Investment Decisions With Firm Strategy: Management Accounting - Literature review Example

The roles of management accounting in appraising and managing major investment decisions, and in linking those decisions to a firm’s strategy and itscompetitive positioning (Style: Harvard) Writer ID #: 19714 Order Issue. 338468 23 November 2009 Table of Contents: Importance of Strategy in Organization Success Michael Porter’s five forces of competitiveness presented that the firms that exist in the ecosystem of rivalry are exposed to major external forces in the form of – bargaining power of suppliers, bargaining power of buyers, threat of new entrants and threat of substitute products and services (Ankli. 1992). Figure 1: The Michael Porter’s model of five forces that shape competition in the market place (Source: Redrawn from the model shown in Ankli. 1992) If we map these external factors in a SWOT model, we will achieve the following outcome: Strengths: Product quality and competitive strengths of a firm which differentiates the firm from the competitors in the markets. Weaknesses: Lack of intrinsic capabilities to continuously enhance the quality of the products at reduced production costs. Opportunities: To analyze deeply on what internal competencies of the organization has contributed to the existing competitive advantages of the firm in the marketplace such that the organization can invest more to enhance these competencies and reduce wastes (like those processes that do not contribute to the core business of the organization). Strengths: Increased bargaining power of suppliers, increased bargaining power of buyers, growing threat of new entrants and growing threat of substitute products and services As explained by Buam and Wally (2003), the firm performance in the modern world is closely linked with strategy decision making speed because the dynamics in the market as presented in Michael Porter’s five forces model have become faster than ever before. The speed and timing of decisions have become as important as the accuracy of the decisions. Increased competition in the markets and reduction of prices to stay in competition is witnessed in almost every industry sector across the world. The days of monopolies and premium pricing are now memories of the past. Ad hoc reduction of prices impacts the profitability and hence reduction of wastes and improvement of organizational efficiency has become mandatory in modern economy. As described by Dixon and Smith (1993), organizations that lose their competitive advantages gradually lack deep visibility into their intrinsic competencies that majorly contribute to the competitive advantages in the market place because the information within the departments are not shared across the organization and analyzed thoroughly using critical thinking techniques. The framework of numbers that the management uses for budgeting and investment decision making are based on accounting reports and hence do not provide detailed information behind the accounting heads such that the investments can be aligned towards the right direction. The vision of the management of every organization is to invest in areas that can result in maximum benefits to the organization in terms of enhanced competitive advantages at the markets and also to reduce costs by cutting down investments on those areas that are not contributing effectively to the enhancement of organizational competitive advantages. This vision can only be fulfilled using management accounting because the management may end up doing the reverse (invest in wastes and reduce investments in most critical areas) by trusting the general accounting numbers and hence cause more damage to the organization than achieving benefits. In the next section, I describe how management accounting helps in identification of the most critical processes and related activities of the organization such that their cost allocations can be prioritized in the budgeting process. Support from Management Accounting in critical ingredients of costing It is not easy to identify wastes in an organizational system unless the information from all departments are integrated and the flow of the organization system right from the first stage till the last stage when the products are delivered to the customers are analyzed thoroughly. Rom and Rohde (2007) explained how management accounting practices can help in analyzing the organizational processes by using integrated information systems such that the management accountants can have integrated view of the processes and their activities in the entire organization. As explained by Babad and Balachandran (1993), such integrated views of the organizational processes and related activities gives indication of the way money is spent in the organization by virtue of cost drivers. They explained how activity based costing can provide deep visibility into the cost drivers of the organization thus bringing to surface the secrets of cash burn-outs which are practically impossible to detect in the accounting statements. The accounting statements present consolidated picture of expenses under various heads but the drill down into those heads to detect every activity based cost can be obtained by using this method. Such a method can provide deep information on the wastes that the organization might be incurring in the form of costing of those activities that do not contribute to the business effectively. Such activities can be detected by close analysis of mapping of organizational key performance indicators with the overall organizational goals. The technique widely popular in management accounting to map key performance indicators and the organizational goals in the balanced scorecard methodology developed by Kaplan and Norton in 1996: Figure 2: Balanced Scorecard linked with strategy (Source: Kaplan and Norton. 1996) The balanced scorecard determines key performance indicators of processes of an organization with respect to four major determinants contributing to the vision and strategy of the organization – Financials, Customers, Internal Business Processes and Learning and Growth. The key performance indicators determine which process contributes to the overall organizational strategies and objectives to what extent. The information collated through the balanced score-carding combined with the activity based costing that provides the cost of every process in the organization leads to the bigger picture that provides in-depth information to the management pertaining to the following in the organization: (a) Which processes contribute the most to the organizational business? (b) Which processes contribute moderately to the organizational business? (c) Which processes contribute the least to the organizational business? (d) Which processes are complete waste and do not contribute to the organizational business? In fact, after going through this process, many organization may come to know that they may be investing significantly in the least significant processes or the wastes and contributing least (or may be cutting down expenses) in the most significant processes. Such blunders happen due to lack of bigger picture and lack of integrated information captured from all departments which is practically impossible to determine from the general accounting statements. Investment decisions with the help of Management Accounting The capital investment decisions in an organization are taken to invest in enhancements and projects that can enhance the competitive advantages of an organization to increase the market shares in existing markets or capture new markets. The traditional method of capital budgeting is the Net Present Value calculation technique whereby the projects with negative NPV projection after the execution period are normally rejected by the board. The NPV calculations explained in the course notes gives me an indication, after studying the Porter’s strategy model and balanced scorecard method of translating strategy into action by Kaplan and Norton, that the returns evaluation that drive the NPV calculations are very superficial and do not take into account the indirect benefits that the organization achieves by virtue of the investments. The returns are calculated based on gross estimates of growth and the associated risks with (probably) little answer on what the organization should do if at a later stage of the project the returns are not as expected. If a market offers an opportunity, the organization calculates the growth by virtue of what the organization shall extract from the market which may just be based on the assumptions of current performance in the existing markets. Management accounting adds new dimensions to the capital investment decisions. It provides in depth information to the organization on the opportunities of improving competencies to extract “more” from the emerging markets and also reduce the costs to achieve better profitability thus making the NPV calculations positive which may be appearing negative at the face value. For example, Ittner and Lanen et al. (2002) explained how activity based costing can help a manufacturing assembly chain to reduce costs by eliminating wastes in the entire process (like high set up costs, unnecessary inventory getting piled up, duplication of work, etc.). The capital budgeting decision making that can identify such wastes at the time of budgeting can focus on enhancing the key processes and reducing costs on the wastes. This can change the framework of costing that has been carried out to evaluate the projected returns from a new project and also can include projections of further cost reductions as the investment in critical processes improve the internal operating efficiency of the organization. Maybe, the overhead costs and variable costs calculated by the low cost airline in the route expansion decision can be reduced gradually as the investments on wastes are reduced and the investments on key contributors (processes) are enhancement. If such cost reduction projection is included in the NPV calculations, even the low growth category may become justified for the investments. In addition, the organization can also take into account the intangible impact on other businesses due to the internal enhancements although may not be easy to convert in money. I can visualize improvement of brand equity in the markets as one of the factors that may attract more customers in the existing market place, reduce wastes by better utilization of shared resources, increase in stock prices thus improving capital earnings, etc. as some of the intangible impacts of the new projects that may be calculated only by the management accounting strategic techniques like balanced score cards. Conclusion: Linking investment decisions with Firm’s Strategy and Competitive positioning with the help of Management Accounting In the concluding section I would try to correlate the investment decisions with firm strategy and competitive positioning with the help of management accounting. When a board is formed to take investment decisions for business expansions, the first aspect they would need is the cost to run the business. The costing would come from the existing accounting statements pertaining to the running businesses. They will get gross information about the fixed and variable costs which would be included in the NPV calculations. However, these costs may not include the details of those existing activities that can contribute very well to the new business by utilizing their extra capacity not used in the existing business. For example, the back-office operations may have enough room to support the new business with minor investments for up-gradations. This means that investing in an entire new back office operation may be a complete waste that may add to the already existing waste due to unutilized capacity in the back office. I have just taken an example to justify what can be classified as waste. Such wastes cannot be detected unless the management accounting tools like activity based costing are used. The management can have a bigger picture of unutilized capacities prevailing in the existing system and try to utilize them in the new business. If I think with the respect to the case study of the low cost airline there probably may be a way to divert an entire aircraft to the new business by making slight changes in the schedules to reduce flights in non-peak hours. These are analytics that require seamless integration among strategic objectives, actionable outcomes of the strategic objectives, competitive positioning in the market, internal in-depth data analysis and investment decisions. If information captured from the management accounting systems can be fed to the investment models, innovative ways of achieving better NPV can be developed thus strategically aligning the new projects to not only utilize the resources from existing businesses but also contribute back to them for their enhancements. These analytics also reduce the probability of failure due to risks of investments in the wrong direction. References Ankli, Robert E. (1992). Michael Porter’s Competitive Advantage and Business History. Business and Economic History (2nd Series). 21: 228-232. Babad, Yair M. and Balachandran, Bala V. (1993). Cost Driver Optimization in Activity-Based Costing. The Accounting Review, 68 (3): p.563-571. Buam, J. Robert and Wally, Stefan. (2003). Strategic Decision Speed and Firm Performance. Strategic Management Journal, 24 (11): p.1107-1115. Dixon, R and Smith, DR. (1993). Strategic Management Accounting. International Journal of Management Science. 21(6): 605-618. Ittner, Christopher D. and Lanen, William N. et al. (2002). The Association between Activity-Based Costing and Manufacturing Performance. Journal of Accounting Research, 40 (3): p.711-719. Kaplan, Robert S. and Norton, David P. (1996). Linking the Balanced Scorecard to Strategy. California Management Review. 39(1): 53-60. Rom, Anders and Rohde, Carsten. (2007). Management accounting and integrated information systems: A literature review. International Journal of Accounting Information Systems. 8: 40-52. 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