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Question 4a

Laudan Advertising Agency (LAA) is based in Geeland and has three autonomous subsidiaries: A, B and C. All three subsidiaries are profit centres and LAA seeks to maximise the long-term wealth of its shareholders. A is based in Geeland, while both B and C are located in other parts of the world. LAA is a highly respected advertising agency, which in the last five years has created advertising campaigns for 25 of the world’s top 100 most recognised brands.

LAA’s four key objectives published on its website are:
– To delight our clients by the quality of our work
– Provide excellent value for money to our clients
– Give our clients access to specialist and local knowledge
– Ensure our clients return to us time after time

There are three main functions within LAA:
1. Campaign management, which involves researching and understanding clients’ requirements and budgets and designing a suitable advertising campaign for them.
2. Creative design, which is where the visual appearance of the advert and graphics are created.
3. Media buying, which negotiates prices with, and buys advertising time and space from, magazine and newspaper publishers, internet search engines and TV companies.

Each subsidiary has its own department for campaign management and for media buying. Only A, however, has a creative design department.

The directors at LAA believe that without visually appealing design, any advertising campaign is unlikely to be successful and meet the expectations of the client. They identified the importance of being able to produce high quality creative design as a critical success factor for the business. Two years ago, they decided to concentrate all of LAA’s creative design at a ‘centre of design excellence’ within A. The intention was to improve the quality of creative design within the business by giving staff access to the latest design technology, and by attracting the most talented designers to work there.

To encourage the three subsidiaries to use the internal creative design department within A, instead of external third party design agencies, the directors created a new additional key performance indicator on which to appraise the performance of all subsidiaries and of subsidiary managers:
– All subsidiaries, including A, must purchase at least 90% of creative design work internally from A.
Prior to the introduction of this performance indicator, 40% of creative design work in each of the three subsidiaries was purchased from external design agencies.

The directors of LAA have become concerned that the introduction of the new key performance indicator may be causing managers to operate in ways which are not helping to meet LAA’s stated objectives. They have asked for comments from subsidiary managers (Appendix 1) about whether they have met the 90% target in the most recent period and if not, to explain why this is.

Appendix 1
Subsidiary managers’ comments on achievement of KPI for 90% creative design work purchased internally

Subsidiary A
‘A purchased 86% of design work from our internal design department in the period. It would have been almost 100%, but we won a large order for a new client who operates in a specialised industry of which we have no experience. As a result, we had to use the services of a specialised external design agency, which was much more expensive than using our in-house team.’

Subsidiary B
‘B purchased 62% of design work internally in the period. Though the quality of the designs is very good, they were more appealing to consumers in Geeland than here in Veeland, where B operates. The internal design department did not seem to understand consumer preferences in Veeland, and many of their designs were rejected by a key client of ours. As a result, an important advertising campaign missed key deadlines, by which time the internal design department had insufficient capacity to finish the work and we had to use an external agency.

‘As there is no formal transfer pricing policy in place at LAA, the basis of the transfer price charged by the internal design department is also unclear to us. It appears to be based on full cost of the design work, including apportioned overheads and an allowance for bad debts and marketing expenses, plus a very substantial mark up. We have spent a long time trying to negotiate this price with A, which is much more expensive than external designers. Furthermore, we are currently being investigated by the tax authorities here in Veeland who have indicated that the prices charged by A for design do seem well in excess of market rates.’

Subsidiary C
‘C purchased 91% of design work from the internal design department in the period, as well as achieving all our other performance targets. A key client of ours ran a major advertising campaign during the period. We used the internal design department for the first time for this campaign, instead of the usual external agency that we have used in the past for work for this client. The client was very unhappy with the extra cost that this incurred, as the number of design hours and the hourly rate was much higher than for previous campaigns. The internal design department refused to reduce the price after long negotiations and we had to give a large discount to the client before they would
settle our invoice. As a result, our gross profit margin for the period was significantly reduced.

‘It would be much fairer if the transfer price charged by A was based on the market price of the services provided.’

Required:

(a) Evaluate how the following help LAA to manage performance in order to achieve its stated objectives:
(i) identifying the critical success factor of producing high quality creative design, and
(ii) setting the key performance indicator for the requirement to purchase 90% of design work internally.
(8 marks)