Data Loading...
Session 2 - Mini Mock Answers Flipbook PDF
Session 2 - Mini Mock Answers
125 Views
47 Downloads
FLIP PDF 207.51KB
Answer 1 (a) Background section of consultancy report One mark per relevant point for discussing any relevant environmental model such as Porters five forces, or PESTLE. Introduction The first part of this report analyses DCS Company’s market and the industry using the Porter’s Five Forces model. (i) Bargaining power of buyers DCS is competing in two markets. In the data communications component market which is more mature and where it has less than 1% of the market share, it is a supplier of marginal significance, despite 65% of its gross profit or cash contribution being generated in this segment. Its customers in the neighbouring single market (30%) with its own currency are likely to demand low prices, high quality and reliability. They may not accept late delivery of orders. It appears that alternative sources of supply are readily available and that switching costs are relatively low. Multinational OEMs have significant bargaining power in this market, particularly the OEM which accounts for 40% of DCS’s current data communications component sales. In the second market, where network management systems are supplied to mainly domestic, SMEs and a few larger companies, the buyers appear to have less bargaining power. DCS is catering for each customer’s specific needs and so each solution is, to some degree, a bespoke solution. This makes it much harder for buyers to compare products and prices of potential suppliers. Alternative sources of supply are much more difficult to find as there only three companies (including DCS) in this specialist marketplace. The bargaining power of suppliers Although DCS manufactures 50% of all components used in its data communications products, reducing its overall reliance on suppliers in this sector, it seems unlikely that DCS will be able to exert much influence on its suppliers, which provide the other 50%. As a relatively small player in the data communications market, the company does not have the power to exert buyer pressure on its two large suppliers, either in terms of price or delivery. Current problems associated with the delivery of components are having a significant impact on the company’s ability to meet customer deadlines and expectations. Suppliers of financial capital, namely lenders, have gained more bargaining power as DCS has had to borrow more to sustain their recent growth. If labour is seen as a supplier, then evidence again suggests that DCS is in a relatively weak position particularly since there has been a limited trade union membership since 2006. However, the union members are mainly in the data communications components division where employee remuneration and employment rights are already compliant with Prydain’s national employment laws. The scenario also indicates the difficulty of finding high calibre network staff with DCS’s small size and location making it difficult to attract the key personnel necessary for future growth in this sector. Threats from new entrants DCS is operating in an industry where the costs of entry are significant because it is capital and knowledge intensive.
Economies of scale compel new entrants to enter at significant output levels or suffer a cost disadvantage. Furthermore, the need to offer comprehensive aftersales support, although a problem for DCS, does also create a significant barrier to new entrants. Finally, the exit costs and barriers such as industry-specific knowledge, skills and assets, reduce the attractiveness of the marketplace to new entrants. Threats from substitutes There is evidence that large, successful, high technology companies are particularly vulnerable to ignoring the challenge from disruptive new technologies which can replace the need for certain high technology products and services overnight. However, the relatively small size of DCS may give it a competitive advantage in its ability to respond quickly and flexibly to change, as long as it can attract the right calibre of expertise to achieve this. Rivalry amongst competitors Very different levels of competition are being experienced in the two market places DCS is operating in. It is clear that the high volume, low-margin component business offers intense competition with buyers who are able to use their size to extract favourable prices. DCS only has 1% of this market. The ability of DCS to generate better market share and volumes through product innovation in this market seems highly unlikely. The intensity of rivalry in the network management systems sector is significantly less in this specialist market. DCS is dealing with a smaller number of large and medium-sized users, designing products specific to their needs. In Porter’s terms, DCS is adopting a focused differentiation strategy. In these low-volume high-margin markets, the emphasis has to be on increasing the volume side of the business, but at the same time making sure that they have the resources to attract and support new customers. (ii)
The following is an evaluation of the performance of DCS against the six capitals of and how these are being transformed at DCS between 2012 and 2015. Financial capital The financial data shows revenue reaching a peak in 2014, before falling away (by just over 9%) in 2015. Although 2014 was a record year for revenues, increased cost of sales meant that gross profit declined significantly. The gross profit margin has declined every year in the period under consideration, and the reasons for this need to be investigated. The rapid fall in 2015 suggests that operating costs have not been brought under control to reflect the sudden sales decline. 2015 2014 2013 2012 Gross profit margin (gross profit/revenue) 28·49% 34·46% 37·50% 44·84% In 2015, although DCS seems to have made reductions in overhead costs, finance costs have increased despite the fall in revenue, leading to a progressive decline in net profit margin in the period under consideration.
2015 Net profit margin (net profit after interest and tax/revenue) 2·16%
2014 8·11%
2013 2012 10·15% 11·37%
The overall financial picture is of a company which has failed to control its core operating and finance costs as it generated increases in revenue until 2014 and as revenues fell in 2015. Finance costs are increasing as a proportion of net profit before interest and tax (NPBIT) as shown below: 2015 2014 2013 2012 Interest cover ratio (NPBIT/finance costs) 1·25 2·74 3·08 5·93 Manufacturing capital Working manufacturing capital seems to be reducing. This is confirmed by the forward contract order book. This has fallen from 3,505 in 2012 to 2,500 which will require fewer components, work-inprogress and finished products needed at the factory. It is also clear that capital budgeting and investment is slowing from 10% to 7% of turnover over the period. The R&D budget is also falling and is at 3% of turnover in 2015 compared with 6% in 2012, which is a 50% decline. These statistics indicate a clear depletion of the manufacturing capital of DCS. Human capital DCS seems to be seeing a depletion of high value human capital and morale may be seen as low. Recruitment and succession planning seem to be poorly planned and coordinated – leading to insufficient skilled people being recruited or promoted to replace staff either leaving the company or retiring early. There is just over 15% fewer staff at DCS in 2015 compared with 2012. However, human capital has performed reasonably well from a productivity perspective. Analysing the data, productivity reached a peak in 2014 and has only fallen slightly in the last financial year: 2015 2014 2013 2012 Sales revenue per employee ($’000) 54·72 54·81 47·55 31·66 The sales support element of human capital is not performing well, however. The number of late contracts has doubled since 2012 and the number of complaints from customers has increased from 1·5% of orders to 3·4%. Social and relationship capital Social capital measures cultural health within the company and one of the ways this can be assessed is by using staff satisfaction surveys. The case indicates that employee satisfaction has been declining between 2012 and 2015. The increase in trade union membership may be a symptom of this. The case indicates that the survey measures such aspects as confidence in the leadership, opinions about personal growth and individual wellbeing. Each year since the surveys were launched, the satisfaction ratings have fallen by more than 15%. Intellectual capital Another area where DCS seems to be failing is in its maintenance and transformation of intellectual capital. There has been a depletion of intellectual capital, through skilled staff being either underutilised or leaving the company. This can be related to two areas: o Staff turnover
o
R&D.
Clearly the stock of intellectual capital is closely correlated to the stock of human and cultural capital. DCS seems to be depleting all three of these and its staff turnover has increased by 150% since 2012. Natural capital It is clear that DCS has a growing carbon ‘footprint’ and that it is unable to identify where precisely in its value chain the carbon footprint is most problematic. The information in the case shows that the overall carbon emissions are increasing. Carbon emissions have risen by 1/3 since 2012. The case clearly indicates that the main cause of the carbon footprint is in the data communications components manufacturing division. This is already a high volume and relatively lower margin sector of the business which will be subject to additional carbon taxes under the government proposals. There is also likely to be a greater carbon cost with this sector as a significant proportion of these components are exported to the nearby continental trading community. Conclusions DCS needs to be aware of the dynamics relating to its market and industry, particularly the power of key customers and over reliance on two main suppliers. It must also be aware of and manage the threats from substitutes and new entrants in its two main business segments. On the company’s performance against the six capitals of , DCS’s performance in several areas is weak and indicates a strategic drift which will need to be addressed. Answer 2 (a) The potential risks which the company could face whether or not it re-aligns its business are as follows: (Note: Candidates only need to discuss any three of these to gain maximum marks) Strategic risk, business risk, financial risk and environmental risk. (Note: Markers can give additional credit for any reasonable risks identified from the case information and give a Professional Skills mark for a reasonable positioning of the risks in the heat map) Heat map for key risks faced by DCS Company
Strategic risk The key strategic risk which DCS faces is the increased competition in the data communications components manufacturing market, the reduced margins and potential decline in the future. At the same time DCS faces the risk of missing an opportunity to use its competencies to develop the potentially more profitable area of its business. DCS currently faces lower market share and declining shareholder value and this is projected to be a 10% decline year on year for the next three years. To reduce or avoid these risks, DCS could re-align its business towards the more profitable domestic market by investing in the network support business in terms of increased R&D, fixed asset investment and improvements in policies relating to staff retention and recruitment to support this potential growth area. This would also reduce its general cost base. Business risk As already explained in the five forces analysis, apart from heavy dependence on its main business sector of data communications (65% of its total turnover), DCS is facing economic risk from overdependence on key customers (one of the OEM customers accounts for 40% of its sales). DCS is also overreliant for its supplies of data communications sub-components on two large multinational suppliers from which it currently faces serious supply shortages. It also risks further losses of staff and greater recruitment difficulties caused by poor staff morale and due to the unattractive location of DCS’s headquarters. Under the TARA framework, it is advisable to reduce these risks by widening the supplier and customer base. From a supply perspective, the benefits of this strategy would be to spread the risk of a disruption to the supplies from one or both of the two current suppliers. The strategy would also help DCS in terms of bargaining power, particularly if it is not getting favourable terms from them. Similarly, widening the customer base, or concentrating on a higher value strategy will reduce its dependence on the data communications business and also the bargaining power of their main OEM customer and help their profitability. DCS can reduce the staff retention and recruitment risk by adopting tactics and implementing policies to improve the culture of the organisation and the morale of their key staff. This could be achieved through offering greater empowerment and devolving more authority to middle managers. An improvement in intrinsic rewards and in pay and conditions, or allowing staff to relocate, or work from other geographical locations which are more attractive to them, may also help to mitigate this risk. Financial risk The main risk is the devaluing currency in the main market into which DCS sells a significant proportion of its data communications components. A weakening currency in the economic community from which customers settle their payments means that DCS is facing a currency translation exposure as monies received in the
devaluing currency will effectively reduce the turnover collected from customers in these markets. Under the TARA framework, the risk could be reduced or transferred by using foreign currency hedging instruments or by taking out loans in the denomination of the weaker foreign currency, using the payments from the continental customers to offset the liability. The other main financial risk is the high level of gearing and the risk of breaking bank covenants and of default. This risk could be mitigated by either converting some of the debt into equity or by repaying or redeeming loans from DCS’s considerable cash reserves, or by issuing more shares. Environmental risk DCS is not itself at risk of potential environmental impact, but is facing a risk of creating an increased carbon footprint or environmental impact which it is not effectively managing and which may itself create environmental costs and incur a carbon tax liability. This risk could be transferred through carbon offset strategies, avoided by ceasing to manufacture or distribute goods in a way that creates such a significant carbon footprint, or reduced through pursuing tactics or strategies to avoid waste and reduce emissions. (b) (i)
Table 1 of exhibit 4 makes a number of assumptions. These are as follows: The ‘do nothing’ strategy is not considered an option by the board. A reasonably quick financial analysis would confirm that this is not a viable option, but that confirmation has not been included in the October board report or in Freddie Lithium’s spreadsheet. Therefore, a financial evaluation of the ‘do nothing’ option against the other two options would give a more complete picture. In fact, are there any other strategic options available to DCS? These do not seem to have been considered by the board. Is it reasonable to extrapolate that a recent decline of 10% in total DCS revenues is indicative of future trends in cash contribution by segment? There seems to be no explanation of how the relative cash contribution of each segment in 2015 was arrived at, other than being calculated after interest and tax. The definition of cash contribution also needs to be investigated further to verify whether it is calculated before capital expenditure or is a free cash flow, because the forecasts might differ, depending on how this cash flow is defined. Is it possible to assume that annual additional fixed costs will be constant in each year of the forecast planning period as stated? In reality, there might be greater fixed cost expenditure in the first year of the new strategy and less in the subsequent years. Is it reasonable to assume that fixed cost savings in the data communications plant would be the same regardless of which growth forecast emerges? This seems unreasonable as potential savings in that division would probably depend to some extent on the level of growth which materialises from Strategy 2, if implemented. The calculations within the spreadsheet all seem accurate, but time value for money has not been taken into account. If the cash flows after interest and tax were discounted, they would need to be discounted by the geared cost of capital, which is estimated at 12%. Making this adjustment to the cash flow will yield a net present value for the project and will change the payback estimate. This is shown below:
Net incremental cash flow from re-alignment:
2016 ($m) –0·09
2017 ($m) –0·02
2018 ($m) +0·12
Net present value = (–0·09 x 1/1·12) – (0·02 x 1/1·1·122) + (0·12 x 1/1·1·123) = (–0·08 – 0·016 + 0·085) = –0·011 This means that Strategy 2 (the re-alignment strategy) has a negative NPV of $11,000 which means it does not pay back in the three-year planning horizon. (ii)
Recommendations to the DCS board The purely financial evaluation in (b) above shows that DCS should not re-align towards the highervalue more differentiated network support segment, although undiscounted payback would indicate that it just repays for itself within three years. However, the strategic and broader business benefits to be gained from re-aligning in this way are that it will help DCS become a differentiator, concentrating on higher value, lower volume business, rather than continuing to maintain an increasingly challenging cost focus. This might be preferable to remaining as active in the high volume low margin data communications manufacturing business, particularly as the company is so reliant on two key suppliers, where supplies are being disrupted and where 30% of their OEM customers are representing an increasing risk of higher currency translation costs. From the performance data in the spreadsheet, it seems that manufacturing cost control is one of the key problems for DCS, so the business benefits will include the ability to transfer resources from the manufacturing to the support side and the potential to make labour cost savings in the manufacturing area which is more labour intensive and where labour and employment costs in Prydain are high. DCS can also reduce its carbon footprint further and reduce its environmental impact. The IT benefits for DCS will be that it will develop greater capability in the new emerging technologies of cloud computing and big data processing services which will give it a competitive advantage over traditional players in the data electronics market. The strategy to re-align the business will make a small negative net present value of –$11,000 over the next three years, which on the face of it would not justify the strategy on financial grounds alone, assuming that the forecasts were valid. However, while DCS directors were unable or unwilling to consider the cash flows beyond a three-year planning period, due to subjectivity and prudence, it is reasonable to assume that there would be additional positive net cash flow benefits accruing to DCS, well beyond the planning horizon. These seem to be rising exponentially from the trend observed. It could also be assumed, particularly in such a competitive and innovative sector as data communications, that the ability of DCS to maintain its current market share and overall turnover over time could be questioned, should no investment or re-alignment of the business take place. Therefore considering both strategic and wider business reasons, DCS would be advised to implement the re-alignment of the business and focus on expanding the network support side of the business and invest in the necessary fixed costs, staff recruitment and working capital required, by using internally generated funds or issuing more shares.