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Question: In November 2012, a consultant was employed

In November 2012, a consultant was employed to review and document the planning and control systems of Integrated Technology Services (UK) Ltd (ITS-UK), to ensure that these were effectively meeting the needs of the business and to provide a basis for staff training. ITS-UK is the British subsidiary of Integrated Technology Services International (ITSI), a technology company, based in the north-east USA, which has history of developing and providing technology solutions to major international corporations and the US Government. It has focused on science and technology as a core strength with a significant Research and Development (R&D) expenditure. It is also noted for its extensive employee share ownership scheme, to encourage staff business awareness. The UK operations are based on two main activities: 1. Consultancy services to a range of businesses; 2. Computing and telecommunications outsourcing support to companies, particularly the oil and gas industry, but increasingly to other industries and to the public sector. The latter activity has been in response to the business opportunities created by a variety of industries that have preferred to focus on their ‘core competencies’ and outsource some of their internal support functions to external providers, particularly in information technology and accounting. The Government has also reinforced the trend by the compulsory tendering of many of its internal services in competition with outside providers. At the same time, outsourcing of information technology (IT) services has developed in the USA, where the parent company has progressed. Project management has been a particular strength within the corporate body, developed over its 30-year history. This expertise has also been used to advantage by its UK subsidiary, with the readily available facilities of US based staff, when dealing with multi-national corporations. ORGANISATIONAL STRUCTURE ITS-UK is structured into three groups of activities: • Consultancy business as a small separate unit • Outsourcing Services on a matrix organisational basis • Staff services, such as Finance, Commercial and Human Resource and Administration EXHIBIT 1:
In November 2012, a consultant was employed to review and document the planning and control systems of Integrated Technology Services (UK) Ltd (ITS-UK), to ensure that these were effectively meeting the needs of the business and to provide a basis for staff training. ITS-UK is the British subsidiary of Integrated Technology Services International (ITSI), a technology company, based in the north-east USA, which has history of developing and providing technology solutions to major international corporations and the US Government. It has focused on science and technology as a core strength with a significant Research and Development (R&D) expenditure. It is also noted for its extensive employee share ownership scheme, to encourage staff business awareness. The UK operations are based on two main activities: 1. Consultancy services to a range of businesses; 2. Computing and telecommunications outsourcing support to companies, particularly the oil and gas industry, but increasingly to other industries and to the public sector. The latter activity has been in response to the business opportunities created by a variety of industries that have preferred to focus on their ‘core competencies’ and outsource some of their internal support functions to external providers, particularly in information technology and accounting. The Government has also reinforced the trend by the compulsory tendering of many of its internal services in competition with outside providers. At the same time, outsourcing of information technology (IT) services has developed in the USA, where the parent company has progressed. Project management has been a particular strength within the corporate body, developed over its 30-year history. This expertise has also been used to advantage by its UK subsidiary, with the readily available facilities of US based staff, when dealing with multi-national corporations. ORGANISATIONAL STRUCTURE ITS-UK is structured into three groups of activities: • Consultancy business as a small separate unit • Outsourcing Services on a matrix organisational basis • Staff services, such as Finance, Commercial and Human Resource and Administration EXHIBIT 1: Consultancy This is the oldest established business unit of ITS-UK. It is relatively independent with a separate client base from that of the outsourcing business, though there is some commonality as its consultancy is essentially for systems applications and integration. It shares the staff services with the rest of the company, with an occasional requirement for the services of the other groups, such as the Infrastructure department, on an advisory basis. Outsourcing Services As with many modern service providers, the functions are divided into those that deal directly with the client, known as the front office, with the back-office delivery managers in charge of departments that provide the actual support staff, as follows: • Marketing department is a small group, which has the responsibility to find new business. Staff will read initial customer requirement reviews and contract negotiations, along with appropriate resources from other departments. • Client Account Managers head small departments who are in direct ongoing communication with the customer, once the contract is approved and work is ready to commence. They are to ensure that the contractual requirements are properly followed to meet customer expectations. This, in practice, is largely to meet the following criteria: (a). That proper resources are provided from the main groups of Applications Infrastructure and e-mail, to meet contract specifications, e.g. the right number of the appropriately qualified systems engineers, as defined in the contract. (b). That excess resources are not allocated to the project, due to support staff lack of contract understanding. The departments are structured on the basis of client requirements. An oil and gas group was originally developed to support one particularly large client, from which many of the staff were transferred to ITS-UK to carry on the work that they had previously provided. This original group was later divided into two, to reflect the two-division structure of the oil industry, the upstream exploration and production and the downstream marketing and refining. The Operations South group covers all other industries and local government departments. • Applications department provides the technical resources to develop and support clients’ IT applications systems. • Infrastructure department provides the technical resources to implement and support all computer hardware, telecommunications and networking requirements. It also includes a front-line help-desk support which is the first point of call for any customer call, such as computer, telephone or application system problems. • E-mail is a specialist group that provides electronic mail services to customers. Planning is a critical function for each of the Applications, Infrastructure and E-mail delivery managers, both with the marketing managers for early warnings as to staff requirements and with client management for ongoing needs. This latter feature has been difficult to achieve due to regular contract change requests by the major clients. The overall organisation is of a matrix nature, where the service delivery managers (SDM’s) provide some 750 people to a broad range of contracts. Some staff may be permanently assigned to a major client, whilst others could be working on several different contracts in a single week. BUSINESS CONTROLS OVERVIEW Expansion in Outsourcing had been rapid, with an emphasis on drive and initiative, to some neglect of a detailed controls framework. The main financial performance measure is the net margin. This is set by corporate headquarters as 6%, which effectively is the prime objective if ITS-UK. Contacts with clients tend to be agreed on a gross margin basis, but which obviously must be carefully set, usually at least 20%. This has been deemed to be the minimum required contribution to cover overheads and profit, although questions were being raised as to the appropriateness of this level as the net margin of 6% is becoming increasingly difficult to achieve, with some of the following points raised as contributory factors: 1. Following the early, large, long-term contracts, which were relatively simple to administer, overhead costs have risen disproportionately due to: • many small contracts, which administratively are often as expensive as much larger ones; overall lower net margins are therefore a natural outcome of the decreasing size of average contracts; • lack of standardisation of contract terms leading to complex administrative and financial controls, e.g. billing • arrangements have to be individually monitored, as computer systems have been unable to fully accommodate all the variations. The 20% gross margin target is therefore contributing increasingly more to overheads than to profit. 2. A further reason for lowering profitability is believed to be that the drive for market share, which had taken precedence over gross margin, has resulted in ‘loss-leaders’ which were not living up to expectations. One particular large contract, started with a 15% gross margin, in the expectancy of leading to other more lucrative work, but has not yet proved to have done so. 3. The mechanism of charging the IT person’s time to the contract, through a timesheet, is not being properly controlled. Staff may work on a number of small contracts in a week, possibly for the same client, which is not always obvious to the person concerned. Time is therefore often incorrectly charged, which results in a waste of administrative effort to correct, along with client dissatisfaction. A particularly difficult situation is where a variety of different types of contracts may be in force with a single client company. A systems engineer may work on a fixed price contract on one day so that time charged to the contract will be for internal ITS-UK purposes only, i.e. it will not affect the charge to the client. Then on the following day, he may be supporting a reimbursable (time and materials) contract, when time charged is reimbursed by the client. If these times get mixed up, the consequences can be significant. A lack of contract understanding therefore may be leading to costs, that should be chargeable to the contract and paid by the client, are not being identified as such. These costs will therefore remain as a charge against ITS-UK’s profits. 4. The increasing complexity of the matrix organisation may be leading to wastage. Ideally, resources should be provided to meet clients’ needs as and when needed. In practice, this flexibility can only be met if there are readily available staff resources at any time, which would inevitably lead to reserve people. However, such standby staff have a price, who generate no income, if not used. A response to the above problems has been to improve financial planning and budgetary controls. Before looking at these two control mechanisms, the nature of the various contractual arrangements must be understood. CONTRACTURAL RELATIONSHIPS ITS-UK receives its income through the provision of technology services, which are governed by various contractual relationships with the client. This commercial relationship will tend to depend upon the balancing of risk and reward. The reward to the contractor will be influenced by the amount of perceived risk, that is, the higher the risk that the contractor is expected to meet, then the higher the reward that the contractor will expect to receive. In practice, where risk is deemed to be high both for its frequency and impact, the customer normally bears this risk, supporting a standard cost reimbursable (or ‘time and materials’) type of contract. For low risk projects, the contractor is more likely to bear the risk with a fixed cost type of contract preferred. An example of the former may be an innovative oil construction computer control system in a frontier zone, whilst ongoing systems support may typify the latter. A third major category has emerged in recent years, where various concepts of sharing risk and reward have been created, to be known as incentive or target cost contracts, frequently as part of long term ‘alliancing’ relationships. All three types of contracts are found within ITS-UK, with the target cost tending to dominate the larger contracts and therefore comprise a significant element of the sales revenue. An example of such a contract is shown in Exhibit 2. EXHIBIT 2: Target contract example (selected items from internal contract brief) Contract scope: Provision of outsourcing arrangements for the Information Systems and Records Management Functions at Company X. Contract type: 2012, Ceiling price with sharing of any underruns only, plus Discretionary Services project work to be remunerated on a time and materials basis (agreed rates listed separately). Ceiling price for 2012: £784 000 Underrun sharing: Company X share: 40% ITS-UK share: 60% Performance award: From –5% to þ5%, payable quarterly. Note - basis for cost calculations is actual cost to ITS-UK plus an agreed mark up of 12%. Calculation of contract profits to ITS-UK at varying levels of actual chargeable costs: Actual ITS-UK contract cost for target contact = £784 000/1.12 = £700 000 Therefore the base for 2012 is that ITS-UK will receive revenue of £784 000 for a cost of £700 000, i.e. a profit (mark-up) of £84 000. This mark-up is payable, regardless of actual cost. For a sample of lower resultant costs, profit share will be as follows: The profit to contractor will be adjusted per the performance award and any costs that are not recoverable, according to contract. CONTRACT COSTS Each client, covering several contracts, or sometimes a single major contract, is treated as a profit centre, to include all costs that are specific to the contract, plus indirect cost allocations, and their revenues. It is crucial to the profitability of all target and time and materials contracts to be as clear as to what is recoverable in the contract, i.e. that which will be paid by the client. The contract should list all categories of support staff and probably their rates, along with all services and equipment. For example, if 50% of an accountant is recoverable per a large contract, but 75% of an accountant’s time is actually used to support the contract, 50% will be charged to the client and the other 25% will have to be absorbed by ITS-UK, i.e. as a general overhead cost, directly charged against ITS-UK’s own profits. These recoverable costs are often known as ‘direct cost’ which is not as normal per cost accounting terminology, where an accountant’s time, partially allocated to a contract, would be regarded as an indirect cost. An example of a small contract build-up, for quotation purposes is as follows: EXHIBIT 3 Contract details for bid preparation Note 1 - FTE - Full-time equivalent person, e.g. 0.5 FTE is half a person’s workload. Note 2 - includes commercial, finance and admin. support (on a pro-rata headcount basis, plus office consumables, telephone and internal IT support). How these are identified to the client will depend on the type of contract. For a fixed price contract, these will be internally recorded costs only: for a target or reimbursable contract, these items will all be specifically agreed with the client, for client’s account. PLANNING For business planning purposes, the time horizon tends to be shorter than for most organisations. Business had been expanding rapidly, with the only real constraint being resources, where there has been a shortage of technically skilled IT people. The larger contracts tended to be for three to five years, so that a high degree of security exists for the levels of income from the major clients in the medium term. Otherwise, the annual budget cycle tends to predominate, to meet corporate objectives, with a general plan for the longer term, mainly focusing on the larger contracts plus a general business view for potential markets. BUDGETING Until recently, the budget had been prepared on a programme basis, i.e. by client, and for the total UK operations, to support corporate planning requirements. Control therefore could only applied to these levels, effectively the client as the profit centre, with the back office groups being excluded, to any detailed extent. The overall results, which were not meeting profit expectations, led to the realisation that further controls were required. From this year, the budget has also been structured by all responsibility centres, that is, to include the back offices as expense centres. An example of the new budgetary structure, with illustrative numbers, is shown in summary below: EXHIBIT 4 Outline of the 2012 budgeting and reporting format (£000): In practice, each of the cost categories will be analysed by individual item, per the ITS-UK chart of accounts: • Labour is broken down by category of job function and numbers of each (FTE’s- full time equivalents), such as the client Management above as: • Agency staff are similarly analysed. • Subcontracts are individually identified. These are often a substantial part of the main contract, such as the provision of specialist geophysical services to an oil company, but which is deemed, by the oil company, to be part of the general systems support by ITS-UK. This is part of the oil industry’s general policy to limit the number of contractors with which it directly communicates. In the above example, the £80,000 Applications sub-contract may be for specialist services, which will be managed by the Applications Service Delivery Manager on behalf of the total contract, so will be accountable to the Client Manager for its performance. • Other costs - these are the recoverable costs of the contract. They are individually identified in the budget, such as hardware maintenance, software licences, telephone and travel costs. The concept is that, for each profit centre (or contract) cost item, the department responsible for that cost will be identified, leading to a bottom line number for each manager, for which he or she will be held accountable. For Applications and Infrastructure, the two main expenditure areas, where any total cost is expected to impact the contract in any way, the manager concerned must discuss and agree this with the client manager. In the above example, the Applications manager is responsible for a budget of £720,000, the limit for which he can spend without any agreement with the Client Manager, providing services meet the contractual specifications. BUDGET PREPARATION The following steps are observed: 1. The year’s programme is agreed, essentially: • Confirm the continuation of existing contracts. • Clarify contract renewal expectations, for contracts that will be up for renewal in the budget period. • Agree scope of any new business. 2. All departmental managers prepare their budget costs, by person and cost detail, for each contract or new business category. 3. Results are consolidated by contract, or new business category, by budget coordinator. 4. Service Delivery Managers then review their results with each of the Client Managers, for agreement as to conformance with contract and to ensure that derived profit margins are as expected. 5. Once agreed, all results are consolidated, along with staff service departments, to produce a draft operational budget for Outsourcing Services, for review by the Group Manager to ensure that corporate objectives are met. 6. Adjustments may be made, as required (they usually are!). MANAGEMENT REPORTING Quarterly reports are transmitted to the head office, for the major contracts, overall actual cost position and full year forecasts. For major international clients, a world-wide consolidation is undertaken for overall ITSI support, i.e. global support for global companies; an increasing expectation of such clients. Internal monthly reports are reviewed by the Operations Manager with his client and service delivery managers. An example of a section of the report is shown below for July 2012, for one particular major client (one profit centre) with six different contracts: Supporting these reports would be cost details on the budget basis, i.e. each cost identified per the service delivery department, so that actual costs would be reported alongside the budget numbers, per Exhibit 4 structure. In practice, this is very limited in its use. The computurised accounting system (a modern integrated ‘enterprise’ reporting system) has the facility to accomodate the input of budget data, but it requires the budget to be prepared at a very detailed level for input, which is very time consuming and has not yet been adequately implemented. Comparisons are therefore made on a manual basis, e.g. by downloading the relevant actual data in the budget format. For example, if the budget identifies a training cost for Applications staff on Exoil Oil & Chemicals, actual data will be extracted manually from the system for direct comparison. This type of work is partially performed, but the problem is the heavy use of resources to prepare the reports; a good example of the increasing overhead costs deemed necessary to support the overall business, but which is cutting into the overall net margin. The gross margin of 20%, per Exhibit 5, was in line with expectations, though only just so; the E-mail operations need to be reviewed, as a minimum. The 20% margin was effectively a contribution to overheads and net profit, with the former of these of increasing significance, as previously discussed. EXHIBIT 5 Service delivery report for July 2012 (extract): The real significance to these overheads is not obvious in these reports, merely a realisation that a 20% gross margin may not be sufficient to meet the 6% corporate net target. The full company financial status is only produced on a quarterly basis. The latest report (Exhibit 6). shows that the absorption of the overheads from the staff services, plus time allocated by the senior staff of the outsourcing operations that does not directly relate to any of the contracts, such as forward planning and marketing, results in a net margin of 3.1% (£2.3 million over £75.0 million sales), an unsatisfactory situation. This position is also down from the total company actual results of 2011, as illustrated below. Further details of the 2011 reported results are shown in Exhibit 7 EXHIBIT 6 Profit statement summary 2011 full year forecast versus 2011, as at 1 July 2012: EXHIBIT 7 Integrated Technology Services (UK) LTD Summarised Published accounts: QUESTIONS: Following the review of the planning and control systems of Integrated Technology Services (UK) Ltd (ITS-UK), the Group Manager James Gunn has asked you, the consultant, into his office to discuss a number of points arising. He is accompanied by the Operations Manager. Mr Gunn opened the meeting, “We have some concern with the net profit margin as the sole performance measure of our business. It is not necessarily the actual percentage of 6% that is giving us trouble, maybe it is a suitable figure as many of our competitors are facing even tighter margins, but it is the concept. Frankly, we are not clear as to why this is the sole measurement criteria, surely there are other ways of measuring how well our business is performing. We believe that we have a good business and the market is there for future growth, but maybe there are other ways of looking at how well we are doing. We are not financial people, so we look to you to help. We would therefore like you to look into this and prepare a report on the merits of this net margin measure and any suitable alternatives that we can propose to our corporate managers. The other item that we want you to review is the budget process. Here, we believe that we have a good system, but we need to get it running properly. The problem is that it is going to take more resources to do so, probably an extra accountant for some £35,000 per year, plus benefits and support costs which will come to nearly £50,000. We therefore need a good case to go to head office to justify this and we would like you to come up with that justification.” REQUIRED: 1. Prepare the report on the net margin, as requested by the Group Manager. 2. Prepare a justification of the budgeting system, covering the principles of the budget, its features and advantages, in general, along with the specific advantages for ITS-UK, to meet the needs of local management.
Consultancy This is the oldest established business unit of ITS-UK. It is relatively independent with a separate client base from that of the outsourcing business, though there is some commonality as its consultancy is essentially for systems applications and integration. It shares the staff services with the rest of the company, with an occasional requirement for the services of the other groups, such as the Infrastructure department, on an advisory basis. Outsourcing Services As with many modern service providers, the functions are divided into those that deal directly with the client, known as the front office, with the back-office delivery managers in charge of departments that provide the actual support staff, as follows: • Marketing department is a small group, which has the responsibility to find new business. Staff will read initial customer requirement reviews and contract negotiations, along with appropriate resources from other departments. • Client Account Managers head small departments who are in direct ongoing communication with the customer, once the contract is approved and work is ready to commence. They are to ensure that the contractual requirements are properly followed to meet customer expectations. This, in practice, is largely to meet the following criteria: (a). That proper resources are provided from the main groups of Applications Infrastructure and e-mail, to meet contract specifications, e.g. the right number of the appropriately qualified systems engineers, as defined in the contract. (b). That excess resources are not allocated to the project, due to support staff lack of contract understanding. The departments are structured on the basis of client requirements. An oil and gas group was originally developed to support one particularly large client, from which many of the staff were transferred to ITS-UK to carry on the work that they had previously provided. This original group was later divided into two, to reflect the two-division structure of the oil industry, the upstream exploration and production and the downstream marketing and refining. The Operations South group covers all other industries and local government departments. • Applications department provides the technical resources to develop and support clients’ IT applications systems. • Infrastructure department provides the technical resources to implement and support all computer hardware, telecommunications and networking requirements. It also includes a front-line help-desk support which is the first point of call for any customer call, such as computer, telephone or application system problems. • E-mail is a specialist group that provides electronic mail services to customers. Planning is a critical function for each of the Applications, Infrastructure and E-mail delivery managers, both with the marketing managers for early warnings as to staff requirements and with client management for ongoing needs. This latter feature has been difficult to achieve due to regular contract change requests by the major clients. The overall organisation is of a matrix nature, where the service delivery managers (SDM’s) provide some 750 people to a broad range of contracts. Some staff may be permanently assigned to a major client, whilst others could be working on several different contracts in a single week. BUSINESS CONTROLS OVERVIEW Expansion in Outsourcing had been rapid, with an emphasis on drive and initiative, to some neglect of a detailed controls framework. The main financial performance measure is the net margin. This is set by corporate headquarters as 6%, which effectively is the prime objective if ITS-UK. Contacts with clients tend to be agreed on a gross margin basis, but which obviously must be carefully set, usually at least 20%. This has been deemed to be the minimum required contribution to cover overheads and profit, although questions were being raised as to the appropriateness of this level as the net margin of 6% is becoming increasingly difficult to achieve, with some of the following points raised as contributory factors: 1. Following the early, large, long-term contracts, which were relatively simple to administer, overhead costs have risen disproportionately due to: • many small contracts, which administratively are often as expensive as much larger ones; overall lower net margins are therefore a natural outcome of the decreasing size of average contracts; • lack of standardisation of contract terms leading to complex administrative and financial controls, e.g. billing • arrangements have to be individually monitored, as computer systems have been unable to fully accommodate all the variations. The 20% gross margin target is therefore contributing increasingly more to overheads than to profit. 2. A further reason for lowering profitability is believed to be that the drive for market share, which had taken precedence over gross margin, has resulted in ‘loss-leaders’ which were not living up to expectations. One particular large contract, started with a 15% gross margin, in the expectancy of leading to other more lucrative work, but has not yet proved to have done so. 3. The mechanism of charging the IT person’s time to the contract, through a timesheet, is not being properly controlled. Staff may work on a number of small contracts in a week, possibly for the same client, which is not always obvious to the person concerned. Time is therefore often incorrectly charged, which results in a waste of administrative effort to correct, along with client dissatisfaction. A particularly difficult situation is where a variety of different types of contracts may be in force with a single client company. A systems engineer may work on a fixed price contract on one day so that time charged to the contract will be for internal ITS-UK purposes only, i.e. it will not affect the charge to the client. Then on the following day, he may be supporting a reimbursable (time and materials) contract, when time charged is reimbursed by the client. If these times get mixed up, the consequences can be significant. A lack of contract understanding therefore may be leading to costs, that should be chargeable to the contract and paid by the client, are not being identified as such. These costs will therefore remain as a charge against ITS-UK’s profits. 4. The increasing complexity of the matrix organisation may be leading to wastage. Ideally, resources should be provided to meet clients’ needs as and when needed. In practice, this flexibility can only be met if there are readily available staff resources at any time, which would inevitably lead to reserve people. However, such standby staff have a price, who generate no income, if not used. A response to the above problems has been to improve financial planning and budgetary controls. Before looking at these two control mechanisms, the nature of the various contractual arrangements must be understood. CONTRACTURAL RELATIONSHIPS ITS-UK receives its income through the provision of technology services, which are governed by various contractual relationships with the client. This commercial relationship will tend to depend upon the balancing of risk and reward. The reward to the contractor will be influenced by the amount of perceived risk, that is, the higher the risk that the contractor is expected to meet, then the higher the reward that the contractor will expect to receive. In practice, where risk is deemed to be high both for its frequency and impact, the customer normally bears this risk, supporting a standard cost reimbursable (or ‘time and materials’) type of contract. For low risk projects, the contractor is more likely to bear the risk with a fixed cost type of contract preferred. An example of the former may be an innovative oil construction computer control system in a frontier zone, whilst ongoing systems support may typify the latter. A third major category has emerged in recent years, where various concepts of sharing risk and reward have been created, to be known as incentive or target cost contracts, frequently as part of long term ‘alliancing’ relationships. All three types of contracts are found within ITS-UK, with the target cost tending to dominate the larger contracts and therefore comprise a significant element of the sales revenue. An example of such a contract is shown in Exhibit 2. EXHIBIT 2:
In November 2012, a consultant was employed to review and document the planning and control systems of Integrated Technology Services (UK) Ltd (ITS-UK), to ensure that these were effectively meeting the needs of the business and to provide a basis for staff training. ITS-UK is the British subsidiary of Integrated Technology Services International (ITSI), a technology company, based in the north-east USA, which has history of developing and providing technology solutions to major international corporations and the US Government. It has focused on science and technology as a core strength with a significant Research and Development (R&D) expenditure. It is also noted for its extensive employee share ownership scheme, to encourage staff business awareness. The UK operations are based on two main activities: 1. Consultancy services to a range of businesses; 2. Computing and telecommunications outsourcing support to companies, particularly the oil and gas industry, but increasingly to other industries and to the public sector. The latter activity has been in response to the business opportunities created by a variety of industries that have preferred to focus on their ‘core competencies’ and outsource some of their internal support functions to external providers, particularly in information technology and accounting. The Government has also reinforced the trend by the compulsory tendering of many of its internal services in competition with outside providers. At the same time, outsourcing of information technology (IT) services has developed in the USA, where the parent company has progressed. Project management has been a particular strength within the corporate body, developed over its 30-year history. This expertise has also been used to advantage by its UK subsidiary, with the readily available facilities of US based staff, when dealing with multi-national corporations. ORGANISATIONAL STRUCTURE ITS-UK is structured into three groups of activities: • Consultancy business as a small separate unit • Outsourcing Services on a matrix organisational basis • Staff services, such as Finance, Commercial and Human Resource and Administration EXHIBIT 1: Consultancy This is the oldest established business unit of ITS-UK. It is relatively independent with a separate client base from that of the outsourcing business, though there is some commonality as its consultancy is essentially for systems applications and integration. It shares the staff services with the rest of the company, with an occasional requirement for the services of the other groups, such as the Infrastructure department, on an advisory basis. Outsourcing Services As with many modern service providers, the functions are divided into those that deal directly with the client, known as the front office, with the back-office delivery managers in charge of departments that provide the actual support staff, as follows: • Marketing department is a small group, which has the responsibility to find new business. Staff will read initial customer requirement reviews and contract negotiations, along with appropriate resources from other departments. • Client Account Managers head small departments who are in direct ongoing communication with the customer, once the contract is approved and work is ready to commence. They are to ensure that the contractual requirements are properly followed to meet customer expectations. This, in practice, is largely to meet the following criteria: (a). That proper resources are provided from the main groups of Applications Infrastructure and e-mail, to meet contract specifications, e.g. the right number of the appropriately qualified systems engineers, as defined in the contract. (b). That excess resources are not allocated to the project, due to support staff lack of contract understanding. The departments are structured on the basis of client requirements. An oil and gas group was originally developed to support one particularly large client, from which many of the staff were transferred to ITS-UK to carry on the work that they had previously provided. This original group was later divided into two, to reflect the two-division structure of the oil industry, the upstream exploration and production and the downstream marketing and refining. The Operations South group covers all other industries and local government departments. • Applications department provides the technical resources to develop and support clients’ IT applications systems. • Infrastructure department provides the technical resources to implement and support all computer hardware, telecommunications and networking requirements. It also includes a front-line help-desk support which is the first point of call for any customer call, such as computer, telephone or application system problems. • E-mail is a specialist group that provides electronic mail services to customers. Planning is a critical function for each of the Applications, Infrastructure and E-mail delivery managers, both with the marketing managers for early warnings as to staff requirements and with client management for ongoing needs. This latter feature has been difficult to achieve due to regular contract change requests by the major clients. The overall organisation is of a matrix nature, where the service delivery managers (SDM’s) provide some 750 people to a broad range of contracts. Some staff may be permanently assigned to a major client, whilst others could be working on several different contracts in a single week. BUSINESS CONTROLS OVERVIEW Expansion in Outsourcing had been rapid, with an emphasis on drive and initiative, to some neglect of a detailed controls framework. The main financial performance measure is the net margin. This is set by corporate headquarters as 6%, which effectively is the prime objective if ITS-UK. Contacts with clients tend to be agreed on a gross margin basis, but which obviously must be carefully set, usually at least 20%. This has been deemed to be the minimum required contribution to cover overheads and profit, although questions were being raised as to the appropriateness of this level as the net margin of 6% is becoming increasingly difficult to achieve, with some of the following points raised as contributory factors: 1. Following the early, large, long-term contracts, which were relatively simple to administer, overhead costs have risen disproportionately due to: • many small contracts, which administratively are often as expensive as much larger ones; overall lower net margins are therefore a natural outcome of the decreasing size of average contracts; • lack of standardisation of contract terms leading to complex administrative and financial controls, e.g. billing • arrangements have to be individually monitored, as computer systems have been unable to fully accommodate all the variations. The 20% gross margin target is therefore contributing increasingly more to overheads than to profit. 2. A further reason for lowering profitability is believed to be that the drive for market share, which had taken precedence over gross margin, has resulted in ‘loss-leaders’ which were not living up to expectations. One particular large contract, started with a 15% gross margin, in the expectancy of leading to other more lucrative work, but has not yet proved to have done so. 3. The mechanism of charging the IT person’s time to the contract, through a timesheet, is not being properly controlled. Staff may work on a number of small contracts in a week, possibly for the same client, which is not always obvious to the person concerned. Time is therefore often incorrectly charged, which results in a waste of administrative effort to correct, along with client dissatisfaction. A particularly difficult situation is where a variety of different types of contracts may be in force with a single client company. A systems engineer may work on a fixed price contract on one day so that time charged to the contract will be for internal ITS-UK purposes only, i.e. it will not affect the charge to the client. Then on the following day, he may be supporting a reimbursable (time and materials) contract, when time charged is reimbursed by the client. If these times get mixed up, the consequences can be significant. A lack of contract understanding therefore may be leading to costs, that should be chargeable to the contract and paid by the client, are not being identified as such. These costs will therefore remain as a charge against ITS-UK’s profits. 4. The increasing complexity of the matrix organisation may be leading to wastage. Ideally, resources should be provided to meet clients’ needs as and when needed. In practice, this flexibility can only be met if there are readily available staff resources at any time, which would inevitably lead to reserve people. However, such standby staff have a price, who generate no income, if not used. A response to the above problems has been to improve financial planning and budgetary controls. Before looking at these two control mechanisms, the nature of the various contractual arrangements must be understood. CONTRACTURAL RELATIONSHIPS ITS-UK receives its income through the provision of technology services, which are governed by various contractual relationships with the client. This commercial relationship will tend to depend upon the balancing of risk and reward. The reward to the contractor will be influenced by the amount of perceived risk, that is, the higher the risk that the contractor is expected to meet, then the higher the reward that the contractor will expect to receive. In practice, where risk is deemed to be high both for its frequency and impact, the customer normally bears this risk, supporting a standard cost reimbursable (or ‘time and materials’) type of contract. For low risk projects, the contractor is more likely to bear the risk with a fixed cost type of contract preferred. An example of the former may be an innovative oil construction computer control system in a frontier zone, whilst ongoing systems support may typify the latter. A third major category has emerged in recent years, where various concepts of sharing risk and reward have been created, to be known as incentive or target cost contracts, frequently as part of long term ‘alliancing’ relationships. All three types of contracts are found within ITS-UK, with the target cost tending to dominate the larger contracts and therefore comprise a significant element of the sales revenue. An example of such a contract is shown in Exhibit 2. EXHIBIT 2: Target contract example (selected items from internal contract brief) Contract scope: Provision of outsourcing arrangements for the Information Systems and Records Management Functions at Company X. Contract type: 2012, Ceiling price with sharing of any underruns only, plus Discretionary Services project work to be remunerated on a time and materials basis (agreed rates listed separately). Ceiling price for 2012: £784 000 Underrun sharing: Company X share: 40% ITS-UK share: 60% Performance award: From –5% to þ5%, payable quarterly. Note - basis for cost calculations is actual cost to ITS-UK plus an agreed mark up of 12%. Calculation of contract profits to ITS-UK at varying levels of actual chargeable costs: Actual ITS-UK contract cost for target contact = £784 000/1.12 = £700 000 Therefore the base for 2012 is that ITS-UK will receive revenue of £784 000 for a cost of £700 000, i.e. a profit (mark-up) of £84 000. This mark-up is payable, regardless of actual cost. For a sample of lower resultant costs, profit share will be as follows: The profit to contractor will be adjusted per the performance award and any costs that are not recoverable, according to contract. CONTRACT COSTS Each client, covering several contracts, or sometimes a single major contract, is treated as a profit centre, to include all costs that are specific to the contract, plus indirect cost allocations, and their revenues. It is crucial to the profitability of all target and time and materials contracts to be as clear as to what is recoverable in the contract, i.e. that which will be paid by the client. The contract should list all categories of support staff and probably their rates, along with all services and equipment. For example, if 50% of an accountant is recoverable per a large contract, but 75% of an accountant’s time is actually used to support the contract, 50% will be charged to the client and the other 25% will have to be absorbed by ITS-UK, i.e. as a general overhead cost, directly charged against ITS-UK’s own profits. These recoverable costs are often known as ‘direct cost’ which is not as normal per cost accounting terminology, where an accountant’s time, partially allocated to a contract, would be regarded as an indirect cost. An example of a small contract build-up, for quotation purposes is as follows: EXHIBIT 3 Contract details for bid preparation Note 1 - FTE - Full-time equivalent person, e.g. 0.5 FTE is half a person’s workload. Note 2 - includes commercial, finance and admin. support (on a pro-rata headcount basis, plus office consumables, telephone and internal IT support). How these are identified to the client will depend on the type of contract. For a fixed price contract, these will be internally recorded costs only: for a target or reimbursable contract, these items will all be specifically agreed with the client, for client’s account. PLANNING For business planning purposes, the time horizon tends to be shorter than for most organisations. Business had been expanding rapidly, with the only real constraint being resources, where there has been a shortage of technically skilled IT people. The larger contracts tended to be for three to five years, so that a high degree of security exists for the levels of income from the major clients in the medium term. Otherwise, the annual budget cycle tends to predominate, to meet corporate objectives, with a general plan for the longer term, mainly focusing on the larger contracts plus a general business view for potential markets. BUDGETING Until recently, the budget had been prepared on a programme basis, i.e. by client, and for the total UK operations, to support corporate planning requirements. Control therefore could only applied to these levels, effectively the client as the profit centre, with the back office groups being excluded, to any detailed extent. The overall results, which were not meeting profit expectations, led to the realisation that further controls were required. From this year, the budget has also been structured by all responsibility centres, that is, to include the back offices as expense centres. An example of the new budgetary structure, with illustrative numbers, is shown in summary below: EXHIBIT 4 Outline of the 2012 budgeting and reporting format (£000): In practice, each of the cost categories will be analysed by individual item, per the ITS-UK chart of accounts: • Labour is broken down by category of job function and numbers of each (FTE’s- full time equivalents), such as the client Management above as: • Agency staff are similarly analysed. • Subcontracts are individually identified. These are often a substantial part of the main contract, such as the provision of specialist geophysical services to an oil company, but which is deemed, by the oil company, to be part of the general systems support by ITS-UK. This is part of the oil industry’s general policy to limit the number of contractors with which it directly communicates. In the above example, the £80,000 Applications sub-contract may be for specialist services, which will be managed by the Applications Service Delivery Manager on behalf of the total contract, so will be accountable to the Client Manager for its performance. • Other costs - these are the recoverable costs of the contract. They are individually identified in the budget, such as hardware maintenance, software licences, telephone and travel costs. The concept is that, for each profit centre (or contract) cost item, the department responsible for that cost will be identified, leading to a bottom line number for each manager, for which he or she will be held accountable. For Applications and Infrastructure, the two main expenditure areas, where any total cost is expected to impact the contract in any way, the manager concerned must discuss and agree this with the client manager. In the above example, the Applications manager is responsible for a budget of £720,000, the limit for which he can spend without any agreement with the Client Manager, providing services meet the contractual specifications. BUDGET PREPARATION The following steps are observed: 1. The year’s programme is agreed, essentially: • Confirm the continuation of existing contracts. • Clarify contract renewal expectations, for contracts that will be up for renewal in the budget period. • Agree scope of any new business. 2. All departmental managers prepare their budget costs, by person and cost detail, for each contract or new business category. 3. Results are consolidated by contract, or new business category, by budget coordinator. 4. Service Delivery Managers then review their results with each of the Client Managers, for agreement as to conformance with contract and to ensure that derived profit margins are as expected. 5. Once agreed, all results are consolidated, along with staff service departments, to produce a draft operational budget for Outsourcing Services, for review by the Group Manager to ensure that corporate objectives are met. 6. Adjustments may be made, as required (they usually are!). MANAGEMENT REPORTING Quarterly reports are transmitted to the head office, for the major contracts, overall actual cost position and full year forecasts. For major international clients, a world-wide consolidation is undertaken for overall ITSI support, i.e. global support for global companies; an increasing expectation of such clients. Internal monthly reports are reviewed by the Operations Manager with his client and service delivery managers. An example of a section of the report is shown below for July 2012, for one particular major client (one profit centre) with six different contracts: Supporting these reports would be cost details on the budget basis, i.e. each cost identified per the service delivery department, so that actual costs would be reported alongside the budget numbers, per Exhibit 4 structure. In practice, this is very limited in its use. The computurised accounting system (a modern integrated ‘enterprise’ reporting system) has the facility to accomodate the input of budget data, but it requires the budget to be prepared at a very detailed level for input, which is very time consuming and has not yet been adequately implemented. Comparisons are therefore made on a manual basis, e.g. by downloading the relevant actual data in the budget format. For example, if the budget identifies a training cost for Applications staff on Exoil Oil & Chemicals, actual data will be extracted manually from the system for direct comparison. This type of work is partially performed, but the problem is the heavy use of resources to prepare the reports; a good example of the increasing overhead costs deemed necessary to support the overall business, but which is cutting into the overall net margin. The gross margin of 20%, per Exhibit 5, was in line with expectations, though only just so; the E-mail operations need to be reviewed, as a minimum. The 20% margin was effectively a contribution to overheads and net profit, with the former of these of increasing significance, as previously discussed. EXHIBIT 5 Service delivery report for July 2012 (extract): The real significance to these overheads is not obvious in these reports, merely a realisation that a 20% gross margin may not be sufficient to meet the 6% corporate net target. The full company financial status is only produced on a quarterly basis. The latest report (Exhibit 6). shows that the absorption of the overheads from the staff services, plus time allocated by the senior staff of the outsourcing operations that does not directly relate to any of the contracts, such as forward planning and marketing, results in a net margin of 3.1% (£2.3 million over £75.0 million sales), an unsatisfactory situation. This position is also down from the total company actual results of 2011, as illustrated below. Further details of the 2011 reported results are shown in Exhibit 7 EXHIBIT 6 Profit statement summary 2011 full year forecast versus 2011, as at 1 July 2012: EXHIBIT 7 Integrated Technology Services (UK) LTD Summarised Published accounts: QUESTIONS: Following the review of the planning and control systems of Integrated Technology Services (UK) Ltd (ITS-UK), the Group Manager James Gunn has asked you, the consultant, into his office to discuss a number of points arising. He is accompanied by the Operations Manager. Mr Gunn opened the meeting, “We have some concern with the net profit margin as the sole performance measure of our business. It is not necessarily the actual percentage of 6% that is giving us trouble, maybe it is a suitable figure as many of our competitors are facing even tighter margins, but it is the concept. Frankly, we are not clear as to why this is the sole measurement criteria, surely there are other ways of measuring how well our business is performing. We believe that we have a good business and the market is there for future growth, but maybe there are other ways of looking at how well we are doing. We are not financial people, so we look to you to help. We would therefore like you to look into this and prepare a report on the merits of this net margin measure and any suitable alternatives that we can propose to our corporate managers. The other item that we want you to review is the budget process. Here, we believe that we have a good system, but we need to get it running properly. The problem is that it is going to take more resources to do so, probably an extra accountant for some £35,000 per year, plus benefits and support costs which will come to nearly £50,000. We therefore need a good case to go to head office to justify this and we would like you to come up with that justification.” REQUIRED: 1. Prepare the report on the net margin, as requested by the Group Manager. 2. Prepare a justification of the budgeting system, covering the principles of the budget, its features and advantages, in general, along with the specific advantages for ITS-UK, to meet the needs of local management.
Target contract example (selected items from internal contract brief) Contract scope: Provision of outsourcing arrangements for the Information Systems and Records Management Functions at Company X. Contract type: 2012, Ceiling price with sharing of any underruns only, plus Discretionary Services project work to be remunerated on a time and materials basis (agreed rates listed separately). Ceiling price for 2012: £784 000 Underrun sharing: Company X share: 40% ITS-UK share: 60% Performance award: From –5% to þ5%, payable quarterly. Note - basis for cost calculations is actual cost to ITS-UK plus an agreed mark up of 12%. Calculation of contract profits to ITS-UK at varying levels of actual chargeable costs: Actual ITS-UK contract cost for target contact = £784 000/1.12 = £700 000 Therefore the base for 2012 is that ITS-UK will receive revenue of £784 000 for a cost of £700 000, i.e. a profit (mark-up) of £84 000. This mark-up is payable, regardless of actual cost. For a sample of lower resultant costs, profit share will be as follows:
In November 2012, a consultant was employed to review and document the planning and control systems of Integrated Technology Services (UK) Ltd (ITS-UK), to ensure that these were effectively meeting the needs of the business and to provide a basis for staff training. ITS-UK is the British subsidiary of Integrated Technology Services International (ITSI), a technology company, based in the north-east USA, which has history of developing and providing technology solutions to major international corporations and the US Government. It has focused on science and technology as a core strength with a significant Research and Development (R&D) expenditure. It is also noted for its extensive employee share ownership scheme, to encourage staff business awareness. The UK operations are based on two main activities: 1. Consultancy services to a range of businesses; 2. Computing and telecommunications outsourcing support to companies, particularly the oil and gas industry, but increasingly to other industries and to the public sector. The latter activity has been in response to the business opportunities created by a variety of industries that have preferred to focus on their ‘core competencies’ and outsource some of their internal support functions to external providers, particularly in information technology and accounting. The Government has also reinforced the trend by the compulsory tendering of many of its internal services in competition with outside providers. At the same time, outsourcing of information technology (IT) services has developed in the USA, where the parent company has progressed. Project management has been a particular strength within the corporate body, developed over its 30-year history. This expertise has also been used to advantage by its UK subsidiary, with the readily available facilities of US based staff, when dealing with multi-national corporations. ORGANISATIONAL STRUCTURE ITS-UK is structured into three groups of activities: • Consultancy business as a small separate unit • Outsourcing Services on a matrix organisational basis • Staff services, such as Finance, Commercial and Human Resource and Administration EXHIBIT 1: Consultancy This is the oldest established business unit of ITS-UK. It is relatively independent with a separate client base from that of the outsourcing business, though there is some commonality as its consultancy is essentially for systems applications and integration. It shares the staff services with the rest of the company, with an occasional requirement for the services of the other groups, such as the Infrastructure department, on an advisory basis. Outsourcing Services As with many modern service providers, the functions are divided into those that deal directly with the client, known as the front office, with the back-office delivery managers in charge of departments that provide the actual support staff, as follows: • Marketing department is a small group, which has the responsibility to find new business. Staff will read initial customer requirement reviews and contract negotiations, along with appropriate resources from other departments. • Client Account Managers head small departments who are in direct ongoing communication with the customer, once the contract is approved and work is ready to commence. They are to ensure that the contractual requirements are properly followed to meet customer expectations. This, in practice, is largely to meet the following criteria: (a). That proper resources are provided from the main groups of Applications Infrastructure and e-mail, to meet contract specifications, e.g. the right number of the appropriately qualified systems engineers, as defined in the contract. (b). That excess resources are not allocated to the project, due to support staff lack of contract understanding. The departments are structured on the basis of client requirements. An oil and gas group was originally developed to support one particularly large client, from which many of the staff were transferred to ITS-UK to carry on the work that they had previously provided. This original group was later divided into two, to reflect the two-division structure of the oil industry, the upstream exploration and production and the downstream marketing and refining. The Operations South group covers all other industries and local government departments. • Applications department provides the technical resources to develop and support clients’ IT applications systems. • Infrastructure department provides the technical resources to implement and support all computer hardware, telecommunications and networking requirements. It also includes a front-line help-desk support which is the first point of call for any customer call, such as computer, telephone or application system problems. • E-mail is a specialist group that provides electronic mail services to customers. Planning is a critical function for each of the Applications, Infrastructure and E-mail delivery managers, both with the marketing managers for early warnings as to staff requirements and with client management for ongoing needs. This latter feature has been difficult to achieve due to regular contract change requests by the major clients. The overall organisation is of a matrix nature, where the service delivery managers (SDM’s) provide some 750 people to a broad range of contracts. Some staff may be permanently assigned to a major client, whilst others could be working on several different contracts in a single week. BUSINESS CONTROLS OVERVIEW Expansion in Outsourcing had been rapid, with an emphasis on drive and initiative, to some neglect of a detailed controls framework. The main financial performance measure is the net margin. This is set by corporate headquarters as 6%, which effectively is the prime objective if ITS-UK. Contacts with clients tend to be agreed on a gross margin basis, but which obviously must be carefully set, usually at least 20%. This has been deemed to be the minimum required contribution to cover overheads and profit, although questions were being raised as to the appropriateness of this level as the net margin of 6% is becoming increasingly difficult to achieve, with some of the following points raised as contributory factors: 1. Following the early, large, long-term contracts, which were relatively simple to administer, overhead costs have risen disproportionately due to: • many small contracts, which administratively are often as expensive as much larger ones; overall lower net margins are therefore a natural outcome of the decreasing size of average contracts; • lack of standardisation of contract terms leading to complex administrative and financial controls, e.g. billing • arrangements have to be individually monitored, as computer systems have been unable to fully accommodate all the variations. The 20% gross margin target is therefore contributing increasingly more to overheads than to profit. 2. A further reason for lowering profitability is believed to be that the drive for market share, which had taken precedence over gross margin, has resulted in ‘loss-leaders’ which were not living up to expectations. One particular large contract, started with a 15% gross margin, in the expectancy of leading to other more lucrative work, but has not yet proved to have done so. 3. The mechanism of charging the IT person’s time to the contract, through a timesheet, is not being properly controlled. Staff may work on a number of small contracts in a week, possibly for the same client, which is not always obvious to the person concerned. Time is therefore often incorrectly charged, which results in a waste of administrative effort to correct, along with client dissatisfaction. A particularly difficult situation is where a variety of different types of contracts may be in force with a single client company. A systems engineer may work on a fixed price contract on one day so that time charged to the contract will be for internal ITS-UK purposes only, i.e. it will not affect the charge to the client. Then on the following day, he may be supporting a reimbursable (time and materials) contract, when time charged is reimbursed by the client. If these times get mixed up, the consequences can be significant. A lack of contract understanding therefore may be leading to costs, that should be chargeable to the contract and paid by the client, are not being identified as such. These costs will therefore remain as a charge against ITS-UK’s profits. 4. The increasing complexity of the matrix organisation may be leading to wastage. Ideally, resources should be provided to meet clients’ needs as and when needed. In practice, this flexibility can only be met if there are readily available staff resources at any time, which would inevitably lead to reserve people. However, such standby staff have a price, who generate no income, if not used. A response to the above problems has been to improve financial planning and budgetary controls. Before looking at these two control mechanisms, the nature of the various contractual arrangements must be understood. CONTRACTURAL RELATIONSHIPS ITS-UK receives its income through the provision of technology services, which are governed by various contractual relationships with the client. This commercial relationship will tend to depend upon the balancing of risk and reward. The reward to the contractor will be influenced by the amount of perceived risk, that is, the higher the risk that the contractor is expected to meet, then the higher the reward that the contractor will expect to receive. In practice, where risk is deemed to be high both for its frequency and impact, the customer normally bears this risk, supporting a standard cost reimbursable (or ‘time and materials’) type of contract. For low risk projects, the contractor is more likely to bear the risk with a fixed cost type of contract preferred. An example of the former may be an innovative oil construction computer control system in a frontier zone, whilst ongoing systems support may typify the latter. A third major category has emerged in recent years, where various concepts of sharing risk and reward have been created, to be known as incentive or target cost contracts, frequently as part of long term ‘alliancing’ relationships. All three types of contracts are found within ITS-UK, with the target cost tending to dominate the larger contracts and therefore comprise a significant element of the sales revenue. An example of such a contract is shown in Exhibit 2. EXHIBIT 2: Target contract example (selected items from internal contract brief) Contract scope: Provision of outsourcing arrangements for the Information Systems and Records Management Functions at Company X. Contract type: 2012, Ceiling price with sharing of any underruns only, plus Discretionary Services project work to be remunerated on a time and materials basis (agreed rates listed separately). Ceiling price for 2012: £784 000 Underrun sharing: Company X share: 40% ITS-UK share: 60% Performance award: From –5% to þ5%, payable quarterly. Note - basis for cost calculations is actual cost to ITS-UK plus an agreed mark up of 12%. Calculation of contract profits to ITS-UK at varying levels of actual chargeable costs: Actual ITS-UK contract cost for target contact = £784 000/1.12 = £700 000 Therefore the base for 2012 is that ITS-UK will receive revenue of £784 000 for a cost of £700 000, i.e. a profit (mark-up) of £84 000. This mark-up is payable, regardless of actual cost. For a sample of lower resultant costs, profit share will be as follows: The profit to contractor will be adjusted per the performance award and any costs that are not recoverable, according to contract. CONTRACT COSTS Each client, covering several contracts, or sometimes a single major contract, is treated as a profit centre, to include all costs that are specific to the contract, plus indirect cost allocations, and their revenues. It is crucial to the profitability of all target and time and materials contracts to be as clear as to what is recoverable in the contract, i.e. that which will be paid by the client. The contract should list all categories of support staff and probably their rates, along with all services and equipment. For example, if 50% of an accountant is recoverable per a large contract, but 75% of an accountant’s time is actually used to support the contract, 50% will be charged to the client and the other 25% will have to be absorbed by ITS-UK, i.e. as a general overhead cost, directly charged against ITS-UK’s own profits. These recoverable costs are often known as ‘direct cost’ which is not as normal per cost accounting terminology, where an accountant’s time, partially allocated to a contract, would be regarded as an indirect cost. An example of a small contract build-up, for quotation purposes is as follows: EXHIBIT 3 Contract details for bid preparation Note 1 - FTE - Full-time equivalent person, e.g. 0.5 FTE is half a person’s workload. Note 2 - includes commercial, finance and admin. support (on a pro-rata headcount basis, plus office consumables, telephone and internal IT support). How these are identified to the client will depend on the type of contract. For a fixed price contract, these will be internally recorded costs only: for a target or reimbursable contract, these items will all be specifically agreed with the client, for client’s account. PLANNING For business planning purposes, the time horizon tends to be shorter than for most organisations. Business had been expanding rapidly, with the only real constraint being resources, where there has been a shortage of technically skilled IT people. The larger contracts tended to be for three to five years, so that a high degree of security exists for the levels of income from the major clients in the medium term. Otherwise, the annual budget cycle tends to predominate, to meet corporate objectives, with a general plan for the longer term, mainly focusing on the larger contracts plus a general business view for potential markets. BUDGETING Until recently, the budget had been prepared on a programme basis, i.e. by client, and for the total UK operations, to support corporate planning requirements. Control therefore could only applied to these levels, effectively the client as the profit centre, with the back office groups being excluded, to any detailed extent. The overall results, which were not meeting profit expectations, led to the realisation that further controls were required. From this year, the budget has also been structured by all responsibility centres, that is, to include the back offices as expense centres. An example of the new budgetary structure, with illustrative numbers, is shown in summary below: EXHIBIT 4 Outline of the 2012 budgeting and reporting format (£000): In practice, each of the cost categories will be analysed by individual item, per the ITS-UK chart of accounts: • Labour is broken down by category of job function and numbers of each (FTE’s- full time equivalents), such as the client Management above as: • Agency staff are similarly analysed. • Subcontracts are individually identified. These are often a substantial part of the main contract, such as the provision of specialist geophysical services to an oil company, but which is deemed, by the oil company, to be part of the general systems support by ITS-UK. This is part of the oil industry’s general policy to limit the number of contractors with which it directly communicates. In the above example, the £80,000 Applications sub-contract may be for specialist services, which will be managed by the Applications Service Delivery Manager on behalf of the total contract, so will be accountable to the Client Manager for its performance. • Other costs - these are the recoverable costs of the contract. They are individually identified in the budget, such as hardware maintenance, software licences, telephone and travel costs. The concept is that, for each profit centre (or contract) cost item, the department responsible for that cost will be identified, leading to a bottom line number for each manager, for which he or she will be held accountable. For Applications and Infrastructure, the two main expenditure areas, where any total cost is expected to impact the contract in any way, the manager concerned must discuss and agree this with the client manager. In the above example, the Applications manager is responsible for a budget of £720,000, the limit for which he can spend without any agreement with the Client Manager, providing services meet the contractual specifications. BUDGET PREPARATION The following steps are observed: 1. The year’s programme is agreed, essentially: • Confirm the continuation of existing contracts. • Clarify contract renewal expectations, for contracts that will be up for renewal in the budget period. • Agree scope of any new business. 2. All departmental managers prepare their budget costs, by person and cost detail, for each contract or new business category. 3. Results are consolidated by contract, or new business category, by budget coordinator. 4. Service Delivery Managers then review their results with each of the Client Managers, for agreement as to conformance with contract and to ensure that derived profit margins are as expected. 5. Once agreed, all results are consolidated, along with staff service departments, to produce a draft operational budget for Outsourcing Services, for review by the Group Manager to ensure that corporate objectives are met. 6. Adjustments may be made, as required (they usually are!). MANAGEMENT REPORTING Quarterly reports are transmitted to the head office, for the major contracts, overall actual cost position and full year forecasts. For major international clients, a world-wide consolidation is undertaken for overall ITSI support, i.e. global support for global companies; an increasing expectation of such clients. Internal monthly reports are reviewed by the Operations Manager with his client and service delivery managers. An example of a section of the report is shown below for July 2012, for one particular major client (one profit centre) with six different contracts: Supporting these reports would be cost details on the budget basis, i.e. each cost identified per the service delivery department, so that actual costs would be reported alongside the budget numbers, per Exhibit 4 structure. In practice, this is very limited in its use. The computurised accounting system (a modern integrated ‘enterprise’ reporting system) has the facility to accomodate the input of budget data, but it requires the budget to be prepared at a very detailed level for input, which is very time consuming and has not yet been adequately implemented. Comparisons are therefore made on a manual basis, e.g. by downloading the relevant actual data in the budget format. For example, if the budget identifies a training cost for Applications staff on Exoil Oil & Chemicals, actual data will be extracted manually from the system for direct comparison. This type of work is partially performed, but the problem is the heavy use of resources to prepare the reports; a good example of the increasing overhead costs deemed necessary to support the overall business, but which is cutting into the overall net margin. The gross margin of 20%, per Exhibit 5, was in line with expectations, though only just so; the E-mail operations need to be reviewed, as a minimum. The 20% margin was effectively a contribution to overheads and net profit, with the former of these of increasing significance, as previously discussed. EXHIBIT 5 Service delivery report for July 2012 (extract): The real significance to these overheads is not obvious in these reports, merely a realisation that a 20% gross margin may not be sufficient to meet the 6% corporate net target. The full company financial status is only produced on a quarterly basis. The latest report (Exhibit 6). shows that the absorption of the overheads from the staff services, plus time allocated by the senior staff of the outsourcing operations that does not directly relate to any of the contracts, such as forward planning and marketing, results in a net margin of 3.1% (£2.3 million over £75.0 million sales), an unsatisfactory situation. This position is also down from the total company actual results of 2011, as illustrated below. Further details of the 2011 reported results are shown in Exhibit 7 EXHIBIT 6 Profit statement summary 2011 full year forecast versus 2011, as at 1 July 2012: EXHIBIT 7 Integrated Technology Services (UK) LTD Summarised Published accounts: QUESTIONS: Following the review of the planning and control systems of Integrated Technology Services (UK) Ltd (ITS-UK), the Group Manager James Gunn has asked you, the consultant, into his office to discuss a number of points arising. He is accompanied by the Operations Manager. Mr Gunn opened the meeting, “We have some concern with the net profit margin as the sole performance measure of our business. It is not necessarily the actual percentage of 6% that is giving us trouble, maybe it is a suitable figure as many of our competitors are facing even tighter margins, but it is the concept. Frankly, we are not clear as to why this is the sole measurement criteria, surely there are other ways of measuring how well our business is performing. We believe that we have a good business and the market is there for future growth, but maybe there are other ways of looking at how well we are doing. We are not financial people, so we look to you to help. We would therefore like you to look into this and prepare a report on the merits of this net margin measure and any suitable alternatives that we can propose to our corporate managers. The other item that we want you to review is the budget process. Here, we believe that we have a good system, but we need to get it running properly. The problem is that it is going to take more resources to do so, probably an extra accountant for some £35,000 per year, plus benefits and support costs which will come to nearly £50,000. We therefore need a good case to go to head office to justify this and we would like you to come up with that justification.” REQUIRED: 1. Prepare the report on the net margin, as requested by the Group Manager. 2. Prepare a justification of the budgeting system, covering the principles of the budget, its features and advantages, in general, along with the specific advantages for ITS-UK, to meet the needs of local management.
The profit to contractor will be adjusted per the performance award and any costs that are not recoverable, according to contract. CONTRACT COSTS Each client, covering several contracts, or sometimes a single major contract, is treated as a profit centre, to include all costs that are specific to the contract, plus indirect cost allocations, and their revenues. It is crucial to the profitability of all target and time and materials contracts to be as clear as to what is recoverable in the contract, i.e. that which will be paid by the client. The contract should list all categories of support staff and probably their rates, along with all services and equipment. For example, if 50% of an accountant is recoverable per a large contract, but 75% of an accountant’s time is actually used to support the contract, 50% will be charged to the client and the other 25% will have to be absorbed by ITS-UK, i.e. as a general overhead cost, directly charged against ITS-UK’s own profits. These recoverable costs are often known as ‘direct cost’ which is not as normal per cost accounting terminology, where an accountant’s time, partially allocated to a contract, would be regarded as an indirect cost. An example of a small contract build-up, for quotation purposes is as follows: EXHIBIT 3 Contract details for bid preparation
In November 2012, a consultant was employed to review and document the planning and control systems of Integrated Technology Services (UK) Ltd (ITS-UK), to ensure that these were effectively meeting the needs of the business and to provide a basis for staff training. ITS-UK is the British subsidiary of Integrated Technology Services International (ITSI), a technology company, based in the north-east USA, which has history of developing and providing technology solutions to major international corporations and the US Government. It has focused on science and technology as a core strength with a significant Research and Development (R&D) expenditure. It is also noted for its extensive employee share ownership scheme, to encourage staff business awareness. The UK operations are based on two main activities: 1. Consultancy services to a range of businesses; 2. Computing and telecommunications outsourcing support to companies, particularly the oil and gas industry, but increasingly to other industries and to the public sector. The latter activity has been in response to the business opportunities created by a variety of industries that have preferred to focus on their ‘core competencies’ and outsource some of their internal support functions to external providers, particularly in information technology and accounting. The Government has also reinforced the trend by the compulsory tendering of many of its internal services in competition with outside providers. At the same time, outsourcing of information technology (IT) services has developed in the USA, where the parent company has progressed. Project management has been a particular strength within the corporate body, developed over its 30-year history. This expertise has also been used to advantage by its UK subsidiary, with the readily available facilities of US based staff, when dealing with multi-national corporations. ORGANISATIONAL STRUCTURE ITS-UK is structured into three groups of activities: • Consultancy business as a small separate unit • Outsourcing Services on a matrix organisational basis • Staff services, such as Finance, Commercial and Human Resource and Administration EXHIBIT 1: Consultancy This is the oldest established business unit of ITS-UK. It is relatively independent with a separate client base from that of the outsourcing business, though there is some commonality as its consultancy is essentially for systems applications and integration. It shares the staff services with the rest of the company, with an occasional requirement for the services of the other groups, such as the Infrastructure department, on an advisory basis. Outsourcing Services As with many modern service providers, the functions are divided into those that deal directly with the client, known as the front office, with the back-office delivery managers in charge of departments that provide the actual support staff, as follows: • Marketing department is a small group, which has the responsibility to find new business. Staff will read initial customer requirement reviews and contract negotiations, along with appropriate resources from other departments. • Client Account Managers head small departments who are in direct ongoing communication with the customer, once the contract is approved and work is ready to commence. They are to ensure that the contractual requirements are properly followed to meet customer expectations. This, in practice, is largely to meet the following criteria: (a). That proper resources are provided from the main groups of Applications Infrastructure and e-mail, to meet contract specifications, e.g. the right number of the appropriately qualified systems engineers, as defined in the contract. (b). That excess resources are not allocated to the project, due to support staff lack of contract understanding. The departments are structured on the basis of client requirements. An oil and gas group was originally developed to support one particularly large client, from which many of the staff were transferred to ITS-UK to carry on the work that they had previously provided. This original group was later divided into two, to reflect the two-division structure of the oil industry, the upstream exploration and production and the downstream marketing and refining. The Operations South group covers all other industries and local government departments. • Applications department provides the technical resources to develop and support clients’ IT applications systems. • Infrastructure department provides the technical resources to implement and support all computer hardware, telecommunications and networking requirements. It also includes a front-line help-desk support which is the first point of call for any customer call, such as computer, telephone or application system problems. • E-mail is a specialist group that provides electronic mail services to customers. Planning is a critical function for each of the Applications, Infrastructure and E-mail delivery managers, both with the marketing managers for early warnings as to staff requirements and with client management for ongoing needs. This latter feature has been difficult to achieve due to regular contract change requests by the major clients. The overall organisation is of a matrix nature, where the service delivery managers (SDM’s) provide some 750 people to a broad range of contracts. Some staff may be permanently assigned to a major client, whilst others could be working on several different contracts in a single week. BUSINESS CONTROLS OVERVIEW Expansion in Outsourcing had been rapid, with an emphasis on drive and initiative, to some neglect of a detailed controls framework. The main financial performance measure is the net margin. This is set by corporate headquarters as 6%, which effectively is the prime objective if ITS-UK. Contacts with clients tend to be agreed on a gross margin basis, but which obviously must be carefully set, usually at least 20%. This has been deemed to be the minimum required contribution to cover overheads and profit, although questions were being raised as to the appropriateness of this level as the net margin of 6% is becoming increasingly difficult to achieve, with some of the following points raised as contributory factors: 1. Following the early, large, long-term contracts, which were relatively simple to administer, overhead costs have risen disproportionately due to: • many small contracts, which administratively are often as expensive as much larger ones; overall lower net margins are therefore a natural outcome of the decreasing size of average contracts; • lack of standardisation of contract terms leading to complex administrative and financial controls, e.g. billing • arrangements have to be individually monitored, as computer systems have been unable to fully accommodate all the variations. The 20% gross margin target is therefore contributing increasingly more to overheads than to profit. 2. A further reason for lowering profitability is believed to be that the drive for market share, which had taken precedence over gross margin, has resulted in ‘loss-leaders’ which were not living up to expectations. One particular large contract, started with a 15% gross margin, in the expectancy of leading to other more lucrative work, but has not yet proved to have done so. 3. The mechanism of charging the IT person’s time to the contract, through a timesheet, is not being properly controlled. Staff may work on a number of small contracts in a week, possibly for the same client, which is not always obvious to the person concerned. Time is therefore often incorrectly charged, which results in a waste of administrative effort to correct, along with client dissatisfaction. A particularly difficult situation is where a variety of different types of contracts may be in force with a single client company. A systems engineer may work on a fixed price contract on one day so that time charged to the contract will be for internal ITS-UK purposes only, i.e. it will not affect the charge to the client. Then on the following day, he may be supporting a reimbursable (time and materials) contract, when time charged is reimbursed by the client. If these times get mixed up, the consequences can be significant. A lack of contract understanding therefore may be leading to costs, that should be chargeable to the contract and paid by the client, are not being identified as such. These costs will therefore remain as a charge against ITS-UK’s profits. 4. The increasing complexity of the matrix organisation may be leading to wastage. Ideally, resources should be provided to meet clients’ needs as and when needed. In practice, this flexibility can only be met if there are readily available staff resources at any time, which would inevitably lead to reserve people. However, such standby staff have a price, who generate no income, if not used. A response to the above problems has been to improve financial planning and budgetary controls. Before looking at these two control mechanisms, the nature of the various contractual arrangements must be understood. CONTRACTURAL RELATIONSHIPS ITS-UK receives its income through the provision of technology services, which are governed by various contractual relationships with the client. This commercial relationship will tend to depend upon the balancing of risk and reward. The reward to the contractor will be influenced by the amount of perceived risk, that is, the higher the risk that the contractor is expected to meet, then the higher the reward that the contractor will expect to receive. In practice, where risk is deemed to be high both for its frequency and impact, the customer normally bears this risk, supporting a standard cost reimbursable (or ‘time and materials’) type of contract. For low risk projects, the contractor is more likely to bear the risk with a fixed cost type of contract preferred. An example of the former may be an innovative oil construction computer control system in a frontier zone, whilst ongoing systems support may typify the latter. A third major category has emerged in recent years, where various concepts of sharing risk and reward have been created, to be known as incentive or target cost contracts, frequently as part of long term ‘alliancing’ relationships. All three types of contracts are found within ITS-UK, with the target cost tending to dominate the larger contracts and therefore comprise a significant element of the sales revenue. An example of such a contract is shown in Exhibit 2. EXHIBIT 2: Target contract example (selected items from internal contract brief) Contract scope: Provision of outsourcing arrangements for the Information Systems and Records Management Functions at Company X. Contract type: 2012, Ceiling price with sharing of any underruns only, plus Discretionary Services project work to be remunerated on a time and materials basis (agreed rates listed separately). Ceiling price for 2012: £784 000 Underrun sharing: Company X share: 40% ITS-UK share: 60% Performance award: From –5% to þ5%, payable quarterly. Note - basis for cost calculations is actual cost to ITS-UK plus an agreed mark up of 12%. Calculation of contract profits to ITS-UK at varying levels of actual chargeable costs: Actual ITS-UK contract cost for target contact = £784 000/1.12 = £700 000 Therefore the base for 2012 is that ITS-UK will receive revenue of £784 000 for a cost of £700 000, i.e. a profit (mark-up) of £84 000. This mark-up is payable, regardless of actual cost. For a sample of lower resultant costs, profit share will be as follows: The profit to contractor will be adjusted per the performance award and any costs that are not recoverable, according to contract. CONTRACT COSTS Each client, covering several contracts, or sometimes a single major contract, is treated as a profit centre, to include all costs that are specific to the contract, plus indirect cost allocations, and their revenues. It is crucial to the profitability of all target and time and materials contracts to be as clear as to what is recoverable in the contract, i.e. that which will be paid by the client. The contract should list all categories of support staff and probably their rates, along with all services and equipment. For example, if 50% of an accountant is recoverable per a large contract, but 75% of an accountant’s time is actually used to support the contract, 50% will be charged to the client and the other 25% will have to be absorbed by ITS-UK, i.e. as a general overhead cost, directly charged against ITS-UK’s own profits. These recoverable costs are often known as ‘direct cost’ which is not as normal per cost accounting terminology, where an accountant’s time, partially allocated to a contract, would be regarded as an indirect cost. An example of a small contract build-up, for quotation purposes is as follows: EXHIBIT 3 Contract details for bid preparation Note 1 - FTE - Full-time equivalent person, e.g. 0.5 FTE is half a person’s workload. Note 2 - includes commercial, finance and admin. support (on a pro-rata headcount basis, plus office consumables, telephone and internal IT support). How these are identified to the client will depend on the type of contract. For a fixed price contract, these will be internally recorded costs only: for a target or reimbursable contract, these items will all be specifically agreed with the client, for client’s account. PLANNING For business planning purposes, the time horizon tends to be shorter than for most organisations. Business had been expanding rapidly, with the only real constraint being resources, where there has been a shortage of technically skilled IT people. The larger contracts tended to be for three to five years, so that a high degree of security exists for the levels of income from the major clients in the medium term. Otherwise, the annual budget cycle tends to predominate, to meet corporate objectives, with a general plan for the longer term, mainly focusing on the larger contracts plus a general business view for potential markets. BUDGETING Until recently, the budget had been prepared on a programme basis, i.e. by client, and for the total UK operations, to support corporate planning requirements. Control therefore could only applied to these levels, effectively the client as the profit centre, with the back office groups being excluded, to any detailed extent. The overall results, which were not meeting profit expectations, led to the realisation that further controls were required. From this year, the budget has also been structured by all responsibility centres, that is, to include the back offices as expense centres. An example of the new budgetary structure, with illustrative numbers, is shown in summary below: EXHIBIT 4 Outline of the 2012 budgeting and reporting format (£000): In practice, each of the cost categories will be analysed by individual item, per the ITS-UK chart of accounts: • Labour is broken down by category of job function and numbers of each (FTE’s- full time equivalents), such as the client Management above as: • Agency staff are similarly analysed. • Subcontracts are individually identified. These are often a substantial part of the main contract, such as the provision of specialist geophysical services to an oil company, but which is deemed, by the oil company, to be part of the general systems support by ITS-UK. This is part of the oil industry’s general policy to limit the number of contractors with which it directly communicates. In the above example, the £80,000 Applications sub-contract may be for specialist services, which will be managed by the Applications Service Delivery Manager on behalf of the total contract, so will be accountable to the Client Manager for its performance. • Other costs - these are the recoverable costs of the contract. They are individually identified in the budget, such as hardware maintenance, software licences, telephone and travel costs. The concept is that, for each profit centre (or contract) cost item, the department responsible for that cost will be identified, leading to a bottom line number for each manager, for which he or she will be held accountable. For Applications and Infrastructure, the two main expenditure areas, where any total cost is expected to impact the contract in any way, the manager concerned must discuss and agree this with the client manager. In the above example, the Applications manager is responsible for a budget of £720,000, the limit for which he can spend without any agreement with the Client Manager, providing services meet the contractual specifications. BUDGET PREPARATION The following steps are observed: 1. The year’s programme is agreed, essentially: • Confirm the continuation of existing contracts. • Clarify contract renewal expectations, for contracts that will be up for renewal in the budget period. • Agree scope of any new business. 2. All departmental managers prepare their budget costs, by person and cost detail, for each contract or new business category. 3. Results are consolidated by contract, or new business category, by budget coordinator. 4. Service Delivery Managers then review their results with each of the Client Managers, for agreement as to conformance with contract and to ensure that derived profit margins are as expected. 5. Once agreed, all results are consolidated, along with staff service departments, to produce a draft operational budget for Outsourcing Services, for review by the Group Manager to ensure that corporate objectives are met. 6. Adjustments may be made, as required (they usually are!). MANAGEMENT REPORTING Quarterly reports are transmitted to the head office, for the major contracts, overall actual cost position and full year forecasts. For major international clients, a world-wide consolidation is undertaken for overall ITSI support, i.e. global support for global companies; an increasing expectation of such clients. Internal monthly reports are reviewed by the Operations Manager with his client and service delivery managers. An example of a section of the report is shown below for July 2012, for one particular major client (one profit centre) with six different contracts: Supporting these reports would be cost details on the budget basis, i.e. each cost identified per the service delivery department, so that actual costs would be reported alongside the budget numbers, per Exhibit 4 structure. In practice, this is very limited in its use. The computurised accounting system (a modern integrated ‘enterprise’ reporting system) has the facility to accomodate the input of budget data, but it requires the budget to be prepared at a very detailed level for input, which is very time consuming and has not yet been adequately implemented. Comparisons are therefore made on a manual basis, e.g. by downloading the relevant actual data in the budget format. For example, if the budget identifies a training cost for Applications staff on Exoil Oil & Chemicals, actual data will be extracted manually from the system for direct comparison. This type of work is partially performed, but the problem is the heavy use of resources to prepare the reports; a good example of the increasing overhead costs deemed necessary to support the overall business, but which is cutting into the overall net margin. The gross margin of 20%, per Exhibit 5, was in line with expectations, though only just so; the E-mail operations need to be reviewed, as a minimum. The 20% margin was effectively a contribution to overheads and net profit, with the former of these of increasing significance, as previously discussed. EXHIBIT 5 Service delivery report for July 2012 (extract): The real significance to these overheads is not obvious in these reports, merely a realisation that a 20% gross margin may not be sufficient to meet the 6% corporate net target. The full company financial status is only produced on a quarterly basis. The latest report (Exhibit 6). shows that the absorption of the overheads from the staff services, plus time allocated by the senior staff of the outsourcing operations that does not directly relate to any of the contracts, such as forward planning and marketing, results in a net margin of 3.1% (£2.3 million over £75.0 million sales), an unsatisfactory situation. This position is also down from the total company actual results of 2011, as illustrated below. Further details of the 2011 reported results are shown in Exhibit 7 EXHIBIT 6 Profit statement summary 2011 full year forecast versus 2011, as at 1 July 2012: EXHIBIT 7 Integrated Technology Services (UK) LTD Summarised Published accounts: QUESTIONS: Following the review of the planning and control systems of Integrated Technology Services (UK) Ltd (ITS-UK), the Group Manager James Gunn has asked you, the consultant, into his office to discuss a number of points arising. He is accompanied by the Operations Manager. Mr Gunn opened the meeting, “We have some concern with the net profit margin as the sole performance measure of our business. It is not necessarily the actual percentage of 6% that is giving us trouble, maybe it is a suitable figure as many of our competitors are facing even tighter margins, but it is the concept. Frankly, we are not clear as to why this is the sole measurement criteria, surely there are other ways of measuring how well our business is performing. We believe that we have a good business and the market is there for future growth, but maybe there are other ways of looking at how well we are doing. We are not financial people, so we look to you to help. We would therefore like you to look into this and prepare a report on the merits of this net margin measure and any suitable alternatives that we can propose to our corporate managers. The other item that we want you to review is the budget process. Here, we believe that we have a good system, but we need to get it running properly. The problem is that it is going to take more resources to do so, probably an extra accountant for some £35,000 per year, plus benefits and support costs which will come to nearly £50,000. We therefore need a good case to go to head office to justify this and we would like you to come up with that justification.” REQUIRED: 1. Prepare the report on the net margin, as requested by the Group Manager. 2. Prepare a justification of the budgeting system, covering the principles of the budget, its features and advantages, in general, along with the specific advantages for ITS-UK, to meet the needs of local management.
Note 1 - FTE - Full-time equivalent person, e.g. 0.5 FTE is half a person’s workload. Note 2 - includes commercial, finance and admin. support (on a pro-rata headcount basis, plus office consumables, telephone and internal IT support). How these are identified to the client will depend on the type of contract. For a fixed price contract, these will be internally recorded costs only: for a target or reimbursable contract, these items will all be specifically agreed with the client, for client’s account. PLANNING For business planning purposes, the time horizon tends to be shorter than for most organisations. Business had been expanding rapidly, with the only real constraint being resources, where there has been a shortage of technically skilled IT people. The larger contracts tended to be for three to five years, so that a high degree of security exists for the levels of income from the major clients in the medium term. Otherwise, the annual budget cycle tends to predominate, to meet corporate objectives, with a general plan for the longer term, mainly focusing on the larger contracts plus a general business view for potential markets. BUDGETING Until recently, the budget had been prepared on a programme basis, i.e. by client, and for the total UK operations, to support corporate planning requirements. Control therefore could only applied to these levels, effectively the client as the profit centre, with the back office groups being excluded, to any detailed extent. The overall results, which were not meeting profit expectations, led to the realisation that further controls were required. From this year, the budget has also been structured by all responsibility centres, that is, to include the back offices as expense centres. An example of the new budgetary structure, with illustrative numbers, is shown in summary below: EXHIBIT 4 Outline of the 2012 budgeting and reporting format (£000):
In November 2012, a consultant was employed to review and document the planning and control systems of Integrated Technology Services (UK) Ltd (ITS-UK), to ensure that these were effectively meeting the needs of the business and to provide a basis for staff training. ITS-UK is the British subsidiary of Integrated Technology Services International (ITSI), a technology company, based in the north-east USA, which has history of developing and providing technology solutions to major international corporations and the US Government. It has focused on science and technology as a core strength with a significant Research and Development (R&D) expenditure. It is also noted for its extensive employee share ownership scheme, to encourage staff business awareness. The UK operations are based on two main activities: 1. Consultancy services to a range of businesses; 2. Computing and telecommunications outsourcing support to companies, particularly the oil and gas industry, but increasingly to other industries and to the public sector. The latter activity has been in response to the business opportunities created by a variety of industries that have preferred to focus on their ‘core competencies’ and outsource some of their internal support functions to external providers, particularly in information technology and accounting. The Government has also reinforced the trend by the compulsory tendering of many of its internal services in competition with outside providers. At the same time, outsourcing of information technology (IT) services has developed in the USA, where the parent company has progressed. Project management has been a particular strength within the corporate body, developed over its 30-year history. This expertise has also been used to advantage by its UK subsidiary, with the readily available facilities of US based staff, when dealing with multi-national corporations. ORGANISATIONAL STRUCTURE ITS-UK is structured into three groups of activities: • Consultancy business as a small separate unit • Outsourcing Services on a matrix organisational basis • Staff services, such as Finance, Commercial and Human Resource and Administration EXHIBIT 1: Consultancy This is the oldest established business unit of ITS-UK. It is relatively independent with a separate client base from that of the outsourcing business, though there is some commonality as its consultancy is essentially for systems applications and integration. It shares the staff services with the rest of the company, with an occasional requirement for the services of the other groups, such as the Infrastructure department, on an advisory basis. Outsourcing Services As with many modern service providers, the functions are divided into those that deal directly with the client, known as the front office, with the back-office delivery managers in charge of departments that provide the actual support staff, as follows: • Marketing department is a small group, which has the responsibility to find new business. Staff will read initial customer requirement reviews and contract negotiations, along with appropriate resources from other departments. • Client Account Managers head small departments who are in direct ongoing communication with the customer, once the contract is approved and work is ready to commence. They are to ensure that the contractual requirements are properly followed to meet customer expectations. This, in practice, is largely to meet the following criteria: (a). That proper resources are provided from the main groups of Applications Infrastructure and e-mail, to meet contract specifications, e.g. the right number of the appropriately qualified systems engineers, as defined in the contract. (b). That excess resources are not allocated to the project, due to support staff lack of contract understanding. The departments are structured on the basis of client requirements. An oil and gas group was originally developed to support one particularly large client, from which many of the staff were transferred to ITS-UK to carry on the work that they had previously provided. This original group was later divided into two, to reflect the two-division structure of the oil industry, the upstream exploration and production and the downstream marketing and refining. The Operations South group covers all other industries and local government departments. • Applications department provides the technical resources to develop and support clients’ IT applications systems. • Infrastructure department provides the technical resources to implement and support all computer hardware, telecommunications and networking requirements. It also includes a front-line help-desk support which is the first point of call for any customer call, such as computer, telephone or application system problems. • E-mail is a specialist group that provides electronic mail services to customers. Planning is a critical function for each of the Applications, Infrastructure and E-mail delivery managers, both with the marketing managers for early warnings as to staff requirements and with client management for ongoing needs. This latter feature has been difficult to achieve due to regular contract change requests by the major clients. The overall organisation is of a matrix nature, where the service delivery managers (SDM’s) provide some 750 people to a broad range of contracts. Some staff may be permanently assigned to a major client, whilst others could be working on several different contracts in a single week. BUSINESS CONTROLS OVERVIEW Expansion in Outsourcing had been rapid, with an emphasis on drive and initiative, to some neglect of a detailed controls framework. The main financial performance measure is the net margin. This is set by corporate headquarters as 6%, which effectively is the prime objective if ITS-UK. Contacts with clients tend to be agreed on a gross margin basis, but which obviously must be carefully set, usually at least 20%. This has been deemed to be the minimum required contribution to cover overheads and profit, although questions were being raised as to the appropriateness of this level as the net margin of 6% is becoming increasingly difficult to achieve, with some of the following points raised as contributory factors: 1. Following the early, large, long-term contracts, which were relatively simple to administer, overhead costs have risen disproportionately due to: • many small contracts, which administratively are often as expensive as much larger ones; overall lower net margins are therefore a natural outcome of the decreasing size of average contracts; • lack of standardisation of contract terms leading to complex administrative and financial controls, e.g. billing • arrangements have to be individually monitored, as computer systems have been unable to fully accommodate all the variations. The 20% gross margin target is therefore contributing increasingly more to overheads than to profit. 2. A further reason for lowering profitability is believed to be that the drive for market share, which had taken precedence over gross margin, has resulted in ‘loss-leaders’ which were not living up to expectations. One particular large contract, started with a 15% gross margin, in the expectancy of leading to other more lucrative work, but has not yet proved to have done so. 3. The mechanism of charging the IT person’s time to the contract, through a timesheet, is not being properly controlled. Staff may work on a number of small contracts in a week, possibly for the same client, which is not always obvious to the person concerned. Time is therefore often incorrectly charged, which results in a waste of administrative effort to correct, along with client dissatisfaction. A particularly difficult situation is where a variety of different types of contracts may be in force with a single client company. A systems engineer may work on a fixed price contract on one day so that time charged to the contract will be for internal ITS-UK purposes only, i.e. it will not affect the charge to the client. Then on the following day, he may be supporting a reimbursable (time and materials) contract, when time charged is reimbursed by the client. If these times get mixed up, the consequences can be significant. A lack of contract understanding therefore may be leading to costs, that should be chargeable to the contract and paid by the client, are not being identified as such. These costs will therefore remain as a charge against ITS-UK’s profits. 4. The increasing complexity of the matrix organisation may be leading to wastage. Ideally, resources should be provided to meet clients’ needs as and when needed. In practice, this flexibility can only be met if there are readily available staff resources at any time, which would inevitably lead to reserve people. However, such standby staff have a price, who generate no income, if not used. A response to the above problems has been to improve financial planning and budgetary controls. Before looking at these two control mechanisms, the nature of the various contractual arrangements must be understood. CONTRACTURAL RELATIONSHIPS ITS-UK receives its income through the provision of technology services, which are governed by various contractual relationships with the client. This commercial relationship will tend to depend upon the balancing of risk and reward. The reward to the contractor will be influenced by the amount of perceived risk, that is, the higher the risk that the contractor is expected to meet, then the higher the reward that the contractor will expect to receive. In practice, where risk is deemed to be high both for its frequency and impact, the customer normally bears this risk, supporting a standard cost reimbursable (or ‘time and materials’) type of contract. For low risk projects, the contractor is more likely to bear the risk with a fixed cost type of contract preferred. An example of the former may be an innovative oil construction computer control system in a frontier zone, whilst ongoing systems support may typify the latter. A third major category has emerged in recent years, where various concepts of sharing risk and reward have been created, to be known as incentive or target cost contracts, frequently as part of long term ‘alliancing’ relationships. All three types of contracts are found within ITS-UK, with the target cost tending to dominate the larger contracts and therefore comprise a significant element of the sales revenue. An example of such a contract is shown in Exhibit 2. EXHIBIT 2: Target contract example (selected items from internal contract brief) Contract scope: Provision of outsourcing arrangements for the Information Systems and Records Management Functions at Company X. Contract type: 2012, Ceiling price with sharing of any underruns only, plus Discretionary Services project work to be remunerated on a time and materials basis (agreed rates listed separately). Ceiling price for 2012: £784 000 Underrun sharing: Company X share: 40% ITS-UK share: 60% Performance award: From –5% to þ5%, payable quarterly. Note - basis for cost calculations is actual cost to ITS-UK plus an agreed mark up of 12%. Calculation of contract profits to ITS-UK at varying levels of actual chargeable costs: Actual ITS-UK contract cost for target contact = £784 000/1.12 = £700 000 Therefore the base for 2012 is that ITS-UK will receive revenue of £784 000 for a cost of £700 000, i.e. a profit (mark-up) of £84 000. This mark-up is payable, regardless of actual cost. For a sample of lower resultant costs, profit share will be as follows: The profit to contractor will be adjusted per the performance award and any costs that are not recoverable, according to contract. CONTRACT COSTS Each client, covering several contracts, or sometimes a single major contract, is treated as a profit centre, to include all costs that are specific to the contract, plus indirect cost allocations, and their revenues. It is crucial to the profitability of all target and time and materials contracts to be as clear as to what is recoverable in the contract, i.e. that which will be paid by the client. The contract should list all categories of support staff and probably their rates, along with all services and equipment. For example, if 50% of an accountant is recoverable per a large contract, but 75% of an accountant’s time is actually used to support the contract, 50% will be charged to the client and the other 25% will have to be absorbed by ITS-UK, i.e. as a general overhead cost, directly charged against ITS-UK’s own profits. These recoverable costs are often known as ‘direct cost’ which is not as normal per cost accounting terminology, where an accountant’s time, partially allocated to a contract, would be regarded as an indirect cost. An example of a small contract build-up, for quotation purposes is as follows: EXHIBIT 3 Contract details for bid preparation Note 1 - FTE - Full-time equivalent person, e.g. 0.5 FTE is half a person’s workload. Note 2 - includes commercial, finance and admin. support (on a pro-rata headcount basis, plus office consumables, telephone and internal IT support). How these are identified to the client will depend on the type of contract. For a fixed price contract, these will be internally recorded costs only: for a target or reimbursable contract, these items will all be specifically agreed with the client, for client’s account. PLANNING For business planning purposes, the time horizon tends to be shorter than for most organisations. Business had been expanding rapidly, with the only real constraint being resources, where there has been a shortage of technically skilled IT people. The larger contracts tended to be for three to five years, so that a high degree of security exists for the levels of income from the major clients in the medium term. Otherwise, the annual budget cycle tends to predominate, to meet corporate objectives, with a general plan for the longer term, mainly focusing on the larger contracts plus a general business view for potential markets. BUDGETING Until recently, the budget had been prepared on a programme basis, i.e. by client, and for the total UK operations, to support corporate planning requirements. Control therefore could only applied to these levels, effectively the client as the profit centre, with the back office groups being excluded, to any detailed extent. The overall results, which were not meeting profit expectations, led to the realisation that further controls were required. From this year, the budget has also been structured by all responsibility centres, that is, to include the back offices as expense centres. An example of the new budgetary structure, with illustrative numbers, is shown in summary below: EXHIBIT 4 Outline of the 2012 budgeting and reporting format (£000): In practice, each of the cost categories will be analysed by individual item, per the ITS-UK chart of accounts: • Labour is broken down by category of job function and numbers of each (FTE’s- full time equivalents), such as the client Management above as: • Agency staff are similarly analysed. • Subcontracts are individually identified. These are often a substantial part of the main contract, such as the provision of specialist geophysical services to an oil company, but which is deemed, by the oil company, to be part of the general systems support by ITS-UK. This is part of the oil industry’s general policy to limit the number of contractors with which it directly communicates. In the above example, the £80,000 Applications sub-contract may be for specialist services, which will be managed by the Applications Service Delivery Manager on behalf of the total contract, so will be accountable to the Client Manager for its performance. • Other costs - these are the recoverable costs of the contract. They are individually identified in the budget, such as hardware maintenance, software licences, telephone and travel costs. The concept is that, for each profit centre (or contract) cost item, the department responsible for that cost will be identified, leading to a bottom line number for each manager, for which he or she will be held accountable. For Applications and Infrastructure, the two main expenditure areas, where any total cost is expected to impact the contract in any way, the manager concerned must discuss and agree this with the client manager. In the above example, the Applications manager is responsible for a budget of £720,000, the limit for which he can spend without any agreement with the Client Manager, providing services meet the contractual specifications. BUDGET PREPARATION The following steps are observed: 1. The year’s programme is agreed, essentially: • Confirm the continuation of existing contracts. • Clarify contract renewal expectations, for contracts that will be up for renewal in the budget period. • Agree scope of any new business. 2. All departmental managers prepare their budget costs, by person and cost detail, for each contract or new business category. 3. Results are consolidated by contract, or new business category, by budget coordinator. 4. Service Delivery Managers then review their results with each of the Client Managers, for agreement as to conformance with contract and to ensure that derived profit margins are as expected. 5. Once agreed, all results are consolidated, along with staff service departments, to produce a draft operational budget for Outsourcing Services, for review by the Group Manager to ensure that corporate objectives are met. 6. Adjustments may be made, as required (they usually are!). MANAGEMENT REPORTING Quarterly reports are transmitted to the head office, for the major contracts, overall actual cost position and full year forecasts. For major international clients, a world-wide consolidation is undertaken for overall ITSI support, i.e. global support for global companies; an increasing expectation of such clients. Internal monthly reports are reviewed by the Operations Manager with his client and service delivery managers. An example of a section of the report is shown below for July 2012, for one particular major client (one profit centre) with six different contracts: Supporting these reports would be cost details on the budget basis, i.e. each cost identified per the service delivery department, so that actual costs would be reported alongside the budget numbers, per Exhibit 4 structure. In practice, this is very limited in its use. The computurised accounting system (a modern integrated ‘enterprise’ reporting system) has the facility to accomodate the input of budget data, but it requires the budget to be prepared at a very detailed level for input, which is very time consuming and has not yet been adequately implemented. Comparisons are therefore made on a manual basis, e.g. by downloading the relevant actual data in the budget format. For example, if the budget identifies a training cost for Applications staff on Exoil Oil & Chemicals, actual data will be extracted manually from the system for direct comparison. This type of work is partially performed, but the problem is the heavy use of resources to prepare the reports; a good example of the increasing overhead costs deemed necessary to support the overall business, but which is cutting into the overall net margin. The gross margin of 20%, per Exhibit 5, was in line with expectations, though only just so; the E-mail operations need to be reviewed, as a minimum. The 20% margin was effectively a contribution to overheads and net profit, with the former of these of increasing significance, as previously discussed. EXHIBIT 5 Service delivery report for July 2012 (extract): The real significance to these overheads is not obvious in these reports, merely a realisation that a 20% gross margin may not be sufficient to meet the 6% corporate net target. The full company financial status is only produced on a quarterly basis. The latest report (Exhibit 6). shows that the absorption of the overheads from the staff services, plus time allocated by the senior staff of the outsourcing operations that does not directly relate to any of the contracts, such as forward planning and marketing, results in a net margin of 3.1% (£2.3 million over £75.0 million sales), an unsatisfactory situation. This position is also down from the total company actual results of 2011, as illustrated below. Further details of the 2011 reported results are shown in Exhibit 7 EXHIBIT 6 Profit statement summary 2011 full year forecast versus 2011, as at 1 July 2012: EXHIBIT 7 Integrated Technology Services (UK) LTD Summarised Published accounts: QUESTIONS: Following the review of the planning and control systems of Integrated Technology Services (UK) Ltd (ITS-UK), the Group Manager James Gunn has asked you, the consultant, into his office to discuss a number of points arising. He is accompanied by the Operations Manager. Mr Gunn opened the meeting, “We have some concern with the net profit margin as the sole performance measure of our business. It is not necessarily the actual percentage of 6% that is giving us trouble, maybe it is a suitable figure as many of our competitors are facing even tighter margins, but it is the concept. Frankly, we are not clear as to why this is the sole measurement criteria, surely there are other ways of measuring how well our business is performing. We believe that we have a good business and the market is there for future growth, but maybe there are other ways of looking at how well we are doing. We are not financial people, so we look to you to help. We would therefore like you to look into this and prepare a report on the merits of this net margin measure and any suitable alternatives that we can propose to our corporate managers. The other item that we want you to review is the budget process. Here, we believe that we have a good system, but we need to get it running properly. The problem is that it is going to take more resources to do so, probably an extra accountant for some £35,000 per year, plus benefits and support costs which will come to nearly £50,000. We therefore need a good case to go to head office to justify this and we would like you to come up with that justification.” REQUIRED: 1. Prepare the report on the net margin, as requested by the Group Manager. 2. Prepare a justification of the budgeting system, covering the principles of the budget, its features and advantages, in general, along with the specific advantages for ITS-UK, to meet the needs of local management.
In practice, each of the cost categories will be analysed by individual item, per the ITS-UK chart of accounts: • Labour is broken down by category of job function and numbers of each (FTE’s- full time equivalents), such as the client Management above as:
In November 2012, a consultant was employed to review and document the planning and control systems of Integrated Technology Services (UK) Ltd (ITS-UK), to ensure that these were effectively meeting the needs of the business and to provide a basis for staff training. ITS-UK is the British subsidiary of Integrated Technology Services International (ITSI), a technology company, based in the north-east USA, which has history of developing and providing technology solutions to major international corporations and the US Government. It has focused on science and technology as a core strength with a significant Research and Development (R&D) expenditure. It is also noted for its extensive employee share ownership scheme, to encourage staff business awareness. The UK operations are based on two main activities: 1. Consultancy services to a range of businesses; 2. Computing and telecommunications outsourcing support to companies, particularly the oil and gas industry, but increasingly to other industries and to the public sector. The latter activity has been in response to the business opportunities created by a variety of industries that have preferred to focus on their ‘core competencies’ and outsource some of their internal support functions to external providers, particularly in information technology and accounting. The Government has also reinforced the trend by the compulsory tendering of many of its internal services in competition with outside providers. At the same time, outsourcing of information technology (IT) services has developed in the USA, where the parent company has progressed. Project management has been a particular strength within the corporate body, developed over its 30-year history. This expertise has also been used to advantage by its UK subsidiary, with the readily available facilities of US based staff, when dealing with multi-national corporations. ORGANISATIONAL STRUCTURE ITS-UK is structured into three groups of activities: • Consultancy business as a small separate unit • Outsourcing Services on a matrix organisational basis • Staff services, such as Finance, Commercial and Human Resource and Administration EXHIBIT 1: Consultancy This is the oldest established business unit of ITS-UK. It is relatively independent with a separate client base from that of the outsourcing business, though there is some commonality as its consultancy is essentially for systems applications and integration. It shares the staff services with the rest of the company, with an occasional requirement for the services of the other groups, such as the Infrastructure department, on an advisory basis. Outsourcing Services As with many modern service providers, the functions are divided into those that deal directly with the client, known as the front office, with the back-office delivery managers in charge of departments that provide the actual support staff, as follows: • Marketing department is a small group, which has the responsibility to find new business. Staff will read initial customer requirement reviews and contract negotiations, along with appropriate resources from other departments. • Client Account Managers head small departments who are in direct ongoing communication with the customer, once the contract is approved and work is ready to commence. They are to ensure that the contractual requirements are properly followed to meet customer expectations. This, in practice, is largely to meet the following criteria: (a). That proper resources are provided from the main groups of Applications Infrastructure and e-mail, to meet contract specifications, e.g. the right number of the appropriately qualified systems engineers, as defined in the contract. (b). That excess resources are not allocated to the project, due to support staff lack of contract understanding. The departments are structured on the basis of client requirements. An oil and gas group was originally developed to support one particularly large client, from which many of the staff were transferred to ITS-UK to carry on the work that they had previously provided. This original group was later divided into two, to reflect the two-division structure of the oil industry, the upstream exploration and production and the downstream marketing and refining. The Operations South group covers all other industries and local government departments. • Applications department provides the technical resources to develop and support clients’ IT applications systems. • Infrastructure department provides the technical resources to implement and support all computer hardware, telecommunications and networking requirements. It also includes a front-line help-desk support which is the first point of call for any customer call, such as computer, telephone or application system problems. • E-mail is a specialist group that provides electronic mail services to customers. Planning is a critical function for each of the Applications, Infrastructure and E-mail delivery managers, both with the marketing managers for early warnings as to staff requirements and with client management for ongoing needs. This latter feature has been difficult to achieve due to regular contract change requests by the major clients. The overall organisation is of a matrix nature, where the service delivery managers (SDM’s) provide some 750 people to a broad range of contracts. Some staff may be permanently assigned to a major client, whilst others could be working on several different contracts in a single week. BUSINESS CONTROLS OVERVIEW Expansion in Outsourcing had been rapid, with an emphasis on drive and initiative, to some neglect of a detailed controls framework. The main financial performance measure is the net margin. This is set by corporate headquarters as 6%, which effectively is the prime objective if ITS-UK. Contacts with clients tend to be agreed on a gross margin basis, but which obviously must be carefully set, usually at least 20%. This has been deemed to be the minimum required contribution to cover overheads and profit, although questions were being raised as to the appropriateness of this level as the net margin of 6% is becoming increasingly difficult to achieve, with some of the following points raised as contributory factors: 1. Following the early, large, long-term contracts, which were relatively simple to administer, overhead costs have risen disproportionately due to: • many small contracts, which administratively are often as expensive as much larger ones; overall lower net margins are therefore a natural outcome of the decreasing size of average contracts; • lack of standardisation of contract terms leading to complex administrative and financial controls, e.g. billing • arrangements have to be individually monitored, as computer systems have been unable to fully accommodate all the variations. The 20% gross margin target is therefore contributing increasingly more to overheads than to profit. 2. A further reason for lowering profitability is believed to be that the drive for market share, which had taken precedence over gross margin, has resulted in ‘loss-leaders’ which were not living up to expectations. One particular large contract, started with a 15% gross margin, in the expectancy of leading to other more lucrative work, but has not yet proved to have done so. 3. The mechanism of charging the IT person’s time to the contract, through a timesheet, is not being properly controlled. Staff may work on a number of small contracts in a week, possibly for the same client, which is not always obvious to the person concerned. Time is therefore often incorrectly charged, which results in a waste of administrative effort to correct, along with client dissatisfaction. A particularly difficult situation is where a variety of different types of contracts may be in force with a single client company. A systems engineer may work on a fixed price contract on one day so that time charged to the contract will be for internal ITS-UK purposes only, i.e. it will not affect the charge to the client. Then on the following day, he may be supporting a reimbursable (time and materials) contract, when time charged is reimbursed by the client. If these times get mixed up, the consequences can be significant. A lack of contract understanding therefore may be leading to costs, that should be chargeable to the contract and paid by the client, are not being identified as such. These costs will therefore remain as a charge against ITS-UK’s profits. 4. The increasing complexity of the matrix organisation may be leading to wastage. Ideally, resources should be provided to meet clients’ needs as and when needed. In practice, this flexibility can only be met if there are readily available staff resources at any time, which would inevitably lead to reserve people. However, such standby staff have a price, who generate no income, if not used. A response to the above problems has been to improve financial planning and budgetary controls. Before looking at these two control mechanisms, the nature of the various contractual arrangements must be understood. CONTRACTURAL RELATIONSHIPS ITS-UK receives its income through the provision of technology services, which are governed by various contractual relationships with the client. This commercial relationship will tend to depend upon the balancing of risk and reward. The reward to the contractor will be influenced by the amount of perceived risk, that is, the higher the risk that the contractor is expected to meet, then the higher the reward that the contractor will expect to receive. In practice, where risk is deemed to be high both for its frequency and impact, the customer normally bears this risk, supporting a standard cost reimbursable (or ‘time and materials’) type of contract. For low risk projects, the contractor is more likely to bear the risk with a fixed cost type of contract preferred. An example of the former may be an innovative oil construction computer control system in a frontier zone, whilst ongoing systems support may typify the latter. A third major category has emerged in recent years, where various concepts of sharing risk and reward have been created, to be known as incentive or target cost contracts, frequently as part of long term ‘alliancing’ relationships. All three types of contracts are found within ITS-UK, with the target cost tending to dominate the larger contracts and therefore comprise a significant element of the sales revenue. An example of such a contract is shown in Exhibit 2. EXHIBIT 2: Target contract example (selected items from internal contract brief) Contract scope: Provision of outsourcing arrangements for the Information Systems and Records Management Functions at Company X. Contract type: 2012, Ceiling price with sharing of any underruns only, plus Discretionary Services project work to be remunerated on a time and materials basis (agreed rates listed separately). Ceiling price for 2012: £784 000 Underrun sharing: Company X share: 40% ITS-UK share: 60% Performance award: From –5% to þ5%, payable quarterly. Note - basis for cost calculations is actual cost to ITS-UK plus an agreed mark up of 12%. Calculation of contract profits to ITS-UK at varying levels of actual chargeable costs: Actual ITS-UK contract cost for target contact = £784 000/1.12 = £700 000 Therefore the base for 2012 is that ITS-UK will receive revenue of £784 000 for a cost of £700 000, i.e. a profit (mark-up) of £84 000. This mark-up is payable, regardless of actual cost. For a sample of lower resultant costs, profit share will be as follows: The profit to contractor will be adjusted per the performance award and any costs that are not recoverable, according to contract. CONTRACT COSTS Each client, covering several contracts, or sometimes a single major contract, is treated as a profit centre, to include all costs that are specific to the contract, plus indirect cost allocations, and their revenues. It is crucial to the profitability of all target and time and materials contracts to be as clear as to what is recoverable in the contract, i.e. that which will be paid by the client. The contract should list all categories of support staff and probably their rates, along with all services and equipment. For example, if 50% of an accountant is recoverable per a large contract, but 75% of an accountant’s time is actually used to support the contract, 50% will be charged to the client and the other 25% will have to be absorbed by ITS-UK, i.e. as a general overhead cost, directly charged against ITS-UK’s own profits. These recoverable costs are often known as ‘direct cost’ which is not as normal per cost accounting terminology, where an accountant’s time, partially allocated to a contract, would be regarded as an indirect cost. An example of a small contract build-up, for quotation purposes is as follows: EXHIBIT 3 Contract details for bid preparation Note 1 - FTE - Full-time equivalent person, e.g. 0.5 FTE is half a person’s workload. Note 2 - includes commercial, finance and admin. support (on a pro-rata headcount basis, plus office consumables, telephone and internal IT support). How these are identified to the client will depend on the type of contract. For a fixed price contract, these will be internally recorded costs only: for a target or reimbursable contract, these items will all be specifically agreed with the client, for client’s account. PLANNING For business planning purposes, the time horizon tends to be shorter than for most organisations. Business had been expanding rapidly, with the only real constraint being resources, where there has been a shortage of technically skilled IT people. The larger contracts tended to be for three to five years, so that a high degree of security exists for the levels of income from the major clients in the medium term. Otherwise, the annual budget cycle tends to predominate, to meet corporate objectives, with a general plan for the longer term, mainly focusing on the larger contracts plus a general business view for potential markets. BUDGETING Until recently, the budget had been prepared on a programme basis, i.e. by client, and for the total UK operations, to support corporate planning requirements. Control therefore could only applied to these levels, effectively the client as the profit centre, with the back office groups being excluded, to any detailed extent. The overall results, which were not meeting profit expectations, led to the realisation that further controls were required. From this year, the budget has also been structured by all responsibility centres, that is, to include the back offices as expense centres. An example of the new budgetary structure, with illustrative numbers, is shown in summary below: EXHIBIT 4 Outline of the 2012 budgeting and reporting format (£000): In practice, each of the cost categories will be analysed by individual item, per the ITS-UK chart of accounts: • Labour is broken down by category of job function and numbers of each (FTE’s- full time equivalents), such as the client Management above as: • Agency staff are similarly analysed. • Subcontracts are individually identified. These are often a substantial part of the main contract, such as the provision of specialist geophysical services to an oil company, but which is deemed, by the oil company, to be part of the general systems support by ITS-UK. This is part of the oil industry’s general policy to limit the number of contractors with which it directly communicates. In the above example, the £80,000 Applications sub-contract may be for specialist services, which will be managed by the Applications Service Delivery Manager on behalf of the total contract, so will be accountable to the Client Manager for its performance. • Other costs - these are the recoverable costs of the contract. They are individually identified in the budget, such as hardware maintenance, software licences, telephone and travel costs. The concept is that, for each profit centre (or contract) cost item, the department responsible for that cost will be identified, leading to a bottom line number for each manager, for which he or she will be held accountable. For Applications and Infrastructure, the two main expenditure areas, where any total cost is expected to impact the contract in any way, the manager concerned must discuss and agree this with the client manager. In the above example, the Applications manager is responsible for a budget of £720,000, the limit for which he can spend without any agreement with the Client Manager, providing services meet the contractual specifications. BUDGET PREPARATION The following steps are observed: 1. The year’s programme is agreed, essentially: • Confirm the continuation of existing contracts. • Clarify contract renewal expectations, for contracts that will be up for renewal in the budget period. • Agree scope of any new business. 2. All departmental managers prepare their budget costs, by person and cost detail, for each contract or new business category. 3. Results are consolidated by contract, or new business category, by budget coordinator. 4. Service Delivery Managers then review their results with each of the Client Managers, for agreement as to conformance with contract and to ensure that derived profit margins are as expected. 5. Once agreed, all results are consolidated, along with staff service departments, to produce a draft operational budget for Outsourcing Services, for review by the Group Manager to ensure that corporate objectives are met. 6. Adjustments may be made, as required (they usually are!). MANAGEMENT REPORTING Quarterly reports are transmitted to the head office, for the major contracts, overall actual cost position and full year forecasts. For major international clients, a world-wide consolidation is undertaken for overall ITSI support, i.e. global support for global companies; an increasing expectation of such clients. Internal monthly reports are reviewed by the Operations Manager with his client and service delivery managers. An example of a section of the report is shown below for July 2012, for one particular major client (one profit centre) with six different contracts: Supporting these reports would be cost details on the budget basis, i.e. each cost identified per the service delivery department, so that actual costs would be reported alongside the budget numbers, per Exhibit 4 structure. In practice, this is very limited in its use. The computurised accounting system (a modern integrated ‘enterprise’ reporting system) has the facility to accomodate the input of budget data, but it requires the budget to be prepared at a very detailed level for input, which is very time consuming and has not yet been adequately implemented. Comparisons are therefore made on a manual basis, e.g. by downloading the relevant actual data in the budget format. For example, if the budget identifies a training cost for Applications staff on Exoil Oil & Chemicals, actual data will be extracted manually from the system for direct comparison. This type of work is partially performed, but the problem is the heavy use of resources to prepare the reports; a good example of the increasing overhead costs deemed necessary to support the overall business, but which is cutting into the overall net margin. The gross margin of 20%, per Exhibit 5, was in line with expectations, though only just so; the E-mail operations need to be reviewed, as a minimum. The 20% margin was effectively a contribution to overheads and net profit, with the former of these of increasing significance, as previously discussed. EXHIBIT 5 Service delivery report for July 2012 (extract): The real significance to these overheads is not obvious in these reports, merely a realisation that a 20% gross margin may not be sufficient to meet the 6% corporate net target. The full company financial status is only produced on a quarterly basis. The latest report (Exhibit 6). shows that the absorption of the overheads from the staff services, plus time allocated by the senior staff of the outsourcing operations that does not directly relate to any of the contracts, such as forward planning and marketing, results in a net margin of 3.1% (£2.3 million over £75.0 million sales), an unsatisfactory situation. This position is also down from the total company actual results of 2011, as illustrated below. Further details of the 2011 reported results are shown in Exhibit 7 EXHIBIT 6 Profit statement summary 2011 full year forecast versus 2011, as at 1 July 2012: EXHIBIT 7 Integrated Technology Services (UK) LTD Summarised Published accounts: QUESTIONS: Following the review of the planning and control systems of Integrated Technology Services (UK) Ltd (ITS-UK), the Group Manager James Gunn has asked you, the consultant, into his office to discuss a number of points arising. He is accompanied by the Operations Manager. Mr Gunn opened the meeting, “We have some concern with the net profit margin as the sole performance measure of our business. It is not necessarily the actual percentage of 6% that is giving us trouble, maybe it is a suitable figure as many of our competitors are facing even tighter margins, but it is the concept. Frankly, we are not clear as to why this is the sole measurement criteria, surely there are other ways of measuring how well our business is performing. We believe that we have a good business and the market is there for future growth, but maybe there are other ways of looking at how well we are doing. We are not financial people, so we look to you to help. We would therefore like you to look into this and prepare a report on the merits of this net margin measure and any suitable alternatives that we can propose to our corporate managers. The other item that we want you to review is the budget process. Here, we believe that we have a good system, but we need to get it running properly. The problem is that it is going to take more resources to do so, probably an extra accountant for some £35,000 per year, plus benefits and support costs which will come to nearly £50,000. We therefore need a good case to go to head office to justify this and we would like you to come up with that justification.” REQUIRED: 1. Prepare the report on the net margin, as requested by the Group Manager. 2. Prepare a justification of the budgeting system, covering the principles of the budget, its features and advantages, in general, along with the specific advantages for ITS-UK, to meet the needs of local management.
• Agency staff are similarly analysed. • Subcontracts are individually identified. These are often a substantial part of the main contract, such as the provision of specialist geophysical services to an oil company, but which is deemed, by the oil company, to be part of the general systems support by ITS-UK. This is part of the oil industry’s general policy to limit the number of contractors with which it directly communicates. In the above example, the £80,000 Applications sub-contract may be for specialist services, which will be managed by the Applications Service Delivery Manager on behalf of the total contract, so will be accountable to the Client Manager for its performance. • Other costs - these are the recoverable costs of the contract. They are individually identified in the budget, such as hardware maintenance, software licences, telephone and travel costs. The concept is that, for each profit centre (or contract) cost item, the department responsible for that cost will be identified, leading to a bottom line number for each manager, for which he or she will be held accountable. For Applications and Infrastructure, the two main expenditure areas, where any total cost is expected to impact the contract in any way, the manager concerned must discuss and agree this with the client manager. In the above example, the Applications manager is responsible for a budget of £720,000, the limit for which he can spend without any agreement with the Client Manager, providing services meet the contractual specifications. BUDGET PREPARATION The following steps are observed: 1. The year’s programme is agreed, essentially: • Confirm the continuation of existing contracts. • Clarify contract renewal expectations, for contracts that will be up for renewal in the budget period. • Agree scope of any new business. 2. All departmental managers prepare their budget costs, by person and cost detail, for each contract or new business category. 3. Results are consolidated by contract, or new business category, by budget coordinator. 4. Service Delivery Managers then review their results with each of the Client Managers, for agreement as to conformance with contract and to ensure that derived profit margins are as expected. 5. Once agreed, all results are consolidated, along with staff service departments, to produce a draft operational budget for Outsourcing Services, for review by the Group Manager to ensure that corporate objectives are met. 6. Adjustments may be made, as required (they usually are!). MANAGEMENT REPORTING Quarterly reports are transmitted to the head office, for the major contracts, overall actual cost position and full year forecasts. For major international clients, a world-wide consolidation is undertaken for overall ITSI support, i.e. global support for global companies; an increasing expectation of such clients. Internal monthly reports are reviewed by the Operations Manager with his client and service delivery managers. An example of a section of the report is shown below for July 2012, for one particular major client (one profit centre) with six different contracts: Supporting these reports would be cost details on the budget basis, i.e. each cost identified per the service delivery department, so that actual costs would be reported alongside the budget numbers, per Exhibit 4 structure. In practice, this is very limited in its use. The computurised accounting system (a modern integrated ‘enterprise’ reporting system) has the facility to accomodate the input of budget data, but it requires the budget to be prepared at a very detailed level for input, which is very time consuming and has not yet been adequately implemented. Comparisons are therefore made on a manual basis, e.g. by downloading the relevant actual data in the budget format. For example, if the budget identifies a training cost for Applications staff on Exoil Oil & Chemicals, actual data will be extracted manually from the system for direct comparison. This type of work is partially performed, but the problem is the heavy use of resources to prepare the reports; a good example of the increasing overhead costs deemed necessary to support the overall business, but which is cutting into the overall net margin. The gross margin of 20%, per Exhibit 5, was in line with expectations, though only just so; the E-mail operations need to be reviewed, as a minimum. The 20% margin was effectively a contribution to overheads and net profit, with the former of these of increasing significance, as previously discussed. EXHIBIT 5 Service delivery report for July 2012 (extract):
In November 2012, a consultant was employed to review and document the planning and control systems of Integrated Technology Services (UK) Ltd (ITS-UK), to ensure that these were effectively meeting the needs of the business and to provide a basis for staff training. ITS-UK is the British subsidiary of Integrated Technology Services International (ITSI), a technology company, based in the north-east USA, which has history of developing and providing technology solutions to major international corporations and the US Government. It has focused on science and technology as a core strength with a significant Research and Development (R&D) expenditure. It is also noted for its extensive employee share ownership scheme, to encourage staff business awareness. The UK operations are based on two main activities: 1. Consultancy services to a range of businesses; 2. Computing and telecommunications outsourcing support to companies, particularly the oil and gas industry, but increasingly to other industries and to the public sector. The latter activity has been in response to the business opportunities created by a variety of industries that have preferred to focus on their ‘core competencies’ and outsource some of their internal support functions to external providers, particularly in information technology and accounting. The Government has also reinforced the trend by the compulsory tendering of many of its internal services in competition with outside providers. At the same time, outsourcing of information technology (IT) services has developed in the USA, where the parent company has progressed. Project management has been a particular strength within the corporate body, developed over its 30-year history. This expertise has also been used to advantage by its UK subsidiary, with the readily available facilities of US based staff, when dealing with multi-national corporations. ORGANISATIONAL STRUCTURE ITS-UK is structured into three groups of activities: • Consultancy business as a small separate unit • Outsourcing Services on a matrix organisational basis • Staff services, such as Finance, Commercial and Human Resource and Administration EXHIBIT 1: Consultancy This is the oldest established business unit of ITS-UK. It is relatively independent with a separate client base from that of the outsourcing business, though there is some commonality as its consultancy is essentially for systems applications and integration. It shares the staff services with the rest of the company, with an occasional requirement for the services of the other groups, such as the Infrastructure department, on an advisory basis. Outsourcing Services As with many modern service providers, the functions are divided into those that deal directly with the client, known as the front office, with the back-office delivery managers in charge of departments that provide the actual support staff, as follows: • Marketing department is a small group, which has the responsibility to find new business. Staff will read initial customer requirement reviews and contract negotiations, along with appropriate resources from other departments. • Client Account Managers head small departments who are in direct ongoing communication with the customer, once the contract is approved and work is ready to commence. They are to ensure that the contractual requirements are properly followed to meet customer expectations. This, in practice, is largely to meet the following criteria: (a). That proper resources are provided from the main groups of Applications Infrastructure and e-mail, to meet contract specifications, e.g. the right number of the appropriately qualified systems engineers, as defined in the contract. (b). That excess resources are not allocated to the project, due to support staff lack of contract understanding. The departments are structured on the basis of client requirements. An oil and gas group was originally developed to support one particularly large client, from which many of the staff were transferred to ITS-UK to carry on the work that they had previously provided. This original group was later divided into two, to reflect the two-division structure of the oil industry, the upstream exploration and production and the downstream marketing and refining. The Operations South group covers all other industries and local government departments. • Applications department provides the technical resources to develop and support clients’ IT applications systems. • Infrastructure department provides the technical resources to implement and support all computer hardware, telecommunications and networking requirements. It also includes a front-line help-desk support which is the first point of call for any customer call, such as computer, telephone or application system problems. • E-mail is a specialist group that provides electronic mail services to customers. Planning is a critical function for each of the Applications, Infrastructure and E-mail delivery managers, both with the marketing managers for early warnings as to staff requirements and with client management for ongoing needs. This latter feature has been difficult to achieve due to regular contract change requests by the major clients. The overall organisation is of a matrix nature, where the service delivery managers (SDM’s) provide some 750 people to a broad range of contracts. Some staff may be permanently assigned to a major client, whilst others could be working on several different contracts in a single week. BUSINESS CONTROLS OVERVIEW Expansion in Outsourcing had been rapid, with an emphasis on drive and initiative, to some neglect of a detailed controls framework. The main financial performance measure is the net margin. This is set by corporate headquarters as 6%, which effectively is the prime objective if ITS-UK. Contacts with clients tend to be agreed on a gross margin basis, but which obviously must be carefully set, usually at least 20%. This has been deemed to be the minimum required contribution to cover overheads and profit, although questions were being raised as to the appropriateness of this level as the net margin of 6% is becoming increasingly difficult to achieve, with some of the following points raised as contributory factors: 1. Following the early, large, long-term contracts, which were relatively simple to administer, overhead costs have risen disproportionately due to: • many small contracts, which administratively are often as expensive as much larger ones; overall lower net margins are therefore a natural outcome of the decreasing size of average contracts; • lack of standardisation of contract terms leading to complex administrative and financial controls, e.g. billing • arrangements have to be individually monitored, as computer systems have been unable to fully accommodate all the variations. The 20% gross margin target is therefore contributing increasingly more to overheads than to profit. 2. A further reason for lowering profitability is believed to be that the drive for market share, which had taken precedence over gross margin, has resulted in ‘loss-leaders’ which were not living up to expectations. One particular large contract, started with a 15% gross margin, in the expectancy of leading to other more lucrative work, but has not yet proved to have done so. 3. The mechanism of charging the IT person’s time to the contract, through a timesheet, is not being properly controlled. Staff may work on a number of small contracts in a week, possibly for the same client, which is not always obvious to the person concerned. Time is therefore often incorrectly charged, which results in a waste of administrative effort to correct, along with client dissatisfaction. A particularly difficult situation is where a variety of different types of contracts may be in force with a single client company. A systems engineer may work on a fixed price contract on one day so that time charged to the contract will be for internal ITS-UK purposes only, i.e. it will not affect the charge to the client. Then on the following day, he may be supporting a reimbursable (time and materials) contract, when time charged is reimbursed by the client. If these times get mixed up, the consequences can be significant. A lack of contract understanding therefore may be leading to costs, that should be chargeable to the contract and paid by the client, are not being identified as such. These costs will therefore remain as a charge against ITS-UK’s profits. 4. The increasing complexity of the matrix organisation may be leading to wastage. Ideally, resources should be provided to meet clients’ needs as and when needed. In practice, this flexibility can only be met if there are readily available staff resources at any time, which would inevitably lead to reserve people. However, such standby staff have a price, who generate no income, if not used. A response to the above problems has been to improve financial planning and budgetary controls. Before looking at these two control mechanisms, the nature of the various contractual arrangements must be understood. CONTRACTURAL RELATIONSHIPS ITS-UK receives its income through the provision of technology services, which are governed by various contractual relationships with the client. This commercial relationship will tend to depend upon the balancing of risk and reward. The reward to the contractor will be influenced by the amount of perceived risk, that is, the higher the risk that the contractor is expected to meet, then the higher the reward that the contractor will expect to receive. In practice, where risk is deemed to be high both for its frequency and impact, the customer normally bears this risk, supporting a standard cost reimbursable (or ‘time and materials’) type of contract. For low risk projects, the contractor is more likely to bear the risk with a fixed cost type of contract preferred. An example of the former may be an innovative oil construction computer control system in a frontier zone, whilst ongoing systems support may typify the latter. A third major category has emerged in recent years, where various concepts of sharing risk and reward have been created, to be known as incentive or target cost contracts, frequently as part of long term ‘alliancing’ relationships. All three types of contracts are found within ITS-UK, with the target cost tending to dominate the larger contracts and therefore comprise a significant element of the sales revenue. An example of such a contract is shown in Exhibit 2. EXHIBIT 2: Target contract example (selected items from internal contract brief) Contract scope: Provision of outsourcing arrangements for the Information Systems and Records Management Functions at Company X. Contract type: 2012, Ceiling price with sharing of any underruns only, plus Discretionary Services project work to be remunerated on a time and materials basis (agreed rates listed separately). Ceiling price for 2012: £784 000 Underrun sharing: Company X share: 40% ITS-UK share: 60% Performance award: From –5% to þ5%, payable quarterly. Note - basis for cost calculations is actual cost to ITS-UK plus an agreed mark up of 12%. Calculation of contract profits to ITS-UK at varying levels of actual chargeable costs: Actual ITS-UK contract cost for target contact = £784 000/1.12 = £700 000 Therefore the base for 2012 is that ITS-UK will receive revenue of £784 000 for a cost of £700 000, i.e. a profit (mark-up) of £84 000. This mark-up is payable, regardless of actual cost. For a sample of lower resultant costs, profit share will be as follows: The profit to contractor will be adjusted per the performance award and any costs that are not recoverable, according to contract. CONTRACT COSTS Each client, covering several contracts, or sometimes a single major contract, is treated as a profit centre, to include all costs that are specific to the contract, plus indirect cost allocations, and their revenues. It is crucial to the profitability of all target and time and materials contracts to be as clear as to what is recoverable in the contract, i.e. that which will be paid by the client. The contract should list all categories of support staff and probably their rates, along with all services and equipment. For example, if 50% of an accountant is recoverable per a large contract, but 75% of an accountant’s time is actually used to support the contract, 50% will be charged to the client and the other 25% will have to be absorbed by ITS-UK, i.e. as a general overhead cost, directly charged against ITS-UK’s own profits. These recoverable costs are often known as ‘direct cost’ which is not as normal per cost accounting terminology, where an accountant’s time, partially allocated to a contract, would be regarded as an indirect cost. An example of a small contract build-up, for quotation purposes is as follows: EXHIBIT 3 Contract details for bid preparation Note 1 - FTE - Full-time equivalent person, e.g. 0.5 FTE is half a person’s workload. Note 2 - includes commercial, finance and admin. support (on a pro-rata headcount basis, plus office consumables, telephone and internal IT support). How these are identified to the client will depend on the type of contract. For a fixed price contract, these will be internally recorded costs only: for a target or reimbursable contract, these items will all be specifically agreed with the client, for client’s account. PLANNING For business planning purposes, the time horizon tends to be shorter than for most organisations. Business had been expanding rapidly, with the only real constraint being resources, where there has been a shortage of technically skilled IT people. The larger contracts tended to be for three to five years, so that a high degree of security exists for the levels of income from the major clients in the medium term. Otherwise, the annual budget cycle tends to predominate, to meet corporate objectives, with a general plan for the longer term, mainly focusing on the larger contracts plus a general business view for potential markets. BUDGETING Until recently, the budget had been prepared on a programme basis, i.e. by client, and for the total UK operations, to support corporate planning requirements. Control therefore could only applied to these levels, effectively the client as the profit centre, with the back office groups being excluded, to any detailed extent. The overall results, which were not meeting profit expectations, led to the realisation that further controls were required. From this year, the budget has also been structured by all responsibility centres, that is, to include the back offices as expense centres. An example of the new budgetary structure, with illustrative numbers, is shown in summary below: EXHIBIT 4 Outline of the 2012 budgeting and reporting format (£000): In practice, each of the cost categories will be analysed by individual item, per the ITS-UK chart of accounts: • Labour is broken down by category of job function and numbers of each (FTE’s- full time equivalents), such as the client Management above as: • Agency staff are similarly analysed. • Subcontracts are individually identified. These are often a substantial part of the main contract, such as the provision of specialist geophysical services to an oil company, but which is deemed, by the oil company, to be part of the general systems support by ITS-UK. This is part of the oil industry’s general policy to limit the number of contractors with which it directly communicates. In the above example, the £80,000 Applications sub-contract may be for specialist services, which will be managed by the Applications Service Delivery Manager on behalf of the total contract, so will be accountable to the Client Manager for its performance. • Other costs - these are the recoverable costs of the contract. They are individually identified in the budget, such as hardware maintenance, software licences, telephone and travel costs. The concept is that, for each profit centre (or contract) cost item, the department responsible for that cost will be identified, leading to a bottom line number for each manager, for which he or she will be held accountable. For Applications and Infrastructure, the two main expenditure areas, where any total cost is expected to impact the contract in any way, the manager concerned must discuss and agree this with the client manager. In the above example, the Applications manager is responsible for a budget of £720,000, the limit for which he can spend without any agreement with the Client Manager, providing services meet the contractual specifications. BUDGET PREPARATION The following steps are observed: 1. The year’s programme is agreed, essentially: • Confirm the continuation of existing contracts. • Clarify contract renewal expectations, for contracts that will be up for renewal in the budget period. • Agree scope of any new business. 2. All departmental managers prepare their budget costs, by person and cost detail, for each contract or new business category. 3. Results are consolidated by contract, or new business category, by budget coordinator. 4. Service Delivery Managers then review their results with each of the Client Managers, for agreement as to conformance with contract and to ensure that derived profit margins are as expected. 5. Once agreed, all results are consolidated, along with staff service departments, to produce a draft operational budget for Outsourcing Services, for review by the Group Manager to ensure that corporate objectives are met. 6. Adjustments may be made, as required (they usually are!). MANAGEMENT REPORTING Quarterly reports are transmitted to the head office, for the major contracts, overall actual cost position and full year forecasts. For major international clients, a world-wide consolidation is undertaken for overall ITSI support, i.e. global support for global companies; an increasing expectation of such clients. Internal monthly reports are reviewed by the Operations Manager with his client and service delivery managers. An example of a section of the report is shown below for July 2012, for one particular major client (one profit centre) with six different contracts: Supporting these reports would be cost details on the budget basis, i.e. each cost identified per the service delivery department, so that actual costs would be reported alongside the budget numbers, per Exhibit 4 structure. In practice, this is very limited in its use. The computurised accounting system (a modern integrated ‘enterprise’ reporting system) has the facility to accomodate the input of budget data, but it requires the budget to be prepared at a very detailed level for input, which is very time consuming and has not yet been adequately implemented. Comparisons are therefore made on a manual basis, e.g. by downloading the relevant actual data in the budget format. For example, if the budget identifies a training cost for Applications staff on Exoil Oil & Chemicals, actual data will be extracted manually from the system for direct comparison. This type of work is partially performed, but the problem is the heavy use of resources to prepare the reports; a good example of the increasing overhead costs deemed necessary to support the overall business, but which is cutting into the overall net margin. The gross margin of 20%, per Exhibit 5, was in line with expectations, though only just so; the E-mail operations need to be reviewed, as a minimum. The 20% margin was effectively a contribution to overheads and net profit, with the former of these of increasing significance, as previously discussed. EXHIBIT 5 Service delivery report for July 2012 (extract): The real significance to these overheads is not obvious in these reports, merely a realisation that a 20% gross margin may not be sufficient to meet the 6% corporate net target. The full company financial status is only produced on a quarterly basis. The latest report (Exhibit 6). shows that the absorption of the overheads from the staff services, plus time allocated by the senior staff of the outsourcing operations that does not directly relate to any of the contracts, such as forward planning and marketing, results in a net margin of 3.1% (£2.3 million over £75.0 million sales), an unsatisfactory situation. This position is also down from the total company actual results of 2011, as illustrated below. Further details of the 2011 reported results are shown in Exhibit 7 EXHIBIT 6 Profit statement summary 2011 full year forecast versus 2011, as at 1 July 2012: EXHIBIT 7 Integrated Technology Services (UK) LTD Summarised Published accounts: QUESTIONS: Following the review of the planning and control systems of Integrated Technology Services (UK) Ltd (ITS-UK), the Group Manager James Gunn has asked you, the consultant, into his office to discuss a number of points arising. He is accompanied by the Operations Manager. Mr Gunn opened the meeting, “We have some concern with the net profit margin as the sole performance measure of our business. It is not necessarily the actual percentage of 6% that is giving us trouble, maybe it is a suitable figure as many of our competitors are facing even tighter margins, but it is the concept. Frankly, we are not clear as to why this is the sole measurement criteria, surely there are other ways of measuring how well our business is performing. We believe that we have a good business and the market is there for future growth, but maybe there are other ways of looking at how well we are doing. We are not financial people, so we look to you to help. We would therefore like you to look into this and prepare a report on the merits of this net margin measure and any suitable alternatives that we can propose to our corporate managers. The other item that we want you to review is the budget process. Here, we believe that we have a good system, but we need to get it running properly. The problem is that it is going to take more resources to do so, probably an extra accountant for some £35,000 per year, plus benefits and support costs which will come to nearly £50,000. We therefore need a good case to go to head office to justify this and we would like you to come up with that justification.” REQUIRED: 1. Prepare the report on the net margin, as requested by the Group Manager. 2. Prepare a justification of the budgeting system, covering the principles of the budget, its features and advantages, in general, along with the specific advantages for ITS-UK, to meet the needs of local management.
The real significance to these overheads is not obvious in these reports, merely a realisation that a 20% gross margin may not be sufficient to meet the 6% corporate net target. The full company financial status is only produced on a quarterly basis. The latest report (Exhibit 6). shows that the absorption of the overheads from the staff services, plus time allocated by the senior staff of the outsourcing operations that does not directly relate to any of the contracts, such as forward planning and marketing, results in a net margin of 3.1% (£2.3 million over £75.0 million sales), an unsatisfactory situation. This position is also down from the total company actual results of 2011, as illustrated below. Further details of the 2011 reported results are shown in Exhibit 7 EXHIBIT 6 Profit statement summary 2011 full year forecast versus 2011, as at 1 July 2012:
In November 2012, a consultant was employed to review and document the planning and control systems of Integrated Technology Services (UK) Ltd (ITS-UK), to ensure that these were effectively meeting the needs of the business and to provide a basis for staff training. ITS-UK is the British subsidiary of Integrated Technology Services International (ITSI), a technology company, based in the north-east USA, which has history of developing and providing technology solutions to major international corporations and the US Government. It has focused on science and technology as a core strength with a significant Research and Development (R&D) expenditure. It is also noted for its extensive employee share ownership scheme, to encourage staff business awareness. The UK operations are based on two main activities: 1. Consultancy services to a range of businesses; 2. Computing and telecommunications outsourcing support to companies, particularly the oil and gas industry, but increasingly to other industries and to the public sector. The latter activity has been in response to the business opportunities created by a variety of industries that have preferred to focus on their ‘core competencies’ and outsource some of their internal support functions to external providers, particularly in information technology and accounting. The Government has also reinforced the trend by the compulsory tendering of many of its internal services in competition with outside providers. At the same time, outsourcing of information technology (IT) services has developed in the USA, where the parent company has progressed. Project management has been a particular strength within the corporate body, developed over its 30-year history. This expertise has also been used to advantage by its UK subsidiary, with the readily available facilities of US based staff, when dealing with multi-national corporations. ORGANISATIONAL STRUCTURE ITS-UK is structured into three groups of activities: • Consultancy business as a small separate unit • Outsourcing Services on a matrix organisational basis • Staff services, such as Finance, Commercial and Human Resource and Administration EXHIBIT 1: Consultancy This is the oldest established business unit of ITS-UK. It is relatively independent with a separate client base from that of the outsourcing business, though there is some commonality as its consultancy is essentially for systems applications and integration. It shares the staff services with the rest of the company, with an occasional requirement for the services of the other groups, such as the Infrastructure department, on an advisory basis. Outsourcing Services As with many modern service providers, the functions are divided into those that deal directly with the client, known as the front office, with the back-office delivery managers in charge of departments that provide the actual support staff, as follows: • Marketing department is a small group, which has the responsibility to find new business. Staff will read initial customer requirement reviews and contract negotiations, along with appropriate resources from other departments. • Client Account Managers head small departments who are in direct ongoing communication with the customer, once the contract is approved and work is ready to commence. They are to ensure that the contractual requirements are properly followed to meet customer expectations. This, in practice, is largely to meet the following criteria: (a). That proper resources are provided from the main groups of Applications Infrastructure and e-mail, to meet contract specifications, e.g. the right number of the appropriately qualified systems engineers, as defined in the contract. (b). That excess resources are not allocated to the project, due to support staff lack of contract understanding. The departments are structured on the basis of client requirements. An oil and gas group was originally developed to support one particularly large client, from which many of the staff were transferred to ITS-UK to carry on the work that they had previously provided. This original group was later divided into two, to reflect the two-division structure of the oil industry, the upstream exploration and production and the downstream marketing and refining. The Operations South group covers all other industries and local government departments. • Applications department provides the technical resources to develop and support clients’ IT applications systems. • Infrastructure department provides the technical resources to implement and support all computer hardware, telecommunications and networking requirements. It also includes a front-line help-desk support which is the first point of call for any customer call, such as computer, telephone or application system problems. • E-mail is a specialist group that provides electronic mail services to customers. Planning is a critical function for each of the Applications, Infrastructure and E-mail delivery managers, both with the marketing managers for early warnings as to staff requirements and with client management for ongoing needs. This latter feature has been difficult to achieve due to regular contract change requests by the major clients. The overall organisation is of a matrix nature, where the service delivery managers (SDM’s) provide some 750 people to a broad range of contracts. Some staff may be permanently assigned to a major client, whilst others could be working on several different contracts in a single week. BUSINESS CONTROLS OVERVIEW Expansion in Outsourcing had been rapid, with an emphasis on drive and initiative, to some neglect of a detailed controls framework. The main financial performance measure is the net margin. This is set by corporate headquarters as 6%, which effectively is the prime objective if ITS-UK. Contacts with clients tend to be agreed on a gross margin basis, but which obviously must be carefully set, usually at least 20%. This has been deemed to be the minimum required contribution to cover overheads and profit, although questions were being raised as to the appropriateness of this level as the net margin of 6% is becoming increasingly difficult to achieve, with some of the following points raised as contributory factors: 1. Following the early, large, long-term contracts, which were relatively simple to administer, overhead costs have risen disproportionately due to: • many small contracts, which administratively are often as expensive as much larger ones; overall lower net margins are therefore a natural outcome of the decreasing size of average contracts; • lack of standardisation of contract terms leading to complex administrative and financial controls, e.g. billing • arrangements have to be individually monitored, as computer systems have been unable to fully accommodate all the variations. The 20% gross margin target is therefore contributing increasingly more to overheads than to profit. 2. A further reason for lowering profitability is believed to be that the drive for market share, which had taken precedence over gross margin, has resulted in ‘loss-leaders’ which were not living up to expectations. One particular large contract, started with a 15% gross margin, in the expectancy of leading to other more lucrative work, but has not yet proved to have done so. 3. The mechanism of charging the IT person’s time to the contract, through a timesheet, is not being properly controlled. Staff may work on a number of small contracts in a week, possibly for the same client, which is not always obvious to the person concerned. Time is therefore often incorrectly charged, which results in a waste of administrative effort to correct, along with client dissatisfaction. A particularly difficult situation is where a variety of different types of contracts may be in force with a single client company. A systems engineer may work on a fixed price contract on one day so that time charged to the contract will be for internal ITS-UK purposes only, i.e. it will not affect the charge to the client. Then on the following day, he may be supporting a reimbursable (time and materials) contract, when time charged is reimbursed by the client. If these times get mixed up, the consequences can be significant. A lack of contract understanding therefore may be leading to costs, that should be chargeable to the contract and paid by the client, are not being identified as such. These costs will therefore remain as a charge against ITS-UK’s profits. 4. The increasing complexity of the matrix organisation may be leading to wastage. Ideally, resources should be provided to meet clients’ needs as and when needed. In practice, this flexibility can only be met if there are readily available staff resources at any time, which would inevitably lead to reserve people. However, such standby staff have a price, who generate no income, if not used. A response to the above problems has been to improve financial planning and budgetary controls. Before looking at these two control mechanisms, the nature of the various contractual arrangements must be understood. CONTRACTURAL RELATIONSHIPS ITS-UK receives its income through the provision of technology services, which are governed by various contractual relationships with the client. This commercial relationship will tend to depend upon the balancing of risk and reward. The reward to the contractor will be influenced by the amount of perceived risk, that is, the higher the risk that the contractor is expected to meet, then the higher the reward that the contractor will expect to receive. In practice, where risk is deemed to be high both for its frequency and impact, the customer normally bears this risk, supporting a standard cost reimbursable (or ‘time and materials’) type of contract. For low risk projects, the contractor is more likely to bear the risk with a fixed cost type of contract preferred. An example of the former may be an innovative oil construction computer control system in a frontier zone, whilst ongoing systems support may typify the latter. A third major category has emerged in recent years, where various concepts of sharing risk and reward have been created, to be known as incentive or target cost contracts, frequently as part of long term ‘alliancing’ relationships. All three types of contracts are found within ITS-UK, with the target cost tending to dominate the larger contracts and therefore comprise a significant element of the sales revenue. An example of such a contract is shown in Exhibit 2. EXHIBIT 2: Target contract example (selected items from internal contract brief) Contract scope: Provision of outsourcing arrangements for the Information Systems and Records Management Functions at Company X. Contract type: 2012, Ceiling price with sharing of any underruns only, plus Discretionary Services project work to be remunerated on a time and materials basis (agreed rates listed separately). Ceiling price for 2012: £784 000 Underrun sharing: Company X share: 40% ITS-UK share: 60% Performance award: From –5% to þ5%, payable quarterly. Note - basis for cost calculations is actual cost to ITS-UK plus an agreed mark up of 12%. Calculation of contract profits to ITS-UK at varying levels of actual chargeable costs: Actual ITS-UK contract cost for target contact = £784 000/1.12 = £700 000 Therefore the base for 2012 is that ITS-UK will receive revenue of £784 000 for a cost of £700 000, i.e. a profit (mark-up) of £84 000. This mark-up is payable, regardless of actual cost. For a sample of lower resultant costs, profit share will be as follows: The profit to contractor will be adjusted per the performance award and any costs that are not recoverable, according to contract. CONTRACT COSTS Each client, covering several contracts, or sometimes a single major contract, is treated as a profit centre, to include all costs that are specific to the contract, plus indirect cost allocations, and their revenues. It is crucial to the profitability of all target and time and materials contracts to be as clear as to what is recoverable in the contract, i.e. that which will be paid by the client. The contract should list all categories of support staff and probably their rates, along with all services and equipment. For example, if 50% of an accountant is recoverable per a large contract, but 75% of an accountant’s time is actually used to support the contract, 50% will be charged to the client and the other 25% will have to be absorbed by ITS-UK, i.e. as a general overhead cost, directly charged against ITS-UK’s own profits. These recoverable costs are often known as ‘direct cost’ which is not as normal per cost accounting terminology, where an accountant’s time, partially allocated to a contract, would be regarded as an indirect cost. An example of a small contract build-up, for quotation purposes is as follows: EXHIBIT 3 Contract details for bid preparation Note 1 - FTE - Full-time equivalent person, e.g. 0.5 FTE is half a person’s workload. Note 2 - includes commercial, finance and admin. support (on a pro-rata headcount basis, plus office consumables, telephone and internal IT support). How these are identified to the client will depend on the type of contract. For a fixed price contract, these will be internally recorded costs only: for a target or reimbursable contract, these items will all be specifically agreed with the client, for client’s account. PLANNING For business planning purposes, the time horizon tends to be shorter than for most organisations. Business had been expanding rapidly, with the only real constraint being resources, where there has been a shortage of technically skilled IT people. The larger contracts tended to be for three to five years, so that a high degree of security exists for the levels of income from the major clients in the medium term. Otherwise, the annual budget cycle tends to predominate, to meet corporate objectives, with a general plan for the longer term, mainly focusing on the larger contracts plus a general business view for potential markets. BUDGETING Until recently, the budget had been prepared on a programme basis, i.e. by client, and for the total UK operations, to support corporate planning requirements. Control therefore could only applied to these levels, effectively the client as the profit centre, with the back office groups being excluded, to any detailed extent. The overall results, which were not meeting profit expectations, led to the realisation that further controls were required. From this year, the budget has also been structured by all responsibility centres, that is, to include the back offices as expense centres. An example of the new budgetary structure, with illustrative numbers, is shown in summary below: EXHIBIT 4 Outline of the 2012 budgeting and reporting format (£000): In practice, each of the cost categories will be analysed by individual item, per the ITS-UK chart of accounts: • Labour is broken down by category of job function and numbers of each (FTE’s- full time equivalents), such as the client Management above as: • Agency staff are similarly analysed. • Subcontracts are individually identified. These are often a substantial part of the main contract, such as the provision of specialist geophysical services to an oil company, but which is deemed, by the oil company, to be part of the general systems support by ITS-UK. This is part of the oil industry’s general policy to limit the number of contractors with which it directly communicates. In the above example, the £80,000 Applications sub-contract may be for specialist services, which will be managed by the Applications Service Delivery Manager on behalf of the total contract, so will be accountable to the Client Manager for its performance. • Other costs - these are the recoverable costs of the contract. They are individually identified in the budget, such as hardware maintenance, software licences, telephone and travel costs. The concept is that, for each profit centre (or contract) cost item, the department responsible for that cost will be identified, leading to a bottom line number for each manager, for which he or she will be held accountable. For Applications and Infrastructure, the two main expenditure areas, where any total cost is expected to impact the contract in any way, the manager concerned must discuss and agree this with the client manager. In the above example, the Applications manager is responsible for a budget of £720,000, the limit for which he can spend without any agreement with the Client Manager, providing services meet the contractual specifications. BUDGET PREPARATION The following steps are observed: 1. The year’s programme is agreed, essentially: • Confirm the continuation of existing contracts. • Clarify contract renewal expectations, for contracts that will be up for renewal in the budget period. • Agree scope of any new business. 2. All departmental managers prepare their budget costs, by person and cost detail, for each contract or new business category. 3. Results are consolidated by contract, or new business category, by budget coordinator. 4. Service Delivery Managers then review their results with each of the Client Managers, for agreement as to conformance with contract and to ensure that derived profit margins are as expected. 5. Once agreed, all results are consolidated, along with staff service departments, to produce a draft operational budget for Outsourcing Services, for review by the Group Manager to ensure that corporate objectives are met. 6. Adjustments may be made, as required (they usually are!). MANAGEMENT REPORTING Quarterly reports are transmitted to the head office, for the major contracts, overall actual cost position and full year forecasts. For major international clients, a world-wide consolidation is undertaken for overall ITSI support, i.e. global support for global companies; an increasing expectation of such clients. Internal monthly reports are reviewed by the Operations Manager with his client and service delivery managers. An example of a section of the report is shown below for July 2012, for one particular major client (one profit centre) with six different contracts: Supporting these reports would be cost details on the budget basis, i.e. each cost identified per the service delivery department, so that actual costs would be reported alongside the budget numbers, per Exhibit 4 structure. In practice, this is very limited in its use. The computurised accounting system (a modern integrated ‘enterprise’ reporting system) has the facility to accomodate the input of budget data, but it requires the budget to be prepared at a very detailed level for input, which is very time consuming and has not yet been adequately implemented. Comparisons are therefore made on a manual basis, e.g. by downloading the relevant actual data in the budget format. For example, if the budget identifies a training cost for Applications staff on Exoil Oil & Chemicals, actual data will be extracted manually from the system for direct comparison. This type of work is partially performed, but the problem is the heavy use of resources to prepare the reports; a good example of the increasing overhead costs deemed necessary to support the overall business, but which is cutting into the overall net margin. The gross margin of 20%, per Exhibit 5, was in line with expectations, though only just so; the E-mail operations need to be reviewed, as a minimum. The 20% margin was effectively a contribution to overheads and net profit, with the former of these of increasing significance, as previously discussed. EXHIBIT 5 Service delivery report for July 2012 (extract): The real significance to these overheads is not obvious in these reports, merely a realisation that a 20% gross margin may not be sufficient to meet the 6% corporate net target. The full company financial status is only produced on a quarterly basis. The latest report (Exhibit 6). shows that the absorption of the overheads from the staff services, plus time allocated by the senior staff of the outsourcing operations that does not directly relate to any of the contracts, such as forward planning and marketing, results in a net margin of 3.1% (£2.3 million over £75.0 million sales), an unsatisfactory situation. This position is also down from the total company actual results of 2011, as illustrated below. Further details of the 2011 reported results are shown in Exhibit 7 EXHIBIT 6 Profit statement summary 2011 full year forecast versus 2011, as at 1 July 2012: EXHIBIT 7 Integrated Technology Services (UK) LTD Summarised Published accounts: QUESTIONS: Following the review of the planning and control systems of Integrated Technology Services (UK) Ltd (ITS-UK), the Group Manager James Gunn has asked you, the consultant, into his office to discuss a number of points arising. He is accompanied by the Operations Manager. Mr Gunn opened the meeting, “We have some concern with the net profit margin as the sole performance measure of our business. It is not necessarily the actual percentage of 6% that is giving us trouble, maybe it is a suitable figure as many of our competitors are facing even tighter margins, but it is the concept. Frankly, we are not clear as to why this is the sole measurement criteria, surely there are other ways of measuring how well our business is performing. We believe that we have a good business and the market is there for future growth, but maybe there are other ways of looking at how well we are doing. We are not financial people, so we look to you to help. We would therefore like you to look into this and prepare a report on the merits of this net margin measure and any suitable alternatives that we can propose to our corporate managers. The other item that we want you to review is the budget process. Here, we believe that we have a good system, but we need to get it running properly. The problem is that it is going to take more resources to do so, probably an extra accountant for some £35,000 per year, plus benefits and support costs which will come to nearly £50,000. We therefore need a good case to go to head office to justify this and we would like you to come up with that justification.” REQUIRED: 1. Prepare the report on the net margin, as requested by the Group Manager. 2. Prepare a justification of the budgeting system, covering the principles of the budget, its features and advantages, in general, along with the specific advantages for ITS-UK, to meet the needs of local management.
EXHIBIT 7 Integrated Technology Services (UK) LTD Summarised Published accounts:
In November 2012, a consultant was employed to review and document the planning and control systems of Integrated Technology Services (UK) Ltd (ITS-UK), to ensure that these were effectively meeting the needs of the business and to provide a basis for staff training. ITS-UK is the British subsidiary of Integrated Technology Services International (ITSI), a technology company, based in the north-east USA, which has history of developing and providing technology solutions to major international corporations and the US Government. It has focused on science and technology as a core strength with a significant Research and Development (R&D) expenditure. It is also noted for its extensive employee share ownership scheme, to encourage staff business awareness. The UK operations are based on two main activities: 1. Consultancy services to a range of businesses; 2. Computing and telecommunications outsourcing support to companies, particularly the oil and gas industry, but increasingly to other industries and to the public sector. The latter activity has been in response to the business opportunities created by a variety of industries that have preferred to focus on their ‘core competencies’ and outsource some of their internal support functions to external providers, particularly in information technology and accounting. The Government has also reinforced the trend by the compulsory tendering of many of its internal services in competition with outside providers. At the same time, outsourcing of information technology (IT) services has developed in the USA, where the parent company has progressed. Project management has been a particular strength within the corporate body, developed over its 30-year history. This expertise has also been used to advantage by its UK subsidiary, with the readily available facilities of US based staff, when dealing with multi-national corporations. ORGANISATIONAL STRUCTURE ITS-UK is structured into three groups of activities: • Consultancy business as a small separate unit • Outsourcing Services on a matrix organisational basis • Staff services, such as Finance, Commercial and Human Resource and Administration EXHIBIT 1: Consultancy This is the oldest established business unit of ITS-UK. It is relatively independent with a separate client base from that of the outsourcing business, though there is some commonality as its consultancy is essentially for systems applications and integration. It shares the staff services with the rest of the company, with an occasional requirement for the services of the other groups, such as the Infrastructure department, on an advisory basis. Outsourcing Services As with many modern service providers, the functions are divided into those that deal directly with the client, known as the front office, with the back-office delivery managers in charge of departments that provide the actual support staff, as follows: • Marketing department is a small group, which has the responsibility to find new business. Staff will read initial customer requirement reviews and contract negotiations, along with appropriate resources from other departments. • Client Account Managers head small departments who are in direct ongoing communication with the customer, once the contract is approved and work is ready to commence. They are to ensure that the contractual requirements are properly followed to meet customer expectations. This, in practice, is largely to meet the following criteria: (a). That proper resources are provided from the main groups of Applications Infrastructure and e-mail, to meet contract specifications, e.g. the right number of the appropriately qualified systems engineers, as defined in the contract. (b). That excess resources are not allocated to the project, due to support staff lack of contract understanding. The departments are structured on the basis of client requirements. An oil and gas group was originally developed to support one particularly large client, from which many of the staff were transferred to ITS-UK to carry on the work that they had previously provided. This original group was later divided into two, to reflect the two-division structure of the oil industry, the upstream exploration and production and the downstream marketing and refining. The Operations South group covers all other industries and local government departments. • Applications department provides the technical resources to develop and support clients’ IT applications systems. • Infrastructure department provides the technical resources to implement and support all computer hardware, telecommunications and networking requirements. It also includes a front-line help-desk support which is the first point of call for any customer call, such as computer, telephone or application system problems. • E-mail is a specialist group that provides electronic mail services to customers. Planning is a critical function for each of the Applications, Infrastructure and E-mail delivery managers, both with the marketing managers for early warnings as to staff requirements and with client management for ongoing needs. This latter feature has been difficult to achieve due to regular contract change requests by the major clients. The overall organisation is of a matrix nature, where the service delivery managers (SDM’s) provide some 750 people to a broad range of contracts. Some staff may be permanently assigned to a major client, whilst others could be working on several different contracts in a single week. BUSINESS CONTROLS OVERVIEW Expansion in Outsourcing had been rapid, with an emphasis on drive and initiative, to some neglect of a detailed controls framework. The main financial performance measure is the net margin. This is set by corporate headquarters as 6%, which effectively is the prime objective if ITS-UK. Contacts with clients tend to be agreed on a gross margin basis, but which obviously must be carefully set, usually at least 20%. This has been deemed to be the minimum required contribution to cover overheads and profit, although questions were being raised as to the appropriateness of this level as the net margin of 6% is becoming increasingly difficult to achieve, with some of the following points raised as contributory factors: 1. Following the early, large, long-term contracts, which were relatively simple to administer, overhead costs have risen disproportionately due to: • many small contracts, which administratively are often as expensive as much larger ones; overall lower net margins are therefore a natural outcome of the decreasing size of average contracts; • lack of standardisation of contract terms leading to complex administrative and financial controls, e.g. billing • arrangements have to be individually monitored, as computer systems have been unable to fully accommodate all the variations. The 20% gross margin target is therefore contributing increasingly more to overheads than to profit. 2. A further reason for lowering profitability is believed to be that the drive for market share, which had taken precedence over gross margin, has resulted in ‘loss-leaders’ which were not living up to expectations. One particular large contract, started with a 15% gross margin, in the expectancy of leading to other more lucrative work, but has not yet proved to have done so. 3. The mechanism of charging the IT person’s time to the contract, through a timesheet, is not being properly controlled. Staff may work on a number of small contracts in a week, possibly for the same client, which is not always obvious to the person concerned. Time is therefore often incorrectly charged, which results in a waste of administrative effort to correct, along with client dissatisfaction. A particularly difficult situation is where a variety of different types of contracts may be in force with a single client company. A systems engineer may work on a fixed price contract on one day so that time charged to the contract will be for internal ITS-UK purposes only, i.e. it will not affect the charge to the client. Then on the following day, he may be supporting a reimbursable (time and materials) contract, when time charged is reimbursed by the client. If these times get mixed up, the consequences can be significant. A lack of contract understanding therefore may be leading to costs, that should be chargeable to the contract and paid by the client, are not being identified as such. These costs will therefore remain as a charge against ITS-UK’s profits. 4. The increasing complexity of the matrix organisation may be leading to wastage. Ideally, resources should be provided to meet clients’ needs as and when needed. In practice, this flexibility can only be met if there are readily available staff resources at any time, which would inevitably lead to reserve people. However, such standby staff have a price, who generate no income, if not used. A response to the above problems has been to improve financial planning and budgetary controls. Before looking at these two control mechanisms, the nature of the various contractual arrangements must be understood. CONTRACTURAL RELATIONSHIPS ITS-UK receives its income through the provision of technology services, which are governed by various contractual relationships with the client. This commercial relationship will tend to depend upon the balancing of risk and reward. The reward to the contractor will be influenced by the amount of perceived risk, that is, the higher the risk that the contractor is expected to meet, then the higher the reward that the contractor will expect to receive. In practice, where risk is deemed to be high both for its frequency and impact, the customer normally bears this risk, supporting a standard cost reimbursable (or ‘time and materials’) type of contract. For low risk projects, the contractor is more likely to bear the risk with a fixed cost type of contract preferred. An example of the former may be an innovative oil construction computer control system in a frontier zone, whilst ongoing systems support may typify the latter. A third major category has emerged in recent years, where various concepts of sharing risk and reward have been created, to be known as incentive or target cost contracts, frequently as part of long term ‘alliancing’ relationships. All three types of contracts are found within ITS-UK, with the target cost tending to dominate the larger contracts and therefore comprise a significant element of the sales revenue. An example of such a contract is shown in Exhibit 2. EXHIBIT 2: Target contract example (selected items from internal contract brief) Contract scope: Provision of outsourcing arrangements for the Information Systems and Records Management Functions at Company X. Contract type: 2012, Ceiling price with sharing of any underruns only, plus Discretionary Services project work to be remunerated on a time and materials basis (agreed rates listed separately). Ceiling price for 2012: £784 000 Underrun sharing: Company X share: 40% ITS-UK share: 60% Performance award: From –5% to þ5%, payable quarterly. Note - basis for cost calculations is actual cost to ITS-UK plus an agreed mark up of 12%. Calculation of contract profits to ITS-UK at varying levels of actual chargeable costs: Actual ITS-UK contract cost for target contact = £784 000/1.12 = £700 000 Therefore the base for 2012 is that ITS-UK will receive revenue of £784 000 for a cost of £700 000, i.e. a profit (mark-up) of £84 000. This mark-up is payable, regardless of actual cost. For a sample of lower resultant costs, profit share will be as follows: The profit to contractor will be adjusted per the performance award and any costs that are not recoverable, according to contract. CONTRACT COSTS Each client, covering several contracts, or sometimes a single major contract, is treated as a profit centre, to include all costs that are specific to the contract, plus indirect cost allocations, and their revenues. It is crucial to the profitability of all target and time and materials contracts to be as clear as to what is recoverable in the contract, i.e. that which will be paid by the client. The contract should list all categories of support staff and probably their rates, along with all services and equipment. For example, if 50% of an accountant is recoverable per a large contract, but 75% of an accountant’s time is actually used to support the contract, 50% will be charged to the client and the other 25% will have to be absorbed by ITS-UK, i.e. as a general overhead cost, directly charged against ITS-UK’s own profits. These recoverable costs are often known as ‘direct cost’ which is not as normal per cost accounting terminology, where an accountant’s time, partially allocated to a contract, would be regarded as an indirect cost. An example of a small contract build-up, for quotation purposes is as follows: EXHIBIT 3 Contract details for bid preparation Note 1 - FTE - Full-time equivalent person, e.g. 0.5 FTE is half a person’s workload. Note 2 - includes commercial, finance and admin. support (on a pro-rata headcount basis, plus office consumables, telephone and internal IT support). How these are identified to the client will depend on the type of contract. For a fixed price contract, these will be internally recorded costs only: for a target or reimbursable contract, these items will all be specifically agreed with the client, for client’s account. PLANNING For business planning purposes, the time horizon tends to be shorter than for most organisations. Business had been expanding rapidly, with the only real constraint being resources, where there has been a shortage of technically skilled IT people. The larger contracts tended to be for three to five years, so that a high degree of security exists for the levels of income from the major clients in the medium term. Otherwise, the annual budget cycle tends to predominate, to meet corporate objectives, with a general plan for the longer term, mainly focusing on the larger contracts plus a general business view for potential markets. BUDGETING Until recently, the budget had been prepared on a programme basis, i.e. by client, and for the total UK operations, to support corporate planning requirements. Control therefore could only applied to these levels, effectively the client as the profit centre, with the back office groups being excluded, to any detailed extent. The overall results, which were not meeting profit expectations, led to the realisation that further controls were required. From this year, the budget has also been structured by all responsibility centres, that is, to include the back offices as expense centres. An example of the new budgetary structure, with illustrative numbers, is shown in summary below: EXHIBIT 4 Outline of the 2012 budgeting and reporting format (£000): In practice, each of the cost categories will be analysed by individual item, per the ITS-UK chart of accounts: • Labour is broken down by category of job function and numbers of each (FTE’s- full time equivalents), such as the client Management above as: • Agency staff are similarly analysed. • Subcontracts are individually identified. These are often a substantial part of the main contract, such as the provision of specialist geophysical services to an oil company, but which is deemed, by the oil company, to be part of the general systems support by ITS-UK. This is part of the oil industry’s general policy to limit the number of contractors with which it directly communicates. In the above example, the £80,000 Applications sub-contract may be for specialist services, which will be managed by the Applications Service Delivery Manager on behalf of the total contract, so will be accountable to the Client Manager for its performance. • Other costs - these are the recoverable costs of the contract. They are individually identified in the budget, such as hardware maintenance, software licences, telephone and travel costs. The concept is that, for each profit centre (or contract) cost item, the department responsible for that cost will be identified, leading to a bottom line number for each manager, for which he or she will be held accountable. For Applications and Infrastructure, the two main expenditure areas, where any total cost is expected to impact the contract in any way, the manager concerned must discuss and agree this with the client manager. In the above example, the Applications manager is responsible for a budget of £720,000, the limit for which he can spend without any agreement with the Client Manager, providing services meet the contractual specifications. BUDGET PREPARATION The following steps are observed: 1. The year’s programme is agreed, essentially: • Confirm the continuation of existing contracts. • Clarify contract renewal expectations, for contracts that will be up for renewal in the budget period. • Agree scope of any new business. 2. All departmental managers prepare their budget costs, by person and cost detail, for each contract or new business category. 3. Results are consolidated by contract, or new business category, by budget coordinator. 4. Service Delivery Managers then review their results with each of the Client Managers, for agreement as to conformance with contract and to ensure that derived profit margins are as expected. 5. Once agreed, all results are consolidated, along with staff service departments, to produce a draft operational budget for Outsourcing Services, for review by the Group Manager to ensure that corporate objectives are met. 6. Adjustments may be made, as required (they usually are!). MANAGEMENT REPORTING Quarterly reports are transmitted to the head office, for the major contracts, overall actual cost position and full year forecasts. For major international clients, a world-wide consolidation is undertaken for overall ITSI support, i.e. global support for global companies; an increasing expectation of such clients. Internal monthly reports are reviewed by the Operations Manager with his client and service delivery managers. An example of a section of the report is shown below for July 2012, for one particular major client (one profit centre) with six different contracts: Supporting these reports would be cost details on the budget basis, i.e. each cost identified per the service delivery department, so that actual costs would be reported alongside the budget numbers, per Exhibit 4 structure. In practice, this is very limited in its use. The computurised accounting system (a modern integrated ‘enterprise’ reporting system) has the facility to accomodate the input of budget data, but it requires the budget to be prepared at a very detailed level for input, which is very time consuming and has not yet been adequately implemented. Comparisons are therefore made on a manual basis, e.g. by downloading the relevant actual data in the budget format. For example, if the budget identifies a training cost for Applications staff on Exoil Oil & Chemicals, actual data will be extracted manually from the system for direct comparison. This type of work is partially performed, but the problem is the heavy use of resources to prepare the reports; a good example of the increasing overhead costs deemed necessary to support the overall business, but which is cutting into the overall net margin. The gross margin of 20%, per Exhibit 5, was in line with expectations, though only just so; the E-mail operations need to be reviewed, as a minimum. The 20% margin was effectively a contribution to overheads and net profit, with the former of these of increasing significance, as previously discussed. EXHIBIT 5 Service delivery report for July 2012 (extract): The real significance to these overheads is not obvious in these reports, merely a realisation that a 20% gross margin may not be sufficient to meet the 6% corporate net target. The full company financial status is only produced on a quarterly basis. The latest report (Exhibit 6). shows that the absorption of the overheads from the staff services, plus time allocated by the senior staff of the outsourcing operations that does not directly relate to any of the contracts, such as forward planning and marketing, results in a net margin of 3.1% (£2.3 million over £75.0 million sales), an unsatisfactory situation. This position is also down from the total company actual results of 2011, as illustrated below. Further details of the 2011 reported results are shown in Exhibit 7 EXHIBIT 6 Profit statement summary 2011 full year forecast versus 2011, as at 1 July 2012: EXHIBIT 7 Integrated Technology Services (UK) LTD Summarised Published accounts: QUESTIONS: Following the review of the planning and control systems of Integrated Technology Services (UK) Ltd (ITS-UK), the Group Manager James Gunn has asked you, the consultant, into his office to discuss a number of points arising. He is accompanied by the Operations Manager. Mr Gunn opened the meeting, “We have some concern with the net profit margin as the sole performance measure of our business. It is not necessarily the actual percentage of 6% that is giving us trouble, maybe it is a suitable figure as many of our competitors are facing even tighter margins, but it is the concept. Frankly, we are not clear as to why this is the sole measurement criteria, surely there are other ways of measuring how well our business is performing. We believe that we have a good business and the market is there for future growth, but maybe there are other ways of looking at how well we are doing. We are not financial people, so we look to you to help. We would therefore like you to look into this and prepare a report on the merits of this net margin measure and any suitable alternatives that we can propose to our corporate managers. The other item that we want you to review is the budget process. Here, we believe that we have a good system, but we need to get it running properly. The problem is that it is going to take more resources to do so, probably an extra accountant for some £35,000 per year, plus benefits and support costs which will come to nearly £50,000. We therefore need a good case to go to head office to justify this and we would like you to come up with that justification.” REQUIRED: 1. Prepare the report on the net margin, as requested by the Group Manager. 2. Prepare a justification of the budgeting system, covering the principles of the budget, its features and advantages, in general, along with the specific advantages for ITS-UK, to meet the needs of local management.
QUESTIONS: Following the review of the planning and control systems of Integrated Technology Services (UK) Ltd (ITS-UK), the Group Manager James Gunn has asked you, the consultant, into his office to discuss a number of points arising. He is accompanied by the Operations Manager. Mr Gunn opened the meeting, “We have some concern with the net profit margin as the sole performance measure of our business. It is not necessarily the actual percentage of 6% that is giving us trouble, maybe it is a suitable figure as many of our competitors are facing even tighter margins, but it is the concept. Frankly, we are not clear as to why this is the sole measurement criteria, surely there are other ways of measuring how well our business is performing. We believe that we have a good business and the market is there for future growth, but maybe there are other ways of looking at how well we are doing. We are not financial people, so we look to you to help. We would therefore like you to look into this and prepare a report on the merits of this net margin measure and any suitable alternatives that we can propose to our corporate managers. The other item that we want you to review is the budget process. Here, we believe that we have a good system, but we need to get it running properly. The problem is that it is going to take more resources to do so, probably an extra accountant for some £35,000 per year, plus benefits and support costs which will come to nearly £50,000. We therefore need a good case to go to head office to justify this and we would like you to come up with that justification.” REQUIRED: 1. Prepare the report on the net margin, as requested by the Group Manager. 2. Prepare a justification of the budgeting system, covering the principles of the budget, its features and advantages, in general, along with the specific advantages for ITS-UK, to meet the needs of local management.





Transcribed Image Text:

Outcome measures - results of strategy Driver measures - leading indicators The Balanced Scorecard Financial Perspective Internal Business Perspective Customer Perspective Innovation & Learning Perspective Planning Process Overview Identify objectives I.D potential strategies Long-term planning process Evaluate strategic options Select alternative actions .. **...... Implement plan as budget Annual control features budgeting Process Monitor actual results Respond to divergencies Sales revenue Actual cost Mark-up Share of underrun (60%) 500000 700 000 600 000 84 000 60 000 84 000 84 000 120000 704 000 500 000 -0 744 000 600 000 784 000 700 000 less Actual cost Profit on contract 204 000 144 000 84 000 41 41 Labour Salary per annum FTE's (see note 1) Services Delivery Manager Systems Engineer Desktop Technician Customer Support Analyst 35000 26 000 0.02 700 0.92 23920 22000 0.1 2200 0.13 1.17 16000 2080 Total salaries 28 900 Staff benefits (22%) 6358 Total labour 35 258 Training (£1 500 per FTE) Overheads (£3 750 per FTE) (see note 2) Other Direct Costs (hardware maintenance 1755 4388 costs - components will be listed) Head Office (5% of direct labour) Contingency (10% of direct labour) 5700 1445 2890 Total 51436 Add margin 25% 12859 64295 Client Cost categories Marketing Management Applications Infrastructure Total contract Labour: Staff 20 67 350 250 687 Agency 150 100 250 Sub contracts 80 200 280 20 40 25 92 140 720 150 700 335 1 552 Other costs Total cost Salary FTE's Labour cost £1 8 000 £37000 £55 000 0.3 Client Manager Service delivery £60 000 £37 000 1.0 Direct labour Staff benefits (22%) Total labour £12100 £67100 YEAR TO DATE JULY Contract Profit centre Contract/project Revenue Project Costs Gross PBT1 f f 1010 4255 Exoil Chemicals London Office 210 000 160 769 49 231 23,4 1019 4255 45 000 42 100 2 900 6.4 56 500 20.2 Exoil Chemicals E-mail 1032 4255 Exoil Chemicals Cludeside 280 000 223 500 1033 4255 320 000 258 123 61 877 19.3 Exoil Refinery Fife Terminal Exoil Refinery E-mail Exoil Refinery Projects Exoil Oil & Chemicals 1059 4255 53 000 54 256 -1 256 -2.4 1072 4255 180 000 131 456 48 544 27.0 4255 1088 000 870 204 217 796 20.0 Note 1- PBT = Profit before Tax; being gross, it also excludes overheads. 2012 Full year forecast Outsourcing Sexises. 2011 Actual Consultancy ITS-UK ITS-UK f million f million Sales revenue 75.0 10.2 85.2 80.5 60.0 15.0 7.9 2.3 67.9 17.3 63.6 16.9 Cost of sales Gross profit Admin. & other expenses 12.7 2.3 1.5 0.8 14.2 3.1 12.9 4.0 Net profit PROFIT AND LOSS ACCOUNT FOR 2011 f millions 80.5 63.6 16.9 Sales revenue Cost of sales Gross profit Administration, selling & other expenses Profit before tax 12.9 4.0 1.2 2.8 Тахation Net profit after tax BALANCE SHEET AS AT 31 DECEMBER 2011 f millions Fixed assets 10.5 Current assets 0.2 33.5 Stock Debtors Cash at bank 2.1 35.8 less Creditors - amounts falling due within one year 28.5 7.3 17.8 Net current assets Total assets less Current liabilities Creditors - amounts falling due after more than one year 2.0 15.8 15.8 Net assets Capital and reserves

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> A study was done to assess the cost effectiveness of driving a four-door sedan instead of a van or an SUV (sports utility vehicle). The continuous variables are odometer reading and octane of the gasoline used. The response variable is miles per gallon.

> For the data set given in Exericise 12.16 on page 453, can the response be explained adequately by any two regressor variables? Discuss. Exericise 12.16: An engineer at a semiconductor company wants to model the relationship between the gain or hFE of a

> Consider the data of Exercise 12.13 on page 452. Can the response, wear, be explained adequately by a single variable (either viscosity or load) in an SLR rather than with the full two-variable regression? Justify your answer thoroughly through tests of

> Suppose that the time to failure T of a certain hinge is an exponential random variable with probability density f(t) = θe−θt, t>0. From prior experience we are led to believe that θ is a value

> In Example 12.8, a case is made for eliminating x1, powder temperature, from the model since the P-value based on the F-test is 0.2156 while P-values for x2 and x3 are near zero. (a) Reduce the model by eliminating x1, thereby producing a full and a rest

> Consider Example 12.3 on page 447. Compare the two competing models. First order: yi = β0 + β1x1i + β2x2i + €i, Second order: yi = β0 + β1x1i + β2x2i+ β11x21i + β22x22i + β12x1ix2i + i. Use R2adj in your comparison. Test H0 : β11 = β22 =β12 = 0. In addit

> Consider Example 12.4. Figure 12.1 on page 459 displays a SAS printout of an analysis of the model containing variables x1, x2, and x3. Focus on the confidence interval of the mean response μY at the (x1, x2, x3) locations representing the 13 data points

> An experiment was conducted to determine if the weight of an animal can be predicted after a given period of time on the basis of the initial weight of the animal and the amount of feed that was eaten. The following data, measured in kilograms, were reco

> Consider the data of Exercise 11.55 on page 437. Fit a regression model using weight and drive ratio as explanatory variables. Compare this model with the SLR (simple linear regression) model using weight alone. Use R2, R2adj, and any t-statistics (or F-

> Consider the data for Exercise 12.36. Compute the following: R(β1 | β0), R(β1 | β0, β2, β3), R(β2 | β0, β1), R(β2 | β0, &I

> Consider the electric power data of Exercise 12.5 on page 450. Test H0: β1 = β2 = 0, making use of R(β1, β2 | β3, β4). Give a P-value, and draw conclusions. Exercise 12.5: The elec

> A small experiment was conducted to fit a multiple regression equation relating the yield y to temperature x1, reaction time x2, and concentration of one of the reactants x3. Two levels of each variable were chosen, and measurements corresponding to the

> Repeat Exercise 12.17 on page 461 using an F-statistic. Exercise 12.17: For the data of Exercise 12.2 on page 450, estimate σ2. Exercise 12.2: In Applied Spectroscopy, the infrared reflectance spectra properties of a viscous liquid used in

> For the model of Exercise 12.5 on page 450, test the hypothesis H0: β1 = β2 = 0, H1: β1 and β2 are not both zero. Exercise 12.5: The electric power consumed each month by a chemical plant is thought to be

> Suppose that in Example 18.7 the electrical firm does not have enough prior information regarding the population mean length of life to be able to assume a normal distribution for μ. The firm believes, however, that μ is surel

> Estimate the proportion of defectives being produced by the machine in Example 18.1 if the random sample of size 2 yields 2 defectives.

> This is an extract from Ducker, H., Head, A., McDonnell, B., O’Brien, R. and Richardson, S. (1998), A Creative Approach to Management Accounting: Case Studies in Management Accounting and Control, Sheffield Hallam University Press, ISBN

> This case study is taken from Ducker, J., Head, A., McDonnell, B., O'Brien, R. and Richardson, S. (1998), A Creative Approach to Management Accounting: Case Studies in Management Accounting and Control, Sheffield Hallam University Press, ISBN 086339 791

> Southern Paper Inc. is a global packaging company headquartered in the United States. The company was founded in the 1880s and has three principal business sectors – forest products, packaging and papers. The forest products division supplies lumber to t

> This case study is taken from Ducker, J., Head, A., McDonnell, B., O'Brien, R. and Richardson, S. (1998), A Creative Approach to Management Accounting: Case Studies in Management Accounting and Control, Sheffield Hallam University Press, ISBN 086339 791

> This case was originally set in the 1960s in rural Vermont. The Majestic Lodge is an old but well-maintained property that has changed ownership several times over the years. It has no restaurant or bar. It is positioned as a mid-price, good quality "des

> The Managing Director of the Kiddy Toy Company (KTC) needs to decide whether a special export order should be accepted or rejected, with reasons provided, for the manufacture of Panda bears. The background Official statistics indicate that China manufact

> Professor Anthony Atkinson, (University of Waterloo) and adapted by Professor John Shank (The Amos Tuck School of Business Administration Dartmouth College) This case is reprinted from Cases in Cost Management, Shank, J. K., 1996, South Western Publishin

> Anjo Ltd was established in 1986 by two brothers, Andrew and Jonathan Bright. They saw a market for providing accessories in the home to accommodate the new era of home entertainment, such as television cabinets, record stands, hi-fi cabinets, tape casse

> Permission to reprint this case has been granted by Captus Press Inc. and the Accounting Education Resource Centre of the University of Lethbridge. Foster’s Construction Ltd: Organizational Background Fosters Construction Ltd (FCL) is a privately owned c

> Airport Complex was founded in Northern Europe in the early 1960s, and at the time it primarily served as a domestic airport. During the 1980s, flights to foreign destinations became an ever more vital activity for the airport. Today, the airport functio

> Hardhat Ltd’s Budget Committee, which has members drawn from all the major functions in the business, is meeting to consider the projected income statement for 2018/2019, which is composed of the ten months’ actuals to

> The Application of Linear Programming to Management Accounting Midland Airport Ltd LEARNING OBJECTIVES: After reading this case study and completing the questions you will be able to: • Formulate the initial linear programming model (ob

> Fleet operates a chain of high street retail outlets selling clothing and household items. In 1995 this company was heading for a financial loss and was deemed to have lost strategic direction. The business formula that had proved successful in the 1980s

> This case study is taken from Ducker, J., Head, A., McDonnell, B., O'Brien, R. and Richardson, S. (1998), A Creative Approach to Management Accounting: Case Studies in Management Accounting and Control, Sheffield Hallam University Press, ISBN 086339 791

> This case was originally set in a specialty manufacturer of industrial measuring instruments in Scotland in 1979. The topic is profit variance analysis. THE FIRM Kinkead has been a leading UK firm since World War II in specialty instruments for measuring

> Company A is in the chemical industry and a manufacturer of industrial paints. At one of its manufacturing sites (site 1) a new system of costing and management information is being considered to replace a traditional system, which was not meeting fully

> The Board of Dumbellow Ltd are meeting on the 23rd January to discuss the draft budget for 2018/19, some two months before the start of that year. The company produces three industrial valves which are incorporated into equipment used in the Oil and Gas

> Learning objectives: After reading this case study and completing the questions you will be able to: • Demonstrate familiarity with two methods of process costing: weighted average and FIFO. • Discuss the treatment of normal loss, abnormal loss and abnor

> The case was prepared as the basis for discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Danfoss Drives A/S is a Danish producer of frequency converters located in Graasten in the southern part

> Company B is a manufacturer of large, complex electrical motors. It has been making them 'to order', in order quantities of, typically, one-four in a jobbing/batch production system for many years. A typical selling price may range from £3000-£20 000 per

> Learning objectives: After reading this case study and completing the questions you will be able to: • Explain the alternative methods of allocating joint costs to products. • Discuss the arguments for and against each

> Mestral is a highly successful company manufacturing a range of quality bathroom fittings. For the past 15 years production has been carried out at three locations: Northern town in the North East of England; at Western town on the Severn estuary; and at

> Kaminsky Ltd manufactures belts and braces. The firm is organized into five departments. These are belt-making, braces-making and three service departments (maintenance, warehousing and administration). Direct costs are accumulated for each department. F

> (a). Flopro plc makes and sells two products A and B, each of which passes through the same automated production operations. The following estimated information is available for period 1: (ii). Production/sales of products A and B are 120 000 units and

> Galuppi plc is considering whether to scrap some highly specialized old plant or to refurbish it for the production of drive mechanisms, sales of which will last for only three years. Scrapping the plant will yield £25 000 immediately, where

> Franzl is a contract engineer working for a division of a large construction company. He is responsible for the negotiation of contract prices and the subsequent collection of instalment monies from customers. It is company policy to achieve a mark-up of

> Paragon Products plc has a factory that manufactures a wide range of plastic household utensils. One of these is a plastic brush that is made from a special raw material used only for this purpose. The brush is moulded on a purpose-built machine that was

> Losrock Housing Association is considering the implementation of a refurbishment programme on one of its housing estates which would reduce maintenance and heating costs and enable a rent increase to be made. Relevant data are as follows: (i). Number of

> Using the discounted cash flow yield (internal rate of return) for evaluating investment opportunities has the basic weakness that it does not give attention to the amount of the capital investment, in that a return of 20 per cent on an investment of &Ac

> The Portsmere Hospital operates its own laundry. Last year the laundry processed 120 000 kilograms of washing and this year the total is forecast to grow to 132 000 kilograms. This growth in laundry processed is forecast to continue at the same percentag

> You are employed as the assistant accountant in your company and you are currently working on an appraisal of a project to purchase a new machine. The machine will cost £55 000 and will have a useful life of three years. You have already est

> Your company is considering investing in its own transport fleet. The present position is that carriage is contracted to an outside organization. The life of the transport fleet would be five years, after which time the vehicles would have to be disposed

> Garrett Automative Ltd (GAL) is a UK subsidiary of a American parent company that manufactures turbochargers for the automative industry. GAL decided to begin its profit improvement programme by examining its factory throughput. Throughput was defined as

> The following information relates to three possible capital expenditure projects. Because of capital rationing only one project can be accepted: The company estimates its cost of capital is 18 per cent. Calculate: (a). The payback period for each proje

> Short flower Ltd currently publish, print and distribute a range of catalogues and instruction manuals. The management has now decided to discontinue printing and distribution and concentrate solely on publishing. Long plant Ltd will print and distribute

> Cassidy Computers plc sells one of its products, a plug-in card for personal computer systems, in both the UK and Ruritania. The relationship between price and demand is different in the two markets, and can be represented as follows: Home market: Price

> Butterfield Ltd manufactures a single brand of dog food called ‘Lots O Grissle’ (LOG). Sales have stabilized for several years at a level of £20 million per annum at current prices. This level is not expected to change in the foreseeable future (except a

> Safety or buffer stocks are held for many reasons. For example, road authorities might want to hold sufficient stock of grit salt in case of bad weather, or firms might build stock of key materials if a price rise is impending. In recent times climate c

> The Boeing 737 jet is the world’s most popular and reliable commercial airliner. The company has manufactured over 8000 jets in the 737 family. In 2005, the 737-900ER was launched, which can carry more passengers over a further range than any previous mo

> Modern day aircraft are complex pieces of engineering, increasingly using more technology, composite materials and more efficient engines. Aircraft engines are in particular improving not only in fuel efficiency, but also in range, thus contributing to l

> South African energy and chemicals company Sasol, like many companies dealing with large-scale projects, needs to prepare cost estimates. Sasol specialize in high value liquid fuels, chemicals and low-carbon electricity. In 2014, the company decided to i

> In the March 2012 edition of CIMA’s Financial Management journal, Christian Doherty asks what will management accountants ten years on be grappling with? This question has been posed before (see, for example, Scapings et al., 2003) and technology is a fa

> According to a US Congressional enquiry, this accident apparently partly resulted from local decisions within the oil multinational BP and its contractors to save relatively immaterial costs by cutting corners in oil exploration safety measures (National

> As one of the pioneers in the low-cost airline market, easyJet’s business model includes some core values: ● Safety – Our number one value, sitting at the core of everything we do. ● Pioneering – We challenge to find new ways to make travel easy and affo

> Insteel Industries decided to implement ABM at the Andrews, South Carolina, plant. The ABM team analysed operations and identified 12 business processes involving a total of 146 activities. The ABM study revealed that the 20 most expensive activities acc

> Taylor, Woods and Cheng Ge Fang (2014) reported on how one UK company moved its target costing system away from profit targets and focused it on product-level economic value added (EVA(TM)) targets. The company, which used the pseudonym Electronics for c

> Management accounting combines accounting, finance and management with the leading-edge techniques needed to drive successful businesses. Chartered management accountants: ● Advise managers about the financial implications of projects. ● Explain the fina

> Following events of September 2001, airport security screening in the US and globally increased dramatically. As we all know, this led to increasing queues at airports which while inconvenient, are paramount to the safety and security of passengers. Sin

> As a result of the recent financial troubles at Tesco its shares declined to an 11-year low in 2014. Terry Smith, chief executive of investment house Fundsmith, stated in an article published in The Financial Times that investors had long ignored warning

> An article by Chen et al. (2015) published in Strategic Finance described how Zhongyuan Special Steel Co. (ZYSCO), a typical Chinese state-owned company, introduced a new strategic management system that would integrate its value creation strategy into e

> Southwest Airlines set ‘operating efficiency’ as its strategic theme. The four perspectives embodied in the balanced scorecard were linked together by a series of relatively simple questions and answers: Financial: Wha

> The Globe and Mail (Canada) quotes an article written by Professor Pietro Micheli in Industry Week in which he listed seven myths about performance management that promote the wrong behaviours. The following is a summary of these myths: Myth 1: Numbers

> Across Europe, just how much – or little – US multinational firms are paying in taxes is coming under intense scrutiny according to an article published in the Washington Post. Most of the investigations revolve around the issue of ‘transfer pricing’, wh

> According to an article in the Financial Times the UK tax authority (HMRC – HM Revenue & Customs) raised £1.1bn from challenging the pricing of multinational companies’ internal deals in 2013–14 – more than twice as much as in the previous year. The incr

> Medical devices are normally associated with use by hospitals and medical practices. Some devices are used by normal consumers and, according to an article on the Medical Device and Diagnostic Industry website (www.mddionline.com), are proliferating. The

> Teva Pharmaceutical Industries Ltd reorganized its pharmaceutical operations into decentralized cost and profit centres. Teva proposed a transfer pricing system based on marginal costs. But the proposed transfer pricing system generated a storm of contro

> The financial mission of a company should be to invest and create cash flows in excess of the cost of capital. If an investment is announced that is expected to earn in excess of the cost of capital, then the value of the firm will immediately rise by th

> From Real World View 19.1, you know that Siemens operates in many countries and has quite a diverse product offering. With such complex and broad operations, there are many factors that can affect the performance of a business sector or division. In its

> German global company Siemens AG had a turnover of almost €76 billion in 2015, recording a profit after taxes of €7.4 billion, according to its annual report. The company operates globally, with 351 000 employees globally. Siemens is a diverse organizati

> A distinguishing feature of today’s digital technology is that it is characterized by zero (or near-zero) marginal costs. Once you’ve made the investment needed to create a digital good, it costs next to nothing to roll out and distribute millions of cop

> In a BBC documentary called Power to the People, Michael Portillo visited a ‘You Decide’ session organized by the local council in Tower Hamlets, London. At this session, local people decide what is to be done with £250 000 of council money. They are giv

> Meditech South Africa (Pty) Ltd provides software solutions to meet the information needs of healthcare organizations in Africa and the Middle East. According to their website, the software can encompass all areas of healthcare from doctor’s offices to h

> Setting standards in an organization may be primarily to assist in the calculation of a standard cost for the product or service for management accounting purposes. Standards are also relevant for operational and customer service managers as they may aff

> Recipes are used in the manufacturing processes of many sectors. In the paper industry, a starch recipe consisting of borax, caustic soda, starch (from maize or potatoes) and hot water is used to glue corrugated board (cardboard) together. This process i

> Once standard costs have been established and used by a business, they should be updated on a regular basis. Actual costs are frequently used as a basis for any updates. SAP, a leading enterprise resource planning (ERP) system, provides tools and data wi

> The internet of things (IoT) refers to an ever-growing network of physical objects which are connected to the internet. This includes household devices and many business and industrial applications. The IoT has given way to a vast array of new products a

> Because of the previous lack of effective control of expenditure by the Han Dan Company, a system of responsibility accounting and standard costing was introduced. The basic principles underlying the responsibility cost control system included: (1). set

> Government crime-fighting targets are a shambles and should be scrapped, claims Chief Superintendent, Ian Johnston. Mr Johnston was speaking ahead of the Police Superintendents’ Association’s annual conference, when he asked the police minister to scrap

> The British government has pledged to spend 0.7 per cent of national aid resulting in £12 billion being allocated to the Department for International Development’s (DfID’s) aid budget despite the fact that the Independent Commission on Aid Impact publish

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