Managing Financial Performance

MODULE TITLE:   MBA Managing Financial Performance

There are three separate questions. All three questions must should be attempted and submitted together on numbered pages. Your answers should be prepared and submitted in Word format. Excel spreadsheets may be used but must be pasted into the Word document and not submitted separately. This should be carefully checked before submission for the use of appropriate and acceptable grammar. The correct use English spelling is to be employed throughout and no other. All submissions must be page numbered and contain your student ID number.

When determining the amount of effort and words for each section of the assignment it will be advisable to examine the weighting of the marks allocated to each question. If any part of the assignment is ignored then this reduces the maximum marks that could be potentially be earned.

The word limit to any potential narrative question in the third section will be a maximum of 1,500 words excluding the bibliography.

The assignment will require a considerable personal investment of time and effort. This is an individual assignment and all calculations, analysis and narrative submitted must be your own work.

The following matrix has been included to help guide you.

Q1

Presented below are the annual financial statements of Clinton Cards Plc for the financial years 2009 to 2011.

Required:

Prepare a business report for the board of directors which analyses the performance of Clinton Cards Plc over the financial period 2009-2011 by using all of the financial information provided and, recommend what the directors should do to address the company’s position.

 (50% Marks)

Appendix 1

Clinton Cards Plc
Statement of Comprehensive Income as at 1st August
2011 2010 2009
£000’s £000’s £000’s
Revenue 364,218 394,007 345,200
 
Opening Inventory 37,653 36,217 49105
Purchases 363138 366,810 306447
Closing Inventory 43,202 37,653 36,217
Cost of Sales 357,589 365,374 319,335
Gross Profit 6,629 28,633 25,865
 
Other operating income 94 148 68
Administrative expenses -13,850 -11,609 -10,276
Loss on plant disposal -985 -1469 -1824
Profit on acquisition   13460
Impairment plant and property  
Operating Profit/loss -8,112 15,703 27,293
 
Finance income 96 253 386
Finance costs -2,992 -3,149 3,089
Loss on financial instruments -824 430
Profit on financial instruments 356  
Write down of property -10 -7 68
provision discount  
 
Profit /Loss before taxation -10,662 11,976 24,092
 
Income Taxes -1,428 3,646 113
 
Profit/Loss from continuing -12,090 8,330 23,979
operations  
 
Loss  from discontinued operations -2943 -952 -57,619
 
Profit/loss for the period -15,033 7,378 -33,640
attributable to owners of the company  
 
Other comprehensive income  
Loss Currency translation differences -233 -92 -4
 
Total comprehensive income/expenses -15,266 7,286 -33,644

 

 

Clinton Cards Plc

Statement of Comprehensive Position as at 1st August
2011 2010 2009
£000’s £000’s £000’s
Non Current Assets
Goodwill 17,326 17,326 17,326
Intangibles 1,750 1,750 1,750
Property, plant and equipment 48,729 58,162 65,204
Deferred tax asset 172 411
Total non-current assets 67,805 77,410 84,691
Current Assets
Inventories 43,202 37,653 36,217
Trade and other receivables 18,917 17,882 19,418
Derivatives 250
Current tax asset 886
Cash and cash equivalents 19,673 7,225 9,056
Total current assets 82,678 62,760 64,941
Total Assets 150,483 140,170 149,632
Equity and Liabilities
Called up share capital 20,693 20,693 20,693
Share premium account 5,873 5,873 5,873
Capital redemption reserve 50 50 50
Currency translation reserve 233 325
Other reserves 308 308 308
(Accumulated losses)/retained earnings -3,951 11,082 3,704
Total equity 22,973 38,239 30,953
Non Current Liabilities
Deferred tax liabilities 1,289
Provisions 2,772 1,909 1,298
Deferred income 9,025 9,417 7,868
Total non-current liabilities 13,086 11326 9166
Current liabilities
Borrowings 53,527 41,566 56,581
Trade and other payables 55,458 47,370 51,265
Derivative financial instruments 218 574
Tax liabilities 456 1,301
Provisions 5,221 639 366
Total current liabilities 114,424 90,605 109,513
Total liabilities 127,510 101,931 118,679
Total equity and liabilities 150,483 140,170 149,632

Financial Information

Company share price and FTSE 100 Index as at 1st August

Year 2009 2010 2011 2012 2013
Share Price

In pence

27.09 35.00 12.50 6.75 6.75
FTSE 100 4682.50 5397.10 5774.40 5712.80 6682.00
           

 

 

Q2

Belling Company Ltd manufactures three types of ceramic coffee percolator, the Basic, Deluxe and the Premium models. The maximum market demand and resource requirements of each of these products are shown below. The percolators are made from an advanced heat-resistant material that gives the firm a competitive advantage. An e-mail from the purchasing manager has informed you that, because of a problem with the supplier, it should be assumed that the half year’s supply of this special material is limited to 28,000kg.

 

Belling Company Ltd operates on a just-in-time production (JIT) method so that opening and closing inventory levels are zero.

 

The sales director has already accepted an order for 1,000 Deluxe percolators that, if not fulfilled, would incur a financial penalty of £2,000. This order is included in the Deluxe’s maximum market demand figure.

 

Belling’s directors need to know whether they should go ahead and satisfy the contract and then prioritise production in the normal way or whether it should consider breaching the contract and incurring the penalty.

 

 

Budgeting Data for first half year 2013

 

  Basic Deluxe Premium
Maximum demand (units per year) 4,500 2,000 4,000
Special ceramic material used per kettle (kg) 2.00 5.00 8.00

 

 

The financial out turns for the previous two half years is as follows;

 

First  Financial Half Year 2012
Basic Deluxe Premium TOTAL
Sales in units 4100 1800 3600
£ £ £ £
Sales 114800 93600 302400 510800
Costs
Raw materials 41000 45000 144000 230000
D Labour 8200 7200 28800 44200
Overheads 60800 42400 56800 160000
Total Costs 110000 94600 229600 434200
Profit/Loss 4800 -1000 72800 76600
 

 

Second Financial Half Year 2012

Basic Deluxe Premium TOTAL
Sales in units 4600 2200 4325
£ £ £ £
Sales 128800 114400 363300 606500
Costs
Raw materials 46000 55000 173000 274000
D Labour 9200 8800 34600 52600
Overheads 64800 45600 62600 173000
Total Costs 120000 109400 270200 499600
Profit 8800 5000 93100 106900

 

 

Required

 

  1. Prepare a product analysed and total marginal cost income statement for the first half year of 2013 assuming that the Deluxe contract is honoured.

 

  1. Prepare a product analysed and total marginal cost income statement for the first half year of 2013 assuming that the Deluxe contract is not honoured.

 

  • Advise the company what action they should undertake based on your analysis above

 

 

 

(30% Marks)

Q3

 

A firm has a role to play in the economic system if transactions can be organised within the firm at less cost than if the transactions were carried out through the market. The limit to the size of the firm is reached when the cost of organising additional transactions within the firm exceed the cost of carrying out the same transaction through the market.

 

Coase, R, H., (1937), The Nature of the Firm, Econimica

 

Critically discuss  how  the current trend amongst Western European based international companies in order to co-ordinate and standardise their finance and accounting functions across their companies’ is to outsource their routine finance activities to a third party supplier in relation to Coase’s arguments and that of Oliver Williamson (1981).

As an alternative Western European companies could establish a centralised Shared Service Centre (SSC) instead of continuing with multiple geographical accounting offices. The initial formation however, would be expensive and time consuming however, this option it is argued could ensure greater control over operations.

Required

Discuss the relative merits and drawbacks of Western European Companies outsourcing their finance function to a third party provider compared to establishing and centralising the finance function in a dedicated SSC with reference to Coase and Williamson.

(20% marks)

 

                 Total 100% MARKS

Model Answers

 

AQ1

 

 

Report

 

From:  Financial Analyst

 

To: Board of Directors Clinton Cards Plc

 

Subject: Financial Performance Analysis 2009-2011

 

Date: 29th May 2012

 

Introduction

 

In compliance with your instructions I have undertaken a financial analysis of the company’s performance for the three financial periods 2009-2011. This comprises both a financial ratio analysis and a trend analysis of the audited published financial statements. The analysis has been mainly undertaken on the pre-exceptional figures to identify the underlying core performance trends of above average performance.

 

 

Profitability

 

The most recent financial statements give rise to concern of the profitability of the company. The latest period analysis reveals a substantial decline in overall profitability with a negative ROCE being realised after two previous periods of high returns when compared to the CIMA performance benchmarks indicating a high risk. This decline has occurred despite the trend of increased revenue streams being matched in 2010 by a parallel rise in the cost of sales indicating that these costs had been passed on to the customers. The trend of sales revenues has declined in the last financial period but cost of sales have fallen by a lesser  proportion  resulting in faltering gross profit margins unable to cover operating expenses leading to reported loss in 2011. This is alarming as in the previous financial periods of 2009 and 2010 above average ROCE returns were recorded as were operating profit margins. This recent dramatic decline is also mirrored in the return on assets which has become negative because of the recorded loss although profits were falling previously but this has become substantial during in the last financial period. The asset turnover has been maintained only due to the rationalisation of the asset base demonstrated in the vertical and horizontal trend analyses which have fallen by 20% over the three years.

 

Liquidity

The trend analysis has shown a growth in current assets principally in the proportion of inventory held and cash arsing from the sales of non-current assets and which have become greater in the last period than the non-current assets. The large cash growth has arisen from the disposals of non-current assets. However the trend in current liabilities had increased due mainly to a combination in the proportionate growth of short-term borrowing and trade payables that has compromised the short term solvency of the company.

The short term solvency of the business as measured by the working capital ratio has been high risk by standard benchmarking over the three periods indicating insolvency although it may be the norm for the business sector if it was supported by growing revenue streams. However, the quick ratio has declined substantially and is below 0.2 to 1 that benchmarks indicate higher levels of inventory are been held as sales demand is growing insufficiently. The inventory turn has increased to 44 days from the previous improvement to 37 days leading to the higher inventory accumulation caused by  management inefficiencies coupled to the falling the falling demand.

Efficiency

The level of trade receivables is more or less stable and the company’s credit control has improved whereas the payables have witnessed an upward trend to 56 days approaching 2009 levels. This indicates a positive cash flow although any further deterioration may damage supplier relations and invoke retaliation once the company’s poor financial performance becomes known

The cash operating cycle measures the time between paying out cash for the purchases of inventory, and receiving cash for the subsequent sale. The company’s cash cycle has remained steady in the last two periods with a slight decline and currently remains favourable in the short-term because payments are being delayed.

  2011 2010 2009
Finished Inventory period 44.10 37.61 41.40
Receivables collection 18.96 16.57 20.53
Payables payment period (56.61) (47.32) (58.60)
       
Operating Cash Cycle in days 6.45 6.86 3.33

 

Gearing

The balance sheet gearing position remains at high risk as it is above average benchmarks and it has increased with the company reliant on short-term borrowing.  The business had reduced its long-term debt which it may have found difficult to secure given its financial performance.

However, the ability to service the debt from operating profit streams had dropped significantly interest cover has dropped alarmingly and it now cannot service its debt from its operating profit, i.e.

 Year 2011 2010 2009
Interest cover

Operating profit /loss finance costs

(2.71)times

(£8112)m / £2992m

4.9 times

£15703m / £3149m

8.8 times

£27293m / £3089m

The 2011 financial statements reveal that the company fortunately had high cash balances from its non-current asset disposals that could meet interest payments albeit within the short -term.

Given the current lack of profitability, and the fear that profitability might deteriorate in future, this will impact on the company’s share price and market capitalisation.

Financial – Share Price

The share price originally recovered in 2010 arising from the reported increased profits and indeed the company outperformed the FTSE 100 Index.  This proved only a temporary trend and the poor results and the extent of the losses reported in 2011 led to the collapse the share price as market confidence in the ability of the company’s management to redress the situation disappeared.

Later movements of the share fell even further so that the company’s market capitalisation has fallen 80.71% since its peak in 2010 and has fallen well below the overall market movement as reflected in the FTSE100

Company Share Price Trend Movement and FTSE100 Trend

Year 2009 2010 2011 2012 2013
Share Price 100% 129.20% 4.48% 2.49% 2.49%
FTSE 100 100% 115.26% 123.31% 122.00% 142.70%

 

Conclusion

The main areas of concern regarding Clinton Cards Plc current position are:

  1. Low profitability
  2. High levels of cash, making Clinton Cards  Plc an attractive takeover target,
  3. Poor management of working capital, and the risk that supplier relationship might be strained.

Clinton Cards requires urgently needed addressing these issues if it is to escape the downward spiral towards corporate failure. Ominously the dramatic downfall of the share indicates that the market regards the company as unsalvageable and is most likely to be no longer a going-concern and the share represents its asset break-up value.

Appendix 1

    Clinton Cards Plc
    Financial Ratio Analysis
  Ratio Formulae metric 2011 2010 2009 CIMA Average
     Benchmark
Profitability Overall ROCE PBIT x100 % -10.60% 19.68% 31.18% 8%-11%
  Cap Employed    
     
  Return on Assets PBIT x100 % -5.39% 11.20% 18.24%  
  Total Assets    
     
  Asset Turnover Revenue x 2.42 2.81 2.31  
  Total Assets    
     
  Net profit NP before int and tax  % -2.23% 3.99% 7.91% 3%-10%
  margin Revenues    
     
  Gross Profit Gross profit x 100 % 1.82% 7.27% 7.49%  
  margin Revenues    
     
Liquidity Working current assets / x:1 0.72 0.69 0.59 1-1.5
  capital ratio current liabilities    
     
  Acid test ca’s – inventories x:1 0.34 0.28 0.26 0.75-1.25
  ratio current liabilities    
     
Efficiency Receivables Trade receivables x365 days 18.96 16.57 20.53 55-85 days
  collection days sales    
     
  Payables Trade payables x 365 days 56.61 47.32 58.60 45-60  days
  payment days cost of sales    
     
  Inventory Cl.Inv. x 365 days 44.10 37.61 41.40  
  turnover cost of sales    
     
Growth Gearing Fixed int cap x 100 % 69.97% 52.08% 64.64% 33%-47%
  capital employed

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Appendix 2

 

Clinton Cards Plc
Statement of Comprehensive Position
as at 1st August Vertical Trend Analysis
2011 2010 2009
Non Current Assets
Goodwill 11.51% 12.36% 11.58%
Intangibles 1.16% 1.25% 1.17%
Property, plant and equipment 32.38% 41.49% 43.58%
Deferred tax asset 0.12% 0.27%
Total non-current assets 45.06% 55.23% 56.60%
Current Assets
Inventories 28.71% 26.86% 24.20%
Trade and other receivables 12.57% 12.57% 12.98%
Derivatives 0.17%
Current tax asset 0.59%
Cash and cash equivalents 13.07% 5.15% 6.05%
Total current assets 54.94% 44.77% 43.40%
Total Assets 100.00% 100.00% 100.00%
Equity and Liabilities
Called up share capital 13.75% 14.76% 13.83%
Share premium account 3.90% 4.19% 3.92%
Capital redemption reserve 0.03% 0.04% 0.03%
Currency translation reserve 0.17% 0.22%
Other reserves 0.20% 0.22% 0.21%
(Accumulated losses)/retained earnings -2.63% 7.91% 2.48%
Total equity 15.27% 27.28% 20.69%
Non -current liabilities
Deferred tax liabilities 0.86% 0.00%
Provisions 1.84% 1.36% 0.87%
Deferred income 6.00% 6.72% 5.26%
Total non-current liabilities 8.70% 8.08% 6.13 %
Current liabilities
Borrowings 35.57% 29.65% 37.81%
Trade and other payables 36.85% 33.79% 34.26%
Derivative financial instruments 0.14% 0.41% 0.00%
Tax liabilities 0.33% 0.87%
Provisions 3.47% 0.46% 0.24%
Total current liabilities 76.04% 64.64% 73.19%
Total liabilities 84.73% 72.72% 79.31%
Total equity and liabilities 100.00% 100.00% 100.00%

 

Appendix 3

 

Clinton Cards Plc  
 
Statement of Comprehensive Position  
Horizontal Trend Analysis
2011 2010 2009
Non Current Assets
Goodwill 100.00% 100.00%
Intangibles 100.00% 100.00%
Property, plant and equipment 74.73% 89.20%
Deferred tax asset 41.85%
Total non-current assets 80.06% 91.40% 100.00%
Current Assets
Inventories 119.29% 103.96%
Trade and other receivables 97.42% 92.09%
Derivatives
Current tax asset
Cash and cash equivalents 217.24% 79.78%
Total current assets 127.31% 96.64% 100.00%
Total Assets 100.57% 93.68% 100.00%
Equity and Liabilities
Called up share capital 100.00%
Share premium account 100.00%
Capital redemption reserve 100.00%
Currency translation reserve
Other reserves 100.00%
(Accumulated losses)/retained earnings -106.67% 299.19%
Total equity 74.22% 123.54% 100.00%
Non -current liabilities
Deferred tax liabilities
Provisions 147.07%
Deferred income 114.71% 119.69%
Total non-current liabilities 142.77% 123.57% 100.00%
Current liabilities
Borrowings 94.60% 73.46%
Trade and other payables 108.18% 92.40%
Derivative financial instruments 37.98%
Tax liabilities 35.05%
Provisions 1426.50% 174.59%
Total current liabilities 104.48% 82.73% 100.00%
Total liabilities 107.44% 85.89% 100.00%
Total equity and liabilities 100.57% 93.68% 100.00%

 

 

Appendix 4

 

 
Clinton Cards Plc
Statement of Comprehensive Income
1st August
Vertical Trend Analysis 2011 2010 2009
Revenue 100.00% 100.00% 100.00%
Cost of Sales 98.18% 92.73% 92.51%
Gross Profit 1.82% 7.27% 7.49%
Operating Profit/loss -2.23% 3.99% 7.91%
Profit /Loss before taxation -2.93% 3.04% 6.98%
Profit/Loss from continuing -3.32% 2.11% 6.95%
operations
Total comprehensive income -4.19% 1.85% -9.75%
/(expense) for the period
attributable to owners of the
company
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Appendix 5

 

 

Clinton Cards Plc
Statement of Comprehensive Income
1st August Horizontal Analysis
2011 2010 2009
Revenue 105.51% 114.14% 100.00%
Cost of Sales 111.98% 114.42% 100.00%
Gross Profit 25.62% 110.70% 100.00%
Operating Profit/loss -29.72% 57.53% 100.00%
Profit /Loss before taxation -44.26% 49.71% 100.00%
Profit/Loss from continuing -50.42% 34.74% 100.00%
operations
Total comprehensive income -45.38% 121.66% -100.00%
/(expense) for the period
attributable to owners of the
company

 

AQ2

 

Separating out the overheads cost structure – High/ Low method

 

Overhead Cost Structure
Basic Deluxe Premium
Units
High 4600 2200 4325
Low 4100 1800 3600
Difference 500 400 725
£’s
High 64800 45600 62600
Low 60800 42400 56800
Difference 4000 3200 5800
VC £’s/Units 8 8 8
Fixed cost
total ohd 64800 45600 62600
less VC 36800 17600 34600
FIXED COST 28000 28000 28000

 

 

 

 

Belling Contribution per unit
Basic Deluxe Premium
Mat’s in Kgs 2 5 8
£ £ £ £ £ £
Sales 28 52 84
Var Costs
D Mat’ls 10 25 40
D Labour 2 4 8
Var Ohds 8 20 8 37 8 56
CPU 8 15 28
Contribution per limiting factor (kgs) 4 3 3.5
Priority Ranking 1 3 2

 

 

 
Assuming Deluxe contract is honoured

 

Demand in Units 4500 2000 4000
per half year
Production Schedule
Units Kgs Total Kgs Cumulative
Kgs
Deluxe 1000 5 5000 5000
Basic 4500 2 9000 14000
Premium bal fig 1750 8 14000 28000 max
 

 

 

Belling
Marginal Cost Income Statement First Half 2013
Assuming Deluxe Contract Honoured
Basic Deluxe Premium TOTAL
Unit Sales 4500 1000 1750
£ £ £ £ £ £ £ £
Sales 126000 52000 147000 325000
Var Costs
D Mat’ls 45000 25000 70000 140000
D Labour 9000 4000 14000 27000
Var Ohds 36000 8000 14000 58000
90000 37000 98000 225000
Contribution 36000 15000 49000 100000
Fixed Overhead 84000
Profit 16000

 

Assuming contract dishonoured
Demand in Units 4500 2000 4000
per half year
Production Schedule Kgs
Units Kgs Total Kgs Cumulative
Basic 4500 2 9000 9000
Premium 2375 8 19000 28000 max
Deluxe 0 5
28000

 

 

 

 

 

Belling
Marginal Cost Income Statement First Half 2013
Assuming Deluxe Contract Dishonoured
Basic Deluxe Premium TOTAL
Unit Sales 4500 0 2375
£ £ £ £ £ £ £ £
Sales 126000 0 199500 325500
Var Costs
D Mat’ls 45000 0 95000 140000
D Labour 9000 0 19000 28000
Var Ohds 36000 0 19000 55000
90000 0 133000 223000
Contribution 36000 0 66500 102500
Fixed Overhead 84000
Profit 18500

 

 

 

 

Decision

 

The revised production plan ignores the Deluxe contract increases contribution by £2,500, which exceeds the £2,000 financial penalty for breaking the contract. In simple financial terms, there is a net gain of £500 for failing to honour the contract and redirecting scarce resources. Indeed, as long as the penalty is less than £2,500, it would be financially worthwhile for Belling Company Ltd to breach the contract.

 

However, this fails to reflect a range of non-financial factors that have financial implications needs to be considered if a good decision is to be made. Key issues to consider in this case include:

 

  • The customer retention, whose contract Belling have reneged on, which may become permanently lost business

 

  • Leakage of the news of Belling’s failure to fulfil a contract if it became common knowledge in the trade, may damage the company’s reputation and the consequent loss of goodwill could amount to in the long term to far more, in terms of lost sales and contribution, than the immediate net gain of £500.

 

  • The decision to manufacture only two types of percolator instead of three products may have a harmful effect on customer loyalty and sales demand.

 

  • The long-term effects of vacating the market for Deluxe kettles invites Belling’s rivals to fill the gap created and thus gain market share.

 

 

Belling will need to get to discover the reasons for the material shortages.  So, working from the revised plan, if the company is able to find extra material from elsewhere, then clearly it should do so, as long as the premium for each kilogram (the cost over and above that already being paid) is less than £3.50. Since the contribution per kilogram of material used in producing the premium percolator is £3.50, this would make it worthwhile to obtain material from an additional supplier(s) if quality can be ensured.

AQ3

 

After the Great War (1914-1918) the role of the company within society was critically debated.  These debates posed awkward questions, about why did companies exist and who were they run for and what the position of the workforce in a company is (Micklethwaite and Wooldridge, 2003:111).  The most prominent economist engaged in this debate was Ronald Coase, (1937), whereby he attempted to explain why the economy had moved beyond individuals selling goods and services to one another. He located the answer within the imperfections of the market and he adjudged it as being particularly related to transaction costs. These were the costs that sole traders might incur in obtaining the most preferential deal and co-ordinating processes such as manufacturing and marketing and arguably now accounting and finance with the advances in IT and communication infrastructures.

 

Coase stated that transaction costs would arise for a company from acquiring information, product pricing, and the payment of commissions or even reaching a point where a contract could be constructed. The consequence of long runs and repetitive transactions would he asserted become significant and so some other form of transaction other than a free market mechanism was desirable. Coase’s arguments required of the company to do things more efficiently than the open market (Micklethwaite and Wooldridge, 2003:127).

 

Coase’s work has been refined further through the work of Oliver Williamson, (1979 and 1981). Williamson suggests that organisations have to choose between two alternative mechanisms to control its resources and operations. These are;

 

  • Hierarchy Solutions whereby management choose to own the assets and/or employ the staff directly and use the policies and procedures of the firm to control their use and performance. Vertically integrated companies are those which have a high reliance on the managerial hierarchy for control or,

 

  • Market Solutions whereby management choose to buy in the use of assets or staff externally under a formally negotiated contract

 

Transaction costs arise at the interface between economic agents, particularly between stages in a production or supply process, i.e. third parties supplying the accounting and finance function.  In addition to the normal cost on external suppliers, a market solution for an input or service in addition to the price for the bought in transaction it will incur the following transactions,

 

  • Negotiating and drafting the contract
  • Monitoring the suppliers’ compliance with the contract with regard to quality, reliability, invoicing etc…
  • Pursuing legal actions for redress due to non-performance
  • Penalty Payments and cancellation payments if the firm seeks to revise the contract

 

 

These costs and risks assumed by both parties to the contract will be increased by two further factors labelled “Transaction Cost Risks”

 

  • Bounded Rationality – When the contract is negotiated both parties are unable to predict how the contract will unfold or predict the future, e.g. the levels and volumes of accounting and finance work expanding or contracting in the future. This leads to detailed contract negotiations and interpretation issues that increase transaction costs. Legal enforcements would further increase the transaction cost from two specific types of risk

 

  • Opportunistic Behaviour – When each agent is seeing to pursue their own economic self-interest and thus contract weaknesses could be exploited for individual benefits (e.g. a minor change in accounting and finance work specification could permit a supplier to exact higher prices because the buyer is bound by the contract to purchase the services). This will lead to expensive variations in contract terms or damage claims for breach of contract

 

 

If these transactions costs become too high then the firm may reduce these by bringing the function in-house under direct managerial control, i.e. a Shared Service Centre (SSC) a hierarchy solution. The final decision will be base on management’s requirement to minimise costs. Therefore Coases’s premise is that companies make sense when the transaction costs associated with buying things on the market exceed the hierarchical costs of maintaining a bureaucracy, then modern technology is generally shifting the balance of advantage away from companies and towards markets and individuals (Micklethwaite and Wooldridge, 2003:175-6). Coase and Williamson’s ideas were empirically tested by Joskow (1987: 168) and he concluded that buyers and sellers make longer commitments to the terms of future trade at the contract execution stage and, rely less on repeated bargaining, when the relationship –specific investments are more important.

The merits of the outsourcing option a market solution therefore would include the fact that Western European companies could draw on the expertise of a company already established in the field of transaction processing and financial reporting. It would be standardised, streamlined and make use of the latest technology. The phenomenon of outsourcing to a third party provider has been described as a transformational phenomenon and largely successful but not without risk (Nolan and McFarlan, 1995:160-162).

If Western European companies decided to outsource offshore to an emerging country, significant savings prima facie might be made in terms of wage costs and cost of premises. A large, experienced supplier might be able to offer a higher quality service than is possible in house because of the ability to make use of expertise or technologies not readily available to Western European companies. It could arguably allow Western European companies’ senior finance people to focus on the creation of value.

The drawbacks of outsourcing are largely to do with the problems of ensuring control and the associated issue of retaining confidentiality of sensitive financial data that could lead to opportunistic behaviour by the agent.

There would also be a potentially large problem if things do not work out with the supplier and Western European companies, having dismantled its existing in house finance provision, has to seek a replacement supplier so that hierarchical solutions no longer are readily available.

By comparison, the merits of setting up a hierarchical dedicated SSC are that Western European companies would enjoy complete control of its Finance and Accounting processes and be in a better position to ensure that confidential items remain confidential. These European companies would avoid the risk involved in contracting out the processing of key financial data.

A dedicated SSC also shares some of the advantages discussed above in respect of outsourcing. By centralising its Finance and Accounting operations, the European companies can reduce head count. It can save on cost of premises because most finance staff will now be accommodated in a single location. Related to this, it can choose the location where labour and other costs are lowest or alternatively where highly qualified staff and the most favourable location for a centre are available. One reason for choosing a particular location for instance could be a favourable tax regime.

There is also the advantage that, in working with other functions such as sales, marketing, Research and Development or production, finance staff within the SSC is relating to members of their own organisation and is more likely to share a common organisational culture. There is likely to be a common understanding which would help problem resolution.

Finally an SSC can benefit from economies of scale. These could derive from learning curve effects, specialisation and from being able to afford to invest in a network system with a common database that provides interactive opportunities and the benefits of sharing data.

A major drawback in comparison with outsourcing however, is the initial setting up of an SSC. This will most likely require the engagement of an outside IT contractor to provide an Enterprise Resource Planning (ERP) system tailored to the needs of the European company and also a certain degree of upheaval as well as the considerable capital expenditure.

 

References

Coase. R, (1937), The Nature of the Firm, Econimica 4 (16), pp. 386-405.

Joskow. P (1987), Contract Duration and Specific Investments: Empirical Evidence from Coal Markets, The American Economic Review, Vol. 77, No.1, pp168-185.

Nolan. R and McFarlan F, (1995), Outsourcing, Harvard Business Review, Vol.73 (4), pp. 160-162

Micklethwaite. A, and Wooldridge.  A, (2003), The Company: A Short History of a Revolutionary Idea, London, Weidenfeld and Nicholson.

Williamson, O, (1979), Transaction-Cost Economics: The Governance of Contractual Relations, Journal of Law and Economics Vol.22 No.1, pp.233-261.

Williamson, O, (1981), The Economics of Organisation:  The Transaction Cost Approach, American Journal of Sociology, Vol. 87, No.3, pp.548-577.

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