SOLUTION AND MARKING GRID The solution that follows is a comprehensive answer showing the range of points and calculations you could undertake. As the matking grid shows, in the exam you would not need to make all the points in order to be awarded high marks. — E c >< ai x o ° =ANSWER TO QUESTION 1A REPORT To: OFO, EL From: Management Accountant Date: 2014 Contents 1 Introduction 2 Terms of reference 3 Identification and prioritisation of issues, 4 Approaches to resolving the main issues 5 Ethical considerations 6 Recommendations 7 Conclusion ‘Appendices SWOT analysis Mendelow’s matrix Joint venture calculations 1 2 3 4 5 Fuel cell and hybrid vehicle calculations tb answer A INTRODUCTION EL is successful, rapidly growing global car manufacturer with ambitious growth plans. Its seeking to ‘continue develop its value chain to build on it successful ditferentiation strategy (Porter); this is central to its growth strategy Whilst the company has been successful in recent years at growing volumes and profits it faces a number of challenges ifit is to break into the worlds top 10 manufacturers; most notably Keeping control over ‘quality as Toyota's recent spate of product recalls has shown, A TERMS OF REFERENCE ‘This report identifies and evaluates the issues facing EL and offers appropriate recommendations, BPP8 IDENTIFICATION AND PRIORITISATION OF ISSUES ‘The issues below have been prioritised based on the potential impact each could have combined with their Urgency. A full SWOT analysis is presented in Appendix 1 3.1 Joint venture — first priority ‘The first pritity in this report is the decision regarding the joint venture, This would representa strategic diversification inta the commercial vehicle market and would provide the opportunity for further growth, However, there are risks attached to any new venture and this one is to use cutting edge technology and @ ‘market unfamiliar to EL. There are also concerns attached to the joint venture partner. As PCV requires an initial answer within 7 days, this issue has been given top priority in this report 3.2 Fuel cell vehicles- second priority The second priority is whether to opt for Fuel Cell or Hybrid technology. The risks involved in developing a mass production fuel cell powered car are much higher but the returns if successful ae likely to be higher in the long tarm too. With Hyundai launching the Tucson in the US, EL isin danger of being ltt behind if ‘his technology proves popular. Because ofthe strategic significance of this issue, it has been ranked as @ ‘op issue but below the joint venture because ofthe more relaxed time scales, 3.3 Union recognition — third priority ‘The third priority is whether to recognise an official independent union in Country X. This would fundamentally change the management's relationship with the employees and could leave the company more vulnerable to strikes, so its important that the decision is considered carefully, There is an element of Urgency as the next walkout is threatened for next month. However, this issue is not as significant strategically as the first two issues, and only affects production in one country for one day (in the short- term at least), so itis ranked third inthis report 3.4 Supp ‘The fourth priority is the choice of supplier. While this is an important issue and the wrong decision could result in quality problems and recalls, there are 3 months in which to make a decision and ensure that the ‘chosen supplier is appropriate. Despite the significant expenditure involved, the cost differentials between the different cuppliers show that in financial terms this decision wil have a relatively modest financial impact, Itis therefore ranked below the first three iscues inthis report, 1 selection — fourth priority 3.5 Other issues facing EL ‘There are issues of lesser importance which have not been prioritised in this report as they are seen as less Urgent and as having minor impact on the organisation as a whole. Ethical issues facing the company have been discussed in a separate section,A APPROACHES TO RESOLVING THE MAIN ISSUES 4.1 Joint Venture — first priority Impact ‘The opportunity wauld represent expansion through product development (Ansoff's Grid). While this would represent a source of risk, the returns could be over X81 70m, The proposal have been analysed using Johnson and Scholes Suitability, Acceptability, Feasibility model Suitability ‘A move into the commercial vehicle sector does not ft with EL’s current portfolio, Recently EL has been ‘tying to presenta brand image to compete with the luxury brands. In that sense van manufacture is not a ‘900d strategic ft However, Mercedes, via Daimler AG is the biggest manufacturer of commercial vehicles, ‘demonstrating itis possible for premium brands to combine with commercial vehicles successfully. There is also the problem of whether PCV would be a good strategic ft, given its association with cheaper models ‘and cost leadership on a narrow scale (Porter's Generic Strategies) Itmay however be the case that EL can learn more about cost management from this partnership which it ccan then use in its core business, ‘The fact that PCV's factory in China pays low wages and has poorer conditions than would be found in factories in the West could have an impact on EL’s reputation, but it appears that the company complies with local legislation. Given the number of global brands manufacturing in China under the same conditions itis nota large risk. However, it would be important to visit the factory to ensure conditions are acceptable. Acceptability ‘The figures in appendix 3 show that even the worst case scenario produces a positive NPV. On that basis the project looks attractive, However, the figures are onty a forecast and sales may not perform as predicted. For instance a competitor could bring out better model, which caused sales to be lower than expected, Another uncertanly lies with the development costs. Given the van will be designed from scratch, using cutting edge technology, itis ikely that there will be problems getting the technology to work, so delays and cost overruns are possible. ‘The success of the venture will partly depend on the manufacturing costs in PCV’s factory remaining low. However, wage inflation in China is currently running at around 10%, with shortages in skilled ‘manufacturing due to the rapid expansion of China's industrial base, Given that PCV is a small company there might be @ question mark over its financial stebilty. However, this ‘could be an opportunity, since if PCV gets into difficulties EL might be able to launch a takeover bid Feasibility ‘The cash required is a significant amount, representing over 15% of EL's cash flows as at 31 Dec 2013 and approximately 25% of EL's expenditure on on-current assets in 2013. It must be questioned whether this «wil result in capital rationing problems for EL is this project is to go ahead. ‘The feasibility of the two partners working effectively needs to be questioned. A clearly defined and agreed design specification will be required to ensure both companies are working to the same goal, The joint venture agreement itself will need to be clear and comprehensive, VW's alliance with Suzuki collapsed when ‘Suzuki purchased engines from FIAT, which VW claimed was in breach of the joint venture agreement. Given each company will be co-operating in the design of the van, issues like patents may arise. Also the logistics of how the two tears of designers will work together will need to be considered. It may be more efficient and effective to have the two teams based on one site. BPP Part E: Mock Exams: Solutions and marking grids LEARNING NEDABPI 4.2 Fuel cell vehicles — second priority Impact ‘Appendix 4 shows that either project would generate a profit over the five years of the forecast and with the hybrid fuel vehicle producing a profit of approximately X$580m and the fuel cell vehicle producing a profit of approximately X$700m. Both forecasts assume that the Euro to X$ exchange rate remains the sare. Although the change in exchange rate would impact both returns in a similar way, if the Euro strengthens cover time it would further favour the fuel cell vehicle since it has a bigger return as the rate moves in EL's favour. Both forecasts are subject to uncertainty and ignore the time value of money. Fuel Cell Vehicle Financial ‘The fuel call vehicle generates the larger profit overall, but because of greater development costs, produces, 4 retum on investment of 21.6%, less than the required hurdle rate. Should the cutting edge nature of the project mean an overrun of development costs this would further dilute the return on investment, On the other hand, the factory costs have been depreciated on the assumption of zero residual value, which may be overprudent Also ifthe subsidy of €1,000 is applied to the average sales of 38,800 per year then average profits would rise by €38.8m p.a, and the RO| would become approximately 27.5% Non-financial Fuel cell technology has several advantages over electric, battery powered vehicles, From an engineering perspective, batteries are heavy and lack range. Recharging takes hours. From an environmental Perspective, the batteries need to be charged from the mains, and most of this power is stll generated from ‘fossil fuels. This is why Hyundai has already launched a hydrogen fuel cell car in the US, and Toyota and Honda are due to launch one in 2015. In Toyota's case this is particularly significant because it had previously partnered with Tesla to develop an electric vehicle but have now decided to focus on fuel cell technology. One limiting factor which will restrict the sales in the short term is the availability of refuelling stations, While the EU is currently committed to increasing the availability of these, policy may change in the future, The increase in sales in the forecast is predicated on this increase in refueling stations. This introduces an element of risk since this change in policy would be beyond EL’s control, Equally the subsidies available for green vehicles could be withdrawn in the future making the cars less attractive However, given the carbon reduction commitments the EU has made itis likely that subsidies and tax breaks will continue into the future ‘The other main issue is whether consumers choose to buy this unknown technology. Hybrid cars like the Prius have been around a long te and are essentially regarded as mainstream and familiar. Consumers may have concems about the safety of hydrogen or whether they are about to commit toa technology that loses’ to electric vehicles. Choice of technology is now quite a common dilemma for consumers, for ‘example the choice between Blu-ray and HO DVD. Hybrid Vehicles. Financial This option produces a return of 37.6%, much higher than both the hurdle rate and the alternative fuel cell, option, Given that there are already such vehicles on the market, the forecast figures are likely to be more reliable. The cash flows would arise much sooner too. This would represent the low risk option and appears to also generate the highest return, However, the overall profits are lower Non-financial One issue here is EL's commitment to be atthe forefront of environmental technology. Although hybrid vehicles are more environmentally friendly than normally powered cars, they do not represent the step change that the fuel cell vehicle would, Also, ifthe company is to launch fuel cell vehicles, given that major ‘competitors will already beat them to the market, ifthe development ofthe fuel cel vehicle is delayed, EL. ‘may find that by the time itis launched the market is cornered by established providers.However, hybrid vehicles can create the capability to make hybrid plug-in vehicles which would fit better with EL’s current strategy of developing electric cars and may offer a stronger long-term direction for EL. 4.3 Union Recogni Impact Employees generally represent ‘Keep informed! stakeholders, but unionising them may convert them to “key players,’ able to dictate wage demands to management, The introduction of an official union could therefore result in higher labour costs. On the other hand Toyota, for example, has 2 union thatis part of the Japanese Trade Union Confederation, and the two parties work together for their mutual benefit. ‘Advantages ‘The main advantage of recognising the IEU would be the avoidance of further unofficial strikes with the ‘consequent saving of XS1m per strike. As wel as this financial benefit, there are many non-financial benefits. By allowing the staff their own union, their motivation levels should improve as they will fee! more ‘empowered and more valued by the company. This may resultin higher productivity and improved quality ‘88 workers take more pride in what they do. Itmay also make it easier to recruit new staff, although the low skilled nature of EL’s operations compared to Japanese manufacturers would make this less of an issue, Allowing recognition of an independent union would also bring benefits from an external stakeholder perspective. It would demonstrate commitment to wider CSR goals where EL is currently focussed on the environment. This may in turn enhance EL's image overseas and improve sales in the West. Unions do not always have a negative impact. When the financial crisis caused a substantial fll in car sales the unions were instrumental in helping manufacturers in the UK cut production and wage costs in order to avoid redundancies. For instance, Honda workers at the Swindon plant agreed to a 9% pay cut to protect, 490 jobs. Disadvantages Recognition of an independent union in Country X would mean giving the employees more power, as if the tunion gains official recognition itis likely mostemployess would want to join it. This would enable the IEU ‘to demand more money backed by the threat of much mate widespread strike action. Granting higher ‘wages would obviously damage EL's competitiveness, especially as cars will be sold mainly into local markets where competitors will stil benefit from lower labour costs, The strikes may also threaten productivity levels, which are key to profitability in mass production environments 4.4 Supplier selection — fourth priority Impact While this is essentially an operational decision, there is an aspect which is of strategic importance. As Toyota discovered when it attempted to grow rapidly, taking on new suppliers can present risks to quality that can end up resulting in recalls and substantial costs, not to mention Toyota's CEO apologising to Congress in the US, Given that the BAS is to be used on an SUV, the suspension and braking will be an important part of the off-road ability and the quality of ride on this luxury vehicle, ie. 2 differentiating factor. From this perspective, itis hard to gauge which supplier is best as the information only considers quality in terms of the defect rates rather than how effective the BAS is when defect free, Certainly a focus on saving money when producing a premium vehicle risks EL becoming ‘stuck in the middle’ (Porter's Generic Strategies) Price ‘While AAB may be the more expensive option it might be thet the sub-assembly is higher quality, producing better handling and being capable of covering rougher ground. Based on the average exchange rate, the Mexican BAS sub-assembly would cost $3,500, which is cheaper but would require transportation from Mexico which would add to the cost and reduce the flexibility, The cost of the Mexican sub-assembly would be subject to exchange rate risk This could be forecast using PPP and hedged using forwards. BPP Part E: Mock Exams: Solutions and marking grids ARNG HEDALocation ‘The lead times are, unsurprisingly, less for the companies nearer to EL. Short lead times are an important ingredient in lean manufacturing, but itis also important the lead time is reliable. Provided production levels ‘and therefore demand can be accurately forecast, the lead time is less important than the ability to rely on the suppliers’ adherence to that lead time. The fact that the Mexican BAS would be imported from another continent, presumably by sea, would mean the lead time being affected by weather unless EEF was to hold buffer stock locally, as is normal with JIT systems. Other factors ‘The fact that CCD is still a relatively young company with a small turnover could be @ good thing as it would ‘ive it rolatvly little supplier power (Porter's Five Forces) but could also mean its less financially stable than the other two companies, The proposal under consideration would more than double C’s existing ‘turmover. Another important factor that isn't covered inthe table is the working relationship possible between the two ‘companies. EL would ideally ikea supplier thats flexible and willing to contribute design ideas and improvernents. This may be harder with the Mexican supplier due to distance and language problems. IF initial sales are indeed 60,000 units and the vehicle proves popular there is a concern over AAB, since its stated capacity is currently 70,000 units. This may mean it would soon be unable to supply EL's needs, requiring finding a second supplier. On the other hand AAB is a large company and should be able to build extra capacity if needed ETHICAL ISSUES 5.1 After sales support Why this fe an ethical issue This is an ethical issue because the company should act with integrity when dealing with customers. While itis true that the requirement for an annual inspection is in the terms and conditions, it seems that the information is currently not sufficiently clear and is not therefore fair on consumers who are attracted by the prospect of 10 years support without understanding the full facts, Vauxhall, Kia and Renault are amongst the car dealers that have been accused of this, although it is common in the industry Recommendation for this ethical issue EL should make itclearer at point of sales that there are conditions attached to the after sales support The corporate website should also rake it clear. EL should also instruct its dealers to send out e-mails to remind customers when the inspection is due. These action steps should be taken before the programme is screened Warranty claims should be reviewed and appropriate compensation offered to the customers affected by problems experienced to date, 5.2 Targeting union leaders for redundancy ‘Why this is an ethical issue This is an issue because it would be acting unfairy to discriminate against workers for being in a trade tunion. If the company has accepted that the workers have aright to a trade union, it would not be acting with integrity to then terget union officials for representing their members, Redundancy is a fair reason for dismissal if there is a genuine fall in the requirement for labour, but then those selected for redundancy should be selected on a fair basis,tion for this ethical issue If the decision is made to recognise the trade union, then the management should acceptall that goas with ‘that, both positive and negative. Should a need arise to reduce headcount through redundancy then the HAL function should formulate a selection policy thats fair and based on merit. 5.3 Failure to act as a socially responsible company Why this is an ethical iesue This is an issue because EL has a stated commitment to operate as a socially responsible company. In knowingly targeting staf in this way itis betraying principles that its claiming for itself in the public domain. This makes EL’s statements on social responsibility misleading for EL’s stakeholders, itis wrong to knowingly make misleading statements, Recommendation for this ethical issue ‘The recommendations in section 6.2 will support the ethical issue described above. In addition, the advisory ‘committe should be reminded of EL's social responsibility commitments. RECOMMENDATIONS 6.1 Joint venture — first priority Recommendation It is recommended that the joint venture is pursued, but that 51% stake is obtained by EL in the joint venture and the development casts are spread evenly over the like ofthe project. Justification Although there are no probabilities attached to the sensitivity analysis, even the most prudent assumption still generates a positive NPV. By taking control of the joint venture and spreading the payments for development costs over seven years El can control the risks and any cash flow problems associated with this project. By entering into a new product area in partnership with an existing provider EL will be able to mitigate the lack of experience and enjoy attractive retus on its investment Action to be taken ‘+ The Board should send a formal response indicating interest in the proposal ‘+ Legal advisors should be appointed to assist in drawing up the joint venture agreement. This should make clear arrangements over profit sharing, conflict resolution procedures and ownership of intellectual property. ‘+ Duediligence should be undertaken on the financial stability of PCV ‘+ Assite visit should be arranged to ensure the Chinese factory operates an acceptable level of ethics, ‘The WV agreement should allow for random spot checks by EL auditors. ‘+ Given the cutting edge technology involved, senior management should closely monitor progress to identify early indications of cost overruns or aspects of the technology proving unworkable. 6.2 Fuel cell vehicles — second priority Recommendation Itis recommended that EL selects the hybrid vehicle option BPP Part E: Mock Exams: Solutions and marking grids LEARNING NEDABPI Justification This is because it will be ready for market much more quickly, is the less risky project and has the better return on investment. Once the engineering resources have completed this relatively short project, they can ‘then focus on fuel cell technology. Although competitors will beat EL to market, that isthe case already, and ‘waiting will enable the technology costs to reduce and reliability to develop before EL attempts to enter the market ‘ction to bo taken ‘+ MrHo should be authorised to begin work on a hybrid vehicle ‘+ Aptoject budget needs to be setand a design brief approved for the project team to work with ‘+ Project toam members should be recruited and managed so that work is run in parallel to minimise the davelopment time. There should be regular meetings ofthe whole project team to ensure goal congruence of the various aspects ofthe vehicle design. This will reduce the problems that can arise ‘when a change in the cosmetic appearance of the car by the marketing department leads to problems with the components then not fitting ‘+ Asteering committe should be formed to receive regular status reports to monitor progress and the possibilty of developing this into a hybrid plug-in electric vehicle, 6.3 Union recognition — third priority Recommendation itis recommended thatthe IU is recognised as an offi union Justification ‘This is because in the short term it will avoid the costs associated with the strike. In the longer term it should improve employee motivation and make it easier to negotiate with the workforce. While unions in the past have been a source of problems, nowadays unions at car plants in the West generally try to co-operate with management. Action to be taken ‘+ MrKim should be invited to a meeting with the Board to discuss recognition of the union. ‘+The offer should be on the basis that the rules governing the union are democratic and fair, to prevent any trade union leader pursuing their own interests without support of the workers ‘© Workers should be balloted on whether they wantan independent union ‘+ Once the union is formed there should be a regular forum for the trade unions representatives to raise matters with senior management in a non-confrontational way 6.4 Supplier selection — fourth priority Recommendation Itis recommended that supplier AAB is chosen. Justification ‘AAB may be the most expensive option, but the BAS sub-assembly is to be fitted into a luxury vehicle and will form part of the differentiating factors in the vehicle, since itis Key to off-toad performance, It also has ‘an acceptable defect rate and the shortest lead time. The main concern is that if sales increase the ‘maximum capacity will be reached and a new supplier may need to found,Action to be taken Due diligence should be performed on AAB and CCD. A site visit to ARB and CCD should be undertaken and trade references sought The sie visit should check the quality of components and establish the quality controls built into the production process, ‘A service level agreement should be signed with AB, including terms to cover defects and lead times, with penalties and break clauses should AAB fail to adhere. AB should agree contractual libilty for any recall costs in the event of@ problem with the BAS sub-assembly. ‘ARB should be provided with the necessary design plans in order that samples can be produced for approval in advance of the production run Discussions should be held with AB management regarding the possibilty of increasing capacity beyond 70,000 units. Until satisfaction commitments obtained from AAB in regard to this, CCD should be maintained as another potential supplier Conc.usion This report has identified and evaluated the issues facing EL and has offered appropriate recommendations. BPPAppendix 1: SWOT analysis ‘Strongths: Weaknesses ‘Strong commitment to the environment | » Lack of investment in fuel cell vehicles. + Access to economies of scale cera aeboesa zal © Lack of R&D resource Opportunities Threats + Jointventure with PCV 1 + Strike ation in support ofan independent rade + Demand for SUVs in India 4 union ae 2 * Choice of poor supplier leading to recalls ‘+ EU subsidies for green’ vehiole technology | * Exchange rate movements ‘© Consumer awareness of environmental Reputation damage frothelsearenty tue issues Appendix 2: Mendelow’s matrix Main stakeholders are; High Interest, Low Power Koop Informed PCV, employees, new suppliers High Interest High Powor Key Players MrB Tan, Advisory Committee Low Interest High Power Koop satisfied National regulators, European Union N.B. Mr Kim and the IEU would appear in here butittis debatable how much power the unofficial union has. Clearly it has succeeded in causing strikes and this may be a factor in causing the Board to consider the issue, butit is not clear how many workers would support the union in a long strike,Appendix 3: Joint venture Joint venture 6% Growth 1 2 13 4 15 16 7 Unit price 15000 18300 1880818918 = 16236 Volume ‘000 80 84.80 © 888 95.28 101.00 Revenue 1200 12971408, «15171640 Gross profit cn a <) Selling expenses 80 88 70 % 2 Incremental admin costs 20 20 20 20 20 Operating profit 258 07BeCsitiSC (8G ET Share of operating profit 1280189151 te 179 Shate of development costs “170 170 Net flows +170 170° 128138154 te 179 DF 10% 0909 ©0828 «0.781 «0.883.821 0.885 O513 PV 155 140 98 98 94 98 2 Negative 1% growth 1 te 13 1 15 18 7 Unit price 15000 14700 1440814118 13886 Volume ‘000 6 8498 8R71 63.07 2.44 Revenue 9758 BBD Gross profit 273 8H BT GD Seling expenses 49 47 46 45 4&8 Incremental admin costs 20 20 20 20 20 Operating profit 206 19818 1179 Share of operating profit 402 99 96 92 0 share of development costs 170 “170 Net flows 170 170 = 102 99 96 92 20 DF 10% 0909 ©0824 0.751 0.883821 0.8685 O58 PV “155 140 7 88 60 82 6 BPPAppendix 4: Fuel cell vehicle v hybrid Fuel cell v Hybrid Fuel cell Unit price Volume ‘000 Revenue (€'m) Gross profit (€'m) Selling expenses (€'m) 2017-2018 = 2019 40000 40000 + 40000 30.00 33.90 38.81 1200 «13581832 312-353 898 96 0-108 128 Incremental admin costs (€'m) 10 -10 0 Amortisation of development costs (€'m) 7 898 Depreciation of plant (@'m) 30-30-80 Operating profit (€'m) 99118196 Development costs 500 Factory tooling 160 650 Hybrid Vehicle Unit price Volume ‘000 Revenue (€'m) Gross profit (€'m) Seling expenses (€'m) Incremental admin costs (€'m) Amortisation of development costs Depreciation of plant Operating profit (€'m) Workings Development costs Design staff costs, Overheads CAD coste Testing Regulatory approval Factory tooling 2015 = 2016 = 2017 25000 25000 25000 40.00 42.00 44.10 1000 1050-1108 220281 243 60 53 55 “10 “10 10 152 160 168 45 45 45 100 107,116 Man Days Cost/day Total (€'m) 40000 1000 40 40000 300 12 20 10 2 84 225 309) 2020 40000 43.29 1731 450 “138 10 an -30 160 2018 25000 46.31 1158 255 58 10 A78 “45 124 2021 40000 48.92 1957 509 157 10 126 30 186 2019 25000 48.63 1216 267 “61 10 185 45 134 194.42 -500 699 221.04 581 Mock Exam 1: Solution and marking ridRotum on investment: Fuel cell vehicle = 69/6 = 21.5% 650 Hybrid vehicle S815 = 376% 309 BPP Part E: Mock Exams: Solutions and marking grids LEARNING NEDAAppendix 5: Answer to Question 1b ‘Sildo 1 Joint Venture ~ Advantages ‘Access to a new market Access to expertise via the venture partner Likely growth in the market Positive NPY of XS8m even at low sales levels. Possibility of buying PCV in the future Sido 2 Joint Venture - Disadvantages Possible clash of cultures as PCV a cost leader ‘Wage inflation in the Chinese plant reducing forecast NPV Failure of the development project eputational damage from working practices in Chinese factory Recommendation: Pursue the joint venture Mock Exam 1: Solution and marking rid