Peanut allergy
Some of Y’s most popular products contain peanuts. This creates a problem for Y because many people are allergic to peanuts and some can suffer life-threatening reactions if they are exposed to the slightest trace of peanuts. The products that contain peanuts are clearly identified on the packaging but there is a danger that there can be ‘cross contamination’ amongst products.
This can occur if Y’s equipment has been used to produce a product that contains peanuts and it is then used for other products or if production staff have handled peanuts and have not changed their gloves or overalls before working on another product.
Problems can also occur because some of Y’s bought-in ingredients contain peanut oil. Again, small traces of those ingredients can be very dangerous to allergy sufferers. Y requires suppliers to identify which of the ingredients that they supply contain peanut oil.
Y’s board has classified the risks associated with peanuts as high impact and high likelihood. Y’s board requires that the risks are kept under constant review. It would be impossible to eliminate peanuts from the production process altogether because too many products contain peanuts or ingredients that include peanut oil.
Cocoa futures
The purchase of cocoa is one of Y’s biggest expenses. Cocoa prices can be volatile because of factors such as weather conditions affecting crops in the main cocoa producing countries. There are two main regions where cocoa is grown and a lack of rain in either of them can reduce yields and consequently cause the price of cocoa to rise.Y has always bought cocoa at the spot price because Y’s directors have always believed that the disadvantages of hedging exceed the benefits.
Cocoa is grown and harvested on small, family-owned farms. The process is very labour intensive and does not lend itself to mechanisation. The farmers themselves are exposed to many of the risks that affect Y and other manufacturers which buy cocoa. If yields are healthy then farmers will harvest more, but that gain is offset by a much lower market price per tonne. In addition, individual farmers are exposed to local threats, such as disease affecting their crop.
Y has recently been approached by a charity that supports farmers in developing countries. The charity proposes that Y should enter into an arrangement whereby it would lease a number of cocoa farms in Africa and Indonesia.
Y would pay the owners of the farms it leases a regular fixed monthly amount for their labour during the year. In return, the farmers and their employees would harvest the annual crop of cocoa on behalf of Y. There would be no inefficiencies in terms of transportation.
If the farms produce their average yields Y would obtain approximately 30% of cocoa it needs from this arrangement. Obviously the yields from these farms are exposed to the same factors as other farms. The accounting team at Y estimates that the charity’s proposal would not result in any cost savings for Y.
The charity has stated that it intends to approach Y’s competitors if Y does not pursue this arrangement.
Cash takings and internal audit
New procedures for the handling of cash in Y’s stores were implemented in April 2014.
The directors were keen to ensure that the processes were running correctly and in October 2014 asked Y’s internal audit department to conduct a thorough investigation of the cash handling procedures in the company’s stores.
The internal audit department sent teams to eight stores. The initial feedback from the audit teams is that store managers view the new procedures as time-consuming and impractical. In three of the stores that were visited the store staff had been instructed by the store managers to revert to the old system.
There has been no suggestion of any theft or fraud in any of those stores. The store managers dislike the new system because store staff are required to count cash more frequently during the store opening hours, which means that there are fewer staff available to serve customers during busy periods.
Required:
(a) (i) Recommend, with reasons, FOUR precautions that Y should take to reduce the risk associated with peanut contamination.
(ii) Evaluate the drawbacks and benefits associated with the four precautions suggested in your answer to (a)(i).
(b) (i) Discuss the difficulties that would be faced when evaluating the financial benefits of hedging the cost of cocoa.
(ii) Evaluate the risks to Y associated with the charity’s proposal concerning leasing cocoa farms and paying their owners a fixed sum to grow and harvest the crop.
(c) Advise Y’s directors of the most appropriate response to the internal audit department’s findings in relation to the adoption of the new cash handling procedures.
Answer:
(i)
One response would be to print a clear warning in the ingredients panel of the box to indicate that the factory uses peanuts in its manufacturing process even though the product itself does not contain this ingredient. It could be made clear that the company takes great care to avoid contamination, but that there can be no guarantee that this will always be effective. That would warn customers who were particularly sensitive to this condition to take care and perhaps avoid Y’s products altogether. This would also protect Y in the event of a reaction because anyone with a food allergy should take care to read the ingredients panel.
All manufacturing staff should be trained on the dangers associated with cross-contamination as part of their induction. Staff should be properly trained in removing any traces of peanuts from their clothing and from any equipment that they have been operating. If they suspect that there may have been some contamination of a product that is not supposed to contain peanuts then they should be encouraged to report that so that the company can either test or scrap potentially contaminated batches. The company should not attempt to assign blame or to penalise staff responsible for such scrappage so that they are not discouraged from making a report.
Production should be scheduled to minimise the risks of contamination. Ideally, there would be two production lines, one for products that contain peanuts and another for products that do not, with each member of staff involved in one production line or the other. If that is not possible then the equipment should be set up to make a large batch of products that contain nuts, followed by a deep cleaning before switching to nut-free products. The fewer cycles of switching to nut-free products the fewer the chances of cross-contamination because of errors in cleaning. Also, staff can be instructed to take greater care when working with nut-free ingredients.
All stocks of peanuts and any raw materials that contain peanuts should be kept in a separate area, with signs indicating their content. Staff should not be permitted to withdraw anything from this area without having a specific instruction to do so. That would reduce the risk of accidentally adding peanuts to a product that is not supposed to contain them. It would also reduce the risk of contamination of materials while in storage.
(ii)The most immediate cost of keeping the risks under review is the time and effort that will be involved. Product safety is clearly an important issue, but this is not an area that is likely to change significantly and so it is unlikely that the risks will change or that new risks will emerge.
There is a danger that a constant review will start to become very superficial and ineffective. If those responsible for the review do not expect to find anything then they may become a little dismissive of potential risks.
The upside to keeping this risk under review is that it could change from time to time. For example, suppliers could add peanuts to their products. The fact that there is a review process will mean that staff are aware of the method of reporting any fresh concerns.
No matter how careful Y is, there is always a slight risk of an incident. The fact that there is an ongoing review process means that the company can defend itself by claiming to have taken all reasonable precautions.
(b)
(i)The first difficulty is in deciding whether there is a material risk. The fact that cocoa prices have been volatile in the past suggests that they will continue to be so in the future. There is an associated question of whether the volatility involves any material cost to the company. If prices vary about a fairly consistent norm then it may be possible to work on the basis of this norm. In that case the company will make smaller profits when cocoa prices are high, but larger profits when they are low. It may also be possible to vary selling prices in line with movements on input costs and so the risk can be passed onto customers.
A second difficulty arises from predicting competitors’ behaviour. If competitors hedge so that they do not need to bear the impact of any increase in cocoa prices then Y may be forced to hedge in order to remain competitive. Conversely, hedging in isolation may lead to Y bearing a higher cost than competitors because it cannot benefit from any future decrease in cocoa prices.
The evaluation is further complicated by the fact that hedging is essentially a zero-sum game. The counterparties to hedging agreements will price their instruments accordingly. In the long term hedging is likely to prove expensive because these counterparties will also aim to make a profit from bearing risk..
Finally, the directors need to understand the shareholders’ interests. Shareholders may find it difficult to articulate their attitudes toward risk. It is difficult for them to be clear in informing the directors as to how much cost they are prepared to bear in order to avoid a risk. The risks themselves may be difficult to identify in any case. A diversified shareholder will regard a movement in cocoa prices as an unsystematic risk that can be disregarded.
(ii)The basic issue here is that Y will pay a fixed amount in expenses for an uncertain amount of cocoa. Y runs the risk that yields will be insufficient for the company to obtain all of the cocoa that it requires for production. Y could include more farms to ensure that the crops are sufficient for its needs and sell any surplus. That could be good in terms of public relations because the cocoa price will be depressed by good yields and Y will have ensured that the farmers will have had a living wage for growing the crop, although the return from such sales is likely to be depressed.
If the farms generate insufficient cocoa because of problems with weather or pests then Y can still buy additional cocoa on the open market. The likelihood of that happening will be reduced by the fact that Y will be using a number of different farms, located in at least two different countries. Hopefully, weather conditions or other problems that affect farms in Africa will not affect farms in Indonesia.
Also, the overall cost of cocoa will be reduced because Y will still be obtaining most of its requirements from the farms at a fixed cost for labour and so on.
Y may suffer agency-type problems from this arrangement. The farmers have a guaranteed return regardless of their yields. They may not feel that there is a great incentive to maximise their yields and may even decide to economise on the running of their farms in order to make a larger profit from this arrangement.
Y could obtain a public relations benefit from this arrangement. The company is effectively bearing a risk that would otherwise have been imposed on farmers in developing countries. Y could claim that its products have been manufactured using ingredients that were purchased at a fair price.
Y may also risk facing accusations of exploitation even though it is guaranteeing the farmers a reasonable wage. The farmers are unlikely to enjoy lifestyles that would appear acceptable to consumers in the developed world. It would, therefore, be easy for a journalist to portray Y as exploiting farmers, particularly if the cost of cocoa peaks and Y’s farmers do not benefit from that because Y has guaranteed them a reward based on hours worked rather than the value of their crop.
Y will suffer the risks associated with entering into any leasing agreement. The company will be signing a contract to lease the farms and so its gearing ratio could increase accordingly.
(c) The basic response should be that it is unacceptable for store managers to disregard formal systems and procedures. The control environment will be undermined if the board is not viewed as the authority on systems.
In the short term the internal audit department should advise the three store managers who are in breach that they must implement the new system. There should be a “light touch” follow-up to those stores to ensure that the agreed changes have been made.
Y’s senior management should email all store managers to remind them that the new system should be implemented as specified. The stores that are in breach should not be named because doing so would embarrass the store managers involved. It is, however, important to send out a message that the changes were introduced by senior management and cannot be regarded as optional. All managers should be asked to acknowledge that they have introduced the changes in order to drive home the message that they do not have any discretion in the matter.
The board should consider the possibility that the new systems are not as cost-effective as intended. Having established the principle that it is a board decision, the directors should commission an exercise to consult a number of store managers to identify the problems created by the new system. It may be possible to change the system further so that the control objectives are met without the associated inconvenience for staff. The consultation exercise will demonstrate a willingness to listen, even if it proves impossible to address the managers’ concerns.
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