AC3193

Accounting: Markets and Organisations

Length of exam + time to submit: 3 hours and 30 minutes

Length of exam: 3 hours and 15 minutes

Rubric: Candidates should answer FOUR of the following EIGHT questions: ONE
from Section A, ONE from Section B, ONE from Section C and ONE further question
from any section. All questions carry equal marks.

Supplementary info: Extracts from compound interest tables are given after the
final question on this paper if these are required to answer the questions.

Word count: Each essay-based answer must not exceed 1,000 words. Anything
beyond 1,000 words will not be read. In-text references will count towards the word
count.

Inspera answer format: Word processor upload

Answer submission instructions: You should complete this paper using word
processing software (i.e. Microsoft Word). This should be saved as a .doc or .docx
file and then uploaded to the exam software as ONE individual file. Please ensure
that your candidate number is written clearly at the top of each page.

Please do not write your name anywhere on any part of your submission.

For all questions (Q1 to Q8): Please note you may hand-write calculations, formulae,
or diagrams, but these should be scanned or copied and included as images in the
Word document that you submit. Please ensure that any images are inserted at the
appropriate point of your document and correctly aligned (i.e. markers will not need
to rotate images to read them)

If you choose to answer Q1 and/or Q2, please handwrite your solutions and append
an image of the workings into your submission to ensure that you only submit a
single document for all your answers.

Workings should be submitted for all questions requiring calculations. Any necessary
assumptions introduced in answering a question are to be stated.

Calculator instructions: You may use any standard non-graphing scientific

calculator for your calculations, but you may not use any computer software or
program to obtain or graph solutions. Credit will only be given if all workings are
shown.

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Please find questions on the following page.

SECTION A

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1. The following exhibits relate to the 2024 performance of two retail companies:
Apollo PLC and Zeus PLC. Apollo PLC operates a cost leadership model and non-
current assets are revalued every two years to fair value. Zeus PLC operates a high-
end luxury model and follows strict historical cost for non-current asset valuation
Historical five year trends show that Apollo PLC has an average growth rate of 8% per
annum compared to 5.5% for Zeus PLC.

Exhibit A: Summarized Statement of Financial Position as at 30.4.2024

Apollo PLC Zeus PLC
$m $m
Non-current assets
Property, plant and Equipment 360 160
Investments 50 100
410 260
Current assets
Inventories 5 6
Trade receivables 15 17
Cash and cash equivalents 12 40
32 63
Current liabilities
Trade payables 4 3
Short term debt 25 5
29 8
Non-current Liabilities 110 40
303 275
Represented by:
Share capital 25p ordinary shares 80 100
Reserves 152 108
Profit for the year 71 67
Shareholder equity 303 275

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 Exhibit B: Share price and Dividend per share
Apollo PLC Zeus PLC
Share Price ($) 5.21 4.98
Dividend per share ($) 0.25 0.35
Exhibit C: Summarized Income Statement for the year ended 30.4.2024
Apollo PLC Zeus PLC
$m $m
Sales 250 300
Less Cost of Sales 105 155
Gross Profit 145 145
Less Expenses 45 61
Operating Profit 100 84
Less finance charges 9 2
Add finance income 4 8
Less taxation 24 22
Profit after Tax 71 67
Required:
a) Calculate the entity value and enterprise value for Apollo PLC and Zeus PLC
and explain why this differentiation is important for investors.

[7 marks]
Enterprise value is the value of operations of a business, regardless of how they are funded.
Entity value is the residual ownership of the business once all other finance has been repaid.
Therefore it is important for a shareholder to identify the value that relates just to the
shareholders and the corporate value that relates to all finance providers
Apollo Zeus
Share price 5.21 4.98
no of shares 320 400
equity value 1667.2 1992
Add LT debt 110 40
Add ST debt 25 5
1802.2 2037
less surplus cash -12 -40
investments -50 -100
enterprise value 1740.2 1897

Zeus has a higher equity value due to the larger number of shares. Equity value for Apollo is
96% of enterprise value, as 4% of value is contributed by finance providers (net of
investments). Zeus has lower levels of debt, which are lower than investment and cash levels.
Consequently equity value accounts for 105% of enterprise value.

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 b) For both Apollo PLC and Zeus PLC calculate the Return on Equity, and further
decompose this into the net profit margin, asset turnover and asset to equity
ratios to enhance interpretation. Evaluate your answer, providing advice to a
potential investor regarding where each company is creating value.

[6 marks]
Apollo Zeus
ROE (profit after tax/shareholder
equity) 23.43% 24.36%
Net Profit margin (A) 28340% 22.33%
Asset turnover (sales/total assets) (B) 0.57 0.93 times
Asset to equity (C) 1.46 1.17 times
A*B*C 23.43% 24.36%

ROE is the same for both companies (24%) but how value is created differs. The main driver
of Apollo's performance is net profit margin (29% compared to 21%), driven by its focus on
low cost leadership. This can be confirmed by lower expenses to sales ratios (18% compared
to 20%) and lower cost of sales (42% compared to 52%). It would be expected that Zeus
would have higher expenses due to the luxury, high model adopted and this is reflected in a
higher sales revenue.
Zeus achieves 13% of its profit from investment income, whereas Apollo only generates 4%
of its profit from investments. Consequently, Zeus would have much lower NP% if relying
solely from trading income.
The main value driver for Zeus is the Asset turnover (0.93 times compared to 0.57 times).
Apollo revalued non-current assets, which are 37% higher than Zeus. Given similar net
profits, the asset turnover will be negatively impacted by this. Consequently, it looks as if Zeus
is deriving high levels of efficiency from its assets but this may be due to more conservative
accounting policies.

c) Using capital market metrics, supported by risk ratios that assess the long-term
solvency of each company, evaluate performance and provide advice to an
institutional investor on which company represents the best investment.

[12 marks]

Apollo Zeus
Debt to Equity 36.3% 14.5%
Debt to capital employed 26.6% 12.7%
Interest cover 11.56 46.00 times

Apollo Zeus
eps 0.44 0.34
Earnings Yield 0.09 0.07
Dividend yield 0.05 0.07
PE Ratio 11.74 14.87 times
net assets per share 0.95 0.69

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 share price to book ratio 5.50 7.24
enterprise value/Revenue 6.96 6.32
Enterprise value/EBIT 17.40 22.58

Total 25 marks

2.
a) What is the Return on Investment (ROI). Outline the drawbacks of using ROI
as a performance measure in practice
[5 marks]
ROI is simply net income divided by net investment, measured by year-end net assets.
It is an accounting based performance measure and so is historic and ignores the
future value of cash flows, and any unrealised income. Asset values may be
understated as intangibles may be absent from the SOFP due to issues of reliable
measurement or may be understated due to prudence and the historic cost convention.

b) Ricardi uses ROI to evaluate the performance of its divisional managers. Two
divisions, the North region and the East region are considering investing in the
same equipment to boost growth. The equipment costs $ 1,600,150 and is
expected to make a contribution before depreciation of $560,000 per year for
the next 5 years. The equipment will have a scrap value of $380,000 at the
end of the 5 years. Ricardi has a weighted average cost of capital of 12%.

The following segmental data is available:

North Division East Division
Revenue $1,000,365 $2,560,598
Net Income $760,025 $905,696
Net assets at year end $2,365,251 $4,211,115

Required:
Calculate the ROI for the two divisions before and after the acceptance of the
project. Give advice whether the managers of the two divisions should accept
the project and whether they would be willing to accept the project.

[12 marks]
Current ROI
North Division East Division
Revenue 1,000,365 2,560,598

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 Net Income 760,025 905,696
Net assets 2,365,251 4,211,115
ROI 32.1% 21.5%

PV of project is -1,600,150 + (560000*3.605)+940000*0.567 = $634,147

Deprecation = cost-scrap/economic life
= 1,600,150 -380,000 / 5 = 244,030
Net assets for project at year end = 1,600,150 – 244,030 = 1,356,120
Net income for project (including depreciation) = 560,000 – 244,030 = 315,970
Revised ROI
North
East Division
project Division with project with project
Revenue 1,000,365 2,560,598
Net Income 315,970 760,025 1,075,995 905,696 1,221,666
Net assets 1,356,120 2,365,251 3,721,371 4,211,115 5,567,235
ROI 32.1% 28.9% 21.5% 21.9%

Advice: The NPV of the project is positive so shareholder funds will increase by $634,147 if
undertaken, assuming forecasts are accurate.
This will decrease the ROI for the North Division from 31.2% to 28.9% so it is unlikely to be
accepted, as bonuses will be reduced. This decision is dysfunctional, as it will not maximize
shareholder wealth.
East Division would be happy to accept the project as it will increase its ROI from 21.5% to
21.9%

c) Critically evaluate the extent to which market based performance measures can
overcome the drawbacks of ROI.
[8 marks]

Market-based measures are easy to measure, timely, objective (in the sense that they might
not be open to manipulation by managers), understandable, cost-effective. If managers are
rewarded with shares and judged on market based measures the rewards are seem as
equitable and achieve goal congruence with shareholders. They are consistent with NPVs, so
any project that delivers a positive NPV, as in the case here, should be accepted and this
would increase share price (if markets are informed and are efficient)
On the downside market measures can be influenced by factors outside of the
managers’ control (at least requiring some modification), market measures reflect
expectations of the future and so economic profit has not been realised, so this may
be imprudent to reward managers on prospects rather than actual performance.
Share prices may be inaccurate -are markets efficient for infrequently traded
companies? Managers may manipulate share price but releasing good information
and withholding bad information about the company’s prospects. Managers will have
asymmetric information on corporate plans that the market does not know about and
therefore has not incorporated into share price. Any inaccuracies renders them
inadequate and suspect. Private companies cannot use them.
SECTION B

3. a) Outline what you understand by the term ‘the earnings-game’ and discuss
any evidence (statistical and empirical) that this exists in practice

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 [12 marks]
Eccles et al 2001 defined this as ‘interactions between firms and stock market
participants over the communication of earnings numbers’. It involves executives
managing earnings so that they meet or beat expectations or attempt to change
the expectations of market participants.
Earnings is a critical market metric, used in a variety of performance indicators
such as EPS, earnings yield, P/E ratios and EBITDA. Graham et al (2004) identified
earnings as the most important metric for company executives. They also found
that earnings are benchmarked – same quarter last year EPS, analysists
consensus forecast of EPS for current quarter, previous quarter EPS. This
benchmarking may lead executives to ‘play the earnings game’ motivated by a
desire to build credibility with the capital market, especially sell-side analysts
(Graham et al., 2005). This is achieved via earnings management. Accounting
regulations give managers discretion over some accounting choice e.g. capitalize
or write off development costs. Opportunistic managers may take advantage of
choice to manipulate earnings either in a beneficial (to signal private information in
a positive way), neutral (maximizing utility) or harmful (to misrepresent) way.

This has statistical support e.g. Degeorge et al., 1999. Empirical examples also
exist e.g. Under Armour Inc. accused of misleading investors as to sales growth by
shipping products earlier to customers than requested. This was predicated
because Armour Inc. failed to meet analyst’s expectations for sales growth.
Recording sales before they are realized is against accounting standards, hence
they were fined $9m by the SEC. Cisco may be used as evidence of not using the
earnings game: EPS decreased by 1p and share price downgraded by 13% as
analysts believed it must be worse than expected if the company could not
manipulate earnings to cover this.
‘The whisper number’ also supports evidence of earnings management in practice.
This is the difference between public opinion of analysts and private opinion (if
analysts were permitted to declare their predictions anonymously). The larger the
difference between the whisper number and public consensus, the greater the
awareness of earnings manipulation.

b) Drawing from the literature, explain why capital market participants partake
in this game and how they do this.

[8 marks]
How they do this: 2 forms. 1. Accruals management. Examples should be
explored in some detail: e.g. income smoothing, big bath accounting, accounting
changes, re-classification of expenditure and revenue manipulation. 2. Real
earnings management – to deviate from normal business practices to change
reported income.
It is not fraud but goings against the spirit of accounting standards, unless
deliberate attempt to deceive. Fine line but it is a breach of ethics.

c) Discuss the problems cause by the earnings game.

[5 marks]

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 Ethical issue as earnings management can benefit executives, e.g. bonuses
related to earnings metrics. A range of problems should be discussed including:
Distortion of corporate decision-making, lack of transparency and hiding problems
(e.g. big bath accounting), wage theft from employees, undermining the work of
analysts.
[Total 25 marks]

4. Compare and contrast the roles of the Investor Relations Officer (IRO), the sell-
side analyst and the buy-side analysts in the communication and provision of
financial information in the stock market.

[25 marks]

An IRO integrates finance, marketing and compliance. Discussion of specific roles (not just
bullet points)

1. Communicate company’s narrative with the investment community. Interacting with

sell-side analysts and institutional investors, organising and co-ordinating earnings
conference calls, press releases, shareholder meetings, publishing reports to the stock
exchange and handling the public response to any financial crisis. Powerful market
influencers by sharing or withholding information, clarification or creating opaqueness.
2. Gatekeepers. IROs control the access of outsiders to senior management. IROs as
gatekeepers. Analysts with considerable experience covering the company are more
likely to gain private access to management, or institutional investors who work for a
large investment firm or mutual fund. Hedge fund managers are less likely to gain
access due to their short position.
3. Messengers: IROs inform senior management on what institutional investors think
about the company
4. IROs managing expectations of the buy side and sell side. Using sell-side analysts to
help IROs convey their company’s message to institutional investors
5. To present a fair valuation via building trust, honesty and openness, whether good or
bad. If IROs present an overly optimistic view they will lose credibility and may have
share recommendations downgraded. Appropriate share price valuation achieved via
interaction with institutional investors, sell-side analysts, business press and company
management. A balancing act: delivering the company line whilst appearing informed,
helpful, honest and trustworthy, (reporting good and bad news

Role of sell-side analysts is very important in helping IROs convey their company message to
institutional investors, particularly analysts with industry knowledge rather than II All-stars or
those that work for large brokerage firms. Sell-side analysts sell ideas. They research
companies and offer advice via a stock recommendation (buy, hold, sell) to investors (whether
a stock is over or under-valued). They usually specialize in industries and work in large
investment banks or specialized research houses. They use a range of information including
industry knowledge, private communications with management earnings conference calls and
financial statements, albeit these are not high on the list of useful sources.
Sell-side analysts provide general feedback to IROs on how their company is perceived by
the Stock Market, knowledge on industry trends and competitors and they help IROs prepare
for conference calls by pre-loading questions in advance. IROs prioritise questions from sell-
side analysis with buy recommendations to set a positive tone for the call and to manage the
narrative in the company’s favour, or if analysts have considerable experience covering the

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company. Private call-backs take place over several days following the public earnings
conference to provide investors/analysts the opportunity to ask detailed questions and seek
clarification. Analysts prefer this so as not to show their hand in the public meeting. Regulation
prevents insider information at private meetings. Institutional investors are more likely to have
a private call-back compared to hedge fund managers.

Buy-side analysts buy information from sell-side analysts in order to make recommendations
to their fund managers to invest. They essentially outsource their research to the sell-side to
enable a significantly wider coverage of individual stocks without incurring large in—house
costs.

Buy-side analysts are unlikely to ask questions in earrings conferences with IROs as they do
not wish to ‘show their hand’ so they approach sell-side analysts to push points on their behalf.

5. ‘The term myopia, short-sightedness or near-sightedness, refers in management

literature to the cognitive shortcomings that managers systematically
display…Myopic managers tend to focus on the short term, either by disregarding
the long-term consequences of their actions, which may lead to unintended
consequences’ (Czakon et al., 2023)

Czakon, Kilmas, Kawa and Kraus (2023). How myopic are managers?
Development and validation of a multidimensional strategic myopia scale. Journal
of Business Research, 157.

Required:
Discuss the statement above, explaining what myopia means from a management
accounting perspective and critically evaluate the potential approaches that a
management accountant can take to minimize the myopia problem in practice.
[Total 25 marks]

Myopia – short-sightedness, from a management accounting perspective relates to a short-

term orientation in management control. Managers that are encouraged to present smooth
earnings growth and to meet market expectations regarding dividends tend not to invest in the
future of the business, as their focus will be on current profit levels. Examples of myopic
behaviour could be discussed such as gamesmanship – adjusting reserves or selling financial
assets to manipulate profits. This goes against efficient markets theories which suggest that
the stock market values business on the basis of the PV of future cash flows. Investors and
analysts will react favourably to strategically important investments, or development of
innovative products where managers are forward focused. Hedge managers have a much
shorter focus and so may put pressure on management to maximise current earnings. The
consequences of myopia are that value will be lost from an organisation if dividend growth is
prioritised over investment, and future resilience will be lost, resulting in an unsustainable
position. Managers are often unaccountable for myopic decisions as they have moved on to
another post before the consequences of their decisions materialise.

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Potential solutions to the problem have been proposed:
• Reduce pressures for short-term profit in the calculation of bonuses. Make the ST
profit targets easier to achieve so management spend more time on LT targets.
Incorporate non-financial targets in performance evaluation.
• Use a more subjective, qualitative approach. Divide income statement into short-term
operating performance with costs of long-term investments below this. This may
encourage gaming, if split is ambiguous.
• Fund development at higher levels (Board) so lower level managers due not have to
be evaluated on development expenditures.
• Distinguish parts of business focused on current operations (today) from those focused
on developing new business opportunities (tomorrow)
• Extend the measurement horizon beyond short-term to 3-5 years, offer stock options
with tie-ins. LT incentive schemes are not popular as payment of bonuses is less
frequent, and management may apply a high discount to defer bonuses. This could
be solved via a claw back scheme.
• Change the basis of value – use economic income (discounted cash flow) rather than
profit or share price to evaluate projects. Highly subjective and subject to errors of
estimation. .
• Improve the accounting measures to align to a period beyond extreme short-term.
Adopt an economic value added approach (e.g. chose depreciation lives to align with
economic lives; Capitalise all leases and expenditure required to generate future cash
flows e.g. R&D, customer acquisition costs etc.; Recognize value changes as they
arise; charge an imputed cost of equity.
• Measure things ‘driving value, e.g. adopt a balanced score card approach. This de-
emphasises financial targets and refocuses on lead factors (more LT) that drive
performance. KPIs should be balance and weighted evenly throughout the quadrants.
This could be discussed in more depth, including the problems associated with poor
application of KPIs and targets.

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6. a) There are many ways that a company can structure its incentive systems.
Analyse a range of incentive systems and explain why one size does not fit all.
[15 marks]
The objective of an incentive system is to create goal congruence and link employee self-
interest to corporate goals. These can be effort directing (what metrics to be achieved) or
effort inducing (rewards for effort made). Incentive systems should attract and retain
personnel. The inclusion of performance related pay switches fixed costs to variable costs,
reducing financial risk. Types of incentive systems should be covered: financial (bonuses,
stock options), non-financial (praise, recognition increased responsibility, status, greater
autonomy, involvement in decision-making) and negative incentives (performance
management, demotion, job loss). Financial incentives include salary increase or short-term
incentives e.g. annual bonuses or monthly commissions. Bonuses can be linked to non-
financial targets (customer satisfaction). Eligibility for bonuses and their size increases as the
employee moves up the organization. LT incentives may be aligned with LT goals to
overcome myopia. These assess performance over 3-5 years, which may be overlapping.
Stock options are a LT incentive scheme, offering employees the right to purchase shares at
a set price and time. Options can be exercised over a number of year but will expire at some
point. If an employee leaves any unvested options are withdrawn. These are beneficial as
they provide incentives without a cash outlay. As management only benefit if share price
increases they should be motivated to make decisions that will result in this. It can increase
staff retention and when managers exercise the option it generates a cash inflow for the
company (if option to buy rather than a stock plan per se). There are downsides: dilution of
control, managers may take riskier decision to hopefully increase share prices. Share prices
are volatile and not within managers control. Staff may also be awarded shares, paid for from
equity reserves. There is often a lock-in period to prevent selling the shares and so are
regarded as retention tools. Group rewards may also be discussed. These link to cultural
controls and are appropriate if individual contribution is difficult to identify. Individual that are
not team players may get a free ride from these schemes but peer pressure either increases
commitment or flags the issue to line managers.

b) Outline the characteristics of an effective incentive scheme and the pitfalls to

avoid when designing an incentive system [10 marks]
Incentive schemes need careful design. A clear purpose and understanding is needed, how
it will work and how employees can calculate their entitlement. Incentives may be based on
a formula, specified in a contract, that details thresholds to be achieved and the metrics used.
Other schemes may be based on the subjective judgment of a line manager, whether to pay
the bonus in full, in part or not at all, whether to weigh any quantitative aspects of the bonus
measure. Choosing the wrong basis may lead managers to focus on inappropriate goals. If
the conditions are flexible managers will be more motivated to perform well overall rather than
attempting to game/manipulate narrow metrics. This will increase the employees’ risks and
may have hindsight bias, or personal bias that leads to demotivation if they work well but do
not get on with their line manager. Therefore trust and a good working relationship is needed
for subjective incentive schemes to work. Effective schemes should not to reward mediocre
performance e.g. low thresholds in a quantitative scheme. Likewise, include upper limits so
windfall events do not lead to excessive payments. Employees can use gaming tactics –
manipulating performance this year to maximise a bonus at expense of future periods, with
the view to leave. Incentives should be banded so subordinates cannot exceed line manager’s
remunerations. Volatile earnings are unattractive for staff, as they need to sustain their
lifestyle. Good incentive schemes should have a number of characteristics: valued by the
recipient, large enough to have an impact understandable to the employee, timely payment of
bonuses, long-lasting, reversible if an evaluator makes a mistake and cost effective.
SECTION C

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7. Phoenix Ltd has expanded overseas, via the purchase of five companies that are
key components in its supply chain. Consequently, 35% of its trade will be made
via divisional transfer. Phoenix Ltd will run each division as a profit centre and
award management performance using operating profit targets. The Board are
debating which transfer-price to use. Details of the divisions are as follows:
i. Division A will procure raw materials and will sell these exclusively to
Divisions B, C, D and E
ii. Division B will produce a specialised component. It will sell 100% of output
to Division C for further modifications. It has no other customers.
iii. Division C modifies components. It can buy these from Division B or from
an external source. It will sell 60% of the modified components to Division
E and 40% to external customers.
iv. Division D produces components that it will sell to Division E. In undertaking
due diligence on the purchase of Division D it was uncovered that Division
D has £2.5m worth of inventory at £4 per unit that is currently trading in the
open market at £3.45 per unit. This inventory is in constant use in Division
E. Market prices are expected to rise to £4.50 within 9 months.
v. Division E is a finishing division that produces products for the external
market. It is highly profitable and has spare capacity to produce partially
completed products that it could transfer to Division C for modification.

Required.
a) What is the purpose of transfer pricing? Outline potential considerations that
Phoenix Ltd should be aware of before setting the transfer pricing for its 4
divisions.

[7 marks]
Transfer prices are artificial prices set by a company that has products or services
that are transferred between divisions. The transfer price will impact the revenue
of one division and the expenses of another. The effect on the pre-tax net income
of the group is unaffected as intercompany transfers are removed at consolidation.
The purpose of TP is to motivate managers to make economic decisions that are
in the best interest of the group e.g. internal transfer or external sale. TP used in
performance appraisal and is central to enable autonomy of managers in running
their operations.
Considerations: overall tax bill for the company. Different tax regimes have
different tax rates. High profits in a high tax jurisdiction will increase tax and
decrease net profit. Companies may operate in countries, which restrict the

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 repatriation of profits. TP should be fair – evaluating a manager on an imposed
transfer price (e.g. marginal cost) that they have no control over may lead to
dysfunctional behaviour and a lack of goal congruence between head office and
the division.

b) Evaluate the situations of the four divisions and discuss whether market-based
or cost-based methods are more appropriate and why. Make recommendations
for the transfer price for each division.
[18 marks]

Total 25 marks

Full cost based TP would not be appropriate for any of the scenarios and this offers
no incentive for the selling divisions to do internal transfers as there is no profit
margin and management appraisal is based on operating profit earnt. For each
division recommendations are as follows, however it should be noted that the
buying and selling division managers should be included in the negotiation process
to ensure the autonomy of the decision rather than TP being imposed by head
office.

i.Division A would use a market-based pricing with perfect competition. TP could

be set at market price. Presumably Division D would earn a profit due to
economies of scale of purchasing in bulk.
ii.Division B: An external market price does not exist for this precise component but
competitors have substitute products but these require modification: a market-
based price with imperfect competition could be used as a TP, but the price may
need to be adjusted to reflect the additional modifications needed to make the
products comparable. The differences in the quality of substitutes should also be
considered. The TP should be competitive to encourage Division C to buy from B
rather than external suppliers. If substitute components are very different in quality
a cost-based TP may need to be used in the absence of a comparable market
price. Using Full cost would be problematic as there would be no incentive for
Division B to sell to C if profit made is zero.
iii.Division C. TP can be based on market price with perfect competition – actual price
charged to customers. If Division B cannot earn a profit from trading to Division C
at market price it is economically unsound for Division C to pay more to prop up
the division. This would lower Division C’s profit and encourage them to buy from
an external source. If this is the case the division should be discontinued and the
component outsourced.
iv.Division D is operating under distress market prices. If inventory procurement is
required before the market recovers Phoenix would be motivated to buy externally
at a lower price. This is not in the best interest of the group as the inventory in
stock and already paid for. An average price may be set for the period before the
market recovers. This would need to be factored into the performance appraisal
of both buying and selling managers. .

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 v.Division E should use a marginal cost based TP as at spare capacity fixed costs
are already covered. This would ensure goal congruence but the manager of
division E would lack any incentive to deliver these products as no profit would be
earnt and it would not improve personal income. A marginal cost plus lump sum
fee could be used or marginal cost plus proration of contribution.

8. The Board of Directors of Cooper PLC are currently debating their approach to
target setting:
• The CEO would like to commission a time and motion study to correctly
identify the time taken for each process within the business and create
associated engineered targets. The aim is to set very tight targets to
maximise efficiency and minimise expenditure.
• The Marketing Director believes that the budgeting system is not cost
effective and so target setting should be based on last year’s budget plus
inflation.
• The Human Resources Manager believes that staff satisfaction would
improve if a negotiated, bottom-up budget was introduced in which budget
holders are given full autonomy over target setting.
• The Chief Operating Office would like to explore beyond budgeting
principles and the replacement of financial targets with a mix of non-financial
and financial targets.
• The Finance Director would like to introduce zero-based budgeting to
eradicate budgetary slack, as tough but attainable targets will achieve the
best results.

Required:
Drawing on relevant literature, critically evaluate the perspectives of each of the
Board members, explicitly identifying strengths and weaknesses in each argument
in relation to tackling common financial performance target issues.
Total 25 marks

Budgets translate into targets that managers will have to meet. The Board have highlighted
five approaches to target setting. Others also exist such as external benchmarks to set
targets. Each of these should be detailed with strengths and weaknesses highlighted. For
example, engineered targets via a time and motion study provide observable targets than

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 can justify standard cost sheets in an objective manner. On the downside this would be
expensive, cause huge disruption and requires buy-in from staff. If anything changes, the
exercise would need to be repeated to remain relevant. Employees may game whilst
being observed to build in slack, so ethical issues may persist. Engineered targets would
need to be flexed to align with output each period. Controllability assignment is a potential
issue as engineered targets are associated with tight controls.

A common issue is how challenging should targets be. The CEO favours tough targets,
the FD tough but attainable targets, whereas the MD and COO’s suggestions would result
in easily achievable targets. Research suggests ‘difficult but achievable’ often best in
terms of outcomes. This works because it increases management commitment, balancing
optimistic projection, motivates managers as they feel they can achieve the targets set for
them. It also reduces the cost of intervention and reducing game playing as manipulation
is not required if targets are achievable. These points should all be covered in more details.
In some circumstances, e.g., where an organization is in extreme difficulty, more
challenging targets may make sense. Participation/involvement in target setting can be a
moderating influence.
Second issue is how much influence should budget holders have in target setting? Only
the HRD suggests true involvement by budget holders. Having high involvement will
enhance management commitment, encourage information sharing, increases
management understanding of goal setting and improve motivation as their knowledge
and expertise is seen to be valued. The other members of the Board are favouring low
involvement. This is justified if the Board have better knowledge of strategy and corporate
vision than subordinates do, or a better overview of the entire business for resource
allocation and how divisions are co-ordinated. They may also have the requisite financial
and forecasting skills. The Board should be neutral in terms of target setting, as they will
not benefit from manipulating specific targets.
The COO approach should be discussed separately as beyond budgeting is a movement
created in response to criticisms of traditional budgeting (gaming, incremental thinking,
inflexibility, stifling innovation, costs exceed benefits etc.) and so would require a complete
change to the system. This is more forward looking and using KPIs based on non-financial
targets can focus on what is driving value (lead indicators) rather than focusing on the
output of value (lag financial indicators). These are frequently used in business e.g. retail
stores could be % of repeat customers, airlines use load factor, hotels room occupancy
levels etc.

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 Present Value interest factor per £1.00 due at the end of n years for interest rate of:
% 1 2 3 4 5 6 7 8 9 10
n
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180
19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149
21 0.811 0.660 0.538 0.439 0.359 0.294 0.242 0.199 0.164 0.135
22 0.803 0.647 0.522 0.422 0.342 0.278 0.226 0.184 0.150 0.123
23 0.795 0.634 0.507 0.406 0.326 0.262 0.211 0.170 0.138 0.112
24 0.788 0.622 0.492 0.390 0.310 0.247 0.197 0.158 0.126 0.102
25 0.780 0.610 0.478 0.375 0.295 0.233 0.184 0.146 0.116 0.092

% 11 12 13 14 15 16 17 18 19 20
n
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065
16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054
17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045
18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038
19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031
20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026
21 0.112 0.093 0.077 0.064 0.053 0.044 0.037 0.031 0.026 0.022
22 0.101 0.083 0.068 0.056 0.046 0.038 0.032 0.026 0.022 0.018
23 0.091 0.074 0.060 0.049 0.040 0.033 0.027 0.022 0.018 0.015
24 0.082 0.066 0.053 0.043 0.035 0.028 0.023 0.019 0.015 0.013
25 0.074 0.059 0.047 0.038 0.030 0.024 0.020 0.016 0.013 0.010
Present Value interest factor for an annuity of £1.00 for a series of n years for interest rate of:
% 1 2 3 4 5 6 7 8 9 10
n

© University of London 2024 Page 17 of 18

 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.678 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.351 14.877 13.590 12.462 11.470 10.594 9.818 9.129 8.514
21 18.857 17.011 15.415 14.029 12.821 11.764 10.836 10.017 9.292 8.649
22 19.660 17.658 15.937 14.451 13.163 12.042 11.061 10.201 9.442 8.772
23 20.456 18.292 16.444 14.857 13.489 12.303 11.272 10.371 9.580 8.883
24 21.243 18.914 16.936 15.247 13.799 12.550 11.469 10.529 9.707 8.985
25 22.023 19.523 17.413 15.622 14.094 12.783 11.654 10.675 9.823 9.077

% 11 12 13 14 15 16 17 18 19 20
n
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675
16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730
17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775
18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812
19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843
20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870
21 8.075 7.562 7.102 6.687 6.312 5.973 5.665 5.384 5.127 4.891
22 8.176 7.645 7.170 6.743 6.359 6.011 5.696 5.410 5.149 4.909
23 8.266 7.718 7.230 6.792 6.399 6.044 5.723 5.432 5.167 4.925
24 8.348 7.784 7.283 6.835 6.434 6.073 5.746 5.451 5.182 4.937
25 8.422 7.843 7.330 6.873 6.464 6.097 5.766 5.467 5.195 4.948
End of paper

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