Financial Accounting

EPM mid sem practice questions with solutions

Practice Question

Sunpanel Pty Ltd manufactures photovoltaic (PV) solar panels. Sunpanel's vision is to be the most cost effective supplier of PV solar panels globally. Located in Shanghai, Sunpanel has access to low cost skilled labour and high-tech expertise. Ximing has been the CEO for 10 years and has always focused on operational efficiency. She is proud of the Sunpanel very 'lean' manufacturing operations, offering product at competitive prices and providing a high return to shareholders. PV manaufacturing is capital intensive, and before she was CEO, Ximing managed a 200 million dollar project that commissioned Sunpanel's main production facility. In her early years as CEO, Ximing achieved impressive sales growth, but in recent years market share has been decreasing in spite of a strong and growing PV market. Since she was first appointed CEO, half Ximing's remuneration has been based on annual return-on-investment (RIO) which continues to grow. ROI is defined as 
operating profit divided by total assets employed. The company's main asset is the production plant and equipment, valued at historical cost less accumulated depreciation and impairment. In spite of generous dividends in recent years, shareholders and analysts have expressed concerns about Sunpanel's performance. Last year, one of Sunpanel's key competitors built a new state-of-the-art PV production facility and has recently launched a product that produces more electrical power than Sunpanel's equivalent product and is offered at a lower price. Sunpanel's Board of Directors turns to you for advice on how to improve its management control system, in particular the performance measures and the CEO's remuneration. 

What changes would you recommend? Briefly explain the rationale for your recommendation. The Board insists that your report must not exceed 250 words.

Suggested response

Sunpanel’s reluctance to spend on innovation and to invest in new technology is evident. Consequently, its competitive advantage in the market is diminishing.

Since half Ximing’s remuneration is based on annual ROI, Ximing has a strong incentive to make decisions that increase ROI in the short term. This ‘short term orientation’ tends to arise whenever a manager’s remuneration is based entirely on annual financial measures. Furthermore, ROI is a weighted average return on assets, which creates a disincentive for managers to pursue investments that may drag down their current ROI (goal displacement).

The book value of the Sunpanel's production plant and equipment would be relatively low after 10 years of depreciation. Replacing with new technology would involve new financing and significant investment. The corresponding increase in operating profits may not be realised for a couple of years. In the meantime, the company’s ROI and therefore Ximing’s remuneration will decrease significantly. This may be why Ximing is delaying R&D expenditure and the acquisition of new technology.

I recommend that Ximing’s remuneration be linked to average economic-value-added EVA over 5 years, together with an appropriate set of non-financial measures such as ‘innovation’ and market share. The EVA should include two adjustments: