Full List of Management Accounting for Decision Makers_11 pdf

CHAPTER 8 MAKING CAPITAL INVESTMENT DECISIONS 306 ‘ REAL WORLD 8.15 Looking on the bright side McKinsey and Co, the management consultants, surveyed 2,500 senior managers wide during the

smoothly ahead Managers will need to manage the project actively through to pletion This, in turn, will require further information-gathering exercises.

com-Management should receive progress reports at regular intervals concerning the ject These reports should provide information relating to the actual cash flows for eachstage of the project, which can then be compared against the forecast figures providedwhen the proposal was submitted for approval The reasons for significant variationsshould be ascertained and corrective action taken where possible Any changes in theexpected completion date of the project or any expected variations from budget infuture cash flows should be reported immediately; in extreme cases, managers mayeven abandon the project if circumstances appear to have changed dramatically for theworse We saw in Real World 8.12, on p 289, that Rolls-Royce undertakes this kind ofreassessment of existing projects No doubt most other well-managed businesses dothis too

pro-Project management techniques (for example, critical path analysis) should beemployed wherever possible and their effectiveness reported to senior management

An important part of the control process is a post-completion auditof the project.This is, in essence, a review of the project’s performance to see if it lived up to expecta-tions and whether any lessons can be learned from the way that the investment process was carried out In addition to an evaluation of financial costs and benefits,non-financial measures of performance such as the ability to meet deadlines and levels

of quality achieved should also be reported We should recall that total life-cycle costing, which we discussed in Chapter 5, is based on similar principles

The fact that a post-completion audit is an integral part of the management of theproject should also encourage those who submit projects to use realistic estimates Real World 8.15provides some evidence of a need for greater realism

CHAPTER 8 MAKING CAPITAL INVESTMENT DECISIONS

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‘

REAL WORLD 8.15

Looking on the bright side

McKinsey and Co, the management consultants, surveyed 2,500 senior managers wide during the spring of 2007 The managers were asked their opinions on investmentsmade by their businesses in the previous three years The general opinion is that estimatesfor the investment decision inputs had been too optimistic For example, sales levels hadbeen overestimated in about 50 per cent of cases, but underestimated in less than 20 percent of cases It is not clear whether the estimates were sufficiently inaccurate to call intoquestion the decision that had been made

world-The survey went on to ask about the extent to which investments made seemed, in thelight of the actual outcomes, to have been mistakes Managers felt that 19 per cent ofinvestments that had been made should not have gone ahead On the other hand, they feltthat 31 per cent of rejected projects should have been taken up Managers also felt that

‘good money was thrown after bad’ in that existing investments that were not performingwell were continuing to be supported in a significant number of cases

Source: ‘How companies spend their money: a McKinsey global survey’, www.theglobalmarketer.com, 2007.

Other studies confirm a tendency among managers to use overoptimistic estimateswhen preparing investment proposals (See reference 1 at the end of the chapter.) Itseems that sometimes this is done deliberately in an attempt to secure project approval

Where overoptimistic estimates are used, the managers responsible may well findthemselves accountable at the post-completion audit stage Such audits, however, can be difficult and time-consuming to carry out, and so the likely benefits must beweighed against the costs involved Senior management may feel, therefore, that onlyprojects above a certain size should be subject to a post-completion audit.

Real World 8.16 describes how two large retailers, Tesco plc and Kingfisher plc, usepost-completion audit approaches to evaluating past investment projects

MANAGING INVESTMENT PROJECTS 307

REAL WORLD 8.16

Looking back

In its 2008 corporate governance report, Tesco plc, the supermarket chain, stated:

All major initiatives require business cases to be prepared, normally covering a minimum period of five years Post-investment appraisals, carried out by management, determine the reasons for any significant variance from expected performance.

In its 2007/8 financial review, Kingfisher plc, the home improvement retailer, stated:

An annual post-investment review process will continue to review the performance of all projects above £0.75 million which were completed in the prior year The findings of this exercise will be considered by both the new Retail Board and the main Board and directly influence the assump- tions for similar project proposals going forward.

Sources: The websites of Tesco plc (www.tescocorporate.com) and Kingfisher plc (www.kingfisher co.uk).

As a footnote to our discussion of business investment decision making, Real World 8.17looks at one of the world’s biggest investment projects, which has proved to be acommercial disaster, despite being a technological success

REAL WORLD 8.17

Wealth lost in the chunnel

The tunnel, which runs for 31 miles between Folkestone in the UK and Sangatte inNorthern France, was started in 1986 and opened for public use in 1994 From a techno-logical and social perspective it has been a success, but from a financial point of view ithas been a disaster The tunnel was purely a private sector venture for which a new busi-ness, Eurotunnel plc, was created Relatively little public money was involved To be acommercial success the tunnel needed to cover all of its costs, including interest charges,and leave sufficient to enhance the shareholders’ wealth In fact the providers of long-termfinance (lenders and shareholders) have lost virtually all of their investment Though themain losers were banks and institutional investors, many individuals, particularly in France,bought shares in Eurotunnel

Key inputs to the pre-1986 assessment of the project were the cost of construction andcreating the infrastructure, the length of time required to complete construction and thelevel of revenue that the tunnel would generate when it became operational

‘

The main points of this chapter may be summarised as follows:

Accounting rate of return (ARR) is the average accounting profit from the project expressed as a percentage of the average investment.

l Decision rule – projects with an ARR above a defined minimum are acceptable; thegreater the ARR, the more attractive the project becomes

– Does not relate to shareholders’ wealth

– Ignores inflows after the payback date

– Takes little account of the timing of cash flows

– Ignores much relevant information

– Does not always provide clear signals and can be impractical to use

– Much inferior to NPV, but it is easy to understand and can offer a liquidityinsight, which might be the reason for its widespread use

l Construction cost was £10 billion – it was originally planned to cost £5.6 billion

l Construction time was seven years – it was planned to be six years

l Revenues from passengers and freight have been well below those projected – forexample, 21 million annual passenger journeys on Eurostar trains were projected; thenumbers have consistently remained at around 7 million

The failure to generate revenues at the projected levels has probably been the biggestcontributor to the problem When preparing the projection, planners failed to take adequateaccount of two crucial factors:

1 Fierce competition from the ferry operators At the time (pre-1986), many thought thatthe ferries would roll over and die

2 The rise of no-frills, cheap air travel between the UK and the continent

The commercial failure of the tunnel means that it will be very difficult in future for projects

of this nature to be funded by private funds

Sources: Annual reports of Eurotunnel plc; Randall, J., ‘How Eurotunnel went wrong’, BBC news, 13 June 2005,

www.newsvote.bbc.co.uk.

Net present value (NPV) is the sum of the discounted values of the net cash flows from the investment.

l Money has a time value

l Decision rule – all positive NPV investments enhance shareholders’ wealth; thegreater the NPV, the greater the enhancement and the greater the attractiveness ofthe project

l PV of a cash flow = cash flow × 1/(1 + r) n

, assuming a constant discount rate

l Discounting brings cash flows at different points in time to a common valuationbasis (their present value), which enables them to be directly compared

l Conclusion on NPV:

– Relates directly to shareholders’ wealth objective

– Takes account of the timing of cash flows

– Takes all relevant information into account

– Provides clear signals and is practical to use

Internal rate of return (IRR) is the discount rate that, when applied to the cash flows

of a project, causes it to have a zero NPV.

l Represents the average percentage return on the investment, taking account of the fact that cash may be flowing in and out of the project at various points in its life

l Decision rule – projects that have an IRR greater than the cost of capital are able; the greater the IRR, the more attractive the project

accept-l Cannot normally be calculated directly; a trial and error approach is often necessary

l Conclusion on IRR:

– Does not relate directly to shareholders’ wealth Usually gives the same signals asNPV but can mislead where there are competing projects of different size

– Takes account of the timing of cash flows

– Takes all relevant information into account

– Problems of multiple IRRs when there are unconventional cash flows

– Inferior to NPV

Use of appraisal methods in practice:

l All four methods identified are widely used

l The discounting methods (NPV and IRR) show a steady increase in usage over time

l Many businesses use more than one method

l Larger businesses seem to be more sophisticated in their choice and use of appraisalmethods than smaller ones

Investment appraisal and strategic planning

It is important that businesses invest in a strategic way so as to play to their strengths

Dealing with risk

l Sensitivity analysis (SA) is an assessment, taking each input factor in turn, of howmuch each one can vary from estimate before a project is not viable

– Provides useful insights to projects

– Does not give a clear decision rule, but provides an impression

– It can be rather static, but scenario building solves this problem

l Expected net present value (ENPV) is the weighted average of the possible outcomesfor a project, based on probabilities for each of the inputs:

– Provides a single value and a clear decision rule

– The single ENPV figure can hide the real risk

SUMMARY 309

– Useful for the ENPV figure to be supported by information on the range and dispersion of possible outcomes.

– Probabilities may be subjective (based on opinion) or objective (based on evidence)

l Reacting to the level of risk:

– Logically, high risk should lead to high returns

– Using a risk-adjusted discount rate, where a risk premium is added to the risk-freerate, is a logical response to risk

Managing investment projects

l Determine investment funds available – dealing, if necessary, with capital rationingproblems

l Identify profitable project opportunities

l Evaluate the proposed project

l Approve the project

l Monitor and control the project – using a post-completion audit approach

CHAPTER 8 MAKING CAPITAL INVESTMENT DECISIONS

1 Linder, S., ‘Fifty years of research on accuracy of capital expenditure project estimates: a review

of findings and their validity’, Otto Beisham Graduate School of Management, April 2005.

If you would like to explore the topics covered in this chapter in more depth, we recommend the following books:

McLaney, E., Business Finance: Theory and Practice, 8th edn, Financial Times Prentice Hall, 2009,

EXERCISES 311

REVIEW QUESTIONS

EXERCISES

Answers to these questions can be found in Appendix C at the back of the book.

Why is the net present value (NPV) method of investment appraisal considered to be ally superior to other methods that are found in practice?

theoretic-The payback method has been criticised for not taking the time value of money into account.Could this limitation be overcome? If so, would this method then be preferable to the NPV method?Research indicates that the IRR method is extremely popular even though it has shortcomingswhen compared to the NPV method Why might managers prefer to use IRR rather than NPVwhen carrying out discounted cash flow evaluations?

Why are cash flows rather than profit flows used in the IRR, NPV and PP methods of investmentappraisal?

8.4 8.3 8.2 8.1

Exercises 8.3 to 8.8 are more advanced than 8.1 and 8.2 Those with a coloured number

have answers in Appendix D at the back of the book If you wish to try more exercises, visit the students’ side of the Companion Website at www.pearsoned.co.uk/atrillmclaney

The directors of Mylo Ltd are currently considering two mutually exclusive investment projects.Both projects are concerned with the purchase of new plant The following data are available foreach project:

Project 1 Project 2

£000 £000

Expected annual operating profit (loss):

Estimated residual value of the plant 7 6

The business has an estimated cost of capital of 10 per cent, and uses the straight-line method

of depreciation for all non-current (fixed) assets when calculating operating profit Neither ject would increase the working capital of the business The business has sufficient funds tomeet all capital expenditure requirements

pro-Required:

(a) Calculate for each project:

(1) The net present value

(2) The approximate internal rate of return

(3) The payback period

8.1

The following data, based on the current level of output, have been prepared in respect ofthe product:

Although the existing equipment is expected to last for a further four years before it is sold for

an estimated £40,000, the business has recently been considering purchasing new equipmentthat would completely automate much of the production process The new equipment wouldcost £670,000 and would have an expected life of four years, at the end of which it would besold for an estimated £70,000 If the new equipment is purchased, the old equipment could besold for £150,000 immediately

The assistant to the business’s accountant has prepared a report to help assess the viability

of the proposed change, which includes the following data:

In the report the assistant wrote:

The figures shown above that relate to the proposed change are based on the current level of output and take account of a depreciation charge of £150,000 a year in respect of the new equipment The effect of purchasing the new equipment will be to increase the operating profit to sales revenue ratio from 18.3% to 26.6% In addition, the purchase of the new equipment will enable us to reduce our invent- ories level immediately by £130,000.

In view of these facts, I recommend purchase of the new equipment.

The business has a cost of capital of 12 per cent

8.2 CHAPTER 8 MAKING CAPITAL INVESTMENT DECISIONS

EXERCISES 313

Required:

(a) Prepare a statement of the incremental cash flows arising from the purchase of the newequipment

(b) Calculate the net present value of the proposed purchase of new equipment

(c) State, with reasons, whether the business should purchase the new equipment

(d) Explain why cash flow forecasts are used rather than profit forecasts to assess the viability

of proposed capital expenditure projects

Ignore taxation

The accountant of your business has recently been taken ill through overwork In his absencehis assistant has prepared some calculations of the profitability of a project, which are to be discussed soon at the board meeting of your business His workings, which are set out below,include some errors of principle You can assume that the statement below includes no arith-metical errors

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Write-off of development costs 30 30 30

= = Return on investment (4.7%)You ascertain the following additional information:

l The cost of equipment contains £100,000, being the carrying (balance sheet) value of an oldmachine If it were not used for this project it would be scrapped with a zero net realisablevalue New equipment costing £500,000 will be purchased on 31 December Year 0 Youshould assume that all other cash flows occur at the end of the year to which they relate

l The development costs of £90,000 have already been spent

l Overheads have been costed at 50 per cent of direct labour, which is the business’s normalpractice An independent assessment has suggested that incremental overheads are likely toamount to £30,000 a year

l The business’s cost of capital is 12 per cent

Required:

(a) Prepare a corrected statement of the incremental cash flows arising from the project Where youhave altered the assistant’s figures you should attach a brief note explaining your alterations.(b) Calculate:

(1) The project’s payback period

(2) The project’s net present value as at 31 December Year 0

(c) Write a memo to the board advising on the acceptance or rejection of the project

Ignore taxation in your answer

Arkwright Mills plc is considering expanding its production of a new yarn, code name X15 Theplant is expected to cost £1 million and have a life of five years and a nil residual value It will

be bought, paid for and ready for operation on 31 December Year 0 £500,000 has already beenspent on development costs of the product, and this has been charged in the income statement

in the year it was incurred

The following results are projected for the new yarn:

Year 1 Year 2 Year 3 Year 4 Year 5

Tax is charged at 50 per cent on annual profits (before tax and after depreciation) and paid oneyear in arrears Depreciation of the plant has been calculated on a straight-line basis Additionalworking capital of £0.6m will be required at the beginning of the project and released at the end of Year 5 You should assume that all cash flows occur at the end of the year in which they arise

Required:

(a) Prepare a statement showing the incremental cash flows of the project relevant to a sion concerning whether or not to proceed with the construction of the new plant

deci-(b) Compute the net present value of the project using a 10 per cent discount rate

(c) Compute the payback period to the nearest year Explain the meaning of this term

Newton Electronics Ltd has incurred expenditure of £5 million over the past three yearsresearching and developing a miniature hearing aid The hearing aid is now fully developed, andthe directors are considering which of three mutually exclusive options should be taken toexploit the potential of the new product The options are as follows:

1 The business could manufacture the hearing aid itself This would be a new departure, sincethe business has so far concentrated on research and development projects However, thebusiness has manufacturing space available that it currently rents to another business for

£100,000 a year The business would have to purchase plant and equipment costing £9 lion and invest £3 million in working capital immediately for production to begin

mil-A market research report, for which the business paid £50,000, indicates that the newproduct has an expected life of five years Sales of the product during this period are pre-dicted as follows:

Predicted sales for the year ended 30 November Year 1 Year 2 Year 3 Year 4 Year 5

The selling price per unit will be £30 in the first year but will fall to £22 in the following threeyears In the final year of the product’s life, the selling price will fall to £20 Variable produc-tion costs are predicted to be £14 a unit, and fixed production costs (including depreciation)will be £2.4 million a year Marketing costs will be £2 million a year

The business intends to depreciate the plant and equipment using the straight-line methodand based on an estimated residual value at the end of the five years of £1 million The busi-ness has a cost of capital of 10 per cent a year

2 Newton Electronics Ltd could agree to another business manufacturing and marketing theproduct under licence A multinational business, Faraday Electricals plc, has offered toundertake the manufacture and marketing of the product, and in return will make a royaltypayment to Newton Electronics Ltd of £5 per unit It has been estimated that the annual

8.5

8.4 CHAPTER 8 MAKING CAPITAL INVESTMENT DECISIONS

314

number of sales of the hearing aid will be 10 per cent higher if the multinational business,rather than Newton Electronics Ltd, manufactures and markets the product.

3 Newton Electronics Ltd could sell the patent rights to Faraday Electricals plc for £24 million,payable in two equal instalments The first instalment would be payable immediately and thesecond at the end of two years This option would give Faraday Electricals the exclusive right

to manufacture and market the new product

inter-to acquire ‘Bazza’ Ramsey would mean that the existing central defender, Vinnie Smith, could

be sold to another club Chesterfield Wanderers has recently received an offer of £2.2 million forthis player This offer is still open but will only be accepted if ‘Bazza’ Ramsey joins ChesterfieldWanderers If this does not happen, Vinnie Smith will be expected to stay on with the club until the end of his playing career in five years’ time During this period, Vinnie will receive anannual salary of £400,000 and a loyalty bonus of £200,000 at the end of his five-year period withthe club

Assuming ‘Bazza’ Ramsey is acquired, the team manager estimates that gate receipts willincrease by £2.5 million in the first year and £1.3 million in each of the four following years Therewill also be an increase in advertising and sponsorship revenues of £1.2 million for each of thenext five years if the player is acquired At the end of five years, the player can be sold to a club

in a lower division and Chesterfield Wanderers will expect to receive £1 million as a transfer fee.During his period at the club, ‘Bazza’ will receive an annual salary of £800,000 and a loyaltybonus of £400,000 after five years

The second option is for the club to improve its ground facilities The west stand could

be extended and executive boxes could be built for businesses wishing to offer corporate hospitality to clients These improvements would also cost £10 million and would take one year

to complete During this period, the west stand would be closed, resulting in a reduction of gatereceipts of £1.8 million However, gate receipts for each of the following four years would be

£4.4 million higher than current receipts In five years’ time, the club has plans to sell the ing grounds and to move to a new stadium nearby Improving the ground facilities is notexpected to affect the ground’s value when it comes to be sold Payment for the improvementswill be made when the work has been completed at the end of the first year Whichever option

exist-is chosen, the board of directors has decided to take on additional ground staff The additionalwages bill is expected to be £350,000 a year over the next five years

The club has a cost of capital of 10 per cent Ignore taxation

(d) Discuss the validity of using the net present value method in making investment decisionsfor a professional football club.

Simtex Ltd has invested £120,000 to date in developing a new type of shaving foam The shaving foam is now ready for production and it has been estimated that the new product willsell 160,000 cans a year over the next four years At the end of four years, the product will bediscontinued and replaced by a new product

The shaving foam is expected to sell at £6 a can and the variable cost is estimated at £4 percan Fixed cost (excluding depreciation) is expected to be £300,000 a year (This figure includes

£130,000 in fixed cost incurred by the existing business that will be apportioned to this newproduct.)

To manufacture and package the new product, equipment costing £480,000 must beacquired immediately The estimated value of this equipment in four years’ time is £100,000 Thebusiness calculates depreciation using the straight-line method, and has an estimated cost ofcapital of 12 per cent

Required:

(a) Deduce the net present value of the new product

(b) Calculate by how much each of the following must change before the new product is nolonger profitable:

(i) the discount rate;

(ii) the initial outlay on new equipment;

(iii) the net operating cash flows;

(iv) the residual value of the equipment

(c) Should the business produce the new product?

Kernow Cleaning Services Ltd provides street-cleaning services for local councils in the farsouth west of England The work is currently labour-intensive and few machines are used.However, the business has recently been considering the purchase of a fleet of street-cleaningvehicles at a total cost of £540,000 The vehicles have a life of four years and are likely to result in a considerable saving of labour costs Estimates of the likely labour savings and theirprobability of occurrence are set out below

Estimated savings Probability of

(a) Calculate the expected net present value (ENPV) of the street-cleaning machines

(b) Calculate the net present value (NPV) of the worst possible outcome and the probability ofits occurrence

8.8

8.7 CHAPTER 8 MAKING CAPITAL INVESTMENT DECISIONS

316

Strategic management accounting

Businesses are increasingly being managed along strategic lines By this we meanthat strategies adopted by a business are increasingly providing the basis for bothlong-term and short-term decisions If management accounting is to help guidedecision making within a strategic framework, the reports provided and techniquesused must align closely with the framework that has been put in place Conventionalmanagement accounting has been criticised, however, for failing to address fully thestrategic aspects of managing a business This criticism does not mean that themanagement accounting techniques discussed so far are obsolete, but it does meanthat the subject must continue to develop if it is to retain a high degree of relevancefor decision makers

Strategic management accounting is still a fairly new topic and there is nogenerally agreed set of concepts and techniques that can help us define preciselywhat is meant by this term Nevertheless, some key features of this new topic can

be identified, and new accounting techniques which are seen as useful for strategicdecision making have emerged

We shall begin the chapter by discussing the nature of strategic managementaccounting and then go on to look at some of the techniques and methods ofanalysis that fall within its scope In this chapter we shall draw on the understanding

of topics covered in many of the preceding chapters of the book, particularlyChapters 1, 5 and 8

INTRODUCTION

9

Strategic management accounting is concerned with providing information that willsupport the strategic plans and decisions made within a business We saw in Chapter 1that strategic planning involves five steps:

1 Establishing the mission and objectives of a business.

2 Undertaking a position analysis, such as a SWOT (strengths, weaknesses,

opportun-ities and threats) analysis, to establish how the business is placed in relation to itsenvironment

3 Identifying and assessing the possible strategic options that will lead the business

from its present position (identified in Step 2) to the achievement of its objectives(identified in Step 1)

4 Selecting the most appropriate strategic options (from those identified in Step 3) and

formulating long- and short-term plans to pursue them

5 Reviewing business performance and exercising control by assessing actual

perform-ance against planned performperform-ance (identified in Step 4)

To some extent, conventional management accounting already supports this tegic process We have seen in Chapter 7, for example, how budgets can be used tocompare actual performance with earlier planned performance We have also seen inChapter 8 the role of investment appraisal techniques in evaluating long-term plans.Nevertheless, there is scope for further development It can be argued that if manage-ment accounting is fully to support the strategic planning process, it must develop inthree broad areas:

stra-l It must become more outward looking There is general agreement that the

conven-tional approach to management accounting does not give enough consideration toexternal factors affecting the business These factors, however, are vitally important

to strategic planning and decision making For example, we need to understand the environment within which the business operates when we are undertaking

a position analysis or when we are formulating plans for the future Management

What is strategic management accounting?

CHAPTER 9 STRATEGIC MANAGEMENT ACCOUNTING

318

LEARNING OUTCOMES

When you have completed this chapter, you should be able to:

l Discuss the nature and role of strategic management accounting

l Explain how management accounting information can help a business gain abetter understanding of its competitors and customers

l Describe the techniques available for gaining competitive advantage throughcost leadership

l Explain how the balanced scorecard can help monitor and measure progresstowards the achievement of strategic objectives

l Discuss the role of shareholder value analysis and economic value added instrategic decision making

accounting can play a useful role here by providing information relating to the onment, such as the performance of the business’s competitors and the profitability

to help a business operate more efficiently, these techniques are not always enough.Rather than seeking simply to count and manage the costs incurred, costs and coststructures may need to be transformed Thus, management accounting has a role toplay in helping to shape the costs of the business to fit the strategic objectives

l There must be a concern for monitoring the strategies of the business and for bringing these strategies to a successful conclusion This means that management accounting should

place greater emphasis on long-term planning issues and on developing a hensive range of performance measures to try to ensure that the objectives of thebusiness are being met The objectives of a business are often couched in both finan-cial and non-financial terms and so the measures developed must reflect this fact

compre-Let us now turn our attention to the ways in which management accounting canhelp in each of the three areas identified

If a business is to thrive, it needs to have a good understanding of the environmentwithin which it operates In particular, it should have a good understanding of thethreat posed by its competitors and the benefits obtained from its customers There is

a strong case for reporting certain information relating to competitors and customers,frequently and routinely to managers By so doing, managers can respond morequickly to any changes in the environment that may occur In this section we considersome of the techniques and measures that may help managers gain a better under-standing of these two important groups

Competitor analysis

To compete effectively, a business needs to acquire a sound knowledge of its maincompetitors As well as helping in strategic planning, this knowledge can also help inpricing and business acquisition decisions When appraising competitors, a businessneeds to understand

l what strategies and plans they have developed;

l how they may react to the plans the business has developed; and

l whether they have the capability to pose a serious threat to the business

To gain this understanding, a careful analysis of each main competitor should be carried out

To illustrate the benefits of competitor analysis, let us say that a business proposes

to reduce its sales prices by 10 per cent What would be the reaction of competitors?

Facing outwards

FACING OUTWARDS 319

‘

Would this reduction be matched by them and thereby cancel out any advantage to begained? Would it lead to a price war where sales prices follow a downward spiral? Ifcompetitors could not match the price reduction, would they be able to continue tosupply, given the likely sales volume reduction that they would suffer? We can see thatthe proposal to reduce prices cannot be fully evaluated until competitors’ likely reac-tion to the proposal is known.

Real World 9.1provides an example of how one business came to realise that it had

to pay more attention to the competition

To find out what drives a competitor and how it might act, four key aspects of itsbusiness must be analysed These are:

1 Objectives Where is the competitor going? In particular, what are its profit

objec-tives, what rate of sales growth is it trying to achieve, what market share does it seek?

2 Strategies How does the competitor expect to achieve its objectives? What

invest-ments are being made in new technology? What alliances and joint ventures arebeing created? What new products are to be launched? What mergers and acquisi-tions are planned? What cost reduction strategies are being developed?

3 Assumptions How do the competitor’s managers view the world? What assumptions

are held about

l future trends within the industry;

l the competitive strengths of other businesses; and

l the feasibility of launching into new markets?

4 Resources and capabilities How serious is the potential threat? What is the

compet-itor’s scale and size? Does it have superior technology? Is it profitable? Does it have

a strong liquidity position? What is the quality of its management?

These four features provide the framework for analysing competitors, as shown inFigure 9.1

Gathering information to answer the questions posed above is not always easy.Businesses are understandably reluctant to release information that may damage theircompetitive position Nevertheless, there are sources of information that can be used

We shall now consider some of these and, given the management accounting focus of

CHAPTER 9 STRATEGIC MANAGEMENT ACCOUNTING

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REAL WORLD 9.1

Angling for recovery

House of Hardy is a world-famous manufacturer of fishing rods and tackle It enjoys anunrivalled reputation for its products and has a highly skilled workforce In recent years,however, it has experienced problems, which have been partly caused by global competi-tion The business is trying to recover and, in analysing its past mistakes, has recognisedthat it has been rather too complacent in its approach to competitors As part of its recov-ery plan it is now paying much more attention to what they are doing It is now analysingthe products offered by competitors and reviewing its own pricing policies in an attempt

to compete more effectively

Source: Based on information from ‘How Hardy lost the lure of heritage’, ft.com, 1 December 2003.

FT

this book, will concentrate on those sources providing information about the financialresources and capabilities of competitors.

A useful starting point is to examine a competitor’s annual report In the UK, all ited companies are legally obliged to provide information about their business in anannual report that is available to the public Similar provisions relate to limited com-panies in most countries in the world The income statement, cash flow statement andstatement of financial position (balance sheet) found in the annual report of a com-petitor can be examined to gain insights about its financial performance and position.Financial ratios may be used to help gain an impression of the profitability, liquidity,efficiency and financing arrangements of the business Trends may be detected overtime and particular strengths and weaknesses identified

lim-Where the competitor is not the whole business, but simply an operating division,the annual reports are likely to be less helpful This is because the results of the relev-ant division will normally be obscured as a result of its aggregation with the rest of the competitor’s operations Though large businesses operating as limited companiesmust publish some information about the sales revenues and profits of their variousoperating divisions, this is often not enough to enable a full picture of the competitor

to be built up Nonetheless, a competitor’s annual report should still offer some useful information Furthermore, a business will have detailed knowledge of its ownprofitability, liquidity, efficiency and so on, which may well help in compiling a pic-ture of the competitor’s position

It may be possible to gain other information from both published and unpublishedsources This could be from

l press coverage of the competitor’s business;

l statements by managers made at conferences or on the competitor’s website;