Strategic management accounting

by Mark Lee Inman

01 Nov 1999

Professional Scheme
Relevant to Paper 3.3

Strategic Management Accounting has been defined as "a form of management accounting in which
emphasis is placed on information which relates to factors external to the firm, as well as non-
financial information and internally generated information."

Back in 1981, Ken Simmonds, probably the pioneer writer on the subject, developed the above definition. He
saw it as the collection of management accounting information about a business and its competitors for
use in developing and monitoring the business strategy. The emphasis was placed upon relative levels
and trends in real costs and prices, volume, market share, cashflow and stewardship of the resources
available to the business.

More recently (1994) Professor Bromwich pointed out that adding the strategic perspective to traditional
management accounting required the role of accounting to extend in two directions. First, costs need to be
integrated into strategy through strategic cost analysis, and thus align costs with strategy. Secondly, to
ascertain, albeit in a fairly general way, the cost structure of competitors and to monitor the changes over
time. In achieving this, Bromwich also sees two distinct approaches:

• costing product attributes provided by the company’s products;

• cost the functions in the value chain which are perceived as giving value to the customer.

Traditional management accounting is perceived as inadequate since it:

• concentrates on the manufacturing and neglects the high cost post-conversion activities;
• ignores the impact of other activities;
• fails to assess the relative cost positions of competitors;
• over-reliance on existing accounting systems;

By contrast, strategic management accounting purports to place emphasis on:

• the relative cost position;

• the ways in which a company may secure a sustainable cost advantage;
• costs of differentiation i.e., what makes their product different and hence more attractive.

This article will take two approaches. First we will look at how Strategic Management Accounting adopts a
different emphasis. Secondly, we will look at areas that need to be the focus of a management accounting
view.

1 Strategic management accounting

One of the main exponents of Strategic Management Accounting is the American M.E. Porter. As you
progress in your studies at final level, you will become very familiar with that name. His 1985 text on
strategic management is regarded as a corner-stone. Porter takes a two pronged approach.

First he assesses different industries in terms of their long-term profitability. He sees five competitive forces
that will contribute to a strategic equation.

(a) The threat of new entrants into the market

While it is influenced by the cost of entry into a market and perhaps the opportunity to make a profit, this
threat remains. In principle, the larger the organisation and the more investment required, the less likelihood
of any competition. However, students have only to look at the recent history of commercial aviation, where
deregulation has allowed small airlines to enter the market and compete successfully, while the UK
telecommunications industry has seen a monopoly situation turned into one of fierce competition.

New entrants can have another implication. They can expand the number of competitors without expanding
the market. Entrants into the UK supermarket business have this problem. In a country of less than 60
million people, who spend about 11% of their income on food, growth in the supermarkets business can only
be at the expense of rivals and the ultimate destruction of the corner shop.

(b) The threat of substitute products or services

There was a time when communication was by letter, then the telephone entered the communications
market. Now we have the Internet, where people can conduct business with all the advantages of letter
writing, but down a telephone line. Telephones historically relied on land lines. Now there is a whole new
area of competition from mobiles.

(c) Rivalry amongst existing organisations within the industry

Again within the UK, the student needs to look no further than his local supermarket. There is intense rivalry
between Sainsbury’s, Tesco and ASDA for a bigger share of the grocery and food market. At the bottom end
of the market, there are a number of smaller and possibly cheaper players, while at the top, the food
departments of Marks & Spencer compete against Waitrose.

On the world scale, the volume automotive industry provides a classic example. Historically, they were
somewhat nationalistic and fought each other for a share of the home market. Now, as major multinationals,
Ford, Volkswagen, FIAT, Toyota and GM compete on a world stage. A few smaller companies, such as
Jaguar and Volvo, are gradually being swallowed up by the major players.

(d) The bargaining power of suppliers

(e) The bargaining power of consumers

These two forces have been put together because they demonstrate the impact upon corporate profitability.
In each of the five forces are the constituents of profitability, prices, costs and investment. Prices are
influenced by the bargaining power of consumers and the threat of substitutes. Costs are influenced by the
bargaining power of suppliers and the rivalry between competitors.

R.M.S. Wilson, in his review of strategic management accounting, illustrates how these forces work both to
the benefit and detriment of various industries. The forces work very favourably for the pharmaceutical, soft
drinks and database publishing industries. As a result, they presently earn very attractive returns. By
contrast, some of the more basic industries, rubber and steel for example, as well as some of the high value-
added industries, such as video games, are under such intense competitive pressure that they are unable to
generate high returns.

You should also be aware that the relative strengths of individual forces can change with time. For example,
look very closely at the pharmaceutical industry. Once it was able to operate a jealously-guarded price
maintenance system. The argument was always based upon the high cost of R&D and the long lead time
because of testing and the need for government approval. This view is now being challenged, especially in
the patent and over the counter section of the market, by the supermarkets.

Secondly, Porter poses the question about the enterprise’s relative position within its industry. The question
of position is important because it influences the ability of a business to generate profits greater or less than
the industry average. Above average returns may be achieved by sustainable competitive advantage. This is
achieved by three basic generic strategies.

(i) Cost leadership

Here an enterprise aims at being the lowest cost producer in the industry. This is achieved by scale
economies, capitalising on experience curve effects, tight cost control and cost minimisation in such areas
as R&D, service, and advertising. The student should think very carefully about the latter two. Tight or over-
excessive or over-zealous cost control could lead to penny wise, pound/dollar foolish decisions being made.
Equally, while advertising may be an easy target for cost savings, well-directed R&D is a positive advantage.
Corporations which concentrate on this strategy are Texas Instruments, Black and Decker and BIC.

(ii) Differentiation

Here an enterprise seeks to offer some different dimension in its products/services that is valued by its
customers and may command a premium price. This can be achieved by image (e.g., Coca-Cola), superior
customer service solutions (IBM and Dell), dealer network and support (e.g., Caterpillar), and product design
(Hewlett Packard).

(iii)Focus

This has two variations — cost focus and differentiation focus. Strategies that are based upon focus i.e., the
narrow segments to the exclusion of others. One obvious example was the review of the hotel portfolio held
by THF when it was acquired by Granada. The basic focus strategy was to eliminate all five and two star and
below hotels. These were sold off. Then the middle three and four star hotels were reviewed under the Post
House and Heritage banners. Those not meeting the agreed criteria were also sold.

Porter identifies the value chain as the next approach in strategic management accounting. Value is what
the customers are prepared to pay, and this is a function of the image of the product. You will see this most
pronounced in the automotive industry. The volume car manufacturers Ford, GM, Rover, FIAT, Toyota,
Nissan, Renault etc., have a ceiling beyond which the customer will not pay. It does not matter what
refinements are fitted to a volume car, there comes a point where the customer will not pay because it is a
volume car and he can move up into the next level. Market research found that this figure was about
$40,000 (£24,000). At that price, a top of the range Ford with every imaginable extra could be acquired.
However, $40,000 also buys an AUDI, a BMW or even a Mercedes. This is why, to move into the lucrative
big luxury car market, Ford produce the Lincoln and have acquired Jaguar and Volvo, while Toyota produce
the Lexus. Likewise, FIAT keep Alfa Romeo and Ferrari separate.

The value chain

This has nine elements, each with operating costs and allocated assets driven by one or more cost drivers.
Some of these cost drivers may be controllable. The elements of the value chain are:

Support activities

1. firm infrastructure;
2. human resources management (and perhaps development);
3. technology development (and perhaps level);
4. procurement.

Primary activities

5. Inbound logistics;
6. Operations (or traditional production);
7. Outbound logistics;
8. marketing and sales;
 9. services.

In making the analysis, attempts must be made to assess the impact of the cost drivers on each of the
elements. Also, the cost of the nine elements must produce a satisfactory margin.

Once this exercise is complete, an attempt must be made to analyse one’s competitors in the same way.
Strategic advantage will then be identified if the total cost of the elements is less than that of the
competitors. Taking a more positive approach, assess if the margins are better than those of the
competition. If they are not, then a strategy must be developed to achieve a lower cost position through
controlling the cost drivers. This may mean cost savings by cost cuttings, or improving productivity.

To achieve this, the student could recall his studies of quality costs and TQM, a popular topic in recent
examinations. The problem of increasing margin could be resolved by examining internal failure costs in the
context of operations. Marketing, sales and service costs could be more productive if external failures were
reduced. An obvious example might be the provision of an excellent customer support service provided by
Volkswagen. If a Volkswagen breaks down while under warranty, a rescue vehicle comes out to it and fixes
it. If it cannot be fixed, then a replacement is provided. This is very good, but very expensive, and begs the
question would better investment in machinery, technology and education at the production operations level
eliminate this expensive and image damaging cost?

There is always a danger with cost reduction. It just may be that the lower cost component may save money
in the short term, but again create a serious failure which will damage the image of the product. Quick,
efficient and courteous rectification is always impressive, but is it too late? Has irreparable damage been
done to product image and customer confidence?

The Bromwich Ideal

The strategy of cost leadership tends, at best, to develop the well-worn traditions of cost accounting.
Emphasis is placed upon:

• the questionable merits of standard costing for performance measurement;

• the dubious use of flexible budgeting for manufacturing cost control;
• a veneration of budgets;
• a strict adherence to traditional product costs in pricing decisions;
• a consideration of competitors’ costs;
• lack of formal consideration of marketing costs.

This serious shortcoming is a direct result of the slavish adherence of cost accountants to what Johnson and
Kaplan call in Relevance Lost (p195) "the financial accounting mentality." The excessive focus on
production costs almost to the exclusion of non-conversion costs has proved disastrous. You should think
carefully here. Traditional blue-collar labour costs have shrunk to around 10% of product cost. Costs of
marketing, promoting, supporting the product or service must be brought into the equation for effective and
meaningful strategic cost analysis.

Professor Bromwich offers an interesting potential solution. Table 1 is based upon a fast food supplier
which provides prepared and partly processed products to its network of selling outlets.

The first thing that you should note is the emphasis on consumer benefits. Clearly the strategy has been to
look at what the customer wants, what he looks for and then place emphasis on the costs of providing those
benefits. It is these benefits that sell the product and provide the differentiation from rival products.
Table 1: The Bromwich fast food example

Product-volume
related costs
Activity related
costs
Capacity
related costs
Decision related
costs
Total costs

Illustrative Costs
PRODUCT BENEFIT
1 Texture
2 Nutritional Value
3 Appearance
4 Taste
5 Consistency of above over outlets and time
6 Quality
7 Low cost relative to competitors
OUTLET BENEFITS
8 Service
9 Cleanliness
10 Outlet facilities
11 Location and geographical coverage
OTHER BENEFITS
12 Product advertising

TOTAL COSTS ATTRIBUTABLE

TO CONSUMER BENEFITS
PRODUCT COSTS NOT
ATTRIBUTABLE TO CONSUMER
BENEFITS
TOTAL PRODUCT COSTS

The categories in Table 1 may need some explanation, and clarification of illustrative costs.

(i) product-volume costs include materials, labour (both preparation and serving) and
variable overheads. Obviously the materials used must provide adequate nutritional value, taste
good and be consistent between outlets. UK students might be interested to know that the
Harvester chain achieve this by strict control over food buying and not allowing any discretionary
 purchases by local managers. Labour costs will also include ensuring an outlet is clean, the service
is rapid and efficient without being obsequious;

(ii) activity related costs include material handling, transport and distribution, quality control,
monitoring quality and service and site and facilities maintenance. Many of these costs can be
readily related to outlet benefits;

(iii) capacity costs include land and building occupancy costs, depreciation and leasing
charges. Again, the emphasis is on the outlet and location. Many of the fast food chains rely on
trade from motorists and thus favour locations along trunk roads and major junctions;

(iv) decision related costs include product and site design, product and site engineering,
quality improvement, marketing, product advertising, personnel and administration. The important
point you should observe here is that costs are not just about placing a meal in front of a customer.
It is about the cost of a meal at a certain location and the provision of the right facilities and
ambience that makes that meal desirable. Oddly enough, the food forms a very small portion of the
costs, it is the labour and the facilities that form both the costs and the important value-added
elements, and it is this that ultimately impresses the customer.

Bromwich emphasises that all these costs can be collected and reported separately, doubtless in a very
traditional way. You may well be relieved by this. Certainly allocation in the way Bromwich suggests would
seem difficult. Even so, what is more important is that relative costs positions can be determined in the
areas where the product competes, ways of ensuring a cost advantage can be readily identified, and the
costs of differentiation can be highlighted and justified. This emphasises again the primary activities
identified by Porter, particularly the operations, outbound logistics, (in the case of fast food — serving and
presentation) and the full range of marketing.

2 Other areas of analysis

Having examined how Strategic Management Accounting differs from conventional or traditional
management accounting, it is now necessary to explore further Ken Simmonds’ area of ideas. The first area
must come under the general heading of competition.

The impact of competition

Before any of the analysis alluded to by Professor Bromwich can be meaningfully undertaken, it is essential
to identify who or even what the competition is. Mistakes have been made in this area e.g., in the United
States, Ford and GM fought each other and overlooked Toyota stealing their market, while in Europe they
failed to tackle the real market leader — FIAT. In certain markets, the competition may not be another brand.
Florists compete with chocolates in the social gift market, but also with wine stores and even restaurants.
The tradition of taking mum out for Mother’s Day rather than giving flowers has seriously eroded one of the
florist’s traditional markets.

Kotler’s analysis of competitors

Kotler in Marketing Management: Analysis, Planning and Control identifies four types of competitor:

(i) Desire

This is the initial stage. The customer has a desire, (say) to buy a present for someone;

(ii) Generic
 These are the alternative ways that such a desire can be met. It could mean a choice between
flowers, chocolates or something more permanent.

(iii)Form

These are the forms that the selected choice can take. Flowers could mean purchasing a bouquet
or ordering flowers by telephone.

(iv) Brand

Flowers do not lend themselves to brands. Sending them usually involves Interflora, but there are
alternatives. Flowers can be posted from the Channel Islands, or another flowers by wire service
chosen. If the delivery is local, then the flowers may be delivered by the local florist.

Porter has also identified barriers to entry. Any review of competition must consider how easy it is to enter a
particular market, and how lucrative and hence attractive a particular market might be. Analysis under this
heading will cover:

(i) Economies of scale

Many industries such as the automotive industry, require large scale operations just to compete. The cost of
establishing and equipping from scratch would be prohibitive. The Japanese achieved their success from a
home-based critical mass that gave them the requisite scale economies to compete. You should also
remember that scale economies are not just confined to production. The prohibitive costs of entry may be
developing effective distribution and service channels. The Japanese automobile companies had to
establish dealer networks, service confidence and parts availability. This was achieved by granting
dealerships to disenchanted former British Leyland dealers. More recently, the Korean Daewoo, have
resolved this problem by integrating distribution with their own brand name, and effectively owning the
distribution and service network.

(ii) Brand loyalty

Many consumer brands have a high level of customer loyalty which would be extremely difficult to destroy.
The cost of wooing loyal customers away from an established well- known brand is high. But it has been
achieved, e.g., Canon has taken a substantial slice of the office copier market.

(iii) Capital requirements

This relates to economies of scale. Daewoo have broken into the volume car market backed by the other
enterprises that the Daewoo Corporation is involved in. The Japanese had their home critical mass and
hence economic base for moving into the world markets.

(iv) Switching costs

There is always the possibility that the customers cannot readily change. In the aerospace industry there is
limited choice worldwide for major components. Certificates of airworthiness depend on aeroplanes being
built of components that have been certified by the licensing authorities.

(v) Access to distribution channels

Any food product, to be successful, must get on the supermarket shelves. If the big three are prepared to
add it to their array of existing products, then success is virtually assured. One obvious example is wine.
Most large supermarkets provide a wide choice of wines selected from the traditional parts of Europe and on
an increasing scale from Australia, New Zealand and South Africa, as well as parts of South America and
California. However, wines from England are difficult to find, as are many wines from Eastern Europe and
the former Soviet Union.

(vi) Non-scale disadvantages

Established companies may have advantages not readily available to new entrants. The English wine
industry lacks image, it is inherently small, often forced to pool processing facilities, and has difficulty getting
into major outlets.

(vii) Government regulation

Many governments are very protective. Japan has a highly complex distribution and legal system to deter
competition in its own home market. France also has complicated procedures designed to keep out foreign
competition.

Traditional management accounting has always ignored the impact of competition and the market. It was so
involved in the introspective aspects of control that it had almost become a closed system within its own
right. At strategic level the competition and the market must be considered.

Under the general heading of ‘competition’ a business should:

• establish a basis for competitive strengths,

• identify the major competitors,
• compare with the major competitors,
• identify potential new competitors.

In analysing the competition, every employee should consider himself involved. A simple example might be
R. C. Townsend’s famous ‘Call Yourself Up’ technique. To test Avis’ response to potential customers, he
used to call himself. The response was then compared with that of the competition i.e., Hertz.

On a grander scale, certain industries have league tables — the automobile industry monitors who has the
top ten model sales each month in a manner not dissimilar to the popular music charts. The media is able to
monitor listener and viewer ratings.

At the lower end of the business scale, the local convenience store owner can see how the competition has
attacked him. Back in the 1960s and 1970s one of the main advantages of these stores was that they were
‘open all hours’.

Three things have threatened these businesses. First, the major supermarkets, themselves fighting for more
and more of the share of a largely static food market, have started to ‘open all hours’ — some even 24
hours. The major advantage of the convenience store has been eroded. Secondly, the petrol companies,
and in some cases the supermarkets, have turned petrol stations into convenience stores. Again, they are
open all hours. However, they also have the third prong of this attack. Many corner convenience stores have
suffered from parking and waiting regulations, so the customer has been literally driven away. The
supermarket, often with an out of town site, or the garage with its ready-made space, enables the mobile
customer to stop.

Leaders, challengers and followers

The market leader is the company or product that is out in front. Leadership may be reinforced by brand
strength. Such companies must be ever vigilant. Leadership is never permanent, the most recent casualty
being Marks & Spencer, where complacency, deteriorating quality and boring products have cost it its
position as the major High Street retailer. By contrast, the challenger attacks either the leader or other
competitors. In the UK, this is most pronounced in the battle of the supermarkets, with Tesco and
Sainsbury’s battling it out for both the top spot and a larger share of the market. While the ‘big two’ battle it
out, threats from new entrants, both from continental Europe, new players at the bottom end and the threat
of the American Wall Mart present other challenges. The follower may recognise his position, know he may
never take the No.1 spot and remain content. The Avis success story is just such an example. They were
never going to be the number 1 for size and volume, but by adopting their famous ‘We try harder’ slogan,
they increased their share of the market and became a better performing company.

Progress measurement
Strategic management accounting focuses on a larger picture and a longer term than traditional budgeting.
The rapidly changing economic world means that planning horizons have shortened, and even then,
projections beyond perhaps twelve months are little more than best estimates written in pencil.

Conventional financial measures have a value and under budgetary control and Economic Value Added,
may be reduced to a few, if not a single financial objective. Control might be through profit, cash generation
or a measure of financial return.

The Balanced Scorecard approach may utilise multiple objectives, comprising of a mix of financial and non-
financial measures. To the traditional financial measures of profit, cash generation and return might be
added tender success rate, reduction in rework, proportion of revenue from new business, market share and
some objective attempt at quantifying customer satisfaction.

However, there is a popular trend to try and move away from strictly quantifiable and financial measures.
Strategy may need to look at a wider series of objectives that "meet the needs of the present without
compromising the ability of future generations." Such a view must go beyond any limit of traditional
economics and accounting measures. By looking at a very recent (March 1999) article in the ACCA’s own
Accounting & Business, you will see a possible way forward for measuring strategic performance. Six
measures are illustrated, viz., Diversity, Added Value, Productivity, Integrity, Health, and Development.
These are then considered under different dimensions, economic, social and environmental. Table 2
illustrates the theme of Diversity, defined as an enterprise’s mix and balance of activities and human,
ecological and economic resources.

Table 2: Diversity categories (from Adams 1999)

Economic Dimension
Business diversification
(Assuming this is an
inherently good strategy
Social Dimension
Employee diversity, employment
of minorities, the disabled and effective
equal opportunities
Environmental Dimension
Resource use diversity
Consumption of non-renewable
natural resources; Consumption
of renewable resources

Conclusion
Having read this article, the student should now be able to:
 • adequately and critically define strategic management accounting;
• be aware of the shortcomings at strategic level of traditional management accounting;
• be aware of the different emphasis;
• understand the importance of the value chain;
• be aware of the contribution of Professor Bromwich’s ideas;
• understand the impact of competition and the market;
• be aware of potential measures of progress towards the objective..

Finally, you should not be a stranger to the use of non-financial information. Concepts in management
accounting stress that the accounting function has access to all the data within the entity so monitoring such
information should not be difficult.

References and further reading

1. Adams Roger, (1999), "Performance Indicators for Sustainable Development" Accounting &
Business, March pp 16 – 19.
2. Bromwich M., Bhimani A. I., (1994), Management Accounting — Pathways to Progress, London.
3. Simmonds K., (1981) The Fundamentals of Strategic Management Accounting, London.
4. Wilson R. M. S., (1995), Strategic Management Accounting, in Ashton et al (eds), Issues in
Management Accounting, 2nd edition, PHI Englewood Cliffs (NJ).

Strategic management accounting - part 1

by Graham Morgan
01 Aug 1999

Professional Scheme
Relevant to Paper 3.5, Paper 3.3
This article will provide an overview of the important linkages between accounting and the strategy
development process in organisations. The article has been organised around the convention of
distinguishing corporate and business strategy. Corporate Strategy is concerned with managing the multi-
divisional company and answering the question, "What business should be invested in?" Business strategy
involves deciding "how a competitive advantage will be achieved in a particular business".

In conducting this review the emphasis will be on how accounting practices need to be modified to better
inform the strategy making process, a process which the accounting function is sometimes excluded from by
default or on occasion by design! In conducting this review, the intention is to suggest that accountants
should accept a team role in this process rather than attempting to claim ownership of strategy frameworks
on the basis of having unique skills in data collection and analysis. The latter approach has sometimes been
suggested (if only implicitly) in articles outlining the potential of strategic management accounting. Finally,
the article will conclude by examining how key activities under the control of the accountant, need to be
modified in light of developments in the strategy field. In this instance, there should be an `opening up' of
this process to allow strategy and marketing specialists to have a more recognised role in areas traditionally
viewed as the preserve of the accountant. Corporate strategy and accounting

Corporate strategy deals with the allocation of resources among various businesses or divisions of an
enterprise i.e., the development and control of a portfolio of businesses.

Porter (1985), has argued that corporate headquarters can exploit four possible areas to build competitive
advantage in the multi-divisional structure. These areas were identified as:

• portfolio management;
 • restructuring;
• transferring of skills; and
• sharing activities.

Each of these areas will be briefly reviewed below:

Portfolio management expertise can be developed to increase the efficiency of capital allocation by
operating an internal capital market. Stock markets facilitate diversification of risk for shareholders and it can
be argued that there is no requirement for corporate headquarters to do this diversification. The rationale for
doing so is based on the advantages headquarters can achieve by their ability to monitor the actions and
behaviour of divisional managers by using strategic benchmarking information to improve capital allocation
between divisions.

Restructuring is an area of expertise associated with multi-divisional companies that actively engage in the
acquisition of under-performing companies. On acquisition, there may be divestment of non core businesses
and the installation of a new top management team to redirect and re-energise the core business. When
successfully turned around the corporate headquarters willingly resell the business in order to provide
capital for future restructuring `targets'.

Transferring of skill activities is associated with companies whose businesses require similar core
competencies in major functional areas such as marketing, distribution, information technology, etc.
Corporate headquarters attempt to gain leverage in these areas of core competencies by transferring key
skill holders into acquired businesses and by the creation of interdivisional working parties to enhance these
areas of competence e.g., brand management, direct selling.

Sharing of activities advantages arise in a multi-divisional organisation where economies of scale can be
exploited to realise cost efficiencies in operational areas such as purchasing, research and development,
advertising, etc. The joint utilisation of corporate resources is seen to be more effective than the
development of these resources in a single company.

The multi-divisional structure poses a number of significant problems for the accountant who wishes to
provide information for the development of corporate strategy. The first major problem is the definition of an
appropriate reporting structure, that is the identification of strategic business units (SBU's). The
legal/organisational boundaries of subsidiaries can cover one or more SBU's and evaluation of investment
potential and performance appraisal should focus on individual SBU'S. Another major problem involves the
issue of transfer pricing where inter-divisional trading is at a significant level. Finally, there can be major
headquarter costs based on the development of core competencies/skills and the sharing of centralised
facilities which have to be assigned to the individual SBU'S. Whilst these issues are potentially problematic,
they have all been addressed within the accounting literature even though they may not have been identified
as strategic management accounting issues.

In the context of portfolio management and restructuring approaches, the role of accounting expertise in
evaluating acquisitions, diversification and divestment decisions is generally accepted. Techniques of
investment appraisal such as shareholder value and discounted cash flow analysis provide theoretically
sound ways of assessing the value of forecasted net cash flows associated with funds to be invested in
acquisitions and additional capital assigned to existing subsidiaries. In deriving the net cash flow forecasts
associated with investments, the accountant will have to review the strategic analysis of markets and
competitors undertaken by SBU's in formulating business strategies. Goold and Campbell (1991), have
identified three broad approaches or `parenting' styles reflecting the degree to which staff at corporate
headquarters become involved in the process of business strategy development (i.e., strategic planning,
strategic control and financial control).

Strategic planning companies (e.g., Cadbury Schweppes, B.P) focus on a limited number of businesses
where significant synergies exist and corporate management play a major role in setting the strategies for
each of the SBU'S. This approach is based on the belief that strategic decisions occur relatively infrequently
and when they do, it is important for corporate headquarters to frame and control the strategic planning and
decision making process.
In contrast, financial control companies (e.g., Hanson, GEC) take a `hands off' approach but set stringent
short term financial targets which have to be met to ensure continued funding of capital investment plans.
Failure to meet financial targets will lead to the possibility of divestment. Such companies generally have a
wide corporate portfolio with limited links between divisions and acquisition and divestment is a continuing
process as opposed to an exceptional event.

Strategic control companies (e.g., ICI, Imperial Group, Plessey) are seen to take a middle course, accepting
that subsidiaries must develop and be responsible for their own strategies (whilst being able to draw on
headquarters' expertise). Evaluation of performance extends beyond short term financial targets to embrace
strategic objectives such as growth in market share and technology development, which are seen to support
long term financial and operational effectiveness.

In light of the above, it will be apparent that the role of the corporate accounting activity will be strongly
influenced by the patenting style adopted by the corporate headquarters. However, in each case, there is a
need to understand the process of business strategy development, which will be reviewed in the next
section. Business strategy and accounting

Two key choices are fundamental to the adoption of a particular business strategy. Firstly, the choice of
customers (and markets) a firm will serve. Secondly, the competencies and strengths it will develop to serve
customers effectively and thereby gain a competitive advantage. The concept of competitive advantage
requires that a given SBU be viewed relative to its competitors with respect to two main areas i.e., product
and price. A competitive advantage can be realised either by:

(a) providing a product with unique attributes for which customers are prepared to pay a premium price, this
premium exceeding the additional costs of providing the unique attribute; or

(b) providing a standard product at a lower cost than competitors and charging either the same (or a lower)
price than competitors.

Porter (1986), characterised these as differentiation and least cost producer strategies respectively.

In essence both approaches involve creating customer value more effectively than competitors. This
understanding of competitive advantage provides an insight into two distinct areas of strategic management
accounting:

1 competitor/market analysis; and

2 strategic cost management;

These two areas which have a planning orientation need to be supplemented by a third area of activity
which can be termed:

3 strategic performance review.

Each of these areas will be considered below:

1 Competitor/market analysis

Strategy and marketing theorists have evolved various frameworks to aid the process of competitor/market
analysis and strategic management accounting initiatives in this area should not be seen as stand alone
activities. Rather the accountant should provide information into a team based review process where each
specialist brings his or her own expertise to the strategic analysis process. Before considering how this
process of integration might occur, let us consider aspects of strategic management accounting which
provide an accounting perspective to the issue of competitor/market analysis.
Moon and Bates (1993), describe an approach to competitor performance appraisal based on published
annual accounts involving four stages of analysis identified as CORE analysis. The first stage involves an
analysis of

context, both internal and external. This is a scene setting stage looking at the enterprise's strategic
objectives, developing an understanding of the market's critical success factors and examining
developments in the external environment of importance to a particular market. The overview stage
involves a broad review of performance using published accounts and industry data sources to monitor
trends in sales, profits, assets, liabilities to understand general developments in the market. The third stage
involves a

ratio analysis of all major competitors using ratios that relate to the strategic objectives identified in the
context stage and also relevant ratios identified in the overview stage. In consequence, ratios are likely to be
market specific rather than a `conventional' unchanging set of ratios. Finally, the evaluation stage requires a
critical review of the ratios generated at the evaluation stage and an assessment of the relative position of all
competitors, both those who are advancing significantly and those who are failing to maintain their position
in the market.

Simmond's (1988), approach aims to chart the competitive position of an enterprise in relation to the market
leader and other significant competitors in relative terms for key variables (such as costs, prices, profit,
return or sales, volumes, market share) for the recent past and for a forward planning period. In undertaking
this kind of analysis, Simmond's argues that it provides a better perspective on overall trends which are not
apparent from an examination of absolute values which fail to allow for overall growth/ decline and the
different levels of success being attained by different competitors. This analysis can highlight possible future
strategic moves by a competitor who might be sacrificing short term earnings to gain long term competitive
advantage by investing in brands, research and development or investing to increase market share.

Jones (1988), adopts a narrower focus than Simmond's analysis, in advocating competitor cost analysis. He
utilises a case study, based on Caterpillar, and argues that competitors should be appraised in key areas
such as manufacturing facilities, scale economies, technology, product design competencies and contacts
with important government agencies who fund leading edge technologies. This analysis should provide an
early warning system of significant cost reducing or product innovation strategies being pursued by
competitors.

Shanks and Govindarajan (1992), have sought to operationalise in an accounting context, Porter's (1986)
Value Chain Analysis. The value chain for any enterprise is the linked set of value creating activities all the
way from basic raw material sources to the ultimate end use product delivered to the final customer. A
particular enterprise places itself and sets a particular scope to its activities on a value chain and in so doing
sets out to claim a share of the total value added created by the overall process. By an examination of
downstream and upstream activities and questioning the existing scope of its activities, the accountant can
get a better understanding of the distribution of profit within the industry and an assessment of the relative
bargaining power of supplier to and customers of the enterprise. More specifically this analysis can provide
valuable insights into make/buy and forward/backward integration decisions.

A final broad area of development is the re-orientation of costing systems via activity based approaches to
give equal importance to evaluating customer and market segment profitability as has been given to product
profitability.

Whilst each of the above areas can be pursued in their own right, it can be argued that their true value will
only be realised when the information is integrated into existing strategy and marketing models. The
potential for this integration into a strengths and weakness analysis does not need to be elaborated. The
case for other instances, such as operationalising Porter's (1985) `five forces model' and the development of
BCG and McKinsey/General Electrical portfolio planning matrices deserves more direct consideration.
Figure 1: Porter's Five Forces Model

Porter's five forces model is

an analytical framework which allows competitive dynamics to be systematically appraised in assessing
existing and future profitability of particular markets/industries. Given that an enterprise's profitability will be
influenced by the profitability of an industry, this is a critical issue. Porter argues that there are five forces
influencing the level of market profitability as illustrated in

Figure 1 above.
Figure 2: McKinsey/GE portfolio matrix

Industry
attractiveness

High
Medium
Low

High
Invest and grow
Invest and grow
Selective
investments

Competitive
strenghs
Medium
Invest and grow
Selective
investments
Harverst or divest

Low
Selective
investments
Harverst or divest
Harverst or divest

Each of these forces has an influence on the level of prices and costs and consequently profits in a market.
This point can be illustrated by discussing some of the more direct and easily understood relationships. For
example, prices can be raised when there are many customers whose buying power is low since individual
customers cannot exert pressure on the enterprise. In converse situations, prices are subject to downward
pressure. The existence of substitutes or alternative purchases for customers and where there are low
barriers of entry into the market, limits the potential to raise prices. A market subject to major swings in
customer demand or in which excess supply capacity exists will be subject to intense competitive rivalry and
downward pressure on prices. This is particularly so where there are high levels of fixed costs and high
contribution margins on incremental sales (e.g., package holiday operators). In a like manner, costs are
influenced by the bargaining power of suppliers and the rivalry amongst competitors for sources of supply.

Each of the strategic management accounting approaches reviewed above have the potential of providing
insights into each of the five forces within Porter's model. Indeed, all have recognised the roots of their work
in Porter's seminal work. Shanks and Govindarajan's value chain analysis will have relevance to evaluating
supplier and buying power whereas the other approaches are more directly focused on potential changes in
competitor's strategies and the overall level of competitive rivalry in the market. The analysis must aim to
assess industry attractiveness in terms of the potential to generate future cash surpluses. This is the primary
measure of industry attractiveness and a measure best understood by the accountant and therefore their
involvement in this assessment is essential.

Where market/industry profitability is low and the dynamics of the five forces analysis suggests that no
significant changes can be anticipated in profit prospects, then divestment/restructuring strategies need to
be examined. This can be done by financial model-based scenario planning utilising the PIMS (profit impact
of market strategy) database. This database run by the Strategic Planning Institute contains key
performance data on approximately 2,000 companies across a range of industries. Using PIMS it is possible
to examine the firms performance against look-a-like businesses in the same industry or in industries with
comparable features e.g., capital intensity, levels of R&D expenditure (a form of inter-organisational
benchmarking). Moreover, it can be used to examine how an industry might be restructured by merger,
strategic alliances or hostile takeover.

The strategic management accountant can also play a part in developing an understanding of market
structure in terms of costs and values created by developing barriers of entry into markets. Ward (1992),
provides an overview of the issues involved.

Guilding and Pike (1991), provide a more extensive analysis of the issues involved in developing brand
loyalty, via brand value management.

Whilst Porter's analysis provides a very powerful basis for examining existing and potential market/industry
profitability, earlier portfolio planning models remain popular. Using matrix diagrams, such models classify
businesses according to their profit potential and cash generating capabilities. The earliest of these matrices
was the widely known BCG matrix which classifies businesses as either cash cows, dogs, problem children
or stars according to the market growth rate and the market share obtained by the particular business. A
more complex model, widening the assessment beyond the two key market statistics central to the BCG
model, is the McKinsey/GE matrix illustrated in

Figure 2.

In this model, the BCG's market growth dimension is replaced by a broader concept, industry attractiveness.
Porter's five forces model gives a systematic basis for making the assessment of industry attractiveness.
The BCG's market share dimension is replaced by a wider concept of competitive strength allowing more
factors to be taken into account when judging whether a business is assigned a high/medium/low ranking in
terms of its position in the market. According to the position of a business on the matrix, investment and
marketing policies should be based on growth, harvest or divestment strategies. Whilst, developed as an
analytical tool to aid corporate strategy (see earlier), the matrix can be used to assess own and competitor
positions in a particular market. In so doing, care needs to be exercised in placing businesses within
high/medium/low segments of the matrix. Having suggested that Porter's five forces analysis can be used in
assessing industry attractiveness, discussion below will focus on the issue of competitive strength.

Competitive strength assessment should reflect the findings of a strength and weaknesses analysis of own
enterprise versus competitors. Some strengths reflecting a core competence of the enterprise may be
enduring and hard to imitate (such as Sony's technical skills in miniaturisation). Whilst other strengths may
reflect market and financial performance, which may or may not be sustainable over time (e.g., market
share, strong financial structure may reflect past performance, subject to leading and lagging effects). The
various aspects of strategic management accounting outlined above, as represented by the work of Moon
and Bates, Simmonds, Smith, Shanks and Govindarajan can be used in making the assessment of
competitive strength. McKinsey and GE argued that this assessment should not be over formalised by
attempting to construct numerical indices involving a weighting system for the various factors involved. They
preferred to see the process as a collective exercise undertaken by senior management characterised by
dialogue and critical reflection rather than precise measurement. This viewpoint is generally accepted and
the inclusion of quality information of the kind proposed above, does not challenge this process, but should
provide a more informed basis for making the necessary judgements.

Portfolio planning matrices whilst useful for developing an understanding of how a busi ness needs to
reposition itself in broad strategic terms (i.e., build, harvest, divest), the positions on the matrix leave the
question of what and how to do, unanswered. Obviously detailed marketing proposals have to be developed
to answer these questions and the viability of such proposals need to be evaluated in terms of capital
requirement and potential pay-offs by the use of investment appraisal techniques which are the stock in
trade of the accountant.

2 Strategic cost management

The term strategic cost management is used here to characterise those accounting practices closely aligned
to the quest for competitive advantage. The management of cost is an issue of importance irrespective of
which of Porter's two generic strategies (differentiation or least cost producer) is being pursued. In making
purchase decisions, customers are seeking to strike a balance between issues of functionality, quality and
price and the control of cost is not the sole concern of the least cost producer. Two broad areas of strategic
cost management can be identified:

(a) Cost Driver Analysis developing work initiated by Porter; and

(b) Target Cost Management based on Japanese management practices.

These two approaches will be reviewed below.

(a) Cost Driver Analysis

Shanks and Govindarajan (1992), make the case for a more extensive and sophisticated use of cost driver
analysis. They argue that traditional management accounting approaches have emphasised volume as the
primary cost driver to the almost total exclusion of other factors. Volume based cost concepts (such as fixed
versus variable cost, cost volume profit analysis, flexible budgeting and contribution margin analysis) form
the bedrock of management accounting practice. They argue that cost structure and cost performance
reflect past strategic decisions (e.g., complexity of product line — a structural driver) and current
management practices (e.g., TQM policies — an executional driver) and that cost analysis must be based
on an understanding of structural and executional cost drivers. Shanks and Govindarajan accredit this
distinction to Riley (1987) and argue that it is preferable to the original analysis developed by Porter (1985).
Following Riley they identify five structural cost drivers reflecting past strategic decisions which determine
the economic structure of the enterprise.

1. Scale: what level of investment has been made in manufacturing, in R&D, and in marketing
resources?
2. Scope: degree of vertical integration. Horizontal integration is more related to scale.
3. Experience: how often has the firm undertaken the business process?
4. Technology: what technological processes have been used at each step of the firm's value chain?
5. Complexity: how wide is the product line or range of service offered to customers?

As stated above, scale has been the focus of traditional management accounting practice. They argue that
the experience cost driver has been subsumed as an experience/learning effect of scale economies as
opposed to being an issue of analysis in itself. Activity-based accounting approaches have begun to
consider the issues of complexity and this is a positive development. However, Shanks and Govindarajan
would argue that a holistic approach is necessary where account is also taken of executional drivers. They
identify the following core executional drivers as having a major impact on cost performance:
 1.work force involvement (participation) — work force commitment to continual improvement.
2.total quality management (beliefs and achievement regarding product and process quality).
3.capacity utilisation (given the scale choices on plant construction). plant layout efficiency (against
current norms within the industry).
4.product configuration (in terms of cost to manufacture and whole life cost).
5.exploiting linkages with suppliers and/or customers, per the firm's value chain.

The above framework suggests that a firm's comparative cost position regarding ongoing improvements and
competitive position cannot be adequately understood using volume based cost concepts. They argue that
strategic management accountants need to develop cost management systems based on the recognition
that:

1. Not all the strategic drivers are equally important all the time, but some (more than one) of them are
very probably very important in every case.
2. For each cost driver there is a particular cost analysis framework that is critical to understanding
the positioning of a firm. Being a well-trained cost analyst requires knowledge of these various
frameworks and being able to select the appropriate framework for a specific situation.

In consequence, strategic management accounting is not a static set of techniques but an analytical process
requiring accountants to review structural and executional cost drivers to understand how cost structures
evolve through time. To illustrate this approach, Shanks and Gavindarajan give examples from the chemical,
steel and paper industries to show how companies have lost competitive advantage by becoming fixated on
lowering costs through scale economies whilst ignoring other cost driver changes of greater significance.
They also cite the competitive realignment within the automobile industry where Ford challenged the pre-
eminent position of General Motors (GM). GM throughout the 1980s produced more than twice as many
cars as Ford and also committed much higher levels of investment in new manufacturing technologies which
should have provided significant cost advantages. GM's position might have been viewed as
unchallengeable with advantages in scale, technology experience and vertical scope. However, Ford
recognised that in chasing volume major diseconomies arising from product line complexity were
undermining other potential cost advantages. Ford significantly reduced the number of models it offered and
were also aided by the fact that GM's technologically advanced plants did not outperform labour-driven
assembly lines which were revitalised by worker empowerment and quality management system cost
drivers. Ford created a superior position in the quality and product line complexity cost drivers that more
than offset GM's superiority in the scale, experience and vertical integration cost drivers.

(b) Target Cost Management

It has been argued by Hiromoto (1991) and others that whereas British management has sought to control
costs during the process of production on an ex-post basis, Japanese management have sought to achieve
cost reduction at design and pre-production stages on an ex-ante basis. The Japanese approach of target
cost management involves working back from a market-based price at which a company seeks to sell a
product to establish a `given' manufacturing cost which has to be attained in achieving a required profit level.
This is a critical stage since an external customer/market based view is driven into the organisation and
explicit decisions are made regarding customer needs and implied trade-offs between price, quality and
costs. Having established a `given' manufacturing cost, design, production engineering and purchasing
functions consider both internal factors and also relationships with component supplying companies, as
exemplified by partnership supply and JIT practices. This approach recognises that 85 _ 90% of product life
cycle costs are determined by decisions regarding product design and manufacturing process specification
issues. In this context, the management accounting activity must be viewed as a shared responsibility
between operations managers skilled in value engineering techniques, vendor analysis, etc., and the
accountant is one member of a team concerned with cost management. In this approach, data collection
and analysis plays a part in creating a cost consciousness culture throughout the workforce, rather than a
stand alone activity controlled by the accountant. The term `Kaizen costing' has been used to describe this
team approach to reduce costs during the manufacturing process. An important aspect here is ongoing
performance evaluation, not simply restricted to production cost control, but also involving issues of
customer satisfaction with current product offerings. This cultural aspect of Japanese management practice
is reflected in total quality management approaches in which everyone is responsible for quality. In
consequence, target cost management can be seen to be a dynamic approach viewing cost management
as a process rather than merely a set of techniques.

Figure 3: Balanced Scorecard

Utilising the work of

Hiromoto, Tomkins and Oldman (1998) argue that cost management techniques (such as target costing) are
given different emphasis according to the strategic intention of particular companies. They argue that target
costing (in the restricted sense of setting a targeted manufacturing cost) is emphasised by companies
pursuing product innovation as a major business strategy, whereas companies utilise Kaizen costing and the
theory of constraints to direct investment to achieve cost reduction in a more stable product line situation.
Other companies, particularly those facing a need for a strategic turnaround, make extensive use of ABC
systems to help reshape product portfolios in attempts to restore profitability.

Both of the broad approaches described above, cost driver analysis and target cost management illustrate
the need for strategic management accounting to have an external, forward looking perspective based on
the need to control costs on an ex-ante as opposed to an ex-post basis.

3 Strategic performance review

The impact of strategic decisions can only be understood over a long time period and the strategic
performance review process must combine a concern with the long term whilst managing the present.
According to Morrow (1992) reporting systems should be developed at three levels reviewing the
management of continuous improvement, the management of change and a longer-term review of such
direction. The first two of these will be briefly examined before concentrating on the issue of strategic review.

The issue of continuous improvements has in part been dealt with in the discussion of strategic cost
management above particularly in terms of the Kaizen approach to operations management. This involves
the aim of improving each and every operation and function by adopting total quality management and
business process re-engineering approaches and their associates performance review systems. The issue
of change management has a longer-time perspective in that it is concerned with managing long term
projects, which underpin strategy. This may involve tangible projects (e.g., building a new factory) or
intangible aspects (e.g., a culture change programme) which require project management systems based on
identified milestones, planned review points and measures involving time, costs, quality, etc.

The reviewing of strategic direction must focus on factors contributing to long term financial success i.e.,
critical success factors. Dixon (1991) reports that senior executives attending a conference to discuss
success in the global economy identified the following factors as being fundamental to long term business
success:

• having an appropriate cost structure;

• service quality and innovation;
• customer satisfaction;
• management development;
• change management.

These factors are very broad ranging and only one of these (costs) is measured in purely financial terms yet
traditional performance systems have focused on financial measures e.g., the monthly `board pack' largely
draws on monthly management accounts and associated variance analysis which emphasises short term
financial performance. The most widely known alternative to this approach is Kaplan and Norton's (1996)
Balanced Scorecard approach illustrated in

Figure 3.

Kaplan and Norton have advocated the balanced scorecard approach as a means by which financial and
non-financial performance measures can be integrated into a broad framework which puts strategy and
mission, and not control, as the centre-piece of a performance measurement system. The balanced
scorecard requires top management and each part of the organisation to look at itself from four different
perspectives and to answer four basic questions:
Perspective

Question

1 Financial
— How do
we look to
our
financiers?

2 Customer
— How do
we look to
our
customers?

3 Internal
— Are we
effectively
process
managing
our internal
activities and
systems?

4 Innovation
— Are we
able to
sustain and
learning
innovation,
change and
improvement
?
Figure 4: Present competitive position

Figure 5: Future strategic potential

With these questions in mind, a limited number of

key measures for each perspective must be identified and monitored to ensure that the strategic direction of
the organisation is maintained. Implicit in the balanced scorecard format is the recognition that not all
perspec tives can be maximised at the same time i.e., that there are trade-offs between the perspectives.
The idea of a balanced set of measures is promoted to avoid the overemphasis of any one performance
measure. There are, of course, no predetermined or industry specific set of measures to fit into the balanced
scorecard. The set of measures chosen will vary over time depending on the specific circumstances faced
by the enterprise and its current vision and strategic objectives.
Another approach, not so widely known as the Balanced Scorecard is that advocated by Grundy (1995),
who emphasises the need to assess an organisation's strategic health which he defines as: "the underlying
competitive position of a business set against the emerging competitive forces and its stream of
opportunities". Grundy argues that most businesses find it difficult to link financial measures of performance
with indicators of strategic health (and vice versa). He advocates a system of tracking performance based
on the development of a set of grid diagrams reflecting own and competitor positions in terms of strategic
health and financial strength. The following draws heavily on an illustrative set of diagrams provided by
Grundy in his book.

Firstly, addressing the issue of strategic health, he argues that this concept needs to be broken down into
two elements:

(a) present competitive position; and

(b) future strategic potential.

Assessments relating to these two aspects of performance would arise out of the kinds of analysis described
under the competitor/market analysis in the business strategy section above. Grundy, in conducting this kind
of assessment, draws a distinction between competitive hardware and competitive software. The former
relates to issues regarding product, quality and attributes, customer base, distribution networks, operational
facilities and cost structure, whilst the latter relates to less tangible aspects such as brand image and
reputation, skills and style, leadership and team working, systems and processes.

Secondly, financial performance is broken down between:

(a) return on capital (measured via returns on net assets); and

(b) cash flow generation.

Figure 6: Strategic health

These dimensions of performance are repre

sented in grid form and he demonstrates the potential of his approach by examining the position of Marks
and Spencer and Tesco in the retail market. His review based on circumstances appertaining to the late 80s
and early 90s is given below, addressing firstly the issue of strategic health and then financial performance.

Figure 4 maps the present competitive position of M&S and Tesco.

The assessments made in placing organisations on the grid should be systematic and based on competitive
benchmarking practices. Whilst these are not available for the example companies, Grundy makes his own
assessment on the basis of analysis presented in his book. Grundy argues that M&S had a very strong
competitive position in terms of its competitive hardware. In his view, Tesco's competitive software was not
quite as strong as that of M&S.

Figure 5 presents his assessment of future strategic potential.

In his view, M&S had a high strategic potential across its businesses especially in exploiting its own brand
with a strong opportunity stream, particularly internationally. However, M&S was vulnerable to increasing
competitive pressures as it moved beyond its existing core markets. Tesco's financial strategic potential was
not quite as high as that of M&S particularly regarding international development. Tesco was also shown as
facing tougher competitive pressures than M&S. The two assessments are then amalgamated in the
strategic health grid in Figure 6 above.

Figure 7 represents his assessment of the companies' positioning in terms of financial performance.

Grundy argues that M&S had a very strong return on capital and cash flow with a rightward movement as
cash flow becomes less strong as its international expansion programme unfolds. Tesco was seen to have
an average return on capital and cash flow.

Figures 6 and

7 are integrated to provide an overview of strategic health and financial performance as shown in Figure 8
above.

M&S is positioned as having strong strategic health and strong financial performance. Tesco is not so well
positioned on either dimension and is seen to be vulnerable to competitive development in the retail sector

Grundy recognises that the positioning of businesses within these grids is not an exact science but a matter
of judgement enhanced by the development of appropriate measures and indicators of performance. The
debate surrounding positioning is seen to be a constructive form of dialogue for top management teams and
is seen to promote an open debate about trade-offs and time lags between short/long term financial
performance and changing strategic positions.

This approach offers a novel presentation format, highlighting areas of reporting which need to be developed
in undertaking a strategic performance review. However, the approach may be viewed by some as too
judgemental to become part of a monthly (or two monthly) reporting process. If the strategic review period is
extended to a time frame more appropriate to appraising strategic development (e.g., every six months),
then it may be considered operationally feasible.

Both of the above approaches to strategic performance review indicate how there needs to be a significant
widening of measure beyond the short-term financial measures associated with monthly accounts.

This article will be concluded next month.

Figure 8: Strategic health and financial performance

Strategic management accounting - part 2

by Graham Morgan
01 Sep 1999

Professional Scheme
Relevant to Paper 3.3, Paper 3.5
In part one of this article ways in which accountants might be able to provide inputs to strategy development
and appraisal approaches, normally under the control of strategy and marketing executives, have been
indicated. This team approach also needs to be implemented in the reverse direction to encourage such
executives to become involved in areas that have been principally controlled by the accountant.

This opening out process should embrace two principal areas:

1. the ongoing evaluation of marketing decisions; and

2. the evaluation of strategic investment decisions.

Each of these areas will be reviewed now.

Ongoing evaluation of marketing decisions

The accountant will need to work with marketing executives to evaluate price review decisions and also the
management of the marketing and sales budgets. Decisions in both of these areas will need information to
be extracted from a database, which allows revenue and cost information to be retrieved and analysed by
product and customer. In the past there has been a tendency for accountants, utilising absorption costing
systems to focus on product profitability without giving due regard to the variability of profit between different
customers and market segments. Developments in activity based costing provide a richer form of analysis
and can be used to inform price and product range decisions. Product range decisions will need to consider
whether the additional revenue generation is sufficient to offset the negative cost driver consequences of
increased product diversity. Similarly, in pursuing a policy of product differentiation, the balance between
additional revenue arising from unique product attributes will have to be assessed against the additional
costs associated with the provision of the product features. Marketing and sales budgets, which involve
significant levels of expenditure also need to be evaluated and new approaches are needed to assess the
effectiveness of expenditures in these `discretionary' areas. For example, some marketing costs (such as
advertising) involve a significant time lag between increase in marketing costs and the resulting increase in
sales revenue which makes it difficult to evaluate this kind of expenditure. At a broader level, the linkage
between general marketing expenditure and the creation of intangible assets (such as brand image,
customer base) is even more problematic given the number of factors which can influence the creation of
such assets. A combined effort by accountants and marketing executives may allow methodologies to be
evolved which provide a rationale for the setting of marketing and sales budgets and the evaluation of
different marketing vehicles which might be used to increase and maintain the customer base.

Evaluation of strategic investment decisions

The evaluation of strategic investment decisions will require the accountant to widen the scope of analysis
beyond investments, which fit with the accountant's convention of distinguishing capital and revenue
expenditures. Capital investment decisions to enter new markets or to build share in existing markets based
on investment in new or updated production facilities are important but do not represent the full range of
strategic decisions made by an organisation. The development of intangible assets of the kind discussed
within the area of marketing above, also applies to other functional areas within the organisation (e.g.,
development of a corporate culture change programme) and these need be evaluated even though there is
no capital expenditure involved. Decisions to invest in tangible or intangible assets will require the
accountant to set their well understood financial appraisal techniques (such as discounted cash flow
analysis) within a wider strategic context as Shanks (1996) and others have advocated. Shanks (1996), in
reviewing the traditional accounting approach to the evaluation of investments in new technology argues that
net present value calculations need to be seen as the starting, rather than the end point of strategic
investment decision making. He warns of the dangers of oversimplifying the decision context and shows
how the decision outcome can be manipulated according to the context in which a strategic investment is
structured or framed. He argues that the strategic implications of technological investments cannot be
effectively evaluated simply in terms of forecasted operating cost savings. The analysis must be extended to
take account of the following factors: implication for supplier and buyer power arising from a five force
analysis; cost driver consequences of a change in technology and any consequences for the generic
strategy (least cost producer/differentiation) being pursued. With respect to the latter he warns organisations
of strategic drift i.e., inadvertently changing generic strategy.

Bromwich and Bhimani (1991), in reviewing the difficulties of appraising investment in advanced
manufacturing technology (ATM) argue that it is inappropriate to restrict the analysis to the quantifiable costs
and benefits. Bromwich and Bhimani argue that there are three categories of benefit which need to be taken
into account:

• those which can be stated in direct monetary terms;

• those which can be `converted' into monetary terms; and
• those which cannot be expressed in monetary terms.

They suggest that ATM investments impact organisational performance in a wide range of areas e.g.,
product enhancement, risk reduction, organisational structure and that the three kinds of benefit can arise in
such areas. They suggest that the different kinds of benefit can be systematically appraised within a
`strategic planning matrix 'which summarises the impact of an investment in different areas without
attempting to merge the three kinds of benefits into a composite measure. They suggest that impacts which
cannot be expressed in monetary terms are assigned scores on a rating scale of _10 to +10 to indicate
negative and positive consequences respectively. The approach allows a wide range of impacts to be
appraised and emphasises that the investment decision must be a question of management judgement as
opposed to a decision based on strict financial criteria.

In a broader context Morgan and Pugh (1998), have advocated an approach to strategic investment
appraisal which seeks to explicitly balance the issues of `strategic fit' and `risk adjusted financial return' as
illustrated in the decision matrix shown in

Figure 9.
The four segments of the matrix identify an acceptance zone, two areas where a proposal might be
sanctioned either on the basis of high strategic fit, or financial attractiveness and a reject zone. Having
outlined the basic framework, it is necessary to consider in more detail how the appraisal of risk adjusted
financial return and strategic fit is assessed.

The horizontal axis combines an evaluation of risk and conventional financial appraisal. In assessing
investment proposals it is necessary to accept that different investments involve different risks. For example,
opening new markets in Russia is subject to greater risk than investing in existing products within existing
markets and anticipated financial returns should be adjusted to allow for relative risk. Using different costs of
capital as a way of adjusting for risk is known to be inappropriate and an alternative approach to this
problem is developed below.

Financial evaluation either of a NPV or a SVA kind should be adjusted to take account of the levels of
perceived risk. This can be done by a weighting system, which allows financial returns of individual projects
to be factored down in relation to the perceived risk of the project. A working format for this kind of
adjustment is given in Table 1.

To promote comparability between projects the weightings attached to each type of risk need to be kept
constant and should reflect experience in managing different kinds of risk. For example, companies with
strong project cost management systems, would assign a low weighting to cost risk, whereas if in the past,
competitor responses have been inadequately anticipated, then a high weighting would be assigned to
market risk. In the example given, technical risk is considered the most problematic area and has been
assigned a weight of 50, followed by market, cost and resource risks assigned weights of 25, 15 and 10
respectively. Having established weightings for each area of risk, particular projects are assessed on a scale
of 100; low risk investments being assessed high percentages to produce a risk adjustment factor which
limits the percentage factoring down of financial returns. In this example, the risk adjustment factor has been
calculated at 80% and this would require a 20% reduction in the values established by conventional financial
evaluation. For example, a calculated Internal Rate of Return (IRR) of 16% would be risk adjusted to a figure
of 12.8%. This adjustment could be applied in a like manner to NPV or SVA calculations depending on the
criteria normally used to evaluate investment proposals. The acceptance level of a risk adjusted IRR is open
to management decision and can be varied over time to reflect current financial requirements. In

Table 1, the acceptance level of the risk adjusted IRR has been set at 12% for sake of illustration.

The vertical axis involves an assessment of how an investment proposal links to the company's mission and
current strategic objectives. The dimensions of strategic fit depend on a specific context. However the broad
issues involved are generally widely understood. Particular companies might wish to emphasise investments
which exploit: high value added technologies, build on current (or new) market/customer bases, exploit and
develop core competencies, provide long term barriers to entry, develop partnership supply relationships etc.
A weighting process similar to that described above can be used to assess strategic fit on a scale of 100.
The procedure is illustrated in Table 2 below, where the strategic fit dimensions are stated in generic terms
for principal strategic issues.

The weighting assigned to strategic dimensions are again a matter of management judgement and would
reflect the relative importance at a particular point in time. In the example given, growth through market
development is a priority reflected by a weight ing of 40, followed by development of core competencies,
competitive impact and development of supplier relationship with weightings of 30, 20, and 10 respectively.

Having established weightings, individual proposals are assessed on a scale of 100, investments having a
good strategic fit are assigned high percentages to produce a high total strategic fit factor. The illustration in

Table 2 has a strategic fit evaluation of 66% which is acceptable in terms of

Table 1 where the acceptance level is set at 60%. As with the adjusted IRR, the acceptance level is subject
to management decision and does not have to remain fixed.

The matrix as proposed and the calculations involved in placing a particular proposal on the matrix is
advanced as a process to break away from detailed financial evaluations which can inadvertently become
the sole preserve of senior financial managers. The procedures suggested above are viewed as a means of
instigating dialogue within a top management team around critical issues which can become submerged in
financial detail. The weighting procedures require top man- agement to explicitly consider the different
dimensions of risk and strategic fit and thereby provide a means of communicating and agreeing a shared
perspective on these important issues. The procedures can be used as an early screening device for
investments so long as management are willing to tolerate tentative financial forecasts before a detailed
business case is developed. The screening estimates can be refined as a project progresses to the final
authorisation stage.

Another way of getting a feel for the issues involved is to use the procedure as a post audit model to
understand why certain investments failed to achieve targeted results. This would promote learning in this
critical area of management decision and would provide an informed base to make assessments of risk and
strategic fit for future investment decisions using the matrix.

Overview The changes suggested in this and in my previous article in the August issue of Student
Accountant imply a very significant re-orientation to conventional management accounting practice. A
summary of the key differences arising from this re-orientation are given in

Table 3.

In summarising the key features of an evolving area of accounting practice, there is a danger of implying that
there is an ideal model to work towards. In reality, strategic management accounting systems will vary
between organisations to reflect specific characteristics of the organisation (e.g., the generic strategy,
corporate culture, parenting style). Moreover, such systems will be continually evolving and the critical
consideration in guiding development will be their contribution to the ongoing achievement of business
success rather than a comparison to some abstract model of ideal practice.
Table 3: Key differences between traditional and strategic management accounting

Traditional management accounting

Strategic management accounting

Reporting unit
Whole organisation
Strategic business unit

Focus
Internal
External

Profitability analysis
Products
Products, customers and markets

Approach to cost analysis

Ex-post cost control via department/product costing systems

Period based manufacturing costs and monthly departmental budgets. Volume the principal cost
driver

Cost analysis set within organisational boundary

Ex-ante cost control based on targeted, future, life-long costings set to attain a required profit
level at market set price.

Process/activity costing based on analysis of multiple cost drivers studied in a specific context

Cost analysis embraces supplier firms in value chain

Performance appraisal
Monthly based financial review
Three/six monthly multi- dimensional review

Investment appraisal
Financial evaluation with strict criteria
Strategic analysis using multiple models to promote decisions based on judgement

Ownership
Stand alone under control of the accountant
Part of a wider MIS with team ownership of strategic review process