Case study: BZCS

BZCS is a wholly owned subsidiary of BeeZed, a listed company. BZCS is a construction

company, and had revenues of €1,267 million in the financial year ended 30 September 2010.
Profit after tax and finance costs was €21.9 million, providing a return on revenues of only
1.73%.
Although BZCS had a good order book at the end of its latest financial year, the market is
getting much tougher. European governments have cut the budgets on public sector projects,
and bidding is more competitive than ever. As Europe accounted for around 54% of BZCS’s
sales revenue in the last financial year, then it is important that the company maintains its good
reputation in the industry for both quality and the ability to deliver projects on time. It would
seem necessary therefore, for BZCS to secure as much private sector work as possible.
For such a competitive market BZCS’s operating profit margins also do not leave much room
for manoeuvre at 2.74% in the last financial year. The Office Building Division’s operating profit
margin for the latest financial year was a little better at 3.86%.
However, it should be noted that other large construction companies are also only achieving
similarly low profit margins. For example the Costain’s operating profit margin was only 2.0%
in 2009, and Balfour Beatty’s profit margin has dropped from 2.0% to 1.5% in the first half of
2010.
So the whole industry is currently struggling with low margins and also reduced demand for
building work.

Top priority – Safety checks

The top priority is the safety checks on site machinery that have not taken place for 2 weeks due
to the appointment of a new sub-contractor, TT. Safety checks is not a procedure that should be
taken lightly and if not addressed quickly could result in work on some sites stopping or indeed
if the matter were to escalate the H & S Executive, sites could be shut down until the H & S
Executive is satisfied that safety checks had been performed. Apart from the ethical aspect of
Head Office stating that work should continue, this could have a large impact on the whole of
BZCS if an accident were to occur.

Second priority – Problems with BZPM

This is considered to be the second priority as BZPM is used extensively throughout the
company and the Project Managers need to have confidence in the integrity of the data. Clearly
the upgrade was not adequately tested and immediate action needs to be taken.

Third priority – Office building proposal

The third priority is considered to be the office building proposal. This is a huge project even by
BZCS standards with a forecast project cost of €525 million. It could be very successful and
generate much publicity and future office proposals or it could turn out to be a large risk with
potentially unsold office space.

Fourth priority – Unfinished sports club for ES

BZCS needs to decide whether to offer to pay the liquidator €3 million to take on legal
ownership of the incomplete sports club in lieu of the debt that ES owes to BZCS or whether to
accept the forecast payout of only 10% of the claim for €18 m. There is also the risk that the
uncompleted sports club cannot be sold at the forecast €20 million.

Safety checks

Recommendation

It is recommended that work on the road building project should stop immediately. It is further
recommended that work should be stopped on all other sites which have not had the site
machinery checked as required by BZCS’s internal safety standards.

Justification

Safety must not be compromised. Machinery at all sites must not be used with immediate effect
until safety checks have been performed by a suitable contractor.

BZCS’s reputation, built up over many years, could be severely damaged if an accident
occurred.

Actions to be taken

Work at all affected sites, including the road building site, should be stopped immediately. All
employees and sub-contractors should continue to be paid.

The Procurement Director, working with all of the Project Managers of the sites affected by the
delay in safety checks, must identify and appoint safety contractors which can start safety
checks immediately.

The Procurement Director must urgently contact TT and review the contract with it and seek
compensation for failure to carry out this critical role. The Procurement Director should also
review why TT was selected when it clearly is not adequately staffed to take on this contract.
The Procurement Director should ask when TT can start to handle all of the contracted safety
check work.

The contractor that the Project Manager of the road building project has identified should be
appointed immediately at a cost of €240 K. This cost is reasonable and is less than the cost of the
site being closed down for more than 3 days.

The Procurement Director should conduct audits on the standard and timeliness of work
carried out for all newly appointed contractors in future.

Problems with BZPM

Recommendations

It is recommended that the cautious approach of re-installing the old software system and the
backed up version of BZPM from last Friday night is chosen. The new software release is not
safe to use until the software company, EAG, has removed all of the faults.

It would be necessary to immediately close down input into BZPM. The IT department should
block access to all users of BZPM while the backed up version is re-installed, except for “read
only” access.
It is recommended that the IT manager re-installs the backed up version from last Friday, and
that with help from the Finance Department and each of the Project Managers, identifies and
transfers of all data for the last 3 days. All users should be advised which data is being
transferred electronically and which data needs to be re-input manually.

There is a need for the reconciliations of data transfers to be made by IT and Finance
departments.

Finally, it is recommended that the re-installed backed up version is tested to ensure that the
data held is accurate. The IT Manager should request that each of the Project Managers should
check the integrity and completeness of data for his / her projects.

Justification

BZPM is too important to compromise the risk of damage to the integrity of the data contained
in it and to risk the loss of confidence by its users.

It is recommended that the backed up version from last Friday using the previous software
should be used as there is too great a risk using the new software release which the software
company, EAG, admits has possible bugs and that its other customers are experiencing
problems with.

Actions to be taken

The IT department should immediately close down BZPM and advise all users of what is
happening and when the re-installed backed-up system will be available. It is advised that
BZPM should still be available on a “read only” basis temporarily to allow management of
projects to continue.

All users should be advised that the backed up version from 3 days ago is being re-installed and
that all new data input or transferred into BZPM will be electronically transferred or re-input.
An agreed deadline and responsibilities for the re-input of data need to be agreed between the
IT department and each of the Project Managers.

The IT department and Finance department need to reconcile all of the data transfers. Finance
Department should draw up a list of the data to be manually input for each project and
responsibility for input of data assigned (Project Management staff or IT department).

BZPM should go live when the data has been transferred or re-input and the system tested for
integrity.

The Finance Director (a key stakeholder in Mendelow’s analysis) together with the IT Manager
should contact EAG, the provider of the BZPM software, in order to gain compensation for the
inconvenience caused by the release of faulty software.

In future, all new software releases should be tested much more extensively before going live.

Office building proposal

Recommendation
It is recommended that BZCS does undertake this large office building proposal. BZCS’s
Commercial Director of the Office Buildings Division should contact Ben Bleur immediately to
say that the company would like to accept his proposal and to work with him on this project.

Therefore it is recommended that the land be purchased at a cost of €50 million and any
funding is requested from the parent company.

It is recommended that BZCS does accept the early sale to DJ at a sales value of €300 million, a
discount of €50 million.

It is recommended that BZCS should undertake a range of actions to try to secure further sales
as early as possible.

Justification

The construction of this office building could generate a high level of sales and a positive NPV
of €36.9m, even with the discount to DJ of €50 million.

The early sale of office space to DJ will allow the project to commence and eliminates the
commercial risk of not achieving the 30% off plan sales target.

The funding requirements are lower with the sale to DJ, as the forecast profile of sales revenue
would occur earlier.

There is a need to undertake a range of sales and marketing initiatives in order to attract
commercial buyers of office space as early as possible.

Actions to be taken

BZCS’s Commercial Director of the Office Buildings Division should negotiate what level of
discount it could offer to DJ, to try to reduce the €50 million. However, the sale to DJ should be
accepted.

BZCS’s Sales and Marketing Director, together with the Commercial Director of the Office
Buildings Division should plan a range of sales and marketing events in order to gain other
corporate customers or investors in the building and to gain media interest in the new office
building.

BZCS’s Finance Director should work with BZCS’s civil engineers to check and understand the
project costings. The Finance Director should prepare a schedule of the funding requirements
for this large project and confirm that BeeZed, the parent company has access to adequate funds
for this project.

In order to help marketing of the office building it is also recommended that:

Large advertising boards are placed around the site as construction work gets underway.
Publicity material should be prominently placed on BZCS’s home page on the internet,
including the association with Ben Bleur. Large scale advertising in both local and national
newspapers should be undertaken, both now and as construction work progresses, and BZCS
should also contact local and national commercial property agents to make them aware of the
project.
The purpose of such initiatives is to trigger interest amongst organisations whose leases may be
coming up for renewal in the city, as well as other organisations that may be looking to relocate
to the European capital city.

Furthermore, an experienced Project Manager should be appointed to manage this project and a
detailed project plan should be prepared.

Unfinished sports club for ES

Recommendation

It is recommended that BZCS should offer to pay €3 million for the unfinished sports club to
liquidator. If this is declined, the offer could be increased to around €5 to €6 million. The
maximum that should be paid is €10.2 million.

It is recommended that BZCS should complete the sports club and locate a buyer at the forecast
sales revenue of €20 million.

It is recommended that BZCS should review its project procedures to ensure that work on
projects does not continue if contracted stage payments are not met.

Justification

The expected payout ratio from ES’s liquidator is very low and will result in a loss of €2.2
million.

If BZCS were to pay €3 million to the liquidator (which is usually welcome as a reasonable
payment for assets) then BZCS could make a profit from a future sale of €9 million, resulting in
an overall profit of €5 million (after the loss to date of €4 million is included). BZCS could afford
to pay the liquidator a little more to secure the sale of the incomplete sports club.

BZCS bears the risk of finishing the sports club and incurring a further €8 million in costs to
complete it, but this would allow BZCS’s employees to continue to work on this project, as there
may not be other projects that require extra manpower. BZCS will also will bear the risk of
perhaps not being able to sell it or not achieving the forecast sales revenue of €20 million.

Actions to be taken

BZCS’s Commercial Director of the Sports Facilities Division, together with the Finance
Director, should negotiate with the liquidator to buy the incomplete sports club, and its opening
offer should be €3 million and the absolute maximum purchase price is €10.2 m, and negotiable
around the €6 million level.

If the offer to acquire the incomplete sports club is accepted then BZCS’s Sales and Marketing
Manager for the Sports Facilities Division should try to locate a customer for the finished sports
club for the forecast sales revenue of €20 million.

The Finance Director needs to tighten up procedures to ensure that work on any project is
stopped if a stage payment is not made on time. The Finance Director should also investigate
why did work did continue on this project when ES missed paying the 2nd stage payment.
Additionally, there is a need for the Finance Department to carry out regular checks on the
financial stability of its customer. BZCS has few customers as it usually operates around 12 – 20
projects at any point. Therefore, it should be investigated why BZCS’s Finance Department did
not foresee that ES had liquidity issues and perhaps should have more closely monitored this
contract.

There is also a need for the Finance Department to regularly review all of BZCS’s customers to
try to protect BZCS from the commercial risk of any of its customers going into liquidation.

Conclusions

BZCS is a successful construction company but it must not become complacent in today’s
challenging business environment. Good management supported by strong IT solutions are
necessary to ensure contracts are delivered on time and to budget.

Strengths Weaknesses
 Profitable company  BZPM has faults and its integrity
 Support and funding from parent is being questioned following a
company BeeZed software upgrade
 Good reputation for quality  Poor control over waste material
construction sub-contractor
 Strong safety culture and CSR  Poor management of ES sports
ethic club contract
 Order book at 30 September 2010  Waste materials wrongly going to
was 30% higher than the previous landfill sites
year
 BZCS exceeded its target for
reduced volumes of waste going
to landfill sites
 Comprehensive CSR statement of
initiatives

Opportunities Threats
 To acquire ES sports club so that  Risk of accidents at the road
it can be completed and sold building project due to safety
 Office buildings project with Ben checks not being carried out on
Bleur site machinery
 To accept DJ’s offer to purchase  Loss of control of projects due to
25 floors of proposed new office faults in BZPM following
building project “off plan” software upgrade
 Risk of delay in completion of
road building contract if work on
site were to be stopped due to the
lack of safety checks
 Low payout to BZCS by ES’s
liquidator
 Will BZCS be able to sell the
 office space in this large project as
planned
 Low sales of proposed office
building and possible threat to
have to re-sell undeveloped land
if 30% sales target is not achieved
 Threat of cost over-runs on the
office building project
 BZCS being investigated for “bid-
rigging” in UK and threat of loss
of future contracts
 Risk of other customers going
into liquidation

PEST analysis

Political/Legal

Investigation by UK government body due to admission of “bid-rigging” Reduction in

government funded projects as a result of government cuts Safety checks not carried out – could
be investigated by H& S executive New EU laws on recycling of waste materials and reduction
of waste going to landfill sites

Economic

The current economic environment has resulted in lower levels of construction work and more
price competition to win contracts Other BZCS customers going into liquidation (like ES)
BZCS’s new buildings are more energy efficient Recession has hit all of the construction
industry Will BZCS find corporate buyers or a property management company for all 50 floors
of the proposed office building

Social

New buildings enhance the quality of life for users (from hospital patients to office workers)

Technological

New office building utilising the latest technology to recycle heat and reduce carbon emissions
New construction methods to reduce costs BZPM has developed faults following the recent
software upgrade which will hamper BZCS’s control of its construction projects
Analysis of costs for the ES sports club

€ million

Costs incurred to date 14

Paid by ES to date 10

Book loss 4

Costs incurred to date are sunk costs and are irrelevant to the future decision.

Alternatives are:

Claim from the liquidator 18

Payout ratio 10%

Forecast payment from liquidator 1.8m

Overall loss = €2.2 million loss (€4 million loss less €1.8 million possible payout from liquidator)

OR

Accept ownership of the part completed sports club

€ million

Proposed payment to liquidator for partially completed building 3

Forecast costs to complete 8

Forecast sales revenue 20

Possible future profit 9

Together with loss to date of €4 million = overall profit of €5 million

Difference between these 2 alternatives is €7.2 million (€2.2 million loss and €5.0 million profit)

Maximum that BZCS could pay to buy the uncompleted sports club is the same as accepting the
payout from the liquidator = €20 million sales less €8 million to complete = €12 million less the
alternative of a payment from the liquidator of €1.8 million

= €10.2 million maximum.

Alternatives figures which include the loss to date are:

Wait for payout by liquidator = €2.2 million loss overall

Or

Buy incomplete sports club to finish and then sell = €5.0 million profit overall.
To: Finance Director

(To be sent to BZCS’s non-financial managers in the Office Buildings Division)

From: Management Accountant

Date: 26 May 2011

Re: NPV calculations for the office building proposal

1. The purpose of a Net Present Value (NPV) calculation is to evaluate the cash flows ONLY and
to adjust them to take into account “the time value of money” and the risk of the project.

2. The time value of money attempts to take into account inflation and put the value of cash
flows in future years into what they would be worth this year.

3. The discount rate (also known as the “hurdle rate”) should represent the company’s cost of
capital and is the return that the company could achieve if it invested the funds in other projects
or invested the money.

4. It is not the cost of the specific finance used for a project but should represent the weighted
average cost of capital for the whole company.

5. The discount rate can also be adjusted to take account of the risk profile of the specific project.

6. An NPV is NOT the accounting profit of the project as it is the added value of the project
based on cash flows only and therefore omits non-cash items such as depreciation.

7. In theory a company should accept all positive NPV projects as this increases shareholder
wealth but in practice a company does not have the resources (financial or manpower) to
undertake every positive NPV project.

8. An NPV is only as accurate as the underlying assumptions, such as the discount rate used
and the forecast of the timings of future cash inflows and outflows, as the further in the future
the greater the degree of uncertainty that surround these assumptions.

9. If sales revenue were overstated, or was delayed to later years, then the NPV would reduce,
as €1.0 million cash inflow next year is worth €0.870 million (at 15% post-tax risk adjusted
discount rate) compared to only €0.572 million in 4 years’ time.

10. It is recommended that BZCS proceeds with the construction of this building and accepts the
sale to DJ at €300 million (a discount of €50 million).