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1 FINANCE
In commercial organizations, managing for value is about creating shareholder value, while in the public sector, it is about
obtaining value for money. Managers must understand the key cost and value drivers affecting their operations. Financial risk is
determined exclusively by gearing, but there are several sources of business risk. Financial risk may be balanced against business
risk, so that the overall risk is managed.
1.1 Finance and strategy
JS&W suggest organizations of all types must deal with three broad issues of finance
1.1.1 Managing for value
1.1.1.1 Shareholder value (commercial organizations)
Shareholder value depends on long-term capacity to generate cash., which will enable dividend payments which will
in turn drive up market value of the business. Three factors influence this ability:
Funds from operations, which are determined by sales revenues and costs
The net cost of financing the capital base of fixed and current assets required to support operations
Capital structure (gearing), which will determine the companys cost of capital and its financial risk
1.1.1.2 Best value in the public sector
While most public sector managers are concerned with managing their budgeted cash spending, they should bear the
efficient exploitation of their fixed assts in making decisions.
1.1.1.3 Drivers of cost and value
Value creation does not occur and costs do not arise evenly across the organization. Managers should
therefore have a firm grasp of the key cost and value drivers affecting their operation
Some of these may be outside the immediate control of the managers and may occur elsewhere in the value
network
Choice of strategy interacts with cost and value
1.1.2 Funding strategies
Funding arrangements can be a major influence on strategy:
A highly geared company is likely to avoid high levels of business risk
A form of ownership may be changed in order to gain access to new sources of funds
A strategy base on acquisition may be driven by the need to reinvest surplus funds or to demonstrate a high
level of growth of the market. Wider strategic considerations may be neglected as a result
1.1.3 Managing risk
JS&W point out that financial risk can, to some extent be balanced against business risk in order to produce an
acceptable level of risk overall. If business risk is perceived as being low, a higher level of financial risk may be
acceptable and gearing increased. Similarly, if business risk increases, a proportionate response might be to aim to
pay off an element of debt.
JS&W illustrates this relationship in the table below based on the BCG matrix.
If the response is positive the company could either abandon the product or market it full scale. If it markets the vylin
full scale, the outcome might be low, medium or high demand, and the respective net gains/(losses) would be (200),
200 or 1,000 in units of $1,000 (the result could range from a net loss of $200,000 to a gain of $1,000,000). These
outcomes have probabilities of 0.20, 0.50 and 0.30 respectively.
If the result of the test marketing is negative and the company goes ahead and markets the product, estimated losses
would be $600,000. If, at any point, the company abandons the product, there would be a net gain of $50,000 from
the sale of scrap. All the financial values have been discounted to the present.
Required
(a) Draw a decision tree.
(b) Include figures for cost, loss or profit on the appropriate branches of the tree.
The frame makers currently have some spare time available and an overseas retail chain has offered the business an
order of 400 frames at a price of $15.60 each. Without considering the wider issues, should the business accept this
order?
Fixed costs are not affected b the choice of product because all three products use the same machine. Machine time
is limited to 148 hours a week.
Which contribution of products should be manufactured if the business is to produce the highest profit?
Shark Ltd should subcontract the component to Ray Ltd as this would be $7 cheaper than producing it internally.
1.11.2.4 Closing or continuation decisions
Many organizations produce separate financial statements for each department or section in order to attempt to
assess the relative effectiveness of each one. By looking at these to look at variable costs, contribution can be
determined. Departments that make a positive contribution should not be closed even if individually it makes a loss.
This as the fixed costs would still be incurred and the organization would be worse off without it.
Example:
MogTown Ltd is a retail shop with three departments all located in the same premises. The three departments
occupy similar sized areas of the premises. The results for the year just ended are as follows:
This suggests that if the cat furniture department was closed, the company as a whole would be $9000 more
profitable per year. However, when the fixed and variable costs are analyzed, the contribution of each department
can be determined. This gives the following results:
This shows the cat furniture department actually makes a positive contribution of $37,000 and should not be closed.
Closing would make the company as a whole $37,000 worse off per year. The fixed costs would continue to be
incurred whether or not the department is closed.