XYZ Chemicals (XYZ) is in chemicals business and sells its products all over the world. As a listed company, the overall objective of the company is to maximise the return to shareholders and it has used return on capital employed (ROCE) as its performance measure for this objective. There has often been comment at board meetings that it is good to have one, easily-understood measure for consideration.

The company has three divisions:

the Basic Chemicals development division develops new chemicals, taking these through the regulatory systems of different countries until they are approved for sale;

the synthetic materials division then makes these compounds;

the sales division then sells them.

XYZs share price has underperformed compared to the market and the chemical sector in the last two years. The chief executive officer (CEO) has identified that its current performance measures are too narrow and is implementing a balanced scorecard (BSC) approach to address this problem. The current performance measures are:

Return on capital employed

Average cost to develop a new drug

Revenue growth

The CEO engaged a well-known consulting firm who recommended the use of a BSC. The consultants began by agreeing with the board of XYZ that the objective for the organisations medium-term strategy was as follows:

Create shareholder value by:

Innovating in Chemicals development

Efficiency in Chemicals production

Success in selling their products

The consulting firm has presented an interim report with the following proposed performance measures:

Financial: ROCE

Customer: Revenue growth

Internal business process: Average cost to develop a new drug

Learning and growth: Training days provided for employees each year

The CEO and the lead consultant have had a disagreement about the quality and cost of this work and as a result the consultants have been dismissed. The CEO has commented that the proposed measures lack insight into the business and do not appear to tackle issues at strategic, tactical and operational levels.

The CEO has decided to take this work in-house and has asked you as the performance management expert in the finance department to assist him by writing a report to the board to cover a number of areas. First, following the disagreement with the consultants, the CEO is worried that the consultants may not have been clear about the problems of using the BSC in their rush to persuade XYZ to use their services.

Second, he wants you to evaluate the choice of performance measures currently used by XYZ and those proposed by the consulting firm.

Third, there has been a debate at board level about how ROCE should be calculated. The marketing director stated that she was not sure what profit figure (of at least four which were available) should be used and why, especially given the large variation in result which this gives. She also wondered what the effect would be of using equity rather than all capital to calculate a return on investment. Some basic data has been provided in Appendix 1 to assist you in quantifying and evaluating these possibilities.

In addition to these concerns, the board is considering introducing a total quality management approach within XYZ. Obviously, quality of output is critical in such a heavily regulated industry where the products can be a matter of life and death. There has been discussion about testing this idea within the production division. The CEO wants to understand, first, the costs associated with quality issues within that division. To aid your analysis, he has supplied some detailed information in Appendix 2. Next, the board requires an outline evaluation of how a total quality management (TQM) approach would fit within the production division.

Required:

a) Evaluate the choice of the current performance measures and the consulting firms proposed performance measures for XYZ. (10 marks)

b) Evaluate the effect of choosing different profit and capital measurements for different measures of return on investment and recommend a suitable approach for XYZ. (7 marks)

c) Analyse the current quality costs in the production division and then briefly discuss how implementation of total quality management would affect the division. (8 marks)

Appendix 1

Financial data for the most recent accounting period

$m

Revenue

8,001

Costs

2,460

Gross profit

5,541

Other costs

3,248

Restructuring costs

482

Operating profit

1,811

Finance costs

266

Profit before tax

1,545

Tax

419

Profit after tax

1,126

Capital structure from the statement of financial position

Shareholders equity

1,161

Long-term debt

8,739

Note: Restructuring costs relate to a major project which completed during the period.

Appendix 2

Cost information for the manufacturing division for the most recent accounting period

1. Batches rejected at factory valued at $17m which have a scrap value of $4m.

2. Training of factory staff which cost $8m.

3. Regulatory fines costing $5m (due to chemical compounds being outside the specified range of mix of chemical ingredients).

4. Discounts given following customer complaints due to late delivery costing $22m.

5. Factory product testing department cost $12m.

6. Cost of raw materials was $1,008m.