What are 3 corporate governance issues at Merran Hill and how can it be resolved?

Merran Hill's difficult year

It is November 2020 and after disappointing profits in the previous year, Merran Hill's Board is dealing with some significant strategic issues to improve performance in the 2021 financial year (1 July 2020 to 30 June 2021).

Company background

Merran Hill is an Australian company that makes and sells chocolates. It is based in Melbourne and has shops in Melbourne, Sydney and Adelaide. Its factory is based in Portland, Victoria where unemployment rates are high and the local government is very supportive of any industry it can retain to support the local economy.

It is the largest privately owned confectionary manufacturer in Australia. It takes its name from the home town of its founder, who sold the company to its current owner, Miles Rubenic seven years ago. Mr Rubenic has a small portfolio of companies he owns but does not operate, preferring to pursue his property development interests. He places key people in the companies he owns and leaves them to run them. He sets challenging targets for both long and short term performance and links the senior managements' remuneration packages to achievement of the targets.

Merran Hill operates solely in Australia, although its products are sold worldwide through distributors. Its three main products are ChocMint, ChocAlmonds and Berry Delight.

The Board of Directors of Merran Hill is responsible for strategic decisions and defines the means for achieving the goals of the company. It approves the financial report and makes decisions relating to the appointment of key personnel, as well as the external auditor. The Board of Directors consists of two executive and two non-executive members.

Executive Directors

Erin Banner Ms Banner was appointed as CEO of Merran Hill by Miles Rubenic in 2014. She completed a Bachelor of Commerce from Deakin University and later attended Harvard Business School. Before joining Merran Hill, Ms Banner held top executive positions for 20 years with Lindt & Sprungli and Darrell Lea in Europe and Australia. Other Boards Ms Banner is a member of include the Bank of Miburn and the Australian Foundation of Company Directors (AFCD).

Jane Oh Ms Oh has run her own successful chocolate business for 30 years. She started making chocolate from her own kitchen when she was a young mum of two. Gradually, through word of mouth, what started off as a hobby, turned into a lucrative business, with hundreds of orders coming through on a daily basis. Ms Oh's husband quit his job and together, they started the OMG chocolate franchise. Many years later, Ms Oh's husband decided to retire and devote more time to their grandchildren. The business was sold to Merran Hill in 2020 on the condition that Ms Oh retain a seat on the Board and be employed as the production manager at Merran Hill for a period of five years after which time she expects to retire.

Non-Executive Directors

Dr Rupert Singh Dr Singh completed his studies with a doctorate in finance and has been a member of the Board since 2009, being retained by Mr Rubenic because of his excellent qualifications. Dr Singh manages his own accounting firm and also holds a board position at BLP (a top 10 listed Australian company).

Mr Peter Boyd Mr Boyd is the Managing Director (MD) of top law firm Madens. He has served on several boards and his advice is often sought by the Board on various risk management, contractual and litigation issues. Considering his role as MD at Madens, Mr Boyd's time is very limited and he is not able to attend all board meetings.

Generally, the Board has worked together well and up until last year the company just met the targets set by Mr Rubenic and the executive directors achieved their bonuses and were able to expand the workforce and continue to sponsor community projects. The drop in profit in the year ended 30 June 2020 came as a shock and the Board is keen to reverse this outcome before it becomes a trend.

Competing approaches to the future

Members of the Board have been exploring potential strategies to improve performance but some differences in opinion have emerged in the process.

Dr Rupert Singh is keen to focus on drilling down through the financials to identify problems and pointed out that the variances between the actual and budget figures for materials are quite alarming. More specifically, he claims that this had a significant role in the failure to meet the budgeted net profit of $1.56m.

He directed the attention of the Board to the detailed budget for the 2020 year end prepared by the company accountant - James Khan. Rupert said that James had identified that the main cause of concern was the materials variance. Merran Hill budgeted to spend $1.5m on materials but ended up spending $2.1m (see Exhibit 1). Anxious to resolve this matter, Erin Banner asked Jane Oh what caused the variance. Jane reminded Erin about the need to source cocoa of a higher quality in January 2020 after an article in a reputable newspaper portrayed Merran Hill in a negative light for using inferior cocoa. Jane reminded Erin that she had sent her a copy of the article (see Exhibit 2) and that the Board was outraged about it and had sued the newspaper for damages. As a result of the newspaper article, the Board also gathered for an emergency meeting in January 2020 and agreed that an expert would be engaged to assess the quality of cocoa used. The expert's results demonstrated that the cocoa quality was not industrial but not A-grade either. The Board had agreed that it was imperative that the cocoa quality was improved.

Erin was a bit impatient because Jane was reminding her about something she clearly could not have forgotten, so Jane quickly went on to explain that in the short-term, the decision had been to use more expensive suppliers who only dealt with A-grade cocoa. Because she had needed to act fast, she had only had limited time to perform an analysis of several suppliers and ended up picking a competitor's supplier, ChocRus Ltd, and was not in a position to negotiate any discounts. Jane went on to talk about some difficulties with other suppliers being unreliable and causing production delays.

Over the years, it is not just materials that have been problematic, production costs have increased dramatically due to higher wages and specialised machinery. When Jane joined the company her experience was with smaller scale production and she struggled to manage the complex production systems at Merran Hill. She is now feeling the pressure of the increased scrutiny of the production side of the business but has a secure tenure so is not too concerned.

Given the increased pressure on her, Jane is particularly conscious that increased costs might be a factor in the dip in performance, so she encouraged the Board to consider outsourcing the production of Berry Delight. She argued that the consistent difficulty in the production process for a soft-centre chocolate is causing problems in the production of the other products too. Cutting the Berry Delight also meant a greater reduction in costs than for the other two products, because it is more labour intensive. She understood the factory manager's reluctance to put people out of work but the only way Jane could see to get back on track in the short term was to outsource production of Berry Delight. Jane undertook some research on companies the production could be outsourced to and came up with two alternatives.

The first alternative is Barry Gallebaut in Switzerland. The Barry Gallebaut Group is the world's leading manufacturer of high-quality chocolate and cocoa products. Focused on innovation, they provide a wide range of services and are committed to sustainable cocoa production.

The second alternative is Madou Ltd in Vietnam. Newly established, Madou would be 30% cheaper than Barry Gallebaut. Jane observes that back in 2014, Vietnam achieved a 'good' rating from Gartner, the world's leading information technology research company and was named as one of the top 30 countries for offshore services.

At the next Board meeting, Jane presented both alternatives to the Board. Some Board members are a bit concerned about Vietnam, and are unsure about what protection the company would have under fair trade practice regulations there and the problems that may be caused by cultural differences. It was agreed that cost would not be the decisive factor in the decision because of the importance of protecting Merran Hill's reputation for fine chocolates and the risk to the whole business if an outsourcing partner did not deliver a quality product. Erin Banner asked Peter Boyd to provide a brief on the potential to build into the contract with the outsourced partner protection for Merran Hill. Peter did not attend the next Board meeting, however, and in the meantime, Rupert Singh decided to look into the strength and reliability of Vietnam's trade practices.

Jane Oh had some preliminary discussion with Madou who offered to manufacture 100,000 boxes of Berry Delight at a cost of $1.65m for the 2021 financial year. James Khan (the company accountant), has gathered information to assist in the evaluation of the proposal (see Exhibit 3). Currently the decision is still pending but a recent email from Rupert Singh has caused concern amongst the Board members (see Exhibit 4).

Erin questioned why the company would specifically want 100,000 boxes and Jane advised that this was based on the prior year actual sales for Berry Delight. Erin advised that, based on her experience, it might be a good idea for the Board to consider moving to a process of rolling forecasts, the key reason being that market dynamics and business growth rates have been changing rapidly.

The Board is also keen to determine the optimal stock of Berry Delight to have on hand. The idea is to make sure that the shops do not run out of inventory but do not have excess inventory either as this would mean extra storage costs. To assist with the efficient management of inventory, the Board asked James to consider if there are any appropriate management accounting techniques to do this. James collected the information in Exhibit 5 as a basis for considering the inventory problem.

James Khan is not on the Board and has been uncomfortable with what he perceives to be the lack of focus in the decision making. He takes an opportunity to suggest to Erin that it would be a good idea to undertake a review to determine whether its product mix is optimal and represents the best use of the company's resources. Erin is convinced that they should not produce Berry Delight themselves based on Jane's many complaints about the complexity of producing a soft-centred chocolate in significant volumes. So, Erin agrees that there is a need to assess which of the two remaining products to keep and in what quantities. Disappointed that a more comprehensive analysis is not to be undertaken, James recognises however that even this study requires significant amount of work including a market summary of the current situation, forecast future demand and price sensitivity. He starts by talking to Jane Oh.

Jane raised a concern that she has had for a while in relation to one of the machines used in the production of ChocMint and ChocAlmond. The regular machine is used for both chocolates and is extremely expensive. The capacity constraint of the regular machine is becoming more urgent, and Jane supports the proposed analysis of the two remaining products because her view is that there are two options: either purchase a new regular machine, or discontinue either ChocMint or ChocAlmond. James discusses options for financing a new machine with Rupert Singh who argues that Merran Hill does not currently have the necessary cash flows to acquire it and he suggests not to look into leasing opportunities for now. James didn't say anything at the time, but he is sure that he could talk Rupert into considering leasing because of the advantages of off-balance sheet financing. Rupert agrees that product discontinuation should be considered though, and would like to see the analysis when it ready. James collected the information in Exhibit 6.

As he was pondering the year to come he struggled with how he could contribute to improving the performance of Merran Hill and whether or not the Board would soon be considering cutting back on the local community projects the company had been sponsoring at his suggestion.

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Ms Banner felt the Board needed external input to break through the impasse that was preventing the Board from really understanding and addressing the issues they faced. She convinced the Board to appoint your team as consultants for the company. Your brief is to identify and investigate the key issues for Merran Hill and write a report to the Board.

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EXHIBIT 1

Budget variance for Merran Hill

	30-Jun-20	30-Jun-20
	Actual	Budget	Variance	% Var
Boxes sold	242,000	240,000	2,000	1%	F
	$	$	$
Sales revenue	$ 7,018,000	$ 6,960,000	$ 58,000	1%	F
Cost of goods sold
Materials	$ 2,100,000	$ 1,500,000	$ 600,000	29%	U
Direct labour	$ 2,400,000	$ 2,350,000	$ 50,000	2%	U
Variable overheads	$ 475,000	$ 480,000	-$ 5,000	-1%	F
Fixed overheads	$ 714,000	$ 720,000	-$ 6,000	-1%	F
Total Cost of goods sold	$ 5,689,000	$ 5,050,000	$ 639,000	11%	U
Gross profit	$ 1,329,000	$ 1,910,000	-$ 581,000	-44%	U
Other costs	$ 345,000	$ 350,000	-$ 5,000	-1%	F
Net profit	$ 984,000	$ 1,560,000	-$ 576,000	-59%	U

EXHIBIT 2

Merran chocolates - is it all downhill?

Local chocolate giant Merran Hill accused of using inferior cocoa.

Our sources confirmed that Merran Hill uses cocoa beans from origins that are inconsistent in quality or prone to off-flavours. Our sources provided the information based on the outcomes of a project supervised by the International Cocoa Organisation (ICCO), which states that there is no single universally-accepted criterion to assess cocoa quality but that some common criteria include the generic origin of the plant, morphological characteristics of the plant, flavour and chemical characteristics, colour, degree of fermentation, drying, acidity and off-flavours. These criteria were applied to the cocoa used by Merran Hill and it was assessed to be industrial grade cocoa is being used. This is a far cry from the high-end expectations of customers paying top dollar for the small but exclusive range of chocolates advertised as being the best in Australia.

Merran Hill was contacted for comment and was prompt to deny the ICCO findings but was either unable or unwilling to provide evidence of the supply chain provenance of the chocolate used in production in the last six months.

EXHIBIT 3

For the 2021 financial year, Merran Hill could manufacture 100,000 boxes of Berry Delight at the following costs.

Berry Delight costs

Cost type	$
Direct materials	600,000
Direct manufacturing labour	1,000,000
Manufacturing overhead	300,000
Total	1,900,000

Additional information collected by James includes the following:

• Only 20% of the manufacturing overhead is truly variable.
• Of the remaining fixed portion:
  • $200,000 is an administration overhead that will not change even if the production of Berry Delight is outsourced to Vietnam;
  • $40,000 is fixed manufacturing overhead related to the production of Berry Delight, which will stop if the production is outsourced to Vietnam.

EXHIBIT 4

Board members received the following email from Dr Rupert Singh:

Dear Board members,

I hope this email finds you well. Earlier this morning, I received an anonymous letter in the mail. The letter specifies that Merran Hill should refrain from doing business with Madou. The reason given is that Madou only uses 10% cocoa in its chocolate production. The remaining 90% is carob powder, a substitute of cocoa made from the carob tree.

The email also suggested that Madou is sourcing the carob powder from plantations that use child labour.

This raises ethical issues which I believe should be addressed by the Board, in order to avoid a scandal that might be similar to the 2016 horsemeat scandal in the UK. I am looking forward to your comments on this matter.

Regards,

Dr Rupert Singh

EXHIBIT 5

Yearly demand Berry Delight	100,000
Cost per order	$50
Carrying cost per box	$5

EXHIBIT 6

ChocMint is made on a regular machine while ChocAlmond requires the regular machine as well as a sophisticated machine. James has provided the following data in relation to the two products.

ChocMint & ChocAlmond costs

Description	ChocMint	ChocAlmond
Selling price per box	$26	$29
Variable cost per box	$19	$21
Total fixed overhead costs	$200,000	$240,000
Hours to produce 1 box on regular machine	0.5	0.6

The capacity constraint on the regular machine is 65,000 hours. There is no capacity constraint on the sophisticated machine. The fixed overhead costs of using the sophisticated machine includes an annual lease payment of $120,000 which is cancellable anytime without any penalties.