T4- Part B Case Study D plc. House-Building case ... docs/2010 syllabus docs/T4/… · D plc....

© The Chartered Institute of Management Accountants 2012

Note: This report is far more comprehensive than would be expected from a candidate in exam conditions. It is more detailed for teaching purposes.

T4- Part B – Case Study

D plc. House-Building case - September 2012

REPORT To: Finance Director From: Management Accountant Date: September 2012

Review of issues facing D plc (D)

Contents

1.0 Introduction

2.0 Terms of reference

3.0 Prioritisation of the issues facing D

4.0 Discussion of the issues facing D

5.0 Ethical issues and recommendations on ethical issues

6.0 Recommendations

7.0 Conclusions

Appendices

Appendix 1 PEST analysis of UK Building Industry

Appendix 2 Five Forces analysis of UK Building Industry

Appendix 3 SWOT analysis

Appendix 4 Force-Field analysis

Appendix 5 Supporting calculations

Appendix 6 Part (b) Presentation on future cash flow concerns


1.0 Introduction

D like other UK house builders is facing difficult times. This is reflected in government statistics on house-building with housing starts in the UK now 43% lower than in 2006 when they reached a record high. A summary of the difficult conditions facing UK house builders is provided in the PEST analysis in appendix 1.This indicates that amongst other difficulties the shortage of mortgage availability is regarded by house builders as the major constraint on progress in the industry. While the depressed state of the UK economy is a major burden, it is also important to note that the competitive conditions in the building industry have been increasing for some time. The Five Forces analysis in appendix 2 suggests that while threats from new entrants, substitutes and the bargaining power of buyers and suppliers is relatively low, the competitive pressure from rivals is very high. This competitive pressure arises from the consolidation and increasing capital intensity that has developed in the UK building industry over the last two decades. The difficult economic conditions and increasing competiveness in the building industry noted above affect all the players in the industry including D. In addition to these constraints however, D faces a number of additional problems including a substantial loss of short term land in its Eastern Region, higher than average operating costs, the complacency of staff in the face of the forces of change affecting the building industry and a dysfunctional organisational structure, culture and systems. These particular problems as well as the major constraints affecting the building industry have given rise to a number of issues and these are summarised in the SWOT analysis in appendix 3. The key issues are prioritised in section 3 of this report and discussed and evaluated in section 4. Section 6 then summarises the main findings and makes recommendations. 2.0 Terms of reference I am the Management Accountant appointed to write a report to the Finance Director which prioritises analyses and evaluates the issues facing D and makes appropriate recommendations. I have also been asked to prepare a presentation for the FD which will enable him to explain to the Board why future cash flow is of concern to D.

3.0 Prioritisation of the issues facing D The priority listing has been arrived at following an evaluation of the essential timing of each issue rather than in terms of an issue‟s ultimate importance to the organisation. 3.1 Top Priority – Cash and profitability The top priority is to ensure that cash flows and any extra funding required is in place to enable the decisions of the board to be fully implemented; in the short term to enable the forecast profitability to be restored and in the long term the continued survival and development of the Company. The Company is facing a number of challenges as discussed below and needs to meet the expectations in particular of its institutional investors. 3.2 Second priority – Product Quality The product quality issue is a major cause of concern. It is affecting orders and therefore potential sales in the largest region (Central) of the Group, with the reputation of the Company at stake it is essential to take action to correct this as soon as possible, otherwise it will damage D‟s brand image and hence future sales. It has adversely affected the profit and cash flows of the Company by £57.0 million in the current year 2012, and will require substantial future investment to correct. It must not be allowed to continue, or spread to other regions.


3.3 Third priority – Loss of short term land The unfortunate animal disease outbreak means that land in the Eastern Region, which generates the highest contribution per sale will be out of use for the medium term. In order to maintain a presence in the region and maintain results, the Company will need to bring forward its investment plans for the region and obtain more land. This will require extra cash in the short term but will enable the Company to continue trading in the Eastern Region and maintain profitability after a short interruption. Whilst this has a considerable financial impact it is not as significant as the product quality issue. 3.4 Fourth priority – Management of change The need to address the forces of change affecting the Company is of fundamental importance if D is to retain its position as one of the UK‟s leading building companies but this process will require time and resources and will necessarily have to await the resolution of the cost cutting and short term land issues. 3.5 Ethical issues The ethical issues of on-site safety wear and expense claims need to be attended to directly but these can be managed alongside the other issues. 4.0 Discussion of the issues facing D 4.1 Overview The Company has suffered a decline in sales and profits since the market peak in 2008 and whilst this is not good, it is in line with the cyclical nature of the industry, and is not seen as a long term problem. The financial position is considered sound, with the reduction of activity reducing the capital and financing requirements, £246.6M of loans being repaid in 2011, and the current capital requirements of the Company adequately provided for. This has rapidly changed however, with the events which have beset the Company there is a requirement for rapid short term investment to restore forecast profits, and for longer term managerial changes. These investments and changes are seen as essential to maintain the good reputation of the Company with all stakeholders and maintain a nationwide presence in the industry. 4.2 Cash and profitability Understanding the difference between cash and profit is key to the continued success of any commercial enterprise. Profit is essentially the residual value after reducing the value of sales by the costs associated with those sales (matching), usually the cost of the items sold themselves, their direct costs and then applying any indirect costs such as premises, factory warehouse office or shop space, marketing, transport and other costs such as training and facilities maintenance and the depreciation of assets used in the business. Profit is calculated by matching as many as possible of these costs to the actual products sold directly, and allocating the other costs to the time period over which the sales take place (accruals and prepayments). As a result the profit calculated for a month, quarter or year will be separate and distinct from the cash flowing around the business. Cash collected from sales will not necessarily be collected at the time of sale; this will depend on the type of business. Large supermarkets and retailers will tend to collect at the point of sale, either in cash or debit/ credit cards, which are usually paid by the card company clearing system within a few days, resulting in relatively rapid cash collection.


These types of organisation, also benefit from considerable buyer power, and apart from being able to use this to negotiate beneficial purchase prices, thus maintaining a profitable margin between sales price and cost, are also able to agree payment terms to suppliers of 60 days or more. All this results in them having collected the cash from their sales before having to pay for the direct cost of those sales, this gives a very favourable working capital cycle. The basic principles of matching sales and expenses are similar in all businesses; care needs to be taken however, in managing the working capital cycle in different types of business. For example in a large engineering or construction company the working capital cycle will be much longer than that described above being related to the products being produced and sold. For example a shipbuilder will have to fund much longer periods of time between selling the finished ship and the construction process during which materials will need to be purchased and workers paid for the work in progress completed. In order to survive this „gap‟ it is normal practice in such industries to agree initial, stage and final payments in accordance with the contracts and customer requirements. Most such projects are undertaken for a specific customer under an agreed contract. To this extent firms in the domestic house-building industry find themselves in a potentially difficult working capital management situation. The working capital cycle can be long, land must be purchased, some speculatively, materials purchased, labour paid and houses built with no specific customer and no stage payments. Because of this the UK house-building industry has experienced much insolvency amongst all sizes of company over the recent past. Effective cash management in D is vital, and the Company needs to ensure that it has the ability and management resources through effective IT and reporting systems to effectively manage its cash position. Frequent profit and cash flow projections and the understanding of the effects of changes in market conditions and other events affecting the business need to be analysed and their consequences understood and communicated effectively as they occur.

From the un-seen and pre-seen case study material it can be seen that the annual profits were originally forecast to improve from the 2011 figure £71.8 million after tax up to £165.0 million for the year to 31 December 2012.

Although the UK economy is unlikely to improve in the near future this improvement in profits would have been pleasing in particular to D‟s institutional investors who have not received a dividend in the past two years. In some ways however D has moved forwards in 2012. The recent cost cutting strategy was currently forecast (from appendix 4 un-seen) to improve the gross profit margin to 22% and the operating profit margin (before finance costs and tax) to 16.2%.

These are a significant improvement over the 2011 figures for D of 13.6% and 8.0% respectively. The 2012 figures for D also compare very favourably with those of two major UK competitors e.g. the operating profit, before exceptional items, for Barratt Developments plc. was 6.6% in 2011, and for Bellway plc. was 8.5%.

The problem for D however, is that the forecasts in appendix 4 (un-seen) are now out of date, and in particular have been significantly affected by the product quality issue in the Central Region and the loss of short-term land in the Eastern Region. These latter two issues are discussed in the following two sections, but their financial impact is quantified below.

When comparing profit and cash flows it should be noted that the cash flows are benefiting from the annual profits, that it is assumed that no investments are being made in the business for on-going replacement of property, plant and equipment and also that working capital investment is not affected by cost inflation, as indicated in the FD‟s report.

It is also noted that the cash flows make no provision for any dividend payments, and that the existing bank loan of £250 million is due for repayment in 2015.


Updated profit forecast: Land and company are not acquired.

Details Notes 2012 2013 2014

Profit before tax: £m £m £m

Current forecast 1 229.1 226.2 223.2

Cost of product quality 2 (57.0) (86.3) (86.3)

Short-term land impact 3 (104.5) (104.5)

Revised profit before tax 172.1 35.4 32.4

Less tax at 28% (48.2) (9.9) (9.1)

Revised profit after tax 123.9 25.5 23.3

Current forecast PAT 4 165.0 162.9 160.7

Notes: 1. From appendix 4 of the unseen case-study 2. From appendix 5 attached 3. From appendix 5 attached 4. From appendix 4 of the unseen case-study

Updated cash flow forecast: Land and company are not acquired.


£m £m £m

Current forecast opening cash balance 1 112.8 261.7 253.6

Add revised profit before tax 2 172.1 35.4 32.4

Add back depreciation costs 3 4.7 4.7 4.7

Less tax paid 4 (27.9) (48.2) (9.9)

Revised closing cash balances 261.7 253.6 280.8

Current forecast closing cash balances 5 318.7 485.5 650.1

Notes: 1. From appendix 4 of the unseen case study 2. From appendix 5 attached 3. From appendix 4 of the unseen case study 4. The tax paid reflects a one year delay in payment i.e. the £27.9 million paid in 2012 is from the 2011 income statement (page 16 of the pre seen case study.) 5. From appendix 4 of the unseen case study.

It is clear from this analysis that D will suffer a significant deterioration in its profit position for the years 2012, 2013 and 2014. The forecasted profits after tax of £123.9 million for 2012 £25.5 million for 2013, and £23.3 million for 2014 leave little room for error. The 2013 and 2014 figures will also need to be reduced by the amortisation of any investment made into resolving the product quality problem. These revised profit figures indicate that it would not be prudent to consider any dividend payments in 2012, 2013 or 2014. It would appear to be necessary in particular to get the institutional shareholders on board with such a decision however, they are a key stakeholder in the business (per Mendelow‟s framework). The cash position is not as severe as the profit situation with forecasted cash balances growing from £261.7 million at the end of 2012 to £280.8 million by the end of 2014. However over the three years to 31.12.2014 D‟s cash position is still forecast to have deteriorated by £369.3 million against forecast (i.e. £650.1 less £280.8 million).


This does not take into account cash requirements for corrective action of the quality issue and the loss of land in the Eastern Region, if both the required investments are implemented the effect will be as outlined below. Profit forecast with acquisition of land and fitting company.




Cost of product quality 2 (57.0)



Less tax at 28% (48.2) (34.1) (57.2)



Notes: 1. From appendix 4 of the unseen case study 2. From appendix 5 attached 3. From appendix 5 attached 4. From appendix 4 of the unseen case study

Cash flow forecast with acquisition of land and fitting company.


£m £m £m

Current forecast opening cash balance 1 112.8 261.7 (12.1)



Investment required (Company & Land) (352.0)

Less tax paid 4 (27.9) (48.2) (34.1)

Revised closing cash balances 261.7 (12.1) 162.7


Notes: 1. From appendix 4 of the unseen case study (opening 2012 cash balance) 2. From appendix 5 attached 3. From appendix 4 of the unseen case study 4. From appendix 5 attached 5. From appendix 4 of the unseen case study

With this course of action the profit after tax for the 3 years improves after 2012 with £87.6 million in 2013 and £147.0 million in 2014 an improvement over the3 years of £185.8 million, this comes as a result of investments of £352.0 million for the fitting company and the extra land in the Eastern region. Funding these from operating cash flows will result in a £12.1 million cash deficit by the end of 2013, and which improves to a surplus of £162.7 million at the end of 2014. Without the agreement of the bank this will not be possible, so action needs to be taken to fund the investment by specific medium term finance.

Again it is noted that D has to find £250 million in 2015 to repay part of its bank loans, although it may be feasible at that time to re-negotiate new loans. D‟s gearing at the end of 2011 was relatively low at 20.3%, but this was still higher than the 10.9% figure for Barratt Developments plc. for example, and as a result loan finance is available, to acquire the fitting company, with a loan of £200.0 million at 8% interest.


Taking this course of action the results can be reforecast as follows: Profit forecast with acquisition of land and fitting company using loan finance




Cost of product quality 2 (57.0)


Extra cost of loan finance (16.0) (16.0)


Less tax at 28% (48.2) (29.6) (52.7)



Notes: 1. From appendix 4 of the unseen case study 2. From appendix 5 attached 3. From appendix 5 attached 4. From appendix 4 of the unseen case study

Cash flow forecast with acquisition of land and fitting company, using loan finance


£m £m £m

Current forecast opening cash balance 1 112.8 261.7 171.9



Investment required (Company & Land) (352.0)

Loan finance to buy company 200.0

Less tax paid 4 (27.9) (48.2) (29.6)

Revised closing cash balances 261.7 171.9 335.2


Notes: 1. From appendix 4 of the unseen case study (opening 2012 cash balance) 2. From appendix 5 attached 3. From appendix 4 of the unseen case study 4. From appendix 5 attached 5. From appendix 4 of the unseen case study

4.3 Product quality in the Central Region. The drive for improved cost performance whilst necessary, since D was lagging behind some of its major competitors, appears to have been badly handled. Whilst gross margins have significantly improved to 22%, this has been at the expense of poor quality in the Central Region. This has had a dramatic effect on future orders, possibly a 45% reduction, and requires significant rectification costs in 2012 for houses built and planned to be built in the final quarter of the year. The impact of this poor quality work in the Central Region is forecast to cost £57 million for rectification work in 2012. It is apparent from customer reaction that poor quality has a relatively rapid and detrimental effect on the product and image of the Company. Radical action is required to correct this situation.


The impact of cancellations is forecast to cost the company £86.3 million in a full year unless action is taken to improve matters – all supporting calculations can be found in appendix 5 to this report. The Finance Director is considering the option of purchasing a fitting company for £200 million. This can be evaluated using Johnson, Scholes and Whittington‟s SAF framework of analysis.

This would be a suitable option for D since it would quickly resolve the situation leading to no drop in forecasted sales volumes and margins for 2013 and 2014, and mitigate rectification costs.

This course of action would be acceptable to all stakeholders, in that it should provide a relatively quick solution and restore the Company image and profitability. In terms of feasibility a payment of £200 million would stretch D‟s finances to a significant extent. The closing cash balance for 2012 was originally forecast to be £318.7 million (from appendix 4 of the un-seen case study), but this is now forecast to be lower at £261.7 million because of the current problems with quality. An investment of £200 million at the beginning of 2013 to buy the fitting company would leave D with £61.7 million in cash going into 2013, but see further discussions on the cash position and analysis above.

In conjunction with the company takeover there is a need to monitor quality of work; this action needs to be taken in conjunction with a policy of continuous improvement.

It is apparent that the (former) owner of the business has these principles as part of his business philosophy and should possibly be encouraged to maintain his involvement for as long as possible, to ensure a smooth transition and improvement in quality.

4.4 The loss of short-term land in the Eastern Region This problem has occurred in the Eastern Region in which planned annual sales are 1,900 units. D is faced with a situation of having no sales in the region during 2013 and 2014 through no fault of its own.

The financial impact for the year 2013 and 2014 is forecast to be a loss of profit of £104.5 million in each year, the supporting numbers can be found in appendix 5 of this report.

D has the option of paying a premium of £10,000 per plot in order to make land available for sales starting again in 2014 in the Eastern Region.

At an annual extra cost of £19.0 million (i.e.1,900 plots x £10,000 per plot) this clearly would be a cost effective investment for D to undertake in profit terms.

However D needs to also consider that it would need to fund 3,800 plots at £40,000 per unit i.e. a cash outflow of £152.0 million in order to restore sales in the Eastern Region in 2014 and 2015.

The acquisition of replacement land, total investment £152.0 million albeit at a premium, will bridge the gap in the build programme and enable a presence to be maintained in the Eastern Region, although the risks of further contamination, and situational issues need to be considered.

In the longer term careful consideration should be given to spreading the risk of land bank purchases in term of geographically diversifying the potential build sites with a view to alleviating the effects of such development problems in the future. Due regard should also be given to the state of the economy and affordability for different types of houses in different areas.


4.5 Management of change in D The issue of change management is of fundamental importance for D‟s long-term survival. The factors restraining change are deep seated and long standing and will take some time to overcome. That said, the drivers for change are strong and growing and in addressing the problem of how to manage change we also need to pay attention to how D might respond to these drivers so as to move the business in the right direction in future. The framework recommended by K Lewin for analysing the driving forces and restraining forces of organisational change can be illustrated by a diagram such as that in appendix 4. As indicated in appendix 4 the drivers of change in D can be divided into two: external drivers and internal drivers. The main external drivers are the state of the UK economy, the scarcity of mortgage availability, competitor strategies, changing customer priorities, technical innovation in the form of MMC, the government‟s zero carbon target and rising energy costs .To some extent, these drivers reinforce each other so for instance the government policy to re-establish the banks on a firm footing constrains mortgage lending, This limitation on mortgages means that house builders are obliged to alter their product mix to build houses for the relatively older affluent buyers who are better able to afford to buy than young people seeking to gain entry on to the property ladder. Similarly, the government‟s zero carbon agenda has encouraged the progressive house builders to make use of MMC as these enable them to build more environmentally friendly houses as demanded by the government‟s drive for sustainability. Likewise the rising cost of energy influences customer priorities and encourages house buyers to consider the purchase of „Green Houses‟ which seek to attain the zero carbon targets. Internal drivers include the changes in D‟s strategies and objectives as the senior management team seeks to put D back on a sound financial and profitable footing following the failure to contain costs and the loss of short term land. These difficulties together with the failure to declare a dividend have resulted in a replacement of the CEO with a brief to turn D around. The external restraining forces include the preference of UK customers for the traditional type of brick or stone built houses and their suspicion of MMC. The other constraint is the culture of conservatism that prevails in the UK Building industry. The main internal restraining factors are the complacent attitudes of staff, especially towards innovation and the poor organisational structure and culture. The internal restraining forces on change are largely a product of D‟s past history. These include the haphazard development of D‟s organisational structure and systems and the complacent assumption that the problems experienced by D are largely the result of the current recession and that once it is over D Company can return to „business as usual‟. Currently the organisation structure interferes with rather than aids communication because the regional divisions have developed a degree of autonomy and when called upon to work together at the boundary of their territory show a tendency for rivalry and conflict rather than cooperation as required. In addition it seems that functional specialisation in which the focus of staff attention is on matters within the functional silos is also limiting communication across functions. This means that rather than aiding efficiency and effectiveness and providing a vehicle for assisting change, it is instead acting as a barrier to change. For instance the fact that each of the divisions operates in a semi-autonomous manner means that any ideas for efficiency savings and greater effectiveness in operations are not shared because of the lack of communication between divisions and the functions operating within them. The culture of D more generally displays aspects of a role culture in which functional specialists have grown used to conducting their activities according to set procedures and with relatively little readiness to work cooperatively with staff from other functions and divisions. Associated with this culture there is also evidence of what has been called elsewhere, a „blame culture‟ in which the


problems of D are attributed to external factors and agencies such as the economic downturn and government legislation. Such attitudes are evidently not those which will best serve either process or product innovation in D Company. The required investment in D systems and procedures at a time of limited resources may also act as a potential brake on the ability of the Company to make substantial internal changes to its mode of operation. Significant funds will be required for instance to upgrade the IT system to enable divisions to share data and information more effectively than at present. Perhaps the most important restraining force however, is the current shared belief amongst a number of D‟s senior managers that any substantial change is unnecessary. The rationale for this seems to be that D‟s current difficulties are wholly due to the prevailing economic recession and that the Company will return to a normal level of sales and profitability when the recession is over. The existence of such beliefs and attitudes amongst senior staff is particularly damaging since they set the example for other staff at lower levels of the organisation. The attitude of complacency and lack of attention to innovation has already been noted by the recently appointed CEO and thus an important step in resolving these issues has taken place. It is evident that given the deep rooted nature of these attitudes that change will need to be driven from the top down. Some ideas for how these attitudinal changes might be achieved are suggested in the recommendations below. 4.6. Other Business Issues Apart from the above four main business issues, D is also facing two other specific issues that have both a business as well as an ethical aspect to them. The ethical aspects are discussed separately in section 5 below. The business aspect of each issue is briefly discussed as follows: 4.6.1 On-site safety wear D is incurring extra costs in hiring substitute labour and the insurance company dealing with injury claims appears to be getting concerned. A local newspaper has also recently run a story on the issue. From a purely business point of view D cannot allow this situation to continue. It is incurring additional labour costs now, and could be faced with higher insurance premiums in the future. Just as important however, is that D risks damaging its reputation in the industry of having an above average safety record. Whilst the additional labour costs and higher insurance premiums may be considered a minor issue in the wider scheme of things, the risk of damage to D‟s reputation could result in significant financial consequences.

The recommendations on this issue are included in the ethics section in 5.

4.6.2 Expense claims The expenses problem with employee EE indicates a potential weakness in D‟s policies regarding entertainment practices and approval of expense claims. D needs to ensure that it has a documented policy on gifts and entertainment and that this is clearly communicated to those employees who have responsibility for the Company‟s affairs. So has employee EE been following company practices? Regarding EE‟s expense claims they would seem to indicate rather extravagant entertainment and that the receipt details are not in line with Company requirements. Yet these expense claims have been approved. The financial impact of these expense claims is unlikely to be of major consequence but nevertheless is an issue that needs to be addressed. The more important issue in this context is the ethical issue. The recommendations on this issue are included in the ethics section in 5


5.0 Ethical issues and recommendations on ethical issues 5.1 On-site safety wear The reason why this is considered to be an ethical, as well as a business issue, is that D cannot be seen to be putting cost cutting measures above the safety and welfare of its workforce, whether they are self-employed or not. As D is providing the safety gloves and knee pads it must ensure that they are fit for the purpose; D has a duty of care to its workforce to act in a responsible manner. D would appear to have three options – either continue to use the same supplier but replace the safety wear more often, to go back to the original supplier, or to seek an alternative source of supply. Recommendations It is recommended that D uses its original supplier for the next orders, but in the medium term tries to find a more competitive price for the same quality of materials. The Central Region should certainly benchmark itself with the other two regions for these products. Current stocks of the cheaper materials can be used up, but local site management must ensure that the workforce changes them more promptly to avoid injuries. It is also recommended that D notifies the local newspaper of the action that it has taken. The rationale for these recommendations is three-fold i.e. in ensuring the welfare of the workforce, trying to reduce its cost base, and to protect its safety reputation in the industry. 5.2 Expense claims The reason why this has an ethical aspect is that as a responsible company, D cannot be seen to be obtaining favourable treatment over its competitors through what may be perceived as excessive entertainment, rather than simply using sound business practices. Even further, employee EE‟s practices have been implicitly condoned by his promotion. Company D could be accused of putting profitability over business ethics by such action. Managers and professionals are expected to observe the highest standards of conduct, and to comply with some fundamental ethical principles and in particular those of integrity (i.e. being honest in business relationships), and also of professional behaviour. Recommendations It is recommended therefore that Company D reviews its policies on both entertainment and on the submission and approval of expense claims, and that these are clearly communicated to all relevant employees in the Company. The rationale is that no employee should be put under pressure to win business for the company through practices that might be construed by an outsider to be dishonest.


6.0 Recommendations

6.1 Cash and profitability 6.1.1 Recommendation Although D is forecast to be profitable over the coming years, there is forecast to be a significant drop in profits over 2012 and 2013 from what was originally planned, as discussed in section 4.2 of this report. This is largely due to the short-term land issue in the Eastern Region, which was no fault of the Company, and poor product quality in the Central Region, which should have been controlled by the Company.

Trading conditions will continue to be tough in the near future because of recession and job uncertainty in the UK, therefore D needs to have tight control over its finances.

It is possible for profitable companies to go out of business if they run out of cash (i.e. technical insolvency) and regular monitoring of cash flows is essential, particularly up to 2015. It is noted that a bank loan of £250 million is due to be repaid in 2015.

All is not “doom and gloom” however. D has appointed a new CEO, and the UK stock market‟s view of house builders is currently positive. Companies such as Bellway and Persimmon are currently not that far off their highest share price of the last 12 months and Bovis Homes has a “buy” view by the Daily Telegraph finance expert.

Accordingly it is recommended that the following actions are put in place:

The Company provides the main Board of Directors with regular cash flow forecasts.

No dividends are paid in both 2012 and 2013, but may be considered for 2014.

The dividend recommendation is discussed with and agreed by major shareholders and in particular the institutional investors, in advance.

That the Company‟s bankers are kept fully informed of D‟s future plans with a view to possibly negotiating a new loan in 2015.

It is vital that sufficient administrative resource and systems are available to produce regular cash and profit forecasts, with the ability to incorporate changing internal and external factors so that the cash requirements of the business can be accurately gauged. This process should involve constantly scanning the horizon being aware of potential threats, as well as opportunities. The rationale for these actions is that D needs the support both of its shareholders and bankers (key stakeholders in Mendelow‟s framework) if it is to survive the next two years in particular. 6.1.2 Justification Cash is king. Potential cash problems such as overtrading, and events which cause forecasts to deviate can alter forecasts rapidly and by large margins. Changes in profit forecasts affect not just the Company but stakeholders, even in difficult circumstances confidence can be maintained if it is apparent that there is good management situational awareness. The Company is entering a turbulent period during which access to and effective management of cash is vital. 6.1.3 Actions to be taken Generally, systems to be put in place to enable information gathering and analysis, resulting in accurate and regular cash and profit forecasting, with cash being monitored and forecast on a daily basis. Regular modelling of „what if‟ scenarios, implications for cash and profit extrapolated. These reports to be available for day to day operational management and also Board meetings; it is essential that these are discussed and communicated appropriately.


This information should also to be available to relevant stakeholders to assist in maintaining and improving investor and banking relationships.

6.2 Product quality

6.2.1 Recommendation

It is important that D embarks on a damage limitation exercise as a matter of urgency. Complaints have already been aired on a prominent television programme, and D needs to move quickly in order to protect its reputation in these tough market conditions. D should consider issuing a response to the television programme, explaining what has happened and what the Company is proposing to do to resolve the problem. Obviously D needs to also instigate a thorough review of what has gone wrong e.g. is it a problem of lack of supervision, or is it really through the use of inferior materials? Is this potentially a problem in the other two regions, or is it just a problem with the Central Region? Lessons can be learned from other regions perhaps. Quick answers are needed here.

This situation needs correcting as fast as possible; it is unacceptable for the image of the Company, which is adversely affecting customer perceptions and therefore the performance of the Company. It is also having a serious impact on company performance. As discussed previously the company is suffering from poor quality control, but this only appears to be affecting the Central Region at present. The drive for improved cost performance appears to have been badly handled in this region resulting in a dramatic reduction in future orders and the need for significant rectification costs. The Finance Director is considering buying a fitting company for £200.0 million. Purchasing the Company for £200.0 million (this figure may be negotiable) would be the best course of action in that sales are planned to return to normal in 2013. Other options such as Company reorganisation and change would take longer and incur cancellation costs in 2013, together with potentially on-going adverse publicity for the Company.

6.2.2 Justification The loss of orders is adversely affecting the immediate and future profitability and cash position of the business, this is unacceptable to the Board and stakeholders. Whilst additional funding will need to be negotiated the purchase of the fitting business offers the fastest and most expedient solution to the problem. The owner and business are already known to D, and whilst the initial overall cost is £200.0 million this may be more than offset by the potential organisational problems and unknowns of establishing an „in house‟ facility. 6.2.3 Actions to be taken

Funds must be made available to purchase the fitting business and integrate this into the Company as soon as possible.

Systems must be put in place to monitor product quality to ensure no repeat of this situation.

D should, as a damage limitation exercise, issue a response as a matter of urgency to the television programme, explaining what has happened and what the Company is proposing to do to resolve the problem.


D should instigate a thorough review of what has gone wrong in the Central Region to determine whether the problem is one of the use of inferior materials or really a problem of poor supervision.

An urgent review of the other two regions is also essential to determine whether the cost cutting initiatives are causing quality problems, and if not, what lessons can be learned for the Central Region.

Awareness that the complacent attitudes of staff, the poor organisational structure and culture are key in understanding the requirement to develop an effective change management philosophy to establish and maintain quality standards.

6.3 Loss of land

6.3.1 Recommendation

As discussed in section 4.4 D is faced with the prospect of having no sales in the Eastern Region during 2013 and 2014 and beyond through no fault of its own. It is recommended that replacement land is acquired at a premium of £10,000 per plot to substitute for that temporarily unavailable, and facilitate a return to anticipated sales volumes in 2014, and 2015.

6.3.2 Justification The lack of a sales presence in the Eastern region for 2 years is not acceptable, competitors will step in, and it may to be difficult to re-establish the business in the area. As the highest value sales and margins the financial effect of the loss is also unacceptable. The additional cost of £19.0 million is significantly lower than the annual loss of £104.5 million gross margin that would otherwise occur. 6.3.3 Actions to be taken

Ensure funding available to purchase land, £152.0 million.

Negotiate purchase price, if possible, although this may be difficult given land is sold at a premium and is potentially in short supply in the region.

Sufficient due care must be exercised to ensure that there are no problems with the proposed purchase, in terms of location and saleability.

A suitable promotional campaign needs to be instigated, emphasising business as usual.

It may be worth D reviewing its insurance policies, particularly for contingencies for business interruption events such as has happened in the Eastern Region. Perhaps some of the forecasted losses can be mitigated by a claim on D‟s insurers, although this is unlikely to be an insurable event for consequential loss.

6.4 Management of Change

6.4.1Recommendations

Managing the external drivers of change The response to external drivers such as the government‟s zero carbon targets; restricted mortgage availability, competitor strategies, technical innovation and rising energy prices are strategic issues that are the province of the CEO and the senior management team. It is of interest to note however, that D‟s major competitors have taken the following steps with apparent success.


Changed their product mix away from flats and small starter homes to the building of larger more expensive family houses.

Adopted MMC especially where this is consistent with producing „Green Homes‟ and is cost effective in construction.

Set up specialist research and development units to assist in the development and evaluation of MMC and to hasten the product development of „Green Homes‟.

Used their design teams to produce houses that combine energy saving features with traditional house designs.

Tailored their sales and marketing effort to help further the acceptability of prefabrication and factory produced modules and pods to help reduce construction costs on site.

All the above measures might be considered in D‟s response to the external drivers of change. Tackling the restraining forces within D Although there is a wide range of views amongst specialists as to how organisational change should be managed there is an emerging consensus that the approach adopted should take account of two major facets, first the substance of change being considered and secondly its context. In the case of D it is evident from the above analysis that the changes required are varied and extensive and that the context is a difficult one of increasing competition in a time of economic recession. Some changes leave little room for manoeuvre and often have to be executed in a dictatorial manner to prevent serious damage to the organisation. Cash flow problems fall into this category. Failure to stem the leakage of cash by curtailing some activities of a business can lead to its demise and unplanned changes will often be necessary and painful. Other organisational problems such as those to do with difficulties in communication between divisions and between functions are long standing and increasingly evident. They are detrimental to the efficient running of the business but are not of such a nature as to call for immediate action: they can be planned for and tackled as time and resources allow. 6.4.2 Justification It will be apparent that unless D responds appropriately by adapting its strategy to manage the drivers of change it will find it increasingly difficult to compete and will suffer further loss of market share. The price of failing to address the internal restraints to change will be that of continuing to operate with a higher than necessary cost base and with a workforce that continues to work with outdated building materials and techniques to the detriment of its product sales. Changes Required In terms of what needs to be changed, a provisional list to be considered by the working group might include the following.

(Items may be added or deleted from the list during a more considered evaluation.)

The complacent attitude among many of D‟s staff which assumes that its problems are due to external events and/or external agencies and will disappear once the economy picks up needs to be challenged. People need to be persuaded that improved performance is possible in the organisation by new patterns of working and that D‟s work-force has the skills and abilities to match the best in the industry through a programme of structured training.

Improvements in D‟s performance also depends on changing the role culture in which the efforts of staff are often limited to tasks laid out in their job description and to the requirements of the departments and divisions in which they operate. A move to a more task orientated culture is required in which employees are encouraged to cooperate more actively with employees in other functions and divisions to get the job done.

Attitude to innovation: there is a need for staff in D to adopt a more entrepreneurial stance toward all aspects of the house-building operation. In particular there is a need to consider


MMC, to re-examine its sources of supply to ensure not only that the price is right but that the quality of materials supplied is right and timely.

To respond to the governments zero carbon agenda: here again there is a need for a shift in attitude from one in which change is forced upon the Company through legislation to one which looks for the opportunities that the environmentally friendly house can offer to those firms that embrace the concept .

Climate change: pressure has been building in recent years for house building to be restricted in low lying areas subject to flooding and to various parts of the south east where low rainfall sets limits on the ability of the utility companies to provide adequate water supply and sewage facilities for high density housing. D Company needs to be more proactive in seeking out sites that others have not thought worthwhile.

6.4.3 Actions to be taken Techniques for managing change A number of lists and recipes have been formulated and recommended for the purpose of facilitating change but one of the more respected is that devised by John Kotter and Leo Schlesinger. They recommend six techniques for the management of change. These are education and commitment, participation and involvement, facilitation and support, negotiation and agreement, manipulation and co-optation and implicit and explicit coercion The virtue of this range of options for the management of change is that it provides a set of tools from which one can choose to tackle change problems in a variety of contexts and at a number of levels. Implementation of change in D In the D context, there will be some issues such as the out of date IT system on which a broad consensus may already exist. In this case, there may be little need to persuade staff of the need for change other than that of making clear the problems of information and data sharing between divisions and functions and setting out the advantages of a more integrated system that overcomes present problems. Some difficulties may well surface at the actual implementation stage from end users of the new system and at this point education in the form of training in the use of the new system, involving employees at all levels in the use of the new software and facilitation and support through help desks and dedicated staff to iron out any problems in usage will also be necessary. By contrast deep seated beliefs and attitudes held by some individuals may be almost impossible to change by participatory methods and so it may well be necessary to adopt more coercive methods of persuasion. The complacent view held by many that everything will be alright when the recession is over needs to be changed and a sense of urgency generated for action to commence on improving the efficiency and effectiveness of the organisation. In this situation a combination of change strategies and techniques may well be necessary ranging from education at one end of the spectrum to coercion at the other. Whatever the ultimate combination of techniques it is essential to begin with education and commitment. This can take the form of a series of briefings in which the new CEO begins by setting out his vision for the future of D and the changes this will entail in the immediate and more distant future. In this it will be essential to stress the challenges facing D and the necessary changes that must take place in the Company if it is to survive into the future. It will be useful for these briefings to begin with the CEO and senior managers and then for the CEO to tour the divisions repeating the same message but perhaps with local content for each division. From that point on, the senior managers can be involved in more detailed briefings of the changes that will need to take place in their specific division and/or functional department.


The human resources department will probably need to play a significant role in the change programme, especially in training and development and in the advice it offers for the setting of new objectives for managers and other staff in the organisation‟s appraisal system. Any employee who is particularly unhappy with aspects of the change programme should be encouraged to discuss their reservations with their immediate superior and in the event that they feel unable to commit themselves to the programme of change can be offered early retirement or appropriate redundancy terms depending on their age and contractual obligations. Again the HR department will be expected to play a key role in counselling, advising employees, arranging for redundancy and recruiting new personnel who have both the skills and appropriate attitudes to work in a more dynamic and entrepreneurial D. The changing of the role culture in D may be particularly difficult to achieve. It has developed over a period of many years and its continuing existence probably owes much to the fact that it allows employees to continue within their comfort zone. Continuing to work to set procedures requires less effort than that of continually searching for more efficient ways of carrying out the job and having to liaise with and respond to specialists in other functions and divisions. There may be a case here for‟ change champions‟ i.e. giving responsibility to able individuals in each function to act as exemplars by adopting a proactive task orientated approach in their particular function. The criteria for receipt of bonus payments and consideration for promotion could also be made dependent on the adoption of a more entrepreneurial stance in one‟s job. Specific changes such as those to do with the adoption of MMC‟s, seeking to capitalise on the opportunities presented by the government‟s zero carbon agenda, ensuring that D„s land bank has sufficient capacity if the concerns of environmentalists puts some existing sites beyond use, designing and implementing a new IT system, seeking out new suppliers who offer the best combination of price quality and on-time delivery probably require working groups of specialists headed up by a senior manager to conduct an evaluation and come up with cost estimates for carrying out these changes. Given limited resources the implementation of such changes will need to be prioritised by the Board prior to implementation. 7.0 Conclusions The Company is facing an extremely challenging period, not only has the general level of economic activity affected the trading position, although this had been planned for, the consequences of its reaction to this have resulted in an unsuccessful cost cutting exercise in one of its regions, and potentially all of the Company. This requires decisive action to understand and resolve as soon as possible, to protect the company image and restore the operating results. The unfortunate quarantining of a large portion of the short term land also needs to be resolved by procuring replacement land as soon as possible. This will enable the Company to maintain a commercial presence in the affected area and restore its operating profits and cash flows. The Company needs to maintain effective relationships with its bankers and institutional shareholders. Expected outcomes and forecasts can change quickly. Their support in raising the additional finance required to facilitate revised plans and cooperation with regard to dividend policy are essential. Changes in the operating procedures and systems need to reflect the rapidly changing environment the Company finds itself in. Operational awareness in all aspects of the business needs constant attention to highlight potential problems and the availability of technical systems with suitably qualified personnel to monitor, recommend and propose suitable plans and strategies, needs to be maintained and further developed.


Appendix: 1 PEST ANALYSIS OF UK BUILDING INDUSTRY

Political

Economic policy: debt reduction &

economic growth

Deregulation: Reform of planning

system to favour business

development and release land for

house building

Sustainable development agenda

Including zero carbon target

Economic

Low economic growth

Investment and mortgage finance

constrained

Housing market depressed

High unemployment especially

amongst young

Rising energy prices

Global economy weak

Social

Falling living standards

Older generation relatively well off

Younger people hard pressed

Home ownership demand still

strong

Environmental concerns

Technological

Developments in MMC

Prototype carbon zero homes


Appendix: 2 FIVE FORCES ANALYSIS OF UK BUILDING INDUSTRY

Threat of new Entrants

Low due to increasing

consolidation and high

capital intensity

Bargaining power

of suppliers

Low due to large

number of small

firms

Competitive rivalry

Fierce between

large national firms

Bargaining power of

buyers

Low because

customers tend to be

single households

Threat of substitutes

Relatively low in form of

various temporary homes

Porter’s Five Forces analysis of UK House Building Industry


Appendix: 3 SWOT ANALYSIS OF D PLC

Strengths

Reputation

Experience; building techniques

Countrywide coverage

Local market Knowledge

Weaknesses

Higher than necessary cost base (leading to cost cutting and subsequent product quality

issue, cash & profitability issues)

Culture of complacency (leading to management of change issue)

Lack of adherence to CSR (leading to ethical issues of lack of due care and excessive

expenses)

Fragmented structure: lack of coordination

Inefficiencies in procurement

Staff resistance to change

Opportunities

Benefits from reform of planning system

Expansion into overseas market

Zero carbon product development

Cost reductions via rationalisation of structure

Productivity improvement through shift to entrepreneurial culture

Threats

Loss of short-term land in Eastern Region (leading to cash flow and profitability

issues)

Difficult economic climate

Market decline even further

Fierce competition

Possible takeover bid, before recovery

Current operational problems


Appendix: 4 FORCE FIELD ANALYSIS D PLC


Appendix 5: SUPPORTING CALCULATIONS

Product Quality and Short term Land Initially the quality problem requires provision for rectification costs of sales in the Central Region for 2012. The Central Region accounts for 9500 X 60% = 5,700 completions X £10,000 rectification costs per house will reduce the 2012 gross margin by £57.0 million. This results in a gross profit of £298.3 million (original forecast £355.3 million) and works through to a profit after tax of £123.9 million for 2012. The cash effect is also a reduction of £57.0 million in forecast cash flows. The effect of 45% order cancellations in the Central Region for 2013 and 2014 will reduce the overall volumes in each year by 9500 X 60% = 5700 X 45% = 2565 completions. This results in a sales loss of 2565 X £153,000 = £392.4 million, and a margin loss of £392.4 million X 22% = £86.3 million. The loss of land from the Eastern Region will result in the loss of sales volume 1900 X the sales value of £250,000 = £475.0 million and margin loss of £475.0 million X 22% = £104.5 million. Summarised 2012 2013 2014 £ million £ million £ million Quality problem Sales loss (392.4) (392.4) Land problem Sales loss (475.0) (475.0) (867.4) (867.4) Quality problem Gross margin loss (57.0) (86.3) (86.3) Land problem Gross margin loss (104.5) (104.5) (57.0) (190.8) (190.8) Forecast profit before tax 229.1 226.2 223.2 Revised profit before tax 172.1 35.4 32.4 Tax 48.2 9.9 9.1 Profit after tax 123.9 25.5 23.3 Cash effect 2012 2013 2014 Loss of margin (57.0) (190.8) (190.8) Change in tax payable - 15.9 53.4 Cash flow change (57.0) (174.9) (137.4) Cumulative cash flow change (57.0) (231.9) (369.3) Original forecast closing bal. 318.7 485.5 650.1 Revised forecast closing bal. 261.7 253.6 280.8 Note: The tax payable will reduce in subsequent years as a result of lower taxable profit.


Recovery situation Given the Board criteria the options can be depicted as follows: The quickest recovery in results is if the business and land are bought at the same time, this will involve an investment of £352.0 million, £200.0 million for the fitting company and £152.0 million for the land purchase. If these strategies are successfully put in place the results should be as follows: Summarised 2013 2014 £ million £ million Gross margin gain 86.3 171.8 (86.3 + 85.5) 86.3 171.8 Forecast profit before tax 35.4 32.4 Revised profit before tax 121.7 204.2 Revised tax payable (34.1) (57.2) Revised profit after tax 87.6 147.0 Note: The profit improvement for land purchase is margin recovered £104.5 million less the premium cost per plot 1,900 plots x £10,000 per annum £19.0 million £85.5 million Cash effect Margin increase 86.3 171.8 Cash investment (352.0) - Change in tax payable - (24.2) (34.1-9.9 or 86.3 x 28%) Change in year (265.7) 147.6 Cumulative change (265.7) (118.1) Closing balance no investment 253.6 280.8 Revised closing balance (12.1) 162.7 There are clearly cash implications in the short term for a strategy of rapid profit improvement Cash balance is negative £12.1 million (revised forecast £253.6 million i.e. 485.5-57.0(2012)-174.8(2013) less £265.7 million) at the end of 2013, before recovering to end 2014, at £162.7 million positive. With the loan repayment of £250.0 million in 2015 extra cash will be required. It is unlikely that a share issue is a good idea given the economic background, likely success in the time available and costs associated with this. This may also introduce ownership uncertainty, and potential takeover issues. The long term relationship with the Company bankers, and the nature of the borrowing, that is against the collateral of business assets and land and the relatively low gearing of the company should mean finance will be available. Whilst this will incur extra interest costs, the relatively rapid performance recovery will inspire confidence and the results will ensure more than adequate interest cover.


Taking a £200.0 million loan to finance the acquisition of the fitting company will change the results as

follows:

Summarised 2013 2014 £ million £ million Gross margin gain 86.3 171.8 (86.3 + 85.5) 86.3 171.8 Less loan interest 16.0 16.0 70.3 155.8 Forecast profit before tax no investment 35.4 32.4 Revised profit before tax 105.7 188.2 Revised tax payable (29.6) (52.7) Revised profit after tax 76.1 135.5 Note: The profit improvement for land purchase is margin recovered £104.5 million less the premium cost per plot 1,900 plots x £10,000 per annum £19.0 million £85.5 million Cash effect Profit increase 70.3 155.8 Cash investment (352.0) - Loan 200.0 - Change in tax payable - (19.7) (29.6-9.9 or 70.3 x 28%) Change in year (81.7) 136.1 Cumulative change (81.7) 54.4 Closing balance no investment 253.6 280.8 Revised closing balance 171.9 335.2


Appendix 6: Question 1 part (b): Presentation

Future cash flow concerns

As a general statement of principle, cash flows can be more important than profitability, since even companies who appear to be profitable can go out of business unless they are properly funded. Short-term profitability is not as good a measure as cash flow generation since the current year‟s profits require judgement in a number of areas, and in particular for house builders relate to land valuation, provisions and contingencies. Cash flows can deteriorate quickly in the short term through poor management of working capital, and over-investment in non-current assets. To ensure stable cash flows all businesses need to focus on four key strategies i.e. increased profitability, effective balance sheet management, good relationship with the Company‟s bankers and the support of the main shareholders. Turning now to D Company we are forecasting a significant deterioration in the cash balances. This is particularly noticeable for 2012 and 2013. Our year end cash balances were originally planned to be £318.7 million end 2012; growing to £485.5 million end 2013 and £650.1 million end 2014. The latest forecasts however are for a cash balance of £261.7 million at the end of 2012, but then decreasing to £253.6 million by the end of 2013. Although this is then forecast to increase to £280.8 million by the end of 2014, the Company needs to consider that a bank loan of £250.0 million is due for repayment in 2015. The reasons for this significant deterioration in planned cash flows are twofold: (1) The product quality issue in the Central Region, and (2) The loss of short-term land in the Eastern Region.

To rectify these will require £352.0 million of investment and result in a £12.1 million negative cash position by the end of 2013, increased borrowing will be required, the detailed impact of these two issues can be found within the main report.

……… end of answer ……..

T4- Part B Case Study D plc. House-Building case ... docs/2010 syllabus docs/T4/… · D plc....

Documents

Transcript of T4- Part B Case Study D plc. House-Building case ... docs/2010 syllabus docs/T4/… · D plc....