T4 - part B – case study report – March 2010 by Chartered Institute of Management Accountants

T4- Part B – Case Study CeeCee - Retail fashion case – March 2010 REPORT To: Carla Celli, CeeCee CEO From: Management Accountant Date: 2 March 2010

Review of issues facing CeeCee Contents 1.0 2.0 3.0 4.0 5.0 6.0 7.0

Introduction Terms of reference Prioritisation of the issues facing CeeCee Discussion of the issues facing CeeCee Ethical issues and recommendations on ethical issues Recommendations Conclusions

Appendices Appendix 1 Appendix 2 Appendix 3 Appendix 4 Appendix 5 Appendix 6 Appendix 7

SWOT analysis PEST analysis Financial and ratio analysis Evaluation of proposed sales bonus scheme Evaluation of closure of 300 small shops and opening of 150 medium-sized shops versus refurbishment of 300 small shops Summary of effect of recommended actions on operating profit for 2010 Summary for presentation to the CeeCee Board on the proposal to close 300 small shops and open 150 medium-sized shops.

1.0 Introduction CeeCee operates a chain of retail fashion shops in Europe selling ladies’ clothes, men’s clothes, children’s clothes and home furnishings. At the end of December 2009, it had 630 shops in operation and sales of almost €2.8 billion.

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2.0 Terms of reference I am the Management Accountant appointed to write a report to the CEO which prioritises, analyses and evaluates the issues facing CeeCee and makes appropriate recommendations. I have been asked to prepare a summary of points for presentation to the CeeCee Board on the proposal to close 300 small shops and this is included in Appendix 7 to this report.

3.0 Prioritisation of the issues facing CeeCee 3.1 Top priority – Sales bonus scheme proposal due to reduced 2010 forecast CeeCee’s latest forecast shows sales €150 million lower than planned for 2010 and action is necessary to boost sales. Therefore, this proposal to incentivise shop-based employees is the top priority. It is a major change in the way CeeCee pays its employees and the proposed introduction date is 1 July 2010 and therefore it is urgent. The proposal could help boost sales to enable CeeCee to achieve the original planned profitability. 3.2 Second priority – Proposal to close 300 small shops This issue is the second priority as it is a major change to the number of shops, and locations, that CeeCee operates. It should not affect sales in 2010, as it is forecast that sales revenue would remain constant as the same sales area will be available in the proposed 150 medium-sized shops. This proposal would allow CeeCee to generate operating efficiencies and achieve a higher operating margin at mediumsized shops. The outcome of this decision will be phased in over 2 years. 3.3 Third priority – Legal case against CeeCee This has been placed as the third priority issue as CeeCee is currently selling clothing that appear to breach another designer’s IPR and a legal challenge has been filed against CeeCee. This is not good business practice and could damage the brand reputation of CeeCee and have a longer term impact on customers’ perceptions of the CeeCee brand name. This long term view should not be influenced by a short term increase of sales for these items. CeeCee also faces the risk of losing the legal challenge. The cost could be €40 million. This would have a significant effect on the profit for 2010 and therefore CeeCee’s share price. An urgent decision is required. 3.4 Fourth priority – Proposal to introduce matching accessories CeeCee currently sells accessories and this proposal is to increase the range by having matching accessories to match some of its clothing ranges. Depending on the level of sales, these new products could generate a large margin of €40 million in 2010. This could contribute towards the forecast shortfall in operating profit. 2 © The Chartered Institute of Management Accountants 2010

However, there is a risk of lower sales, but even at the lower level of sales, a positive contribution is made, although the net margin is low due to inventory write downs. This is a new innovative way of attracting customers to spend more in each transaction by having a range of matching accessories.

A SWOT analysis summarising the strengths, weaknesses, opportunities and threats is shown in Appendix 1. A PEST analysis is shown in Appendix 2.

Note: It was acceptable for candidates to have ranked the reduced sales forecast as the top priority issue and gained full marks in Prioritisation.

4.0 Discussion of the issues facing CeeCee 4.1 Overview CeeCee is facing challenging times with the latest forecast which shows sales revenue €150 million lower than planned, which is a fall of 5% from plan. This forecast fall in sales revenue results in operating profit being €76 million lower, a fall of 11%. Therefore, CeeCee is faced with how to boost sales. There is a clear need to motivate shop-based employees to generate higher sales revenues and also for CeeCee to find ways to generate additional revenues, such as the proposal to introduce the new matching accessories range. CeeCee faces a new risk to its reputation which also could affect the forecast profits for 2010. It is facing the risk of a legal challenge. It is a high risk strategy to pursue the dispute to court, and this could also prove to be a strain on management time. If CeeCee were to lose the legal challenge in court it would face a €40 million payout. This is too risky and the alternative action of settling the dispute quickly and out of court is lower risk but would still result in an adverse impact on profits, but only €10 million. CeeCee’s marketing strategy is to differentiate itself based on Porter’s Generic Strategies, by delivering large ranges of new products. The product life cycle of each product line is short, as it does not hold inventory for very long. Unlike Marks and Spencer, which holds the same products throughout each season (such as Winter season, where the same products are available from October through to March in European shops), inventory in CeeCee shops is constantly being replaced by new, but similar, product lines. These issues in this case are all discussed in more depth below. 4.2 – Sales bonus scheme proposal CeeCee needs to take action to try to boost sales revenue. The latest forecast shows a fall of €150 million.

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The proposal is to incentivise and motivate shop-based employees to generate higher sales revenue. The proposal is that even at the latest forecast level of sales, of €2,835 million, all shop-based employees could earn 5% more than they did earn previously, in the form of a bonus. This should motivate shop-based employees to ensure that total sales revenues do not slip further. Most High Street retailers run some form of bonus scheme to allow their shop-based employees to be rewarded when the shop they work in reaches agreed sales targets. Amongst these shops is Next plc, as well as smaller upmarket clothing retailers such as Jigsaw which operate in the UK. The total cost of the sales bonus scheme proposal will vary depending on the level of sales achieved in 2010. At the highest bonus rate of 14% bonus, the extra cost to CeeCee would be €57 million in sales bonus payable to shop-based employees. This would increase CeeCee total wage bill for shop-based employees from €410 million per year (at current staffing levels) to €467m, an increase of 14% in a full year. However, the higher wage bill would be more than offset by higher gross margin that could be generated on higher sales. If sales remained at the latest forecast level of €2,835 million, then CeeCee would be worse off under this proposal, as the gross margin would not increase but the cost of the bonus would be €21 million. This would result in a further fall in operating profit of €21 million, down from the latest forecast of €614 million to a possible €593 million. Furthermore, the worse case scenario is that the bonus scheme did not boost sales at all, and that sales revenue fell a further 4% or more. At this level of sales, no bonus would be payable, but the gross margin would fall by €68 million. The effect of the proposed sales bonus scheme is shown in Appendix 4 to this report and is summarised in the table below: Bonus payable € million

Gross margin change from “Base case” € million

Full year effect on operating profit € million

If sales of €2,835 million achieved

-21

If sales increase by 8% to €3,062 million

+136

+79

If sales decrease by 4% or more

-68

The latest forecast includes sales revenue at €150 million less than originally planned. Even at this level of sales a bonus of 5% will be payable as it is considered that this will incentivise shop-based employees not to allow sales revenue to slip any further. However, at the latest forecast sales levels the cost of the bonus scheme would make a negative impact on operating profit of €21 million. The sales bonus would reward employees to help achieve the required growth in sales and the additional gross margin generated by higher sales would more than cover the cost of the bonus scheme. If sales were to increase by 2% or greater, then the extra gross margin generated will cover the cost of the sales bonus.

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The sales bonus proposal is a good way to achieve goal congruence as it ensures that all shop-based employees are focussed to achieving greater levels of sales. 4.3 - Proposal to close 300 small shops CeeCee had 630 shops operational at the end of 2009. These included 300 small shops which achieve a low average operating profit margin of only 13.2%. The proposal is to either close the 300 small shops and replace them with 150 mediumsized shops or to refurbish the 300 small shops. The “Zara” chain of fast fashion clothes shops has undergone a review of its shops over the last 2 years and has opened very large shops, “flagship” shops, in the capital cities of most of the countries in which it operates throughout the world. It has also closed some of its smaller shops, which were opened when the Zara chain of shops was much smaller and less well known. It has replaced some of these with medium or large-sized shops, in a very similar way to this proposal for CeeCee. The closure of the 300 small shops would result in CeeCee only operating 480 shops, and would result in 150 locations where CeeCee does not have a shop. Whilst the sales area of the proposal is forecast to stay the same (as the mediumsized shops will have double the sales area of a small shop), it is not yet known whether the chosen locations of the new 150 medium-sized shops could immediately double the sales revenue. Just because a larger shop is opened does not necessarily mean that sales will be greater. However, assuming the forecast sales data is correct, the NPV for closing 300 small shops and opening 150 medium-sized shops is €622 million. This is shown in Appendix 5 to this report. This compares to the NPV of just €353 million if the 300 small shops were to be refurbished. Therefore the closure of the small shops generates a higher NPV than re-furbishing shops, of €269 million higher (which is 76% higher). This is a significant difference. It would also allow CeeCee to achieve higher operating margins with fewer mediumsized shops by increasing shop efficiencies. The difference in the NPV of 76% is large and should be sufficient to persuade CeeCee’s management to take the bold action to close the 300 small shops. Medium-sized shops would also allow greater ranges of items to be sold, including children’s clothes, home furnishings and other high gross margin products. There is a negative aspect of closing the 300 small shops as this could have an adverse effect on brand image and CeeCee would have fewer shops in operation. The shop closures and opening of 150 new shops would occur over a period of at least one year. By the end of 2010, CeeCee has plans to have 650 shops open, rising to 800 by the end of 2014. A reduction of 150 shops will become less significant. Furthermore, it is the sales area which is the key statistic in this industry. The sales area would remain unchanged by the closure of 300 shops. There could be an impact on customer loyalty as shops in 150 (or more) locations will close and not have a CeeCee shop, as the medium-sized shops may not be opened in exactly the same places or towns where the small shops used to be. This would give CeeCee’s management a chance to select new locations where higher sales could be generated.

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However, there are challenging sales targets for medium-sized shops. The big question is whether each shop location can generate double the revenues and whether the sales figures are realistic? There are many ways to boost early sales by offering existing customers discounts or incentives to visit the new shops. The selection of the locations for the 150 medium-sized shops would need to be carefully made. There may be some reasonably well performing small shops. As the average operating profit to sales for small shops is 13.2%, it could well be that some are achieving far lower than 13.2%, perhaps running at breakeven or even a loss. Some could be exceeding the 13.2%. The locations of any small shops that are performing well should be retained and these locations should be upgraded to a medium-sized shop. The locations with better performing shops should not be closed down. The average operating profit to sales ratio for medium sized shops is given as 23.5%, against a company wide margin of only 22.8%. Following the closure of the underperforming small shops over the next 2 years, the company wide margin should rise above 23% and perhaps increase to nearer 24% due to operational efficiencies. The operating margin for all shops should be continuously monitored to identify any shop with a lower operating profit margin, so that remedial management action can be taken, such as promotional events to raise the local profile of the shops in the competitive High Street market. It will probably be possible for CeeCee to negotiate cheaper rental agreements on new shops, due to the effect of the current economic environment. Therefore the rent payable on medium sized shops is likely to be far less than double the cost of the small shops, despite the medium-sized shops having double the selling space. This is a good strategic opportunity for CeeCee to negotiate rental agreements at lower cost. Perhaps CeeCee should try to re-negotiate the rental agreements on other shops to see if any savings in rent can be achieved. Many shopping centres and High Streets have seen clothes shops close and the shops remain empty. Landlords therefore receive no rent from these empty shops. An example of this is all of the empty “Woolworths” shops across the UK following the company going into liquidation at the end of 2008. There may be scope for CeeCee to achieve some rent savings with the promise to remain at the specific location for a further period of 3 years. Landlords may be willing to reduce rent, especially when they become aware of the closure of the 300 small shops. They may be keen to retain CeeCee’s rent and be willing to negotiate downwards for some security of rental period. There is also the concern over staff issues surrounding shop closures as fewer employees will be required overall at the new 150 medium-sized shops. Additionally the location of some of the new 150 medium-sized shops will change. In many towns, the small shops will close and a medium-sized CeeCee shop will re-open simultaneously and the impact on staff (and customers) will be minimal. The mediumsized shops will require additional employees, and therefore there is an opportunity to offer jobs to employees of CeeCee shops that are closing in a nearby location. Overall there is likely to be some redundancies, although this will be reduced by some employees that will leave anyway before the shop is closed. To minimise the level of redundancies, CeeCee should offer an attractive package to employees to transfer to work in another CeeCee shop in the 150 new locations, some of which may not be too distant.

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The Finance Director, Diane Innes, has stated that the finance for this substantial investment of €580 million can be made available, and €360 million is already included in the 5 year plan capital expenditure budget for the previously planned refurbishment of the 300 small shops. This additional capital expenditure of €220 million could be financed by cash generated from operations over the next 2 years or by an additional loan. The return on sales of 22.8% is far higher than the loan interest payable and as it is a positive NPV project, the theory is that finance should be made available. The small shops could be considered to be “problem children” in the Boston Consulting Group (BCG) matrix as they generate a smaller operating profit margin than the group overall. The medium-sized shops could be considered to be “stars” or they could move on to become “cash cows”. Note: Candidates were awarded marks for their discussion of a range of alternative NPV values – see Appendix 5 on page 19.

4.4 - Legal case against CeeCee There are a number of aspects to this issue. The most urgent aspect is what action CeeCee should take concerning the legal challenge that KK has filed against it for breach of intellectual property rights (IPR’s). However, the underlying issue concerns control over CeeCee’s designers and what rules should be established to ensure that IPR’s are not breached in the future as many of CeeCee’s designs are based on global fashion houses’ designs. CeeCee has 2 clear choices in respect of the legal challenge by KK. It can defend its position and go to court or it could concede the case and settle out of court. Both actions will have a negative impact on profits in 2010. This is a similar situation to the legal challenge that Burberry made against a small fashion retailer which copied its plaid designs. Burberry was successful in its legal challenge and was able to claim substantial damages. If CeeCee were to defend its position and to state that it does not consider that it has breached KK’s IPR’s then it could continue to sell these products. They are selling well and CeeCee has recently placed additional orders with its suppliers. Including these new orders, the loss from inventory write-offs and an out of court settlement to KK would cost €10 million. However, if CeeCee were to go to court and lose the case, the cost (including damages) could exceed €40 million. This is a high risk and potentially very dangerous to CeeCee as it could encourage other designers to challenge other CeeCee product lines and potentially open the flood gates to other legal challenges. Furthermore, the impact on CeeCee’s profits for 2010 would be a further reduction of €40 million and this could affect CeeCee’s share price. This could also have a negative damaging long-term effect on CeeCee’s reputation. There is, however, a chance that CeeCee could pursue the case to court and be successful. CeeCee’s advisors have assessed that the risk of losing is 50% and therefore the chance of winning is also 50%. The decision as to whether to pursue the case to court will be influenced by the risk appetite of the CeeCee Board. However, risk should always be minimised. The Board is already faced with how to boost profits in 2010 after a forecast fall of €150 million in revenues and therefore, the directors would be heavily criticised or could even be asked to resign by 7 © The Chartered Institute of Management Accountants 2010

shareholders if the decision were to pursue the legal action, and then CeeCee lost. It is a dangerous decision to make which could have severe consequences. CeeCee currently has a good reputation and a loyal customer base. Customers currently believe that CeeCee operates ethically and that it does not knowingly sell copies of other designers’ products. This reputation could be damaged if CeeCee were to lose the legal case. CeeCee’s legal advisors have stated that they assess that there is only a 50% chance of winning the case. The safer option would be to settle out of court now. This would mean writing off and destroying all inventory and paying an out of court settlement to KK, with a total cost of €10 million. To ensure that CeeCee does not find itself in this situation again there needs to be closer control of designs. CeeCee needs to ensure that its designs, even if based upon the latest catwalk fashions, do not breach accepted IPR rules and that CeeCee does not face further legal challenges. Overall, recommendations will be made below, but the safest alternative action, which has the smallest impact on operating profit would be to settle now, as this would have the smallest impact on operating profit of €10 million reduction. It would also not distract management time away from other urgent issues such as ways to boost sales and whether to close the 300 small shops. However, it should be considered by the CeeCee Board, that other companies may perhaps pursue similar legal claims if they consider that CeeCee will not defend the ownership of IPR’s to a court decision. 4.5 – Proposal to introduce matching accessories Currently CeeCee sells ranges of accessories which generate an average gross margin of 75%, which is higher than that achieved on clothes and other products, which averaged 60.1% in 2008. The proposal to introduce matching accessories is forecast to generate an even higher gross margin of 80%. However, there is also a higher risk of inventory write offs. If the products do not sell as well as expected, the matching accessories may also have to be written off. However, the other side of this alternative is that greater sales could be achieved as customers could spend more on each transaction as they buy some of the accessories available to match the main product they have chosen to purchase. The financials show that even at the “Low” level of sales, which includes an inventory write-off, there is a positive operating profit margin. Therefore these matching accessories could generate additional operating profit for CeeCee. Even if the operating profit was low, it is still worth selecting these new product lines. The backdrop to this case is that the forecast operating profit in 2010 is only €614 million, some €76 million lower than the original plan. There is the problem with the potential cost of €10 million if the legal case with KK is settled out of court and the additional cost of the proposed sales bonus scheme. Therefore any new proposal that has the potential to increase operating profit should be welcomed. There is a risk that if products don’t sell as expected, then the matching accessories will not sell either. At the low level of sales, the operating profit falls to only €5 million, 8 © The Chartered Institute of Management Accountants 2010

which is only 33% in 2010 and only €4 million in 2011. However, at least there is a positive contribution to profits. Furthermore there is only a 40% chance of this occurring. At high sales level, which has a 60% probability of success, the effect on operating profit is large, with a forecast increase in operating profit of €40 million. The latest forecast for 2010 is a fall of €76 million in operating profit. If this proposal is successful in the next 9 months, it could generate more than half of the forecast profit shortfall. The probability for achieving the high level of sales is good and has a 60% probability of success. However, if low sales were to occur, the operating margin would be low at only 33% in 2010 (and only 20% in 2011) but this still would generate an additional €5 million in operating profit, even after inventory write offs. In summary, as both high and low sales levels achieve a positive effect on operating profit, it is therefore sensible that this proposal should be pursued. 5.0 Ethical issues and recommendations on ethical issues 5.1 Range of ethical issues facing CeeCee There is a range of ethical issues that will be discussed and recommendations made, including the following: 1. Transportation of clothes by air freight – the suggestion to stop air freight for 2 months and then resume after the fuss has died down is not an ethical stance 2. Legal case against CeeCee – it is not good business practice to knowingly breach IPR’s and carry on selling goods in breach of IPR’s 3. Staff redundancies due to closure of small shops 5.2 Transportation of clothes by air freight 5.2.1 Why this is an ethical issue There are 2 different ethical aspects to this issue: The first is whether CeeCee is operating ethically by air freighting any products at all as this generates a large volume of carbon emissions. In the current climate whereby carbon emissions are recognised to be an important feature of a company’s profile, the use of air freight could have an impact on CeeCee’s reputation as some customers could consider that CeeCee is not acting in a responsible way. Indeed, the press has already criticised CeeCee for having a “large carbon footprint”. The second aspect is Jim Bold’s suggestion to stop all air freight for 2 months until the fuss dies down and then to resume air freight transportation. This is little more than a lie.

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5.2.2 Recommendations for this ethical issue It is recommended that CeeCee looks carefully at all of the product lines that are currently air freighted with a view to changing the transportation method to either shipping from Asia or alternatively manufacturing in Europe. The total volume of products currently air freighted is 10% of CeeCee’s total purchases. This is a vast amount. Therefore there is great scope for reduction in air freight transportation. Jim Bold should be reprimanded for suggesting that CeeCee simply carry on air freighting when the fuss following the press criticism has died down. This is not responsible behaviour for a senior member of the management team. It is recommended that the volume of products imported by air freight is cut drastically and this is phased in over the next 6 months. The target for the volume to be air freighted should be cut back significantly with a preliminary target of, say, only 2%. Therefore the volume of goods air freighted should be reduced by 80% from 10% of total volume to just 2%. CeeCee could even generate some positive press surrounding a decision to reduce the volume of products that are air freighted to Europe. The press should be advised of this decision to reduce air freight and to give a positive impression of CeeCee’s attempts to reduce its carbon emissions. There is also a business aspect to the air freight issue, which is that as shipping costs are lower, a move to reduce the volume of products air freighted to Europe could also help CeeCee to reduce costs, which is important due to the forecast lower profit for 2010. However, the decision to reduce air freight transportation needs to be phased in carefully to ensure that the new products coming into shops are not delayed too much as sales targets need to be achieved. 5.3 Breach of IPR’s 5.3.1 Why this is an ethical issue CeeCee has produced goods that appear to have breached KK’s IPR’s and KK has filed a legal challenge. Whether the case goes to court or not, it is not ethically correct for CeeCee to proceed with selling goods that have been legally challenged. All of the goods should be withdrawn from shops immediately. 5.3.2 Recommendations for this ethical issue There are 2 different aspects to the recommendations for this ethical issue. Firstly the KK legal challenge. It is recommended that CeeCee should settle out of court without accepting liability for breach of IPR’s. All products associated with the possible breach of IPR should be withdrawn from shops and destroyed. An audit of inventory items for these products should be conducted to ensure that all products have been withdrawn so that CeeCee does not breach the out of court settlement. The agreed out of court settlement should be paid to KK. The Income statement should be charged in respect of the out of court settlement and all inventory write off’s, which is expected to be €10 million.

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The second aspect of this ethical issue concerns controls that CeeCee should establish, or tighten, over new designs to ensure that CeeCee does not face any future legal challenges for breach of IPR’s. With the volume of designs being produced (around 15,000 new designs each year) it would be impractical for all of them to be approved by the Head Designer, Laura Russo. However, there may a small number of designs that are close copies of “catwalk” designs that Laura Russo should monitor and approve before the designs are sent to CeeCee suppliers for manufacture. Therefore a new step in the design and production procedure needs to be introduced to ensure that Laura Russo, the Head Designer, is actively involved with approving any possibly design which is a similar copy, and which could possibly breach a designer’s IPR. This should be approved before manufacture. In the spirit of TQM, CeeCee should ensure it “get’s it right first time”. It is always better to pick up any particular problem and deal with it at the beginning of the process rather than after the manufacture of thousands of products. 5.4 Staff redundancies 5.4.1 Why this is an ethical issue If the decision to close 300 small shops is taken, there will be the need for some staff redundancies. The ethical issue here is that CeeCee should treat its staff fairly and ensure that opportunities to transfer employees to other shop locations are offered before new employees are recruited. 5.4.2 Recommendations for this ethical issue There are 2 aspects to this recommendation. One is to try to retain as many employees as possible so as not to lose experienced employees. If 300 small shops are closed and 150 medium-sized shops are opened, there will be at least 150 locations where CeeCee will not have a shop. There could be more than 150 locations affected if a medium-sized shop is not opened in the same town or city location as a small shop was located. The employees at the small shops which are due to close should be kept informed of the decision at the earliest opportunity and offered a package to encourage them to transfer to other CeeCee shop locations. This could be in the form of a package to support a move to another town, or it could be a long-term subsidy for extra travelling costs to a shop that is further away from their current location. CeeCee should do all that it can to retain the skills of these employees. The second aspect of the recommendation is that employees that do not wish to move to a different shop, or where no suitable jobs are available (as not all 150 shop managers will be required) should be offered a reasonable redundancy package. CeeCee should ensure that it assists these employees to apply for other jobs outside the company, and provide support to its employees, in what is a difficult time for them. The key here is open channels of communication and fairness and equality of treatment to employees that will be made redundant.

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6.0 Recommendations A summary of the possible effect of the recommended actions in this report on the operating profit for 2010 is shown in Appendix 6. 6.1 - Proposal to introduce sales bonus scheme to shop-based employees 6.1.1 Recommendation The recommendation of this report is to proceed with the implementation of the new sales bonus proposal as this will incentivise shop-based staff to generate higher sales. 6.1.2 Justification The latest forecast for 2010 shows a fall in sales revenue of €150 million. This fall in revenue must be addressed by CeeCee’s management in many ways. One of the ways to try to fill this revenue shortfall is to encourage shop-based employees to make more sales. The proposal is not asking them to work harder or to work longer hours. It is asking its employees to work together to try to stimulate sales revenue, of which they will get a share. Many clothing retailers incentivise their employees by offering bonuses or by having daily or weekly targets. Next plc have weekly and monthly sales targets by shop location and if targets are exceeded then a bonus is paid to all employees at the shop. This is similar to the CeeCee sales bonus proposal, except the CeeCee proposal is more generous as it will still pay a bonus if the current target is achieved or even if there is 2% fall in the target. Other retailers, such as “Jigsaw clothing” have different sales bonus arrangements, whereby the value of individual transactions attract one-off bonuses for each employee that served a customer that result in individual transactions over a certain value. It is hoped that if CeeCee employees take an active part in trying to achieve sales targets and thereby earn their bonus, the overall level of sales achieved will be higher than the latest forecast and closer to the original plan. If sales were to increase by 4% (less than the 5% fall from plan) then CeeCee would generate a higher gross margin of €68 million and would pay its employees bonuses totalling €37 million (in a full year), and this would have a net positive effect of €31 million on CeeCee’s operating profit. However, the level of customer service should not change and CeeCee’s employees should not “pester” prospective customers simply to achieve sales. However, if sales do not increase at all from the latest forecast, then the sales bonus will have a negative impact on CeeCee’s operating profit for 2010. The full year effect would be €21 million reduction in operating profit. However, the introduction of the sales bonus is worth the risk, as if sales were to increase to 8% higher, then employees would share sales bonuses of €57 million, and the operating profit would still increase by €79 million, after the cost of the bonus. 6.1.3 Actions to be taken There should be an announcement of the introduction of the sales bonus scheme effective from 1 July 2010. Human Resources Director, Alan Howard, should amend employee contracts to include the new bonus arrangements. 12 © The Chartered Institute of Management Accountants 2010

The targets should be prepared for each shop for each month for 2010 and agreed with shop managers. When the targets are agreed, then employees should be briefed on what the targets are. Employees should also be briefed on how actual sales are monitored against target. All employees should also be briefed that it is not CeeCee’s policy to “pester” customers into making purchases as this would be against the principle of CeeCee’s long-term business model. 6.2 - Proposal to close 300 small shops 6.2.1 Recommendation It is the recommendation of this report that CeeCee should close its 300 small shops and replace them with 150 medium-sized shops. This proposal achieves a far higher positive NPV that refurbishing the 300 small shops. 6.2.2 Justification The NPV for closing the 300 small shops and replacing them with 150 medium-sized shops is €622 million, which is €269 million, 76%, higher than refurbishing the 300 small shops. The 76% difference in the NPV’s is significant. The opening of medium sized shops will enable CeeCee to achieve cost savings, including rental costs and employee costs. These cost savings will help the group to achieve higher operating profit margins which is a key business statistic. 6.2.3 Actions to be taken Announcement to be made to employees and shop managers before CeeCee makes a press announcement of the closure of 300 small shops. Ruth Giddens, the Head of Property Management, needs to immediately start work identifying suitable locations for the 150 medium-sized shops, or even if it is possible in some locations for the CeeCee shop to be enlarged. It may be possible for some CeeCee shops to move to a larger shop in the same High Street or shopping centre following the closure of some shops due to the current economic environment, as many shopping centres have empty shop premises. The selection of which are the best of the current 300 small shop locations should be made in the new few weeks by Paulo Badeo. As soon as the closure of small shops is announced, all employees at the 300 small shops will be worried about their jobs. As soon as possible the decision on which locations will stay and which will close should be taken. This decision should be communicated to all shop-based employees. Alan Howard, HR Director, should hold briefings at all shops that are due to close and re-assure staff about transfers to other CeeCee shops and what the redundancy package will be for those who do not want to transfer further away from their current base.

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6.3 - Legal case against CeeCee 6.3.1 Recommendation It is the recommendation of this report that CeeCee should settle out of court immediately. This will involve destroying all affected inventory and paying the agreed out of court settlement. The total effect is forecast to cost CeeCee €10 million, and a provision for this should be made in the latest monthly management accounts. 6.3.2 Justification It is too risky to continue selling products when CeeCee is facing a legal challenge for breach of IPR’s. The risk of losing the case and facing a total cost, including damages, of €40 million is too large. Additionally, it is not good business practice to fight a breach of IPR and the adverse publicity of a legal case could have long-term damage on CeeCee’s reputation and could further harm sales. The latest forecast shows a reduction of 5%, €150 million, and CeeCee should not take any actions that could have any further detrimental effect on sales revenue. It should concede this legal challenge and destroy all affected inventory. CeeCee also needs to introduce a procedure, or tighten existing procedures, to ensure that its designs, which are sometimes based on “catwalk” fashion designs are approved before production if they are considered to be a close copy or impression of another designer’s clothes. 6.3.3 Actions to be taken Contact KK and agree to settle out of court and make required payment. All products affected by this possible breach of KK’s IPR’s should be returned from all shops and sent to the distribution centre. An audit of all clothes returned should be agreed to CeeCee’s CCIPL inventory control system to ensure that there are no products accidentally left in shops. All of this inventory affected by the IPR’s should be destroyed. A new procedure should be prepared to ensure that no further breaches of IPR’s occur. Laura Russo should actively monitor and approve (perhaps in consultation with CeeCee’s legal advisors) all new designs which are copies based on the latest “catwalk” fashion, in case they breach the IPR of the original designer. Only after approval should the orders, based on the new designs, be placed with suppliers. 6.4 – Proposal to introduce matching accessories 6.4.1 Recommendation It is the recommendation of this report that CeeCee should proceed with the proposal to introduce matching accessories. At the “High” sales level this will generate additional operating profit of €40 million in 2010, rising to €64 million in 2011. Even at the “Low” sales level, after any inventory write offs, this generates a positive effect on operating profit of €5 million.

14 © The Chartered Institute of Management Accountants 2010

6.4.2 Justification This proposal generates a positive effect on operating profit and will boost profits between €40 million and €5 million, depending on the level of sales achieved. 6.4.3 Actions to be taken The designers of the products and the matching accessories should be advised to place orders with suppliers so that all of the matching clothing and accessories arrive into shops at the same time. As the high level of sales generates such a high margin, perhaps CeeCee should undertake some additional marketing to promote the matching accessories as this could boost the level of sales of both the clothing and also the matching accessories. 7.0 Conclusions CeeCee is operating in a competitive market in difficult trading conditions. It has a successful brand and the company is operating 630 shops throughout Europe. With the above recommendations for change, CeeCee could make a positive move towards achieving the agreed planned level of profitability for 2010 and motivate and reward its shop-based employees to generate higher sales. The closure of the 300 small shops would be a positive move towards achieving higher operational efficiencies and a higher operating margin. It will also enable all of CeeCee’s shops to stock a wider range of is its products. The future for CeeCee looks very promising.

15 © The Chartered Institute of Management Accountants 2010

Appendix 1 SWOT analysis for CeeCee Strengths Listed company with a market presence in 18 European countries Has 630 shops Positive cash generating company Experienced Board members Strong brand name Profitable High operating profit margins at around 23% Good designers generating over 15,000 new designs each year Low inventory write-offs Reliable high quality suppliers Opportunities Better motivated shop-based employees if they are paid a sales bonus aligned to group target sales levels Close 300 small shops and replace with 150 medium-sized shops Increased operating efficiencies by having 150 medium-sized shops Reduced logistics with having fewer shops but retaining the same sales areas in square metres Expand the range of accessories to include “matching” accessories Expansion programme Expansion outside of Europe Lower manufacturing costs if more clothing is manufactured in Asia

Weaknesses Operating profit margins affected significantly by small falls in sales Sales always difficult to forecast Closure of small shops could be considered by market analysts as a sign of difficulties Difficult to increase margins due to fast fashion model Dependant on suppliers for quality

Threats Loss of investor confidence and fall in CeeCee share price if agreed planned profit for 2010 is not achieved, as latest forecast is 11% lower Risk of losing the legal challenge by KK Loss of customer loyalty arising from closing 300 small shops – will customers who shop at these shops currently travel further to shop at a medium-sized CeeCee shop. Risk of not achieving higher sales at some of the new 150 medium-sized shops (that replace the 300 small shops) Very competitive market and brand loyalty is difficult to maintain New competition as customers turn to “value” clothing sector in the recession Inventory write offs could be greater than usual for the proposed new range of “matching” accessories

Note: The above SWOT analysis is detailed for teaching purposes and in exam conditions a SWOT containing far fewer bullet points, which cover the main issues from the case and the unseen material, is expected.

16 © The Chartered Institute of Management Accountants 2010

Appendix 2 PEST analysis

Political/Legal Increased personal taxation which could impact on reduced disposable income for its customers The possibility of new taxes on carbon emissions New laws on recycling of waste materials Economic Price competition The current economic environment could lead to further falls in sales revenue Other competitors going into liquidation due to the economic environment The need to reduce prices to achieve sales due to competitive forces Social Changes in fashion and taste Customersâ&#x20AC;&#x2122; concept of whether CeeCee is operating in a social and ethical way (Gap lost sales following the publication of child labour being used for manufacturing some of its products) Due to current economic environment, customers are going on fewer holidays and attending fewer parties, and therefore are not buying the same volume of new clothes Technological New materials available New production methods to produce lower cost clothing and household products. CeeCee has just launched its new website at the end of 2009. CeeCee could exploit this new technology to generate sales which are additional to sales achieved at its shops Use of e-commerce to reach customers more effectively than direct mail marketing

17 ÂŠ The Chartered Institute of Management Accountants 2010

Appendix 3 Financial and Ratio analysis All data for the financial year ended 31 December

No of shops: - end year

Actual

Forecast

Plan

Latest forecast

2008

2009

2010

Change from plan 2010

610

630

650

590

620

640

Sales area - average for year Square metres

600,000

648,000

680,000

Sales revenue

€ million

2,700

2,781

2,985

2,835

-150

Operating profit

€ million

616

634

690

614

-76

Sales revenue per shop € million

4.58

4.49

4.66

4.43

-0.23

Sales revenue per square metre €

4,500

4,292

4,390

4,169

-221

Operating profit per shop € million

1.04

1.02

1.08

0.96

-0.12

Operating profit per square metre €

1,027

978

1,015

903

-112

+14.5%

+3.0%

+7.3%

+1.9%

-5.0%

-average for year

Growth in sales revenue

18 © The Chartered Institute of Management Accountants 2010

Appendix 4 Evaluation of proposed sales bonus scheme

“Base case” sales level of €2,835 million (which is the latest forecast for 2010)

Bonus percentage paid to shopbased employees

Bonus Payable (on salary cost of €410 m)

CeeCee group sales targets

Gross margin at 60.2%

Gross margin change from “Base case”

Full year effect of bonus scheme on operating profit

€ million

2,835

1,707

-21

7% 9% 11% 14% maximum

29 37 45 57

2,892 2,948 3,005 3,062

1,741 1,775 1,809 1,843

+ 34 + 68 + 102 + 136

+ 5 + 31 + 57 + 79

2% 0%

8 0

2,778 2,722

1,672 1,639

- 35 - 68

- 43 - 68

For each change from this “Base case”: + 2% extra sales + 4% extra sales + 6% extra sales + 8% or more extra sales Or a reduction: - 2% reduction in sales - 4% or more reduction in sales

19 © The Chartered Institute of Management Accountants 2010

Appendix 5 Evaluation of closure of 300 small shops and opening of 150 medium-sized shops versus refurbishment of 300 small shops Proposal: Closure of 300 small shops and opening of 150 medium-sized shops Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

€ million

Investment Post-tax cash flows with growth at 7%

(290)

260

278

297

318

340

Net cash flows

(290)

(30)

278

297

318

340

Discount rate at 8% Discounted post-tax cash flows Cumulative discounted cash flows

1.000

0.926

0.857

0.794

0.735

0.681

(290)

(28)

238

236

234

232

(290)

(318)

(80)

156

390

622

NPV Proposal: Refurbish 300 small shops Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

€ million

Investment Post-tax cash flows with growth at 5%

(180)

160

168

176

185

194

Net cash flows

(180)

(20)

168

176

185

194

Discount rate at 8% Discounted post-tax cash flows Cumulative discounted cash flows

1.000

0.926

0.857

0.794

0.735

0.681

(180)

(19)

144

140

136

132

(180)

(199)

(55)

221

353

NPV

353

Difference in NPV

269

Difference %

+76%

Note: There were a range of valid NPV calculations that were awarded full marks. In respect of the proposal to open 150 medium sized shops, the case material stated that these shop openings would be phased in over 2 years. If the capital expenditure had been included as year 1 and year 2, then the resultant NPV was €664 million. This was awarded full marks. The case material was not specific about when the refurbishment of the 300 small shops would occur and a range of NPV’s were acceptable for full marks. These included the NPV shown above of €353 million, or the NPV of €379 million or €341 million.

Appendix 6 Summary of effect of recommended actions on operating profit for 2010

Operating profit

Original plan for 2010

Latest forecast for 2010

Possible outcome following recommendations for 2010

€ million

690

614

Recommendations: Sales bonus scheme Outcome not known But assume sales increase by 4% Close 300 small shops – profit effect for 2010 not known and likely to minimal due to closure costs

+31

Legal case with KK Out of court settlement

(10)

Proceed with matching accessories Assume “high” sales level is achieved

+40

Possible overall effect on Operating Profit for 2010

675

Overall shortfall from original plan

(15)

Appendix 7 Summary for presentation to the CeeCee Board on the proposal to close 300 small shops and open 150 medium-sized shops

Recommendation is to close 300 small shops and replace them with 150 medium-sized shops NPV for closing 300 small shops and opening 150 medium-sized shops is €622 million This is a higher NPV than re-furbishing small shops, €269 million higher (76% higher) Medium-sized shops will allow CeeCee to achieve higher operating margins and increase shop efficiencies Medium-sized shops will allow greater ranges of items to be sold, including children’s clothes, home furnishings and other high gross margin products Shop closures could have a negative effect on brand image and CeeCee would have fewer shops in operation Customer loyalty will be challenged as shops in 150 (or more) locations will close and not have a CeeCee shop Challenging sales targets for medium-sized shops – can each shop location generate double the revenues – are sales figures realistic? Locations for the 150 medium-sized shops need to be carefully chosen Staff issues surrounding shop closures – as staff at 150 small shops will be made redundant unless they accept a transfer to work in another CeeCee shop (assuming 150 medium-sized shops open in the same city / town as the old small shop)

Note: The above bullet point summary is slightly more detailed for teaching purposes and in exam conditions brief bullet points are expected.