Case study november 2010 illustrative script 2 ICAEW

This candidate achieved a clear majority of the competent grades in Requirement 2 review of Australian project, and a bare majority in Requirement 1 financial statement analysis, but ac

SECOND ILLUSTRATIVE SCRIPT AND EXAMINERS’ COMMENTS

In the commentary below, extracts from the scripts are shown in italics; spelling, grammar, sentence construction and punctuation from the original script have been retained The commentary follows the order and numbering of the script with references to the topics in the marking key It should be read in conjunction with the review of the First Illustrative Script and also the full Examiners’ Report for this session

Examiners’ comments – overview

This script failed the exam It was an average length script (but as always this depends on the actual handwriting) which contained two competent sections, with evidence of poor time management In terms of professional skills this candidate achieved overall competent grades – Clearly Competent

(CC) and Sufficiently Competent (SC) – in 4 out of 7 grade boxes for Assimilating and Using

Information; in 7 out of 14 boxes for Structuring Problems and Solutions; 4 out of 11 boxes for

Applying Judgement and 7 out of 10 boxes for Conclusions and Recommendations

The original 24 -page length of the manuscript version may be broken down as follows

 Cover and contents – 1 page

 Terms of reference – 1 page

 Executive summary – 3 pages

 Report (main body) – 13 pages

 Appendices/workings – 6 pages

The 13 pages of the main body of the report address the key issues but with varying degrees of thoroughness The appendices, which are included at the end of each section, are not always easy to distinguish from the body of the report This candidate achieved a clear majority of the competent grades in Requirement 2 (review of Australian project), and a bare majority in Requirement 1

(financial statement analysis), but achieved insufficient competent grades in Requirement 3 (strategic review) and none for Executive Summary

Terms of reference and executive summary

The report starts with a short terms of reference and disclaimer section, which acts as the introduction

to the report

In the introductory section to the executive summary there is an example of the quality of the

numerical analysis to follow “the 2010 draft accounts show a decline in total revenue by 34.3% due to

the exhaustion of the AEPS database, with only 18,873 installations remaining at the end of 2009”

For the decline mentioned, the candidate provides no absolute figure as a reference point for the analysis The candidate then goes on to provide an absolute, and falsely precise, figure for the

installations which might remain to be completed, which is based on a broad estimate from the

Advance Information It would have been better to describe the remaining element of that installation project in comparative terms, of time or life – the reader has no way of knowing how much work 18,873 installations might represent

Overall the 3 pages of the executive summary are thin and very patchy, being split unevenly between the three main topics The summary of the financial analysis of EEE’s management accounts contains only percentage analysis of the financial information with no absolute figure against which to evaluate that analysis No mention is made of the cash flow statement analysis This section is thin on detail

In the section dealing with the proposal to expand into Australia, the executive summary includes only very brief profit calculations for the project with the proposed call success rate of 1:3, and the creation

of a loss if there is a reduction in the success rate to 1:5 A mention is made of reviewing the

assumptions but with no details given There is little of value on the opportunities and threats for this project

In the strategic review of the solar panel business activity section, the candidate presents a superficial summary of the economic benefits and risks with no real identification of the ethical issues or possible solutions

Overall the executive summary was poor and did not cover any of the areas sufficiently There was obvious evidence of time pressure caused by poor time management and there was insufficient

competence demonstrated on the use of numbers

To score better grades on this section, the candidate should have:

 Provided more data regarding the financial analysis of EEE’s business and the Australian project

 Provided more discussion of EEE’s financial performance,

 Provided a critical review of the assumptions for the project in Australia

 Provided a more detailed summary of the economic benefits and risks for this project

 Identified and considered the ethical issues surrounding the solar panel industry

 Developed conclusions from the above, and made key recommendations

Review of EEE’s 2010 financial performance [Requirement 1]

The financial statement analysis in this section is accompanied by an appendix (see detailed

commentary below) which provides the numerical analysis to underpin the answer to this requirement The review starts with a section on the business context that makes a number of points which are not very well linked The analysis identifies the overall decline in revenue in absolute and percentage terms and then moves into the detail of the business activities The detailed analysis concentrates on the solar panel success and also covers revenue from stoves, but the commentary on commissions

and installation work is limited to “Commissions and insulation installation now compose 66.5% of the

sales mix as a combination, compared with 86.8% in 2009” which is not a particularly helpful

commentary on its own

For the gross profit analysis, there is a similar lack of detailed commentary: “As a result of the

changing sales mix, total gross margins are 33.6%, compared with 26.5% in the prior year” Although

this is correct, it does not spell out the reasons for, or impact of, this changing percentage, nor does it set this change in the context of a falling gross profit in absolute terms

The analysis of the operating profit margin starts well “The operating profit margin has remained at

8.9% underlying this however, are significant changes in overheads” but unfortunately the subsequent

analysis only covers two expenses: the reduction in marketing expenses with some incorrect analysis; and the increase in staff training costs which was dealt with very briefly

The analysis of the cash flow statement suffers by being a comparative exercise in places, with

percentage changes against 2009 being identified: “EBITDA has fallen 29% to £1.220k as a result of

the decline in sales activity” and “The net change in cash over the year however is up £549k (173%)

to £867k” In order to analyse the cash flow statement, which is already a comparative document, it is

necessary to explain what has happened during 2010 – this candidate has not really done this

The conclusions and recommendations, whilst not fully consistent with the analysis, are sufficiently competent

This is an adequate section of the report which demonstrates some competent financial statement analysis skills

To score better grades on Requirement 1, the candidate could have:

 Provided more discussion of revenue changes in total and by business activity

 Provided more discussion and judgement on the gross profit margins

 Provided more detailed analysis of the components of overheads

 Provided more analysis of the cash flow statement such as the inflow from operations and more analysis of all working capital changes

Proposal to expand into Australia [Requirement 2]

The financial data analysis in this section is accompanied by Appendix 2, which provides a 5-year profitability calculation based on a 1in 3 call success rate with a market for EEE of 100,000

households This is an appropriate numerical starting point from which to comment on the project proposal – although the candidate does question the 100,000 households versus a calculation of 75,000 households (based only in Melbourne) as being the appropriate market before using on

100,000 as the market size

The candidate uses good professional scepticism to comment on the assumptions such as “Assuming

the UK call centre will be used and hence applying a 90.5% margin or i.e 9.5% cost/revenue, may not provide an accurate analysis because staff may require a higher rate of pay due to the time difference between UK and Australia requiring staff to work at unconventional hours”

This candidate also draws attention to the fixed costs “A further breakdown of the incremental fixed

costs would allow for assessing the reasonableness of the AUS$400k per annum and £1,300k per annum” Unfortunately this candidate does not go on to consider the Australian project from a

“contribution” perspective which would have provided a more complete review

There is a good start to the sensitivity analysis concerning call success rates – “The key assumption

made is the 1 in 3 success rate This is unlikely to be achieved in early years and is overly optimistic Using a rate of 1 in 5 to be in line with EEE’s track in the UK, EEE will install insulation on 40,000 fewer homes (appendix 2)…” However this candidate then goes on to offer a somewhat bizarre

additional piece of commentary “…resulting in $146 contribution lost on each job.” which, although a

contribution analysis for this project would be important, is not the appropriate contribution

consideration to follow from the sensitivity analysis for this project

The analysis of, and commentary on, the opportunities and threats is rather weak The comment on the exchange rate risk covers only some of the necessary issues and is not fully developed by any critical analysis The commentary on exchange rate risks is rather general, and not very well

expressed; however a sensible point is made in that the exchange risk will be “mitigated through

matching”

There is very little judgement shown and although there are competent conclusions there are

insufficiently competent recommendations

To score higher marks on Requirement 2, the candidate could have:

 Evaluated more critically the opportunities and threats surrounding this project

 Provided better commercial recommendations

Strategy for increasing revenue from solar panels [Requirement 3]

The answer to this requirement started with a brief positive analysis of the business context for the development of the solar panel revenue stream

However the benefits and risks section of this requirement is rather brief – an indication perhaps of poor time management – but there is evidence of some good analysis although it is not always clearly expressed An example is when this candidate considers how the solar panel installation activity

might develop: “However, subcontractors are less reliable than in house staff, and any decision to

retrain engineers, to obtain micro generation scheme certification, should be weighed against the likelihood of staff to leave EEE, or the solar stream declining in the short to medium term”

The ethical section is extremely short, although it contains some relevant points

There are some competent conclusions and recommendations which improve the quality of this

section “Sourcing from various overseas suppliers often results in poor quality panels, which is

worsened by poor installation all of which upsets consumers when it coincides with mis-selling and exaggerating the benefits of solar”

To score better grades on Requirement 3, the candidate should have:

 Provided more analysis of the economic benefits and risks for EEE of the solar panel business

 Provided a more detailed analysis of the concerns identified by the directors, about which more information was contained in the news articles throughout the case

 Made better use of the articles in the Advance Information and the Exam Paper to assess critically the specific ethical issues for this business

Appendices

Appendix 1 relates to Requirement 1 and comprises 3 pages of numerical analysis The analysis

starts with revenues and contains a comparison of 2010v2009 and 2009v2008 (which was not

required) For the 2010v2009 column, the absolute changes for each of the revenue streams and total revenue has been calculated together with the percentage changes There is also a calculation on the sales mix for both 2010 and 2009 For the gross profit margin calculations have been made for each business activity, and overall, showing the absolute change between 2009 and 2010 and the gross profit percentage for both 2010 and 2009 The operating profit analysis includes a detail review

of changes in each element of the overheads between the years 2010 and 2009

There is a section which analyses the cash flow statement; however this is shown as a series of comparative calculations between the statement for 2010 and 2009 rather than an analysis of the

2010 cash flow statement This appendix contains some, but not all, of the necessary analysis

Appendix 2

This appendix relates to Requirement 2 – the Australian project – and starts with a calculation of the number of potential households as the market for EEE in Victoria which arrives at 75,000 as the potential market However the candidate corrects this figure to 100,000, being the number given in the table in the Exam Paper The calculation for the 5-year project profit is correct using a 1:3 call

success rate The sensitivity analysis is calculated using a 1:5 success rate which produces a loss

No sensitivity analysis is conducted on exchange rates

Apart from the weaknesses identified above, these appendices – although not entirely correct – demonstrate that the candidate knew what had to be done and provided the numerical evidence from which to write some of the analysis in the report

Overall paper

This was an answer which followed a logical format in answering the detailed requirements There were some lapses in style, the use of some jargon, and the use of the first name of a director in the report, so the structure and style was not sufficiently competent However the report attempted to answer all three requirements, but was weaker on Requirement 3 and not sufficiently competent on the executive summary As a result although there were some sufficiently competent sections, overall this candidate failed the exam

ILLUSTRATIVE SCRIPT

DRAFT REPORT

TO THE BOARD OF

EEE

From: GUNTER JENSEN LLP

DATE: 3 NOVEMBER 2010

CURENT YEAR PERFORMANCE AND FUTURE OPPORTUNITIES

Terms of Reference

The purpose of this report is to provide an analysis of current year performance, evaluate expansion to

Australia, and consider the issues regarding solar panels

It has been prepared for the Board of Eastern Energy Experts (EEE) and should not be distributed to any other parties without prior written consent No liability can be accepted in the event of such distribution

This report is based solely on the information provided by the EEE board members and no attempt has been made to corroborate or independently verify any of this information

Executive Summary

Introduction and wider business context

Although EEE has grown revenue dramatically between 2006 and 2009 (at a compared annual rate of almost 70%), the 2010 draft accounts show a decline in total revenue by 34.3% due to the exhaustion of the AEPS database, with only, 18,873 installations remaining at the end of 2009

However, government initiatives for energy efficiency around the world present new opportunities in light of Kyoto and rising energy prices to expand overseas and shift to alternative energy generation

Analysis of Draft 2010 accounts

Revenue from AEPS commission and installations fell by 45.9% and 50.6% respectively

This is because EEE has reached the more complex remaining customers on the database

However solar panel revenue growth is impressive at over 131% and the rate has increased from 90% in prior years despite the recession

 Revenue mix has shifted so that solar now comprises 25.2% of total revenue, indicating EEE should refocus to solar as UK loft insulation reaches the end of its life cycle

 EEE should consider retraining staff to focus on sales of solar

 To avoid engineer redundancy, EEE should analyse the benefits and costs of training engineers to obtain micro generation scheme certification to install solar

 EEE should seek to source panels from more ethical suppliers

Australian Expansion

 The project is expected to make a profit of £2,650k as it stands However hit rate sensitivity indicates the project will be loss making by £270k due

 This is due to a 1in 5 rate reducing the market by 40,000

 EEE needs to revaluate the assumptions used for the hit rate and the fixed cost drivers

 EEE should understand Australian government schemes and the level of competition it will face

Solar Panels

 EEE needs to consider using more ethical suppliers to avoid brand reputation damage

 The roof renters venture should be considered further in order to target more households

 Supervision on installations needs to be increased to improve standards of workmanship

 Customers are aware of mis-selling

(1) FINANCIAL STATEMENT ANALYSIS

BUSINESS CONTEXT

The UK economy continues to suffer from the effects of the recession EEE has seen a decline in revenues from loft insulation, which has historically formed the largest most significant business stream

As loft insulation reaches the end of its product life-cycle due to the dwindling market, the solar panel boom is picking up, as a result of increased consumer awareness of green issues and as influenced by government policy with the FIT scheme under the green deal, in meeting with the Kyoto accord

Revenue

Revenue has fallen by £5,185k (34.3%) (see appendix 1) in 2010 This appears very disappointing when compared with a growth rate of 15.7% in 2009, and an average growth rate of approximately 70% per annum for the past four years

However, the decline, led by falling commission and installation revenue was to be expected as EEE’s remaining target AEPS market becomes more difficult to penetrate

The four revenue streams have not all declined, however, as explained below

Revenue mix

Solar revenue formed 25.2% of total revenue in 2010 (2009:7.2%) (app 1), and is the only revenue stream to see growth in 2010;

Solar revenue is up £1,425h (131.3%) on 2009 solar revenue This is a dramatic increase, and the growth rate of 131.3% exceeds the 90% growth rate seen in the previous year

This will largely be due to increased public awareness of green issues and the government incentives

on offer such as the Feed In Tariff scheme

This is particularly noteworthy as solar has seen exceptional growth despite the negative press

coverage with regards to installation and panel quality

Stove revenue on the other hand, has not seen the same success as revenue With revenue down by

£84k (9.2%) on prior year

This is likely to be due to alternative energy stoves being regarded as a fashionable item

Stoves do however represent 8% of the sales mix (2009:6%) (app1) This is due to insulation related revenue falling by a much larger degree, than stoves revenue

Commissions and insulation installation now compose 66.5% of the sales mix as a combination,

compared with 86.8% in 2009

Due to the decline in this market, and the increasing importance of alternative energy items such as solar, EEE should seriously consider the issues discussed in parts 2 and 3 of this report, as a matter of urgency in deciding the future strategy of EEE As it is unlikely that focussing on loft insulation for much longer, is a viable strategy

Gross profit

The decline in commissions margins from 90.5% to 83.4% reflects the make up of the remaining

customers on the AEPS database, as being the more difficult targets, and suggests a declining hit rate from 1 in 5

Margins for the other revenue streams have not changed significantly

Margins on installations have increased slightly to 7.3% from 6.2%, suggesting better control of

subcontractor material wastage

Solar margins have largely been maintained at 56.6% (2009: 56.9%) due to continuing to source panels from the Asian suppliers, due to the shortage in the UK

As a result of the changing sales mix, total gross margins are 33.6%, compared with 26.5% in the prior year

Operating Profit

The operating profit margin has remained at 8.9% underlying this however, are significant changes in overheads (appendix 1)

Marketing costs have decreased £123k (28%) and reflects that as solar becomes an increasingly important revenue stream, some reliance can be placed on customers being made aware of initiatives through other organisations

The increase in staff training costs by £69k (83%) is due to retraining call centre staff and engineers for solar sales

Cash Flows

EBITDA has fallen 29% to £1.220k as a result of the decline in sales activity

The net change in cash over the year however is up £549k (173%) to £867k This reflects the improved working capital management of £270k (app1, e) in cash generated from operations and is helped by the reduction in the dividend payout by £300k to £200k compared with £500k in 2009

This appears a reasonable decision in the face of economic and strategic uncertainty for EEE

Conclusions & Recommendations

EEE’s performance in 2010 is, although expected due to declining insulation market, disappointing, and

is the first year since trading began that total sales have declined

Government incentive emphasis on alternative energy couldn’t have come at a better time as EEE needs to move away from its historically core market

It is recommended that EEE:

- Consider retraining staff to focus on solar sales

- To avoid making engineers redundant, perform a cost benefit analysis of retraining them to obtain micro-generation scheme certification to install solar

- Analyse whether the higher margins achievable by sourcing panels from Asia, outweigh the operational and ethical risks as raised in your emails and as discussed further in this report

Appendix 1

a) Revenue Growth

2010 v 2009 2009 v 2008

£000 % £000 %

Total revenue (5185) (34.3) 2052 15.7

b) Sales Mix

2010 2009

% %

c) Gross Profit Margin

2010 2009

Total Margin 3,347 33.6 26.5

d) Operating Profit

2010 2009

Operating profit £888k £1,351k

Depreciation £290k

Variance £51k ie 15% lower £341k

Loss on PPE disposal £42k

Variance £13k ie 45% higher £29k

Overheads:

2010 v 2009

Movement

£’000

Movement

%

e) Cash Flows

2010 2009

Movement (£50k)

(29%)

2010 v 2009 2009 v 2008

Net change in cash over the year £867k £318k

Variance £549k

+173%

Dividends paid

2010 2009

Variance (£300k)

(60%)

Working capital changes:

Cash generated from operations v cash flows from operating activities

2010 2009

1,490 – 1,220 = £270k 1.586 – 1721 = (£135k)

2 Expansion to Australia

Business Context

As the AEPS target market reaches the end of its life cycle for loft insulation, it is worthwhile for EEE to consider the viability of emulating its business model and success in a different geographic region

Australia seems attractive as two of the four Board members have links to it, and also due to having the right to work there would be able to take a hands on approach to managing operations out there

In addition, Australia only signed up to the Kyoto accord in December 2007, and so EEE would potentially be able to secure some first-mover advantage in the market

Expansion Project Appraisal

The project will make a profit of £2,650k over the 5 year life cycle, taking account of Dany Parker’s assumptions (see appendix 2)

However, despite detailing an estimated 1 in 3 hit rate, the 5 year work profile totals to 100,000 installs, as opposed to 75,000 which results from Dany’s assumptions Nevertheless, 100,000 has been taken to be the target total figure in calculating the initial profitability

Assumption evaluation

Using 100,000 assumes there is no cold calling occurring and this is unlikely as EEE experience that around 5%

of customers are lost through cold calling in the UK

Assuming the UK call centre will be used and hence applying a 90.5% margin or i.e 9.5% cost/revenue, may not provide an accurate analysis because staff may require a higher rate of pay due to the time difference between UK and Australia requiring staff to work at unconventional hours

Such a time pattern change may be met with resistance and require EEE to take on additional shift workers and hence pushing up the cost