Summary of Business - Strategy - Application - Level - Question - Bank - With Immediate Answers

Business strateg
1 West Highland Granite Ltd

Note: Assume that the current date in the question is January 2008.
West Highland Granite Ltd (WHG) makes kitchen tops made out of polished granite.
Company background
WHG was established on 1 January 2005 as a management buyout (MBO) from a large
international company, Hillert Ltd, which manufactures and retails kitchens and
bathrooms. The MBO was financed largely with venture capital and significant borrowing.
Under the buyout agreement, Hillert had agreed to an exclusive, two-year contract from 1
January 2005 to acquire all of its granite kitchen tops from WHG. The price was agreed at
CU400 per square metre, which was the transfer price used prior to the MBO when WHG
was a wholly-owned subsidiary of Hillert. After this contract expired, Hillert could acquire its
granite tops from any supplier it wished, and it would be free to negotiate prices, if it chose to
continue acquiring its granite tops from WHG.
It was clear to the new management of WHG that the long-term success of WHG
depended on establishing sales to customers other than Hillert, while attempting to retain
the Hillert contract beyond 2006 under reasonable terms.
Industry background
Granite kitchen tops are amongst the most expensive work surfaces that can be fitted to
kitchens. They are therefore normally only purchased by a minority of consumers who buy
expensive kitchens. During a recession, industry sales tend to suffer significantly, as many
cheaper alternatives to granite are available.
Granite is a natural product but, in order to produce polished kitchen tops, it needs
significant processing and refinement. The costs of production are therefore high.
Granite comes in many different quality grades, which are sometimes numbered 1 to 6,
with number 6 being the best grade. WHG produces grades 3 to 5. A cheaper alternative
to granite kitchen tops is synthetic tops, which are significantly lower cost than grade 1
granite.
There are many producers of granite kitchen tops in the UK and the industry is price very
competitive, as granite occurs naturally and thus has some characteristics of a commodity
product. Despite this, quality differences in the basic product or in its finishing can demand a
price premium.
Establishing the business (2005-2006)
During the years 2005 and 2006 WHG made the following sales:
Sales to Hillert Ltd Sales to other customers
Years to 31 Square metres Price per metre2 Square metres Price per metre2
December
2005 30,000 CU400 6,000 CU350
2006 25,000 CU400 10,000 CU350
The variable operating cost of producing granite tops has remained fairly constant at
around CU250 per square metre. Fixed operating costs are about CU3 million per year.
WHG board meeting – November 2006

Towards the end of 2006 a board meeting was called to discuss the company's strategy beyond 2006.
Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

mozumder@organic-crop.com Cell-01711-981920 Page 1
The finance director was pessimistic: 'We have failed to establish enough new markets and new
customers. Once the contract with Hillert expires, the continued viability of WHG is entirely at their
mercy. If they decide to source their granite tops from another company, then we are finished as a
company. If they decide to offer us a much lower price than the CU400 they have paid up to now, then
we may be finished anyway.'
The marketing director disagreed: 'We might not yet have built up a sufficient market other than Hillert,
but we are getting there, as we now have 35 different companies buying from us. Sales to other companies
are growing and we have had good feedback from these customers. Also, my best guess is that Hillert will
continue buying from us. It may be smaller quantities and a lower price but this will give us time to
establish other customers and to grow.'
A year of transition (2007)
At the end of 2006 Hillert eventually agreed to a further contract with WHG, but this would only be for
one year from 1 January 2007 and WHG would no longer be Hillert's exclusive supplier of granite tops.
Under the terms of the contract, 15,000 square metres would be supplied by WHG to Hillert during 2007,
at a price of CU350 per square metre.
During 2007 sales to other customers were 20,000 sq. metres at CU350 per square metre. Variable
cost per square metre and annual fixed costs will continue at their previous levels during 2007.
WHG board meeting – December 2007
By December 2007, while negotiations were continuing, it had become very probable that Hillert would
not renew its contract with WHG for a further year. A board meeting was therefore called to develop a
survival strategy for 2008, assuming that there would be no renewal.
Strategy 1
Was supported by the marketing director. This strategy would be to lower the selling price to CU300 in
order to penetrate the market more effectively and win new customers. The marketing director estimated
that, at this price, the sales volume would increase to 35,000 square metres per year. [Assume variable cost
per square metre and annual fixed costs continued at their previous levels.]
Strategy 2
Was supported by the finance director. This strategy would be to downsize the business to accommodate
the lower level of sales. It would also mean that annual fixed costs would decrease to CU2 million. Lower
quality granite would also be produced (grades 1 to 2). As a result, it is assumed that variable cost per square
metre would decrease to CU200. It is also assumed that selling prices would be maintained at CU350 per
square metre and annual sales volumes would be 15,000 square metres.
Requirements
(a) Prepare a schedule showing operating profit for each of the years ending 31 December 2005, 2006 and
2007. Briefly explain, with additional data analysis, the factors which have affected the operating profit
of WHG during this period. (14 marks)
(b) Determine the break even output of WHG in 2007 and explain the key risks to which the company is
exposed. Ignore the two proposed strategies. (7 marks)
(c) Prepare a schedule showing expected operating profit for 2008 under each of the two
alternative strategies being put forward.
Using these operating profit calculations and the assumptions of the directors, show the expected
operating profit percentage margin on sales for 2008 under each strategy. Briefly explain why each
strategy has caused this figure to change compared to 2007. (10 marks)
(d) As an outside consultant, prepare a memorandum for the board of WHG which:
(i) Discusses how WHG may use market research to determine the impact of the change in
selling price on expected demand for Strategy 1.

(ii) Explains how the two strategies would affect the market positioning of WHG in
terms of the price-quality trade-off.
(iii) Provides a reasoned recommendation as to which strategy, if either, WHG should adopt. Refer
to previous calculations where appropriate. (14
marks)
(45
marks)
1 West Highland Granite Ltd
Marking guide
Marks
(a) Operating profit calculations 4

Data analysis 5
Qualitative analysis 5
14
(b) Break even 3
Key risks 4
7
(c) Operating profit 2008 4
Margin 2
Explanation 4
10
(d) (i) Market research 6
(ii) Market positioning (price-quality) 6
(iii) Recommendation 2
14
45
(a)
2005 2006 2007
CU'000 CU'000 CU'000
Sales 14,100* 13,500** 12,250***
Variable costs**** (9,000) (8,750) (8,750)
Fixed costs (3,000) (3,000) (3,000)
Operating profit 2,100 1,750 500
(b) (30,000 CU400) + (6,000 CU350)

(d) (25,000 CU400) + (10,000 CU350)
(e) (15,000 CU350) + (20,000 CU350)
**** CU250 36,000/35,000/35,000
Factors affecting performance
Pricing
The contract with Hillert has had a favourable effect on profit partly because it has
been set at a favourable price of CU400 per square metre compared to the market
price to other customers of CU350.

This has had a favourable impact on profit of CU1.5m (CU50 30,000) in 2005 and
CU1.25m (CU50 25,000) in 2006.
Adjusting the above sales and operating profit figures for this price effect, the profits would have been,
at a standard price for all sales of CU350:
Sales revenues Operating profits
CU'000 CU'000
2005 12,600 600
2006 12,250 500
2007(as previously) 12,250 500
Volumes
The contract with Hillert has also had a favourable effect on sales volumes. WHG is only
establishing its sales to third parties (i.e. non-Hillert sales) during this period but it is clear from the
table below which shows the position without the Hillert sales that WHG would be unviable by a
significant margin.
2005 2006 2007
CU'000 CU'000 CU'000
Sales 2,100* 3,500** 7,000***
Variable costs**** (1,500) (2,500) (5,000)
Fixed costs (3,000) (3,000) (3,000)
Operating (loss) (2,400) (2,000) (1,000)
* (6,000 CU350)
** (10,000 CU350)
*** (20,000 CU350)
**** CU250 6,000/10,000/20,000
Thus, without Hillert, in 2005 WHG would not even have covered fixed costs. By 2007 the loss is only
CU1 million which would be covered by a further increase in sales volume of 10,000 square metres
(which was the increase achieved in 2007 compared to 2006).
Therefore on the positive side, WHG has quickly grown the third party business such that, following the
growth trend, there is a strong possibility the company will become viable in the near future.
Mix
The mix between Hillert sales and other sales has been important. This is partly from the price
differential perspective (i.e. CU400 compared to CU350), but also as a measure of reduced
dependence on Hillert as the major customer. The mix in (i) sales volume and (ii) sales value has been:
% of sales to Hillert
Volume Value
2005 83% 85%
2006 71% 74%
2007 43% 43%
Cost structure
The high level of fixed costs has meant operating gearing is high and therefore profits have fallen more
rapidly than sales.
In order to compare like with like, if we look at the above table using constant prices at CU350 (and
thus extracting pricing effects in order to look at the effects of costs on profit arising from volume
changes) it can be seen that in the period 2005 to 2007:
Sales have decreased by 3% (from CU12.6m to CU12.25m)
Profits have decreased by 17% (from CU0.6m to CU0.5m)

(b) Break even
Contribution CU(350 – = CU100 per square metre
250)
Fixed costs = CU3 million
Break even = CU3m/ CU100
= 30,000 square metres
Key risks
Risk may be assessed by both probability and impact. In this context the key risk is clearly
the partial or complete loss of the Hillert contract. The scale of impact of this is shown in
(b) above. It would also appear that the loss is highly probable.
In 2007, the level of sales of 35,000 square metres has a margin of safety of only 5,000 square
metres. A relatively small, 14.3%, fall in sales volume would therefore begin to generate losses for
WHG.
More significantly, it is not just the relative narrow margin of safety that creates a risk, but
the probability that a fall in sales will occur. In particular, there is only a one year contact
with Hillert and, despite the reduced volumes of trade in 2007 compared to 2005 and 2006,
this customer still makes up a large proportion (43%) of sales.
The key risk with respect to volume of sales is therefore that some, or all, of the Hillert
contract will be lost, and other sales will be insufficient to compensate.
Other risks include:
 Granite is a luxury product thus in recession there is disproportionate pressure on
sales and prices. 

 There is a high level of fixed costs thus high operating gearing. Profits are therefore
volatile with respect to changes in sales. 

 The 'significant borrowing' adds the risk of financial leverage to operating leverage. 
(c)
Strategy 1 Strategy 2 2007
CU'000 CU'000
Sales 10,500* 5,250** 12,250
Variable costs (8,750)*** (3,000) (8,750)
Fixed costs (3,000) (2,000) (3,000)
Operating profit (1,250) 250 500
Operating Profit/(loss) % (11.9%) 4.8% 4.1%
* 35,000 CU300
** 15,000 CU350
*** CU250 35,000
**** CU200 15,000g
The operating profit % is affected by the following variables:
  Selling price 
  Volume of sales 
  Variable cost per unit 
 Total fixed costs 
Strategy 1
Comparing Strategy 1 with the 2007 performance, a key factor that would make the

operating profit margin lower (and indeed negative in this case) would be the lower selling
price of CU300 compared to CU350.
However, the selling price is not independent of the volume of sales. The expected loss of the Hillert
contract is a major cause of the lower margin but the lower selling price has at least increased the
volume of other sales from 20,000 square metres to 35,000 square metres. This would have a
favourable impact on operating margins – though not enough to compensate for the lower selling
price and the loss of the Hillert contract.
Strategy 2
Comparing Strategy 2 with the 2007 performance, there is actually an improvement in the operating
margin in % terms, although the overall operating profit, in absolute terms, would actually be lower
with Strategy 2 than in 2007.
The difference is due to the fact that while profit has halved, sales revenue has decreased by more
than half. The fall in sales revenue is not due to a price change as with Strategy 1 but, rather, due to a
decrease in sales volume.
Nevertheless, two factors had a favourable effect of operating margins: (i) the reduction in fixed costs;
and (ii) the reduction in variable costs per square metre. The net effect is to create a high % operating
margin on a lower level of sales revenue.
(d) Memorandum
To: Board of WHG
From: A Consultant
Subject: Market research and market positioning
Date: XX/XX/XXXX
(i) Market research normally involves many aspects of marketing rather than just price and demand.
This particular piece of market research, however, is focused solely on the relationship between
price and demand. Nevertheless, in order to establish the relationship between these two
variables it is important in the research project to ensure that other factors which could affect
demand are held constant (other factors may include product, position, place) in order to
isolate the impact of price.
Desk research
This is the gathering and analysis of existing (or secondary) data from internal and
external sources. This may include:
Past experience of price changes: Unfortunately WHG is in a difficult position in determining
sensitivity to demand as it has little history of selling to customers other than Hillert. Experience of
changes in demand to previous price changes is not therefore available as the price charged to Hillert
may be an artificial transfer price. Indeed, this is indicated by the fact that Hillert was being charged
CU400 per square metre while other customers were only being charged CU350.
Any desk research therefore needs to rely mainly on industry data rather than company
specific data.
Trade journals/surveys: These may give documented evidence of:
  Different suppliers of granite tops charging different prices 

  The experience of other granite suppliers following price changes 
 General market surveys of customer attitudes to price changes in the industry. 
Demand for rivals: Evidence from local rival companies changing prices e.g.
  Have customers come over to WHG because of price increases by rivals? 

  Have rivals first increased, then later reversed, price increases? 
 Are rivals known to have downsized or cut staffing levels following price increases? 

Field research
Experience of salespeople with customers: A key factor is likely to be whether
existing customers are likely to buy more if the price were to be reduced and whether the
suggested price change is of the right magnitude (is it excessive or perhaps not enough?).
Typically customers might indicate: whether they are also being supplied granite by other
suppliers, what proportion they are supplied by WHG and what price they are paying to
other suppliers.
Competitive conditions: A key factor affecting demand in a competitive market is the
price being charged by other suppliers for similar goods. This is particularly important for
commodity type, non-branded goods. Moreover it is not just the price of granite but the
price of substitutes such as synthetic tops, which are lower quality but cheaper. The cost
difference would be narrowed with Strategy 1 and this may increase demand.
Questionnaire surveys: Existing customers could be surveyed to ascertain their response to
price changes. These could be open questions to see if price is mentioned – such as what factors
would deter you from continuing to use WHG? Alternatively, or additionally, they could directly
ask the customers about potential price changes. The characteristics of different customers could
be noted (e.g. small vs large) to ascertain different responses from different market segments.
In depth interviews: This is similar to a questionnaire but more detailed responses can be
obtained. This may cover general attitudes to price changes and a more comprehensive study
of a range of price changes.
Experimentation or test marketing: Prices could actually be changed in one area, or a
small representative group of customers, in order to observe actual customer responses to
price changes. This could be followed up by a questionnaire at a later date.
Critical appraisal
 Questionnaire surveys and similar types of field research need to be undertaken using
an appropriate sampling method in order to extrapolate the results into the
population on a valid basis. 

This can include for example: random sampling, quota sampling and panelling. 

 The sample size also needs to be adequate to draw statistically significant conclusions.
With only 35 customers it would probably be necessary to consider them all in any
market research. 

 The period of any survey needs to be considered. Sampling around seasonal peaks
for instance may produce different results than the remainder of the year. 

 The answers people give in response to surveys and questionnaires may not be the
same as their actual actions would be in practice (the external validity problem). 

 Surveys may pick up a short term response to price changes but this may differ from
the longer term response as people become accustomed to the new price level. 

 A decrease in price may affect the perception of the product in that, if price decreases,
there may be a perception that the underlying quality has declined as there is evidence
that price may be taken as a signal of quality. This is particularly the case for
commodity products where the quality is not easily observable. 

 Survey evidence may relate to a one-off price increase but the response may
differ depending on whether rival companies follow the price change or not. 

(ii) A product can be positioned in a number of ways e.g., via a price or emphasis on a particular
characteristic or set of characteristics. In other words, positioning means giving a product a
place relative to its competitors on factors such as quality, price, image, being exotic,
providing status, etc. The price-quality trade-off is therefore just one aspect of market
positioning.
The two strategies take a very different view of the trade off between price and quality.

Strategy 1 attempts to reduce price while maintaining quality, in order to penetrate the
market. Strategy 2 takes the opposite view by maintaining price but reducing quality.
Price
High A
B
C
E
Low
Perceived quality
Very poor Poor Reasonable Good Very good
In the diagram:
C represents Strategy 1 where price has been cut to CU300 and quality maintained
B represents Strategy 2 where price has been maintained at CU350 and quality reduced A
represents companies selling the highest grade 6 granite tops at high prices
D and E represent companies selling non-granite, synthetic kitchen tops at low prices
It is clear that from the customers' perspective, C dominates B as it is both lower price and
better quality. However, this raises a number of issues:
 Customers cannot choose between B and C as these are alternative strategies for WHG.
The key positioning is against other companies selling granite at grades 1 to 5. 

 Quality is a question of perception where it is not always readily observable by the
customer. It may be that demand will be based largely on the fact that the product is granite
(which is verifiable) and the price rather than the precise grading of 1 to 6. 

 The relative price difference between granite compared to D and E synthetic tops is more
observable. 

 Short-term and long-term price-quality effects may be different as reputation may ultimately
be affected. 
Another way of looking at the issue of market positioning for WHG is through Kotler's 3Cs:
  Costs 
  Customers 
 Competitors 
This view sees the price-quality trade-off in comparison to competitors as the key issue.
'Parity pricing' is where the price and quality are equivalent to the company's major
competitors.
Around this 'parity level' of pricing there is a 'zone' of acceptable prices.
Below parity price – sales will be made but, if the prices are too low, then costs will exceed
revenues and no profit will be made.

Above parity price – if the prices are too high, the product becomes uncompetitive and no
sales will be made, as products of the same quality can be obtained by customers from
competitors.
Whatever price is being charged it must however be supported by the remaining elements of
the marketing mix.
(iii) The calculations in requirement (c) show that, for 2008, WHG generates an operating
profit of CU250,000 under Strategy 2 but makes an operating loss of CU1,250,000 under
Strategy 1.
While it is difficult to compare an operating profit with an operating loss, it is also clear that
Strategy 2 generates a better return. Indeed, even if Strategy 1 had earned the same absolute
level of operating profit as Strategy 2, the operating profit margin would be much lower, as
the sales revenue with Strategy 1 is double that of Strategy 2 (i.e. twice the level of revenue
needs to be generated to earn the same profit).
In the short term therefore Strategy 2 is preferable as the difference, in terms of
operating profitability is quite substantial.
In the longer term, however, there may be good reason to suppose that there may be
benefits for Strategy 1 that would not be reflected in current profitability. Specifically:
 The policy of 'penetrating the market' means selling more volume but in so doing it
involves not just selling more to existing customers but expanding the customer base in
order to build loyalty. This is likely to provide a better basis to grow sales volumes in
future and perhaps later be able to increase prices as at present there are only 35
customers. The lower prices may entice customers away from rivals and having done so
they may remain with WHG even if prices rise in future. 

 The quality of the product may be something that is not immediately observable but, in
the medium term, the lower quality in strategy two may damage reputation. 

 With Strategy 2 even if the quality is observable, because the grade is disclosed as 1 or 2,
this means that by maintaining the price at CU350 the price competition is even more
severe as the company is competing with lower cost producers than previously when
grades 3 to 5 were being sold at the same price. 

 If the price is lowered to CU300 than this might be a key factor in retaining some of
the Hillert sales, which had been indicated as highly improbable at CU350. This may
help retain a major existing customer. 
Strategy 2 however has some advantages over Strategy 1, other than short term
operating profits:
 Strategy 2 takes the opposite view to Strategy 1 by maintaining selling price but reducing
quality in order to make a higher contribution per square metre. While recognising that
sales volumes may fall, the higher margin per unit outweighs this and earns profits in the
short term without depending on the uncertain possibility of future growth as with
Strategy 1. 

 The price cut in Strategy 1 may be copied by competitors and therefore the level of
market penetration expected may not be achieved. 

 While the lower price in Strategy 1 means that a higher volume is likely to be sold, the
low margin and high fixed costs mean that the break even point has increased very
substantially, making a high level of sales necessary to break even. 
Break even
Contribution (300 – 250) = CU50 per square
metre
FC = CU3 million
Break even = CU3m/ CU50

= 60,000 square metres
Sales are thus only 58% of the break even level with Strategy 1 despite the significant price cut.
They are clearly above break even level with Strategy 2, partly due to the lower fixed costs.
Recommendation
The reduction of price in Strategy 1 in order to penetrate the market in a price sensitive
industry has much to commend it. However, the scale of the price decrease means that the
lower price seems unsustainable, given the high break even level created by the low
contribution margin per unit. There might also be problems in future if subsequent raising of
prices meets customer resistance.
If Strategy 1 is to be followed then perhaps a smaller price decrease would be appropriate
for a small period and only then if it is believed that competitors will not copy the price
reduction.
Strategy 2 appears to generate profits, but the fact that it is dominated in price-quality terms
by other options is likely to be perceived by customers and thus may not be sustainable.
Perhaps a small price decrease in line with the decrease in quality would be appropriate
having regard for the market price of grade 1 and 2 granite.
2 Deebee Ltd
Deebee Ltd (hereafter Deebee) is listed on the Stock Exchange and runs a chain of 105
roadside restaurants offering a wide range of meals served by waiters/waitresses at mid-
market prices. The restaurants are mainly located in the South East of England. One quarter
of the ordinary shares in the company are held by the two founder directors with most of the
remainder being owned by financial institutions. The company has financed expansion by
issuing new equity and borrowing significant amounts in recent years including an overdraft.
Overall the company is near its current borrowing limit and this has been reflected by a fall in
its credit rating.
Company history
Deebee commenced trading in 1978 at a single site. After an uncertain start the business
began to grow with operating cash flows being reinvested, along with debt and equity
capital, into purchasing land and building new restaurants.
The restaurants are normally located on out-of-town major roads with a target market of
motorists stopping for meals and snacks, offering a quick service to get them back on the
road as soon as possible. Frequently, restaurants are located next to petrol stations to
encourage motorists to stop.
As the business grew, the restaurants became a recognisable sign at the roadside with market
surveys showing over 95% of car drivers in the South East recognising the brand. The business
growth gave greater buying power and distribution economies as well as more general
economies of scale.
Food is delivered by suppliers to a central depot which is then distributed weekly by
Deebee's own refrigerated lorries. Suppliers have been the same for many years and are only
changed if they prove to be unreliable.
In order to keep costs low the company attempts to minimise its marketing and human
resources overheads. Also, the management structure of the company has not changed since
1984 with the manager of each restaurant reporting directly to senior managers at head office
who in turn report to the board. The style of management is top down and prescriptive, with
all but the most trivial decisions being taken by head office.
The prices charged and the menu offered is the same at all restaurants. Prices have been
increased above inflation over the past few years.

After a period of expansion, the company obtained a listing in 1998. Since that time
however the share price has underperformed both the market generally and the average
of the sector.
The competition
The competition comes in several forms. A rival and very similar chain, Travel Grill Ltd, is
operated as a subsidiary of a major listed company which includes hotels and other leisure
interests. It offers a similar menu to Deebee and while the prices used to be slightly higher
than Deebee's they are now marginally lower. Travel Grill's chain is much larger than
Deebee's and is continuing to grow. Currently, Travel Grill have some 435 restaurants, it has
national coverage and has received significant investment in all aspects of the business in
recent years.
Further competition comes from fast food restaurants with a very limited range of meals (e.g.
hamburgers) which offer self-service and low prices. They also offer a quick turnaround for
customers.
Deebee's performance
The accountant of Deebee produced the following five-year summary for the company for the years ending
30 September.
Year Restaurants Revenue Operating profit Total assets
CUm CUm CUm
20X5 75 112.50 13.50 90.00
20X6 80 116.00 12.76 100.00
20X7 87 121.80 12.18 113.10
20X8 95 128.25 11.54 128.25
20X9 105 136.50 10.92 147.00
The current situation
The finance director recently resigned and has made the following statement:
'The company's investment policy has been dominated by the opening of new restaurants. This has put a
significant strain on financial resources to the extent that liquidity is a problem. Equally significantly, there
has been a lack of investment in existing restaurants. Many of the older sites are shabby and are in need
of investment to the extent that it is damaging the company's reputation.
Similarly, there has been little investment in information technology, meaning a lack of information for
inventory control, performance measurement and planning. I also disapprove of the recent attempt to cut
costs by reducing the number of staff servicing each restaurant, offering wage rises below inflation and
appointing junior staff to circumvent minimum wage legislation. We now offer the lowest wages in our
sector of the industry. There has also been little other attempt to improve employee performance. All this
has impacted upon employee goodwill, resulting in high staff turnover and harming customer service.
Also, despite significant changes in road traffic patterns and population shifts, there has been little
attempt to identify underperforming restaurants and thus there have been very few closures. A
restaurant is kept open if it shows an operating profit before the allocation of head office costs.'
Requirements
(a) Using the data and other information provided, evaluate the performance of Deebee over the period
20X5 to 20X9. (10 marks)
(b) Assess Deebee's current position using SWOT analysis. Each point should be clearly explained and
the most important factors should be highlighted. Where appropriate, make reasonable assumptions.
(12 marks)
(c) Write a memorandum to the directors, as a strategic adviser, which develops the above SWOT
analysis to set out the key features of a strategic plan for Deebee Ltd. The memorandum should deal
only with the following matters:
  Future investment policy and financial resources 

 Organisational structure 
 Future strategic direction (11 marks)
(33 marks)
2 Deebee Ltd
Marking guide
Marks
(a) Data analysis 5

Qualitative analysis 5
10
(b) Strengths 3
Weaknesses 3
Opportunities 2
Threats 2
Key points 2
12
(c) Future investment 4½
Organisational structure 2½
Strategic direction 4
11
33
(a) Performance measurement

Performance measurement needs to be considered at three levels: corporate performance, head
office performance and individual restaurants.
Corporate performance should ultimately be judged by the market in terms of share price. This is
related to the profitability and cash flow generation that can be achieved which in turn is
determined by the performance of the restaurants. However, the market takes a long term view
of future profitability rather than measuring performance using current year profit alone. One
example would be the reduction of real wage levels adding to profit, but there is likely to be a
lagged effect upon future sales as standards of service to customers decline.
Head office performance is more difficult to measure as it has no easily quantifiable output.
Nevertheless performance targets could be set in terms of customer and employee satisfaction,
total revenue, purchase costs, supplier reliability and total head office costs. These targets could
be monitored and tightened year on year.
Individual restaurant performance determines the overall performance of the business. Ultimately,
it is future performance that matters rather than past performance hence an assessment of
potential rather than past achievement needs to be considered before any decision regarding
closure could be
considered. On a similar theme the performance of the unit needs to be distinguished from
the performance of the manager. A badly performing unit could be improved by changing the
manager or it could be the inevitable consequence of changes in road traffic patterns,
additional local competition or other non controllable factors.
The following calculations indicate existing performance:
Revenue per Op profit/ Op profit/ Total assets
Year restaurant Revenue Total assets per restaurant
CUmillion % % CUmillion
20X5 1.50 12% 15.00% 1.20
20X6 1.45 11% 12.76% 1.25

20X7 1.40 10% 10.77% 1.30
20X8 1.35 9% 9.00% 1.35
20X9 1.30 8% 7.43% 1.40
It can be seen that:
 Revenue per restaurant is falling despite investment in new sites, an increasing
average cost per site and increases in selling prices above inflation. 

 Profit margin on revenues is also falling. This might be that variable costs are
increasing more quickly than revenues or that volumes are falling and fixed costs are
not being covered to the same extent. 

 Return on total capital employed (i.e. total assets) is falling as an almost inevitable
consequence of the above. 
In order to measure performance, information is clearly needed on individual sites and
investment in IT will produce more comprehensive and up to date information to do this.
Nevertheless, it should be clear which restaurants are performing well and which are not,
both currently and with respect to changes over time. More generally it should be clear
whether there is any correlation between the age of a site and its performance. Has
performance declined at the old sites? Are the new sites performing well? Does it take some
time for a new site to establish adequate sales?
In measuring performance, for the purpose of deciding whether to keep a restaurant open,
the use of the absolute profit figure is unlikely to be adequate in a number of ways:
 It reflects historic depreciation rather than current values. 

 Operating profit excludes any capital charge. In this context the value of selling the
site is relevant. This would show the cash that would be generated by alternative
investment in the company, even if only to reduce debt. 

 Similarly, there is no charge for head office costs. While many of these will be fixed,
some costs are likely to have a variable element and to this extent they need to be
considered. 

 Exit costs such as redundancy would also need to be considered. 

 Revenue might be transferred to other restaurants if one site is closed. 
The use of residual income and return on investment are likely to have many of the same
problems as operating profit outlined above.
(b) SWOT
analysis
Strengt
hs
A market quotation makes raising of further equity capital easier.
There are a significant number of existing sites giving critical mass and economies of scale.
There is a record of strong recent growth with many modern restaurants (30 of the 105
being opened in the last four years i.e. 29%).
Many sites are at prime locations on major roads and near other facilities for the target
markets. Planning permission may prevent rivals opening proximate sites.
There is a well known brand name and recognisable roadside presence.
Reasonable distribution systems exist arising from the fact that restaurants are concentrated in
a geographical region making supply chains shorter.
Geographical concentration also generates increasing market recognition within the target area.
Low labour costs relative to competitors.

Weaknesses
Liquidity difficulties with near debt capacity, resulting in a fall in credit rating and probably a higher cost
of debt as a result.
There is no apparent system for reviewing the performance and price competitiveness of suppliers.
Share price has underperformed the market and indicates that investors are not happy about future
performance.
Despite the growth in restaurants and in total revenue, the revenue per restaurant has fallen as has
overall operating profit. This is despite an increase in investment with a significant rise in total assets.
Many of the older restaurants have not been refurbished which may damage the brand
without significant investment.
IT facilities are poor with a consequent impact upon information availability.
Staffing appears to be a problem with a poor human resources policy.
Opportunities
Expansion outside the South East is feasible.
There is an expanding market with the number of cars on the road increasing each year.
A more active policy with respect to changing suppliers may reduce costs and/or provide a better
service.
Divestment of less profitable restaurants may provide some funds for investment or reduce
liquidity problems. The number of relatively small restaurants with few interconnections with other
parts of the business makes divestment relatively easy.
Advertising and marketing initiatives may increase sales.
Threats
There is a possibility of insolvency given debt capacity, falling profits and higher interest rates due to
falling credit ratings.
The major competitor appears to have the financial backing of a large listed company and is itself
far larger than Deebee gaining greater benefits from economies of scale and market recognition. It
has also invested more than Deebee.
Fast food competitors are competing with respect to quick turnaround which Deebee appears
to regard as a core competence, and at the same time they are undercutting Deebee on price.
Falling profits may damage share price further without appropriate action.
Key points
Liquidity problems – possibly due to over-expansion and this is likely to constrain future development.
Declining profitability – despite increased investment, profits and share price have fallen. This
is unsustainable.
Competition – competitors are actively developing in the same market as Deebee.
Human resources policy and IT policy – both appear significantly underdeveloped and form a
poor basis for a sustainable future strategy.
(c) Strategic planning memorandum

Memorandum
To: All directors
From: Strategic adviser
Subject: Strategic plan
Date: XX/XX/XXXX

Investment policy and financial resources
The company's investment policy in recent years appears to have been dominated by the
opening of new restaurants. The success of this policy in terms of the profitability of these
new restaurants compared to older restaurants needs to be considered and this is
reviewed under the section on performance measurement below.
Other areas of capital investment appear to have been neglected in the policy to expand.
While the constraint on capital means that choices may have to be made between
competing projects it is important to consider the long term impact upon reputation and
strategic direction as well as the more immediate impact upon profit when developing
investment appraisal criteria.
Regarding refurbishment, if many of the older restaurants are run down this may affect the
value of the brand image and thus ultimately affect all restaurants. This is particularly the case
if Travel Grill is investing heavily. It may be that ultimately Deebee will be viewed as
downmarket from Travel Grill with a consequent effect upon trading volumes and prices that
can be charged. Benchmarking against Travel Grill may be appropriate in this and some other
respects.
Investment in IT also needs to be considered in order to monitor individual
restaurants. This is particularly the case if decisions are to continue to be imposed by
head office. The benefits may include more efficient stock ordering, marketing
information for promotions, information for performance appraisal and facilitating
financial controls over staff.
In terms of intangible assets, investment may also be required in training and human
resources (see below) and developing the marketing function in order to promote sales.
Although the brand is well recognised this does not necessarily mean it is recognised for
the right marketing reasons.
Clearly, the investment policy is constrained by the available financial resources. If debt policy
is reaching its capacity then alternative forms of finance may need to be considered. Raising
equity may be possible but the market does not view the company favourably at the moment
and if the directors believe, on the basis of inside information, that the share price is too low,
then the timing of such an issue might not be ideal. An alternative might be leasing finance but
this could be regarded as debt finance in another form and there might be a similar
reluctance by lessors to engage in such contracts. Sale and leaseback might be possible but
this might give similar problems.
An alternative might be the sale of less profitable restaurants and the use of the finance to
invest in existing sites and support activities as noted above.
Organisational structure
Consideration needs to be given to the top-down philosophy. The appropriateness of the flat
management structure and the integration of new or enlarged functional departments such as
human resources and marketing may be questioned. More generally, the entire management
philosophy needs reviewing and consideration of a senior appointment at board level may be
appropriate in these circumstances.
Consideration might be given to decentralising responsibility down to restaurant manager
level where local knowledge would be available and greater incentives given arising from
profit centre, or even partial investment centre, responsibility.
Future strategic direction
Continued failure to refurbish older restaurants would appear to be an unsustainable position.
While funds for such investment appear to be constrained for the time being it would seem to be
a priority. Given such funding constraints, it might not be appropriate to open any more
restaurants in the immediate future and indeed divestment of the badly performing
restaurants which cannot be turned around may generate some funds.

On this basis, a set of criteria for closure and a performance review of restaurants is essential.
IT facilities may assist this but even basic accounting information should be sufficient to make
most closure decisions.
Similarly, a review of Head Office is appropriate, particularly in terms of achievable cost savings
and in terms of the value of the support service it provides to restaurants.
A human resources section probably needs to be set up as it would appear that staff morale is
low. This is particularly significant in a service sector industry. This may include examining pay
structures, but within an overall framework of cost review.
In terms of generating more revenue, a marketing function would be useful. However a preliminary
idea might be using price discrimination – both geographically and between business and leisure
customers. This is possible to the extent that the demand of different classes of customer differs
with respect to price. For example the demand of business customers is likely to be less price
elastic than leisure customers. An example of price discrimination in this context might be using
discount vouchers for families which business customers are unlikely to use.
Given the fall in volumes the extent to which customers have responded to the recent price
increases might also be subject to review.
Additionally, more revenue may be raised by longer opening hours to extract greater utilisation from
the assets. This needs to be considered with employees to prevent further loss of employee goodwill.
Consideration needs to be given to raising further finance. If the above procedures are
implemented and profit increases as a consequence the market may view future prospects more
favourably. In these circumstances investors may be more willing to subscribe and a higher share
price is likely to be obtained.
3 Security Parking Ltd

Security Parking Ltd (SP) is a large, private company that operates ten city centre car
parks in the UK. Members of one family own 75% of the ordinary shares of SP.
Company history
SP was set up in 1985. It acquired rough land near the city centre of Birmingham and turned
it into a car park by installing, at minimal cost, an exit barrier and a cabin. Employees were
hired working shifts to staff the site and take customers' money. By 2005, SP had acquired
another nine sites of rough land near the centres of different cities in the UK and developed
them into car parks.
By 2007, land was becoming increasingly expensive near city centres and it was becoming
difficult to make a reasonable return on investment. Some rival car parking companies have
been selling land to be redeveloped as offices or apartments. Also, due to environmental
concerns, it has become increasingly difficult to obtain local government planning permission to
develop land into car parks near city centres.
Strategic plan
A meeting of the board of directors of SP was called to discuss the problems:
The marketing director put forward a proposal: 'I believe that we have maintained a steady
operating performance for our existing business but further expansion of city centre car parks
is difficult and costly. I suggest that we try a different type of car park by acquiring out-of-
town land cheaply and providing a regular bus service to take people to the city centre by
operating a 'park-and-ride' scheme. The bus fares could be charged to customers separately.'
The finance director has reservations: 'The buses can be leased, but the land will need to be
purchased. However, we have reached our borrowing capacity and we cannot raise more
share capital. As a result, the only way we could fund the new car parks would be to sell one
or more of the existing car parks. However, we need to be sure that the car parks we are
buying will perform better than the car parks we are selling. I would suggest we sell the

current car park, or car parks, with the lowest residual income or the lowest return on
investment.'
The chief executive has some issues: 'We cannot assess the potential performance of the
new car parks unless we know the likely volume of business and the prices we are to charge
for parking and for the bus service. We need to do some market research to determine these,
but it is clear that people will not pay as much for out-of-town parking as they will for in-town
parking. Indeed, the price to park out-of town could be only half of the in-town price. I also
have a problem with which car parks we should sell to finance the new venture. I think we
should sell the oldest car parks, as the land was cheap then, and we will make a large profit on
disposal.'
The chief accountant has put together some illustrative data (see Exhibit). As an example,
he has reported actual performance achieved for two current in-town car parks (Birmingham
and Liverpool), which could be divested to fund the new out-of-town car park strategy. The
illustrative data also shows estimates of a possible new out-of-town site, although there are a
number of similar sites that could also be acquired in addition to this one.
SP uses a required annual interest rate of 10% to determine residual income and as the
required return on investment. Customers are currently charged per day or any part thereof.
All car parks are open 360 days per year.
Exhibit – Illustrative data
Birmingham Liverpool Proposed site out-of-town (estimates)
Purchase date 1985 2006 2007
Original cost CU750,000 CU3 million CU1 million
Current value CU2 million CU3 million CU1 million
Capacity 100 cars 160 cars 400 cars
% Utilisation 80% 70% unknown
Revenue (p.a.) CU288,000 CU403,200 unknown
Operating costs (p.a.) CU38,000 CU43,200 CU400,000*
* Including lease payments and other costs of operating the buses.
Requirements
(a) Determine the return on investment (i.e. return on capital employed) and the residual income of
the Birmingham and Liverpool car parks using:
(i) Original costs; and
(ii) Current values (4
marks)
(b) Explain how SP should determine which of the current car parks, if any, should be divested in order to
finance the new out-of-town car parks. Where appropriate, refer to your calculations in requirement
(a) and make any additional relevant calculations. (11
marks)
(c) As an external consultant, you have been asked to consider the proposal for acquiring new out-of-
town car parks. Write a memorandum to the board of SP which explains, and critically appraises,
the following:
(i) The benefits and disadvantages that may arise from the strategy of switching from in-town to
out-of-town car parks.
(ii) The market research that SP should undertake in order to determine the likely volume of
customers and the most appropriate prices, specifying data sources where appropriate.
(15
marks)
(30
marks)

3 Security Parking Ltd
Marking guide
Marks
(a) Original costs 2

Current values 2
4
(b) Factors identified 5
Judgement skills 3
Use of data 3
11
(c) Switching strategy – Benefits 4
– Problems 4
Market research – Nature and argument 5
– Data sources 2
15
30
(a) (i) Original cost

Birmingham (ROI)
CU250,000/CU750,000 = 33%
Liverpool (ROI)
CU360,000/CU3m = 12%
Birmingham (RI)
CU250,000 – (CU750,000 10%) = CU175,000

Liverpool (RI)
CU360,000 – (CU3m 10%) = CU60,000

(ii) Current value
Birmingham (ROI)
CU250,000/CU2m = 12.5%
Liverpool (ROI)
As above for cost 12%
Birmingham (RI)
CU250,000 – (CU2m 10%) = CU50,000

Liverpool (RI)
As above for cost CU60,000
(b) Given that there is insufficient cash available, then the adoption of the new out-of-town
strategy is dependent upon divestment of one, or more, of the existing car parks. This
raises two issues:
The performance (however measured) of the new car park(s) should be better than the old
divested car park(s) being replaced.
There is a change in strategic direction from an in-town strategy towards an out-of-town

strategy that needs to be considered in the wider context of the capabilities and performance
of the company as a whole.
In terms of operating performance, the illustrative data provided by the FD is actual historic
data. However, in making any decision it is only the future that matters. Thus, for instance,
the Liverpool site is relatively new and the data may reflect a 'bedding-in' period, whereby
sales need to be established and customers won over by changing their parking and travel
habits. This may take some time and thus the current performance would not reflect future
performance.
In terms of the capital invested the RI and ROI should both meaningfully be based on current
values rather than on the original cost (although given the recent purchase of the Liverpool
site these values are the same).
If, however, the company has 'maintained a steady operating performance', as the marketing
director indicates, then the change in RI and ROI for the Birmingham site indicates that
performance relative to capital invested has decreased significantly (e.g. from a 33% ROI to
12.5%) mainly because of the increase in land values.
If, in future, land values continue to rise in city centres, then ROI and RI will continue to fall
and may fall below the 10% threshold. However, operating performance is only one aspect
of total performance. If land values rise in city centres, due to scarcity and planning
regulations, then a gain would be made by SP from holding the asset, which would be
independent from any operating profit achieved from car parking fees.
The capacity to make such capital gains in future must therefore be considered for in-town
versus out-of-town sites alongside their relative operating performance. It is recognised,
however, that predicting future property prices is a difficult task.
In terms of ROI and RI operating performance then, under normal circumstances, RI is the preferred
measure as it gives an absolute gain after recognising a capital charge. In these circumstances of
constrained capital, however, RI is not such a good measure as it fails to reflect the scarcity of capital.
In these circumstances, the 10% is an inadequate measure of the cost of capital and the ROI % return
would have more credibility than is usually the case.
What is really required is the RI per CU1 invested or a credible marginal opportunity cost of capital.
Thus, for instance, although the Liverpool site has a larger RI than the Birmingham site, this is largely
because of the larger scale of the Liverpool site, rather than reflecting the efficiency with which it is
using its capital. Therefore, if the Liverpool site were to be sold, it would finance three new out-of-
town sites. Compare this to the Birmingham site, which would only finance two out-of-town sites.
The opportunity cost of retaining the Liverpool site is thus larger.
Another way of examining the issue, to compare like-with-like, is that if we had three sites like
Birmingham or alternatively two like the Liverpool site (so we had an equivalent CU6 million invested
in each) the three Birmingham type sites would yield an RI of CU150,000 and the two Liverpool type
sites would yield an RI of CU120,000 using current values.
Leaving aside the relative operating performance of the two existing sites, it is clear that in absolute
terms, they are only marginally profitable (ignoring capital gains). If land prices rise further, and
operating performance fails to improve, then it may be that the return will fall below the threshold of
10% and should thus be divested, irrespective of whether the funds are reinvested in out-of-town
sites. In these circumstances the investment and divestment decisions would be independent.
(c) Memorandum
To: Directors of Security Parking Ltd From:
External consultant
Subject: Out-of-town parking strategy
Date: XX/XX/XXXX
(i) Strategic benefits and
problems Strategic benefits

The new strategy is different in terms of location to the existing business but, other than the
operation of the buses, it is a similar operational activity with similar core competences to the
existing in-town business.
The major advantage of the new strategy is the lower cost of land. The illustrative data shows
that 400 parking spaces are available for a land cost of CU1 million (i.e. the capital cost of
providing one parking space is CU2,500). This can be compared to town centre capital costs per
parking space of CU20,000 for Birmingham and CU18,750 for Liverpool at current values. Thus,
in these cases the in-town cost per space is 7.5 or 8 times greater than out-of-town spaces.
The lower land prices may yield benefits which may be viewed in a number of ways:
 Lower fixed costs and thus lower operating gearing 

 Potential from capital gains in future if land prices rise from their current low level (although
this is dependent on market conditions) 

 Lower capital cost for market entry when capital is constrained 

 Potentially, a better return on investment with a lower investment cost. 
Of course, to generate value the available parking spaces need to be occupied by customers,
but the indicative capital cost base is favourable.
A further benefit of the out-of-town strategy is that it is appropriate to environmental policies
being put forward by national and local governments, which are likely to encourage out-of-town
parking and discourage in-town parking. These policies may reduce in-town parking capacity
and therefore increase demand for out-of-town facilities. Similarly, there is a growing culture,
among some individuals at least, to behave in an environmentally friendly manner.
There may be greater ease of access to out-of town car parks where cities are congested. Bus
lanes and other facilities may then ease access to city centres by using the park-and-ride system.
The bus service may attract additional customers and generate additional revenue. If priced
separately from parking it may attract new revenue streams. Also, however, people living
close to the out-of-town car parks may use the buses, but not the car park, if it is preferable
to the local bus services.
Problems
While the land cost is lower for out-of-town parking, the annual operating costs are higher
after the bus service costs are taken into account. Thus, for out-of-town car parks the
illustrative data shows that 400 parking spaces are available for an annual operating cost of
CU400,000 (i.e. the operating cost of servicing one parking space per annum CU1,000). This
can be compared to town centre costs of CU380 for Birmingham and CU270 for Liverpool.
Thus, in these cases the annual in-town cost is significantly lower than the out-of-town.
More significantly, these figures are based upon maximum capacity. To the extent that
operating costs are fixed (e.g. lease rentals for buses) then operating gearing may be higher
in the out-of-town sites. Thus, if only 50% utilisation is achieved then the operating cost per
annum for each space actually used will rise to CU2,000.
In terms of cost structure therefore the balance between capital costs (which favour
out-of-town) need to be balanced against operating costs (which favour in-town).
The revenue side is considered in more detail below (under (ii) Market research) but it should
be noted that the new strategy is likely to be subject to more risk as revenue streams at the
existing sites are likely to be reasonably predictable on the basis of past experience. On the
other hand, the revenues from the new out-of-town venture are more uncertain, even with
the benefit of market research.
It may therefore be appropriate to increase the required return above 10% to compensate
for the additional risk – at least in assessing performance in the early years.
Alternative aspects of risk are:

 Exit route: If the out-of-town venture fails then the exit costs from the venture would
appear to be low. Land normally has a ready market value, particularly if there are
limited additional development costs incurred, as is the case here where rough land has
been used with little modification. The lease contracts on the buses may have some
problems in being terminated but initial short-term contracts would limit this. 

 Barriers to entry: If land is readily available out-of-town and the venture is successful
then there are few barriers to entry for competitors. As a result there is likely to be a
contestable market in the out-of-town sector, that was not the case in the in-town
sector, where land is scarce and regulations prevent new entrants. 

 Barriers to re-entry: If the out-of-town strategy fails it may be difficult to re-enter
the in-town sector as sites are scarce. This out-of-town strategy therefore has the risk
of being difficult to reverse if it fails. 

(ii) Market
research
Introduction
Market research is the systematic gathering, recording and analysing of information about
problems relating to marketing of goods and services. Market research therefore involves
gathering information about the 4Ps of marketing. The particular focus in this case is price but
the other 3Ps will affect the price that can be charged and will be relevant to the volume of
business achievable at that price.
In particular, the key objective for market research in this case is to determine the likely volume
of customers and the most appropriate prices. Relevant to this objective are the following:
Place: The location of the car park is likely to be critical to the price and level of demand. This
means that any market research is only likely to be valid with respect to a particular car park
location. The idea of assessing the out-of-town strategy in the abstract without specific locations
is therefore likely to be largely invalid.
Price: The price that potential customers are willing to pay is clearly a specific objective of the
exercise although the current policy of charging 'per day or any part thereof' may be reviewed,
and possibly changed, as a result of the research.
Product/service: In this case, the service needs to be considered in terms of the attributes that
are likely to generate demand: (e.g. convenience; security; availability; frequency of buses).
Promotion: As a new venture, the initial impact of advertising and other promotion on price
and demand should be considered.
A further factor to consider in market research is that essentially two separate services are being
provided, and these may need to be priced, and researched, separately – i.e. car parking and the
bus service.
In this case the subject matter being provided by SP is a service. Compared to market research
on a product, this can limit the type and method of market testing that is possible or that is likely
to be valid. The two broad areas of market research are however:
  Desk research 
 Field research 
Desk research
Desk research is the gathering and analysis of existing or secondary data.
In particular, this might relate to the total size of the potential car parking market for a particular
city and the likely market share a new out-of-town car park may achieve.
Data sources for the total market size may include:

  Local government surveys of traffic volumes or car ownership 
  Other transport economics research (e.g. universities) 
  Environmental studies 
 Any information made available by government authorities (e.g. the DVLA) 
 Programmes of regular or special events (football and other sports matches). In
reviewing the information above, particular reference may be made to: 

 Any 'day of the week' effects (e.g. weekend v commuters on weekdays) 

 Any planned developments of out of-town shopping centres (which would reduce demand)
or in-town facilities (which may increase demand). 
Data sources for likely market share include:
 Locations of existing car parks 

 Utilisation levels of existing car parks (are any full on a regular basis?) 

 Total capacity of existing parking facilities 

 Any planned changes in parking facilities in future (e.g. new car parks being built; closure or
redevelopment of existing car parks) 

 Consider the sub-market of a city where any car park might be located. Thus, if an out-of-
town car park is located to the north of a city, the target market is likely in most cases to
be only those people travelling to that city from the north. Any data sources should then
specifically relate to this sub-area. 
Data sources for price include:
  Prices being charged by existing in-town car parks 

  Prices being charged by existing out-of-town car parks 
  Prices being charged by local trains that include station parking 
 Prices being charged by local buses and the density and frequency of service. 
Field data
Data sources for the market size may include:
 Surveying existing car parks to count vehicles on a sample basis at different
times of the day and the week. 

 Interviewing local government personnel responsible for traffic 

 Interviewing other local researchers 

 Review planning applications for new developments. 

 New housing developments or population changes in the sub area which SP is
targeting with a specific out-of-town car park. 
Data sources for likely market share and price include:
 Questionnaires of potential customer using other car parks/trains/buses 

 Internet survey of local potential customers 

 In depth interviews 

 Surveying existing car parks to count vehicles on a sample basis at
different times of the day and the week. 

 Target closest competitor car park to do in-depth analysis of prices and traffic
movements. 
4 Oscar Hardcastle Ltd

Oscar Hardcastle Ltd (Hardcastles) was founded in 1863 as a manufacturer of confectionery. By 1976
the company commanded approximately 10% of the UK sugar confectionery market. At this time 50%
of its sales were represented by one type of boiled sweet, 'Oscars Sherberts'. These are supplied to
the retail trade in large bottles and sold on in loose paper bags, often on a pick and mix basis. The
remainder of the company's product range was composed of other boiled sweets sugar confectionery,
such as 'Ice Mints', 'Fruit Drops' and 'Old Fashioned Humbugs'. Products were marketed under one of
the company's three house names, 'Oscars', 'Hardcastles' or 'Erics'.
Over the years Hardcastles achieved good profits and grew steadily by a policy of vertical integration
into wholesaling and by consolidating its product range under its three house names. However, after
2001 financial performance began to deteriorate sharply with falling sales and decreasing profits. In
2006 for the first time in its history the firm recorded a net loss.
Ownership
Hardcastles is very much a family firm. Nearly 60% of its shares are held by the Hardcastle family, who
also fill most senior management positions. The remaining shares are all held by employees.
Operations
All production is concentrated at one factory in Barnsley and is delivered to customers by Hardcastles'
own distribution fleet and wholesaling network. Sweets are manufactured to long-established recipes by
traditional means, often using methods developed by the founder Oscar Hardcastle. Finished sweets are
packed in large bottles. Costs are closely monitored by a standard costing system with weekly reports of
variances to production managers. Recently instability in world sugar prices has led to large variations in
unit cost.
Sales
The company's sales force consists of three selling units: one with two sales managers who sell to large
retail accounts, the other two consisting of 50 salesmen who each deal with smaller outlets. In the latter
two groups salesmen are allocated to one of the company's house names (Oscars, Hardcastles or Erics)
and only sell products under this brand. This sometimes leads to duplication of sales calls but the
chairman is of the view that it would not be effective for one representative to handle three brands.
Recently all three sales teams have experienced difficulty in meeting targets. At a recent board meeting
the sales director was called on to explain the poor performance of his team. He explained that
decreasing sales were not due to lack of effort by the sales force but to national trends such as
increasing concern about tooth decay caused by sweets and an increase in the popularity of savoury
snacks. In addition there was an increasing concentration of confectionery sales in supermarkets at the
expense of traditional outlets. Supermarkets demanded sweets in a pre-packaged form that Hardcastle
found difficult to meet. He also noted a worrying trend in incursions into the sugar confectionery
market by national manufacturers of chocolate products.
Planning
Planning at Hardcastles is handled by the finance director who operates a system of annual
budgets. These are based upon the previous year's actual results suitably adjusted for known
changes such as increases in wage rates, sugar price, etc. Draft budgets are then reviewed by
the board which adjusts budgeted revenue to include new business targets and ensure that
budgeted results meet the Hardcastle family's objective for the business of 'Providing a
worthwhile financial performance while preserving our independence and offering secure
employment for our workforce.'
The finance director, who is not a family member, is becoming very disillusioned by the
planning process. He feels that the adjustments made by the board are increasingly optimistic
and result in targets that are simply not achievable. In addition, the process of budget
revision by the board often drags on for several months due to disagreements over what
constitutes an acceptable level of return. At a recent meeting he explained his worries to
other board members and expressed his doubts over whether the existing Hardcastle
business could achieve the budget the board had set. If the board wished to achieve the

budgeted level of profit, he argued, they would have to consider new strategies. When asked
for suggestions he said that in his view two opportunities were open to the firm, i.e.:
(1) Either to adopt a programme of product development in the savoury snacks area; or
(2) Consolidate the current position in present markets and develop sales through supermarkets.
Requirements
(a) Prepare an analysis of the current strategic position, internally and externally, of Oscar Hardcastle
Ltd
and clearly identify what you consider to be the major issues. (12
marks)
(b) Critically evaluate the current objectives of the business, suggest how the statement of
objectives may be improved and outline the benefits of any changes you suggest. (8
marks)
(c) Evaluate the new strategies suggested by the finance director and discuss whether they are likely to
return the business to profitability. (9
marks)
(29
marks)
4 Oscar Hardcastle Ltd
Marking guide
Marks
(a) Strengths 3
Weaknesses 3
Opportunities 3
Threats 1½
Major issues 2½
Total available 13
Maximum 12
(b) Current objectives 4

Improvements 4
8
(c) Product development 3½
Consolidate 3½
Return to profitability 2
9
29
(b) Current strategic position of Oscar Hardcastle Ltd
Long-established brand names which Narrow product range

could still have value in the eye of the
Packaging still in large bottles, which is inappropriate
consumer to many retailers
Vertical integration into wholesaling, Poor financial performance leading to failure to
giving good distribution network achieve objectives
Family and employee held shares Family members may lack the required management
resulting in little pressure for immediate
skills
recovery and allowing a longer-term
view to be taken Outdated production methods could result in high
Ownership of traditional recipes may be cost

a source of product differentiation Lack of salesmen for large retailers which represent
the bulk of sales
Duplication of sales visits adding to cost
Poor planning routines, no strategic plan, optimistic
targets which are not achieved
No clear statement of objectives
S W
O T
Increasing sweet sales in the hands of Falling national demand for sugar sweets due to
supermarkets health awareness
Increasing market for savoury snacks Increasing popularity of savoury snacks eroding the
sweet market
Decline of independent sweet shops at which much
of Hardcastles' output is directed
Potential competition from chocolate manufacturers
which are used to dealing with supermarkets
Instability in sugar price which could erode margins
A SWOT analysis of Hardcastles is given above. The major issues arising are as follows.
(i) Its total reliance on the boiled sweet business
(ii) The falling demand for this type of product, due to increasing health awareness
(iii) Failure to obtain business in the supermarket sector, due to a poorly structured sales team
and incorrect packaging of the product.
If these issues are not addressed quickly the business is heading for collapse.
(c) Objectives
The current objective set for the business has several problems:
 In places it is not specific. The phrase 'a worthwhile financial performance' could refer to
profits, dividends, sales or other items. 

 In places it is not measurable. While the concept of independence can be
measured by % ownership of shares, there is no measure of financial performance or
job security. 

 At present the objective seems wildly optimistic, given the SWOT analysis presented
above. 

It lacks a timescale; does it refer to the short run (this year) or the long run? 
These weaknesses are leading to confusion in the planning process and over-optimistic targets.
On the positive side it is, however, relevant to the major stakeholders in the business (the family
and employees). The statement of objectives could be improved in several ways.
The board should first consider setting a mission statement. This should reflect the reason
for the company's existence, any values or beliefs that it holds, and details of what the
company is providing. A mission statement is set for the long term and should reflect the
needs of the various statements. It can be set in very general terms. The firm's current
objective could form the basis of a mission statement. Once set it will give long-term
direction to the company. 

Objectives should then be set and convert the overall mission into detailed
targets for achievement. The board may wish to set some general objectives in
terms of profitability, ownership and job security but at some stage these need

to be converted into precise statements of what the board wishes to achieve. 

For example, in the area of profitability the board will need to decided upon how
profit is going to be measured (ROCE, EPS, net margin etc), what level needs to be
achieved (a return on capital employed of 20% etc) and a target date for achievement. 

The benefit of this approach is that it will give the business a clear target at which to aim.
This will allow the identification of gaps between actual and target performance and the
development of strategies to bridge these gaps. It will also allow a control system to be
developed whereby future performance can be compared with objectives and remedial
action be taken. 

 Evaluation of strategies
A successful strategy should build upon a company's strengths, eliminate or reduce its
weaknesses, exploit opportunities and counter threats. If this is achieved it should allow a
firm to achieve its objectives.
Product
development
Advantages
 Widens product base and removes the total reliance on sugar sweets 
 Savoury snacks appear to be a growing market 
It may be able to employ its existing brand names in this new area. 
Disadvantages
 The firm has no production experience in this area 

 Given recent financial resources it may lack the required investment funds 

 This would not cure the marketing problem faced by the firm. It would still need to
break into supermarket sales to achieve high volume. 
Consolidate current position and develop sales through supermarkets
Advantages
 Developing supermarkets sales could quickly improve sales and hence profits 

 Sales resources appear to be available to do this if sales teams are reorganised 

 Some alteration to packaging would be required but presumably this is
reasonably easy to achieve. 
Disadvantages
 Attempting to improve sales in their traditional market (small retail outlets) may be
futile if this market is contracting. 

 If the national market for sugar sweets is shrinking, the policy of developing
supermarket sales may give only short to medium-term success. 

 There is a danger that chocolate manufacturers may provide stiff competition in
supplying sugar sweets to supermarkets. 
Restoration of profitability
Both strategies have their attractions and problems. It is recommended that to restore
short-term profitability Hardcastles look to supermarket sugar sweets sales. However, in the
longer term it needs to expand its product base: developing a range of savoury snacks may
give long-term profitability.
5 Pasta2go Ltd
Pasta2Go Ltd (hereafter Pasta2Go) operates a chain of 25 outlets, located throughout the North of

England, providing take-away food and a home-delivery service of hot pasta and pizza meals.
All meals are cooked to order. For take-away food, customers call in person to collect their
meals, although some customers may telephone their order in advance to save waiting. For
home-delivery meals, orders are normally telephoned to outlets by customers and deliveries
are made to them (within five miles) at no extra charge if the order exceeds CU10. Any
greater distance is considered individually.
Company history
The business was set up by Carlos Alberto and Roberto Riva in 1985. It became incorporated
in 1991 with the entire shareholding held equally by the two founders, who were also the only
directors. Expansion has been rapid in recent years with the opening of two new outlets in
each of the past five years. There is also a central depot located in Northern England from
which outlets are supplied with ingredients. All property is leased.
The target market for the company is busy, young professionals, working long hours, who do
not wish to cook when getting home from work. The menu is constantly revised to
accommodate their changing tastes and market conditions.
Competitive positioning
The directors believe that their success, compared with competitors, is due, firstly, to their closely guarded
recipe using fresh ingredients; and secondly, they have a rapid and reliable motorbike delivery service which
guarantees that, within five miles, hot meals will be with the customers in less than 30 minutes of their
telephone order. The motorbikes also include an insulated box to retain heat.
The food is competitively priced and, although this means a low margin on each sale, it generates a high
revenue.
Competition comes in a number of forms.
 Other types of take-away and home-delivery food are available in most areas operated by Pasta2Go.
This includes Chinese, Indian and British food as well as other providers of Italian meals 

 From restaurants 

 From home-cooked food 
Board meeting
A recent board meeting identified two significant problems.
(1) Measuring the performance of individual outlets and that of the company as a whole.
(2) The most appropriate method of future expansion.
(1) Measuring performance
While revenue has increased rapidly, profitability has grown much more slowly. In particular, the
directors are concerned about the costs involved in setting up new outlets and the fact that it
takes at least two years for each new outlet to become established and achieve profitability.
The directors do not believe that financial measures alone would be a reasonable reflection of
the strategic success of the company or of individual outlets. Moreover, in assessing the
performance of managers it is considered unreasonable to use only profit, particularly in new
outlets.
(2) Future expansion
Proposal 1
Carlos Alberto believes that expansion should be more rapid and is in favour of considering
offering franchising arrangements to expand the network of outlets in all areas of Britain.
Proposal 2

Roberto Riva agrees that the rate of expansion should be increased but has been negotiating with
BurgerGrill Ltd (hereafter BurgerGrill), a large company with an international chain of 20,000
hamburger restaurants. He has negotiated a potential arrangement whereby:
 BurgerGrill would take up a one-third shareholding in Pasta2Go by subscribing for new
share capital. There would be an option to extend this to a 50% holding after five years. 

 BurgerGrill would also provide significant loans to Pasta2Go which are likely to be much
greater than its new share capital investment. These loans would be at commercial interest
rates. 

 Expansion in the number of Pasta2Go outlets would take place mainly in the South of
England. There would also be expansion into the restaurant market, setting up a new
division which would use the new brand name, Pasta2Stay. These restaurants would be mid-
market and would be located throughout Britain, with some adjacent to BurgerGrill
restaurants. Identical meals to those currently served would be offered. 

 There would be a shared distribution network between Pasta2Go and BurgerGrill for
inward deliveries. 

 Pasta2Go would help to develop the recipe for a new 'pasta-burger' to be sold in
BurgerGrill restaurants. 
Requirements
(a) Identify and explain two key critical success factors (CSFs) relevant to companies
operating in the market for home-delivery meals. Explain how such companies may
implement the use of these two
CSFs to promote competitive advantage. (7
marks)
(b) Prepare a balanced scorecard for Pasta2Go using each of the following headings.
  Financial perspective 
  Customer perspective 
  Internal business perspective 
 Innovation and learning perspective. 
Note: Ignore potential expansion plans. (12
marks)
(f) As a strategic consultant, write a memorandum to the directors of Pasta2Go which
describes and evaluates the key factors with respect to the two proposals for
expansion put forward by the directors. Use the following headings.
  Economies of scale 
 Operating, financial and strategic risks 
 Competitive positioning. (18
marks)
(37
marks)
5 Pasta2Go Ltd
Marking guide
Mar
ks
(a) Identify 2 key CSF 1

Explain 2 key CSF 2
Implementation 4
7
(b) Financial perspective 3
Customer perspective 3
Internal business perspective 3
Innovation and learning perspective 3
12
(c) Ansoff matrix 2
Economics of scale 6
Risk – Operating 2
– Financial 2
– Strategic 2
Competitive position 4
18
37
(a) Critical success factors

Critical success factors (CSFs) can be defined as 'those components of strategy where the
organisation must excel to outperform competition. These are underpinned by competences which
promote this success.'
Two CSFs may be
(i) Meal quality: The nature and quality of the meals, which distinguishes the product from
other similar suppliers of take-away and home-delivery meals.
(ii) Delivery: The speed and quality of delivery from order to customer receipt. This includes
transport and cooking times, but also maintaining the food's temperature in transit. Most
obviously this applies to home-deliveries, but waiting times for take-away food may also be
a source of competitive advantage. Such times need not only to satisfy the customer but
also to outperform rivals to give a competitive advantage.
Having identified appropriate CSFs, such as those above, the following stages might be appropriate
in their implementation to establish a competitive advantage.
(1) Identify the underpinning core competences for each CSF which generate a
competitive advantage. These might include
(a) Meal quality
  Ability of cooks relative to competitors 

  Access to non-standard ingredients 
  Superior cooking equipment 
 Quality and variety of recipes 

(b) Delivery
 Delivery vehicles compared to competitors (e.g. insulation facility, or motorbikes
to avoid queues) 

 Local knowledge and reliability of the driver 
Delivery charges 

Geographical areas of operation (proximity to areas of dense population
compared to rivals) 

Ensure that core competences continue to give competitive advantage by constant
comparison with rivals.

Identify the Key Performance Indicators (KPIs) necessary to outperform rivals.
These might include measures to assess the following.
Meal quality
 Number of customer complaints or expressions of satisfaction 

 Sample test results 
 Number of new customers (particularly recommendations) 
 Amount of repeat business (number of regular customers) 
Results of surveys of customers. 

Delivery
 Average time from order to completion of cooking 

 Average time from completion of cooking to receipt by customer (for home delivery) 
 Variances between promised delivery times and actual times 
 Number of complaints about slow delivery 
Number of complaints about cold food 

Ensure that competitors cannot imitate core
competences.
Use of secret recipe(s)
Constant improvement in meals and service
Lower cost base enabling lower prices
Geographical dominance acts as barrier to entry (e.g. loyal customer base,
insufficient localmarket to sustain more similar take-away outlets)
Respond appropriately to new moves by competitors concerning their product, delivery
or price that may affect competitive advantage.
(b) Balanced
scorecard
Financial
perspective
Goals Measures
Survive Cash flow

Succeed Total profit
Profit per outlet
Return on capital employed
Total revenue
Revenue per outlet
Prosper Increase in revenue
Increase in revenue per outlet
Local market share
Customer perspective
Goals Measures

Meal quality Number of customer complaints
Results of sample testing
Number of new customers
Amount of repeat business
Delivery on-time Promised delivery times v actual times
Average time from order to cooking
Average time from cooking to receipt
Number of complaints about slow delivery
Number of complaints about cold food
Competitive price Comparison with competitors
Price-based complaints
Response of customers to price changes
Improve perception Advertising
Promotions
Special offers
Internal business perspective
Goals Measures
Quality of supply Wastage of meals/ingredients

New sources of supply of ingredients
Orders received on time from suppliers
Quality of output (i.e. meals) Staff training
Quality of equipment (new cooking equipment)
Quality of delivery and service
Staff training
Speed of cooking (new/more equipment)
Speed of delivery (new/more motorbikes)
Geographical span
Innovation and learning perspective
Goals Measures
New products Number of new menu items
Proportion of sales from new items
New cooking techniques Use of new recipes
Use of new ingredients
New peripherals Response to new packaging
Response to new outlet refurbishment
Response to new service
New ordering E-mail (number of e-mail orders)

Regular customer priority (increased sales)
(ii) Memorandum
To: Directors of
Pasta2Go From: A
strategic consultant
Subject: Proposals for
expansion Date: Today
Introduction
This memorandum considers two proposals for expansion:
Franchising
The arrangement with BurgerGrill.
While this memorandum will consider the relative merits of the two proposals, they may
not entirely be mutually exclusive and expansion may be able to take place using both
methods.
Expansion can be viewed within the Ansoff matrix.
Products
Existing New
Existing Core business New menu items
Markets
Franchising
(in South of
New Pasta-Burger
England)
Pasta2Stay
Economies of scale
Economies of scale are likely to take different forms and may provide different benefits in
different circumstances.
The different types of expansion, which may give rise to economies of scale, include the following.
  Growth of the number of outlets in the existing region (increased concentration) 

  Geographical expansion (into the South of England) 
 Product expansion (restaurant market). 
Franchising
Under a franchise a firm grants other firms or individuals the right to use its brand, its product or its
know-how. There is likely to be a degree of central control and support. In return, the franchisee will
provide a lump sum, share of earnings and specific payments.
The benefits of franchising the Pasta2Go brand in the context of economies of scale are likely to
include:
 Quicker business expansion than using Pasta2Go's own financial resources alone, as there are

new sources of capital from franchisees 

 Retains incentives with franchisees keeping residual rewards and using local knowledge, thus
profitability per outlet may be greater than by employing managers 

 More franchised outlets may increase both concentration in the existing regions and geographical
expansion. Given the lack of experience in the restaurant industry, this type of expansion may,
however, be more difficult when using franchising. 
The consequential benefits include
  Reduced distribution costs (if concentration increases) 

  Little increase in central fixed costs 
  More effective advertising 
 More income-generating units without an equivalent increase in capital invested by Pasta2Go. 
The drawbacks of franchising in respect of economies of scale include
 The need to share profits means less profits are being reinvested to expand the business 

 Franchisees are likely to be small and thus may help with retail expansion but, unlike BurgerGrill, they
are unlikely to provide any help with large-scale distribution into the South of England. 
BurgerGrill
BurgerGrill is providing economies of scale in two respects – increased financial capital and access to
BurgerGrill's operations.
(1) Increased financial capital is provided by BurgerGrill in the form of both share capital and loans.
This enables increases in the number and the type of outlets.
The benefits of this include those already cited above, except that franchisees are residual
claimants whereas, in respect of their equity holding at least, BurgerGrill is a proportionate
claimant.
(2) Access to BurgerGrill's operations involves significant synergistic benefits to Pasta2Go. These
include
 Access to BurgerGrill's distribution network 

 Access to BurgerGrill's expertise in the restaurant market 

 Access to a new market outlet in the form of the 'pasta-burger' through BurgerGrill's
restaurants 

 Common benefits where restaurants are adjacent (e.g. car park, reduced building costs) 

 Common advertising, promotions and offers. 
Risk
Franchising
Franchising can affect risk in a number of ways.
 Strategic risk 

– Poor franchisees may generate the risk of harming the brand name beyond their
individual outlet. 

– It may be more difficult to change the strategic direction of the business in future if
franchisees have a degree of autonomy over the operation of their outlets. 

Financial risk 

– Reduced risk by having franchisees' own capital, thus the cost of failure is shared by the
franchisee. This reduces the maximum potential loss from the failure of an outlet, but
also provides an increased incentive for franchisees to succeed. 

– Given that it takes two years for an outlet to achieve profitability, there may be early
financial failures by franchisees due to lack of liquidity. 


 Operating risk 

– There is a need to monitor franchisees as, while franchising maintains some central control,
there is a risk that franchisees will have different objectives, methods and abilities
compared to Pasta2Go. 

– There is a reduced risk in that if franchising is to be taken up by many small operators,
then Pasta2Go is not dominated by its business partner. 
BurgerGrill
The following risks may arise from the arrangement with BurgerGrill.
 Financial risk 

– Increased financial gearing arising from the new loans (which are greater than the increase in
equity provided by BurgerGrill). 

– Given that the company is not listed, a market value needs to be determined for Pasta2Go
in order for BurgerGrill to buy-in at an appropriate value. Similarly, if an increase in
BurgerGrill's shareholding to 50% is to be achieved, then a valuation method needs to
be agreed on a pre-determined basis. An inappropriate valuation method risks losing
value for existing shareholders. 

– The new division, Pasta2Stay, may be set up as a subsidiary to reduce risk using limited
liability. In reality, however, lenders are likely to require security against the assets of
the parent company, or else charge a significant risk premium. 

– Rapid expansion carries the risk of overtrading. 

 Operating risk 

– Pasta2Go's existing shareholders risk losing control of the company if BurgerGrill takes up
the option to increase its equity holding to 50%. This may result in a stalemate
situation regarding important decisions. 

– There may be confusion in the market-place over the two separate brands. 

 Strategic risk 

– Expansion into the restaurant market is new, with a new brand name, and risks failure, as it
is different from BurgerGrill's existing product and Pasta2Go's existing method of
delivery. As a result, customers and competition may respond in an unexpected
manner. 

– The South of England is a different geographical market, which may have different types
of consumer and competitor. 
Franchising
Increased size arising from franchising should give Pasta2Go a stronger competitive position due to:
  Stronger market presence in existing markets 

  Stronger market presence in new geographical markets 
 Lower cost base from economies of scale to enable improved price competition 
Overall, however, if franchising is to affect only the size of the current operations, and not its
nature, then there should not be a significant effect on the market positioning of Pasta2Go.
BurgerGrill
There appears to be some scope for market confusion on the competitive positioning of Pasta2Go.
 The new Pasta2Stay restaurants are mid-market, but take-away food tends to operate in the
down-market sector of the hot food industry. Yet they are presumably selling the same, or
very similar, food. 


 The partnership with BurgerGrill is therefore one between a down-market provider
(burgers) and a mid-market provider (Pasta2Stay). 

 The original market segmentation strategy of targeting young professionals returning from
work may not be appropriate to Pasta2Stay customers, who might also be different from
BurgerGrill's target market. 
The prices to be charged are likely to reflect this confusion over market position, with perhaps
very different prices for eat-in and take-away pasta/pizza. This can be compared with very similar
prices normally charged for eat-in and take-away burgers.
This is particularly likely to be the case where the different products are being offered in the
same geographical market.
6 Lipidtech Ltd
Lipidtech Ltd is a biotechnology company which was floated on the Stock Exchange in
1990. Its financial year ends on 30 June. A majority of the company's shares are held by
various institutions which are represented on the company's board.
In May 2007 Lipidtech Ltd acquired another quoted biotechnology company, and it has
now been approached by a much larger British based pharmaceutical company, Xerxes
Ltd, which wishes to take it over. The board of Lipidtech Ltd has recently met to consider
the proposition.
The industry profile
Although each of the largest 10 companies in the world pharmaceuticals industry has annual
revenues in excess of CU10,000 million, there are approximately another 40 to 50
companies all of which have yearly sales of over CU2,500 million. Currently, however, there
is a move towards consolidation, for which there are two main reasons.
(i) On the demand side, the purchasers of healthcare (i.e. governments and insurers) are
faced with ageing populations, rising expectations, and new and expensive treatments.
This is reflected by the fact that over the past 30 years, despite economic growth, the
proportion of GDP spent on drugs in developed countries has doubled. As a result,
governments have been driving harder bargains with pharmaceutical companies and, in
many countries, specialist committees or private businesses have sprung up to help
governments and health care insurers obtain value for money.
(ii) On the supply side, there has been a slowing in new drug launches at a time when
patents on the bestselling compounds over the past two decades are expiring. These
drugs were often developed as a result of advances in biochemistry in the 1960s,
whereas the new generation of compounds gradually coming on-stream are derived as a
result of developments in biotechnology and other advances in medicine. However, the
cost of developing new drugs is getting ever greater. It is estimated that only 5 out of
every 10,000 laboratory researched drugs are ever licensed by government agencies for
production and, for those that do make it, the time span from the initial research to
public use is typically 10-15 years. Direct investment in this period can be up to CU100
million. In fact, a new compound is subject to various phases of development which
involve rigorous testing before production licences are sought – and even then, only
about 40% which survive the final clinical stages of testing go through to production.
In such an environment, even the largest multinationals have been trying to reduce their exposure to
increasing risks. They have typically been doing this by broadening their already well diversified drug
portfolios, pooling their research efforts, and making more effective use of their marketing networks. At
the same time, some of the middle range companies have adopted a slightly different strategy, reducing the
proportion of revenues that they invest in R&D from the industry average of 14-18% to around 6%. They
concentrate on manufacturing a fairly narrow range of drugs and making full use of the specialist sales forces
they possess in North American, European and Pacific Rim countries. To succeed, they have to purchase

the exclusive rights to manufacture and sell ethical drugs (i.e. those which are patent protected) at a late
stage in their development. In addition, they manufacture and sell generic drugs (i.e. those out of patent
protection).
Although a considerable amount of research in biotechnology, and similar modern scientific techniques, has
been undertaken in the laboratories of well established pharmaceutical companies, a number of much
smaller independent businesses (such as Lipidtech Ltd) are engaged in this activity. In the US, for example,
there are well over 200 such companies whose securities are publicly traded and which together annually
invest CU2,800 million in R&D. In the UK this sector has grown much more slowly.
The acquiring company – Xerxes Ltd
Xerxes Ltd has grown rapidly in recent years, its revenue increasing from CU120 million in 1997 to
CU420 million in the year to 30 June 2007, pre-tax profits over the same period rising from CU27 million
to CU110 million, yielding a current capitalised market value of CU900 million. Xerxes' strategy over the
past few years has been to concentrate on its competitive advantage in marketing, and consequently –
although it has a portfolio of some 60 products – it has only invested around 6% of revenue in R&D. While
looking for major partners that fit well with its own activities, the Xerxes' directors have decided that they
should now try to increase their commitment to research and development. It is for this reason that they
have expressed interest in acquiring Lipidtech Ltd, which has a number of promising products which are at
various stages of development.
Lipidtech Ltd's profit record since it gained a listing has been poor, the figures (in CU million) for the last
three years to 30 June being:
Revenue R&D (expensed) Profit before tax
2005 80 20 2.0
2006 85 22 1.5
2007 90 25 1.0
Sales revenues have come from manufacturing a small number of ethical drugs under licensing agreements
with Japanese and Italian companies. Net assets shown in the draft balance sheet at 30 June 2007 amounted
to CU30 million.
On the positive side there are five compounds which are currently in the final stages of testing, three of
which could earn very high net revenues if they are licensed for production and sale in the US. It is
because of this that Lipidtech Ltd's share price has risen by 50% above the market index for
pharmaceutical stocks over the past six months, lifting the capitalised market value to CU100 million.
The views of Lipidtech Ltd's directors
At Lipidtech Ltd's board meeting on 5 July 2007, sentiment was generally in favour of the approach from
Xerxes Ltd. The discussion mainly centred on what value to place on Lipidtech Ltd and what consideration
would be regarded as acceptable.
The chairman felt that it would be difficult to get Xerxes Ltd to pay much more than the current
capitalised market value of CU100 million, especially in view of the declining trend in reported profits, which
only yielded 3.3% on net capital employed. Moreover, this would be far above the net asset value.
The managing director disagreed. He pointed out that for companies such as those in the pharmaceutical
sector, it is not unknown for profit figures reported in the statutory accounts to go down, while the market
value of the business goes up. In such circumstances it is even more important than usual to refer to other
information when trying to evaluate strategic performance and future prospects. In his view there was a
very strong probability that the company's pre-tax profits would fall to zero in the next few years for the
years but thereafter increase significantly. He therefore argued that company had the right strategy and it
pursue this. He therefore argued that Lipidtech should reject the offer until profits had been restored.

The marketing director made the point that both companies should benefit to some
extent from the tie up. Certainly access to Xerxes Ltd's distribution network, especially in
the United States, would enable Lipidtech Ltd to market its new compounds to good effect.
Requirement
As an assistant to the finance director of Lipidtech Ltd draft a memorandum for the
board which, in the context of a bid from Xerxes Ltd, should explain:
 The strategic options available to the company (e.g. horizontal v vertical expansion;
organic growth or expansion via merger; etc) 

 Potential cost savings (in R&D, production, marketing and distribution, and overheads) 

 Ways in which the company's competitive position can be improved (e.g. by
differentiating products, creating barriers to entry, accessing an established
distribution network, etc) 

 How exposure to risk might be reduced (e.g. by developing portfolios of drugs,
seeking patent protection, innovation, etc). 
(30
marks)
6 Lipidtech
Marking guide
Marks
Strategic options 8
Cost savings 6
Risk exposure 8
Conclusions 2
30
Memorandum
To: The Board of Lipidtech
From: Assistant to Finance Director
Date: XX/XX/XXXX
Subject: Issues arising from Xerxes bid
(1) Introduction
This memorandum deals with the strategic issues arising from the Xerxes bid.
(2) The strategic options available to the company
The strategic options available should be considered in light of the situation that Lipidtech
finds itself in, in particular the industry it operates in. The pharmaceuticals industry has one
the highest margins of any industry in the UK. Despite pressures that are apparent,
particularly from the buyers of drugs, it is fundamentally a very profitable industry. The key to
success in the long term is successful research and development backed up by active patent
protection. Hence any strategic option should be to improve our position in the industry.
Size is an important strategic issue as the costs of research and development are very
high, yet the benefits are uncertain. To be a big player a significant R&D budget is needed
to be successful. This requires deep pockets in terms of finance. Most strategic options
will therefore be related to increasing size and power in the industry.

Possible strategic options include:
(i) Horizontal integration (i.e. integrating with other companies doing similar activities)
We have already done this successfully and if the right partner is available it will be
worthwhile to do so again. Xerxes are offering a form of horizontal integration.
Tutorial note
At the top of the market Glaxo and Wellcome joined together and have seen benefits from cost
cutting and combined research.
(ii) Vertical integration (i.e. integrating with a supplier or a distribution channel)

It is unlikely that this is appropriate for Lipidtech due to the costs and problems
involved. It is more appropriate to continue to be very good at what we are going at
present by staying with our core competences of drugs development and production.
Purchasing a supplier is also unlikely to be a good strategy. We purchase from
chemicals companies and these operate in a far less profitable industry than ours.
Obtaining supplies is not a problem, which would be the only reason for pursuing this
course. Xerxes are also offering a form of this, due to their selling abilities.
Tutorial note
Merck in the US purchased its channel and has argued that this will give it more power in its markets.
(iii) Organic growth

This is attractive due to the control we would maintain and the rewards that would
remain with our shareholders. Many biotechnology companies have grown successfully
taking this approach. There are constraints to do with finance and expertise which
would stop this from being an immediate success, but in the long term, if the institutions
are willing to support us, it could be the best option. Once the market recognises the
value in the company it could be a good idea to take the exit route offered by the stock
market or a take-over.
(iv) Merger
There have been many mergers in the industry over recent years in order to help
pharmaceutical companies grow. This is a good strategy to help deal with the issue of
size and make sure that the company has sufficient critical mass to sustain the necessary
R&D, and benefit from economies of scale. Xerxes is offering a merger and this would
help secure our survival, and future growth.
(3) Potential cost savings
The cost savings that are apparent from the merger are many. Their expertise is in
marketing, which we know little about, whilst ours is in R&D, which they have not invested
in heavily in the last few years. Therefore there are benefits for both parties.
In particular savings in the following areas are apparent:
(a) Research and Development
Although it only invests 6% of its turnover in R&D, its overall R&D operations are around the
same size as ours (6% CU420m = CU25m). This should still give scope for cutting some
duplication of effort. As this area is the basis for the future success of the company it would be
unwise to cut too drastically.
(b) Production
We do some manufacturing at present but we will get a major boost if we join with Xerxes as

they have extensive operations. We will be able to use any spare capacity they have to
produce our drugs once they come on stream and this will produce a massive saving in
comparison to setting up our own operations if we did not merge with Xerxes.
(c) Marketing and distribution
This is the major area which we can save costs and take advantage of areas that Xerxes is
particularly strong in. Setting up distribution channels is very expensive, particularly in
overseas markets, and marketing costs will be substantially reduced by using Xerxes'
knowledge and bargaining power. Thus we will save a lot if the bid goes ahead.
(d) Overheads
There is some scope for savings in overheads by reducing head office costs. These costs
include property costs, head office costs and administration salaries, as Xerxes may consider
that they can run the combined business themselves. Hence it may be necessary to see what
level of job protection is on offer before the bid progresses.
(4) Ways to improve the company's competitive position
The key to long term success is R&D. Hence to improve our position then we need to look at new
areas our existing research can be applied to or that we can address. This will help to differentiate us
and to make us attractive to investors. We need to monitor our business and its environment to make
sure that we are aware of the opportunities available.
Once we have found areas to research into and drugs to develop this will help create a barrier to
entry to the market – if we have a lead in a particular area others will be put off following as they may
well not catch up. Once we have the drugs then protection via patents needs to be sought and then
enforced. Large pharmaceutical companies have thwarted many attempts to produce similar drugs to
their own through the power of their patent protection. A patent agent with international presence
needs to be employed to ensure world-wide protection (as far as possible). Patent protection is
another barrier to entry.
The competitive position of the company will be greatly enhanced by access to the Xerxes
distribution network as Xerxes have made this one of their main strengths. In particular access to the
US market is vital to ensure that drugs realise their full profit potential.
(5) Reduction of exposure to risk
(a) Portfolio of drugs/developing drugs
There is a large failure rate of drugs during research and even in bringing them to the market.
This means that the more successful research that is being done the better, so that the quantity
of potential drugs will mean that enough will survive. Also it is necessary to make this an
ongoing process so that drugs are brought into the market over time. This cuts down the risk of
not having a steady flow of income over time.
(b) Missing out on new areas of innovation
A series of liaisons may be possible through the industry to research into particular areas.
This follows the example of the computer industry, where these alliances are commonplace.
Microsoft, for example, has many alliances with software, communications and hardware
companies.
(c) Patent protection

This has been discussed in the previous section as there are risks that someone
else will cash in on the R&D the company has undertaken. This protection is
necessary once the drug is ready for production and even afterwards.
(d) Risk of key employees leaving
This is a problem and contracts and incentives need to be arranged to stop this
expertise leaving the company. A share of profits from the drugs is a powerful way
of doing this.

(e) Technological developments
These could wipe out a successful drug at a stroke. The market needs to be
monitored for this possibility and research needs to be carried out to improve
drugs currently marketed.
(f) Changes – government policy
The government, and government overseas, can affect a pharmaceutical
company if they switch their buying away from lack of selling channels in
overseas countries and foreign currency risk. This can best be done by entering
into licensing agreements.
(g) Lack of selling channels in overseas countries and foreign
currency risks Foreign currency risks can be dealt with via a
range of hedging procedures.
(6) Conclusions
Size is important in the industry to support the key reason for competitive advantage
in R&D. Horizontal growth is worthwhile, though if it is via a merger with Xerxes it
will be necessary to get enough consideration for the potential our company has. The
cost savings and gains in expertise are considerable and this is the main reason for
agreeing to the merger. Finance is not a major consideration.
There are ways that our competitive position and risk situation can be improved, with
or without the merger. The merger is a way of helping with the competitive position
and many of the risks at one go, so is recommended. Without the merger, all of the
ways suggested of improving position are worth considering to preserve the profit
potential that we enjoy.
7 Coffee & Go Ltd

Coffee & Go Ltd (hereafter CAG) was established by Scott Nicholas in 2001. Scott initially
owned 100% of the share capital and was the only director.
Company history
Upon incorporation, CAG bought a disused petrol station site near to London's wealthy
financial centre and converted it into a high quality coffee and hot snacks café which
included a drive-through facility. The three key target markets were:
(1) Early morning commuters, particularly those driving to work, who could collect a high
quality coffee and hot breakfast snack prior to starting work. Frequently other coffee
shops had no nearby parking facilities and are therefore not easily accessible by car-
based commuters. Customers of CAG could also text message orders in advance
from home to speed up their service.
(2) Lunch time market. This included passing trade from drivers who were constantly on
the move. CAG also had some large nearby offices under contract and it would deliver
up to 200 sandwiches per day to some of these major account customers.
(3) Travelling home traffic.
By 2007 CAG had experienced strong growth in sales and the business had expanded to seven
outlets, all based in busy and affluent commercial areas of London and all with a drive-through
facility. In order to achieve this growth Scott had needed to borrow significant amounts of
finance and had raised new share capital from individual investors such that by 2007 his
shareholding was only 55% of the total share capital.
Key procedures

Key corporate themes placed on the wall at every outlet were:
  Never make the customer wait. Better overstaffed than understaffed. 

  Quality product, quality service. 100% customer satisfaction is our aim. 
 Mr Nicholas will visit every site every day. 
Further expansion
Scott is keen to expand the company further in the next few years as his business idea
has proved profitable. In particular, he believes there is growth potential in provincial
cities in the UK. It is clear, however, that further borrowing is not possible in the
foreseeable future.
The strategies identified for expansion are therefore as follows:

(i) Organic growth by reinvesting net operating cash flows.
(ii) Franchising the business outside London. This would give the right to use the CAG name. CAG
would also supply franchisees with all food and paper products at contractually agreed prices. CAG
would also receive 10% of the sales revenue generated by the franchisees and an initial capital
payment.
(iii) Raise new share capital from a small number of rich individual investors to acquire new outlets in
provincial cities in the UK. This would mean Scott would have a minority shareholding and there
would need to be a new board of directors. One of the other shareholders had commented:
'Scott, you're a great entrepreneur, but an awful manager because you won't delegate – if you're
going to grow the business you will need help'.
Requirements
(a) Prepare a SWOT analysis for CAG, briefly describing each of the key points.
Ignore the strategies for expansion for this purpose. (10 marks)
(b) Evaluate each of the three proposed strategies for expansion for CAG under the following headings:
(i) Governance and control
(ii) Growth and profitability
(iii) Strategic risks. (15 marks)
(25 marks)
7 Coffee & Go Ltd
Marking guide
Marks
(a) Strengths 3
Weaknesses 3
Opportunities 1½
Threats 2½
10
(b) Governance and control 5
Growth and profitability 5
Strategic risks 5
15
25
(a) Strengths

Successful business model – that has delivered a profitable and expanding business in the past
few years.
Quality product – serving high quality coffees and snacks appears to have helped attract a
substantial customer base.
Quality service – similarly the good quality and quick service appears to be part of the core
competence in attracting customers in a hurry and/or in transit.
Large contracted sales to offices – a substantial core business appears to be reasonably secure under
contract and is available outside normal peak commuter times.
Key locations – the locations in central London are important in attracting customers, as rival
companies do not appear to have comparable sites to enable collection by car.
Known brand name – the brand name seems to have become well known and is thus recognisable.
This reinforces reputation.
Weaknesses
Reliance on Scott – much of the control and culture appears to depend on one person. There is thus a
risk if Scott leaves or is ill. There is also limited capacity for one person as the business grows.
Lack of further debt finance – expansion is constrained by lack of financial resources.
There is a high level of debt which needs servicing – the high debt creates financial risk.
Capacity has been reached in London where management has expertise – there seems little scope to
expand further within the known London geographical market. Wider geographical expansion may
be outside management's experience and the business model may not 'travel' well outside London.
High fixed cost base through over-staffing.
Possible poor management by Scott (if co-director to be believed) as he will not delegate
appropriately.
Opportunities
Provincial expansion – there is an opportunity to expand in other cities even if London has
reached capacity for suitable sites.
New investors appear to be available to supply new resources for expansion.
Brand name is capable of being franchised.
Threats
Contestable market – there appear to be few barriers to entry (except perhaps appropriate sites)
for rivals to copy the business model and compete away the excess profits of CAG.
There is a threat to the personal control of Scott if more shareholders are needed – Scott would
lose control of the company under strategy option (iii). Thus while the business may succeed Scott's
investment may not if this source of external finance is used.
There is a need to change organisational structure as the business grows – this may affect business
model. If Scott's 'hands on' approach is making the business succeed this may not be available as the
business expands and new management is brought in.
The business is not diversified – a change in market would have a major effect. (e.g. a trend of decline
in the premium coffee market).
Reliance on a few large office contracts – loss of one or more of these may severely damage
the business.
Inability to service high debt costs if business declines or over-expands.

(b) Strategy 1 – Organic
growth Governance and
control
Few ownership problems as Scott would retain control of the company.
Business management and control issues would arise as the business grows and expands
geographically. Scott cannot visit every outlet every day. This may change the control
culture away from an entrepreneurial culture.
Growth and profitability
Growth is restricted by financing and may be very slow.
Profit growth is also limited as the business may be unable to take advantage of economies
of scale through expansion.
Risk
Lower operational risks compared to other options as speed of expansion is limited by
historic performance in order to generate cash flows.
There is however limited additional financial capital to help finance expansion or repay debt.
Also growth is dependent on future operating cash flows being generated. A decline in sales,
perhaps due to competition in London, would limit growth outside London.
Strategy 2 –
Franchising
Governance and
control
Under a franchise a firm grants other firms the right to use its brand, its product or its
know-how. There is also likely to be some central control and support. In return, the
franchisee will normally provide a lump sum, share of earnings and specific payments.
In the current context, a franchise is likely to be on a geographical basis in order to
segregate the markets of the individual franchisees. Key points are:
 It maintains some general contractual control over franchisee but loses some operational control 

 If franchising is to be taken up by many small operators, then CAG is not dominated
by their business partner(s) 

 There is a need to monitor franchisees 

 There are quality control issues to ensure reputation is protected. 
 Need to share profits with franchisee 

 Retains incentives with franchisees' keeping residual rewards and using local knowledge 

 Quicker business expansion than using CAG's own financial resources alone as with
organic growth. 
Risk
 Logistics of supplying food products on time increases risks of delays and failures in the
supply chain 

 Bad quality franchisees may harm brand name 


 There needs to be some incentive to purchase a franchise and without successful
establishment in the market outside London this may be unlikely 

 Few risks from franchisee losses 

 Reduced financial risk by having franchisees' own capital. 
Strategy 3 – New share capital

Governance and control
Scott will lose control of the company and is thus dependent on the other shareholders. He is also
likely to have reduced influence on the board of directors.
As the business grows and expands geographically Scott cannot visit every outlet every day. This may
change the control culture. The other directors and shareholders may also want to change the control
and reporting structure given the new stakeholder structure.
If significant new capital can be raised then growth could be rapid in terms of the number of outlets.
Profit growth will only be rapid if the new outlets are successful.
Economies of scale and economies of scope are likely as the business expands. This should
increase profitability.
The sites in provincial cities are likely to be lower cost than London thus enhancing profitability.
There may not be similar markets outside London (fewer parking problems, fewer very large offices).
This may restrict profit growth.
Additional equity capital will lower financial risk through reduced gearing.
Requirement for dividend or exit route by new investors may limit future availability of funds.
Risk
Expansion outside London is a different market on the current business model may be inapplicable,
not as successful, or more uncertain.
The brand name may be unknown outside London and thus needs to be established in each
individual city. This may not be easy or quick.
There may not be the local knowledge and core competences within CAG to operate successfully
in provincial cities.
8 Monteverdi Master Appliances Ltd

Monteverdi Master Appliances Ltd (hereafter MMA) is a company listed on an international stock exchange.
It manufactures electrical kitchen appliances and sells in the low to medium price sector of the market.
Company profile
MMA manufactures three different types of electrical appliances: cookers, washing machines and fridges.
The company currently has four manufacturing sites located in Malaysia, Russia, England and the United
States. Each of the factories currently manufactures all three products and, in general, sells them in the
region of the world in which that factory is located.
While sales are internationally diversified, market research has shown that different geographical regions
require different designs and features. As a result, each factory has developed each of the products
separately with different features and capabilities which are appropriate to the market in its own
geographical region.
Cost competitiveness and cost reduction

Each of the factories is a separate profit centre. Profitability has declined in all four of the factories in recent
years and thus profitability for the company as a whole has fallen steeply.
The central board has attempted to improve matters by reviewing costs, engaging in internal benchmarking
exercises and applying a series of cost reduction programmes. Each of these cost reduction programmes tended
to focus on one factory at a time and extended over periods of up to a year. At a board meeting to discuss the
results of the latest cost review exercise the finance director summarised the results.
'It is clear that some of our factories can produce at a lower cost than others, but the results are not
consistent. Take, for example, the Malaysian factory. It produces fridges and cookers cheaper than any of
our other factories, but it is the highest cost producer of washing machines. What is more, when there is a
major change in the exchange rate, the whole cost comparison exercise changes.
Another concern is that we have repeatedly engaged in cost reduction programmes by: selective
redundancies, shifting production, changing reporting structures, reducing capacity and outsourcing
functions, to name but a few. Despite all this, there has been no permanent cost reduction of any
significance.
Also, there has recently been an unexpected major new entrant into the industry from
South East Asia, which has low costs and low prices. If we are to compete we will have to
reduce costs much more significantly than we have able to do in the past.'
Global production
In response to the concerns of the finance director a proposal was put forward to globalise
production. The key features of the proposal are as follows:
 Each of the three products would be made in only one basic design, and all of the world
production of each product would be made at a single factory. 

 As a result only three factories would be needed in future; one factory would therefore close. 

 Each factory would be a cost centre and marketing would be centralised functionally
worldwide. It would therefore be outside the responsibility of the factory managers in
future. 

 The change would be pushed through urgently with the aim of completion of the change
programme within six months. 

 It is intended that larger scale specialist production would significantly reduce
production costs, but the situation would be reviewed in two years' time given the
uncertainties involved in such a major change. 
Requirements
(a) Compare the type of change programme engaged in by MMA in the previous cost reduction exercises
with the current proposal to globalise production. (10 marks)
(b) Examine how the globalisation change programme is likely to impact upon key
stakeholders. Assess the implications for MMA in communicating the nature of the changes
in each case. (8 marks)
(c) Give examples of barriers to change that may arise and which may cause resistance to the
implementation of the globalisation change programme in MMA. (8 marks)
(26 marks)
8 Monteverdi Master Appliances Ltd
Marking guide
Marks
(a) Levels of change 4

Types of change 6
10
(b) Shareholders 2
Employees 2
Management 2
Customers 1
Suppliers 1
8
(c) Cultural 3
Groups 2
Personal 3
8
26
(a) Comparison of types of change programmes

(1) Levels of change
Change can take place at different levels within an organisation.
  Strategic level 
  Structural level 
 Process level 
The current proposal for the change to globalisation is at the strategic level. This is a
change that affects the long-term direction of the entire organisation both in terms of its
production capability and in terms of its market competitiveness.
Previous cost reduction exercises appear to have been at a lower level in the company, being
restricted to individual factories. This has included changes at the structural level. This is
change in organisational structure which appears to have arisen from changes in reporting
structures according to the FD, but may also have arisen from outsourcing if this was
significant.
Previous cost reduction exercises have also included changes at the business process level.
These are the changes necessary in processes, activities and the management of people in
order to implement the chosen strategy. These are likely to have occurred as a result of
selective redundancies, shifting production, and reducing capacity reported by the FD.
It should be noted, however, that while the new proposal is primarily at the strategic level
the implementation of this strategy will also include changes at the structural and process
levels.
(2) Types of change
The current proposal also differs from the previous cost reduction exercises in terms of
the type of change. There are four main types of change identified by the scale of change
involved for the organisation. Two measures of scale can be used – impact and
predictability.
 Impact 

– Adaptive – limited change which does not disrupt existing working methods 

– Fracturing – which disrupts current structure and working practices and
requires a major change in culture. 

 Predictability 

How much is known about the effect of change on technology, finances, human resources. 
By combining the two measures it is possible to see not only the four main types of
change but also obtain guidelines for the best approach to change management.

Regarding impact, the current proposal for globalisation appears to be fracturing change,
as it would appear to be necessary to disrupt production worldwide. There are also
changes in the current structure (profit centres to cost centres) and working practices,
and requires a major change in culture.
By contrast the previous cost reduction exercises appear to be more localised and
largely adaptive, taking place within a longer timescale and of more limited impact.
Regarding predictability, the entry of a new competitor appears to be unexpected.
Moreover, the change is so fundamental that the consequences are likely to be uncertain.
This is also implied by the need for a post implementation review after two years.
By contrast the previous cost reduction exercises appear to be more repetitive, limited
and thus predictable.
In summary the globalisation proposal involves high impact and low predictability.
This is sometimes called transformational change (or revolution).
By contrast the previous cost reduction exercises involve low impact and high
predictability. This may be regarded as small scale project planning (sometimes called
evolution).
If the cost reduction exercises were major, they could be regarded as large scale project
planning (sometimes called reconstruction).
(b) Impact of globalisation change programme

Shareholders
Shareholders require reassurance that the strategy will be implemented successfully and will result in a
successful overall strategy that will enable MMA to compete and add value despite the new competition.
Regular and effective communication with shareholders about the nature and impact of the changes is
important (having regard to insider trading regulations which require that information must be
communicated openly and equally).
Employees
Production employees in one factory are to be made redundant – unless relocated internationally
which seems unlikely in most cases.
Other production employees may have greater security arising from the changes. In particular if the
new entrant in South East Asia is to focus on its local market the Malaysian factory may be most at
threat under the existing structure but may be more secure under the new structure in serving a
global market.
Marketing employees at each site may be made redundant or subject to a new reporting structure,
given that marketing is to be global rather than at factory level.
Management
Local management may be made redundant in the factory which closes but may be more likely to be
relocated than production staff. Other management will need to work under a new cost centre
structure with less autonomy. Management may also be key figures in implementing change and acting as
change agents. Management support is thus vital to the implementation of the change programme. They
therefore need to be consulted and informed of the changes.
Customers
Customers may be affected by
  Short-term disruption of supply 

  No longer obtaining a product which is adapted to different geographical markets 
  Cheaper prices if costs are reduced 
 Longer lead times if supply is from a greater distance (depending on inventory holding policies). 
Customers may be reassured by advertising. Stockpiling may also be necessary prior to the change to ensure

continuity of the quantity of supply and the type of supply during the factional change period.
Suppliers
Given the geographical shift in production there may need to be major changes in suppliers. These changes
could be favourable to some suppliers where new production is located to their local factory.
To other suppliers the change may result in the termination of the relationship with MMA.
Suppliers need to be informed of the changes if increased quantities or changes in the types of supply
are to be satisfied under the new arrangement.
Where long-term contracts exist that are to be breached, then negotiation of contract termination
needs to commence with possible legal advice.
(c) Barriers to change
There may be a number of barriers to change arising from
  The organisational culture 

  Groups of stakeholders with common interests 
 Individuals. 
(1) Cultural barriers

Structural inertia is the cumulative effect of all the systems and procedures the organisation
has installed over the years to ensure consistency and quality. These act as barriers to
change.
The new proposal for MMA puts forward fundamental changes that will affect the culture of
the organisation. In order to change this, Lewin argues that the old culture of profit centres
and geographical responsibility will need to be unfrozen; the changes made; and then a
refreezing of the new culture should take place.
Power structures may be threatened by the redistribution of decision-making authority or
resources, or the changing of lines of communication. In particular the change from profit
centres to cost centres is indicative of a reduction of decision making authority in each
division and increased centralisation of decision making, including for example the marketing
function.
This will in particular affect management and thus management may be reluctant to
implement changes which will be against their own interests.
(2) Groups
Group inertia may block change where the changes are inconsistent with the norms of teams
and departments, or where they threaten their interests. The factory most likely to close is
most probable in forming a group. Also however the marketing employees in all four factories
may form a group to resist change knowing that their jobs are most at risk.
(3) Personnel barriers
There are also barriers which affect individuals and result in them seeing the change as a
threat. This may affect not only the factory that is closed, but also the employees in the
other factories where there are likely to be substantial changes in work practices and also
redundancies of old skills in favour of new skills.
Habit, because habitual ways of work are hard to change, and the new and unknown is often
uncomfortable. For example, the cost reduction programmes may involve greater
mechanisation which will affect work patterns.
Security is almost inevitably threatened – job security and the security of familiarity. This
may vary according to which site is seen as most under threat of closure.
Effect on earnings – continuing cost reductions and changes in work practices may affect
the earnings of individuals.

Fear of the unknown reduces people's willingness and interest in learning new skills; they
may lack the confidence to take on a new challenge where work practices change. While
there is uncertainty over which factory will close, this may affect all employees.
9 London Limos Ltd

Jared Patel is the founder and sole shareholder of London Limos Ltd, (hereafter LL), a
specialist chauffeur business in its third year of trading.
Company history and background
Jared, a wealthy entrepreneur, set the business up in February 2005 to cater for guests at top
hotels in the London area, providing transport to theatres, airports and conferences. A
number of the original clients were acquaintances of Jared. A lack of tourists visiting London in
the summer of 2005 led to a significant drop in business and, as a result, a change of strategy.
LL has now decided to focus on attracting additional custom from clients with access to their
own or company aircraft, targeting senior executives and wealthy private individuals who
typically use this form of transport.
In the year ended 31 January 2007 LL made a profit of CU55,000 on revenues of CU250,000.
Jared wants to accelerate growth and is looking for sales to double in the year to 31 January
2008.
LL's headquarters is located in East London. The 2012 Olympics, which have been awarded to
London, are widely expected to create more inward traffic to this area and Jared expects extra
business to be generated as a result. In addition, the use of private and chartered aircraft is
forecast to grow ten-fold by 2015.
Clients are not price sensitive, so margins are higher than a typical hotel to airport journey. LL's
focus is on excellent service and personal relationships and this has led it to acquire 25
contracts which provide a reasonable level of repeat business. Clients are collected in an
immaculate, top of the range BMW or Mercedes. The drivers are smart, reliable, punctual and
discrete. In the car, clients are offered refreshments and newspapers and LL can provide a
variety of additional services e.g. theatre tickets, restaurant reservations and sightseeing tours.
Jared has continued to rely on personal contacts and word of mouth to build a customer base. At the
outset he did approach some listed companies and financial institutions for potential clients. LL's
promotional activity has subsequently been limited to an unsuccessful mail shot and occasional adverts
placed in prestige magazines.
Jared believes that LL now needs to attract more clients for continued growth.
Industry regulation
There are over 2,000 licensed private hire operators offering a variety of services in the London area,
including taxis, limousines and chauffeur driven vehicles. Any individual or company accepting bookings is
required to be licensed by the Public Carriage Office (PCO) as a private hire vehicle (PHV) operator. A PHV
operator will be issued with a licence valid for five years provided they meet the conditions of licensing, which
include inspection of the premises and vehicles, and confirmation of appropriate insurance cover. Operators
are then subject to ongoing compliance inspections throughout the life of the licence. The purpose of the
regulations is to give passengers confidence that they are dealing with an honest, professional organisation
with reliable drivers and safe vehicles.
Once an operator has obtained a PCO licence and a vehicle, there are few other barriers to entry and as a
result it is important that LL builds market share and additional customer loyalty quickly.
Current business model
LL currently leases three cars, each costing CU1,000 per month.
Other fixed costs amount to CU3,000 per annum per car. Office rental, staff, website, marketing and other

administration costs are CU38,300 per annum. The PCO licence costs CU2,500 per annum.
The cost of a driver amounts to CU12 per hour. Fuel and other variable costs are estimated at CU10 per
hour. The typical fare for clients from the private aviation industry is CU50 per hour.
In order to maximise the utilisation rate, cars are also hired out to other customers at evenings and
weekends for social occasions (e.g. birthday trips to nightclubs, weddings) at a rate of CU30 per hour.
Currently the weekend and evening trade accounts for 15% of total hire hours.
Requirements
(a) Discuss whether the decision to focus on the private aviation industry is an example of a traditional or
emergent strategy. (5 marks)
(b) Identify and explain appropriate critical success factors for London Limos. (5 marks)
(c) Calculate the number of hire hours per annum required for London Limos to break even, stating clearly any
assumptions. Comment on the implications of your calculations for Jared's plans to increase
sales. (7 marks)
(d) As part of a potential marketing strategy for London Limos, discuss the use of the following:
(i) A segmentation strategy
(ii) Promotion strategy
(iii) Competitive pricing strategies. (13 marks)
(30 marks)
9 London Limos Ltd
Marking guide
Marks
(a) Traditional or emergent 5

(b) CSFs – Definition 2
CSFs – Application 3
5
(c) Break even calculation 2
Assumptions 2
Implications 3
7
(d) Segmentation 4
Promotion 5
Pricing 4
13
30
(a) Traditional or emergent

The traditional strategy process follows a series of steps: strategic analysis, choice and implementation.
The process starts with strategic analysis which usually incorporates a SWOT analysis. The mission
and objectives of the organisation are then set by reference to the stakeholders. Strategic choice then
involves developing and selecting strategy options for the business, followed by implementation of the
selected options.
The emergent approach is more flexible. In the emergent approach, strategy emerges over time,
adapting to human needs. The process is evolving, continuous and incremental. There is continual
adaptation to the environment and a strategy is likely to be tried and developed as it is implemented
so the strategic choice and implementation stages are not separated.

It is unclear whether LL used the traditional approach to develop the initial strategy of providing
transport for hotel guests as there is no evidence of a formal mission/objectives. It is quite likely
that no deep analysis was carried out and that Jared simply used his wealth to develop a business on
the back of his personal contacts.
The decision to switch strategy and focus on private aviation clients was essentially unplanned, and a
response to human element and the changing environment.
Jared's response appears experimental and could be said to be more akin to the emergent process –
in the light of possible failure, he was prepared to change, rather than spend the next three years
continuing to implement the strategy that had been chosen originally.
If LL fails to achieve critical mass then further amendments to the product will be required and the
strategy will need to continue to evolve.
(b) Critical success factors
Critical Success Factors (CSFs) can be defined as those components of strategy where the organisation
must excel to outperform competition. These are underpinned by competences that ensure its
success.
In competing in a niche market, LL may outperform rivals if it has superior skills which can be
sustained.
An alternative definition of CSF is 'a small number of key goals vital to the success of an
organisation' i.e. 'things that must go right'.
The key issues for competitive advantage appear to be the ability to outperform
competitors in the following areas:
 Quality of service – punctuality, reliability and efficiency 

  A level of personal service that is difficult to copy – relies on hiring and retaining the right drivers 
– ability to react to conversation, knowing when to keep quiet, discretion etc 

 Quality of vehicle – clean, air-conditioned, spacious, standard of IT equipment, facilities 

 Local presence in SE London and hence local knowledge and specialisms 

 Ability to get last-minute table reservations/tickets etc (e.g. through contacts developed) 

 Good links for generating business e.g. with concierges at top hotels/ private aviators etc 

 Developing and maintaining the relationship with customers 

 Maintaining a good reputation with existing customers for repeat business 

 Superior skills in marketing and promotion, website design etc (not yet shown by LL). 
If LL is able to maintain these CSFs then they will experience an increase in rebooking
rate by customers, enquiries by new customers, vehicle hirings and utilisation rates.
(c) Break even
calculation
Fixed costs
Lease payments =12 1000 3 = 36,000
Other car costs =3 3000 = 9000
Admin = 38,300
PCO licence = 2500
Total FC = 85,800
Average revenue per hour = (0.85 50) + (0.15 30) = CU47
Average contribution per hour = 47 – 12 – 10 = CU25
Break even hours = 85,800 / 25 = 3,432 hours p.a. = 66 hours per week = 22 hours per car
Assumptions

  Only one PCO licence is required by the business 
  Sales mix remains constant at 85/15 
  No step changes in FC 
 No discounts in hire rates or VC 
Implications
The break even number of hours looks low given that a typical car is likely to be available for
around 16 hours per day, 7 days per week.
If we assume figures and sales mix applied in year ended 31 January 2007:
Profit of 55,000 add back FC of 85,800 = contribution of 140,800
Total contribution / average contribution per hour = 140,800 /25 = 5632 hours
Year 1 level of hire out = 5632/52 = approx 108 hours per week or just over 36 hours per
car per week.
(or CU250,000 revenue / CU47 average rev = 5319 hours which is 102 hours per week or
34 hours per car)
The implication is that the current business probably only justifies 2 cars (assuming that they
are not all required simultaneously at peak times). Therefore there is plenty of spare capacity
to take up extra business generated by increased marketing effort.
Instead of increasing the fleet to generate growth, Jared needs to use the existing fleet better.
Assuming there is scope to expand the aviation hires, this will have a greater impact on revenue and
profit due to the higher rates charged.
Sales mix information suggests that hire for weddings and parties currently accounts for between 5 and
6 hours per car per week (15% 36 hours). Thus there appears to be a lack of utilisation of cars at
evenings and weekends. LL should increase promotion of weddings etc as there is likely to be little
increase in fixed costs.
Note: If the sales mix changes such that the proportion of evening and weekend hires increases, the
break even hours would increase as these sales are at a lower margin.
(d) Marketing strategy
(i) Segmentation strategy
Segmentation is the division of the market into homogenous groups of potential customers who
may be treated similarly for marketing purposes. LL should adopt a niche marketing strategy,
concentrating on one or two segments.
This would work by following the current strategy and dividing the market into:
  Aviation/business customers 
 Social customers 
Since the two groups of customers have different needs.
Aviation/business
Given the premium nature of the core product and service, LL need to segment by socio-
economic group, targeting professionals and high income individuals in class A.
Marketing should be targeted to reach the users of the service and also those who are likely to
book it:
  PAs to time-pressed executive bosses 

  Directors of CU100m+ businesses in M25 corridor 
  Wealthy families 
  Business travel agents 
 Operators of executive jets, pilots, ground crew etc. 

Social customers
Separate segmentation is required for the weddings and party business.
The off-peak hire-out market could be segmented by family life cycle – wedding hires for newly
weds, party limos for those at bachelor stage, and so on.
LL should target their marketing at events organisers, party planners, wedding coordinators etc.
Whereas advertising of services for private aviation can take place wherever business flyers are
present, LL need to focus advertising for social customers on the local market.
(ii) Suitable methods of promotion
LL should adopt a targeted advertising message offering a solution that is relevant to the issues
faced by each segment of its market.
Due to the type of business, word of mouth is likely to be key, but LL also needs to target the
right people with their promotion and focus this on the service they can offer.
Since the two types of business have a different brand image, it will be important not to dilute the
prestige image of the aviation business e.g. magnetic signs/phone numbers on the top of the cars to
attract social customers would not work for the prestige business market.
Promotion should emphasise CSF's noted above and could include use of the following:
 Website 

– Revamp and include testimonials from satisfied clients 

– Encourage visits to site through Internet advertisements, registration with search
engines and adverts in magazines/ papers. 

 Mailings 

– Obtain customer lists – assess profile of existing customers and then buy database of
similar people e.g. Companies House 'Directors at Home' database. 

– Need to follow up mailings by e-mail and phone to maximise benefit, possibly using an
outside agency to provide telemarketing support 

 London newspapers, magazines etc 

– Write articles e.g. for specialist/travel press 

– Produce press releases for trade magazines, bridal magazines 

– Aim for editorial coverage e.g. in upmarket magazines and broadsheets rather than
advertising. 

 Customer facing 

 – Trade fairs/exhibitions/conferences/wedding fairs 
– Social events for customers – ask them to bring along contacts. 

 Increase brand awareness 

 – Yellow pages, Yell.com and similar 
– Promote links with key hotels, nightclubs and party venues. 

(iii) Price
 Target for the private aviation business is the quality end of the market so
service, reputation etc is key and price is unlikely to be the deciding factor. 

 A 'perceived value' pricing strategy is likely to be appropriate – LL have cultivated a
prestige image and are therefore likely to be able to charge premium prices. 

 A separate pricing strategy is appropriate for wedding hire outs and parties. LL should
maximise contribution by operating price discrimination due to the separate markets

and their differing elasticities of demand. 

 Price is likely to be more of an issue for the evening and weekend market so 'Going
rate' pricing may be more relevant here. 

 There will be constraints on price e.g. competitor prices so LL should benchmark
their price against prices for similar journeys/services in their local market. 

10 The Complete Furniture Group Ltd
The Complete Furniture Group Ltd (CFG) is the UK's largest furniture manufacturer. Listed
on the London Stock Exchange, it manufactures and sells a wide range of furniture to
businesses in the building trade (trade sales) and to individual retail customers (retail sales).
Company profile
CFG has always positioned itself as a low cost provider, but has recently experienced a
continued decline in performance resulting in an overall published loss, and as a result the
share price is depressed. In the year ended 31 December 2006 CFG made an operating loss of
CU0.45m (2005: CU48.2m profit) on revenues of CU1,054m (2005: CU1,038m). CFG's
average share price was CU0.81 in 2006 and CU1.08 in 2005. No final dividend was declared
by CFG for 2006.
The business is currently organised into three divisions: retail sales, trade sales and manufacturing.
Retail sales
The loss-making retail division operates nationwide, from 120 out-of-town
furniture showrooms and15 high street stores.
The out-of-town showrooms are located on dedicated retail shopping parks, situated away
from the town centre, with good road links and ample parking. The high street stores are
significantly smaller and located in the centre of major towns and cities, with good public
transport links and favouring access by pedestrians.
Information for each type of store for 2006 is set out below:
Typical out-of-town store Typical high street store
Revenue CU4,677,563 CU1,969,500
Space occupied 2,500 m2 1,000 m2
Rental per square metre CU150 CU250
Number of transactions p.a. 11,700 7,800
The stores range in size between 1,000 and 3,000 square metres. Each offers a complete
range of furniture for the kitchen, living room, bedroom, bathroom and home office, on
direct sale to the general public.
The product margins vary considerably and some products are not price-competitive
after allocation of store and delivery costs in the pricing calculation.
Kitchens and bedroom furniture account for over 80% of revenue and gross margin, but
a significantly lower proportion of selling space.
Trade sales
The trade sales division supplies kitchens, doors, window frames and other wood products to
the building trade. Customers are mainly local builders, small developers and specialist
kitchen installers. This division has seen rapid growth and rising profits and is currently the
star of the group. It has around 300 sales centres across the UK, 15 of which were opened in
2006. The board expects a similar number of new sales centres to be opened in 2007.
Manufacturing division
The manufacturing division consists of four factories and eight distribution centres. It has
historically manufactured and supplied the majority of components and finished goods for

the retail and trade sales divisions. It only supplies products internally and the goods are
priced at cost.
The board meeting
CFG's board is under pressure to improve performance and so it urgently needs to improve
margins, control costs and generate cash. As a result the directors are currently assessing the
store portfolio and the supply chain and need help implementing the strategic review.
The directors have expressed some views:

Director of manufacturing division:
'Our high street stores are simply not big enough to carry a sufficient range of stock and the rent is very
high. Sales from the high street have fallen as internet sales have become more popular. Besides, anyone
with transport tends to go to one of our out-of-town locations. The high street shops are an obvious
candidate for closure.'
Director of retail sales division:
'We have always had a reputation as a low cost supplier but the problem is we can no longer compete with
our rivals who have increasingly outsourced production to low cost countries. I believe it is time to close our
in-house manufacturing division which is inflexible and inefficient. This will give us more flexibility and allow
us once again to compete on price. It would also allow us to save costs by halving the number of distribution
centres.'
Director of trade sales division:
'Whatever we decide, we need to ensure the changes are handled carefully and communicated properly to
our staff and our shareholders. In trade sales we have a successful business model and I am concerned that
our reputation might be damaged by all the bad publicity surrounding job losses. We don't want anything to
get in the way of our growth plans.'
Appendix 1: Financial performance
2006 2005
CUm CUm
Retail sales
Revenue 591 618.82
Operating loss (78.15) (23.47)
Trade sales
Revenue 463.35 419.32
Operating profit 77.7 71.7
Requirements
(f) Using the information available, identify and calculate appropriate Key Performance Indicators (KPIs)
for a typical out-of-town and a typical high street store. Suggest further financial and non-financial
measures that could be used to provide management with more information as to the performance of
the various stores. (8 marks)
(c) Referring to your calculations in (a) where appropriate, and addressing the comments made at the
board meeting where relevant, set out and evaluate:
(iv) Potential strategies for the retail sales division.
(ii) The proposal to close the manufacturing operation and outsource production. (12 marks)
(d) Assume it is decided that the closures suggested by the directors take place. As an external consultant,
prepare a memo for the board of CFG addressing the following aspects of the change management
programme:
(i) Planning the change
(ii) Explaining barriers to change and how staff can be motivated in the period
(iii) Communicating the change plan to stakeholders (15 marks)

(35 marks)
10 The Complete Furniture Group Ltd
Marking guide
Marks
(a) KPI calculation 2

Financial measures 3
Non-financial measures 3
8
(b) Strategy for retail division 6
Proposal 6
12
(c) Planning the change 5
Barriers to change 5
Communication plan 5
15
35
(a) Performance indicators

KPI calculations
Out-of-town High street
Revenue per square metre CU1,871 (4,677,563/2,500) CU1,970 (1,969,500/1,000)
Revenue per CU rental CU12.47 (4,677,563/(2,500 150)) CU7.88 (1,969,500/(1,000 250))
Average transaction value CU 400 (4,677,563/11,700) CU253 (1,969,500/7,800)
Other KPIs for stores
Financial measures
  Year on year sales growth 

  Store gross margin 
  Operating income as % revenue 
  Contribution per square metre 
  Contribution per CU rental 
  Product sales as % total sales, by store and also for retail division 
  Product contribution as % total contribution, by store and also for retail division 
  Sales per CU spent on wages 
  Inventory turnover 
 Store ROI 
Non-financial measures
  Sales per hour 

  Orders per week 
  Conversion rate (number of walk-ins that convert into customers) 
  Number of items sold per transaction 
  Level of returns per store 
  Number of product lines carried 
  Inventory obsolescence 
 Staff turnover 

(b) Strategy for retail division
Options for retail division include some or all of the following:

 Sale of whole division to allow management and resources to be focused on
more profitable trade sales division 

Currently the retail division is making a sizeable loss (CU78m) which in 2006 has entirely negated
the operating profit made by the trade sales division. Sales have fallen 4.5% from 2005 to 2006. 

By contrast the trade sales division has seen a growth in sales of 10.5% and maintained
operating profit at around 17% turnover. 

If CFG cannot compete on cost then they may need to assess the viability of the whole
division retail sales division. 

Do CFG need to retain any stores? Closing stores and promoting an online home
delivery business would considerably reduce wages and rental costs. It would also free
up management time to focus on expanding the profitable trade sales business. 

 Closure of high street stores as suggested by the manufacturing director 

The manufacturing director has suggested closing all high street stores. These account for
11% of the store portfolio by number, 5% of total sales and 8% of total rental costs. 

Potentially they are taking a disproportionate amount of management time. However if CFG
want cost reductions on a large scale, simply closing the high street stores is unlikely to be
sufficient. 

Calculations in (a) imply that high street stores are typically making better utilisation of
selling space (higher revenue per square metre) but due to rental costs, the revenue per
CU rental is significantly lower. 

A typical high street store is 40% of the size of the out-of-town store but makes two-thirds
the number of transactions. As a result a high street store is making more sales per day than
the out-of-town store. This could mean that the high street staff are better able to convert
walk-ins to sales but out-of-town staff are better at trading up the sale. Alternatively the
higher average transaction value for out of town could be due to the fact that they have the
space to carry higher value items. CFG should promote a home delivery function for the
higher value items in their high street stores. 

CFG may be less likely to lose sales/customers to competitors if there is another CFG
store nearby. Most customers are likely to be mobile. In the event of closure, CFG
should promote their nearest out-of-town store to try and prevent loss of customers to
competitors. Alternatively lost sales could be minimised by setting up an online business. 

 Possible closure of out-of-town stores 

KPI's suggested in (a) could be used to identify weak performers and therefore
additional candidates for closure. 

Different stores may be at different stages in their life cycle, e.g. a newly opened store may
be in the growth phase, a more mature store may be seen as a cash cow. As a result their
performance may not be comparable. 

Poor store performance may be down to store location/ market conditions/central decisions
rather than the manager – CFG should identify and retain their most able store managers i.e.
decision re closure of store and termination of manager contracts should be made
separately. In deciding which stores to close, CFG should assess the relevant exit costs and
likely savings: 

– Penalties may apply to terminating the lease on certain stores 

– Costs of redundancy may vary from one store to the next depending on profile of staff 

– Need to consider savings likely to be made on closure e.g. some rents will be higher than
others. If objective is to improve cash flow and profits, may target most expensive

locations. 

– Other central costs / allocated overheads may not be eliminated by closure. 
 Remodel/ downsize/ relocate stores 


If CFG believe they have a competitive product (or will have after relocating manufacturing)
they could try to remodel weak stores, rather than close them: 

– Relocate stores to locations where rental is cheaper. 

– Consider changing the nature of the high street stores to offer a design and ordering service
for later delivery. This would minimise the stockholding, reduce the space required and
hence rental cost but keep the name on the high street. 

– The fact that kitchens and bedrooms are contributing 80% of turnover/ gross margin but
occupying significantly less than this proportion of space implies that CFG could reduce
rental costs by reducing the size of their stores without significantly affecting profitability. 
Other initiatives to improve performance of stores could include:
– Improve operating efficiency
– Train sales staff
– Increase cross selling / trading up of sales e.g. sell kitchens as 'fitted'
– Implement a customer loyalty programme
– Improve delivery options.
 Change product mix 

– Streamline product range to exit unprofitable products and focus on ranges with the highest
sales and profit potential, as demonstrated by KPIs suggested in (a), e.g. kitchens and
bedrooms. 
Issues to consider if decide to focus on certain product lines include:
– Interdependence of product lines – do customers expect a one-stop shop?
– Some locations within store will be better than others e.g. opposite front entrance v corner of
top floor. This needs to be taken into account when comparing product performance.
– Who controls costs of floor space and allocation of space to products – sales could be
influenced by changing the allocation of floor space.
 Set up Internet sales business 

– Develop online shopping with home delivery as an alternative distribution method 

– Provides sales opportunity without need for high rental costs 

– This could be done from the existing distribution centres if the manufacturing facility is
retained 

– May minimise the impact that store closures have on sales 

– Could be used for the product lines that take up considerable store space but make lower
margins 

– Online market likely to be very competitive and need to consider whether management
have the necessary expertise 
Closing manufacturing and outsourcing production
Issues to consider
 Closing manufacturing 

– Currently all production is sold internally – is this a strategic decision/ a capacity issue or
because there is no external demand for goods manufactured by CFG as they are too
costly? Lack of external market pressures may have led to complacency and inefficiency. 


– The division may not be manufacturing sufficient volumes to generate economies of scale. 

– In-house manufacturing requires significant capital investment and WC. 
– CFG have a fixed source of supply so are therefore less flexible in responding to changes
in market/ technology/ buyer preferences.
– Manufacturing requires different management skills from management of retailing.
Closure would free directors up to concentrate on sales side of business.
– There is an argument for manufacturing in house if it contributes to competitive
advantage but the retail division director's comments imply this is not the case here.
– According to the retail director there will be knock on effects in terms of savings
in distribution costs.
 Outsourcing 

– May give access to cheaper products e.g. through low cost labour and/or exchange
rate advantages. 

– May improve competitive advantage. Closing the manufacturing division and outsourcing
the production overseas as suggested by the retail director may reduce the costs and
improve sales and performance of the retail division. The director's comments imply
that competitors have benefited from this. 

– Reduces fixed costs and hence operating gearing 

– Reduces risk exposure 

 However CFG may encounter potential problems if closure occurs 

– May be problems in controlling supply chain: there will be admin costs and time spent
in coordination 

– May be harder to guarantee supply 

– Delays in delivery may arise if products are being imported from overseas locations 

– May be harder to control quality, particularly with a variety of suppliers 

– There may be hidden costs e.g. impact of 'kick backs' required to do business in
certain countries 

– Managing this change will require considerable time and effort on the part of management 

– Closure costs may be prohibitive: redundancies, exit penalties etc. 

 In order to make the decision, CFG need to consider the impact on the
other divisions 

– Is weak performance of retail division down to poor selling/store location or
poor buying/uncompetitive cost of manufacture? 

– What is anticipated impact on sales and operating income of both sales divisions of
reducing costs of manufacture through outsourcing? 

– Problems with supply, quality, timing of delivery etc may have adverse impact on growth
of trade sales division 

– It may be better to consider whether costs can be reduced by rationalising existing set up
and improving efficiency – reducing number of factories and distribution centres,
moving to Just In Time manufacturing etc. 
(c) Memorandum
To: Directors of CFG Ltd

From: A N Consultant Date:
XX/XX/XXXX
Re: Change management programme
As requested this memo sets out the issues that the Board need to consider in planning and
implementing the various strategic changes under consideration.
(i) Planning the change
In order to plan there is a need to understand the context for change:
 Timescale: To what extent is CFG in immediate crisis or do they have the time available to
plan carefully? E.g. gradual closure of high street stores. 

 Scope of change: The closure of the UK factory could be considered a transformational
change, requiring a major shift in culture. The closure of some retail outlets and the
remodelling of others is more likely to be brought about within the current paradigm
and could therefore be seen as realignment. 

 Capability: Do CFG management have the capacity and capability to implement the change 

 Power: Does the change leader have the power to bring the changes about? 

 Readiness: Are staff aware of the need to change and willing to do so? What
management approach is needed to ensure success? 

 Resources: Are there adequate resources (people, finance, equipment) for the change? 

 Culture: Does the existing culture represent a barrier to change? Does there need to be
an interim internal programme to develop the structures, competences and commitment
to tackle the major changes ahead of the adoption of the strategic change? 

 Stakeholders: Level of power and interest of the various groups that are likely to be
affected. Has CFG communicated the need for change to all stakeholders? How will
CFG handle resistance from unions and employees? Is the change cosmetic e.g. to
placate shareholders or will it deliver real results? 
Effective change planning involves considering:
  What are the aims and intended outcomes for the change programme? 
  How will the change be resourced? 
  How much support / resistance is there to the change? 
 What are the practical methods to be used? 
A blueprint should be prepared which needs to record for each desired outcome:
 What action is to be taken, when the action will start, how long it will take and when it will
finish? 

 Who will do what? 

 How will the actions be carried out? 

 Why – the purpose of the actions? 

 How, when and by whom evaluation will be carried out? 

 Must include launch: how to position the changes to gain most support? 
Monitoring and coordination is required to ensure everything keeps moving forward according
to the blueprint:
 A senior and influential group of CFG executives must take responsibility for
overall leadership and coordination. 

 There must be a clear blueprint even if some of the precise timings are provisional.

 The blueprint must cover the whole range of activities planned. 

 Carrying out the actual work of investigating what is needed and implementing new
systems and policies should involve key people in the change target group. 

 Change leaders should be carefully chosen for their skill and support. 

 Methods of making changes following evaluation should be included. 

(ii) Barriers to change
There may be a number of barriers to change in CFG arising from:
(1) The organisational culture
(2) Groups of stakeholders with common interests
(3) Individuals
(1) Cultural barriers
 Structural inertia is the cumulative effect of all the systems and procedures that CFG
has installed over the years to ensure consistency and quality. These act as barriers
to change. 

 The new proposal puts forward changes that will affect the culture of the
organisation. In order to change this, Lewin argues that the forces which maintain
behaviour in its current form need to be unfrozen; the changes made; and then a
refreezing of the new culture should take place. 

 Redistribution of decision-making authority or resources, or the changing of lines
of communication may threaten the existing power structures within CFG. 

 This will in particular affect management who may be reluctant to implement changes
if they perceive them to be against their own interests e.g. director of manufacturing
division. 

 CFG employees will be suspicious of changes to the comfort zone in which they
are used to working. There may be conflicts due to changes in roles and
responsibilities e.g. relocation of high street staff to out of town stores. 

(2) Stakeholder groups
 Group inertia may block change where the changes are inconsistent with the norms
of teams and departments, or where they threaten their interests. 
Examples include:
 Strikes and other forms of resistance to change implementation by CFG staff to
be made redundant. 

 Shareholders selling shares as a result of the changes. 

(3) Individuals
 There are also barriers which affect individuals and result in them seeing the change
as a threat. This may affect not only the UK factory that is to be closed but also the
employees in the other divisions, particularly if there are some store closures. 

 Habitual ways of working are hard to change, and the new and unknown is
often uncomfortable. 

 Job security and earnings will inevitably be threatened and changes to the
usual environment cause uncertainty. 

 Focus on continuing cost reductions and changes in work practices may bring
concerns about the impact on earnings. 

 Fear of the unknown reduces people's willingness and interest in learning new skills; they
may lack the confidence to take on a new challenge where work practices change. 


 Selective information processing results in employees ignoring management
argument for change. 
Motivating staff during the change period

 Communication about the reasons for change, the implications for jobs etc 

 Participation in the process may improve motivation 

 Emphasise training and development opportunities 

 Prospects of retention or transfer within CFG may limit resistance to change 

 Offer assistance for staff who are to be made redundant 

 If staff are to be made redundant, they may be motivated by making negotiation of
redundancy terms, references and assistance with alternative employment contingent on
smooth transition 

(iii) Communication plan
Stakeholders Interests Needs Communication method
Shareholders Interested in impact on Reassurance re state of Press

share price and their investment and how
Website
profitability / dividends. strategy will benefit them
Have seen share price / improve results AGM
fall 25% in 2006.
Financial statements
Institutional investors
may have different view
to smaller shareholders
Staff Will be concerned re Help to adapt to changes Briefings / team meetings
earnings and job
Training and support One-to-one interviews with
security. Possibility of
HR / line manager
redundancy will increase Information about
their resistance to impact on earnings and
change. Could employ job security
tactics to delay closures
Counselling / help finding
new employment
Management Will want to know how Acknowledgement and One-to-one meetings
they are going to be involvement in the
Senior group meetings
involved in the process. process
Likely to be supportive
Reassurance re position
of change, unless like
/ power
manufacturing director
or certain store Up-to-date information
managers they believe
their jobs are under
threat

Stakeholders Interests Needs Communication method
Customers Availability of supply Motivation to stay loyal Adverts

Impact on quality and Website
price
Press releases / coverage
Reliability of delivery
Financial press How and why has Knowledge of what is Briefings
/ analysts decision been made and happening
how will it be
A good story
implemented. What will
future impact be on the
business?
Potential CFG will represent a Information Trade press/ magazines
suppliers new source of business.
Website
What supplies will they
want in future and on Meetings/letters/e-mail
what terms? depending on size of
prospective supplier
Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group, mozumder@organic-
crop.com Cell-01711-981920 Page 63
CFG should ensure groups are informed in a logical sequence to minimise unrest and rumours.
Timing of communication will be critical to success.
11 Pine Paper Ltd
Pine Paper Ltd was incorporated in 1948 and has been wholly owned by members of the McCoist
family since that date. The board of directors consists solely of family members. The company
manufactures newsprint for sale in the newspaper and magazine industry at a single site near Glasgow
in Scotland. In terms of the paper industry it may be regarded as a small to medium-sized
manufacturing company.
The company profile
Markets: The company's major customer has for many years been the Glasgow Evening Star, for
which it is the sole supplier of newsprint. The contract is renewable each year and the price is
determined on a cost plus basis, with a mark-up of 25%.
Historically the Glasgow Evening Star contract has made up about 30% of the company's revenue, but
during recent difficult trading conditions other business has suffered significantly. As a result the
Glasgow Evening Star contract made up about 40% of total revenue in Pine Paper Ltd's latest
accounting year. The remaining 60% of sales is mainly to magazines and free newspapers which are
published and circulated across Scotland and the north of England. Frequently orders have been won
by Pine Paper Ltd's willingness to provide small quantities of newsprint from short production runs
and its promise of prompt delivery.
Raw materials: The major raw material for Pine Paper Ltd is pulp. Rather than rely on the major
pulp manufacturers, which import timber from Canada and Scandinavia, the company is supplied
exclusively under short-term contracts from a privately-owned Scottish mill, Pulp Products Ltd,
which processes local softwoods.
In recent years Pine Paper Ltd's purchases have accounted for 8% to 10% of Pulp Products Ltd's
revenue. Whilst these supplies of pulp are slightly more expensive than those that can be purchased
from the larger manufacturers, they have the advantage of short and certain delivery times, enabling
Pine Paper Ltd to carry negligible inventories of raw materials.
Production: Pine Paper Ltd makes a single product, reels of newsprint. The company's
manufacturing operations have been built up over time and as a result, a small proportion of its
operating non-current assets are replaced each year. Given the scale of its activities, the business is
not as capital intensive as many of the larger operators in the industry; consequently it has a higher
proportion of labour costs per tonne of output than the industry average. In fact, Pine Paper Ltd
struggles to compete when tendering for major orders as it uses more pulp per tonne of output than
would be the case if it could operate large-scale, modern machinery. In compensation, however, set-
up costs are much lower, and this enables small production runs to be accommodated, ensuring
greater flexibility in production scheduling. Due to weak trading volumes the company has only been
operating at 70% of productive capacity this year, and a similar level of 30% surplus capacity is
expected next year.
The competitive environment
The British paper industry is dominated by ten major listed companies, whose operations are
primarily based in England or Wales. All produce both commodity newsprint and a variety of branded
paper products for specialist markets. There are also a number of smaller companies, of similar size
to Pine Paper Ltd, which mainly specialise in niche markets. Additionally, there are a number of major
paper companies based in continental Europe which sell into the British market. A growing
phenomenon affecting all sectors has been the growth of the low-cost, low-quality recycled paper
market, supported by subsidies from some foreign governments for their own producers.
The paper industry has been affected significantly by a recession in the newspaper industry, in favour of
online news media, with most companies operating with excess capacity. This in turn has led them to
cut margins when tendering for contracts. The following are other features of the competitive
environment.
 Depressed pulp and paper prices (a reflection of their historic volatility). 

 The failure of one or two small operators and downsizing by the survivors as they
rationalise their operations. 

 An increased tendency towards diversification. 
A strategic dilemma
The chairman of Pine Paper Ltd has recently been informed that the Glasgow Evening Star has been acquired by a
multinational and that when the existing commitment expires at the end of this year, the contract to supply
newsprint will be put out to tender on an annual basis. He has also been told that the terms of the new contract
will be that all the newsprint which the Glasgow Evening Star requires next year will be supplied by the successful
bidder at the pre-determined tender price per reel. The bids have to be submitted by 30 September and the
successful bid will be announced a month later. The contract will not be awarded solely on the basis of price, but
this is likely to be a major factor. At the board meeting called to discuss these developments the following views
were expressed.
The marketing director: 'It has long been my view that we have been over-dependent upon the Glasgow Evening
Star as a customer. Even if we do win the contract next year, there is no guarantee that we will be able to retain it
in future. In my opinion it is therefore essential that we seek out new markets and new products. In particular, we
are too small to be a commodity producer of newsprint without the Glasgow Evening Star contract. We need to
develop into niche markets within the paper sector by producing differentiated branded products. In fact, there is
currently an opportunity for us. A small local firm, Pharmopaper Ltd, is currently looking for a buyer. It has been
very profitable, specialising in exploiting the growing demand in the market for pharmaceutical paper products, but
it has experienced severe cash flow problems recently due to overtrading.'
The production director: 'I agree with the need to diversify, but making newsprint is what we are good at. We
have no experience of other markets. I have just been told that Pulp Products Ltd's shareholders are looking to sell
the company due to recent losses arising from weak world pulp prices. In my opinion this represents an ideal
opportunity to secure pulp supplies at low cost. I am also in favour of purchasing more modern large scale machinery
in order to drive down marginal costs. This will enable us to compete in the long run in our core activity.'
The finance director: 'Even if an acquisition strategy is felt to be appropriate, it is very difficult to evaluate the
feasibility of the two options in precise monetary terms as much will depend on the prices of the two businesses. In
my judgement Pine Paper Ltd is sufficiently liquid to fund one or other of the options suggested but, given current
uncertainties, it would be difficult to raise finance for both of them.'
The chairman: 'My immediate concerns are: first, we need to consider how to proceed with a strategic plan
without knowing whether we will be successful in retaining the Glasgow Evening Star contract; and, second, how are
we to decide the price at which we should tender for that contract? The finance director has produced some
figures that can be used to calculate the minimum price to cover our costs, but the actual price at which we tender
will have to be based on wider considerations.'
Requirements
As a management consultant you have been commissioned to prepare briefing notes for the directors of Pine
Paper Ltd. The notes should:
(i) Assess the factors to be considered with respect to the price at which the company should tender for
the Glasgow Evening Star contract. (8 marks)
(ii) Analyse the current strategic position of the company, employing SWOT or another appropriate
method of assessment. (12 marks)
(iii) Evaluate the future strategic options available to the company by appraising the factors to be
considered with respect to both:
 The general appropriateness of a strategy of diversification to the company 
 The particular diversification/acquisition strategies suggested. (14 marks)
(34 marks)
11 Pine Paper Ltd
Marking guide
Marks
(a) Analysis of factors 8

(b) Strengths 3½
Weaknesses 2½
Opportunities 2½
Threats 3½
12
(c) Diversification strategy 6

Pulp Products 4
Pharmopaper 4
14
34
Briefing notes
To: Directors, Pine Paper Ltd
From: Management Consultant
Date: Today
Subject: Current strategic position and future options of Pine Paper Ltd
1 Factors to be considered in relation to the tender price
(i) The original pricing policy of cost plus 25% allowed Pine Paper a large margin, which
may have encouraged the company to ignore possible production inefficiencies.
It is not clear exactly which costs the mark-up was based upon and this would be useful
information.
It is likely, however, that in order to secure this price in the past Pine Paper will have had to reveal its
costs to the Glasgow Evening Star (GES). This will have given the customer considerable power over Pine
Paper and is therefore a disadvantage of such a policy.
(ii) It will be important to know what other newsprint companies are likely to be involved in the tender.
The management at GES, with whom Pine Paper has enjoyed a long relationship, should be able to give
this information although, initially at least, they may wish to preserve confidentiality and therefore refuse
to disclose the identity of other bidders.
Using the directors' experience of the industry, Pine Paper must nevertheless estimate the general
nature of such competitors' costs and therefore possible tender levels.
(iii) Pine Paper has enjoyed a long business relationship with GES and it is important that it continues to stay
on good terms with the GES management as they are likely to have a major impact on the awarding of the
contract.
Due to previous contact with GES, Pine Paper may be able to identify the likely non-price
conditions/expectations attaching to the successful bid (e.g. level of service agreement).
(iv) If Pine Paper were to lose the contract, it might have an impact on its reputation in the paper industry
and a consequent loss of business from other sources.
(v) The company currently has spare capacity, like most of the industry. While it is unlikely this can be used
at the moment, the overall capacity in the industry is decreasing and Pine Paper may be able to utilise
some of its spare capacity in the future.
If the contract is won, even at a low price, the workforce will be kept on, allowing Pine Paper to take
advantage of any upturn in the industry.
(vi) Pine Paper could find out from GES whether cheaper quality pulp, and hence paper such as recycled
paper, would be acceptable.
This would drive down Pine Paper's costs.
(vii) Pine Paper may be able to find out from GES management how likely it is that the contract will be
awarded to different companies each year, or whether there is a strong possibility that the initial
successful bidder will keep the contract for some time.
2 Analysis of current strategic position Key
issues
A single product company, operating at well below capacity which will either lose its major customer or, to
retain the customer, will have to price the contract near to cost.
Strengths
 Pine Paper is family-owned and managed, and knows its customers well. 

 It is willing and able to do short production runs which are required by small papers and
magazines. 

 It is known for its prompt delivery. 

 It has an annual contract with a supplier for 10% of that company's output and so exercises some power over
its supplier, although this power would be diminished if the GES contract were lost. 

 Apart from GES, its customers are small and individually hold little power over Pine Paper. 

 It operates out of a single site which makes control over the operations easier. 

 It appears to be the only Scottish-based newsprint manufacturer and uses Scottish produced pulp in its
product. 
Weaknesses
 GES currently accounts for 40% of its production. This gives the customer power over
Pine Paper, particularly in the area of price, and this has recently been exercised. 

 The company appears to have a high wage content and a low capital investment. Although a
weakness as unit costs will therefore be high in cases of high volume, it may also be a strength
when there is low production volume if the labour force can be easily increased or decreased. 

 Pricing for GES has been on a cost plus basis which gives the customer knowledge of Pine
Paper's cost base, thus allowing it to squeeze margins if required. 
Opportunities
 The margin on GES can be reduced considerably, and hence the price, while still making a profit. 

 With spare capacity of 30%, opportunities must exist for using this capacity. 

 The opportunity to diversify generally is available, and in particular by buying either
Pharmopaper or Pulp Products. 

 The opportunity exists to bid for larger contracts by reducing unit costs on longer
production runs. This will only be possible with large capital investment. 
Threats
 The immediate threat is the loss of the GES contract or its retention at such a low price
that Pine Paper makes little profit. 

 Recycled paper, currently with excess supply and therefore cheap, is a threat, particularly
if subsidised by governments. 

 Imports generally are a threat. 

 Although there has been some rationalisation in the industry, there continues to be
surplus capacity, which is likely to drive down prices even further. 

 The company relies on a single product. While not in a market which is disappearing, there is
certainly excess capacity. It is too small to compete with larger organisations on a cost basis. 
General strategic position
Pine Paper is continuing to compete with a single product in a market in which it can be undercut on
price. This is not a sustainable position. It will need to readdress its approach to this market or look
at new products and/or new markets.
3 Future strategic options and diversification
Pine Paper appears to have four options:
  Stay with the same product in the same market 

  Exploit new markets 
  Introduce new products into the same market 
 Look at new products in new markets 
(i) To stay with the same product in exactly the same market does not appear viable as there is
currently 30% excess capacity and competitors are increasingly encroaching on major contracts.
(ii) The company could penetrate its market by increasing the scale and efficiency of production by
investing heavily in capital equipment and so supply newsprint for much larger production runs
at lower cost.
This was suggested by a director but this sector would seem to be even more competitive
with excess capacity in the industry and is not likely to be a successful strategy.
(iii) It is difficult to envisage what other products could be successfully marketed to Pine
Paper's current customers using its existing core competences, although it may be worth
the board considering.
(iv) The best option is likely to be new products in new markets, i.e. diversification, although a related
product and market is likely to be a more successful venture than one which is completely
unrelated.
Such a strategy will diversify the company's operations and will reduce the risk of the business and
benefit the shareholders who, as the directors in the business, are unlikely to hold a diversified
portfolio of investments.
4 Diversification opportunities identified
The attractiveness of diversification will depend on the reduction in risk that can be achieved and any other
possible synergy. Generally this has been found to be greatest where there are some shared activities or a
transfer of skills.
Both these companies are in the same industry as Pine Paper but they have different attractions.
Pulp Products
While this would guarantee pulp supplies, Pine Paper is still reliant on the same product and market. The
only new element introduced is Pulp Products' other customers and it is obviously having problems in
keeping its price high enough to make profits.
Even so, Pine Paper has found it to be more expensive than larger manufacturers.
There are unlikely to be many shared activities (in production, marketing or distribution) or much transfer
of skills.
The only other benefit would be to secure a Scottish pulp supply and market the whole process as a Scottish
enterprise. This however is a tenuous reason for vertical integration of this kind. Variable costs would be
converted to fixed costs and the company would be more sensitive to any downturn in the market. It is also
not clear whether the company has any core competences in the pulp industry.
Pharmopaper
This successful but badly managed company (allowed to overtrade) is in a similar business and there may well
be some shared activities in the paper production process. Much will depend on the extent of the production
and marketing synergies between the two operations. Whilst some differentiation is required, if the products
and processes of Pharmopaper are too different from those of Pine Paper, then the consequence may be little
more than two independent divisions with few opportunities to save costs by increasing scale and by joint
processes.
If however there are some synergies, this would allow for greater economies of scale, greater utilisation of
spare capacity and the possible disposal of some machinery and other surplus assets. In addition, transfers of
skills and resources would be possible, including management expertise, working capital, and marketing and
distribution.
Pharmopaper is made more attractive as an acquisition target by its growth potential in a niche market.
Conclusion
Generic business strategy should concentrate on differentiation, cost or focus. It is difficult for Pine Paper to
make its newsprint different from other suppliers as it is a commodity type product, and it can never hope
to be cheaper than others. It must therefore try to focus on some area where competition is lighter, and
establish a niche market.
Pharmopaper would seem on the basis of the information given to represent a potential move into such a
market with a profitable and successful business.
12 Krimpaz Ltd
Krimpaz Ltd has a financial year ended on 30 June. It operates five ladies' hairdressing salons in rented
premises in the West Midlands. Below are its summarised accounts for 20X5/X6 and 20X6/X7, together
with alternative budgets A and B for 20X7/X8.
Income statements
Years to 30 June 20X6 20X7 20X8
Budget A Budget B
CU'000 CU'000 CU'000 CU'000
Sales 500 524 550 275
Rentals 210
485
Supplies*1 (60) (63) (66) (66)*2
Fixed staff costs (160) (168) (180) (90)
Other fixed costs (264) (276) (296) (294)
Profit 16 17 8 35
*1
12% of sales
*2
12% of Budget A sales
The business profile
Krimpaz Ltd was incorporated in 20W4, when the company's two directors, Warren Christie and
Julie Beatty, opened their first hairdressing salon. They soon gained a following, and over the next
ten years they opened a further four high street salons in neighbouring towns in the West
Midlands. Altogether the business employs 20 stylists, assistants and beauticians, as well as the two
directors themselves.
Competition amongst ladies' hairdressers is intense, and to ensure success it is necessary for
salons to employ good stylists who keep up with the latest fashions. It is also necessary to offer
related beauty care facilities (e.g. provide sunbeds and employ beauticians). In the past Krimpaz
Ltd has been able to compete effectively, but the directors – who own all the shares – are now
keenly aware that they need to refurbish the salons if they are to maintain their place in the
market.
The two budgets for 20X7/X8
With this in mind the directors have budgeted to invest CU84,000 in new fixtures and fittings in
the next financial year, which they regard as being the minimum necessary to maintain market
share.
Initially they prepared Budget A for 20X7/X8 assuming that the business would operate in the
same way as in previous years. Lack of access to capital means that most of the additional funding
would have to come from the bank. However, Warren Christie feels that it may be unwilling to
advance the extra CU50,000 required as it already has substantial second mortgages over the
directors' homes. He has therefore prepared an alternative forecast for 20X7/X8, Budget B. This
follows recent practice in the trade whereby many salons rent out chairs to stylists, who in
return receive the takings from their clients. Under this scenario the company would still be
responsible for supplying all materials and facilities. Such a franchising arrangement for ten of the
employees would reduce the company's fixed costs, provide flexibility, increase annual profits
more than fourfold compared to Budget A, and lower the funding required from the bank by
around CU27,000.
Other options
Julie Beatty believes that other options should also be considered. One possibility would be to
make the salons unisex, catering for the needs of men as well as women. Another would be to
close the existing shops if alternative arrangements could be made to open salons within
department stores. However, she thinks the most advantageous option would be to sell out to
one of the larger regional chains of hairdressers.
The company accountant also made the point that the way risks are shared alters when stylists
rent their own chairs. They will have a stronger incentive to satisfy clients' needs but, if they are
successful, Krimpaz Ltd will not participate in the upside potential unless an appropriate ratchet-
based profit sharing arrangement is agreed. On the other hand, the exposure of Krimpaz Ltd to
downside risks will be less. In her view, if the business is to be offered for sale to rival chains, it
will be necessary for differences in risk-sharing to be reflected in the valuation.
Requirements
(a) (i) Calculate the level of sales revenue at which the salons would break even under Budget A;
and
(ii)
Determine the level of profit which would be achieved under Budget B, assuming the same
total
number of customers as the break even level under Budget A. (6
marks)
(b) As the assistant to the company's accountant, prepare a memorandum for the directors of
Krimpaz Ltd which examines the key strategic issues and the advantages and disadvantages of
each of the strategic options being considered.
The memorandum should deal only with the following issues:

 Treating each of the salons as a separate decision unit (e.g. with respect to pricing,
whether or not to rent out chairs, etc) 

 Maintaining the salons' competitive position (e.g. through discriminatory pricing policies,
providing complimentary and complementary services, etc) 

 Employing staff versus renting out chairs to stylists (considering in particular the risks
which will be borne by them rather than the company) 

 Converting the shops to unisex salons 

 Closing the salons and taking concessions in department stores 
 Selling out to a local chain of hairdressers. (26
marks)
(32 marks)
12 Krimpaz Ltd
Marking guide
Marks
(a) Budget A 3
Budget B 3
6
(b) Separate decision units 5
Maintaining competitive position 5
Employment v chair rental 5
Unisex salons 4
Concessions 4
Selling out 3
26
32
(a) Break even

(i) Under Budget A let sales = R
then R – 0.12R – 180 – 296 =0
0.88R = 476
R = 541 i.e. CU541,000
(ii) Under Budget B
0.5R + rent – 0.12R – 90 – 294 = profit/loss
When R = 541
Then 0.5 (541) + 210 – 0.12 (541) – 90 – 294 = 31.58 i.e. CU31,600
(b) Memorandum
To: Board of directors,
Krimpaz Ltd From:
Assistant to company
accountant Date: Today
Subject: Strategic options for Krimpaz Ltd
(1) Strategic

considerat
ions
Separate
decision
units
Krimpaz Ltd has competed successfully to date having built up a good reputation
in its five salons. However, the problem facing the firm is the need to invest
CU84,000 to refurbish salons, when raising this sum could prove difficult.
For most purposes the five salons should be considered separately.
 Having been opened at different times they do not all need refurbishing
at the same time. The figure of CU84,000 should be examined to see if
costs, and hence finance, can be staggered. 

 Customers will be loyal to particular stylists, so are unlikely to
frequent more than one salon. Different prices could thus be charged
to reflect reputation and demand. 

 Not all of the shops have to be sold at the same time. Those with the
lowest profits could be sold and the others kept. 
However, as far as renting out chairs is concerned, it may be better to adopt one policy
across the company.
 Stylists in one town who want to rent chairs may become demotivated if refused,
when those in other towns are given the opportunity. 
This may cause them to leave and set up on their own in competition (the issue of renting
out chairs is discussed in more detail below).
Competitive position
The hairdressing industry is a fragmented market made up of small businesses. The reasons
for this are as follows.
 With the exception of purchasing supplies and some administration costs there are
few economies of scale to be gained by larger firms. 

 Customers expect a personal, local service and have a high degree of loyalty to particular
stylists. Again, a larger firm is unlikely to have an advantage here over smaller competitors. 
Recognising this, the key factor necessary for success is to have good stylists. In all of the
options being considered, this must be borne in mind. Assuming that good stylists are present,
other differentiating aspects should be improved, such as the following.
 Improving sunbed and beautician services 

 Improving the quality of complimentary tea, coffee and biscuits 

 Price discrimination to smooth demand across the week – in itself this might reduce
revenue but it could facilitate servicing customers with fewer staff, resulting in
considerable cost savings. (Losing a single stylist could nearly double profits!) 

(2) Specific options
 Renting out chairs 
Pros Cons/Problems
If a stylist loses clients then Krimpaz
– A fourfold increase in profit still gets the rent
– Reduced exposure to downside risk. – May enable Krimpaz to keep its best

stylists who might otherwise leave
to set up on their own – Scheme may be rejected by stylists as
figures given result in their making a loss
– Reduced fixed costs and hence lower
risk CU'000
Revenue 275
– Improved flexibility
Rent (210)
– Reduced bank funding requirements as Salary forgone (90)
staff costs saved can be spent on Loss (25)
refurbishment
– Reduces financial gearing – To break even stylists would need to
increase business by 15% on 20X7 figures.
This represents a high risk undertaking
for them, although they have stronger
incentives
– Reduced upside potential particularly as the
best stylists are likely to be most keen on
chair renting. If refused they may leave
– Control issues – for example there may be
conflict on allocating new clients to stylists

 Unisex salons
Pros Cons/Problems
– Diversification of risk – Potential loss of female customers who

prefer the atmosphere of ladies' salons
– Extra income from male customers
– Existing stylists may not have experience of
– Men are becoming more concerned
men's fashions so further training/staffing
with health/beauty issues so this could
costs will be incurred
be a chance to tap into a growing
market – Lack of competitive advantage as men are
unlikely to be impressed by the reputation
of ladies' stylists
– Does not really help the financing problem
– Less scope for high perceived quality
pricing
 Taking concessions in department stores 
Pros Cons/Problems
– Can still capitalise on the main – Costs of closing existing salons (cancelling
strengths of Krimpaz – its brand leases, moving equipment, necessary
name and the reputation of its stylists repairs, etc)
– Lower running costs (presumably) – Negotiating a suitable contract with the
store especially with set-up costs, profit
– Increase in image by being associated
share, rental costs, control, etc
with a prestigious store, resulting in
higher profits and lower risk – Finding a prestigious store not already tied
into existing agreements. It would be a
– Lower financing requirements
mistake for Krimpaz to do a deal with a
(presumably)
downmarket store
– Potential for further growth if the
store has branches in other towns
 Selling out to a local chain of hairdressers 
Pros Cons/Problems
– Consideration will enable the – The most likely form of the sale would be
shareholders to repay the second an earn-out forcing the two directors to
mortgages over their homes and will keep running Krimpaz for, say, the next
solve the financing problem two years. This may not fit in with their
discussed above plans
– Capitalises on existing reputation of – Restriction of trade agreements in the sales
Krimpaz and the quality of its stylists contract may stop the directors earning
any money
– Problems in valuing the business

Preliminary recommendations
The main strength of the firm is its stylists. Conversion to unisex salons does not capitalise on this
strength and so should be discounted. Renting out chairs will not help profitability: profits will go
down if the best stylists are given the chance to rent and they will be lost if not given the chance.
Opening concessions could resolve financing problems if a suitable contract could be negotiated,
but on balance the option of selling out seems the most attractive enabling the owners to resolve
their financing problem.
13 Gull Training Ltd

Gull Training Ltd (hereafter Gull) is a company that provides courses on Stock Market regulations
and financial services compliance issues in the UK.
Industry background
Companies seeking a listing on the London Stock Exchange have to satisfy stringent conditions to ensure
that public confidence in the integrity of the market is maintained. Stockbroking firms also have to comply
with rules for dealing with clients and transactions in relation to the London Stock Exchange. Staff of such
firms therefore have to obtain appropriate qualifications to prove that they are an 'authorised person'
before they can operate as a broker. Recently there have been job losses in the stockbroking industry
due to the use of new technologies and the introduction of paperless transactions. About half a dozen
firms of stockbrokers account for over 90% of the market.
Similarly, individuals wishing to be registered to sell financial products have to qualify as
Independent Financial Services Advisors (hereafter IFSA). This market contains established high
street financial institutions such as banks and building societies, as well as many smaller, specialist,
organisations.
The regulators also insist that stockbrokers and IFSAs keep up to date with latest developments in
the industries via post qualification development (PQD) training. This is to ensure that they are aware
of changes to regulations and new financial products.
In the last few years there have been a number of scandals involving the Stock Market and the
financial services industry. This has shaken public confidence and prompted the government to
consider extra regulations and controls.
Demand for financial services products is usually linked to the strength of the Stock Market, and the
FTSE 100 Index, which has fallen from a high of 7000 at the end of 1999 to a low of 3400 in early 2003.
The market is susceptible to erratic swings, both up and down.
The market for providing qualifications to the relevant organisations is dominated by a handful of
training companies. There has been a lot of consolidation in the training industry in recent years.
Company background
Gull was formed in 1970 by three former stockbrokers. The company initially operated from
former school premises in Sussex and offered intensive residential courses to individuals
working within the stockbroking industry. With the liberalisation of financial regulations in the
mid 1980s the company expanded into offering IFSA qualification courses in a number of large
cities in the UK. Many of Gull's competitors have merged, but the three directors have always
been fiercely independent and have been reluctant to reduce their control over the business.
The company employs both full time staff, who specialise in teaching individual subjects, as well as
freelance staff who are utilised at busier times of the year. In addition, Gull Training uses a number
of authors to write textbooks and exam-based material for the professional qualifications that it
teaches. Full time staff are paid highly competitive salaries and receive an annual bonus based on the
company's performance. As a consequence staff tend to stay with the company for many years.
Although the market is very competitive, Gull's students have consistently produced pass rates that

exceed the national averages.
The company also provides PQD training for both stockbrokers and IFSAs.
Recent developments
Gull has invested heavily in an online learning module that allows candidates to test
themselves on an ongoing basis to provide instant feedback for their learning to date. The
early feedback from the testing of the online training module has been positive from both
students and employers. If the module is used by candidates, it will halve the time they have
to spend attending courses at Gull's teaching centres.
At present the module is only geared towards the exam based courses, but Gull believes that it
can be expanded into PQD training too. They hope to have the product endorsed by the
regulatory bodies, as it can log the number of hours of time each person takes studying ongoing
issues in the industries, and so acts as proof for both individuals and authorities that the
requisite amount of time has been spent on PQD.
Requirements
Prepare a memorandum for the directors of Gull that:
(a) Provides an analysis of the training industry in which Gull operates using Porter's Five Forces model.
(12 marks)
(b) Identifies the likely reaction of competitors to the launch of the online training module. (5 marks)
(c) Assesses the core competences of Gull's business. (7 marks)
(24 marks)
13 Gull Training Ltd
Marking guide
Marks
(a) Potential entrants 2½

Competitors 2½
Customers 2½
Substitutes 2
Suppliers 2½
12
(b) Competitors' reactions 5
(c) Competitive architecture 4

Reputation 2
Strategic assets 1
7
24
(a) Memorandum
To: Directors of Gull Training Ltd
From: A Consultant
Date: Today
Subject: Industry analysis, competitors' reaction and core competences
Five Forces analysis

Potential entrants
 There are significant barriers to market entry given that the staff required to deliver the courses
would have to have specialist knowledge and skills. New entrants would therefore have to either
invest large sums in training staff, or pay a premium to attract staff from existing providers. 

 The existing market is dominated by a handful of suppliers; they are likely to have close links with
their clients and so it would be difficult for a new entrant to gain a foothold in the market. 

 If a new entrant does appear, then existing firms will take action to prevent it from gaining any
market share. 

 The volatile nature of the market for qualified staff, which is very cyclical in terms of stock
market and City activity, would act as a deterrent to potential entrants as it would create
uncertainty and risk in terms of potential profitability. 

 Conclusion: Barriers to entry are high. 
Competitors
 The fact that the market is dominated by a handful of suppliers suggests an oligopolistic industry.
There will be fierce competition for contacts with the decision makers within the individual
stockbroking firms who award the training contracts. 

 Such a market usually features non-price competition, with individual suppliers trying to
differentiate them from other firms in the industry via branding. Each firm watches rivals very
closely, and prices are often 'sticky' as price cuts are matched, as each firm is worried about
losing market share, but price rises may not be followed, as competitors see this as an
opportunity to gain share. 
 Given the consolidation in the market, it is likely that these features may be amplified
in the training industry. 

 The best way for the training companies to maximise profits is to act as an informal
cartel, with an agreement not to cut prices or offer discounts to clients. 

 Conclusion: Competitive pressures are high. 
Buyers
 Given that the stockbroking market is dominated by half a dozen firms, they are likely
to wield considerable power. 

 Switching costs are likely to be relatively low, as the training industry is service
orientated, and no development or design costs are likely to exist. 

 Buyers will have full information about training costs charged by the individual training
companies. As a consequence they can exploit this and try to play the training companies
off against each other in terms of prices. 

 The smaller stockbroking firms, and resit students who have to pay for their own
courses, are likely to have to accept the market price. 

 Conclusion: Buyers' powers are strong and could restrict profitability. 
Substitutes
 Good teaching and communication skills are likely to be held in high regard, so in this
respect will be difficult to substitute. 

 The new online product being developed by Gull could be viewed as a competitor to the
taught courses already supplied in the market. 

 There is also the opportunity for forms of distance learning, but these are likely to be less
flexible or popular than taught courses. 

 Conclusion: Substitute pressures are relatively weak in the industry. 
Suppliers

 The main suppliers to the industry are freelance lecturers. There are likely to be
relatively few suppliers with the requisite skills to teach on these specialist courses, which
will give them some power, but the training companies will be able to easily switch
between them. 

 If there are peaks and troughs in terms of demand for lecturers, as appears to be the
case, then costs may rise during this period. 

 If there are 'star' lecturers who are very popular this may give them extra bargaining
power with individual training companies. However the small number of firms in the
training industry may mean that they operate as a cartel and refuse to meet higher wage
demands. 

 Conclusion: Suppliers' powers are weak in the industry. 

(b) Competitors' reaction
 Competitors' reactions can be identified as one of four profiles: laid back, selective,
tiger or stochastic. 

 Given the oligopolistic nature of the market, with the fear of losing market share to
Gull, competitors are likely to adopt the tiger profile and may react aggressively to the
launch of the new product. In a market where product differentiation is very important,
keeping up with the latest delivery methods is essential to ensure survival. 

 Competitors are likely to be already developing a similar product themselves, as the high
profile nature of the stockbroking industry is one that would normally embrace new
technologies, or will attempt to copy Gull's new product. 
 Given the costs in terms of both capital and time involved in creating such a product are significant,
this may give Gull a competitive advantage in the marketplace, and act as a barrier to entry if all
the stockbroking firms decide to buy into Gulls' product. 

 If sufficient resources exist, one of Gull's competitors may decide the time is right to take over
Gull. This would give them direct access to the new product, and also increase their market
share, as they would also acquire the existing customer base of Gull. 

 An alternative response is that competitors may aggressively criticise the new product, in an
attempt to prevent stockbroking firms from using it for their staff. 

(c) Core competences
Competitive architecture
Internal architecture
 Gull has highly skilled and motivated staff, who will be keen to achieve the bonuses on offer for
hitting performance targets. 

 If Gull have recruited 'star name' lecturers this will give the company a competitive advantage in
the market place, but may increase employment costs. 
External architecture
 There is little evidence that Gull has any advantages over competitors in this regard. 

 Clients are likely to want detailed feedback on the progress and chances of examination success of
their staff, and this could be provided by an information system accessible by clients, and also from
the online training module. 
Innovative ability
 The new online module suggests that Gull is an innovator, and this will establish the company as a
market leader in the eyes of customers. 

 It is essential that Gull maintains this reputation and continues to utilise new processes as clients

are likely to be very demanding and will expect constant improvement in terms of the services
offered. 
Reputation
 Gull has a good reputation with customers because it produces high exam pass rates. This
reputation can easily evaporate if there are a few sets of poor results, so it is essential that the
company offers high quality teaching and modern teaching methods to clients. 

 The high levels of staff retention may help Gull to attract high quality new staff, who will see this as
an example of a enjoyable and stimulating working environment. 
Strategic assets
 The nearest thing to a strategic asset that the company possesses is the online training module,
but this is very much an unproven asset. 

 It could be argued that the staff of Gull are a further asset. 
14 Santay Ltd
Santay Ltd was formed twenty years ago when a number of medium-sized companies
manufacturing and supplying medical equipment merged their activities, the group shortly
afterwards obtaining a listing on the Stock Exchange.
In recent years the company's revenue seems to have flattened out at around CU120 million,
with pre-tax profits stagnating at CU15.5 million. As a result, the group's newly appointed
chief executive has requested the finance director to carry out a preliminary review of the
company's product portfolio.
The company's product portfolio
Santay Ltd sells a wide variety of products, many of which are relatively small pieces of
equipment that are now being bought by GPs in the UK and abroad (e.g. lung, heart and foetal
monitors; equipment for testing vision, hearing and blood; and equipment for minor
operations). Other equipment is manufactured and primarily sold to hospitals (e.g. kidney
dialysis machines, including small versions which can be used at home by patients; various types
of X-ray scanner, including those used by surgeons to monitor the situation while they are
carrying out microsurgery operations; endoscopes; and resuscitators). However, the
company's newest product, for which there is considerable demand in the UK and overseas
and in which it has a competitive advantage over most rivals, is a patented 'virtual reality'
machine that enables surgeons to learn how to perform new ground-breaking operations via
simulation.
Monitors Test equipment Equipment

Lung Heart Foetal Vision Hearing Blood for minor
operations
% of Santay Ltd's
revenue 7 6 5 5 3 5 10
Markets
Geographic %
UK 50 40 40 65 70 75 65
US 10 20 10 8 6 5 15
Germany 15 15 30 15 9 9 11
Other EU 25 25 20 12 15 11 9
Customer %
Hospitals 45 40 35 5 10 15 5
GPs 55 60 65 95 90 85 95
Year current model
first sold 1999 2003 2001 1996 1995 1999 2005

Kidney dialysis X-ray scanners Endoscopes Resuscitators Surgery
machines simulation
equipment
% of Santay Ltd's 18 17 10 10 4
revenue
Markets
Geographic %
UK 60 50 43 70 65
US 15 22 20 8 25
Germany 13 20 20 12 6
Other EU 12 8 17 10 4
Customer %
Hospitals 85 90 85 80 100
GPs 15 10 15 20 0
Year current model 1993 2003 2004 1995 2007
first sold
The board meeting
At a board meeting the newly appointed chief executive suggested that the group had too diversified a
product portfolio and that it should concentrate on those newer lines developed from 1998 onwards which
comprised the greater part of current revenue.
The marketing director expressed reservations. He felt that some of the older products were important in
generating cash for the business and there were relatively few products that might be phased out because they were
becoming obsolete. The main ones which might fall into this category were vision, hearing and blood testing
equipment. However, there were common costs in marketing many of the group's products, and so long as sales
revenues exceeded production costs there was no strong case for eliminating them.
With respect to the different geographical markets in which Santay Ltd sold its products, the company was the
market leader in the UK for equipment for minor operations, kidney dialysis machines, endoscopes and resuscitators,
and ranked in the top four for lung and heart monitors and vision testing equipment. The US market was far more
competitive, however, and Santay Ltd's market share put it outside the top ten for all products except X-ray
scanners, endoscopes and surgery simulation equipment. It was much the same story in Germany, where however it
was the major supplier of foetal monitoring and X-ray scanning equipment.
As for the company's existing marketing strategy, the marketing director felt that it was time that a new
incentive scheme was introduced for sales representatives, which might be expected to increase sales in
existing markets. This could be devised to maximise sales, although this would not necessarily maximise
contribution. At the same time he recommended the adoption of a strategy to break into new but as yet
relatively unexploited markets (e.g. Australasia and Japan).
The production director pointed out that on the manufacturing side there were also substantial joint or
common costs between products. These might to some extent be avoided if their production were to be
subcontracted, but it would be necessary to try to assess whether such an option was really better
for the company in terms of net contribution than if the group stopped manufacturing and selling
various lines. He wondered whether an analysis applying activity based costing might be helpful in this
context.
The finance director argued that it would really be necessary to try to assess the competitive
advantage the company possessed over its rivals for each product, and this could perhaps best be
done in terms of value chain analysis. However, he was not hopeful that such a step would really
prove very helpful because of the commonalties between products both in production and at the
marketing stage. He also felt that in any analysis of the product portfolio, it would be necessary to
take into account the fact that foreign exchange risk would be altered if certain lines were dropped.
The director of research and development made the point that the surgery simulation equipment
had only recently been developed at considerable cost – which was one of the reasons that profits had
stagnated, in fact – but that market research suggested that the company was on to a winner. It
appeared that Santay Ltd was some way ahead of its rivals and was protected from immediate

competition by patents, which would not expire for another twenty years. Sales representatives
reported strong demand for the equipment in the US and Germany as well as in the UK, and he
predicted that within three years revenues from such sales would account for more than 40% of
turnover. His main concern was that additional investment should be allocated for further
development of this product and for the search for new products to come on-stream in four to five
years' time. This would reduce over-reliance on sales of a single key product while at the same time it
would enable the company's growth momentum to be sustained.
Price discrimination
The marketing director confirmed that reports from the company's sales representatives with
respect to the surgery simulation equipment were extremely optimistic, but it was necessary to think
hard about an appropriate pricing strategy for this product. He felt that it was desirable to practise
price discrimination in different markets to take account not only of different price and income
elasticities, but also of changing exchange rate parities. However, he was aware that it might be
necessary to justify prices to regulatory authorities in various countries.
Given the high element of research and development costs incurred in the past, the finance director
considered that a reasonable rate of return on capital employed for this type of product would
probably be 40% per annum, and this would convert itself into a profit margin on sales of 10%. In fact,
it appeared that the company could exercise a considerable degree of discretion in allocating costs
and assets to particular product lines, quite apart from choosing specific fixed asset depreciation and
amortisation rates. On the other hand, by itself this would not appear to justify price discrimination in
different markets. This could best be achieved, perhaps, by manipulating transfer prices on goods sold
to overseas subsidiaries, although any such manoeuvres would need to be handled carefully, not least
because of tax considerations.
Requirements
(a) Calculate the implicit 'sales/capital employed' ratio which would convert a 40% per annum rate of
return on capital employed into a margin on sales of 10%. In so doing, show the relationship
between the ratios. (3 marks)
(c) As an assistant to the finance director of Santay Ltd, prepare a draft preliminary report
for the company's chief executive which assesses:
(i) The company's product portfolio identifying, as far as possible from the information given, using
the Boston Consulting Group matrix (12 marks)
(iii) How useful such an analysis is likely to be when there are on the one hand manufacturing and
marketing commonalties between products, and on the other the various lines are sold in
different but complementary markets (10 marks)
(iii) The arguments for adopting price discriminatory policies and being able to justify differential pricing
to regulatory authorities in terms of accounting determined cost-plus calculations (9 marks)
(iv) The company's R&D strategy in view of the need to secure patent protection and maintain an
attractive product portfolio over time. (6 marks)
(40 marks)
14 Santay Ltd
Marking guide
Marks
(a) Calculations 3
(b) BCG matrix 12

BCG analysis 10
Pricing 9
R&D strategy 6
37
40
(a) Implicit 'sales/capital employed' ratio
Profit = 40% Profit = 10%

C.E. Sales
Sales Profit Sales
and =
C.E. C.E. Profit
1
= 0.4
0.1
(b)
Report DRAFT ONLY
For: Chief Executive Santay Ltd
Prepared by: An Assistant
Date: XX/XX/XXXX
Subject: Analysis of Santay's Product Portfolio and Pricing Policy
This report will:
(1) Look at the company's product portfolio in terms of the BCG matrix
(2) Analyse how useful such an analysis is
(3) Review the arguments for adopting price discrimination; and
(4) Consider the company's R&D strategy.
(1) Company's product portfolio
The BCG matrix is a method of grouping a company's products into
different categories according to:
  The % of total market share they possess relative to the strongest competitor 
 The % growth of the overall market 
According to where a product fits into the matrix different strategies present themselves.
Because of the different timing of the cash flows associated with the classification of
products in the matrix it is considered beneficial to have a range of products, across
the categories.
In terms of Santay Ltd's product range the following products can be grouped as follows:
Problem child: Surgery simulation equipment

Santay has the largest market share here for a product with very high growth potential.
Because of the current small size of the market it will be some time before this product generates
significant amounts of cash. It needs development to move into the star category.
Stars: Products which may be classified as stars are:
X-ray scanners and endoscopes. Santay has the largest market share in the US and Germany for
the former and in the UK for the latter.
Because the products were first sold in 1994/5 respectively the growth potential is presumed to be

strong.
Cash cows
Lung and heart monitors – UK
Foetal monitors – Germany
Vision testing equipment – UK
Kidney dialysis machine – UK
Resuscitators – UK
These products all achieve the largest market share in the market specified for Santay Ltd.
None of these products is new and it can be presumed that the growth potential in the markets is
relatively limited.
Appropriate strategies would therefore be to consider trying to find new markets in which to sell
the products.
Dogs
These are products where Santay has a low market share in a market which is not growing very
strongly.
Products classified here would be:
 Testing equipment for hearing and blood 
Other products classified as cash cows may be moving in the product cycle towards becoming
dogs, they are:
  Resuscitators 
 Kidney dialysis machine 
These products were all developed over 9 years ago and the strategy to be adopted would be:
 Milk as much revenue from them without investing any significant new resources in them, or 

 Sell the production rights/facilities and refocus on alternative products. If the dogs are
making a positive contribution towards profits this does not seem appropriate, purely on
commercial grounds. 

 In identifying the categories mentioned above, it is important now to examine the internal
balance of the portfolio. 
Resources should be appropriately allocated to the key stars; the cash cows should be able to
generate sufficient cash to cover overheads, permit investment (i.e. support) problem children
and stars, enable debit interest to be serviced and provide dividends to shareholders.
 For the longer the longer term it is also necessary to ensure that there will be successor
products when present cash cows become dogs, and stars become cash cows. 

 The portfolio analysis also helps identify and evaluate competitor's positions and assess risk. 

 For Santay the information available only permits a very tentative analysis along these lines (e.g.
there is no indication of the expected growth rates for the industry or of demand for products).
However, it is clear that a number of lines (e.g. vision, hearing and blood testing 
equipment; kidney dialysis machines; and resuscitators) have been on the market for a
long time. Certainly they have reached their maturity stage, but it does seem that most if
not all are still money spinners, providing a positive contribution to profits. In other
words, it seems likely that they are 'warhorses' rather than 'dogs'.
(2) Use of analysis
For Santay, a major point is that there are not only joint costs, but also joint revenues. This
makes it rather difficult to apply the BCG matrix in a very meaningful way. In practice, of

course, most businesses engage in activities where there are joint production and/or marketing
costs and where there are products which to a greater or lesser extent can also be viewed as
joint. It may be possible to look at clusters of products and/or markets, but even if this is
impossible the BCG approach, employed with other techniques, can help focus management's
attention on the internal balance of the portfolio.
There are a number of problems with using the BCG terminology as a basis for
developing strategies for the company.
(i) Definition of market
The company sells its products in a range of markets. It is a market leader in some of
these but not in others.
For example, in the UK it is the market leader for lung and heart monitors but not in
the top ten in the US.
This will make it difficult when it comes to making specific production or investment
decisions using a BCG matrix. It makes little sense to consider ceasing to sell a product
in one overseas market, such as the US where it might be classified as a dog, when in
other markets, such as UK or Germany, it may be a cash cow or even a star.
(ii) Common costs
The BCG analysis would suggest that the 'dogs' identified should be divested or run down.
The problem with this analysis is that there are many common costs in for example
marketing the products, (e.g. products marketed together in brochures and with
salesmen visiting GPs and hospitals). Even a contribution analysis on a product basis is
hard to perceive due to the pervasive commonalties.
(iii) Spin off benefits
Santay may gain a number of benefits from its commitment to the production of a
wide range of products.
These include:
 Accumulation of internal skills and resources particularly in terms of production
and marketing methods. 

 Establishment of contacts with GPs and hospitals will establish a reputation for
Santay as a reliable and efficient supplier (a 'one-stop' supplier). 

(3) Price
discrimination
Arguments for
 Any consideration of pricing policy will always consider the market in which the goods
are being sold and whether that can be effectively separated (in Santay's case,
geographically). 

Price discrimination recognises that there are different elasticities of demand according
to the particular market in question. There must also be no possibilities of arbitrage and
a degree of monopoly power on the part of the seller. 

Therefore from a producer's point of view it is sensible economically to price its product
according to this. Charging higher prices is less competitive, demand-inelastic markets. 
 The granting of a patent is a legally enforceable monopoly and is essential if companies are
going to invest large sums in research and development. 

In order for the firm to recoup these R&D expenses price discrimination allows the
maximum consumer and producer surplus which will maximise profitability. 


Many drug companies will sell patented drugs at a huge discount to underdeveloped
countries which otherwise would not be able to afford them. This is price discrimination, but
allows them to recoup both their initial investments by charging premium prices in Western
countries and to provide life saving drugs to underdeveloped countries. 

In terms of accounting determined cost-plus calculations there will be some legitimate
grounds for altering the price of goods sold. These include: 

– Different overhead cost involved in different markets. Marketing expenses may be
higher, or rent, rates etc. 

– Transport costs to different markets. 

– Different rates of taxation on profits/capital allowances given. 

– Allowances for exchange risks. 

 Cost plus pricing will never ensure profit maximisation, even in monopoly conditions. It can
however be useful to justify prices to a prying regulator. Any allocation of common costs will
be arbitrary but ABC might provide a degree of justification. 
Arguments against
 The Regulatory Authorities often view price discrimination as an example of the abuse of
monopoly power. This was demonstrated in the recent EU investigation into price
discrimination in the EU motor industry. 

 If Santay chooses to practice price discrimination regarding its surgery simulation equipment
this may give the firm both adverse publicity and be a factor considered when the next patent
application is put forward. 

(4) Company's R&D strategy
It is essential that the company secures patents over new products in order to recoup the
investment in R&D it has made over the course of a product's development.
The strategy of focusing efforts on developing new products is clearly necessary to the extent
that the company considers that its technological expertise is one of its key strengths.
The nature of R&D in this area is that the rewards for a successfully patented product are
potentially very large. The commensurate costs, however, are also very significant.
Therefore the long term funding should be in place to bridge the gap between incurring the
investment and seeing the cash flows materialise.
The search for new products to come in line in 4-5 years should ideally ensure a balance of
products which will smooth out the cash flow.
The costs and risks associated with this strategy should however be carefully considered
particularly since the users of the surgery simulation equipment is currently based on estimates
and market research.
15 Holiday Cottage Company Ltd

Note: Assume that the current date is mid-December 20X5.
Norman Hogg had been a director of a large holiday company for 25 years, but he was made redundant in
20X4. Using his redundancy money, he set up the Holiday Cottage Company Ltd (hereafter HCC) in
December 20X4. His initial business model was to provide a link between: owners of holiday cottages
who wished to rent them out and families looking to rent this type of accommodation for their holidays.
Revenues are generated for HCC by charging the owners of properties a percentage of the rentals
generated.
Industry background
The UK holiday property rental market consists of a range of different properties including cottages, flats,

caravans and lodges. Many are individual privately owned properties, but there are also large sites with
many properties, owned by major holiday companies and which provide a range of additional recreational
facilities including swimming pools, bars, and organised activities.
Within the private rental market many individuals have purchased second homes in holiday areas in recent
years in order to take advantage of increases in property prices, to earn rental income, and to enjoy
holidays themselves. Some property owners attempt to rent out their properties themselves, through
advertising and personal contacts, while others offer a block of perhaps 30 weeks a year to intermediaries
such as HCC to market and administer rentals on their behalf.
Commissions charged by holiday property intermediaries, such as HCC, range from 10% of rentals for a
basic service, to about 30% charged by some large companies. The larger companies tend to sell their
services on the basis of significant advertising and exposure to a large population, rather than by providing a
comprehensive and individual service to property owners.
HCC's current business model
Norman's vision is that, although the holiday rentals industry is competitive, profits can be made at the
upper end of the market with good quality properties being let out to high income holiday-makers,
where both parties would appreciate a premium service.
The HCC business focuses on the South West of England, where Norman lives and where HCC is
based. This geographical concentration enables a knowledgeable, manageable and high quality service to
be provided on behalf of property owners. His mission statement, which captures this idea, is: 'We
worry about your property, so you don't have to.' The premium service provided includes
administration, insurance, advertising, cleaning and a hand-over service between rentals.
The company employs cleaning and administration staff on a casual basis due to the uncertainty over the
volumes of lettings and the seasonality of the business.
HCC advertises in quality newspapers and magazines offering holiday accommodation. Also, Norman writes
articles in magazines and newspapers about the benefits and pitfalls of holiday letting, and uses this platform
to advertise his own company and its services to potential property owners. HCC also has a website giving
details of the properties and the services that the company offers.
At the current date of mid-December 20X5, HCC is expected to achieve the following results for 20X5:
 A total of 400 holiday lettings at an average gross rental fee to the holiday-maker of CU800
per property 

 Fixed costs for the year will be CU80,000 

 Average commissions charged by HCC will be 25% of the rental fee generated (i.e. CU200 for
the average rental) 

 Variable costs will be 5% of each rental fee generated (i.e. CU40 for the average rental). 
Customer feedback has been good for the 20X5 season with a number of repeat bookings from property
owners and holiday-makers for 20X6. Despite this, Norman is conscious of the fact that he has done
little more than break into the market and that he needs to expand the business significantly if he is to
make adequate profits.

Norman is also aware that this is a very competitive market with large companies at one end of the spectrum and
many individual owners selling directly to the public at the other end.
Future growth
If HCC is to continue with the current business model then the expected growth in rental incomes generated
from the 20X5 base is expected to be 10% per annum in terms of the volume of rentals, and 5% per annum in the
fees per rental. Fixed costs are expected to grow at 5% per annum. HCC's commissions are expected to remain
at 25% of rental incomes generated. Variable costs are expected to remain at 5% of rental incomes generated.
Norman is, however, considering departing from the current business model by expanding
the HCC product range and he has identified the following two strategies for expansion.
Strategies for expansion
Strategy 1
Many UK residents have purchased properties in Northern France in recent years. This is a
popular holiday destination for UK tourists. Norman therefore believes that he could rent out
properties in Northern France with UK owners to UK tourists. This strategy would use the
existing website and hence few additional fixed overhead costs would be incurred, but the variable
costs of service and support would be higher per property than in the UK.
Strategy 2
In addition to offering a premium service, Norman believes he can offer a 'no frills, introduction
only' service via the Internet. This would involve property owners buying a HCC website
subscription. HCC would heavily advertise the website and charge the property owners for each
successful rental, but no further service would be offered. The charge in this case could be as low
as 10% of rental income generated. This strategy would require a significant new investment in the
website and new advertising, but there would be almost no additional variable costs per rental.
Requirements
(a) Ignoring the strategies for expansion, determine each of the following:
(i) Calculate what would have been the break even revenue for HCC in 20X5 using
the data provided for that year.
(ii) Using the projected growth figures, determine the first calendar year in which HCC will make a
profit. (Show all workings clearly.) (8 marks)
(f) Prepare a memorandum for Norman which:
(i) Explains the critical success factors for HCC and the key performance indicators
that may be used to measure these.
(ii) Develops HCC's marketing strategy for:
– Property owners
– Holiday-makers (14 marks)
For this purpose ignore the strategies for expansion.
(c) Identify and explain the following for each of the two new strategic proposals.
(iv) Core competences necessary to deliver each strategy successfully
(ii) Risks (11 marks)
(33 marks)

15 Holiday Cottage Company Ltd
Marking guide
Marks
(a) Break even calculation 4

Year of first profit 4
8
(b) CSFs 3
KPIs 3
Marketing strategy – owners 4
Holiday makers 4
14
(c) Core competences 6
Risks 5
11
33
(a) (i) Contribution per rental = CU200 – CU40 = CU160

Break even = CU80,000/CU160 = 500 rentals
Break even for commissions = 500 CU200 = CU100,000
Break even for gross rentals = 500 CU800 = CU400,000
(ii) Revenue is growing at (1.1)(1.05) =

15.5% per annum Current revenue is
CU800 400 = CU320,000
20X6 20X7 20X8
Revenue (15.5% growth) 369,600 426,888 493,056
Contribution (20% Revenue) 73,920 85,378 98,611
Fixed costs (5% growth) 84,000 88,200 92,610
Profit/(loss) (10,080) (2,822) 6,001
Thus HCC will make a profit in 20X8 for the first time in the absence
of any expansion strategies.
(b) Memorandum
To: Norman
Hogg From: An
Accountant
Date: Mid-
December
20X5
Subject: Holiday Cottage Company – CSFs and marketing strategy
(i) CSFs
Critical success factors (CSFs) can be defined as:

Those components of strategy where the organisation must excel to
outperform competition. These are underpinned by competences that ensure
this success.
An alternative definition of CSFs is: 'A small number of key goals vital to
the success of an organisation' i.e. 'things that must go right'.
As a relatively small player in the industry and still a new entrant it seems
unreasonable to compete with the major companies across a wide spectrum of
the market or attempt to copy the level of facilities they can provide. In
competing in a niche market it may however be possible
to outperform rivals. In this context the key issues for competitive advantage from the
above appear to be:
 Maintaining and developing the relationship with customers 

 Maintaining a good reputation with existing customers for repeat business 

 Offering a level of support service that is difficult to copy 

 Offering knowledge and specialisms and local presence in the geographically constrained
SW England market. 
Key performance indicators can be used to measure CSFs including the following.
  Rebooking rate by property owners 

  Rebooking rate by holiday makers 
  Growth in lettings 
  Lettings made divided by lettings available 
  Market satisfaction surveys 
  Exposure rate 
 Number of enquiries 

(ii) Marketing strategy
There are two markets that need to be considered for marketing:
  Property owners 
 Holiday-makers 
Promotion
Both need to be attracted simultaneously in order to bring the two aspects together. Property
owners need to be encouraged to use HCC by perceiving there to be a supply of holiday-
makers visiting the website. However, holiday-makers will only visit the website if there are
available properties.
There are three aspects to HCC's advertising:
(1) The website – to encourage people to enter the website there needs to be advertising
elsewhere including on the Internet, in books and magazines etc to encourage holiday-
makers to visit HCC's website rather than rival websites and other rival advertising media
for holiday cottages.
(2) The properties on the website – once potential holiday-makers enter into the website
each home needs to be advertised to its maximum potential in order to encourage further
enquiries and bookings.
(3) Other advertising in magazines and newspapers causing customers to book holidays or offer
properties directly without using the website.
General promotion strategies

  Writing more articles – perhaps in specialist or travel press. 
 Obtaining customer lists from clubs/associations of holiday home owners. 
Segmentation strategy
Property owners
A geographical segmentation strategy is suitable for property owners given the focus on the
SW of England. This might include:
  Databases of self catering holidays in SW England 

  Estate agents selling new buy-to-let properties 
 Advertising by other local holiday letting companies. 
A key problem is that while all the properties are located in the SW, the owners are likely to
live elsewhere.
Given the concentration in the SW other segmentation strategies (e.g. socio-economic
groups) may be too wide-ranging and thus ineffective. To the extent that socio-
economic segmentation is valid then higher income groups may be targeted.
Holiday makers
The segmentation strategy is likely to include higher income groups given the premium
nature of the properties and the service provided. This might include professionals and high
income groups.
The nature of the target market also includes families so advertising in upmarket family
magazines may be appropriately for targeted advertising.
Pricing strategy
One aspect of the marketing strategy is the pricing strategy.
There are two aspects to pricing:
(1) The price charged for a week's rental to holiday-makers.
(2) The percentage commission fee charged by HCC to the property owners
(based on the rental).
(1) Rental charge
The rental charge to holiday-makers needs to be agreed between the owner and
HCC. If it is too high there is no point in HCC taking the client as it is unlikely to
be rented out.
The target market is the quality end of the properties and customer base,
thus the price should be in accordance with this as:
 Where the customer cannot fully observe the product or service prior
to purchase then perceived value pricing indicates that the price is a
signal of quality. 

 If the properties are of good quality then a high price consistent with
this can be attained and repeat business based on full information is
still possible. 
Constraints on the price may however include:
 Prices charged by direct competitors for similar accommodation 

 Prices charged by comparable accommodation (e.g. hotels, holiday sites) in
the SW of England. 

(2) Commission

The success of HCC in renting out property is based upon the actual and
perceived service delivered to the clients. This consists of:
 The comprehensiveness of the service for any one letting (administration,
advertising, cleaning, a hand-over service between rentals and insurance). 

 The volume of lettings achieved by HCC and thus the utilisation
achieved by the property owners. 
Prices charged by direct competitors for similar services will be a key constraint,
but as a newcomer to the industry HCC might need to consider charging a
lower fee to break into the market, despite its high level of service.
(c) (i) Core competences
Core competences are linked with the critical success factors noted above for the
existing business. The two new strategies however operate in different sectors of
the market from the existing business. The key question is therefore whether the
existing core competences can be transferred into these new market sectors for the
proposed strategies.
Strategy 1 – France
 Local knowledge no longer applies as it does in SW England so this core
competence of local knowledge is lost. 
 SW Cornwall is similar in some respects to NW France, therefore there may be a similar
customer base of property owners with which HCC is familiar (i.e. the same customer
base may generate a similar segmentation strategy). 

 The target market for holiday makers is also similar, except for the geographical difference. 

 Core skills in website design and marketing enables cross selling between the two markets. 

 There is a language advantage for UK holiday-makers and UK property owners over
French competitors although this becomes a disadvantage in managing local services,
employment etc. 

 No experience in the French market (locations, pricing, competition). 
Note the key question is not whether HCC has the above skills but whether they are superior
to those of competitors and potential competitors, based in the UK and in France, and that they
can be sustained to generate a competitive advantage.
Strategy 2 – No frills
 Existing high service, high price, culture and expertise is lost. 

 Specialist knowledge of the SW is not relevant so it is not clear where there is
any competitive advantage over similar websites and holiday property agents. 

 The target market for holiday-makers is different from the existing market, being broader.
So there is little market knowledge transfer from the existing business as the client base is
wider. 

 There appears to be little to suggest that HCC has an industry cost advantage other than
the fact that it has an established web site. 
It would seem therefore that HCC has few core competences to support this strategy.
(ii) Risks
Strategy 1 – France
 Currency risk as some costs are in euros but rentals and commissions are in sterling. 

 Low operating gearing as there are few additional fixed costs. This lowers risk. 


 Unknown market with limited experience of service provision. 

 Diversion of management attention from core market. 

 The market may be saturated already with French providers of holiday homes. These may
have advantages of language, communication and local contacts over UK providers, even for
UK holiday makers. 
Strategy 2 – No frills
 High initial fixed costs mean these costs are sunk and irrecoverable if the venture fails. 

 High risk from high operating gearing. 

 Could lose some existing business as there may be a substitution effect between the
existing and the new business. 

 Brand confusion (down market v up market). The two products may confuse customers
as to whether the company offers a premium service or a no frills service. 
Break even
The break even calculations in (a) show that the company has existing rentals of 400, whilst 500
are needed to break even. The new strategies thus need to be seen in the light of a loss making
business. Strategy 1 incurs few additional fixed costs and thus the break-even point would be
similar. Additional sales in France combined with more sales in the core market may enable
break even to be achieved.
Strategy 2 however will incur more fixed costs and raise the break-even position.
16 MagicCarpets Ltd
MagicCarpets Ltd (hereafter MC) is a manufacturer and retailer of carpets. It
operates through two separate divisions.
The company history
The company was established nearly 70 years ago as a manufacturer of good quality, all-
wool carpets, under the Magico brand label, from a single factory in a prosperous area in
the South of Bangladesh.
Around 30 years ago the company decided to integrate vertically by opening ten up-market
retail outlets, which are located in prime high street locations throughout Bangladesh and sell
only Magico carpets.
Twenty years ago a separate division, called Costocarp, was opened following the
acquisition of another carpet manufacturing company. As a result MC acquired a low-
cost factory situated in the North of England.
The company profile
The Magico division
The Magico brand is a high added-value product that sells at a high price. Significant
advertising supports the brand image. The mission statement of the Magico division has a
customer focus stating: 'We deliver quality from the loom to your room'. This was intended
to convey the image that the division controls all aspects of supply to the customer as it
manufactures, sells and fits its own carpets. An additional, but optional, carpet cleaning
service is also provided to customers. The carpets have a ten-year guarantee.
Most of the staff in the Magico division are skilled or semi-skilled. Recently, new
machinery was purchased for the factory, following a tendering exercise from equipment
suppliers, which was organised by head office.

Magico carpets are not now distributed through outside retailers, but only through the
company's own retail outlets. Manufacturing and retailing of good quality carpets are
treated as separate profit centres within the Magico division. All the divisions' carpets are
marketed using the Magico brand name.
The Costocarp division
This division uses the brand Costocarp and manufactures low-cost carpets made from
basic, synthetic materials. Labour is largely unskilled. The Costocarp carpets are not sold
through MC's own retail outlets, but sold in bulk to carpet warehouses and industrial
contractors. While the division corrects any faults found in its products, there is no other
after-sales service given the wholesale nature of the business.
Head office
The company treats each division as a profit centre and, while maintaining tight financial
control over new investment, it gives significant autonomy over operations to divisional
managers.
Human resource management is operated centrally and takes a strict approach to
discipline regarding customer complaints. Training is provided for skilled and semi-skilled
staff, but little for unskilled staff.
Ordering of raw materials and scheduling of customer deliveries is controlled centrally
using the company's IT systems. This permits tight inventory control. Moreover, the large
quantities of raw materials ordered by MC enables it to impose a just-in-time inventory
system on its suppliers.
Head office also provides all financing and marketing support for the two divisions using its
IT systems. This includes providing and administrating credit facilities for customer
purchases. A two-year credit facility is provided for customers of the Magico division, but a
strict 30-day credit policy is applied to Costocarp division customers.
Performance measurement
The Magico division consists of two separate profit centres – manufacturing and retail. The division
makes reasonable profits overall and the transfer pricing system, of actual full cost plus 10%, achieves a
profit for both profit centres.
The Costocarp division is making losses as it has difficulty competing with low cost imported carpets in terms
of price. The division has engaged in several cost-cutting exercises but it has continued to struggle.
Labour issues at the Costocarp division
Much of the cost cutting has involved decreasing labour costs both from reductions in the number of staff
and from low, or zero, wage increases. However, despite these reductions, continued operating losses
forced the company into the strategic decision to cease manufacturing low cost carpets and instead import
them from overseas and act solely as a wholesaler. The decision has not yet been announced but the
intention is that carpets would still be sold using the Costocarp brand label, but there would need to be
significant downsizing, particularly in the number of staff to be employed, which would be reduced from
1,000 to 400.
It is intended to make the necessary staff reductions during 20X4, but two issues arise.
(c) Some of the skills of existing staff are needed for the new business, so 300 of these staff need to be
retained.
(d) New skills are also needed requiring 100 new employees to be recruited; thus labour planning needs
to manage a reduction of 700 existing staff to bring down labour to the required new level.
Significant labour resistance has been experienced as the cost reductions have meant that similar unskilled
workers in the Magico division are better paid than those in the Costocarp division, despite doing the same
jobs. The justification given by management has been that the financial performance of the Magico division

has been better, thus higher wages are more affordable. Further labour resistance is expected as a result of
the downsizing announcement.
Requirements
(e) (i) Draw Porter's value chain diagram for the Magico division. It should include brief descriptions of
the relevant activities within the diagram.
(f) Draw Porter's value chain diagram for the Costocarp division, but this should include
descriptions of only those activities which are different from the value chain of the
Magico division. (Ignore the proposal to cease manufacturing for this purpose.)
(iii) Briefly explain and compare the two value chains. (21 marks)
**** Assess the extent to which the profit achieved by each of the two profit centres in the Magico
division adequately measures their performance. Briefly suggest alternative measures of performance.
(8 marks)
* Suggest how the changes within the Costocarp division can best be managed when the strategy is
announced. (5 marks)
(34 marks)
16 MagicCarpets Ltd
Marking guide
Marks
(a) (i) Magico value chain 10

(ii) Costocarp value chain 7
(iii) Explanation and comparison 4
21
(b) Profit and performance 6
Alternative measures 2
8
(c) Change management 5
34
(a) Value chains

The 'Magico' division
Company HQ – shared management, profit-orientated culture, strategic autonomy, tight

FI
financial control
IT ordering Delivery IT credit
systems, IT systems arrangement
TD inventory systems
control, payables
management
Training HO Manufacturing Delivery Discipline Training of

supply staff skills training, IT systems relating to fitters
HRD
generally and in working training customer issues
IT systems. practices
Bulk buying, Tendering Marketing Financing and
managing system for department administration
supplier new of customer
P relationships, equipment, credit facilities
payables significant
management financing
support
Optimal Latest Prime sites Fitting for Optional
delivery, equipment, for shops, customers, cleaning service,
Primary sourcing high prime site delivery to advertising 10-year
activity quality wool factory, skilled customers guarantee
labour
IL O OL M/S S
The 'Costocarp' Division
FI Company HQ – shared management, profit-orientated culture, strategic autonomy,

tight financial control
TD IT ordering Delivery IT IT receivables
systems, systems systems
inventory
control,
payables
management
HRD Limited Working Delivery IT Discipline
training practices, systems relating to
limited training customer issues
training
P Bulk buying, Some Receivables
managing financing administration
supplier support and
relationships, management
payables
management
Primary Optimal Low cost site Direct Make good
activity delivery factory, low delivery to defaults
systems, JIT, cost unskilled customers in
sourcing low labour bulk
cost synthetic
materials
IL O OL M/S S
The value chain can be used to examine where value can be created using the resources of a

business to generate strategic options.
The primary activities are those that create value and are directly concerned with providing the
product/service. The support activities do not of themselves create value but enable the
primary activities to take place with maximum efficiency.
The 'Costocarp' Division is pursuing a low-cost strategy within Porter's generic activities and should
thus focus upon low-cost resources to produce a low-cost product. This is reflected in the low
labour and materials costs in the supply side and operating activities of the value chain and the
truncated delivery chain to customers, which provides only a basic service.
Conversely, the high added value product of the 'Magico' division is reflected in the higher value and
better quality activities in the value chain. This includes better materials, skilled labour and advanced
machinery in the supply side and operating activities of the value chain and the full sales and after
sales service to customers in the latter stages of the value chain.
(f) Performance measurement
The transfer pricing system currently in use adopts a fixed 10% mark-up on full cost. Given that this
is imposed and does not represent a market value, it does not in any real sense reflect the
performance of either the sections or the section managers.
Given that the retail function sells only 'Magico' carpets (and sells all 'Magico' output of carpets)
there is a lack of access to outside markets. This reinforces the notion that performance is not
represented by the profit of each section. It may be that 10% is too high or too low depending on
market conditions in the manufacturing and retail markets for this type of product.
The adequacy of any profit earned as a measure of performance, however, thus depends on
how the transfer price is set. Alternatives include market prices, cost plus, two-part transfer
prices, dual pricing and negotiated prices.
A problem with all these prices is that there is only one seller and only one buyer (unless
purchasing and selling of carpets is to be permitted outside of the group in future) and
thus any transfer price is likely to be artificial in its determination. The resulting profit is
thus likely to be inappropriate as a performance measure for both sections of the division.
Any increase in the overall profit of one section would have a corresponding reduction in
the profit of the other section. In terms of measuring overall contribution to the company,
any profit centre measure is thus likely to be inappropriate.
Moreover, if the manufacturing section increases the prices charged, then there may be a
reduction in volumes purchased by the retail section as it may charge a higher price to
customers. This may be to the detriment of the company as a whole.
There are a number of other problems.
 A budget or some other measure of expectations is needed against which to judge profit. 

 The sections have no control over new investment (i.e. they are not
investment centres). As a result, any element of their performance arising from new
equipment, or the lack of it, is not attributable to section managers. 

 Given that there is a mark-up on cost, there is an incentive for the
manufacturing section to pass on any inefficiencies as any increase in costs can be
passed on to the retail division, with a 10% premium on top. There is thus the
perverse incentive that the greater the inefficiency in cost control in the
manufacturing section the greater its profit. 
One of the issues with these measures is that they are solely financial. A balanced scorecard
approach would give a series of critical success factors and key performance indicators
which are both financial and non financial. The four key headings would be Financial
Perspectives, Customer Perspectives, Internal Business Perspectives, and Innovation and
Learning Perspectives.

A further option would be to assess the performance of each section in relative
terms by using benchmarking. This could involve comparing its performance against
competitor companies (i.e. competitive benchmarking) or against the performance of
similar functions (i.e. activity/process benchmarking). These methods are likely to be
imprecise and involve a degree of subjectivity.
**** Change management
Change such as that suggested may be described as reconstruction. The whole business is
affected but the cultural paradigm remains the same. All change tends to be resisted by
employees. Obviously changes involving redundancy and downsizing of operations will be
resisted even more strongly.
Barriers to the change will stem from the very real fears about job security and earnings,
fear of the unknown as the newly styled organisation will be very different from the
current one and from a feeling that the psychological contract between employee and
company is being breached. It will be essential that these forces resisting the change are
broken down.
The key stakeholders involved must be identified and encouraged to support the change.
Unions must be consulted and the case for change to ensure survival of the division made
clear.
A change agent may be appointed to oversee the reorganisation. Ideally someone from
outside the division, the change agent must be able to communicate the benefits of
change and where possible involve the remaining staff in the process. This will help to
strengthen the forces for change.
Communication will be an essential part of the process – with the press (to preserve PR)
and key customers (the warehouses and contractors will need reassurance about quality and
reliability), as well as with staff.
Once the change has occurred, Lewin would argue it is necessary to 'refreeze' the new
methods. This will involve ensuring that the remaining staff adapt to the new business model and
are motivated to work within it. The newly appointed staff should not present a problem as
they had not worked under the old one.
Techniques such as introducing new reward systems and changing the way in which activities are carried out
should help to embed the new model
17 Foodfair
Company history
Foodfair was established thirty years ago by three friends, Alan Bates, Charles Davis and
Eric Foster who remain the company's only shareholders. The firm is in the catering
business and currently has an output of about 26,000 meals per week. Eric Foster retired
from full-time employment with the company five years ago and was appointed chairman;
he was regarded as the most talented manager and astute businessman of the three
founders. Bates and Davis are still full-time working directors but will probably retire
within the next five years or so.
Products and markets
The company produces ready-to-eat meals for factories, schools, airlines and social events.
Sales are of two main types – to other catering organisations which have sub-contracted to
Foodfair (these customers are referred to by Foodfair as 'bulk buyers') and to 'final users'.
A breakdown of revenue and gross profit (GP) shows the following.

Bulk buyers Final users
% of % of
revenue GP% revenue GP%
Current year 50 8 50 15
20X9 55 10 45 14
20X8 45 11 55 13
20X7 40 12 60 13
20X6 35 12 65 12
The products which Foodfair sells to the two types of customer are different. Meals sold
to other caterers tend to be bulk sales allowing long production runs of one menu.
The catering customers of bulk sales specify very closely the portion sizes, contents,
nutritional value and cost of the meals; the menus are often standardised. Meals being
produced for final users, however, have much more variety and are less standardised.
Final users take Foodfair's advice, and the company employs chefs and a nutritional
expert to design and oversee the production of these meals.
Foodfair has long-established links with many food suppliers who are adept at supplying
ingredients of the proper quality. A considerable range of quality is used, depending on
how the food is to be cooked and on the cost limits imposed by buyers. Bulk buyers are
particularly precise when stipulating meal contents.
Recently a batch of meals was rejected because the carrots had been chopped into circles
rather than into little sticks. The final users are not as fussy.
Until recently Foodfair followed a pricing policy of full cost plus about 14% on all its
contracts. However, the bulk buyers have become very well informed about the raw
material and processing costs, and are thus able to make a good assessment of Foodfair's
costs. Contracts have become very competitive. The most recent bulk contract attracted
eight bids; the buyer took the three best bids and divided the order amongst them at the
price given by the lowest quotation.
Production
Steve Little (the general manager) and Graham Wilson (the executive engineer) saw
increased efficiency as the key to the firm's survival, and the firm recently spent CU500,000
on efficiency improvements (work study, machine modification, new machines and incentive
schemes). Some of these changes were in anticipation of stringent EU hygiene legislation.
Graham Wilson subsequently left, taking with him enormous practical expertise. Steve Little
estimates that maximum meal production at the present factory is 30,000 per week.
Recently it produced 28,000 meals. Preoccupation with the new machinery and efficiency
improvements has meant that Steve Little has shelved plans to look for a larger building
which would have given scope for even greater production.
Management and personnel

Since Graham Wilson's departure the only managers left below board level with any significant experience
are Steve Little and the sales manager. Steve Little sees his major role as that of coordinator. Training is
not given a high priority and no managers have been given any training beyond technical subjects. Turnover
amongst staff is low and there is a friendly atmosphere; wages are regarded as fairly good. However, Steve
is himself thinking of leaving as he can see no prospect of improving his position at Foodfair unless he were
to obtain a seat on the board. Recently a friend of his set up a catering business and has had a very
profitable first year. Steve provided CU5,000 of the start-up capital.
Foodfair's recent performance
Despite the problems noted above, recent sales have been strong. The company has a good reputation and
a lot of business comes by recommendations from satisfied customers. Foodfair does not advertise
extensively, although recently it did send out a mail shot to local businesses offering catering facilities for

meetings, presentations and general entertainment functions. There was a negligible response that could be
traced to this.
The future
Minutes and reports of recent meetings have raised the following points:
** Amongst several large contracts coming up for tender is one for a local large engineering works
(1,200 employees). Despite its size this would not be regarded as a bulk buy contract.
** Changes in the food manufacturing business mean that there is an increasing trend among end users
to sub-contract the running of their canteens to caterers which act as catering facility managers.
Fewer companies are willing to employ their own catering staff. EU law has imposed new hygiene
laws, and businesses are wary of having themselves to administer and run canteens.
** One major catering company is currently building its own food production facility.
** Decisions on the firm's future are likely to be made solely by Bates and Davis, with little attention
being paid to the views of senior managers. Charles Davis has recently overruled Steve Little on a
number of production decisions and this caused a loss of efficiency and the scrapping of a significant
number of meals. In addition, a sales representative was appointed by Bates without reference to the
sales manager.
Requirements
*** For each of the five years for which information is supplied, calculate the company's overall
weighted average gross profit percentages. Comment on these figures and on the figures supplied to
you.
(7 marks)
**** Write a memorandum to the chairman which covers the following areas:
An analysis of competitive pressure within the two customer groups
Appropriate generic strategies
The implications of chosen strategies for organisational structure
Options for production capacity.
Your memorandum should make recommendations for what you consider to be the key issues facing
the company. (23 marks)
(30 arks)
(17) Foodfair
Marking guide
Marks
(a) Calculations 4
Comments 3
7
(b) (i) Competitive pressure 8½
(ii) Generic strategies 3
(iii) Organisational structure 4½
(iv) Production capacity 4
Recommendations/conclusions 3
23
30

(a) Gross profit percentages
The overall gross profit percentage will be a weighted average of the margins of the two sectors.
Current year (50% 8%) + (50% 15%) = 11.5%
20X9 (55% 10%) + (45% 14%) = 11.8%
20X8 (45% 11%) + (55% 13%) = 12.1%
20X7 (40% 12%) + (60% 13%) = 12.6%
20X6 (35% 12%) + (65% 12%) = 12.0%
Since 20X7 the company's overall gross profit percentage has fallen. This has been caused by
two factors:
*** The proportion of the low margin bulk sales business increasing
*** The bulk sales margin itself decreasing.
The effects would have been worse if the margin on sales to final users had not increased. In the
current year the proportion of sales to the two sectors has moved back towards final users. If this
had not happened the overall margin would have fallen even more.
(b) Memorandum
To: Eric Foster
From: Consultant
Date: Today
Subject: Operational and management changes, and strategies available to Foodfair Ltd
(i) Analysis of competitive pressures
Foodfair serves two main customer groups: bulk buyers and final users. The characteristics
of these groups are different and there must be separate analyses.
Bulk buyers
 There are relatively few of these customers and they possess professional
purchasing skills. They have shown that they are very precise in their requirements
and will not hesitate to refuse delivery of goods not meeting their exact
specifications. 

 There is very severe price pressure, and the gross margin from this sector
has shown a steady fall. 

 One major customer appears to be attempting to become self-sufficient in food production. 

 There is strong price competition from rivals and the product is viewed as a commodity. 

 Switching costs are very low. 
Final users
 There are many of these customers; often they are not skilled purchasers. 

 They often seek Foodfair's advice on menus; this gives a greater opportunity to sell on
more than mere price. 

 Price competition is much less severe and gross margins have improved steadily. 

 Impending EU legislation should mean market growth as more organisations opt not
to run their own canteens and kitchens. Once again, there is an opportunity to
compete on expertise and service. 

 Switching costs can be made relatively high as customers will be reluctant to spend

time and money assessing alternative suppliers. 
It seems clear that the final user customer group is much more attractively structured
than the bulk buyer group.
(ii) Appropriate generic strategies
The term 'generic strategy' refers to how Foodfair should trade so as to obtain
competitive advantage over its rivals.
To service the bulk buyer group, a strategy of cost leadership will have to be adopted. This
group monitors its costs very carefully and there is keen price competition. It is worth pursuing
this sector only if you are convinced that you can compete on cost so that good profits are
made.
To service the final user group you will be expected to supply tailored solutions and
products. This is a strategy of differentiation. You make your products and services
different from those of competitors and you will therefore be able to charge premium
prices.
(iii) Organisation – implications of the strategies
The competitive strategies adopted have implications for the organisational structure of Foodfair.
In brief, cost leadership implies an emphasis on efficiency and stringent control of costs. This
is normally accomplished with large production runs of standard products, low cost labour
carrying out specialised tasks, clearly defined hierarchies with centralised control, well-
defined jobs and a management information system that monitors and controls costs and
output.
Differentiation, on the other hand, implies an emphasis on design, service, flexibility, good
costing systems, more consultative management styles with greater delegation and
participation. Because there will be a greater variety of products made in shorter
production runs, design, sales purchasing and production must be very well co-ordinated.
You will see that many of the requirements for the two strategies differ and may be in
conflict. It may be difficult to serve successfully both of your customer segments, as
compromises may have to be made which could put you at a disadvantage compared with
competitors who specialise in one of the segments.
The different structures, styles and values needed to serve the two sectors may best be achieved
by separating the activities. Divisionalisation of the sales and design teams could allow each to
focus on its respective segment. Production could remain as a shared resource, but see the
section below on production capacity.
 Production capacity
The current maximum production capacity is 30,000 meals per week, and actual production has
recently been close to 28,000 meals per week, averaging 26,000. If the large contract for the
engineering works is won, there will be approximately 6,000 extra meals per week to prepare.
Therefore, the factory is likely to be operating above its planned maximum capacity, and any
future growth will be inhibited by capacity constraints.
Foodfair has some choice:
Look for larger premises that will allow higher production of all output.
Look for additional premises that will allow another production line to be set up.
Stay with your existing premises and limit output by concentrating on the more attractive,
higher profit, final user sector.
Option (1) would keep production centralised and it is likely that this could bring economies of
scale in the storage, production, distribution and quality control of the food. Option (2) could be

made to fit in with divisionalisation and would allow all operations of the company to be
separated to serve each sector. However, the costs of operating from two sites are likely to be
greater. Option (3) would mean that Foodfair has taken a major strategic decision to withdraw
from one of the market segments, or at least not to pursue it as actively.
Conclusion
Urgent decisions are needed on the following matters:
 Management strength and succession 

It is important for Foodfair to retain its remaining experienced managers if the company is to
continue successfully. To retain the managers, the two existing directors must become less
autocratic. This could be helped by making one or both of the managers board members. You
would need to attend board meetings regularly to give support to the new member(s). These
points must be explained to Bates and Davis; as they will be retiring soon they should see that it
is in their interest to ensure that a competent succession is in place. 

 Which markets to pursue 

The final user market appears to be much more attractive than the bulk buyer market. If the
company intends to pursue both, then it will need extra production capacity and reorganisation,
perhaps divisionalisation, to serve each market. This option would appear to have relatively high
risk, especially at a time when management of the company is weak and the two directors are
close to retirement. A safer option would be to concentrate on the final user market and to
withdraw from, or not vigorously pursue, the bulk buyer market. Although the company does
seem to have been successful in the final user market, you are reminded that the structure, style
and values needed for success in this segment imply great cooperation between different
functions in the company. 
18 Rix Crisps Ltd

Note: Assume that the current date is June 20X7.
James Rix was not happy. 'Sales are suffering from this growing trend for healthy eating,
and I am not clear what we can do.'
Company background
James had established Rix Crisps Ltd (RC) in 20X0 and he continues to be the main
shareholder and chief executive. James set up the business by purchasing an out-of-town
factory from the administrator of a potato crisp manufacturing company which had
become insolvent. The forced sale meant that James had been able to obtain the property
and machinery for a very low cost.
James personally maintains tight operational and financial controls over the business in
order to minimise costs.
The RC business model is to sell each packet of crisps for just 10p per 30g bag. This price is
significantly lower than rival companies, which tend to sell 35g bags of crisps to retailers for
around 25p each. Low price rivals using multi-buy bags can be priced as low as 15p, but RC
is by far the lowest priced seller in Bangladesh.
RC employs mainly unskilled workers at the minimum wage. Labour turnover is high, but
there is significant local unemployment and there are numerous students from a nearby
university. This means that RC can always employ new staff at the minimum wage.
The potatoes, which are the main ingredient, are low quality remnants from farms across
Eastern Europe. These are the potatoes which are left over after the higher quality potatoes

have been sold. RC only has three large suppliers in order to keep the ordering function simple
and enable quantity discounts. Ordering is also facilitated by the consistent levels of production
each day, so the quantities of potatoes needed are regular and known in advance. The potatoes
are used as soon as they arrive, so inventory control is informal and limited. With only a few
suppliers, control of accounts payable is maintained by one employee.
RC only produces three basic flavours: ready salted, cheese and onion, and salt and
vinegar. No other snacks are produced except potato crisps. RC has many small
customers, but only one large customer, Bibi Supermarket.
The crisp industry
The 'bagged snacks' industry in Bangladesh consists of crisps, nuts and other savoury
snacks. It has total annual sales of CU2,200 million, although this is declining by around 3%
per annum, largely due to the trend towards healthy eating. Crisp sales make up 47% of the
'bagged snacks' market sales. Most sales are to small- and medium-sized grocers shops and
to large supermarket chains.
A few large companies dominate the crisp market with large advertising budgets. They
tend to have a wide range of crisps and snacks, and high volumes of sales.
The crisp manufacturing process is highly automated and involves taking the potatoes then
slicing, washing, frying and bagging the crisps all within 30 minutes.
The crisp industry has been criticised by government and pressure groups for producing
unhealthy, high calorie, fried food that lacks nutrition. However, while sales have fallen,
they remain very popular, with a market penetration of nearly 90% (i.e. almost 90% of
people surveyed said they had eaten crisps in the previous year).
Financial data
Summary financial data for RC for the most recent three years is as follows:
Revenues Operating costs
Bibi
Supermarket Other Fixed Variable
Year to 30 June CU'000 CU'000 CU'000 CU'000
20X5 4,000 6,200 3,800 5,100
20X6 4,000 6,100 3,900 5,050
20X7 (expected) 4,000 6,000 4,000 5,000
The annual production capacity of the factory is currently 120 million bags of crisps per annum.
After the company was initially established in 20X0, it grew rapidly, as it was able to penetrate the market
with its low pricing policy. Market penetration was achieved only in the niche, low-price end of the market.
Profit margins per bag have always been low, but this was compensated for by high sales volumes.
In a meeting last month James Rix summarised the market positioning of RC: 'Nobody can compete with
us on price, so they don't bother trying. We have this sector of the market to ourselves. Not even cheap
imports can compete with us, as although the finished product is not heavy, it is bulky, so transport costs
would be high.
We require our potatoes to be delivered directly to our factory in bulk by our suppliers. We do not
pay transport costs.
Our distribution system is also unique. We have ten large out-of-town warehouses located throughout
Bangladesh and the crisps are delivered to these locations in our own vans, which are in use 24 hours per
day. Customers then come to collect them themselves. Customers are required to pay immediately on
collection (except Bibi Supermarket which has one month's credit). Most of our customers are schools,
colleges, universities and small grocer shops. Most of the big supermarkets will not purchase our crisps

because they say the product is poor quality – but what do they expect for 10p?
Our biggest customer is, however, the low cost supermarket chain, Bibi Ltd. They have an annual contract
which is negotiated each year. They tried to push us down on price but we held firm at 10p and in the end they
agreed. It is our proud boast that we have only ever sold crisps at 10p to anyone since we opened.
We do not need to advertise as our price is the only advert we need.'
The Bibi contract
The new contract negotiations with Bibi for the year to 30 June 20X8 were not going well and agreement
had still not been reached at this late stage. In essence, Bibi's management had presented an ultimatum
that the contract price should be 9p per bag, or they would look elsewhere for a supplier.
Strategic dilemmas
Since 20X4 sales had begun to fall, largely because of the trend towards healthy eating. This is affecting all
customers but, in particular, the number of schools buying RC crisps had fallen from 200 in the year to
30 June 20X4 to 150 in the year to 30 June 20X7. This was partly because of new government regulations
banning unhealthy snacks from vending machines in schools.
There is a further concern regarding costs. The machinery that had originally been acquired is now old and
is starting to become unreliable. An increasing number of faults in manufacturing were occurring causing
faults in batches of product.
Also, there is no flexibility in the machinery for making alternative types of snacks, as is the case with more
modern machinery. From the year to 30 June 20X8 onwards, there are likely to be increased costs of
repair and replacement amounting to additional annual fixed costs of CU400,000.
A new rival company has announced its intention to enter the crisp manufacturing market some time during
20X8. This company is an off-shoot of a large food and drinks company. It has started selling 35g bags of
crisps and snacks for 12p per bag. James Rix believes it is making losses at this price, but that it is trying to
penetrate the low cost crisp and snacks market.
Requirements
(f) Determine the impact on the overall profit of RC, compared to the year ended 30
June 20X7, of each of the following:
(i) Losing the Bibi contract for the year to 30 June 20X8.
(ii) Accepting the Bibi contract for the year to 30 June 20X8 at the revised price of 9p per bag.
Show appropriate calculations and state any assumptions. (8
marks)
(b) Prepare a value chain diagram for RC. In so doing, identify and evaluate the key
elements of RC's value chain. Explain how RC can use the value chain to support its
low cost strategy. Ignore the strategic dilemmas. (15 marks)
(c) As an external business adviser write a memorandum to the board of RC which:
Explains the factors that should be considered in deciding whether to accept
the price of 9p per bag being offered by Bibi.
Evaluates the risks and threats posed by the strategic dilemmas facing RC.
Describes the realistic actions that RC may take in light of the threat from the trend towards
healthy eating, including the key change management issues. (15
marks)
(38
marks)
18 Rix Crisps Ltd

Marking guide
Marks
(a) Losing contract 4

Accepting at 9p 4
8
(b) Value chain 9
Supporting low cost strategy 6
15
(c) Factors in accepting 9p price 6
Risks and threats 5
Realistic actions and change management 4
15
38
(a) Revenues = CU10m

Number of bags sold CU10m/CU0.10 = 100million
Contribution per bag = (CU10m - CU5m)/100m = CU0.05
(i) Profit in the year to 30 June 20X7 = CU10m - CU9m = CU1m
Profit in the year to 30 June 20X8 = CU6m - CU4m – (0.6 CU5m) = (CU1m)
Therefore reduction in profit is CU2m
 Contribution from Bibi contract in 20X8:
Revenue less VC
(CU4m 90%) - (CU5m 40%)
CU3.6m - CU2m
CU1.6m
Contribution from Bibi contract in 20X7:
 CU4m - (CU5m 40%)
 CU2m
Therefore reduction in profit is CU0.4m
Or
CU0.01 40 m = CU0.4m
Assumptions
 Total fixed costs remain constant. 

 Variable cost per unit remains constant. 

 Demand from Bibi does not rise as a result of the price reduction. 

 There is no leakage between markets or other changes in sales volumes or
sales price for non-Bibi customers. 

(b)
One factory, 10 warehouses, main shareholder on board, tight operational controls, tight financial
FI
control
Simple ordering Basic, old Own vans used
systems, limited technology 24 hours per
TD inventory control day
and creditor
management
Limited training; Limited training, Limited training, Limited training,
employees employees employees employees
HRD
replaced; minimum replaced, replaced, replaced,
wage minimum wage minimum wage minimum wage
Bulk buying, low Machines low Purchased own No receivables
quality, managing cost from vans (except Bibi) so
P supplier administrator no admin for
relationships, credit control
simple creditor
management
Constant amounts Low cost site and Direct delivery Collected by Replace faulty
delivered, organised factory to RC customers; no products
by suppliers, simple machinery, low warehouses advertising
Primary
delivery systems cost unskilled
activity
labour, only three
different flavours,
simple operations
IL O OL M/S S
The value chain can be used to examine where value can be created using the resources of a
business to generate strategic options. It can also help identify the cost drivers behind RC's
least cost strategy.
The primary activities are those that create value and are directly concerned with
providing the product/service. The support activities do not create value of themselves
but enable the primary activities to take place with maximum efficiency.
RC is pursuing a least cost strategy within Porter's generic activities and should thus focus
upon low cost resources to produce a low cost product. This is reflected in the low labour
and materials costs on the supply side and operating activities of the value chain and the
truncated delivery chain to customers, which provides only a basic pick-up service from a
regional warehouse.
Low cost features are built in throughout the value chain including:
  Low cost product machines (acquired from a company administration) 

 Low cost labour at the minimum wage for production and support staff 
 Low cost materials which are remnants from Eastern Europe 
 Minimal distribution costs 
 Costs of inbound logistics shifted to suppliers 
 Only three flavours so longer production runs. 
RC can use the value chain to examine whether all areas are contributing to its strategy of
least cost and hence identify inconsistencies e.g. the old machinery is necessitating increased
repair costs and reducing margins. In so doing it helps identify RC's source of competitive
advantage.

The value chain can also be extended to the whole supply chain to ensure suppliers also
contribute to the least cost strategy.
The value chain can assist in identifying further scope for cost reduction e.g. increase the
number of potential suppliers so the company can shop around for best price or to invest in
technology to make for more efficient production.
RC is likely to need to create even more cost reductions where there may be new low cost entrants.
(c)
To: Board of RC
From: Business Adviser
Subject: Bibi contract and strategic dilemmas
Date: XX/XX/XXXX
Bibi contract
It may be that the Bibi negotiators would be willing to pay 10p per bag (as they have in the
past) rather than lose RC as a supplier, but they may be attempting to force down the price
in negotiations. Much will depend on the availability of alternative suppliers. For the time
being at least there does not appear to be any cheaper alternative.
A judgement therefore needs to be made as to how serious Bibi negotiators are and what
their alternative course of action is if they are not supplied by RC. Some indication may be
given by whether they are primarily dissatisfied by price or by quality.
If the Bibi contract is lost then RC would no longer appear to be viable as it would
generate losses. Based on the year to 30 June 20X7 without Bibi the loss would have
been:
CU6m - (60% CU5m) - CU4m = loss of CU1m
In 20X8 the increase in fixed costs of CU400,000 would increase the loss to CU1.4m (if
sales volumes continue to fall this may be even higher).
RC is therefore fundamentally dependent on Bibi to continue as a going concern.
Other points:
 40% of operating capacity would be lost and thus economies of scale may be reduced. 

 The chances of replacing Bibi look to be low given market trends. 

 Are any fixed costs avoidable? 

 Presence of a competitor increases Bibi's bargaining power as RC may face
competition for the contract. 

 Will Bibi seek additional reductions in future years? 

 Is there any way to reduce costs further or to pass on price reduction to suppliers? 

 Could try to mitigate price reduction by getting Bibi to pay more promptly or increase volumes. 

 Will other customers start demanding a reduced price? 

 Will more existing consumers buy RC's crisps at Bibi? 

 Loss of Bibi may cause bank to question going concern and withdraw financial support. 
Risks and threats of strategic dilemmas
Healthy eating trend

The healthy eating threat is a shift of market tastes against RC's only product. According to
the industry data provided the market for crisps is falling by 3% per annum. However, the
sales volume of RC has only declined by 1% per annum in total over the period 20X5 to
20X7 – although all this reduction is concentrated in the non-Bibi market (which has fallen
by around 1.6% per annum).
Thus, while the general market has declined – and this has affected RC – it has gained
market share which has partially off-set the effect of the overall reduction in the market.
Nevertheless, the overall decline of the market is a major risk and there is nothing to
suggest that market share will carry on rising and the overall market decline may
accelerate with protective legislation by governments over healthy eating in schools.
The high levels of operating gearing with high fixed costs mean that any downward
trend in sales volumes will have a disproportionate effect on profits.
Costs
One of the reasons that a low cost operation has been sustainable is that the machinery and site were
acquired for a low cost from an administrator. Now that this initial machinery is reaching the end of its
useful life, the question of replacement arises – presumably at much greater costs. This has a number
of risks:
 The increased costs of machinery will increase overall costs and may mean that the low
cost model may not be as effective as it has been in the past. 

 The increase costs are fixed costs which raise operating gearing further and increase risks. 

 Any new investment would be a sunk cost and may not be recoverable if RC invests and
later becomes unviable. 
The new machinery may, however, be an opportunity and thus present upside potential:
 It may permit a new strategy to be followed with the new machinery – e.g. low cost healthy
snacks, which are not attainable with the current machinery given its lack of flexibility. 

 Maintenance costs would be saved. 

 There may be improved quality of the product which may enable a greater price to be
charged and/or greater sales volumes to be sustained. 
New rival
The new rival is a concern as it is invading the niche market that RC previously had to itself.
Nevertheless, the new rival is more expensive than RC in terms of cost per bag. It may however offer
more marketing and distribution services to customers and it may be a better quality product that
customers will be prepared to pay for, even at the lower end of the market. Equally, it may be able to
sustain a loss leader strategy for a while because of parental support.
If the new rival does take some of RC's market share then the operating gearing effect may push it
into losses. The threat may, however, be moderated by two factors:
 The new company might be targeting different customers despite the price similarity (e.g.
other large supermarkets). 

 If the low price is generating losses for the new rival then this might not be sustainable, even
with the support of a large parent company. 
Actions
Healthy eating trend
The obvious solution is to add different products to the portfolio including healthy eating snacks.
However

  RC is not known for this type of snack 
  RC may not have any core competences in this area 
 Investment in new machinery would be needed. 
An alternative is to continue with crisps against the general trend as other companies may be ceasing
to produce high fat products or are reducing advertising on them to indicate a better corporate image.
Thus while demand may be falling, the supply side may also reduce and become less competitive. This
would be lower risk than changing strategic direction with new investment.
Another alternative is to seek an exit route if the market has become unviable. From the perspective
of the product life cycle, RC crisps may have reached their 'decline phase'. Sale of assets and the
closure of the business may be a lower risk and more viable opinion than new investment in an
unfamiliar market in which it is likely to be unable to replicate the low cost model previously used.
Change management
The exit route strategy is likely to maximise resistance to change as all employees
would lose their jobs hence the process of disengagement may be difficult unless it
is achieved quickly.
Even if there is increased investment this is likely to mean greater mechanisation
with more efficient machinery and thus fewer jobs. Unless this can be achieved
through natural wastage then fear by employees may involve barriers to change.
This may arise from expected redundancies or revised working practices with the
new machinery.
19 Lo-Sport Ltd
Lo-Sport Ltd (LS) is a manufacturer of sports equipment. It was set up in the south of
England in 1988 by two famous, retired professional tennis players, Rodney Connors and
James Laver, who are the directors and sole shareholders.
Company profile
Compared to many of its rivals, LS is a small company, with a revenue of only CU15
million per year. The company currently produces two types of product – sports rackets
and sports shoes.
It manufactures specialist rackets for squash, tennis and badminton, using the latest
technology, making them suitable for professional and advanced players. The rackets sell
for approximately ten times the average price of rackets available in the high street. LS
has a 6% share of this specialist market, but only a very small share of the rackets
market overall. Despite small increases in industry sales, LS's revenue has been static for
some time, due to significant competition from larger rivals. These rivals dominate this
specialist rackets market, with the market leader having a 24% share of worldwide
industry sales of CU100 million.
LS also manufactures sports shoes for the mass market. The company's sales of these shoes
have, however, been declining for some years, largely due to severe competition from much
larger international manufacturers. There has also been a decline in industry sales in recent
years. Sports shoes are nevertheless still seen as a fashion item and the large companies support
their products with significant advertising.
A new product
A friend of the LS directors, Barry Borg, who is a retired research scientist, is employed by
LS. Last year he developed a new rubber product, Katex, which he incorporated into a
redesigned sports shoe. Early tests of the 'Katex shoe' proved extremely successful,

demonstrating enhanced comfort, durability and performance. The product was patented
by LS but sales have not yet commenced. However, a major marketing boost was given to
the product recently when a proto-type shoe was used by an athlete to achieve a world
record time for running 400 metres.
Rodney Connors was extremely enthusiastic: 'This product could sweep the market.
Within a few years Katex could form the basis of almost every sports shoe in the world.
Meanwhile I would suggest selling it at a premium price to skim the market, then gradually
lower the price a little while still staying at the top end of the mass market. I therefore
suggest we make the development of the Katex shoe our prime focus.'
James Laver was more cautious: 'Even if this product is successful, we do not have the financial or
physical resources to manufacture, promote and distribute this product in any major way. It could be
successful nationally, or even internationally, but we are a small company. Moreover, it is at a very early
stage, it might not be successful, and we should not neglect our existing business that easily.'
James Laver continued: 'I have, however, recently been approached by a number of sports equipment
manufacturers, both large and small. They are very interested in exploring the possibility of developing
the Katex shoe and other Katex products either with us or on our behalf. They appear to be offering
not only production facilities but also a distribution network, which in some cases extends to
international sales. I think we could benefit from their involvement but we need to be careful about
the precise terms of any arrangement.'
Requirements
(a) Identify and explain the strategic position of each of LS's products within the Boston Consulting
Group Matrix.
Assess the implications of this positioning within the Boston Consulting Group Matrix, in
determining the extent to which LS should invest in each of its products. (12 marks)
(3) As an external consultant write a memorandum to the directors of LS outlining the merits
and demerits of each of the following joint development strategies in respect of Katex
shoes:
 Licensing 
 Franchising 
A joint venture 
 A merger. (16 marks)
(28 marks)
19 Lo-Sport Ltd
Marking guide
Marks
(a) Diagram 3
Rackets 3½
Sports shoes 2
Katex shoe 3½
12
Licensing 4
Franchising 4
Joint venture 4
(b) Merger 4
16

28
(d) BCG position
Rackets
The manufacture of rackets for tennis, squash and badminton are all within a well-established industry
which appears to be in the maturity phase of the life cycle model. This is characterised by market
saturation and stiff competition. Market growth is thus low.
LS is a small company in the rackets industry generally and could thus be considered as a dog within
the BCG matrix. This would also be indicated by the stable company sales.
On the other hand, the industry could be considered as the niche market of professional, up-market
rackets. While not a market leader, it could be considered that LS has a reasonable share of this
specialist sub-market. In this case it could still be regarded as a dog according to the BCG matrix with
only a 6% market share, but it would alter its position within the relevant segment.
Implications
Consideration could be given to the continued viability of this product. However, thought also needs
to be given to the continuing cash flow generation compared to any disposal price that could be
attained.
There could also be wider considerations such as interdependencies between products. For example,
the shoe product side of the business may be partly dependent in cash, marketing or operational
terms on the continued existence of racket manufacturing.
In the absence of significant other factors, further investment in this product would, however, be
questioned by the BCG framework.
Existing sports shoes
This industry appears to be in the decline phase of the life cycle model based on the information

available – although this may merely be a temporary fall in industry sales. However, unless this is the
case, market growth within the BCG matrix is negative.
LS is a small company in the shoes industry and could thus be considered as a dog within the BCG
matrix. This would also be indicated by the decline in company sales.
Implications
This would indicate divestment within the framework of the BCG matrix, or at least no further
substantial new investment to support the product.
The Katex shoe
While there does not seem to be any current sales, there appears to be significant prospective sales
and significant potential sales growth.
The positioning in the BCG matrix depends, however, on how the market is defined. If it is defined
widely as the sports shoe market, then clearly the potential market share is probably low and market
growth is uncertain despite this discovery of Katex (unless Rodney Connors' optimism is well
founded).
If, however, the market is defined more narrowly as the Katex market or as a specialist section of
the shoe market, then LS could be considered to have the potential for a substantial market share
with significant market growth.
The Katex shoe could thus be considered, potentially at least, as a problem child (or question mark)
within the BCG matrix.
Implications
As a problem child the market is attractive but the lack of market share may need significant
investment in order to grow by comparison with major competitors. This may include physical
investment in larger scale productive activities, but also in advertising to promote the brand in
a fashion conscious industry.
There is therefore likely to be a need for a major cash injection. As there are no cash cows
in the product portfolio, this may need to come from some form of joint development
strategy as suggested by James. Alternatively, or additionally, new debt or equity capital
could be raised.
Ultimately the aim, within the BCG matrix framework, should be to shift the product
towards being a 'star' and then a 'cash cow' as the product cycle progresses.
4 Memorandum
To: The Directors of Lo-Sport
Ltd From: An External
Consultant
Date: Today
Subject: Joint development strategies
Introduction
The need for a joint development strategy stems from the inability of LS to exploit the
potential of Katex using existing resources, or those that could reasonably be acquired
(e.g. by debt or equity issues). Even with a joint development, however, additional capital
may be needed to fully exploit Katex within any partnership. However, a new product is
subject to significant risk and the impact of the alliance on the existing customer and
product base also needs to be considered alongside that of Katex. This of course assumes
that the company will continue to make the other products.
Licensing

Licensing involves selling the right to use a brand, a product, know-how or other asset.
This may include the right to sell the product, or the right to manufacture and sell it.
Unlike franchising it tends not to have a high degree of central control or support.
Katex could be licensed to one or a few large companies, possibly including manufacturing
rights, or to many smaller companies, although in this latter case franchising may be more
appropriate.
Clearly, there needs to be some incentive for other companies to purchase the licence,
which normally means they are unable to replicate the product themselves. This may be
because
 The product is patented 

 Competitors are unable to copy the production process to replicate the qualities of Katex 
The brand name associated with the product is important to customer perceptions. 
Overall, licensing is likely to be difficult to sell based upon initial testing alone and it may be
necessary to establish Katex in a wider market to demonstrate its success before it
becomes a saleable brand under licence. It may also be necessary to demonstrate, not only
the technical qualities of the product, but also its commercial viability at premium prices.
The form of the licensing agreement could be in terms of geographical spread (e.g. for
sales of Katex shoes in a region or country) or it could be on a product basis (e.g. the
right to manufacture Katex shoes might be separated from the right to manufacture other
Katex products).
Franchise
As with a licence, under a franchise a firm grants other firms the right to use its brand, its
product or its know-how. In this case, however, there is likely to be more central control
and support. In return, the franchisee will provide a lump sum, share of earnings and
specific payments.
In the current context a franchise is likely to be on a geographical basis in order to
segregate the markets of the franchisees. This is likely to be on a similar basis to
licensing.
The advantages of franchising Katex include:
 Quicker business expansion than using LS's own financial resources alone 

 Reduced risk by having franchisees' own capital 

 Retains incentives with franchisees keeping residual rewards and using local knowledge 

 Maintains some control 

 If franchising is to be taken up by many small operators, then LS
is not dominated by their business partner(s). 
The drawbacks of franchising Katex include:

 The need to share profits 

 The need to monitor franchisees 

 Poor franchisees may harm brand name 

 Franchisees are likely to be small and thus may help with retail and distribution, but
they are unlikely to provide any help with large scale production of Katex. 
Because of the central control franchising is more likely to attract smaller companies, perhaps on the
retailing side, rather than the manufacturing side.
However, overall, as with licensing, there needs to be some incentive to purchase a franchise, and

without successful establishment in the market this may be unlikely.
Joint venture
A joint venture may take a number of forms but most commonly the partners form a separate
company in which each holds an equity stake. Management is normally provided jointly according to
the relative expertise of the partners.
The benefits of a joint venture for Katex would include:
 Access to capital provided by the partner(s) 

 Access to the core competences of the other partners; these are likely to include the
need for large-scale production and access to a distribution network 

 A joint venture may remove a potential competitor(s) 

 It may give access to wider geographical markets nationally, and possibly internationally 

 If it becomes successful it gives the company an exit route from this market by selling its
shares in the joint venture; this enables it to profit from Katex without staying in this market
permanently, and be able to return to its original business. 
The disadvantages of a joint venture include:
 A share of the benefits of an innovative product are 'given away' in return for access to
more commonplace activities of production and distribution 

 Disputes may arise over the relative rights and obligations of the parties 

 Access to Katex know-how is given away unless protected contractually 

 The terms of the joint venture need to be negotiated and may depend upon the relative
strengths of the two parties; if LS is the smaller partner, because it wants access to economies of
scale it may be disadvantaged. 
The more Katex is established in the market prior to any joint venture the better would be its
negotiating position in any agreement and the more 'marriage partners' it is likely to attract.
Merger
A merger (or an acquisition) would involve integrating not only the Katex product but all existing
products.
A merger would normally involve new shares being issued in a combined entity.
Many of the same advantages and disadvantages apply to mergers as to a joint venture. Additionally,
however, the following need to be considered.
 If LS is the smaller partner then the merged entity would be dominated by the larger partner
in terms of management and operations. 

 The founding directors are likely to have significantly diminished influence and, unless they
desire an exit route, their individual positions, not only with respect to Katex but the entire
company, are likely to be severely diminished. 
 There needs to be appropriate synergy to both parties for there to be any advantage in a
merger. 

 A merger would have the advantage of extending synergies of production
and distribution to products other than Katex. 

 A merger is likely to be between two parties, whereas a joint venture may
access the core competences of a number of companies. 

 A merger could be with another manufacturing company in the sport

industry to exploit horizontal synergies, or it could be with a
retail/distribution company to exploit vertical synergies. 

 There may be significant costs of integrating the two entities. 

 The merger terms are likely to be dependent upon what LS, and particularly
Katex, has to offer the partner. As with the other types of joint development
strategy, this is likely to be improved by establishing Katex in the market before
attempting to extend its appeal by some form of external agreement. 
20 The Slate Snooker Table Company Ltd

Note: Assume that the current date is June 20X5.
The Slate Snooker Table Company Ltd (hereafter SSTC) is a large private company which
manufactures snooker tables.
Industry background
Snooker is a traditional game, which enjoyed a major revival in the late 1970s when it was first
televised on a widespread basis. Since that time, snooker's popularity has varied but it still maintains
enthusiastic support.
Slate snooker tables vary in price, with new slate tables in the UK selling from about CU2,000 to
over CU20,000. There is also an active second hand slate snooker table market, which competes
with the new market. Increasingly, both new and used snooker tables are sold by individuals and by
companies over the Internet. Few tables are exported, or imported, as the transportation costs
would be high given their weight and the risk of damage.
Many low cost wooden and toy snooker tables exist, but these are of a significantly poorer quality than
slate tables making them unsuitable for serious players. In general, wooden tables are regarded as a
separate market from slate tables.
The company background
SSTC was established in 1879. It has specialised in making slate snooker tables and, unlike many
competitors, it does not sell any other products. Indeed, it makes only one type of table, 'The
Standard', which sells for CU3,000.
SSTC has two types of customers: snooker clubs and private homes. Tables are supplied to the
customers' premises and assembled on site by SSTC employees. The company takes pride in its
reputation of providing customers with a good service and it has a good reputation for quality in the
industry.
SSTC is organised functionally with production, marketing and administration being the three
sections. SSTC's main factory and showroom is in central England, but it also has showrooms
in Scotland and in London.
Estimated financial information for the year to 30 June 20X5
CU'000 CU'000
Sales
Private homes 9,000
Clubs 6,000
15,000
Variable costs 2,500

Fixed costs
Direct labour (fitters) 500

Other fixed costs 13,000
(16,000)
Loss (1,000)
At a board meeting a number of strategic proposals were put forward to improve the poor results.
The board meeting
Proposal 1
The marketing director suggested: 'Our basic problem is that we are a quality company but we
are not charging enough for our product. A great opportunity has arisen for us to sponsor the
national snooker championship in July 20X5 as the original sponsor has withdrawn. They will use
our tables, which will be seen on national television. The sponsorship cost would be CU2 million
but the exposure would mean that we will be able to increase our prices immediately, or
alternatively sell a lot more tables.'
Proposal 2
The finance director disagreed: 'The problem is that we only sell one product. We should sell a
range of tables and accessories, but more immediately an opportunity has arisen for us to acquire
the entire share capital of National Snooker Clubs Ltd (NSC). This company runs a chain of about
100 snooker clubs around the UK and, at the moment, they are not one of our customers. They
have only been breaking even so we should not need to pay any more than the value of the assets
to acquire the company. NSC could then be run as a separate division from the existing SSTC
business, with each division having its own divisional manager.
I estimate that the SSTC division would provide the NSC division with 500 tables a year. This
alone would be enough to turn our existing SSTC business into profit and it would mean lower
cost tables for NSC. It could also provide 100 new sales outlets if we expanded into snooker
accessories.'
Proposal 3
The human resources director saw the problem from a different perspective: 'Our fitters who
install the tables on site are paid a fixed weekly wage and a two-man team is expected to install
one table per day. The problem is that our direct labour is in effect a fixed cost. When there is no
work they still get paid. I also understand that they sometimes finish the day around mid-afternoon
and go home. They are capable of doing more, but they do not have the incentives. If we start
paying overtime they will just stretch the job out to earn more money. Also, when there has been
a big snooker tournament on television the demand is high, but they just cannot cope with the
volume of work. What we need is more flexibility by turning direct labour into a variable cost by
introducing payment by results, rather than by time worked. We also need to measure the
performance of our fitters in order to improve efficiency and maintain quality.'
Requirements
(a) Using the marketing director's information under Proposal 1, calculate:
(i) The amount by which selling price; and
(ii) The amount by which the volume of sales
would need to increase in order to achieve break-even profit for the year ending 30 June 20X6.
Assume that, other than any changes arising from the marketing director's suggestion, variable
costs per unit and fixed costs remain as they were in the year ending 30 June 20X5.
Ignore Proposals 2 and 3. Consider (a)(i) and (a)(ii) separately. (6 marks)
(b) Appraise the marketing director's suggestion under the following headings:
(i) The scale of the changes required to break-even

(ii) Strategic and operating risks
(iii) Competitive position. (9 marks)
(c) Evaluate the merits and demerits of the finance director's suggestions in Proposal 2. (9 marks)
 Adopting the human resource director's suggestion, calculate the impact on the break even
output if all direct labour costs (i.e. the cost of the fitters) became variable costs. Ignore
Proposals 1 and 2. Assume, for the purpose of these calculations that there is no change in the
fitting time per table. (4 marks)
(iv) Briefly identify non-financial indictors that might be used to measure labour performance by fitters.
(4
marks
)
(32 marks)
20 The Slate Snooker Table Company Ltd
Marking guide
Marks
(a) Selling price change 3

Volume change 3
6
(b) Scale of changes 3
Risks 3
9
(c) Profit 3
Performance measurement 3
Other issues 3
9
(d) Calculations 4
(e) Non-financial performance measures 4

32
(a) Snooker tables sold = CU15m/CU3,000

= 5,000 tables
Variable cost per table = CU2.5m/5,000
= CU500
Contribution per table = CU3,000 – CU500
= CU2,500
(i) Existing loss = CU1,000,000
Additional cost = CU2,000,000
Additional revenue required = CU3,000,000
Additional revenue per table = CU3m/5,000
= CU600

(ii) Number of additional tables to break even = CU3m/CU2,500
= 1,200 tables
(d) Scale
Price change
An increase in price of 20% would be needed to break even. A price increase of 13.3% would be
needed just to cover the sponsorship costs. This however assumes that the reputation effect of the
sponsorship only lasts for one year.
Volume change
An increase in volume of 24% would be needed to break even.
A volume increase of 800 tables (i.e. 16%) would be needed just to cover the sponsorship costs.
Thus break even is 6,200 tables with the marketing director's suggestion.
Existing break even is = CU13.5m/CU2,500
= 5,400 tables
Beyond 20X6 this would also approximate to the break even position as sponsorship costs are only
incurred in one year (under current proposals). If reputation, and thus demand, are improved in
the long term then a break-even position may be more readily attained beyond 20X6.
Strategic and operating risks
The higher level of fixed costs with sponsorship will increase operating gearing very significantly in
20X6. This will lead to significantly increased operating risk if the estimates of increases in selling
prices and sales volume are not achieved.
Volatile demand in the industry will cause uncertainty in the sales prices and sales volumes achieved
by SSTC.
There is a risk of losing customers by increasing the price. While there might be a short term
reputation effect from sponsorship there is a risk that the increased price is unsustainable in the
longer term. This may cause confusion in the market about the positioning of SSTC's product.
There is a risk of competitor reactions to a price or volume change in terms of their own
marketing/advertising in order to change their own reputation and competitiveness. They may
also change price to respond to SSTC's price change.
The price increase from CU3,000 to CU3,600 will lead to a different strategic positioning in the
market for SSTC. This may alter SSTC's market position bringing it into more direct competition with
higher quality producers than previously. While sponsorship may improve the perceived quality of the
product it will not improve actual quality.
The sponsorship, however, is a short-term effect and whether this reputation improvement is
sustainable on the basis of one year's sponsorship is questionable. Alternatively, a long term
sponsorship commitment may be required to sustain the improved reputation, but this will increase
fixed costs in the long term.
SSTC also operates in two distinct markets – snooker clubs and the home market. It is possible that
snooker clubs will be less concerned than the home market about reputation.
The snooker clubs market may also be more concerned about price than the home market and thus
demand may be more elastic.
One possibility would be to price discriminate by considering market positioning separately in each of

the two markets.
(c) Impact on profitability
This suggestion is one of downstream vertical integration. It is, however, unusual in that
the vertical integration is not with an existing customer. There may therefore be some
increase in profitability to the group entity, as snooker tables are in effect being acquired at
their variable cost of manufacture rather than the price previously paid by NSC to their
previous supplier.
Strategically however SSTC has no core competences in snooker club management and thus
there are questions over management's strategic ability to control and improve the
profitability of NSC from its current break-even position.
The expansion into snooker accessories may also enhance group profit although this is a
new business where there appear to be few existing core competences in either division
and the business would need to compete with other established suppliers of accessories.
Divisional performance measurement
The transfer price will partly determine the relative performance of the two divisions.
Unless this is set at an arm's length market price this will distort divisional performance.
Even where the transfer price is at arm's length, it is suggested by the finance director that
NSC will purchase its tables from SSTC in future while it does not do so at present. This
implies some form of compulsion on the divisional head of NSC in changing the supplier of
tables from the existing supplier. If this is the case, it becomes difficult to measure the
performance of that division, and that of its manager, as there are restrictions on their
decision making.
If the finance director's other suggestion of selling accessories is implemented then it is
unclear whether they will be sold by one, or by both, divisions. In the latter case there
may be some inter-divisional conflict in making sales.
New reporting structures and management information systems will be required.
Risk
Risk adjusted performance will need to be considered. A significant fixed cost investment
has taken place in NSC which will increase operating gearing.
Conversely, however, there is some diversification into other products. Unfortunately, these
are still all systematically linked to the popularity of the sport of snooker so a common and
systematic industry risk exists from fluctuations in the sport's popularity.
New organisational structure
The new organisational structure is a mixture of divisions and functions if the existing
functional lines of reporting are maintained. This may then look like a matrix structure.
Alternatively the functions could be kept within the divisions.
The separation of management of the divisional structure may be appropriate as:
(i) This would maintain autonomy with transfer prices and assist divisional
performance measurement
(ii) The core competences of each business could be developed separately to
maintain existing management skills.
Other issues of vertical integration
Other issues include:
 There is reduced flexibility for NSC to change the suppliers of its tables. This may be
restrictive as SSTC only makes one type of snooker table. 


 Liquid resources will be consumed in the acquisition of NSC. 
(d) Snooker tables sold = CU15m/CU3,000

= 5,000 tables
Variable cost per table = CU3m/5,000
= CU600
Contribution per table = CU3,000 – CU600
= CU2,400
Number of tables for B/E = CU13m/CU2,400
= 5,417 tables
Thus the break-even position has increased from 5,400 to 5,417 by changing labour into a
variable cost.
(e) Measures might include:
 Quality measures – faults, complaints, customer call outs. 

 Balanced scorecard – financial, innovation, customer, internal business. 

 Benchmarking – internal (against other fitters), competitive (other companies), activity
(other similar self-assembly activities), generic (fitters in other industries e.g. kitchens). 

 Budget targets – targets per month for number of jobs without additional call outs,
low rectification costs. 
21 Furbiton & Frobisher Ltd

Note: Assume that the current date is December 20X5.
Furbiton & Frobisher Ltd (hereafter FF) is a listed company which operates a small chain of up-
market department stores throughout the UK.
Company history and background
FF was established in 1948 with a single store in London selling only top quality clothing. The business
grew rapidly in the following years and, according to the chairman, the factors leading to this success
were:
  Strong brand name and reputation 

  Access to internationally known suppliers with up-market brands 
 Inelastic demand for sales, based upon a high income customer base, resulting in high profit
 margins 
 Recruitment of good quality staff with high salaries for the industry 
By 20X5, the FF chain had grown to ten stores spread throughout the UK. Each store has 2,000 to
3,000 square metres, with two or three floors. This is smaller than many large rival store companies,
but FF sells only four types of product in each store through separate departments: clothing,
furnishings, cosmetics and electrical.
All the stores have prime, city centre locations and are leased. The lease rentals vary
considerably, depending on the location, size, lease terms and condition of the building.
The four departments within each store are profit centres. The rental costs of each store are
charged to the four departments in that store on the basis of floor area occupied. Other fixed costs,
including head office costs, are divided equally between the departments.

Staff are recruited with the help of the human resources section at head office, but the departmental
manager has the final decision. Staff are not usually transferred between departments as the
departmental managers have autonomy to retain their own staff. Also, there is specialist knowledge in
selling each of the different types of products which makes staff transfers difficult.
The departments
Clothing
The clothing departments are normally considered to be the core of the business. Only well-known,
quality brands are sold. A few of the very best international brand companies supply a restricted
number of outlets in the UK, so competition for FF is constrained in respect of these designer labels.
Unfortunately, one of the very best Italian designers informed FF that it will no longer supply it after
the end of 20X5. Part of the reputation of FF depends on selling these international quality labels.
Furniture
The furniture departments were introduced into FF stores in 20X2, but revenues have grown
rapidly, with an emphasis on modern styles from quality manufacturers. The departmental
managers of five of the furniture departments were recently recruited by a rival company and left
FF in November 20X5. These were five of FF's best departmental managers.
Cosmetics
FF commenced selling luxury cosmetics in 1980. FF places itself at the top end of the cosmetics
market by its products and by the level of service it offers, including make-overs and special
evenings for loyal customers. Profit margins are high but revenue generated is smaller than the
other three departments and it has not grown in recent years. A high proportion of sales are in
November and December prior to Christmas.
Electricals
This department has performed poorly in recent years due to increased price competition
from rival department stores, specialist suppliers and internet suppliers.
Performance
The estimated financial performance for the year to 31 December 20X5 is:
Clothing Furniture Cosmetics Electrical Total
CUm CUm CUm CUm CUm
Revenue 80 30 20 70 200
Direct costs (55) (20) (8) (65) (148)
Rental costs (8) (4) (4) (8) (24)
Other fixed overheads (6) (6) (6) (6) (24)
Profit/(loss) 11 0 2 (9) 4
A board meeting
At a recent board meeting the possibility of closing all the electrical departments was considered.
A dilemma that arose was what to do with the vacated floor space if the closures took place.
Two strategies were put forward:
Strategy 1
Lease the space vacated to an external specialist retailer, Thinebury Brothers, which sells up-
market glassware and tableware. It has previously expressed an interest in taking space in FF
stores. The lease agreement would need to be for at least five years.
Strategy 2
Expand the remaining three departments to take up the vacated floor space. To make this strategy
credible it would be necessary to expand the product range for each department. The board has
suggested that a 'Furbitons' own-label brand should be used. These products would be good

quality but not as up-market as existing goods. The brand name of the new suppliers would not be
shown, as these goods would be sold under the 'Furbitons' label, utilising the company's own
reputation, rather than that of the suppliers. Selling prices for 'own-label' goods would be lower
than for existing products.
Requirements
(b) Explain how each FF store should measure:
Departmental performance
The performance of departmental managers.
In so doing, evaluate the factors that should be considered in deciding whether to close the
electrical departments. Provide supporting calculations where appropriate.
For this purpose ignore the proposed future strategies. (12 marks)
(e) Assume that the electrical departments are to close. As a consultant, prepare a memorandum for
the board of FF addressing each of the following aspects of the change management programme:
Planning the change programme
Explaining the barriers to change and how staff can be motivated during the change period
(iii) Communicating the change plan to stakeholders. (13 marks)
(c) Evaluate the likely financial and strategic effects for FF of the two proposed strategies. (12 marks)
(37 marks)
(iv)Furbiton & Frobisher Ltd
Marking guide
Marks
(a) Departmental performance 6

Departmental managers 6
12
(b) Planning the change 4
Barriers to change 3
Motivating staff 2
Communicating the change 4
13
(c) Strategy 1 – Financial 3
– Strategic 3
Strategy 2 – Financial 3
– Strategic 3
12
37
 (i) Departmental performance

Financial measures
The measure of performance used should be consistent with the company's overall
objectives in order to assess the contribution that each department makes towards achieving
the goals of the organisation.
As a listed company, the objective would normally be to maximise the wealth of the
shareholders, which would be equivalent to the discounted future income stream of each
department. In measuring current performance therefore it is difficult to identify one indicator of

future earnings generation.
Current performance therefore does not need to be measured by only one criterion but rather
by a range of measures that may capture aspects of both current performance and potential
future performance.
Comparative measures
The existing measure of performance used by FF appears to be profit, as each of the departments
is a profit centre. On its own, however, profit is not enough, as some benchmark is needed
against which to judge profit in order to judge performance. This might be:

 Budgeted profit 

 Profit per unit of a constrained resource, such as floor space 

 Return on investment (ROI) 
 Residual income (RI) 
The particular method used will also depend upon the purpose to which the performance
measure is to be used. Two possible uses are as a comparative measure (i) between different
departments within one store and/or (ii) between similar departments in different stores.
In this case, any basis of comparison needs to be valid. For instance if ROI or RI is to be used
then the capital base on which the measure is determined needs to be constant. Thus for
instance, the historic cost of a store built in the 1950s would not be comparable with a new
store which was recently purchased. The depreciation figure and the capital base would both be
distorted.
Even measures such as floor space may not be comparable. Within any store a square metre of
floor space in the corner of the third floor would not be as valuable as a square metre by the
ground floor main entrance to the store.
Allocating costs
A related issue is that of charging departments with overheads. Allocations of fixed costs are
arbitrary (e.g. head office costs) and this is likely to distort performance in any circumstances.
The equal allocation of such costs irrespective of size as in the case of FF appears to be
particularly distorting.
Allocations of floor rental costs is also arbitrary. This is partly due to the fact that there is no
direct cause and effect relationship between the amount of floor space and the profit generated.
This is partly because, as already noted, floor space is not homogeneous as certain areas of floor
space are more valuable than others depending on the location within the store.
Also, however, what is really important with respect to the allocation of store space between the
departments is to maximise overall performance. This is achieved not by how much profit is
generated on average per square metre, but which department can use space, at the margin, to
generate the greatest marginal profit.
One method of reducing profit measurement problems is to examine the contribution per
department rather than the profit. However, while this reduces cost allocation problems, many
of the other issues cited above remain.
The contributions generated by each department are as follows:
Clothing Furniture Cosmetics Electrical Total
CUm CUm CUm CUm CUm
Revenue 80 30 20 70 200
Direct costs (55) (20) (8) (65) (148)
Contribution 25 10 12 5 52
This table shows that all departments make a positive contribution but it leaves unresolved the
issue of rental costs which are avoidable at the individual store level of performance and are a

constrained resource.
Contribution per CU1 of rent (which reflects floor space) are:
Clothing CU3.13
Furniture CU2.50
Cosmetics CU3.00
Electricals CU0.63
This shows that, on average, Clothing departments use floor space most effectively and
Electricals least effectively. The difficulties of assessing contribution from marginal usage of
floor space and future contribution also remain. For instance, will Clothing be as profitable
next year having lost the Italian supplier?
Non-financial measures
In addition to measuring the financial performance of departments a series of non financial
measures can be used to widen the basis on which performance is measured and capture, to
a greater extent, the objectives of the organisation.
Non financial measures can include:
 Benchmarking – internal benchmarking can look at the performance of the best FF
store and measure the others against this. Competitive (i.e. external) benchmarking could
look at the best performing stores in the industry. 

 Balanced scorecard – looks at CSFs and measures these with KPIs appropriate in
each case. The four perspectives include: financial, customer; innovation and learning; and
internal business. 

 Customer satisfaction measures – surveys of customers, field research. 

 Stakeholder relationship surveys – employees, suppliers (e.g. for clothing the
reasons for losing the Italian supplier). 
Other issues
The performance measures should fit in with the wider strategy. Thus, for instance if
reputation is a key CSF for long term profit then this should be a major issue in selecting the
non-financial performance measures.
There may be conflict between objectives. For instance short term profits could be made by
raising prices significantly, or by cutting costs by reducing sales staff, but in the longer term
this may damage reputation and thus may be value reducing.
Different strategies may be appropriate for different departments. As a result, different
performance measures may be appropriate for different departments. For instance, the furniture
department is recently established and may be in the growth phase of its life cycle (a question
mark in the BCG matrix). Growth objectives and breaking into the market may be thus more
important for furniture than for other departments. For instance, clothing is a mature
department and may be seen as a cash cow in the BCG matrix, and thus different objectives
such as cash generation may be appropriate.
(c) Department managers' performance
Many of the same issues arise for measuring the performance of managers as for measuring
divisions' performance. In addition, however, there is an emphasis on controllability of costs and
revenues and on autonomy.
The key issue here is that it is unreasonable to hold managers responsible for factors over
which they have little or no control. Unfortunately, this leaves a large 'grey area' for the many
issues that managers can influence, but which are also affected by internal and external factors
which they do not control. Such areas are a matter for qualitative judgement rather than precise
quantitative measurement.

The idea of control is manifest in responsibility centres and the responsibility centre used by FF
is that of a profit centre. This requires that managers have control over revenues and any costs
included within the profit centre calculation.
The costs that should be included are controllable costs, but this raises some questions in the
context of FF.
In terms of revenues, the managers of the electrical departments may be very able but adverse
market and competitive conditions, beyond their control, seem to have meant that the market is
very weak.
In terms of costs of acquiring inventories, it is not clear whether the managers are responsible for
sourcing the products sold in their departments. If not, then any weak performance may be as a
result of poor buying, rather than poor selling, which would be beyond the control of the
departmental manager. One way to bring such costs within the control of mangers would be to
give them responsibility for purchasing policy but they may have no competence in performing
this function.
Control over floor space costs may similarly be beyond the managers' control. However allocations
of floor space costs need not relate to actual rental costs. One way to give managers more control
would be for managers to bid for floor space so there is an internal market pricing mechanism like a
transfer price. This would make floor space costs a more relevant opportunity cost, and bring them
within the control of mangers for performance measurement purposes.
Other overhead cost allocations appear to be entirely beyond managers' control. It would appear
unreasonable to include these within controllable costs for the purpose of assessing the
performance of mangers.
One particular point of note is that the furniture managers in five departments have left to join a
rival company. This may suggest:
 They were performing well as a rival company has 'poached' them from FF. 

 In a competitive labour market that they were not being remunerated sufficiently to retain
them or that the measure of performance used to determine remuneration was not
capturing their 'true' performance as discerned by the external labour market for this type
of manager. In the furniture departments' case there was no profit earned on which to pay a
bonus but, as a new and growing department, this may not have captured their managers'
achievements. 
Closure of electrical departments
The electrical departments currently make a positive contribution of CU5 million per annum.
However, this is not enough, on its own, to keep them open as:
 Future forecasts may be for continued decline given the difficult market conditions and
it is only the future that matters in the closure decision 

 Alternative strategies may generate a contribution of more than CU5 million using
the vacated floor space 

 The wider strategy of product mix needs to be considered not just short-term contribution. 
It may be that an intermediate solution of closing only the worst performing electrical
departments is possible as it is unlikely they are all performing the same. This however leaves
open the question of whether a critical mass remains (e.g. to obtain quantity discounts in
purchasing).
 Memorandum
To: The Board of Furbiton and Frobisher Ltd
From: A Consultant

Date: Today
Subject: Change management programme
Planning the change programme
Initially it is necessary to consider the aims of the change programme to close Electricals and
replace them with the decided alternative strategy.
Blueprint
The blueprint needs to record for each desired outcome:
  What action is to be taken 

  When the action will start, how long it will take and when it will finish 
  Who will do what 
  How the actions will be carried out 
  Why – the purpose of the actions 
  How, when and by whom evaluation will be carried out 
 Must include launch: how to position the changes to gain most support 
Monitoring and co-ordination
There is a wide variety of ways to monitor and co-ordinate the change programme to ensure
everything keeps moving forward according to the blueprint. The key principles are:
 There must be a senior and influential group of executives to take responsibility for overall
leadership and co-ordination. Perhaps a senior executive of FF overall and store managers
have control at a lower level. 

 There must be a clear blueprint, even if some of the precise timescales are provisional.
This might be limited however by the timing of any contract with Thinebury Brothers. 

 The blueprint must cover the whole range of activities planned to deal with the three elements
of financing, competition and resourcing. 

 Carrying out the actual work of investigating what's needed and implementing new systems
and policies should involve key people in the change target group. 

 Change leaders should be chosen carefully for their skill and support. 

 Methods of making changes following evaluation should be included. 
Barriers to change
Specific points
Electrical department – there are limited employee transfers despite replacement of floor space with
other strategy options. There is therefore a high probability of redundancy for any given employee.
This will increase the self-interest of employees in electrical departments to resist change, but reduce
their ability for resistance given the transformational nature of the change and that they will not be
involved in the new regime.
Some employees if they cannot stop closure may press for Strategy 2, replacing electrical
departments as there may be more jobs generated within FF, thereby facilitating at least some
employee transfers within the company. Given the different skills this may, however, be limited.
A further means of resistance would be to delay the closure as long as possible in order to extend the
employment period.
Other non-electrical department employees may favour the change, particularly under Strategy 2
as there may be more opportunities for promotion in larger departments.
General change issues
Cultural barriers

 Group inertia – the closure may disrupt group norms e.g. if other departments have to
expand and adopt different procedures. These will need to be overcome. 

 Structural inertia – the new strategies may involve new structures and therefore there
may be resistance to abandoning existing structures. 

 Power structures – the existing hierarchy within stores may change and resistance by
those groups affected may be incurred. 
Personal barriers
 Effect on earnings – those made redundant will lose significant earnings and will probably be
most resistant to change, perhaps moderated by the size of any redundancy payout. 

 Security – the potential for change of work, pay, position, status etc may cause loss of
security and thus potential resistance. 

 Habit – existing habits of work may need to be changed. 

 Fear of the unknown – if the new regime is not explained and believed then fear of the
unknown may cause individuals to attempt to maintain the status quo. 

 Selective information processing – people may hear what they want to hear and thus not
believe management reassurances about change processes and consequences. 
Motivating staff during the change period
If it is certain that staff are to be made redundant then they may be motivated by:
 Negotiation of redundancy terms (above statutory minimum) being dependent on
smooth transition. 

 References for another job, and help with alternative employment, being dependent on
smooth transition. 
If it is less certain about redundancy, then the prospects of retention (subject to legal redundancy
requirements) may limit resistance in the hope of replacement jobs elsewhere in the company.
A policy of communication to employees and participation by employees in the change process
may also help motivation.
Communicating the change plan to stakeholders
There should be a detailed communication plan for stakeholder groups for the closure of the
Electricals departments and the implementation of the new strategy once it is decided. This
should specify who the key stakeholders are, and what their information needs are, for each
part of the change process. The timing of the release of information will also need to be
considered.
The following table summarises the key elements of such a plan for FF:
Stakeholder Their needs What they want to know How to communicate
Shareholders Reassurance That there is well thought The press

through strategy. How the
Financial statements
strategy will benefit them.
AGM
Website
The press A good story What's happening, the Briefings
rationale, and that the changes
are under control
their working
Suppliers Information How the changes will affect

relationship (if
Meetings face-to-face
any, for electrical suppliers)
with major suppliers.
Letters or e mail to
small suppliers

Customers Motivation That service in the stores will The press
continue uninterrupted Advertisements
Departmental Acknowledgement How they will be involved and One-to-one meetings
managers and involvement any role in the new structure.
Reassurance, or at least
clarity, over employment
position
Staff Help to adapt or to Retraining and support Briefings
facilitate redundancy
Redundancy terms for One-to-one with line
Electrical Departments manager/HR
(c) Strategy 1
Financial
Electrical departments generate a positive contribution of CU5 million. This could therefore set a floor price
for the contract with Thinebury. However this does not compare like-with-like as the Thinebury contract is
for five years.
An assessment therefore needs to be made in terms of the present value of the likely contributions that
Electricals would have generated over the next five years. This then needs to be compared to the rental
charges that could be made to Thinebury.
Also, while the electrical departments as a whole are generating a modest contribution, it needs to be
considered whether electrical departments in all of the stores should be closed or whether some are
profitable and should be retained with Thinebury taking up space only in selected stores. As already noted,
the availability of quantity discounts from suppliers might determine the feasibility of a partial closure
strategy.
Within the five-year period the rentals are reasonably certain so there is a reduction of financial risk in this
period.
Strategic
A key consideration is whether the alternative strategies are consistent with the longer-term strategic plan
of FF (i.e. 'strategic fit'). This might be in terms of the product mix, the ethos of the stores and the
customer requirements.
Given that the Thinebury contract is for a five-year fixed term this locks FF into the contract and
reduces future strategic flexibility if markets change. This increases strategic risk.
Reputation is important to FF thus there is a reputation risk to the contract with Thinebury as
there may be limited control over its procedures, unless controls are built into the contract. In
particular, customers are unlikely to distinguish FF from Thinebury in their perception of quality
and service.
Conversely, Thinebury may walk away after five years so this can only be a medium-term
strategy unless renewal is reasonably certain.
Strategy 2
Financial
There may be loss of contribution on existing sales if customers buy the new brands instead of
the old brands (substitution effect).
There is likely to be substantial up-front cost from reorganisation and establishing new
supply chains, whereas the additional initial cost may be small with Thinebury. The up-front
cost includes additional investment in working capital for new inventories.
Despite the higher initial fixed costs with Strategy 2 there is likely to be more upside

potential if sales are high and contributions similarly increase.
It is necessary to compare any additional expected contribution over a five-year period with
the rental that can be negotiated with Thinebury. The estimated probability of renewal will
also need to be considered.
Compare the risk of Strategy 2 with the Thinebury contract which may be largely risk free
income. Thus a risk adjusted premium may be required from Strategy 2 compared to
Strategy 1.
The new product mix may not actually increase total sales.
Strategic
There may be an impact on reputation of going 'downmarket' by using less well know brands
that are perceived to be lower quality.
Own labels may have limited brand value if unknown to customers as a product brand.
While the FF name is currently known to customers, it is as a retailer brand rather than a
product brand.
There may be a better 'strategic fit' as there is more control over service and products than with
Strategy 1.
There is more strategic flexibility to change Strategy 2, (compared to Strategy 1) if it does
not work out, as it is within the control of FF. There is thus a more immediate 'exit route'
with Strategy 2 than Strategy 1.
Requirement (c) asked candidates to assess the financial and strategic effects of the two proposed
strategies. In general, this was reasonably well answered with most candidates separately identifying
the key financial and strategic issues for each of the change strategies. A weakness with some
candidates was a failure to draw any comparisons between the two alternative strategies. Weaker
candidates failed to mention more than a few basic points on this section.
22 Cabot Tours Ltd

Cabot Tours Ltd (CT) is an established tour and travel operator which provides UK clients with a full
range of package holidays through high street shops and also an online travel agency. In an attempt to
capitalise on the growing market for medical tourism, CT is considering offering 'Sun & Surgery' holidays
to India.
Customers would be offered a complete package which would include arrangements for surgery,
travel, accommodation in a private hospital and a post-operative holiday with recuperation time.
Market information
There are two types of market for surgery:
(1) Elective surgery – this includes cosmetic surgery, fertility treatment, cosmetic dentistry and
weight reduction.
(2) More urgent medical treatment – this includes heart surgery, joint replacement and kidney
transplants.
A study by the Confederation of Indian Industry suggests that the medical tourism market could be
worth 100 billion rupees (approx CU1.2 billion) by 2012. It is estimated that around 150,000 medical
tourists visited India in 2006, with the numbers currently rising by 15% p.a. The Indian government is
planning to introduce medical visas to facilitate the process which would allow patients to return up to
four times in a year for check-ups and post-operative care.
The growth in demand has arisen because of:
 The rising cost of healthcare and the ageing population in Western Europe 


 The ease and affordability of international travel 

 Favourable exchange rates – the rupee has continued to decline in value against both the CU
and the euro 

 Improving technology and infrastructure in India 

 Certain patients being rejected for treatment in their own countries e.g. due to obesity
or age 

 The availability in India of a large pool of highly skilled doctors 
Packages range in price from CU1,500 to CU8,000 depending on the treatment required. A knee operation
costing CU10,000 in the UK would cost around CU4,900 in India, including travel and accommodation.
The directors of CT have some concerns about the risks of the 'Sun & Surgery' venture and want help
putting together a business plan and deciding on a suitable structure. In particular they are concerned
about the necessary medical provision and are considering a possible arrangement with a private medical
group who have hospitals in three cities in India.
Requirements
As an external consultant, brought in to help with the business plan
 Prepare, for initial discussion by the board of Cabot Tours Ltd, a PESTEL analysis for entry into the
medical tourism industry in India. (9 marks)
(b) Identify and explain the potential business risks associated with the proposed venture. (8 marks)
(4) Identify alternative business structures that could be used for the venture and advise the directors of
the advantages and disadvantages of each arrangement. (11 marks)
(28 marks)
(v)Cabot Tours Ltd
Marking guide
Marks
(a) Political 2
Economic 2
Social 2
Technological 2
Environmental ½
Legal ½
9
(b) Identifying/classifying risks 1½
Explaining risks 6½
8
(c) Organic growth 3
Joint venture 3
Strategic alliance 3
Other 2
11
28
(d) PESTEL analysis

Political
Introduction of medical visas by the Indian government will encourage travel 

NHS budget constraints and limited resources mean certain patients are rejected for UK
treatment 

Waiting lists are increasing and people are less prepared to wait / may not have the luxury of
time 

Private treatment in the UK can be very expensive so cheaper options will be attractive 

NHS has begun sending patients to Europe to address backlog so idea of overseas treatment is
not new 

Need to consider political stability of Indian government and region. Future governments may
not support medical tourism 

Continuing barriers to medical tourism expansion, including a lack of governmental
agreements on payment for treatment abroad and insurance coverage 

UK Government may place constraints on patients getting post-operative follow up care back in
UK. 
Economic
 Rising cost of healthcare in the UK 

 Favourable exchange rates – a strong pound reduces the effective cost of treatment. However,
future changes in exchange rates may increase cost 

 Affordability and availability of travel 

 CII study suggests favourable market growth 
 Increasing supply of medical tourism products, leading to greater competition 

 An increasing role for tourism suppliers in the packaging and marketing of medical tourism 

 Growing international private sector investment and joint ventures. 
Social / demographic
 People live longer and have a more active retirement so want to be comfortable / well
enough to enjoy it 

 The population is much more willing and accustomed to travel 

 Increasing media publicity re hospital league tables, care for the elderly and MRSA may
encourage some people to look overseas 

 People may have a preference for Europe rather than India due to shorter and cheaper flights 

 Growing ethical concerns about medical tourism, which may limit growth or damage reputation 

 Geographical distance may be an issue for relatives of the patient 

 Potential clients may be concerned re risks of surgical failure or hygiene overseas (MRSA etc). 
Technological
 Medical staff highly trained so have the requisite skills 

 Internet facilitates shopping around for information and provides lots of choice 

 Improving technology and infrastructure in India to support the venture 

 Equipment in private hospitals likely to be as sophisticated as that of UK 

 May be additional logistical requirements for transporting sick patients 

 Indian software sector have already been successful in providing outsourcing
facilities for UK, USA etc which may pave the way for other sectors. 
Environmental
 Growing environmental concerns may have an impact on affordability / ease of travel in future. 
Legal
 Potential litigation costs if things go wrong / need to consider insurance. 

(b) Busine
ss risks
Exchan
ge risk
 If sterling weakens the cost of packages increases and demand may fall 

 CT need to consider whether they can pass on costs of unexpected exchange rate changes. 
Political risk
 Subject to vagaries of Indian economy and Indian government, e.g. should they
decide to withdraw medical visas or increase costs or create legislation to prevent
influx of overseas nationals requiring treatment 

 Changes in NHS or UK private medical care may reduce demand 

 Potential for UK government reaction, e.g. may act to create barriers to overseas
treatment or refuse to accept patients for follow up in UK 

 Increased bureaucracy e.g. need to arrange visas will increase costs and
potentially create barriers to travel. 
New venture/market inexperience
 As with any new venture, risks are higher due to uncertainty 

 No experience of medical sector – need to choose partner carefully 
 Will need funds to establish operation and likely volume of transactions is uncertain – impact
on existing cash flow? 

 Language issues/differing tax and legal systems 

 Diversion of management attention from core business 

 Possible change in operating gearing e.g. high initial FC to establish venture 

 Will be easy for competition to set up similar ventures. 
Reputation and other ethical issues
 Medical treatment is not without risk 

 Increased risk of ill health/fatality whilst patient in ML's care e.g. risks of flying post surgery may
lead to emergencies in the air 

  If complications arise there will be a need to extend accommodation / change or delay flights etc 
– disruption costs 

 Potential litigation claims may be costly 

 Spotlight may fall on CT even if poor treatment is down to the hospital 

 Bad publicity may damage CT's reputation 

 Public disapproval of the venture may lead to boycott of CT's existing core business 

 Even if no medical complications, travellers likely to be older and in a higher risk category – more

costly in terms of time / staff input / increased reliance on holiday reps etc 

 Quality of partner may affect/damage CT reputation. 

(c) Business structures
Options for structuring the venture include the following:
  Organic growth, i.e. ownership of new venture 

  Joint venture 
 Alliance. 
Organic growth
Set up new venture themselves with full ownership
Advantages:
  Direct involvement may give a better understanding of the market 
  Does not require sharing of expertise/knowledge/information 
  CT retains control and gets all rewards 
  No problems of conflicting culture/expectations 
 Would not be tied to one group of hospitals. 
Disadvantages:
  CT lack expertise in medical market 

  May be language and cultural barriers 
  Higher risk 
  Increased costs 
 May be looked on less favourably by Indian government as no local involvement. 
Joint venture
Form a separate company, both businesses take an equity stake and management decisions are shared.
Most JVs are separate legal entities with own board, appointed by the shareholders.
Advantages:
 Reduces risk as this is shared 

 Access to skills of each party: can use the specialist skills of both CT and the medical group to
maximise the effectiveness of the new business 
 Cost savings for CT as these new skill sets need not be learnt or bought in e.g. experience
and understanding of Indian market 

 Cost savings as CT only contributing half of the capital needed for the new venture 

 Because the joint venture is a separate entity, CT can sell its stake in the company at a later
date if it so desires relatively easily. 
Disadvantages:
 Potential conflicts with the medical group over strategic and cultural issues of the new
business could be difficult to resolve. 

 Could be possible disputes over how business should be run /costs incurred /
management charges etc 

 CT may have to move key staff to the operation of the JV which may affect profitability
and effectiveness in the running of the core business 

 CT may not like the fact that they do not have complete control over the business 

 Rewards of the new business will have to be shared 

 The objectives of the business may not be totally clear or communicated to the staff involved 

 There may be an imbalance in the amount of expertise, investment or assets brought into
the joint ventures by the respective parties. 
Strategic alliance
Similar to a joint venture in some respects but a strategic alliance is some form of contractual
relationship designed to secure an international venture without involving a shareholding. CT
would have a looser arrangement with the medical group such that they work together but do not
go as far as forming a separate company.
Advantages:
 Like JV, uses joint expertise and commitment, allowing each party to focus on what they do best 

 CT keeps its independence and does not lose key staff 

 Less commitment required as the nature of the agreement is looser. 
Disadvantages:
 Arrangement may fail if both parties are not committed to it 

 Needs constant work to keep the relationship on a sound footing 

 Nature of linkage is essentially weak so less likely to survive in long term. 
May also mention the following:
Supplier arrangement
MT simply contracts with the Indian hospitals to provide the medical element of the service.
Agency agreement
Indian medical group acts as the agent for MT and bears the operating risk.
Conclusion
Risks associated with the venture are high, so CT would be advised to structure the venture
separately to avoid damaging their existing brand / reputation. They could set up the new division
as a separate company to limit risk but as they do not have the necessary medical expertise would
be best entering into some form of partnership. Careful consideration must be given to the choice
of partner and the nature of the agreement to ensure CT minimise risk and enjoy maximum
possible returns.
23 Jenny and Bob

Jenny and Bob Lindsay are directors of Lindsay Leisure Ltd (3L), a small entertainments and
leisure company which they formed in 1988. 3L currently owns a DVD and computer game
rental business with three small outlets in neighbouring towns in the West Midlands. The
business has traded profitably since its formation, but has recently suffered reduced margins
due to competition from large national rental companies, and from the increased access to
cable and satellite television in the area.
For some time Jenny has been suggesting to Bob that they consider expanding their business
into related areas, and they have now been offered the opportunity to buy a cinema in the
town of Bridge Stanton. 'The Bijou' is a fully operational 200-seat cinema, with a lounge bar
and refreshments kiosk, situated on the main market square of the town. It was built in 1924
and traded profitably as a cinema until the late 1960s when, due to falling audiences, it was
converted into a bingo hall.
The Bijou is owned by Stan Collymore, an 81-year-old businessman, who wishes to retire and
is asking CU180,000 for the freehold premises and a further CU20,000 for goodwill and
inventory. Jenny estimates that an additional CU200,000 would be required to refurbish the
cinema and install new projection equipment. 3L has CU100,000 available to invest, but the

remainder would need to be raised from external sources.
Jenny has an article from a recent issue of Leisure World magazine which reports a five per
cent annual growth in cinema audiences over the last three years, and this has led her to
believe that it will be possible to run the Bijou profitably. Bob is less confident, but agrees
that the modern 'multiplex' cinema ten miles away in Broadley is always very busy when he
drives past on Friday or Saturday evenings.
In order to proceed 3L needs to approach its bank with a view to raising the additional
finance required. The bank has requested a business plan for the proposed venture, and
Jenny has approached your firm to assist with the preparation of the plan.
Requirements
As a member of staff with the 3L accountants, prepare an initial memorandum to 3L
which covers the following:
 The likely contents of a business plan which will be suitable for submission to the bank
in connection with raising the required finance.
 An indication, under each of the general plan headings, of factors relevant to the proposed venture.
(21 marks)
23 Jenny and Bob
Marking guide
Marks
Structure of the business plan 3

Details of business background and operations 4
Industry information 4
Financial data 3
Additional information 3
Other factors and conclusions 4
21
Memorandum
To: Lindsay Leisure Ltd
From: Accountant
Date: Today
Subject: Preparation of a business plan for the 'Bijou Cinema' project
General issues
 The business plan will cover a time period appropriate to the business and industry. Commonly this is
three to five years, but in this case the period of the plan will be the period of the loan, with less detail
for later years. 

 The plan document should make use of graphs and charts to aid understanding, and should not be too
detailed. Any large tables such as financial forecasts should be presented in detail in the appendices and
summarised, or referred to, in the text. 

 If the plan document is very long an 'executive summary' should be included, which should highlight
key issues and summarise the main conclusions of the document. 
The major sections of the plan document will include the following.

Statement of purpose
This will include the circumstances behind the 'Bijou cinema' project and the need for finance.
The Business
This section will summarise:
  A description of the business 

  The general history of 3L (in so far as it is not already known to the bank) 
  Marketing information on the new and existing businesses (e.g. 5% growth) 
  Competition (e.g. the multiplex ten miles away) 
  Operations details (e.g. size, staffing, sourcing films) 
  Personnel 
 Insurance. 
Financial data
(a) Loan applications (existing and proposed)
(b) Capital equipment and supply list (cost of property, goodwill and inventory of CU200,000 and the
further refurbishment cost of CU200,000)
(c) Balance sheet
(d) Breakeven analysis

(e) Pro-forma income projections (forecast income statements)
  Three-year summary 
  Detail by month, first year 
  Detail by quarters, second and third years 
 Assumptions upon which projections were based 

(f) Pro-forma cash flow
 Follow the headings as above for income statement projections 

(g) Supporting documents
  Tax returns of the existing business and owners for last three years 
  Personal financial statement (all banks have these forms) 
  Copy of proposed purchase agreement for the cinema 
  Copy of licences and other legal documents (e.g. copyrights) 
  Copy of CVs of Bob and Jenny and managers 
 Copies of letters of intent (or contracts) with suppliers of films etc. 
Industry factors relevant to the proposed venture
Specific industry issues relevant to the project may include:
 Political issues relevant to the cinema industry might include industry-specific legislation on
copyright or restrictive practices, health and safety on licensing. 3L should also consider any
government assistance available to the West Midlands or the cinema industry. 

 Economic factors will include an assessment and forecast of consumer spending on leisure,
and any relevant macroeconomic variables such as inflation and unemployment. 

 Social factors relevant to the project will include the demographics of the population within
the area of the cinema, together with any forecasts of changing attitudes to leisure pursuits
which might significantly affect demand levels. 

 Any recent or predicted developments in entertainment technology must be considered,
such as video, cable, satellite or Internet developments. These may all have an impact on

the success of the cinema. 

 The industry structure should be analysed in terms of rivalry from other cinemas such as the
nearby multiplex, but also to predict the impact of substitutes such as video, television and
sports. Any likely new entrants should also be identified, and barriers to entry discussed. It is
likely that the film companies may have a very strong bargaining position in the industry. 
Environment/industry analysis
In this section the plan will summarise the context within which the business will operate, using
'PESTEL' analysis and the cinema industry structure. In addition to the current environment, the
plan should highlight any trends and attempt to predict any major changes.
Objectives
The objectives of the business, both financial and non-financial, should be stated in a form which will
make it possible for the organisation's performance to be assessed. As the plan is for discussion with
the bank it is likely to focus on financial performance, and an appendix will contain detailed forecasts
of balance sheet, profit and loss and cash flow. Appropriate key ratios may also be forecast, such as
ROCE and ROI, interest cover and liquidity.
Position analysis
As this is a new venture there will be no analysis of the current position in terms of trading
performance. However, the plan may describe the current business in terms of the premises, facilities
and any staff.
Strategy
This section should evaluate the alternative strategies available to the cinema, and select those most
appropriate in the light of the previous sections. The issues considered will include the following:
 The general positioning and marketing of the cinema. Will it be specialising in less well-known films or
competing head-to-head with the multiplex? 

 Any additional products to be offered, such as restaurant, bingo or conference facilities. 

 Assumptions used in forecasting prices, customer numbers and spending in order to derive the profit
and loss and cash flow forecasts included in the appendix. 
Financing
As this is primarily a plan for raising finance, this section will be comprehensive. The CU300,000 required
will be analysed to show exactly what it will be its use, and this section will propose repayment terms and
security offered. Some discussion will be necessary of the impact of changing interest rates and risk
assessed in view of the PEST analysis.
Conclusions and recommendations
In addition to being necessary for raising the required finance, the business plan will also achieve
other objectives.
 It will allow Jenny and Bob to assess the viability of the project, particularly as Bob seems to be less
confident in the project. 

 It will increase their understanding of the business and industry. 

 It will form a basis for the management and control of the cinema business. 
3L should therefore prepare a detailed business plan for the project, based on the advice contained in this
report. My assistance is offered, if required, to ensure that the application for finance is successful.
Note: There is some flexibility as to the precise headings and structure used in the business plan. The key
issue is that it is appropriate for the purpose for which it is to be used.

24 Claude Citron Ltd
Claude Citron Ltd (hereafter CC) has manufactured a range of toiletries using the Citron
brand for over thirty years. These have mainly been sold through supermarkets. The
Citron brand has established a reputation in the lower to mid-market toiletries range for
giving good value.
The board of CC decided that the company should diversify into perfumes during 20X3 and,
after significant investment in research, a new fragrance was developed, 'Potion by Citron'.
Initial market research indicated that the fragrance would be popular and could be launched at
the beginning of 20X3, but there were different opinions as to how the perfume should be
marketed. Thus a board meeting was called.
The board meeting
The chairman was enthusiastic about the new perfume: 'This is just what the company
needs to take up the surplus production capacity that we have been running. I think that,
given its popularity, we could sell this product up-market with a high price to signal quality.'
The marketing director, Ted, was a little more cautious: 'Look, let us not get carried
away, we need some decent market research first. Even then, we essentially sell basic
toiletries. No one is going to buy a high price perfume with a down-market toiletries brand,
no matter how good it smells. We need to consider the whole marketing mix.'
The finance director, Michelle, argued: 'I agree with Ted. I have produced some figures for a price in
20X3, but at this stage they are little more than a guess. In essence the two choices are:
Option 1 – to launch 'Potion by Citron' at a low price in order to penetrate the perfume market. This
would be implemented by using a cost plus pricing formula of budgeted incremental costs (i.e. relevant cash
flows) in 20X3 plus 10%.
Option 2 – to have a high price, of CU27 per bottle, with heavy advertising and premium packaging to
develop an up-market brand image. I would suggest hiring external marketing specialists on a fixed fee
contract if we adopt this option.'
The finance director's calculations for the expected production and sales of 'Potion by Citron' in 20X3 are
as follows.
Option 1 Option 2
Sales and production volume (number of bottles) 200,000 120,000
Costs already incurred developing the product CU220,000 CU220,000
Labour cost (per bottle) Note (1) CU4 CU6
Materials and variable overheads (per bottle) Note (2) CU3 CU4
Fixed production overhead costs (per bottle) Note (3) CU5 CU5.50
Variable internal marketing costs (per bottle) CU1 –
Fixed payment to external marketing firm – CU600,000
Notes:
(ix) Each bottle would take, on average, one hour of labour time to produce, with an extra half hour for
the premium packaging under Option 2. Labour is paid CU4 per hour but there is an agreement with
the union for no redundancies, despite the fact that there are currently 50,000 surplus labour hours
each year.
(x) Materials and variable overheads include ingredients already in inventory under both options, at CU0.50
per bottle. If they were not to be used for 'Potion by Citron' production they would need safe disposal
at a cost of CU0.10 per bottle.

(xi) In the finance director's calculations, fixed production overheads are allocated according to the total
number of units of output of the company (i.e. aggregating the number of bottles, sprays, bars of soap
etc). The estimated annual fixed production overheads for the company for 20X3, (excluding
production of 'Potion by Citron'), was CU12,480,000 allocated over 2,400,000 units. With 'Potion by
Citron' fixed production overheads would increase to CU13,000,000 under Option 1 and to
CU13,860,000 under Option 2.
Requirements
(f) Calculate the expected incremental cash inflows and outflows for 'Potion by Citron' for 20X3, using
each of the two suggested pricing policies (i.e. Option 1 and Option 2). Clearly state any assumptions
made. (9 marks)
(h) Assess how Claude Citron Ltd might use all aspects of the marketing mix (i.e. the '4Ps') to promote
'Potion by Citron'. Make appropriate recommendations and refer to your answer in (a) where
relevant. (18 marks)
(27 marks)
24 Claude Citron Ltd
Marking guide
Marks
(a) Option1 4½
Option 2 4½
9
(b) Price 5
Product 3½
Place 2
Promotion 3½
Recommendation 4
18
27
(a) Incremental flows

Option 1 Option 2
CU CU
Labour cost
(200,000 – 50,000) CU4 600,000
[(120,000 1.5) – 50,000] CU4 520,000
Materials and variable overheads
(CU3 – 0.60) 200,000 480,000
(CU4 – 0.60) 120,000 408,000
Fixed production overheads 520,000 1,380,000
Variable marketing costs 200,000
Fixed marketing costs 600,000
Incremental cost 1,800,000 2,908,000
Revenue
(1,800,000 + 10%) 1,980,000
(120,000 CU27.00) 3,240,000
Profit 180,000 332,000

Research costs of CU220,000 are sunk, and should thus be ignored.
(b) M
a
r
k
e
t
i
n
g
m
i
x
P
r
i
c
e
Superficially, the higher profit is earned by the price of CU27 under Option 2, thus
this price appears to be more favourable. There are, however, a number of other
factors that need to be considered before deciding on the most appropriate price.
 The above two prices represent only two possible options. There is a whole
spectrum of other possible prices that may be preferable to either of the two
options being considered. 

 The short-term price to maximise short-term profit may not lead to the best
long-term profit, as front-end costs may need to be incurred in order to
establish the brand in the perfume market and reap longer-term rewards. 

 Both calculations of revenues are based upon particular assumptions about
the demand curve facing 'Potion by Citron'. The results assume the following
demand schedules. 
Option 1 Option 2
Price (1,980/200) CU9.90 CU27
Demand 200,000 120,000
While it is reasonable that more items will be sold at CU9.90 than at CU27,
these figures are based upon 'little more than a guess'. Appropriate market
research is needed to establish a more precise relationship between price and
demand (i.e. price elasticity), including the impact of marketing.
This is likely to take the form of field research (e.g. sample

testing, test marketing, experimentation, trial testing) as it is a
new product.
 Once a more precise demand relationship is established, there are two
reasons why the two suggested prices may be inappropriate. 

(1) They are not at the point on the demand curve that maximises profit (i.e.
there are other prices which generate a greater profit).
(2) The suggested price and demand may not be on the demand curve at all.
Thus there will be unsold inventory (i.e. if the price is too high and thus the
suggested price-quantity combination is above the demand curve) or
shortages (i.e. if the price is too low and thus the suggested price-quantity
combination is below the demand curve).
 The estimates of costs are also dependent upon the expected volume of output with respect to
allocations of fixed costs. 

In the case of Option 2, there are both fixed production costs and fixed marketing costs. If
demand, and thus production, is lower than expected, then cost per unit will be higher than
expected. 

In the case of Option 1, if sales and production volumes are lower than expected, at the suggested
price of CU9.90, then fixed cost per unit will rise and thus total cost per unit will rise. Given the
use of the cost plus pricing formula, this will have the effect of increasing the selling price (by the
cost increase plus 10%). However, given a downward sloping demand curve, sales volume will fall
again, fixed costs will again and thus price will need to rise again in a continuing, yet unsustainable,
spiral. 

 There are much greater fixed costs with Option 2 than Option 1 as incremental fixed production
costs are more than double that of Option 1 and there are also significant fixed marketing costs. As
a result, operating gearing and thus operating risk are higher with Option 2. The higher level of
profit therefore needs to be considered in the context of increased risk. 

 The pricing policy needs to be appropriate to the wider marketing strategy. A low price may
penetrate the market, but it also sends a signal about the quality of the product. Once established
as a down-market perfume in Option 1, it would be difficult to improve its image and increase the
price later. 

 After 20X3 there will no longer be surplus inventories of one of the ingredients. This would
increase the cost, and thus reduce the profit, of both options by CU50,000 from 20X4 unless this
can be passed on by a price increase. 
Product
In the marketing mix 'product' refers to the quality of the product as perceived by potential
customers. This relates to the product's suitability for its stated purpose, including aesthetic factors,
durability, brand, packaging and associated services.
What is particularly important is not how well these factors are satisfied as such, but how they
compare with the key competitors in the market niche selected. In this context the competitors are
likely to be rather different for Option 1 and Option 2.
With respect to the product itself, CC has little expertise in perfume production and may thus lack
the core competences of competitors in producing an appropriate smell, appearance and packaging.
Nevertheless, the test of this will be in consumers' reaction to the product; this could be revealed in
anonymous market testing.
As important as the actual quality of the product itself, is consumers' perception of quality. This will be
influenced by other aspects of the marketing mix (level of price, advertising, type of outlets) but also by
the product.

 Packaging – this needs to be appropriate to an up-market image (Option 2) or to convey value
within the context of a lower market sector (Option 1). 

 Aesthetics – in most products this would normally include smell as a peripheral concern but, in
the context of perfume, this goes to the core of the product. Other aesthetic factors might
include the appearance of the liquid and the bottle. 

 Mix – context within a range of products. If CC does not have other complementary products with
the same fragrance, it may be less acceptable to consumers (e.g. matching, lotions, soaps, cosmetics,
shampoos etc). It is not clear that its existing toiletries range achieves this. 

 Branding – the brand of Citron is more associated with low to mid market toiletries. It may therefore
be unacceptable to use Citron in Option 2, which would require an up-market brand image to
compete effectively. This may mean inventing an entirely new brand, rather than one which uses the
company name of Citron, but this may be preferable to an inappropriate brand. Under Option 1,
however, the Citron brand may be appropriate to the target market niche. 
Place (distribution)
Supermarkets may be appropriate to Option 1, but they are unlikely to be consistent with the up-
market brand image intended with Option 2. Alternative means of distribution may therefore need
to be found.
The right distribution channel may actually enhance the up-market image of the product (e.g. an
up-market store selling up-market perfumes).
Unfortunately, the company may not benefit from economies of scope with Option 2 if it uses
a different type of store to sell 'Potion by Citron', as it will be unable to take advantage of
common distribution channels with its toiletries products.
Other channels may be considered such as mail order, Internet selling, direct selling, perfume
parties through agents.
With Option 1, the advantage of cost, reputation and relationships can be gained by using existing
supermarkets as distribution channels, although additional customers may be considered for 'Potion
by Citron'.
Promotion
Promotion is about communication – informing consumers about the product and enhancing
their perception of the product in a manner that persuades them to buy it.
Promotion needs to be to the consumer (the ultimate user) but also to the customer (the
purchaser of the goods from CC, such as a supermarket).
Customer
In terms of promoting to the customer there may need to be a much greater effort under Option 2
in order to establish an up-market brand image (and perhaps establishing a new brand). Under
Option 1 there may already be customer acceptance of CC products in the lower market range.
Promoting to the customer may include discounts (e.g. for quantity, initial penetration, to
favoured outlets).
Consumer
In terms of promoting to consumers there is a range of methods including advertising;
sponsorship, offers, discounts.
Advertising is likely to be the most important means of sales promotion for 'Potion by Citron'. If the
brand is to be up-market (i.e. Option 2), this needs a significant marketing effort to promote this
image, because other Citron products are down-market. If a new non-Citron brand is to be used
then, similarly, a greater initial marketing effort will be required, reflected by the use of outside

marketing specialists and a significantly larger marketing budget than for Option 1.
In either case, however, significant up-front advertising expenditure is needed to promote a new
product. It normally takes significantly more resources to establish a new brand image than to
maintain it. Nevertheless, the corollary of this is that the front-end costs incurred in advertising in
20X3 may have enduring benefits.
Market research may reveal a particular market segment where 'Potion by Citron' most appeals
in terms of its attributes, image and appearance. This may mean that more effective advertising
could take place as efforts could then be targeted using a segmentation strategy. This may of
itself help to determine whether Option 1 or Option 2 has more appeal to the largest market
niche.
Recommendations
Recommendations are likely to depend on the results of further market research revealing:

 Consumers' response to the fragrance 

 Consumers' response to the brand 

 Consumers' likely response to advertising 
 The price that consumers would be willing to pay, given the above factors. 
Notwithstanding the above, Option 2 is an entirely new departure in which:
 The existing brand is likely to be entirely inappropriate 

 There is limited existing core competence in manufacturing this type of product 

 There is very limited existing core competence in marketing this type of product 

 Significant competition already existing in the many designer perfumes already on the
market with valuable brand reputations. 
It seems, therefore, subject to significant doubt as to whether Option 2 can gain a sustainable
competitive advantage. Thus, despite yielding the greater short-term profit according to the finance
director's initial estimates, its adoption would probably not be recommended.
As a result, Option 1 appears to be much more favourable as being within existing market experience
although, even here, it is a new departure where price and marketing will need to be carefully
considered.
25 Chibb Ltd
Chibb Ltd is a company listed on the London Stock Exchange, with a year-end of 31
December. Chibb manufactures and retails fine china tableware at the upper end of the
market, operating through two divisions, the manufacturing division and the retail
division.
The manufacturing division sells exclusively to the retail division with no external sales. The
manufacturing site is at one factory in South Wales which has several processes for making
and painting its range of china tableware.
Similarly, the retail division purchases only from the manufacturing division. It operates from
shops located throughout the UK, normally sited in large towns and cities. The transfer price
between the two divisions is set at the retail selling price minus 30%.
The fine china industry has suffered a decline in sales in the past few years. However, the
performance of Chibb has been particularly poor, with a sharp decline in its sales, profits and
share price over the last year. As a result, a meeting of the directors was called.
The board meeting
Chairman: 'This situation cannot go on. The company is under-performing in terms of

profitability and share price. What we need are some key measures of performance and a means
to improve performance.'
Finance director: 'I agree, but what we do not know is which division is under-performing,
as the transfer price between them is arbitrary. What we need is to set transfer prices based
upon market values – then we will see which division is the problem. I have provided some
projections for the year to 31 December 20X4.' (Exhibit 1).
Managing director of retail division: 'How can we set a transfer price based upon
market prices? We only buy and sell from each other, which is the whole point of our
strategy of protecting the brand by keeping it in-house throughout the supply chain. While
competitors' products may be similar, they are not identical, and thus there is no readily
observable market price. I vote that we stay with the current system but also look at non-
financial measures of performance.'
Managing director of manufacturing division: 'We need a fair transfer price that
ensures both divisions make a profit. If the company makes a profit, we both contribute to
it and we should therefore both share it.'
Chief executive: 'I think the problem is that we do not know whether we are a
manufacturer or a retailer. Perhaps we should just concentrate on one or the other. I think
we should use benchmarking to determine which division is performing well relative to
standards set outside the company. We can then use the knowledge we get from
benchmarking to improve performance or, if not, divest ourselves of that part of the business.'
Exhibit 1 – Projections for the year to 31 December 20X4
Manufacturing Retail
division division
CUm CUm
Estimated retail sales – 24
Variable costs 8 3
Fixed costs 10 2
The above figures exclude the cost of goods transferred between the two divisions.
Requirements
(e) Using the figures provided in Exhibit 1 determine
(i) The expected profit or loss to be made by each division in the year to 31
December 20X4, assuming transfer prices are set on the existing basis of
retail price minus 30%
(ii) The transfer pricing formula (i.e. the retail price minus a specific profit percentage), which
would
enable the manufacturing division to break even in the year to 31 December 20X4. (6
marks)
(b) Examine the benefits and problems of Chibb using transfer prices based on retail price minus a profit
margin. Refer to your calculations above where appropriate. (6 marks)
(b) As an external consultant, write a memorandum to the board of Chibb which evaluates the
comments made at the board meeting with respect to divisional performance measurement and the
potential divestment decision. Use each of the following headings:
 Profit based divisional performance measurement 

 Non-financial divisional performance measurement 
Benchmarking 
 Closure of a division – relevant criteria. (18 marks)
(30 marks)

25 Chibb Ltd
Marking guide
Marks
(a) Profit/loss calculation 3

Transfer pricing formula 3
6
(b) Benefits 2
Problems 4
6
(c) Profit divisional performance measurement 5
Non-financial divisional performance measurement 4
Benchmarking 5
Closure of a division – relevant criteria 4
18
30
(a) Profits and losses

(i) TP set on existing basis
Manufacturing Retail
division division
CUm CUm
Estimated retail sales – 24.0
Estimated internal sales/purchases 16.8 (16.8)
Variable costs (8.0) (3.0)
Fixed costs (10.0) (2.0)
(Loss)/profit (1.2) 2.2
(ii) TP set on break-even basis
Sales needed to break even = CU18m
18 ÷ 24 = 0.75
Thus transfer price to enable manufacturing to break even is retail price minus 25%.

(b) Problems and benefits
Problems
The use of retail price less a profit percentage as a method to set selling prices has a
number of problems.
 It is not clear how the profit margin is determined. 

 No apparent attempt is made to determine a market price for the goods at the
point in the supply chain relating to internal transfers. 

 The price appears to be imposed by head office, rather than negotiated by the parties; thus
autonomy is damaged as is any attempt to measure the performance of the divisions, or their
managers, using a profit based performance measure (e.g. absolute profit, residual income,
ROI). 

 The transfer price does not affect overall profit in the short term as the total company profit
is the same. It may, however, affect motivation and thus influence overall profit in the longer
term. 

 There is no effective measurement of divisional performance, given that the arbitrary
nature of the profit margin means an artificial selling price for the manufacturing
division and an artificial purchase cost for the retail division. 

 The retail division controls the ultimate retail selling price and thus can, to a large
extent, determine the transfer price. Thus, if it lowers its selling price to increase
sales, the manufacturing division would suffer 80% of the price cut without any
control. 

 Moreover, if retail prices are volatile then the transfer price may be difficult to
determine at the time of transfer. 
Benefits
 There is an incentive to cut costs for each division – unlike cost plus. 

 The transfer price is derived from an externally determined market price. 

 If the profit margin has been based upon that applying in the outside market (after
adjusting for difference in product, service and delivery) then it may be a reasonable
measure of performance. The margin would, however, need to be kept under constant
review to ensure it is in line with market conditions, rather than being fixed in the long
term. 

(c) Memorandum
To: The Board of Chibb
From: External
Consultant Date: 11
June 20X3
Subject: Divisional performance measurement and management
Profit based divisional performance measurement
As noted in Appendix A (i.e. part (a)) the arbitrariness of the transfer pricing formula makes
the profit of each division artificial, and thus weak as a measure of performance. However, any
other basis for setting transfer prices would suffer similar problems unless a market price can
be determined.
Even so, using profit to measure the divisional performance of Chibb would have problems. If
the market price could be determined, it would still need to be imposed by head office as a
transfer price as there is no actual trading with the outside market in terms of transfers (i.e.

the manufacturing division does not sell outside the company and the retail division does not
purchase inventory from outside the company).
While the price may be set in terms of market rates, the volume of business is determined by
retail division and yet affects the performance of the manufacturing division as well. Thus if
retail division determines an inappropriate selling price, or fails to market the product
properly, then sales volumes would fall and the manufacturing division would also suffer as
fixed costs per unit would rise – indeed, due to higher operating gearing, it would suffer more
than the retail division.
Profit measures (including those measures derived from profit such as residual income and ROI) only
measure short-term performance, and historic performance at that. While this may be appropriate for
some purposes, it is more important that long-term wealth is created. In this case, however, the fall in
the share price would indicate that the stock market’s assessment of long-term wealth is falling just as
profit is falling – though not necessarily to the same extent.
Measuring performance involves not only measuring divisional performance but also managerial
performance. In this case the key element is controllability. It is clear that an imposed transfer price
does as little to meet this criterion of measuring the performance of managers as it does to measure
the performance of the divisions that they operate.
The suggestion of the MD that the transfer price should be set on the grounds of fairness is inappropriate
in assessing the performance of the two divisions. It is not appropriate to set a transfer price, on the
grounds of fairness, that creates an artificial profit for an under performing division that is damaging the
performance of the company as a whole.
Given the problems of setting transfer prices, the use of profit centres to measure divisional
performance may be inappropriate. The manufacturing division could become a cost centre and its
performance could be based upon cost targets.
Non-financial divisional performance measurement
In order to obtain the broadest possible measure of performance the company should use as wide a
range of measures as possible, both financial and non-financial. Non-financial measures can include the
following:
Manufacturing division
  Number of new products developed 

  Employee turnover 
  Returns inwards from retailing division 
  External recognition of achievements 
 Speed of supply to retail division. 
This is an approach for linking performance measurement systems to broader strategic goals by first
identifying the crucial elements of the firm's business strategy. These are critical success factors (CSFs)
which are 'those components of strategy where the organisation must excel to outperform competition.
These are underpinned by competences which ensure this success. A critical success factor analysis can
be used as a basis for preparing resource plans.'
The attraction of the approach lies in the fact that it provides a methodology for identifying strategic
goals (or CSFs) by basing them on the strengths, or core competences, of the firm. These are
implemented though the development of KPIs which give milestones in the processes for delivering the
CSFs.
One tool by which this can be achieved is the balanced scorecard. This includes multiple performance
measures based on financial and non-financial criteria. They employ the methodology of CSFs and KPIs to
measure objectives and targets. The four perspectives used by the balanced scorecard are:
  Financial 
  Customer 
 Innovation and learning 


 Internal business. 
Benchmarking
Benchmarking can be defined as 'the establishment, through data gathering, of targets and
comparators, through whose use relative levels of performance (and particularly areas of
underperformance) can be identified. By the adoption of identified best practices it is hoped that
performance will improve.'
The problem with accounting indicators such as profit, is that they are of limited use in steering a
company, e.g. they may indicate to what extent a fall in revenue is due to a fall in sales volume and
how much to a fall in price. They do not indicate why people are less inclined to buy Chibb's
product or are now only prepared to buy it at a lower price.
The purpose of benchmarking is to help management understand how well the firm is carrying out
its key activities, and how its performance compares with competitors and with other organisations
who carry out similar operations.
(a) Internal benchmarking: These are other branches within the same organisation. The basis of
this approach is to identify which branch conducts each measured activity the best, to enable
best practice to be identified and transferred to other branches. For retailing division this may
be the best performing shop. For manufacturing division it could be the most efficient process.
(b) Competitive benchmarking: This involves comparing performance with rival companies.
This presents problems with data access and hence is usually carried out through a
benchmarking centre. This will be 'a central authority' – such as an industry association. It will
collect data from each participant then supply an analysis to each firm showing its relative
performance against the 'best in class' under each activity as well as its overall relative position
in the industry. This requires identification of a similar company but would indicate best
practice as to what could be achieved under difficult industry conditions.
(c) Activity (or process) benchmarking: The firm may share operations in common with non-
competitor external organisations which might be 'best in the class' for a particular function.
This might include inventory management, manufacturing processes or customer service.
(d) Generic benchmarking: This is benchmarking against a conceptually similar process. It is
unlikely that this will result in comparison of detailed measures, e.g. with respect to glazing
pottery it could be that high temperature paint technology could be used from the chemical
industry. For the retail division it could be that employee training could draw upon the
practices of accounting firms!
The point is that benchmarking is not solely a means of measuring performance relative to a best
performing unit – although it fulfils this function. It is also a means of identifying why the best
performing units have achieved this and thereby attempting to implement this in the other areas of
the business.
Closure of division
To some extent division closure would represent an extension of performance measurement, as
it would be based upon an assessment of inadequate performance. There are, however, some
further considerations depending upon which of the two divisions was being considered for
closure.
A key problem would be the interdependencies between the two divisions. For example, if the
manufacturing division were closed, then the key core competence of the retail division could also
be lost in terms of access to the unique resource of Chibb products.
Similarly, if the retail division were closed if would be necessary for the manufacturing division
to establish retail outlets willing to stock its goods and pay appropriate prices for them.
Other considerations include the following:

 Strategic implications of closure in terms of protecting the brand throughout the supply chain 

 Sunk costs locked into the divisions, i.e. how much would be earned by a sale of assets or as
a going concern 

 Ability of external replacement to add as much value as internal function closed 

 Whether the decision is irreversible 

 Whether the decision can be delayed until a more informed judgement can be made 

 Whether the resources generated by divestment can be usefully redeployed by the
remaining division. 
26 Fizzical Ltd
Note: Assume that the current period is September 20X6.
Fizzical Ltd ('Fizzical') is a company that manufactures and distributes soft drinks in the UK.
Industry background
The soft drinks industry is divided into three main areas. Carbonated and non-carbonated flavoured
drinks, fruit juices, and bottled mineral water. Overall sales of such products increased by 47% between
20W5 – 20X5, because of increased consumption of bottled water and fruit juices. However, flavoured
drink sales have been falling since 20X3. This is mainly due to increased consumer awareness of the health
risks associated with products high in sugars. Many companies in the industry introduced No Added Sugar
('NAS') products to sit alongside their original drinks. This has halted the decline in flavoured drinks, as
consumers switched from sugar to NAS products.
The industry is dominated by two large American companies, Inca Cola ('Inca') and Simply Cola ('Simply').
Both these companies have products across the whole range of soft drinks, but are best known for their
Cola-based products which are global brands supported by marketing budgets of around CU1.5 billion
each around the world. A lot of this marketing is in the form of television advertising, and sponsorship of
national sports competitions.
These companies also control most of the vending machine market in the UK which are used to sell
soft drinks. Vending machines were originally introduced into workplaces, but since 20X1 Inca and
Simply started to market their machines to schools. A school makes on average CU2,500 per year
commission from allowing these machines on their premises, with Simply and Inca making profits on
each unit sold. Over 90% of sales from vending machines are carbonated flavoured drinks. Both
companies have been reluctant for third party products to be sold in their vending machines.
Inca and Simply have both been criticised for their attitudes towards the environment and staff.
Both companies have a reputation for transferring production to least cost countries in order to
maximise profits.
Recent industry developments
In March 20X6 a government sponsored report into childhood obesity reported that the current
generation of children born in the UK would for the first time have a life expectancy that was lower
than that of their parents. The report recommended that sales of flavoured drinks, confectionery and
other products high in sugar and salt content be banned from school premises. These should be
replaced by yoghurt drinks, fruit juices and water. In addition all television advertising for products that
are of little nutritional value should be banned before 9pm, in an attempt to reduce the exposure of
children to such products.
The bottled water industry has been criticised for selling a product that is not significantly different from
tap water, which in the UK is safe to drink, and for the environmental cost of large number of plastic
bottles that are used to sell the product. Furthermore, when Simply tried to break into the UK bottled
water market in 20X2 with its well known brand Aquaice, it was revealed that the company was merely

selling tap water which had been purified, rather than mineral water from a natural source. The company
was forced to withdraw the product after a public outcry. There are also fears that supplies of mineral
water would start to run out, especially in the UK, where some areas of the country have been
experiencing low rainfall for a number of years.
Company background
Fizzical was founded in 1904, in Cardiff, Wales, selling 'health tonics' to consumers, before introducing
a mixed fruit carbonated drink, Zestiva, in 1931. The recipe of Zestiva is only known by two people at
Fizzical, Clare and David Pritchard, who are both related to the original founders of the company.
Clare and David own 76% of the share capital of Fizzical, and are board members. Zestiva consumers
tend to be older than for other carbonated drinks, as the less sweet taste and the children focused
marketing of rivals have resulted in younger consumers preferring different brands.
Sales of Zestiva have been slowly falling for some time and the company has 3% of the total UK soft
drinks market in 20X5, although the share is about 6% in Wales, as it is seen as a local product. The
company has followed industry trends in introducing new versions of the product, such as a NAS and
non-carbonated, in an attempt to maintain market share. These efforts have slowed down the decline
in sales, but the overall trend is still negative. The NAS version of Zestiva now accounts for over 40%
of sales. Zestiva is currently only sold in the UK as Fizzical has no experience of foreign markets.
Fizzical has not tried to compete with the huge marketing budgets of Inca and Simply, but has always
aimed to sell their product at about 5 – 10% below the price of the larger companies. Most sales are
made through small retailers and supermarkets.
In 20X4 Fizzical entered the bottled water market with a brand called 'Red Dragon', produced from
a natural spring which has a high mineral content, on land that has been owned by the Pritchard
family for many generations. Wales has far higher rainfall than the rest of the UK and there is no
evidence that supplies will diminish, even if production is increased. Water from the spring is
currently used as a component in Zestiva, and contributes towards the unique and slightly bitter
taste of the product. The spring water also contains natural, but legal, stimulants that help maintain
alertness and concentration. This has resulted in Zestiva being popular with students and late night
revellers.
Fizzical's production facilities are based in a part of Wales that suffers from high unemployment.
Many employees have been with the company for long periods of time, and the company has always
prided itself on good staff relations.
The board meeting
At a board meeting in August 20X6, Clare and David advised the other directors that they wanted
to change the business as they feel that it could not continue in its present form in the long term.
They were uncertain whether there is a future in the industry for a small company such as Fizzical.
They have appointed consultants who have suggested two alternative courses of action.
Option 1 – enter into an arrangement with Inca, which has expressed interest in Zestiva, so that
Zestiva can be sold overseas. This deal could include Zestiva being included within the Inca product
range for vending purposes. Clare is however concerned about losing the independence of the
company.
Option 2 – introduce a marketing campaign to make consumers aware of Zestiva outside of the UK
prior to an overseas launch of the product.
Requirements
You are a newly qualified chartered accountant working on secondment from the auditors of
Fizzical and have been asked by the board to review the above information and undertake the
following:
(a) Prepare a Porter's Five Forces model for the whole UK soft drinks industry. (11 marks)

 Identify and explain Fizzical's competitive position using Porter's Generic Strategy Model. (5 marks)
 In respect of Option 1, advise the board on the advantages and disadvantages of an
arrangement with Inca. Describe the different types of relationship that could exist between
Fizzical and Inca, and whether such relationships would affect Clare's concerns and relations
with staff and consumers.
(9 marks)
(d) In respect of Option 2, suggest how Fizzical could exploit some of its critical success factors to
form the basis of a successful marketing campaign for Zestiva outside of the UK. (7 marks)
 During the course of your review, you accidentally are copied into an e-mail from Clare to David
Pritchard. The e-mail reveals that one of the ingredients used in the NAS version of Zestiva contains
a compound that is ten times more harmful to teeth than sugar. Clare suggests in the e-mail that
because only David and herself know the exact recipe for the product, they should not reveal this
potential problem to the rest of the directors.
Describe the ethical issues to consider in relation to the discovery of the contents of this e-mail.
(6 marks)
(38 marks)
26 Fizzical Ltd
Marking guide
Marks
(a) New entrants 4

Substitutes 1
Suppliers 1
Customers 3
Competition 2
11
(b) Porter's Generic Strategy Model 5
(c) Advantages 2
Disadvantages 2
Relationships 5
9
(d) Product-based CSFs 3
Market-based CSFs 4
7
(e) Personal 2
Directors 2
Corporate 2
6
38
(a) Porter's Five Forces for UK drinks industry

New entrants
There are significant barriers to entry for new entrants. The high level of marketing spending by the
two market leaders means that they have significant brand loyalty for their products. Any new entrants

will therefore have to invest heavily in advertising spending to build up awareness for their products.
Economies of scale are likely to exist in the form of raw materials such as carbon dioxide for
carbonated drinks, fruit supplies bottling and canning operations.
Significant capital expenditure on bottling, product design (for flavoured drinks) and access to mineral
spas will further reduce the number of companies who can afford to enter the market.
The existing producers have control over the vending market, which is one part of the distribution
chain. They are also likely to have contracts with the main supermarkets to supply them with a range
of drinks.
The market is relatively unregulated, but government initiatives in relation to vending machines and
schools will reduce demand for flavoured drinks, so making this market unattractive to new entrants.
The position is reversed however in relation to NAS and mineral water.
Overall the threat from new entrants is low.
Substitutes
There are some substitutes for soft drinks, such as tap water and milk. Potentially there is a threat
from yoghurt drinks too. Within the existing soft drink market there is likely to be further substitution
away from flavoured drinks towards bottled water and NAS products.
Overall the threat from substitutes is moderate.
Suppliers
The only raw material that appears to be in short supply is that of mineral water. However, it
is unlikely that individual owners of water springs would be able to command higher prices as
the large producers in the soft drinks industry have more power.
Overall the threat from suppliers is low.
Customers
Individual consumers have little power as they buy minute amounts compared to the whole
market. However, the collective movement towards more healthy options means that the
industry needs to monitor changes in demand.
Supermarkets are a bigger threat, in that they can make or break individual products via their
purchasing methods and can negotiate bulk discounts from producers. If one of the
supermarkets were to take the moral high ground and refuse to stock 'unhealthy' products
then the industry might be struggling for an outlet for some of its goods.
Schools are one customer area which would appear to be a problem due to the government
decision to ban high sugar content products from school premises. There is scope here for
the industry to respond by focussing on more healthy options.
Because the vending machines are controlled by companies within the industry there is little
danger of not being able to supply goods using this distribution method, other than finding
suitable locations in which to place the machines.
Overall the danger from customers is moderate.
Competition
The move towards more healthy drinks is a double edged sword as far as the industry is
concerned. There is likely to be some loss of sales of sugared flavoured drinks, but this can
be absorbed by NAS products, fruit juices and bottled water.
Yoghurt drinks are a possible threat, but do not seem to have a significant market share at present.
If there is a backlash against bottled water on environmental grounds, then there could be a
switch back to tap water, which would reverse a significant driver or increased sales over recent
years.

 Porter's generic strategy position
Fizzical appear to be taking a focus based approach within the generic strategy model. 

This occurs when a particular market sector is targeted by a manufacturer. 

This is evidenced by Zestiva being popular with an older part of the demographic
market, and also the fact that Fizzical is seen as being a Welsh company employing
local employees. 

Within the focus approach Fizzical has managed elements of both differentiation (in
terms of taste) and cost focus too (by selling below the price of the global players). 

Fizzical can therefore seen to carve a reasonable niche position by being seen to be different. 

 Advantages
Could be included in deals that Inca sign with supermarkets, and so gain a more
prominent place alongside Inca's products. 

Potential for increased marketing spend on Zestiva, with economies of scale on
marketing costs being generated as Inca already has a large budget in this area. 

Access to new customers both overseas and via vending machines. 
Disadvantages
 Potential loss of local Welsh customers, who might see Zestiva as no longer being a local
delicacy. Inca may put pressure on Zestiva to be sold at a higher price to bring it in line with
Inca's existing product range. 

 Inca may gain access to the secret recipe for Zestiva. 
Types of relationship
Clare and David could sell their shareholding in Fizzical to Inca, and thus transfer all
responsibility and control over the business to the new owners. Such a policy would cause
employees to fear that production of Zestiva may be moved overseas to a cheaper production plant,
or merged with Inca's existing production facilities in the UK. Zestiva appears to have strong local
support amongst consumers, and this may be lost. 

A joint venture could be formed with Inca. This would potentially involve the creation
of a separate company, with ownership and decision-making shared between Fizzical and Inca. This
would allow Fizzical access to Inca's expertise in marketing soft drinks to a wider audience, whilst
retaining some independence. This is likely to placate both employee and consumer groups. There is
a danger of Inca and Fizzical disagreeing over how to promote Zestiva, and a method of resolving
such disputes should be embedded in the contract. 

Fizzical could give a licence to Inca to sell Zestiva overseas. This would have the
benefit of production remaining in Wales, and an extra revenue stream being generated from the
licensing income. The licence could be for a fixed period of time, with an option for renewal if it
suited both parties. 

Inca could act on an agency basis for Zestiva overseas and in those parts of the UK
where sales are weak. However, Inca is unlikely to promote Zestiva over its own products, so this
relationship is not one that could be recommended. 

 Critical success factors and marketing
The main CSFs in relation to Zestiva are taste, the unique recipe and the fact that the
product is popular with a different age group to its competitor products. 

This gives Fizzical some intellectual resources that its competitors do not possess. 

In addition the product has a relationship with local consumers which exploits its

Welsh heritage and access to spring water that is used in the production process. 
This could be used in a marketing campaign for Zestiva as follows:
 Product: Emphasise the unique taste and recipe of Zestiva, and also the fact that it is a local rather
than global product. This is likely to appeal to consumers who want something that is less generic
than many soft drinks.
 Promotion/Place: Because Zestiva is currently popular with older consumers, consider targeting
places that this age group tends to use, such as magazines, universities, pubs and clubs. Also
consider sponsoring some television programs that such an age group is likely to watch. Emphasis
could be placed on the range of Zestiva products that cater for all needs. Fizzical could also use
some Welsh celebrities to promote the Zestiva brand as one that is part of the heritage of the
country.
 Price: To gain a foothold in new markets, consider 'Buy One Get One Free' offers and free
samples at targeted outlets.
(e) Ethical issues
Personal ethical issues
 As a chartered accountant you have a responsibility to follow the ethical code of
the ICAB. However, as you are on secondment to the client, you also have a duty
of care to the company. Whether this duty of care extends to the customers of
Fizzical is less clear. 

 Just because a product is labelled NAS does not mean that it is healthy for
consumers, and so there could be justification for non-disclosure of the
information. 

 The first thing you should do is discuss the matter with your manager at the firm of
accountants where you work, and then contact the ICAB ethical department for
advice. 
Directors' ethical responsibilities
 The fact that Clare and David are aware of the potential problem is a governance
issue, and the fact that they are keeping it secret from the remainder of the board is
a breach of their duties to the company as a whole. 

 Clare and David have not however, done anything that appears to be illegal. There is
a difference between breaches of legislation and activities that appear to be
unethical. 
Corporate ethical responsibilities
 As a company Fizzical has a responsibility towards its customers and their
wellbeing. Many corporate entities do have a code of ethics which covers all
stakeholders. Although the other directors are unaware of the issues relating to the
ingredients in the product, it could be argued that this is due to poor internal
controls, which should identify issues of this nature. The responsibility for
maintaining a system of internal controls lies with the board as a whole, and so they
could be collectively responsible for the failings to identify any health related
concerns. 
27 MicroKleen Ltd
Note: Assume that the current period is June 20X2.
MicroKleen Ltd (Micro) provides sterilisation services to hospitals, mainly in London and the South East of
England. The company recently floated on the Alternative Investment Market and has a market capitalisation of

CU30 million. Significant new capital was raised at the time of flotation to finance further expansion.
Industry background
The largest hospitals build and operate their own sterilisation units. However, many smaller hospitals have
neither the resources nor the necessary volume of activity to make such a unit viable. They therefore need to
contract-out sterilisation services. The process of contracting-out is priced by competitive tendering.
Sterilisation services have become particularly important amid growing concerns about hospital-spread
infections resistant to treatment. This has meant an increasing use of contracting-out sterilisation
services by hospitals, and thus a strong growth in this market over the past few years.
Until recently there were four major private sector sterilisation companies in the UK, including Micro.
A new company of similar size to Micro has, however, recently entered the industry, encouraged by the
growing market.
Company strategy
Micro currently has outsourcing contracts with 60 hospitals, generating a total annual revenue of
CU14 million. These contracts have an average of four years remaining. Competition is, however,
growing, making it increasingly difficult to win new contracts and earn a profit on them. Nevertheless, the
company's business plan has estimated significant future growth, based upon an expanding market and
sustaining its historic 30% success rate in winning outsourcing contracts.
In order to satisfy anticipated extra demand, the company intends to build four new 'clean rooms'
at CU500,000 each to provide on-site sterilisation of equipment in hospitals.
A new opportunity
Micro was approached in March 20X2 by a group of 20 Russian hospitals, based in and around Moscow, to sign
a six-year sterilisation contract. No contract has yet been signed, but the marketing director has carried out
some initial negotiations and is keen to proceed. He argues: 'We can take advantage of the low labour costs in
Russia and it will also give us a foothold in Eastern Europe that can be exploited in future'.
Other sterilisation companies have not shown an interest in the contract, and thus it would not be
possible to establish a price by tendering. Instead, the use of actual full cost plus 10% is being suggested for
the contract price.
In determining the contract price, the basis of allocating fixed overheads between the UK and Russian
contracts is undecided. Preliminary negotiations have suggested that either labour cost or labour
hours would be an acceptable basis for charging overheads.
Cost estimates for the first full year of the contract are as follows.
UK Russian
Variable costs
Labour CU3.2m CU0.4m
Other CU4.0m CU1.2m
Labour hours 480,000 240,000
Annual fixed overheads for the company will total CU7.2 million if the Russian contract
is accepted, but only CU6.2 million if it is rejected. Revenue from UK operations can be
assumed to remain at CU14 million.
Requirements
 Use a PEST analysis to assess Micro's business environment in both the UK and Russia, explaining the
significance of each factor. (11
marks)
 Using full cost plus 10%, calculate the profit on the Russian contract and on
UK operations, assuming total fixed overheads are allocated under each of the

following alternative assumptions:
(g) Labour hours
(ii) Labour costs. (6 marks)
(e) (i) Comment upon the reasons for the differences in the two calculations in (b) above
Examine their implications for pricing the Russian contract
Assess the viability of the Russian contract.
In so doing, identify the benefits and problems of actual full cost plus pricing in
the circumstances of the Russian contract, suggesting alternative methods of
pricing. (12 marks)
(d) Assuming that the Russian contract is accepted, write a memorandum to the
directors of Micro which assesses:
(i) The risks of the Russian contract
(ii) Micro's competitive position in both the UK and Russian markets. (12
marks)
(41 marks)
27 MicroKleen Ltd
Marking guide
Marks
(a) Political 3
Economic 3
Social 3
Technological 2
11
(b) Labour hours 3
Labour costs 3
6
(c) Reasons for differences 2
Implications 2
Viability 3
Benefits, problems, alternatives 5
12
(d) Risks 5
12
41
(a) PEST analysis

Political/legal
UK operations
Public expenditure on the NHS may be uncertain in future, depending upon the political will of
different parties. This may affect the ability to pay for non-core services such as non-essential
sterilisation.
Public sector policy may influence the trade-off between in-house sterilisation where employees would be

public sector, or outsourcing to the private sector.
The risk of infection may give rise to litigation from patients. This could include private sterilisation
firms acting for the NHS.
Health and safety regulations are likely to be significant, causing additional costs if they are tightened.
This could relate both to the standard of sterilisation and to employee safety.
There is a tendency to increase the size of hospitals while reducing their number. This would reduce
the number of small hospitals outsourcing sterilisation services and increase the number of large
hospitals providing in-house sterilisation.
Russian operations
There is continuing political uncertainty in Russia whereby laws governing health and foreign
investment may be subject to significant change.
There may be political pressure to source as many inputs as possible from local suppliers.
Rules governing the conversion and repatriation of funds may be uncertain in the absence of a liquid
foreign currency market.
Work permits may be necessary for UK residents working in Russia. This may restrict flexibility in the
use of UK management.
Economic
UK operations
The growth of GDP in the UK economy will partly determine the available public sector funds out of
which health expenditure can be met. This will, in turn, affect the ability to pay all health suppliers,
including sterilisation services.
Taxation policy will similarly affect the funds available for health services.
Russian operations
The exchange rate between the UK and Russia will affect the values of both cost and income streams.
To the extent that these are both in roubles any effects may cancel out each other. However, if the
price set in the contract is in terms of sterling, there may be exchange rate risk if the rouble changes in
value against the pound. Similarly, some costs of the Russian contract may be incurred in the UK, and
thus in sterling.
If the Russian economy declines there may be less ability to pay for health expenditure.
Conversely, if the Russian economy grows there may be competitors willing to tender when the
current contract expires. These may be from within Russia or elsewhere in Europe.
The willingness of Russian governments over time to spend tax revenues on health may vary, causing
significant uncertainty.
Heading Heading
CU CU
Type here 1,000 1,000
Social
UK operations
There appears to be growing demand for health services in the UK. This creates an expanding
market for sterilisation services.
Public concern over health and safety has created a growing awareness of hospital-
generated infections. To the extent that this culture puts pressure on hospitals, it may
increase the range of items sterilised and the required quality of that sterilisation.

The balance between private and public sector health service providers may change over time.
The current market for Micro appears to be within the NHS, and the growth of the private
sector may be a potential threat unless it can extend into this market.
Employee social and welfare costs tend to be increasing over time and, given the high
proportion of labour costs in the cost structure, this may be an issue for concern.
Russian operations
There may be 'home bias' to have health contracts provided by Russian contractors to
maximise local employment.
There may be an insufficient pool of appropriately skilled labour for some tasks.
The culture and attitude to work may vary between the UK and Russia, creating different
managerial problems and work procedures. Part of this problem may be created by the background
of lower pay.
Public attitudes to health, safety and to an acceptable risk of infection may vary between
different cultures.
Technology
UK operations
The increasing incidence of resistant 'superbugs' may be both an opportunity and a threat. It
may be a threat as sterilisation needs higher temperatures or longer periods of treatment,
thereby increasing costs. Conversely, if the process becomes more specialised, then there may
be an increasing use of outsourcing, as more hospitals may be unable to provide the
technology to cope with the new demands.
Advances in medical science may mean that the quality and quantity of medical equipment may
change over time. This may require different sterilisation procedures.
Changes in technology mean that advances in sterilisation equipment are likely to take place.
These will probably involve cost and efficiency improvements for a given level of service.
Russian operations
Technology available locally that cannot be imported from the UK may be of a different
standard or type.
If land is available more cheaply in Russia, then there may be more space available to
accommodate different types of machinery and work practices.
 Full cost plus
prices Using
labour hours
UK Russia
Variable costs CUm CUm
Labour 3.2 0.4
Other 4.0 1.2
Fixed costs (W1) 4.8 2.4
Total costs 12.0 4.0
Profit (residual) 2.0 (10%) 0.4
Revenue 14.0 4.4
WORKING
480
(1) UK CU7.2m = CU4.8m
720

240
Russia CU7.2m = CU2.4m
720
Using labour costs
UK Russia
Labour 3.2 0.4
Other 4.0 1.2
Fixed costs (W2) 6.4 0.8
Total costs 13.6 2.4
Profit (residual) 0.4 (10%) 0.24
Revenue 14.0 2.64
WORKING
3.2
(2) UK CU7.2m = CU6.4m
3.6
0.4
Russia CU7.2m = CU0.8m
3.6
 Pricing discussion
Differences
The allocation of fixed costs according to labour hours gives a higher profit than the use of labour
costs for the Russian contract, for UK operations and for the company overall. This method is
therefore to be preferred from Micro's perspective if the Russian hospitals agree it as legitimate.
The reason for the difference is that the low cost of Russian labour means that a lower proportion
of costs is allocated to the Russian contract than would be the case using labour hours.
Implications
The consequence of this is that the additional costs allocated to the Russian contract are recovered by
Micro according to the cost plus formula, with an extra 10% added. Clearly, the more costs allocated
in this way will mean the greater the revenue for the Russian contract and the higher the overall
profit.
Conversely, the more fixed overheads are allocated to the Russian contract, the fewer are the
costs allocated to UK operations, and thus profit is increased by an equivalent amount.
Viability
The Russian contract is viable in incremental terms irrespective of the method of cost allocation. This
is shown as follows.
Labour hours Labour cost
Labour 0.4 0.4
Other 1.2 1.2
Incremental fixed costs 1.0 1.0
Total incremental costs 2.6 2.6
Profit (residual) 1.8 (residual) 0.04
Revenue 4.4 2.64
If the Russian contract were not undertaken fixed costs would be CU6.2 million. This would generate
a profit for Micro of CU0.6 million (14 – 3.2 – 4 – 6.2). This is greater than the profit made by UK
operations using the labour cost allocation method with the Russian contract. Nevertheless, it is less
than the overall company profit of CU0.64m made with the Russian contract using this method. The
difference is the incremental contribution made of CU0.04m.

Benefits
 Where there is no market, competitively set prices are inapplicable. In this case there
are no alternative bidders and there is no saleable ultimate product, health being a
public sector service. Cost plus pricing is thus a possible alternative method in this
non-competitive market. 

 It gives a reasonable rate of return to the supplier. 

 Prices on a medium-term contract such as this can vary in line with costs over time,
giving some protection against risk arising from fluctuating costs. 

 Price increases can be justified. 
Problems
 There is no incentive to control costs. Indeed, there is a positive incentive to
increase costs, as they can be recovered with an additional 10%. 

 Methods of allocating overheads are arbitrary, yet they have significant
commercial consequences in setting the price on the Russian contract (see (b) above). 

 The costs incurred by Micro are not readily observable by the Russian hospitals.
Some third party verification is likely to be needed to ensure that calculations and costs
incurred are in accordance with the terms of the contract. 

 Fixed costs form a high proportion of total costs. Their allocation is thus of
significant magnitude in assessing the price of the contract. 

 The low cost of Russian labour is of no advantage despite the claim of the
marketing director, as under a cost plus formula the contract price is reduced
equivalently. 
Alternatives
 Given that much of the problem revolves around fixed cost allocations, then variable
cost plus could be used. 

 Instead of actual cost plus (full or variable) budgeted cost plus could be used. This
would give an incentive to reduce actual costs, as any cost savings would increase
Micro's profit. 

 If none of the above methods is acceptable then pricing could be by negotiation.
This might involve elements of: 

– Perceived value pricing, i.e. pricing according to the value of the service to the customer 

– Target costing, i.e. pricing according to negotiation to obtain the best price
possible, then engaging in cost reduction to achieve target profitability – i.e.
price minus. 
It should be noted that an apparently very similar service is being delivered in Russia
for a much lower price than in the UK. This means a practice of price discrimination
is being followed, due to the separation of the two markets and their different
capacities to pay.
(d) Memorandum
To: The directors, MicroKleen
Ltd From: An adviser
Date: Today
Subject: Review of operations
Risks of the Russian contract

Foreign exchange risk is significant, given that the rouble is not a liquid currency on the
foreign exchange market. Risk of convertibility of the currency, and possibly of repatriation,
may cause significant problems for Micro. If the contract were determined in sterling this
risk would be reduced. The Russian economic environment may not be as stable as the UK,
causing uncertainties.
A significant investment is likely to take place in non-current assets located in Russia. At the
end of five years there is a question as to their net realisable value if Micro fails to renew the
contract or establish additional business. The assets could be repatriated, but transport costs
may outweigh any benefit.
They could be sold to the new contractor, but this would probably be a forced sale at a low price.
The operating gearing is high, so that a significant volume of business is needed. Unless the contract is
exclusive to Micro (i.e. Micro is the only provider of sterilisation services to contracted hospitals)
volumes may decline and costs may not be covered. This is a greater risk if variable cost plus is
employed, as increased fixed costs could not then be passed on.
If the contract is expected to be profitable, it needs to be questioned why other European and
domestic companies were not prepared to tender.
At the end of the contract, if it has been viable, new entrants to the market will be attracted. It may
thus be difficult to hold on to the contract in the long term.
UK operations
The scale of UK operations has expanded recently, due to a growth in the market for sterilisation
activities and an above-average success rate in tendering for contracts (i.e. 30%).
The new capital raised will support future expansion, but some doubts must exist over the expansion
of UK operations, due to:
 The new market entrant 

 The development of a trend towards building larger hospitals which could supply sterilisation
services internally. 
If competition increases, there are two effects:
(iv) On average fewer contracts may be won as there are more competitors
(v) Bids for contracts may need to be lower, thus there is a lower profitability on those contracts
that are won.
Sterilisation is not a service that can easily be quality differentiated in the context of Porter's generic
strategies (i.e. it has a high degree of homogeneity). As a result, competition is likely to be based
largely on price competition (which is damaging to profitability) and it is difficult to obtain a specific
market niche.
Some limited differentiation is, however, possible on the following grounds:
 Promptness of service 

 Reliability of service 

 Geographical presence concentrated around London; thus local back-up is available if a unit fails
or there is peak demand at one unit exceeding supply 

 Some specialist high temperature sterilisation may not be made available by all competitors. 
There may be a threat from substitute technology in future (e.g. chemical sterilisation, disposable
instruments).
The high degree of fixed costs means that high demand and utilisation is essential, as the high operating

gearing makes profit sensitive to volumes.
Existing contracts have an average of four years to run. This provides some degree of security. This is
to be expected, as a long-term contract gives incentives for companies to tender in order to be able
to recover their capital outlay. On the other hand, a contract that is lost will be unavailable for further
bidding for some time.
Further new entrants are possible although barriers to entry do exist, including:
  Initial capital costs 

  High fixed costs, needing sales volumes to reach a critical mass to attain viability 
 Existing contracts are long term; thus it is difficult to break into a large sector of the market. 
Russian operations
If the Russian contract is agreed, it should make a positive contribution using either
of the bases for allocating fixed costs. This will be sufficient to improve Micro's
overall profitability.
Moreover, this represents a foothold in the Russian market for the future, not only
with respect to renewing the current contract, but perhaps for winning further such
contracts in countries with developing markets, e.g. in Eastern Europe.
Significant barriers continue to exist in this respect, however, and it may be that the
current contract has merely been a one-off situation. Competition is likely to be
severe from both indigenous and international companies. Other difficulties, noted
above, also are likely to continue.
The long-term possibility of Russia entering the EU may change the competitive
environment significantly with respect to such contracts, including issues of labour
mobility, the right to compete, and exchange rate risk with the adoption of the euro.
28 Mintern Ltd
Note: Assume that the current period is June 20X2.
Mintern Ltd has manufactured quality gentlemen's and ladies' shoes for 113 years,
and the 'Mintern' label has become a valued brand. The shoes are hand-made by
craftsmen and sell at the top end of the market, retailing at about CU200 per pair.
The company's shareholders are all members of the Mintern family.
Company background
The shoes are made at a single factory near London and are distributed via a
small, select group of up-market retailers that Mintern Ltd monitors closely.
These are located throughout the UK but over 60% of the sales are in the
Greater London area.
The company's sales have been as follows:
Year Pairs of shoes
('000s)
20W9 150
20X0 135
20X1 125
20X2 (projected) 120
Shoes are sold to retailers at an average price of CU150 per pair and the
variable manufacturing cost per pair is CU80. Annual fixed costs are CU9
million. These amounts have been constant for some time.
Strategic dilemma

The company has made reasonable profits in recent years. There has,
however, been an increase in the popularity of designer Italian shoes, also
priced at around CU200 per pair, particularly amongst fashion-
conscious younger customers. This has meant a significant fall in Mintern Ltd's sales and, as a result, the
company has started to make losses.
A further loss of sales to Italian designer shoe companies is not expected, as the majority of the remaining
customers are older and prefer a more traditional shoe.
The board of directors met to consider various strategic options, and the views of the directors were as
follows:
Martin Mintern (managing director)
'I have been approached by Sells & Finchney Ltd (S&F), the large, mid-market department store chain. They are
asking us to put a proposal together to supply them with up to 200,000 pairs of shoes a year. My initial estimate
is that we will sell to them at CU45 per pair and they will sell to consumers at CU60 per pair.
The shoes would carry the S&F brand name rather than our own, but clearly S&F wants it made known that
they are using suppliers of our quality. It would be a lower quality shoe than our own brand, but
nevertheless this is a major opportunity to expand sales and diversify our customer base into the mid-
market range with further sales contracts. This contract will only be for two years at first, but it could well
turn into the cash cow that saves the business in the long term.'
Alexis Ferguson (production director)
'I have some concerns with the S&F contract. First, we have no experience in the mid-market range and we
are trying to compete with other manufacturers which have significant production and marketing
experience in this area. Second, our existing organisational structure and culture would need to change and
we will need both a major investment in new machinery and a continuous production process to mass-
produce shoes for S&F.'
Kieran Keeson (finance director)
'Look, the new contract makes a profit so it must be the right strategy. I estimate that the variable cost of
manufacture will be about CU30 per pair of shoes. Additional annual fixed costs will be CU2 million, mainly
depreciation charges over seven to ten years on the initial investment. We can raise debt to finance the
outlay.'
Arnold Vanger (marketing director)
'I agree with Alexis. S&F does not really want our shoes, it wants our brand. But why should our customers
pay CU200 for a pair of our shoes when they can get a similar pair for CU60? This could damage our
reputation and our existing customer base irreparably. I suggest that we focus on our existing market
where we have experience and examine our cost structure and pricing policy. I have estimated that if we
increase our price to retailers to CU165, our annual demand will only fall from 120,000 to 110,400.
I have also found an alternative supplier of leather. This would reduce variable manufacturing costs by CU5
per pair of shoes. It is not quite as good quality but we must cut costs.'
Requirements
 (i) Calculate the price elasticity of demand for Mintern Ltd's existing market, using the information
provided by the marketing director.
(ii) Without further calculations, comment on the meaning of this price elasticity and its implications for
cons ider ed.
Mintern Ltd's pricing policy, noting any further factors affecting pricing that would need to be ( 6 marks)
(iii) Consider both proposals (i.e. the potential contract with S&F and the marketing director's proposals)
under each of the following headings.
Profitability of proposals (showing supporting calculations)

Marketing mix
(iv) Risk. (21 marks)
(27 marks)
28 Mintern Ltd
Marking guide
Marks
(a) Calculation – elasticity 3

Comment 3
6
(b) Profitability 6
Competitive positioning 5
Marketing mix 5
Risk 5
21
27
(a) Price elasticity

(i) Calculation
110.4 120 165 150

Pe
120 150 0.8
(ii) Comments
As the demand elasticity is between 0 and –1, demand is inelastic. Thus, at this
particular price and output level, a price increase will produce a less than
proportionate decrease in demand. This means that total revenue will increase,
although this does not necessarily mean that total contribution will increase.
Some further factors should be considered:
 The elasticity calculated above is a point estimate and thus might not apply
for further price increases.
 It tends to measure a short-term response, thus there may be a longer-
term reaction to price changes by the consumer.
 Competitors may change their prices in response to Mintern's price
increase. It is not clear what assumptions the marketing director has made
in this respect when calculating the change in demand.
The price gives a signal of quality and thus may alter consumers' perceptions of the product.
Leaving aside the above qualifications, the implication would appear to be, in the short term at
least, that the company should increase the price.
(b) Consideration of proposals
(i) Additional profitability
Impact of price change

Price Variable Contrib. Volume Total Fixed Profit/
cost per unit Pairs of Contrib. cost (loss)
CU CU CU shoes CU CU CU
150 80 70 120,000 8,400,000 9,000,000 (600,000)
165 80 85 110,400 9,384,000 9,000,000 384,000
Overall increase in contribution is CU984,000.
Impact of price increase with cost reduction
Price Variable Contrib. Volume Total Fixed Profit/
cost per unit Pairs of Contrib. cost (loss)
CU CU CU shoes CU CU CU
150 75 75 120,000 9,000,000 9,000,000 Nil
165 75 90 110,400 9,936,000 9,000,000 936,000
Sells & Finchney contract
CU
Contribution CU(45 – 30) 200,000 3,000,000
Fixed overheads * (2,000,000)
Additional profit 1,000,000
* Depreciation could be ignored but the necessary incremental capital outlay should then be
considered by other means.
Both the Sells & Finchney contract and the price increase policy add a similar amount to short-
term profit at CU1 million and CU984,000 respectively.
The cost reduction exercise adds a further CU552,000 (or CU600,000 if there is no price
increase or change in demand).
There is nothing to suggest that the strategies are mutually exclusive. Thus if all three policies
were implemented, short-term profitability would increase from a loss of CU600,000 to a profit
of CU1,936,000. This is an overall increase of CU2,536,000.
(ii) Competitive positioning
The existing competitive position appears to be that Mintern has lost sales to manufacturers from
overseas. This may be due to:
 Changes in fashion for a different style of shoe 

 More-competitive imports due to the strength of sterling 

 Newly-established competition in the UK in Mintern's market sector that had not previously
existed. 
The consequence of this competition is that sales volumes have fallen and, with a high operating
gearing, this has had a significant effect on profit. Prior to these changes at the 20W9 volume of
sales, the profit would have been as follows:
CU
Contribution CU(150 – 80) 150,000 10,500,000
Fixed overheads (9,000,000)
Additional profit 1,500,000
The response of the managing director is to search for a new market sector with a similar, but not
identical, product. Within the terms of the Ansoff matrix this could be regarded as market
development if the shoes can be regarded as similar to existing products; or as related

diversification if the product is sufficiently differentiated. The difference in variable cost and
method of manufacture would lead toward the latter conclusion.

The company will thus need to consider its competitive positioning in two separate markets.
Existing shoes
Within Porter's generic strategies, the existing competitive position would appear to be that of
differentiation focus. The product is differentiated by quality and is focused on a particular
segment of the market.
The entrance of more fashionable Italian shoes appealing to the younger market but in the same
price bracket, would appear to take a sector of the Mintern market, further reducing its focus. It
would seem, however, that the more traditional customer base of Mintern would not be
threatened by the new fashion shoes, as this would be a different market sector with different
characteristics.
New contract with S&F
This is a new market for Mintern and thus the company could be regarded as a new entrant.
While it has little experience in this market, it does have some major advantages in establishing
its competitive position:

 A good brand name in the industry 

 The potential of a major new customer to give an initial critical mass 
 Significant experience in the shoe-making industry, albeit in a different sector of that market. 
There are, however, some disadvantages.
 The scale of production is different from that previously experienced 

 The method of production is different from existing methods 

 It is not clear that Mintern has the operating or marketing core competences to compete in
this sector of the market against incumbent manufacturers. 
Marketing mix
General considerations
The existing market of a few years ago seems to have segmented into traditional shoes and those
sold through S&F. Elements of the marketing mix need to be considered separately for each of
these market segments in order to be consistent with each brand image.
A segmented market strategy could thus be adopted, focusing on the characteristics that appeal
to each target market.
Product
Under the marketing director's proposal, the reduction in the quality of the leather may damage
the value of the brand. This may not occur in the short term if consumers cannot immediately
discern the quality difference in the product. In the long run, however, the company's reputation
may decline and repeat sales may fall.
Similarly, the production of a lower quality shoe for S&F may cause customers to perceive a
reduction in quality of all of Mintern's shoes.
Given the increasing age of customers for the traditional shoe, future product design may need
to appeal specifically to this older market segment.
Price
If the price is to be increased, as suggested by the marketing director, a careful monitoring of
customer reaction needs to be made. In particular, the extent to which this price increase is
passed on to the ultimate consumer by retailers needs to be monitored. This may include an
appropriate analysis of sales and testing of consumers' reactions by questionnaires and field
research.
The policy of market segmentation can have a number of advantages and has been operated by a

number of designer clothes companies which operate diffusion labels (e.g. Georgio Armani using
Emporio Armani). In particular, it enables price discrimination between Mintern's traditional
market and that of S&F. This is particularly the case as the proposed price difference to the
consumer is significant, between CU200 and CU60.
While Mintern may have some control over the price at which it sell its shoes to S&F, it has little
control over the price at which S&F sells to its own customers.
Promotion
The finance director's view that 'the new contract makes a profit so it must be the right strategy'
appears short sighted. Short-term profitability may be unaffected by reducing quality, but long-
term profitability may be very much affected by a decline in the brand image, which may reduce
the ability of the company to promote the existing shoes as a quality product.
Promotional strategies need to be different for each type of shoe in order to be appropriate to
its brand image and price. This may include the type and medium through which advertising takes
place.
Similarly, in promoting the traditional shoes the age profile of customers appears to be increasing.
This will also influence the type of marketing and the advertising medium to be used, as it will
specifically need to appeal to this age range.
A particular problem, however, is that as S&F is selling the shoes under its own label, it will be
responsible for promotional activities, thereby reducing Mintern's control of this aspect of the
marketing mix.
Selling shoes through two types of locations – traditional up-market shops and S&F – reinforces
price discrimination and enables separated brands and promotional activities.
In addition to marketing to consumers, it is necessary to market the product to customers (i.e.
retailers). In this context it may be worth expanding the group of retailers stocking Mintern
shoes outside the London area to expand the geographical market.
The new contract seems to have been initiated by S&F. A marketing effort is needed, however, to
persuade S&F, as a large customer and major distribution channel, to continue with the contract and
to promote Mintern's shoes over those of other manufacturers at each of its outlets.
Risk
Doing nothing has a major risk, as the company has declined into losses in recent years. Unless
this situation can be reversed there is a significant risk of liquidation. Any risks from decisions
must therefore be viewed in this context.
Specific risks include the following:
Damaging the brand: It has already been noted that the brand may be damaged as a result of
the policy of selling a mid-market shoe and of reducing the quality of leather.
Diversification: Moving into a new mid-market shoe may represent diversification in the
context of the Boston Consulting Group matrix, and may reduce dependence upon the up-
market sector and create a cash cow for the business. The core competence view, however,
suggests that such diversification is frequently unsuccessful, as companies have little experience
outside their own sector and thus fail to compete successfully.
Exit costs: The new contract involves significant investment (7-10 years CU2m depreciation =
approx CU17m) and, if the S&F contract fails, there may be significant exit costs as machinery has
to be sold and redundancy costs may be incurred.
Duration: The contract is only for two years, but it would seem that the depreciation on non-
current assets (being the major fixed cost) relates to a period of 7 to 10 years. If the contract is

not renewed and the assets cannot be sold for their carrying amount, the annual fixed costs may
be much higher.
Gearing: The additional borrowing and fixed costs incurred by the new
contract will increase financial and operating gearing. This increases the volatility
of future earnings in relation to sales fluctuations, thereby generating increased
risk.
Large customer dependence: There is significant dependence on a single large
customer for mid-market sales. This is only secure for the two years of the
contract. Thus there is significant risk of losing all sales in this sector at once if the
contract is not renewed and if no further similar business can be generated.
Liquidity: While fixed costs increase largely as a result of depreciation charges,
the full cash cost of the new non-current assets is met from borrowing. This may
place a significant strain on liquidity.
Change in culture: The movement from solely hand made manufacturing to
using a continuous process may alter the quality culture of the company, and may
damage the existing employee motivation and attitude.
29 WaterWear Ltd
Note: Assume that the current period is September 20X3.
WaterWear Ltd (hereafter WW) is a private company that was set up in the South West
of England twenty-four years ago. The company's sole activity is the manufacture of
wetsuits for use by surfers.
Company profile
In the context of the industry WW is a small company, with a revenue of CU16 million per year.
According to an independent survey the company makes 'some of the best wetsuits
available on the European market'. They are manufactured from high quality materials and
have good insulation properties, which will keep surfers warm for prolonged periods in
cold water.
Despite the quality of its product, the company has had a difficult 20X3 summer season
competing against larger manufacturers. This was largely due to a weak brand image in a
very fashion conscious sporting activity. A board meeting was called to analyse the
problems.
The board meeting
Tony East, the managing director, summarised the feelings of his fellow directors.
'We have a better product than our major competitors but, because they have a well
recognised brand label, backed up by large advertising budgets, they can sell 20 times more
than us. However, a logo won't keep you warm in the water. Their wetsuits also retail at
CU300 each. The retail price of our wetsuits to consumers is only CU250. What is more,
the smaller retailers that we use take a 20% margin on sales, but larger retailers, used by
our competitors, would require a greater margin to take our product by offering us a lower
price.'
His fellow directors argued in favour of a number of possible growth strategies.
Strategy 1
The marketing director responded to the managing director: 'That's all true, but the fact
is we need to develop a strategy for next summer's season to deal with the situation. At
the moment, we are not getting the wetsuits to the attention of potential customers

because we have almost no advertising budget. We need to advertise to promote our
brand and bring our product to the attention of a wider market. I estimate that if you gave
me an advertising budget of CU1 million for 20X4 we could increase our selling price
significantly without affecting sales volumes.'
Strategy 2
The production director disagreed: 'Any competitive advantage we have is in the quality
of our product, but if we do not have a decent distribution system we cannot
communicate this. We should move over to selling only online through the Internet, using
our website. This would cut out the retailers' margins and give us direct access to potential
consumers. I believe we could set up an online selling facility by January 20X4 for an initial
fixed cost of CU500,000. Apart from the existing costs, the only other costs to be
incurred would be an additional variable marketing cost of CU25 per wetsuit.'
Strategy 3
The chairman, Andrew East, took a different view: 'Our basic problem is that we are too
dependent on one product. We need to diversify to create an entire product range in the
market and to develop our brand image. I have started early negotiations with an
Australian company that makes surfboards. They do not make wetsuits, so they are
interested in a strategic alliance with us. The details are yet to be determined, but the
basic idea is that we would sell their surfboards under our brand name in Europe during
our summer. Similarly, they would sell our wetsuits in Australia in their summer. Each
party would get a commission of 20% on the sales of the other party's product.'
Financial details
The finance director provided some forecast results for the year to 31 December 20X3. While the
year is not yet complete, the surfing season is effectively over and the forecast is therefore reliable.
CU'000
Sales 16,000
Variable costs (10,000)
Fixed costs (7,000)
Operating loss (1,000)
Requirements
 For each of Strategies 1 and 2, determine the price that WW would need to charge for the
company to break even overall in 20X4. Assume there is no change in sales volumes, variable
cost per unit or annual fixed costs from those in 20X3. State any assumptions.
Briefly compare and comment on these calculations. (9 marks)
(b) For Strategies 1 and 2, critically examine how each of the factors within the marketing mix (the 4Ps)
might impact upon each strategy. (14 marks)
(c) Assess the merits and demerits of the strategic alliance approach in Strategy 3. (7 marks)
(d) Describe, giving examples, the tools and techniques WW would need to use to ensure the smooth
running of a large scale project such as a strategic alliance with an overseas partner. (7 marks)
(37 marks)
29 WaterWear Ltd
Marking guide
Marks

(a) Calculation Strategy 1 3
Calculation Strategy 2 3
Comparison and comment 3
9
(b) Price 4½
Product 2
Promotion 4½
Place 3
14
(c) Nature of strategic alliance 1
Merits 3
Demerits 3
7
(d) Project management 7
37
(a) Break even calculations

Strategy 1
WW's selling price to retailers = CU250 80% = CU200
Units sold = CU16m ÷ CU200 = 80,000 units
Variable cost per unit = CU10m ÷ 80,000 = CU125
Fixed costs with advertising = CU7m + CU1m = CU8m
Break even contribution per unit = CU8m ÷ 80,000 = CU100
Break even selling price = CU100 + CU125 = CU225
Assumes fixed and variable costs in 20X4 are the same as in 20X3.
Strategy 2
Fixed costs with website = CU7m + CU0.5m = CU7.5m
Variable cost per unit = CU125 + CU25 = CU150
Break-even contribution per unit = CU7.5m ÷ 80,000 = CU93.75
Break-even selling price = CU93.75 + CU150 = CU243.75
Strategy 2 appears to have the higher break even price, but this is not comparing like with like. The
Strategy 2 price is the ultimate retail price to the consumer, whereas the Strategy 1 price is the
wholesale price to the immediate customers (i.e. the retailers).
If the retailers were to maintain their 20% margin, this would give an ultimate selling price of
CU281.25 in Strategy 1. At this price demand is likely to be lower (all other things being equal) than in
Strategy 2. The impact of advertising would therefore have to compensate for the increased price. In
addition, the higher fixed costs in Strategy 1 will mean higher operating gearing and therefore higher
risk.
(b) Marketing mix
Price
Strategy 1

Under Strategy 1 the ultimate price charged to the consumer at CU281.25 (assuming the retailers
maintain their margins) is greater than the existing price of CU250. Advertising will therefore need to
induce an outward shift of the demand curve in order to sustain existing demand (see Promotion
below).
It is important to note, however, that at CU281.25 the company actually breaks even, whereas at the
old price of CU250 it made a loss of CU1 million. Nevertheless, there is a risk that the required sales
will not be made at CU281.25.
Perversely, however, the higher price may signal quality and thus of itself raise demand and more
appropriately signal the quality of the product relative to competitors.
If retailers maintain the same percentage margin, then the absolute amount they make from selling
WaterWear's wetsuits will increase, thereby giving greater marketing incentives at the point of sale.
Strategy 2
The price of CU243.75 directly to the consumer is lower than the existing price. Yet, if achieved, it
will generate a break-even position rather than the existing loss.
Nevertheless, the Internet is a different market with different demand conditions and some different
customers. Not all surfers may use the Internet, and those that do may expect greater discounts and
demand greater assurances – thereby altering price elasticity.
For both strategies the price should not be considered in isolation but also in relation to the
company's competitors and their response to any price changes.
Product
Strategy 1
While the product itself is the same as previously and the same as for Strategy 2, the perception of the
product may differ. This may be due to the advertising promoting brand awareness, or the price
signalling quality as already noted.
However, the quality of the product appears to remain the key core competence of the company, and
any marketing strategy should build on this to develop any sustainable competitive advantage.
Strategy 2
As with Strategy 1, while the product itself is the same, the Internet provides opportunities and
restrictions which may alter the perception of the product to customers.
Promotion
Strategy 1
Promotion is the key aspect of this strategy, given the significant increase in the advertising
budget. A key point, however, is that the advertising budget for 20X4 might support a higher
selling price in that year but may require to be sustained at that level if the selling price is to
remain high.
Given the wide market but a narrow interest group, it is clear that the budget needs to be
focused. The form of advertising might therefore be important, e.g. surf magazines, sponsoring
events, localising on surf beaches.
Perhaps, even more importantly, the objectives of the advertising need to be clear – particularly in
terms of the product characteristics that it intends to promote, e.g. quality, durability, insulation,
fashion, comfort etc. Some of these may be conflicting, and trying to promote too many
characteristics may cause confusion of the brand image.
Promotion could also be a part of the style or appearance of the wetsuits themselves, e.g. a
prominent logo.
Similarly, packaging and presentation at the point of sale may be significant in promotion.

Strategy 2
Promotion over the Internet appears to be a risky strategy as it appears to be instead of, rather
than as well as, using existing retailers.
The Internet thus becomes the sole channel of selling, but also the primary means of promotion.
The major advantages for Internet promotion are that:

 The marginal cost is relatively cheap 

 The potential geographical market is worldwide 
 The medium is continuous from year to year 
 There is access to promote directly to
consumers. The major disadvantages for Internet
promotion are that: 

 Not all surfers may use the Internet 

 Those who do use it may do so for information but not to engage in transactions 

 There may be a preference by consumers to inspect the physical product and compare it
with those of competitors, which would require retailers. 
Promotion may also be available on other (surfing related) companies' websites, rather than only
one's own – perhaps with a reciprocal arrangement.
Strategy 1
Distribution remains limited through existing retailers, as larger retailers would charge a
higher margin, putting significant pressure on WW's margins. With this strategy there appears
to be little opportunity to expand distribution through existing channels.
Distribution in Europe may be possible but is made more difficult by:

 Language barriers 

 Geographical differences 

 Differences in taste and style 
 Regulation differences. 
A significant number of outlets would require inventories to be spread very thin (e.g. different
sizes, colours, male/female). Inventory holding and reorder costs would therefore be very high.
Strategy 2
Distribution can be provided centrally but transport would need to be efficient and cheap to transport
wet-suits to consumers quickly across Europe, or indeed across the world.
Moreover, if there were a fault with the goods and they needed to be returned, there would be
significant additional transport costs as there is no local retailing support overseas.
Under both options alternative distribution channels could be available for alternative uses of the
wetsuits, e.g. for diving, canoeing, wind surfing. These would be alternative markets for a similar
product and would thus represent 'market development' in the Ansoff matrix and could require rather
different distribution channels to market the product successfully. It may also require different prices
(price discrimination) and methods of promotion. Essentially, however, the product is the same and
would thus exploit similar core competences.
(c) Strategic alliance
A strategic alliance arises where two or more firms agree to work together to exploit common
advantages.

Such alliances may take a number of forms, varying from informal agreements, through contractual
arrangements to a more formal joint venture company.
The benefits of a strategic alliance for WW would include the following:
 Access to a complementary product – surfboards. 

 Access to the core competences of the other partners. Most significantly this is likely to include
access to a distribution network in Australia. 

 It may give access to wider geographical markets, initially Australia, but perhaps later
internationally, based on this experience. 

 It smoothes seasonal demand over the year, as sales in Australia would be in the European
winter when there is little existing demand. 

 There are some distribution economies, as WW's retailers would now have more products
available to them from WW and the fixed costs of distribution would be easier to cover. 
The disadvantages of a strategic alliance include the following:
 The contract or arrangement would need monitoring. 

 The price would need to be separately determined in a separate market and this might need to
be mutually agreed between the partners. 

 Disputes may arise over the relative rights and obligations of the parties. 

 There is additional currency risk. 

 The terms of the strategic alliance need to be negotiated and may depend upon the relative
strengths of the two parties. If the Australian company is the larger partner, it may have a
comparative advantage in negotiations as more distribution outlets are being offered. 

 There is little existing knowledge of the UK surfboard market and the reactions of competitors
in this market to the Australian boards need to be considered. A similar issue may arise with the
familiarity of the Australian company to the Australian wetsuit market. 

(d) Project management
The first task WW would need to carry out would be to create a Work Breakdown Structure which
would divide the project into work packages and identifying the individuals responsible for each
element of the project. The different packages might include import of surfboards, export of wetsuits,
marketing, finance procurement and so on.
Within each element the tasks must then be further broken down into all the specific activities that
must be carried out and the people charged with the task. For example imports would be broken
down into logistics, legal arrangements, packaging and then each of those broken
down again into the specific tasks involved at each stage.
Once all the different activities have been identified they can be portrayed graphically.
This will provide WW with a clear picture of the order in which the various tasks must
be carried out (network analysis) and provide them with a schedule of work to follow
(Gantt charts).
Another key task will be to keep all key stakeholders up-to-date with progress.
Stakeholders would include the board and any key staff involved in all aspects of the
project. The other key stakeholder would obviously be the alliance partner. This would
take the form of regular project reports and key stage reviews (formal review meetings)
held at every significant stage of the project. Given the location of the partner, although
there may be the occasional visit, many of the meetings would probably take place using
phone or video conferencing.
It will be essential too, that the importance of the project is underlined by providing

a clear governance structure – demonstrating the authority within the hierarchy of
any staff member put in charge of the change alongside the directors.
30 Avantgarde Electrical Appliances Ltd

Note: Assume that the current date is December 20X3.
Avantgarde Electrical Appliances Ltd (hereafter AEA) has made significant progress since it opened its
first factory in South East England over fifty years ago. It is now a major UK listed company,
manufacturing household electrical goods, which it sells throughout the world generating annual
revenues of over
CU4 billion.
Company history up to five years ago
AEA initially manufactured low-cost electric lighting but, as it grew, it developed a wide product
range of household electrical appliances, including fridges, cookers, televisions, DVD systems and
personal computers. All of these have a reputation for giving good value as basic, low-priced
products.
The company has had a centralised organisational structure with the group head office maintaining
close operational and financial control over operating divisions. In order to control costs in very
competitive markets, tight budgets were set by group head office, and regular cost control
programmes were implemented. Divisional performance was judged against achievement of detailed
budget targets.
There was a separate division for each type of product, but head office exercised functional control.
Thus, for example, the financial controller of a division reported to the divisional head, but was also
closely monitored by the group finance director. There was a similar control relationship with other
functions such as marketing, production and research and development. There was normally tension
and poor relationships between divisional heads and group head office management.
A dispute over organisational structure in early 20X0
In recent years there have been difficult trading conditions, with cheaper imports undercutting many of
AEA's products on price in a number of its markets around the world. As a result of falling profits and a
drop in share price, the board has been forced to reconsider its strategy. One of the key conclusions
was that any new strategy, if indeed a new strategy were appropriate, should be devised by individual
divisions – not head office. As a consequence the board had been willing to rethink its organisational
structure.
The chairman argued: 'We need to change the way we work. Centralisation is just too slow. We
are not adapting quickly enough to changes in technology and market conditions – decision making
needs to be closer to the customer. By the time a division has put a proposal for strategic change
to head office and we have approved it, our competitors have implemented similar changes and
moved on. We are always one step behind.'
The chief executive disagreed. 'We are a low-cost producer and that means controlling costs
and co-ordinating activities. This is best done centrally.'
The majority of the board supported the chairman. In January 20X1 AEA therefore made the
following fundamental changes to its group structure:
 All divisions became subsidiary companies. 

 Each subsidiary was to become a strategic business unit (SBU) and to be operated as an
investment centre. 

 Services such as marketing, R&D and administration could continue to be acquired

centrally from group head office at full cost, or they could be purchased from outside the
group. 

 Finance could only be raised by divisions from group head office at an annual rate of 10%,
which was intended to reflect risk. 

 The performance of divisions was to be measured by a combination of 

Residual income,
Revenue growth, and
Average production cost per unit of output.
20X1
During 20X1 several problems became apparent with the new organisational structure. Divisional
heads had normally worked for the company for many years and were unfamiliar with strategic
decision-making. Some divisional heads made several obvious strategic errors, but the group board
was reluctant to intervene as it considered it might damage the new culture of divisional autonomy.
Most divisions made very few purchases of central services from the group and, as a result, there
were significant redundancies at head office. Most divisions took on additional administrative staff
to assist in the new divisional management procedures, instead of purchasing head office services.
Of even more concern to the group board was the small investment in non-current assets or in
R&D by divisions. While residual income had improved in most divisions, there was a feeling
amongst the group board that this was a short-term, tactical policy and there was insufficient
long-term planning in the new regime.
20X2
In order to encourage greater long-term investment, head office services would be offered at
variable cost, which was a very significant reduction from the full-cost transfer pricing policy
applied in 20X1. In addition, money could now be borrowed by divisions from external sources,
but they would also be offered finance by the group at 5% per annum.
Many of the divisional heads retired or were removed during 20X2.
20X3 up to December
The low cost of head office services meant that demand increased significantly such that, towards
the end of the year, head office staff exceeded its pre 20X1 level and head office was being
operated at a significant deficit.
Some subsidiaries, which had borrowed heavily from banks, were having problems in
meeting debt repayments in difficult trading markets.
Some views
The group finance director summed up her view of the changes: 'This change in structure has been a
disaster for us. Overnight we have thrust people with 20 or more years of experience as good
administrators of centrally determined strategic policy into the role of entrepreneurs. We may have
quicker decisions based on local knowledge, but there is no central co-ordination and, quite frankly, we
were better strategic decision-makers than the divisional heads will ever be.'
The group marketing director agreed: 'Production methods at each division may be largely
independent, but there is now no co-ordination of marketing. We sell to the same market – or even the
same customer
– and each division has no idea what other divisions are doing.'
Requirements
(a) (i) Briefly describe which of Porter's Generic Strategies is being followed by AEA, and explain
how this strategy may give the company a competitive advantage.

(2) Examine the strategic risks for AEA that may prevent it from successfully pursuing this
strategy.
(Ignore the changes in organisational structure for this purpose). (12
marks)
(b) Write a memorandum which critically evaluates the changes in AEA's organisational structure
under each of the following headings:
  The advantages and disadvantages to AEA of centralisation and decentralisation 

  Measuring divisional performance 
 Assessment of how the change process was managed in 20X1 
 Pricing head office services (26
marks)
(38 marks)
30 Avantgarde Electrical Appliances Ltd
Marking guide
Marks
(a) Generic strategies 7

Strategic risks 5
12
(b) (i) Centralisation 5
Decentralisation 5
(ii) Divisional performance measurement 8
(iii) Change process 3
(iv) Pricing head office services 5
26
38
(a) Generic strategy and

strategic risks Generic
strategy
AEA is pursuing a strategy of overall cost leadership, i.e. the production of a basic,
no frills product delivered to the market at a lower cost than competitors.
Competitive advantages
Achieving the industry's 'lowest delivered cost to the customer' provides a number
of competitive advantages to AEA.
 It reduces the impact of competitive rivalry by allowing the firm to make
superior profit margins at the prevailing level of industry prices – the firm can
also become the price leader because no other firm is able to undercut it. 

 It reduces the impact of buyer and supplier power by giving the firm a unique
cushion of profits against cost increases and price cuts – indeed, buyer and
supplier power will be the forces which drive rivals from the industry. 

 Low costs provide a barrier to entry against potential new entrants and hence

safeguard long-term profits. 
AEA is a large company with a revenue of CU4 billion. It can thus take advantage of economies of
scale to deliver low costs. This may include:
 Lower unit costs due to spreading their fixed costs across a larger output 

 The ability to drive better bargains with their suppliers 

 Movement along the experience and learning curves 

 Distribution economies where different products are distributed through the same channels (e.g.
there may be few production economies between DVDs and washing machines but they could be
sent to the same customers overseas and benefit from common distribution costs). 
It should be noted that cost savings are not only within the organisation, but throughout the supply
chain.
Strategic risks
 There is the risk that new entrants, particularly from overseas countries with low cost bases (e.g. low
labour costs), may undercut the selling prices of AEA. Indeed this appears to have happened. 

 If the company is deflected from its low cost strategy by keeping up with latest developments in
the industry (i.e. providing 'frills') it may leave the firm 'stuck in the middle', being neither a low
cost producer nor a differentiator. 
Technological change could eliminate a low cost base or past learning effects in the following ways:
  Imitation of low-cost techniques by industry entrants 

  Products become out of date because the firm will not invest in them 
 Domestic inflation or exchange rate changes may destroy cost advantage at home and abroad. 

(b) Memorandum
To: The Board of Avantgarde Electrical Appliances Ltd
From: A Consultant
Date: Today
Subject: Organisational structure
The costs and benefits to AEA of centralisation and decentralisation
Centralisation/decentralisation refers to how much authority/decision-making ability is diffused
throughout the organisation.
In centralised structures the upper levels, such as the group board, retain authority to make key
strategic decisions.
In decentralised structures the ability to make decisions (i.e. commit people, money and resources)
is passed down to lower levels of the hierarchy, such as divisions.
Factors affecting the degree of centralisation
Strategy: A key factor is that the structure should be appropriate to the strategy. While the company
has adopted a low cost strategy, there are many other aspects to the corporate strategy and the
environment of the company that should be considered in adopting an appropriate organisational
structure.
Management style: This was initially authoritarian before 20X1 with tight budgetary controls. This
lends itself to the centralised structure in place in this period, which focuses control at the top of the
organisation.
Size of organisation: As size increases, decentralisation tends to increase. In the case of AEA,
however, it had grown from modest beginnings to a large organisation while appearing to maintain its
centralised structure.

Extent of activity diversification: The more diversified, the more the tendency towards
decentralisation. All AEA's products are in a similar market of consumer electrical goods, which would
tend towards enabling centralisation, given the degree of similarity.
A counter argument would be, however, that these markets are in fact different (e.g. PCs and
washing machines) with different consumer pressures and different competitors. They may also be
regarded as being in different industries (as opposed to different markets) which require different
production skills.
Effectiveness of communication: Centralisation will not work if information is not
communicated downwards. With AEA the major means of achieving this communication appears
to be through the budgetary system.
Ability of management: The more competent the divisional managers are, the better
decentralisation tends to work. However, in the case of AEA the managers may have been
competent within the old regime of implementing a strategy dictated by head office, but this does
not mean they can devise appropriate strategies.
Speed of technological advancement: Lower managers likely to be more familiar with changing
technology, therefore decentralisation can mean more informed and quicker decision making.
Geography of locations: If locations are spread, decentralisation is normally appropriate, as
knowledge of local conditions becomes more important and direct control from the centre
becomes more difficult. In the case of AEA, however, production is concentrated in the UK but
marketing is worldwide. This thus gives conflicting considerations.
Advantages of decentralisation
 Senior managers of AEA are more free to concentrate on group wide strategy while day
to day decisions are delegated to lower levels of management 

 Motivation for lower managers from increased delegation/responsibility 

 Local expertise of managers improves decisions based on local knowledge 

 Quicker and more effective responses to local conditions 

 Career paths for managers/employees. 
Disadvantages of decentralisation
 More difficult to co-ordinate the AEA organisation, as lots of people are making the
decisions rather than just a few 

 Incongruent decisions, i.e. different levels of management may pursue different objectives.
This may be a problem for AEA where they are selling different products into the same
market or even the same customer 

 Loss of control by senior management 

 Complicated structures 

 Problems with transfer prices (see below) 

 Evaluating divisional performance becomes difficult (see below) 

 Duplication of some roles (e.g. administration) 

 In pursuing a low cost strategy there may be significant economies of scale from
centralised and collective activity (e.g. in sourcing some common raw materials in bulk
from suppliers) and economies of scope (e.g. in common distribution systems of electrical
goods from different divisions to similar regions or even the same customer). 

Measuring divisional performance
Pre 20X1
Hopwood considered the way in which budgetary systems are used to assess divisions and their
managers. Three distinct styles are identified.
Budget constrained style: Primary emphasis is on manager's ability to meet the budget in the short
term.
Profit conscious style: Performance is measured in terms of overall ability to improve long-term
effectiveness and profitability of area of responsibility.
Non-accounting style: Performance is measured in ways other than budgets.
Pre 20X1 the company appeared to have adopted a budget-constrained style. By contrast, after 20X1
it seemed to change to something like a profit-conscious style.
The effects of the two styles are as follows:
Budget constrained Profit conscious
Involvement with costs High Medium
Job related tension High Medium
Manipulation of data Significant Some
Relationships with superiors Poor Reasonable
However, the budgetary style should be appropriate to the circumstances of the company. Thus, in a
dynamic market, such as consumer electrics, a budget-conscious style may be inappropriate as the
underlying assumptions of the budget may be rendered invalid by rapid market and technology
changes. This may lead to tensions.
Post-20X1
After 20X1 divisions were measured on the basis of a mixture of
(i) Residual income
(ii) Revenue growth and
(iii) Average production cost per unit of output.
The use of residual income is consistent with the adoption of divisions as investment centres, as it
requires divisional managers to take investment decisions but charges them for capital used.
However, one needs to be careful to charge interest on a comparable basis for externally raised
finance and for head office finance.
Other points to note are as follows:
 All the measures of performance are financial measures. A balanced scorecard approach, for
instance, may be appropriate to measure other attributes. 

 In the same vein, the measures of performance are all short-term; thus the concern that arose
about lack of investment and short-term decision making may have as much to do with the
methods of performance measurement as the cost of capital or the central recharging
mechanism. 

 There appears to be little trading between operating divisions, so transfer pricing is not a major
issue in performance measurement. 

 Acquiring head office services is optional thus should not distort divisional performance adversely
(as divisional managers can purchase from outside the group if the head office attempts to charge
excessively.) It may, however, distort performance measures favourably as services and finance
are being offered at below market rates in 20X2 and after. 
Residual income

This suffers many of the same problems as accounting profit. These include:

 Valuing assets at HC or current value 

 Depreciation method may be arbitrary and based on HC 

 Which assets to include in capital employed 

 There may be manipulation of accounting policies 
 The interest rate used is difficult to determine. 
Revenue growth
Over-emphasis on revenue growth may lead to revenue maximisation rather than profit
maximisation (although the other two criteria are a control on this). It may, however, give an
indication that market share is significant, and that growth and size may be important in the long
run to gain scale economies.
Average production cost per unit of output
In a low-cost strategy an emphasis on costs may be appropriate. However, where fixed costs are
high, this measure is sensitive to changes in volume of output as fixed costs per unit are likely to
rise.
Managing the change process in 20X1
The change was both fundamental and rapid.
It was not only a change in organisational structure but also a change in culture from
one of centralised management to one of divisional autonomy.
It would seem that many of the problems arose, not from the nature of the changes, but
from the manner and speed of their implementation.
More specifically:
 The personnel in place appeared unable to fulfil their new roles, and many left or were removed
in the following year. This may have been because they were the wrong people for the new roles,
or it could have been a lack of HRM and investment in education and training for the new roles. 

 It appears that the changes were decided at board level and thus it is not clear that there
was much participation in the decisions from the divisional heads who would be
implementing the new policy. 

 The changes could have been introduced piecemeal to reduce the transitional problems such
that autonomy was transferred progressively rather than suddenly. 

 The reversal in 20X2 of some early decisions appeared to indicate that early errors were
made and the behavioural impacts of the new system were not fully anticipated. 
Pricing head office services
The initial pricing of head office services appears to have been too high, as few divisions
chose to purchase them and they also chose to raise finance outside the group.
The divisions were only being charged at full cost (i.e. no profit) and yet they appeared to be
acquiring the same services from outside providers (which were presumably making some profit)
at lower cost.
This may be indicative that head office had been operating inefficiently under the old regime by
being able to recover all its costs from divisions by internal charge as they had no choice.
As a result, the pricing seems excessive in market terms.
An alternative explanation might be behavioural, in that divisional heads, wanted reduced
dependence on the head office and thus to reduce links.
The move to variable cost pricing appears to have swung the pendulum in the opposite direction

with excessive use of head office services at the low variable cost pricing basis.
While this could have unfavourable long-term effects as it may lead to

 Unwarranted over-investment due to an excessively low cost of capital. 

 Excessive use of services where the cost to the group exceeds the benefit to the divisions. 
Summary
The change in structure for AEA is not of itself a change in strategy but a means for engaging in a
change of strategy. Nevertheless, it involves a change in corporate culture, incentives,
performance measurement and ultimately, in all probability, a change in the strategy of many
SBUs.
Such changes are unlikely to emerge in full within a few years, and thus a longer-term assessment
of the changes may be necessary. Even then, one does not know what would have happened if
the old structure had been maintained. Indications were, however, that there would have been
increasing problems in continuing to pursue this policy.
31 Online clinic
PHC is an independent charitable clinic working for better public health in a major city. It carries out
research, policy analysis and development activities, working on its own, in partnerships, and through
government funding. It is a major resource to people working in health and social care, as well as
providing health care and advice in its local community through its own dedicated clinic. The clinic has
been chosen to be the subject of a national scheme to measure clinic performance. Amongst a number
of factors, the 'quality of care provided' has been included as an aspect of the service to be measured.
Three features of 'quality of care provided' have been listed:
(iv) Clinic's adherence to appointment times
(v) Patients' ability to contact the clinic and make an appointment without difficulty
(vi) The provision of a comprehensive patient health monitoring programme, made up of
various stages that need to be completed
Operating costs for the clinic are currently running at CU7,000,000 per annum. PHC has just learned
that it is facing large cuts in the amount of money that it receives from the government as a subsidy to
its service, which will threaten the quality of patient care and ultimately its entire operations. It has
nevertheless set itself the task of improving its service, and raising funds to continue its work, through
the creation of a comprehensive online facility which will become fully operational in 2008. This will
include online advice on minor medical matters and online booking of all clinic appointments, including
monitoring and follow-up services. The PHC trustees estimate the start-up costs of such a service to be
CU2,000,000, and annual operating expenses to be CU500,000.
A market research report was commissioned to establish the viability of the project, and the report's
key findings identified the 'user friendliness' of the website as a critical factor in the success of the
service. The market research company then decided to conduct an online survey of 2,000 Internet
users in PHC's local area to establish the likely take-up of the service.
A summary of key findings is given below.

Key results from the online survey and market research report
 60% of those surveyed believed that such a service would be useful 

 50% said that they would be prepared to pay an annual membership fee of
between CU100 and CU300 


 Up to 200,000 individual users, and 2,000 organisational members, are forecast for the site by 2008 

 Up to 500 organisational members are forecast to be 'income generating'
advertisers on the site by 2008 – each expected to generate a minimum of
CU50,000 each year from that presence, of which 10% will be donated to PHC 

 Internet usage in the local area is set to double over the next four years 

 The market research company indicated that their forecasts of net cash flows
could vary between +/- 30% 
Two funding models have been developed for the clinic following the market research.
First, the company could allow advertising access to the website to local organisations in
return for a flat fee of CU500, plus a 10% commission on any income generated from
goods and services sold directly via the site. Individuals who wish to use the site could do
so for free.
Alternatively, memberships could be offered to local organisations, and any individuals who
want to use the site for their own healthcare requirements. Memberships would cost
CU100 for individual members and CU300 for organisations, but there would be no
advertising access and hence no commission revenue.
Requirements
(h) Provide a financial forecast based upon the funding models identified, showing:
(i) Net annual cash flow
(ii) How the forecasts might vary with the possible errors in the forecast data
identified by the market research company
(iii) When the project would break even.
You should explicitly state any assumptions you need to make. (12 marks)
(b) Provide clear recommendations concerning the project, from both a financial and non-
financial perspective. Consider issues of suitability, feasibility and acceptability in your
answer, and give clear justification for the decision reached. (12 marks)
(iv) Suggest a set of performance measures which can be used by PHC to identify the level of
achievement
of each of the three 'quality of care provided' features listed. (6 marks)
 The absence of the profit measure in non-profit seeking organisations causes
problems for the measurement of their performance. With reference to PHC,
briefly explain why this is the case.
(5 marks)
(35 marks)
31 Online clinic
Marking guide
Marks
(a) Net annual cash flow 4

Vary forecasts 4

Break even 4
12
(b) Issues of suitability, feasibility and acceptability 10
Justification 1
Recommendations 1
12
(c) Set of performance measures 6
(d) Problems of performance measurement 5

35
Note: As in real life, the data in this question is ambiguous. There is more than one possible answer.
You should state your assumptions, show your workings and demonstrate a careful and logical
approach to answering the question.
For part (c), remember that indicators need to be compared against a yardstick to be of any use for
performance measurement purposes. For example, the fact that 8% of appointments is cancelled is
useless information. When considered in conjunction with a target of 5%, it becomes useful.
Like many examination questions, part (d) can be answered by taking a logical, structured approach that
is offered to you by the wording of the question itself.
Take note of the examples about objectives that have been provided – they may prove useful in your
exam, as this requirement is perhaps one of the more likely to appear in any question concerning not-
for-profit (NFP) organisations.
(a) Assumptions
(i) Assume that only 50% of individuals would be prepared to pay the annual
membership fee of CU100.
(ii) Assume that the organisational users and individual users are mutually exclusive.
(iii) Assume that the 30% variances apply uniformly over all costs and revenues.
(iv) Assume the CU0.5m expenses are variable costs.
Data common to both models
Respondents 2,000
Prepared to pay 50%
Number of advertisers 500
Revenue generated by each advertiser CU50,000
Forecast annual individual site users 200,000
Forecast annual organisational users 2,000
Model variance – plus or minus 30%
Start-up costs CU2,000,000
Annual expenses CU500,000
Model 1
Fee CU500
Commission 10%
Annual cash flow CU
Organisations' fee revenue (CU500 x 2,000) 1,000,000
Commission revenue (500 x CU50,000 x 10%) 2,500,000
Total revenue 3,500,000
Annual expenses 500,000
Net annual cash flow (after start-up costs) 3,000,000
Model 2

Individual membership CU100
Organisational membership CU300
Annual cash flow CU
Individuals' fee revenue (CU100 x 200,000 x 50%) 10,000,000
Organisations' fee revenue (CU300 x 2,000) 600,000
Total revenue 10,600,000
Annual expenses 500,000
Net annual cash flow 10,100,000
As the data provided in the brief indicates that forecasts could vary between +/-30%,
variation in projected cash flow is as follows:
High Low
Model 1 3,000,000 x 1.3 = CU3,900,000 3,000,000 x 0.7 = CU2,100,000
Model 2 10,100,000 x 1.3 = CU13,130,000 10,100,000 x 0.7 = CU7,070,000
Clearly with a projected capital cost of CU2m, there would be a payback within the first
year even at the lowest level of projections and, with Internet activity levels forecast to
double, this looks even better. However, it would be unwise to ignore the fact that the
market research appears to have been conducted on a statistically unsound basis (with a
very small sample size) and thus the projections are likely to be unsafe.
Further market research would be advisable, using sample sizes that would provide an
acceptably high statistical level of confidence.
(b) Recommendations
Financial
Both models are financially feasible and, if they are not mutually exclusive, both could be undertaken.
If they are mutually exclusive, then Model 2 would give the greater financial return, and would cover
current level of operating costs. Purely based on financial criteria, the project should be undertaken.
However, it would be unwise to base a recommendation on financial criteria only, for the reasons
described above. There are several assumptions built in to the analysis as outlined, which may prove
to be inaccurate.
Among the problems associated with strategic decision making such as that faced by is the lack of
certainty associated with forecasting. The risk that results will not be as forecast (in PHC's case, that
the cash flows are potentially volatile and uncertain) will serve to increase the required rate of return
of the project. To protect cash flows, it might be made a condition of the project that it should pay
back within a certain period of time.
Non-financial
The strategic choices faced by PHC can be evaluated according to their suitability (to PHC and its
current situation), their feasibility (in terms of its usefulness and PHC's competences) and their
acceptability (to relevant stakeholder groups such as PHC management, clients and the government).
Suitability
Suitability relates to the overall logic of the strategy. It needs to fit PHC's operational circumstances
and provide positive answers to questions such as these:
 Does the strategy exploit PHC's strengths as a major health care resource? 

 Does it deflect threats, such as the proposed cut in funding? 

 Will it satisfy the goals and objectives of the organisation to improve public health? Will targets
on appointment times, for example, be able to be met? 

 Is there an acceptable level of risk? 

Feasibility
Feasibility asks whether PHC can in fact implement the service with its existing competences. New
competences take time and money to acquire.
 Are there enough resources (manpower, finances, technological in particular) to deliver the
online services? The website is likely to have significant demands made upon it by up to 200,000
individual users 

 Is there enough time to implement the strategy? 

 Is there any likely response from similar organisations? 
Acceptability
The acceptability of a strategy relates to people's expectations of it. It is here that stakeholder analysis
may be brought in.
 Management and banks needs to be sure that cash flow objectives are met 

 Clients may object to the proposed new service, particularly if they are not computer literate, do
not have Internet access or are effectively excluded because of the CU100 fee. 
Statistical methodology
The statistical methodology appears to be flawed and if it is not intended that a larger and more
structured survey be undertaken, then I would recommend that the launch be undertaken with
caution. The forecast rates of growth, forecasting the doubling of Internet usage by 2008, could be
optimistic. The margin of error of +/-30% indicates poor sample construction and thus any resultant
recommendation could be based upon unsound market research.
External environment
The environment in which PHC operates needs to be considered. The model takes no
account of similar operations elsewhere in the country, if any, and whether or not they have
been successful. Market research on such services needs to be undertaken, and any findings
built into the model. In addition, no questions are asked about continued Internet access and
developments in the market.
Another consideration revolves around the ethics of providing online advice on medical
matters, especially if such a service is to be paid for. Experts who administer the website
would need to be very careful to restrict their involvement to advice, and not to diagnose
illnesses under any circumstances, as this should only be done by a competent doctor in the
physical presence of a patient. This also applies to health monitoring programmes.
Overall
The project should be undertaken only with extreme caution, after further statistically
sound market research, and only then after a pilot project is undertaken. The ethical
aspects of the service need to be fully appreciated.
 To measure performance, objectives or targets for performance need to be established.
Since the 'quality of care' features that have been identified cannot be expressed financially,
non-financial targets must be used. The effective level of achievement could be measured by
comparing actual performance against target.
Adherence to appointment times
 Percentage of appointments kept on time 

 Percentage of appointments no more than 10 minutes late 
 Percentage of appointments kept within 30 minutes of schedule 
 Percentage of cancelled appointments 

Average delay in appointments 
A problem with these measures is that there is an implied assumption that all patients will
be at the clinic by their appointed time. In practice, this will not always be the case.
Patients' ability to contact the clinic and make appointments
 Percentage of patients who can make an appointment at their first preferred time, or
at the first date offered to them by the online facility 

 Average time from making an appointment to the appointment date 

 Number of complaints about failure to successfully use the website, as a
percentage of total patients seen. 
Comprehensive monitoring programme
Measures might be based on the definition of each stage within a monitoring programme for
a patient. It would then be possible to measure the following:
 Percentage of patients receiving every stage of the programme (and percentage
receiving every stage but one, every stage but two, and so on) 

 If each stage has a scheduled date for completion, the average delay for
patients in the completion of each stage. 

(d) In a profit-making organisation, objectives can be expressed financially in terms of a target profit
or return. The organisation, or profit centres within the organisation, can be judged to have
performed well (that is, they have met targets or budgets) if they have achieved a target profit
within a given period.
In not-for-profit organisations (NFPs) performance cannot be measured in this way. PHC's
objectives cannot be expressed in purely financial terms, and non-financial objectives need
to be established. Performance could be measured in terms of whether targeted non-
financial objectives have been achieved, but there are several problems involved in trying to
do this.
(1) The organisation might have several different objectives which are difficult to reconcile with
each other. Achieving one objective might only be possible at the expense of failing to achieve
another. For example, PHC might wish to provide lengthy and comprehensive consultations for
every patient, but this would conflict with its objective of adhering to appointment times.
(2) A NFP organisation will invariably be restricted in what it can achieve by the availability of
funds. PHC, for example, has the objective of providing health care, but since funds are
restricted there is a limit to the amount of care that can be provided, and there will be
competition for funds between different parts of its service.
(3) The objectives of NFPs are also difficult to establish because the quality of the service
provided will be a significant feature. The service can only be judged by establishing what
standard or quality of service is required.
(4) With differing objectives, none of them directly comparable, and none that can be expressed in
profit terms, human judgement is likely to be involved in deciding whether an organisation has
performed well. This is most clearly seen in government organisations where political views
cloud opinion about the government's performance.
(5) When resources are limited, their consumption needs to be controlled, and the output
produced by the organisation needs to be compared with the resources employed or used up
to achieve that output. However, since NFP organisations often have several different
objectives, it is difficult to compare the resource usage of one health clinic (for example) with
that of another.

32 Waltex Ltd
Waltex Ltd (Waltex) is a large, unlisted company which manufactures watches. Its shares are
held equally by three groups: the Waltex family, venture capitalists and employees.
Customers are jewellers shops which are located throughout Europe and the Far East,
although 90% of Waltex's sales are in the UK.
Company history
Waltex was established in Wales in 1924 as a manufacturer of watches, positioned in the
low to medium price range. It has maintained a good reputation as a manufacturer of
traditional style mechanical watches. Waltex has not copied many of the larger
watchmakers which have moved to making quartz watches and have adopted sports or
fashion stylings. Moreover, Waltex does not try to compete with the major watchmakers
of international quality and reputation, which use precious metals and support their
brands with significant advertising. The brand image that Waltex has tried to promote has
been a good value, classic style and traditional mechanical mechanism that appeals mainly
to the over-45s age group.
All watches are currently sold under the Waltex brand name. There are 59 different product lines (i.e.
types of watch) which are sold to retailers in the price range CU35 to CU100. Retailers normally have a
30% mark-up on cost when selling to the public.
The UK watch market
The UK watch market generates retail sales of around CU1,100 million per year. Wrist watches dominate
the market, but there are three main types: quartz digital, quartz analogue and traditional mechanical
watches. There is very high market penetration with around 70% of adults in the UK owning a watch.
There is a trend in the UK market for consumers to buy cheaper watches. This is partly due to 'watch
wardrobing', whereby consumers own different watches for different occasions. This has given rise to the
role of watches as accessories. The success of cross-branding (a marketing approach to enhance two brand
names of different companies by associating them with each other) and seasonal collections from the major
suppliers have encouraged this trend.
The market for watches is fragmented, with a significant number of suppliers and retailers. In watch
retailing, the entry of large market participants (for example, supermarkets and clothing chains) has
increased the competition in recent years for traditional retailers such as jewellers, as large retailers and
supermarkets have significant buying power. The Internet, through online sales of watches, has created
competition for traditional retailers and has also generated greater transparency in the market, as it is
easier for consumers to make comparisons before buying.
The UK market for watches, in sales value terms, will probably experience a decline in the next few years,
caused by continuing selection of cheaper watches; slower growth in the UK economy; and competition
from other products in the leisure and consumer electronics markets.
Strategies for change
The poor performance of Waltex in recent years has caused some concern amongst shareholders and in
September 2007 some of the executive directors, who did not own shares, resigned, with a new chief
executive and finance director being appointed almost immediately. After a period of evaluation, several
strategies for change were identified. These are not mutually exclusive.
Strategy 1
Increase the advertising expenditure from CU1 million in 2007, to CU2 million in 2008, in order to
promote the brand and increase sales.
Strategy 2
Launch a new range of watches with a new brand name. These would be ladies' quartz watches, branded

with the name Splash! They would have a fashion orientation and a distinctive pink and yellow striped design.
This would be part of a joint venture with a well-known fashion company, Kuchi Ltd, who would adopt the
same design for their matching Splash! range of women's clothes. The Splash! watches and clothes would be
jointly marketed to the same retailers, which would be fashion clothing and accessories shops, none of
which have been previously used by Waltex. No separate joint venture company would be set up, but
contractual obligations would be entered into to produce adequate volumes to match approximately the
other venturer's production. Additional joint advertising obligations would also be needed to support the
cross-branding (this would be independent of the CU2 million commitment in Strategy 1). The Splash!
watches are expected to retail at CU90, while the matching Kuchi clothing would retail at an average of
around CU250. Initial cash costs of CU10 million would be incurred by Waltex to set up a quartz watch
production line. Incremental annual fixed costs (in addition to the initial cash outlay) of CU3 million would
be incurred in manufacture. Variable costs are expected to be CU40 per watch in the expected range of
output, although sales volumes are very uncertain.
Strategy 3
Accept an offer from a large UK supermarket, Yarmack Ltd, to buy 40,000 watches in 2008 with the possibility
there would be a further contract in 2009 if sales went well. These watches would normally have a price to
jewellers of CU45, but Yarmack is only willing to pay Waltex CU36 per watch. Yarmack would then sell the
watches for about CU46. Yarmack is not currently a customer, but this contract would make it Waltex's
largest customer.
The board meeting
A meeting of the new board was held to discuss the proposed strategies for change.
The marketing director spoke first: 'I would undertake all three of the strategies for
change. From a marketing perspective we need to grow sales volumes and all three of these
proposals achieve that.'
The finance director responded: 'The company has performed poorly in the past few years, as
shown in the preliminary data I have provided for the UK market and the company (see Exhibits
1 and 2). However, I am not yet sure whether the poor performance is because of a difficult
market or because there has been internal mismanagement. I agree that there needs to be change,
but we first need to establish what has been going wrong. I have provided some information from
a marketing survey to help us (Exhibit 3). However, it is not just about making sales, we need to
look carefully at our costs.'
The production director also expressed some concerns: 'There is some spare capacity in the
factory at the moment, but we need to make sure that we can supply all these new sales initiatives.
I reckon our annual capacity is currently 1.2 million units. If we set up the quartz production we
will probably lose factory floor space and cut annual production capacity of existing mechanical
watches to around 1.1 million units.'
Exhibit 1
UK watch market data
2003 2004 2005 2006 2007
(Estimate)
Total UK retail sales (CUm) 998 1,049 1,112 1,125 1,100
UK media advertising expenditure on 26.5 27.2 28.9 27.0 26.5
watches (CUm)
Exhibit 2
Waltex data
2003 2004 2005 2006 2007
(Estimate)
Revenue CUm 49.5 44 42.5 42.75 45

Fixed operating costs CUm 20 20 20 20 21
Total variable operating costs CUm 27 24 25.5 28.5 30
Operating profit/(loss) CUm 2.5 0 (3) (5.75) (6)
UK media advertising expenditure 0.8 0.8 0.90 0.96 1.0
(CUm)
Units sold (watches millions) 0.90 0.80 0.85 0.95 1.00
Number of product lines 45 47 53 57 59
Exhibit 3
Marketing survey (in 2007)
Waltex UK industry
average
Age: (percentage of sales to over-45s) 62% 29%
Higher socio-economic groupings: (percentage of sales to groups A and B) 19% 24%
Gender (women's watches as a percentage of total sales) 54% 51%
Gender (percentage of watch purchases made by females, including gifts) 60% 53%
Average wholesale price CU45 CU50
Requirements
(b) (i) Using the data in Exhibit 1and Exhibit 2, prepare a memorandum which provides a
preliminary analysis to help explain the performance of Waltex over the period 2003 –
2007. Show supporting calculations where appropriate.
(i) Indicate any further data that you would reasonably require for a more detailed performance
report, including any additional breakdown of the existing data. Ignore the proposed
strategies for change and the marketing survey. (11 marks)
(g) With respect to Strategy 1 explain:
(i) The types of advertising that would be appropriate to each of the market segmentation
groups (i.e. age, socio-economic and gender) identified in the market survey in Exhibit 3.
(ii) How you would evaluate the impact of the proposed advertising campaign (assuming that the
evaluation would take place in January 2009) use the data provided to support your arguments.
Ignore the other proposed strategies for change. (11 marks)
(vi) For each of Strategy 2 and Strategy 3, identify the potential risks and benefits, and give a reasoned
recommendation of whether the strategy should be undertaken in each case. (11 marks)
(33 marks)
 Waltex Ltd
Marking guide
Mar
ks
(a) Sales revenue 2

Sales volumes 2
Costs 2
Supporting calculations and data analysis 4
Other information 3
Total possible marks 13
Maximum full marks 11

(b) Strategy 1
Market segmentation 7
Impact of campaign 6
(c) Strategy 1 and 2
Risks 7
Benefits 3
Recommendation 3
33
General comments
The scenario in this question is a manufacturer of traditional, mechanical watches. The company has
struggled to maintain sales in a competitive market which is dominated by quartz watch
manufacturers. Three strategies for change have been put forward: first, to significantly increase the
advertising budget; second, to enter a cross-branding joint venture with a clothing manufacturer; and
third, to accept a large new customer, a supermarket, by selling at a discounted price.
(a) (i) Analysis of basic data

2003 2004 2005 2006 2007
Average price per unit CU55 CU55 CU50 CU45 CU45
Market share (revenue x 90%) / industry 4.5% 3.8% 3.4% 3.4% 3.7%
sales
Advertising expenditure as % of industry 3.0% 2.9% 3.1% 3.6% 3.8%
Average variable cost per unit CU30 CU30 CU30 CU30 CU30
Break even (units) 0.8m 0.8m 1m 1.33m 1.4m
Contribution per unit CU25 CU25 CU20 CU15 CU15
Sales revenues
The volume of sales has increased by 100,000 units (11.11%) over the period
2003 – 2007 while, at the same time, sales revenues have fallen by CU4.5m
(9.09%) over the same period.
The sharp fall in the average selling prices of CU10 (18.2%) appears to
explain at least some of this difference. However, more information is
needed to determine the cause of the underlying fall in selling prices.
Specifically, each of the following factors may be relevant:
 Prices of individual items may have been reduced in order to
maintain or increase the volume of sales.
 The selling prices of individual items may not have changed substantially
but there may have been a change in the mix of sales, with an increase in
the proportion of lower priced items being sold within the price range of
CU35 to CU100. This explanation is consistent with the 'trend in the
market for consumers to buy cheaper watches'. The new product lines
introduced may also have been at the bottom end of the product range.
A less important effect may also be a change in exchange rate on overseas
sales, but these only make up 10% of sales.
Sales volumes
As already noted, sales volumes have increased significantly (11.1%)

although not enough to compensate for the reduction is sales prices.
While more information is needed, the possible reasons for the increase may be:
 The reductions in selling prices may have increased demand. 

 There may have been a change in the market desire to purchase
traditional mechanical watches in general, and Waltex watches in
particular. 

 Increased advertising in absolute terms has increased. This may be
important as watches are competing with 'other products in the leisure
and consumer electronics markets'. However, the levels of advertising in
these industries would need to be assessed in order to provide evidence
of whether the increase is sufficient to persuade customers to buy
watches in preference to other consumer products. 

 Increased advertising relative to the industry average. This is important to
improve market share. However, despite the increased advertising
compared to the industry average, the market share of Waltex has fallen.
Care needs to be exercised here however, as market share is in sales
value terms, where Waltex has not performed well. Market share in
volume terms may have increased, and more information is needed in this
respect. 
In terms of profitability, the company has performed poorly over the period
2003 – 2007 with a CU2.5m operating profit turning into a CU6m operating
loss. Other costs such as financing costs may make these figures worse,
although tax effects may moderate the decline.
Revenue factors have already been considered but costs are
relevant to any analysis of performance.
Costs
Variable costs per unit have remained constant over a long period. A number of factors might
have caused variable costs to change but may have acted in opposite directions.
Variable costs might have been expected to fall as output increased with longer production
runs (this would depend however on how much of the new output was due to the new
product lines) 

Fixed costs remained constant, except in 2007 when they increased to CU21 million 

Inflation may have been expected to increase costs (e.g. wage inflation). 

 Further information
Further information that is needed in respect of sales and marketing would be:
Analysis of sales volumes for each type of product to evaluate whether there has been a
shift in the mix from high value to low value 

A listing of selling price changes on individual products 

Prices of the new product lines compared to existing product lines 
In order to assess the performance on costs the following information would be needed:
 Detailed analysis of costing for each product 

 Split of overseas and UK costs to examine if overseas sales, at only 10% of the total revenue
(and made to many different countries) are viable 


 Impact of inflation of costs compared to underlying efficiency gains 

 Identification of cost drivers to consider activity-based costing and the viability /
performance of each of the 59 different product lines. 

(b) (i) Demographic – age
 Advertising in magazines that are read mainly by over-45s 

 Radio and TV – day-time slots are cheaper and a proportion of over-45s may be retired and
not working 

 TV advertising during programmes which are popular with the over-45s 

 Use of actors and images which are recognised and valued by over-45s age group 

 Appearance of shops, packaging and staff that would appeal most to over-45s. 
Socio-economic
  Advertising in newspapers and magazines read by middle income groups 

  Direct mail – to occupations known to be in middle to low income ranges (C1 and C2) 
  Selective use of satellite TV for programmes popular with middle income groups 
  Public transport – is used disproportionately by low to middle income groups 
 Internet – identify commonly used websites for middle income groups. 
Gender
 While females make up the largest proportion in this group, the male purchasers are also
substantial and target marketing on a gender basis may not be sufficiently focused on a
significantly large majority of customers 

 Segmentation in this case may mean (rather than focusing on one gender group) advertising
to each gender in different ways to attract consumers to the different features of
male/female watches 

 There is a difference between the consumer (male/female watches) and the customer (the
retailers in the case of Waltex and, for the retailers themselves, it is the person who buys
the watch) 
 Promoting a female image of the watches to excess may make the watches less
attractive to male customers 

 To the extent that market segmentation is followed, then this may be similar to
the above but on the basis of gender: 

– Female magazines 

– TV and radio programmes popular with females 

– Packaging and shop appearance that would have a feminine preference (but not
at the cost of putting off male customers/consumers). 

(ii) Identifying the impact of the advertising campaign would depend on the type of
advertising and its objectives. Any evaluation should therefore be in comparison to the
related objectives.
If the objective of advertising is to promote long-term recognition of the brand, or a
particular image of the brand, then the effects in terms of sales may not be noticed by
January 2009. Additional market research may therefore be needed to assess the impact in
terms of customer recognition (e.g. questionnaires, interviews). This may determine
whether there is increased recognition of the brand before advertising (pre-test) and after
advertising (post-test) or, more directly the extent to which people can remember the

advert or other form of promotion.
If the objective is more short term, such as promotion of a particular offer, or to
stimulate sales of a particular product line, then sales figures could be examined
before and after the adverts. The problem is that other factors are also changing (e.g.
price, fashions etc) so changes in sales may not be entirely due to advertising.
In addition, retailers could be asked to give customer feedback on why they
purchased a watch (e.g. as part of filling in the guarantee on the watch which is then
submitted to Waltex).
Notes:
 In each case significant sales are made outside the segmental target groups and
it may be appropriate not to ignore these entirely. 

 The above are single variable segmentations. It may be appropriate to identify
multivariable segmentation e.g. females over-45. 

(c) Strategy 2 – Cross-marketing joint
venture
Risks
This is a new venture that requires a new investment of CU10 million. If the venture
fails thenthere is a risk that exit costs may be high. However, as the investment is
mainly in machinery to manufacture quartz watches, they are not specific to this
venture and may be utilised in alternative product and market strategies in
manufacturing quartz watches.
There is a core competence in mechanical watch making. It is not clear that this
competencecould be readily transferred to quartz technology. It is the same
watch market but largely a different industry, or at least a different production
technique.
Break even. The higher fixed costs may mean that break even will increase annually.
The annualbreak even is CU3m/(CU90 - CU30) = 50,000 units (or CU450,000 or
revenue). However, this ignores the depreciation on the initial outlay which will
increase the break even.
The contractual joint venture depends on a new partner Kuchi. Waltex is therefore at
risk fromthe actions of the partner in terms of reputation, fulfilment of contract
terms and acting reasonably in dealing with Waltex.
The venture is based on a particular fashion design which may be short term. There is
thereforea risk of sustainability of the market which is the subject of the joint
venture.
There is a risk that in focusing on ladies' watches in the new venture that the Waltex
brand willbe identified as a feminine brand and lose sales of men's watches.
 The contractual obligations of the joint venture may give rise to problems of meeting supply
requirements under the arrangements. 

 The selling price of CU90 is low in comparison to the joint partner's average revenue of CU250.
The costs of the JV should therefore be considered on this basis of disproportionate benefits. If
the cost are shared equally then this would present an additional risk. 

 Even if break even can be attained in the short term, there needs to be a sustainable revenue in
order to recover the initial outlay of CU10 million over the life of the project. 


 Some customers may switch from traditional to quartz watches, thus sales could be replacement
rather than incremental. 

 The production director appears to be concerned that the new production line might have a
negative impact on existing capacity. 

 As this is a new venture it is likely to require significant management time which could cause
them to take their eye off the core business. 

 As well as the extra operating gearing, funding the investment is likely to result in increased
financial gearing. In addition there may be further WC requirements beyond the initial CU10m,
particularly if the business is expanding. 
Benefits
 The venture may change the image of the company as well as that of the specific products in the
venture. 

 It diversifies out of mechanical watches, which have particular market attributes. Quartz watches
may appeal to a different market. 

 This is a high margin product at CU60 per unit. If sales exceed the break even level then additional
profits will be made. The break even level needs to be assessed as to whether it is attainable using
market research but, at 50,000 units, it is low by comparison to existing output. 
Recommendation
There are some concerns which need to be addressed before entering into the agreement. These
include the following:
 The terms of the joint venture need to be established clearly so Waltex does not incur a
disproportionate share of the costs. 

 Market research needs to be completed to establish whether the break even is likely to be
attained over the life of the project. 

 The reputation and benefits of the joint venture partner need to be considered in terms of the
benefits of cross marketing. Any alternative partners who can deliver a better package of benefits
and costs of cross marketing may be considered. 
Subject to these concerns there seems to be merit in investigating the venture further.
Strategy 3 – Yarmack offer
Risks
 Additional fixed costs may be incurred in addition to the variable costs. 

 There may be some opportunity costs in terms of lost sales to the extent that people buy
Waltex watches from Yarmack rather than other retailers. To the extent that this occurs, then
there is a lost contribution of CU5 per watch for each item purchased in this manner. 

 The contract is short term and thus may fail to deliver benefits in the long term. 

 The contract may reinforce the downmarket image of Waltex. 

 If the contract is undertaken alongside Strategy 2, then there is no spare capacity in the factory to
benefit from increased output – particularly if additional advertising is undertaken in Strategy 1. 
 As a large and powerful buyer Yarmack may put further pressure on

Waltex e.g. delayed payment, more stringent quality requirements. 
Benefits
 Potential additional sales of 40,000 watches generating a contribution of CU240,000. 


 Yarmack may improve the exposure of Waltex and thus improve the promotion of the
product. 

 The contract may be renewed, perhaps at an increased volume, in future years if
they sell well in the first year of the contract. 
Recommendation
The benefit of the increased sales needs to be weighed against the lower margin
and the risk to existing sales from lost sales and lowering of reputation.
Subject to these concerns, there seems to be merit in entering into the contract this
year as the loss in revenue is only CU5 compared to the existing price, while the
potential increase in volume is 4% of existing output.
33 Newsville Ltd
Newsville Ltd (Newsville) owns and operates a regional newspaper, The GC Voice, which covers the
areas in and around Chittagong, a large provincial city in Bangladesh.
Company background
The GC Voice has a geographical target market of individuals living within 25 miles of the centre of
Chittagong, which has a population of 500,000 people. There are about 800,000 people living in the
target area, although the population has been slowly declining over a long period.
The GC Voice is published each evening, but only six days a week (i.e. excluding Sundays) and, other than
in Dhaka, it is one of the largest and oldest, regional daily newspapers. In common with similar regional
newspapers around the country, sales of The GC Voice have declined significantly in recent years and are
currently at about 105,000 copies per day. The cost to consumers has been constant for the past four
years at 40p per copy and retailers are charged on average 35p per copy.
The major operations at The GC Voice include: editorial (i.e. journalism), printing, marketing and
administration. The printing resources are idle for parts of the day, but are fully utilised in the hours
before the newspaper goes to print. Distribution, in common with most other newspapers, is
outsourced to specialist distributors, which need to accommodate tight deadlines following each print
run.
The main sources of income are revenues from the sale of the newspapers and from advertising in
the newspaper.
The GC Voice has a website which gives details of the paper and contacts for stories or adverts, but it
does not have website subscribers or an electronic version of the newspaper.
Rival local newspapers
There is no other major evening newspaper in Chittagong, but there is a local morning newspaper,
called The World operated by a rival company. The World is selling about 24,000 copies per day at a
price to consumers of 40p. In the past few months, however, a limited number of copies of The World
have been distributed free of charge, on a targeted basis, at railway stations and in business districts.
The aims of providing some free copies are threefold: to increase general circulation in order to
encourage advertisers; to increase circulation specifically amongst high income groups; and to bring The
World to the attention of people who do not currently buy it.
There are also a number of small circulation, local newspapers in Chittagong, normally with a
special interest perspective.
Industry background
The Bangladesh newspaper industry can be analysed in a number of different ways. Most obviously,
national newspapers and regional newspapers have very different geographical target markets, and
are different in coverage, with the largest national papers having a daily circulation of between two

and three million copies. The largest regional newspaper is in Dhaka, with a daily circulation of over
300,000 copies. Other leading regional newspapers have circulations of around 100,000 copies.
Another way of analysing the industry is by timing of publication, consisting of: morning, evening
and Sunday papers. Alternatively, a distinction can be made between 'paid for' newspapers and
'free' newspapers, the latter depending entirely on advertising revenues.
The Bangladesh newspaper industry currently generates revenues of around CU8,000 million per
annum of which CU4,200 million is generated by national papers and CU3,800 million by regional
papers.
In terms of the source of industry revenues, about 62% is from advertising and about 38% from
sales of newspapers. This mix of revenues differs significantly, however, between the nationals
and the regional papers, which generate about 45% and 80% respectively of their revenues
from advertising.
The regional newspaper sector is very fragmented, with both large and very small operators. A
recent survey found that there are 1,301 regional press titles in the Bangladesh. These included
110 dailies (96 are paid-for and 14 free), 13 paid-for Sunday titles, 9 free Sunday newspapers, 522
paid-for weekly titles and 647 free weeklies.
Circulation has been falling in the industry for decades, but the past few years have been
particularly difficult times. The growing influence of online news media and 24 hour satellite TV
news, have meant that sales of newspapers have fallen at an increasing rate (see Exhibit 1). In
response to on-line competition, many newspapers have set up an electronic version, where
subscribers can log on around the world to access the newspaper content and emerging news
stories.
As a consequence of the increased competition in providing news, attracting advertising has been
difficult for traditional newspapers. The competition for advertising has arisen from the growth of
online communications, but also from free newspapers and other forms of media. Overall, the
newspaper industry has suffered a 4.4% decline in advertising revenues this year, resulting in fierce
competition within the industry.
The growth of free newspapers has been another of the major features of increased supply in the
industry. The largest regional free newspapers have distributions of between 200,000 and 300,000
copies.
Following the decline in circulation and continuing loss of advertising revenues, a series of strategy
meetings were held for the directors and management of Newsville to discuss the future strategic
direction of the business.
Strategic meetings
The finance director was among the more pessimistic of the directors: 'Look, things have been
pretty bad, but they could have been even worse. As yet, there has not been any serious threat of
the launch of a free newspaper in Chittagong. I would be in favour of us starting our own free
newspaper, which we could distribute with a guaranteed circulation. This would improve
advertising revenues and discourage anybody else entering this market and threatening our core
business. If we launched a free morning daily or a free weekly publication it should not harm our
existing sales of The GC Voice.
The editor had a different view: 'The circulation has dropped and we need to ask ourselves why
this has happened and the extent to which it is due to internal factors as well as market
conditions. Publishing The GC Voice is what we know and what we are good at. We just need to
put more resources into journalism, to make the content of the paper a little better. However,
we need to do market research to
find out what people want to read and how much they would be willing to pay for the newspaper.
We need to sell more good quality newspapers to distinguish ourselves from the free-copy, low
quality journalism – and the price needs to be increased to reflect this'.

The marketing director had a different perspective: 'About 80% of our revenue comes from
advertising. We should decrease the price of The GC Voice to 20p per copy. We may make less
revenue from newspaper sales but, if we increase our circulation, we will make more from
advertising'.
Two strategic proposals

After much discussion two potential strategies emerged for new titles. It was considered that the company
could undertake both strategies if this is considered desirable.
Strategy 1: Launch a free local newspaper
This idea would be to maintain The GC Voice at its current price and adopt the finance director's proposal of
launching a free local morning daily newspaper.
Strategy 2: Launch a new magazine for 16- to 18-year olds
There is a gap in the national market for a magazine aimed at 16 to 18 year olds still in school or college
studying for 'A' levels or similar examinations for university entrance or employment at age 18. The
proposal is to publish a free magazine, Eighteen+, for this group each month. Articles could include: advice
on university applications, finding jobs, exam tips, advice pages, articles from exam boards and examiners
and more general older teenage issues. Evidence suggests that advertisers would wish to target this age
group of above average intelligence students, with high potential future earnings. The target market would
be across England and Wales. There is currently no such broad based magazine of this style in the market.
The target market group consists of about one million young people, and Newsville would aim to provide
each of them with one copy of the magazine. The distribution would be in batches to schools and colleges
who would be requested to give the magazine to each individual student.
Exhibit 1 – Circulation data (average copies per day)
2004 2005 2006 2007
(estimated)
The GC Voice 129,000 125,000 115,000 105,000
The World 28,000 25,000 23,000 24,000
Regional newspaper industry* 1,397,000 1,299,000 1,216,000 1,165,000
National daily newspaper industry 12,152,000 11,790,000 11,496,000 11,148,000
* The 'regional newspaper industry' figures are a selected portfolio of 12 leading evening daily regional
newspapers from across the Bangladesh.
Exhibit 2 – Four-year operating profit schedule for The GC Voice
2004 2005 2006 2007
(estimated)
CUm CUm CUm CUm
Revenue:
– Sales of newspapers 16.0 15.5 14.6 13.6
– Advertising 64.0 60.5 55.5 50.3
80.0 76.0 70.1 63.9
Operating costs:
– Editorial 22.0 22.0 21.0 20.5
– 25.5 24.5 23.5 22.5
Printing
–
Marketing 7.5 7.5 7.5 7.5
– Other 5.0 5.0 5.0 5.0
60.0 59.0 57.0 55.5
Operating profit 20.0 17.0 13.1 8.4
Requirements

(e) Using the data and other information provided, evaluate the competitive position and performance of
The GC Voice over the period 2004 to 2007. Indicate any additional information that you would require
for a more complete assessment. For this purpose, ignore the two strategic proposals.
(12 marks)
(v) As part of a SWOT analysis, identify and clearly explain the threats to Newsville.
(You are not required to address the other three aspects of a SWOT analysis.)
Ignore the two strategic proposals for this purpose. (5 marks)
(c) Evaluate both sides of the argument about pricing highlighted in the discussion between the editor
and
the marketing director. Prepare a recommendation with reasons. Ignore the two
strategic proposals for this purpose. (7 marks)
(d) Write a memorandum, as an external consultant, which evaluates the two strategic
proposals under each of the following headings:
  Market research 
 Strategic impact of the proposals 
 Risks of the proposals (16
marks)
(40
marks)
33 Newsville Ltd
Mark plan
The marking plan set out below would be used to mark this question. Markers would be
encouraged to use discretion and to award partial marks where a point was either not
explained fully or made by implication. More marks are available than can be awarded for
each requirement. This allows credit to be given for a variety of valid points made by
candidates.
Marking guide
Mar
ks
(a) Performance of The GC Voice over the period 2004 to 2007 4

competitive position 4
Data analysis 6
Additional information 2
(b) Threats to Newsville
(c) Evaluate both sides of the argument about pricing 8
Recommendation 2
(d) Evaluates the two strategic proposals
Strategy 1

Market research 4
Strategic impact 3
Risks 3
Strategy 2
Market research 4
Strategic impact 3
Risks 3
40
(a) Competitive position

2004 2005 2006 2007
(estimated)
Share of regional newspaper industry market by 9.2% 9.6% 9.5% 9.0%
The GC Voice
Share of local market (i.e. the local market being defined as 82.2% 83.3% 83.3% 81.4%
The GC Voice and The World combined)
The above table shows that in the local Chittagong market The GC Voice continues to dominate
local circulation (i.e. The GC Voice and The World combined) with over 80% of local sales. These
figures need to be treated with care however, as there are other newspapers in Chittagong which
also may have a small current circulation but are nevertheless competitors with some market
share and are likely to have the potential to grow.
Also the local market is influenced by the national papers sold in the Chittagong area, which may
be regarded as competitors to The GC Voice. For example, there may be regional variations on
national papers (e.g. for local football teams). To the extent that the local Chittagong population
may choose to buy a national morning paper, rather than the local evening paper, the nationals
are competitors and circulation may therefore be influenced by relative prices.
Despite the significance of the nationals to the sales of The GC Voice, the data provided is not
helpful in this respect as it relates to the whole of Bangladesh. More data is needed on the sales
figures of national newspapers in Chittagong and surrounding areas.
While the table shows that The GC Voice continues to dominate the local market, it also gives an
indication of changes in its competitive position with respect to The World over the period 2004-
2007.
Specifically, The GC Voice gained market share in 2005 and maintained this position in 2006.
However, in 2007, there was a significant loss in local market share compared to The World. This
was partly because The GC Voice decreased its circulation and partly because The World increased
its circulation.
It may be that the increase in circulation of The World was due to the free copies distributed
rather than normal competitive conditions. Nevertheless, there is a significant local competitive
threat, irrespective of the underlying cause.
The data showing the share in the regional market has The GC Voice with a declining market
share ending up at 9% in 2007. In terms of competitive position however this tells us very little
as The GC Voice is not really completing with other regional newspapers. The data is useful
however as a benchmark of performance and is referred to again below.
Performance
Circulation
2007

2004 2005 2006 (estimated)
The GC Voice 129,000 125,000 115,000 105,000
(-3.1%) (-8%) (-8.7%)
The World 28,000 25,000 23,000 24,000
(-10.7%) (-8%) (+4.3%)
Regional newspaper industry 1,397,000 1,299,000 1,216,000 1,165,000
(-7%) (-6.4%) (-4.2%)
National daily newspaper industry 12,152,000 11,790,000 11,496,000 11,148,000
(-3%) (-2.4%) (-3%)
% figures in brackets show year-on-year change
The table above indicates the performance of The GC Voice relative to its major competitor
groups in terms of circulation. This indicates that the circulation of The GC Voice has fallen more
substantially than any of these three groups. This is however a short-term trend and other
explanatory factors would be needed to make a fuller assessment including:
 A longer-term trend – as 2004 might represent an unusual 'high' for The GC Voice 
 Changes in price. Competitors may have decreased price (perhaps to zero as
for some copies of The World) while The GC Voice has maintained the same price. 
The World has only reduced its price (selectively) 'in the past few months'. More detailed analysis
on the impact on sales of The GC Voice is needed over this sub-period, in order to give a better
indication of the longer-term impact, as the full year's figures would not fully reflect this new
competition.
Circulation is, however, only one measure of performance. Aspects of financial performance also
need to be considered.
Revenues
An examination of revenues generated by The GC Voice indicates that revenue from newspapers
have declined in line with sales as there has been no price change. As already noted this decline
is substantial and is of concern.
Of even more concern is that advertising revenues have fallen even more sharply than newspaper
sales revenue. This is indicated in the following table:
Percentage of revenue generated by newspaper sales and advertising
2007
2004 2005 2006 (estimated)
CUm CUm CUm CUm
Revenue:
– Sales of newspapers 20% 20.4% 20.8% 21.3%
– Advertising 80% 79.6% 79.2% 78.7%
100% 100% 100% 100%
Another way of looking at the relative decline in revenue streams is that over the period 2004 – 07
revenue from newspaper sales fell 15% (1 – 13.6/16) while advertising revenues fell 21.4% (1 –
50.3/64).
The relative decrease in advertising revenues compared to newspaper sales is not substantial but
it is a worrying trend. Of more concern is the absolute decrease in advertising revenues of 21.4%
over a three-year period.
Operating costs
A newspaper is likely to have substantial fixed costs as the editorial content is more or less the
same, irrespective of how many newspapers are sold. The fact that some savings have been made
might indicate cost reductions have been achieved. If this has meant reduction in quality it may
have contributed to the more substantial decline in sales in 2007. More information is needed in

terms of market research to establish the link between journalistic quality and sales volumes (but
this is considered in part (c) below).
The printing costs are likely to have fixed cost (e.g. labour, depreciation) and variable cost
(e.g. newsprint) elements. Perhaps as a consequence, printing costs have decreased by
only 11.8% compared to the decline in sales volumes of 18.6% over the period 2004 – 07.
Marketing and other costs appear to be entirely fixed as they have not changed over the period.
As a consequence of high fixed costs, there is high operating gearing, thus operating profit has
fallen 58% over the period 2004 – 07 while sales revenues have decreased by 20% over the
same period.
Summary
It is clear that the decline is due, in part, to difficult industry conditions as other newspapers have
also suffered declining circulations. Nevertheless, the fall in sales of The GC Voice is greater than
any of the benchmarks which indicate that the decline is not entirely explained by industry-wide
factors.
Comparisons with The World are inevitably crude but, to the extent on which they can be
relied, it would also appear that local market conditions in Chittagong do not explain the
decline of The GC Voice.
The disproportionate decline in advertising revenues is further evidence that financial performance is
even weaker than editorial/circulation performance.
More external information is needed to improve benchmark comparisons (market research,
breakdown of industry data to local level) and more internal information is needed to highlight areas of
underperformance (journalism quality, marketing, operations, day-by-day sales analysis).
(b) Competition from new entrants: Especially free newspapers. Free newspapers would enable rapid
market penetration into the Chittagong area and may quickly capture part of the market of The GC
Voice. This would be more damaging still if the newspapers were evening editions. A national chain or
another regional paper may be able to give financial support to such a venture and may have existing
print and distribution facilities. The fact that Chittagong is a large city without a free newspaper may
indicate that such a market entry has a high probability of realisation.
The World increasing the number of free copies: While more evidence is needed there is some
indication that, due to the policy of providing some free copies, The World has increased its circulation
in 2007, while The GC Voice has reduced its circulation in the same period. If the free copies were to
be increased in volume then the impact on sales of The GC Voice may be more substantial.
National newspapers: There is a competitive threat from national newspapers which have much
greater circulations and economies of scale than local papers. The GC Voice is distinguished from
national papers in two respects: first, it is published in the evening and hence has a different 'news
window' in terms of timing; and second; it has a local focus to the news. However, to the extent that
national papers have regional editions for each area of the country, then they present a threat to The
GC Voice which may be increased by better quality journalism.
Internet: The growth of online news media is a growing threat to all of the newspaper industry. The
threat is two-fold, in that people may buy fewer newspapers if they can access news online advertisers
may prefer online media where a wider variety of images and features can be brought to the attention
of consumers
Small local newspapers: There may be growth in competition from the smaller newspapers in
Chittagong which may develop and take market share, particularly if they are free or low priced.
Population changes: The population around the Chittagong area is substantial but it may continue
to decline over time, thus reducing the customer base.
(c) The responsiveness of circulation to price needs to be considered by market research. One of the
difficulties with such a regular purchase is that people's initial response to a price change may not be

the same as their response over time. For instance, a price increase may be followed by an initial
decline in sales as people resist the increase, but over time they may restore their demand patterns.
The issue here however is twofold. A change in price may alter circulation and this will affect the
revenue generated from the sales of newspapers. However, there is a secondary, and more important,
effect in this industry, which is the increased advertising revenues that a higher circulation will
generate.
The case for lower prices (the marketing director's view)
 Higher circulation means more advertising revenues 

 Compete more with free copies of The World on a like-for-like basis 

 Need to restore readership following reductions in circulation 

 The case against lower prices 

 May give perception of poor quality journalist content. This may (i) discourage advertisers who
do not want to be associated with poor quality papers (ii) discourage readers and therefore push
down demand rather than increase it 

 If demand is inelastic then revenues from newspaper sales will fall. 
The case for higher prices with improved journalism: (the editor's view)
  If demand is inelastic then revenues from newspaper sales will increase 

  Higher quality journalism may attract new readers 
  Higher quality may attract advertisers 
  Distinguish from The World 
 Compete more with the Nationals. 
Disadvantages of higher prices with improved journalism
Needs more market research as presenting a package of two new features (i)
higher price, (ii) better journalism 

People may not be willing to pay more particularly when some free copy is available 

People may not want 'better' journalism if it means a change in the style or language of the paper 

Costs will increase to attract more or better journalists 

A higher quality higher price newspaper may bring The GC Voice into more direct
competition with national newspapers. 

 Strategy 1: Free local
newspaper Market
research
A free local newspaper is a new venture and thus market research may be difficult
to obtain. Nevertheless, both desk and field research may give a reasonable idea.
Desk research
Obtain data on:
The success of free newspapers in other cities that are similar to Chittagong
in terms of population and incumbent paid-for newspapers (e.g. from the
press association) 

Whether the success of free newspapers in other cities impacted on the circulation
of paid for newspaper in that area 


What features and style the free newspapers have that have proved successful 

To what extent free newspapers are read (e.g. just the sports pages; a brief glance; or
reading in detail) 

The impact on The World's circulation arising from giving away free newspapers
would indicate the success of this type of operation 

The success of small-circulation, free newspapers in the Chittagong area 

Whether there is any noticeable impact on advertisements appearing in The World
following the free distribution policy 

Whether there is any noticeable impact on advertisement fees for appearing in
The World following the free distribution policy. 
Field research
Questionnaire surveys amongst existing readers may ascertain whether they would:
 Be likely to obtain and read a free newspapers 

 Intend to stop buying other newspapers and if so whether this would include The GC Voice 

 Intend to place personal advertisements in a free newspaper and would this be in
preference to adverts in The GC Voice 

 What style and contents they would like to see in a new free newspaper. 
Questionnaire surveys of non-readers might also be appropriate, particularly if the answers
are compared on a statistical basis to answers from readers of The GC Voice. This may
indicate the extent to which Newsville would be widening its readership and thus its
advertising base.
Another form of field research would be a trial testing of a free newspaper for a few weeks or in only
part of the region. A problem with this strategy is it would detract from the initial impact of a new
launch and may be half hearted unless sufficient resources can be committed.
Strategic impact
This would depend on the measures used to determine success.
Two possible (and interdependent) aspects of success would be:
 Circulation achieved (specifically the 'readership' volume as any amount of newspapers could be
given away) 

 Advertising revenues generated 
Of these, the circulation/readership might be regarded as an early hurdle for viability as advertising
revenues might take a little longer to become established as advertisers need to be assured of the
value of the new paper. Also, advertisers may be locked into existing contracts and may not be able to
move easily in the short term.
There are however some difficulties in these measures:
 The incremental advertising revenues generated need to be measured against the
incremental costs of publication including editorial, printing, marketing and distribution costs. A
break even level would be one measure of viability although this could be measured after an
initial period of losses to penetrate the new market 

 The net revenue impact needs to be assessed in terms of lost sales and lost advertising in
respect of The GC Voice in order to give a wider picture of viability to Newsville 

 There may be opportunity costs e.g. if contracted-in printing is used in future there may be
lost revenues if the printing of the new free paper consumes significant printing capacity. 

Strategy deters competition – if Newsville does not launch a free newspaper then another rival
company may do so and damage sales of The GC Voice anyway. In this respect the free newspaper may
prevent a competitor from occupying this product-space in the market. Strategic impact therefore
needs to be seen in the context of competitors adopting the same strategy.
Risks
 The World may retaliate by launching its own free paper 

 The World may expand the number of free copies particularly around the time that Newsville
launches its paper. The idea would be to prevent it getting a 'toehold' in the market 

 Front end costs may be sunk if the project fails 

 Exit costs may be high if the project fails 

 There may be reputational loss to The GC Voice if the project fails 

 There may be an unexpected impact on the circulation of The GC Voice despite market research 

 A high initial circulation may not be followed by advertising but there may be a delay in realising
this with significant costs being caused in the meantime. 

 Market saturation may occur with an additional newspaper and perhaps competitor reaction.
This may damage all participants in the Chittagong area newspaper market 

 Liquidity risks from investment in new project in advance of new advertising revenue streams. 
Strategy 2: Launch of Eighteen+
Market research
This is a new venture where the target market is well defined but it leaves open the issue of
readership (will anyone read the paper?) and advertising capacity. The market research objective
would initially need to attempt to quantify these two issues.
Desk research
Obtain data on:
 The newspaper and magazines currently being read by the target group and the extent to
which such publications address the issues that Eighteen+ intends to aim at 

 Any 'official' literature, or other literature available in the education sector, which
covers the issues of exams and universities in a similar manner to that intended by
Eighteen+ 

 Where advertisers such as universities and employers currently place advertisements 

 Size of market of students/pupils in full time education (national statistical office) 

 Spending ability and patterns of target market if available from existing research groups. 
Field research
Schools and students:
 Approach schools colleges to assess their willingness to distribute Eighteen+ to
students/pupils (write to a sample of head teachers or college heads) 

 Questionnaire survey to students/pupils to assess whether they would read a free magazine
with indicative contents 


 Questionnaire survey to students/pupils to assess what contents would encourage them to read 
Eighteen+ 

 Questionnaire survey to provide new evidence of spending ability and patterns of target market 

 Consider whether there is an additional market in second/third readers of Eighteen+ e.g.
parents, siblings 


 Questionnaires to be divided by sub categories (e.g. gender, age (16,17,18), geographical
region, establishment i.e. school or college etc) to see if there is a different level or type of
response which may influence the nature of the advertising 

 Issue a copy on a limited trial basis and survey the reaction (e.g. in a particular region
or in selected schools/colleges). 
Advertisers
 Approach universities and employers to ascertain whether they would be
interested in advertising in Eighteen+ (e.g. questionnaires; face-to-face interviews) 

 Approach universities and employers to ascertain their advertising budgets and amounts that
they might be willing to spend 

 Approaching other potential advertisers to assess the level of interest (e.g. advertisers in
other older teenage magazines) 

 Offer free advertising on the trial issue in return for monitoring the response. 
Strategic impact
As with Strategy 1, impact needs to be seen in terms of both (i) readership/circulation and (ii)
potential advertising revenues.
Also incremental costs need to be compared to incremental revenues. Again, initially any
comparison may be unfair as Eighteen+ needs to break into the market. In a steady state
however, viability may best be judged by the ability of advertising revenues of Eighteen+ to cover
incremental costs and thus break even.
In this instance there would appear to be few interdependencies of circulation or advertising
revenues with The GC Voice. However, there are likely to be economies of scale with respect to
printing costs and administration. There may be limited editorial synergies.
Distribution costs are however likely to be very different as Eighteen+ is national distribution and
The GC Voice is local. Also, as distribution is outsourced, this is likely to be a significant new cost
with few scale economies or economies of scope linked to the existing distribution system.
A key issue to control incremental distribution costs is whether Eighteen+ is distributed through
schools/colleges or to individuals. The lower cost option is clearly to schools/colleges as this
enables far fewer deliveries of larger numbers. This, however, gives dependence on
schools/colleges being willing to implement effective internal distribution systems so the paper
reaches its target audience.
Seasonality is an issue because universities would probably only be interested in advertising at
key times in their recruitment cycle, thus any assessment of viability needs ideally to have a full
cycle.
Publishing frequency – monthly may be viable but fortnightly may not be depending on initial
response. Monthly may be initially a way of breaking into the market.
There may be opportunity costs e.g. if contracted-in printing is used in future there may be
lost revenues if printing Eighteen+ consumes significant printing capacity.
Risks
If the project fails, then many of the financial risks are similar to those noted above for Strategy 1
(e.g. sunk costs, exit costs, front end cash outflows with delayed revenues).
The reputational risks of failure may however be less as Eighteen+ is a segregated market from The
GC Voice with limited local association and less likelihood of retaliation by competitors.
The uncertainty over readership and advertising revenues is however much greater than with
Strategy 1 as this is an unfamiliar readership both in nature and in geographical coverage.

The distribution of the paper also gives more uncertainty of costs.
If the venture is successful there would appear to be few barriers to entry that would prevent
competitors entering the same market and competing away any profits. Even if first mover
advantage enabled Eighteen+ to maintain its position as leader in this market, this may not be
enough to sustain long-term viability if there are new entrants.
34 Multi-Services Ltd (MS)

Multi-Services Ltd (MS) is a business which offers building services including: building,
plumbing, joinery and electrical work. Jack Fegan and Sean Phillips are the only
shareholders, each having a 50% holding having merged their firms.
Company history
Jack Fegan started his building business in 1987 as a sole trader offering building services to
householders in the North West of England. Typically, he would take on small- to medium-
sized jobs. While prices were above the industry average for a small building firm,
customers were obtained through a reputation for good workmanship, use of high quality
raw materials and reliability. Larger building firms, with specialist skills, charge more than
firms like Fegan, but they tend to produce higher quality work. Very small building firms,
with one or two employees, charge significantly less than Fegan, but the quality of their
work is variable and, in many cases, poor.
The business grew rapidly and by 2001 Fegan had 50 employees consisting mainly of builders
and joiners. At this time, each employee was charged out to customers at CU150 per day,
with about 250 chargeable days per employee, per year, including overtime days.
The merger
In 2001 Jack met Sean Phillips who owned a business offering skilled plumbing and electrical
services using qualified tradespeople. Sean had 75 skilled employees, all being charged out at
CU200 per day, plus travel costs, each with about 250 chargeable days per year. Almost all
of Sean's trade was as a subcontractor for a large building company called Henton Ltd
(Henton).
In 2001 Jack and Sean decided to merge their businesses to form MS. The new company
would be able to offer a wider range of services both to private householders and to
Henton and, being much larger than either of the separate businesses, it would have greater
market visibility. MS adopted the pricing and quality policies previously used by Jack and
Sean.
The business model of MS is to offer a comprehensive range of household building services
with a reputation for good quality. The pricing policy is to set prices that are perceived to
be fair and transparent in order to avoid the public perception that some tradespeople
charge excessive prices for the quality of the work performed. Prices charged to Henton
were initially higher than those charged to individuals, but Henton work is subject to
review and also there had to be a quick response to urgent requests.
The private household business remained, as before, in the North West, but the work for
Henton was over a wider geographical area covering the North of England. The reason for
this was that Henton Ltd was willing to pay travel and accommodation costs for MS
employees, while individual householders would only use local tradespeople. Most MS
tradespeople spent some time on Henton assignments and some time on individual
household assignments to ensure all staff had a breadth of experience. However, MS
normally allocated their best employees to the Henton contract to ensure quality. These
were also the most flexible employees who were willing to travel, and they therefore spent
a large majority of their time working for Henton.

In 2006, a new marketing director of MS was appointed, Jane Wise, to manage the
customer relationship with Henton and to promote the business to individual
households.
By 2007 MS had grown to 200 tradespeople. In terms of revenue generated and prices, the Henton
contract had remained constant at the 2001 levels, as had the number of tradespeople assigned to the
Henton contract. The daily charge-out rate to individual households had, however, increased to CU200.
Staff costs are about CU80 per labour day, and raw materials costs are about 25% of revenues earned at
the current pricing levels. Fixed costs are about CU2 million per year.
The Henton contract
In November 2007 the new procurement director of Henton wrote to MS as follows:
To: The Board of Multi-Services Ltd
From: Debbie Cheng, Director, Henton Ltd
Date: 30 November 2007
Subject: Procurement services
Let me introduce myself. I am the new procurement director of Henton. I have undertaken a review of all
our subcontracting arrangements and I have decided that from 1 January 2008 we will begin, in most cases,
to use our own employees for all building activities. We will gradually take on more staff throughout 2008
to fully implement this strategy.
If, however, you were willing to reduce your prices from CU200 to CU150 per day we may be willing to
offer you some work during 2008 while the transition takes place. We would expect any work that we may
offer you, to reduce continually throughout 2008 from its present level. From 1 January 2009 we will not be
requiring any services from your company.
Regards,
Debbie Cheng
Henton Ltd
Board meeting
A meeting of the directors took place to discuss the situation.
Sean Phillips opened the conversation: 'What are we going to do? I have built my whole business around
serving Henton, we have never let them down, we have charged reasonable prices and now this happens. I
blame the new procurement director – this would never have happened with the previous director. We
were good friends and we knew each other socially as well as professionally'.
Jack Fegan interrupted: 'The point is that we have a problem and we need to accept the loss of Henton and
do what we can. In just over a year, a large proportion of our current employees will have nothing to do –
and even that is a best case situation if we reduce our selling prices drastically. We need to increase sales
or to downsize our staff quickly, but I am not even sure that we can afford the redundancy payments at the
moment'.
Jane Wise added: 'There is not enough potential in the local market to expand sales sufficiently to replace the
Henton work within 12 months. On the one hand, we do not want to lose reliable employees with the right
skills as they are hard to find. Nevertheless, on the other hand we cannot pay them to be idle for several years
until we grow the business. I think we need to keep downsizing to a minimum through cutting our prices to
accelerate growth. However, we also need to cut our costs by buying cheaper raw materials, freezing the wages
of those employees remaining with us and cutting our fixed costs by streamlining our head office and support
services. This may lead to some inefficiencies but, as I see it, we have little choice.'
Requirements
(g) So far as the information permits:

(i) Explain the financial and non-financial impact of the loss of the Henton contract for MS; and
(ii) Advise on the factors that the company should consider in deciding whether to accept the
suggested price reduction for Henton for 2008. (14 marks)
Note: For this purpose ignore Jane Wise's suggestions.
(2) Explain the change management problems that are likely to occur as a result of the
downsizing that will follow the loss of the Henton contract. Discuss how these
problems may be mitigated.
(11
marks)
(3) Evaluate Jane Wise's suggestions to reduce prices and costs. Include an assessment of the impact
that
this strategy will have on MS's competitive position. (9 marks)
(34
marks)
34 Multi-Services Ltd (MS)
Marking guide
Mar
ks
(a) Henton contract

Financial impact 8
Non-financial impact 2
Factors to consider concerning price reduction 8
(b) Explain the change management problems 6
Discuss how these problems may be mitigated 8
(c) Evaluate Jane Wise’s suggestions to reduce prices and costs 6
Impact that this strategy will have on MS’s competitive position 6
34
(a) (i) Impact on losing Henton contract

Total revenue is:
CU200 x 200 employees x 250 days = CU10 million
Of which the Henton revenue is
CU200 x 75 employees x 250 days = CU3.75 million
Thus, the downsizing in terms of volume of activity is 37.5% which is substantial. This
assumes that employees are equally productive on both types of contract in terms of

days employed to days charged. However, if this is the case, then of the 200
employees, 75 would need to be made redundant if the Henton contract were to be
lost in full on 1 January 2008, assuming there is no compensating growth elsewhere in
the company.
In terms of the impact on profit, if the Henton contract were to be lost in full on 1
January 2008, and there is no compensating growth or price changes elsewhere in the
company, then the situation would be as follows:
2007 total Loss of Henton 2008
CU'000 CU'000 CU'000
Revenue 10,000 3,750 6,250
Labour costs 4,000 1,500 2,500
Raw material costs 2,500 937 1,563
Fixed costs 2,000 - 2,000
Profit 1,500 1,313 187
This assumes:
  Labour and raw material costs occur evenly over the Henton contract and other customers 
  Compensation for travel costs paid by Henton are ignored 
 Fixed costs will not reduce with the Henton contract being lost. 
Therefore, while the company will still generate a profit without the Henton
contract, the margins will be much smaller than was previously the case. Also,
this is only the case if the redundancies can be made in full to compensate for
the loss of trade from Henton. The calculations also ignore any one-off
redundancy costs to be incurred in 2008.
Other than the immediate financial impact from operating activities, there are the
other consequences of downsizing to consider. These include the liquidity problems
of finding enough funds to pay redundancy costs.
There may, however, be some positive financial effects if surplus assets can be sold
off or spare capacity can be utilised in some other way.
Non financial effects may include:
 Loss of reputation – if it is widely known that MS has lost the Henton contract
there may be a perception that MS has been at fault or its work has been found
inadequate 

 The scale of the company is smaller so it has less market presence to attract customers. 

 Economies of scale may be lost, thus the reduction in costs may be less than pro
rata. This might include: quantity discounts on raw materials; loss of access to
larger suppliers; flexibility in work scheduling where many jobs are being carried
out simultaneously. 

(ii) Price reduction
2008 Henton Henton
Without Henton (full year at current activity level) (50% of activity)
CU'000 CU'000 CU'000
Revenue 6,250 2,812 1,406
Labour costs 2,500 1,500 750
Raw material costs 1,563 937 469
Fixed costs 2,000 – –
Profit 187 375 187
The first column assumes that the non-Henton part of the business continues at its current level
of activity and prices as above.

The second column calculates the effect of continuing the Henton contract at reduced prices but
at the current level of activity.
The third column calculates the effect of continuing the Henton contract at reduced prices but
with the level of activity falling from its current level to zero over the year (and therefore
averaging half of its current level over 2008).
It can be seen that the continuing of the Henton contract will double profit in 2008. There may
also be additional favourable effects:
 It would provide an adjustment period where the scaling down of activities would take place
gradually over a year rather than almost immediately 

 The implementation of the new procurement strategy may be delayed by Henton, thus
providing work for MS beyond 2008. 

 There may, despite the indication of Henton's procurement director be a real option for
more work in the future, if the business contact is maintained (e.g. if Henton's new strategy
is not working out) 

 There is a liquidity advantage from deferring redundancy costs 

 Some staff may leave due to the uncertainty thereby reducing eventual redundancy costs.
MS should also consider the following: 

 Henton's motives for the change in procurement strategy – Debbie Cheng could be using
this as a bluff to put pressure on prices 

 As a new employee Debbie's actions may be unpopular internally and the strategy may
prove to be short-lived 

 Due to the peaks and troughs of business, it would be unusual for a large building company
such as Henton, to only operate with employees. At peak periods Henton is still likely to
require some contract work and this will give it more flexibility to cut costs in recessionary
times 

 Given its size, some fixed costs may be saved as a result of the loss of the Henton contract. 

(b) Change management problems
The change management needs to be appropriate to the nature of the change.
Moreover, this is not planned change, but a sudden change in the environment. The change is
therefore reactive rather than proactive by the company.
In this case the change is fundamental in scale, although it does not fundamentally alter the nature of the
business or the way it is carried out. Nevertheless, the change is of a 'transformational' nature.
The transformational and reactive nature of the change therefore classifies it as 'Forced Change',
according to the Johnson, Scholes and Whittington model. Moreover, given the circumstances it needs
to be implemented quickly.
In terms of managing the impact of change then there are very different effects for employees staying
with the company and those being made redundant. Given that the change is one of scale, rather than
of changes in process or operations, the ultimate effect on those employees who are to be retained
may be small. While there is a major effect on those being made redundant, in the longer term they
will not be employees so, while the leaving process needs to be managed, there is may be limited long-
term effect on motivation if the change is well managed.
However, in the shorter term (i.e. during 2008) the employees will not know which of the two groups
they will fall into, and thus all employees may be demotivated by the uncertainty in this period. This
may have adverse effects on quality of work and reputation.
There is also a danger of focusing only on change with respect to employees. Other

stakeholders should also be considered including:
 Continuing customers – who need to be reassured that they will continue to be
delivered a quality service 

 Suppliers – that while quantities ordered may be reduced in future, there will be a
continuing relationship. 
However, change not just involves people but also:
 Changes in management structure due to the smaller scale of the business but also that the
Henton contract may have required different types of administration (e.g. settlement terms,
recording of operations, quality control reviews). These functions may no longer be needed. 

 Change in culture. Although the merger took place in 2001 there may still be elements of the
two separate cultures in existence. A particular issue in this case is that the two separate
cultures of Sean and Jack may persist and the customer base that is lost relates very largely
to Sean's business. There may therefore by a group conflict between: 

 – The two sets of previous employees 
– Jack and Sean 
To the extent that the two groups have integrated and that there are new employees
recruited since 2001 then this cultural conflict may be reduced.
Mitigating the change management problems
A change plan is necessary to design and implement the change process in the most effective
manner. This may include the following:
Step 1
Determine the need or desire for change.
The need arises from the loss on the Henton contract. The communication of the cause for
change and that it is external to the business (the 'external enemy') may improve the
acceptance of change amongst employees.
Step 2
Prepare a tentative plan. Brainstorming sessions are a good idea, since alternatives for change
should be considered.
A key issue is the scale and timing of the loss of business from Henton over 2008 (assuming
that the price change is accepted). The reduction in the workforce needs to match the fall in
sales over this period.
The manner of implementing redundancies is also important e.g. voluntary or compulsory. This
will affect timing but also the mix e.g. voluntary redundancies first and then compulsory, but also
consider natural wastage.
Legal advice also needs to be taken to ensure compliance with employment law.
Step 3
Analyse probable reactions to the change.
Involve trade unions or employee representatives at an early stage.
Step 4
Make a final decision from the choice of alternative options. The decision may be taken
either by group problem-solving (participative) or by a manager on his own (coercive).
Selection of which employees for any compulsory redundancies is likely to be important as the
best employees are currently working on the Henton contract which is disappearing. Legal rules

regarding selection of employees for redundancies must be complied with, which may make it
difficult to make the less able employees currently working on household jobs redundant.
Step 5
Establish a timetable for change.
There needs to be rapid implementation, but this needs to be consistent with satisfying remaining jobs
for Henton over the year.
Step 6
Communicate the plan for change to stakeholders. This is really a continuous process, beginning at
Step 1 and going through to Step 7.
Step 7
Implement the change.
Step 8
Review the change. This requires continuous evaluation. For instance, Henton's strategy may change in
nature or scale during the year.
It may be that the effects could be moderated if Henton is taking on new staff, they may employ some
MS employees – thereby reducing the need for redundancies and cutting redundancy costs.
Barriers to change in these circumstances are likely to arise from uncertainty. A quick and clear
decision will enable those who are not being made redundant to avoid the need to feel threatened and
thus may not resist change.
Those who are to leave may be demotivated but their term of employment is limited and they will at
least have more time to plan their departure and alternative employment. Meanwhile their work may
need to be closely monitored.
(c) Jane Wise's strategy is to cut selling prices and cut costs per unit but, as a consequence, reduce
quality.
The reduction in selling price is intended to increase the volume of activities (in terms of days charged
out). This assumes that demand for building services is price elastic and that the lower price will have a
disproportionate effect on demand.
Market research is required in order to substantiate this notion. This might include:
 Assessing customer resistance to previous price changes 

 Assessing the number of failed quotes for work and whether price was mentioned as a factor 

 Reviewing the prices charge by rivals (e.g. where customers disclose other firms' quotes on a
proposal). 
If demand is elastic, and therefore responsive to price, then the advantage of this scheme is that
activity levels will be raised and redundancies reduced and therefore, as far as possible, maintaining the
workforce as employees.
There are, however, a number of problems with the proposal:
 The business model to date has been to offer a good quality service with good quality raw
materials. This proposal will therefore breach the way the company has historically sold itself to
customers. 

 The price may be a signal of quality (perceived quality pricing) if the price falls, then the
perception of quality may fall and demand may actually fall rather than rise. 

 The margin is likely to fall per labour hour with the price cut. The cost-cutting would therefore

need to be consistent with the price cutting in order to restore the margin. To the extent that
the new margin is lower, then increased sales volume would be required. 

 The price cutting may be unnecessary, as if customers are loyal to MS, they may be willing to pay the
higher prices. New customers or those customers lower in the socio-economic groupings may
however respond positively to a price cut. Some form of flexible pricing such as price 
discrimination may allow MS to offer a high price, high quality service to some
customers and a lower price, lower quality service to others.
 The competitive position of MS would be affected. 
A product can be positioned in a number of ways e.g. via a price or emphasis on a particular
characteristic or set of characteristics. In other words, positioning means giving a product
or service a place relative to its competitors on factors such as quality, price, image,
providing status, and so on. The price-quality trade-off is therefore just one aspect of
market positioning.
The new proposed strategy takes the view of lowering price and but reducing quality. This
can be seen in the following diagram.
Price
High A
B
C
E
Low
Perceived quality
Very poor Poor Reasonable Good Very good
In the diagram:
C represents the original strategy where price per labour day has been set at CU200
and quality maintained at a high level
D represents the proposed new strategy where price and quality have been reduced
B represents companies which fit the perception of unacceptably high prices for the
customers for the work produced
E represents smaller building companies charging very low prices

A represents larger building companies with particular specialist skills charging high prices.
Within this mapping, one might regard any of the positions on the price-quality trade off as
acceptable, other than B (which is dominated by position C which offers better quality at a lower
price).
However, quality is a question of perception where it is not always readily observable by
the customer. It may be that demand will be based largely on the fact that the service and
materials used in the past have been good quality.
 The relative price difference between companies is more observable than quality 

 Short-term and long-term price-quality effects may be different as reputation may
ultimately be affected. 
Another way of looking at the issue of market positioning for MS is through Kotler's 3Cs:
  Costs 
  Customers 
 Competitors 
This view sees the price-quality trade off in comparison to competitors as the key issue.
'Parity pricing' is where the price and quality are equivalent to the company's major
competitors. Around this 'parity level' of pricing there is a 'zone' of acceptable prices.
 Below parity price: Sales will be made but, if the prices are too low, then costs will
exceed revenues and no profit will be made. 

 Above parity price: If the prices are too high, the product becomes uncompetitive and
no sales will be made, as products of the same quality can be obtained by customers from
competitors. 
Whatever price is being charged it must however be supported by the remaining elements of the
marketing mix.
35 Cappen Ltd
The Orange Juice Division (OJD) is based in the UK and is part of Cappen Ltd
(Cappen), a large, international food and drinks manufacturing company.
Company background
OJD imports oranges from around the world, processes them and then packages the juice
for supermarkets and other retailers throughout the UK and Europe. Cappen is a
divisionalised organisation with each division having responsibility for a product type or
brand. The control structure in Cappen requires divisional managers to provide head office
with a monthly analysis of revenue and operating costs. Capital expenditure and other key
decisions are taken centrally and, so long as managers satisfy their budget targets, they are
left to day-to-day operations without interference. There are few incentives or expectations
at divisional level to innovate or develop new products. All new initiatives come through
central management at head office. The key functions including: finance, human resources,
IT, R&D and marketing, are all operated and controlled centrally as a service to divisions.
The products made by OJD range from high quality fresh orange juice with a short shelf life,
to lower quality concentrate juices with much longer shelf lives. They are sold under a
variety of well known brand names and OJD is one of the market leaders in this section of
the industry, being the third largest producer of packaged orange juice in the UK. Packaging
is in plastic or lined-cardboard containers of one litre or two litres. Most consumers are

families shopping at supermarkets. Revenue generated by the division is about CU40 million
per year.
A new development
A new, young head of OJD, Helen Huang, had been appointed last year but was already
becoming frustrated at the lack of interest by head office in any ideas she had for
development of the division. At a monthly meeting between Helen and Head Office
Management, she proposed a new development:
'I met with the owner of a small business in our industry last week and I think he is on
to something and OJD should be a part of it. His name is Adam Highton and I would like
you to meet him.'
The meeting was called and Adam explained his ideas. 'I own a company, CaféO Ltd, which
operates a chain of 20 cafés. We are mainly known for selling a range of premium juices,
made from a variety of fresh fruits. We have developed a new mixed fruit drink product,
'JudoJuice' that is slightly fizzy. This is produced at our central factory and distributed to our
cafés freshly made each day, along with our other juices. It is really selling well in our cafés
and I know there is a wider retail market. Several supermarkets are already interested if we
can get larger scale operations and packaging correct. Some independent market research
that I had carried out is also very favourable.
My idea is that there are major markets for 'JudoJuice' as a high energy sports drink and as a
kids' snack. My thought is that it should be sold only in small containers, of say 125ml, for
one quick drink. The problem is that I have had trouble getting suitable containers and the
container would be part of the marketing. My idea is that we sell them in batches of eight
containers (to make up a litre in total), not individually. The containers are biodegradable so
they are environmentally friendly and can be thrown away. My problem is that the
containers need to cope with fizzy drinks that may create pressure when shaken. At the
moment, I cannot quite get the design to work properly, despite buying in some assistance,
and the development is getting costly for me to obtain a final operational version.
I know that I need help as I am not big enough to develop this product properly, nor do I have the
necessary expertise. However, I am not willing to work as an employee of Cappen, no matter what the pay
or position. I am, however, flexible on the way the co-operation is structured, but I have several criteria
that I would need satisfied:
 CaféO Ltd and its café chain is to remain unaffected by any co-operative arrangement over 'JudoJuice'. 

 I am not disclosing the 'JudoJuice' recipe without firm contractual guarantees and a viable solution to
the container problem. 

 I need either to have some control of the joint operations or at least have my idea protected by having
rights over how the product is profitably developed and exploited over time. 

 I also need to be assured that the financial performance of this product can be separated from other
Cappen products, so we can determine the sharing of profits fairly.' 
Helen joined in: 'I have seen how well these drinks sell in several of Adam's cafés and it would add to OJD's
product range. I know there are experts in container design in other divisions in the Cappen group, but the
present organisational structure does not encourage this type of cross-divisional co-operation. Also, there
are no incentives for our managers to take on this project at the moment, so they are just not listening
when I talk to them.'
Requirements
(c) Explain the internal factors which may limit Adam's ability to successfully develop, produce and sell
'JudoJuice' without co-operation from an external partner. (9 marks)
(g) As a senior manager within Cappen, write a memorandum to the board which:
(i) Explains the advantages and disadvantages of the current organisational structure of Cappen;

(ii) Assesses the benefits and problems to Cappen of working with Adam in developing 'JudoJuice';
and
(iii) Explains and evaluates the desirability of a joint venture with Adam to produce and sell the
'JudoJuice' product. In so doing, explain the nature of a feasible joint venture agreement and the
extent to which it can satisfy Adam's criteria. Assume for this purpose that the market research
is correct and sales of 'JudoJuice' are likely to be significant. (17 marks)
(26 marks)
35 Cappen Ltd
Marking guide
Marks
(a) Internal factors which may limit Adam’s ability

Development 3
Production 4
Sale 5
(b) Memorandum to the board
Advantages and disadvantages of the current organisational structure 8
The benefits and problems in developing ‘JudoJuice’ 4
Explains and evaluates the desirability of a joint venture 4
The nature of a feasible joint venture agreement 4
26
(a) Two issues arise in this context:

 Whether Adam would be able to successfully operationalise 'JudoJuice' in the context of
packaged volume sales to intermediary customers (e.g. supermarkets) 

 Whether Adam could achieve the above independently, but would be more successful working
in co-operation with a larger partner (e.g. due to scale problems) 
Adam appears to have successfully developed 'JudoJuice' as a successful product with consumer
appeal. However he still faces a number of problems:
(1) Development of the container
(2) Establishing large scale production operations
(3) Marketing and distribution
(1) Development of the container
 Financial resources: It seems doubtful whether Adam has the financial resources to
complete the development of an appropriate container as he indicates 'the development
is getting costly for me to obtain a final operational version' 

 Other resources: In addition to finance there is a need for physical resources
to adequately develop and test the container

 Core competences: Adam and his employees are essentially juice retailers and thus are
unlikely to have the core competences to develop containers with technical attributes. 

(2) Establishing large scale production operations
 Adam has demonstrated that his company can produce 'JudoJuice' successfully on a small scale
with short time scales between production and consumption. Larger scale production of the juice
with a delay before consumption of 'JudoJuice' is likely to meet more problems of storage,
hygiene and quality control. 

 Once the juice is produced, Adam has no expertise in the technology to insert the juice into
containers and secure the contents. This would require 

 – Large scale initial investment 
– Expertise in training and operating the equipment efficiently. 

 Large scale production would require support processes. With a chain of 20 shops Adam may
have some of these but their scale and nature are likely to be different for large scale
commercial production. These may include: HRM, IT, procurement and other business
processes. 

 Adam could outsource aspects of production/distribution – but would need to consider what
other potential partners are available. 

(3) Marketing and distribution
While there has been some interest from supermarkets any new product requires significant
marketing to establish sales and promote customer and consumer interest.
Issues include:
 Financial investment: In promotion and other marketing activities. Adam may have
limited access to funding 

 Marketing expertise: Adam may have engaged in marketing activity but is unlikely to have
established marketing relationships as a partner such as Cappen will have done 

 Distribution: JuiceO has a distribution chain based on a retailer model where customers come
to the company. With the new product, the goods need to be sent to the customer. An efficient
distribution chain is very important as the product is perishable and the longer it takes the
shorter the residual shelf life for the supermarkets. A partner such as Cappen will have
established distribution chains not just for OJD but for much of its food and drink product range.
Economies of scope are therefore available from Cappen but lacking in Adam's business 

 Large scale marketing and sales will lead to economies of scale thus even if Adam could
perform all the above functions on a small scale he may still be more successful with a larger
partner such as Cappen (depending on the terms of the agreement) 

 Adam will lack the experience of dealing with the large supermarkets and will have relatively little
bargaining power. 

 Branding: depending on how the product is branded, as a market leader, Cappen may be a
stronger brand than CaféO and therefore attract more customers for the new product. 

(b) To: The Board of Cappen Ltd
From: Senior manager
Date: 10 December 2007
Subject: Potential co-operative venture with Adam Highton
(i) Current organisational structure
The current organisational structure of Cappen is product-based divisionalisation. While there is day-
to-day operational autonomy there is close financial control of divisions and key strategic initiatives are
centralised and top-down. Divisional managers therefore have little long-term autonomy over the
activities of their division.
The benefits of the product-based divisionalised structure with central control include the following:
(a) Individual managers can be held accountable for the profitability of individual food and drink products. To
the extent that individual revenues and costs can be identified for groups of products then their
performance and viability can be assessed. Pricing decisions linked to cost can also be better measured.
(b) Specialisation can be developed. For example, employees will be trained in aspects of production related to
a particular product (e.g. specific food hygiene issues). Managers may become more aware of rival
companies' strategies for the same product type. Service engineers who specialise in a single product
should also provide a better service.
(c) The different functional activities and efforts requiring specialisation are concentrated together at group
level permitting expertise in finance, HRM and IT for example, as well as avoiding duplication of activities.
(d) The decentralisation of key strategic decisions is important where rapid responses are required in a
changing and dynamic environment. However, food and drinks manufacture is a reasonably stable
environment which is more suitable to slower, more considered decision making.
(e) Cappen is a large company and, as size increases, decentralisation tends to increase to enable at least
lower level operating decisions to take place without central approval. The speeds up decision making
(f) The more diverse the organisation, the greater the need for lower level decision making. In the case of
Cappen however, there is a concentration in food and drink so centralised control of decisions may be
more appropriate as the specific knowledge of divisional managers is not dissimilar from that of central
management.
Disadvantages of Cappen's organisational structure include the following.
 It increases the overhead costs and managerial complexity of the organisation as service centres need to
recharge their service using artificial transfer pricing mechanisms 

 Highly centralised structures tend to stifle innovative strategic solutions and result in less flexibility to
react to changing marketplaces 

 Divisionalised structures restrict collaboration and 'joined up' strategies. With few managerial links
between divisions there is lack of shared expertise and experience 

 Bureaucratic structures focus on maintaining the status quo. This is indicated by the lack of incentives to
innovate and develop new products from divisional initiatives 

 Profit centre and not investment centres are used so divisional managers have limited control over
expansion, development and new investment 

 The result of some of the above factors is that managers are likely to be demotivated. 

(ii) Benefits and problems of 'JudoJuice' project
The arrangement with Adam, if it is to be acceptable, must do something for Cappen that it cannot do for itself.
Careful and sceptical scrutiny is therefore needed of the unique benefits that Adam is claiming to be offering and
the costs and risks that might be incurred by Cappen as a consequence of entering into any arrangement with
him.
Benefits
Adam appears to be offering a blend of fruit juices that is popular and he has unique access to the recipe. In
support of this, subject to evidence being obtained he offers:
 Market testing in his cafes where it appears popular 

 Some additional independent market research 

 Favourable contacts with supermarkets but without any contractual or other commitments from them. 
The benefits to Cappen are potentially:
 Access to a new product which appears to have significant potential 

 The new product is in the core area of OJD and thus would complement existing products, perhaps
with some synergies 

 Cappen's distribution channels and production facilities would put it in a strong negotiating position
compared to Adam to capture most of the profits generated by the 'JudoJuice' 

 Potential access to innovative skills of Adam in future, if these are not available within Cappen to
bring new products to market. 
Problems and risks
 Setting up an agreed structure and mechanism for sharing the benefits (see (iii) below) 

 Even with an agreed arrangement there is potential for major conflicts of interest over profit
shares, amounts invested, the marketing strategy and the management of the joint venture or other
arrangement 

 Problems in protecting intellectual property, such as the recipe, as this will become common
knowledge once the agreement is entered into 

 Adam will not be disclosing the recipe without firm contractual guarantees and a viable solution to
the container problem. This means significant costs and undertakings will be entered into before
access to detailed knowledge is provided 

 Danger that partner may seek to leave joint venture if its priorities change (e.g. shortage of funds) and
thus the agreement may need to be disengaged 

 Lack of sustained Cappen management interest. The JV will be seen as outside of the main structures
of the parent firms 

 Exit routes may be unclear if the venture fails, including sharing of the assets generated in the
venture 

 Most of the financial investment appears to be with Cappen in developing the container and setting up
new operations. If the venture fails then most of the costs may be sunk and will have fallen on Cappen.
The financial downside risk of the venture is therefore very one sided. 
Despite marketing evidence of current demand being high this may not be realised as it may be a short-term
fashion or taste fad, but be unsustainable. Alternatively, it may popular in the context of juice bars but not as
a take away sports drink or kids' snack.
If JudoJuice is seen to be inappropriately targeted at children, there is a risk that any venture may damage
Cappen's main business
(iii) A joint venture
The arrangement would need to be a departure from the current organisational structure of Cappen.
Any acquisition of JuiceO, or merger or buy-in seems to be excluded by Adam's first criterion, but there
may be alternatives to a full JV arrangement such as a looser strategic alliance or a licensing arrangement.
Nevertheless, the present focus is on a joint venture.
Joint venture
There are two broad types of joint venture that can be set up between Cappen and Adam.
Joint venture entity: Two or more organisations set up a third organisation or co-operate in some
other structured manner to share control.
A joint venture arrangement: is a 'contractual arrangement whereby two or more parties undertake an
economic activity which is subject to joint control'.
In a joint venture entity with Cappen it would appear that Cappen is incurring most of the costs and risks and it
is delivering most of the added value. Any joint venture entity would therefore need to deliver the majority of
the benefits to Cappen. Shared ownership is not therefore likely to be in equal proportions between Cappen
and Adam.
Nevertheless, Adam's criteria require that he maintains some control. This could be achieved by contractual
agreement with specific rights over the recipe.
Given that the recipe is to be released late in the development process (e.g. after the container design is
finalised) then any JV would need contractual arrangements that commit Adam at an early stage before major
costs are incurred by Cappen.
Another of Adam's criteria is: 'I also need to be assured that the financial performance of this product can be
separated from other Cappen products, so we can determine the shares of the benefits fairly'.
This is a difficult objective to achieve as production processes are likely to have some commonality with OJD's
existing production – indeed, synergy is one of the advantages to Cappen of entering into any arrangement.
This is likely to be true whether or not a JV entity is set up, but is particularly the case if it is only a JV
arrangement.
The issues of overhead allocations, joint costs, recharging container development costs, recharging central
service costs, common distribution costs are all likely to cloud the issue of the costs that can be directly
attributable to the JV and thus the sharing of benefits.
A final concern on desirability is that a JV arrangement is outside the normal divisionalised structure of Cappen.
This may be regarded as a problem in accommodating something different for the sake of a small project and as a
result may be unlikely to receive head office support. Alternatively, it may be seen as an opportunity and as a pilot
for cross divisional co-operation and a model to develop more new designs and products.

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Business strateg

1 West Highland Granite Ltd

WHG board meeting – November 2006

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

(a) Operating profit calculations 4

(b) (30,000 CU400) + (6,000 CU350)

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

  Different suppliers of granite tops charging different prices 

  Have customers come over to WHG because of price increases by rivals? 

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

Very poor Poor Reasonable Good Very good

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

  Future investment policy and financial resources 

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

(a) Data analysis 5

(a) Performance measurement

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

(c) Strategic planning memorandum

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

3 Security Parking Ltd

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

(a) Original costs 2

(a) (i) Original cost

CU250,000 – (CU750,000 10%) = CU175,000

CU360,000 – (CU3m 10%) = CU60,000

CU250,000 – (CU2m 10%) = CU50,000

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

Data sources for price include:

  Prices being charged by existing in-town car parks 

4 Oscar Hardcastle Ltd

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

(b) Current objectives 4

(b) Current strategic position of Oscar Hardcastle Ltd

Long-established brand names which Narrow product range

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

(a) Identify 2 key CSF 1

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

(a) Critical success factors

  Ability of cooks relative to competitors 

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

 Number of customer complaints or expressions of satisfaction 

 Average time from order to completion of cooking 

Survive Cash flow

Saiful Islam Mozumder, Manager Finance & Accounts, Organic Group,

Internal business perspective

Quality of supply Wastage of meals/ingredients

Innovation and learning perspective