Question 1 of Sep/Dec 2021 Past Exam

Hi,

I just finished question 1 of the Sep/Dec 21 exam.
Can any one take a look at my answer and provide some comments regarding the quality and relevance of my answer? Thanks.

To: The Board of Freuchie Retail
From: An Accountant
Date: 1 September 20X5
Subject: Review of quantitative and qualitative aspects of the performance reporting,
discussion of operational gearing and the implications for Freuchie’s management
and an assessment of the quote “What gets measured, gets done” and other jargons as discussed

Per the instructions from CEO, this writing shall first discuss the qualitative and narrative elements of the report and also a rework of the narrative commentary for the report. Then the writing dives into a
calculation of operational gearing and an assessment of the implications for Freuchie’s management. Finally, an assessment shall be conducted on the quote “What measures, gets done” and other jargons such
as “tunnel vision, sub-optimization, myopia and gaming and illustrations of these jargons based on Freuchie’s business.

i): Current performance reporting: quantitative

This part of the writing shall break down the discussion of the quantitative area of the performance reporting in the following three parts:
– Whether the strategic performance report directly addresses the objectives of the organization
– Recommendation of other key performance indicators for decision-making
– Assessment of the presentation of the current performance reporting

Whether the strategic performance report directly addresses the objectives of the organization:

Based on the mission of Freuchie, the key aim of the organization is to deliver returns to shareholders above the average for the retail sector. And the means to achieve such aim are as follow:

– Providing a superior customer experience through:
1. The appearance of the stores
2. Attractive range of clothes
3. Enthusiasm of the staff

Taking into account the ultimate aim of Freuchie into account, which is to deliver returns to shareholders above the average for the retail sector, the report does not include completely performance measures
directly related to the returns delivered to shareholders as stated in the mission. First of all, the report only measures the dividend per share, which is not equal to the total shareholder return. The shareholder
return is equal to dividend yield plus capital gain (loss). And both the dividend yield and capital gain (loss) are not calculated in the report. Second, the average growth in the returns to shareholders of the retail
sector is not provided in the report and therefore, no comparison between the rate of returns to shareholders of Freuchie and the average rate of returns to shareholders of the whole sector. As a result, due to
lack of such comparison, no solid conclusion can be made on whether Freuchie has managed to deliver returns to shareholders above the average for the retail sector or not.

To accomplish the level of returns to shareholders above the average of the whole industry, the ultimate strategy is the customer experience. However, there are no indicators in the report directly measuring the
level of the customer experience throughout the two years, from which either the growth or deterioration of the customer experience can be derived. The growth in the revenue in 20X5 can be a possible indicator
for the increased level of customer experience. However, no increase in the revenue due to the increase in the number of stores is noted in the report. Hence, it is unclear of the rate of the revenue growth arising
from the increased level of customer experience.

The required level of customer experience required to achieve the ultimate mission is accomplished through the three supporting strategies as mentioned above. Details of the reporting of the performance of
those three supporting strategies are as below:

1. The appearance of the stores:

There are no measures in the report directly related to the appearance of the stores. Financial indicators as noted in the report are unlikely to be able to capture the improvement or deterioration in the
appearance of the stores. Indicators to quantify and measure the appearance of the stores can be a total or average numerical score given by customers on a given scale, which should be documented in the
report. Such quantified measure of the appearance of the provides a clear picture of the extent of the achievement of the required customer experience based on the appearance of stores since which this metric
is measured solely based on the customers’ opinions. Alternatively, the measures to assess the performance of the stores’ appearance can be collected from a third-party service provider, in which a comparison
between Freuchie and other competitors is drawn, which depicts the level of customer experience attained by the organization relative to the customer experience provided by the competitors and therefore gives
a clear insight to whether the level of customer experience of Freuchie can deliver the returns to shareholders above the average for the retail sector.

2. Attractive range of clothes:

The financial indicators in the report are not broken down by product line in the report. Therefore, there is no measurement on the performance of various product lines in the report. As a result, the extent of
achieving the required level of customer experience based on the attractive range of clothes is unknown. The revenue, cost of sales and gross profit segments by product line should be displayed in the report.
In this way, the product line that eithers gives the highest growth rate in revenue or gross profit, or contributes the highest portion to the total revenue is clearly identified. Then the product line that provides the
highest contribution to the required customer experience or is the most disliked by customers can be focused or abolished in order to further support the aim of achieving the required level of customer
experience. Besides, the segmental analysis by product line also highlights which product line delivering the highest or lowest gross margin, which is helpful in recognizing the product line that gives the highest
support to the overall aim of delivering the returns to shareholders and the clothes type that negatively impact the ability to achieve such aim.

3. Enthusiasm of the staff:

Again, the level of enthusiasm is not measured in the report, giving no indication to how the staff’s enthusiasm has supported Freuchie to achieve the required level of customer experience. The enthusiasm of
staff can be quantified by numerical rating given on a specific scale by direct supervisors of the staff at stores or measuring the sales above the targets throughout the historical periods. Such measurement
helps reveal a big insight into how the enthusiasm of staff has either elevated or reduced the customer experience delivered by Freuchie.

Recommendation of other key performance indicators for decision-making:

– In the current performance reporting, the revenue amounts are presented as total revenue. However, we do not have a clue of whether the revenue growth is mainly attributed to purchase of new stores or
actual growth in the sales of current stores. Therefore, to be able to verify whether the revenue growth is actually an organic growth resulting from increased sales of current stores or just purely purchase of
stores, a volume-price analysis should be implemented in the report. Revenue and profit should be broken down by store so that a growth by revenue or profit per store can be revealed. Besides, the revenue
growth should be broken down into growth arising from new stores and the one as a result of current stores. In this way, the overall performance of the stores can be fully assessed.

– Even though the mission is to deliver returns to shareholders, there is no measure on the return on the capital employed (ROCE) in the report, which would indicate how much shareholders get per dollar
invested Freuchie. Without the ROCE ratio, the current performance reporting does not fully address the key aim stated in the mission.

– Costs listed in the report include rent and property costs, marketing, head office costs and staff costs and are therefore not related to the key aim and supporting strategies stated in the mission. To better
assist decision-making in achieving the mission, costs not related to the objectives of Reuchie should be classified as general admin expenses or other costs so that the board of Freuchia would not be confused
by too detailed and unnecessary costs.

– The budget for 20X5 is presented in the report, which is useful for planning and controlling the performance of Freuchie so that the performance can be aligned with cost-controlling purpose. However, since the
mission is to focus on strategic performance, which positions Freuchie against competitors and the average performance of the sector. Alternatively, external measures should be employed so that the reporting
can address the mission with such strategic performance focus. A comparison can be made between sales, profit and sales growth of Reuchie and those of key competitors in the industry.

– Only the current year and last year are presented in the report, which are not sufficient to establish a trend in the financial performance of Freuchie throughout history and thereby assess whether the objectives
have been achieved or not. One or more previous years should be included in the report so that an overall trend in the performance of Freuchie can be identified, revealing how far the performance has come in
achieving the objectives.

Assessment of the presentation of the current performance reporting:

In terms of presentation, the report is structured in a format of profit or loss statement, which is easy to be read by those familiar with financial statements. However, the structure and content of the report do not
address the mission and supporting strategies of Freuchie. The report does not dive in segmental analysis, in which financial indicators such as revenue, gross profit, gross margin or profit are broken down by
store or product line. Such analysis would help imply the level of detailed performance by either store or product line, directly related to two of the supporting strategies stated in the mission. Critical information
that allows for comparison with competitors or average performance of the industry are lacking, which makes the report unable to fully address the mission. Such lacking information include average ROCE or
total shareholder return of the retail sector or revenue, gross margin or profitability of other key competitors of the sector.

ii) Current performance reporting: narrative:

In general, the commentary does not address the mission and objectives of Freuchie. The comment that “Overall performance is satisfactory as the business has maintained its dividends” is irrelevant to the
overall mission of Freuchie, which is to deliver returns to shareholders above the average for the retail sector. This is because there is no narrative comparison of the total shareholder return of Freuchie with the
average figure of the retail sector. Furthermore, there is no mentioning of the total shareholder return of Freuchie but dividend only, which is not fully related to the mission. There is also no comment on the
ROCE to indicate how much return has been generated per $ invested in, which would be compared with that of the industry if the mission was to be fully addressed.

In regard to the supporting strategies, there are no comments that fully discuss the performance of Freuchie on these three areas. No discussions are done on customers’ opinions of the stores’ appearance or
opinions from third-party experts. Financial indicators such as revenue, gross profit, gross margin per store or product line are not discussed in the narrative commentary part either, giving no insight to the
performance on the attractive range of clothes. There is a slight decrease in the gross margin by 0.2% point from 40.8 % to 40.6%. Therefore, it is not correct to state the comment that gross margin has held
at about 41%. The comment on the inventory write-down is irrelevant since it addresses neither Freuchie’s performance on the supporting strategies nor the overall aim of the mission.

Suggested improved commentary:

– The revenue of xx product line has grown/ declined by xx% in 20X5 compared to 20X4 and is so far the product line that gives the most/least significant contribution to the required level of customer experience
– The stores with an appearance of xx tend to be the most favored/disliked by customers with an overall rating of xx out of xx.
– The enthusiasm of staff has been improved/worsened in 20X5 compared to 20X4 as indicated increased in the increase/decrease in xx amount of sales above the sales targets in 20X5 compared to 20X4.
– The total shareholder return has exceeded/been lower than the xx amount of the average shareholder return of the retail sector in 20X5 and has grown/declined by xx% in 20X5 compared to 20X4.

iii):

Operating risk refers to the level of business risk arising from the variability income due to the business activities of the organization. This can result from the organization’s products, suppliers, or cost structure.
The operational gearing is measured as contribution/PBIT. If operating gearing is high, this indicates that a large portion of the organization’s operating costs are fixed. Fixed costs make profit more volatile as
PBIT becomes more vulnerable to downturns in business volume. Please see below for details of the calculation of operating gearing for Freuchie:

Budget Actual Actual
20X5 20X5 20X4
$m $m $m
Revenue 641.0 638.1 577.7
Cost of sales -380.5 -378.9 -342.1
Adjusted for:
Other fixed costs 47.2 47.1 42.3
Insurance 18.2 18.2 16.2
Utilities 12 11.9 10.8
Depreciation 17 17 15.3
Variable staff costs -6.4 -6.4 -5.8

Contribution 301.3 299.9 272.1
PBIT 7.4 6.7 3.2
Operating gearing (Contribution/PBIT) 40.7 44.8 85.0

In the case of Freuchie, the fixed costs include insurance, utilities, depreciation. Therefore, the fixed costs need to be added back to revenue less cost of sales. The variable staff costs are further deducted from
gross profit less the fixed costs to arrive at the contribution. The fixed costs mainly do not vary in accordance with the sales.

Overall, the gearing of Freuchie in 20X5 is 44.8, indicating a very high fixed cost structure and exposing Freuchie to a business risk that a small loss of sales can cause Freuchie to lose its profit and incur a net
loss. Therefore, Freuchie is a high risk business with volatility in sales potentially leading to net loss.

However, the operating gearing has significantly improved as indicated by the decline by 47.4%. This signifies that Freuchie has been able to lower the fixed cost proportion in its cost structure and becoming less
volatile with variances in sales. However, the company is still a risky business since the sales are still fairly volatile as indicated by the 10.5% growth in revenue shifting the loss in 20X4 to a profit in 20X5.

iv:)

Often, directors and employees will be judged on the results of performance measures. It has been said that “Whatever gets measured gets done” and it refers to the fact that employees will tend to concentrate
on achieving the required performance when it is measured. Whatever does not get measured doesn’t get done and the danger is that employees will ignore area of behavior and performance which are not
assessed. In the case of Freuchie, revenue, gross profit or gross margin per product line are not measured. Therefore, employees will tend not to focus on which clothes gives the greatest level of customer
experience and leads to the highest returns to shareholders. In this way, the attractive range of clothes cannot be identified and the mission and supporting strategies are not fulfilled because the relevant
indicators by product line are not measured. In contrast, the inventory write-downs are measured in the report, likely causing a constrain in the types of clothes stored as a result of control for loss of inventory
and therefore potentially leading to a failure in achieving the attractive types of clothes.

Tunnel vision refers to undue focus on performance measures to the detriment of other areas. For example, if Freuchie focuses too much on profitability and tries to cut costs like training, R&D, and incentives,
there is likely to be deterioration in areas like product quality, customer satisfaction, technical skills of staff and staff motivation, which all impact the long-term success of Freuchie. This term is linked to the quote
since some measures are focused while other areas are not measured and become deteriorate.

Sub-optimization occurs where undue focus on some objectives will leave others not achieved. This term is linked to the quote since only a few key objectives are focused while other ones, which are also critical
to the success of the organization, are not fulfilled. For example, if Freuchie is only to focus on the revenue growth only and no other measures are established for cost control, the operating can capex costs may
spike and become uncontrollable, severely impacting the profitability and potentially rendering the organization unable to deliver the returns to shareholders as expected in the mission.

Myopia refers to short-sightedness leading to the neglect of longer-tem objectives. In the scenario of Freuchia, myopia is not linked to the quote since the mission of Freuchie is to deliver the returns to
shareholders through customer experience, which is a long-term strategy. Since Freuchie sets long-term objectives in its mission, myopia is not linked to the quote in this scenario.

Gaming is where there is a deliberate distortion of the measure in order to secure some strategic advantage. It is not linked to the quote since “whatever gets measured get done” refers to objectives, CSFs and
indicators that are measured are accomplished while the gaming refers to the scenario in which the measures in place are distorted to provide factitious results for gaining of some strategic advantages.