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Professional level
Strategic Case Study
Strategic Case Study - practice exam
Pre-seen information will be issued to students in advance of the strategic case study exam.
Students are expected to familiarise themselves with the pre-seen information in advance of
the exam.
Additional information relating to the case study will be provided in the exam itself.
Students will need to consider both the pre-seen and the additional information when
answering exam questions.
Airco Ltd – Case study
Pre-seen information
Introduction
Airco Limited (Airco) is a leading distributor of air conditioning and refrigeration equipment
in Ghana. It obtains supplies from distributors in China and Europe, and distributes them inside
Ghana through a number of retail stores and through direct selling to building contractors and
other businesses in the building trade. The retail stores provide equipment to small businesses,
households and small building contractors. The direct selling team deal with large corporates
and large building contractors.
The company head office is in Accra, where most of its full-time employees are based. It
currently employs about 250 full-time employees.
In addition to acting as distributors of air conditioning and refrigeration equipment, the
company also installs the equipment, and operates a maintenance and repair service for
customers who sign up to agreements lasting between one and three years.
Airco was incorporated in 2008 following the merger of two established companies, and it has
enjoyed rapid growth in subsequent years. Its business operations are restricted to Ghana,
mainly in and around Accra, Kumasi and Sekondi-Takoradi, but the board of directors has
ambitions to develop an international business, initially through expansion into other countries
in West Africa.
In the years since the company was formed, it has grown organically, but also by making
acquisitions of a number of smaller competitors.
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The board of directors has also considered manufacturing its own air conditioning equipment,
but has concluded that this would not be a viable business proposition, at least for the next few
years.
Corporate values
Airco has not been in business for many years, but it has already gained a reputation for
distributing and installing good quality equipment and making it available to a large number
of customers. The board is proud of this reputation and has developed a series of “core values”,
which it expects its employees to support. These are:
Trading fairly and honestly: being an ethical company
Being responsive to customer needs, and seeking to improve continuously
Employing committed people and providing training opportunities to develop their skills.
Business operations
Airco has two business divisions, Air Conditioning Services (ACS) and Refrigeration
Equipment Services (RES), which operate separately. However the two divisions operate in a
similar way.
Each division has its own warehouse for storing imported equipment.
Each division has its own full-time employees who carry out major installations and
maintenance and repair activities, and they also have their own external sales teams, based in
Accra.
The divisions distribute their equipment, and in many cases they also install it for
customers. However, with some sales to large building contractors, the building contractors
themselves do the installation work and do not require any follow-up repairs or maintenance
services from Airco.
Both divisions also use self-employed individuals to install small items of equipment, such
as air conditioning units in private homes.
Each division operates its own retail outlets to sell their air conditioning and refrigeration
units. Some retail outlets operate under the Airco trading name. Other outlets, acquired since
2008, continue to trade under their original business names, so that Airco can take advantage
of the customer goodwill that each of these outlets had developed with customers.
Each division also has its own logistics arrangements. The direct sales teams have their own
small transport fleet, with delivery vehicles for taking equipment to customers’ premises. The
retail outlets are sometimes able to use their division’s transport vehicles for delivering items,
but they also use external transport companies or the vehicles of their self-employed
contractors.
Competition within the industry
There are a number of companies in Ghana that distribute air conditioning and refrigeration
equipment, so that competition is strong. However Airco prides itself on the efficiency of its
administrative and IT systems, and its ability to respond quickly to customers, deliver high
quality installation and provide reliable repairs and maintenance services.
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Board of directors and management board
The board of directors consists of a non-executive chair, a chief executive officer (CEO), a
chief finance officer (CFO) and one non-executive director. The non-executive director, Ejo
Adomako, is the sister of the board chair, Afram Gbeho.
In addition the company has a management board consisting of the CEO, the CFO, a
procurement and IT manager, a Human Resources manager, and the managing directors of the
two operating divisions. The management board reports to the board of directors.
Organisation structure
Each of the two operating divisions has a divisional executive management team based in
Accra. In addition to the managing director for the division, each team includes senior
executives with responsibilities for operations, sales, logistics and human resources and
accounting.
An organisation chart is shown in Appendix 1.
Financial structure and ownership
The company has 200,000 shares in issue. It has succeeded in attracting some interest from
institutional investors, who have bought shares in the company over the past five years. The
ownership of the company is now split in the following proportions:
Institutional investors 8%
Individual investors 92%
(including board members and senior management)
Financial performance and position
The acquisitions strategy of the company since 2008 has led to high levels of goodwill. In some
cases, newly-acquired businesses have underperformed and failed to meet profit expectations.
Some seriously underperforming businesses have been disposed of, and there has been some
impairment of the amount of goodwill in the statement of financial position.
A summary of the company’s profit and loss statement for the previous financial year and a
statement of financial positon as at the end of that year are shown in Appendix 2.
The dividend in the most recent financial year was GH¢ 1.75 per share, which represents an
increase of 10% above the previous year’s dividend. The board of directors is confident that
profits and dividends in future years will continue to grow at a similar annual rate.
Statement by the board chair about the strategic objectives of Airco Ltd
The chair of the board has declared four strategic objectives for the company. These are:
(1)To be the market leader in the countries of the world where it operates; and to seek
international expansion for the business, initially into other countries in West Africa
(2)To de-leverage the company (reduce the gearing) by disposing of retail outlets that do not
contribute sufficiently to corporate profits and fail to meet minimum performance standards,
and to shift the focus of the business more towards scale distribution and installation for large
contracts and away from sales to households
(3) To strive continually to improve the company’s services
(4) Eventually to seek a listing for the company’s shares on the Ghana Stock Exchange.
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Comparison of performance of the two operational divisions
The performance of the two divisions in the previous financial year, and their respective net
assets as at the end of that year, are shown below. The assets attributable to the retail outlets
are apportioned between the divisions on the basis of sales revenue.
Performance
Air Conditioning
Services
Refrigeration
Equipment
Services
GH¢’000 GH¢’000
Revenue 26,976 10,491
Operating profit 967 273
Assets employed
Services Services
GH¢’000 GH¢’000
Non-current assets
Intangible assets 667 723
Property, plant and equipment 961 1,289
Current assets
Inventories 3,640 802
Trade and other receivables 2,755 1,061
Non-current assets employed by the company at its head office were GH¢ 100,000
Source of products
Airco Ltd prides itself on operating an efficient supply chain and developing strong
relationships with equipment suppliers in China and Europe that manufacture quality products.
It grants preferred supplier status to most of its suppliers, and has entered into long-term supply
agreements with them. Purchased equipment is delivered to one of the company’s two
warehouses, and the direct sales units and the retail outlets are supplied from the warehouses.
Strategic developments
Airco aims to increase its market share in Ghana by making repeat sales through its direct sales
teams and retail outlets, and by attracting customers away from competitors. If it takes a
decision to distribute equipment to another country, such as Nigeria, it will seek further growth
through international diversification. It is also considering whether to enter the market for
distributing air conditioning systems for cars.
The CEO, Kofi Traoré, is seeking ways of improving the company’s logistics, both in
delivering goods from the warehouses to the direct sales units and retail outlets, and also in the
distribution of equipment to customers. The company currently has only a small number of its
own vehicles, and deliveries to customers often rely on external transport companies and the
vehicles of self-employed contractors. Kofi Traoré believes that increasing the size of the
company’s own transport vehicles will improve the perceived quality of the company’s
services and in many cases will also speed up the delivery of equipment to customers.
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Corporate responsibility aims and corporate ethics
Airco Ltd aims to provide excellent customer service across both its operational divisions.
The board expects to reinforce this excellence of customer service by means of:
providing a high level of staff training and development, with strong concentration on
technical skills and customer liaison and communication skills
adherence to high ethical standards
actions to minimise environmental damage through its operations in terms of
greenhouse emissions: unfortunately, air conditioning and refrigeration equipment
emit large amounts of greenhouse gas (carbon dioxide) when used
the promotion of product integrity through the distribution of products that are safe
and reliable and meet international production standards.
The board of directors is aware, however, that the company does not yet have a strong
corporate culture and that the ethical aspirations of the board might not be shared by all of
the company’s employees.
Appendix 1
Airco Ltd: Organisation structure
Board of
directors
Management
board
Head
office
Air
Conditioning
Services
Refrigeration
Equipment
Services
Finance and
accounting
Operations:
distribution,
installation,
repairs
Operations:
distribution,
installation,
repairs
Human
Resources
Retail outlets Retail outlets
IT and
procurement
Note: Some of the retail outlets operate under the trading name Airco. Most retail
outlets acquired since 2008 continue to operate under their original business names.
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Appendix 2
Extracts from Airco Ltd’s statement of profit or loss and statement of financial
position
GH¢’000
Revenue 37,467
Cost of sales 27,345
Gross profit 10,122
Operating costs 8,882
Operating profit 1,240
Finance costs 292
Profit before tax 948
Tax 237
Profit for the year 711
Statement of financial position as at 31 December of the year just ended
GH¢’000
ASSETS
Non-current assets
Intangible assets: goodwill 1,390
Property, plant and equipment 2,350
Total non-current assets 3,740
Current assets
Inventory 4,442
Trade and other receivables 3,816
Cash 160
Total current assets 8,418
Total assets 12,158
EQUITY AND LIABILITIES
Equity
Share capital and retained earnings 6,343
Non-current liabilities
Bank loans 700
Current liabilities
Bank loans and overdrafts 2,546
Trade and other payables 2,569
Total current liabilities 5,115
Total liabilities 5,815
Total equity and liabilities 12,158
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Airco Ltd – Exam
Airco Ltd – Part 1
Additional information
This Case Study question relates only to the Air Conditioning Services (ACS) Division of
Airco Ltd.
The ACS Division operates a network of retail outlets and external sales units located
throughout Ghana. These retail outlets and external sales units are serviced by a distribution
warehouse. The retail outlets operated by the ACS Division supply to a wide range of
customers including independent builders, tradesmen and the general public.
ACS Division operations
The ACS Division uses a number of selected suppliers from China and Europe. It manages
these suppliers through a supplier management team and through the operation of a “preferred
supplier” programme. This supply chain management system links the Division’s warehouse
digitally to its suppliers, to enable direct re-ordering of the most popular and fast moving
products.
ACS also uses point-of-sale software to collect data on every purchase made by customers at
each retail outlet. The procurement team based in the Division’s warehouse uses the sales data
to produce orders for products. The procurement teams also work closely with retail outlet
managers to ensure that product sourcing is focused on the needs of the local customers of each
retail outlet.
Customers can buy products at the counter of retail outlets or through on-going customer
contracts for large volume supplies. Additionally, the Division has a direct sales team that
focuses on sales to large corporates and major building contractors. In the last five years, ACS
has also seen an increase in the number of sales made via Airco’s website, where customers
can view the whole range of products sold by ACS and then place orders online.
Customer feedback comments are sought by ACS every time a purchase is made, either via an
internet based questionnaire or through direct contact with the customer at the counter. ACS
also offers service guarantees whereby if customers are not happy with the quality of any
product, they are given a refund or discount on future purchases. ACS is increasingly trying to
encourage a greater focus on customers in its supply chain management to ensure that customer
satisfaction is maximised. Excellence in customer service is considered by Airco to be a critical
success factor in its business. (See pre-seen material.)
ACS invests heavily in staff training. All its staff undergo regular training in order to maintain
high levels of customer service. On joining the company, all new staff are trained in the
company’s ethical behavioural standards (for example, not knowingly selling goods to
customers which are suspected of being faulty, and displaying honesty and integrity in all
dealings with customers) and customer service policies and practices. Staff also receive
information on all new products received into inventory.
Strategic development options
The board of Airco Ltd has asked the Managing Director of the ACS Division to investigate
two investment opportunities that have just arisen, with a view to reporting to the board on
whether either of the investments might be worth pursuing. Both investment opportunities are
in neighbouring countries, so the investments would be consistent with the company’s strategic
ambition to expand its business into other countries (Pre-seen objectives).
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For the purpose of reviewing these investment opportunities, a pre-tax cost of capital of 10%
should be used for both options.
For financing reasons, these two investment options should be considered mutually exclusive.
Option 1
The ACS Division is considering whether to set up a number of new retail outlets in Country
X, where it believes it can rapidly become market leader. Country X has a developing economy
and many large scale building projects are currently underway. The Government of Country X
forecasts that there will be further developments in urban development and house building in
the country over the next 10 years. There are a number of well-established competitors in
Country X. To set up new retail outlets in Country X would involve an initial capital outlay of
GH¢ 1.5 million (Time 0) and the forecast pre-tax net cash flows, converted into cedis at the
expected exchange rate, are as follows:
Years
1 – 5 GH¢ 0.24 million per year
6 – 10 GH¢ 0.34 million per year
Option 2
There is an opportunity to acquire several retail outlets in Country Z. These retail outlets
specialise in the supply of specialist air conditioning equipment for use in environmentally
sustainable building projects. Profit margins for such equipment tend to be high and currently
there are few other distributors and installers of this type of product. Sustainable building
development is a growing area of business in Country Z. The retail outlets of ACS currently
operating in Ghana do not stock supplies of this specialist equipment and ACS staff therefore
are not familiar with them. ACS could acquire these retail outlets for an initial payment of GH¢
1.45 million (Time 0) followed by a further investment of GH¢ 0.45 million to upgrade the
facilities at the end of the first year of operations (Time 1). Research has provided the following
projected probabilities of pre-tax net cash flows, converted into cedis at the expected exchange
rate:
Year
1 – 10 GH¢ 0.30 million
per year
GH¢ 0.45 million
per year
GH¢ 0.25 million
per year
Probability 0.5 0.3 0.2
These net cash flows will only be achieved if the investment to upgrade the facility is carried
out and do not reflect the level of expected performance of the target acquisition under its
current ownership.
ACS’s divisional strategy
The management team of the ACS Division constantly reviews the Division’s activities in
order to ensure that it offers value for money to its customers and that it remains one of the
most efficient suppliers of air conditioning equipment in the market. The team also considers
that a focus on customer service, linked closely to the corporate responsibility aims of Airco
Ltd (see the pre-seen material), has a high correlation with the achievement of strong financial
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performance. Therefore, operational efficiency and excellence in customer service are the key
aims of the Divisional strategy of ACS.
Required:
(a) (i) Evaluate the primary activities undertaken by the Air Conditioning Services (ACS)
Division. Your answer should clearly explain how each of these activities should be
organised to add value to the Division’s customers.
Note: You should use Porter's Value Chain to structure your answer, but you are NOT
required to draw the value chain as part of your answer. You should also focus your
answer on primary activities in the value chain. (12 marks)
(ii) Discuss how the ACS Division can achieve an effective supply chain management
strategy. (6 marks)
(b) For the two strategic development options being considered by the ACS Division:
(i) Calculate:
(a) The Net Present Value for Option 1
(b) The Net Present Value for Option 2
(c) The Net Present Value for the worst case outcome for Option 2.
(10 marks)
(ii) Discuss the potential benefits and difficulties for the ACS Division of
undertaking each of the strategic development options. Your answer should
include an evaluation of the calculations provided in part (b)(i) of your answer.
(10 marks)
(iii) Recommend, with reasons, which of the two strategic development options
should be undertaken by the ACS Division to achieve Airco Ltd’s strategic
objectives. You should use your answers to parts (b)(i) and (ii) to support your
answer. (4 marks)
(c) Discuss how the effective implementation by the ACS Division of any TWO of the
key areas identified in the Corporate Responsibility aims of Airco Ltd (see pre-seen
material) can impact on the successful achievement of the Divisional strategy of ACS.
(8 marks)
(Total: 50 marks)
Note: Discount factors at 10%:
Year 1: 0.909
Years 1 – 5: 3.791
Years 1 – 10: 6.145
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Airco Ltd – Part 2
Additional information
The chair of the Airco Ltd board, Afram Gbeho, is preparing the agenda for the next board
meeting. It promises to be a difficult meeting, since there are several issues where board
members have strongly-opposed views.
(1) The latest quarterly figures for the current year show that sales in the Refrigeration
Equipment Services Division (RES) are fairly static, just 1% above sales for the
corresponding quarter in the previous year. In contrast, sales in the Air Conditioning
Services Division (ACS) are up 15% on the corresponding quarter in the previous year. It
seems clear to Afram Gbeho that the Refrigeration Equipment Services Division is falling
badly behind that of the Air Conditioning Services Division and that organisational change
is called for. He will be proposing to the board meeting that the two Divisions should be
merged into one, although he knows already that this proposal is opposed by Kofi Traoré,
the CEO.
(2) Jojo Dubango, the Chief Finance Officer, is concerned about profitability, debt and
dividend policy, and he believes that these issues are closely connected. He believes that
the low profit margins for the business and return on assets cannot be improved
significantly, so that if the company is to pursue a strategy for growth, it needs to retain a
greater percentage of profits, abandon the policy of deleveraging by selling off poor-
performing units, and borrowing more. He wants to minimise additional borrowing,
however, because of the business risk from higher interest rates. He therefore wishes to
propose a new financial strategy to the board, based on lower dividends but higher gearing
(leverage).
(3) The company’s institutional shareholders have spoken with Afram Gbeho and have
expressed their dissatisfaction with corporate governance arrangements in the company.
They are urging a restructuring of the board, with more non-executive directors, but the
removal of Ejo Adomako from the board. Afram Gbeho has argued that there was no need
for any more non-executive directors, since the executive directors held a large percentage
of the company’s shares. He argued that it would be reasonable for the company to have
governance arrangements in line with the OECD principles of good governance, but it
would be inappropriate to establish governance arrangements based on something like the
Code of Best Practices in Corporate Governance. The institutional shareholders were not
satisfied with the arguments of Afram Gbeho, however, and he has promised to raise the
issue of board restructuring at the next board meeting.
(4) Airco Ltd holds large quantities of inventory and uses an IT system for inventory
management to record the movements and balances of inventory items. Many of the
products held in inventory are valuable and very small, for example the components of
small air conditioning and refrigeration units. These are attractive targets for staff theft and
this has led to the inventory management system’s balances disagreeing with the inventory
count as the records are not accurate.
Another cause of missing inventory might be theft by self-employed engineers. They may
be using less equipment than they withdraw from the warehouse, and selling (and
installing) the unused equipment for personal profit.
Airco Ltd has a system of counting inventory once every year, with the warehouses being
closed for the two days that it takes to complete a physical inventory count. The main aim
of the count is to provide an accurate physical count that can be used to correct the figures
held in the inventory management system. A secondary aim is to remove damaged and
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obsolete items from inventory so that the losses can be recorded and inventory levels
replenished if necessary.
The Chief Financial Officer Jojo Dubango is proposing to change from an annual inventory
count to continuous inventory counts whereby sections of inventory are selected and
counted at different times. All inventories would be counted at least once per year. The
results of the counts would then be compared with the figures held in the inventory
management system and any errors corrected. It will no longer be necessary to close the
warehouses for an annual inventory count at the year end.
The counts would be conducted by the warehouse staff, who would be taken off of their
regular duties as and when required.
This proposal is resisted by the managing directors of both the Air Conditioning Services
and the Refrigeration Equipment Services Divisions.
Required:
(a) Discuss the arguments for and against restructuring the organisation by merging the
two operating Divisions into a single Division, headed by a single Managing Director.
(12 marks)
(b) (i) Use Porter’s Five Forces model to explain why Airco is unlikely to be able to
increase profit margins substantially. (4 marks)
(ii)Giving your reasons, and bearing in mind the board’s ambitions for company
growth, recommend whether or not you would support the proposals of the Chief
Financial Officer to:
(a )retain a greater percentage of profits
(b) abandon the policy of deleveraging by selling off poor-performing units
(c) borrow more (10 marks)
(iii)If Airco were to finance growth strategies by borrowing more, evaluate the
business risks that the company would face arising from movements in interest rates
and bank liquidity. (6 marks)
(c) Discuss the arguments for and against a restructuring of the board, to dismiss the
current non-executive director (NED) and appoint a number of new NEDs. (10 marks)
(d) Discuss two advantages and two disadvantages to Airco of switching to a system of
continuous inventory counts. (8 marks)
(Total: 50 marks)
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SUGGESTED SOLUTIONS
Airco Ltd – Part 1
(a) (i) Inbound logistics
ACS has a number of suppliers in China and Europe, offering the customers of ACS a range
of products. It seems likely that customers demand prompt supply of products when they order
them, so it is important that ACS should hold adequate inventory levels to meet customers’
needs.
Having a range of suppliers around the world should add value to ACS customers as they
should be able to find a product to suit their requirements. However, a wide choice for
customers must be supported by high levels of product availability, as and when customers
demand products. Therefore close relationships with suppliers are critical for efficient inbound
logistics, to ensure that value added is realised.
However, specialist products, or slow moving lines, should not be re-ordered automatically as
the speed of sale of these items is not known and is difficult to predict. ACS needs to have the
ability to obtain supplies of products ordered by customers on a fast turnaround so as not to
lose customer loyalty. ACS also needs to ensure efficient delivery from suppliers to its
warehouses to reduce costs.
Operations/ Outbound logistics
ACS is not involved in any manufacturing process. Its operations consist of distributing, and
in many cases installing and maintaining, air conditioning equipment. ACS may wish to
undertake quality control tests on products from a variety of suppliers.
However, it is important that the operations at the distribution warehouse and the retail outlets
are effective and customer-focused and that products are distributed to customers in the most
effective and efficient way. ACS should provide an efficient and prompt distribution network
to fulfil its customers’ orders. The retail outlets stock locally-focused products, thus adding
value to local customers as products are focused on local needs. Customers can buy at the
counter, through supply contracts or via the website, which allows a degree of flexibility for
customers depending on their needs.
In order to retain its customer base, ACS needs to ensure that it can fulfil customer orders from
its own warehouse. If customers were to get deliveries straight from a foreign supplier, why
use ACS in the future? ACS could be simply cut out. ACS needs to add value to the products
procured by offering a ‘seamless’ delivery service of all products ordered to meet the prompt
delivery timescales demanded by customers.
Sales and marketing
Sales are carried out at the counter, through the website and through direct sales. Therefore,
there is a range of methods by which sales can take place. This offers flexibility to customers
and this adds value.
Through more effective marketing ACS may be able to increase sales and also by targeting
promotions to customers for specific products. The website is a useful tool that can be used for
marketing products to customers and allowing them to view product specifications before
purchase.
Additionally, through the use of e-marketing, ACS could reduce its marketing costs.
Promotions should be held to improve the volume of online orders. This would help ACS to
plan and control inventory levels more effectively and reduce stock-outs, thereby adding value.
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ACS’s website could show all the details / dimensions of the products, to reduce queries and
time at its retail units, thereby helping customers.
Customer service
Customer surveys are regularly carried out by ACS. This shows to customers that ACS values
their opinions. ACS also offers service guarantees to customers which should encourage
customer loyalty and should also add value to the customer experience.
Summary
As can be seen from the above primary value chain analysis, most of the primary activities
undertaken by ACS are done to add value to its customers and to maximise customer service.
This is driven by the management’s strategic focus upon high levels of customer service being
a driving force in sound financial performance.
(ii) Supply chain management is a key element of Airco’s strategic objective to improve its
customer services continually. Supply chain management involves all the activities and
information flows necessary to get the goods from the original supplier to the end customer.
For ACS, as the distributor and installer of the final product, this involves all of the processes
involved in identifying sources of supply, transportation of products from suppliers to its
warehouse and then distribution of the products to the retail outlets or direct to the customer.
Some of this will be done digitally through supply chain management technology whereby the
suppliers’ systems are directly linked to ACS’s systems. Most importantly though, is that the
supply chain maximises the level of satisfaction for ACS’s customers. Therefore an effective
supply chain management strategy would need to consider:
Potential suppliers (location, size, product range available)
The number of suppliers (large numbers add to complexity but increase product diversity
for customers)
Cost, quality and speed of delivery.
Customer service is clearly a high priority for the management of the ACS Division and an
effective supply chain management strategy would help in the achievement of this. In the
traditional supply chain model, the suppliers of the raw materials or products are at one end of
the supply chain. They are connected to the distributor which in turn is connected to the end
customer. The supplier would then “push” the products through the distributor to the customer.
This form of supply chain strategy is largely driven by the supplier.
However, a greater emphasis should be placed on the relationship between the end customer
and the distributor/installer, whereby the customers are becoming more empowered and create
a ‘pull’ driven supply chain strategy. This means that the supply chain is more focused on the
needs of individual customers, i.e. a more customer- and market-oriented supply chain. In the
case of ACS, the Division has focused specifically on the needs of its customers and in
developing relationships with its suppliers to ensure that the products that they distribute
through its procurement team and stock management systems are what the customers demand
when they demand them. ACS works in a highly competitive market and therefore it must focus
on a customer-driven supply chain in order to remain competitive in the market place.
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(b) (i) Calculation for Option 1
(a)
Year Net cash flow Discount factor at 10% PV
GH¢ million GH¢
million
0 (1.50) 1.000 (1.500)
1 – 5 0.24 3.791 0.910
6 – 10 0.34 2.354 0.800
NPV 0.210
(b) Calculations for Option 2
Weighted EV calculations
Cash inflows
Most
likely
Best
outcome
Worst
outcome
Weighted
average
Annual cash
flow
GH¢ 0.30
million
GH¢
0.45
million
GH¢
0.25
million
Discount
factor, Years
1 – 10
6.145 6.145 6.145
PV GH¢
1.844
million
GH¢
2.765
million
GH¢
1.536
million
Probability 0.5 0.3 0.2
Weighted
average
GH¢
0.922
million
GH¢
0.830
million
GH¢
0.307
million
GH¢ 2.059
million
Cash outflows and weighted average NPV
Year Amount Discount
factor
GH¢ m GH¢
m
Cash outflow 0 1.45 1.000 1.450
Cash outflow 1 0.45 0.909 0.409
1.859
Weighted average of inflows 2.059
Weighted average NPV 0.200
(c) Worst outcome NPV
GH¢ m
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PV of cash outflows 1.859
PV of cash inflows (worst outcome) 1.536
NPV (worst outcome) – negative (0.323)
(ii) Option 1: Investment in Country X – set up own retail outlets
Option 1 is an example of organic growth in a new country within which ACS has not
previously operated retail outlets. It is essentially the same business that ACS operates now,
but located in Country X, with the risks that this might involve. There is risk in that ACS is not
familiar with the market conditions in Country X. Although the staff of ACS are highly skilled
in the area of product sales, the business is a commodity business and, as such, is sensitive to
price wars, increases in variable costs and changes in demand. Organic growth is likely to be a
much lower risk to ACS than growth through acquisitions, but the risk is increased by operating
in a country which is unknown to it. However, the risk is lessened to a degree in that it is
operating with familiar products and in a familiar industry environment.
However, ACS will need to ensure that staff operating in Country X would receive full training
in ACS methods and procedures, and will need continual monitoring to ensure that their
standards of efficiency and effectiveness match those of staff in retail outlets in Ghana.
A further consideration is that there is a high level of competition in Country X which is likely
to respond aggressively to entry by ACS into the market, and it must be prepared for aggressive
competitor activities such as price wars.
This project involves the investment of GH¢ 1.5 million and will offer a net present value of
GH¢ 0.21 million. On purely financial grounds, Option 1 in Country X is viable, although in
view of uncertainty about cash flow estimates, an NPV of GH¢ 0.21 million over 10 years for
an initial outlay of GH¢ 1.5 million might seem low.
Option 2: Acquisition of existing retail outlets in Country Z
Option 2 also has a positive NPV on the basis of weighted average cash inflows, and so would
appear to be a financially viable project. The EV of NPV is GH¢ 0.20 million, which is slightly
less than the NPV for Option 1. However there is a higher investment cost for Option 2 at GH¢
1.9 million compared to Option 1 at GH¢ 1.5 million. The worst case scenario, with a 20%
probability should be of concern to ACS as this would result in a negative NPV. Even the most
likely outcome would have a slightly negative NPV.
Additional non-financial aspects of the venture which need to be considered are that the
investment is inherently risky due to the differentiated nature of the products which ACS would
sell. ACS would have to become familiar with a new product range, different from the one that
it currently sells. Whilst success in the current business model is most likely to be based on
cost efficiency, the proposed business involves a differentiated product and, consequently, a
different approach to marketing. Forecasts suggest that the market has a strong future, and
could be a highly successful venture for the ACS Division. In general the profit margins
available in differentiated markets are higher than those for commodity products. Also there
are likely to be fewer competitors in this market place and this could be an opportunity for ACS
to move into this niche area and become the market leader, both in Country Z and then also in
Ghana. This is clearly a growing area of business and offers a potential area for ACS to increase
its overall market share.
It must also be considered that this option involves an acquisition, with the risks associated
with this type of strategy. The retail outlets in Country Z deal in specialised equipment and, as
such, it is likely that demand will be difficult to assess. In addition, as an acquisition, integration
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costs should be considered and the further on-going costs of training. The probabilities
presented are highly variable and show huge diversity in possible outcomes which should
indicate the level of risk involved in this venture.
(iii)Both options are financially viable taking into account the weighted average expected value
for Option 2, as both indicate a positive NPV on the investment. The main determinant is the
risk appetite of the company and the likely future impact that each investment might have on
achieving Airco’s strategic objectives. However, a significant consideration between the two
options must be the fact that there is a considerable risk, at 70% (20% + 50%), that there could
be a negative NPV for Option 2.
On the basis of the arguments put forward above, it is recommended that ACS should invest in
Option 1. Organic growth is likely to be significantly less risky than an acquisition despite it
being within a country within which ACS has not operated previously. It is likely that the
Government of Country X will take a favourable stance towards ACS as it is actively
encouraging economic growth in the country and therefore might offer incentives to ACS to
set up in the country. Less training for staff will be required as the business model is familiar
and the marketing approach can remain unchanged.
(c)Note: Answers should discuss any two of the following of the corporate responsibility aims:
Airco’s corporate responsibility aims focus upon four key areas:
(1) Staff training and development
(2) Commitment to the highest ethical standards
(3) Environmental performance management
(4) Product integrity, which means the supply of safe and reliable products that are of the
required quality in the most efficient way possible.
The Divisional strategy of ACS is focused on maximisation of operational efficiency and also
the achievement of high levels of customer service in line with Airco’s corporate
responsibilities. Therefore, it is important that ACS should apply the principles of Airco’s
corporate responsibility aims through its own corporate responsibility activities.
Staff training and development
It is essential that employees in ACS Division should have expert knowledge of its products so
that they can deal efficiently with customers and maximise sales. Customers are looking for
expertise from ACS and may rely on ACS advising which products work well together and
which do not. Customers also rely on ACS staff for efficient and high quality installation and
maintenance work. So continuous product training leads to knowledgeable and motivated
employees.
Safety training should help to improve efficiency and so minimise delays in getting products
delivered to customers.
Training in communication skills should also help to improve the Division’s relationships with
its customers, and encourage them to remain loyal. Over time, this should help to improve
Divisional sales and profits, as well as improving the quality of the Division’s customer service.
Demonstrating commitment to staff and managers through training and development should
also lead to higher levels of staff satisfaction and retention. This in turn will lead to increased
productivity and motivation, improved quality of operations and customer service, and reduced
costs.
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All of this should assist in the achievement of the Divisional strategy of focusing upon customer
service and operational efficiency which in turn supports Airco’s strategic objectives.
Commitment to the highest ethical standards
ACS is committed to observing the highest ethical standards both internally and externally. If
ACS is to expand its market share and maintain a sustainable business for the future it must
operate in an ethical way and treat its employees and its suppliers and customers fairly and
honestly.
Conducting business responsibly and with integrity minimises risks related to fraud and
corruption and strengthens the reputation of ACS. It also makes the business more efficient
because it avoids costly disruptions. Compliance programmes strengthen internal controls and
relationships with suppliers and customers. High ethical standards increase reputation and
should increase customer satisfaction levels.
ACS should have a clear pricing policy with no hidden costs and should be able to deliver
products to customers and install them in accordance with contracts and committed delivery
dates. ACS must put in place a distribution system to ensure that it continues to meet customers’
needs and deals with them honestly and with integrity.
In its relationships with suppliers, ACS needs to negotiate on prices paid but act honestly with
no unfair practices. The ethical stance for a company is not what it says on its website, or what
it tells its employees, but it is in the way it conducts its business.
Environmental performance management
Environmental performance management means that ACS will encourage the sale of
equipment that consume less energy and fuel, and discharge fewer pollutant gases, in order to
reduce the negative effect of the business activities on the environment. Measuring the
environmental performance of the equipment that it sells and installs will enable ACS to
become more aware of the environmental effects: awareness of a problem is often a first step
to tackling it.
In addition, ACS can strive to be a positive link in the sustainable construction supply chain. It
is important that ACS should source its products from reputable suppliers that produce
equipment that is more “environmentally friendly”. This might assist ACS to gain market share,
by exploiting new market opportunities and by attracting and maintaining customers through
new customer services and high standards in environmental performance.
By using efficient transportation/logistics systems, ACS should try to minimise its damage
through traffic pollution. It should try to ensure that the transport vehicles that it owns or uses
meet acceptable standards for emissions and fuel consumption.
Product integrity
By working with its suppliers ACS should aim to maintain high standards of product quality
and safety. The quality of the products that ACS supplies to the housing and building
construction sector must be sound to ensure that the construction projects are not damaged due
to faulty goods.
ACS should also use suppliers that can demonstrate adherence to corporate responsibility
policies, which in turn will improve product quality, integrity and customer service.
Compliance with its product integrity policy reduces risks of litigation, business disruption and
increases levels of customer satisfaction and service. ACS has a responsibility to test samples
of products on a regular basis from all suppliers to ensure agreed specifications are adhered to.
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ACS also has a responsibility to audit its suppliers to ensure they meet the terms of their
contracts and are themselves acting correctly in respect of their employees, safety standards
and quality control.
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Airco Ltd – Part 2
Case Study Question 2: Indicative solutions
(a)A merger of the two Divisions is likely to lead to some improvements in efficiency and
some losses of efficiency and the directors will have to identify both the costs and savings. A
merger of the two Divisions should be justified on grounds of cost savings or improved
revenues.
There are likely to be savings if the two Divisions have a number of customers in common. If,
for example, there are large building companies that buy both air conditioning equipment and
refrigeration equipment from Airco, there could be synergies arising from a merger of the
Divisions. There would only be one relationship to be managed by the direct sales team or by
the account managers. There could also be major savings in terms of distribution and delivery
if deliveries of both air conditioning and refrigeration supplies can be combined.
There would also be cost savings if some of the retail outlets for air conditioning and some of
those for refrigeration equipment could be combined into a single outlet. In addition, benefits
might be obtained by combining the transport fleets of the two divisions into a single fleet that
delivers both types of equipment.
However, the complexity of combining the two Divisions may lead to inefficiencies if one
large operating division is created out of two smaller ones. There could, for example, be a need
for an additional layer of management in order to ensure that the merged entity remains
controllable. That will add to the cost of managing the company and will also complicate
decision making. Staff may need to be trained in both types of equipment, adding to training
costs. The likelihood of potential savings being realised should be considered. It is possible
that staff reductions will prove difficult to implement if managers resist redundancies, perhaps
by creating posts or by delaying dismissals.
The costs of the merger will have to be considered. Reducing staffing levels may lead to
redundancies and there could be other restructuring costs, such as consultancy fees.
Considerations of costs savings or inefficiencies are operational concerns; and although these
are important for profitability, it is also important to look at the strategic issues.
The Air Conditioning Services Division (ACS) is much bigger than the Refrigeration
Equipment Services Division (RES), in terms of annual revenue, operating profit and assets.
In the current financial year, revenues (and presumably profits) of RES are up only slightly on
the previous year, whereas revenues of ACS are up by 15%. The future prospects of RES do
not seem good, and some action is needed to improve the performance of this part of the
business. Combining the two Divisions, to give the overall business a common identity and
purpose, might be a sensible strategic move. If future growth in the business is expected to
come mainly from air conditioning services, and if much of this growth is expected to come
from expanding the business into other countries, the current organisation structure for
operations will almost certainly need to be changed at some time in the future.
If the two Divisions are merged, there will presumably be just one Managing Director of
operations. This means that one of the existing MDs would be required to stand down, possibly
to a subordinate role. Both MDs are currently members of the management board, and the loss
of status would almost certainly be resisted by the MD adversely affected. This MD may also
be a shareholder in Airco. It may also be decided to appoint the overall MD to a position on
the company board, for example as Chief Operating Officer (COO). It is likely that there would
be a considerable amount of in-fighting as individuals throughout the company seek to maintain
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or improve their status – or their jobs – and the difficulties of managing the change from a
merger should not be under-estimated.
(b) (i)Porter’s Five Forces model can be used to assess profitability within an industry or
market. When any of the “five forces” are strong, profit margins will be lower than they would
otherwise be.
In the previous financial year, Airco made an operating profit of ¢1,240,000 on sales of
¢37,467,000 – giving an operating profit margin of just 3.3%.
In the market in Ghana for air conditioning and refrigeration services, there are a large number
of (foreign) suppliers of equipment and seemingly a large number of customers. This means
that there is no powerful supplier or powerful customer with a dominant bargaining position
over supply or demand in the market.
There is no obvious substitute product for air conditioning or refrigeration equipment, although
if Airco were to try raising prices for equipment installation, customers might switch to doing
more of the installation work themselves.
However, two of the five forces appear to be strong. The first is the existence of competitors in
the market and the rivalry between them. When competition is strong there is downward
pressure on prices and profits.
In addition, there appear to be few barriers to entry into the market. If prices and profits were
to improve, this would probably attract new competitors into the market, able to set up in
business, and the increase in competition would act as a new restraint on higher prices and
better profits.
(ii)The company has a strategic aim of being the market leader in the countries where it
operates. At the moment this is just Ghana, but the company also has ambitions for international
expansion. Growth must be financed.
(a)
Some growth will need to come from equity funding. Airco has succeeded in attracting some
investment from institutional investors, but most of the company’s shares are in private hands.
There would seem to be little prospect in the foreseeable future for a listing on the Ghana Stock
Exchange, so most new equity funding is likely to come from retained profits.
The dividend in the previous financial year was ¢350,000 (200,000 shares × ¢1.75) which was
about half the company’s after-tax profit. The dividend last year was also 10% higher than in
the previous year. If the board (and the company shareholders) are serious about wanting to
grow the company, a review of dividend policy is advisable. However, shareholders might have
expectations of high dividends and dividend growth, and a change in dividend policy is not
recommended without first discussing the issue with the company’s shareholders. Any
conscious change in dividend policy should be formally announced and justified by the board.
(b)
The CFO has suggested that the policy of selling off poorly-performing business units should
be abandoned. This is presumably because when a loss-making business unit is closed down
or disposed of, it may be necessary to write of some of the goodwill in the statement of financial
position. A write-off of goodwill would reduce equity.
However, the CFO’s suggestion does not make commercial sense. If a business unit is making
a loss, and efforts to turn it round have not been successful, it should be disposed of, to prevent
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further losses in the future. The company should focus on growing its profitable businesses,
not protecting those that make a loss.
(c)
If the company is to grow, it may be necessary to raise some finance through borrowing. At
the end of the previous financial year, the company’s total borrowings were ¢3,246,000 and its
total assets excluding goodwill were ¢10, 768,000. Gearing (leverage) would therefore appear
reasonably low. Finance costs last year were ¢292,000, indicating an average interest cost on
borrowings of about 9%.
However most of the company’s borrowings are short-term, and at the end of last year long-
term borrowings were just ¢700,000. If debt is used to finance growth, it should be long-term
debt. It is not clear whether the company would be able to raise a large amount of new long-
term debt unless it also reduces short-term borrowings.
It is therefore recommended that the company should consider ways of raising more long-term
debt finance, but this might be a difficult task.
In summary it is also recommended that the board of Airco should consider the underlying
concern of the CFO, who is correct to say that business growth must be financed. The board
needs to decide how much it intends to invest in growth, and where the finance should come
from.
(iii)At the company’s current low level of gearing, the risk from higher interest rates is perhaps
not a serious concern. The company’s total borrowings were ¢3,246,000 at the end of the
previous year, and an increase of 1% (100 basis points) in the average interest rate would add
just ¢32,460 to annual finance costs.
However higher interest rates might possibly make banks more reluctant to roll over short-term
borrowings by the company. In addition, any expansion in the business financed by long-term
debt would need to earn a return in excess of the cost of borrowing. Since the return on capital
last year (operating profit/total assets) was 10.2% (1,240/12,158) any increase in interest rates
might make it more difficult for the company to justify growth initiatives unless the return is
much higher than the current average.
In conclusion, the main business risk from expansion financed by long-term borrowing is that
any rise in interest rates might mean that growth is difficult to justify financially.
(c)The current board is quite small, with a non-executive chair, two executive directors and
one non-executive director. A management board of six senior executives reports to the
company board, but it might be argued that there is insufficient representation on the board for
individuals with a working knowledge of the business. If the two operating Divisions are
merged into one, there would be a strong argument for appointing the MD of the merged
Divisions on to the main board, to strengthen management representation.
The existing non-executive director (NED) is the sister of the board chair. This might not be
unusual in a family-owned and family-run business, but it seems inappropriate for a company
such as Airco, which was created by the merger of two separate companies in 2008. The sister
could be seen as an individual who would give full support to the views of the board chair, and
so a person who might not be sufficiently independent in outlook. A proposal to ask this NED
to step down from the board should be supported.
There is no clear requirement for Airco to appoint NEDs to its board. The Code of Best
Practices in Corporate Governance applies to listed companies, and not to a non-listed company
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such as Airco. For the purpose of good governance, Airco (as a company seeking to grow its
business) should apply the OECD Principles of corporate governance, but these do not call for
non-executive directors. They simply require the directors to act in the best interests of the
shareholders.
However, there are good reasons for appointing some NEDs to the board. One is that NEDs
can bring experience and knowledge to the board and its deliberations that the board and the
company’s management currently lack. For example, it may be appropriate to appoint an
individual with knowledge of banking and the financial markets (to contribute to discussions
on company financing) and an individual with knowledge of business markets in other
countries (to contribute to discussions about international expansion). A NED with knowledge
of accounting and finance might also provide valuable additional insights.
The board chair, CEO and CFO are probably shareholders in the company as well as board
members; and it might be argued that as shareholders, they will represent the best interests of
all shareholders, so that it is not necessary to appoint NEDs. However, the institutional
investors clearly do not accept this point of view, and their concern is that the board does not
adequately represent their interests above those of management. The appointment of NEDs,
particularly independent NEDs, would give them better representation, provided that the NEDs
fulfilled their role properly. If the company expects to attract additional investment in the future
from institutional investors it would be advisable to respond positively to the concerns of the
existing institutional investor shareholders, and take measures to restructure the board.
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(d) Only two advantages and two disadvantages are required for an answer to part (d).
Advantages
Airco will be able to avoid the disruption associated with a single annual/periodic inventory
count. It will not be necessary to lose two days’ business for the sake of the inventory count.
Staff may be utilised during quiet periods to complete part of the annual cycle without
disrupting sales.
Problems with the company’s inventory management systems or with staff theft will be
revealed by the ongoing counts. The present arrangements might not highlight such problems
until the year end when the annual inventory count occurs.
Airco will be able to target high risk items that can be counted more frequently than the annual
count implied by the traditional model.
Disadvantages
Continuous inventory counts may prove a distraction because they require frequent small tasks
to be completed. The continuous inventory counts will only be a small part of managers’
responsibilities and so they may be overlooked.
It may be easier to overlook problems arising from continuous counts because errors will be
discovered in isolation. An annual count will tend to draw more attention to the total value of
any difference from book stock.
There is also some concern that stock is being stolen by self-employed individuals that Airco
uses for installation work. If the stock they take out from the warehouse is properly recorded,
and the “theft” takes place because unused items are not returned, any system of inventory
count will not identify the problem.