You have recently been appointed as the financial manager of NetW Ltd, who reports directly to the Financial Director. NetW Ltd operates in the Information, Communication and Technology (ICT) industry.
NetW Ltd has historically focused on the supply of computer hardware, while also providing integration and consulting services, and particularly storage solutions, to clients. However, the downturn in the South African ICT sector, which has resulted in diminishing margins and increased competition, has also had an adverse effect on NetW Ltd. As a result, the company reported significantly lower earnings for the year ended 30 June 2003. The company is therefore now analysing its overhead costs and seeking ways to improve operating margins. NetW Ltd is also considering diversifying into new areas of business which are expected to have higher gross margins. The abridged income statement of NetW Ltd for the years ended 30 June 2002 and 2003 is set out below:
NETW LTD
INCOME STATEMENT
For the years ended
2003 2002
R'000 R'000
Revenue 392 060 461 250
Cost of sales (307 770) (349 080)
Gross margin 84 290 112 170
Operating costs (72 435) (67 070)
Depreciation (5 050) (5 900)
Profit from operations 6 805 39 200
Finance cost (1 840) (1 700)
Profit before tax 4 965 37 500
Income tax expense (1 495) (11 200)
Profit after tax 3 470 26 300
The Financial Director of NetW Ltd has requested your assistance in assessing various issues and opportunities facing NetW Ltd. These concern an analysis of customer profitability, a possible new business unit, hedging of currency risks, and lastly improvements to the incentivisation scheme for employees.
ISSUE 1 Customer profitability analysis
NetW Ltd has not previously analysed profitability per customer, nor has the company allocated overhead costs to specific activities or divisions. The Financial Director is concerned that the company may be servicing customers who do not contribute to the bottom line. Independent consultants were accordingly engaged to review NetW Ltd's overheads and analyse profitability per customer. The consultants applied activity-based costing techniques to allocate indirect costs to activities. This process involved significant input from the employees of NetW Ltd.
The independent consultants have forwarded the results of the activity-based costing analysis to management for their review. The indirect costs of NetW Ltd for the year ended 30 June 2003 were analysed and allocated to eight identified key activities by means of appropriate cost driver rates. The primary focus of the review process was to analyse profitability by major customer.
The salient results of the costing analysis for each of the three major customers and other customers together, and for the company as a whole, are set out below:
Customer
Abacus Barbel Clidet
Total of
major
customers
Other
customers
Company
as
a whole
Year ended 30 June 2003 R'000 R'000 R'000 R'000 R'000 R'000
Revenue from customer 86 250 74 650 63 800 224 700 167 360 392 060
Cost of hardware supplied (64 700) (58 300) (48 615) (171 615) (102 830) (274 445)
Direct employee costs (7 700) (5 200) (4 785) (17 685) (15 640) (33 325)
Gross margin 13 850 11 150 10 400 35 400 48 890 84 290
Sales commission (1 725) (1 493) (1 276) (4 494) (3 347) (7 841)
Net margin 12 125 9 657 9 124 30 906 45 543 76 449
Customer attributable
costs
Sales visits (2 750) (2 300) (990) (6 040) (2 180) (8 220)
Preparation of sales quotes (880) (1 300) (310) (2 490) (935) (3 425)
Customer order processing (210) (240) (135) (585) (2 115) (2 700)
Purchase orders to fulfill
customer orders
(180)
(210)
(115)
(505)
(1 925)
(2 430)
Materials receiving and handling
(865)
(695)
(505)
(2 065)
(3 560)
(5 625)
Deliveries to customers (320) (360) (230) (910) (4 790) (5 700)
Technical support and
service
(370)
(340)
(260)
(970)
(3 290)
(4 260)
Credit collection (1 640) (710) (330) (2 680) (3 610) (6 290)
Contribution to higher
level sustaining expenses
4 910
3 502
6 249
14 661
23 138
37 799
ISSUE 2 Possible new business unit
South African banks are busy upgrading their point of sale terminals infrastructure in order to comply with international standards. NetW Ltd perceives the supply of such point of sale terminals to South African banks as a major new business opportunity. NetW Ltd is at an advanced stage of discussions with AlphaData Plc, an electronic payment technology company based in the United Kingdom, regarding the acquisition of a licence to distribute certain AlphaData Plc products in sub-Saharan Africa.
AlphaData Plc is a leading developer and manufacturer of point of sale terminals in Europe. They have not at any time supplied products to African customers because of their focus on European customers. They are prepared to grant NetW Ltd the exclusive licence to distribute their products in designated African countries.
The proposed business relationship between the parties is summarised below:
- Upon entering into the licensing agreement, NetW Ltd will pay AlphaData Plc US $566 667 for the exclusive right to distribute their point of sale terminals in sub-Saharan Africa.
- NetW Ltd will also pay AlphaData Plc a royalty, quarterly in arrears, calculated as 5,0% of invoiced sales of point of sale terminals.
- The point of sale terminals sold by NetW Ltd will be branded as "AlphaData" products. These terminals will be sourced from suppliers of AlphaData Plc in the Far East at the same FOB US $ prices as those enjoyed by AlphaData Plc.
- The licensing agreement will be for a period of ten years.
- AlphaData Plc undertakes to provide intensive training to eight existing NetW Ltd employees for a three-month period. AlphaData Plc will bear the training costs, but NetW Ltd will have to pay their employees' travel expenses to the United Kingdom and accommodation expenses during the training period.
- AlphaData Plc undertakes to provide technical support and assistance to NetW Ltd in respect of the point of sale terminals product range.
- AlphaData Plc will allow NetW Ltd to distribute any new point of sale terminals developed by AlphaData Plc.
A task team of NetW Ltd employees was created to investigate the point of sale terminals opportunity and negotiate the licensing agreement with AlphaData Plc. The task team has prepared a draft capital budget covering the expected revenues and costs associated with pursuing this opportunity, which is summarised below:
BUSINESS UNIT DRAFT CAPITAL BUDGET
POINT OF SALE TERMINALS
Notes Year 0 Year 1 Year 2 Year 3 Year 4
R'000 R'000 R'000 R'000 R'000
Cost of acquiring licence 1 (4 250)
Initial training and
accommodation costs
2
(1 244)
Other set-up expenses (500)
Revenue 9 000 22 500 45 000 56 250
Cost of sales 3 (5 400) (13 500) (27 000) (33 750)
Sales commission (180) (450) (900) (1 125)
Royalties (450) (1 125) (2 250) (2 813)
Operating costs 4 (2 500) (3 250) (3 900) (4 290)
Financing costs 5 (900) (1 300) (1 100) (200)
Working capital (2 300) (2 000) (3 500) (1 000)
Cash flow generated 6 (5 994) (2 730) 875 6 350 13 072
Notes
1 The cost of acquiring the licence has been translated at an exchange rate of US $7,50.
2 Initial training and accommodation costs include the following for eight employees for the threemonth period:
R
Travel costs 68 000
Accommodation costs 576 000
Salaries 60 000
3 NetW Ltd intends to adopt a cost-plus pricing strategy.
4 Operating costs included in the capital budget are incremental costs that NetW Ltd will incur in operating the point of sale terminals business unit.
5 The set-up and operations of the point of sale terminals business unit is to be funded by means of a five-year term loan obtained from a commercial bank. The term loan will bear interest at the prime overdraft lending rate.
6 Cash flows generated by the point of sale terminals business unit after year 4 are expected to increase by 5,0% annually.
NetW Ltd has determined its cost of capital to be 20,0%. However, in view of the higher risk associated with the new business venture, the Financial Director has requested that the projected net cash flows of the point of sale terminals business unit be discounted at a rate of 25,0%.
ISSUE 3 Hedging of currency risks
The Financial Director of NetW Ltd is concerned about the escalating risk faced by the company due to movements in exchange rates. NetW Ltd has historically sourced storage devices from local agents of international manufacturers. Now the company is investigating importing computer hardware directly from foreign suppliers in order to improve gross margins. In addition, the possible new business unit that NetW Ltd is investigating would also import devices, which would further increase the currency risks.
5
The Financial Director suggests establishing hedging policies to protect the company against losses arising from movements in exchange rates. NetW Ltd intends to import products mainly denominated in US $. The rand has been particularly volatile against the US $ in recent times. The average exchange rates of US $ : rand over the past four quarters are summarised below:
Spot rates
US $1 = rand
31 December 2002 8,50
31 March 2003 7,70
30 June 2003 7,30
30 September 2003 7,50
ISSUE 4 Incentivisation of employees
The Financial Director of NetW Ltd has been asked by the board of directors to suggest amendments to the incentivisation policies of the company. The current policies are summarised below:
- Sales representatives receive a 2,0% commission on all invoiced sales. There are no other
incentives for sales representatives.
- Executive directors and other key employees share in an annual bonus pool to which the company contributes 5,0% of pre-tax profits each year. Allocation of the bonus pool to individuals is discretionary and determined by the Managing and Financial Directors.
- All other employees of NetW Ltd receive a 13th cheque in the event that the company achieves profit before tax of at least 80% of budget.
The board of directors is concerned that the current incentivisation policies may be encouraging inappropriate behaviour by sales representatives and be providing insufficient incentive for executive directors and other key employees. The Financial Director has been asked to recommend alternatives to the current incentivisation schemes. In particular, the Financial Director has been asked to consider an EVA-based incentive scheme for the executive directors and other key employees of NetW Ltd, which would include a "bonus bank" whereby a portion of bonuses earned in any financial year are carried forward to future years.
REQUIRED
(a) Analyse the abridged income statements of NetW Ltd for the years ended 30 June 2002 and 2003, and compute key ratios from the information available. Outline and discuss the important issues evident from your ratio analysis that management should address in the 2004 financial year.
(b) Critically analyse and provide detailed comments on the results of the customer profitability analysis prepared by the independent consultants to NetW Ltd. Your answer should include ratio analysis and a comparison of the contribution made by each of the three major customers and the remaining customers to the profitability of NetW Ltd.
(c) Critically evaluate the draft capital budget of the new business unit prepared by the task team and identify any errors or omissions it may contain.
(d) Indicate, with reasons, whether NetW Ltd will be able to deduct the cost of acquiring the licence and the other initial costs associated with establishing the new business unit for income tax purposes.
(e) Calculate, after adjusting for errors and omissions identified, the net present value at year 0 of the expected cash flows of the new business unit using a discount rate of 25,0%.
(f) Discuss, with reasons, whether you agree with the Financial Director's view that a higher discount rate than the company's cost of capital should be used to discount the future cash flows of the new business unit.
(g) Identify and explain the risks faced by NetW Ltd in pursuing the point of sale terminals new business opportunity.
(h) Discuss the accounting treatment that NetW Ltd should adopt to record the acquisition of the licence and the incurral of other costs of setting up the new business unit.
(i) Assuming NetW Ltd establishes the point of sale terminals business unit,
(1) outline the general and transactional risks faced by the company from movements in exchange rates; and
(2) recommend general and specific hedging techniques to minimise identified exchange rate risks.
(j) Discuss the potential shortcomings, from the perspective of NetW Ltd, of the current incentivisation policy for sales representatives.
(k) List the potential pitfalls, from the perspective of NetW Ltd, of the current incentivisation policy for executive directors and other key employees and indicate whether an EVA-based scheme would address these issues.