Strategic Management Accounting and Control

Strategic Management Accounting and Control

By: Dr Clive Vlieland-Boddy FCA FCCA MBA

Professor of Accounting

 European University & EADA Barcelona

  

1. Introduction

As business environments have become increasingly dynamic and competitive, it has become vitally important for managers to develop coherent, internally and logically consistent business strategies and to have tools and models which provide useful information to support strategic decision-making, planning and control. In response to these needs, there have been many highly relevant developments, in both management accounting research and practice that focus on the use of accounting data and related information regarding strategy and operations for these purposes. The key developments in strategic planning and control have been:

• The balanced scorecard, a comprehensive set of mainly qualitative performance measures designed to assist managers in implementing competitive strategies and monitoring performance with respect to them.

• Strategic variance/profitability analysis.  Systems which break down the measures of budgeted versus actual net income into variances which managers can relate logically to a firm's or strategic business unit's (SBU's) mission and business strategy and therefore use to evaluate quantitative performance from a strategic perspective.

• Profit-linked performance measurement systems, models which decompose measures of changes in profitability over time into measures of changes in constructs such as productivity and price recovery, which can be logically linked to a firm's or SBU's mission and business strategy and analysed from those perspectives. Performance management as 'a process which contributes to the effective management of individuals and teams in order to achieve high levels of organisational performance. As such, it establishes shared understanding about what is to be achieved and an approach to leading and developing people which will ensure that it is achieved.

• levers of control, a comprehensive framework for organizing and employing management control systems to promote strategic objectives (see Simons 2000). These levers are:

• Beliefs systems used to inspire and direct the search for new opportunities.

• Boundary systems used to set limits on opportunity-seeking behaviour.

• Diagnostic control systems used to motivate, monitor and reward achievement of specified goals.

• Interactive control systems used to stimulate search and learning, allowing new strategies to emerge as participants throughout the organisation to respond to perceived opportunities and threats.

As a fourth lever of control, these systems focus attention on strategic uncertainties and enable strategic renewal.

 2. Summary of this paper

(i)             Discusses management accounting information systems which are beneficial for strategic planning and control, in the context of Porter's (1980, 1985, 1991, 1996) strategy framework.

(ii)            Briefly introduces strategic variance analysis.

(iii)           Provides a more substantial introduction to profit-linked performance measurement systems.

(iv)          Introduce the issues and benefits of the balanced scorecard. 

(v)           Illustrate how the measures in multi-product, multi-period models can be related to Porter's framework, and critical success factors.

(vi)          Strategic operating choice variables (cost and revenue drivers),

(vii)         Analysis of Continental Airlines following deregulation.

(viii)        Discusses ways the models can be used for strategic planning, control and cost management.

3. The Design of Strategic Cost Management and Control Systems

If management accounting information systems are to be useful for strategic purposes, that is, to help managers increase the likelihood that they can achieve their strategic goals and objectives, their designs and use must follow from firms' missions and competitive strategies.

In Porter's framework, strategy should follow from an analysis of the determinants of the nature and intensity of competition: the firm's bargaining over its consumers and suppliers, threats from new entrants and substitute products (barriers to entry and exit), and the intensity of rivalry in product markets.

To generate a sustainable competitive advantage, a strategy must:

(i)             Establish a unique market position based on low cost leadership, product differentiation, or a workable combination of the two, with an appropriate scope of markets (broad or focused/niche);

(ii)            Be differentiated from competitors' strategies, through unique product variety, ability to satisfy customer needs, and/or access to particular customer segments.

(iii)           Employ chains of complementary value added activities which are difficult for competitors to replicate.

The chosen strategy, should in turn:

(i)             Determine the firm’s critical success factors, such as delivering superior product and service quality and achieving high price recovery for pursuing differentiation strategies. This could well include achieving economies of scale, improving productivity and delivering threshold product and service quality at low prices for pursuing low cost leadership strategies.

(ii)            Carefully evaluating choices regarding the design of products and configuration of operations which drive costs and revenues. For a set of performance measures to exhibit content validity in a strategic context, then, it must measure constructs related to the mission and strategic framework, the selected strategies, the firm's critical success factors, and operating choice variables.

Performance measurement systems should, to a great extent, be based on profit-generating processes. When managers take actions the models should assist to improve performance along one or more dimensions, so intended benefits are likely to materialise.

Thus, the models should incorporate current as well as future relationships and linkages, capturing cause and effect between activities, as well as performance throughout the firm both horizontally and vertically across the entire value chain.  Finally, the measures should also have 'good' theoretical and empirical measurement properties.

4. Strategic Variance Analysis

Strategic variances can be divided into:

• Mutually exclusive - collectively exhaustive sets of variances which capture the separate impacts of key underlying causal factors, for example, deviations between actual and budgeted sales volumes and mixes, market sizes and shares, manufacturing costs, contribution margins.

• Discretionary costs. Conceptualising mission in terms of profitability and a build, hold or harvest perspective and strategy in terms of low cost leadership or product differentiation.

By analysing the variances with explicit reference to a firm's mission and business strategy, you can determine the extent to which deviations between actual and budgeted performance are or are not consistent with the mission and strategy and identify specific dimensions of performance which need improvement. Analysing the variances without reference to mission and strategy can be uninformative or misleading.

5. Profit-linked Performance Measurement Systems

Profit-linked models evaluate measures of return-on-investment and net income into:

• Productivity

• Price recovery

• Capacity utilization

• Other managerially relevant dimensions of performance.

Profit variances can be divided into:

• Effectiveness variances (market size, market share, selling prices, and product volume and mix variances) 

• Efficiency variances (materials and labour price and efficiency, discretionary and committed cost spending variances, and/or activity-based cost variances).

Effectiveness variances are of particular importance to business units pursuing differentiation strategies and efficiency variances to units pursuing low cost, high volume strategies.

6. Theoretical and Empirical Relationships between the Measures, Porter's Framework, and Operating Choice Variables

In Porter's framework, to achieve a competitive advantage, a firm must devise a strategy to defend against, or take advantage of, the structural determinants of the nature and intensity of competition. The levels and time-paths of the ratios reflect outcomes of managers' efforts to exploit sources of bargaining power over consumers and suppliers and to reduce threats from new entrants and substitutes, as well as the intensity of competition.

Emphases on improvements in productivity and capacity utilization, shifts in product mix toward products with lower unit costs, and low price recovery are consistent with low cost strategies.

Less emphasis on productivity and capacity utilisation, changes in product mix which may be more costly but serve less price sensitive consumers, and higher price recovery are consistent with differentiation. These relationships are fairly general and should hold for any industry or SBU.

Operating choice variables of structural and exceptional cost and revenue drivers and their relationships to the ratios are conceptually similar across industries but often industry-specific in terms of measurement. Within industries, the design of each SBU's products differs depending upon the SBU's particular customer and market orientation and the configuration as well as characteristics of each SBU's operations.

7. Models for Strategic Planning and Control

The values of profit-linked performance measures are driven by variables that managers must take as given when making decisions or variables that reflect actions managers must take to improve performance. They can be systematically linked to constructs and measures involved in business strategies, critical success factors, and product and process design.

As a result, the models can be useful for formulating strategies, evaluating realised strategies relative to planned strategies, and evaluating the impacts of related managerial decisions. Managers can use the models to examine the impacts of strategic choices and events on each component dimension of performance, understand the trade-offs involved more clearly, and therefore devise more coherent strategies and tactics.

Once managers have specified and estimated a model for their specific objectives, they can use it to facilitate strategy formulation and implementation, and to support an on-going, evolutionary process of motivating and monitoring progress toward strategic goals and objectives and adapting choices in response to feedback obtained (continuous improvement).

Prior to choosing new strategies, managers can analyse the time-paths of the component measures and operating choice variables, computed with historical data, These are normally better done in conjunction with information regarding past intended strategies, events, distinctive competencies as well as weaknesses, to evaluate the effectiveness of past strategies.

They can determine the extent to which they have been achieving a low cost or differentiation strategy (whether explicitly formulated and intended or not), or a combination of the two, and dimensions along which performance has and has not been consistent with those strategies.

The model can also be used for simulation and sensitivity analysis, to identify feasible alternative strategies and project the time-paths of the ratios and operating variables required to implement each successfully. During implementation, managers can monitor the values of the ratios and operating choice variables over time, relative to projected targets or benchmarks, to determine the extent to which they are achieving their objectives.

These measures can be employed in responsibility accounting systems, to orient performance measurement and evaluation around achieving critical success factors and strategic objectives and to motivate and reinforce behaviour on the part of managers which is congruent with the strategic goals.

Since most of the ratios' values are mathematically related, the measures can be used to compare the performance of SBU’s particularly to evaluate SBU’s that perform similar functions or pursue common strategies (for example, a subset of SBU’s engaged in manufacturing and pursuing low cost strategies or a subset pursuing differentiation strategies in related niche markets).

Responsibility for aggregate measures can be assigned to SBU managers with responsibility for implementing and revising strategy, for monitoring as well as explaining actual results relative to the intended strategy. Responsibility for component measures can be assigned to individuals and teams who are responsible for improving the relevant dimensions of performance and making and explaining changes in particular product and process design variables.

For example, productivity is a weighted average of measures of changes in partial productivity (productivity by input as opposed to total factor productivity). Therefore, responsibility for individual partial productivity measures can be assigned to the relevant supervisors or plant teams. Price recovery can be expressed as a weighted average of changes in price recovery by product, so responsibility for changes by product can be assigned to product line managers and evaluated with respect to the strategy selected for each product (low cost leadership or differentiation).

8. Extensions for Strategic Cost Management

The design and use of strategic cost management systems are oriented around the application of three basic tools: cost and revenue driver analysis, value chain analysis, and strategic positioning analysis.

Important developments during the past two decades include activity-based costing, target costing, life-cycle costing, customer profitability and value analysis, along with models for measuring and managing quality, environmental and capacity costs. These systems are designed to provide managers with relevant, accurate and timely information, by:

• Highlighting previously hidden costs

• Related non-financial data

• Trade-offs between cost categories.

Managers need to be able to identify opportunities for improvement, weigh trade-offs, set priorities, and take actions to reduce costs and increase revenues which are consistent with intended strategies.

Profit-linked models can be refined in many ways to make them more useful for strategic cost management.

For example, the measures can be broken down further.

• Productivity

• Capacity Utilisation

• Innovation (Technical advancement)

• Product quality

• Economies of scale

• Allocation efficiency

• Product Mix

Productivity and capacity utilisation can be divided into measures of pure technical change.  Innovation highly influences changes in the structural cost drivers.  Revenue drivers are affected when they involve simultaneous improvements in product quality.  Changes in technical and allocation efficiency capture the impacts of changes in economies of scale.

9.  The Balanced Score Card

The balanced scorecard is a strategic planning and management system that is used extensively in business worldwide to align business activities to the vision and strategy of the organization, improve internal and external communications, and monitor organization performance against strategic goals. It was created by Drs. Robert Kaplan and David Norton as a performance measurement framework that added strategic non-financial performance measures to traditional financial metrics to give managers and executives a more 'balanced' view of organizational performance. 
The balanced scorecard has evolved from its early use as a simple performance measurement framework to a full strategic planning and management system. The balanced scorecard transforms an organization’s strategic plan from an attractive but passive document into the "marching orders" for the organization on a daily basis. It provides a framework that not only provides performance measurements, but helps planners identify what should be done and measures it, and thereby enables executives to truly execute their strategies.
It assists organizations to clarify their vision and strategy and translate them into a plan. It provides feedback around both the internal business processes and external outcomes in order to continuously improve strategic performance and results. When fully deployed, the balanced scorecard transforms strategic planning from an academic exercise into the nerve centre of an enterprise.
By focusing not only on financial outcomes but also on the operational, marketing and developmental inputs to these, the Balanced Scorecard helps provide a more comprehensive view of a business, which in turn helps organizations act in their best long-term interests. This tool is also being used to address business response to climate change and greenhouse gas emissions.
Organizations were encouraged to measure, in addition to financial outputs, those factors which influenced the financial outputs. For example, process performance, market share / penetration, long term learning and skills development, and so on.
The underlying rationale is that organizations cannot directly influence financial outcomes, as these are "lag" measures, and that the use of financial measures alone to inform the strategic control of the firm is unwise. Organizations should instead also measure those areas where direct management intervention is possible. In so doing, the early versions of the Balanced Scorecard helped organizations achieve a degree of "balance" in selection of performance measures. In practice, early Scorecards achieved this balance by encouraging managers to select measures from three additional categories or perspectives: "Customer," "Internal Business Processes" and "Learning and Growth."

Adapted from The Balanced Scorecard by Kaplan & Norton

10.  Continental Airlines

In response to deregulation, competition increased, and all of the carriers had increasing productivity ratios and decreasing price recovery. However, carriers’ primarily realizing differentiation strategies had relatively high price recovery and low productivity. Carriers’ primarily realizing low cost strategies had high productivity and low price recovery.

Continental Airlines entered deregulation as a relatively high-cost, moderate-quality carrier.  They reduced costs but without much emphasis on exploiting bargaining power over labour, realigning its network into a hub-and-spoke system, or maintaining fare levels. As a result, its price recovery was slightly above the sample average, productivity was below average and increasing, and low capacity utilisation.

When Frank Lorenzo took over Continental in October 1981, he immediately began to pursue a low cost leadership strategy, in manners reflected in increasing productivity and capacity utilisation but declining price recovery. The strategy included hub efficiencies, high productivity, low fares, and aggressive efforts to exploit bargaining power over suppliers. During this period, productivity increased, but labour management problems led to strikes by mechanics in August 1983 and pilots and flight attendants

in October 1983.

In September 1983, Lorenzo filed for bankruptcy protection, eliminated nearly two-thirds of Continental's employees, rewriting their contracts,  reducing wages and salaries by nearly 50%, cutting benefits, and imposed work rules to increase productivity.  Productivity did not decrease much during the mechanics' strike because Lorenzo hired replacement labour and continued operations at 85% to 93% of normal levels. The pilot and flight attendant strikes and bankruptcy proceedings are reflected in a sharp decrease in productivity, as Continental maintained less than 80% of normal services.

In January 1984 Continental emerged from bankruptcy as a low cost carrier, with increasing productivity and capacity utilisation but decreasing price recovery. Although there were claims that Continental was improving service quality during this period, the airline had one of the poorest record of complaints in the industry. Finally, they expanded and threatened competitors aggressively. Lorenzo repeatedly initiated changes which increased the intensity of competition.

References

Rajiv D. Banker ,Holly H. Johnston Strategic Management Accounting and Control

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Deregulation", Working Paper, October 2000.

Drs. Robert Kaplan and David Norton (1992) "The balanced scorecard: measures that drive performance", Harvard Business Review Jan – Feb pp. 71-80.

Kaplan R S and Norton D P (1993) "Putting the Balanced Scorecard to Work", Harvard Business Review Sep – Oct pp2-16

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Notes:

1.  The Value Chain

The value chain is a linked set of value-creating activities, from raw materials acquisition to the completion of finished consumption goods and post-sales service, in which a firm.

2.  Strategic Business Unit

A strategic business unit is a defined segment of a business whose mission and operations are critically important to achieving the strategic goals and objectives of the overall business.

3.   DuPont

Measures of profitability can be developed into expressions for return-on-investment via DuPont analysis, decomposing the measure of return into profit margin and investment turnover ratios. ROE can be influenced by gearing, efficiency as well as profitability.

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