TOPCIMA Analysis Hanging by a Thread

Hanging by a Thread

The TOPCIMA Pre-seen material for September and November 2006, presents a  European woman’s garment manufacturer, Kadgee Clothing, in a precarious competitive and financial position. Adrian Sims of BPP Professional Education reviews its situation and considers what problems and decisions Kadgee’s management may face in the future. In other words what candidates may face in the two examinations to be based on this case study. This case describes a very depressing situation. Sadly it is one familiar to ‘high cost’ European manufacturing firms that now have to fight for business against lower cost operations within the enlarged EU and outside. Red is the new black 

In the past Kadgee produced profits and had cash. It was ‘in the black’ at the bank. But not recently. Now it teeters on the edge of losses and has deepening debts. Red is this season’s colour for Kadgee. But it’s not a colour that will suit either its shareholders or its bank. Consider the facts. The firm grew well until the 1990s at which point margins started to slip under the combined pressures of changes in retailing and increasing global competition. From 1998 it made losses till 2002 when some extra nip and tuck  measures by management allowed it to return to profits between 2004 and 2005 but now these are on the slide again. Its cash position is so bad that in 2005 it increased its  bank overdraft by 61%. And there’s not much in the case to say it will get better. Kadgee Clothing is hemmed in by a very hostile operating environment. In terms of  Porter’s Five Forces it faces considerable buyer power from the heavily concentrated retail sector where 73% of its sales are to just three clients and major clients want their own labels instead of Kadgee’s. It has suffered market entry based on price from global competition, most recently from China following its admission to the World Trade Organisation. So, competitive rivalry will increase further and threatens to finally stitch up the company. Things continue to unravel. Kadgee’s second largest client, Forum, has withdrawn its contract with effect from the end of August. At this point Kadgee will need to decide how to rationalise to reduce output by 22.6%. It has already posted 34 redundancies due in September 2006 to save wage costs. But three of its six factories make Forum’s clothes. Would closing an entire factory be more sensible so that overheads can also  be avoided? Morale is low, quality is falling, and the firm hasn’t fashioned a strategy to turn itself  around. The style of TOPCIMA

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CIMA now sets this examination four times a year. This means that the Pre-seen material for Kadgee Clothing must support two sets of unseen material and examination requirements, the September and November exams. The competences you are required to demonstrate are detailed on the Assessment Matrix attached to the Kadgee Pre-seen. You will be given a fresh copy of this matrix, along with a fresh copy of the Pre-seen material, on exam day. These competences are Technical, Application, Diversity, Focus, Prioritisation, Judgement, Integrati on, Logic and Ethics. This article does not have the space to explain them in detail. However, September’s Study Notes contained a detailed guide to TOPCIMA bu the Case Writer  and Head Examiner, there are also numerous study resources on the CIMA website, including the Examiner’s own Post Examination Guidance documents; you can also consult commercial TOPCIMA study publications. However they have different marks available so let’s spend a little time on seeing what the heaviest-weighted criteria require you to do. The Examiner has set the same requirement in every examination since September  2005. Therefore let’s assume a pattern has been set and that you will be facing the following requirement: ‘Prepare a report that prioritises and advises on the main issues facing Kadgee Clothing and makes appropriate recommendations’. Therefore the 5 pages of Unseen material you receive on exam day will be where the examiner will introduce ‘twists’. In past examinations the Unseen materials have each contained 8 or so additional ‘issues’ for candidates to deal with. Many candidates fall into the trap of assuming that each new issue should be given equal weight and then complain that the exam is ridiculously time pressured and that they couldn’t ‘do justice’ to it all. I understand this complaint but, with the greatest respect to the candidates that make it, it misses the mark. One of the key competences being tested by the TOPCIMA exam is the ability of the would-be Chartered Management Accountant to  prioritise issues by using  judgement to decide which are very important and which are less so. Candidates must learn to cut their cloth to suit their purse. In other words (and taking the opportunity to squeeze in yet another pun) they must tailor their report to the time available in the exam room. Read the requirement closely. It says  prioritise the issues faced by Kadgee Clothing and advise on the main ones. In other words you don’t have to deal with them all in the same degree of detail. You have to  focus on the main ones. You will have 3 hours (plus 20 minutes reading time) to do this and let’s not have any excuses. The assessment matrix has given 20 marks to Judgement this time, compared to 15 last time, at the expense of Focus which has been reduced from 15 to 10.

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 Now another popular misconception springs up in candidates’ minds. Is there one key  priority in the Unseen which the Examiner is expecting you to spot and to base your  report on? Does the Examiner have a clear pecking order for prioritising issues that you must reproduce? In short, if you don’t see the priorities in the same way as the Examiner does it mean you will fail?  No. The Examiner has made clear many times (in suggested solutions, in Post Examination Reviews, in student script reviews and at the CIMA Lecturers’ Conference) that where there are several leading issues then a candidate can deal them in any sequence providing they justify to the reader of the report why they are  presented in this sequence. However the Examiner is prepared to be critical of, and so to mark down, candidates who write reports that put the obviously insignificant matters ahead of really important ones. So how do candidates know what’s important to Kadgee Clothing? An important first step is to understand the situation of the firm described in the Pre-seen material.

The strategic fit of Kadgee Clothing.

Pages 2 and 3 contain a potted history of Kadgee Clothing. Don’t spend too much time analysing this as it has limited value because it describes events long before 2006. It merely sets the scene. The points that stand out from the rest of the pre-seen are: •

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Kadgee is a private company rather than a listed company with 39% of its shares held by two retired persons Bruno Burnak and Anton Kramer who no longer have daily connections with, nor perhaps even loyalties to, Kadgee given that they have received no dividends for at least two years. They are likely to resist any radical changes in business direction and it is not clear why Anton Kramer continues to support Kadgee given that he received nothing from his shares. Kadgee has not been very pro-active in expanding its business and has come to depend on a small number of key contracts. One of these it has recently lost and the rest are up for renegotiation. Its main response to competitive challenges has  been to improve efficiency. The business has been retrenching rather than seeking to find new markets and businesses based on its core competences. Some managers have sought to move the company away from the hard bargaining around price by instead utilising CAD and Supply Chain Management solutions. It is presently negotiating for 2007. Seemingly Forum felt able to give 6 weeks notice of termination of contract and was persuaded to continue buying until August 2006. This means that further contracts could be terminated between now and the first exam on September 4 th and this would affect the Unseen material. The loss of Forum seemed to have come out of the blue and as a shock to Dieter  Stutt. Is there more bad news to come before the exam day? Is Dieter Stutt concealing bad news from the board?

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Kadgee seems to be facing price reductions in the order of 4%, assuming the failed negotiations with Forum are typical. These would reduce revenue to below operating costs and Dieter Stutt’s explanations of where cost savings could be made are less-than convincing.. Falling quality, due to low staff morale, is endangering its prices, contracts and its  premium market position. This morale has been further dented by the knowledge that Kadgee is considering cutting-out at least 34 staff in September 2006. Cashflows are in a mess. The cash flow statement shows that the company is a net cash burner and that the reasons for this are poor working capital management due to excessive inventory, increased credit given and reduced credit received. The Company is very heavily dependent on Dieter Stutt and without him would  probably not have survived this long. It is vulnerable to staff in other ways. Presently it has 5 very skilled machinists and an undisclosed number of other staff. These staff are dedicated to Kadgee  because they have few other employment opportunities. However some have already been absent with stress and it does seem that Kadgee relies very heavily on the efforts and goodwill of staff to improve its business. There are potential ethical issues here.

Some analysis of Kadgee

This pre-seen will be the subject of a lot of commercially produced analysis. You should buy at least one of them. But you can’t take pre-printed analysis into the exam room with you. And of course you have to analyse the unseen data on exam day on your own. You need to practice your analysis skills as well as read what others have written. Okay, health warning over, what can we read into the Kadgee case? Financially the firm has problems: Operating profits fell 18% between 2004 and 2005 despite only a 2% fall in revenues. Given that we are told that output increased from 8.25m to 10.9m  between 1998 and 2005 this reinforces the message that prices are falling. Margins are very thin. The average sales price of a garment in 2005 was (€74,420,000/10.9m) €6.83 against a cost per unit of €6.66 (€72,580,000/10.9m). A profit measured in cents per item and a margin of only 2.47%. This firm offered to reduce prices by 4% to keep the Forum contract and yet it still lost it. It can’t seem to afford a 4% cut, let alone a bigger cut. For example if all other costs stayed the same in 2006 and just revenue fell by 4% it would make an operating loss of €1.14m. Its overdraft has risen by €580,000. This seems principally due to the fall in operating profits but also to some working capital issues. These include a slow down in inventory turnover from 31 days to 40 days. Holding 40 days’ stock in a fashion-based industry like clothing is hazardous because seasons and fashions change. Moreover this extra inventory has sucked in €1.89m of scarce working capital and so is incurring overdraft charges. It seem likely that there is some •

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unsold stock in the warehouse or that stock is being supplied to retailers to hold and which is paid for only in the event of its sale. It may appear that there is some scope for borrowing. Kadgee has gearing at 21% (Loans + overdraft and a percentage of loans + overdraft + equity) and interest cover of 3.5 times. But this way lies disaster. Its earnings are volatile as can be seen by a calculation of its operational gearing (% change in operating profit divided by % change in turnover) which stands at (17.5%/1.5%) 11.7% - i.e. for  every 1% change in revenue profit changes by 11.7%. This firm has already lost  €16.8m of revenue from Forum and is facing the prospect of 4% price cuts from the remaining clients. The asset base of the firm is depleting. Non-current assets have fallen by €1.68m (14.6%) and, commensurate with this, the depreciation charge for each of the years exceeds the purchases of tangible fixed assets. This said some of the high depreciation may have been a prudent writing down of the remaining investment in IT needed to set up the Design Centre in 2001. But IT too needs keeping up to date and so it’s a worrying sign. Our attention has been directed to one shareholder for some reason. In 1998 Frankie Bayane spent €32,000 at €8.00 a share to buy 2% of a then loss-making Kadgee. She played her part in turning the company around. But we are bound to ask whether her investment was worthwhile? We need to do a business valuation. Given that the net assets of Kadgee were €22,257,000 in 2005 this means her 2% is worth €111.29 per share on a net asset valuation basis against an income valuation basis which is likely to be much lower. As a rough calculation of the latter , EPS in 2005 was €4.62 which amounts to a total income value €57.75 on the most generous income valuation basis. This has been calculated as €4.62/8% and for convenience I used 8% because there is no cost of capital available in this Pre-seen and the bank seems to content to lend at this rate. If another company raised debt to buy Kadgee it would get tax relief on the interest and so the rate would be less, say 6.1% if it paid at the small companies rate. On the other hand using equity to buy Kadgee would make the cost of capital higher due to the risk  involved. And regardless of financing it is a brave assumption to suggest that  present profits will continue into perpetuity as, from the Pre-seen, it’s unlikely that it can sustain its present earnings for much longer. Of course Kadgee is unquoted so there is no ready market or a willing buyer for  Frankie’s shares. She is essentially locked-in, holding shares that give no divided and which cannot easily be sold. In the March 2006 exam the same situation existed and a director had resigned and wanted her shares bought back. What I am getting to is that it seems likely that the break up value of Kadgee may exceed its earnings value and that shareholders who presently receive no dividend would be minded to take an offer from home or overseas for the assets of the  business. Of course net assets are very different from cash proceeds from liquidation. It seems unlikely that anyone will be willing to buy clothing manufacturing equipment in Europe given the hostile market conditions we have already discussed. This calculation also ignores redundancy costs that, as the Rover experience alluded to below shows, can be a deal breaker. But the shareholders of Kadgee shouldn’t assume that liquidation is the only way to get value from this business. Switching off the lights and closing the company is always a terrible last resort and shows a failure to be more creative.

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Management, that’s you, need to think of ways to improve the earnings of the  business. Here Ansoff’s matrix will be useful. How can they penetrate their  existing market better (cut costs and prices further? Increase differentiation by launching its own design label?). What market development is available to Kadgee (Menswear? Workwear? New sorts of retailers such as supermarkets?). What new products can be developed for the stores they supply (Shoes? Cosmetics? Accessories?). Can Kadgee diversify (Open shops? Direct selling via catalogue or e-commerce? Manufacture other textile products such as curtains and  bedding?). Some of these ideas may be sensible and some misguided. In the exam you may  be presented, in the Unseen material, with proposals to do some of these. You will have to evaluate them using numerical techniques such as NPV but also against the broader Johnson & Scholes criteria of Suitability, Acceptability and Feasibility. Don’t come into the exam room with a preconceived strategy of ‘sell the company’ (many students fail because they write rote-learned answers that don’t fit the circumstances in the exam). You must be prepared to evaluate and advise on the basis of the information you are given in the Unseen. And have some suggestions of your own to discuss if you have time once you have dealt with what you are given, but only a few. Another cause of failure is candidates ignoring the Unseen and writing down loads of great ideas of their own.

Acceptability brings us back to shareholders and attitudes, i.e. the balance of power  amongst shareholders. Presently the Father and Son team of Bruno and Andrin Burnak have 58% of the shares and, we assume, an attachment to the family company. But suppose they broke ranks on an issue, say a takeover approach or a risky ‘bet the business’ investment? It would leave one or other needing to assemble a coalition of shareholders with differing power and interests to get their way. The percentage shareholdings discussed on page 3 seem almost contrived to cause this. If my guess is right, and we have seen it from your Examiner before in last March’s exam, it suggests a stakeholder analysis might be useful as part of your preparation. Fashioning a future for Kadgee

The pre-seen material gives strong pointers towards the sort of decisions that the management of Kadgee must take: Whether to follow the lead of its rivals and to make some or all of its clothing outside its present high-cost European home country. If this is done then there will  be implications for risk, control and redundancies; What further competitive advantage could be gained from IT/IS applications. One interesting connection here is the tendency for contracts to be leading to shorter  runs of a greater diversity of production lines. This could help explain the rising inventory costs and would presumably also have implic ations for overheads costs given that set-ups are a recognised cost driver. How to cope with the loss of the Forum contract by stripping out 34 staff jobs without on the one hand upsetting the morale of the reminder further and, on the •

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other, using scarce cash to pay 34 sets of redundancy settlements. Perhaps transferring the affected staff to part-time contracts might provide a solution. How to restore quality and the TQM system again. Particularly if buyers insert  penalty payments for poor quality into their purchasing contracts. Finding another client to take up the capacity released by Forum. Consider whether it is possible to win Forum back by offering lower prices or  improved supply-chain solutions.

Clearly some of these are short term issues and will have to be dealt with immediately. The decision on relocation is more difficult and needs greater  consideration. The growth of China as an economic giant has been one of the major business dynamics in this first decade of the 21 st Century. Studies suggest that manufacturing  production costs there are lower than European costs by a factor of 80% or more. The EU has policies on the textile industry. You may recall reading about EU Trade Commissioner Peter Mandleson finding himself immersed in a problem of embargoed imports of China-made clothing which exceeded the voluntary quotas set by China itself. Try to find out more about this. I just tapped ‘Mandleson china clothing’ into a search engine and found 64,000 items about the EU and Chinese clothing. It is for candidates to read around on this and to consider what has happened to many of the European firms affected by this. Don’t limit your research to clothing because the same issues have confronted makers of consumer durables, bicycles, furniture and even cars (the week before the Kadgee pre-seen came out the “bones” of UK car  manufacturer, Rover Group, was sold to Nanjing Automobile following Rover’s collapse when a UK government brokered shotgun marriage between it and the Shanghai Automotive Corporation fell through). I found some very interesting articles when I tapped ‘China impact on European clothing industry’ into a search engine (actually it was 5 million items including one that told me that wishing someone ‘interesting times’ is a curse in China). So then, interesting times face Kadgee. What can they do? This is almost certainly going to be what you evaluate and recommend in your exam day report. European manufacturers have responded in a number of ways: They relocate production to China but retain product development and marketing in their home countries. Perhaps the Design Centre and the networks of Dieter  Stutt are the only really valuable competences that Kadgee has from which to rebuild its business? They seek to avoid the price competition by developing distinctive brands at home that can command premium prices. The Pre-seen states that ‘most’ output goes under the labels of the client stores. This suggests that Kadgee does have some  brands of its own. But building a premium brand will take a more cash than Kadgee can afford. They can adopt mass customisation under which the basic products are made in a low cost location but then are customised nearer to the customer to add value. The references to the 5 expert machinists could be read as a hint in this direction; •

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They seek to improve the supply chain such that clients rely on the company to save them costs of inventory and logistics or to remove the problem of stock-outs. Kadgee has played this card already and restored profitability in the past few years. But profits are sliding again and working capital management is worsening so again. What more can they do?

You need to consider whether any of these are suitable, acceptable and feasible for  Kadgee. Consider their implications for jobs, skills, finance, marketing and organisational structure. Research the real world firms in the textile and clothing industry and see what happened to them. Getting ready for the examination

This pre-seen material is very open. Many things could happen to the Kadgee Clothing and the Examiner has a lot to choose from. Below is a list of possible issues or events that could come from the Pre-seen. They are not tips on what will be coming up, they are just this tutor’s guess. The real issues will be the ones you are given in the Unseen on exam day. But you can use these to  practice developing your thinking: • • • •

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Discussion of the implications of buying-in clothing from a Chinese manufacturer  Discussion of developing production facilities in a nother country Evaluation of closure of one or more of its 6 factories Evaluation or pricing decision on a new contract to supply clothing to a major  store Diversification into alternative lines of clothing (e.g. sports, uniforms, workware, men’s clothing etc.)

There will also be 10 marks for ethical issues. In the past these have been introduced in the Unseen material. We can speculate that the ethical issues might include: • •

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Fair treatment for staff being made redundant Issues surrounding the labour practices and lack of labour protection in low labour  cost countries Problem of stress-inducing working practices Discovery that Dieter Stutt has been making inappropriate payments to gain contracts (a similar issue appeared in the Nov 2005 exam)

These are only ideas. Please don’t assume they will be the real issues in the exam room. Don’t go to the exam with preconceived ideas of what the issues are and what the firm should do. You have to deal with the actual issues in the Unseen information and will be marked accordingly. The key to passing the exam is to practise planning answers and writing answers. But these are exercises in how to develop answers, they are not ‘practice runs’ of how to write the answer quickly. Only the Examiner knows what you will be facing in your exam so please don’t try to second guess.

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This article was intended to give you a few pointers. Please don’t treat this exam like all the others you have sat. The experience of planning and writing an answer that takes 3 hours is quite different from the previous levels of CIMA you have experienced. You need to practise this too. Writing practice can be obtained by using the exercises in commercially published exercises based on Kadgee or from attempting the past TOPCIMA questions in the CIMA Learning System for this exam. The Examiner has made clear that passing this exam will be about good preparation rather than good luck. Of course you do need to prepare fully and hope this article has helped. But we all deserve a little luck too. So I wish you good luck too!

 Adrian Sims is the Subject Manager for TOPCIMA at BPP Professional Education and is responsible for the compilation of BPP’s TOPCIMA Toolkit. Adrian teaches TOPCIMA at BPP’s centres in Luton and Milton Keynes.

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