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by Martin Webb 03 Jan 2000 Diploma in Financial Management Relevant to All Papers

Many questions in the Business Analysis paper require students to analyse the role of the accountant, or of the Accounting & Finance Department, in relation to Corporate Strategy. Martin Webb of London Guildhall University reports on how this role may be divided into two parts: one during the formulation stage of strategy and one during the implementation stage.

Formulation Stage
The formulation stage of strategy requires the organisation to analyse first the external environment (perhaps using PEST and Porter's Five Force models) and then to analyse the internal position of the organisation (perhaps using the value chain or resource audit). These analyses are brought together by means of a SWOT analysis. There then should follow a wide-ranging search for possible strategies. This is a creative process and often requires people to think what appears to be the unthinkable. A list of possible strategies should result and each of these should be tested against three standards of suitability, feasibility and acceptability. The suitability test is the test for 'strategic fit' or the 'matching' of the organisation's strength within the market opportunities. The feasibility test is the test to see if it is possible to put the strategy into effect; the acceptability test is the test to see that the strategy is acceptable to stakeholders.

Accountants and Accounting & Finance Departments should maintain a general watching brief over all aspects of strategy formulation. However, they are particularly concerned with the feasibility and acceptability tests.

The feasibility test is largely concerned with whether the orgainsation has the resources to carry out the proposed strategy. As far as the accountant is concerned, this means the financial resources. Most strategies will require capital expenditure. The accountant must assess how much capital expenditure is involved and when it has to be carried out. He must then estimate the future operating cash flows for the length of time for which the strategy will operate; in other words, a full cash budget or cash-flow projection is required for the years ahead. In preparing this cash budget, the accountant will be largely dependent of the work of others. For construction costs, for instance, he will be dependent on engineering estimates and for sales on marketing estimates. The accountant is not an expert in these areas, but he should review the work of others to see that it is reasonable. He is then responsible for bringing together all the work of others and using it to prepare the final cash budget.

One of the prime functions of the cash budget is to reveal whether the organisation has sufficient cash resources of its own to carry out the strategy or whether more finance will have to be raised. If more finance is required, the cash budget should reveal whether this is for the short term or the long term. It is then up to the Accounting & Finance Department to consider how this finance is to be obtained; if it is short term, bank borrowing facilities might suffice; on the other hand, if it is for the long term, the Accounting and Finance Department must consider the merits of issuing more debt or more equity and all the consequences of that decision in terms of Modigliani and Miller analysis on cost of capital effects.

As well as estimating future cash flows, the Accounting & Finance Department should attempt to estimate the risk associated with the cash flows. Various scenarios can be built in association with other departments. The 'worst case' scenario will test the robustness of the strategy, that is, seeing if it will still work in the worst imaginable conditions. Sensitivity analysis should be used to test the result of varying each of the factors in the equation individually. This will show which factors are important and deserve the most management time. The break-even point should be calculated to see what physical quantity of sales, or what sales revenue, is required for the strategy just to make neither a profit nor a loss. If the anticipated sales quantity or sales revenue is above this point, the difference between the two is the 'margin of error', the greater the margin of error, the lower the risk.

The accountant or Accounting & Finance Department is heavily involved in the acceptability tests. First the Board of Directors, or other controlling body of the organisation, must decide which stakeholders are to be taken into consideration when making strategic decisions. If the organisation is a public limited company, almost certainly the shareholders will get prime consideration. Modern theory suggests that the objective of public companies should be to maximise shareholder's wealth. One way of maximising shareholders' wealth is to maximise the company's net present value which can be achieved by selecting projects with the highest net present value. This in turn will maximise the market price of the company's shares, given assumptions about market efficiency. When dealing with strategy, the accountant should think of the strategy as a whole as a project and calculate its net present value using the appropriate risk-adjusted discount rate. The strategy which yields the highest net present value should then be selected. Apart from net present value, other measures which affect the shareholder should also be calculated. The most important of these are earnings per share and return on capital; the effect on dividends should also be calculated. Although these measures are not the ones to maximise according to modern theory, some directors and shareholders will still think in these terms.

If the company is a private company, maximisation of share price has no meaning as there is no market for the shares. Usually, this type of company has few shareholders and their preferences in terms of future estimated cash flows, risk and possibly also lifestyle, can be ascertained and a consensus reached about a suitable strategy. If the organisation is a not-for-profit organisation the Board should attempt to lay down the objectives so that possible strategies can be measured against these objectives

Implementation Stage
Once the optimum strategy has been decided upon, it must be implemented. This can be the most difficult part. Action plans must be prepared for each function involved and the plans monitored. Projects involving capital expenditure must be initiated and the costs and timings controlled by the accountant. Consideration must be given to reorganising the entity and here the accountant has a crucial role to play; he must see that a Responsibility Accounting system is put into force. An identifiable person must be responsible for each item of revenue and cost. This needs the organisation to be dvided into Responsibility centres. Various types of centre can be used. The most common one is a ‘profit centre’. This is a department or division which is responsible for running its activities at a profit. Other centres that can be used are ‘revenue centres’ which are responsible solely for obtaining income and ‘cost centres’ which are responsible solely for controlling the costs of a particular activity. Investment centres are responsible for earning a return on capital for their activities. There can be a hierarchy of centres, some centres being sub-divisions of other centres. For example, let us take a hotel. The restaurant, bar and accommodation could each be regarded as profit centres. The maintenance departments could be regarded as an independent cost centre. It is difficult to think of a revenue centre in this context but the hotel as a whole could be treated as a profit centre or even as an investment centre.

Once Responsibility centres have been set up, accounts should be prepared for them, usually on a monthly basis. The accounts incorporate a system of budgetary control so that actual amounts are monitored against budgeted amounts. In this way it can be seen whether the strategy is being followed. If it is not, it may be necessary for management to take corrective action or even to change the strategy. Management appraisal schemes, such as profit related pay, may be based on the Responsibility accounts. The objective of such schemes should be to motivate management therefore it is important to ensure that the accounting is carried out in a fair and accurate manner. If not, there could be serious effects on morale.

As well as Responsibility accounts, accountants should prepare accounts to support other aspects of strategy. Product accounts are an example. Companies need to know how much contribution each product is making. This information could be used to reinforce analysis using the Boston matrix. If, for instance, we have categorised a product as a ‘cash cow’ because it has high market share in a low growth market, it is useful to confirm that we are actually deriving a lot of cash from it. Each customer should also be analysed with respect to their profitablity.

The accountants should not only consider their own organisation. In a market environment it is highly desirable to obtain estimates of the cost structures of competitors. This can be difficult as rivals will not want to divulge the information. However, intelligent guesses can be made based on information derived from newspaper reports, annual reports and so on. Going to view rivals’ premises, even from the outside, can be useful as can investigation of their products by our own engineers. We might not get detailed answers, but we will probably be able to discern if, for instance, they are labour or capital intensive and from this, a person with knowledge of the industry will be able to make a reasonable attempt at estimating their costs.

If we take everything into consideration, we can see that the role of the accountant, or the Accounting and Finance Department, in relation to Corporate Strategy, is a major one. Both the formulation and implementation stages are involved. In carrying out this work, the Accounting & Finance Department should see itself as providing a service to other departments. It should not act negatively. Neither should it go to the opposite extreme and attempt to take over or control the entire process. The reason for this is that Corporate Strategy crucially requires a creative input. Accountants may, or may not, have creative ability (although they are not traditionally noted for it!) but other departments, such as marketing, human resources or engineering will have it in at least equal measures and their contribution must be encouraged.

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