GSK Plc Profitability Essay: Zero Base Budgeting, Balanced Scorecard, And Investment Decision.

You are required to produce an individual report based on your own independent work.

Using financial ratios, you are required to produce a critical analysis of the profitability of the UK based global pharmaceutical company GSK PLC. You should use the financial statements for both the years 2016 and 2017. This analysis should assess the profitability of the company. Comparisons for both of these years to one peer group company of your choice should be made. Your analysis should take account of the competitive and macro-economic influences on these ratios.
This should be based on the following 3 ratios:
• Return on Capital Employed
• Operating profit margin
• Earnings per Share

Using supporting evidence from a range of academic sources, including text books and journal articles, critically compare and contrast the benefits and drawbacks of the zero base budget setting technique. Conclude as to which circumstances would make this the most appropriate method of budgeting to use.

Using supporting evidence from a range of academic sources, including text books and journal articles, critically evaluate the strengths and weaknesses of the Balanced Score Card form of performance measurement. In particular discuss the extent to which it has been successfully adopted in professional practice by large global companies, and what the draw backs have been.

As a senior manager, recommend the key financial issues you would consider before making a decision about a significant financial commitment to a new investment project in your business. You are to assume that the project has been developed by managers who report to you, and this project has been presented to you for final approval. You should make clear the relative importance and weight that you would give to the financial issues that you raise.

Part 1: Analysis of GSK Plc profitability

The report deals with four parts, which provide understanding about different topics. The first part covers the profitability analysis of GSK Plc for the year 2016-17 by calculating key financial ratios for the company. The outcomes of the ratios are then compared to its competitor AstraZeneca Plc, a company operating in the same industry. The second part provides insights about the concept of Zero-based budgeting and its application in the businesses; followed by explanation of balance scorecard, its weaknesses, strengths and application in the third part. The last part highlights the financial issues noted by a manger before making an investment decision, followed by a conclusion at the end.

GlaxoSmithKline Plc is a British multinational company, involved in the business of development, creating, manufacturing and marketing of vaccines, medicines and other health related consumer products across the country. The company operates through four segments named Vaccines, Pharmaceuticals, Consumer Healthcare and Pharmaceuticals R&D. GSK provide pharmaceutical products that involve medicines in therapeutic areas like antivirals, dermatology, rare diseases, respiratory and others. Whereas, AstraZenca is an Anglo-Swedish company based in UK. The company a competitor of GSK that also deals in multinational pharmaceutical and biopharmaceutical products (Bloomberg 2018). The company manufactures medicines for major diseases including gastrointestinal, cancer, infection, cardiovascular, inflammation, neuroscience and respiratory. On comparing the financial analysis of both the companies it can be said that GSK is comparatively excelling in the pharmaceutical market. In addition, the earning per share of the company has increased in 2017 from 2016. While in the company AstraZeneca, the earning per share of the company has reduced from 8% to 5%.

Further the fact should be noted that ratio analysis is basically a financial analysis tool and technique used for measuring the overall performance and position of the company from each and every aspect. It is conducted by many financial analysts with an objective to provide insights to the investors about the profitability, liquidity, solvency and efficiency of the business (Bragg, 2012). The analysis is based on the quantitative data presented in the annual report of the company such as balance sheet and income statement (Bogsnes, 2016). The analysis help in interpreting the trend followed by the company in its past years and facilitates future decision making for the investors (Gibson, 2011). In order to analyse the profitability of GSK, following ratios have been calculated on the basis of data presented in its annual report of 2017 and the same has been compared to its competitor AstraZeneca Plc (Appendices 1).

• Return on capital employed

Part 2: Zero Base Budgeting and its application

It is a financial ratio that evaluates company’s profitability by measuring the amount of return generated from its capital employed in the business. It is calculated by dividing company earnings before income and tax with its capital employed. EBIT is also known as operating profit and the excess of total assets over firm’s current liabilities is represented by capital employed (Godwin and Alderman, 2012). 

It can be observed from the below table that GSK’s ROCE has improved during the past two years. In 2016, it was 4.84% which significantly rose to 11.82 in 2017.

From the analysis of return on capital employed, it can be seen that in the year the ROCE was 4.84% which further increased to 11.82% in the year 2017. This increase directly shows that the profitability rate of the company also increased. In addition to that, the improved sales and reduction in total assets of GSK also enhanced the ROCE that indicated that the firm has made efficient utilization of its capital. When compared to AstraZeneca Plc, it has been observed that its ROCE in 2017 was 5% that was anyway lower than the GSK (Morningstar, 2018). Thus, looking at this analysis it can be said that GSK is comparatively more profitable than AstraZeneca. Resulting to which GSK is providing better returns to its stakeholders than AstraZeneca.

• Operating profit ratio

It is also one of the profitability ratios which reflect the amount of earnings left out of total revenue, after paying all the operating expenses and cost of goods sold. It expressed the amount of profit earned before interest and income tax as a percentage of total sales (Vogel, 2014). 

GSK’s OPR increased from 9.32% to 13.54% due to the upsurge in company’s total sales and its operating profit. The pharmaceuticals sales were up by 7%, vaccines sales reported an increase of 12% and the sale of consumer healthcare products increased by 8% which contributed to the increase in the entire turnover of GSK. Continued tight control of operating cost over the three businesses and increased sales have contributed to the growth of GSK’s operating profit. All such upsurges boosted up the ratio in 2017. The operating margin of AZN was 9.1% lower than GSK in 2017 due to low turnover and operating profit (Morningstar, 2018).

• Earnings per share

It is also a profitability metric which reflects the portion of company’s earnings allocated to each outstanding share of common stock (Warren and Jones, 2018). 

Part 3: Balanced Scorecard and its evaluation

The EPS of GSK has increased from 0.18 to 0.31 due to the significant increase in its net income available to shareholders. Also, the issue of shares has boosted up the ratio and profitability of the company. The EPS of AZN also showed the same trend as it was 1.185229068 in 2017, less than GSK’s EPS (Morningstar, 2018).

Overall, it can be concluded that the profitability of GSK has improved in 2017 and was much better than its competitor AstraZeneca Plc. The company made high revenue and profits thus reflecting strong growth in its profitability position.  

Zero base budgeting is a method of budgeting in which all the expenses are justified in a single period of time. This type of budgeting is called Zero Base Budgeting because it starts from zero bases where each and every function of the organization is analysed on the basis of its needs and cost. This type of budgeting helps the top management to build strategic goals by analysing every aspect of the budget and justify all the expenditures as well. Further, the fact should be noted that there are certain myths about zero base budgeting due to which people believe that it lead to inefficient cost management for the company. Like, people believe that the idea behind zero base budgeting is to create the budget from sum zero but instead the main motive of this type of budgeting is to capture the cost accountability and effectively manage the cost as well.

Zero based budgeting is a method in which the budgeting process starts from the base of zero without considering the previous years’ budgets, estimates or actual performance. All the elements of the budgets start with the zero balance and then every department function is reviewed completely with the approval of all the expenditures. The main objective of applying ZBB in the business is to make the optimal allocation and utilization of the available resources in the part of the business where they are most needed (Ekanem, 2014). Under this method, all the managers are required to justify every activity in their department in order to get the resources allocated to them. By following this practice, ZBB helps the company to remove the unjustifiable activities or expenditures from the process (Graham, Harvey, and Puri 2015). The method has some benefits and limitations which are explained below.

Benefits of Zero-based budgeting

• It is very much appropriate for the current year, as it does not assume previous years’ allocation of resources that eventually forces the organization to re-evaluate all its expenditures from a zero base. Furthermore, ZBB removes the inefficient and obsolete activities and it curbs the unnecessary expenditure (Glass, Stefanova and Prinzivalli, 2014).
• It pays more emphasis on bottom-up approach to budgeting that brings accuracy as each and every item is re-examined by the managers which eventually lead to cost reduction and  income efficiency.
• One of the advantages of ZBB is that it results in efficient allocation of resources as it ignores the historical numbers and takes into account the actual figures.
• The method helps in identifying the opportunities and determining the most cost-effective way of doing things by eliminating all the unnecessary and unproductive activities from the business.
• ZBB overcomes the limitation of incremental budgeting of budget inflation as it re-evaluates every line item from the scratch and the one which are justified.
• It also led to the motivation in employees by involving them in the decision-making process. It stimulates proper and improved coordination and communication with the department (Nnoli, Adeyemi and Onuora, 2016).

Limitations of Zero-based budgeting

• It is a very lengthy and time-consuming exercise for public and private entities to be carried out every year.
• It also requires large number of employees as the budgets are framed or prepared from the scratch. However, many departments of the organization do not have that much time and human resource (Bawono, 2015).
• Providing explanation of every line item and every cost is difficult and requires expertise. For that purpose, the managers are required to be trained properly.
• Being practiced in a large organization, ZBB involves a lot of paperwork due to huge number of business activities that becomes unmanageable for the company.
• Managers may find it difficult to change or modify their decisions that are taken at time of preparing the budgets. This could affect the business if the budgets prepared failed to react to the emerging opportunities and threats (Miller, 2018).

Part 4: Key financial issues in investment decision

From the above analysis, it can be clearly seen that apart from benefits, there are various drawback of using ZBB that can limit the functions of the company. However, this type of budgeting is best suited for private companies and not for profit organizations. In private sector, the adoption criteria are flexible as the companies do not have to face any legal constraints like federal or public sector agencies. In this regard, the can successfully adopt ZBB in order to reduce the spending and increase performance. Companies like Texas Instruments and Xerox has adopted ZBB and ultimately enjoyed the increase in their profits by approximately 60%. Whereas in public sector organization, this type budgeting will not work effectively because public organization face fiscal constraints and legal obligations on a regular basis. Implementing ZBB in areas where the company need to ask approval for every decision will make the budgeting process lengthy and inefficient. Thus, it can be said that this type budgeting is more suitable for private organisations.

Also, it should be noted that the private companies can more easily afford the cost of implementing ZBB in their business as compare to federal agencies as and when required (Deloitte 2018). Overall, it can be said that the ZBB is more appropriate for the smaller companies that have flexible operations and are not surrounded by the legal laws and regulations. Although the procedure results in efficient utilization of resources but it is also a lengthy method and may not fit for the public sector companies, as they require considering political forces and pressuring from government bodies. Although this type of budgeting was introduced by Federal Government but as, they faced difficulty in managing it due to which it can be said that this type of budgeting is unfavourable for public sector. This type of system is best used in circumstances where the company need to effectively reduce the expenditure and find the areas that are hidden in normal budgeting and cause wastage of resources (Barr, and McClellan 2018).

Performance measurement is very important for the business as it helps the management to analyse the areas where they are lacking and work on them to attain the identified objectives in the market. Balance Scorecard is a form that helps the business to identify their growth and inefficient areas that need improvement. BSC helps the business to link the performance measures with the strategy objectives of the company to improve their financial performance. This tool focus on the financial, internal process, customer and learning and growth activities to provide relevant feedback for the strategic execution of plan (Hladchenko 2015).

Conclusion

The terminology of BSC suggested that every organization should review its performance on the basis of four perspectives including financial, consumer, internal process and learning and growth. It should measure, target and develop its KPIs on the basis of these perspectives only. The financial view point deals with review of financial performance of the company along with the use of its financial resources (Boscia and McAfee, 2014). Consumer perspective allows the firm to measure its performance from the viewpoint of customers or its stakeholders. The internal process reviews the quality and efficiency of the company’s product or services or any other key business processes. As far as the perspective of learning and growth is concerned, the company evaluates its performance on the basis of infrastructure, human capital, culture, technology and other capacities. Although it is the widely used management tool, but it also has some advantages and disadvantages which are to be kept in mind while implement it in the business.

• It provides a framework or a structure to formulate organization’s strategy and help the managers to ensure that all the key and important areas of the organization are covered. It keeps the goal centralized, uses specific measurements and takes initiatives to track the progress (Anjomshoae, et. al., 2017).
• It goes for a more comprehensive and balanced approach for the purpose of reviewing and judging the performance and setting the goals and objectives while keeping in mind the four perspectives (Quesado, Aibar Guzmán and Lima Rodrigues, 2018).
• It facilitates effective communication and clear understanding of the business targets and strategy at all the level of an organization. It aims at establishing clear communication between the managers and employees of the entity(Vieira, Soares, and Sousa 2017).
• By centralizing the goals, Balance scorecard makes the management more focus and stop it from deviating from the set targets.
• It takes into account the financial and non-financial measures into a single system (Bergeron 2017).

• One of the weaknesses of BSC is that it only focuses on the four perspectives while other viewpoints such as managerial development perspectives, social responsibility perspective and others are also proved to be important at time of measuring the performance (Kerai, and Saleh 2017).
• It is a vague approach of controlling an entity as it does not have any standard performance measure for its four perspectives (Akkermans, and Van Oorschot 2018).
• It just measures the operational performance of a firm and do not provide suggestions about how it can be improved and what steps should be taken to make the performance better and others (Nørreklit and Mitchell, 2014).

Despite having such strengths and weaknesses, the approach of balance scorecard has been adopted by many companies at a global level. According to the recent survey of Bain & Company it has been found that more than 62% of the organization uses BSC around the world (Hendricks, Menor and Wiedman, 2004). It has been considered as the higher adoption rate in comparison with the other management tool like total quality management, supply chain integration and others. Many companies are using BSC like Volkswagen, Philips Electronics, Thomson Reuters, Mobil North America Marketing and Refining (NAM&R) and others operating in different sectors. Philips successfully implemented the scorecard with a purpose of aligning the company’s views and to motivate the employees by letting they know the key drivers of the business (Levy 2015). The company enjoyed many benefits of applying the approach as the employees use it to improvise the results. Management make use of scorecard to communicate the strategy to the employees. On a whole, Philips was successful in implementing the balance scorecard and succeeded in measuring its business performance from diverse perspectives (NC State University. 2004).

However, there are some companies also who failed at implementing BSC in their business. Also, there are certain drawbacks of adopting the same. Firstly, it is very time consuming and costly procedure. The correct application of the tool requires through understanding of the procedure and expertise knowledge. Furthermore, the tool will work only when the complete, accurate and relevant information is provided. Selection of wrong elements may result in the failure of process. Being a most advanced method, the implementation requires trainings of employees that make them to put extra time for learning the balance scorecard approach. This might result in the resistance from the employees as they need to go through a lot of training sessions (Rompho, 2011). Therefore, for a company to successfully implement BSC in its business, full support of everyone is required so that maximum success can be achieved. Overall, it can be said that the adoption of balance scorecard is a good move for the companies who know how to deal with the changes in the system and have the full knowledge about the new performance tool. While on the other side, the companies that lack expertise have faced many problems while implementing BSC in their business. So, on a whole BSC is an appropriate performance management tool that can give high and improved results to the company and can increase the chance of their growth and success in near future (Balance Scorecard 2018). Thus, the fact should be noted that balance scorecard is an effective tool measure the performance of the company and it will support the performance of these organizations as well.

Basically there are two types of expenditure in the business, one is capital expenditure and other one is revenue expenditure. Capital expenditure refers to the cash spent on investment normally whereas revenue expenditure refers to the cash spent on day to day expenditure. Considerably decisions of capital expenditure are much important because it require huge amount of investment on non-current asset having an economic life. Being a senior manager of the organization, it believe it is my utmost responsibility to consider various issues related to investment decision for a project. Further, the factors that should be taken into consideration by senior management before initiating investment decisions are discussed below:

Risk-Return Parity: It refers to the portfolio allocation strategy using risk to determine allocations across various components of an investment portfolio. It is very important for the manager to understand the return on the project against the risk involved in it. It is an important point to consider, as the amount of return should always be more than the level of risk. Risks in an organization brings volatility and it is important for the manager to manage the level of risk with the rate of return. It is said the higher rate of risk brings higher level of returns for the company but the organization should adopt level of risk that they can easily handle. Volatility of the project should never harm the financial planning of the company. So, it should be noted that is an important aspect that the manager needs to consider before initiating the investment decision in an project. Uniformity in the level of risk and return should be created by the management before investing in a project.

Level of Productivity: Productivity is the most important issue that should be considered before investing in the project. A business makes investment in the project with a basic purpose to attain productivity from that project. As capital investment require huge amount to invest, thus being a senior manager it is important for me to consider that the investment will provide equivalent level of productivity or not. Productivity of a project can be directly linked to profitability of an organization. Companies with higher level of productivity are associated with higher level of investment growth. So, the investment decision should be based on the level of productivity that the project will provide to the organization. The cost of capital of the project should be considered at it creates negative impact on the investment growth of the company. Cost of capital helps the company to evaluate the profitability of the project towards the investing decision of the company.

Financial Feasibility: Financial feasibility helps in determining that whether the project is viable for the business or not. It is important for the manager to analyse the feasibility of project along with the financial feasibility of the company to invest in the project. Under the aspect of project feasibility, the manager should analyse whether the adoption of the project will not hamper the current growth of the company. Further, the project should also be approachable by the organization. Further, talking about financial feasibility, I being the senior manager of the company should look after the aspect that whether the organization have adequate funds to invest on the project. If the organization is currently not having funds to invest on the project then from where they can manage or arrange the funds. All these questions should be answered before deciding the financial feasibility of the company to invest in a certain project.

Alignment of KPIs with results: Key performance indicators are the quantifiable measures that are used to evaluate the success of the organization. For instance, a key performance indicator for the organization can be to increase the revenue by 5%. Further, it should be noted that as investment decision is an important aspect for the business so do the KPIs. It is important for the business to align the financial decisions with the KPIs of the company. If the project will not help the company to achieve its KPIs then the development of the project is of no use. The KPIs helps the management to attain information that the business is growing financially. So, the investments should be made at places that align with the KPIs defined for the company.

Liquidity of Organization: Liquidity of the company is also one of the financial issues which should be kept in mind by the managers while making an investment decision. The management must make sure that the company should have a strong financial position so as to fund the new project. A proper balance has to be maintained between the debt and equity element of the firm and availability of cash should be there so that the company can easily make investment in new project. Therefore, it can be said that liquidity is one of the factors required to be consider as it reflects the potentiality of the firm in managing its obligations and investments. It is also prioritized after looking at the issues discussed above. Liquidity of the organisation is important to consider because it will help the business in case the project does not achieve success. Thus, it can be said that it is important for the manager to look at the aspects that can help the business in cases the project does not achieve its desired growth.

Thus, being a part of the senior management team, it is important for me consider the above mentioned financial issues before making investment decision into a certain project.

Conclusion

Thus, in the limelight of above mentioned events, the fact should be noted that the profitability of GSK has improved in 2017 as compare to 2016 and its competitor AstraZeneca. Further, the implementation of techniques like zero based budgeting and balance scorecard has improvised the overall position and performance of many companies. The last part concludes that it is very important for a company to consider all the financial issues that can arise at time of taking any investment decision.

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