonesty, 
incompetence, activities that do unnec essary harm to the environment or 
unethical behaviour. It can be caused by an i ndividual or by the behaviour of a 
company as a whole.

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 201 
 Johnson & Johnson: good and bad reputation 
 In 1982, Johnson & Johnson were widely praised for their handling of a 
series of deaths that were caused by poisoned Tylenol (a product they 
make).  
The CEO made the decision to recall a ll Tylenol products.   The decision 
raised some eyebrows amongst analysts as it reduced their market share from over 30% to under 10% and the view was they would never recover. 
However, it transpired that the com pany were subject to a sabotage and 
were seen as one of the victims.  As a result of their prompt actions, and 
the ensuing investigations, their reputation was enhanced and they regained a market share of over 30%. 
In 2010, the company was in the news again, once again related to 
Tylenol. Customers started to complain of a musty, mildew smell from the 
product in 2008 and there were complaints of stomach pains. The company decided not to report the conc erns.  In 2009 it started to recall 
certain batches of Tylenol.  As the number of recalled batches started to 
increase, anxiety grew amongst cu stomer about what was wrong and 
whether they were impacted.  At a similar time a riva l started to give away 
bottles of their own version of the medicine and Johnson & Johnson lost 
significant market share as a re sult of their slow response. 
Their response was widely derided and held up as a perfect example of 
how to damage the reputation of a company. 
 
 CIMA survey 
 CIMA conducted a global survey in 2013 of over 1,500 finance leaders.  It 
found that companies are beginning to put a higher priority on reputation 
and in some cases are putting reputat ion before profit. The survey 
identified three main factors behind this: an increase in the need for 
transparency, the increased use of soci al media (more on social media in 
chapter 8) and incidents  happening at a competitor  or other leading 
organisation that led to  reputational damage. 
2 Sources of reputational risk 
2.1 What could cause reputational risk? 
The sources of reputational risk are many and very diverse.  It could manifest 
itself in anything from acc ounting deficiencies, poor cust omer service, lack of IT 
security or failure to meet expected standar ds of quality. All of these could lead 
to media coverage resulting in negative perceptions of the brand and company.  
These negative perceptions can then lead to investors and customers going 
elsewhere.

202  
 Tesco’s accounting issues 
 In 2014 Britain’s biggest supermarket c hain revealed it had overstated its 
profits by around £250 million. In August t hat year it told the market half 
year profits would be £1.1 billion,  but 4 weeks later it announced the 
overstatement. The issue related to  discrepancies between when profits 
from deals with suppliers were accounted for and when costs were paid. 
This lead to over £214 million in fines and compensation claims, but also 
reputational damage.  In vestors no longer trus ted the company and 
started to sell their shares - the shar e price fell by over 50% in a year.  
2.2 Social and environmental considerations 
The PESTEL framework can often help identi fy the sources of reputational risk. 
From that framework, tw o key areas to consider are social and environmental. 
Some factors are very obvious, for exam ple it would be detrimental to a firm’s 
reputation to encourage an unhealthy lifestyle, endorse violence, be involved 
with forced labour, or knowingly damage areas of outstanding natural beauty or 
of significant historical interest.  However most social and environmental 
considerations are more co mplex than these examples. 
 
 Environmental considerati ons and reputational risks 
 Environmental legislation may have been identified as being particularly 
important to a chemicals producer. A co mpany in this sector is likely to 
get significant bad press if they ar e not compliant with legislation.  
It should therefore set up a series of targets to measure compliance. For 
example: 
 level of fines 
 number of environmen tal prosecutions 
 number of environmenta l enforcement actions 
 number of ‘notifiable’ incidents (loc al legislation will define what is 
‘notifiable’ and what is not) 
 percentage of employees work ing within an ISO 14001 compliant 
Environmental Management System 
 the firm’s rating in independent benc hmarking such as the ‘Business 
in the Environment’ Index.

Chapter 4 
 203 
 Facebook 
 One of the biggest social medi a companies Facebook are facing 
reputational issues from a variety of  sources. There is public concern 
about issues from the spread of fake news on its platform to the misuse 
of data in the Cambridge Analytica scandal. 
This has led to user numbers declini ng in its most valuable markets, the 
US, Canada and Europe. While overall Facebook is still growing, losing 
user numbers in these key markets is a concern. 
Facebook aim to give people the opport unity to express their views. 
However the line between opinion and fact can sometimes be hard to 
identify. There is also a risk of data  misuse: selling t he data on its users 
provides Facebook with a business opportunity for Facebook, but it can 
only do so if it complies with the l egislation about dat a use (see chapter 
8). Non-compliance could lead to si gnificant reputational damage as well 
as fines. 
2.3 Business ethics 
 Ethics is a set of moral principles that guide behaviour, based on what is 
‘felt’ to be right. 
 Comprises principles and standar ds that govern business behaviour. 
 Actions can be judged to be right or  wrong, ethical or unethical by 
individuals inside or outside the organisation. 
For example, is it ethical to: 
 experiment on animals? 
 drill for oil? 
 build roads through the countryside? 
 allow smoking in public areas? 
 pay senior executives large increases in salary? 
 train students to pass exams? 
Different individuals will have differ ent views on each of these issues. 
 
 Illustration – Nestle and Ethics 
 Nestlé was criticised in the past for taking advantage of the poor and 
uneducated populations in developing countri es in order to increase their 
own profits. 
The company gave gifts and incentives to local health officials, as 
encouragement for promoting their baby milk formula and therefore 
discouraging breast feeding. Nestlé employees were heard telling 
midwives that 'all western women use formula to feed their babies, so 
that they grow up big and strong'.

204  
 Nestlé didn't educate mothers about  sterilising bottles and therefore 
mothers mixed the formula with dirty wa ter at the cost of many babies' 
health. The free samples provided to mothers in hospitals and clinics 
soon dried up, but not bef ore the mothers and babi es had become reliant 
on them because the mothers had st opped producing their own milk. The 
mothers then had to pay almost wester n prices for the baby milk formula, 
a price that most families could not afford. 
 
Apart from any moral duty to be ethical,  the prime purpose of a business is to 
maximise shareholder wealth and the c hance of this happening is increased by 
the adoption of ethical behaviour. 
 
 Test your understanding 1 (integration) 
 Required: 
How can the adoption of ethical behav iour by an organisation help to 
assist to maximise  shareholder wealth? 
2.4 Corporate social responsibility 
 Corporate social responsibility (CSR)  refers to the idea that a 
company should be sensitive to t he needs of all stakeholders in its 
business operations and not  just shareholders. As su ch, ethics is just one 
dimension of corporate social responsibility. 
CSR and risk management 
By aligning the company's core values wi th the values of so ciety, the company 
can improve its reputat ion and ensure it has a long term future. 
Benefits of a CSR strategy 
 Differentiation – the firm's CSR strategy can act as a method of 
differentiation. 
 High calibre staff will be attracted and retained due to the firm's CSR 
policies. 
 Brand strengthening – due to the firm's honest approach. 
 Lower costs – can be achieved in a num ber of ways, e.g. due to the use of 
less packaging or energy.  
 The identification of new market  opportunities and of  changing social 
 A resultant overall increase in profitability. 
 NPVs will also increase due to increased sales, lower costs, an extended 
project life and a lower level of risk.

Chapter 4 
 205 
 Test your understanding 2 (integration) 
 Required: 
Many commentators believe that CSR is a morally correct pursuit, but 
there are powerful arguments agains t it. Identify and discuss these 
arguments. 
CSR and metrics 
It is really important fo r the organisation to have some clear goals in mind with 
regards to its CSR strategy. 
Remember, things that get measured get done more often than things that 
are not measured. Therefor e, the company should meas ure the result of any 
CSR programme using appropriate metrics. 
 
 Illustration – Tesco and performance metrics 
 In the Tesco illustration earlier, one of the issues that led to the 
overstatement in profit was the pus h to achieve and improve profit 
performance as a key performance metric. As the half year profits release 
approached, heads of division were reported to be putting pressure on 
buyers to “find an extra £30 million”.  This would have flowed down 
through the organisation, creating a pressu re to achieve the profit target 
in any way. 
The CEO that came in after the scandal recognised the culture needed to 
change and that integrity needed to be central to the way the business 
behaved. 
 
 Illustration – The influence of metrics on the banking crisis 
 The collapse of Lehman br others, a sprawling global bank, in September 
2005, almost brought down the worl d’s financial system. The then 
governor of the bank of England, Me rvyn King, criticised City banks who 
rewarded staff with huge sums for taking risks and concluded that the 
credit crisis was caused, in part, by bankers betting on high-risk complex 
financial products. A culture of risk taking had developed due to the huge 
potential bonuses and reward s offered to bankers. 
3 Code of ethics 
As Chartered Management Accountants,  students throughout the world have a 
duty to observe the highest standards of  conduct and integrity, and to uphold 
the good standing and reputation of the profession. They must also refrain from 
any conduct which might discredit the profession. Members and registered 
students must have regard to these guidelin es irrespective of their field of 
activity, of their contract of employ ment or of any ot her professional 
memberships they may hold.

206  
The Institute promotes the highes t ethical and business standards, and 
encourages its members to be good and responsible professionals. Good 
ethical behaviour may be above that required by the law. In a highly 
their integrity and remember the trust and confidence which is placed on them 
by whoever relies on their objectivity and professionalism. Me mbers must avoid 
actions or situations which are inconsis tent with their professional obligations. 
They should also be guided not merely by the terms but by the spirit of this Code. 
CIMA has adopted a code of ethics based on  the IFAC (Inter national Federation 
of Accountants) code of et hics which was developed with input from CIMA and 
the global accountancy profe ssion. The CIMA Code of Ethics is freely available 
on CIMA's website – https://www.cimagl obal.com/Professionalism/Ethics/CIMA-
code-of-ethics-for-professional-accountants/. 
seek legal advice as to both legal rights and any obligations (s)he may have. 
 Part A establishes the fundamental pr inciples of professional ethics and 
provides a conceptual framework for applying those principles. 
 Parts B and C illustrate how the conceptual framework is to be applied in 
specific situations: 
– Part B applies to professi onal accountants in business. 
– Part C applies to professional accountants in public practice. 
 
 3.1 Fundamental principles

Chapter 4 
 207 
 More on fundamental ethical principles 
 Integrity 
 materially false or to contain misleading statements 
 provided recklessly 
 incomplete such that the report or communication becomes 
Accountants need to ensure that their business/professional  judgement is 
However, there are many situat ions where objectivity can be 
compromised, so a full list cannot be provided. Accountants are warned to always ensure that their objectivity is intact in any business/professional relationship. 
There are two main considerations under this heading: 
(1) Accountants are required to have the necessary professional 
(2) Accountants must follow applic able technical and professional 
Appropriate levels of professional  competence must first be attained and 
then maintained. Maintenance implies keeping up to date with business and professional developments, and in ma ny institutes completion of an 
annual return confirming that conti nuing professional development (CPD) 
requirements have been met. 
Where provision of a professional se rvice has inherent limitations (e.g. 
reliance on client information) then t he client must be made aware of this. 
Confidentiality 
The principle of confidentiality implies two key considerations for 
(1) Information obtained in a busines s relationship is not disclosed 
professional services is not  used to personal advantage.

208  
 The need to maintain confidentiality is normally extende d to cover the 
accountant's social environment, in formation about prospective clients 
and employers and also where business relationships have terminated. Basically there must always be a reas on for disclosure before confidential 
information is provided to a third party. 
The main reasons for disclosure are when it is: (1) permitted by law and authorised by the client (2) required by law, e.g. duri ng legal proceedings or disclosing 
law), e.g. provision of information to the professiona l institute or 
would bring discredit to the pr ofession should be avoided. 
An accountant is required to treat a ll people contacted in a professional 
capacity with courtesy and consider ation. Similarly, any marketing 
activities should not bring t he profession into disrepute. 
 
 The fundamental ethical  principles include: 
A Communication B Objectivity C Professional competence and due care D Integrity 
 
 Fair dealing and truthfulness is im plied within the ethical principle 
of: 
A Confidentiality 
B Objectivity C Professional competence and due care D Integrity

Chapter 4 
 209 
 Compliance with all relevant laws a nd regulations is implied within 
the ethical principle of: 
A Professional behaviour 
B Objectivity C Professional competence and due care D Integrity 
 
clients and organisations. 
A client has called John, asking for his annual accounts to be finalised as 
a matter of urgency. Apparently, one of  John’s staff promised that the 
accounts would be completed a week  earlier. John asks his staff 
member, a part-qualified a ccountant, to tell him the situation relating to 
the client’s accounts. The staff member says that the accounts need 
another four or five hours’ work. As it is Friday, t he staff member offers to 
complete the accounts at home, over the weekend, and to deliver them to 
the client on his way to work on Monday morning. 
For John to allow this would be in breach of which fundamental 
ethical principle (according to  CIMA’s Code of Ethics)? 
B Objectivity C Professional competence and due care D Confidentiality E Professional behaviour 
 
 L is a CIMA Member in Practice, and advises a range of individuals and 
organisations. An owner manager of one of L’s clients has contacted her 
to ask if she can urgently contact t he bank on the client’s behalf in order 
to give a credit reference. Without an injection of funds from the bank, the 
client’s business will be unable to cont inue trading. The client, a personal 
friend of L’s has asked for this to be done as a ‘favour’. Both L and the 
client are aware that the business’ cash flow problems are severe and a 
positive reference would be misleading.

210  
 For L to give the bank a positive cr edit rating would be in breach of 
which fundamental ethical principles? 
Select ALL that apply.  
A Integrity. B Objectivity. C Professional Competence and Due Care. D Confidentiality. E Professional Behaviour. 
3.2 Conceptual framework approach 
 The circumstances in which man agement accountants operate may give 
rise to specific threats to comp liance with the fundamental principles. 
 It is impossible to define every sit uation that creates such threats and 
specify the appropriate mitigating action. 
 A conceptual framework that r equires a management accountant to 
identify, evaluate and address threats to compliance with the fundamental 
principles, rather than merely comply with a set of specific rules which may 
be arbitrary, is, t herefore, in the public interest. 
 
 Ethical threats 
  The self-interest threat 
May occur due to personal financial in terest in a situation creating 
conflict. 
 The self-review threat 
May occur when previous judgement  needs to be re-evaluated by 
the member responsible for that judgement. 
 The advocacy threat 
May occur when a member promotes  a position or opinion to the 
point that subsequent objectivity may be compromised. 
 The familiarity or trust threat 
May occur when, because of a cl ose or personal relationship, a 
member becomes too sympathetic to the interests of others. 
 The intimidation threat 
May occur when a member may be det erred from acting objectively 
by threats, whether real or perceived. 
 The adverse interest threat  
May occur when a member does not act with integrity because their 
interests are opposed to the employer.

Chapter 4 
 211 
 John is a CIMA member, working as Financial Controller of a listed public 
company. 
John’s wife owns a large number of shares in the company, and John 
knows that the share price depends, to some extent, on the reported 
profits. John is responsible for pr oducing the published accounts of the 
company. 
This represents which type of ethi cal threat (according to CIMA’s 
Code of Ethics)? 
A self interest 
B self review C advocacy D intimidation E familiarity 
3.3 Ethical issues as sources of risk 
 As stated above, CIMA's code of et hics has a 'threats and safeguards' 
approach to resolving ethical issues. 
 If identified threats are other t han clearly insignificant, a management 
accountant should apply safeguards to eliminate the threats or reduce 
them to an acceptable level such t hat compliance with the fundamental 
principles is not compromised. 
 Note that the ethical threat does not necessarily have to relate to personal 
ethics but could focus on a business dec ision and its possibl e implications. 
 
 Ethical safeguards 
 Safeguards 
Safeguards are actions or other measur es that may eliminate threats or 
reduce them to an acceptable level. 
There are two basic types of safeguards: 
 Safeguards created by the profes sion, legislation or regulation 
– Educational, training and expe rience requirements for entry 
into the profession. 
– CPD requirements. – Corporate governance regulations. – Professional or regulatory monitoring and disciplinary 
– External review by a legally empowered third party of the 
reports, returns, communications or information produced by a 
professional accountant

212  
  Safeguards in the work environment 
– Firm-wide safeguards 
– Engagement-specific safeguards  
 
 One of B Company’s products, a com puter printer, has been found to be 
at risk of setting alight if left pl ugged in for long periods of time. The 
directors of B Company are meet ing to decide whether to begin a 
universal recall of the product or do not hing and just settle any claims for 
compensation as they arise. 
B company’s risk assessment concluded that due to safety mechanisms 
built in to the printer, serious injuri es as a result of the fault are very 
unlikely and that the likelih ood of fire in the first place is less than 1 in 
100,000. 
Which of the following are likely ri sks to B Company if they decide 
not to recall the product?  
A Risk that the company’s sales of other products suffer if knowledge 
of the fault becomes public 
B Risk that the cost of compensatio n claims outweigh the cost of the 
recall 
C Risk that serious injury occurs and a recall is necessary anyway D Risk that the company’s decision not to recall the product becomes 
public and the company is seen as unethical. 
 
 D is an importer and processor of a product called R33, which is a 
material used in many household produc ts. It is mined in some of the 
world’s poorest countries where lar ge communities rely on it for their 
incomes. These incomes support education, sanitation and health 
facilities in these countries. 
Recently, independent research discover ed that R33 was very harmful to 
human health, particularly in its raw mined form. Some of the respiratory 
diseases it caused remained inactive in the body for decades. Doctors had suspected this to be the case  but it had never been confirmed 
before. 
The board of D have met to discuss a report commissioned on whether 
the health risk to workers could be managed with extra internal controls over safety measures. The repor t concluded that, unless expensive 
redesign of facilities took place and breathing apparatus was issued to all 
employees, this was unlikely. The repor t also pointed out that the workers 
in the poorest nations were more afraid  of losing their jobs than the health 
implications of working with R33.

Chapter 4 
 213 
 The board recognise they have an ethical dilemma associated with how 
they manage the risks associated  with the mining of R33.  
Which of the following statements are correct with respect to the 
ethical dilemma associated with risk management in this case? 
A The board of D has a duty towards its employees to safeguard their 
health and so must act on the repo rt, regardless of whether this 
leads to job losses. 
B D has a duty to the local communi ties supported by its mines which 
are under threat because of the report findings. 
C If the workers in the poorest devel oping countries are willing to take 
the risks to their health, D has a duty to keep providing work. 
D Legally, D must provide the sa fety equipment and redesign the 
facilities regardless of cost. 
E D can choose to ignore the repor t and continue with its existing risk 
 
CIMA's Financial Managem ent magazine has a sect ion on ethical dilemmas 
each month. 
4 Ethical dilemmas and conflict resolution 
4.1 What is an ethical dilemma ? 
 A dilemma will only occur if there are two or more interests at stake, even 
if it is only an ethical duty to oneself. 
 An ethical dilemma exists when one or  more principles of the code are 
threatened. 
 You may have discovered something unethical, illegal or fraudulent going 
on where you work, or perhaps you feel that you have been asked to do 
something that compromises your professional integrity. 
 Conflicts of interest and confidentia lity issues are also ethical problems. 
 In general, ethical issues should be  dealt with by taking actions (called 
safeguards) to reduce them to a level where they are no longer significant 
or of any consequence.

214  
 4.2 Ethical conflict resolution 
 
CIMA recommends the following process fo r addressing situations of ethical 
conflict: 
 Gather all facts and relevant information. 
 Ascertain the ethical issues involved and identify the fundamental 
principles related to the matter in question. 
 Escalate concern internally, i.e. to direct management. 
 Escalate issue further to your manager's boss, the Board or a non- 
executive director (following any in ternal grievance or whistleblowing 
procedure). 
 Seek advice from CIMA. 
 Report externally to auditors or relevant trade/regulatory body. 
 Remove yourself fr om the situation. 
 
 Ethics and CIMA 
 Going downhill fast 
Danielle Cohen shares the true story of a CIMA member who contacted 
the institute’s ethics helpline for advice. His problem stemmed from 
allowing what seemed, on t he face of it, a minor i ssue to snowball into a 
job-threatening situation. 
Andrew was the management accountant of a small firm that was part of 
a plc. His boss, Chris, was the firm ’s CEO. Several months before Chris 
had approached him with a query about the month-end figures that 
Andrew has produced, saying that they  must be wrong. At  the time there 
was a certain amount of confusion, bec ause their firm had just taken over 
another small company, so Andrew  adjusted them as instructed.

Chapter 4 
 215 
 Next month Chris questioned the numbers again, and Andrew duly 
changed them once more. This happened at several more month-ends until he began to suspect that Chris’ s reasons for changing the numbers 
might not be valid – and that the business was simp ly not performing. He 
raised the issue with his boss, who assured him that he would sort everything out. Relieved that Chris recognized that the matter needed to 
be dealt with, Andrew dropped it. 
At the end of the firm’s financial y ear, Chris announced that he had, as 
promised, found a solution to the pr oblem of the ongoing adjustments. 
Unfortunately, this was very different  from what Andrew was expecting. 
Chris proposed that he own up to the discrepancies, admit that they were 
the result of a simple error and then resign to prevent any further 
questions from being asked. In return for carrying the can, Andrew would receive a glowing reference – on t he understanding, of course, that he 
kept quiet about the whole affair. 
Shocked and unsure about what to do,  Andrew contacted CIMA’s ethics 
helpline. He had gone from accepti ng a small month-end adjustment to 
his figures to finding himself about to lose a job. Our guidance to Andrew 
was that he should consider taking t he problem to more senior people in 
the group, since raising it with Chris wasn’t an option. Andrew had some 
concerns about the possible repercussi ons of doing this, particularly 
because Chris was well respected in the group, and he was worried that his version of events would not be believed. The lack of an internal 
grievance or whistle blowing procedur e made it hard for him to predict 
how his case would be handled. 
Given all these factors, Andrew  questioned whether quitting was an 
acceptable solution. A good referenc e had been promised, but was this 
pledge worth anything coming from Ch ris? And how would he explain to 
any future employer why he had left? And what would happen if a colleague were to complain to CIMA about his lack of competence? If this 
were to happen, he could potentially lose his membership. Even worse, lying to accept responsibility would be another breach of CIMA’s code of 
ethics. If discovered, this would also have consequences for his membership. 
After further discu ssion, Andrew identified a potential ally (a financial 
controller) at group level. He ar ranged a meeting through a trusted 
colleague in order to minimize the chances of discovery by Chris. 
We suggested that Andrew should speak  to the Institut e’s legal advice 
line for expert guidance on his legal obligations and employment rights, 
and also to the whistle-blowing ad vice line for free, confidential, 
independent advice on raising his concerns. 
Andrew spoke to the financial contro ller and Chris was eventually forced 
to resign. But Andrew’s ongoing compliance with his boss’s wishes was enough to have tarnished his reputation. A few months later he resigned of his own accord.

216  
 Andrew’s case is a reminder of how cr ucial it is to use your professional 
judgment, heed the warning signs and est ablish the facts at the first sign 
of an ethical dilemma. Armed with t hese and CIMA’s code of ethics, you 
can decide whether or not you need to act and, if so, what that action 
should be. 
So how exactly do you know when an ethical dilemma is an ethical 
dilemma? As Oscar Wilde observed: ‘M orality, like art, means drawing a 
line someplace.’ When the amount of money  is not material, the report is 
only for internal purposes or when no one else seems to think there’s an issue, how can you be sure where that line is? 
Taking time to consider the situation from all angles will help you to know 
for sure. In the code of ethics, t he line is where a threat to our 
fundamental principles is anything more than trivial. Although the changes that Andrew made to the number s in that first month might not 
have been material, the patte rn that they established was. If he had stood 
up to Chris the first time he was ask ed to adjust the figures, the situation 
might never have developed. 
Danielle Cohen is CIMA’s ethics manager. This article appeared in 
Financial Management, November 2007 . 
 
 The procedure for ethical conflict solution is: 
A To check the facts; escalate internally; escalate externally; 
dissociate with the conflict 
B To check the facts; escalate externally; escalate internally; 
C To check the facts; dissociate with the conflict; escalate internally; 
escalate externally 
D Escalate internally; escalate exte rnally; check the facts; dissociate 
with the conflict 
 
 JJ is the management accountant at D Co, a small family company run by 
a board of three directors who ar e husband, wife and son. There are no 
other managers within the organisation. 
The son also owns another company with his wife and JJ is aware that he 
has been selling D Co’s products to th is company at prices below cost. 
This has caused the profit margin in  D Co to fall considerably. The son 
has now asked JJ to alter the figures in the management accounts before signing them off as he would prefer to explain the transactions to his 
parents at a later date.

Chapter 4 
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 JJ is certain that the other direct ors know nothing about the sales and 
realises that disclosure of the situat ion will have long term implications for 
the future of D Co including JJ’s job. 
Which of the following courses of action appear reasonable for JJ at 
this stage? 
A Alter the figures since a professional accountant in business should 
support the objectives established by their employer. 
B Report the correct figures direct ly to the board of directors. 
C Obtain advice on the best course  of action from other managers 
within D Co. 
D Seek legal advice. E Follow the formal dispute resolution process within D Co. F Ask the son to speak to his par ents immediately since changing the 
figures is not possible. 
4.3 Case study – Nike 
Nike is one of the famous franchises in t he world that sells sportswear for all 
ages. But it is mostly famous for athlet e shoes and apparel and it is also one of 
the major manufacturers of sport equipment . The slogan for Nike is “Just Do It”. 
Nike was founded in January 1962 in Oregon, United States by Philip Knight 
and Bill Bowerman. Nike has around 700 retail outlets spread all over the world, 
and approximately 45 offices outside t he United States employing 30,000 
people all over the world. The company had a revenue excess of $16 billion in 
2007. Nike’s factories are most ly located in Asian countries like Pakistan, India, 
Malaysia, China, Indonesia, Philippi nes, Taiwan, Vietnam and Thailand. 
The primary stakeholders of the com pany will be the shareholders, business 
partners, the employee s, and the customers/ consumers. What the 
shareholders and the investors want from th e company is that it achieves its 
profits, the employees of  the expect work satisfaction, pay, and good 
supervision and the customers are c oncerned with quality, safety and 
availability of services when they r equire them. When any primary stakeholder 
group is not satisfied the organisation's progress becomes questionable. 
The secondary stakeholders of the co mpany would be the community. Most 
companies like Nike exist under a char ter or licenses and operate within the 
limits of safety laws, environmental pr otection and other laws and regulations. 
The socially responsible organisations lik e Nike should consider the effect of 
their actions upon all stakeholders. What a ll of these stakeholder s want from the 
company is that the company is ethicall y and socially responsible and when this 
secondary stakeholder group becomes dis- satisfied, the reputation of the 
company gets tarnished (for example, the debate about sweatshops tarnished 
the reputation of Nike).

218  
Issues faced by Nike: 
 Child labour and the sweat shop problem; 
 Workers given a very low wage, and overtime in countries like Vietnam, 
China and Indonesia under a subcontract; 
 Poor or squalid working conditions and forced labour in the factories that 
manufacture their products; 
 Environmental damage done to society by air and water pollution, noise, 
and change in the climate due to po llution. (Stockdale & Crosby, 2004) 
There are different kinds of guiding pr inciples that can prevent Nike type 
scandals, and this is what the company did: 
PR campaign 
Nike decided to use a PR campaign to  repair its social image after the 
sweatshop debate. The PR campaign covered the following actions: 
Employment Practices 
The management of Nike looked at its employment practices; it made sure that 
the company was following appropriate pol icies on recruitment, training, health, 
safety and welfare. Management also ov ersaw environmental practices – to 
make sure that the company followed responsible procedures regarding waste 
disposal and avoidance, and energy inputs. 
Training Plan 
They conducted and designed a trai ning program for the employees. 
Management remembered that training and development programs are not 
universal solutions to every need of the company – effective job design, 
selection, placement and other activiti es of the HR department are also very 
Assessing Performance 
They set targets and identified a range of  performance measure standards. For 
performance to be rated accurately, m anagement must assess every relevant 
performance dimension. 
Ethical Responsibility 
The management of Nike understood that ethical re sponsibility was needed 
within the company – because it is the obligation of an organisation’s 
management to make decisions and take actions that will grow the welfare and 
interest of society and the organisati on. This would include activities and 
commitments related to human right s, governance and ethics, development, 
working conditions of the employees , community involvement, customer 
satisfaction, relations with the company ’s suppliers and customers and respect 
for diverse cultures  and different people.

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4.4 Case study – BP 
BP plc is one of the largest oil and alter native energy companies in the world. It 
has set targets with regard to reducing its CO2 emissions and the development 
of alternative sources of energy such as  solar power. However, in recent years 
BP’s environmental image has been ta rnished. Whether BP has acted 
unethically is considered to be ambiguous by some. 
British Petroleum plc developed their image considerably.  They altered the 
meaning of BP to mean ‘Beyond Petroleum’ and aimed to ‘reduce … 
greenhouse gas emissions by 10%’ (B ulkin, 2010) between 1990 and 2010 – 
which they did successfully. This signa lled their intent to either aid the 
environment with their business practices or simply to cultivate a ‘greener’ 
image to ensure the ever more environment ally aware public would favour their 
products, and to capture the developing market for alternative energy. BP’s 
ethical stand point appears to consider  the broader responsibilities contributing 
to their businesses’ decisions and po licies. However it is necessary to 
established whether ethical decisions  and Corporate Social Responsibility 
(CSR) are based upon intentions, goals, outcomes; or, a mixture of each. 
BP have adopted a ‘progressive approach to environmental protection’; setting 
targets and producing reports on their env ironmental development progress. 
The ‘Ethical Conduct Policy’ consider s factors such as adhering to Human 
Rights regulations; ensuring that all operations are fair and legal, and 
dismissing those who act unlawfully (as t hey did in 2006); and zero tolerance of 
bribery or gifts as facilitation payment s. These factors are demonstrated by 
management in decisions, policies and acti ons. Moreover, pledging its name to 
the United Nations Global Compact ( UNGC) and partnering the Red Cross’s 
appeal for financial support all demons trate BP’s commitment to being a 
ethically astute corporate citizen. Ther efore, can it be ar gued that BP is an 
ethical company? Or are these actions simply the mask of an organisation 
whose only responsibility is to its shareholders and top management? 
Many of BP’s actions have, contrasti ngly, been regarded as extremely unethical 
e.g. the Alaskan oil spills, Texas City refinery fire, treatment of Colombian 
farmers and the explosion in the Gulf of Mexico. Decisions were made which 
ultimately lead to destructive consequenc es for many stakeholder groups. The 
complex ethical dilemmas facing BP ar e thus: how to weight emphasis on 
different stakeholders, to what extent  are immediate mistakes and unethical 
practices allowable in pursuit of a better,  more sustainable future; and, to what 
extent is it ethical to publicise the firm’s ethics and CSR for the predominant 
purposes of profit maximisation. 
It could be argued that BP should: adopt riskier  strategies that result in higher 
returns; cut safety costs;  and exploit small minorities. The results could provide 
a benefit for a great number of people ov er time. Adopting this view, FDI host 
nations, customers and shareholders woul d benefit most, leading to greater 
levels of investment and higher revenues . Thus, more investment could then be 
made by BP to develop alternative energy sources and create a more 
sustainable future. So ex ploitation of, and accident s regarding, small numbers 
of employees, the environment, and local co mmunities can all be seen as blips, 
even calculated casualties, in t he pursuit of a better world.

220  
However, environmental destructi on and human deaths would widely be 
considered unethical. This contradict s the human rights of  the employees. 
Therefore short-term oper ational decisions, such as ensuring that safety 
standards are appropriate for employees  should be implement ed; rather than 
pursuing additional profits and hiding beh ind a mask of public relations. Viewed 
from this perspective, ‘calculated cas ualties’ don’t provide the greatest amount 
of good; it simply highli ghts an unethical and ruthless pursuit of profits. BP’s 
employees could be seen to act unethicall y as the immediate results of some 
decisions induce suffering and detriment al effects to the environment, 
employees and local communities. The firm ’s “green-washing” of its CSR to 
gain public approval of its practises and generate profits, could be considered 
unethical. 
An alternative view of BP’s ethical behav iour suggests that those who are in 
charge of safety should ensure that t heir job has been completed thoroughly. 
BP should not view the employees or env ironment as factors of production used 
to maximise profits for shareholders; s uggesting that any reduction of safety is 
acting unethically and irresponsibly. Some  say that BP's CSR and sustainability 
image are a marketing gimmick. 
Thus, it can be seen that one view provi des a moral standpoint for BP; looking 
to the future as it atte mpt to pioneer alternative energy sources; aiming to 
please the greatest number of people. However, another view demonstrates 
that BP acts selfishly to maximise prof its quickly. Another view suggests that 
BP’s decision makers employ unethical practi ces. They don’t just fail to consider 
all stakeholders, but consciously exploi t many in order to increase efficiency 
and cut costs, often at the expense of safety. 
However, traditional ethical theories shoul d not be viewed as complete ‘rules’, 
but as contributing to a wider ethica l understanding for decision making. BP’s 
business actions are complex and have impl ications for all stakeholders. Senior 
management will often squeeze deadlines which force decision makers to ‘cut corners’. Hence, an variety of ethica l perspectives are needed to conclude on 
whether the actions that lead to the Te xas City Fire, the Gulf of Mexico 
explosion and other events, were a re sult of conscious  unethical decision 
making or unexpected and unf ortunate casualties of good business practice in 
the pursuit of future global  improvements. However, it could conversely be 
argued, that BP is simply a collection of human beings who have limited insight 
into the full consequences of their acti ons and thus, are justified in pursuing 
their own self-interests, regardless of other human’s de mands. Therefore, 
interpretation of BP’s CSR and ethical policy is ambiguously subjective and open to conflicting perspectives.

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5 Conflicts within employing organisation 
 The syllabus makes specific refer ence to the importance of exercising 
ethical principles in conducting a nd reporting on internal reviews. 
 There may be times, however, when a professional accountant's 
responsibilities to an employing or ganisation and their professional 
obligations to comply with the fundamental princi ples are in conflict. 
 Ordinarily, a professional account ant in business should support the 
legitimate and ethical objectives est ablished by the employer and the rules 
and procedures drawn up in s upport of those objectives. 
 Nevertheless, where compliance wit h the fundamental principles is 
threatened, a professional accountant  in business must consider a 
response to the circumstances. 
5.1 Pressures that may be faced 
A professional accountant may be put under pressure by managers, directors or 
other individuals to: 
 act contrary to law or regulation 
 act contrary to technica l or professional standards 
 facilitate unethical or illegal earnings management strategies 
 lie to, or otherwise intentionally mi slead (including misleading by remaining 
silent) others, in particular: 
– the auditors of the employing organisation – regulators 
 Issue, or otherwise be associated with, a financia l or non-financial report 
that materially misrepresents the facts,  including statements in connection 
with, for example: 
– the financial statements – tax compliance – legal compliance – reports required by securities regulators. 
5.2 Safeguards to be applied 
The significance of threats arising from such pressures, such as intimidation 
threats, should be evaluated. If they are other than clearly insignificant, 
safeguards should be considered and applied as necessary to eliminate them or 
reduce them to an acceptable level.  Such safeguards may include: 
 obtaining advice where appropria te from within the employing 
organisation, an independent professi onal advisor or a relevant 
professional body. 
 the existence of a formal dispute resolution process within the employing 
 seeking legal advice.

222  
6 Ethical budget setting 
Conflicting objectives 
Imagine you are a manager and you hel p upper management establish the 
master budget (the planning phase). Fu rthermore, you are evaluated based on 
achieving budgeted profit on a quarterl y basis (the control phase). You will 
receive a $10,000 quarterly bonus, in addition to your basic salary, if you meet or exceed budgeted profit. There is an i nherent conflict between the planning 
and control phases of this process. Y ou are helping the company plan, but you 
also want to be sure budgeted profit is as low as possible so you can get the $10,000 bonus. 
Establishing a sales and profit budget that  is considerably lower than what is 
likely to happen causes problems for t he entire organisation. Production may be 
short of materials and labour, causing ine fficiencies in the production process. 
Selling and administrative support may be lacking due to underestimating sales. 
Customers will not be satisfi ed if they must wait for the product. The dilemma 
you face as a manager in this situation is  whether to do what is best for you (set 
a low profit estimate to earn the bonus ) or do what is best for the company 
(estimate accurately so the budget refl ects true sales and production needs). 
Organisations must recognize this c onflict and have processes in place to 
ensure both the interests of individual  employees and the interests of the 
organisation as a whole are served. For example, employees can be rewarded 
not just for meeting goals but also for providing accurate estimates. Perhaps a 
long-term share option incentive system woul d provide motivation to do what is 
best for the organisation. Whatever incentive system is implemented, 
organisations must promote honest empl oyee input and be aware of fraudulent 
reporting to achieve financial targets. 
Undue pressure 
Imagine another ethical scenar io – your manager is pr essurising you to meet 
the budget. This could involve you and your  staff working overtime that you 
don't want (and are not contracted) to do,  through to 'window dressing' of the 
actual results by delaying or pulling forward costs and revenues in to the required time period to meet the budget. 
You know that your manager will not  be happy if you don't meet the budget. 
What should you do? 
There are two main courses of action available to you: You could do as you are told. This would keep your manager happy and 
probably make your life easier. It ma y enable you and your manager to earn a 
reward or bonus. However, if you lose the trust of your st aff or effectively 
mislead higher management by lying about t he state of the budget then this is 
not good for you or the company. It is likely to become apparent in the near 
future and it is an unethical course of action.

Chapter 4 
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You could work as hard as you can to m eet the budget but if it doesn't work out, 
then take the wrath of your manager. This  is probably the most ethical course of 
action, but it may make y our job harder in the futu re. Your manager might be 
angry with you and make your future work ing life difficult. However, there are 
other courses of action open to you. Y ou could face your manager and state 
that he or she is being unreas onable, and unethical in thei r request. If this falls 
on deaf ears and your position becomes untenable, then you could escalate 
your concerns to a higher level of management, human resources or perhaps 
the audit committee. They should take y our issue seriously and investigate the 
manager’s actions. Your manager, if f ound to have exerted undue pressure on 
you, should be reprimanded and probably investigated further since their 
actions may not have been a 'one-off' inci dent. Their 'moral compass' may be 
questionable and at this point high leve l management should ask whether they 
want such a manager working for their co mpany. However, in some cases, high 
level management may also agree with the manager 'pushing' to meet targets. 
At this point you should question whether you want to work for such an organisation. CIMA's code of ethics suggests  that resignation may be your final 
option. 
 
 CIMA’s code of ethics identifies six categories of common threat.  
Which of the following are part of the six threats?  
A Self interest B Self review C Familiarity D Confidentiality E Advocacy 
 
 When you form a close relationship with others so that your 
professional judgement becomes compromised this is considered to be the threat of: 
A Self review 
B Self interest C Familiarity D Advocacy

224  
 Safeguards against ethical threats might include: 
A Intimidation B Disciplinary actions C Disclosure of confidential information D Training E Internal control systems F Inducements 
7 Impact of strategy on brand and reputation 
7.1 The difference between brand and reputation 
To understand how your stra tegy impacts brand and re putation, it’s first 
important to make sure that the diffe rence between these two words is clear. 
They are often used as if they are the same thing and they are not. 
 Brand  – is something that the organisation  can control to a certain extent.  
It’s about what the organisation does  and how it approaches its products, 
services and interactions. 
 Reputation  – is what people think about an organisation, and crucially 
what they communicate about an organisation. This is much harder to 
control – doing the things that the brand sets out is a good way to go about building a reputation, but  it doesn’t guarantee it. 
 
 Illustration – your brand versus your reputation 
 If we view ourselves as an organisation then our brand is what we say 
we are going to do and our reputation is whether we keep to our word. 
Imagine you borrow some money from a friend. You may promise to pay 
them back next week, when you have been paid. This sounds good, and 
is the right thing to say to reassu re someone that they will get their 
money back. 
If you then don’t pay the money back when you have been paid as you 
said you would, the chance of that  friend lending you money again is 
reduced – by not keeping to your pr omise you have broken their trust. 
In the same way, a customer that is disappointed by an organisation is 
likely less to come back.

Chapter 4 
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7.2 How strategy helps 
So where does the strategy come in? In the previous chapter we discussed 
what strategy is: 
An organisation needs to develop appropriate  strategies, to make sure it 
understands its environment and  what it can do internally and makes the right 
choice about where and how to compete. Ha ving the right strategy also links to 
conveying the right brand image to achi eve success in the market place the 
organisation has chosen. 
It also involves developing strategies to  ensure the organisation has the right 
resources available and the right people in  place, with the time they need to do 
the job well, to deliver on their brand and their strategic promise and to achieve 
a good reputation.  
It’s important that the board recognises that managing the brand and reputation 
is difficult – it is much more than a public relations exercise or a marketing 
message. Without delivering on the prom ise, they are just words, which 
eventually people stop believing. 
Like most risks, it requires the whole organisation to work together, which is 
why the strategy chosen and the message t he board conveys to the rest of the 
organisation is so important. 
 
 Illustration – Consistency 
 The organisation as a whole must work together to deliver the strategy 
and brand – this gives the reputation the best chance of aligning to the 
brand. 
If different functions across an org anisation interpret the message the 
board sends out in different ways, they  will act in a different ways and this 
can lead to confusion internally and as  a result the external perception of 
the company is unlikely to be as the board originally set out. 
7.3 Strategic alignment 
Strategic alignment starts at the very  top of an organisation and is about the 
board making sure that the strategic goals, the company culture and business 
processes align for the reason the or ganisation exists, achievement of the 
mission. 
If the board gets this right, then the organisation has the best chance of 
enabling the reputation to matc h the brand they promise.

226  
 Illustration – Southwest Airlines versus Northwest Airlines 
 Southwest Airlines is a low cost ai rline based in America, which was 
established in 1967, and set out a very clear vision: 
“To become the world’s most loved,  most flown and most profitable 
airline.” 
By acting out their mission or purpose: 
“Connecting people to what’s important  in their lives through friendly, 
reliable and low-cost air travel.” 
To achieve this, they recognised t he importance of aligning the people 
that work for their organisation and as  part of that they had this motto to 
help instil the correct culture: 
“If employees are happy, satisfied, dedicated, and energetic, they'll take 
real good care of the customers. When the customers are happy, they 
come back. And that ma kes the shareholders happy”. 
They recognised the link between t heir stakeholders (from shareholders, 
to employees, to customer and beyond), a consistent message coming 
from the top of the org anisation that sets out the brand promise, and also 
the culture within the organi sation to fulfil that pr omise and allow them to 
develop a reputation that aligns with it. 
According to a US Department of Transportation Origin and Destination 
survey in for the 12 months to t he end of June 2018, Southwest Airlines 
carried the most passengers in the US.  Their website also states they 
have achieved 46 consecutive years of profitability. 
By contrast Northwest Airlines, who were founded in 1926 but no longer 
exist, had a brand promise of: 
“Safety. Reliability. Comfort.  Fairness. Courtesy. Honesty” 
Sounds like a great brand promise, but  it needs to be aligned throughout 
the organisation.  
The connection was never made and, as  an example of the issues that 
Northwest airlines had with their staf f, in 1998 they were in dispute with 
their pilots and shutdown the airli ne for more than two weeks as they 
couldn’t agree a deal with their uni on. The pilots were unhappy, other 
staff were affected by the shut down and the connection between the 
strategic aims, the culture and brand promise was never aligned. Their 
promise was broken on many occasions leading to them filing for 
bankruptcy in 2005 and eventually me rging with Delta Air Lines.

Chapter 4 
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 Illustration – Toyota 
 Toyota are often cited for adopting new techniques, from TQM to JIT 
production and Lean manufacturing. It is un surprising to find that Toyota 
were very quick to understand the need for their strategy, culture and 
brand to align to give them the re putation they needed to continue their 
success. 
The company have always followed guiding principles such as being true 
to your duties and creating a good at mosphere at work, but in 2001 they 
adopted the Toyota Way. This lin ked performance with respect for 
people, giving employees the opport unities to develop and perform and 
stating specifically that “a relati onship of mutual trust and mutual 
responsibility between labour and  management” is essential; they now 
give stable employment and improv ing work conditions the highest 
priority. 
This feeds through to the way thei r staff behave and fulfil the brand 
promises they make.  
When the Toyota Way was founded in 2001, the company was for a long 
time the third largest automotive manufacturer in the world, behind 
General Motors and Ford, but in 2006 they became the largest and have 
held that title every year since (apart from 2011 when an earthquake and 
tsunami disrupted production). 
8 Transfer Pricing as a source of reputational risk 
In an organisation with profit centres and investment centres,  there will almost 
certainly be some inter-connection bet ween different centres. Some profit 
centres will supply goods and services to others. 
When inter-divisional (inter-company) trading takes place between profit 
income from the transfer. Unless it receives income from the transfer, it will 
make a loss on the transaction. 
For example, if Division A provides item s to Division B that cost $10 each to 
make, Division A must earn at least $10 fr om the transfer, ot herwise it will make 
a loss. If decision making is delegat ed to profit centre management, the 
manager of Division A would refuse to s upply Division B unless it is allowed to 
earn income of at least $10 for each unit. 
the transfer price.  
 The transfer is treated as an internal  sale and an internal purchase within 
the organisation. It provides sales in come to the supplying division and is 
a purchase cost for the receiving division. 
 The sales income of one division is offset by the purchase cost of the 
other division. The transfer  therefore affects the prof its of the two divisions 
individually, but has no effect on the pr ofit of the organisation as a whole.

228  
 Setting a transfer price: In ter-divisional trading policy 
 it determines how the total pr ofit is shared between the two 
 in some circumstances, it could affect decisions by the divisional 
managers about whether they are willi ng to sell to or buy from the 
other division. 
 A selling division will not agree to sell items to another division 
 Similarly, a buying division will not wish to purchase items from 
another division unless it is profitable for the division. 
Transfer prices have to be established and agreed.  They could be 
 They could be imposed by head office. 
 Alternatively, they could be decided by commercial negotiation 
 If decentralisation is to delegate the power of decision making to 
profit centre managers, they sh ould have the authority to agree 
transfer prices by discussion or  negotiation between themselves. 
Inter-divisional trading should take place within a broad company policy, 
that: 
 for a ‘selling division’, given the c hoice between making a sale to an 
external customer or supplying goods  or services to another division 
 for a ‘buying division’, given the choice between purchasing from an 
external supplier or from another division within the company, the 
preference should be to purchase internally.  
However, a division should be allow ed to sell externally rather than 
transfer internally, or buy externally rather than internally, if it has a good 
commercial reason. Good commercial r easons would include an external 
customer offering a higher price, or an external supplier offering a lower 
price.

Chapter 4 
 229 
 Objectives Of Transfer Pricing 
 (1) Goal Congruence  
Within a divisionalised com pany, divisional managers will have 
responsibility for, and will be judged on, their division's 
performance. They will act independently, autonomously and selfishly in the best interests of their own division. They neither 
know nor care what is happening in other divisions. 
It is the task of the management accounting system in general, and 
the transfer pricing policy in particula r, to ensure that what is good 
for an individual division is good for the company as a whole. 
(2) Performance Measurement  
The transfer pricing system should re sult in a report of divisional 
profits that is a r easonable measure of the managerial performance. 
(3) Maintaining Divisional Autonomy 
One of the purposes of decentralis ation is to allow managers to 
exercise greater autonomy.  There is little point in granting additional 
autonomy and then imposing transfer prices that will affect the 
profitability of the division. 
(4) Minimising the glob al tax liability  
When a divisionalised company operates entirely within one tax 
regime the transfer pricing poli cy will have a minimal impact on the 
corporate tax bill. However multi national companies can, and do, 
use their transfer pricing policies to move profits around the world 
and thereby minimise their global tax liabilities. 
(5) Recording the movement of goods and services  
In practice, an extremely important  function of the transfer pricing 
system is simply to assist in recording the movement of goods and services. 
(6) A fair allocation of profits between divisions  
Most of the advantages claim ed for divisionalisation are 
behavioural. Insofar as transfer pricing has a material effect on divisional profit it is essential that managers perceiv e the allocation 
of corporate profit as being fair if the motivati onal benefits are to be 
retained. 
Needless to say, a number of these objectives can conflict with 
each other, and prove difficult to achi eve in practice. It is highly 
unlikely that any one method would m eet all the firm's requirements 
in all circumstances the best that can be hoped for is a reasonable compromise.

230  
8.1 International Transfer Pricing 
Transfers within an international gr oup will often be cr oss-border, between 
transfer pricing, the issues already de scribed in this chapter still apply. In 
addition, other factors need to be considered. 
8.2 Different tax rates 
A multinational company will seek to mini mise the group’s total tax liability. One 
way of doing this might be to use transfer pricing to: 
 reduce the profitability of its subsidiaries in high-tax countries, and 
 increase the profitabilit y of its subsidiaries in low-tax countries. 
Changes in the transfer price can r edistribute the pre-tax profit between 
subsidiaries, but the total pre-tax profit will be the same . However, if more pre-
tax profit is earned in low-tax countr ies and less profit is earned in high-tax 
countries, the total tax bill will be reduced. 
 
 Taxation and Transfer Pricing 
 International and intra-group trading is a very important part of business 
today . One-third of the UK’s expo rts to Europe are intra-group 
transactions. Foreign-owned assets in Europe and the USA have increased considerably. In one decade, foreign-owned assets in the USA 
tripled, but the tax paid changed very  little, as more than half the 
companies involved repor ted no taxable income. 
International intra-group transfe r pricing has its own special 
considerations, and so a multinati onal organisation will have matters 
other than behavioural ones to consider when it sets its transfer prices. 
There is a natural inclination to set tr ansfer prices in order to minimise tax 
payments. 
Taxation 
tax rates, the overall group corporat ion tax bill could be reduced by 
manipulating the transfer pric es between the subsidiaries. 
For example, if the taxation rate on pr ofits in Country X is 25 per cent and 
in Country Y it is 60 per cent, the group could adjust the transfer price to 
increase the profit of t he subsidiary in Country X and reduce the profit of 
the subsidiary in Country Y. 
Thus, if the subsidiary in Country X provides goods or services to the 
subsidiary in Country Y, the use of a very high transfer price would 
maximise the profits in the lower-tax  country, and minimise the profits in 
the higher-tax country.

Chapter 4 
 231 
 There is also a temptation to set up marketing subsidiaries in countries 
with low corporation tax rates and transfe r products to them at a relatively 
low transfer price. When the products ar e sold to the final customer, a low 
rate of tax will be paid on the di fference between the two prices. 
According to a survey by Ernst and Young, more than 80 per cent of 
multinational companies viewed transfe r pricing as a major international 
tax issue, and more than half of t hose companies saw it as the major 
issue. The taxation authorities in most countries monitor transfer prices in 
an attempt to control the situation and in  order to collect the full amount of 
taxation due. Double taxation agreem ents between countries mean that 
companies pay tax on specific transac tions in one country only. However, 
if the company sets an unrealistic transfe r price in order to minimise tax, 
and the tax authority spots this, the company will pay taxation in both 
countries, that is, double taxation. Th is additional payment can amount to 
millions of pounds and, as a result, is  quite an effective deterrent. On the 
other hand, the gains of avoidi ng taxation may be even greater. 
There have been many cases of transfer price fixing for one reason or 
another over the years. One of the most  notorious of UK transfer pricing 
cases was that of Hoffman La Roche,  as it was then called. Hoffman La 
Roche had developed the dr ugs Librium and Valium. The products were 
imported into the UK at prices of  $437 and $979 per kilo, respectively. 
The UK tax authority accepted the prices; however, the Monopolies 
Commission sprang into life and questi oned the prices on the grounds 
that the same chemical ingredient s, which were unbranded, could be 
obtained from an Italian company for $9 and $28 per kilo. Hoffman La Roche argued on two grounds: (1) that the price was not set on cost but 
on what the market would bear, and (2) they had incurred the research and development costs and so had to recover those in the price. 
However, this was not accepted and they were fined $1.85 m in 1960. 
In the UK, Nissan was caught for unpai d tax of $237m for falsely inflated 
invoices that were used to reduce profits. The freight charges were 
inflated by 40–60 per cent by a Norwegian company. The next year Nissan was required to pay $106 m in unpaid tax in the USA because the authorities felt that part of thei r USA marketing profits were being 
transferred to Japan as transfer prices on imports of cars and trucks were 
too high. Interestingly, the Japanese tax authorities took a different view 
and returned the double tax, which is a very rare occurrence. 
Most countries now accept the Or ganisation for Economic Co-operation 
and Development’s (OECD)  guidelines. These guidelines were produced 
with the aim of standardising national approaches to transfer pricing as 
part of the OECD’s charter to enc ourage the freedom of world trade. 
They provide guidance on the applicat ion of ‘arm’s length’ principles. 
They state that where necessary trans fer prices should be adjusted using 
an ‘arm’s length’ price, that  is, a price that would have been arrived at by 
two unrelated companies acting indepen dently. There are three methods 
the tax authorities can use to determine an arm’s length price.

232  
 The first is the comparable price me thod. This is the most widely used 
and involves setting the arm’s length pric e by using the prices of similar 
products, that is, the market pric e or an approximation to one. The 
method is known as using comparabl e uncontrolled prices (CUPS) and is 
the preferred method wherever possible. This may seem a 
straightforward basis but, as most  international trade is carried out 
between related companies, meaningful  comparisons are hard to find. 
For example, at one time in the UK , it was possible to use independent 
car distributorships to find a CUP but  now that car manufacturers have 
developed their own dependent  distributor networks, finding arm’s length 
comparability is much more difficult. 
Where a CUP cannot be found, or is  inappropriate, one of two gross 
margin methods should be used. These involve a review of gross margins in comparable transactions between uncontrolled organisations. The resale price method is used for the transfer of goods to distributors and marketing operations where goods are sold on with little further processing. The price paid for a final product by an independent party is used and from this a suitable mark-up (to allow for the seller’s expenses 
and profit) is deducted. The second gro ss margin method is the cost-plus 
method. Here an arm’s length gross ma rgin is established and applied to 
the seller’s manufacturing cost. 
These methods are of little help when attempting to establish an arm’s 
length price for intangible property such  as a patent right or trade name. 
Also, much of the data needed may not be in the public domain and so 
setting fair transfer prices is not easy.  In the past, this did not matter so 
much but today it is often up to th e taxpayer to ‘prove’ the price. 
For example, the US section 482 r egulations on transfer pricing cover 
300 pages and the onus is on the taxpay er to support the transfer price 
with ‘timely’ documentation. If this  is not done, a non-deductible penalty 
of up to 40 per cent of the arm’s lengt h price may be levied. In the past in 
the UK, it was up to the tax authoriti es to detect cases of inappropriate 
transfer pricing. This left the UK vu lnerable to a cert ain amount of tax 
leakage. But now under the self-a ssessment regulations, the onus has 
switched to the taxpayer to provid e correct information. Failure to 
demonstrate a reasonable attempt at an arm’s length price in the tax 
return will give rise to a penalty of  100 per cent of any tax adjustment. 
Other European countries are also tightening their regulations in 
response to the USA and OECD’s moves. 
To safeguard the position, the tax payer may enter into an Advanced 
Pricing Agreement (APA) with the rele vant two tax authorities involved. 
This is a new approach and is done in advance to avoid any dispute and the costly penalty of double taxation and penalty fees. According to the 
Ernst and Young survey referred to ear lier, more than 60 per cent of 
companies intend to do, or are doing this.

Chapter 4 
 233 
8.3 Government action on transfer prices 
Governments are aware of the effect of transfer prici ng on profits, and in many 
countries, multinationals are required to justify the transfer prices that they 
charge. Multinationals coul d be required to apply ‘arm’s length’ prices to transfer 
prices: in other words, they might be required under tax law to use market-
based transfer prices, to remove t he opportunities for tax avoidance. 
It is also possible, on the other hand, t hat some countries wishing to attract 
business might have tax laws that are ve ry favourable to business. A country 
with the status of a ‘tax haven’ might offer: 
 a low rate of tax on profits 
 a low withholding tax on dividends paid to foreign holding companies 
 tax treaties with other countries 
 no exchange controls 
 a stable economy 
 good communications with t he rest of the world 
 a well-developed legal framework, within which company rights are 
Multinationals might set up subsidiary companies in tax havens, trade through 
these companies, and hope to reduce their total tax liabilities. 
8.4 Transfer pricing to manage cash flow 
Some governments might place legal restrictions on dividend payments by 
companies to foreign parent companies. 
In this situation, it would be tempting fo r a multinational to sell goods or services 
to a subsidiary in the country concerned from other divisions in other countries, 
and charge very high transfer prices as  a means of getting cash out of the 
country. 
This tactic is not possible, however, w hen the country’s tax laws require that 
transfer prices should be set on an arm’s length basis. 
 
 Transfer pricing at Starbucks 
 Starbucks – the international coffee c hain, has been in the UK news over 
the past few years due to its Board decla ring it profitable in the UK, yet 
reporting losses in its financial statement s, and paying very little or no UK 
corporation tax. 
Over a three year period Starbucks has reported no profit and paid no UK 
tax on UK sales of £1.2 billion. (By comparison, McDonalds had a tax bill 
of £80 million on £3.6 billion of UK sales.) 
This apparent contradiction arises from  perfectly legal tax avoidance – a 
tactic used by many multi-nationals the world over. 
Starbucks achieves this, in part, thr ough transfer pricing. Starbucks buys 
coffee beans for the UK through a S witzerland based subsidiary. Before 
the beans reach the UK they are roast ed at the subsidiary  in Amsterdam.

234  
 The tax authorities in the Nether lands and Switzerland require Starbucks 
to allocate some profits from its UK  sales to its Dutch roasting and Swiss 
trading units. 
The Dutch roasting plant declares a small operating profit, while in 
Switzerland the Swiss trading unit is  not required to publish accounts. 
Corporate profits ar e taxed at 24% in the UK, 25% in the Netherlands, but 
as low as only 5% in Switzerland. In th is way it minimises its UK tax bill. 
Starbucks was subject to a UK cust oms enquiry in 2009 and 2010 due to 
its transfer pricing practices, but it  was resolved without further action or 
penalties. HMRC declined to comment. 
9 Other risks linked to reputational risk 
9.1 Fraud 
Fraud can be defined as: 
'Dishonestly obtaining an advant age, avoiding an obligation or causing a loss to 
another party'. 
 
 Prerequisites for fraud 
 There are three prerequisites for fraud to occur 
 Dishonesty on the part of the perpetrator. 
 Opportunity for fraud to occur. 
 Motive for fraud. 
 an ability to rationalise  the fraudulent action and hence act with 
dishonesty  – virtually anyone can justify almost any dishonest or 
illegal action that they undertake. The idea is that  many people obey 
the law because they believe in it and/or they are afraid of being shamed or rejected by people they care about if they are caught. 
However, some people may be able to rationalise fraudulent actions as: 
– necessary – especially when done for the business 
– harmless – because the victim is large enough to absorb the 
impact 
– justified – because ‘the victim  deserved it’ or ‘because I was 
mistreated.’ 
 a perceived opportunity to commit fraud – this can cover a vast 
range of circumstances, from the board of dire ctors (whose position 
almost always gives some opportunity to publish fraudulent statements) to members of staff or the general public who think that 
the system might be weak.

Chapter 4 
 235 
  a motive, incentive or pressure to commit fraud – this can range 
from the members of the board wishing to maximise the value of 
their performance-related remunerat ion packages to greed on the 
part of a dishonest employee or third party. 
All three factors generally exist within all organisations and at all levels. 
There is more detail on fraud in Chapter 6. 
9.2 Link to reputational risk 
If a fraud becomes public knowledge it can affect a company's reputation. The 
control systems within the company will be considered weak, which will worry 
investors. The share price may fall ( dependent on the size of the fraud and the 
investors’ opinion of it). Future invest ors will be wary and it could prevent the 
company from raising future finance. 
(In the past companies have adopted two diff erent attitudes to the disclosure of 
fraud – admit to it, or hide it. Hiding fraud is unethical. Also, often the press find 
out and the consequences are worse than they would have been if the company 
had come clean in the first place.) 
9.3 Bribery 
Bribery occurs when someone in a positi on of trust receives a benefit as a 
reward for voluntarily acting in breach of  that trust. The benefit can take many 
forms including, but not limited to cash , luxurious gifts or favours to the 
9.4 Link to reputational risk 
If an organisation is found to have been involved in bribery, then as with fraud it 
can lead to negative connotations.  
A writer for the Harvard Business School, George Serafeim, stated that 
'bribery's most significant impact is it s negative effect on employee morale', 
highlighting that reputati onal risk can lead to issues  other than just reduced 
sales, and declining share price. In t he same way that a good reputation can 
attract employees, reputational damage can lead to loss of skilled workers. 
10 Managing reputational risk 
Warren Buffett, a famous American businessman, once said “It takes 20 years 
to build a reputation and five minutes to ruin it. If you think about that, you'll do 
things differently”. 
A good reputation therefore has  many benefits from attr acting higher calibre 
employees to attracting loyal customers.  This can then lead to higher sales, 
both from these satisfied customers, and from new customers attracted as a 
result of referrals. Such a positive image can then lead to easier access to finance and a share price that outper forms the market. Finally, a good 
reputation can help build relationship s with legislators and regulators which 
could mean being meaningfully involved in discussions around changes in regulations.

236  
There are many ways to manage reputati onal risk, here are some examples: 
 governance 
 employee relations 
 environmental awareness 
 external relations 
 risk professionals 
 a policy framework  
 risk sensing tools 
 
 More on managing reputational risk 
 In more detail: 
There is more detail on governance in chapter 5 and in the ERM section 
of chapter 2.  It is im portant for the board of directors to be aware and 
open minded about the possible reputat ional damage that the company 
could cause through its actions. In par ticular they must be alert to new 
risks that are not currently inclu ded in the risk register or risk 
management processes of the company. 
A culture of doing the right thing,  again linking to one of the ERM 
principles – the control environment – will help set the appropriate tone. 
Employee relations 
In line with the ERM framework, every single person within the 
organisation has a responsibility to manage risk, includi ng reputation risk. 
Using bribery as an example, it doesn’t have to be a senior figure 
accepting or making the bribe, it  could be someone working at an 
operational level, but the bribe could still lead to concerns over the culture within the organisation. 
Regular communication with the wo rkforce, including training and 
education on the potential for reputa tional risk, should be provided – 
reminding them about the ways to deal with any concerns. 
External relations 
Transparency with stakeholders should be as great as is possible without 
giving away information that prov ides a competitive advantage. There 
must be clear and transparent comm unication with stakeholders about 
what the organisation is doing and why it is doing it. 
Environmental awareness 
This relates to being aware of not only the impact that the company and 
its supply chain is having on the envir onment, but also changes in beliefs 
about how society should interact with the environmen t. For example, 
diesel engines were previously perceived to be more environmentally friendly than petrol, and there is no w a much increased awareness of the 
damage that single use plastic is having on the environment.

Chapter 4 
 237 
 Monitoring 
Monitoring can mean internal monitoring of certain metrics or controls to 
ensure that policies and procedures  are being undertaken as they 
should. It can also be applied to moni toring of external  sources, for 
example social media, to gain an aw areness of what is being said about 
the company, the competit ors and potentially the i ndustries the company 
is involved in. 
Risk professionals 
A company could employ or hire the se rvices of an expert in risk and risk 
management. These individuals could re view known risks and mitigation 
strategies, but also consider emergi ng risks relating to strategy and the 
changing environmental and social factors. 
Policy framework  
Setting up a framework relating to ri sks, and in particular highlighting 
reputational risk, can help employees  with identificati on of potential 
issues, and will also enable clear and consistent assessment and management of risks. 
Risk sensing tools  
As the rise of social media is part of the reason for an increased focus on 
reputational risk, organisations are in vesting significantly in tools to 
analyse text and linguistics used in social media posts and reviews to understand what is being said about thei r firm. They are aiming to do this 
in real time, so they effectively hav e a live feed of public opinion, giving 
them time to act quickl y and avoid surprises. 
10.1 How to respond in a crisis 
Prevention is an excellent approach, but the reality is, as with every risk, 
complete prevention is unrealistic, so it is also sensible for an organisation to 
have a crisis response plan for an event  that may damage t heir reputation. 
Options a company could use: 
 setting up a crisis response team  
 scenario planning 
 
 Reputation crisis response 
 Crisis response team 
Having a team of people who are responsible for coordinating a 
companywide response will help make sure the message is consistent 
with the overall strategy, br and and culture of the firm.  
Having a crisis response team shoul d include a clear escalation policy for 
the whole company. This should include who should be informed and when and what any indivi dual should say should a new reporter phone or 
ask any questions outside the companies premises.

238  
 Scenario planning 
As reputational risk is becoming more and more of a strategic issue, it 
makes sense to use strategic tool s to assist with risk management and 
A risk committee, or potentially th e crisis response team, could model 
various reputational issues, for ex ample a backlash from customers on 
social media and plan a coordinated and considered response to such events, rather than having a reactive response that could lead to further 
issues.  
 
 Test your understanding 16 – Pr ivate hospital (Case study) 
 Scenario 
A private hospital has a canteen that provides staff and visitors with 
subsidised meals and refreshments. The canteen’s selling prices are 
supposed to cover running costs, so that there is no net cost to the 
hospital. Over the past eighteen mont hs the canteen has been reporting 
losses that have been increasing st eadily despite monthly sales 
remaining constant. The cost of purc hases has grown substantially for no 
apparent reason. The purchasing of s upplies and the choice of suppliers 
is the sole responsibility of t he Canteen Manager. The current Canteen 
Manager has been in post for almost two years. 
Trigger 
The hospital’s Chief Executive ask ed the Head of Internal Audit to 
investigate why the canteen wa s making losses and a thorough 
investigation was conducted under t he supervision of F, an experienced 
auditor and qualified accountant. The in ternal audit team discovered that 
the losses started shortly after the Canteen Manager changed suppliers. 
F compared the invoiced prices char ged by the new supplier with those 
charged by the former supplier and di scovered that the new supplier was 
significantly more expensive. 
F interviewed the Canteen Manager , who claimed the change in 
suppliers was because the new supplier was more reliable and provided higher quality products. F was suspic ious and contac ted a number of 
alternative suppliers. None of the pot ential suppliers whom F contacted 
would have charged as much as the canteen was paying for basic commodities such as rice and pot atoes. Furthermore, the canteen’s 
invoices showed that it was paying fa r more than the normal market price 
for branded goods, such as crisps and chocolate bars.

Chapter 4 
 239 
 F was in the Canteen Manager’s office one lunch time, saw a laptop 
computer open at an email to the supplier and investigated further. The 
Canteen Manager had been using a personal  email account to email the 
owner of the supplier on a daily ba sis. The emails revealed that: 
 the owner had been inflating the selling prices of all goods sold to 
the hospital by 20%; 
 the Canteen Manager passed these inflated invoices for payment; 
and 
 the owner then paid half of t he 20% that had been overcharged to 
the Canteen Manager in cash. 
F confiscated the laptop, which was the Canteen Manager’s personal 
property, and submitted it, along with a full report, to the Head of Internal 
Audit. 
Two weeks later, F was asked to meet with the hospital’s Chief 
Executive. The hospital’s directors had discussed the report carefully and had interviewed the Canteen Manager and decided that they did not wish 
to refer the matter to the polic e. The Canteen Manager had been 
accompanied by a lawyer, who stat ed that the Canteen Manager denied 
all charges of fraud and pointed out that  there was very little evidence to 
support F’s accusations. F could have easily falsified the emails on the 
laptop and the owner of the food supplier had suppl ied the lawyer with a 
statement that no pay ments had been made to the Canteen Manager. 
The Chief Executive had agreed that  the hospital would return the 
Canteen Manager’s laptop and would make  him a substantial payment in 
return for his agreement to resign qui etly. The Chief Executive had also 
promised that the Canteen Manager would receive a positive reference. F 
was asked to destroy any remaining notes and documents relating to this 
investigation and to remain silen t, not discussing the case with anyone 
either within the hospita l or any third parties. 
Task 
(a) Critically evaluate the decision by the Chief Executive to pay the 
Canteen Manager to resign quietly. 
(b) Advise F on the ethical issues  arising from destroying the notes 
taken and maintaining silence on this investigation. 

240  
 Test your understanding 17 – M mobile telephones (Case study) 
 Scenario 
M is the leading retailer of mobile telephones in its home country. The 
company has almost 100 branches, with at least one branch in every 
major town and city. Some branches ar e located within walking distance 
of one another. 
M has a highly aggressive management t eam. It views sales growth as 
the key to the company’s continuing su ccess. It believes that increasing 
their share of the retail market will  enable M to negotiate large discounts 
from manufacturers and network provi ders. It also creates economies of 
scale in the advertising and promoti on of the company and its services. 
Two years ago the directors abandoned tr aditional budgeting and target 
setting. They decided that budgets did not  necessarily give branch staff a 
sufficient incentive to maximise sa les because they tended to work 
towards achieving but not surpassing sales targets. They introduced a new management control system with the followin g features: 
 Shop sales are recorded using el ectronic point of sales (EPOS) 
cash registers that are linked to head office. Every sale indicates the 
branch and the member of staff responsible for the sale. These 
transactions are recorded in real ti me during the course of the day. 
 A terminal in every shop lists a running total of that shop’s sales for 
the day, analysed between each mem ber of sales staff. The 
terminal also indicates the shop’s r anking for the day relative to all 
of M’s other shops. 
 Every shop manager must be at work  at least an hour before the 
shop opens. During that hour the manager receives a telephone call 
from the regional sale s manager to discuss the previous day’s sales 
and the likely sales during the day ahead. 
 Each shop manager is permitted c onsiderable freedom to introduce 
special offers and promotions, s ubject to achieving an acceptable 
margin on each sale made. 
 At the end of every week the ma nager and staff of the ten shops 
with the highest sales are giv en a substantial bonus. The manager 
and staff at the ten shops with the poorest sales are given one 
week’s notice to improve or they face being moved to other shops or 
even dismissal. 
 Sales have grown rapidly sinc e this system was introduced, 
although the rate of growth has been declining recently.

Chapter 4 
 241 
 The Director of Human Resources has  investigated staff absenteeism 
and turnover and has discovered that many of M’s branch managers and 
sales staff have been with the company fo r several years. They seem to 
thrive in the competitive environ ment and the company pays staff with 
good sales records a substantial sala ry compared with other retailers. M 
also suffers a high staff turnover ev ery year and some members of staff 
are frequently absent for health reasons, with their doctors certifying them 
as ill due to stress ‐related conditions. 
Trigger 
M’s Chief Accountant is concer ned that the company’s management 
accounting systems are unethical and s he has provided the board with a 
copy of CIMA’s Code of Professional Ethics. 
Task 
Write a letter to the B oard advising on the ethical implications of their 
approach to personnel management. 
 
 Test your understanding 18 – Grove council (Case study) 
 Scenario 
Grove Council is the local government authority responsible for the 
running of public services in a dist rict of approximately 200 square miles 
and with a population of ov er 300,000. The Grove district comprises a 
mixture of towns, villages and rural areas. 
The Council employs approximately 13,000 staff in a wide variety of 
occupations. The Council is responsible  for the maintenance of the entire 
public infrastructure in its area of responsibility, including the roads and 
sewerage systems. The Council al so manages education and cares for 
vulnerable residents such as the el derly and infirm. The Council has a 
divisional structure, with divisions taki ng responsibility for specific matters 
such as education, roads and so on throughout the Grove district. 
Employment law requires that every employer, including Grove Council, 
must maintain a register of all work place injuries sustained by employees. 
There is no precise definition of a r eportable injury, but Council guidelines 
indicate that anything that require s a dressing, such as a bandage or 
sticking plaster, must be reported as mi nor injuries. Injuri es are classified 
as “serious” if they require the vict im to be absent from work for more 
than three days and “severe” if they  require admission to hospital or 
involve a fatality.

242  
 Trigger 
The latest injury statistics show t hat there were 150 injuries during the 
last year, of which 20 were seriou s injuries and 3 were severe. The 
Council’s Director of Operations (D O) is satisfied with these figures 
because the number of injuries is no worse than in previous years. The 
DO holds the view that such figures are to be expected given the diverse 
range of jobs, many of which are risky, throughout the Council. The Chief Executive of the Council does not shar e these views: but believes that 
the Council should try to prevent all in juries by eliminating accidents in 
the workplace. 
The Chief Executive asked Grove Counc il’s internal audit department to 
review the systems for reporting inju ries. As part of their response a 
CIMA qualified member of internal audi t was sent to investigate the repair 
depot that maintains the Council’s fleet  of vehicles. The depot employs a 
team of over 40 mechanics and is equi pped with a full range of welding 
and lifting equipment. 
The depot’s injury register had only two entries for the year prior to the 
internal audit visit. Both injuries we re severe and each involved an injury 
that required an ambulance to be ca lled and an employee to be admitted 
to hospital. 
On enquiry, several of the mechanics explained that the small number of 
reports is due to the depot manager refusing to record injuries unless 
they are either serious or severe . Several of the depot mechanics are 
trained in first aid and no records are kept  of any injuries that they treat. 
All of the mechanics refused to put t hese allegations in writing for the 
internal auditor. 
The internal auditor asked the Head of  Internal Audit to send an urgent 
report to the Chief Executive, but the Head of Internal Audit refused to do 
so on the grounds that there was insu fficient evidence of manipulation. 
The Head of Internal Audit threatened to suspend the internal auditor if 
these allegations were repeated to anyone else either inside or outside of 
the Council. The internal auditor is di ssatisfied with the Head of Internal 
Audit’s response and is considering w hether to take t he matter further. 
Task 
As the internal auditor prepare br iefing notes, which may be used in a 
meeting with the Audit Committee, covering: 
(a) An analysis of the ethical dilemma  faced by the internal auditor. 
(b) The recommended course of action t hat the internal auditor should 
take if Head of Internal Audi t cannot be persuaded to draw the 
allegations of under-reporting of injuries  to the attention of the senior 
management of Grove Council. 

Chapter 4 
 243 
 Test your understanding 19 – SPQ (Integration) 
 As a CIMA member, you have rec ently been appointed as the Head of 
Internal Audit for SPQ, a multinational  listed company that carries out a 
large volume of Internet sales to customers who place their orders using 
their home or work computers. You report to the Chief Executive although 
you work closely with the Finance Direc tor. You have direct access to the 
Chair of the audit committee whenever  you consider it necessary. 
One of your internal audit teams has been conducting a review of IT 
security for a system which has been in operation for 18 months and 
which is integral to Internet sales.  The audit was included in the internal 
audit plan following a request by the Ch ief Accountant. Sample testing by 
the internal audit team has revealed several transactions over the last 
three months which have raised concerns about possible hacking or fraudulent access to the customer/o rder database. Each of these 
transactions has disappeared from t he database after deliveries have 
been made but without sales being reco rded or funds collected from the 
customer. Each of the i dentified transactions was fo r a different customer 
and there seems to be no relationsh ip between any of the transactions. 
You have received the draft report from the inter nal audit manager 
responsible for this audit which suggests serious weaknesses in the design of the system. You have discu ssed this informally with senior 
managers who have told you that such a report will be politically very unpopular with the Chief Executive as he was significantly involved in the 
design and approval of the new syst em and insisted it be implemented 
earlier than the IT department co nsidered was advisable. No post-
implementation review of the system has taken place. 
You have been informally advised by several senior managers to lessen 
the criticism and work with the IT depar tment to correct any deficiencies 
within the system and to pr oduce a report to the Audit Committee that is 
less critical and merely identifies the need for some improvement. They 
suggest that these actions would avoid criticism of the Chief Executive by 
the Board of SPQ. 
Required: 
Explain the ethical principles t hat you should apply as the Head of 
Internal Audit for SPQ when reporting t he results of this internal review 
and how any ethical conflicts should be resolved. 

244  
 Test your understanding 20 – Erasmus (Integration) 
 You are the newly-appointed financia l controller of Erasmus, a fully 
owned subsidiary of the Think Group. The following matters have come to your attention: 
(1) Your assistant, a newly-qua lified Management Accountant, is 
heavily in debt to a junior member  of the finance staff, who has a 
considerable amount of personal wealth  in spite of his fairly junior 
position in the company. 
(2) The CEO of the company was in the habit of making accounting 
adjustments to the financial stat ements prepared by the finance 
director in order to ‘smooth out variances’ if actual performance was 
not going to plan. 
(3) A member of your departm ent, another Management Accountant, 
recently made significant errors in  completing the sales tax returns 
to the tax authorities, which resu lted in a fine and interest charges 
for an underpayment of the sales tax liability. 
Required: 
Discuss how you would deal with each of  these three problems in order 
to bring about an improvement in the ethical standards in the systems of 
management. Indicate any problems you might expect to arise when you 
attempt to bring about change. 

Chapter 4 
 245 
 Test your understanding 21 – Five et hical situations (Integration) 
 In all of the ethical situations below, the people involved are qualified 
members of CIMA. 
 A applies for a job and enhances his CV by indicating he obtained 
first time passes in all his examin ations, although he actually failed 
three exams at t he first attempt. 
 B is the management accountant in C Ltd. B is paid a bonus based 
on the profits of C Lt d. During accounts preparation B notices an 
error in the inventory calculation wh ich has the effect of overstating 
profits. B decides to take no action as this would decrease the bonus payable. 
 D is responsible for the purchase of computer equipment in E Ltd. 
Quotes from three suppliers have been received for installation of 
new hardware; one supplier, F Co, has promised a 10% discount, payable to D, if thei r quote is accepted. 
 G is preparing the management acc ounts in H Ltd. Part of the 
information presented to him indica tes that H Ltd entered into an 
illegal agreement with I Ltd to fix price increases in the goods H and 
I supply. H and I together supply 90% of the total market. The price 
setting enabled H and I to obtain higher  than expected profits for 
their sales. 
 J is preparing the management acc ounts for K Ltd. L, the senior 
management accountant, has instruct ed J to omit the negative 
overhead variance from the accounts on the grounds that they show 
an ‘unacceptable loss’ with the inclusion of the variance. 
Required: 
(a) Explain how professional codes of ethics address possible conflicts 
of interest facing accountants. (15 minutes)  
(b) For each of the situations above: 
(i) Identify and explain the ethi cal threat to the accountant. 
(ii) Discuss the ethical safeguards  available to overcome that 
threat. (30 minutes)

Chapter 4 
 247 
  Ethical behaviour is likely to be favoured by:  
– customers: resulting in higher  sales volumes and/or prices 
– employees: resulting in the at traction/retention of the best 
employees and increased employee productivity. 
– business collaborators: resulting in increased opportunities for 
profitable projects. 
 Ethical behaviour reduces risk and gives access to cheaper funds 
which in turn increase project NPVs. 
 Unethical behaviour wi ll, at some point be discovered resulting in a 
damage to reputation and pot ential legal charges. 
 
  The purpose of a business is to make  profits. Profit is a good thing 
in its own right as it supports stab le employment, innovation, allows 
higher taxes to be paid and makes economies richer. Companies have no need to feel guilty about making profits and buying off some of that guilt by embarking on good works. 
 The prime stakeholders are the shareholders and directors should 
always attempt to maximise share holder wealth. If directors embark 
on a CSR programme, have shareholders given permission? It is, after all, shareholders’ money that is being used. 
 CSR allows directors to feel  generous and righteous – but with 
someone else’s money. Better, perhaps, that directors and 
shareholders make private donations out of their remuneration and 
 What is the democratic basis which companies use to choose 
between CSR projects? Simply c hoosing a project because the 
chief executive likes it does not mean the money is being well spent – the project could be already well-funded. 
 
The fundamental principles are int egrity, objectivity, professional 
competence and due care, pr ofessional behaviour and 
CONFIDENTIALITY (not communication).

248  
 
 C 
Allowing a part-qualified co lleague to complete the work at home exposes 
the firm to a high risk that the work will be rushed and not up to the 
quality expected. 
 
 A, B and E 
 Option A – Integrity implies fair dealing and truthfulness. L would not 
be telling the truth if she provided the reference. 
 Option B – L’s objectivity is likely to be threatened anyway given she 
is a personal friend of the client. 
 Option C – There is nothing to suggest L is compromising her duty 
to maintain her skills. 
 Option D – The client is clearly giving L permission to contact the 
bank. 
 Option E – Giving a misleading reference would discredit the 
accountancy profession if k nowledge of it became public. 
 
 A 
John can benefit directly from any manipulation or questionable 
judgements he makes concerning the accounts.

Chapter 4 
 249 
 A and D 
 Option A – Potential customers ma y see B’s products as less safe 
as a result of the issue. 
 Option B – Unlikely given B Company’s risk assessment. 
 Option C – As option 2 above. 
 Option D – A recall is more ethical since, if successful, it will prevent 
injury completely. 
 
 A and B 
 Option A: The board has a fiduciary  responsibility to its employees. 
It could be argued this responsibility is more important than ever 
when employees are vulnerable – for example in very poor countries. 
 Option B: If it is no longer safe to mine R33, the communities are 
indeed under threat since the mining is their main source of funds. 
 Option C: The board of D has a duty to set a suitable ‘tone from the 
top’ and a high level commitment to internal controls and risk 
management. They must conduct regular risk assessments and would be unable to ignore the findings of the report. 
 Option D: The poorest nations are unlikely to have detailed 
employment laws with regards to safety. 
 Option E: See Option C above. 
 
The correct order of events is to firs tly check the facts. Then once you are 
sure of the facts to escalate inte rnally. If the issue cannot be resolved 
internally then you should escalate it externally e.g. call CIMA. Finally if 
the ethical issue continues you shoul d dissociate with the conflict i.e. 
possibly resign

250  
 B, D and F 
 Option A: This is not appropriate si nce the employer’s objectives are 
fraudulent. 
 Option B: This is a reasonable cour se of action although it will cause 
upset. 
 Option C: There are no other managers in D Co. 
 Option D: This is a reasonable, al though expensive course of action. 
 Option E: D Co is a small, family -run business, which is unlikely to 
have a formal dispute resolution process. 
 Option F: This is the most imm ediately practical although may not 
get results since the son may refuse to comply. 
 
 The correct answers are A, B, C and E 
The six ethical threat s are self-interest, se lf review, advocacy, 
intimidation, familiarity and adverse interest. 
 
Training, disciplinary actions and inter nal control systems should help to 
safeguard against ethical threats. 
Intimidation, inducements and disclosur e of confidential information may 
cause ethical issues.

Chapter 4 
 251 
 (a) It would be unacceptable for the Chief Executive to make this 
arrangement in order to protect t he reputations of the hospital’s 
senior management. If the public becomes aware of the fraud then 
the fact that the seni or management team had not detected it sooner 
could lead to criticism of the hospital’s governance arrangements. 
The Chief Executive may have been acti ng in the best interests of the 
hospital. Under the circumstances, it would have been necessary to 
have suspended the manager from  duty on full pay until the 
allegations could be proper ly investigated. It w ould almost certainly 
have been impossible for this investigation to reach a satisfactory conclusion and so the suspension would have been prolonged and expensive. Paying the manager to l eave made it possible to restrict 
the cost of the settlem ent to the agreed sum. 
The hospital would also have been unable to appoint a replacement 
Canteen Manager while the investigat ion was still in progress. The 
payment will leave the post vacant and so a new appointment can be made to this important role. St aff may be demotivated if they 
discover that the control system had broken down in this way and that a major fraud had been committ ed. Paying the manager to 
leave quietly will enable the directors to maintain the impression that 
the control environment is functioning. 
The payment will, of course, co me from funds that had been 
intended to treat patients. Even if the payment is justified as the 
least expensive resolution of this problem, it is undesirable for hospital resources to be spent in this way. 
(b) Qualified accountants are generally subject to ethical codes that are 
almost identical to CIMA’s C ode of Ethics for Professional 
Accountants . That code applies within the company and to contact 
with third parties. Thus, F is subjec t to a formal dut y to respect the 
confidence of the hospital and not divulge this arrangement to 
anybody else, either within t he hospital or outside of it. 
This duty of confidence does not necessarily apply in every case. F 
has a wider duty to the stakeholders involved and so society in general. F could breach this duty of  confidence if doing so was in 
the public interest. F should consi der that possibility, although it 
seems unlikely to be the case given the facts. The amounts stolen 
from the hospital are unlikely to be sufficiently large as to warrant 
breach of confidence. On the othe r hand, the fact that the manager 
will receive a positive reference c ould mean that he will be able to 
repeat the fraud, which could create so me justification for F to report 
the matter to, say, the police. 
F is obliged to act with integrit y. It could be argued that F has 
already discharged his responsibilit y by reporting the suspected 
fraud to the head of internal audit,  who has clearly reported the 
matter to senior management. It  appears that the management 
team has reached a decision that is in the hospital’s best interests and so there is no real need for F to take any further action.

252  
 Address 
Date Dear Board of Directors, Re: Ethical principles CIMA’s Code of Professiona l Ethics states that a professional accountant 
is required to comply with five fundamental principles. 
Integrity 
A person should be straightforward and honest in all professional and 
business relationships. 
A person should not allow bias, conflict of interest or undue influence of 
others to override professi onal or business judgements. 
A person has a continuing duty to ma intain professional knowledge and 
skill at the level required to ensure that  an employer or customer receives 
a competent professional service. 
A person should respect the confidentia lity of information acquired as a 
result of professional relationships and should not disclose any such information to third parties  without proper authority. 
A person should comply with relevant laws and regulations and should 
avoid any action that discredits the company.  
Not all of M’s directors will be prof essional accountants but the code of 
ethics will still be appropriate to a pr ofessional company such as M and 
its directors. The Director of Human Resources is concerned that M has a 
high staff turnover, linked to the high absence rate due to ‘stress related 
conditions’ at M. The highly comp etitive environment at M is being 
blamed for this. 
Sales have grown rapidly although the ra te is now slowing. It is possible 
that in the past sales staff have been adopting an aggressive sales 
technique which only works once with customers, since they are not 
pleased with their purchase and don’t re turn to make another. This is a 
short‐sighted sales technique, where sale s growth will be high at first, but 
then fewer repeat purchases are made and sales staff struggle to meet 
their objectives in the future. 
Staff will become very worried about the implications of failing to meet the 
sales objectives if they think that t hey have only a week to correct their 
actions, or face being moved to anot her shop or dismissed. Moving to 
another shop may be inconvenient fo r their home life, and dismissal 
would be worrying in that they may not  be able to find another job quickly, 
becoming unable to provide for any family they may have.

Chapter 4 
 253 
 If moving to another store is seen as  a threat by st aff then this is 
unethical, since professi onal staff and companies s hould not use threats 
to incentivise their staff. 
The employer has a responsibility to treat informa tion about their 
employees in confidence . If the staff's results are being published, 
anyone can identify under ‐performers, which breaches confidentiality. 
The environment at M may suit certain individuals who thrive on 
competition, but for other s it will be very stressful if they are not natural 
sales people and they have dependents that  rely on their salary. From a 
director’s point of view, working a member of staff so  hard that they 
become ill is unethical. 
Sales staff may be driven to ‘hard ‐sell’ products to customers, and may 
even tell un ‐truths to secure a sale. This goes against the principle of 
integrity stated in the code of ethics.  M’s reputation will become tarnished 
if it becomes public knowledge that their employees mislead customers 
into buying a product that is not suitable for them. 
Similarly rewarding a member of staf f for high sales that may not have 
been made ethically will reflec t badly on the management of M. 
New staff members are unlikely to meet the sales growth objective 
straight away. They will be unfami liar with some of the products and 
could misadvise a customer. They s hould be allowed a period of settling 
in. The new staff are possibly the majo r part of the high staff turnover at 
M. 
The high absenteeism and staff turnover  is not good for M as it is very 
costly to pay someone to be off work or to frequently recruit new members of staff. 
New staff will learn sales techniques from the more established staff 
members, which may not always be et hical sales methods. The element 
of competition may lead them to lack objectivity in their sales dealings. 
Older sales staff should not have undue influence over the new staff, and 
the new staff should be encouraged to have their own ethical principles. 
I hope this clarifies any queries you had. Should you require any further 
information, please do not hesitate to ask. 
Yours sincerely, A.N. Accountant

254  
To:  Audit Committee 
From:   Internal auditor 
Subject:   Ethics 
(a) The internal auditor has reason to  believe that records are being 
falsified that could threaten the health and safety of staff at the 
depot. If members of staff stop r eporting minor cuts and bruises 
then the Council will not be aware of  risks that could result in a 
more serious accident, such as a safety issue with a particular 
machine. That could lead to avoidable accidents occurring because the need for repairs or modificati ons was not apparent. Remaining 
silent about these allegations could be viewed as a breach of the requirement to apply profe ssional competence and due care. 
Bypassing the Head of Internal A udit by reporting directly to the 
Chief Executive or another senior officer would breach the duty to 
demonstrate professional behaviour. But the internal auditor is 
subordinate to the head of departm ent who has ruled that the 
matter is to be taken no further. Any report that cannot be substantiated could lead to a wast e of time and effort and could 
undermine the credibility of internal audit. 
Any report to a third party would breac h the internal auditor’s duty of 
confidence. As an employee, ther e is a duty not to divulge any 
information to a third party. As a CIMA member, the internal auditor 
is also bound by CIMA’s Code of Ethics for Professional 
Accountants, which makes that duty even more significant. 
(b) The internal auditor should consid er whether there is any reason to 
believe that inaction is likely to lead to a serious risk to life or health. 
If the records that are being suppre ssed relate to trivial cuts and 
bruises and are unlikely to leave staff exposed to mo re serious risks 
then there is no need to do anything further. 
It would be possible to approach the depot manager and seek an 
explanation as to whether these a llegations are true. If the manager 
makes a genuine commitment to r eport honestly then the problem 
will be resolved. 
If a review of the facts suggests t hat the depot’s reporting practices 
are significantly increasing the ri sk of severe injuries then the 
auditor should take matters furthe r. The depot had two out of only 
three severe injuries for the Counc il as a whole. Failing to act on 
such information could be viewed as criminal negligence.

Chapter 4 
 255 
 Any report should be made in the fi rst instance to an appropriate 
senior Council officer, possibly ad dressed to the Chief Executive in 
the first instance. There is only a need to report to a third party, such 
as the Health and Safety Executiv e, if the risk is high enough to 
justify the breach of confidence a nd the internal report is ignored. 
If the Head of Internal Audit is by passed then the auditor may feel it 
necessary to resign. 
 
 The fundamental principles that relate  to the work of accountants as 
internal auditors are integrity (acting honestly and avoiding misleading 
statements); objectivity (impartia lity and freedom from conflicts of 
interest); professional compet ence and due care; confidentiality; 
professional behaviour and the avoi dance of conduct that might bring 
discredit to CIMA; and technical competence (the presentation of 
information fully, honestly and professionally). 
Most of these principles apply in the present case. If the evidence justifies 
it, integrity and objectivity require  that it be brought to the audit 
committee’s attention. However, pr ofessional and technical competence 
requires that the Head of Internal A udit be confident in the audit findings 
before doing so. 
CIMA’s Ethical Guidelines describe the process for resolving ethical 
conflicts. Accountants working in or ganisations may encounter situations 
which give rise to conflicts of interest, ranging from fraud and illegal 
activities to relatively minor situati ons. An ethical conflict is not the same 
as an honest difference of opinion. 
CIMA members should be constantly c onscious of, and be alert to factors 
which give rise to conflicts of inte rest. In the present case, the ethical 
conflict is the real or perceived pre ssure placed on the Head of Internal 
Audit not to embarrass the Chief Execut ive. There is also the question of 
divided loyalty to the Chief Executiv e, to the audit committee, and to the 
Head of Internal Audit’s professional responsibilities as  a CIMA member. 
Although it has not been suggested to t he Head of Internal Audit that the 
matter not be reported, t here is a suggestion that  the report be softened 
and that work carry on behind the scenes to improve the system. 
However, it is important that a dra ft report be produced and submitted for 
comment before it is sent to t he audit committee. This presents the 
opportunity for other views to be aired.  One course of action may be to 
discuss the matter with the Finance Dir ector to determine his/her view 
and with the Chief Executive to determi ne that person’s reactions to the 
draft audit report.

256  
 When faced with ethical c onflicts, members should: 
 Follow the organisation’s grievance procedure. 
 Discuss the matter with the member’s superior and successive 
levels of management, always with the member’s superior’s 
knowledge (unless that person is involved). 
Discussion with an objective adviser  or the professional body may be 
useful to clarify the issues involved and alternative courses of action that 
are available, without breaching any dut y of confidentiality. Throughout, 
the member should maintain a detail ed record of the problem and the 
steps taken to resolve it. 
If an ethical conflict still exists after fu lly exhausting all levels of internal 
review, the member may have no recourse on significant matters other than to resign and report the matter to the organisation. Except when 
seeking advice from CIMA or when legally required to do so, communication of information regardi ng the problem to persons outside 
the employing organisation is not considered appropriate. 
 
 (1) Indebtedness of the assistant to the junior staff member  
This situation might call in to question the independence and 
objectivity of the assistant in carr ying out his work within the finance 
function. It could also threaten my own position, if it were generally 
known that a member of my staff is receiving financial assistance 
from a junior colleague. 
The position of the assistant is difficult, because he is presumably 
unable to repay the debt immediat ely, and he might be unaware of 
the fact that he has put the internal audit section into an embarrassing position. 
I should discuss the position with hi m, and explain the problem that 
it has caused. He should be remi nded of CIMA’s ethical guidelines 
about the need to maintain objecti vity and independence. I should 
find out how quickly he plans to repay the debt. If this will not 
happen quickly, I should ask whet her he might be able to obtain a 
loan to repay the debt. (The company might possibly be willing to provide a loan for such a purpose. 
If the assistant is unable to agree to my suggestion, I should have to 
consider recommending that he should be moved to another 
position where his independence and objectivity would not be 
compromised.

Chapter 4 
 257 
 (2) CEO’s accounting adjustments  
It is my responsibility to provi de the CEO with financial information 
that is competently and accurate ly prepared. The CEO presumably 
shares the financial information wi th board colleagues and the board 
of the parent company. I need to c onsider whether any adjustments 
made by the CEO to financial statem ents that I prepar e will bring my 
integrity into question. 
I should resist attempts by the CEO to amend financial results to 
make them seem better than they actually are. It would be particularly worrying if figures hav e been altered in order to improve 
the financial rewards for the CEO. On the other hand, some prudent 
adjustments to the figures  might be justifiable. 
I should discuss the situation with the finance director and the CEO, 
and establish whether the CEO intends to continue altering financial 
statements in the future, and t he reasons for doing so. If the 
situation cannot be resolved, I should have to consider my position within the company. I should not rema in in a position where I know 
that my integrity is being compromised. 
(3) Errors in the sales tax returns 
CIMA members have an ethical duty to carry out their work with 
professional competence. Techni cal competence means that the 
staff in my department should un derstand the necessary rules in 
relation to the tax work they do. Ignorance is no excuse for mistakes, and a repetition of the errors – and the fine – must be 
avoided. 
I need to ensure that the staff who carry out specialist tasks are 
competent to carry them out. Tr aining should be provided if 
required. Suitable instructions  and guidance should also be 
available for reference.

258  
 (a) There are a number of possibl e threats to f undamental ethical 
principles which lead to conflicts of  interest affecting accountants in 
their work. Professional codes  of ethics aim to enable the 
accountant to understand how to resolve these conflicts of interest. 
Conflicts of interest and their resolution are explained in the 
conceptual framework to the code of ethics. A framework is needed 
because it is impossible to define every situation where threats to 
fundamental principles may occur or  the mitigating action required. 
Different assignments may also  create different threats and 
mitigating actions – again it is not possible to detail all the assignments an accountant undertake s. The framework helps to 
identify threats – using the fundam ental ethical principles as 
guidance. This approach is prefer able to following a set of rules 
which may not be applicable in a particular case. 
Once a material threat has been ident ified, mitigating activities will 
be performed to ensure that complia nce with fundamental principles 
is not compromised. 
Where conflicts arise in the applic ation of fundamental principles, 
the code of ethics provides guidance  on how to resolve the conflict. 
The conceptual framework: – provides an initial set of a ssumptions, values and definitions 
which are agreed upon and shared by all those subject to the framework. 
– is stated in relatively general terms so it is easy to understand 
and communicate. 
– recognises that ethical issues may have no 'correct' answer. – provides the generalised guidelines  and principles to apply to 
any situation. 
(b) Situation 1  
Ethical threat – dishonesty 
Accountants need to be honest in stating their level of expertise –
and not mislead employers by implyi ng they have more expertise 
than they actually possess. In this  situation, A is implying he was 
better at studying for his exams t han his actual exam success rate. 
This may make the potential employ er view A more favourably, or 
enable A to meet a recruitm ent criteria of ‘first time passes only’ for 
success in obtaining the job.

Chapter 4 
 259 
It is difficult to stop provision of in correct information in this instance. 
However, A should be following the fundamental ethical principle of 
integrity in applying for the job. Alte rnatively, the potential employer 
could ask all applicants to confir m that information provided is 
accurate as a condition of empl oyment. Any errors or omissions 
found later could act as initial grounds for disciplinary action. 
Situation 2 
Ethical threat – overstatem ent of profits and salary 
B’s bonus is determined by the same accounts that B is working on. 
The threat is that B will overstate profits in so me way to ensure that 
the bonus payable is as high as possible. Again, accountants should act with integrity and honestly, alt hough these ideals conflict in this 
case with B’s remuneration. 
Ethical safeguards 
The main safeguard will be to ens ure that someone other than B 
determines the amount of B’s bonus (and checks the accounts 
produced) – or that the bonus is not linked to the accounts that B is 
preparing. This removes the conflict of interest. 
Situation 3 
Ethical threat – receipt of bribes/gifts 
D stands to gain 10% of a contract  price by accepting the quote 
from F rather than another compan y. This means D’s objectivity 
may be breached leading to a preference for the quote from F. There is also an issue of conf identiality because presumably D will 
want to keep the payment ‘secret’ from E Ltd so t he employer does 
not know of the inducement. 
Ethical safeguard 
From D’s point-of-view, the obvi ous ethical safeguard is not to 
accept the bribe. This removes the objectivity issue leaving D free to 
choose the best system rather than the one with the most financial advantage. Alternatively, D can inform the senior management 
and/or board of E Ltd, provide the relevant information on the three 
quotes, and let the board make the final decision. Should the board choose F then again D should not accept the bribe.

260  
 Situation 4 
Ethical threat – price fixing 
In most situations, G would keep the affairs of the cli ent confidential, 
and would be acting with integrity in taking this action. However, there is a conflict as H and I appear to have been acting illegally; 
increasing their profits at the expense of t heir customers. G can 
either choose to keep quiet about  the situation or disclose the 
information to relevant third parties , effectively ‘blowing the whistle’ 
on H and I. 
G could report to the ethics commi ttee or audit committee in H, 
should the company have either of  these committees. As long as 
some appropriate action was taken, then this relieves G from external reporting obligations. Exte rnal disclosure should only be 
made after taking into account various  issues such as the gravity of 
the matter, the number of peopl e affected and the likelihood of 
repetition. As many people are a ffected and repetition seems likely 
then external disclosure is likely to be appropriate. 
Situation 5 
Ethical threat – incorrect financial information 
Accountants need to be able to prepare information honestly and 
with objectivity. However, in this situation, J is being pressured into producing information which will be in correct, simply to show K Ltd 
in a better light. The instruction pr ovides a conflict with J’s integrity 
because he wants to follow the instru ctions of L but may not be able 
to do so because this would be dishonest. 
J needs to consult with other people apart from L in an attempt to 
determine the correct course of action. J can consult with any 
committee charged with governance (e.g. the audit committee or 
ethics committee) or if necessary ta ke advice from his professional 
body. If after these discussions, the situation cannot be resolved, J may have to consider resignation.

261 
Corporate governance 
A3. Ways of managing risk (a) Roles and responsibilities .  
B3. Explain governance risks (a) Explain the role of board 
and its committees in managing strategic risk
.  
(b) Explain failure of 
governance and its impact on strategy. Chapter 
5

262  
 
 1 What is corporate governance? 
Corporate governance has been defined in m any different ways, but generally it 
can be described as: 
‘the system by which companies are dire cted and controlled in the interest of 
shareholders and other stakeholders’. 
There are different codes and practices ar ound the world but they tend to cover 
similar areas: 
 The role of the board of directors. 
 The reliability of financial reports  and the relationship between the 
company and its auditors. 
 The interest of the company 's shareholders in the company. 
Importance of corporate governance 
 In most developed countries, list ed companies are required to operate 
systems of corporate gover nance laid down either by statute or by 
professional organisations (such as the Securities and Exchange 
Commission (SEC) in the US or t he Financial Conduct Authority (FCA) 
and Prudential Regulation Authority in the UK). 
 The requirements are oft en given the support of the stock exchanges, in 
that they are built into listing rules

Chapter 5 
 263 
 The development of corporate gov ernance codes is closely associated 
with the UK, hence the UK is a useful  model to discuss best practice. 
 The UK Corporate Governance Code fo llows a principles-based approach 
(see next section), and is endorsed by the London Stock Exchange. The 
US system has been much more legisl ative with the introduction of the 
Sarbanes-Oxley Act of 2002 (to be discussed later in this chapter). 
 It should be appreciated that cor porate governance has links to risks and 
internal controls. Whilst good corpor ate governance cannot stop company 
failure or prevent companies failing to achieve their objectives, it is a major 
help, and well-run companies tend to achieve their objectives in a less risky way. As a result it is part of risk reduction. 
Development of corporate governance 
 Governance regulations have developed la rgely as a result of a series of 
corporate failures in th e 1980s and early 1990s. 
 The corporate governance themes that began to emerge from these 
collapses were: 
– poorly-run companies, especially com panies with a board of directors 
dominated by a single chair/chief executive figure, and companies 
with ‘greedy’ or ‘fat cat’ direct ors (demonstrating the agency problem 
of a company failing to operate in the best interests of its 
shareholders) 
– poor financial reporting, raising questions about auditing and internal 
control systems, and 
– an apparent lack of interest by the ma jor investment institutions in the 
performance of the companies in which they invested. 
 The UK Corporate Governance Code was developed further in 
accordance with the 2008–09 global financial crisis. 
 
 Company collapses 
 Several issues or problems appear to emerge when there is a corporate 
governance ‘scandal’ and a company has collapsed. 
 The company has not been well-r un by its board of directors. 
 In many cases, there has been an  individual who has dominated the 
board and exerted excessive influence on decision-making by the 
board. In many cases, this individ ual held the positions of both chair 
of the board and chief executive officer. 
 A board of directors might hav e lacked sufficient breadth of 
knowledge and experience to apprecia te the problems the company 
was in and the risks it faced.

264  
  Companies were being run in the interests of the executive 
directors, who received high remuneration packages and generous 
bonuses, but the rewards were not being given for the achievement of objectives that were in the best interests of the shareholders. The 
interests of the directors were not properly aligned with those of the shareholders. 
 Financial reporting was unreliable and the published accounts did 
not seem to give any indication of the true financial position of the 
company. In some cases there was a suspicion that the auditors were not sufficiently independent of the company and so not fulfilling 
their responsibilities adequately. Al ternatively, the auditors were 
accused of doing their job badl y or of being misled by the 
company’s directors and managem ent. (In 2002 audit firm Arthur 
Andersen collapsed from the consequenc es of its involvement in the 
Enron scandal.) 
 Whenever a company collapsed unexpectedly, there have been 
suspicions that the internal cont rol system was ineffective. There 
usually appears to have been inadequate risk management generally. 
 Questions have also been asked about major institutional 
shareholders, and whether they could have done more to identify 
problems in companies and persuade or  force the dire ctors to make 
 
 Maxwell Communications Corporation 
 Robert Maxwell was born in to ex treme poverty in Czechoslovakia in 
1923. By the time of his death (accident or murder was never established) in 1991 he was a media mogul, having built a publishing empire that spanned the world. In the weeks that fo llowed his death 
however, news emerged of the stat e of his company's finances. 
After the Second World War he set up Pergamon Press publishing 
scientific journals. It became very pr ofitable and he turned his attention to 
politics, later becoming a Member of Parliament for the Labour Party. His 
relationship with the Party was an uneasy one since anyone who criticised him was confronted in the courts. This was when signs emerged 
of his dishonesty. 
In 1969, Maxwell agreed a takeover  bid for Pergamon by Leasco (an 
American financial and dat a processing group). T he profits of Pergamon 
were questioned by Leasco and eventually talks fell apart as a Department of Trade and Industry (D TI) enquiry ensued. Inspectors 
found that the profits depended on tr ansactions with Maxwell family 
private companies. The DTI concluded that Maxwell 'is not a person... who can be relied upon to exercise proper stewardship of a publicly 
quoted company'.

Chapter 5 
 265 
 In 1980 Maxwell took over the tr oubled British Printing Corporation 
renaming it Maxwell Communications Corporation. In 1984 he bought 
Mirror Group Newspapers  (MGN) and Macmillan publishers, which put 
his company further into debt. In 1991 he floated MGN as a public company desperate to raise cash that would save the Group from 
bankruptcy (with debts over £2 billion). After Maxwell's death it transpired 
that he had taken money from the pension funds to keep the companies afloat and boost the share price. 
 
 Enron 
 In December 2001, US energy trader Enron collapsed. Enron was the 
largest bankruptcy in US history.  Even though the United States was 
believed by many to be the most regul ated financial market in the world, it 
was evident from Enron’s collapse that investors were not properly 
informed about the significance of of f-balance sheet transactions. US 
accounting rules may have contributed to this, in that they are concerned 
with the strict legal ownership of invest ment vehicles rather than with their 
control. By contrast, Internati onal Accounting Standards follow the 
principle of ‘substance over form’. There were some indications that 
Enron may have actively lobbied agai nst changing the treatment in US 
financial reporting of s pecial purpose entities us ed in off-balance sheet 
financing. Overall, there was a clear need for greater transparency and 
trust in reporting. 
The failure of Enron also highlighted the over-dependence of an auditor 
on one particular client, the employment of staff by Enron who had previously worked for the auditors, t he process of audit appointments and 
re-appointments, the rotation of audi t partners and how auditors are 
monitored and regulated. 
As a consequence of the failure of Enron and WorldCom, the United 
States has introduced Sarbanes-Oxley le gislation to address many of the 
criticisms of reporting and auditing pr actice. In their comments on the 
failure of Enron, the Association of Certified Chartered Accountants 
recommended the need for global financial markets to have a global set 
of principles-based financial reporti ng standards and a global code of 
corporate governance, arguing that legalistic, rules-based standards 
encourage creative, l oophole-based practice. 
Former chief executive Kenneth Lay di ed in 2006 before he could stand 
trial. Enron’s former ch ief financial officer Andrew Fastow was sentenced 
in late 2006 to six years in pris on for stealing from Enron and devising 
schemes to deceive investors about the energy company’s true financial 
condition. Lawyers have to date won settlements totalling $US 7.3 billion from banks including JPMorgan Chase, Bank of America, Citigroup, etc.

266  
 Barings Bank 
 Barings Bank was Britain’s oldes t merchant bank, having existed for 200 
years before it collapsed as a result of uncontrolled derivatives trading by 
Nick Leeson in the bank’s Singapore office. 
The collapse of Barings Bank in 1995 was caused by Nick Leeson, a 26-
year-old dealer who lost £800 million in unauthorised dealings in derivatives trading from his bas e in Singapore. Leeson suppressed 
information on account ‘88888’ which he used for trading between 1992 and 1995, which management was unawar e of. The losses wiped out the 
Bank’s capital. 
As only a small amount of money (a  margin) is needed to establish a 
derivatives position, it is possible to face financial obligations beyond an 
organisation’s ability to pay. Therefor e, strict controls are needed. There 
are many risk management and control lessons to be learned from the 
failure of Barings. 
Barings had placed Nick Leeson in char ge of both the dealing desk and 
the back office. The back office reco rds, confirms and settles trades 
made by the front office and provides the necessary checks to prevent unauthorised trading and minimise the potential for fraud and 
embezzlement. In this dual positio n, Leeson was able to relay false 
information back to London. 
An internal audit report in Augus t 1994 concluded that Leeson’s dual 
responsibility for both the front and back office was an excessive 
concentration of powers and warned of the risk that Leeson could 
override controls. The internal audito rs’ responsibility was to make sure 
the directors were aware of the risk they were facing by not implementing 
the separation of duties. However, directors did not implement these 
recommendations. Their response was that there was insufficient work for a full-time treasury and risk m anager. There was also a lack of 
supervision of Leeson by Barings’ managers, either in Singapore or London. 
Senior managers of Barings had a super ficial knowledge of derivatives, 
did not understand the risks of the business, did not  articulate the bank’s 
risk appetite or implement strategies  and control procedures appropriate 
to those risks. 
When the Singapore exch ange made margin demands on Barings, large 
amounts of cash had to be paid out but still no steps were taken by the 
London head office to investigate t he matter. Eventually, the amounts 
required were so great that Barings were forced to call in receivers. The trading positions taken out by Leeson were unhedged and the cost of closing out the open contra cts was US$1.4 billion. 
The information in this case study comes from the Report of the Board of 
Banking Supervision (Bo BS) Inquiry into the Circumstances of the 
Collapse of Barings.

Chapter 5 
 267 
 Worldcom 
 WorldCom filed for bankruptcy protec tion in June 2002. It was the biggest 
corporate fraud in history, largely a result of treating operating expenses 
as capital expenditure. 
WorldCom (now renamed MCI) admitt ed in March 2004 that the total 
amount by which it had misled investors over t he previous 10 years was 
almost US$75 billion (£42 bi llion) and reduced its st ated pre-tax profits for 
2001 and 2002 by that amount. 
WorldCom stock began falling in late 1999 as businesses slashed 
spending on telecom services and equipment. A series of debt downgrades had raised borrowing costs for the company, struggling with 
about US$32 billion in debt. WorldCom used accounting tricks to conceal 
a deteriorating financial condition and to inflate profits. 
Former WorldCom chief executive Be rnie Ebbers resigned in April 2002 
amid questions about US$366 million in personal loans from the 
company and a federal probe of its accounting practices. Ebbers was 
subsequently charged with conspiracy to commit securities fraud, and 
filing misleading data wit h the Securities and Exchange Commission 
(SEC). Scott Sullivan, former chief financial officer, pleaded guilty to three 
criminal charges. 
The SEC said WorldCom had committed ‘accounting improprieties of 
unprecedented magnitude’ – proof, it sa id, of the need for reform in the 
regulation of cor porate accounting. 
 
 Parmalat 
 In December 2003, Italian dairy-f oods group Parmalat, with 36,000 
employees in 30 countries, went in to bankruptcy protection with US$ 8–
10 billion of vanished assets. The company was 51% owned by the Tanzi 
family. 
Parmalat defaulted on a US$185 milli on bond payment that prompted 
auditors and banks to scrutinise company  accounts. Thirty-eight per cent 
of Parmalat’s assets were supposedly held in a bank account in the Cayman Islands but no such account ever existed. Letters received from 
the bank by auditors were forgeries. 
Parmalat has been one of the largest financial frauds in history. The 
company falsified its accounts over  a 15-year period. This was not 
identified by two firms of auditors, Grant Thornton and Deloitte Touche 
Tohmatsu. At least 20 people have been involved in the fraud, including 
members of the Tanzi fa mily, the chief financial officer, board members 
and the company’s lawyers. Calisto Tanzi the founder and chief executive 
was arrested on suspicion of fraud,  embezzlement, false accounting and 
misleading investors. 
Tanzi admitted that he knew the account s were falsified to hide losses 
and the falsified balance sheet was us ed to enable Parmalat to continue 
borrowing. He also confessed to  misappropriating US$620 million, 
although prosecutors believe it coul d be as much as US$1 billion.

268  
 Equitable Life 
 During the 1960s to 1980s the 242-year-old Equitable Life had sold 
thousands of policies with guaranteed retu rns, some as high as 12%. The 
company ran into problems in 2000 w hen it closed to new business after 
years of excessive returns to spec ial policy holders had left the company 
with no money to absorb a deterioration in the value of its stock market 
investments. It had a ‘black hole’ in its finances estimated at £4.4 billion 
because it had been paying out more to policy holders than it held in reserves. Equitable lost a case in the House of Lords in 2000 that led to a further deterioration in its financ ial position of £1.5 billion. 
A report by Lord Penrose published ear ly in 2004 said that the former 
management was primarily culpable fo r Equitable’s near collapse, aided 
by the failure of regulators to i dentify the mutual insurer’s financial 
position. The autocratic former Chie f Executive and chief actuary Roy 
Ranson was blamed for keeping regulator s and the board of Equitable in 
the dark about the precarious state of Equitable’s financial position 
throughout the 1990s. The Penrose repor t also said that there had been 
weaknesses in the way that insu rance companies were supervised 
throughout that period. The ‘light t ouch’ approach to regulation had not 
been changed to meet the requirements of an incr easingly sophisticated 
and risky investment industry. 
The Penrose report said that management had been dominated by 
‘unaccountable’ actuaries, a board of  non-executives who had no idea 
what was going on at the company t hey were charged with overseeing 
and, a regulator that failed to act as any kind of protector for policy 
holders. 
Lord Penrose said, "The board at no stage got fully to grips with the 
financial situation faced by the Soci ety. Information was too fragmented 
[and], their collective skills we re inadequate for the task". 
 
 The lack of knowledge and supervision by management, and the 
excessive concentration of power placed on one employee enabling the 
overriding of controls  was prevalent at: 
A Enron B Maxwell Communications Corporation C Barings Bank D Worldcom

Chapter 5 
 269 
 Money secretly taken from the pens ion fund to keep the company afloat 
and boost the share price was the cause for concern at: 
A Enron B Maxwell Communications Corporation C Barings Bank D Worldcom 
 
 The most recent update in 2018, the focus areas were Directors’ 
Remuneration to reduce the likelihood of excessive pay and bonuses, and 
running the organisation with a long term view. 
 
 Volkswagen 
 In September 2015, Volkswagen Group, the German multinational 
automotive manufacturing company, were issued with a notice of 
violation of the Clean Air Act by the United States Environmental 
Protection Agency. The Agency found that Volkswagen had deliberately 
programmed certain diesel engines v ehicles to automatically activate 
their emission controls to meet US standards during labor atory testing but 
emit more than 40 times more nitr ogen oxide emissions in real world 
driving conditions. 
This is an example of managers prio ritising short term  profitability and 
receiving their bonuses over the intere sts of shareholders. For a decision 
of this nature to have been taken, t he tone from the t op of the group 
appears to be inappropriate. Since the scandal, various investor advisory 
groups have criticised the responses to the issue. For a period of time one of the criticisms wa s that the senior m anagers of the Volkswagen 
group had not been held accountable for intentionally cheating on the 
test, although charges have been brought now. 
The group have failed to publish reports into the issue despite promising 
it would make certain documents public. This shows a lack of transparency towards sharehol ders and other stakeholders. 
After the scandal, a management board wa s set up to lead integrity and 
legal affairs but high profile mem bers of this board then left raising 
concerns that the internal investigat ions and culture of the organisation 
were at fault and there was little desire to make meaningful change. 
One of the changes the company  did make was to change the 
remuneration policy for the directors,  reducing the bonuses available, but 
this was also criticised by advisory groups as the reduction in bonuses was accompanied by what was descr ibed as “drastic and unexplained 
increases in base salary”.

270  
2 Principles of good corporate governance 
The Listing Rules of the London Stock Exchange require each listed company 
to state in its annual report: 
 How it has applied the principles of  the UK Corporate Governance Code. 
 Whether or not it has complied with the provisions of the Code throughout 
Although there are some legal requirem ents relating to corporate governance, 
the main approach is that listed companies  are required to ‘comply or explain’ 
with the provisions of t he Code. This is referred to as a principles-based 
approach. 
The Code is constantly evolving and in t he most recent update the principles of 
the UK Corporate Governance Code relate to the following areas: 
 Board Leadership and Company Purpose 
 Division of Responsibilities 
 Composition, Succession and Evaluation 
 Audit, Risk and Internal Control 
 Remuneration. 
Board leadership and company purpose 
The focus on this principle appears to  have increased. The provisions here 
were predominantly included in the princi ple previously ca lled ‘Relations with 
shareholders’.  
Every company should be headed by an effective and ent repreneurial board 
which is collectively responsible fo r the long-term success of the company, 
creating wealth for shareholders and benefitting the community. This board 
should be responsible for setting the purpose, values and strategy of the 
company and making sure the culture is aligned with them. T he members of the 
board should lead by example with regard to  the culture of th eir organisation 
and behave with integrity. 
It is the board responsibility to make sure  appropriate resources are available to 
help the company meet its objectives and review performance, this includes 
creating and monitoring controls to review and manage the risks it faces. 
The board as a whole has responsibility fo r ensuring that a satisfactory dialogue 
with shareholders and stak eholders takes place. The board should engage with 
them and encourage participat ion from them. One of these stakeholder groups 
is the employees and to help this stakeholder group the company should 
develop policies and procedures consist ent with the values of the company. 
There should also be a facility for employees to raise any issues.

Chapter 5 
 271 
 Board leadership and company purpose 
 The board should consider the strategy upon which the company intends 
to generate wealth over the long term and report on both opportunities 
and risks to the continued success of the business. 
The board should pay particular attention to the workforce and assess if 
the culture is appropriate  for the policies and pr ocedures that are aligned 
to the company’s purpose, values and strategy. If there are any issues, corrective action should be taken and explained within the annual report. 
The chair should ensure that t he views of shareholders are 
communicated to the boar d as a whole. The chair should discuss 
governance and strategy with major shareholders. The senior independent director s hould attend sufficient m eetings with a range of 
major shareholders to listen to thei r views in order to help develop a 
balanced understanding of the iss ues and concerns of major 
The chairs of the audit, remunerat ion and nomination committees should 
also engage with the shareholders with regard to their areas of 
The interests of key stakeholders should be considered and details of 
discussion around these interests should be described in the annual report. In particular, there is guid ance for engaging with the workforce 
either through: 
 a director appointed from the workforce 
 a formal workforce advisory panel 
 a designated non-executive director 
If one of these options is not impl emented the alternative arrangements 
and their efficacy should be explained. 
A formal whistleblowing policy should be in place for the workforce to 
raise concerns in confidence and – if desired – anonymously. Any 
concerns should be reviewed and followed up on by the board. 
The board should seek to identify any conflicts of interest and ensure 
there do not compromise the company’s ability to achieve its objectives. 
Directors should record any concerns  they have about the operations of 
the board in the board minutes and if a NED resigns they should provide 
a written statement about any concer ns they had to the chair, which 
should be circulated to the board. 
If more than 20 percent of shar eholders vote against a board 
recommendation for a resolution, then an explanation should be given 
regarding what actions the board will take to understand the shareholders 
concerns. The views received and ac tions taken should be published 
within 6 months of t he shareholders meeting.

272  
Division of responsibilities 
There should be a clear division of re sponsibilities and no single individual 
should have unfettered powers of decisi on (See Maxwell illustration earlier.). 
The chair is responsible for leade rship of the board and ensuring its 
effectiveness. Non-executive directors should constructively challenge and help 
develop proposals on strategy. 
 There should be a clear division of  responsibilities between running the 
board (the role of the chair) and the ex ecutive responsibility for the running 
of the company’s business (the role of the CEO). 
 The roles of chair of the board and CEO should not be held by the same 
This was not the case at  Marks and Spencer plc in 2008 when they appointed 
Stuart Rose as CEO and Chair. The com pany stated that it was a temporary 
role for 3 years until they identified a new CEO from within the company. Major 
shareholders – Legal and General, didn' t agree with this and a heated debate 
ensued, not least because the dual role  went against the then called UK 
'Combined Code' of corporate governance.  Other investors, Schroders, said 
that M&S were setting an 'appalling example' to other UK companies. 
The Board eventually agreed to Stuart Ro se being put up for re-election every 
year, and they appointed a new 'heavy we ight' NED as senior independent 
director to 'keep an eye on him'. 
Many smaller investors were very happy with the arrangement. 
Stuart Rose remained CEO and Chair at  M&S for over two years until Marc 
Bolland (formerly of Morrisons) took over as CEO and Robert Swannell took 
over as Chair (also chair of HMV). 
 
 The Chair and CEO in more detail 
 Chair 
The chair should be independent on appointment. The following are 
situations that could appear to impair independence: 
 was an employee within the last 5 years 
 represents a significant shareholder 
 has close family ties with Co. 
 holds cross-directorships or has  significant links with directors 
through in other companies or bodies 
 receives other pay or benefits in  addition to a directors' fee  
 had material business relationshi p with the Co. within the last 3 
years 
 has served on the board for more than 9 years.

Chapter 5 
 273 
 The chair should not remain the chai r beyond 9 years fr om the date of 
their first appointment to the board.  This can be extended for a limited 
period if it helps the succession pl anning and development of a diverse 
board. An explanation should always be provided if this is the case. 
The specific responsibilities of the chair, inter alia, are to: 
 provide leadership to the board,  supplying vision and imagination, 
working closely with the CEO 
 take a leading role in determining the composition and structure of 
the board which will involve regular assessment of the 
– size of the board – balance between executive directors and NEDs – interaction, harmony and effectiveness of the directors 
 set the board’s agenda and plan board meetings 
 chair all board meetings, directing debate toward consensus 
 ensure the board receives appropriat e, accurate, timely and clear 
information 
 facilitate effective contribution from NEDs 
 hold meetings with the NEDs, wi thout the executive directors 
present 
 chair the AGM and other shareholder s’ meetings, using these to 
provide effective di alogue with shareholders 
 discuss governance and major stra tegy with the major shareholders 
 ensure that the views of shar eholders are communicated to the 
board as a whole 
CEO 
The specific responsibilities of the CEO, inter alia, are to: 
 develop and implement policies to execute the strategy established 
by the board 
 assume full accountability to the board for all aspects of company 
operations, controls and performance 
 manage financial and physical resources 
 build and maintain an e ffective management team 
 put adequate operational, financial,  planning, risk and internal 
control systems in place 
 closely monitor operations and fin ancial results in accordance with 
plans and budgets 
 act as an interface between board and employees 
 assist in selection and evaluation of board members 
 represent the company to major s uppliers, customers,  professional 
associations, etc.

274  
 One person has carried out the roles of CEO and chair since BB Co was 
floated on the stock exchange 20 y ears ago. Recently, analysts have 
begun to criticise this policy explaini ng that since the CEO acts as his 
own boss because he has no chair to report to, unchecked risk taking may result and although this can produc e strong short-term results it can 
also ending up harming a company. 
The board of BB Co however believes that a single Chair/CEO may 
provide advantages in both leadership and oversight in light of his or her 
superior knowledge of the organisation. 
Best practice dictates that t he roles should be separated.  
Which of the following could be im proved by splitting the roles of 
CEO and Chair? 
A Accountability. B Transparency. C Compliance. D Speed of decision making. E Unity of leadership. 
 
 Non-Executive Di rectors (NEDs) 
Non-executive directors should scrutin ise the performance of management in 
meeting agreed goals and objectives and m onitor the reporting of performance. 
They should satisfy themselves on the in tegrity of financial  information and that 
financial controls and systems of risk management are robust and defensible. 
They are responsible for determining appr opriate levels of remuneration of 
executive directors and have a prime ro le in appointing and, where necessary, 
removing executive directors,  and in succession planning. 
through the appropriate channels of c hair, CEO or finance director. 
These functions are, to some extent, carri ed out as part of their positions on key 
committees – remuneration committee,  nominations committee and audit 
committee – as well as discussions as part of the main Board.

Chapter 5 
 275 
 Further details on NEDs 
 Rules 
 
Strategy role: this recognises that NEDs have the right and responsibility 
to contribute to strategic success, challenging strategy and offering 
advice on direction. 
Scrutinising role: NEDs are requir ed to hold executive colleagues to 
account for decisions taken and re sults obtained. They should meet 
without the chair present at least annually (or more if  necessary) to 
review the chair’s performance. 
Risk role: NEDs ensure the company has an adequate system of internal 
controls and systems of ri sk management in place. 
People role: NEDs oversee a range of responsibilities with regard to the 
appointment and remuneration of exec utives and will be involved in 
contractual and disciplinary issues. 
To be effective, a NED needs to: 
 build a recognition by executives of their contribution in order to 
promote openness and trust 
 be well-informed about the comp any and the external environment 
in which it operates 
 have a strong command of issues relevant to the business 
 insist on a comprehensive, formal and tailored induction, continually 
develop and refresh their knowled ge and skills to ensure that their 
contribution to the board re mains informed and relevant

276  
  ensure that information is provided sufficiently in advance of 
meetings to enable thorough consider ation of the issues facing the 
board 
 insist that information is suffi cient, accurate, clear and timely 
 uphold the highest ethical standar ds of integrity and probity 
 question intelligently, debate cons tructively, challenge rigorously 
and decide dispassionately 
 promote the highest standards of  corporate governance and seek 
compliance with the provisions of the Combined Code wherever 
possible. 
The primary fiduciary duty that NEDs owe is to the company’s 
shareholders. They must not allow t hemselves to be captured or unduly 
influenced by the vested interests of other members of the company such 
as executive directors, tr ade unions or middle management. 
There are also concerns over the recruitment of NED’s and the challenge 
that this may bri ng to independence. 
Recruiting those with previous industry involvement can result in a higher 
technical knowledge, a network of contacts and an aw areness of what 
the strategic issues are within the i ndustry. While these might be of some 
benefit to a NED’s contribution, they  can make the NED less independent 
as prior industry involvement might also reduce the NED’s ability to be 
objective and uncontaminated by previously held views. 
Accordingly, it is sometimes eas ier to demonstrate independence when 
NEDs are appointed from outside the industry. 
In practice, many companies employ a mix of NEDs, and it is often this 
blend of talents and areas of expe rtise that is what makes a non-
executive board effective. 
 To reduce accusations of self -interest in the behaviour of 
executives.

Chapter 5 
 277 
 Threats to independence 
 
 A Company is a large retailer wh ich operates supermarkets all over 
Country E. It has a board of 11 direct ors, 5 of whom are non-executive 
(NED). None of the directors have any experience of the grocery market 
in Country E and over half are newly appointed (within the last year). 
Country E’s industry is fast moving and dynamic. The executive directors 
are finding it time consum ing to explain strategic decisions to the NED’s 
and when they do, a perceived lack of understanding on the NED’s part 
often leads them to disagree with the executive directors and delay things 
further. 
The CEO has suggested that the exec utive directors meet without the 
NED’s in order to make strategic decisions on a timely basis. These 
decisions could then be explained to the NED’s at a later date. 
Which of the following may be c onsequences of the NED’s only 
finding out about strategic decisions after they are made? 
A Management’s performance in m eeting objectives will not be 
assessed by the NED’s. 
B NED’s will be unable to ensur e risk management processes and 
systems are robust. 
C Decisions will be more relevant to  the business since they will be 
made by the most knowledgeable staff. 
D Strategic decisions may not be made in the best interests of 
E The NED’s will be able to concentrate  on other aspects of their role 
and improve their knowledge about A Company since time will be saved.

278  
Composition, succession and evaluation  
There should be a formal procedure for t he appointment of new directors to the 
board and an appropriate succession plan for the board and senior management, not just the CEO. Appoint ments and succession plans should be 
based on ability to do the roles and with that context, enable diversity (social, 
ethnic, gender). 
The board and its committees should hav e the appropriate balance of skills, 
experience, independence and knowledge. A ll directors should be able to 
allocate sufficient time to the com pany to discharge their responsibilities 
effectively. 
All directors should be subject to an annual evaluation regar ding whether they 
are contributing appropriately. There should also be an annual review of the 
board’s composition and how effective t he members of the boar d are at working 
together to achieve company  objectives and diversity.  All directors should be 
submitted for re-election at regular interv als, subject to continued satisfactory 
 
 Nomination Committees 
 The need for nomination committee is identified in many codes of best 
practice. 
In terms of best practice, a majority  of the members of the nomination 
committee should be independent non-executive directors. 
The chair can be on the committee, but should not chair the committee 
when it is deciding on the appoi ntment of a new chair. 
As an example, the UK Corporat e Governance Code requires that there 
should be a formal, rigorous and transparent procedure for the appointments of new directors to the board.  
The main responsibilities and duties of  the nominations committee are to: 
 Review regularly the structure,  size and composition of the board 
and make recommendations to the board. 
 Consider the balance between ex ecutives and NEDs on the board 
of directors. 
 Ensure appropriate management of diversity to board composition. 
 Provide an appropriate balance of power to reduce domination in 
executive selection by the CEO/chair. 
 Regularly evaluate the balance of skills, knowledge and experience 
 Give full consideration to succe ssion planning for directors. 
 Prepare a description of the role  and capabilities required for any 
particular board appointment incl uding that of the chair. 
 Identify and nominate for the approval by the board candidates to fill 
board vacancies as and when they arise. 
 Make recommendations to the b oard concerning the standing for 
reappointment of directors. 
 Be seen to operate independently for the benefit of shareholders.

Chapter 5 
 279 
There should be a formal and thorough review of the board performance, 
including, chair, committees and individual directors on an annual basis. 
Consideration should be given to involving an external party in this review on 
occasion, for FTSE 350 companies this should be every three years. 
The chair is responsible for acting on the results of the review, including 
celebrating the strengths and improving the weaknesses identified. Directors 
should take appropriate individual action to  develop any areas of weakness that 
have been identified within their responsibility. 
 
 The annual report and the nomination committee 
 The work that the nomination commi ttee does should be included in the 
annual report, details could include: 
 The process it uses for succession planning and how any 
appointments were made dur ing the period, including a reference to 
how this incorporates diversity. 
 How any board evaluation has been ca rried out, the re sults of this 
evaluation and action taken. 
 Any policy on diversity, how it links to objectives and how the 
implementation of the policy is progressing. 
 The gender split of the board, the first level of management below 
the board and their direct reports, plus the company secretary. 
 
 The need for succession planning 
 A lot of companies have a succession pl an for the role of chief executive 
officer that is not always the case wit h the rest of the board. According to 
a 2018 survey by Robert Half Management Resources, almost half of more than 1,100 chief financial officers surveyed do not have a succession candidate in line.  
It is estimated that it can take l onger than six months to search for an 
appropriate candidate to fill the CFO, this then leads to a gap in the 
strategic leadership of an organisati on, where productivity could decline 
and decisions made without appr opriate consideration. 
Also, if good quality finance professiona ls, do not have appropriate career 
progression opportunity at their cu rrent employer they may look 
elsewhere for the opportunity to become a CFO. 
The work that the nominations committ ee does is therefore vital for the 
strategic benefit of a business, but also for the retention and progression 
of their workforce.

280  
Audit, risk and internal control 
The board should create policies and procedur es to make sure that internal and 
external audit are independent and effect ive, and that financ ial statements are 
produced with integrity. 
The board should present a balanced and understandable asse ssment of the 
company’s position and prospects. 
The board is responsible for determining t he nature and extent of the significant 
risks it is willing to take in achieving it s strategic objectives. The board should 
maintain sound risk management and inte rnal control systems. The board 
should establish formal and transparent a rrangements for considering how they 
should apply the corporate reporting and risk management and internal control 
principles and for maintaining an appropr iate relationship with the company’s 
auditor. 
 
 Audit committee 
 The board should establish an audit commi ttee of at least three, or in the 
case of smaller companies two, independent non-execut ive directors. 
The company chair should not be a me mber of the comm ittee. The board 
should satisfy itself t hat at least one member of the audit committee has 
recent and relevant financial experienc e. The committee should, overall, 
be competent in the sector the company operates in. 
The audit committee's role is: 
 to monitor the integrity of the financial statements of the company 
and any formal announcements relati ng to the company’s financial 
performance, reviewing signific ant financial reporting judgements 
contained in them; 
 to, if asked by the board, prov ide appropriate gui dance about if the 
annual report is fair, balanc ed and clear enough for the 
shareholders to assess the company’s performance and strategy; 
 to review the company’s internal financial controls and, unless 
expressly addressed by a separate board risk committee composed 
of independent directors, or by the board itself, to review the 
company’s internal contro l and risk management systems; 
 to monitor and review the effect iveness of the company’s internal 
audit function and if there is not one, to consider if there is a need 
for one on an annual basis and make the appropriate 
recommendation to the board; 
 to make recommendations to th e board, for it to put to the 
shareholders for their approval in gener al meeting, in relation to the 
appointment, re-appointment and remo val of the external auditor 
and to approve the remuneration and terms of engagement of the 
external auditor;

Chapter 5 
 281 
  to review and monitor the ex ternal auditor’s independence and 
objectivity and the effectiveness of  the audit process, taking into 
consideration relevant UK profe ssional and regulatory requirements; 
 to develop and implement policy on the engagement of the external 
auditor to supply non-audit services, taking into account relevant 
ethical guidance regardi ng the provision of non-audit services by the 
external audit firm, and to repor t to the board, identifying any 
matters in respect of which it c onsiders that action or improvement 
is needed and making recommendations  as to the steps to be 
taken. 
The terms of reference of the audit committee, including its role and the 
authority delegated to it by the board, should be made available.  
A separate section of the annual repor t should describe the work of the 
committee in discharging t hose responsibilities. 
The audit committee should review a rrangements by which staff of the 
company may, in confidence, raise concerns about possible improprieties in matters of financial reporting or other matters. The audit committee’s 
objective should be to ensure that arrangements are in place for the 
proportionate and independent investigation of su ch matters and for 
appropriate follow-up action. 
The audit committee should monitor and review the effectiveness of the 
internal audit activities. Where there is no internal audit function, the audit 
committee should consider annually  whether there is a need for an 
internal audit function and make a re commendation to the board, and the 
reasons for the absence of such a function should be explained in the 
relevant section of the annual report. 
The audit committee should have primar y responsibility for making a 
recommendation on the appointment, re- appointment and removal of the 
external auditor. If the board does  not accept the audit committee’s 
recommendation, it should include in the annual report, and in any papers 
recommending appointment or re-appoi ntment, a statem ent from the 
audit committee explaining the recommendation and should set out reasons why the board has ta ken a different position. 
The annual report should explain to  shareholders how, if the auditor 
provides non-audit services, auditor objectivity and independence is safeguarded 
 
 Risk management and internal control 
 The board are responsible for carrying out a thorough review of both 
emerging risks and key risks that have been identified as either likely or 
that have a significant impact on the competitive strategy, reputation or 
future performance of the company or  both. The board should incorporate 
in the annual report a description of t he key risks, the processes in place 
to identify emerging risks and how these risks are being dealt with.

282  
 The board should, at least annually, conduc t a review of the effectiveness 
of the company’s risk management and internal control systems and should report to shareholders that they have done so. The review should cover all material controls, including financial, operational and compliance controls. 
The board should also state whether t hey consider it appropriate to use 
the going concern basis of account ing in preparing the financial 
statements and make it cl ear if there are any uncertainties over the 
company’s ability to continue to operate like that into the future and meet 
the obligations as they fall due, in cluding any assumptions in reaching 
that conclusion. 
Levels of remuneration should be appropriate  to the strategy and lead to long 
term sustainable success.  
No director should be able to decide their own remuneration. 
There should be a clear process to the policy for establishing the remuneration 
of directors and senior management. 
Directors should exercise discretion and consider wider business issues, the 
performance of the company and how the individual has performed when 
authorising remuneration levels. 
 
 Remuneration Committees 
 The board should establish a remunerati on committee of at least three, or 
in the case of smaller compani es two, independent non-executive 
directors. In addition the company c hair may also be a member, but not 
chair, of the committee if he or she was considered independent on 
appointment as chair. Before bec oming chair of the remuneration 
committee the individual should hav e been a member of a remuneration 
committee for at least 12 months. 
The remuneration committee should have delegated responsibility for 
setting remuneration for all executive directors and the chair, including 
pension rights and any compensation payments. The committee should 
also recommend and monitor the level and structure of remuneration for senior management. The definition of ‘senior management’ for this 
purpose should be determined by the board but should normally include 
the first layer of managem ent below board level. 
The remuneration committee shoul d consider overall company 
remuneration policy, the approach to  rewards and incentives and the 
impact on culture when setti ng director remuneration. 
Remuneration should alig n with creating long term shareholder value, 
and so should promote long term s hareholdings by directors. The 
remuneration committee develop a policy for post employment shareholding.

Chapter 5 
 283 
 Pension contributions rates for exec utive directors shoul d be in line with 
the rest of the workforce. Basic salary should be the only basis for 
pension contributions and the pension c ontributions should be considered 
in any decisions about increasing in basic salary  
Levels of remuneration for non-executiv e directors should reflect the time 
commitment and responsibilities of the role. Remuneration for non-
executive directors should be in line with the Articles of Association. 
Remuneration for non-executive di rectors should not include share 
options or other perform ance-related elements.  
Remuneration schemes should include the option to use judgement in 
share awards and prevent formulaic out comes. Particularly, there must 
be the option to withhold share awards in situations where it would be 
inappropriate to award shares. 
Notice or contract periods should be se t at one year or less. If it is 
necessary to offer longer notice or contract periods to new directors 
recruited from outside, such periods  should reduce to one year or less 
after the initial period. The rem uneration committee should carefully 
consider what compensation co mmitments (including pension 
contributions and all other elements) t heir directors’ terms of appointment 
would entail in the event of early termination. The aim should be to avoid 
rewarding poor performance. They s hould take a robust line on reducing 
compensation to reflect departing director s’ obligations to mitigate loss. 
The remuneration committee should make available its terms of 
reference, explaining its role and the authority delegated to it by the 
board. Where remuneration consult ants are appointed,  a statement 
should be made in the annual report including whether they have any 
other connection with the company. 
 
 Director remuneration policy and procedures 
 The remuneration committee should addr ess the below considerations 
when setting up the policy and procedures. 
 clarity  – the remuneration shoul d be transparent and help 
shareholders and employees engage effectively. 
 simplicity  – the remuneration structure should be easy to 
understand. 
 risk – remuneration policy should consider the risks such as 
reputational damage for excessive pay , or behavioural implications 
for performance related pay ar e identified and mitigated. 
 predictability  – the range of rewards should be made clear to 
individuals, plus any pot ential for judgement changes. 
 proportionality  – the policy should not reward poor performance 
and the link between award, strategy and long term company 
performance should be clear. 
 alignment to culture  – consideration of the company purpose, 
values and principles should be incorporated to encourage 
appropriate behaviours.

284  
 Remuneration committee and the annual report 
 The work of the remuneration commi ttee is vital to the company and 
therefore it should be det ailed in the annual repor t. These are some of 
the things that could be included: 
 the strategic reasoning behind di rectors’ remuneration policies, 
structures and KPIs. 
 an explanation about why the remuneration is reasonable, using 
both internal and external informati on, such as ratios and pay gaps. 
 an explanation of how the remuneration relates to the policy and 
practices for director remuneration. 
 whether the policy was applied as  intended, and if not why not, and 
how it will have been changed. 
 what communication there has been with shareholders and 
employees about remuneration an d the impact this has had on 
policy. 
 what communication there has been with employees about 
director’s remuneration and how cons istent this is with the overall 
pay structure. 
 whether any judgement has been us ed regarding remuneration and 
why. 
 
 PK is a large listed company. The remuneration committee consists of 
four Directors with the Finance Direct or chairing the committee. The other 
three members are NED’s alth ough only two of these have been 
assessed as independent by t he nominations committee. The 
remuneration committee has responsib ility for both executive and non-
executive pay policy with these policies being put forward by approval at the AGM by shareholders. 
What actions should PK take to comp ly with best practice corporate 
governance?  
A The Finance Director should resign from PK B The remuneration committee should not have responsibility for NED 
remuneration 
C The non-independent NED should resign from the remuneration 
committee 
D The Finance director should re sign from the remuneration 
committee 
E All NEDs on the remunerati on committee should be replaced

Chapter 5 
 285 
 Remuneration policy – The Sage Group plc 
 The following is an extract of the Remuneration Report (2011) of The 
Sage Group plc: 
'Remuneration Policy 
The Remuneration Committee, in setting the remuneration policy, 
recognises the need to be competitive in an international market. The 
Committee's policy is to set remunerat ion levels which ensure that the 
executive directors are fairly and res ponsibly rewarded in return for high 
levels of performance. Remunerat ion policy is designed to support key 
business strategies and to create a strong, perfo rmance orientated 
environment. At the same time, the policy must attract, motivate and 
retain talent... The Remuneration Co mmittee considers that a successful 
remuneration policy must ensure t hat a significant part of the 
remuneration package is linked to the achievement of stretching 
corporate performance target s... generating a strong alignment of interest 
with shareholders... Around 75% of eac h executive's total compensation 
value is delivered through performance-related incentives, and is therefore 'at risk' if stretching performance targets are not reached. 
Performance Share Plan (PSP) 
The Committee established the PSP as the Group's main long-term 
equity incentive to drive financial and market performance... The individual limit on award levels under  the Plan is 300% of salary. PSP 
awards will normally have a maximum value of 210% of salary. This represents a 'core' awar d to the value of 140% of salary, which, if 
maximum EPS (earnings per share) grow th is attained, and TSR (total 
shareholder return) performance is  ranked upper quartile against the 
comparator group, could rise to 210% of salary... 
A sliding scale based on EPS is used. 25% of the award vests at the end 
of the period if the increase in EPS exceeds RPI (retail prices index) by 
9% over the period; 100% of the award vests at t hat time only if RPI is 
exceeded in that period by 27%... 
Awards are also subject to a TSR 'mul tiplier' whereby the level of vesting 
based on EPS achievement is adjusted according to TSR performance over the same three year period co mpared with a group of international 
software and computer services co mpanies.' (These include Adobe 
Systems, Cap Gemini, Microso ft, Oracle, SAP amongst others.)

286  
 The Report goes on to detail audited information including outstanding 
awards granted to each director under  the PSP. For example, the Chief 
executive Officer's details were: 
 Awarded 
1 Oct 
2010 
number Awarded 
during the 
year 
number Vested 
during 
the year 
number Lapsed 
during 
the year 
30 Sept 
2011 
number Vesting 
date 
G S Berruyer 361,647 – (95,167) (266,480) – 3 March 
2011 
 745,649 – – – 745,649 3 March 
2012 
 507,280 – – – 507,280 4 March 
2013 
 – 737,795 – – 737,795 10 March 
2014 
Total 1,614,576 737,795 (95,167) (266,480) 1,990,724  
 
 'The market price of a share on 10 March 2011, the date of the 
awards made in the year ended 30 September 2011 was 272.1p. 
 The market price of a share on 3 March 2011, the date the above 
awards vested in the year ended 30 September 2011 was 280.8p. 
The market price of a share on 3 March 2008, the date on which 
these awards were granted was 202.25p.' 
As you will be able to calculate from the illustration, t he awards are well-
worth receiving if company perform ance meets the targets set. The 
targets are reasonably straightforwar d, there being only two – EPS and 
TSR; however, the calculation of the award does become reasonably 
complicated. 
The time period for tie-in is 3 year s which is in line with the UK stock 
exchange listing rules/the UK Cor porate Governance Code, whereby 
directors should get a reasonable time to prove themselves but not so 
long that the company cannot refr esh the Board should it wish to. 
 
 3 Directors' remuneration 
Remuneration is defined as payment or compensation received for services or 
employment and includes basic sala ry, bonuses and any other economic 
benefits. 
Behavioural impact 
Whatever remuneration package is determined,  it is essential to ensure that the 
directors' objective is to do a good j ob for the stakeholders of the company. 
The remuneration package should be motiva tional, not too small or too easily 
earned. The remuneration committee shoul d design a package that attracts, 
retains and motivates the director. This s hould take into account the market rate 
i.e. comparable companies  remuneration packages.

Chapter 5 
 287 
Components of the director s' remuneration package 
 Basic salary – covering the job itsel f, the skills required, the directors' 
performance, their contribution to co mpany strategy and market rates; 
 Performance-related pay – remuner ation dependent on the achievement 
of some performance measure. This c ould be short-term e.g. a bonus paid 
to the director at the end of the a ccounting year for achieving a certain 
level of profit or earnings per shar e, or long-term e.g. executive stock 
options. Stock/share options are contra cts that allow the director to buy 
shares at a fixed price. If the share price rises above the exercise price the 
director can sell the shares at a pr ofit. This encourages the director to 
manage the company in such a way that the share price increases, 
therefore share options are believed to align the directors' goals with those 
of the shareholders. Problems arise when the directors' actions are solely 
focussed on the share price to th e exclusion of other stakeholder 
objectives. Also, if the share price rises too much  the director could be 
tempted to sell their shares and retire, which defeats the objective of trying 
to tie the director in to t he company for the long-term. 
 Pension contributions – the remuner ation committee should consider the 
pension consequences of increases in basic salary; 
 Benefits in kind – are various non- wage compensations e.g. a company 
car, or health insurance. 
Share (stock) options 
Bonuses to directors based on the current  year's profit can lead to short 
termism, in that the directors will maximi se the current year's profit by not 
investing in new products and not develop ing existing ones (these costs would 
reduce the current year's profit). Not investing in new products and not 
developing existing ones will adversely affect future profits and may threaten 
the long-term existence of the business. 
It is argued that share options are an e ffective way of paying directors and of 
avoiding short-termism, as the value of a share should be a reflection of the 
long-term profitability of the company. 
Until recently, there has been no charge in the company's profit and loss 
account for share options, so the shareholde rs are not aware of the value of the 
options granted to the directors. Howeve r, share options can be very valuable to 
directors. Excluding the cost of shar e options from the financial statements 
understates director s' remuneration. 
The grant date is the date when the employee and employer enter into an 
agreement that will entitle t he employee to receive an option on a future date, 
provided certain conditions are met. 
The service date is the date or dates on which t he employee performs the 
services necessary to become uncondi tionally entitled to the option. 
The vesting date is the date when the employee, having satisfied all the 
conditions becomes unconditionally  entitled to the option. 
The exercise date is when the option is taken up.

288  
Normally, the option is granted at the mark et price of the s hares at the grant 
date (e.g. 250p a share). If , at the exercise date of, say, 30 June 2010, the 
value of the shares is 290p, the direct or will buy the shares from the company 
for £2,500,000 and immediately sell them in the market for £2,900,000, making 
a gain of £400,000. If the value of t he shares is less than 250p on 30 June 
2010, the director will not purchase the s hares (as he/she would make a loss), 
so the director's gain on the option will be zero. 
Interestingly, most directors of UK lis ted companies buy and sell the shares at 
the exercise date (30 June 2010 in this case ). Only a small mi nority of directors 
buy the shares at the option price and continue to hold them. 
Share options as a measure of long-term profitability 
The 'theory' of share options is that  the share price on 30 June 2010 will be 
based on the company's long term profitability , so if the company is doing well, 
the share price will be higher  and the director's profit  on buying the shares (and 
subsequently selling them) will be higher. So the director's gain on selling the shares will reflect the director's succe ss in increasing the long-term profits and 
hence the share price of the company. 
To a certain extent, this 'theory' is co rrect in that the share price tends to 
increase if the company's profitabilit y increases. However, share price 
movements also depend on other factors, such as the general price movement 
of other shares and investors' views about the future profitability and growth in 
the particular type of trade the company is  in. For instance, in late 1999 and 
early 2000 there was an enormous increas e in the value of telecom and 
dot.com shares, yet many of these companies had nev er made a profit. Thus, 
the increase in the share price di d not depend on the prof itability of the 
companies, and it could be argued that t he prices of these shares increased 
because this was a fashionable sector of the market in which to invest. At the 
same time as the increase in value of  telecom and dot.com shares there was a 
substantial fall in the va lue of other shares, including well-known retailers. 
Sometimes, share prices were falling, despite the fact that the companies’ 
profits were increasing. So, it can be seen that the incr ease in the share price of 
a company may be more related to market conditions than its long-term 
profitability. Thus, awarding options on s hares may not be a very effective way 
of paying directors, as t he change in the share price may have little to do with 
profitability of the company and the direct ors' contribution to increasing those 
profits. 
Regarded as a way of boosting productivi ty and employee retention, share 
options have become less popular since t he economy turned bearish. Fuelled in 
the late 90s by dot com promises of  untold future wealth, option-holding 
employees had little or no prospect of realising any value. When the economy 
suffered, staff became more interested in staying in progressive, well-paid jobs 
with quantifiable packages, so there has been less reason to implement 
schemes. (Some employers had been accused of using share options for employees as a way to pay salaries  of less than the market rate.) 
Microsoft recently ended its own option scheme. It decided to grant shares 
instead (not options on shares), explaining  this practice is recorded on balance 
sheets, giving analysts a better view of  the company’s financial state and 
workers a tangible incentive.

Chapter 5 
 289 
To compound matters, the International Accounting Standards  Board proposes 
that firms put the cost of share-based awards thr ough the income statement. 
 
 Executive Share Options (ESOPs) 
 Executive share options (ESOPs ) have been blamed for almost every 
business scandal that has made t he headlines in the past decade. 
An ESOP is part of a manager’s re muneration package. The features 
generally involve the following: 
 Each eligible manager is granted an allocation of options as part of 
his or her annual remuneration. T he number of options will generally 
be decided by the remunerati on committee, comprising non-
executive directors. 
 The options themselves will norma lly have a striking price that is 
equal to, or slightly higher than, the share price at the date the 
options are granted. 
 There is usually a vesting peri od of a few years that must pass 
before the options can be exercis ed. If the manager resigns or 
leaves the company during that per iod then the options will lapse. 
 The options can normally be exerci sed on a specific date at the end 
of the vesting period. 
(The vesting period and the fact that the options must be exercised on a 
very specific date make them more di fficult to value than the more typical 
traded options that can be bought and sold by third parties.) 
There are two main reasons why s hareholders might be keen to reward 
their directors with options. 
 If the directors hold large numbers of options then they will have a 
financial incentive to maximise t he share price. Provided the share 
price exceeds the exercise price at  the relevant date the directors 
can exercise their options and buy shares for less than their market 
value. They will then either retain those shares as an investment 
(acquired at a bargain price, so providing an attractive return) or resell them at a guaranteed capital gain. If the share price does not 
rise during the vesting period then the directors will receive little or 
no value and so they will have a di rect financial stake in delivering 
an increased share price. 
 An investment opportunity that would be attractive to the 
shareholders because the potential returns are high might be 
unacceptable to the directors because they will be exposed to the risks of it going wrong and the loss of  their jobs. For example, a new 
product that fails might have a very  limited impact on shareholders’ 
total investment portfolios but coul d end the careers of  the directors 
who were responsible for recomm ending that it should proceed. 
Thus, if the shareholders really wish to align the directors’ interests 
with their own they need to find some way to encourage the directors to accept the risks that they would choose to accept for 
themselves and ESOPs provide the answer.

290  
 If the directors hold large numbers of  options then they will have an 
economic interest in accepting risky in vestment opportunities that they 
might otherwise be inclined to rejec t. If the investment  succeeds and the 
share price rises then their options will be worth far more at the exercise 
date and they will not be exposed to any  specific loss (at least on their 
options) if the investment fails  and the share price plummets. 
Thus, ESOPs give the shareholders t he reassurance that the directors 
will wish to work hard to increase the share price and also accept realistic 
risks provided the potential return is high enough. They will also 
encourage the directors to take a l ong-term view and to remain with the 
company rather than move else where and lose their options. 
Directors should only be permitted to hold share options of any kind if 
they are honest and upright individuals.  Clearly, many company directors 
are both but there will always be a few di shonest individuals in every walk 
of life. For example, in  the past directors have purchased call options with 
their own money and then manipulated the share price by distorting the 
financial statements so t hat the options could be exercised at a massive 
profit. It was felt that company dire ctors had too much of an incentive to 
cheat and manipulate when they held opt ions and so it became illegal for 
them to own them. 
In the late 1980s company director s were being accused of taking 
excessive salaries and bonuses and steps were taken to reduce the 
amounts being paid. In the USA a law was passed to restrict 
remuneration to $1m per annum. Sharehol ders were nervous that such a 
limit would give directors very littl e incentive to work hard and so ESOPs 
were used as a way round the restriction.  It is extremely difficult to value 
the options granted under ESOPs and th is meant that they were not 
accounted for in the total disclos ed in the financial statements. 
Major scandals such as Worldcom in  the 1990s and the recent Credit 
Crunch have been blamed on the pressure s created by the possibility of 
directors earning huge amounts from any manipulation of t he share price, 
timed to coincide with the ex ercise date of ESOP options. 
 
 Which of the following executiv e remuneration package elements will 
best align the interests of executive directors and shareholders? 
A Cash bonus paid to director if company achieves profit growth 
targets 
B Cash bonus paid if director achiev es a range individual performance 
related targets 
C Share option bonus scheme that is paid if company achieves profit 
growth targets 
D Private Health insurance for director and immediate family

Chapter 5 
 291 
 Which of the following are principl es of the UK Corporate Governance 
Code: 
Select ALL that apply A The role of chair and CEO should be separate B Non-executive direct ors should be appointed 
C The Board should meet once per month D The Board is responsible for det ermining the nature and extent of 
the significant risks the company will face 
 
 4 Corporate governance and internal controls 
 
The board  is responsible for: 
 maintaining a sound system of internal control, 
 reviewing the effectiveness of internal controls, and 
 reporting to shareholders that this review has been carried out. 
It is the responsibility of management  to: 
 identify and evaluate the risks faced by  the company, for consideration by 
the board 
 design, operate and monitor a suit able system of internal control. 
Turnbull Report 
This is the most specific report regardi ng the requirements for internal control. 
(See Internal Control: Guidance for Dir ectors on the Combined Code 1999 and 
revised 2005) 
The Turnbull Report requires that internal  controls should be established using 
a risk-based approach.  Specifically a company should: 
 Establish business objectives. 
 Identify the associated key risks. 
 Decide upon the controls to address the risks. 
 Set up a system to implement the r equired controls, including regular 
feedback. 
In establishing this structure, the Tu rnbull Report summarises the way that 
businesses should be controlled (and also how this examination paper links the topics of risk and control). 
In addition, the Turnbull Report addresses the responsibilities of directors and 
management in relation to risk and control, as discussed above.

292  
Turnbull suggested that direct ors should review internal controls under the five 
headings identified by COSO in 1992: 
 Control environment. 
 Risk assessment. 
 Control activities. 
 Information and communication. 
 Monitoring. 
The Turnbull Report went on to suggest t hat internal audit makes a significant 
and valuable contribution to a company. 
 
 The Turnbull Report requires that: 
A Internal controls should be es tablished using a risk-based approach 
B The CEO and chairperson are separate roles C An audit committee is set up D Director’s remuneration is fully disclosed 
 
 The principles of good corporat e governance in the UK Corporate 
Governance Code include: 
Select ALL that apply A Division of responsibilities B Composition and succession C Audit, risk and internal control D Remuneration E Board leadership and company values 
 
 More on reviewing the effectiveness of internal controls 
 Management is accountable to the board for monitoring the system of 
internal control. The board has a responsibility for reviewing its 
To review the effectiveness of the internal control system, the board 
should not rely on the existence of  suitable embedded internal control 
processes. It should also receive regul ar reports on risks and controls, in 
addition to carrying out an annual assessment. 
When reviewing reports on inter nal control, the board should: 
 consider the significant risks and how they have been identified, 
evaluated and managed 
 assess the effectiveness of the in ternal controls for managing each 
significant risk

Chapter 5 
 293 
  consider whether any controls are weak and action is necessary to 
strengthen them. 
‘Should the board become aware at any time of a significant failing or 
weakness in internal control, it should determine how the failing or weakness arose and re-assess the effectiveness of management’s 
ongoing processes for designing, operat ing and monitoring the system of 
internal control’ (Turnbull Report). 
The annual assessment of the system of  internal control should consider: 
 the changes since the assessment ca rried out in the previous year 
 the scope and quality of management ’s ongoing monitoring of risks 
and of the system of internal control 
 the extent and frequency of the comm unication of the results of this 
monitoring to the board 
 the extent and frequency of internal control weaknesses and failing 
that have been identifi ed during the year 
 the effectiveness of the company ’s public reporting processes. 
 
 More on board's statement on internal control 
 The annual report should provide su fficient meaningful and high-level 
information to enable the shareholders to understand the main features of 
the company’s risk management processes and system of internal control. 
At the very least, the board should disclose: 
 that there is an ongoing proce ss for identifying, evaluating and 
managing the significant risks faced by the company 
 that this process has been in place throughout the year 
 that the process is regular ly reviewed by the board, and 
 that it accords with the Turnbull Guidance. 
The statement should include an acknowle dgement by the board that it is 
responsible for the company’s system of  internal control and for reviewing 
its effectiveness. 
The board should also summarise the process by which it reviewed the 
effectiveness of the control systems, whether that review was conducted 
directly or through, say, an audit committee. 
 
 5 Corporate governance and the audit committee 
 
Audit committees were first requir ed under the Cadbury Code (and are now 
required by the UK Corporate Governance Code) in response to criticisms of 
the relationship between t he directors and the auditors.

294  
It was felt that the auditors were not  sufficiently independent of the board of 
directors and that, as a resu lt, the auditors were not providing their monitoring 
and reporting role as they should be. 
Particular criticisms of the relationship were about: 
 Remuneration of the auditors – decided by the directors. 
 Appointment of the auditors  – at the discretion of t he directors in practice. 
 Reports of the auditors – received by the directors. 
 The directors had the power to give  other lucrative work to auditors. 
To address these concerns, audit commi ttees were to be established. 
 Audit committees are made up of non-ex ecutive directors (at least one of 
which should have recent relevant financial experience) and have formal 
terms of reference. 
 The audit committee should meet at leas t three times per year, and also at 
least once a year have a meeting with the auditors without the presence of 
any executive directors. 
Responsibilities of an audit committee 
The responsibilities of the audit co mmittee would typically include: 
 Review of the financial statement s, and any interim reports produced. 
 Review of the company's system of internal financial controls. 
 Discussion with the auditors about any significant matters that arose on 
the audit. 
 Review of the internal audit progr amme and significant findings of the 
internal auditors. 
 Recommendations on the appointment and removal of the auditors. 
 The setting of the audit fee in discussion with the auditors. 
 Review of the audit report and any  management letter provided by the 
 Review all the company’s internal  control and risk management systems 
(unless this is delegated to a separate risk committee). 
 Ensure that a system is in place for whistleblowing. 
 
 Audit committee and financial reporting 
 The key roles of the audit commi ttee are ‘oversight’, ‘assessment’ and 
‘review’ of other functions and systems in the company. 
The audit committee should review t he significant financial reporting 
issues and judgements in connecti on with the preparation of the 
company’s financial statements. Management is responsible for 
preparing the financial statements and the auditors are responsible for 
preparing the audit plan and carrying out the audit. 
The audit committee needs to satisfy it self that the fi nancial statements 
prepared by management and approved by the auditors are acceptable.

Chapter 5 
 295 
 It should consider: 
 the significant accounting policie s that have been used, and whether 
these are appropriate 
 any significant estimates or judgements that hav e been made, and 
whether these are reasonable 
 the method used to account for any significant or unusual 
transactions, where alternative a ccounting treatments are possible 
 the clarity and completeness of the disclosures in the financial 
The committee should listen to the views of the auditors on these 
matters. If it is not sa tisfied with any aspect of the proposed financial 
reporting, it shoul d inform the board. 
 
 Audit committee and internal control 
 In relation to internal controls, the audit committee should: 
 review the company’s internal financial controls 
 review all the company’s internal c ontrol and risk management 
systems, unless the task is taken on by a separate risk committee or 
the full board 
 give its approval to the statem ents in the annual report relating to 
internal control and risk management 
 receive reports from management  about the effectiveness of the 
control systems it operates 
 receive reports on the conclusion s of any tests carried out on the 
controls by the internal or external auditors. 
 
 Audit committee and internal audit 
 The audit committee should monitor and review the effectiveness of the 
company’s internal audit function. If the company does not have an internal audit function: 
 the committee should consider annual ly whether there is a need for 
an internal audit function and make  a recommendation to the board, 
and 
 the reasons for the absence of an internal audit function should be 
explained in the relevant section of the annual report. 
Where a company does have an inte rnal audit function, the audit 
committee has an important role in preserving the independence of the 
internal audit function from pressure or interference.

296  
 The audit committee should: 
 approve the appointment or terminat ion of appointment of the head 
of internal audit  
 ensure that the internal auditor ha s direct access to the board chair 
and is accountable to the audit committee 
 review and assess the annual internal audit work plan 
 receive a report periodically about the work of the internal auditor 
 review and monitor the response of  management to the findings of 
the internal auditor 
 monitor and assess the role and e ffectiveness of the internal audit 
function within the company’s overall risk management system. 
 
 Audit committee and external auditors 
 The audit committee is responsible for oversight of the company’s 
relations with its external audit ors. The audit committee should: 
 have the primary responsibility fo r making a recommendation to the 
board on the appointment, re-appoi ntment or removal of the 
external auditors 
 ‘oversee’ the selection proce ss when new auditors are being 
considered 
 approve (though not necessarily  negotiate) the terms of 
engagement of the external auditors  and the remuneration for their 
audit services 
 have annual procedures for ensuring the independence and 
objectivity of the external auditors 
 review the scope of the audit with t he auditor, and satisfy itself that 
this is sufficient 
 make sure that appropriate plans are in place for the audit at the 
start of each annual audit 
 carry out a post-completion audit review. 
 
 P Company follows a principles ba sed code of corporate governance and 
has both an audit committee and a risk committee.  
Which of the following roles woul d be carried out by the audit 
A Review of the financial stat ements, and any interim reports 
produced. 
B Review of the company's system of internal financial controls. 
C Discussion with the auditors about any  significant matters that arose 
on the audit.

Chapter 5 
 297 
 D Recommendations on the appointment and removal of the auditors. 
E Act on any recommendations put forward by the auditors in the 
management letter. 
F Review all the company’s inte rnal control and risk management 
systems. 
 
 Within the UK Corporate Governance Code it states that  the chair should 
arrange for several stakeholder groups to attend the AGM. These 
include: 
Select ALL that apply A The audit, remuneration and nomination committees 
B The directors 
C The Chief Executive Officer 
D The chairpersons of the audi t, remuneration and nomination 
committees 
E All non-executive directors 
 
 Responsibilities of an audit committee include:  
A Review of the financial statement s and any interim reports produced 
B Review of the company’s system of internal financial controls 
C The detection of fraud 
D Ensuring a system is in place for whistleblowing 
 
 Lehman Brothers 
 Lehman Brothers was founded in 1850 and by 2008 it was the fourth 
largest investment bank in America,  behind only Goldman Sachs, Morgan 
Stanley and Merrill Lynch. It empl oyed over 25,000 people globally, but 
on September 15th 2008 it filed for bankruptcy  and started what many 
people called the credit crunch or  global financial crisis. 
There are usually many reasons why something goes wrong, and in this 
case, many reasons why a business fails, but one area that was certainly a large factor in the failure on Lehman Brothers was Corporate 
Governance, or poor corporat e governance to be precise. 
It wasn’t that they didn’t have a boar d of directors, it was more the 
makeup of that board.  There were 10 people on the board at Lehman 
went it filed for bankruptcy. And fo r an investment bank, it was very 
lacking in financial expertise at boar d level; there are different reports 
about exactly how many had financial experience, but they generally 
range between zero and two.

298  
 A diverse range of skills is often considered a good thing, but included on 
the board at Lehman, and reportedly on the audit committee, and the 
finance and risk committee, was a theatrical producer. One former CEO 
on the board may provide useful insight s, but Lehman Brothers didn’t just 
have one former CEO – they had at l east five – but not very much 
experience in other key business areas.  
There were some undoubtedly tal ented people on the Lehman Brothers 
board, but they were often carrying out  too many roles to be effective for 
Lehman. One member of Lehman board,  whose roles included Chair of 
the nominations committee, member  of the remuneration committee and 
also part of the risk committee, was al so reportedly serving on at least 
three other boards at the same time. 
Finally, the Chairman and CEO of t he board was the same person, and 
based on some of the descriptions of his character, and the fact that 
according to some reports he asked t he firm’s chief risk officer to leave 
the boardroom during key discussions, it does not sound like the dual role 
was appropriate. 
6 International developments 
Sarbanes-Oxley Act 
The US financial world was rocked by a number of very serious financial 
scandals around 2000/2001, the most well known of which were Enron and Worldcom. The problems of Enron and Worldcom brought into question US 
accounting practices (for example, by exploiting loopholes in US accounting, 
Enron did not show its problems in its st atement of financial  position) and also 
the corporate governance exercised by direct ors. In order to restore confidence 
in the results of US companies t he Sarbanes-Oxley Act was introduced. 
 The SOX legislation is extremely deta iled and carries the full force of the 
law behind it. 
 The Act also includes requirement s for the Securities and Exchange 
 It is relevant to US companies, directors of s ubsidiaries of US listed 
businesses and auditors who are working on US listed businesses. 
Differences to the UK Code 
Overall the two main differences between SOX and the UK Code are: 
(i) Enforcement  
The UK Code is a series of voluntary codes (a ' principles-based  
approach') whereas SOX takes a robust legislative approach which sets out clear personal responsibility for so me company directors with a series 
of criminal offences that are punis hable by fines (both company and its 
officers) or lengthy jail sentences (a ' rules-based  approach'). 
(ii) Documentation  
SOX creates a much more rigorous  demand for evidencing internal 
controls and having them audited.

Chapter 5 
 299 
Key points of SOX 
 
 UK Code vs. SOX 
 Most countries in the world now have Governance codes, and this 
chapter has looked at the UK Co de and SOX, as t hey provide good 
examples of a Principles (UK Code)  and a Rules (SOX) based approach. 
Certification of accuracy the financial statements 
A rules based approach gives personal responsibility for the accuracy of 
the firm's financial statements to its pr incipal executive officer (CEO) and 
the chief financial officer (Finance Dir ector), who must provide a signed 
certificate to the Securities and Exchange Commission (SEC) vouching 
for the accuracy of the statements signed by the two officers above. It is a 
criminal offence to file def ective financial statements. 
The CEO and CFO must also hand back any bonuses for previous years 
if the financial statements need to be amended due to defective financial 
This is a far more specific require ment than in a principles based code 
which would only provide for a statem ent about the responsibility of the 
board for preparing financ ial statements and a goi ng concern statement. 
Increased financial disclosures 
Whilst a principles based code would focus more on directors and their 
accountability to shareholders, a rules based code would be likely to 
include a number of provisions for gr eater, or more rapid, disclosure of 
financial information: 
 In its financial reports the compan y must disclose details about its 
off balance sheet transactions and their material effects. 
 Material changes should be disclosed on a rapid and current basis 
i.e. new off balance sheet transacti ons, loss of a major customer or 
a one-off writing down charge.

300  
 Internal control report 
Companies need to include a report on 'internal control over financial 
reporting' in their annual report. This must: 
 Include a statement of managemen t's responsibility for adequate 
control systems. 
 Identify the framework to evaluate internal control. 
 Provide an assessment of the effe ctiveness of internal control and 
any material weakness. 
Again this follows the principles ba sed approach quite closely regarding 
the board's responsibilities and the role of the audit committee in reporting on the effectiveness of financial controls. 
Audit committee 
In the same way as the UK Code, SOX requires companies to comply 
with certain audit committee requirem ents. However, the US stock 
exchanges are prohibited from listing any firm that does not comply. 
As per the Combined Code the committee should: 
 Be independent (in the UK NEDs). 
 Have responsibility for appoint ing and compensating auditors. 
 Oversee the auditors. 
 Establish whistleblower pr ocedures regarding questionable 
accounting or audit matters. 
Unlike the UK Code, however, the ru les based SOX goes much further in 
restricting auditors and non-audit work. A number of specific non-audit 
activities are explicitly prohibited. 
Whilst the principles based example of the UK Code discourages auditors 
carrying out non-audit work, an explanat ion of how companies safeguard 
auditor independence in the annual report is  usually sufficient if additional 
work is carried out. 
The rules based approach of SOX also requires a compulsory rotation of 
the lead audit partner work ing on a corporate client . 
 
 In the US, the accuracy of the fi nancial statements is vouched for by: 
A The board of directors B The audit committee only C The chief financial officer D The chair only E The chief executive officer

Chapter 5 
 301 
 The most heavily regulated corpor ate governance provisions are in: 
A The UK B The US C Canada D South Africa 
 
 The risk of no corporate governance 
 Imagine a poor country with no corpor ate governance at all. Should we 
trade with businesses within that country ? Do we have a responsibility to 
encourage corporate governance? 
In answer to the first question – s hould we trade with that country, the 
answer could be 'yes' or 'no'. Firstly – yes, the country is poor, prices 
might be low, the population might need employment. Our company could benefit from lower prices and benefit from good public relations by 
providing much needed jobs. 
However, without corpor ate governance, businesses may not operate to 
the standards expected of our own c ountry which could bring reputation 
risk. We might not be able to trust them. 
So maybe the answer should be 'no'. The overseas company may be 
badly run by its management, with tota l disregard for the 'rules' we 
operate within our own country. The benefits to us now may be 
outweighed by any future costs in te rms of lost reputation should an 
adverse event occur. 
In answer to the second question – should we encourage corporate 
governance, then the answer should probably be 'yes'. Our richer 
countries’ success may be founded on oper ating within the guidelines of 
corporate governance – well-run com panies following the 'rules'. The 
poorer country companies might learn fr om this and see that more profit 
can be made through trade with other countries that comply with 
This will not happen overnight and is not costless. However, by asking 
those poorer companies to make small changes over time (such as having non-executive directors or not dealing using bribes) we would 
encourage trade with them, which in itself would bring monetary 
advantage which could be reinvested to  improve their company in the 
future.

302  
 Country N is a poor developing na tion with no cor porate governance 
structures in place. Several lar ge international organisations have 
recently publicised decisions not to trade with Country N because its 
government and business structures  are seen as corrupt and its 
treatment of workers is poor. 
Company Q, one of the world’s lar gest manufacturers has however 
decided to maintain its relationship wit h Country N, from where it sources 
many of its components at competit ive prices. Company Q has issued a 
media statement detailing how it intends to encourage the government 
and companies within Country N to adopt corporate governance ‘best 
practice’. 
Which of the following are r easons why Company Q might 
encourage Country N to adopt corporate governance principles 
rather than simply c ease trading with them? 
A If Country N follows best prac tice corporate governance this will 
attract trading partners and potentiall y increase the wealth of the 
nation. 
B Company Q will be able to continue to source it’s components from 
Country N without disruptions to supply whilst carrying out plans to 
encourage corporate governance best practice. 
C Company Q is likely to satisfy stakeholders who are concerned 
about CSR through encouraging bette r working conditions in 
Country N. 
D Company Q may be seen as ethical and progressive if it 
encourages better governance standards in Country N. 
E If suppliers in Country N improve the way they are controlled, there 
are less likely to be problems with the components Company Q 
purchases. 
The Harvard Law School in the US pr oduced a report in 2013 considering the 
Board's responsibility towards managing  its stakeholders interests. It is 
reproduced, in part, below: 
Companies today are being called upon by their stakeholders to not only boost 
their profits, but also to help address so me of their country’s most challenging 
problems, including those concer ning economic development and the 
environment. Corporate stakeholders (whi ch typically include shareholders, 
employees, customers, suppliers, the general public, governments and 
regulators) are demandi ng that companies recognise their responsibilities in 
addressing those problems. As a resul t, companies are increasingly working 
with stakeholders to understand their views and concerns on various 
environmental, social, corporate gov ernance and economic issues and to 
incorporate and address those views and co ncerns in the company’s strategic 
decision-making processes. 
The Corporate Social Responsibility (CSR ) report can be a key component of a 
company’s stakeholder engagement strategy.

Chapter 5 
 303 
Why should the Board be responsible for managing stakeholders' 
interests? 
Corporate Value . Stakeholder engagement includes the formal and informal 
ways a company stays connected to its st akeholders (the individuals or parties 
that have an actual or pot ential interest in or impact on the company, its 
operations and financial result s). Stakeholders often have the ability to influence 
the success (or failure) of a company at various levels. A primary objective of 
corporate stakeholder engagement is to build  relationships with stakeholders to 
better understand their perspectives and concerns on key issues (including CSR issues) and to integrate those perspectives and concerns (when and where feasible and prudent) into the co mpany’s corporate strategy. Companies 
tend to recognise certain value a ssociated with stakeholder engagement, 
 enabling informed board and m anagement decision making; 
 avoiding or reducing business risks due to better business intelligence; 
 developing and expanding busine ss opportunities, brand value and 
reputation; and 
 bringing diverse perspectives t ogether to facilitate innovation;  
all of which help drive long-term sustainability and shareholder value. 
Rise in Shareholder Activism . Shareholder activism on  CSR issues continues 
to rise, necessitating further engagem ent between companies and their 
shareholders and other stakeholders. Rela ted stakeholder concerns can be 
proactively discussed and addressed, companies may be able to avert a potentially costly and prolonged proxy fight, and relationships between companies and their stak eholders may be nurtured. 
Rise in Sustainable and Responsible Investing.  Stakeholder engagement 
and understanding and addressing stakeholder s’ CSR concerns have become 
especially important as shareholders and potential inve stors are increasingly 
evaluating CSR issues when analysing inve stment decisions. Under sustainable 
and responsible investing (“SRI”) prin ciples, investors apply various CSR 
criteria in their investment analysis. It has been reported that SRI grew by more 
than 22% to $3.74 trillion in managed a ssets during the period from 2010–2012. 
For instance in 2011, the California P ublic Employees’ Retirement System 
(“CalPERS”),  as part of it s “total fund” approach to investment, adopted three 
core themes for integrating CSR issues  into its investment decisions: (1) 
corporate governance (including iss ues such as shareowner rights and 
executive compensation), (2 ) climate change (including issues related to water 
stress, carbon emissions, energy effi ciency, clean technology and renewable 
energy) and (3) human capital (including issues of health and safety, responsible contracting and diversity). 
Why CSR and the CSR Report? 
CSR is defined many ways but generally refers to how a company addresses 
and manages its environmental, social , corporate governance and economic 
impacts and how such impacts may affe ct the company’s stakeholders. CSR 
provides companies an opportunity to strengthen their business (through cost 
savings, risk mitigation and value enhancement ) while contributing to society.

304  
CSR should focus on the im portant areas of interact ion between the company 
and its key stakeholders and address val ue creation actions as part of the 
company’s strategy. 
A 2013 global consumer survey repor ted that CSR remains a powerful 
differentiator, influencing both consumer  behaviour and corporate reputation. 
Nearly all consumers in that survey  noted that when companies engage in CSR 
they have a more positive image of the co mpany, would be more likely to trust 
that company and would be more lo yal to that company. Consumer 
respondents added that it is acceptable if  a company is not perfect, provided 
that the company is honest and tr ansparent about its CSR efforts. 
The CSR report, therefore, provides  a company with an opportunity to 
communicate its CSR efforts to the company’s stakeholders and to discuss 
(within the confines of a single do cument) certain company successes and 
challenges on a wide array of CSR iss ues, including corporate governance, 
climate change, employee and supplier di versity initiatives, and community 
investments and partnerships. The CS R report is also a medium for 
transparency (which often improves a company’s reputation with certain 
stakeholders, particularly shareholders, employees, suppliers and communities 
within which the company operates) and may be used as an effective outreach tool as part of an ongoing shareholder re lations campaign. In addition, the CSR 
report provides existing and potential invest ors with CSR information to assist in 
analysing investment decisions. 
The CSR Report 
Corporate CSR reports address issues  most important to each of the 
company’s key stakeholders, for example: 
Shareholders  – addressing the company’s business model and corporate 
governance, including disclosing the role  of the board in risk management, in 
sustainability reporting and in  evaluating CSR performance. 
Employees  – addressing diversity, health and safety, training and mentoring, 
employee relations, and wages and benefits. 
Customers  – addressing customer service and privacy. 
Suppliers  – addressing labour standards and whether suppliers are required to 
implement their own CSR programs. 
Communities  – addressing corporate philanthr opy and charitable contributions, 
community investment and partnerships, volunteer ism and the environmental 
impact of operations. 
Governments and Regulators  – addressing lobbying,  public policy and the 
effects of and compliance wit h environmental regulations. 
Other Considerations 
With respect to CSR, the CSR re port and stakeholder engagement, a company 
and/or its board of direct ors may also want to consider the following:

Chapter 5 
 305 
CEO Responsibility and Board Oversight.  The chief executive officer should 
ultimately be responsible for establis hing effective communications with the 
company’s stakeholders with CSR over sight by the board or board committee 
(or committees). Such oversight may include (1) review of CSR trends and 
impacts on the company’s operations, fi nancial results and stakeholders and (2) 
periodic updates from the chief executive officer/ management concerning the 
company’s positions on and actions tak en relating to relevant CSR issues and 
how such positions and actions have a ffected or may affect stakeholders. 
Focus on Impact.  Because management time and resources are limited, 
companies should focus on those CSR issues that may have the greatest 
impact on them and their operations and finances. 
Stock Exchange Reporting Initiatives.  Although the CSR report is not 
currently mandated by any federal law or regulation, there is a reported global 
effort by certain groups, including inve stors, to mobilize stock exchanges to 
adopt a listing requirement regarding sust ainability (CSR) reporting. Regulators 
in the United Kingdom, for example, ar e requiring companies listed on the main 
market of the London Stock Exchange to publis h full details of their greenhouse 
gas emissions for reporting years ending on or after September 30, 2013. While 
there currently is no mandatory sustai nability (CSR) reporting requirement for 
companies listed on the New York  Stock Exchange or NASDAQ, both 
exchanges have joined the United Na tions’ Sustainable Stock Exchanges 
initiative, which aims to explore how exchanges can work together with 
investors, regulators a nd listed companies to enhanc e corporate transparency 
on CSR issues and encourage respons ible long-term approaches to 
Identify Corporate Team . Companies should identify  the corporate team that 
will be responsible for their CSR report and include, at a minimum, employees 
from their investor/public/community rela tions, legal, compliance, regulatory and 
human resources departments. 
Other Components of Stakeholder Engagement.  The CSR report is only one 
component of an effective stakeholder engagement strategy. Other components 
of such strategy may include supplem ental reports (e.g., Carbon Disclosure 
Project reports), regulatory filings, the annual meeting of shareholders and 
direct dialogue with stakeholders (e.g., community town hall and employee as 
well as supplier meetings). 
 
 Generally share options shoul d not be awarded to non-executive 
directors. However, if they are awarded the non-execut ive director may 
sell them: 
A Whenever he or she wants to B When they leave the non-executive Board C At nil profit D One year after leaving the non-executive board

306  
7 Governance and strategy 
 The implications of governance for strategy 
 The results of the increasing focu s on governance issues are as follows: 
 Increasing power of governance bodies. 
 Increasing shareholder power, ensu ring that compani es are run with 
shareholders’ interests prioritised. 
 Greater pressure on boards to formulate strategy and be seen to 
control the businesses concerned. 
 Greater scrutiny of quoted busine sses, resulting in more short- 
termism. 
 Greater emphasis on risk assessm ents, so directors may feel 
pressured to undertake lower-risk (and hence lower-return) projects. 
 Greater scrutiny of mergers and acquisitions in particular.  
How does corporate governance im pact organisational strategy? 
Corporate governance is very important to  help maximise the effectiveness of 
 Corporate governance wor ks to ensure that no indi vidual can dominate the 
board of directors (by ens uring the CEO and Chair roles are separated as 
well as the presence of independent non- executive directors). This helps 
to ensure that no-one is powerful enough to force through inappropriate or ineffective strategy. The non-exec utive directors should be able to 
impartially assess whether a proposed strategy is in the best interests of 
 Corporate governance should help to im prove the diversit y of the board of 
directors. This allows the board to  identify a wide range of possible 
strategies, as well as analyse them from  a variety of different viewpoints. 
 Adequate internal audit and contro l systems should ensur e that the board 
has accurate information about the curr ent operations of the company. 
This will enable them to develop mo re effective strategies for the 
organisation. In addition, strong internal  control increases the chance that 
the organisation will be able to impl ement its strategies successfully. 
 Having good corporate governance is attractive to investors. This will 
make it easier for the organisation to raise the funding necessary to invest 
in the new strategies t hat they have identified. 
It is therefore extremel y important that compani es consider corporate 
governance principles if they wish to develop and implement successful 
strategies.

Chapter 5 
 307 
 HMV 
 HMV was the place to go for music in the 1980s, and in the 1990s the 
company expanded its range to take advantage of technological 
advancements and was the place to go for videos, DVDs, computer 
games and other things as well as music. Such was its power and dominance, it was charging nearly  £20 for a CD and the House of 
Commons investigated it s huge profits in the 1990s. 
The music retailer, should therefore have been perfectly placed to 
continue the technological progression and become the place to 
download digital music, and then se t up a streaming service.  
The Managing Director at the time, St eve Knott, described digital music 
as “just a fad”. Instead of the boar d assessing the risks and opportunities 
around them, developing an appropriate digi tal strategy that would enable 
them to compete with the likes of Amazon or iTunes, HMV failed to adapt 
their strategy to the market condi tions and continued to do more of the 
same. They acquired Waterstones, a book retailer that was also struggling with online and digital riva ls.  This failed to change their 
fortunes and was eventually sold to pay off debts in 2011.  
HMV still did not embrace digita l music, and eventually entered 
administration for the first time in 2013. They were taken out of 
administration by Hilco. Under their new ownership they finally launched a music download service, almost 10 years after iTunes had launched and 
around 6 years after Amazon o ffered such a service.  
By this time the trend for consumi ng music was changing from digital 
downloads to streaming services such  as Spotify, who launched in 2008. 
HMV entered administration again in December 2018. 
 
 Which of the following are usually staffed by non-executive directors? 
A The risk committee B The nominations committee C The audit committee D The remuneration committee

308  
 Test your understanding 18 – H electronics (Integration) 
 H is a company that manufactures bas ic electronic components such as 
capacitors and printed circuit boards for the IT industry. The company 
has recently appointed K as a non-ex ecutive director. K was the founder 
and chief executive of a quoted execut ive recruitment consultancy and 
employment agency. She has stood down from that role and has 
accepted the position on H’s board in order to seek fresh challenges. 
H’s board meets twice every year fo r a formal discussion of company 
strategy. These meetings tend to l ook back at H’s performance for the 
previous half-year. This discussion mainly focuses on a report based on the monthly management accounts for the previous half year and then 
briefly considers the future im pact of these. Monthly management 
accounts are presented to the board at their monthly board meetings. 
K has attended two of the meetings rela ting to strategy. At the conclusion 
of the second meeting she expressed two concerns about the half-yearly 
board meetings. Firstly the meetings  focus on feedback rather than feed 
forward. K argued that the board should be const antly forward looking 
and aiming to identify new opportuniti es. K believes that historical 
summaries of past performance distract from the need to plan for the future. Secondly, K believes that the half-yearly meetings focus on details 
associated with the existing busine ss model rather than strategic 
direction. She believes that it w ould be a more productive use of the 
board’s time at these meetings to work towards identifying strategic 
opportunities that might be pursued over  the next three to five years. 
When she was chief executive of her  employment agency the board met 
at least once per year and frequently  more often to think about new 
strategies that might be pursued. 
H’s Production Director has complained that K has really misunderstood 
the board’s responsibility for the management of H. The Production 
Director believes that her first argument  is invalid because the distinction 
between feedback and feed forward cont rol is more about day to day 
tactical management rather than strategic management. The Production 
Director believes that feed forward is  more about fine tuning rather than 
strategic management. The Production Director also believes that K’s comments about strategic direct ion demonstrate a very limited 
understanding of manufacturing electroni cs. H must respond and react to 
the requirements of the IT industry.  H cannot really innovate. The life 
cycle of the company’s products is such that changes to H’s strategic direction happen infrequently. The Pr oduction Director has suggested 
that K should restrict her comme nts to the information prepared for 
consideration by the full board, espec ially as she has come from the 
service sector and has no real understanding of manufacturing.

Chapter 5 
 309 
 Required: 
(a) Evaluate the respective argum ents put forward by K and by the 
Production Director concerning th e need for H’s full board to be 
forward looking rather than focussing on past performance. 
(b) Evaluate K’s argument that H’s board should review the company’s 
strategic direction at its half-yearly meetings. 
(c) Evaluate the Production Directo r’s argument that K should not 
comment on the manner in which H is run because of her background and lack of experience in a manufacturing company. 
 
 Test your understanding 19 – C consultancy (Case study) 
 Scenario 
C is a partnership that offers a r ange of consultancy services involving 
structural engineering. The firm s pecialises in examin ing plans prepared 
by architects to ensure that the buildings being planned are structurally 
sound. This requires careful consider ation of the design and the materials 
being used to ensure that the result ing building will be stable and can 
withstand the effects of t he wind and other forces of nature. C specialises 
in major contracts and the firm often advises on complex designs that use 
innovative building techniques. 
C has a reputation for having a com petitive culture. The firm offers 
salaries that are much higher than the industry average. There is an "up 
or out" culture which means that qua lified staff must demonstrate the 
potential to be promoted to the next leve l of seniority within a relatively 
short period or they will be encouraged to leave. 
C has 45 partners, all of  whom are qualified stru ctural engineers, and 
approximately 400 professional staff. C's professional staff comprises 
engineers at different st ages in their careers, ranging from team leaders 
to junior trainees. The team leaders  are all experienc ed engineers who 
are eligible for promotion to partner ship in the event that a vacancy 
arises. Selection for partnership depends on the ability to consistently complete assignments to a high standard and within budget. 
Trainee engineers are appointed on a thr ee year contract, during which 
time they are expected to pass t heir professional exams. C takes on 
approximately 50 trainees every year . Those trainees who demonstrate 
the necessary qualities to succeed in C are offered the opportunity to stay 
with the firm at the conc lusion of their training contracts. Those who do 
not receive such an offer must leave.

310  
 Each partner is responsible for a portfolio of assignments, and each 
portfolio is accounted for as a profit centre. Partners are expected to be 
aware of the opportunities to bid for assignments and to win new business despite competition from  other engineering firms. C has a 
reputation for bidding aggressively and accepting tight deadlines. Each 
partner is responsible for a portfolio of assignments, each of which will 
involve a team leader and several assi stants. Professional staff time is 
charged to assignments on an absorption costing basis and the firm’s time recording system calculates a notional profit for each assignment 
based on the cost of time c harged against the fee generated. 
At the end of every financ ial year each partner receives an equal share of 
the firm’s annual profit, but it is a matter of pride for each partner to 
generate more profit for t he firm than he or she re ceives from the annual 
profit share. 
All partners enjoy equal seniority and major strategic decisions are 
decided by a simple majority vote of  the partnership. The firm is managed 
on a day to day basis by a management committee which comprises three partners. Every part ner is expected to take a turn as a member of 
the management committee at some stage in his or her career. One 
person joins the committee every year to take over from the committee 
member whose term of offi ce has expired. The third year of service on 
the management committee is spent as the firm’s managing partner. 
There is no additional reward for se rving on the management committee, 
but during that year the committe e members are not expected to be 
responsible for a full complement  of assignments and the managing 
partner is not expected to be re sponsible for any assignments. 
Task 
As an external consultant, write a letter to the audit committee evaluating 
the strengths and weaknesses of C’s governance arrangements with 
respect to the partnership  and its management committee. 
 
 Test your understanding 20 – P chemicals (Case study) 
 Scenario 
P is a major quoted company that manuf actures industrial chemicals. The 
company’s Board comprises a Chief Executive and five other executive 
directors, a non-executive chair and four non-executive directors. 
Trigger 
Two of the non-executive directors have served on P’s board for five 
years. The company has a policy of  asking non-executive directors to 
stand down after six years and so  the Chair has established a 
Nominations Committee to start the pr ocess of selecting replacements.

Chapter 5 
 311 
 Three replacements have been suggested to the Nominations 
Committee. The nominees are: 
 S, who is on the main board of C Pensions, an investment institution 
which owns 5% of P’s equity. S has worked for C Pensions for 20 
years and has always worked in t he management of the company’s 
investments, initially as an analyst and more recently as director in 
charge of investments. Before working for C Pensions, S was an 
investment analyst with an insura nce company for 15 years. 
 T, who is a CIMA member, is about to retire from full-time work. T 
has had a varied career, completing the CIMA qualification while 
working as a trainee accountant with a food manufacturer, then as a 
management accountant with an engin eering company and finally 
as a senior accountant with a commercial bank. T was promoted to the bank’s board and has been Finance Director for eight years. 
 U, who is a former politician. Afte r a brief career as a journalist, U 
became a member of parliament at  the age of 35. After spending  
20 years as a politician, including  several years as a government 
minister, U has recently retired fr om politics at the age of 55. U 
already holds two other non-execut ive directorships in companies 
that do not compete wit h and are not in any way connected to P.  
The Chair of P is keen to recruit mo re non-executive directors as a matter 
of priority because the Remunerati on Committee faces a difficult task. 
The executive directors are presentl y remunerated with a combination of 
a salary and executive stock options. P’s shareholders have expressed concern about the pressures creat ed by these stock options and have 
asked that they be repl aced by individual bonus es that reflect the 
personal contribution made by each of the executive directors. 
The Chair and the non-executive dire ctors are discussing the level of 
bonus that should be awarded for t he current year. This has been 
complicated because P made a loss for the first ti me. The Chief 
Executive has stated that it would not be appropriate to accept a bonus 
from a loss-making company, but the ot her executive directors claim that 
the loss was attributable to economic  and industrial conditions and that 
their leadership minimised the loss. A ll of the executive directors other 
than the Chief Executive have asked for substantial bonuses to reflect their leadership in difficult times. 
Task 
Prepare a briefing note to the Chair, in  your capacity as a non-executive 
director, which: 
(a) Evaluates the suitability of  each of the three nominees. (30 minutes)  
(b) Discusses the problems associated with determining a suitable level 
of bonus for each of P’s executive directors. (20 minutes)

312  
 Test your understanding 21 – JKL (Case study) 
 Scenario 
JKL is a profitable but small FTSE 500 company in a technology-related 
service industry with annual sales of  £150 million. Its gearing is 50% of 
total assets, secured by a mortgage over  its main site. The industry is 
highly competitive but  there are major barriers to entry for new 
competitors and the long-term future of  JKL is considered by industry 
analysts to be sound. 
The Board comprises a non-executive chair, a chief executive who has a 
large shareholding, an executive financ e director, operations director and 
marketing director and a non-executiv e director with wide knowledge of 
the industry and who retired from the company 3 years ago. The board 
only has one committee, an audit committee. The audit committee 
consists of the chair, non-execut ive director and finance director. 
There is no internal audit function in  JKL but the external auditors are 
relied on to report on any weaknesses in control and their letter of engagement authorises them to carry  out work over and above the 
financial audit in relation to internal  control. The external auditors have 
always given a ‘clean’ audit report to the company and hav e reported that 
internal controls within JKL ar e sound. There is no formal risk 
management process in place in JKL although board meetings routinely 
consider risk during their deliberations. 
Trigger 
The chair and chief executive both believe that compliance with corporate 
governance reforms will not benefit JKL and is likely to be too costly. This 
is disclosed in JKL’s Annual Report. 
Task 
Write a report to the Chair 
(a) evaluating the key reforms and best practice in: 
– corporate governance – risk management that have taken pl ace over the last few years 
and which affect JKL; (30 minutes)  
and (b) with reasons, which (if any), of those reforms should be adopted by 
the company. (15 minutes)

Chapter 5 
 313 
 Test your understanding 22 – HFD (Case study) 
 Scenario 
HFD is a registered charity wit h 100 employees and 250 volunteers 
providing in-home care for elderly persons who are unable to fully take 
care of themselves. The company structure has no shareholders in a 
practical sense although a small number of issued shares are held by the 
sponsors who established the charity many years previously. HFD is 
governed by a seven-member Board of Directors. The Chief Executive Officer (CEO) chairs the board which co mprises the chief financial officer 
(CFO) and five independent, unpaid non-ex ecutive directors who were 
appointed by the CEO based on past business relationships. You are one of the independent mem bers of HFD’s board. 
The CEO/Chair sets the board agendas, distributes board papers in 
advance of meetings and briefs board members in relation to each agenda item. At each of its quarterly meetings the Board reviews the 
financial reports of the charity in some detail and the CFO answers 
questions. Other issues that regul arly appear as agenda items include 
new government funding initiatives for t he client group, and the results of 
proposals that have been submitted to  funding agencies, of which about 
25% are successful. There is rarely any  discussion of operational matters 
relating to the charity as the CEO believes these are outside the directors’ experience and the execut ive management team is more than 
capable of managing the delivery of  the in-home care services. 
The Board has no separate audit committee but relies on the annual 
management letter from the external aud itors to provide assurance that 
financial controls are operating effect ively. The external auditors were 
appointed by the CEO many years previously. 
Trigger 
HFD’s Board believes that its co rporate governance could be improved 
by following the principles applicable to listed companies. 
Task 
Prepare briefing notes for a meeting with the Board: 
(a) Recommending how HFD’s Board should be restructured to comply 
with the principles of good corporate governance. (30 minutes)  
(b) Explaining the aspects of CIMA ’s ethical prin ciples and the 
conceptual framework under lying those principl es which you would 
consider relevant to continuing in your role as an independent 
member of HFD’s Board. (20 minutes)

314  
 Test your understanding 23 
 Which of the following is NOT a st rategic aim of corporate governance? 
A To reduce costs within the organisation B To increase the organisation’s  transparency to stakeholders 
C To improve investor conf idence in the organisation 
D To ensure that the organisation abides by relevant laws and acts 
ethically 
 
 Test your understanding 24 – ADF – (Case Study) 
country F. You have just received t he following email from the Managing 
Director (MD), Carlos Smith: 
To:  Anne Accountant  
From:  Carlos Smith  
Date:  1/5/20XX  
Subject:  Review of corporate governance arrangements 
Hi Anne, As you may be aware, we are cu rrently reviewing our corporate 
governance arrangements within the company after some of our investors expressed concerns. I felt that you would be the right person to 
ask about this as I’m aware you’ve studied this topic. 
You’re probably aware that ADF’s ex ecutive directors are all employees 
who have worked their way up through the company. Half of the board is 
made up of non–executive directors. 
If you remember, the Chair of the board is a retir ed director of a major 
electrical retailer. All of the other non–executive directors are personal 
friends of his and were appoi nted on his recommendation. 
As you know, only one member of t he board is female. All the directors 
The company does have a small inter nal audit department but this is 
understaffed. The Head of Internal Audi t has stated several times that the 
work undertaken on ADF’s stores is mi nimal and that a num ber of stores 
have never been visited by internal audit. 
concerned that its current market is saturated and is looking to expand 
abroad into neighbouring countries, though the Chair has expressed 
concern over this as he feels it is too risky.

Chapter 5 
 315 
 I’d be grateful if you could identify any weaknesses in our corporate 
governance. Please could you explain how each weakness will affect the 
company strategically? I’m meeti ng a few other Board members to 
discuss this in 20 minutes, so I be grat eful if you could give this some 
urgent attention. 
Thanks Carlos 
Required: 
Draft a reply to Carlos, as requested. 

Chapter 5 
 317 
 The correct answer is C – Nick Leeson had responsibility of both the back 
and front office dealings of Barings Bank, dealing with i ssues that none of 
his managers understood. 
 
 A, B and C 
 Option A: Yes because the CEO has a named person (The Chair) in 
addition to the NED’s to whom he or she must account for the 
company’s performance and his or her own behaviour. 
 Option B: Yes – It is clear that the CEO is directly involved in the 
management of the company and the chair can adopt a more 
supervisory position. 
 Option C: Yes – It is considered best practice because it provides a 
reassurance to the shareholder s and ensures compliance with 
relevant codes. 
 Option D: No – It could be argued that decision making is quicker 
with just one leader who does not need to seek the approval of the 
chair. 
 Option E: No – There is a danger  that the leadership becomes 
fragmented, especially if the two mo st senior members of staff do 
not agree and cannot provide a united front. This can lead to a lack 
of goal congruence in an organisation.

318  
 D and E 
 Option A – The NEDs will st ill be able to assess management’s 
performance in meeting objectives; it  is the objectives themselves 
they will not be involved in setting. 
 Option B – provided the NEDs are informed on a timely basis about 
strategic decisions they will be abl e to carry out their risk role. 
 Option C – it appears that the ED s are no more knowledgeable than 
the NEDs in this scenario. 
 Option D – The role of the NED is to scrutinise decisions made by 
EDs and act on behalf of sharehol ders and other stakeholders. 
Without this involvement there is a risk decisions are made in the best interests of the executive directors. This is a key reason why NEDs should be involved in strategic decision making. 
 Option E – It cannot be disputed that time will be saved and the 
NEDs could use it to carry out ot her duties. This does not make the 
proposal correct. 
 
 B, C and D 
The remuneration committee should consist of independent NEDs and 
should not consider NED remunerati on. This should be decided by the 
board as a whole and/or sharehol ders depending on the specific 
requirements in the company Articles of Association. 
A – there is no need for the FD to resign from the company but they 
shouldn't be on the remuneration committee. 
E – there is no need to replace all NEDs 
 
 C 
Whilst the best trigger for the awardi ng of a bonus would be the director 
achieving a range of individual perfo rmance targets, share options would 
best align remuneration to shareholder  interests as both parties would 
want the company share price to rise to maximise their individual financial 
return. 
 
 The correct answers are A, B and D – The Board should meet regularly, 
not necessarily monthly.

Chapter 5 
 319 
 The correct answer is A – By definition. 
 
 The correct answers are A, C and D – Composition and succession 
should also include evaluation. Val ues should instead read as purpose. 
 
 A, B, C and D 
 Option E the audit committee would review the management letter 
and actions taken by the board but not take action themselves. 
 Option F would be carried out by the risk committee. 
 
 The correct answers are B, C and D – Only the chairs of each of these 
committees are suggested to attend. 
 
 The correct answers are A, B and D – The detection of fraud is 
management’s responsibility. The audit committee could advise on any fraud found. 
 
 The correct answers are C and E – In the US, the accuracy of the 
financial statements is vouched for by the chief financial officer and the chief executive officer. 
 
 The correct answer is B – The US has a ‘rules-based’ corporate 
governance provision. This has been prompted by the higher number and 
higher value of corporat e scandals occurring there.

320  
 B, C, D and E 
 Option A – is a reason why good governance may benefit Country 
N. It is not specific to Company Q. 
 Option B, C, D and E all relate to Company Q. 
 
 The correct answer is B, C and D – A risk committee can be staffed by 
executive directors. The other co mmittees are covered by corporate 
governance codes and are staffed by non-executive directors. 
 
 (a) K’s basic argument is that t he board ought to be forward looking, 
with a view to setting a strategic dire ction for H. That is a far more 
constructive approach to running t he company than focussing on past 
performance. Part of her concern may be due to the fact that the half-
yearly reports are really just  an amalgamation of the monthly 
management accounts that have al ready been considered by the 
executive directors during their monthly meetings 
The Production Director’s response is logical because the present 
arrangements appear to focus on looking at H’s present position and reflecting on the effectiveness of its strategies. That is not as pointless nor is it as backward looking as K suggests. H’s management team is aware that  the board will be looking at 
performance on a half-yearly basis and so there will always be an incentive to perform well in terms of working towards the company’s 
strategic objectives. Presumably the main board has agreed that six 
months is a suitable interval over which to review progress, although it is also clearly only a brief period in terms of the company’s 
product life cycle. 
The Production Director could be co rrect in the sense that feed 
forward control is largely about det ermining corrective action on the 
basis of predicted results. Strate gic management should be largely 
about setting targets and developing tactics to achieve those results. Feed forward control is more appropriate to the monitoring 
of the effectiveness of tactics.

Chapter 5 
 321 
 It is to be hoped that neither dire ctor is arguing too strongly for one 
approach to managing H. K is not necessarily asking that the board 
does not use historical information in  order to inform its deliberations 
and the Production Director does not appear to be arguing for all board meetings to be backward thinking. 
(b) It could be argued that the board ought to provide senior and middle 
management with a clear strategic di rection. Strategies ought to 
have clear and specific objectives that give management something 
to work towards. For example,  H’s board may ask management to 
develop plans that will increase production capacity by 50% over the next three years. 
Once a strategy has been put in  place it should be kept under 
review and changed if necessary. Ho wever, changes should be kept 
to the minimum, otherwise mana gement will become confused and 
may be demoralised. H’s board shoul d aim to motivate management 
by demonstrating commitm ent to the strategy rather than actively 
engaging in making changes to it. Otherwise, strategic management 
may be driven by day-to-day ch anges and circumstances and H will 
have no real direction. 
H is a manufacturing company that  requires complex and expensive 
technology. Many changes in strategy will prove expensive to implement. H exists to service demand for components from a wider industry. Many aspects of strategy will be set by H’s customers and H will have to be responsive to t he industry’s demands. It would 
make considerable sense for H to consider progress towards implementing strategies on a half-yearly basis but it is unlikely that it 
will be feasible for the company to make meaningful changes of 
strategic direction twice per year. 
On balance, it appears that K’ s arguments have been influenced by 
her experience in the service sector , where it is likely to be possible 
to be far more innovative because the costs of following different 
strategic directions are likely to be lower. 
(c) The Production Director’s argum ents raise significant questions 
about the role of the non-executive director. It would make little 
sense for K to have a seat on the board if she was not judged 
capable of making a meaningful cont ribution to the board’s work. 
It could be argued that non-executiv e directors have a significant 
role to play in providing oversight  of the workings of the board as a 
whole. To an extent, it would be desirable for the non-executives to 
maintain some distance from the active management of the 
company, even at the strategic level, because they will then be 
capable of being a little more impart ial in their oversight. K’s role 
could be more concerned with making sure that the executive directors have a clear and consistent direction in mind for the company, rather than in partici pating in developing a strategy 
herself.

322  
 It may be possible for the non-exec utive directors to offer some 
fresh insights that would not hav e occurred to their colleagues on 
the executive board, without comp romising their independence. K 
comes from a completely different background and may be able to ask questions that would not be considered by the executive 
directors. From time to time it is healthy to challenge accepted 
norms and to ask whether things could be improved. K clearly has an entrepreneurial outlook and that  could raise questions about 
whether H could identify new rev enue streams or meet customer 
needs in a different way. 
If the non-executives are to provid e effective oversight then they 
should not be constrained by the ex ecutive directors. They should 
be permitted to raise questions about  any aspect of the company’s 
management. The executive directors should recognise that the search and appointment process s hould ensure that only competent 
and capable people are appointed to the board and should respect the non-executives accordingly. 
 
 Address 
Date Dear Audit Committee, It was a pleasure meeting with several of your colleagues at C recently. 
Further to those meetings regar ding C's governance arrangements and 
the management committee,  I write to inform you of my findings. 
Strengths 
The fact that there is no benefit in terms  of salary or seniority means that 
the partners are not likely to be in competition for promotion to the 
management committee. That has the advantage of ensuring that they 
focus on winning business and supervising assignments. The management committee will be made up of  practising engineers who fully 
understand the important issues in the running of the firm. The fact that 
the members will return to normal par tnership within three years means 
that they will not introduce any r adical developments that may be 
beneficial to themselves but harmful to the partnership  as a whole. 
The partnership will include a num ber of members who have served on 
the management committee, which wil l give them a better understanding 
of the firm’s management.

Chapter 5 
 323 
 Weaknesses 
Partners may view the need to serve on the committee as an interruption 
of their professional activities as engineers. Their reduced commitment to 
assignments during the first two year s and withdrawal from assignments 
in the third year could cost t hem contact with the architects and 
contractors on whom they rely for referrals. 
Partners may be tempted to take on an excessive workload while serving 
on the committee and so the firm’s leader ship will suffer because it is not 
a top priority. Partners who are el igible for membership of the 
management committee may feel that  it will interrupt their ongoing 
careers and so may start to lobby fo r exclusion. That will defeat the 
objective of every partner taking it in  turn and may mean that only those 
partners who are willing, who ma y not be the best candidates, will 
participate. 
The annual change of managing partner means that there will be no real 
continuity in that position, alt hough each new incumbent will have spent 
the previous two years on the committee. 
The fact that there is no room for professional management on the 
committee means that the administrat ive aspects of managing this 
engineering firm may not  enjoy the prominence they deserve. 
The fact that major strategic decisi ons are left to the partnership as a 
whole may mean that t he management committee tends not to look 
beyond the immediate future. 
Major strategic changes may be difficult to implement if it is necessary to 
obtain a majority of the votes from 45 partners. 
Should you have any further queries,  please do not hesitate to ask. 
Yours sincerely External consultant

324  
 (a) Briefing notes  
To:  The Chair  
From:  A non-executive director  
Subject:  Suitability of nominees and bonuses  
Suitability of nominees 
S is employed by a major shareholder, which is regarded as a 
problem for potential non-executives in terms of the guidance in the 
Combined Code. There is a risk that S will suffer a conflict of interest in that decisions that are good for P as a whole may not be 
ideal for C Pensions and vice versa. That problem could be 
overcome to an extent by recognising S’s interest, as and when it becomes an issue, and making sure  that there ar e sufficient 
independent directors to compensate. S has no skills or experience that would be directly relevant to the strategi c management of a 
manufacturing company. Having said  that, it could be that S will 
bring a fresh perspective to board m eetings and so the lack of direct 
experience could be an advantage. S also has a great deal of 
experience of managing investment portfolios and that could be valuable in terms of presenti ng arguments to the board from the 
perspective of institutional investor s. S’s experience in that regard 
could be useful in areas such as financial reporting and so S may be a valuable member of the audit committee. 
T is a qualified accountant and will pr ovide skills that will be directly 
relevant to the financial reporti ng and control aspects that are 
generally associated with non-executiv e directors. T has had a full 
and varied career and that will give a range of perspectives that may 
be valuable to P. T’s experience includes the manufacturing sector 
and that may give insights into th e management of capital intensive 
businesses such as P. T has a ran ge of contacts in  banking that will 
undoubtedly be useful w hen it comes to negotiating with potential 
lenders . T is about to retire and so s hould have suffici ent time to 
devote to this position.

Chapter 5 
 325 
 U has had very little experience that is directly relevant to the 
management of P. U’s parliamentary career could, however, have 
provided skills that are of some value, such as assessing the interests of different stakeholders . That could be a major benefit in the management of a company that  manufactures chemicals. U’s 
political contacts could also pr ove valuable, partly in terms of 
evaluating proposals that could a ffect P’s position and partly in 
terms of lobbying to ensure that any changes are not too damaging 
to the company. U’s reputation as a former senior pol itician will give 
an incentive to act with integrit y and that will enhance P’s reputation 
for honest management. The fact that U appears keen to have a number of directorships is a worr y because it implies that P will not 
necessarily have sufficient time and attention. Furthermore, lobbying 
for companies that have different issues may mean that U will not 
always be free to put P first when using former political contacts. 
(b) Bonuses  
One concern is that the bonus  mechanism may encourage 
dysfunctional behaviour. The remuneration committee will have to determine bonuses in such a way that  directors cannot improve their 
rewards by making decisions that are harmful to the company, such as cutting expenditure on discretionar y areas such as training in 
order to improve short-term profit  at the expense of the long-term. 
Assessing the contribution of individual board members will be 
difficult because it may be difficult  to identify the impact that an 
individual has had on the running of the company. Measuring 
contribution effectively requires speculation about the performance 
that would have occurred in the director’s absence. That would 
probably involve discussion with the di rector, who is hardly objective 
under these circumstances. 
One problem with basing the bonus  on the contribution of each 
individual director is that the ex ecutive board members may start to 
compete with one another fo r the sake of maxi mising their bonus. 
Individual directors may feel that it  is in their personal interests to 
withhold information from the re st of the board and to avoid 
discussing ideas in case they do not receive full credit for their 
contribution. 
The shareholders may feel that t he system is a cynical attempt to 
extract more pay from the co mpany. The remuneration committee 
members will have to ensure that they do everything they can to 
reassure the shareholders that any bonus payments are deserved 
otherwise the board as a whole may lose the shareholders’ 
confidence. 
There is even a danger that the s hareholders may start to lose 
confidence in the ability of t he non-executives to act in an 
independent manner in their contri bution to the oversight of the 
company.

326  
 The directors will have to receive a realistic reward for their 
services; otherwise they may feel  disillusioned and demotivated. It 
probably makes very little difference that they are well paid in relation to P’s other managers and employees. They are likely to measure their rewards in relation to the directors of other quoted 
 
 Report 
To:  Chair 
Subject:  Corporate governance  
You have asked me to report on the key reforms in corporate governance 
and risk management that have taken pl ace recently which affect JKL 
and to recommend (with reasons), which (if any), of thos e reforms should 
be adopted by JKL. 
This report addresses the following issues: corporate governance, in 
particular non-executive director s and the audit committee; and risk 
management, internal control and in ternal audit. The recommendations 
are contained at the end of this report. 
Corporate governance in most of the western world is founded on the 
principle of enhancing shareholder value.  Major corporate collapses have 
been a feature of recent business history in the United Kingdom and 
elsewhere, and the publicity surrounding these collapses and the actions of institutional investors have raised corporate governance to 
prominence. The emergence of cor porate governance can be seen as a 
result of regulatory action in response to past failings; changing financial markets including the desire of institut ional investors to be more active 
and the dependence of an ageing population on pensions and savings which have been affected by declining confidence in stock markets. 
The main principles of corporate gover nance are in relation to directors, 
the remuneration of dire ctors, accountability and audit, relations with 
shareholders, and in particular wit h institutional shareholders and 
disclosure . The ‘comply or explain’ approac h requires listed companies to 
disclose how they have applied the principles in the Corporate 
Governance Code and to either comply  with the Code or to explain any 
departure from it. Under the C ode, board effectiveness can be 
summarised as the effective splitting of the roles of chair and chief effective; the role of non-executive di rectors and the role of remuneration, 
nomination and audit committees of the boar d. In JKL, the roles of chair 
and chief executive are split but JKL does not comply with recommendations in relation to non- executive directors or the audit 
committee. I shall deal with each of these in turn.

Chapter 5 
 327 
 Non-executive directors 
The board should include a balance of executive and non-executive 
directors, and in particular ‘in dependent’ non-executives. It is 
recommended that a smaller company  (outside FTSE 350) should have 
at least two independent non-execut ive directors. The notion of 
independence precludes non-executives  from having recently been an 
employee of, or in a material bus iness relationship with the company; 
receiving performance-related pay or  a pension; having family ties or 
cross directorships; representing a substantial shareholder, or having 
been a board member for an ex cessive period of time. 
Non-executive directors should be  independent in judgement and have 
an enquiring mind. They need to be a ccepted by management as able to 
make a contribution; to be well informed about the company and its 
environment and be able to have a command of the issues facing the business. Non-executives need to insi st that information provided by 
management is sufficient, accu rate, clear and timely. 
There should be a formal, rigorous  and transparent procedure for the 
appointment of new director s to the board. Levels of remuneration should 
be sufficient to attract,  retain and motivate directors of the quality 
required to run the company successf ully. All directors should receive 
induction on joining the board and s hould regularly update and refresh 
their skills and knowledge. The board should undertake a formal and 
rigorous annual evaluation of its own performance and that of its 
committees and individual directors. 
The Code states that t he board of smaller companies (below FTSE350) 
should establish an audit committee of at least two members, who should 
all be independent non-executive direct ors. At least one member of the 
audit committee should have recent and relevant financial experience. 
The audit committee has a role to act independently of management to 
ensure that the interests of shareholder s are properly protected in relation 
to financial reporting and internal  control. The main role and 
responsibilities of the audit commi ttee should include monitoring the 
integrity of the company ’s financial statements; reviewing the company’s 
internal control and risk management syst ems; monitoring and reviewing 
the effectiveness of the internal a udit function; making recommendations 
to the board for the appointment, re -appointment and removal of the 
external auditor and approvi ng the terms of engagement and 
remuneration of the external audi tor, including the supply of any non-
audit services; reviewing and moni toring the external auditor’s 
independence and objectivity and the effe ctiveness of the audit process. 
There should be no less than three audit committee meetings each year 
held to coincide with key dates in the financial reporting and audit cycle 
as well as main board meetings. JKL’ s audit committees should have, as 
part of its terms of reference, the responsibility to assess risk management and internal control within JK L. Each of these is considered 
in turn.

328  
 Risk management 
Risk management is the process by which organisations systematically 
identify, evaluate, treat and repor t risk with the goal of achieving 
organisational objectives. Risk managem ent increases the probability of 
success and reduces both the probability of  failure and the uncertainty of 
achieving the organisation’s objectives. 
A risk management strategy should include the risk profile of the 
organisation that is the level of risk it finds acceptable; the risk 
assessment and evaluation processes the organisation practices; the 
preferred options for risk treatment; the responsibility for risk management and the reporting and m onitoring processes that are 
required. Resources (money, experienc e and information, etc.) need to 
be allocated to risk management. 
The benefits of effective risk ma nagement include being seen as 
profitable and successful with fewer su rprises, predictable results without 
profit warnings or reporting major ex ceptional items. Being seen to have 
a system of risk management is also likely to be reflected in reputation 
and credit rating. 
JKL has no clear risk management syst em in place and while the board 
considers risk, it does not do so syst ematically. Consequently, there may 
be risks faced by JKL that it has not recognised. 
Internal control 
The Code incorporates what is know n as the Turnbull Guidance, which 
recommends the adoption by a company’s board of a risk-based approach to establishing a sound system of internal control and reviewing 
The board should acknowledge that it is responsible for the company’s 
system of internal control and for re viewing its effectiveness. It should 
also explain that the system is designed to manage rather than eliminate 
the risk of failure to achieve busin ess objectives, and can only provide 
reasonable but not absolute assurance against material mis-statement or 
loss. The board’s statement on internal  control should disclose that there 
is an ongoing process for identifyi ng, evaluating and managing the 
significant risks faced by the company, that it has been in place for the year and up to the date of approval of the annual report and accounts, and that it has been regularly reviewed  by the board and conforms to the 
Turnbull Guidance.

Chapter 5 
 329 
 Reviewing the effectiveness of inte rnal control is one of the board’s 
responsibilities, which needs to be carried out on a continuous basis. The Board should regularly review reports  on internal control – both financial 
and non-financial – for the purpose of  making its public statement on 
internal control. When reviewing managem ent reports on internal control, 
the board should consider the significant risks and assess how they have been identified, evaluated and managed;  assess the effectiveness of 
internal controls in managing the si gnificant risks, having regard to any 
significant weaknesses in internal c ontrol; consider whether necessary 
actions are being taken promptly  to remedy any weaknesses and 
consider whether the findings indi cate a need for more exhaustive 
monitoring of the system of internal control. 
For risk management and for the board’ s assessment of the adequacy or 
otherwise of internal control, an in ternal audit function should be 
Internal audit is an independent apprai sal function established within an 
organisation to examine and evaluate its activities and designed to add 
value and improve an organisation’s operat ions. The main role of internal 
audit is to provide assurance that  the main business risks are being 
managed and that internal contro ls are operating effectively. 
The need for an internal audit function will depend on the scale, diversity 
and complexity of business activities and a comparison of costs and benefits of an internal audit functi on. Companies that do not have an 
internal audit function should revi ew the need for one on an annual basis. 
Changes in the external  environment, organisati onal restructuring or 
adverse trends evident from monito ring internal control systems should 
be considered as part of this review. An internal audit may be carried out 
by staff employed by the company or be outsourced to a third party. 
In the absence of an internal audit  function, management needs to apply 
other monitoring processes in order to  assure itself and the board that the 
system of internal control is functioni ng effectively. The board will need to 
assess whether those processes provide sufficient and objective 
assurance. 
Recommendations 
JKL’s single non-executive director is  not, under the Code, considered to 
be independent. It is recommended t hat JKL appoint two independent 
non-executive direct ors to the board. 
In JKL, the audit committee currently c onsists of the chair, non-executive 
director and finance director. It is recommended that the two newly 
appointed independent non- executives (recommended above) be 
appointed and that both the chair and the finance director attend, but not 
be members of, the audit committee.

330  
 The audit committee should review  JKL’s risk management system and 
put in place an appropriate policy and syst em that reflects the risks faced. 
JKL’s internal controls appear to be adequate based on the external 
auditor’s report; however, it is recomm ended that JKL’s boar d specifically 
consider the adequacy of the exter nal audit report in  reviewing the 
effectiveness of internal control in JKL. 
The audit committee should also c onsider the outcomes of the 
recommended risk management system before accepting the adequacy of internal controls. 
This report does not recommend the appointment of internal auditors 
separate to the external audit func tion. However, once the board has 
implemented a risk management system and assessed the adequacy of internal controls, the va lue of internal audit func tion should be reassessed. 
 
To:  The Board  
Subject:  Corporate governance and ethics  
(a) Good corporate gover nance requires that a company be headed by 
an effective board with a clear divi sion of responsibilities between 
running the board and running the company /charity with no individual having unfettered decision-making power. There should be a balance of executive and non-ex ecutive directors so that no 
individual or group can dominate the board. There should be a 
formal and rigorous process for t he appointment of directors who 
should receive induction training. Information should be supplied in a timely manner to board members so that the board can discharge 
its duties. The board should then evaluate its performance both 
individually and collectively each year. 
These principles do not seem to have been applied at HFD as it is 
dominated by the chief executiv e who also acts as chair and 
appears to dominate the board th rough his appointment of non-
executive directors and his contro l over the agenda.  To meet the 
principles of good corporate governance, HFD should: 
– Separate the roles of chief ex ecutive and chair with the chair 
being a non-executive director. 
– Ensure that all directors ar e independent of influence by the 
chief executive. Positions should be advertised with interviews being conducted, perhaps initia lly by an independent person. 
Appointments should be for a defined period, after which directors should stand for re-election.

Chapter 5 
 331 
 – Provide induction training to  new board members in the goals 
and operations of the charity. 
– Annually evaluate the performanc e of each director and the 
board as a whole. 
– Accountability and audit pr inciples of good corporate 
governance require that a board should be able to present a 
balanced and understandable asse ssment of the company’s 
position and prospects, should maintain a sound system of 
internal control and maintain an appropriate relationship with 
the company’s auditors. 
– HFD’s Board does not seem to be able to make a balanced 
and understandable assessment of the company’s position 
and prospects, given the narro w confines of what the 
CEO/Chair allows it. The CEOs relationship with the external 
auditors is not appropriate 
– To meet the principles of  good corporate governance, HFD 
should: 
– Set an agenda for board meetings that encompasses a 
wide variety of strategic matters including the charity’s strategy, operations, risk m anagement, internal controls 
and not be limited to financial reports and proposals for funding. 
– Consider meeting more frequently than quarterly. – Obtain an independent assessment of the company’s 
internal controls by appoi nting a firm to act as 
(outsourced) internal auditor. 
– Affirm the reporting relationship of the external auditors to 
the board as a whole, and not to the CEO. The external auditors may need to be changed if they are unwilling to accept this changed relationship. 
Although it is good practice, it is not necessary to have a separate audit 
committee, but if not, the functi ons of the audit committee should be 
carried out by the full board itself. 
The disclosure principle requires that  a company’s annual report contains 
a high level statement of  how the board operates and the decisions taken 
by the board and management, details of board members, meetings, 
performance evaluation, etc. HFD s hould provide adequate disclosure of 
board functioning in its annual report to  make this aspect of the charity 
transparent.

332  
 (b) CIMA’s Code of Ethics for Pr ofessional Accountants makes clear 
that an accountant’s responsibility is more than satisfying the needs 
of a client, he/she must also act in the public interest. It is irrelevant 
whether or not the CIMA member is  paid for his/her services, which 
are still expected to comply with the ethical principles. 
There are 5 fundamental principles in  the Code of Ethics: integrity, 
objectivity, professional compet ence and due care, confidentiality 
and professional behaviour. 
Of particular relevance to HFD ar e objectivity, and professional 
competence and due care. Objectivity may be impeded due to bias because of his/her appointment by the CEO or the influence of the 
CEO or other persons on the board who may align themselves with 
the CEO. 
The demands of professional co mpetence and due care means that 
the accountant must look beyon d the narrow focus on financial 
statements set by the CEO to a broader perspective including non-
financial risks (mainly in relation to  the charities operation) and the 
adequacy of internal controls (as it is  insufficient to rely wholly on 
the external auditor’s a nnual management letter). 
The conceptual framework underlyi ng CIMA’s ethical principles 
requires accountants to risk manage t heir own position in relation to 
the work they are performing and in  so doing to identify, evaluate 
and mitigate any risks they face. The main risks faced by an 
accountant include those relating to self-interested behaviour, self-
review, advocacy, familiarity and intimidation. 
The major threats faced in rela tion to HFD are familiarity and 
intimidation. The accountant has been appointed to the board as a 
result of some prior business rela tionship which may affect his/her 
objectivity. The CEO/Chair of HFD also appears to be a dominating 
individual and the accountant may be intimidated by this individual, 
resulting in the accountant’s vi ews not being presented accurately 
and/or forcefully. 
The accountant as board member needs to identify and evaluate the 
risks of familiarity and/or intimidati on that s/he faces, and ensure 
that s/he takes appropriate ac tion (ultimately resignation
 from the 
board) to maintain his/her independence and objectivity.  
 
may, in fact, have the opposite effe ct due to the management time and 
additional staff required by  corporate governance codes.

Chapter 5 
 333 
 To:  Carlos Smith  
From:  Anne Accountant  
Subject:  Review of corporat e governance arrangements 
Dear Mr Smith, Thank you for your email. I have looked through the information you 
Most of the directors in ADF are older  men from country F. There is only 
Having a diverse board can ensure t hat the company has  a wide range of 
experience to draw on  when making decisions. 
other countries or with experience of these foreign markets, the company 
would be far better placed to achieve this growth. 
All the non–executive direct ors are linked to the Chairman. This makes it 
This could lead them to reject acc eptable projects, such as the proposed 
Weak internal audit 
The fact that the directors allow AD F to have such an inadequate internal 
audit function indicates an alarming lack of  control. If they are unable to 
rely fully on the accounts produced, they  may find it difficult to implement 
sensible strategies in the future. 
Overall 
The ultimate goal of corporate gover nance is to provide investors with 
damage ADF's reputation with investors.  This may harm its share price 
and make it harder for the company to  raise much needed finance in the 
future – which is likely to be impor tant if it is planning overseas 
I hope this helps. If you need any further information, please let me know. 
Kind regards Anne

335 
A3. Ways of managing risk. (a) Discuss roles and 
responsibilities. 
C1. Internal controls systems (a) Discuss roles and 
responsibilities for internal controls 
(b) Discuss the purpose of 
internal control 
(c) Analyse the features of 
internal control systems 
C2. Recommend internal controls for risk management (a) Discuss the COSO internal 
control framework. 
(b) Assess control weakness (c) Assess compliance 
failures 
(d) Recommend internal 
management Chapter 
6

336  
 
1 Internal control systems 
 In order to manage their risks, busine sses need to set up internal control 
systems. 
 These internal controls apply across all parts and activities of a business . 
 
There are a number of different definitions  of internal control systems, but all 
have similar features . One definition is: 
'The whole system of controls, financia l and otherwise, established by the 
management in order to carry out t he business of the enterprise in an 
orderly and efficient manner, ensure adherence to management policies, 
safeguard the assets, prevent and detec t fraud and error and secure as far 
as possible the completeness and accuracy of the records.' 
An internal control system can be thought  of as a system for management to 
control certain risks and therefore help businesses achieve their objectives. 
  Internal controls and risk management 
 Internal controls can be considered as part of the risk reduction method of 
responding to risk. 
 The need for a robust system of inte rnal control and risk management is 
seen as a major element of  good corporate governance. 
 In the UK for example, the Corp orate Governance Code requires the 
board of directors to review the syst em of internal control in their 
organisation, and satisfy themselves t hat a suitable system is in place.

Chapter 6 
 337 
 Objectives of internal control 
 A definition of an internal  control system included: 
Definition Commentary 
...the orderly and 
efficient conduct of 
its business, including 
adherence to 
internal policies' There will be systems in place from ensuring 
that all transactions are recorded (so the business is conducted in an orderly manner) to following policies such as provision of good customer service. 
...the safeguarding of assets' Assets, in this case, include buildings, cars, 
cash etc. (e.g. those things that can be touched), through to other assets including the intellectual property of the company (e.g. those 
things which cannot be touched but are still an asset of the business). 
...the prevention and 
detection of fraud 
and error' This will include fraud and error at the 
operational level through to the strategic level 
(e.g. off balance sheet fi nance or the adoption of 
incorrect or suspect accounting policies (think of Enron). 
...the accuracy and 
completeness of the 
accounting records and ...' Again, ensuring that all transactions are 
recorded – so liabilities are not 'hidden' and assets are not overstated. 
...the timely 
preparation 
of financial 
information.' Reporting deadlines in many jurisdictions are 
quite strict (60 days in the US for some reports) 
hence the need to ensure information is available to produce those reports in a timely fashion. 
The main point to note here is that the internal control system encompasses the whole business,  not simply the financial records. 
2 The Turnbull Report 
In October 2005, the Financ ial Reporting Council issued  'Internal Control –
Revised Guidance for Directors on the Combined Code', known more commonly as the Turnbull Report (origi nally published in 1999). The report 
covered the importance of internal contro l in companies. An extract is detailed 
below. 
The importance of internal c ontrol and risk management 
(1) A company's system of internal c ontrol has a key role in the management 
of risks that are significant to the fu lfilment of its busi ness objectives. A 
sound system of internal control contributes to safeguarding the shareholders' investment and the company's assets.

338  
(2) Internal control facilitates the effectiveness and efficiency of operations, 
helps ensure the reliability of inte rnal and external reporting and assists 
compliance with laws and regulations. 
(3) Effective financial controls, including the maintenance of proper 
accounting records, are an important elem ent of internal control. They help 
ensure that the company is not unnec essarily exposed to avoidable 
financial risks and that financial information used within the business and for publication is reliable. They also  contribute to the safeguarding of 
assets, including the prevent ion and detection of fraud. 
(4) A company's objectives, its intern al organisation and the environment in 
which it operates are cont inually evolving and, as a result, the risks it faces 
are continually changing. A sound system  of internal control therefore 
depends on a thorough and regular evaluati on of the nature and extent of 
the risks to which the company is expos ed. Since profits are, in part, the 
reward for successful risk-taking in business, the purpose of internal 
control is to help manage and control risk appropriately rather than to 
eliminate it...... 
Responsibilities 
(15) The board of directors is responsible  for the company's system of internal 
control. It should set appropriate po licies on internal control and seek 
regular reassurance that will enable it to satisfy itself that the system is 
functioning effectively. The board must  further ensure th at the system of 
internal control is effective in managi ng those risks in the manner which it 
has approved... 
(16) All employees have some responsibility for internal control as part of their 
accountability for achieving objectives.  They, collectively, should have the 
necessary knowledge, skills, informa tion, and authority to establish, 
operate and monitor the system of inte rnal control. This will require an 
understanding of the company , its objectives, the industries and markets 
in which it operates, and the risks it faces. 
Elements of a sound system of internal control 
(19) An internal control system encom passes the policies, processes, tasks, 
behaviours and other aspec ts of a company t hat, taken together: 
– facilitate its effective and effici ent operation by enabling it to respond 
appropriately to significant bus iness, operational, financial, 
compliance and other risks to achieving the company's objectives. This includes the safeguarding of assets from inappropriate use or 
from loss and fraud and ensuring that  liabilities are identified and 
managed; 
– help ensure the quality of internal and external reporting. This 
requires the maintenance of pr oper records and processes that 
generate a flow of timely, relev ant and reliable information from 
within and outside the organisation; 
– help ensure compliance with applic able laws and regulations, and 
also with internal policies with re spect to the conduct of business.

Chapter 6 
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(20) A company's system of internal cont rol will reflect its control environment 
which encompasses its organisational st ructure. The system will include: 
– control activities; – information and communications processes; and – processes for monitoring the cont inuing effectiveness of the system 
of internal control. 
(21) The system of internal control should: 
– be embedded in the operations of the company and form part of its 
culture; 
– be capable of responding quickly to  evolving risks to the business 
arising from factors within t he company and to changes in the 
business environment; and 
– include procedures for reporting imm ediately to appropriate levels of 
management any significant control failings or weaknesses that are 
identified together with details of corrective action being undertaken. 
(22) A sound system of internal contro l reduces, but cannot eliminate, the 
possibility of poor judgement in dec ision-making; human error; control 
processes being deliberately circum vented by employees and others; 
management overriding controls; and the occurrence of unforeseeable 
(23) A sound system of internal control therefore provides reasonable, but not 
absolute, assurance that a company will not be hindered in achieving its 
business objectives, or in the orde rly and legitimate conduct of its 
business, by circumstances which may reasonably be foreseen. A system of internal control cannot, however , provide protection with certainty 
against a company failing to meet its business objectives or all material errors, losses, fraud, or breac hes of laws or regulations. 
('Internal Control – Revised Guid ance for Directors on the Combined  
Code' – Financial Reporting Council – October 2005) 
3 Features of internal control systems 
 COSO model of internal control 
In 1992 COSO (Committee of Sponsoring Organisations) stated that effective 
internal control systems consist of five integrated elements. 
Control environment 
The control environment can be thought of as management's attitude, actions  
and awareness  of the need for internal controls. 
If senior management do not care about inter nal controls and feel that it is not 
worthwhile introducing internal contro ls then the contro l system will be weak.

340  
Management can try to summarise their commitment to controls in a number of 
ways: 
 Behave with integrity and ethics (c orporate governance is covered more 
thoroughly in Chapter 5). 
 Maintain an appropriate culture in the organisation. 
 Set up a good structure – for exam ple, an independent internal audit 
function, and ensure s egregation of duties. 
 Set proper author isation limits. 
 Employ appropriately qualified staff and conduct staff training. 
When auditors assess the control system s of business for the audit, if the 
environment is poor they will place no reliance on any detailed control 
Risk assessment 
Risk assessment (as discussed in chapter 2) feeds directly into the internal 
control system. A risk assessment must  be performed and should identify: 
 Controllable risks  – for these risks, internal  control procedures can be 
 Uncontrollable risks  – for these risks, the company may be able to 
minimise the risk in other ways outsi de the internal control environment. 
Uncontrollable risks could be risks that are caused by the external environment that the company operates in. For example, the best internal 
control processes in the world cannot reduce the risk of inflation or the 
economy going into recession. 
Control activities 
Once controllable risks have been identified,  specific control activities can be 
undertaken to reduce those risks. There is  a huge variety of control activities 
that companies can adopt at all levels  of management and in all parts of the 
Due to the need to adapt and change contro l systems, most companies use a 
variety of different control processes to  ensure that the business achieves its 
The typical processes that could be used are: 
 having a defined organisation structure . All staff need to understand 
how their role fits in with the rest  of the organisation to aid their 
understanding of the job. They need to know who to report to on a daily 
basis and also points of contact for when they need to deal with other departments or divisions; 
 having contracts of employment  with individuals at all levels. Contracts 
of employment guide an employee’ s behaviour. Typically, they include 
hours of work, job title, salary and pension entitlement s, holiday, data 
protection rules through to codes of  dress. A major control within the 
contract of employment is the section on disciplinary action which outlines 
what constitutes a disciplinary procedur e and the resulting event which will 
usually include dismissal;

Chapter 6 
 341 
 establishing policies , and subsequently procedures  to ensure the policies 
are followed. Organisations typically have policies on health and safety, 
travel expenses, dignity at work, et c. Procedures might include the setting 
up of an audit department to ensure t hat the policies are adhered to; 
 setting up a suitable discipline and reward system.  Discipline has 
already been mentioned, how ever, rewards can also control an individual’s 
behaviour. If an employee knows that  there is a month-end bonus for 
meeting a particular sales target then most , if not all, of their actions will be 
focussed on that outcome. The objective is performance and conformance. However, if rewards ar e not structured correctly they can 
lead to 'dysfunctional behaviour' which is covered later in the chapter; 
 ensuring a system of performance appraisal and feedback . Appraisals 
are usually at least an annual even t (perhaps more often whilst an 
employee is being trained). During the appraisal the manager and 
employee should have an opportunity to discuss whether the job is being 
performed satisfactorily, whether prev ious objectives have been met, and 
what any future objectives are. An employee’s behaviour is controlled via an appraisal since they know that their manager will be watching their 
work in order that a discussion can be held. It is an opportunity for the manager and employee to feed back on any issues that concern them or 
activities which may have been performed well. 
Information and communication 
In order for managers to oper ate the internal contro ls, they need information 
and therefore a good information system must be set up. The information 
provided to managers must be: 
 Timely. 
 Accurate (and therefore reliable). 
 Understandable. 
 Relevant to the actions being taken. 
Computer systems have led to increased quality of information being provided 
to managers but the systems must be integr ated into the business strategies if 
they are to provi de what managers need. 
Information systems and information managem ent are a specific part of this 
syllabus because they are so important to the successful r unning and control of 
business. These topics are covered in more detail in other chapters. 
The company may have produced a very good internal control system but it 
must be monitored. If the system is not monitored it  will be very difficult to 
assess whether it is out of contro l and needs amendment. Internal control 
systems are also dynamic in that they need to evolve over time as the business 
evolves. 
The internal audit function is often the key monitor of the internal control 
system. Internal auditors will examine the controls and control system, identify 
where controls have failed so  that the failures can be re ctified, and also make 
recommendations to management for new  and improved systems. More will be 
seen in later chapters on internal audit.

342  
Updates to the framework in 2013 
In 2013 COSO  updated the framework by adding 17 principles.  These 
principles sit within the five com ponents to help explain the fundamentals 
behind them and to help make the fr amework more principles-based.  
COSO have emphasised that the additional detail is not m eant to make it a tick 
list, but more to make the components cl earer and therefore easier to apply. 
It is intended to apply to all types of or ganisation, from profit seeking, to 
governmental and not for profit . It also, in line with t he external changes over 
the last 20 years, increases focu s on non-financial considerations and 
recognises the increased use of technology. 
 
 Components of an internal contro l system including principles 
 COSO identify five components of an effective control system. 
(1) Control environment  
This is sometimes referred to as  the ‘tone at the top’ of the 
organisation. It describes the ethi cs and culture of the organisation, 
which provide a framework within wh ich other aspects of internal 
control operate. The control envir onment is set by the tone of 
management, its philosophy and m anagement style, the way in 
which authority is delegated, the way in which st aff are organised 
and developed, and the commitment of  the board of directors. 
The control environment has been defined by the Institute of Internal 
Auditors as: ‘The attitude and ac tions of the board and management 
regarding the significance of cont rol within the organisation. The 
control environment provides the discipline and structure for the 
achievement of the primary objecti ves of the system of internal 
control. 
The principles that underpin the control environment component are: 
– The organisation shows a commitment to ethical values. – The board has appropriate expertise and oversees the five 
competencies. 
– Management must establish an appropriate organisational 
structure to help achiev ement of the objectives 
– Human resource policies and practices to help attract, develop 
and retain suitable talent. 
– Accountability of employees for their areas of responsibility.

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 343 
 (2) Risk assessment  
There is a connection between the obj ectives of an organisation and 
the risks to which it is exposed. In order to make an assessment of 
risks, objectives for the organisati on must be established. Having 
established the objectives, the ri sks involved in achieving those 
objectives should be identified and assessed, and this assessment 
should form the basis for deciding how the risks should be managed. 
The risk assessment should be conducted for each business within 
the organisation, and should consider, for example: 
– internal factors,  such as the complexity of the organisation, 
organisational changes, staff turnover leve ls, and the quality of 
staff 
– external factors,  such as changes in the industry and 
economic conditions, technological changes, and so on. 
The risk assessment process should also distinguish between: – risks that are controllable:  management should decide 
whether to accept the risk, or to  take measures to control or 
reduce the risk 
– risks that are not controllable:  management should decide 
whether to accept the risk, or whether to withdraw partially or 
entirely from the business activi ty, so as to avoid the risk 
The principles that underpin t he risk assessment component are: 
– Clear objectives to allow ri sk identification and assessment 
– That risk identification and analysis does take place across the 
entity. 
– The potential for fraud arising in pursuit of the stated objectives 
must be considered. 
– The internal controls system mu st be reviewed for changes in 
the external environment. 
(3) Control activities  
These are policies and procedures that ensure that  the decisions 
and instructions of management are carried out. Control activities 
occur at all levels within an organisation, and include authorisations, verifications, reconciliations, approvals, segregation of duties, 
performance reviews and asset secu rity measures. These control 
activities are commonly referred to as internal controls. 
The principles that underpin the c ontrol activities component are: 
– Select of appropriate controls  to mitigate the risks to the 
achievement of objectives. 
– Specifically controls over technology are included. – Policies and procedures est ablish how the controls are 
implemented.

344  
 (4) Information and communication 
An organisation must gather informa tion and communicate it to the 
right people so that they can ca rry out their responsibilities. 
Managers need both internal and external information to make informed business decisions and to report externally. The quality of 
information systems is a key factor in this aspect of internal control. 
The principles that underpin t he Information and communication 
component are: 
– Appropriate information is generated and used to assess 
controls 
– The information is communicated appropriately internally to 
support the internal control process. 
– The information is communicated to appropriate external 
parties. 
(5) Monitoring  
The internal control system must be monitored. This element of an 
internal control system is associat ed with internal audit, as well as 
general supervision. It is important t hat deficiencies in the internal 
control system should be identif ied and reported up to senior 
management and the board of directors. 
The principles that underpin the monitoring component are: 
– Appropriate evaluations of the controls are carried out. 
– Any issues with controls ar e communicated to appropriate 
people (including the board where necessary). 
 
 COSO stated that effective inter nal control systems consist of five 
integrated elements. These included:  
Select ALL that apply A Risk B Control activities C Control environment D Monitoring E Information and communication

Chapter 6 
 345 
 COSO categorises objective setting into four categories. These do 
include:  
Select ALL that apply A Strategic B Management C Operational D Reporting 
 
 Five elements make up an effe ctive internal control system.  
Which of the following is regarded as the most important? 
A Risk assessment 
B Monitoring C Information and communication D Control environment 
Operational features of internal control systems 
There are considered to be three featur es of a sound internal control system:

346  
 More on sound internal control systems 
 The Turnbull guidance described th ree features of a sound internal 
control system: 
 Firstly, the principles of  internal control should be embedded  within 
the organisation’s structures, proc edures and culture. Internal 
control should not be seen as a st and-alone set of activities and by 
embedding it into the fabric of the organisation’s infrastructure, 
awareness of internal control iss ues becomes everybody’s business 
and this contributes to effectiveness. 
 Secondly, internal control systems should be capable of 
responding quickly  to evolving risks to the business arising from 
factors within the company and to changes in the business environment. The speed of reaction is an important feature of 
almost all control systems. An y change in the risk profile or 
environment of the organisation wil l necessitate a change in the 
system and a failure or slowness to respond may increase the vulnerability to internal or external trauma. 
 Thirdly, sound internal control systems include procedures for 
reporting immediately, to appropriate  levels of management, any 
significant control failings or weakne sses that are identified, together 
with details of corrective action being undertaken. Information flows 
to relevant levels of managem ent, capable and empowered to act 
on the information, are essential in  internal control systems. Any 
failure, frustration, distortion or obfuscation of information flows can 
compromise the system. For this reason, formal and relatively rigorous information channels are o ften instituted in organisations 
seeking to maximise the effectiveness of their internal control systems. 
 
 J Company is suffering from working capital problems and the directors 
wish to make several changes to internal controls over purchases, inventory and sales in order  to try and improve cash flow. They feel that 
currently there is no real  commitment or belief in the internal controls 
system. The sales director keeps high levels of finished goods on site to 
give customers plenty of choice and the purchasing manager keeps high 
levels of raw materials as he is afraid of shortages. Each blames the other for J Company’s current probl ems. Suppliers are paid within 25 
days despite agreed terms being 30 days because the CEO wishes to maintain good relationships with them. Customers are encouraged to 
take credit with J Company in order to increase sales. Staff are generally 
well paid (with sales related bonus es) and staff turnover is low. J 
Company is seen as a good place to work and management are respected.

Chapter 6 
 347 
 Which of the following are likely to be reasons that embedding the 
principles of internal controls in J’s culture will be difficult? 
A There is a blame culture wit h the sales and purchasing managers 
each feeling the other is responsible for cash flow problems. 
B Senior management are not fully committed to solving the working 
capital problems. 
C Sales related bonuses encourage staf f to think of increasing sales 
rather than whether the debt is recoverable. 
D Staff turnover is low meaning  staff will be set in their ways. 
E Staff are well paid and happy in the workplace. 
4 The detail of controls 
As discussed in the COSO model of internal  control, specific control activities 
will be undertaken to reduce risks. Some examples of organisational controls 
include: 
Segregation of duties 
Most accounting transactions can be br oken down into three separate duties: 
authorisation or initiation of  the transaction, the handling of the asset that is the 
subject of the transaction, and the recordin g of the transaction. This reduces the 
risk of fraud and the risk of error. 
For example, in the purchases system, the same individual should not have 
responsibility for: 
 Making a purchase; 
 Making the payment; 
 Recording the purchase and payment in the accounts. 
If one individual had responsibility for all of  these activities they could record 
fictitious purchases (for personal use) and pay themselves for transactions that 
had not occurred, which is fraudulent. 
Also segregation of duties makes it easier to spot unintentional mistakes. 
Physical controls 
Physical controls are meas ures and procedures to protect physical assets 
against theft or unauthorised acce ss and use. They include: 
 using a safe to hold cash and valuable documents; 
 using a secure entry system to buildings or areas within; 
 dual custody of valuable assets, so that two people are required to obtain 
access; 
 periodic inventory checks; 
 hiring security guards and usi ng closed-circuit TV cameras.

348  
Authorisation and approval 
Authorisation and approval c ontrols are established to ensure that a transaction 
must not proceed unless an authorised in dividual has given his approval, 
possibly in writing. 
For spending transactions , an organisation might establish authorisation 
limits, whereby an individual manager is aut horised to approve certain types of 
transaction up to a certain maximum value. 
Management control 
Controls are exercised by management on t he basis of information they receive. 
 Top level reviews.  The board of directors or  senior management might 
call for a performance report on the pr ogress of the organisation towards 
its goals. For example, senior managem ent might review a report on the 
progress of the organisation toward  achieving its budget targets. 
Questions should be asked by senior  management, prompting responses 
at lower management levels. In this way, top level reviews are a control activity. 
 Activity controls.  At departmental or divisi onal level, management should 
receive reports that review performance or highlight exceptions. Functional 
reviews should be more fr equent than top-level reviews, on a daily, weekly 
or monthly basis. As with top-level re views, questions should be asked by 
management that initiate control acti vity. An example of control by 
management is the provision of regul ar performance reports, such as 
variance reports, comparing actual  results with a target or budget. 
Supervision 
Supervision is oversight of the work of other individuals, by someone in a 
position of responsibility. Supervisory cont rols help to ensure that individuals do 
the tasks they are required to and perform them properly. 
Organisation controls refer to the c ontrols provided by the organisation’s 
structure, such as: 
 the separation of an organisation’ s activities and operations into 
departments or responsibility cent res, with a clear division of 
responsibilities 
 delegating authority within the organisation 
 establishing reporting lines within the organisation 
 co-ordinating the activities of di fferent departments or  groups, e.g. by 
setting up committees or project teams.

Chapter 6 
 349 
Arithmetic and accounting 
Controls are provided by: 
 recording transactions properly in the accounting system 
 being able to trace each individu al transaction through the accounting 
records 
 checking arithmetical calculations, such as double-checking the figures in 
an invoice before sending it to a customer  (sales invoice) or approving it 
for payment (purchase invoice) to make sure that they are correct. 
Personnel controls 
Controls should be applied to the select ion and training of employees, to make 
sure that: suitable individua ls are appointed to positions  within the organisation; 
individuals should have the appropriate  personal qualities, experience and 
qualifications where requir ed; individuals are given suitable induction and 
training , to ensure that they carry out t heir tasks efficiently and effectively. 
Staff should also be given training  in the purpose of controls and the need to 
apply them. Specific training about contro ls should help to increase employee 
awareness and understanding of the risks of  failing to apply them properly. 
Remember that any controls recommended in the exam should cost less than 
the benefits  they bring. For example, you w ould not recommend the hiring of a 
security guard at £35,000 per annum to watch over the petty cash tin which held 
£100. 
Mnemonic 
The above controls can be remem bered using the m nemonic SOAPSPAM 
Supervision, Organisation, Arithmetic and accounting, Personnel, Segregation 
of duties, Physical, Authorisation and approval and Management.  
 
 Test your understanding 5 – Ty pes of control (Integration) 
 Recommend the types of control that  a company could put in place for 
the following risks: 
(1) Shoplifting from a retail business. (2) Goods being sent to customers but not invoiced. (3) Poor quality supplies being purchased. (4) Incorrect prices being charged.

350  
 The internal control whereby an accounting transaction is broken into 
three separate tasks – initiation, handl ing and reporting, and dealt with by 
three different staff, is called: 
A Authorisation and approval B Supervision C Segregation of duties D Arithmetic and accounting 
 
 The risk that orders could be taken from  a customer that is unable to pay 
or unlikely to pay for a long time could be controlled by: 
A Checking that all goods delivered  notes are matched to an invoice 
B All new customers being subject to a credit check C Picking goods for despatch by usi ng a copy of the customer’s order 
D Customer statem ents being sent out 
 
 X plc has been criticised for its apparent  lack of internal control. Staff 
behaviour is considered to be unprofessional, management don’t appear 
to reprimand staff for this (often because their allocated staff changes 
frequently) and there is no annual asse ssment or feedba ck on staff.  
Which of the following controls  should help to reduce these 
problems? 
A Organisation structure B Contracts of employment C Policies and procedures D Discipline and rewards E Performance appraisals 
 
 The COSO framework consists of  8 interrelated components which 
include:  
Select ALL that apply A External environment B Risk assessment C Control activities 
D Monitoring

Chapter 6 
 351 
 Classification of controls 
Controls can be understood as falling within three broad categories: 
 Financial controls; 
 Non-financial quantitative controls; 
 Non-financial qualitative controls. 
Financial controls 
 These controls express financ ial targets and spending limits. 
 Examples include 
– budgetary control 
– controls over sales, purchases, payroll and inventory cycles. 
 
 Sales cycle 
 Objectives of controls 
The objectives of controls in t he sales cycle are to ensure that: 
 sales are made to valid customers 
 sales are recorded accurately 
 all sales are recorded 
 cash is collected within a reasonable period. 
Below is a summary of the sales cycl e, showing examples of possible 
risks and the related controls: 
Process Risks Control procedures 
Receive an 
order. Orders may be taken 
from customers that are unable to pay or unlikely to pay for a long time. All new customers 
subject to credit check. 
Goods are 
despatched to customer. Incorrect goods may be 
sent to customers leading to loss of goodwill. Pick goods using a copy 
of the customer's order. 
Invoice is raised. Invoices may be 
missed, incorrectly raised or sent to the wrong customer. Checked that all goods 
delivered notes (GDNs) match an invoice. 
Sale is recorded. Invoiced sales may be 
inaccurately recorded. Customer statements 
sent out (customers let you know if incorrect).

352  
 Cash received. Customer may not pay 
for goods. Review aged debt listing 
and investigate (customer underpaid). 
Cash recorded. Cash received may be 
stolen. Regular banking/physical 
security over cash (i.e. a safe). 
A more detailed list of possible ri sks and control procedures is shown 
below: 
Receive an 
order. Orders may not be 
recorded accurately. Confirm order back to 
customer (or) get all orders in writing. 
 Orders may be taken 
from customers that are unable to pay or unlikely to pay for a long time = financial loss. All new customers subject 
to credit check. 
  Perform regular credit 
checks on existing customers. 
 Orders cannot be 
fulfilled and therefore customer goodwill is lost (and possibly the customer). Credit limit check before 
order is accepted. 
  Check inventory system 
before issuing order. 
  Automatic re-ordering 
system linked to customer 
order system. 
Goods are 
despatched to customer. Goods may not be 
despatched for orders made. Use sequentially 
numbered customer order pads. Send a copy to the warehouse where they are filed numerically and sequence is checked to ensure that all are there (none missing). 
 Incorrect goods may 
be sent to customers leading to loss of goodwill or goods may not be in inventory. Pick goods using a copy of 
the customer's order.

Chapter 6 
 353 
   Get the copy signed by the 
picker as correct. 
  When GDN is raised check 
it matches with the customer order (staple together and file). 
  Get the customer to sign a 
copy of the GDN and return to the company. 
  Use sequentially numbered 
GDNs, file a copy numerically and check that they are all there. 
missed, incorrectly 
raised or sent to the wrong customer. Copy of sequentially 
numbered GDN sent to 
invoicing dept, stapled to copy of the invoice, checked all GDNs are there and having invoice to match. 
 Credit notes may be 
raised incorrectly, 
missed or to cover cash being misappropriated. On copy of the invoice sign 
as agreed to original order 
and GDN, signed as agreed to customer price list, signed as agreed it adds up properly. 
  Credit notes to be allocated 
to invoice it relates. 
  Authorised by manager and 
sequence check done on a 
regular basis. 
Sale is recorded. Invoiced sales may 
be inaccurately recorded, missed or recorded for the wrong customer. Review receivables ledger 
for credit balances (paid for goods but no debtor recorded). 
  Perform a receivables 
ledger reconciliation (check info in individual ledger matches that in nominal). 
  Computer controls. 
 . Perform receivables ledger 
control account reconciliation. 
  Customer statements sent 
out (customers let you know if there is an error).

354  
 Cash received. Incorrect amounts 
may be received. Agree cash receipt back to 
the invoice. 
 Customer may not 
pay for goods. Review receivables ledger for 
credit balances (customer overpaid). 
  Review aged debt listing and 
investigate (customer 
underpaid). 
  Review aged debt listing 
regularly, phone when 
overdue by 30 days, another letter at 45 days final letter threatening legal action at 60 days. 
  Refer receivable to solicitor. 
Cash recorded. Cash maybe 
incorrectly recorded or recorded against the wrong customer account. Customer statements. 
 Cash received may 
be stolen. Customer statements. 
  Regular banking/physical 
security over cash (i.e. a 
safe). 
  Reconciliation of banking to 
cash receipts records. 
  Segregation of duties. 
The purchases cycle  is similar to the sales cycle but concentrates upon 
the risk of staff ordering goods for themselves, more goods being ordered 
than necessary (leading to obsolescenc e or theft), payments being made 
to fictitious suppliers (theft), and goods  being overpriced by the supplier. 
Controls might include segregation of  duties so that one staff member 
cannot order goods for themselves or payments be made to a fictitious 
supplier. Recruitment and training pr ocedures in addition to a fraud policy 
statement might help. Agreeing a supp lier invoice to a supplier quote or 
price list and recomputing the invoic e for quantity, pric e and tax will 
ensure that the correct amount enters the financia l statements.

Chapter 6 
 355 
 Bank and cash controls 
 Bank and cash 
Objectives of controls 
The objectives of controls over bank and cash are to ensure that: 
 cash balances are safeguarded 
 cash balances are kept to a minimum 
 money can only be extracted from bank accounts for authorised 
purposes. 
Below is a summary showing exampl es of possible risks to cash and 
bank accounts and the related controls: 
Risks Control procedures 
Cash is stolen from the 
premises. Safes/strongroom/locked cashbox with 
restricted access. 
 Tills emptied regularly. Money is taken from bank 
accounts for unauthorised 
purposes (i.e. stolen). Restricted list of cheque signatories. 
 Regular bank reconciliations reviewed by 
person with suitable le vel of authority. 
below: 
premises. 
  Safes/strongroom/locked cashbox 
with restricted access. 
 Security locks. 
 Swipe card access. 
 Key access to tills. 
 Night safes. 
 Imprest system. 
 Use of security services for large 
cash movements. 
 People making bankings vary 
routes and timings. 
 Tills emptied regularly. 
 Frequent bankings of cash and 
cheques received.

356  
 Money is taken from 
bank accounts for unauthorised purposes (i.e. stolen).  Restricted list of cheque signatories. 
 Dual signatures for large amounts. 
 Similar controls over bank transfers and 
on-line banking, e.g. secure passwords 
and pin numbers. 
 Cheque books and cheque stationery 
locked away. 
 Regular bank reconciliations reviewed 
by person with suitable level of authority 
 
 Controls in other departments 
 Controls over human resources  i.e. employees, managers and directors 
might include: 
 Recruitment policies including the completion of an application form 
and the checking of any relev ant qualifications to independent 
documentation. e.g.  certificates; 
 References being taken up prior to appointment; 
 Continuous training; 
 Eligibility to work in the country (visa); 
 Contract of employment. 
Controls over the distribution department  might include  
 The human resources controls listed above; 
 Signed goods received and goods despatched notes; 
 Regular inventory counts; 
 Monitored CCTV cameras ar ound the distribution depot; 
 Security guards at exits; 
 Bag searches when staff leave their shift. 
 
 B has a chain of service stations across motorways in Country X. These 
service stations sell fuel, confectionary and newspapers and also have a café offering hot food. 
The directors of B are concerned t hat there have been incidences of 
fraud in the café’s in several service stations and they have linked this to poor recruitment policies. The HR departm ent insists that they carry out 
rigorous checks before offering positions  in the service stations but the 
directors wish extra controls to be implemented. Since staff turnover in 
the service stations is so high, it is expected that new controls should 
make a difference quickly.

Chapter 6 
 357 
 Which of the following controls over HR should be implemented to 
make fraud less likely in the caf é’s at the service stations? 
A Include induction training for each new member of staff. B Only candidates with recent expe rience of working in a café or 
restaurant should be recruited. 
C Each new staff member should provide two recent character 
references before they ar e offered a job at B. 
D New staff members should be asked to work a six week 
probationary period before they are given a contract to ensure their 
suitability for the job. 
E Shift patterns and teams should be varied so that no staff member 
works alone in the café or with the same team members on a regular basis. 
 
 B is a training college offering courses in professional qualifications. Each 
course has a tutor who lectures fr om the front of the room and passes 
around a class register at  the start of the day which students sign to 
confirm attendance. The register is systems generated and any student 
whose name does not appear on it due to late enrolment is asked to add their name and signature to the bottom so  that B can invoice them for the 
course. 
On day one of the course, text books and notes are available at the front 
of the classroom for students to colle ct on their way into the room. A 
separate materials register is left at the front of the r oom for students to 
sign to acknowledge they have received materials. 
Recently B’s management has receiv ed reports of students attending 
class for the first session and then not returning after mo rning break. In 
addition, there have been cases of students being observed simply passing the class register on instead of signing or adding their name to it. 
B is concerned that it may be losi ng revenue if these incidents are 
occurring on a larger scale.

358  
 Which of the following control procedures could help prevent 
revenue loss in B? 
A Class registers to be taken aroun d the room by and signed under 
tutor supervision. 
B Class register taken later in t he day rather than first thing. 
 Material to be given or sent to students on enrolment rather than left 
at the front of the room. 
C Tutor to carry out head count to en sure the number of signatures on 
the register matches the num ber of people in the room. 
Discrepancies checked immediately. 
D Only students enrolled and whos e names appear on the register 
should be allowed to attend the course. 
Non-financial quantitative controls 
 These controls focus on targets against which performance can be 
measured and monitored. 
– balanced scorecard targets 
– TQM quality measures 
 It is important that a feedback loop exists: 
– performance target (standard) set 
– actual result recorded – compared with target – control action taken (if required). 
Non-financial qualitative controls 
 These form the day-to-day controls over most employees in organisations. 
– employee training 
– management control methods (suc h as organisation structure, 
contracts of employment) 
– physical controls – project management.

Chapter 6 
 359 
 The Bribery Act 
 The Bribery Act is a type of non-financial control. It came in to force in the 
UK on 1st July 2011 and it is designed to bring the UK in line with international norms on anti-corruption legi slation. It will make it a criminal 
offence to give or receive a brib e. It will also introduce a corporate 
offence of failing to prevent bribery. 
The Serious Fraud Office will be abl e to prosecute both domestic and 
foreign companies, providing they have some presence in the UK. Bribes committed in the UK and abroad could be prosecuted under the Act. 
Some experts have argued the new law could put British companies at a 
disadvantage as it goes further t han similar legislation in other 
Individuals will face up to 10 years in prison and an unlimited fine if found 
guilty of committing bribery. 
For example, a former court work er became the first person to be 
convicted under the Bribery Act 2010. He was jailed for six years having 
been convicted of bribery and misconduct in  a public office after admitting 
that he received a bribe in his role as an administrative officer at a Magistrates' Court. The administrative officer pleaded guilty for requesting and receiving a £500 bribe to  "get rid" of a speeding charge 
and to misconduct in public office for other similar offences. He was sentenced to three years for briber y and six years for misconduct in a 
public office, to be served concurrently. 
 
 If found guilty of committing bribery, the UK Bribery Act states that 
individuals will face: 
A Up to 5 years in prison and an unlimited fine B Up to 10 years in prison and an unlimited fine C Up to 5 years in prison and a £10,000 fine D Up to 10 years in prison and a £10,000 fine 
 
 5 Evaluation of an internal control system 
Developing an adequate control system 
The first step in designing an adequate co ntrol system is to ascertain the 
objectives of the system in question. Fo r example, the system may be human 
resources and their objectives are many , but include sourci ng, recruiting, 
training and retain ing quality staff. 
Secondly, research should be conducted r egarding the current systems in place 
(if any) and communication with employees  (questionnaires and interviews for 
example) would help to co llate useful information.

360  
Inputs to the process shoul d be identified to check whether they meet the 
intended objective (or create the desired output). For exam ple, the objective of 
retaining quality staff will not be met if, a review process is not carried out when 
well-trained but unhappy staff repeatedly leave the company. 
In order to work out whet her the system currently wo rks, the company should 
have use a comparator, for example, HR may set a target labour turnover 
figure. If this is met or surpass ed then action should be taken since it 
demonstrates that the current  system is not effective at  retaining a certain level 
of staff. 
In this example, the control system appears to work – it has identified a problem 
with labour turnover, however, it has  also identified a problem in the HR 
process. This now needs to be resolved. 
New controls can be implemented, such  as regular appraisals – giving an 
employee a forum to discuss their job sa tisfaction, or setting up a new policy on 
staff welfare which might include an open-door policy, a whistleblowing policy or 
even just a suggestion box. 
These new processes now also need suit able controls to be put in place and 
indicators chosen that will be acted on are required. Appraisals need to be done 
for all staff on, say, a yearly basis . The number of suggestions put in the 
suggestion box needs to be logged and a re cord kept of the number which have 
been actioned. 
A responsible individual then needs to a scertain whether these extra controls 
have led to a reduction in the number of leavers and whether this is now at a 
satisfactory level. If not, then furthe r corrective action needs to be taken. 
Costs v benefits 
The internal control system of the busi ness is no different to other business 
activities – the benefits of maintaining the system must outweigh the costs of 
operating it. As part of the monitoring process t herefore management must 
consider the costs and benefits. 
However, it can be difficult to quantify t hose costs and benefits as they are often 
not direct cash costs. 
Costs of an internal control system will include: 
 time of management involved in the design of the system 
 implementation: 
– costs of IT consultants to implement new software 
– training all staff in new procedures 
 maintenance of system: 
– software upgrades 
– monitoring and review. 
Benefits  are to be found in the reduction of the risks and achievement of 
business objectives.

Chapter 6 
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Limitations of intern al control systems 
Warnings should be given regarding over-reliance on any system, noting in 
particular that: 
 A good internal control system c annot turn a poor manager into a good 
one. 
 The system can only provide reasonable assurance regarding the 
achievement of objectives – all inter nal control systems are at risk from 
mistakes or errors. 
 Internal control systems can be by -passed by collusion and management 
override. 
 Controls are only designed to cope with routine transactions and events. 
 There are resource constraints in pr ovision of internal control systems, 
limiting their effectiveness. 
To protect employees’ health and safety  whilst at work, a statement might be 
issued that all staff are supposed to fo llow. This statement might include: 
The company aims to protect the health, safety and welfare of people at work, 
and to safeguard others, mainly members of the public, who may be exposed to 
risks from the way wo rk is carried out... 
HSE believes in firm but fair enforcement of health and safety law. This should 
be informed by the principles of proporti onality in applying the law and securing 
compliance; consistency of approach; targeting of enforcement action; 
transparency about how the regulator oper ates and what those regulated may 
expect; and accountability for the regulator’s actions... 
Those whom the law protects and those on whom it places duties (dutyholders) 
expect that action taken by enforcing aut horities to achieve compliance or bring 
dutyholders to account for non-compliance should be proportionate to any risks to health and safety, or to t he seriousness of any breach... 
...making sure that contacts are target ed primarily on those whose activities 
give rise to the most serious risks or where the hazards are least well 
controlled; and that action is focused on the dutyholders who are responsible for 
the risk and who are best placed to control it – whether employers, 
manufacturers, suppliers, or others... 
Decisions on enforcement action are discr etionary, involvin g judgement by the 
enforcer. All enforcing authorities s hould have arrangements in place to 
promote consistency in the exercise of discretion, including effective 
arrangements for liaison with ot her enforcing authorities...

362  
Transparency 
Transparency means helping dutyholders to  understand what is expected of 
them and what they should expect fr om the enforcing authorities... 
Investigations are undertaken in order to determine: 
 causes; 
 whether action has been taken or needs to be taken to prevent a 
recurrence and to secure compliance with the law; 
 lessons to be learnt and to influence the law and guidance; 
 what response is appropriate to a breach of the law... 
While the primary purpose of the enforcing authorit ies is to ensure that 
dutyholders manage and control risks effe ctively, thus preventing harm, 
prosecution is an essentia l part of enforcement... 
Prosecution of individuals 
Subject to the above, enforcing author ities should identif y and prosecute or 
recommend prosecution of individuals if t hey consider that a prosecution is 
warranted. In particular, they should consider the management chain and the 
role played by individual direct ors and managers, and should take action 
against them where the inspection or inve stigation reveals that the offence was 
committed with their consent or connivance or to have been attributable to 
neglect on their part and where it would be appropriate to do so in accordance 
with this policy. Where appropriate , enforcing authorities should seek 
disqualification of directors under the Company Directors Disqualification Act 
1986. 
Publicity 
Enforcing authorities should make arr angements for the publication annually of 
the names of all the com panies and individuals who have been convicted in the 
previous 12 months of break ing health and safety law... 
Action by the courts 
Health and safety law gives the courts  considerable scope to punish offenders 
and to deter others, including imprisonment  for some offences. Unlimited fines 
may be imposed by higher courts. 
Death at work 
Where there has been a breach of the law leading to a work-related death, 
enforcing authorities need to consider w hether the circumstances of the case 
might justify a charge of manslaughter or corporate mans laughter...If in the 
course of their health and safety inve stigation, the enfor cing authorities find 
evidence suggesting manslaughter or co rporate manslaughter, they should 
pass it on to the police. 
An example of compliance failure could include the death of an employee 
several years ago.

Chapter 6 
 363 
The employee was clearing a dyke bank  of green waste material using a 
mechanical digger. The employee was trained to be wearing a lifejacket in the event that the digger should slip down the dyke bank into the water, or if the employee fell out of the cab into the dyke water. 
The employee found the lifejacket cumber some to wear and so, despite his 
training, he chose not to w ear it. Unfortunately the digg er did slip down the bank 
into the water, and the employee died from drowning. Several compliance 
issues were raised during an investigation: 
(1) Had the employee been sufficiently trai ned to know that the wearing of the 
lifejacket was compulsory? When was the last time he was trained? 
(2) Was the lifejacket operational? (The canisters blowing up the lifejacket 
have a finite life.) 
(3) The employee was trapped by the digger, so would the lifejacket have 
helped? 
(4) Should there have been a second empl oyee assisting the first, so in the 
event of an accident he could have tried to save the employees life or report the accident to the emergency services? 
(5) Should 'second' employees be advis ed to assist a drowning colleague? 
Many more questions were asked during the investigation,  but the employee 
had ultimately failed to comply with com pany rules by not wearing the lifejacket. 
And the company had failed to implement su fficient controls to prevent such an 
accident. 
This compliance failure would be allocat ed a 'serious' rating due to a 'death at 
work' and post-investigation many new controls would be implemented to prevent any future occurrence. Em ployee training woul d probably feature 
heavily within any new controls. 
6 COSO model applied to fraud prevention  
 Fraud 
 Fraud can be defined as: 
'dishonestly obtaining an adv antage, avoiding an obligation or causing 
a loss to another party' 
Fraud is a crime , but does not have a precis e legal definition. The 
term ‘fraud’ refers to an intentio nal act by one or more individuals 
among management, those charged with governance, employees or 
third parties, involving the use of dec eption to obtain an unjust or illegal 
advantage. (International Standard of Auditing 240 The Auditor's Responsibility to Consider Fraud in an Audit of Financial Statements). 
A distinction is made between: 
 fraud , which is deliberate falsification, and 
 errors , which are unintentional mistakes.

364  
 Examples  of fraud include: 
 the theft of cash or other assets 
 false accounting: this includes concealing or falsifying accounting 
records with a view to personal gain  or providing false information 
that is misleading or deceptive 
 crimes against consumers or c lients, e.g. mi srepresenting the 
quality of goods; pyramid trading schemes; selling counterfeit 
goods 
 employee fraud against employers, e.g. payroll fraud; falsifying 
expense claims; theft of cash 
 crimes against investors, consumers and employees, e.g. 
financial statement fraud 
 crimes against financial institutio ns, e.g. using lost and stolen 
credit cards; fraudulent insurance claims 
 crimes against government, e.g. social security benefit claims 
fraud; tax evasion 
 crimes by professional criminal s, e.g. money laundering; advance 
fee fraud 
 e-crime by people usin g computers, e.g. spamming; copyright 
crimes; hacking 
Prerequisites for fraud 
 A major reason why people comm it fraud is because they are 
allowed to do so. 
 The likelihood that fraud will be committed will be decreased if the 
potential fraudster believes that the rewards will be modest, that 
they will be detected or that t he potential punishment will be 
unacceptably high. 
 Therefore, a comprehensive syst em of control is needed to 
reduce the opportunity for fraud and increase the likelihood of 
detection. 
There are three prerequisites for fraud to occur: 
 Motive  for fraud.

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 Fraud risk indicators 
 Fraud indicators fall into two categories: 
Warning signs 
Warning signs have been described as orga nisational indicators of fraud 
risk. Examples include the following: 
 Absence of an anti-fra ud policy and culture. 
 Lack of management supervision of staff. 
 Inadequate recruitment processe s and absence of screening. 
 Dissatisfied employees who have access to desirable assets. 
 Lack of job segregation and independent checking of key 
transactions. 
 Poor physical security of assets. 
 Management compensation hi ghly dependent on meeting 
aggressive performance targets. 
 Highly competitive market condi tions and decreasing profitability 
levels within the organisation. 
 Rapid changes in information technology. 
Fraud alerts 
Fraud alerts have been described as spec ific events or red flags, which 
may be indicative of fraud. Examples include the following: 
 Anonymous emails/letters/telephone calls. 
 Emails sent at unusual times, wit h unnecessary attachments, or to 
unusual destinations. 
 Discrepancy between earnings and lifestyle. 
 Unusual, irrational, or inconsis tent behaviour. For example members 
of staff who arrive firs t in the morning and leav e last in the evening, 
do not take holidays, or who keep an area of the office for their 
exclusive use and do not share files with others. 
 Alteration of documents and records. 
 Subsidiary ledgers, which do not reconcile with control accounts. 
 Extensive use of ‘suspense’ accounts. 
 Inappropriate or unusual journal entries. 
 Confirmation lette rs not returned. 
Fraud risk management strategy 
In common with any other type of risk, a risk management strategy needs to be 
developed for fraud. This strategy should include three key elements: 
 Fraud prevention. 
 Fraud detection. 
 Fraud response.

366  
Together, these should result in a f ourth element – risk deterrence. 
For example, fraud detection acts as a deterrent by sending a message to likely 
fraudsters that the organisation is acti vely fighting fraud and that procedures are 
in place to identify any illegal activity t hat has occurred. Sim ilarly, the possibility 
of being caught will often persuade a potential perpetrator not to commit a 
fraud. 
As well as addressing the legal aspects of fraud, this process operates within 
the wider context of the organisation' s risk management strategy, corporate 
governance and ethical culture. 
 
 Fraud prevention using the COSO model 
The main elements of an internal contro l system should be in place for dealing 
with fraud. In general terms, managing t he risks of fraud is similar to the 
management of other types of risk and consists of the following elements: 
 Control environment . Management should show an active interest in the 
prevention and detection of fraud. T here should also be a fraud policy 
statement on how to respond to suspici ons of fraud, to ensure that timely 
and effective action is taken in a c onsistent manner, and that management 
responsibilities are clear. For exam ple, should initial suspicions be 
reported to the line manager  in whose area of operations the suspected 
fraud is taking place, or should the ma tter be reported to senior accounts 
management for investigation? 
 Risk recognition and assessment  
– Identify risk areas. Management shoul d identify those areas that are 
vulnerable to fraud risk. 
– Activities where the risks might  be high include cash handling and 
payments, purchasing and payroll.

Chapter 6 
 367 
 Assess the scale of the risk. T he scale of the risk depends on the 
probability of fraud and the si ze of potential losses if  fraud occurs. It also 
depends on the measures that are alr eady in place to prevent fraud, and 
their apparent effectiveness. The scale of  the risk to be considered is the 
‘residual risk’ after allowing fo r the existing control measures. 
 Control activities and procedures . The responsibility for the 
management of each risk to specific i ndividuals. Specific controls are 
suggested below. 
 Information: monitoring and reporting . Information should be provided 
regularly to management so that they can monitor performance with 
respect to efficiency and effectiveness in achieving targets, economy and 
quality. Effective monitoring can detect ce rtain types of fraudulent activity. 
A company might use internal auditors to investigate a problem, after line 
management have established the basic fact s. Any risk of continuing fraud 
should be dealt with if possible, for ex ample by halting further payments or 
changing operating procedures unt il the matter is resolved. 
 Monitoring  activities and correcting deficiencies 
– Identify the need for revised controls. The adequacy of existing 
controls should be evaluated. Where appropriate, the need for 
specific additional controls shoul d be identified, to reduce or 
eliminate the ri sk of fraud. 
– Implement the revised controls. – Monitor the implementation of the revised controls, to assess their 
effectiveness. One way of doing this is to carry out an internal audit 
investigation. 
‘The risk management cycle should be treated as an iterative pr ocess. If the 
implementation of revised controls is not  sufficient to eliminate the threat of 
fraud, then the cycle must begin again’ (HM Treasury). 
Fraud detection 
A common misbelief is that external audito rs find fraud. This is actually rarely 
the case – in fact their letters of engagement typically state that it is not their 
responsibility  to look for fraud. Most frauds ar e discovered accidentally, or as 
a result of information re ceived (whistleblowing). 
Some methods of discovering fraud are: 
 Performing regular checks, e.g.  stocktaking and cash counts. 
 Warning signals or fraud risk indica tors (see previous section). For 
example: 
– Failures in internal control procedures 
– Lack of information provided to auditors 
– Unusual behaviour by individual staff members – Accounting difficulties. 
 Whistleblowers.

368  
 Fraud response 
 The fraud response plan sets out the arrangements for dealing with 
suspected cases of fraud, theft or corruption. 
 It provides procedures for evidenc e-gathering that will enable decision- 
making and that will subsequently be admissible in any legal action. 
 The fraud response plan also has a deterrent value and can help to restrict 
damage and minimise losses to the organisation. 
The organisation's response to fraud may include: 
 Internal disciplinary action, in  accordance with personnel policies. 
 Civil litigation for t he recovery of loss. 
 Criminal prosecution through the police. 
 
 Investigation of fraud 
 When a fraud comes to light, inte rnal auditors might be asked to 
investigate it. The purpose of in vestigating a fraud should be to: 
 Establish the facts. 
 Establish how the fraud occurr ed and initially went undetected. 
Were the internal controls weak or inadequate? Or were the internal 
controls by-passed or  not properly applied? 
 Consider whether anyone else might have been involved in the 
fraud. 
 Establish or estimate the size of the loss. 
The investigator should look at all relevant documents and files, listen to 
recorded telephone conversations and read the fraudster’s e-mails. Individuals working with the fraudst er should be interviewed, such as 
colleagues, supervisor and manager. 
Great care must be taken to ens ure that evidence is gathered and 
maintained in a manner that could be used in any criminal proceedings 
that the company institutes. The company might also have to defend 
allegations of unfair di smissal or defamation by an employee who claims 
they have been wrongly accused. 
As a result of an investigation, an auditor should make recommendations 
about the system. These are likely to be t hat, if the risk of  losses is high, 
either: 
 the existing internal controls are not sufficient to limit the risk; new 
controls or stronger controls should therefore be introduced, or 
 the existing internal controls shoul d be sufficient to limit the risk, but 
were applied inadequately or were  ignored in the past; measures 
should therefore be taken to ensure that the contro ls are properly 
applied in the future.

Chapter 6 
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 Theft of the petty cash tin occurred at  Y plc. This was the second time it 
had happened in three years. The tin held £750 in the first instance and £7,500 in the second instance (due to a new van being paid for later in the day). Normally the tin would only hold around £100. 
Controls that should be in plac e to prevent these thefts are:  
A Insurance B Maximum limits on the value of cash held C Confidentiality D Keeping the tin locked when unused 
 
 O is a multinational organisation wh ich sells a large number of goods, 
including books and DVD’s online to i ndividual customers. A review of 
one of the IT systems which processe s internet sales has revealed 
several transactions over the last few months which suggest there has 
been some ‘hacking’ or fraudulent a ccess to the customer database. 
Each transaction resulted in no payment from the customer and 
transactions being immediately delet ed from the customer database so 
that sales were not recorded. 
Which of the following control recommendations may help to 
prevent a reoccurrence of the issues outlined above? 
A Only despatch goods where payment has been received in full. B Monitor system access from internal  sources, using a control log, to 
identify whether staff in the IT  department are placing fraudulent 
orders. 
C Only sell to those customers who have an account set up with O. 
D Check a number of transactions at  regular intervals on a daily basis 
to make sure they are not deleted. 
E Invest in fraud insurance to co ver losses resulting from unauthorised 
access.

370  
 A new member of staff has started working in the receivables department 
of ABC Ltd. She previously worked  in the sales department at ABC’s 
main competitor.  
Which controls should be implemente d to ensure that the new staff 
member operates in the correct manner at ABC?  
A Employment contract B Confidentiality clause C Training D Supervision 
 
 Examples of non-financial quant itative controls include:  
Select ALL that apply A An organisation structure B Physical controls C The number of faulty goods returned D The percentage of staff attendi ng training courses each year 
 
 The risk that money could be stolen from PQ’s bank account could be 
reduced by:  
Select ALL that apply A Having a restricted list of dual cheque signatories B Locking away cheque books C Annual bank reconciliations D Having secure passwords and PIN numbers 
 
 A sole trader, Yu Yang, owns a new consultancy business employing ten 
highly-skilled, autonomous staff. 
Yu Yang has just attended a new business education lunch, run by a 
government advisory committee, set up to help new business. The topic 
of discussion at lunch was internal control systems. Yu Yang has come 
back to the office enthused by t he lunch and looking to start the 
implementation of new controls.

Chapter 6 
 371 
 Advise Yu Yang which THREE of the following are limitations to the 
effectiveness of internal controls within his consultancy business. 
A An employees could ignore the internal control 
B Internal control systems will only target manufacturing companies 
C Additional controls could negativ ely affect employee motivation 
D Internal controls can slow down the companies’ response time to 
market 
E There likelihood of a major accident is low given the work of Yu 
Yang’s business, therefore inter nal controls are not necessary 
F Internal controls are only needed if the company is a limited 
company 
 
 TT is a passenger ferry operator whic h operates several vessels between 
busy ports in countries A and B. 
One of TT’s larger ships was damaged in high winds during a crossing. 
The damage led to multiple passenger injuries and compensation claims against TT which the company was not adequately insured for. It was 
acknowledged that TT should not have operated the particular ferry 
service due to the weather conditi ons and that control failures were 
largely responsible for the incident and injuries. 
TT has a history of control weakness and the internal audit team have 
listed the main weaknesses which were in evidence on the day of the incident. The management of TT now wish to establish which control 
weaknesses contributed to the incident. 
Which of the following weaknesses w ould have made the incident 
more likely to occur? 
Select  ALL that apply
. 
A Passengers not being provided with  suitable safety equipment to 
use in an emergency. 
B Crew members failing to secure  the ship adequately against the 
weather on departure due to  time constraints. 
C TT’s internal procedures lacking r outine weather checks and instead 
relying on each ship’s captain to decide locally on safety to operate 
D Inadequate checks on the relevance and extent of insurance over 
incidents involvin g weather damage. 
E The captain overriding speed controls in order to meet the 
scheduled arrival time.

372  
 Test your understanding 20 – Pr ivate hospital (Integration) 
 A private hospital has a canteen that  provides staff and visitors with 
F interviewed the Canteen Manager, w ho claimed that the change in 
for branded goods, such as crisps and chocolate bars. 
F was in the Canteen Manager’s office one lunch time. He saw a laptop 
and 
 the owner then paid half of the 20% that had been overcharged to 
Audit.

Chapter 6 
 373 
 Two weeks later, F was asked to meet with the hospital’s Chief 
to refer the matter to the po lice. The Canteen Manager had been 
investigation and to remain silent, not discussing the case with anyone 
Required: 
Discuss the difficulties associated with proving that the Canteen Manager 
was fraudulent. 
 
 Test your understanding 21 – Fra ud and mitigation (Integration) 
 XYS is a company manufacturing and selling a wide range of industrial 
products to a large number of busine sses throughout the country. XYS is 
a significant local employer, with 2,000 people working out of several locations around the region, all link ed by a networked computer system. 
XYS purchases numerous components from 500 local and regional 
suppliers, receiving them into a c entral warehouse. The company carries 
about 20,000 different inventory item s, placing 15,000 orders with its 
suppliers each year. 
The Accounts Payable Department of XYS has five staff who process all 
supplier invoices through the company’s computer system and make payment to suppliers by cheque or electronic remittance. 
Required: 
Explain the risk of frau d in Accounts Payable for a company like XYS and 
how that risk can be mitigated. 

374  
 Test your understanding 22 – College (Case study) 
 Scenario 
A large college has several sites and employs hundreds of teaching staff. 
Trigger 
The college has recently discovered a serious fraud involving false 
billings for part-time teaching. 
The fraud involved two member s of staff. M is a clerk in the payroll office 
who is responsible for processing paym ents to part-time teaching staff. P 
is the head of the Busi ness Studies department at  the N campus. Part-
time lecturers are required to comple te a monthly claim form which lists 
the classes taught and the total hours claimed. These forms must be 
signed by their head of department, who s ends all signed forms to M. M 
checks that the class codes on the cl aim forms are valid, that hours have 
been budgeted for those classes and i nputs the information into the 
college’s payroll package. 
The college has a separate personnel de partment that is responsible for 
maintaining all personnel files. Additi ons to the payroll must be made by a 
supervisor in the personnel office. The payroll package is programmed to reject any claims for payment to em ployees whose personnel files are not 
present in the system. 
M had gained access to the personnel department supervisor’s office by 
asking the college security officer for the loan of a pass key because he had forgotten the key to his own office . M knew that the office would be 
unoccupied that day because the s upervisor was attending a wedding. M 
logged onto the supervisor’s com puter terminal by guessing her 
password, which turned out to be the registration number of the 
supervisor’s car. M then added a fictit ious part-time employee, who was 
allocated to the N campus Business Studies department. 
P then began making claims on behalf of t he fictitious staff member and 
submitting them to M. M signed off t he forms and input them as normal. 
The claims resulted in a steady series  of payments to a bank account that 
had been opened by P. The proceeds of the fraud were shared equally between M and P. 
The fraud was only discovered when t he college wrote to every member 
of staff with a formal invitation to the college’s centenary celebration. The 
letter addressed to the fictitious le cturer was returned as undeliverable 
and the personnel department became suspicious when they tried to contact this person in order to up date his contact details. By then M and 
P had been claiming for non-existent  teaching for three years. 
The government department respons ible for funding the college 
conducted an investigation and conclud ed that the college’s management 
had relied excessively on the applicat ion controls programmed into 
administrative software and had paid too little attention to the human resources aspects of the system.

Chapter 6 
 375 
 Task 
(i) Write a memorandum to the B oard evaluating the difficulties 
associated with preventing and/ or detecting this fraud. 
(ii) Write a letter to t he Dean of the college which: 
(a) Advises on the weaknesses in the college's systems and 
procedures; and 
(b) Discusses the suggestion that the human elements of control 
systems are frequently more im portant than the software 
elements in ensuring that records are correct. 
 
 Test your understanding 23 – G Manufacturing (Case study) 
 Scenario 
G is a manufacturing company t hat employs 800 production staff and 90 
administrative staff. The company  operates from a single site. 
Trigger 
A new Chief Executive was appointed in  July. She was recruited from a 
much larger manufacturing company  where she was the Marketing 
Director. The company is also an indirect competitor of G’s. 
Since her appointment the Chief Exec utive has focussed on learning as 
much as she possibly can about the company’s culture.  She spent the 
whole of August meeting representatives from all levels of staff within the 
company and other stakeholders such as  customers and suppliers. She 
has called a board meeting to discuss her findings. 
Her findings are as follows: 
 The company manufactures high quality products that are popular 
with customers. All mem bers of G’s staff are proud to be associated 
with the manufacture of the products. 
 G’s managers and supervisors take  a very relaxed approach when 
working with subordinates. Staff are empowered to make decisions 
on their own without consulting their superiors if they are confident 
that they are acting in the company’s best interests. 
 The relaxed management  style has harmed the control environment 
immensely. Only a minority of  the company’s staff take the 
budgetary control system seriously  and hardly any of them pay 
serious attention to variance repo rts. In contrast to all other 
departments, morale in the accounts department is very low because the members of the accounts staff feel  that they waste a 
significant amount of time every month chasing heads of 
departments for reports and for ot her important information.

376  
  These attitudes are echoed by external stakeholders. Customers 
are delighted with the quality of G’s products, but often find that G’s 
invoices and monthly st atements contain errors. Suppliers claim that 
invoices submitted to G are settl ed very promptly 90% of the time, 
but the remainder have to be chased because G’s accounts staff do not always receive accurate and comp lete records of orders placed 
and goods received. 
The Chief Executive has warned the board that the cont rol environment 
must be improved as a matter of priority. She proposes to send an email to all staff congratulati ng them on their achievements on product quality, 
but stating that the ra ther lax attitude towards management and record 
keeping will have to stop. Over time , she plans to impose disciplinary 
measures on staff who are responsible for bookkeeping errors or delays. 
She also proposes that G should cr eate an internal audit department to 
monitor compliance with formal processes and procedures. 
The Production Director has argued that  the Chief Executive’s proposals 
are counter-productive and that most  of the delays and omissions are 
due to employees giving priority to the creation of an excellent product. 
Task: 
(a) Explaining why it is necessary to improve G’s control environment; 
and 
(b) Evaluating the Chief Executive’ s proposal to impose disciplinary 
measures on staff who are responsib le for bookkeep ing errors or 
delays. 
 
 Test your understanding 24 – U internet (Case study) 
 Scenario 
U is an internet ‐based company that sells books, DVDs and CDs to 
consumers. U’s customer s are required to create an account, to which 
they register their name, address and credit card details. The customers 
must also create a password, which t hey must use whenever they wish to 
log into their account in order to u pdate their details or place an order. 
Registered customers can log in and place orders very easily because all 
of their delivery and payment details ar e already on file. That feature is 
one of the main factors behind U’s success.  The other main factor is that 
U’s software tracks each customer’s purchases and uses that information 
to email recommendations based on past orders. Many customers buy 
recommended products and the proporti on is growing because U’s 
tracking software becomes increasingly accurate as more data is gathered.

Chapter 6 
 377 
 Trigger 
U has recently suffered a security breach involving 2,000 of its highest 
spending customers. One of U’s analysts had b een asked to write a 
report about those customers’ buyi ng habits. The report was required 
urgently and so the analyst copied t he customers’ files onto a memory 
stick, which he took home to analyse  on his home PC over the weekend. 
He copied the final report onto the sa me memory stick, but lost the stick 
during the train journey into work. 
The analyst had one of his flatmates em ail him a copy of the report, 
which was still on the hard drive of hi s home PC, so the report’s deadline 
was met. The analyst did not report the loss of the memory stick because 
he did not wish to get into trouble for losing the data. He hoped that anybody who found the stick woul d simply erase the files. 
Over the next two weeks, U started to  receive complaints from customers 
that orders were being placed without  the account holders’ permission. 
U’s policy in these circumstances is to  seek clarification from the account 
holder and suggest that the order c ould have been placed by a family 
member who knew the account password. The volume of complaints was higher than usual and the analyst was asked to investigate them to 
determine whether there was a secu rity problem. The analyst quickly 
realised that many of the complain ts were from the 2,000 customers 
whose files were on his memory st ick and that the person who had found 
the stick was abusing that informat ion. He admitted the loss of the 
memory stick and was suspended. 
U’s customer services department wrot e to all of those customers whose 
accounts had been compromised and offered to cancel any disputed charges on their accounts. The custom ers were also advised to contact 
their credit card providers and to study  their card statements carefully in 
case the thief had used that informati on to defraud them. Several of these 
customers complained to a nati onal newspaper and U received many 
further complaints concerning disput ed charges, mainly from customers 
whose details had not been copied by the analyst. 
Task: 
Write a report to U's Board which: 
(a) Advises on the weaknesses in bo th the control environment and the 
internal controls that led to this loss of data; 
(b) Recommends, stating reasons, ac tions that U’s board should take: 
(i) to restore the confidence  of its existing and potential 
customers; 
(ii) to prevent similar probl ems occurring in the future. 

378  
 Test your understanding 25 – V (Case study) 
 Scenario 
V is a quoted company. Its board co mprises an equal number of both 
executive and non-executive director s. The company has a remuneration 
committee, comprised entirely of non-executives. 
Trigger 
A major institutional investor in V has written to the chair of the 
remuneration committee to raise so me concerns about the manner in 
which the performance of V’s exec utive directors is controlled and 
rewarded. 
At present, each of the executive dire ctors receives a fairly substantial 
fixed annual salary combined with options granted under an executive 
share option scheme (“ESO S”). The ESOS is designed in order to align 
the directors’ interests wit h those of the shareholders: 
The remuneration committee reviews each director’s performance during 
the financial year and grants a number of share options in accordance 
with performance. 
The options are issued “at the money” (t hat is, the exercise price is the 
same as the market price) so that  the directors have an incentive to 
increase the share price. 
The options can only be exercised on a specified date that falls three 
years after their issue. 
If a director leaves the company t hen any outstanding options will lapse 
without compensation. 
The institutional investor has expressed concern about the ESOS 
arrangement because of t he underlying financial im plications of the 
scheme. V first introduced ESOSs in order to motivate the executive 
directors to act in the shareholders’ interests. If the directors work 
towards maximising V’s share price then the options wil l provide higher 
returns if they are in the money when they come due for exercise. In 
addition, V’s directors are much less lik ely to reject positive net present 
value investment opportunities if they  hold options. Normally the directors 
are more risk averse than the shar eholders when it comes to project 
appraisal, but holding options ma kes risk-taking more appealing. 
The institutional investor is c oncerned that the options may have 
encouraged dysfunctional behaviour by  the directors, although it is 
difficult to be certain that that  has arisen because of the limited 
information that is available to the shareholders. 
The institutional investor has sugges ted that the executive directors 
should be rewarded with a simpler sc heme, such as an annual profit-
related bonus. At present, it is un clear whether the reward system in 
place provides the executive direct ors with meaningful feedback on their 
performance. As a shareholder, the inve stor wishes to see a clearer link 
between the directors’ performa nce and their remuneration.

Chapter 6 
 379 
 Task 
Write a letter to the inst itutional investor which: 
(i) Explains why the introducti on of ESOSs could motivate V’s 
executive directors to accept positive net present value (NPV) 
projects; 
(ii) Explains how an ESOS scheme could affect the actions taken by 
the directors (other than t he project appraisal decision). 
Write a memorandum to the remuneration committee which evaluates the 
advantages AND disadvantages of rewa rding executive directors by 
paying a bonus based on a simple and transparent measure such as profit. (15 minutes)  
 
 Test your understanding 26 – Cliff (Integration) 
 Day-to-day internal controls are im portant for all businesses to maximise 
the efficient use of resources and prof itability. Your firm has recently been 
appointed as auditor to Cliff, a private company that runs a chain of small supermarkets selling fresh and frozen food, and canned and dry food. Cliff has very few controls over inventory because the company trusts local managers to make good decisions regarding the purchase, sale and 
control of inventory, all of which is controlled locally. Pricing is generally 
performed on a cost-plus basis. 
Each supermarket has a standalone co mputer system on which monthly 
accounts are prepared. These account s are mailed to head office every 
quarter. There is no integrated invent ory control, sale or purchasing 
system and no regular system for in ventory counting. Management 
accounts are produced twice a year. 
Trade at the supermarkets has increased in recent years and the number 
of supermarkets has increased. Howeve r, the quality of staff that has 
been recruited has fallen. Senior m anagement at Cliff are now prepared 
to invest in more up-to-date systems. 
Task 
(i) Discuss the problems you would expect  to find at Cliff as a result of 
the poor system of internal control. 
(ii) Recommend four improvements to  the internal control system at 
Cliff, explaining the advantages and disadvantages of each. 
(35 minutes)

380  
 Test your understanding 27 – SPD (Integration) 
 DSPD has been approached by Q, a spec ialist manufacturer of extremely 
expensive high performance cars. Q is  in the process of developing a 
new car that will be one of the fast est in the world. The car will be 
designed to be driven on public roads, but the owners of such cars often 
take them to private race tracks w here they can be driven at very high 
speeds. 
Q has designed an electronics system to enable an average driver to 
drive the car safely at high speed. The system will monitor the engine, brakes and steering and will compensat e for errors that could cause a 
crash. The system will, for example, sense that the car is about to skid 
and will compensate for that. The el ectronics system will be based on a 
circuit board that Q wishes to have built by SPD. 
Building Q’s circuit board will pose a number of challenges for SPD. The 
circuit board will be subject to a great  deal of vibration when the car is 
driven at speed. The cars are expected to last for a very long time and so there could be problems if the circ uit boards deteriorate with age. The 
circuit board will be installed in an i naccessible part of the car where it will 
be difficult to inspect or maintain. 
Many of the component s on the board will be m anufactured by SPD, but 
some crucial components will be supp lied by a third party that has 
already been selected by Q. 
Required: 
Discuss controls that should be in pl ace to reduce the risks faced by SPD 
if they accept an order from Q. 
 
 Test your understanding 28 – Rh apsody Company (Integration) 
 Rhapsody Co supplies a wide range of garden and agricultural products 
to trade and domestic customers. T he company has 11 divisions, with 
each division specialising in the sale of specific products, for example, 
seeds, garden furniture, and agricultura l fertilizers. The company has an 
internal audit department which prov ides audit reports to the audit 
committee on each division on a rotational basis. 
Products in the seed division are offe red for sale to domestic customers 
via an Internet site. Customers review  the product list on the Internet and 
place orders for packets of seeds onto Rhapsody Co's secure server using specific product codes, along wit h their credit card details. Order 
quantities are normally between one and three packets for each type of seed. Order details are transferred m anually onto the company's internal 
inventory control and sales system, and a two part packing list is printed 
in the seed warehouse. Each order and packing list is given in a random alphabetical code based on the nam e of the employee inputting the 
order, the date and the products being ordered.

Chapter 6 
 381 
 In the seed warehouse, the packets of seeds for each order are taken 
from specific bins and despatched to  the customer with one copy of the 
packing list. The second copy of the pa cking list is sent to the accounts 
department where the invent ory and sales computer is updated to show 
that the order has been despatched. The customer's credit card is then 
charged by the inventory control and sales computer. Irrecoverable debts 
in Rhapsody are currently 3% of the total sales. 
Finally, the computer system checks that for each charge made to a 
customer's credit card account, the or der details are on file, to confirm 
that the charge was made correctly . The order file is marked as 
completed confirming that the orde r has been despatched and payment 
obtained. 
Required: 
In respect of sales in the seeds division of Rhapsody Co 
(a) identify and evaluate weak nesses in the sales system. 
(25 minutes) 
(b) provide a recommendation to alleviate each weakness. 
 
 Test your understanding 29 – Bassoon Ltd (Integration) 
 Bassoon Ltd runs a chain of shops se lling electrical goods all of which 
are located within the same country. 
It has a head office that deals with purchasing, distribution and 
administration. The payroll for the w hole company is administered at 
head office. 
There are 20 staff at head office and 200 staff in the company’s 20 shops 
located in high streets and shoppi ng malls all over the country. 
Head office staff (including directors) are all salaried and paid by direct 
transfer to their bank accounts. 
The majority of the staff at the co mpany’s shops are also paid through the 
central salary system, monthly in a rrears. However, some students and 
part time staff are paid cash out of the till. 
Recruitment of head office staff is in itiated by the depar tment needing the 
staff who generally conduct inte rviews and agree the terms and 
conditions of employment. Bassoon has an HR manager who liaises with 
recruitment agencies, places job adver ts and maintains staff files with 
contracts of employment, etc. 
Shop managers recruit their own staff. Shop staff receive a basic salary based on the hours worked and 
commission based on sales made.

382  
 The company has a fairly sophisticat ed EPOS (electronic point of sale) till 
system at all shops. The EPOS system  communicates directly with the 
head office accounting system. 
When making a sale, all staff have to log on with a swipe card which 
identifies them to the s ystem, and means that the sales for which they are 
responsible are analysed by the s ystem and commissions calculated. 
Store managers have a few ‘guest cards’ for temporary and part time 
staff, who generally do not receive commissions. 
Store managers and regional supervisors are paid commissions based 
on the performance of thei r store or region. Dir ectors and other head 
office staff usually receive a bon us at Christmas, depending on the 
company’s performance. This is deci ded on by the board in consultation 
with departmental managers and put thr ough the system by the payroll 
manager. 
The payroll manager is responsible for adding joiners to the payroll and 
deleting leavers as well as for impl ementing changes in pay rates, tax 
coding and other deductions and for maki ng sure that the list of monthly 
transfers is communicated to the bank. 
The computerised payroll system is a standard proprietary system which 
is sophisticated enough to incorpor ate the commission calculations 
mentioned above which ar e fed in directly from the EPOS system. 
The company employs an IT manager  who is responsible for the 
maintenance of all IT systems and installing new hardware and software. 
Required: 
Identify the risks inherent in t he payroll system at Bassoon Ltd and 
recommend any changes which you think are appropriate. 

384  
 
 The correct answers are A, C and D – The four categories of objective 
setting are strategic, operat ional, reporting and compliance. 
 
 D 
Control environment refers to t he attitudes of management and in 
particular directors towards controls . An organisation may have all of the 
other five aspects of internal contro l in place but they cannot be relied 
upon if management and directors do not regard them as important. Their 
actions may override or disregard control failures. A poor control environment therefore can undermine an otherwise sound internal control 
system. 
 
 A and B only 
 Option A: A blame culture means it is unlikely that staff will integrate 
controls into their jobs for f ear of being blamed if problems are 
uncovered. 
 Option B: The CEO’s attitude towards suppliers shows he is not 
committed to solving the problems,  as do the views of the sales 
director and purchasing manager. 
 Option C: This may be true but it w ould not prevent internal controls 
principles being embedded within J. 
 Option D: Similarly, staff who have worked in J Company for a long 
term may actually be more commi tted to solving its’ problems and 
happy to incorporate internal co ntrols as part of their jobs. 
 Option E: Well-paid happy staff ma y be complacent but they may 
also be willing to adapt to change with minimal fuss, especially if 
they have respect for management.

Chapter 6 
 385 
 (1) Shoplifting  
– CCTV cameras in the shop. – Security tagging of products. – Stock reconciliations to detect theft. – Employment of security guards. 
(2) Goods not invoiced  
– Reconcile goods despatch notes to invoices. – Check sequences of goods despatch notes and invoices. – Segregation of dut ies between despatch and invoicing. 
– Reconcile stock movement and sales figures. 
(3) Poor quality supplies  
– Inspection of all goods when received. – Approval of suppliers who can supply high quality. 
(4) Incorrect prices  
– Arithmetic checks on invoices. – Computer system control to ensur e that every invoice is priced 
on current price levels. 
– Authorisation of staff who can change price levels. 
 
 The correct answer is C – By definition. 
 
 The correct answer is B – By definiti on. A ensures that all deliveries have 
been invoiced. C ensures the corre ct goods are despatched. D will 
remind the customer to pay but if t hey are unable to pay it will not help. 
 
 The correct answers are A, B, C, D and E – All of the controls should help 
to some extent. 
 
 The correct answers are B, C and D – The COSO framework does not 
mention the external environment, but does mention the internal 
environment.

386  
 C only 
 Option A may help staff learn about B and its operations but not 
guard against fraud. 
 Option B may make the café r un more smoothly but not guard 
against dishonesty. 
 Option C may ensure only trustw orthy staff are recruited. 
 Option D may ensure suitability for the job but any dishonest recruit 
could just wait six wee ks before perpetrating a fraud. 
 Option E is not a HR control, rather an operational control. 
 
 A, C and D 
 Option A: This would ensure every student present signs the 
register and so is invoiced for the course. 
 Option B: This would prevent st udents turning up, signing in and 
leaving but it would not pick up those students who do not sign the 
register at all and so  do not get charged. 
 Option C: This would prevent thef t of material from students not 
enrolled however may not be prac tical unless students enrol early. 
 Option D: This would ensure that  all students signed in and could be 
invoiced for the course. 
 Option E: This may cause a loss in revenue since provided there is 
room in the class students who turn up on the day should be 
allowed to attend. They can be invoiced later as long as their details are recorded by B. 
 
 The correct answer is B – By definition. 
 
 The correct answers are B, C and D – Insurance does not prevent theft. 
Amounts over £100 should be dealt with by cheque or bank transfer, and 
not through petty cash. Transactions should be kept confidential – it would appear that som eone knew when to steal the tin, while large 
amounts were held.

Chapter 6 
 387 
 A and B only 
 Option A: This will prevent deliveries being made without the 
customer being invoiced or the cash being received. 
 Option B: The computer systems appear to have been accessed by 
third parties with the aim of obtai ning goods without paying. It could 
be that IT staff are actually perpe trating the fraud and this control 
will detect if this is the case as well as act as a deterrent to staff 
attempting to place such orders. 
 Option C: Since there is a possib ility of customer accounts being 
hacked, this control will not rem edy the weakness in the system. 
 Option D: This may highlight a r eoccurrence of the issue but it will 
not prevent it from occurring in the first place. 
 Option E: This may help minimise  financial losses from goods being 
‘given away’ but will not prevent  the hacking from occurring. 
 
 The correct answers are A, B, C and D – All of the controls should help. 
 
 The correct answers are C and D – A and B are non-financial qualitative 
controls. 
 
 The correct answers are A, B and D – Annual bank reconciliations will not 
be often enough to spot a fraud. 
 
 A, C and D 
Note: 
 B – internal control systems can be applied to service organisations 
as well 
 E – internal controls address more than just major accidents 
 F – internal controls are needed for all types of organisation

388  
 B, C and E 
 Option A may have contributed to more injuries but not made the 
incident more likely to occur. 
 Option D would have caused monetary loss to TT but not made the 
 
 There is very little evidence agains t the manager and the law will almost 
certainly require the hospital to prove that the C anteen Manager was 
fraudulent. The material and the info rmation that has been gathered by F 
is persuasive but most of it could simply be denied by the Canteen Manager. 
The hospital can prove that the C anteen Manager’s purchases cost more 
than might have been charged by  another supplier, but t hat is not in itself 
proof of fraud. The manager could claim to have been careless in 
permitting the supplier to overcharge the hospital, but could deny any fraudulent intent. The purchases clearly did take place because the food was received and sold through the canteen. The transactions were authorised by the manager, who was empowered to authorise new 
suppliers and to sign for purchases. All of the documentary evidence proves that the canteen purchases  were made from an authorised 
supplier for the purpose stated in the bookkeeping records. 
The only way to prove that t he manager had defrauded the hospital 
would be to seek a formal statement  from the supplier that there had 
been fraudulent collusion. The suppl ier is owner-managed and the owner 
is clearly implicated in the fraud. All the owner has to do is to claim that 
the sales actually occurred at the re corded prices. If the owner admits to 
participating in the fra ud then s/he will be admitting to a criminal offence 
and will then be open to the threat of criminal charges. The hospital might 
also be able to reclaim the overstatem ent of the prices  from the owner. 
The only correspondence concerning the fraud is in an electronic format. 
By his own admission, the inter nal auditor has accessed the email 
account and so the manager could cl aim that the files and messages 
have been tampered with. There is no dire ct proof that the emails were 
sent to and from the Canteen M anager and the owner. Anybody could 
have created that email account and sent and received bogus emails describing a fraud. The manager could si mply deny ever having sent or 
received those messages.

Chapter 6 
 389 
 Computer systems provide a particular opp ortunity for fraud, although this 
requires dishonesty by employees, opportunity to commit fraud, and 
motive. Accounts Payable in particu lar presents the opportunity for 
unscrupulous suppliers to claim payment for goods not delivered or services not supplied, or to overchar ge. It also provides the opportunity 
for employees to redirect payments to themselves, or third parties, rather 
than to the intended supplier,  either alone or in concert with third parties. 
Some controls are preventative – des igned to limit or prevent an event 
from occurring. This could include physical access controls over the 
computer system, selection and traini ng of staff, separation of duties 
between invoice and payment processi ng or authorisation levels for 
invoices and payments. Other controls are detective: they identify events 
that have already occurred,  through, for example, the reconciliation of 
invoices to a supplier statement. Internal audit, based on risk identification and assessment  procedures have an impo rtant role to play 
in detective controls. Finally, correctiv e controls correct events after they 
have occurred (e.g. recovering overpay ments from suppliers, or seeking 
recompense from employees under a fraud response plan). 
It is particularly important that st rong controls exist over programme 
alterations to accounts payable softw are, physical and logical access 
controls to accounts payable systems, authorisation levels for invoices 
and payments and control over forms such as cheques and electronic 
bank remittances. 
The risk of fraud can be reduced thr ough fraud prevention,  identification 
and response policies. Fraud prevent ion requires an anti-fraud culture 
and risk awareness which is part of the control environment; sound control systems; and an effect ive whistle-blowing policy. 
Fraud can be identified through regular internal audit checks, warning 
signals such as late payments, wo rk backlogs, untak en annual leave, and 
the lifestyle of staff where it is incommensurate with their salary. Fraud 
response should include disciplinar y action under human resource 
policies, civil litigation for reco very and criminal prosecution.

390  
 (i) Memorandum 
Subject:  Fraud mitigation  
This fraud would have been extremely diffi cult to prevent and/or to detect. 
The fraud involved collusion between tw o members of staf f. Segregation 
of duties is one of the most powerful means of preventing fraud, but it can 
be defeated by fraudulent collusion. It would be virtually impossible to make a system effective without re lying on segregation of duties. 
The fact that one of the perpetrators was a senior member of staff made 
it more difficult to prevent. T he head of an academic department in a 
college would be regarded as a trust ed member of staff, who would not 
normally be expected to steal from the college. 
Systems are often designed in the ex pectation that senior members of 
staff will not betray such trust. 
The system was further defeated by the falsification of a record on the 
personnel department. There was a sound control in place that was only 
defeated because of a combinati on of human error and blatant 
falsification. It would be almost impo ssible to design any system so that it 
was foolproof in preventing all mi stakes and in preventing fraudulent 
falsification. 
Once the fictitious entry had been made in the personnel files the fraud 
would be difficult to detect because it  would add only a very small amount 
to the overall payroll. A college woul d have a large num ber of lecturers 
and there would be a substant ial turnover in staff. 
The only people who could be expec ted to detect this fraud were 
implicated in it. 
(ii) Letter 
Address Date Dear Sir, I am writing in answer to your reques t to advise on the weaknesses in the 
college's systems and procedures. I also  cover the suggestion that the 
human elements of control systems ar e frequently more important than 
the software elements in ensurin g that records are correct. 
(a) Additions to the payroll should r equire further authorisation than just 
the head of the department in whic h he or she would be teaching. 
That is not just to pr event fraud and error, but also to ensure that 
those appointed are compet ent and well qualified. 
Teaching time should be budgeted and allocated to specific classes. 
That should be part of the norma l planning and budgeti ng process.

Chapter 6 
 391 
 Again, that is lar gely about ensuring that the college obtains value 
for money from teaching rather th an merely trying to prevent fraud 
and error. This budgeting should be c onducted, or at least reviewed 
in detail, by a dean of faculty or an assistant principal rather than the 
heads of individual departments. 
Pass keys should not be issued to anybody other than designated 
security and cleaning staff. If a mem ber of staff requires a door to be 
unlocked then the security guard should open the door personally 
rather than making a loan of a pass key. Computer passwords 
should be issued to staff so that they  cannot invent their own, easily 
guessable passwords. The college should have a policy of holding staff responsible for all input made using their electronic identities –
regardless of whether they were act ually involved – so that they are 
motivated to take care over l ogging out of systems and protecting 
access. 
Human controls 
(b) It could be argued that the most important aspect of any secure 
system is authorisation. 
Software can compare entries in  different files and highlight 
discrepancies, but it cannot ma ke meaningful decisions about 
whether a transaction should be processed. For example, a 
bookkeeping package will process any transaction that is input by a 
user with access rights, regardle ss of whether that entry makes 
sense. The physical security of any system is dependent on the behaviour of the people who operate it. It is, for example, common 
for security to break down because staff are careless over locking doors or restricting access to authorised personnel. The most important changes that are made, such as amendments to standing 
data, often require some judgem ent on the part of the person 
responsible for authorising the change. 
If that person is not careful in agreeing to make the change then the 
fact that the software is program med to ensure that the change has 
been authorised will be almost poi ntless. Most fraud involving 
computers tends to be relatively lo w-tech. For example, the input of 
fictitious purchase invoices in t he hope that this leads to a payment 
that can be intercepted. Such fra ud is more easily detected by a 
human being than a computer programme. 
I hope you have found my advice and suggestions useful. However, 
if you have any further queries, please do not hesitate to contact 
me. 
Yours faithfully, A.N. Accountant

392  
Subject:  The control environment at G 
Introduction This report covers an explanation of why it is necessary to improve G’s 
control environment and evaluates t he Chief Executive’s proposal to 
impose disciplinary measures on staff who are responsible for bookkeeping errors or delays. 
(a) The control environment  
The control environment is essentiall y a reflection of the attitudes of 
senior management towards the operation of the system. If 
management is seen to condone control weaknesses and compliance failures then the staff at more junior leve ls will tend to 
interpret that as an indication that controls do not matter. 
It is clear that G’s senior managem ent has tolerated a situation in 
which the staff are concerned only with the technical success of the 
production process. That has led to problems with the bookkeeping 
and administrative arrangements, whic h could prove very costly to 
the company. The delays and errors in those areas could disrupt cash flows and irritate customers. The fact that t he accounts staff 
are demotivated means t hat there is a risk t hat they will leave and 
so time and energy will have to be invested in appointing replacements.

Chapter 6 
 393 
 (b) Disciplinary measures  
G has been successful because its staff have tended to focus on the 
quality of the product and the custom er satisfaction with the product 
itself is evidence of that. It ma y be that the relaxed working 
relationships mean that staff can focus on product innovation and 
quality management and that has enhanced the company’s 
reputation. Any changes that are introduced will have to be 
undertaken with some sensitivity in case they lead to staff becoming 
demotivated in the process. It ma y not be constructive to use the 
threat of disciplinary action in the first instance. The fact that the 
new Chief Executive is keen to im prove the administrative side of 
the company could be communicated to  all staff as a positive step 
that will make the company more se cure and efficient. The company 
will be unable to function, and to  provide employment in the 
process, if it is unable to pay for materials or to bill customers properly because of accounting erro rs or lost documentation. It 
should be possible to communicate  a positive attitude and 
encourage staff to view the account ing aspects of the company’s 
operations as an extension of t he whole organisation. The same 
attitude could be taken towards budgets and variance reports because they can help to ensure t he smooth and efficient running of 
the organisation. The threat of disciplinary action may help to demonstrate that the Ch ief Executive takes these matters seriously 
and should send a clear message to st aff. The problem is that the 
workforce is motivated and hardworking and so it may be counter ‐
productive to make that threat unless other approaches have been 
tried and failed. Quite apart from  damaging relations with the 
workforce, if G threatens to discipline staff and does not carry out that threat, then the impressi on that errors and delays are 
acceptable will be reinforced. 
The threat of swift and decisive action may motivate and encourage 
the bookkeeping staff. The fact that  the Chief Executive is prepared 
to take action against employees who make their jobs more difficult 
could make the bookkeeping staff feel valued and reassured that there will be a change for the better. 
In summary, the control environm ent at G is very important and 
should be improved. Disci plinary action, where threatened, must be 
carried out to prevent a future  culture of carelessness.

394  
Subject:  U's control environment and recommended improvements 
This report covers the weaknesses in both the control environment and 
the internal controls that led to th is loss of data. It goes on to recommend 
actions that should be taken to rest ore the confidence of existing and 
potential customers, and to prevent similar problems occurring in the 
future. 
The control environment 
There appear to be major shortcomi ngs within U’s control environment. 
The analyst’s behaviour suggests that  staff may be overworked, which 
will lead to errors and possibly short ‐cuts such as taking files home. The 
fact that the analyst was af raid to admit to the loss of the files adds to the 
sense that the env ironment is unsupportive and punitive. 
Staff should have been trained about the s ensitivity of personal details in 
a company such as U. The information that has been lost may be very personal in nature and could lead to losses because of identity theft and 
related fraud. Such training should have reduced the risk of a member of 
staff leaving a file of cust omer records on an unsecure PC. 
Staff should not be permitted to c onnect personal disk drives to U’s 
computers. There is a danger that these will carry viruses or other 
malware. Ideally, staff PCs should not have open USB sockets to reduce the risk of this occurring. Any file s that need to be shared with colleagues 
can be transferred over the firm’s network. 
The files themselves should not be accessible in their entirety. Only 
accounts staff need details of credit card numbers and so access to those should be restricted to them. Fields within files should be made available 
to U’s staff on a strictly "need to k now" basis. The analyst did not need to 
know customers’ names and full postal addresses. It would have been sufficient to have identified customer s by a user number and provided the 
analyst with a buying history for each.

Chapter 6 
 395 
 (a) Recommendations  
(i) The first priority is to make a public announcement that all 
affected customers have been in formed about the loss of their 
records. That will reduce the speculation about the loss and 
may reduce the number of claims  from customers who have 
not been affected by the loss. 
U should close all affected acc ounts and assist customers to 
create replacements. T hat will prevent customers’ claims that 
there are unauthorised char ges to their accounts. 
U should offer to assist customers who open replacement 
credit card accounts in order to  prevent fraudulent charges. U 
should reimburse any fees or charges and should also offer a discount or a voucher as a goodwill gesture for the inconvenience. 
U should take steps to remedy  the control weaknesses and 
should announce the fact that security has been improved. The fact that sensitive data could be compromised in this way will be a concern to all customer s, particularly given that U 
initially refused to assist affected account holders. 
U should quietly change its policy of denying all responsibility 
for claims of fraudulent charges. Care will have to be taken in case customers attempt to deny liability for genuine purchases 
in the hope that U will cancel their balance. It is hardly acceptable for U to claim that  customers are mistaken about 
false charges when the company has been responsible for the loss of data. 
(ii) The company should make it very clear that the removal of 
files without authorisation is a se rious breach of company rules 
and that any offenders will be deal t with. The threat should 
hopefully deter any recurrence and will also ensure that there 
is no doubt that files cannot be taken home. 
If it is ever necessary for file s to be taken home there should 
be a provision made for secure cu stody of the data. Files could 
be encrypted and staff could be issued with a company laptop that is password protected and equipped with all relevant 
antivirus and firewall software. 
There appear to be major shor tcomings within U’s control 
environment which need to be improved. Several recommendations have been made including a public announcement, closure of all affected accounts, reimbursement of fees  and the improvement of  future security 
measures.

396  
 Address 
Date Dear institutional investor, I write regarding your recent concerns  over director's remuneration at V. 
This letter should explain why the in troduction of ESOSs could motivate 
V’s executive directors to accept  positive net present value (NPV) 
projects, and how an ESOS scheme could affect the actions taken by the 
directors. 
Motivation to accept positive NPV projects (i) There is a difference between the risk profiles of shareholders and 
executive directors. Shareholders s hould hold diversified portfolios, 
in which case they are subject only to systematic risk. Directors cannot diversify in the same wa y because each director has only 
one career and can generally only be an executive director of one 
company at a time and so the dire ctors are subject to total risk. 
A director who is offered an invest ment that has a positive NPV at 
the shareholder’s required rate of retu rn may implicitly evaluate that 
investment using a higher rate t hat reflects total risk and so may 
reject it. 
If the directors hold options then the value of those options is 
directly related to the total risk of the underlying security and so the 
directors could be motivated to accept  riskier securities in order to 
increase the value of their options. There is a huge pot ential gain if 
the option is in the money when it is time to exercise it, but there is 
no symmetry because there is no spec ific loss other than the expiry 
of the options if it is out of t he money. This means that there is 
effectively only an upside risk to t he directors with respect to their 
options and that may make them  less risk averse in project 
evaluation.

Chapter 6 
 397 
 Memorandum 
To:  The remuneration committee 
From:   A. N. Accountant 
Subject:   Executive directors pay 
This memorandum evaluates the advantages AND disadvantages of 
rewarding executive directors by pay ing a bonus based on a simple and 
transparent measure such as profit. 
Any form of feedback-based control system is designed to ensure that 
positive impacts are encouraged and re inforced and negative impacts are 
discouraged and penalised. Feedba ck measures and controls 
performance by referring to actual outcomes. From t he shareholders’ 
point of view, that suggests that the directors are incentivised to progress 
towards a specific goal such as in creasing profit or share price. 
The simplicity of such a scheme makes it easier to understand the 
directors’ motives. A more co mplicated appraisal and performance 
scheme may simply create more opportuni ty for the directors to indulge in 
dysfunctional behaviour or otherwise pl ay games in order to maximise 
their rewards at the shareholders’ expense. 
From the shareholders’ point of view , it may be that maximising reported 
earnings is suboptimal and that a more complicated set of benchmarks 
would be preferable. On  the other hand, a simple benchmark does have 
the advantage of making the directors accountable for a specific aspect 
of performance. A simple control and feedback mechanism may be more 
effective simply because it has the potential to work. 
There is a risk that linking pay to reported earnings will simply lead to 
creative accounting and the over statement of ear nings figures. 
Reported earnings is also a relati vely short term indicator for most 
entities. The directors are being en couraged to adopt a planning horizon 
of twelve months which could mean t hat longer term cycles, such as the 
development of new products or the acceptance of longer term projects 
will be overlooked because a high NPV project may be a short term loss 
maker. The shareholders will have to ensure that they look out for 
evidence of such actions rather than simply taking the reported figures at 
face value.

398  
 (a) Problems expected at Cliff: poor internal control 
(i) I would expect the company to experience some level of over-
ordering, leading to reduced profitab ility as a result of inventory 
going past its `best before' date. 
(ii) Inventory that is not well- controlled in a supermarket may 
result in a breach of health and safety regulations which may result in fines or even closure of the supermarkets. 
(iii) I would expect there to be st ock-outs leading to the potential 
loss of business to other supermarkets. 
(iv) I would expect there to be ineffi ciencies as a result of a lack of 
central ordering system resulti ng from quantity discounts not 
being obtained. 
(v) All of the problems noted above are likely to be exacerbated 
where local managers or staff are either inexperienced or 
possibly dishonest – the question states that poorer quality 
staff have been recruited recently. 
(vi) Supermarket inventory is very easily pilfered eit her by staff or 
customers even where it is well- controlled. The lack of regular 
inventory counts in particular means that pilferage is very easy to hide. 
(vii) I would expect there to be a lack of understanding in the 
business as a whole as to the availability of new products, 
products with high margins or othe r areas in which profitability 
might be improved. 
(b) Four recommendations, ex planation of advantages and 
disadvantages: improvement s to internal control 
Recommendation  1: that an integrat ed system be introduced 
across all supermarkets that links sales, purchases and inventory 
records. 
This would provide the company with an overall view of what 
inventory is held at any particular time, enable it to order centrally 
and reduce the scope for pilferage. It  would result in reduced stock-
outs and reduced inventory obsolescence. 
This would require considerable c apital investment in hardware, 
software and training. It would also  take control away from local 
managers which would almost ce rtainly cause resentment. 
Recommendation 2:  the imposition of r egular, or continuous 
inventory counting procedures t ogether with the prompt update of 
inventory records for discrepancie s found and investigation of the 
reason for the discrepancies.

Chapter 6 
 399 
This would further reduce the possi bility of stock-outs and provide 
evidence of over-ordering, whic h would enable purchasing patterns 
to be refined. 
There are costs in terms of staff ti me and, again, a certain level of 
resentment among staff who may feel that they are being `spied on', 
or that they are no l onger trusted. Training would also be required 
and additional administrative work  would need to be undertaken by 
local managers 
Recommendation 3:  that management acc ounts are produced on 
at least a quarterly basis, that fi gures relating to each supermarket 
are provided to head office on a monthly basis, and that an analysis 
is undertaken by head office on the performance of individual supermarkets and inventory lines. 
This would enable the company to determine which supermarkets 
are performing better than others. It  would also enable the company 
to identify those inventory lines t hat sell well and those that are 
profitable. 
The production of more regular and detailed information will be time 
consuming. Local managers may feel that they are unable to service 
the particular needs of their cust omers if decisions are made on a 
global basis; customers ma y feel the same way. 
Recommendation 4:  that sales price decisions are made by head 
office. 
This would enable the company to experiment with the use of `loss 
leaders', for example, and to impose a degree of consistency across supermarkets to prevent inappropri ate pricing decisions being taken 
by local managers. 
Again, loss of control at a local level is likely to result in resentment 
and the possible loss of good staff. What sells well in one 
supermarket may not do so in anot her. To the extent that head 
office have less experience of local conditions than local staff, it is 
possible that inappropriate pricin g decisions may be made by head 
office.

400  
 Reputation risk could be managed by actively warning drivers of the 
system’s limitations. That could in volve insisting that Q signs an 
acknowledgement that the system cannot prevent all crashes. This 
document should be kept in a safe place at SPD for future reference if need be. The warning could be repeat ed in the owner’s handbook which 
should be signed for by the driver, and, again, a copy should be kept at SPD. 
Any promotional material published by Q should stress that the system is 
designed to enable drivers to be ev en safer when driving within their 
limits but that responsibility for an y failure cannot be accepted by SPD. 
SPD could insist that the circuit board is designed to “fail safe” conditions. 
It could have a diagnostic routine progra mmed into it which will check that 
it is functioning correctly whenever it is  switched on. In the event that this 
routine fails the circuit board will i mmobilise the engine. A contract drawn 
up by their solicitors would be requir ed to absolve SPD of any blame for 
failure. 
SPD should ask Q to accept responsib ility for the work done by the third 
party and get this put in writing. A gain a solicitor would need to deal with 
this. Any lost business due to dela ys or failures to meet delivery 
deadlines should be compensated. SPD will also have to insist on its own quality control procedures over this  component. That may involve having 
the right to request details of the te chnical specificat ion of the part and 
the subsequent testing of it on a regular basis.

Chapter 6 
 401 
 Tutorial note:  It is not recommended that you lay out answers to 
examination questions in a tabular form at such as that shown below. Full 
sentences and paragraphs will ensure that you explain points in enough 
detail to earn full marks. 
Weakness Evaluation of 
weakness Recommendation 
Recording of orders   
Orders placed on the 
Internet site are 
transferred manually 
into the inventory and sales system. Manual transfer of order details may result in information being 
transferred incompletely 
or incorrectly, for example, order quantities may be incorrect or the wrong 
product code recorded. Customers will be sent 
incorrect goods 
resulting in increased 
customer complaints. The computer systems 
are amended so that 
order details are 
transferred directly between the two computer systems. This will remove manual transfer of details 
limiting the possibility of 
human error. 
Control over orders 
and packing lists   
Each order/packing list 
is given a random 
alphabetical code. While this is useful, using this type of code makes it difficult to check 
completeness of orders 
at any stage in the despatch and invoicing process. Packing lists can be lost 
resulting either in goods 
not being despatched to the customer (if the list is lost prior to goods being despatched) or 
the customer's credit 
card not being charged (if lost after goods despatched but prior to the list being received in the accounts 
department). Orders/packing lists are 
controlled with a 
numeric sequence. At the end of each day, gaps in the sequence of packing lists returned to 
accounts are 
investigated. 
Obtaining payment   
The customer's credit 
card is charged after 
despatch of goods to 
the customer, meaning 
that goods are already 
sent to the customer 
before payment is 
authorised. Rhapsody Co will not 
be paid for the goods 
despatched where the 
credit company rejects 
the payment request. 
Given that customers 
are unlikely to return 
seeds, Rhapsody Co 
will automatically incur 
a bad debt. Authorisation to charge 
card is obtained prior to 
ensure Rhapsody Co is 
paid for all goods 
despatched.

402  
 Completeness of 
orders    
The computer system 
correctly ensures that order details are available for all charges to customer credit cards. However, there is no overall check that all orders recorded on the inventory and sales system have actually been invoiced. Entire orders may be 
overlooked and consequently sales and profit understated. The computer is 
programmed to review the order file and orders where there is no corresponding invoice for an order, these should be flagged for subsequent investigation. 
 
Risks Recommendation 
Cash paid to part time staff 
(easier to misappropriate cash). Apply the payroll system to all 
No control over the appointment 
of head office staff the HR Manager deals with (may recruit unnecessary staff). Head office staff should be 
approved by the board. 
No control over shop staff, the 
shop manager recruits own staff. Should be approved by head 
office. 
Guest cards, could be anybody 
and they could steal a card to 
access till at a later date to steal money. A control system to monitor guest 
cards so management know who 
has a specific card. 
Lack of segregation of duties, the 
payroll manager is responsible for 
all processing. Split the responsibilities up, maybe 
get a manager to review the payroll 
manager's work. 
In the question it states the IT 
manager is responsible for 
systems, but doesn't state there is restricted access. Place passwords on the system 
and change them on a regular 
basis.

403 
C1. Internal control systems. (a) Discuss roles and 
C3. Internal audit in organisations. (a) Discuss forms of internal 
audit 
(b) Discuss internal audit 
process 
(c) Discuss effective internal 
audit 
(d) Discuss the internal audit 
report Chapter 
7

404  
 
 1 Management review of controls 
 
The UK's Turnbull committee says that a re view of internal controls should be 
an integral part of management 's role. The board or committees should actively 
consider reports on control issues. In  particular they should consider: 
 The identification, ev aluation and management of all key risks facing the 
organisation; 
 The effectiveness of internal control – financial, operational, compliance 
and risk management controls; 
 Communication to employees of risk objectives with targets and 
performance indicators; 
 The action taken if any weakness is found. 
The report goes on to recommend t hat the board should consider: 
 The nature and extent of the ri sks which face the organisation; 
 The threat of those risks occurring; 
 The organisation's ability to reduce the probability and consequences of 
the risk, and to adapt to any changing risks; 
 The costs and benefits of any controls implemented.

Chapter 7 
 405 
An effective internal control system should keep management properly informed 
about the progress of the organisation (or la ck of it) towards the achievement of 
its objectives. Management and supervisors have a responsibility for monitoring 
controls in the area of operat ions for which they are re sponsible. Internal control 
might also be monitored by an internal audit function 
 
 What is internal audit ? 
 
Internal auditing is an indep endent and objective assurance activity designed to 
add value and improve an organisation's op erations. It helps an organisation 
accomplish its objectives by bringing a systematic approach to evaluating and 
improving the effectiveness of risk management, control, and governance processes. Internal auditing improves  an organisation’s effectiveness and 
efficiency by providing recommendat ions based on analyses and assessments 
of data and business processes. 
Internal auditing provides value to gover ning bodies and senior management as 
an objective source of independent advice. 
The scope of internal auditing within an organisation is broad and may involve 
topics such as the efficacy of operations , the reliability of financial reporting, 
deterring and investigating fraud, sa feguarding assets, and compliance with 
laws and regulations. 
Internal auditing frequently involves measuring compliance with the entity's 
policies and procedures. However, internal  auditors are not responsible for the 
execution of company activities; t hey advise management and the Board of 
Directors (or similar oversight body) regarding how to better execute their 
An internal audit function therefore acts as an internal control, to ensure that the 
internal control system is operating effectively. 
 
 Risk management vs. internal audit 
 A risk management team would be considered to own the entire risk 
 They would be ultimately responsible  for all aspects of this process 
including identification and maintenanc e of the company’s risk register, 
assessment, prioritisation, treatment of  risks and establishment of controls 
to manage these risks. 
 The team would lead the company in developing a risk response strategy 
and would act in an advisory capacity s upporting all areas of the business. 
 Provision of training and development  by risk staff would facilitate 
operational managers’ ability to identify risks in their area of work and 
devise controls by which to manage them.

406  
 The role of internal audit is that of monitoring and reviewing the 
effectiveness of the controls im plemented by operational managers. 
 In the context of risk management thei r key activity is in the testing and 
evaluation of the risk cont rols (hence ensuring that those who design 
controls should not test them ). 
 In a wider context the internal audit department can carry out special 
investigations as directed by managem ent, and can assist the organisation 
in review of the effici ent use of resources. 
 Internal audit teams can provi de support and assistance to senior 
management in a range of projects, so me of which may fall outside the 
risk management arena. 
 They are often able to contribute to  the work of operational teams in 
identifying risks due to their extensive knowledge of the business, but this 
is not their primar y responsibility. 
In summary, risk management identify ri sks or problems, management devise 
controls which they think will prevent t he risk or problem and the auditors check 
that the control works. If it doesn't, then it is still a problem and management will 
implement further or different controls  which audit will check again. And so the 
process goes on until the risk or problem is  minimised to the satisfaction of 
management i.e. it is within t he companies attitude to risk. 
There are three different parties involved in the process review – risk 
management, managers and auditors, to ensure independence and the best 
solution for the company. 
 
 Factors affecting the n eed for internal audit 
 There are a number of fa ctors that affect the need for an internal audit 
Factor Comment 
The scale, diversity 
and complexity of the company’s activities The larger, the more diverse and the more 
complex a range of activities is, the more there is to monitor (a nd the more opportunity 
there is for certain things to go wrong). 
The number of employees As a proxy for size, the number of employees 
signifies that larger organisations are more likely to need internal audit to underpin investor confidence than smaller concerns. 
Cost/benefit 
considerations Management must be certain of the benefits 
that will result from establishing internal audit 
and they must obviously be seen to outweigh the costs of the audit.

Chapter 7 
 407 
 Changes in the 
structures, reporting processes or underlying information systems Any internal (or exte rnal) modification is 
capable of changing t he complexity of 
operations and, accordingly, the risk. 
Changes in key risks 
could be internal or 
external in nature The introduction of a new product, entering a 
new market, a change in any of the 
PEST/PESTEL factors or changes in the industry might trigger the need for internal audit. 
Problems with existing internal control systems. Any problems with existing systems clearly 
signify the need for a tightening of systems and increased monitoring. 
An increased number of unexplained or unacceptable events. System failures or similar events are a clear 
demonstration of internal control weakness. 
Where there is no internal audit department, management needs to apply 
other monitoring processes in order to assure itself and the board that the 
system of internal control is functioning as intended. In these circumstances, the board will need to assess whether such procedures provide sufficient and objective assurance. 
 
 Teddy plc is a small UK-based fam ily run company selling traditional 
wooden toys from a small chain of s hops. The firm has seen rapid sales 
growth since engaging in e-commerce via a website and selling via large 
third party online retailers. 
The newly appointed Finance Director is the first board member from 
outside the family and has suggested it would be a good idea for Teddy plc to consider establishing an internal audit department as he has 
already noticed a large inventory discrepancy. 
Which THREE of the following fact ors are the main reasons for the 
need for an internal audit at Teddy plc? 
A If a company is listed on the stock ex change it must have an internal 
audit 
B The growing scale and diversity for Teddy plc suggests there is 
more to monitor 
C Potential internal control issues are starting to arise at Teddy plc 
D The introduction of e-commerce at Teddy plc E The fact the board has majority family members F The wish of the shareholders at Teddy plc.

408  
 Z is the head of the risk management team at P Co, a large listed 
manufacturer. P Co also has a well- established internal audit team which 
is run completely inde pendently of any operational  functions within the 
company in accordance with best practice. 
Each year P Co takes on around 20 graduate trainees and in their first 
month of employment they undergo a det ailed induction. As part of this 
training they listen to presentations  on the role of several departments 
within P Co including internal audi t. This year, the board of P Co has 
decided to ask Z to speak to the graduates about the role of the risk 
management team and how it differs  from that of internal audit. 
Z is preparing her presentation. Wh ich of the following should she 
include and explain as roles of  the risk management team? 
A The maintenance of P Co’s risk register B The establishment of controls to manage risks 
C The evaluation and testing of risk controls D The provision of training and dev elopment to operational staff to 
help them to identify risk 
E Review of the efficient use of resources across the organisation 
F Overall responsibility for risk management within P Co 
2 Scope and standard of internal audit work 
Scope of internal audit work 
The internal audit department will typically have the following scope and 
objectives as prescribed by t he management of the business: 
(Do not treat this as a comprehensive lis t of all the areas that the internal 
auditor considers, as management may prescr ibe different functions to meet the 
needs of their company).

Chapter 7 
 409 
 
 More on scope of internal audit work 
  
Work area Comment 
Reviewing accounting 
and internal control 
systems (financial audit) This is the traditional view of internal audit. The 
internal auditor checks the financial controls in 
the company, possibly assisting or sharing work with the external auditor. The internal auditor would comment on whether appropriate controls exist as well as whether they are working correctly. In this work, the internal auditor does not manage risk, but simply reports on controls. 
Examining financial and operating information Internal auditors ensure that reporting of 
financial information is made on a timely basis and that the information in the reports is factually accurate. 
Reviewing the economy, efficiency 
and effectiveness of 
operations This is also called a value for money (VFM) 
audit (see more later in this chapter). The 
auditor checks whether a particular activity is 
cost-effective (economical), uses the minimum inputs for a given output (efficient) and meets its stated objectives (effective).

410  
 Reviewing 
compliance with laws 
and other external regulations This objective is particularly relevant under 
corporate governance codes where the 
internal auditor will be carrying out detailed work to ensure that internal control systems and financial reports meet stock exchange 
Special investigations Investigat ions into other areas of the 
company’s business, e.g. checking the cost estimates for a new factory, or investigating suspected fraud. 
Assisting with the 
identification of 
significant risks In this function, the internal auditor does start 
to work on risks. The auditor may be asked to 
investigate areas of  risk management, with 
specific reference on how the company identifies, assesses and controls significant risks from both internal and external sources. 
Assisting in carrying 
out external audit procedures The internal audit team may work closely with 
the external auditors and provide information that can be utilised in the external audit. There is an obvious benefit to the company from this 
in the form of a reduction in the audit fee. 
 
Standard of internal audit work 
The internal audit function would be expec ted to carry out t heir work to a high 
professional standard. To achieve th is the audit function should be well 
managed and have clear and appropriate proc edures for carrying out its work. 
It would be expected that: 
 There is a formal plan of all audit work that is reviewed by the head of 
audit and the board/audit committee. 
 The audit plans should be reviewed at least annually. 
 Each engagement should be conducted appropriately: 
– Planning should be performed. 
– Objectives should be set for the engagement. – The work should be documented, reviewed and supervised. – The results should be communicated to management. – Recommendations for action should be made. 
 The progress of the audit should be m onitored by the head of internal 
audit, and if recommendations that the head feels are appropriate are not 
acted on, the matters should be brought to the attention of the board.

Chapter 7 
 411 
 Standards of internal audit work 
 Internal auditors can follow the sa me standards as external auditors. 
However, there are also International  Standards for Internal Audit issued 
by the Internal Auditing Standards Board (IASB) of the Inst itute of Internal 
Auditors 
 Attribute standards  deal with the characteristics of organisations 
and the parties performing internal auditing activities. 
 Performance standards  describe the nature of internal auditing 
activities and provide quality criteria for eval uating internal auditing 
services 
Attribute standards for internal audit 
Objective of 
standard Explanation 
Independence The internal audit activity should be 
independent, and the head of internal audit should report to a level within the organisation that allows the internal audit activity to fulfil its responsibilities. It should be free from interference when deciding on the scope of its assurance work, when carrying out the work and when communicating its opinions 
Objectivity Internal auditors should be objective in 
carrying out their work. They should have an 
impartial attitude, and should avoid any conflicts of interest. Fo r example, an internal 
auditor should not provide assurance services for an operation for which he or she has had management responsibility within the previous 
year. 
Professional care Internal auditors should exercise due 
professional care and should have the competence to perform their tasks. They should have some knowledge of the key IT risks and controls, and computer-assisted audit techniques.

412  
 Performance standards for internal audit 
Area of work Explanation 
Managing 
internal audit  The head of internal audit should manage 
the internal audit activity to ensure that it adds value to the organisation. 
 The head of internal audit should 
establish risk- based plans to decide the 
priorities for internal audit work, consistent with the organisation’s objectives. 
 The internal audit plan should be 
reviewed at least annually. 
 The head of internal audit should submit 
the plan of work to senior management 
and the board for approval. 
Independence is maintained by the internal 
auditor/audit committee being able to decide the scope of internal audit work without being influenced by the board/senior management. 
  The internal audit department should 
identify and evaluate significant risk 
exposures and contribute to the improvement of risk management and control systems. It should evaluate risk exposures relating to governance, operations and information systems, and the reliability and int egrity of financial and 
operating information, the effectiveness 
and efficiency of operations, safeguarding 
of assets, compliance with laws, regulations and contracts. 
auditor being given access to information on all these areas and being able to report freely on any errors or omissions found. 
Control 
  The internal audit department should help 
to maintain the organisation’s control 
system by evaluating the effectiveness and efficiency of controls, and by promoting continu ous improvement. 
Independence is again maintained by ensuring 
full provision of information and independent reporting lines (via the audit committee).

Chapter 7 
 413 
 Governance 
assess the corporate governance 
process and make recommendations 
where appropriate for improvements in 
achieving the objectives of corporate governance.  
auditor being able to report breaches of corporate governance c ode without fear of 
Internal audit work 
  Internal auditors should identify, analyse, 
evaluate and record sufficient information 
to achieve the objectives of the engagement. 
 The information identified should be 
reliable, relevant and useful with regard 
to the objectives of the engagement. 
 The auditors’ conclusions should be 
based on suitable analysis and 
 Information to support the conclusions of 
the auditors should be recorded. 
auditor being able to show that normal standards of internal audit work have been followed; that there has been no pressure to 'cut corners' either fr om senior management or 
because the internal auditor decided to carry 
out the work to a lower standard. 
Communicating 
results 
  Internal auditors should communicate the 
results of their engagement, including 
conclusions, recommendations and action plans. 
 The results should be communicated to 
the appropriate persons. 
Independence is maintai ned by the internal 
auditor being able to communicate to a 
committee or person separ ate from the board 
who also has the power to take appropriate action on the internal auditors' 
reports.

414  
3 Structure, independe nce and effectiveness of internal audit 
 Structure and independence of internal audit 
To ensure that the internal audit functi on provides an objective assessment of 
control systems and their weaknesses, t here should be measures in place to 
protect the independence of t he internal audit department. 
 The internal auditors should be in dependent of executive management 
(but have direct access to the highes t level of management if required) 
and should not have any involvement in th e activities or systems that they 
audit (free from operational responsibility). 
 The head of internal audit should repor t directly to a senior director. 
 In addition, however, the head of inter nal audit should have direct access 
to the chairman of the board of dire ctors, and to the audit committee, and 
should be accountable to the audit committee. 
 The audit committee should approve the appointment and termination of 
appointment of the head of internal audit. 
 In large organisations the inter nal audit function will be a separate 
 In a small company it might be the re sponsibility of individuals to perform 
specific tasks even though there wil l not be a full-time position. 
 Some companies outsource their inter nal audit function, often to one of the 
large accountancy firms. 
 The internal auditor will review the accounting and control systems, 
perform testing of transactions and balances, review the 3E's, 
implementation of corporate policies, carry out special investigations, and 
assist the external a uditors where necessary. 
 They should be technically competent  and exercise due professional care 
by planning, supervising and reviewing any work performed. 
Documentation should be kept, resu lts communicated to management and 
recommendations made.

Chapter 7 
 415 
 The Board of NN, a large drinks manufacturer, decided to set up an 
internal audit function. The proposal was to appoint an internal auditor at 
mid-management level who would report di rectly to the Finance Director. 
NN had recently expanded its pr oduct range and this had created the 
need for greater control over internal  activities. The need was highlighted 
by a recent event where internal quality checks were not carried out and thousands of units of producti on were wasted as a result. 
The board discussed whether to promot e internally or appoint the new 
internal auditor from outside the company and they also expressed 
concerns over the level of authorit y the internal auditor may expect. 
Although they recognised the post as important, they believed too much 
authority might compromise the oper ational effectiveness of other 
Which of the following statements are likely to be correct with 
respect to the board’s deliberations?  
A Reporting to the Finance Directo r is a clear threat to the 
independence of the internal auditor. 
B Recruiting an internal auditor from outside the organisation may 
help with independence and objectivity. 
C Appointment of an internal auditor will ensure events such as the 
loss of production due to poor quality control do not re-occur. 
D The internal auditor will not be involved with the work of other 
departments and so the fears of  the board over operational 
effectiveness are groundless. 
E Internal auditors must operate as a separate department within NN 
and so a single appointment will not be adequate. 
 
 Outsourcing internal audit 
 In common with other ar eas of a company’s operat ions, the directors may 
consider that outsourcing the inter nal audit function represents better 
value than an in-house provision. Loc al government authorities are under 
particular pressure to ensure that all their services represent ‘best value’ 
and this may prompt them to dec ide to adopt a competitive tender 
approach. 
Advantages of outsourcing internal audit 
 Greater focus on cost and efficiency of the internal audit function. 
 Staff may be drawn from a broader range of expertise. 
 Risk of staff turnover is passed to the outsourcing firm. 
 Specialist skills may be more readily available. 
 Costs of employing pe rmanent staff are avoided.

416  
  May improve independence. 
 Access to new market place te chnologies, e.g. audit methodology 
software without associated costs. 
 Reduced management time in administering an in-house 
Disadvantages of outsourcing internal audit 
 Possible conflict of interest if provided by the external auditors. 
 Pressure on the independence of the outsourced function due to, for 
example, a threat by managem ent not to renew contract. 
 Risk of lack of knowledge and under standing of the organisation’s 
objectives, culture or business. 
 The decision may be based on cost  with the effectiveness of the 
function being reduced. 
 Flexibility and availability may not be as high as with an in-house 
function. 
 Lack of control over standard of service. 
 Risk of blurring of roles between in ternal and external audit, losing 
credibility for both. 
Minimising these risks 
Some general procedures to minimi se risks associated with outsourcing 
the internal audit f unction will include: 
 Controls over acceptance of inte rnal audit contracts to ensure no 
impact on independence or ethical issues. 
 Regular reviews of the quality of audit work performed. 
 Separate departments covering in ternal and external audit. 
 Clearly agreed scope, responsibilities and reporting lines. 
 Performance measures, m anagement information and risk 
 Procedure manuals for internal audit.

Chapter 7 
 417 
 X plc is a financial services company. Shares in X have recently been 
listed on the UK stock exchange. 
You are a Management Accountant of X, and have been talking to your 
CEO about the need to implement a system of internal controls in order 
to comply with corporate governanc e requirements. X already has an 
Internal Audit function, which r eports direct to the CEO. The CEO 
believes that Internal Audit should  be outsourced to one of the many 
audit firms offering such services, but NOT the company’s external 
auditor. 
Advise the CEO which THREE of the following are ADVANTAGES of 
doing this. 
A Specialist skills may be more readily available 
B Risk of staff turnover is passed to the outsourcing firm C Better understanding of the organisa tion’s objectives and culture 
D May improve independence E Decisions relating to Internal Audit can be based solely on cost 
 
 Ethical threats to independence 
 Situations could occasionally aris e in which an auditor, especially an 
internal auditor, might be asked to behave (or might be tempted to 
behave) in a way that conflicts wit h ethical standards and guidelines. 
Conflicts of interest could relate to  unimportant matters, but they might 
also involve fraud or some other illegal activity. 
Examples of such ethical conflict s of interest are as follows: 
Threat Example 
There could be pressure from an 
overbearing super visor, manager 
or director, adverse ly affecting the 
accountant’s integrity. The auditor is asked not to report 
adverse findings. The threat could be made more personal, e.g. by indicating that the auditor’s employment will be terminated if disclosure is made. 
An auditor might mislead his employer as to the amount of experience or expertise he has, when in reality the expert advice of someone else should be 
sought. The auditor wants to retain his 
position within the internal audit department or gain respect because of the apparent experience that they have.

418  
 An auditor might be asked to act 
contrary to a technical or 
professional standard. Divided loyalty between the auditor’s superior and the required professional standards of conduct could arise. An auditor is told to ignore the 
incorrect application of an 
accounting standard or the incorrect reporting of directors’ remuneration. 
Resolution of ethical c onflicts of interest 
Conflict resolution has been covered earlier. 
Effectiveness and efficiency of internal audit 
The work of an internal audit depar tment should be monitored to assess 
effectiveness in the broader context of the company’s risk management 
systems. 
The internal audit process must prov ide benefits in excess of its cost. 
 The efficiency  of internal audit can be assessed by comparing actual 
costs and output against a target, such as: 
– the cost per internal audit day – the cost per audit report – the number of audit reports produced. 
 The effectiveness  of internal audit needs to  be measured in a way that 
indicates the extent to which it pr ovides assurance to management, the 
audit committee and the board about the effectiveness of the system of 
– This can be done by identifying evi dence of improvements in internal 
control. 
An internal audit report can be prepared for many company activities or 
systems. E.g. payroll. 
If an internal audit was to be performed it might consider the following: 
(1) At the front of the r eport there would usually be an executive summary . 
This would cover the main objecti ves and scope of the audit, the work 
performed in brief, the result s found and recommendations made. 
(2) The scope of the assignment  would be elaborated on in the next section. 
This would detail the methodology us ed e.g. observation, questionnaires, 
etc, and the areas covered e.g.  joiners, leavers, etc. 
(3) The next section might be observations and recommendations  i.e. what 
the auditor observed during his testi ng, whether the system was working 
as it was designed to, and whether any recommendations should be implemented. It should also say who is responsible for any implementations and by when they s hould be undertaken. The number of 
recommendations could range from none i.e. the system is working 
perfectly, to many. This is probably the most practical and most useful part 
of the report for management.

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(4) The recommendations may be graded by importance . For example a 
Level 1 recommendation may need to be implemented immediately since 
it poses a significant risk to the company, whereas a Level 5 recommendation, say, might be desir able but not necessarily business-
critical so can be implemented later. 
(5) Finally there will be a statement of responsibility  from the internal 
auditor. This will detail any Auditing Standards (standard te sts or rules an 
auditor should follow) used during the course of the work and any 
limitations in the audit work that was performed. To a cynic, this is the 
auditors 'get out' clause i.e. some might read it as 'we performed the audit work to the best of our ability, but we can't test everything, so if we missed 
something, we are sorry but it wasn't our fault'! The auditor will finally sign 
the report. 
The internal audit report is often seen as a 'trigger for risk management'  both 
in the real world and in the CIMA strategic case study exam. 
4 Internal and external audit 
To a large extent, the work of internal auditors and external auditors is similar, 
and overlaps. It is therefore important that their effort s should complement each 
other, rather than duplicate each other. 
Comparison of internal to external audit 
 External audit Internal audit 
Role required by: Statute, for limited 
companies. Directors and 
shareholders, usually in larger organisations. 
Appointed by: Shareholders or dire ctors. Directors, via the Chief 
Internal Auditor (CIA). 
Reports to: Shareholder (primary duty) 
and management (professional responsibility). Directors, via the CIA. 
Reports on: Financial statements. Internal controls mainly. 
Forms opinions on: True and fair view and proper 
presentation. Adequacy of ICS as a 
contribution to the economic, efficient and effective use of resources. 
Scope of 
assignment: Unlimited, to fulfil statutory 
obligation. Prescribed by directors. 
Relationship of internal audit to external audit 
The audit plan of the external audito rs should be drawn up taking into 
consideration the work of internal audi t, and the extent to which the external 
auditors can rely on the findings of the internal auditors in  reaching their audit 
opinion.

420  
Factors that the external audi tor should consider include: 
 the status of internal audit within the organisation 
 the scope of the internal audit function 
 whether management act on the recomm endations of the internal auditor 
 the technical competence of the internal auditors 
 whether the objectives of  the internal audit work are aligned with that of 
the external auditor 
 whether the work of the inter nal audit function appears to have been 
planned, supervised, reviewed a nd documented with due professional 
care. 
Note that there is no particular expectati on that the external auditor will be able 
to rely on the work done by internal audit. The duties of both sets  of auditors will 
differ and hence the work of internal audit may be of very little relevance to the 
external auditor. 
However, in some instances, the exte rnal auditors do rely on the internal 
auditors work if areas of the exter nal auditors audit progr am have been covered 
(and the factors mentioned above can be me t). Providing the testing performed 
meets the scope and quality leve l that the external audi tor requires, then the 
external auditor will place ‘some’ reli ance on the work already performed by 
internal audit, and consequently reduce the am ount of further testing required in 
order to state an opinion. 
However, the external auditors would not  place ‘total’ reliance on the internal 
auditors work. (They would effectively need to audit the internal auditors work 
by testing it in part before they could rely on it.) 
For example, internal audit might know that during the annua l external audit 
purchase compliance tests are performed to  ensure that, say, all purchases are 
backed up by an order, the order is author ised, etc. The sample normally taken 
by the external auditor might be, say, 20 transactions. Internal audit could 
choose to perform this work during the course of the year and present their 
findings to the external auditor when t hey arrive to perform the annual audit. 
The external auditors would then check the internal auditors work by re-
performing the compliance tests on a fe w transactions, say, 3 of the 20. 
Providing no errors were found, the ex ternal auditors woul d then perform their 
own, new compliance tests on a reduc ed number of, say, 5 transactions. 
More testing will have been performed sinc e both internal and external audit 
have been involved, giving a higher assurance level (or lower risk). 
Also, this ‘sharing’ of work can lead to a reduced external audit fee, because 
some of the testing has been done internally at a reduced cost. 
Management letter 
In addition to an internal or external audit report, the auditor will usually produce 
a 'management letter'. This letter usually  includes a list of 'issues' that the 
auditor came across during the course of his audit work. 
The letter usually includes a table of: 
 issues concerning the auditor (usually a control that could be improved); 
 recommendations to implement  or improve the controls.

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The auditor would usually state a time fr ame by which the new controls should 
be implemented and then re-visit the department to ensure that the 
implementation had taken place. 
The management are at liberty  to reply to the auditor. They may state that the 
recommended control has been implemented, or explain why it hasn't been, 
perhaps because it was too costly, or is on-going. 
 
 In a large company which complie s with the UK Corporate Governance 
Code, the head of internal audit should report directly to: 
A A senior director B The external auditor C The audit committee D The risk manager 
 
 The primary scope of an inter nal auditor’s work includes: 
Select ALL that apply A Examining financial and operating information B Reviewing compliance with laws and regulations C Identifying risk D Assisting with external audit procedures 
 
 Internal audit can be outsourced. A disadvantage of this might be: 
A Cost B Skill C Independence D Control 
 
 Differing perspectives on fraud 
 The external auditor  is responsible for identifying material 
misstatements in the financial statement s in order to ensure that they 
give a true and fair view. By definit ion then, the external auditor is 
responsible for detecting any material  fraud that may have occurred. 
However, they have no specific res ponsibility with regard to immaterial 
frauds. If they identify them, they will be reported to those charged with 
governance, but there is no duty to identify them.

422  
 Internal auditors may be given an assignment: 
 to assess the likelihood of fraud,  or if a fraud has been discovered, 
 to assess its consequences and 
 to make recommendations fo r prevention in the future. 
 
 Fraud investigation 
 Fraud investigation can be carri ed out by an auditor. It is not their 
primary objective  when carrying out an audit, but they are duty bound 
to report a fraud if during the cour se of their work they identify 
fraudulent activities . 
It is the company directors who are responsible for identifying fraud. 
A fraud investigation should cover the following steps: 
(1) Ascertaining the facts of the fraudulent activity. 
(2) Gathering evidence of the crim e – documentary, interviews with 
witnesses, observational, etc. 
(3) Corroborating the evidence. (4) Consider whether you have the ri ght of access to the evidence you 
require. Many cases have been thrown out of court because evidence has been improperly obtained. 
(5) Maintaining confidentiality so that the perpetrator doesn't realise 
they are being investigated. 
(6) Consider the cost of the investi gation versus the value of the fraud, 
although ethically all frauds should be stopped. 
(7) Ascertain the value of the fraud. (8) Consider the loss of reputat ion if the fraud becomes public. 
 
 Test your understanding 8 – SHD (Integration) 
 SHD is a property development company involved in multiple 
development projects across the country . In the last year a member of 
the finance department has establis hed an expenses fraud through the 
use of a false supplier. Invoices are raised in the name of this supplier on a monthly basis for miscellaneous mate rials to the various development 
sites. These invoices are paid dire ctly via the accounts payable system 
without going to the si te project managers. 
This fraud has increased the variable co sts of construction projects by 
15% in the last year, a point which has been identified by the external 
auditors in their recent audit. The auditors approached the management accountant for further informa tion on the cost increase. 
Required: 
Discuss the differing views of external  auditors and internal auditors to 
this increase in variable costs.

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 Test your understanding 9 – Z (Case study) 
 Scenario 
Z is a government agency that is res ponsible for promoting road safety. 
Trigger 
Z needs to buy a fleet of 24 buses t hat have been converted into mobile 
exhibition spaces so that they can be driven around to educate community groups about the im portance of safe road use. 
The management board of Z has decided  to use a sealed bid system to 
tender for this fleet of buses. T he sealed bid system is as follows: 
 Suppliers who wish to bid for the contract to supply and modify 24 
buses should submit a sealed bid to Z’s chief buyer. 
 The bid should be submitted in a plain envelope with a typed label 
stating "Bus Bid". There should be  no other writing on the envelope. 
 The bid should identify: 
(1) The supplier 
(2) The type of bus to be modified (3) Details of all the modifications to be undertaken (4) The price of supplying 24 modified buses 
 On receipt of the sealed envelope the chief buyer of Z will sign 
across the flap of the envelope a nd place the bid in the safe. 
Z’s chief executive contacted the head of internal audit immediately 
before the end of the bi dding process and request ed that the internal 
audit department attend the meeting at which the envelopes would be 
opened. A senior member of the in ternal audit department was assigned 
to the task. In addition, the meeting would be attended by the chief buyer, 
the head of operations and the depar tmental manager who would be 
responsible for managing the exhibitions. 
At the meeting the chief buyer announced that four bids had been 
received. The envelopes were opened in random order by the internal auditor. 
The contents were: Envelope 1: a bid of GBP 2.8 million from supplier L 
Envelope  2: a bid of GBP 3.0 million fr om supplier K and a letter to 
withdraw a previously submi tted bid of G BP 2.0 million 
Envelope 3: a bid of GBP 3. 2 million from supplier M  
Envelope 4: a bid of GBP 2.0 million from supplier K 
The details of the bids in envel opes 2 and 4 from supplier K were 
identical except for the price.

424  
 Supplier L’s bid of GBP 2.8million was rejected immediately because the 
bidder was planning to use a slightly smaller model of bus than the others 
and planned to use poor quality material s for the modifications. It was, 
therefore, agreed that t he winning bid would be the revised offer to supply 
the buses for GBP 3.0 million from s upplier K. The head of internal audit 
was concerned that there could be so me irregularities in this bidding 
process and asked the chief executive to postpone placing an order for the buses until the internal  audit department had undertaken an 
Task 
(a) Explain THREE factors that c ould have caused the head of internal 
audit to be concerned about the bi dding process for the buses. 
(b) Recommend, with reasons, the work that the internal auditor should 
undertake if the bidding process fo r the buses is investigated. 
(c) Write a note to the chief executive which recommends TWO 
advantages and TWO disadvantages of  the internal auditor being 
actively involved in the inve stigation of suspected fraud. 
5 Types of audit work 
As there are many risks and many cont rols within a busi ness, there will be 
many different types of audit that can be performed. All types will essentially 
ensure the same thing – that the com pany’s processes are being adhered to. 
Some different types of audit work are discussed below, but the list is not 
exhaustive.

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 More on audit types 
 Compliance audit 
 Compliance audits check the implementation of written rules, 
regulations and procedures. 
 They were used originally for financial transactions, because the 
government (tax authorities) needed assurance that the financial 
figures were correct. 
 The concept of compliance has been extended to other areas, such 
as regulatory inspections and qua lity audits, where there is a 
requirement to verify t hat activities are being  performed in strict 
compliance with approved standards and procedures. 
Transactions audit 
 A transactions audit involves the checking of a sample of 
transactions against documentary evidence. 
 This method can be used where controls are weak or where 
transactions are high risk.

426  
 Risk-based audit 
 A risk-based audit refers to a systems audit in which the auditors 
use their judgement to decide on the level of risk that exists in 
different areas of the system, and to plan their audit tests so that 
more effort is directed to wards the most risky areas. 
 In this way, less time and effort  is spent on elem ents of the system 
that are relatively ‘safe’. 
Quality audit 
 A quality audit is a systematic in vestigation to establish whether 
quality objectives are being met. 
 A quality audit might look into  the system for setting quality 
standards, the relevance of t hose standards, the system for 
comparing actual performance against the quality standards and 
whether the quality contro ls work effectively. 
Post-completion audit (o r post-completion review) 
 A post-completion audit is an obj ective and independent  appraisal of 
the measure of success of a project. 
 It should cover the project throughout  its lifecycle fr om the planning 
and implementation stages through to performance after 
commissioning. 
 The review should take place at some time after the project or 
process has been completed or is being used. Review should not be 
too soon, where the project or process hasn't been given a chance 
to 'bed in'. But it should also not be too late where important 
feedback and learning has not been applied on later projects. 
 Its objective is to provide feedback as to the success of a project or 
otherwise, and acts as a learni ng tool for future projects. 
 Projects are often assessed on thr ee criteria: time, cost and quality. 
Was the project implemented on tim e? Did the project come in on 
budget? Was the project delivered at  the expected quality level, or 
more commonly, did it solve the original issue that prompted the 
project? 
 Post-completion audits are often performed by internal audit, as 
long as they are not involved in th e original design of the project 
itself. The auditor will source t he documentation which stated the 
original objectives of the projec t, and then follow the process carried 
out to ensure that all activities led to the successful completion of 
these objectives – in an economical, efficient and effective way. If the objectives were not met, why not? And what should be done 
about it?

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The latter four types of audit work will now be considered in more detail. 
Value for money audit 
An area that internal auditors have been getting increasingly involved in is value 
for money audits. These have been replaced in terminology more recently by 
'best value' audits, but many of the principles remain the same. 
In a value for money (VFM) audit the auditor assesses three main areas. 
Economy 
 The economy of a business is assess ed by looking at the inputs to the 
business (or process), and decidin g whether these are the most 
economical that are available at an acceptable quality level. 
 The efficiency of an operation is a ssessed by considering how well the 
operation converts inputs to outputs. 
 The effectiveness of an organisation is assessed by examining whether 
the organisation is achieving its objec tives. To assess effectiveness there 
must be clear objectives for the organisation that can be examined. 
 
 More on VFM audit 
 A VFM audit is ‘an investigation into whether proper arrangements have 
been made for securing economy, efficiency and effectiveness in the use of resources’. It is an audit into the ‘3 Es’ in  an item or operation. 
 Economy  means obtaining the required resources at the lowest 
cost. There would be a lack of econom y, for example, if there was 
overstaffing in a particular department  or if an excessive price was 
paid for materials of the required qualit y. It is important to remember 
that economy does not mean achieving the lowest cost possible: it 
means keeping costs within acce ptable limits for obtaining 
resources of the desired quality. 
 Efficiency  means using the minimum quantity of resources to 
achieve a given quantity and quality of output. Efficiency can be 
measured either in terms of: 
– maximising the output for a giv en quantity of input, such as the 
maximum quantity of services provided per employee or per 
£1 spent, or 
– achieving a given quantity of output with the minimum 
resources possible. 
 Effectiveness  exists when the output fr om a system achieves its 
intended aims and objectives.

428  
 Managers are responsible for achieving economy, efficiency and 
effectiveness in the operations for which they are responsible. A VFM audit provides a check to confirm that management is fulfilling this responsibility properly. 
VFM audits have commonly been associated with auditing in the public 
sector, but they are applicable in any type of organisation, in the public or 
private sectors. 
Problems with VFM audits 
There are several problems  with conducting a VFM audit. 
 It might be difficult to measure outputs , particularly in government 
services. For example, the output from an education system can be 
measured in many different ways,  both in terms of the numbers 
educated and the quality of  education. In the health service, outputs 
might be measured in terms of t he numbers of pati ents treated; on 
the other hand, successful prevent ive medicine would be measured 
in terms of reductions in the numbers of patients treated for 
particular conditions. 
 The objectives of the activity might  be difficult to establish , 
particularly in the public sector . For example, what are the 
objectives of the police service? If an activity has several different objectives, the problem is then how to decide their priorities. For 
example, the objective of the police force might be to maintain public order, arrest criminals, deter criminals, and so on. 
 The focus must be EITHER on economy and efficiency OR on 
effectiveness.  It is difficult to report on both issues simultaneously 
because costs can almost always be reduced by cutting back on the 
quality of service, while outputs can almost always be improved by 
spending more. 
 Quality might be ignored when  economy and efficiency are 
measured . For example, a government might succeed in reducing 
the costs of secondary education, but only by making schools overcrowded and by lowering th e standards of the education 
provided. VFM tends to focus more on economy and efficiency because those are much easier to  measure than effectiveness.

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 Test your understanding 10 – Seatown (case study) 
 Scenario 
Seatown is located on the coast. The town’s main industry is tourism with 
an emphasis on family holidays and c onsequently the cleanliness of the 
town’s beaches is a major factor in the town’s success. 
The town council, which is the loca l government authorit y, has a cleaning 
department that is responsible fo r keeping the beaches clean and tidy. 
Early every morning, as soon as the tide has gone out, the beaches are swept using equipment that is tow ed behind tractors. This equipment 
skims the top layer of sand and runs it through a filter to remove any litter 
before returning the cleaned sand to t he beach. Most litter takes the form 
of paper and plastic packaging, but it can include glass bottles and 
aluminium cans. 
To try to prevent litter being left on the beach the town council also places 
bins on the beaches above the high water mark. Litter bins need to be emptied regularly otherwise holidayma kers pile their rubbish beside the 
bins and that leads to litter being spread by the wind or by seabirds 
scavenging for food scraps. 
The cost of cleaning the beaches is a major expense for the town council. 
Trigger 
The management team of the town council has asked the internal audit 
department to investigate whether the town is getting good “value for 
money” from this expenditure. The head of internal audit has sought clarification from the town managers on whether the audit should focus 
on the economy and efficiency of t he cleaning operations or their 
effectiveness. Economy and efficiency audits generally focus on whether cost can be reduced for the same level of service and effectiveness 
audits ask whether better service can be achieved for the same cost. 
Task 
Prepare a letter addressed to the town council's internal audit 
(a) Recommending, giving reasons, t he matters that they should study 
in order to evaluate the ec onomy and efficiency of the beach 
cleaning activities. 
Your answer should include advice on how to obtain the necessary 
data and information. (20 minutes)  
(b) Recommending, giving reasons, t he matters that they should study 
in order to evaluate the effe ctiveness of the beach cleaning 
(c) Explaining why it is easier to in vestigate the economy and efficiency 
rather than the effectiveness of the cleaning activities. 

430  
Social and environmental audit 
Environmental audit 
An environmental aud it is defined as: 
'A management tool comprising a systematic, documented, periodic and 
objective evaluation of how well organisations, managem ent, and equipment 
are performing, with the aim of contribut ing to safeguarding t he environment by 
facilitating management control of env ironmental practices, and assessing 
compliance with company policies, whic h would include meeting regulatory 
requirements and standards applicable.' 
It is possible that an 'accounting' trai ned auditor could be asked to perform one 
of these audits but it is unlikely that they would be able to perform the task with 
the proper competence. The auditor is unlikely to have the necessary skills and 
therefore it would be professionally wrong to accept the assignment. 
Social audit 
The social audit would look at the com pany's contribution to society and the 
community. The contributions made could be through: 
 Donations. 
 Sponsorship. 
 Employment practices. 
 Education. 
 Health and safety. 
 Ethical investments, etc. 
A social audit could either confirm stat ements made by the di rectors, or make 
recommendations for social policies that the company should perform. 
 
 Environmental reporting 
 The environmental report that is included in the annua l report by many 
companies is sometimes accompani ed by an 'auditors' statement'. 
The environmental report produced by companies will normally contain 
information about: 
 Sustainability. 
 Targets achieved. 
 Compliance with regulations  
 Emissions. 
 Industrial legacies. 
 Obtaining ISO 14001 (environm ental management systems). 
Many companies conduct an inter nal audit on these matters, and then 
have the audit verified by external assessors. It is possible that the 
external auditor could be asked to be an external assessor, however, it is 
more likely with environmental ma tters that the person will be an 
appropriately qualified env ironmental assessor.

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Management audit 
A management audit is sometimes called an operational audit.  
A management audit is defined by CIMA  as 'an objective and independent 
appraisal of the effectiveness of manager s and the corporate structure in the 
achievement of the entitie s' objectives and policies'. 
 Its aim is to ident ify existing and potentia l management weakness and 
recommend ways to rectify them.' 
 This type of audit would require t he use of very experienced staff who 
understand the nature of the business. 
 
 More on management audit 
 The objectives of a management  audit might be: 
 re-focusing resources towards ‘mission-critical’ objectives 
 improving efficiency (improving work  flows, eliminating unnecessary 
activities, eliminating duplicated activities, etc) 
 improving the effectiveness of management support tools (such as 
improvements in controls, automated system support etc) 
 assessing the appropriate levels of service for an activity or 
operation 
 identifying cost savings 
 identifying opportunities to enhance revenue 
 improvements in governance. 
The elements of a management audit  might include: 
 a review of policies and procedures 
 a general review of workloads , work methods and work flows 
 an evaluation of systems and processes 
 a review of management practices 
 a review of resource utilisation 
 a detailed cost analysis. 
The findings of a management audit  might focus not so much on 
compliance with policies and procedures, but on: 
 a lack of technical competence or knowledge of the business 
amongst managers, and insuffici ent management training 
 an unwillingness to delegate 
 regular failure to achi eve standards or targets 
 inadequate management information systems 
 poor communications within or between departments 
 poor management/staff relationships 
 an absence of clear leadership 
 a failure by management to make good decisions.

432  
Systems-based audit 
A systems-based audit is an audit of inter nal controls within an organisation. 
Although the term refers to any type of system, it is often associated with the 
audit of accounting systems, such as t he sales ledger system, purchase ledger 
system, receipts and payments, fixed asse t records, stock records and so on. 
The aim of such an audit is to identif y weaknesses in the system (weaknesses 
in either the controls or in the application of controls, such that  there is a risk of 
material inaccuracy in financial record s and statements, or a risk of fraud).  
A systems-based audit would take the following steps: 
 Identify the objectives of each system 
 Identify the procedures 
 Identify why the system might not meet its objectives 
 Identify ways to manage the above 
 Identify if current controls are adequate 
 Report on the above. 
 
 Checking a sample of transactions against documentary evidence is an 
example of: 
A A transactions audit B A compliance audit C A value for money audit D A risk based audit 
 
 An objective and independent measure of the success of a project is 
known as: 
A A quality audit B A compliance audit C A value for money audit D A post completion audit 
6 The audit process 
This chapter looks at a typical audit pr ocess as it would be carried out by the 
internal auditor to audit a company's systems or processes. A key point to consider when going through this proc ess is the problems that might be 
encountered when attempting to audit these different areas.

Chapter 7 
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The audit process 
The audit process can be summari sed in the following diagram: 
 
7 Audit planning 
Audits should be planned. There should be an audit programme for each 
financial year, in which the internal auditors set out which activities or 
operations they will audit, and what the purpose of the audit will be in each 
case. 
 Objectives of the audit  
– For example, to check whether the in ternal controls within a particular 
operation are adequate and ar e applied properly. 
 Conduct of the audit  
– The auditors need to decide what information they need and what 
investigations they need to carry out. 
– Decisions have to be made about: 
– how to collect and record evidence, and – how much evidence to collect

434  
 Resources and timing  
– The auditors should assess how much  time and effort  will be required 
to carry out the audit, and sched ule the work accordingly. 
 
 Risk-based approach 
 
 Most audits are now carried out using a risk-based approach, whereby the 
auditor assesses whereabouts the ke y risks are in a system, and then 
concentrates the audit effort at those key risks. 
 The result of this approach is that the audit should be more efficient and 
effective at achieving its objecti ves than if another approach were 
followed. 
 Bear in mind from earlier chapters that  the internal control system should 
be built on the back of risk assessments. 
 One of the key ways an auditor c an try to identify risk is by 
benchmarking.  
 
 Types of benchmarking 
 Benchmarking  is the process of compari ng one's business processes to 
best practice from other industries.  Management identifies the best firms 
in their industry, or in another indu stry where similar processes exist, and 
compares the results and processes of  those studied to one's own results 
and processes. In this way, they l earn how well the targets perform and, 
more importantly, the business proce sses that explain why these firms 
are successful. They often then try to replicate them in their own 
company. 
There are many different types of benc hmarking, since it is simply the 
comparison of one thing to another , but some examples include: 
Process benchmarking  – the company focuses its observation and 
investigation on business processe s with a goal of identifying and 
observing the best practices from  one or more benchmarked firms. 
Process analysis is required where the objective is usually to benchmark 
cost and efficiency. This is increasi ngly applied to back-office processes 
where outsourcing may be a consideration. 
Product benchmarking  – the process of designing new products or 
upgrades to current ones. This proc ess can sometimes involve reverse 
engineering which involves taking apar t competitor’s products to assess 
their strengths and weaknesses. 
Functional benchmarking – a company will focus its benchmarking on a 
single function e.g. Production, to impr ove the operation of that function. 
Complex functions such as Human Resources, Finance and Information 
Technology are unlikely to be directly comparable in cost and efficiency terms and may need to be disaggregated into processes to make valid 
comparison.

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 Competitor benchmarking  – involves studying the leading competitor or 
the company that best carries  out a specific function. 
Environmental benchmarking  – This is the process of collecting, 
analysing and relating environmenta l performance data of comparable 
activities with the purpose of evaluating and comparing performance 
between or within the entities. Entities  can include processes, buildings or 
companies. Benchmarking may be internal within a single organisation, or – subject to confidentiality restri ctions – external between competing 
entities. 
 
 Environmental benchmarking 
 Environmental and sustainability benchm arking is a tool for comparing 
the environmental and sustainab ility performance of different 
organisations. This form of benc hmarking is becoming increasingly 
important as these issues gai n prominence within businesses. 
A major retailing company in the UK produces an annual report on their 
environmentalism and sustainability. It covers many angles, including their targets for: 
 recycling and waste management; 
 information about their 'green stores' which are built and run using 
environmental techniques such as using hemp walls, biomass 
heating systems and rainwater recycling; 
 carbon emissions including their investment in their aerodynamic 
road transport fleet; 
 staff shopping where employees a nd customers are encouraged to 
donate or swap clothing, etc to manufacture new garments, donate 
clothing to charities or to reduce waste; 
 sustainable supplies includi ng Fairtrade, recycled and organic 
products; 
The company publishes 20 different tar gets, some with m any sub-targets, 
and gives information on whether they have been achieved, are 'on plan', 
are 'behind plan' or have been cancelled (and if so, why). 
Competitor firms will use this informati on to generate their own targets, to 
compare (benchmark)  and to learn.

436  
 Using the financial statements to benchmark 
 During the planning stage of any audit, internal or external, the auditor 
must identify the key risks a company faces. One of the ways an auditor 
can do this is by using the financia l statements or management accounts 
over several periods or years. 
Performing ratio analysis, such as calc ulating the gross pr ofit margin, net 
profit margin, and receivable, payable and inventory turnover days will enable the auditor to compare the result s with previous years, or their 
expectations. This may, in turn, help them to identify 'anomalies' or risks 
that the financial stat ements are incorrect in certain areas. 
For example, imagine a company has had a gross profit margin of 40% 
and a net profit of 20% for several year s. This year the auditor calculates 
the gross profit margin to be 40% but the net prof it margin to have fallen 
to 15%. This may indicate that cert ain expenses have inflated or that 
there may be errors within the expenses (but not sales or cost of sales as 
this would have affected the gross prof it margin also). So the auditor has 
narrowed down the problem to being somewhere within expenses. They 
could now calculate each expense as  a percentage of sales and compare 
them to previous years. Let us im agine that the auditor identifies that 
'repairs and renewals' has increased dr amatically compared to previous 
years. They would then investigate this account and might identify that 
several items of expenditure that should have been capitalised (to appear 
on the statement of financ ial position) have inadver tently been posted to 
repairs and renewals. A simple journal correcting this can now be performed. i.e. credit repairs and r enewals, debit non-current assets. 
(Depreciation will need to  be recalculated too.) 
The auditor would then r eperform their ratio anal ysis, recalculating the 
net profit margin which should now be in line with the expected 20% of 
previous years. 
On the other hand, there may have been good reason why the net profit 
margin had fallen. It may be that, say, rent had increased due to their 
landlord increasing their rental charges. This would not be a financial statement error, but could be as certained through discussions with the 
finance department/finance di rector. In this case , it may be that the 
financial statements are in fact correct and that in the future the net profit 
margin is expected to be 15%. 
The key point is that the auditor spo tted an 'anomaly' or risk, investigated 
it and resolved to their satisfaction whether there was a risk that the 
financial statements were incorrect.

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 Annual audit plan and risk analysis 
 When preparing an audit plan for the year , the internal auditors should try 
to focus on those areas of operat ion where the potential risk to the 
business is greatest. 
One way of assessing risk is to consi der, for the operations or procedures 
subject to audit: 
 the inherent risk, and 
 the quality of control. 
Inherent risk  is the risk in the activity or operation, ignoring the controls 
in the system. For example, a cash based business such as a market stall or a taxi business is inherent ly risky due to possible theft or mis-
declaration of tax payable. 
Inherent risk relates both to the severi ty and the incidence of the risk, i.e.: 
 the potential loss if an adverse si tuation or event arises, and the 
probability that an adverse sit uation or event will arise. 
The size of the inherent risk will depend on a variety of factors, such as: 
 the size of the operations unit, or the size of the expenditure budget 
 the nature of the assets used or  handled (e.g. systems involving the 
handling of cash or payments to s uppliers have high inherent risk, 
due to the opportunities  for fraud or loss) 
 the extent to which pr ocedures are computerised. 
The quality of control  is the perceived quality of  the existing controls for 
the activity. Confidence in the qua lity of control will be affected by: 
 the apparent effectiveness of  management and supervision 
 pressures on management to achieve targets 
 changes in the system ac tivities and procedures 
 changes in key personnel 
 a high staff turnover 
 a rapid expansion in operations and the volume of transactions 
handled 
 the length of time since the last a udit of the activity was carried out. 
Confidence in the quality of contro ls will diminish over time without 
fresh reassurance from  another audit that t he controls are still 
effective. 
The activities which should be given priority for audit are those where the 
inherent risk is high and the quality of control is low.

438  
 Audit risk 
 This is the risk that the auditors might give an inappropriate opinion on 
something which they tested i.e. they say that a process is well controlled 
when in fact it is out of control. Using the example of auditing the financial 
statements, audit risk has three components elements: 
Inherent risk.  This is the risk that an amount in the financial statements 
(for an asset or liability, or a transac tion) might be stated as a materially 
incorrect amount, ignoring the existenc e of existing internal controls. 
Control risk.  This is the risk that the existi ng controls are not sufficient to 
prevent or detect a material mis-stat ement of a value in the financial 
Detection risk.  This is the risk that the audi tors’ substantive tests will not 
reveal a materially incorrect amount in the financial statements, if such an 
error exists. 
 
 Materiality 
 The term ‘materiality’ is often used in the context of financial reporting. An 
item in the financial st atements is material if its omission or a 
misstatement of its value would be likely to influence a user of the 
financial statements. However, materiality cannot be specified 
mathematically, because it has a qualitative as well as a quantitative 
aspect. 
Materiality should also be considered in  relative terms. For example, the 
risk of valuing an asset incorrectly by $100,000 would be material in the 
context of a company with assets of $1 million, but far less material in the 
context of a company wit h assets of $100 million. 
 
 CC is a house builder in Country Y wh ich specialises in developing large 
sites with many hundreds of houses ac ross all regions of the country. It 
has an internal audit team who are currently preparing an audit plan for 
the year ahead focussing on areas of oper ation where the potential risk to 
the business is greatest. 
Which of the following are inherent risks for CC? 
A The risk that the economic downt urn will encourage management to 
overstate progress on cert ain housing developments. 
B The risk that expensive inventory is  stolen from sites which are not 
secured properly overnight. 
C The risk that the internal audit plan omits a particular area of risk 
which could have significant  implications for CC. 
D The risk that government regul ations over house building will 
change and CC will be in breach of new rules. 
E The risk that sites for devel opments, once work has begun are 
found to be unsuitable and must be abandoned.

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8 Systems investigation and documentation 
The auditors should document both the system or operation subject to audit, 
and their findings or judgements. They will need to ascertain what the system is 
and also the controls that  operate over the system. 
Ascertaining systems 
The auditor could use the following sources and methods to ascertain how the 
systems operate: 
Flowcharts  These could be examined or created from 
discussions with staff who use and operate 
systems. 
Interviews/Questionnaires  The staff who operate the system can describe 
how they use it. This has an advantage over other existing system documentation as it 
identifies how the staff actually use the system even if this is out of line with the proper 
Systems documentation  The auditor can find the documentation of the 
system from when it was produced to identify how it operates. Documentation tends to be best for computerised systems as they will have gone through a proper systems development approach and also they tend to be least well 
understood by users. 
Observation  The operation of the syst em can be observed. 
Ascertaining controls 
To specifically assess the controls in systems an auditor could use standard 
control questionnaires. These documents are structured so as to identify all key 
internal controls and also enable t he auditor to assess the quality of the 
controls. 
 
 More on audit tools 
 Flowcharts 
Flowcharts might be used to record: 
 the sequence of activities and checks within an operation or 
procedure 
 which individuals carry out each procedure or check. 
The advantages of flowcharting the stages in an operation are that: 
 a flowchart is more often effective at presenting information in an 
understandable form than a narrative description 
 if there are weaknesses in the controls within an operation, these 
might be easier to identify by studying a flowchart.

440  
 Questionnaires 
A questionnaire is a list of questions for which the auditor needs to finds 
answers in order to gather the in formation or evidence he needs. The 
questions should be specific, and should ideally call for a ‘Yes’ or ‘No’ 
answer, although room should be le ft on the form for additional 
comments to be added if required. 
The answers to the questions  help the auditor both to: 
 establish the facts, and 
 identify potential control weaknesses.  
9 Control assessment 
Once auditors have ascertained what the controls are, they need to make an 
assessment of the internal controls  and whether they will achieve their 
 
 Example of controls 
 A company has a small accountin g department, in which the same 
individual is made responsible for a ccounts payable and also for carrying 
out the bank reconciliation checks. Ideally, these tasks should be segregated, because there is a risk t hat the individual might be making 
payments to their own personal bank  account, and the fraud would not be 
identified by the bank re conciliation process. 
To overcome this weakness in the control system, a number of controls 
might be applied, such as: 
 requiring that all payments are revi ewed by a senior manager in the 
company, instead of paid automatically 
 a review by the individual’s supervisor of all bank reconciliations 
 a periodic listing from the company’ s bank of all the payments out of 
the company’s bank account in the period, for review by a senior 
manager. 
10 Audit testing 
Having made an assessment of the existi ng controls and identif ied the areas of 
greatest risk the auditor will move onto the testing. 
Auditors need to carry out tests, to  ensure that procedures are performed 
correctly, and that controls to prev ent or detect errors are adequate and applied 
effectively.

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Types of testing 
 Compliance testing  (test of controls): 
 
The test of controls should be carried out to ensure that the c ontrols identified at 
the planning stage operate as they should. 
If the controls are not being complie d with then there will be a material 
weakness in the control system and the re sult could be serious errors or fraud 
and the business objectives may not be achieved. 
 
 The results of the compliance te sting should indicate whether: 
 
 the controls are effective, or 
 the controls are ineffective in  practice, even though they appeared 
adequate ‘on paper’. 
Substantive testing  (test of balances or transactions): 
Substantive testing, on t he other hand, does not look at the controls in the 
system – it rather concentrates on the out put and ensuring that the output is as 
expected. 
Substantive testing is normally associ ated with financial systems but can also 
be used for non-financial systems. 
The purpose of the substant ive tests is either to: 
 confirm that the controls are effective 
 where the controls are ineffe ctive, to establish the apparent 
consequences. 
For example, an audit of a quality contro l system would give the following types 
of testing: 
Substantive test  Monitor the number of qual ity control failures as 
a proportion of good output. 
Compliance test  Observe the functioning of the quality control 
staff to ensure they are checking output. 
In the exam, students should for look for options with words like reconcile, 
analyse, observe, monitor or sample  at the beginning of  a sentence that 
recommends an audit test. Try to avoid optio ns with the word 'check' since that 
can be construed as vague, unless it explai ns fully what they would be checking 
for and why.

442  
 Which of the following is a substantive audit test? 
A Observing the functioning of the qua lity control staff to ensure that 
they are checking output 
B Matching customer orders to invoices C Monitoring the number of quality cont rol failures as a percentage of 
output 
D Observing staff clocking in and out to  ensure that productive time is 
recorded accurately 
 
 Test your understanding 15 – Co mpliance testing (Integration) 
 Company X has recently empl oyed John. John went through the 
company's interview process – after submitting his curriculum vitae and filling in the standard application form,  he attended two interviews (one 
individual and one group). He was then offered the job and asked to start 
the following Monday. 
John has been at X for a month now  and his manager is not happy with 
his work. He is frequently late in to the office, and he frequently makes 
mistakes in the tasks he is given. 
His manager has heard a ru mour that the qualific ation he stated on his 
application form is false, whic h could explain his poor work. 
Required: 
Discuss the problem at X and suggest cont rols that should be in place to 
prevent this occurrence. 
Detail appropriate compliance tests t he internal auditor should perform on 
the recruitment process to ensure t hat this does not happen in the future. 
 
 Test your understanding 16 – Audit testing (Integration) 
 Recommend some compliance and substantive tests that could be 
undertaken by an auditor to check whet her errors are occurring in payroll 
processing. Staff are paid weekly in cash. The objective of the audit is to ensure that: 
(i) payments are only made to genuine employees. (ii) all deductions from pay are calculated correctly. (iii) employees are paid only for hours worked. 
(iv) deductions are paid over to the appropriate authorities

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11 Sampling 
With any audit testing it will probably be nec essary to undertake some form of 
sampling. 
Sampling is testing a proportion of a population to gain assurance about the 
population as a whole. 
 
 Audit sampling 
 
The application of audit procedures to less than 100% of the items within an 
account balance or class of transactions  to obtain and evaluate evidence about 
some characteristic of the items select ed in order to form a conclusion on the 
population. 
Risks that occur with sampling 
As soon as an auditor decides to sample a population, there are risks that are 
brought into the audit: 
Sampling risk This is the risk that the auditor’s conclusion, 
based on the results of the sample, may be different from the resu lt that would have been 
obtained had all items in the population been tested. (This risk can never be removed if sampling is done.) 
Non-sampling  risk This is the risk that the auditor may use 
inappropriate procedures or misinterpret evidence that the test re sults give. As a result 
the auditor would fail to recognise an error. (This risk is avoidable if auditors use the 
appropriate procedures.) 
 
Test your understanding 17 
 The risk that an amount in the financ ial statements might be stated as 
materially incorrect (ignoring the exist ence of current internal controls) is 
called: 
A Detection risk B Control risk C Inherent risk D Sampling risk

444  
12 Analytical review 
Analytical review is arguably the most impor tant test available to the auditor as 
they can be used in the audit of most items – both financial and non-financial – 
and can be used at various points in the audit process. 
 
 Analytical review is the examinati on of ratios, trends and changes in the 
business from one period to the next, to obtain a broad understanding of 
the results of operations, and to i dentify any items requiring further 
When the results appear abnormal the auditors will investigate more 
closely to find out the cause(s)  by performing further work. 
 
 Ratios 
 During the audit of any part of the fi nancial statements, analytical review 
often involves the calculation of ratios, such as:

Chapter 7 
 445 
Nature of analytical review 
Comparisons of information could be with 
 Examples 
 Prior periods/anticipated results 20X1 20X1 20X0 
 Actual Budget Actual 
Number of new produ cts launched 9 11 10 
    
 Predictive estimates Depreciation for year = 15% × y/e cost 
 Similar industry info Staff turnover v industry average 
 
 Uses of analytical review 
Analytical review will be used at all stages of the audit. 
Planning  They will be used to identify risks, and therefore 
help in deciding the level of testing, and its nature and timing. 
Substantive testing  Analytical review is a very important substantive 
procedure that can provide sufficient audit evidence in some areas. In practice in the audit 
of financial information, expenses in the income 
statement, accruals an d prepayments are all 
audited by substantive analytical procedures. 
Overall review  The procedures are used to conclude whether 
the area being tested is consistent with the auditors’ knowledge of the business entity and 
the expected results. 
 
Test your understanding 18 – Ca r dealership (Integration) 
 You are an internal auditor for a car dealership with a number of 
branches. You have responsibility for looking at where efficiency gains 
could be made. From the following information, recommend, with reasons, which region you would look at first. 
 North South East West 
Number of salesmen 16 12 10 24 Total sales value in the last 
month (£000) 2,700 2,520 2,320 2,400 
Number of sales or ders 180 156 160 190 
Number of sales discu ssions 660 364 432 740

446  
 More on analytical review 
 In order to use analytical procedur es effectively you need to be able to 
create an expectation. It will be difficult  to create an expectation if 
operations are significantly different from last year, more so if the 
changes haven’t been planned for. If the changes were planned, we can 
compare the actual with the foreca st. It will also be difficult to use 
analytical procedures if there have been lots of one-off events in the year 
as there will be nothing to compare them with. 
 
 Test your understanding 19 – D courier company (Case study) 
 Scenario 
F is a member of the internal audit  department of D, a courier company. F 
has recently completed a compliance audit of the extent to which the 
company’s delivery vans are being maintained in accordance with the 
company’s policy. 
Each of D’s depots has a full ‐time mechanic. The company’s policy is that 
the depot mechanic is required to check each van’s fluid levels and give a 
road test on a monthly basis. The Depot Manager is responsible for 
ensuring that every van has been checked in this manner. 
Trigger 
One of D’s delivery drivers was re cently involved in a road traffic 
accident. The police report relating to this accident indicates that the 
van’s brakes had failed because of a l eak in the brake pipe. The delivery 
driver has been charged by the police with an offence because it is illegal 
to drive a vehicle with defective brakes. 
D’s Transport Manager has reviewed the van’s maintenance log. The log 
shows that the depot mechanic had not  inspected the van during the six 
weeks before the accident. The Head of  Internal Audit has reviewed F’s 
report and has noticed that, alt hough F had visited the depot shortly 
before the accident occu rred, he had reported that  policies were being 
adhered to. 
The Head of Internal Audit has ask ed F to explain why he gave a positive 
report when records prove that  policies had not been adhered to. F 
explained that the Depot Manager had admitted that the vans had not 
been inspected as frequently as company policy required because the depot mechanic had been absent for two weeks because of ill health. There were no other qualified mec hanics available to carry out these 
inspections and the depot’s repair budget was insufficient to pay for the 
vans to be inspected by a third party. The Depot Manager had asked F not to note this omission in the audi t report because it would lead to 
disciplinary action, which would harm the Depot Manager’s career. F 
agreed not to report the missed inspections provided that the Depot Manager promised that all of the v ans would be inspected as soon as 
possible when the depot mechanic returned to work.

Chapter 7 
 447 
 The Head of Internal Audit was di ssatisfied with F’s behaviour alleging F 
had not acted in an independent manner . F denies that accusation 
because he has no connection to t he Depot Manager or  any of the 
depot’s other staff. Additionally, F has pointed out that the Depot 
Manager could easily have falsified t he maintenance records to conceal 
the fact that the vans had not all been inspected on schedule and a 
negative internal audit report would simply encourage Depot Managers to 
falsify their records in future. 
Task 
(a) Evaluate the Head of Internal Audit’s assertion that F had not 
behaved in an independent manner. 
(b) Discuss the implications of F’s behaviour for the governance of D. 
The Head of Internal Audi t wishes to conduct a thorough 
investigation into the level and fr equency of the inspection of the 
company’s delivery vans. 
(c) Prepare a briefing note from the Head of Internal Audit to the 
internal audit department recomm ending the tests that could be 
conducted to ensure that the depot mechanics are inspecting vehicles in accordance with company policy. You should explain the purpose of the tests that you have recommended. 
13 Audit reporting 
Audit report 
The final stage of an audit is the audit repor t. In an internal audit assignment the 
audit report does not have a strict structur e, however, it would be expected to 
feature a number of different parts: 
 The objectives of the audit work. 
 A summary of the proce ss undertaken by the auditor. 
 The results of tests carried out. 
 The audit opinion (if an opinion is required). 
 Recommendations for action. 
When giving recommendations auditors  must always ensure that the 
recommendations are practical and cost-effective. 
The auditor will need to consider whether the residual risk will be reduced by 
the recommendation. If it will not, t he recommendation is not worthwhile. 
 The internal auditor should have a pr ocess of post-implementation review 
to ensure that recommendations  have been actioned by management.

448  
 The head of the internal audit team will usually meet with the head of the 
department being audited and will discu ss the points that are being 
reported. The head of t he department being audited can comment on the 
points raised and the comments are in corporated into the report. This 
makes the audit process less thre atening because the departments being 
audited know that they will not be  reported on to senior management 
without at least having some advance warning and the opportunity to make their own arguments. 
The circulation of the report is also important; typically the internal audit 
team would discuss the report with the manager of t he department being 
audited. Once this has been done they would submit the report for review 
within internal audit and then provi de the audit committee with a copy. The 
external auditor would also be able to refer to reports. The content of the 
report would otherwise remain confident ial within the organisation, partly 
to avoid embarrassing audited managers, whose reputations could be affected by negative reports, particularly if they are taken out of context. 
 
Test your understanding 20 
 The audit process is made up of the following steps: 
A Plan the audit; document systems and controls; test compliance 
with controls; report to board 
B Plan the audit; report to the boar d; document systems and controls; 
test compliance with controls 
C Document systems and controls; test compliance with controls; 
report to board; test application of controls 
D Document systems and controls; te st application of controls; test 
compliance with controls; report to board 
 
 H is the internal auditor of S Co and has been carrying out work on the 
purchases cycle to assess the internal controls in place and make recommendations for improvements. He is due to present his findings to 
the audit committee and has been asked to prepare a report. 
Which of the following are sections to be included in the report?  
A Executive Summary B Observations and work done C A signed opinion D Recommendations E A statement of complianc e with the relevant laws

Chapter 7 
 449 
14 Audit of computer systems 
In the case of computer systems, audits are carried out: 
 to check whether the system is ac hieving its intended objectives, and 
 in the case of accounting systems, to  check that the information produced 
by the system is reliable. 
Problems of auditing computer systems 
Auditing computer syste ms gives some different  problems and some new 
opportunities to auditors to test system s. There are several problems for the 
auditor of computer system s that do not occur with ‘manual’ systems, including: 
 
 More on problems with auditing computer systems 
 The auditor may encounter several pr oblems with computer systems that 
do not occur with ‘manual’ syst ems. These include: 
 Concentration of controls  in the IT department. In large computer 
systems, many of the controls ov er data are concentrated in the 
central IT department. This can be a potential weakness in the control system, if users are not aw are of an accidental or deliberate 
corruption of data or programs.

450  
  A lack of primary records . In some computer systems, the 
document originating a transac tion might not be created. For 
example, in an on-line system a customer order received by 
telephone might be keyed into t he system. The system might then 
generate a despatch document and an invoice, and update the 
inventory and customer files. The auditor would not be able to trace 
these documents back to a paper sales order. 
 Encoded data . When data are entered into  a computer system and 
encoded, there is a risk of error in the input details. Auditors need to 
consider the effectiveness of pr ogram controls, such as data 
validation checks (incl uding check digit checks) to prevent the 
acceptance of incorrect data by the system, especially changes to 
standing data on a master file. 
 A loss of audit trail. Ideally, in an accounting system, there should 
be an audit trail providing evidence of the file updates that occur 
during the processing of a specific  transaction. With an audit trail, 
the auditor can trace a transaction from beginning to end, to confirm that it has been processed correct ly. In a manual system, evidence 
is provided by the existence of har d copy records at each stage of 
the transaction. Computer syst ems, however, are generally 
designed to minimise the amount  of paper produced. Control is 
applied through the output of except ion reports, rather than the 
printout of lists of transactions. The auditor is therefore unable to 
trace a transaction through the system  from originating document to 
financial statement. 
 Overwriting of data.  When data are stored on a magnetic file, the 
file will eventually be overwritt en with new data. If the auditor needs 
some of this data to carry out audit tests, it will be necessary to take 
steps to make the data available.  The auditor might therefore need 
to take copies of data files during the course of the year, and retain 
them for audit purposes. 
 Program controls.  The auditor has to test the controls in the 
computer system on which they in tend to rely. This means that 
testing the controls written into th e computer programs.  To do this, it 
will be necessary to use computer-assisted audit techniques. 
Errors 
Additionally, when auditors audit comput er systems they need to be aware of 
the types of errors that occur in the syst ems. The characteristics of errors are: 
 No one-off errors unless deliberat e amendment of individual items. 
 Systematic errors which repeat across all transactions. 
 Higher danger that input errors will not be detected.

Chapter 7 
 451 
Audit approach 
The audit approach for computer auditing  is often summarised in one of two 
ways: 
 through the computer; or 
 round the computer. 
Round the computer 
Under this approach the auditor does not attempt to understand the operation of 
the computer system, but ra ther treats it as a 'bla ck box'. To audit the system, 
the auditor matches up inputs to predicted outputs to ensure that the outputs 
are being processed correctly. 
The approach is good in that it does not requi re a high level of expertise of IT in 
the audit teams, but it is only suitable if the following conditions are met: 
 Computer processing is relatively simple 
 Audit trail is clearly visible 
 A substantial amount of up-to-dat e documentation exists about how the 
system works. 
Problems with auditing round the computer include: 
 Computer files and programs are not  tested, hence there is no direct 
evidence that program is  working as documented 
 If errors are found it may be impossi ble to determine why they have 
happened 
 All discrepancies between predicted and actual results must be fully 
resolved and documented no matter how small (this is because controls 
are being tested). 
Through the computer 
This approach actually interrogates the computer files and computer controls 
and relies much more on the proce sses that the computer uses. 
The auditor follows the audit trail through the internal comput er operations and 
attempts to verify that the processi ng controls are functioning correctly. The 
computer controls are directly te sted and the accuracy of computer-based 
processing of input data is verified. 
To audit through the computer requires more expertise and a longer set-up 
time; however, the results c an be of very good quality. 
This approach utilises different com puter-assisted audit techniques (CAATs) 
such as test data and audit software, discussed below.

452  
 15 Computer-assisted au dit techniques (CAATs) 
 
Computer-assisted audit techniques are me thods of using a computer to carry 
out an audit of a computer system. Ther e are two main categories of CAAT: 
 audit software, such as audit interrogation software 
 test data. 
Audit interrogation software 
Audit software consists of computer programs used by auditors to interrogate 
the files of a client. Normally the cli ent's data files are input into the audit 
software program on the auditor's computer , and the auditor can then test those 
files. Examples of what audit software can do include: 
 Extract a sample according to specified criteria 
– Random 
– Over a certain amount – Below a certain amount – At certain dates 
 Calculate ratios and select  those outside the criteria 
 Check calculations (for example, additions) 
 Prepare reports (budget vs. actual) 
 Produce letters to send out  to customers suppliers 
 Follow items through a computerised system 
 Search for underlying relati onships and check for fraud.

Chapter 7 
 453 
Packages are generally designed to: 
 read computer files 
 select information 
 perform calculations 
 create data files, and 
 print reports in a format specified by the auditor. 
Audit software enables large volumes of data to be processed very quickly and 
accurately. The main drawback of audit softw are is that it can take a long time 
to set up the systems with the client data, and it will require expertise. 
 
 CAATs and fraud detection 
 Audit software includes a variety of routines for identifying transactions 
where there could be a suspicion of fraud, such as: 
 comparing the home addresses of employees with the addresses of 
suppliers, to identify employees who are also suppliers 
 searching for duplicate cheque numbers 
 analysing the sequence of transactions to identify missing invoices 
or cheques 
 identifying suppliers with more than one supplier code or more than 
one mailing address 
 finding several suppliers all with the same address 
 listing payments for transactions that fall just within the spending 
authorisation limit of the individu al who has authorised the payment. 
 
 Benefits and weaknesses of CAATs 
  
Benefits of CAATs Examples 
CAAT’s force the auditor to rely on 
programmed controls during the audit. Sometimes it may be the only way to test controls within a computer system, therefore enables the auditor to test program controls. Credit limits within a system can 
only be changed by the accountant. A computer assisted check will test that this is the case. 
Large number of items can be tested quickly and accurately. Checking the depreciation 
charged on each asset would be quicker with a computer assisted program than manually.

454  
 CAAT’s test original 
documentation instead of print 
outs, therefore t he authenticity of 
the document is more valid this way. Actual wages will be tested 
instead of paper copies. 
After initial set-up costs, using 
CAATs are likely to be cost-effective, as the same audit software can be used each year as long as the system doesn’t change. Examples of use or audit tests 
(1) Calculation checks (2) Reviewing lists of old or 
outstanding items and investing those specifically 
(3) Detecting for unreasonable 
items 
(4) Detecting violation of the 
system rules 
(5) New analysis (6) Completeness checks (7) Selects samples (8) Identifying exception 
reporting facilities. 
Allow the results from using 
CAATs to be compared with ‘traditional’ testing. If the two sources of evidence 
agree then this too will increase the overall audit confidence. 
 
Weaknesses of CAATs Recommendations 
CAAT’s will be limited depending 
on how well the computer system is integrated. The more integrated the better the use of CAAT’s. For example, the invoices should be computer generated and then processed through the accounts system to feed in to the financial statements. Ensure understanding of the 
system to assess whether audit software will be relevant for the company. Need to assess whether there is a need for the audit software. 
It takes time to design CAATs tests therefore, may not be cost-effective if the auditor is dealing with a bespoke system, as there may be a lot of set-up costs. The reason for this is it takes time to write specific test data or to program the audit software to the needs of the client. A cost-benefit analysis from 
the audit point of view should be carried out prior to deciding to use the audit software.

Chapter 7 
 455 
 If the company you are auditing 
cannot confirm all system 
documentation is available, then the auditors will be unable to perform the tests effectively due to lack of understanding. Do not use audit software until 
these have been identified. 
If there is a change in the 
accounting year, or from the previous year, then the audit software will have to be reset and designed, therefore may be costly. A cost-benefit analysis from the 
audit point of view should be carried out prior to deciding to use the audit software. 
 
 Test your understanding 22 – A udit software (Integration) 
 Recommend how audit software could be used in the audit of a mail 
order company concerned that deliverie s are not being invoiced and that 
stock files are not being updated. 
Embedded audit facilities 
Embedded audit facilities might be written in to a program, particularly in on-
line/real-time systems. These facilities can carry out automatic checks or 
provide information for s ubsequent audit, such as: 
 extracting and storing informati on for subsequent audit review, with 
sufficient details to give the auditor a proper audit trail 
 identifying and recording items that are of some particular audit interest, 
as specified by the auditor. 
Test data 
Test data can be used by inputting the data into the system and checking 
whether it is processed correctly. T he expected results can be calculated in 
advance, and checked against the actual output from the syst em. The auditors 
might include some invalid data in the tests, which the system should reject. 
It will only be used if the auditor is intending to do a 'test of controls' audit, and it 
must be considered cost effective. 
Live data  = test data are processed dur ing a normal production run. 
Dead data  = test data are process ed outside the normal cycle. 
The stages involved in using test data are: 
(1) Gain a thorough understanding of how the system being tested is 
supposed to work and the controls  that are included in it. 
(2) Devise the test data set. This should be a set of data containing both valid 
and invalid items. The controls in t he system should identify the invalid 
items. 
(3) Run the test data. This can be 'liv e' (within the normal processing at the 
client), or 'dead' (outside the normal processing). Live runs give more 
reliable results but are more risky to operate. 
(4) Evaluate the results. It is important  that the auditor fully evaluates the 
results of the test data and does further  work if unexpected results occur.

456  
Risks with test data 
Risks Controls 
Damage to the system as the system 
is tested to its limits. Ensure auditors understand the 
system and have software support. 
Corruption of the sys tems data if test 
data are not properly removed. Ensure process for data removal. 
System down time if ‘dead’ data us ed. Establish when system can be used 
with minimum disruption to the business. 
 
 Examples of test data 
  
Tests Reason for the test 
Revenue  
Input an order into the client's 
system that would cause a customer to exceed their credit limit The order should not be accepted, or 
should raise a query whether you are sure you wish to proceed. If this happens then the auditors will have confidence the system is working properly 
Input a negative number of 
items on an order Ensures only positive quantities are 
accepted 
Input incomplete customer 
details The system should not process the 
order unless all information is completed 
Input an excessive amount There are reasonable checks in the 
system to identify possible input errors. A warning should appear on the screen confirming the number 
Purchases  
Raise an order from a supplier not on the preferred supplier list A query should be raised as to whether 
you want to proceed with this transaction 
Process an order with an unauthorised staff ID The system should reject the process 
altogether or send the request through to an appropriate person for 
authorisation 
Try and make changes to the 
supplier standing data using the ID of someone who is not 
authorised to do so The system should reject the process 
altogether or send the request through to an appropriate person for authorisation

Chapter 7 
 457 
 Payroll  
Try and set up a new 
employee up on the payroll system using an 
unauthorised ID The system should reject the process 
altogether or send the request through to an appropriate person for authorisation 
Try and make employee changes of detail using an unauthorised ID The system should reject the process 
Make an excess change, for example increase someone’s salary by $1,000,000 by someone authorised The system should have parameters in 
place to question this amount, and maybe reject it due to it being outside the normal range 
 
 E Company administers payments to home owners to enable them to 
insulate their homes, or up-grade their heating system. E is in receipt of a 
central government grant which it mu st only distribute to home owners 
whose income is below a certain level or who fall into a ‘vulnerable’ category, as stipulated by  the government guidelines. 
E Company must not administer payment s twice to the same address, or 
breach a maximum award amount. E company must also receive proof (in the form of an invoice)  that the money awarded has been used for the 
intended items. E Company maintain s computerised records of all 
payments awarded with inbuilt controls to ensure they do not breach 
government guidelines. 
The internal auditors of E Company  are using ‘test data’ to perform 
checks on whether the computer contro ls over awarding payments are 
working correctly. They are using ‘dead data’ to test the system. 
Which of the following issues is th e test data unlikely to detect? 
A Whether the system will allow a payment which breaches the upper 
limit to be processed. 
B Whether the system works consistently in the same way C Whether the system will allow a payment to be made to the same 
address twice. 
D Whether the system will allo w a payment to be made to an 
individual not classed as vulnerable or on a low income. 
E Whether an address which has received a grant is valid. F Whether ‘spot checks’ at addresses were carried out correctly.

458  
 Test your understanding 24 
 Factors affecting the need for an audit include: 
Select ALL that apply A The number of directors B Turnover C The diversity of the company’s activities D A change in organisational structure E Net assets 
 
 Test your understanding 25 
 The testing and evaluation of controls is usually performed firstly by 
which one of the following? 
A Risk management B External audit C Internal audit D Management 
 
 Test your understanding 26 – G Manufacturing (Case study) 
 Scenario 
Trigger 
A new Chief Executive was appointed in July 2013. She was recruited 
from a much larger manufacturi ng company where she was the 
Marketing Director.  The company is also an indirect competitor of G. 
whole of August meeting representative s from all levels of staff from 
within the company and other stakeholders such as customers and 
suppliers. She has called a board m eeting to discuss her findings. Her 
findings are as follows: 
with customers. All me mbers of G’s staff ar e proud to be associated 
that they are acting in the company’s best interests.

Chapter 7 
 459 
  The relaxed management  style has harmed the control environment 
significant amount of time ev ery month chasing heads of 
departments for reports and for ot her important information. 
 These attitudes are echoed by external stakeholders. Customers 
invoices and monthly statements contain errors. Suppliers claim 
that invoices submitted to G are settled very promptly 90% of the 
time, but the remainder have to  be chased because G’s accounts 
staff do not always receive accurate and complete records of orders placed and goods received. 
must be improved as a matter of priority. She proposes to send an email to all staff congratulat ing them on their achiev ements on product quality, 
Task 
Write a briefing note to the Chie f Executive recommending, stating 
reasons, the steps that she should take  in order to create an effective 
internal audit department. (30 minutes)  
 
 Test your understanding 27 – Mu ltinational car manufacturer 
 Scenario 
M is a multinational car manufacture r. M sells six models of car around 
the world. Each model has its own assembly factory. Each of the 
factories is located in a different c ountry and each factory is incorporated 
as a company. Car assembly is heavily automated, using robots to assemble and weld, and so final assemb ly is generally in a country that is 
chosen for its proximit y to major markets. 
M has many other factories that make components. For example, one 
factory manufactures all of  the music systems for every car sold by M and 
another manufactures all of the wi ndscreens. These factories can be 
located in countries that offer low labour costs. For example, the music 
systems are built using unskilled labour in a developing country.

460  
 Each country in which M sells cars has its own M subsidiary that deals 
with distribution. All sales are to  car dealerships and each dealership 
buys cars directly from its local M subsidiary. 
National governments are k een to ensure that intra- group transfers are at 
arm’s length prices and are set so that M will not pay too little tax. Therefore the transfer pric ing policy in M is that transfers should be at 
“market price”. Consequently the transfer prices that are used by M do not necessarily reflect the manuf acturing costs and so some group 
members report very sma ll profits. The company’s reward system for its 
senior managers and directors is linked to the profit s that are reported by 
their subsidiary. 
M’s transfer pricing arrangements ta ke up a great deal of management 
time. In many cases, a rm’s length market prices are difficult to identify 
because there are no direct comparis ons available. For example, the 
subsidiary that manufactures music systems does not sell its products to 
anyone other than the six assembly co mpanies. Even if similar products 
can be found that are traded openly by other manufacturers, there are 
very specific problems with determini ng an objective market price. For 
example, there are transport costs and questions over the discounts that 
are granted for bulk sales. There is an even greater problem with finished 
cars because M sells its cars at higher prices in more prosperous markets. 
Trigger 
M’s main board is concerned that t he company may be investigated by 
the tax authorities in one or more of the countries  where it does business. 
The Head of Group Internal Audit has  been asked to assist the board by 
conducting an internal investigation in order to establish whether M 
should change any of its tr ansfer pricing practices. 
Task 
Write a briefing note to t he Board advising on the matters that it should 
cover when briefing the Head of Gr oup Internal Audit in order to be 
certain that its requirements are met by the internal au dit investigation 
into M’s transfer pricing practices. 
Write a note to the Head of Group Inte rnal Audit discussing four factors 
that they should consider when assessi ng the possibility that a subsidiary 
could be investigated by its local tax authority. 

462  
 
 B, C, D 
Note: 
 A – just because the company is a plc, it does not necessarily follow 
that it is listed 
 E – family run companies do not necessarily have weaker controls 
or higher risks 
 F – while one would hope the shar eholders would want an internal 
audit department, this reason is not as  important as the other factors 
highlighted 
 
 A, B and D 
 Option C: This is an internal audit role. The risk management team 
cannot establish controls and then test them objectively. 
 Option E: This is a role that internal audit may carry out. 
 Option F: This is a re sponsibility of the board. 
 
 A and B only 
 Option A: True – The internal audit or cannot report to a director who 
might be the subject of an internal audit. 
 Option B: True – Since objectivity is  the key attribute of an internal 
auditor, an outside appointment, without  any personal grievances or 
conflicts within NN, will be mo re independent than an internal 
promotion. 
 Option C: False – The internal auditor could review controls over 
quality control for adequacy but not  directly prevent the re-
occurrence of any events. 
 Option D: False – In carrying out t heir work, the internal auditors will 
need to question operational staff and observe them carrying out 
their roles. This will inevitably take time. However, improvements 
suggested by internal audit should outweigh any short term loss of 
 Option E: False – Many organisati ons have a single internal auditor. 
Whilst a team and a separate departm ent are ideal, they are not 
compulsory.

Chapter 7 
 463 
 A, B, D 
Note: 
 C – Internal staff are more likel y to have a better understanding of 
the organisation’s objectives and culture 
 E – the decision should be based  on a range of factors including 
cost, quality, skills, etc 
 
 The correct answer is A – Reporting should be to a senior director. They 
should also have access to the chairm an, and be accountable to the audit 
 
 The correct answers are A, B and D – Identifying risk is the role of risk 
management. Internal audit test the contro ls in place to prevent or detect 
risk. However, if in the course of in ternal audit work a risk is identified 
then it will be reported to risk management (which is  a secondary role for 
audit). 
 
 The correct answer is D – By outsourcing the internal audit function 
control may be lost. 
 
 External audit perspective 
External auditors fo rm an opinion on whether the financial statements 
show a true and fair view. This means they will seek explanations for any unusual items, areas of expenditure, etc so they can fo rm their opinion. 
The fact that variable overheads hav e increased means that they will 
require evidence (such as approved invo ices) to verify these expenses, 
They will need to ensure that expenditure  is bona fide to the business. If it 
appears difficult to determine why these expenses have been incurred, then the issue of legitimate business expense is raised. 
At the extreme there is the possibility of reporting under the Proceeds of 
Crime Act of 2002 that the busine ss may have been involved in fraud or 
money laundering.

464  
 Internal audit perspective 
The lack of apparent reason for incurring the additional overhead 
expenses also appears to be a weakness in the internal control systems. 
Segregation of duties is poor and this  has allowed someone to set up a 
supplier and process invoices for payment to that supplier. 
The internal auditors will be concerned by such weaknesses in control 
and seek to rectify the situation. 
They may also notice the increas e in expenditure and question the 
efficient use of resources on the development projects. 
 
 (a) The whole point of this type of  tendering process is to ensure that 
each bidder has an incentive to tender at the lowest possible acceptable price. Doing that requires that the bidding parties know 
as little as possible about one another  and that the bids themselves 
are kept secure. 
There are a number of areas of concern in this case: The winning 
bidder withdrew what would have been the lowest offer and replaced it with a higher bid. Ther e could be an innocent explanation 
for that, but it is a matter of some  concern that the bid was replaced 
because it could indicate a knowl edge of the other bidders’ tenders. 
If that is the case then ther e could have been some collusion 
between the bidder and a member of  staff in Z’s buying department. 
Alternatively, the bidder coul d have colluded with the other 
companies that were most likely to have placed bids for this contract. 
The winning bid was not the lowest one submitted. That could 
signify some favouritism on the pa rt of the selection committee. 
There may be a perfectly valid justif ication for rejecting a lower bid, 
but it seems strange that a bidder fo r a major contract  would submit 
a tender for a product that is not fit for purpose. The process was 
not particularly secure. The bids themselves were addressed to a relatively junior manager and were  not stored under conditions of 
great secrecy. The chief buyer could easily have opened incoming 
bids and put them in replacemen t blank envelopes without that 
being obvious to anybody. The internal auditor was not involved until very late in the process and most of those present at the 
opening were directly involved in the project. The internal audit 
department could have taken a more active role in the whole process of safeguarding bids an d in opening them under secure 

Chapter 7 
 465 
 (b) The internal auditor should atte mpt to establish who had access to 
the sealed bids after they had been received. It would be an easy matter for anybody who had access to the safe to type a label and put the bid in a new envelope. It woul d not be particularly difficult to 
forge a colleague’s signature (or for the chief buyer to sign the 
envelope). 
The easiest way for the auditor to  determine who had access would 
be to visit the buying department and to  note the location of the safe 
and the occupants of the office in wh ich it is located. The auditor 
should use indirect, open ‐ended questions to determine whether the 
safe is normally kept locked when the office is occupied and who 
has access to the key or combination. The opened envelopes, which should have been retained, should be examined and the chief buyer asked to confirm that all of  the signatures were genuine. That 
would effectively mean that the ch ief buyer was accepting personal 
responsibility for the bids that we re considered. The internal auditor 
should attempt to establish whether there is any form of relationship 
between any member of the buying department and the winning 
bidder. Even those who could not access the safe would possibly know who had tendered from the cove ring letters, which were kept 
separately, and that could have permitted the winner to gather 
information that led to submi tting a higher winning bid. The 
purchase ledger should be checked to determine whether Z had any previous dealings with the winning bidder. 
The reasons for the rejection of the cheaper bid should be 
investigated. The fact that the bu s was slightly smaller could be a 
reason for rejection as could the s pecification for th e modifications, 
but these might not be material to  the selection. If the buses were 
large enough and within the parameter s of the tender document and 
the materials were of an accept able specification then the cheapest 
bid should have been accepted. 
(c) Note  
To:  The Chief Executive 
Subject:  The advantages and disadvantag es of the internal auditor 
being actively involved in the investigation of suspected fraud. 
Dear Sir, The advantages include: The internal auditor should be independent of those who are being 
investigated. It would be difficult to identify anybody else outside of 
the buying department with the nec essary understanding of the 
process.

466  
 The internal auditor will have the necessary skills to undertake the 
investigation and also knows and understands the entity’s culture 
and systems. An external auditor c ould undertake the investigation, 
but would not have this insight. The entity can be assured of the internal auditor’s discretion and so there should be very little risk of 
the facts leaking out without the board’s permission. Internal audit 
staff are generally prof essionally qualified and are also trained to be 
discreet 
The disadvantages include: Using the internal audit department in  this way could make it more 
difficult for the internal audito rs to maintain a good working 
relationship with those under audit. Internal auditors are generally 
reluctant to investigate potentia l fraud because it may undermine 
their relationship with line staff. 
The audit could be very time consuming and could be a major 
distraction from the ongoing schedule of internal audit activities. The 
internal audit department’s time is  a valuable resource and it will 
generally be allocated to specific ta sks as part of a plan. The fact 
that the evidence has been gather ed by the company’s own staff 
could undermine its credibility if, say, the company seeks compensation as a result of the in vestigation or pursues criminal 
charges. If there has been any sta ff fraud then the police will require 
a clear and unambiguous chain of  evidence and the fact that 
colleagues have been involved in t he initial investigation may 
interfere with their ability to build a criminal case. If you have any 
further queries please do not hesitate to ask. 
Best wishes A.N. Accountant

Chapter 7 
 467 
 Address 
Date Dear Sirs, Re: The economy, efficiency and effectiveness of beach cleaning 
(a) The total cost of all activities should be measured against budget 
and previous years. That cost should be broken down according to 
whether it relates to sweeping or em ptying bins and by the nature of 
the expense within that (e.g. labour or  vehicle running costs) so that 
any costs can be identified and managed. 
The breakdown of the total should be linked to the cost drivers in 
order to measure trends or spot anom alies. For example, the cost of 
running tractors should be divided by  the number of tractors or the 
number of kilometres travelled to determine the cost per vehicle or 
vehicle-kilometre. Much of this information should be readily available from existing management  accounting records maintained 
by the town. 
It may be possible to break costs down to reflect the cost of cleaning 
specific beaches or stretches of beach. If so, that might indicate 
whether a particular stretch is cost ing a disproportionate amount of 
time and money because of issues over location or problems such as rocks or soft sand. It may be po ssible to reduce costs by closing 
such beaches to the public during quieter parts of the holiday season. Analysing costs in this way will almost certainly require staff 
to maintain logs for a period in  order to show how time and 
resources are being applied. 
Any deviations from budget should  be investigated, as should any 
fluctuations in the measures over time. 
Comparable statistics s hould be obtained from ot her towns in order 
to determine whether there is scope to benchmark. There is no 
reason for other towns to withhold that information because the 
nature of any competition is unlik ely to be affected by expenditure 
on cleaning services. 
For the purpose of any comparison the total cost should be related 
to the number of beaches being cl eaned and the length of the 
beaches in order to adjust for the scale of the operation.

468  
 (b) The quantity of refuse colle cted by each means (sweeping v 
emptying bins) should be measured in  order to reflect the output 
from the service. 
The number of complaints lodged by holidaymakers and residents 
should be monitored. Those relating to the cleanliness of the beach 
should be highlighted as an indi cator of public perceptions. 
The town council should conduct market research to ask beach 
users what they think about the amenities provided and the questions should include some discussion of the cleanliness of the beach. That should be repeated regul arly throughout the holiday 
season, partly because the problem may change in response to peaks and troughs in the number of users and partly because the use of the beach may change dependi ng on whether families are 
using it for play during the summ er holidays or older couples are 
simply walking on the beach when the weather is cooler at the 
beginning and end of the holiday season. 
The number of incidents attended by  the beach first aiders should 
be analysed to highlight injuries such as cuts caused by broken glass. 
The town council should conduct det ailed audits of the beach itself 
by inspecting areas immediately after the sweeping operation and 
also during the day. That will requir e setting a standard for the audit, 
such as deciding what constitutes a piece of litter (for example, should a small shred of paper that woul d be difficult to filter out of 
the sand be counted in the same manner as, say, an empty soft 
drinks can?) 
Compliance with the town council’s  standards should be monitored. 
For example, there should be a che ck to ensure that the bins are 
actually emptied according to the schedule. Any deviation should be 
investigated to establish whether that is due to staff failure or 
because the schedule is impractical. 
(c) In general, effectiveness audits are more difficult than economy and 
efficiency audits. 
Economy and efficiency is a matter of  cost accounting. The cost of 
providing the cleaning services is la rgely a matter of using traditional 
accounting techniques to analyse data that would be collected for 
financial reporting and management accounting purposes anyway. 
There are some subjective decisio ns that may have an impact, such 
as identifying relevant costs, but  even those problems are largely 
questions of definition. 
Effectiveness involves making so me difficult decisions about 
measuring performance. Surrogates, such as the quantity of litter 
uplifted, can lead to dysfunctiona l behaviour because that could 
encourage more frequent emptying of  bins at the expense of 
sweeping. Sweeping will not necessarily collect a huge quantity of 
material but it might  remove dangerous objects such as broken 
glass.

Chapter 7 
 469 
 It may also be necessary to set targets for the end result of the 
cleaning activities and that could be difficult. What is an acceptable 
level of litter? What matters more , perceptions of litter or actual 
cleanliness? The two could differ because many users may not be aware of litter on the beach. 
Yours Faithfully 
A.N. Accountant 
 
 The correct answer is D – By definition. 
 
 A and D. 
 Option A is an inherent risk which exists regardless of internal 
controls. 
 Option B is a control risk. 
 Option C is a detection risk. 
 Option D is an inherent risk which exists regardless of internal 
controls. 
 Option E is a control risk. 
 
 The correct answer is C Substantive tests concentrate on output (the end 
result) ensuring that it is as expected. 
A, B and D are compliance te sts (on the process) to test that controls are 
operating as they were designed to.

470  
 Company X appears to have a recruitm ent 'process' – application forms 
and interviews, although this may not have taken the process far enough. 
Once a candidate has been selected their application form should be 
verified, usually by checking their qualific ations to actual certificates (not 
copies) and taking up references (usually two – one work and one personal). There is no mention of  this happening at X and may be the 
reason that John cannot perform the j ob satisfactorily. The rumour may 
be true. 
John's start date appears to be too soon to enable the aforementioned 
controls to be implemented. There should be a sufficient period between 
interview and any start date to enable all claims made on the application 
form to be verified. 
Personnel/human resources should be the department to verify the 
application form, which they may not  have done. Therefore the internal 
auditor should visit the department, a scertain the recruitment process and 
test that the process is adhered to. 
Compliance tests might include: 
 Select a sample of employee fi les and test to see whether the 
application form is present. 
 From the application forms, tr ace the references taken up. 
 Check that the references were pos itive i.e. that previous employers 
found the staff punctual, trustworthy, etc. 
 From the application forms, trace t he copies of certificates (taken 
from the originals) which ba ck up any qualifications stated. 
 Qualifications could be further tested by contacting the relevant 
body to ascertain whether they have record of said employee. 
The controls at X appear to be ineffective since the process does not 
cover these vital activities. Alternativ ely these activities might be part of 
X's personnel process, and the personnel staff have not followed them. Either way the personnel staff need to be reprimanded and further 
controls implemented to prevent future occurrences.

Chapter 7 
 471 
 Compliance tests 
 Look for evidence of the approval of  new workers, such as a formal 
instruction to the payroll department. 
 Check that the timesheets are all approved by a supervisor. 
 Check that all overtime has been approved. 
 Observe the wages payout to ensure: 
– wages are only collected by the person being paid; 
– all staff sign for their wages. 
 Ensure that a PAYE/NIC control a ccount is reconciled and reviewed 
each month by an appropriate manager. 
Substantive tests 
 Take a sample of timesheets and re-calculate wages and 
deductions. 
 Perform a reconciliation of total hours worked to gross pay and 
compare month by month. 
 Check a sample of payments to t he pay rate records to ensure they 
are being used correctly. 
 Re-perform the PAYE/NIC control a ccount for a month to ensure it 
has been done correctly. 
 
 The correct answer is C – Detection ri sk is the risk that the auditor’s tests 
do not reveal a materially incorrect amount. 
Control risk is the risk that the exis ting controls are not sufficient to 
prevent or detect a ma terial mis-statement. 
 
 Test your understanding 18 – Ca r dealership (Integration) 
 A number of performance ratios coul d be calculated across the different 
regions to compare performance: 
Sales value per salesman (£) 168,750 210,000 232,000 100,000 
Sales discussions per 
salesman 41 30 43 31 
Average orders per 
discussion 0.27 0.43 0.37 0.28 
Average value per order (£) 15,000 16,200 14,500 12,600

472  
 From the above performance measures  it can be seen that the West 
region is the most inefficient. In all meas ures this region is at or very near 
the bottom performance criteria which indicates there should be room for 
efficiencies. This region should be selected for audit. 
 
 Test your understanding 19 – D courier company (Case study)  
 (a) An independent auditor would r eport honestly, without any bias or 
conflict . Independence is an attitude of mind that involves making a 
truthful report regardless of the consequences. In this case, F 
appears to have identified with the Depot Manager, despite there being no particular reason for doing so. F has been sympathetic to the Depot Manager’s position and t hat sympathy has resulted in a 
distorted internal audit report.  F’s duty was to investigate 
compliance with a specific rule concerning maintenance and to report the results to s enior management. It was not part of F’s duty 
to consider whether a truthful  report would harm the Depot 
Manager’s career. The responsibility for deciding whether to take action against the Depot Manager lay with D’s board and F should 
have provided a full report on the circ umstances. That report could 
have included a summary of t he Depot Manager’s predicament 
arising because of the abs ence of the mechanic. 
F should not accept responsibility fo r the impact of a truthful report 
on the Depot Manager’s career. The Depot Manager could have 
dealt with the fact that there was inadequate cover when the 
mechanic was absent by reporting the situation to head office. The Depot Manager should not have asked F to deal with this omission 
retrospectively by lying in  the internal audit report. 
(b) The internal audit department is  a vital element of the control 
environment in any large entity. The directors rely on internal audit 
to ensure that formal control processes and procedures are 
operating as they should. The directors cannot observe the 
workings of these systems for themselves unless the entity is very small and so the internal audit de partment provides vital feedback. 
If the directors cannot trust the inte rnal audit department to report 
honestly and accurately then they will have no way of knowing whether their policies and instructions  are being carried out. That is 
a major issue in terms of good corporate governance because the 
shareholders hold the directors responsible for the governance 
arrangements and expect them to r un the company an effective 
manner. Cases where problems have arisen because of compliance failures by managers and staff have tended to reflect badly on the board.

Chapter 7 
 473 
 F’s behaviour is also sending a very clear signal to D’s staff. If 
breaches are not reported and act ed upon then staff may decide not 
to comply. If the internal audit de partment, whose very existence is 
to report compliance failures, does not  act then the staff could start 
to become demotivated and lazy. If D’s board does not act quickly 
and decisively then its ability to manage the company effectively will be seriously compromised by this audit failure.  
(c) The first thing would be to revi ew the records maintained by the 
depot. These should indicate that the inspections were carried out and the mechanic should have signed as proof. This test will not actually prove that t he tests took place because the mechanic could 
have signed the documents recklessl y, but the signature does at 
least prove that the st aff are willing to accept responsibility for the 
inspections having been carried out. In ternal audit could review the 
records relating to repairs and breakdowns for each depot. This would be a useful analytical review exercise that could identify any 
depots that were at a higher risk of not carrying out adequate 
inspections. Ideally, the cost of repairs should be separated from the 
cost of routine maintenance. 
During branch visits the internal audit staff should be aware of the 
work being done by the depot me chanics. The depot staff may 
behave differently during an audit visi t, but it would be reassuring to 
see whether the mechanics were in specting vehicles. The auditor 
could supplement these observations by asking the mechanics and the drivers to explain the mainte nance procedures in order to 
establish indirectly whether they  volunteered information about the 
regular fluid checks. 
The internal auditor could conduct a s pot check on the fluid levels of 
a sample of vehicles at the depot. These should focus on vans that have recently been checked. If the fl uid levels are low then there is 
a strong likelihood that the c hecks were not carried out. 
 
 The correct answer is A The correct order of events is to: Plan the audit; 
document systems and controls; test compliance with controls; test 
application of controls; report to board  
 
 A, B and D 
 Options A, B and D are typical of an internal audit report on internal 
controls. 
 Options C and E are more in keeping with an external audit report.

474  
 Possible use of audit software: 
 Sequence checks on delivery note file and invoice file. 
 Computer can check that every delivery results in an amendment to 
the invoice file and the stock f ile (with list produced of every 
exception). 
 Exception reports generated of zero value invoices and non- 
invoiced deliveries. 
 Calculation checks on all invoices to ensure in line with price lists. 
Check on agreement of deliveries against order files. 
 
 B, D, E and F 
 Option A: The internal auditor can attempt to process payments 
which both breach and do not breach the upper limit .Those that do 
breach it should be rejected. 
 Option B: Dead data means test data are processed outside the 
normal cycle. It is not possible to conclude with certainty that the 
‘live’ system would work in the same way. 
 Option C: Same address payments should be rejected. 
 Option D: The test data will chec k computer controls, not whether 
proof of income etc. has actually been seen. 
 Option E: As long as an addre ss has not been awarded a payment 
before it should be accepted by the system. This does not mean it is 
a valid address, only that it has not been recorded before. 
 Option F: The test data will check co mputer controls, not the work of 
staff performing spot checks. 
 
 Test your understanding 24  
 The correct answers are B, C, D and E The number of employees (not 
directors) may affect the need for an audit – the more employees, the 
higher the risk that supervision ma y not be an effective control. 
 
 The correct answer is C – This is internal audit’s key activity, hence 
ensuring that those who design t he controls do not test them.

Chapter 7 
 475 
 Test your understanding 26 – G Manufacturing (Case study)  
To:  Chief Executive 
Subject:   Creating an effective internal audit department 
Dear Sir, Firstly, the board should decide the level of commitment that it is going to 
make to internal audit. A half-hearted attempt will lead to an under resourced and ineffective department. A realistic staffing level should be 
decided before anything further is  done and the associated costs should 
be budgeted for. 
The terms of reference should be decided. Those will include the powers 
that will be enjoyed by internal audit and the internal auditor’s access to the board. It will be easier to recr uit an experienced Head of Internal 
Audit if it can be shown how t he department will be viewed within the 
organisation as a whole. 
The Board should recruit the Head of Internal Audit before interviewing 
for the other audit staff. That will enabl e G to offer the Head of Internal 
Audit the opportunity to have some sa y in recruitment to ensure that 
suitable staff are taken on. G should use a recruitment agency to identify 
suitable candidates because agencies are likely to have access to lists of potential applicants who are interest ed in moving on to new challenges. 
The remainder of the audit team shoul d be recruited, perhaps also using 
an agency, under the Head of Internal Audit’s overall supervision. The 
team members should have appropr iate skills and qualifications, 
including membership of a professi onal body, or be working towards a 
qualification if they are to be employed in a junior role. 
The department should be based in a suitable location, with realistic 
provision for administrative support such  as secretarial support. If internal 
audit is not shown to be adequately re sourced then its credibility will 
suffer in the eyes of the other staff. 
The Board should provide internal  audit with a statement of the 
department’s powers to request in formation and documents. Giving 
internal audit a formal charter within the organisation will help to ensure the department’s credib ility and its freedom to conduct meaningful 
investigations.

476  
 The initial reports submitted by internal audit will have to be seen to 
receive the Board’s endor sement in order to underpin the directors’ 
support. That could involve request ing a follow-up to deal with any 
weaknesses or compliance failures. The Board should not take disproportionate action, otherwise the internal audit department will be 
viewed as a threat, but it should be clear  to all staff that  the internal audit 
reports will be read and taken seriously. 
 
 (a) Briefing note  
To:  The Board 
Subject:  Investigation into transfer pricing 
The board has to provide the Head of  Internal Audit with a very clear 
objective for this audit. This is a ve ry specific task that could prevent 
the company from being tied up in  a number of investigations 
around the world. The board should identify the problem areas that 
are likely to prompt a tax invest igation in one or more of the 
subsidiaries and brief the internal  auditor accordingly so that the 
group is aware of the “w orst possible case”. 
The Head of Internal Audit should be briefed on the extent to which 
evidence should be gathered. This  could be a desk-based audit 
carried out from head office or it could involve local teams visiting 
subsidiaries. The Head of Internal  Audit should be given a detailed 
budget of the time and resources that are to be invested in this study. 
If the audit team is to visit s ubsidiaries and engage with local 
management, then the audit staff will have to know how much they 
are permitted to reveal about the in vestigation. Transfer pricing is 
clearly a very controversial matte r for M and local managers may be 
unsettled by any suggestion that pr icing policies may be changed. 
The timetable should be estab lished. If the board requires the 
findings quickly then it  will either have to accept a less detailed 
investigation or it will have to reallocate internal audit resources from other areas.

Chapter 7 
 477 
 (b) Note  
To:  Head of Group Internal Audit 
Subject:   Tax investigation 
Dear Sir, I attach some notes regarding fa ctors that should be considered 
when assessing the possibility that a subsidiary could be investigated by the local tax authority. 
National tax rates 
The countries that are most likely to investigate transfer prices are 
those that have the highest tax ra tes. Ranking tax rates and import 
tariffs will provide the internal aud it team with an indication of the 
subsidiaries that are at greates t risk of being the subject of an 
Credibility of tax charge 
The manipulation of transfer pricing is associated with the 
underpayment of tax. The internal  audit team should calculate the 
tax paid by each subsidiary as a percentage of accounting profit. A 
subsidiary with a very low effective rate of tax is more likely to be 
investigated for the distortion of transfer prices. Alternatively, the 
authorities may relate the tax c harge to other statistics. For 
example, a company that has a healthy reported revenue and a very small tax liability may be suspected of manipulation 
History of tax investigations 
The history of individual count ries may also be relevant. For 
example, the UK government wa s concerned about the potential 
underpayment of tax by some mult inational companies and so any 
UK subsidiaries may be more at ri sk of an investigation by the tax 
authorities 
Visible market prices 
The nature of the products being suppl ied may also affect the risk of 
an investigation. For generic items such as nuts and bolts or spark 
plugs, there will be a readily observable market that is visible to the tax authorities. If M’s transfer pr ices are close to the observable 
market prices for such items then there is very  little risk that a tax 
investigation will occur and so ther e is less point in conducting an 
audit investigation. If the pricing implications are complicated because there is no meaningful comparison then any tax investigation will be more disruptiv e and it could be useful to pre-
empt that with an audit  investigation so t hat M has its defence 
ready.

479 
Cyber security threats 
D1 Analyse cyber security 
threats. (a) Analyse nature and impact 
of cyber security risks. 
(b) Analyse types of cyber 
security risks 
(c) Analyse risk of security 
vulnerabilities 
D2 Review cyber security processes (a) Review cyber security 
  Chapter 
8

480  
 
1 Overview of cyber security threats 
Organisations deal with a wide variety of sensitive information on a daily basis. 
It is important to understand what constitu tes sensitive information, how it is 
used, what an organisation’s objectives regarding cyber security might be and how different organisations may interact with technology. 
1.1 Types of sensitive information  
Sensitive information can take many fo rms.  Broadly speaki ng there are three 
main types of sensitive information: 
 Personal information : often referred to a Pe rsonally Identifiable 
Information (PII), this is anything t hat can be used either on its own or with 
other information to identify, c ontact or locate a single person. 
 Business information : this is anything that may cause a risk to the 
company if discovered by an external party, for example a competitor.  It 
includes things like research dat a, marketing plans and new product 
developments. 
 Classified information : this usually refers to information that a national 
government has put special restrict ions on where disclosure could harm 
public safety and security.

Chapter 8 
 481 
 Expandable text: Sensitive information 
 Personally Identifiable Information includes but is not limited to the 
 Names 
 Addresses 
 Date of birth 
 Credit card numbers 
 Bank account numbers 
 Personal health information 
 Information about sexual activity or orientation 
 Information about race or ethnicity 
 Information about political opinions 
 Information about religious  or philosophical beliefs 
 Students’ registrati on with an awarding body 
 Students’ Kaplan ID number!! 
Business information could incl ude, but is not limited to: 
 Financial information for internal reporting  
 Financial information for external  reporting, prior to publication 
 Confidential sales information (c ustomer lists, order information) 
 Payment card information maintai ned for ease of customer ordering 
 Confidential employee information 
1.2 Understanding how technology interacts with the organisation 
To enable an organisation to protect itself from any cyber security threats, it 
must understand how technology interacts with the organisation. This includes 
the following considerations: 
 Type of technology the company uses: 
Enterprise Resource Planning (ERP) systems, Data Centres 
 The different ways the organisati on is connected with technology: 
Virtual Private Network (VPN),  routers, virtual servers 
 The different service providers the company uses: 
Cloud provider, software providers, call centres 
 How the company delivers its produc t or service to the customer: 
Transmissions to vendors, online re tail channel, wholesale customers 
All of these factors provide an opportunity for an issue to  arise, if they are not 
properly understood and controlled.

482  
 Expandable text 
 Type 
 Enterprise Resource Planning (ERP)  systems link a wide range of 
activities that managers could us e to control information flow and 
employee behaviour. They are often used to automate work traditionally done by the managem ent accountant, such as 
accounting entries, inventory ordering, monitoring and human 
resource planning. 
 Data Centres  are large groups of network ed computer servers that 
are usually used by organisations  for storage, processing or 
distributing large amounts of data. 
Connection type 
 Virtual Private Network (VPN)  extends a private network across a 
public network and enables users to send and receive data across 
shared or public networks as if their computing devices were directly 
connected to the private network . Often used by organisations 
whose staff work remotely so they can access shared data drives or intranet. 
 Routers  are networking devices that e ffectively direct the computing 
traffic between computers on networks.  Data sent using the internet 
(for example a web page or email) is  put in the form of a data packet 
and the packet is sent from one router  to another until it reaches the 
destination that requested it (web page), or the destination it was 
told to go to (email). 
 Virtual servers  take advantage of improvements in technology. A 
modern server is now so powerful that having one server for a 
single function is very inefficient. Servers can now perform multiple functions and can be located offsit e and often controlled by a third 
party. The resources the server prov ides are often used by multiple 
users and each user can administer it as though they have complete control over it. 
 
 The Cloud 
 The cloud is a form of remote data storage. The name cloud is given to it 
as data storage could be at a great di stance from the ac cess point e.g. on 
another continent remote from the PC rather than held on the PC’s local 
storage. It is not actually stored in a cloud. 
Although it uses new technology and concep ts, this is similar to very early 
computing when no-one held data locall y and it was all held on a large 
central computer owned and run by the company (at that time known as a 
mainframe). 
There are benefits and risks associat ed with using cloud storage.

Chapter 8 
 483 
 One of the main benefits is cost: 
– only paying for the storage used – in-house staff are not required to maintain and protect the data 
The costs relate to the risks involved: 
– remoteness can be a problem, if  communications break down you 
cannot gain access to your data 
– reliance on a third party to pr otect the integrit y of the data  
– sharing storage space with others which may compromise your 
data 
In 2014 there was a high profile breach of a major cloud service provider 
in which private details, calendars,  phone call logs and photographs were 
stolen. This was possible owing to a control issue t hat allowed the 
hackers to make unlimited attempts  at guessing the users passwords. 
 
Many organisations depend on their digital strategies.  The threats to these 
strategies can be complex and are bec oming more so as the reliance on 
information systems increases. As entities l ook to exploit greater efficiency from 
technological advances, new and unfor eseen threats are created. Smart 
technology, and devices being linked together  to create networks, increases the 
vulnerabilities, and a system or a network  is only as secure as the weakest 
device in the network. 
 
 Increasing and unexpected threats 
 In December 2018 over 32 million mobile phone users suffered network 
outages on the O2 network. The netwo rk outages meant that data access 
was not possible using the mobile net work. This is an inconvenience for 
an individual, but most people have a ccess to Wi-Fi networks at home, at 
work or in a local coffee shop so can work around it. 
However, the issue is that businesses now rely on data connectivity and, 
as a result of this network outage, some companies like Uber, Deliveroo, 
Transport for London, and many smaller businesses like market traders 
who rely on data networks to take cr edit cards payments, were affected. 
 
As countries’ physical defences becom e stronger, and the use of computers 
increases, the ability to attack or gather intelligence through physical means diminishes. This has led to an increased focus on cyber warfare, where a nation 
state seeks to penetrate another nation’s computers, online control systems and 
networks to cause damage, disruption or to try and access confidential 
information. While a nation may be the intended target, the process can also lead to organisations suffering collateral damage.

484  
 Cyber warfare 
 In June 2017 a global cyberattack call ed Notpetya primar ily targeted the 
Ukraine on the eve of a nat ional Ukrainian holiday. It is estimated that 
80% of infections were in the Ukraine, with several banks, metro systems and the Chernobyl Nuclear power  plant going offline.  
Germany was also badly hit, with ar ound 9% of the infections reported 
there, including personal care com pany Beiersdorf and logistics company 
DHL. Other collateral damage was reported around the world by firms like the American pharmaceutical company Merck, and Danish transportation, 
logistics and energy provider Maersk. 
1.3 Cyber security and the external environment 
It is also important to determine what environmental, technological, 
organisational and other changes have o ccurred during the period that could 
have a significant effect on the entity’ s cyber security risks and therefore the 
cyber security risk management program. 
 
 Types of changes that could affect cyber security risk management 
 As an organisation goes about its bus iness, there are a variety of 
changes that could affect the cyber  security risks and therefore the 
management of those risks. These coul d include, but are not limited to: 
 Expansion – for example addi ng an additional manufacturing 
operation. This will require an addi tional connection to the local area 
network, which in turn leads to an additional area for protection. 
 Acquisition – an acquisition or merger  is a very challenging time for 
an organisation, but part of that c hallenge often links to integrating 
different software packages, leading to risks such as data loss during the changeover process and potential breaches through 
additional access points. 
 Restructure – if an organisation were to undertake an internal 
restructure that would impact cyber  security. Reporting lines would 
change, and IT users would require  their access to be updated to 
match their new roles. 
 Hardware update – rolling out any kind of update poses a risk as it 
means people will need to change the way they do things. Also old 
hardware must be disposed of secu rely, as data stored on the hard 
drive could be accessed if it wasn’t  correctly wiped and fell into the 
wrong hands. 
 Regulations – Any changes in le gal requirements or regulatory 
frameworks can have an effect on cyber security risk management. 
For example the introduction of GDPR  in the EU has put pressure 
organisations that operate in t he EU, but has also led other 
government organisations to consi der improvements to their data 
privacy laws and so could have implications for other companies.

Chapter 8 
 485 
 Changeover methods 
  Direct changeover  – This is where the old system is switched off 
and then the new system is switc hed on. This is appropriate when 
the two systems are very different, or  it is too expensive to run two 
systems. Although this method is cheap,  it is also risky since if the 
new system doesn't work properly the company might be unable to revert to their old system quickly. (A lso, staff trust in the new system 
would be lost.) 
 Parallel running  – The old and new systems are run together for a 
period of time, until it is considered  safe to switch the old system off. 
This method will be costly (inputting data twice and possibly employing more staff to do this),  however, it will be less risky than 
direct changeover. 
 Pilot changeover  – This is where one part of the business changes 
over first. Once the system operates  correctly there, the rest of the 
business will change over. The pilot department or division could be using direct or parallel changeover. A gain, this is a safer method of 
changeover as only one part of the business will be affected if anything goes wrong. However, when the system is rolled out 
across the rest of the company t here may be different problems in 
each location and the IT team’s  resources will be stretched. 
 Phased changeover  – This involves bringing in the new system 
one part of the business at a time, say,  by department or division. It 
differs from pilot changeover in t hat all departments or divisions are 
staggered with respect to receivin g the new system. The downside 
is that this method is time-consum ing. However, it is less risky as, 
should there be a problem in any particular department or division, 
and the IT staff will be able to deal with the problems one at a time. 
 
 TSB software migration 
 TSB Bank Plc is a retail and commercial bank, based in the UK. They 
operate around 550 branches across England, Scotland and Wales. They were in the news when they migrated from their old banking systems to a 
new system geared towards more cust omer friendly digital banking and 
provide an example of a change  that could affect cyber security risk 
management:  
In 2015 the Spanish banking group, Sabadell, acquired TSB from Lloyds 
Banking Group and wanted to integrate TSB into the same core banking 
system used by the rest of Sabadell. 
The reasons for the change were com pelling for Sabadell, providing not 
just alignment with rest of the gro up, but also the chance to offer new 
fintech services that the TSB legacy system couldn’t offe r, allowing them 
to compete in new markets for TSB.

486  
 Changeover method 
TSB chose to move customers across using a pilot approach. They 
moved some services first, including a new mobile banking app, and planned to move everything else acro ss in the final quarter of 2017. The 
final stage was delayed, according to TSB to allow for an expected 
interest rate rise, but as can be the case with a pilot change over, when they did eventually undertake the fi nal stage they had many problems as 
discussed further below 
1.4 Cyber security objectives 
The management of t he organisation must establish cyber security objectives. 
As with all good forms of risk managemen t, it is risk based, so the cyber 
security objectives will link to the cy ber security risks th at may impact the 
achievement of the organisations ultimate business objectives. 
The Association of Inter national Certified Professi onal Accountants (AICPA) has 
identified a reporting framewor k for cyber security and th is outlines some of the 
key cyber security objectives. They include: 
 Availability : One of the reasons that the us e of websites and applications 
is so attractive to organisations a nd individuals is the flexibility of 
continuous access to, and use of, in formation and systems. Organisations 
can make sales 24 hours a day, and cu stomers are not limited to bricks 
and mortar stor e opening hours. 
 Confidentiality : organisations create and obtain a huge amount of 
information, from proprietary informat ion to personal information, and it 
must be protected from unauthorised access and disclosure, including 
complying with privacy requirements. 
 Integrity of data : organisations must make su re they take steps to 
prevent unauthorised modification of  or destruction of information. 
 Integrity of processing : Guarding against the improper use, modification, 
or destruction of systems. 
 
 Objectives – online retailer 
  Availability  – an online retail store w ould need to provide 24 hours 
a day, 365 days per year access to t heir website for their customers. 
 Confidentiality  – an online retailer will know many things about 
each customer, from PII such as name, address, payment details to 
the things they like, when they shop, how much they spend etc. 
 Integrity of data  – an online retailer must make sure financial 
information for both internal and external purposes is reliable, and 
also that customer informati on is correct and up to date. 
 Integrity of processing  – making sure goods sold are as described 
on their website and the service matches the description they 
provide, for example deliv ery within 2 working days.

Chapter 8 
 487 
 TSB software migration – objectives  
 Continuing the TSB system migration, we can now look at what aspects 
of their cyber securi ty were affected. 
 Availability  – TSB customers, previously used to 24 hour access to 
their accounts had been warned of slight  disruption but were in fact 
unable to access their account s for a five day period. 
 Integrity of data  – as the issue was well publicised, it became an 
opportunity for unauthorised access. It is reported that fraudulent 
attacks increased 70 times, with around 1,300 customers defrauded as a result of t he failed IT upgrade. 
 Confidentiality  – some customer’s personally identifiable 
information was compromised as many customer reported being 
able to access other cust omers’ accounts and data. 
 
 RBS – availability issues 
 In 2012 an outage occurred for RBS, Natwest and Ulster Bank. 
Customers could not access their f unds for a week or more and the 
banks had to manually update account balances. 
RBS received a fine ₤56m from regulators because of the outage. CA 
Technologies, who were the software suppliers that caused the outage, 
paid the bank millions of pounds.  
Although the public rarely get to know  the true cause of the problems, 
reports suggest the issue was caus ed by someone in an RBS operation 
in India pressing the wrong button. 
 
As well as understanding their cyber securi ty objectives, consideration must be 
given to how these objectives are established, approved and maintained. 
A typical process could be that on a regular basis, the board review overall 
objectives and approve them as appropriate. These t hen flow down into the 
business objectives where the most senior  member of the IT team will align the 
cyber security objectives with them. This would then be approved at board level. 
This may include stating any industry standards the company complies with – 
for example PCI DSS (Payment Card Industry Data Security Standards). 
 
 PCI DSS 
 PCI DSS was brought in to ensure businesses process card payments 
are secure, protect sensitive cardholder data and help to reduce card fraud. It sets tight controls over the storage, transmission and processing 
of the cardholder data that businesses handle.

488  
 Which of the following are true of cyber risks? 
A It is a type of operational risk. B It could be a deliberat e and unauthorised breach of security to gain 
access to information systems to emba rrass, extort or spy on a firm. 
C It could manifest itself through IT  issues from poor systems integrity 
or other factors. 
D It is a strategic risk. E The likelihood and impact are reducing all the time. 
F Anti-virus software will stop all cyber risks. 
 
 The most risky changeover method is : 
A Phased changeover B Pilot changeover C Parallel changeover D Direct changeover 
 
 Ashveer Holloway is a loyal custom er of Proud Ltd, a pharmaceutical 
company. Ashveer was born on 28th January 1990. He buys a specialised medication from Proud,  which cannot be sold without prior 
approval from a doctor because it is very  strong. Ashveer needs it to treat 
a very rare medical condition that he has.  He pays for the medication 
using direct debit and it is delivered to his house on the 1st of each month. 
Which of the following pieces of  PII do Proud Ltd necessarily hold 
about Ashveer? 
A Name. B Credit card details. C Date of birth. D Information about religious beliefs. E Personal health information. F Proud Ltd customer account number. G Address.

Chapter 8 
 489 
 An accountancy training company have developed an online system to 
support their students in their studie s. Through this system students can 
access all of their printed material s, plus additional questions and videos. 
The company’s students all study at di fferent times of the day as they 
have students all over the world, and t he exams they are studying for are 
have flexible dates, so can be taken all year round.  
As the volume of data stored on the system has increased,  the training 
company has noticed that the speed of processing has started to decline. 
Customer feedback had given them some  new ideas about how to set up 
the online material but this set up idea is not supported by the current 
system. As a result of these devel opments, the company has decided to 
change its systems, to improve both layout and response time. As the online system is so valuable to thei r customers they have decided to do a 
phased changeover – to make sure t hat students can access the system 
during the changeover process. 
Which one of the cyber security obj ectives are the training provider 
concerned about by adopting the phased changeover? 
A Integrity of data 
B Integrity of processing C Confidentiality D Availability 
 
 A newspaper article has described a form of technology in the following 
paragraph: 
“This allows the user to extend a company network across a public 
network, and enables users to send and receive data across shared or public networks as if thei r computing devices were directly connected to 
the private network. It is usua lly secured and requires two step 
authentication by the user through a password and randomly generated 
passcodes.” 
Which one of the characteristics of  technology is being described? 
A Type 
B Connection type C Service providers D Delivery channels E Confidentiality

490  
 GH are a US based company that specialise in online grocery sales for 
delivery to customers’ homes. T hey have been very successful and 
decided to expand geographica lly. In the last year  they have successfully 
acquired a European grocer who has pr eviously only provided sales from 
outlets in areas with high population densities in three major European 
countries. GH are in the process of integrating the system s with a view to 
launching online sales for delivery in  one of the European countries, and 
increasing this further next year. 
Which of the following aspects of the company’s environment have 
experienced changes that could affect the cyber security risk 
management of GH? 
A Regulation B Expansion C Acquisition D Culture E Hardware update F Internal restructure G Personally Identifiable Information. 
 
 X is a multi-site retail organisation, formed by the recent merger of four 
independent retailers. You were prev iously Management Accountant of 
one of the retail companies, and have recently been appointed Systems 
Accountant for the merged organisation. 
Each of the merged companies current ly uses a different information 
system for the recording and processing of inventory. X is planning to 
replace these systems with one new syst em that will be common to every 
site. You have been talking to the Finance Director about the need to standardise systems, and he has expr essed concern regarding the 
disruption that will be c aused by the changeover. 
Advise the Finance Director wh ich of the following system 
changeover methods can be used. 
A Direct B Parallel C Pilot D Phased

Chapter 8 
 491 
2 Types of cyber security risks 
 
2.1 Malware   
Malware is the term used for malicious  software, regardless of the intended 
purpose.  It can do any number of th ings, ranging from the stealing of 
credentials, other informati on or money to the general wreaking of havoc, or 
denial of service. There are various wa y to execute malware, they include: 
 Ransomware  is designed to prevent a busi ness from accessing its data, 
information or a whole computer system until a specified amount of money 
is paid. 
 Botnets are networks of private comput ers that are infected with a 
malware and controlled by a “bot net agent” designed to follow the 
attacker’s instructions without t he knowledge of the owner of the 
computer. They are often asso ciated with a DDoS (see 2.2). 
 Trojans  are named after the Trojan horse in an ancient Greek story where 
a wooden horse was allowed into the city as it was deemed harmless but 
which concealed soldiers inside ready to attack the city. This type of 
malware does a very similar thing: it  pretends to be a useful piece of 
software whilst secretly releasing ma lware into the system, usually with 
the capability to be controlled by the attacker from a different location, 
(known as a remote access trojan or RAT). 
 Malvertising is when online advertisements have malware written into 
their code. It can involve hiding the malicious code in legitimate online 
advertising networks and web pages. The code may direct the victim to a 
malicious site where the malware can be installed or it may directly infect 
the victim’s computer when they visit the page that contains the advert, 
even if the user does not click on any thing to do with the online advert. 
Malvertising is a serious threat that requires little or no user interaction. 
 Viruses are designed to endlessly replicate themselves and infect 
programs and files to damage or destroy data . Worm viruses spread 
across networks to infect other devices. 
 Spyware  is designed to spy on the vi ctim’s systems without being 
detected and gather information to send to the hacker. Keyloggers  are 
similar – every keystroke typed by the victim is recorded and forwarded to 
the hacker.

492  
 Example: Ransomware 
 In 2017 ransomware became big news as several outbreaks hit a variety 
of organisations throughout the year. 
 Wannacry shutdown more 80 NHS  organisations in England, 
leading to around 20,000 cancell ed appointments, GP surgeries 
having to return to pen a paper and some hospitals diverting ambulances as they were unable to  take anymore emergencies. 
 NotPetya later in the year  spread through a version of an 
accounting program that was us ed in Ukraine. It affected 
multinational companies such as shipping firm Maersk and 
pharmaceutical company Merck. No tPetya reportedly cost Merck 
more than $300 million per quar ter in Q3 & Q4 of 2017. 
All these attacks stemmed from a weakness in Microsoft’s Windows 
operating system that could run pr ograms on other computers on the 
same network. It is believed that k nowledge of this flaw was originally 
used by the NSA, who gave it a codename EternalBlue. 
Incidents like these have raised the pr ofile of cyber security threats and 
made more organisations aware of  the damage that can be done.  
2.2 Application attacks   
As with malware, application attacks is t he broad term for a variety of different 
ways of attacking a victim, this time by attacking an application (app). This kind 
of approach is becoming more common as application development is 
increasingly based on the w eb. Whether it is the applications on our smart 
phones and various connected devices at home or a complex business 
application, we are using applications more  and more and this leads to potential 
vulnerabilities. 
The intention with applicat ion attacks is usually the same as with malware 
attacks – stealing data from database serv ers, running attack scripts on other 
users’ computers, stealin g user credentials, etc. 
Below are some of the more common types of application attacks: 
 A  denial-of-service (DoS) attack  overwhelms a system’s resources so 
that it cannot respond to service requests. A  Distributed-denial-of-
service (DDoS) attack  is also an attack on system ’s resources, but it is 
launched from a large num ber of other host machi nes that have already 
been infected by malicious software controlled by the attacker.

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 Example: Facebook 
 When a major firm has system down time (as Facebook did in March 
2019 where Facebook, Instagram and Whatsapp were all offline 
simultaneously for almost 24 hours) , the truth about why it happens can 
take a long time to come out. 
The company stated that it had made some changes to server 
configuration that tri ggered a series of issues. Many commentators are 
unconvinced by the explanation and bel ieve that Facebook was flooded 
with traffic and ultimately ov erwhelmed by a DDoS attack. 
Facebook could be unlikely to admit to an attack of this nature as it would 
indicate that they are susceptible to such an attack and others may try to 
exploit this weakness.  
 
 SQL (Structured Query Language) injection  has become a common issue 
with database-driven websites. It occurs when the attacker uses an 
unprotected input box on the company’s  website to execute a SQL query 
to the database via the input data from the client to server. A successful 
SQL injection can read sensitive dat a from the company’s database, 
modify (insert, update or delete) dat abase data, execute administration 
operations (such as shutdown) on t he database, recover the content of a 
given file, and, in some cases, issue commands to the operating system. 
 
 SQL Query 
 An SQL query is a request for so mething to be done on a database.  
For example, when logging in to a website you input your username and 
password. When you press ‘enter’ the website queries your inputs 
against the database of usernames and pa sswords to check for a match.  
If the query finds a match in the databas e the user is allowed access, if 
no match is found then access to that ar ea of the website is not allowed. 
 
 Cross-site scripting attacks (XSS attacks)  occur when a victim is 
attacked when they visit another organisa tion’s website.  The attacker 
uses the third-party web resources to  run scripts in the victim’s web 
browser or scriptable a pplication. Specifically , the attacker injects 
malicious code (often associated wit h JavaScript) into a website’s 
database. When the victim requests a page from the websit e, the website 
transmits the page, with the attacker’s code as part of the HTML body, to 
the victim’s browser, which executes the malicious script. For example, it 
might send the victim’s cookie to the attacker’s server, and the attacker 
can extract it and use it for session hijacking. 
 Buffer overflow attack – A buffer overflow occurs when a system cannot 
store as much information as it has been sent and consequently starts to 
overwrite existing content.  A buffer overflow attack occurs when an attacker sends a malicious programme  which deliberately overloads the 
system and starts to overwrite existing data.

494  
2.3 Hackers   
Hacking is the gaining of unauthorised acce ss to a computer system. It might be 
a deliberate attempt to gain access to  an organisation’s systems and files to 
obtain information or to al ter data (perhaps fraudulently). 
Once hackers have gained access to the system, there are several damaging 
options available to them. For example, they may: 
 gain access to the file that holds all the user ID codes, passwords and 
authorisations 
 discover the method used for generating/authorising passwords 
 interfere with the access control s ystem, to provide the hacker with open 
access to the system 
 obtain information which is of potent ial use to a competitor organisation 
 obtain, enter or alter data for a fraudulent purpose 
 cause data corruption by the in troduction of unauthorised computer 
programs and processing on to th e system (computer viruses) 
 alter or delete files 
Hackers could be thieves operating from  outside the organisation such as 
business competitors or nat ion-states. They can also be insiders, such as 
disgruntled, or otherwise malicious, employees. 
 
 Example: Target Corporation 
 One of the largest dep artment store retailers, Target Corporation, 
suffered a major security  breach in late 2013. 
Hackers used credentials they stole from  a third party – one of Target’s 
suppliers. The third party supplied heat ing, ventilation and air conditioning 
services to Target and, as such, h ad access to the Target network to 
monitor energy consumption and te mperatures at various stores. 
Once into the network, the hacker uploaded malware into the Point of 
Sale systems. The hackers reportedly used the malware to steal data from around 40 million credit and debit card s in the US in a two to three 
week period. 
This example is explored further la ter in this chapter and the next 
chapter. 
 
“Hackers” is a broad term, but there are actually different types of hackers, 
defined according to their reason for ha cking. Regardless of their reason they 
all require a certain level of skill.  
 Black hat hackers:  these are the stereotypic al hackers that hack with 
malicious intent.  They typically br eak in to secure systems and networks 
to steal data, destroy it or perhaps just  modify it. Critically, it is all done 
without the company’s permission. 
 Grey hat hackers  generally sit in the middle, they are not specifically 
malicious or well-intentioned, but usually  sell their skills for monetary gain.

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 White hat hackers  usually hack with the company’s permission. They are 
trying to help the company understand what a black hat hacker may try to 
do so it can protect t he computer network Some  people describe the white 
hat hacker as an ethical ha cker or a security expert. 
 
 Social engineering 
Social engineering is the manipulation of people to make them perform specific 
actions or reveal confidential informati on. The principle relies heavily on the 
ability to influence people to do something that they wouldn’t normally do, or in 
a lot of cases should not be doing.  
Dr Robert Cialdini has studied this area and has identif ied six principles used to 
persuade or influence someone. These are: 
 Reciprocity  – this is the idea that people often feel obliged to do 
something in return for a favour  or a gift they have received. 
 Scarcity  – something that is in short supply is perceived to be more 
valuable. 
 Authority  – if someone is deemed to be an expert they carry more power. 
 Consistency  – it is human nature to like rh ythms or routines – people like 
to behave as expected, and like people who behave as expected. 
 Liking  – people sharing some common tr aits are more inclined to like 
each other. People are more likely to do something for someone they like. 
 Consensus  – people like to follow the behav ioural norms of others. 
In the context of cyber security, social engineering relies on t hese principles to 
carry out techniques known as phishing  or spear phishing to gain access to a 
system or network. 
 Phishing refers to the use of fraudulent me ssages to try to steal sensitive 
information such as passwords or cr edit card numbers, or to install 
malware onto a user’s computer. Ph ishers often use a combination of 
communication tools to dec eive their victims.  
Examples include: SMS text message – smishing 
Email impersonation Telephone calls – voice phishing or vishing Fake websites 
 Spear phishing is when a phishing attempt tar gets a specific user, rather 
than a blanket communication sent to many people. Spear phishing 
usually involves carrying out research into the specific person and their 
role and interests.  This allows th e attacker to modify  the communication 
to be more appealing or relevant to t he victim, increasing the likelihood of 
its success.

496  
Individuals working within an organisa tion are often one of the biggest cyber 
security risks. Research has found that em ployees often feel that they are not 
part of the information security defence systems. This can lead to individuals 
taking actions or making choices that compromise the organisation. This is 
particularly risky when spear phishing is used, as it deliberately focusses on an 
interest and therefore a weakness in that individual’s decision making. 
 
 Example: Social engineering 
 In 2013 Yahoo were compromised when hackers used social engineering 
to manipulate an engineer who had s pecial access to the system. The 
engineer was duped by a spear phis hing email and the hackers gained 
access to every single customer a ccount, more than 3 billion accounts. 
The data was made available to buy on the dark web. 
Yahoo initially said that around 500 million accounts had been 
compromised; it wasn’t until October  2017 that the full extent of the 
breach was revealed. 
Another huge cyber security issue for an organisation to consider to, is 
reputational damage (as discussed in Chapt er 4). Situations like this can 
cause massive reputational damage as consumers lose trust in the organisation, as well as leadi ng to significant fines. 
2.4 Cryptocurrency 
The cyber security threats discussed abov e are made more significant by the 
development of cryptocurrencies like bi tcoin, which make it possible for the 
perpetrators of ransomware to send and receive money anonymously.  
There is more detail on cryptocurrency in chapter 9.  
 The Senior Finance Manager at Hacke rs Ltd received an email that 
appeared to be from the Hackers’ bank. The email asked for the manager to confirm some securi ty information by clicking on a link and answering 
several questions. At the end of t he week, one of the manager’s direct 
reports flagged some unusual transacti ons whilst carrying out routine 
bank reconciliations. There were several large payments to unknown sources.  
Which of the following cyber-attacks does it appear that Hackers Ltd 
were a victim of? 
A Distributed denial of service 
B Botnets C Phishing D SQL injection

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 FGY company has been subject to a Ransomware attack. 
Which one of the following cyber -threats has FGY become exposed 
to? 
A Personal and Business Inform ation held on the system has been 
stolen 
B The company computer system has  been shut down until a payment 
is made to release it 
C The FGY website has been overl oaded as a result of multiple 
simultaneous requests for service being sent from a number of 
different IP addresses 
D Malware has infected the adver ts appearing alongside the company 
web pages 
 
 LPU company has recently been t he victim of a cyber-attack.   
A member of the company’s proc urement team logged onto a trusted 
supplier website using a pre-set user name and password.  Unfortunately 
the cyber-attacker had previously in jected the supplier’s website with 
malicious code and was able to access this log-on information as it was 
entered.   
The attacker then used this informati on to log-on to the supplier site, 
pretending to be LPU, and was able to  gain access to LPU’s sensitive 
business information. 
The above cyber-attack is an example of which form of web 
application attack? 
A Distributed denial of service (DDoS) attack 
B Structured Query Language (SQL) injection attack C Cross-site scripting (XSS) attack D Buffer overflow attack 
 
 One of WRY company’s competitor s has recently been subjected to a 
structured query language (SQL) attack.  
The board of WRY is keen to ensure t heir website is not also vulnerable 
to such an attack. 
Which ONE of the following could be  employed by th e board to help 
test the robustness of their systems? 
A Internet troll 
B Black hat hacker C White hat hacker D Botnet

498  
3 Social media 
3.1 What is social media? 
Social media is a catch-all term for a r ange of sites that may provide radically 
different social interactions. 
 
 Illustration 1 – Examples of social media sites 
  Twitter is designed to let people s hare short updates or 'tweets' with 
others. 
 Facebook, in contrast is a complete social networking site that 
allows for sharing updates, photos , joining events and a variety of 
other activities. 
 LinkedIn is a professional bus iness-related networking site 
 Instagram is a free photo-sharing program. 
 
 Opportunities offered by social media 
 Social media offers a number of opportunities. These include: 
 Advertising  – for example, Starbucks is tweeting to customers and 
you can join their Facebook site to find out about its news and 
promotions. 
 Brand development  – for example, Volkswagen uses Flickr to 
develop its brand. Individuals are able to post pictures of their 
Volkswagen Beetle or thei r campervan on the site. 
 Big Data analytics  – by monitoring when a brand is mentioned, by 
who and in what context, market ers are now able to target 
advertising through social medi a better than ever before. 
 Method of listening to customers  – sites where customers and 
potential customers disc uss the products of the company, and of its 
competitors, can be an opportunity to deal with compliments, complaints or support queries openl y and honestly, e.g. customer 
ratings or feedback on Amazon.com or Tripadvisor.co.uk. 
 Real-time information gathering  – in the past it would take days or 
weeks for businesses to conduct a survey to gather enough 
responses to generate conclusive  data. Now on social media, 
businesses can gather instant feedback with quick polls. 
 Communication – for example, Deloi tte Australia have held 
employee performance reviews in Wo rld of Warcraft and BDO uses 
Second Life as an avenue for meetings, presentations and events for staff and for clients.

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  Recruitment and selection  – firms seeking to recruit staff can 
ensure a wide range of potential candidates see their advert by 
using social networking sites such as Facebook and Twitter. Organisations can avoid costly recruitment fees and are more likely to find candidates already engaged with their brand. 
 Selection  – many firms are screening candidates by researching 
their web presence, for example on LinkedIn or Facebook to see 
what interesting facts, photos and  opinions can be found that might 
be relevant to their future careers. 
3.2 Risks of social media to organisations 
As always, with opportunity there also risks. Some of the risks presented by 
social media include: 
 Human error  – a mistake by an employee could range from being hacked 
after clicking on fraudulent links on t heir work computer, to making 
inappropriate comments on social m edia (either through their personal 
account, or if they have access to  it, via the company account). 
 Productivity  – while there are clearly posit ives to be gained from social 
media, if employees can access social media at work it can disrupt their 
work and reduce the operational efficiency of the company. 
 Data protection  – regulatory requirements are increasing around how 
companies gather, use and store data about their cu stomers. Firms need 
to make sure they have secure networks and they comply with all legislation. 
 Hacking  – as with any computer program, a hacker may try to infiltrate 
social media accounts for malicious reasons. 
 Reputation  – any mistakes a company makes on social media, (such as 
an inappropriate post made by a staf f member) could have a negative 
impact on the brand of the organisation and result in lost customers, sales 
or even employees. 
 Inactivity  – as maintaining an online presence becomes increasingly 
important, not using social media or not keeping existing accounts up to 
date, could be as damaging as using it badly. 
 Costs  – in theory using social media cost s nothing, but to use it well, and 
control the accompanying risks, could co st a significant amount. Also, any 
fines from non-complianc e with regulations could also be significant.

500  
 Illustration – Examples of social media problems 
  A well-meaning employee at Adidas  sent a tweet from the company 
account congratulating runners for “surviving the Boston Marathon”; 
unfortunately this brought back images of the 2013 bombing for 
many social media uses. Adidas very quickly took down the tweet and issued an apology. 
 In March 2017, McDonald's posted a surprisingly critical tweet of 
President Trump: It turned out that  the tweeter wasn't McDonald's – 
in fact someone had hacked into t heir account to send the tweet. 
McDonalds quickly removed the o ffending tweet, but it further 
illustrates that even mu ltinational organisation s are susceptible to 
hacking in various forms. 
 Sometimes the company may do nothing, but a comment from 
someone else, a celebrity, for exam ple, can lead to issues. A tweet 
from Kylie Jenner reduced the mark et value of Snap Inc (the parent 
company of Snapchat) by $1.3billion, when she posted on a different form of social media t hat she no longer used the Snapchat 
application. 
3.3 Risks of social media to individuals 
The risks of social media are not just to organisations.  Poor use of social media 
can create risks for individuals too: 
 Going viral  – people often make social media posts in a very informal 
way, without considering who may see it or how it may be perceived. This 
can lead to a previously little-k nown person becoming well-known very 
quickly around the world. The reasons for this fame can be both good (taking a strong stance for a good cause) and bad, for example an ill 
thought out joke can lead to thousands of abusive responses. People have been known to disable their accounts after receiving such abuse. 
 Internet trolling  – the abusive responses mentioned above are often 
referred to as trolling. Trolling is where someone uses social media to 
deliberately upset or incite emotional  responses from another individual. 
 Employment  – companies now include social media reviews as part of 
their recruitment process. People have al so lost their jobs as a result of 
going viral in a negative way. 
 Legal sanction  – law enforcement organisations can view social media 
posts to help identify where suspects were, or in some cases what they 
were doing, at a particular time. 
 Physical theft  – posting from a holiday reso rt overseas, or just posting 
from a significant distance from home, can signal to thieves that a property 
is unoccupied and is likely to remain so for several hours or days. 
 Identity fraud  – fraudsters can build up a significant portfolio of 
information from a social media acc ount with poor privacy settings, such 
as home address, date of birth, interests etc.

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 Permanence  – once a social media post has been made it is very difficult 
to remove. Even if you delete it someone else may have already taken a 
screenshot of your post. This can lead diffi culties in the future (going viral, 
employment issues) even if the person making the post has changed their views or admitted to  their mistake. 
 
 Squeeks is an app development company based in Donlon, the capital 
city of a large EU member country. The company first set up in 2007 and 
due to their innovative approach to app lication design, customer focus 
and positive culture, managed to su rvive a very tough economic 
environment in the first few years. 
They feel that a positive team spirit is vital to their success, and as they 
have grown, invested heavily in staff entertainment, such as pool tables, 
massage chairs, games consoles and a free continental breakfast bar. They also feel that it is import ant for staff to be able to express 
themselves and so have consciously avoided any kind of social media policy. 
What are the consequences that S queeks faces as a result of its 
policy on social media? 
A Employees will raise the profile of Squeeks by putting messages out 
about their work. 
B Squeeks will be able to monitor the profile of their brand and 
analyse who is saying what and use this to target advertising  
C An employee may click on a frau dulent link that appears on their 
social media feed and compromise the Squeeks systems. 
D Theft from a staff member’s hom e because they have been posting 
about their holiday.  
E An employee making inappropriate comments and damaging 
Squeaks’ reputation.  
F Staff may spend too long on social  media and not meet critical 
deadlines.  
G The company can review the social media activity of potential new 
recruits to get a better understanding of whether they would fit in 
with the culture at Squeeks.

502  
4 Risk of security vulnerabilities 
Being aware of the vulnerabilities that  could create problems for an organisation 
is one thing, but being aware of the implic ations of the vulnerabilities is also 
vital. 
Vulnerabilities can be classified as eit her technical, procedural or physical:  
 Technical deficiencies  include issues like defects in the software being 
used, or not using appropriate protec tion (such as encryption) correctly. 
 Procedural deficiencies  are either IT relat ed (for example system 
configuration mistakes or not keepi ng software security patches up to 
date) or user related (for example not complying with company guidelines 
on changing passwords or using pa sswords that are too simple). 
 Physical  where a physical event, like a fire or flood, causes damage to 
the information technology system. 
Whatever the reason for the vulnerability, its exploitation can lead to costly 
problems for the organisation involved. 
The following are some exampl es of the implications fo r an organisation that is 
compromised in some way: 
 Down time : where the organisation is unable to carry out normal 
procedures leading either to loss of  production or potentially lost revenue 
generation opportunities. 
 
 Illustration – Lost sales 
 Even the biggest online retailers suffe r downtime, and in July 2018 during 
Amazon’s Prime Day some customer s were unable to access the site. 
It is believed the site was down for around one hour and based on 
forecast sales of $3.4 billion across the 36 hour event that equated to 
almost $100 million of lost sales. 
Amazon are not alone – it is estima ted that Fortune 1000 companies lose 
close to $2.5 billion every year  because of website downtime. 
 
 Reputation damage : where the organisations name and brand value can 
be negatively affected, leading to lost sales. 
 Customer flight : this is especially critical with increasing levels of e-
commerce. It is often argued the bi ggest financial consequence is lost 
business. 
 
 Illustration – Facebook 
 As a result of negative publicity about the way Facebook uses – and 
allows other companies to use – t he data it has collected, and continues 
to collect, from the active users of it s site, it has experienced a decline in 
user numbers in what the company c onsiders to be its most valuable 
markets (the US, Canada and Europe).

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 Industry consequences : in health care and financial services for 
example, cyber security breaches can be very costly as they are more 
highly regulated.  
 Legal consequences : fines, lawsuit costs and settlements can be very 
significant. In 2018 new legislation ca me in relating to data protection 
within the EU with significant fi nes for breaching the legislation.  
 
 Legislation surrounding inform ation systems (UK and EU) 
 General Data Protection Regulation (GDPR) 
The GDPR is a regulation in EU la w and in the UK replaced the Data 
Protection Act (DPA), on 25th May 2018. 
The GDPR has two main objectives. 
 Protection of fundamental rights and freedoms of individual persons 
with regard to proce ssing personal data. 
 Protection of the principle of fr ee movement of per sonal data within 
the EU. 
The UK Government has published it s new Data Protection Bill that 
repeals the DPA and enshrines the GD PR into UK law post-Brexit. 
It is overseen and enforced in the UK  by the Information Commissioner’s 
Office (ICO). The aim is to keep pe rsonal data secure at all times. 
 Passwords should protect files and digital devices 
 Sensitive documents should be lock ed away whenever they are not 
in use (and print outs s hould be picked up promptly. 
 Personal data must sent/transmitted securely 
 When it is no longer needed, per sonal data must be securely 
disposed of (e.g. shredded or securely deleted) 
Key principles 
The key principles of GDPR are around lawful and responsible use of 
personal data. It also looks at the appropriate collection of data; just 
because data can be collected, doesn’t mean it should be. 
Exemptions to the Act 
EU Member States can introduce exemptions from the GDPR’s 
transparency obligations and indivi dual rights, but only where the 
restriction respects the essence of the individual’s fundamental rights and 
freedoms and is a necessary and propor tionate measure in a democratic 
society to safeguard things like national security and breaches of ethics in regulated professions.

504  
 Rights 
Data subjects have enhanced rights under the GDPR compared to the 
DPA. These include, but are not limi ted to, things like requesting access 
to the data held about them ; in certain situations they can even request 
their data is deleted. They can also claim compensation for damages caused by infringement of the GDPR  from the company controlling or 
processing their data. 
Enforcement 
A breach of GDPR could lead to fines as follows: 
 An organisation could be fined up to 
€10,000,000 or 2% of global 
income for a failure to implement  measures to ensure privacy by 
design and default, or to maintain re cords or to maintain appropriate 
security.  
 An organisation could be fined up to €20,000,000 or 4% of global 
income for a failure to comply wit h the principles of lawfulness, 
individuals’ rights or conditions for consent. 
Computer Misuse Act 1990 
Computer crime is defined as 'a ny fraudulent behaviour connected with 
computerisation by which som eone attempts to gain dishonest 
advantage' (Audit Commission). Comput er crime was enshrined within 
the Computer Misuse Act 1990. 
The key objective of the Act was to ma ke crimes of 'hacking' and the theft 
of data. 
Unfortunately the Act does not  provide a definition of: 
 Computer. 
 Program. 
 Data. 
Criminal offences 
The Act created three new  criminal offences: 
 Unauthorised access, e.g. by an employee who exceeds their 
authority – a minor offenc e (tried in the Magistrates Court) – penalty 
six months imprisonment/fine/both. 
 Unauthorised access with intent to  commit and then facilitate the 
commission of a further offence, e.g. divert funds – a serious 
offence – penalty five years imprisonment/fine/both. 
 Knowingly causing an unauthorised m odification of the contents of 
any computer with the intention of interfering with the operation of 
that computer, preventing access to a program or data,  or interfering 
with the operation of the program or  the reliability of the data –
includes introducing a virus to a system – penalty five years 
imprisonment/fine/both.

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 505 
 Examples of other legislation 
 US 
In the US there is no single data pr otection law. Each state has laws 
protecting the PII of their residents. Ho wever it is something that is being 
reviewed and there are two major acts being considered: 
Honest Ads Act 
The Honest Ads Act links to perceived foreign interference in US 
elections. Digital advertising in the 2016 US elections is reported to have 
reached $1.4billion – around 7 times that  spent in the 2012 election. The 
Act seeks to ensure that companies  like Facebook and Google employ 
reasonable efforts to ensure fore ign governments and agents are not 
purchasing advertising on their platform  in order to attempt to influence 
voters.  
The California Privacy Act 
Is deemed to be the toughest privacy r egulations in America and will take 
effect from 2020. Users will be allowed to ask for the data a company has 
collected about them and w ho that data has been sold to. It will also allow 
users to request that the company stops  selling their data if they do not 
like how it is being used. 
The Act is still not as stringent as the GDPR regulations but allows 
individuals some similar rights. 
Asia-Pacific 
Partly because of the implementation of GDPR in Europe, countries like 
China, Singapore, Sout h Korea, Japan, Australia, Malaysia, and the 
Philippines have either updated or will be updating their data protection 
rules and cyber security laws. 
China 
China has introduced some of the mo st comprehensive data protection 
regulations in the Asia-Pacific region. In June 2017 a new Cybersecurity Law was enacted, requiring companies  that conduct business in China, 
even if they do not have a physical pr esence in the country, to review 
their data protection polic ies and ensure compliance. 
China is also introducing e-commerce legislation covering areas such as 
data anonymisation, big data, overseas  data transfers, and information 
security. As with GDPR, any companies that fail to comply with the law could face severe financial sanctions t hat could include losing their rights 
to conduct business in China. 
Singapore 
The country has changed its Personal Data Protection Act to include 
aspects of the EU GDPR, on areas such as mandatory breach notification and the appoi ntment of a data protection officer. 
As a result of this, in early 2018 several insurance and financial 
organisations based in Singapore received fines for failing adequately secure personal data, or for breachi ng rules on the use of personal data.

506  
 Following on from the Ta rget Corporation exampl e earlier, in March 2015, 
Target reached a class-action settl ement with affected consumers for 
more than $10 million (once attorney  fees were included) and in May 
2016, Target settled with affected banks and credit unions for more than 
$39 million. 
 
 Example: GDPR 
 The first German data protection aut hority to impose a fine under GDPR 
fined a social media company 20,000 EUR for failing to ensure data security of processing personal data . The reason for the breach was that 
a hacker managed to steal and publish 330,000 email addresses and passwords. 
Given the levels of fine possible under GDPR, 20,000 EUR may be 
considered quite a low figure. The r eason for such a low fine was that the 
authority took into consideration t he cooperation and willingness of the 
company to implement its recommendations. 
If the data breach at Yahoo (d iscussed earlier) had happened after 
GDPR had come into effect, the co mpany would have faced significant 
fines, in part because of the delay in disclosing the severity of the data 
breach (GDPR requires companies di sclose the breadth of the breach 
within 72 hours). Given t hat Yahoo’s revenue in 2012 was over $4 billion, 
depending on a variety of fa ctors, including how cooperative they were, 
they could have been fined betwe en $80 million and $160 million. 
 
 RPDG is a supermarket chain based in  the EU country of Fratugal. They 
have for many years operated a loyalt y scheme that involves customers 
registering their personal details (s uch as name, date of birth, address 
and contact phone number).  Once regist ered the customer swipes their 
loyalty card at the checkout during the payment process. This allows 
RPDG to understand more about thei r customers’ shopping habits, 
including where and when they shopped, what they bought and how 
much they spent.  
RPDG also make sales online 24 hour s day, for home delivery.  Once 
customers have set up an account as par t of the loyalty scheme, if they 
log in and order food for delivery, it automatically includes the purchases 
under the customer’s  account profile.

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 From this, RPDG can gain various co mpetitive benefits, for example they 
have recently improved the layout of  their shop to ma ke sure that 
commonly purchased products are located nearby. Sometimes the results were surprising, such as nappies and alcoholic  beverages – the 
marketing analysts were able to deduce that new parents were less able to go out for an alcoholic drink and so were more likely to consume alcohol at home. They also send offe rs to customers linked to products 
they buy regularly (or that are bought  regularly by ot her customers who 
purchase similar items). 
During a recent system upgrade an issue occurred and the upgrade took 
longer than planned. Some customers were unable to log in to their 
accounts to make purchases at prim e online ordering times. Additionally 
some customer were unable to log in to their own accounts, but were able 
to login to another customer’s account and view and change their customer details. The issue allowing customers to log in to the wrong 
accounts only lasted for one hour before RPDG were able to restore normal operations. RPDG have made no public comment about the issue 
since it occurred over one week ago. 
Which of the following would be implications of the systems 
upgrade issues at RPDG? 
A RPDG could face significant legal fines for the data breach. 
B Staff could be concerned about the personal information held by 
RPDG about them. 
C RPDG customers may feel rea ssured by the speed at which the 
system issue was fixed. 
D RPDG may have lost significant sales revenue during the time that 
customers were unable to log in. 
E The lack of comment and clarity from RPDG could increase the 
level of fine they receive. 
F RPDG customers will shop more fr equently in store in future to 
avoid issues where they cannot log in to their accounts. 
 
 Test your understanding 14 (integration) 
 The chapter has taken a detailed look  at all the potential considerations 
for cyber security threats, including types of sensitive information, known 
modes of attack, the objectives of the organisation and the risks associated with cyber security issues . Using the approaches outlined in 
this chapter: 
(a) Consider the various cyber secu rity issues facing an organisation 
like CIMA. 
and (b) Consider the cyber security iss ues that face the organisation that 
you work for.

508  
 Test your understanding 15 – Steelcast (Case study) 
 Scenario 
You work as a senior manager for St eelcast a manufacturer of luxury 
watches. The company have just comp leted the takeover of another 
watchmaker, Hantime that makes wa tches using quartz movement – a 
technique which Steelcast does not currently use. 
Trigger 
The finance director stops by your workplace, holding a copy of the local 
newspaper.  You are told the following: 
“We have just completed our takeover  of Hantime. Our intention has 
always been to identify and exploit synergies between the two companies, including the development of a range of Steelcast watches 
that will use the Hantime movements in place of our traditional clockwork 
mechanisms. 
The markets are a little sceptical of the value of our acquisition. I have 
brought you a copy of an article that appeared in this morning’s paper. 
The CEO has asked me to draft a br iefing before our next meeting and I 
need your help. 
The briefing deals with the need to  integrate the two companies’ 
information systems. This is an iss ue that frequently leads to problems 
during the period following an acquisi tion. The manager in charge of 
Steelcast’s IT systems has contact ed her counterpart at Hantime and 
they have arranged to meet as a matter of some urgency to discuss 
matters. 
Newspaper article: 
Hiland Business Times 
Market analysts sceptical about Steelcast takeover 
Steelcast’s takeover of Hantime c oncluded yesterday. Not surprisingly, 
Steelcast was able to acquire 100% of Hantime’s equity. In addition, 
Steelcast has persuaded the members of Hantime’s Board to sign five-
year contracts to continue in post. 
Steelcast has made no secret of its desire to acquire Hantime’s quartz 
movement technology for its own range of battery-powered luxury 
watches. Insiders also claim that Steelcast can add some value to Hantime’s operations, perhaps by  opening up new approaches to 
marketing and distribution. 
Steelcast’s share price was a littl e depressed yesterday, despite the 
successful completion of the takeover. 
Task 
I need practical advice on the following matters: 
(a) What are the implications if  we do not integrate Hantime’s 
information system with that of Steelcast? (15 minutes)  
(b) How would you recommend that  we should adopt a coherent 
strategy for integrating the information systems? (15 minutes)

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 509 
 Test your understanding 16 – Flower House (Case study) 
 Scenario 
You work as a senior manager for Flower House Brownies Ltd (FHB) a 
manufacturer of delicious brownies  for sale online and delivered via a 
logistics provider.  
FHB is a fairly small operation with onl y 2 directors, and a workforce of 
less than 20 people. They are based on one  site in the EU country of 
Peninsulaland; the currency there is the P$. 
Trigger 
The finance director asks you into her office. 
“We have just decided to expand our online sales opportunities. As you 
know the managing director has always been very active on social media 
and has raised awareness of our fant astic brownies through her presence 
there. She’s decided that now is the time to expand our sales operations. 
We’ve done very well selling solely through our own webs ite; the profit 
last year almost doubled from P$44, 000 to P$78,000. We will now sell 
our brownies via an online retailer and, as  you know she likes to think big, 
and so she has chosen the bigge st online retailer there is. 
I was reading this article and I’m conc erned that they are describing FHB 
perfectly. We use an ERPS system and have a third party cloud storage 
for our regular customer account deta ils. This would be a really bad time 
for us to have any issues with this. I know we have used a website security firm but I’m worried we ma y not have covered all our cyber 
threats.” 
Peninsula Business Times 
Cyber security biggest thr eat to online retailers 
Many online retailers have been c aught unawares by the increased 
legislation around personally identifiabl e information and cyber security. 
The issue seems to stem from organisations not fully appreciating how 
they interact with technology and therefore the potent ial access points 
that any hackers would have. 
It’s also been very apparent that organi sations in Peninsulaland are not 
aware of the potential iss ues that cyber vulnerabilities could have and are 
not clear on what their key objective s are with regard to cyber security.

510  
 Task 
I need to understand our cyber security issues more clearly. Please could 
you advise me on the following matters: 
(a) Please could you explain the sorts of information we have that 
needs protecting?  Specifically what  sort of Personal ly Identifiable 
Information we collect and why we need it? Do we hold any other information we need to protect? (10 minutes)  
(b) Please explain the interactions we have with technology based on 
our business model? (10 minutes)  
(c) What should our cyber security objectives be? (15 minutes)  
(d) What would be the risks to  FHB of any cyber security 
vulnerabilities? (15 minutes)

512  
 The correct answer is A, B and C 
While cyber risks can have very significant consequences for an 
organisation, they most commonly ar ise as a result of operational 
mistakes, so is an operational risk. 
Unauthorised breach of information system s is a cyber risk and it could it 
could manifest itself in the form of poor syst ems integrity. 
As technology is utilised more and more, the likelihood and impact are 
increasing all the time. 
Anti-virus software is a useful part of any defence, but cannot remove 
cyber risk completely. 
 
This is where the old system is  switched off and the new system is 
switched on at the same time. This  is only appropriate where the two 
systems are very different or it is too expensive to run both. This method 
is cheap but very risky since if t he new system doesn't work then the 
company may be unable to revert to the old system. 
 
 The correct answer is A, C, E, F and G 
The name and address are needed for delivery, the personal health 
information because of the product he buys, the date of  birth will have 
been provided on setting up the cust omer account, and the account 
number will have been created then too. 
As Ashveer pays by direct debit ther e is no need for Proud to know his 
credit card details and there is no r eason for them to hold any information 
about his religious beliefs. 
 
As the exams are on demand and can be ta ken at any point, they want to 
make sure that the systems remain available to students 24 hours a day, 
7 days a week, and 365 days a year.

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The description is of a virtual private network, which is a connection type. 
 
They are expanding through acquisitio n into a geographical area that has 
different regulations about data priv acy. The target company has not 
operated online before so may well not have systems and controls in 
place to comply with the regulations in  the way that GH will require. It is 
likely that the European target will need their computer hardware updated 
to enable the online sales. 
There is unlikely to be an internal rest ructure – they are more likely to add 
a new geographical division on to  the current structure. 
The culture of the target may need to  change to fit with GH, but this is 
unlikely to impact the cyber se curity risk management of GH. 
PII is a type of sensitive informati on rather than something that will 
experience change at GH. 
 
 The correct answer is A, B and D 
Pilot changeover cannot be used, as it assumes that any ‘lessons 
learned’ in the first changeover can be tr ansferred to all of the other sites. 
We are told that each of the merged companies currently uses a different 
information system, suggesting that results of one pilot would be of limited usefulness when look ing at other locations. 
 
 The correct answer is C.  
The attackers have used a fraudulent email pretending to be from the 
company bank to get the information they needed to access the bank accounts themselves. 
 
Ransomware is a type of malicious software designed to block access to 
a computer system until a sum of money is paid.

514  
The scenario describes an XSS attack.   
A DDoS attack occurs where an attacke r floods a firm’s systems (e.g. its 
website or servers) with requests fr om multiple interconnected devices 
which causes the system to crash.   
A SQL injection attack occurs when the attacker is able to inject code into 
an input box on a company’s website (f or example an unprotected search 
box) which then sends a request to t he database supporting the website.  
The attacker could then maliciously download or alter the database.   
A buffer overflow occurs when a system cannot store as much 
information as it has been sent and consequently starts to overwrite 
existing content.  A buffer overflow attack occurs when an attacker sends 
a malicious programme which deli berately overloads the system and 
starts to overwr ite existing data. 
 
A white hat hacker is someone with the technical knowhow to hack 
systems who, with the permission of  the company, tries to hack the 
system to identify weaknesses.  
A black hat hacker is someone who hacks without permission, often with 
malicious intent.  
An internet troll is someone who posts abusive responses on social 
media posts.   
A botnet is a network of interconnect ed computers infected with a ‘botnet 
agent’ which the attacker can use to control the computers. . 
 
 The correct answers are C, E, and F. 
A, B and G are advantages of social media and Squeeks could benefit 
from using social media in this way. 
D is more of a risk to an  individual than to Squeeks.

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 The correct answers are A, B, D and E. 
These are examples of legal consequences (A and E), reputation 
damage (B) and downtime (D). 
Any data breach is likely to concern cu stomers, regardless of how long it 
took for the company to fix it. In a competitive market like the one in 
which RPDG operates, issues like this  could lead to customers to move 
to shopping with an online competit or rather than inconveniencing 
themselves by going to a physical store. 
 
 (a) CIMA 
Types of sensitive information 
CIMA will have lots of PII about students and members: 
Names 
Adresses 
Date of birth Credit card details 
CIMA contact ID! 
From a business perspective they wil l also hold employee details along 
similar lines plus payment details for staff salaries, and business 
Technology interactions 
They will probably use VPNs for remote working for sales staff and 
potentially for examiners/markers to send questions or candidates scripts 
securely. 
Software providers (such as pearson VUE) may be used for exam 
hosting and CIMA also provide a contac t centre for students to email or 
phone with any queries. 
In terms of delivery, they sell CPD courses which can be accessed 
online, so they will require secure  channels to transmit them through. 
Types of changes 
CIMA have recently gone through a qualification update – moving from 
the 2015 syllabus to the current syllabus. This is in part because of the rate of technological advancemen t and the impact it is having on how 
finance professionals work.  
In terms of systems, in 2015 when CIMA first moved to exams on 
demand from the previous written exams,  they used a direct switch over, 
so that Nov 2014 was the last sitting for paper based exam, and from 1
st 
Jan all exams were online.  
The latest syllabus update seems to follow a phased changeover with the 
objective test exams moving in the final part of 2019, while the case 
studies moves over to the new updated syllabus in early 2020.

516  
 Cyber security objectives 
 Availability – as a global professional body CIMA will want to have 
24/7/365 access to their website so  that prospective students, and 
current students and members can access their accounts and any relevant information as required. 
 Confidentiality – As they hold significant PII and operate within the 
EU they must comply with GDPR  and there is a Data Protection 
Officer listed in their privacy policy. 
 Integrity of data – to make any changes to your data you require a 
CIMA ID and a password to log in. 
Cyber security risks 
CIMA will be subject to the threat s listed from malware, application 
attacks and hackers. They are probably less likely to be affected by malvertising as there are limited adverts on their websites, although 
employees may visit sites that host malvertising. 
There website may be targeted by a DDoS attack to take it offline, or an 
SQL injection attack through the log in functions to access students/members personal data. 
Social media 
CIMA have active social media pages on both Facebook and Twitter 
which are used to raise awareness of  CPD events, syllabus changes and 
so on. 
Risk of security vulnerabilities  
Downtime – would lead to lost CP D course sales, and potentially could 
lose new students. 
Reputation damage – given their stature and the cu rrent association with 
best practice cyber reporting, any  downtime or hack would have a 
negative impact on their reputation and credibility. 
Customer flight – linked into t he downtime, potentia l new students may 
be put off by any online issues an d choose an alternative professional 
body. 
Legal consequences – with EU operati ons, any breaches could lead to 
GDPR sanctions. 
These are just a sample of the cons iderations for an organisation that 
students and tuition providers may be aware of, ther e will be other 
considerations too. 
(b) There is no answer to this, but you can use the headings from a) to 
help generate ideas of potential issues for your organisation

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 517 
 Integrating IS  
It may be that the two companies will operate largely independently of 
one another and that a lack of integr ation will cause relatively few 
problems in terms of operations. Ther e could be difficulties in terms of 
Hantime scheduling production and making deliveries to meet Steelcast’s 
needs. That problem could be addr essed by finding an alternative 
approach to placing orders and so the impact may not be that serious. 
Maintaining the group’s IS will be complicated if there are two independent systems in operation.  
That could mean that maintenance co sts and the risks of disruption are 
doubled. The lack of integration will m ean that Steelcast’s Board may not 
be able to request the same level of r eporting from Hantime as they take 
for granted from Steelcast. Requests  may be more difficult and more 
complicated to fulfil. The prepar ation of consolidated management 
accounts and financial statements may be complicated by different IS.  
Strategy for integration  
The first question would be to examine the systems in place in each 
entity with a view to deciding whether  one is superior. It makes sense to 
change only one system if that would be possible, so that costs and 
disruption are minimised. The next step would be to work with 
management teams to determine what they need. Even if we choose to 
standardise on one or other of the existing systems, it may be worth 
considering whether that system c ould be enhanced in a cost-effective 
manner.  
Any local issues need to be taken into account. For example, local 
regulations might have implications for the accounting system used and 
so those differences will have to be taken into account. We need to ensure that all specific needs are fully understood by both sides during 
any ongoing discussions because such differences may not be obvious. 
There should be a steering committee appointed from the key functional 
areas in both Hantime and Steelcast. Hantime’s representatives should 
be assured that the intention is not si mply to export Steelcast’s system to 
their company.

518  
 Information that needs protecting 
In terms of PII we will have collected this type of information from both 
employees and customers, particularl y our regular customers who have 
set up an account. 
In terms of employees; we will hold details such as name, address, date 
of birth, bank details etc. We need th is for a variety of reasons including 
paying our staff, complying with la w and business contin uity planning. 
For our customers: we will need name, address and payment details to 
take payment for their orders, but  also to arrange delivery with our 
logistics provider. For our customer s who have set up an account we will 
hold more information to help identify them: things like dat es of birth, and 
answers to security questions for if they forget their passwords. 
We do have other information that needs protecting too: our recipe and 
mixing /cooking processes give us a competitive advantage, anyone can 
make a brownie, but they don’t all ta ste as good as the ones we make – 
which is how we’ve grown so much over recent times. 
In terms of technological interactions , we obviously have our website that 
our customers order th rough. We protect this  through a third party 
security firm and we must regular revi ew this arrangement to ensure they 
are competitive in terms of their securi ty features and processes. If any of 
their other clients have had security breaches this could be a concern for 
us. 
Our ever expanding customer base and their details are stored in our 
third party cloud storage, so again we must ensure that this connection is 
secure and that our provider follows good security processes. 
We also need to make sure our  communication channels with our 
logistics provider are secure as t he transmission of PII details to them 
could lead to potential issues. 
Cyber security objectives 
There are four core objectives with r egard to cyber security: availability, 
confidentiality, integrity of dat a and integrity of processing. 
Availability – as we are online, we  need our website to be available 24 
hours a day, 7 days a week 365 days a y ear, so that our customers can 
order brownies whenever they need to (whether it is for their own benefit 
or as a last minute gift fo r a friend or relative).  
Confidentiality – as I have outlined in this email we have both PII and 
business information that we need to  keep secure. We need to make 
sure that only authorised people have access to all the confidential 
information we have, whether it is our baking team who make the brownies and are reviewing the reci pe/processes or our dispatch team 
getting the parcels ready to be ta ken by our logistics provider. 
Integrity of data – it is important that the data we retain about our 
customers remains up to date. Other wise payments may fail and orders 
may get delivered to the wrong addresses.

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 519 
 Integrity of processing – we need to  ensure that the work we do is 
consistent with the policies and procedur es that we have set up. This is 
important both to maintain the qualit y of the brownies we produce and to 
make sure we comply with hygiene standards in food production and health and safety regulations for our  employees. We need to maintain 
controls over who can amend thes e policies and procedures, and any 
legitimate changes must be communica ted to our staff appropriately. As 
we are quite a small operation this should be easy to control at the moment, but we must remain vigilant  about these issues as we continue 
to grow.  
Risks of cyber security vulnerabilities 
If our website should be unavailable for any reason it could lead to 
customers being unable to order from us and so we could lose sales. Our 
website being unavailable would also  mean we would lose opportunities 
to raise awareness about our products and brand. 
Potentially even worse, any downtime could lead to customers finding 
alternative gift ideas or replacements for the brownies we make and sell. 
We operate in a very competitive environment and any issues with the 
website being unavailable, of any other cyber related issues, could mean 
our customers choose a competit or’s product over our own. 
Another consideration from any issues with cyber security would be 
reputational damage. Alt hough we our expanding our sales opportunities, 
it is currently our website that is our core sales point. Going forward we could make sales through other online sources, but any cyber security 
issues associated with our systems and procedures could mean customers avoid our brownies, regar dless of the distribution channel. 
Given our location within EU jurisdiction, any cyber security issues are 
likely to lead to GDPR issues and potentia l fines. So as well as the lost 
sales and reputation damage we could be face significant fines, which would put the liquidity of the bus iness at risk and further damage our 
reputation.

521 
Cyber security 
processes 
D2 Review cyber security processes (a) Cyber security objectives 
(b) Security controls (c) Centralisation in security Chapter 
9

Cyber security processes 
522  
 
1 Cyber security organisational characteristics 
To achieve the security objectives and mitigate the types of risk discussed in 
the previous chapter, the AICPA cyber  security framework recommends a 
security mechanism based around three principles: 
 Protection 
 Detection 
 Response 
These three principles will be applied in different ways across the different 
levels within the system. Key to t heir success are factors core to risk 
management in general: corporate gov ernance, tone from the top and 
communication of appropriate in formation for decision making. 
1.1 Cyber security risk governance 
As part of the reporting framework that the AICPA have devised (see chapter 10 
for more detail), management are required to give specific consideration to 
cyber security risk governance. This would include: 
 How the management set t he tone from the top.  
 Standards for conduct.  
 The extent of, and access to, IT  expertise at board level.  
 Responsibility for overall cyber se curity within the organisation and across 
reporting lines.  
 The hiring and training of cyber security personnel.

Chapter 9 
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 Cyber security risk governance 
 There are various ways for a company to address these governance 
considerations, they include,  but are not limited to:   
 A company handbook detailing polic ies and procedures relating to 
IT (acceptable use, confidentiality, information security). 
 Regular board meetings, potentially quarterly but more or less often 
as appropriate, where cyber securi ty risk management is discussed. 
 In the same way the corporate gov ernance guidelines require recent 
relevant financial experience on an audit committee, if a director has 
recent relevant IT experience, it would help with board oversight, 
although using external IT consult ants could also help with this. 
 Each organisation has different  needs, but consideration should be 
given to the appointment of a chief information officer (CIO) with 
overall IT responsibility to the boar d, a risk committee,  a chief risk 
officer (CRO) with overall responsibi lity for risk, a chief technology 
officer (CTO) to look  after technology and resources to support 
internal operations reporting into  the CIO and a chief information 
security officer (CISO) to head up the cyber security program and 
also report into the CIO. 
 As well as appropriate reporting lines and accountability for cyber 
security, a company needs to make sure it has competent personnel 
in cyber security roles through t he organisation. Hiring appropriately 
qualified staff is a first step, but making sure they are given time and 
training to stay up to date in this dynamic area is critical. 
1.2 Cyber security information and communication 
In chapter 1 we looked at CIMA’s risk management cycle and illustrated the 
importance of information for decision making, with each stage in the cycle providing information to help make appr opriate decisions regarding risks and 
the management of risks. This also applie s to cyber security risks, chapter 8 
introduced the cyber security objectives  of an organisation: 
 Availability 
 Confidentiality 
 Integrity of data 
 Integrity of processing 
It is important that the organisation has appropriate channels and methods for 
communicating not only its cyber secu rity objectives, expectations and 
responsibilities, but any key information to  both internal and external users.  
Internal 
For internal communications a company may do any of the following: 
 Include cyber security objectives, expectations and responsibilities in a 
company handbook.  
 Have policies available on a shared drive or intranet.

524  
 Initial on boarding training, incl uding signing the handbook to confirm 
understanding.  
 Appropriate reminder training sessi ons for all staff on an annual basis.  
 Annual review of objecti ves and handbook/training content.  
 Designated IT updates for critic al/urgent sharing of information 
External 
For external communications a com pany may do any of the following: 
 Develop an appropriate policy for di sclosure of information with external 
parties.  
 Set up communication channels for external parties, including law 
enforcement, to raise issues  
 Use of electronic mail, conference ca lls, or face to face meetings to 
disclose any issues.  
 Appoint legal and communications team s to be responsible for any media 
communications. 
 
 Cyber security information and communication 
 Internal 
The use of a company hand book and on boarding training is seen as a 
very good way to set the right tone fo r all new hires. The employees can 
be left in no doubt about the importance the organisation places on cyber 
security when they first start. 
Appropriate reviews of this content should be carried out by employees 
with cyber security responsibilities to  make sure it remains relevant, and 
regular (potentially annual) training for all other staff to help maintain the 
prominence for all of the workforce. 
Employees who have cyber security responsibilities should have 
additional technical update training to make sure that they remain up to 
date. 
Any employees with access to sensitive data (both employee and 
customer) will also need additional training to ensure compliance with 
legislation and appropriat e incident management. 
External 
The policy for external communications should be included in the 
employee handbook. Any employees who deal with external parties need 
to receive appropriate training in how  to deal with the third parties and 
what data/information should be made av ailable. In particular legal and 
confidentiality principles should feature prominently in any policy 
documents and training.

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2 Protection 
2.1 Areas to be protected 
 Servers : a device or program that pr ovides functionality for other 
programs or devices. A single overall set up is distributed across multiple 
processes or devices.  
Most personal computers today are c apable as acting as a network server, 
however usually a dedicated piece of  hardware carries out the task and 
has specific capabilities such as a fast  processor to facilitate efficient use 
of the computers on the network. 
 Desktops : a personal computer designed for regular use at a single 
location, usually on a desk, due to its size and power requirements. They 
are normally connected to the server to access shared resources like data 
storage or hardware like printers. 
 Laptops : a small, portable version of a desktop, differentiated here 
because its mobile capabilities in crease the risks to the business. 
 Mobile devices : a computing device small enough to hold and operate in 
the hand for example smart phones, tabl ets that now have very similar 
capabilities to laptops and desktops. 
 Networks : a method of connecting various devices and allowing them to 
share resources, applications and other devices. Networks often allow 
multiple users to share a device, like a printer, or allow easy access to shared files through shared network data storage. Networks can be of 
differing sizes, from a local area networ k (LAN) in a particular office, to a 
company-wide network 
 Data storage : the recording and storing of  data and information to be 
accessed by devices on a network. Oft en this incorporates the use of 
cloud based storage, where the data is held on servers in a remote 
location. Often cloud storage is operated by a third party. 
 Business applications : In modern terminology t hese are often referred to 
as apps. They have existed for many years but awareness of apps has 
been raised by the increased capabiliti es of technology and in particular 
mobile devices. Business applications are software tools that allow users to perform certain tasks relating to  their work, for example word 
processing, calculation, graphing and tabulation. Additionally a company may use an accounting application to  record its financial data. 
2.2 Methods of protection 
 Policies and policy management : the process of creating, 
communicating, and maintaining IT  policies and procedures within an 
organisation. These policies can be varied and can range from remote 
working policies, acceptable use of the internet, protection of personal 
information, etc. All are design ed to protect the company and the 
employees from harm.

526  
 Software updates : Updates contain important  changes to improve the 
performance, stability and security of the applicati ons and operating 
systems that run on the various types of devices. If the software is not kept 
up to date then the security features  become out of date, which exposes 
the company to potential hacking attempts. 
 Configurations : removing or disabling unnec essary functionality from 
systems can greatly improve the securi ty of systems. C onfiguration can 
link to the types of hardware and softw are that may be used and, in line 
with policies and procedures, can help protect a company from 
unauthorised access. 
 Security products : such as antivirus software can add to system level 
controls. Failure to use these products can increase the likelihood of a 
breach either from an attack resulting from visiting an inappropriate site or 
downloading inappropriate files. 
 Application software controls : These are controls to ensure that data 
are correctly input, processed and  correctly maintained, and only 
distributed to authorised personnel. 
Application controls are specific to  each application, but can be grouped 
Input controls: 
 Checking and authorising source documents manually. 
 The use of batch controls. 
 Pre-numbered forms. 
Processing controls: 
 Computer verification and validation checks. 
 Error detection controls such as 
– control totals 
– balancing. 
Output controls: 
 Monitoring of control logs. 
 Physical checking of output. 
 
 Example: Smart phones 
 Application controls are not just found in the workplace, most smart 
phones have application software c ontrols built in to them.  
If a new application (app) is downl oaded onto a phone it cannot access 
data on the phone without authorisation. For example a messaging app 
may ask for permission to access the microphone or photos stored on the 
phone. Without the user’s approval t he application is unable access the 
stored data.

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 527 
 Example: Purchase ledger 
 A purchase ledger system might have: 
Input controls : 
 Some inputs have to be authorised  manually – like the addition of 
a new supplier account. 
 Some inputs use batch controls – like the system notifying the 
input clerk how many invoices have been processed. This is then 
checked to the physical number of invoices and highlights if too 
few or too many have been entered. 
Processing controls : 
 The software checks that invoiced goods have been ordered and 
received – linking the details in the purchase ledger and inventory 
files. 
Output controls : 
 A supervisor receives a daily exc eption report, with a nil report in 
the event of there being no exceptions. 
 The supervisor must acknowledge and act upon the exceptions. 
 
IT systems can undermine segregation of duties because they can initiate 
transactions, move assets and keep record s, therefore these systems must be 
designed very carefully. 
2.3 Forms of protection 
The first line of defence is to try to pr otect information assets and systems from 
attack. Protection can take a variety of forms: 
 Identification : things like usernames and unique access codes, so that 
the system has a record of who a ccessed what and when they did it.  
 
 Example: Google documents 
 Even shared documents on a Google drive have the capability to show 
who has opened them and, in particula r, highlight who has edited them 
and what changes were made. The ident ity provided in this case is 
usually the person’s email address. 
 
 Authentication : to enable confidence in the identification, each 
username or unique access code should be verified.  This may be by 
means of a password, or pin number or more recently using biometrics 
such as a finger print scan or facial recognition software.

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 Expandable text – Passwords 
 Password systems can only be e ffective if users use them 
conscientiously. There are severa l inherent problems with a password 
system: 
 Authorised users may divulge their password to a colleague. 
 Many passwords may have associat ions with the user so that a 
hacker can discover them by experimentation. 
 Passwords are often written dow n close to the computer (e.g. 
pinned to the notice board inside  the office) and so easily 
discovered. 
Passwords have been used for a long time, and quality of passwords is 
becoming increasingly impor tant; there are a number of precautions that 
should be adopted: 
 Length – it is increasingly common to have to create a password at 
least 8 characters long. 
 Variety – it is often recommended that passwords have a variety of 
characters for examples upper and lower case letters, numbers, 
special characters (*&%!) 
 Significance – using a date or na me that is significant to an 
individual is advised against. They should be memorable though. 
 Change – users should be requi red to change their passwords 
regularly 
 Unwritten – users should be enc ouraged never to write down their 
passwords 
 Private – there should be strict controls over passwords – they 
should never be ‘lent’ or written do wn where they can be easily 
seen. 
 
 Authorisation : as well as recording what an individual looks at or enters 
into the system, it is also possible to  limit what any particular user can 
access within the system. This means t hat they will only be able to view 
and enter information appropriate to their skill/employment level. 
 
 Example: Password responsibility 
 As well as guidance about length, va riety and significance, it is also 
important employees are aware of other good practices with passwords. 
It is vital that people do not shar e passwords, and that people do not 
write them down in obvious places  to help them remember them. A 
common example is sticking a piece of  paper with a password on to their 
laptop or monitor. 
To help enforce these behaviours in  terms of password quality and 
password protection, some companies make sure that users know that 
they are responsible for everyt hing done in the system using their 
password.

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 Protecting secrets : making sure that only authorised people or systems 
can view the data/information. This is often referred to as encryption . The 
encryption happens both at rest (while the data is stored) and in transit 
(while the data is being transmitted). 
 
 Example: Whatsapp 
 The messaging service Whatsapp has end to end encryption built into its 
application so that all messages sent  and received are only visible by the 
intended recipient(s). Not even Whats app can view your message. They 
see this as a vitally important f eature because of cases where hackers 
have illegally accessed private data and photos. 
 
 The attack at Target Corporation (see previous chapter) is said to have 
resulted partly from the retailer's fa ilure to comply with regulations and 
properly protect its data by s egregating systems handling sensitive 
payment card data from t he rest of its network.  
Target initially claimed it was the vi ctim of a sophisticated cyber crime 
and said it was hard to avoid because of the sophistication. 
Target had a valid reason for allowing the HVAC company access to its 
network, but no individual from t he HVAC company should have had 
authorisation to access anything else  in the system other than energy 
and temperature data. 
Payment card Industry Data Security  Standard (PCI DSS) specifies that 
this type of network segmentation s hould be used to protect sensitive 
cardholder data. 
The malware used to intercept and steal  payment card data from Target's 
POS systems was indeed sophisticated, but the hackers should have 
been unable to install the malware because of network segmentation 
practices. 
 
 Physical security : is also a key way of protecting hardware, from 
desktops to smartphones to server s – all should only be accessible by 
authorised personnel. Attackers may use information they have stolen 
from online files to break in to a st orage facility, or certain access may only 
be allowed via a specific computer te rminal, which is in a secured room. 
Companies often have policies about  how devices should be stored, 
particularly mobile ones away from  the company premises, to reduce 
likelihood of theft.

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In terms of physically securing premis es, there are various basic methods 
of controlling access to sensitive areas. These include: 
 security guards in buildings 
 working areas to which access is through a locked door or a door 
with an ID card entry system or ent ry system requiring the user to 
enter a personal identification code (PIN number) 
 using safes and lockable filing cabinets 
 closed circuit TV used to monito r what is happening in a particular 
part of a building – this may be backed up by security video cameras 
 doors automatically locked in t he event of a security alarm. 
Additionally, procedural controls to protect files and output include: 
 items containing information like USB drives should not be left lying 
around on desks and working surfaces 
 computer printout should be shre dded or otherwise destroyed before 
being thrown away. 
Location of IT facilities 
It is imperative that the location of the system is considered, and hence all 
equipment is located so as to protect against: 
 Fire 
 Flood 
 Smoke 
 Food 
 Drinks 
 Power failure 
 Environment. 
 Personnel controls : Recruitment, training and s upervision needs to be in 
place to ensure the competency of those responsible for programming and 
data entry. One of the key methods of protection, whether it is password 
policy or how to spot a phishing atte mpt, is employee training. A company 
should initiate regular training on key issues, often to serve as a reminder, 
so that people don’t adopt bad habits. 
 
 Example: Kaplan 
 At Kaplan employees are required to take annual information security and 
privacy training, this gives the com pany opportunity to remind employees 
of their responsibilities about pa sswords, social engineering, 
safeguarding computers, the use of social media, safe remote working, 
etc. 
As well as mandatory completion, the company sometimes initiate tests 
to check that the training is being complied with. One example was an 
internally generated phishing email o ffering free coffee from a well-known 
coffee outlet- to access the free coffee a link had to be clicked.

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 The email had several warning signs that  it was not a legi timate offer, for 
example spelling errors. However seve ral employees did click the link, 
and doing so meant they were assi gned additional security training. 
2.4 Certification 
Certificates play a significant part in t he protection process and act as a kind of 
digital handshake. They are particu larly important wh ere payments or 
transmission of sensitive data is concerned.  
Certificates can be used to verify the identity of t he sender, allow the 
transmission of encrypted confidential information and also allow the receiver to know whether the information has been tampered with – the equivalent of tamper proof tape in the virtual world. Authentication and prot ecting secrets are 
very much part of t he certificate’s role. 
There are different types of certific ate. The most common was SSL (secure 
sockets layer) certificates but these are being replaced by TSL (Transport Layer 
Security) certificates. 
 
Expandable text – Certificates 
 There is a public and private part of a certificate. The private part must 
stay secure and not be transferred between parties. 
Within organisations they are often centrally managed to allow users to 
access the public certificate for a per son they want to send encrypted 
information to. 
For external use public certificates ar e issued by third-party certificate 
authorities that verify the identification of th e parties using them. 
 
 Importance of certificates 
 In the previous chapter one of t he examples highlighted the network 
outages that O2 suffered in December 2018.  
The issue was caused by faulty so ftware provided by mobile network 
equipment group Ericsson. The fault was due to an expired certificate in 
software versions installed with t he customers, meaning the validity and 
the security of the softwa re could not be verified. 
O2 and Ericsson are not the first to suff er issues as a result of expiring 
certificates, in 2013 Xbox Live and  Azure both suffered downtime 
because of an expired certificate.

532  
2.5 Man in the middle attacks (MitM) 
This is a type of attack where the attacker secretly and independently makes 
connections between two parties and passes messages between them.  The aim is to make them think they ar e communicating directly with each other 
whilst in reality is the attacker is cont rolling the conversation. This kind of attack 
is often used to collect information, to help a further attack, for example 
discovering specialist knowledge about a ta rget in order to carry out a spear 
phishing attack. 
Certificates are vital in protecting com panies and individuals fr om MitM attacks, 
allowing both parties to s ee whether the identity of t he person they believe they 
are communicating with is authentic or not. 
 
 Man in the middle attacks 
 DigiNotar were a Dutch Certificate i ssuing Authority.  A hacker accessed 
their web server and because of poor enforcement of the rules on the 
DigiNotar systems, the hackers m anaged to get through the segmented 
network protection and access the serv ers that issued certificates.  
From there the hacker star ted issuing rogue certificat es so that the user 
could start impersonating various dom ains which enabled them to carry 
out a large scale MitM attack against gmail users in Iran, intercepting 
messages to and from an estimated 300,000 gmail users until the hack 
was discovered. Investigations discove red that over 500 fake certificates 
were issued and as a result majo r web browsers revoked trust in 
certificates issued by DigiNotar. 
This event can be linked to reputati onal risk discussed earlier in the P3 
syllabus.  For a firm supposedly in  the business of helping secure 
companies and individuals against cy ber threats, being hacked in this 
way was not good for their reputation, and it is unsurprising that shortly 
after this incident DigiNotar filed for voluntary bankruptcy. 
3 Detection 
In the modern world it is unrealistic to  think that protection strategies will be 
enough and so, as well as protective and preventative strategies, organisations 
must also have robust detection strategies in place to identify when (not if) any 
threats occur.  
As with most things, the sooner any issues  are detected the easier it (usually) is 
to fix them. The detection strategies ar e effectively a computer equivalent to 
having a security camera set up. 
The following are some of the detecti on strategies that organisations can 
employ: 
 Event monitoring  – if a log of events is re corded in files then these can 
be reviewed to look for unusual activity. 
 Intrusion detection a nd prevention systems  – it is now possible to run 
applications that can monitor activities on an ongoing basis.

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 Intrusion detection a nd prevention systems 
 Intrusion Detection Systems (IDS):  analyse and monitor network traffic 
for signs of suspicious behaviour that  might indicate attackers are using 
a known cyberthreat to infiltrate th e network or steal information. The 
system works by comparing current net work activity to both expected 
traffic and a threat database to detec t problems such as like security 
policy violations or malware. It is  a passive system which will not 
prevent attacks. 
Intrusion Prevention Systems (IPS ): behave in the same way as a 
firewall, creating a filter between the outside world and the internal 
network. IPS are active applications which will deny suspicious network 
traffic if it appears to represent a k nown security threat.  However they 
can only act on security threats that are already identified. 
 
 Threat monitoring  – studying the way hackers  attempt to compromise 
organisations, including the techniques  and the software tools. This can 
then be used to develop and share intelligence on the types of threats which in turn can help to develop new controls. 
 User reports  – this links into the first point, event monitoring, and the user 
reports can identify unusual activity.  
 
 Example: Threat monitoring and sharing intelligence 
 Dr Ian Levy, Technical Director at the National Cyber Security Centre 
NCSC (part of Government Communi cation Headquarters – GCHQ) was 
the subject of an attempted hack by a prankster in 2017. 
The prankster – who has duped some ve ry high profile individuals – sent 
Dr Levy an email that looked like it wa s from a colleague . Dr Levy spotted 
that something was wrong with the ema il but he took the unusual step of 
asking the prankster to help him educat e people about the signs to look 
out for that you have received a ph ishing or spearphishing email.  
A prime example of the security co mmunity working together and sharing 
threat intelligence with each other , but also the wider public. 
While there was no malicious intent in this case, the method was very 
similar to type of emails sent with ma licious intent. Dr Levy said that he 
was very close to clicking on the link that he had been sent and had he 
been in a rush, or if he had viewed the email after having had an alcoholic drink or two, he probabl y would have clicked the link. 
Together they wrote a blog on the NCSC website, detailing what the 
prankster had done and how Dr Ian Le vy had spotted something was not 
quite right.

534  
4 Response 
As mentioned in the detection secti on, it is no longer a case of if an organisation 
comes under attack, it is when . This means that as well as detection processes 
and strategies, organisations must also have responses ready. This has led to the creation of Computer Incident Re sponse Teams (CIRTs) or Computer 
Security Incident Response Teams (CSIRTs). 
When an organisation comes under attack, the key role of the CIRT or CSIRT is 
to keep the business functioning, or some  people refer to it as “keeping the 
patient alive”. The primary functi ons of the CIRT or CSIRT are: 
 Minimise any losses 
 Restore normal operations as soon as possible 
 Assist with any investigations , internally or externally 
 Help provide data and informati on to support decision making and 
developing a planned response 
 Assist with communications during the critical periods, with various 
stakeholder groups – customers,  suppliers, media, etc. 
 
 Example: Maersk NotPetya 
 Maersk chair Jim Hagemann Snabe discussed the 2017 NotPetya 
malware outbreak at a World Ec onomic Forum event. He described 
how Maersk had to reinstall their “ent ire infrastructure” which he then 
explained was “4,000 new server s, 45,000 new PCs, and 2,500 
applications”, describing the response “a heroic effort over 10 days” as 
it should have taken nearer six months. 
Whether this was an intentional Disas ter Recovery Plan, or accidental 
is not entirely clear. 
In terms of business continuity , Maersk managed to continue operating 
over that 10 day period, with onl y a 20% drop in volumes, Jim 
Hagemann Snabe put it down to “human resilience”. This still cost them 
between $250 and $300 million. 
He described the event as a “w akeup call”, because Maersk were 
“average” at cyber security.  
He also explained that Maersk we re very open about what happened to 
them in an effort to help others, a nother example of threat monitoring 
and sharing intelligence.

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 The IT director of NBV company is  aware that that incidences of 
malvertising have become increasi ngly common in the webpages of 
suppliers to their industry. 
Which THREE of the following res ponses would be MOST suitable 
to address this threat? 
A Upgrade application firewalls 
B Update antivirus software C Encrypt data sent to suppliers D Increase the levels of authentication required to log-on to supplier 
systems 
E Install advert blocking software 
 
 YUB company needs to send highly confidential information from its head 
office to the production system in its overseas manufacturing facility. 
Which ONE of the following forms of cyber-security would be MOST 
likely to ensure that only the intende d recipient is able to access the 
A Encrypting the data 
B Monitoring access to and use of the system C Instituting a network firewall D Backing up the data 
 
 Bhogal Plc is a software development  company that was initially set up 
by Sachkartar and his friend Justyna.   They met at university while 
studying information technology and rema ined friends when they started 
working in IT graduate positions after they left university. They gained several years’ experience, but deci ded they wanted to go into business 
together. 
After several years of growth, they  recently floated on their country’s 
stock market.  Justyna and Sachkart ar are both directors on the board 
and they have, with the rest of the board, been very focussed on complying with the country’s prin ciples-based code of corporate 
At a recent meeting wit h representatives from their risk committee, the 
discussion moved onto cyber security and how they could improve their cyber security risk governance.

536  
 Which of the following would be a ppropriate actions for Bhogal Plc 
to take to address cyber security risk governance? 
A Appoint an external IT consultant  to provide the board with some 
recent relevant IT experience. 
B Create a company handbook detai ling policies and procedures on 
acceptable use of IT, confident iality and information security. 
C Make sure that they have appropri ate cyber security staff, in terms 
of qualifications and numbers, ensuri ng that they get regular training 
to stay up to date. 
D Ensure that at least 50% of t he risk committee are non-executive 
directors 
D Ensure that cyber security ri sk management is discussed regularly 
at board meetings. 
 
 The cyber security risk management team at PAAH Ltd are working on 
their internal handbook to advise em ployees on acceptable use of IT, 
confidentiality and information security. As part of this document, and for 
regular training reminders, they in tend to include some information on 
password best practice 
Which ONE of the following would be the most secure password to 
include as an example? 
A P!ssword 
B p8$sw0rD C Pa$s3!) D Password1234 
 
 Howerson Ltd have decided to issue a ll of their sales team with laptops, 
and are considering appropriate fo rms of protection to prevent 
unauthorised access to company data. 
Which of the following would be a ppropriate methods of protection 
to use? 
A Reviewing configurations  of each laptop prior to  giving them to their 
sales team and disabling any unnecessary features. 
B Installing antivirus software on each laptop. C Training the sales team on physical security including where to store 
their laptops when not is use and offsite. 
D Encourage employees to copy any  critical information onto a 
portable USB drive in case they lose their laptop.

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 E Download user reports on a regular basis to identify unusual activity. 
F Set up a Computer Incident Respons e Team for the sales team to 
contact should they have trouble logging in. 
5 Defending against the cyber security risks 
The previous chapter cover ed the types of cyber security risks.  As a reminder 
below are the key security risks: 
 Malware 
 Application attacks 
 Hackers 
Being aware of the risk is part of the solution and th is section will cover how 
they can be defended against. The AICPA refer to this as applied cyber 
security  and see centralisation as a key aspect of this.  
5.1 Desktops   
Modern operating systems are now full of security features, from password 
protected screen savers through to centrally managed software protocols, 
software updates and security updates “pat ches” that can be pushed through to 
the end users’ desktop.  
The centrally managed softwar e protocols also allows  a directory of user 
profiles which means that users can a ccess their information from multiple 
Other defences such as enabling the pa ssword protected screensaver when the 
user leaves their desktop, or logging o ff the network when the user leaves the 
desktop unattended are also critical. It c an be those within the organisation who 
are trying to gain unauthorised access to  parts of the system.  Leaving a 
computer accessible while leaving it for a short time, for ex ample to go to the 
toilet or get a drink of water, can o ften lead to a detailed conversation with 
another colleague, meaning there is now a potential access point for someone 
with malicious intentions. 
Other centralised controls like an autom atic screen lock after a certain number 
of minutes of computer idle time can al so be implemented to protect against this 
sort of issue. 
5.2 Laptops   
Laptops have a lot of similarities to deskt ops, in terms of the security features 
and the centrally managed security benefits. The key difference, and their main 
benefit, their mobility, means they hav e additional risks. Most pertinent being 
the risk that they could be lost or st olen and this makes whole disk encryption 
an essential feature to  ensure the security of data on laptops.

538  
Also, companies implement policies di ctating how laptops and other mobile 
devices are stored and secured.  Often these policies are common sense, like 
not leaving devices on a car seat or in a car overnight – there is the obvious 
theft issue, but also devices do not perform well if exposed to extreme 
temperatures (either hot or cold) and l eaving them in a car could increase the 
risk of this. 
In terms of physical security meas ures, devices can be locked to a desk 
although this can be fairly easily defeated. 
 
 Example: Security cables 
 Desktops and laptops can sometimes be secured to a desk by a security 
cable, fairly similar to the type that are used to secure bikes. The idea, as with a bike, is to prevent theft of t he device to protect the data stored on 
it, or to avoid someone attempting  to use it to enter the network. 
The issue is that, as with bike security cables, with the right tools and 
enough time, the cable can be broken. 
5.3 Mobile devices   
Some of the threats associated with mob ile devices link to the way the user 
operates the device. For example, to  save time an aircraft engineer may 
download the company manual on the device so it can be accessed quickly and 
remotely. While in the shor t term this may save some  time, it may also mean 
that the version of the manual the engi neer is using does not get updated and 
so procedures are not carried out to exact company specif ication.  Alternatively 
someone may gain access to the device and alter the manual so that 
subsequent work is not carried out in accordance with the appropriate safety 
Organisations that allow staff to downl oad key material, must have clear policies 
in place to ensure staff also download and install any updates. (This would have 
also been the case for paper documents, that someone must have responsibility 
for printing out updated policie s and procedures to make sure a file or folder 
stayed up to date.) 
Another issue can arise if a device is left logged on for too long.  As with 
humans, our nightly shutdown and sleep help sort and restore our body, 
regularly shutting down a device allows  updates to be installed. Most 
companies include these types of behavi ours in their acceptable use of IT 
policies.

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 Example: Traveller laptops 
 Some companies whose employees tr avel to remote or sensitive 
locations, set up what are referr ed to as traveller laptops. 
These are devices that are specifica lly for the trip and often have whole 
disk encryption, with only data necessary for the particular trip set up on 
the device. When the person returns, files used on the trip are saved and 
the operating system and files are completely removed and reinstalled for 
future use. In some cases the comput er is destroyed rather than run the 
risk of compromising proprietary informa tion. The reason for this is that 
deleted files are often recoverable because they are not immediately 
overwritten and there is so ftware available that can reinstate deleted files.  
The only completely secure way to make  files inaccessible is to physically 
destroy the disk, drilling holes in t he disk where the data is stored or 
crushing or burning the hard drive. 
This is quite an extreme action and is reserved for particularly sensitive 
destinations. 
5.4 Bring your own device (BYOD)    
Some organisations use what is referred to as bring your own device (BYOD) 
programmes, but then require employees to submit the devices to the same 
companywide laptop security policies as  company owned devices. Users may 
prefer the convenience of having just  one device, however they may have 
malicious intent to use their dev ice to gain unauthorised access to the 
organisations network. 
As such, some organisations insist on co mpany owned devices only, or if they 
allow BYOD, they prohibit the dow nload and use of any non-company 
As with access to other systems, so metimes companies create different 
configuration profiles for diffe rent types/levels of users. 
An issue for BYOD is compat ibility of software, as a user may open a file with 
different software from t hat mandated by company standards and lose some of 
the functionality or data. 
Also, if a user is allowed to BYOD, but then leaves the organisation, they could 
easily download information from the network, or already have sensitive information on their own device. As discussed in the traveller laptop example, it 
can be very difficult to overwrite file s completely, opening up issues with regard 
sensitive information.

540  
5.5 Network configurati on management (NCM)   
A vital part of the security proces s, NCM enables companies to set up a 
network to meet its communicati on needs. It involves organising and 
maintaining information about its network  such as locations, IP addresses, 
default settings, even the versions of softwa re that are installed. By doing this 
the company can enforce policies, segment  the network to prevent cross over 
into different parts of the network, m onitor configuration changes and ensure 
compliance with software updates across a range of devices on the corporate 
network, from desktops to laptops and mobile devices.  
Network level controls like this are very difficult to get round. 
 
 Example: University Wi-Fi  
 The volume of people that may want to access Wi-Fi at an organisation 
like a university creates potential cyber  security issue - that someone 
may gain unauthorised access. 
A possible solution is set up the network  configurations so that there are 
different Wi-Fi networks, for example one for staff (that allows access to 
potentially sensitive information on the network) and one for students. 
NCM allows these networks to be set up so that they are completely 
segregated meaning that  there is absolutely no crossover.  
Gaining access to the student Wi-Fi would be available with minimal 
controls, but gaining access to the staf f Wi-Fi would require proof that you 
are on an authorised device. 
 
 Example: Network configuration 
 Network configuration has reduced the effectiveness of ransomware as 
organisations have the data backed up and accessible so are no longer willing to pay. 
The solution for the attackers is to  do the exact opposite of locking data 
away, they are threatening to publis h it for everyone to see, an attack 
known as doxware. 
 
 Example: USB drives 
 As a network expands and more devic es are included within a network, 
so too do the attack points and t he vulnerability of a network. 
As part of their NCM some companies ban the use of USB drives, as the 
risk that one containing malware coul d be inserted to a computer on the 
network is too great. In terms of assessment of identified risks, and 
responses using the TARA model, this would be an example of avoiding the risk.

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 Other approaches include using antivirus  software to scan any files that 
attempt access to the computer – the software should reject any software 
that is infected. This is an example of a control to reduce the likelihood of 
(rather than completely prevent) an i ssue as the antivirus software may 
be fooled by the malware. 
To protect sensitive data held on a USB drive, a company may set up 
controls requiring the USB drive to be encrypted before any company 
data can be copied onto it.  This pr otects the company should the device 
be lost or stolen. 
5.6 Firewalls 
There are two main types of firewall.  
 Network firewalls  are like perimeter fenc es around the network and 
include policies about who can access what areas of the system.  They 
can be used to restrict access to specif ic websites, or types of websites, 
for example social media. Access cont rol lists implement ed at the network 
level can be used to provide certain people with access to sites that may 
not be allowed to other users. Certai n mainstream sites are less risky to 
visit than say a site dedicated to il legal software, and sites that offer 
something for free, for example music,  are more likely to be risky than a 
site that requires payment for the musi c. Where content is free, then there 
has to be some other way for the si te to make money, whether through 
advertising, or installing malicious so ftware onto a computer to mine for 
data. 
The most common approach, is to blo ck staff access to certain sites or 
categories of sites, however some more  risk averse companies have a list 
of allowable sites and block access to everything else. 
 
 Example: network firewalls 
 The employees in communications teams like customer service and 
marketing are often authorised to us e social media sites for company 
purposes, perhaps to assess what is being said on social media about 
the brand or to start discussions about  the brand or raise awareness of 
product initiatives. However other staff members may not be allowed 
access as it is often perceived to provide a distraction and reduce 
 
 Application firewalls  are additional security to  network firewalls and can 
be used by an organisation to monito r the inputs, outputs and operations 
of a particular application. It effe ctively filters dam aging content passing 
through to the application – like viruses or any attempt to exploit a known flaw in the software.

542  
 Expandable text – App lication Containerisation 
 In the world of cyber security a container is a method for deploying 
applications and securing their data on mobile devices. An application is held within a container so it has its own operating environment. Software 
written specifically for an organisation’ s environment is put in a container 
so that employees do not need to use the mobile device’s applications for 
company data. The container is ent irely encrypted so company data can 
be kept safe from mixing with any personal data or malicious applications. 
These are popular for basic services  such as exchange email or 
calendar. 
5.7 Antivirus and endpoint security    
Antivirus software and endpoint security ar e additional security features that 
may be used by organisations to augment the security already provided by the centralised management of  the operating system. 
Endpoint security is vital where or ganisational systems are accessed by a 
number of different users, from a variety of locati ons, with numerous different 
types of devices. Each device with a re mote connection to the network creates 
a potential access point for anyone wanti ng to gain unauthorised access to the 
network. 
These sort of security products can help the organisation to comply with internal 
policies and external standards. They al so provide an opportunity to check the 
integrity of applications and detect viruses on the machine. They have the ability 
to block accounts and activity if anything of concern is discovered. 
 
 Example: Security controls cen tralised management patches 
 The Wannacry and NotPetya malware mentioned in the previous chapter, 
both exploited a flaw in Micros oft’s operating system that had been 
discovered by the NSA and that the NSA used to access information.  
The NSA suspected that the in formation about EternalBlue had been 
stolen and so they alerted Microsoft. Once Microsoft were aware of the 
flaw, they issued patches to remove the flaw. Not all users installed the patches and also Microsoft only issued patches to operating systems that were currently supported. 
After the Wannacry and NotPetya iss ues Microsoft took the unusual step 
of issuing patches to legacy oper ating systems that  they no longer 
supported. 
It is thought that the next wave of ransomware will start once a new 
vulnerability has been discovered.

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 Example: high profile attacks a nd their wider implications 
 Throughout this section we have used the Wannacry and NotPetya 
examples, highlighting some high pr ofile companies that the attacks 
affected. The reality is a lot more co mpanies were also affected by it, but 
to a less severe extent. 
Since these attacks many organisations have increased their focus on 
cyber security, partly because of the impact it had on companies like 
Merck & Mearsk, but in many cases because they were also compromised, only in a smaller way. 
The attacks brought into sharp focus the problems that can arise of an 
organisation is not aware of all the devices on its network and the importance of making sure t hat software is up to date. 
5.8 Business continuity  and disaster recovery 
Most organisations now expect to be s ubject to a cyber-attack.  Therefore part 
of the cyber risk management process must  be to set up business continuity 
plans and disaster recovery plans  (although the use of thes e plans is not limited 
to recovery from cyber-attacks). 
 Business continuity planning  – is proactive and designed to allow the 
business to operate with minimal or no downtime or service outage whilst 
the recovery is being managed. 
 Disaster recovery planning  – is reactive and limited to taking action to 
restore the data and applications  and acquire new hardware. 
Disaster recovery planning takes place in  order to recover information systems 
from business critical events after they have happened. It involves: 
 Making a risk assessment 
 Developing a contingency plan to address those risks. 
Examples of back-ups that organisations use now are: 
 Mirror site  – this is effectively a complete copy of a website, but hosted 
on a different URL (web address). It can be used to relieve traffic on a 
server to speed up performance of a webs ite, or it can be used if the main 
website goes down for any reason. It is a very expensive approach, but if 
something is business critical it c ould be cheaper than the costs incurred 
as a result of not having one if something goes wrong. 
 Hot back up site  – this is a building that ph ysically replicates all of the 
current data centre/servers, with all systems configured and ready to go 
with the latest back up. 
 Warm back up site  – this is a building that has  all the critical hardware for 
the servers and systems in place but  they will need to be configured and 
the most recent back up of the data/ information installed before the site 
can take over the organisation’s activities. 
 Cold back up site  – this is an area where, should anything go wrong, new 
hardware could be set up and a recovery operation could begin. None of 
the hardware needed is actually in place, so it would take a significant 
amount of time to restore operations. This is the cheapest option.

544  
 More on disaster recovery plans 
 An unexpected disaster can put an ent ire computer system out of action. 
For large organisations, a disaster mi ght involve damage from a terrorist 
attack. There could also be threats fr om fire and flood damage. A disaster 
might simply be a software or har dware breakdown within a system. 
Disaster recovery planning involves assessing what disasters might occur 
that would pose a serious threat to t he organisation, and trying to ensure 
that alternative arrangement s are available in the event that it occurs. 
In the case of a computer system for a clearing bank, this would mean 
having an entire back-up computer system  in place that could be brought 
into operation if a disaster puts the main system out of action. 
Not all organisations have extensive disaster recovery plans. Certainly, 
however, back-up copies of major data f iles should be kept, so that in the 
event that the main files are destr oyed, the data can be re-created with 
the back-up files. 
 
 System back-ups 
 All files containing important in formation should be backed up on a 
regular basis. Backing up provides  protection against the loss or 
corruption of data due to: 
 faults in the hardware (e.g. hard disk) 
 the accidental deletion of a file by a computer operator 
 damage to a data file by a hacker. 
A back-up is simply a copy of the file. If  the original file is lost or becomes 
corrupt, the back-up can be substituted in its place, and the master file 
can be re-created. 
There may still be some loss of data if  inputs to the system occurred after 
the most recent back-up copy  of the file was made. 
 However, if back-ups are made r egularly, the loss of data should be 
limited. If there are paper  records of input transactions made after 
the most recent back-up copy wa s made, the file can be brought up 
to date by re-inputting the data. 
 Some systems provide back-up copi es of both master files and 
transaction data files. C opies of these files can be used to re-create 
an up-to-date master file if the or iginal master file is lost or 
corrupted. 
Back-up copies might be stored on the same physical computer file as 
the original file, but this is risky, since damage to the physical file will 
result in the loss of the back-up as well as the main file. 
Back-up files can also be created by c opying them on to a disk or tape. 
Where security is important, any such back-up copies should be held in a 
secure place, such as a safe. 
To counter the risk of damage to a file due to a fire or similar disaster at 
the premises where the IT system is located, a back-up copy might be 
taken off-site and held somewhere else.

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 The need for robust disaster recovery plans 
 In May 2017 British Airways had an issue with the power supply to 
business critical IT systems which led to BA's check in systems, call 
centre and website all going off line. 
The company was criticised for its failu re to have an appropriate disaster 
recovery plan for systems critical to  its core operation. Questions have 
been raised as to why an uninterruptible power supply was not used, why there was no back-up power supply to start up automatically if the power 
supply was compromised, and why there was no back-up server running alongside the main system. 
The impact of this disaster was sti ll being felt by passengers three days 
later and is expected to cost the company a significant amount in compensation payments, with some estimates as high as £100 million. 
This is an example of a situation where maintaining a hot back up site 
would have been worth the investment. 
 
 Business continuity planning 
 QuadrigaCX, Canada’s leading cr yptocurrency exchange company, 
made international headlines  due to their business continuity planning, or 
rather their lack of it. 
The founder Gerald Cotton passed away while travelling to open an 
orphanage in India due to complic ation with Crohn’s disease. 
Unfortunately for QuadrigaCX and their clients Mr Cotton had sole responsibility for looking after the f unds and coins. This meant he was the 
only person with the password key to a ccess the money (which was held 
in what is referred to as cold stor age i.e. stored offline to protect the 
money from hackers). 
This meant that money, which some be lieve may be in the region of $190 
million, in both cryptocurrency and normal money, is completely inaccessible.  Experts have been brought in to try and break the encryption but so far have been unable to do so. 
If the company had been more proacti ve in their management of the 
risks, they would have identified t hat someone with a m edical condition 
being the sole guardian of a business- critical password or key was poor 
risk management and been able to put controls in place to manage the risk more appropriately. 
5.9 ISO27001    
ISO27001 is a standard produced by t he International Organisation for 
Standardisation (ISO) and concerns info rmation security management systems. 
It is a framework that focusses on all as pects of an organisation’s information 
risk management processes. The ISO developed ISO27001 to provide a model 
for establishing, implementing, operating,  monitoring, review ing, maintaining 
and improving an information security management system

546  
The key principle behind the standard is, in line with the AICPA approach: to 
ensure a proactive rather than reacti ve approach to cyber security risk 
 
 Expandable text – ISO27001 
 ISO 27001 uses a top down, risk-based approach and is technology-
neutral. The specification defines  a six-part planning process: 
 Define a security policy. 
 Define the scope of the Informa tion Security Management System 
(ISMS). 
 Conduct a risk assessment. 
 Manage identified risks. 
 Select control objectives and controls to be implemented. 
 Prepare a statement of applicability. 
The 2005 version of the standard heavily employed the PDCA, Plan-Do-
Check-Act model to structure the proc esses, and reflected the principles 
set out in the Organisation for Economic Co-operation and Development (OECD) guidelines.  
The 27001 standard does not mandate specific information security 
controls, but it provides a checklist of controls that should be considered 
in the accompanying code of practice, ISO27002. 
The ISO 27002 standard was originally  published as a rename of the 
existing ISO 17799 standard, a code of pr actice for information security. 
It basically outlines hundreds of  potential controls and control 
mechanisms, which may be implement ed, in theory, subject to the 
guidance provided within ISO 27001. 
In 2013 ISO27001 was updated to place more emphasis on measuring 
and evaluating how well an organisation 's ISMS is performing. A section 
on outsourcing was also added with this  release, and additional attention 
was paid to the organisational co ntext of information security. 
 
Given the high regard for ISO standards, a lot of larger organisations require 
B2B partners to be ISO27001 compliant  or to be progressing towards 
compliance before they will do business with them; this a is further risk 
mitigation. 
6 Blockchain technology 
6.1 What is Blockchain technology? 
 A blockchain has been described as  a decentralised, distributed and 
public digital ledger that is used to record transactions across many computers so that the record cannot  be altered retroactively without the 
alteration of all subsequent blocks and the consensus of the network. 
Alternatively, it has be en defined by the Bank of England as a technology 
that allows people who do not know each other to trust a shared record of 
events.

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carried out by just one party. If the system is hacked, there is little control to 
prevent such modifications from happening.  
 Illustration – A blockchain 
 A simple illustration is the relation ship that individuals have with their 
banks or credit card companies. If you carry out a transac tion with either 
(for example, you use y our credit card to pay fo r goods or services) only 
one party records the transaction – your credit card company. How is that 
company to know that the transac tion is valid? If the details appear 
reasonable, the transactions will be aut horised.  This allows those who 
carry out credit card fraud to make their (illegal) gains. 
 
public, as it is a form of distributed l edger; it has been described as a form of 
collective bookkeeping. 
 In a blockchain system, transactions  are recorded by a number of 
participants using a network which operat es via the internet.  The same 
records are maintained by a number of different parties; as a transaction is entered, it is recorded by not just two parties, but instead by all of the 
parties that make up the overall c hain. This can happen because all of the 
records in the blockchain are public ly available and distributed between 
 When a transaction takes place (f or example, between a buyer and a 
 The process of verifying the transacti on is carried out by computers; it is 
effectively the computers which ma ke up the network that audit the 
transaction. If all of t he computers review the transaction and verify that 
the details are correct, the systems of  all participants in the blockchain 
have updated records. The computers wo rk together to ensure that each 
transaction is valid before it is added to  the blockchain. This decentralised 
network of computers ens ures that a single system cannot add new blocks 
to the chain.

548  
 When a new block is added to a blockchain, it is linked to the previous 
transactions in the blockchain becaus e all of the subsequent blocks must 
be altered first. 
the transaction will not be recorded.  
 
 Illustration – Cryptocurrency 
cryptocurrencies exist, such  as Ethereum and Litecoin. 
over the internet. Unlike traditional currencies, Bitcoin is decentralised, 
meaning it is not controlled by a single bank or government. Instead, 
Bitcoin uses a peer-to-peer (P2P) payment network made up of users with Bitcoin accounts. 
Bitcoins can be acquired in 2 diffe rent ways: 1) exchanging other 
Bitcoin exchange such as Mt.Gox or  CampBX. These exchanges allow 
users to exchange sterling, dollars etc. for bitcoins. 
is designed to generate increasingly more complex maths problems which ensures that new bitcoins are generated at a consistent rate. 
Bitcoin.

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6.2 The relevance of blockchai n technology to accountants 
Ultimately, blockchain provides an unal terable, transparent record of all 
accountancy-related data. 
Examples of how blockchain can benefit the accounting profession include: 
 Reducing the cost of maintaining and reconciling ledgers. 
 Providing absolute certainty over t he ownership and history of assets, the 
existence of obligations and the m easurement of amounts owed to a 
business and owed by a business. 
 Freeing up time to allow staff to conc entrate on other responsibilities such 
as planning, valuation, reporting etc., rather th an record-keeping. 
 
 Blockchain potential 
 It is believed that blockchain can streamline and speed up organisations 
business processes, improve defences against cyber risks and reduce or entirely remove the need to use expensive third party security applications. 
Some commentators are suggesting that blockchain could do for 
networks of organisations what enter prise resource planning (ERP) did 
for an individual business. That is  allow an understandi ng of business 
operations and common processes across enterprises, improving 
integration and impr oving efficiency. 
Some benefits of using blockchain include reduced procurement costs, 
lower inventory levels.  The use of crypto currency could even avoid the 
use of foreign exchange as businesse s are using virtual currencies which 
would result in far lower administrative costs. 
6.3 Risks 
Despite initial claims that a blockchai n was unhackable, like everything it still 
has risks, and inevitably is not unhackabl e. As anything increases in use, it 
becomes more attractive to those wis hing to use it for unauthorised purposes, 
meaning more time gets spent  analysing ways to overcome  the controls that are 
in place and to discover how money can be made/stolen. 
 
 51% rule 
 One of the current issues  that has arisen is that if a trader controls over 
50% of the mining power in a cryptocu rrency chain they can overwrite the 
controls and spend the same money again. As with other aspects, the more mainstream crypto currencies are less likely to be hacked in this way (the cost to do this with Bitcoi n would be prohibitive) but it may be 
possible on some of the smaller exchanges.

550  
7 Centralised monitoring  
There has been an increase in the number  of organisations whose systems are 
now accessed by a large variety of devices  logging on from all over the world. 
Users are creating potential points fo r unauthorised access with every additional 
device that is used. The need for centra lised monitoring of systems activity has 
also evolved in line with these changes. 
There are many components to centra lised monitoring, these include: 
 Event logging and aggregation  – modern computer  operating systems 
keep a record of their activity as standard, collecting information such as: 
– Who logged in – What programmes they accessed/used – What files were used – Areas / systems that they tried to access or run, but were unable to 
Most of this information is fairly s uperficial and generally will not be looked 
at, but it is essential for administr ative and accountability purposes, as well 
as – if there is an issue – forensic analysis. 
As much of this could be deemed sensitive information, privacy 
considerations mean that these record s should only be viewed by security 
personnel. Best practice would be to send the records to a central 
monitoring point either a security operations centre (SOC) or a data 
centre.  
 Security information and event management (SIEM)  – these systems 
have been developed to make this monito ring more effective. They work 
alongside firewalls, antivirus software, IDS/IPS etc and so make event monitoring more effective. SIEMs analyse  all of the available data (from 
the different systems) and look for pa tterns that suggests unusual activity 
that could be a security compromise or a possible attack. The ability to 
piece together all the different source s of information allows the system to 
identify security risks that t he individual systems may miss. 
SIEM systems have allowed organisati ons to analyse data in a positive 
and useful way which would previous ly have been impossible (or at least 
extremely time consuming and unlikely to yield results). 
When the SIEM system identifies a pot ential threat, an incident response 
process can then be initiated. 
 Modern security operations centre (SOC) functions  – SOC have also 
evolved over time and could hav e a range of teams or functions: 
– Incident response team – Threat intelligence team – Hunt team – Insider threat team

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  Incident response team 
When the SIEM identifies a potent ial threat, an incident response 
process is initiated. The focus of this team is business continuity.  
 Threat intelligence team 
The mission of the threat intellige nce team is to monitor trends and 
identify threats arising, most comm only in the industry sector that 
the company operates. These teams then pass on information to the team responsible for moni toring activity via the SIEM. 
 Hunt team 
This team operates on the assump tion that the organisation has 
been breached already but no one has yet identified the breach. 
The hunt team is theref ore looking for any sign that there has been 
an intrusion into the systems. 
 Insider threat team 
Research shows that a lot of sys tem breaches come from within the 
organisation; perhaps from someone who feels they have been unfairly treated (a missed prom otion opportunity or a poor 
performance evaluation) or an employee who is suffering financial challenges. However investigating fo r internal involvement can have 
serious considerations (privacy, legal, HR etc). 
 
 Example: Threat intelligence and hunt teams 
 The gap between security breaches  and detection is increasing as 
attackers are often acting in a more discrete manner. 
In the Verizon 2018 Data Breach Investigations Report: 
 In 87% of breaches it took only minutes or less for attackers to 
compromise systems. 
 Only 3% were discovered quickly, and 68% went undiscovered for 
months or more. 
 The only industry where the threat fr om insider action is greater than 
the external threat is in the Healthcare industry. Although human 
error was found to be a major factor and curiosity was another (for example where a celebrity had recently been a patient).

552  
 An oil company uses an IT server for a major system and the management 
believe that it is ess ential that the continuity  of processing must be 
assured at all times. 
Which of the following risk control measures is the most appropriate 
for ensuring that this happens? 
A A secure password protection system 
B A standby server C Surplus capacity in the memo ry of the operational server 
D Fire safety measures 
 
 GKJ company allows many of its em ployees to work remotely on mobile 
devices. 
Which ONE of the following actions would it need to implement to 
ensure its information security  management system (ISMS) 
complied with the ISO27001 standards? 
A Develop a security policy for use of mobile devices 
B Limit use of business applications by mobile devices 
C Forbid employees to leav e mobile devices unattended 
D Ban downloading of company po licies from central servers 
 
 The board of JLK company has been warned by its Threat Intelligence 
team that a new form of cyber-atta ck has just been reported by other 
companies operating in the same industry. 
Which TWO of the followi ng responses to the ri sk identified by the 
team would be MOST appropriate  for inclusion in JLK’s cyber-
security risk management programme? 
A Review the company security  information and event management 
(SIEM) system for evidence that  such an attack has occurred 
B Enter into a blockchain system with other companies in the industry 
C Update network firewalls D Conduct an updated assessment of  the company’s information 
E Require all staff to change t he passwords used to access the 
system

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 JPI company relies on goods provided by a complex network of 
interlinked suppliers.  It wishes to ens ure that all member s of the network 
are able to transact securely with each other. 
Which ONE of the following actions  would be the MOST appropriate 
way to achieve this objective? 
A Introduce a blockchain system linking the network members 
B Set up a shared insider threat team C Install a network firewall D Introduce a network configur ation management (NCM) system 
 
 Test your understanding 10 – H training company (Case study) 
 Scenario 
H is a training company that provi des executive training in management 
subjects. H provides short courses t hat range from a single day to five 
days. H has five offices and each o ffice has between ten and twenty full-
time trainers. 
H’s courses are very expensive. Delegates are senior managers and 
company directors. All courses are pai d for by employers who are keen to 
equip their staff with new skills or to update existing knowledge. Many 
courses are taught in H’s offices to  small groups of delegates, each of 
whom has come from a different co mpany. These courses are advertised 
on H’s website and some, like “financ e for non-financial managers”, are 
taught frequently throughout the year. H will also adapt an existing course 
or even write a new course from scra tch and offer it in-house for a client 
company. Trainers often have to trav el away from home and stay in 
hotels in order to present in-hous e courses at clients’ offices. 
Each course delegate receives a print ed copy of the course materials and 
an electronic copy on a memory sti ck. Feedback indicates that delegates 
like to refer to the paper copy dur ing the course and then take the 
electronic copy for ease of storage and future reference. 
Courses are presented using laptops and projectors. Slides are written on 
an industry-standard presentation so ftware package. H has provided 
each trainer with a laptop and all of the company’s training rooms are 
equipped with projectors. Client compani es also have projectors that are 
available for presentations. 
Each course has a very specific sy llabus and the course materials are 
written to a very high standard. A ma ster copy of the material used on 
each course, including client-specific  “in-house courses” is stored on a 
PC at H’s head office and updated copies are backed up to a server at another office. Courses are re viewed regularly and updated when 
required. The company-specific cour ses are held so that they can be 
adapted if necessary for other com panies or to become a general 
offering.

554  
 Trigger 
‘Image’ is very important and H’s trai ners all take great pride in their 
personal appearance. They all take ca re to ensure that they are well 
dressed. That pride also extends  to being seen to have the latest 
technology. Many of H’s trainers have bought themselves tablet 
computers that they can use instead of their laptops. There are different 
operating systems for these machi nes, but all can run the software 
required to edit and present course ma terials and all of the trainers have 
purchased models that can work with standard proj ectors. The trainers 
feel that these tablets look more im pressive and that they are lighter to 
pack when they have to work away fr om home on in-house courses. The 
tablets have also been used to go online and access H’s systems. 
H’s Head of IT is concerned that there could be problems associated with 
the trainers using their own tabl et computers in this way. 
Task 
As a senior employee in the IT depar tment write a memorandum to the IT 
director of H which: 
(a) Discusses the risks associated wi th H’s staff using their own 
equipment (for example tablets) instead of the laptops provided by 
H; and 
(b) Recommends, with explanations, t he policies and procedures that H 
should adopt for the use and purchase of laptops and other devices 
used by the trainers. 
 
 Test your understanding 11 – Royals (Case study) 
 Scenario 
You are a senior manager in the finance department for Royals, a budget 
gym operator in the country of Hyl andia. Karl Judd, the chief financial 
officer, has just sat do wn at your desk. He pa sses his tablet with the 
Twitter app open displaying a series of tweets between one of Royals gym staff and several patient reco mmended by doctors to the Make 
Hylandia Healthy initiative: 
“Take a look at these tweets! 
The CEO has just had a call from a seni or official at the Ministry of 
Health, who is furious at the tweet s that have been posted in the last 24 
hours. This has apparently gone viral. The CEO is demanding that this 
gym staff member be di smissed immediately. 
I’ve just spoken to one of the regi onal managers who has already been in 
contact with Tim Beam, the gym staf f member concerned. Tim says he is 
very sorry for his tweets, but has  been under pressure from all the 
additional work he is having to do. He also stated that he had not had any 
assistance or information about the Make  Hylandia Healthy initiative from 
head office. The regional manager also pointed out to me that we do not 
provide any training on social media use to gym staff nor do we operate 
any policy on staff usage of social media.

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 555 
 What are the ethical issu es we need to consider in relation to this 
incident, both from Royals’ perspective as the employer and from the employee’s perspective? 
Social media is something that is part of daily life,  but the CEO will need 
some convincing that we should not shut down Royals’ twitter account 
completely.  
I need some information from you, firstly on the benefits to Royals 
of using social media as a business communication tool and 
secondly, how should we control our  social media communications 
to make sure nothing like this happens again? ” 
Trigger 
Alison Tree  @alitree454 
Just been to my first session at @RoyalsGym. V disappointed. Gym 
instructor uninterested in me and I won’t be going back. So much for 
helping me get fit #makehylandiahealthy #wasteoftime 
Tom Ray  @tjray127 
@RoyalsGym was a waste of time. No  induction help. Had no ideas what 
to do. Won’t be getting fit at  this rate #demotivated 
Mr Fitness  @timebeam123 
@alitree454 sorry you were disappoint ed with my help at Royals today. 
Perhaps if you spent less time talking to your friends and more time exercising you wouldn’t be so unfit #timewaster 
@tjray127 I’ve been working at Royals  for 3 years – not seen many like 
you. Clearly you have never set foot in a gym in your life before. Ha ha ha. I’ve got better things to do with my time. #anothertimewaster 
@timebeam123 you are meant to enc ourage us and not be disrespectful 
to customers. I wonder if your bo ss @RoyalsGym know how you feel? 
Joanne Rouse  @JoJoRouse17 
@alitree454 I had a dreadful experience too. I attended @RoyalsGym 
last week on the #makehylandiaheal thy programme. As a 60-year old 
with no previous experience I expect ed some help. None was given. 
@JoJoRouse17 let’s face it. You’re t oo old to be going to a gym. Put your 
feet up and have a biscuit! I’ve had enough of all this chat now. None of you are paying, so you’re not real  customers anyway. It doesn’t matter 
what you think. #leaveittotheexperts 
Task 
“Please prepare me briefing notes on t he three issues I’ve just mentioned 
so that I can advise the CEO on t he approaches we should take.”  

Chapter 9 
 557 
 The correct answers are A, B and E 
Malvertising occurs where adverts  shown on webpages visited by the 
company system contain malicious c ode which can infect the computer 
whether or not the user takes any acti on (such as clicking on the advert).   
Advert blocking software will prevent t he adverts from being displayed so 
that they cannot act.   
Application firewalls can prevent vi ruses passing through to particular 
applications and antivirus software is des igned to prevent viruses but also 
to detect and remove any that hav e managed to compromise the system. 
Increasing authentication layers and encrypting data would not prevent 
the adverts from being seen or from  infecting NBV’s system once they 
had been displayed. 
 
Encryption of data involves scrambli ng the contents in such a way that 
only authorised recipients can unscramble and access it.   
Monitoring the system may alert the co mpany to attempts by hackers to 
access the system, a network firewall can prevent company employees from accessing certain sites and ba cking up data can help the company 
to reconstruct files in the event that data is lost  or corrupted.  
 
These are all ways in which cyber security risk governance can be 
addressed. 
A is a way a company could address cyber security risk governance, but 
given that both Sachkartar and Justyna have recent relevant IT experience and hold positions on the board they already satisfy this 
There is no requirement for how a risk committee is made up for 
corporate governance or for cyber  security risk governance.

558  
It is 8 characters long, with 4 different  types of character (3 lower case, 1 
uppercase, 2 numbers and a special character. 
While A is 8 characters long, it has less variety. 
C has good variety but is less than 8 characters. D is the longest but is very familia r and would be a prime target for a 
hacker to experiment with. 
 
 The correct answers are A, B and C 
These are all realistic and appropriat e forms of protection to use. 
D creates an additional copy of t he company data and if lost could 
compromise company data. A secure  back up on a remote server would 
be more appropriate. 
E is a detection technique rather  than a form of protection. 
A CIRT is a response should a system breach be detected and is not 
designed to help with routine IT issues. 
 
 The correct answer is B  
A standby server (in a different lo cation) can ensure continuity of 
processing, provided that backup f iles of the system are continually 
produced (and also stored in a different location). 
 
 The correct answer is A  
Although the ISO27001 standards requi re organisations to maintain 
security policies they do not includ e any mandatory information security 
controls.  Instead they contain a list of potential contro ls that may be 
considered but leave organisations to assess their own specific security 
risks and develop controls as appropriate.

Chapter 9 
 559 
JLK’s Threat Intelligence team has i dentified a new form of cyber-attack 
but at this stage it is not clear how  it works to attack the system.  
Therefore responses to the risk will be high level – assess the risk and seek to identify whether the com pany has been affected.  Specific 
responses cannot be specified until mo re is known about how the cyber 
attack works to threaten the system.  
Passwords are a form of authenticati on that increase an organisation’s 
confidence in the identification of  those accessing a system via a 
legitimate channel.  
Blockchain systems will not permit any modification of data within a 
system unless all the system participants consent.  
Network firewalls restrict access to  the system by system users.   
All these responses might mitigate t he risk but only if the new form of 
cyber-attack exploits the weaknesse s they are designed to prevent.  
 
Blockchain technology allows for t he synchronisation of all data and 
transactions across a network and each member must verify the 
transaction before it can be approved. It is increasingly being used to link supply chains.   
A network firewall is designed to c ontrol access to certain areas inside a 
computer network.  
A NCM system allows for the or ganisation and maintenance of 
information about all the different elem ents in a computer network such 
as locations, IP address,  default settings, versions of software installed 
etc.   
An insider threat team works to i dentify those within an organisation who 
may wish use their position to effect a system breach.

560  
To:  IT director 
From:   Senior IT employee 
Subject:   The use of tablets – risks, policies and procedures 
(a) Risks with the use of tablets 
The most immediate risk is that t hese tablets are being connected to 
H’s servers in order to both download files and upload edited and 
modified versions. H has no way to  ensure that these devices are 
free of viruses and other malwa re and so the systems could be 
corrupted. The laptop s are a known quantity and H can specify the 
security software that mu st be used and kept up to date 
The files that are given to del egates are also potentially open to 
infection . The delegates could open their organisations up to a threat 
and H could be held liable. 
H’s IT staff may not be able to  support these devices. If a 
compatibility issue arises with ei ther hardware or software then the 
staff will be unable to seek support fr om H and that could affect the 
smooth running of a presentation.  There are several different 
platforms for tablet computers and so it would be difficult for H’s 
staff to be familiar with all of them. 
Tablets do not always run indus try-standard software, but use 
simplified packages that claim to  be able to edit these files. 
The creation or modification of a file using a “compatible” software 
suite may mean the file cannot be opened or that some of the 
formatting is lost. That could make H’s presentations seem far less professional. 
Tablets and similar devices ma y be less robust than a business 
laptop and so the courses could be disrupted by machines breaking 
down or failing. 
The software running on the tablets may not be licenced and H may 
be open to accusations of copyright  theft if its staff are using 
unauthorised copies. 
In the event that a trainer leaves  the company it will not be as easy 
for H to request the return of its files because they will be on the 
trainer’s personal tablet. 
There are very few upside risks, but this arrangement does mean 
that H’s trainers will often appear to be at the forefront of 
technology. It also gives H the oppor tunity to experiment with new 
technology at very little direct cost to the company.

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 (b) Policies and procedures over the use of tablets  
The starting point should be to insist  that staff use only the hardware 
and software that have been provided by the company. That will give H control over the platforms that are being used to develop and 
deliver courses. 
H should have a designated eval uation group to evaluate new 
technology as it becomes availabl e. That group should comprise 
both IT experts and trainers, so that the new technology can be 
assessed from both a technical an d a practical point of view. H 
needs to ensure that it makes the best possible use of new technology as and when it becomes available in a reliable and cost-
effective product. H should avoid getti ng carried away by the rush to 
adopt new technologies that are at the “bleeding edge” because 
early adopters pay more and bear most of the risks. 
New hardware and software should be evaluated against a detailed 
checklist covering both security and compatibility. H has to be certain that none of its materials will be at risk of infection or 
corruption and that files will al so be capable of being opened, 
edited, stored and passed onto clients.  Security should be evaluated 
by referring to third-party reviews by security specialists because it 
is unlikely that H will have sufficient  expertise in-hou se to test the 
firewall and anti-virus systems on a new computer platform 
When new devices require a change in software, such as a switch 
to a cut-down version of a pack age that can be run on a tablet, H 
should insist that the presentations are reviewed slide-by-slide to 
ensure that they all open and have the required format. H should 
consider insisting that the materi als continue to be updated using 
industry-standard packages and that  the new hardware should be 
used to present courses using copies of the updated files. 
There should be a genuine business reason for making the change 
to new platforms, otherwise H will be exposed to the risks 
associated with the new technology simply because trainers want to 
use the latest “toys”. That would not prevent H from agreeing to use 
new hardware simply for the sake  of impressing clients because 
image is very important in this business.

562  
To:  Karl Judd  
From:  Senior manager  
Subject:  Social media  
Ethical issues 
Royals has a duty of care to our employ ees to train them to carry out their 
job effectively. I do not believe that  we have achieved this in this 
instance. We must investigate if the claims made by the gym instructor 
are true, as he could be merely making an excuse for his poor behaviour. But if we find out that gym staff were  not fully informed or provided with 
sufficient guidance regarding this init iative and that gym staff have been 
over-worked or not given appropriate guidance and support, then this is 
lack of professional competence on our behalf. 
Nevertheless, the gym staff member  in question did not act with the 
correct level of professi onal behaviour in his responses to the customers 
using his twitter account. He lacked integrity and objectivity in his responses and in his manner of communi cating to customers. There is no 
excuse for these kind of comments, whatever the pressure he was under. 
It is certainly not acceptable, particu larly if these were carried out via 
Royal’s own twitter account. 
We must investigate this situation before we terminate the employment of 
this gym staff member. It could be considered as gross professional 
misconduct if proved to be true but we must find out the opinion of other 
gym staff as to whether his claims about no communication are true. If we 
do not operate a twitter usage policy and have no training on this as a communication tool, then this is a si gnificant weakness in our training 
programme and we must immediatel y instigate a social media usage 
policy and guidance to all staff immediately. 
Benefits of social media as a business communication tool 
Social media can help us to generate a huge amount  of data about 
Royals customers in real time. Social  media activity could provide us with 
a wealth of information about our custom ers, such as who they are, what 
they like, and how they feel about our brand. Through active engagement 
and social listening, we can gather re levant customer data and use that 
information to make improved business decisions. 
A presence on social media will also ma ke it easier for our customers to 
find and connect with us. By connecting with our customers on social media, Royals is more likely to increase customer retention and brand 
loyalty. Social media ads are also  an inexpensive way to promote the 
business. Social media increases sa les and customer retention through 
regular interaction and timely customer service.

Chapter 9 
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 It is now an expectation of custom ers that businesses have a social 
media presence. Customers expect fa st response times and 24/7 support 
– just like our service delivery. One of  the biggest benefits of social media 
is using it to increase our website tr affic. Not only does social media help 
direct people to our website, but the more social media shares we 
receive, the higher our search rank ing will be. Also, with social media 
monitoring we can gain key information about our competitors. This kind 
of information will allow us to make strategic business decisions to stay 
ahead of them.  
With the help of social media, spec ifically when it comes to sharing 
content about the business, all we need to do is share it on our social 
network accounts. Importantly, social  media is a two-way channel where 
we have the opportunity to enrich rela tionships with our customers. This 
kind of social media dialogue bet ween us and our customers is 
something traditional advertising cannot achieve. 
Controlling social media environment 
Royals must implement a compan y-wide staff policy on the usage of 
social media as soon as possi ble. Regional Managers should be 
responsible for initial training and any necessary on-going training and 
updates on social media usage by staf f in their own regions. All new 
members of staff should be induc ted and trained on the appropriate 
usage of social media when operating as a Royals employee and we must make it clear in staff contracts that violation of our corporate social 
media usage policies will result in disci plinary action or in extreme cases, 
Guidance and training should also be given on personal usage to ensure 
that staff are aware that pers onal usage violations could have 
repercussions for Royals. It must be made clear in our social media 
usage policy that any contact with cu stomers must be carried out in a 
professional and objective manner and that any correspondence which 
brings the company name into disr epute will be disciplined. We must 
make available to staff our discipli nary procedures for any abuse of social 
media activity. 
We should also ensure that a member of the IT team is  responsible for 
monitoring Royals social media activi ty and that we have some form of 
process whereby we can actively track any social media activity related to 
Royals. We must keep up to date on w hat customers and staff are saying 
and ensure that it falls within the b ounds of what is acceptable to us. 
All social media communications from Royals should be provided via one 
source. We should consider only ha ving one or two members of staff, 
probably from the marketing team, who respond to any social media 
comments made by customer s, rather than allowin g any direct comments 
from staff to customers. However, we would need to investigate this as 
we would not want to lose our personal touch with customers.

565 
Cyber security tools, 
techniques and reporting 
D3 Discuss cyber security tools and techniques (a) Discuss forensic analysis 
(b) Discuss malware analysis (c) Discuss penetration 
testing 
(d) Discuss software security 
D4 Evaluate cyber risk 
reporting (a) Evaluate cyber risk 
reporting frameworks Chapter 
10

Cyber security tools, techniques and reporting 
566  
 
1 Cyber security tools and techniques 
Throughout the CIMA syllabus there ar e examples of companies using 
techniques to learn from the results of their actions.  Whether it is variance 
analysis or a post completion audit, the common theme of t he models is that 
they look back and learn from events that have occurred.  
The obvious aim of cyber security is comp lete prevention.  However this aim is 
unrealistic and in practice the risk of a cy ber attack is similar to the risk that a 
project is delayed, or a budgetary target is missed.  This chapter explores how 
companies can look back and learn from any cyber-attacks and so improve their 
cyber security. 
 
 Example: Permanent state of alert 
 In 2018 it was estimated that small businesses in the UK alone were the 
target of 65,000 attempted cyber-attacks every day. 
Just looking at small businesses, there were sometimes as many as 
359,000 attacks in a 24 hour period. 
As technology is used more and more this number is only likely to 
increase. 
2 Forensic analysis 
As with any crime scene, virtual or physical, something is always left behind. Forensic analysis is the process of ex amining the things that have been left 
behind by the attack/atta cker to increase understandi ng about the attack and 
how the systems were breached to be able to  improve defences in the future.  
There are three main areas to consider  in forensic analysis of cyber-attacks and 
cyber security. They are: 
 System level analysis . 
 Storage analysis  
 Network analysis . 
Each of these will be ex plored in more detail.

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2.1 System level analysis 
Once it is known that a system has been compromised, the first stage is to 
identify what part of the system is affected. This often referred to as looking for 
‘footprints in the sand’ to identify w hat, if any, changes have been made to the 
system. 
 System components : the components of the operating system are often 
changed after malware has been installed. 
 Configuration changes : settings of the system and how programmes run 
can be affected by malware. 
 Services enabled without authorisation : once the malware is installed 
the attacker needs to be able to access the system again in the future to 
enable theft or further intrusion. 
 Fake accounts created : setting up fake accounts is a common way to re-
enter a system. 
 
 Example: Social media 
 Facebook and other social media co mpanies are trying to remove as 
many fake accounts as possible. Attackers use fake accounts as 
opposed to hacking into a legitimate user ’s account – as the user is likely 
to spot that something is unusual  about their account and report it. 
In a recent quarterly update, Facebook  announced it had disabled almost 
1.3 billion fake accounts in a 6 month period. 
A significant proportion of the fa ke accounts were bots (autonomous 
programs designed to behave like  a human) and created with the 
intention of conducting scams and spreading spam. 
Facebook is publishing these sort of st atistics for multiple reasons, one is 
to hold itself accountable, but perhaps  a bigger reason is to show to 
users that it is taking action against this problem. 
2.2 Storage analysis 
Computers and devices have a huge amoun t of storage on them which can 
make locating particular files difficult and conversely make it much easier to 
hide a file that is not  meant to be seen. 
The introduction of cloud storage has m ade this aspect of forensic analysis 
harder. Since a third party owns the se rvers that store t he data, obtaining 
access to review any changes can be harder. 
Another difficulty with regard to stor age analysis is that although files can be 
deleted, in most cases the deleted files still exist but in an unreferenced way.  
They continue to take up storage and can even still be accessed (although the recovery process is very time consuming and complex).

568  
 Example: Deleted items recovery 
 In the run up to the 2016 US General  Election, the FBI were investigating 
Hilary Clinton’s use of her private computer server for classified 
information. Reports stated that de spite over 30,000 emails having been 
deleted, the FBI were able to recover some of the emails, both personal 
and work related. 
2.3 Network analysis 
Network analysis is focussed on monitori ng the amount of data moving across a 
network at a single point in time, often referred to as network traffic. It is a 
similar concept to monito ring traffic on the roads, although using quite advanced 
number plate recognition. The monitoring process doesn’t allow the company to see what is in the car (i.e. what data is being transferred), but it does tell you 
whose car it is that is on the road (i .e. which users are on the network).  
As with the traffic flow of cars – usua lly busy in the morning around 9am and the 
late afternoon around 5pm – there are pa tterns in the volume and identity of 
users on a network at a particular time . If there are unexpected users on the 
network, or if the level of traffic is une xpectedly high, these could be cause for 
concern leading to further investigation. 
Forensic analysis reviews this network tr affic after a cyber attack, to identify 
patterns in the traffic leading up to the infection. This information can then be 
used to help detect and mitigate future atta cks before they can have an effect.  
By sharing the data with ot her organisations, coordinated responses can be 
developed and IDS / SIEM systems can be improved. 
Analysing network traffic using third party cloud storage services can cause 
privacy issues that would not ar ise on company-owned hard drives. 
 
 Forensic analysis 
 After the attack on DigiNotar menti oned in the previous chapter, the 
Dutch government commissioned Fox-IT to carry out forensic analysis on 
the DigiNotar Network. As always wit h these incidents, the public never 
find out the whole story, but some repor ts say that they were able to find 
digital “fingerprints” on one of the servers and from this they were able to 
work out that it was the same attacker who had also compromised 
another certificate authority called Comodo based in New Jersey in 
America.  
This story suggests that the securi ty preventing unauthorised access to a 
firm’s network appears easier to get round than the security that certificates provide.

Chapter 10 
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 A similar situation happened with ca r security systems. Cars were 
becoming so hard to break into that criminals were breaking into houses 
to steal keys to cars, ra ther than breaking into t he cars themselves. The 
weakest link in any control is ofte n a mistake made by a person, for 
example leaving the front door unlock ed and the car keys near the front 
door. Relating this example back to cyber security, it could be an employee at a Certificate Authority clicking on phish ing email link allowing 
a hacker access to the network and ulti mately being able to issue rogue 
certificates, rather t han the hacker finding a way to impersonate the 
certificates. 
3 Malware analysis 
Ideally no malware would get on to an entit y’s systems, but the r eality is it will.  
Once malware has been identified, analysi s of the software should be carried 
out to understand as much as possible abo ut the malware. The aim of malware 
analysis is to understand how the malware  got on to the computer and its 
purpose, including whether it  was intended specifically for the organisation. 
Obtaining this information means organisa tions are better able to improve their 
defences in the future. 
3.1 Reverse engineering 
Reverse engineering is a commonly us ed technique – not just with regard 
malware. The process is used to deconstruc t the subject – to understand how it 
was designed and how it wor ks. In terms of cyber security and malware, the 
design and functionality are of intere st, but discovering how the malware 
infiltrated the system provides a key piece of information to help patch flaws and 
prevent further infiltration. 
Developers of malware are aware of the risk that thei r malware will be 
discovered and reverse engineered to learn more about it, so t hey aim to make 
it as difficult as possible to reverse engineer. A technique known as layering is 
used to protect the malware code and functi onality.  Several layers of code are 
written to protect the ma lware code and each layer must be uncovered, usually 
in different ways, before the malware c ode is revealed. A term used in IT to 
describe this is obfuscation (making some thing obscure or unclear). The more 
bizarre a hacker can make their malware code, the easier it will be for them to 
protect it. 
During reverse engineering, a key aim is  to discover whether the attack was 
targeted or not. Clearly, a targeted attack is more of a concern – it means you 
have something that someone wants and they  have taken the time to write code 
and hide that code to get at  it. Targeted attacks are likely to have better layering 
as they do not want the tar get to know where the atta ck comes from, what they 
are trying to access and why. Of course , untargeted attacks are still a concern 
as it means the organisation’s security  processes have been breached.  In the 
Mearsk example mentioned earli er it probably didn’t provide much comfort to 
know that the NotPetya was targeti ng the Ukraine – it still caused them 
significant damage.

570  
 Example: targeted attacks 
 Most targeted attacks are agains t organisations with a lot of 
information/data or with signific ant money. The number one most 
targeted organisations are Government s, and the second most targeted 
are financial institutions  (for example banks). 
3.2 Decompilation and disassembly 
Once the layers of code have been re moved and the organisation has access to 
the malware, it is vital that analysis is carried out to understand how it works 
and why it was put into their system, parti cularly if it was a targeted attack. 
Since the malware will be written in a specific programming language, it is 
important that appropriate tools ar e used and people with appropriate skills 
carry out the task. 
As in a fraud investigation, understandi ng how the opportunity  to infect the 
company’s systems occurred and discoveri ng the motive of the attacker will 
help the company understand what data/information is attractive and how it 
could be vulnerable. 
4 Penetration testing 
Penetration testing is another important step in the process of improving cyber 
security, it is effectively testing how good the cyber security of a company is. 
This can often involve the use of whit e hat hackers who are hired to try and 
penetrate the network or system. 
4.1 Network discovery 
Network discovery is sometimes called external network or infrastructure 
penetration test. This part of penetration testing proc ess involves understanding 
the scope of the network i.e. identifying a ll of the devices t hat are on a network 
and connect with the internet and other external systems. There are obvious 
devices like desktops, laptops, tablet s and smart phones, but as connectivity 
improves and the “internet of things” develops more and more, other devices 
are joining the network such as like printers, televisions, alarm systems, 
thermostats, lights and many more. 
Some of the issues that can be discove red through this type of penetration test 
are: 
 Operating systems, applications and server managemen t systems that do 
not have the most up to date security patches 
 Insecure or unused network protocols 
 Software, firewalls and operating system  that are not configured correctly

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 Internet of things (IoT) 
 The internet of things is a network  of devices, most commonly associated 
with devices around the home, where machines such as vehicles and 
home appliances contain software and sensors and communicate with one another either through the Wi-Fi or via Bluetooth. 
This allows simple tasks to be cont rolled and monitored from a remote 
location, for example; turning the heating on as you are going home.  
The internet of things can be applied to various forms of business too: 
the internet of medical things (IoMT)  or the healthcare IoT, the industrial 
IoT etc. In the business environm ent remote monitoring and control 
facilitates greater levels of automation or central control often provides an 
opportunity for efficiency savings. 
 
 IoT for business 
 The Internet of Things creates vu lnerabilities for both individuals and 
businesses because smart devices are not always sufficiently secure and 
can often be interrogated wirelessly to reveal access codes. 
A factory’s heating system could be c ontrolled by wireless sensors linked 
to the main server and a hacker pa rked outside could pick up the signals. 
In a business context, it may be wort h considering running network cable 
to replace wireless connections, and at  home it may be worth foregoing 
the convenience of being able to contro l the lights through your mobile 
phone. 
Hackers might try social engineering to gain access to the network by 
ringing staff and asking for passwords, or  make practical attempts such 
as trying doors that should be locked,  checking desks for passwords that 
have been written down and left visible etc. 
A business must decide whether the c onvenience that the IoT provides is 
worth the additional vul nerabilities and therefore se curity measures that 
would be required. 
4.2 Vulnerability probing 
Once the scope of the network is dete rmined, the next step is to identify the 
devices on the network that are most vulnerable to intrusion. 
Organisations can access online databases of known vulnerabilities or 
weaknesses that have been identified fo r common business systems.  Software 
can be used to probe the system and identify, quantify and rank the 
vulnerabilities in terms of  their potential impact.

572  
 Example: Smart breakfast 
 Fiction has for a long time used th e concept of being able to automate 
repetitive parts of life, for example the semi-aut omated breakfast in the 
film “Wallace and Gromit: the wrong tr ousers”. The concept of pressing a 
button to boil the kettle and start the t oaster while you are still in bed is 
now much more realistic, but the process turns mundane devices into 
potential security vulnerabilities.  
If the kettle or toaster do not have adequat e security features they could 
become the access point for a cyber-attack. 
4.3 Exploiting vulnerabilities 
The next step in penetration testing is to attempt to exploit the potential 
weaknesses by seeing: 
(i) If a white hat hacker can gain access to the system  and  (ii) What can be exploited usi ng the access that has been gained. 
For example setting up a fake administrat or profile able to install software 
(malware) onto the system or send dat a to an external source without 
authorisation. 
The goal is to understand if access is po ssible, how long it takes, and what 
access can be gained. As with most thefts, if the attacker is given long enough they will gain unauthorised access, but if the process is too consuming it can 
discourage the attacker from persisting. 
 
Example: Printer hackers 
 In 2018, a YouTube vl ogger appealed to his fans to help promote 
subscriptions to his channel because his position as ‘Most subscribed to creator’ on YouTube was under threat  from another YouTube creator. 
Some of his followers went to extreme lengths to help. 
They exploited security flaws in wireless printers around the world by 
taking control of them and printing  out a message urging the printer’s 
user to unsubscribe from their riva l and subscribe to the vlogger instead, 
then finally urging them to  “Fix your printer”. 
The hackers claim to have accessed over 100,000 printers around the 
world, but also say that since their hack, people have taken notice and improved security on vulnerable prin ters. They have also reportedly 
hacked into other devices such as Google’s Chromecast dongle, playing a video asking for subscriptions and again, highlighting the security flaw.

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4.4 Internal network penetration testing 
An internal network penetration test ident ifies any vulnerabilities that exist and 
are accessible to both approved and unappr oved users. As an attack can often 
have internal assistance, this test a llows an organisation to test the damage an 
internal user could do, but also considers if unauthorised access could be 
possible. 
The type of issues identified by this type of test are: 
 Inappropriate access by internal users 
 Unsecured workstations 
 Weak or unchanged passwords 
 
 As part of Kaplan’s security proc esses they have employed someone to 
try to hack into the system and set up an administrator profile to install 
malware, or pretty much what ever else they wanted.  
This is not a one off event, but something that happens on a regular basis 
– the hacker comes to a Kaplan office , so is on the internal Kaplan 
network, and attempts to set up the profile. The first time the person 
hacked in fairly quickly and was able to do everything they wanted. Kaplan were given a report from the hacker and worked on the various issues identified.  
The next time the hacker was asked to  attempt to gain access, whilst they 
did get into the system, they were unabl e to set up any profiles and failed 
to access any information or set up any malware. 
As ways to hack into systems develop, Kapl an will revisit this security test 
and continue to work on pr otecting Kaplan’s data. 
4.5 Web application penetration testing 
This aspect of penetration testing is to identify any security issues from poor 
design, coding and publishing. In the m odern business world, applications are 
critical to many organisation and are often used to process personal data 
including payments details; they can ev en process or store proprietary data. 
 Identify potential for injection (lack of validating processes) 
 Cross-site scripting opportunities 
 the ability for a user to gain access to  more of the application or site than 
they should (often called privilege escalation).

574  
4.6 Wireless network penetration testing 
This type of penetration testing is looki ng for any access points or devices that 
should not be in an organisations secured environment. 
 Open access points or rogue access points 
 Badly configured wireless networks 
 Accidental duplication of wireless networks 
 Insecure wireless encryption  
4.7 Simulated phishing testing 
Simulated phishing testing is used to asse ss how susceptible the workforce is to 
breaking security policies or divulging sensitive information either verbally, in an email or entering it into a website. 
 
 The example about Kaplan in chapter 9 discussed a situation where an 
coffee outlet was sent to all staff, this  is an example of simulated phishing 
testing. The members of staff who c licked on the link were identified as 
being more susceptible and so received additional training on how to spot 
suspicious communications and how to react to them. 
5 Software security 
Software security is the process of writi ng security into the software. As attacks 
on software can be complex, the security needs to be considered in different ways, typically there are three levels to consider: 
 Level 1  – This primary level seeks to pr event the attacker from gaining 
access to the software at all. 
 Level 2  – Unfortunately it is no longer realis tic to expect t hat preventative 
security will always work, so the second level is concerned with making 
sure that if a breach occurs an alert notifies the appropria te parties that an 
attack has breached the level 1 security. 
 Level 3  – While the alert will mean that  the appropriate parties can 
investigate the security breach, time is  critical in any attack and in a very 
short space of time data can be compromised, so the third level takes automatic urgent action, for example locking down accounts and sensitive 
information.

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5.1 Design review 
As with various techniques, if there is a focus on something at the very early 
stages it is easier to control the co sts or make the product/process more 
efficient. The same is true for software se curity. An organisati on should go right 
back to the design stage of key processes and systems to make sure that security is part of the design.  Some  systems and processes may well lack this 
focus as they were designed long bef ore the realisatio n of the power and 
importance that tec hnology would have. 
Of particular concern should be accessibilit y to PII, IP and financial information 
such as payment details. 
 
 Design review 
 The extent to which our phones, watc hes and, since the development of 
the IoT, other devices, have become int egral to the way we live and work, 
was not envisaged when the software for these devices was originally created. 
This has led to a need to improve the se curity features designed into the 
software. 
5.2 Code review 
A code review looks at how code is written, with a focus on how someone 
proves they should be allowed access to  a system that c ontains sensitive 
information. Often companies have an inte rnal manual detailing best practice 
and this stage of the review can check t hat software code is complying with the 
best practice manual. 
In terms of authentication processes, multi factor authentication is being 
introduced to reduce the risk of hacki ng and other security breaches and so 
help to secure an organisation. 
 
 Two step verification compared to two factor authentication 
 Lots of companies and suppliers  are switching to two factor 
authentication to increase security. Some have previously used two step verification which is still very secure. 
Two step verification  requires users to input two forms of the same type 
of information, each from a different  source, so for example a password 
that you remember as a first step, then a password that you are sent via 
email or SMS as a second step. 
Two factor authentication  requires the user to prove they should 
access the system in two different wa ys, so the first step could be the 
password that you must remember , but the second step requires 
something different – like a finger prin t or proof that you have the trusted 
device for the account.

576  
5.3 Security testing 
Finally in software security, in addition to  assessing the strength of the controls 
in key areas of vulnerability, an internal audit-type review will be required to test 
whether the controls are actually being carried out (compliance) and are 
appropriate for the risk  area (substantive). 
 
 Software security within organisations 
 Cyber security and compliance experts say that two of the key software 
controls in existence in most organisations today are version control and patch management. 
Version control  – links into network configuration management (NCM) 
and monitors the various devices on the network to make sure that the software operated is still supported by the software provider. As software 
gets older, the flaws in that so ftware become better known, and so 
become more susceptible to hacks. A fter a given period of time software 
providers state that a product is at  the end of its lif e and will no longer 
Patch management  – as discussed earlier this is where the software 
provider becomes aware of a flaw in their software that could be exploited 
by an attacker and issues an update to  the software to correct the flaw. 
Again using NCM organisations will push software updates through to 
devices. Depending on company policy and the severity of the flaw, this 
can happen at different times. Some  companies run updates on a daily 
basis, others do so less frequently but push through any critical updates 
ahead of planned updates. 
This sort of approach is compliant with ISO 27001 suggested controls. 
 
 Nimrag Plc are a large national reta il chain and recently have suffered a 
cyber-attack. They identified that the breach before any major damage 
was done, managing to limit the a ttack to one computer. It was 
discovered when their network m onitoring and logging processes 
highlighted unusual activity  from that desktop ev en when it was logged 
off. They were therefore able to det ach the computer from the network. 
To help them understand what happened and improve their defences in 
future they are carrying out forensic  analysis. The computer affected was 
an administrator computer which limit ed access to specific individuals.  
From reviews of logins to that te rminal the company could then review 
what had been accessed and downloaded. 
The breach occurred when one of t he senior administrators had 
accessed their personal webmail account and opened an email that 
related to their personal areas of in terest.  It appears that the email had 
been designed after researching the s enior administrator’s interests 
which were openly available on social media.

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 The file downloaded by the administrat or appeared to be legitimate, but 
hidden inside was unauthorised softw are that was allowed to run 
because of poor security awareness by  the administrator – the file 
continuously asked for approval to run until the senior administrator clicked ‘ok’. 
Which of the following statements are correct? 
A A policy on social media, preventing access to these sites from 
work computers, would have prevented this attack. 
B The attack was started by  a spear phishing email. 
C User training regarding how personal information can be easily 
accessed and used would have made the attack less likely to be successful. 
D User access controls to prevent employees visiting higher risk sites 
from a sensitive computer w ould help protect Nimrag better. 
E It appears the attack was caused by malvertising on the website the 
employee visited. 
F User training about how to spot and deal with suspicious emails 
may have helped reduce the lik elihood of this attack. 
G Network monitoring controls should be introduced to help reduce 
the impact of future attacks. 
 
 BHJ bank wishes to improve the cyber security in place over procedures 
for accessing a customer’s financial information within the system. It will 
now require users to confirm their i dentities in two different ways before 
allowing them access to  the information. 
Which ONE of the following fo rms of security does this new 
requirement represent? 
A Two step verification 
B Two factor authentication C Two part certification D Two layer validation

578  
 FTY company is a small family owned business making cakes and 
biscuits for sale in the local area.  The company’s systems link its head 
office, two factories and a temperatur e-controlled warehouse. The board 
of FTY is meeting to discu ss its cyber security risks. 
Which TWO of the following statem ents made by members of FTY’s 
board members are TRUE? 
A Cyber-attacks are an external th reat to the company’s systems 
B Keeping anti-malware and anti-viru s software up-to-date will ensure 
the company is protected from cyber-attack 
C Monitoring the amount of data movi ng across the network at a given 
time can alert monitors to potential attacks 
D The company will be protected fr om viruses provided staff never 
open emails from senders they don’t recognise 
E Endpoint protection only works if the scope of the company’s 
network is regularly reassessed 
 
 The board of directors at GS D company have been discussing the 
importance of improving cyber security. 
Which THREE of the following stat ements made by GSD’s directors 
about cyber security are TRUE? 
A The Internet of Things has in creased the import ance of endpoint 
security 
B Code reviews to audit application source codes will help establish 
whether proper system security controls have been built in 
C With the right software security in  place the company will be able to 
prevent the risk of a security breach 
D Black hat hackers can be employ ed to help the company identify 
vulnerabilities in the system 
E Business process controls are an im portant tool in strengthening the 
company’s defences against cyber risk

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 After a recent cyber attack BTR com pany has employed a specialist team 
to perform a forensic analysis to learn more about the attack. 
The team has just identified several services that have been enabled so 
that they can be access ed without authorisation. 
Which area of the team’s forensic analysis would have been MOST 
likely to identify this change? 
A System level analysis 
B Vulnerability probing C Network analysis D Penetration testing 
6 Digital resilience 
In their book, Beyond Cybersecurity: Protecting Your Digital Business, 
published in 2015, Tucker Bailey, Jame s Kaplan, Alan Marcus, Derek 
O’Halloran and Chris Rezek discuss a c oncept called Digital  Resilience. The 
concept is about doing more than the minimum to protect the company and 
comply with regulations, but  to integrate cyber security into the business 
They identify six actions an organisation mu st consider to achieve their digital 
resilience, each of the six actions is considered below. 
6.1 Identify all the issues 
First of all a company must consider  what information is at risk, what 
information an attacker may want and why they may want it. Then they should 
consider the controls an attacker would need to circumvent to access the data they desire – for example to access a system the user needs a valid username 
and password, all systems access is logged,  data within a system is restricted 
to a user’s needs etc. 
The key is then to integrate this k nowledge as the defences will be much 
stronger if they operate t ogether than if they are co nsidered in isolation. 
6.2 Aim toward a well-defined target 
The logic here, as with all good targets, is  to set a cyber security plan that is 
challenging but attainable - to help moti vate people towards achieving it. It is 
also important to translate it into language that people can understand, so that 
non IT leaders within the organisation can explain it and make sure that the 
workforce support the plan. 
The well-defined target should include priori tisation of the cyber security risks to 
the business. Once these have been asse ssed they can use three types of 
control to improve the security. 
 Business process controls – for example SOAPSPAM (see chapter 6) 
 IT controls – for example passwor d protection to login to a system. 
 Cyber security controls – for example encryption.

580  
The tendency is often to focus on the fi nal one of these, which can lead to 
unnecessary expense. 
6.3 Work out how best to deliver  the new cyber security system 
This area links into change management, and looks at how a company takes 
these challenging targets and turns them in to a reality. As wit h all controls the 
workforce can often resist what are perce ived to be additional controls believing 
they will inhibit creativity, cause probl ems with current procedures or increase 
the time to get things done. 
Roles and reporting are import ant here, and part of the adv ice is to have a high 
level manager responsible for all aspects  of cyber security, perhaps reporting 
into the board or potentia lly dual reporting into t he leading risk manager within 
the company too. 
6.4 Establish the risk resource trade offs 
Considering the risk resource trade offs takes account of  the fact that there is 
no one solution to managing cyber risk and that different companies have 
different attitudes towards ri sk and different risk appetites. 
The guidance here is that different options should be created each of which 
require different levels of resources and reduce risk to different levels. The 
board can then assess the different opti ons and choose the option that is most 
appropriate for the organisation. 
 
 Example 
 A company could set up three packages: 
Basic – this would be the lowest cost package and lead to the lowest 
level of security, only covering absolu tely essential (legal) requirements. 
Standard – this would be a package t hat included a higher level of 
security, potentially in line with activities of a business’s primary competitors. It would also cost more to implement than the basic 
package. 
Premium – this package would include the top level security, and could 
potentially differentiate a firm from its rivals. It would also cost a 
significant amount more than the other packages. 
This is just an illustration and four  or five different packages maybe 
created for analysis and selection. 
6.5 Develop a plan that aligns business and technology 
Meeting regulatory requirem ents is important for all companies but identifying 
the key business risk areas and ensuring that cyber security processes are designed to deal with the biggest issues must be a priority. 
This should not just be limited to current  operations, it is also important for 
senior people within the organisation to  understand internal developments and 
projects and consider how these will impact cyber security in the future.

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 Example:  
 If a company, or some part of the organi sation, has just started to use, or 
is considering using, cloud based softwar e or storage, then it is important 
that cyber security processes are aligned to this. 
6.6 Ensure sustained business engagement 
Cyber security is increasingly cited by directors and CEOs as being the biggest 
risk area for business and so it is one t hat must be addressed at a strategic 
level. Financial backing for cyber security  is not the only consideration - as with 
all risks, cyber security risk management requires attention across all aspects of the business from the board level ri ght down to the operational staff. 
 
 Example: GDPR and Kaplan 
 GDPR came into force in May 2018 and to reduce the risk of non-
compliance all staff need to be trained.   At Kaplan all staff, even those 
who are not regularly involved wi th handling private information on 
computers, have been trained. This in cludes for example the warehouse 
staff who prepare t he orders for shipment –  they are handling personal 
data and if the wrong delivery note wa s put into the wrong delivery 
package this could potentially reveal confidential information to another 
Kaplan customer. 
 
 The board of BKM company has been m eeting to consider the company’s 
digital resilience as they are planning to launch a digital resilience programme.  They plan to integrate cyber security into their business 
operations using a six step approach. 
They have established the cyber risks they are facing and have defined 
the programme objectives.  An organi sation structure showing the key 
roles and responsibilities has been developed and a suitable firm of specialists has been identified to assi st BKM develop the programme.  A 
mechanism to track on-going progre ss and reinforce cyber security has 
also been agreed. 
Based on the information provided  which TWO of the following 
actions from the six-step approach has BKM not yet taken? 
A Establish the risk v resource trade offs 
B Ensure sustained business engagement C Develop a detailed plan to align with business and technology D Identify all the issues  E Determine how to deliver the system

582  
7 Frameworks 
As cyber security risks and cyber securi ty risk management increase in focus, 
so too does the need to report on them to stakeholders. At present there is no 
regulatory requirement to report on cyber security and, because of the 
complexity and rapidly changing environment in  which cyber security sits, it is 
unlikely any regulatory r equirements will come in.  
This has left both organisations and stakeholders in a difficult situation. 
Organisations would like their stakeholders to know that they have robust cyber 
security procedures in place, but don’ t know how to convey this to the 
stakeholder. Equally stakeholders are c oncerned about whether cyber security 
is receiving the attention it requires within the organisation but don’t know if 
what they are told has any real meaning. 
As a result, frameworks have been created that, although they are not 
mandatory, give an organisation somethi ng credible to show stakeholders to 
confirm that they do have robust processes and controls in place. 
7.1 AICPA 
 CIMA & AICPA 
 Since 2011 CIMA and the American Institute of Certified Public 
Accountants have been working together .  In 2012 they launched the 
Chartered Global Management Acc ountant (CGMA) designation and in 
2016 members of each association approv ed the creation of a new global 
association representing management  and public accountants on a global 
level. In 2017 the Association of In ternational Certif ied Professional 
Accountants AICPA was formed. 
 
In 2017 the AICPA launched a cybersecurity risk management reporting 
framework that would: 
“Assist organisations as they communica te relevant and useful information 
about the effectiveness of their cyber security risk management programs.” 
The information included in the r eporting framework is designed to: 
“Assist senior management, boards of directors, analysts, investors and 
business partners gain a better under standing of organisations' efforts.” 
The aim of the framework was to consider the needs of the various 
stakeholders in any organisation from t he board, managers, investors, funding 
providers, etc by using a common language for risk ma nagement reporting – 
along similar lines to financial reporti ng principles. Part of the process 
emphasises that cyber security is no longer  just an IT problem (if it ever was 
just an IT problem), but it is part of  the enterprise risk management process.

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 Cyber security concerns for stakeholders 
 The board and regulatory authoritie s are not the only stakeholders 
concerned with minimising the risk of cyber-attacks and associated 
losses. Customers and other stakeholders are concerned that their 
personal information is safe, while investors and business partners are 
interested in how cyber-attacks woul d affect the business and therefore 
their investment. 
Some institutional investors have been asking boards about their 
organisations’ cyber security ri sk management programs as a way to 
gauge the risk to their investments. 
7.2 Cyber security risk management reporting 
The framework the AICPA have set up r equires management to prepare certain 
information and then for a qualified accountant  at the organisation to review it. 
The report has three key components: 
 Management’s description  
 Management’s assertion  
 The practitioner’s opinion 
 
 More on the three key sets of information 
  Management’s description 
This first section provides a descr iption of the firm’s cyber security 
activities, including how the organisa tion identifies its most sensitive 
information, how it manages the cyber risks associated with this information, what the key polices and processes it has in place to protect against the risks etc.  The descriptions should be in 
accordance with AICPA description criteria. 
This part of the report provides the context for the next two sections. 
 Management’s assertion 
This section gives management the opportunity to state whether, in 
their opinion, the risks were descri bed in accordance with the criteria 
and whether appropriate controls were in place and effective. 
 The practitioner’s opinion  
The final section is where a qual ified CPA accountant gives their 
opinion on the description of the ri sks and whether the controls in 
place are effective.

584  
7.3 Criteria 
As with all approaches to analysing risk, ident ifying key considerations is easier 
with a model, tool or guide of some de scription. For example, PESTEL is a 
classic tool to assist in identifying threats and opportunities for a chosen firm. 
To assist with the writing and evaluati on of the management description and to 
improve the comparability of  the reports produced the AICPA uses two sets of 
criteria: 
 Description criteria 
This is a detailed (33 page) document  giving guidance on the areas that 
should be considered when identifying t he cyber security risks the entity 
faces and the controls it puts in place. 
 
 More on the description criteria 
 The description criteria incorporates the attributes  of suitable criteria as: 
Relevance  – to the business operation 
Objectivity  – free from bias 
Measurability  – the criteria can be r easonably measured using a 
consistent approach. 
Completeness  – that relevant factors (that could affect the decisions of 
the users of the repor ts) are not omitted. 
There are nine categories  of description criteria  that the management 
should consider, including the considerations in developing control 
 Nature of business and operations 
An explanation of what business t he entity is involved in and day to 
day operations. 
 Nature of information at risk 
Consideration of the types of s ensitive information the entity is 
involved with (creation, collection,  transmission, storage) that would 
be subject to cyber security risk. 
 Cyber security objectives 
To explain the entity’s main cyber security objectives. Consideration 
should be given to availability, conf identiality, integr ity of data and 
processing, plus the process for establishing, maintaining and 
approving the objectives. 
 Factors that have a significant e ffect on inherent  cyber security 
risks 
– technologies, connection types, service providers and delivery 
channels 
– organisational and user characteristics 
– changes in the period that could affect cyber security risks 
including environmental, technolog ical, organisational or other 
aspects

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 585 
  Cyber security risk governance structure 
Consideration of the processes involved in making sure that 
integrity and ethical values are at  the heart of cyber security risk 
management. It also considers b oard oversight, accountability, 
recruitment and development of qualified personnel.  
 Cyber security risk assessment process 
– consideration to how cyber security risks and other factors 
that could affect the progr am have changed in the period. 
– risks related to the achievement of cyber security objectives. 
– considering the risks associated with business partners and 
vendors. 
 Cyber security communications and quality of cyber security 
Disclosure about how objectives, expectation and responsibilities 
are communicated to appropriate st akeholders, both internally and 
externally including thresholds for when an event/response requires 
communication. 
 Monitoring of the cyber security risk management program 
Disclosure of the process used to assess the effectiveness of key 
controls in the cyber securi ty risk management program. This 
should include information about action taken when threats or 
control weaknesses are discovered. 
 Cyber security control processes 
– the process for developing a response to, and where 
necessary mitigating, the assessed risks 
– the characteristics of the entit y’s IT infrastructure and network 
– the key security processes and policies to address the cyber 
security risks identified 
 
 Illustration of application of description criteria 
 Below is an example of the di sclosures which may be made by a 
manufacturer, distributor and reta iler of consumer products when 
applying aspects of the description criteria. 
 Nature of business operations 
What it manufactures, where this  takes place, how it makes its 
sales (online, in store), the ma in regions it makes sales. Any 
collaborative ventures used to ma ke sales and distribute goods. 
Financial information for reporting, sales information (customers, 
pricing, orders), payment card details of customers retained for ease of ordering, customer prof iles, product specifications and 
design ideas, employee information.

586  
  Cyber security objectives 
Availability  – consideration of the need to provide 24 hours a day, 
365 days a year sales opportunities online, the need to supply manufacturing information during shift hours 
Confidentiality  – keeping employee and customer information 
confidential and complying with la ws around this (including credit 
card details), corporate data on sales and financial reporting  
Integrity of data  – preventing the impr oper modification or 
destruction of data to support t he production of information for 
internal and external reporting pur poses and to assist with business 
Integrity of processing  – making sure there are controls to 
prevent improper use, alteration or destruction of systems to support deliveries, processing tr ansactions, manufacturing goods to 
the correct specifications and pr otecting employees in hazardous 
situations in the manufacturing facilities. 
Process for establishing, maintaining and approving the 
objectives  – the board establishes and approves overall objectives, 
this feeds into business objective s and the most senior IT manager 
aligns cyber security objectives which are then approved at board level. May also include references to relevant standards for example GDPR, ISO 270001 and PCIDSS. 
 Factors that have a significant eff ect on inherent cyber security 
risks 
For a manufacturer, distributor  and retailer could include: 
Technologies, connection types,  service providers and delivery 
channels: 
ERP systems 
Cloud provider  Call centre Virtual Private Network (VPN) for a sales team Software providers Organisational and user characteristics : 
A description of the IT teams organisational structure: 
– Chief Information office (CIO) – Teams to support applications, technology and security – Chief Technology Officer (CTO) in the technology team – Chief Information Security Office r (CISO) in the Security team 
The users of the systems: 
– Customers both consumer & wholesale 
– Any business partner em ployees with systems access 
– Call centre staff (potent ially could be third party) 
– Employees

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Changes in the period that could affect cyber security risks it be 
environmental, technological, orga nisational or other aspects : 
For example an additional manufacturing operations set up, how this was 
carried out and what IT infras tructure was in place. 
Also any security incidents that occurred during the period should be 
included here: 
Any attempted hack e.g. a DDoS on the website, the implications of the 
attack e.g. any compromised data like PII of consumers or commercial customer info, the work done to fix the issue, potentially including outside 
contractors helping to review t he issue, any changes to security 
procedures as a result. 
 Cyber security risk governance structure 
Integrity and ethical values are at  the heart of cyber security risk 
management, may include: 
– Tone from the top – Code of ethics – Policy and reward structur es promoting control and 
– Board activities, for ex amples review meetings 
– Employee policies – code of conduct, employee handbook, IT 
policy 
Board oversight:  – Details of the boards IT experience, including NEDs – Details of any specific committees for example a risk 
committee 
Accountability: – the work of any risk committees – reporting lines for people like the CISO, CTO Recruitment and development of qualified personnel in cyber 
security: 
– Evaluation of applicants education, experience and 
background checks 
– Signing handbook adhering to po licy, confidentiality and non-
disclosure agreements. 
– Regular training as required – Policy on contractors – Organisational charts 
– Annual appraisals 
– Policies on performance impr ovements for underperforming 
staff

588  
  Cyber security risk assessment process 
The process used to identify cyber security risks and other changes 
that could affect the risk m anagement program and to assess risks 
related to the achievement of  cyber security objectives. 
– Annual risk assessments – Internal audit cyber security reviews – Vulnerability assessments and penetration tests 
Considering the risks associat ed with business partners and 
vendors: 
– Vendors assessed against cyber threat criteria 
– Tiering system based on the goods /services provided and the 
importance to the company 
– Vendors must detail hardware, software and information 
requirements of the work done  
– PII or confidential information only disclosed as appropriate 
– Annual risk assessments, incl uding regulatory requirements, 
changing vendors, economic changes 
Disclosure about how objectives, ex pectation and responsibilities 
externally.  
– Internal policies, available as required (intranet) – Handbook, signed upon hiring – Training course – Cyber security specialists to undertake additional training 
– Communication policy to report security events (e.g. phishing 
attacks) 
Including thresholds for when an event/response requires 
– Disclosure policy – Events assessed by appropriate committees – Legal and communications experts used as required 
Effectiveness of controls in t he cyber security risk management 
program.  
– Any frameworks involved (ISI 270001), NIST cybersecurity 
– Internal audit tests – Regular vulnerability asse ssments and penetration tests 
– Reports from external suppliers (cloud services) 
– Risk based assessments (internal and external)

Chapter 10 
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 Information about action taken w hen threats or control weaknesses 
are discovered. 
– The work of any risk committees – Vulnerability tracking incl uding any mitigation required 
– Use of KPIs to assess respons es to threats or weaknesses 
The process for developing a response to the assessed risks. 
– Development of any committees – Work of committees – Insurance (business disruption) 
The characteristics of the entitie s IT infrastructure and network 
– Description of internal networks – Cloud based applications and management – Segmentation to limit exposure of any breach 
– Controls over any third party access, for example call centre 
work 
– Authentication processes us ed for any employees using a 
VPN connection 
The key security processes and policies to mitigate the cyber 
– Policies and procedures about use of information 
– Preventative measures such us er specific access, data back 
up, antivirus softwar e, patch management 
– Detective measures like a securi ty team monitoring activity for 
unusual events and a response plan 
– Reviews of process capacity to assess adequateness and 
alert levels established and set 
– DRP and BCP processes, back up sites with sprinkler systems 
to put out fires, secure d physical access to site 
– Policies for retention and destruction of data in accordance 
with legal requirements 
 
 Control criteria 
This is even more detailed (over 300 pages) document giving guidance on 
the types of risks and controls that  may have been identified in the 
description criteria and exam ples of other controls that could be used, that 
managers and qualified acc ountants can use in their assertions and 
reports. There are significant referenc es to the COSO Internal Control 
Framework, which should not be surpri sing given that cyber security risk 
management is concerned with consi dering the effectiveness of the 
controls in the organisation’s program.

590  
 Example of information in the control criteria guidance:  
 The document is a wide ranging document, but this gives an insight into 
the contents. 
Consideration : 
The organisation has a structure, r eporting lines and responsibilities to 
aid the development, operation and monitoring of systems to manage 
security risks. 
Example risk : 
The structure does not provide necessary resources or enable 
appropriate flow of informati on to manage security risks. 
Possible control : 
The organisation reviews organisational  structure, reporting lines and 
responsibilities as part of its ongoi ng risk assessment and revises these 
as appropriate to meet system and security needs. 
Physical access to the facility/faciliti es where the data centres (or other 
critical equipment) are lo cated is limited to au thorised personnel only. 
Example risk 1 : 
Unauthorised access could be gained to the location leading to damage, 
fraudulent processing or information being compromised. 
Possible control 1 : 
The organisation issues ID cards to all authorised personnel and the 
facility has an access control system  at all entry and exit points. 
Example risk 2: 
A person who has had access revok ed either through termination of 
employment or change in employment  role continues to access the 
facility. 
Possible control 2 : 
The personnel responsible for access to the facilities review access to the 
restricted facility on a regular bas is and requests for changes are made 
promptly. 
Processing capacity is sufficient to meet usage requirements including at 
peak demand requirements 
Processing capacity is insufficient to  meet system requirements and peak 
demand requirements. 
Processing capacity is monitor ed on an ongoing basis and assessed 
against KPIs.

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 Consideration : 
Disaster recovery plans (DRP) to s upport system recovery are tested to 
make sure they meet the or ganisation’s commitments and system 
DRPs are not designed appropriately and backups are not enough to 
allow recovery of the s ystem to meet the organi sation’s commitments and 
system requirements. 
Business continuity plans (BCPs) and DRPs including restoring backups 
are tested at least annually. Test re sults are reviewed and plans are 
adjusted accordingly. 
Mitigating controls exists to prevent  or detect and correct errors in 
processing to meet processing in tegrity and system requirements. 
Processing error, fraudulent action or another external event leads to 
data loss. 
Daily incremental backups are autom atically performed and full weekly 
backups are also carried out. 
Confidential information is protect ed during system design, development, 
testing and implementation to meet organisational confidentiality and 
system requirements.  
Data used in test systems is not  appropriately protected from 
unauthorised access and loss. 
The organisation uses masking software to  create test data that removes 
and replaces any confidential data wit h dummy data prior to the creation 
of the test database. 
The organisation’s privacy commitment s are communicated to internal 
and external users appropriately, and internal users are able to carry out 
their roles as required while adhering to those commitments. 
Internal and external users are not aware of the privacy commitments 
and how PII is collected and used.  
The organisation makes its privacy commitments and practices available 
to all data subjects both internal and external upon first collection of data, 
and any updates to policy are comm unicated as appropriate and through 
agreed preferences to the data subject.

592  
This gives a flavour of the content, but it is impossible to reproduce it all in this 
chapter. There are huge amounts of info rmation available to help organisation 
implement the AICPA cyber security  risk management framework. Further 
research is possible just type it into a search engine, but be careful to only click 
on secure and trusted sites. 
7.4 NIST cybersecurity framework 
 NIST 
 The NIST is the National Institute of Standards and Technology. It is a 
non-regulatory agency of the US departm ent of Commerce. As with many 
governments around the world they seek to give advice about cyber 
security. In the UK GCHQ has a section called the National Cyber 
Security Centre that gives advice to UK organisations and individuals 
about staying safe online. 
 
The NIST cybersecurity framework is voluntary guidance to help organisations 
mitigate cyber security risk. As with  the AICPA framew ork, part of the 
framework covers communications with internal and external stakeholders. 
The Cybersecurity Framework consists of three main components: 
Implementation Tiers 
Implementation Tiers prov ide context – helping organ isations to choose the 
appropriate level of rigor for their cy bersecurity programmes and often used as 
a communication tool to discuss risk appetite, mission priority, and budget. 
Core 
The core provides a set of desired cyber security activities and outcomes using 
simple easy to understand language. The core is based on five principles: 
 Identify  threats to an organisations systems and data 
 Protect  against threats. 
 Detect  when a system has been breached. 
 Respond  effectively to systems breaches 
 Recover  any compromised data and the systems affected. 
Profiles 
Profiles help the organisation map its own requirements and objectives, risk 
appetite, and resources against the desired outcomes included in the core.   
7.5 AIC Triad 
Another commonly used approach to cyber se curity is the AIC Triad (sometimes 
also referred to as CIA Triad (alt hough it has no connection to the Central 
Intelligence Agency) and also the Security Triad). The model is aimed at helping 
organisations understand information security  and set up policies to help protect 
It is known as the AIC (or CIA) Tri ad because of the three elements that 
underpin it, seen by many as the most important aspects of cyber security.

Chapter 10 
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 Availability  – put simply systems must be online and available, otherwise 
organisations cannot do business. 
 Integrity  – making sure that people who modify data are authorised to do 
so means the data is more likely to be accurate and trustworthy. 
 Confidentiality  – when data is being stored and when it is in use or in 
transit there need to be rules in plac e to limit access to those who are 
authorised to use it. 
Hopefully you will recognise these as being fundamental concepts that are part 
of the AICPA approach, but this prov ides a more accessible approach, and 
therefore is more likely to be the start point for smaller businesses. 
 
 AIC Triad in more detail 
  Availability 
As online is increasingly becoming the main way that organisations 
do business, keeping the system onl ine becomes more and more 
important. Organisations can use a variety of methods to help 
protect against downtime: 
– Keeping up to date with software patches 
– Understanding networks r equirements and busy times 
– Disaster recovery planning – Business continuity planning 
 Integrity 
Integrity relates to how trustworthy t he data is, so it is important to 
ensure that is cannot be alter ed during processing and only 
authorised users have access to make changes. Some of the considerations to protect integrity are: 
– User access controls – Checks on data to ensure it is the same before and after 
transmission 
– Version controls, so if data is  accidentally deleted back up can 
be restored. 
Confidentiality and privacy are often used interchangeably in the 
way the AIC triad works. It is focu sed on putting controls in place to 
ensure that private information is onl y viewed by those authorised to 
see it. Often companies will categor ise data relating to different 
levels of risk should it fall into the wrong hands, with more stringent 
controls in place around the most sensitive data. 
Considerations to ensure confidentiality include: 
– Training on risk factors and pr otecting against them including: 
– Social engineering approaches – Password best practices – Data encryption

594  
 Technological advances mean that all frameworks including the AIC triad 
must evolve. Some developments that  pose particular challenges include: 
Big data  – extra challenges arise because of the huge volume of 
information that needs to be protected,  the variety of sources and types 
of information and the speed with which it is updated. Making use of it 
can be challenging, but also making sure  that it is accessible, trustworthy 
and private can become very costly. 
Internet of things  – as with any network, the more you increase the size, 
the more access points are creat ed and so the bigger the threat 
becomes. The issue for the AIC tr iad is both privacy and security. 
Privacy  – it may only be fragments of dat a that are accessible from each 
of the various endpoints, but when they  are collated they can constitute 
personally identifiable information.  
Security  – while computers get regular  software patches and invariably 
have good security configurations, many  of the devices in the IoT that 
connect to them don’t have the ability  to receive software updates or do 
not require passwords. 
 
 BPR company has included the followin g paragraph in its Assertion of 
Management section at the start of its cyber security risk management 
report. 
We assert that the description thr oughout the period January 1, 20X1, to 
December 31, 20X1, is presented in accordance with the description 
criteria. Our cyber security team, which has unparalleled cyber security 
expertise, has performed an extensive evaluation of the effectiveness of 
the controls included within the cy ber security risk management program 
throughout the period, using the required criteria for security, availability, 
and confidentiality.  Based on this evaluat ion, we assert that the controls 
were effective throughout the period January 1, 20X1, to December 31, 
20X1, to achieve the entity’s cyber security objectives based on the control criteria. 
Which one of the following attri butes, required by the AICPA 2017 
cyber security risk management reporting framework, has been breached by this paragraph? 
B Objectivity C Measurability D Completeness

Chapter 10 
 595 
 KQT company was advised that it  could purchase cyber security 
insurance to mitigate some of the risks associated with a cyber security 
attack and after an investigation to  determine whether it would be 
worthwhile, purchased appropriate cover with a reputable insurance 
company. 
The board is aware that this decision may impact the disclosures included 
its report ‘Description of KQT company ’s cyber security risk management 
program’ which is produced in acco rdance with the AICPA 2017 cyber 
security risk management reporting framework. 
Which of the following matters shoul d be disclosed in the report? 
A The insurance company used B The insurance policies chosen C The process for identifying which risks could be mitigated by the 
purchase of insurance 
D The amount spent on cyber security insurance E The role of insurance in the company’s risk control processes 
 
 FHG company designs and manufactures technologically advanced 
products which it sells to busine ss customers via an on-line ordering and 
payment system. The market is highl y competitive, and employees are 
required to sign confidentiality agreements before t hey are appointed, 
after which they are entered into t he payroll system by an outsourced 
payroll service.  FHG company is financed by a mixture of equity and long-term bank loans. 
The board of FHG is aware of the requi rement to consider the needs of 
stakeholders when reporting on its cyber security risk management 
programme. 
Which of the following stakeholders should FHG take into account 
when producing their report? 
A Competitors B Shareholders C Customers D Payroll service providers E Lenders

596  
 The management of WRT company are confident that the controls they 
have set up to protect the company against the risk of a cyber security attack are effective. They intend to co mmunicate this to stakeholders in 
the company’s cyber security risk management report, which is being 
produced in accordance with the AICPA 2017 cyber security risk 
management reporting framework. 
Which section of the report should management use to 
communicate their belief in the effectiveness of the control 
A Description of the cyber se curity risk management program 
B Practitioner’s opinion C Management’s assertion D Chief information security officer (CISO)’s report 
 
 In order to improve the cyber se curity risk management, the board of 
YTD company have insisted that all employees mu st read and then sign 
a copy of the cyber security risk policy handbook. 
The company cyber risk security team  is now considering the content to 
be included in its report ‘Description of  YTD company’s cyber security risk 
management program’ which is to be produced in accordance with the 
AICPA 2017 cyber security risk management reporting framework. 
Which TWO of the following heads within the report would be MOST 
likely to contain a reference to this policy? 
A Cyber security objectives 
B Factors affecting inher ent cyber security risks 
C Cyber security risk assessment process D Cyber security communications E Cyber security risk governance structure

Chapter 10 
 597 
 Test your understanding 12 – Nouveau Cakes (Case study) 
 Scenario 
Nouveau Cakes Ltd is an online cake making and delivery company 
based within close proximity to the c apital city and with good transport 
links to the rest of the country. They offer to make delicious cakes for any 
special occasion, with a wide variety of designs and deliver them to the 
customer’s door withi n 24 hours of ordering on their website. 
They have been in operation for 5 years and originally started when 
founder and current executive chair Larissa Shazam became disillusioned with her office job and decided to follow her passion for cake 
baking. She originally audi tioned for a television bak ery contest to try and 
raise her profile but failed to get  through the auditions. Undeterred she 
started doing local cake making and delivery within her home town and 
surrounding village.  
She quickly built up a good reputation, and started to use social media to 
raise her profile. Requests for cakes star ted to come in from further afield 
due to her presence on social media and, keen to capitalise on this interest, she collaborated with a loca l distribution company and applied to 
the bank for financing to increas e the size of her operation. 
The company now has its own website wh ich is the primary source of its 
orders and regular custom ers are able to set up an account for ease of 
ordering and payment. The company  has had to collaborate with a 
national logistics company for their next day delivery services as the demand for its cakes is incr easing throughout the country. 
Trigger 
The finance director asks you in her office, she’s holding a copy of the 
local newspaper, and is looking concerned. 
“Thank you for the work you did for me last week, it was really useful. I 
need your help again, I’ve just been reading about a local company that 
has suffered a major setback due to  a hacker gaining access to their 
customer database. I’m concerned that  as we expand, we may become a 
target for such activi ties.  We have hundreds of  regular customers who 
have set up an account and have stored payment details. 
A friend of mine works in IT and is obsessed by cyber security and was 
telling me all about the various frameworks and how they can be reported now. I didn’t really understand it all, but I understand there are loads of 
different approaches and that there is currently no standard approach. I 
wondered if we should be doing somethi ng on cyber security now. I know 
Larissa is considering listing the co mpany if our success continues, she’s 
even talking about overseas expansion!

598  
 Task 
Please can you prepare the following for me for a meeting I have with 
Larissa and the rest of the board to morrow morning. I need it within the 
hour so I can have a good look over it and ask you any questions: 
(a) Outline the issues that we should be considering with regard to 
cyber security.  (15 minutes)  
(b) An evaluation of the benefits and risks of adopting a cyber security 
framework. (15 minutes)  
(c) A brief evaluation of the cyber security frameworks available and a 
recommendation for which one we should use. (15 minutes)  
 
 Test your understanding 13 – Couchweb (Case study) 
 Scenario 
You work as a senior manager fo r Couchweb, a media streaming 
company which offers access to media content over the internet at any 
time and from anywhere. Subscribers pay  a small monthly fee, in return 
for which they can log into Couchweb’s website and view content online. Subscribers can connect to the servic e using almost any device that can 
access the internet, including smart televisions, laptops, tablets and smartphones. 
The content is exclusively enterta inment, primarily TV programmes and 
movies. Subscribers log in using their own devices and can search 
Couchweb’s catalogue until they find so mething they wish to watch. The 
chosen content is then streamed to their device. They can watch their 
choice of programmes while they ar e connected to the site, but until now, 
they have not been able to download the material to watch offline. 
Trigger 
local newspaper, and is looking concer ned. She passes a copy to you. 
Mayland Daily News 
Couchweb launches new app 
Couchweb has launched a new app that permits subscribers to download 
up to five programmes or movies to a portable device such as a laptop, 
tablet or smartphone. This was created in response to feedback from subscribers, who would like to watch their favourite TV  programme while 
commuting but cannot always acce ss the internet while doing so. 
Once a subscriber reaches the limit of five items, the website prevents 
the download of further content un til one or more of the previous 
downloads have been deleted. Th e content is encrypted to prevent it from 
being copied and used for some other purpose. 
Couchweb reported an enthusiastic uptak e of the new service. More than 
11 million subscribers had downloaded the new app within 24 hours of its 
launch.

Chapter 10 
 599 
 “As you can see from this newsp aper article, we launched the new 
download app yesterday. However we have already had to suspend the download service. Ronsteel Producti ons, one of the studios that license 
most of our content to us, has already discovered some of its 
programmes on internet pirate sites. The electronic signatures on those files indicate that they originated from Couchweb. 
In preparation for the launch of the app,  we encrypted copies of the files. 
These should have been impossible to play other than through the 
subscriber’s app, linked to the su bscriber’s Couchweb account. The 
encryption has been extensively tested,  but we now know that it is 
possible to defeat it. 
We have been able to identify the subscribers who were responsible for 
the pirated copies and have c ancelled their subscriptions. 
Task 
The CEO has asked me to brief him later today and I need your help in 
preparing for the briefing. I need practi cal advice on the following matter: 
(a) How would Enterprise Risk Management (ERM) provide an 
effective approach to the prevention of this type of incident at 
Couchweb in the future? (30 minutes)

600  
8 Chapter summary

Chapter 10 
 601 
 The correct answers are B, C, D and F. 
The attack did start from a spear fishing email, a spear fishing email is 
one that is specifically ta rgeted at a particular user. 
User training to help people understand what information is available 
about them online, how it can be used, and how to spot suspicious emails 
may have prevented the attack happening. 
User access controls preventing employees visiting sites of personal 
interest on work computers would have prevented this attack. 
A policy on social media preventing access to these sites from work 
computers would not have stopped this attack, the infection didn’t come 
from a social media site and prevent ing employees from using social 
media entirely is unlikely to be enforceable. 
The attack seems to describe a Trojan ma lware, as it is disguised in what 
seems to be a legitimate file. There is no mention of advertising on the 
websites visited which is how malvertising works. 
Nimrag already have network monitoring controls and they appear to be 
working well having limited the damage caused in this case. 
 
Two factor authentication is  a method of confirming the identity of a user 
in two different ways (e.g. pa ssword plus finger print).   
Two step verification is another method of  confirming a user’s identify by 
using one type of information (for example passwords) but using the 
information from two different source s (e.g. user-remembered plus texted 
code).  
Certification is a method of prot ecting data sent between two parties 
which is locked using a public code but can only be unlocked using a private code.

602  
Networks are often more extensive than businesses realise and endpoint 
protection must be extended to cover any new entry points. Levels of 
data traffic across a network can o ften be predicted and unusual levels 
can be signs of suspicious activity.  
Cyber attacks can come from disgruntled employees inside the 
organisation.   
Malware and virus protection software are vital but are not sufficient to 
guarantee an organisation is safe from  cyber-attack (in practice all 
organisations are always at risk).   
Emails containing viruses can come fr om known senders (or purport to). 
 
The Internet of Things (Connecting ev eryday objects via the Internet) has 
expanded the size of co rporate networks, incr easing the number of 
access points and thus increasing the importance of endpoint security.   
Basic business process controls ar e as important as IT and cyber 
security controls in protecting businesses from cyber risk.   
Code reviews are designed to audit source code and verify the existence 
and correct working of security controls.   
Black hat hackers are malicious hacke rs working without the company’s 
permission – white hat hackers work with the company to help identify 
system weaknesses.   
No level of software security can fu lly eliminate the risk of a security 
breach. 
 
 The correct answers is A 
System level analysis is designed to  identify what parts of the system 
have been affected.  Network analysis focuses on monitoring levels of 
traffic across a network.  Penetration te sting is the process of determining 
how robust the company’s cyber security defences are and vulnerability probing is part of that process – finding the devices on the network that 
are most vulnerable to intrusion.

Chapter 10 
 603 
 The correct answers are A and C 
Establishing the risks satisfies step one – identifying the issues.  Defining 
the programme objectives satisf ies step two – setting well defined 
targets.   
The planned organisation structure and appointment of a specialist firm 
satisfies step three – determining  how to deliver the system.  
However step four – the risk v res ource trade off is outstanding – 
management have not yet been offered a r ange of options to decide what 
level of protection they need and are prepared to resource.   
Step five – a detailed plan whic h aligns with their business and 
technology requirements has also not been developed.  
Step six – ensuring sustained busine ss engagement is satisfied by the 
work done to track progress and reinforce the controls adopted. 
 
Objectivity requires that the report is free from bias.  Statements such as 
‘unparalleled experti se’ should therefore be avoided.  
 
The disclosures included in the description do not need to cover the 
specifics of the insurance cover se lected – but should instead focus on 
how the decision regarding the use of  insurance are taken and the role 
that insurance plays in helping to mitigate risks that cannot effectively 
mitigated otherwise.

604  
 The correct answers are B, C, D and E 
The AICPA lists senior managem ent, board members, analysts and 
investors and business partners as the ke y stakeholders interested in the 
management of an entity’s cyber security risk.  
A cyber security attack could impac t FHG’s stakeholders in many ways. 
Lenders may be concerned that liquidity (and therefore FHG’s ability to 
pay its debts) could be impacted by an attack on the on-line purchase and payments system.   
An attack on this system could also compromise the Business 
Information the company holds  on its customers.   
Shareholders may be concerned that  confidential product design 
information could become compromised a ffecting profitability and Payroll 
service providers may have an in terconnected system which would be 
affected by any attack on FHG.   
FHG’s competitors may be interested in their cyber security risk but 
would not be considered key stakeholders  for the purposes of the report. 
 
The AICPA recommends a three part repor t into an entity’s cyber security 
risk management program.   
Management describe the program in  an often lengthy description 
section.   
They then provide a separate assertion section in which they confirm that 
the description provided meets the AI CPA description cr iteria and that 
their controls are effective.   
An independent practitioner (a certif ied public accountant) then carries 
out an assurance engagement on the same areas and expresses their 
opinion.  
A CISO may assist the board and the independent practitioner but they 
do not produce a separate se ction of the report. 
 
 The correct answers are D and E 
A cyber security risk policy for em ployees forms part an enterprise’s 
overall governance structure.  Th e use of the handbook is a way of 
communicating relevant cyber secu rity information internally.

Chapter 10 
 605 
 Issues to consider on cyber security 
One of the first things we must co nsider on cyber security is what 
information we have that needs protecti ng, this could be customer, staff 
or business information. Any PII we  hold on employees or customers 
(such as names, addresses, payment deta ils) must be protected.  As this 
is a legal consideration in most count ries, we should be doing it already. 
In terms of business information, our  recipes are the standards that our 
staff follow and should any of these be altered it would adversely affect 
our business. 
We also need to consider the types of technology we use, for example 
servers for hosting our website, the database we store customer details 
on, the communication channels we hav e with our 3rd party providers 
such as the delivery company etc. 
We have also undergone fairly recent c hanges in terms of the growth that 
we have experienced.  Often a change to business operations leads to a 
change in the way we use technology, and this will usually add to the cyber security considerations. For ex ample, moving to online ordering is 
a significant change and involves co llecting PII from  a website and 
storing it on our database. 
Social media is an important consider ation as we used this to grow our 
business.  Now we have our own websit e it is important that if we keep 
our social media pages they remain up to date – if not it could tarnish our 
reputation.  Also someone could pot entially gain unauthorised access to 
our accounts and post inappropriate comments. 
Other risks would include malware infect ing our systems, in an attempt to 
steal information, phishing attacks from  hackers, or application attacks to 
either take our website offline or  gain access to our customer PII. 
Benefits and risks of adopting a cyber security framework 
Benefits 
The benefits of adopting a recognised approach to cyber security are 
plentiful. First and foremost as with any risks, being aware of the risks 
that we face, the potential impact and likelihood of them, being able to 
prioritise the key issues and put appropriate controls in place, is vital. 
As technology is critical to our business operations, following recognised 
guidelines will help us make sure that we have considered as many of the 
issues as possible and will help us to respond when an issue occurs. It is 
a question of when rather than if; we may not be specifically targeted by 
an attack, but we could still be compro mised by an attack that targets a 
software flaw.

606  
 Most cyber security frameworks don’ t just focus on how to prevent an 
attack, they also include responses to an attack - this would help us to 
get our operations back in order as qui ckly as possible. With our primary 
source of orders coming from our website, reducing the downtime we 
have is vital. If a customer cannot a ccess our website they will most likely 
find another cake company that they can order from and we may not just lose one sale but future sales too. 
Risks 
There is a risk that we apply a fr amework and then assume this means 
we are now completely protected agains t cyber security risk. This is not 
the case; as with any control, cyber security controls can be 
circumvented by collusion and error,  indeed the human element in any 
control systems creates a weakness – we  can all make mistakes. Using a 
framework to assist our risk managem ent of cyber security is good 
practice but it cannot completely e liminate the cyber threats that can 
impact our business. 
Technological advancements are rapid and varied, and so too are the 
risks that we face – from any source but particularly with regard to cyber threats. This means that regular re view, reinforcement and refinement of 
policies is vital. For example, a key control would be to train all our employees, even those involved with ma king the cakes or decorating the 
cakes, about basic controls like password security and avoiding social engineering.  However we should make sure that we give them regular 
reminders to make sure they do not slip into bad habits and we can update them to any changes. 
Evaluation of the cyber security frameworks 
AIC Triad 
The AIC triad is a nice simple  approach to help an organisation 
understand the information security  risks it faces and the potential 
responses it could take. AIC stand s for availability, integrity and 
confidentiality.  
In the same way that I started th is piece of work, it starts with 
understanding what information we have that could be of interest to 
others and therefore we need to protec t, like our customer data and our 
recipes. The integrity aspect considers how we make sure the data we 
have is trustworthy, i.e. only c hangeable by authorised users. For 
example our customers updating thei r delivery addresses or payment 
information, or authorised staff updating the recipes we use for the cakes. 
It also requires that we consider how we keep our systems online in the event of a breach or atta ck, i.e. that we have a disaster recovery plan. 
NIST cyber security framework 
The NIST framework provi des voluntary guidance.  As with the AIC triad, 
it is aimed at helping organisati ons understand the issues it must 
consider to mitigate cyber risk. This one has five principles, so is more 
detailed than the AIC tr iad and therefore it c ould be argued would help 
protect our organisation more robustly.

Chapter 10 
 607 
 ISO27001 
This is from the International Organisation for Standardisation and so 
carries with it additional credibility.  This kind of standard would give 
additional credibility to NC if we were  to move into business-to-business 
sales. It follows very similar risk management processes including setting 
up a security policy, using risk assessment and managing the risks identified, and prepar ing a statement on the risks and controls in place. It 
does not mandate specific controls, but does provide a checklist of controls to consider. 
AICPA cyber security risk management reporting 
This is probably the most comprehens ive and detailed of the frameworks 
that exist at present, as such it w ould probably be the most expensive for 
NC to undertake, but the result w ould be that our consideration and 
controls would be perceived to be of the highest order. Again, it cannot 
guarantee that NC would be immune from  cyber security threats, but 
would show our stakeholders that we ta ke cyber security very seriously. 
Given that Larissa has talked to you about listing, this level of reporting 
would certainly give investors more c onfidence in our cyber security risk 
Summary 
Given our current size, I think that we  should start by us ing either the AIC 
triad or the NIST framew ork. This will give us a good basis for control and 
if we continue to expand we c ould look to adopt ISO27001 and the 
AICPA cyber security risk management reporting. 
 
 Enterprise Risk Management (ERM)  
It could be argued that it is dis appointing that Couchweb has not 
implemented ERM already because ERM is essentially a process that 
ensures that risk management is cons idered in the context of business 
strategy. ERM would ensure that  Couchweb had a proportionate and 
realistic approach to the identific ation and management of risks, avoiding 
risks that exceeded the company ’s risk appetite. Risks would be 
addressed in a top down m anner, with staff at all le vels being aware of 
the risks associated with their areas of responsibility. There would be 
systems and procedures in place to  manage those risks and staff would 
be motivated to adhere to them.

608  
 ERM would have given Couchweb’s risk management a formal direction, 
which should have both reduced the like lihood of a problem and offered a 
defence in the event that a problem arose in the future. For example, 
Couchweb is heavily dependent upon IT for both the delivery of its 
service and for the processing of s ubscribers’ payments. An ERM system 
would ensure that the Boar d took an active interest in IT security and 
continuity of service and made sure that the necessary resources were 
available to staff to deal with risks. Staff would be aware of the systems 
and procedures and there would be regular compliance tests to ensure 
that these functioned properly. 
It could, however, be argued that Couc hweb’s exposure to risk would not 
have been reduced by the adoption of ER M. Taking the piracy case as an 
example, the company was well aw are of the threat and had put an 
encryption system in place to addre ss that. ERM would not necessarily 
have affected the safeguards put in place by Couchweb because the risk 
had been formally evaluated in this case and had been addressed by what appeared to have been a realisti c response. As with any risk 
management process, Couchweb was left with a residual risk that it chose to accept and so it was unfort unate that the piracy occurred. The 
only way to prevent it from occu rring would have been to have continued 
to restrict access to  streaming only.  
There may be a risk that ERM could create a false sense of comfort if it is 
approached in a mechanical, box-t icking way. Couchweb clearly 
understood the risks associated with th is new venture and had taken the 
necessary steps to prevent them. T he introduction of ERM may formalise 
risk management, which is potentially benefic ial, but it could also prove a 
distraction from the ongoing busin ess of identifying and managing the 
risks themselves. Couchweb’s busine ss model requires the company to 
focus a great deal of attention on spec ific risks such as those relating to 
IT systems and that focus may be weak ened slightly by a wider process.

Index 
 I.1 
3Es.....427 
A 
Ability to bear risk.....78 
AIC Triad.....592 
AICPA.....582 Analytical review.....444 Antivirus.....542 Application attacks.....492 Arithmetic and accounting.....349 
Assurance map.....60 
Audit committee.....280 
Audit 
analytical review.....444 
CAATs.....452 
committee.....293 
computer systems.....449 
environmental.....430 
external.....419 
internal.....406 
management.....431 
planning.....433 
process.....433 
report.....447 
risk.....434, 438 
sampling.....443 systems-based.....432 
testing.....440 
types.....424 
value for money.....427 
Audit, risk and internal control: Corporate 
governance.....280 
Authorisation a nd approval.....348 
B 
Backward integration.....66 
Benchmarking.....434 
Blockchain technology.....546 
Board leadership and company purpose: 
corporate governance.....270 
Botnets.....491 
Bribery.....235 
Bring your own device.....539 
Business 
continuity.....543 
risk.....9 
C 
Centralised monitoring.....550 
Certificates.....531 
SSL.....531 TSL.....531 
Certification.....531 Chair.....272 
Changeover methods.....485 Chief executive officer (CEO).....273 CIA Triad.....592 
CIMA risk management cycle.....6 
Classification of controls.....351 Cloud.....482 Committee of Sponsoring Organisations 
(COSO).....39, 339, 342 
audit.....280, 293 
nominations.....278 
remuneration.....282 
Commodity price risk.....9 
Compliance 
risk.....8 tests.....441 
Composition, succession and evaluation: 
Corporate governance.....278 
Computer Misuse Act.....504 
Computer-assisted audit techniques 
(CAATs).....452 
Conceptual framework (ethics).....210 
Confidentiality.....207 Contractual inadequacy risk.....9 Control 
activities.....340, 343 
environment.....339, 342 Physical.....347 
management review of.....404 
Corporate 
development.....263 division of respons ibilities.....272 
governance.....261, 280 
definition.....262 
principles.....270 reputation risk.....20 
social responsibility (CSR).....204 
Credit 
crunch.....12 risk.....17, 22 
Culture risk.....22 
Currency risk.....17 
Cyber 
risk.....18 security objectives.....486 security processes.....521 
security threats.....479

Index 
I.2  
D 
Data protection legislation.....503 
Desktops.....537 
Digital resilience.....579 
Directors 
non-executive.....274 remuneration.....287 
Disaster recovery.....543, 544 
Disruption.....167 Disruptive inno vation.....167 
Diversification.....65 
Downside risk.....2, 38 
E 
Economic risk.....12 Embedded audit fa cilities.....455 
Employee malfeas ance risk.....22 
Enterprise Risk Management (ERM).....39 Environmental 
audit.....430 
benchmarking.....435 
risk.....18 reporting.....430 
Ethics.....203, 206 
budget setting.....222 
code of.....205 
conflict resolution.....214 dilemmas.....213 
fundamental principles.....206 
safeguards.....211 
threats.....210 
Executive Share Options (ESOPs).....289 Expected values.....51 
External audit.....419 
F 
Financial risk.....16, 22 Firewalls.....541 Forensic analysis.....566 
Forward integration.....66 
Frameworks.....582 
Fraud.....234, 363 
detection.....367 investigation.....422 
Investigation of.....368 
prevention.....366 response.....368 
risk.....9, 20 G 
Gearing risk.....17 
Governance.....262, 291 
Gross risk.....77 
H 
Hackers.....494 
white hat.....570 
Hedging risks.....68 Horizontal integration.....66 
I 
Information and co mmunication.....341 
Inherent risk.....438 
Innovation disruptive.....167 Input controls.....526 
Integrity.....207 
Interest rate risk.....17 
Internal audit.....406 
definition.....405 effectiveness.....418 
independence.....417 
outsourcing.....415 scope of.....408 
standards.....410 
structure.....414 
Internal controls 
Operational features.....345 system.....336, 339, 359 
International risk, 22 
Internet of things.....571, 594 ISO27001.....545 
L 
Laptops.....537 Legal/litigati on risk.....8, 22 
M 
Malvertising.....491 
Malware.....491 
analysis.....569 
audit.....431 control.....348 
Materiality.....438 
Mobile devices.....538 Monitoring.....341

Index 
 I.3 
N 
Net risk.....77 
Network 
analysis.....568 configuration.....540 
NIST cybersecurity framework.....592 
Nominations Committee.....278 
Non-Executive Directors (NEDs).....274 
Normal distribution.....53 
O 
Objectivity.....207 One tail test.....56 Operational risk.....9 
Organisation.....348 
Organisational structure.....340, 348 Output controls.....526 
P 
Penetration testing.....570 Personal information.....480 Personnel controls.....349 
Phishing.....574 
Physical controls.....347 Political risk.....8 
Pooling.....65 
Prerequisites for fraud.....364 Probabilities.....52 
Processing controls.....526 
Product reputation risk.....9 Product risk.....9 Professional behaviour.....208 
Professional competence and due care.....207 
Pure risk.....3 
R 
Ransomware.....491 Regression analysis.....51, 59 Regulatory risk.....8 
committee.....282 
corporate governance.....282 
directors.....286 
Reputational risk.....199, 200 
Residual risk.....45, 71, 77 Reverse engin eering.....569 Risk.....2 
acceptance (TARA).....68 
appetite.....45 assessment.....41, 47, 340, 343 
attitude.....45 
avoidance (TARA).....68 benefits....., 4 
capacity.....45 
categories.....7 committee.....48, 85 
commodity price.....10 
compliance.....8 contractual i nadequacy.....10 
controllable.....340 
cube.....71 
currency.....17 
economic.....12 environmental.....18 
financial.....16 
fraud.....20 identifica tion.....48 
interaction.....81 
legal/litigation.....8 management.....38 
manager.....86 
map.....60 
operational.....10 
political.....8  
product reputation.....10 
product.....9 
quantification.....51 reduction (TARA).....68 
register.....49 
regulatory.....8 reporting.....47, 73 
reputational.....200 
response.....64 roles.....84 
sharing.....68 
sources.....7 
strategic.....9 
strategy.....45, 73, 79 TARA.....68 
treatment.....47, 64 
types.....7 uncontrollable.....340 
Round the co mputer.....451 
S 
Sampling.....443 
Sarbanes-Oxley (SOX).....298 
Security Triad.....592 Segregation of  duties.....347 
Sensitive information.....480 
Share options.....287

Index 
I.4  
Shareholder value.....41 
Simulation analysis.....51, 60 Social audit.....430 Social engineering.....495 
Software security.....574 
Speculative risk.....3 Spyware.....491 
Standard deviation.....51 
Storage analysis.....567 Strategic risk.....9 
Substantive tests.....441 
Supervision.....348 System back-up.....544 Systems investigation.....439 
Systems-based audit.....432 
T 
TARA.....68 Technology risk.....17 
Test data.....455 The Bribery Act.....359 
Through the computer.....451 
Transfer Pricing.....227, 229 Transferring risk (TARA).....68, 65 
Trojans.....491 
Trojan remote access (RAT).....491 Turnbull report.....291, 337, 346 Two tail test.....56 
Two-way risk.....3 
U 
Uncertainty.....3 
Upside risk.....2, 38 
V 
Value at risk.....51, 59, 53, 56 Value for money (VFM).....427 Vertical integration.....66 
Viruses.....491 
Volatility.....51, 52