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Strategy Formation Processes, Including Data Gathering Structures, SWOT Analysis and Ethics
Part A Suggested References

When you are studying this topic we suggest the following references: Primary References
Section
5
th
Anthony, R.N. and Govindarajan, V., Management Control Systems, 12 edition, 2007, Chapter 2. Porter, M.E., Competitive Advantage: Creating and Sustaining Superior Performance, 1985, Chapters 1-4. Supplementary References Atkinson, A.A., Kaplan, R.S., Matsumura, E.M. and Young, S.M., Management Accounting, 5th edition, 2008, Chapter 1. Dess, Gregory; Lumpkin G.T. (2003) Strategic Management Creating Competitive Advantage. st 1 edition McGraw-Hill Irwin 2003. Govindarajan, V. and Shank, J.K., 1992. Strategic cost management: Tailoring controls to strategies, Journal of Cost Management, Fall, 1992, pages 14-24. Grant, R.M., Contemporary Strategy Analysis, 6 edition, 2008, Chapter 1. Hong Kong Institute of CPAs, "Code of Ethics for Professional Accountants (Effective June 2006) Horngren, C.T., Datar, S.M., Foster, G., Ittner, C., and Rajan, M. th Managerial Emphasis, 13 edition, 2008, Chapter 13. Cost Accounting A
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Johnson, G., Scholes, K. and Whittington R, Exploring Corporate Strategy, 7 edition, 2006. Lei, David; Slocum Jr., John W. Strategic and organisational requirements for competitive advantage Academy of Management Executive, Feb 2005, Vol. 19 Issue 1. Porter, M.E. What is Strategy, Harvard Business Review, Nov Dec 1996. Shank, J.K. and Govindarajan, V., Strategic cost management and the value chain, in Readings and issues in cost management, 1995, edited by J.M. Reeve, Reading 1.2. Smith, M., Strategic management accounting: Issues and cases, 1995, Chapter 4. Steiner, G.A., Strategic Planning, What Every Manager Must Know, 1997, p.15. Tant, K., Business Ethics and the Treasury Professional, CorporateTreasury in Asia, Hong Kong, EFP Publishing, 1997. The Bridge Guide to
Hong Kong Institute of CPAs Financial Management Module
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Part B
Topic Strategy formation processes, including data gathering structures and SWOT analysis: Learning Outcomes On completion of this module, you should be able to: i) ii) iii) iv) v) vi) vii) Identify the steps involved in the formulation of strategies and understand the relationship with budgets. Complete an internal and external analysis of a business, including SWOT and industry analysis. Describe the main planning model types and implications for strategy design. Describe recent analysis theories and associated impact on prices, costs and investment. List the nature and uses of different types of business plans. Demonstrate how to translate the organisations objectives and strategies into business plans. Outline available options associated with business planning.
The nature of strategic planning and its stages Environmental analysis Types of planning models Selecting long term objectives Competitive strategies Industry life cycle Relationship between strategic planning and budgeting Ethics in strategy formation, operations and evaluation Global financial crisis and business strategy
viii) Estimate and forecast both operational and developmental revenues and costs associated with business plans. ix) x) List the tests available for evaluating strategies. Appreciate the importance of ethics in strategy formation, operations and evaluation.
You may choose to complete this topic in a step-by-step way or skip ahead, depending on your knowledge and assessment of your own competency in relation to the above Learning Outcomes.
Part C
Contents of this Section 5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.9 5.10 Introduction ......................................................................................................................... 2 The nature of strategic planning and its stages .................................................................. 5 Environmental analysis ....................................................................................................... 8 Types of planning models ................................................................................................. 12 Selecting long term objectives .......................................................................................... 13 Competitive strategies ...................................................................................................... 17 Industry life cycle .............................................................................................................. 20 Relationship between strategic planning and budgeting .................................................. 22 Ethics in strategy formation, operations and evaluation ................................................... 22 Global financial crisis and business strategy .................................................................... 35
5.1
Introduction
To survive in the global economy, businesses must plan for both growth and financial stability. In order to achieve these combined objectives long-range strategies need to be formulated and appropriate practical techniques used to formulate operational level activities. The operational level activities need to be aligned with the long-range objectives.
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This section examines the strategic planning (long-range planning) process. In particular, we: look at and analyse a definition of strategic planning (section 5.2.1); cover the usual steps involved in the strategic planning process (section 5.2.3) and consider the relationship with shorter-term plans (i.e. budgets). For some of you, this coverage may be repetitive of earlier studies. Nevertheless, it is important we cover this to establish our starting point for the section; consider two main types of analyses which are used to carry out the strategic planning process: environmental analysis; and competitive strategy analysis. Environmental Analysis Within environmental analysis, we cover: the technique of strengths, weaknesses, opportunities and threats (SWOT); and Porters five-forces industry analysis. SWOT analysis can be used not only as an environmental analysis technique but also to evaluate how strategies are being met, i.e. in a performance measurement type of role (see Figure 1 below). Porters industry analysis technique gives us an indication about our environment from the 1 industry perspective. It provides some signs about whether abnormal profits can be earned. Competitive Strategy Analysis To succeed in business we need a strategy that not only takes into account our environment but also builds on our competitive advantage(s). This second area is where competitive strategy analysis can be useful. Within competitive strategy analysis we consider how such planning models, as the matrices developed by Boston Consulting Group (BCG) and General Electric Company/McKinsey and Company can be used to determine product characteristics and associated operational activities to achieve those characteristics. Structure of this Section Figure 1 below outlines the structure of this section and the relationships among the various techniques that are employed. As a starting point, the managers of an organisation should have a clear vision of what is to be achieved in the long term and should be able to describe the organisations overall mission and purpose. Sometimes the mission statement is agreed before carrying out the environmental analysis and sometimes it is the other way around. There is no one correct order. A SWOT analysis and a five-forces industry analysis can assist in achieving some understanding of the environment. At this point the business management should then be able to answer the question: Why do we exist as a business?
Abnormal profits (sometimes called supernormal profits) are profits in excess of the cost of capital. Alternatively abnormal profits exist when the rate of return generated by the firm is greater than the required rate of return. Abnormal profits add value to the firm.
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A business then needs to determine its overall strategies in order to achieve its mission. The BCG and McKinsey matrices are two techniques to provide information about where to invest and where not to invest. Similar information is gained by using such techniques as the Ansoff matrix and Porter's generic strategies. These techniques are useful at the next stage where micro-level strategies are developed. These micro-level strategies should be consistent with the long term strategies, which, in turn, are consistent with the overall mission. A budget quantifies these micro-level strategies. Figure 1: Concept Map The Planning Process
ENVIRONMENTAL & INDUSTRY ANALYSIS SWOT, industry analysis Strategic Planning DETERMINE OVERALL MISSION/PURPOSE Planning models for long term strategies e.g. BCG, McKinsey matrices
SELECT LONG -TERM OBJECTIVES
DEVELOP APPROPRIATE STRATEGIES
Planning models for competitive strategies e.g. Ansoff, Porter
PREPARE THE BUDGET
Master budgeting
Budgeting
MEASURE PERFORMANCE Variance analysis, SWOT analysis, industry analysis, other techniques
ANALYSE REASONS FOR DEPARTURE FROM PLAN
Performance is measured once the business activity commences and feedback is obtained using a variety of techniques. Significant departures from budget may cause the business management to review its environment using (say) SWOT analysis and so the process continues.
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5.2
5.2.1
The Nature of Strategic Planning and Its Stages

Definition
A good place to start this topic is with a definition of strategic planning. The following definition illustrates the practical approach to strategic planning:
Strategic planning is the systematic and more or less formalised effort of a company to establish basic company purposes, objectives, policies, and strategies and to develop detailed plans to implement policies and strategies to achieve objectives and basic company purposes. (G.A. Steiner, Strategic Planning, What Every Manager Must Know, p.15). Although this definition focuses on companies, any entity (for example, government bodies like the Hong Kong Government Department of Trade, charity organisations like the Red Cross, or business partnerships like some accounting firms) can and should carry out strategic planning. Profit-seeking entities are not the only types of entities with objectives. For example, the Red Cross might have as an objective to improve the quality of health care in Africa. To achieve this long-term objective it will need to raise funds, employ doctors and nurses and train people from African nations in hygiene, self-sufficiency and so on. A specific shorterterm goal might be to raise 10% more funds from donations. In this section, however, we concentrate on profit-seeking entities. There are some important points to note about the definition of strategic planning. Firstly, the process is aligned with long term outcomes. Secondly, strategic planning is a process to identify and plan the best way forward for an organisations existing and proposed services/products.
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5.2.2
The Strategic Planning Period
An important characteristic of strategic planning is that it is long-term. We plan where we want to be in (say) five years and not next month or next year. Normally strategic plans cover from three to ten years. However, entity-specific factors can provide an indication about how long we should plan ahead. Willson, et al (1995) identify six factors (a to f below) which can be used to determine the strategic planning period, all of which have a positive relationship with the suggested strategic planning period. That is, for each factor, as that factor increases, so does the strategic planning period. a) Lead Time for Product Development
This is the length of time from the generation of an idea to the distribution of the product/service to the end customer. Consider the lead times for product development for a new bicycle model versus a new drug to combat the common cold. To build the new bicycle the production facilities may not even need to be altered. All that is required is some market surveys, design and engineering work to be done and then production can commence. The lead time may be as short as six months or even shorter for very efficient entities. For the new drug the period of research alone may take years. And, of course, there are many examples of new services/products that would fall between these two extremes. b) Length of Product Life
This is the length of time before a product/service becomes obsolete. Consider a McDonalds Big Mac versus a Honda sedan. The Big Mac has the longer product life because it will be many years before it is considered obsolete. However, we see new models of Hondas (and most other makes of motor vehicle) about every two to three years. Length of product life has little to do with product durability (you can use a car much longer than you can use a Big Mac); it is the model life that determines the length of product life. Strategic planning at Honda would be shorter-term than strategic planning at McDonalds. c) Market Development Time
This is the length of time it takes for the market to change. Perhaps the simplest way to think about this is to consider whether the market is new and has to be developed, or whether it already exists. Similarly, the core competency may be new or may already exist. The 2 x 2 matrix below indicates a set of 4 possible strategies. This matrix is reproduced, with permission, from material published by SmartSims Limited.
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These are described in more detail in the table below. This can be used as a start to the process of defining the basic marketing strategy that an organization must adopt to succeed. Type of Strategy Continuous Improvement Leverage Re-Invent New Business d) Description of Marketing Strategy This strategy suggests that low cost is the critical strategic lever. In this case continuous improvement of the existing systems is key. This is the type of strategy most consistent with Michael Porter. This strategy suggests that there is a new market that may be tapped using an existing process or competency. This strategy requires a new competency to be developed for an existing market. This strategy is to build or buy a new market and a new competency.
Development Time for Raw Materials and Components
A merchandising firm needs very little time to acquire raw materials because it needs only to search for potential suppliers and then negotiate cost, quality, delivery times and so on. However, a decision by that firm to divest and invest in the paper industry by acquiring a new pine plantation would mean that the trees would have to grow before any return could be made. Therefore, if investing in the paper industry becomes part of the merchandising firms official mission (i.e. part of its strategic plan), the development time would lengthen the period of the plan. e) Time for Construction of Physical Facilities
A university decides, as part of its mission, to increase fee-paying student numbers. It decides to do this by attracting overseas students and constructing new student accommodation (the university has no available space). A period of about two years would be required and the strategic plan needs to cover at least this period. For some new strategies this may not be an issue e.g. a new style of shoe that will use existing factory machinery and facilities. f) Payback Period for Capital Investment
A long payback period can be due to new products which require significant capital investment and which are expected to recover the investment cost steadily over time. For example, a private venture to build a toll-road around a major city requires significant up-front investment. As tolls are collected, the cost is recovered. However, the payback period is likely to be long due to significant initial costs, the length of time to generate revenue and the low unit revenue. Although the quantity of unit sales (vehicles paying tolls) is expected to be very high, this long payback period means the entity undertaking the project needs to plan for factors that can affect the revenue stream for some years. For example, will advances in technology mean that fewer people use their vehicles (some new form of public transport)?
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5.2.3
The Strategic Planning and Control Cycle: Seven Steps
Willson et al, (1995), identified the following seven steps in the strategic planning process: 1. 2. 3. 4. 5. 6. 7. Analysis of the industry and business environment and status. Determining the corporate mission or purpose . Selecting the companys long-term objectives. Developing appropriate strategies. Preparing the long-range plan, including the financial plan. Measuring actual performance against the plan. Analysing the reasons for departure from the plan, and taking any appropriate action.
2
As we are concerned with strategy formulation in this section, we consider the first four steps. Steps five to seven will be considered later when we cover budgeting and performance measurement and analysis. The next part of this section covers analysis of the industry and business environment and status (environmental analysis).
5.3
Environmental Analysis
The greater the uncertainty in the organisations environment, the more importance should be placed on strategic planning. How do we determine uncertainty in the environment? We will now introduce some useful techniques for carrying out this process. There are two major areas with which environmental analysis is concerned: situational analysis; and identification of critical success factors. Two common approaches for performing situational analysis are: SWOT analysis (strengths, weaknesses, opportunities and threats); and industry analysis (e.g. Porters five-forces industry analysis or PESTE analysis. PESTE is an acronym for Political, Economic, Societal, Technological Environment). Figure 2: Environmental Analysis Techniques
Environmental analysis
Situational analysis
Identify critical success factors
SWOT analysis
Industry analysis
Note that these two steps may in some cases be reversed or done as one step.
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5.3.1
SWOT Analysis
SWOT analysis is a systematic method for detailing the strengths, weaknesses, opportunities and threats to an organisation. It attempts to provide a picture of the organisations position relative to the impact of important internal and external factors and is therefore a useful part of the first step in formulating strategies. The issues that are typically considered in preparing a SWOT analysis are: financial performance; competitiveness; market impact; and environmental factors. The analysis should explicitly consider the extent to which the objectives of the organisation, as set out in the mission statement and business plan, are being achieved. The SWOT analysis may result in the modification of some objectives due to the gap between the objectives and what is practically attainable. How can we start a SWOT analysis? One approach is to follow these four steps: 1. 2. 3. 4. List the key factors for success. Outline the major outside influences and their impact on our business. Give an assessment of our company versus our competitors. Highlight the differential strengths and weaknesses. Give an explanation for good or bad performance.
A potential problem with SWOT analysis is the development of a long list of unweighted factors. If the situation review is to be of assistance to strategic planning, these factors must ultimately be ranked in order of priority to the organisation. This allows for greater focus when developing specific strategies. The message with SWOT analysis is to keep it short and simple. A way of organising the four factors is in a table, as follows: Strengths 1 2 3 Weaknesses 1 2
Opportunities 1 2 3 4
Threats 1 2 3 4 5
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5.3.2
Porters Five-forces Industry Analysis
Another technique that can be used to provide a comprehensive analysis of the organisations current position is Michael Porters five-forces industry analysis. Porter (1985) developed a fivepart model of the existing competitive position that is used to highlight key factors that are likely to affect the achievement of the organisations objectives. The five forces comprise: 1. 2. 3. 4. 5. the threat of new entrants; the level of industry rivalry among existing competitors; the threat of possible substitute products; customer negotiating power; and supplier negotiating power.
Porter argues that although the relative strengths of the five forces will vary from industry to industry and may change over time, the collective strength of these five forces will determine whether organisations in an industry can earn rates of return greater than their cost of capital. The five forces are critical to industry profitability because they influence the prices, costs, and required investment in an industry. We can illustrate the inverse relationship between the strength of all the forces and the profitability of the industry with the following simple graph:
More Profitable
Profitability of the industry
Less Profitable
Collective strength of the five forces

Weaker Stronger
As the collective strength of the five forces increases, the profitability of the industry declines and vice versa. For example: The threat of new organisations entering the market limits the prices that can be charged for products, and also means that investment is required to deter new entrants. Intensity of rivalry between existing competitors is a major influence on both prices and costs. This may be determined by many factors, including level of industry growth, differences between products and brand identities. The size of the market for a product is reduced by the emergence of substitute products. Powerful customers can drive down prices but also demand a more costly (and hence less profitable) service. The bargaining power of suppliers determines the cost of raw materials and other inputs. Thus, the five-forces framework allows an organisation to identify some of the factors that are critical in its industry. In doing so it directs the energies of the organisation toward the aspects of industry structure that are critical to long run profitability. It also allows the organisation or business unit to formulate effective strategies.
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A potential problem with this type of analysis is the assumption that industry participants always act rationally, i.e. that competitors have a profit motive and adequate information to be able to strategically align themselves if there are any market shocks. This may not always be the case, for a variety of reasons. For example, if poor internal reporting processes provide inadequate cost information for pricing decisions, we may observe firms pricing products at less than cost. Of course, these firms will take action when losses begin to be made, but they may not identify the root cause immediately it may take them some time. For example, consider a firm that benchmarks its prices against those of a competitor which has a more efficient production process and a better costing system. Is it the costing system or the efficient processes that need to be corrected? 5.3.3 PESTE Analysis
The term PESTE was coined by Johnson and Scholes (1997). This form of analysis considers the business environment in which an organisation operates and identifies the elements that could have some impact on the products that it produces or intends to produce. Usually a lot of data will need to be analysed, so structuring and summarising the data will be important. A major consideration is the quality of the information. It can be argued that the better the quality of the information, the better the decision, and that the most current information is generally the most valuable. However, it is often the most ill defined. The trick is to identify the key data from a vast array of it, and to convert it to knowledge useful for decisions. The PESTE analysis is useful to this end, and relates to the Political Economic Societal Technological and Environmental
conditions in which a firm operates. It provides an overview of the overall environment and can be completed at a number of different levels anywhere from trivial to an exhaustive level taking months and even years to complete. The objective is to put on one page all the main issues that relate to the enterprise and the industry in which it is competing. It is best to start simple and to gather more information about each of the areas over time. 5.3.4 Identification of Critical Success Factors
How can a firm identify its critical success factors (CSFs) or key performance indicators (KPIs)? Here are some characteristics, which CSFs (KPIs) should have: The CSF should be essential to the successful completion of the organisations objective(s). For example, a CSF for a universitys accounting department might be to receive an adequate number of well-qualified student applications per year seeking enrolment in the commerce undergraduate degree. If the student demand for the university departments product is not strong, the number of students declines and the departments survival is threatened. The CSF should be expressed as an action. For example, a manufacturer of dairy products may have as one CSF: if a major competitor introduces a new yoghurt product we will respond by launching a competing product in the market within four months. The number of CSFs should be kept to a minimum for better control and ideally should be no more than ten.
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Some ways to identify products/services that should have CSFs include: The firm should identify the CSFs of all the businesses it operates including those products/services which have the greatest growth potential. For example, a television manufacturer currently training the employees of its repairs division in the repair and maintenance of digital televisions is likely to experience significant growth in demand for that divisions service in the coming years. CSFs will need to be developed with that service in mind along the lines of quality, profitability, service and so on. Those products/services that contribute the most to profit, i.e. high gross margin products/services.
5.4
Types of Planning Models
The environmental analyses (SWOT and industry analyses) are useful in highlighting the constraints and opportunities for the organisation with regard to its goals and overall mission. However they do not provide a specific recommendation or set of solutions as to how the organisation should proceed. They do not provide, for example, mission statements for the business units that comprise the organisation. The main reason for the preceding analysis was to assist with the identification of potential courses of action that are aligned with objectives. We now examine how the organisation can go about determining more specific courses of action that it will pursue in attempting to achieve its goals and objectives by using planning models. Planning models are used to assist managers in deciding how and where to allocate resources so that the business strategies can be best met. In this section we cover boxes three and four of the strategic planning process outlined in the concept map in page 4-3 above. For selecting the firms long-term objectives (see section 5.5 below) we consider the two most common planning models: the Boston Consulting Group (BCG) 2 2 (two by two) matrix; and the McKinsey 3 3 (three by three) matrix.
For developing appropriate strategies (see section 5.5 below) we consider: the Ansoff matrix; and Porters generic strategies.
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5.5
5.5.1
Selecting Long Term Objectives

BCG Growth/Share Matrix (2 x 2 matrix)
An alternative approach to conceptualising the organisations current strategic position has been developed by the Boston Consulting Group. The BGC matrix method is based on the product life cycle theory that can be used to determine what priorities should be given to individual products in a companys portfolio of products. To ensure long term value creation, a company should have a portfolio of products that contains both high growth products in need of cash inputs and low growth products that generate lots of cash. Using this approach a company classifies all its strategic business units (SBUs) products or services according to the growth-share matrix. The matrix has two dimensions, market share and market growth, and is illustrated below:
The vertical axis is measured in terms of market growth rate and is intended to be indicative of the attractiveness of the existing market. The horizontal axis indicates the organisations relative market share. This is suggested to be a proxy for its strength within the market. By splitting the growth-share matrix four types of SBUs/products or services can be identified. Stars are high-growth, high-share businesses or products. They typically need heavy investment to finance their rapid growth. Eventually their growth will slow down and they will turn into cash cows. A hold strategy is appropriate for these products. Cash cows are low-growth, high-share businesses or products. These established and successful SBUs/products or services need less investment to hold their market share. They produce a lot of cash that the company uses to pay its bills and to support other SBUs/products or services that need investment. Some experts suggest that when a markets annual growth rate falls to less than 10% the star becomes a cash cow if it still has the largest relative market share. A harvest strategy is appropriate for these products. Question marks are low-share business units in high-growth markets. They require a lot of cash to hold their share, let alone increase it. Management has to think hard about which question marks it should try to build into stars and which should be phased out. A build strategy is appropriate for these products.
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Dogs are low-growth, low-share businesses and products. They may generate enough cash to maintain themselves, but do not promise to be large sources of cash. The firm should consider divesting itself of these products/services. Note that in preparing a growth-share matrix the relative market share is drawn on a log-scale. This means that equal distances represent the same percentage increase. The suggestion is that the relative market share axis be divided into high and low using 1.0 as the separating line. In terms of the vertical axis a market growth rate above 10% is typically considered to be high. Thus the BCG growth share diagram highlights those areas of the business and its environment that are critical to the achievement of its goals and objectives. The problem with all matrix approaches is that they focus on classifying current businesses, products or services but provide minimal advice for future planning. In this regard management must still use its own judgement to set the business objectives for each SBU/products or services. This is the very essence of management. Example 1: BCG Growth/Share Matrix
The BCG growth/share matrix attempts to relate critical strategic issues to the different phases of the product life cycle and to show how successful strategies must be appropriately tailored to the changing needs of the business. Required Choosing from the four possibilities for each characteristic for each type of product, complete the following table. For instance, if you expect that a product/service that is a star should have a controller style of management then put controller in that cell. You would then have to choose which of the remaining three types of management styles should be entered into each of the remaining cells. a) Management style:
controller, marketing/growth, entrepreneurial or cost minimisation
b)
Business risk:
very high, high, medium or low
c)
Financial risk:
high, medium, low or very low
d)
Cash flow position:
positive, neutral, negative or neutral
e)
Critical success factor:
maintain market share at minimum cost, growth in market share, successful new product development or minimise cost base
f)
Control measure typically considered to be appropriate with respect to each dimension of the BCG growth/share matrix:
return on investment, discounted cash flow, R&D milestones or free cash flow.
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How do I approach this question? Having undertaken previous study and read the technical information provided in this Section 5, do I have sufficient knowledge of the product life cycle, critical strategic issues and an understanding of the Boston Consulting Group matrix to classify each characteristic for each of the cash cow, star, question mark and dog products. If no, you will need to go to the primary and supplementary references provided in the section and gain more information. If yes, proceed to answer this question, commencing with an answer plan. Work through each of the pertinent steps. For example: 1. 2. Determine the identifying factors of each of the cash cow, star, question mark and dog products. Assess the relevance of each characteristic to each product.
Now you should have some idea of our answer expectations. Read the required first, then the facts, then read the required again. Plan your answer and then commence. Your workings:
Cash Cow a) Management style
Star
Question Mark
Dog
b) Business risk
c) Financial risk
d) Cash flow position
e) Critical success factor f) Control measure
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Suggested Solution Example 1: BCG Growth/Share Matrix
The following table has been constructed based on the suggestions of Ward (1992, pp.41-47).
Cash cow Management style Business risk Financial risk Cash flow position Critical success factor Control measure Controller Medium Medium Positive Maintain market share at minimum cost Return on investment Star Marketing/ growth High Low Neutral Growth in market share Discounted cash flow Question Mark Entrepreneurial Very high Very low Negative Successful new product development R and D milestones Dog Cost minimisation Low High Neutral Minimise cost base Free cash flow
5.5.2
The General Electric Company/McKinsey and Company Matrix (GEM)
The GEM matrix also determines one choice from four possible missions in a similar way to the BCG matrix. So the outputs of the planning models are the same. It is the way that we determine our competitive position that is different. With the GEM matrix the vertical axis (industry attractiveness) relates not only to market growth rate as it does with the BCG matrix, but also considers such factors as: market size, level of barriers to entry and technology. On the horizontal axis, the GEM matrix uses such factors as market share, and internal strengths such as research and design, engineering, marketing skills, alliances with suppliers and so on, to determine the business strength. The BCG matrix only uses market share to determine current business strength. It can be argued that the GEM matrix provides a more thorough analysis because of its consideration of other relevant factors. However, whether a more thorough analysis results in a more or less accurate determination of current position is uncertain. For example, if we introduce fuzzier factors to consider do we become more or less accurate? Practically it is probably best to use both method types and, if differences arise, look for reasons why, and take these into consideration when making the final decision. a) The Portfolio Matrix
Business strength Strong Industry attractiveness Average Weak
High
W inners
W inners
Question Marks
Average
W inners
Average businesses
Losers
Low
Profit producers
Losers
Losers
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b)
Recommended Business Strategies

Business strength Strong Industry attractiveness Invest/Grow strongly (Build) Invest/Grow selectively (Build) Earn/Protect (Hold) Average Invest/Grow selectively (Build) Earn/Protect (Hold) Weak Dominate/Delay/ Divest
High
Average
Harvest/Divest
Low
Harvest/Divest
Harvest/Divest
Example Wireless Rentals (WR) rents PCs, televisions, hi-fi equipment, video cassette recorders and video cameras to its customers. WR operates in an established industry with three other major competitors. Together, the four competitors hold about 95% of the electrical equipment rental market. WR holds about 35% of the total market and has a good reputation. Staff morale is generally good although in recent times some redundancies have occurred. WR operates at the lower end of the market because more affluent people prefer to buy these types of goods rather than rent them. Barriers to entry are average because basically all that is required to begin business is to purchase the equipment and obtain some service and repair skill. Significant capital investment is not required. However, obtaining a large market share is relatively difficult due to the market dominance of four different players. Market size seems to be diminishing in the well-established products such as television, video cassette recorder and video camera rental. This is partly due to the reduction in cost of these items. PC rental, which was very popular in the early 1990s, has also become less popular with many consumers deciding to purchase instead, although this market has levelled out in the last two years. Overall gross margins from all rentals have become tight in recent years. With the established products WR is likely in the Cash Cow quadrant in the BCG matrix and probably in between the Average Business Quadrant in the top GEM matrix. These positions translate into harvest and hold business strategies under each of the planning models respectively. This means WR should continue to milk existing product.
5.6
Competitive Strategies
Competitive strategies are specific courses of action designed to create sustainable competitive advantages in particular products or identified markets in the pursuit of identified objectives. They should be designed to build on the strengths, and take opportunities. They should be aligned with overcoming or reducing the internal weaknesses and threats to the organisation, as identified in the earlier SWOT analysis. Consequently, competitive strategies should be the most precise level of strategic planning since they relate to actions regarding products and markets which are to be implemented to achieve the most specific (i.e. lowest level) objectives of the organisation.
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5.6.1
Ansoff Matrix
A useful approach for identifying potential growth opportunities is the product/market expansion grid, otherwise known as the Ansoff matrix. This is represented as follows:
Products
Existing New
Existing
1. Market penetration strategy
3. Product development strategy
Markets
2. Market development strategy 4. Diversification
New
The Ansoff matrix recognises the fact that an organisation can increase its sales of products by: selling greater volumes to its existing customers (i.e. market penetration via increased market share); finding new customers to sell the product to (i.e. market development); acquiring or developing new products to sell to its existing customers (product development); or acquiring or developing new products for new customers (diversification). The choice is made from the first three potential strategies by considering the relevant strengths and weaknesses identified for that business. A SWOT analysis can assist here. For example, at WR gross margins have become very tight in recent years. Top management at WR decided that to accomplish WRs strategic mission of becoming the market leader within five years, they had to diversify. WR acquired 500 large-screen projector-style televisions for installation into hotels and boutique-bars. WR was trying to penetrate the sporting drinker market. By adopting this strategy, WR introduced a new product and penetrated a new market. This is the bottom right quadrant of the Ansoff matrix above. 5.6.2 Porters Generic Strategies
Porter (1985) identifies several potential generic strategies that will allow an organisation to obtain a competitive advantage. He argues that there are two basic types of competitive advantage an organisation can possess: low cost and differentiation. These stem from industry structure and are a result of the organisations ability to cope with the five forces (discussed earlier) better than its competitors. When the two basic types of competitive advantage are combined with the scope of the organisations activities, a third generic strategy focus can be identified. Focus strategies aim at cost advantage or differentiation in a narrower market segment than the pure low cost or differentiation strategies. Thus, if an organisation is to attain a competitive advantage it must make a choice about: a) b) the type of competitive advantage that it seeks to attain; and the scope within which it will attain that advantage.
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We can illustrate the choice of strategy on the following continuum. Note that it is not a discrete choice. Firms can choose where they want to be on the continuum. We show the choice of low cost versus differentiation on a continuum because firms dont have to make a discrete choice. Many firms compete on a combination of the two extremes. Furthermore, some firms have different strategies for different products. Porters Generic Strategies on a Continuum
Low Cost Strategy
Differentiation Strategy
The three main strategies are: Cost Leadership Under this strategy an organisation aims to become the lowest cost producer in its industry. The organisation has a broad scope and serves many industry segments. Note that the organisation must be the cost leader, not merely one of several organisations attempting to attain this position. Differentiation Under this strategy the organisation seeks to be unique in its industry along some dimension(s) that are valued by buyers. The organisation selects one or more attributes that many buyers perceive as important and uniquely positions itself to meet those needs. The means for differentiation will vary between industries. The reward for this uniqueness is the ability to charge a premium price. Focus This strategy is quite different from the others because it rests on the choice of a narrow competitive scope within an industry. The focuser selects a segment or group of segments in the industry and tailors its strategy to servicing them to the exclusion of others. By optimising its strategy for the target segments, the focuser seeks to achieve a competitive advantage in its target segments even though it does not possess a competitive advantage overall. There are two potential aspects to this approach, a cost focus or a differentiation focus. In cost focus, the organisation seeks a cost advantage in its target segment, while in differentiation focus it seeks differentiation in its target segment. The target segments must have buyers with unusual needs, or else the production and delivery system that best suits the target segment must differ from that of other industry segments. Porter suggests that an organisation that engages in each generic strategy but fails to achieve any of them is stuck in the middle. That is, it does not possess any competitive advantage and will usually experience below-average performance (relative to the industry). As the industry matures, the performance gap between organisations with a generic strategy and those without will widen considerably. Porter argues that the value chain plays a fundamental role in identifying sources of competitive advantage. The value chain identifies the total value added to the conversion of a product or service. The value added by the organisation is determined in terms of each primary (e.g. manufacturing) and support activity (e.g. administration) carried out by the organisation. The objective of the analysis is to determine the activities that contribute most significantly to the products/services total value and to develop strategies to improve, or defend, the organisations current share of that value added.
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The value chain focus is therefore external to the organisation, with each activity viewed in the context of the overall chain of value-creating activities of which it is only a part. This is in contrast to traditional management accounting that adopts a focus that is largely internal to the organisation, with each activity viewed in context of its purchases, its processes, its functions, its products, and its customers. The key theme in traditional analysis is to maximise value-added. Porter (1985, p.39) contends that the value added approach, unlike the value chain approach, fails to highlight the linkages between an organisation and its suppliers that can reduce cost or enhance differentiation.
5.7
Industry Life Cycle
The last key strategy concept to be examined is that of the industry life cycle. All products must go through a product life cycle of introduction, growth, maturity and decline and likewise must all industries. It is better of think of an industry as being a living ecosystem rather than a static snapshot, because your best strategy for today will not necessarily still be valid tomorrow. This concept was introduced in the BCG Matrix Using a very traditional Product Life Cycle approach, Dess and Lumpkin (2003) created the following table to link Porters Generic Strategies to the industry lifecycle.
INTRODUCTION GENERIC STRATEGIES GROWTH MATURITY DECLINE
Differentiation
Differentiation
Differentiation Cost Leadership
Cost Leadership Focus Negative Few Changing Low Low General Management & Finance Consolidate, maintain, harvest, or exit
MARKET GROWTH RATE NUMBER OF SEGMENTS INTENSITY OF COMPETITION EMPHASIS ON PRODUCT DESIGN EMPHASIS ON PROCESS DESIGN MAJOR FUNCTIONAL AREA OF CONCERN
Low Very few Low Very high Low Research & Development Increase Market Awareness
Very large Some Increasing High Low to moderate Sales and Marketing Create Consumer Demand
Low to moderate Many Very Intense Low to moderate High Production
OVERALL OBJECTIVE
Defend Market Share & extend product life cycles
However for a more recent perspective on Industry Ecosystems we have included the reading below by Lei and Slocum (2005). Using their terminology they say that an Industry can be described as an economic complex adaptive system by two defining characteristics: The existence of a life cycle that guides evolution within the system The rate of technological change that can dramatically reshape the configuration of the system itself
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Using this definition they have divided industries into four types as shown in the diagram below.
Rate of Technological Change

Low
3. Steady Evolution Stable Industry Structure Well-established competitors Few opportunities for product differentiation Scale and size important Cost efficiency predominates Knowledgeable customers 1. Fast Growth
High
4. Creative Destruction Rise of technological change New entrants from other industries New technologies reshape underlying value proposition Established firms face market share loss
Lifecycle Phase
Mature
2. Wild, Wild West Market boundaries uncertain Multiple competing technologies and standards Numerous entrants from a wide number of industries Value proposition in flux Need to establish customer lock-in
Growth
Focus on developing core product concept Rivals attempt to differentiate from one another Emphasis on scalability, replicable business models Value proposition seeks to build customer loyalty
Quadrant One, Fast Growth A new product concept or idea becomes the basis for fast industry growth. Firms will try to stake out and expand key portions of the market by offering their own distinctive value proposition for customers Quadrant Two, Wild, Wild West A combination of fast growth and technological ferment attracts numerous upstarts who bring novel ideas and new technologies to a highly dynamic setting. Quadrant Three, Steady Evolution Industry maturity is characterised by a stable industry structure, where large firms enjoy significant market shares. Market share for competitors has become well established, making it essential for firms to capture and sustain cost-driven efficiencies. Quadrant Four, Creative Destruction Firms in highly mature industries face the onslaught of new technologies and other technological changes from outside their industry that promise to transform the very essence of their survival.
For a more detailed discussion of the industry types and the types of strategies that firms can employ in those situations then read the following article: Strategic and organisational requirements for competitive advantage by: Lei, David; Slocum Jr., John W. Academy of Management Executive, Feb 2005, Vol. 19 Issue 1. However the key point to take away is that an industry is dynamic and that its life cycle and rate of technological change can be two key drivers in affecting the firms within in.
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5.8
Relationship Between Strategic Planning And Budgeting
In large organisations the strategic planning activity is usually separated from the budgeting activity. This does not mean that the two activities are unrelated in their objectives. It means that different levels of management are responsible for their development. We consider this relationship in more detail in Section 7. In that section it is noted that: Budgets usually involve one year (short term), whereas strategic plans cover periods longer than one year, and often five years. Strategic plans tend to contain relatively little financial data, whereas budgets are usually financially based. The strategic plan is often structured by product/service, whereas a budget is normally structured by responsibility centre.
It should also be noted that there is a strong relationship between strategic planning and capital budgeting. Often, capital budgets are viewed as concrete financial embodiments of strategic plans. Capital budgeting is discussed in detail in Section 12.
5.9
Ethics In Strategy Formation, Operations And Evaluation
The problems that confront business executives are many. Some of the most complex and difficult involve situations concerning right and wrong where values are in conflict. These situations are called ethical dilemmas. With corporate scandals and billion-dollar bankruptcies dominating headlines, ethics has almost become a hotter topic than earnings in the business world. Corporate icons such as Enrons former chairman Kenneth Lay were once held up as examples of successful business leaders. Now they have re-emerged as subjects of corporate case studies in what not to do. In the Asia/Pacific region, the H.I.H. scandal in Australia has highlighted the fact that these ethical issues are not confined to North America. 5.9.1 Do Business and Ethics Go Together?
It is sometimes argued that business and ethics do not go together. For example, succeeding in business is largely about advancing our own private interests - aggressively competing against other people, beating them out for the same prize, and having unlimited ambition for money, position, and power. The moral life, by contrast, focuses on our duties to others - not to hurt anyone (deliberately or accidentally), to place other peoples interests ahead of our own when its called for, and always to treat others with the dignity and respect they deserve. Being scrupulously honest and caring in our business dealings with others can sometimes cost us sales, deals, money, and promotions. Refusing to go along with other peoples unethical behaviour can sometimes even cost us our jobs. However, when taken too far in business, even healthy self-interest, competitiveness, and ambition can turn into selfishness, aggression, and greed - traits that are clearly at odds with the moral life. It seems, then, that taking ethics seriously in business extracts a price and may make success more difficult to come by. However, it is inconceivable that most people would ever freely endorse the idea that dishonesty, manipulation and taking advantage of other people were acceptable, fundamental traits of the basic mechanism by which society makes and distributes essential goods and services.
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5.9.2
Obeying the Law
We assume that where laws are involved, you plan to obey them. This isnt to say that its always morally wrong to break laws. But in ethical dilemmas that arise in business, the laws generally establish at least a bare minimum for how you should act. Besides, if a business regularly breaks laws, it becomes an anti-social force in society. And no matter how much money is involved, at that point, there is not a huge difference between a business and organized crime. A wide range of laws needs to be understood by strategic decision makers, including company law, advertising law, employment law, health and safety, contract, fraud, negligence, and specific laws relating to the organisations business products. 5.9.3 Examples of Unethical Corporate Strategies
Many types of business strategy may be considered unethical by some or most people, while not always breaking the law of the country in which the organisation is operating. Examples include: Unethical advertising: breaking advertising codes and standards Not telling customers about known risks associated with the companys products Lack of social responsibility: e.g. Non observance of human rights Subjecting employees to an unhealthy or unsafe working environment Use of child labour Discrimination against minorities
Lack of respect for the environment; short term gains at the expense of long term environmental damage Lack of accountability for actions: e.g. Provision of minimum financial information to stakeholders Creative accounting, bordering on fraud
Corruption: giving and receiving bribes to further business interests
The opportunities for unethical behaviour increase as new technologies emerge. For example, e-commerce has now opened new ways in which unscrupulous organisations can make unfair gains. 5.9.4 Who Determines what is Ethical and Unethical Behaviour?
Clearly this is a difficult question to answer, as different religions, cultures and philosophies provide differing guidance. Professional organisations, societies and trade organisations attempt to add to this general guidance and to supplement the requirements of laws relating their specific areas. However, there is a need for some generally acceptable ethical standards which will help organisations to compete on a level playing field.
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Hong Kong Institute of CPAs Code of Ethics for Professional Accountants The HKICPA Code of Ethics was revised effective June 2006 and requires a professional accountant to comply with the following fundamental principles: a) Integrity A professional accountant should be straightforward and honest in all professional and business relationships. b) Objectivity A professional accountant should not allow bias, conflict of interest or undue influence of others to override professional or business judgements. c) Professional Competence and Due Care A professional accountant has a continuing duty to maintain professional knowledge and skill at the level required to ensure that a client or employer receives competent professional service based on current developments on practice, legislation and techniques. A professional accountant should act diligently and in accordance with applicable technical and professional standards when providing professional services. d) Confidentiality A professional accountant should respect the confidentiality of information acquired as a result of professional and business relationships and should not disclose any such information to third parties without proper and specific authority unless there is a legal or professional right or duty to disclose. Confidential information acquired as a result of professional and business relationships should not be used for the personal advantage of the professional accountant or third parties. e) Professional Behaviour A professional accountant should comply with relevant laws and regulations and should avoid any action that discredits the profession. These five requirements apply not only to professional accountants in public practice, but also to professional accountants in business. The Code of Ethics has a separate section dealing with professional accountants in business. This section (Section 300) contains guidance in a number of areas as follows: Threats and safeguards Potential conflicts Preparing and reporting of information Acting with sufficient expertise Financial interests Inducements, including receiving and making offers
Candidates should obtain a copy of the Code of Ethics and read the provisions to obtain more details.
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5.9.5
The Characteristics of Ethical Organisations
Mark Pastin, in The Hard Problems of Management: Gaining the Ethics Edge (Jossey-Bass, 1986), provides the following four principles for highly ethical organizations: 1. They are at ease interacting with diverse internal and external stakeholder groups. The ground-rules of these firms make the good of these stakeholder groups part of the organizations' own good. They are obsessed with fairness. Their ground-rules emphasise that the other persons' interests count as much as their own. Responsibility is individual rather than collective, with individuals assuming personal responsibility for actions of the organization. These organizations' ground-rules mandate that individuals are responsible to themselves. They see their activities in terms of purpose. This purpose is a way of operating that members of the organization highly value. And purpose ties the organization to its environment.
2. 3.
4.
Doug Wallace asserts the following characteristics of a high integrity organization: 1. 2. 3. 4. 5. 6. There exists a clear vision and picture of integrity throughout the organization. The vision is owned and embodied by top management, over time. The reward system is aligned with the vision of integrity. Policies and practices of the organization are aligned with the vision; there are no mixed messages. It is understood that every significant management decision has ethical value dimensions. Everyone is expected to work through conflicting-stakeholder value perspectives.
Solving Ethical Dilemmas Generally speaking, there are two major approaches that philosophers use in handling ethical dilemmas. One approach focuses on the practical consequences of what we do; the other concentrates on the actions themselves. The first school of thought basically argues "no harm, no foul"; the second claims that some actions are simply wrong. Thinkers have debated the relative merits of these approaches for centuries, but for the purpose of getting help with handling ethical dilemmas, think of them as complementary strategies for analyzing and resolving problems. Here is a brief, three-step strategy that shows you how to combine them. Step 1: Analyze The Consequences Assuming you are going to obey the law, what next? Its probably easiest to start by looking at the consequences of the actions youre considering. Assume you have a variety of options. Consider the range of both positive and negative consequences connected with each one. Who will be helped by what you do? Who will be hurt? What kind of benefits and harms are we talking about?
After all, some "goods" in life (e.g. health) are more valuable than others (e.g. a cash bonus). A small amount of "high quality" good can outweigh a larger amount of "lower quality" good.
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By the same token, a small amount of "high quality" harm (the pain you produce if you betray someones trust on a very important matter) can outweigh a larger amount of "lower quality" pain (e.g. the disappointment connected with waiting another few months for a promotion). How does this entire look over the long run as well as the short run?
After looking at all of your options, which one produces the best mix of benefits over harms? Step 2: Analyze The Actions Now consider all of your options from a completely different perspective. Dont think about the consequences. Concentrate instead strictly on the actions. How do they measure up against moral principles like honesty, fairness, equality, respecting the dignity of others, respecting people's rights, and recognizing the vulnerability of individuals weaker or less fortunate than others? Do any of the actions that you are considering "cross the line," in terms of anything from simple decency to an important ethical principle? If there's a conflict between principles or between the rights of different people involved, is there a way to see one principle as more important than the others? What you are looking for is the option whose actions are least problematic. Step 3: Make A Decision Now take both parts of your analysis into account and make a decision. This strategy should give you at least some basic steps you can follow. The American Accounting Association Model In 1990, the American Accounting Association (AAA) published a casebook, Ethics in the 3 Accounting Curriculum - Cases and Readings . These cases reflect ethical issues that accountants may encounter in the context of their professional activities. Each case is analysed using a seven-step model. The seven step decision-making model used in this case book was 4 adapted from an eight step model by Langenderfer and Rockness . This model attempts to review Aristotles three aspects of human acts: Principles and Causes; Means; and Ends of Consequences. The use of the AAA Model is advocated as a way of dealing with ethical dilemmas. It does not supplant the Hong Institute of CPAs Code of Ethics. Rather it is suggested as a tool to enable professional accountants to deal with real-life ethical dilemmas in a practical way.
3 4
See for example Ethics in the Accounting Curriculum: Cases and Readings cited by W M May, American Accounting Association, Sarasota, Florida, 1990 H Q Langenderfer and J W Rockness, Integrating Ethics into the Accounting Curriculum - Issues, Problems and Solutions, Issues in Accounting Education, 1989, 4, 1, pp. 58-69
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The American Accounting Association Seven-Step Result 1. Determine the Facts What? Who? Where? When? How? What do we know or need to know if possible, that will help define the problem? 2. Define the Ethical Issue List the significant stakeholders. Define the ethical issues. Make sure what precisely the ethical issue is (e.g. conflict involving rights question over limits of an obligation, etc.) 3. Identify the Major Principles, Rules and Values (e.g. integrity, quality, respect for persons, profit) 4. Specify the Alternatives List the major alternative courses of action, including those that represent some form of compromise or point between simply doing or not doing something. 5. Compare Values and Alternatives - See if Clear Decision Determine if there is one principle or value, or combination which is so compelling that the proper alternative is clear (e.g. correcting a defect that is almost certain to cause loss of life). 6. Assess the Consequences Identify the short and long, positive and negative consequences for the major alternatives. The common short-run focus on gain or loss needs to be measured against the long-run considerations. This step will often reveal an unanticipated result of major importance. 7. Make your Decision Balance the consequences against your primary principles or values and select the alternative that best fits. 5.9.6 Case Study Using the AAA Decision-making Model
Example John CPA was appointed as Managing Director of Huge Profits Limited on 31 May 2009. Huge Profits Limited is a publicly listed company that has reported regular profits for the last 5 years. Unusually, given the recent economic problems, 2009 has been an exceptionally profitable year with the company winning a number of overseas contracts. Whilst the future for Huge Profits Limited still appears favourable, some of these contracts were one-offs, and so reported profits for future years may not be as high as 2009. One of Johns first tasks as Managing Director is to facilitate the completion of the companys financial statements for the year ended 30 June 2009. Whilst John is pleased with the exceptional profit recorded in the companys draft financial accounts, he is aware that the nonrecurring nature of some of the contracts may result in a reduced profit for 2010. As this will be his first year at the helm of the company, a drop in profits may reflect poorly on his performance and his 2010 bonus. With that in mind, John is considering the possibility of raising a number of large provisions in 2009 which would have the effect of smoothing out the profits over 2009 and 2010.
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These provisions are causing John some concern because the company has a profit incentive scheme for middle and top level managers. Any reduction in profit will directly correlate to a reduction in bonuses. Using the AAA model, work through this situation to determine what John should do. Suggested Solution 1. Determine the Facts 2. John, a Certified Public Accountant, has recently been appointed Managing Director of Huge Profits. Johns appointment is just prior to the end of the financial year. The company has historically reported profit, however, this year it is likely to report large profits due to some one-off contracts. John has reviewed the preliminary profit figures and is considering raising a number of significant provisions. John is concerned that if profits fall in the following year, his performance as a Managing Director may be questioned. His bonus in 2010 will also be affected. Any reduction in profits will result in a reduction in bonuses paid to middle and top level management in 2009 and their potential postponement till 2010.
Define the Ethical Issue Stakeholders: John. The employees of the company (particularly middle level and top level managers). Shareholders of the company. Potential investors. The Hong Kong Institute of Certified Public Accountants. Johns integrity in the reporting of financial results Johns obligation to employees, shareholders and potential investors Johns obligation to employees, shareholders and potential investors -vPersonal self-interest (objectivity) in the evaluation of his own future performance and 2007 bonus. Maintenance of technical standards and competence and, accordingly, Johns responsibilities to conduct himself in a manner consistent with the good reputation of his profession. Personal self-interest.
-v-
-v-
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3.
Identify the Major Principles, Rules and Values Objectivity John must not allow the judgement of his own performance to impact the preparation of the current year financial statements. Integrity John has a responsibility to shareholders, employees and future investors to provide them with honest information concerning the performance of the company. Technical Standards/Competence Preparation of the companys Financial Accounts must be complete in accordance with technical and professional standards.
4.
Specify the Alternatives The major alternatives are as follows: John can report the figures as they are. John can book the provisions. John can look for alternative means of disclosure.
5.
Compare Values and Alternatives By reporting the figures as they are, John will maintain his integrity and objectivity. This course of action may however result in a personal cost. John can book the provisions which may impair his integrity, objectivity and result in a possible breach of technical standards/competence. Booking the provisions also raises moral and ethical considerations in relation to the payment of bonuses. By the use of alternative disclosures, e.g. Notes to the Accounts, John may be able to report the true result thus maintaining his integrity, objectivity and technical standards, fulfil his moral obligations with respect to the payment of bonuses, and not detract from his own performance in the future.
6.
Assess the Consequences By reporting the actual figures, John will ensure shareholder and employee satisfaction. A drop in future profits may not only have an adverse effect on him personally, but on potential investors who invest in the company based on the current years results. If these profits are not sustainable, then the reporting of lower profits in the future may result in losses to investors. Booking provisions and effectively smoothing out profits may prove to be more palatable to John personally, and possibly potential investors. Current shareholders and certainly employees who will receive reduced bonuses/dividends in the current financial year will be disadvantaged. Adopting alternative means of disclosure may result in a win/win situation. Detailed disclosure may provide an opportunity to report actual results for the current financial year and, therefore, benefit the relevant stakeholders. In addition, by disclosing that profits were the result of one-off contracts, any future profit reductions may not be judged adversely against John. Further potential investors may consider the current year in isolation when forming their investment strategies. This is based on the assumption that markets are efficient.
7.
Make Your Decision Balance the consequences against your primary principles or values and select the alternative that best suits.
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5.9.7
The Legal and Professional Environment
In free-market economies the over-riding legal obligation of all companies is to maximise shareholders wealth. The legal and professional framework sets minimum standards that must be observed in pursuit of that goal. For example: The Companies Ordinance, the Securities & Future Ordinance and Corporate Governance guidelines protect the interests of the shareholders and creditors. Health, safety and employment laws protect the interests of employees. Consumer legislation protects the interests of the customers.
A business can observe the letter of the law strictly but still attract allegations of unethical behaviour. Recent examples would include: Excessive pay for directors. Paying dividends while at the same time laying-off staff. Selling tobacco, alcohol, weapons or other potentially harmful products.
One powerful American executive (now fallen from grace) once boasted that he would sell a legal product even if he knew that it was dangerous. His duty was to make money; it was up to the government to protect the consumer. 5.9.8 The Demands of Stakeholders
Legally, the shareholders are the most important group of stakeholders. However, in practice there are other groups who may have the power to influence a companys policies. It is the directors duty to balance these conflicting demands, while at the same time preserving the interests of the shareholders. Examples of stakeholders, their power and their interests are noted below: 1 Shareholders
Traditionally, shareholders who do not have board control have been passive investors, and almost apathetic when it came to protecting their own interests or monitoring the behaviour of their company. Shareholders themselves come in two groups: the small private investor and the institutional investors. 1a Private Investors
These people have relatively little influence over company policies. They only tend to exert their power if their shares are performing badly at the same time that the directors are receiving payrises. They become powerful during takeover battles, although they probably follow the lead set by the big institutional shareholders. There is little evidence that private investors have any influence over (or desire to influence) the ethics of their company.
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1b
Institutional Shareholders
Quite often, the majority of shares in large publicly quoted companies not owned by controlling shareholders are held by institutions. Many such institutions are pension funds. This has the strange affect that in a highly capitalist country like Britain, one of the main beneficiaries of that capitalism is the old age pensioner. This might lead you to suspect that these institutions would invest in companies that showed a social conscience and behaved ethically. However, a pension fund is legally required to maximise the benefits available for its pensioners. This means that they must invest in the companies that pay the best dividends and show the biggest increase in the value of their shares. It is of no concern to them how those profits have been made in the first place. In recent years ethical investment funds have been formed. These funds either avoid investing in certain areas (e.g., weapons, tobacco, polluting industries) or seek out positively good companies that, say, have a good investment record in developing countries. Obviously, these funds will encourage some companies to maintain their ethical standards, but as yet they are not powerful enough to exert pressure on companies who do not have such high standards. 2 2a Directors Directors Pay
Legally, the Directors are the servants of the shareholders. However, in practice they have their hands on the company cheque book, and they are often accused of using it to their own advantage. Most of the recent guidelines on Corporate Governance have centred on the disclosure of directors pay and benefits. The argument is that there is no right or wrong level of pay for a director. As long as the shareholders are made aware of the full amount of pay that directors receive, it is then up to the shareholders to decide whether they can earn their pay at the annual general meeting when the shareholders vote on the annual accounts which contain such sums. In this situation Directors earn their pay by increasing the companys profits, dividends and share-price. Recently though, there have been suspicions that there is no link between pay and performance. In September 2002 William McDonough of the US Federal Reserve pointed out that executive remuneration was 400 times that of the average production worker, whereas it was only 42 times twenty years ago. He went on to comment that Executive pay is excessive, it should be adjusted to more reasonable and justifiable levels truly related to the benefit of shareholders and other stakeholders such as workers and the community. The argument is that excessive pay is unethical, even if it is legal. However, it will be up to the Board as a whole and the shareholders to ensure a return to more reasonable levels of pay. 2b Controlling the Directors
The directors control the business, but we have seen that the shareholders have been unable or unwilling to control the directors. The Combined Code for companies listed on the London Stock Exchange requires companies to have non-executive directors. These directors should monitor the conduct of the executive directors. Their most obvious task is to set executive pay, but they are also meant to ensure that the companies business as a whole is being run properly. The financial side of this responsibility should be straight-forward. Financial controls are fairly standard, and they are easily monitored by internal audit departments. However, there is an implication that they should be responsible for ensuring good conduct in the operational side of the business as well. This role has not yet been fully developed.
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In some European countries, such as Germany, the Board of Directors is controlled in turn by a Supervisory Board. The Supervisory Board contains representatives elected by shareholders and workers. This structure was certainly influential in improving the pay and conditions for German workers, which would suggest that they have a positive ethical influence on a companys policies. However, now that the German Economic Miracle is well and truly over there are doubts as to whether its influence was for the long-term good of the German worker. Also, there was little evidence that other stakeholders benefited from the arrangement, such as customers, guest workers or the unemployed. In Hong Kong companies listed on the Stock Exchange are characterised by family controlled companies. The listing rules, while evolving to follow international trends, serve to make directors pay and actions more transparent, and for connected transactions to be approved by disinterested/unconnected shareholders. Independent non-executive directors are taking more prominent roles in corporate governance. 3 Workers
Workers often have formal representation within a business, either at Board level or via their Trade Union. They are able to influence company policy through negotiation, backed up by the threat of strike action. Traditionally workers and unions have campaigned for better pay and working conditions, which would suggest a positive ethical influence on their employers. However, globalisation has caused ethical uncertainty. Good pay can lead to job losses as production is switched to low cost countries. Job losses in your own country are bad, and a company could be accused of being unethical. But maybe it is more ethical to create jobs in a poor country than preserve them in a rich country? In Hong Kong, there is neither statutory right nor a general practice for workers to be represented at Board level. 4 Customers and the General Public
Customers have no formal connection with the management of a business, but in practice they can have the biggest influence on its ethics. During the Apartheid years in South Africa many customers boycotted South African produce. Many businesses in Britain, Europe and America were forced to disinvest in South Africa (and some probably disinvested voluntarily). However, many other famous global companies continued to operate profitably in South Africa and suffered little damage from these boycotts. So, customers are powerful, but their influence is not always fair. 5.9.9 Cultural Traditions
Most companies will be familiar with their own cultural traditions. However, globalisation means that businesses might expand overseas, or be taken over by a foreign parent. International regulations and standards (such as European Union Directives or International Accounting Standards) are increasing being adopted by many countries. These all raise the possibilities of cultural conflict, and, perhaps, over-compensation. A few examples are noted below. Gifts When is a gift a bribe? In many Asian countries the giving of presents is merely good manners rather than a bribe. This might seem unethical to a westerner, but it is routine for British audit firms to take key clients to the opera or rugby match at the cost of a couple of hundred pounds per head. Whats the difference?
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Relations with Staff Most multi-nationals are meritocracies, where the bright young star can rise quickly. In other countries age may be as important as ability when it comes to promotion. Personal contacts might be essential before hiring a manger. Western companies often have a slightly ruthless approach to hiring and firing, whereas Asian companies (in good times) have been reluctant to shed staff. Relations with Bankers and Shareholders Many European companies have closer links with their banks than with their shareholders. From the British or American point of view this is tantamount to insider dealing and a breach of duty towards the shareholders. Europeans think that the British method is unfettered capitalism at its worse. Ethics The corporate ethic of a business and the personal ethics of its managers and staff should enable a business to reconcile these conflicts to the benefit of all concerned. Rule books and procedure manuals will be no substitute for personal honesty and integrity, and the example of good behaviour should be set from the top. This may be one reason why excessive executive pay can taint a whole organisation. In practice, a company should consider how the various stakeholders would interpret their actions. When devising strategy the directors should consider its impact on the various stakeholders, and consider how they would judge the companys behaviour. Because there must always be a trade-off between the various interest groups, the directors must justify their choices, and show that they are to the benefit of all concerned. In particular, they must re-assure shareholders that a policy that might cause lower profits in the short-run will lead to better profits in the long-run. The non-executive directors and internal audit departments would have a key role to play in ensuring that corporate policies were being carried out properly, and that ethics were being maintained throughout the organisation. Example 2: Kowloon Copper Products
Kowloon Copper Products (a fictitious company) is a thriving manufacturer of all types of plumbing supplies. It employs one thousand skilled workers in Hong Kong. It has made good profits over the years, and the hundred or so shareholders are all now quite wealthy. However, it has recently been suffering from intense competition from metal producers based in lower-cost economies, and it has barely made a profit for the last three years. The company is now facing difficulties in servicing its bank loans. The Board have proposed that all copper production should be shifted to Zambia. Zambia has been chosen because it is close to the raw materials, offers very low labour costs and is at the heart of one of their major export markets. The move will cause 500 job losses in Hong Kong. The remaining staff will continue to design and manufacture the more high-tech plumbing supplies, such as pumps, boilers and so on. These products are profitable and they have been subsidising the losses made from the copper side of the business. Tasks a) Gauge the reaction to this proposal from the following stakeholders.

The shareholders. The workers. The local economy.
b) c)
What questions should a non-executive director ask about the proposals? As a director shows that your proposal is in the best interests of all concerned.
(printed May 2010)
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Suggested Solution Example 2: Kowloon Copper Products
Kowloon Copper Products a) The Likely Reaction to the Proposal from the Stakeholders
The shareholders They will probably support the proposal. They will not be making much money on their shares at the moment, and they are in danger of losing their company altogether if it defaults on its loans. In the absence of any better proposals, they have no alternative but to support the plans. The workers They will not be pleased about the loss of 500 jobs, but it seems that the alternative would be the loss of all one thousand jobs. It may be that as the company will be keeping the more high-tech aspects of the business in Hong Kong then there will be good prospects for future growth leading to more work and better pay in the long run. The local economy This will suffer an immediate hit with the loss of 500 wage earners and wage-spenders. However, this is better than losing all one thousand workers. Also, the economy will benefit from the profits remitted back from Zambia, making Hong Kong wealthier. This money can then be used to fund new investment and new jobs. If KCP were to go out of business, then the Banks would lose money, reducing the amount of capital available for new investment. b) What questions should a non-executive director ask about the proposals? c) How financially secure the investment in Zambia will be. Where the cash for the investment will come from. What inducements have been offered by the Zambian government to invest there. What conditions might be attached to any inducements. How easy it will be to control the operations in Zambia. What redundancy packages will the 500 workers receive?
As a director shows that your proposal is in the best interests of all concerned. The alternative to closing the copper division is closing the whole business. In future the profits from the high-tech side of the business can be re-invested in new ventures rather than being swallowed up by the loss making copper business. The Zambian operation should be successful, and the profits will be remitted to Hong Kong. The Zambian investment will create jobs and new customers in a poor country.
(printed May 2010)
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5.10
Global Financial Crisis and Business Strategy
The global financial meltdown which occurred in 2008 2009 had some significant implications for business strategy, especially strategic risk management. A detailed coverage of risk management may be found in CLP Section 14, but some observations are appropriate at this 5 point. These observations are drawn from an article by Geof Mortlock , published in March 2009. At any stage of an economic cycle, sound risk management, supported by effective governance, is essential to an organisations strategy. This is true for all sectors of the economy, including households, businesses and government. It is especially true in periods of economic stress. Inadequacies in risk management have been one of the main causes of the current global economic difficulties. This has been clearly evident in the financial sector in the United States and Europe, where high-risk lending, excessive leverage, poorly managed off-balance exposures and inadequate liquidity have contributed to widespread financial distress. Deficiencies in strategic risk management and governance have also been prevalent in parts of the business sector in many countries. As economies around the world move deeper into recession, weaknesses in risk management and governance are being increasingly exposed. The current economic downturn will place a premium on sound strategic risk management. For many businesses, large and small, and across all parts of the economy, the ability to identify, monitor and manage risks will be a major influence on whether they survive. 5.10.1 Risks Need to be Managed All business activity involves taking risks. This is an essential part of being in business. Running a sound business is not about eliminating risks. But it does require a clear understanding of what risks you are taking, of knowing when risks are and are not justified by the rewards available, and of being able to manage the risks to which the business is exposed. A well-run business will have much greater capacity to endure periods of economic stress than one with poor risk management. For every business, sound risk management requires systems and procedures for the identification, monitoring and management of all material risks. It also requires internal controls and audit to ensure that the risk management systems are being applied properly. And no risk management system or internal control will be effective without people with the requisite expertise to run them.
Mortlock, Geof, Exposing the cracks and fixing them, Chartered Accountants Journal, March 2009
(printed May 2010)
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5.10.2 The Need to Monitor the Business A fundamental need of any business, and a vital element of risk management, is the ability to identify and monitor key financial information relating to the business. The required information will vary greatly depending on the size and nature of the business. At the least, there is a need for accounting systems that enable the owners, the board of directors, and management to reliably identify, measure and monitor the business income and expenses, margins by key business lines, profit and profitability, cash flow, assets (including inventory), liabilities and offbalance sheet positions. These information systems should also enable the identification, measurement and management of key risk positions, such as those relating to liquidity, credit exposure concentration, dealings with related parties, duration of accounts receivable and payable, market risk positions, and inventory turnover. The systems need not necessarily be sophisticated, particularly for small businesses. But they do need to be reliable and to produce information that is complete, accurate, relatively frequent and timely. It is also important that the information is subject to periodic external audit or review to ensure its completeness and accuracy. 5.10.3 Cash Flow and Liquidity Risk A fundamental risk for most businesses is cash flow and liquidity. If a business cannot meet its obligations as they fall due, regardless of how profitable it may be, it will not be in business for long. In periods of economic downturn, many businesses will come under liquidity stress. Weakening revenue, delayed payment of receivables, higher levels of inventory, de-leveraging and potentially a shortened average maturity of debt are likely to put many businesses under liquidity pressures. This places a premium on the need for businesses to manage liquidity carefully. Sound liquidity management depends on the nature of the business, but typically includes a reliable means of tracking cash inflows and outflows, projecting future cash flow and maintaining adequate levels of liquid assets. It also means having the capacity to access liquidity from external providers, such as banks and the business owners, preferably through more than one source. It is especially important for businesses to maintain the confidence of their banker, ensuring that the bank is provided with regular updates on the business. For financial institutions, the management of liquidity is more complicated and requires not just holding sufficient liquid assets for expected outflows, but also to have contingency arrangements for unexpected liquidity shocks. It also means paying close attention to maturity mismatch between assets and liabilities, with a view to avoiding excessive mismatch positions.
(printed May 2010)
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5.10.4 Managing Assets and Credit Risks For many businesses, a critical aspect of risk management is the management of assets and credit risks on exposure positions. This is especially so in a period of economic downturn, given the risk of falling asset prices, lowered returns on assets, an increased risk of counterparty default and the build-up of excessive levels of inventory. Wherever possible, businesses need to ensure that funds are held in productive assets, rather than in assets that have little or no prospect of investment return. It is always important to recognise that a significant cost of holding any asset is the foregone return from investing the funds in an alternative asset or in repaying debt. This suggests the need for careful attention to holdings of fixed assets, which can impose significant funding and opportunity costs on a business. For businesses which trade in goods, there is a need to ensure that inventory is monitored and managed closely, including the capacity to identify fast and slow-moving inventory and to pare back inventory with low turnover. For financial institutions, the management of credit risk is fundamental. In periods of recession, credit risks tend to increase as growing proportions of borrowers struggle to service their debt and asset prices fall. This exposes a risk of losses for financial institutions, particularly in a situation where there is a combination of weakening incomes, rising unemployment and falling collateral prices. Financial institutions with a significant proportion of their portfolio in loans with high debt servicing-to-income ratios and loan-to-valuation ratios, are especially vulnerable to increasing provisioning expenses and loan write-offs. It is therefore important for financial institutions and other firms that extend credit to ensure that credit proposals are subject to close scrutiny and stress testing, and that credit is only extended on the basis of prudent lending criteria. In periods of economic stress, it is also important for financial institutions to prudently manage under-performing exposures, loans in arrears and impaired assets. Early intervention is essential, both for the lender and the borrower. Wherever possible, the focus should be on assisting the borrower to get through the period of stress, or otherwise to implement a plan that minimises losses for both parties. Related party lending is another important source of risk. It is crucial that all proposals for extending credit to related parties are subject to particular scrutiny (including by independent directors), are on strictly arms length terms and are subject to conservative limits. 5.10.5 Liability Management Sound management of assets is crucial for survival in periods of economic stress, and so too is the prudent management of a firms liabilities. In particular, the level of debt relative to total assets (leverage) is a key factor in determining a firms ability to survive economic stress. Business failures in any sector of the economy are often associated with excessive leverage. This is particularly the case in periods of economic downturn, due to falling revenues, weakening profit (or losses) and volatile cash flows. It is therefore crucial that businesses try to establish and maintain levels of debt that can be serviced comfortably in lean times. This suggests the need for firms to conduct stress tests to assess the ability of the business to continue to service its debt in situations where revenue, profit and cash flow are all under stress. The maturity profile of debt is also an important risk that needs to be managed carefully. Firms with a prudent level of leverage may still fall victim to economic stress if they have a large concentration of short-term debt. In good times, firms may be able to roll over short-term debt quite easily. In bad times, banks and other providers of debt funding may be cautious in extending credit to even quite sound firms. It is therefore prudent to try to spread the maturity of funding and to avoid excessive concentration of short-term debt.
(printed May 2010)
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5.10.6 Market Risks A significant risk for many businesses is market risk, defined as the potential impact on profit and capital resulting from the movement in market prices. Market risk can arise in numerous ways. The most common forms are interest rate risks (the potential losses arising from changes in interest rates) and foreign exchange risk (the potential loss arising from changes in exchange rates). Strategies to manage these risks are covered extensively in CLP Sections 13 and 14. 5.10.7 Operational Risk A risk that all too often is over-looked in businesses is operational risk. Operational risks are wide ranging in nature and vary considerably from business to business. They can include risks arising from inadequate internal controls, lack of separation between functions with conflicts of interest, key person risk, business continuity risk, IT risks, fraud or defalcation, litigation risks and documentation risks. These risks can be difficult to identify, measure and control. However, several tools are available to assist businesses to do this. These include: periodic operational risk assessments, the use of well-designed internal controls, an effective internal audit process, robust separation of conflicting functions, information documentation procedures, staff rotation, succession planning, and IT system back-up arrangements. A good starting point as with all risks is awareness of the potential for loss arising from operational risks. 5.10.8 Corporate Governance The effectiveness of risk management will much depend on the adequacy of corporate governance. Sound governance is the foundation for effective risk management. All businesses, no matter how large or small, need robust governance arrangements. The nature of governance arrangements will obviously vary greatly depending on the size and nature of the business, and on its legal form. Small firms, and particularly those that operate as sole traders, need only relatively simple governance arrangements, while larger firms and those operating in corporate form need more structured governance arrangements. But governance is always crucial. Regardless of the size or nature of a business, the basic governance principles remain much the same. In essence, any business needs to ensure that its owners and/or board: establish and periodically review the strategic direction for the business identify the strengths, weaknesses, opportunities, threats and risks of the business ensure that all material risks are being effectively identified, measured, monitored and managed ensure that the incentive structures within the business are designed to promote the long-term soundness of the business and do not create perverse incentives such as an excessive focus on short-term results at the expense of longer term financial health ensure that the performance of all aspects of the business is kept under close review maintain close oversight of the management team.
(printed May 2010)
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For businesses which have a board of directors, some basic principles and practices can help to promote effective corporate governance. A board should have sufficient numbers of directors to provide diversity of view, a blend of skills and knowledge, and the capacity to provide effective scrutiny of management. Boards with just one or two directors even for quite small businesses are likely to be less effective in overseeing the business, and in providing robust scrutiny of management, than a board with at least four or five directors. A board should generally have at least some truly independent directors, i.e. persons with no business or personal connections with the firm. Depending on the business, a majority of independent directors can be desirable. Independent directors have the capacity to bring fresh perspectives on the strategic direction of the business, to provide scrutiny of dealings with related parties and to enhance the boards oversight of the management team. It is generally desirable to have a non-executive chairman of the board; and often desirable for the chairman to be fully independent. This increases the effectiveness of board scrutiny of senior management. There should be a thorough process for selecting and appointing directors, with careful attention to ensuring the right blend of skills and knowledge for the board, avoidance of significant conflicts of interest, ensuring that any appointee can devote the requisite time and energy to the director position, and ensuring that prospective appointees are subject to scrutiny for integrity and reputation. The board should have a charter, setting out the key functions and operating rules of the board. This should be reviewed from time to time to ensure it remains relevant to the business as it evolves. The board needs to focus its attention on the management of the firms risks, the effectiveness of internal controls and the audit process. In larger firms this is often best achieved through dedicated board committees (such as risk management committees, compliance committees and audit committees) which are chaired and mainly comprising non-executive directors. In small firms there might not always be scope to maintain board committees for these functions, but there should still be structured processes for the board to oversee these vital aspects of the business. The board should take responsibility for, and oversee, periodic stress testing of the business, i.e. procedures for assessing the firms capacity to withstand economic and financial shocks. This helps to inform the adequacy of risk management structures, including capital, and to help the board adjust these structures to help ensure the firms survival in periods of stress. An important function of the board is to periodically ensure that the firms governance and risk management arrangements are subject to external review, beyond the annual audit process. It is equally important for the board to periodically assess its own performance and to seek feedback from owners, management, relevant staff and external parties.
5.10.9 Conclusion Hong Kong has been in a period of considerable economic stress. This has tested the capacity of many businesses. A key to survival was robust governance and risk management. The economy has emerged from the recession and has begun the next cyclical upturn, but the need for vigilant strategic risk management and governance will continue. Indeed, all too often it is in periods of economic buoyancy that firms forget the lessons learned in hard times and relax their standards to their subsequent regret.
(printed May 2010)
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Part D
Practice Question 1 [20 Marks]
You are a CPA and a management accountant for a manufacturing company. Your immediate superior is a very forceful domineering individual and you have accepted his views over the last two years on the level of work in progress (WIP). He has given you specific assurances that WIP has increased by 200% during the current reporting period, and instructed you to report this level in the monthly management accounts. The year end draft financial statements show that the firm has only just met its business plan financial targets. Evidence then becomes available (of which you were not aware when the draft financial statements were produced), to indicate that something is clearly wrong and that the WIP has not increased at anywhere near the rate advised by your superior. Required Use the American Accounting Association (AAA) Model to analyse the ethical issues involved. Suggested solution Practice Question 1 Timing (minutes) Total time spent on question: 30 30 minutes [20 Marks]
As usual with ethical dilemmas, there is no easy solution to this issue, particularly when you are a subordinate in an organisation. The AAA Model results in the following solution. 1. Determine the facts
Consider the firm's policies, procedures and guidelines, accounting standards, best practices, code of ethics, and applicable laws and regulations. Is the evidence that the work in process (WIP) is incorrectly stated supported by other documentation? For example has there been an analytical review of cost of goods sold and product profit margins. Or is there evidence in the firm's detailed costing records, which would support an appropriate WIP figure? 2. Define the ethical issues
The stakeholders are: Yourself, as an employee and a CPA Your superior Other employees of the company Senior management of the company The directors of the company Current and future creditors and investors in the company
The major ethical issue is whether you should condone a practice which you believe to be suspect. This may compromise the ethics of your profession, as well affect other employees, directors and shareholders, and current and future creditors and investors.
(printed May 2010)
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3.
Identify the major principles, rules and values
Integrity - As a CPA, you have a responsibility to senior management, shareholders, and future investors, to ensure that accounting records and reports are reliable. Will you be able to demonstrate that the financial statements are reliable without redrafting? Objectivity - How will you be able to maintain your objectivity, given that your immediate superior is a forceful and perhaps intimidating individual? Technical and Professional Standards - Are the draft financial statements prepared with proper regard for the technical and professional standards expected of a member of HKICPA? 4. Specify the alternatives
The major alternatives appear to be: 5. Leave the draft financial statements as they are. In other words, rely on your superior's valuation of WIP Discuss the issue further with your superior Bring the issue to the attention of senior management, and if necessary to the Board. Compare values and alternatives
Preparing the draft financial statements by including a WIP figure that you suspect is incorrect, will be compromising the ethical standards of the profession. As discussed above, the relevant ethical standards are integrity, objectivity, and technical and professional standards. If you discuss the issues with your superior you can inform him of the consequences of the overvaluation of the WIP. Other things being equal, this overvaluation will translate into an inflated profit figure. This in turn will mean that the firm's actual financial results will fall short of the business plan targets. If your supervisor's response is not appropriate you will need to explain to him that the matter will have to be discussed with the next level of management above him. This will put you in a delicate position with your supervisor If no satisfactory resolution is obtained, at this point it will be necessary to bring the whole matter to the attention of senior management and, if necessary, the Board. 6. Assess the consequences
Before you go ahead you should check the relevant facts by corroborating with other available documentation. This might include detailed product costing records, cost of goods sold calculations, product margins, and previous inventory counts of WIP. By agreeing to a WIP figure which you know to be incorrect, you will undermine the organisation's policies and procedures, tacitly approve misleading financial statements, lose credibility as a professional employee, and violate the HKICPA ethical guidelines. By discussing the issue with superior, you may be compromising your future with the company. However, if you have the intestinal fortitude to carry through to the level of senior management and the Board, your position may be tenable. 7. Make your decision
The material above suggests that you should initially discuss the issue with your superior, and it is possible that he may approve an appropriate WIP figure at that point. If he does not then you should take the issue to a meeting with the next level of management above your superior, and if necessary to the Board of Directors as well. During this resolution process it may be helpful to document your involvement, the substance of the discussions held, who else was involved, what decisions were made and why.
(printed May 2010)
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Practice Question 2 Scenario
[20 Marks]
James Lee, Chair of the Board of Tiger Travel Limited, announced today that the company has plans to enter into the Mainland China airline market. James stated: Last year we obtained approval to enter the Hong Kong to China airline market. We have made arrangements for the lease of two Airbus 320 aircraft on a trial basis to fly the Hong Kong to Shanghai route. We are planning to equip the aircraft as a one-class configuration, but have comfortable seating and a free meal of good quality. We intend initially to base the aircraft in Hong Kong and schedule one return flight each day for each aircraft. The first aircraft will depart Hong Kong early morning and return by mid afternoon, and the second will depart Hong Kong in early afternoon and return late evening. Tiger Travel believes that there is a niche market for such a service, and that it will be a natural fit with the other operations and strengths within the company. These include: Market leader position in wholesale distribution of international airfares and ticketing services in Hong Kong and the Mainland. Market leader position in the representation of international airlines. An internationally recognised airfares database and electronic distribution system. Strong brands and relationships in the tourist industry in South East Asia. Experienced and committed management team.
James added: We are aware that there may be some risks with this strategy, including the escalating costs of fuel and the level of competition on the route. However, the continuing rapid economic development in the Shanghai area means that there are profitable opportunities on the Shanghai route. You are employed by Asia Pacific Equity Limited, a private equity funding firm. Your firm is performing an analysis of Tiger Travel. You have been assigned the task of assessing the strategic viability of the companys recently-announced move into the Hong Kong to China airline market. Your supervisor has suggested that you use SWOT Analysis when carrying out your assessment. You have gathered some information which may assist your SWOT Analysis. Among this information is the following: The company has a number of senior management staff who are important to the ongoing success of the business. The Chinese airline industry has experienced significant growth over the last few years. This has manifested itself in high profits for Chinese airlines. Alliances with other airlines may be possible.
Required a) b) Outline briefly the nature of SWOT analysis. Prepare a SWOT analysis for a report on the strategic viability of the Tiger Travel venture into the Hong Kong to China airline market.
(printed May 2010)
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Suggested Solution Practice Question 2 Timing (minutes) Total time spent on question: a) The nature of SWOT analysis Part a) b) 12 18 30 minutes [20 Marks]
SWOT analysis involves an assessment of an organisations internal strengths and weaknesses, and external opportunities and threats. It is a very basic but very useful way to get an idea of where the organization stands at a particular point in time. SWOT analysis is simply a list of key issues facing the organisation. The strengths/weaknesses relate to the internal aspects of the organization, and the opportunities/threats to the external aspects. Because of its simplicity, this tool helps prioritise issues. The analysis that it generates can be repeated over time and to a greater depth to give more insight. Some commentators warn against being too ignorant of the weaknesses of SWOT; in particular they highlight the following potential weaknesses: Strengths may not lead to an advantage Having a strength does not necessarily translate into gaining a competitive advantage, i.e. the strength must be appropriate for the market that you are competing in. SWOTs focus on the external environment is too narrow SWOT tends to focus on todays environment and the competitors you face today and does not necessarily encourage you to look for new threats on the horizon. SWOT gives a one-shot view of a moving target SWOT is a static assessment of a moment in time, the criticism is that while you can see results in a snapshot you need to look at time series data to see trends. SWOT overemphasises a single dimension of strategy SWOT can encourage you to focus too much attention on single strength or key feature that may blind you to new opportunities as they emerge.
(printed May 2010)
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b)
Apply SWOT Analysis to airline venture
Internal Strengths 1. Leading market positions 2. Market leader in the wholesale distribution of international airfares and ticketing services in Hong Kong and Mainland China. Market leader in Hong Kong and Mainland China in the representation of international airlines.
World class technology The companys airfares database and electronic distribution system is used by travel agents world-wide to access fares.
3.
Experienced and committed management team Senior management appear to be experts within the travel industry.
4.
Strong platform for growth The product range, industry position, technology, management and expertise to capitalise on growth opportunities, provide a strong platform. The range of services offered to customers can be increased within the existing infrastructure. Acquisition opportunities will continue to arise through anticipated industry rationalisation.
Internal Weaknesses Although the company appears to have a number of strengths the following potential internal weaknesses may be identified: 1. Reliance on key personnel. The company has a number of senior management staff who are important to the ongoing success of the business. Should a significant number of these people leave the firm, the company would be adversely affected. Availability of experienced senior management in the airline industry. The scenario is silent on this, but such management expertise will be necessary for the successful operation of the airline venture. Reliance on technology. Should the companys IT systems suffer a catastrophic breakdown, or should they not be upgraded when needed, the companys performance will be weakened substantially. Credit risk. Tiger will be exposed to credit risk in relation to some of its customers, particularly those in some overseas countries. This potential weakness needs to be managed carefully. Industry disputes. Although the company does not appear to have a problem in this area, it could happen. It is not clear whether the company has contingency plans in place to deal with this eventuality.
2.
3.
4.
5.
(printed May 2010)
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External Opportunities Among the opportunities that may be identified are the following. 1. Expand into other routes to and within China, including Beijing. The Chinese airline industry is experiencing unprecedented growth. Chinese airlines' bottom lines are benefiting directly from the explosive growth in passenger traffic; the CAAC reported that China's airlines earned a record US$11.46 billion in revenue during the first half of 2007, and this upward trend has continued, especially in the recent past. Seek an alliance with Cathay Pacific or another international airline. This would enable cost sharing and (maybe) code-sharing, which is likely to improve passenger traffic and reduce costs. Leverage off customers on the airline to sell them other services including hotels, rental cars, restaurant meals, and tourism packages in the Shanghai area,
2.
3.
External Threats These would include: 1. External shocks affecting the travel business. There have been a number of external shocks in recent years, including SARS, the Iraqi war, and bombings in some Asian locations. Unfortunately such incidents are likely in the future and have the potential to affect the airline travel industry. Economic conditions. Since a substantial portion of airline travel for both business and leisure is discretionary, the air travel industry tends to experience greater fluctuations in financial performance during general economic downturns than otherwise. Any such general reduction in airline passenger traffic could have a material adverse effect on the companys business. Competition. The Hong Kong to China airline market is competitive. The companys financial performance or operating margins could be adversely affected if the actions of competitors or potential competitors become more effective. Loss of major preferred supplier arrangements or significant changes to supplier terms. The nature of Tigers business is that it is highly dependent on continuing positive relationships with the companys key suppliers. If these were to break down there would be a substantial negative impact on the company. Adverse changes in regulation. There is always a chance that the companys business, both in Hong Kong and overseas, may be adversely affected by changes in industry regulation. This has just happened in the China airline market, and may not be the last regulation promulgated by CAAC.
2.
3.
4.
5.
(printed May 2010)
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Part E
How do I know I have succeeded in this topic? Can I: Should I do more research
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After working through this Section
Identify the steps involved in the formulation of strategies and understand the relationship with budgets. Complete an internal and external analysis of a business, including SWOT and industry analysis. Describe the main planning model types and implications for strategy design. Describe recent analysis theories and associated impact on prices, costs and investment. List the nature and uses of different types of business plans. Demonstrate how to translate the organisations objectives and strategies into business plans. Outline available options associated with business planning. Estimate and forecast both operational and developmental revenues and costs associated with business plans. List the tests available for evaluating strategies. Appreciate the importance of ethics in strategy formation, operations and evaluation.
(printed May 2010)
After talking to my Workshop Facilitator
After my examination preparation
After my Workshop

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Strategy Formation Processes, Including Data Gathering Structures, SWOT Analysis and Ethics

Part A Suggested References

Hong Kong Institute of CPAs Financial Management Module

(printed May 2010)

Hong Kong Institute of CPAs Financial Management Module

(printed May 2010)

Hong Kong Institute of CPAs Financial Management Module

(printed May 2010)

SELECT LONG -TERM OBJECTIVES

DEVELOP APPROPRIATE STRATEGIES

Planning models for competitive strategies e.g. Ansoff, Porter

PREPARE THE BUDGET

ANALYSE REASONS FOR DEPARTURE FROM PLAN

Hong Kong Institute of CPAs Financial Management Module

(printed May 2010)

The Nature of Strategic Planning and Its Stages

Hong Kong Institute of CPAs Financial Management Module

(printed May 2010)

The Strategic Planning Period

Hong Kong Institute of CPAs Financial Management Module

(printed May 2010)

Development Time for Raw Materials and Components

Hong Kong Institute of CPAs Financial Management Module

(printed May 2010)

The Strategic Planning and Control Cycle: Seven Steps

Identify critical success factors

Hong Kong Institute of CPAs Financial Management Module

(printed May 2010)

Hong Kong Institute of CPAs Financial Management Module

(printed May 2010)

Porters Five-forces Industry Analysis

Profitability of the industry

Collective strength of the five forces

Hong Kong Institute of CPAs Financial Management Module

(printed May 2010)

Hong Kong Institute of CPAs Financial Management Module

(printed May 2010)

Types of Planning Models

Hong Kong Institute of CPAs Financial Management Module

(printed May 2010)

Selecting Long Term Objectives

Hong Kong Institute of CPAs Financial Management Module

(printed May 2010)

controller, marketing/growth, entrepreneurial or cost minimisation

very high, high, medium or low

high, medium, low or very low

Cash flow position:

positive, neutral, negative or neutral

Critical success factor:

Hong Kong Institute of CPAs Financial Management Module

(printed May 2010)

Cash Cow a) Management style

d) Cash flow position

e) Critical success factor f) Control measure

Hong Kong Institute of CPAs Financial Management Module

(printed May 2010)

Suggested Solution Example 1: BCG Growth/Share Matrix

The General Electric Company/McKinsey and Company Matrix (GEM)

Hong Kong Institute of CPAs Financial Management Module

(printed May 2010)

Recommended Business Strategies

Hong Kong Institute of CPAs Financial Management Module